Prospects for growth and the environment in Mexico in the 1990s

Pergamon

World Development, Vol. 24, No. 2. pp. 307-324, 1996 Elsevier Science Ltd. Printed in Great Britain

0305-750x(95)00137-9

Prospects for Growth and the Environment in Mexico

in the 1990s

JAIME ROS University of Notre Dame, Notre Dame, Indiana, U.S.A.

JOOST DRAISMA The World Bank, Washington, DC, U.S.A.

NORA LUSTIG Brookings Institutions, Washington, DC, U.S.A.

and

ADRIAAN TEN KATE* Ministry of Commerce and Industrial Promotion, Mexico, D.F:

Summary. - This paper reviews the economic reform process in Mexico since the mid-1980s and its association with disappointing growth. The sluggishness is linked to a deterioration of the current account vs. growth tradeoff and unsatisfactory productivity growth and capital formation. Real currency appreciation and declining savings figured in these developments. Social and environmental sustainability will require faster growth in the future. Appropriate policy changes could move the economy toward a higher growth path while addressing its major environmental problems.

1. INTRODUCTION

Mexico has repeatedly been mentioned as a suc- cessful example of economic reform. Several years of dismal economic performance as a consequence of the debt crisis were followed by a recovery in the early 1990s which many thought was here to stay. Prudent fiscal and monetary policies, bold market-oriented reforms in the areas of trade, the public sector, financial markets, and the elimination of many regulations and restrictions on ownership and the operation of markets appeared to have opened the way to sustained growth. Nonetheless, economic recovery proved to be weaker than anticipated. Undoubtedly part of the problem arose from the uncertainty which surrounded the passage of the North American Free Trade Agreement (NmA) by the US Congress in 1993 and that created by political events in the fust half of 1994: the peasant uprising in Chiapas, the assassination of the PRI presidential candidate, and the climate sur- rounding the outcome and consequences of the presidential elections. Yet the recovery had petered out before some of these uncertainties made their appear- ance.

*Nora Lustig and Jaime Ros are responsible for economic analysis, and Joost Draisma and Adriaan Ten Kate for environmental issues. The authors are grateful to Gary Gordon for research assistance. Note to Reader: Since this paper was written, Mexico was pushed into a financial crisis triggered by the devaluation announced on December 20, 1994. What was meant to be a corrective devaluation on the part of the Mexican government prompted a sweeping reaction from foreign portfolio investors because the devaluation destroyed - for a while at least - credibility. This paper explains the underlying forces that existed behind the large current account deficit but does not analyze the characteristics or behavior of international financial markets. Nor does it examine the implications of the financial crisis on Mexico’s growth prospects. Undoubtedly, in the short run, the prospects are gloomy. Devaluation will be contractionary in the short run as a result of the decline in real incomes and as firms with large dollar debts are forced to contract their investment. In the medium term, an undervalued exchange rate, the openness of Mexico’s economy, and an ample margin for import-replac- ing production to flourish should translate into a net export- led recovery. The massive adjustment of the trade deficit in January, done partly as a result of a 35% increase in exports, provides ground for optimism.

307

308 WORLD DEVELOPMENT

This paper analyzes the factors that account for the weak recovery, and discusses the implications that slow growth could have on environmental sustainability. Sluggish economic growth could be especially worrisome in the face of the country’s pressing social and environmental problems. Although Mexico is in the midst of a demographic transition toward much lower rates of population growth than in the past, the expansion of its labor force - on account of the changing population age structure and rising participation rates in the labor market, especially for women - is likely to proceed at very high rates (close to 3% per year) for the foreseeable future. As a consequence, the “socially necessary” growth rates, required to absorb the new entrants into the labor force, remain well above those recorded in the recent past. In the face of these demographic trends, and the nature of the country’s major environmental problems, environmental sustainability will also require higher growth rates. Reducing the currently high levels of air and water pollution calls for substantially increased environmental investments while the high rates of soil erosion and deforestation are unlikely to be reversed without a rapid improvement in the living conditions in the rural areas.

2. RECENT ECONOMIC HISTORY

Mexico’s growth performance until the debt crisis was very impressive. Starting in 1940, the economy showed high and relatively stable rates of economic growth of close to 7% per year and a yearly rate of increase of per capita incomes of the order of 3% for four decades. The distribution of the benefits of this process of economic expansion remained, however, highly skewed’ while the state of the environment in the country deteriorated substantially during this period. The very high rates of population growth (over 3% per year) and the nature of the economic development both contributed to this outcome. Rapid energy and pollution-intensive industrialization, the concentration of economic activity in a few urban areas, and the expansion of agricultural land put increasing stress on the country’s natural resources and the environmental conditions.

This long period of economic expansion came to a halt in the early 1980s as a consequence of poor domestic policies and a series of external shocks. By mid- 1982 Mexico was in a deep economic crisis. The international economic environment was adverse to an economy saddled with foreign debt. World interest rates were high, the price of oil (Mexico’s main export) was falling, and commercial banks had stopped lending. This unfavorable international environment exacerbated the consequences of sharp macroeconomic imbalances and contributed to ram- pant inflation, capital flight, and chaos in the financial

and foreign exchange markets. To confront the internal imbalances and accommodate the adverse external conditions, Mexico was compelled to adjust its expenditures, reorient its output, and find new ways to foster growth.

(a) Stabilization policies

Two important domestic causes of the 1982 crisis were the real appreciation of the peso during the oil boom of 1978-81 and the rising fiscal deficit after 1980. With the external borrowing option no longer available after 1982, drastic adjustments took place in exchange rate policy and public finances. Major real devaluations took place during the 1982 financial crisis and in 1986-87 in response to the sharp decline in world oil prices in early 1986 (see Table 1). Fiscal imbalances were reduced and government policies soon generated a primary fiscal surplus that was especially remarkable considering the halving of oil export revenues during 1983-89.

How was the adjustment of public finances accom- plished? On the revenue side, oil-related income accounted for a large proportion of the initial rise in revenues (1983-85). The main contribution came from higher taxes paid by PEMEX on domestic sales and the indirect taxes on gasoline, reflecting an adjustment of the internal prices of oil derivatives. Another source of higher revenues was the increase in the value-added tax from 10 to 15%, along with a reduction in the number of exemptions. Later, the 1986 and 1988 tax reforms resulted in further increases in tax- based revenues as a proportion of GDP (see Table 1). These reforms included changes in indexation mechanisms to reduce the real income losses derived from collection lags, an increase in taxable items (including a 2% tax on business assets) and measures that tight- ened enforcement of tax compliance (the “crusade against tax evasion”).2

The public spending side of the fiscal equation on the aggregate was subject to less fortunate changes than the revenue side. To meet fiscal deficit targets non-interest government spending had to be cut sharply. Public investment was the major casualty. It was cut in half during this period, from about 8% of GDP in 1982 to close to 4% in 1988 (see Table l), and non-oil investment as a proportion of GDP reached its lowest level in the post-WWII era. Particularly hard hit were investments in fishing, tourism, industry, rural development, and energy, with cumulative declines of between 53 and 87% during 1982-91.

During 1983-88, the Mexican government focused its economic policies on restoring stability through fiscal deficit reduction. It finally succeeded with the crucial help of incomes policy, through the cooperation mechanism imbedded in the Economic Solidarity Pact adopted in late 1987. Through price

MEXICO 309

controls and an initial exchange rate and quasi-wage freeze, the “Pacto” brought inflation down to the lowest levels in the decade, at a small cost in terms of output losses and wage reduction (see Table 1). By 1988, fiscal and monetary discipline had been attained and runaway inflation had been checked. During the five years that preceded the “Pacto” the average growth rate of GDP per capita was negative (see Table 1). Stagnation imposed high social costs on the population as per capita real disposable income fell on average by 5% per year during 1983-88. Wages fell even more, social expenditures contracted, and poverty was on the rise.3

A sustainable recovery required a turnaround in the large net resource transfers abroad that persisted as a result of high interest payments, the reduction in external credit and foreign investments, and domestic capital flight. A first initiative was to seek a reduction in the stock and service of the external debt. In mid- 1989 Mexico signed an agreement in principle with its creditors to reduce its medium- and long-term debt under the so-called Brady Plan. Then, the Salinas administration accelerated the change in development strategy that had begun in the mid- 1980s under the de la Madrid presidency. Reforms sought to reduce state intervention and regulation so as to open new investment opportunities, build business confidence, and create a more flexible and efficient incentive structure. These reforms have called for substantial modifi- cations in the legal and institutional frameworks that will probably shape the economy for decades to come. In what follows, we summarize the main components of this reform program.

