Staff Report for the 2005 Article IV Consultation: Prepared by the Staff Representatives for the 2005 Consultation with Mexico

This 2005 Article IV Consultation highlights that the economic recovery in Mexico that began in mid-2003 has continued in 2005, though at a slower pace. A broad-based expansion of economic activity in 2004, driven by a rebound of private consumption and private investment, took growth up to 4.4 percent. The fiscal accounts improved in 2004 on the strength of rising oil revenues and restraint of current expenditures, and the authorities achieved their target for the traditional deficit of 0.3 percent of GDP.


This 2005 Article IV Consultation highlights that the economic recovery in Mexico that began in mid-2003 has continued in 2005, though at a slower pace. A broad-based expansion of economic activity in 2004, driven by a rebound of private consumption and private investment, took growth up to 4.4 percent. The fiscal accounts improved in 2004 on the strength of rising oil revenues and restraint of current expenditures, and the authorities achieved their target for the traditional deficit of 0.3 percent of GDP.

I. Context and Key Issues

1. A shift in policies and economic structure over the last decade has fortified Mexico’s economic fundamentals and produced a stronger and more stable economy. Fiscal consolidation has reduced the ratio of gross public debt to GDP below 50 percent, and the structure of the public sector balance sheet has been strengthened. Monetary policy has brought inflation down to the low single-digits and gained increasing credibility, in the context of an inflation targeting regime and floating exchange rate. A series of reforms has strengthened the financial sector and boosted its development, while NAFTA contributed to opening the economy further and integrating it in the world economy—with fast-growing manufacturing links to the U.S. At the same time, the multi-party democracy has developed. These improvements are reflected in Mexico’s investment-grade rating, uninterrupted access to foreign capital at low cost, and resilience to shocks, such as the 2001-02 recession of the world economy.

2. Still, as the authorities well recognize, challenges remain to entrench macroeconomic credibility fully, and achieve rapid sustainable growth. Fiscal policy has earned broad credibility as annual targets have been met. But it has yet to be set in a medium-term framework that would promote effective management of oil wealth over time and further strengthen the public sector balance sheet. Inflation has come down, but remains above the central bank’s 3 percent target. Most fundamentally, structural reforms are needed to achieve a transition to high growth. Although there is now broad acknowledgement of the need for reforms—in the energy and telecommunications sectors, the labor market, judicial system, tax system, and regulatory and business environment—political stalemate has frustrated the achievement of many elements of the reform agenda established by the administration of President Fox. Constitutional disputes between the executive and congress this year suggest that the practice of multi-party democracy continues to evolve, even as the country prepares for the July 2006 elections that will turn over the presidency as well as all seats in congress.

3. Recent Article IV consultations with Mexico have emphasized consolidation of the public finances and management of oil income, continued inflation reduction and enhancements of the monetary policy framework, and the need for structural reforms. By and large, staff has agreed with the authorities on their objectives of continued progress in these areas, and so the discussions have usually centered on the specifics, and the appropriate pace, of moving ahead. On fiscal policy, saving of rising government oil income has generally been less than suggested by the Fund (although in 2004 savings turned out to be greater than projected at the time of the consultation). The authorities have emphasized that political consensus in favor of saving oil income has been weak, especially as projected oil prices have continued to rise. They have pointed in particular to Mexico’s large investment needs, including in the oil sector, with a potentially high return. On monetary policy, disinflation has proceeded, and continuing development of the inflation targeting framework has addressed issues of transparency and communication, although a detailed inflation forecast is not published. On the structural policy front, the Fund has supported the wide agenda defined by the Fox administration, much of which required congressional approval, while regretting that implementation of this agenda has fallen short of the authorities’ goals.

4. In this context, the 2005 consultation discussions focused on:

  • Fiscal policy: the need for a medium-term framework to promote fiscal consolidation and improve management of oil wealth.

  • Monetary policy: evaluation of the policy stance following a period of rapid tightening, and the operational development of the inflation targeting framework.

  • Financial markets: the implications of the significant reforms and development of credit and bond markets in recent years and the remaining financial reform agenda.

  • Competitiveness and reforms: the challenges to raise productivity, competitiveness and growth.

  • Safeguarding confidence and stability in the run-up to the 2006 election and over the medium-term.

II. Recent Developments

5. The economic recovery that began in mid-2003 continued into 2005, but at a substantially slower pace (Figure 1). A broad-based expansion of economic activity in 2004, driven by a rebound of private consumption and private investment, took growth up to 4.4 percent. Growth slowed to 2.8 percent in the first semester of 2005,1 mainly reflecting sector-specific developments, including a soft patch in U.S. industrial production, re-tooling in the automobile sector, and lower agricultural yields. At the same time, domestic demand began to moderate, and an increasing share of demand fell on imports rather than domestic production.

Figure 1.
Figure 1.

Mexico: Real Sector Developments, 2000–2005

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

Sources: Mexican authorities; U.S. Federal Reserve; and Fund staff estimates.

6. The economic recovery was accompanied by a boost to confidence, capacity utilization, and formal employment. By early 2005, business confidence recovered to its pre-recession level, as did capacity utilization in manufacturing, although both have slipped in recent months. Formal employment grew by 4.6 percent from end-2003 to July 2005. Still, the labor market remains dominated by informal employment (see Selected Issues paper). Out of the economically active population of more than 43 million, only 12.8 million persons were employed formally in the private sector as of mid-2005.

7. Bank credit to the private sector has grown at a fast pace, starting in mid-2003. Consumer and housing bank credit showed the fastest rates of growth, but from a very low base. Nonbank financial intermediaries continue to play an important role in these new markets (Box 1), although bank lending in these sectors is catching up. The availability of new credit has helped the recovery of investment, especially in the housing sector. Private investment expenditure was up more than 8 percent in 2004 and by 6 percent in the first half of 2005.

