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IMF Concludes 2002 Article IV Consultation with Mexico
On September 23, 2002 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mexico.1
The economic slowdown in the United States triggered a sharp weakening in Mexican economic activity in 2001 from the rapid pace in the preceding year. There was also a marked deceleration in domestic demand growth, as disposable income was adversely affected by a contraction in employment and confidence sagged. Last year's recession, which was characterized by a 0.3 percent decline in real GDP, was the first in Mexico's recent history not associated with a domestic economic crisis. The 12-month inflation rate slowed to 4.4 percent at end-2001, well under the target of 6.5 percent. The weakness in domestic demand last year contributed to a narrowing of the external current account deficit to 2.8 percent of GDP from 3.1 percent of GDP in 2000. The current account deficit was more than financed by foreign direct investment (FDI), reflecting the US$12.5 billion purchase of Banamex by Citibank. Other capital inflows were also strong, helped by investors' perception of Mexico as a "safe haven" among emerging markets.
Economic activity rebounded strongly in the second quarter of 2002, as exports were supported by stronger demand from the United States and final domestic demand grew sharply. The 12-month inflation rate rose to 5.3 percent in August 2002, owing largely to increased transport and electricity tariffs, and a weather-related hike in food prices; the core inflation rate continued to decline to under 4 percent. The external current account deficit continued to moderate in the first half of 2002. About 90 percent of the deficit during this period was financed by net inflows of foreign direct investment.
Net international reserves increased by US$1.7 billion during the first eight months of 2002, following a gain of over US$9 billion in 2001. Gross international reserves amounted to more than US$46½ billion at the end of August 2002, equivalent to 125 percent of short-term debt by residual maturity and 82 percent of annual gross external financing requirements.
The authorities made progress in rebalancing the policy mix in 2001 as fiscal policy was tightened on a cyclically-adjusted basis and monetary policy was relaxed. Monetary policy was tightened in September 2002 in response to an uptick in inflation expectations and the turbulence in international markets, in line with the Bank of Mexico's strategy of achieving a decline in inflation to low levels. Domestic interest rates fell during 2001 and the first four months of 2002, but that fall subsequently has been partly reversed.
Mexican financial markets have weakened since early April 2002 in response to the rise in global risk aversion and developments in Brazil. Nevertheless, market sentiment towards Mexico remains favorable, supported by the country's investment-grade rating which has contributed to a widening of the investor base. The peso depreciated from end-March 2002, which contributed to some gain in competitiveness. In any case, the peso still has appreciated significantly in real effective terms in recent years both in relation to relative consumer prices and (by less) in relation to unit labor costs.
The government has made substantial progress in improving public sector debt management, resulting in a lower cost of funding, longer maturities and reduced external vulnerability. Nonetheless, exposure to short-term interest rates and the large gross financing needs of the public sector still constitute vulnerabilities for the public sector.
Executive Board Assessment
Directors commended the authorities for maintaining prudent fiscal and monetary policies in the face of weak economic activity. As a result, inflation has declined, the external current account deficit is moderating, and international reserves have strengthened significantly. Directors noted that last year's recession was the first in Mexico's recent history not associated with a domestic economic crisis—demonstrating a resilience that distinguishes the country as a relatively "safe haven" among emerging markets.
Directors observed that the difficult external environment had weakened Mexico's economic performance in 2001, but that growth has begun to rebound this year in line with the pick up in activity in the United States. Continued skillful macroeconomic management and strong focus on trade, as well as further progress in structural reforms, will be essential for achieving faster growth and continuing to reduce poverty.
Directors welcomed the authorities' medium-term economic program (PRONAFIDE), which centers on structural reforms aimed at strengthening further the fiscal position, enhancing competitiveness and increasing productivity. Full implementation of the reforms is now essential to place the economy on a higher growth path that would facilitate poverty reduction. Directors emphasized the particular importance of reforms in the tax system to reduce reliance on oil revenues, as well as in the energy and telecom sectors, the labor market, and the judicial system, including improvements in governance.
Directors welcomed the authorities' commitment to a fiscal framework aimed at a sizable reduction in the fiscal deficit and public debt by 2006. They stressed that successfully implementing the authorities' objective of a front-loaded fiscal adjustment in 2003 would be important to further enhance Mexico's market credibility, following the easing of the fiscal policy stance this year. Achieving this objective would also reduce pressure on real interest rates, allowing room for increased private sector activity, and raising Mexico's resilience against external shocks.