(b) Introducing structural reforms

Trade reform started in mid- 1985.4 Liberalization proceeded gradually at first and was consolidated in 1988. After the measures introduced in December 1987, the number of tariff rates was reduced to five, the maximum tariff was set at 20%, the production- weighted tariff was reduced to 1 l%, official reference prices were abolished, and domestic production covered by import licenses settled at about 20% (compared to 92.2% in 1985). In December 1989, licenses were still important to a few sectors: natural gas (100%). petroleum refining (86.4%), transportation equipment (41.0%), and agriculture (38.4%). About 20% of food and beverage domestic production was covered by import licenses.5

Changes in trade policy also implied the elimination or reduction of direct export subsidies. To a great extent, their elimination or reduction occurred within the context of the bilateral Understanding on Subsidies and Countervailing Duties signed between Mexico and the United States in 1985. By 199 1 export

incentives primarily included a tariff exemption on temporary imports and a program exempting exporters from import licenses on inputs. Export restrictions were also reduced. In early 1991 export permits applied only to commodities and goods sub-

ject to price controls or international agreements, such as coffee, sugar, steel, and textiles (about 24% of non- oil exports). Export tariffs were set at a maximum of 5.5% and were applied to commodities subject to export restrictions.

These unilateral trade liberalization measures were accompanied by a flurry of multilateral and bilateral initiatives. The most significant were Mexico’s acces- sion to General Agreement on Tariffs and Trade (GATT) and the negotiation of the NAFTA with the United States and Canada. Mexico joined the GATT in 1986.6 In practice, Mexico’s trade policy reforms went far beyond those required by the protocol signed on entry into the GATT. For example, Mexico agreed to bind its tariff schedule to a maximum tariff level of 50% ad valorem and to reduce tariffs on the majority of its import classification headings to levels of 2&50% over a period of 30 months. The current maximum tariff level, established in the trade liberalization measures of December 1987, is 20%.

In August 1990 President Salinas made an official request to start talks on a free-trade agreement with the United States. In September 1990 President Bush responded by notifying Congress that he would like to pursue negotiations. In February 1991 Canada offi- cially decided to join the negotiations. In late May the US Congress approved the extension of “fast-track” procedures for two more years beginning June 199 1. The extension came after several months of often bit- ter debate. Eventually, NAFTA was signed, approved and it came into effect January I. 1994.

Since the early 1960s the Mexican government had relied on sector- or firm-specific programs to promote industrial development. These industrial programs consisted of providing import licenses, fiscal incentives, and access to preferential credit, in exchange for a schedule of local content and export targets. One of the leading programs was developed for the automo- bile and auto parts industry in 1962.

During 1983-85, although industrial policy continued to be an important ingredient of Mexico’s trade regime, the number of programs was reduced to a few in areas identified as “priority” industries (in particular, automobiles, pharmaceutical, capital goods, and microcomputers).‘From mid- 1985 on, when trade liberalization and deregulation became an integral part of economic policy, the industrial programs started to be dismantled. Although some quantitative restrictions on imports were maintained, the government reduced many of the programs’ other incentives and regulations (government procurement rules, energy subsidies. tax credits, domestic content requirements). Further changes were introduced in 1989. For

Tab

le 1

. Ind

icat

ors

of e

cono

mic

pe

rfor

man

ce

1981

-93

(gro

wth

ra

tes

in p

erce

ntag

e un

less

spe

ci$e

d)

E

Ave

rage

19

93

1983

- 19

83-

1986

- 19

88-

1991

- 19

81

1982

19

83

1984

19

85

1986

19

87

1988

19

89

1990

19

91

1992

(P

r)

88

8.5

87

90

93

Ou

tpu

t an

d in

com

e*

Gro

ss D

omes

tic

Pro

duct

(a)

Gro

ss D

omes

tic

Pro

duct

per

capi

ta

(a. b

)

8.8

-0.6

4.

2 3.

6 2.

6 -3

.8

1.9

1.2

3.3

4.4

3.6

2.8

0.4

0.2

0.6

-1.0

3.

0 2.

3

5.9

-3.1

-6

.5

1.2

0.3

-5.9

-0

.3

-0.8

1.

3 2.

5 1.

7 1.

1 -1

.3

-2.1

‘1

.7

-3.2

1.

0 0.

5

Infl

atio

n*

Con

sum

er p

rice

s (c

) A

nn

ual

ave

rage

D

ec./D

ee.

(d)

27.9

58

.9

101.

9 65

.4

57.7

86

.2

131.

8 11

4.2

20.0

26

.7

22.7

15

.5

9.8

92.9

75

.0

109.

0 53

.6

16.0

28

.7

98.8

80

.8

59.2

63

.7

105.

7 15

9.2

51.7

19

.7

29.9

18

.8

11.9

8.

0 86

.7

67.9

13

2.5

33.8

12

.9

Pri

vate

dem

and*

In

vest

men

t (e)

C

onsu

mpt

ion

s (f

) 13

.9

-17.

3 -2

4.2

9.0

12.2

-1

0.4

6.8

10.9

9.

5 13

.3

12.7

20

.4

1.5

-0.3

-2

.5

7.4

-2.5

-5

.4

3.3

3.6

-2.3

a.

2 1.

8 6.

3 6.

1 4.

6 5.

9 -0

.1

0.1

0.4

-2.2

11

.2

11.3

-1

.3

4.7

3.4

4 E

Wag

es*

Wag

es q

uo

ted

by

indu

stri

al su

rvey

(g)

5.0

0.1

-24.

1 -6

.8

1.1

-6.9

-6

.5

-0.5

8.

9 3.

2 4.

8 9.

8 4.

9 -7

.7

-10.

6 M

inim

um

(h

) w

age

1.0

-0.1

-2

1.9

-9.0

-1

.2

-10.

5 -6

.3

-12.

7 -6

.6

-9.3

-4

.3

-4.6

-1

.2

-10.

5 -1

1.1

Avg

. re

al r

emu

ner

atio

n in

m

anu

fact

uri

ng (

d, i

) 3.

8 0.

7 -2

2.8

-7.1

-2

.8

-5.9

-1

.9

-1.3

9.

0 3.

0 4.

8 9.

9 4.

9 -7

.3

-11.

3

Ext

ern

al se

ctor

Impo

rts*

6)

Exp

orts

* (k

) N

on-o

il e

xpor

ts*

(1)

Bal

ance

of

trad

e (U

.S.$

bil

lion

s) (

m)

Cu

rren

t acc

t. b

alan

ce (U

.S.$

bil

lion

s)

(n)

(U.S

.$ b

illi

ons)

(0)

G

ross

int’

d re

serv

es--

end

of p

erio

d (U

.S.$

bil

lion

s) (

p)

Cap

ital

flig

ht

(U.S

.$ b

illi

ons)

(q)

A

vera

ge in

tere

st ra

te on

on

e m

onth

C

ET

ES

(%

) (r

) N

omin

al

Rea

l

17.7

-3

7.9

-33.

8 17

.8

11.0

-1

2.4

5.0

36.7

21

.3

18.8

16

.6

24.3

5.

2 1.

4 -4

.7

11.6

21

.8

13.6

5.

7 4.

5 3.

2 10

.1

5.8

2.5

3.5

5.1

8.2

12.3

5.

5 4.

7 9.

0 -1

4.0

32.5

20

.7

-9.2

41

.0

23.7

15

.2

7.5

12.0

12

.8

9.7

17.4

19

.5

13.2

-3

.8

6.8

13.8

12

.9

7.1

3.7

7.2

0.3

-2.6

4.

4 -1

1.3

-20.

7 -1

9.1

7.9

11.3

-16.

1 -6

.2

5.4

4.2

1.2

-1.7

4.

0 -2

.4

-5.4

-_

t -

- -

1.8

3.6

- -

- -

_ _

4.2

-2.4

-5

.8

-7.5

-1

4.9

-24.

8 -2

1.0

- -

5.0

1.8

4.9

8.1

5.8

6.8

13.7

6.

6 6.

9 10

.3

18.1

19

.3

24.0

7.

7 6.

3 11

.6

6.5

2.7

1.6

0.7

-2.2

0.

3 1.

1 -2

.9

na+

n

a n

a n

a 0.

7 1.

7

- -

56.6

48

.6

60.2

86

.7

96.0

69

.2

45.0

34

.8

19.3

15

.6

14.9

68

.7

55.1

-

- 3.

8 1.

2 9.

9 12

.3

2.9

29.2

29

.9

8.4

3.6

4.3

7.4

7.1

2.3

b

-4.1

25

.4

- 6.

6 3.

9 -

32.1

11

.5

- 5.

5 -2

.3

-17.

0

1.2

- -

- -5

.2

-20.

2

10.3

7.

9 20

.5

-1.0

n

a n

a

91.3

49

.0

16.6

4.

4 22

.1

5.1

Con

tinue

d ov

erle

af

Tab

le

1. C

onti

nued

Ave

rage

19

93

1983

- 19

83-

1986

- 19

88-

199-

19

81

1982

19

83

1984

19

85

1986

19

87

1988

19

89

1990

19

91

1992

(P

r)

88

85

87

90

93

Exp

ort

oil

pric

e,

avg.

