MEXICO: PUSHING FOR ECONOMIC GROWTH

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP04T00907R000100200001-0
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 28
• Document Creation Date: December 22, 2016
• Document Release Date: March 28, 2012
• Sequence Number: 1
• Publication Date: May 1, 1987
• Content Type: REPORT

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Mexico:
Pushing for
Economic Growth
et
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ALA 87-10027
May 1987
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Directorate of
Intelligence
Mexico:
Pushing for
Economic Growth
This paper was prepared b
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Office of African and Latin
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American Analysis. It was coordinated with the
Directorate of Operations. Comments and queries are
welcome and may be directed to the Chief, Middle
America Caribbean Division, ALA
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Secret
ALA 87-10027
May 1987
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Mexico:
Pushing for
Economic Growth
Scope Note This Assessment is part of a continuing effort within the Directorate of In-
telligence to analyze the Mexican economy and its impact on the United
States. It examines President de la Madrid's economic growth plan,
assesses its prospects for success, and presents alternative outcomes for
Mexico should the economy prove unresponsive to the government's
stimulative measures or should oil prices change significantly. We have
limited the scope of our Assessment to the shortly after de la
Madrid's successor takes office.
Conclusions of the paper were supported by the Agency's econometric
model of Mexico.
Secret
ALA 87-10027
May 1987
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Key Judgments The next 18 months, in our view, will be crucial for both Mexico's
Information available economic and political well-being. The approach of a presidential election
as of 15 April 1987 in 1988, at a time of lagging public support for the ruling Institutional Rev-
was used in this report.
olutionary Party (PRI), is certain to make the incumbent administration
even more sensitive to the impact of economic policy on its immediate
political prospects, as well as on the legacy it leaves to its successor. Indeed,
President de la Madrid already appears convinced of the need to abandon
austerity and embark upon a new and risky economic growth program.
We believe such expansionist fiscal and monetary policies are likely to
combine with Mexico's new $13.7 billion financial relief package to
generate a moderate economic recovery this year-with 2 to 2.5 percent
growth-and somewhat better performance in 1988. Nevertheless, this
upturn will come with some painful tradeoffs, particularly in terms of
higher inflation. In addition, the deep-seated problems that prevent
sustained growth are unlikely to be addressed. As a result, we expect the
President to turn over to his successor in late 1988 an economy in some
ways worse off than the one de la Madrid inherited in 1982.
As it so far has unfolded, the government's growth program relies largely
on massive increases in both public and private sector investment. A new
tax policy is central to achieving both of these goals. De la Madrid hopes
more lenient depreciation schedules, writeoffs, and lower tax rates will
expand the tax base to generate the resources sufficient to finance greater
government investment spending. Mexico City also believes a more
aggressive tax collection strategy will boost federal income. Despite the
administration's efforts, we expect investment to run below optimistic
government expectations over the next two years. Our calculations suggest
that budgetary constraints will help limit increases in public investment,
and we anticipate a sluggish response from the private sector to de la
Madrid's newfound supply-side economics.
Should the economy fail to respond with moderate growth in 1987, we are
convinced the de la Madrid administration would resort to further fiscal
stimulus in 1988. With the presidential campaign in full swing, increases in
v Secret
ALA 87-10027
May 1987
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government spending probably would be financed through money creation
and deficit financing, since these measures are more politically acceptable
than tax hikes. Although these moves probably would produce growth by
election time, they also would generate dramatically higher inflation and a
sizable increase in the public-sector deficit.
When de la Madrid leaves office in September 1988, none of the problems
identified at the beginning of his term-such as high levels of inflation, un-
employment, and budget deficits-will have been alleviated, despite deep
sacrifice by the Mexican people. Indeed, unless oil prices rebound marked-
ly, the economic problems faced by the new president will be substantial
and the pressures to find lasting solutions to Mexico's problems will be
even greater than those faced by de la Madrid. Most likely, he will be
forced to respond to the challenges with fewer resources than his predeces-
sor had.
Mexico City's inability to raise living standards and create sufficient jobs
to satisfy its growing labor force will create a wide range of problems for
the United States. As Mexican interest groups increasingly vie for slices of
a shrinking pie, we expect unemployment and social discontent to grow.
This could prompt even higher rates of illegal emigration to the United
States, although new US immigration laws almost certainly will have a
mitigating effect. We also anticipate a surge in Mexican drug cultivation
and narcotics trafficking as more Mexicans turn to illicit activities to
supplement their incomes. On the financial side, Mexico almost certainly
will continue to look to the United States to arrange future financial rescue
packages, and a new deal may be needed as early as mid-1988. If Mexico
were unable to service its debt, US moneycenter banks would stand to lose
the most should debt be written down or payments suspended. These banks
have shouldered most of Mexico's financing burden, and will continue to do
so, in our view.
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Shifting the Emphasis to Growth
Major Constraints 6
A Troubled Long-Term Outlook 14
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Mexico:
Pushing for
Economic Growth
Mexican President Miguel de la Madrid's actions in
recent months have made it clear that he is dramati-
cally shifting policy gears to achieve economic growth
over the next two years. His decision to avoid tough
austerity measures in favor of growth reflects, in our
view, the President's perspective on political reality:
the economy must improve to prop up lagging support
for the ruling Institutional Revolutionary Party (PRI)
before the presidential election in 1988. De la Madrid
appears convinced his Program for Growth and Ad-
justment, or PAC, by its Spanish acronym, will
guarantee such results.
Judging from recent financial agreements, de la
Madrid also appears to have convinced the IMF and
commercial banks that economic growth is critical to
Mexico's well-being (see inset). The program signed
with the IMF in September 1986 broke new ground,
setting only lenient performance targets and even
going so far as to provide contingencies to compensate
for falling oil prices and lagging economic recovery.
While the IMF accord set precedents, the agreement
with commercial creditors was largely a return to the
stopgap solution adopted in 1984: massive new lend-
ing and rescheduling of existing debt.
Having achieved a temporary respite from external
obligations, de ]a Madrid now is faced with the
challenge of delivering on his promises of growth
without sparking an inflationary spiral. We believe
the next 18 months will be crucial; the PRI dearly
hopes to use this time to restore popular confidence in
the government's ability to manage the economy and
allot economic resources-roles central to the domi-
nance of the party. Equally important, the way de la
Madrid pursues a growth policy today will shape the
problems the next Mexican President faces.
are explored, involving both internal obstacles to
growth and changes in oil prices. Finally, the paper
assesses the longer-term outlook for Mexico and the
implications for the United States.
The President's change in strategy comes against a
backdrop marked by early success and, more recently,
by economic problems. After achieving remarkable
economic results by painful austerity early in his
term, the de la Madrid administration reverted to a
heavy dose of stimulation before the midterm election 25X1
in July 1985. Plummeting oil prices compounded
fiscal and monetary excesses, lea vin the economy in
a near shambles by mid-1986. 25X1
as early as
November 1985, key Mexican leaders decided that
the economy must be put on a growth path in order to
prepare the ground for that national election in 1988.
Indeed, by February 1986 de la Madrid had pledged
in a major public speech that renewed growth would
be an imperative during the last two years of his
administration.
