Staff Report for the 2011 Article IV Consultation

Strong fundamentals and a policy track record helped Mexico to withstand the fallout from the global crisis and aided recovery. The policy challenges have to take due account of significant global uncertainty, employment generation, and long-term fiscal reforms. The economy will benefit from rebuilding fiscal policy buffers over the medium-term. The flexible exchange rate regime has helped Mexico. The long-term challenges include declining oil reserves relative to GDP and population aging. Advancing structural reforms to increase productivity and promote investment will help in increasing the growth potential.


Strong fundamentals and a policy track record helped Mexico to withstand the fallout from the global crisis and aided recovery. The policy challenges have to take due account of significant global uncertainty, employment generation, and long-term fiscal reforms. The economy will benefit from rebuilding fiscal policy buffers over the medium-term. The flexible exchange rate regime has helped Mexico. The long-term challenges include declining oil reserves relative to GDP and population aging. Advancing structural reforms to increase productivity and promote investment will help in increasing the growth potential.


1. Mexico’s rapid rebound from the fallout of the global crisis attests to its strong fundamentals and to the authorities’ skillful management of the economy. The V-shaped recovery in output and domestic demand has been underpinned by sound public, private, and financial balance sheets, as well as by the presence of a credible policy space to deploy an effective countercyclical response (Box 1). The authorities’ adroit management of the economy has been instrumental, within the context of the global recovery, to Mexico’s strong economic rebound. In particular, fiscal and monetary policies have been sound, and Mexico’s flexible exchange rate regime has provided a useful shock absorber, helping support the recovery. The three successive FCL arrangements have backed the authorities’ macroeconomic strategy by providing a significant buffer against potential tail risks.1

2. Robust growth has brought output back to pre-crisis levels. Manufacturing exports have led the recovery, with a rebound in domestic demand helping sustain the momentum. Strong links with the U.S., particularly in manufacturing, have helped jump-start growth. The recovery in consumption has also been pronounced, linked to a recovery in employment, while the upswing in investment, which has been more subdued, now appears to be gaining momentum as excess capacity is being absorbed. Output has returned to pre-crisis levels, while a broad set of economic indicators suggests that demand pressures remain subdued. While employment has been improving, unemployment and underemployment remain above pre-crisis average levels. Credit to the private sector is recovering firmly, with growth still below pre-crisis rates. In this context, inflations dynamics have remained benign, with headline and core inflation declining to close to the 3 percent target.

3. Mexico’s cyclical recovery and easy foreign financing conditions have rekindled capital inflows and currency appreciation. Portfolio inflows reached US$37 billion in 2010, a historical high, with most of these flows (US$23 billion) into government bonds. This responded in part to the inclusion of Mexico in the global bond index WGBI, which has attracted long-term institutional investors to Mexico’s strong sovereign credit. Inflows into treasury bills accelerated early this year, linked in part with carry trade operations.

Figure 1.
Figure 1.

Mexico: Evolution of the Real Sector, 2005-11

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Corporates and Households Balance Sheets

Leverage levels in Mexico are moderate. The government debt level is quite manageable, while corporate and households leverage is modest. Mexico’s V-shaped recovery has been supported by the lack of significant balance sheet repair needs.

Corporates remain profitable and with moderate leverage. A sample of 159 large corporates suggests that profits were resilient to the crisis, and that leverage levels remain modest. While the average share of foreign debt has declined to about 30 percent of the total, short-term debt still accounts for about two-thirds of total debt.

Household debt remains relatively low, at about 20 percent of disposable income. Consumer credit amounts to less than 7 percent of disposable income and has not returned to pre-crisis levels. Mortgage lending has been more dynamic, but remains below 15 percent of disposable income.


Profits to Assets Ratio

(in percent)

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Source: EconomaticaNote: Distribution according to deciles. The darker tones correspond to the middle deciles, and paler tones to the top and bottom ones.


(Assets to Equity Ratio)

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Households debt, 2005-10

article image
Source: Banxico, INEGI, and Staff estimates.

4. While the policy stance has supported the recovery, the policy mix has helped contain the effects of abundant global liquidity. Following the fiscal and monetary stimuli introduced in the wake of the global financial crisis, fiscal consolidation is underway to withdraw the stimulus while monetary policy remains appropriately supportive. The prudent policy mix, together with long-standing judicious banking regulations, has helped limit the effects of capital inflows in the context of ample global liquidity. Ongoing efforts to improve the structure of the public debt, including with a noticeable lengthening in average maturities, have also helped improve resilience.2

  • Fiscal consolidation is underway to withdraw the 2009 fiscal stimulus (3 percent of GDP). The 2010 tax package (1 percent of GDP) and spending restraint this year and last will help unwind the stimulus (in part by saving oil revenue windfall). In this context, gross public debt has stabilized at about 43 percent of GDP.

  • Monetary conditions remain relatively accommodative. The policy rate has been kept at its lowest level of 4.5 percent since mid-2009, equivalent to a rate of around 1 percent (ex-ante) in real terms. The appreciation of the peso (nearly 10 percent against the U.S. dollar over the past year) has partially offset the monetary stimulus. Inflationary pressures remain subdued and medium-term inflation expectations are firmly anchored, albeit still somewhat above target.

  • The tightening of the fiscal stance, in the context of a somewhat accommodative monetary policy and longstanding prudent banking regulation on FX liquidity, has helped ease capital inflows associated with carry trade operations (Box 2).

  • The real effective exchange rate has appreciated considerably since the global financial crisis, but remains somewhat below the average level before the crisis. CGER estimates indicate that the peso is broadly in line with fundamentals, with the external current account deficit expected to remain moderate over the medium term (Box 3).

