Despite improved fundamentals, Mexico has not escaped the world economic recession. The global manufacturing downturn and the collapse of trade, notably with the United States, have depressed the real sector. Reduced availability of credit has started to bear on activity, although the financial sector has so far weathered the global crisis. Low oil prices are putting pressure on budget revenue, despite a welcome hedging this year. The change of sentiment of international investors towards emerging-market borrowers has led to reduced net capital inflows and a large depreciation of the currency. The outbreak of influenza is likely to also contribute to the downturn. Thus, growth is set to be negative this year and recover only gradually in 2010. The authorities have responded with liquidity measures, lower interest rates, foreign currency interventions and a fiscal stimulus. But there might be room for more policy action.
Assessment and recommendations
Mexico is affected severely by the global recession, like many other OECD countries, with negative economic, budgetary and social consequences. Although the banking sector has so far weathered the financial crisis rather well, manufacturing industries are being severely affected by the downturn of global demand, particularly in high-value added industries. Shipments of goods to US markets have plummeted at a fast pace, following a global readjustment of industrial inventories and leading to a sharp contraction of industrial production. Like other emerging markets, Mexico has suffered from reduced net capital inflows, as investments returned to safer havens, contributing to a decline in equity prices, rising interest rate spreads and a large depreciation of the peso. In addition, several country-specific shocks have had adverse consequences, such as the outbreak of influenza A H1N1. Also, the budget has been put under pressure by the sharp decline in energy prices, as oil exports provide a large share of tax revenues, although temporary relief comes from a price hedge and weaker peso. The rise in uncertainty has depressed business and consumer confidence to record lows, which, coupled with tightening credit conditions at home and abroad, is bearing on consumption and investment. Despite the slowdown in activity and declining commodity prices, inflation has remained persistently high as prices of tradables and food are adjusting with a lag.
Overcoming the financial crisis and the macroeconomic downturn
Despite improved fundamentals Mexico is being hit by the financial turmoil and world economic downturn. As in other emerging markets, there has been a reduction in net capital inflows, which contributed to a large depreciation of the peso in the last quarter of 2008 and in the first months of 2009, although since then the peso has stabilized at a lower level. Access to foreign capital has become more restricted and costly. With a relatively small and well regulated financial sector Mexico has been able to weather the initial shock. The global recession has, however, hit the real sector through the trade channel, reflecting the heavy dependence on the US market. Another shock is the collapse of oil prices, which is depressing fiscal revenues, though these prices have recovered with respect to the minimum levels observed at the end of 2008. Business and consumer confidence have fallen considerably. The outbreak of influenza is also likely to contribute to the downturn. Growth is set to drop substantially this year and start to recover slowly next year. The authorities have responded with liquidity measures, foreign currency interventions, lower interest rates, external borrowing and fiscal stimulus. There might be some room for more monetary easing, if the economy deteriorates further, while fiscal stimulus should be better targeted. The scope for further fiscal measures is limited by uncertainties of future oil revenues, higher cost of funding and the risk of inefficient spending. Although banks remain sound, the authorities should closely monitor bank portfolios, which may be adversely affected by the worsening economic outlook.
Managing the oil economy
Fiscal policy is highly dependent on volatile oil income. The balanced budget rule can create a bias for spending oil revenues as they are earned, especially as transfers to the stabilization funds are limited by caps at low levels. This can potentially lead to a pro-cyclical bias in fiscal policy. Revenues have also been lower than they could have, if gasoline prices had adjusted with international prices instead of a price smoothing mechanism for the domestic price. The system also benefits mostly welloff consumers and has important environmental costs. To better manage budget cycles and oil wealth, Mexico should establish a structural deficit fiscal rule. To improve transparency oil revenues should be reported in gross terms in the budget. A price mechanism that leads to a closer alignment between domestic and international gasoline prices should be adopted and other energy subsidies eliminated and an energy excise tax introduced. To reduce dependence on oil revenues and prepare for the exhaustion of oil reserves, further tax reform is needed to cut exemptions and broaden the tax base. A rapid and adequate implementation of the reform of the state oil company is required to boost oil revenues, increase efficiency and investment in future exploration. While the recent reform passed by congress is expected to improve governance and allow Pemex to use performance based contracts, its implementation is key.
Achieving higher performance
Despite progress over the past two decades Mexico’s health and education indicators remain well below the average of the OECD and some of its Latin American emerging market peers. Health insurance coverage is incomplete, especially for low-income families, and access to health services is highly uneven. There are several separate vertically integrated insurance networks, which increases administrative costs and results in an inefficient use of facilities. In education, lower secondary schools enroll only two thirds of the relevant age group and the quality of education is low, as indicated by poor PISA scores. This reflects poor teaching quality, a consequence of non-transparent teacher selection processes until recently, and limited school autonomy in budgeting, instruction and personnel decisions. Accountability to the government and parents is also low as there is no national exit exam after secondary education and the existing evaluation schemes are fragmented. Recent health and education reforms have started to address these issues, but more needs to be done to increase the efficiency of spending by increasing the coverage of health insurance, reducing the fragmentation of the health system, increasing enrolment in lower secondary education, and improving the quality of teaching.
Pedal to the metal
While Mexico’s growth performance has gradually improved over the past decades, its convergence toward OECD countries has been less rapid than in several other emerging markets.The recent significant reductions in import tariffs should help the economy take fuller advantage of trade and investment integration, which could be a relative strength for Mexico given its geographic location. Reforms introduced in the past two years, including those to promote competition and transparency in the financial sector and, to a lesser extent in telecommunications, will also stimulate the dynamism of the economy. Despite this progress, further reforms are needed to boost overall and within-sector productivity. Relative weaknesses in education, infrastructure, financial development, the rule of law, as well as a lack of competition come out in various studies as explaining why Mexico has not grown as fast as other countries. Focusing attention now on reforms in areas with rapid payoffs such as improving competitiveness and infrastructure could yield double benefits in supporting the recovery from the current recession and longer-term growth. This can be achieved by increasing competition, especially in network industries, liberalizing further the foreign investment and trade regimes, and improving education coverage and trade-related infrastructure.
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