(U

.S.$

pe

r ba

rrel

) (s

) 33

.2

28.7

26

.3

26.8

25

.5

12

16.1

12

.2

15.4

19

.1

14.8

15

.1

13.2

19

.8

26.2

14

.1

15.6

14

.4

Rea

l ex

chan

ge

rate

(1

980

= lo

o)

(t)

118.

7 86

.8

79.7

97

.2

100.

9 69

.2

63.6

77

.4

83.5

83

.1

91.1

96

.8

102.

1

Fisc

al

acco

unts

Pr

imar

y go

verm

nent

su

rplu

s (%

of

GD

P)

(u)

-8.0

-2

.5

4.0

4.8

3.9

2.5

5.7

8.1

8.6

7.8

5.6

5.7

3.7

4.8

4.2

4.1

8.2

5.0

Publ

ic

sect

or

borr

owin

g re

quir

emen

t (P

SBR

) (%

of

GD

P)

(u)

14.1

16

.9

8.6

8.5

9.6

15.9

16

.1

12.5

5.

6 4.

0 1.

5 0.

5 2.

5 11

.9

8.9

16.0

7.

4 1.

5 Pu

blic

in

vest

men

t (%

of

GD

P)

(w)

1.5

1.5

0.8

0.8

0.9

1 .o

0.9

0.5

0.5

0.8

1.0

1.1

1.1

0.8

0.8

1.0

0.6

1.1

Tot

al t

ax r

even

ue

(v )

12.9

13

.2

15.0

14

.5

14.4

13

.2

14.1

13

.6

14.4

14

.4

15.1

14

.9

na

14.1

14

.6

13.6

9.

4 15

.0

Gov

ernm

ent

bill

(% o

f GD

P)

wag

e (w

) 7.

3 8.

0 6.

7 6.

5 6.

6 6.

5 6.

4 6.

I

6.0

5.1

5.8

4.8

5.2

6.5

6.6

6.4

5.9

5.3

*Ann

ual

perc

enta

ge

chan

ge

t -n

ot

appl

icab

le.

*not

ava

ilabl

e.


example, in the new auto industry decrees passed in December 1989, automakers were allowed to import cars and trucks of their own manufacture and brand- name to supplement their domestic production. Beginning in 1990 and with model year 1991, imports would gradually open. Automakers also would no longer be restricted in the number of lines and models they could produce. Moreover, domestic content requirements were liberalized.*

Beginning in 1984 the regulatory framework governing foreign direct investment became gradually less restrictive.9 Legal restrictions in specific sectors were removed or relaxed (including petrochemicals and later the financial system) and regulations for the approval of investment projects were considerably simplified. In May 1989 a new set of rules repealed all prior regulations governing foreign investment. The 1973 law was not changed, but the new regulations expanded the range of operations open to 100% foreign ownership and, provided certain conditions were met. did not require investors to seek approval from the regulating body. The new rules were also designed to standardize requirements and increase efficiency in the authorization process. New mechanisms were also introduced to allow for foreign investment through the stock exchange and in early 1991 the money market was opened to portfolio investment. Eventually. these changes were incorporated into a new Foreign Investment Law which replaced the 1973 Law and was approved by the Mexican Congress in 1993.

With a background of piecemeal reforms and tacit negotiations with the United States, the Mexican government passed a new intellectual property rights law in June 1991 which extended patent life from 14 years to 30 years and trademarks from five years to 10 years. The law also simplified administrative procedures for registering patents and trademarks and improved judi- cial procedures to punish violators. A new copyrights law was also passed in July 1991. The law “extends to all copyright owners exclusive reproduction and distribution rights for a term of fifty years, exclusive rental rights, and significantly stiffened criminal and civil penalties for copyright infringement.““’ Increased protection for intellectual property has been a fundamental demand of the US business community, and the passage of this new Mexican legislation was crucial for free-trade negotiations to proceed swiftly.

A program to divest public enterprises started with de la Madrid but gained momentum under the Salinas government. Motivations to divest public entities have been varied. To raise public revenues, enhance allocative and managerial efficiency, and-above all - recover the business sector’s confidence were primary objectives. From 1983 on, public enterprises were privatized. closed, merged, or transferred from federal to state or regional entities. From the more than 1.000 public enterprises at the end of 1982. there were only 269 in mid-1991.” In December 1987 the

government announced areas and activities that would continue to be owned and operated by the state. These were upstream petroleum activities, that is, explo- ration, extraction, and refinement of crude oil and basic petrochemicals (PEMEX); electricity (CFE); national railways (FERRONALES); and food distribution (CONASUPO). The government implicitly announced (by not mentioning them) it would relin- quish telecommunications, airlines, steel production, transport equipment, chemicals and fertilizers, min- ing, sugar, as well as other industrial and service activities.

The major privatization took place in 1991-92 and involved the sale of the national telephone company (TELMEX) and the commercial banks that had been nationalized in 1982.‘? These accounted for over 18 of the US$22 billion obtained in privatization revenues by the Mexican treasury during 1989-92 (with TELMEX alone representing nearly 30% of the total). Other significant sales included the two leading airlines, Mexicana and Aeromexico and the copper min- ing company CANANEA.

Financial liberalization included two types of action: the liberalization of financial markets and the reform of the legal and institutional frameworks that regulate financial intermediaries (for example, banks, the stock exchange, and insurance companies).” The liberalization of the banking system began in 1985 and went through several stages. First, banks were allowed to engage in market operations similar to those of stock brokerage houses such as money market accounts and other financial innovations. Reforms introduced in 1988 and 1989 liberalized the banks’ reserve requirements and the determination of interest rates on loans and deposits. Reserve requirements were reduced from 80 or 90% of deposits to a “liquidity coefficient” equivalent to 30% of total deposits. Finally, changes introduced in 1990 allowed private sector majority ownership of banks and minority ownership by foreign investors. Capital requirements were updated according to risk and vulnerability considerations, and supervision of banking operations was strengthened. The new banking regulations provide the framework for “universal banking” in line with current trends allowing greater flexibility in banking services.

By the early 1990s the stabilization and reform programs had produced deep changes in the structure of the Mexican economy. Public finances turned from an operational deficit of over 5% of GDP to a small surplus. Following the “Pacto.” the economy returned to moderate inflation rates, of the order of 20% per year since 1988-89 and in continuous decline in recent years (in 1993, one-digit inflation was achieved for the first time since the early 1970s. see Table I ). The structural reforms of the second half of the decade transformed Mexico into a very open economy, on both the trade and capital accounts, and substantially

MEXICO 313

reduced the state’s participation in production and distribution activities.

During 1989-92, the sign of resource transfers changed as the selling of several public enterprises and banks, the prospects of greater integration with the US market, and attractive returns in the stock exchange translated into a jump in capital repatriation and foreign investment. For the first time since 1981, GDP per capita growth rates were positive for three consecutive years. The per capita rate of growth however, was lower every year until in 1993 when it was negative (see Table 1). Such a disappointing outcome ran counter to what had been expected to happen in Mexico. In the next section we address the question of why Mexico’s economic recovery has not been consolidated.

3. THE BUMPY ROAD TO RECOVERY

In the view of Mexico’s policy makers and most analysts of the Mexican economy, economic growth during the 1980s had been restrained by macroeconomic instability, the lack of business confidence, and the unfinished task of microeconomic reform. By and large, these obstacles to growth had been removed in the early 1990s. Yet, a strong and sustained economic recovery remained elusive. We now address two related questions: What accounts for the slow pace of economic growth that has characterized the Mexican economy in the postreform period since 1988-89? and what role has been played by external shocks, macroeconomic adjustment, and market-oriented reforms in the recent performance and changing prospects for economic growth?

Our analytical framework is a three-gap model of the determinants of the rate of growth of potential output. The model is presented formally in the appendix and is summarized in Figure 1. The sf-g schedule shows the rate of foreign savings (sf) required to finance the current account deficit at different rates of output growth (8). The schedule is positively sloped since higher growth rates generate larger current account deficits on account of the effects of investment on capital goods imports and the negative effects of capacity utilization on net exports. Its position is determined by a number of factors: the (exogenous) determinants of productivity growth, the domestic savings rates (public and private), the structural trade balance (i.e. the trade balance at given real exchange rate and capacity utilization), and the real exchange rate.

The 0-g schedule shows the rate of actual capital inflows as a function of the output growth rate. The schedule is also positively sloped on account of the accelerator effects of growth on foreign direct investments and the effect of growth on lender’s risk: given an initial external debt-GDP (or exports) ratio: the higher output growth rate, the larger the flow of foreign

indebtedness consistent with a nonexplosive path of the debt/GDP ratio. Provided that accelerator effects are not too large and the initial debt/GDP ratio not too high, the schedule is flatter then the sf-g curve. The position of the schedule depends on the state of business confidence and investment opportunities for foreign capital. The intersection of the two curves, at point A in Figure 1, determines the rate of output growth consistent with the equality between actual and required capital inflows. This growth rate, g*. is thus the maximum compatible with a sustainable long-run position in the balance of payments.14 The rest of this section will explore the recent evolution of each of the factors determining this rate of economic growth.

