Mexico: 2006 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion

Mexico’s two main economic policy challenges are to fully entrench stability and to remove remaining obstacles to economic growth, necessary to end poverty. The floating exchange rate policy continues to serve Mexico well. An essential part of Mexico’s stability is the resilience of the financial system. The oil sector poses a policy dilemma, exacerbated by institutional constraints and governance issues. Although the near-term growth outlook remains closely linked to that of the U.S. economy, medium-term growth depends on structural reforms.


Mexico’s two main economic policy challenges are to fully entrench stability and to remove remaining obstacles to economic growth, necessary to end poverty. The floating exchange rate policy continues to serve Mexico well. An essential part of Mexico’s stability is the resilience of the financial system. The oil sector poses a policy dilemma, exacerbated by institutional constraints and governance issues. Although the near-term growth outlook remains closely linked to that of the U.S. economy, medium-term growth depends on structural reforms.

I. Context and Key Issues

1. Amid a favorable external environment, the economic recovery that began in 2003 has continued, Mexico has extended its record of macroeconomic and financial stability, and inflation has fallen to historic lows. At the same time, important structural challenges remain—to accelerate growth and poverty reduction, and to address medium-term fiscal issues centered on oil revenue reliance.

2. Recent Article IV consultations with Mexico have emphasized consolidation of the public finances in a favorable external environment, the development and implementation of the inflation targeting framework, and the structural reform agenda. In broad terms, staff agreed with the authorities on the direction of their policies and objectives. On fiscal policy, the staff supported the authorities on the need for tax reform, and highlighted the need for an efficient and cautious approach to managing oil income and wealth. The authorities have used part of their oil windfall for deficit reduction, and recently a fiscal responsibility law was passed. Monetary policy has brought inflation to the low single digits, and the authorities have significantly enhanced monetary policy transparency and communication. On the structural policy front, the staff supported the authorities’ agenda, but implementation was often frustrated by lack of political consensus.

3. Good short-term prospects and a still-favorable external environment allowed the discussions to focus on structural issues and medium-term challenges. The discussions also built on the findings of this year’s FSAP Update, and focused especially in three areas:

  • Financial markets: progress since the 2001 FSAP, in terms of both stability and efficiency; and the remaining financial reform agenda.

  • Fiscal policy: the need to address underlying vulnerabilities and to counter pressures that will mount over the medium term, including in light of uncertainty concerning future levels of government oil income.

  • Growth, reforms, and competitiveness: the challenges in raising productivity, competitiveness and growth (Selected Issues Chapter I).

4. The Article IV discussions took place ahead of the July 2 elections, the results of which are under legal challenge. After the electoral institute announced that Mr. Calderon (PAN) narrowly edged Mr. Lopez Obrador (PRD) in the presidential race, the PRD began a legal challenge, on which the electoral court will rule by early September at the latest. The elections yielded a congress divided among the three main parties, with the PAN having the greatest representation, followed by the PRD.

2006 Congressional Election Results 1/

(in number of seats)

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Party seat allocation in new Congress (and gain or loss). Preliminary results, as of July 2006.

II. Recent Developments

5. After a slowdown early last year, growth recovered in the second half of 2005 and early 2006 (Figure 1). Growth in 2005 slowed to 3.0 percent, but is estimated to have rebounded to almost 5 percent in January-May 2006. Domestic demand grew somewhat faster than output, as private consumption and private investment were both strong. Manufacturing has accelerated this year, related to stronger U.S. industrial production and a rebound of auto exports. Employment grew by more than 5 percent in 2005, and formal employment finally surpassed its 2000 level.

Figure 1.
Figure 1.

Mexico: Real Sector Developments, 2000-2005

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

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

6. Bank credit continues to grow strongly, from a very low base. A favorable macroeconomic environment, stronger bank balance sheets, better credit information, and mortgage insurance provided by a specialized development bank boosted consumer and housing bank credit in 2005 and so far in 2006. Credit to enterprises also has grown, but at a slower pace.

7. Inflation, after an extended period above target, converged to the 3 percent target1 in late 2005 (Figure 2). Subsequently, when headline inflation moved up in early 2006—mainly reflecting volatile food prices—core inflation remained steady and the headline rate came quickly back down.

Figure 2.
Figure 2.

Mexico: Inflation and Monetary Policy, 2000-2005

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

Sources: Mexican authorities; and Fund staff estimates.

8. Amid declining inflation and inflation expectations, the Bank of Mexico (BoM) in August 2005 began to unwind its earlier monetary tightening, before stopping in April 2006. The overnight bank rate—for which the BoM targets a minimum level—was reduced from a peak of 9¾ percent to 7 percent in April, when the BoM ruled out additional easing “in the foreseeable future.”2

9. The BoM has adhered strictly to its policy of avoiding discretionary purchases or sales of foreign exchange (Box 1). Still, NIR has trended upward, as the BoM receives the foreign exchange cash surplus generated by the public sector—including the state oil company, PEMEX. The pace of such accumulation has been moderated by the rule for selling a fixed share of this surplus. NIR reached US$68.6 billion at end 2005, about 4½ months of imports and 1.6 times short-term external liabilities, and rose further to US$76.7 billion in July 2006.

10. With financial markets continuing to show confidence in Mexico, prices of Mexican assets have tended to move broadly in line with external markets (Figure 3). Movements in the sovereign spread have tracked other emerging market spreads, with the level well below the EMBI index and at one point crossing briefly below 100 bp. The stock market, after doubling during 2004-05, hit a new peak in early May, but then followed other emerging markets downward, through mid-June. Mexico was not among the group of emerging markets hit hardest during the May-June global selloff, although this occurred amid pre-election uncertainty.

Figure 3.
Figure 3.

