Mexico is an open economy with strong real and financial links to the rest of the world with risks of spillovers from global turbulence. Recent gains in market share in the U.S. manufacturing market are owed to improved relative unit labor costs and reemergence of a location advantage. Mexico’s current fiscal framework requires measures to offset the emerging challenges of a decline in oil revenues and the projected increase in health- and pensions-related spending. The sustained increase of bank credit after the global crisis has been reversed. The effects of migration depend on labor reform.

Abstract

Mexico is an open economy with strong real and financial links to the rest of the world with risks of spillovers from global turbulence. Recent gains in market share in the U.S. manufacturing market are owed to improved relative unit labor costs and reemergence of a location advantage. Mexico’s current fiscal framework requires measures to offset the emerging challenges of a decline in oil revenues and the projected increase in health- and pensions-related spending. The sustained increase of bank credit after the global crisis has been reversed. The effects of migration depend on labor reform.

I. Mexico: A Closer Look at Global Spillover Channels1

Mexico is a highly open economy with strong real and financial links to the rest of the world. It has close linkages to the U.S. through trade and remittances, and thus is particularly sensitive to U.S. developments. In turn, Mexico’s open capital account, good macroeconomic fundamentals and liquid foreign exchange markets have led to a close integration with global financial markets, resulting in substantial portfolio flows. This warrants close vigilance to the risks of spillovers from global turbulence.

A. Introduction

1. Mexico is a highly open emerging market with strong linkages to the rest of the world. This chapter discusses and illustrates these linkages, and provides some examples of possible spillovers to Mexico of global shocks through the real and/or financial channels. Section B provides a description of Mexico’s main linkages and potential channels of transmission. Section C illustrates the relative importance of real sector and financial shocks on Mexico’s GDP, and the sensitivity of Mexico’s asset prices to global developments. Section D concludes.

B. Mexico’s Linkages with the U.S. and the Rest of the World

2. Mexico has three key direct external linkages: (i) substantial trade with the United States—particularly in manufacturing; (ii) large remittance flows from the U.S. and (iii) highly open and liquid financial markets. Mexico has significant trade ties with the U.S., and Mexican manufacturing firms are highly integrated into the U.S. supply chain.2 Mexico also receives significant remittance flows from the U.S. In addition, Mexico’s deep and liquid foreign exchange and domestic government bond markets make it susceptible to risks of financial contagion from global developments. These linkages are discussed in more detail below.

Trade channel

3. The U.S. is Mexico’s largest trading partner. Exports to the U.S. are about a quarter of GDP and account for 80 percent of Mexico’s total exports. Approximately 80 percent of total exports are in manufactured goods (95 percent of total non-oil exports). Trade openness has risen significantly over the last 30 years, particularly after Mexico joined NAFTA in 1994. Mexico’s share in the U.S. manufacturing market temporarily declined after China joined the WTO but it has recovered since 2005.3

Figure 1.
Figure 1.

Trade to GDP: Mexico vs. Selected Emerging Markets

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: IFS, Haver Analytics, country authorities, and staff calculations.
Figure 2.
Figure 2.

Mexico: Trade with World and U.S.

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics, and staff calculations.
Table 1.

Top Mexico Export Destinations 1/

(percent share to total exports, as of December 2011)

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includes only countries with shares greater than or equal to 1 percent. Source: EMED database and staff calculations.

Table 2.

Mexico and US GDP Cointegration Post-NAFTA

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Trace test indicates 2 cointegrating eqn(s) at the 0.05 level

denotes rejection of the hypothesis at the 0.05 level

MacKinnon-Haug-Michelis (1999) p-values

4. Through the trade channel, Mexico’s output fluctuations have been closely linked to that of the U.S. Several papers in the literature provide robust evidence that output fluctuations have become closely synchronized with the U.S. cycle after Mexico joined NAFTA in 1994.4 This empirical evidence includes simple correlation coefficients, variance decompositions from bivariate vector autoregressions (VARs) of Mexico’s GDP and exports with U.S. output, and results from cointegration tests between Mexico and U.S. GDP.5 For instance, bivariate VAR results show that U.S. GDP explains about 30 percent of the variability of Mexico’s real GDP. Results also show that the strongest links are related to trade and manufacturing, underscoring Mexico’s manufacturing exports integration with the U.S. manufacturing supply chain, particularly for the automobile industry.