Bank Credit Growth

Following years of contraction, commercial bank lending to the private sector has resumed growing—and at a fast pace. Credit growth has been relatively rapid in consumer and housing lending, markets first taken up by nonbank intermediaries following the 1994–95 financial crisis (Figure 1).

Figure 1.
Figure 1.

Real bank credit growth

(excluding non-performing loans)

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

The underlying factors are multiple: the recovery of activity and confidence; continuing disinflation; greater competition in the financial sector; and banking reforms which strengthened balance sheets while improving tools to assess the creditworthiness of potential borrowers and enforce collateral (see Selected Issues paper for a description of the reforms and a study of their effects). In the housing sector, government guarantees and direct lending programs leading to the introduction of conforming mortgages have also played a key role.

Although bank credit still lags that of other countries (Figure 2), its fast growth—provided it continues to be based on adequate risk management frameworks—will continue to enhance banks’ financial intermediation and growth-promoting role. So far, despite the rapid growth of new lending, the stock of total bank financing as a share of GDP has increased only moderately because banks have also been writing off non-performing loans, many from the 1994–95 crisis, at a fast pace.

Figure 2.
Figure 2.

Commercial Bank Loans, March 2005

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

1/ Ratio for 1999–2002.

Importantly, other domestic sources of financing, such as corporate debt, are also expanding. Nonbank financial intermediaries (Sofoles), whose lending is now close to a third of commercial banks’ financing, have shown particularly fast growth (Table 1). These institutions do not take deposits and are licensed to grant credit to specific segments of the economy. The bulk of their financing comes from the government, but they have started to tap the private market. Mortgage Sofoles are the most important type.

Table 1.

Sources of Financing to the Non-Financial private sector

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INFONAVIT is a public fund financing housing developers and mortgages with a fixed portion of social security contributions.

8. After rising through 2004, inflation has moderated in 2005, although it remains somewhat above the 3 percent target—as does expected inflation (Figure 2). The 12-month headline inflation rate peaked at 5.4 percent in November 2004, but declined thereafter with the unwinding of last year’s supply shocks as well as a moderation of core inflation. Headline inflation moved below 4 percent in August 2005. Overall core inflation—which had been little affected by supply shocks—has also come down, to 3.3 percent, while wage increases have been steady at around 4½ percent. Nevertheless, inflation expectations for end-2006, and for the next several years, remain somewhat above the official inflation target—averaging about 3.7 percent as of September.2

Figure 2.
Figure 2.

Mexico: Inflation and Monetary Policy, 2000–2005

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

Sources: Mexican authorities; and Fund staff estimates.

9. The Bank of Mexico (BoM) signaled an end to its monetary tightening cycle in June 2005, and initiated an easing in August. The tightening of monetary conditions in this cycle was substantial—with the overnight interbank interest rate rising from about 5 percent in early 2004 to near 10 percent by spring 2005. From early 2004, the BoM has taken a number of steps to enhance its communication with markets, including through beginning to signal a desired minimum level of interest rates. While retaining its traditional corto instrument, the BoM started using changes in the corto to signal changes in the overnight interbank rate, and directed the market’s attention to the shorter, more focused press releases following its regular monetary policy meetings. From May 2004, the BoM used these statements also to link movements in the overnight interest rate to hikes in the U.S. Fed Funds rate. In June 2005, the BoM dropped this link to U.S. policy and emphasized instead the need to maintain the present monetary stance, signaling the end of the tightening cycle. Two months later, the BoM announced that monetary conditions could ease by up to 25 bp (but without changing the corto). In September, a further 25 basis point cut was signaled, bringing the interbank rate down to 9¼ percent (still with no change in the corto).


Short-term interest rates, corto increases, and U.S. Federal Funds Rate.

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

10. The fiscal accounts improved in 2004 on the strength of rising oil revenues and restraint of current expenditures (Figure 3). The authorities achieved their target for the traditional deficit, 0.3 percent of GDP, and the broadly-defined deficit (the augmented deficit) narrowed to 2 percent of GDP, from 3.1 percent in 2003. After rising in 2003, current expenditure returned to its 2002 level as a share of GDP. Rising oil revenue helped finance an increase in capital expenditure, particularly in the oil sector. However, the 2004 outcome on the augmented deficit also reflected in part a “temporary saving” from oil revenues, in that 0.4 percent of GDP of funds earmarked for additional PEMEX investment were not yet spent in 2004. Gross public debt declined to 46.5 percent of GDP, in part through the write-off of some of the bank restructuring debt.

Figure 3.
Figure 3.

Mexico: Fiscal Sector

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

Sources: Mexican authorities; and Fund staff estimates.

11. In 2005, oil revenues are rising again, but the impact on the broader deficit is being more than offset by a deterioration in the non-oil fiscal balance. The spot price of Mexican oil averaged US$ 41.6/bl through September, almost 15 dollars above the price assumed in the budget. Oil income for the year is now projected by staff to be up by about ½ percentage point of GDP from 2004 (and about 1 percentage point over budget projections). So far, it appears that under the annual budgetary rules, this excess revenue will go to compensate for shortfalls in non-oil revenue, and toward transfers for additional investment spending by PEMEX and the states, as implied by the budget law (this year, less than 0.1 percent of GDP will be available to be sent to the oil stabilization fund). In contrast to 2004, the composition of spending appears to have tilted back toward current expenditures, and staff project that the non-oil augmented deficit will widen this year, by 0.8 percent of GDP.

Public Sector Debt, 2004

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Source: Mexican authorities.

12. As in previous years, the increase in the government’s oil revenue was moderated by energy pricing policies that shielded consumers from rising world prices. Most significantly, gasoline prices “at the pump” have increased only in line with the domestic inflation rate, as a once substantial excise tax on gasoline has been steadily reduced. Revenue on this tax has fallen from a peak of 1.8 percent of GDP in 2002 to 0.7 percent of GDP in 2004, and to a projected 0.2 percent of GDP this year.

