Theme: The performance of the Mexican economy in 2004.
Summary: The deceleration of the Mexican economy, which began in 2001 due to the sharp drop in activity in the US market –producing negative GDP growth of 0.1%–, was followed by two years of stagnation during which the Mexican economy achieved a significant degree of stability. These past three years have now given way, in 2004, to a recovery based mainly on the dynamism of exports, accompanied by the recovery of investment in associated sectors. For this reason, consolidation will depend on whether the current uncertainties in the international economy –derived from the American economy, which is the main market for Mexican exports– are dispelled and on the complex process of boosting the dynamism of the domestic market.
Analysis: GDP has grown by 3.7% and 3.9% in the first two quarters of the year and it is estimated that it will grow by more than 4% in the third quarter, making it likely that the forecasts for overall growth of 4% will be met this year. This significant recovery has been due to the intense growth in exports stimulated by demand from Mexico’s main trading partner, the United States, and by the increase in foreign sales of oil at new international market prices. Mexican exports have reacted quickly and flexibly to US demand for manufactured products, leading to a significant recovery in investment in machinery and equipment (which has increased by 5%, after registering negative rates over the past three years). This new expansion has fueled a positive atmosphere which has stimulated private consumption. It has also been supported by greater remittances from emigrants to the United States, a slight improvement in employment levels and the expansion of consumer credit.
The dynamism of exports to the United States has contributed to the recovery of the machinery and equipment industry, which was responsible for 40% of the expansion in the manufacturing sector to the month of September. This industrial sector –whose most important sub-sectors are transport vehicles and electronic products and components– exports 60% of its production. These exports represent 70% of manufacturing exports. It is not surprising, therefore, that the pace of economic growth in the country is closely linked to that of these sectors. This explains the stagnation of the preceding years: as long as the American market failed to recover the dynamism required to boost Mexican exports, activity could not return to where it was before the contraction that started in 2001. Growth in the manufacturing industry has been both in the maquila sector and in the rest of industrial activities. Overall, in the first nine months of the year, growth has reached 12.5%.
External demand, along with industries associated with the expanded production of transport vehicles –such as the rubber and plastic industries and oil products–, has stimulated the export of ‘other manufactured goods’ (which have risen from a rate of -8.3% in 2003 to an estimated 6% in 2004) and the non-metallic minerals industry (which has risen from zero growth to a growth rate above 5%). In the same way, the intense expansion of investment has stimulated the growth of the intermediate goods industry –mainly steel-making and metal processing (above 6%) and the wood industry (which is growing at a rate of 3%)– as well as metal products, machinery and equipment, although in the latter industries the main stimulus remains demand from the United States, as mentioned above.
This expansion of manufacturing activity has boosted mining production (non-metallic minerals and iron have registered double-digit growth, according to INEGI). This growth has also been aided by renewed expansion in the construction industry, which could easily double the growth registered in 2003. Construction, which is growing both through housing and investment in infrastructure, has also helped stimulate the production of basic metals, cement and ceramics, etc. Regarding infrastructure, the government plans to invest an overall 5.5 billion dollars this year in highways and freeways and in improvements to the railway system and airports. These will be financed through tax income from oil, taking advantage of high current prices on the international market.
The dynamism of the export sector, the expansion of construction and the recovery of investment have led to a significant recovery in manufacturing activity. They have not, however, helped create a surge in new employment. It is true that open unemployment began to drop in February and that this was a significant change from the trend in recent years. But it is also true that the creation of employment that accompanied this new period of economic recovery has been greater in agriculture, construction and services than in the manufacturing sector, to a higher degree than may have been expected. This situation, however, is far from unusual as shown by the experience of other countries. The manufacturing sector is under intense international competitive pressure and must maintain high productivity by increasing the capital/labour ratio, which leads –at the start of a period of growth after stagnation– to expansion through increased use of installed production capacity with the fewest possible number of workers. This would explain why the number of maquila workers assembling automobiles and electronic products and components remains between 20% and 30% below levels at the end of 2000.