Figure 3.
Figure 3.

Annual GDP Growth Rates

(In percent)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics
Table 3.

Matrix of Correlation Coefficients 1/

(year-on-year growth rates)

article image
Sources: Haver Analytics and staff calculations.

All variables are in real terms, except construction.

Sample is from 2007-2011.

Table 4.

Variance Decompositions from Bivariate VARs: Mexico Real GDP

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Sources: Haver Analytics and staff estimates.

Sample from 2006-2011 only.

Table 5.

Variance Decompositions from Bivariate VARs: Mexico Real Exports

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Sources: Haver Analytics and staff estimates.

Sample from 2006-2011 only.

5. Trade ties with the U.S. are expected to remain strong. In the past 10 years, some diversification in terms of Mexico’s export markets has occurred, but it still remains limited. For example, real export growth to Europe and emerging and developing countries has been very strong over the last decade, but exports to these countries remain a small share of total exports. Mexico’s export sector is expected to remain an important engine for growth. This is supported by continued FDI into the manufacturing sector, improved relative labor costs particularly with respect to China, and relatively high oil prices over the medium term, increasing transportation costs.6

Table 6.

Mexico: Real Export Growth by Region

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Sources: EMED database, country authorities, and staff calculations.
Table 7.

Announced Plans for Future FDI in Mexico, 2012

(in million US dollars)

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Source: Newspaper articles.

Remittances

6. Remittances from the U.S., particularly from workers in the construction sector, represent an important source of income for Mexico. At about 2 percent of GDP in 2011, remittances have been highly correlated with U.S. construction activity, particularly since 2006, following the downfall of the U.S. construction sector.

Figure 4.
Figure 4.

Mexico: Workers’ Remittances vs. U.S. Value of Construction

(U.S. millions, SA)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics, and staff calculations.
Figure 5.
Figure 5.

Mexico: Workers’ Remittances vs. Value of Construction

(Cyclical components)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics, and staff calculations.

Financial Channel

7. Mexico is highly financially integrated with the rest of the world. Mexico’s stock of foreign assets and liabilities in percent of GDP, a common measure of financial integration, was about 112 percent in mid-2012. Mexico is a net recipient of foreign capital, with its foreign liabilities at 72 percent of GDP, doubling over the last 30 years.

Figure 6.
Figure 6.

Financial Integration: Mexico vs. Selected Comparator Countries

(In percent of GDP; 2011)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: IFS
Figure 7.
Figure 7.

Mexico Financial Integration: Foreign Assets and Liabilities

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Mexican Authorities, and staff calculations.
Figure 8.
Figure 8.

Foreign Liabilities Position

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Banxico
Figure 9.
Figure 9.

Foreign Asset Position

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Banxico

8. The composition of Mexico’s foreign assets and liabilities has evolved. Foreign portfolio liabilities have increased rapidly since 2009, reaching more than 30 percent of GDP in mid-2012 and represent the most important source of potential financial spillovers for Mexico. Inward FDI has also increased, reaching 28.5 percent sof GDP. On the asset side, Mexico has built up reserves (broadly maintaining coverage in terms of balance sheet exposures) and increased foreign investments abroad.

9. Close to half of the FDI in Mexico comes from the U.S., mostly in the automotive industry. Another 11 percent comes from Spain, mostly banking- and tourism-related. In terms of outward FDI, the U.S. is the top destination (46.2 percent) followed by Brazil (15.5 percent).

