Private investment in Mexico : an empirical analysis

Trad, Fkwh,*. mW hdua y Latn America and te Carbbean Country Department The World Bank April 1989 WPS 183 Private Investment in Mexico An Empirical Analysis Alberto R. Musalem In 1985, Mexico shifted to a growth strategy based on private investment and exports rather than on import substitution and public sector investment. The policy implications of this study are that to increase investment, Mexico should follow policies aimed at reducing investment adjustment costs and increasing factor mobility and credibility in the program of structural reforms rather than at subsidizing investment. htai .Ucy,Phom n&ndResruchCplzditihPMWonkingPspctodianinstchcfindinsofwoskiri I and to ragcthzhaneafxid.a amgBak saffand al h . ined e developatim These a canythes o dhe authors. refled only their views. and shuld beused and cited accorningly. Mc findings, iuapretio.a. and catchiwrs amethe au hw own. They should not beatsuibted to tie Wold Bank. its Board of Di,or iits mtngemanotr any dfitsmunbrcie  Pd,3R@ Im Tmde, Flnum, and hduWy Mexico s past growth strategy - based on To the extent that trade liberalization is not import substitution and public sector investment accompanied by policies that facilitate real - proved unsustainable in the face of the exchange rate depreciation, investment would be financial crisis and the drop in oil prices. More- affested in two ways - first, profitability in the over, with strong linkages between public and tradeables sector would be reduced in the short private investment, cutbacks in one forced run, Increasing adjustment costs and impairing cutbacks in the other. The result was a magni- resource mobilization. Second, expectations of fied cost of adjustment. real depreciation will build up as economic agentx anticipate that the long-run equilibrium To resume sustainable growth, the Mexican level of the real exchange rate consistent with authorities adopted a new strategy whereby impon liberalization is higher. As a result, private investment and exports rather than destabilizing capital outflows may increase real import substitution and public sector investment interest rates and reduce confidence in the would lead growth. However, in the past, govemment's ability to sustain trade policies. investment responded extremely slowly to changes in the incentive system. This behavior As stabilization efforts continue, expecta- may reflect high adjustment costs, uncertainties, tions of inflation wiU be reduced, increasing the risks, and credibility problems induced by past demand for money and therefore the real interest macroeconomic instability. Also, distortions in rate. As the government continues its policy of the factor and goods markets may have impaired relying less on the inflationary tax, however, the mobility of resources. Consequently, favorable developments may follow: structural reform began with the 1985 trade reform, and was strengthened by the privatiza- * Financial deepening will reduce intermedia- tion of public enterprises, economic deregula- tion costs and spreads, increase access to finan- tion, and tax and financial sector reforms. cial services, and stimulate investment. Further trade liberalization may be needed * The unanticipated risk of capital losses on - removal of the remaining quantitative restric- holding domestic assets wiU decline, thereby tions, particularly on imports of used capital increasing their liquidity and demand, and goods - to encourage investment, both directly reducing the real interest rate. (through the price effect) and indirectly (as an instnunent to promote trade and capacity * The improved macromanagement will make utilization). relative prices less volatile, will reduce uncer- tainties, risks, and adjustment costs, and wiU increase the short-term investment response. This paper is a product of the Trade, Finance, and Industry Division, Latin America and the Caribbean Country Department II. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Lerick Spear, room 18-127, extension 30081 (32 pages with charts and tables). The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these fndings out quickly, even if presentations are less than fully polished. The fndings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank. Produced at the PPR Dissemination Center  PRIVATE INVSTfiEET IN MMXICO. AN DIPIBCAL ANALYSIS Table of Contents Page No. 1. Introduction .................................. 1 2. Economic Background ..... .. ........................ . 2 3. The Model ................................ 7 4. Private Investment ................................ 9 5. The Relative Price of Investment ......................... 14 6. The Real Interest Rate ................................ 18 7. Concluding Remarks ... ............................. 24 8. Data ................................ 27 9. Statistical Tables ................................ 30,31,32 I am grateful to Bela Balassa, Joaquin Cottani, Edgardo Barandiaran, Sreenivasa Ramachandran and Louis Fischer for their comments. All remaining errors are my sole responsibility.  