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While at the time indicated support for 25X1 1
more expansionary economic policies, agreement was
not universal. For example, to gain a consensus on a
new growth policy, de la Madrid asked Finance
Minister Silva Herzog, the primary proponent of
continued austerity, to step down in June 1986. It is
generally acknowledged that Silva Herzog lost an
economic battle with Programming and Budget Min-
ister Salinas, who has eyes on the presidency.' Salinas
is a strong advocate of economic expansion, and his
'The Finance Ministry and the Programming and Budget Ministry
are two distinct government agencies in Mexico. Historically, their
respective missions often have put them at odds, since the former is
charged with generating the revenues that the latter spends
This paper examines the prospects for economic
growth over the next two years. It assesses the course
chosen by the de la Madrid administration and
outlines the tradeoffs involved. Alternative scenarios
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Mexico's agreement with the IMF in July 1986
represented a departure from traditional Fund strate-
gy. Instead of pushing for tough domestic austerity
measures, the Fund agreed to an approach recogniz-
ing the Mexican economy's need to grow if the
country were to meet its external obligations. Specifi-
cally, the agreement called for massive amounts of
foreign credits, an explicit commitment to economic
growth, and a contingency provision to adjust financ-
ing to changes in oil prices. Mexico City promised
little in return. The only targets Mexico committed
itself to for the length of the agreement deal were
with maximum levels offforeign borrowing and the
country's level offoreign exchange reserves. All other
targets were to be set on a quarterly basis through the
first quarter of 1988. As a result of the first two
quarterly consultations, Mexico has eased through
the program with relatively lenient performance crite-
riafor the budget deficit and foreign exchange reserve
targets.
Mexico also gained repayment concessions from the
creditor banks, although far short of the interest
payment relief that de la Madrid originally sought.
The banks agreed to stretch out the maturity on
$43.7 billion in public-sector debt borrowed before
1983 and grant a seven-year grace period. The com-
mercial lenders also pushed back the maturity on
1983 and 1984 loans from Mexico's last bailout
package and gave the country a three-year grace
period. In a compromise, Mexico will pay 13/16th of
a percent above the London Interbank Offer Rate on
past and future loans. Finally, the de la Madrid
subsequent ascendancy over economic matters after
Silva Herzog's dismissal virtually assured that foreign
debt or other problems would not hinder efforts to
stimulate the economy. Once consensus was achieved,
action followed quickly. One week after Silva Her-
zog's departure, newly appointed Finance Minister
Petricioli unveiled the PAC plan. The announcement
was designed to deflect mounting public criticism
from labor and other elements within the PRI that de
la Madrid had placed the needs of foreign creditors
before those of the Mexican people.
administration has engaged creditors in negotiations
for the rescheduling of Mexican private-sector debt.
Mexico hopes these will be concluded by this sum-
mer.
In terms offinancing, international creditors initially
put together a $1.6 billion bridging loan to tide
Mexico over until the bailout package was signed and
delivered. Another $1 billion was loaned to Mexico
from the IMF and the World Bank. Additional bank
lending was delayed, however, as the country's Bank
Advisory Committee struggled to get a 100 percent
commitment to the $7.7 billion commercial bank
contribution. The final $300 million of the package
came only grudgingly, as European and small US
banks proved the most difficult to bring on board.
Announcements in late January 1987 that Mexico
actually built its currency reserves by $500 million
caused some banks already committed to question
the country s true need, but Brazil's payment suspen-
sion in February helped to convince reluctant credi-
tors, and the agreement was finalized on 20 March.
In essence, the banks' $7.7-billion contribution to the
package buys them an uninterrupted flow of interest
payments until at least mid-1988. From the Mexican
perspective, the agreement allows President de la
Madrid to leave the country's debt problem to his
successor. We believe international lenders share the
President's short-term perspective, preferring this ap-
proach to the possible interest payment suspension
that a tougher stance risked.
The Path to Expansion
Mexican officials have said publicly that they are
aiming for modest growth. By adopting policies de-
signed to stimulate only a gradual expansion of
economic activity, they also hope to reduce inflation.
This strategy, combined with the nine-month delay in
commercial bank lending, has already prompted gov-
ernment forecasters to scale back initial promises of
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Figure 1
Mexico: Government and Private
Investment, 1982-88
Although de la Madrid is emphasizing investment as
an expedient to achieve his short-term growth targets,
we believe higher levels of investment are also critical
ingredients for Mexico's longer term economic health.
In addition to creating jobs and fueling the demand
for goods and services, higher levels of investment are
needed to modernize the deteriorating industrial base
so that it can sustain economic growth.
plants and infrastructures-especial-
ly in the petroleum, steel, electricity, and transporta-
tion sectors-have become rundown, inefficient, and
obsolete. We judge that, unless these conditions are
reversed, the economy could become unresponsive to
even heavy government stimulus. From a purely
political perspective, an unresponsive economy also
could take away one of the PRI's election tools.
2 Estimated.
b Projected.
4 percent growth in 1987 to the 2- to 3-percent range.
This slower rate of growth also will qualify the
country for $500 million in additional contingency
financing from its foreign creditors. Mexico City does
not yet appear to have a firm set of plans for 1988,
although we believe de la Madrid wants to pursue
policies directed at inching growth up toward the 3- to
4-percent range by the September 1988 elections.
According to government announcements, the de la
Madrid administration is counting heavily on in-
creased investment to revitalize the economy. Current
plans call for a 15-percent real boost in public-sector
investment this year, and policymakers similarly hope
to spur an 8- to 9-percent real increase in private
investment. In our opinion, both are much-needed
moves: according to government statistics public in-
vestment has fallen 45 percent in real terms since
1982, and the private sector's lack of credit and
confidence sharply cut its investments in 1986 (see
figure 1).
The de la Madrid administration plans to free re-
sources for investment by altering its traditional
spending mix. According to government announce-
ments, increases in current federal expenditures 2 will
be limited to less than 1 percent, while capital outlays
are scheduled to rise 15 percent. The shift to an
emphasis on investment represents a reversal of tradi-
tional spending patterns. In the past, the government
has redirected funds earmarked for public investment
into current consumption, both because the economy
is more responsive to such spending and because it is
more politically popular. Recognizing that this bias
has been costly over the longer term, the de la Madrid
administration now appears committed to avoiding
some of its past mistakes by directing funds to capital
outlays in such sensitive areas as petroleum explora-
tion and development and infrastructure, which
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lagged while current spending surged (see figure 2). 25X1
Mexico City plans to generate a major portion of the
funding for its ambitious investment objectives from
the proceeds of new tax laws based on supply-side
incentives (see inset). To finance government invest-
ment, Mexican officials have announced plans to
' Current outlays are those expenditures used for existing projects
and operations, including salaries, the cost of goods and services
consumed by the government, and subsidies on various goods.
Investment spending, on the other hand, is associated with the
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Figure 2
Mexico: Government Consumption
and Investment, 1982-88
0
0 0 ? Investment
-40 1982
a Estimated.
b Projected.
