Public Information Notice No. 01/99

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Mexico

September 27, 2001

On August 2, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mexico.¹

Background

The Mexican economy performed well in 2000, although economic activity and the external accounts weakened toward end-year, mainly reflecting the deterioration in the external environment. Output growth decelerated during the fourth quarter from the rapid pace seen earlier in the year, bringing real GDP growth for the year as a whole to nearly 7 percent. The 12-month inflation rate declined to 9 percent in December (below the official target of 10 percent), associated partly with strength in the value of the peso.

Real GDP contracted slightly on a seasonally adjusted basis in the first quarter of 2001 (growing by 1.9 percent over a year ago). The authorities have revised downward projected real GDP growth to 2½ percent in 2001, from the originally envisaged 4½ percent. There are risks that the slowdown could be deeper, reflecting expected developments in the U.S. economy. The 12-month inflation rate declined to 6.6 percent in June; the core inflation rate declined to 6.4 percent in June from 7½ percent at end-2000. After growing by nearly 6 percent in 2000, real wage growth continued strong in the first quarter of 2001, as a large proportion of wage contracts were negotiated in the first two months of the year when domestic demand was still perceived as strong.

The 2000 fiscal deficit (0.9 percent of GDP) was broadly in line with the official target. Using a comprehensive definition of the fiscal balance-the "augmented balance" or "public sector borrowing requirement"-the 2000 deficit was 4 percent of GDP (down from over 7 percent of GDP in the previous year). Public sector revenues were higher than budgeted, as stronger oil revenues more than offset shortfalls in nonrecurring revenues (in particular from privatization). Non-oil tax revenues were broadly in line with the program (despite a substantially stronger-than-expected pace of economic activity), owing mainly to judicial decisions ordering the return of certain VAT and sales tax receipts. The excess total revenue was used to finance additional expenditures-mainly by public enterprises-and to finance the Oil Stabilization Fund.

The BOM maintained a tightening bias in 2000 and into early 2001 during which time monetary policy was tightened six times amid strong demand pressures. Domestic short-term interest rates averaged 6 percent (in real ex ante terms) in 2000 and increased to 10 percent in the first quarter of 2001. However, as domestic demand weakened and domestic interest rates began to decline, the BOM reduced (in May and July 2001) the "corto" (commercial banks' settlement balances with the BOM). These decisions spurred a further reduction of interest rates and helped reduce appreciation pressure on the peso. Despite the strong international reserve build up, the monetary base has been within the expected range of its projected levels for 2000-01. Bank credit to the private sector fell 10 percent in real terms in 2000. Nevertheless, there are indications that bank credit is resuming in 2001.

The overall external current account deficit remained broadly unchanged at 3.1 percent of GDP in 2000, as markedly higher oil and non-oil exports were offset by stronger-than-anticipated import growth associated with the rapid expansion of domestic demand. The non-oil current account deficit rose to 6 percent of GDP (compared with 5 percent in 1999). However, both export and import growth started to decelerate in the second half of 2000. Capital inflows in 2000 were led by foreign direct investment (which financed about three-fourths of the current account deficit) and sizable corporate borrowing. Capital inflows strengthened in the first quarter of 2001, with foreign direct investment at US$3.6 billion, despite the economic slowdown. The level of international reserves almost covers external short-term debt by residual maturity but falls short of full coverage of the annual gross financing requirement (which also includes the external current account deficit).

There has been a considerable improvement in the health of the Mexican banking sector since the last Article IV consultation discussions. Financial strength indicators show a marked improvement, although with some limitations. The overall capital adequacy ratio, after adjustments to the book value of certain assets and liabilities by the FSAP mission, complies with the minimum requirement of 8 percent of risk-weighted assets. Asset quality indicators have improved in recent years-largely reflecting the conclusion of debtor relief programs.

Executive Board Assessment

Directors commended the authorities for maintaining prudent fiscal and monetary policies in the face of recent financial turbulence in emerging markets, the slowdown of economic growth in the United States, and the elections of 2000. They congratulated the authorities for achieving a smooth, democratic political transition. Directors noted that investor confidence in Mexico remains buoyant, with capital inflows holding strong and sovereign debt spreads being affected little by the turbulence in some other emerging markets. As a result, international reserves have increased and the peso has strengthened.

