Mexico: Review Under the Flexible Credit Line Arrangement
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Review Under the Flexible Credit Line-Press Release; Staff Report

Abstract

Review Under the Flexible Credit Line-Press Release; Staff Report

Context

1. Mexico’s economy has shown resilience as a key risk envisaged in the current FCL arrangement appears to be materializing. Since January 2017, the United States has indicated that it would like to renegotiate the North American Free Trade Agreement (NAFTA), which could lead to a fundamental change in Mexico’s trade regime with its most important trading partner. There are other U.S. policy issues affecting Mexico, including immigration reform and a border wall. This policy uncertainty led to a sharp depreciation of the peso vis-à-vis the U.S. dollar, rising yields on Mexican government securities, and falling domestic equity prices through January 2017. Since then, asset prices have recovered, partly because the tone of the discussions on NAFTA has moderated. However, the uncertainty remains. Formal discussions on a possible renegotiation of NAFTA are likely to begin later this year, and at this stage it is unclear whether these discussions will be straightforward or protracted and complex.

2. This resilience stems in large part from the fact that Mexico’s policies and policy frameworks remain very strong. The flexible exchange rate has continued to play a key role in helping the economy adjust to external shocks, as shown during the recent episode of volatility. Monetary policy is anchored on a credible inflation-targeting framework, with medium-term inflation expectations remaining close to the target. Fiscal policy is guided by the Fiscal Responsibility Law, and the authorities have reiterated their commitment to gradually reduce public debt in relation to GDP over the medium term. The 2016 FSAP concluded that the financial regulatory and supervisory framework was strong. Medium-term growth should benefit from a range of structural reforms, while the anti-corruption reform has the potential to strengthen governance further. Mexico’s external position is broadly in line with fundamentals and desirable policies. In concluding the 2016 Article IV consultation, Executive Directors expressed confidence that the country’s strong fundamentals and policy frameworks will continue to underpin the economy’s resilience. They welcomed Mexico’s commitment to fiscal consolidation, but encouraged the authorities to strengthen the fiscal framework further.

3. Mexico’s FCL has provided a reassuring signal on the strength of Mexico’s policies and a valuable insurance against tail risks. Mexico’s deep integration into the global economy, with particularly strong links to the United States, through both trade and financial channels, has helped boost productivity and improve competitiveness, lower financing costs and diversify the investor base (Box 1). At the same time, it has exposed Mexico to abrupt shifts in investor sentiment, especially in the face of uncertainty about Mexico’s trade regime with its key trading partner. In 2016, non-residents held 35 percent of local-currency-denominated sovereign bonds and total foreign portfolio investment in Mexico reached US$28.6 billion (2.7 percent of GDP). Finally, as during past episodes of increased volatility, market participants highlighted Mexico’s access under the FCL during the recent episode, which sends a clear signal of the strength of Mexico’s policy framework and provides a complement to Mexico’s net international reserves.

Trade and Financial Linkages Between Mexico and the United States

Mexico is particularly exposed to the United States, through both trade and financial channels.

  • The United States is Mexico’s top export market, representing 71 percent of Mexico’s exports. The United States is also Mexico’s top supplier, representing 51 percent of Mexico’s imports. In value-added terms, 14 percent of Mexico’s GDP ends up being consumed by its northern neighbor.

  • The United States is also Mexico’s biggest foreign investor accounting for 40 percent of Mexico’s FDI inflows. Just over half of U.S. FDI goes into manufacturing and a large share into border states. According to the IMF’s Coordinated Portfolio Investment Survey (CPIS), the United States is the source of nearly 46 percent of total reported portfolio investment in Mexico, 66 percent of portfolio equity investment, and 38 percent of portfolio investment in debt securities.

uA01fig01

Value Added Exported by Mexico in 2011

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Source: OECD; IMF Staff calculations.
uA01fig02

FDI Inflows by Origin, 2012-2016*

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

*2016Q3Source: National authorities.
uA01fig03

Portfolio Investments by Origin, June 2016

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Source: CPIS.

