As the global recession deepens and the U.S. economy begins to contract, Mexican decision-makers are bracing for a very tough year. While Mexico is much better positioned to absorb the shock today than it was on the eve of the crises in 1982 and 1994, recent indicators suggest that Mexico’s economic cushion is not as deep as policymakers previously thought. In 2009, the Calderon administration will face two urgent challenges: preparing a financial safety net and mitigating the social impact of the recession. Mexico is well positioned to meet these challenges, but it will need support from Washington to do so.
The nature of the economic shock about to hit Mexico is well understood. The Mexican economy is tightly connected to the U.S. economy through four channels—the trade channel (85 percent of Mexican exports go to the United States), the remittance channel (billions of dollars from Mexican workers in the United States are the country’s second-largest source of foreign exchange), the investment channel (some 50 percent of Mexican foreign direct investment comes from U.S.-based investors), and the financial channel (the U.S. and Mexican financial systems are highly integrated).
As the U.S. economy contracts, Americans consume fewer Mexican imports, Mexican workers in the United States send home less money, U.S. firms with businesses in Mexico invest less, American-owned banks in Mexico make fewer loans, and the quality of U.S. financial assets in Mexican hands deteriorates further. Add to this the collapse in confidence in the U.S. economy, which is likely to spread to other economies closely connected to it, including Mexico’s. The result will be a potentially deep and protracted recession in Mexico.
Things did not always look so bleak. In 2007 and 2008, many argued that Mexico was relatively insulated from the U.S. slowdown. With oil prices in the three digits, revenues from Mexican oil exports were pouring in. Even when oil prices plummeted, Mexico appeared to be sitting pretty—it cleverly hedged all of its 2009 oil revenues, fixing the sale price at a $70 per barrel. (The price is now in the low $40s.) Also, Mexico’s fiscal position is much stronger than on the eve of past crises. Mexico’s public sector ran surpluses in 2006 and 2007, the stock of public-sector external debt has fallen by nearly two-thirds since 2000, and the structure of that debt is much less weighted toward the short term. Also, the banking system—whose poor governance and weak regulation caused financial meltdown in 1995—is today much better managed and capitalized.
However, signs of serious trouble ahead are on the horizon. In December, Mexico’s industrial production fell by 6.7 percent on a year-on-year basis, the largest drop in almost seven years. Mexico—a major producer of cars and auto parts for the Big Three automakers—is feeling Detroit’s pain. Auto production plunged by 51 percent in January of this year. In addition, remittances fell by 3.6 percent last year, the first time a drop has been recorded since statistics were first collected in 1996. Oil prices have dropped significantly, and it is very unlikely that Mexico will be able to hedge its oil exports again at an affordable cost. In short, a major recession is coming; most experts estimate that this year’s contraction will be between one and two percent of GDP.
Aside from trying to jump-start demand through public spending, the Calderon administration’s first key challenge is to prepare for a financial emergency. While Mexico has not been shut out of international markets yet, the risk is that capital for emerging market countries like Mexico will dry up as developed countries rush to international markets to finance gargantuan stimulus packages and budget deficits. In addition, investors’ fears about Mexico’s deteriorating security situation and slowing economy are making it more expensive for Mexico to borrow. For the first time since 2001, Mexico is now paying a higher risk premium on its bonds than Brazil. The combination of crowding out in financial markets and a collapse in confidence could leave Mexico in need of emergency financing to meet external obligations, many to U.S. investors.
To guard against this, in October the Federal Reserve extended Mexico a temporary swap line, under which Mexico (along with Brazil, Singapore, and South Korea) can receive up to $30 billion in emergency liquidity to cover dollar-denominated debt. Mexico has not drawn on this facility. The swap line will expire April 30, but keeping it open for another year should remain a priority. In addition, should Mexican policymakers decide they need to approach the IMF for emergency assistance, the United States, as the Fund’s largest shareholder, should be ready to help disburse financing quickly.
A tricky element of the financial crisis involves Citigroup, the troubled financial giant most likely to be taken over by U.S. regulators. Citigroup happens to own Banamex, Mexico’s second-largest commercial bank, which accounts for about a fifth of Mexico’s commercial banking system. Banamex appears to be in good shape, but it will likely face rapidly-mounting defaults on its consumer-loan portfolio as the economy slows. At the same time, with the parent company in so much trouble, Citi will likely cut back on all types of lending in Mexico and other countries.
The situation will present the U.S. and Mexican governments with a delicate and unprecedented political question, assuming the U.S. government takes a controlling stake in Citi: Will the government-controlled Citigroup pump more money into its Mexican subsidiary to help boost its neighbor’s sagging economy, at a time when the U.S. authorities are under pressure to minimize losses to taxpayers and to save the parent bank from collapse? The answer is far from clear, but coming up with a solution that allows U.S. regulators to save Citigroup without exacerbating the crisis in Mexico will require considerable diplomatic and financial skill. The situation will be complicated by Mexican regulation, which prohibits foreign governments from owning domestic banks. Rumors are already circulating that Brazilian banking giant Itau-Unibanco is interested in buying Banamex should Citi be forced to sell.
The second challenge facing the Calderon administration will be to mitigate the social crisis that will accompany the economic contraction. Official unemployment currently stands at four percent. Hundreds of thousands of jobs are expected to be lost in 2009. Actual unemployment numbers will be much higher than the official statistics, as the informal sector—which is excluded from the official numbers—accounts for some 40 percent of the Mexican economy. To help, the government has frozen fuel and electricity prices and raised the ceiling on how much the unemployed can draw from their savings accounts. And like the Obama administration, Calderon’s government has announced major spending in infrastructure projects.
To meet the social challenge, the Mexican authorities will need to implement highly targeted social programs because the crisis will affect sectors of the economy and regions of the country very differently. For example, export-oriented manufacturing, especially that which relies on imported inputs, will be hardest hit, while commercial agriculture may actually benefit from the currency’s devaluation. Emergency programs to help the unemployed will have to focus first on those sectors and localities that will be decimated by the shock. Fortunately, the infrastructure to do this already exists, thanks to the long-running Oportunidades program, a conditional cash-transfer program that reaches low-income families across Mexico. The United States can help indirectly, by encouraging the multilateral development banks to create or expand lending instruments that help the Mexican and other governments provide this kind of targeted support.
With a financial safety net in place and social programs at the ready, the Calderon administration should be reasonably well prepared for one of the toughest years in living memory. Meeting the challenges of the crisis in 2009 will highlight the importance of U.S.-Mexico economic cooperation, but it may also introduce complex tensions into the bilateral relationship.