PRIVATE INVESTNINT IN MEXICO: AN EDIRICAL ANALYSIS Alberto R. Musalem Introduction Mexico's growth rate averaged 6.6Z p.a. between 1950 and 1974. Between 1978 and 1982, the economy grew at no less than an average of 8.72 p.a.; while between 1982 and 1987, Mexico did not grow at all. However, during the 1978-1982 period, the external debt tripled from US$29 to 86 billion. The ratio of external debt to GDP jumped from 28 to 521. This period was brought to a crashing halt during the mid-1982 debt ctisis. Lower investment on the one hand, and restrictive demand management on the other, induced no real growth between 1982 and 1988 and hence a severe decline in per capita income. The analysis of Mexico s private investment explains some of the country economic performance and its determinants are examined in this paper. The findings suggest that investment responded extremely slowly to changes in the incentive system in Mexico. This result suggests that the adjustmient costs of changing capital to the desired stock were relatively high --possibly due to high uncertainties and risks, and credibility problems induced by macroeconomic instability-- and also, that distortions in the factor and goods markets impaired the mobility of resources. The policy implications of this atudy indicate that to iicrease investment and, therefore resume growth, Mexico would be better off with policies aimed at reducing the cost of adjustment on attaining the desired capital stock and  -2- increasing factor mobility, rather than providing subsidies to stimulate investment. This analysis also demonstrates that investment is responsive to the real interest rate, the relative price of investment and the rate of capacity utilization. In addition, the relative price of investment is determined by the price of new capital equipment in the United States. Moreover, the real interest rate in Mexico responds to the behavior of the real lnterest rate in the United States, but in the short run it is also affected by expectations of movements in the real exchange rate, the rate of domestic credit creation, the initial ratio of money to capital, the unanticipated inflationary shocks and interest rate ceilings. A simple model for the formation of expectations about changes in the real exchange rate indicated that a real appreciation of the Mexican peso in the previous year induced expectations of a real depreciation in the current year. Also, relaxation of quantitative restrictions on imports created expectations of a deterioration in the trade balance and a depreciation of the Mexican peso in real terms. Economic Background The outburst of public spending in the late 1970a, the subsequent decline in oil prices and increases in real interest rates payable on the external debt caused serious public finance problems. These problems in turn triggered an increase in inflation not previously seen in Mexico's economic history. Since high and variable inflation rates go together with high relative price variability, an unpredictable macroeconomic environment increases uncertainties and risks embodied in investment decisions, thereby rising the cost of adjustments and reducing investors' responsiveness.  - 3 - The fiscal adjustment after 1982 was unavoidable given the sudden lack of access to international capital markets and the series of adverse terms of trade shocks that took place over the period. As a by-product, the severe fiscal cutbacks greatly increased public sector efficiency. A divestiture program was successful in closing, selling, or transferring roughly two-thirds of the 1155 public enterprises that existed in '.982. In addition, few, if any, of the many dubious large projects of the late seventies remain in the public sector investment program. Cutting the public sector investment budget from almost 1O of GDP in 1982 down to an estimated 3.32 of GDP in 1988 clearly has had its costs; government investment has a role to play in areas that heavily complement private investment and in the social sectors. Also, private investment has not made up for the decrease in public investment. Private investment is now aproximately at its pre-oil-boom level of 11-12Z of GDP (Figure 1). Inflation, rather than slowing down, accelerated towards the end of the period. The de-facto targeting of the real exchange rate at a relatively high level during 1986-1987, together with an increase in the frequency of wage and cost adjustments, introduced an element of inherent instability into the system. This later became fully apparent towards the end of 1987. The temporary opportunity for private debt buy-backs evolving from the 1987 debt rescheduling together with the stock market plunge triggered a run on the peso. This resulted in reserve losses and eventually a 37Z depreciation, fueling inflation and expectations of further exchange rate depreciations. Mexico responded with the Pacto de Solidaridad, a concerted effort to bring down inflation which had reached triple digits.  FIGURE 1: MEXICO - GROSS PRIVATE AND PUBLIC SECTOR INVESTMENT TO GDP RATIOS 15.0- .v ~~~~ I I l l i l i l ' i a f 12.5-~ 1 - 10-0- PUBLIC l9*vO 1965 1970 1975 1980 1985 (in percent)  The Pacto was negotiated in December 1987 by representatives from the Government, labor, farming, and industry. The program consisted of further tightening of fiscal and monetary policy, and renewed structural reform efforts. Trade liberalization was accelerated, credit subsidies substantially reduced, and the progrsm of public enterprise divestiture reinforced. These measures were supr .;mcnted by a freeze on minimum wages, public sector prices and tariffs. A corner stone of the Pacto was pegging the exchange rate to the U.S. dollar. This partial freeze was originally intended to last a couple of months but it has been extended at three month intervals throughout 1988. At the beginning of 1989, the exchange rate was set at a crawling