Public Information Notice No. 04/140

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Mexico

December 23, 2004

On October 18, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mexico.¹

Background

After three years of weak activity, the broad-based recovery underway this year provides encouraging evidence that the factors holding back Mexico's growth were temporary. Business confidence and investment have risen, foreign direct investment (FDI) inflows are strengthening, exports have picked up sharply, and market perceptions of Mexico remain favorable. While inflation has risen moderately above the authorities' objective, it remains far below levels historically experienced by Mexico. Higher oil prices and a recovery in non-oil exports have led to a narrowing in the current account deficit. The current account deficit has been more than matched by FDI inflows.

Economic activity accelerated to 3.8 percent in the first half of 2004 over the previous year. This recovery is partly attributable to strengthening U.S. industrial production, as reflected in growth in Mexican manufactured exports of 10½ percent (seasonally adjusted) in the first seven months of 2004 over the same period in 2003. Inflation accelerated from 4 percent at end-2003 to 5.1 percent in September, boosted by supply shocks, including a temporary suspension of some meat imports from the United States, higher oil and commodity prices, and their impact on administered prices. Core inflation was lower, standing at 3.8 percent, but has shown no signs of decelerating since early 2003.

Net international reserves increased to US$58 billion in August 2004, compared with US$48 billion at end-2002, reflecting strong PEMEX receipts. A change was made to the mechanism for auctioning international reserves in March 2004. The Banco de Mexico continues to pre-announce the amount of dollars to be sold in the market, equal to 50 percent of net reserve accumulation in the previous three-month period. The sale of dollars will now, however, be spread over the following 12 months, as opposed to three months, to reduce volatility in the amount sold throughout the year.

Targets for the traditional deficit have been met in recent years. But the pace of fiscal consolidation, viewed in terms of the augmented public sector deficit, has been slower than envisaged in the authorities' 2002 medium-term plan. While this deficit was reduced from 3.7 percent of GDP in 2000 to 3.1 percent in 2003, gross public debt rose by about 1.75 percentage points to 51 percent of GDP during those years, reflecting both currency depreciation and slow growth. For 2004, the augmented deficit is expected to remain broadly unchanged, while the traditional deficit would fall slightly to 0.4 percent of GDP, in line with budget targets. The draft budget for 2005 calls for a decline in the augmented deficit to 2.2 percent of GDP, while the traditional deficit would fall to 0.1 percent of GDP.²

The Banco de Mexico has tightened policy seven times since the beginning of 2004 via increases in the corto (the borrowed reserves objective). In addition, domestic market conditions have been affected by the two increases in the U.S. federal funds target rate. The overnight inter-bank (fondeo) rose from about 5 percent in January to slightly over 8 percent in mid-September. Long-term interest rates rose by slightly less over this period, with the 10-year government bond yield increasing from about 8½ percent in January to 10½ percent in September. The peso depreciated by 2 percent through end-September after falling by 6½ percent against the U.S. dollar in 2003.

Market sentiment toward Mexico remains positive, as reflected in its investment-grade status. After a short-lived spike to 250 basis points in mid-May as U.S. interest rates rose, Mexico's EMBI+ spread has fallen back to about 180 basis points.

The government has made significant progress in strengthening the structure of public debt. Several liability management operations, including an exchange of global bonds in early 2004, have helped to improve the efficiency of the yield curve. Domestic public debt management has concentrated on extending maturities, improving the liquidity of benchmark issues, and deepening domestic financial markets. Nevertheless, some public debt vulnerabilities remain, with a large portion of domestic debt either short term or linked to short-term interest rates. The public sector also has a significant gross financing need.

Executive Board Assessment

Executive Directors commended the Mexican authorities for their continued pursuit of sound macroeconomic policies, and welcomed signs that recently the economic recovery has strengthened and become more broadly based, while business confidence and investment have risen. Meanwhile, FDI inflows have been strong, exports have picked up, and market perceptions of Mexico remain favorable. Progress in modernizing the financial sector has continued, and balance sheets appear healthy. The key challenges going forward will be to enhance Mexico's economic performance on a lasting basis by bringing inflation down to the long-term objective, reducing debt vulnerabilities, and reinvigorating the program of structural reforms.