Mexico: Financial Market Developments

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

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

11. The peso, after generally appreciating since early 2004, reversed course in March 2006. The initial depreciation was associated with a marked rise in U.S. long-term interest rates. In May, the peso weakened further, amid the global selloff of emerging market assets, and almost returned to its April 2004 low. Subsequently, announcement of the July 2 election results triggered a sharp appreciation (and stock market gain, as well as a drop in the sovereign spread).

Operation of the Exchange Rate Regime

The value of the Mexican peso is continuously market-determined, in the absence of discretionary foreign exchange purchases or sales by the central bank. At the same time, BoM accumulates NIR from: (i) interest earned on its reserves; and (ii) its role as foreign exchange conversion agent for the government and PEMEX, which together generate a net foreign exchange cash surplus.


Decomposition of Annual NIR Flows

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

Rising oil export prices since 2002 have boosted this foreign exchange surplus and NIR accumulation. In March 2003, the authorities began to sell foreign exchange to the market, introducing a rule in which half of each quarter’s NIR accumulation is subsequently sold, in equal-sized daily auctions.1 This rule has been respected since its inception, irrespective of exchange rate developments.

Under this rule, NIR grew at an average annual rate of about US$7 billion in 2003-2005, while BoM auctions of foreign exchange averaged about US$5 billion. The ratios of NIR to imports, and to GDP, were broadly stable in 2004-05.

Under this policy regime, the variability of the peso has been similar to that of other flexible exchange rates. For example, from March 2003 to June 2006, the variation of the peso/dollar exchange rate (measured by the standard deviation of daily, weekly, or monthly changes) was broadly comparable to that of the exchange rates of the Canadian dollar and Euro. During this period, short-run fluctuations in the Mexican exchange rate were significantly correlated with movements in emerging market bond spreads (declines in the EMBI+ index were associated with appreciation of the peso). Shifts in world oil prices may also have influenced the peso in this period, but the statistical evidence for this relationship is much weaker. Statistically, it is not possible to discern any link from the BoM’s daily foreign exchange sales to movements in the peso (as would be expected, given the very smooth rate of foreign exchange sales).2

1. The BoM sells by auction half of the NIR accumulation that would have been registered over the quarter were it not for the foreign exchange sold under the rule. When the rule was adopted in March 2003, half of each quarter’s accumulation was sold into the market over the next quarter. In March 2004, the rule was modified to sell the same amount over the next four quarters, reducing quarterly fluctuations in foreign exchange sales.2 BoM foreign exchange sales are small in relation to the turnover in the peso-dollar market. End-2004 figures indicate a daily turnover (spot and forward) of US$15 billion, more than a thousand times the BoM’s daily foreign exchange sales.

12. The fiscal accounts showed a further consolidation in 2005, helped by a modest rise in oil revenues and a better-than-expected balance of the development banks (Figure 4). Although oil export prices were up sharply, net oil revenues rose by just 0.4 percent of GDP, reflecting a weak production outturn,3 as well as structural factors (see below). This modest gain helped narrow the augmented deficit, to 1.4 percent of GDP. The non-oil deficit narrowed slightly, to 7.2 percent of GDP. Although current expenditure turned up in 2005, this was offset by better non-oil revenue performance and negative net lending by the development banks, reflecting their sale of loans.4 In terms of the traditional budget measure, the government again met its target, as the traditional deficit fell to 0.1 percent of GDP.

Figure 4.
Figure 4.

Mexico: Fiscal Sector, 2000-2006

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

Sources: Mexican authorities; and Fund staff estimates.

Mexico: Financial Operations of the Public Sector, 2001-2006

(in percent of GDP)

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Sources: Mexican authorities; and IMF staff estimates.

IMF staff definitions. Augmented revenue is based on budgetary revenue minus adjustments for non-recurring revenue, capital gains on debt buy-backs and premium on par-bonds. Augmented expenditure includes budgetary expenditure plus adjustments for financial requirements of development banks, Pidiregas, IPAB, FARAC, Oil Stabilization and PEMEX Investment funds, debtor support program, and other adjustments.

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

Including fuel excise tax and net of PEMEX imports.

13. The fiscal windfall from rising world energy prices has remained relatively modest. Hydrocarbon production in Mexico is much smaller in relation to the size of the economy than in other oil exporting countries. Another factor is that Mexico’s hydrocarbon import bill—roughly half as large as its hydrocarbon export receipts—has also been pushed up by rising prices. Further, the fiscal gain from PEMEX’ domestic sales has been significantly limited by the longstanding practice of holding domestic gasoline prices constant in real terms.5 Staff estimates that if such fuel prices had tracked world prices since 2002, revenue in 2006 would be some 2 percent of GDP higher than now projected.6

14. Proven reserves of oil declined again in 2005. As in recent years, oil was pumped out much faster than “new” oil was added to proven reserves, which are now down to about 11 years’ production (Box 2).

15. The external position has continued to improve, helped by favorable external conditions that stayed ahead of the effect of rising domestic demand on imports (Figure 5). Although imports grew strongly, rising remittances (Selected Issues Chapter II) and oil exports reduced the current account deficit to less than 1 percent of GDP in 2005, and in the first quarter of 2006 the current account moved into surplus. Non-oil exports performed well overall, with a rebound in the maquila sector. Mexico’s share in its main export market, the U.S., stabilized in 2005, after three years of decline. Foreign direct investment more than matched the current account deficit in 2005. Within the capital account, the public sector significantly reduced its external borrowing, while net borrowing of the corporate sector turned positive for the first time in several years.

Figure 5.
Figure 5.

Mexico: External Sector, 2000 - 2005

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.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.

16. The public debt ratio declined further in 2005, with gross public debt just under 45 percent of GDP. External debt fell to about 13 percent of GDP. If the central bank’s international reserves were taken into account, net external public debt would be less than 5 percent of GDP. Of the domestically-issued debt, foreigners held about US$12 billion at mid-2006 (about 1½ percent of GDP).

