Javier Guzmán Calafell: The Mexican economy in an adverse external
environment - challenges and policy response
Remarks by Mr Javier Guzmán Calafell, Deputy Governor of the Bank of Mexico, at "Santander
Mexico Day", Mexico City, 11 January 2016.
* * *
The views expressed in this document are strictly personal.
I would like to start by thanking Banco Santander for the opportunity to share with such a
distinguished audience some views about the Mexican economy, the challenges deriving from
a harsh external environment, and the policy approach that has been implemented to cope
with these challenges.
More than seven years after the eruption of the worst financial crisis since the Great
Depression, the world economy continues to face a difficult situation. Global growth remains
below its long-term trend, affected by a low rate of expansion of advanced economies (AEs)
and a sharp deceleration in emerging market economies (EMEs). Although difficulties of a
cyclical nature are behind these developments, the persistence of this trend points to the
presence of structural causes as well. In this context, the volume of world trade has continued
to moderate and seems in fact to be declining at the margin,1 and as a result of a combination
of demand and supply forces, commodity prices are showing a generalized retrenchment. The
situation is further complicated by persistent nervousness in international financial markets and
the consequent volatility of capital flows.
Naturally, these difficult external conditions have affected the Mexican economy. I would stress
in particular three developments in this regard:
First, the US economy remains one of the best performers in the advanced world. During 2015,
GDP growth in this country is estimated at 2.5 percent, above calculations for potential growth.
This compares with a figure of only around 1.5 percent for the rest of AEs. Nonetheless, the
expansion of economic activity in the US has been unequal among sectors. In particular,
industrial output has remained stagnant since early last year as a result of the appreciation of
the dollar, lower output and investment in the oil sector following the decline in oil prices, and
weak global growth. Since there is a close association between the industrial sectors in Mexico
and the US, this has had an adverse impact on exports and economic activity in Mexico.
Second, the price of the Mexican oil mix has declined by 77 percent since mid-2014. This has
had important repercussions on the Mexican economy, particularly in view of the importance
of oil revenues in the fiscal accounts. And the impact has been worsened by a pronounced fall
in oil output. The latter, of around 33 percent since 2004, has also adversely affected industrial
production through direct and indirect channels. In addition, as export capacity has been
reduced, Mexico has become a net oil importer. To have an idea of the magnitude of the shock,
it is worthwhile to note that the oil trade balance switched from a surplus of 0.7 percent of GDP
in 2013 to a deficit of 0.8 percent of GDP in the period January-September 2015.
Third, uncertainty in international financial markets has also influenced economic
developments in Mexico. Concerns have related partly to the expected normalization of
monetary policy in the US. But financial markets in Mexico have also been affected by other
developments, such as nervousness about the situation in several EMEs, especially China,
the divergent monetary policy stances in the main advanced economies, and problems of a
geopolitical nature. In this context, net portfolio capital flows to Mexico fell from US$ 39 billion
in January-September 2014 to 20 billion in the same period of 2015.
The exchange rate has worked as the main adjustment mechanism to these shocks. Thus, the
nominal peso-dollar rate has shown a significant depreciation, of around 37 percent from early
September 2014 to January 8, 2016. It should be noted that depreciation of the Mexican peso
vis-à-vis the US dollar is consistent with movements observed in the currencies of some
commodity exporting AEs, such as Canada and Norway. Likewise, the evolution of the peso
compares favorably with the exchange rates of other EMEs in that period.2 It is also important
to stress that, as I will explain in more detail later on, the pass-through from the depreciation
of the peso to domestic prices has been modest.
Furthermore, adjustment of the Mexican peso has been orderly, as shown not only by the
volatility of foreign exchange options, well below the average for EMEs, but also by the
behavior of capital flows. In particular, notwithstanding the prevailing uncertainty, investments
by foreigners in long-term government securities denominated in pesos have shown resilience.
These are developments worth noting, particularly since the Mexican economy is one of the
most open to international capital movements among the emerging world. Indeed, the orderly
depreciation of the peso has been supported by a solid macroeconomic position, the
mechanisms that have been implemented to provide liquidity to the foreign exchange market,
the high level of international reserves, and the FCL agreement currently standing with the
IMF.
What have been the implications of these developments for economic growth and inflation in
Mexico?
Naturally, the difficult external environment has adversely affected economic growth. In the
face of weakness in industrial production in the US, and an even more complicated situation
in the rest of the world, manufacturing exports have remained flat over the course of 2015.
