Article

Mexico’s Experience with Adjustment

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1990
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After the onset of the debt crisis in 1982, Mexico launched a major policy effort aimed at correcting its macroeconomic and structural imbalances. Progress, however, was uneven, as the slow pace of structural changes hampered Mexico’s adjustment efforts from 1982-88. It became apparent that a broad-based and sustained effort was required for Mexico to achieve durable macroeconomic stability and economic growth. In late 1988, Mexico accelerated the reform process, supported by the Fund and the World Bank, by formulating a comprehensive growth-oriented program based on the experience gained in the previous years. A combination of financial and incomes policies was supplemented by a wide range of structural reforms. At the same time, the authorities sought and obtained financial support from the international community, including significant debt and debt-service reduction, as part of a financial package arranged with the commercial banks (see accompanying article by Mohamed A. El-Erian).

The complex process of adjustment in Mexico since late 1982 provides a useful case study for other countries undertaking similar economic programs. The Mexican experience suggests that countries with macroeconomic imbalances and structural rigidities can return to sustainable growth and financial stability, but only by implementing wide-ranging economic and structural measures and by persevering with the reform effort.

Background

Mexico experienced rapid growth in the three decades through 1970, with the growth of real GDP, largely based on expansion of the private sector, averaging over 6 percent, or double the rate of population growth. However, because of a policy of increased government intervention in economic affairs, high fiscal deficits, and rigid exchange rate policies, Mexico began to experience severe balance of payments problems in 1976. The authorities subsequently embarked on an adjustment program supported by the Fund through an extended arrangement.

Aided by rapidly increasing oil production and prices, as well as large foreign financing, economic activity rebounded during 1978-81, with public sector spending providing the main impetus to the expansion of domestic demand. The high growth in government expenditure, an economic slowdown in industrial countries, and higher international interest rates combined to produce a large deterioration in the fiscal and balance of payments accounts by 1981. The fiscal and external deficits that resulted were financed primarily through substantial foreign borrowing from commercial banks, with net external public debt rising by $20 billion, or 60 percent, in 1981 alone.

The situation deteriorated further in 1982. The resulting squeeze on foreign reserves, accentuated by capital flight, forced the Bank of Mexico to withdraw from the foreign exchange market twice during the year, leading to a sharp depreciation of the peso. In August 1982, the authorities announced their inability to service fully the country’s external debt. Subsequently, the Government imposed strict exchange and trade controls and nationalized the banking system, and Mexico began to develop external payment arrears on private sector debt service. The combination of a large public sector deficit and the lack of foreign financing led to a rapid acceleration of inflation from an annual rate of under 30 percent in 1981 to almost 100 percent in 1982. At this point, Mexico was a highly regulated economy with severe macroeconomic imbalances and limited access to external creditors. The challenge of economic recovery seemed daunting and prosperity almost out of reach.

In late 1982, a new administration under President Miguel de la Madrid adopted an adjustment program. This was supported by the Fund with an extended arrangement covering 1983-85, while Mexico obtained additional financial resources and a rescheduling of its external debt from official and commercial bank sources. The program called for a major strengthening of financial policy and a liberalization of exchange and trade controls; it provided for a large initial devaluation, followed by frequent adjustments in the exchange rate based on projected inflation. The program’s early achievements were considerable: internal and external imbalances were reduced greatly, while inflationary pressures declined. Moreover, economic activity began to recover.

But the improvement did not last long. By early 1985, it became evident that the initial adjustment efforts were not being sustained. Moreover, the efforts of the authorities were hampered by emergency spending necessitated by the September 1985 earthquake, as well as the sharp drop in the price of oil (from $25 a barrel in 1985 to an average price of $12 a barrel in 1986). As a result, the fiscal and external positions weakened, with public sector revenues and export receipts plummeting by the equivalent of about 6 percent of GDP.