Figure 2.
Figure 2.

Mexico: Monetary Policy, 2005-11

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Sources: Banxico, EMED, Haver Analytics, Bloomberg LLP, WEO, and IMF staff calculations.1/ Defined as overnight interest rate minus 12 months ahead inflation expectations.
Figure 3.
Figure 3.

Mexico: Fiscal Sector, 2006-11

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Sources: SHCP, Haver Analytics, and IMF staff calculations.

Foreign Exchange Liquidity Coefficient

International experience has shown that maturity and currency mismatches in the banking sector can amplify an exchange rate shock and create banking and balance of payments disruptions. In addition, Mexico’s past crises revealed that FX risk exposures can be higher than suggested by net open positions, because banks can be actively engaged in a variety of operations, including speculative structured notes in domestic currency linked to the exchange rate.

Learning from past crises, Mexico’s central bank has had long-standing regulations on foreign exchange exposures, including through a liquidity coefficient in foreign currency. These regulations encourage banks to have limited twin currency/maturity mismatches, maintaining adequate liquidity in foreign currency, thereby requiring them to internalize the risk of operating in a currency for which the central bank has limited lender of last resort capacities.

The FX liquidity coefficient makes it very expensive for banks to borrow in foreign currency and lend in pesos, limiting capital inflow intermediated by the banking system and its ability to be counterparty in carry trade operations. To prevent regulatory avoidance, the central bank has included in the definition of foreign exchange positions the peso-denominated notes that are linked to the exchange rate. In the event, the FX liquidity coefficient proved useful to limit the impact of volatile capital flows on Mexican banks during the 1998 Russian crisis and the recent global financial crisis.

5. Mexico’s foreign reserves buffers have been reinforced through oil revenue windfalls and an increased FCL insurance.

The authorities have enhanced foreign reserve buffers predominantly through higher sales from the state oil company (Pemex), while the FCL remains a significant insurance against tail risks. Gross international reserves stand now at US$131 billion, up US$27 billion over the last 12 months, with intervention through rule-based options amounting to less than US$6 billion. Moreover, the authorities have complemented their own international reserves buffers with a new FCL arrangement in January 2011 (with an increased access from 1000 to 1500 percent of quota, or about US$73 billion) to insure against the tail risk of renewed major global dislocations.

6. The financial sector in Mexico proved resilient during the global financial crisis, with credit growth supporting the recovery. Financial soundness indicators did not deteriorate significantly during the crisis, with the absence of major strains in the banking system owing, in part, to a large deposit base, the absence of large complex off-balance sheet activities, and limited cross-border linkages. Capital adequacy ratios and liquidity indicators are now above pre-crisis levels. Non-performing loans, which rose only moderately, have fallen back and are well provisioned. The recent stress testing by Mexico’s Financial Stability Council confirmed the resilience of the banking system to potential adverse shocks. In addition, related party lending regulations have been tightened further. Credit growth to the private sector has recovered, and is now expanding in line with the cyclical recovery in financing needs.

Mexico: Exchange Rate Assessment

Mexico’s real effective exchange rate (REER) has increased considerably since the trough of the peso during the global crisis. Although this increase amounted to 18 percent through April 2011, the REER is still about 4 percent below the average pre-crisis level. In this context, Mexico’s export performance has improved and its market share in the U.S. has recovered from pre-crisis lows, moving above the early-2000 levels.

The current account deficit, which narrowed during the global crisis, is expected to widen gradually over the medium term. Mexico’s oil balance is expected to deteriorate gradually under the production and consumption trajectories currently envisaged. The declining oil balance is expected to be partially compensated by the improvement in the non-oil balance. As a result, the current account deficit will widen gradually to about 1½ percent of GDP by 2016, a moderate and sustainable level.

CGER estimates indicate that the peso is broadly in line with fundamentals. The macroeconomic balance approach suggests that the real effective exchange rate is only marginally (6 percent) above its medium-term value, although the result is sensitive to the envisaged trajectory of the oil balance. The equilibrium real exchange rate and external sustainability approaches show the real exchange rate to be modestly below its medium-term value. 3 On average, there is no strong indication that the peso is significantly apart from its equilibrium level.


Mexico: REER developments


Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Sources: BIS, and INS

Mexico: Market Share in the U.S.

(in percent of U.S. imports)

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Source: DOTS

Mexico: Current Account Developments

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Sources: Banxico, and staff calculations
3 The macroeconomic balance, equilibrium real exchange rate, and external sustainability approaches show the peso to be broadly in line with its estimated medium-term value at, respectively, 6 percent above and −11 percent and −1 percent below the estimated norms.
Figure 4.
Figure 4.

Mexico: Evolution of the External Sector, 2005-11

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Sources: Banxico, IFS, Haver Analytics, and IMF staff calculations.1/ Defined as the difference in the 3-Month risk free interest rate swap of Mexico and the United States divided by the volatility of a 3-Month at-the-money USD/MXN option.
Figure 5.
Figure 5.

Mexico: Financial Sector, 2005-11

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Sources: Banxico, Bloomberg LLP, Dealogic, Economatica, CNBV, WEO, Haver, Financial Soundness Indicators Database, and IMF staff calculations.1/ Size of bubbles represents total assets2/ The horizontal axis is cut at 30 in order to present the largest 11 banks, which account for 90% of the banking system.


7. Strong growth is envisaged to continue this year and into 2012, bringing output in line with potential, but important downside risks persist linked to the global outlook. The near term outlook is supported by the expected continued recovery in the U.S. and solid domestic demand growth in Mexico, notwithstanding some softening in growth in the first half of this year. Over the medium term, growth is envisaged to converge to Mexico’s potential growth rate, estimated at 3¼ percent in the absence of comprehensive structural reforms (Selected Issues Paper).

