MEXICO ECONOMIC
OUTLOOK (2016-2018)
Alfredo Coutiño
University of Toronto
Project LINK
Institute for Policy
Analysis
Toronto, Canada
October 19-21, 2016
Articulo original publicado por University of Toronto - Rotman School:
1. Recent Trends
The economy
performed at its limited potential capacity in the first half of 2016, but started to
show signs of deceleration. The ongoing fiscal adjustment and monetary
normalization are withdrawing the stimulus to domestic market. Inflation
remains below the 3% target but shows an upward trend, which will be fueled by
the persistent currency depreciation. Growth will decelerate to below potential
rates this year. Prospects for the medium term are subject to the size of structural
changes to be produced by reforms in place.
In the first semester,
the economy advanced at a rate just around potential growth. Since the economy
has been running at a steady speed consistent with its production capacity, the
output gap has closed. The output gap's closure indicates that the economy was
functioning at capacity or full employment of resources. Therefore, the fiscal
and monetary stimulus measures are no longer needed and prolonging them could
fuel inflation to rates above the 3% target. Pushing the economy beyond its
steady state will only develop macroeconomic imbalances.
Growth was
reported at 2.5% in the second quarter and 2.4% in the first quarter. Growth
has averaged 2.6% in the past eight quarters, indicating that the economy has
reached its steady state. Even though the external environment has not improved
significantly, the economy has stayed around its potential growth (2.6%). The
national industry advanced further, benefiting from a domestic market propelled
by monetary expansion.
Inflation is
showing an increasing trend as the positive factors have vanished this year.
Consumer prices are now moving more consistently with the structure of price
formation. Certainly, inflation still stays below the 3% target, but has
increased from 2.1% last December to 2.9% in September. Core inflation is
reflecting the pass-through effect from the currency depreciation to prices of
imported merchandise, thus increasing from 2.4% in December to 3.1% in
September. Inflation will continue to trend up as the currency pass-though will
affect consumer prices. In fact, the prolonged money expansion and the
depreciation of the peso will prevent inflation from remaining below target.
Monetary
conditions moved into neutral territory in June of 2016, after staying
stimulative for domestic absorption with most of the stimulus still
accommodating in imports and some inflation. The policy rate has been hiked by
125 basis points from its expansive level of 3% in the previous two years. The
peso remains depreciated, but the interest rate is now used as a second buffer
since February when the central bank was forced to implement a surprising and
significant rate hike. In June, the policy rate was increased by another 50
basis points to 4.25%, and will probably report at least one more hike before
the end of the year.
The labor
market has advanced slowly because of the economy’s below-potential
performance. Some temporary jobs have been created, although private firms
remain cautious in hiring since they are affected by domestic uncertainty and
global volatility. Employment will improve as the economy strengthens, but the
creation of jobs will be limited since the increase in productivity generated
by reforms will displace low-skilled workers.
The Mexican
peso has weakened significantly since the end of 2015 and remains depreciating
since the currency adjustment is mostly a correction. Domestic monetary policy has
tightened in 2016, mainly to reduce capital outflows generated by the monetary
reversal in the U.S. The loss of competitiveness in the bond market is forcing
policymakers to act ahead of the Federal Reserve’s rate hike cycle. Further
monetary tightening could be necessary in the event of the ongoing currency
depreciation. This way, Mexico will deal with the financial
volatility—generated by the global monetary tightening—by using the more
effective dual system of shock absorbers: the exchange rate and the interest
rate.
Mexico’s new
reforms will benefit the economy’s potential capacity in the medium term. However,
the size of the economic impact will depend on the magnitude of the structural
changes produced by the main reforms. The key is not the quantity but rather
the quality of reforms. The country is moving in the right direction by
strengthening the fundamental sources of permanent growth, but it will take
time for the economy to increase its production capacity.
2. National Policy
Assumptions and International Environment
Our Baseline Scenario for the
Mexican economy is based on three main assumptions: economic policy, structural
changes, and international conditions.
The first assumption establishes the country’s
return to macroeconomic discipline as a necessary condition for preserving
stability and keeping the economy near the equilibrium. Economic policy, in
general terms, will be mainly focused on stability in order to create favorable
conditions for growth and employment. However, in order to generate growth and
employment, stability will not be sufficient. Therefore, economic policy must
have to be accompanied by public policies to directly promote social progress
and reinforce the fundamental sources of permanent growth (saving-investment,
productivity, and technological change), which in turn will increase the
country’s potential to grow. However, in the short run economic policy has focused
on strengthening the domestic absorption in order to compensate for the
prolonged external weakness, which has so implied wider fiscal and external imbalances.
The second assumption considers the effective
implementation of the already-approved structural reforms, particularly in the second
half of the ongoing administration (2016-2018). The fiscal reform will continue
to improve the efficiency of the tax system, while the energy reform will
increase the production capacity in the oil industry. The government could also
implement changes that do not require Congress approval, particularly those
reinforcing institutions and the application of the law. In the medium and long
term, there is a possibility of deepening the reform process, which will increase the country’s production
capacity throughout the next decade.
