Report No. 20236-ME Mexico: Fiscal Sustainability (In Two Volumes) Volume I: Executive Summary June 13, 2001 Mexico Country Management Unit PREM Sector Management Unit Latin America and the Caribbean Region Document of the World Bank CURRENCY EQUIVALENTS Currency Unit - Mexican Peso (mxp$) EXCHANGE RATE MARCH 17,2000 9.35 MXP / I USD WEIGHTS AND MEASURES Metric System FISCAL YEAR July 1 - June 30 ABBREVIATIONS AND ACRONYMS ADE Acuerdo de Apoyo Inmediato a Deudores de la Banca ADEFAS Adeudos de Ejercicios Fiscales Anteriores ASA Aeropuertos y Servicios Auxiliares BANCOMEXT Banco Nacional de Comercio Exterior, S.N.C. BANJERCITO Banco Nacional del Ejercito, Fuerza Aerea y Armada, S.N.C. BANOBRAS Banco Nacional de Obras y Servicios Publicos, S.N.C. BANRURAL Banca Nacional de Cr6dito Rural, S.N.C. BoM Banco de Mexico CAPUFE Caminos y Puentes Federales de Ingresos y Servicios Conexos CFE Comisi6n Federal de Electricidad CNBV Comisi6n Nacional Bancaria y de Valores CONASUPO Compafila Nacional de Subsistencias Populares EMBI Emerging Market Bond Index FAMEVAL Fondo de Apoyo al Mercado de Valores FARAC Fideicomiso de Apoyo al Rescate de Autopistas FIDEC Fondo para el Desarrollo Comercial FIDELIQ Fideicomiso Liquidario de Instituciones y Organizaciones Auxiliares del Credito FINA Financiera Nacional Azucarera FINAPE Programa para el Financiamiento del sector Agropecuario y Pesquero FIRA Fideicomisos Instituidos en Relaci6n con la Agricultura FNM Ferrocanriles Nacionales de Mexico FOBAPROA Fondo Bancario de Protecci6n al Ahorro FOPYME Programa de Apoyo Financiero y Fomento a la Micro, Pequefta y Mediana Empresa FOVI Fondo de Operaci6n y Financiamiento Bancario a la Vivienda GDP Gross Domestic Product IMF Intemational Monetary Fund IMSS Instituo Mexicano del Seguro Social INEGI Instituto Nacional de Estadistica, Geografia e Informatica IPAB Instituto de Protecci6n al Ahorro Bancario ISSSTE Instituto de Seguridad y Servicios Sociales de los Trabajadores del Estado LFC Luz y Fuerza del Centro LOTENAL Loteria Nacional para la Asistencia Publica MXP Mexican Pesos NAFINSA Nacional Financiera, S.N.C. NIPA National hicome Products Account OECD Organization for Economic Co-operation and Development PEMEX Petr6leos Mexicanos PIPSA Productora e Importadora de Papel SCNM Sistema de Cuentas Nacionales de Mexico SCT Secretaria de Comunicaciones y Transporte SHCP Secretaria de Hacienda y Cr6dito Publico VAT Value Added Tax The Bank team that produced this report was headed by Stephen Everhart (LCSPE)-task manager, under the guidance of Marcelo Giugale (LCCIC)-program team leader. Members of the Bank team include: Craig Bumside (DECRG), Joost Draaisma (LCC1C), Robert Duval (LCCIC), Andrew Feltenstein (IMF, Virginia Tech), Russ Murphy (Virginia Tech), Claudia Sepulveda (LCSPR), and Aaron Schwartzman (Ernst & Young-Mexico). Production assistance was provided by Michael Geller and Elizabeth Toxtle (LCCIC). The Bank appreciates the invaluable support and advice of Eliana Cardoso (LCSPE) and Vicente Fretes-Cibils (LCC4C). This study was undertaken under the general direction of Mr. Olivier Lafourcade (Director, LCCIC). Peer reviewers are: Messrs. Luis Serven (Lead Specialist - Regional Studies, LCSPR) and Anwar M. Shah (Principal Evaluation Officer, OEDCR). ii VOLUME 1: EXECUTIVE SUMMARY TABLE OF CONTENTS Fiscal Sustainability,Mexico: A Synthesis Rationale for the Study .....................................................I Issues and Focus .....................................................2 Fiscal Policy, Business Cycles, and Growth in Mexico ......................................................2 Infrastructure, External Shocks, and Mexico's Fiscal Accounts .....................................................3 Infrastructure, Private Costs, and Payoffs from Additions to Infrastructure ...................................................5 Fiscal Impact of Contingent Liabilities .....................................................6 Fiscal Deficit, Public Debt, and Fiscal Sustainability in Mexico .................................................... 10 An Extension: Balance Sheet Approach and Quality of Fiscal Adjustments ................................................ 16 The Mexican Case .................................................... 19 Implications of the Balance Sheet Approach ..................................................... 23 Conclusions: The Link Between Fiscal Sustainability and Fiscal Reform ................................................... 25 References ..................................................... 27 List of Tables Table E. 1 Estimate of the Overall Cost of the Financial Rescue, June 1999 Table E.2 Contingent Liabilities Recognized by the Federal Government Table E.3 Mexico Federal Debt as a Percentage of GDP List of Figures Figure E.1 Concentration and Growth of Subnational Debt, 1994-1998: Selected States Figure E.2 Gross Federal Debt as Percent of GDP: International Benchmarks Figure E.3 Selected Latin American Eurobond Spreads Figure E.4 Mexico Budget Indicators: 1980 - 1998 Figure E.5 Tax Revenue as Percent of GDP, Selected Countries 1992 - 1998 Figure E.6 Primary Deficit vs. Public Investment (percent of GDP) Figure E.7 Primary Deficit vs. Public Investment (percent of GDP) 5 UMI Countries Figure E.8 Primary Deficit vs. Public Investment (percent of GDP) 6 LMI Countries Figure E.9 Primary Deficit vs. Privatization Revenues (percent of GDP) Figure E. 10 Primary Deficit vs. Public Investment (percent of GDP) Mexico Figure E. 1 1 Primary Deficit vs. General Government Consumption (percent of GDP) Mexico Figure E.12 Public Investment vs. Oil Prices Mexico Figure E. 13 Programmable Expenditure Decomposition (percent of GDP) Mexico. Figure E.14 Primary Deficit vs. Privatization Revenues (percent of GDP) Mexico Figure E. 15 Deficit Reduction and Oil Dependence Figure E. 16 Components of Tax Revenues as a Percent of GDP, Mexico 1980-1998 iii VOLUME II: BACKGROUND PAPERS TABLE OF CONTENTS Chapter 1. Fiscal Policy, Business Cycles, and Growth in Mexico Perspectives on Mexico's Fiscal Accounts from 1980-98 ............................................. 2 The Business Cycle in Mexico ............................................. 3 Trends and Cycles in Mexico's Fiscal Accounts ............................................. 6 The Cyclically Adjusted Budget Surplus in Mexico ............................................. 16 Methods for Computing the Cyclically Adjusted Budget Surplus ................. ............................ 17 Budget Surplus Estimates for Mexico ............................................. 19 How Fiscal Policy and Output Affect Each Other in Mexico ............................................. 23 A Small VAR Model of the Mexican Economy ............................................. 24 How Does the Fiscal Surplus Affect Output? ............................................. 25 Dynamic Behavior of the Fiscal Surplus ............................................. 27 Policy Conclusions ............................................. 29 References ............................................. 31 Appendix ............................................. 33 Chapter 2. Infrastructure, External Shocks, and Mexico's Fiscal Accounts Background ............................................. 43 Model Structure ............................................. 45 Production ............................................. 46 Banking ............................................. 48 Consumption ............................................. 48 The Government ............................................. 49 The Foreign Sector and Exchange Rate Determination ............................................. 49 Money Supply ............................................. 50 Data Sources, Calibration, and Simulation ............................................. 50 Simulations ............................................. 55 The Benchmark Case ............................................. 55 A Shock to Confidence in the Banking System ............................................. 55 Trade Shock ............................................. 57 Conclusion ............................................. 60 References ............................................. 61 Appendix ............................................. 62 Chapter 3. Infrastructure, Private Costs, and Payoffsfrom Additions to Infrastructure Background ............................................. 68 The Model ............................................. 72 The Data ............................................. 74 Sample Horizon ............................................. 75 Limitations ............................................. 75 Estimation of the Model ............................................. 76 Methods ............................................. 76 Infrastructure ............................................. 76 Estimnation Limitations ............................................. 77 Results ............................................. 