The Mexican economy: A call for stronger fundamentals

Remarks by

Manuel Sanchez

Deputy Governor

The Bank of Mexico

at the

OMFIF Meeting

London, U.K.

October 21, 2016

I would like to thank the Official Monetary and Financial Forum for the invitation to
talk to you today. I am honored by the privilege of participating in this excellent

platform for worldwide public-private-sector interaction in finance and economics.

On this occasion, I will exchange my views with you on Mexico's economy in the face
of a challenging international environment. I will first consider economic
developments and prospects in the country, where external demand, and
particularly its effects on the manufacturing sector, are key. I will then analyze the
impact of global risk factors on financial markets and why it is important to fortify
macroeconomic fundamentals in a context of worldwide uncertainty. Finally, I will

look at monetary policy and inflation.

As usual, my views are entirely my own and do not necessarily reflect those of the

Bank of Mexico or its Governing Board.

Softer economic growth

During the last few years, the world economy has decelerated, with year-on-year

growth declining to rates below long-term averages. Since last year, moderation has

+ For a graphic presentation accompanying these remarks, see Sanchez, M. (2016). "The Mexican

economy: A call for stronger fundamentals," presentation at the OMFIF Meeting, October.
http://www.banxico.org.mx/publicaciones-y-discursos/discursos-y-presentaciones/presentaciones/%7BA1D7C9D7-F64D-
71FB-AD64-67CE393BD1EA%7D.pdf


come mainly from sluggishness in advanced countries, while emerging economies

have improved somewhat.

For Mexico, conditions in the United States, its main trading partner, are the most
important external determinant. U.S. GDP annual growth has been falling since
2015, reaching only 1.3 percent in the second quarter of 2016. What is worrisome
for Mexico is that this slowdown has coincided with contracting trends in industrial

and manufacturing production.

Nowhere is Mexico's economic integration with the United States more evident than
in the high correlation between both countries' industrial and manufacturing
outputs. Furthermore, causation runs from the larger country to the smaller one.

Inevitably, U.S. manufacturing fragility translates into a slower sector in Mexico.

A significant driver of weakness in U.S. manufacturing can be found in foreign trade,
in the context of a global tendency in recent years of smaller international flows of
goods, extending to the United States. In particular, both U.S. manufacturing imports
and exports have been shrinking, and statistical evidence suggests that reduced

foreign trade is sapping vigor from the manufacturing sector in that nation."

A warning sign comes from forward-looking indicators for U.S. manufacturing, such

as those estimated as diffusion indexes based on surveys. The manufacturing PMI,

? See Banco de México (2016). Informe Trimestral Abril-Junio 2016, August, Box 2, pp. 30-33.

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calculated by the Institute of Supply Management, recently touched contraction

territory and since then has stayed close to it.

Against this backdrop, Mexico's annual GDP growth has been relatively stable
during the last three years at around its long-term average of 2.3 percent, with a dip
in the second quarter of 2016. This development has resulted from two opposing

forces: expansion in services and a weaker industrial sector.

Weakness in industrial production reflects both domestic and external restrictions.
On the one hand, mining has been dropping significantly, mainly due to a
longstanding decline in oil extraction. This, in turn, reflects near depletion of the
most profitable oil fields, as well as insufficient investment by the state-run oil

company, Pemex, and poor results from exploration projects.

On the other hand, slower manufacturing is linked to softening U.S. production, as
suggested earlier. Mirroring developments in the United States, Mexican
manufacturing exports, especially those directed to that country, are subdued at

negative growth rates, largely explaining trends in manufacturing output.

This has occurred in spite of substantial real peso depreciation vis-a-vis the U.S.
dollar. Although peso competitiveness has allowed Mexican exports to gain some
market share in the United States, this price effect has been more than offset by a

negative effect associated with lower external demand for Mexico's goods.

In contrast, services are still relatively robust, constituting the most significant
engine of recent economic growth. However, expansion in the services sector has
stalled lately, partly reflecting spillover from contracting foreign trade. For example,
slower trends are present in both commerce and trucking, which are tightly linked

to external trade.

On the demand side, private consumption has continued to increase at relatively
high rates, while total investment has been falling, particularly that related to public
works. Investment expenditure cuts have been the main avenue for fiscal

adjustment in the face of lower international oil prices.

