## cr17129

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---

### EXECUTIVE SUMMARY — CONTEXT
- Mexico’s policies and policy frameworks have helped it navigate a complex external environment characterized by heightened risk of protectionism and financial market volatility.
- Increased uncertainty is likely to weigh on investment and growth.
- Inflation is above the central bank’s target, reflecting mainly the transitory effects of the liberalization of domestic fuel prices and the pass-through from the currency depreciation.
- Downside risks remain elevated amid continued uncertainty about the outcome of the discussions with the United States on trade, as well as a possible renewed surge in capital flow volatility.
- Mexico’s flexible exchange rate has helped the economy adjust to external shocks and the inflation-targeting framework has kept medium-term inflation expectations well anchored.
- Mexico’s external position is broadly in line with fundamentals and desirable policies.

### RECENT ECONOMIC DEVELOPMENTS AND POLICIES — KEY STATISTICS & FINDINGS
- Real GDP:
  - In the first three quarters of 2016, real GDP expanded by 2¼ percent (y/y).
  - Growth for 2016 was 2.3 percent.
- Inflation and monetary policy:
  - Inflation rose to the target of 3 percent in September 2016 and reached 3.4 percent (y/y) by end-2016.
  - Headline and core inflation expectations over the next twelve months were at 4 percent as of March 2017.
  - Longer term inflation expectations (horizon between 5 and 8 years) returned to the historical average of around 3½ percent as of March 2017.
  - Bank of Mexico policy rate timeline:
    - 3.00 percent in November 2015
    - 4.75 percent in September 2016
    - 5.75 percent by December 2016
    - 6.5 percent by March 2017
- Output components:
  - Services performed strongly in 2016; real private investment slowed to 2.1 percent (y/y) in the first three quarters of 2016 (down from 8 percent in 2015).
  - Unemployment rate fell to 3.7 percent in December 2016.
- Financial markets and external flows:
  - Between November 8 and January 22, the peso depreciated 18 percent.
  - 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 between November and January.
  - Non-residents held 35 percent of local-currency-denominated sovereign bonds in 2016.
  - Total foreign portfolio investment in Mexico reached US$28.6 billion (2.7 percent of GDP) in 2016.
  - FEC announced auctions of up to US$20 billion of non-deliverable forwards (NDF); US$1 billion auctioned so far; first auction (US$1 billion on March 6, 2017) received total bid-to-cover of 2.1 times.
  - Discretionary foreign exchange intervention used once on January 5 (Banxico sold US$2 billion through direct sales).
- Inflation drivers in early 2017:
  - Headline inflation reached 5.35 percent (y/y) in March 2017 following up-to-20-percent m/m increase in domestic fuel prices in January.
  - Direct effects of fuel price increases explain 1.3 ppts of the 2 ppts change in y/y headline inflation between December 2016 and March 2017.
  - Pass-through to non-food merchandise explains 0.3 ppt; base effects and administered price adjustments explain 0.2 ppt.
- Fiscal policy:
  - PSBR initially targeted at 2.9 percent of GDP for 2017 (the outturn for 2016); will be cut to 1.4 percent of GDP by channeling all the 2016 surplus of Banxico to reduce the deficit.
  - Authorities committed to a PSBR of 2½ percent of GDP in 2018 and beyond.
  - Public debt increased to 58.5 percent of GDP in 2016; projected to decline to 54.8 percent of GDP in 2017 and stabilize slightly below that level over the medium term.
  - Public debt-to-GDP ratio increased by 12.1 ppts during 2014-16; real peso depreciation contributed 6.7 ppts; pension reform securitizations contributed 0.7 ppts and 0.9 ppts; cumulative primary deficits accounted for 2.1 ppts.
- Structural and institutional reforms:
  - Continued implementation across energy, telecommunications, financial, competition, and education sectors expected to boost growth potential.
  - 2016 FSAP concluded financial regulatory and supervisory framework was strong.

### TRADE AND FINANCIAL LINKAGES WITH THE UNITED STATES (HIGHLIGHTS)
- Trade:
  - The United States represents 71 percent of Mexico’s exports and 51 percent of Mexico’s imports.
  - In value-added terms, 14 percent of Mexico’s GDP ends up being consumed by the United States.
- Investment and portfolio linkages:
  - The United States accounts for 40 percent of Mexico’s FDI inflows.
  - According to 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.

### FLEXIBLE CREDIT LINE (FCL) — ARRANGEMENT, QUALIFICATION, ROLE
- FCL arrangement:
  - On May 27, 2016, Executive Board approved a 24-month arrangement with Mexico under the FCL in the amount of SDR 62.3889 billion (700 percent of quota, about US$85 billion).
  - Authorities intend to continue treating the arrangement as precautionary.
- Qualification and staff view:
  - Mexico continues to meet the qualification criteria for access to FCL resources specified under Decision No. 14283-(09/29).
  - Staff recommends the Board completes the review under the FCL arrangement, allowing purchases until expiration on May 26, 2018.
- Role of the FCL:
  - Provided reassuring signal on strength of Mexico’s policies and insurance against tail risks, complementing Mexico’s net international reserves.

### PEMEX, CORPORATE, AND BANKING SECTOR — IMPLEMENTATION & RESILIENCE
- PEMEX implementation:
  - Ongoing restructuring involves sharp expenditure cuts, increased use of joint ventures, and disposal of non-core assets.
  - Restructuring proceeding as expected and has helped stabilize PEMEX’s financial position.
- Non-financial corporate sector:
  - Large corporations have adequate foreign currency earnings to hedge foreign currency liabilities.
  - Some corporations reduced FX exposure by refinancing foreign currency debts with domestic bank loans and bonds.
  - The sector remains liquid.
- Banking sector:
  - Asset quality remains high; system well capitalized and liquid.
  - CNBV bank stress tests (using December 2016 balance sheet information) indicate resilience even in a severe 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; systemic banks would not face difficulties.