In mid-1986, the Mexican Government responded to the worsening economic situation by adopting a new economic program, which the Fund supported with a stand-by arrangement. Financial support was sought from all of the creditors that had financed Mexico’s development in the past, with a view to restructure Mexico’s external debt from official and commercial bank sources and to offset the loss in export earnings. Fiscal and monetary policies were tightened, the exchange rate was depreciated sharply in real terms, and substantial efforts were made to liberalize trade and privatize the public sector enterprises (see box on structural adjustment). These efforts, aided by a marked increase in oil prices, led to a sizable improvement in the balance of payments, allowing Mexico to enjoy a period of moderate economic growth in 1987.

The price-wage pact of 1988

The strong improvement in the external position of Mexico in 1986-87 was accompanied, however, by a marked deterioration in price performance, with the 12-month rate of inflation accelerating from under 65 percent in December 1985 to 160 percent in December 1987. Nominal interest rates were correspondingly high, which put additional pressure on the borrowing requirement of the public sector. The inflationary spiral, which was aggravated by the increased frequency of wage and official price adjustments, together with the crash in the Mexican stock market in October 1987, resulted in significant capital outflows late in that year. In response, the Bank of Mexico withdrew its support of the exchange rate in the free market causing the peso to depreciate sharply.

The process of structural reform

Mexico has undertaken structural adjustment measures to open its external trade system, rationalize public sector enterprises, make the tax system more efficient, liberalize and privatize its financial system, ease restrictions on foreign investment, and deregulate specific economic activities. These reforms are helping to increase economic efficiency and are paving the way for medium-term growth.

Opening of the trade system. Since mid-1985, Mexico has opened up its economy through an extensive trade reform. Trade liberalization has reduced the coverage of import licensing to less than one fourth of the imports that were covered in mid-1985. Maximum import tariffs were reduced, in several stages, to 20 percent by December 1987, while the minimum tariff for most items was set at about 10 percent, making the levels of effective protection more uniform. To increase the credibility of its domestic efforts, Mexico joined the General Agreement on Tariffs and Trade (GATT) in 1986.

Divestiture of public sector enterprises. The authorities have cut the number of state-owned entities from over 1,100 in 1982 to about 350 by end-March 1990 through a process of mergers, liquidation, and sales. More significantly, the recent divestiture has targeted some of the biggest enterprises in the public sector. Further, in May 1990 a bill was submitted to the Mexican Congress to allow for the reprivatization of commercial banks expropriated in 1982. The divestiture policy has allowed the public sector to concentrate its limited resources on priority sectors and has allowed the private sector to participate in the development of critical areas of the economy.

Tax reform. In 1987, the authorities implemented a major reform of the tax system with a view to correct distortions (especially the effects of inflation) and to enhance Mexico’s external competitiveness by harmonizing the domestic tax system with those abroad. The reform was accelerated in 1989-90 by significantly widening the tax base and reducing marginal tax rates. In particular, the Government introduced a new minimum tax of 2 percent on firms’ assets; abolished tax exemptions granted to certain sectors of the economy; reduced the corporate tax rate from about 40 to 36 percent, while changing the system of taxing corporate dividends to discourage tax evasion and encourage reinvestment of profits; and lowered the tax rate on the highest personal income bracket to 35 percent.

Financial liberalization. To encourage financial savings and improve the allocation of credit, the Government, in March 1989, eliminated controls on interest rates and maturities for most traditional bank instruments. Further, the former system of mandatory lending from banks to the public sector through reserve requirements was replaced by a simplified system of liquidity requirements, and the role of open-market operations for monetary control was enhanced. In addition, interest rate subsidies implicit in some loans by national development banks were reduced. Also, in late 1989, legislation was passed that strengthened supervisory powers of the Bank of Mexico over the banking system.

Liberalization of foreign direct investment. Over the medium term, the Government expects foreign direct investment to play an important role in promoting growth. It announced a substantial liberalization of foreign investment regulations in May 1989; foreign investors may now own 100 percent of enterprises valued up to $100 million, without prior approval from the National Foreign Investment Commission, provided that certain conditions on location and net foreign exchange needs are met. The new regulations permit foreigners to invest in the Mexican stock market through specially designed Trust Funds.