Table 8.

Mexico: Top Ten Sources of FDI, 2010

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Source: CDIS, country authorities, and staff calculations.
Table 9.

Mexico: Top Ten Destinations of FDI, 2010

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Source: CDIS, country authorities, and staff calculations.
Table 10.

Mexico: Stock of Portfolio Liabilities by Region

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Sources: CPIS and staff calculations.
Figure 10.
Figure 10.

Mexico: Portfolio Liabilities vs. Real World Interest Rates

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics, country authorities, and staff estimates.1/ Real world interest rate estimated as the difference between LIBPR and US CPI.

10. Since 2010, portfolio inflows have gained substantial momentum, due to both domestic and external factors. Domestic pull factors include Mexico’s strong fundamentals and sound macroeconomic management, deep and liquid exchange rate and bond markets, and highly open capital account. The inclusion of Mexico in Citigroup’s WBGI was also a significant contributor to a stock increase in portfolio investment since 2010. External factors have been dominated by the lax monetary conditions in advanced economies and investors’ consequent search for yields. Recurrent bouts of unsettled conditions in Europe have also affected external conditions for Mexico. The U.S. is also Mexico’s main source and destination of portfolio investment. Over half of portfolio liabilities are with U.S. residents and another one third are with Europe.

11. Experience during the U.S. subprime crisis and the collapse of Lehmann shows that portfolio flows in Mexico can be volatile. Portfolio outflows during these periods ranged between 0.5 and 1 percent of GDP in one quarter. In turn, outflows associated with residents’ portfolio investments abroad have also been volatile and substantial, reaching about 25 percent of the stock in 2009.

Figure 11.
Figure 11.

Annual Change in Residents’ Portfolio Investment Abroad

(In USD, billions) 1/

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Note: 1/ A positive value denotes an FX outflow in the BOP

12. Financial integration in Mexico is associated with liquid foreign exchange and local sovereign debt markets:

Foreign exchange market. Mexico has a deep and liquid foreign exchange market. The Mexican peso is traded globally onshore and offshore. Based on the 2010 BIS Triennial Central Bank Survey, the daily average foreign exchange market turnover in Mexico was estimated at US$17 billion (almost double the amount recorded in 1998). The bulk of these operations consisted of cross-border trades involving peso/US dollar transactions conducted by dealers abroad. The depth and liquidity of the foreign exchange market, in the context of Mexico’s floating exchange rate regime, has allowed market participants worldwide to use the peso to take positions in reaction to external developments. As such, a large part of Mexico’s currency volatility in recent years has reflected global sentiments rather than country-specific factors.

Local government debt markets. In recent years, the deepening of the foreign exchange market has been accompanied by a substantial increase in foreign investment in domestic currency-denominated government bonds, reaching 32 percent of the total stock. Following Mexico’s inclusion in the WGBI, the pool of investors in the government bond market has shifted to long-term institutional investors. During recent periods of global volatility, investors have opted to hedge foreign exchange exposures but not to divest from government paper. As a result, the exchange rate has shown significant volatility during periods of heightened global stress but domestic interest rates have remained stable.

Figure 12.
Figure 12.

Daily Foreign Exchange Market Turnover

(USD, billions)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: BIS Triennial Central Bank Survey, December 2010.
Figure 13.
Figure 13.

VIX and FX Rate

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Bloomberg and Haver Analytics.
Table 11.

Mexico: Stock of Domestic Public Sector Debt Held by Foreigners (end-September 2012)

article image
Sources: Country authorities and staff calculations.