We begin by looking at the determinants of the sf-g schedule. Three major factors appear to have determined a deterioration of the growth-current account balance tradeoff in recent years (i.e. an inward shift in the sf-g schedule): a slowdown of productivity growth, a decline in the domestic savings rate. and a deterioration of the structural trade balance.

A rather well-established and noncontroversial result of recent studies refers to the productivity growth slowdown during the postreform period since 1985 or 1988.” Some estimates put the rate of total factor productivity (TFP) growth at zero percent while other results suggest a decline of productivity levels. In any case, all the studies agree that TFP growth has been well below historical performance.

At the same time, productivity performance has been very unequal across sectorQh In manufacturing.


productivity has shown a significant recovery from the low rates of growth that prevailed during the industrial slowdown in the first half of decade. Although its pace since the last cyclical peak (1985) remains on average below historical performance, this recovery has been gaining strength since 1988, and reaching an increasing number of industries. In 1990-93, labor productivity growth was, in fact, proceeding at a faster pace than historical rates and faster even than the recovery of output itself (which by 1992 was showing signs of a significant deceleration). The countertrend was, of course, declinings levels of employment and a shrinking share of manufacturing in total employment.

In contrast to the acceleration of productivity growth in manufacturing, productivity levels in traditional, low-productivity sectors (agriculture, con- struction, services) have been declining ever since the early 1980s. Declining productivity in traditional sectors and labor relocation away from high productivity sectors, stand in sharp contrast with historical trends before the 1980s when productivity increases and falling employment shares in traditional sectors accounted for a large proportion of overall productivity increases (of the order of 40% in the 1970s) and a rapid decline of informal employment (from 15.6% of total employment in 1970 to 7.6% in 1980).

In discussing the slowdown of TFP growth for the whole economy, Edwards (1994) has suggested that the sluggishness of deregulation in the agricultural and services sectors (in contrast to the early reduction of protection in most of manufacturing) explains the lagging productivity growth in agriculture and services as compared to manufacturing. In this interpre- tation, the impact on productivity of recent trade and land tenure reforms in agriculture and the reduction of government involvement in the services sector (tele- comunications and financial services) will only be felt with a lag. In our view, while the uneven pace of reform may explain why productivity growth outside manufacturing has been slower than otherwise, it does not give an account of the important role that labor relocation away from manufacturing has played in the worsening productivity performance.

There seems to be an important endogenous element in the slowdown in TFP growth, a consequence of the low rate of capital accumulation and the sluggish growth of the economy as a whole. Their effects operated probably through two main channels: the decline in capital productivity associated with the changing structure and age of the capital stock, and the expansion of underemployment and low-productivity informal activities resulting from a declining employment share of manufacturing. The falling employment levels in manufacturing are, in turn, a response of domestic firms to the profit squeeze and the loss of external competitiveness brought about by the trade liberalization cum real appreciation episode since

1988. In its absence, the improvement in the productivity performance of manufacturing would have determined a higher rate of manufacturing output growth and encouraged a faster reallocation of resources toward the high and fast-growing productivity sector, both of which would have contributed to a faster rate of change in overall productivity.

(ii) The decline in the domestic savings rate During 1980-92, the domestic savings rate

declined by about 10 percentage points of GDP, with most of this drop being explained by the collapse of private savings (see Table 2)” This decline took place in two stages, one in 1980-89 (4.6 percentage points) during the adjustment to the debt crisis and the 1986 oil price shock, and the other in 1989-92 (5.4 percentage points) during a period of massive capital inflows.

During the first period, the decline in private savings, as well as that of the overall savings rate, appears related to the decline in the population’s real incomes that took place during the macroeconomic adjustments in 1982-87 and, especially, during the adjustment to the 1986 oil price collapse.r8 Initially, the contraction of oil export revenues represented a shock to external public savings which, as a result, virtually disappeared by 1989. But through exchange rate and fiscal adjustments, involving a contraction of private disposable incomes, the shock was transmitted to the private savings rate.rq

In the second period, after 1989, savings fell in the midst of massive capital inflows from abroad. The positive capital account shock appears to have crowded out domestic savings, and especially private savings, through various channels. First, the decline in interest rates and the greater availability of consumer credit after a decade of severe credit rationing led to a rapid expansion of expenditures on consumer durables especially during 1992. The consumption boom was also probably stimulated by wealth effects on private consumption arising from the stock market boom up to mid-1992.20 Finally, the capital inflows allowed the peso to appreciate in real terms. The real appreciation of the peso eroded the real value of the government’s oil export revenues, with a negative effect on public savings, while at the same time producing a profit squeeze in the traded goods sector that probably caused corporate savings to decline.*’ To these mechanisms, one may add the note of fiscal policy during this period which through tax reductions further stimulated the expansion of consumption expenditures.

(iii) The worsening of the structural trade balance Table 3 shows the external adjustments that took

place throughout the 1980s in response to the debt crisis. the oil price shock and during the trade liberalization cum real appreciation episode since 1988.

The adjustment to the debt crisis involved a massive turnaround in the trade balance (in the order of

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Table 2. Domestic savings 1980-92 (as % of GDP at constant 198Oprices)

1980 1989 1990 1991 1992

Domestic savings* Public savingst

Extemal$ Domestic

Private savings5 External savingsp Real interest payments11 (public sector) Real private income per capita

(index 1980 = 100)

21.1 17.1 16.6 15.9 11.7 8.0 3.5 7.4 6.5 6.7 4.1 0.0 1.3 0.8 3.9 3.5 6.1 5.7

13.7 13.6 9.2 9.4 5.0 6.4 2.0 3.1 5.9 8.X

9.6 5.2 3.5 3.1 100.0 85.7 X0.5 81.8

*Deflated with the price of gross fixed capital formation. tDeflated with the price of gross fixed capital formation. Adjusted for the inflationary component of public sector interest payments. *As % of nominal GDP. Oil export revermes minus interest payments on external debt. aDeflated with the price of gross fixed capital formation. Adjusted for the inflationary component of public sector interest payments. TDeflated with the price of gross fixed capital formation. IlAs 8 of nominal GDP. Sources: ODCE (1992) (for 1980). Banco de Mexico, Informe Annual (1990 and 1992. Plow of funds table) and Banco de la Mexico lndicadores Econdmicos.

US$17 billion) from a deficit to a surplus during 198 l-84. Except for a modest increase in oil and non- oil exports (of the order of US$2 billion each), the external gap created by the capital account shock was largely closed through a sharp import compression. The overwhelming presence of oil in the export structure (over 70% at its peak in 1982-83) largely accounts for this type of adjustment. Given its low supply elasticity, oil export revenues reduced the overall export response to the exchange rate adjustments of the period. Moreover, the adjustment in the non-oil current account was, for the same reason, exacerbated. Thus for a given exchange rate adjustment, the overall reduction in domestic expenditure necessary to achieve the required current account adjustment to increase.??

Analogous reasoning explains why, when oil revenues were severely curtailed by the 1986 crisis, external adjustment had to be very different from the preceding period. Since both the private sector trade deficit and the public sector trade surplus were now smaller, so too were the contractionary effects of devaluation on absorption. With a larger increase in non-oil exports - resulting from past devaluations and an exceptionally high real exchange rate in 1986-87 - and a lesser degree of external credit rationing, the balance-of-payments adjustment was made less severe and much more efficient, relying on export expansion rather than import contraction.

A sharp reversal of past changes in the trade balance has taken place in the posttrade liberalization period. Capital inflows of massive proportions after 1989 have allowed the financing of a current account deficit in continuous expansion. The import boom in

this period has reached such proportions that, despite continued export growth, the decline in the trade balance during 1987-92 has exceeded by the far the improvement that took place during 198184.

By 1992, the economy was thus generating trade deficits that were larger than those of the early 1980s despite a higher real exchange rate and lower levels of capacity utilization. While part of this structural deterioration is the consequence of the drop in oil revenues-by six billion dollars compared to 198 1, or 1.8% of 1992 GDP - another part - also of the order of six billion dollarsz3 - must be attributed to a structural decline in the non-oil trade balance. The latter clearly suggests that the upward shift in import functions, resulting from import liberalization, has so far more than offset the positive effects of trade reform on the performance of non-oil exports. Recent trends in the composition of imports suggest that the upward shift in import functions has been particularly significant in the case of consumer goods and points to the important role played by the late 1987 liberalization of consumer goods imports: out of the 6.3 billion dollars decline in the non-oil trade balance, around five billion are associated to the surge in consumer goods imports after 1987.

