Manuel Sánchez: The United States and Mexico - a lasting bond
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the Mosbacher
Institute, Bush School of Government and Public Service, Texas A&M University, College
Station, Texas, 15 September 2016.
* * *
It is a pleasure and an honor to participate in the series "Conversations in Public Policy" held
by the Mosbacher Institute at the Bush School at Texas A&M University. The occasion is
important for at least two reasons. Texas A&M is a world-renowned educational and
research center, with a 140-year history, and it is located in the state with the most significant
social and economic connections to Mexico. The longstanding relationship between the Lone
Star State and Mexico is deeply rooted in a common cultural and social heritage.
Today, I would like to talk first about the long-term economic ties between the United States,
in particular Texas, and Mexico. Second, I will focus on financial markets and challenges.
Third, I will examine recent economic developments and the outlook, and finally, discuss
inflation and monetary policy in Mexico.
As usual, my remarks are entirely my own and do not necessarily reflect those of the Bank of
Mexico or its Governing Board.
Long-term economic ties
Mexico has long been in a process of increasing economic integration with the United States,
encompassing goods and services, capital, and labor markets. These links, reinforced by the
North American Free Trade Agreement, have yielded substantial benefits on both sides of
the border, including more competition, efficiency, job creation, and consumer wellbeing. The
most significant bond with any state is with Texas, given its place as the tenth largest
economy in the world and the extensive border it shares with Mexico.
In terms of trade of goods, the United States is Mexico's most important partner in both
imports and exports, while Mexico is second in exports and in imports for the United States.
Texas, however, is number one in both categories for Mexico - and vice versa.
The backdrop to bilateral merchandise trade is a long-term, growing industrial integration
between the two countries. In particular, Mexico's manufacturing production holds an
extraordinarily high correlation with U.S. manufacturing output.
Also, the United States, and Texas in particular, are important providers of foreign direct
investment to Mexico, transferring technology and knowhow, while exploiting mutually
advantageous business opportunities. In fact, Mexico is the second most important
destination for Texan foreign direct investment, following only Canada.1
Finally, Mexico's net labor migration to the United States and Texas has been significant
over the years. However, Mexican net labor flows to the United States have diminished
notably since 2008 and have been negative in some years. Several factors may be behind
this phenomenon, including falling fertility rates and cyclical factors, such as low growth in
U.S. economic sectors which typically have been Mexican labor absorbers - for example,
construction - as well as rising employment in Mexico.2
Worker remittances from the United States dropped amid the global financial crisis, and
since 2010 have exhibited a discontinuous recovery, reaching nominal pre-crisis levels only
recently. These money transfers contribute substantially to the standard of living of many
families in Mexico, helping them to meet basic needs, such as longer schooling and better
housing.3
Going forward, it is only natural that social and economic integration between the two
countries augment. An increasing array of opportunities will continue from the current reform
agenda undertaken by Mexico. Telecom and energy reforms are already making themselves
felt. The latter is especially important for an energy power house such as Texas.4
Financial markets and challenges
Since the middle of 2014, risk aversion has increased, hitting emerging markets especially
hard. A reflection of this has been a decline in the prices of many commodities and
emerging-market financial assets, including some upward pressure on interest rates, but
more persistently, widespread downward pressure on currency levels against the U.S. dollar.
Behind this shift are various factors, beginning with worries over the state of the Chinese
economy and policy moves there to handle any deterioration. Also, geopolitical
developments such as Brexit may have had a part. However, the most important by far has
been uncertainty over imminent U.S. monetary policy normalization.
Market expectations and the beginning of normalization have had significant implications for
financial flows to emerging economies. Around the world, U.S. monetary accommodation
fueled the search for yield through significant portfolio capital inflows to emerging markets.
Since 2014, however, these flows have slowed, turning negative in some recent quarters.5
Furthermore, data-driven U.S. monetary policy has generated financial volatility. Portfolio
capital flows are highly sensitive to revised expectations of changes in U.S. policy rates.