Sustainability Issues in the Oil Sector

Oil revenues are key to the medium-term outlook for the public finances. Although oil plays a much smaller role in the economy of Mexico than in some other oil-exporters, the fiscal significance of oil is magnified by the lack of private participation in the sector. Thus all the oil sector’s revenues, as well as its operating costs, import bill, and investment needs, directly influence the public finances. With oil-based revenues comprising around 40 percent of total public sector revenues, the performance of the sector—as represented entirely by PEMEX—is critical to the dynamics of the public finances.

Source: PEMEX.1/ Crude and condensates.

The sustainability of PEMEX production is a potential concern. In recent years, oil production has grown little. Moreover, proven oil reserves have declined steadily from about 17 billion barrels in 2002 to 14 billion barrels in 2005. The ratio of proven reserves to annual production fell from about 15 years in 2002 to 11 years in 2005 (the measure of proven plus probable reserves declined similarly, from the equivalent of about 26½ years of production to about 21½ years.)

Future oil output will depend largely on PEMEX’s success in developing and exploiting new oil fields. Oil production from the “supergiant” Cantarell field—which currently accounts for about 60 percent of total output—is projected by PEMEX to fall by almost 50 percent by 2010. Finding adequate replacements for this relatively accessible field will be a challenge. PEMEX expects that declining Cantarell output can be more than compensated over the next few years by developing existing fields (particularly the KMZ field) and exploring new oil sources. However, oil production forecasts, particularly for new fields, are subject to great uncertainty, and analysts do not rule out the possibility that total production could begin to decline in the next few years.

Significant investment expenditure and new technology will be required to exploit geologically challenging terrain and deep-sea sources. Already, PEMEX investment has recently climbed to over US$10 billion annually, from less than US$1 billion in the 1990s. Although foreign technology is often acquired through equity participation by other oil majors in new projects, this is prohibited by Mexico’s constitution.


PEMEX Output Forecast

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

17. Debt management emphasized improvement in maturity as well as a shift away from external debt. The government conducted a number of liability management operations aimed at reducing the share of external debt, creating liquid benchmark bonds in the international market, and diversifying the investor base. The authorities have announced that the federal government has no foreign financing need for the rest of 2006; in June, the government announced that it will pre-pay about US$7 billion of external debt to the World Bank and Inter-American Development Bank (see later). In the domestic debt market, the authorities continued to increase the share of fixed rate instruments and increased the average maturity of central government debt, which rose to almost 40 months in 2005, from 38 months in 2004. In the broader augmented public debt, however, substantial short-term debt remains, including on the books of IPAB, the deposit protection agency.

18. Since the 2005 Article IV consultation, a number of significant reforms were approved by congress and became law. These reforms (discussed later) include: (i) a budget and fiscal responsibility law; (ii) a strengthened competition law; (iii) a modified securities market law; and (iv) a bank resolution law.

III. Report on the Discussions

A. Outlook

19. The mission and authorities agreed that the overall economic outlook for 2006-07 was positive, in the context of a continued favorable external environment. Staff expects growth this year to reach at least 4 percent, then to come closer to trend at around 3½ percent in 2007. This view takes account of the strong performance in the first half of 2006 and assumes continued steady growth in the U.S.. Growth would be fairly balanced, with consumption growing only slightly faster than GDP, and continued strong investment, while healthy export volume growth would roughly offset import volume growth. With the benefit of higher oil export prices, the already small external current account deficit would nearly disappear in 2006, before widening slightly in 2007. The authorities’ view was broadly similar, but they noted that growth could be somewhat higher in both years (subsequently, the BoM raised its 2006 growth projection to a range of 4 to 4½ percent).


Real GDP and U.S. Industrial Production

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

Sources: INEGI, consensus forecasts, and staff estimates

20. Inflation in 2006-07 is expected to remain close to the 3 percent target. The BoM projects 3 to 3½ percent inflation this year. Staff projections, based on a constant policy interest rate of 7 percent for the remainder of this year, put inflation at 3.3 percent at end-2006 and 3 percent in 2007. Surveys of private expectations are similar for 2006, and around 3.4 percent for 2007.

21. Staff projects a slight widening of the augmented fiscal deficit in 2006, with a larger increase in the non-oil deficit. The 2006 budget targets a zero balance on the traditional measure, but was based on an oil price significantly below current forecasts (and below the actual 2005 price), and a cut in expenditure (in real terms, relative to the 2005 outcome). This year’s average price will likely exceed the budget’s assumption by almost 50 percent (and the 2005 price by more than 25 percent), while the budget’s adjustors will require the spending of much of the unbudgeted oil revenue. Relative to the 2005 outcome, oil revenue this year would rise by almost 1 percent of GDP; with some increase in oil-related capital expenditure, the oil balance would improve by 0.7 points. On the non-oil balance, current expenditure would hold about steady on the staff’s projections, but with the expected resumption of net lending by the development banks and a projected fall back in non-oil revenue, staff projects that the non-oil augmented deficit would widen somewhat, to near 8 percent of GDP.

22. For the near-term outlook, uncertainties include the U.S. economy and a further tightening of global liquidity conditions. As the U.S. economy moves closer to full employment, the balance of risks from Mexico’s tight link to the U.S. tilts less to the upside. Further tightening of global liquidity conditions could act to slow demand and activity, although Mexico would be less affected than some other emerging markets. Of course any sign of a major shift in macroeconomic policy discipline would represent a risk, particularly in light of the still-significant public financing needs. (More specific risk scenarios are discussed in Section E and Annex V.)

23. Medium-term prospects depend importantly on Mexico’s ability to implement structural reforms to address constraints to growth (Section IV, and Selected Issues Chapter I). In the absence of major new reforms, staff projects that potential output would grow at about 3½ percent through the medium-term, a bit faster than recent historical experience. The authorities’ view is similar, in a range of 3½ to 4 percent. Staff and the authorities agree that a transition to a much faster growth trend would require significant reforms. Regarding the medium-term fiscal outlook, the main factors will be implementation of the newly-established budget target (see below) and the continued containment of off-budget flows.

