Mexico economic outlook, December 2022

Private consumption, on the other hand, was supported by the recovery seen in the labor market² and real wages, record-breaking remittances,³ and the easing of pandemic-related mobility restrictions. Private consumption currently stands 3% above its prepandemic levels (figure 2). In the wake of the pandemic and restrictions on mobility, online sales accelerated sharply (+30% annually in 2021), which led to significant divergence between the consumption of imported goods (+17% annually between January and July 2022) and the consumption of national goods (+2.9% annually). Although this has had a positive effect on consumption, it has also surfaced as a drag on net exports.⁴

Although there are signs of a deceleration as we approach the end of the year, things are looking a bit brighter than previously expected. We estimate an annual growth of 2.6% for this year (up from 2.1% anticipated previously). However, we forecast a slowdown to hit the Mexican economy next year, with growth expected to slip down to 1.5%. 

Our main assumptions for 2023 are as follows: 1) Inflation will continue its downward trend but will remain above 4% throughout the year, eroding households’ purchasing power and lifting input costs for businesses. 2) Interest rates will remain high, putting pressure on borrowing costs and dampening private sector credit. 3) Mexican policymakers will continue to favor fiscal austerity, which will do little to catapult growth. 4) The expected slowdown in the United States⁵ will weigh heavily on Mexico, given the strong trade and investment links between the two countries. On the upside, manufacturing activity and foreign investment could accelerate in the wake of nearshoring.

Continuing with the austerity pledge

Although austerity measures are serving Mexico well in a postpandemic world where countries face higher debt and interest burdens,⁶ the administration’s policy priorities and its optimistic economic growth forecasts for 2023 are concerning. 

The Mexican policymakers recently approved the 2023 budget criteria, where they also refreshed the outlook for 2022.⁷ The budget continues to favor fiscal austerity, aiming to deliver a largely balanced primary budget of 0.1% of the GDP for this year and a small deficit of 0.2% for 2023 (figure 3). The goal will likely be accomplished with higher-than-expected revenues, which will come mainly from higher oil revenues and anti-evasion efforts. Also, the expected tax collection is based on the possibility that the economy will expand 3% in 2023, something that seems difficult to achieve at this stage. The market consensus for Mexico’s economic growth in 2023 currently is merely 1%.

Those higher-than-expected revenues will be mainly focused on maintaining social spending (figure 4). The 2023 budget dedicates approximately half of its programmable expenditure to social spending and priority investment projects. Social spending imperatives—such as subsidies, flagship programs, and pensions—will increase by 30% in real terms in 2023 with respect to 2022, whereas public investment will rise to 3.4% of GDP in 2022 and 3.6% in 2023, the highest since 2016, thus finally coming out of its historical slump.

Covering social spending with cyclical, rather than new structural, revenue sources will lead to fiscal pressure afterward.⁸ Additionally, fiscal prospects could be affected by lower financial buffers as fiscal stabilization funds have been virtually depleted—fiscal stabilization funds went from 1.6% of GDP in 2018 to 0.2% in the third quarter of 2022. 

Certain domestic policy decisions focused on restricting private participation and expanding the role of the state in certain economic activities, such as energy and mining, represent other downside risks to growth prospects. Recently, the United States and Canada requested dispute settlement consultations with Mexico under the United States-Mexico-Canada Agreement (USMCA).⁹ This is due to Mexico's energy policies, as the United States and Canada say it favors Mexico’s state-owned electrical utility. Potential retaliation of the United States or Canada could hinder Mexican exports to those markets.

Inflation: Higher for longer

The main attention of policymakers has been focused on price pressures, which are proving quite stubborn. This phenomenon is being witnessed all around the world as higher input prices have pushed the costs of final goods.¹⁰ In Mexico, although most of the inflationary pressures come from abroad, there are also internal factors that have influenced inflation’s upward trajectory. 

In the first phase of the pandemic, the demand for goods soared and for services collapsed. Then, as countries eased mobility restrictions, the demand for services recovered, but the demand for goods remained high. These developments put upward pressure on both producer and consumer prices. During the second quarter of 2021, inflation breached the Bank of Mexico’s (Banxico’s) target inflation range of 3%. Furthermore, annual average inflation went from 3.4% in 2020 to 5.7% in 2021, reaching a maximum of 7.4% at the end of the year.¹¹

The pandemic caused changes in human activity, as people spent more time at home than outside of it. Therefore, demand for goods related to households increased, such as furniture and appliances like stoves, fridges, and vacuum cleaners. Similarly, the global chip shortage made electronic devices¹² and automobiles more expensive. Finally, the reactivation of services in the country and the relaxed travel restrictions caused a sudden surge in tourism-related services (flights, hotels, travel packages) (figure 5). Higher oil prices in 2021, meanwhile, translated into higher gasoline prices that went from a negative annual variation in December 2020 (–8.8%) to a double-digit annual expansion in April 2021 (+35%).

