Abstract
This Selected Issues paper analyzes the global crisis and potential growth in Mexico. The paper uses two methodologies to assess to what extent the global crisis is likely to weigh on Mexico’s growth potential. The first approach is sectoral, examining the historical relationship between financial stress and growth in manufacturing industries. The second approach uses a growth-accounting framework to take a closer look at likely developments in the factors that drive potential growth. The paper also examines spending patterns and risks of expenditures volatility from unanticipated shocks in macroeconomic variables under two alternative fiscal rules.
I. The Global Crisis and Potential Growth in Mexico1
A. Introduction and Summary
1. Financial crises tend to lead to some permanent output loss by slowing not only actual but also potential growth. The range of the estimated permanent effects is large—at the high end, Cerra and Saxena (2008) suggest 4 to 16 percent loss in medium-term potential output, while others estimate smaller losses, with Furceri and Mourougane (2009) suggesting some 1½ to 4 percent, and the European Commission (2009) 3 to 5 percent.
2. Given the importance of distinguishing between shortfalls in output and a reduction in productive capacity, a well-considered view of the impact of the global financial crisis will be a key input to policy decisions over the coming years. This paper uses two methodologies to assess to what extent the global crisis is likely to weigh on Mexico’s growth potential.
The first approach is sectoral, examining the historical relationship between financial stress and growth in manufacturing industries. Empirical results suggest that financial stress tends to act as a drag on growth, the more so the larger the sector’s exposure to external (bank or market) financing. As persistently stressed conditions may reduce the likelihood that the associated output loss would be recouped over the medium term, the impact could show in lower actual as well as potential growth, particularly over the short term.
The second approach uses a growth accounting framework to take a closer look at likely developments in the factors that drive potential growth. Slower capital accumulation due to higher funding costs and weaker confidence, combined with a dip in total factor productivity growth imply a sizeable drop in potential growth over the near term. Normalization in these factors following the crisis allows potential growth to recover gradually.
3. Both approaches suggest a short-term drop in potential growth of about ¾ to 1 percentage points, with gradual recovery to pre-crisis levels. Comparing the implied potential output path with a counterfactual that assumes steady potential growth of about 3 percent (average growth in 2002-07) suggests a permanent output loss of about 2 ½ percent by 2014. Although this falls in the lower range suggested by the literature, it is significant, and highlights the importance of growth-enhancing reforms.
Potential GDP (billions of 2003 pesos)
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Potential GDP (billions of 2003 pesos)
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Potential GDP (billions of 2003 pesos)
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
B. Financial Stress, Sectoral Growth, and Implications for Potential
4. Disruptions to financial intermediation are expected to influence various economic sectors differently, depending among others on the sector’s exposure and links to the financial system. The direct impact of the crisis would be reflected in the performance of the financial intermediation and real estate (FIRE) sector. Other sectors would be indirectly affected: persistently tight financial conditions would slow investment and—as Estevão and Severo (2010) suggest—sectoral TFP growth through lower R&D and innovation, with the strength of the effect likely larger in sectors that use financial intermediation services more extensively.
5. The direct impact on FIRE services may remain modest in Mexico. Reflecting ongoing re-intermediation in the aftermath of the 1995 crisis, the FIRE sector’s growth contribution averaged 0.8 percent in the 2004-07 period—higher than the 0.6 percent seen in the U.S. over the longer term or over the same period. However, the Mexican financial sector has experienced less stress and is looking ahead to less significant balance sheet adjustment than financial firms in the US. This suggests that the direct effects on the sector would be smaller and shorter-lived, probably close to or below the lower end of the 0.6 to 0.2 percent range suggested for the U.S. by Barrera et al (2009).