### STRUCTURAL REFORM IMPLEMENTATION — SELECTED OUTCOMES
- Telecommunications reform: attracted FDI; sizable reduction in prices of telecommunication services.
- Energy reform: 39 contracts awarded with expected investment flows of US$50 billion.
- Financial reform: increasing competition in mortgage segment by reducing refinancing costs and facilitating portability of loans.
- Anticorruption reform: secondary legislation promulgated; moving to implementation phase.

### OUTLOOK, RISKS, AND PROJECTIONS
- Growth under heightened uncertainty:
  - Real GDP growth expected to slow to 1.7 percent in 2017.
  - Output growth projected to recover only slightly to 2 percent in 2018.
- Inflation:
  - Expected to remain high at 5.1 percent at end‑2017.
  - Projected to converge to the target by early 2019 as depreciation and domestic fuel price effects dissipate and monetary tightening takes effect.
- Current account and NIIP:
  - Current account deficit projected to improve slightly from 2.7 percent of GDP in 2016 to 2.3 percent by 2022.
  - NIIP 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.
- External risks:
  - Risks include renegotiation of NAFTA, prolonged negotiations, increased protectionism, and a faster‑than‑expected pace of U.S. interest rate hikes.
  - Updated external stress index improved somewhat since the FCL request but remains sensitive to factors not captured by the index.

### KEY INDICATORS SUPPORTING FCL QUALIFICATION
- External debt and NIIP:
  - External debt about 39 percent of GDP.
  - Net foreign asset position projected to decline to below minus 40 percent of GDP by 2022.
- Sovereign market access and financing:
  - Sovereign bond (EMBI+) spread and five‑year CDS spreads stood at 202 and 126 basis points, respectively (as of April 24, 2017).
  - Recently placed a 30‑year, fixed‑rate domestic currency bond with a yield of 7.85 percent that attracted 43 percent of foreign participation.
  - Government’s external financing needs for 2017 fully covered; only US$ 1.1 billion remains to be financed in 2018.
  - Authorities pre‑financed 30 percent of redemptions for 2019 through several placements in March 2017.
- International reserves:
  - Gross international reserves stood at US$179 billion at end‑March 2017 (marginally below US$182 billion at time of FCL approval).
- Public finances and debt:
  - Fiscal consolidation plan envisages reducing PSBR from 4.6 percent of GDP in 2014 to 2.5 percent of GDP in 2018.
  - Public debt‑to‑GDP ratio projected to decline to 54.8 percent in 2017 and stabilize slightly below that level over the medium term.
- Financial system soundness:
  - Capital adequacy ratio for the banking system stood at 14.9 percent in December 2016.
  - Provisioning at 157 percent of nonperforming loans.
  - Private pension funds hold assets of about 16 percent of GDP.

### INSTITUTIONAL QUALITY, GOVERNANCE, AND SAFEGUARDS
- World Bank Governance Indicators (2016):
  - Government effectiveness: 62nd percentile.
  - Control of corruption: 25th percentile.
- Anticorruption reform:
  - Constitutional reform adopted May 2015; secondary legislation promulgated July 2016.
  - Implementation begun; institutional setting at federal level nearing completion.
- Anti‑money laundering:
  - Mexico undergoing a full assessment; report expected in late 2017.
- Safeguards assessment:
  - Safeguards procedures for Mexico’s 2016 FCL arrangement completed.
  - EY México issued an unqualified audit opinion on Banco de Mexico’s 2015 financial statements.
  - Improvements in quality and transparency of annual financial statements noted; steps taken to enhance independence of Bank’s Audit Committee.

### STAFF APPRAISAL AND POLICY RECOMMENDATIONS
- FCL assessment:
  - FCL arrangement supported market confidence and served as insurance against tail risks.
  - Arrangement remains valuable given elevated external risks; authorities treat it as precautionary and temporary.
  - Staff welcomes authorities’ exit strategy aiming for reduced access in subsequent FCL arrangements conditional on reduced external risks.
- Fiscal policy recommendations:
  - Continue fiscal consolidation to place public debt‑to‑GDP on a downward trajectory.
  - Decision to use full profit transfer from the central bank for a net reduction in the PSBR for 2017 is welcome but one‑off.
  - Strengthen the fiscal framework by:
    - Tightening the link between desired public debt level and PSBR targets.
    - Limiting use of exceptional circumstances clauses.
    - Introducing a non‑partisan fiscal council.
  - Beyond 2018, aim for a more ambitious PSBR target to rebuild fiscal buffers more quickly.
- Qualification and recommendation:
  - Mexico continues to meet qualification criteria for access to FCL resources.
  - Staff recommends completion of the review under the FCL arrangement for Mexico.

### BOX 2 — UPDATED EXTERNAL ECONOMIC STRESS INDEX (METHODOLOGY & SCENARIOS)
- Methodology:
  - Uses model, proxy variables, and weights from prior index presented in November 2014 and Flexible Credit Line—Operational Guidance Note, IMF Policy Paper, June 2015.
  - Calculation choices: selection of relevant external risks; selection of proxy variables; choice of weights.
- Risks included: U.S. economic developments (exports, remittances, inward FDI), global financial conditions, world energy price developments.
- Proxy variables:
  - U.S. growth (risks to exports, remittances, inward FDI).
  - Change in U.S. Treasury 10-year yield (risks to debt portfolio flows).
  - Emerging market volatility index (VXEEM) (risks to equity portfolio flows).
  - Change in world oil prices (risks to oil industry).
- Weights (expressed as shares of GDP):
  - Weight on U.S. growth: 0.47
  - Weight on change in the U.S. long-term yield: 0.33
  - Weight on the VXEEM: 0.16
  - Weight on change in the oil price: 0.4
- Scenarios:
  - Baseline uses WEO projections for U.S. growth, oil prices, and the U.S. 10-year bond yield; VXEEM projections in line with VIX futures as of March 30, 2017.
  - Downside scenario assumptions:
    - U.S. growth 1.5 percentage points lower than projected in 2017.
    - Oil prices about 25 percent lower than in the baseline.
    - 10-year interest rates 0.3 percentage points lower than in the baseline.
    - VXEEM would rise by 3 standard deviations.

