Can global headwinds slow down Mexico’s economy?

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Uncertainty surrounding the global economy remains high. Despite relative calm in the markets, several black clouds are on the global economic horizon in 2012, with potentially serious consequences for Mexico, depending on how complicated the global situation becomes.

These threats include:

• The Euro-zone poses the main risk to the global environment with its unresolved financial and fiscal problems and with the threat of an imminent recession.
• The anemic growth of advanced economies is also cause for concern, although less so than the Euro-zone. Even in the United States, which appears to be experiencing a sustained recovery, growth is slower than in previous post-crisis periods.
• The uncertain growth of China and volatile oil prices –in part due to tensions in the Mideast–are other risk factors that weigh on world economic forecasts.

How does this scenario affect Mexico?

Despite the uncertain global climate, economic forecasts for 2012 are fairly positive. Under the so-called benign scenario –no new global recession- Mexico's economy will grow by over 3% with growth driven by the recovery of manufacturing, the solid increase in domestic demand, prudent macroeconomic management and a financial system with limited risks for external contagion.

Under a pessimistic scenario, a sharp global economic slowdown, Mexico's terms of trade, finances and economic forecasts will take a dip. Mexico's economy will suffer trade losses from a decline in export demand, raw material prices dropping, a shrinking credit and exchange rate pressures. Mexican consumers and businesses could reduce their demand for goods and services – postponing consumption and investment decisions as an adverse reaction to the economic uncertainty.

However there is no reason for alarm. The Mexican economy is well prepared to absorb external shocks. Its key strengths include an absence of financial and fiscal imbalances and a prudent sovereign debt management –an achievement that opens doors on the international capital markets. Additionally, Mexico has implemented a flexible exchange rate that helps absorb external shocks -for example, by mitigating a decline in external demand (as Mexican exports would benefit if the local currency depreciates).

Substantial international reserves and a flexible line of credit from the IMF are additional financial cushions against external shocks, allowing external financing needs to be covered in a complex global economic scenario.

Domestically, inflation will remain moderate at less than 4%, with inflation forecasts held at bay on the credibility of current macroeconomic policies. Stability and solvency of Mexico's financial system will be a continued source of strength and a support to domestic demand.

Obviously, our economy is not risk free. Fiscal policy response is currently weaker than in 2007 (the primary fiscal deficit in 2011 is approximately 0.3% of GDP, compared with a surplus of 1.5% in 2007).

These fiscal risks could be mitigated with stabilization funds from oil revenues and with oil hedges that protect against declines in oil prices. On the social front, poverty and unemployment have yet to recover their pre-crisis levels and both indicators could worsen should another external shock hit Mexico.

Even if no global storm disrupts Mexico's economy, there is no room for complacency. Mexico should address several pending issues.

Reducing growth and inequality gaps are priority tasks. Growth in Mexico has not been able to reduce its per capita income gap with the United States (for the past century, the average per capita income in Mexico has remained below 25% of its neighbor's). Promoting inclusive growth is crucial: poverty and inequality reach almost half of Mexico's population.

To address these gaps fiscal and business reforms should take place. Fiscal reforms would increase tax revenue –an important source to finance better social protection systems for the poor.

Reforms promoting private investment and business productivity would free Mexico from a century-old growth trap --preventing long-term growth and narrowing of the per capita income gap.

This blog post was first published in Spanish on CNN Mexico.