13. The external current account balance has been broadly stable recently, with a continued rise in oil exports and household remittances compensating for some widening of the non-oil trade deficit (Figure 4). With the recovery of economic activity in 2004, imports of investment and especially consumer goods grew strongly. Weak auto exports to the U.S., and enhanced competition from China, slowed non-oil exports. On the other hand, oil exports and household remittances3 continued to grow.

Figure 4.
Figure 4.

Mexico: External Sector, 2000–2005

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

Sources: Mexican authorities; Haver Analytics; and Fund staff estimates.1/ FDI excludes the US$12.5 billion Citibank acquisition of Banamex in 2001Q3 and the US$4 billion BBVA acquisition of Bancomer in 2004Q1.

14. Mexican financial markets have recently performed strongly, as have other emerging markets (Figure 5). Sovereign bond spreads have continued to decline. As elsewhere in Latin America, both the stock and currency markets have tended to strengthen. At end-September, the stock market was up more than 70 percent (in domestic currency terms) since end-2003, with much of that gain coming since April of this year. From late April through early August, the peso gained some 7 percent against the dollar, amid indications that foreign investors were increasingly attracted by the significant interest rate differential with the U.S. and growing signs that the BoM’s effort to reduce inflation would succeed.4 The BoM has continued to abstain from market purchases of foreign exchange, but rising foreign exchange receipts from the state-owned oil company (PEMEX) have tended to push NIR upward.5 NIR reached US$ 61 billion by end 2004, about 4½ months of Mexico’s imports and 1.6 times its short-term external liabilities.

Figure 5.
Figure 5.

Mexico: Financial Market Developments

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

Sources: Bloomberg LP; Mexican authorities; and Fund staff estimates.

Mexico: Recent Private Capital Inflows (In billions of U.S. dollars)

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Source: Bank of Mexico

15. The authorities have taken further steps to reduce vulnerabilities associated with the public debt. The average maturity of the domestic debt of the federal government was extended to 3.1 years by June 2005, up from 2.6 years in early 2004 (and 1.5 years in 2000). Exposure to currency depreciation has declined further as the public sector’s annual foreign exchange earnings from oil now exceed US$ 30 billion, against interest payments on its foreign debt of US$ 9 billion. Furthermore, the authorities used the oil stabilization fund to hedge the government’s external oil revenue for 2005. Finally, at mid-year the authorities announced that the federal government had accumulated enough foreign currency liquidity to allow it to forego any external bond issues through 2007.6

III. Report on the Discussions

A. Outlook

16. It is clear that GDP growth for 2005 will be lower than last year’s strong pace. This moderation reflects a slowdown of growth already seen in the first half of 2005—though the consensus view is that much of this weakness reflected sector-specific shocks that may soon fade. Accordingly, staff project growth of about 3 percent in 2005, picking up to 3½ percent in 2006. With a fast-developing financial sector and a continued recovery of investment, domestic demand should support growth. At the same time, the link with the U.S. economy, especially U.S. industrial production, will continue to be key to Mexico’s growth performance. The staff’s projection is therefore contingent on the current consensus view that U.S. manufacturing will pick up from its recent downturn. The authorities broadly shared this view of the outlook, while considering growth in 2005 likely to be somewhat higher.


Real GDP and U.S. Industrial Production

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

17. Inflation is projected to converge gradually to the 3 percent target. Staff expect that inflation will end 2005 at somewhat below 4 percent, declining to about 3½ percent at end-2006 and 3 percent in 2007. The projection for 2006 and 2007, somewhat below those of private forecasters, assumes no new substantial supply shocks; it also assumes that the BoM will conduct policy with a focus on achieving the 3 percent target, and that private perceptions of the credibility of that objective will continue to strengthen, albeit gradually. The BoM has indicated that it expects inflation to end this year somewhat below 4 percent, and to decline further in 2006.7

18. The main uncertainties for the near-term outlook include developments in the U.S. economy, global liquidity conditions and the possibility of shifts in confidence. A moderate slowdown in the U.S. would have an immediate adverse effect on Mexico’s economy through its impact on exports, confidence, and FDI (a more challenging U.S. shock scenario is discussed in Section IV). Sectoral considerations will also be important, including the performance of new auto models manufactured in Mexico for the U.S. market. Confidence could also become more fragile if for example, as few consider likely, the political environment were to deteriorate such that doubts began to surface about the commitment to macroeconomic discipline.

19. Medium-term growth prospects have upside potential, depending on the prospects for political breakthrough on structural reforms. While the authorities continue to project somewhat higher medium-term growth than the staff (3.6 percent versus 3.1 percent), this relatively small difference reflects staff’s more conservative judgment of the growth effects of financial sector reforms and the ongoing recovery of investment, and is within the margin of error of such estimates. Staff and the authorities agree that a transition to a significantly higher growth path requires comprehensive structural reforms. As noted, reforms critical to unwind the most pressing supply-side constraints have been identified for some time in the energy sector, telecommunications, labor market, judicial system, governance and the regulatory system.

B. Fiscal Policy

20. The authorities emphasized their commitment to maintaining fiscal discipline, noting also the broad public consensus for such discipline. The traditional deficit target was met in 2004, as has been the case in recent years. Furthermore, the deficit has been declining during the past few years and the draft budget for 2006 aims at a small surplus on the traditional measure. The augmented deficit had also been reduced, and this was supporting a gradual decline in the public debt/GDP ratio.

21. Regarding 2005, the authorities expected again to meet their deficit target, with the windfall (unbudgeted) oil revenue used to offset non-oil revenue shortfalls and expenditure overruns from budgeted levels. Oil windfall revenues are projected to be close to 1 percent of GDP, of which about one third would be transferred, according to budget rules, for investment projects by PEMEX and the states. The remaining unbudgeted oil revenues would be used mainly to compensate for revenue shortfalls from budgeted levels, and additional expenditures partly to accommodate spending changes made by congress. Thus the non-oil augmented deficit would widen in 2005, more than offsetting the slight improvement of 2004. Still, the overall fiscal outcome was expected to be adequate to support a small decline in the public debt ratio.

