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Economy & Business Environment Blog

Jun
27
2017

Why Mexico’s Economy Is Putting On The Breaks

by Ataman Ozyildirim

A Conference Board analysis was recently released and projected Mexico’s economy to grow at 1.8 percent in 2017.  This marks a downward revision from an earlier projection of 2.6 percent made last November, and slower than the estimate of 2.1 percent in 2016.

So what accounts for the slowdown?

No single culprit exists.  Instead, look to a trifecta consisting of rising inflation and interest rates, a possible trade conflict with the US and business sector uncertainty.  Together, they have formed the perfect storm – and the serious punch they pack warrants a look at each.

Mexican-Economy2

Heightened Inflation Concerns And Tightening Monetary Policy

In May, the central bank of Mexico (Banixco) raised its benchmark interest rate to 6.75 percent – up from 3.75 percent a year earlier, largely because inflationary pressures have been increasing.  Back in April, the peso weakened against the dollar by 7.2% relative to a year earlier, fueling concern about the rising prices of imports.

As the weakening currency makes its pain felt in higher import prices, the inflation outlook is also compounded by the recent fuel price hike, and public service costs continue rising. Inflation will likely stay high throughout 2017.  Overall inflation stood at 5.7 percent in April, its highest rate since December 2008, when it clocked in at 6.3 percent.

The expected interest rate increases by the US Federal Reserve also raise the prospect of more tightening by central banks in emerging markets, including Mexico. Another constraint on Mexico’s growth comes from fiscal consolidation, which will reduce public spending over the next few years.

A Potential Trade Conflict With The US

Mexico has much to lose if its trade relationship with the US turns sour. In 2014 alone, global demand accounted for close to 20% of Mexico’s GDP. And within that slice of 20%, over half came from consumption and investment of products in the US. In other words, the US end of the value chain has been the main impetus for Mexico’s external sector and a key determinant of its GDP.

A trade war with the US could deal a blow to Mexico’s manufacturing sectors. Among the potential victims: the transport and electrical equipment industries, which depend on exports to the US. Also, the country’s metals, machinery, and chemicals sectors may be hurt as they depend on imports from the US.

Higher Uncertainty In The Business Sector

Consider the political dynamics inside and outside of Mexico. Looking abroad, the North American Free Trade Agreement (NAFTA) stands out. Still, it is anyone’s guess as to how a renegotiation of NAFTA will affect industrial value chains. Internally, Mexico will conduct its state elections next month, and next year it will hold its presidential election.

Along with political factors, also consider the workforce and its productivity. Mexico’s labor cost per unit of output has dropped since 2013 and has made the economy more competitive. However, competing on low-cost is not necessarily the way to sustain Mexico’s competitiveness in the medium term. This will require faster productivity growth which doesn’t seem to be in the cards without more investment and reforms beyond the energy and oil sectors. Mexico could easily lose business to countries like China, which show productivity improvements despite rising wages and strong currencies.

First, some silver linings among the 2017 clouds exist. In the first quarter of 2017, leading economic indicators rebounded, reversing a marked deterioration at the end of 2016 caused by falling confidence and oil prices. Also, US trade rhetoric toward Mexico has recently moderated. Confidence of businesses and consumers also has rebounded. And this year, Mexico will likely benefit from a cyclical upswing in the global economy, especially in manufacturing and global trade.

Looking beyond 2017 to the decade ahead, successful qualitative growth sources such as human capital, innovation, and digital transformation, will have to go a long way — beyond quantitative sources such as growing labor force and more investment — toward Mexico achieving its full potential. Mexico could conceivably more than double its current economic growth over the next 10 years to an average potential growth rate of 3.9 percent, but at least a third of that growth would have to come from those qualitative sources.

What could ignite such qualitative sources to fully materialize? That depends on a host of economic reforms such as improvements in education, labor markets, telecoms, and financial markets.

This piece originally appeared in Emerging Market Views.



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