Additionally, asset prices react rapidly to any economic news. If the perception is of a
stronger-than-expected economy, they tend to fall in anticipation of tighter policy, and vice
versa.6
Mexican financial markets have adjusted to this environment mainly through the exchange
rate. Long-term interest rates, low by historical standards, have remained relatively stable
since an upward adjustment in 2013 in the wake of the infamous taper tantrum.
Along with other emerging-market currencies, the Mexican peso has depreciated significantly
since 2014. However, during the present year, the weakening of the currency has been more
substantial than in other emerging economies. In addition to fears surrounding U.S. hikes,
other aspects more specific to Mexico seem to be at play.
A first contributing factor is Mexico's weak fiscal position. Over the last several years, the
historical balance of public-sector borrowing requirements relative to GDP has been
persistently rising, to reach around 50 percent in 2016. Also, financial deterioration in
stateowned oil company Pemex, due in large part to lower international oil prices, has been a
concern. The fiscal gap has been mirrored in a widening current account deficit, mainly
reflecting the oil trade account.
Mexico's fiscal finances may be on an unsustainable path, and the public debt ratio appears
to have reached a limit, at levels that may not be healthy. Relative government indebtedness
is already higher than in many other emerging markets. Also, Mexico's sovereign credit risk
perception, as measured by CDS premiums, has remained above that of other countries with
the same rating. Furthermore, rating agencies have given Mexico a clear warning this year in
the form of a downward change in perspective.
A second contributing factor to peso depreciation may be markets' disappointment on
lowerthan-expected growth in Mexico. A third cause may stem from uncertainty on the forthcoming
U.S. presidential election and its implications. Finally, given the depth and liquidity of the
peso market, and the fact that derivatives are used to hedge peso positions and as a proxy
for other emerging-market asset investments, price swings for the Mexican currency may be
exacerbated.
Volatility could easily increase in the future, in light of so many unknown global geopolitical
and financial variables. This situation could be even more risky in the face of Mexico's high
exposure to foreign holdings of peso-denominated government debt. These holdings
represent one of the highest proportions of the total outstanding of local currency debt in the
emerging-market group, decreasing somewhat during the last two years, at close to a third,
with the drop concentrated mainly in short-term securities. The still high ratios of foreign
holdings could be interpreted as a positive sign. The tables could rapidly turn, however, if
perception of strength evaporates.
Therefore, it is absolutely urgent that Mexico strengthen its fiscal stance in an unambiguous
way, cutting public expenditures significantly in order to stabilize, and eventually reduce, total
government debt to GDP. Obviously, monetary policy should also continue to carry its weight
in the effort to fortify macroeconomic fundamentals.
Recent economic developments and outlook
Since 2014, GDP has risen at a relatively stable rate of around 2.3 percent year-on-year,
including a dip in the 2016 second quarter. Two offsetting forces have contributed: expansion
in services and decelerating industrial production. Recently, the pace has slowed in both
sectors.
The main drag on industrial output has been a contraction in mining, driven by a
longstanding decline in oil extraction. Manufacturing production has also been slowing to
almost no growth recently. To a large extent, these developments have resulted from a
falling trend in U.S. manufacturing production and a contraction in manufacturing exports to
the United States since 2015, despite the significant real depreciation of the Mexican peso
against the dollar.7
Less Mexican manufacturing dynamism seems to have begun to affect important segments
of the services sector, such as commerce and transportation, highly correlated with
manufacturing, a worrisome event given that the services sector has been a key growth
engine in the past few years. On the demand side, Mexico's economic slowdown is evident
in lower increases in private consumption, and especially a decelerating trend in total
investment.
