Manuel Sánchez: Mexico in an unfriendly world economy
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the 2016
Mexico Opportunities Conference "Harvesting Growth", organized by J.P. Morgan, Mexico
City, 21 June 2016.
* * *
It is a pleasure to be here with you this morning. I would like to thank J.P. Morgan for the
invitation to participate in this annual conference devoted to opportunities for attaining higher
economic growth in Mexico.
In my talk, I would like to focus on the challenges and prospects for the Mexican economy in
the current difficult international environment. To this end, I will touch first on Mexico's
economic developments and outlook; then, I will briefly analyze the impact of widespread
uncertainty on the country's financial markets; and finally, I will make some comments on
inflation and monetary policy.
Before I begin, I should note that my remarks are entirely my own and do not necessarily
reflect the positions of the Bank of Mexico or its Governing Board.
Economic developments and outlook
A natural starting point for my comments is found in international economic conditions, which
during the last couple of years can be characterized as less favorable for emerging markets.
In particular, advanced nations continue to witness a slow recovery amid decelerating growth
in emerging economies and stagnant global trade. Added to this condition are doubts and
concerns over monetary policy stances and expected monetary divergence among
developed countries.
Worries over the health of the Chinese economy, in turn, persist amid uncertainty growing on
geopolitical issues, with Brexit currently the number-one fear. In addition, commodity prices
are expected to remain low for some time. Finally, this environment has fueled heightened
risk aversion, which has hit emerging economies especially hard.
In this complicated world, the Mexican economy has maintained relatively stable and
moderate growth since 2014, reaching 2.8 percent in the first quarter of 2016 on a
year-onyear basis. The main driver has been an expanding services sector, as industrial production
had decelerated somewhat, although picking up recently.
Three factors behind softer industrial growth are clear. First and foremost, oil extraction has
seen a longstanding decline. Construction activity, for its part, has slowed and is somewhat
erratic, apparently still affected by the restructuring process to which this sector has been
subject in the last few years. To round out the list, manufacturing production, which holds a
tight relationship with industry and manufacturing in the United States, has been less
dynamic.
Given significant vertical integration between the two countries, slower U.S. industrial activity,
reflecting the downsizing of the oil sector amid low prices, has capped the expansion of
Mexican manufacturing. As a result, manufacturing exports have lost steam, with declining
rates of annual growth falling into negative territory in recent quarters.
This deceleration has taken place in spite of significant real peso depreciation, which has
occurred along with that of other emerging-market currencies. This fact highlights the
dominant negative effect stemming from a decline in external demand, notably from the
United States, Mexico's main trading partner, but also from other nations as well.1
In short, the main engine of recent Mexican economic expansion has been domestic
spending, largely by the private sector, including both consumption and investment. Yet it is
worth noting that, although representing a smaller weight in total aggregate demand,
government consumption was expanding, thereby supporting spending as well. In the 2016
first quarter, however, this trend changed. Additionally, public investment, an even smaller
contributor to aggregate demand, continues to contract.
As with the global economy and most world regions, Mexico's economic outlook has been
subject to downward revisions, with a modest recovery projected for this and the following
year. Even in this lackluster scenario, Mexico distinguishes itself, with expected expansion
higher than the average pace foreseen for Latin America.2
This does not mean we should be satisfied with only middling growth. As an emerging
economy, Mexico should eventually enjoy much higher rates of economic expansion,
breaking out of its previous long-term, not excessively encouraging, record.
To be sure, in the short term, real challenges prevail. Specifically, Mexico's scenario of
modest improvement faces risks, among which the downside forces seem more numerous.
Let me mention three.
In the first place, U.S. imports and industrial output may slow further, potentially not only
inhibiting the country's manufacturing production, but also generating spillover effects on the
services sector and private investment. Second, producer and consumer sentiment could
deteriorate due to less favorable international financial events. Finally, a
larger-thananticipated fall in Mexican oil extraction could occur. On the upside, however, recent
structural reforms could start to yield greater-than-expected benefits.3
Financial markets
International financial markets have been affected by uncertainty on the implications of the
extraordinary lax monetary stances undertaken in advanced nations and the normalization
process in the United States. As central banks in these regions are navigating unchartered
waters, the consequences are impossible to predict.
Meanwhile, portfolios have been adjusted away from emerging markets, with lower capital
inflows and even outflows in some cases. Asset prices, at the same time, including those of
emerging market bonds and currencies, have seen downward pressure.4
Also, spikes in financial volatility have hit amid geopolitical jitters, including fears over Brexit.
These developments reflect tensions and headwinds against emerging markets, testing the
strength of their fundamentals.
In Mexico, the unprecedented shrinkage of the oil balance has resulted in a larger current
account deficit. This gap still remains, however, only slightly below 3 percent of GDP.
The enlargement of the current account deficit has caught the attention of many observers,
perhaps not so much because of the sheer magnitude of the total balance, but likely because
of the underlying trends, which may eventually trigger external financing restrictions. This
type of concern should not be neglected, and must be properly assessed.