### APPENDIX I — EXTERNAL DEBT SUSTAINABILITY ANALYSIS (HIGHLIGHTS & DATA)
- Baseline external debt (percent of GDP) series: 29.2; 31.4; 32.9; 36.2; 39.3; 40.3; 40.5; 40.8; 41.0; 41.1; 41.2.
- Debt-stabilizing non-interest current account 6/: -1.3.
- Change in external debt (annual): 5.1; 2.3; 1.5; 3.3; 3.1; 0.9; 0.3; 0.2; 0.3; 0.1; 0.1.
- Identified external debt-creating flows (4+8+9): 0.1; -1.6; -1.3; 2.7; 0.9; -0.1; -0.2; -0.8; -1.0; -1.1; -1.1.
  - Current account deficit, excluding interest payments (4): -0.3; 0.6; 0.0; 0.7; 0.2; -0.4; -0.3; -0.6; -0.8; -0.9; -0.9.
  - Net non-debt creating capital inflows (negative) (8): -0.7; -2.7; -2.0; -2.3; -3.5; -1.9; -2.2; -2.5; -2.5; -2.4; -2.4.
  - Automatic debt dynamics 1/ (9): 1.1; 0.4; 0.6; 4.3; 4.2; 2.1; 2.3; 2.3; 2.3; 2.2; 2.2.
    - Contribution from nominal interest rate (10): 1.7; 1.9; 2.0; 2.2; 2.5; 2.8; 3.1; 3.3; 3.3; 3.3; 3.3.
    - Contribution from real GDP growth (11): -1.0; -0.4; -0.7; -1.0; -0.9; -0.6; -0.7; -1.0; -1.0; -1.1; -1.0.
    - Contribution from price and exchange rate changes 2/ (12): 0.3; -1.0; -0.6; 3.1; 2.7; ...
- Residual, incl. change in gross foreign assets (2-3) 3/: 5.0; 3.9; 2.7; 0.6; 2.2; 1.1; 0.4; 1.0; 1.2; 1.1; 1.1.
- External debt-to-exports ratio (percent): 89.3; 99.0; 102.0; 103.2; 103.3; 101.8; 101.1; 99.5; 97.4; 94.6; 92.6.
- Gross external financing needs (US$ billions): 85.4; 128.8; 138.5; 143.9; 127.9; 94.2; 101.5; 109.6; 116.1; 111.7; 121.2.
- Key macro assumptions (selected):
  - Real GDP growth (percent): 4.0; 1.4; 2.3; 2.6; 2.3; 2.2; 2.7; 1.7; 2.0; 2.7; 2.7; 2.7; 2.7.
  - Current account balance, excluding interest payments (percent of GDP): 0.3; -0.6; 0.0; -0.7; -0.2; 0.0; 0.5; 0.4; 0.3; 0.6; 0.8; 0.9; 0.9.
  - Net non-debt creating capital inflows (percent of GDP): 0.7; 2.7; 2.0; 2.3; 3.5; 1.9; 0.9; 1.9; 2.2; 2.5; 2.5; 2.4; 2.4.
- Public Debt Sustainability Analysis highlights:
  - Nominal gross public debt (percent of GDP) series (selected): 42.9; 53.7; 58.5; 54.8; 54.8; 54.6; 54.6; 54.4; 54.3.
  - EMBIG (bp): 199.
  - Public gross financing needs (percent of GDP) — selected values: 11.0; 12.7; 14.0; 9.2; 10.5; 11.2; 10.4; 10.5; 10.1; 5.
  - Y CDS (bp): 127.
  - Real GDP growth (percent) — projections: 2.4; 2.6; 2.3; 1.7; 2.0; 2.7; 2.7; 2.7; 2.7.
  - Inflation (GDP deflator, percent): 4.5; 3.0; 4.6; 6.3; 3.5; 3.6; 3.3; 3.6; 3.4.
  - Effective interest rate (percent): 7.0; 6.4; 6.7; 6.0; 6.2; 6.4; 6.7; 6.9; 7.1.
- Contribution to changes in gross public sector debt (selected):
  - Change in gross public sector debt (cumulative): 1.2; 4.2; 4.8; -3.7; 0.0; -0.2; 0.0; -0.2; -0.1; -4.2.
  - Identified debt-creating flows: 1.1; 4.0; 4.8; -2.4; -0.1; -0.3; -0.2; -0.3; -0.2; -3.5.
    - Primary deficit: 0.3; 1.1; -0.5; -1.8; -0.7; -0.8; -0.9; -1.0; -1.1; -6.5.
  - Automatic debt dynamics 5/: 0.5; 2.5; 3.0; -1.2; 0.4; 0.0; 0.3; 0.2; 0.5; 0.3.
    - Real interest rate (contribution): 1.0; 1.5; 1.0; -0.2; 1.4; 1.4; 1.7; 1.7; 1.8; 7.8.
    - Real GDP growth (contribution): -0.9; -1.2; -1.2; -0.9; -1.0; -1.4; -1.4; -1.4; -1.4; -7.5.
- Public DSA baseline assumptions (selected):
  - Real GDP growth: 1.7; 2.0; 2.7; 2.7; 2.7; 2.7.
  - Inflation: 6.3; 3.5; 3.6; 3.3; 3.6; 3.4.
  - Primary Balance: 1.8; 0.7; 0.8; 0.9; 1.0; 1.1.
  - Effective interest rate: 6.0; 6.2; 6.4; 6.7; 6.9; 7.1.
- Stress tests:
  - Macro-fiscal stress tests include Primary Balance Shock; Real GDP Growth Shock; Real Interest Rate Shock; Real Exchange Rate Shock; Combined Macro-Fiscal Shock.
  - Example scenario projections are provided in the source tables for each shock.

