BY JOYDEEP MUKHERJI
Mexico appears to disappoint both optimists and pessimists. Despite many years of reform, it has not been able to attain the economic dynamism needed to rapidly create new jobs and reduce poverty. Its long transition towards a more open and pluralistic political system has not erased sharp political divisions within society, nor met the high expectations of most Mexicans.
On the other hand, Mexico has made solid progress in strengthening its economy to avoid the type of economic instability that plagued it in previous decades. Moreover, the Mexican government has been able to progress with important reforms to strengthen its tax base, fix its future pension problems, and slowly improve the country’s physical infrastructure while running prudent fiscal policy. Such progress has allowed Mexico to remain stable and keep growing at a modest pace, even as the U.S. economy stumbles.
Moreover, it provides Mexico with the time to undertake reforms that could boost its economic growth rate in coming years as the world economy gradually recovers. (…)
Mexican GDP growth is expected to decline towards 2 percent-3 percent in 2008 (down from 3.3 percent in 2007), depending on the extent of the downturn in the U.S. economy. While this is a disappointing performance for Mexico, it is better than many had feared. Moreover, the slowdown is not likely to hurt Mexico’s investment grade sovereign credit rating.
SOLID MACRO-ECONOMIC PANORAMA
Mexico is in a far stronger position to withstand the impact of slow U.S. growth today than it was during previous decades, thanks to reforms that have strengthened its public finances and its monetary system. The public sector borrowing requirement, which includes the central government and public entities like IPAB (the bank deposit insurance agency) and borrowing through the Pidiregas program (mainly for investments by Pemex), has remained below 1 percent of GDP in the last 2 years, and will likely remain at a similar level in 2008. The low level of borrowing has gradually reduced the burden of debt.
Mexico passed a tax reform in 2007, widening the corporate income tax base. The reform was done from a position of strength, while oil revenues were high, increasing Mexico’s fiscal flexibility before a potential fall in oil prices. The government also reformed the pension system for federal civil servants last year, leading to the creation of more pension funds that will boost the size of the local capital market. (…)
Inflation in Mexico has gone up in 2008, as it has globally, now exceeding 5 percent. However, expectations about inflation remain low, thanks to the central bank’s greater credibility in the market. The government has increased subsidies on key products, and tried to cajole the private sector to constrain the rise in prices for some basic products, in order to cope with inflation. Such steps may help in the near term to maintain confidence and reduce the impact of higher prices on the poor, despite imposing a budgetary cost on the government. While inflation has become a sensitive political issue, it does not pose a threat to macro-economic stability as it did in the past. (…)
Over 80 percent of the banking sector (measured by assets), and much of the non-bank financial sector, is foreign-owned after a period of consolidation and privatization. (…)
While still low by international standards, the growing availability of credit to private firms and to consumers has helped to sustain GDP growth. (…)
On the external front, the North American Free Trade Agreement (NAFTA) continues to serve as an ‘anchor’ for expectations about Mexico’s economic policies and an insurance policy against U.S. protectionism. Free trade has led to greater two-way flows and higher import content in Mexican exports. That, in turn, has increased the correlation between Mexico’s imports and exports, imparting greater stability to its balance of payments. Mexico’s current account balance (exports versus imports of goods, services, and remittances) has been in a small deficit below 1 percent of GDP in recent years. Inflows of foreign direct investment have exceeded the deficit in the current account, allowing Mexico to reduce its net indebtedness with the rest of the world.
Compared with many countries in South America, Mexico depends less on commodity exports (mainly oil), and is thus less vulnerable to a sharp fall in commodity prices. The dynamism of Mexico’s non-oil export sector is reflected in the fact that manufactured goods comprised more than 80 percent of Mexico’s exports in recent years, compared with less than 50 percent of the rest of Latin America and the Caribbean. Falling commodity prices may help Mexico via their beneficial impact on the U.S. economy, boosting non-oil exports from Mexico.
