Mexico
2007 Article IV Consultation: Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion for Mexico

This 2007 Article IV Consultation highlights that the economic expansion of Mexico has continued albeit slowed by developments in the United States. Despite some pickup in the second and third quarter, growth is projected to be close to 3 percent for 2007 as a whole. Fiscal policy is on track to achieve balance for 2007, on the traditional budget measure, as required by the new Fiscal Responsibility Law. Executive Directors have commended the improvements in macroeconomic and financial policies that have helped Mexico to reduce significantly external and internal vulnerabilities over the years.

Abstract

This 2007 Article IV Consultation highlights that the economic expansion of Mexico has continued albeit slowed by developments in the United States. Despite some pickup in the second and third quarter, growth is projected to be close to 3 percent for 2007 as a whole. Fiscal policy is on track to achieve balance for 2007, on the traditional budget measure, as required by the new Fiscal Responsibility Law. Executive Directors have commended the improvements in macroeconomic and financial policies that have helped Mexico to reduce significantly external and internal vulnerabilities over the years.

I. Context and Key Issues

1. Since the 1994–95 crisis, Mexico has achieved broad domestic and external economic stability, and vulnerabilities have been sharply reduced. Strengthened macroeconomic policies have brought sustained low inflation and a declining public debt ratio; a fully flexible exchange rate regime has been introduced; financial regulation and supervision have been greatly strengthened; and the public debt has been redeemed of “original sin” and its maturity extended. Given these improved fundamentals, as well as a decline in the current account deficit and external debt to low levels, Mexico has become increasingly resilient to external shocks, and has not been subject to disruptive episodes of capital flight or sharp exchange rate movements. Partly as a consequence, the economy has experienced its own “great moderation,” with output now much less volatile, albeit closely linked to the U.S. cycle.

Selected Vulnerability Indicators, 2006

(In percent of GDP, unless otherwise indicated)

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Source: IMF staff estimates.

Current account balance plus maturing external debt.

For Mexico, public sector includes public enterprises.

Overall fiscal deficit plus debt amortization and rollover.

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.

Credit to the private sector.

2. Despite these successes, Mexico is far from achieving its potential. Notwithstanding the advantages of proximity to the United States, Mexico has not joined the league of fast-growing emerging markets, and there has been no sign of income convergence with the United States. Poverty and inequality remain high (Figures 1 and 2), accompanied by a substantial informal sector and large-scale emigration to the United States. Underlying this are a host of structural problems, including weak infrastructure and education; insufficient competition in key sectors and inflexible formal labor markets; still-limited financial intermediation; and weaknesses in the rule of law. At the same time, new challenges are emerging, most importantly—with oil accounting for more than a third of budget revenues—the fiscal implications of declining oil reserves.

Figure 1.
Figure 1.

Mexico: Social Indicators

After 25 years of low growth, the Mexican economy faces important social and economic challenges-raising income per capita and reducing poverty, regional disparities, and inequalities.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: EMED; Haver Analytics; INEGI; World Bank; and IMF staff calculations.1/ Schneider, Friedirch. 2007. “Shadow Economies and Corruption all over the World: New Estimates for 145 Countries”, University of Linz, Department of Economics.
Figure 2.
Figure 2.

Mexico: Economic Growth from an International Perspective

Economic growth remains insufficient to allow convergence in living standards. Low productivity, rigid markets, and insufficient infrastructure are holding up Mexico against global competition.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: OECD Employment Outlook, 2006; World Economic Forum Global Competitiveness Report, 2007-2008; World Bank; IMF World Economic Outlook; and IMF staff calculations.

3. The new government that took office last December has made an impressive start in addressing these challenges. At the outset of his term, President Calderon set the goal of abolishing extreme poverty and raising GDP per-capita to US$29,000 by 2030. As a first step, in mid-2007, the National Development Plan, set out a wide ranging policy agenda, including ambitious plans to raise infrastructural expenditure and move ahead with structural reforms, with the aim of raising Mexico’s potential growth from 3½ percent to 5 percent by 2012. Moreover, despite the administration’s lack of a congressional majority, several major reforms have been enacted, including a comprehensive fiscal package to help offset declining oil revenues, a reform of civil service pensions, and measures to increase competition in the financial sector and expand access to finance.

