MEXICO CITY, Mexico — The following is a concluding statement that describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’) with Mexico. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.
- COVID-19 has exacted a tragic human, social, and economic toll on Mexico. Over 75,000 lives have been lost; unofficial estimates are notably higher. Of around 12 million workers who lost their jobs, most of whom came from the informal sector with no safety net, over 4 million remain outside the workforce. The share of the population in working poverty jumped from 36 to 48 percent. This points to the disproportionate burden of the shock on the poor and the vulnerable.
- The large social and economic costs are expected to persist. A two-speed recovery is underway, with a bounce back in manufacturing driven by external demand, alongside weak domestic demand. We project output growth at nine percent in 2020, 3½ percent in 2021, and close to 2 percent thereafter. Based on these projections, employment, income, and poverty will take several years to return to pre-pandemic levels. Not only are the gains of the past decade in these areas being set back, Mexico’s long-standing challenge of low growth appears set to worsen. Amid high uncertainty over the pandemic, risks to the economic outlook are tilted to the downside, reflecting the possible resurgence of COVID-19 domestically, prolonged disruption in labor markets, renewed global financial volatility, lower oil prices, and adverse growth outcomes in key trading partners. On the upside, early vaccine availability, advanced economy buoyancy benefiting from large policy interventions, and faster-than-expected re-absorption of workers into the labor force could boost confidence and growth.
- Against this backdrop, it is critical to limit the damage from the pandemic, set the stage for a robust recovery, and pursue strong, durable, and inclusive growth. Building on Mexico’s strengths in terms of its macroeconomic policy framework and broadly sound external and financial sector fundamentals, the authorities are encouraged to implement a comprehensive package of near-term fiscal and monetary support, credible medium-term plans to anchor fiscal sustainability, and reforms to boost investment and growth. Larger temporary near-term fiscal support would alleviate current distress as well as limit lasting economic damage. Credible medium-term fiscal reform would increase space in the near term, reduce risk premia, and generate needed resources for public investment and social spending. Further monetary easing, against the backdrop of well-anchored inflation expectations, would help support financing as well as the recovery. Our analysis suggests that—even abstracting from the benefits of reforms that tackle long-standing constraints—implementation of such a macroeconomic policy package could raise real GDP by four percentage points over the medium term and reduce the public debt-to-GDP ratio. Coupled with steadfast implementation of reforms to overcome supply constraints, this package could generate further growth and debt reduction benefits.
Mexico needs more near-term fiscal support and credible medium-term reforms
- The authorities are providing very modest near-term direct fiscal support. They increased health spending and direct budget support to households and firms by 0.7 percent of GDP. However, this compares with over three percent of GDP support among G20 emerging markets (EMs). They made available support through loans, reallocated some spending, front-loaded social pension payments, and accelerated procurement processes and VAT refunds, among other actions. They continued tax policy and administrative efforts that yielded better-than-expected revenues. The draft 2021 budget maintains these tight policy settings aimed at limiting new debt issuance. There are no concrete medium-term tax reform plans yet. Stabilization and trust fund buffers are expected to be drawn down substantially. Our preliminary projections, based on more prudent nominal growth, oil production and tax buoyancy assumptions, foresee a PSBR of 5.8 percent of GDP in 2020 and, relative to the authorities’ targets, fiscal gaps of 1¼–2 percent of GDP in 2021 and beyond. Gross public debt is projected to stabilize near 65 percent of GDP, assuming fiscal gaps are closed.
- To stem the decline in economic activity and rise in poverty, Mexico would benefit from higher temporary near-term fiscal support of 2½–3½ percent of GDP (relative to pre-pandemic policy settings). Mexico has some fiscal space and enjoys comfortable market access that could be used during these difficult times:
- Health spending.Fully accommodating pandemic-related spending on health care should remain the top priority so that cost and access are not insurmountable barriers to combating the pandemic.
- Households.The coverage of social safety net programs could be increased to include readily eligible individuals that are not receiving any benefits, people who are likely to fall into poverty owing to the pandemic, and informal workers in hard-hit sectors.
