2009-3 Informe inglés reparado 2 VERSIÓN FINAL 290110 1200 ... · INFLATION REPORT JULY – SEPTEMBER 2009 3 The average of annual inflation during the third quarter has behaved

Inflation Report July – September 2009

OCTOBER 2009

BOARD OF GOVERNORS

Governor

GUILLERMO ORTIZ MARTÍNEZ

Deputy Governors

ROBERTO DEL CUETO LEGASPI

GUILLERMO GÜÉMEZ GARCÍA

MANUEL SÁNCHEZ GONZÁLEZ

JOSÉ JULIÁN SIDAOUI DIB

FOREWARNING

This text is provided for the reader’s convenience only. Discrepancies may

eventually arise from the translation of the original document into English.

The original and unabridged Inflation Report in Spanish is the only official

document.

Unless otherwise stated, this document has been prepared using data

available as of October 27, 2009. Figures are preliminary and subject to

change.

CONTENTS

Inflation Report July – September 2009

1. Introduction ................................................................................................................................... 1 2. Recent Developments in Inflation ............................................................................................... 4

2.1. Inflation……………………....................................................................................................... 4 2.2. Producer Price Index……….................................................................................................. 13 2.3. Wages………………………. ................................................................................................. 14

3. Main Determinants of Inflation................................................................................................... 17 3.1. External Conditions………. ................................................................................................... 17

3.1.1. World Economic Activity ............................................................................................ 17 3.1.2. Commodity Prices...................................................................................................... 19

3.1.2.1. Food Commodities ...................................................................................... 20 3.1.2.2. Energy Commodities ................................................................................... 21 3.1.2.3. Metal Commodities...................................................................................... 23

3.1.3. Inflation Trends .......................................................................................................... 23 3.1.4. Financial Markets....................................................................................................... 27

3.2. Developments in the Mexican Economy............................................................................... 34 3.2.1. Economic Activity....................................................................................................... 34

3.2.1.1. Production by Sector ................................................................................... 35 3.2.1.2. Aggregate Demand ..................................................................................... 38 3.2.1.3. Employment and Productivity...................................................................... 42 3.2.1.4. Regional Economy ...................................................................................... 46 3.2.1.5. External Sector……….. ............................................................................... 47

3.2.2. Financial Saving and Financing................................................................................. 54 3.2.2.1. Monetary Base, Net Domestic Credit, and International Assets ................. 54 3.2.2.2. Measures Undertaken in Mexico’s Financial System ................................. 55 3.2.2.3. Financial Saving………. .............................................................................. 58 3.2.2.4. Financing…………………............................................................................ 59

3.3. Some Considerations on the Determinants of Inflation ........................................................ 64 4. Monetary Policy........................................................................................................................... 67 5. Final Remarks.............................................................................................................................. 77 6. Monetary Policy Announcements and Publication of Inflation Reports in 2010.................. 79

Boxes

1. Price Setting under the Current Economic Environment ...........................................................................................................7

2. Recent Developments in World Inflation ..............................................................25

3. Measures Implemented by Banco de México in the Financial System ............................................................................................56

I N F L A T I O N R E P O R T J U L Y – S E P T E M B E R 2 0 0 9

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1. Introduction

The main purpose of the Inflation Reports published by Banco de México is to analyze the most relevant aspects that affect the recent developments in inflation. The final part of the document usually includes a section with the central bank’s updated forecasts on the main macroeconomic variables for the following quarters. Moreover, an assessment of the balance of risks around these forecasts is also presented. However, at the time of publishing this Report, the government’s draft proposal for the Federal Budget for 2010, submitted by the President to Congress, is still being debated by legislators. Consequently, this Inflation Report focuses on informing only on the state of the economy during the third quarter of 2009. Once the fiscal proposal is approved by Congress, Banco de México will publish, no later than four weeks after the approval, an addendum to this Report that will include both the central bank’s forecasts on the main macroeconomic variables for the next quarters and the balance of risks.

Global economic activity, which started to recover during the second quarter of the year, gained strength during the third quarter, after having contracted sharply during the last quarter of 2008 and first quarter of 2009. Economic activity has recovered more soundly in Asian emerging economies, although this pattern is becoming widespread worldwide. The fiscal and monetary stimulus programs implemented by different advanced and emerging economies, as well as the actions taken to reestablish orderly conditions in international financial markets, have influenced the aforementioned recovery.

In the U.S., economic contraction seems to have come to an end during the third quarter, and the economy is beginning to grow at faster rates than those expected in previous months. Timely information on the third quarter also points to an improvement in economic activity in the Eurozone, although this region still remains relatively stagnant. In the case of Japan, available information suggests that its economy continued to recover during the third quarter. Emerging economies seem to have grown in a more widespread fashion and at a faster rate than advanced economies during the same period. Economic activity in these countries has benefited from the measures implemented in recent years to strengthen their economic fundamentals, the actions that have been taken to tackle the global financial crisis, and the new increase in commodity prices.

Despite the global economic rebound that has been observed recently, the world economy is expected to grow in the coming years at slower rates than during the time prior to the current financial crisis. Furthermore, this recovery is also subject to considerable risks due to, among other factors, the difficult situation that still prevails in international financial markets, weak labor markets in most economies, and the high levels of households’ debt in some countries.

As a result of the weakening of economic activity and the existence of negative output gaps in a significant number of countries, world inflation remained low during the third quarter. In some advanced economies, annual consumer inflation remained negative during the quarter. In the absence of inflationary pressures and in the presence of uncertainty about the soundness of economic recovery, the central banks of the main advanced economies decided to keep

B A N C O D E M É X I C O

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their policy rates at low levels, in some cases even close to zero. They also continued to adjust their financial stimulus programs in order to foster financial intermediation and promote credit. In general terms, inflation in emerging economies also decreased during the July-September period, although more markedly in Asian countries. During the third quarter of 2009, most emerging economies left their policy rates unchanged or continued to reduce them but more moderately.

As a consequence of the recovery of the world economy, together with the measures to support the financial system, financial conditions in international markets continued to improve during the third quarter, while risks of a general collapse diminished considerably. Although the measures implemented by the authorities of some countries continued to be crucial in providing support to the financial system, this improvement also reflected a more positive feedback between the outlook for growth of the real economy and the financial environment. Nevertheless, it is important to stress that conditions in financial markets have not yet gone back to normality and they continue facing significant challenges.

As for economic activity in Mexico, most recent information on production suggests that its trend reached an inflection point at the beginning of the third quarter. Indeed, during this quarter, GDP is expected to have grown around 3 percent in seasonally adjusted terms when compared to the previous quarter (which would imply a fall in GDP of between 6 and 7 percent in annual terms, but favorably compared with the 9.2 percent fall in annual terms observed during the first half of the year). Two factors have influenced these results: first, the world economic recovery, which has made Mexico’s external demand perform less unfavorably; and, second, the fading of the effects of some temporary factors, which affected the economy during the second quarter. In particular, the levels of activity of various services, which had been affected by the outbreak of the influenza A virus (H1N1), recovered during the third quarter. At the same time, the levels of automotive production and exports rebounded considerably, as a result of the return to normal operations of some car assembly plants which had entered into temporary shutdowns during the previous quarter, and the positive effect on automotive exports of the program to support vehicle sales in the U.S. Nevertheless, although productive activity in Mexico has recently shown signs of an eventual recovery, it is still foreseen to remain for some time at levels below those prior to the onset of the financial crisis.

During the third quarter of 2009, annual headline inflation continued on the downward trend it had been following since the beginning of the year. All CPI subindices followed the same pattern. Moreover, in all regions, annual inflation kept following a common downward trajectory. These developments are mainly attributed to four factors: first, the absorption of the inflationary effects originated by diverse supply shocks that had taken place before; second, the government’s pricing policy that froze gasoline prices in non-border cities, and reduced other fuel prices in 2009; third, the slackness that prevails in the economy; and, fourth, the greater stability of the exchange rate together with the fact that most of the pass-through from the exchange rate adjustments to consumer prices is expected to have already been absorbed. Nevertheless, it is important to point out that despite the severe contraction of the Mexican economy during the first half of the year, the velocity and magnitude at which inflation has declined in Mexico has been below those of other countries.


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The average of annual inflation during the third quarter has behaved accordingly to Banco de México’s forecasts, by falling within the forecast interval specified in the two previous Inflation Reports. Taking into account the four elements mentioned in the previous paragraph, despite the foresight that economic activity will continue to recover for the remainder of 2009 and during 2010, favorable conditions are expected to prevail so that inertial inflation continues to adjust downwards (that is, without considering the possible effects some of the fiscal measures proposed for 2010 could have on inflation).

In response to the economic environment described above, in its monetary policy announcement of July, Banco de México’s Board of Governors cut its target for the overnight interbank rate by 25 basis points (after reducing it by a total of 350 basis points during the first half of the year), and decided to make a pause in the cycle of monetary policy loosening. Once these policy actions were taken, the interbank rate reached 4.5 percent. Subsequently, in its announcements of August, September and October, the Board left the target unchanged at 4.5 percent. Moreover, in the announcements of the last two months, the Board pointed out that the central bank future actions will be consistent with the balance of risks and that such balance will consider the impact on inflation that might result from, on the one side, the fiscal measures to be approved by Congress and, on the other, the evolution of the economy and the expected path of the output gap. These effects will be taken into account in order to meet the 3 percent annual inflation target.


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2. Recent Developments in Inflation

2.1. Inflation

At the end of the third quarter of 2009, annual headline inflation was 4.89 percent, as compared with 5.74 percent at the end of the preceding quarter. Inflation has declined widespread throughout all CPI subindices during the analyzed period (Graph 1). Inflation has also followed a downward trend in all regions of Mexico. However, the decline in inflation has been modest and slow in spite of the fall in aggregate demand experienced by the economy and the general decline in international commodity prices (Box 1).

Graph 1 Consumer Price Index Annual change (percent)

4.09

4.29

4.09

4.05

3.98

4.11

4.21

3.99

3.95

3.98

4.14

4.03

3.79

3.74

3.93

3.76

3.70

3.72

4.25

4.55

4.95

5.26

5.39

5.57

5.47

5.78

6.23

6.53

6.28

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5.98

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S2006

D M J S2007

D M J S2008

D M J S2009

CPICoreNon-core

During the third quarter of 2009, annual headline inflation followed a

downward pattern mainly due to a combination of the following four factors:

1. The absorption of supply shocks which had mostly taken place during the previous year and particularly affected the price quotes of processed foods, livestock products, and public transportation.

2. The Mexican government’s pricing policy which led to the freezing of gasoline prices and the reduction of prices of both propane and natural gas and of peak rate electricity fees. The price of propane was lowered and later frozen.

3. The weakness of economic activity during the first half of the year which has had a greater impact on services prices.

4. A more stable exchange rate, along with signs that most of the pass-through effect of the previous exchange rate depreciation (the main factor containing the rate of deflation during the first half of the year) on prices has materialized. This has been particularly reflected in the


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trajectory of non-food prices, which began to show a slight change of trend.

At the end of the third quarter of 2009, CPI’s core and non-core components registered annual variations of 4.92 and 4.82 percent, respectively, as compared with 5.39 and 6.72 percent in June 2009. The decline in annual core inflation mostly resulted from the lower growth of both merchandise and services prices. In addition, the decline in annual non-core inflation was mainly due to the disinflation of the subindex of goods and services with administered and regulated prices, given that the disinflation of agricultural prices was small (Table 1).

Table 1 Consumer Price Index and Components

Annual change (percent)

CPI 5.74 5.44 5.08 4.89 Core 5.39 5.32 5.10 4.92

Merchandise 6.87 6.79 6.48 6.38 Foods 7.93 7.60 7.11 7.00 Remaining merchandise 6.00 6.12 5.97 5.88

Services 4.01 3.96 3.80 3.56 Housing 3.22 3.09 2.99 2.97 Education 5.67 5.60 5.08 4.13 Remaining services 4.24 4.29 4.21 4.01

Non-core 6.72 5.75 5.04 4.82 Agricultural 13.47 12.14 11.58 12.76

Fruits and vegetables 14.08 13.84 15.88 20.28 Livestock goods 13.09 11.06 8.90 8.03

Administered and regulated 3.32 2.51 1.74 0.80 Administered 2.24 1.39 0.65 -0.32 Regulated 4.41 3.64 2.83 1.92

June 2009 July 2009 August 2009 September 2009

The annual inflation of the CPI’s core price subindices, (merchandise and services) declined between June and September of 2009. The core merchandise price subindex shifted from 6.87 to 6.38 percent in the referred period, while that of services fell from 4.01 to 3.56 percent (Table 1 and Graph 2a).

Processed foods contributed the most to the downward path of core merchandise prices during the third quarter of 2009 by registering an annual inflation that fell from 7.93 percent in June to 7.00 percent in September (Graph 2b). This result was mainly attributed to the fading effects of the supply shocks that took place during the previous year and their impact on the price formation of different food products, particularly fresh and pasteurized milk, rice, vegetable fats and oils, and ham. However, a factor that prevented a greater decline in this group’s price inflation was the increase in sugar price quotes, which was mostly determined by supply factors, especially the impact of adverse weather conditions on sugar production in Brazil and India, two of the most important world producers. Mexican sugar production contracted (10.1 percent during the 2008-2009 agricultural cycle as compared with that of 2007-2008), while Mexican exports of sugar to the U.S. rose (Graph 3).


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Graph 2 Core Price Index (Components)

Annual change (percent) a) Core b) Merchandise c) Services

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

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D M J S2006

D M J S2007

D M J S2008

D M J S2009

Core

Merchandise

Services

DecDec Dec

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7

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D M J S2006

D M J S2007

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Merchandise

Food products

Remaining merchandise

DecDec Dec

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S2005

D M J S2006

D M J S2007

D M J S2008

D M J S2009

Services

Housing

Education

Remaining services

DecDec Dec

Graph 3

Sugar Prices a ) Domestic and International Wholesale

Prices1/

Pesos per ton

b) Domestic Consumer and Producer Prices Annual change (percent)

2000

4000

6000

8000

10000

12000

14000

S2005

D M J S2006

D M J S2007

D M J S2008

D M J S2009

Mexico (wholesale-SNIIM) 2/Mexico (producer-FORMA) 3/U.S. 4/World 5/

Dec Dec Dec

-40

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-20

-10

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D M J S2009

Sugar CPI

Sugar PPI

Dec Dec Dec

1/ Reference prices. In the case of International prices, neither freight costs nor import taxes for Mexico are included. 2/ National Market Data and Integration System (Sistema Nacional de Información e Integración de Mercados, SNIIM) Ministry of the Economy.

Average for standard and refined sugar (Iztapalapa). 3/ Sugar Trust Fund (Fideicomiso para el Mercado de Azúcar, FORMA). Average for standard and refined sugar. 4/ U.S Department of Agriculture (USDA). Contract 14, duties paid in New York. 5/ U.S Department of Agriculture (USDA). Simple average. Contract 11 and Contract 5.


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Box 1 Price Setting under the Current Economic Environment

Once inflation in Mexico reached its highest level of the recent past, from the end of 2008 onwards it began to decline at a smaller rate and less rapidly than in advanced economies and other emerging economies. Inflation’s resistance to decline (downward resistance) does not seem to be consistent with the significant contraction of economic activity in Mexico, which has been more severe than in other economies, both advanced and emerging.

In order to have a better grasp of this phenomenon, Graph 1 shows the recent dynamics of inflation, from January 2006 to September 2009. Annual Consumer Price Index inflation is divided into both tradable (merchandise and agricultural products) and non-tradable (services) goods, and in goods and services with administered and regulated prices. This graph also shows, for the same period, the annual inflation of the primary commodity price indices calculated by the International Monetary Fund, the annual depreciation of the peso against the US dollar, and the annual growth of the Mexican Economic Activity Index (Índice General de Actividad Económica, IGAE).1 The latter indicators illustrate the three main shocks that could have affected inflation temporarily in recent months.

The first shock took place at the end of 2007 and at the start of 2008 due to the increase in commodity prices and initially affected tradable goods and, with a certain lagged effect, inflation of goods and services with administered and regulated prices. Later, at the end of 2008 and the beginning of 2009, three shocks took place almost simultaneously: two supply-related shocks and one demand-related shock. The first supply shock is the significant deflation in international commodity prices. The second supply shock is the depreciation of Mexico’s currency exchange rate, which surpassed 30 percent. Finally, the demand shock is the fall in aggregate demand, represented in the graph by the growth of the IGAE, which has significantly widened the output gap.

1 The IGAE is shown up to July 2009 (latest available figure).

From the three shocks, that related to the exchange rate generates inflationary pressures. The other two act by reducing inflation.

The three aforementioned shocks have been of different magnitude and have also affected inflation’s components differently. Although in Graph 1 it is not possible to distinguish each shock’s effect controlling for the effects originated by the other two, it is possible to appreciate that both shocks seem to have neutralized each other. The shock from the exchange rate seems to be the one that has most affected tradable goods’ inflation, while that from commodity prices has affected more inflation of goods and services with administered and regulated prices. Finally, up to now, the demand-related shock does not seem to be playing a relevant role in affecting inflation, although a certain effect can be observed at the end of the sample.

In order to understand the factors that determine the speed of adjustment of inflation in Mexico as well as inflation’s response to different types of shocks, the way in which Mexican firms adjust their prices must be analyzed, and the origin and types of rigidities that may appear in the price formation process need to be identified as well.

1. Price Setting Models 1.1. Time-dependent Price Setting vs. State-dependent

Price Setting According to the economic literature, there are two predominant models on the policy adopted by firms when deciding to adjust their prices. On the one side, there are the models known as “time-dependent”, which assume that firms adjust their prices in time periods determined exogenously. Following this reasoning, a private firm can adjust its prices every fixed period (Taylor, 1980) or randomly every period (Calvo, 1980). Since the mechanism inherent to this type of models is exogenous,

Graph 1Consumer Prices, Exchange Rate, International Commodity

Prices, and IGAE Annual change (percent)

-15

-5

5

15

25

35

45

Jan-

06M

ar-0

6M

ay-0

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Sep-

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-07

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-07

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-07

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p-09

-80

-60

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80Tradables Exchange rateNon-tradables IGAEAdministered and regulated Commodities (right axis)

Inflation Shocks


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there is no selection on the types of firms that adjust their prices during a certain period.

In contrast, in the other type of models known as “state-dependent”, firms decide to adjust their prices according to the effect of the shocks -either common or idiosyncratic- on their cost structure and the decision to change prices is therefore endogenous to each firm. In this type of models, price rigidity is generated by frictions such as costs related to price adjustments (menu costs) or problems related to imperfect information, among others.

1.2. The Role of Market Structure

In both types of price formation models, firms are assumed to have a certain degree of market power (usually, monopolistic competition), which directly affects the level of price adjustment in the economy. Thus, market power is an additional factor that affects price formation.

In those sectors of the economy characterized by a low level of competition, producers have the market power to fix prices above the marginal cost of production of the goods they sell. In the event of demand or supply-related shocks, these firms are able to keep their prices unchanged for longer periods than those that are in sectors facing greater competition, which do not have the necessary profit gains that would allow them to absorb more easily eventual shocks.

In particular, the interaction between market power and state-dependent price setting leads to foresight less frequent price adjustments in lesser competitive markets, because firms in these types of markets have more profit gains. These types of price rigidities should be understood in a setting where firms perceive the shocks affecting the economy as temporary (although very persistent); otherwise, even firms in smaller competitive markets would be incentivized to adjust their prices rapidly.

Castañón et al. (2008) offer empirical evidence on the relation between the level of competition and the downward rigidity in prices in Mexico’s manufacturing industry. After carrying out a survey on a representative sample of manufacturing firms during the second half of 2005, the authors report that firms in industries with a small number of participants give more importance to profit gains as a determinant factor for prices, while firms in more fragmented industries consider their competitors’ prices as a more relevant factor.

Since the economy’s response to various shocks differs among firms’ price setting models, it is important to distinguish which of these models explains more thoroughly the stylized facts concerning price formation in Mexico.

2. Evidence of Price Setting in Mexico

In the case of Mexico, Gagnon (2009) presents a study that covers the period 1994-2004 and uses data on prices at the store level for a total of more than three million individual prices. This study shows that the economy shares many of the features of time-dependent models when annual inflation is low and stable. In particular, when inflation is below 10-15 percent, the frequency under which firms adjust their prices does not seem to be associated with the level of inflation. In these cases, the magnitude of the adjustment in prices is more tightly related with the inflationary process. On the contrary, when the annual inflation rate rises beyond 10-15 percent, price formation in Mexico seems to be of the state-dependent type. In this case, both the frequency and the average magnitude of price adjustment seem to be strongly associated with the general price level.

According to Gagnon’s study, the relationship between price increases and price decreases is essential to identify the behavior of the Mexican economy under periods of low and high inflation. Under low inflation, movements in the frequency of price decreases partly offset movements in the frequency of price increases, and therefore inflation’s variance is affected in a smaller magnitude by the frequency under which firms adjust their prices. However, when inflation is high, there are no enough price reductions to counterbalance the rising occurrence of price increases and, therefore, the frequency of price adjustments is highly correlated to the level of inflation.

The previous evidence shows that models’ predictions differ more in the presence of large shocks; for example, when inflation adjusts from high to low levels or when the economy faces a very large depreciation. In these cases, firms react by adjusting the frequency under which they modify their prices and therefore time-dependent models do not seem appropriate in explaining firms’ price adjusting schemes. In the case of Mexico, although price formation seems to adjust to the predictions of time-dependant models when inflation is relatively low, as it is currently, in the presence of significantly large shocks, like those that have affected the economy recently, state-dependent models seem to better explain the effect of the three shocks mentioned at the beginning of this box.

In the following sections, various factors that might be affecting price formation under a framework of an endogenous price-adjustment frequency, as defined by state-dependent models, are analyzed. Particular emphasis is made on the mechanism through which these factors can help to understand CPI inflation’s response to the significant fall in aggregate demand observed recently.

3. Factors Affecting Price Setting

3.1. Asymmetric Response to Supply and Demand-related Shocks

One factor that might explain the slow adjustment of inflation to the fall in aggregate demand is the fact that firms are more sensitive to supply-related than to demand-related shocks. This result might be because information regarding firms’ costs is easier to obtain than that on the demand for a particular product (Bhaduri and Falkinger, 1990). Moreover, firms can react less to shocks related to the demand for a particular product, because they are unwilling to change their long-term relationship with their customers (Okun, 1981; Rotemberg, 2004).

This greater sensitivity of firms to shocks from the supply side seems to be present in Mexico, at least in the manufacturing industry. Castañón et.al. (2008) show that 89 percent of the surveyed firms consider changes in costs as a relevant factor in their price revisions, while only 24 percent of manufacturing firms surveyed mentioned to have revised their prices under a demand-related shock.

3.2. Asymmetric Response to Positive and Negative Shocks

Another variable related with price setting which is necessary to rationalize the slow response of prices to the current economic conditions is the presence of asymmetries in firms’ price adjustments. Ball and Mankiw (1994) suggest that when inflation is positive, the existence of “menu costs” can induce firms to adjust their prices upwards immediately in the event of a positive supply shock than to adjust them downwards in the event of a negative shock. The presence of asymmetries in the event of production-cost shocks is consistent with the empirical evidence, as confirmed by Peltzman (2000) in the case of the U.S. The author reports that in a sample of both consumer and producer prices, the analyzed prices respond significantly faster to an


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increase than to a reduction in input prices. Although in the long term these asymmetrical responses tend to disappear, its effect prevails at least eight months after the shock to production costs has taken place.

The stylized fact documented by Peltzman (2000) for the case of the U.S. is consistent with the data for the Mexican economy, as confirmed by the evidence presented in Gagnon (2009), which shows that when inflation is low in Mexico, it is possible to observe both small and large reductions in prices. On the contrary, price reductions prevail less as inflation increases. In fact, under high inflation, the distribution of the price adjustment is biased towards price increases.