78 Overview ............................................. 79 iv Payoffs from Additions to Infrastructure ....................................................................... 84 Static Costs and Benefits of Increased Infrastructure ................................................ ....................... 85 Optimal Infrastructure Stocks ....................................................................... 86 Conclusions ....... ................................................................ 87 References ....................................................................... 88 Appendices ....................................................................... 90 Chapter 4. Fiscal Impact of Contingent Liabilities: The Case of Mexico Coverage of the Study ....................................................................... 107 Government Accounting Issues ....................................................................... 110 Methodology .......................................................................1 Illl Deposit Insurance Scheme for Private Banks ....................................................................... 112 The 1995 Banking Crisis ....................................................................... 113 Expected Fiscal Costs of Resolution of the Crisis ........................................................................ 114 Govermment Credit Assistance Programns ........................................................................ 120 Characteristics of Direct Loans and Loan Guarantees . ...................................................................... 121 Expected Fiscal Cost of Government Credit Programs and the Budget ......................... ............................ 126 Liabilities Related to Social Security Programs ....................................................................... 127 The Financial Condition of IMSS ....................................................................... 127 The Financial Condition of ISSSTE ....................................................................... 128 Expected Fiscal Costs of Social Security Programs and the Budget .......................................................... 129 Private Provision of Infrastructure and Government Guarantees .............................................. ................. 129 Power Plants ....... ................................................................. 129 Highways ....................................................................... 130 The Fiscal Cost of Government Insurance Programs ....................................................................... 130 Policy Inplications ....................................................................... 132 References ....... ................................................................ 134 Chapter 5. Fiscal Deficit, Public Debt and Fiscal Sustainability in Mexico The Mexican Fiscal Accounts: Stylized Facts .......................... .............................................. 138 Debt Management ....................................................................... 140 Budget Indicators ........................................................................ 142 Tax System ........................................................................ 143 Government Expenditure Composition ........................................................................ 146 Is Mexican Fiscal Policy Sustainable? ........................................................................ 148 Accounting Approach to Fiscal Solvency ........................................................................ 148 Pricing Approach to Fiscal Solvency ....................................................................... 149 Intertemporal Approach to Fiscal Solvency: The Medium and Long Term ................... ........................... 151 The Short and Medium Term ........................................................................ 152 The Long Term: A Time Series Analysis 1980:01-1999:05 ....................................................................... 154 Testing the Intertemporal Budget Constraint: Unit Roots ........................................................................ 155 The Case of a Stochastic Discount Rate ........................................................................ 156 Testing for a Change in Regime ........................................................................ 157 Testing the Intertemporal Budget Constraint: A Co-integration Approach ................... ............................ 160 Testing Long-Run Relationship Between Government Spending Inclusive of Interest Payments and Revenue ....................................................................... 161 Testing Long-Run Relationship Between Government Spending Exclusive of Interest Payments, Interest Payments and Revenue ....................................................................... 163 Policy Conclusions ....................................................................... 165 References ....................................................................... 167 Appendix .......169 v List of Tables Table 1.1 Summary Budget Figures, 1980-81 1997-98 Table 1.2 Cyclical Properties of Public sector Revenue and Expenditure Table 1.3 Main Components of Public Sector Revenue and Expenditure, 1980-81 and 1997-98 Table 1.4 Estunates of Revenue and Expenditure Elasticities Table 1.5 Impulse Response Functions from the VAR Table 1.6 Variance Decomposition of Output Table 1.7 Variance Decomposition of the Unadjusted Prinmary Fiscal Surplus Table l.A1 Estimates of a Piecewise Linear Trend in the Logarithm of Seasonally Adjusted Real GDP Table 2.1 Real GDP, 1980-97 Table 2.2 Stocks of Infrastructure, 1970-90 Table 2.3 Cost Elasticities by Sector and Infrastructure Type Table 2.4 A Benchmark Simulation, 1995-2000 Table 2.5 Reduction in the Interest Elasticity of Money Demand, 1995-2000 Table 2.6 Interest Elasticity Decline Combined with an Infrastructure Increase 1995-200 Table 2.7 Trade Shock: Real World Income Stagnates, 1995-2000 Table 2.8 Trade Shock Combined with an Infrastructure Increase, 1995-2000 Table 2.9 Infrastructure Elasticities = 0 Table 3.1 Compound Annual Growth Rates 1960-93 Table 3.2 Infrastructure Compound Annual Growth Rates, 1960-93 and 1983-93 Table 3.3 Physical Infrastructure, Average Annual Growth Rates Table 3.4 Correlations: Physical and Financial Infrastructure Measures Table 3.5 Primary Data: Means and Standard Deviations Table 3.6 Estimated Private Sector Cost Elasticities with Respect to Public Infrastructure Stocks Table 3.7 Estimated Private Sector Cost Elasticities with Respect to Public Infrastructure Stocks Table 3.8 Estimated Private Sector Cost Elasticities with Respect to Public Infrastructure Stocks Table 3.9 Estimated Private Sector Cost Elasticities with Respect to Public Infrastructure Stocks Table 3.10 Mean Elasticities Table 3.11 Static Cost and Benefits of Increased Infrastructure Table 3.12 Optimal Infrastructure Stocks Table 3.13 OLS Panel Elasticities Table 3.14 OLS Random Effects Elasticities Table 3.15 FGLS Elasticities - Hetero, ARI Table 3.16 Growth Rates Used for Norminal Electricity Infrastructure Table 3.17 Coefficient Estimates Table 3.18 Coefficient Estimates (se's in (s), Dummy Variables Excluded Table 4.1 Fiscal Risk Matrix Table 4.2 Federal Insurance Programs with Major Fiscal Risks Table 4.3 State Government Debt Table 4.4 State Government Pension Liabilities: 1997 Table 4.5 Pro Forma Balance Sheet of FOBAPROA, February 1998 Table 4.6 Estimation of the Cost of the Financial Rescue, June 1999 Table 4.7 Executed Fiscal Cost on Programns of Financial and Debtors Rescue Table 4.8 Estimates of Total Losses of Resolving Major Bank Insolvenses Table 4.9 Government Loans by Major Program Area, Fiscal 1997 Table 4.10 IMSS Retirement System Actuarial Deficit, December of 1994 Table 4.11 Government Net Liability as a Result of the 1995 Pension Reform Table 4.12 Pro Forma Balance Sheet of FARAC as of November 1998 Table 4.13 Contingent Liabilities and Fiscal Deficit Adjustments Table 4.14 Contingent Liabilities Recognized by the Federal Government Table 5.1 Accounting Approach Mexico in 1998 Table 5.2 Short and Medium-Term Indicators of Fiscal Sustainability as a percentage of GDP Table 5.3 Testing for Nonstationarity in Undiscounted and Discounted Net Public Debt, 1980:01- 1999:05 vi Table 5.4 The Zivot Andrews Unit Root Test for Undiscounted and Discounted Public Debt Table 5.5 Testing for Nonstationarity in Real Interest Rates, 1980:1-1998:07 Table 5.6 Testing for Nonstationarity in Real Government Spending Inclusive Interest Payments and Government Revenues, 1980:1-1999:05 Table 5.7 Results of Co-integration Government Spending Inclusive Interest Payments and Goverrnent Revenue, 1980:01-1999:05 Table 5.8 Testing for Nonstationarity in Real Government Spending, Interest Payments and Government Revenues, 1980:1-1999:05 