Washington, DC: Mexico faces a challenging environment as global inflation has surged. Even though the post-pandemic recovery has been relatively gradual, domestic inflation has accelerated to levels not observed in two decades. Near-term growth prospects for the United States have weakened, as real incomes are eroded by inflation and both fiscal and monetary policy are tightening. In general, global financial conditions have tightened as central banks have responded to high inflation, increasing the risks of capital flow reversals in emerging market economies.
Mexico is well placed to navigate this potentially turbulent environment, given prudence in macroeconomic policy and solid fiscal and monetary policy frameworks . Nevertheless, scarring from the pandemic and the more difficult global environment could compound the long-standing problems of low growth and high inequality. As a result, despite strong outturns in the first half of 2022, growth is projected to decline in the next few quarters. Inflation is expected to plateau in the second half of 2022 and then decline gradually, as higher raw food prices and other cost-push factors continue to feed into prices. The balance of risks to the growth outlook is tilted to the downside while inflation risks are skewed to the upside. More persistent global or domestic inflation, another spike in international oil or food prices, a greater-than-expected tightening of global financial conditions, or a sharper slowdown in U.S. growth are the main downsides that Mexico may need to contend with. On the upside, an acceleration in nearshoring of economic activity for better access to the North American market could moderate the impact of lower U.S. growth.
Tackling High Inflation
Banco de México (Banxico) has taken a proactive approach to addressing increasingly broad-based inflation. Successive and gradually larger increases in the reference rate have brought the ex ante real policy rate (i.e., the nominal rate adjusted for one-year ahead inflation expectations) to restrictive levels. This has been an appropriately calibrated response to the upward surprises to inflation. Banxico has also rightly indicated its intention to further increase the policy rate.
Returning to low and stable inflation will likely require some further increases in the policy rate by the end of the year and maintaining it there for some time. The proactive policy tightening already put in place, alongside some further hikes broadly consistent with market expectations as well as incoming data, should lead to a decline in inflation. However, there is significant uncertainty about the timing, speed, and durability of the downward path for inflation in 2023. Further, there are important upsides to inflation from commodity prices, supply chain constraints, local food prices, a feed through to prices from the increase in the minimum wage, inertia in wage and price formation, and increases in near-term inflation expectations. As such, a risk management approach would argue for policy rates to be clearly restrictive for some time to mitigate these upside risks and firm up near-term inflation expectations around Banxico’s 3 percent target.
Particularly in the current environment of uncertainty, clear monetary policy communication will increase policy effectiveness. Banxico has begun publishing inflation forecasts and an indication of the likely direction of future rate changes with each monetary policy decision. These efforts will help the public better understand how the Governing Board sees the current economic environment and the policy decisions they have taken. To further strengthen this understanding, Banxico could start publishing information on the policy rate path that underpins its macro forecast, including the expected terminal rate in the tightening cycle and its duration. This path should be viewed as guidance and not a policy commitment. However, even as this expected path changes over time it would provide valuable information on the central bank’s policy reaction function. A broader review of the experience with Banxico’s inflation targeting framework in due time could also provide useful suggestions for further improvements to the policy framework and the communications toolkit, building on recent improvements.
Continued large minimum wage increases could create upside risks to inflation. Minimum wages are now close to the formal sector median wage, which creates risks of adverse employment effects and an increase in informality. The large minimum wage increases envisaged for the next two years could further add to inflationary pressures at a time when it is critical to return to low and stable levels of inflation.
Many of the fiscal measures put in place to mitigate the impact of the rising cost of living have been untargeted. Retail fuel price stabilization has reduced cost pressures for the economy, likely lowering inflation by close to 2 percentage points around the recent peak of global oil prices peaked. However, this has come at a sizeable budgetary cost (estimated at 1.4 percent of GDP in 2022) and has also benefited higher income households. Furthermore, by diluting price signals, the policy has short-circuited the needed adjustment in fuel demand. The budgetary cost of measures to mitigate the impact of higher food prices have been smaller, although they have sought to address multiple objectives and their overall economic impact is difficult to assess. In addition, the large increases in social (noncontributory) pensions in the past few years have also contributed to cushion the rising cost of living.