J
their advantage.
tion reduces its effectiveness-because results will be
slow in coming and because they question the next
administration's resolve to follow through-while oth-
ers are confident they can find loopholes to use to
initial private-sector response has been mixe : many
businessmen believe the plan's gradual implementa-
ment.
expand the tax base by lowering rates and enhancing
collection efforts. At the same time, the new law
contains incentives, such as accelerated depreciation
and increased deductions, to stimulate business invest-
provide needed funding for investment.
In addition to projected tax revenues, Mexico's finan-
cial rescue package from foreign creditors also will
housing projects, export stimulation, and labor-inten-
Meanwhile, in addition to the
new money, rescheduling of the country's public-
sector debt (see figure 3) will free additional resources
over the next several years that could be used for more
productive purposes.
In addition to higher levels of investment, Mexico
plans to pursue a looser monetary policy and a slower
devaluation of the peso in order to achieve more
growth. Such a policy would be a reversal of the
strategy that in 1986 allowed the country to meet its
external obligations while weathering an $8.5 billion
A 70-percent increase in
the money supply so far this year and a decrease in
the peso's slide relative to the dollar probably reflect
the Budget Minister's dominance over economic
policy.
Prospects for the Growth Program
On the basis of our calculations,' we conclude that
Mexico City will not realize the 4-percent level of
economic growth that its IMF program was designed
to achieve. Our analysis of the PAC-factoring the
government's own assumptions into our econometric
forecasts-suggests that Mexico can achieve the low-
er end of the 2- to 3-percent level Mexican policymak-
ers now are projecting. However, this lower level of
growth masks a number of key constraints that could
' Our analysis of the impact of government policies and external
shocks on the Mexican economy is based in part on the results of an
econometric model. Although we recognize that no model can
gauge with precision the exact effects policy changes will have, we,
nevertheless, are confident that the results provide a good measure
of the orders of magnitude involved. For a technical description of
Mexican officials reportedly will allocate $2
billion in foreign loans to be disbursed this year for
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Mexican policymakers are counting heavily on new
tax laws to finance expansionary fiscal policies,
according to press reports and official announce-
ments. Essentially, the government hopes to increase
the tax base through incentives designed to boost
private spending and investment, as well as efforts to
enhance collection. For example:
? Tax rates have been lowered in the hope that
consumers and businesses will spend more, thereby
increasing the tax base and boosting tax revenues.
? Incentives, such as more rapid depreciation allow-
ances and increased deductions, are designed to
encourage greater private-sector investment
activity.
? Finally, Mexican officials have vowed to boost tax
receipts by a more vigorous collection campaign
and the enforcement of laws that require taxes to be
paid more promptly.
The supply-side measures officials are counting on
often are effective in Western economies, but we are
skeptical that they will work for Mexico. For one
thing, the gradual implementation of the program-
evenly spread out over four years-will work to
dampen the immediate economic benefits. Moreover,
since so many Mexicans are at or below subsistence
levels, and by some estimates would need to spend
almost three-quarters of their income to purchase the
Mexican minimum daily nutritional requirement,
much of any increase in their disposable incomes
resulting from lower income tax bills would go to
increased purchases of.food. In addition, since many
food prices are subsidized by the government, and
these subsidies are scheduled to be gradually phased
out, the net impact could be quite small.
a Taxpayers delaying their payments benefit at the government's
expense because, with inflation accelerating so rapidly in Mexico,
The private sector's lack of confidence in the economy
could dull the effectiveness of tax incentives, as well.
In many cases, uncertainty about the prospects for
growth beyond the next two years is likely to take
precedence over the attractiveness of an investment
that would reduce a company's tax bill. This problem
is exacerbated by the fact that the tax laws will not
be fully implemented until Mexico has a new (cur-
rently unpredictable) president.
We are similarly skeptical of the effectiveness of
enhanced collection plans. Mexicans traditionally
have been adept at avoiding taxes. Not surprisingly,
the wealthiest have tended to be the most successful
evaders. Taxes of many lower-class workers often are
withheld by their employers, but most middle-class
workers-who would be paying higher taxes-do not
face such deductions from their earnings and find
evasion easier. More efficient tax collection is cer-
tainly a worthwhile objective in Mexico, but we agree
with the US Embassy's assessment that it is unlikely
to be successful.
At the same time, some provisions in the new tax
code could induce a repatriation of Mexican capital.
A continuation of the "reverse capital flight" seen
during the first few months of this year could provide
substantial benefit to Mexico, both in terms of reduc-
ing its dependence on foreign banks and giving confi-
dence to foreign investors. Domestic interest-bearing
investments now are more attractive because only the
noninflationary component of interest income must be
declared. Moreover, under the new provisions, it is
far less attractive for private Mexican businesses to
borrow to finance their investments since they can
only deduct the noninflationary component of their
interest payments.
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Figure 3
Mexico: Scheduled Principal Paymentsa
Before and After Rescheduling,
1986-2004
Billion US $
a Public-sector debt.
b Under Mexico's previous rescheduling, pay-
ments would be completed in 1999.
cause problems in 1988. Moreover, even the modest
recovery we foresee will come only with costly trade-
offs. Specifically:
? We forecast a real GDP growth of 2 to 2.5 percent
this year and 3 to 4 percent in 1988. Our projections
show modest increases in private-sector investment
of 3.5 percent and 2.5 percent in 1987 and 1988,
respectively.
? We do not foresee progress on controlling inflation.
Our projections place the level at 130 percent by the
end of 1987 and 140 percent by the end of 1988.
Our forecasts also indicate that real private consump-
tion-after falling 4.4 percent in 1986-will rise 1.5
to slightly more than 2.0 percent annually over the
next two years. The increased economic activity is
likely to create roughly half a million new jobs over
the next two years, but a rapidly expanding labor
force will drive unemployment up 2 to 3 percentage
points before de la Madrid's term is over.
Although the growth we project is far from spectacu-
lar, it is a clear improvement over the 3- to 4-percent
contraction in 1986. (see figure 4). We believe it will
be enough to satisfy de la Madrid's primary political
objectives, which are to diffuse opposition criticism of
the government's economic management and ensure a
smooth victory for the PRI in 1988. Toward these
ends, we believe government spending will be targeted
to key PRI constituencies-especially labor-to cre-
ate jobs, increase incomes, and generate political
capital for the party. Consequently, we expect to see
rapid growth in housing projects and public works
programs. In addition, stronger domestic demand,
both public and private, is likely to not only boost
employment but also to help fuel the underground
economy, which is estimated by scholars to be equiva-
lent to 30 percent of Mexico's GDP and is vital to the
livelihood of unemployed and underemployed
Mexicans.
Major Constraints
A number of factors are likely to restrict growth to
the 2- to 2.5-percent level we project, under the most
likely circumstances. For example, our modeling re-
sults reveal a sluggish response to the new tax pro-
gram, which will create a revenue problem for the
Mexican Treasury. We are not confident that the
supply-side tax incentives will increase the tax base
significantly, and we are skeptical that an enhanced
tax-collection program will work any better in Mexico
than it does in other Third World countries.
