Depending on the measurement used, Mexico is either the 13th- or 14th-largest economy in the world, and it also among the most liberalised economies in Latin America. Over the 2000-10 period, the country has seen a rapid expansion of the middle class, with 17% of the population, or 20m people, achieving this status. By size of population and GDP – 122.3m and $1.26trn, respectively – Mexico is the second-largest economy in the region after Brazil.
Unlike Brazil, however, where governments have pursued protectionist policies, Mexico is committed to free trade, and is closely integrated with its northern neighbours, the US and Canada, through the North American Free Trade Agreement (NAFTA), in force since 1994. Mexico is also a party in the Trans-Pacific Partnership, signed in October 2015, a member of the OECD and the pro-free-trade bloc Pacific Alliance, with fellow founding members Chile, Colombia and Peru.
The link with the US, the world’s largest economy, has led to an unprecedented boom in some industrial sectors, such as automobiles. In 2014 Mexico was the world’s fourth-largest exporter of vehicles. There is also a very large Mexican-American community in the US and the financial remittances it sends home are an important factor in the Mexican economy. Trade between the two countries is worth more than $1bn a day, and in 2015, a time when some of its neighbours were struggling with recession, inflation and fiscal imbalances, Mexico stood out for its solid macroeconomic management, fiscal responsibility and relatively high foreign currency reserves.
Compelling Reform Story
The Mexican economy does have its share of concerns, but the way they are being addressed is part of a compelling national story. The government of President Enrique Peña Nieto, which took office in December 2012, diagnosed these problems as including a persistently below-potential growth rate, oligopolistic market distortions, low productivity and financial exclusion. On a greater scale than any of his immediate predecessors, Peña Nieto launched a major package of structural economic reforms designed to address these issues. It is by far the most ambitious project of its kind in the region today.
The package’s most eye-catching component is its ending of seven decades of state monopoly in the oil and gas sector, designed to attract major international oil companies to invest in the country and reverse 10 years of declining production by Petróleos Mexicanos (Pemex), the state-owned oil firm (see Energy chapter). In total, during the 2012-15 congressional session, the government pushed through 11 major reforms, many requiring constitutional amendments. There were reforms to energy, telecommunications, competition policy, the financial sector, fiscal management, labour, education, the penal code, citizens’ rights, electoral regulation and freedom of information/transparency. The legislature also passed smaller but still significant changes in areas such as state government finances, insurance and monitoring of corruption.
Faster Growth Challenge
Ultimately the success of this ambitious programme of structural reforms will hinge on whether it can correct the persistent challenge of the country’s relatively slow growth. Over the past two decades the Mexican economy has expanded at a slightly slower rate than the rest of Latin America. Average GDP growth in the five years to 2005 was 2.7% for Latin America and 1.9% for Mexico; in the following five years to 2010, Latin America was further ahead, at 4% compared to 2% for Mexico. The gap may be narrowing. In the five years to 2014 Latin America’s growth rate dropped to 3.4%, compared to 3.3% for Mexico. The aim of the reform package is to raise Mexico’s longer-term growth rate, which has been trending in the 2-3% per annum range. Government officials and private sector analysts have argued that reforms will lift that rate by one or two percentage points.
Peña Nieto Reforms
In a special paper produced for OBG, the economic research team of Grupo Financiero Banorte (GFN orte) noted, “The structural changes approved over the first two years of Peña Nieto’s administration are unprecedented. The previous period of structural change in Mexico took place more than 20 years ago. In that period, NAFTA was approved, making this the first long-term economic policy commitment of the Mexican government to an open economy.” GFN orte pointed out that the changes required a level of cross-party political agreement not seen in Mexico for two decades.
The reforms were conceived not as a set of discrete and compartmentalised changes, but rather as an integrated approach to a series of related issues.
The headline problem facing the Mexican economy was seen as low productivity, caused by a lack of competitiveness often reflecting highly concentrated ownership structures, with several industries classified as monopolies or oligopolies. Perhaps the most acute economic concern was perceived as the inability of two state-owned monopolies, Pemex and the power company Comisión Federal de Electricidad (CFE), to boost investment and output, as both are regarded as bloated and inefficient bureaucracies. Falling oil production and revenue was regarded as a threat to government financing, since one-third of its income comes from the oil and gas sector. Meanwhile, high electricity prices were seen as a threat to the cost base of the otherwise profitable manufacturing sector.
