Mexico has made substantial progress over the past decade in strengthening its economic framework and enhancing resilience. Inflation has been anchored in a low range and public and private balance sheets have been substantially strengthened. Most importantly, public external debt and financing requirements have been sharply reduced. The external current account position has been solid and official reserves have been built up steadily, though not to the extent in some other emerging markets. The banking system is highly profitable and well-capitalized. This performance has been underpinned by a solid, rules-based macro-institutional policy framework. Inflation targeting has achieved a high degree of credibility in the context of a freely floating exchange rate regime. Sizeable fiscal adjustment earlier in this decade and the introduction of a fiscal responsibility law have been additional support.

However, the external environment has deteriorated sharply in the last months, presenting a new test for Mexico’s resilience and current policy framework. The global financial shock-wave, which for many months had not severely affected Latin America, has intensified following the failure of Lehman Brothers. Financial markets in Mexico too have been affected by shortages of liquidity, and a pull back by foreign investors leading to asset price drops across the board. In addition to tighter financial conditions, the weakening outlook for U.S. activity, remittances, and international oil prices all weigh on prospects for Mexico. The authorities have responded with measures to address liquidity problems— including through foreign exchange intervention—and support domestic debt markets, and with fiscal stimulus to support demand. The central bank has put its tightening cycle on hold in view of the outlook for a widening output gap and reduced inflation pressures.

As market conditions suddenly worsened post-Lehman, the authorities responded with policy actions on multiple fronts:

• Exchange rate policy. In early October 2008, at a time of several episodes of sharp depreciation and low market liquidity, the central bank (Banxico) intervened in the foreign exchange market for the first time in a decade—and on a large scale, with a mix of small rules-based and extraordinary dollar auctions.
• Stabilizing debt markets. The treasury announced a reduction in the duration of planned government bond issuances over the next 12 months to support demand for government bonds, while Banxico expanded interest rate swaps. Public sector financial institutions have provided guarantees on MBS and commercial paper markets, and taken on the role of buyer-of-last-resort in a number of cases.
• Securing external financing. Banxico entered into a dollar swap facility with the Federal Reserve, for US$30 billion, in place through April 2009. The authorities announced additional financing of US$5 billion from IFIs (World Bank and IDB).
• Fiscal stimulus. The congress approved a modification of the balanced budget target of the Fiscal Responsibility Law, which effectively eased the fiscal stance by about 0.6 percent of GDP in 2009 (relative to the previous version of the rule). The overall fiscal impulse for 2009 is expected to be close to 1 percent of GDP.
• Monetary policy. While the monetary stance remains moderately restrictive, the increased provision of liquidity by the central bank effectively led to overnight rates sometimes below the 8¼ percent target.

(Extracted text from ©2009 International Monetary Fund February 2009 IMF Country Report No. 09/53 )