Mexico is in much better shape to face the global turbulence than it was in past decades, but will continue to move forward too slowly.
BY JUAN PEDRO TREVIÑO
Mexico has been quite successful in consolidating its macroeconomic stability. Central to this are its fiscal discipline, the prudent management of monetary policy and the sound development of the financial system. These factors have facilitated the reduction of inflation to one-digit levels for the past eight years and allowed for recurrent crises to become a thing from the past.
Unfortunately, economic growth in the past decade has been contained to a yearly average below 4.0 percent, quite low relative to other emerging economies, especially India, China and South Korea. Moreover, despite the fact that various indicators of poverty and inequality show significant improvement, development appears to be insufficient to meet the needs of the society, especially regarding job-creation.
These shortcomings pose serious challenges to the society as a whole. All elements of the population need to participate if the country is to move forward with structural changes that aim to promote growth and development. Of course, short-term issues are important, such as how to cope with the economic downturn in the United States. Yet, the main focus should be on those factors that determine Mexico’s long-run performance.
Political life, however, appears to move sluggishly relative to these social and economic needs. Rather than serving as a base for growth, politics, in some instances, appears to be an obstacle. The relatively recent transition to a democratic regime has had significant redistributive implications that have yet to be resolved. For example, many strong interest groups are potentially and de facto affected by political and economic changes. As a result of their involvement, however, it seems at times that relevant decision-making processes stall, with high costs for Mexico’s growth and development.
The present administration has faced the need to gain increased political clout, especially after the highly controversial electoral results of 2006. We have seen some important changes, such as a reform of the pension system for public employees, fiscal reform and changes to Petróleos Mexicanos (PEMEX), the state-owned company. However, even though these changes represent important political achievements, they have been obtained at the price of losing a great deal of their initial substance. Meanwhile, more substantial solutions continue to be postponed.
It seems that we have done part, but not all, of our homework. Changes that could be dubbed as "first-stage" reforms have been implemented successfully. Unfortunately, "second-stage" structural reforms are virtually absent.
The so-called tequila crisis the country experienced in 1994-1995 was characterized by one of the largest drops in economic activity in Mexico’s history and a significant surge in inflation. After growing 4.4 percent in 1994, GDP fell 6.2 percent in 1995, as reported by the National Statistics Institute. At the same time, according to the Central Bank, annual inflation rose from 7 percent in December 1994 to 52 percent in December 1995. Even though GDP growth bounced back quite rapidly and remained solid between 1996 and 2000 (ranging from 3.8 percent to 6.8 percent), it was not until April 2000 that the country saw one-digit annual inflation again.
The causes of the crisis are still under discussion. Soon after it occurred, various hypotheses emerged, ranging from fiscal indiscipline to political instability. Officially, the trigger was the combination of unfavorable political events and external shocks in the context of a highly underdeveloped and distorted financial environment. This set the stage for a major crisis along the lines described by Kaminsky and Reinhart (1999), where the collapse of the exchange-rate-regime brought about a major balance-of-payments correction and a very costly banking crisis.
Economic activity recovered fairly quickly, largely as a result of the real depreciation of the currency in the aftermath of the crisis, which favored rapid export growth. However, domestic public and private spending remained weak for quite a while, a consequence of the credit crunch that the crisis provoked. Banking credit extended to the private non-financial sector, which had equaled around 40 percent of GDP in 1994, declined steadily, only to bottom out in 2002, when it reached a bit less than 7 percent of GDP. Using the consumer price index as a deflator, this implied a reduction of banking credit of almost 80 percent in real terms, spread over eight years. Since then, credit-to-GDP has recovered steadily, although this ratio remained below 15 percent in 2008.
The sluggish recovery in banking credit since 2002 reflects a loss of confidence in the banking sector brought about by recurrent crises every six years. The story goes back at least to 1982 (although the first balance-of-payments crisis the country experienced was in 1976), when the government decided to nationalize the banking industry, supposedly to repay public debt obligations in foreign currency. Since then and until 1991, when the re-privatization process was terminated, the publicly-owned banking system had little experience in assessing and managing risk. Also, the recurrent crises generated a public perception of mistrust due to the potential expropriation of savings.