The productivity growth slowdown, the decline in the domestic savings rate and the deterioration of the structural trade balance have determined a worsening of the tradeoff between the rate of economic growth and the current account in the balance of payments. The upward shift in the sfg schedule is shown in Figure 2 which puts recent trends in a long-term per- spective by presenting the historical relationship between the current account deficit (as percentage of


Table 3. External adjustments in three periods

Changes within the period 1981-84 1984-87 1987-92 1991-92

Billions of US dollars Trade balance* Oil exports Non-oil trade balance Non-oil exportst Imports Consumer goods Intermediate Capital goods

16.9 -4.1 -25.2 12.4 2.0 -8.0 -0.1 6.1

14.9 3.9 -25.1 -6.3 2.2 4.9 10.1 17.2

-12.7 1.0 35.2 23.5 -2.0 -0.1 7.3 5.2 -5.7 1.0 12.4 7.7 -5.0 0.1 15.5 10.6

*Includes nonfactor services. tIncludes maquiladora exports. Source: Fresidencia de la Republica, Criterios Generales de Politica EcomSmica, and Banco de MBxico, hdicadoros Econdmicos.

GDP) and the GDP growth rate (lagged half-year, i.e. a two-year moving average of the growth rate). As suggested by the figure, from the mid- 1960s to around 1987 there had been a fairly stable tradeoff between the GDP growth rate and the current account balance. This tradeoff was clearly influenced by factors such as abnormally low levels of the real exchange rate or terms of trade shocks, which explain some of the out- lier observations (in particular, 1975, 1981 and 1986). These factors, however, cannot account for the extent to which, since 1988, all the observations lie outside the historical relationship, suggesting that a deterioration has taken place in recent years in the traditional growth-current account tradeoff.*“ While a current account deficit of the order of 4.2% of GDP (the average since 1989) would have normally been associated

to growth rates of 8% per year, recent GDP growth has been proceeding at rates in the order of 3%.

(b) Capital inflows and economic growth

While the current account - growth tradeoff has deteriorated, the capital account-growth relationship has improved in recent years. The dynamic behavior since late 1988 of private external indebtedness and foreign direct investments as well as the emergence of new capital inflows, such as portfolio investments in stocks and short-term bonds that were non- existent before 1989, have been amply documented.25 A variety of factors explain the recovery of capital inflows. Some, such as the US recession and the

6-

83 -4 n ’ I I I I I I I I I I I I

-3 -2 -1 0 I 2 3 4 5 6 7 8 9 10

GDP growth rate (two year average)

Figure 2. Historical relationship between current account deficit (as percentage of GDP) and the GDP growth rate (lagged a half-year). Source: INEGI, Estadisticas Histdricas de MPxico, Banco de Mkxico, Indicadores Econdmicos.

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decline in international interest rates, are external to the Mexican economy. Others are related to domestic regulatory changes - such as the opening of the stock and money markets to foreign investors (in 1989 and 1991 respectively) and the deregulation of foreign direct investment, the 1989 debt relief agreement with foreign creditors, and the privatization of large public enterprises in the early 1990s. Finally, another important factor explaining the rise in capital flows is NAFTA.

The shift in the capital account-growth relationship is illustrated by the following equation for foreign direct investment (FDI) estimated with annual data for 1960-92 (see Ros, 1994b):

FDI=-101.669+0.0121 Y*xD1+O.O153yYxD2+ (-2.437) (11.771) (3.91)

1.403 Y/Y* + 0.140 er - 0.219 CR (2.061) (-5.108) - 0.327 YIY*us - 0.137 MC (-2.165) (-2.616)

(t statistics are shown in parentheses).

The equation shows real FDI flows as a positive function of the deregulation measures since 1984 (reflected in the dummy variables Dl and D2),26 potential GDP (Y*), capacity utilization (Y/Y*), and the real exchange rate (er), and a negative function of country risk (CR, measured by the ratio of external interest payments to exports, capacity utilization in US manufacturing (Y/pus), and import controls (MC, the percentage of imports subject to licenses). A sim- ple exercise, keeping potential GDP on its historical trend value (extrapolated from 1960-81) and capacity utilization on its historical average value, suggests that FDI flows in 1992 were around 40% larger than otherwise on account of the effects of reforms to the regulations affecting foreign investment (25 percentage points), the reduction in country risk (8.4 percentage points, associated with the debt relief agreement and the drop in international interest rates in the recent past), and the trade policy reforms undertaken since 1985 (7.4 percentage points).

This improvement of the capital account represents an upward shift in the y-g schedule of Figure 1 which has tended to offset the negative effects on growth (and the current account deficit) of the shift in the sf-g schedule. The movement of these two sched- ules, with respect to their historical positions, is shown in Figure 3. As suggested by recent growth performance, although the upward shift in the y-g schedule has allowed the economy to resume positive growth rates (in contrast to 1982-88), it has been insufficient to recover the historical GDP growth rates in the order of 6.5% per year. The reason is the inward shift of the s&g schedule which had kept the economic recovery in check by impeding structural reforms

from achieving their full potential effects on capital inflows and economic growth. The effect of the shift in the sf-g schedule can be illustrated with the estimated equation for FDI flows: when the downward change in the trend of potential GDP since 1984 is taken into account,*’ its negative effect on FDI flows ends up offsetting much of the positive effect of deregulation, trade liberalization and the reduction in country risk. The observed FDI flows in 1992 were thus similar to those estimated by the equation, despite the fact that foreign investments were larger at each given level of potential GDP.

4. THE ENVIRONMENT AND THE ECONOMY

There are no signs that the growth slowdown since the early 1980s has had a beneficial effect on the environment. Although it is sometimes stated that reduced economic growth may be positive for the environment, it is unlikely that the environmental conditions improved during this period. As a result of the recession, investment (both public and private) was cut substantially, including investment in pollution- abatement equipment. Public investment cuts, continued population growth and rural-urban migration meant that the supply of urban infrastmcture fell increasingly short of demand. It is the lack of basic infrastructure - potable water, sewerage, solid waste collection, electricity - that has a severe impact on living conditions and health of the population in a large number of urban settlements. At the same time, environmental concerns have become increasingly important during the past decade. Degradation, mainly due to past neglect, is already leading to considerable economic costs as the health of the population is negatively affected (reducing labor produc-

Figure 3. Shift of sf--g and y-g schedulex.


tivity and raising medical treatment costs) and the productivity of natural resources decreases (as in the case of lower agricultural productivity due to soil erosion). In addition, the outward orientation of the current development strategy is exposing the country to international pressures to adopt stricter environmental regulations and quality standards. This section reviews the country’s main environmental problems, presents estimates of the costs of environmental degradation and discusses some of the major issues facing environmental policies.

(a) Main environmental issues

The more serious environmental problems that Mexico is facing include air pollution in urban areas, water availability and pollution, and soil erosion and deforestation. Air pollution affects some of the larger urban areas, especially the Metropolitan Area of Mexico City (MAMC), and is the result, to a large extent, of emissions by transport and industry that are mainly due to the combustion of fuels. Geographical and meteorological conditions of the MAMC aggra- vate the air pollution problem as they do not favor the dispersion of these emissions into the atmosphere. The number of people affected by below-standard air quality and its possible long-term impact on their health, has made the air quality of the MAMC one of the most visible environmental policy issues. Measurements indicate that 80% of the days per year, air quality is below standard. Peak concentrations of ozone and suspended particulate matter are more than four times the national and international norms.

In the MAMC, a total of 43 million liters of fuel is consumed on a daily basis leading to annual emissions of 4.5 million tons of pollutants. Transport is responsible for 76% of these emissions although, on a toxic- ity-weighted basis, it accounts for 48% of pollutants (see World Bank, 1992). Within the transport sector, private transport accounts for approximately 70% of the emissions. The concentration of manufacturing industry in the MAMC makes industry the second next priority for policy measures to reduce the emis- sion of pollutants.

The availability of water is probably the strongest environmental limiting factor for sustained economic development. The geographical distribution of population and economic activity is inversely related to the availability of water resources: whereas 76% of the population is living above an elevation of 500 meters above sea level, only 18% of the surface water is located in these areas.

Water used for irrigation represents over 80% of total water consumption (excluding the requirements for hydroelectricity generation). Although at a national level the natural recharge of aquifers outweighs exploitation of groundwater, at a regional level there

are 36 aquifers being overexploited mainly located in the northern and central areas. The overexploitation of aquifers is a serious environmental problem as it may lead to the destruction of the aquifer through intrusion of salty waters, an irreversible reduction of reservoirs, and increased costs to pump water from lower levels. The excessive use of irrigation may also lead to salin- ization of soils, thereby reducing agricultural productivity. Pricing of water resources, electricity rates to pump irrigation waters and the infrastructure required for irrigation have traditionally been heavily subsi- dized. Another problem with the overexploitation of groundwater resources is the subsidence of the terrain. Problems with subsidence have occured in Mexico City with potentially high costs involved in the damage this causes to urban infrastructure.

Reported access to water supply and sewage services increased substantially over the past few years and reached a coverage of 84 and 67% respectively in 1992 (see Presidencia de la Rephblica, 1993). After the reappearance of cholera in the US continent and the outbreak of a number of cases in Mexico, a program was launched to improve the quality of the water for human consumption by increasing the coverage of disinfection systems (chloration). According to some estimates this coverage increased from 52% in early 1991 to over 90% in 1993. Nevertheless, gastrointestinal diseases have for long been the prime cause of death in Mexico and water pollution is the main factor in the spread of these diseases.