Deregulation of economic activities. Complementing the measures mentioned above, the authorities have taken steps to deregulate specific sectors, particularly in the areas of transportation, communication, petrochemicals, and fisheries.

In mid-December 1987, the Government responded by further strengthening financial and structural policies and by incorporating a new element in its policy package—an incomes policy based on a social pact among business, labor, and government. The agreement called for strict fiscal and monetary policies and accelerated reforms of the trade and financial systems. Moreover, after initial adjustments, a generalized freeze through end-1988 was placed on wages and prices of a wide range of goods and services, as well as on the exchange rate (after a small adjustment in February) for the US dollar. These measures dramatically reduced the 12-month rate of inflation from 160 percent at the end of 1987 to 52 percent at the end of 1988.

The decline in inflation during 1988, however, was not accompanied by an equivalent decline in nominal interest rates, reflecting, in part, private sector uncertainty concerning the sustainability of economic policies. Moreover, real GDP grew by only 1 percent, while a sharp rise in imports, a decline in official borrowing, and substantial early repayment of debt by the private sector led to a worsening in the overall balance of payments, which recorded a deficit of almost $7 billion.

Against this background, a new administration under President Carlos Salinas de Gortari introduced a more comprehensive strategy in December 1988 to overcome the country’s remaining economic problems, including the achievement of a medium-term solution to Mexico’s debt problem.

The 1989-92 program

The objective of the authorities’ program was to seek economic growth over the medium term consistent with price stability and a sustainable balance of payments. The economic recovery was to be led by growth in private sector investment, financed through increased private and public sector savings. To achieve these goals, the authorities felt that it was essential to tackle the external financing constraint by reducing the external debt burden. They announced their intention to seek a multiyear financing package from the country’s creditors, which would substantially reduce the transfer of resources abroad, along with a comprehensive debt reduction program to be agreed upon with the commercial banks.

Domestic measures. The authorities’ domestic policies were centered on a further fiscal correction, supported by a tight monetary stance to reduce inflationary pressures. Complementing the macroeconomic policies, the authorities announced measures to deepen further the process of structural reform of the economy.

To achieve its economic objectives, the new Government negotiated an extension of the wage-price pact through the end of July 1989, which was subsequently extended through January 1991, in order to consolidate the gains on the inflation front, while the Government negotiated with the country’s creditors in a stable environment. To protect external competitiveness of the wage-price pact, the peso was initially depreciated daily by Mex$l per US dollar (at an average annual rate of 15 percent) and subsequently, by Mex $0.80 per US dollar (at an average annual rate of 10 percent). Further, minimum wages and public sector prices and tariffs were adjusted periodically, in line with the objectives of the economic program.

International efforts. The authorities also sought the backing of the international financial community and official donors for their economic program. The Fund approved a three-year extended arrangement with Mexico on May 26, 1989, for the amount of SDR 2.8 billion (equivalent to about $3.6 billion). The amount of the arrangement was subsequently augmented by SDR 466 million (about $600 million) to provide support for debt and debt-service reduction operations, while SDR 0.8 billion of the initial access under the arrangement was set aside for this purpose.

Shortly after the approval of the Fund arrangement, the Paris Club creditors agreed to reschedule $2.6 billion of Mexico’s debt-service obligations on official debt falling due in the next three years. Concurrently, Mexico concluded negotiations with the World Bank on several sectoral loans to support structural reforms in trade, financial, and fiscal sectors. In June 1989, the Bank approved sectoral loans to Mexico amounting to almost $2 billion (of which $760 million was earmarked for debt and debt-service reduction operations) and agreed to provide additional loans averaging $2 billion during the subsequent three years. In January 1990, the Bank approved an additional $1.26 billion for financing debt and debt-service operations.