Directors commended the authorities for the strong performance of the Mexican economy through most of 2000, although economic activity had stagnated in the later part of the year, reflecting the slowdown in the United States. In light of the authorities' strong commitment to macroeconomic stability and the projected revival of the U.S. economy, many Directors expected economic activity to rebound later this year. However, some Directors felt that the rebound might be somewhat weaker than the previous estimate of 2.5 percent real GDP growth by the authorities, and they noted the staff's downward adjustment of the real GDP growth forecast in 2001. Directors supported the shift to a formal inflation-targeting framework in the context of the strong domestic banking sector, and commended the authorities for their success in lowering inflation, noting that expected inflation is now below the official target of 6.5 percent during 2001. Noting the importance of maintaining competitiveness, they emphasized the desirability of wage restraint to curb the recent rise in unit labor costs.

Directors welcomed the authorities' commitment to stick to the budget deficit target in 2001, recognizing that this will require further fiscal tightening on a cyclically adjusted basis. They concurred that this policy stance is warranted to maintain investor confidence, lower borrowing costs, and promote economic growth. They also commended the authorities for the considerable progress made in improving fiscal transparency, including through the monthly publication of traditional fiscal data and the quarterly publication of a more comprehensive measure of the fiscal balance and the augmented debt. Directors considered it desirable that the authorities complete a ROSC module on fiscal transparency.

Directors attached considerable importance to the authorities' efforts to reform the tax system, emphasizing that these efforts are critical for medium-term fiscal sustainability, reduced reliance on oil proceeds, and to lower the debt burden. They cautioned, however, that the planned administrative measures would be fully effective only if they are accompanied by a comprehensive tax reform. Directors noted the authorities' motivation for shifting the value-added tax from an accrual to a cash basis, but generally agreed with the staff that this change should be carefully considered since it potentially makes enforcement more difficult.

Directors endorsed the Bank of Mexico's current monetary policy stance in view of the favorable outlook for inflation and the weak prospects for economic growth in 2001. They felt that monetary policy should remain focused on achieving the long-term inflation target, namely, lowering inflation to 3 percent by 2003. While Directors agreed that the corto has proven to be a flexible and efficient monetary policy instrument, most considered that a move toward direct interest rate targeting over the medium-term will facilitate the communication of monetary policy intentions and will be appropriate once monetary policy credibility is sufficiently well established.

Directors welcomed the FSAP mission's main findings, namely, that the banking system does not pose a risk to financial stability and that other sectors of the financial system are not expected to be sources of systemic risk in the near future. They also commended the progress in the observance of international standards, practices, and codes. Nevertheless, Directors agreed with the authorities that additional actions are required to increase the financial system's resilience to shocks and to achieve full observance of international standards. In this sense, they considered that the FSAP mission took place at an opportune moment, when major legal reforms were under way. They encouraged the authorities to quickly follow up on remaining issues identified by the mission, including resolution procedures for nonviable banks, structural reforms to modernize the state-owned development banks, and an action plan to further strengthen banking supervision. Directors saw the main challenge for the banks as the resumption of broad-based and sound lending to the private sector, and expected that this will be facilitated by a sustained reduction in interest rates and by reforms to improve the credit infrastructure.

Directors regarded the present level of international reserves as satisfactory, as it almost fully covers external short-term debt by residual maturity, but noted that it falls short of full coverage of the annual gross financing requirement. Given its overall sound economic management, Directors felt that Mexico would benefit from having precautionary lines of credit, including possibly a contingency credit line (CCL). Several Directors encouraged the authorities to follow up with the Fund on this, including with the preparation of appropriate actions. Several Directors observed that, despite the successful floating exchange rate regime, the level of the real exchange rate poses some concerns for external competitiveness. In this respect, they supported the rebalancing of the policy mix, which will be reinforced further through the planned fiscal reform. Directors commended the authorities for their plan to extend a current bank debt monitoring system to provide monthly data on banks' total external financing. In addition, however, they advised the authorities to monitor carefully the debt of private nonbank corporations, as this is a potential source of vulnerability.

Directors noted that net capital inflows, including foreign direct investment, are expected to cover external financing needs. They commended the authorities for their prudent debt management strategy, which is leading to a manageable external debt profile and will provide protection against turbulence in international capital markets. Notwithstanding the generally favorable outlook, Directors observed that a negative credit shock in emerging markets would pose a risk to capital inflows for Mexico. They welcomed the authorities' awareness of this risk and their willingness to take prompt action, and agreed that any adverse impact should be short-lived in view of the country's impressive track record of implementing prudent macroeconomic policies.

Directors noted that Mexico's data are of good quality, timely, and adequate to conduct surveillance effectively.