Pollution of surface water due to the discharges of untreated municipal and industrial waste water isse- vere in some 20 river basins out of a total of 320. They receive about 90% of the urban-industrial waste water (see SedesoVINE, 1993). Out of an estimated total of 115 cubic meters per second of municipal waste water some 15% is treated before discharge. Additionally an amount of 82 cubic meters per second of industrial waste water is generated compared to installed capacity of treatment plants of 12.2 cubic meters per second. Increased emphasis on water quality is likely to increase the investments in the area of waste water treatment. New regulations on water pollution and collection of discharge rights by the federal water commission are likely to be an important incentive for the installation and operation of waste water treatment facilities.

The development of the country has had a severe impact on ecosystems mainly due to changes in land use. In a country that was once covered up to 60% with forests, at present only a quarter remains forested. Deforestation continues at rates estimated between 3300-8000 square km per year, which is equal to a 0.7-1.6% annual reduction of the total forested area (see SedesolllNE, 1993). The main cause of deforestation is the conversion of land use to agricultural purposes and, in particular, to extensive cattle ranching. Deforestation not only leads to a

MEXICO 3 I 9

reduction of the natural habitat of Mexico’s rich biodi- versity, but is also an important source of soil erosion.

Estimates show that 80% of the territory is subject to some degree of soil erosion, a third of which is severe erosion (see SedesolIINE, 1993). Such a degradation of soil leads to lower agricultural productivity, decreased water retention and aquifer recharges and the siltation of waterways and dams. The negative impact of soil erosion on the economy may be substantial due to the permanent loss of productivity once erosion has taken place.

(b) The economic costs of environmental degradation and depletion

A number of studies indicate that the cost of environmental degradation and depletion may be quite significant. Two recent investigations present some rough estimates on the size of environmental problems in the country. In a first attempt to integrate environmental and economic accounting, van Tongeren et al. (1991) estimated environmental accounts for 1985. Both the degradation and the depletion of natural resources were included in these estimates. The study calculated the economic cost of degradation of natural resources mainly on the basis of avoidance cost of such degradation and of reducing pollution to acceptable levels. Estimates are quite high and amount to 7.6% of GDP. Over half of these costs are accounted by air pollution (3.9% of GDP), followed by water pollution (1.6%) and soil erosion ( 1.1%). The fact that valuation of air pollution came out relatively high is likely a reflection of the infor- mation available on the issue in Mexico City and the amount of resources dedicated to reduce air pollution levels in this area.

The study also estimated the depletion of natural resources. Calculations based on the net rent method - i.e. on the basis of the difference between market value and the cost of extracting the resource - yield a value of the total annual depletion of 5.7% of GDP. If alternative calculations are made, however, on the basis of the amount of assets that would have to be reserved for reinvestment, a depletion allowance, the figure for depletion is estimated at a much lower level, 0.6% of GDP. In both cases, the value of natural resource depletion is mostly accounted by depletion of oil reserves. Given the size of oil reserves available in Mexico, the depletion of these reserves is likely to be of much lesser concern than environmental degradation issues. It is worth noting, however, that although the figures presented in this study may have been overestimated, they give rise to concern when one takes into account that the national accounts for 1985 yield an investment rate, net of depreciation, of 11.2% of GDP. This implies that if, indeed, depletion and degradation of natural resources combined have

to be valued at levels of up to 13.3% of GDP. the economy was not accumulating total assets to generate income growth but only substituting natural resources for produced capital or even consuming its natural capital.

Based on a different methodology, Margulis (1992) presented rough estimates of the damage costs of major environmental problems. These damage costs are equivalent to the economic benefits obtained if remedial action were undertaken and are mainly limited to productivity loss and health treatment costs caused by degradation of natural resources. The total costs - caused by air and water pollution and soil erosion - amount annually to US$7 billion or approximately 2% of GDP. According to the study, the reduction of water pollution would result in the largest benefits given its inci- dence on gastrointestinal diseases. The damage cost could be greatly reduced with a more extensive application of Oral Rehydration Therapy, and access to safe water supply and sewage systems would also contribute to a reduction of damage costs. The high cost level associated with air pollution in Mexico City is due to the number of people exposed to a number of pollutants above air quality standard concentrations. Finally. soil erosion appears to have a substantial annual cost due to lost productivity in agricultural output. Annual costs of soil erosion are high because the impact of erosion on the quality of land is permanent and the reduction of agricultural output is considered into perpetuity and discounted to the year in which erosion occurred.

Despite the considerable differences in the results of these studies on the size of the economic costs of degradation of natural resources and/or of prevention of such degradation, it is clear that an increasing proportion of GDP will have to be spent on pollution- abatement equipment, adequate waste treatment and other areas of environmental protection. The major part of these expenditures will have to come from private economic activities rather than from the public sector, in accordance with the polluter pays principle. The public intervention needed to bring about an adequate level of expenditures in environmental protection will require a budget for policy design and enforcement. In addition, public sector-owned companies, mainly in the energy sector (PEMEX and CFE), will have to incur expenditures to reduce their emissions and contribution to environmental degradation.

(c) Publicpolicy. NAFTA and the environment

The main challenge for the public sector lies in the implementation of an efficient environmental policy which includes both direct regulation and economic instruments and integrates environmental considerations in the design of economic policies. Thus far, this


policy has been heavily oriented toward the use of direct quantity regulation, i.e. norms and standards. The Mexican environmental legal regime is established in the General Ecological Equilibrium Law promulgated in early 1988. The law covers land-use management, impact studies, protection of natural areas and pollution prevention and control. Additional regulations to the law rely on quantitative technical norms and environmental standards for air and water pollution and emissions from fixed sources. Thus far, some 83 norms and standards have been enacted. They are based on health and technical criteria and often resemble international accepted norms. The enforcement mechanisms set out in the law are closure of production facilities, imposition of fines, administrative arrest and criminal penalties. Temporary closure of facilities is a commonly used instrument to provoke negotiations between the authorities and the firms. Reopening is allowed only after individual agreements on environmental improvements have been reached. Limited funds available at the federal government agency in charge of inspection and enforcement of environmental protection is often mentioned as one of the weaker points in this regime.

As elsewhere, only limited use has been made of economic instruments in environmental policy. The deregulation of economic activity however, that has taken place over the last few years of structural reforms also touched on the framework of norm setting. The new 1992 law on Metrology and Normativity requires a cost-benefit analysis and consultation with the private sector before a norm is promulgated. The use of economic instruments has thus far been limited to water discharge rights (as of October 1991), a temporary price markup for gasoline in Mexico City (only during a few months in 1991) and a tradeable permit system for the production of CFCs.

The use of economic instruments is probably best seen as a complement to direct regulation. Public policy to address issues of market imperfections, such as environmental degradation due to inadequacy of market prices for scarce resources, consists of a range of intervention instruments which includes direct regulation and economic (dis)incentives.

One area in which economic policies and the environment are interacting increasingly is international trade. Fears about Mexico becoming a pollution haven for US fums trying to escape more stringent regulations in the United States and the deteriorating environmental conditions of the Northern border area, arising from an increasing shortage of adequate infrastructure, were some of the major concerns behind the inclusion of environmental provisions in NAFTA and the negotiation of a side agreement on the environment.

There were three principal features of the NAFTA side agreement on the environment. First, there is the recognition of the right of each of the parties to estab- lish their own policies, priorities and levels of envi-

ronmental protection. Thus, the side agreement does not explicitly seek a harmonization of standards among the parties. On the contrary, each of the parties has the right to set its own standards. Still, it should be borne in mind that the main text of the NAFTA estab- lishes the prevalence of some international environmental agreements, all of them dealing with global or regional environmental phenomena, over the NAFTA itself, which at least implies a degree of harmonization of obligations with respect to those phenomena. At the same time, even though the agreement does not empower a government to take action in order to guar- antee the application of environmental laws in the territory of another party, there is the commitment on behalf of the governments to enforce their environmental laws effectively.

A second important feature of the side agreement is the possibility it opens to impose monetary penalties on parties which by a supranational dispute settle- ment mechanism are found not to comply with their environmental obligations derived from the agreement. In order to compel the payment of the monetary penalties it is even possible that the demanding party suspends trade benefits derived from the NAFTA to the demanded party, a precedent in international legislation on trade and the environment.

The third, and in our view most important, feature of the side agreement is the establishment of channels for environmental cooperation between the participat- ing parties. In fact, the Commission for Environmental Cooperation, its Council and its Secretariat set the stage for a far-reaching trinational cooperation in matters concerning the environment, such as technical assistance in the collection and analysis of data, infor- mation management, data communications, pollution- prevention strategies, the use of economic instruments of control, border zone problems, to mention only a few of them. Probably, the stimulating effect of such a cooperation will in the long run contribute more to the preservation of the environment than the preventive effect from the possibility of applying sanctions. In combination, the ample collaboration in environmental matters and the threat of applying sanctions against noncompliance will undoubtedly play a mutually rein- forcing role.