Recent Economic Developments and Policies

4. In the first three quarters of 2016, real GDP expanded by 2¼ percent (y/y), while inflation rose to the target of 3 percent. Economic activity was supported by a strong performance in the services sector, which more than offset subdued manufacturing activity and falling oil production (Figure 2). Improved labor market conditions (Figure 3) and strong remittances supported real private consumption growth, while the growth in real private investment slowed to just 2.1 percent over the same period, down from 8 percent in 2015. Inflation rose to 3 percent (y/y) in September 2016, reflecting the unwinding of several one-off factors that had pushed inflation well below target in 2015 as well as the pass-through effects of the depreciation of the peso vis-à-vis the U.S. dollar, which picked up starting in early 2016.1 In late 2015 the Bank of Mexico began to raise the policy interest rate, which reached 4.75 percent in September 2016, compared with 3.00 percent in November 2015 (Figure 4).

Figure 1.
Figure 1.

Mexico: Evolution of Selected Financial Market Indicators 1/

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: Bloomberg, National authorities, and Fund staff estimates.1/ Data through May 3, 2017 unless otherwise indicated.2/ GFC : Global Financial Crisis. Time t denotes September 15, 2008 for GFC; May 21, 2013 for Taper tantrum; and November 8, 2016 for the US Presidential election.
Figure 2.
Figure 2.

Mexico: Real Sector

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: National authorities, Haver Analytics, and Fund staff estimates.
Figure 3.
Figure 3.

Mexico: Labor Market Indicators

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: National authorities, Haver Analytics, and Fund staff estimates.
Figure 4.
Figure 4.

Mexico: Prices and Inflation

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: National authorities, and Haver Analytics.1/ Based on hours worked.

5. Mexico’s asset prices weakened in the period November 2016-January 2017. The peso depreciated 18 percent between November 8 and January 22 (Figure 1). On November 8, exchange rate bid-ask spreads exceeded levels seen during the global financial crisis. Yields on the 10-year local-currency government bond increased 145 basis points over the same period, reflecting a shift in long-term U.S. interest rates but also higher sovereign spreads.

6. In response, on November 9, the authorities reaffirmed their commitment to maintaining the policy framework. The government indicated that it would stick with its announced path for fiscal consolidation, which envisages a reduction of the public sector borrowing requirement (PSBR) from 4.6 percent of GDP in 2014 to 2.5 percent of GDP by 2018 to bring the primary surplus above the debt-stabilizing level. Banxico would continue to direct monetary policy at keeping medium-term inflation expectations anchored, while relying on exchange rate flexibility as a shock absorber. They emphasized the credibility of the policy framework, the resilience of the financial system, and the strength of the international reserve buffer, complemented with the resources available under the current FCL.

7. This response helped preserve macroeconomic stability. Growth in the fourth quarter of 2016 turned out somewhat stronger than expected, keeping growth for the year at 2.3 percent. The labor market continued to strengthen with the unemployment rate falling to 3.7 percent in December 2016. By end-2016, headline and core inflation reached 3.4 percent (y/y). The Bank of Mexico raised the policy rate to 5.75 percent by December 2016, with no foreign exchange intervention.2

8. So far in 2017, Mexico has benefitted from improved market sentiment and confidence in the country’s macroeconomic fundamentals. Since late January, the exchange rate and credit spreads have returned to close to pre-U.S. election levels and net capital inflows have picked up (Figure 5). Notably, non-resident holdings of local-currency long-term government securities have increased since last November. It is, however, too early to determine whether this improved sentiment translated into a recovery in FDI which remained flat for the last three quarters of 2016. Inflation continued to increase in recent months to 5.35 percent y/y in March, following an up-to-20-percent m/m increase in domestic fuel prices in January, as part of the liberalization of these prices. As of March 2017, headline and core inflation expectations over the next twelve months were at 4 percent, while longer term expectations (at a horizon between 5 and 8 years) inched up slightly to return to the historical average of around 3½ percent.3 The Bank of Mexico raised the policy rate further to 6.5 percent. On February 21, the Foreign Exchange Commission (FEC) announced the introduction of a framework for auctions of up to US$20 billion of non-deliverable forwards (NDF), with US$1 billion auctioned so far.4

Figure 5.
Figure 5.