Mexico: Fiscal Indicators, in percent of GDP

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Based on gross oil revenue, net of PEMEX operational expenditure and interest.

Gross oil revenue, including fuel excise tax.

22. The mission recognized that broad fiscal discipline had been maintained in recent years, but noted that the fiscal position has come to rely increasingly on high oil prices. Oil-related revenue is estimated to have increased by almost 2½ percentage points of GDP since 2002, reaching nearly 40 percent of revenue in 2005. Government receipts would have increased by a further 1½ percent of GDP if increases in world market prices had been fully transmitted to domestic consumers, rather than offset with reductions in gasoline excise taxes—see Box 2. The mission noted that budgetary expenditures had risen somewhat during this period, while part of the additional oil income essentially compensated for declining non-oil revenues (partly reflecting a phased income tax reduction approved in 2004). The overall result, comparing 2005 to 2002, was a reduction of the overall augmented deficit by about 1 percent of GDP, but a significant widening of the non-oil augmented deficit by about 1¼ percent of GDP.8 Thus, if oil prices were to decline compensating measures would need to be taken swiftly to avoid a weakening of the fiscal position. The authorities noted their efforts to direct new spending away from programs that would create spending inertia, although they recognized that additional spending was being undertaken by states, as a result both of rising transfers and borrowing on the strength of future transfers. They noted also that in 2004 unbudgeted oil revenues helped to support additional investment, particularly in PEMEX, where public investment could have a high financial return, and represented a form of saving.

The Mexican Energy Sector Amid Rising Fuel Prices

The energy sector is a smaller part of the Mexican economy than in many other oil-exporting countries. At the same time, the sector is critical to the fiscal accounts, because the sector is entirely state-owned, and because non-oil tax revenue is low, although the policy of smoothing of domestic gasoline prices somewhat dampens the fiscal gains (and losses) from changing world oil prices. The existing fiscal framework for managing oil income focuses on achieving annual fiscal deficit targets; it is not designed to save a large share of the income from a multi-year oil price boom.

The energy sector is a relatively small part of Mexico’s economy. After domestic energy needs are met, Mexico is able to export oil in an amount that represented about 4 percent of GDP in 2004. For comparison, this oil export/GDP ratio was around 15–20 percent for Ecuador, Norway, Russia, and Trinidad and Tobago, and 30–50 percent for Algeria, Nigeria, Saudi Arabia, and Venezuela.

Domestic use takes up a substantial part of Mexico’s energy production—and some fuels are imported. Of crude oil production, about 45 percent is consumed in Mexico and the rest exported. Mexican production covers about 90 percent of domestic consumption of refined oil products, and about 80 percent of domestic use of natural gas; imports provide the balance.

Mexican oil has a somewhat lower than average value. Mexican oil production is mainly heavy crude, and the price of the Mexican oil mix tends to be some US$5–10/barrel below the world average (APSP) petroleum price. The size of this discount has widened recently, implying that recent “oil windfall” gains have been somewhat less in Mexico than for other oil exporters.

Nevertheless, oil income is of great significance to the Mexican public finances, reflecting state ownership of the sector and the low level of non-oil tax revenue. The fully state-owned company PEMEX is the sole producer of crude oil, natural gas and refined products, and the sole marketer of refined products in Mexico, as required by the country’s constitution. With rising prices, PEMEX’s total sales reached US$69 billion in 2004, or about 10 percent of GDP. PEMEX accounts for a critical share of public sector revenue, which reached nearly 40 percent in 2005. This reflects also that non-oil tax revenue in Mexico is relatively small, about 10 percent of GDP.

Investment and oil reserves: For many years, PEMEX investment had been relatively low, below the level required to maintain a stable level of proven reserves. After 1996, however, oil investment has grown steadily, through expansion of PIDIREGAS investments. 1/ From an average annual US$7 billion in 2000-02, PEMEX investment in 2003-05 is expected to average US$11 billion (an increment of about 0.6 percent of annual GDP). Currently, proven oil reserves are the equivalent of about 11 years of annual oil production. PEMEX expects the reserve replacement ratio to reach 100 percent by 2010, if the recent investment rate is maintained.

PEMEX governance issues: PEMEX’s board is comprised of government officials and union representatives. Without a clear mandate to maximize the value of PEMEX, there is a potential lack of transparency and accountability of the management process, allowing the company to pursue a range of objectives. The fact that PEMEX’s budget is part of the federal budget assures that any quasi-fiscal activity by PEMEX will be reflected in the fiscal statistics, but this relationship may at times constrain the company’s ability to maximize its value. Moreover, the ban on private equity financing requires PEMEX to have relatively high debt, and it also prevents the Mexican government from diversifying its assets away from the high-volatility energy sector and thereby reducing the volatility of its income.

Macroeconomic impacts of rising oil prices

With no private ownership in the Mexican energy sector, when world oil prices rise, all incremental income accrues to the public sector.

From a macroeconomic viewpoint, an increase in world oil prices could be thought of as an increase in a tax on consumption of oil, but this effect is largely offset in Mexico, as consumers are shielded from rising world prices. The government’s oil windfall (based on all sales, domestic and foreign) exceeds the nation’s windfall (which arises only from exports). In practice, however, the government’s windfall is dampened because gasoline excise taxes are adjusted to smooth the price paid by domestic consumers. Domestic gasoline prices are administered, generally set to rise at a rate similar to that of inflation. For example, as world oil prices have risen, revenue from the gasoline excise fell from 1.8 percent of GDP in 2002 to a projected 0.2 percent of GDP in 2005. (Moreover, most consumers receive electricity at a subsidized price, with a fiscal cost of 0.8 percent of GDP recently.)