Altogether, even though there is an obvious need to refine the instruments and mechanisms of environmental control proposed by the NAFTA and the side agreement further and even though those instruments and mechanisms must be considered as mere first steps, they seem to be in the right direction and set a precedent in the field of international rule making on trade and the environment.

5. CONCLUSIONS

In the early 1990s the Mexican economy appeared

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to be trapped in a low-growth equilibrium. Given the projected growth of the labor force, productivity trends, and public investment and social spending requirements, this growth rate falls short of the socially necessary rates of growth required to prevent unbalanced income distribution and absolute poverty from worsening over time. Recent studies suggest, indeed, that this “socially necessary” growth rate is no less than 4% per year, and perhaps 5%, for the rest of the 1990s (see Casar, 1994; Ros, 1994~). Even if it were economically stable, the current path of the Mexican economy may not be socially sustainable.

Environmental sustainability would also seem to call for higher growth rates. The experience of continued degradation in the 198Os, the nature of the country’s environmental problems and priorities, and the prospect of continued fast growth of the labor force, all suggest that any hope of reversing environmental degradation can only be achieved in the context of faster growth. Indeed, the requirements for environmental infrastructure and protection activities - especially in the areas of air and water pollution - are likely to take a substantial part of GDP in Mexico over the near future. A lack of attention to environmental protection and of resources for investment in urban infrastructure in the past, continued population growth and increased public scrutiny (both national and international) about the degradation of natural resources are some of the driving forces behind these increasing expenditure requirements. Income growth is needed to alleviate existing situations of (extreme) poverty of large segments of the population as well as to generate an adequate amount of resources for environmental protection and infrastructure facilities. At the same time, environmental investments and a tighter enforcement of environmental protection laws will yield long-run economic benefits that will tend to offset over time their possible short-run adverse impact on economic growth. This is what is suggested by estimates of the damage costs of environmental degradation. Moreover, a number of pollution reduction measures and investments may also lead to important savings in inputs in the production process, in particular in the case of energy use.

The slowdown of the rate of economic growth in the postreform and postadjustment period compared to historical levels has been largely determined by the fall in domestic savings and the decline in the structural trade surplus associated to the effects of the adverse external shocks of the 1980s and the period of macroeconomic instability and economic stagnation which followed. Market reforms were expected to operate on growth through an increase in the rate of growth of total factor productivity and higher inflows of foreign investment. The effects on TFP growth remain to be seen since for several years in the recent past productivity growth has in fact fallen below historical performance. The impact of stabilization and

reform has thus been a larger inflow of capital from abroad. Despite their magnitude (well above historical trends over the last four years), these inflows have been, however, insufficient to compensate for the negative effects of other factors on the GDP growth rate. Further increases in the foreign savings rate appear to be severely constrained by the slow growth of the economy as they would lead to explosive paths of the debt/GDP ratio (see Ros, 1994~).

The policy challenges facing the Mexican economy revolve around the implications of the deterioration of the growth-current account tradeoff. One area in which these implications have not been recognized enough is that of macroeconomic policy. The structural deterioration of the current account implies that the real exchange rate consistent with external balance and a high degree of resource utilization is now higher (i.e., a more depreciated peso) than it was at the time of trade protection and abundant oil revenues. Meanwhile, the actual real exchange rate has been moving in the opposite direction. The gap has been filled through a downward adjustment of output and investment and by short-term capital inflows attracted by high domestic interest rates. But rather than substituting for it, the high interest rate policy only post- pones the adjustment of the real exchange rate. In fact, it may further accentuate the problem. For the combination of an overvalued peso and high interest rates further contributes, through a number of side effects, to the deterioration of the structural current account with its deleterious effects on the sustainable growth rate: by shifting the composition of domestic and foreign investments away from the tradable goods sector, encouraging the accumulation of foreign debt by the domestic private sector, and through the crowding-out effects that high government interest payments have on public investment.

Macroeconomic policy reform could then be followed by microeconomic policy innovation. First. in the tasks of improving the structural trade balance and broadening productivity increases across the economy, new forms of industrial policy can play an important role. In the current trade policy regime. industrial policy means competition-enhancing policies that will have to concentrate on providing the investment in infrastructure, such as modem telecom- munication networks and transport facilities, required to compete in global markets, finding new and appropriate incentive structures for the development of industries with high growth potential and dynamic externalities, and for the adoption and dissemination of modem technologies throughout the economy. Second, reforms in the pension system and in the pro- vision of private consumer credit will have to be introduced to raise private savings on a more permanent basis. Third, the banking system; regulatory framework and its enforcement mechanisms will have to undergo a major overhaul to bring the banking system


up to modern standards and forestall a recurrence of ability played an important role in causing the 1995 the current situation in which, because of a lax or crisis and making recovery more difficult. unenforced regulatory framework, the bank’s vulner-

NOTES

1. For example, in 1977 the top 10% of the population received 36.8% of total income while the bottom 40% received 10.4%. See Lustig (1992, Chapter 3, Table 3-12).

10. U.S.-Mexico Free Trade Reporter (1991). On the subject, see USITC (1990) and Villarreal Gonda (1991).

2. These reforms had other objectives besides increasing tax collection: they brought corporate tax rates closer in line with international standards, reduced the bias against equity and in favor of corporate debt financing, and reduced the maximum personal income tax.

11. The number of divested public enterprises was larger during de la Madrid’s administration. Most of them however, were relatively small or minority-interest companies.

3. See Lustig (1992, Chapter 3).

4. For a detailed discussion of trade liberalization, see Zabludovksy and L6pez-de-Silanes (1989). USITC (1990), Lustig (1992). Ten Kate (1992). and Ros (1994a).

12. The reprivatization of the banking system, announced in May 1990, was perhaps one of the most important moves to restore business confidence and the goodwill of the linan- cial community in Mexico and abroad. The significant capital inflows and sharp drop in domestic interest rates that followed the announcement reflected the improvement in business confidence.

13. SeeUSITC(1990),Cordoba(l99l),CAIE(l99l). 5. The reasons differ in each case. There was probably great fear that in agriculture, particularly in the corn sector, rapid liberalization could cause major labor displacement. In the case of petroleum refining, sovereignty considerations were important. In the case of transportation equipment, the government wanted to honor its commitments to the automo- bile companies, most of which are multinational corpora- tions. These companies had based their investment decisions on past industrial programs that ensured protection in exchange for sector-specific balance of trade performance.

6. Shortly before joining the GATT, the Mexican govem- ment introduced fundamental changes in its trade laws. Of particular significance is the Foreign Trade Regulatory Act and the Regulations Against Unfair International Trade Practices of 1986. These include comprehensive anti-dump- ing and countervailing duty laws and procedures for carrying out investigations. The act and regulations are in conformity with the GATT, except that the act fails to explicitly require the use of a “material injury” test. Mexican officials have addressed concerns about this omission by assuring other countries that the act would be applied in accordance with the GATT.

14. Above the y-g schedule, the debt-output ratio is rising and through either increases in the interest rate or a contractionary public investment policy, the overall rate of investment and growth falls. Analogously, the growth rate increases when the economy is below the y-g schedule. Assuming that the economy is always on the sf-g schedule, it will thus converge to point A provided that the y-g schedule is flatter than the sf-g curve. Note, therefore, that the assumed adjustment mechanisms break down if the initial debt-output ratio is so high that the y-g schedule becomes steeper than the sf-g curve.

15. SeeMartin (1992), Edwards (1994), Ros (1993).

16. See Ros (1993).

17. Savings rates are presented in their “operational” definition, i.e. excluding from private savings (and including in public savings) the purely nominal component of interest payments representing a compensation for the erosion of the value of existing public nonmonetary debt by inflation.

7. A fifth program, for petrochemicals, was established in 18. See Ros (1992) for further analysis, and Alberro 1986, but it aimed only to define rules for entry by private (1991) for econometric evidence on the role of liquidity con- sector firms. On the industrial policy reforms of this period, straints and current disposable income in the behavior of see Peres (1990), World Bank (1990), Ros (1994a). consumption during the 1980s.

8. The government also announced it would introduce changes in the pharmaceutical and microcomputer programs. Among these was the end of preferential treatment given to Mexican pharmaceutical firms in purchases made through public bidding. In microcomputers the government reached an agreement in 1990 with industrialists to remove the sector’s quantitative restrictions and domestic content and foreign exchange requirements by 1992.

19. The reduction in private savings during this period is not apparent in the table. This is due to the temporary recovery of private savings in 1988 and 1989 that was associated to the large income transfers from the public to the private sector that resulted from the high real interest rates that accompanied the transition from high to low inflation.

For detailed analysis of these reforms, see USITC ;1990), Lustig (1992), Ros (1994b).