Furthermore, the government’s dependence on oil revenue highlighted a major weakness – Mexico’s low overall tax take as a proportion of GDP. Additionally, in the telecoms sector, a lack of competition was resulting in high telephone and broadband internet access charges, another threat to competitiveness.
The authorities have sought to tackle these issues to promote growth in a number of sectors. The following sections outline proposed reforms for each sector.
A major constitutional reform passed in late 2013 ended the state monopoly over the country’s oil and gas production and power generation. State ownership of sub-surface hydrocarbons was maintained, but private sector involvement in all stages of the value-chain downstream from the wellheads is now allowed. Both Pemex and CFE lost monopoly rights, but remain as state-owned players in a competitive market. Independent directors were appointed to their boards and semi-autonomous regulatory bodies have been established. An oil and gas licensing round, known as Round 1, was undertaken in 2015 to allow private firms to bid for exploration and production contracts.
Government officials expected annual licensing rounds to bring in around $12.5bn of investment in each of the next four years, starting with Round 1 in 2015, Round 2 in 2016, and so-on up to Round 4 in 2018, the final year the current government will be in office. However, the outcome of the first round of bidding, which saw two out of 14 blocks awarded in mid-July, means investment in 2015 will be short of expectations.
An additional component of energy reform lays out a gradual reduction in the government’s use of Pemex oil and gas revenues. Pemex will steadily pay less discretionary tax as it moves to a common tax regime shared by a number of competing oil companies. Fiscal reforms begun in 2014 were designed to compensate for this emerging shortfall by raising general taxation rates across the non-oil economy, which was the lowest in the OECD and among the lowest in Latin America. Excluding revenues from Pemex, Mexico’s total tax take in 2012 was only 9.7% of GDP. Comparative data for 2010, including Pemex revenues, showed that Mexico’s total tax take in that year was 19% of GDP, compared to 26% in Turkey, 31% in Greece and 36% in Germany. The reform, which took effect at the beginning of 2014, raised the tax take by an estimated 1.4% of GDP, through various mechanisms such as increases in income tax, introduction of a 10% capital gains tax on stocks and shares, higher taxes on soft drinks (prompted in part over health concerns around the high incidence of diabetes in Mexico) and the elimination of a long-standing value-added tax discount applied across Mexico’s northern states.
In the telecoms sector, reforms authorised regulators to aggressively break up communications monopolies. A semi-autonomous regulator, the Federal Institute of Telecommunications (FIT) was empowered to take action against market players found to be “preponderant” – defined as having market shares of over 50%. Under the terms of the new law the FIT has imposed “asymmetric measures” against América Móvil, the dominant telecoms provider, and Televisa, the dominant TV broadcaster (both have market shares of close to 70%). Measures that have been applied so far include forcing these companies to grant smaller competitors access to their infrastructure and technical distribution platforms. Ultimately, FIT is empowered to force these players to divest part of their assets. The reform is credited with attracting AT&T of the US to enter the Mexican mobile telephony market to compete with América Móvil. It has also forced an initial reduction in telephone charges through the elimination of high long-distance call rates (see Telecoms chapter).
A series of banking reforms and regulations were designed to encourage greater lending and strengthen the role of development banks in financing. Reforms have given lenders greater security and made it easier for them, in the case of defaulted loans, to obtain ownership of assets submitted as collateral. “To increase the number of loans and reduce interest rates from commercial banks, a judicial reform must be implemented in order to protect the interests of banks and financial institutions,” Joseph Sasson, adjunct director-general of Finmex, which provides financial services to small businesses, told OBG. “The financial reform aims to do this, but a more in depth judicial reform is also needed,” he added.
Competition & Labour Reforms
The business environment has been further strengthened by reforms to the legislative framework and governance bodies overseeing competition and labour issues.
A constitutional amendment passed in June 2013 created a watchdog body, the Federal Economic Competition Commission, with powers to take action against “anti-competitive practices”. Legislation governing competition policies came into force in July 2014 further bringing Mexico in line with international best practices.
A series of changes were designed to promote greater labour flexibility, boost employment, democratise trade unions and modernise labour tribunals.