6. In contrast, indirect effects are likely to be more significant. For the US, Barrera et al (2009) estimate that the magnitude of indirect effects is about two-thirds of the direct effects. In Mexico, this ratio could be higher. Although Mexican firms are less exposed to market and bank financing, U.S. financial conditions exert a significant influence on economic activity in Mexico—in fact, the financial channel for spillovers appears to dominate the trade channel (Swiston and Bayoumi (2008)).
7. To calibrate the indirect impact of the financial crisis, a closer look at sectoral growth and financial stress in the U.S. is warranted. As a first step, a panel regression was estimated for the 1982-2007 period on annual data, linking growth in Mexico’s manufacturing sectors to a measure of financial stress in the US:
The dependent variable is log change in industrial production for 8 industries.2 The explanatory variables include U.S. growth (gUS) measured in log changes; the Financial Stress Index for the U.S. (FSIUS); a dummy variable taking the value of one in 1995 and zero otherwise (d95); and industry constants (c).
8. The Financial Stress Index (FSI) captures the extent to which the financial system is under stress and its ability to intermediate is impaired. During periods of stress, there may be large shifts in asset prices, uncertainty, risk; reduced liquidity; and concerns about the banking sector. To capture these factors, Cardarelli et al (2009) and Balakrishnan et al (2009) constructed an index summarizing developments in security and exchange markets and in the banking sector. For advanced economies, the components of the index include (i) corporate bond spreads, stock market returns and stock return volatility (to capture the status of securities markets); (ii) exchange rate volatility (to capture the status of FX markets); and (iii) banking-sector stock price volatility, the interbank rate—treasury yield spread and the slope of the yield curve (to capture the status of the banking sector).3 The index is normalized such that its long-term average is zero and its variance is one.
9. Empirical results confirm that the strength of the effect of financial stress on growth shows significant dispersion across industries. As the Figure illustrates, the estimated coefficients on FSIUStend to be higher in sectors that are more exposed to external financing (as measured by the modified Rajan-Zingales (1998) index constructed by Estevão and Severo (2010)) both in Mexico and in the US.4 The cluster of industries most affected by financial stress includes basic metals, fabricated metals, and machinery—industries with high reliance on external finance, and in the case of Mexico, strong ties to the US.
Mexican manufacturing industries Impact of financial stress on growth and industry dependence on external financing 1/
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Mexican manufacturing industries Impact of financial stress on growth and industry dependence on external financing 1/
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Mexican manufacturing industries Impact of financial stress on growth and industry dependence on external financing 1/
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
U.S. manufacturing industries Impact of financial stress on growth and industry dependence on external financing 1/
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Source: Rajan, R. - Zingales, L, (1998), “Financial Development and Growth”, American Economic Review, 88(3): 559-586, INEGI, Haver Analytics, and IMF staff estimates.1/ The vertical axis depict the index of dependence on external financing. The horizontal axis represents the estimated sensitivity of industry growth to financial stress.U.S. manufacturing industries Impact of financial stress on growth and industry dependence on external financing 1/
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Source: Rajan, R. - Zingales, L, (1998), “Financial Development and Growth”, American Economic Review, 88(3): 559-586, INEGI, Haver Analytics, and IMF staff estimates.1/ The vertical axis depict the index of dependence on external financing. The horizontal axis represents the estimated sensitivity of industry growth to financial stress.U.S. manufacturing industries Impact of financial stress on growth and industry dependence on external financing 1/
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Source: Rajan, R. - Zingales, L, (1998), “Financial Development and Growth”, American Economic Review, 88(3): 559-586, INEGI, Haver Analytics, and IMF staff estimates.1/ The vertical axis depict the index of dependence on external financing. The horizontal axis represents the estimated sensitivity of industry growth to financial stress.10. To capture the idea that the effect of financial stress may vary with the sector’s exposure to external finance, the relationship between sectoral growth and the interaction of FSIUSand the indicator of dependence on external finance was also examined. Table 1 reports results from estimating the following equation:
where MRZi is the modified Rajan-Zingales index of the sectors’ dependence on external finance, calculated as the fraction of capital expenditures not financed by cash-flow from operations.