We believe public investment is likely to fall short of
government expectations because government income
will be less than anticipated. Foreign loans and a more
rapid growth in the money supply should offset these
constraints somewhat, but the revenue shortfall will
put added pressure on the federal budget. Moreover,
Mexico City's commitment to avoid crowding-out-a
situation where high levels of government spending
result in a sharply reduced level of credit for the
private sector-also will limit capital spending. Taken
together, these factors will limit increases in federal
investment to only 13 percent this year. Government
plans for 1988 are unclear but, on the basis of
the
constraints we envision, we believe federal investment
will increase 10 percent over the expected levels for
1987.
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Figure 4
Mexico: Selected Economic Indicators-Most Likely Case, 1982-88
a0
M 00 00 l0 10 00
.r W W 00 00 00 00
a Estimated.
b Projected.
N
D\ M 00 Vt 'D r- 00
- 00 00 00 00 00 00
Private Consumption
Real percent change
-10 o0O .0 a
D\ M 7 V1 ~0 r 00
.- o0 00 00 00 00 00
Mexican Exports (fob)
Billion US $
N .0
00
- M 00 00 00 00 00
,-. OO 00 00 OO 00 00
Private Investment
Real percent change
-30
0o m 0
00 "Zr 00 '0 00 00
Mexican Imports (fob)
Billion US $
N .0 L
00 tO
M 00 v1 ~0 00 00
.--00 00 00 00 00 00
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We expect real private-sector investment to increase
3.5 percent this year and 2.5 percent in 1988, but a
host of factors are likely to produce results well below
government hopes of growth in the 8-percent range.
Among those factors working to dampen private
investment would be the effect inflation could have on
the federal deficit. Inflation levels in excess of official
projections of 70 to 80 percent would increase govern-
ment expenses-especially its domestic interest bill-
more than anticipated. This, in turn, would necessi-
tate more domestic government borrowing and de-
crease the amount of credit left over for the private
sector to use for investment. On the positive side,
funds from foreign lenders are likely to help mitigate
some of the factors restraining liquidity, allowing the
government to make some more credit available for
private business.
Over the next two years Mexico will be struggling to
overcome the dramatic drop in export revenues in
1986, further straining its ability to achieve growth.
The severe constraint that lower oil income placed on
growth in 1986 will be alleviated, in part, by the
higher prices industry experts project, and we assume
that Mexican export levels will hover around govern-
ment targets of 1.35 million barrels per day. We
project a 15-percent increase in oil revenues for 1987.
Still, this year's figure will be nearly 50 percent below
the levels for 1985 and will rise only another 15
percent in 1988. We believe that nonoil exports, the
bright spot in Mexico's trade picture for 1986, will
continue to perform well over the next two years,
although they are likely to increase less than last
year's impressive 34-percent rise, because of what we
expect to be a slower depreciation of the peso and a
somewhat higher domestic demand for goods.
Despite an improving export picture, the current
account deficit is likely to grow as greater import
demand-fueled by the higher level of domestic
growth-tends to offset gains on the export side. If
our growth projection is on track, we calculate a
25-percent rise in Mexican imports between now and
the end of 1988. This growth, combined with a public
and private annual debt-servicing bill of about $9.7
billion, translates into a current account deficit of
about $3 billion for 1987 and nearly $4 billion in
1988.
Looking at Mexico's overall foreign financial situa-
tion, the country appears to be in good shape, al-
though current account pressures should begin to
build in 1988. New lending and foreign-exchange
reserves probably will be used to finance the current
account gaps, and Mexico almost certainly will have
sufficient resources left over to meet its IMF target
for 1987 of a $900 million increase in foreign curren-
cy reserves. Already we believe these holdings have
increased from a low of about $2 billion in August
1986 to a level of nearly $8 billion by May 1987. By
the end of 1988, however, we expect the increasingly
larger current account deficit to begin to strain
Mexican foreign-exchange reserves. On the basis of
our projections, these reserves still would be sufficient
to cover the gap, but to maintain what Mexican
officials consider an adequate cushion-probably $4-5
billion in gross terms-Mexico probably would return
to the bank lending windows once again
Costly Tradeoffs
Even the modest recovery that we think de la Madrid
can achieve before the 1988 election will bring signifi-
cant costs. Contrary to official Mexican Government
estimates, we predict that inflation will accelerate
well above the 1986 level of 106 percent to peak at
about 130 percent by the end of 1987 (see inset).
the basis of policies now being followed, we estimate
that in 1988 inflation probably will reach 140 percent.
Recent actions by Mexican officials suggest that
Mexico City already has conceded the fight against
inflation, despite public statements to the contrary.
The inflationary spiral in Mexico is fueled by the
government's lack of progress in cutting the federal
budget deficit significantly.
Moreover, the relatively lenient
IMF targets to date lead us to conclude that the
government is making little progress in cutting the
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Despite emergency wage hikes and government prom-
ises to make adjustments quarterly in 1987, the
minimum wage still has failed to help workers keep
pace with inflation-since 1982, their buying power
has decreased 43 percent, according to the US Em-
bassy. In our judgment, this trend is likely to contin-
ue as inflation increases and the financially strapped
government fails to match it with proportionate wage
hikes.
Rapidly rising inflation is forcing Mexicans to spend
a larger portion of their salaries to purchase basic
necessities, particularly food. According to Mexican
press reports, the minimum wage is insufficient to pay
for the minimum nutritional requirements for a
family of five, and many families must choose be-
tween buying food and paying for other necessities
such as clothing, utilities, and rent. More specifically:
? According to the latest census, 21 percent of the
work force earns the minimum wage while 61
percent earns even less.
? A National Minimum Wage Commission study
concluded that 3,305 pesos per day were needed in
1986 to pay for minimal family needs, yet the
minimum wage last year was only 2,060 pesos.a
Although government subsidies and food coupons
help reduce food costs, press reports reveal that many
vendors make sales of desired food conditional on the 25X1
purchase of other foods, or they hoard goods in
anticipation of price increases. As a result, families
have been forced to substitute less expensive foods
and even eliminate their intake of some essential
goods:
? During 1986, while the minimum wage increased 94
percent, prices for tortillas, a key ingredient in
nearly all Mexican diets, rose 306 percent, accord-
ing to the Mexican press.
? At the same time, bread prices rose 380 percent;
milk prices, 168 percent; and egg prices, 117 per-
cent.
? By November 1986, food costs in the Federal
District-which encompasses Mexico City-con-
sumed 73 percent of the minimum wage, leaving the
remaining 27 percent to cover clothing, housing,
transportation, and schooling.
budget deficit. Consequently, we see the deficit as a
share of GDP falling only 2 percentage points from
the level for 1986 of nearly 17 percent, and we expect
little improvement in 1988.
In addition to the direct trade-off between govern-
ment economic stimulation and inflation, government
actions indirectly are tending to give rise to price
increases. Widespread pessimism about the govern-
ment's ability to control inflation raises inflationary
expectations, leading workers to demand higher
wages, retailers to charge higher prices, and credit to
become more expensive. Ironically, rumors of an
"Azteca Plan" (see inset on pages 10-11) to attack
inflation, similar to programs implemented in Brazil
and Argentina, have created the same "fueling"
effect. some workers are 25X1
demanding higher salaries in anticipation of wage
freezes and that private businessmen have increased
their prices before they, too, are fixed.