peg at a rate of Mex$ 1 per day. On almost every target that is under direct or indirect control of the government, performance under the Pacto has been exemplary and often has gone beyond what was initially planned. Trade reform has been accelerated, partly because of the potential efficiency gains, partly because of the hope of restraining the effect on price increases. Total governmental expenditure, net of interest payments, has fallen by about ten percentage points of GDP over the past few years, from 282 in 1982 down to an estimated 182 in 1988. The fiscal deficit is now more in line with the low inflation targets embedded in the Pacto. This effort is noteworthy given the negative budgetary impact of further drops in oil prices and increasingly high real interest rates on the foreign debt experienced towards the end of 198a. Moreover, this has been achieved in spite of the extremely high level of domestic real interest rates. These have been at around 302 in  - 6 - real terms for most of 1988, and have crept up to a compounded real rate in excess of 40Z towards the end of 1988. All this oecurred while real interest rates on government debt had been negative (-3Z) in 1987. With the internal debt now at around 202 of GDP, such a turn around has resulted in a massive increase in real interest payments to service the domestic debt. This turn around explains how a 2 percentage point improvement in the non-interest surplus was not enough to prevent a 5.1Z deterioration in the operational deficit. High real rates probably reflect anticipations of a resurgence of inflation and exchange rate devaluation. Exchange rate uncertainty has forced the government to run very restrictive credit polcies to avoid reserve losses given the fixed exchange rate. The real exchange rate with the US appreciated by 9.2Z between January and August 1988, and by 5.5? since March of the same year, the first month with low inflation. The real appreciation of the dollar between March and September 1988 has added to the pressure (on a trade-weighted basis, the real exchange rate has appreciated by 7.4Z between March and August). This should be set against a sharp real depreciation of 42Z on a trade-weighted basis between July 1985 and December 1987. July 1985 was the month preceding a nominal devaluation of 17? and the beginning of a much more aggressive exchange rate policy. However, falling oil prices and rising foreign interest rates in the second half of 1988 may have added upward pressure on the real exchange rate. In addition, the significant policy of trade liberalization undertaken in December 1987 has also contributed to the pressures on the real exchange rate, as will be seen below.  -7- It is clear that because of short-term problems, fiscal policy cannot be the main engine of growth, and balance of payments considerations leave no option but export-led growth. However, supply bottlenecks can be expected to develop in time, with a consequent need for additional investment. At present, gross domestic investment stands at about 162 of GDP, its lowest historical level. With fiscal tightening necessary in the face of low inflation targets and the likely negative impact of external shocks on public finance, private investment will have to lead the way. This is also more in line with the structural reforms currently underway in Mexico; these reforms seek to reduce rather than increase the role of the public sector. The Model The model assumes that Mexico is a price taker in international markets. That is, the foreign real interest rate and the foreign currency denominated prices of tradeable goods are given; among them, the price of new capital equipment. Moreover, Mexican wealth-holders can decide on the composition of their portfolio between holdings of three assetst domestic real assets (a composite asset including installed capital goods or equity and domestic real bonds which are perfect substitutes), money and foreign real bonds based on the real yield of each asset. The model assumes that domestic assets are non-tradeable, that assets are gross substitutes and that the monetary authority has a passive role with respect to wealth- holders' decisions of changing their portfolio composition between domestic and foreign assets by allowing accumulation or de-accumulation of foreign reserves. In other words, the nominal exchange rate is a policy instrument. Therefore, asset demand depends on rates of return and wealth:  (1) m - M/P - a* r, rf + De@, (-DP/P))v (2) p,(r) x - (Pk K/P) + (C|r P) - k + b -a ( r, rf + Dee, (-DP/P)g )v (3) f - (E F/rf P) - af ( r, rf + Dee, (-DP/P)O ) v where r is the real interest rate on domestic real assets Cx) rf + Deg is the real expected return on foreign real bonds (f), since rf is the real interest rate and Dee is the expected rate of change in the real exchange rate; (-DPIP)O is the expected rate of inflation (the negative yield of real money, a); Pk is the market price of capital; K is the number of units of capital; P is the price level; B is the number of units of domestic real bonds yielding a constant value Mexican peso at perpetuity; px is the market price of the composite domestic real asset, which is inversely related with the real interest rate; E is the nominal exchange rate defined in units of Mexican pesos per US dollar; and F is the number of units of foreign real bonds yielding a constant value US dollar at perpetuity. Finally, real wealth (w) equals the real value of asset holdings: (4) v - m + pxCr) x + f The system (l)-04) boils down to only one equilibrium condition, the domestic real asset market condition, s, since we assume that: the nominal exchange rate (E), the US real interest rate 'rf), the expected rate of change in the real exchange rate (Dee), and the rate of expected inflation ((DP/P)e), are exogenous. Equation 1 and 3 collapsed into one based on the assumption on monetary policy, and due to Walras' Law can be ignored.  - 9 - Equation 2 will determine the equilibrium real intwoost rate. The assumption that domestic real bonds and capital are perfect substitutes implies that the price of capital relative to the price of real bonds is nearly constant. However, the rate of return on capital may be different than the real interest rate on dometic financial assets due to a constant risk and liquidity premiums. The analysis will first study investment and then the determination of the real interest rate. Private Investment Gross fixed private investment in Mexico fluctuated between 10.5 and 16.5Z of GDP from 1960 to 1987 (Figure 1). A model of gross fixed private investment incorporates three effects: (i) the replacement of depreciation; (ii) the adjustment of the actual level of the capital stock to the desired level; and (iii) the capacity utilization of the actual capital stock. A low rate of capacity utilization will render much of the existing capital stock redundant, hence lowering investment. The proxy variable used for capacity utilization is the output-capital ratio. Thus, PRIVt - d kt-1 + vo (k*t - kt-1) + vl (Y/K)t (5) PRIVt - (d-vo) kt.I + vo k*t + vl (Y/K)t where: PRIV is the annual rate of gross fixed private investment in billions of Mex$ at 1980 prices; kt-l is the stock of capital at the beginning of the year in billions of Mex$ at 1980 prices; d is the annual rate of depreciation of the capital stock (d > 0); vO is the coefficient of adjustment of the desired capital stock (vo > 0); vi is the coefficient of investment response to the rate of capacity utilization of the actual capital stock (vl > 0);  - 10 - (Y/K) is the ratio of output to capit.',l stock lagged one year, as a percentage; and k* is the desired capital stock. The desired capital stock is derived from the long run equilibrium condition where the value marginal product of capital (VMPk) is equal to the rental cost of capital. We assume that the production function is linearly homogeneous in labor and capital. Thus, (6) VMPk - MPk ( K, L, PUI, t ) P (r+d) PI; and HPkk, MPLL < 0* Hence, (7) K* -K* (r, p, PUI, L, t, d) where MPk is the marginal product of capital; L stands for labor; PUI is the public sector investment; p is the relative price of investment (PI/P); and t stands for the unincorporated technological change. An increase in the real interest rate on domestic real assets or in the relative price of investment will require an increase in the MPk to maintain the equilibrium condition of Equation 6. This can be attained by a decline in the desired capital-labor ratio, which for a given quantity of labor, will be obtained through a fall in the desired stock of capital. Moreover, public sector investment is seen as affecting private sector investment. Public investment in infrastructure could increase the MPk if they are complementary. However, in Mexico a restrictive regulatory  - 11 - framework which has linked private sector production to public enterprise (PE) activities in both the goods and factor markets hi.s prevailed. As a result public sector investments have become a determining factor in private sector investment, far exceeding the usual complementarity between public infrastructure and private undertakings. More specifically, an expansion in the PEs' capacity to produce industrial inputs (e.g., basic petrochemical can only be produced by PEMEX) was a precondition for the complementary private sector 'ownstream investments (e.g., secondary and tertiary petrochemicals). Conversely, an increase in PEa' demand resulting from capacity expansion has fostered some private sector investment undertaken for the purpose of satisfying this additional demand (e.g., capital goods sector expansion to satisfy PEMEX's and other PEs demand). Moreover, this complementary relationship may have been encouraged through the granting of selective incentives for directing private investment to fulfill the desired policy goals. Figure 1 shows a predominantly positive relationship between public and private investment as shares of GDP. However, the relationship between both variables seems to have changed after 1982. Accordingly, the equation for the desired capital stock and the gross fixed private investment can be written as: (8) k* - ko + kl r + k2 P + k3 PUI , and (9) PRIVt- voko + vok, rt + vOk2 Pt + vOk3 PUIt + vl (Y/K)t + (d-vo) kt1.l where: ko incorporate the effects of L, t and d on the desired capital stock, discussed in Equation 7; kl, k2 < 0 ; and (complements) 0 < k3 0 O (substitutes). In addition,  - 12 - r is the ex-Dost after tax average real interest rate on banking instruments, as a percentage; p is a relative price index as a percentage, defined as the ratio between the gross investment implicit price deflator and the GDP deflator; and PUI is the public sector gross fixed investment in billions of MHeS at 1980 prices. A simple OLS estimate of Equation 9 for private investment on an annual basis during the period 1962-1987, yields the following resultas (10) PRIVt - -339 - 2.87 rt1l - 2.3 Pt + .6 PUlt + 12.4 (Y/K)t + .036 kt-1 (-1.3) (-2.1) (-1.8) (5.7) (3.5) (5.6) R2 ; 96.3Z R2 . 