The problem is that the newly privatized banking system that operated between 1991 and 1994 did so under considerable distortions and in an overly optimistic macroeconomic environment. For example, the deposit insurance was implicit, rather than explicit, and an assumption that full coverage existed became widespread. At the same time, there was no credit bureau in place to compile borrowers’ profiles. Also, the lack of supervision encouraged obscure practices and excessive risk-taking that was prompted by the predetermined exchange-rate regime.
In the end, the financial bailout associated with the 1994-1995 crisis amounted to almost 20 percent of GDP. But clearly one of the costliest effects was the collapse of the banking system and the sluggishness in bank financing for the private sector 13 years later. Moreover, in some cases, the sense of popular mistrust continues. Fortunately, significant action was taken in order to solve the problem, to the extent that, today Mexico’s banking system is solid.
The crisis provided some important lessons. At the macro level, fiscal discipline and monetary autonomy in a flexible exchange-rate regime allowed one-digit inflation to prevail for eight years. At the same time, external public debt reduction diminished the country’s exposure to exchange-rate fluctuations, while financial innovation allowed for public debt instruments in local currency to fully develop. For example, until 1990, government bond tenure did not exceed one year. Three and five-year bonds were introduced in 2000, 10-year in 2001, 20-year in 2003 and 30-year bonds were introduced in 2006. At the same time, the peso has become one of the most liquid currencies among emerging economies.
The collapse of the banking sector also made clear to virtually everybody that for a country to aspire to high and sustained growth, a sound financial system is a necessity. In the years following the crisis, deregulation allowed for fresh capital to flow into the system and banking-business "know-how" to develop. In the context of an increasingly integrated banking system, prudent regulation and supervision took a highly proactive role, and has been relatively successful in its task of ensuring the system’s good functioning. Credit penetration, however, remains low, especially compared with other Latin American countries such as Brazil. This lackluster performance may explain part of why the country has not been able to achieve higher growth more than 10 years.
OPEN AND SURVIVE
As was mentioned above, another important factor that allowed the Mexican economy to grow rapidly after the 1994-95 crisis was the North America Free Trade Agreement (NAFTA). Indeed, since joining NAFTA, Mexico has become one of the most open economies among emerging markets. In 2007, imports plus exports amounted to nearly 70 percent of GDP (between 1991 and 1993, the figure averaged about 32 percent). When we look at GDP growth in 1995, we observe a significant collapse of economic activity in the first half of that year, followed by a fast recovery in the third and fourth quarters.
To further illustrate the value of openness, in the 1982 crisis Mexico experienced a long-lasting downturn after the sovereign debt default and the nationalization of the banking industry. Many international transactions had to be authorized by the government at a specific exchange rate. The induced distortions set the stage for additional adjustments in the following years. In 1995, the story was different, as openness allowed for a rapid recovery driven by strong growth in the United States, which favored the demand for Mexican manufactures.
During the negotiation process more than 15 years ago, the idea was that a free trade agreement with the United States and Canada would increase Mexico’s export capacity and its ability to attract foreign investment. At no point during this process was it said that the trade agreement would, by itself, turn Mexico into a developed economy. Moreover, nothing was said about the redistributive impact of opening the country to free trade. This point is both positive and negative, as we shall see.
When we look at the dynamics of exports, imports and foreign investment since 1994, NAFTA has been quite a success. For example, according to the Mexican Statistics Institute, exports to the United States amounted to somewhat less than $43 billion in 1993, while in 2006 they amounted to $212 billion, a fourfold increase in 15 years. Growth in exports to Canada was also very dynamic. According to Canadian authorities, Mexican exports to that country rose from $2.9 billion in 1993 to $14.1 billion in 2006.
These statistics largely reflect a significant increase in manufacturing exports. Yet, agricultural and other natural resource exports have also increased significantly since NAFTA. For example, average monthly exports of manufactures amounted to $4 billion in 1993, while agricultural and oil, gas, and mineral exports were about $250 million. In 2006, these figures reached more than $18 billion in the case of manufactured goods, and nearly $800 billion for oil, gas, minerals and agriculture.
