Roberto García-Saltos

Mexico has come a long way in developing policies conducive to macroeconomic and financial stability, creating a sound environment to invigorate growth prospects. The results of the policy framework implemented since the 1994–95 crisis include fiscal consolidation, low and stable inflation amid a floating exchange rate, and a sound financial system. In that context, greater integration with the global economy has been consistent with greater stability and reliable access to foreign finance. At the same time, Mexico’s increased linkage with the U.S. economy has led to more synchronization with the U.S. business cycle. Recently, IMF staff analyzed these transformations and their implications, as well as the need for further financial development and structural reforms to accelerate growth and further reduce poverty.

There can be little doubt that Mexico learned well and implemented the lessons of the 1994–95 financial crisis. Consistent policy implementation has brought a new era of stability and resilience to external shocks. Three components of economic policies, along with the role played by the North American Free Trade Agreement (NAFTA), explain how Mexico achieved this transition to stability.

First, sustained fiscal consolidation has translated into lower gross public debt (on the broadest “augmented” measure), which fell to 42 percent in 2007, down from 50 percent in 2000 (and much higher levels previously). Jenker (2004), Soueid (2005), and Moissinac (2005) analyze how this fiscal performance was complemented with proactive public debt management strategies, reducing fiscal vulnerabilities. Mexico’s shift in the structure of public debt away from foreign-currency-denominated instruments created a financial infrastructure that improved the liquidity and depth of the domestic bond market.

Second, the consistent implementation of an inflation targeting framework, within a symmetrically floating exchange rate regime, steadily reduced inflation and inflation expectations to low levels. From near 10 percent at the beginning of this decade, Mexico’s inflation over the last five years has consistently approached the 3 percent target. Faal (2005), Batini, Barkbu, and Garcia-Saltos (2006), and recent studies at Mexico’s central bank (Capistran and Ramos-Francia, 2007) document the significant reduction in inflation persistence and volatility.

Third, financial sector reforms that followed the 1994–95 financial crisis have greatly enhanced the stability of the financial sector and created a new basis for financial intermediaries to provide credit to the private sector (IMF, 2006). Moissinac (2005) documents the reforms on bank supervision and on capital and securities markets infrastructure, which has contributed to the rebound of commercial bank lending in recent years. Moreover, Espinosa and Zanforlin (2007) explain that the recent rapid credit growth in housing finance appears to be grounded in a more solid basis than in the past. While the mortgage-backed securities market in Mexico is still relatively small—with fewer systemic implications, and on a sounder footing, than in some developed countries—this study points to lessons from the recent financial turbulence in other countries, which could help Mexico avoid pitfalls and maintain its financial stability.

The adoption of NAFTA and its interactions with domestic policies has also contributed to Mexico’s new economic landscape, and has had important impact on the economic structure, exports, economic volatility and synchronization as they relate to the U.S. economy. On the economic structure, Kose, Meredith, and Towe (2004) document the significant increase in the contributions of exports and investment to GDP growth that followed the implementation of NAFTA. From a commodities-oriented export structure, Mexico has moved toward exporting manufacturing products, with the U.S. market taking up more than 80 percent of the country’s exports. These studies show that NAFTA could also account for an important share in the reduction in Mexico’s output and investment volatility, which since 1996 decreased by about one-third. At the same time, the business cycles of Mexico and the United States have become significantly more synchronized, with large increases in the cross-country correlations of the major macroeconomic aggregates (Sosa, 2007; Österholm and Zettelmeyer, 2007; and Swiston and Bayoumi, 2008). Blavy and Juvenal (2007) found that NAFTA has contributed to significantly reduced transaction costs between Mexico and the United States, and thus to increased price-level synchronization, albeit still to a lesser extent than between the United States and Canada. For the post-NAFTA period, Sosa (2007) found that shocks to U.S. demand for Mexico’s exports represent about 40 percent of Mexico’s output fluctuations, in fact constituting the largest source of foreign disturbances. The size of the apparent effect of U.S. real variables on Mexican GDP is rather large and goes beyond its immediate and direct influence on Mexico’s exports. Indeed, changes in U.S. economic activity are also important in driving—directly or indirectly—output fluctuations in the services sector, which accounts for more than 65 percent of Mexican GDP. Given the presumably small direct exposure—through trade channels—of the service sector to the U.S. economy, these results suggest that there are also other spillovers or multiplier effects transmitting shocks from the export sector to the rest of the Mexican economy. A possible additional channel is through the effect of workers’ remittances on boosting private consumption (Mehrez, 2006; Roache and Gradzka, 2007; and Mishra, 2007).

Going forward, Mexico’s fundamental challenge remains to put in place policies to achieve a sustained and substantial acceleration in GDP growth and a further reduction in poverty and inequality. While faster integration with the global economy could account for lower output volatility, Mexico has not joined the league of fast-growing emerging markets, and there have been no signs of income convergence across regions (Serra and others, 2006) or with the United States. The priorities for the reform agenda are well defined, and include polices to increase the extent of competition so as to allow key markets to function more efficiently, strengthen the business environment to encourage investment-led growth and increase the accountability of public spending, especially at the level of subnational governments (Bulíř and Swiston, 2006; Moissinac, 2006; Ahmad and others, 2007). One significant element that warrants future attention is the pervasiveness of informal economic activity in Mexico, the explanations for which go beyond labor market issues, and which is likely to be both a cause and consequence of other problems that may slow growth, including low labor productivity, high levels of tax evasion, and low levels of access to financial services ( Mehrez, 2005).