Mexico: Financial Sector

(As of May 2017)

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: Bloomberg, National authorities, and Haver Analytics.

9. The authorities remain committed to their fiscal consolidation plans. For 2017, the PSBR was targeted at 2.9 percent of GDP (the outturn for 2016), but the government will now cut it to 1.4 percent of GDP, as it channels all the 2016 surplus of Banxico to reduce the deficit (in line with the staff advice during the 2016 Article IV consultation).5 The authorities are also committed to a PSBR of 2½ percent of GDP in 2018 and beyond. Public debt increased to 58.5 percent of GDP in 2016 in large part due to valuation effects, but is projected to decline to 54.8 percent of GDP in 2017 and stabilize at slightly below that level over the medium term (Figure 6).6 Staff has taken the view that, while the fiscal target for 2018 is manageable and appropriate, aiming at a lower PSBR for 2019 and beyond would lead to a faster decline in the public debt-to-GDP ratio, thus helping strengthen fiscal buffers. Moreover, staff continues to believe there are benefits to strengthening the fiscal framework as highlighted during the 2016 Article IV consultation. Possible steps include tightening the link between the desired level of public debt and PSBR targets, limiting the use of exceptional circumstances clauses, and introducing a non-partisan fiscal council.

Figure 6.
Figure 6.

Mexico: Fiscal Sector

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Source: National authorities, World Economic Outlook. Fitch Ratings, and Fund staff estimates.1/ LA-6 excluding Mexico is comprised of Brazil, Chile, Colombia, Peru, and Uruguay.2/ EM comparator group is comprised of India, Indonesia, Poland, Russia, Thailand, and Turkey.3/ Fitch sovereign credit rating peer group includes Brazil, Chile, Colombia, India, Poland, Russia, South Africa, Thailand, and Turkey.

10. The implementation of PEMEX’s business plan is on track. The ongoing restructuring of PEMEX, which involves sharp expenditure cuts, increased use of joint ventures, and disposal of non-core assets is proceeding as expected and has helped the company stabilize its financial position. Turning PEMEX into an efficient and profitable company in the medium term remains a critical priority of the authorities’ fiscal consolidation plan and would require perseverance.

11. The financial and non-financial corporate sectors showed resilience to heightened volatility. The non-financial corporate sector has weathered the currency depreciation well as large corporations have adequate foreign currency earnings to hedge foreign currency liabilities. Some corporations have also reduced their FX exposure by refinancing foreign currency debts with domestic bank loans and bonds and the sector remains liquid (Figure 9). Banks have shown resilience as well. Asset quality remains high and the system is well capitalized and liquid (Figure 10). The latest CNBV bank stress tests, using December 2016 balance sheet information, show that the banking sector would remain resilient even in a severe (albeit short-lived) adverse scenario including a decline in real GDP of 6.7 percent, and a 40-percent currency depreciation. Bank capital needs under this scenario would be small, at 1.1 percent of total banking assets, and systemic banks would not face difficulties.

Figure 7.
Figure 7.

Mexico: External Sector

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: National authorities, Haver Analytics, Dealogic, and Fund staff estimates.1/ Data through December 2016.2/ Data through December 2016.
Figure 8.
Figure 8.

Mexico: Reserve Coverage in an International Perspective, 2016 1/

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: World Economic Outlook, Balance of Payments Statistics Database, and Fund staff estimates.1/ The assessing reserve adequacy (ARA) metric for emerging markets comprises four components reflecting potential balance of payment drains: (i) export income, (ii) broad money, (iii) short-term debt, and (iv) other liabilities. The weight for each component is based on the 10th percentile of observed outflows from emerging markets during exchange market pressure episodes, distinguishing between fixed and flexible exchange rate regimes.
Figure 8.
Figure 8.

Mexico: Reserve Coverage in an International Perspective, 2016 1/ (concluded)

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: World Economic Outlook, and Fund staff estimates.
Figure 9.
Figure 9.

Mexico: Nonfinancial Corporate Sector

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: Bloomberg, External Debt Statistics, Financial Soundness Indicators, and Fund staff estimates.
Figure 10.
Figure 10.