On fiscal policy, Directors welcomed the authorities' continuing commitment to medium-term fiscal consolidation, and commended the authorities' track record in meeting fiscal targets. They noted that the budget is dependent on volatile oil revenues. In this context, most Directors encouraged the authorities to aim at saving significantly more of the excess oil revenues for the medium term, while some considered the use of part of these revenues for productive investments to be a prudent strategy. Looking ahead, Directors urged the authorities to establish stronger mechanisms to ensure that a substantial portion of the windfall is saved. This will require redoubled efforts to ensure that medium-term expenditure reduction is combined with measures to achieve significant increases in non-oil revenues.

Directors considered that fiscal reforms will have a crucial role to play in achieving further consolidation. In particular, formal fiscal responsibility principles based on the augmented fiscal measures should be helpful in avoiding slippages in meeting medium-term targets. Directors regretted the setback to efforts aimed at enhancing the efficiency of the tax system and promoting fiscal stability. They believed that tax reform to raise non-oil revenues will be needed to avoid budget cuts that could jeopardize spending in social areas and on public infrastructure. Pension reform will also be required to ensure that the fiscal accounts remain on a sound path. Directors encouraged the authorities to take actions to enhance the accountability and efficiency of several public enterprises, including PEMEX, in order to strengthen the fiscal position and raise the quality of Mexico's infrastructure.

Directors identified several other key elements of the reform agenda that should be pursued. These include stepped up efforts to improve governance and enhance flexibility in the labor market. Directors considered that building a consensus around these efforts, as well as on actions to enhance competition in the telecommunications sector, will be vital for promoting private investment.

Regarding monetary policy, Directors recognized the success of Mexico's inflation targeting framework in bringing inflation down to low single-digit levels. They noted that, although the long-term inflation target is close to being met, sustained achievement of the target is proving to be problematic in an environment of repeated price shocks. Directors accordingly viewed the recent tightening of the monetary stance as appropriate to ensure the credibility of the authorities' commitment to lowering inflation. Looking ahead, Directors agreed that a tightening bias in policy will remain appropriate until there are clear signs that inflation expectations are declining toward the long-term objective.

Directors supported the authorities' efforts to refine monetary policy announcements to signal the policymakers' views more directly to markets. Steps in this direction have led to more stable short-term interest rates in recent months, as well as to more predictable market responses to policy actions. Directors generally agreed that there is scope to further increase transparency and predictability in policy implementation over time, including by moving to an interest rate instrument when conditions warrant. Directors were encouraged by the refinements to the inflation-targeting framework. Many Directors acknowledged the drawbacks to moving toward publication of an official inflation forecast in the immediate circumstances, given the evolving nature of monetary instruments and the risks of adding to uncertainty about policy intentions at a critical time. However, this issue should be kept under review.

Directors observed that Mexico's flexible exchange rate regime has been effective in cushioning the economy from external shocks. They viewed external competitiveness to be broadly consistent with a sustainable balance of payments position. They agreed that the rules-based mechanism for accumulating foreign reserves appropriately reflects the authorities' transparent approach to reserves management and their commitment to a market-determined exchange rate.

Directors welcomed the continued improvement in broad indicators of banking sector soundness. They noted that the banking system as a whole has a sound level of profitability and capital adequacy. A significant challenge in the period ahead will be to deepen financial activity without excessive risk-taking, and to streamline financial regulation to encourage innovation and competition. In this regard, Directors encouraged the authorities to review the operations of the nonbank financial sector and the development banks to ensure that they do not pose a source of hidden financial risks.

Directors endorsed the authorities' continued commitment to reduce vulnerabilities relating to public debt. In addition to sustained progress with fiscal consolidation, they welcomed plans to improve the debt structure further by continuing to increase fixed-rate domestic-currency instruments, extending the domestic yield curve, and diversifying the investor base.