In terms of short-term economic growth, rising oil prices may be expected to have a slightly negative effect in Mexico. Again, the Mexican private sector receives no profit income from the energy sector. In practice, much of the potential drag on domestic demand from higher prices has either been avoided (by not passing price increases to consumers) or has been offset by a deterioration of the non-oil fiscal balance. The most relevant channel on growth is through higher oil prices’ potential negative impact on the U.S. economy, in turn affecting Mexican exports.

Fiscal framework for oil income fluctuations

The fiscal framework for oil income has taken a year-at-a-time approach. The framework is centered on distributing the within-year oil windfall (that is, excess oil income defined relative to the budget’s assumptions, rather than to a long-term oil price).

In practice, actual oil prices and revenue have exceeded budget assumptions in recent years. The advantage of having a conservative budget assumption lies in avoiding the need (in order to meet a deficit target) to cut budgeted expenditures if the oil price declines unexpectedly during the budget year. Such a budgeting approach may also help contain the growth of recurrent expenditure programs that would add inertia to government expenditure.

Each year’s budget law then specifies a formula for distributing any oil windfall. However, the windfall for this purpose is measured after first compensating for shortfalls in budget revenues and financing overruns in certain non-discretionary spending (including for example spending arrears from the previous year, higher interest payments, and higher energy costs).

This approach to oil price fluctuations has been consistent with the achievement of annual targets for the traditional budget deficit. At the same time, saving of the incremental oil income since 2002, as measured by the narrowing of the augmented fiscal deficit, has been limited, for several reasons. First, in the budget adjustors, “excess” oil income is defined relative to an annual budget assumption that has been raised over time. Second, as noted, this excess income is defined net of certain negative developments elsewhere in the budget. Finally, the budget adjustors formulas agreed each year specifically assure that an important fraction of the remaining windfall will be spent. In short, the framework is not designed to achieve financial savings of temporary income from a multi-year oil price boom, but rather to support compliance with annual deficit targets.

1/ PIDIREGAS investments are infrastructure projects first executed and financed by the private sector and later transferred, as well as the debt associated to them, to the public sector.

23. Setting fiscal policy in a context of oil income volatility and uncertainty over future oil prices is inherently complex. The authorities observed that the system of budget adjustors used in Mexico in recent years was focused on addressing fluctuations of oil prices affecting a single budget year. The approach helped assure achievement of annual fiscal deficit targets, but it was not geared toward managing income from a multi-year oil price boom.9 Moreover, without an established mechanism for identifying “temporary excess” oil income, disputes on its size and use had dragged on in congress. Indeed, the authorities noted the broader difficulty of finding consensus with the congress on fiscal policy—as illustrated by the fact that the 2005 budget had gone to the Supreme Court, and still remains under dispute.

24. The authorities agreed that Mexico would benefit from a new medium-term framework for setting the fiscal policy stance and managing oil income. They pointed to a reform proposal now in congress, which would take a more medium-term approach, based on an oil reference price. The proposed budget law would establish, as an ongoing target, that each annual budget be balanced when evaluated at an oil reference price. The authorities expected that a zero balance on the traditional measure would be consistent with an augmented fiscal deficit of about 1½ percent of GDP and a tendency for the public debt ratio to decline.10 In contrast to past practice, the oil price used in the budget would aim to capture a long-run, or underlying price, determined according to a pre-set formula (rather than by annual negotiations with congress), thus smoothing expenditures over the oil cycle. The proposal would also reduce the range of potential “leakages” whereby unbudgeted windfall oil income during the year is measured net of certain negative developments elsewhere in the budget, before being distributed to spending or saving.

25. The mission agreed that these changes would represent a step forward, while noting areas in which such a new framework could be enhanced. First, it would be desirable to anchor fiscal policy by linking the framework to a medium-term debt objective. While focusing operationally on the fiscal balance, the framework could explicitly establish an objective for gradually reducing the public debt ratio. The authorities saw the point, but were concerned that proposing agreement on a specific debt target level at this stage would complicate and likely delay congressional approval. They also noted their expectation that the proposed deficit target would be consistent with a gradual decline in the public debt ratio. Second, the staff observed that the new approach—while it should support a greater saving of oil income than in the past—would put rather low upper limits on such saving. The proposal would establish three saving funds, but once these reached certain levels (about 1½ percent of GDP, for the combined funds), all subsequent oil windfall money would go to expenditure. The mission suggested easing, or eliminating, these limits on saving, but the authorities felt that a consensus for a greater saving of oil income was not yet established.11 The saving funds would still provide an important cushion, and they emphasized that the proposed framework was symmetric: during times of low oil prices, dissaving would also be limited.

26. With regard to the 2006 budget, the mission supported the authorities’ intention to maintain consolidation efforts and increase saving of oil revenue. To reduce the public debt further, the mission recommended reducing the augmented deficit to no more than 1½ percent of GDP in 2006, and in any case to avoid a weakening of the non-oil balance. In September, the authorities submitted a draft budget that was in line with the medium-term fiscal scenario set out by the government in its 2002 economic program. The budget thus aimed at a small surplus on the traditional balance, and an augmented deficit of 1½ percent of GDP, based on general expenditure restraint and an oil price assumption of US$31.5 per barrel (about one-third below prices for the Mexican oil mix prevailing in September 2005). Should oil prices turn out higher than the budget’s assumption, the outcome for the underlying fiscal stance—as indicated by the non-oil augmented balance—would again depend on the budget’s procedures for allocating unbudgeted oil income. Based on the proposed budget mechanisms, as well as consideration of potential leakages and pressures likely to emerge again in budget negotiations, staff project that the non-oil deficit would stay essentially constant in 2006 (this projection is based on a cut in the expenditure ratio from 2005, although not as large as the decline in the budget proposal).

