How Much Danger Does Mexico Face in This Turbulent Time?

By Claudio Loser
Published in the Dialogue’s Latin America Advisor, June 1, 2009

Originally published in Claudio Loser’s “By the Numbers” column for the Dialogue's daily Latin America Advisor

WASHINGTON—Mexican Finance Minister Agustin Carstens recently announced that gross domestic product will decline by more than 5 percent in 2009. Only a few weeks ago, in a recent paper on the subject, I suggested that GDP might decline by up to 3 percent. The worsening performance of the Mexican economy is a matter of concern even as the International Monetary Fund is providing the most significant support package granted in recent times and rating agencies have not yet modified Mexico's rating. It has been almost 15 years since the eruption of the Tequila Crisis in 1994-95. After a long stop-and-go process, the period from the Tequila until 2008 was one of the most stable in Mexico's recent economic history. Economic growth was steady, although low, and in general followed the path of the US economy. The macroeconomic management showed a prudence that allowed for a sharp and sustained reduction in inflation and a strengthening of the balance of payments, and the Central Bank was able to accumulate a record level of international reserves.

The smooth macroeconomic performance, in the context of a sustained period of world economic expansion, gave Mexicans a sense of security and even of complacency that was unwarranted. The government found it increasingly difficult to push its structural reform agenda; the emergence of China as a main trade competitor and the decline of oil sector output hurt Mexico's competitiveness. These developments hampered Mexico's growth potential, and may explain a mediocre growth performance, even with high foreign direct investment. In addition, Mexico's climate has been affected by drug wars, even if geographically constrained, and the now abated swine flu.

Mexico is now confronting its worst economic crisis since the Tequila as it is being hit by the US-originated but already worldwide crisis. Export prices and external demand have dropped sharply, output and business confidence are plummeting, workers' remittances are declining, stock prices and corporate finances have weakened, the peso has depreciated sharply and there are growing concerns about Mexico's ability to maintain its hard-won macroeconomic stability. The ability of the country to engage in an expansionary policy is limited, even with the financial support just offered by the IMF, because of its limited access to financial markets. Moreover, the corporate sector has been particularly vulnerable in recent months, as the case of Cemex illustrates, even as risk ratings have remained deceptively stable. Losses in Mexico arising from the world financial debacle are estimated at more than $300 billion, not including the losses from investments abroad that can amount to $50 billion.

Even under these difficult conditions, Mexico has shown a resiliency that is not always recognized and seemed well prepared to deal with an external crisis. The government was able to shield itself from the effects of the crisis in the short run, including through financial support from the Federal Reserve and the IMF. Unfortunately, the shock is far greater and the defenses may not be enough to deal with the consequences of the crisis. Moreover, the government's intention to lend to firms in difficulty entails a rise in contingent liabilities that will seriously aggravate its financial position.

All these developments have been further clouded by what can be described as a mistakenly low assessment of risks by ratings agencies that may be corrected but will further burden Mexico. S&P's change in Mexico's debt outlook to negative for the first time since the Tequila is a step in the right direction, but this should be reflected in a reduced rating, to be fair in conjunction with that of other countries' bonds. The authorities have a full plate in finding a balance between economic stimulus and support of corporate survival on the one hand and financial viability on the other. However, even if a revival of US economic activity, an adequate assessment of the situation by rating agencies and the pursuit of the right policies are likely, they are not, unfortunately, a foregone conclusion.

Claudio Loser is a Senior Fellow at the Inter-American Dialogue and former head of the Western Hemisphere Department at the International Monetary Fund.