3.3. Heterogeneity in the Frequency of Price Adjustment among Sectors

An additional factor that might be affecting the speed of adjustment of inflation is the heterogeneity in the frequency of price adjustments among sectors. In this regard, Carvalho (2006) mentions that the heterogeneity among sectors regarding the frequency of price adjustment generates differences in the velocity of adjustment to various shocks. In particular, in the presence of strategic complementarities, sectors with slower adjustment frequencies tend to have a disproportionate effect on the general price level.2 The rationality is that firms in sectors with higher adjustment frequencies will avoid to determine prices that deviate too much from the aggregate price level in the future and will therefore reduce their adjustments. Following the same line, strategic complementarities in the presence of sectors with downward rigidities might be generating asymmetries in the response of the aggregate price level to increases or reductions in costs.

The statistical data of the individual prices obtained by Gagnon (2009), and manufacturing firms’ responses reported by Castañón et al. (2008) show how relevant sector heterogeneity may turn out to be for the speed of adjustment of inflation in Mexico. In particular, Gagnon (2009) reports that firms in the food and non-alcoholic beverages sector register a frequency of price adjustment of around 40 percent during the period 2002-2004, while during the same period, other categories had a frequency of no greater than 10 percent (e.g., hotels and restaurants).

3.4. Other Factors that Might Affect Price Formation

There are other factors that in the presence of market power and state-dependant price formation can affect firms’ decisions regarding their prices. In particular, it is possible that in some industries, firms respond to different shocks by adjusting different margins other than their prices. Just to mention a few: a) firms might react by changing the quality of their products; b) firms might change product quantity to reduce costs; and, c) firms might reduce the variety of their product supply.

4. Evidence for the Mexican Case

As mentioned previously, the information presented in Graph 1 does not show the effect that each one of the three shocks might have on the inflation process, once the effect of the other shocks and of other variables that affect the development of inflation is controlled for. In order to analyze the effect of some of these shocks in a conditional setup, an autoregressive vector (VAR)

2 Strategic complementarities arise when a person or firm obtains higher

returns for choosing a particular behavior, as the number of people or firms choosing that particular behavior gets larger.

was estimated to isolate both a demand and an exchange rateshock, controlling for the presence of other effects.3

Graph 2a presents the response of imports prices’ (in pesos) and of both producer and consumer tradable goods’ prices, to an exchange rate shock. Each line represents the response of the annual change of each index to a shock to the annual rate of depreciation of the exchange rate of 3 percentage points. The response of the rate of depreciation is also presented for comparison purposes.4 First, the pass-through effect to import prices is complete, but as it begins to reach and go through the production chains it starts to diminish and once it reaches consumer prices it is very small. Despite these observations, the impact on consumer prices is still significant. The results of this graph indicate that, indeed, firms respond to exchange rate shocks and that market power possibly exists throughout the production chain. The results also seem to indicate that consumer “tradables” prices may need to rely on a significant part of non-tradable goods (e.g., transportation or labor) in order to reach final consumers.

Graph 2 Inflation Response to Exchange Rate Shocks and

Demand-related Shocks a) Exchange rate shock

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0

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1

1.5

2

2.5

3

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

Exchange rate

Imports

Tradable goods (PPI)

Tradable goods (CPI)

Inflation

b) Demand-related shock

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Inflationó

3 The VAR includes, in the following order, the Mexican Economic Activity

Index (IGAE, for its acronym in Spanish), the interest rate on 28-day CETES, the peso-US dollar exchange rate, and different price indices (imports and exports –in pesos- producer tradable goods, producer non-tradable goods, consumer tradable goods, consumer non-tradable goods, goods and services with administered and regulated prices, and wages). The following were considered as exogenous variables: industrial production, the interest rate on 3-month T-bills, the consumer price index, all from the United States; and the IMF primary commodity price indices. All variables were estimated in annual growth terms. The mechanism to identify the shocks is recursive. The results presented are robust to different arrangements that identify exchange rate and demand-related shocks. The BIC determined that one lag properly captured the system dynamics. The period under study goes from January 1997 to July 2009. For a similar VAR applied to advanced economies, see Choudhri et al. (2005).

4 The shock is of one standard deviation to the rate of depreciation. All responses shown in Graph 2b are statistically significant at conventional levels.


10

Graph 2b shows the response of both producer and consumer tradable goods and non-tradable goods’ prices to a demand shock. Each line represents the response of each index annual change to a shock to the annual growth rate of the IGAE of -1.75 percentage points.5 First, the effect on producer prices is greater than on consumer prices, which also indicates the presence of certain market power in the production chain. Second, the responses of consumer prices were not statistically significant at conventional levels. Nevertheless, it is important to mention that the estimated responses are economically significant, although less than what might be expected from price setting conventional models (e.g., Phillips curve).For example, the estimated response for inflation of consumer non-tradable goods prices implies that a fall of 10 percentage points in the IGAE could lead to a cumulative fall of 2.8 percentage points in this index.

Overall, the previous results indicate that consumer prices in Mexico do seem to respond more to supply shocks than to demand shocks.

Graph 3 Inflation Response to Demand-related Shocks

a) Cumulative Response of Tradable Goods’ Inflation (Producer Price Index)

-3

-2

-1

0

1

2

3

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

Positive shock

Negative shock

b) Cumulative Response of Non-tradable Goods’ Inflation

(Producer Price Index)

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

Positive shock

Negative shock

The same VAR was used to analyze possible asymmetrical responses to positive and negative shocks. The only evidence of asymmetries was found in producer price responses to demand-related shocks. Graph 3 illustrates these responses. In this case, since the responses are shown as cumulative, they can be interpreted as a response of price indices rather than of annual inflation. In all cases, the shock corresponds to 1.75 percentage points of the IGAE’s growth rate (-1.75 for the negative shock). Graph 3 shows clearly that the response to positive shocks is

5 The shock is of one standard deviation of the annual growth rate of IGAE.

The only responses from Graph 2b that are statistically significant at conventional levels are those of producer prices.

greater than to negative shocks, which might have direct incidence on inflation’s downward rigidity to the current negative shock on aggregate demand. In all cases, the responses are statistically significant at conventional levels.

5. Some Considerations on Price Index Measurement

During the different stages of the economic cycle, service suppliers with certain market power are expected to establish (or change) price discrimination schemes. Thus, during a recession service suppliers (e.g., education, medical and transportation services) often reduce the price they charge to a particular group. Nevertheless, the lowest available prices for a limited group of people or households are almost impossible to compute in practice, because in most cases these prices are only available to specific consumers (e.g., school-fee scholarships in a private school or phone medical consultations free of charge). In this regard, the best practices on price index data compiling suggest these product discounts must not be considered in the statistics.6

Likewise, during recession periods, retailers frequently offer discounts instead of reducing their prices. This might partly be due to the fact that it is easier to reestablish the previous effective prices once the economic conditions improve. In the cases where these discounts are offered widespread with no binding restrictions, they are compiled in the price statistics. Nevertheless, the best practices show that conditioned discounts (e.g., discounts applied to a minimum purchase of 2 products) should not be considered when compiling price index data. The reason for this practice is due to the difficulty in identifying the proportion of consumers that might benefit from the discount. This proportion might be affected by the restrictions faced by customers when trying to benefit from the discount (e.g., liquidity restrictions or lack of a specific payment means applied to the discount) or the restrictions related to the discount might prevent consumers from reaching a higher level of satisfaction on their purchase.

Considering the aforementioned, it is possible that in the current phase of the economic cycle, price statistics are not fully reflecting the decline in the rate of growth of the cost of living of those population sectors that are benefiting from certain product discounts.

6. Final Remarks

In the last months, inflation in Mexico has been affected by three shocks: two cost-related shocks and one demand-related shock. One of the cost-related shocks generates inflationary pressures, while the others tend to pressure inflation downwards. Nevertheless, inflation seems to be responding slowly to the demand shock, a surprising fact considering the significant contraction in aggregate demand.

This box has deepened into some of the possible reasons for

Inflation´s slow response to the demand shock. In the presence of market power and state-dependant price formation (which is possible triggered due to the magnitude of the shocks, regardless of an environment of relatively low inflation) there are various firms’ reactions which are consistent with the observed inflation dynamics. Some firms in Mexico seem to respond more to supply-related shocks than to demand-related shocks. Likewise, some firms seem to be more sensitive to shocks that lead them to raise their prices than to shocks that lead them to reduce them. Another factor that might be having an incidence in this behavior is the heterogeneity in the frequency of price 6 See Consumer Price Index Manual: Theory and Practice (2004), edited by

WLO, IMF, OECD, Eurostat, United Nations, and World Bank (Chapter 6, p. 92).


11

adjustments among sectors, given that those sectors that adjusttheir prices less frequently could be over-represented. In addition, given the market structures, some firms might prefer to face the different shocks by adjusting different margins other than their prices; for example, by adjusting the quantity, quality or variety of their products or services.

Finally, it is possible that due to the current stage of the business cycle some segments of service users might have benefited from certain product discounts that have not been captured by the statistics, as a result of the use of better practices to deal with cases of price discrimination when compiling price indices.

References Ball, L. and Mankiw, N.G., (1994), “Asymmetric Price Adjustment and Economic Fluctuations”, The Economic Journal, Vol. 104, 423, 247-261. Barro, R., (1972), “A Theory of Monopolistic Price Adjustment”, Review of Economic Studies, 39, 17-26. Bhaduri, A. and Falkinger J., (1990), “Optimal Price Adjustment under Imperfect Information”, European Economic Review, Vol. 34, 941-952. Bils, M. and Klenow, P., (2002), “Some Evidence on the Importance of Sticky Prices”, Journal of Political Economy, 112, 947-985. Calvo, G., (1983), “Staggered Prices in a Utility-maximizing Framework”, Journal of Monetary Economics, 12, 383-298.

Carvalho, C., (2006), “Heterogeneity in Price Stickiness and the Real Effects of Monetary Policy Shocks”, Frontiers of Macroeconomics, 2(1). Berkeley Electronic Press. Castañón, V., Murillo, J. A. and Salas, J., (2008), “Formación de Precios en la Industria Manufacturera de México”, El Trimestre Económico, Vol. LXXV, Núm. 297, 143-181. Choudhri, E. U., Faruqee, H. and Hakura, D. S., (2005) “Explaining the Exchange Rate Pass-through in Different Prices”, Journal of International Economics, 65, 349-374. Gagnon, E., (2009), “Price Setting During Low and High Inflation: Evidence from Mexico”, The Quarterly Journal Of Economics, Vol. 124, 3, 1221-1263. Klenow, P. and Kryvtsov, O., (2008), “State-Dependent or Time-Dependent Pricing: Does it Matter for Recent U.S. Inflation?”, Quarterly Journal of Economics, Vol. 123, 3, 863-903. Okun, A.M., (1981), “Prices and Quantities: A Macroeconomic Analysis”, Washington, The Brookings Institution. Peltzman, S., (2000), “Prices Rise Faster than They Fall”, The Journal of Political Economy, Vol. 108, 3, 466-502. Rotemberg, Julio J., (2004), “Fair Pricing”, NBER Working Paper, W10915. Taylor, J.B., (1980), “Aggregate Dynamics and Staggered Contracts”, Journal of Political Economy, Vol. 88, 1, 1-23.

The fall in core merchandise inflation during the analyzed period was also influenced, although to a lesser extent, by the decline in the group of non-food merchandise prices, from 6 percent in June to 5.88 percent in September. Although this reduction is quite relatively small, it suggests that most of the pass-through effect of the exchange rate depreciation that took place in 2008 has already been absorbed. This fact is in line with the evidence obtained from the survey mentioned in the inflation report of the preceding quarter as well as its forecasts.

The inflation of the three groups making up the core services subindex declined in June and September 2009. At the end of the third quarter, the annual price variations of the housing, education and the remaining services groups were 2.97, 4.13 and 4.01 percent, respectively, as compared with 3.22, 5.67 and 4.24 percent, respectively, in June. The deflationary pattern of these three groups is mainly attributed to the weakness of economic activity in Mexico.

As for non-core inflation, the slower growth of administered and regulated prices during the third quarter of 2009 was mainly due to three factors: first, the freezing of domestic prices of gasoline in non-border states along with the reduction of propane and, natural gas prices and peak rate electricity fees throughout Mexico (prices of the first of these fuels were also frozen); second, the non-recurrence of significant rises in public transportation fares (large increases were observed in areas with a substantial influence in the CPI, such as the Mexico City metropolitan area in 2008); and third, significant discounts in prices of mobile phone services, which were reflected in the local telephone service item (Graph 4 and Graph 5).

Between June and September of 2009, the annual price variation of the agricultural products’ subindex declined, mainly in response to the partial fading of the effect of the supply shocks that took place during the previous year and at the start of 2009 on livestock prices. The annual inflation of livestock prices thus decreased from 13.09 to 8.03 percent during the referred period. This result was partly offset by the inflation of fruits and vegetables prices, which rose from 14.08


12

to 20.28 percent (Table 1). It is important to point out that the high volatility of fruits and vegetables’ price quotes is mainly a consequence of its supply being highly dependent on weather conditions, which can be extremely unstable. For this reason, fluctuations in this indicator mostly have a temporary effect on inflation.

Graph 4 Non-core Price Index

Annual change (percent) a) Non-core b) Administered and Regulated c) Agricultural

-8

-4

0

4

8

12

16

20

S2005

D M J S2006

D M J S2007

D M J S2008

D M J S2009

-15

-5

5

15

25

35

Non-core

Administered and regulated

Agricultural

Dec DecDec

-1

1

3

5

7

9

11

S2005

D M J S2006

D M J S2007

D M J S2008

D M J S2009

Administered and regulated

Administered

Regulated

Dec Dec Dec

-8

-4

0

4

8

12

16

20

S2005

D M J S2006

D M J S2007

D M J S2008

D M J S2009

-15

-5

5

15

25

35

Agricultural

Livestock products

Fruits and vegetables

Dec DecDec

Graph 5

Subindex of Administered and Regulated Prices of Goods and Services Annual change (percent)

a ) Administered b) Regulated

-6

-4

-2

0

2

4

6

8

10

12

14

16

18

20

S 2005

D M J S 2006

D M J S 2007

D M J S 2008

D M J S 2009

AdministeredGasolineElectricityGas for residential use

Dec Dec Dec

-10

-5

0

5

10

15

20

25

S 2005

D M J S 2006

D M J S 2007

D M J S 2008

D M J S 2009

Regulated

Local phone services

Minibus

Dec Dec Dec

Finally, at a regional level, inflation followed a widespread downward

trend throughout the country during the third quarter of 2009. The slower price growth recorded in the center-north and northern-border regions was noteworthy (Graph 6).1 In September 2009, the annual inflation in these two regions was 4.39 and 4.41 percent, respectively, after having been 4.96 and 5.44 percent during the previous quarter.

1 The northern border subindex includes data from Tijuana, Cd. Juárez, Mexicali, La Paz, Matamoros and

Cd. Acuña. The center-north subindex includes Guadalajara, León, San Luis Potosí, Aguascalientes, Querétaro, Morelia, Colima, Cortazar, Jacona, and Tepatitlán.


13

Graph 6 Regional Consumer Price Indices


0

1

2

3

4

5

6

7

8

Sep

-05

Dec

-05

Mar

-06

Jun-

06

Sep

-06

Dec

-06

Mar

-07

Jun-

07

Sep

-07

Dec

-07

Mar

-08

Jun-

08

Sep

-08

Dec

-08

Mar

-09

Jun-

09

Sep

-09

Northern borderNorth-westNorth-eastCenter-northCenter-southSouthMexico City metropolitan area

Dec DecDec Dec

Source: Banco de México.

2.2. Producer Price Index

The Producer Price Index (PPI) of finished goods and services, excluding oil, recorded an annual average variation of 5.19 percent during the third quarter of 2009, as compared with 5.21 percent in the previous quarter (Graph 7a). Within the group of community, social and personal services, the following specific items registered the largest price reductions: system analysis and data processing as well as legal services. In the manufacturing industry, the fall in the annual variation of non-metallic minerals price quotes, such as cement and glass containers, was also outstanding (Graph 7b).

Graph 7 Non-oil Producer Price Index

Annual change (percent) a ) Merchandise and Services b) Manufactures and Non-metallic Minerals

0

2

4

6

8

10

12

14

16

S2006

N J M M J S2007

N J M M J S2008

N J M M J S2009

PPIManufacturing industryCommunity services

Dec Dec

0

2

4

6

8

10

12

14

16

S2006

N J M M J S2007

N J M M J S2008

N J M M J S2009

Manufacturing industry

Non-metallic minerals

Dec Dec


14

2.3. Wages

The average growth of both the Mexican Social Security Institute (Instituto Mexicano del Seguro Social, IMSS) reference wage and contractual wages in firms under federal jurisdiction slowed during the third quarter of 2009. Wages negotiated by workers of privately-owned firms account for this reduction.2

During the third quarter of 2009, the IMSS reference wage grew at an annual average rate of 4.0 percent as compared with 4.6 percent in the preceding quarter. This indicator declined in all three branches of economic activity reported by IMSS. The most noteworthy decrease was in the services and commerce sector, which grew 3.3 percent in annual terms during the analyzed period, as compared with 4.0 percent during the preceding quarter (Graph 8 and Table 2).

Graph 8 IMSS Reference Wage 1/

a) Total Annual change (percent)

4.0

4.6

2.0

3.0

4.0

5.0

6.0

7.0

I II2006

III IV I II2007

III IV I II2008

III IV I II2009

III

IMSS nominal reference wage

Average annual inflation in the quarter

b) By Sector of Activity Annual change (percent)

3.54.05.4

5.7

3.34.0

-6

-4

-2

0

2

4

6

8

10

12

14

16

I II2006

III IV I II2007

III IV I II2008

III IV I II2009

III

Primary 2/

Secondary 3/

Tertiary 4/

Source: Prepared by Banco de México with data from IMSS. 1/ This indicator considers IMSS-insured workers. Coverage: 13.8 million workers on average during the first nine months of 2009,

which represents 32 percent of total remunerated workers. 2/ Includes agriculture, cattle farming, forestry, fishing, and hunting (2.9 percent of workers). 3/ Includes extractive, electric and manufacturing industry, and the the construction sector (37.6 percent of workers). 4/ Includes the commerce and services sectors (59.5 percent of workers).

2 The IMSS reference wage considers the daily average wage earned by IMSS-insured workers during a

certain period, and some fringe benefits (e.g. end-of-year bonuses, vacation bonuses, and commissions). Contractual wages, on the other hand, include only the direct increase to the salary rate negotiated by workers of firms under federal jurisdiction and that will be in effect for a year. The monthly figures for this indicator are constructed on the basis of information from firms that were engaged in wage settlements, usually during the same period of the year. For this reason, this indicator follows a seasonal behavior. The reference wage should therefore be analyzed using comparable successive time periods and contractual wages by employing annual comparable periods.


15

Table 2 IMSS Reference Wage Annual change (percent)

I II III IV Jan-Dec I II III Total 4.9 5.2 5.6 5.7 5.3 5.3 4.6 4.0

Primary sector 3.3 4.3 5.7 5.8 4.8 5.0 4.0 3.5Agriculture, cattle farming, forestry, hunting, and fishing 3.3 4.3 5.7 5.8 4.8 5.0 4.0 3.5

Secondary sector 5.8 6.2 6.5 7.1 6.4 6.7 5.7 5.4Extractive industry 10.6 11.7 11.6 12.8 11.7 14.5 14.9 15.3Processing industries 6.0 6.4 6.5 7.1 6.5 6.5 5.1 4.7Construction 5.3 5.1 5.4 5.8 5.4 4.2 3.7 2.7Electric and water supply industries 5.1 6.7 6.8 5.4 6.0 5.5 4.8 5.7

Tertiary sector 4.3 4.7 5.0 4.8 4.7 4.5 4.0 3.3Commerce 3.7 5.0 5.6 5.9 5.1 5.4 3.9 3.5Transport and communications 3.3 4.0 3.9 4.5 3.9 4.5 4.0 3.9Services for firms, individuals, and homes 4.8 4.4 4.6 4.0 4.4 3.4 3.6 2.5Social and community services 5.3 5.7 6.1 6.0 5.8 6.5 5.9 5.1

2008 2009

Source: Prepared by Banco de México with data from IMSS.

As for contractual wages, during the July-September period of 2009, firms under federal jurisdiction negotiated an average increase of 4.7 percent, 0.1 percentage points below that negotiated during the same period of 2008. The highest increases were negotiated in publicly-owned firms (4.9 percent as compared with 4.8 percent during the same period of 2008). Wage settlements in the oil industry mainly account for this result. Workers in privately-owned firms negotiated a 4.6 percent increase during the third quarter of 2009, as compared with 4.7 percent during the same period of the previous year. Worth mentioning is the magnitude of the slower wage growth rate in the automotive and autoparts industry (Graph 9). During the third quarter of 2009, privately-owned firms revised their wages in the extreme sides of the wage increase range (Table 3).

Graph 9 Contractual Wages 1/

a) Total Firms Figures in percent

4.8 4.7

2.0

3.0

4.0

5.0

6.0

7.0

I II2006

III IV I II2007

III IV I II2008

III IV I II2009

III

Total contractual wages (quarterlyaverage)Inflation expectations (next 12 months)

b) Publicly-owned and Privately-owned Firms Figures in percent

4.94.8

4.64.7

2.0

5.1

1.0

2.0

3.0

4.0

5.0

6.0

I II2006

III IV I II2007

III IV I II2008

III IV I II2009

III

Publicly-owned

Privately-owned

Automotive

Source: Prepared by Banco de México with data from the Ministry of Labor (Secretaría del Trabajo y Previsión Social, STPS). 1/ Includes wage negotiations in firms under federal jurisdiction. Coverage: 1.9 million workers in 2008, which represents 4.7 percent of

total remunerated workers of that year.


16

Table 3 Contractual Wage Revisions in Privately-owned Firms by Range of Increase

Distribution (percent)

I II III IV Average I II III

0.0 - 2.9% 2.1 1.7 2.5 2.6 2.1 9.7 12.7 15.93.0 - 5.9% 92.9 91.0 90.1 90.9 91.5 83.5 81.0 67.16.0 - 7.9% 3.2 5.9 5.2 5.4 4.7 5.7 4.4 9.38.0% - above 1.9 1.4 2.2 1.1 1.7 1.1 1.9 7.7

Range of Increase2008 2009

According to number of workers benefited

Source: Prepared by Banco de México with data from the Ministry of Labor.


17

3. Main Determinants of Inflation

3.1. External Conditions

3.1.1. World Economic Activity

After having contracted significantly during the fourth quarter of 2008 and the first quarter of 2009, world economic activity began to recover in the second quarter of this year (Graph 10), and seems to have gained strength during the July-September period. The fiscal and monetary stimulus measures implemented in diverse advanced and emerging economies have contributed to this recovery. Although growth has been generalized, recovery has been stronger in emerging countries, especially in Asia.

Graph 10 World Economic Growth by Group of Economies

Annualized quarterly change (percent)

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

I2005

II III IV I2006

II III IV I2007

II III IV I2008

II III IV I2009

II III IV I2010

II III IV

WorldAdvancedEmerging

Source: IMF.

During the second quarter of 2009, the U.S. economy fell 0.7 percent at an annualized quarterly rate (3.8 percent compared to the same period of the previous year), a significant improvement from the 6.4 percent fall observed during the first quarter (-3.3 percent in annual terms). The lesser weak economic conditions during this period mainly responded to a slower contraction in investment, particularly in equipment and software, and to the positive contribution of public expenditure and net exports.

The latest information suggests economic activity stopped contracting during the third quarter, therefore ending the longest and deepest recession of the postwar period. Consumption rebounded partly as a result of fiscal stimulus measures, improved consumer confidence and the temporary effects of programs in the different sectors of the economy. Furthermore, signs of recovery in the real


18

estate sector increased, while the change in inventories ceased to represent an obstacle to economic growth during the July-September period.

There is also evidence on the supply side suggesting that the recession ended towards the middle of the year. Industrial production expanded significantly during the third quarter, after having fallen sharply during the five preceding quarters.3 This performance was buoyed by the program to help consumers replace their old “gas guzzling” vehicles with new more fuel-efficient automobiles (“Car Allowance Rebate System”, also known as ”Cash for Clunkers”) and efforts to replace inventories. The use of installed productive capacity therefore rebounded from the historically minimum levels recorded at the end of the preceding quarter (Graph 11).