C. Monetary and Exchange Rate Policy

27. The authorities explained that the tightening of monetary conditions in 2004 and 2005 had been necessary to contain, and then reduce, inflation. Following a series of supply-side shocks that pushed up the headline inflation rate, the authorities had been concerned to see rising private inflation expectations in 2004 and moved quickly to avoid second-round effects and a potential de-anchoring of expectations. Beyond that goal, policy action had been required to take inflation down to the 3 percent target—the authorities emphasized that a settling of inflation in the upper part of the 2–4 percent “variability range” would not be acceptable.

28. The mission agreed that the tightened stance had prevented spillovers of temporary price shocks, and helped to further the convergence of inflation to its target. Wage increases had not accelerated, and inflation expectations had been revised downward. By mid-2005, both core inflation and inflation expectations had eased.

29. Against this backdrop, the mission agreed that it had been appropriate to end the monetary tightening cycle in mid-2005. The tightening had taken short-term real interest rates up to around 6 percent, and some of the effect of this tightening action on demand was likely still in the pipeline (subsequent to the mission, it became clearer that domestic demand was moderating). Barring unexpected new inflation pressures, the stance appeared to be sufficiently restrictive to support convergence to the inflation target—raising the issue of the timing and pace of phasing out the tight stance.

30. The authorities emphasized that the policy stance was continually reassessed for consistency with the inflation target, noting several complexities and risks of the current setting. Although the economy had grown rapidly in 2004, the authorities did not yet see generalized demand pressures on prices. With the recovery of credit, arising mainly from structural factors, the link from monetary policy to domestic demand was less certain, complicating assessment of the appropriate policy stance. The substantial interest rate differential with the U.S. also raised several considerations. Were this to lead to a significant short-term real appreciation of the peso (along with other underlying factors pushing up the real rate, such as rising oil exports and remittances), monetary conditions would effectively tighten further. The authorities also noted that the attractiveness of the Mexican capital market to foreigner investors, partly spurred by current global liquidity conditions, was difficult to predict.


Real monetary conditions index

Citation: IMF Staff Country Reports 2005, 427; 10.5089/9781451825640.002.A001

Source: IMF staff calculations.

31. The mission broadly shared this assessment, noting that the timing and pace of easing was linked also to the need to entrench recent credibility gains. Moving too soon or too rapidly could risk being misread as a sign that the BoM was satisfied with inflation near the top end of the variability range (as currently suggested by indicators of market inflation expectations). However, given the restrictiveness of the policy stance, and taking account of monetary policy lags, it would be natural to begin relaxing the stance ahead of actually achieving the 3 percent target. The importance of solidly anchoring market expectations on the official target, in order to realize the full benefits of the inflation targeting regime, would argue for a gradual and cautious approach to easing until inflation expectations finally coincide with the target.

32. The authorities explained the role that enhanced communication has played in the functioning of the inflation targeting framework, with a number of key operational changes since early 2004. Importantly, policy announcements during that period have been shortened to a single page, have emphasized that the central bank’s target is 3 percent (not the 2–4 percent variability range), and most fundamentally have guided more explicitly the evolution of short-term interest rates. It is clear to markets, the authorities noted, that monetary conditions and monetary policy are now increasingly conceived of in terms of the overnight interest rate. That said, the authorities were on the whole comfortable with the continued use of the corto as the official policy instrument, and did not see a clear case to shift now to an explicit interest rate target. In its August and September communiqués, the central bank signaled that interest rates could fall, but did not change the corto. Some analysts viewed this as a further shift toward using the interest rate as the policy tool, while others felt that the authorities wanted to send a more moderated signal to the market than might have been implied by a cut in the corto. Staff acknowledged that the current operational approach had proven workable so far, as the BoM had demonstrated effective control of the overnight interest rate; however, they also suggested that moving to a single instrument would provide more clarity to markets.12

33. The persistence of private inflation expectations above the official inflation target—at all horizons—raises the question of what more could be done to enhance the policy framework. The mission welcomed that the BoM has conveyed publicly its own projection of inflation over the near term (e.g., since January 2005, the BoM has stated its expectation that headline inflation would decline enough to end the year just inside the 2–4 percent variability range). The mission suggested that if the BoM were to go further—by publishing a forecast corresponding to a conventional monetary policy horizon, or by announcing a “convergence horizon” within which policy aims to achieve the 3 percent target—this could help manage private expectations, in turn making it easier to achieve the inflation target. The authorities saw the potential for such a benefit, but considered that it was still outweighed by the risks they had cited earlier of losing flexibility and credibility in a fast-changing economic environment, especially in the period before convergence with the target (“the final disinflation step”) has been achieved.

34. Finally, it was agreed that Mexico continues to be well-served by its floating exchange rate regime. The mission commended the authorities’ adherence to a floating exchange rate regime, accompanied by a rules-based reserve accumulation policy. The rule’s formula for selling back reserves, although essentially a rule of thumb, has the key advantage of being transparent and avoiding the suggestion of an exchange rate target. The staff believed that the level of reserves was reasonably healthy, but further accumulation was not problematic, and in fact could provide some support to confidence in an election year context. The authorities noted that the “carrying” cost of reserves had climbed, with the widening Mexico-U.S. interest differential, but viewed this as a temporary phenomenon that was already being reversed.

D. Financial Sector Issues and Policies

35. The mission noted continued improvement of a wide set of financial sector indicators (Table 5). In particular, the mission noted the strong offsite supervision of the risk management practices of commercial banks and the largest nonbank financial intermediaries (the mortgage Sofoles13), increased reliance on market discipline mechanisms, and the growing participation of institutional investors with large assets under management. In addition, commercial banks are adequately capitalized, profitable, and appear to have sound risk management systems. Nonperforming bank loans (NPLs) are relatively low at less than 2½ percent of total loans, down from 5 percent at end 2001. Banks have also built sizeable provisions against NPLs, with coverage ratios around 200 percent. Recent stress tests by the authorities show that commercial banks would withstand severe market and private credit risk shocks. While credit growth has been partly supported by guarantee schemes (targeted to SMEs) through which development banks take on credit risk, these schemes are still limited in size (around 0.2 percent of GDP at mid-2005).

