Manuel Sánchez: Is Mexico different from other emerging economies?
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the University
of York, York, United Kingdom, 19 April 2016.
* * *
It is an honor to be with you today in this historic English city to speak at the prestigious
University of York. This academic center has received much recognition in its first
halfcentury for its achievements in both research and education, with a distinguished faculty and
cosmopolitan student community.
I would like to talk about how Mexico has fared in the present international environment of
heightened risk aversion, and some of the challenges that lie ahead. In particular, I would like
to examine whether or not Mexico's structural and policy framework has set the country
sufficiently apart from other emerging economies.
Differentiation is a highly desirable outcome as it would contribute to better economic
conditions. I will argue that Mexico should make further progress in this regard in order to
consolidate price stability and enhance potential output growth.
As usual, my remarks are entirely my own and do not necessarily reflect the position of the
Bank of Mexico or its Governing Board.
The rise and fall of emerging economies
Starting in 2010, emerging economies enjoyed a favorable financial environment
characterized by substantial capital inflows in the search for yield amid extraordinarily lax
monetary policies in advanced countries. At the same time, commodity prices rose and
remained high, supporting growth in commodity exporters. Also, asset prices in emerging
markets tended to increase, including some bouts of currency appreciation vis-à-vis the U. S.
dollar.
While the taper tantrum in 2013 sparked a transitory rise in risk aversion, the market mood
really changed around mid-2014 as previous trends reversed, including a contraction of
portfolio investment inflows in the second half of the following year, something which had not
been seen since the global financial crisis. In a few words, emerging economies went from
beauty to beast in the eyes of international fund managers.1
Among factors spurring this turn of events was the apparent perception that the process of
U.S. monetary policy normalization was about to begin, given the end of longstanding
assetpurchase programs in October 2014, and worries about the health of the Chinese economy
and policy measures there.
The result has been an almost continuous decline for commodity and financial asset prices in
emerging economies over the last two years, only partly attenuated in recent weeks. Energy
prices have been the most affected, but those of metals and agricultural products have also
taken a knock. Growth prospects and public finances have been hurt in countries heavily
dependent on commodity exports.2
Simultaneously, external borrowing costs for emerging economies have increased and their
currencies have weakened significantly versus the U.S. dollar. Some nations have found
themselves in a difficult spot given that fiscal and financial imbalances were built up during
the preceding bonanza.
Problems run from high debt in domestic and foreign currencies and deterioration of financial
institutions' balance sheets to overly appreciated real estate in some cases. As a result,
several economies have been tightening monetary policy in the face of rising inflation and
inflation expectations, a development that contrasts with that of advanced nations.
The real impact on Mexico
There are two noticeable avenues through which this adverse external environment has
affected Mexico's actual and potential economic activity. One is through lower commodity
prices, where the impact can be expected to be milder than that for primarily commodity
exporters.
Beginning in the 1980s, Mexico undertook a deep economic transformation by expanding its
integration with the rest of the world, tearing down foreign trade and investment barriers.
Among other treaties signed by Mexico, the North American Free Trade Agreement of 1993
notably consolidated the country's links with the United States. Throughout these years,
manufacturing and services gained substantial share, in trade and economic activity,
respectively, while agriculture and mining lost relative weight in both.
The most important commodity produced and exported by Mexico continues to be oil.
Currently, oil and gas extraction accounts for roughly five percent of GDP, and crude, only
around six percent of total exports. A large part of the reduced size of the sector comes from
the shrinking production trend observed since 2004 due to the depletion of high-yield oil
fields.3
Whereas Mexico now depends much less on commodities for production and trade than
several other emerging economies, particularly in Latin America, the possible real effect of
low oil prices is not trivial, especially if they are sustained for a long time. Further oil
extraction in certain areas may no longer be profitable, and the return on new investments as
well as the possibilities for financing may be more limited. Negative spillovers to other
production sectors, such as mining-related services, may be considerable.4
Another real external effect has come from the slowdown of U.S. industrial production, partly
due to the downsizing of the oil sector in that country after the price drops. Mexico's GDP is
highly correlated with industrial production in the United States, reflecting the vertical
integration of processes between the two nations, such as in the automotive and electronic
sectors.