Financial Stress and Industry Growth Rate
Dependent Variable: Industry Growth Rate 1/
OLS estimates. Growth for select manufacturing industries measured in log differences.
Dependence on external financing is measured by the modified Rajan-Zingales index Financial stress is measured by the Balakrishnan & al financial stress index for the US. The financial stress index is lagged 2years.
Financial Stress and Industry Growth Rate
Dependent Variable: Industry Growth Rate 1/
| Coeff | Std. err | t-stat | Coeff | Std. err. | t-stat | |
|---|---|---|---|---|---|---|
| Dependence on external financing * US FSI 2/ | -0.016 | 0.01 | -2.90 | -0.013 | 0.01 | -1.84 |
| US growth | 0.771 | 0.22 | 3.51 | 2.452 | 0.31 | 7.91 |
| Fixed effects | y | y | ||||
| 1995 dummy | y | n | ||||
| Estimation period | 1982-2007 | 1998-2007 | ||||
| Number of observations | 208 | 88 | ||||
| Adjusted R-squared | 0.18 | 0.54 | ||||
| F-s tatis tic | 5.46 | 12.53 |
OLS estimates. Growth for select manufacturing industries measured in log differences.
Dependence on external financing is measured by the modified Rajan-Zingales index Financial stress is measured by the Balakrishnan & al financial stress index for the US. The financial stress index is lagged 2years.
Financial Stress and Industry Growth Rate
Dependent Variable: Industry Growth Rate 1/
| Coeff | Std. err | t-stat | Coeff | Std. err. | t-stat | |
|---|---|---|---|---|---|---|
| Dependence on external financing * US FSI 2/ | -0.016 | 0.01 | -2.90 | -0.013 | 0.01 | -1.84 |
| US growth | 0.771 | 0.22 | 3.51 | 2.452 | 0.31 | 7.91 |
| Fixed effects | y | y | ||||
| 1995 dummy | y | n | ||||
| Estimation period | 1982-2007 | 1998-2007 | ||||
| Number of observations | 208 | 88 | ||||
| Adjusted R-squared | 0.18 | 0.54 | ||||
| F-s tatis tic | 5.46 | 12.53 |
OLS estimates. Growth for select manufacturing industries measured in log differences.
Dependence on external financing is measured by the modified Rajan-Zingales index Financial stress is measured by the Balakrishnan & al financial stress index for the US. The financial stress index is lagged 2years.
11. The magnitude of the estimated coefficient on the financial stress variable, taken together with the average dependence of Mexican manufacturing on external finance, suggests that a unit of financial stress tends to reduce manufacturing growth by about 0.4 percent.56 The effect is economically significant: these estimates suggest that easy financing conditions added an annual ¾ percentage points to average manufacturing industry growth during 2003-07. Based on historical correlations, this would translate to an impact on GDP growth of about 0.4 percentage points.7
12. With the caveat that the recently observed levels of financial stress are unprecedented in the sample, and simple extrapolation may be misleading, an estimate of the growth impact of the financial crisis can also be ventured.
The observed levels of financial stress in 2008-09 would imply a cumulative drag of about 2½ percent in 2009-10 on manufacturing growth, or a GDP growth effect of about 1½ percent.
Assuming that stress levels for the next few years will moderate considerably but remain around levels observed in 1986-87, the aftermath of the Savings & Loans crisis in the US, manufacturing growth would be lower by about ¾ percentage point, and GDP growth by about 0.4 percentage point. The effect would peter out over the longer term as financial conditions normalize.
13. How to translate these back-of-the-envelope calculations for the impact on actual growth to the impact on potential growth? The first observation is that the effects on actual growth are likely to represent an upper bound; indeed, proper policy responses to crises may mitigate the drag on potential growth as they minimize or offset lasting effects on labor input and TFP. The second observation is that, given the likely persistence of financial stress, most of the associated output loss is nevertheless unlikely to be recouped over the next few years—that is, the hit to potential growth may be similar to the hit to actual growth.