Mexico: Banking System

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: National authorities, Haver Analytics, Dealogic, Bloomberg, and Fund staff estimates.1/ As of January 2017.

12. Implementation of a broad structural reform agenda remains on track. Mexico is implementing a broad range of structural reforms in several areas including energy, telecommunications, financial, competition, and education. Most notably, the telecommunications reform has already attracted FDI into the sector and has led to a sizable reduction in the prices of telecommunication services. Under the energy reform, 39 contracts have already been awarded with expected investment flows of US$50 billion. The financial reform is increasing competition, particularly in the mortgage segment, by reducing the costs of refinancing and facilitating portability of loans. A recent anticorruption reform—with secondary legislation promulgated last year—is moving to the implementation phase and has the potential to improve governance.

Outlook and Risks

13. The heightened uncertainty would slow real GDP growth, while inflation returns to target. Increased uncertainty and tighter financial conditions are expected to weigh on consumption and investment, particularly in the export-oriented manufacturing sector. These factors are likely to more than offset a positive stimulus derived from the currency depreciation and stronger external demand as U.S. growth picks up, thus slowing real GDP growth to 1.7 percent in 2017. With prolonged uncertainty about the NAFTA negotiations also being compounded by political uncertainty related to the 2018 elections in Mexico, output growth would recover only slightly to 2 percent in 2018.7 Inflation would remain high at 5.1 percent at end-2017, and converge to the target by early 2019 as the effects of the depreciation and domestic fuel price increases dissipate and the monetary tightening takes effect. The current account deficit is projected to improve slightly from 2.7 percent of GDP in 2016 to 2.3 percent by 2022 (Figure 7). The NIIP is projected to improve to minus 45.4 percent of GDP in 2017 and then continue to strengthen to around minus 40 percent of GDP by 2022.

14. Mexico’s external position remains broadly consistent with medium-term fundamentals and desirable policy settings. The current account deficit is broadly in line with medium-term fundamentals and desirable policy settings. The sharp depreciation of the peso vis-à-vis the U.S. dollar in late 2016 and early 2017 largely reflected risks of rising protectionism. With the recent appreciation, as of March 2017, the peso was about 1 percent weaker in real effective terms relative to its 2016 average. In staff’s assessment, the peso is currently moderately weaker than the level suggested by fundamentals, under a baseline in which protectionism risks do not materialize. Foreign exchange reserves are adequate according to a range of indicators (Figure 8).

15. Although one year into the FCL arrangement the global environment has improved, external risks for Mexico remain high. External demand has been strengthening and financial market volatility has moderated considerably. Nevertheless, some of the risks identified at the time of the approval of the FCL arrangement have increased as the U.S. has indicated that it would like to renegotiate NAFTA, which could lead to a fundamental change in Mexico’s trade regime with its most important trading partner. Protracted negotiations would prolong the current uncertainty and increase financial market volatility. Moreover, and as noted in the April 2017 World Economic Outlook and the Global Financial Stability Report, global risks remain slanted to the downside with policy uncertainty being a key component. Particularly relevant for Mexico are the risks of increased protectionism and a faster-than-expected pace of interest rate hikes in the United States. The former could lead to lower global growth due to reduced trade and cross-border investment flows, while both risks could lead to a resurgence in volatility in Mexican asset prices. While the discussions surrounding NAFTA have calmed in recent weeks, the issues to be discussed with the U.S. are complex and mean that the uncertainty will remain high and that the risk of further rounds of sharp volatility are elevated. Finally, although the updated external stress index (Box 2) has improved somewhat since the FCL request reflecting some improvements in the global environment and financial stability, factors not captured by the index are critical to risks affecting Mexico at the current juncture and could lead a sharp deterioration in external conditions in a downside scenario.

The Flexible Credit Line and Review of Qualification

16. The authorities highlighted that the FCL arrangement continues to support their macroeconomic strategy, providing an insurance against tail risks. The FCL has complemented Mexico’s very strong policies and policy frameworks, and international reserves. Over the past several years, Mexico has successfully weathered several bouts of volatility, including the most recent episode during end-2016/early-2017, and the authorities believe that the arrangement will continue to protect Mexico against the external risks highlighted above. Moreover, they are committed to continue enhancing Mexico’s resilience to external shocks through steadfast implementation of the ongoing fiscal consolidation plans, continued anchoring of inflation expectations, gradual rebuilding of reserve buffers, and strong oversight of the domestic financial system.

