Manuel Sánchez: Mexico - economic integration, challenges and outlook
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the United
States-Mexico Chamber of Commerce, California Regional Chapter, Los Angeles, 5 August
2016.
* * *
It is certainly a pleasure to be back in Los Angeles to share my views with you on Mexico's
economic prospects. I would like to thank the California Regional Chapter of the United
States-Mexico Chamber of Commerce for the kind invitation.
I will organize my presentation in three parts. First, I will briefly discuss Mexico's growing and
very dynamic partnership with the United States. I will follow with a focus on growth and
financial developments for the Mexican economy, in conjunction with these close ties. And
finally, I will make some comments on inflation and monetary policy in Mexico.
As usual, my remarks are entirely my own and do not necessarily reflect the position of the
Bank of Mexico or its Governing Board.
Economic integration with the U.S.
A natural starting point for this discussion is the tight relationship between our two countries.
Mexico is increasingly linked to the United States, through high levels of bilateral exports and
imports, significant FDI and technology transfers, and substantial remittances, among other
channels. These bonds have yielded dividends on both sides of the border, including
business and job creation, wider and more advantageous consumer choices, and higher
living standards.1
California, home of a long border and migration history with Mexico, is one of the country's
most important trade and cultural partners. Merchandise trade has expanded continuously
through recent years. Mexico and California, the world's sixth largest economy, both gain
greatly from these mutually beneficial exchanges.
One of the most profound and longstanding links between Mexico and the United States
comes through tightly integrated industrial operations. This is more than clear in the high
correlation between U.S. industrial and Mexican manufacturing data over time.
Recently, structural reforms undertaken by Mexico have opened up even more opportunities
for the two countries. The overall reform agenda is extremely ambitious, encompassing
broader and greater access to telecom services via more competition, an unprecedented
opening of the energy sector to private investment, and changes to rules governing the labor
market. However, its ultimate effectiveness obviously depends on the quality and depth of
implementation over the coming years.2
In any case, some of the reforms are indeed in their first phase of implementation, and they
have likely only begun to produce results. Furthermore, the advantages they bring could very
well be enhanced down the road through a more effective rule of law, better public security,
and improvement to Mexico's physical infrastructure.
Growth and financial developments
Let me move on to the second part of this talk, which covers shorter-term developments. On
a year-on-year basis, since 2014 Mexico's GDP has grown at an average rate of
2.3 percent, not far from the historical performance, with a dip occurring in the second
quarter this year.
Behind this relatively stable backdrop in the past two and a half years, two opposing forces
have been at play. Momentum in services has been offset by a slowdown in industrial
production.
Softening industrial output in Mexico seems to result from two shocks. One is falling oil
extraction due to the near depletion of Pemex's most profitable oil fields. The other is slowing
U.S. industrial production. Consistent with this panorama, manufacturing exports to the
United States have been on the downswing, aggravating the drag exerted by low demand for
Mexican products from other countries.
U.S. manufacturing appears to have a larger impact on Mexican exports to the U.S. than
does the bilateral exchange rate. Econometric estimates for the long-term behavior of
Mexican manufacturing exports to its northern neighbor point toward an elasticity to U.S.
manufacturing production almost four times as high as that for the bilateral real exchange
rate.3
However, a weaker peso may be partly responsible for the fact that Mexican exports have
captured greater U.S. market share. For example, in the last four and a half years, the share
of Mexico's automotive exports in total U.S. automotive imports has increased by almost five
percentage points.
Private consumption has been a driver of economic expansion, partly compensating for the
loss of steam from external demand. Consumption growth seems to have been supported by
several factors, including improvement in labor market indicators.
Since 2012, the unemployment rate has fallen from five percent to less than four percent,
close to the long-term average. Note that this improvement has occurred in conjunction with
relatively stable labor force participation. Additional favorable factors are foreign remittances
and consumer lending, exhibiting an almost coincident rebound with consumption.
Investment, on the other hand, is contracting, sending up a warning sign on possibilities for
future improvement. Also, forward-looking indicators such as purchasing managers' indexes
for both manufacturing and nonmanufacturing are declining, with the latter breaching the
contractionary zone. As is the case in the United States, Mexico is expected to face a
slowdown this year, while growth next year should pick up moderately.4
Mexico's growth scenario faces risks. The world economy may decelerate further, affecting
U.S. prospects. A greater-than-expected slowdown in U.S. imports and industrial production
could hurt the outlook for Mexico. Also on the radar are weaker consumer and producer
confidence, a worse-than-expected drop in crude oil output, and potentially more volatile
financial markets, which could bring constraints for financing in both the public and private
spheres. To the upside, structural reforms might yield more benefits.