14. Putting these considerations together, the combined direct and indirect effects suggest that the financial crisis may have lowered potential growth in Mexico by about ¾ to 1 percentage point. As the performance of financial intermediation recovers and stress lessens, so should the drag on capital stock building and TFP growth, allowing potential growth to accelerate. Applying these markdowns to the potential growth estimate of about 3 percent in the years before the crisis suggests a slowdown to the 2 to 2¼ percent range followed by a gradual recovery to pre-crisis levels.
C. What Factors of Production Drive the Projected Potential Growth Path?
15. Potential growth projections can also be approached from a growth accounting perspective. In As Barrera et al (2009) and Estevão and Tsounta (2010) assume for the case of the U.S. and Canada, potential output growth can be thought of as the sum of potential total factor productivity (TFP) growth, contribution from potential capital stock growth, and contribution from potential labor input growth. the Cobb-Douglas case with standard labor and capital share assumptions, the growth accounting exercise yields the following decomposition of potential output growth:
16. That is, potential growth (measured as log change in potential output) on the left hand side is decomposed into:
The contribution from potential (or trend) TFP growth dap;
The contribution from potential capital stock growth—that is, the capital contribution assuming that the actual capital stock is fully utilized (the capital utilization rate is at its trend level utilp);
The contribution from potential labor input growth—that is, the labor contribution assuming that both the participation rate and the unemployment rate of the actual working-age population (wp) are at their trend level (partp and up, respectively).
17. Taking a bottom-up approach, the respective paths for the underlying potential growth components (illustrated in the Figure) were constructed as follows:
Capital stock was estimated based on the perpetual inventory methodology, assuming annual amortization of 7½ percent. Looking forward, staffs World Economic Outlook projections for investment are used to extend the series.
Trend capacity utilization was assumed to stabilize around 81 percent in the future, broadly in line with the long-run average in U.S. manufacturing.8
The projection for working-age population growth was based on World Bank estimates.
The smoothed participation rate was assumed to stabilize at 59.4 percent, while the structural unemployment rate was assumed to increase a notch in 2009-10 before returning to 3.4 percent over the medium term.9
For potential TFP growth, the observed dip in 2008 to 0.2 percent was assumed to persist in 2009-10. It then gradually recovers to around 0.6 percent, about the same level as observed on average in 2000-07.
18. Of course, the historical decomposition of potential growth is subject to considerable error. Data availability, including relatively short time series and the lack of hours and capital stock data, limits the robustness of the analysis. The short history complicates the identification of trends; it is particularly problematic to control for the effects of the 1995 crisis. In addition, the methodology used to estimate the capital stock may lead to understating TFP contribution to growth. Depreciation rates may be sensitive to structural shifts and crises, with a larger share of the capital stock amortizing as, for example, the economy becomes more open to trade and the environment changes significantly for some sectors. Not taking this into account would tend to bias estimated capital stock growth upwards and TFP growth (both actual and potential) downwards.
19. Projections are also surrounded by considerable uncertainty. Growth-enhancing structural reforms may boost medium-term TFP growth, and the recovery of investment may be stronger than projected as the global economy recovers and financial conditions normalize. Considerable uncertainty surrounds labor market projections as well—participation rates may continue rising as a result of higher female participation, and reforms may influence the structural unemployment rate.
Decomposition of potential growth, 1995-2014
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Decomposition of potential growth, 1995-2014
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
Decomposition of potential growth, 1995-2014
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
20. With these caveats in mind, the resulting path for potential growth suggests that investment and TFP developments would be driving changes over the medium term. The significant reduction in potential growth from around 3 percent in the past few years to 2-2¼ in 2009-10 is mostly the result of lower capital contribution—the consequence of the investment collapse during the crisis—with some added drag from lower TFP growth. The projected medium-term acceleration of potential growth back to around 3 percent is driven by the return of capital growth to its longer-term trend and a gradual recovery of TFP growth.