17. The authorities have retained the exit strategy they presented at the time of the FCL renewal in May 2016. The authorities re-affirmed their commitment (expressed in the FCL request) that Mexico does not intend to make permanent use of the FCL. They emphasized though that, although some global risks highlighted at the time of the request have receded somewhat, external risks for Mexico associated with uncertainty about the outcome of the discussions on the bilateral relationship with the U.S., as well as the possibility of sudden surges in capital flow volatility, remain elevated. Nevertheless, conditional on a reduction of these risks, they intend to seek possible subsequent FCL arrangements with lower access, with a view to eventually exit the facility.

18. Staff assesses that Mexico continues to meet the qualification criteria for an arrangement under the FCL. The authorities have continued to implement very strong policies in line with their frameworks. Monetary policy has continued to be guided by a credible inflation-targeting framework in the context of a flexible exchange rate regime, while fiscal policy has been guided by the Fiscal Responsibility Law (Figure 11). Underpinned by these policy frameworks and very strong policy track record, Mexico retains policy space to contain the fallout from the materialization of downside risks and the authorities remain committed to take appropriate actions if such risks materialize.

  • Sustainable external position. The external current account deficit is broadly in line with medium-term fundamentals and desirable policies. The updated external debt sustainability analysis (Annex I) continues to show that Mexico’s external debt is relatively low (about 39 percent of GDP) reflecting the low current account deficits and a manageable net foreign asset position, projected to decline to below minus 40 percent of GDP by 2022.

  • Capital account position dominated by private flows. The bulk of Mexico’s external debt is owed to private creditors. Private portfolio flows (debt and non-debt creating) and FDI continue to be large relative to overall balance of payments flows.

  • Track record of steady sovereign access to international capital markets at favorable terms. Mexico remains among the highest-rated emerging markets. Mexico’s sovereign bond (EMBI+) spread and five-year CDS spreads increased sharply toward the end of 2016 and in early 2017, but they have partially reversed thereafter, standing at 202 and 126 basis points, respectively (as of April 24, 2017). Mexico continues to place successfully sovereign bonds in international capital markets, recently placing a 30-year, fixed-rate domestic currency bond with a yield of 7.85 percent that attracted 43 percent of foreign participation. Moreover, government’s external financing needs for 2017 are fully covered, and only US$ 1.1 billion, most of which is due to international financial institutions, remains to be financed in 2018. The authorities have also pre-financed 30 percent of redemptions for 2019 through several placements in March 2017.

  • Relatively comfortable international reserve position. Gross international reserves stood at US$179 billion at end-March 2017, very marginally below the US$182 billion at the time of the approval of the current FCL arrangement. This level is adequate relative to the standard reserve coverage indicators.

  • Sound public finances, including a sustainable public debt position, and a commitment to fiscal consolidation. Fiscal policy remains prudent and is underpinned by the rules in the Fiscal Responsibility Law. The authorities are undertaking a fiscal consolidation plan—announced in 2014—that envisages reducing the PSBR from 4.6 percent of GDP in 2014 to 2.5 percent of GDP in 2018. The target for 2015 was met, and the authorities went slightly beyond the 2016 target. Moreover, they have committed to save the entirety of a large transfer from the central bank, which is expected to lead to an over performance in the PSBR target this year by the full amount of the transfer. As a result, the public debt-to-GDP ratio would decline to 54.8 percent in 2017 and stabilize at slightly below that level over the medium term. An updated debt sustainability analysis shows that the debt trajectory is overall robust to standard shocks (Annex II). The debt projection is sensitive to growth, exchange rate fluctuations, and the evolution of oil prices, but debt would remain contained even under severe negative shocks.