  • The near-term balance of risks appears tilted to the downside, associated with the global outlook. A more protracted slowdown in the U.S., particularly if it involved manufacturing, would represent a material drag to Mexico’s growth given its close integration with the U.S. economy. Renewed global financial turmoil from unsettled conditions in Europe could adversely affect Mexico, given its close integration with international capital markets, especially if contagion were to spill over to countries beyond the epicenter and rekindle counterparty uncertainty and generalized risk aversion. Downside risks to global growth could also arise from a persistent increase in oil prices, which could have a limited positive direct effect on Mexico but a strong indirect negative effect associated with a slowdown in the U.S. economy.

  • Longer-term risks stem primarily from domestic structural sources. Main downside risks for Mexico are linked to a rise in fiscal pressures, notably a decline in oil revenues as a share of GDP and an increase in age-related spending. On the other hand, the staff and authorities agreed that the effective implementation of productivity-enhancing reforms could provide considerable upside to the growth outlook.


A. Near-Term Macroeconomic Policies

8. With growth in Mexico expected to continue on a firm footing, discussions focused on how to gradually adjust the policy stance and rebuild policy buffers, taking into account heightened global uncertainties. Mexico implemented an effective countercyclical policy response to the global crisis, which has supported a V-shaped output recovery. In this context, discussion centered on how to balance domestic cyclical conditions and increased global downside risks in adjusting macroeconomic policies going forward.

9. The authorities’ intend to continue with fiscal consolidation in 2012 to unwind the past stimulus. They considered that a gradual fiscal consolidation this year and next was warranted to withdraw the fiscal stimulus introduced in 2009, at the time of the global crisis.3 They noted that the 2010 fiscal package already envisaged reducing the fiscal deficit during the 2010–12 period, through a combination of higher tax rates and contained expenditure growth. They indicated that their plan was to return in next year’s budget to the balanced-budget rule and lift again the ceiling on the accumulation of resources in the oil stabilization fund, as they did in 2010 and 2011. Thereafter, Mexico’s balance-budget rule would help maintain the public debt broadly stable as a share of GDP. Staff supported the authorities’ approach, noting that, with growth on a firm footing, plans for fiscal consolidation were not expected to jeopardize the recovery. The augmented primary balance is envisaged to improve by about 1 percentage points of GDP in 2011 (to -0.5 percent of GDP) and by ½ percentage point in 2012 (to balance). Staff also noted that continuing with the gradual adjustment of domestic fuel prices to align them with international prices, as planned by the authorities, would reduce the current fiscal cost (about 1 percent of GDP in 2011) and remove the untargeted subsidy.

10. With fiscal consolidation underway, the challenge of balancing domestic cyclical conditions and the potential impact of increased global downside risks would befall on monetary policy. Staff concurred that, at present, demand pressures appear muted and that the task going forward will be to assess the speed of the economic recovery in Mexico and the level of remaining slack in resource utilization.4 While the potential for supply shocks having second-round effects and possibly affecting inflation expectations warrants Banxico’s close monitoring, the external outlook has become more clouded, introducing an element of uncertainty with respect to the appropriate timinig for future monetary policy tightening. Moreover, as pointed out by the authorities, the recent appreciation of the peso has in effect contributed to some tightening in Mexico’s monetary conditions. On balance, given the still-benign inflation landscape and firmly-anchored inflation expectations, the authorities and staff concurred that there is room for Banxico to continue assessing the evolution of domestic and external circumstances in the coming months in deciding the course of monetary policy. Moreover, Banxico’s officials underscored that the important efforts undertaken recently to enhance communications will strengthen the public’s understanding of the delicate balancing act behind the monetary policy decisions and help further anchor inflation expectations (Box 4).

11. Mexico’s floating exchange rate has proven an important buffer against external shocks. Major progress in reducing external vulnerabilities over the last decade and the established inflation-targeting framework have allowed for the unencumbered working of the floating exchange rate regime. The depreciation of the peso during the global financial crisis helped cushion the adverse external shock to external demand, public finances, and financing conditions. The appreciation of the peso since then has mainly responded to Mexico’s improved cyclical position and its increased recognition among foreign investors as a strong sovereign credit. The authorities indicated that the appropriate response to increased capital inflows remained an adequate macro policy mix (fiscal, monetary and financial) and the full working of the flexible exchange rate regime. Mexico’s existing sound prudential framework, particularly the long-standing FX liquidity coefficient, would mitigate the potential risks associated with a surge in inflows.

12. International reserves remain comfortable for normal times. The recent build-up of reserves, mostly through higher renenues from Pemex with rule-based intervention playing a limited role, is consistent with the authorities’ objective of increasing its level of external insurance, reflecting the lower coverage of balance sheet exposures relative to peers, which had been a concern for investors during the global crisis. The level of reserves appears adequate for normal times. Given that the global environment remains highly uncertain, the authorities and staff agreed that the FCL is a useful complement to self-insurance and an important buffer against potential tail risks.

Central Bank Communication and Inflation Dynamics

The adoption of an inflation targeting (IT) framework in the early 2000s represented a key milestone in the evolution of Mexico’s monetary policy regime. Together with the implementation of prudent fiscal policies, the IT framework succeeded in controlling inflation, bringing it down from nearly 20 percent in 1999 to an average level of about 4 percent since 2003, or close to the authorities’ 3 percent target. Reflecting gains in Banxico’s credibility, the price formation process in Mexico has also become much less persistent under the IT regime (e.g., Chiquiar et al., 2010), and medium-term inflation expectations have been very firmly anchored—albeit somewhat above the target—despite fluctuations in headline inflation.