Although economic activity will increase in 1987, we
do not believe Mexicans will see much improvement
in their well-being, and their living standards certain-
ly will remain far below historic levels. The de la
Madrid administration appears ready to grant more
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Rumors that Mexico will try to harness its accelerat-
ing inflation by adopting a program of wage, price,
and currency controls similar to Brazil's Cruzado
Plan and Argentina's Austral Plan have circulated
the plan exists, it has taken on a life of its own:
many groups
inside Mexico once saw the Azteca Plan as a
panacea. Although their confidence no doubt has
been shaken by the failure of Brazil's program,
many may judge that the risk of failure is better
than unabated inflation, and perhaps believe that
Mexican policymakers could learn from mistakes
of their Brazilian counterparts. If inflation reaches
into the 150 percent range, as we suspect it could,
public clamor for relief could push de la Madrid
into adopting such a plan, which generally produces
a quick, albeit temporary, political payoff
? According tol press accounts,
retailers had been keeping their prices artificially
high in anticipation of a price freeze.
? To placate labor and allay concerns of a wage
freeze, Mexico City has hinted that workers' pay
will be indexed to inflation.
Although) Ide la Madrid be-
lieves Brazil's current economic crisis resulting from
the failure of the Cruzado Plan vindicates his own
cautious economic policies, we think it is useful to
look at what an Azteca Plan would mean for Mexico.
Mexican officials would try to implement the shock
program without revealing their intentions in ad-
vance, but there are a number of indicators that
would presage such a plan. Among these measures
are:
? Allowing prices to reach their equilibrium levels
through the elimination of nearly all subsidies and
freeing of prices controlled by the government.
? Permitting interest rates to become more market
sensitive, with a premium given to short-term rates.
This flexibility is essential so that rates immediate-
ly fall once inflation slows.
? Facilitating greater competitiveness in the exchange
rate by making it more sensitive to the market.
? Allowing wages to rise with inflation for a period of
time. Given the political importance of organized
labor in Mexico, we would expect a series of wage
hikes before implementing the plan in order to
enable workers to fare better once prices were
frozen.
Once such a program was announced, Mexico City
almost certainly would introduce a new currency-
most likely valued at 1,000 pesos-and a mechanism
for converting peso liabilities. In addition, we would
expect the real growth in government spending to be
cut in half. Finally, we would expect de la Madrid to
appeal to the Mexicans' sense of patriotism to en-
courage retailers to adhere to price freezes and for
consumers to report violations. The experience in
Brazil and Argentina suggests that such an appeal,
combined with strict laws to punish offenders, can be
effective in the short run.
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Would the plan work? Forecasts are mixed: Brazil's
experience cautions against such a plan, but there is a
wide body of opinion among economists that supports
such a move and holds that the short-term benefits
could be substantial for Mexico. These economists a
predict that:
? Real GDP growth will be lower in 1987 than in our
most likely case, but the 1988 increase would be 4
to 6 percent.
? Inflation will be slashed from 110 percent in 1986
to 60 to 70 percent in 1987. The projected range for
1988 would be about 40 percent.
? As a share of GDP, the budget deficit of GDP will
fall impressively, from about 17 percent in 1986 to
9 percent in 1987 and only 5 percent in 1988. F_
This remarkable recovery would be led by a surge in
domestic demand after a short lag, but soon problems
could emerge if the infrastructure were unable to
adjust or de la Madrid were unable to keep the reigns
tight. For example, the higher level of real wages
would allow private consumption to surge. The subse-
quent increase in jobs could be as high as 1.6 million
by 1989, according to one forecast. Although Mexi-
can firms currently are beset by overcapacity, the
spending boom eventually would strain output. If
private business were unable or unwilling to adjust,
black markets and hoarding most likely will emerge,
as was the case in Brazil and Argentina.
a The private economic forecasting firms that we surveyed were
convinced an Azteca Plan would produce major economic benefits
for Mexico. We have averaged their forecasting results, but caution
that these projections give little weight to political factors and
their influence on key economic variables. In short, they present
the best possible outcomes on paper, devoid of political constraints.
Meanwhile, the demand for imports would soar while
domestic demand sapped exports. Thus, Mexico
could see a sharp deterioration in its trade balance,
jeopardizing its ability to remain current on its
foreign debt or borrow additional money to fund
business expansion.
Many observers believe that the short-term gains of
an Azteca Plan would eventually give way to even
greater economic problems than those currently fac-
ing Mexico. These skeptics point to Brazil as an
example, where President Sarney s popularity initial-
ly soared with the success of the plan, but political
pressure from forthcoming elections forced him to
sustain the Cruzado Plan longer than he should have.
In addition, strong pressure from organized labor-
also a key player in Mexico-prevented wage con-
trols from being effective. Now, after abandoning
"Cruzado II, " Brazil's problems are worse: the coun-
try has rocked the international financial community
by indefinitely suspending interest payments, and
inflation is expected to surpass levels before the
program went into effect.
We suspect that in Mexico these same forces could
combine with other obstacles often cited-the porous
northern border and the lack of export diversity, for
example-to limit the effectiveness of an Azteca
Plan. Consequently, de la Madrid may find it prefer-
able to leave the problem of inflation and the Azteca
option to his successor.
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frequent wage increases, but rapidly rising inflation is
likely to keep real earnings depressed and combine
with high unemployment-especially during the first
three quarters of 1987-to limit the growth in private
consumption. What savings Mexicans may realize
from lower tax bills could be offset further if the
government proceeds with plans to lower subsidies on
basic foods and essential services. As a result, the
Mexican people will continue to sacrifice, and domes-
tic manufacturers probably will not see much im-
provement in their sales.
The de la Madrid administration's narrow focus on
short-term growth could prove most costly by restrict-
ing the ability of the regime to generate sustained
longer term growth. Even the Mexican Government
has agreed that a number of structural reforms (see
inset) are needed to achieve growth in the outyears,
but these officials remain reluctant to ask for sacrifice
now in order to realize benefits in the future. Al-
though loans that Mexico City will receive over the
next year could be used to soften the blow of these
adjustments, the de la Madrid administration appears
set on choosing the course that brings the quickest
return. Consequently, we believe that the government
and the PRI will continue to resist structural adjust-
ments, since such politically risky measures are un-
popular with many Mexicans and are opposed by
labor and other powerful interests within the ruling
party.
In recognition of the longer term price that will be
paid for even a modest recovery, some of the Presi-
dent's closest economic advisers
have counseled de la Madrid to move slowly in
loosening the money supply and opening federal cof-
fers, Because campaign
politics take precedence, we believe their efforts to
influence policy will be fruitless, and current pressures
to expand will almost certainly intensify as the presi-
Most economists are convinced that Mexico must do
the following to achieve lasting growth:
? Sell, liquidate, or merge state-owned enterprises,
especially the larger firms, in order to increase
efficiency and reduce the heavy burden on the
government.
? Allow foreign investment to increase and permit
majority foreign ownership in order to further
increase efficiency in domestic production.