Table 5.9 Results of Co-integration Noninterest Government Spending, Interest Payments and Government Revenue, 1980:01-1999:05 List of Figures Figure 1.1 Real GDP in Mexico, 1980-98 Figure 1.2 Seasonally Adjusted Real GDP, 1980-98 Figure 1.3 (a) Trends and Cycles in Real GDP: HP Trend Figure 1.3 (b) Trends and Cycles in Real GDP: Deviations from Trend Figure 1.4 Trends in Public Sector Revenues, 1980-98 Figure 1.5 Cyclical Components of Revenue, 1980-98 Figure 1.6 Trends in Public Sector Expenditure, 1980-98 Figure 1.7 Cyclical Components of Expenditure, 1980-98 Figure 1.8 The Budget Surplus and the Fiscal Impulse, 1980-98 Figure 1.9 Cyclical Fluctuation in Output Caused by Fiscal Shocks Figure l.AI Trends in Real GDP Figure l.A2 Cyclical components of Real GDP Figure 3.1 Changes in Electric, Transport, and Communications Infrastructure Figure 3.2 Education Infrastructure Index Figure 4.1 Contingent Liabilities related to Potential Crisis of the Banking Sector Figure 5.1 Mexico Public Net Debt and Prirnary Deficit (+) as a percentage of GDP, 1980 - 1998 Figure 5.2 Mexico Overall and Primary Deficit (+) as a percentage of GDP, 1980-1998 Figure 5.3 Mexico Domestic and Foreign Public Net Debt as a percentage of GDP, 1980-1998 Figure 5.4 Public Sector Domestic Debt as a percentage of GDP, 1982-1998 Figure 5.5 Mexico Public Foreign Debt: Termn Structure, 1982-1998 Figure 5.6 Mexico Budget Indicators, 1980-1998 Figure 5.7 Total Tax Revenues as a percentage of GDP-Selected Countries Figure 5.8 Oil Revenues as a percentage of Total Revenues Figure 5.9 Seignorage as a Source of Government Revenue Figure 5.10 Federal Govermment Revenue Tax Mix Figure 5.11 Total Expenditure of the Central Government as a percentage of GDP-Selected Countries Figure 5.12 Total Government Expenditure (million p$1994) Figure 5.13 Expenditure Composition Figure 5.14 Real Annualized Interest Rate CETES 28 days Figure 5.15 Brady Bonds Discounts Figure 5.16 EMBI Spread Rate Figure 5.17 Credit Rating for Mexico (100 lowest chance of default) Figure 5.18 Mexican Net Public Debt, 1980:1 - 1999:5. Undiscounted at Market Value (in Bill. P$1994) Figure 5.19 Sequential Zivot-Andrews Unit Root Test for the Mexican Undiscounted and Discounted Public Net Debt, 1980:1-1999:5 Figure 5.20 Govermment Spending Inclusive Interest and Government Revenues, 1980:1-1999:5 Figure 5.21 Government Spending, Interest Payments and Government Revenues: 1980:01-1999:05 vii EXECUTIVE SUMMARY FISCAL SUSTAINABILITY-MEXICO: A SYNTHESIS Rationale for the Study 1.1 The stabilization efforts and successes that preceded and have underpinned Mexico's sweeping market-oriented structural reforms since the late 1980s have been anchored in strong fiscal adjustment. Fiscal deficits were drastically reduced (from 15 percent of GDP in 1987 to 1.24 percent in 1998), allowing for tighter monetary policy and lessened inflationary pressures (over the same period, inflation fell from 160 percent p.a. to the current level of 13 percent per anum). This created an environment in which long-needed structural reform could proceed. The sustainability of those fiscal adjustments is thus central to the Government's macroeconomic policy and, ultimately, to the country's development future. 1.2 It has become apparent in recent years, however, that potential imbalances may remain behind the positive results posted in Mexico's fiscal accounts, imbalances that, if unattended, could bring into question the permanence of the heralded adjustments. Contingent liabilities in the unfunded, pay-as-you-go social security system (that was partially reformed recently), unlimited bank deposit insurance schemes, off-balance-sheet financing of public investments, public guarantees for private sector investments, state and municipal borrowing/indebtedness and accelerated depletion in public infrastructure, among other issues, have been the focus of increasing attention by practitioners (and academics) as part of the "quality" analysis of the Mexican fiscal adjustment.' 1.3 The authorities are well aware of the risks embedded in those imbalances and have been rightly prudent in the implementation of their fiscal policy. This study seeks to support their efforts by providing a body of technical analysis that: (i) sheds light on underlying fiscal trends by correcting them for various business-cycle effects; (ii) builds a simulation model to assess the sensitivity of the fiscal budget to exogenous shocks (for example, changes in oil prices and exchange rates) under several structural scenarios, with particular attention being paid to the depletion of Mexico's infrastructure stock; ' The idea that posted fiscal accounts may not adequately represent the public sector's pressure on an economy's resources, or the "quality" of fiscal adjustments, has been addressed in the literature by, among others, Towe ("Are all Summary Indicators of the Stance of Fiscal Policy Misleading?", IMF Staff Papers, vol. 36, No. 4, December 1989), Mackenzie ("The Budgetary Control and Fiscal Impact of Government Contingent Liabilities", IMF Staff Papers, vol. 38, No. 1, March 1991), and Easterly ("When is Fiscal Adjustment an Illusion?", mimeo, World Bank, April 1998). Executive Summara (iii) estimates the direct and indirect potential impact on the fiscal accounts of closing public infrastructure gaps and funding contingent liabilities; and (iv) consolidates the financial accounts of the main public sector institutions to assess the sustainability of their aggregate debt path. In brief, the report is meant to assist Mexican policymakers in the design of sustainable fiscal policy. Issues and Focus 1.4 In general, fiscal accounts are subject to many sources of instability, explicit and implicit, realized and contingent, expected and unexpected. Some are within the control of policymakers, and others are exogenous to the budget process. This spectrum of fiscal pressures also applies to Mexico. The report will not seek to cover the whole of that spectrum; instead, it focuses on selected sources of instability that, at the margin (that is, given existing analytical work), appear to be the most critical and urgent from the point of view of future fiscal policy design. More specifically, we first attempt to disentangle underlying policy stances from business cycle effects. Then the study will address four sources of fiscal instability: external shocks, infrastructure gaps, contingent liabilities, and consolidated public sector debt accumulation. Chapter One: Fiscal Policy, Business Cycles, and Growth in Mexico 1.5 The identification of Mexico's fiscal budget's cyclical (and seasonal) properties is critical to isolating the components of fiscal policy that have an exogenous impact on output-that is, to separating the short- and long-run output effects of fiscal shocks from the feedback rules implicit in the way output fluctuations, in turn, affect fiscal outcomes. This information is important for policymakers because it allows them to formulate fiscal policies that can smooth, rather than exacerbate, real cycles, as well as to predict the government's financing requirements more accurately. 1.6 This section addresses three main questions: * what is the role of fiscal policy in deterrnining output in the short and medium termn; * how does fiscal policy, in turn, respond to the business cycle; * what is the "persistence" of fiscal policy, and how can the authorities use this persistence to forecast the government's financing needs? 1.7 The chapter looks at these particular issues for a number of reasons One traditional role fiscal policy plays in industrial economies is that of a cyclical stabilizer. Fiscal policy is typically designed to "lean against the wind." That is, it is usually designed to stimulate output when the economy moves into recession and to be contractionary when an expansion broadens. This is usually accomplished in two ways. 2 Executive Summarv The first way is by having components in the budget that respond automatically to the business cycle, such as tax revenues (which respond positively) or unemployment benefits (an expenditure item that responds negatively). The second way is by using discretionary components in the budget to provide a stimulus during bad times. A fiscal policy designed in this way leads to a strongly procyclical budget surplus. 1.8 Our findings indicate that Mexico's fiscal policy does not lean against the wind. The analysis in this chapter will show that the budget surplus is quite strongly countercyclical, so that fiscal policy leans with the wind. The automatic stabilizers in place are weak, and are further weakened by the tendency of another automatic component of the budget, oil-based revenue, which responds sensitively to exogenous world oil prices, to move countercyclically. Furthermore, the discretionary component of the budget surplus also tends to move countercyclically. 