4. In this context, the discussions focused on four areas:

  • near-term implications of the recent deterioration in the global economic situation;

  • making the most of recent fiscal reforms, and preparing to address medium- and longer-term fiscal challenges, including declining revenue from oil;

  • catalyzing financial development while maintaining financial stability; and

  • identifying immediate priorities within the long-structural reform agenda.

II. Recent Economic and Financial Developments

5. The economic expansion has continued on a solid footing, albeit affected increasingly by developments in the United States. After an unusually rapid increase through mid-2006, GDP growth has slowed in line with the United States (Figure 3), with solid consumption growth—aided by booming household credit—offset by slowing investment and exports. Despite some pickup in the second and third quarter, in part reflecting a rebound in the U.S. auto industry, growth is projected to average just under 3 percent for 2007 as a whole.

Figure 3.
Figure 3.

Mexico: Real Sector Developments

The economy has slowed, broadly in line with U.S. cyclical developments; so far confidence and domestic demand have held up well.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: Consensus Forecasts; EMED; Haver Analytics; and IMF staff calculations.

6. With inflation—and inflation expectations—above target, the Bank of Mexico (Banxico) has tightened monetary policy this year. After converging briefly to the 3 percent target, inflation has been closer to 4 percent since September 2006, boosted by a series of supply shocks to world food prices, especially corn, sugar and milk. Wage growth so far has not accelerated, and medium-term inflation expectations have been broadly stable—although remaining ½ point above the 3 percent target. In that context, Banxico acted to raise short-term interest rates to 7¼ percent in April, and further to 7½ percent in October, citing the need to avoid second-round effects and to guide downward inflation expectations.

7. Fiscal policy is on track to achieve balance for 2007, on the traditional budget measure, as required by the new Fiscal Responsibility Law (Figure 4). The non-oil augmented fiscal deficit for 2007 is projected to be close to 7 percent of GDP, broadly similar to recent years level.1 2 Within this, a 0.4 percent of GDP decline in net oil revenues, reflecting declining oil production, is being offset by a reduction in operational outlays, while investment and social expenditures increase. Following longstanding policy, PEMEX’ prices for domestic sales of gasoline and diesel were held essentially constant in real terms, now representing a subsidy (since international prices have risen above the Mexican level).

Figure 4.
Figure 4.

Mexico: Fiscal Issues

If the expected decline in oil revenues materializes, gradual improvement in non-oil revenues will be needed. The recent tax reform is an important step in the right direction.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: EMED; Haver Analytics; Mexican authorities; and IMF staff calculations.

Mexico: Financial Operations of the Public Sector, 2002–2008

(in percent of GDP)

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Sources: Mexican authorities; and IMF staff estimates.

IMF staff definitions.

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.

8. Public debt trends remain generally favorable. The public debt to GDP ratio has been steadily declining, and the average maturity of central government traded domestic debt has increased—with the government recently able to issue 30-year nominal fixed rate bonds, albeit in small amounts—although annual rollover of the augmented public debt is relatively high. That said, the net wealth of the public sector may be declining with the continued depletion of Mexico’s proven oil reserves, now down to only 10 years’ production.

9. The external position remains solid, notwithstanding a decline in oil production and negative shocks from the United States (Figure 5). Net oil exports contracted as production faltered, and auto exports to the United States weakened markedly after surging in 2006. Recorded remittances—previously on a strong upward trend—also slowed, seemingly reflecting increased uncertainty over U.S. immigration policy and slowing U.S. activity.3 As a result, the current account deficit rose modestly in the first half of 2007, and a deficit of ¾ percent of GDP is projected for the year as a whole. As in the past, net inflows of foreign direct investment have significantly exceeded the current account deficit this year. In contrast to 2006,4 official reserves have risen this year, by US$5 ½ billion in the first three quarters of 2007; reserves are about 1½ times short-term total external debt on a residual maturity basis (Figure 6).

Figure 5.
Figure 5.

Mexico: External Sector - Trade and Current Account

Mexico’s current account balance strengthened through 2006, helped by rising oil exports and fast-growing remittances. Going forward, these trends may not continue.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: Mexican authorities; EMED; Haver Analytics; IFS; and IMF staff estimates.
Figure 6.
Figure 6.

Mexico: External Sector - Capital Account

Mexico’s capital account has strengthened in recent years, with a reduction in external debt, consistent foreign direct investment, and despite declining private net inflows. International reserves have increased steadily.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: Mexican authorities; Haver Analytics; U.S. Treasury TIC benchmark surveys; and IMF 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.