In support of its growth-oriented adjustment program, the authorities pressed for a multiyear financing package with commercial banks, which would involve debt and debt-service reduction operations sufficient to produce a substantial decline in the country’s external debt. The strategy received a boost in March 1989, when the US Secretary of the Treasury announced the support of market-based and voluntary debt and debt-service reduction programs for the most heavily indebted developing countries. Negotiations were initiated with the commercial banks in April 1989, and an agreement in principle was reached on July 23, 1989.

Mexico: selected economic indicators
1980198119821983198419851986198719881989
(In percent of GDP)
Public sector borrowing requirement7.313.817.79.48.49.515.615.912.95.9
Gross domestic investment27.227.422.920.819.921.218.119.820.922.4
Gross national savings23.221.819.224.322.321.617.221.418.218.2
External current account−4.0−5.6−3.73.62.40.4−0.92.8−1.6−2.7
(In billions of US dollars)
External debt51.475.089.693.094.094.898.5107.5100.995.3
Overall balance of payments1.01.2−6.85.53.0−3.4−1.26.6−6.9−1.0
Source: Mexican authorities, and Fund staff estimates.
Source: Mexican authorities, and Fund staff estimates.

Chart 1Mexico: real GDP growth, 1980-90

Source: Mexican authorities.

Chart 2Changes in the consumer price index, 1980-901

Sources: Mexican authorities, and Fund staff estimates.

1 Change over the same month of the previous year.

Chart 3The real effective exchange rate

(Base 1980=100)

Sources: Mexican authorities, and Fund staff estimates.

Heartening results

The results to date of the authorities’ efforts have been encouraging (see table and charts). Real GDP grew by almost 3 percent in 1989, with indications of a similar growth rate for 1990. Correspondingly, private investment grew markedly in 1989, reflecting increased domestic savings and the inflow of private foreign capital. Inflation was reduced to less than 20 percent during 1989, and a further reduction is expected in the medium term. Fiscal performance was strong in 1989, with the overall deficit declining in one year from 13 to 6 percent of GDP. Mexico’s overall balance of payments deficit in 1989 amounted to $1 billion, after a deficit of almost $7 billion in 1988. Domestic interest rates have remained high in real terms, but have declined substantially since mid-1989, following the announcement of the financial package with commercial banks.

The wide range of structural reforms, aimed primarily at improving the micro-economic environment, have led, in conjunction with strong macroeconomic policies to a rebound in private sector activity, particularly investment, reflecting improved private sector confidence. In particular, financial savings have risen sharply following the financial liberalization, while the public finances have improved because of tax reform, expenditure control, and divestiture of public enterprises. Moreover, the revisions in foreign investment regulations, the intended privatization of domestic commercial banks, and the deregulation of economic activity have attracted significant amounts of private foreign investment and repatriation of private capital from abroad.

Conclusion

Mexico’s performance clearly shows the need to maintain strong and consistent macroeconomic policies, which should be adapted quickly in the face of unexpected shocks. Moreover, the persistence for much of the period since 1982 of low or negative economic growth and inflationary pressures underscores the importance of complementing financial policies with prudent incomes policies, significant structural adjustment measures, and external financial support.

The 1989-92 economic program is a comprehensive one. The authorities have implemented particularly strong fiscal and monetary policies, as evidenced by the impressive fiscal adjustment since 1982, equivalent to over 12 percentage points of GDP. Further, the use of an incomes policy, in combination with the consistent application of financial policies, has helped break the inertial element of inflation in a manner that has averted heavy social and economic costs. More recently, to avoid the emergence of relative price distortions, the authorities have been gradually reducing the scope of wage and price controls. The liberalization of the financial system and regulations concerning direct investment have complemented other structural economic reforms. The improvement in price performance and reduction in financial imbalances in recent years has set the stage for a recovery in economic activity and helped release resources for private sector investment.

The authorities’ reform efforts, accompanied by external assistance—including wide-ranging debt and debt-service reduction—have substantially improved the prospects for Mexico’s return to satisfactory growth. The attainment of the Mexican authorities’ medium-term goal, however, rests upon the continued implementation of sound financial and structural policies.

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