In an effort to further strengthen the IT framework, Banxico has taken important measures to enhance its communication, bringing it in line with the international best practice. In particular: (i) in 2011 Banxico started publishing the minutes of its policy meetings, which include detailed analyses of the global and domestic economies, and covering extensively discussions amongst board members, presenting the nuances behind each policy decision and helping the private sector better understand the importance of various factors shaping the views of the board; (ii) its quantitative assessment has increased in granularity, using for instance fan charts showing baseline projections and the balance of risks; and (iii) there has been an increase in the number of public speeches and presentations by Banxico authorities, expanding communication beyond formal channels.

Staff research underscores the benefits of enhanced central bank communications. Tang and Yu (forthcoming) illustrate how clear central bank communication about the bases for its policy decisions can help better anchor market perceptions of the monetary policy response function. Based on parameters similar to those estimated for Mexico, the paper’s simulates stylized scenarios involving uncertainty about the size, nature, and persistence of macroeconomic shocks to illustrate quantitatively how improved communications can bring about more stable inflation and smoother interest rate adjustment.


Inflation and inflation expectations

(year on year)

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

Source: Banxico

Variability of MT inflation expectations

(2006-2010 1/)

Citation: IMF Staff Country Reports 2011, 250; 10.5089/9781462325429.002.A001

1/ Standard deviation of 5-year ahead inflation expectations divided by the meanSource: Consensus Economics

13. Mexico’s prudential framework is ahead of new international standards, with banks well positioned to implement them.

The authorities noted that Mexico will be implementing most Basel III prudential regulations ahead of the international schedule.

  • Capital requirements today are broadly compliant with future Basel III guidelines (Box 5). In addition, subordinated debt, which counted toward Tier-2 capital, will be phased out. Most banks are already compliant with the short-term liquidity requirement of Basel III.5

  • Staff commended the authorities for the early adoption of a Financial Stability Council to monitor systemic risks and coordinate efforts to address potential financial vulnerabilities (Box 6).

  • While Mexico’s regulatory perimeter is already broad, plans to gather information and allow non-bank financial intermediaries (Sofoles/Sofomes) to come into the regulatory perimeter are judicious, given their difficulties experienced during the global crisis. These non-bank intermediaries are being brought into the regulatory perimeter by allowing them to apply for banking licenses subject to certain conditions or to voluntarily adhere to certain regulatory standards. The authorities are also taking steps to eliminate the possibility of regulatory arbitrage by foreign non-subsidiary banks.

  • In addition, steps are being taken to monitor vulnerabilities that surfaced in the corporate sector during the crisis. With respect to derivative positions, progress has been made on data requirements for listed corporates, although some data gaps remain for non-listed firms that may have operations with off-shore counterparts. Regarding derivatives regulation, Mexico is planning to create a trade registry for OTC operations, in coordination with pending U.S. regulations, given that most transactions are with U.S. counterparties.

  • An FSAP Update will be take place in the fall of 2011. Mexico’s financial reforms and capacity building efforts over the past decade have solidified the stability of the financial sector, which showed its payoff during the recent global financial crisis.

14. However, international financial regulatory reforms, while beneficial for global financial stability, could have unintended consequences on Mexico’s banking system. In particular, the authorities expressed concern that the introduction of new capital surcharges for systemic and trading risks, as well as a recalibration of capital charges for sovereign risks could negatively affect Mexico. A more thorough consideration of the side effects of international regulatory reforms on countries that are host to subsidiaries (or branches) of global banks would be needed.

  • Capital surcharge for systemic institutions could have a disproportionate effect on Mexico because of the large share of systemic banks in its financial sector, leading to lower credit growth and higher intermediation margins. The authorities also highlighted the asymmetry in information sharing between home and host countries for global institutions.

  • There is also a concern about Basel III’s capital surcharges for risks on banks’ trading books. Banks in Mexico are important financial intermediaries, with their trading activities being an important source of liquidity for domestic sovereign debt and derivative markets. There is a concern that the new regulations could reduce market liquidity and increase spreads.

  • A recalibration of sovereign risks in the balance sheet of global financial institutions, an issue already identified under Basel II, could also affect domestic debt markets. Under Basel guidelines, global banks could treat the holdings of domestic debt by subsidiaries as foreign debt, requiring higher capital and potentially creating incentives for divesting from domestic debt holdings and an increase in required interest.

Basel III

Mexico is well positioned to adopt the regulatory changes envisaged under Basel III. Banks already fulfill the new capital requirements and, with the exception of some smaller banks, the liquidity requirements. The authorities are therefore considering an accelerated pace of implementation of Basel III, ahead of the international schedule.

Capital requirements. The authorities plan to introduce new capital requirements in 2012.

  • Common equity. Banks will need common equity of 4.5 percent of assets plus a capital conservation buffer of 2.5 percent, and a counter-cyclical buffer (ranging from 0-2.5 percent). The conservation buffer imposes constraints on earning distributions when the situation of a bank deteriorates. At end-2010, all banks complied with the minimum requirements set for 2019, with common equity at 13.8 percent, significantly exceeding requirements. While the authorities are working on the practicality of instituting counter-cyclical provisioning, the introduction of expected loan-loss provisioning has brought about an element of counter-cyclicality. Pending a decision on counter-cyclical buffers, common equity is to be increased by 2.5 percentage points in the meantime.