1.9 If fiscal policy simply did not matter, then whether or not it leaned with or against the wind would be of little consequence. However, in Mexico, as in many other countries, fiscal policy does matter. The analysis suggests that an increase in the discretionary surplus of 1 percent of gross domestic product (GDP) causes GDP to decline by 0.6 percent in less than a year. Because in Mexico such increases typically occur during contractions, and these contractions are relatively short-lived (typically less than two years), this implies that discretionary policy exacerbates the cycle. 1.10 The results also imply that Mexico's fiscal policy lacks a design that makes it a stabilizing feature of the economy. Furthermore, it has not been designed to render itself more sustainable. With procyclical fiscal policy (a countercyclical fiscal surplus), deficits cause debt to accumulate during economic expansions, but when the economic expansion inevitably ends, this debt suddenly becomes extremely costly. To finance it, the government must either take drastic discretionary fiscal measures, or it must finance the debt by borrowing at high real interest rates, or by printing money and inducing rapid inflation. No matter which action the government takes, the implications are similar: a worsening of the economic downturn. This chapter is intended to allow policymakers to formulate fiscal policies that can smooth, rather than exacerbate, real cycles, and that are therefore more readily sustained in the medium term. Chapter Two: Infrastructure, External Shocks, and Mexico's Fiscal Accounts 1.11 In the past 25 years Mexico's economy has been subjected to a variety of shocks, both internal and external, including sudden increases and declines in world oil prices, changes in U.S. interest rates, economic collapses in Russia and Asia, and bank panic in Mexico. The aim of this chapter is to determine whether changing the provision of certain types of infrastructure can mitigate the effects of such shocks. If this is indeed the case, then choosing alternative infrastructure paths could help stabilize the Mexican economy. 1.12 This chapter investigates the first- and second-order impacts of major exogenous shocks (such as changes in the international price of oil or in the nominal exchange rate, 3 Executive Summarv or confidence-driven contractions in money demand) on Mexico's fiscal accounts. How is that impact affected by the choice of the public infrastructure investment path? These two questions, which are at the forefront of fiscal policy design in Mexico, are investigated in this chapter. 1.13 A dynamic general equilibrium model is presented to analyze issues of stability in the Mexican economy. It focuses on whether increased provision of infrastructure can reduce the impact of exogenous shocks on the real economy. That is, would the impact of a shock be less if higher levels of infrastructure spending were in place at the time of the shock? 1.14 The answer to this question is a qualified yes. All else being equal, higher stocks of infrastructure will tend to reduce the declines in real income caused by certain types of shocks. We reach this conclusion by carrying out a series of numerical exercises based on a model that incorporates various types of estimated Mexican data. The model incorporates four types of infrastructure in the production process: electricity, telecommunications, transportation, and education. In general, the estimates indicate that in Mexico, increased provision of infrastructure, either by the public or private sector, tends to be cost reducing. 1.15 Using a variety of Mexican data sources, we calibrate our model to the years 1995-97 as part of a six year simulation for the years 1995-2000. We subject the model to two types of shocks. The first is a shock to the interest elasticity of money demand that causes the absolute value of the elasticity to decline. Such a shock might be caused by a sudden loss of confidence in the banking system, and tends to increase holdings of money and reduce bank deposits. Over time, this shock brings about an increase in the real interest rate, a deflation, and a reduction in real gross domestic product (GDP) amounting an annual average of about half a percentage points over the six years of the simulation. 1.16 We then suppose that prior to the shock infrastructure spending was higher, in real terms, on each of the four types of infrastructure. 7he increased provision of infrastructure reduces private sector costs and, as a result, real GDP rises to a somewhat higher level than in the initial pre-shock simulation. We thus conclude that higher levels of infrastructure stocks can indeed insulate the Mexican economy from certain types of shocks. 1.17 The second shock is an external shock: stagnation of the world's real income for the six years of the simulation. This lowers the demand for Mexican exports and, accordingly, the rate of growth of real Mexican income. In this case, as before, a higher level of expenditure on infrastructure before the shock and throughout the period of the simulation tends to neutralize the impact of the shock on real Mexican income. We therefore conclude that the positive implications of increased infrastructure outweigh the negative impact on the budget deficit. Enhanced infrastructure prior to shocks seems to offer a way to avoid the ex post remedies that have been tried so often, frequently with little success. 4 Executive Summary Chapter Three: Infrastructure, Private Costs, and Payoffs from Additions to Infrastructure 1.18 The role public spending plays in enhancing economic productivity has long been a concern for policymakers. In recent decades, public expenditure has primarily been evaluated in terms of two roles: enhancing macroeconomic stability and mitigating market failure. An equally important role concerns the ability of public investments in infrastructure capital to reduce the costs of private firms. Particularly for developing economies, this role may be critical because it may allow the private sector to become more resilient to external shocks. A major concern related to the recent fiscal adjustment in Mexico is that it was carried out partly by depleting public infrastructure stocks. This depletion could significantly retard future growth by imposing an additional drag on private sector costs and output. 1.19 This chapter provides a macroeconomic estimate of Mexico's public infrastructure shortage, or "gap," as well as the fiscal cost of closing that gap. It first examines general evidence at the macro level to establish the actual relationship between current rates of growth and the aggregate stock of public infrastructure. This will be supplemented by an examination of sectoral evidence in education, transport, electricity and telecommunications, considering historical patterns of public spending on infrastructure across sectors. 1.20 The chapter also provides estimates of the potential (partial equilibrium) payoffs from increased investment in public infrastructure and calculates (in a static context) the optimal infrastructure stocks implied by the elasticity estimates. The chapter also considers the role that public infrastructure plays in improving the efficiency of the private sector. In particular, it focuses on the short-run, static gains that accrue to private firms because of government investments in electric, transportation, and communications infrastructure. 1.21 Our findings suggest that public infrastructure in Mexico has generally small, but significant, negative effects on private sector costs. The base case estimates of the elasticity of private sector costs with respect to infrastructure suggest a mean value of - 0.106 across 14 sectors of the economy (with a range of -0.563 to 0.355). In general, electric infrastructure appears to have the most beneficial effects on private sector costs (mean base case elasticity of -0.1 71), and transportation infrastructure has the next most beneficial effects (mean base case elasticity of -0. 165). 1.22 Using the electricity, transportation, and communications estimates, rough calculations based on these elasticities suggest that a 1 percent increase in public infrastructure stocks would cost approximately mxp 6.6 billion and provide annual benefits across 14 sectors of the economy of mxp 12.4 billion (both in terms of real 1980 pesos). These are static, partial equilibrium estimates, but they suggest that at least in the short run, additional investment in public infrastructure stocks could be welfare improving. Given sensible depreciation rates, the present value of these benefits over future years might be roughly nine times the single year gross benefits. If the base case elasticity estimates are correct, static calculations of the optimal size of infrastructure 5 Executive Summarg stocks suggest that electric and transportation stocks should have been 2.5 and 4 times as large as they actually were in 1993. Chapter Four: Fiscal Impact of Contingent Liabilities 1.23 One result of the financial crises affecting Asia, Latin America and other emerging economies over the recent past has been a renewed emphasis on the fiscal risks (liabilities) governments' face and means to quantify and mollify such risks. In general, liabilities can be either contingent or direct. Contingent liabilities are defined as "obligations that may or may not come due, depending on whether particular events occur. The probability of their occurrence may be exogenous to government policies (for example, if they are related to natural disasters) or endogenous (for example, if government programs create moral hazard)." In contrast, direct liabilities are defined as ''obligations whose outcome is predictable." 