The modest levels and slow rate of job creation in the manufacturing sector, agriculture, construction and services, left open unemployment at 4.35% in August and 4.01% in September, still far from the level in 2000, before President Vicente Fox took office. Two worrying phenomena accompany this slow rate of job creation: the minimal improvements in wages and the worsening quality of employment. Negotiated wages are one percentage point below current inflation rates and several decimal points below projected inflation. Although the gap between real and projected inflation seems to be narrowing (to 4.3% in September), all indications are that there will be a loss in purchasing power (A. Vieyra and P. Ibarlucea, Banamex, nr 944 and nr 946). Furthermore, more than half the jobs created are temporary and the worst-placed workers in the labour market are suffering from eroding wages. Workers who earn less than the minimum wage have increased throughout the year and in August accounted for 10.7% of the labour force. Likewise, workers classified as being in ‘critical employment conditions’ rose from 8.9% in August 2003 to 9.2% in August 2004 and to 9.1% in September 2004. This means that more than 20% of the labour force receives less or much less than the minimum wage.
Despite the modest creation of employment and the slight rise in wages, demand for consumer credit has been stimulated by the increase in remittances from emigrants and, especially, by the positive expectations that accompany the long-awaited recovery. All these factors together explain the growth of private consumption –which has been growing at nearly the same rate as GDP in the nine first months of the year– and the recovery of sectors associated with the demand for products such as food, drinks and tobacco, textiles, clothing and leather goods (which rose from -9% in 2003 to 2.7% growth this year). The latter activities, which were a significant part of the country’s exports, were displaced by competition from similar products from China. On this occasion, their very modest recovery was due to internal demand. However, it must be kept in mind that next January the ‘Multifibre Agreement’ will no longer be in force and perhaps the Mexican textile and garment industry will be able to recover some part of its exports. Consumer demand also extends to imports, with clear growth in the importation of consumer goods, particularly automobiles.
The way to stability: controlling public deficit and inflation and managing public debt
The government is persevering in its strategy to keep the public deficit under control. Its goal in 2004 has been to hold the deficit to 0.3% of GDP. To do this, it has tried to control spending increases and take advantage of the currently favourable international oil prices, in order to increase income and use some of it to make investments. Public income in Mexico is equivalent to 22.7% of GDP. Of this, 34% is from oil (11% from PEMEX, ie, a third of public sector income from oil); only 42% of income comes from taxes (10.8% of GDP), while the rest comes from non-tax income and the results of other public companies that account for 21% of all public sector income and 5.2% of GDP.
As we indicated in a previous analysis by the Elcano Royal Institute (La economía de México en 2003, ARI, January 14, 2004), it is not surprising that Mexico, along with Venezuela, is the country with the lowest ratio of tax collection to GDP among the major Latin American countries. This must change in order for fiscal policy on the income side to come into line with other modern market economies and to reduce its dependence on oil income and PEMEX resources. The fact that this company’s resources are part of public sector income has diminished its ability to invest in the expansion of oil activity. This has limited increases in its extraction capacity and, therefore, future increases in income derived from larger oil sales.
The government prepared the budgets for 2004 based on an estimated oil price of 20 dollars a barrel. In fact, the real price has been considerably more than 50% above this price. At the same time, the level of activity is also enabling significant increases in indirect taxation and, to a lesser extent, in direct taxation. Therefore, the projected goal of a deficit of 0.3% of GDP will very likely be reached or even bettered, despite the predicted increase in investment resulting from the current oil bonanza. The deficit is larger when the public sector’s financial commitments are included in public accounts. These financial commitments include government losses through the IPAB (commercial banks’ rescue fund, established in the 1990s), Pidiregas and other trusts.
This favourable development has made it possible to continue with the strategy of reducing the stock of public debt. The policy followed by the Fox government has been to keep the debt stock under control and, where possible, to reduce it in terms of GDP. Net public debt at the end of August 2004 was equivalent to 24.8% of GDP, a level lower than that registered at the end of 2003 (25.2%). This does not take into account the debt of other public entities such as the IPAB, Piridegas, Farec and other trusts which, altogether, came to 43% of GDP at the end of 2003. The strategy designed for public sector financing includes progressive increases in internal financing and reduced recourse for resources in the international markets. This would not only reduce the financial vulnerability of the public sector but would also boost the development of the domestic capital market. This is why, along with the deficit goal, the government has proposed to continue reducing the debt stock, in particular, external debt.