  • Tier 1 capital of 6 percent. At end-2010, Mexican banks had an average Tier one capital ratio of 14.7 percent.

  • Leverage ratio of 3 times Tier 1 capital. The leverage requirement is expected to become effective by 2018, but it is not currently binding for any bank in Mexico.

Liquidity requirements. The Liquid Coverage Ratio and the Net Stable Funding ratio will be subject to an observation period, with a review to assess unintended consequences.

  • Liquidity Coverage Ratio (LCR). It requires banks to maintain a stock of “high-quality liquid assets” that is sufficient to cover net cash outflows for a 30-day period under a stress scenario. In Mexico, banks’ liquid assets are large in relation to short-term liabilities. A mid-2010 assessment suggests that only some of the smaller banks may not yet comply with this ratio.

  • Net Stable Funding Ratio (NSFR). This standard requires a minimum amount of funding that is expected to be stable over a one-year horizon, based on liquidity risk factors assigned to assets and off-balance sheet liquidity exposures. Mexico has a significant deposit base which places it well with respect to this requirement.

Financial Stability Council

In 2010, Mexico established a Financial Stability Council (FSC) to identify and address systemic risk, facilitating coordination and information exchange among policy makers and financial regulators.

The Council is chaired by the Minister of Finance, and includes representatives from the central bank, the bank and exchange supervisor (CNBV), the insurance supervisor (CNSF), the pension funds regulator (CONSAR), and the deposit insurance institute (IPAB). Although it is formally established to work under a majority voting rule, it is in practice envisaged to operate by consensus, with each institution responsible for the implementation of policies within its legal mandate.

The Council has set up four working groups to strengthen its assessment of risks seeking to: (i) standardize and collect information relevant to monitoring financial stability; (ii) develop a framework to analyze financial system vulnerabilities, identify relevant variables, and assess specific risks in a timely manner; (iii) design metrics and methodologies for the measurement of systemic risk, complementing the analysis of vulnerabilities; and (iv) ensure that financial market participants have sufficient and timely information for making decisions.

The FSC has recently published its first annual report, in which it assessed the resilience of Mexico’s financial sector, based on its stress testing analysis. It highlighted a set of systemic risks, including a potential reversion of capital flows, the impact of the European crisis on the Mexican financial system, and a more protracted slowdown in global economic activity.

B. Global Spillovers

15. Spillovers from fiscal and monetary stimuli in advanced economies in the aftermath of the global crisis, particularly in the U.S., have been largely positive for Mexico. The authorities concurred that efforts to sustain domestic demand in advanced economies during the global crisis were beneficial for Mexico through real/trade channels, as well as improved access to external financing.

  • Mexico is strongly integrated with the United States. About 80 percent of Mexican non-oil exports go to the U.S. market, and Mexico’s industrial production closely tracks that of the U.S.6 This reflects, in part, the high degree of integration of Mexican manufacturing into the U.S. industrial production chain.

  • Stabilized financial markets and low interest rates also helped improve Mexico’s external financing conditions. Capital inflows into Mexico have become increasingly more important, mitigated by an appropriate policy mix and the flexible exchange rate. If U.S. monetary conditions remain loose for a protracted period, the pace of capital inflows to Mexico could intensify. In this context, Mexico’s flexible exchange rate would serve well to contain excesses, while it would be a good opportunity to advance the pace of fiscal consolidation and rebuild policy buffers. Mexico is well prepared to absorb increased capital flows, with moderate household and corporate leverage and a sound prudential framework. The authorities stressed that the use of capital controls in other emerging market economies to deal with easy foreign financing conditions may have negative spillovers for financially open economies, by diverting capital flows and limiting exchange rate adjustments.

  • Going forward, the eventual withdrawal of stimuli in advanced economies could entail new challenges, including the risk of a rapid reversal of capital flows.

16. A potential surge in global risk aversion from unsettled market conditions in Europe remains a concern. Mexico’s main direct link with Europe is through the large presence of Spanish banks (Santander and BBVA) in its domestic financial system. The authorities have tightened regulations and supervision of subsidiaries of foreign banks, including with limits on dividend distribution (to avoid an erosion of capital) and related-party lending. They see the bank channel as well ring-fenced, an assessment shared by market participants and local analysts. 7 Although the direct impact from unsettled conditions in Europe is seen as limited, an increase in global risk aversion and generalized flight to quality could affect even strong sovereign credits like Mexico. Mexico’s debt structure and reinforced reserve buffers would help limit the effect of an increase in global risk aversion, but the increased liquidity and participation of foreign investors in Mexican securities markets in recent years could make this a potential channel in a tail scenario.8

17. Competition with China in the U.S. market. Although direct trade and FDI linkages between China and Mexico are limited, China is a key competitor in manufacturing with Mexico. The authorities have viewed China’s undervalued currency as a contributing factor to Mexico’s loss of export market share in the U.S. in the 2000s and the relocation of manufacturing activities from North America to China and Asia more general. More recently, however, the appreciation of the renminbi against the peso, together with higher relative wage inflation in China, appears to have helped reverse part of the competitiveness disadvantage and regain some of the lost market share in the U.S. Going forward, unleashing Mexico’s productivity growth would also be important to recovering its export potential and market share (Selected Issues Paper).

C. Longer-Term Challenges

18. Mexico’s strong macroeconomic policies and frameworks are expected to continue to ensure stability over the medium-term. Sound fundamentals, including an established inflation-targeting regime with a flexible exchange rate, a fiscal framework ensuring debt sustainability, a comfortable level of international reserves, and a sound prudential framework, have helped secure macroeconomic stability in Mexico and enhanced resilience to external shocks.