- Businesses.Beyond the loans made available for micro and small firms, liquidity support measures (e.g., tax and social security contribution deferrals) and cost-reduction assistance (e.g., wage subsidies) could be provided to viable firms.
- The announcement of a credible medium-term tax reform would increase the space for providing near-term fiscal support and is an imperative for helping close fiscal gaps, lower public debt, and finance public investment and social spending. A well-designed tax reform could raise revenues by 3–4 percent of GDP, thereby also narrowing the gap in tax collections relative to peers.
- Income taxes.Personal income tax revenues lag in international comparison owing to high informality and inequality. While raising rates can add some limited revenues, a broadening of the base is needed, and can be achieved by rationalizing inefficient and regressive tax expenditures and reducing the threshold for the top income tax bracket.
- Property taxes. Raising subnational property and vehicle registration taxes would be efficient and progressive. To avoid fragmentation of property tax administration, a federal-level agency could be created to update the cadaster and coordinate policies at the subnational level.
- Value added taxes (VAT). Apart from a few key foodstuffs, domestic zero-rate items could be eliminated and exemptions curtailed. In this regard, social safety nets could be strengthened to mitigate distributional concerns. Recent steps to improve the tax administration are welcome; consideration could be given to improving the tax agency’s organizational structure, moving toward a high-coverage audit process for VAT returns, further increasing the use of electronic means, and strengthening sanctions against tax fraud. Not renewing the border tax regime, a temporary provision for 2019–20, would limit distortions of the tax base and raise collections.
- Gasoline excises.The current policy of guaranteeing cumulative retail price growth below inflation disproportionally helps the well off and should be reconsidered.
- A reprioritization of public spending would promote inclusive medium-term growth , through high-quality public investment and stronger social protection:
- Social protection. Apart from the near-term imperative of expanding social safety nets on a temporary and targeted basis, reforms are needed over the medium term to durably strengthen social protection. These include introducing a nation-wide unemployment benefits system, and strengthening social safety nets by reducing overlaps, duplications, and leakages, as well as increasing coverage in a cost-effective way.
- Pensions. The government’s recent reform proposal can improve the adequacy and sustainability of the pension system. Considering that many workers move frequently between formal and informal arrangements during their career, complementary reforms are strongly advisable to tackle informality and increase contribution densities.
- Public investment.At about 1½ percent of GDP in 2019, non-Pemex capital spending is very low. Mexico needs higher physical and human public investment to improve productivity, enhance inclusion, and meet the Sustainable Development Goal in healthcare.
- Pemex’s business strategy is crowding out resources for essential spending. Given its widening losses, it is advisable to focus production only in profitable fields, sell non-core assets, curb plans to increase refining output at a loss, and postpone new refinery plans until it is profitable to do so. Partnering with private firms would supply needed capital and know-how. Conditional on changes to the business strategy and governance, procurement and oversight reforms, consideration could be given to fiscal support that eases Pemex’s high financing needs.
There appears to be room for further monetary easing
- Faced with challenging tradeoffs in a very complex environment, the central bank has eased monetary policy. The easing cycle commenced last year, and accelerated following the outbreak of the pandemic, including in two unscheduled meetings that signaled their readiness to act, for cuts totaling 400 basis points so far. The central bank also expanded or established several facilities, with access up to 3.3 percent of GDP, to support market functioning and credit provision. Use of the latter has been limited, owing in part to lower loan guarantees (e.g., via development banks) than during the global financial crisis and to delays in making one facility available. The flexible exchange rate has facilitated absorption of shocks. Comfortable international reserves, access to the U.S. Federal Reserve swap line, and the IMF’s Flexible Credit Line have bolstered the ability to withstand external stress.
