Two basic ideas have changed dramatically the course of modern Mexican economic history: stabilize and open. After the tumultuous decades of the 70s and 80s these ideas seemed radical for a country that had explored alternative routes trying to find its way into the future. Mexico excelled at both and became an example for other emerging economies.
As the world continues its march towards nationalism and populism, it appears that these pillars of the Mexican economy are under threat. Looming credit downgrades and a challenging environment for domestic institutions are already fueling a generalized sense of pessimism even before a tough renegotiation of the bilateral relationship with the US kicks off. The decline in the value of the currency and other Mexican asset is being used by financial and political pundits to alarm people about an upcoming crisis. They will be disappointed.
At a time when Mexico was making global headlines for its reformist impetus in energy, competition and telecom, among other sectors, a series of sequential shocks turned upside-down a bright economic outlook. A deteriorating domestic political environment only magnified the negative effect of subdued growth and a challenging fiscal reality, mainly triggered by a decline in oil production and prices. A global recession of industrial production and trade over the past four years has only made matters at home worse.
Although growth projections in Mexico have been revised down for the past 4 years, this has been mainly due to a weak overall external environment. Negative revisions to GDP growth forecasts have occurred in developed and emerging economies consistently since 2013 (see graph). In a sense, the world has been adjusting gradually to a new paradigm of lower economic growth, due to a number of structural and cyclical factors.
The Mexican economy has been experiencing excess domestic demand, as credit growth has surpassed nominal GDP growth in recent years and a strong labor market has fueled consumption, turning it into the most important driver of growth. Thus the external accounts have been deteriorating both because of the negative terms of trade shock related to oil and the widening of the fiscal deficit. Notwithstanding the conservative constitutional and legal framework for the use of public debt in Mexico, it has gone from 37% of GDP in 2011 to more than 50% this year.
But in spite of these challenges, the Mexican economy remains resilient. The existence of deep and liquid local financial markets have allowed the exchange rate and interest rates to fluctuate, operating as automatic stabilizers and facilitating the macroeconomic adjustment required to go back to sustainable growth. Monetary and fiscal policy have been operating in coordination to face the current shock and becoming the main anchors of the economy.
The Central Bank has raised interest rates more than 300bps in the current tightening cycle and markets still expect more, while fiscal policy has also delivered a significant reduction of the public sector borrowing requirements, going from 4.1% of GDP in 2015 to 2.9% in 2016 and a further 0.5% of tightening is expected for this year. The recent increases in gasoline prices are a testament to the government’s commitment to fiscal responsibility even in a complex domestic political environment.
Tighter fiscal and monetary policy are already helping to stabilize the current account deficit even after the deterioration of the oil related trade balance. The steep depreciation of the real exchange rate is also playing a countercyclical role contributing further to an improvement in the current account, mainly through a growth pick up of non-oil exports. BlackRock’s proprietary GPS indicators show that there is a broad recovery underway of external demand, which means that Mexican exports are likely to continue well supported.
Although inflation has started to go up due to the pass through of currency depreciation and the recent gasoline price hike, medium term expectations have remain contained. Sequential inflation may be already peaking, even allowing the Central Bank to hike less than current market expectations.
Uncertainty about the course of the US-Mexico bilateral relationship during the Trump administration has triggered a further adjustment on Mexican financial asset prices (see graph below). But the adjustment may have gone too far, making Mexico one of the most attractive emerging markets (EM) to invest this year. The peso has already recovered some of the lost ground and is already one of the best performing EM currencies so far this year.
The real challenges that Mexico faces are actually not cyclical but structural. Even with all the benefits to the manufacturing sector that NAFTA brought, Mexico has been lagging behind the rest of the world when it comes to productivity growth. There are several factors behind the lack of productivity growth but the most important may be that Mexico has shown little progress on institutional quality in recent years. Evidence shows that when countries reach certain level of GDP per capita and become middle income economies, just like Mexico did in the 1970s, stronger institutions become a necessary condition to continue increasing GDP per capita (see graph below).
No country in the world has ever become rich without having strong institutions. There isn’t a nation that has had significant improvement in its institutional framework but continues to be poor. The engines of productivity growth are not just those related to the structure of the economy but the things that allow good business decisions to be effective and have an impact: rule of law, control of corruption, transparency, voice and accountability and government effectiveness. While Mexico ranks relatively high in the Doing Business survey it lags behind its peers like South Africa, Chile and Brazil when it comes to institutional strength.
It took almost two decades to stabilize and open the Mexican economy in the 1990s. It took another 20 years to conclude an ambitious reform agenda for telecoms, competition and energy. Let’s hope that it doesn’t take that long to address the institutional challenges that Mexico currently faces.
Despite all the pessimism in the air, Mexico may end up this year as the top performing FX and fixed income market of all emerging economies, but the medium term institutional challenges are daunting.