*Source: IMF staff report chapter on Mexico (cr17129).*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### CONTEXT
- Mexico’s very strong policies and policy frameworks have helped it navigate successfully a complex external environment characterized by the heightened risk of protectionism and financial market volatility.
- Increased uncertainty is likely to weigh on investment and growth.
- Inflation is above the central bank’s target, reflecting mainly the transitory effects of the liberalization of domestic fuel prices and the pass-through from the currency depreciation.
- Downside risks remain elevated amid continued uncertainty about the outcome of the discussions with the United States on trade, as well as a possible renewed surge in capital flow volatility.
- Mexico’s flexible exchange rate has helped the economy adjust to external shocks and the inflation-targeting framework has kept medium-term inflation expectations well anchored.
- Mexico’s external position is broadly in line with fundamentals and desirable policies.

### RECENT ECONOMIC DEVELOPMENTS AND POLICIES
- Real GDP:
  - In the first three quarters of 2016, real GDP expanded by 2¼ percent (y/y).
  - Growth for 2016 was 2.3 percent.
- Inflation and monetary policy:
  - Inflation rose to the target of 3 percent in September 2016 and reached 3.4 percent (y/y) by end-2016.
  - Headline and core inflation expectations over the next twelve months were at 4 percent as of March 2017.
  - Longer term inflation expectations (horizon between 5 and 8 years) returned to the historical average of around 3½ percent as of March 2017.
  - The Bank of Mexico policy rate timeline:
    - 3.00 percent in November 2015
    - 4.75 percent in September 2016
    - 5.75 percent by December 2016
    - 6.5 percent by March 2017
- Output components:
  - Services performed strongly in 2016, offsetting subdued manufacturing activity and falling oil production.
  - Real private investment slowed to 2.1 percent (y/y) in the first three quarters of 2016, down from 8 percent in 2015.
  - Improved labor market conditions and strong remittances supported real private consumption growth; unemployment rate fell to 3.7 percent in December 2016.
- Financial markets and external flows:
  - Between November 8 and January 22, the peso depreciated 18 percent.
  - 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 between November and January.
  - Non-residents held 35 percent of local-currency-denominated sovereign bonds in 2016.
  - Total foreign portfolio investment in Mexico reached US$28.6 billion (2.7 percent of GDP) in 2016.
  - Since late January 2017, the exchange rate and credit spreads returned close to pre-U.S. election levels and net capital inflows picked up; non-resident holdings of local-currency long-term government securities increased since last November.
  - The Foreign Exchange Commission (FEC) announced auctions of up to US$20 billion of non-deliverable forwards (NDF), with US$1 billion auctioned so far; the first auction (US$1 billion on March 6, 2017) received total bid-to-cover of 2.1 times.
  - Discretionary foreign exchange intervention was used once on January 5 (Banxico sold US$2 billion through direct sales).
- Inflation drivers in early 2017:
  - Headline inflation reached 5.35 percent (y/y) in March 2017, following an up-to-20-percent m/m increase in domestic fuel prices in January as part of liberalization.
  - Direct effects of fuel price increases explain 1.3 ppts of the 2 ppts change in y/y headline inflation between December 2016 and March 2017.
  - Further increases in prices of non-food merchandise from pass-through explain 0.3 ppt.
  - Base effects and administered price adjustments explain another 0.2 ppt.
- Fiscal policy:
  - The authorities reaffirmed commitment to fiscal consolidation and the Fiscal Responsibility Law.
  - For 2017, the PSBR was initially targeted at 2.9 percent of GDP (the outturn for 2016) but will be cut to 1.4 percent of GDP by channeling all the 2016 surplus of Banxico to reduce the deficit.
  - Authorities are committed to a PSBR of 2½ percent of GDP in 2018 and beyond.
  - Public debt increased to 58.5 percent of GDP in 2016, projected to decline to 54.8 percent of GDP in 2017 and stabilize slightly below that level over the medium term.
  - The public debt-to-GDP ratio increased by 12.1 ppts during 2014-16; the real peso depreciation contributed 6.7 ppts, pension reform securitizations contributed 0.7 ppts and 0.9 ppts, and cumulative primary deficits accounted for 2.1 ppts.
- Structural and institutional reforms:
  - Continued steady implementation of the structural reform agenda, including strengthening the rule of law and anti-corruption measures, would boost growth potential.
  - The 2016 FSAP concluded that the financial regulatory and supervisory framework was strong.

### TRADE AND FINANCIAL LINKAGES WITH THE UNITED STATES (BOX HIGHLIGHTS)
- Trade:
  - The United States represents 71 percent of Mexico’s exports and 51 percent of Mexico’s imports.
  - In value-added terms, 14 percent of Mexico’s GDP ends up being consumed by the United States.
- Investment and portfolio linkages:
  - The United States accounts for 40 percent of Mexico’s FDI inflows.
  - According to 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.

### FLEXIBLE CREDIT LINE (FCL) AND QUALIFICATION
- FCL arrangement:
  - On May 27, 2016, the Executive Board approved a 24-month arrangement with Mexico under the FCL in the amount of SDR 62.3889 billion (700 percent of quota, about US$85 billion).
  - The authorities intend to continue treating the arrangement as precautionary.
- Qualification:
  - Mexico continues to meet the qualification criteria for access to FCL resources specified under Decision No. 14283-(09/29), adopted on March 24, 2009, as amended.
  - Staff recommends that the Board completes the review under the FCL arrangement, which would allow Mexico to make purchases until the expiration of the arrangement on May 26, 2018.
- Role of the FCL:
  - The FCL has provided a reassuring signal on the strength of Mexico’s policies and a valuable insurance against tail risks, complementing Mexico’s net international reserves.