95.1? DV - 2.07 RHO - .04 (.86) F -81.4 w,here the values in parenthesis correspond to the t-statistics. The results indicate that: (i) the capital replacement effect dominated the stock adjustment effect, the latter being too small (possibly, no higher than 22 p.a.);l (ii) public sector investment strongly complemented private investment; (iii) private investment was negatively related to the relative price of investment; (iv) private investment responded negatively to the one-year lagged real interest rate, possibly 1I From the Equation 9, the coefficient of the lagged capital stock is equal to d-vo. The estimated value of this coefficient is 3.6Z. Hence, an overall rate of depreciation of 5.62 (higher than that reported in the National Accounts) will be needed to obtain a coefficient of adjustment of 2Z p.a.  - 13 - because investors form their expectations on the real interest rate based on its level of the previous year; and (v) private investment was positively related to capacity utilization. Table 1 shows the short- and long-run effects on private investment due to changes in the level of its determinants, assuming that the adjustment coefficient is 2Z p.a. This small value may imply relatively high adjustment costs, thus resulting in large differences between short and long term effects. In fact, the high cost of adjustment may be a reflection of the relative instability of the macroeconomic environment that characterized the period under study. This may have increased the uncertainties and the risks of investment decisions, thereby, fostering an extremely cautious response of Mexican investors. Moreover, the small coefficient of adjustment may also reflect imperfections and immobilities in the goods and factor markets, as well as, problems of credibility in the structural reforms adopted in the past. Table 1. MEXICO: Short- and Long-Run Effects on Private Investment (Billions of 1980 Mex$) Short-Run Long-Run Increase of one percentage poiit in r -2.87 -143.5 Increase of one percentage point in p -2.3 -115.5 Increase of 1 billion in PUI .6 30.0 Increase of one percentage point in Y/K 12.4 620.0  - 14 - These results suggest that the greatest stimulus to private investment will come from policies directed at reducing the cost of adjustment, and increasing factor mobility and credibility on the ongoing policies of structural reform. That is, improved macromanagement inducing greater stability in the real exchange rate, real interest rate, and relative prices in general should provide a supportive macroenvironment for a faster investment response. Also a review of the regulatory framework and policies, aimed at improving competition and mobility in the goods and factor markets should improve credibility and the opportunities for a quicker adjustment in response to changes in the system of economic incentives. To confirm the slow adjustment result, however, further research would still be needed. At this time, our analysis continue studying investment behavior by estimating equations for the relative price of investment and the real interest rate. The Relative Price of Investment Since the price of investment includes new capital equipment which is a tradeable, these prices reflect those in the United States. Also, changes in QRs on total imports may have affected domestic prices of new capital goods to the extent that QRs on new capital goods also changed. Moreover, an improved net foreign asset position may have facilitated import licensing approvals, in particular, those of new capital goods. Consequently, the relative price of investment may be negatively related to the level of net foreign assets. Finally, there is a lagged response in actual prices (p) to the equilibrium prices (p-), thus:  - 15 - (11) Pt - Pt-i + (Pt - Pt-I) Pt - (1-z) Pt-i + AP-t. and (12) P-t - bo + blpft + b2 QRt + b3 at hence (13) Pt - zbo + :blpft + ab2 Qlt + 0b3 at + (1-a) Pt-I where: bl, b2 > O and b3 < O; pf is the domestic currency price of the U.S. producer price for capital equipmaet relative to Mexican GDP deflator, as a perccntage (i.e., the real exchange rate for capital goods); QR is an index of quantity restrictions on imports an a percentage; and a is net foreign assets of the consolidated banking systes in billions of 1980 Mez$. The OLS estimate of Zquation 13 for the behavior of the relative price of investment on an annual basis during the period 1962-1987 yields the following results: (14) Pt - 20.0 + .19 pft + .104 QRt - .024 at + .50 Pt-i (1.19) (3.1) (1.29) (-2.8) (3.8) 2 .81.92 2 - 78.4Z Durbin h - -.12 7 - 23.7 where the values in parenthesis correspond to the t-statistics. The results indicate that: (i) there is a lagged response of actual prices to the equilibrium level; (ii) the domestic price of investment is related to the behavior (3f the real exchange rate for new capital equipment; (iii) quantity restrictions on total imports are marginally binding; and (iv) the level of net foreign assets is negatively related to the relative price of investment, indicating that licensing of imports of new capital goods depended on the level of net foreign reserves. Table 2 shows the short and long-run effects of changes in the level of the explanatory variables on the relative price of investment.  - 1 - Table 2. MXXISC0 Short- and Long-Run lifects on the Relative Price of Znvestment (in Percentage Points) Short-Run Long-Run Increase of one percentage point in pf .19 .36 Increase of one percentage point in QRs .104 .21 Increase of I billion 1980 Mex$ in a -.024 -.05 Figure 2 indicates that the rolative price indez of investment in Mexico has always been below the U.S. relative price of new capital goods in Mexican pesos. This explains that capital equipment is indeed a component in the implicit cost of investment, albeit an important one. Accordingly, a possible incentive for investment could come by further liberalizing trade policy, that is to reduce the cost of a major component, namely, capital equipment. Although QRs for new capital goods have been abolished, QRs still remain for used capital goods. Moreover, Rule 8 of the Tariff Code allows imports of parts for assembling new capital goods with ad valorem tariffs ranging from 0 to lOS, instead of the simple average nominal tariff on imports of new capital goods of 13.5Z (12.6Z weighted). To improve efficiency in the allocation of resources, a more neutral tariff treatment for imports of new capital goods would be desirable. On the other hand, imports of used durable goods (e.g. used capital goods) under Rule 10 are subject to the same tariffs as imports of new capital goods, but with a depreciation schedule that discriminates against imports of used capital goods. A more realistic depreciation schedule for imports of used capital goods would provide Mexican investors with access to cheaper capital goods, and possibly with a wider variety of  - 17 - FIGURE 2: MEXICO - RELATIVE PRICE OF NEW CAPITAL GOODS 225- 200- UNITED p. STATES' IN | 175- MEXICAN, PESOS 150- 125 1001 1960 1965 1970 1975 -1980 71985  - 18 - incorporated technology. Mexico has not had a good experience with imports of used capital goods in the past. This was due, in part, to the fact that a non-competitive and protected market offered opportunities for imports of obsolete capital goods. However, under present more competitive markets, there is little room left for imports of capital goods that are inefficient to operate in competitive foreign markets. The Real Interest Rate As assumed above, Mexican wealth-holders, besides having to decide between holding the composite asset integrated by domestic real financial assets and productive capital, also have the opportunity to hold foreign real bonds. The last possibility creates the linkage between domestic and foreign real interest rates. Figure 3 shows that there was a close relationship between the real interest rate in Mexico and that of the United States up until the mid- 19709. However, since 1976, Mexico's real interest rate has been systematically negative and significantly smaller than the one in the United States. Hence, there are other factors that have played a eole in the determination of the real interest rate in Mexico. The arbitrage process will also take into account macroeconomic conditions; in particular, expectations of changes in the real exchange rate. Thus expectation of a real appreciation of the Mexican peso will increase the expected income stream of domestic real assets in terms of foreign currency; hence, increasing the demand for Mexican real assets in general and, thereby, reducing the real interest rate.  - 19 - The policy of interest rate controls has had some responsability for the outcome of negative real interest rates in the face of accelerating inflation (Figure 4). Moreover, changes in the rate of domestic credit creation induce flow disoquilibium in the asset markets and changes in the expectations of inflation thus fostering a portfolio shift between money and real assets and changes in the domestic real interest rate. Also, unanticipated inflationary shocks such as those that have taken place since 1982, have helped generate negative ex-post real interest rates. Ultimately, the level of equilibrium of the donestic real interest rate will result when all asset markets clear. Therefore, wealth holders' decisions on the composition of their portfolio will affect the equilibrium real interest rate. The ratio of money to the composite domestic real asset will be a key variable in the determination of the real interest rate. Accordingly, a higher initial ratio of money to real domestic assets creates an excess supply of money and an excess demand for real domestic assets, which can only be resolved by an increase in the composite price of the real domestic assets, that is, a decline in the real interest rate. Consequently, the equation for the real interest rate is written ass 15) rt m go + g1 rft + 92 Deet + g3 ct + g4 (M/K)t_j + g5 du where: g1, g2 > 0 and g3, g4, g5 < 0; rf is the ex-post real interest rate on U.S. Federal Funds as a percentage; Dee is the expected annual rate of change in the real exchange rate as a percentage (Dee > 0 means a expected real depreciation of the Hexican peso). D is the first- difference operator and e is the log of the real exchange rate;  - 20 - c is the annual rate of chtnge in domestic credit creation as a percentage; (M/K)t-l in the ratio of the stock of money and quasi-money to the stock of capital as a percentage measured at the beginning of the year. This variable is a proxy for the more appropiate ratio of money to real domestic assets discussed above; and du is a dummy variable to capture the unanticipated inflationary shocks experienced since 1982. It adopts a zero value for each of the previous years, and a unit value for 1982 and thereafter. To complete the analysis, we need to specify a model for the formation of expectations of changes in the real exchange