Data on imports and foreign investment point in the same direction. Average monthly imports amounted to about $5 billion in 1993, while in 2006 they reached almost $25 billion. Foreign direct investment (FDI) also experienced an important increase since NAFTA. In 1993, total FDI amounted to a bit less than $5 billion. In 2006, FDI reached almost $20 billion, while in 2007 it amounted to $23 billion. In 1982, FDI was less than $2.1 billion and between 1980 and 1990 it averaged less than $2.4 billion.
The conclusion is that NAFTA has indeed been successful, since it has met the original objectives of increasing international trade and attracting more foreign investment. Yet, at the beginning of 2008 there was some concern regarding the possibility of the agreement undergoing revision, at least on the Mexican side. On January 1, 2008, the last tariffs and quotas on imports and exports between the three countries were eliminated. A few days later, a massive protest took place demanding a renegotiation, especially regarding those chapters dealing with the primary sector. This demand was puzzling since the full opening of those products, considered as "sensitive," had been extended to 15 years instead of the usual 10-year World Trade Organization (WTO) standard. Moreover, most of these tariffs and quotas had already been reduced significantly. For example, import tariffs on corn fell from 206 percent before NAFTA to 18 percent in 2007.
The protests, led by the opposition parties (PRI and PRD) and by various social organizations related to the agricultural sector, came to an end a few days later. Yet, the question of what drove them remains an open issue. It was not free trade per se that was actually being challenged, but rather the role of the government in the development (or lack of development) of the primary sector. Originally, various organizations received subsidies from the Mexican government, to then redistribute them among various producers. However, the administration of resources within these organizations was neither transparent nor accountable. In an attempt to prevent obscure practices the government decided to start distributing resources directly to producers, rather than through these organizations, which led to the aforementioned protests.
Transiting from autarky to free trade has redistributive implications. From a social equality perspective, one need only put in place a mechanism to compensate the "losers" to guarantee that everybody is better off with free trade.
In an undistorted environment, the redistributive mechanism par excellence is precisely the market. Full flexibility, both nominal and real, would guarantee the allocation of resources necessary to ensure that everyone ends up improving from a welfare point of view. However, in a highly distorted environment, the market alone may not do the job of redistributing the gains from trade. This does not mean that an authority should intervene to redistribute gains. Instead, it means that the authority should do whatever it has to do to reduce market distortions to allow for the market to redistribute those gains.
Interestingly, early in the U.S. presidential campaign, the contenders also suggested bringing NAFTA under revision. This took place in those states where significant job losses occurred once the agreement was approved. This was a result of the redistributive effects associated with free trade, but not with the overall impact on social welfare. In the end, the argument that NAFTA was the main cause of these job losses seems doubtful. After all, every single consumer in all three countries has benefited from a wide variety of goods at relatively lower prices than before the agreement was signed. Instead of renegotiating the agreement, either unilaterally or through coordination, the obstacles that prevent some sectors from taking full advantage of free trade should be eliminated. This, however, is not an easy task.
The Mexican economy has experienced significant changes in the past 25 to 30 years. We have seen the nationalization, privatization, bailout and re-privatization of the banking system. We have also witnessed a transition from a closed to a near-to-fully open economy. We have observed increased integration of financial markets. But we have not yet seen growth rates similar to those in China, India, South Korea or Chile.
Changes that could be dubbed "first-stage" reforms have been made successfully. Unfortunately, "second-stage" structural reforms are virtually absent, and it is clear that this absence is what leads to reduced growth and slow development. Political life appears to move so sluggishly relative to these social and economic needs that, at times, it seems to go in the opposite direction. Rather than a base for growth, in some instances, it appears to be an obstacle.
During the PRI’s rule, the approval of reforms and political agreements was accomplished through the executive branch, while the legislature and the judiciary played virtually no role. Political support, however, came at a cost, essentially in the form of preferential treatment for different groups, such as labor unions and businessmen. This practice concentrated economic activity in various sectors of the economy which, in turn, undermined the social and economic impact of almost any changes. Unfortunately, the relatively recent transition toward a multi-party democratic regime has not been able to fully solve this problem, and may actually have made things worse in some ways.