Penal Code Reforms
Reforms to the justice system created a single federal penal code, replacing different and sometimes inconsistent state-level codes. The changes also relate to a long-running project to introduce an oral, adversarial trial system into Mexican courts, which aims to speed up the administration of justice, currently operated on an inquisitorial, paper-based system. These reforms seek to tackle a number of very difficult issues facing Mexico’s criminal justice system, which often struggles to deal in a timely fashion with a large number of cases.
According to a 2015 report by the Institute for Economics and Peace, the gradual introduction of the oral and adversarial trial system had helped reduce the proportion of prisoners awaiting trial from around 40% of the total prison population in 2013 to 33% in 2014.
Education reforms were regarded as a response to Mexico’s consistently poor performance in international educational quality tests, such as the OECD’s Programme for International Student Assessment (PISA) tables (see Education chapter). The last set of PISA tests were published by the OECD in 2012, with Mexico ranked 53rd out of 65 countries. Poor-quality education is seen by many as one of the main obstacles to Mexican competitiveness. Alberto Serdán, head of the education lobby Mexicanos Primero, has said that the average number of years students spend in school in Mexico is currently low, at 8.3, compared to an average of 14 years in other countries.
The reforms were resisted by powerful teachers’ unions, but succeeded in bringing in compulsory assessment and performance management of teachers. They also began the introduction of a national curriculum and extended school hours, a move that should help bring the system into line with international norms. “The school calendar offers only 200 days of classes a year, and within that there are only 572 hours of effective teaching. Compare that to South Korea where there are around 1200 hours of effective teaching per school year,” Serdán told local press.
Among the other reforms approved by Congress were measures to strengthen citizens’ rights and the application of habeas corpus; new laws on data protection and freedom of information; and a set of political and electoral reforms to ensure the application of federal electoral rules to replace state regulations. In addition, the electoral reform package also created a national watchdog for elections, the National Electoral Institute.
Families Of Factors
Of particular importance to the economy starting from 2014-15 has been the interplay of three different “families” of factors, described as, a) those relating to the structural reforms themselves; b) those relating to “external shocks” caused by changes in the global economy; and c) those that can be described as a more normal component of cyclical macroeconomic management. A crude summary is that the structural reforms had an initially negative impact on growth – essentially because the fiscal reform slowed the economy down in 2014 when it had already been performing quite weakly. Although there are disagreements among analysts over their timing and force, it is expected that the structural reforms will hereafter begin to have a slow but positive effect on the economy, initially through lower electricity and telecoms tariffs, later through the impact of new investments in the energy sector and improvements in productivity across the economy. Global economic developments are also having an overall impact on Mexico. The main issues include the sharp fall in international oil prices in late 2014 going into 2015, the pace of recovery in the US economy and the previously expected normalisation of US interest rates in 2015 (billed by the US Federal Reserve as the ending of its quantitative easing programme). The third family of factors relates to how the economic team responds to these events; how, for example, the central bank responds to tighter US monetary policy when it materialises. Francesc Noguera, CEO of Sabadell Bank, told OBG, “A rise in interest rates in the US could lead to the exit of foreign investment from the country, mostly non-direct investment, but with a limited impact. Changes in global markets will keep affecting Mexico, but not like they did before. Mexico’s macroeconomic standing and sound finances should allow it to keep growing, even in adverse situations.”
Article IV Consultation
At the time of the IMF’s Article IV consultation with Mexico at the end of the third quarter of 2014 the fund took the view that the country was on-track for a gradual recovery in GDP growth, after a significant slowdown in 2013 caused by weak external demand as well as a decline in construction activity. The recovery, with GDP expansion of 2.4% estimated for 2014 and 3.5% for 2015, was seen as being based on stronger growth in the US, which was stimulating Mexican manufacturing exports to its northern neighbour, a rebound in construction and residential investment, and an increase in government spending on infrastructure.
Unemployment of close to 5% was seen as indicating that the economy continued to operate below potential, helping to keep inflation subdued.
Nevertheless, the IMF noted that consumer price inflation had risen to 4.5% in early 2014, reflecting the once-off tax changes introduced at the beginning of that year, including the elimination of value-added tax discounts and the addition of new taxes on soft drinks. However, it expected inflation to stabilise at around 4% and then fall further in 2015.
