Last year, Mexico registered its best economic performance in twenty years, thanks to strong growth and moderating trends in the country’s current account deficit, external debt, and unemployment and inflation rates.
The country’s GDP grew 7%, bringing average annual growth over the last five years to a healthy 5.5% Core inflation dropped to 7.5% in December 2000 from 14.2% at the end of 1999, and dipped under 7% this January.
In spite of a strengthening currency, Mexico’s current account deficit was contained at an estimated 3.1% of GDP. As a result, the country’s open unemployment rate fell to a record low 1.9% in December 2000 from a record high 7.6% in August 1995.
The external debt picture, which has traditionally been one of Mexico’s biggest problems, now reflects the best debt ratios seen in more than 30 years. External debt-to-GDP was an estimated 27% at the end of last year, while debt-to-exports registered nearly 78%, the lowest ratio ever recorded. The administration of President Ernesto Zedillo at the end of last year cleared Mexico’s outstanding debt with the IMF, the first time this has happened since 1970.
There is no doubt that a positive external environment heavily favored this performance. Oil prices reached a 10-year high. Economic expansion in the US helped non-oil exports grow 18.6%. Export growth contributed to about half of GDP growth over the past six years, on the back of both Nafta and continued US expansion. As a result, exports now represent almost 30% of Mexico’s GDP and 89% of all Mexican exports go to the US. This means that now, more than ever, Mexico is linked to the US business cycle.
The Mexican economy therefore faces considerable uncertainty this year given the slowdown in the US. Although some economists still expect the US to grow by more than 2% this year, consensus is for expansion of 1%- 2%. Although there remains a strong possibility that a US recession will materialize, it is expected to be short-lived and should dissipate by the third quarter. Nevertheless, such a scenario would have an important effect on the demand for Mexican exports and would lead to lower growth for the economy as a whole.
The latest indicators on economic activity for the Mexican economy already reflect a slowdown. If seasonally adjusted annual rates are used to track GDP growth instead of the traditional year-on-year growth rates used in Mexico, growth peaked at 11.8% in the first quarter of 2000, slowed down to 6.7% in the second quarter and fell to 5.8% in the third quarter.
The global economic activity index shows a seasonally adjusted rate of 3.8% for October and a drop of 1.8% in November. The trend series for the same index confirms a constant downward trend as of March of last year. Finally, industrial production in December registered a year-over-year drop 0.46%, which is the first negative growth rate over the past 72 months. These numbers suggest that the Mexican economy will have grown somewhere around 5% in the fourth quarter, with a downward inertia that should push the first quarter of 2001 towards 2.4%.
A Self-Styled Slowing
Despite the slowdown in the US, it is more likely that monetary policy in Mexico is responsible for the deceleration in economic growth. Lower export demand toward the end of the fourth quarter explains part of the Mexico’s economic deceleration, but the Central Bank began pursuing an increasingly restrictive monetary policy last year, as the growth rate has been inconsistent with a decelerating rate of inflation.
While sustained economic growth in Mexico has created more than four million jobs in the formal sector, it has also caused labor shortages for semi-skilled and skilled workers in certain regions of the country. This has caused real wages to increase at an average near 7% for what time period in almost all sectors of the economy. The combination of low unemployment and real wage growth has caused real disposable income to rise, which explains an increase in consumer spending that topped 10% in the third quarter of 2000.
Given that real wages have increased faster than productivity growth in many sectors of the economy, the Bank of Mexico tightened monetary policy six times last year and once again this January. As a result, real interest rates remained high throughout the second half of the year and the economy finally started to slow down in the fourth quarter. Nevertheless, inflationary expectations have not diminished, causing monetary authorities to remain firm and not loosen their position.
The biggest challenge ahead for the Mexican government is not in avoiding a slowdown, but rather in trying to synchronize its business cycle with that of the US. If the US economy slows ahead of the Mexican economy, export growth will fall while import growth will remain strong. This will cause an increase in demand for foreign exchange, which will be satisfied either through increased capital flows and a higher current account deficit, or a depreciation of the exchange rate.
With the economy facing more moderate growth, it is unlikely that capital flows will increase significantly. The Mexican government announced that it has no net borrowing requirements this year and the private sector is likely to avoid increasing its external debt load at this time. This leaves foreign direct investment (FDI) as the only possible source of increased foreign exchange for the year. If FDI increases sufficiently, the current account deficit would grow, increasing the overall vulnerability of the economy.
However, FDI is not expected to grow much, meaning that it is unlikely that capital flows will increase over last year’s level. This means that the adjusting variable would have to be the exchange rate. Nevertheless, the increased depreciation should lead to higher inflationary pressures, especially now that the economy is so much more open.
In order to avoid these problems, it is imperative that the Mexican business cycle should begin moving in accordance with the US economy. This means that a slowdown in economic activity is necessary at this time. If it is achieved in a satisfactory fashion, the current account deficit will remain near current levels, the exchange rate should face only moderate depreciation and inflation will continue to drop.
While the external environment is the key issue affecting this Mexico’s economic outlook, the outcome of pending reforms is also important. President Fox will be reintroducing only a slightly modified version of the ill-fated electricity sector reform that Zedillo proposed. While there is widespread agreement that fresh new capital is needed to increase electricity supply, Congress remains deeply divided. Outright privatization of the sector has been ruled out and the government is proposing to open up the sector to private capital. However if the right incentives are not approved, it is doubtful that private firms will be interested in making large investments.
The widely anticipated fiscal reform will be the top issue in the next Congressional session. Mexico has one of the lowest tax revenue rates in all of Latin America and in order to carry out much of what Fox promised during his campaign and meet public expectations, an increase in tax collection is essential. Nevertheless, no party is considering increasing tax rates, which leaves little maneuvering room for successful proposals.
Solutions such as a reduction in paperwork and improved incentives for taxpayers are being considered, but there is considerable controversy over the proposed elimination of value added tax exemptions for food and medicines. Both the PRI and the PRD, the two left-of-center political parties that form the opposition to Fox’s PAN, are afraid that supporting the proposal will come at a huge political cost. Yet at the same time, they realize that it is probably the only measure that will successfully increase tax revenues.
If fiscal reforms are approved in line with government proposals, the budget deficit will finish the year closer to a balanced budget than to the approved ceiling of a deficit of 0.65% of GDP. This means that the government will be able to increase spending on badly needed educational programs, health services and poverty programs. Nevertheless, in the short run we will see an increase in inflation of up to two percentage points, as food and medicine prices will increase in line with the higher taxes.
Successful fiscal reform will help the government reduce its domestic debt in the medium term by achieving a small fiscal surplus rather than sacrificing spending. At the same time, improved public finances and higher export growth will allow the government to avoid having to resort to external borrowing. This possibility is likely to induce Standard & Poor’s to approve an investment-grade rating, ending Mexico’s current split-rating status following Moody’s upgrade in March 2000.
In spite of the growing optimism that this would bring, there are many issues that must still be faced. Labor reform is necessary to help create quality jobs. Judicial and institutional reforms are necessary to strengthen the rule of law. Corruption and impunity remain at embarrassingly high levels. Nonetheless, while the short-term outlook seems more complex than the previous years, Mexico seems headed to a much-improved mid-term outlook. LF
Jonathan Heath is chief economist for LatinSource Mexico.