- While 1-year ahead inflation expectations remain well anchored, consideration could be given to cutting rates further. The recent edge-up in inflation and the effects of the pandemic have raised concerns about the balance of risks for inflation, highlighting a difficult tradeoff confronting the central bank. In our view, recent price pressures reflect transitory factors, such as passthrough from peso depreciation and supply shocks, that should be offset by the sustained weakness in demand. Thus, confronted with historic drops in output and labor dislocations, rates can be lowered further while inflation expectations remain anchored. The policy rate remains above the trough in rates reached in 2014–15 and the monetary stance is modestly accommodative. The real policy rate is also one of the highest among EM peers, whose rates are at or below their historic lows and several of whom have pursued additional stimulus through asset purchase programs.
- Lower rates would provide further relief to the economy, with likely limited risk to external financial stability. A lower cost of borrowing would help reduce debt servicing pressures, especially among weaker borrowers, possibly boost investment, and increase the marginal attractiveness of the credit facilities of the central bank. But given the sudden stop in capital flows in March-April and amid still unsettled global conditions, another difficult tradeoff concerns capital outflow and peso depreciation risks related to Mexico’s deep and liquid local currency markets. Acknowledging these concerns, it is worth noting that, since the outbreak of the pandemic, issuance and inflows in hard currency Mexican debt have been strong owing to the perceived creditworthiness of the sovereign and corporates. Meanwhile, outflows from local currency bond markets have been driven largely by external factors such as global risk aversion. Very strong policy support by major advanced economies is helping to restore the normal functioning of global financial markets. Their expected prolonged monetary accommodative stance has also improved the outlook for, and reduced the downside risks of, portfolio flows of EMs.
- An independent review of the monetary policy framework could be considered. Although inflation levels and volatility have declined following the introduction of inflation targeting, inflation and inflation expectations have remained somewhat above target. Following nearly two decades of inflation targeting and in view of the potential changes in the strategies of major central banks, a review could among others explore inflation determinants, measures, and the policy toolkit.
- Close monitoring of risks in the banking sector remains crucial, while closing regulatory and supervisory gaps would help boost financial resilience. At 16.5 percent, the banking sector enjoys high levels of capitalization and, at 2.1 percent, a relatively low nonperforming loan ratio. It is important to continue upholding minimum regulatory and supervisory standards and using the inherent flexibility within the framework to cope with challenges. In particular, loan restructuring regulations should ensure reclassification of distressed loans and recognition of losses. Given the still considerable uncertainty over the outlook, limiting capital distribution (e.g., suspending dividends) would be prudent until the economy is clearly recovering. Consideration could be given to closing regulatory and supervisory gaps, such as enhancing the definition of “common risk” and “related party” in the area of bank exposures, improving the resolution regime for financial holding companies and strengthening the authorities’ power to request pre-emptive actions, and ensuring adequate access to funding for the deposit insurance and resolution authority.
Reforms to tackle long-term impediments can support the recovery
- Reform reversals create policy uncertainty that can impede the recovery. USMCA has reduced trade-related uncertainty. However, domestic reform reversals that weighed on investment before the pandemic have continued (e.g., in the energy sector and cancelation of some large private investments), potentially weakening the recovery and limiting gains from USMCA, including the on-shoring of supply chains to North America.
- Boosting investment and delivering lasting improvements in productivity requires steadfast implementation of reforms to tackle long-standing structural impediments including informality, limited access to financial services, entry barriers that limit competition, and crime. Recommendations to this end include:
- Taking a comprehensive approach to tackling informality: while informal employment has traditionally recovered quickly after shocks, informality is widespread in sectors highly affected by the pandemic, such as services and trade, that may continue to struggle. Moreover, passive and active labor market reforms to tackle informality would be a timely complement to the proposed pension reform (see for example IMF WP/19/257 and SDN/19/04).
- Promoting involvement of the private sector in the energy sector to help finance significant investments in oil production (e.g., through risk-sharing arrangements and restarting energy auctions) and enhancing the electricity grid (including green investments) and to provide specialized expertise.
- Enhancing the independence and ensuring the capacity of regulators to support competition and removing barriers to trade in services (e.g., in transportation and logistics).
- Fostering financial inclusion to enhance welfare and offset ongoing credit contraction.
- Strengthening governance by focusing on swift and effective implementation of anti-corruption measures and enacting pending legislation of the AML/CFT framework.