Mexico: Decomposing Potential Output Growth
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
source: INEGI, OECD, Haver Analytics, and IMF staff estimatesMexico: Decomposing Potential Output Growth
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
source: INEGI, OECD, Haver Analytics, and IMF staff estimatesMexico: Decomposing Potential Output Growth
Citation: IMF Staff Country Reports 2010, 070; 10.5089/9781451981834.002.A001
source: INEGI, OECD, Haver Analytics, and IMF staff estimatesReferences
Balakrishnan, R., S. Danninger, S. Elekdag, and I. Tytell (2009), “The Transmission of Financial Stress from Advanced to Emerging Economies”, IMF Working Paper No. 09/133, Washington, DC.
Barrera, N., M. Estevão, and G. Keim(2009),“U.S. Potential Growth in the Aftermath of the Crisis,” IMF Country Report No. 09/229, International Monetary Fund.
Cerra, V. and S. Saxena(2008), “Growth Dynamics: The Myth of Economic Recovery,” American Economic Review, Vol. 98(1), pp. 439–457.
Cardarelli, R., S. Elekdag, and S. Lall(2009), “Financial Stress, Downturns, and Recoveries”, IMF Working Paper No. 09/100, Washington, DC.
Estevão, M., and T. Severo, (2010),“Financial Shocks and TFP Growth”, IMF Working Paper No. 10/23, Washington, DC.
Estevão, M., and E. Tsounta (2010), “Canada’s Potential Growth: Another Victim of the Crisis?” IMF Working Paper No. 10/13, Washington, DC.
European Commission (2009), “Impact of the Current Economic and Financial Crisis on Potential Output,” Occasional Papers No. 49, June 2009, Directorate-General for Economic and Financial Affairs.
Furceri, D., and A. Mourougane (2009), “The Effect of Financial Crises on Potential Output”, OECD Economics Department Working papers No. 699.
International Monetary Fund (2009a), World Economic Outlook, Sustaining the Recovery, October.
International Monetary Fund (2009b), World Economic Outlook, Crisis and Recovery, April.
Rajan, R., and L. Zingales (1998), “Financial Development and Growth”, American Economic Review, 88(3): 559–586.
Swiston, A., and T. Bayoumi (2008), 2008, “Spillovers across NAFTA”, IMF Working Paper No. 08/03, Washington, DC.
Prepared by Kornélia Krajnyák.
One-digit manufacturing industries according to the old industry classification. “Other” industries were dropped from the sample.
The construction of the FSI for emerging markets includes a somewhat different list of variables (banking sector beta, stock market returns and volatility, sovereign spreads, and an indicator capturing exchange rate and reserve developments). For Mexico, the index is available from 1997, and moves very closely with the U.S. FSI in the 1997–2007 period.
The U.S. sample includes a more detailed breakdown of manufacturing industries. Right-hand-side variables in the estimated equation are lagged GDP growth, lagged FSI, and industry constants.
Industry weights were calculated based on production weights for manufacturing industries as reported by INEGI in http://www.inegi.org.mx/prodserv/contenidos/espanol/biblioteca/Default.asp?accion=2&upc=702825001785& s=est&c=15696.
Indirect effects through U.S. growth may amplify the negative impact. The estimated coefficient for U.S. industries is virtually identical, but stronger dependence on external finance amplifies the average effect to 0.6 percent.
GDP growth and manufacturing growth co-moved strongly over the last decade, with a linear regression coefficient around 0.6.
The available capacity utilization series for Mexico is short, and is not conducive to deducing trends. The smoothed historical series are based on an HP-filter run on the available data.
For both the participation and the unemployment rate, the smoothed series are generated by HP-filtering.
