Following a deep recession associated with a strong global downturn, Mexico is experiencing a robust recovery, with GDP growth of 5½ per cent in 2010 and 4½ per cent in 2011. Export growth is expected to slow after the exceptional rebound of 2010, but stronger domestic demand should keep the recovery on track. Several labour market indicators have improved, although unemployment is decreasing only slowly. Mexico has already started to withdraw the fiscal stimulus of 2009 and increased taxes to calm market worries about fiscal trends. If the recovery unfolds as expected, the government should fully implement its plans to lower the budget deficit further through spending restraint. Since inflation has come down, monetary policy can support the recovery by keeping rates low in the near term.

Thanks to past improvements in the macroeconomic policy framework and financial supervision, Mexico weathered the global recession of 2008-09 without fiscal or financial crises – a major improvement compared to previous episodes. The economic recovery has so far unfolded at a robust pace. Nevertheless, the recession was deep. There is thus a need for Mexico to continue preparing itself to confront future shocks through macroeconomic and structural policy measures. Oil revenues, which account for around one third of budgetary receipts, are highly volatile, especially due to price movements, and the prospects for production are uncertain, even though less so than in previous years. Reforms to have stronger fiscal buffers, increase non-oil tax revenues and enhance the efficiency of government spending are therefore important. Mexico’s weak potential growth performance and slow convergence towards average OECD living standards highlight the need for structural reforms to raise productivity, especially in a context where Mexico faces pressures due to the integration of other economies with labour-intensive factor endowments into the world economy. Structural reforms should address macroeconomic volatility, limited competition in a number of sectors and remaining weaknesses within the education system.

Improvements in the macroeconomic policy framework over the past two decades and prudent regulation of the financial system have contributed to reduce output volatility in Mexico relative to other OECD countries. The sharp recession in 2008-2009 illustrated that output volatility has nonetheless remained high. The fiscal rule has helped to balance the federal budget and keep the level of government debt low, while enhancing fiscal credibility, but it should be strengthened to allow building a larger buffer of financial assets to respond to shocks. Although output contracted sharply in early 2009, actual and expected inflation remained above target, in part because rigidities in product and labour markets limit price flexibility. This constrained the monetary policy response. The banking system withstood the recession of 2008-2009 well, but the contraction in bank credit was sharper than in other OECD countries, in part related to a boom-and-bust cycle in consumer credit that preceded the recession. While in other OECD countries the services sector stabilises output, in Mexico it contributes to output volatility. The volatility partly reflects the dominance of services with strong links to manufacturing, while modern and more stable consumer-related services remain underdeveloped. Output volatility could be further reduced by amending the fiscal rule to accumulate larger buffers of financial assets during economic upswings or periods of high oil prices, and by taking measures to enhance the flexibility of prices. Mexico should also adopt internationally-accepted statistical conventions for its budget accounts to make them more easily comparable with those in other countries. There would be merit in moving towards macro-prudential regulation and supervision to reduce the pro-cyclicality of the financial system. Finally, entry barriers to services should be lowered to boost the development of a modern consumer-related services sector.

With slow growth and high inequality Mexico needs investments in infrastructure, education and social policies. Mexico has increased spending in all of these areas. This was easily financed thanks to fiscal reforms in 2007 and 2009 as well as high oil prices in recent years. Oil revenues, which account for around one third of budgetary receipts, are highly volatile, especially due to price movements, and the prospects for production are uncertain, even though less so than in previous years. Mexico has the lowest tax revenues as a share of GDP in the OECD and much of Latin America, even when oil-related revenues are included. The government should improve the efficiency of its public spending. Mexico spends significant sums on energy subsidies, which are in large part captured by higher-income groups. Moreover, these subsidies are not in line with Mexico’s ambitious goals to reduce greenhouse gas (GHG) emissions. These subsidies should be gradually withdrawn in line with the government’s goals. Extending cash benefits to the poor instead would be much more efficient to fight poverty and help citizens and the economy as a whole to buffer income shocks. Agricultural spending should be re-structured to finance more investment in public goods and less support for producers, which has proven ineffective in increasing agricultural productivity. Broadening the tax base by withdrawing some of the most distortive tax expenditures would make an important contribution to strengthen revenues. This would also help make the tax system simpler, thus reducing compliance costs as well as opportunities for tax avoidance and evasion. Efforts to enhance tax enforcement should continue.

Productivity growth has been insufficient over the past two decades for a convergence of Mexican living standards to the OECD average. Structural reforms in the areas of business regulation, competition policy and education will be crucial to stimulate productivity and foster the catching up process. The OECD has worked with Mexico in all of these areas to develop reform strategies. Efforts to reduce the regulatory burden for firms, including start-ups, should continue. There is also a need to better co-ordinate ongoing administrative simplification efforts at the federal and state levels. The recent competition law reform will strengthen enforcement of cartel law. Undue restrictions on firm entry and expansion in key network industries should be lifted to enhance productivity in potentially competitive segments. Higher quality education and more equitable access to it will be needed to help Mexicans develop their productivity potential in full. A key ingredient will be better teachers. Clear standards for teacher performance are needed to improve their initial education and professional development and to develop a teacher evaluation system that would guide their career development and help them develop their potential. School financing is currently complicated and uneven, leading to inequities. Given that overall spending on education is comparable to OECD levels, Mexico should work towards efficiency gains in the sector and creating a system that provides more reliable funding for all schools.

Mexico has a relatively large informal sector by OECD standards. While this is in part a symptom of limited development and low productivity, it can also be to some extent its cause, as informal firms stay small to hide their activities and have limited access to productivity-enhancing government services, such a protection of property rights and training. A long-term and broad-based strategy with education at its core is needed for Mexico to reach its productivity potential and fight informality. Lowering the costs of formality, while enhancing its benefits and increasing the cost of non-compliance with labour and tax laws, will be an important part of this strategy. This would include more flexible labour laws, a further reduction in the business regulatory burden and a rethink of the social security package to enhance its attractiveness for low-wage workers and limit costs by making service provision more efficient.