10. Mexican financial markets have weathered recent global financial volatility well. As in other emerging markets, the global repricing of risk resulted in a significant decline in equity markets, which shed most of their 2007 gains; a modest rise in sovereign bond and CDS spreads (Figure 7); and a modest depreciation of the peso. By October, all these movements had been largely reversed. With Mexican institutions reported to have little or no direct exposure to U.S. sub-prime assets, domestic financial markets have continued to function normally, without need for policy intervention by the authorities. There does not appear to have been significant contagion or withdrawal of liquidity through foreign-owned banks (which account for close to 80 percent of banking system assets).5

Figure 7.
Figure 7.

Mexico: Bond Market Developments

Bond market developments-stable interest rate expectations and low sovereign and currency risks-reflect benign global financial conditions and greater domestic macroeconomic stability.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: Bloomberg L.P.; Consensus Forecasts; Datastream; Haver Analytics; IMF Information Notice System; and IMF staff calculations.

11. The banking system appears sound although rapid consumer credit growth needs careful monitoring. Commercial banks remain well capitalized, profitable and liquid, and nonperforming loans are low. The main potential concern remains rapid growth of bank credit to the private sector (31 percent annual growth through June), primarily to households; delinquent consumer loans have recently edged up, from a low base, although the risks are limited by households’ relatively low debt service ratio (Figure 8).6 Credit to enterprises has recently picked up, but remains very low; corporate financial indicators are relatively strong (Figure 9).

Figure 8.
Figure 8.

Mexico: Household Sector

The household sector has played an important role in the current growth cycle, supported by rising income from wages and remittances and by greater access to bank credit.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: Bank of Mexico; EMED; Haver Analytics; INEGI; and IMF staff calculations.
Figure 9.
Figure 9.

Mexico: Corporate Sector

Indicators of corporate profitability have been strong in recent years. Despite dynamic corporate bond issuance recently, access to finance remains a problem for many firms.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: Bank for International Settlements; CNBV; and IMF staff calculations.1/ Data from the IMF Corporate Vulnerability Utility, based on Worldscope database and covering publicly traded companies only (sample of about 105 corporations).2/ The index is based on Kaplan and Zingales (1997) capturing the degree to which firms are constrained in their access to external financing. A more negative number indicates lesser constraints.3/ Includes nonfinancial public corporations.

III. Outlook and Risks

12. With the economy estimated now to be close to potential, external conditions are key to the near-term outlook (Box 1). While Mexico will benefit from rising oil prices, it will be significantly affected by the weakening in the United States, with staff forecasts of U.S. growth in 2008 revised downward by almost 1 percentage point to 1.9 percent since July. Against this background, the staff project growth at close to 3 percent in both 2007 and 2008—below trend, and gradually reopening a modest output gap. The authorities saw the staff projections as somewhat pessimistic, noting that the staff’s U.S. growth forecast was below Consensus Forecasts; they also thought the impact of the U.S. downturn would be smaller than previously since it was concentrated in housing, while industrial production—which affects Mexico more directly—had been less affected.

13. There was agreement that near-term risks to growth were slanted to the downside. While recent reforms would have a positive impact on confidence—reflected inter alia in sovereign rating upgrades by Fitch and S&P—Mexico would be vulnerable to a more rapid slowdown in the United States. In this event, given Mexico’s much improved fundamentals, there could be room to ease monetary policy, consistent with the inflation targeting framework.

uA01fig01

Risks to the outlook

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

14. Looking into the medium term, staff project that growth will pick up, first through cyclical recovery, but also reflecting faster growth of potential output. The combination of greater infrastructure investment, enhanced efficiency of public investment, and lower long-term interest rates as a result of fiscal reforms should raise potential growth noticeably above the past trend (near 3½ percent). Looking forward, the authorities and staff saw significant upside risks as structural reforms are implemented, with the authorities targeting potential growth to reach 5 percent by 2012.

15. A significant aspect of the medium-term baseline scenario is that—given the combination of slowing oil production and rising domestic fuel consumption—Mexico will lose its status as a net exporter of hydrocarbons. On the fiscal side, lower production will result in a decline in the public sector’s oil income to about 7 percent of GDP in 2012, so that a steady reduction of the non-oil fiscal deficit will be needed to comply with the zero budget balance target (as projected) and avoid a rising public debt ratio (see Section IV.B). On the external side, the combination of slowing exports and rising imports would essentially eliminate the oil trade surplus, shifting the current account into moderate deficit by 2012, and removing the main impulse to the accumulation of official reserves (Section IV.A).