  • Low and stable inflation. Headline inflation has recently exceeded the 3 percent target owing mainly to a sharp increase in the prices of domestic fuel, as part of the process of liberalization of these prices, and the pass-through from the currency depreciation, but is expected to converge to the target by early-2019. While near-term inflation expectations are relatively high, medium-term inflation expectations remain close to the target, pointing to the transitory nature of much of the current inflation pressure as well as the credibility of monetary policy. To achieve this, Banxico has tightened monetary policy considerably since December 2015, and stands ready to adjust monetary policy as needed to bring inflation in line with the target.

  • Sound financial system and the absence of solvency problems that may threaten systemic stability. The capital adequacy ratio for the banking system stood at 14.9 percent in December 2016 and provisioning, at 157 percent of nonperforming loans, is high. Corporate balance sheets remain resilient to exchange rate shocks as large corporations are naturally-hedged, while some corporations have recently reduced exchange rate risk as they switched financing to peso loans and bonds. The broader financial system is also sound. Private pension funds, which hold assets of about 16 percent of GDP, have a conservative investment profile. All insurance companies comfortably satisfy the capital requirements under a Solvency II-type regime adopted in April 2015.

  • Effective financial sector supervision. The 2012 FSAP concluded that banking supervision in Mexico was effective. Mexico adopted the Basel III capital rules in 2013, and the Basel Committee assessed it as compliant in 2015. Liquidity coverage ratio (LCR) minimum requirements have been in place since January 2015. The regulation of financial groups was enhanced in January 2014 through the implementation of supervision at the group level. The authorities monitor closely the operations of foreign bank subsidiaries—about 70 percent of banking system assets—to ensure compliance with regulatory norms. The 2016 FSAP found that significant progress has been achieved in strengthening financial sector prudential oversight since 2012. The FSAP recommended several areas for further progress, especially to strengthen the governance of the supervisory agencies and IPAB.

  • Data transparency and integrity. The overall quality of Mexican data continues to be high and adequate to conduct effective surveillance as described in the June 2015 data ROSC update. Mexico remains in observance of the Special Data Dissemination Standards (SDDS).

Figure 11.
Figure 11.

Mexico: Qualification Criteria

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Sources: Bloomberg L.P., Datastream, EMED, Haver Analytics, and Fund staff estimates.1/ Combined permanent 1/4 standard deviation shocks applied to interest rate, growth, and current account balance.2/ Red bar shows ratio for end-year 2015.3/ Not taking into account offsetting measures required under the balanced budget rule.4/ Combined permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.5/ One-time 10 percent of GDP increase in debt-creating flows.

19. International indicators of institutional quality show that Mexico has above average government effectiveness. The institutional quality of economic policy is underpinned by the inflation-targeting framework (anchored by a strong, independent central bank), the Fiscal Responsibility Law, and the effective prudential and regulatory framework for financial supervision. According to the 2016 World Bank Governance Indicators, Mexico’s government effectiveness ranks at the 62nd percentile among all countries. A weaker area is control of corruption, where Mexico stands at the 25th percentile. However, a constitutional reform (adopted in May 2015) and secondary legislation (promulgated in July 2016) further empowers the federal government to investigate, prosecute, and sanction corrupt activity in Mexico. The reform creates a National Anticorruption System, increases transparency requirements in the use of public funds, and lengthens the statute of limitations. Implementation has begun with the institutional setting at the federal level nearing completion. Finally, Mexico is currently undergoing a full assessment of its anti-money laundering framework, and the report (expected in late 2017) will provide further recommendations to the authorities for strengthening the effectiveness of anti-money laundering measures.

Safeguards Assessment

20. Staff has completed the safeguards procedures for Mexico’s 2016 FCL arrangement. The authorities provided the necessary authorization for Fund staff to communicate directly with Banco de Mexico’s external auditor, Mancera, S.C. (EY México). EY México issued an unqualified audit opinion on the Bank de Mexico’s 2015 financial statements. Staff reviewed the 2015 audit results and discussed these with EY México. Staff noted improvements in the quality and transparency of the annual financial statements, including commencement of their publication on the bank’s website. While no significant issues emerged from the conduct of the safeguards procedures, the authorities have already taken steps to enhance the independence of the Bank’s Audit Committee.