### OUTLOOK, RISKS, AND STAFF VIEWS
- Outlook:
  - The increased uncertainty is likely to weigh on investment and growth.
  - Medium-term growth should benefit from structural reforms and anti-corruption measures.
- Risks:
  - Downside risks remain elevated due to uncertainty over NAFTA renegotiation outcomes, other U.S. policy issues (including immigration reform and a border wall), and possible renewed capital flow volatility.
  - Mexico is exposed to abrupt shifts in investor sentiment given deep integration with the United States through trade and financial channels.
- Staff recommendations and views:
  - Continued steady implementation of structural reforms, including progress in strengthening the rule of law and anti-corruption measures, to boost growth potential.
  - Fiscal policy: staff views that aiming at a lower PSBR for 2019 and beyond would lead to a faster decline in the public debt-to-GDP ratio, helping strengthen fiscal buffers.
  - Staff suggests benefits to strengthening the fiscal framework, including:
    - Tightening the link between the desired level of public debt and PSBR targets.
    - Limiting the use of exceptional circumstances clauses.
    - Introducing a non-partisan fiscal council.

*Prepared by a team comprising Costas Christou, Frederic Lambert, Damien Puy, Fabian Valencia (all WHD), Julian Chow (MCM), Charlotte Lundgren (SPR), and Florian Misch (FAD); Daniela Muhaj and Misael Galdamez provided assistance. May 4, 2017.*

### 10.      The implementation of PEMEX’s business plan is on track. The ongoing restructuring

### 10.      The implementation of PEMEX’s business plan is on track. The ongoing restructuring

### PEMEX implementation
- Ongoing restructuring involves sharp expenditure cuts, increased use of joint ventures, and disposal of non-core assets.
- The restructuring 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.

### Financial and non‑financial corporate sector resilience
- 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 reduced FX exposure by refinancing foreign currency debts with domestic bank loans and bonds.
  - The sector remains liquid (Figure 9).
- Banking sector:
  - Asset quality remains high and the system is well capitalized and liquid (Figure 10).
  - CNBV bank stress tests (using December 2016 balance sheet information) indicate resilience 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.

### Structural reform implementation
- Broad structural reform agenda remains on track across energy, telecommunications, financial, competition, and education sectors.
- Telecommunications reform:
  - Has attracted FDI into the sector.
  - Has led to a sizable reduction in the prices of telecommunication services.
- Energy reform:
  - 39 contracts have already been awarded with expected investment flows of US$50 billion.
- Financial reform:
  - Increasing competition, particularly in the mortgage segment, by reducing refinancing costs and facilitating portability of loans.
- Anticorruption reform:
  - Secondary legislation promulgated last year; moving to implementation phase with potential to improve governance.

### Outlook and risks: growth, inflation, external balances, NIIP
- Growth projections under heightened uncertainty:
  - Real GDP growth expected to slow to 1.7 percent in 2017.
  - Output growth projected to recover only slightly to 2 percent in 2018 given prolonged uncertainty about NAFTA negotiations and political uncertainty related to the 2018 elections.
- Inflation:
  - Expected to remain high at 5.1 percent at end‑2017.
  - Projected to converge to the target by early 2019 as depreciation and domestic fuel price effects dissipate and monetary tightening takes effect.
- Current account and NIIP:
  - Current account deficit projected to improve slightly from 2.7 percent of GDP in 2016 to 2.3 percent by 2022 (Figure 7).
  - NIIP 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.

### External position and risks
- External position:
  - Current account deficit broadly consistent with medium‑term fundamentals and desirable policy settings.
  - As of March 2017, the peso was about 1 percent weaker in real effective terms relative to its 2016 average.
  - Staff assesses the peso is currently moderately weaker than the level suggested by fundamentals under a baseline where protectionism risks do not materialize.
  - Foreign exchange reserves are adequate according to a range of indicators (Figure 8).
- External risks one year into the FCL arrangement remain high:
  - Risks include renegotiation of NAFTA leading to fundamental change in trade regime, prolonged negotiations, increased protectionism, and a faster‑than‑expected pace of U.S. interest rate hikes.
  - These risks could lower global growth, reduce trade and cross‑border investment flows, and cause resurgence in volatility in Mexican asset prices.
  - Updated external stress index has improved somewhat since the FCL request, but factors not captured by the index remain critical and could lead to a sharp deterioration in external conditions in a downside scenario.

### The Flexible Credit Line (FCL) and review of qualification
- Authorities’ view:
  - The FCL arrangement supports macroeconomic strategy by providing insurance against tail risks.
  - The arrangement complements Mexico’s strong policies, policy frameworks, and international reserves.
  - Authorities committed to enhancing resilience through fiscal consolidation, anchoring inflation expectations, gradual reserve rebuilding, and strong financial oversight.
- Exit strategy:
  - Authorities retained the exit strategy presented at FCL renewal in May 2016—do not intend permanent use of the FCL.
  - Conditional on reduced external risks, they intend to seek subsequent FCL arrangements with lower access, with a view to eventual exit.
- Staff assessment: Mexico continues to meet FCL qualification criteria, underpinned by:
  - Monetary policy guided by a credible inflation‑targeting framework within a flexible exchange rate regime.
  - Fiscal policy guided by the Fiscal Responsibility Law.
  - Policy space to contain fallout from downside risks and commitment to appropriate actions if such risks materialize.