An important challenge facing Mexico is the management of the energy sector, a highly controversial topic. Oil production fell 5 percent in 2007 and is reported to be falling in 2008. From the perspective of economic stability and Mexico’s sovereign rating, a continued decline in oil production has a bigger impact on the government’s fiscal balance than on other rating factors such as the balance of payments or GDP growth. (…)
The biggest vulnerability posed by declining oil production lies with government revenue. Total oil-related revenue equaled just over one-third of total government revenue in 2007. Fiscal revenues from the oil sector exceeded 8 percent of GDP in 2007, almost equaling the 9 percent of GDP that comes from income tax and value-added tax. Total tax revenues from the non-oil sectors of the economy were below 11 percent of GDP in 2007, low by regional standards. The failure to build a stronger non-oil tax base has led Mexican governments to depend heavily on Pemex's resources, thereby depleting the company's ability to modernize and undertake more exploration and production.
Despite the negative trends in oil production, the Mexican economy is much more flexible in macro-economic terms today. In contrast with the situation facing Mexico in 1994 during the ‘Tequila’ financial crisis, the country does not have to defend an exchange rate with its foreign exchange reserves. The combination of an autonomous central bank, floating exchange rate, and inflation-targeting, monetary policy has given Mexico more capacity to absorb the kind of external shock that typically led to a crisis in previous decades. The government has much greater flexibility to fund its debt, reducing the risk of depending upon volatile international financial markets. Moreover, Mexico can rely on modest domestic sources of growth to sustain economic activity during the U.S. downturn.
WEAK MICRO-ECONOMIC FOUNDATIONS
Macro-economic stability is necessary, but may not be sufficient for rapid economic growth. Poor micro-economic foundations and the lack of flexibility in key sectors of the economy prevent Mexico from advancing more rapidly despite its stronger macro-economic position. The Mexican economy grew at an average annual rate of only 3.3 percent during 2003-2007, a period of much faster growth in the world economy and in Latin America as a whole. The relatively modest growth rate has helped to reduce poverty and improve human development indicators, but the pace of change has been disappointing for most Mexicans. (…)
Key sectors of the economy that have an important spillover into the wider economy carry the non-competitive legacy of the corporatist past, imposing a burden on the entire country. For example, the persistence of public sector monopolies (as in oil) and the large public sector presence in key sectors such as gas and electricity, combined with a perceived low level of competition in other sectors (such as telecom) keep some costs artificially high and reduce prospects for investment and growth.
Growing competitive pressures in many industries in recent years raised the threat of job losses, forcing many unions in the private sector to soften their approach to labor negotiations. In contrast, public sector unions facing no such competitive or political pressure (such as unions in Pemex, the Social Security Institute of Mexico [IMSS], the Federal Electricity Commission [CFE], Luz y Fuerza del Centro) have remained largely intransigent, maintaining many of the worst practices of the past. (…)
Emigration and oil revenues have helped to ease political pressures in Mexico, providing a ‘safety valve’ for the country that allows it to muddle through without making difficult reforms. Failure to advance more rapidly with reform runs the risk of turning Mexico’s dependence on these two factors into a chronic addiction. The benefits from both emigration and oil may decline in coming years, as immigration to the United States becomes more difficult (especially as the U.S. economy decelerates) and as oil production keeps falling from its peak output level in 2004. (…)
The Mexican Congress has been holding exhaustive debates during 2008 on President Felipe Calderón’s proposals to reform the energy sector, seeking to strengthen Pemex financially and managerially, and to modestly enlarge the role of the private sector in the oil business. Such trends augur well for the country’s ability to modernize and prosper, albeit slowly.
The legacy of Mexico’s corporatist system is not the only constraint on faster economic growth. For example, recent surveys show that large companies spend 2 to 5 percent of their expenses on security, a reflection of the serious problem of crime in many parts of Mexico and its negative impact on the private sector. Other factors, such as poor physical infrastructure, also dampen growth prospects. The challenge for Mexico is not necessarily to fix all its problems at once before making progress, but to remove the most binding constraints on growth in order to unleash more economic dynamism.
The near-term challenge for Mexico is to maintain its recent, hard-won stability in the face of potentially worse global conditions. The longer-term challenge is to move beyond stability and modest growth, by making the necessary changes to create a dynamic economic environment that would reduce poverty and improve living standards.
Joydeep Mukherji is team leader for Latin American sovereign ratings at Standard & Poor’s in New York, where he has worked since 1996. Previously, he spent five years in corporate and investment banking at CIBC Wood Gundy in Canada, working mainly with asset securitization.
This column is based on an excerpt of a policy paper that was published by the University of Miami’s Center for Hemispheric Policy for its task force on “Mexico Under Calderon.” Republished with permission of the center.