Manuel Sánchez: Mexico's economic outlook and challenges
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the Conference
"Regulatory reform, the global economic outlook, and the implications for Mexico's financial
sector", organized by the Institute of International Finance and Banorte, Mexico City,
20 February 2013.
* * *
It is a privilege to speak at the close of this conference devoted to the implications for Mexico
of recent regulatory reforms and the global economic outlook. I would like to thank the
organizers of this seminar, the Institute of International Finance and Banorte, for the
opportunity to share some thoughts with you on Mexico's economic conditions and
prospects.
I would like first to review the recent developments in the Mexican economy and its outlook in
today's weak world economic environment. Then, I will analyze the implications of currently
benign financial conditions. And finally, I will discuss some of the present challenges for
monetary policy in Mexico. As usual, my remarks are entirely my own responsibility and do
not necessarily reflect the views of the Bank of Mexico or its Governing Board.
The Mexican economy in a weak global environment
The performance of the Mexican economy last year continued to be constrained by a weak
global environment. The world economy expanded at a slower pace than the average
observed in the two decades before the big financial crisis. In the United States, GDP grew
moderately, and for a fifth consecutive year, output remained below its secular trend. Signs
of improvement in several variables in the United States are encouraging, including those
suggesting the beginning of a turnaround in the housing market and the gradual recovery of
bank lending to the private sector. However, the level and characteristics of unemployment
as well as the sluggishness of private investment remain sources of concern.
Additionally, U.S. industrial production, which exerts substantial influence on Mexico's
production and trade, has lately exhibited a deceleration. The rebound in U.S. output after
the crisis has been disappointing, especially in light of significant stimulus provided through
previous fiscal packages and the ongoing extraordinarily expansionary stance of monetary
policy. Subpar economic performance may be partly explained by uncertainty regarding the
speed and distribution of costs in the pursuit of fiscal consolidation. Recent fiscal accords
may have reduced the risk of a GDP contraction.
On the other hand, during 2012, the euro area fell into recession with unemployment rates at
record highs. To a large extent, the problems in the region stem from institutional limitations
of the design of the monetary union that have complicated dealing with the aftermath of
national financial crises. Progress in revamping the EMU architecture, bailout programs for
troubled economies and, especially, decisive measures undertaken by the ECB have
lowered perceived risk for sovereign and bank debt, especially in the peripheral countries.
Although further meaningful structural measures will be required to attain a full economic
recovery, the financial stabilization achieved may suggest that the worst of the crisis is over
in the euro area.
Consistently, the most recent consensus estimates for 2013 and 2014 posit a gradual
recovery for the world economy, moderate deceleration followed by higher growth in the
United States, and a slight contraction and later an expansion in the Eurozone.1
In spite of this challenging environment, last year Mexican economic activity continued to
exhibit a positive trend, with a firmer expansion in services than in industry. In the fourth
quarter, annual growth was the same as in the previous quarter, although both figures were
not as high as in the first half of the year. Annual GDP growth for the full year was
3.9 percent, virtually the same as in 2011; this growth is noteworthy, especially in the present
world context, as it is almost one percentage point higher than Mexico's average growth rate
during the twenty years prior to the crisis.
On the back of this progress, external demand, as reflected prominently in manufacturing
exports, has shown some moderation in growth in the past several months, with a recovery
in the most recent quarter. By far, the main source of deceleration came from countries other
than the United States, and in particular in automotive exports. This slowdown is partly
explained by restrictions imposed by Brazil and Argentina on auto imports from Mexico.
At the same time, domestic demand continued expanding. Private consumption, the largest
component of domestic spending, maintained its momentum, as indicated by available data
on retail sales up to November. The strength of consumption has been supported by a
sustained increase in formal employment, a moderate decline in unemployment, and a
significant expansion in consumer lending.
Gross fixed investment kept rising, with machinery and equipment showing higher growth
rates than construction. Additionally, measures of business confidence up to January 2013,
such as the Manufacturing Orders Indicator (IPM), reveal that business managers foresee
that the economy will maintain its expansion.
Given the expected slowdown in the U.S. economy largely due to fiscal consolidation,
analysts predict that Mexico's economic growth in 2013 will be slightly lower than that of the
previous year, with a recovery occurring in 2014.2 There are both downside as well as upside
risks to this scenario. A fiscal adjustment in the United States applied in a disorderly way or
lacking credibility, or a complication in policy implementation in the Eurozone that augments
financial uncertainty, stand out as possible negative external factors. However, the recovery
in the United States may be faster than forecast, and investor confidence in Mexico could
increase as a result of progress on structural reforms favoring long-term growth.
Capital inflows and benign financial conditions
During the last four years, the yield curve in Mexico has successively shifted downward, a
process that has continued so far this year, leaving current interest rates for all terms close to
or at their all-time lows. Aside from variations due to changes in risk aversion, the main
driving force for these shifts has been almost synchronic shifts in the U.S. yield curve,
resulting from the different stages of monetary easing there.