The negative impact has been transmitted through a deceleration of Mexico's manufacturing
exports to its northern neighbor. Even so, the hit has tended to be smaller than that
experienced by many other emerging economies with exports oriented to countries other
than the United States, as this economy has shown one of the clearest upturns among
advanced nations after the crisis, albeit disappointing in a historical context.
Since 2014, Mexico's GDP has been growing at roughly 2.5 percent, slightly below the
average of the previous two decades. The main engine of the ongoing rebound has been the
services sector and, on the demand side, private consumption. However, history tells us that
unless the external sector eventually supports the upturn, the economy's vitality will not
continue.
The outlook for the Mexican economy is one of a gradual recovery along with that of the
United States. However, downward risks prevail, including most importantly,
less-thanexpected U.S. industrial improvement, and secondly, a larger-than-anticipated contraction in
oil production. Of course, long-term growth potential depends heavily on adequate
implementation of the structural reform agenda, which seeks more efficiency in many sectors
such as energy and telecommunications.5
The financial impact on Mexico
The adverse international environment has also had financial repercussions on Mexico
through two main channels. The first is a slowing in portfolio investment inflows, which
nevertheless have tended to remain positive in contrast to those of many other emerging
economies, where they have been significantly negative.
As a result, nonresident holdings of peso-denominated government securities, a favorite for
fixed-income investors for several years, continued to increase, and since 2015 have
remained roughly constant in nominal terms. Hence, the share of these holdings in the total
outstanding has recently declined only moderately. However, this proportion is still one of the
highest among emerging-market local-currency-denominated government securities.
High and stable exposure to foreign holdings is a sign of strength. The confidence shown by
investors in Mexico possibly reflects the depth of the bond and peso markets and the
credibility of the economic policy framework. The resilience of foreign portfolio investment
has contributed to the relative stability shown by medium- and long-term market interest
rates for government bonds. Maintaining the preference of nonresident investors is obviously
of paramount importance and can never be taken for granted.
The second route for external impact has been in the public finances, originating, again, in
lower oil prices. As with other large oil producers, Pemex, the state-owned oil extracting
enterprise, has seen its financial conditions deteriorate significantly. This, along with more
than a decade-long decline in oil production, has resulted in a considerable increase in
credit-risk perception. The rise for Pemex credit default swap (CDS) spreads has been more
acute than for many other major oil-producing firms.
More importantly, lower oil prices have dented the prospects for healthy Mexican public
finances. The fragility is due, first, to the fact that because Pemex is state-owned, markets
assume the government will back its debt under the pressure of contingencies. Second,
public-sector budgeted revenues depend heavily on oil income, which accounts for slightly
less than one-third of the total, among the highest ratios in the emerging-market universe.6
These weaknesses are amplified by the fact that during the last few years, the ratio of
accumulated total public-sector financial requirements to GDP has consistently increased.
For the public finances to be sustainable, this proportion must stop growing and eventually
stabilize at lower levels, a goal which has been explicitly stated in federal budget plans.7
The resulting vulnerability has been reflected in two ways. One, during the first few weeks of
this year, Mexican government CDS spreads increased more rapidly, and have tended to
remain higher than those for governments with equivalent credit ratings.
Another is the increasing correlation between the peso-U.S. dollar exchange rate and oil
prices. Since mid-2014, the peso tracked the average emerging-market currency in its
substantial weakening trend, with nothing to distinguish its performance.
Furthermore, in January and until mid-February this year, the peso depreciated at a faster
rate than other emerging-market currencies. This period also overlapped with the worst of
the deterioration in CDS spreads. Since then, along with other emerging-market currencies,
the peso has recovered somewhat, in tandem with higher oil prices.
In short, Mexico has been affected financially by external circumstances. Furthermore, new
financial pressures may emerge as the sources of international volatility have not
disappeared and could even resurface. For this reason, Mexico needs to strengthen its
macroeconomic fundamentals.
