Public Information Notice No. 05/160

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Mexico

December 1, 2005

On November 9, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mexico.¹

Background

The economic recovery that began in mid-2003 has continued, though at a slower pace in 2005. A broad-based expansion of economic activity in 2004, driven by a rebound of private consumption and private investment, took growth up to 4.4 percent. The economic recovery was accompanied by a boost to confidence, capacity utilization, and formal employment. In the first semester of 2005, growth slowed to 2.8 percent, reflecting several sector-specific developments, including a soft patch in U.S. industrial production. The most recent indicators point to a strengthening of activity in the third quarter of this year.

After rising through November 2004, inflation has come down significantly in 2005, approaching the Bank of Mexico's 3 percent inflation target. The 12-month headline inflation rate peaked at 5.4 percent in November 2004, but has declined thereafter, to 3.1 percent in the first half of October 2005. Core inflation also has come down, to 3.2 percent.

After tightening monetary policy since early 2004, the Bank of Mexico (BoM) signaled an end to its monetary tightening cycle in June 2005, and began to reverse that tightening in August. The firming of monetary conditions in this cycle was substantial—with the overnight interbank interest rate rising from less than 5 percent in early 2004 to 9 ¾ percent by spring 2005. Since August, rates have come down to 9 percent, as the BoM has signaled 25 basis point cuts in the desired floor interest rate, in each of August, September, and October. From early 2004, the BoM has taken a number of steps to enhance its communication with markets, including signaling a desired minimum level of interest rates—yet maintaining the corto instrument (the borrowed reserves objective).

The fiscal accounts improved in 2004 on the strength of rising oil revenues and restraint of current expenditures. The authorities achieved their target for the traditional deficit, 0.3 percent of GDP, and the broadly-defined deficit (the augmented deficit) narrowed to 2 percent of GDP, from 3.1 percent in 2003. Rising oil revenue helped finance an increase in capital expenditure, particularly in the oil sector. Gross public debt declined to 46.5 percent of GDP, in part through the write-off of some of the bank restructuring debt.

In 2005, oil revenues are rising again, but their impact on the broader deficit is being more than offset by a deterioration in the non-oil fiscal balance. Staff project that the traditional deficit will narrow slightly, to 0.2 percent of GDP in 2005, while the augmented deficit widens to 2.3 percent of GDP. Oil income for the year is projected to be up by about ½ percentage point of GDP from 2004 (and about 1 percentage point over budget projections). It is expected that almost all of this unbudgeted revenue will go to compensate for shortfalls in non-oil revenue, and toward transfers for additional investment spending by PEMEX and the states, as implied by the budget law, with a small part going to the oil stabilization fund and reduction of the traditional budget deficit.

The external current account deficit has remained modest, with a continued rise in oil exports and household remittances compensating for some widening of the non-oil trade deficit. With the recovery of economic activity in 2004 and 2005, imports of investment and especially consumer goods grew strongly, while weak auto exports to the U.S., and enhanced competition from China and other countries, slowed non-oil exports.

Mexican financial markets have recently performed strongly, as have other emerging markets. Sovereign bond spreads have continued to decline, recently to less than 150 basis points. At end-October, the stock market was up more than 75 percent (in domestic currency terms) since end-2003, with much of that gain coming since April of this year. The peso also has tended to strengthen this year though giving up some of its gains since August. The BoM has continued to abstain from market purchases of foreign exchange, but rising foreign exchange receipts from the state-owned oil company have pushed NIR upward. NIR reached US$61 billion by end 2004, about 4½ months of Mexico's imports and 1.6 times its short-term external liabilities; at October 28, 2005, NIR was US$62.3 billion.

The authorities have taken further steps to strengthen the public finances. The average maturity of the domestic debt of the federal government was extended to 3.1 years by June 2005, up from 2.6 years in early 2004. Exposure to currency depreciation has declined further as the public sector's annual foreign exchange earnings from oil now exceed US$30 billion, against interest payments on its foreign debt of US$9 billion. Furthermore, at mid-year the authorities announced that the federal government had accumulated enough foreign currency liquidity to allow it to forego any external bond issues through 2007.