Perhaps one of the most important changes after the presidential election in 2000 was not the end of the PRI’s 70-year-plus rule, but rather what it meant for the presidency. Until that year, the president was the most important and powerful political figure in the country, to the extent that no other power or person had any possibility of contradicting, questioning or even criticizing him. After 2000, a large share of the power of the presidency was transferred to Congress. The idea was to balance power among the three branches of government.
While this transition was seen as a positive development after decades of authoritarianism, in some instances it has proved very costly for the country’s political and economic progress. It has brought a significant redistribution of power, with the result that many interest groups with strong bargaining power have survived — and do so in an environment where there appears to be no clear leadership in terms of where the country should go. During Vicente Fox’s administration (2000 – 2006), for example, the PRI did not allow significant legislative changes, including the blocking of discussions concerning structural reforms in Congress.
Contrary to the PRI’s expectations, voters understood the negative impact of this approach, which became evident in the 2006 elections. For the first time in decades, not only did the PRI not win, or even place a close second, but it came in a distant third in virtually all the positions contested that year. The presidential election was controversial not because of a near tie between the PRI and the PAN, but because of an alleged fraud that favored PAN candidate Felipe Calderón over the PRD’s Andres Manuel López Obrador. The results for the PRI were so disappointing that immediately after Felipe Calderón was declared the winner by the electoral authorities, the PRI’s candidate, Roberto Madrazo, virtually disappeared from the scene and the party decided to stay out of the spotlight.
The good news is that, after what can be dubbed as a political disaster, the PRI appears to have learned that being obstructionist does not generate political benefits. During the current administration, in contrast, the PRI has not only been open for discussion, but has also become more proactive in terms of the legislative agenda. Its position has been aided by Congress’s highly-divided composition, in which no single party has an absolute majority.
The divisions are the result of the post-electoral controversy led by López Obrador (a large share of the PRD’s affiliates still do not recognize Felipe Calderón as the president). As a result, the PRI has become the party to negotiate with from both the right and the left, and it plays a crucial role in the success of the reforms proposed by the executive.
As a result of the political conditions and some risks associated with fiscal revenues in the medium term, Mexico has seen some structural reforms act approved, such as a reform to the pension system of public employees, fiscal reform and energy reform. Unfortunately, and despite these reforms’ political significance for Felipe Calderon and the PAN from a political perspective, getting support from the PRI has meant a high cost in terms of economic substance: The fiscal reform did not reduce the government’s dependence on oil revenue (currently, about one-third of fiscal revenues are obtained from oil sales) and did not address issues of transparency and accountability, while the energy reform was reduced to a rather mediocre administrative reform of PEMEX.
As a result of this more conciliatory approach, the PRI has been able to regain some of the ground it had lost among voters. However, circumstances external to the party have also played an important role, especially considering that the PRI itself has not undergone a deep reorganization or a significant change in its way of doing politics. The PAN, for example, has not met people’s expectations in terms of growth and development. Also relevant is the more recent radicalism and division within the PRD. All these circumstances mean that we may see the resurgence of the PRI in the 2012 elections, including the presidential election. This is interesting as it to some extent resembles political developments observed in some formerly centrally-planned economies in Eastern Europe, where a retreat from democracy has threatened to materialize.
The current situation in the United States posts big challenges to Mexico, as the country’s economy is perhaps one of the most sensitive among emerging markets to the U.S. business cycle. While Mexico is one of the most open economies in the world (imports plus exports amount to around two-thirds of GDP), it is one of the least diversified. Practically 80 percent of exports have the United States as their final destination, which means that exports to the United States amount to about 25 percent of the country’s GDP.
Fortunately, Mexico continues to open up and diversify away from the United States, albeit at a relatively slow pace: Ten years ago, exports to the United States amounted to almost 90 percent of total exports. As of November 2008, non-oil exports to the United States grew at an accumulated annual rate of 3.4 percent, while the corresponding sales to other destinations grew 25.1 percent. The sad news is that, within non-oil exports, manufacturing exports contracted quite significantly in the last three months of 2008. This is especially important since such exports amount to nearly 85 percent of total exports. The effect is driven in part by a significant slowdown in automobile sales abroad.