? Reduce import quotas and restrictions while con-
tinuing to diversify the export base away from
petroleum.
? Reverse the urbanization trend by providing eco-
nomic incentives for migration to the country and
training the rural labor force.
An Unresponsive Economy
Although we are confident that the Mexican economy
will rebound in 1987, we recognize that there is a
chance it may not respond as quickly as Mexican
officials hope or as our model calculates. Indeed, the
impact of Mexico City's policies on the economy in
recent years has been hard to gauge. The austerity
measures de la Madrid implemented upon taking
office, for example, produced a far deeper recession
than was anticipated. In 1987,
Mexican planners are trying to
"fine-tune" the economy, believing they can moderate
inflation by calibrating the rate of economic expan-
sion-a difficult task even in developed, well-orga-
nized economies.
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If an economic recovery fails to materialize in 1987,
we believe de la Madrid will sharply increase fiscal
and monetary expansion in order to ensure growth
going into the presidential election. To achieve this,
Mexico City is likely to aggressively increase govern-
ment consumption to complement already planned
increases in investment. Stimulating the economy by
boosting government consumption in the past has
proved more effective than merely increasing invest-
ment. With the presidential campaign in full swing by
early in 1988, we assume that de la Madrid would
most likely opt to finance the increased spending by
printing more money and running up the public-sector
deficit, rather than by increasing taxes. In our opin-
ion, the government correctly assumes that the aver-
age Mexican is much more likely to protest tax
increases than growth in the federal deficit or money
supply.
We believe it would take much larger doses of
government spending to achieve a strong recovery.
If, for example, de la Madrid were to increase real
government consumption in 1988 by 10 percent-
equivalent to former President Lopez Portillo's pre-
election expansionary efforts-while proceeding with
already planned investment outlays, we project he
would:
? Fuel real GDP growth to 5 percent, as compared
with 3 to 4 percent in our base forecast, and
stimulate a 3.4-percent climb in real private invest-
ment.
? The increased activity would generate, according to
our calculations, an increase in real disposable
income 4 percentage points higher than we other-
wise would expect, nearly doubling real growth in
private consumption. In addition, we estimate that
some 500,000 jobs could be created by the end of
1988.
Such heavy government spending would carry sub-
stantial economic penalties, especially sharply rising
deficits and inflation. The strain on the federal deficit
would be intense: instead of the modest decline we
projected in the most likely case, the deficit as a share
of GDP probably would rise 1 to 2 percentage points,
exceeding the 17-percent level of 1986. The increase
we predict in inflation is even more dramatic-from
the expected level for 1987 of 130 percent to as much
as 200 percent by the end of 1988.
Dramatic Impact if Oil Prices ...
... Tumble Again. To some degree, Mexico is protect-
ed from a dramatic fall in oil prices, because its
recently negotiated financial package provides contin-
gency financing should Mexican oil prices fall below
$9 per barrel. ? Our analysis, however, concludes that
the oil price set by the IMF probably is too low,
because it is below the level needed to assure econom-
ic growth or an uninterrupted flow of interest pay-
ments to Mexico's creditors. In other words, if oil
prices fall to just above $9 per barrel-$4.50 less than
in our baseline scenario and the equivalent of a $2 25X1
billion drop in exports-we estimate that:
? Real GDP would contract 0.6 percent in 1987, and
growth for 1988 would be only a modest-and
probably politically unacceptable-1.4 percent.
? Inflation would rise to about 150 percent in 1987
and 180 percent in 1988 as Mexico City turned to
deficit financing and faster money supply growth to
mitigate the loss of oil revenues
Mexico would be hard pressed to weather the loss in
oil revenues without external assistance. In terms of
the current account, we estimate that Mexican oil at
$9 per barrel would translate into deficits of $4 billion
for 1987 and $5.7 billion in 1988. Given the govern-
ment's aversion to a substantial reduction in foreign-
exchange reserves and our certainty that it would be
unwilling to make needed internal adjustments before
the 1988 election, we do not see Mexico meeting its
foreign obligations without further concessions from 25X1
the banks. Therefore, we would expect the country to
demand that creditors reopen negotiations or face a
suspension of interest payments.
' Prices referred to here are keyed to averages for Mexican Isthmus
crude (light, roughly 40 percent of exports) and Mayan crude
(heavy, about 60 percent of exports). Historically, there has been a
$2 to $3 per barrel differential between lower priced Mexican oil
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... Reach OPEC Targets. On the other side of the
coin, successful OPEC price coordination 5 could lead
to higher than expected oil revenues 6 and significant-
ly boost growth. Mexican export prices of $18 per
barrel would translate into oil revenues $2.2 billion
higher this year than forecast in our baseline case; in
1988, our assumption of Mexican oil at $24 per barrel
yields revenues of $5.2 billion higher. If all of the
windfall were channeled into domestic programs and
original government plans were maintained, we calcu-
late that Mexico could:
? Achieve a sizable increase in real GDP, from the
2- to 2.5-percent range in our most likely scenario to
about 6 percent in 1987. Growth in 1988 would
surge from about 3 to 4 percent in the baseline to
nearly 6.5 percent.
? Ease strains on the federal deficit and thereby slow
inflation. In this scenario, we project an inflation
rate of 110 percent for 1987 and a 90-percent level
for 1988.
? Experience a surge in private consumption of 5
percent in both 1987 and 1988 as compared with
baseline projections of 1- to 2-percent growth. The
return to pre-1980s consumption patterns would
create jobs and expand private businesses, and could
stimulate significant increases in foreign investment
as domestic markets revitalized.
We project that by the end of 1988 such an economic
upturn would generate as many as two-thirds of the
900,000 jobs needed annually to satisfy the demands
of the growing work force. Moreover, additional
resources almost certainly would be used to raise
government wages, which subsequently would tend to
drive up all workers' pay.
6 Although not often referred to, the other end of Mexico's of price
contingency calls for reduced external financing should prices rise
above $14 per barrel. In such a case, foreign lending would be
reduced by an amount equal to the excess (over $14 per barrel) oil
We believe, however, that for reasons of political
expedience Mexican leaders would not use the addi-
tional revenues to ease the pain of structural adjust-
ment needed for sustained growth. Similarly, in-
creased oil export earnings would not necessarily
translate into current account surpluses. According to
our calculations, the large boost in oil revenues would
be offset by a surge in import demand in both years
and larger domestic debt-servicing costs from the
higher interest rates, which we project if oil prices
rise. Consequently, in this scenario, despite a $1
billion and $2.5 billion improvement in the current
account this year and next, when compared to our
baseline forecast, we still calculate deficits of about
$1 billion and nearly $2 billion, respectively.
A Troubled Long-Term Outlook
While we do not predict an economic breakdown in
Mexico during the remainder of de la Madrid's term,
we believe there is little hope for major improvement.
Most likely, the economy will muddle along at modest
levels of growth. We believe there is a good chance,
however, that de la Madrid will leave his successor in
the throes of a financial crisis shortly after he takes
office in December 1988. Beyond that period, slow oil
price increases and decreased oil production may
combine with creditor unwillingness to lend additional
money and upset the preelection growth pattern on
which the PRI has come to depend.
credits.