However, these fiscal measures and the increases in the minimum wage—alongside the post-pandemic rebound in the broader economy—have helped support real incomes. CONEVAL data suggests that real per capita labor income increased by 4 percent as of mid-2022, while labor income poverty decreased further (to around 40 percent of the population from a peak of 46 percent in late 2020). Primarily, these achievements reflect the economic recovery, improving labor market conditions, and a continued high level of remittance inflows. However, higher minimum wages and untargeted fiscal support have also helped protect the vulnerable. With global oil prices falling, the budgetary costs of the fuel pricing mechanism should be declining.
The neutral fiscal stance in 2022 and 2023, underpinning the proposed budget, balances well the need to support monetary policy in disinflating the economy while not creating a material drag on activity. With the economy currently operating at close to potential and a priority to restore low and stable inflation, a restrictive monetary stance and broadly neutral fiscal stance appears to be an appropriate policy mix. However, contingency plans should be developed so as to have ready targeted support strategies that could be deployed in the event that downside risks to activity were to materialize.
Policies to Manage Downside Risks
There is scope to make the fiscal position more responsive to demand conditions while maintaining a prudent overall framework . Mexico’s fiscal framework includes both a balanced budget rule and constraints on debt issuance, which significantly constrains the ability of fiscal policy to play a countercyclical role in the event of a downturn. Modest steps could, however, increase the ability of fiscal policy to provide support in the event that downside risks materialize:
Changes to the domestic fuel pricing regime would enhance fiscal flexibility. Higher oil revenues are typically able to cover the higher cost of the retail fuel price stabilization mechanism when global oil prices increase. However, some greater passthrough of global fuel price changes to domestic retail prices would create fiscal space in the budget when oil prices are high that could be used for increased spending on existing social safety net programs that would provide targeted support to those most affected by the increase in retail prices.
Further adjustments to Pemex’s business strategy would insulate the budget from the risk of having to absorb losses if oil prices fell substantially. It would also increase the profits when prices are high. Adjustments could involve encouraging greater private sector participation or sales of non-core assets, which could be used to lower Pemex’s debt burden.
· Rebuilding fiscal buffers soon would allow fiscal policy to respond quickly in the event of a negative shock. The stabilization fund ( Fondo de Estabilización de los Ingresos Presupuestarios) has less than 0.1 percent of GDP in resources available to respond in the event that downside risks are realized—rebuilding these reserves to around 0.3 to 0.5 percent of GDP would increase the ability to respond at a relatively small fiscal cost.
A more comprehensive assessment of the institutional framework for fiscal policy may prove useful. Such a reform could include an explicit debt anchor with narrowly defined escape clauses and a clear mechanism to return to the debt path following periods of deviation. This would help increase transparency and guide market expectations for the medium-term fiscal path, while providing flexibility to respond to unanticipated shocks.
In the event of an unexpected tightening of global financial conditions and larger capital outflows, peso depreciation would act as a shock absorber . With deep foreign exchange (FX) markets and contained FX mismatches in balance sheets, the economy is expected to remain resilient if downward pressure on the peso materialized. Policy rate hikes could be used to counter any marked inflation passthrough or a rise in inflation expectations, while FX intervention could be considered in the case of disorderly market conditions.
Mexico has a robust financial system but with low levels of financial inclusion. Systemic vulnerabilities appear broadly contained and the financial system is emerging from the pandemic with higher capital buffers, lower private sector leverage, and no sign of stretched asset prices. However, the system provides less finance to the real economy than in peer countries although digital finance, while still embryonic, holds the promise of increasing financial access.
The FSAP found that the financial system appears resilient. Under the adverse scenario, with low growth and high inflation in major economies and disruptive global financial tightening, high initial levels of capital and strong profitability would help banks absorb most credit and market losses. Liquidity risks for individual banks and other financial institutions are expected to be well-contained. However, some areas—contingent credit lines and concentration risks—merit supervisory attention. System-wide liquidity risks also appear contained, but global liquidity shocks could generate tail-risks. Overall liquidity conditions should continue to be monitored carefully and the high reliance on short-term funding by development banks merits a closer look, though risks are mitigated by the sovereign guarantee for their liabilities. Risks from cyber and climate events are important additional concerns. Climate risk analysis, while uncertain, points to long-term adaptation needs, as in other parts of the globe.