Effects of the U.S. Deceleration on the Mexican Economy

Especially since the introduction of NAFTA, Mexico has exhibited strong sensitivity to the U.S. business cycle, which has continued recently. Real external linkages now seem more important for Mexico than financial linkages.

  • Staff’s analysis of the Mexican business cycle (Selected Issues, Chapter I) confirms that a close relationship with U.S. cycle continues. The co-movement between Mexican GDP and U.S. real activity is strong, with a close alignment of turning points.

  • Changes in U.S. real economic variables can account for as much as 45 percent of Mexican output fluctuations. This likely reflects the close trade integration with the United States; more than 85 percent of Mexico’s exports destined to the U.S. market.

  • Indicators of U.S. output—whether industrial production, or total GDP—seem more important than U.S. domestic demand, reflecting that much of Mexico’s exports are intermediate goods, rather than final consumption goods. This export structure could work to Mexico’s advantage if the U.S. external account deficit were to contract sharply (since U.S. final demand would then fall faster than U.S. output).

  • Staff’s analysis suggests that external financial conditions, and international oil prices, also influence Mexican GDP, but to a much lesser extent than real variables. This finding contrasts to some recent analyses for other emerging markets in Latin America (e.g., Zettelmeyer et al, 2007), where financial linkages seem more important. A possible explanation is that Mexican balance sheets are stronger (and so less vulnerable to tightening of international financial conditions). The smaller degree of financial intermediation in Mexico, and smaller external debt, may make Mexico less sensitive.

  • Data limitations prevented quantifying the role of remittances in transmission of the U.S. business cycle, but other work suggests that U.S. downturns do lead to slower remittances. While remittances to Mexico are much less important (about 3 percent GDP, or 5 percent of private consumption) than elsewhere, a sharp slowdown could still have a non-negligible impact on domestic demand.

uA01fig02

Economic activity in Mexico and the United States

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: IMF staff projections for GDP; U.S. industrial production projections from Consensus Forecasts.

Implications for the near-term outlook:

The current deceleration of U.S. activity is expected to have less impact on Mexico than in the past, as this time U.S. industrial production is expected by most analysts to fare better than U.S. GDP (in contrast to the 2001–02 cycle, with the opposite pattern).

Mexico: Medium-Term Staff Scenario: Main Elements

(In percent of GDP, unless otherwise indicated)

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Sources: Mexican authorities; and IMF staff estimates.

IMF staff definitions.

IV. Policy Discussions

A. Monetary Policy and Foreign Exchange Management

16. Banxico has been generally successful in containing the impact of inflation shocks. While inflation—as in other countries—recently has been pushed upward by a series of supply side shocks from international food prices, medium-term inflation expectations have remained anchored, albeit modestly above the 3 percent inflation target (Figure 10). Importantly, such expectations seem no longer to be backward looking, but consistently have looked beyond the effects of recent supply shocks, predicting that inflation will fall back, to around 3½ percent. Yet the situation is not fully satisfactory, since it leaves open the question of convergence of inflation to the 3 percent inflation target.

Figure 10.
Figure 10.

Mexico: Inflation and Monetary Policy

Inflation has remained at about 4 percent in recent quarters; the central bank has twice tightened monetary policy in 2007, seeking convergence to the 3 percent inflation target.

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: Bloomberg L.P.; EMED; Haver Analytics; INEGI; and IMF staff calculations.
uA01fig03

Observed and expected inflation

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Sources: EMED; Haver Analytics; and IMF staff calculations.1/ Expectations for 2003–2004 are annual average of 2005–2008.Expectations for 2005–2007 are annual average of 2006–2009.