One fact is precisely the weakening of the oil trade balance, reflecting lower extraction and a
significant deterioration of the oil terms of trade. A second is that the other component, the
nonoil balance, has been improving, partly aided by real exchange rate depreciation.
Nevertheless, this performance has not been sufficient to completely offset trends in the oil
balance. In a word, recent less favorable balance-of-payments developments reflect
Mexico's oil situation.
To preclude the continuation of these tendencies and support financial stability, an
adjustment in public-sector spending, already underway, is obviously called for. The
necessity is clearly confirmed by rising Pemex credit risk perception, where higher CDS
spreads beginning in mid-2014 and coinciding with lower oil prices should not be surprising,
with slightly less pressure since last February.
An important consequence is the contamination that Pemex credit risk perception has
exerted on Mexico's sovereign debt. Inaction from the state oil company is definitely not
acceptable, if for nothing else, because of the danger of further contagion on country risk
perception.
Additionally, the share of nonresident holdings of peso-denominated government securities
in the total outstanding has decreased, with a change of composition away from short-term
zero coupon instruments (cetes) and in favor of long-term bonds. These portfolio changes
could be interpreted as a natural investor reaction to less optimistic views on emerging
markets. Hence, so far, those seeking the exit have been mainly holders of short-term
securities, while holdings of long-term bonds have risen in absolute terms during the year. In
any case, developments of foreign funds in Mexico must continue to be monitored.
As in other emerging-market economies, heightened risk aversion since the taper tantrum
has widened interest-rate spreads. It is worth noting that current spreads are not
unprecedented, as they are similar to those observed at the beginning of 2012, when fears
surrounding the sustainability of the euro area also fed risk aversion.
As in other countries, a flexible exchange rate has performed the crucial role of buffering
markets in an adverse financial environment. The Mexican peso has depreciated significantly
since mid-2014, hurt more than other emerging-market currencies in the present year.
These difficult developments underscore the importance of ongoing fiscal strengthening, a
necessary and welcome development to face external headwinds. Adjustment already
includes at least four measures, starting with financial and business restructuring being
implemented in Pemex. Additionally, cuts to 2016 budgeted public expenditures are in
process, with an initiative sent to Congress for a positive primary balance in 2017. Finally, in
the aim of keeping the public finances sustainable, a commitment is in place for the
stabilization and decline of the total balance of public-sector borrowing requirements over
GDP in the medium term.5
Inflation and monetary policy
Annual inflation has continued to be benign at unprecedented low levels. Specifically, for
13 months in a row, inflation has remained below the permanent 3 percent target. This is
quite an achievement, as convergence to this objective assumes inflation to fluctuate
sufficiently close to 3 percent, sometimes above and sometimes below. Before 2015, inflation
persistently ran around an average above 4 percent.
Lower inflation has resulted from both relatively contained core price increases and declining
noncore inflation. A surge in core merchandise inflation reflects a modest effect from peso
depreciation on tradable goods prices.
At the same time, the core services component has remained subdued, benefiting from
persistently falling telecom tariffs resulting from competition enhanced by reforms in that
sector. It may also suggest the absence of significant overall aggregate demand pressures to
date. Falling noncore inflation reflects reduced agricultural price increases, as well as
contractions in the index for energy and government-determined prices.
Short- and medium-term inflation expectations, as reflected in analysts' surveys, are
gradually moving towards the 3 percent permanent target, while those extracted from market
instruments seem to have converged to the target, a significant advance in light of a history
of high inflation.6
Some threats to the consolidation of inflation convergence to the target prevail. Upward risks
are particularly substantial in view of the relatively short time inflation has remained anchored
on the target. The biggest menace may come from further peso weakness, which could
result in greater pass-through and misalignment of inflation expectations.
Another risk could emerge in aggregate demand pressure, as total absorption has increased.
Agricultural price rises may also pick up, reverting to the medium-term average, carrying
second-round price effects.
Thus, monetary policy must avoid complacency, remaining on watch to consolidate inflation
convergence. Results, although recently positive, include no guarantee for the future. In
addition, exchange rate considerations have to be viewed from the perspective of the Bank
of Mexico's price stability mandate.
For time-consistency considerations, the relative monetary stance vis-à-vis the United States
should continue to be a factor. However, challenges to price stability may surface whatever
the U.S. Federal Reserve does. Hence, monetary policy actions can be independent of the
Fed. In any case, the Bank of Mexico will continue to act in a timely and decisive way to
consolidate price stability.
Conclusions
Let me conclude by saying that Mexico's economic fundamentals are being tested. Structural
reforms, an improved rule of law, and better security could produce more rapid growth in the
medium to long term. With the financial state of Pemex weak and posing contamination risks
to the Mexican sovereign, meanwhile, adjustment of the fiscal stance is a welcome
development.
Fortifying economic fundamentals is an ongoing challenge for policy makers. As recent good
inflation performance is not guaranteed, complacency cannot be allowed to seep into
monetary policy. Pursuit of permanent convergence to the target must continue.