Public Information Notice No. 06/110

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Mexico

October 11, 2006

On September 6, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mexico¹.

Background²

The economic recovery that began in 2003 has continued. After slowing in the first half of 2005, growth has since rebounded, to exceed 5 percent in the first half of 2006, amid strong growth in both domestic and external demand. Manufacturing has accelerated this year, related to stronger U.S. industrial production and a rebound in auto exports. Employment in the formal sector increased at an annual rate of more than 6½ percent in June, its fastest pace for the past six years. Bank credit continues to grow strongly, from a low base.

The 12-month headline inflation rate converged to the official target of 3 percent for the first time toward the end of 2005. While headline inflation picked up again in early 2006 as a result of volatile food prices, core inflation remained steady and the headline rate came quickly back down. At mid-August 2006, the annual rates of both headline and core inflation were 3.3 percent. Inflation expectations as reported by central bank surveys have gradually come down, although they remain slightly above the inflation target.

Amid an improving inflation outlook, the Bank of Mexico (BoM) began in August 2005 to unwind its earlier monetary tightening, before stopping in April 2006. In the process, the overnight interbank rate declined from 9¾ percent to 7 percent. Since April, the BoM has held monetary conditions steady. The BoM has continued to abstain from discretionary intervention in the foreign exchange market, following the rule for its foreign exchange sales announced in early 2003. Still, net international reserves tended to accumulate over time, driven mainly by the foreign exchange surplus of PEMEX, the state-owned oil company.

With financial markets continuing to show confidence in Mexico, prices of Mexican assets have moved broadly in line with external markets. After posting strong gains in recent years, the stockmarket followed other emerging markets downward from May through mid-June 2006, and the peso and sovereign bond also lost some value during this period. Subsequently, announcement of the July 2 election results appeared to trigger a broad-based rally of Mexican assets.

The fiscal deficit, and public debt ratio, has continued to decline. The 2005 augmented deficit, at about 1½ percent of GDP, was half a percentage point of GDP lower than in 2004, helped by higher oil revenues, a better performance of non-oil revenue collections, and negative net lending by the development banks. Deficit reduction, combined with the effects of faster growth and a stronger peso, brought gross augmented debt down to 44 percent of GDP in 2005, from about 50 percent of GDP in 2003. For 2006, staff projects the augmented deficit to stay close to last year's level. While oil-related revenues will rise this year, spurred by higher prices, adherence to the budget's fiscal adjustors will require the spending of much of the unbudgeted oil revenue. Assuming a rebound of development banks' net lending, the non-oil augmented deficit is projected to rise, to near 8 percent of GDP.

The external position has continued to improve, helped by favorable external conditions. Although imports grew strongly, rising remittances and oil exports reduced the current account deficit to less than 1 percent of GDP in 2005, and the external current account was near balance in the first semester of 2006. Non-oil exports have performed well recently, and Mexico's share in its main market, the U.S., stabilized in 2005 after three years of decline. Foreign direct investment in 2005 was more than double the size of the current account deficit.

Public debt management has continued to focus on lengthening debt maturity and shifting away from external debt. The average maturity of the federal government domestic debt rose from 38 to almost 40 months in 2005. The public sector significantly reduced its rate of external borrowing in 2005. In August 2006, the authorities began to implement a sequence of debt management operations that will effectively reduce external debt, and net international reserves, by about US$12.5 billion. This operation left international reserves at about US$66 billion at end-August, approximately 1½ times Mexico's total short-term external debt (measured on a remaining maturity basis).

Executive Board Assessment

Directors commended the Mexican authorities for establishing the macroeconomic and financial stability needed to foster growth and resilience to shocks. Fiscal policy has earned broad credibility and put public debt on a gradual downward trend. A prudent monetary policy has achieved low inflation, and the floating exchange rate regime has allowed smooth external adjustment. Directors noted the important progress made in strengthening the financial sector and creating conditions for its further development. The challenge ahead will be for the new government to put in place structural reforms that will remove remaining obstacles to growth while fully entrenching macroeconomic stability.

Directors commended the authorities for reducing the fiscal deficit and the public debt ratio, and improving the public debt structure. At the same time, they noted that continued reliance on oil revenues renders the achievement of fiscal policy objectives potentially vulnerable to a decline in oil prices or production, and therefore suggested containing the non-oil fiscal deficit.

Directors welcomed the adoption of a fiscal responsibility law and medium-term budget framework. They noted that the chronic weakness of tax revenues will have to be addressed to achieve the new fiscal target over the medium term, and encouraged the authorities to give fresh consideration to tax reform proposals. Directors also noted the scope for better targeting expenditures to make room for more productive social and investment spending. Directors welcomed renewed investment in the oil sector, but pointed to the need to improve governance at the state-owned oil company and allow risk-sharing with the private sector in the financing of its investment program.

On debt management, Directors commended the authorities for the substantial progress in reducing the public sector's external exposure. Looking forward, they welcomed the authorities' intention to continue extending the maturity of the domestically-issued debt, thereby reducing public sector gross financing needs. They also suggested consolidating the management of all forms of public debt.

Directors commended the success of monetary policy in achieving convergence with the authorities' inflation target. Directors noted that inflation expectations are declining and are likely to also converge to the inflation target as the Bank of Mexico continues to focus policy on that target.

Directors considered that Mexico has been well served by its exchange rate policy, which is characterized by transparency, symmetric flexibility, and a rules-based approach to reserve accumulation. This has facilitated external adjustment and given the private sector appropriate incentives to manage currency exposures. Concerning Mexico's external competitiveness, Directors considered that it would depend mainly on the implementation of structural reforms.

Directors welcomed the considerable progress made in strengthening the financial sector and capital markets and reducing potential vulnerabilities. They encouraged the authorities to continue with their agenda of financial sector reforms, and highlighted the need to secure the institutional and budgetary independence of supervisory bodies, improve consolidated supervision of financial groups, create clearer rules for interagency contingency planning, and enhance the monitoring of fast-growing household credit.

Directors noted that the financial sector was becoming more dynamic, and that bank credit was expanding after a long period of stagnation. They encouraged continued efforts to deepen financial intermediation and promote competition.

Noting that achievement of macroeconomic and financial stability had brought a more favorable environment for growth, Directors encouraged the authorities to move ahead with ambitious structural reforms to create the conditions for fast economic growth in the medium term. They highlighted the major challenges faced by Mexico, including improving the education system and building human capital, enhancing infrastructure, and improving further judicial systems, security, and other aspects of the business and regulatory environment. They underscored that market flexibility and competitive forces should be given more room to spur productivity growth. Directors welcomed recent reforms such as the new competition law and the modified securities market law, and encouraged the authorities to remove barriers to labor market flexibility and to the opening of industries that are now occupied by state monopolies. They considered that implementation of such pro-growth reforms is the best way to assure Mexico's international competitiveness and ability to take full advantage of globalization.

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.

² Methodological differences mean that the figures cited in this PIN may differ in some cases from those published by the Mexican authorities.