At the same time, sources of domestic growth are not sufficiently strong in Mexico to fully offset the U.S. recession. This is highly related to the limited size of the banking system, as explained earlier. Yet it is not exclusively related to banking. As mentioned earlier, the Mexican economy is characterized by numerous rigidities that complicate the possibility for individuals and entrepreneurs to adjust to adverse effects. At the same time, for historical reasons, the authorities have limited room for policy action. The central bank, for example, has limited room for easing monetary policy to contribute to a soft-landing of the economy. Unlike the Federal Reserve Bank in the United States, but in line with a vast number of central banks around the world, Banco de México has a single mandate of price stability.
In the context of significant currency depreciation, there is great uncertainty regarding the question of whether inflation has indeed started to subside, and the central bank appears to be very concerned about this matter. As a result, it must continue to focus on the achievement of price stability. In this sense, the experience during 2008 constitutes a clear example of the trade-off between credibility and flexibility that inflation-targeting generates. In the long-term, however, it is desirable for the central bank to focus on inflation rather than on economic activity. Economic theory and experience worldwide have proved this is the best way for a central bank to contribute to sustained growth. Thus, the idea of providing the central bank with a mandate for growth is not only misleading, but potentially dangerous for the country’s macroeconomic stability.
In the specific case of Mexico, even though fiscal dominance is no longer an issue and the central bank is both de jure and de facto autonomous, there is the additional problem that institutions are unfortunately not strong enough to prevent a central bank with a dual mandate from inflating and inducing even less growth. This means that a single mandate guarantees long-term stability, admittedly at a cost in the short-term in extreme circumstances like those prevailing today. Yet, this is the traditional trade-off between credibility and flexibility under any policy framework.
Regarding fiscal policy, a history of indiscipline that resulted in a highly pro-cyclical public spending pattern by Mexican governments, and hence in increased business-cycle volatility and persistence, allowed policymakers to develop mechanisms that prevent excess public spending. The most representative has been the recent approval of the Fiscal Responsibility Law, which states that the public debt must be as close to zero as a proportion of GDP as possible. As for the case of monetary policy, and more specifically central bank independence, this has facilitated macroeconomic stability.4 The downside, however, is a significant loss of flexibility in extreme circumstances. In the context of one of the worst recessions in U.S. history, fiscal policy in Mexico may help soften the impact. Yet the room for movement is limited.
Admittedly, Mexico is in much better shape to face the global turbulence than it was in past decades. It is a more open and diversified economy. Banking credit-to-GDP is twice as large as in the most recent crisis. The financial system in general is well capitalized. Firms and the government have access to external financing on better terms. Overall, internal demand conditions appear relatively healthy. Yet, the magnitude of the crisis is likely to be of proportions not seen in decades, and the country remains in a structurally weak position. Therefore, the challenge not only to the authorities, but to the civil society in general, is to focus on long-term structural issues.
While Mexico has done part of its homework by introducing "first-stage" reforms in the past two decades, there is still much work to be done on the structural front. As was noted previously, structural reforms have been virtually absent for a long time. While Mexico saw a fiscal reform approved in 2007, it was only a small step in terms of economic significance, as it did not address issues of transparency and accountability from the expenditure side directly, and it did not have any significant effect on the size of the tax base.
Since 1938, when the oil industry was expropriated by then-president General Lázaro Cárdenas, and since 1971, when one of the largest oil fields in the world was discovered by a fisherman named Rudesindo Cantarell on his boat Centenario del Carmen, oil production, sales and exports have been a very important source of revenue for the government. Currently, oil-related revenue flowing to the government amounts to somewhat more than one-third of total fiscal revenue. This is especially important considering that non-oil-tax-revenues-to-GDP have averaged around 12 percent since 1975. Unfortunately, it is not clear what happens to the revenue from these resources. According to the law, most revenues are distributed among state governments. Yet, their use at the local level is not subject to audit and therefore is not accountable. Looking ahead, as the country lacks capacity to explore deep waters, as well as extract and process oil, there is a high risk of significant declines in production, with a potentially dangerous impact on public finances.