19. However, Mexico will face fiscal challenges over the longer term arising from diminishing oil revenues and increasing age-related spending. Addressing these issues to ensure fiscal sustainability will require a combination of revenue mobilization efforts with expenditure rationalization, and foresight over an extended horizon, in part to incoporate the long implementation lags of some of the reforms (Selected Issues Paper). The authorities concurred with staff’s broad assessment of longer-term challenges. In the area of pensions, they emphasized that the reforms already implemented had helped address the imbalances of the previous regime and that the remaining issues were largely associated with the transition cost of these reforms.

  • Oil revenues are expected to decline relative to GDP, in the context of broadly stable oil production and prices.9 While risks associated with oil production seem to have declined, linked to a more balanced distribution of production and higher investment, reliance on oil revenues represent a significant challenge to the longer term fiscal outlook in the absence of a significant increase in volumes. At present, oil revenues account for a third of government revenues, and there is a risk that they could fall by about 4 percentage points of GDP by 2030, as the economy grows. Staff noted that the non-oil revenue mobilization efforts that will be needed to compensate for such a loss would need to focus, inter alia, on broadening the tax base of the value added and personal income taxes and revamping tax mobilization by subnational governments. The authorities agreed and underscored that subnational governments’ revenues, in particular, should play a key role, in part to help align spending incentives at the local level (Box 7).

  • Population aging and the transitional costs from the reform of the old pension system are expected to put significant pressure on health and pension spending. The number of pension beneficiaries will increase rapidly as the population ages, while public spending in healthcare will rise because of aging and medical costs. Staff noted that both effects could increase public spending by about 3 percent of GDP by 2030, pointing to the need to revisit the main parameters of the pension system, including the retirement age.

Tax Mobilization in Mexico

With oil revenues as a share of GDP envisaged to diminish in the future, a tax mobilization effort would be needed to replace lost revenues and address age-related spending pressures. The level of non-oil tax revenue in Mexico is one of the lowest in the region and the lowest amongst OECD countries. Recent revenue trends show non-oil tax revenue in Mexico to be around 10 percent of GDP, with income taxes accounting for 50 percent of non-oil tax revenues and VAT for 40 percent. Key elements of Mexico’s tax system and potential areas for reform include:

Personal income tax (PIT). The PIT in Mexico has a narrow base because of uncapped deductions, preferential regimes, and exemptions. Revenue productivity is low, despite a 30 percent top rate, as collections amounted 2.3 percent of GDP in 2010—one of the lowest in the OECD. The PIT would need to be simplified, its base broadened, and its progressivity enhanced. A reform of the PIT would bring exempt incomes (e.g., bonuses, overtime pay) into the tax base and replace existing deductions (e.g., mortgage interest) with higher basic exemption allowances for all taxpayers.

Corporate income tax (CIT). Mexico’s CIT is generally sound and competitive. The base of the CIT could be broadened by bringing in medium and large businesses in agriculture, forestry, and transportation from the simplified regime.

VAT. While VAT collections have been increasing slowly over the past decade, widespread zero rates and exemptions continue to seriously reduce their yield. These weaknesses, together with a reduced VAT rate in the border areas, complicate administration and make the VAT in Mexico the least revenue productive in the OECD. The VAT should be broadened by minimizing exemptions, unifying the rate across the country, and limiting zero rates to exports.

Fuel taxation. Domestic fuel prices in Mexico are administered. Given the spike in oil prices at the end of 2010, Mexico’s policy of gradual gasoline price increases led to a “negative” excise tax in 2011. Gasoline pricing should continue to be increased and aligned with international process to regain a positive gasoline taxation in Mexico.

Subnational taxation. Subnational government revenue mobilization in Mexico is very low and should be enhanced. At around 1.3 percent of GDP, local tax collection is well below most OECD countries. For instance, municipal taxation of real estate yields ¼ percent of GDP compared to about 1 percent of GDP on average in OECD countries and ¾ percent of GDP in other Latin American countries.

20. Further enhancing Mexico’s fiscal framework could help reduce procyclicality. The strong fiscal framework in Mexico has been critical to ensuring public debt sustainability. In the near-term, staff suggested that permanently removing the ceilings on the accumulation of resources in the oil stabilization fund would help save oil revenue windfalls and mitigate the potential procyclicality during upturns embedded in the fiscal rule. Over the medium term, Mexico’s strong fiscal framework could be enhanced by focusing on a structural balance measure. The authorities acknowledged the asymmetries of the current framework (potentially procyclical during upturns and broadly acyclical during downturns) and considered that, in the future, a structural fiscal rule could be contemplated to mitigate upturn procyclicality.

21. Enhancing the coverage of subnational government finances and strengthening local revenue mobilization would help align spending incentives at the subnational level. Over 90 percent of subnational government revenues currently come from central government transfers, reducing incentives for prudent fiscal management at the subnational level. Staff also noted that, although subnational government debt remains moderate, at about 2½ percent of GDP, implicit pension liabilities are estimated to be considerable higher. In addition, short-term borrowing by some local governments has increased, warranting close monitoring. In this context, staff stressed that broadening the reporting and coverage of subnational governments’ accounts, including their implicit pension liabilities, would help assess fiscal policy and public sector liabilities in a more comprehensive manner.