In considering the mix of adjustment measures, Directors noted the authorities' firm commitment to curtail spending as needed to achieve the medium term fiscal targets. They welcomed the fact that, despite the tight spending constraints, the authorities had increased social expenditures markedly in recent years, which had led to an improvement in poverty indicators. Directors supported the authorities' intention to continue to build support for the much-needed second stage of fiscal reforms, especially the harmonization of the VAT rates, and commended the authorities' continued efforts to improve tax administration.
Directors welcomed the main findings of the fiscal ROSC mission, namely, that the government has made considerable progress in improving transparency and complying with international standards. Major initiatives included reforms to the budgetary process, timely disclosure of fiscal information, and strengthening of internal controls. The recent publication of the fiscal ROSC is an important example of this progress. Nevertheless, Directors noted that additional actions are still needed, including a redefinition of the institutional coverage of government, and presentation of the budget within a medium term context.
Directors noted that Mexico's central bank has gained considerable credibility in recent years in the conduct of monetary policy. In light of the recent uptick in inflation expectations and the turbulence in international markets, they endorsed the bank's monetary policy stance, including today's tightening of policies, as appropriately geared toward achieving a decline in inflation to low levels. An easing of monetary conditions could be considered at a later stage should prospects for economic recovery weaken, and provided inflationary expectations are successfully reduced.
Directors welcomed the authorities' intention to strengthen further the inflation targeting framework, and the announced adoption of a long-term inflation objective for 2004 and beyond. Most agreed that the "corto" continues to be a flexible and efficient monetary policy instrument that allows for appropriate adjustments in interest rates. Moving forward, some Directors saw merit in considering a shift toward the direct targeting of short-term interest rates as a means of further enhancing transparency in monetary policy—especially in a strengthened inflation targeting framework—and reducing interest rate volatility, while others noted that such a move could increase volatility in the exchange rate.
Directors welcomed the continued strengthening of the financial system, and the additional measures that are being introduced, aimed at achieving international standards. In particular, they noted the measures to reduce the Bank of Mexico's credit risk associated with the payments system, and the recent legislation to modernize the state-owned development banks. Some Directors expressed concern about the stagnation in bank credit to the private sector, but took note of the authorities' expectation that a resumption in lending could be facilitated by the reforms introduced to improve the credit infrastructure, including the framework for creditor rights, and to strengthen bank supervision.
Directors viewed the present level of international reserves as broadly adequate in the context of a flexible exchange rate regime, noting that reserves more than fully cover short-term debt. A few Directors felt that a further accumulation of reserves would be desirable to provide an extra margin of safety. As regards external competitiveness, several Directors observed that the timely implementation of productivity enhancing measures as proposed by the authorities would help allay possible concerns about the appreciation of the real exchange rate in recent years, although it was noted that Mexican exports continue to gain market share in the United States, its main trading partner.
Looking ahead, Directors noted that despite favorable economic prospects uncertainties remain, including the strength of the recovery in the U.S., volatility in equity markets, and the weakening of sentiment toward other emerging market economies. In addition, a number of Directors pointed to the risks related to the large public sector financing requirement, and the structure of public and corporate debt, and cautioned that delays in implementing the authorities' medium-term fiscal adjustment and structural reform agenda could increase the economy's vulnerability and lower growth prospects. In this context, Directors took note of the results of the stress simulations that suggest that the external sector could weather well a potential sizable capital account crisis. They welcomed the authorities' efforts to further improve public debt management through continued issues of long-term fixed-rate instruments, and by establishing benchmarks in the domestic debt market. They also welcomed the authorities' intention to undertake a World Bank-led ROSC on corporate governance, and encouraged them to continue their close monitoring of the corporate sector. In general, Directors were reassured by the authorities' well-deserved reputation for addressing adverse circumstances through prudent economic management, and by the measures that have been taken to strengthen the institutional basis for maintaining economic and financial stability.
Directors noted that Mexico's data are generally of good quality, timely, and adequate for conducting surveillance effectively.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.
IMF EXTERNAL RELATIONS DEPARTMENT