### Key indicators supporting FCL qualification (findings)
- External debt and NIIP:
  - Mexico's external debt is relatively low (about 39 percent of GDP).
  - Net foreign asset position projected to decline to below minus 40 percent of GDP by 2022.
- Capital account:
  - Dominated by private flows; bulk of external debt 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.
- Sovereign market access:
  - Mexico remains among highest‑rated emerging markets.
  - Sovereign bond (EMBI+) spread and five‑year CDS spreads stood at 202 and 126 basis points, respectively (as of April 24, 2017).
  - Recently placed a 30‑year, fixed‑rate domestic currency bond with a yield of 7.85 percent that attracted 43 percent of foreign participation.
  - Government’s external financing needs for 2017 fully covered; only US$ 1.1 billion, most of which is due to international financial institutions, remains to be financed in 2018.
  - Authorities pre‑financed 30 percent of redemptions for 2019 through several placements in March 2017.
- International reserves:
  - Gross international reserves stood at US$179 billion at end‑March 2017, very marginally below the US$182 billion at the time of approval of the current FCL arrangement.
- Public finances and debt:
  - Fiscal consolidation plan announced in 2014 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; authorities went slightly beyond the 2016 target.
  - Authorities committed to save entirety of a large transfer from the central bank, expected to lead to over performance in the PSBR target this year by the full amount of the transfer.
  - Public debt‑to‑GDP ratio projected to decline to 54.8 percent in 2017 and stabilize at slightly below that level over the medium term.
  - Updated debt sustainability analysis shows debt trajectory overall robust to standard shocks; debt projection sensitive to growth, exchange rate, and oil prices but would remain contained even under severe negative shocks.
- Inflation:
  - Headline inflation recently exceeded the 3 percent target mainly due to a sharp increase in domestic fuel prices and pass‑through from currency depreciation, but expected to converge to target by early‑2019.
  - Banxico tightened monetary policy considerably since December 2015 and stands ready to adjust policy as needed.
- Financial system soundness:
  - Capital adequacy ratio for the banking system stood at 14.9 percent in December 2016.
  - Provisioning at 157 percent of nonperforming loans.
  - Corporate balance sheets resilient to exchange rate shocks; some corporations switched to peso financing.
  - Private pension funds hold assets of about 16 percent of GDP and have a conservative investment profile.
  - Insurance companies satisfy capital requirements under a Solvency II‑type regime adopted in April 2015.
- Supervision and regulation:
  - 2012 FSAP concluded banking supervision was effective.
  - Mexico adopted Basel III capital rules in 2013; Basel Committee assessed it as compliant in 2015.
  - Liquidity coverage ratio (LCR) minimum requirements in place since January 2015.
  - Regulation of financial groups enhanced in January 2014 via supervision at group level.
  - Authorities monitor foreign bank subsidiaries—about 70 percent of banking system assets—to ensure regulatory compliance.
  - 2016 FSAP found significant progress since 2012 and recommended further strengthening of governance of supervisory agencies and IPAB.
- Data transparency:
  - Overall quality of Mexican data continues to be high and adequate for surveillance per the June 2015 data ROSC update.
  - Mexico remains in observance of the Special Data Dissemination Standards (SDDS).

### Institutional quality and governance
- World Bank Governance Indicators (2016):
  - Government effectiveness ranks at the 62nd percentile among all countries.
  - Control of corruption at the 25th percentile.
- Anticorruption reform:
  - Constitutional reform adopted May 2015 and secondary legislation promulgated July 2016 further empower federal government to investigate, prosecute, and sanction corrupt activity.
  - Reform creates a National Anticorruption System, increases transparency in public funds use, and lengthens statute of limitations.
  - Implementation has begun with the institutional setting at the federal level nearing completion.
- Anti‑money laundering:
  - Mexico undergoing a full assessment of its anti‑money laundering framework; report expected in late 2017.

### Safeguards assessment
- Safeguards procedures for Mexico’s 2016 FCL arrangement completed.
- Authorities authorized 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 Banco de Mexico’s 2015 financial statements.
- Staff reviewed 2015 audit results; noted improvements in quality and transparency of annual financial statements, including commencement of publication on the bank’s website.
- Authorities have taken steps to enhance independence of the Bank’s Audit Committee.

### Staff appraisal and policy recommendations
- Assessment of FCL benefits:
  - FCL arrangement has supported market confidence and served as insurance against tail risks.
  - Given elevated external risks (NAFTA uncertainty, potential surges in capital flow volatility), the arrangement remains valuable; authorities treat it as precautionary and temporary.
  - Staff welcomes authorities’ exit strategy aiming for reduced access in possible subsequent FCL arrangements conditional on reduced external risks.
- Fiscal policy recommendations:
  - Continue building on fiscal consolidation to place public debt‑to‑GDP on a downward trajectory.
  - Recent decision to use the full profit transfer from the central bank for a net reduction in the PSBR for 2017 is welcome but is a one‑off measure.
  - Strengthen the fiscal framework by:
    - Tightening the link between desired public debt level and PSBR targets.
    - Limiting use of exceptional circumstances clauses.
    - Introducing a non‑partisan fiscal council.
  - Beyond 2018, aim for a more ambitious PSBR target to rebuild fiscal buffers more quickly and strengthen resilience to downside risks.
- Qualification and recommendation:
  - Mexico continues to meet qualification criteria for access to FCL resources.
  - Staff recommends completion of the review under the FCL arrangement for Mexico.

*Source: IMF staff report chapter on Mexico (cr17129).*

### Box 2. The Updated External Economic Stress Index

### Box 2. The Updated External Economic Stress Index

### Methodology and Context
- 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.
- Calculation required three main choices:
  - (i) selection of relevant external risks,
  - (ii) selection of proxy variables capturing these risks,
  - (iii) choice of weights for these variables.
- The updated index uses the same model, proxy variables, and weights as previously applied.

### Risks Included in the Index
- 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.
- Oil production and fiscal revenues depend on world energy price developments.

