Mexico - Economic Briefing January 2003

Outlook Limited by U.S. Economy and Monetary Tightening (continued)

Exchange rate continues weakening trend until end of 2002 as headline inflation exceeds target
The peso finished 2002 at 10.40 to the US$, which represents a depreciation of 11.9% in nominal terms compared to the 2001 year-end level. Last year’s peso developments can be split into two phases: The first phase lasted until April 2002 and was characterised by a strong peso, which saw the currency appreciating in the first months of the year to 9.00 pesos to the US$. This strong peso phase was followed by a rapid deterioration in the peso throughout the remainder of the year. The weakening marked an end to a three-year period of extraordinary exchange rate resilience, which had earned the currency the nickname “super-peso”. The three-year stretch of unaccustomed vigour had followed on a period of rapid deterioration in value up to January 1999. In part, the peso strength reflected the growing awareness of the market that the Mexican Central Bank was successfully containing inflation. The weakness observed in the second part of the year, was partly due to the fact that inflationary expectations were beginning to rise again. However, even though headline inflation exceeded the official 4.5% target in 2002 – a 0.44% price increase in December raised the annual rate from 5.4% in November to 5.7% - core inflation remains under control. With a year-end core inflation rate of 3.8%, the Central Bank is now within reach of its proclaimed long-term objective of lowering inflation to international levels and the decision to tighten monetary policy to rein in inflationary expectations on 10 January underpins the seriousness with which authorities are pursuing the 3.0% target. Therefore, most analysts are convinced that the currency weakening period is likely to be drawing to an end and expect the peso at 10.56 to the US$ on average by the end of this year, a nominal depreciation of less than 2.0%.


2003 budget approved in Congress but spending higher than planned
In mid-December, the Mexican Congress approved the 2003 budget. Since President Fox lacks a majority in Congress, the opposition was able to alter the draft budget originally submitted to Congress. The approved 2003 budget foresees spending of 1.52 trillion pesos (US$ 148 billion), which exceeds the budget proposal by 47.6 billion pesos (US$ 4.6 billion or 3.1%). The increased spending is destined for the agricultural, education and health sectors, as well as new highway construction projects. States and municipalities will also receive a larger share of the tax take than envisioned in the original budget. The fiscal deficit target for 2003 however, remained unchanged at 32.9 billion pesos (US$ 3.2 billion), the equivalent to 0.5% of GDP. The increase in some revenue forecasts and tweaking of the assumptions underlying the budget enabled the deficit-neutral spending hike. The final 2003 budget assumes an average oil price of US$ 18.35 per barrel of the Mexican mix of crude oils, compared to US$ 17.0 per barrel assumed in the original proposal, which raises income by 24.7 billion pesos (US$ 2.4 billion). Other assumptions, such as GDP growth and inflation were left unchanged (details see table).


Higher spending “financed” by less conservative oil price assumptions
The less conservative oil price estimates have been criticised by some observers who point out that the current spike in oil price markets is inflated by Iraq war concerns and temporary supply difficulties in Venezuela. Once these concerns cease, the oil price may drop again since the current soft spot of the global economy is likely to keep oil demand subdued. By the end of 2002, the price for the Mexican mix, which trades at a substantial discount to WTI and Brent, had reached US$ 26.3. Even though the current price appears to give a comfortable margin compared to the budget assumptions, oil markets can shift drastically and a sudden drop in oil prices would force the Fox administration to cut spending. As in the pervious three years, the budget law contains automatic stabilisers, which prompt the government to adjust spending in order to maintain the fiscal deficit target. However, in contrast to previous budgetary periods, the government has been limited by Congress in its ability to cut spending. The current budget law binds the administration to focus cuts in current spending and prohibits reductions in social or investment outlays. Nevertheless, the Consensus remains optimistic that the government will achieve its 0.5% fiscal deficit target, which will represent an improvement over 2002. While the 2002 deficit target was officially 0.65% of GDP, in December Congress approved a one-time operation to replace Mexico's rural development bank, Banrural, with a new institution, a process that technically more than doubled the fiscal deficit to 1.44% of GDP. The operation involved liquidating Banrural, which costs an estimated 48.8 billion pesos (US$ 4.7 billion). However, Finance Ministry officials said the operation was a bookkeeping move outside the normal budgetary process that did not imply the government was straying from its deficit targets.