In financial markets, since the middle of 2014, an international trend toward greater risk
aversion has hurt emerging markets in particular. In emerging economies, the financial
variable most affected has been the exchange rate, with a tendency toward generalized
depreciation against the U.S. dollar. To date this year, the Mexican peso has been hit harder
than other currencies in this group. The obvious question is why this has been so.
Exacerbated peso depreciation may stem from several factors. One is the role of the
Mexican peso, the most traded currency among emerging economies, as an international
hedge mechanism. Increased risk aversion has been a constant for currencies, bonds and
other investments in the last couple of years, and investors appear to have latched onto the
tactic of shorting the Mexican peso as an easy way to hedge their risks when other
emerging-market assets face headwinds.5
Another factor, however, is Mexico's weakened fiscal position. The nation has seen a
longstanding rising trend in overall public-sector debt over GDP. Additionally, Pemex net oil
export revenues have dropped drastically.
A stronger fiscal stance is necessary given a historic balance of public-sector borrowing
requirements that has grown 14 percentage points relative to GDP in a matter of just a little
more than seven years. This situation is more critical given the worsening of Pemex finances
and the persistence of low oil prices, with widening negative net income in the state-owned
company. The difference between revenues and expenditures maps very closely the rising
oil deficit in Mexico's current account.6
Finally, holdings of peso government securities by nonresidents have fallen lately, driven by
drops in those of short maturities. This bears watching, given that further bouts of
international financial volatility could easily occur.
On the world stage, in the wake of Brexit, deeper monetary accommodation is foreseen in
most developed countries. Partly as a result, leverage is rising worldwide. Furthermore, the
perception of the low effectiveness of monetary policy in terms of intended goals may hurt its
credibility.7
A highly unusual characteristic of the overall scenario is that advanced nations are saddled
with increasing proportions of public and private debt with negative yields. Geopolitical jitters
will likely continue. Also, European banks suffer not only from squeezed margins in light of
the low and negative interest-rate environment, but also from weak balance sheets. Finally,
doubts over the sustainability of the Chinese economic recovery and policy interventions
there persist.
Monetary policy and inflation
Let us now focus on monetary policy and inflation in Mexico. Since last year, annual inflation
has remained moderate. For 15 consecutive months, it has been below the 3 percent target.
This is unprecedented and calls for consolidation of the trend.
This benign result has been supported by unusually low noncore price increases, including
soft international agricultural and domestic government-determined prices. On the other
hand, core inflation has been rising gradually, reflecting the effect of peso depreciation on
tradable goods prices. This is very clearly shown by the behavior of merchandise inflation.
Additionally, an accelerating rise in the producer price index also reveals an impact from
peso weakening.
Medium-term inflation expectations, as measured by analysts' surveys, have remained
relatively stable, albeit above the target. Market-derived expectations appear to show a
recent spike.8
In this context, monetary policy has been preemptive, with interest rate hikes seeking to avert
deviations of inflation expectations and to anchor them on the target, particularly in the face
of significant peso depreciation. The resulting flattening of the yield curve seems to reflect
confidence that inflation will continue to be contained.
It is worth emphasizing that the Bank of Mexico does not target any level of the exchange
rate. Its primary objective is maintaining low inflation, and Mexico adheres to a freely floating
exchange-rate regime. This does not mean that movements in the exchange rate have no
impact on inflation. In fact, as mentioned, moderate pass-through has occurred from the
exchange rate to consumer prices, concentrated in durable goods. But this may change, and
monetary policy should remain vigilant.
Some risks to the consolidation of convergence of inflation to the 3 percent permanent target
prevail. The most notable danger is more weakening of the peso with a generalized impact
on prices, knocking inflation expectations off track. Also, rises in noncore prices could
accelerate, returning to historic rates, possibly producing second-round price effects. Finally,
given uncertainty on the level of potential GDP, aggregate demand pressures could surface.
Conclusions
Over the course of many years, Mexico and the United States have benefited from increased
integration, both cultural and economic. Mexican economic activity, however, has recently
decelerated and confronts downside risks, among them, the possibility that the U.S. industrial
sector's performance will turn out to be softer than anticipated.
Other dangers are weaker consumer and producer confidence, a steeper-than-expected fall
in oil output, and possibly more volatile financial markets. The latter might squelch financing
for the government and private firms.
Greater risk aversion could become exacerbated by geopolitical events. In this context,
Mexico's fiscal stance should be fortified, and its monetary policy must continue to employ
complete flexibility in order to consolidate the convergence of inflation to the permanent
target, thereby shielding the economy with stronger macroeconomic fundamentals.