Other Federal Government Bonds; IPAB bonds and BREMS are not included

C. Sensitivity of Mexico’s Growth and Asset Prices to Global Shocks

13. U.S. shocks explain a large share of Mexico’s macroeconomic fluctuations after NAFTA. To illustrate the relative importance of real and financial channels on growth, a multivariate VAR was estimated using the VIX, U.S. GDP, world interest rates, terms of trade and Mexico real GDP (with quarterly data from 1994 to 2011).7 Results from impulse response functions indicate that Mexico’s output is most affected by shocks to U.S. output. For instance, a one standard deviation increase in U.S. GDP (0.7 percentage points) would result in a 0.6 percentage point increase in Mexico’s GDP. In turn, a one standard deviation increase in the terms of trade would increase output by 0.4 percentage point. A one standard deviation increase in the VIX would result in a 0.3 percentage point decline in Mexico’s real GDP after one quarter.

Figure 14.
Figure 14.

Response of real GDP to selected indicators

(Multivariate VAR)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics and staff calculations.

14. Spikes in the volatility of Mexico’s asset prices are closely associated with periods of global stress. To examine the sensitivity of Mexico’s asset prices to global market developments, four markets were considered: the foreign exchange market, stock market, sovereign debt market, and the corporate debt market. The 3-month rolling standard deviation of asset prices in each of these markets was calculated and compared to the 3-month rolling standard deviation of the VIX, which was used as an indicator of global stress. Results show that spikes in the volatility of Mexico’s asset prices in all four markets are closely correlated with periods of global stress.

Figure 15.
Figure 15.

Response of Market Prices to Shocks in Global Financial Conditions

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics and staff calculations.

15. Results of bivariate VARs illustrate the sensitivity of asset prices to global stress. For example, impulse response functions show that a one standard deviation shock in the VIX is estimated to result in a 1 percent depreciation, a 4 percent decline in stock prices, an 8 percent increase in EMBI Mexico spreads (about 10 basis points), and an almost 9 percent increase in the CEMBI Mexico spreads (over 30 basis points).

Figure 16.
Figure 16.

Impulse Response to One Standard Deviation Innovations in the VIX 1/

(Bivariate VARs)

Citation: IMF Staff Country Reports 2012, 317; 10.5089/9781475543551.002.A001

Sources: Haver Analytics, Bloomberg, and staff calculations.1/ One standard deviation of the VIX = 8.4

D. Conclusion

16. Over the last two decades, Mexico has become highly globally integrated through trade and financial channels. Increased integration has been very beneficial, supporting productivity and growth, particularly in the manufacturing sector, but it has also heightened the sensitivity of output and financial markets to global developments. Thanks to its strong fundamentals and robust policy frameworks, including the flexible exchange rate and foreign exchange buffers, Mexico is well positioned to weather global volatility.

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1

Prepared by Gilda Fernandez.

2

Trade to other regions has grown quickly in recent years, but given the gradual process of diversification, trade exposure to the U.S. is still high.

3

See “What Explains Mexico’s Recovery of U.S. Market Share?,” Chapter 2 of the Selected Issues Paper.

4

The fact that Mexico has not had home-grown crises since 1994 has probably contributed to the higher correlation with the U.S. business cycle.

5

See, inter alia, “How has NAFTA Affected the Mexican Economy: Review and Evidence,” M. Ayhan Kose, Guy M. Meredith, and Christopher M. Towe, IMF Working Paper 04/59, April 2004; “External Shocks and Business Cycle Fluctuations in Mexico: How Important are U.S. Factors?” Sebastian Sosa, IMF Working Paper 08/100, April 2008l; “A Note on Mexico and U.S. Manufacturing Industries’ Long-term Relationship,” Daniel Chiquiar and Manuel Ramos-Francia, Banco de Mexico Working Paper 2008–08; and “Mexico’s Business Cycles and Synchronization with the USA in the Post-NAFTA Years,” William Miles and Chu-Ping C. Vijverberg, Review of Development Economics, 15(4), 638–650, 2011.

6

Announced FDI plans in Mexico through August 2012 amount to about US$6.5 billion, mainly in the automotive industry.

7

The real world interest rate was estimated as the difference between the LIBOR and U.S. inflation.

Mexico: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.