The third assumption includes the improvement
of the global economy. The U.S. economy will continue to strengthen in the
coming years. Growth this year will be around
1.5%, and will stay between 2% and 2.5% in the following two years. In the
medium term, with most of fiscal problems resolved, the U.S. economy is
expected to advance at rates consistent with its potential growth. We expect
the Fed to continue normalizing the policy interest rate between the end of
this year and along 2017, moving the rate at a very gradual pace toward
neutrality to let the economy advance in an environment of price stability.
Domestically,
monetary policy is expected to return to a management consistent with the
“inflation targeting” approach in
order to keep inflation under control and preserve the currency stability. In
the short term monetary policy will move into restrictive territory to avoid
the inflation acceleration. It will stay a little restrictive next year, with
the possibility of tightening even more in case of a significant inflation
rebound generated by the steady peso depreciation. The central bank will effectively
apply the use of the dual mechanism of external-shock absorption through the
flexibility of the exchange rate and interest rate. In case of unexpected
volatility, this automatic mechanism could be accompanied by discretionary
monetary interventions to restore market stability. In the following three
years fiscal policy will still remain in deficit, although decreasing. At some point
in the medium term, fiscal policy is expected to be
managed by the effective application of the structural rule in order to better
contribute to macroeconomic stability.
The international market of oil will remain affected
by geopolitical events in the short term. In the longer term prices will start
to adjust up as demand and supply return to more normal conditions. The price
for the light crude in New York (WTI) will average around $38 dollar per barrel
(dpb) this year, around $40 next year, and will recover a little more in 2018.
The price for the Mexican crude will average around $35.50 dpb this year, $37.50
next year, and around $40 in 2018.
3. Forecast Summary
Our Baseline
scenario foresees an economy with no improvement this year, advancing at still-limited
rates since the impact of reforms will only be felt in the medium term. The medium-term
recovery will be the result of some positive factors: a domestic market gaining
some steam by the improvement in purchasing power, some strengthening of the external
demand, and positive effects generated by new reforms. Even though growth will
still remain restricted by the limited potential capacity, the economy will
advance at a rate of 2.2% this year, after 2.5% in 2015, and will grow 2.4 in
2017. In the medium term, the economy will advance at rates determined by the
increased production capacity, between 3% and 3.5%.
Inflation will end this year above
the 3% central target, pushed by the significant currency depreciation and the
still remaining excess liquidity. Next year, inflation will be higher since it
will return to its structural rate around 4%. Under these circumstances,
policymakers will keep monetary conditions mildly restrictive until the fiscal
policy corrects the imbalance and opens space for monetary policy to return to
neutrality. Rates could turn even more restrictive if volatility worsens as a
result of a market overreaction to the Fed’s monetary normalization.
New reforms will certainly
benefit the economy’s potential capacity. However, the size of the economic
impact will depend on the magnitude of the structural changes produced by main
reforms. The greater the economic opening the bigger the impact on potential
growth. Mexico is certainly moving in the right direction of strengthening the accumulation
of capital, which in the end will increase productivity and promote
technological progress.
The flexible exchange rate mechanism will be
preserved, with the hope that the foreign exchange market will adjust the
Mexican peso at a speed equivalent to at least the differential of inflations
between Mexico and the U.S. However, in the medium term there exists the
possibility of a significant arrival of foreign direct investment attracted by
new reforms. Therefore, the current account deficit will increase –in absolute
and relative terms– as a result of the economy’s dynamics and also as a
consequence of some currency misalignment.
The new
production capacity generated by reforms, together with the positive effects
from the U.S. recovery, will determine growth in the future. However, in order
to promote a growth path free of imbalances, in the long run the economy should
be functioning around its new steady state rate (3.0%-3.5%).
4. Uncertainties
Some downside risks remain in the horizon,
which could generate a pessimistic scenario in the near future. On the domestic
side, there is an important downside risk that has to do with a potential
increase in the country’s vulnerability to financial shocks. Persistent fiscal
and external imbalances and the associated potential loss of policy credibility
could make the country more vulnerable to speculation and financial crises. As
a result, the economy’s capacity could be hurt significantly, with significant consequences
for social well being.
On the external side, we identify three main
risks. First, since the Mexican economy is highly
dependent on the U.S. performance, the main risk comes from a potential
weakening of the northern neighbor. Under that scenario, the U.S.
weakness will have significant impact on the Mexican economy. Second, a scenario of a return to recession
in Europe and more severe fall in oil prices would impose severe constraints to
Mexico's performance in coming years. Third, the potential collapse of the
Chinese housing market with severe consequences on the economy and the global
financial system, thus affecting the U.S. economy and consequently Mexico.