B. Fiscal Policy

24. The mission welcomed the fiscal consolidation achieved in recent years that had been key to Mexico’s improved economic position. Declining annual targets for the fiscal deficit had been consistently met, and the broader augmented fiscal deficit had also been reduced, inducing a gradually declining trend in the debt ratio. Looking forward, implementation of the new Budget and Fiscal Responsibility Law would help maintain broad fiscal discipline (Box 3).

25. However, several underlying fiscal problems will need to be resolved:

  • Fiscal dependence on oil revenue. Amid low tax revenue, the public finances are heavily reliant on an oil revenue stream that is uncertain, subject both to oil price risk and to risk of resource depletion. In the context of relatively low and declining oil reserves, the non-oil augmented deficit—more than 7 percent of GDP—remains uncomfortably large.

  • Public debt is still higher than desirable. While the public debt ratio is not unusually high by international standards, it would be prudent to bring debt down more rapidly, particularly in light of the above-mentioned oil risks.

  • Spending pressures will rise over the medium term. These include costs of public employee pensions, access to public health insurance, and infrastructure and education needs.

  • Limited accountability and control over state government expenditures. State-level expenditures—supported by federal government transfers—are more important than in the past, highlighting the need for progress on this front.

26. The authorities explained the approaches to these issues taken so far, including the passage of a fiscal responsibility law. Although their tax reform proposals had not found support in congress, the proposed reform of pensions for public employees is under discussion in congress. To contain exposure to a decline in oil prices, budgets had been designed to avoid letting rising oil income translate into inertial expenditure, instead channeling it into contingent spending, including investment in the oil sector, as well as deficit reduction. The mechanism for handling oil income in the new Budget and Fiscal Responsibility Law continues in this direction, although there was some concern that it could allow a too-rapid increase in expenditure if oil prices rose abruptly. And the authorities noted that transfers to states would go up further with rising oil prices, making it more important to improve accountability and control of such expenditure.

27. On the sustainability of oil income, the authorities explained the need to balance risks, inside a given legal framework. To counter the prospect of declining production, PEMEX investment spending had been raised significantly, from a low base. Although the decline in proven reserves had not yet been arrested, these investments were expected to pay off with some lag, enough to avoid a decline in production. On the other hand, oil investments have inherent risks, and concerns about PEMEX governance could add to these. Unfortunately, a proposal to reform PEMEX governance and allow some risk-sharing with the private sector had not cleared congress.

28. The mission agreed that PEMEX governance reform would be a critical step in ensuring that the oil industry operates most efficiently. Mexico could follow other countries that have put national oil companies on a more commercial footing. It would also be important to reconsider the existing constraints on PEMEX financing—in which raising oil sector investment essentially requires either fiscal policy tightening or the issuance of public debt—since this may put too much strain on the public sector balance sheet, while denying PEMEX access to technologies and advantages that other oil companies obtain through joint ventures.7

The New Budget and Fiscal Responsibility Law

This law enacted in March 2006 establishes: (i) an ongoing fiscal balance target; (ii) mechanisms for budgeting amid oil price uncertainty; and (iii) a medium-term expenditure framework.

Fiscal target. Future budgets are to aim at a zero balance on the traditional fiscal measure. Under exceptional circumstances, a weaker budget may be proposed, but this requires explicit justification and plans for returning to zero balance. (A stronger than required budget also may be proposed.) The law does not limit the augmented deficit, but does require projection and monitoring of this broader fiscal measure.

Medium-term implications and debt sustainability. Provided that off-budget flows do not rise above recent levels, consistent achievement of the targeted zero traditional balance would imply that the augmented deficit would remain near its recent level of 1½ percent of GDP. Such a stance would be consistent with a continued gradual reduction of the augmented public debt ratio.

Response to oil price fluctuations and saving of oil revenue. The law calls for a limited amount of financial saving and dissaving in response to fluctuations in oil prices. Federal oil revenues for each annual budget will be projected using a reference oil price. This price will be set by a formula based mainly on oil futures prices (a mix of short-term and medium-term futures), with a one-quarter weight on the average price of the last 10 years. Any excess income, that results from actual oil prices above the reference price, may first be used to compensate for certain budgetary overruns (e.g., higher interest costs, and the higher fuel bill of the state electricity company). The remainder is to be split between several stabilization funds (90 percent) and state-level investment projects (10 percent). Once these funds reach ceilings, totaling about 1½ percent of GDP, any subsequent excess is to be used for investment projects (75 percent) and eventual pension reform costs (25 percent). If the oil price turns out below its reference level, the stabilization funds can be drawn down, over time, but once exhausted, fiscal tightening is required.

Expenditure smoothing. As described, the new law does not aim to isolate expenditure completely from oil revenue fluctuations, even those that might appear to be temporary. While temporary and permanent price changes are difficult to gauge, the new reference price formula includes elements that may be related to long-run price tendencies. The new rule is built to play a smoothing role, and it will induce a degree of caution in times of rising oil prices. Still, there is the possibility that the new law could allow a rapid rise in public expenditure, including because the oil reference price formula puts much weight on short-term oil futures prices, which often move closely with the spot oil price. (An earlier proposal for the formula, analyzed in the previous Article IV consultation, put more weight on medium-term futures prices, and would have implied more smoothing, but was not supported by congress.) Against this, the practice of holding the domestic price of gasoline steady in real terms, if maintained, will reduce fluctuations in government revenue, and therefore limit the increase in expenditure that might otherwise be triggered by the new fiscal rule when oil prices rise.