1.24 Delineating further, "Explicit liabilities are specific obligations, created by law or contract, that governments must settle. Implicit liabilities represent moral obligations or burdens that, although not legally binding, are likely to be borne by governments because of public expectations or political pressures."2 1.25 This chapter addresses the measurement of contingent liabilities for Mexico within the government's traditional budget accounting framework. The key research problem is to identify, quantify, and understand the future fiscal risks posed by the government's contingent liabilities. The lack of a unified measure of contingent liabilities makes difficult the assessment of the sustainability of the fiscal policy. Therefore, the objective of this chapter is to provide an overview of the problem in Mexico and suggest an analytical construct for assessing the magnitude of the problem. 1.26 For many years, federal government insurance programs were a policy instrument for the Mexican authorities. Those programs were primarily concentrated in four areas: government-guaranteed borrowing; infrastructure franchising; unlimited bank deposit insurance; and, more recently, coinsurance of the social security system. Those programs were supposedly justified on the basis of observed market failures (including information-based imperfections in credit markets, high risks in the provision of infrastructure, systemic risk in the banking system in the case of bank failures, imperfect pooling arrangements in the private insurance sector with respect to certain types of insurance, and the like). In effect, before the crisis of 1994, the budgetary implications of these contingent liabilities were largely overlooked. 1.27 Since the crisis, however, it has become clear that the financing requirements to cover the realized losses in those insurance programs have the power to destabilize the Government's overall fiscal adjustment efforts. More critically, while the latent fiscal 2 Polackova, Hana, "Contingent Government Liabilities: A Hidden Fiscal Risk"; Finance & Development, March 1999. 6 Executive Summarv cost of the various insurance programs is widely believed to be large, there is no solid estimate available of the eventual cash outlays that the budget will have to afford, mainly because those programs were not (and, to a certain extent, are still not) considered in the traditional budgetary accounts. 1.28 Two important contingent liabilities are omitted in the analysis due to data limitations: first, the expected effects on the federal fiscal accounts of the debt restructuring of states and municipalities since the 1995 crisis; and second, the analysis of the pensions of sub-national governmental institutions. Assessing these areas is difficult because of incomplete and inconsistent data, however these are clearly contingent liabilities at the federal level. The chapter provides estimates of the debt stock at the state level only (very limited data exists at the municipal level), where disturbing trends in both the size and the concentration of the debt at the state level are developing: the debt of the Federal District, State of Mexico, Nuevo Le6n has grown from 33 percent in 1994 to 65 percent of the total outstanding in 1998, more than doubling the outstanding sub- national debt stock over the period (see Figure E.1 below). The chapter also provides sobering evidence on the health of the 32 sub-national pension systems (31 states plus the Federal District): 11 of these are either in actuarial deficit now or will be by 2001. 7 Executive Summary Figure E.1 Concentration and Growth of Subnational Debt, 1994-1998: Selected States Total Subnational debt more than doubled over the period 1994-1998; some states witnessed a ten-fold increase... Estado de Mexdco 25000 - _ _._ __ .00 and concentration has increased dramatically. 20000- 0 m 7_ Q 15000 - 0 10000 1994 50000 E 5000 <_ _ _ _ _ Mexico 0 -- --20% 1994 1995 1996 1997 1998 44 u Nuevo Leon 10% AU others Federal District 63% Fed. Distrct 7% 25000 rs 20000- x E 15000 . 10000 5000- 0 T 1998 1994 1995 1996 1997 1998 Nuevo Leon Nbxico All others 26% 25000- 35% 20000 -.o Leon Cx 10% E15000 _ 10000 _ Fed. Cistrict c10000 29% 5000 1994 1995 1996 1997 1998 8 Executive Summarv 1.29 Table E. 1 presents the most recognized (and highly politicized) contingent liability facing the government, the banking system rescue, with resolution costs estimated to be on the order of 19.3 per cent of GDP. Of this 19.3 percent, 3.1 percent has already been spent, leaving a government-acknowledged remaining liability of 16.2 percent of GDP. Table E.1 Estimate of the Overall Cost of the Financial Rescue, June 1999 Billion of pesos % of GDP Debtors Aid Programs 174.3 3.9 Cost of banking intervention 579 12.8 and clean up Purchase of non performing 101.8 2.2 assets Toll Roads Program 18 0.4 Total 873.1 19.3 Source: IPAB 1.30 Since 1998 the Ministry of Finance has made an effort to report what they recognize as the contingent liabilities of the government. Table E.2 below presents their most recent report, reflecting the increased cost through time. Table E.2 Contingent Liabilities Recognized by the Federal Government (billions of pesos) Balance Balance Change Balance Change Dec, 1998 Mar, 1999 from Jun, 1999 from Dec 1998 Dec 1998 FOBAPROAa 425.03 435.17 10.14 451.79 26.76 FARAC 73.63 79.09 5.46 83.32 9.69 Credit 143.57 153.51 9.94 160.19 16.62 Assistance Programs b Development 10.08 11.34 1.26 12.02 1.94 Banks FAMEVAL 4.07 4.33 0.26 4.48 0.41 Others c 5.18 4.72 -0.46 4.66 -0.52 Total d 661.56 688.16 26.60 716.46 54.90 a/ Includes only the explicitly guaranteed liabilities by the Federal Government. b/ Includes mainly FIRA, FOVI, FIDEC and FIDELIQ. c/ Includes mainly the Federal Electricity Company, CFE. d/Preliminary data. It excludes guarantees established in the organic laws of the Development Bank. Source: SHCP 9 Executive Summary 1.31 Public estimation of these liabilities by the government is an important step toward resolution of the problem. However, it must be pointed out that these estimates exclude all sub-national debt, sub-national pensions, some unrecognized FOBAPROA debt, and obligations of state-owned enterprises. Our findings suggest the figures above substantially understate the true contingent liabilities facing the government. Chapter Five: Fiscal Deficit, Public Debt and Fiscal Sustainability in Mexico 1.32 While the numbers shown above are somewhat startling (and the quarter to quarter run-up is quite expensive), it is important to view the problem from an intemational perspective. Even with the addition of the govemment's estimate of the contingent liabilities to the existing explicit stock of debt, Mexico compares favorably to G-7 nations on a debt to GDP basis. Table E.3 illustrates that even when the contingent liabilities are added to the explicit stock of debt, Mexico would easily qualify for European Union membership, whereas Figure E.2 illustrates that of the G-7 nations, only France would qualify.3 Table E.3 Mexico Federal Debt as a Percentage of GDP Gross Public Debt 29.2 Cost of Financial Rescue 16.2 Other Contingent Liabilities' 5.9 Total 51.3 Source: SHCP, Informe sobre la Situaccion Economia, las Finanzas Publicos y la Deuda Publica, Segunda Trimestre 1999. Cost of Financial Rescue: IPAB estimates 1/ Includes credit assistance programs, FARAC, Development Banks, FAMEVAL, and CFE. 3 The fiscal criteria under the Maastricht Treaty are set in terms of a general government debt/GDP ratio ceiling of 60 percent and a govermnent financial deficit/GDP ratio ceiling of 3 percent. 10 Executive Summary Figure E.2 Gross Federal Debt as Percent of GDP: International Benchmarks 140 118.7 117.9 120 100 95.8 8 80 40 ~~~58.2 61.1 62.2 62.1 60 51.3 4 0 29.2 20 0 CD w~~~~~~~~ Source: October 1999 IMF World Econornic Outlook for G7 Countries, Bank staff estimate for Mexico Note: 1998 estimates for G7 countries, June 1999 for Mexico 1/ Includes direct and contingent liabilities. 2/ Includes only direct liabilities. 