Soft growth environment, medium-term challenges persist

Mexico has a track record of prudent macroeconomic and fiscal policies that underpin a certain degree of macroeconomic stability. Its economy performed surprisingly well during the first three quarters of 2022, which led a reduction of the output gap and notable improvement in the labor market. However, it returned to its pre-pandemic level only in Q3 2022, later than regional peers. Looking ahead, we expect economic growth to decelerate significantly over 2023 to +1% because of several factors: weak fiscal support, high inflation, aggressive monetary policy and impending disruptions in external relations and international supply chains. The dearth of fiscal support for consumers and businesses in 2020-21 has left lasting scars in the form of permanent business closures and a poorer-quality job market; strong inflationary pressures will also erode households' purchasing power and lift input costs for businesses. Growth should remain weak in the forecast horizon – +1.5% on average between 2024-2026 – given the unsupportive business and regulatory environment in key economic sectors and weak investment.

We expect inflation to remain high for some time yet as the knock-on effects of the Russia-Ukraine war will take longer to dissipate. Amid growing price pressures, the Banco de México (Banxico, the central bank) is expected to remain hawkish. We expect Banxico to lift rates to a peak in early 2023 to maintain wide interest-rate differentials with the US and minimize capital flight. Aggressive monetary-policy tightening will increase borrowing costs and dampen private sector credit. Economic growth will also be heavily affected by the impending technical recession in the US, given the strong trade and investment linkages between the two countries.

The Heritage Foundation’s “Index of Economic Freedom 2022” survey assigns the country rank 67 out of 177 countries, above the regional and world averages. However, weak rule of law, bias towards state-owned enterprises and policies that harm the private sector will continue to weigh on the business climate.

Political risk is moderate. Morena will remain the dominant political force ahead of the next presidential and legislative elections, which are due in June 2024. An opposition alliance that includes the centrist Movimiento Ciudadano (MC, a small but growing minority party) may have a better chance of dethroning Morena, but policy differences and haggling over power quotas will make building that kind of coalition a difficult task. Against this backdrop, we believe that Morena is in pole position ahead of the 2024 presidential race. Any opposition candidate will face a difficult battle in uniting ideologically diverse parties, mobilizing disaffected voters and countering Morena's incumbency advantage.