Medium-term expenditure framework. Annual budgets now will be presented in the context of a long-term quantitative framework, with projections for the next five years, and the costs of new fiscal measures will have to be explicitly shown. Previously, each administration was required to publish only one medium-term fiscal plan, in its first year. Other provisions to strengthen expenditure management include greater transparency and controls over the use of trust funds, greater accountability in the selection of investment projects and the granting of subsidies, and stricter monitoring of within-year budget execution. Finally, the law includes steps toward performance-based budgeting, requiring the establishment of indicators to measure program outcomes.

29. In the meantime, absent such reforms, the mission recommended that fiscal policy be more cautious than required by the budget law, given the risk of an eventual decline in oil income. The mission suggested taking advantage of the currently very favorable external environment—high oil prices, as well as still-low international interest rates—to adopt a fiscal stance that would be more ambitious than the minimum required by the Budget and Fiscal Responsibility Law. In particular, the mission recommended avoiding an increase in the non-oil augmented deficit from its 2005 level, which would translate into targeting a surplus on the traditional budget measure in 2007.

30. The authorities agreed that the 2007 budget should aim to save more oil income than will be possible this year. They planned to prepare a draft of the 2007 budget which the incoming administration could consider before submitting its own budget to congress. They noted that the approved 2006 budget will require spending a considerable share of this year’s unbudgeted oil income, and that there was not much room to overperform on the 2006 budget.

31. The mission noted that a more ambitious fiscal stance could be based on a combination of revenue measures and selective expenditure cuts. Tax reform, along the lines proposed earlier by the authorities, was essential. The recently-published “tax expenditure” estimates—quite high at 6.7 percent of GDP in 2005—give an indication of the room available for broadening the tax base.8 Improved tax administration could also play a role. Another possibility could be to adjust the administered price of gasoline—not only to remove the implicit subsidy that recently emerged when world prices surged, but also to move to restore the once-important excise tax on gasoline, which would also address negative externalities of gasoline consumption.9 On the expenditure side, savings could come for example from reducing and better targeting subsidies, such as that on electricity use.

C. Monetary and Exchange Rate Policy

32. The mission commended the adept implementation of the inflation targeting framework, noting the enhanced credibility that had resulted from recent convergence. Following the earlier tightening of monetary policy, the August 2005 decision to begin reversing that tightening seems well-timed—inflation was brought down, without inducing an undershooting of the target. Subsequently, when food price shocks took headline inflation to the top of the variability band, inflation expectations did not rise (in contrast to similar episodes in the past), suggesting increased credibility. Moreover, the authorities had been able to reduce interest rates during a time of peso weakness in March and April, without sacrificing credibility, as it was understood that the inflation outlook justified the moves.

33. The authorities explained the factors that had led them in April to rule out further easing in the foreseeable future. They did not see any sign of a threat to inflation from demand pressures or labor market tightness and estimated that some output gap remains; they also noted the price-disciplining effect of competition from China. On the other hand, there were some potential upside risks to inflation from external sources, and the uncertainty surrounding an election period argued for extra caution. Inflation expectations still about a half point above target also argued for holding a stance that could be characterized as still somewhat restrictive. The mission shared this assessment of the stance and risks, noting that continued focus on achieving the inflation target will further entrench credibility.

34. The authorities considered that inflation expectations would align fully over time with the 3 percent inflation target, as policy continued to aim at keeping inflation outcomes centered on that target. They were broadly satisfied with the results of their stepped-up efforts to communicate policy to the public. The mission agreed that private expectations would continue gradually to adjust after having been too pessimistic and suggested that additional traction could perhaps be gained by further steps in communicating with the public. The inflation reports published quarterly are an essential communication device as well as the regular statements after meetings, and the BoM has been increasingly forthcoming about its inflation projections. The BoM could go further by regularly publishing formal forecasts at multiple horizons, or by publishing a model of how it views the inflation process. The authorities indicated that such ideas were kept under consideration, and their potential advantages and disadvantages were being weighed. On monetary instruments, it was agreed that the interest rate signals given in the monthly policy announcements were clear and effective in governing monetary conditions.

35. The floating exchange rate policy continues to work well. The mission noted the advantages of the authorities’ hands-off policy regarding the exchange rate, in terms of transparency, promoting hedging by the private sector, and keeping expectations focused on the inflation target. The rule for selling a fixed share of the public sector’s foreign exchange surplus fits well inside this policy of symmetric exchange rate flexibility.

36. The mission and authorities agreed that NIR had reached a healthy level, according to standard indicators of reserve adequacy. If the authorities were to decide that NIR was growing faster than necessary, the mission recommended that any modified rule preserve the best features of the current one, in which NIR does not respond to exchange rate developments. Subsequently, the authorities in June announced a debt management operation that will have the effect of slowing NIR growth this year, while leaving the existing exchange rate policy mechanisms intact. In this operation, central bank NIR will be used to pre-pay about US$7 billion of the government’s external debt to the World Bank and IDB.10

As a consequence, staff projects that while NIR will continue to grow this year, the increase will be considerably less than in 2005, notwithstanding higher oil export prices.

D. Financial Issues and Policies

37. The FSAP Update found considerable progress since the 2001 FSAP, and confirmed the overall strength and resilience of the financial system. Although financial intermediation overall is still relatively limited, conditions for its further development are improving.

38. Since the 2001 FSAP, a major reform effort has aimed at enhancing the stability of the financial sector and strengthening its role in providing credit to the private sector. The supervision of banks and securities has improved significantly. The audit and debt exchange of disputed bank restructuring bonds removed an important source of legal uncertainty in the banking system. Market infrastructure has improved, with new legal and regulatory frameworks for various intermediaries and the modernization of large value payments systems. Derivatives markets have grown significantly, allowing better management of risks.