Graph 11 U.S. Industrial Production Indicators

a) Industrial Production Monthly change (percent)

b) Manufacturing Sector Capacity Utilization Rate 1/

-5

-3

-1

1

3

J2005

A J O J2006

A J O J2007

A J O J2008

A J O J2009

A J

60

65

70

75

80

85

90

95

100

Jan-

48

Jan-

54

Jan-

60

Jan-

66

Jan-

72

Jan-

78

Jan-

84

Jan-

90

Jan-

96

Jan-

02

Jan-

08

Source: Federal Reserve and NBER. 1/ Shaded areas correspond to recession periods as

defined by the NBER.

Source: Federal Reserve and NBER. 1/ Shaded areas correspond to recession periods

as defined by the NBER.

The fiscal and monetary support measures, the improvement in financial conditions and the modest recovery in business and consumer confidence have led to an upward adjustment in economic growth forecasts for the third and fourth quarters of 2009. Nevertheless, the economy is still weak, as revealed by the main macroeconomic indicators, which continue to register significant falls in annual terms. Recovery is also expected to be slower than during previous business cycles due, among other factors, to the high levels of household indebtedness, the sharp fall in household wealth, and the need to improve a large number of firms and financial institutions’ balance sheets. Empirical evidence shows that recovery processes are longer in cases where the economic downturn is accompanied by a financial crisis. It is also important to point out that the recovery is not free of risks. Although the financial system is in better conditions, it is still far from returning to normality. Furthermore, the authorities will have to implement a strategy to reverse the fiscal and monetary stimulus measures in a way that does not imply a new outbreak of inflation or hinder economic growth.

3 This indicator grew 5.2 percent in annualized quarterly terms during the third quarter, as compared with

falls of 19.0 and 10.3 percent during the first and second quarters of the year, respectively.


19

Economic activity in the Eurozone and Japan also improved during the second quarter. Eurozone GDP contracted 0.7 percent in annualized quarterly terms (-4.8 percent in annual terms), comparing favorably to the fall of 9.6 percent observed during the first quarter (-4.8 percent in annual terms). Indicators available for the third quarter, confidence and purchase manager’s indices in particular, show further improvement, although they remain at low levels. In Japan, during the second quarter of 2009, GDP grew 2.3 percent in annualized quarterly terms (-7.2 percent in annual terms), interrupting a series of four consecutive falls. Indicators for economic activity in different sectors, the Tankan business confidence indicator, and industrial production all suggest that the economy continued to recover during the third quarter. In contrast, the U.K. economy contracted for the sixth consecutive time during the third quarter, albeit at a slower rate than during previous quarters.

During the last months, emerging economies have grown faster than advanced economies. Domestic demand in some of these economies, particularly China and India, has been spurred by the substantial fiscal and monetary stimulus packages the authorities have implemented. Many economies have also benefited from the rebound in commodity prices. In China, economic activity continued to strengthen and GDP grew 8.9 percent in annual terms during the third quarter, one percentage point above the figure observed during the April-June period. In India, timely indicators also suggest stronger economic activity during the third quarter. The average annual growth of industrial production in this country rose from an average of 3.8 percent during the second quarter to 10.4 percent in August. Meanwhile, the Russian economy is exhibiting less weakness. Its GDP fell 9.4 percent in annual terms during the July-September period, after having contracted 10.9 percent in the preceding quarter.

In Latin America, some countries began a process of economic recovery during the second quarter of the year, which appears to have become more widespread during the third. The IMF forecasts that Latin America GDP will fall 2.5 percent in real terms during 2009, mainly as a result of the weakness observed during the first half of the year.

3.1.2. Commodity Prices

After having peaked during the second quarter of 2009, commodity prices in general tended to stabilize during the third quarter, although with some differences among products due to, among other reasons, the lack of a significant recovery in demand which might have reduced inventories (Graph 12). In October, the prices of several commodities, in particular, energy, grains and metals rebounded as a result of increased appetite for risk, revised demand forecasts, lower inventories, and a depreciated US dollar.


20

Graph 12 Commodity Prices

December 31, 2002=100 a) Total and Oil-related b) Non-energy and Agricultural c) Non-energy and Metals

50

100

150

200

250

300

350

400

450

500

03 04 05 06 07 08 09

TotalOil

50

100

150

200

250

300

350

03 04 05 06 07 08 09

Non-energyAgriculturalGrainsCattle

50

100

150

200

250

300

350

400

450

03 04 05 06 07 08 09

Non-energyPrecious metalsIndustrial metalsNon-precious metals

Source: Bloomberg. Source: Bloomberg. Source: Bloomberg.

3.1.2.1. Food Commodities

During the third quarter of 2009, international prices of grains followed a downward path in response to favorable weather conditions which allowed for abundant harvests in the most important producing countries. Thus, between June and September the international prices of corn, soy, wheat, and rice posted annual variations of -22.4, -20.0, -25.4 and -4.8 percent, respectively. This trend reverted slightly in October. The prices of several of these commodities are expected to continue rising in the following months (Graph 13).

The decline in the international prices of grains has curbed the pressure on cattle feeding costs, which together with sluggish demand led to a sideways shift in the international price of beef during the third quarter of 2009. Thus, between June and September this price grew 0.3 percent. Although the international price of pork remained relatively stable during in the first half of 2009, during the third quarter of the year, an increase in production under recessive conditions led to a 12.2 percent fall in the prices of this meat between June and September.


21

Graph 13 International and Futures Prices of Grains1/

a) Corn b) Soy

1

2

3

4

5

6

7

O 2005

A O 2006

A O 2007

A O 2008

A O 2009

A O 2010

CornFuture 28/07/2009Future 27/10/2009

OctOctOct Oct

Observed

Future

1

3

5

7

9

11

13

15

17

O 2005

A O 2006

A O 2007

A O 2008

A O 2009

A O 2010

SoyFuture 28/07/2009Future 27/10/2009

OctOctOctOct

Observed Future

c) Wheat d) Rice2/

2

3

4

5

6

7

8

9

10

11

12

O 2005

A O 2006

A O 2007

A O 2008

A O 2009

A O 2010

WheatFuture 28/07/2009Future 27/10/2009

Oct Oct Oct Oct

Observed Future

6

8

10

12

14

16

18

20

O 2005

A O 2006

A O 2007

A O 2008

A O 2009

A O 2010

RiceFuture 28/07/2009Future 27/10/2009

Observed Future

Oct Oct Oct Oct

Source: United States Department of Agriculture (USDA) and Chicago Board of Trade (CBT). 1/ USD per bushel. 2/ USD per CWT (USD/100Lb). Observed prices of September 2009 are preliminary.

3.1.2.2. Energy Commodities

The international prices of energy commodities exhibited mixed results throughout the third quarter of 2009. Oil and gasoline prices remained relatively stable around levels observed since June. The international price of natural gas continued to follow a downward pattern, while prices of propane and oil rose. During October, there was a generalized increase in energy commodity prices, except gasoline prices which still did not reflect the recent increases in crude oil prices. Nevertheless, the international prices of energy commodities are still far below those observed by the middle of the year. Between June and September of 2009, the international prices of gasoline, propane, natural gas and crude oil registered annual variations of -7.1, 11.8, -21.7 and -0.3 percent, respectively (Graph 14).


22

Graph 14 Observed and Futures Prices of Energy

a ) Regular Gasoline1/

50

100

150

200

250

300

350

400

O 2005

J A J O 2006

J A J O 2007

J A J O 2008

J A J O 2009

J A J O 2010

Regular gasolineFuture 28/07/2009Future 27/10/2009

Future

Observed

Oct Oct Oct Oct

b) Propane2/

40

60

80

100

120

140

160

180

200

220

240

O 2005

J A J O 2006

J A J O 2007

J A J O 2008

J A J O 2009

J A J O 2010

PropaneFuture 28/07/2009

Future 27/10/2009

FutureObserved

Oct Oct Oct Oct

c ) Natural Gas 3/

2

4

6

8

10

12

14

16

O 2005

J A J O 2006

J A J O 2007

J A J O 2008

J A J O 2009

J A J O 2010

Natural gasFuture 28/07/2009Future 27/10/2009

Future

Observed

Oct Oct OctOct

d) WTI Oil4/

20

40

60

80

100

120

140

160

O 2005

J A J O 2006

J A J O 2007

J A J O 2008

J A J O 2009

J A J O 2010

WTI oilFuture 28/07/2009Future 27/10/2009

Future

Observed

Oct Oct Oct Oct

Source: Bloomberg, Energy Information Administration (EIA) and New York Mercantile Exchange (NYM). 1/ Texas. US cents per gallon. 2/ Mont Belvieu, Tx. US cents per gallon. 3/ TETCO, Tex. USD per MMBtu. 4/ USD per barrel.

Futures markets suggest that international prices of crude oil and natural gas will increase slightly during the following months, while gasoline and propane prices are anticipated to remain mostly stable. Although the downturn in world economic activity seems to have come to an end during the first half of 2009, a high level of uncertainty remains and the world economy is expected to recover gradually. Under this environment, OPEC is not anticipated to make any significant changes in its production levels which, together with the relatively high level of oil inventories, would offset any possible impact of a larger-than-expected increase in world demand. Thus, energy commodity prices are not anticipated to become an important source of inflationary pressures.


23

3.1.2.3. Metal Commodities

During the third quarter of 2009, the international prices of copper and aluminum continued to follow the upward pattern they have exhibited throughout the year. Just as forecasted in the previous inflation report, the downward pattern followed by international steel prices reverted in June this year, reaching levels similar to those observed at the end of 2008 in September. Between June and September of 2009, the international prices of copper, steel and aluminum grew 22.9, 48.2 and 21.7 percent, respectively. However, the international prices of these commodities remain below the levels observed throughout most of the previous year. Thus, in September 2009, these prices registered annual variations of -11.7, -44.1 and -18.2 percent, respectively. Prices of copper and aluminum continued to increase in October, while those of steel decreased slightly.

3.1.3. Inflation Trends

Although annual CPI inflation registered negative figures in many advanced economies during the third quarter of 2009, in the U.S. and Europe it stopped following the downward trend it had exhibited since mid 2008 (Graph 15). Core inflation, already at very low levels, continued to decline in several of these countries in response to the persistence of wide output gaps. In the absence of inflationary pressures and uncertainty regarding the sustainability of the recovery, the major central banks decided to keep their policy rates at very low levels.4

Graph 15 Inflation in Selected Advanced Economies

Annual change (percent) a) Headline b) Core

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

J2006

M M J S N J2007

M M J S N J2008

M M J S N J2009

M M J S

Canada JapanU.S. EurozoneU.K.

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

J2006

M M J S N J2007

M M J S N J2008

M M J S N J2009

M M J S

Canada JapanU.S. EurozoneU.K.

Source: Statistics bureaus of selected countries. Source: Statistics bureaus of selected countries.

In the U.S., annual headline inflation continued registering negative variations throughout the third quarter, although this mainly reflected the record falls in monthly inflation during the October-December period of 2008, which in

4 In most advanced economies, policy rates have been cut to between 0.25 percent (Canada and the

U.S.) and 1.0 percent (Eurozone). The central banks of several of these economies have continued to turn to unconventional measures to supply liquidity to their economies and support their financial systems.


24

turn originated from a weak domestic demand. During most of 2009, month-on-month inflation has been positive mainly due to the effect of recent increases in gasoline prices. Meanwhile, after having followed a downward path for four months, annual core inflation rose in September of 2009, reaching 1.5 percent (1.7 percent in June). This result partly reflected the increase in prices of new automobiles as the “Cash for Clunkers” program ended. The Federal Reserve considers that although economic activity has started to pick up, high levels of idle capacity will dampen cost pressures and inflation expectations will remain stable. Under this environment, the Federal Reserve decided to leave the federal funds target rate unchanged at a range of 0 to 25 basis points during the third quarter, while in its press release of September 23 it also reiterated its belief that its policy rate will remain at exceptionally low levels for a long period.

Headline CPI inflation in the Eurozone continued to register negative figures in annual terms during the third quarter of 2009, slightly increasing the rate of contraction, from -0.1 percent in June to -0.3 percent in September. Core inflation in September was 1.2 percent, below the level observed at the end of the second quarter (1.4 percent). Although the rate of contraction of economic activity in the area slowed significantly during the third quarter, the European Central Bank (ECB) left its policy rate unchanged during the period. In Japan, annual headline consumer inflation and annual core inflation continued to fall, reaching -2.2 and -2.4 percent, respectively, in August. Under this scenario, the Bank of Japan decided to keep its benchmark interest rate unchanged at the level of 0.10 percent set since the end of last year. In the U.K., average annual headline CPI inflation decreased from 2.1 percent during the second quarter to 1.5 percent during the third, while core inflation was 1.8 percent during the same period (1.6 percent on average during the second quarter). Due to the weakness of the U.K. economy, the Bank of England decided to keep its policy rate on hold at the historically minimum level of 0.5 percent.

In general terms, inflation in emerging economies has also slowed, although less than in advanced economies. This has been due, among other factors, to the lower pass-through effect of lower energy prices on inflation in emerging economies, the greater impact of exchange rate depreciations on domestic prices in these countries, and the presence of less competitive market structures in some of them (Box 2). In China, the annual price variation of headline CPI inflation has remained negative since February, reaching -0.8 percent in September. In India, wholesale prices grew 0.7 percent in annual terms in September. Meanwhile, double-digit inflation continued in Russia (10.7 percent in annual terms in September). Inflation in Latin America continued to follow a downward pattern during the third quarter in annual terms, reaching 4.3, 3.2, -1.1 and 1.2 percent in Brazil, Colombia, Chile and Peru, respectively, in September. In contrast, in Venezuela, inflation rose during the quarter, reaching 28.9 percent in September.


25

Box 2 Recent Developments in World Inflation

As has been mentioned in previous inflation reports, world inflation followed an upward trend from 2006 until the middle of 2008 as a result of factors including the robustness of world economic activity and the rise in the international prices of commodities. Later, towards the end of 2008, as the feedback between problems in financial markets and the real sector of different advanced economies worsened, economic activity decreased significantly. This led to a contraction in international trade which eventually started to affect economic activity in emerging economies severely. Inflation in advanced economies reached a turning point during the second half of 2008, while in emerging economies, by the end of the year.1

Although the fall in inflation has been widespread, it has differed among economies in terms of its rate and magnitude. Following is a description of several indicators which cast light on how differently inflation has fallen in advanced and emerging economies.

An analysis of the decline in annual headline inflation from its highest level in 2008 to its current levels, together with the number of months it has been decreasing, allows for calculating an indicator on the rate of decline of inflation in each economy; more specifically, on the average monthly decrease in annual headline inflation. This indicator reveals that inflation has fallen at a faster rate in advanced economies (5.6 percent on average each month) than in any of the three subgroups of emerging economies (Latin America, 4.5 percent; Asia, 4.5 percent; and Eastern Europe, 3.3 percent) (Graph 1).

Graph 11/ Monthly Decline in Average Annual Headline Inflation

Percent

3.3 4.5 4.5 5.6

0

1

2

3

4

5

6

7

8

Aus

tralia

ECB

U.S

.U

.K.

Nor

way NZ

Swed

enS

witz

erla

ndG

erm

any

Italy

Fran

ceC

anad

a

Mex

ico

Chi

leC

olom

bia

Braz

ilPe

ruK

orea

Isra

elIn

dia

Phi

lippi

nes

Indo

nesi

aM

alay

sia

Thai

land

Turk

eyH

unga

ryPo

land

Cze

ch R

ep.

Rus

sia

Bul

garia

Sou

thC

roat

iaLa

tvia

Lith

uani

a

Average Average:Average:Average:

1/ Refers to the average monthly rate of change (composed), calculated based on the percentage change from its highest level in 2008 to its current level, and on the number of months that annual inflation has been declining. Source: Official web sites of each country.

1 Advanced economies considered are: U.S., Japan, Canada, Norway, New Zealand,

Australia, United Kingdom, Sweden and Switzerland; and, from the Euro Zone: Germany, Italy and France. As for emerging economies, three subgroups are considered: a) from Latin America: Brazil, Chile, Colombia, Peru, Ecuador, Paraguay, Uruguay and Mexico; b) from Asia: Philippines, Malaysia, Korea, Thailand, Indonesia, Israel, and China; c) from Eastern Europe: Estonia, Poland, Hungary, Czech Republic, Bulgaria, Russia and, additionally, South Africa and Turkey. Australia and New Zealand report inflation on a quarterly basis and therefore most recent headline and core inflation figures correspond to the second quarter of 2009.

It is important to mention that Mexico is among the countries with the slowest decline in inflation (2.5 percent on average per month). Headline inflation fell from 6.53 percent in December 2008 to 4.89 percent in September 2009 (164 basis points). This means that, as a percentage, it has fallen by only 25.1 percent (in Latin America it has fallen on average 55.9 percent and in the group of emerging economies, 65.6 percent).

As shown in Box 1 of the Inflation Report January-March 2009, the abovementioned differences could be attributed to three main factors: i) the decline in the international prices of energy commodities and each country’s policy for determining their domestic prices for these products; ii) the depreciation of the exchange rate observed in a large number of countries; and, iii) the deterioration of economic activity.2

i) Decline in International Energy Prices

The contribution of the fall in international energy prices during the second half of 2008 and the start of 2009 to the decline in headline inflation mainly depend on each country’s policy for determining the prices of energy goods. This contribution also depends on the relevance of these prices in each country’s CPI basket (direct effect) and the pass-through effect of adjustments in firms’ costs to consumer prices (indirect effect).

Box 1 mentioned above showed an exercise measuring the direct effect of the adjustments in local prices of energy on the recent decline in inflation in each country. The reduction in annual headline inflation from its highest level recorded in 2008 to its most recent level and the contribution (incidence) of the decline in inflation of energy commodity prices to such fall. After updating the exercise, the size of the fall in energy inflation is found to have contributed significantly to the recent decline in inflation in several countries. Among the countries with the largest drops in inflation of energy commodity prices are: in the advanced economies’ group: Canada, Norway and the U.K.; and, in the emerging economies’ group: Chile, Turkey, Estonia, Bulgaria, and Thailand (Graph 2).

Graph 2 Change in Headline Inflation from its Highest Level in 2008

to its Current Level Basis points

-1600

-1400-1200

-1000

-800-600

-400

-2000

200

Aus

tralia

Can

ada

U.S

.Fr

ance

Nor

way NZ

U.K

.Sw

eden

Bra

zil

Chi

leC

olom

bia

Ecu

ador

Mex

ico

Para

guay

Per

uU

rugu

ayP

hilip

pine

sM

alay

sia

Thai

land

Bul

garia

Esto

nia

Hun

gary

Pol

and

Cze

ch R

ep.

Sou

thTu

rkey

Energy goods' contribution (industrialized)Energy goods' contribution (emerging)

Source: Prepared with data from Bloomberg, central banks’ web sites, and statistics bureaus of each country.

2 Even though in this exercise it is not considered explicitly, the reduction in the international prices of food and other commodities might have also contributed to the decline in inflation.


26

ii) Exchange Rate Depreciation

As has been pointed out, some economies experienced considerable depreciations in their exchange rates during the last quarter of 2008 and the start of 2009. Although in some cases this phenomenon has partly reverted in the last two quarters, the exchange rates of most countries’ currencies did depreciate from the levels they had registered during the first half of 2008.

Under these conditions, the depreciation of the exchange rate could be related to the fact that core inflation has declined at a relatively small rate in most of the countries analyzed. In fact, the countries which have registered the largest depreciation in their exchange rates such as Canada, New Zealand and the U.K., are those which have also registered the smallest reductions in core inflation. Likewise, the emerging economies of Mexico, Poland and Turkey are among those which have experienced the largest depreciations in their exchange rates and the smallest reductions in their core inflation (Graph 3).

Graph 3 Change in Core Inflation and Fluctuations in the Nominal

Effective Exchange Rate Percentage points and percent

AUS

CANUS NOR

NZ ROU

CHEEUR

BRA

BGR

CHL

COL

KOR

PHL

HUN MEXPER POL

CZERUS

ZAF

THATUR

-0.10.10.30.50.70.91.11.31.51.71.92.12.32.5

-20

-10 0 10 20 30 40

-2.0-1.00.01.02.03.04.05.06.07.08.09.010.011.0

Cha

nge

in c

ore

infla

tion2/ Emerging

economieS

Advanced economies

Exchange rate fluctuations1/

1/ The horizontal axis shows the depreciation of the exchange rate from

September 15, 2008 to date. A positive adjustment represents depreciation of the multilateral effective nominal exchange rate.

2/ The vertical axis shows the decline in core inflation from its highest level in 2008 to its most recent level. For South Africa, headline inflation figures were considered.

Source: Prepared with data from Bloomberg and JP Morgan. iii) Economic Activity

It is well know that the sharp contraction in world economic activity has led to a substantial reduction in expenditure and to an environment of relatively slackened economic conditions (negative indicators of output gap). This slackness has also contributed to the fall in core inflation, which has been more significant in advanced economies. For instance, the countries with the most considerable slackened conditions (a narrower

output gap) expected for 2009 are also those recording the largest falls in core inflation (Graph 4). However, in the case of emerging economies, this phenomenon is less clear. As shown in Box 1 of this report, this might be due, among other factors, to the existence of less competitive market structures in these economies.

Given the sharp contraction of economic activity during the first half of 2009, loose economic conditions are expected to continue, despite expectations of economic recovery for the second half of the year and during 2010. Taking this into consideration, it is foreseeable that these conditions will continue to draw inflation downwards, especially in advanced economies.

Graph 4 Minimum Level of Output Gap in 2009

And Change in Core Inflation Basis points

US

ROU

DEUFRA

ITACANSWE

NOR

NZ

BRACOL

MEX

PERKOR

PHL

THAHUN

POL

CZE

TUR-9-8-7-6-5-4-3-2-10

-600

-500

-400

-300

-200

-100 0

Min

imum

gap

in 2

009

2/

Emerging economies

Industrialized economies

Change in core inflation 1/

1/ The horizontal axis shows the decline in core inflation from its highest level in

2008 to its most recent level. For South Africa, headline inflation figures were considered

2/ The vertical axis shows the lowest level estimated for the output gap for each country in 2009 considering both observed figures of economic activity for the first quarters of the year and forecasts for the second half of the year. The output gap is obtained using a HP filter with tail correction.

Source: Prepared with data from Bloomberg and forecasts from Consensus Forecasts and JP Morgan.

To conclude, inflation in Mexico has declined less than in advanced economies and in most emerging countries. The recent mixed behavior of inflation among the different countries analyzed, particularly in terms of the rate and size of the fall in inflation, seems to be related with the abovementioned factors. First, the decline in the price of energy commodities together with each country’s policy for determining local prices seems to have contributed significantly to the decline of headline inflation in some countries. Second, in countries where their currencies’ exchange rate has depreciated the most, core inflation has decreased at a smaller rate. Third, the slack in economic activity originated by the sharp contraction in expenditure has created an environment favorable for inflation to decline, especially in advanced economies.

Policy interest rate cuts have been generally smaller in emerging economies than in advanced economies. This is partly the result of a combination of higher inflations in emerging economies at the start of the crisis and pressures originated by the depreciation of their exchange rates. Although most of these countries continued cutting their policy interest rates during the third quarter, a moderation of these reductions was observed.

Defining the correct moment to start withdrawing monetary stimulus measures in advanced and emerging economies is one of the key challenges for monetary policy in the coming months. In fact, in August, the Bank of Israel raised its policy rate by 25 basis points to 0.75 percent, although it emphasized that it considered this level to still be expansionary monetary policy. This decision was


27

followed by the Bank of Australia, which increased its policy rate by 25 basis points to 3.25 percent and suggested the start of a gradual reduction of monetary stimulus measures. Nevertheless, due to the more advanced phase of the business cycle and less anchored inflation expectations in most emerging economies, the process of tightening monetary policy can be expected to take place at a faster rate in these economies than in advanced economies.