22. Decisively pressing ahead with an ambitious program of structural reforms would be key to boosting Mexico’s growth, particularly in an environment of sluggish external demand. Despite the strong macroeconomic framework underpinning stability, the integration into NAFTA, and favorable demographics, Mexico’s growth only averaged about 3¼ percent a year over the two decades preceding the global crisis. This growth outcome has underperformed that of comparable peers. Going forward, staff and the authorities shared the view that, with the global environment likely to remain challenging and prospects for external demand subdued, stepping up structural reform efforts—some of which could yield rapid payoffs—would be essential. These reforms would also help to improve employment opportunities in the formal sector of the economy, which are limited in Mexico. There is broad consensus that reforms should focus on the following areas:

  • Boosting competition. Concentration remains very high in key sectors of the economy (e.g., telecommunications, transportation, energy). The recent antitrust reform is a welcome step to increase competition by enhancing the powers of the regulatory body. Moreover, ongoing efforts to distribute radio spectra through open auctions would contribute to more competitive markets. At the same time, there is scope to further build on recent reforms of state-owned energy companies to strengthen their productivity (e.g., further promoting limited-scope PPPs) and governance.

  • Broadening access to credit, including SMEs and households. While Mexico’s financial system is sophisticated, access to credit by some segments of the economy remain limited. Advancing initiatives to facilitate credit availability for SMEs, such as improving information flows on borrowers and strengthening the legal framework for the use of collateral, could help support investment and growth of these firms, increase their productivity, and bolster employment creation. Measures to promote private financing of infrastructure projects, including through PPPs, would also strengthen investment and contribute to unleashing higher growth. With household debt at a moderate 20 percent of disposable income, further efforts to reduce frictions in the financial system and enhance households’ access to financial services could support more efficient saving and investment decisions.

  • Improving education and labor flexibility. While enrolment has increased over the years, the quality of education seems to remain below that of peers. Measures to improve the quality of education, including through teachers’ incentives, could significantly increase investment in human capital in Mexico. Also, long-standing contractual rigidities have weighed on employment in the formal sector of the economy, constraining an effective allocation of labor. Expediting reforms to enhance labor flexibility would be an important step toward creating a more dynamic labor market, including among the young.

  • Reinforcing domestic security. Ongoing efforts to fight organized crime, including through the strengthening of the AML framework, are important to foster investment and growth.


23. Mexico’s very strong fundamentals and policy track record proved crucial to withstand the fallout from the global crisis and to the V-shaped recovery. The strong rule-based policy framework introduced in Mexico over the past decade includes the inflation targeting and flexible exchange rate regimes, the balanced-budget fiscal rule, and a sound prudential system. This framework has helped secure macroeconomic stability, enhance resilience to external shocks, and enable the authorities to implement a credible counter-cyclical policy response during the global crisis.

24. With Mexico’s economy expected to continue on a firm recovery, the policy challenges ahead include:

  • Over the course of this year and next, how to gradually adjust the overall policy stance, taking due account of significant global uncertainty. Following the effective countercyclical response to the global crisis, the gradual withdrawal of policy stimuli requires delicately balancing domestic cyclical conditions with global risks, with different fiscal and monetary timings.

  • Over the medium term, how to unleash Mexico’s growth potential and employment generation, while tackling its long-term fiscal challenges. Decisively addressing Mexico’s longer term issues will require anticipating well the fiscal challenges and pressing ahead with ambitious growth-enhancing reforms.

25. After the stimulus provided during the global crisis, ongoing fiscal consolidation plans are judicious, on cyclical and structural grounds. The planned return in next year’s budget to the balanced-budget rule and the lifting of the ceiling on the accumulation of resources in the oil stabilization fund will help further unwind the fiscal stimulus. They will also bring the structural balance closer to pre-crisis levels, and help regain some fiscal space for potential downside risks to the global economy. Thereafter, the balanced-budget rule would help keep Mexico’s public debt-to-GDP ratios broadly stable. The gradual adjustment in gasoline prices should continue, to bring them in line with international prices by next year. The elimination of the fuel subsidy could be complemented by enhancements in the safety net to protect the most vulnerable segments of the population from large increases in fuel prices.

26. Mexico would benefit from gradually rebuilding fiscal policy buffers over the medium term. Fiscal buffers before the crisis proved critical to pursuing a countercyclical policy response in the midst of extraordinary global circumstances. Gradually rebuilding these buffers would help provide additional insurance against potential downside risks. In that respect, permanently removing the ceiling on the accumulation of resources in the oil stabilization fund would help save revenue windfalls and reduce procyclicality. Further, consideration could be given to enhancing Mexico’s strong fiscal framework by focusing on a structural balance measure. Also, broadening the reporting of subnational governments’ accounts, including their implicit pension liabilities, would help assess fiscal policy and public sector liabilities more comprehensively.

27. Monetary policy has successfully supported the recovery, and the challenge ahead will be to balance the domestic cyclical conditions with global uncertainties. Key to the balancing task will be the speed of the economic recovery and weighing the level of remaining slack in resource utilization, the potential for supply shocks contaminating inflation expectations, and the potential for negative effects from the global environment. The benign inflation dynamics of recent months and firmly-anchored inflation expectations provide the monetary authorities with room to decide on the best timing for the policy response to domestic and international developments. Recent efforts to enhance Banxico’s communications will help to better convey the balancing of domestic and global conditions in policy decisions.

28. The flexible exchange rate regime has served Mexico well, playing an important role in adjusting to domestic and external conditions. In real effective terms, the Mexican peso has appreciated since the global financial crisis, responding to Mexico’s improved cyclical position and its increased recognition as a strong sovereign credit. CGER estimates suggest the peso is broadly in line with fundamentals. The increase in international reserve buffers has stemmed mostly from high Pemex oil sales, with rule-based intervention playing only a limited role. As noted, the FCL remains a significant additional insurance against global tail risks.