39. New legislation continues these efforts by strengthening corporate governance, authorizing private mortgage insurance, deregulating credit that is not funded by deposits, and creating a new bank resolution framework. The new stock market law considerably strengthens investors’ rights and enables stock-market listings for smaller firms. Non-bank credit institutions (Sofoles, which are not permitted to take deposits) will be deregulated: licensing requirements and restrictions on the market segment they can enter are being withdrawn gradually. The new bank resolution framework, once complementary regulations are implemented, will provide clear mechanisms to deal with insolvent commercial banks.

40. Helped by good macroeconomic policies, sound oversight, and a favorable external environment, the financial system has increased its resilience to adverse shocks. Overall, private banks are profitable and liquid, and their capital is high (currently over 15 percent of risk-weighted assets).11 Commercial banks appear capable of withstanding significant market and credit risk shocks, according to tests conducted for the FSAP Update.

41. Commercial banks’ asset quality continues to improve, although strong growth of consumer credit could eventually bring some deterioration of credit portfolios. In that context, the authorities are moving to strengthen further the monitoring of consumer credit risk. For now, the level of household debt is significantly lower than in other countries, and overall non-performing loans remain low for both banks and non-bank credit institutions. Loan loss provisions, in excess of required levels, provide a reassuring cushion.

42. Even with the recent growth of credit and securities markets, financial intermediation overall remains relatively limited, while the INFONAVIT housing fund plays a significant role.12 Commercial bank credit to non-financial enterprises is no more than 10 percent of GDP. (In comparison, funds channeled through INFONAVIT reached 5 percent of GDP in 2005.) Local corporate debt issuance increased in 2005, but remains low at 2 percent of GDP. Domestic equity issuance remains small, somewhat less than US$2 billion in 2005, although this did represent a ten-fold increase with respect to 2004. The market for asset-backed securities has been the fastest growing segment of Mexico’s private debt market, since their legal framework was strengthened in 2003.

43. Among the recommendations from the FSAP Update, the mission highlighted priorities for future policies in three areas:

  • Enhancing the supervisory regime and contingency planning, to entrench resilience. Next steps should include full-fledged consolidated supervision of financial conglomerates, further enhancing the monitoring of consumer credit risk, creating clearer rules for inter-agency contingency planning, and adopting a legal framework to guarantee the political and budgetary autonomy of supervisory bodies.

  • Further rationalization and reform of development banks. Some development banks have been reformed and have developed market-friendly instruments to promote access to finance, but some have not reformed (see FSSA report). The challenges include redefining the mandates of those banks, further consolidating and rationalizing the system, continuing with current plans to establish a “subsidies bureau” to rationalize the various financial subsidy and guarantee programs, and implementing performance indicators. In the growing housing finance market, the SHF, a specialized development bank for housing, has played a key role in developing the market; it will be appropriate to stick to the timetable for the SHF to withdraw from financing mortgages.

  • Promoting access to financing and competition. Along with continuing efforts to strengthen creditors’ and investors’ rights, steps to promote greater competition would help improve access to financing. For banks, the mission endorsed the authorities’ work to foster competition by improving disclosure of information on availability and costs of credit and retail payment services, and by fostering greater cooperation among institutions in the use of financial infrastructure. For pension funds, the mission welcomed plans to require transparent disclosure of each fund’s investment performance, including with reference to investment benchmarks.

44. The authorities generally concurred with the findings and recommendations of the FSAP Update. They noted that their most recent reform efforts aimed to address many of the issues. Regarding financial market development, they and the staff expected the effects of reforms implemented in recent years to accumulate over time.

E. Vulnerabilities and Measures to Boost Resilience

45. The mission noted Mexico’s success in reducing vulnerabilities and building resilience. In addition to the strengthened financial system, Mexico benefits from: (i) an improved public sector balance sheet, especially strong in terms of low exposure to exchange rate risk;13 (ii) the flexible exchange rate in the context of a credible inflation anchor; and (iii) levels of external debt and external financing needs, of both the public and private sector, that are relatively low in international comparisons.

Selected Vulnerability Indicators, 2005

(In percent of GDP, unless otherwise indicated)

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Source: Staff estimates.

Current account deficit plus amortization of external debt.

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.

As of end 2005 for Mexico and as of end 2004 for the sample of emerging market countries.

46. To further reduce vulnerabilities, the mission emphasized continuing efforts to reduce the public debt ratio and strengthen the debt structure.14 Short-term external financing needs are low, but the average maturity of the domestic component of the total public debt, while increasing, is still relatively short. This generates significant gross financing needs, estimated by staff to be 11½ percent of GDP this year. It would be important also to bring down further the share of domestic debt indexed to the interest rate. The authorities confirmed that they would continue in these directions, taking into account also the costs of extending maturity in the context of an upward-sloping yield curve.

47. The mission commended the transparent, non-opportunistic approach to public debt issuance, which has helped build confidence. In an adverse scenario, including a hypothetical loss of confidence in Mexican assets, it would be advisable to stick to this debt strategy, and in particular to avoid a large shift in issuance toward debt that is either very short-term or indexed to interest rates. The authorities commented that fiscal policy would be the most effective response to such a shock. Finally, the mission recommended consolidating the analysis and management of public debt to the extent possible, including shifting the sizable debt of the deposit protection agency (IPAB) to the books of the federal government. The authorities noted that the latter would require legislation.

48. Staff’s sensitivity analysis of potential shocks highlights the importance of continuing to extend debt maturity and of reducing oil risks. A hypothetical “confidence shock” episode with a hike in interest rates and a sharp depreciation, along with weaker growth, could put the public debt on an upward path, though not an extreme one. However, gross public sector financing needs could rise significantly if a shock were sustained and short-term debt began to be used intensively to finance amortization. Oil risk was also examined. In the near-term, this is centered on a possible sharp drop in oil prices, but over longer horizons there is the risk of declining production, and the mission also discussed a scenario in which oil production would fall in the medium term (Annex V).

49. The mission suggested that oil-related risks could be contained in two ways:

  • Strengthening the non-oil fiscal balance. Especially if proven oil reserves were to continue to decline, it would be prudent to aim at a significant reduction over time of the non-oil deficit.