Staff Appraisal

21. Mexico continues to benefit from the FCL arrangement. The country has weathered well bouts of market volatility since the approval of the FCL. The FCL arrangement has supported market confidence by providing a reassuring signal on the strength of Mexico’s institutions and policies, and has served as an additional insurance against tail risks. Although the global environment has improved somewhat since the approval of the current FCL, Mexico continues to face elevated external risks associated with uncertainty about the outcome of the discussions on the bilateral relationship with the U.S. and with possible surges in capital flow volatility. The authorities believe that the arrangement will continue to protect Mexico against these risks. They intend to continue treating the FCL as precautionary and consider it a temporary supplement to international reserves. Staff welcomes the authorities’ exit strategy, which foresees a reduction in access in possible requests for subsequent FCL arrangements, conditional on a reduction of the external risks affecting Mexico.

22. The government’s commitment to fiscal discipline is welcome. It is important that the authorities continue to build on the fiscal consolidation efforts of recent years and put the public debt-to-GDP ratio on a downward trajectory. To this end, the recent decision to use the full profit transfer from the central bank for a net reduction in the PSBR for 2017 is welcome, although this is a one-off measure, and should help enhance the credibility of fiscal policy in a period of heightened uncertainty. It would also be important to strengthen the fiscal framework by tightening the link between the desired level of public debt and PSBR targets, limiting the use of exceptional circumstances clauses, and introducing a non-partisan fiscal council. Beyond 2018, aiming at a more ambitious PSBR target would allow rebuilding fiscal buffers more quickly and strengthen Mexico’s resilience to confront downside risks.

23. Mexico continues to meet the qualification criteria for access to the FCL resources. The IMF Board assessment of the 2016 Article IV consultation completed in November 2016 noted Mexico’s strong policies and policy framework. The authorities have a successful record of sound policy management and are firmly committed to maintaining prudent policies going forward. Staff therefore recommends completion of the review under the FCL arrangement for Mexico.

The Updated External Economic Stress Index

The external economic stress index for Mexico was initially presented in Mexico’s staff report on the previous arrangement under the Flexible Credit Line, November 2014. Its methodology is explained in Flexible Credit Line—Operational Guidance Note, IMF Policy Paper, June 2015. The calculation of the index required three main choices: (i) selection of relevant external risks, (ii) selection of proxy variables capturing these risks, and (iii) choice of weights for these variables. The updated index is presented below using the same model, proxy variables, and weights.

Risks. Mexico’s exports, remittances, and inward FDI are closely related to U.S. economic developments. The open capital account and the significant stock of debt and equity portfolio investment expose Mexico to changes in global financial conditions. Finally, oil production and fiscal revenues depend on world energy price developments.

Variables. Risks to exports, remittances and inward FDI are all proxied by U.S. growth. Risks to debt and equity portfolio flows are proxied by the change in the U.S. Treasury 10-year yield and the emerging market volatility index (VXEEM), respectively. Risks to the oil industry are proxied by the change in world oil prices.

Weights. The weights were estimated using balance of payment and international investment position data, all expressed as shares of GDP. The weight on U.S. growth (0.47) corresponds to the sum of exports, FDI, and remittances; the weights on the change in the U.S. long-term yield (0.33) and the VXEEM (0.16) correspond to the stocks of foreign debt and equity; and the weight on the change in the oil price (0.4) corresponds to oil exports.

Baseline scenario. This scenario corresponds to the WEO projections for U.S. growth, oil prices, and the U.S. 10-year bond yield. The VXEEM projections are in line with the VIX futures as of March 30, 2017.

Downside scenario. The scenario is based on staff estimates of the global macroeconomic effects from a sharp rise in global protectionism (global increase in trade barriers with a temporary rise in risk premia), which is broadly consistent with the tail risks presented in this paper. Specifically, it is assumed that U.S. growth would be 1.5 percentage points lower than projected in 2017. As a result of weaker global growth, oil prices would be about 25 percent lower and 10-year interest rates 0.3 percentage points lower than in the baseline. In addition, the downside scenario assumes an increase in global financial market volatility, with the VXEEM rising by 3 standard deviations. The downside scenario is illustrated in the chart by dots, which represent the level to which the index would fall if the described risks would materialize.

uA01fig04

External Economic Stress Index

Citation: IMF Staff Country Reports 2017, 129; 10.5089/9781484301364.002.A001

Table 1.