This fiscal strategy has brought about positive results, despite the fact that in the past six years the ‘fiscal adjustors’ have not worked. Since 1998, the budgetary laws have included so-called fiscal adjustors, an instrument introduced to keep public spending from growing more than income and guaranteeing that the projected deficit will be met or even reduced. In practice, the fiscal adjustors have not worked, or more to the point, they have been used to reduce spending when income falls, but when income is higher than projected, instead of reducing the deficit or debt, the decision has always been made to increase investment spending. This is why the fiscal policy can be considered pro-cyclical: when income is lower, spending is reduced to meet projected deficit goals and when income is higher –during expansive periods– spending is increased instead of reducing the deficit or reducing debt. The only fiscal adjustment mechanism has been oil income, through the Petroleum Stabilisation Fund (FEP). The FEP provides resources when tax income falls –during periods of increasing oil prices–, and in times of high taxation the Fund’s resources rise with oil income.
Growth faces risk factors in the coming years
However, there are risk factors that threaten growth in the coming years. For now, the slowdown in private consumption in the United States has not had negative effects on the export of Mexican manufactured goods, since these are still concentrated in certain sectors of the maquila industry, such as electrical and electronic products and parts and components for vehicles and automobiles. But if demand trends change, the effects of this on Mexican exports will soon be felt. A major slowdown in the foreign sector would negatively affect prospects for employment, which would impact private consumption and, in turn, the recovery of domestic demand. Furthermore, the Mexican Central Bank (Banxico), aware that inflation is already over the projected limit of 4%, has continued to tighten monetary policy and in October raised ‘el corto’ from 51 to 57 million pesos a day. At the very least, this will make money more expensive and will moderate the pace of expansion of consumer credit.
Even so, symptoms of inflationary pressures continue. This is reflected in the evolution of underlying inflation, although the main components of inflation are not in the underlying category. Since the traditional components have lost their capacity to control inflationary pressure –that is, indexed salaries established through collective bargaining, as well as companies with sufficient market power to translate cost increases into higher prices– the inter-temporal coherency of monetary policy has facilitated the predictability of the exchange rate and has reduced the degree of pass-through from fluctuations in the exchange rate to inflation. In this way, administered prices are now those that have the greatest influence on the march of inflation. However, it must be kept in mind that in the coming months a lower exchange rate could have a significant impact on inflation.
For the year as a whole, projected inflation has been revised to 5.4%, making it likely that Banxico will continue to raise ‘el corto’ as part of its strategy to maintain a tight monetary policy. This would prevent the likelihood of projected inflation leading to a more passive monetary policy, which in turn would stimulate a greater depreciation in peso exchange rates, a high pass-through from the exchange rate to inflation and, once again, a circle of instability. However, the signals from Banxico are clear: monetary policy will remain tight in order to demonstrate the bank’s commitment to the goal of controlling and, as much as possible, reducing inflation, to maintain a stable exchange rate and low pass-through.
In this tighter monetary context, companies will likely review their investment decisions and moderate the pace of their growth. It should be noted that if the rate of growth of the US economy slows, the projected growth rate of the Mexican economy could force changes in the projections for 2005. The projected rate of 3.7% is already less than the 4.3% rate for 2004, and it could drop even further.
Dealing with unresolved structural problems
In structural terms, there are two factors that will always hinder the dynamism of the Mexican economy, unless the right measures are taken. First of all, for its medium- and long-term growth, the country cannot ignore the need to make investments in energy, electricity and infrastructure. Investments in these areas are relevant not only because of their contribution to GDP growth, but also because they are essential to increase productivity and competitiveness. The State is taking advantage of excess resources resulting from high oil prices and is devoting a part to investment in infrastructure. But little headway has been made on the design of a strategy to stimulate investment in energy resources and electricity. The lack of structural reforms in these areas is one of the main obstacles to economic growth in the coming years. The second problem is income distribution. This is key to the modern configuration of a domestic market capable of generating a certain degree of dynamism in the economy, so that growth does not depend entirely on favourable winds blowing in from the foreign market. However, this is an issue absent from the agendas both of the country’s economic agents and its political parties.