  • Diversifying risk. From a financial perspective, risks to the public sector could be reduced by allowing some sharing of risk with the private investors in PEMEX investment. This would allow the public sector balance sheet to have a safer structure: a lower level of debt, and a lower share of its assets invested in the oil sector.

50. Also discussed was a scenario involving lower U.S. and world growth, prompted for example by a possible loss of confidence in U.S. assets and rising global interest rates. Activity in Mexico would be particularly affected, through the country’s tight links to the U.S., while a drop in world oil prices (which is assumed to be triggered by weaker U.S. and global activity) would reduce fiscal revenues. In such a scenario, the fiscal deficit could widen by 1 to 2 percentage points of GDP, mainly from effects of lower oil prices and higher interest rates. Again, it was agreed that a fiscal policy response—as indeed would be required by the new fiscal responsibility law—would be important, while monetary policy should remain focused on the inflation target.

F. Growth, Competitiveness, and the Reform Agenda

51. During the past decade, a number of accomplishments have helped set the stage for faster growth. These include macroeconomic and financial system stability, reforms to promote a deeper capital market and financial intermediation, and a range of specific reforms to improve the business environment, and the functioning of particular sectors. Just recently, laws were passed to improve corporate governance and help fight anti-competitive practices. Attention also has been given to human capital, with the development of incentive-based social assistance programs and broader access for health insurance.

52. Still, Mexico faces significant structural problems that together have prevented the gains in productivity needed for fast growth (Selected Issues Chapter I). The problem has several dimensions: the need for better infrastructure to integrate Mexico further with the rest of North America; the challenge of improving the education system and building human capital; and the need to address deficiencies in governance, the rule of law and security, judicial systems, and the regulatory environment. In such dimensions, Mexico generally lags not only other OECD member countries but also other investment grade emerging market countries—especially in East Asia. While Mexico has made some progress, reforms in such areas take time, and it is clear that much room for improvement remains.

53. Growth is also held back by barriers to flexible resource reallocation and in some areas by lack of sufficient competitive forces to spur productivity growth. In the energy sector, legal constraints support a state oil monopoly, and ban nearly all competition in the electricity sector. Moreover, the governance of PEMEX constrains the company’s ability to pursue efficiency.15 In the private sector, a number of key sectors are highly concentrated, and this may translate into pricing power on important inputs16 and limit incentives to adapt. Regulation makes formal labor markets too rigid (the large informal sector is more flexible, but participation in the informal sector can be inefficient from a broader point of view, with negative externalities that slow growth).

54. Barriers to the dynamic functioning of markets could be addressed on multiple fronts. The authorities were hopeful that the recent reform of the competition law, strengthening the federal competition commission, would work as a powerful tool. As discussed earlier, steps are being taken to promote competition in the financial sector, from licensing new entrants, to information and transparency requirements that will help consumer choice. The mission also recommended removing those barriers to external competition that still exist in the form of import licensing requirements and limitations on FDI. While the bulk of Mexico’s trade is with other NAFTA members—on a very liberal basis—tariffs on goods from other countries could still be streamlined and reduced.17 More competition could be allowed in the energy sector. Cutting across sectors, reform of labor regulation would allow a more flexible allocation of resources, and promote active competition by firms for labor.

55. In facing challenges in terms of international competition, the authorities and the mission agreed that these would best be addressed by the structural reforms needed to boost productivity and growth. Greater microeconomic flexibility—spurred by competition—was essential, along with a more highly-skilled work force. Attempts to hold on to existing low-wage activities would be counterproductive to the goal of raising economic well-being, as well as unlikely to be successful over the medium term. The mission noted that one symptom of Mexico’s international competitiveness may be the rate of inward FDI, which is rather low by international comparison (Figure 6). Again, this highlights the need for structural reforms.

Figure 6.
Figure 6.

Mexico: Competitiveness Indicators

Citation: IMF Staff Country Reports 2006, 352; 10.5089/9781451825695.002.A001

1/ Rank in 2006 survey out of 117 countries.2/ Rank in 2006 survey out of 60 countries.Sources: Haver Analytics; IFS; UN COMTRADE; Mexican authorities; and Fund staff estimates.

56. Regarding the real exchange rate, the authorities emphasized that this was a market-determined relative price that could be expected to respond flexibly to productivity developments. They considered that there were now no distortions that should cause the real exchange rate to deviate from a notional equilibrium level.18 The mission shared this view, and noted that with the external current account near balance, export volume growing faster than overall GDP, and Mexico’s export market share recently stabilizing, there were no clear symptoms of exchange rate overvaluation.19 The mission also agreed that the exchange rate is not an available policy tool for influencing competitiveness. Any attempts to use nominal policies to manipulate the real exchange rate would run the risk of boosting inflation, while failing to address underlying competitiveness issues.

57. In the evolution of Mexico’s real exchange rate, factors seem to be at work in both directions. The productivity growth differential and supply push from China especially is a continuing force for real depreciation of the peso. In the other direction, rising receipts from remittances and oil exports—to the extent that these trigger greater domestic demand20—are forces for real appreciation.

IV. Staff Appraisal

58. Mexico has come a long way toward establishing the macroeconomic, financial and social stability needed to foster rapid economic growth. Fiscal discipline has put public debt on a downward trend and supported confidence. Monetary policy has achieved low inflation, in the context of a floating exchange rate regime that has promoted smooth external adjustment. Indeed, the independent central bank has been an important component of institutional strength and continuity, including at times of political transition. The financial system—once a source of instability—has been put on a sound footing. Progress also has been made in reducing poverty through targeted programs. A transition to a multi-party democracy and a more transparent government is also laying the basis for better governance and faster growth.

59. Mexico’s two main economic policy challenges are to fully entrench stability and to remove remaining obstacles to the economic growth necessary to end poverty.