3.1.4. Financial Markets

The risk of a widespread collapse in international financial markets has decreased considerably and the situation in these markets has clearly improved. Although at the beginning of the crisis markets were mainly supported by the stimulus measures implemented by different countries’ authorities, the current improvement also reflects the positive feedback between prospects for real economic growth and financial conditions.

Notwithstanding the above, financial markets continue under turmoil and the risk of another period of uncertainty prevails. It is also important to take into account that the current situation, characterized by, among other factors, abundant liquidity, extremely low interest rates, fiscal stimulus measures and a faster-than-expected recovery of some financial institutions, could lead to a larger decrease in risk aversion than that justified by fundamental conditions.

During the third quarter, the U.S. Federal Reserve Bank continued to reduce the amount of funds auctioned through the Term Auction Facility (TAF) and the Term Securities Lending Facility (TSLF), a measure unveiled at the end of the second quarter, and announced that these reductions would continue until January 2010.

In its press release of September 23, the Federal Open Market Committee (FOMC) reiterated its willingness to employ a wide range of tools to foster the economic recovery and preserve price stability. In particular, it confirmed its intention to purchase mortgage-backed securities and debt issued by government-sponsored enterprises (GSEs). The Federal Reserve also signaled that it would continue these purchases until the end of the first quarter of 2010, and that its purchases of 300 billion US dollars of Treasury securities would be completed by the end of October 2009.

On September 18, the U.S. Department of the Treasury announced the end of the guarantee program for money market funds. As for the Troubled Asset Relief Program (TARP), in August the U.S.Treasury announced that three banks had repaid loans granted through the program, raising the amount of amortization to 70.3 billion US dollars. The U.S.Treasury also signaled that 130 million dollars of TARP funds were channeled to nine commercial banks in August.

Finally, on August 17, the Federal Reserve Board and the Treasury announced the extension of the Term Asset-Backed Securities Loan Facility (TALF). Loans granted against the purchase of newly issued asset-backed securities (ABS) and legacy commercial mortgage-backed securities would be extended to March 31, 2010. Meanwhile, loans against newly issued commercial mortgages-backed securities (CMBS) would be extended to June 30, 2010.


28

On July 6, the European Central Bank (ECB) announced the start of the gradual implementation of the eurosystem covered bond purchase program.5 The program intends to maintain the decline in money market interest rates, ease funding conditions for credit institutions and firms, encourage banks to lend to their clients, and improve liquidity in important segments of the private-debt market. According to the ECB, this program has contributed to narrow spreads in the cost of private debt and has allowed issuers to refinance under better terms. Finally, the ECB extended the term of refinancing operations with eurozone commercial banks to 12 months.

During the third quarter, concerns arose about the size of the Bank of England’s financial asset purchase program.6 Some analysts believed that greater efforts to increase the supply of credit were needed, while others saw signs of recovery and therefore considered the continuation of this program unnecessary. Under this setting, on August 6, 2009, the Bank of England decided to increase purchases of financial assets by 50 billion pounds sterling for a total of 175 billion pounds. Meanwhile, the Bank of Japan decided to extend the life of temporary measures such as the security and corporate bond purchase programs.

During the third quarter, liquidity conditions in the interbank market improved the most since the start of the crisis. In September, the spread between the US dollar London Interbank Rate (LIBOR) and the three-month Overnight Index Swap (OIS) reached its lowest levels since August 2007 (Graph 16). As for the spreads between interest rates on commercial paper and the federal funds rate, they continued to follow the downward pattern exhibited since the start of 2009. The improvement of confidence during October allowed both of these spreads to further narrow.

As for perceptions about the vulnerability of the banking sector, the cost for insuring debt against default decreased throughout the third quarter and the start of the fourth, due to the positive financial results registered during the second and third quarters and the continuation of programs to support the banking system. In addition, the percentage of institutions reporting tighter credit approval conditions has gradually decreased (Graph 17). Nevertheless, the persistence of problems in several sectors, including the mortgage sector, the meager progress in removing devalued assets from commercial banks’ balance sheets, and regulatory challenges mean that banks are foreseen to undergo a long deleverage process. This situation in turn could imply tighter credit conditions for firms and consumers.

5 Covered bonds are instruments issued by a credit institution which grants the purchaser a guarantee

(collateral) on the bond made up of an asset portfolio. If the issuer goes bankrupt, holders of these bonds have priority over the guarantee.

6 The Bank of England creates money to finance these purchases by crediting the reserve account of the seller’s bank with the funds from the assets purchased, and the bank credits the account of the seller with a deposit. This increases both the monetary base and broad money (the main component of which is the public’s bank deposits) at the same time.


29

Graph 16 U.S.: Spread on Libor Rate and Credit Default Swaps

Percentage points and basis points Spread Between 3-Month Libor in USD, 3-

Month OIS1/ and 3-Month T-bills2/ b) Credit Default Swaps (CDS)

in Selected Banks

0

1

2

3

4

5

J2007

A J O J2008

A J O J2009

A J O

Libor 3m-Tb 3m

Libor 3m-OIS 3m

0

100

200

300

400

500

600

700

800

J2007

A J O J2008

A J O J2009

A J O

Bank of America

Citigroup

Barclays

UBS

JP Morgan

Deutsche Bank

Source: Bloomberg. 1/ The OIS (Overnight Index Swap) reflects expectations for

the reference rate average for the next three months. 2/ As of July 27, 2009.

Source: Bloomberg.

Graph 17 Conditions for Granting Credit

Balance of responses

-40

-20

0

20

40

60

80

100

03 04 05 06 07 08 09

JapanEuropeU.S.U.K.

Source: Central banks.

During the third quarter of 2009, interest rates on U.S. Treasury Bills decreased slightly from the levels observed at the end of the preceding quarter. This downward trend was influenced, among other factors, by the Federal Reserve’s reiteration to keep its target rate at exceptionally low levels for a long period, which more than offset the upward adjustments caused by lower risk aversion. During the July-September period, 30, 10, 5 and 2-year rates fell 29, 22, 23 and 16 basis points, to 4.03, 3.31, 2.31 and 0.95 percent, respectively. Meanwhile, 1-year and 3-month rates, more directly influenced by both the federal funds rate and policy decisions expected for the following months, decreased by


30

16 and 5 basis points, respectively, ending the quarter at 0.40 and 0.14 percent (Graph 18). From the end of the third quarter to October 26, interest rates for almost all terms increased in response to better prospects for growth, reduced risk aversion, and the impact of the Treasury bond record issue at the end of the month.7

Stock markets of advanced economies continued to follow the upward trend exhibited since March. The rise in stock markets was particularly noteworthy from mid July as a series of economic indicators and better-than-expected corporate earnings were announced. It is worth mentioning that improved corporate results mainly stemmed from cost cutting exercises, particularly layoffs, which could have negative implications for future economic growth. In the second half of September, doubts about the justification for the sharp rise in stock markets caused the rally to falter and a modest fall was observed. Although during the third quarter stock markets continued to recover some of the ground lost during the previous year, they still remained below the levels that had before the start of the crisis (Graph 19). During the third quarter, the Dow Jones, S&P-500 and NASDAQ indices gained 15.0, 15.0, and 15.7 percent, respectively. Meanwhile the stock exchanges of Canada, Germany, France and the U.K. gained 9.8, 18.0, 20.9 and 20.8 percent, respectively. Japan’s stock market rose 1.8 percent, the smallest increase among advanced economies. From the end of the third quarter to October 27, the main advanced economies’ stock markets registered mixed results.8

Graph 18 U.S. Interest Rates

Annual percent

0

1

2

3

4

5

6

J M M J S N J M M J S N J M M J S

3 months1 year2 years5 years10 years30 years

2007 2008 2009

Source: Federal Reserve.

7 During this period, 30, 10, 5 and 2-year rates rose 34, 28, 22 and 11 basis points, reaching 4.37, 3.59,

2.53 and 1.06 percent, respectively, while the 3-month rate declined 6 basis points to 0.08 percent and the 1-year rate increased slightly (1 basis point) to 0.41 percent.

8 During this period the Dow Jones and the S&P-500 gained 1.7 and 0.6 percent, respectively, while the NASDAQ fell 0.3 percent. The stock markets of the U.K. and Japan also rose by 1.3 and 0.8 percent, respectively, while those of Germany, Canada and France declined 0.7, 3.0 and 1.4 percent, respectively.


31

The US dollar depreciated during the third quarter, reaching new lows for the year. Most of the depreciation took place in July, and from August until the end of the quarter no clear trend was observed. The pound sterling, which had appreciated the most during the preceding quarter, was the only major currency which depreciated against the US dollar (2.9 percent). This behavior responded to the weakness of the U.K. economy and concerns about the sustainability of its fiscal position. During the July-September period, the US dollar depreciated 4.1, 8.9 and 6.9 percent, respectively, against the euro, the Canadian dollar, and the yen. In the case of the first two currencies this trend continued during the first 27 days of October.9 The significant appreciation of Canada’s currency against the US dollar is mainly attributed to the rebound in commodity prices and the improvement in the country’s economic growth forecasts. During the quarter, the effective US dollar exchange rate against the broad index and the major currencies index depreciated 2.6 and 4.4 percent, respectively (Graph 20).10 From the end of September to October 23, both indices followed a sharper downward pattern, depreciating 1.3 and 1.5 percent, respectively.

Graph 19 Stock Markets of Advanced Economies

a) Stock Markets of the U.S. 01/01/2008=100

b) Stock Markets of other Advanced Economies

01/01/2008=100

40

50

60

70

80

90

100

110

J 2008

M M J S N J2009

M M J S

Dow JonesS&PNasdaq

25

50

75

100

125

J 2008

M M J S N J2009

M M J S

CanadaEnglandFranceGermanyJapan

Source: Bloomberg. Source: Bloomberg.

9 Between September 30 and October 27, the US dollar depreciated 1.1, 0.4 and 2.4 percent against the

euro, Canadian dollar and the pound sterling, respectively, while it appreciated 2.3 percent against the yen.

10 The Federal Reserve defines the exchange rate against the main currencies as a weighted average of the foreign exchange value of the US dollar against 7 major currencies. The broad index is a weighted average of the foreign exchange value of the US dollar against 26 currencies. Weights of this index are calculated based on the share of each country in U.S. total exports and imports.


32

Graph 20 USD Exchange Rate (Effective, Broad, and Major Currencies)

Indices a) USD Effective Exchange Rate

Index 1/ b) USD Exchange Rate against Selected

Currencies 1/ January 2000=100

60

70

80

90

100

110

120

130

140

Jan-00 Jan-03 Jan-06 Jan-09

Broad

Major currencies

50

60

70

80

90

100

110

120

130

Jan-00 Jan-03 Jan-06 Jan-09

EuroPound sterlingYenCanadian dollar

Source: Federal Reserve. 1/ Broad index January 1997=100 and Major Currencies Index

March 1973=100. An increase in the index equals a USD appreciation.

Source: Bloomberg. 1/ An increase in the index equals a USD appreciation.

In general terms, the currencies of emerging economies generally appreciated during the third quarter (Graph 21), although some of them depreciated as the influence of factors such as risk aversion decreased and other specifics about these countries gained relevance. The currencies of Brazil, Columbia and Poland appreciated more than 10 percent, while those of Argentina, Chile and India depreciated, although in all cases by less than 3.0 percent. The Brazilian currency continued to appreciate in the first 27 days of October (1.3 percent), as did the currencies of Argentina, Chile and India (0.5, 3.4 and 2.5 percent, respectively), while that of Colombia depreciated (3.4 percent).

Credit default swaps (CDS) of emerging economies fell sharply once more during the third quarter, extending the trend followed since the second week of March (Graph 22). The return of appetite for risk had a positive influence on these results by contributing to a 126.5 point reduction as compared with the level observed at the end of the second quarter. EMBI Global sovereign risk spreads also narrowed during the third quarter (96 basis points), reaching 337 basis points at the end of the period. Under this setting, the flow of funds to emerging economies continued to recover during the period. From the end of the third quarter to October 27, the EMBI Global continued to decline (6 basis points), while CDS rose slightly (7 basis points).


33

Graph 21 Emerging Economies’ Exchange Rate vs. US dollar1/

31/12/2007 = 100

65758595

105115125135145155165175185195

J2008

M M J S N J2009

M M J S40

60

80

100

120

140

160

180

200

220

240Mexican pesoBrazilian realIndian rupeeRussian rubleHungarian forintTurkish liraPolish zlotyIcelandic crown

Source: Bloomberg. 1/ An increase in the index equals a USD appreciation.

During the third quarter, the stock markets of various emerging economies recorded substantial gains, particularly those of Eastern Europe and South Korea. Although China’s stock price index gained 1.7 percent during the quarter, it declined from the beginning of August due to doubts over share values. Most emerging economies’ stock markets continued to improve in October.11

Graph 22 Sovereign Risk Spreads and Credit Default Swaps of Emerging Economies

Basis points a) Sovereign Risk Spreads of Emerging

Markets (EMBIs) b) Credit Default Swaps of Emerging Markets

(CDS)

0

100

200

300

400

500

600

700

800

900

1000

J 2007

A J O J2008

A J O J2009

A J O

Global AsiaEuropeLatin America

Lehman Brothers' collapse

0

200

400

600

800

1000

1200

J2007

A J O J2008

A J O J2009

A J O

Lehman Brothers' collapse

Source: Bloomberg. Source: Bloomberg.

11 From September 30 to October 27, the stock markets of China, Russia and Brazil rose 6.9, 13.3 and 2.7

percent, respectively, while that of South Korea dropped 1.4 percent.


34

3.2. Developments in the Mexican Economy

3.2.1. Economic Activity

The recent behavior of timely indicators suggests that economic activity in Mexico reached an inflection point at the start of the third quarter and, as a consequence, seasonally adjusted GDP increased by around three percent from its level of the preceding quarter (this would imply a fall of between 6 and 7 percent in annual terms, comparing favorably with the annual fall of 9.2 percent observed during the first half of the year; see Graph 23).12 Indeed, the latest information suggests that during the July-September period of 2009, both the services and manufacturing sectors grew in seasonally adjusted terms as compared with the second quarter of the year. This implies that in annual terms the falls were smaller than those registered in the preceding quarter. Different indicators on aggregate demand are also in line with a change of trend of economic activity during the analyzed quarter.

Graph 23 Gross Domestic Product


-12

-8

-4

0

4

8

I II III IV I II III IV I II III IV I II III IV I II III IV I II III

OriginalSeasonally adjusted

200720062005 2004 2008 e/

2009

Source: INEGI. Seasonal adjustments to the third quarter of 2009 by Banco de México. e/ Estimate.

The increase in productive activity during the third quarter of 2009 responded to a combination of two factors. First, the recovery of the world economy has influenced the external demand faced by Mexico, leading to a slower negative trend of exports of goods and services. Second, the impact of different temporary factors which affected the levels of activity in previous months has dissipated. The most noteworthy of these factors are: i) the fading of the effects of the influenza A(H1N1) virus outbreak on some services activities, resulting in an increase in their production as compared to the preceding quarter;

12 This figure was estimated on the basis of available information at the time of publishing this report, which

includes the Economic Activity Indicator (Indicador Global de la Actividad Económica, IGAE) up to July 2009, industrial activity up to August, and foreign trade figures up to September as well as other timely indicators for different economic activities. The latter indicators include figures up to September on extraction of crude oil and natural gas; sale of electricity; tons/km transported by the main railway companies; sea freight cargo; number of air travel passengers; occupancy in main resorts; automobile production; and, commercial sales of ANTAD members.


35

and, ii) the resuming of operations of several car makers after the temporary shutdowns they underwent during the previous quarter. This, together with a greater demand for vehicles made in Mexico stemming from the program of vehicle renewal in the U.S., led to a significant increase in automobile production and exports as compared with the preceding quarter.

3.2.1.1. Production by Sector

Available information on the most recent performance of the different sectors of the economy suggests that, during the third quarter of 2009, production in both the industrial and services sectors increased in seasonally adjusted terms from the levels reached in the preceding quarter. This implied that these sectors posted a smaller contraction in annual terms than in previous quarters. In particular, in seasonally adjusted terms, the IGAE recorded a monthly increase of 2.4 percent in July, its second consecutive positive monthly growth, and above the 0.4 percent increase registered in the preceding month. This result stemmed from monthly increases in the production of both the industrial and services sectors (Graph 24).

Graph 24 Indicator of Economic Activity (IGAE)

2003=100; seasonally adjusted figures

102

107

112

117

122

J A2006

J O J A2007

J O J A2008

J O J A2009

J

IGAEIndustrialServices

Source: INEGI.

Thus, in annual terms the IGAE decreased 6.9 percent in July 2009, which compares favorably with the annual contraction of 10.4 percent observed during the second quarter of the year. As for production by sector, the industrial and services sectors declined 6.5 and 7.6 percent, respectively, in July. These figures compare favorably with the falls of 11.5 and 10.4 percent posted by these activities during the second quarter of the year. In July, agricultural activity fell 1.7 percent in annual terms due to the effects of delayed rains on the spring-summer cycle temporal areas already planted, as well as on the yield of some autumn-winter crop and perennial harvests.

Although IGAE information available at the time of publishing this report includes the performance of the different sectors of the economy up to July, figures available for industrial production already consider the behavior of sectors


36

included in industrial activity up to August. This statistic shows that industrial activity increased during the July-August period as compared with the second quarter. During the referred period the average level of seasonally adjusted industrial production rose 1.7 percent as compared with the second quarter. This increase reflected positive figures in the four sectors that comprise Mexican industrial activity. During July-August of 2009, manufacturing, mining, electricity and construction grew 2.2, 1.7, 1.3 and 0.3 percent in annual terms, respectively (Graph 25). In line with these results and using original figures, during the same period industrial production registered a negative annual variation of 6.9 percent, a smaller rate than the fall of 11.5 percent posted during the second quarter.13

Graph 25 Production

2003=100; seasonally adjusted figures a) IGAE, Industrial and

Manufacturing Production b) Electricity and Construction c) Mining

99

104

109

114

119

J A J O J A J O J A J O J A A

Industrial production

Manufacturing production

IGAE

2006 2007 2008 2009

112

114

116

118

120

122

124

126

128

130

132


Electricity

Construction

2006 2007 2008 2009

90

100

110

120

130

140

150


Total mining

Oil-related

Non-oil

2006 2007 2008 2009

Source: INEGI.

The evolution of the industrial sector described above was significantly influenced by manufacturing activity. One important feature of the recent performance of this sector is that both the subsector of transport equipment manufacture (which basically includes the terminal automobile industry and auto part industry) and that of remaining manufactures, grew in seasonally adjusted terms during the July-August period 2009, as compared with their average levels during the second quarter (Graph 27a).

As for the Mexican automobile industry, during the third quarter of 2009 exports and production reached higher levels than those observed during the first half of the year (Graph 26). This recovery mainly responded to two factors. First, the reestablishment of higher production levels after the end of the temporary shutdowns implemented by several car makers, some of which lasted for most of the second quarter.14 Second, the influence of the “Car Allowance Rebate System” (CARS, also known as the “Cash for Clunkers” program) implemented in the U.S, which made a positive contribution to Mexican automobile exports to that country. Sales in the U.S. of vehicles exclusively produced in Mexico rose 13.5

13 During the July-August period of 2009, manufacturing and construction fell in annual terms by 10.4 and

6.4 percent, while mining and electricity grew in annual terms 2.1 and 1.8 percent, respectively. These results compare favorably with the -16.4, -8.9 0.7 and -1.4 percent registered by these sectors, respectively, during the second quarter.

14 The greater influence of these temporary shutdowns on economic activity in Mexico was the final outcome of the situation undergone by two firms with a large share in domestic car manufacturing activity, which entered into bankruptcy proceedings in the U.S.


37

percent in annual terms during the third quarter of the year, after having contracted 27.8 percent in annual terms during the first half of the year. This result reflected annual contractions in Mexican vehicle production and exports of 27.6 and 21 percent, respectively, during the third quarter of 2009, figures significantly lower than the falls posted in the first half of the year (43 and 41.5 percent). Meanwhile, domestic vehicle sales fell 29.9 percent in annual terms during the referred quarter (35.8 percent during the second quarter).

Graph 26 Automobile Industry

a) Automobile Industry Production Annual change (percent) of

number of units

b) Vehicle Production and Exports Monthly units, seasonally adjusted figures

-25.

0-4

8.0

-40.

81.

1

-39.

821.1

1.94.0

-37.7

7.9

8.7

-44.

9-2

7.6

-46.

5

-33.

8-2

2.9

-1.0

-23.

2-3

3.4-2

5.0

0.6

-39.

9-3

9.8

-47.

6

-27.

3

-1.2

-43.

4

13.0

4.5

-42.

5

2006

2007

2008

2009

Quarte2009

A M J J A S

2008

I II III IV I II IIIQuarter

Seasonally adjusted

J-S

Aug. 07199,353 Oct.08

190,034

Oct. 08 150,757

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

J2003

J J2004

J J2005

J J2006

J J2007

J J2008

J J2009

J S

Total productionExports

-25.

7%

-24.

4% 141,

121

113

,918

Source: Prepared by Banco de México with data from AMIA and ANPACT.

Graph 27 Manufacturing Production

Annual change (percent) of seasonally adjusted figures 1/ a) Production of Transport Equipment and

Remaining Manufactures b) Manufacturing Production in Mexico and

the U.S.2/

-10

-8

-6

-4

-2

0

2

4

6

J A J O J A J O J A J O J A J O J A J-45

-40

-35

-30

-25

-20

-15

-10

-5

0

5

10

15

20

25

Manufacturing industry excl.transport equipment

Transport equipment

2005 2006 2007 2008 2009

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

J A J O J A J O J A J O J A J O J A J

Mexico U.S.

2005 2006 2007 2008 2009

Source: INEGI. 1/ Three-month moving average.

Source: INEGI and Federal Reserve Bank. 2/ The series for Mexico excludes freight services and that

for the U.S. excludes both the automobile industry and high technology sector.


38

Activity in the rest of the manufacturing industry also rose during the July-August period. Several subsectors dedicated to manufacturing consumer and intermediate goods posted monthly increases in their levels of production. In this regard, increases in the clothing, wood, and plastic and rubber industries were outstanding. Nevertheless, the manufacturing industry continues to be affected by the lower levels of demand (Graph 27b).

Graph 28 Services

2005=100; seasonally adjusted figures1/

83

88

93

98

103

108

113

118

J2006

A J O J2007

A J O J2008

A J O J2009

A J A

Restaurants

Transport and mail services

75

85

95

105

115

125

J2006

A J O J2007

A J O J2008

A J O J2009

A J A

Entertainment and recreational

Private health care

Source: INEGI. 1/ Seasonal adjustments by Banco de México. Figures smoothed with a three-month moving average, except from 2009 onwards.

Finally, it is important to point out that, as a result of the positive results registered during the third quarter as compared with the levels observed in the preceding quarter, the considerable rate at which the services sector had been contracting during the first and second quarters of 2009, slowed significantly during the analyzed quarter. Indeed, in July the IGAE of services declined by 7.6 percent in annual terms, comparing favorably with the 9 percent annual fall posted during the first half of the year.

3.2.1.2. Aggregate Demand

During the third quarter of 2009, the negative trend exhibited by external demand eased mainly in response to the recovery of world economic activity. Consequently, and as will be shown in the corresponding section, merchandise exports contracted at a slower annual rate during the analyzed quarter. Various indicators of private consumption have also recovered in recent months. However, considering gross capital formation, it seems to have stopped falling, while imports of capital goods followed a positive trajectory during the analyzed quarter.

Among the timely indicators of consumption which suggested a change in pattern of this aggregate, total ANTAD sales was noteworthy. During the third quarter, these sales, measured in real and seasonally adjusted terms, recorded quarterly growth of 1 percent, after having grown 0.3 and 0.4 percent during the


39

first and second quarters, respectively.15 It is important to mention that such a large quarterly growth in these sales had not been seen since the second quarter of 2008 (Graph 29a). The higher growth of this indicator during the period suggests a recovery in aggregate consumption is underway.