11 Executive Summary With this information, coupled with one measure of the international investment community's current diagnosis of Mexico's fiscal health, eurobond spreads (shown below in figure E.3), one could easily conclude the need for such stringent analysis is dubious. Figure E.3 Selected Latin American Eurobond Spreads (basis points) 800 Argentina 900 Brazil 700 Soo 600 600 0oo 600 400 500 300 300 200 200 IO ' O ' 0 0 i i 1 0 0 o 800 ~Colombia 7,0O0 Ecuador 700 Meic6,2000Vnzul 600 5,000 500 4,000 400 300 3,000 200 2,000 100 1,000 0 111 1 111 1 ii 0 li 111 11 350 Mexico 1,200 Venezuela 300 1,000 250 S00 200600 t00 Nt calel 400 50 200 0 domestic poliis 0 ut, O he can also be exlane by50 MexicssONso's vulonerabiliOty to change 1.33 However, problems remain. Since the early 198Os, Mexico has faced recurrent crises at approximately six-year intervals. These crises can be attributed largely to poor domestic policies. But, they can also be explained by Mexico's vulnerability to changes in external variables. Examples include the fall in oil prices in 1982 and 1986 and the rise in foreign interest rates and sharp decline in foreign capital flows in 1994. The continued dependence on oil as a source of revenue is particularly worrisome. 1.34 The unpredictability of fiscal revenues as a consequence of its dependence on oil has forced the government to make drastic expenditure cuts. As a fraction of GDP, non- interest expenditures fell from about 25 percent in the 1980s to 19 percent in the 1990s, a drop of 23 percent. By contrast, non-oil revenue remained roughly constant at about 16.25 percent of GDP over this period. 12 Executive Summary Figure E.4 below illustrates the expenditure and revenue cuts over the period 1980 to 1998. Figure E.4 Mexico Budget Indicators: 1980 - 1998 45 40 35 30 25 20 1980 1981 1982 1983 19M 1985 1986 1987 1998 1988 1990 1981 1992 1993 1994 1933 199 1997 1898 |_ TOTAL REVENUE OIL REVENJE TOTAL EXPENDITURE -U-NON INTEREST EXPENDITURES Source: SHCP The Mexican tax system has undergone major reforms since 1980. A value added tax (VAT) and indexation to neutralize the effects of inflation were introduced. Personal and corporate income taxes were integrated, ensuring more neutrality between retained and distributed profits. Despite these measures, tax revenues as a percent of GDP have not increased substantially. As figure E.5 illustrates, by regional and international standards, Mexico does not compare favorably. Clearly, fiscal reform is long overdue. Figure E.5 Tax Revenue as Percent of GDP, Selected Countries 1992 - 1997 45 40 35 30 25 20 15 10 5 0 .. 1992 1993 1994 1995 1996 1997 2 Hungary SI Chile * Mexico 0 Uruguay E] Venezuela Source: WDI-World Bank 13 Executive Summary Thus, while current conditions appear tenable, further investigation is certainly warranted. Summarizing the results of chapter five: * Budgets are affected by oil prices, as total revenues follow the cycle of oil revenues quite closely. In response to this vulnerability to oil prices and the effect of interest rates, the stance of fiscal policy has remained cautious. The latter has been achieved by running consecutive primary (interest exclusive) surpluses since 1983. * This primary surplus has been obtained primarily by drastic expenditure cuts. As a fraction of GDP, non-interest expenditures fell from about 25 percent in the 1980s to 19 percent in the 1990s, a drop of 23 percent. By contrast, non-oil revenue remained roughly constant at about 16.25 percent of GDP over this period. In particular, the major adjustment in the 1990s came from capital expenditure. * Mexico's public debt, relative to GDP, fell from 115 percent in 1986-87 to about 29 percent in 1998, due to primary surpluses and a debt management strategy centered on lengthening maturity and reducing interest payments after the peso crisis. - The short and medium term projections of fiscal sustainability using an intertemporal approach for the Mexican economy between 1999-2006 show that the required adjustment in the primary surplus will be around 0.5 and 0.8 percent of GDP. The government can increase government spending or reduce taxes. This under the assumption that government expenditures to GDP remained constant at the 1998 level and the bailout of FOBAPROA is not taken into account. - However, results change if FOBAPROA bailout is included. Assuming a discount rate of 5 percent, the government will have to increase taxes or reduce government spending in the next years approximately between 0.3 and 0.8 percent of GDP. If the discount rate is 3 percent this adjustment will be only necessary in 2005 and 2006 for an amount of 0.1 percent of GDP. * The numbers obtained from this simple exercise do not seem implausible and only barely effect the fiscal solvency of the Mexican government. As a cautionary note, this exercise does not include all contingent liabilities. * The Mexican government has responded to the increase in interest payments on the outstanding debt by running primary surpluses. Thus, the change in fiscal policy in recent decades is a signal that the government is trying to meet its intertemporal budget constraint through fiscal adjustment instead of inflation or default. * The Mexican government has run a primary surplus since 1983. After each major economic crisis the government has tightened its fiscal policy as part of the stabilization program. In the two years following the debt crisis of 1982, the primary surplus averaged 4.9 percent of GDP. After the 1986 crisis, the primary surplus rose further to 6.5 percent of GDP. Following the December 1994 crisis, tighter fiscal policy yielded primary surpluses averaging 4.5 percent of GDP in 1995 - 96. Since then, the stance of fiscal policy has been cautious, to consolidate macroeconomic stability. 14 Executive Summarv * By contrast, Mexico has run an overall budget surplus (including interest payments) only 3 times in the last 19 years. The difference between the primary and overall- deficit is the interest payments on the government domestic and foreign debt (as a percentage of GDP). Thus during the 1980s, the overall deficit was largely explained by interest payments. 15 Executive Summary An Extension: Balance Sheet Approach and Quality of Fiscal Adjustments 1.35 Admittedly in many countries there is a need to cut fiscal deficits and spending, yet there are many routes to this end. By providing the authorities a comprehensive review of their fiscal sustainability, better decisions can be made in the process of fiscal adjustment. In this study we present the conventional approach to fiscal sustainability, emphasizing only the right-hand side of the balance sheet. 1.36 Reasons for this rest in the nature of the available data-it exists for liabilities. Very little information on the assets of the nation are available. Buiter (1983) and Bean and Buiter (1987) suggest that the ideal approach would require evaluating a consolidated public sector balance sheet valued at current prices. In this way fiscal policies could be evaluated in termns of the impact of the government's net worth. Easterly (1999) outlines numerous examples of costly fiscal adjustments where the left hand side of the balance sheet is sacrificed in the short-run with deleterious long-term consequences. 1.37 Under this approach, a govermment balance sheet would include financial assets, real capital, land and mineral assets, the present value of fature tax programs and seigniorage on the asset side, with government debt, the stock of high-powered money, and the present value of social security and other entitlement programs, on the liability side (Blejer and Cheasty, 1991). While the balance sheet approach to fiscal accounts is theoretically straightforward in giving an idea of a government net worth, it presents many empirical problems. In particular, when measuring assets intertemporally, strong assumptions on interest rates, inflation, demographics and natural resource pricing have to be made. 1.38 Because of these empirical problems, some alternative approaches have appeared following the theoretical line of government net worth, but employing simpler empirical methods. Easterly (1999) follows this strategy investigating policy aspects of fiscal adjustments mandated by the IMF and The World Bank. The author indicates four lines of action that governments may implement in order to avoid a real fiscal adjustment. These are reduction of public investment, privatization, shifts of revenue and expenditure over time and run up of implicit liabilities. 1.39 Following Easterly's work, we analyze budget deficit reductions in selected Latin American countries from 1980 to 1997. Specifically, the achievement of fiscal adjustments by means of reductions in public investment and privatization are investigated. 1.40 A first glance at a plot of budget deficit versus public investment4 trends in 11 Latin American economies (Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, 4 Where Gross Domestic Fixed Investment of the Public Sector is used as a measure of public investment and Primary Budget Deficit as a measure of Budget Deficit. The reason for choosing the latter is that interest payments play an important role in the composition of budget deficit, but since they are not fully predicted in advance they may give us a misguided idea of the government efforts in reducing its deficit. In the Public Sector we include central government, related institutions and state-owned enterprises, whenever the data is available. 