17. At the present juncture, Banxico faces the challenging task of weighing upside inflation risks from supply side shocks against downside risks from weakening external demand. On the one hand, the authorities noted that external supply-side shocks—most recently, wheat prices—continued, while the recent tax reform would put upward pressures on prices in 2008, although the extent was difficult to estimate (partly reflecting concerns that these could adversely affect expectations, the introduction of the gasoline excise was delayed to January 2008). On the other hand, the 50bp reduction in the Fed Funds rate in September was a de facto tightening for Mexico; and looking forward, the weakening U.S. outlook could be expected to reduce demand pressures, and thereby the risk of second round effects. Overall, the team considered that the current policy stance—judged moderately restrictive—was appropriate for the time being, with the next move depending importantly on incoming data, including with respect to developments in the United States, as well as wage settlements and inflation expectations. The authorities emphasized that they would continuously evaluate the policy stance in light of the 3 percent inflation target; in October, Banxico raised rates by 25bp, to 7½ percent.

18. The team welcomed the progress being made in enhancing Banxico communications. In May 2007, Banxico for the first time published a conditional forecast that convergence to the inflation target would occur within a specified time horizon (in that case, about 18 months); the monthly monetary policy press releases were also revamped to focus more on factors affecting inflation beyond the short term. In October, Banxico took the further step of publishing a projected quarterly path for inflation over a 2-year horizon, indicating convergence to target near the end of 2009. The team observed that these measures, especially the communication of a projected inflation path, along with Banxico’s rolling commitment to achieve the inflation target, would facilitate market adjustment to recent and future shocks, as well as convergence of inflation and inflation expectations to target. Looking forward, a further desirable step would be to publish Banxico’s inflation model.

19. Mexico operates an independently floating exchange rate system, and the team welcomed the continued observance of the transparent auction rule in place since early 2003 (Box 2). Banxico passively accumulates part of the public sector’s net foreign exchange cash flow, but abstains entirely from discretionary purchases or sales of foreign exchange, and thus the market-determined exchange rate remains fully flexible in both directions. This transparent regime—applied equally during times of peso appreciation and depreciation—has facilitated the inflation targeting framework, and by allowing continuous adjustment, it has avoided making Mexico a target of speculative inflows or outflows of capital.

The Foreign Exchange Policy Regime, and Accumulation of Reserves

  • The Bank of Mexico (Banxico) has not engaged in discretionary purchases or sales of foreign exchange in this decade.

  • Still, Banxico accumulates reserves passively, partly from capitalization of interest earnings, but mainly by (net) purchases of the public sector’s net foreign exchange cash flow (principally, proceeds from oil exports and from external borrowing, less amortization of external debt). Of these net inflows, Banxico sells 50 percent to the private market, via daily auctions, following a rule established in early 2003.

  • The exchange rate is completely flexible on any given day, and in general is free to react fully to changes in fundamentals. At the same time, the pace of Banxico’s passive reserve accumulation, via oil export revenue, can be influenced by fluctuations in oil export prices; this may dampen the sensitivity of the peso to such price fluctuations (relative to an alternative policy in which Banxico would auction 100 percent of the oil earnings it receives).

  • Over the 2003–06 period, Mexico’s reserves expanded by approximately US$17 billion, about 2 percent of 2006 GDP. Compared to other emerging markets during this period, Mexico’s reserve accumulation was among the slowest.

uA01fig04

Gross international reserves in twenty emerging markets

Citation: IMF Staff Country Reports 2007, 379; 10.5089/9781451825817.002.A001

Source: IMF staff calculations.
  • At end-2006, Mexico’s reserves—again, viewed in relation to GDP—were second-smallest in this sample, at about 9 percent. Still, Mexico’s reserves appear adequate by standard indicators, such as ratios to short-term external debt, imports, and M2 (Tables 3 and 6).

  • The staff also applied the Jeanne-Ranciere (2006) model of “optimal reserves” to Mexico. While results from this approach are very sensitive to parameter assumptions, they tend to support the view that Mexico’s reserves were too low some years ago, but have reached an adequate level.

Table 1.

Mexico: Selected Economic, Financial, and Social Indicators, 2000–2008

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

Includes adjustments for development banks, Pidiregas, oil stabilization fund, IPAB.

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, 2003–2012

(In percent of GDP)

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Sources: Mexican authorities; and IMF 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.

PSBR excl. nonrecurrent revenue

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.

Transfers to subnational governments include revenue-sharing and earmarked transfers, but excludes decentralization agreements.

Table 3.

Mexico: Summary Balance of Payments, 2003–2012

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

Includes pre-payment of external debt.

Includes financing of PIDIREGAS.

Excluding oil exports and petroleum products imports.

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, 2000–2007 1/

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Sources: Bank of Mexico; National Banking and Securities Commission; and IMF 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.