The main transmission mechanism for lower interest rates has come from persistent capital
inflows. As in other emerging economies, Mexico has received substantial capital flows from
foreign investors seeking higher yields in both equity and bond markets. Also, foreign
investors may feel more confident about the Mexican economy because of its sound
macroeconomic and financial fundamentals, the openness of its capital account, the flexibility
and depth of its foreign exchange market, and higher expectations for structural reforms,
among other factors.
As a result, from 2009 to 2012, the proportion of non-equity financial assets held by
foreigners relative to the broadest monetary aggregate, M4, increased from five to seventeen
percent. There are indications that inflows have speeded up during the current year in many
emerging economies, including Mexico.
The abundance of foreign savings was supportive of Mexico's recent economic growth.
However, the possibility of a change in the perceived conditions that gave rise to the inflows
makes it likely for those flows to stop and even revert. Such reversals have occurred on
innumerable occasions in many countries, including Mexico, for reasons not necessarily
related to the recipient country, causing substantial financial disturbances. The obvious case
at present could be the expectation that the Federal Reserve will start unwinding its
expansionary monetary policy.
Before such an eventuality occurs, for whatever reason, and about which only the timing and
magnitude are uncertain, it is absolutely necessary for savers and borrowers as well as
financial intermediaries to take into account that interest rates will eventually rise. The real
danger is to believe that this time will be different and that somehow present favorable
conditions will last forever. Such myopic behavior has often led to excessive risk-taking,
overleveraging and the formation of bubbles in credit and real estate markets, frequently the
prelude to financial crises and painful massive redistributions of wealth.3
Fortunately, Mexico's banks have been operating cautiously, thereby maintaining strong
balance sheets and healthy loan portfolios. Also, no lending bubble is apparent. However,
authorities will have to continue monitoring threats to stability in any part of the financial
system, in order to act in a timely way if they emerge.
The challenges to monetary policy
In 2012 annual inflation exhibited a rising trend to a maximum of 4.8 percent in September.
During seven months it surpassed the upper limit of the variability interval of plus or minus
one percentage point around the permanent target of 3 percent established by the Bank of
Mexico. Factors exerting pressure on inflation included the international draught and the
domestic bird flu epidemic that resulted in significant agricultural price increases, and some
pass-through from peso depreciation to merchandise prices.
In December 2012 and January 2013, inflation fell to below 4 percent, a welcome
development in light of the previous considerable deviation from the target. Nevertheless, the
recent decline in inflation should be seen with caution. This is because, first, it is based only
on two observations, which cannot yet be proven to be the beginning of a new trend.
Second, the drop in inflation depended significantly on sharp declines in telecom prices and
moderating agricultural price increases. If one were to exclude the effect of telecom prices on
inflation in December and January, inflation would have been above and practically on the
upper limit of the variability interval, respectively. Also, as occurs with negative disturbances,
positive shocks like the recent ones sooner or later die out and could be followed in their own
turn by adverse shocks.
Third, the proportion of the components of the National Consumer Price Index (INPC) basket
with annual increments higher than 4 percent is still substantial. Fourth, the two most recent
inflation prints exceed the target and do not even correspond to the lowest inflation rates
observed in Mexico during recent years.
These caveats are all the more important as the target has not been achieved in the past, in
the sense that inflation has not been fluctuating around 3 percent. In fact, since the end of
2003 when this objective became effective, inflation has varied around a mean of
4.3 percent. Moreover, during the nine years after the establishment of the target, inflation
has not exhibited any clear path of convergence towards it. This lack of convergence may
partially explain why inflation expectations for the short and medium terms, as reflected in
analysts' surveys, have long remained stubbornly above the target.4
These considerations call for vigilance in monetary policy. The target is the principal guide
and has not been attained. Furthermore, negative shocks could easily complicate
convergence. Risks include the following: weather and animal health problems could fuel
agricultural price rises; new episodes of heightened risk aversion could trigger currency
depreciation with some effects on inflation; public-sector prices could be higher than
anticipated; and finally, some aggregate demand pressures may arise in light of conventional
measures suggesting that slack in the economy has disappeared.
Concluding remarks
In spite of a weak global environment, Mexico's GDP kept growing at rates surpassing
historical records. Analysts' outlook for the Mexican economy posits a slight deceleration in
2013 and a recovery the following year. There are both downside and upside risks to this
scenario, including on the positive side, further progress on structural reforms.
Substantial capital inflows resulting in unusually favorable financial conditions in Mexico have
been supportive of economic activity. However, economic agents should remain prudent as
these flows, for many reasons, could stop and even revert. Finally, the short period of recent
improvement in inflation, the extraordinary factors that explain it, and the absence of
convergence toward the inflation target, require a vigilant monetary policy. Convergence of
inflation to the permanent target demands more than a few months of good results.