60. Monetary policy is well developed, and its job of disinflation nearly complete. The recent monetary tightening and easing phases were implemented deftly, and the convergence of inflation to the targeted 3 percent was critical to credibility. Inflation expectations are now within a half-point of that target; the final disinflation step will be to close that gap through the maintenance of the central bank’s steady focus on its inflation target. In the meantime, the authorities could extend their advances in monetary policy communication by regularly publishing a fuller quantitative forecast of inflation.

61. The floating exchange rate policy, implemented steadfastly and symmetrically, continues to serve Mexico well. As the central bank for years has abstained from discretionary intervention, it is now well understood in Mexico that the exchange rate is market-determined, and that monetary policy is focused on the inflation target. In addition to facilitating continuous external adjustment, this policy has given the private sector appropriate incentives to manage currency exposures.

62. An essential part of Mexico’s stability is the resilience of the financial system. This year’s FSAP Update documented this resilience, and the important steps that continue to be taken to secure it. Looking ahead, the FSAP Update provides a possible roadmap for further progress. Among the recommendations, several stand out as most fundamental to entrenching stability, including securing the institutional and budgetary independence of financial supervisory bodies, improving consolidated supervision of financial groups, creating clearer rules for interagency contingency planning, and enhancing the monitoring and analysis of fast-growing household credit. It will also be important to improve further the mandates, functions, and instruments of the development banks, and rationalize their operations.

63. To serve Mexico fully, the financial system will need to be not only stable but also deeper, providing credit on a larger scale. Today, there are hopeful signs of an emerging dynamism in the financial sector, and it is likely that further benefits of recent reforms are in the pipeline. Still, it will be important to continue with reforms and policy steps to deepen financial intermediation and promote competition.

64. Sustained fiscal policy discipline has fostered economic stability, as the fiscal stance has been strong enough to gradually reduce the public debt ratio. However, chronically weak tax revenue has added to the challenge of providing for adequate social and investment expenditures while maintaining fiscal discipline. Tax reform proposals deserve fresh consideration.

65. Indeed, new policy efforts will be needed to maintain an appropriate fiscal stance over the medium term. Expenditure pressures can be expected to mount steadily. Some, such as pressure to expand energy subsidies, should be resisted. Instead, expenditure on such subsidies should be reduced, by eliminating them or targeting them to those with low income. Other pressures, such as for enhanced infrastructure and appropriate social expenditures, are important for long-term growth and poverty reduction, but will be difficult to meet without raising tax revenue.

66. So far, oil income has compensated for the fundamental weakness of low tax revenue—but oil can be an uncertain source of income. Wary of the risks of allowing public expenditure to track oil prices upward, the authorities have sought to steer the rising oil receipts of recent years into a mix of deficit reduction and discretionary (non-inertial) spending, including on investment; so far, they have been able to avoid a major increase in the non-oil fiscal deficit. Still, the level of the non-oil deficit appears uncomfortably high, taking into account the relatively low level of proven oil reserves, as well as the size of public debt. If oil reserves were to continue their decline, fiscal policy will need increasingly to take into account uncertainties about future oil production and the sustainability of the non-oil fiscal position.

67. The oil sector poses a policy dilemma, exacerbated by institutional constraints and governance issues. On one hand, a low rate of investment in oil could mean a decline in production, fiscal receipts and exports. On the other hand, committing to additional investment may be difficult, given concerns about the efficiency of PEMEX, and legal constraints that mean that oil sector investment can be financed only by public debt, which may not be desirable. In this context, proposals to reform PEMEX governance, and to allow risk-sharing with the private sector, deserve new consideration.

68. To address other potential sources of vulnerability, the staff recommends that debt management strategy continue along recent lines. Great progress has been made in reducing the public sector’s exposure to peso depreciation. The relevant challenge now is to improve still further the structure of domestically-issued debt, especially to reduce the still-substantial gross financing needs of the public sector. Debt management would be facilitated by consolidating the management of all forms of public debt.

69. While the near-term growth outlook for Mexico remains closely linked to that of the U.S. economy, medium-term growth will depend on structural reforms. Having achieved stability, Mexico still has a distance to go in creating conditions for fast growth. The challenges include improving the education system and building human capital; enhancing infrastructure; and further improvement in judicial systems, security, and other aspects of the business and regulatory environment. Moreover, to spur productivity growth, labor market flexibility and competitive forces in general need to be given more room. The authorities are right to emphasize reforms such as the new competition law, steps to promote competition in the financial sector and to remove barriers to labor market flexibility, and the opening of industries now occupied by state monopolies. Implementation of such pro-growth reforms is the best way to assure Mexico’s international competitiveness and ability to take full advantage of globalization.

70. It is recommended that the next Article IV consultation with Mexico be held on the standard 12-month cycle.

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.

Estimated as as the difference between the augmented fiscal balance, as reported by SHCP, and public investment, as reported in the national accounts.

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, excise tax on gasoline) and PEMEX operational expenditure, interest payments, and capital expenditure.

Table 3.

Mexico: Summary Balance of Payments, 2002-2011

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Sources: Bank of Mexico; Secretariat of Finance and Public Credit; and Fund staff projections. Staff presentation, aggregated from more detailed Bank of Mexico data.

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.

Excluding oil exports and petroleum products imports.

Table 4.

Mexico: Summary Operations of the Financial System, 1999-2006 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.

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

Commercial banks, performing loans only.

Table 5.

Mexico: Financial Soundness Indicators for Commercial Banks, 2000-2006

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Source: CNBV

compiled based on annual flow data and annual average of end-of-month stock data.

Table 6.

Mexico: Indicators of External Vulnerability, 2001-2006

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

Does not include loans associated with FOBAPROA/IPAB debt-restructuring programs.

In U.S. dollar terms net of maquila.

Increase = appreciation.

The short-term debt by residual maturity includes pre-payment of debt.