Additional measures would help Mexico remain resilient in a changing financial and regulatory landscape . Good progress has been made in rolling out critical Basel reforms, improving supervisory approaches, building cybersecurity capacity, and enhancing recovery and resolution planning of commercial banks. The evolving risk environment flags the need for upgrading the financial sector oversight and crisis management frameworks to close identified gaps and address emerging challenges. The FSAP highlights the following recommendations:
(i) Strengthen the autonomy of regulatory government agencies and the legal protection of supervisors. The evolving risk environment (e.g., climate and cyber risk) points to the need for increasing the resources and skills in the regulatory agencies;
(ii) The framework for, and application of, consolidated supervision needs significant enhancement. CNBV could strengthen supervisory techniques by simplifying and using more principle-based methodologies. Consideration could be given to integrating climate risks into prudential supervision and introducing disclosure requirements for firms and investors;
(iii) Plans for finalizing and publishing a guideline for the countercyclical capital buffer are welcome. Action on the process to introduce limits on loan-to-value and debt-service-to-income ratios would help to build resilience to housing risks in the medium term as the current early stage of the financial cycle evolves;
(iv) Banxico and CNBV have made significant progress in strengthening the cyber resilience of the financial system, but further enhancements are needed on strategy, oversight, implementation, and information sharing. Continued careful consideration in the design phases of Banxico’s central bank digital currency project will be needed;
(v) Banxico’s approach to liquidity management demonstrated flexibility and resilience during the pandemic but some refinement of the Emergency Liquidity Assistance could be considered; and
(vi) There is a need to grant power to the resolution authority to remove impediments to banks’ resolvability and to eliminate barriers to the effective use of purchase and assumption and bridge bank tools.
Policies to encourage financial inclusion should be deepened in order to combat inequality and support growth. Recent efforts remain relevant to promote access to financial services including to broaden access to digital connectivity; and improve the transparency of financial services. The authorities should continue to foster entry and expansion of new participants, in particular fintech, to increase competition in the financial sector, encourage financial institutions to seek a wider base of customers, and reduce intermediation costs while maintaining safeguards to ensure financial stability.
Enhancing the effectiveness of the AML/CFT framework is the next step in strengthening the regime. Mexico has made good progress in aligning its legal and regulatory framework with Financial Action Task Force standards. The challenge is now to strengthen enforcement of the AML/CFT regime, including through adequate resourcing. Efforts should also continue to ensure the availability of high-quality beneficial ownership information, strengthen consolidated supervision, and monitor emerging financial integrity risks related to fintech.
Policies for Higher and More Equitable Growth
A broader structural policy agenda would enable Mexico to raise prospects for growth and job creation. Despite increased trade openness and macroeconomic stability since the 1990s, productivity growth has been weak with the growth in output per worker averaging close to zero over the past 15 years. In response, the authorities are seeking to promote trade (including in poorer Southern regions through infrastructure projects that support trade integration) and to reduce inequality (through increases in the social pension and the minimum wage). This agenda will address some obstacles to higher productivity and growth but additional efforts are needed on: (i) addressing corruption, crime, and the weak rule of law; (ii) fiscal reforms to raise human capital and address infrastructure bottlenecks; and (iii) reducing labor and product market rigidities.
Determined implementation of the anticorruption framework would enhance its effectiveness. A new law treating corruption and fraud as felony offenses is expected to enable more comprehensive investigations of corruption. With an anticorruption framework in place, implementation and assessing effectiveness of the policies are now the priority. Strengthening prevention, facilitating reporting including whistleblower protection, and further empowering institutions in charge of investigation, prosecution, and oversight can improve implementation. IMF staff encourages Mexico to participate in the IMF’s voluntary assessment of transnational aspects of corruption in the next Article IV. Furthermore, strengthening the enforcement of contracts by the judiciary would support business investment and job creation.