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

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

### Scenarios for the Index
- Baseline scenario:
  - Uses WEO projections for U.S. growth, oil prices, and the U.S. 10-year bond yield.
  - VXEEM projections are in line with the VIX futures as of March 30, 2017.
- Downside scenario:
  - Based on staff estimates of global macroeconomic effects from a sharp rise in global protectionism (global increase in trade barriers with a temporary rise in risk premia), broadly consistent with the tail risks presented in the paper.
  - Specific assumptions:
    - U.S. growth would be 1.5 percentage points lower than projected in 2017.
    - Oil prices would be about 25 percent lower than in the baseline.
    - 10-year interest rates would be 0.3 percentage points lower than in the baseline.
    - VXEEM would rise by 3 standard deviations.
  - The downside scenario is illustrated in the chart by dots, representing the level to which the index would fall if the described risks materialize.

*Box 2. The Updated External Economic Stress Index (excerpt).*

### Appendix I. External Debt Sustainability Analysis

### Appendix I. External Debt Sustainability Analysis

### External debt baseline trajectory and dynamics
- Baseline: External debt (in percent of GDP) — 29.2; 31.4; 32.9; 36.2; 39.3; 40.3; 40.5; 40.8; 41.0; 41.1; 41.2.
- Debt-stabilizing non-interest current account 6/: -1.3.
- Change in external debt (annual): 5.1; 2.3; 1.5; 3.3; 3.1; 0.9; 0.3; 0.2; 0.3; 0.1; 0.1.
- Identified external debt-creating flows (4+8+9): 0.1; -1.6; -1.3; 2.7; 0.9; -0.1; -0.2; -0.8; -1.0; -1.1; -1.1.
  - Current account deficit, excluding interest payments (4): -0.3; 0.6; 0.0; 0.7; 0.2; -0.4; -0.3; -0.6; -0.8; -0.9; -0.9.
  - Net non-debt creating capital inflows (negative) (8): -0.7; -2.7; -2.0; -2.3; -3.5; -1.9; -2.2; -2.5; -2.5; -2.4; -2.4.
  - Automatic debt dynamics 1/ (9): 1.1; 0.4; 0.6; 4.3; 4.2; 2.1; 2.3; 2.3; 2.3; 2.2; 2.2.
    - Contribution from nominal interest rate (10): 1.7; 1.9; 2.0; 2.2; 2.5; 2.8; 3.1; 3.3; 3.3; 3.3; 3.3.
    - Contribution from real GDP growth (11): -1.0; -0.4; -0.7; -1.0; -0.9; -0.6; -0.7; -1.0; -1.0; -1.1; -1.0.
    - Contribution from price and exchange rate changes 2/ (12): 0.3; -1.0; -0.6; 3.1; 2.7; ... (table continues).
- Residual, incl. change in gross foreign assets (2-3) 3/: 5.0; 3.9; 2.7; 0.6; 2.2; 1.1; 0.4; 1.0; 1.2; 1.1; 1.1.
- External debt-to-exports ratio (in percent): 89.3; 99.0; 102.0; 103.2; 103.3; 101.8; 101.1; 99.5; 97.4; 94.6; 92.6.

### Gross external financing needs
- Gross external financing needs (in billions of US dollars) 4/: 85.4; 128.8; 138.5; 143.9; 127.9; 94.2; 101.5; 109.6; 116.1; 111.7; 121.2.
- Gross external financing needs (in percent of GDP) — selected values shown: 7.2; 10.2; 10.7; 12.5; 12.2; 10-Year 10-Year 8.7 8.8 9.0 9.0 8.2 8.5. (table presents additional percentile/benchmark context).

### Scenario and stress-test descriptions (external)
- Individual shocks described as permanent one-half standard deviation shocks; permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
- One-time real depreciation of 30 percent occurs in 2016 (real depreciation shock 4/).
- Historical scenarios: historical averages calculated over the ten-year period and used to project debt dynamics five years ahead.
- Figures in scenario boxes represent average projections for respective variables in baseline and scenario; ten-year historical average for variable also shown.

### Key macroeconomic assumptions underlying baseline (external DSA)
- Real GDP growth (in percent): 4.0; 1.4; 2.3; 2.6; 2.3; 2.2; 2.7; 1.7; 2.0; 2.7; 2.7; 2.7; 2.7.
- GDP deflator in US dollars (change in percent): -2.6; 4.9; 0.6; -13.6; -11.2; -0.9; 9.3; 2.0; 4.2; 3.2; 2.6; 2.8; 2.7.
- Nominal external interest rate (in percent): 7.3; 6.8; 6.5; 6.1; 6.2; 7.2; 1.1; 7.3; 8.1; 8.7; 8.6; 8.4; 8.4.
- Growth of exports (US dollar terms, in percent): 6.0; 3.4; 4.4; -3.5; -1.4; 4.8; 12.8; 7.7; 7.6; 8.4; 8.3; 8.8; 7.9.
- Growth of imports (US dollar terms, in percent): 5.2; 2.9; 5.1; -1.5; -1.9; 4.9; 12.7; 6.9; 8.4; 8.2; 7.9; 8.7; 7.8.
- Current account balance, excluding interest payments (in percent of GDP): 0.3; -0.6; 0.0; -0.7; -0.2; 0.0; 0.5; 0.4; 0.3; 0.6; 0.8; 0.9; 0.9.
- Net non-debt creating capital inflows (in percent of GDP): 0.7; 2.7; 2.0; 2.3; 3.5; 1.9; 0.9; 1.9; 2.2; 2.5; 2.5; 2.4; 2.4.