Executive Board Assessment

Executive Directors commended the Mexican authorities for the improvements they had made in economic policies, institutions and structures over the last decade, which have contributed to greater macroeconomic stability and reduced financial vulnerability. Fiscal policy has earned broad credibility, with a track record of achieving the annual deficit targets, and a prudent monetary policy has established a low-inflation environment. A series of reforms has strengthened the financial sector and boosted its development. Directors welcomed that economic policy making is taking place in a setting of greater inclusiveness and transparency in government. The challenge ahead will be to launch a new round of structural reforms that will enhance the economy's efficiency and competitiveness and ensure the transition to a more rapid growth path, while entrenching the considerable progress that has already been made in economic policy design and implementation.

Concerning fiscal policy, Directors commended the authorities for achieving declining annual targets for the fiscal deficit, reducing the public debt ratio, and improving the debt structure, and they encouraged them to continue their efforts. At the same time, Directors noted that the overall fiscal balance has been benefiting increasingly from rising world oil prices, and that a reversal of oil prices could complicate fiscal policy if expenditures could not be reduced quickly. Most Directors urged the authorities to avoid a further widening of the non-oil fiscal deficit in 2006. A few Directors recommended monitoring closely the increase in spending by the state governments.

Directors supported Mexico's intention to implement a medium-term budget framework, with the objectives of reducing public debt further, strengthening the public finances, limiting vulnerability to oil revenue fluctuations, and allocating resources efficiently to essential investments, especially in the oil and social sectors. Noting the important share of oil revenues in total government revenues, Directors also encouraged the authorities to take measures over the medium term to strengthen the tax system and broaden its base, including by bringing more of the economy into the formal sector. Directors considered that the current high oil prices make it more important than ever to ensure that the operations and investments of the state-owned oil company (PEMEX) are effective.

Directors agreed that the monetary tightening of 2004 and early 2005 had been necessary to contain the rise in inflation and reverse inflation expectations. They were reassured that headline and core inflation are now close to the 3 percent target. With inflation expectations also moving down in recent months, the improved inflation outlook has allowed the Bank of Mexico to begin gradually loosening its policy stance. Directors recommended that the Bank continue to proceed cautiously in this direction, noting that inflation expectations have not yet converged to the 3 percent inflation target.

Directors welcomed the changes in the operational framework of monetary policy since early 2004. The Bank of Mexico's steps to refocus and sharpen its policy statements, provide an indication of its estimate of inflation for the current year, and shift toward defining policy changes through signalling a minimum level of interest rates have enhanced communication and the market's understanding of monetary policy objectives. Some Directors suggested that the authorities make public inflation forecasts for both the current year and a somewhat longer horizon, and adopt fully and explicitly an interest rate policy instrument.

Directors considered that Mexico has been well served by its floating exchange rate regime. External competitiveness appears to be broadly adequate at present, as reflected in the sustainable balance of payments position.

Directors welcomed the considerable progress made in strengthening and reforming the financial sector and capital markets and reducing potential vulnerabilities, setting the stage for an environment conducive to economic growth. Commercial banks appear to be well capitalized, profitable, and provisioned against nonperforming loans. Directors were encouraged that bank credit has begun to expand after a long period of stagnation. They noted the efforts to further enhance financial sector supervision.

Directors expressed disappointment with the slow pace of structural reforms in recent years in spite of the authorities' commitment to move forward in this area. At the same time, they supported the authorities' emphasis on implementing small-scale reforms to improve structural competitiveness in specific sectors. Nevertheless, Directors emphasized that to confront Mexico's external competitiveness, productivity, and growth challenges effectively in the future, more thoroughgoing structural reforms will be indispensable, including in the energy and telecommunications sectors, the labor market, the judicial system, the tax system, and the regulatory and business environment. In that light, Directors were encouraged that there is a growing popular understanding of the need to implement an ambitious structural reform agenda. They advised the authorities to continue to stand ready to move ahead quickly to implement these reforms at the appropriate juncture.