A gradual increase in productive government spending, financed by policy reforms to raise tax revenues, would promote growth and equity. Higher spending on education, health, public investment, and social protection is critical for improving human capital and infrastructure and narrowing the significant variation in social outcomes across states. A gradual, permanent increase in public spending of 2 to 3 percent of GDP, would be a feasible step towards achieving Mexico’s Sustainable Development Goals. To be effective, this higher spending would need to be accompanied by increased program and public investment efficiency, building on recent steps taken by the authorities to improve spending control and program design. For example, the efficiency of social assistance programs could be strengthened by lowering the sizable leakage of benefits to high-income groups and reducing overlaps and coverage gaps across multiple programs (e.g., by creating a single beneficiary registry).
There are a range of options to raise tax revenues. Before the pandemic, Mexico’s non-oil revenues were nearly 6 percent of GDP below Latin American peers and only about half the OECD average. Recent tax administration reforms, including through OECD Base Erosion and Profit Shifting actions, have helped buoy revenues. However, a credible and well-designed medium-term tax policy reform could generate additional revenues of 3 to 4 percentage points of GDP without having a deleterious growth impact. Reforms could draw on the following menu of options:
Value added tax (VAT). Eliminating zero-ratings (except for a few essential foodstuffs), rationalizing exemptions and differences in rates, and further reducing compliance gaps. This should be accompanied by increases in targeted benefits to offset the impact of such changes on the poor.
Personal income tax. Eliminating exclusions (e.g., of income on personal business activities and independent services), reducing tax expenditures, and widening the top personal income tax bracket would increase revenues while making the system more equitable and progressive.
Subnational taxes. Property tax collections could be increased by updating the cadaster, enhancing policy coordination between the federal and subnational governments, and simplifying and better enforcing the local vehicle tax.
Carbon tax. The carbon tax introduced by Mexico in 2014 remains relatively narrow in scope (natural gas is de facto exempt). The tax rate of USD 3 per ton of CO2 could be raised gradually to USD 50 per ton of CO2 by 2030. Doing so would be consistent with the global carbon tax floor proposed by the IMF for G20 economies. As with changes in the VAT, increases in the carbon tax should be combined with targeted compensation to offset the impact on poor households.
Together, such budget reforms would increase growth and help to maintain a sound fiscal position ( IMF Staff Report 2021 ).
Recent labor market reforms should be adapted to lessen their negative effects on formal sector employment. Reductions in the number of qualifying weeks for pension eligibility risk reducing labor supply incentives for older workers. Meanwhile, informality remains high at 55 percent of the working population. Based on current policy intentions and adjusted for expected inflation, minimum wages could increase to the current median wage levels in the formal sector by 2024, increasing the incentives for informality. Changes to the current strategy could include: (i) continuing to improve labor dispute resolution mechanisms, building on the experience of the 21 states that have already implemented it; (ii) lowering firing restrictions; (iii) reducing the regulatory costs of formalizing a business; and (iv) aligning increases in the minimum wage more closely with expected inflation plus the increase in productivity of lower wage workers.
The implementation of the USMCA trade agreement will help bolster growth. The agreement with the U.S. and Canada reduces regulatory divergence, complementing the elimination of many tariffs under NAFTA. An important challenge for Mexico will be to increase the domestic value-added content of exports to meet the tighter rules of origin included in the USMCA (particularly in the automotive and textile sectors). Strengthening education and training and fostering greater competition among suppliers would help increase the attractiveness of Mexico as a supply chain location, raising the value added of local manufacturing.
Putting in place a more predictable energy policy that is more open to private sector participation would boost competitiveness and investment. Reestablishing more market-oriented regulatory frameworks would leverage Mexico’s large and diverse renewable energy resource base. It would also incentivize investments that would ultimately create a cheaper, more reliable, sustainable, and competitive energy supply.
Further steps toward carbon pricing would reduce greenhouse emissions. The expansion in 2023 of the emission trading system (ETS), which is currently in pilot phase covering a small number of large entities, will be an important step towards comprehensively pricing emissions. But ensuring adequate coverage, enforcement, and monitoring of polluting activity, introducing legally binding emissions caps, and introducing the planned auction system for allowances are key to making the ETS fully functional. Further, sectoral measures, such as feebates, public investment in clean energy infrastructure networks, and regulatory reforms in the energy sector could increase the impact of carbon pricing.
The IMF staff team is grateful to the Mexican authorities and other counterparts for their time and constructive discussions.