### Public Debt Sustainability Analysis — highlights and projections
- Nominal gross public debt (percent of GDP) — selected series: 42.9; 53.7; 58.5; 54.8; 54.8; 54.6; 54.6; 54.4; 54.3.
- EMBIG (bp) 3/: 199.
- Public gross financing needs (in percent of GDP) — selected values: 11.0; 12.7; 14.0; 9.2; 10.5; 11.2; 10.4; 10.5; 10.1; 5.
- Y CDS (bp): 127.
- Real GDP growth (in percent) — projections: 2.4; 2.6; 2.3; 1.7; 2.0; 2.7; 2.7; 2.7; 2.7.
- Inflation (GDP deflator, in percent): 4.5; 3.0; 4.6; 6.3; 3.5; 3.6; 3.3; 3.6; 3.4.
- Nominal GDP growth (in percent): 7.0; 5.7; 7.0; 8.1; 5.5; 6.4; 6.1; 6.4; 6.2.
- Effective interest rate (in percent) 4/: 7.0; 6.4; 6.7; 6.0; 6.2; 6.4; 6.7; 6.9; 7.1.

### Contribution to changes in gross public sector debt (selected items)
- Change in gross public sector debt (cumulative): 1.2; 4.2; 4.8; -3.7; 0.0; -0.2; 0.0; -0.2; -0.1; -4.2.
- Identified debt-creating flows: 1.1; 4.0; 4.8; -2.4; -0.1; -0.3; -0.2; -0.3; -0.2; -3.5.
  - Primary deficit: 0.3; 1.1; -0.5; -1.8; -0.7; -0.8; -0.9; -1.0; -1.1; -6.5.
  - Primary (noninterest) revenue and grants: 23.4; 23.1; 23.2; 22.6; 21.0; 20.8; 20.8; 20.8; 20.8; 126.8.
  - Primary (noninterest) expenditure: 23.7; 24.2; 22.6; 20.8; 20.2; 19.9; 19.9; 19.8; 19.7; 120.3.
- Automatic debt dynamics 5/: 0.5; 2.5; 3.0; -1.2; 0.4; 0.0; 0.3; 0.2; 0.5; 0.3.
  - Interest rate/growth differential 6/: 0.1; 0.3; -0.2; -1.2; 0.4; 0.0; 0.3; 0.2; 0.5; 0.3.
    - Real interest rate (contribution): 1.0; 1.5; 1.0; -0.2; 1.4; 1.4; 1.7; 1.7; 1.8; 7.8.
    - Real GDP growth (contribution): -0.9; -1.2; -1.2; -0.9; -1.0; -1.4; -1.4; -1.4; -1.4; -7.5.
  - Exchange rate depreciation 7/: 0.4; 2.2; 3.1; ... (table continues).
- Other identified debt-creating flows: 0.3; 0.4; 2.3; 0.6; 0.2; 0.5; 0.5; 0.5; 0.4; 2.7.
- Asset changes: 0.3; 0.4; 2.3; 0.6; 0.2; 0.5; 0.5; 0.5; 0.4; 2.7.
- Residual 8/: 0.1; 0.3; 0.0; -1.3; 0.1; 0.1; 0.2; 0.2; 0.1; -0.7.

### Public DSA baseline and alternative scenario assumptions
- Baseline underlying assumptions (selected):
  - Real GDP growth: 1.7; 2.0; 2.7; 2.7; 2.7; 2.7.
  - Inflation: 6.3; 3.5; 3.6; 3.3; 3.6; 3.4.
  - Primary Balance: 1.8; 0.7; 0.8; 0.9; 1.0; 1.1.
  - Effective interest rate: 6.0; 6.2; 6.4; 6.7; 6.9; 7.1.
- Historical scenario assumptions (selected):
  - Real GDP growth: 1.7; 2.2; 2.2; 2.2; 2.2; 2.2.
  - Primary Balance: 1.8; -0.7; -0.7; -0.7; -0.7; -0.7.
  - Effective interest rate: 6.0; 6.2; 6.4; 6.6; 6.8; 7.0.
- Constant Primary Balance scenario:
  - Primary Balance constant at: 1.8; 1.8; 1.8; 1.8; 1.8; 1.8.

### Stress tests and alternative scenarios (public)
- Macro-fiscal stress tests include: Primary Balance Shock; Real GDP Growth Shock; Real Interest Rate Shock; Real Exchange Rate Shock; Combined Macro-Fiscal Shock.
- Example scenario values (selected):
  - Primary Balance Shock projections (Real GDP growth; Inflation; Primary balance; Effective interest rate): 1.7; 6.3; 1.8; 6.0 (2017) and subsequent year values 2.0; 3.5; 0.1; 6.2; etc.
  - Real GDP Growth Shock projections: Real GDP growth 1.7; -0.7; 0.0; 2.7; 2.7; 2.7 under shock scenario.
  - Real Interest Rate Shock projections: Effective interest rate 6.0; 6.2; 6.5; 6.8; 7.4; 7.8; 8.2 in shock years.
  - Combined Shock projections show compounded deviations (table entries listed verbatim in source).

### Debt profile, market indicators, and risk-assessment benchmarks
- Public Debt Held by Non-Residents (in percent of total): 51% (figure in composition/heat-map context).
- Heat map and indicators use benchmarks for risk assessment and color-coding: gross financing needs benchmark of 15 percent; external financing requirement benchmarks at 5 and 15 percent of GDP; bond spread shocks at 200 and 600 basis points; change in share of short-term debt benchmarks at 0.5 and 1 percent; public debt held by non-residents benchmarks at 15 and 45 percent; share of foreign-currency denominated debt benchmarks at 20 and 60 percent.
- As of April 10, 2017: table entries include EMBIG (3-month average 10-Jan-17 through 10-Apr-17) and ratings: Moody’s A3/A3; S&P BBB+/A; Fitch BBB+/A- (as shown).

*International Monetary Fund — Appendix I. External Debt Sustainability Analysis (cr17129)*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17129.pdf_