The recovery of these sales during the third quarter of the year was mainly driven by department store chains, which made greater and more extended use of discounts and interest free payment plans.16 The improvement was observed across most of their different product lines and included both non-durable as well as durable goods. Stronger sales of the latter are particularly noteworthy given that, in several cases, these high quarterly growth rates had not been observed since the first quarter of 2008 (Graph 29b).

Graph 29 Domestic Demand: Consumption 1/

Quarterly change (percent) of seasonally adjusted figures a) ANTAD Sales in Real Terms b) ANTAD Sales of Different

Product Lines

-4

-2

0

2

4

I II2007

III IV I II2008

III IV I II2009

III

ANTAD

Supermarkets

Department stores

Specialized stores

-10

-5

0

5

10

15

II2006

III IV I II2007

III IV I II2008

III IV I II2009

III

GroceriesFurnitureMajor appliancesApparel and footwearElectronic,video equipment,computers

Source: ANTAD. 1/ Seasonal adjustments by Banco de México.

Other indicators of private consumption also improved during the third quarter of 2009. Such is the case of consumer goods’ imports which now seem to be following a pattern in line with a recovery in domestic spending. Consumer goods’ imports fell 33.3 percent in annual terms in current US dollars (29.1 percent excluding gasoline imports and 23.1 percent excluding both gasoline and vehicle imports; Graph 30a). This figure compares with falls of 37.6 and 39.9 percent during the first and second quarters of the year, respectively.

Gross fixed investment in Mexico grew at a monthly rate of 0.3 percent in seasonally adjusted terms during July, after having grown 0.5 percent during the preceding month. Investment therefore seems to have stopped contracting during the third quarter of 2009 (Graph 31). It is important to mention that 15 These sales grew 2 percent in annual terms during the analyzed quarter. This figure represents an

improvement from the 1.7 and 0.7 percent recorded during the first and second quarters of 2009. 16 In 2008, sales from the National Association of Supermarket and Department Stores (Asociación

Nacional de Tiendas de Autoservicio y Departamentales, ANTAD) accounted for approximately 30 percent of total retail sales in Mexico. Excluding retail sales of vehicles, vehicle spare parts and fuels, the corresponding figure is 43 percent.


40

investment in imported machinery and equipment registered consecutive monthly increases in seasonally adjusted terms between June and August. This behavior reflects an annual contraction of 14.1 percent in original figures for gross fixed investment during July 2009, as compared with the declines of 7.3 and 15.1 percent registered during the first and second quarters of 2009, respectively.

Graph 30 Domestic Demand: Consumption

Annual change (percent) a) Consumer Goods Imports

b) Domestic Retail Sales of

New Vehicles

-60

-50

-40

-30

-20

-10

0

10

20

30

40

50

I2004

II III IV I2005

II III IV I2006

II III IV I2007

II III IV I2008

II III IV I2009

II III

Total

Automobiles

Excluding gasoline, butaneand propane

-3

.9

-23.

6

0.7

-3.5

-6

.8

-30.

5

-5.8

4.

2

-18.

1 -2

5.9

-35.

8 -2

9.9

-37.

7 -3

8.2

-31.

6 -3

3.8

-31.

3

2006

2007

2008

2009

2009

A M J J A S

2008Quarter

I II III IV I II IIIQuarter

J-S

Source: Banco de México. Source: AMIA.

Graph 31 Domestic Demand: Investment

a) Gross Fixed Investment and Components 2005=100, seasonally adjusted figures and 3-month moving average, except from 2008

a) Gross Fixed Investment Annual change (percent)

86

96

106

116

126

136

146

156

166

J A J O J A J O J A J O J A J O J A J

Total

Construction

Mach. and equipment(imported)Mach. and equipment(domestic)

2005 2006 2007 2008 2009

-11.

8

9.8

8.4

8.1

-7.3

-15.

1

-16.

6-1

6.5

-12.

3-1

4.10.6

3.0

7.2

4.9

4.5

-13.

4

-7.2

6.4 7.

0

0.4

-14.

6

-14.

5

-11.

1

-14.

5

2006

2007

2008

2009 2009

I II III IV

2009

A M J J

♦Sesaonally adjusted

Jan-

Jul

Quarters

I II 2008

Source: INEGI.

Finally, some business climate indicators such as those prepared by Banco de México and INEGI in their Monthly Business Opinion Survey (Encuesta Mensual de Opinión Empresarial, EMOE), as well as indicators of business


41

confidence and prospective indicators for the Mexican economy, are in line with the change economic activity seems to be undergoing. In particular, the Manufacturing Purchasing Managers’ Index-Mexico (Indicador de Pedidos Manufacturero, IPM) and the Producer Confidence Index followed a positive trend from March 2009 onwards. This performance is in line with that shown by the Purchasing Managers’ Index (PMI) in the U.S. (Graph 32a). Furthermore, the recent evolution of leading indicators on the Mexican economy also suggests an upturn in the coming months (Graph 32b). It is worth pointing out that both the consumer confidence index and the private sector economic analysts’ confidence index have also followed a positive trend in recent months (Graph 33).

Graph 32 Business Climate Indicators and Leading Indicators

a) Purchasing Managers’ Index-Mexico, Producer Confidence Index, and Purchasing

Managers’ Index-U.S.; seasonally adjusted figures1/

b) Leading Indicators: INEGI and Conference Board


30

35

40

45

50

55

J2006

A J O J2007

A J O J2008

A J O J2009

A J S

PMI Mexico

Producer confidenceindex 2/

PMI U.S.

104

109

114

119

124

129

134

J2006

A J O J2007

A J O J2008

A J O J2009

A J

INEGI

Conference board

1/ Indicators with 50 point reference. 2/ Original series.

Graph 33 Business Confidence Indicators

a) Private Sector Analysts’ Confidence Index 2004=100; seasonally adjusted figures

b) Consumer Confidence Index January 2003=100; seasonally adjusted figures

20

30

40

50

60

70

80

90

100

J2006

A J O J2007

A J O J2008

A J O J2009

A J S

73

78

83

88

93

98

103

108

113

J2006

A J O J2007

A J O J2008

A J O J2009

A J S


42

3.2.1.3. Employment and Productivity

During the third quarter of 2009, the behavior of some labor market indicators such as unemployment and underemployment rates remained unfavorable. Although this partly reflects the seasonal characteristics of July and August caused by the pressure of young people looking for work during the summer vacations, even seasonally adjusted figures for unemployment rose as compared with the preceding quarter. Nonetheless, the demand for labor (measured by the number of IMSS-insured workers) seems to have stopped contracting in recent months, although it continued to decline in annual terms. The labor market’s performance during the quarter could partly be due to this market’s lagged response to the apparent changes in economic conditions in Mexico.

At the end of the third quarter of 2009, the number of IMSS-insured workers totaled 13,900,551, an increase of 106,790 workers as compared with the end of the preceding quarter. This figure compares with the fall of 87,116 workers observed during the second quarter of the year. However, it is worth emphasizing that this behavior is partly influenced by the seasonal nature of the number of IMSS-insured workers. According to seasonally adjusted figures, between July and September of 2009 the number of IMSS-insured workers fell by 36,581 as compared with the 234,808 and 131,498 observed during the two previous quarters, respectively. Thus, the rate of quarterly contractions in the number of IMSS-insured workers has slowed considerably.

In annual terms this indicator decreased by 540,213 workers (3.7 percent) compared to September of the previous year. This reduction compares with the annual contraction of 596,200 workers (4.1 percent) registered at the end of the previous quarter and was due to reductions of 513,177 workers in permanent jobs (4 percent) and of 27,036 workers in temporary jobs in urban areas (1.7 percent; Graph 34).

Graph 34 IMSS-insured Workers

a) Number of Workers Annual change of original figures

b) Permanent and Temporary Workers in Urban Areas

Annual change in absolute terms

-540

,213

(-3.

74%

)

525,

386

(3.8

7%)

603,

400

686,

103

-37,

535

(-0.

27%

)

J M M J S N J M M J S N J M M J S N J M M J S200820072006 2009

-513,177-4%

Apr. 2007505,922

4.3%

-27,036-1.7%

Jul. 2006184,78214.4%

-600,000

-500,000

-400,000

-300,000

-200,000

-100,000

0

100,000

200,000

300,000

400,000

500,000

600,000

J A J O J A J O J A J O J A J O J A J S

Permanent

Temporary in urbanareas

2005 2006 2007 2008 2009 Source: IMSS.


43

During the third quarter of 2009, the annual change in formal employment remained negative, mostly in the industrial sector. In September, the number of IMSS-insured workers in the manufacturing industry fell 8.5 percent in annual terms (325 thousand workers), while in the construction and services sectors, the reductions were of 10.5 percent (130.6 thousand) and 0.9 percent (78.7 thousand), respectively. However, it is important to point out that, despite these results, levels of formal employment do seem to have stopped falling, particularly in the industrial and services sectors (Graph 35).

Graph 35 Employment

a) IMSS-insured Workers by Sector 1/ Annual change (percent)

b) Permanent and Temporary Workers in Urban Areas

Million individuals; seasonally adjusted figures

-8.5

-10.5

-1.3

-1.6

-12

-8

-4

0

4

8

12

F2005

A J AODF2006

A J AODF2007

A J AODF2008

A J AODF2009

A J AS

Manufactures

Construction

Commerce

Services for firms,individuals and homes

7.5

7.7

7.9

8.1

8.3

8.5

8.7

J2006

A J O J2007

A J O J2008

A J O J2009

A J S4.7

4.9

5.1

5.3

5.5

5.7

5.9

6.1ServicesIndustrial

Source: IMSS. Seasonal adjustments by Banco de México. 1/ Three-month moving averages, except in 2008 and 2009.

Based on the results from the National Occupation and Employment Survey (Encuesta Nacional de Ocupación y Empleo, ENOE) conducted by INEGI, and which covers Mexico’s total labor market, Banco de México estimates that during the analyzed quarter, the total employed population grew slightly upwards in annual terms (Graph 36a). As for the real wage bill, it continued to decrease considerably in annual terms in the total economy and, in particular, in the formal sector. These results mirrored the fall in both job creation and real average earnings (Graph 37).17

17 In September 2009, the total wage bill in the formal sector fell 4.6 percent in anual terms as a result of

falls of 3.7 percent in the number of IMSS-insured workers and 0.8 percent in the IMSS average reference wage in real terms. On another front, the real wage bill indicator prepared with data from the ENOE (quarterly survey) fell 4.4 percent in annual terms during the April-June 2009 period. This figure resulted from reductions of 1 percent in paid workers and 3.5 percent in real average earnings.


44

Graph 36 Employed and Underemployed Population

a) Employed 1/ Annual change (percent) and moving average

of two quarters2/

b) Underemployed Percent in relation to employed population;

seasonally adjusted figures

-6

-4

-2

0

2

4

6

8

II III2006

IV I II III2007

IV I II III2008

IV I II2009

III-10

-8

-6

-4

-2

0

2

4

6

Total

Manufactures

ServicesConstruction

9.00

5

6

7

8

9

10

11

12

I II2005

III IV I II2006

III IV I II2007

III IV I II2008

III IV I2009

II III

Source: ENOE, INEGI. 1/ The employed population series is obtained from INEGI’s Occupation and Employment Survey (Encuesta Nacional de

Ocupación y Empleo, ENOE) and include the three sectors (primary, secondary, and services). Figures for employed population of the third quarter of 2009 are estimated by Banco de México.

2/ Except 2009.

Graph 37 Wage Bill and Average Earnings in Real Terms


-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

J MM J S N J MM J S N J MM J S N J MM J S-8

-6

-4

-2

0

2

4

6

8

Wage bill in theformal sector

Total wage bill

20082006 2007 2009

-2.0

-1.0

0.0

1.0

2.0

J MM J S N J MM J S N J MM J S N J MM J S-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

2006 2007 2008

Real average earnings in the formal sectorTotal average earnings

2009

Source: Prepared with data from IMSS (average reference wage and number of workers insured) and INEGI (Occupation and Employment Survey-Encuesta Nacional de Ocupación y Empleo, ENOE, using earnings per hour-worked, hours worked per week, and paid workers).

During the analyzed quarter unemployment rates rose as compared with the second quarter, despite the temporary effects of the A(H1N1) flu outbreak during the latter period. Indeed, according to the National Occupation and Employment Survey (Encuesta Nacional de Ocupación y Empleo, ENOE) conducted by INEGI, the seasonally adjusted national unemployment rate was 5.7 percent during the second quarter of 2009, while in the third quarter, 5.9 percent (Graph 38a). During the analyzed quarter, the seasonally adjusted


45

unemployment rate in urban areas reached 7.3 percent, as compared with 7 percent during the second quarter. The higher unemployment rates registered since the fourth quarter of 2008 and, particularly up to March 2009, have reflected the greater impact of layoffs associated with the prevailing economic conditions (Graph 38b).

The underemployed population, which are those individuals who reported needing or being willing to work more hours than their current job allowed, accounted, in seasonally adjusted terms, for 9 percent of the working population during the third quarter of 2009. This figure is considerably lower than the 11.1 percent observed during the preceding quarter (Graph 36b) and partly reflects the fading of the effects of the flu virus on underemployment during April and May of 2009.18 Nevertheless, underemployment during the analyzed quarter was still higher than during the first quarter of the year, before it was affected by the flu outbreak (7.9 percent).

Graph 38 National Unemployment Rate and Causes for Unemployment

a) National Unemployment Rate Percent and seasonally adjusted figures

b) Causes for Unemployment Percentage in relation to unemployed population with working experience 1/

5.90

7.25

2.8

3.2

3.6

4.0

4.4

4.8

5.2

5.6

6.0

6.4

6.8

7.2

I2003

III I2004

III I2005

III I2006

III I2007

III I2008

III I2009

III

National

Urban

53.66

35.93

28

32

36

40

44

48

52

56

60

I2005

II III IV I2006

II III IV I2007

II III IV I2008

II III IV I2009

II III

Lost or ended its job

Quit or left its job

Source: ENOE. 1/ Figures for the third quarter of 2009 estimated by Banco de México.

Output per worker for the total economy, calculated with information from both ENOE and Mexico’s National Accounts, grew -9.2 percent in annual terms during the second quarter of 2009, 2 percentage points below the preceding quarter’s figure. This result was due to the faster decline in production. This indicator declined less in the manufacturing sector, from -9.7 percent in annual terms during the first quarter of 2009 to -7.8 percent during the second quarter of the same year (Graph 39).

18 As pointed out at the time in the Inflation Report April-June 2009, indicators of unemployment and

particularly those of underemployment were influenced upwards by the effects of the preventive measures implemented to avoid the spreading of the A(H1N1) virus and by the effects of this outbreak on the demand for some activities during April and May 2009. The seasonally adjusted underemployment rate was 10.84 and 13.15 percent, respectively, during the referred months.


46

Graph 39 Output per Worker: Total Economy and Manufacturing Industry 1/

Annual change (percent) a) Total Economy b) Manufacturing Industry

-9.2

2.31.7 1.4 1.3

2.8

1.00.4 0.7

0.0 0.1

-7.2

-12

-10

-8

-6

-4

-2

0

2

4

6

III2006

IV I II III2007

IV I II III2008

IV I II2009

Output per worker

Production

Workers employed

-9.7

-7.8

1.61.31.5

3.62.3

5.8

1.40.40.9

-0.5

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

8

III2006

IV I II III2007

IV I II III2008

IV I II2009

Output per worker

Production

Workers employed

1/ To calculate the average output per worker, data on production from the National Accounts and on employed population from the

Occupation and Employment Survey (Encuesta Nacional de Ocupación y Empleo, ENOE) is considered.

3.2.1.4. Regional Economy

During the third quarter of 2009, economic activity in the different regions of Mexico moved towards an inflection point with several indicators signaling a possible change of trend.19 This change was more evident in the north region, which is characterized by a higher degree of synchronization with the international business cycle, and which is starting a phase of expansion. In this region, manufacturing production grew moderately, while formal employment exhibited positive monthly variations in August and September.

Seasonally adjusted formal employment in the north region registered a positive annual variation for two consecutive months at the end of the third quarter (Graph 40a). In addition, annual employment growth stopped falling in the north and center-north regions; however, this pattern is not observed in the south region (Graph 40b).

Manufacturing production expanded slightly in the north and center-north regions and it seems to have stopped contracting in the rest of the country at the end of the third quarter (Graph 41a). These results are based on a regionally representative survey of around 500 firms conducted by Banco de México (at the end of the first three quarters of 2009). In September 2009 manufacturers in all regions believed industrial activity will probably expand during the following quarter (Graph 41b).

19 The country regions are: North (includes Baja California, Chihuahua, Coahuila, Nuevo León, Sonora,

and Tamaulipas); Center-north (includes Baja California Sur, Aguascalientes, Colima, Durango, Jalisco, Michoacán, Nayarit, San Luis Potosí, Sinaloa, and Zacatecas); Center (Mexico City, Estado de México, Guanajuato, Hidalgo, Morelos, Puebla, Querétaro, and Tlaxcala); and, South (Campeche, Chiapas, Guerrero, Oaxaca, Quintana Roo, Tabasco, Veracruz, and Yucatán.


47

Graph 40 IMSS-insured Workers

a) Monthly change (percent) of seasonally adjusted figures

a) Annual change (percent) of seasonally adjusted figures

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

J2007

A J O J2008

A J O J2009

A J

NorthCenter-northCenterSouthNational

-10

-8

-6

-4

-2

0

2

4

6

J2007

A J O J2008

A J O J2009

A J

NorthCenter-northCenterSouthNational

Source: Estimates of Banco de México with data from IMSS.

Graph 41 Indicators of Activity in the Manufacturing Industry

a) Regional Survey on Manufacturing Activity Diffusion index 1/

b) Regional Survey on Manufacturing Activity for the Following Quarter

Diffusion index 1/

3438 36

4745

4743 43

54 5349 50

0

10

20

30

40

50

60

70

80

North Center-north

Center South

MarchJuneSeptember

45 46 46 47

5652

4951

62 63 6267

0

10

20

30

40

50

60

70

80

North Center-north

Center South

MarchJuneSeptember

Source: Banco de México. 1/ A value above 50 points indicates growth and below 50 points, contraction.

3.2.1.5. External Sector

During the third quarter of 2009, the behavior of Mexico’s external accounts was affected by a less unfavorable performance of external demand and higher levels of domestic expenditure. Indeed, during the analyzed period deficits were observed in both the trade and current account balances, in contrast with the surpluses registered by these accounts during the preceding quarter. This behavior mainly responded to the fact that goods’ imports rebounded and exports of goods and services have ceased to contract at the same rate as in previous


48

quarters. Although the fall in exports was curbed by the fading of the effects of the A(H1N1) flu outbreak on the flow of international travelers, the reestablishment of activity in some automobile plants and the impact on external vehicle sales of the car allowance rebate system in the U.S., the more recent behavior of exports of goods and services seems to have also be reflecting the recovery of the world economy. Finally, another factor which has affected Mexico’s external accounts during the quarter is the fact that astringent conditions prevailing in international financial markets since the end of 2008 and during the first half of the current year showed signs they were gradually loosening.

The main aspects characterizing the external sector during the analyzed quarter were as follows:

a) The trade balance shifted from surplus during the second quarter of 2009 (776 million US dollars) back into deficit during the third quarter (3,145 million). The non-oil trade balance deficit was 5,154 million US dollars during the July-September period of 2009, higher than the 1,843 million US dollar deficit registered during the second quarter, but below that of 9,652 million recorded during the third quarter of 2008. The behavior of the trade balance during the analyzed period mainly reflects stronger merchandise imports, although non-oil exports contracted at a slower rate. Under this setting, higher levels of domestic spending and manufacturing activity seem to be the main cause of larger external deficits.

b) During the third quarter of 2009, total exports fell by 25.9 percent in annual terms. This decline stemmed from reductions of 43.6 percent in oil exports and 21.7 percent in non-oil exports (Graph 42a).20 These results compare with the annual contractions of 31.6 percent in total exports, 52.8 percent in oil exports and 26.5 percent in non-oil exports observed during the preceding quarter.

c) The decline in the value of oil exports during the third quarter of 2009 (43.6 percent in annual terms), reflected reductions in both the average price of the Mexican crude oil export mix and in oil export volume.21 It is worth menntioning that, as a result of the increase in oil prices during recent months, the referred fall was below that observed during the second quarter of the year (-52.8 percent; Graph 42a). During the analyzed period the average price of the Mexican crude oil export mix was 63.90 US dollars per barrel, significantly below the average of 105.89 US dollars reached during the third quarter of 2008. Export volume fell 8.4 percent as compared to the third quarter of 2008. During the third quarter of 2009, oil product imports fell at an annual rate of 45.2 percent. As a result, during the July-September 2009 period, the oil trade balance recorded a surplus of 2,009 million US dollars, as compared with 3,225 million during the third quarter of 2008.

20 Oil exports fell 42.2 and 57.6 percent during the last quarter of 2008 and the first quarter of the current

year, respectively. During the same periods, non-oil exports declined 8 and 22.1 percent. 21 In 2009, the impact of the fall in the international reference price of crude oil will be partially offset by the

revenues from the federal government’s oil hedging in international financial markets.


49

Graph 42 Merchandise Exports and Imports

Annual change (percent) of seasonally adjusted figures and 2-month moving average a) Exports b) Imports

-30

-20

-10

0

10

20

30

J MM J2006

S N J MM J2007

S N J MM J2008

S N J MM2009

J S-80

-60

-40

-20

0

20

40

60

80

Non-oil

Oil-related

-40

-30

-20

-10

0

10

20

30

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J S

Total Non-oil


d) The value of non-oil exports decreased by 21.7 percent in annual terms during the third quarter of 2009, due to falls of 19.7 percent in automotive exports and 22.3 percent in exports of other non-oil products (Table 4 and Graph 43). The non-oil exports decrease was slightly smaller than that observed during the second quarter of the year (-26.5 percent). In general terms, it is possible to see that non-oil exports ceased to contract during the analyzed quarter (Graph 43).

Graph 43 Non-oil Merchandise Exports

Three-month moving average, except in 2008 and 2009 a) 2004=100 and seasonally adjusted figures b) Annual change (percent)

70

80

90

100

110

120

130

140

150

160

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J S

Total

Automotive

Remaining

-50

-40

-30

-20

-10

0

10

20

30

40

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J S

Total

Automotive

Remaining


Regarding non-oil exports, the decline in automobile exports during the July-September period (-19.7 percent) was substantially lower than


50

during previous quarters (-41 and -40.3 percent during the first and second quarters, respectively). This reflects the return to normal activity in some car makers after production was interrupted for most of the second quarter, combined with the favorable impact of the “Car Allowance Rebate System” in the U.S. on automobile exports. As for remaining non-oil exports, the annual fall of 22.3 percent was the same as that observed during the preceding quarter. From a regional perspective, non-oil exports to the U.S. contracted 21.7 percent, after having fallen 26.5 percent in the preceding quarter, while those to the rest of the world contracted by 22.1 and 26.4 percent during the same periods (Table 4 and Graph 44).

Graph 44 Manufacturing Exports to Different Markets

Seasonally adjusted figures, 3-month moving average, except in 2008 and 2009

Automotive a) 2004=100 b) Annual change (percent)

60

110

160

210

260

310

360

410

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J S

TotalTo the U.S.Rest of the world

-7.7-4

.8-2

0.2

-60

-40

-20

0

20

40

60

80

100

J MM J2006

S N J MM J2007

S N J M M J2008

S N J MM2009

J S


Manufacturing Non-automotive

c) 2004=100 d) Annual change (percent)

100

120

140

160

180

200

220

240

260

280

300

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J S


-20.

3-2

0.8

-18.

