Mexico - Economic Briefing February 2003

Central Bank Tightens Policy as Peso Weakening Accelerates

The peso weakening continued to accelerate in January, threatening to feed into higher prices. Moreover, inflationary expectations have remained persistently above the Central Bank’s inflation target for this year, prompting monetary authorities to tighten the reins yet again. The monetary policy shift comes at an unwelcome time, since domestic demand continues to waver, as the U.S. economy is not providing the anticipated boost to demand.

Economy disappoints in November …
The economy presented itself in a weak condition towards the end of 2002. In November, the monthly indicator for economic activity (IGAE, Indicador Global de la Actividad Económica) rose only 0.9% in real terms compared with the same month in 2001. The reading remained well below expectations, which had seen the economy adding 1.5% over the same period and represented the weakest growth rate registered for a month in the second half of last year. Moreover, according to seasonally adjusted data, the economy actually declined 0.75% over the preceding month, which was the worst performance in 2002. The dismal November performance dashed hopes that the Mexican economy would finally pull clear from its anaemic growth path, which has held a grip over the country over the last two years. Optimism about a recovery had run high in the first half of 2002, when the seasonally adjusted indicators had shown a continuous upward movement in the economy and the U.S. economy seemed to resume its role as the locomotive of the Mexican economy via a strengthening of demand for Mexican manufactures. But a weakening of U.S. manufacturing in the second half of 2002 quickly spilled over to the Mexican economy, prompting the tentative recovery to ebb before being able to take a firmer grip.

… as industry slumps
The dismal performance of the industrial sector in 2002 was again reflected in November, which otherwise saw services activity expanding 2.4% annually and agriculture output dropping 6.9%. After 1.3% growth in October 2002, industrial activity dropped 0.5% in November compared to the same month in 2001. With the exception of construction, all sub-sectors comprising the industrial sector weakened compared to October. The manufacturing industry declined by 1.3% (October: +1.5% year-on-year), as the domestic side of the industry dropped by 1.5%, which was only partially offset by a 0.3% increase in the maquiladora industry. Even though the growth in the maquiladora industry represents a slowdown from the 1.6% expansion observed in October, the performance is remarkable, since it represents the second consecutive month of positive year-on-year growth in that sector and contrasts with the crippling double-digit contractions seen in the first half of 2002. Mining also developed favourably, adding 3.2% on an annual basis. The improvement was driven by an increase in non-oil mining (+12.4% yoy) but mitigated by a decline in the oil industry (-2.9% year-on-year). Construction grew 1.7% and the electricity, gas and water sector added 1.2% compared to the same month in 2001.

Growth estimate lowered for 2002 amid dismal November results
Despite the dismal November performance, Consensus Forecast panellists are upbeat that the economy picked up steam in the final month of the year, seeing growth of the monthly indicator for economic activity at 2.5% on average. Nevertheless, the November dent has affected fourth quarter estimate, which has been lowered from 2.5% last month to 2.3%. Forecasts for the year as whole were remained unchanged from last month at 1.1%, in line with the latest Central Bank estimate, presented in the quarterly inflation report published late January.

Central Bank sees pickup in consumption in first half of the year and further acceleration in the second
For 2003, monetary authorities see four principal factors shaping the development of the economy. First, the recovery of the U.S. economy, in particular its industrial sector, would affect Mexican external and industrial sectors favourably. This would lift domestic consumption and investment. In particular, monetary authorities expect consumption to pick up at the beginning of 2003, gaining further speed throughout the remainder of the year, as formal employment picks up and consumer credit expands. Second, the development of the oil price will be key to economic developments by affecting the export level and fiscal accounts. Third, Mexico’s conditions of access to internal financial markets, which will be key for the government/businesses to ….. And finally, the progress in structural economic reforms, such as the reform of the electricity sector and tax reform, which are considered tantamount to more sustainable longer term growth. Given the anticipated pattern of the consumption recovery, the Central Bank anticipates growth to average 2.5% in the first half of the year (Consensus: 2.9%), advancing one percentage point to 3.5% in the second half (Consensus: 3.8%). For the year as a whole, monetary officials expect the economy to grow around 3.0%, which is a notch less optimistic than the current 3.1% estimate of the Consensus.

Slower U.S. recovery and inflationary pressures identified as major downside risks for growth in 2003
Next to the baseline scenario, the inflation report highlights the major downside risks for economic expansion in 2003. The Bank identifies a slower recovery of the U.S. economy or, in the worst case, a slump back into recession as the major external risk. The Central Bank believes that a prolonged military conflict in Iraq, a quick drop in consumer spending in the wake of a negative wealth effect and/or a rapid adjustment of the current account deficit with detrimental side effects on international capital markets could trigger a US slowdown. In addition, monetary authorities believe that further financial or political crisis in the region or higher international instability could also serve to dry up of capital flows to Mexico. On the domestic side, the Central Bank sees risks in a gradual advancement on structural economic reforms with detrimental impacts in the medium to long term and a slower growth in formal employment, which would slow the consumption recovery. On the monetary side, the slow adjustment of wage contracts to lower inflation rates, which are in particular affecting salaries in the services sector, is considered a key risk. Finally, the rapid weakening of the peso could feed through to rising inflationary pressures, which would have to be countered by a tighter monetary policy.