The central bank, Banco de México (Banxico), had cut its policy rate by 50 basis points in June 2014 to 3% to inject a degree of stimulus into a weak economy. Fiscal management had been broadly in line with plans, with the public sector borrowing requirement for 2015 coming in at slightly over 4% of GDP. Commercial bank credit to both households and companies had been on a moderately falling trend, while lending by the public sector development banks was rising sharply from a low base. The current account deficit was expected to remain at around 2.1% of GDP as rising factor payments offset an improving trade balance. Exchange rates had depreciated modestly since 2013. Foreign currency reserves were considered “adequate for normal times according to a range of standard reserve coverage indicators”, according to the Article IV consultation report.
The IMF also noted that in February 2014 ratings agency Moody’s had raised the country’s foreign currency reserve rating to “A3” reflecting the positive impact of structural reforms on future growth. Overall, the Article IV consultation was strongly positive: a press release by the fund said its directors had “underscored the importance of strong and steady implementation of the structural reform agenda. Properly sequenced and executed, these reforms would boost productivity and output growth over the medium term”.
Oil Slump Affects Growth
While much of the IMF’s diagnosis remains true, in the six-month period following the Article IV consultation the sharp decline of international oil prices created a new situation.
Lower oil prices had two negative effects for Mexico: first, they reduced fiscal revenues at an inconvenient time – the government had previously been able to reduce its tax dependency on the oil industry; and second, they weakened international interest in the liberalisation of Mexico’s oil and gas sector, meaning the government did not meet its target of $12.5bn of new investment for the initial round of hydrocarbons bidding. By the April 2015 update of the IMF’s World Economic Outlook, the fund had adjusted its growth projections for Mexico downwards. In general terms it noted that Latin America faced growing headwinds caused by lower commodity prices. The IMF now estimated Mexico’s 2014 GDP growth at 2.1%, down from 2.4%, and forecast 2015 growth of 3%, down from 3.5%. Growth is expected to rise 3.3% in 2016, though this is less than the previous estimate of 3.8%. The IMF, nevertheless, stressed that “even though earlier forecasts have been pared back once again”, Mexico retained a “comparatively favourable outlook”. It noted that demand from the US was supporting Mexican activity levels although domestic demand and business confidence had yet to perk up. Lower oil prices would have a limited impact on growth because the oil sector now represents a relatively small share of GDP, but they were prompting a “modest fiscal tightening” for 2015.
The IMF also said that, “potential long-term gains from reforms in the telecommunications and energy sectors remain significant, though persistently low oil prices could dampen investor interest over time.”
Many economists share the view that the Mexican recovery will continue throughout 2015, but there is a range of opinions over how strong it will be. GFN orte’s research team told OBG, “We expect the Mexican economy to grow slightly above 2% year-on-year in 2015, after 2.1% in 2014 and 1.4% in 2013. Our forecast is based upon these pillars: an important boost coming from external demand, on the back of positive growth prospects in the US, particularly in terms of consumption, manufacturing activity and the fact that some of the recent investments in the car industry will start production in 2015; and better consumer and business sentiment, as we have left behind the negative effects of the fiscal reform. However, lower oil output has been an important drag this year.”
Carlos Serrano, chief economist for Mexico at BBVA Bancomer, told OBG, “Mexico can achieve a trend growth rate of 3%, but in 2015 we think we will see a lower number, perhaps in a 2.2% to 2.8% range.” He gave three reasons for this: “First, Mexico is closely linked to the US economy, and although the US looks good, it had a slow start to the year in the first quarter. Second, Mexico has suffered two external shocks, a combination of lower oil prices and production, which will have a negative impact on state finances. Third, a number of infrastructure projects, including large road and rail investments, have been cancelled or postponed.”
The End Of Quantitative Easing
There was also a degree of uncertainty over financial variables. The key issue was the likelihood of increased US interest rates in the second half of 2015, a move which in the worst case scenario could lead to an investor flight to quality, increasing capital outflows, accelerating peso depreciation and forcing a sharp rise in domestic Mexican interest rates, thereby slowing the economy again. However, the markets remained confident of Banxico’s ability to respond in a measured and proportionate fashion to any US monetary policy changes, which had in any event not materialised as of October 2015.