None of this was addressed by the so-called fiscal reform of 2007, and less so by the recently-approved energy reform. This suggests that the discovery of oil was in fact the worst thing that could have happened to Mexico: Oil became an easy way for the government to obtain resources, at a high cost in terms of public policy development and with disastrous implications in terms of wealth distribution. The oil industry has remained in the hands of the government, along with a handful of interest groups, and the outlook is simply disastrous.
Those who argue against privatization admittedly have a point when one considers previous privatization processes in Mexico (banking and telecommunications), which were not particularly transparent nor open to competition. Yet, the argument is archaic given that even countries with highly-centralized political regimes, such as Cuba, are convinced that private participation is necessary for certain industries to achieve success.
Another problematic issue is education, or the lack of it. We currently see pointless debates concerning proposals to go back toward a fully-centralized regime and/or a closed economy, both of which have proved useless in generating prosperity. This reflects the fact that the country has ignored the role of ignorance itself, as Mexico lacks a competitive public education system. In addition to producing an enormous drag on growth and development, this has reinforced a highly-skewed distribution of wealth, as lower-income families have limited access to better education. This reduces their social mobility, which in turn, tends to affect social indicators negatively.
Unfortunately, a legacy of the prior, nearly-centralized system was the emergence of powerful interest groups that have made it difficult to develop a fully democratic regime. This, along with a lack of transparency and the virtual inexistence of accountability in various matters resulting from a weak institutional framework, has made the transition very slow and highly costly. It is clear that human capital is crucial for development and growth. In addition, its absence also generates insecurity. As a result, the focus must be on structural matters, especially education. The solution must incorporate the dissolution of powerful monopolies and the adoption of modern techniques and technology. However, this requires a broader set of actions that allow for people to actually attend school, as a high percentage of the population prefers to work rather than study, because the latter is not ex ante profitable.
The new government has engaged in a frontal confrontation against drug-dealing in Mexico that has involved the army. The signal is that there will be zero tolerance to crime. While this was initially seen as positive, some critics have emerged recently, due to the high number of resulting deaths seen so far. Critics also say involving the army means that this institution is prone to corruption as it is directly exposed to bribery. A second criticism is that involving the army has made explicit the incompetence of police corps. Third, what if the army cannot solve the problem? Fourth, in order for this measure to be successful, there is need for structural change that provides potential producers and consumers of drugs with alternatives for making a living. This means improved education, increased flexibility to set up businesses, and better access to financing, to mention only a few specifics. Clearly, to the extent that structural matters are not resolved quickly, the outlook is not very promising. In the end, it is clear that we need changes that imply short-term policy changes. But in order for these changes to be successful, in terms of having a long-lasting impact, they should be reinforced and complemented by reforms that imply a structural change.
Mexico was typically considered a role model among emerging market countries in Latin America. This, however, changed when Chile took over as one of the fastest-growing, stable and continuously developing economies in the region. Recently, Mexico attempted to continue the process toward improving the life of its citizens and its position in the global economy. This process has been difficult, costly and slow. Yet, significant steps have been taken, and there is a strong vision among people in the country of where it has to go. Unfortunately, the obstacles ahead, and the problems inherited from the past, make this process particularly challenging.
We have seen glimmers of success on various fronts, but various steps forward bring a few steps back. The problem is that the global environment, particularly recently, has become especially complicated. Countries like India and China continue to invest in education and become increasingly competitive, which means that Mexico is losing precious time, especially considering the difficulties on the horizon. The lack of flexibility will clearly make it more difficult for Mexico to deal with the current situation, and brings the risk of losing ground and undoing what has been accomplished. Fortunately, people appear to understand and learn from experience. As a result, we will most likely continue to move forward, although perhaps somewhat slower than is necessary.
Juan Pedro Treviño is chief economist and head of research for HSBC Mexico, in Mexico City. He joined HSBC as director of macroeconomic research in 2006. Previously, Mr. Treviño held several positions at the Banco de México, the last being senior economist in the monetary affairs division, where he conducted various research projects on monetary policy and interest rates, among others. Early in his career, he worked in the research department of the International Monetary Fund.
This column is based on an excerpt of a policy paper that was published by the Mexico Under Calderon Task Force of the University of Miami’s Center for Hemispheric Policy. Republished with permission of the center.