The rules of the financial game are already changing.
Mexico's difficulty in obtaining commitments for 100
percent of commercial banks' share of its $13.7 billion
financial package and the recent debt moratorium by
Brazil suggest that current debt strategies will have
evolved significantly by the time Mexico once again
returns for new money.' Given these likely changes in
the international financial arena, Mexico City may be
hard pressed to offset fiscal excesses with foreign
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While short-term palliatives, such as increased bor-
rowing, will relieve some of Mexico's economic prob-
lems over the next two years, many of these problems
are more intractable. Higher than expected oil prices
would postpone-but certainly not alleviate-some of
these problems. For example, unemployment has
more than doubled since mid-1982 and currently
stands at over 18 percent nationwide; there may be
another 30 percent who are underemployed. The
problem is even worse in urban areas where approxi-
mately two-thirds of Mexico's more than 80 million
people reside. Current strains will only intensify: US
forecasting firms estimate that the economy would
need 6- to 7-percent growth per year to satisfy the 3.5-
percent annual increase in the labor force. This harsh
reality, coupled with prospects for further losses in
real wages unless inflation is controlled, is likely to
lead organized labor and other groups to intensify
their efforts to gain greater job security, control over
subsidies, and more frequent wage hikes, in our
judgment.
Moreover, the demographic strains now gripping
Mexico are sure to worsen. The population, which has
doubled in the last 25 years, will reach 104 million by
the end of the century, according to the US Bureau of
the Census. Meanwhile, the search for jobs will
intensify the rush to Mexico's cities, contribute to the
burgeoning slums-which now contain 20 percent of
the country's population-and place additional strains
on the government's already inadequate ability to
meet rising demands for water, health, and other
services.
Even looking well beyond de la Madrid's term, we see
almost no chance of sustained growth and little
chance for the robust growth of the 1960s and 1970s
in any one year-unless it is an election year. The
political realities suggest that neither de la Madrid
nor his successor will make much progress in imple-
menting the structural economic reforms that are
needed to achieve growth on a sustained basis. Be-
cause these policy changes run counter to the en-
trenched view of government as the protector of
domestic employment and industry, we do not expect
much progress in opening the economy to trade and
investment or a significant reduction in dominance of
the government over the economy
When de la Madrid leaves office in September 1988,
Mexican citizens almost certainly will assess his eco-
nomic performance negatively even if his stimulative
policies revive the economy. Although a disastrous
earthquake and the plunge in oil prices were unavoid-
able setbacks, we believe none of the problems identi-
fied at the beginning of his term-including slow
economic growth, massive budget deficits, high infla-
tion and unemployment, sharply reduced living stan-
dards, and current account deficits-have been
solved, despite deep sacrifice by the Mexican people.
Indeed, most of the positive trends set in motion
through their sacrifice will have been reversed. From
a broader perspective, economic growth will average
far lower and inflation much higher during de la
Madrid's six years in office than at any other time in
recent Mexican history (see figure 5).
We conclude that the economic demands on the next
president will be substantial and that the pressures on
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will be even greater than those faced by de la Madrid.
Most likely, he will be forced to respond to this
challenge with fewer resources and an unhealthy
economy made shakier by the economic policies of his
predecessor. Moreover, we believe de la Madrid's
"muddle-through" strategy, which is dependent on
periodic external bailouts, will be increasingly diffi-
cult to preserve
If short-term solutions are unavailable, the next presi-
dent would have several options for dealing with
Mexico's economic problems. He could react either by 25X1
taking tough structural adjustment measures-decid-
ing to ask the Mexicans to sacrifice the present for a
better future-or, conversely, by increasing further
the government's economic role. History would argue
for the latter approach. In addition to using the
government's economic dominance to buy political
support, the next president could respond by:
? Allowing populist considerations to dominate his
economic decision making.
? Adopting an "inward" orientation, which stresses
nationalism and the need for Mexicans to be self-
reliant.
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Figure 5
Mexico: De La Madrid's Legacy
Real GDP, 1965-88
Percent change
Inflation, 1965-88
Percent change in CPI
/ Yearly
a Estimated.
b Projected.
? Becoming increasingly unwilling to compromise
with creditors or, in the extreme, suspending debt
payments.
In any case, we believe the Mexican people are
headed for even more difficult times than those
experienced over the past four years.
Implications for the United States
We believe Mexico's long-term economic prospects
depend to a great extent on conditions in the United
States. Export sales are linked to US import demand,
and changes in US interest rates directly affect
international rates, thus determining the size of Mexi-
co's debt-servicing bill. Although both countries are
becoming more economically linked, in our view,
Mexico is more beholden to the United States than
the converse. For example:
? Mexico sells about 60 percent of its petroleum
exports to the United States, yet this figure only
accounts for 16 percent of US imports and 5 percent
of US consumption.
? Mexico's border industry program-its second-
largest source of foreign exchange and one of the
few truly bright spots on its horizon-is totally
dependent on continued access to US markets.
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Secret
Tourism, Mexico's third-most important source of
foreign earnings, also is influenced by US economic
conditions and public perceptions of Mexico's good
will.
? Mexican exports to the US provide a shot in the arm
for the Mexican economy, with the US market
providing much of the impetus to growth of Mexi-
co's nonoil exports. As the US dollar continues to
depreciate, however, Mexicans will be forced to
increase their competitiveness if they hope to contin-
ue to diversify their export base.
Perhaps more important, Mexico's financial depen-
dence on the United States will continue to grow, and
Mexico City-and its commercial creditors-almost
certainly will look to Washington for more financial
support, possibly by the end of 1988. In our judgment,
the difficulty in once again raising large sums of
money for Mexico is likely to change the rules of the
game. If Mexico is unable or refuses to service its
debt, US moneycenter banks stand to lose more than
other creditors should Mexican debt be written down
or payments suspended. Moreover, whatever the di-
rection of change, we believe the international finan-
cial community will look to Washington to limit the
pain.
Mexico City's inability to raise living standards and
create sufficient jobs to satisfy its growing labor force
will significantly strain the Mexican system, creating
additional problems for Washington and the US
southern border. As interest groups in Mexico vie
more desperately for pieces of a shrinking resource
pie, we expect strains in the system to intensify. One
consequence of this will be an increase in the thou-
sands of Mexicans that immigrate illegally to the
United States. If new US immigration legislation
proves effective in narrowing what has become a vital
safety valve for Mexico, additional political strains
could confront the PRI. According to press reports,
significant numbers of illegal emigrants already are
returning to Mexican villages and swelling ranks of
the unemployed! We also expect an upsurge in
Mexican drug cultivation and narcotics trafficking as
more Mexicans turn to illicit activities to supplement
their incomes.
We conclude that economic conditions in Mexico will
continue to shape its bilateral relations with the
United States. Moreover, this reality is likely to 25X1
transcend economic relations between the two coun-
tries, spilling over into other areas of mutual concern,
such as foreign policy and border issues. A prolonged
economic slump in Mexico would have a mixed
impact on Mexican-US relations. Although Mexico
City may respond to such a situation by increasing its
reliance on Washington and becoming more sensitive
to US concerns, we believe that fierce Mexican
nationalism will require its leadership to continue to
publicly distance itself from the United States. Eco-
nomic prosperity in Mexico also could cut both ways.
