Public Information Notice No. 09/19

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with Mexico

February 13, 2009

On February 6, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mexico.¹

Background

Mexico has made substantial progress over the past decade in strengthening its economic framework. However, the external environment has deteriorated sharply since last year, testing Mexico's resilience and current policy framework.

Since September 2008, financial markets in emerging markets, including Mexico, have been disrupted by shortages of liquidity, and a pull back by foreign investors leading to substantial asset price drops. Credit growth in Mexico has also decelerated markedly. The abrupt currency depreciation in October last year resulted in sharp losses for some Mexican companies on foreign currency derivative positions.

The weakening outlook for U.S. activity, remittances, and international oil prices all weigh on prospects for Mexico. Growth has begun to decelerate as the U.S. has slowed sharply and consumer confidence in Mexico has weakened. Real GDP growth is projected at minus 0.3 percent in 2009 with a gradual pick-up in 2010 to annual average growth of 2.1 percent. Headline inflation reached almost 6.5 percent year-over-year by end-December—above the 3 percent target—mainly pushed up by external supply shocks. However, inflation is expected to fall towards the target over the next year in the face of a widening output gap.

The current account deficit is expected to widen in 2008—from 1 percent of GDP in 2007—and then remain in a broadly stable range of 2-2.5 percent of GDP over the next years. Non-oil export volumes have begun to weaken, reflecting especially the slowdown in the U.S., compounding the effect of falling oil export receipts and remittances. However, there will be some offset as imports are expected to slow in line with moderating domestic demand and the weaker exchange rate.

The authorities have responded promptly with a comprehensive policy package. On financial markets, measures including foreign currency intervention and steps to buoy up domestic debt markets have helped contain stresses, although some pressure points remain. The announcement of a swap agreement with the Federal Reserve has also supported confidence.

On macro policies, the fiscal stance is set to ease, with a stimulus of about 1.5 percent of GDP budgeted in 2009. Fiscal policy is on track to achieve balance in 2008−09, on the traditional budget measures, as required by the Fiscal Responsibility Law (FRL). But reflecting the planned stimulus, the augmented balance is set to widen in 2009 by over 1 percent of GDP from a projected minus 1.7 percent of GDP deficit in 2008. The government's oil price hedge policy is expected to safeguard room for maintaining spending levels in 2009 to support needed investments and social spending. Meanwhile, the central bank cut its policy rate by 50 basis points in January, pointing in its statement to an expected downward trend in inflation and the deteriorating outlook for growth.

Executive Board Assessment

Executive Directors commended Mexico's significant improvements in its macroeconomic policy framework over the last decade, including the flexible exchange rate and rules-based fiscal and monetary policies, and in strengthened public, corporate and banking sector balance sheets. Directors noted that, as a result, the economy faces the current external crisis from a more robust position than in the past and for the first time the authorities can respond to a downturn with countercyclical policies, while maintaining stability and without jeopardizing medium-term sustainability. They observed that market sentiment had also been supported by the swap facility agreed with the U.S. Federal Reserve.

Directors endorsed the planned 2009 fiscal stimulus, which should, along with increased development bank intermediation, provide timely support to economic activity. They observed that the counter-cyclical spending increases would protect employment and support low-income families, increase competitiveness of small-and medium-sized businesses, and augment infrastructure. Such measures were partly financed in effect by the authorities' prudent price hedging of oil sold by PEMEX.

Directors considered that if the economic situation were to deteriorate more or longer than expected, there could be scope for further fiscal easing in 2009 and also to smooth the planned withdrawal of fiscal stimulus in 2010. They welcomed the authorities' recognition of financing and implementation constraints and the need to carefully weigh the potential impact on hard-earned policy credibility.

Looking forward, Directors noted that providing the fiscal space for needed public investment and social expenditures was a key challenge, especially in view of projected lower oil revenues and rising pension costs. They encouraged the authorities to advance efforts to improve tax administration and restrain current expenditure, including by refocusing untargeted subsidies. Directors also encouraged the authorities to refine the fiscal policy framework by giving consideration to moving from the current balanced budget rule to a fiscal rule that would allow greater expenditure smoothing in response to cyclical fluctuations, while ensuring policy credibility.

Directors generally saw the balance of inflation risks as tilted to the downside, suggesting room for monetary policy easing. Nonetheless, they recognized that still-high headline inflation and above-target inflation expectations are complicating factors, underscoring the importance of communication efforts to explain the outlook and downside risks. In that light, they welcomed the timely interest rate cut in January 2009.

Directors agreed that the flexible exchange rate has been an important shock absorber, and viewed central bank intervention as having helped address liquidity shortages in the foreign exchange market, while preserving essential aspects of the flexible currency regime. Directors noted the staff's assessment that the peso may be somewhat undervalued from a medium-term perspective.

Directors welcomed the staff finding that the banking sector was well-capitalized, profitable, and supported by a robust regulatory framework. However, they noted that financial conditions remain tight and emphasized the need to carefully monitor risks in individual financial sector segments, including smaller intermediaries and corporate financing. Directors encouraged the authorities to press ahead with efforts to bolster the risk management framework—including by advancing the proposed reform of the bankruptcy framework for banks, and extending current risk assessments for analyzing liquidity and funding risks for banks and corporates. Directors welcomed the enhanced coordination amongst the different financial sector regulators and emphasized the importance of finalizing protocols for joint action and information sharing.

Directors considered that acceleration of the reform agenda remained key to improving growth prospects over the medium term. They welcomed the recently approved reforms in the energy sector and import tariff reductions as positive steps forward. However, Directors noted that significant additional progress was needed, including product and labor market reform, improving infrastructure and education, and strengthening competition.