Confidence indicators imply that economic activity may continue to wane. In
particular, declining producer confidence may signal further potential weakening in

investment in the short term.

Analysts' consensus forecasts are for moderate economic improvement in 2017 for
the world and U.S. economies, and to a lesser extent for Mexico, where growth is
foreseen rising from an estimated 2.1 percent this year to 2.2 percent in the next. It
is worth noting that the outlook for Mexico's growth next year is for a return of

growth to approximately the aforementioned long-term average, obviously

insufficient to meet the requirement of significantly improving general living

standards.3

This necessity and the recognition that the main long-term growth problem in
Mexico is stagnant productivity led the country to undertake an ample set of
structural reforms, now being put into place. Their benefits depend crucially on the

quality of implementation, and will fully be felt only in the medium term.

In addition, Mexico's growth scenario faces downside risks. In the short term, there
is the potential for a greater slowdown in the global and U.S. economies, particularly
manufacturing, as well as a larger-than-expected fall in crude oil output, and further

deterioration in consumer and producer confidence.

In the medium term, global-wide protectionist tendencies are on the rise. Finally,
again on the domestic front, obstacles to adequate implementation of structural

reforms could arise.

Heightened risk aversion

Since 2014, rising risk aversion has hit emerging markets especially hard in terms

of lower capital flows and asset prices. Sources of concern have included economic

3 Analysts' estimates for global and U.S. GDP are, respectively, 2.5 and 1.5 percent in 2016, and 2.8 and
2.2 percent in 2017. See Consensus Forecasts and Latin American Consensus Forecasts, October 2016.

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and political issues, such as Chinese economic health and policy actions there, and

Brexit.

However, a persistent factor during the last few years has been uncertainty over the
degree of monetary accommodation in advanced countries, particularly the United
States. Central banks have become more proactive, and their communication and

actions have sometimes generated undue volatility.

More importantly, increasingly loose, sustained, and far-reaching monetary stances
in developed countries confront at least two challenges. One is maintaining
credibility in light of perceived low and decreasing policy effectiveness. Not only has
expansionary monetary policy faced difficulties attaining the intended objectives,
including support for growth, but lately, such as in Japan and the euro zone, even
their financial effects, in terms of exchange rates and other asset price movements,

seem to be the opposite of those expected.

The other challenge is to deal with the consequences of asset price distortions as a
result of monetary accommodation and consequent financial stability risks. For this
and other reasons, future amplification of uncertainty and volatility cannot be ruled

out.

To date, heightened risk aversion has not greatly affected Mexico's key financial

quantities, such as non-resident holdings of peso-denominated government

securities. These foreign portfolio investments are among the highest in emerging
markets, a fact which could be interpreted as a sign both of strength and possible
vulnerability, for instance, if a sudden change occurs in market sentiment towards

emerging markets or Mexico.

These holdings have been relatively stable in absolute terms during the last few
years, largely reflecting lower short-term asset positions, namely zero coupon Cetes,
while those of long-term M bonds have increased persistently. This behavior may
suggest that investors' positive long view on Mexico remains firm. Caution is

appropriate, however, as international conditions can always change.

The adverse international environment has exerted a clear effect on Mexico's asset
prices. In particular, market interest rates, especially those of medium duration,
have been rising, along with risk perception. Consistently, spreads against the
United States have been widening, as interest rates in that country have either fallen

or stayed flat.

More notably, the value of the dollar in peso terms has been trending upward
sharply, along with its value in terms of a basket of emerging-market currencies.
However, so far in 2016, the Mexican peso has decoupled from other currencies,

with a further substantial weakening, while the others, on average, have

appreciated. The obvious question is why the Mexican peso has been hurt more

severely.*

Several factors could be behind peso underperformance, in particular, three
possibly interrelated causes. One is rather mechanical and refers to the fact that the
Mexican peso is a highly liquid currency in international markets. This characteristic
leads investors to see the peso as an attractive vehicle for hedging against an ample

set of risks.

A second, deeper reason may stem from concerns over the results of the imminent
U.S. presidential election and its possible impact on its southern neighbor. A third
probable factor may be perception of Mexico's fiscal fragility, including weak

financial conditions at state-owned oil company Pemex.