5

-30

-20

-10

0

10

20

30

40

J MM J2006

S N J MM J2007

S N J M M J2008

S N J MM2009

J S




51

Table 4 Growth of Non-oil Exports to Different Markets

Percent

Q-III2007 2008 2009 Q-I Q-II Sem-I Q-III

Total 100.0 100.0 100.0 5.17 -22.07 -26.46 -24.39 -21.74U.S. 82.54 79.86 79.29 1.75 -21.97 -26.47 -24.33 -21.66

Automotive 20.41 18.57 18.22 -4.32 -40.11 -39.37 -39.73 -16.28Other 62.13 61.29 61.07 3.74 -16.11 -22.51 -19.49 -23.13

Rest of the world 17.46 20.14 20.71 21.34 -22.48 -26.44 -24.64 -22.07Automotive 4.11 4.57 3.95 16.78 -44.92 -44.26 -44.57 -32.35Other 13.35 15.57 16.76 22.74 -15.33 -21.31 -18.63 -19.17

Total automotive 24.52 23.14 22.17 -0.78 -41.02 -40.33 -40.66 -19.68Total other 75.48 76.86 77.83 7.10 -15.96 -22.26 -19.32 -22.31

ShareAnnual 20092008

Annual Growth


e) During the third quarter of 2009, the value of merchandise imports fell 27.8 percent in annual terms as compared with the annual decline of 33.3 percent registered during the second quarter. During this period, oil-product imports dropped 45.2 percent (49.6 percent during the second quarter), while the remaining imports contracted by 25 percent (-31.2 percent during the preceding quarter).22 By type of goods, imports of consumer, intermediate and capital goods fell by 33.3, 26.7 and 27 percent, respectively. Seasonally adjusted figures suggest that imports followed a positive trend during the third quarter, in line with the gradual recovery of the domestic market (Graph 45).

Graph 45 Non-oil Imports


30

50

70

90

110

130

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J S

Consumer incl. automotive

Consumer excl. automotive

70

80

90

100

110

120

130

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J S

Intermediate use goods

Capital goods


During the July-August 2009 period, revenues from international travelers fell 21.4 percent in annual terms (-27.1 percent during the second

22 The contraction of non-oil imports was the result of falls of 28.3 percent in non-oil consumer goods’

imports, 24.1 percent in non-oil intermediate goods’ imports, and 27 percent in capital goods’ imports.


52

quarter). This result compares with the significant contractions of 49.2 and 28.9 percent observed in May and June, respectively. Thus, this behavior as well as the recent performance of hotel occupancy in Mexico, reflects the gradual fading of the effects of the flu outbreak on the flow of international travelers to Mexico (Graph 46). During the third quarter of 2009, revenues from workers’ remittances totaled 5,356 million US dollars, thus implying a 16.3 percent contraction in annual terms, after having fallen 4.9 and 17.9 percent in annual terms during the first and second quarters of 2009, respectively. Remittances therefore continued to follow a negative pattern in line with the contraction of employment in the U.S. housing construction sector.23 Despite the aforementioned, the nominal depreciation of the peso against the US dollar meant that, measured in domestic currency, revenues from remittances were higher during the third quarter of 2009 than during the same period of 2008 (Graph 47).

Graph 46 Tourism Indicators

a) Revenues from International Travelers Seasonally adjusted figures,

Million USD

b) Hotel Occupancy in Mexico in 2009 Annual change (percent) of number of

occupied rooms per week

550

650

750

850

950

1,050

1,150

J M M J2006

S N J M M J2007

S N J M M J2008

S N J M M2009

J A

-60

-50

-40

-30

-20

-10

0

10

20

30

16-M

ar

06-A

pr

27-A

pr

18-M

ay

08-J

un

29-J

un

20-J

ul

10-A

ug

31-A

ug

21-S

ep

05-O

ct

Total

Beach resorts

Cities

Influenza**

2008 2009Easter*

Source: Banco de México. Source: Prepared by Banco de México with data from the

Ministry of Tourism. * Easter 2008: March 17-23; Easter 2009: April 6-12. ** Outbreak began April 24.

The abovementioned, together with available information on other external account items, suggests that during the third quarter of 2009 the current account deficit of the balance of payments will have reached a 1.9 billion US dollar deficit, as compared with a 549 million surplus and a 4.5 billion deficit during the second quarter of 2009 and third quarter of 2008, respectively (Table 5).

________________________ 23 In 2008, 20.9 percent of all Mexican migrants working in the U.S. were employed in the construction

industry as compared with 18.7 percent during the period of January-September 2009.


53

Graph 47 Workers’ Remittances

Seasonally adjusted figures a) 2006= 100 b) Annual change

79.9

84.9

75

80

85

90

95

100

105

110

115

120

J N M J N M J N M J N M J

2005 2006 2007 2008 2009

US dollars

Constant pesos

Dec DecDec

S

-15.

51.

8

-24

-18

-12

-6

0

6

12

18

24

30

J N M J N M J N M J N M J

2005 2006 2007 2008 2009

US dollars

Constant pesos

Dec Dec Dec Dec

S


Table 5 Balance of Payments

Million US dollars

Q-I Q-II Q-III Jan-Sep Q-I Q-II Q-III Jan-SepCurrent account -2,647 -2,095 -4,463 -9,205 -3,452 549 -1,934 e/ -4,837 e/

Trade balance -1,648 -865 -6,427 -8,940 -1,961 776 -3,145 -4,330 Exports 70,084 79,403 78,467 227,954 49,996 54,338 58,162 162,496 Imports 71,732 80,268 84,894 236,894 51,957 53,562 61,307 166,826 Non-factor services -792 -1,938 -2,399 -5,130 -1,074 -1,758 -1,713 -4,545 Factor services -6,060 -6,233 -2,141 -14,433 -5,956 -4,173 -2,527 -12,656 Transfers 5,852 6,941 6,504 19,298 5,539 5,704 5,451 16,694 Workers' remittances 5,756 6,824 6,398 18,978 5,476 5,603 5,356 16,435

Capital account 8,831 1,727 2,297 12,854 -1,220 -3,498 3,875e/ -843e/

Errors and omissions -143 1,998 -185 1,670 -1,925 -1,729 - - -3,654e/

Change in net international reserves 6,051 1,629 -2,359 5,322 -6,585 -4,675 1,941 -9,319

Valuation adjustments -11 0 7 -3 -12 -3 0 -15

2008 2009

Source: Banco de México. e/ Estimated figures. Note: The capital account of the third quarter of 2009 includes errors and omissions.

Capital account figures for the third quarter of 2009 reflected less restrictive conditions in international financial markets.24 According to the latest preliminary information available, during the third quarter of 2009 the capital account (including errors and omissions) is expected to have recorded net inflows of around 3.9 billion US dollars. The latter was the result, among other factors, of

24 Revenue from the federal government’s oil hedging will be entered in the capital account in the fourth

quarter of 2009, at the maturity of the financial instrument. Total revenues will depend on the behavior of crude oil prices during the year. On the basis of observed prices up to August, during the first nine months of 2009, revenues from the referred hedging would total 4,988 million US dollars.


54

net inflows of 2,098 million US dollars of foreign investment in the stock market and 2,232 million in the money market, while during the July-August period, 818 million US dollars were registered as net foreign financing to the public sector. A modest inflow of foreign direct investment is also expected to have entered the country. Finally, during the third quarter, the International Monetary Fund made two Special Drawing Rights (SDR) allocations for the benefit of all its member countries. Mexico was allocated a total of 2,561.2 million SDR (around 4 billion US dollars), which were entered as international reserves at Banco de México, the counterparty being an increase in the central bank’s external liabilities.

Summing up, during the third quarter of 2009, the current account deficit is expected to have amounted to 1.9 billion US dollars, while the capital account (including errors and omissions) is anticipated to have recorded net inflows of 3.9 billion US dollars.25 During the analyzed quarter, Banco de México’s net international reserves increased by 1,941 million US dollars. As a result, at the end of the same quarter, the stock of international reserves was 76,122 million US dollars.

3.2.2. Financial Saving and Financing

3.2.2.1. Monetary Base, Net Domestic Credit, and International Assets

During the third quarter of 2009, the growth of the monetary base continued to slow down, from an average annual growth of 18.8 percent and 20.5 percent during the first and second quarters of 2009 to 16.2 percent during the third.26,27 During the January-September 2009 period, the monetary base recorded a negative flow of 52,757 million due to seasonal factors, and international assets decreased by 7,403 million US dollars as compared with December 2008. As a result, on September 30, the stock of international assets totaled 87,829 million US dollars. These factors implied an increase of 59,218 million pesos in Banco de México’s net domestic credit (Table 6).

25 Given the information available it is difficult to identify from these 3.9 billion US dollars how much

corresponds to the capital account and how much to errors and omissions. As a result, only the sum of these two concepts is considered. Table 5 shows the total amount of these resources in the capital account, while a value of zero is given to errors and omissions.

26 Changes calculated on the basis of the quarterly average of daily stocks. 27 The lower annual growth could be due to the gradual fading of two factors, mentioned in previous

inflation reports, which might have created a higher demand for monetary base: i) the gradual fading of the effect of the Tax on Cash Deposits (Impuesto a los Depósitos en Efectivo, IDE) on the composition of liquid asset portfolios towards greater demand for banknotes and coins, and ii) the dissipation of the greater use of cash associated with federal elections.


55

Table 6 Monetary Base, International Assets, and Net Domestic Credit

Millions Annual % Change

I II III (A) Monetary base (pesos) 577,543 524,786 14.4 -43,723 -2,189 -6,844 -52,757

(B) Net international assets (pesos) 1/ 2/ 1,317,292 1,185,052 9.1 -138,775 -57,350 84,150 -111,975

Net international assets (USD) 2/ 95,232 87,829 -11.2 -9,564 -4,158 6,318 -7,403

(C) Net domestic credit (pesos) [(A)-(B)] 1/ -739,750 -660,267 5.3 95,052 55,160 -90,994 59,218

(D) Gross reserves (USD) 95,302 87,806 -11.2 -9,665 -4,160 6,330 -7,495 Pemex 2,716 2,092 4,739 9,547 Federal government -4,714 -429 773 -4,369 Foreign exchange market operations 3/ -5,715 -5,920 -4,000 -15,635 Other 4/ -1,952 97 4,818 2,962

(E) Liabilities with less than six months to maturity (USD) 9,861 11,684 -24.9 -3,080 515 4,389 1,824

(F) International reserves (USD) [(D)-(E)] 5/ 85,441 76,122 -8.6 -6,585 -4,675 1,941 -9,319

At 30 Sep. 2009

Stocks

At 31 Dec. 2008

At 30 Sep. 2009

Accumulated at30 Sep. 2009

Quarter

Flows in 2009

1/ Net international assets’ cash flows in pesos are estimated using the exchange rate applied to each transaction. 2/ Net international assets are defined as gross reserves plus funding arrangements with foreign central banks with more than six months to maturity, minus total

liabilities payable to the IMF and funding arrangements with foreign central banks with less than six months to maturity. 3/ Corresponds to US dollars sold to commercial banks in this market through the following mechanisms: i) daily US dollar auctions at an exchange rate of at

least 2 percent above the exchange rate of the previous business day; ii) daily US dollar auctions without announced minimum price; and, iii) extraordinary sales of US dollars in the foreign exchange market.

4/ Includes yields on net international assets and other transactions. 5/ As defined by Banco de México’s Law.

3.2.2.2. Measures Undertaken in Mexico’s Financial System

During the third quarter of 2009, several measures were implemented to foster the orderly functioning of financial markets, particularly the foreign exchange market. Starting in June, Banco de México also implemented several measures to promote transparency and competition among banks, ensure greater access to banking services, and adequately protect the public’s interests (see Box 3).

In September 2009, for the third time in the year, the Foreign Exchange Commission updated its assessment on the balance of payments’ expected behavior, confirming that Mexico will face favorable conditions to finance the current account deficit in 2009.28 The current account deficit is therefore expected to be 11,617 million US dollars, figure below the previous projection of 18,108 million dollars published in May this year. This reduction resulted from an upward revision in forecasts for net exports as compared with previous estimates. Under these conditions, the Commission expects lower exchange rate volatility in response to improved global financial conditions and measures implemented in Mexico to restore the orderly functioning of financial markets, as well as less restrictive external financing conditions.

28 See Foreign Exchange Commission press release of September 1, 2009. Regarding the two previous

forecasts on the expected balance of payments’ results during this year, see the Exchange Commission press releases of March 5 and May 29 2009.


56

Box 3 Measures Implemented by Banco de México in the Financial System

One of Banco de México’s main goals is to promote the orderly development of the financial system. For this reason, the central bank has implemented a series of measures to encourage transparency in commission charging and competition among financial institutions, as well as to improve users’ protection and broaden the access to banking services.

I. Measures to Foster Transparency in Commission Charging, Competition among Financial Institutions, and to Improve Financial Service Users’ Protection.

1. Rules governing Commissions (Published in the DOF on July 21, 2009)

The Law for the Transparency and Regulation of Financial Services (Ley para la Transparencia y Ordenamiento de los Servicios Financieros, LTOSF), approved by Congress at the end of 2007, established that Banco de México must keep record of the commissions charged to customers of commercial banks and non-bank intermediaries (Sofoles and Sofomes), and register any changes to them. This record has allowed for setting principles on the charging of commissions which banks must comply with. Among these are the following:

• Commissions must be clear and transparent.

• Commissions shall only be charged on services actually provided and operations carried out by financial service users.

• Commissions should not hinder competition or user mobility.

Based on these principles, Banco de México issued regulations in order to reduce inappropriate practices in the charging of commissions. These included:

• Commissions for account management and for not maintaining a minimum balance in deposit accounts (checking and payroll accounts) cannot be charged together in the same period.

• Commissions cannot be charged to bank customers for bounced checks deposited in their accounts.

• Commissions to a bank customer for exceeding or trying to exceed their debit card account balance are eliminated. A similar rule applies to credit cards.

• Commissions cannot be charged when cancelling any of the following banking services: deposit accounts, credit or debit cards, direct debit agreements, and internet services.

2. New Regulations for Calculating and Publishing the Annual Percentage Rate of Charge (CAT, for its acronym in Spanish) (Published in the DOF on September 4, 2009)

Banco de México’s new regulations concerning the calculation and publication of CAT came into force on November 17, 2009. These rules intend to foster transparency and competition by standardizing calculation criteria and simplifying how CAT is presented in terms of publicity/advertising, contracts, and account statements. This will provide consumers with better information when choosing a credit product.

The formula and overall methodology for calculating CAT remains unchanged. However, modifications have been made to some assumptions:

• For reasons of publicity and advertising, CAT calculations will be based on a product’s average interest rate instead of on its maximum interest rate.

• In contracts, CAT calculations will be based on the product and each particular user’s specific interest rate.

• In account statements, calculations will be based on the user’s personalized interest rate.

• The Value Added Tax will not be considered in CAT calculations.

3. Publication of Effective Credit Card Interest Rates (September 10, 2009)

As part of its efforts to foster competition in the financial system, on September 29, 2009, Banco de México began to publish a Report on Effective Credit Card Interest Rates. The report provides information on credit card interest rates (excluding VAT) by banking institution and type of customer (returning and total). The report includes information on the number of cards, outstanding credit stocks in million pesos, the interest rate weighted by outstanding stock, the interest rate median, and the distribution of the credit stock by interest rate level.

4. Direct Debit Rules (Published in the DOF on September 22, 2009)

On December 1, 2009, rules to standardize and simplify the setting up of direct debit services were introduced for the benefit of customers:

• Commercial banks should use standardized forms for service arrangements, cancellation and charge disputes.

• Users can make direct debit arrangements directly with the bank holding their accounts or the provider of goods and services.

• In all cases, the cancellation of direct debit agreements will be free of charge and shall be done within 3 days as of June 1, 2010. Before this date, the time limit to cancel direct debit agreements will be 10 days.

5. Commissions for ATM use (October 12, 2009)

In order to bolster existing financial service users’ protection regulations by improving transparency in the charging of commissions and eliminating practices that obstruct healthy competition in both the broadening and use of the ATM network, Banco de México issued new regulations on the charging of commissions for ATM cash withdrawals and balance enquiries. These rules consider the following:

• Commissions Charging. When ATM operations are carried out with cards from a different bank than that of the ATM being used, only one of the two banks involved can charge a commission for the service.

• Information on ATM screens. ATMs do not currently display the total commission to be charged for the service requested. Under the new rules, the ATM screen must show the total amount of commission to be charged before the cash withdrawal or balance enquiry is authorized.

These regulations will go into force on January 15, 2010 for transactions where the card used is issued by the same bank as that operating the ATM, and on April 30, 2010 for operations where the issuing bank is different from that operating the ATM.


57

II. Measures to Improve Access to Banking Services

1. Mobile Accounts (June 26, 2009)

Banco de México issued regulations for a new type of commercial bank deposit account named “Simplified File Account” or “Mobile Accounts”. These accounts are part of a joint effort by several institutions to improve people’s access to banking services via mobile telephones. The rules also establish measures to foster competition and prevent possible discriminatory practices in fund transfer operations.

Mobile accounts can be opened by bank agents, including mobile telephone service providers.1 To open this type of accounts, a file (simplified) containing the bank customer’s full name, date of birth, and address must be included. Funds deposited in these accounts can be accessed by ordering electronic transfers (by mobile phone) to other mobile accounts and other deposit accounts in the same bank or among different banks.

1 Bank agents can be individuals with business activity or firms that will be able

to receive deposits from people, offer services and facilitate bank customers’ operations in the name of the bank and on its behalf.

As mentioned above, the level of international reserves strengthened during the third quarter due to the IMF’s SDR allocation. In order to provide liquidity to the world economy, on August 7, 2009, the Executive Board of the International Monetary Fund approved the allocation of SDRs equivalent to 250 billion US dollars agreed by the G20 in April this year. In addition, on August 10, the Fourth Amendment to the IMF’s Articles of Agreement came into force, providing for a special one-time SDR allocation of around 33 billion US dollars.29 As a result of these allocations Banco de México received a total of 2,561.2 million SDRs. The first general allocation for 2,337.2 million SDR, equal to 3,655 million US dollars, came into effect on August 28, 2009. Later, on September 9, Banco de México received a further 224 million SDR equal to 353 million US dollars from the special one-time allocation.30

On October 16, 2009, the IMF executive Board completed its six-month review of the Flexible Credit Line granted to Mexico in April this year and endorsed the country’s continued qualification to access FCL resources.31 This credit line is still a precautionary arrangement.

Given the expected improvement in Mexico’s external position and the orderly conditions in the exchange market, the Foreign Exchange Commission decided to: i) continue daily US dollar auctions without announced minimum price for 50 million US dollars until September 30, interrupting this mechanism on October 1; ii) continue daily auctions of 200 million US dollars at a minimum exchange rate 2 percent above the immediate previous business day’s exchange rate; and, iii) maintain the ability to carry out extraordinary currency sale auctions if market circumstances should require.

During the third quarter of 2009, a total of 4 billion US dollars were sold, mainly through auctions without announced minimum price. A total of 3,250 million US dollars were tendered through this mechanism, while 750 million were sold through auctions with announced minimum price.32

29 See Banco de México’s press release of August 27, 2009. 30 These SDR allocations were reflected in the growth of the “SDR Holdings” asset account which forms

part of the central bank’s international reserves in accordance with fraction IV of article 20 of Banco de México’s Law. This operation generates a long-term liability and is therefore not discounted from the international reserves (see the weekly report on Banco de México’s balance sheet of September 1, 2009).

31 See Foreign Exchange Commission press release of October 16, 2009. 32 During the January-September 2009 period, US dollar funding to the market totaled 15,735 million

dollars, of which 10,250 million were sold through the mechanism of daily auctions without announced minimum price, 3,650 million through auctions with announced minimum price, and 1,835 million through extraordinary auctions.


58

3.2.2.3. Financial Saving

As a result of the contraction in economic activity and employment, as well as the astringency and limited access prevailing in international financial markets, annual effective flows of both foreign and domestic financial resources have declined (Table 7). Information available up to the second quarter of 2009 on the sources and uses of financing show that the annual effective revalued flow from total sources of financing equaled 4.3 percent of GDP, implying a reduction in the availability of financial resources as compared with the first quarter of 2008 (4.8 percent of GDP).

Table 7 Total Funding for the Mexican Economy (Sources and Uses)

Percentage of GDP

2006 2007 2008 2009 Jun-09 % Structure Total sources 7.4 3.1 4.8 4.3 74.4 100.0 Domestic sorces 1/ 7.2 4.4 5.3 5.1 57.2 76.8 Foreign financing 2/ 0.2 -1.4 -0.4 -0.8 17.3 23.2 Total uses 7.4 3.1 4.8 4.3 74.4 100.0 Public sector 3/ 0.4 0.7 1.5 3.4 38.4 51.5 States and municipalities 0.1 0.1 0.1 0.3 1.5 2.1 Private sector 2.9 3.9 3.5 0.4 30.9 41.4 Households 2.1 1.6 1.5 0.0 12.9 17.3 Consumption 1.2 1.0 0.6 -0.6 4.1 5.5 Housing 4/ 0.9 0.6 0.9 0.6 8.8 11.8 Firms 0.7 2.3 2.0 0.4 18.0 24.1 International reserves 5/ 1.9 -0.9 1.4 -1.3 8.3 11.2 Other 6/ 2.2 -0.8 -1.6 1.4 -4.6 -6.2

StcockAnnual Flows to June of

Note: Figures may not add up due to rounding. Figures expressed as a percentage of average GDP of the last four quarters. The information on revalued

flows is stripped from the effect of exchange rate fluctuations. 1/ Annual revalued flows of Domestic sources exclude the effect of the reform to the ISSSTE Law on the monetary aggregate M4. Information on the

stock of Domestic sources corresponds to the monetary aggregate M4 (including the effect of this reform). 2/ Includes foreign financing for the federal government, public institutions and entities, and financed investment projects (PIDIREGAS), commercial

banks’ foreign liabilities and financing to the non-financial private sector. 3/ Public Sector Borrowing Requirements (Requerimientos Financieros del Sector Público, RFSP). The stock as a percentage of GDP refers to Public

Sector Borrowing Requirements’ historical stock (SHRFSP, for its acronym in Spanish) as reported by the Ministry of Finance (SHCP). Figures of revalued flows exclude the impact of the reform to the ISSSTE Law on PSBR. Information on SHRFSP does include the effect of this reform on the public debt.

4/ Total portfolio from financial intermediaries and from the National Housing Fund (Instituto del Fondo Nacional de la Vivienda para los Trabajadores, Infonavit). Includes debt-restructuring programs.

5/ As defined by Banco de México’s Law. 6/ A positive flow (negative) of this concept refers to a use (source) of financial funds.

Financial saving is defined as the monetary aggregate M4 less banknotes and coins held by the public, and is composed of residents and non-residents’ saving slightly slowed down during 2009. In the July-August period, this saving grew on average 7.3 percent in real annual terms or 3.4 percent if the effect of the change of ISSSTE’s Law is excluded (Graph 48a).33

Non-residents’ holdings of domestic financial assets are mostly made up of medium and long-term fixed interest government bonds and respond mainly to interest rate spreads as well as this type of investor’s appetite for risk. When conditions in financial markets began to deteriorate in October 2008, non-

33 The new ISSSTE’s Law effect does not constitute an effective flow of saving; rather it is recognized by

the public sector as a liability from ISSSTE workers.


59

residents withdrew significant amounts of financial resources. Although the recent improvement in prevailing financial market conditions and higher appetite for risk have led to positive monthly flows during the July-August period (Graph 48b), this type of saving contracted substantially in annual terms (15.8 percent in real terms) (Graph 48a). 34, 35

Voluntary saving by the country’s residents exhibited a lateral movement in its growth rate (3.7 percent in real average annual terms during the July-August 2009 period) (Graph 48c). The growth of residents’ compulsory financial savings (retirement and housing funds included in M4) rebounded, despite the fact that it has been adversely affected by the reduction of formal employment. This result responded, among other factors, to a greater channeling of Siefores’ resources to instruments included in the monetary aggregates and to a recovery in the market value of medium and long-term securities.36

Graph 48 Financial Saving

a) Domestic Financial Saving1/ Real annual change (percent)

b) Domestic Financial Saving 1/ December 2006 = 100; seasonally

adjusted figures

c) Voluntary Financial Saving

-2

0

2

4

6

8

10

12

14

16

18

J2004

J J2005

J J2006

J J2007

J J2008

J J2009

J-40

-20

0

20

40

60

80

100

120

140

160 Total 2/Residents 2/Non-residents

80

90

100

110

120

130

J2006

J J2007

J J2008

J J2009

J80

100

120

140

160

180

200

220 TotalResidents 2/Non-residents

-20

-10

0

10

20

30

40

J2004

J J2005

J J2006

J J2007

J J2008

J J2009

J

Private securitiesPublic securitiesBank depositsTotal

1/ Defined as M4 less the stock of banknotes and coins held by the public. 2/ Dotted lines exclude the effect of the coming into effect of the new ISSSTE law.