As expected by the IMF and others, retail inflation had come back down into the central bank’s 2-4% target range (3.1% in the 12 months to April 2015). As a result, Banxico has left its key interest rate unchanged at 3% since mid-2014, with analysts expecting it to remain at that level for a number of months. GFN orte notes, “Banxico has adopted a hawkish tone that suggests the monetary authority will hike rates in tandem with the US Fed.” It further expects the central bank to maintain the spread between Mexico’s rate and the US federal funds rate, rather than focusing on the absolute level of the Mexican rate. GFN orte thus foresees a tightening cycle in 2015 of 50 basis points, with the Mexican rate ending the year at 3.5%. As of July, it was at 3%.
Sergio Martín, director of economic studies at Bancomext, a state development bank specialised in lending to the export sector, is optimistic over the long term. Although Mexico is experiencing a moderate recovery, it has a strong medium-term potential, he said. “We can be confident of achieving high growth, some 5% per annum, neither more nor less than that, on the basis of Mexico’s structural economic changes and its favourable international position, shared only with Canada, of having a frontier with the world’s number-one consumer market, the US,” he told OBG.
Some analysts suggest that the sluggishness of Mexico’s recovery may reflect the segmentation of its economy. While in the past there has been discussion of “two Mexicos” (one advanced, one less developed), some economists now talk about three. Manuel Molano, deputy director of the Instituto Mexicano para la Competividad (IMCO) has developed a theory that segments the country according to rates of return on investment. “We think there are three Mexicos,” Molano told OBG. “There is a part of the Mexican economy which is like China. It is closely linked to free trade and to business activities that rely on networks, things like transport, telecoms, banking and automobiles. It represents about 35% of GDP and the activities within it grow at annual rates of 4.5% to 18% – the average is probably close to double digits.” The second part of Mexico, according to IMCO, representing approximately 45% of the economy, is more closely linked to domestic consumption and is stagnant. “The largest activity here is real estate services, representing 20 percentage points of GDP and growing at around 2.5% per annum. This is where most Mexicans’ savings are going: we invest heavily in property probably because we are risk averse,” Molano said. “The third part of the Mexican economy is made up of sectors that are lagging behind, where value is being destroyed. This segment makes up 16-17% of GDP and includes oil and gas, residential construction and agriculture,” he added.
A Matter Of Method
Others divide up the Mexican economy in different ways. One approach is to see it geographically, with high-productivity manufacturing linked to the US market dominating the north, a more domestic-consumption focused sector, with oli-gopolistic features occupying the centre of the country, and a poorer more informal sector in the south.
The common feature of these segmentation-type theories is that they seek to explain why the current stimulus generated by the strong US economy appears to be having an unequal effect. Seen from this perspective, one of the hoped-for results of the structural reforms is to achieve greater integration between the different parts of the Mexican economy.
In many ways the key issue holding back economic growth is the division of the workforce into formal and informal workers. Informal workers are those who are outside the tax and benefits system. This segment of the labour pool is estimated to represent around 58.2% of the economically active population.
This high level of exclusion, coupled with also-high poverty rates means that traditional instruments of fiscal and monetary macroeconomic management are much less effective than would otherwise be the case. Government attempts to reduce informality have so far failed to achieve major progress.
Molano felt the existing tax structure did not help. “I think we have put too high a price on the formal sector in Mexico,” he told OBG. “A well-off salary earner in Mexico pays a 35% tax rate, while someone who is poor pays 20%, but the well-off individual has a lot of expenses which are tax-deductible, such as medical bills, mortgage interest, children’s education and so on, so the richer person ends up paying a lower effective rate of tax than the poorer person. So there is very little incentive for the poorer person to be a formal tax-payer.”
During the second quarter of 2015 the economy remained on a slow and slightly mixed improvement path. Industrial production was weak in the first quarter, and mining contracted, described by Neil Shearing, chief emerging markets economist at Capital Economics, as giving an overall impression “of an economy that is not yet firing on all cylinders”.
While initial investor and market excitement over the structural reforms has been tempered by low oil prices and a degree of nervousness over the potential effects of monetary tightening in the US, it remains the case that Mexico is set for growth in 2015, a process that will continue into 2016. The expansionary trajectory forecast for the country comes at a time when a number of major Latin American economies (such as Brazil, Argentina and Venezuela) are expected to be in recession. As a result, Mexico is highly likely to grow faster than the Latin American average over the next couple of years and beyond, reversing the trend of the last two decades. Despite a number of uncertainties this looks set to stand out as an important achievement.
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