Although a sustained period of growth would decrease
the country's need for US support and could lead
Mexican leaders to take a tougher stance in areas
where mutual interests conflict, it also could relieve 25X1
the pressure on top Mexican leaders to make the
economic changes necessary to put the country on a
sounder, and more politically stable, economic foot-
in 25X1
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Appendix
An Econometric Model
of Mexico
The econometric model of Mexico used in this paper
is designed to help analysts make conditional esti-
mates of Mexican economic prospects. It provides a
convenient mechanism for looking at the interactions
of many economic factors simultaneously and for
studying the potential impact of policies and economic
events on the path the economy is expected to follow.
? Foreign economic developments. These influences
on the Mexican economy include the level and
changes in US real economic activity, the US
inflation rate, changes in US real per capita dispos-
able income, and US imports of agricultural goods.
Mexico's import and export prices in dollar terms
are also considered exogenous variables, along with
the level of net foreign transfers and several catego-
ries of Mexican exports.
The model can be used to project four groups of
variables. These groups-the model's endogenous
variables-include measures of:
? Real domestic economic performance. The key vari-
ables include gross domestic product, private con-
sumption, and private fixed investment.
? The government's financial position. In this catego-
ry we include the overall public-sector deficit and
the amount of public-sector borrowing from the
monetary authorities.
? Balance-of-payments accounts. This group of vari-
ables includes components such as the balance of
trade, the current account balance, and the change
in international reserves.
? Inflation. The model projects changes in the gross
domestic product deflator.
All forecasts derived from the model are conditioned
by assumptions regarding three groups of exogenous
variables:
? Fiscal policies. The more important of these mea-
sures are public-sector consumption and investment
and the aggregate implicit tax rate. Also included
are net transfers to the private sector, nontax reve-
nues of the public sector, and the deficit of the
public-sector enterprises.
? Monetary policies. These include government debt-
management policy, changes in the required reserve
ratio for the banking system, and the level of public-
sector foreign borrowing.
One hundred and fifty-seven equations connect the
exogenous and endogenous variables of the basic
model. Of these equations, 20 involve econometric
estimates of relations among variables. The rest of the
equations are accounting identities. The model can be
collapsed for presentational purposes into a demand-
and-supply framework of 18 equations. This simpli-
fied model ignores most national income accounting
identities, trade disaggregation, and lag structures.'
The general structure of the model consists of four
sectors-real demand, aggregate supply, price forma-
tion, and financial.
Components of Real Demand
Gross domestic product (GDP) equals private con-
sumption (CP) plus private investment (IP) plus gov-
ernment consumption (CG) plus government invest-
ment (IG) plus exports (X) less imports (M).
' Copies of a discussion of the complete model, including its
parameter estimates and policy multipliers, are available on
request.
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Private consumption (CP) depends on current dispos-
able income (DY), on the rate of inflation (INFL), and
on a real wage rate index (WAGE).
CP=f(DY,INFL,WAGE)
Disposable income (DY) equals gross domestic prod-
uct (GDP) minus taxes (T) plus transfer payments and
government subsidies (TR).
Private investment (IP) depends on the change in the
level of GDP [del (1:GDP)], on real money supply
(RM2), and on the gap between the actual and the
trend level of gross domestic product lagged one year
[GAP(- 1)].
IP = f [del(1:GDP),RM2,GAP(-1)]
Nonoil exports (X) depend on economic activity in the
United States (USGNP), on the ratio of exchange-
rate-adjusted Mexican prices to US prices (PMA/
PUS), and on the lagged level of exports [X(- 1)].
X=f [USGNP,PMA/PUS,X(- 1)]
Oil exports are projected outside the model.
Imports (M) depend on gross domestic product (GDP),
on the ratio of exchange-rate-adjusted US prices to
Mexican prices (PUSA/PM), and on the lagged ratio
of the current account deficit to export earnings
[BAL(- 1)/X(- 1)].
M = f [(GDP-X),X/PM,PM/YPD]
Imports (M) depend on gross domestic product netted
of total exports (GDP -X), on exports deflated by the
import price deflator (X/PM), and on import prices
relative to the GDP deflator (PM/YPD).
Government consumption (CG) and government in-
vestment (IG) are exogenous variables.
Aggregate Supply
The trend level of output (GDPTREND) equals the
lagged level of trend output [GDPTREND(- 1)], plus
an estimated function of real private investment from
the current year and each of the last four years
weighted in decreasing value.
GDPTREND = GDPTREND(- 1) + f [IP,IP(-1),
IP(- 2),IP(- 3),IP(- 4)]
The difference between actual GDP and trend GDP
(GAP) is used as a measure of excess demand pres-
sure, and is an explanatory variable in the private
investment equation.
Price Formation
The inflation rate (INFL) depends on the percentage
change in the money supply (ddM2), on the percent-
age change in the exchange-rate-adjusted import
price index (ddPMS), and on the percentage change in
a wage rate index (ddWAGE).
INFL = f(ddM2,ddPMA,ddWAGE)
Financial Sector
The money base (MB) equals net foreign reserves in
pesos (NFR) plus net credit from the Central Bank to
the public sector (NCPUB) plus net credit from the
Central Bank to the private sector (NCPRI) less
liabilities of the Central Bank (CBLIAB).
MB = NFR+ NCPUB + NCPRI - CBLIAB
M2=f(MB)
The accumulated treasury deficit (ADEF), equals last
period's deficit [ADEF(- 1)], plus loans from the
Central Bank, which are assumed to equal the public-
sector deficit (PSDEF).
ADEF=ADEF(-1)+PSDEF
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The public sector deficit (PSDEF) equals government
consumption (CG) plus government investment (IG)
plus net government transfer payments (TR) less taxes
(T), less net government foreign borrowing (GFB).
Total tax revenues (T) are equal to the sum of tax
receipts from petroleum exports (TP), domestic gaso-
line sales (TG), and the level of disposable income
(TY).
Petroleum tax revenues are assumed to equal a fixed
proportion (PTXRATE) of oil export revenues (OR).
Gasoline tax receipts are calculated as a fixed propor-
tion (GTXRATE) of gasoline sales (GS).
The remaining tax revenues are assumed to equal a
fixed proportion (YTXRATE) of disposable income.
Net foreign reserves (NFR) equal lagged net foreign
reserves (NFR) equal lagged net foreign reserves
[NFR(- 1)] plus export earnings (X) less imports (M)
plus net government foreign borrowing (GFB) plus net
private foreign borrowing (PFB).
NFR = NFR(- 1)+ X - M + GFB + PFB
The exchange rate (XR) can be treated either as an
exogenous variable or as an endogenous adjustment to
differing rates of inflation in Mexico and the United
States. In the latter case the exchange rate is equal to
the exchange rate last period [XR(- 1)], times one
plus the rate of Mexican inflation (INFL) divided by
one plus the US inflation rate (ddUSP).
XR=XR(-1)X(1 +INFL)/(1 +ddUSP)
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Secret
Secret
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