Table 1.

Mexico: Selected Economic, Financial, and Social Indicators

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Sources: National Institute of Statistics and Geography; Bank of Mexico; Secretariat of Finance and Public Credit; and Fund staff estimates.

Total exports are defined net of imports by the maquila sector. Correspondingly, total imports do not include maquila sector imports.

Includes the IMF and public development banks and trust funds net of the collateral of Brady bonds.

In percent of short-term debt by residual maturity. Historical data include all prepayments.

Table 2.

Mexico: Financial Operations of the Public Sector, 2001–2006 (In percent of GDP)

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Sources: Mexican authorities; and Fund staff estimates. Data refer to non-financial public sector, including PEMEX and other public enterprises but excluding state and local governments (except as noted).

Based on version approved by Congress.

Total tax revenue excluding excise tax on gasoline.

Also includes transfers to IPAB and the debtor support programs (amounting to about 20 percent of total interest payments)

Treats transfers to IPAB as interest payments.

Excludes oil revenue (oil extraction rights, PEMEX net income, oil excess return levies, IEPS on gasoline) and PEMEX operational expenditure and interest payments.

Table 3.

Mexico: Summary Balance of Payments, 2002–2010

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Sources: Bank of Mexico; Secretariat of Finance and Public Credit; and Fund staff projections.

Total exports are defined net of imports by the maquila sector. Correspondingly, total imports do not include maquila sector imports.

Includes pre-payment of external debt.

Includes financing of PIDIREGAS.

Defined as the sum of the current account deficit, debt amortization (including short-term debt), and gross reserves accumulation.

Excludes balances under bilateral payments accounts.

In percent of short-term debt by residual maturity. Historical data include all prepayments.

The financing requirement excludes pre-payments of public sector debt and reserve accumulation.

Table 4.

Mexico: Summary Operations of the Financial System, 1999–2005 1/

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Sources: Bank of Mexico; National Banking and Securities Commission; and Fund staff estimates.

Financial system includes Central Bank, commercial and development banks, and nonbank financial institutions (e.g. Sofoles, pension funds). The presentation, different from that of the BoM, is based on International Financial Statistics methodology.

NIR figures are as published by Banco de Mexico, which are defined net of foreign currency denominated liabilities to Mexico’s government. NDA figures are different from those published by the BoM due to differences in the accounting of foreign assets other than international reserves.

Includes loans, securities, non-performing loans, and other credit.

Table 5.

Mexico: Financial Soundness Indicators, 2001–2005

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Source: National Banking and Securities Commission; and Fund staff estimates.

March 2005.

Covering all commercial banks.

NPLs are loans overdue by 60 days or more

Fund staff estimates.

TIIE = Interbank rate, CPP = Cost of funding

36. Although potential risks to the financial system appear limited in the short-term, continued vigilance and increased efficiency in the allocation of credit to the private sector remain essential. While Sofoles’ non-performing loans remain low (about 2.7 percent of total loans), they have shown an upward trend this year, suggesting the need for Sofoles and their supervisors to closely monitor the quality of their credit (taking into account that non-performing loans are often a lagging indicator). The mission also noted that commercial banks’ exposure to the public sector, although stable, remains high. In addition to making banks sensitive to potential changes in the value of government securities, these claims can crowd out the private sector, contributing to lower access to bank funding and potentially higher financing costs.

37. The authorities explained that the near-term reform agenda included corporate governance, the bank resolution framework, and the optimal supervision of Sofoles. A proposed new securities market law, which has been submitted to congress but has run into intense counter-lobbying, aims at raising corporate governance standards and encouraging smaller firms to use equity finance by strengthening minority shareholder rights. The government is in the final stage of preparing new bank resolution legislation. Although there are already a series of procedures for prompt corrective actions in place, the passage of a new bankruptcy law would eliminate some loopholes that currently could complicate the resolution of financial institutions. Finally, the authorities plan to allow Sofoles to branch into leasing and factoring, de-regulating those Sofoles that do not take deposits from the public, and thus are not seen as representing a systemic risk.

38. The authorities were also considering steps to promote more diversified investment strategies among private pension funds (Afores). Although Afores’ regulations have been changed to allow greater diversification and thus efficiency,14 Afores continue to invest heavily in mostly short-duration government instruments. Most Afores invest in very similar portfolios, perhaps because they do not derive much of their income from the value of their assets under management. To lessen this investment concentration, each Afore has had to establish two mutual funds, one entirely in fixed-income securities, and another one in debt securities and equities. The authorities are in the process of fine-tuning this “benchmarking” in coordination with the industry.

39. The mission welcomed Mexico’s track record in financial reforms. As documented in the two Selected Issues papers on the banking sector and domestic debt market, an impressive series of reforms has strengthened the stability of the banking sector, while promoting nonbank sources of financial intermediation. A number of the 2001 FSAP’s key recommendations have been addressed, including in the area of the payments system, banking regulation, and offsite supervision of banks’ risk management practices. In order to better assess the current strengths of the financial system and to serve as a reference for the next administration, the authorities plan to soon request an FSAP update.

E. Vulnerabilities and Measures to Boost Resilience

40. The authorities underscored that economic fundamentals are solid and resilience to shocks has been fortified. The level of gross public sector debt, at around 45 percent of GDP, does not raise concerns of sustainability, and the current fiscal stance is already adequate to avoid a rise in this debt ratio. Furthermore, the average maturity of domestic debt has increased in recent years. As the government has shunned dollar-indexed debt and shifted away from external debt, and as oil export prices have risen, there is no longer concern about the budget’s net exposure to peso depreciation. External debt is mainly long-term, and the authorities consider that the federal government will not need to issue in the global bond market before 2007.