3.2.2.4. Financing

Available information shows that financing granted to the non-financial private sector continued to grow at slower rates during the third quarter of the year. The following factors possibly contributed to this deceleration. First, although there is evidence that private sector spending has recovered recently, demand for credit remains weak. Second, on the supply side, despite some improvement, there are still constraints in financial market conditions. Finally, the sources of funding have decreased and there has been a recomposition between public and private sectors’ use of this financing. The public sector has demanded a higher amount of financial resources and the fact that a deficit has been established as the objective for the public sector’s economic balance in 2009 implies an increase in its financial requirements (Table 7). It is important to point out that the current 34 Preliminary information on non-residents’ holdings of government securities shows the flow of

investment remained positive in September this year. 35 The comparison base contributed to this saving’s contraction given that historically maximum levels were

observed in August and September 2008 (398.4 and 399.3 thousand million pesos, respectively). 36 In January-August 2009, holdings of Bonos M and Udibonos accounted for 48.4 percent of Siefores’

portfolio and 29.7 percent of SAR resources included in the monetary aggregates.


60

shocks make it difficult to determine whether the reduction in financing to the private sector is the result of lower demand for financing or less available resources due to a reduction in the supply of financial funds and/or a greater use of resources by the public sector (“crowding out” effect).

The public sector has demanded an increasing amount of financing, using a growing proportion of the available financial resources. Information on the sources and uses of financing shows that the effective annual flow of funding to the public sector (including states and municipalities) has risen, reaching a level equal to 3.7 percent of GDP and 87 percent of total annual financing flow until June 2009 (as compared with 1.6 percent of GDP and 31 percent of total financing up to the second quarter of 2008). Meanwhile, the annual flow of financing to the non-financial private sector has declined, reaching 0.4 percent as a proportion of GDP until June 2009 (as compared with 3.5 percent of GDP until June 2008).

In recent months, states and municipalities have demanded more financing in order to compensate for the reduction in revenue sharing resulting from lower tax and oil revenues. In September 2009 a financing operation was carried out in an attempt to offset this reduction in revenue sharing. The operation is designed to leverage resources from the State Revenues Stabilization Fund (Fondo de Estabilización de Ingresos de las Entidades Federativas, FEIEF) that these governments will receive in 2009. It will allow them to obtain an additional 32,000 million pesos in credit for a term of 13 years and includes the participation of twelve of the country’s financial institutions.37

As for non-financial private firms’ use of financial resources, firms with access to various sources of financing (usually large companies) have changed their use of these sources according to the conditions prevailing in each different credit market. Up to the third quarter of 2007, external financing was an important source of funding for these firms. The deterioration of conditions in international financial markets stemming from problems in the subprime mortgage sector led to tighter access conditions to this source of financing (Graph 49a). In this environment, firms switched towards domestic sources of financing (debt instruments and credit) (Graph 49b). As a result, the debt market of non-financial private firms grew significantly during the first three quarters of 2008. Later, the worsening and spreading of the international financial crisis after the collapse of Lehman Brothers led to a substantial deterioration in domestic debt markets. This deterioration severely limited financing through new debt instrument placements in this market, especially medium-term issues (Graph 49c). Credit granted by commercial banks was also an alternative source of financing for these firms and in 2008 there was a shift in the direction of this credit from firms with less than 100 employees to large firms (Graph 50a). Finally, in recent months, the restoring of more favorable conditions to domestic debt markets has allowed for their greater use as a source of financing.

Both domestic and external sources of financing to non-financial private sector firms have decelerated in recent months. Despite the improvement of conditions in international financial markets and the decline in risk aversion, access to funding from these markets remains limited. Information available up to the second quarter of 2009 shows that the stock of external financing, expressed

37 See Ministry of Finance press release of September 14, 2009.


61

in US dollars, contracted 4.9 percent in annual terms (Graph 49a). On the other hand, domestic financing grew at an average annual rate of 2.2 percent in real terms during the July-August period (5.9 percent in the second quarter) (Graph 49b).

As for the recent developments of domestic financing to non-financial private firms, the recovery in the debt market, particularly medium-term instrument placements, and the significant deceleration of commercial banks’ performing credit to this sector are noteworthy. During the third quarter of 2009, firms’ average monthly placements of medium-term debt totaled 7.6 thousand million pesos (2.0 and 3.9 thousand million pesos in the first and second quarters of the year, respectively). As a result, the stock of non-financial private firms debt instruments in circulation grew on average 2.3 percent in real annual terms during the referred period (-0.6 percent in the second quarter of 2009) (Graph 49c). Commercial banks’ performing credit to non-financial private firms grew on average 4.0 percent in real annual terms in the July-August 2009 period (Graph 50b). The recent contraction in this type of financing has been observed both in that granted to firms with less than 100 employees as well as that granted to large firms (Graph 50a and Graph 50b). In addition, the portfolio quality of commercial banks’ credit to firms has deteriorated slightly (Graph 50c).

Graph 49 Total Financing to Non-financial Private Firms

a) Foreign Financing to Firms in USD


b) Domestic Financing to Firms

Real annual change (percent)

c) Private Securities from Non-financial Firms

Real annual change (percent)

-20

-10

0

10

20

30

40

S2006

D M J S2007

D M J S2008

D M J S2009

TotalDirectIssue

Sep 08Jun 07

-20

-10

0

10

20

30

40

M2006

S M2007

S M2008

S M2009

S

TotalCreditIssue

Sep 08Aug 07

-20

0

20

40

60

80

S 2006

M S 2007

M S 2008

M S 2009

-60

0

60

120

180

240

300

Total

MediumtermShortterm

Sep 08 Aug 07

The gradual improvement in financial market conditions during recent months has been reflected in lower financing costs. In international markets, interest rate spreads on Mexican corporate debt placements abroad have declined, although they remain above the levels prevailing before the international financial crisis deepened (Graph 51a). The cost of domestic financing has also decreased. The average weighted interest rates on new commercial bank credit to private firms have followed a downward trend, reaching 9.4 percent in June 2009 (Graph 51b). Meanwhile, interest rates on debt placed in the domestic market have also fallen substantially (Graph 51c). The spreads on these rates have tended to stabilize, and in the specific case of the spread on medium-term debt placements, it is currently at levels similar to those observed in the months prior to September 2008.


62

Graph 50 Commercial Banks’ Performing Credit to Non-financial Firms by Size of Firm, Performing Credit to Non-

financial Firms, and Delinquency Rates a ) Credit to Non-financial Firms by

Size of Firm (Number of Employees)

Real annual change

b) Performing Credit to Firms1/ Real annual change (percent)

Basis points

c) Delinquency Rate and Adjusted Delinquency Rate of Credit to

Firms3/

Percent

-10

10

30

50

70

90

J 2006 J J 2007

J J 2008 J J 2009

Lessthan 100workersMorethan 100workers

Sep 08Aug 07

23.617.3

26.4

29.6

18.316.0

-1.0-1.2

-40

-10

20

50

80

110

140

F2006

A F 2007

A F2008

A F2009

A-10

0

10

20

30

40

50Monthly annualized 2/

Half year average

Credit to Firms

0

2

4

6

8

F2006

A F2007

A F2008

A F2009

A

Delinquency rate

Adjusted delinquency rate

1/ Since February 2009, figures are affected by the reclassifying of credit granted to small and medium-sized firms (PyMES, for its acronym in Spanish) from

consumer credit to credit granted to non-financial firms. 2/ Seasonally adjusted figures. 3/ The delinquency rate is defined as non-performing portfolio divided by total loan portfolio. The adjusted delinquency rate is defined as the sum of non-

performing loans plus any write-offs or losses recognized by banks during the twelve previous months divided by total loan portfolio plus the abovementioned write-offs or losses. Source: Banco de México and CNBV.

Graph 51 Non-financial Private Firms’ Financing Costs

a) Interest Rate Spread on Non-financial Resident Firms’

Corporate Debt Instruments 1/

Basis points

b ) Weighted Average Interest Rate on Commercial Bank’s

Monthly Credit Use 2/ Percent

c) Weighted Average Interest Rates on Private Debt Securities

Percent

0

200

400

600

800

1,000

1,200

1,400

1,600

J 2006

J J 2007

J J 2008

J J 2009

J

Sep 08Aug 07

5

7

9

11

13

15

J 2006

J J 2007

J J 2008

J J 2009

Sep 08Aug 07

5

7

9

11

13

15

J 2006

J J 2007

J J 2008

J J 2009

J

ShorttermMediumterm

Sep 08Aug 07

1/ Spread in relation to risk-free rate on 5-year Treasury bill. Prepared by Banco de México with data from Bloomberg. 2/ Weighted average of nominal interest rate on credit granted by commercial banks’ to firms in pesos during the month. This indicator is calculated

considering the observations with minimum value coincident with the average bank deposits’ cost (Costo de Captación Promedio, CCP) of the coresponding month and stripped from atypical values. Banco de México estimates with data from CNBV.

Financing to households continued to decline sharply. Commercial banks’ performing consumer credit continued to contract, registering an average reduction of 21.3 percent in real annual terms during the period July-August 2009 (Graph 52a). Regarding the cost of this credit, the average weighted effective


63

interest rate of financing through credit cards was 33 percent in June 2009.38 It is possible that credit restructuring programs have mitigated the fall in this type of financing.39 Such programs might have contributed to the increase in the number of performing credit cards used during the first two quarters of 2009 (Graph 52b). Despite this restructuring, the quality of commercial banks’ consumer credit portfolio continues to deteriorate. On August 2009, the delinquency rate (Índice de Morosidad, IMOR) was 8.6 percent and the adjusted delinquency rate (Índice de Morosidad Ajustado, IMORA) was 23.9 percent (Graph 52c).40

Graph 52 Commercial Banks’ Performing Consumer Credit, Used Credit Cards, and Delinquency Rates

a) Performing Consumer Credit 1/ Percent and real annual change

(percent)

b) Used Credit Cards as a Percentage of Valid Credit

Cards 3/ Percent

c) Delinquency Rate and Adjusted Delinquency Rate of Consumer

Credit 4/ Percent

30.824.9

15.1

-23.1-18.1

2.8

-18.7

43.0

-60

-40

-20

0

20

40

60

80

100

F2006

A F 2007

A F2008

A F2009

A-40

-20

0

20

40

60Monthly annualized 2/Half year average

Consumer credit

62

64

66

68

70

72

74

76

78

80

M2006

J S D M J 2007

S D M J 2008

S D M J 2009

0

5

10

15

20

25

30

F2005

A F2005

A F2005

A F2005

A F2005

A

Delinquency rate


1/ Includes consumer credit granted by commercial banks’ subsidiaries Sofomes E.R. Since February 2009, figures are affected by the reclassifying of credit

granted to small and medium-sized firms (PyMES, for its acronym in Spanish) from consumer credit to credit granted to non-financial firms. 2/ Seasonally adjusted figures. 3/ Refers to the credit cards used during the quarter as a percentage of performing credit cards during the quarter. Valid credit cards are those that

commercial banks’ grant customers and have been activated by them. Includes holder and additional credit cards. 4/ The delinquency rate is defined as non-performing portfolio divided by total loan portfolio. Figures from March 2008 include consumer credit granted by

commercial banks’ subsidiaries Sofomes E.R. The adjusted delinquency rate is defined as the sum of non-performing loans plus any write-offs or losses recognized by banks during the twelve previous months divided by total loan portfolio plus the abovementioned write-offs or losses. Figures from March 2008 onwards include consumer credit granted by commercial banks’ subsidiaries Sofomes E.R. Source: Banco de México and CNBV.

Finally, commercial banks’ performing mortgage credit continues to grow at lower real annual rates. During the July-August 2009 period, this portfolio grew on average 3.6 percent in real annual terms (Graph 53a). As for the cost of this type of financing, the Total Annual Cost (Costo Anual Total, CAT) of a standardized mortgage product has remained stable since March 2009, reaching 38 Last September 10, Banco de México published the Effective Credit Card Interest Rates Report. This

document includes bimonthly indicators on the average weighted by the stock and average of effective credit card interest rates by banking institution and type of customer. In particular, the indicators shown in this inflation report refer to the effective average weighted interest rate of the system and returning customers, excluding VAT.

39 In order to support users of banking services who are behind in their loan payments, particularly those from credit cards, the National Commission for the Protection and Defense of Users of Financial Services (Comisión Nacional para la Protección y Defensa de los Usuarios de Servicios Financieros, Condusef), together with the Mexican Bank Association (Asociación de Bancos de México, ABM), established a process to facilitate debt restructuring. This process began in January 2009.

40 The delinquency rate is the ratio of non-performing portfolio to total loan portfolio. However, since this indicator is affected by banks’ decisions on sales and penalties for this portfolio, a more accurate indicator of debtors’ liabilities going into default is used: the adjusted delinquency rate. The adjusted delinquency rate is defined as the stock of non-performing loans plus charges or losses acknowledged by banks during the twelve previous months divided by total loans plus charges or losses aforementioned (see Financial System Report 2007, p.51, Box 21 and Inflation Report of July-September 2008).


64

14.4 percent in August of the same year (Graph 53b). The quality of the mortgage portfolio has also deteriorated. On August 2009, the delinquency rate of commercial banks’ mortgage portfolio was 4.3 percent and the adjusted delinquency rate, 5.9 percent (Graph 53c).

Graph 53 Commercial Banks’ Performing Credit for Housing, Housing Credit CAT, and Delinquency Rates

a) Commercial Banks’ Performing Credit for Housing

Percent and real annual change in percent

b) Housing Credit Annual Percentage Rate of Charge

(CAT) and Spread for Mortgage Credit Interest Rates3/

Annual percent

c) Delinquency Rate and Adjusted Delinquency Rate of Housing

Credit4/ Percent

-5.0

61.0

2.57.39.8

27.044.6

37.6

-20

0

20

40

60

80

100

120

140

160

F2006

A F 2007

A F2008

A F2009

A-10

0

10

20

30

40

50

60

70

80

90

100Monthly annualized 1/Half year average

Housing credit 2/

8

10

12

14

16

18

20

22

F2005

A F2006

A F2007

A F2008

A F2009

A0

5

10

15

20Range CAT min-max

Simple average (CAT)

Spread average rate and 10-year bond

0

2

4

6

8

10

F2005

A F2006

A F2007

A F2008

A F2009

A

Delinquency rate


1/ Seasonally adjusted figures. 2/ The dotted line excludes the purchasing of portfolio from mortgage Sofoles by commercial banks. 3/ Simple average, which summarizes the annual percentage rate of charge (APCR or CAT, for its acronym in Spanish) for a standard mortgage product.

The range of dispersion of the mortgage credit CAT (max-min range) is defined using the maximum and minimum indicators reported by commercial banks for the CAT for a standard mortgage product during a particular month. CAT information is obtained from Banco de México’s Search Engine Simulator of Mortgage Credits. The spread is defined using both the simple average of interest rates of mortgage credits (standardized product) granted by commercial banks, the 28-day TIIE, and the interest rate on 10-year government bonds.

4/ The delinquency rate is defined as non-performing portfolio divided by total loan portfolio. The adjusted delinquency rate is defined as the sum of non-performing loans plus any write-offs or losses recognized by banks during the twelve previous months divided by total loan portfolio plus the abovementioned write-offs or losses. Source: Banco de México and CNBV.

3.3. Some Considerations on the Determinants of Inflation

The analysis and information of the previous pages suggest that, although the trajectory of aggregate demand seems to be changing, it still remains at levels below the country’s output capacity. Furthermore, the performance of international prices of commodities and their futures suggest they will probably continue at lower levels during the following year than those observed in 2008. These two points are discussed in greater detail below.

Reflecting the most recent behavior of aggregate demand, the use of installed capacity rose slightly during the last few months, although it continues at very low levels. This is in line with indicators on manufacturing industry installed capacity use which, despite their modest increase in the July-August 2009 period as compared with the preceding quarter, still remain below the average levels observed during the 2006-2008 period (Graph 54a). Other indicators also suggest that the manufacturing industry has not faced shortage of skilled labor, probably as a result of the current labor market conditions (Graph 54b).


65

Graph 54 Manufacturing Sector

a) Capacity Utilization Percent

b) Labor Shortage Two-month moving average of balance of

responses

62

66

70

74

78

J A J O J A J O J A J O J A JA

Original

Seasonally adjusted

2006 2007 2008 2009

-30

-20

-10

0

10

S2000

M S M S2002

M S M S2004

M S M S2006

M S M D2008

MJ S2009

ProductionAdministration and sales

Greater difficulties to hire skilled labor in areas of:

Source: Results from Banco de México’s Monthly Survey on Manufacturing Activity. Balance of responses refers to the weighted

percentage of companies mentioning having faced difficulties to hire labor minus those mentioning having faced lesser difficulties to hire labor.

In line with the above, it is particularly relevant to mention that, given the recent behavior of the Mexican economy, the output gap (i.e. the difference at any given time between an economy’s observed GDP and potential GDP) is currently at levels considerably negative. In fact, Graph 55 uses GDP calculations for the third quarter of 2009 described above to update output gap estimates shown in the April-June 2009 Inflation Report. In particular, the red and blue lines correspond to output gap estimates obtained using the Hodrick-Prescott filter with tail corrections and a model of non-observed components, respectively. The shaded area shows a 95 percent confidence interval for the output gap, based on the latter methodology.41 As can be seen, both calculations suggest that, due to the contraction of GDP during the first half of the year, the output gap is currently negative, despite having increased during the third quarter in response to the rebound in economic activity described previously. Thus, according to these results, observed GDP is significantly below potential GDP. This also suggests that aggregate demand has not constituted a significant source of inflationary pressures but, on the contrary, it has tended to reduce the impact on prices of other shocks, such as the pass-through of exchange rate fluctuations observed at the end of last year and the start of this year.

In line with the deceleration in private spending during the lower stage of the current business cycle, a reduction was observed in the available sources of financial saving and in financing to the non-financial private sector. In addition, under the present environmen where public expenditure, both consumption and investment, is stronger than that of the private sector, the public sector has used more financial resources. Given the current scarcity of financing, this greater requirement of financial resources by the public sector tends to reduce the amount of available resources, effectively crowding out the private sector. Although the

41 These methodologies are described in the inflation report of the second quarter of 2009. See Banco de

México (2009), “Inflation Report, April – June 2009”, p.74.


66

nature of the shocks faced by the Mexican economy make it difficult to determine whether the reduction in financing to the private sector is the result of credit supply or demand factors, lower financing to the private sector is contributing to curb the growth of private spending and, thereby, to reduce the pressure on prices.

Graph 55 Output Gap Estimates

-12

-9

-6

-3

0

3

6

9

2004 2005 2006 2007 2008 2009

HP with tail corrections

Unobserved components

Interval at 95% level of confidence

In terms of the above it is also important to point out that the modest recovery which to date seems to be taking place in expenditure and manufacturing, caused Mexico’s trade balance and current account to shift from the surplus recorded during the second quarter to a deficit during the analyzed quarter. This behavior was mainly the result of higher imports. Although the aforementioned suggests that demand was stronger during the third quarter, the fact that the current account deficit remains at low levels does not seem to indicate the presence of significant demand side pressures on the external accounts or of any difficulties in financing it.

Regarding possible inflationary pressures associated with international commodity prices, after the increases observed during the first half of the year, these prices generally tended to stabilize during the third quarter. This behavior placed international commodity prices at lower levels than those observed during the previous year. Futures curves for most commodities also suggest that during the following twelve months prices of food, energy and metal commodities will remain below the levels recorded in 2008.

Summing up, the recent behavior of different indicators on aggregate demand as well as those associated with the output gap and the country’s external accounts, plus the development of international commodity prices, suggest that all of these have contributed to the reduction in inflation during the analyzed quarter. Under this context, the fact that the decline in inflation has been modest and slower than in other economies does not seem to have been the result of demand side pressures or of international commodity prices.


67

4. Monetary Policy

Inflation continued to fall during the third quarter. In September, annual headline inflation was 4.89 percent, after having reached 6.53 percent in December 2008. As has been explained, the depreciation of the real exchange rate in Mexico led to an increase in the relative price of merchandise as compared to those of services (Graph 56a). Thus, during the first three quarters of 2009 annual core merchandise inflation remained above core services inflation (Graph 56b). The former continued to follow the downward trend it had exhibited since May, decreasing from 7.17 percent in April to 6.38 percent in September. This decline was helped by the fact that the pass-through effect from the exchange rate depreciation to consumer merchandise prices has apparently been absorbed. Meanwhile, the annual core inflation of services also continued to follow the downward pattern it had started in January of this year, falling from 5.07 percent in December 2008 to 3.56 percent in September 2009.

Graph 56 Relative Price of Merchandise in terms of Services,

Bilateral Real Exchange Rate between Mexico and the U.S., and Headline Inflation and Core Merchandise and Core Services Inflation

a) Relative Price of Merchandise in terms of Services1/ and Bilateral Real Exchange

Rate between Mexico and the U.S.2/ Logarithm Index 2000=100

b) Headline Inflation and Core Merchandise and Core Services Inflation

Percent

4.40

4.45

4.50

4.55

4.60

4.65

4.70

4.75

4.80

J J J J J4.50

4.60

4.70

4.80

4.90

5.00

5.10

5.20

5.30Relative price M/S

RER (right axis)

1992 1996 2000 2004 2008

4.89

6.38

3.56

1.0

1.52.0

2.5

3.03.5

4.0

4.5

5.05.5

6.0

6.57.0

7.5

J D J D J D J D J D J D J

Headline inflationMerchandiseServices

2003 2004 2005 2006 2007

Dec 08

2008 2009

1/ The relative price of merchandise is defined as the ratio of the core merchandise price subindex to the core services price subindex. Last figure: September 2009.

2/ Increases in the bilateral real exchange rate index represent depreciations.

The improvement in inflation is also evident when different backward-looking indicators are analyzed, which are useful to analyze its recent evolution. The trimmed means of headline inflation continued to decline, shifting from 4.95 in June to 4.09 in September (Graph 57a). This suggests that the improvement in inflation can be attributed to progressively lower increases in the prices of a large number of products.42 A similar result is obtained from the trimmed means of core 42 The trimmed means of inflation offer information on prices of products located in the center of the

distribution, i.e. those whose price changes have not been extreme and are therefore not at the tails of the distribution. In this case, these indicators consider 80 percent of the basket of the referred price


68

services inflation which fell from 3.50 in June to 3.24 in September (Graph 57c). Meanwhile, the trimmed means of core merchandise inflation, which had followed an upward trend until July, reaching 5.98 percent in that month, began to decline in August, reaching 5.52 percent in September (Graph 57b).

Graph 57 Annual Inflation and Inflation Indicators excluding the Contribution of Extreme Upper and Lower Price

Variations Trimmed at 10 Percent 1/ Annual percent

a) Headline Inflation b) Core Merchandise Inflation c) Core Services Inflation

4.89

4.09

1.01.52.02.53.03.54.04.55.05.56.06.57.07.5


Annual headline inflation

Trimmed mean 10 percent

2003 2004 2005 2006 2007

Dec 08

2008 2009

6.38

5.52

1.01.52.02.53.03.54.04.55.05.56.06.57.07.5


Merchandise inflation


2003 2004 2005 2006 2007

Dec 08

2008 2009

3.56

3.24

1.01.52.02.53.03.54.04.55.05.56.06.57.07.5


Inflation services


2007

Dec 08

200920082003 2004 2005 2006

1/ The trimmed mean excludes the contribution of extreme variations in certain items’ prices from headline inflation. To strip these variations, the following calculations are done: i) monthly seasonally adjusted variations of CPI prices are arranged in descending order; ii) the items with the highest and lowest variation are excluded, considering up to 10 percent of the CPI basket, respectively, in each distribution tail; and, iii) with the remaining items, which, by construction, are located at the center of the distribution, the trimmed mean is constructed.