20. Consumer durables expenditures (with an increase of 14% in 1992) was clearly the most dynamic component in the recent expansion of consumer’s spending. See Banco de

MEXICO 323

Mexico (1992) and, for an analysis of private savings and 23. In fact, somewhat more since this figure does not cor- durables consumption during the 198Os, see Arrau and Oks rect for the lower real exchange rate and higher capacity uti- (1992). lization of the early 1980s.

2 1. Another explanation emphasizes the role of NAFTA, stabilization and reforms in determining, through their anticipated effects on economic efficiency and productivity, expectations of higher permanent future incomes and thus a higher level of consumption in the present (see OECD, 1992). Although there may be an element of truth in this hypothesis, the fact is that these anticipations may turn out to be a “self-destroying prophecy,” particularly if our argument that TFP growth has been limited by the low rate of capital accumulation is correct.

22. The reduction of domestic spending was, in fact, induced by devaluation for in those conditions the exchange rate was bound to affect external balance through Hirschman and Diaz Alejandro effects, i.e. through contractionary effects on private income and spending.

24. Changes in the measurement of the balance of payments since 1989 led to an upward revision of worker remit- tances (an additional 1% of GDP) and to lower estimates of the current account deficit (compared to those based on the old methodology). Thus, on a comparable basis, recent years would lie even further apart from the historical relationship.

25. See. among others, Banco de Mexico ( 1993) and Ros ( 1994b).

26. Dl is a dummy variable with value one before 1984 and zero otherwise, and 02 i a dummy variable with value one in 1984 and after and zero otherwise.

27. The growth rate of potential GDP fell from 6.4% per year (196&83) to 1.6% per year from 1984 onward.

REFERENCES

Alberro, J. ‘The macroeconomics of the public sector deficit in Mexico during the 1980s.” Mimeo (Mexico City: El Colegio de Mexico, June 1991).

Arrau, P., and D. Oks, Private saving in Mexico, 198&90, Policy Research Working Papers (Washington, DC: World Bank, 1992).

Banco de Mexico, The Mexican Economy, I993 (Mexico City: Banco de Mexico, 1993).

Banco de Mexico, Inform Annual (Mexico City: Banco de Mexico, 1992).

Casar, J., La Gran Promesa. Competitiviaixd Industrial y el Futuro de la Economia Mexicana (Mexico City: Fondo de Cultura Economica, forthcoming).

Centro de Analisis e Investigacidn Economica (CAIE), ‘The liberalization of financial services in Mexico,” The Mexican Economy: A Monthly Report, Vol. 8 (February 1991).

Cordoba, J., “Diez lecciones de la reforma econ6mica en Mexico,” Nexos (Mexico), No. 158 (February, 1991).

Edwards, S., Trade and industrial policy reform in Latin America, Mimeo (Washington, DC: World Bank, 1994).

Lustig, N., Mexico. The Remaking of An Economy (Washington, DC: The Brookings Institution, 1992).

Margulis, S., “Back of the envelope estimates of environmental damage costs in Mexico,” World Bank Working Paper (Washington, DC: World Bank, 1992).

Martin, R., Sources of growth in Latin America (Washington, DC: World Bank, 1992).

OECD, Estudios Econdmicos de la OCDE: Mexico (Paris: OECD, 1992).

Peres, W., Foreign Direct Investment and Industrial Development in Mexico (Paris: OECD, 1990).

Presidencia de la Reptiublica, Quint0 Informe de Gobiemo (Mexico City: Presidencia de la Republica, 1993).

Ros, J., “Mexico’s trade and industrialization experience since 1960,” in G. K. Helleiner (Ed.), Trade Policy and Industrialization in Turbulent Times (New York: Routledge, 1994a). pp. 17&216.

Ros, J., “Mercados tlnancieros y flujos de capital en

Mexico,” in J. A. Ocampo (Ed.), Los Capitales Extranjeros en las Economias Iatinoamericanas (Bogota: FEDESARROLLO y Banco lnteramericano de Desarrollo, 1994b), pp. 209-260.

Ros, J., “La economia mexicana en el largo plaza,” Document0 preparado para el Primer Congreso Mexican0 sobre Prospectiva, Fundaci6n Javier Barros Sierra (Mexico: September, 1994).

Ros. J., “Trade liberalization with real appreciation and slow growth: sustainability issues in Mexico’s trade policy reform,” in G. K. Helleiner (Ed.), Manufacturing for Export in Developing Countries (New York: Routledge, 1993).

Ros, J.. “Ajuste macroeconomico, reformas estructurales y crecimient en Mexico,” Mimeo (Notre Dame, IN: University of Notre Dame, 1992).

Sedesol/INE, Informe de la Situation General en Materia de Equilibrio Ecoldgico y Protecidn al Ambiente 1992-1992 (Mexico City: Sedesol, 1993).

Ten Kate, A., “Trade liberalization and economic stabilization in Mexico: Lessons of experience.” World Development, Vol. 20, No. 5 (May 1992). pp. 659672.

Van Tongeren, Jan et al. “Integrated environmental and economic accounting: A case study of Mexico,” Environment Working Paper No. 50 (Washington. DC: World Bank, 1991).

United States International Trade Commission (LJSITC). Review of Trade and Investment Liberalization Measures by Mexico and Prospects for Future United States-Mexican Relations, Phase 1: Recent Trade and Investment Reforms Undertaken by Mexico and Implications for the United States. Investigation 332-282, Pub.2275 (Washington, DC: USITC. 1990).

U.S.-Mexico Free Trade Reporter, “New Mexican Copyright Law Praised by U.S. Music Industry,” (July 22, 1991).

Villarreal Gonda. R.. “La nueva ley mexicana en materia de propiedad industrial,” Mimeo (Mexico City: July, 1991).

World Bank, Development and the Environment. World


Development Repoti 1992 (New York: Oxford Zabludovsky, J., and F. Lopez-de-Silanes, “Trade and indus- University Press, 1992). trial policy for structural adjustment in Mexico,” Mimeo

World Bank, Mexico: Industrial Policy and Regulation (Mexico City: Secretarfa de Comercio y Foment0 (Washington, DC: World Bank, 1990). Industrial, July 1989).

APPENDIX

The effects of external shocks, macroeconomic adjust- All flow variables are expressed as a fraction of ment, and market reforms on medium-term economic growth potential output and refer to nominal values deflated can be approached from the analytical framework below. bv the GDP mice index. Kev exoeenous variables are The model desegregates savings into public, private and foreign (current account deficit), each determined by a behav-

oil exports atid interest on eitemadebt, respectively a

ioral equation (equations 2,3, and 4 below). Capital inflows revenue and expenditure item in both the fiscal and external accounts.

are decomposed into foreign direct investment and external indebtedness. The former is determined as a share of overall

Substituting the domestic savings functions (equa-

investment and a term reflecting country risk and the effects tions 2 and 3) into the savings-investment identity (1) yields:

of foreign investment regulations (equation 7). Foreign debt is assumed to grow at the same rate as output; external j indebtedness, as a fraction of outout. is thus given bv the ini-

= s, + sI X u + (x0* -j*) X e + sr (9)

tial debt-output ratio and the output growth rate. _ SO = z, + 6,

i = s* + s, + s,

% = z, + z, x u +(x0* -j*) X e

5 =6,+6,xu

Sf =mXu-FXe-(x0*-j*)Xe

c$ ‘if+4

if =P,+&xi

(l) S] =z,+6 1

(2) Eliminating u from (4) and (9), substituting into

(3) the growth equation (8), and solving for sf yields the equation for the sf-g schedule:

(4)

(5) s’ a o =y;kj;;-ax(so+bxs,+(xo*-j*)xe)-

(10)

(6) a = ml(m + s,) b = (v_ x e + (no* -j*) x e)lm

4 =d,xg

&? =g,+kxi

i = gross investment u = capacity utilization sg = public savings SP = private savings

Sf = foreign savings (current account deficit) x 0 * = oil export revenues (in foreign currency) x,0 = non-oil exports m = import propensity

(7) Equation (10) expresses the current account

(8) deficit as a function of the output growth rate as well as: (a) the parameters (s, and sI) of the domestic savings functions and external public savings (x0* -j*); (b) the structural trade balance - or more precisely the ratio of exports (net of interest) at given exchange rates to full capacity imports: (k x e + (x0* - j*) x e)/m; (c) the real exchange rate, operating through both the non-oil trade balance and the real value in domestic currency of external public savings; (d) the efficiency of investment (k) and the _ .

‘* J = interest on foreign debt (in foreign currency) autonomous growth rate g,) retlectmg employment e = real exchange rate and productivity trends.

g = growth rate of potential output Substituting now equations (6) and (7) into (5) and $ = capital inflows solving for @ as a function of g (using the growth equa- zr = foreign direct investment tion 8), yields the equation for the Q-n schedule): 2, = initiz debt-output ratio

_

9 = external indebtedness 0 = P, + (d, + P W x g - (P ,W x 8, (11)

Documents

Prospects for growth and the environment in Mexico in the 1990s