Mexico: Selected Economic, Financial, and Social Indicators

Sources: World Bank Development Indicators, CONEVAL, National Institute of Statistics and Geography, National Council of Population, Bank of Mexico, Ministry of Finance and Public Credit, and Fund staff estimates.

CONEVAL uses a multi-dimensional approach to measuring poverty based on a “social deprivation index,” which takes into account the level of income; education; access to health services; to social security; to food; and quality, size, and access to basic services in the dwelling.

Percent of population enrolled in primary school regardless of age as a share of the population of official primary education age.

Contribution to growth. Excludes statistical discrepancy.

Includes domestic credit by banks, nonbank intermediaries, and social housing funds.

Includes public sector deposits.

Data exclude state and local governments and include state-owned enterprises and public development banks.

Table 2.

Mexico: Statement of Operations of the Public Sector, Authorities’ Presentation 1/

(In percent of GDP)

Sources: Mexican authorities and IMF staff estimates.

Data exclude state and local governments, and include state-owned enterprises and public development banks.

Includes revenues from the oil-price hedge for 0.6 percent of GDP in 2015 and 0.3 percent of GDP in 2016; and Bank of Mexico’s operating surplus transferred to the federal government for 0.2 percent of GDP in 2015, 1.2 percent of GDP in 2016, and 1.5 percent of GDP in 2017.

Includes social assistance benefits.

Due to lack of disaggregated data this item includes both financing and capital transfers.

The 2014 amendment to the FRL introduced a cap on the real growth rate of structural current spending set at 2.0 percent for 2015 and 2016, and equal to potential growth thereafter. Structural current spending is defined as total budgetary expenditure, excluding: (i) interest payments; (ii) non-programable spending; (iii) cost of fuels for elect ricity generation; (iv) public sector pensions; (v) direct physical and financial investment of the federal government; and (vi) expenditure by state productive enterprises and their subsidiaries.

Table 3.

Mexico: Statement of Operations of the Public Sector, GFSM 2001 Presentation 1/

(In percent of GDP)

Sources: Mexico authorities; and Fund staff estimates and projections.

Data exclude state and local governments, and include state-owned enterprises and public development banks.

Includes revenues from the oil-price hedge for 0.6 percent of GDP in 2015 and 0.3 percent of GDP in 2016, treated as revenues from an insurance claim. It includes also Bank of Mexico’s operating surplus transferred to the federal government for 0.2 percent of GDP in 2015, 1.2 percent of GDP in 2016, and 1.5 percent of GDP in 2017.

Interest payments differ from official data due to adjustments to account for changes in valuation and interest rates.

Includes transfers to state and local governments under revenue-sharing agreements with the federal government.

Includes pensions and social assistance benefits.

Includes Adefas and other expenses, as well as the adjustments to the "traditional" balance not classified elsewhere.

This category differs from official data on physical capital spending due to adjustments to account for Pidiregas amortizations included in budget figures.

Adjusting revenues for the economic and oil-price cycles and excluding one-off items (e.g. oil hedge income and Bank of Mexico transfers).

Negative of the change in the structural primary fiscal balance.

Corresponds to the gross stock of PSBR, calculated as the net stock of PSBR as published by the authorities plus public sector financial assets.

Corresponds to the net stock of public sector borrowing requirements (i.e., net of public sector financial assets) as published by the authorities.

Table 4.

Mexico: Summary Balance of Payments

Sources: Bank of Mexico, Ministry of Finance and Public Credit, and Fund staff estimates.

Goods procured in ports by carriers.

Crude oil, oil derivatives, petrochemicals, and natural gas.

Table 5.

Mexico: Financial Soundness Indicators

(In percent)

Sources: Financial Soundness Indicators
Table 6.

Mexico: Financial Indicators and Measures of External Vulnerabilities

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

Excludes balances under bilateral payments accounts. For 2009, 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.

The ARA metric was developed by the Strategy and Policy Review Department at the IMF to assess reserve adequacy. Weights to individual components were revised in December 2014 for the whole time series.