Proof of the little headway made to clarify the fiscal panorama can be found in the content of the Law on Income passed in the Chamber of Deputies this November. The National Tax Convention (Convención Nacional Hacendaria) presented a proposal in September and this was used by the government to prepare the Law on Income that it has presented for discussion in the Chamber of Deputies, but its contents were significantly modified. No reductions in VAT or in tax rates for individuals have been approved; however, approval has been granted to reduce corporate income tax from 33% to 30% in 2005, to 28% in 2006 and to 27% in 2007, and to change the tax regime of PEMEX in order to reduce its contribution to the federal government. At the same time, the door has been left open to a new kind of compensatory ‘fiscal adjustor’ that would allow taxes to rise when the price of oil falls on the international market. Meanwhile, approval was given to reform the pension system of the Mexican Social Security Institute (IMSS), dealing with the system’s long-term commitments, but leaving short- and medium-term commitments unresolved.
Are we seeing a new international insertion that favours the reduction of external vulnerability?
A smaller negative current transactions balance is being registered at the same time that a significant expansion of the economy is occurring. This has been a trend in recent years and may not be the result of aspects of the recessionary period in 2001-03. This trend is contrary to that seen in the nineties, before the tequila crisis in late 1994. Then, the expansion of economic activity was accompanied by high current account deficits which in turn required increasing inputs of capital. Now, however, the deficit level corresponding to each point of growth is significantly lower. This shows, as we indicated in the previous ARI, that the Mexican economy could be developing a new model of insertion in the international economy: shifting from a capital account insertion to a trade account insertion and, therefore, changing its external financing scheme.
Along with the growth in the export of goods (greater than expected due to high oil prices in the last six months), the export of services also increased –led by tourism revenue– as did current transfers of remittances by emigrants, equivalent to more than 80% of oil exports and nearly 2.4% of GDP. At the same time, imports grew, as did interest payments, amortisations of debt and the repatriation of profits by foreign investors. This has led to a current account deficit that will reach about 1.4% of GDP at the end of 2004. But this deficit is financed by inflows of foreign direct investment, which in 2004 will come to a total of about 16.5 billion dollars –twice the size of the current account deficit–. It is true that a significant part of this flow is due to the purchase of a new stake in Bancomer by Banco Bilbao Vizcaya Argentaria (BBVA), worth 4.9 billion dollars; but it is no less true that while direct investment in services represents more than 50% of the total, investment in industrial activities still absorbs about 40%. This is why the free trade agreement signed with Japan last September is meant to be a powerful instrument to attract Japanese direct investment to Mexico, in particular to industrial activities.
Mexico has managed to increase both gross and net international reserves and reduce external vulnerability in the short, medium and long terms. A significant short-term improvement has been achieved in liquidity, since reserves stood at over 60 billion dollars in late August. Liquidity measured by the relationship between short-term external debt and net international reserves is estimated at a ratio of 0.56. Something similar has occurred with the evolution of external solvency (measured by the relationship between total external debt and exports): in August the ratio stood at 0.8, compared with 2.7 in Brazil and 5.2 in Argentina.
Conclusions: In 2004, the Mexican economy has successfully taken advantage of favourable winds from the American economy and has achieved a growth rate close to 4.3%. Its dynamism has centred on exports, but demand has increased so intensely that it has stimulated the recovery of investment, first in export activities and then in other related sectors. At the same time, tourism revenue has also increased, as have remittances from emigrants. This new context has led to more positive expectations, despite the limited recovery of employment levels and the modest increase in wages, which has stimulated consumption, in conjunction with the greater volume of remittances and expanded credit. Since the middle of the year, inflation has been rising above projections. But economic policy has followed a line of monetary discipline and a peculiar kind of fiscal discipline in order to stay on course towards its priority objectives: the control of inflation and of the public accounts deficit and proper management of the public debt. Reducing external vulnerability has perhaps not been deliberately pursued as a priority. Nevertheless, the Mexican economy appears to be managing to establish, at least for now, an external insertion of the trade account variety, which leaves it less dependent on international financial flows and favours the accumulation of reserves.
Alfredo Arahuetes García
Lecturer in International Economy, currently Vice-dean of the Faculty of Economic and Business Sciences (ICADE) at the Comillas Pontifical University of Madrid and Contributing Analyst in International Economics for the Elcano Royal Institute