29. The financial sector proved to be resilient during the global crisis, and the prudential framework is generally ahead in the implementation of new international standards. Mexico’s financial sector indicators remain sound, back to pre-crisis levels, with credit growing at a sustainable pace, in line with the cyclical recovery. Most Basel III prudential regulations will be applied ahead of the internationally-agreed schedule, with banks well positioned to implement them. Mexico has also been a leader in the setting up of a Financial Stability Council (FSC) to monitor systemic risks and help coordinate efforts to address potential financial vulnerabilities. The FSCs’ broad data collection effort underway is welcomed, helping to identify systemic risks. In addition, Mexico could play a critical role in international fora to close remaining gaps, including for non-listed firms that have operations with off-shore counterparts. Monitoring the external debt of corporates, including positions in the derivatives market, will continue to be critical to assess vulnerabilities. With lending to subnational governments increasingly concentrated on a few smaller banks, close monitoring of those institutions is also warranted.

30. Mexico faces longer term fiscal challenges arising from a projected decline in oil revenues relative to GDP and population aging. Addressing these issues to ensure fiscal sustainability will require a combination of non-oil revenue mobilization efforts and expenditure rationalization. Given the long implementation lags of the reforms that are needed, it will be important to initiate the reform effort in the near future. The 2011 budget documents highlighted several long-term risks, and further progress toward a comprehensive statement of fiscal risks would be important. Non-oil revenue mobilization efforts that will be needed to compensate in part for the oil revenue loss would need to focus, inter alia, on broadening the tax base for the value added and personal income taxes and revamping tax mobilization by subnational governments. The latter will also help align spending incentives at the subnational level. To deal with the expected increase in transitional pension spending, consideration could be given to revisiting the main parameters of the old pension system, including the retirement age.

31. Unleashing Mexico’s growth potential would require advancing structural reforms to increase productivity and promote investment, building on recent reform efforts. Mexico’s growth over the last two decades has lagged comparable peers, in part due to negative external shocks. Given lackluster external demand prospects for Mexico, it would be important to undertake additional reform efforts to increase productivity and competitiveness and encourage domestic sources of growth. Some of these reforms may prove to have rapid payoffs, including those associated with improving infrastructure and enhancing efficiency in the service sectors. Recent reform progress to improve anti-trust regulations is welcome, with the task ahead being to establish the credibility of the improved regulatory power. A comprehensive reform strategy to foster growth would help assess the more pressing constraints and prioritize reform efforts going forward. These efforts would help improve limited employment opportunities, especially among young adults. Further reforms would be needed to strengthen the quality of education, increase labor flexibility (with the recent legislative proposal a welcome step), improve performance of state energy companies (building on recent efforts to promote limited-scope PPPs and improve governance), and advance initiatives to facilitate access to credit for SMEs and financing for infrastructure.

32. Potential global spillovers warrant close monitoring. The authorities are carefully assessing possible implications of changes in the global environment for Mexico. Moreover, these potential spillovers have actively informed their assessments and policy analysis, which have been reflected, for instance, in the report of the FSC and Central Bank publications. Economic prospects and policies in the U.S. remain critical for Mexico, with a relapse in U.S. growth having direct implications for growth in Mexico. The large presence in Mexico of subsidiaries of systemic foreign banks has emphasized the need to contain spillover risks through prudential regulation and active supervision, which the authorities have been proactively pursuing. The direct impact from unsettled global market conditions is therefore expected to remain contained, but a surge in risk aversion could affect even strong sovereign credits, like Mexico’s.

33. It is proposed that the next Article IV consultation with Mexico take place on the standard 12-month cycle.

Table 1.

Mexico: Selected Economic, Financial, and Social Indicators, 2007-2012

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

Federal Government plus Social Security and State-owned Companies, excl. nonrecurrent revenue and net lending of development banks.

Authorities definition. The break in the series in 2009 is due to definitional and accounting changes of PIDIREGAS.

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

Debt service on gross external debt of the federal government, development banks and nonfinanical public enterprises (adjusted for Pidiregas).

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

Table 2.

Mexico: Financial Operations of the Public Sector, 2006-2016

(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).

Total tax revenue excluding excise tax on gasoline.

Includes transfers to IPAB and the debtor support programs.

The break in the series in 2009 is due to definitional and accounting changes.

Public Sector Borrowing Requirements 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.

Change in the structural balance measured using a domestic resource approach (adjusting tax revenue for the cycle, excluding PEMEX external trade balance, and oil hedges).

Table 3.

Mexico: Summary Balance of Payments, 2006-2016

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

Including the Financing of PIDIREGAS.

Includes pre-payment of external debt.

Break in the series in 2009 due to accounting changes.

Excluding oil exports and petroleoum products imports.

Excludes balances under bilateral payments accounts. For 2008, includes the allocation of SDR 2,337 billion in the general allocation implemented on August 28, 2009, and another SDR 0.224 billion in the special allocation on September 9.

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

Includes gross external debt of the federal government, development banks and non-financial public enterprises, and is adjusted for PIDIREGAS.

Includes amortization on medium and long-term bonds and debt, and interest payments.

Table 4.

Mexico: Financial Soundness Indicators

(in percent)

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Sources: FSI & CNBV.

As of February 2011

Table 5.

Mexico: Indicators of External Vulnerability, 2005-2011

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Sources: Bank of Mexico; National Banking and Securities Commission; National Institute of Statistics and Geography; Secretary of Finance and Public Credit; and IMF staff estimates

In US dollar terms.

Increase represents appreciation.

Short-term debt by residual maturity includes pre-payment of debt.

Table 6

Mexico: Baseline Medium-Term Projections, 2006-16

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

Excluding oil expports and petroleum products imports.