Another set of indicators that offers information on the recent evolution of inflation is obtained by monthly analysis of the annual price variations of each product included in the CPI. This study allows for calculating the accumulated distribution of these price changes, which can be used to infer which proportion of CPI basket items register annual price variations above or equal to a certain level.

In the case of the CPI, these indicators continued to improve during the third quarter. Thus, while in June 2009, 37 percent of the CPI basket exhibited annual price variations of 3 percent or lower, in September this share increased to 40 percent (Graph 58a). Meanwhile, the proportion of the basket with annual price variations below or equal to 4 percent rose from 47 to 53 percent during the same period. However, in the case of the core merchandise subindex, this indicator has still not exhibited any significant improvement. The share of the basket with annual price variations of 3 percent or below was 24 percent in September, a level similar to that registered in June (25 percent) (Graph 58b). The proportion of the basket with annual price variations of 4 percent or below remained at 34 percent during the third quarter. Indicators for the core services subindex continued to improve during the analyzed quarter. The percentage of the basket with annual price variations of 3 percent or below rose from 37 percent in June to 40 percent in September, while the proportion with price variations of 4 percent or below increased from 53 to 58 percent during the same period (Graph 58c).

________________________ index due to the fact that products with the highest and lowest price changes are excluded and account for 10 percent of the index’s basket on each distribution tail. As a result, a decline in the trimmed means of inflation of a particular index indicates that the price increases of most products in the index are progressively lower.


69

Graph 58 Cumulative Share of the Consumer Price Index According to its Annual Price Variations 1/

Annual percent a) CPI b) Core Merchandise Subindex c) Core Services Subindex

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

-3 -1 1 3 5 7 9 11 13 15

Shar

e of

CPI

Jun-09

Sep-09

Lower inflation

Higher inflation

0.530.47


0.37

0.40

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

-3 -1 1 3 5 7 9 11 13 15

Jun-09

Sep-09

Lower inflation

Higher inflation


Shar

e of

mer

chan

dise

sub

inde

x0.240.25

0.340.34

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

-3 -1 1 3 5 7 9 11 13 15

Jun-09

Sep-09

Lower inflation

Higher inflation

Sha

re o

f ser

vice

s su

bind

ex


0.400.53

0.58

0.37

1/ The cumulative distribution of the annual price variations in a price index is calculated as follows: i) a proxy is obtained of the density function of the annual

price variations of a particular index; ii) a cumulative distribution is obtained considering the weights of each item within the subindex, from its lowest to its highest annual price variations.

The abovementioned indicators show that the effects of the slackness in economic activity became more evident during the third quarter. As has been pointed out, in the case of merchandise during the first months of the year this effect was offset by the pass-through effect from the depreciation of the exchange rate. However, as merchandise prices have absorbed this effect, the impact of economic contraction on core merchandise inflation has started to become more evident. Starting in August 2009, the decline in annual core merchandise inflation not only responds to lower annual price variations of the processed foods, beverages and tobacco group, but also to the lower annual inflation in the remaining merchandise group (Graph 59a). In the case of the core services subindex, the lower annual price variations observed during the third quarter are attributed to reductions in the annual inflation of all three of its components: housing, education, and remaining services (Graph 59b).

Graph 59 Core Price Subindices Annual change (percent)

a) Merchandise Subindex b) Services Subindex

0

2

4

6

8

10

12

14

D J D J D J D J

Merchandise

Remaining merchandise

Processed foods, beveragesand tobacco

Dec 08

20072006 2008 2009

0

1

2

3

4

5

6

7

8

D J D J D J D J

ServicesHousingRemaining servicesEducation Dec 08

20072006 2008 2009


70

As is well known, annual inflation indicators can be influenced by “step” effects. It is therefore useful to compliment the study of the recent path of inflation with monthly inflation figures. These indicators offer information on the direction of the changes inflation has undergone recently at the margin. For this reason, indicators on the monthly inflation trend of different price subindices are described below.43

In the case of the core merchandise subindex, the indicator on the path of its monthly inflation started to follow a downward trend since February 2009, three months before its annual inflation indicator started to decline in May (Graph 60a). Within this subindex, the indicators for the processed foods, beverages and tobacco group began to fall in January 2009, while that for the remaining merchandise group started to do so in April 2009. As mentioned, the improvement in merchandise inflation indicators has become more widespread as the pass-through effect from the depreciation of the exchange rate to merchandise prices has been absorbed. This phenomenon is shown by indicators on the monthly path of the inflation of various subgroups within the remaining merchandise group. Indicators for the subgroups of furniture, domestic appliances and accessories, as well as health and personal care, followed a downward trend since the second quarter of the year (Graph 60b). In the case of the education and leisure subgroup, after having followed an upward trajectory during the first half of the year, the corresponding indicator ceased to increase during the third quarter and even fell slightly in September. However, indicators on the subgroups of apparel, footwear and accessories, and transportation still rose slightly during the third quarter. It is worth mentioning that, the first three subgroups whose monthly inflation indicators exhibited a downward trend, account for 60.6 percent of the core merchandise subindex, while the share of the latter two subgroups with monthly inflation indicators is 39.4 percent.

Largely in response to the phase of the business cycle the Mexican economy is currently undergoing, indicators on the monthly inflation of the core services subindex reached an inflection point during the third quarter of 2008 and began to decline since then (Graph 60c). Also, the impact of the slackness in economic activity on services inflation is shown by the decreases observed in the monthly inflation trend indicators of the housing, education and remaining services groups during recent quarters. In fact, the indicators for practically all the subgroups within the remaining services group have been declining in the last few quarters (Graph 60d).

The indicators described above show that the improvement observedin inflation during 2009 has been in line with the forecasts published in the last two inflation reports.

As pointed out in the previous Inflation Report, due to the sharp contraction of economic activity in Mexico during the first half of the year, different output gap indicators suggest that it widened considerably during that period. The size of the output gap prevailing towards the end of the first half of the year is estimated to have been of such magnitude that, despite the recovery anticipated for the second half of 2009 and for 2010, it is expected to remain substantially 43 To obtain these trend indicators, seasonal and irregular components are removed from an index’s

monthly inflation figures. This is done by identifying the information included in frequencies of up to 16 months in the interest variable’s time series, which is then stripped in order to obtain the trend indicator. For a description of this methodology, see Ysusi, C., 2009, “Analysis of the behavior of inflation in Mexico using wavelets”, Research Document No. 2009-09, Banco de México.


71

negative for some time. It is therefore foreseeable that this will contribute to a continued slow downward inertial trend in inflation during the following quarters (that is, without taking into account the possible effects on inflation of some of the fiscal measures proposed for the 2010 budget).

Graph 60 Trend Indicators of the Monthly Change in Core Price Subindices 1/

Monthly change (percent) a) Merchandise Subindex b) Remaining Merchandise

0.0

0.2

0.4

0.6

0.8

1.0

1.2

D J D J D J D J

Merchandise

RemainingmerchandiseProcessed foods,beverages and tobacco

Dec 08

20072006 2008 2009

0.0

0.2

0.4

0.6

0.8

1.0

1.2

D J D J D J D J

Apparel, footwear and accesories

Health and personal care

Transportation

Education and entertainment

Furniture, and domestic appliancesand accesories

Dec 08

20072006 2008 2009

c) Services Subindex d) Remaining Services

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

D J D J D J D J

ServicesHousingRemaining servicesEducation

Dec 08

20072006 2008 2009

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

D J D J D J D J

Health

Automobile services

Personal care

Apparel cleaning

Entertainment

Professional and funerary services

Hotels, tourism exp., and air travel transport

Fast food, rest, bars and cafeterias

20072006 2008 2009

Dec 08

1/ The trends of monthly price changes were calculated using wavelets (Haar base). This type of methodology allows for filtering

time series in different scales. All changes corresponding to cycles below 16 months were stripped from the series to obtain a trend estimate.

Regarding the inertial outlook for inflation in the near future, it is important to complement its analysis with data from another set of forward-looking indicators. First, economic agents’ prospects for inflation at the end of 2009 obtained directly by Banco de México from its survey of private sector economic analysts indicate that economic agents are in line with the forecast that inflation will continue to diminish during the fourth quarter of the year. In particular, the average of responses to this survey place inflation at 4.3 percent at the end of 2009 (Graph 61a).


72

Nonetheless, economic analysts’ previsions for inflation for the end of 2010 increased during the third quarter. In the case of Banco de México’s survey, the consensus among private sector analysts’ forecasts rose from 3.86 percent in June’s survey to 4.28 percent in that of September (Graph 61a).44 This increase is composed of a rise in the consensus among analysts’ expectations for core inflation for the end of 2010, from 3.80 to 4.09 percent and from 4.04 to 4.85 percent in their prospects for non-core inflation (Graph 61b).45,46 Clearly, the deterioration in economic analysts’ inflation expectations for the following year can mostly be attributed to the possible effect on inflation of some of the measures included in the fiscal budget for 2010 put before Congress on September 8 this year.

Graph 61 Expectations for Annual Headline Inflation

Annual percent a) Expectations for Annual Headline Inflation

b) Expectations for Annual Headline Inflation

for the end of 2010

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

D M J S D M J S D M J S

Next 12 months

End 2009

End 2010

2008 2007 2009

Dec 08

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

D J F M A M J J A S

Headline

Core

Non-core

2009

Source: Banco de México’s Survey. Source: Banco de México’s Survey.

Although the rise in inflation expectations for 2010 constitutes a risk for inflation, up to now the increase in inflation forecasts for longer-term horizons has been more modest. In the case of inflation expectations for the end of 2011, the consensus among analysts rose from 3.71 percent in the June survey to 3.83 percent in that of September (Graph 61a). Meanwhile, the consensus of expectations for average annual inflation during the following four years rose from 3.63 to 3.81 percent in the referred period. According to Infosel’s survey, the consensus of economic analysts’ expectations for average annual inflation for a horizon of 5 to 10 years has remained around 3.45 percent since the end of June.

As shown in previous inflation reports, another indicator that allow to extract information on economic agents’ long-term inflation expectations is the

44 Infosel’s survey of inflation expectations showed similar results. The consensus of forecasts for headline

inflation for the end of 2010 rose from 3.73 to 4.30 percent. 45 Expectations for non-core inflation are taken from information on forecasts for headline and core inflation

published in the surveys. 46 A similar result is obtained in Infosel’s survey of expectations. From the survey of June 25 to that of

October 23, the consensus of forecasts for core inflation for the end of 2010 increased from 3.71 to 4.03 percent, while forecasts for non-core inflation rose from 4.0 to 5.10 percent.


73

compensation for inflation indicator (inflation expectations plus a risk premium) demanded by investors for holding nominal long-term peso denominated bonds (10 years). This indicator, obtained from the difference between the nominal yield on 10-year bonds and the real yield on same term indexed debt instruments (Udibonos), rose from around 4 percent at the end of June to around 4.5 percent at the end of October, if with a certain amount of volatility common to this type of indicator (Graph 61b).47

The recent behavior of indicators offering information on inflation expectations suggests that although prospects for longer-terms increased slightly during the third quarter, they have remained relatively well anchored. Nonetheless, it is important to continue monitoring closely the future performance of these indicators in the future.

Graph 62 Expectations for Annual Headline Inflation, and Compensation for Inflation and

Inflationary Risk on Long-term Bonds Annual percent

a) Expectations for Annual Headline Inflation1/

b) Compensation for Inflation and Inflationary Risk on Long-term Bonds2/

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

5.50

D J D J D J D J D J

Banxico survey:expectations next 4 years

Infosel survey:expectations next 5-10years

Banxico survey:expectations end 2011

Dec 08

2005 2006 2007 2008 2009

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

5.50

D J D J D J D J D J

Compensation implicitin 10-year bonds

Moving average 20days

Dec 08

2005 2006 2007 2008 2009

Source: Banco de México and Infolsel Surveys. 1/ In the case of Infosel Survey, a monthly average is used.

Source: Bloomberg. 2/ Compensation for inflation and inflationary risk implicit in

10-year bonds are calculated on the basis of nominal and real interest rates from the secondary market.

As mentioned previously, appetite for risk in international financial markets improved during the third quarter. Under environment, sovereign risk indicators for emerging economies continued to decline, while these economies’ nominal exchange rates appreciated and interest rates on their long-term local currency denominated sovereign bond issues fell slightly (Graph 63). In the case of Mexico, as has been pointed out in the last three Inflation Reports, the measures adopted by the financial authorities also contributed to the recovery of the referred indicators.48 However, it is clear that indicators on the Mexican economy have improved less than those of other economies in the region, particularly in the case of the exchange rate (Graph 63b). As shown, this mainly 47 Due to their nature, this type of indicator tends to be affected by changes in liquidity conditions prevailing

in the money market. Their highly volatile variations should therefore be interpreted with caution. 48 See inflation reports of October-December 2008, January-March 2009 and April-June 2009, Banco de

México.


74

seems to be the result of ongoing uncertainty surrounding the structural weakness of public finances and the Mexican economy’s capacity to make progress in the field of structural reforms.

The events described above have been reflected in the development of the yield curve in Mexico. Due to the decline of 25 basis points in the target for the overnight interbank rate in July, the yield on the 3-month bond went from around 4.85 percent at the end of June to 4.60 percent at the end of July, remaining around this level for the rest of the quarter and the first weeks of October (Graph 64a). On another front, in an environment of greater appetite for risk in international financial markets, during the reference period longer-term interest rates declined less than shorter-term rates. In particular, the yield on the 10-year bond fell from levels close to 8.20 percent at the end of June to around 8.15 percent in recent days, although with some volatility. As pointed out, this took place in an environment where long-term inflation expectations have remained relatively well anchored. Thus, the yield curve slope, measured as the difference between the yield on 10-year and 3-month bonds, steepened slightly from levels observed at the end of the first quarter (335 basis points), to those recorded recently (355 basis points) (Graph 64b).

Graph 63 Sovereign Risk (EMBI), Nominal Exchange Rate, and Long-term Interest Rates in

Some Emerging Economies a) EMBI

(1-Jan-08 =100) b) Exchange Rate in some Latin

American Economies (1-Jan-08 =100) 1/

c) Long-term Interest Rates1/

50

100

150

200

250

300

350

400

450

D M J S D M J S

BrazilChileColombiaMexicoPeru

2008 2009

31 Dec 30 Jun

70

80

90

100

110

120

130

140

150

D M J S D M J S

BrazilChileColombiaMexicoPeru

2008 2009

31 Dec

30 Jun

0

5

10

15

20

25

D M J S D M J S

0

4

8

12

16

20 Brazil (right scale)ChileColombiaMexicoPeru

2008 2009

31 Dec 30 Jun

Fuente: Bloomberg. Source: Bloomberg.

1/ US dollar exchange rate. An increase equals depreciation.

Source: Bloomberg. 1/ For Colombia, the interest rate is of 6 years; for

Brazil, 7 years; and, for Chile, Mexico and Peru, 10 years.

During the third quarter interest rates corresponding to the middle of the yield curve did not decline, remaining at levels around 5.4 percent. This could be attributed, among other factors, to: i) the rise in inflation expectations for 2010; ii) an increase in the risk premia demanded by investors in response to uncertainty associated with the structural weakness of public finances; and/or iii) expectations of higher short-term interest rates in the future, above all resulting from the possible impact on inflation of the different fiscal measures proposed for 2010.

As a result of the behavior of interest rates in Mexico, together with those of the U.S, which remained at low levels (although longer-term rates exhibited some volatility), during the third quarter and the first weeks of October


75

the spread between overnight interest rates in both countries have remained close to 425 basis points since July 17 (Graph 65). The spread between 10-year interest rates remained around 465 basis points during the reference quarter and recent weeks, although with some volatility.

Graph 64 Interest Rates in Mexico

Annual percent a) Interest Rates 1/ b) Yield Curve

4.04.55.05.56.06.57.07.58.08.59.09.5

10.010.511.011.512.0

D M J S D M J S D M J S D M J S

1 day (overnight)3 months2 years10 years

2006 2007 2008

31 Dec

2009

30 Jun

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0 31-Dec-0830-Jun-0927-Oct-09

day months years

1 63 11 2 5 10 20 30

1/ Since January 21, 2008, the one day series corresponds

to the target for the Overnight Interbank Rate (Banco de México’s operating target).

Graph 65 Interest Rate Spreads between Mexico and the United States

Basis Points

150200250300350400450500550600650700750800850

M J S D M J S D M J S D M J S D M J S D M J S

1 day (overnight)2 years10 years

2006 2007 2008 2005 2004

31 Dec

2009

30 Jun

Summing up, in an environment where the world economy continued to

show signs of recovery, economic activity in Mexico improved during the third quarter. Inflation in Mexico continued to follow a downward path which was seen across all CPI subindexes. However, given the size of the output gap, it is


76

noteworthy that the pace and size of the reduction in inflation in Mexico are smaller than those observed in other emerging economies.

In this regard it is worth briefly considering the recent behavior of inflation and the prospects for it during the following quarters. As mentioned, although inflation has not fallen in Mexico to the same extent as in other countries due to the larger depreciation in the exchange rate and differences in public policies for determining energy prices (which also meant that during the phase before the crisis these prices did not rise as much in Mexico as in other countries), it would seem that there are different distortions in the economy which reduce firms’ reaction to adverse demand shocks. In general, the response of firms in terms of how they determine their prices seems to be asymmetrical depending on the type and direction of the disturbances they face. That is to say, they generally seem to react more to cost shocks than to those of demand and seem to respond more strongly to shocks which lead to price increases than those which cause price reductions (Box 1). In this way, the distortions in the Mexican economy not only cause lower growth, such as Banco de México has reiterated on several occasions, but are also probably leading to a strong downward rigidity in inflation.

Under these conditions, after having cut the target for the Overnight Interbank Rate by 375 basis points during the first seven months of the year, in its press release of July, Banco de México’s Board of Governors announced its decision to pause the cycle of monetary easing (Graph 66). As a consequence, in August, September and October the Board kept the target for the Interbank Rate unchanged at 4.5 percent.

Graph 66 Overnight Interbank Rate1/

Annual percent

3

4

5

6

7

8

9

10

11

D M J S D M J S D M J S D M J S D M J S D M J S D M J S20062004 2005 2007 20082003 2009

1/ The target for the Overnight Interbank Rate (Banco de México’s operating target) is shown since January 21,

2008.


77

5. Final Remarks

On September 8, the Mexican Federal Government submitted to Congress its draft proposal for the Federal Budget for 2010. However, at the time of publishing this Report, it continues to be debated by legislators in terms of different actions concerning public revenues and expenditures. Since a definite and final version has still not been approved by Congress, this section focuses on informing only on the outlook for the world economy and the risks it still faces. Banco de México will publish, no later than four weeks after the fiscal proposal has been the definitely approved, an addendum to this Report that will include the central bank’s forecasts on Mexico’s macroeconomic scenario as well as updated forecasts for growth and inflation and the balance of risks. The addendum will be based on two main elements: the international environment and the effects the fiscal measures could have on economic activity and price formation in Mexico.

The recovery of world economic activity is expected to gradually consolidate in 2010. According to IMF estimates, world GDP could grow around 3 percent next year, driven mainly by the emerging economies and, especially, by China, India, and other Asian economies. Emerging economies are expected to grow 5.1 percent in 2010. In the case of advanced economies, the IMF forecasts GDP growth of 1.3 percent for next year.

Under these conditions, after having started to grow since the third quarter, GDP in the U.S. is expected to continue growing in 2009 and throughout 2010. Although as a result of the fall in economic activity in the U.S. during the first half of the year economic analysts forecast contractions of 2.5 and 10.1 percent in U.S. GDP and industrial production, respectively, for the entire 2009, both indicators are foreseen to grow 2.5 percent and around 3.3 percent, respectively, in 2010. Among the factors influencing this foresight are: i) the gradual return to normal conditions in financial markets; ii) the fact that the significant inventory liquidation in the U.S. observed from the last quarter of 2008 seems to be ending; iii) the signs of strength that have been observed in the residential home sector in the U.S.; and, iv) the recovery of private consumption, as a result of the fiscal incentives to revamp domestic demand and the less weaker conditions in the labor market.

The recovery of economic activity and the support measures implemented by the financial authorities have allowed for a positive feedback between the real and the financial sectors, which is expected to continue in the next quarters as a result of the gradual return to normal conditions in financial markets and in the levels of risk appetite. Conditions in international financial markets are therefore expected to continue improving at the end of 2009 and in 2010.

Expectations of a gradual recovery of the global economy suggest that world inflation will remain low, under the assumption that the monetary and fiscal stimuli will be withdrawn efficiently and in a timely manner. According to IMF forecasts, inflation in advanced economies is expected to reach 1.1 percent in 2010 (as compared with 0.1 percent in 2009) and in emerging and developing economies, 4.9 percent (as compared with 5.5 percent in 2009). Among the latter


78

group of economies, those of Latin America and Eastern Europe would register the highest inflation rates (5.2 and 4.2 percent, respectively).

The world economy is expected to recover more slowly than in the prior cyclical stages and significant downward risks continue to prevail. In the case of the U.S., despite the recovery of the levels of activity, unemployment is still high and various financial sector segments continue facing unstable conditions and are still requiring government support. In addition, the levels of consumption are expected to recover meagerly, due to households’ need to contine to deleverage, the high levels of unemployment, and the devalued levels of wealth. Moreover, there is a considerable number of excess homes available in the market and the rate of disclosure due to lack of mortgage payments will possibly remain high for some time, which will in turn affect the rate of growth of residential construction. Commercial mortgage activity has remained downwards, mirroring the decline in both the rate of employment and in real estate rental prices. In the business sector, the considerable excess of installed productive capacity will probably be a factor that will ease the rate of spending in capital. Banks and financial institutions will probably remain cautious as they restablish their capital requirements and adapt to the current conditions, and could therefore continue limiting the granting of credit.

From a more general overview, all of the aforementiond factors show how vulnerable the economic recovery process still is. On the one hand, in its initial stage, the economic recovery will depend mostly on the positive contribution of both the change in inventories and government expenditure to GDP growth, under an environent where private demand is not expected to react as strong as in other cyclical stages. On the other hand, it has become significantly relevant that the authorities’ strategy to revert the fiscal and monetary stimuli measures does not imply reducing the speed to restablish economic activity or prompting a rebound in inflation. Also, despite the recent improvements, world financial conditions are still far from entirely returning to normality. Many financial institutions are in a process of improving their balance sheets and a new episode of uncertainty in international financial markets should not be cast aside.

Finally, the possibility that the world economy grows higher than expected cannot be discarded as well. For example, the improvement of confidence in financial markets could make consumption and investment in several advanced and emerging economies grow more than expected.

The fiscal proposal which at this moment is being discussed in Congress will possibly affect the macroeconomic framework for 2010 and the coming years. As it is well known, Mexico currently faces significant challenges to improve its growth and development opportunities in the next years. In particular, in view of the structural deterioration of the country’s public finances, it is necessary to make progress in different fronts like making them less dependant on oil revenues, increasing the taxable base and the number of taxpayers, and decisively improving the public budget exercise by making it more efficient, transparent, and accountable. In this regard, it is essential that the different political actors reach ample consensus to achieve the necessary agreements that can allow for consolidating macroeconomic stability and foster the country’s competitiveness under more sound and permanent foundations.


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6. Monetary Policy Announcements and Publication of Inflation Reports in 2010

The following calendar includes eleven dates, one per month (except in December), for monetary policy announcements. Nevertheless, should extraordinary events that would require the central bank’s intervention take place, Banco de México, as in previous years, reserves its right to modify the monetary policy stance in dates different from those predetermined in the calendar.

Calendar for 2010

Month Monetary Policy Announcements Inflation Reports

January 15 27 1/

February 19March 19April 16 28May 21June 18July 16 28August 20September 24October 15 27November 26 1/ Includes Monetary Program for 2010.

Documents

2009-3 Informe inglés reparado 2 VERSIÓN FINAL 290110 1200 ... · INFLATION REPORT JULY – SEPTEMBER 2009 3 The average of annual inflation during the third quarter has behaved