16 Executive Summarv Dominican Republic, Mexico, Panama, Peru and Venezuela) reveals a close relationship between these series (see figure E.6).s The first and largest deficit-investment reduction comes in 1982 and goes until 1985; this reduction was generated by the 1982 oil crisis. During the middle eighties two other reductions in primary deficit took place (one in 1987 and the other in 1990), the latter was again accompanied by reductions in public investment. The correlation coefficient between the two series is 0.78. Figure E.6 Primary Deficit vs Public Investment (percent of GDP) 91 Selected Counties: 8 / Argentina, Brazil, Chile, Mexico, O Ck / \ \ Venezueta, Eoliia 0 7 SX Colombia, Costa Rca, Dorninican Z1.1 ~~~~ ~ ~~~~~~~Rep.Z Panama & Peru 6 -2 4 -~~~~~~~~~~~~~~~~~~~~4 3 -5 c=> c O 00 0 4 t O 00 00 00 00 00 (ON ON~ ON ON - - - Public Investment Primary Deficit Source: IMF-Government Financial Statistics, LDB- World Bank, SHCP for Mexico. 1.41 Because figure E.6 averages very heterogeneous economies, we split the sample of countries according to income level. Argentina, Brazil, Chile, Mexico and Venezuela form the upper-middle income (UMI) group; while the lower-middle income (LMI) group is formed by the rest of the countries in the original sample. Figures E.7 and E.8 show the trends in investment and deficit for the sub-samples. As we can see for the two groups, the series follow each other closely, but a remarkable similarity exists for the LMI countries. While the 1982 fall is stronger for UMI economies, (because oil production is essential for countries like Mexico and Venezuela) after that shock the trends under study seem to follow paths that are more independent. Correlation coefficients are 0.53 versus. 0.70 for the UMI and LMI countries respectively. There are many reasons for this divergence in correlation; in particular largest economies in the UMI sample have a more complex economic system that allows them to reduce their deficit with different policies like higher taxes, revenues from privatization, etc. 5 Figures are the result of a simple average across countries. No weighting factor was used because all the data is expressed on a percent of GDP basis. 17 Executive Summarv Figure E.7 Primary Deficit vs. Public Investment (percent of GDP) 5 UMI Countries 11 0 Selected Countries: 10 Argentina, Brazil, Chile, -1 9 ~~~~~~~Mexico, Venezuela, -2 Wn 7 \ A -4 E 5 ~~~~~~~~~-62S 4 ~~~~~~~~~~~~~~~~-7 3 -8 2 -9 O ES T O 00 0 N 00 00 00 00 00 ON O r ON ON ON O ON (ON ON~ ON~ ON ON O - - - Public Investment -Primary Deficit Source: IMF-Governrment Financial Statistics, LDB-World Bank, SHCP for Mexico. Figure E.8 Primary Deficit vs. Public Investment (percent of GDP) 6 LMI Countries 8 2 6 o' 4 -2 -3 Selected Countries: 9w3Bolivia, Colombia, Costa -3 Rica, Dominican Rep. 2 Panama & Peru 4 o es r O 00 0 Cel 00 00 00 00 00 ON ON ON ON ON O ON1 ON ON ON ON ON ONl - - - Public Investment Primary Deficit Source: IMF, Government Financial Statistics, & LDB, World Bank. 1.42 Figure E.9 plots the budget deficit trend versus privatization revenues for both groups of countries. Except for Chile, which started its structural reforms during the end of the seventies under Pinochet's dictatorship, the wave of privatization in Latin America came at the beginning of the nineties. For the UMI countries there is a slight negative relationship between the two trends (a contemporaneous correlation of -0.04, and a 1-lag correlation of -0.29), this would imply that privatization revenues have played a small role on budget deficit reductions. Nevertheless, this statement must be taken with prudence because we are only accounting for direct revenues of privatization and not looking at the expenditure reductions that come from discontinued support for the 18 Executive Summarv privatized enterprises. The same plot for LMI countries shows also a negative correlation between the series (-0.12). Figure E.9 Primary Deficit vs. Privatization Revenues (percent of GDP) 8w Selected Countries: Selected Countries: n 7 Argentina, Brazil, -2 : 3.5 Bolivia, Colombia, Costa A -0.5 Chile,Mexico, Pfi Rica, Panama&Pesu -1 C 415 5 -4 2 ~~~~5- a4 XC .,2I X -s~~~~~~~~~~~ ~~~2.5~ 3 ~~ ~~~-6' 2 1.53 2 -7 A -3.5~~~2 -8~~~~. -4 0:6 / 06O -4.5 o -es t m 'Io , O r -r t O8: N ON ; s CN 0y oll>0 8 ECo0 _~ a_, .1 _N ON _% _~ ON_ NO NC - --- Privatization Revenues Primary Deficit --- Privaization Revenues Pimary Deficit Source: IMF-Government Financial Statistics, LDB-World Bank, SHCP for Mexico. Note: Dominican Republic excluded due to lack of data on privatization revenues. The Mexican Case 1.43 From the fifties to the beginning of the seventies the Mexican economy presented a remarkable performance in growth with low inflation. These golden years are known as the "Desarrollo Estabilizador" (Stabilizer Development), during this period Mexico went through a rapid process of development and industrialization. 1.44 By the first half of the seventies the Mexican economy started to reveal signs of exhaustion. Growth slowed and inflation picked up due to loose fiscal policies. During this period the State played a central role in the Mexican economy, producing many "private" goods and protecting domestic producers from trade. Expenditure expansions at the beginning of 1970 were financed mainly by external debt. In 1976 when several oil reserves where discovered and oil prices were still high, optimistic Mexican policy makers accelerated the process of indebtedness to finance fiscal and current account balance deficits. In 1981 declining oil prices resulted in capital flight and the government response was to finance the exit with higher external debt. By 1982 the situation was unsustainable and a severe crisis ensued. 1.45 In the years following the crisis, the government implemented a radical fiscal adjustment process, a central condition to receive IMF loans and restructure debt with foreign commercial banks. In order to evaluate to what extent these policies (and the ones that followed during the 1980s and 1990s) were effective in increasing government net worth we extend the previous analysis to Mexico. Again our main concern is to see if deficit reductions were "real" in terms of augmenting government saving or whether they simply hide movements in government balances, leaving net worth unchanged. 19 Executive Summary 1.46 Figure E. 10 presents the Mexican budget deficit/public investment relationship. In the beginning of the decade both variables were strongly related, suggesting that the- deficit trend was guided by shifts on public investment. While public investment continued to fall steadily by around 2 percent of GDP, primary deficit reduction from 1986 to 1989 doubled that amount and in 1992 deficit started to grow again. Contemporaneous correlation between the series is 0.82, suggesting public deficits were cut via investment reductions. This notion is confirmed by looking at figure E. 11, revealing a stable path of general government consumption around 9 percent of GDP. The remarkable similarity between the two trends from 1989 forward suggests that recent primary budget deficits were incurred in order to finance government consumption. 1.47 Figure E. 12 relates oil prices to public investment for Mexico. This figure shows that Mexican public investment is strongly related to oil prices. Part of the decline in investment may be explained by the privatization process, taking place from 1988 to the present, with PEMEX (the Mexican oil state-owned company) remaining as one of the few state-owned enterprises. 1.48 Decomposition of Public Programmable Expenditure6 into its components (figure E. 13) shows that a large amount of the reductions in expenditure were due to cuts in fixed investment. From 1981 to 1989 programmable expenditure fell by 11.6 percent of GDP, while the fixed investment component fell by 8.12 per cent of GDP. At the same time the current expenditure component followed a more or less stable pattern. 1.49 At first glance privatization revenues do not appear to play an important role in deficit reduction over the last decade (see figure E. 14). However, the contemporaneous correlation between budget deficit and these revenues is of -0.61. Here it is necessary to clarify the objective of privatization. Even when budget deficit reductions and privatization policies are desirable, the latter should be undertaken based on efficiency arguments solely and not in search of fiscal reductions. As Easterly (1999) points out, "(privatization) may allow efficiency gains, but something is amiss when governments develop a sudden interest in privatization during fiscal austerity." 