The start of the war in Ukraine triggered another global supply shock.¹³ Fuel and food prices, which were already rising, shot up further. Because of speculative trades, the price increases for oil far outpaced any changes in supply and consumption. Moreover, supplies of some key grains and fertilizers were disrupted, and consumer food prices accelerated worldwide.¹⁴ In Mexico, processed food prices (included in core inflation) went from an annual increase of 5% in January 2021 to 15.2% in September 2022. As a result, services related to food increased their prices, creating a spiral that has spread from production costs to the final consumer. For example, for restaurants and other related sectors, inflation ended 2020 at an annual rate of 3.9%, which rose to 6.6% by the end of 2021, and by September 2022, it had reached 10%. Also, services that are highly correlated with international fuel prices (such as airfares) have also seen sharp price increases.

Inflation is expected to come down in 2023―from 8.5% at end-2022 to 5.0% at end-2023. However, the pace of this downward trajectory will be gradual and subject to risks. On the upside: 1) Global supply chains continue to show improvement,¹⁵ which has already begun to be reflected in merchandise prices. 2) The decrease in international food prices has started to feed through.¹⁶ 3) The expected economic slowdown will help reduce demand-side pressures. On the downside: 1) Adverse weather conditions, especially because of climate change, could drive inflation.¹⁷ 2) External inflationary pressures associated with the pandemic do not ease effortlessly, which would keep core inflation at high levels for longer. 3) The Russia-Ukraine conflict keeps going, which may still have a negative impact on agricultural and livestock product prices and on energy prices. 

If this downward trajectory of inflation is fulfilled, the Bank of Mexico (Banxico) could have space to cut the reference rate as of the second half of 2023 and be able to decouple from the Federal Reserve (FED). During the last six meetings, Banxico has replicated the increases made by the FED and we expect it to continue doing so at least until the first quarter of 2023. In light of this, we are expecting a 50 basis points (bps) hike in December 2022, and another 25 bps in the first quarter of 2023. This means that our terminal rate is 10.75% in Mexico. Later in the year, we expect a decoupling and anticipated 150 bps in accumulated cuts from Banxico (vs. only –25bps by the Fed), with the rate closing 2023 at 9.25%.

The manufacturing boom

As mentioned earlier in the article, Mexico’s manufacturing activities have grown significantly, bolstered by improving trade conditions and resilient US demand. However, another factor has played a role in this: nearshoring. Several factors have led companies to establish resources in Mexico to serve the US market,¹⁸ including lower transportation and labor costs. There is partial evidence that this is already happening.

As of August 2022, investment in machinery and equipment in Mexico was already 17.4% above levels seen in January 2020, that is, just before the pandemic hit, and 8.3% higher than in the fourth quarter of 2018, when investments reached their peak. This means that companies have been involved in significant acquisitions of capital goods to increase their production. Also, construction of industrial plants and warehouses grew 12.9% between January to August 2022 compared to the same period in 2021. However, it is still 35% below the Q4 2018 levels. This implies that industrial plants and warehouses that are already installed in Mexico continue to invest further, but the expansion of plants or the installation of new ones is more limited.

Another factor supporting the significant recovery in manufacturing is the foreign direct investment (FDI). Since 2021, FDI has been increasing in specific states and sectors of the economy, especially in the cities bordering the United States (Figure 7). In the first six months of 2022, FDI into Mexico reached 27 billion dollars, an increment of 24.5% compared to the first half of 2021. Also, employment has increased significantly in the north and center-north of the country, where most of the manufacturing is based. 

As of Q2 2022, manufacturing production in Baja California was almost 30% above its 5-year average (2015-2019); in Chihuahua it was 18% higher; in Sinaloa 17% higher, and in Nuevo Leon and Michoacan it was 16% higher.

Although the main manufacturing product in Mexico is motor vehicles and parts (it is still 3% below prepandemic levels), the manufacturing sectors that are driving growth this time around include electrical equipment (22% above January 2020), computer and electronic products (+13.2%), and plastics (+15.6%). This boom has resulted in manufacturing activities as a percentage of GDP to reach 16.5% from 15.9% in 2019.

In closing, Mexico has a golden opportunity in the form of nearshoring, as it could drive investments, exports, and overall economic growth, especially in the manufacturing sector. Nearshoring can also be a driver for Mexico to implement long-due structural changes to its economy, which will help the country’s medium-term growth prospects. Creating proper conditions to cash-in on this opportunity, thus, becomes critical.