IMF approves new credit line for Mexico as fiscal outlook darkens

Central bank’s success in reducing inflation may be compromised by fiscal weakness
Mexico City
Mexico City: economic stability greatly weakened by narrow fiscal base and overreliance on tax payments of Pemex

The International Monetary Fund approved a new flexible credit line (FCL) for Mexico on November 22, as the economy suffers stagnant growth and a challenging fiscal outlook.

The IMF’s approval will support the Bank of Mexico’s efforts to boost the economy with lower rates, but a weak fiscal balance may imperil the central bank’s strategy.

A weaker peso in 2016 and 2017 boosted year-on-year inflation over the 3% target to 6.6% in August 2017. The central bank started a sharp tightening cycle that took interest rates to a record-high 8.25% in December 2018, from 5.25% in November 2016. Tighter financial conditions helped reduce GDP growth to just below 2% in 2018, from 3% in 2016. This year it is expected to be close to zero.

The higher policy rates helped to progressively reduce inflation, which returned to the 3% target in September for the first time in three years. This success allowed the Bank of Mexico to start cutting rates this year in a bid to boost growth. Since August, it has implemented three 25 basis point rate reductions, which have taken the key rate to 7.5%.

After the last rate cut on November 14, the Bank of Mexico acknowledged the negative side-effects of higher rates had been more severe than forecast.

“The latest information on the third quarter of 2019 shows the stagnation [that] economic activity has been exhibiting for several quarters continues, thus implying that slack conditions have widened more than anticipated,” says the policy statement.

“Output is likely to be essentially flat over 2019 as a whole. This would be the worst performance of any large emerging country bar Argentina,” says John Ashbourne, senior emerging markets economist with consultancy Capital Economics.

In this weaker economic environment, the new credit line granted by the IMF may be more necessary than in the past. It is a two-year arrangement, making available $61 billion for national authorities. The IMF and Mexico had previously agreed to reduce it from the $86 billion in the previous FCL, signed in November 2017. Mexico first secured an FCL in April 2009, right after the fund created the instrument.

Output is likely to be essentially flat over 2019 as a whole. This would be the worst performance of any large emerging country bar Argentina
John Ashbourne, Capital Economics

The IMF said the credit line aimed “to reduce the perceived stigma of borrowing from the IMF, and to encourage countries to ask for assistance before they face a full-blown crisis”. Mexican authorities treat the FCL as a precautionary instrument and have never drawn on its funds.

The IMF restricts access to the programme to countries with solid policy frameworks and balanced public finances. Since its creation, only Poland, Colombia and Mexico have secured access to it. None of them have ever drawn on FCL funds and Poland left the scheme in November 2017.

Nonetheless, in contrast to Colombia’s continued stability, Mexico’s growing fiscal weaknesses may force its authorities to resort to the IMF funds.

Weak fiscal outlook

Mexico’s economic stability is greatly weakened by its narrow fiscal base and overreliance on the tax payments of national oil company Pemex.

In 2018, the company transferred 932.8 billion pesos ($47.6 billion) in taxes to the Mexican federal government, according to the Mexican Institute for Competitiveness (IMCO). This represents 17.6% of the national budget, which was 5.27 trillion pesos last year.

But Pemex has accumulated hefty debts and its oil production has fallen consistently over the last decade. Credit ratings agency Moody’s downgraded its outlook on the company from stable to negative in June.

“The lowering of the BCA [baseline credit assessment] to Caa1 reflects our expectations of ongoing negative free cashflow at Pemex and declining proved reserves, despite efforts to cut costs and boost capital spending,” said Moody’s. “Pemex has weak liquidity and is highly dependent on government support.”

The corporate-debt downgrade for Pemex could contribute to a sovereign one and a depreciation of the peso, followed by higher inflation.

Due to its vital importance, the state has attempted to avoid this scenario, easing Pemex’s financial difficulties. Public subsidies to the company have reached more than 2% of GDP this year, according to Carlos Serrano, chief economist at BBVA Bancomer in Mexico.

“It has been repeated ad nauseam that Mexico has a serious tax-collection problem. The country only collects 14% of GDP,” Serrano told Central Banking. “This not only represents the lowest level of all countries that are part of the Organization for Economic Co-operation and Development (OECD), but it is also lower than the collection levels of most Latin American countries.”

Currently, public spending on pensions is equivalent to 3.6% of GDP.

“It is worrying that this expense is greater than the public investment that is around 2.6% of GDP,” said Serrano. ”We are spending more in the past than in the future and most of this investment goes to Pemex, and the social returns it offers are very low.”

To break the doom loop between the company and the state, Serrano thinks it necessary to replace public investment with private money.

“The company requires high levels of investment to reverse the downtrend in oil production and you don’t have the fiscal space for it,” he said. “We must fight to reduce the informality that prevails in the country. The main problem in Mexico is not tax rates, but a very small base.”

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