41. Staff agreed that Mexico’s economy has been considerably strengthened. The exchange rate is flexible, the commitment to low inflation is credible, and exchange rate pass-through to inflation has become low. Moreover, the public sector balance sheet especially is stronger than in the past, and compares favorably to other emerging markets’ in terms of exposure to currency depreciation. Furthermore, external debt, and external financing needs, of both the public and private sectors are smaller in Mexico than in many other countries, and the modest current account deficit has been more than covered by FDI.

Selected Vulnerability Indicators, 2004

(In percent of GDP, unless otherwise indicated)

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Source: Staff estimates.

Current account deficit plus amortization of external debt; 2005 estimate for Mexico.

For Mexico, public sector includes public enterprises.

Overall fiscal deficit plus debt amortization and rollover; 2005 estimate for Mexico.

Debt in foreign currency or linked to the exchange rate, domestic and external.

Short-term debt and maturing medium- and long-term debt, domestic and external, excluding external debt to official creditors.

42. Still, the mission noted that further steps to bolster resilience continue to be important. Annual public sector financing needs are estimated to exceed 10 percent of GDP, and the fiscal position could be affected significantly by an oil price decline (as a rough rule of thumb, a decline in the oil price of US$10/b1 reduces government revenue by about 1 percent of GDP). While Mexico’s public debt ratio is not out of line with other OECD or emerging market countries,15 there is room to reduce public sector financing needs by reducing that ratio and also by further extending the average maturity of the public debt—especially of the domestically-issued debt, which was 3.1 years at mid-2005.1617 In addition, an estimated 17¾ percent of GDP in public domestic debt carries a floating interest rate or is short-term. The authorities agreed that further extending the maturity of the public debt is important; they also noted that most of the public sector’s financing need was in terms of pesos, and that account should also be taken of the public sector’s liquid assets.18

43. Staff observed that its analysis of various potential shocks (Annex V) illustrates the importance of continuing to extend the effective maturity of public debt. While calculations show that a “confidence shock” episode19 with a hike in interest rates and a sharp depreciation, along with weaker growth, could put the public debt on an upward path, the rise would be fairly limited. However, gross public sector financing needs could rise significantly if a shock were sustained and the authorities were forced to rely on short-term debt to finance amortization. The mission, therefore, underlined the importance of reducing rollover risk and continuing to seek an extension of debt maturity, even if interest rates were to become less favorable.

44. Like other emerging markets, Mexico would be challenged by a scenario involving lower U.S. and world growth, especially if it were prompted by a significant loss of confidence in U.S. assets and rising foreign interest rates. In such a setting, Mexico would be particularly affected through its important export links to the U.S. and by a demand-induced drop in world oil prices. Economic activity in Mexico would be strongly affected. Moreover, in the absence of new fiscal measures, the augmented fiscal deficit could widen by several percentage points of GDP (mainly from the oil price and interest rate effects). In such a scenario, it was agreed, an early and decisive fiscal policy response would be essential.

F. Structural Reforms and Competitiveness

45. A political breakthrough on major structural reforms appears unlikely in the context of the run-up to the 2006 elections. The mission noted that public awareness of the need for reforms had improved significantly over the past several years, as a result of the government’s efforts. Still, full-fledged reforms critical for medium-term growth, including governance, labor market, energy and telecommunication sectors, and taxes, would probably have to wait. Some political analysts suggested that a window of opportunity for reform would come during the parliamentary session immediately after the elections (September-December 2006), before the new President takes office.

46. In the meantime, the authorities emphasized they would continue to press for smaller-scale reforms aimed at improving structural competitiveness for specific sectors. Already, a number of laws dealing with specific sectors (mining and farming) and public procurement had been approved so far in 2005 through a special working group on competitiveness in the Senate—established in 2005 with broad political, business, and public sector participation. Progress was also being made through administrative measures to reduce red tape at the local level and to enhance tax collections. The authorities will continue this approach in 2006, through further addressing regulatory concerns identified by the private sector. Another area of progress was regional economic integration, which a recent security and prosperity partnership agreement with the U.S. and Canada is expected to promote.

47. The mission welcomed these efforts, highlighting the need to move ahead with reforms of PEMEX corporate governance. Higher oil prices, and higher resource flows to PEMEX, made it more important than ever to assure PEMEX’s optimum performance. Administration proposals of governance reforms for PEMEX had not advanced in congress.

48. The mission noted that progress on the structural reform agenda would help counter a loss of competitiveness in the face of intense competition from China and other markets with lower wages. Conceptually, such competition was pulling against the tendency of the real exchange rate to appreciate as a result of higher oil export prices (and the spending of some of the additional oil income on domestic goods and services). For now, given the current external terms of trade, the real exchange rate is broadly in equilibrium. The real exchange rate has been fairly stable, and the current account deficit has remained small, implying declining external debt ratios. The mission observed also that the non-oil trade deficit had not greatly weakened, and that the growth of non-oil exports was continuing, at a respectable though not dynamic pace. On the other hand, the rate of FDI into Mexico was rather low by international comparison, and the mission and authorities agreed that Mexico’s competitiveness will face ongoing risks, highlighting the need for structural reforms (Box 3). The authorities noted the relative lack of high productivity manufacturing in Mexico to which resources could shift as traditional maquila manufacturing was gradually moving to markets with lower wages. Looking forward, it would be important to encourage investment and enhance competitiveness by improving the supply of skilled labor and modern infrastructure, and by addressing high production costs (especially energy and telecommunication) and problems of public and corporate governance.

Mexico and Selected Countries: Foreign Direct Investment, in percent of GDP

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Source: World Economic Outlook.

Argentina, Brazil, Chile, Colombia, Venezuela.

The Czech Republic, Estonia, Hungary, Latvia, Poland, and Slovakia.

Cyprus, Greece, and Portugal.