Mexico: looking forward with caution

Economics Department
Page 14 

Despite a difficult global environment, Mexico’s economic performance has been broadly satisfactory. The next presidential elections are in 2000 and the government will need to hold a steady course until then. 

With the crisis of confidence that accompanied the 1994 presidential elections fresh in everyone's mind, what are the elections in 2000 likely to hold in store? It does indeed appear that uncertainty mounts considerably during election periods in Mexico. At least that was the case in 1994, when the crisis resulted in the depreciation of the peso by 76% between December 1994 and May 1995 and the introduction of a draconian stabilisation plan. The impact soon made itself felt: by the end of 1995, inflation was running at over 50% and GDP had fallen by an average of 6% over the year.

Since then, the situation has improved dramatically: real GDP growth has topped 5% per year since 1996 and employment in the formal sector has risen by 14% against pre-crisis levels. Another positive factor is that the economic fundamentals are considered to be broadly satisfactory. The current account deficit is only 3.8% of GDP, inflation is now at least under control, the public sector deficit currently stands at only 1.25% of GDP and go-vernment debt, at no higher than 30% of GDP, is relatively low.

Admittedly, the financial instability triggered by the 1997 Asian crisis forced the government to steer a fairly prudent economic course. The risk of fallout from the crisis in Russia in August 1998, together with the continued decline in oil prices -- the source of over 30% of government revenues -- served only to harden this position. Although the restrictive monetary and fiscal policies put in place have not been totally successful in curbing the inflationary impact of the depreciation of the peso, they have been broadly effective in preserving confidence and hence bolstering the real economy.

That said, the good performance of the Mexican economy should be put in perspective. Real wages are still 20% lower than in 1994 and despite three years of growth, per capita output has risen by around only 3% or so.

Furthermore, there is an enormous development lag between Mexico and most other OECD countries, despite its significant progress in recent years. Clearly, given a new political and economic context, the government will have to continue to steer a careful course until at least 2000, if it is to keep investors confident and ensure a smooth transition.

The past year has brought its difficulties. Faced with continuing uncertainties on the international front, the go-vernment decided to persist with a restrictive macroeconomic policy in 1999. The crisis in Brazil in January prompted a further tightening of monetary policy. This quick response limited the contagion, since the rise in interest rates and the fall in the peso were short-lived and not nearly as marked as in the aftermath of the Russian crisis (see chart). In addition, the share index recovered by almost 40% in the first four months of the year. The news on the international front has at last also begun to look favourably on Mexico: the world price of crude oil has begun to pick up and demand in the United States, Mexico's main export market, has continued strong.

Resist lowering the guard

Nevertheless, the Mexican government cannot allow itself to be lulled into adopting a less cautious approach. There are still major areas of uncertainty and Mexico is still probably vulnerable to external developments. Oil prices may fall again for a start, and this would compromise tax revenue forecasts. Meanwhile, it would be foolhardy to rule out the risk of renewed turbulence on international financial markets. Lastly, a more pronounced slowdown in growth or simply a sharp interest rate hike in the United States would soon have repercussions on the Mexican economy.

How can Mexico build up market confidence? The last 18 months have, at least, given the Mexican government more credibility, which bodes well for the future. If the relatively limited impact of the recent Brazilian crisis is any indication, the markets view Mexico today as a different proposition to four years ago. There are a number of reasons why this is so. First, Mexico's adoption of a floating exchange rate has prevented the accumulation of major disequilibria, while providing enough flexibility to respond to external shocks. Second, when the government tightened macroeconomic policy in 1998 it did so on both the fiscal and monetary fronts. When the oil crisis threatened to undermine fiscal objectives, the government responded with three successive expenditure cuts to offset the shortfall in revenues and thus was able to meet its 1.25% deficit target. At the same time, it tightened monetary policy in order to stifle inflation -- which had already started to fall in March 1999. All the above is evidence of good policy co-ordination and has proved effective in maintaining equilibrium in the key areas of the economy.

On the domestic front, several challenges are looming. In the short term, policy continuity will be needed to reassure the markets as the elections approach. At the end of 1998, the go-vernment unveiled its macroeconomic scenario for 1999-2000. One of the stated objectives of the strategy that it outlined was to create the climate for a smooth hand-over to the next administration. Although a tight fiscal policy is to be maintained until 2000 at least -- a decisive factor in bolstering investors' confidence -- a genuine medium-term framework for at least the next four years would also be advantageous.

Broadening the tax base

Beyond these immediate considerations, certain specific areas require energetic action. One such area is the low level of tax revenues. Some measures have been taken this year and should boost receipts by almost one percentage point of GDP. Nevertheless, tax reform needs to continue. The priority is to broaden the tax base by keeping preferential schemes to a minimum, reducing the large number of goods and services that are exempt or zero-rated for VAT purposes, limiting the preferential treatment of corporation tax in specific sectors (agriculture, fisheries, land transport, publishing) and cutting the exemption of fringe benefits in personal income tax. Besides diluting revenue, these preferential schemes complicate the administration of the tax system and leave grey areas that make tax evasion easier. One possible option would be to limit zero-rating for VAT to a few staple products at most. This would be a much less costly way of focusing transfers on low-income groups.

Cutting spending in response to the pressure of events is costly because it postpones or reduces the scale of programmes, that would bring great economic and social benefits. Public spending in Mexico is among the lowest in the OECD area, at just 10% of GDP (excluding debt servicing). At the same time, the country is clearly lacking in physical infrastructure and is lagging badly behind in the social sector. The infant mortality rate, for instance, is almost 20 per thousand, as opposed to 5 to 10 per thousand in most other OECD countries. Also, substantial educational needs still have to be met; school-age children (five-to fourteen-year-olds) account for almost a quarter of the total population, which is double the OECD average. The government allocates 26% of public spending to education, which is the highest percentage in the OECD area (including Korea), but as a percentage of GDP it is substantially lower than the average spent on education.

Mexico has to make up for its lags in human resources and infrastructure provision, though to do so requires more financial resources. To avoid having to rely too heavily on oil revenues -- which are highly vulnerable to world price fluctuations -- the priority should be to increase revenue-generating capacity. The government should also commit itself to further structural reforms in several areas, particularly the financial sector, in order to secure strong and sustainable growth.

One of the major challenges for Mexico in the future will be to create employment for the rapidly growing labour force -- nearly 1 million people enter the labour market every year. Further progress towards the government's social objectives must also be made, despite the financial constraints. Initiatives in areas such as education, health care and poverty alleviation will only deliver results in the relatively long term and must therefore not be postponed, whatever the outcome of the next elections.


Mexico Economic Survey, OECD Paris, 1999. 

©OECD Observer No 217/218, Summer 1999 

Economic data


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