Two notable statistics on public finances put analysts and market participants on
alert. One is the rising trend observed since 2009 in the historic balance of public-
sector borrowing requirements relative to GDP. Although this ratio continues to be
inferior to frequent values encountered in the developed world, it does not compare

favorably with those of many emerging economies. A second statistic has to do with

4 See the JP Morgan Index of emerging-market currencies, which includes Brazil, Chile, Mexico, Hungary,
South Africa, Turkey, Russia, China, India and Singapore.

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Mexico's sovereign risk premium, which has risen above those of other countries

with equivalent credit ratings.>

In this scenario, Mexico needs to buttress its fiscal stance without delay. Deep
adjustments to public finances are necessary given at least three significant
restrictions: reduced oil prices and production, limits to ongoing investment
expenditure cuts, and inertia in long-standing growth in current public

expenditures.

Markets should be convinced that authorities will do what it takes to stabilize the
ratio of public debt to GDP. These actions cannot be postponed for public finances

to become sustainable.

Monetary policy challenges

Since last year, inflation has remained benign, for several months below the 3
percent target established by the Bank of Mexico since 2003. Obtaining inflation this
low and close to the target is an unprecedented achievement which took a long time

and must be preserved.

5 The debt-to-GDP ratio rose from 36.2 percent in 2009 to an estimated 50.5 percent in 2016. See SHCP
(2016). Criterios Generales de Politica Econémica 2017. For sovereign risk premium developments, see,
for instance, the 5-year Credit Default Swaps for countries with a BBB+ rating from Standard & Poor's,
which are Mexico, Poland, Spain, Peru, and Thailand.

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One important consideration is that recent contained inflation has been supported
by unusually low noncore price increases. This phenomenon may prove to be

transitory.

Core inflation, on the other hand, has been rising in 2016, basically pulled by the
impact of peso depreciation on tradable goods prices, as illustrated by the behavior
of merchandise inflation, which lately reached almost 4 percent. It is worth noting,

however, that this pass-through from peso depreciation has been relatively mild.

Recently, break-even inflation breached the 3 percent target, which may indicate
possible future price pressures. Additionally, inflation expectations based on
analysts' surveys have stopped falling, thus possibly suggesting that further

reductions of inflation are not in sight.®

Upside risks to inflation would appear to have the upper hand. The main negative
possibility seems to come from widespread contagion of exchange-rate
depreciation to inflation and expectations. A second risk stems from the reversion
of noncore inflation to historical averages. Third, an upsurge of aggregate demand
pressures could occur, in particular considering uncertainty over the degree of

slackness in the economy.

© See Banco de México, Encuesta sobre las Expectativas de los Especialistas en Economia del Sector Privado.

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These dangers could cause the price formation process to unravel, with lasting
consequences. Prudence is all the more important given the time and effort it took

for inflation to reach the target.

Since December 2015, the policy interest rate has been raised four times for a total
of 175 basis points, to 4.75 percent, a level just above that in the second half of 2009,

in the wake of the global financial crisis.

These moves should be interpreted as preemptive, in full view of the fact that
monetary policy exerts its full effects with lags. One central objective has been to
avert deviation of inflation expectations from the target due to pass-through. The
Bank of Mexico does not target any exchange-rate level. However, exchange-rate
developments are taken into account to the extent that they may influence inflation

and expectations.

In a more general sense, the hikes have sought to contribute to stronger
macroeconomic fundamentals in the face of an adverse international environment.
Other factors considered include the relative monetary stance vis-a-vis that of the
United States, as well as the phase of the economic cycle. Going forward, monetary

policy will remain vigilant.

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Conclusions

A disadvantageous international environment has hobbled Mexican economic
performance, and bouts of amplified risk aversion could easily recur. This makes the
urgency with which Mexico needs to buttress its macroeconomic fundamentals,

including its fiscal stance, overwhelmingly clear.

On the monetary front, pre-emptive policy action has been required. Especially
given the time it has taken to reach the 3 percent permanent inflation target, policy
will be on the alert to avert any problems that would prevent consolidation of

convergence of inflation to this target.

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