Consequently, the upturn in economic activity observed in 2015 is mostly explained by
domestic demand.3 On the one hand, the increase in employment, the recovery of real wages
made possible by low inflation, higher remittances in peso terms and the expansion of bank
credit have stimulated private consumption. At the same time, private investment, mainly in
machinery and equipment, has shown an upward trend. When seen from the supply side,
services has been the leading sector, as industrial production has been affected by the decline
in oil output and stagnation of this sector in the US.
It is reasonable to expect the continuation of a gradual strengthening of economic activity in
2016 and 2017. The anticipated revival of industrial output in the US, coupled with depreciation
of the peso, should reflect in the evolution of manufacturing exports. In addition, consumption
growth would be supported by a favorable behavior of its main determinants. By enhancing
confidence, the expansion of exports and consumption should provide additional stimulus to
private investment. The latter would also be underpinned by the ongoing efforts of structural
reform. On the other hand, it is important to note that downside risks for growth persist, and
that a negative output gap is expected to prevail until the end of 2017.
Expectations for economic growth in Mexico for 2015 and 2016 have been adjusted
downwards, but to a lesser extent than in other EMEs.4 On the other hand, even though current
GDP growth (around 2.5 percent at annual rate through the first three quarters of 2015)
remains insufficient, this has to be seen against the context of the adverse shocks that the
economy has faced, the anticipated pickup in coming years, and a Latin American region which
is estimated to have contracted in 2015 and foreseen to show very modest, if any, GDP growth
in 2016.
In the case of inflation, performance has been better than expected. Headline CPI inflation
registered eight consecutive months of historical minima in the period May-December 2015,
with a figure of 2.1 percent in December. This is explained by a low and stable core component,
and a downward trajectory of non-core inflation. In this context, short-term inflation
expectations have been adjusted downwards, while those for the medium and long term have
remained stable.
These favorable inflation results have been achieved despite the significant depreciation of the
peso. In fact, the impact of the exchange rate has concentrated on the prices of tradable goods,
without second round effects.
The latter is explained by a combination of factors. The most important among them is the
credibility of monetary policy and in general of the macroeconomic policy framework over the
course of many years. This has allowed a structural change in the process of price
determination in Mexico, which has yielded, among other results, a decline in the pass-through
from the exchange rate to inflation. In addition, the measures of structural reform carried out
by the government have led to declines in the prices of several key inputs, telecommunications
and electricity among them. This has combined with a negative output gap and a favorable
evolution of the prices of agricultural goods, which have also contributed to contain inflation.
Of course, upside risks to inflation must not be disregarded. The recent behavior of the
exchange rate in the context of strengthened recovery of economic activity might result in a
higher pass-through from the exchange rate to prices. In addition, given the natural uncertainty
that surrounds estimates of potential growth, the output gap might close faster than anticipated.
The relatively favorable evolution of the Mexican economy in the face of major shocks, has
been enabled by an adequate economic policy framework. This includes:
First, as I already noted, a credible monetary policy. In the context of the inflation targeting
framework, the implementation of monetary policy in Mexico has focused on achieving an
efficient convergence to the 3 percent target, i.e. at the lowest possible cost in terms of
economic activity. On the basis of this rationale, Banco de México responded to internal and
external developments by reducing its benchmark interest rate by 150 basis points from March
2013 to June 2014. Headline inflation fell from 4.3 percent in March 2013 to 2.1 percent at the
end of 2015. In other words, the monetary policy stance allowed to simultaneously reduce the
inflation rate and support economic activity.
On December 17, 2015, Banco de México's Board decided to increase the target for the
overnight interbank rate by 25 basis points to a level of 3.25 percent. The presence of record
low levels of inflation, stable medium- and long-term inflation expectations, and the anticipation
of a negative output gap during the period of influence of monetary policy supported an
unchanged monetary policy stance. However, with the increase in interest rates in the US,
such a strategy would have implied costs well above the potential benefits.
In particular, it carried the risk of disorderly capital outflows and an additional depreciation of
the peso. This would have endangered both the inflation target and financial stability. It is also
important to take into consideration that, notwithstanding the interest rate increase, monetary
conditions in Mexico remain very lax, due to the significant real exchange rate depreciation.
Thus, the impact of an increase in the reference rate on economic activity should be modest.
Looking ahead, monetary policy in Mexico will continue to be implemented in a highly uncertain
environment. To start with, while first adjustment of interest rates in the US has removed a
major source of concern for the world economy and normalization of monetary policy in that
country is expected to proceed gradually, it is also true that the implications of further increases
in the federal funds rate for international and domestic financial markets are unclear.
Furthermore, as I already mentioned and as underlined by the events of the last days, the
world economy is facing a particularly challenging situation.