Certainly, in the face of the possible persistence of reduced oil prices, a tight fiscal stance is
highly advisable. Appropriately, last February, the federal government announced budget
expenditure cuts, especially for Pemex.8
Monetary policy and inflation
Since 1994, the Bank of Mexico's primary objective as mandated by the country's
constitution is price stability. Like that of other emerging economies, Mexico's monetary
policy has formally been implemented within an inflation-targeting framework since 2001.
The permanent annual inflation target is 3 percent. Attaining this target has been a long
quest.
Recent inflation developments differ from those in other emerging economies in two
interrelated ways. First, since 2015, inflation has not only been lower than that in several
other emerging economies, especially in Latin America, but it has also been consistently
below target for the longest period on record in Mexico. Consequently, inflation struck
alltime lows last year.
A second difference, perhaps more noteworthy, is the fact that pass-through from currency
depreciation to price changes has been virtually inexistent. While, as expected, currency
depreciation has directly affected the prices of particular tradable goods, no second-round
effects have occurred either on the generalized price formation process or medium- and
long-term inflation expectations.
The absence of pass-through is quite an achievement given Mexico's long history of high
correlation between currency devaluation and inflation until the 1990s under successive
regimes of predetermined exchange rates. To be sure, under inflation targeting and a flexible
exchange rate, pass-through has diminished substantially in the past 15 years, a result that
may be traced to lower and more stable inflation. Furthermore, statistical evidence shows
that pass-through has been lower than in other Latin American countries during this century.9
An interesting question is why pass-through has been muted in the present context. Although
the answer still awaits rigorous statistical examination, I would like to put forth three possible
reasons for this phenomenon, which could be complementary, though with varying degrees
of significance.
First is slack in the economy. While one cannot rule it out as a factor, slack is also present in
other Latin American countries, not just Mexico, and they have seen more significant
passthrough.
Second, last year saw positive supply shocks, including the elimination of national
longdistance telephone charges, a reduction in government-mandated gasoline and electricity
price increases, and unusually soft agricultural prices. It is possible that these shocks have
given entrepreneurs maneuvering room for delaying price increases stemming from greater
import costs. However, some of these bonuses have begun to wane this year, and yet
inflation remains benign.
Third, inflation expectations for the medium- and long-term horizons, contained in analysts'
surveys, have continued to be stable, although slightly above the target. This is perhaps the
most important factor behind the absence of pass-through, possibly reflecting credibility on
the commitment to price stability.10
To face the risks posed by the external scenario, Mexico's monetary policy was adjusted
twice recently, with a 25-basis-point hike in December and a 50 basis-point hike in February.
Considerations behind these measures were consistent with arguments in favor of vigilance
emphasized in previous monetary policy communications.
In particular, an important argument supporting the first hike was to maintain the relative
stance vis-à-vis the United States in light of the first fed funds rate increase since 2006. The
second hike came in conjunction with the government's announcement of expenditure cuts,
and sought to prevent contamination of inflation expectations from currency depreciation, as
well as to contribute to stronger macroeconomic fundamentals.
Trust gained over years of consistent endeavor, however, can be lost in an instant. Mexico
has an unprecedented opportunity to consolidate convergence to the inflation target, given
unusually subdued price pressures.
Upward risks to inflation imply that monetary policy must remain particularly on guard.
Dangers include further peso depreciation that does lead to second-round effects, despite
their past absence; more rapidly rising agricultural prices that may contaminate other prices;
and aggregate demand pressures which may eventually arise with the economy's recovery,
something particularly relevant in light of uncertainty on the degree of slack in the economy.11
Finally, although actions by the U.S. Federal Reserve must continue to be taken into
account, the need for further adjustments may arise independently of U.S. policy moves, for
example if inflation expectations become misaligned as a result of international volatility.
Concluding remarks
Mexico has set itself apart from other emerging economies in some respects. However, to an
extent, markets continue to treat the country as if it were an average case, and sometimes,
below the mean in its asset class. This implies that Mexico must make further progress on
possible sources of differentiation. These include improvement of macroeconomic
fundamentals, with sustainable public finances and timely monetary-policy adjustments to
consolidate price stability.
A well-capitalized and highly liquid banking system must continue to be the case. Structural
reforms should also be implemented appropriately. Finally, Mexico's potential growth will
increase if improvements to the rule of law and public security are attained.