Analysts' consensus forecasts are for a transitory loss of vigor in the Mexican economy this
year, followed by a growth figure slightly below the historical average in 2017. The economic
scenario, however, faces risks, among which those to the downside seem to prevail.8
In the short term, possible negative effects include a deeper deceleration for the global
economy and U.S. manufacturing production, additional reductions in Mexican oil extraction,
and softer business confidence and private investment. In the medium term, dangers
encompass obstacles to adequate implementation of structural reforms, where education
stands out, as well as growing international protectionism.
Inflation and monetary policy
Since 2015, inflation in Mexico has exhibited benign behavior. In annual terms, it has
converged to the 3 percent target established by the Bank of Mexico more than 10 years
ago. Furthermore, and in stark contrast with previous trends, inflation has been continuously
below the target.
Subdued headline inflation has been supported by unusually reduced rises in the noncore
component of the CPI. Specifically, since the middle of last year, noncore inflation has
averaged only 2.3 percent, contrasting with the roughly 6 percent average during this
century.
On the other hand, core inflation has been growing gradually this year, largely reflecting
moderate pass-through from currency depreciation to tradable goods prices. So far, this
effect has been relatively mild, and core inflation has not breached 3 percent. In addition,
exchange rate pass-through to merchandise prices has been somewhat compensated for by
lower telecom prices, reflecting more competition in the sector.
Two warning signals that would argue against continued consumer price stability are a rising
trend in producer price changes, which could be partly translated to final goods, and an
interruption in convergence of medium-term inflation expectations to the target, as measured
by analysts' surveys.9
Upside risks to inflation appear to dominate. The largest concern relates to the possibility of
higher contagion from Mexican peso weakening, which could generate deviation of inflation
and expectations from the target. Sudden increases in pass-through cannot be ruled out.
Two other risks are the reversion of noncore inflation to its historical mean, with possible
second-round effects. The potential emergence of aggregate demand pressures are also
important, given uncertainty regarding the true level of potential GDP.
Throughout recent years, monetary policy has been conducted in alignment with the primary
objective of sustained price stability. Consistently, since December 2015, the policy rate has
been raised three times, for a total of 125 basis points. These moves were preemptive, as
inflation has remained under control. The hikes sought to fortify macroeconomic
fundamentals in conjunction with announced government expenditure cuts, and to avert
deviation of inflation expectations from the target that may arise from pass-through.
Going forward, the implications of exchange-rate developments will remain an important
input in monetary policy decisions. But let us be clear: the Bank of Mexico does not target
any exchange-rate level and hence, there does not exist a benchmark value at which
monetary policy would react. This does not mean, however, that the effects of currency
behavior are irrelevant. They will continue to be taken into account to the extent that they
may impact inflation and expectations.
Other factors considered by monetary policy include the state of the economy and the
relative monetary stance vis-à-vis that of the United States, especially important given the
close nature of the U.S.-Mexican relationship.
In short, monetary policy must remain on guard. Its lags are long and variable. It will continue
to be implemented with all the flexibility, timeliness, and independence required to
consolidate price stability.
Concluding remarks
As with the United States as a whole, Texas and Mexico continue to enjoy longstanding and
profound cultural, social, and economic ties. Mutual benefits accrue on both sides of the
border from bilateral trade, as well as capital and labor investments. Ongoing structural
reforms in Mexico should enhance this process.
Significant not only for Mexico, but for the larger emerging-market universe, is the influence
of U.S. monetary policy. Shifting expectations for U.S. policy moves have tended to fuel
volatility in global financial assets, with prices tending to move in the opposite direction of
economic news. Mexican markets have adjusted to changes in views on U.S. monetary
policy normalization mainly through the exchange rate. The Mexican peso has depreciated
more than other emerging-market currencies this year, with idiosyncratic factors partly
responsible for this trend.
Mexico's economic dynamism faces downside risks, particularly those coming from slowing
U.S. manufacturing production. Also, given a context of greater risk aversion, which could
become worse, Mexico needs to reinforce its fiscal stance. Monetary policy, for its part, will
continue to be implemented with flexibility and timeliness, keeping at bay dangers to
sustained convergence of inflation to the permanent target.