Naturally, the evolution of inflation in Mexico will be responding to a combination of many
factors, both external and domestic, and a careful monitoring of them will be required. The
Board of Banco de México has made clear that close attention will continue to be paid to all
determinants of inflation and to medium- and long-term inflation expectations, with particular
focus on the relative monetary position between Mexico and the US, the pass-through of
movements in the exchange rate to prices, and the degree of slack in the economy. The Board
has also stressed that any additional measures required will be implemented, with due
flexibility and whenever this is needed, to consolidate the efficient convergence of inflation to
the target.
Second, a timely adjustment of fiscal policy. Oil revenues account for a high share of total
public revenues, thus implying a significant vulnerability to fluctuations in oil prices.5 In view of
this risk, the government has decided to hedge oil prices yearly since 2005. This allowed to
ensure an oil price for the Mexican mix for public finance purposes of 76 dollars per barrel
(dpb) in 2015 (against the observed average of 47 dpb) and of 49 dpb for 2016 (24 dpb at
present). In addition, a number of measures on the revenue and expenditure sides have been
implemented to guarantee the sustainability of the fiscal accounts. On these bases, the
government remains committed to reduce the PSBR (public sector borrowing requirements)
from 4.1 percent of GDP in 2015 to 3.5 percent in 2016, and further to 2.5 percent in 2018.
This will also allow a downward path for public debt as a share of GDP.
Third, a sound financial system. Mexico was one of the first EMEs to meet the Basel
capitalization requirements, and as of November 2015 the schedule for compliance with Basel
liquidity standards was met by the required banks, with nearly all others having met this
regulation in advance. In addition, the levels of corporate and household indebtedness are
moderate, and as a share of GDP well below the figures observed in other EMEs and in AEs.6
Furthermore, risks from corporate foreign-currency liabilities are alleviated by long amortization
periods, fixed interest rates, natural hedging and the prudent use of derivatives. It is also
important to note that a comprehensive framework has been set in place for monitoring
financial stability risks. On the other hand, risks must be carefully assessed, particularly in view
of the difficult external environment. For these reasons, it will be essential to persevere in the
strengthening of the macroeconomic framework and in the implementation of any regulatory
measures required to cope with those risks.
Fourth, a major effort of structural reform. The potential rate of GDP growth in Mexico during
the last decades has been insufficient to meet the population's needs. The measures of
structural reform adopted since late 2012, considered by the OECD as the most ambitious
among the organisation's membership,7 have been focused on overcoming this problem, by
increasing both private investment and productivity. It is worth to highlight the broad-ranging
scope of such efforts, as they comprise not only several key sectors of the economy, but also
measures aimed at improving the institutional framework. Even though the full impact of these
structural changes on potential GDP will take time to materialize, some effects are readily
visible in a number of areas. These include, among others, a more flexible labor market;
increased competition in several sectors of the economy; a fall in the prices of some widely
used key inputs; higher private investment in areas such as telecommunications, gas and
electricity generation; widespread participation of private firms in oil field auctions; and a more
important role of the financial system, through both private and public intermediaries, in
supporting economic growth.
Two additional implications of the policies implemented are worth noting. According to the
World Bank, the business climate in Mexico has improved significantly in recent years, to levels
close to best performers in the emerging world.8 Also, Mexico's creditworthiness, as measured
by credit ratings assigned to government securities, has continued to ameliorate over the last
couple of years, to levels above most EMEs, while still maintaining a positive outlook amidst a
difficult external environment.
To conclude, I would like to emphasize that, notwithstanding major economic shocks, the
Mexican economy has shown a relatively good performance, and it is reasonable to expect a
gradual strengthening of economic activity in the next couple of years. In fact, Banco de
Mexico's forecasts currently place real output growth at 2.5-3.5% in 2016, and at 3.0-4.0% in
2017. In addition, following an ambitious program of structural reform, Mexico is one of the few
EMEs where an increase in potential GDP is expected. Meanwhile, CPI inflation is projected
to rise moderately from the current minima to levels around the 3 percent target throughout
both 2016 and 2017. It should also be noted that with the recent increase in the federal funds
rate signaling confidence of US authorities in the economic outlook, Mexico is likely to benefit
in coming years from close links to that economy.
However, external conditions for Mexico will probably remain very difficult. Not only is the world
economy moving across a particularly complicated juncture, but major structural challenges
need to be overcome.
Therefore, it will be essential to continue to implement a prudent and flexible monetary policy;
adhere strictly to the announced strengthening of public finances; pursue the overall stability
of the financial system, while promptly addressing emerging risks; and maintain the structural
reform momentum, by ensuring that the policies underway are timely and efficiently
implemented, as well as by adopting any additional measures required to achieve a rate of
potential growth in accordance with the country's needs.