6 Programmable expenditure is total expenditure minus interest payments, transfers to local goverrnents and payments for expenditures made in previous fiscal years. 20 Executive Summary MEXICO Figure E.10 Primary Deficit vs. Public Investment (percent of GDP) 18 8 16 6 ~14 4 P 12 2 ~~~~~~~10~~~~~~~~~~ 6 64 2 -8 o - e. en I* t(N t- 00 ON 0 - ( C o N ^ 0 O oo0000 00000 00 000000 00 C ON~ ~0 ON l 7 oNN CN oE oll Ch oi oo cl o\ Co CN C7 C) CN 0o cl CN ON -- ~-- - -- - - -- - - -- - - - Public Investiint - Budget Deficit Source: SHCP and LDB-World Bank. Figure E.11 Primary Deficit vs. General Government Consumption (percent of GDP) 18 8 0- 16 6 14 4 >12 20 2 8 ~~~~~~~~~~-2 6 -~~~~~~~~~~~~~4 4 ~~~~~~~~~~~~~~~~-6 2 ~~~~~~~~~~~~~~~~-8 O -10 o e0 00 0 oo o C 00 00 00 00 00 ON ON ON ON ON (ON ON ONl ON ON ON ON ON - -- Central Govm Consumption Budget Deficit Source: SHCP and LDB-World Bank. 21 Executive Summary Figure E.12 Public Investment vs. Oil Prices 35 14 ' ~ *~ oil prices /\~~~~~~~~~~~~~~~~~~1 25 30 0 20 rv public investmn 15 to 2 5 0 o - N ~ ~ % '0 0~ 000% 0% - N a, V, N Source: LDB-World Bank and INEGI. Figure E-13 Programmable Expenditure Decomposition (percent of GDP) 301 20 15 I10 10 ., . % 0 ,:.,' ,'',,'., ','' '., """" ""- """ '- 00"" ':" l T . . cqtzena Ex o d ~~...... .. . l t i1:' W-g g 0 00 00 00 00 00 0000 0 00 c% 00 a, " 0I 0a ,c Source: SHCP. 22 Executive Summary Figure E.14 Primary Deficit versus Privatization Revenues (percent of GDP) 9 0 8 7 ~~~~~~~~~~~~~~~~~-2 6 ~~~~~~~~~~~~~~~~~~~-3 . 5 ~~~~~~~~~~~~~-4 4 ~~~~~~~~~~~~~~~~~-5 3 ~~~~~~~~~-62 .~2 -7 o -9 00 O 0 - _ e t- 0 r 00 00 O\ 0r Oa O o. 05 0, a\ ON O. 0. ON O\ ON 0. CN 0. al - - - Privatization Revenues Primary Deficit Source: SHCP & LDB, World Bank. Implications of the Balance Sheet Approach 1.50 In this section, we presented evidence on fiscal adjustment processes for several Latin American countries during the past 17 years. The main finding is that there is a clear reduction in public investment when going through periods of fiscal adjustment, particularly for LMI countries. Cutting current expenditures is often a perilous political proposition and governments did not rely heavily on privatization until 1993; hence, the only path to their fiscal goals was cutting investment. The evidence remains strong even when some countries in the sample, as in Costa Rica, based a significant amount of their 7 deficit reductions on cuts on operations and maintenance spending. The consequences of such policies on economic performance and development may be dramatic in the long run. 1.51 On the other hand, we have the upper-middle income Latin American economies where the process of fiscal adjustment was more complex. There seems to be some relationship between public investment cuts and deficit reductions, but not as direct as for the other group of countries. In these economies several factors come into play and may hide the extent to which governments are relying on public investment cuts and privatization to avoid real cuts in their current expenditure. For example in the Brazilian case, the large deficit reductions in 1987 and 1990 were due to the structural adjustment program "Plano Cruzado," increasing government revenues by means of higher taxation and controlling inflation with income policies, thereby evading radical expenditure reduction. In the Chilean case, the government based fiscal adjustment post-1982 on 7 See Easterly (1999) p.60. 23 Executive Summary current expenditure reductions combined with other macroeconomic policies, providing a stimulus to the economy and increasing the government revenue.8 1.52 The most significant cases of deficit reduction by means of public investment- cuts in the UMI group are Mexico and Venezuela. One explanation of this finding is that both economies depend heavily on oil production.9 A significant amount of public investment was and still is oil-related. Thus, when a crisis in oil prices occurs, the natural candidate to pay for the adjustment is oil investment expenditures. 1.53 Two final remarks are in order: first, the methodology used in this review is quite simple. Plots of figures and correlation coefficients between series are a first approach to the subject. The problem is that the information used is generally available on an annual basis. If we add to these problems the lack of data on different periods for different countries, we find ourselves confronting the impossibility of making a reliable pool regression analysis. Therefore, this exercise must be taken as a first approach whose strength must be reinforced by a closer look at each country's recent economic history. 1.54 Second, we must keep in mind that a public investment reduction per se is not necessarily a bad idea. If governments are cutting inefficient investment expenditure this may be a good step towards economic efficiency and growth. Additionally, there is evidence that in Latin America public investment crowded-out private investment [Easterly, Rodriguez and Schmidt-Hebbel, (1994)1. However, one concern stemming from our analysis is that there are strong reasons to believe that in some cases Latin American governments cut more than simply the inefficient investments. This could slow or even stop the growth process of the underdeveloped countries of the region, hence the need for persistent investment and expenditure reviews, thereby enhancing the quality of fiscal adjustment. 8. Actually, the public investment cuts made during the first fiscal adjustment period occurred in the first years of Pinochet's government. 9. Recall oil revenues represent about one third of Mexican government revenues. 24 Executive Summarv Conclusions: The Link Between Fiscal Sustainability and Fiscal Reform 1.55 Mexico faces a number of challenges on the fiscal front, among them: * procyclical fiscal policies and the absence of automatic stabilizers * under-provision of infrastructure stocks, and * sizable contingent liabilities. Yet the financial markets confirm the favorable econometric findings presented in chapter five. Narrowing sovereign bond spreads, a strong peso, and the March 2000 sovereign upgrade by the ratings agencies endorse the measures taken by the authorities. However, the favorable fiscal sustainability outlook can only be maintained via fiscal reform. There are limits to expenditure cuts. 1.56 Figure E.15 makes clear the authorities have reigned in spending dramatically over the past fifteen years. In fact, a review of figures E.10 and E.12 (public investment), indicates authorities may have overcompensated on expenditures. The problem is one of revenue. Figure E.15 Deficit Reduction and Oil Dependence 50 45 40 35 30 25 20 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1998 1997 1998 TOTAL REVEBUE OIL REVENUE TOTAL EXPENBDITURE Source: SHCP 1.57 As previously stated, the continuing fiscal dependence on oil is worrisome. Oil exports as a percentage of total exports have fallen from 80 percent in 1982 to less than 10 percent in 1999, yet oil revenues to total tax revenues still approach 30 percent. Strengthening other areas of the tax system would mollify these concerns. 25 Executive Summary 1.58 There are a number of challenges facing the tax authorities. First, the overly- complex tax system creates incentives for noncompliance among private agents.- Duplication of tax declarations and poor coordination between collectors' agencies are but two examples of a list of administrative problems. 1.59 Add to this a large informal sector that contributes only marginally to fiscal revenues and weak law enforcement to motivate possible evaders. Estimates of foregone VAT revenues in the informal sector approach 0.1 percent of GDP. 1 1.60 The VAT system is in need of reform as well. Numerous exemptions exist (e.g., zero rate for many domestic transactions) and collection surveillance is weak. As Figure E. 16 shows, the VAT contribution is second only to the income tax, followed by production and services taxes. Figure E.16 Components of Tax Revenues as a Percent of GDP, Mexico 1980-1998 6 5- 0r) 0 o X o o t o o X r- oc o o o - o o o r- 0 0 00 00 00 00 00 00 00 00 Ol al O~ O7 O\ 0~ ON ON 0~ 5~ OC 3 ON ON l O~ 0~ aN C% O~ oll a~ ON Ol~ O, ON O~ O~ M Income Tax EB On production and services * Others 1 Imports O VAT Source: SHCP 1.61 Estimates of lost revenues due to VAT and income tax evasion of are on the order of 5 percent of GDP."1 Reducing exemptions and stronger surveillance would augment revenues. Undoubtedly, strengthening tax administration would add a few GDP points to the tax coffers. '° CIDE (1999). l2 percent for VAT and the rest for income tax. CIDE (1999). 26 Executive Summary References Blanchard, 0. (1990) "Suggestions for a New Set of Fiscal Indicators", OECD Working Papers No 79, April. Blejer M. and A. Cheasty. 1991. "The Measurement of Fiscal Deficits: Analytical and Methodological Issues", Journal of Economic Literature, XXIX, (December): 1644- 1678. Bean C. and W. 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