rate. We first postulate that the expected real exchange rate in year t is a weighted average of the actual real exchange rate in the previous two years and a function of the contemporaneous structural policies affecting the trade balance, in particular, trade policy. Due to the availability of data, the only trade policy variable that will be considered is the degree of quantitative restrictions on imports. Thus, an increase in QRs will induce expectations of an immediate improvement in the trade balance, hence an appreciation of the Mexican peso in real terms. Accordingly, the equation for expectations of the real exchange rate can be expressed as follows: 16) eet - (1-ho) et-1 + ho et-2 + hl QRt wheres: 0 < ho < 1 and hl < 0. Hence, the expectation of changes in the real exchange rate becomest 17) Deet - et - et_l - -ho (et-l - et-2) + h, QR - -ho Deti, + h, QRt That is, an appreciation in the Mexican peso in real terms in the previous year generates expectations of a depreciation in the current year. Replacing the results of Equation (17) into (15), we can finally express the equation for the real interest rate as:  - 21 - FIGURE 3: MEXICO - EX-POST REAL INTEREST RATES (in percent) 10 UNITED i MEXICOX -25 ,,, W I,,, . I, . I * | . . 1960 1965 1970 1975 1980 1985  - 22 - FIGURE 4: MEXICO - NOMINAL INTEREST RATE AND INFLATION (annual, in percent) 150- 725 7!i| l~~~~~~~NFLATIONI\ 100 25i ,+ /OINAL o88r,f" 8-o / INEREST 0-I~~~~~~~~~~~~~~~~~~~~~~ 1950 19B5 1970 1975 1980 l985  - 23 - 18) rt - 50 + 51 rft - *2ho Det-1 + g2hl Q1t + 83 Ct + 54 (MIX)t-l + gs du The OLS estimate of Equation 18 for the annual real interest rate for the period 1963-1987 yields the following results: 19) rt - 23.5 + .76 rft - .13 Det-l - .26 QRt - .12 Ct - .58 (MZ')t-. - 11 du (11) (5) (-3.1) (-8.8) (-6.2) (-3) (-5.6) R2 * 94.52 R2 - 92.32 DV - 2.03 RHO . -.13 (-.52) F . 41.9 where the values in parenthesis correspond to the t-statistics. The results accept the hypothesis that the real interest rate in Mexico is proportionally adjusted to changes in the US real interest rate. This result suggests that domestic and U.S. real bonds are close substitutes. Moreover, the real interest rate incorporates expectations of changes in the real exchange rate. The model accepts that both, a real appreciation of the Mexican peso in the previous year and a contemporaneous policy of trade liberalization induce expectations of a real depreciation in the current year. This will foster a change in portfolio composition favoring holdings of foreign real assets at the expense of domestic real and monetary assets, therefore, increasing Mexico's real interest rate. These results may provide some of the explanation for the high level of the real interest rate during 1988 and 1989. However, these are some of the reasons for generating a differential between the domestic and foreign real interest rates. In addition, the level of the Mexican real interest rate responds to conditions in domestic asset markets. In particular, a high initial ratio of cash balances to capital creates an excess supply of mon2y and an excess demand for domestic real assets. Equilibrium will be restored through capital flight and an increase in the price of real assets -- i.e.,  - 24 - a fall in the real interest rate. Moreover, an acceleration in the rate of domestic credit creation will create a flow excess supply of money and excess demand for real assets -- the liquidity effect. This effect will be reinforced by a fall in the demand for money due to expectations of rising inflation ttemming from the acceleration in the rate of credit e*pansion, which, in turn, induces a fall in the desired ratio of money to real assets in wealth holders' portfolios. Ultimately, equilibrium will be restored through capital flight and a fall in the real interest rate. However, this model is a short run model of real interest rate determination. In the long run, the real interest rate cannot be affected by monetary policy, it will have to reflect either consumers' rate of time preference, or the level of foreign real-interest rates, which are independent of monetary variables. Finally, estimates confirm that unanticipated inflationary shocks have negatively affected the ez-post real interest rate. The caDital losses that this implies, in turn, may have forced a significant increase in the ex-ante real interest rate to cover for the higher risk of holdings of domestic financial assets. Concluding Remarks Mexico's past growth strategy based on import substitution and public sector investment proved to be unsustainable as expansionary fiscal policies came to an end with the financial crisis and drop in oil prices in the 19809. Moreover, complementary liriks between public and private investment, necessarily implied that the cutbacks in the former also forced contraction in the latter. The result was a magnified cost of adjustment, particularly where linkages were high (e.g., capital goods).  - 25 - To resume sustainable growth, the Hexican authorities adopted a now strategy whereby expansion in aggregate demand would have to come primarily from exports rather than from import substitution and fiscal deficits. Accordingly, the structural reform process began with the trade reforms in 1985. Table 1 shows that the greatest effect on investment corresponds to the rate of capacity utilization. At present, there is no other sustainable source for increased capacity utilization than through increasing non-oil exports. Also, the trade reform has reduced distortions in the price of capital goods, thereby stimulating investment. However, to the extent that trade liberalization is not accompanied by a supportive macroeconomic environment, particularly by an improvement in the Government budget or a simultaneous devaluation in the Hexican peso to offset the deteriorating balance of trade effect stemming from the trade liberalization policies, expectations of depreciation of the Mexican peso in real terms will develop. This, in turn, will induce a portfolio shift against holdings of domestic assets in favor of foreign assets, thereby increasing the real interest rate. Accordingly, investment may be discouraged, a consequence of an ill fated trade liberalization policy due to a lack of consistent macroeconomic policies. Further trade liberalization measures may still be needed, especially the removal of the remaining QRs, in particular, those on imports of used capital goods. This would encourage investment, both directly through the price effect, and indirectly as an instrument to promote trade. To obtain these benefits, it is necessary to review Rule 10 of the Tariff Code on the method for assessing the value of used durable goods, and replace it with a market determined system of depreciation.  - 26 - As the stabilization efforts continue, the rate of domestic credit creation should be reduced. This policy, as in the past, may induce a reduction in the expectations of inflation. This, in turn, could increase the ratio of money to real assets in wealth holders' portfolios, thereby increasing the real interest rate thus discouraging investment. However, this is a short run effect since monetary policy cannot change the long run real interest rate. As the Government continues its policy of reducing reliance on the inflationary tax as a source of finance, more important and favorable developments will occur. First, financial deepening will reduce intermediation costs and spreads and increase access to financial services and thereby stimulate investment. This effect is being strengthened by the ongoing economic deregulation in the financial sector. Second, the unanticipated risk of capital losses on holding domestic assets will decline, thereby, increasing their liquidity and demand and reducing the real interest rate. Third, incentives for managing the exchange rate to repress inflationary pressures (thus inducing appreciation of the Mexican peso in real terms and expectations of depreciation and a higher real interest rate) will greatly be reduced. But more important of all, improved macromanagement will reduce the volatility in relative prices in general and therefore uncertainties, risks and adjustment costs, and will increase credibility and the short run response of investment to the gap between the desired and actual stocks of capital. In addition, the Government has recognized the need for reforming the regulatory framework in order to foster a more competitive market structure and to unleash private sector decision making from public sector performance. These reforms are expanding private sector opportunities to  - 27 _ new areas of activities while improving factor mobility and the supply response to the change in the incentive system, hence stimulating private investment. Data The definition and sources of the data used in the estimates are discussed below while the data is shown in Table 3. Real Money and Quasi-Honey. It is defined as the aggregate of money and quasi-money of the consolidated banking system deflated by the GDP deflator. The source was the monetary survey in IFS, IMF. Net Foreign Assets. It is defined as net international reserves of the consolidated banking system less long-term foreign liabilities and deflated by the GDP deflator. The source was the monetary survey in IFS, IF, Yearbook, 1987 and August 1988. Capital Stock The data was obtained from a survey done by the Bank of Mexico for the period 1960-1985. Villalpando Hernandez. L.H. and Fernandez Moran, J., "La Rncuerta de Acervos, Depreciacion y Formacion de Capital del Banco de Mexico 1975-1985, Subdireccion de Investigaciones Economica, Banco de Hexico, October 1986. The capital stock for 1986 and 1987 was obtained by adding net investment from the National Accounts, INEGI, to the previous years' capital stock figures. The U.S. Real Interest Rate. Is the ex-post real interest rate calculated as the ratio between one plus the Federal Funds rate and one plus the U.S. producer price inflation rate. The source was IFS, IM.  - 28 - Gross Fixed Private and Public Sector Investment. These series were obtained from National Accounts, INCI. Implicit Price Deflators. Both the implicit price deflator for investment and GDP were obtained from the National Accounts, IGCI. Output-Capital Ratio. It is the ratio of CDP and capital stock lagged one year. The data on CDP was obtained from National Accounts, INEGI. The Real Interest Rate. Is the ex-post real interest rate calculated as the ratio between one plus the nominal interest rate and one plus the inflation rate in the implicit CDP deflator. The nominal interest rate is a weighted average of after tax yields of banks instruments. The source was: Gil Diaz F., lexlicot Macroeconomic Policies Adjustments and Growth in the Long-Rung, 1988, Table A56. The Real ExchanRe Rate. It is a trade-weighted real exchange rate. World Bank staff estimates. The Index of Quantify Restrictions on Imports. It reflects the percentage of imports subject to quantity restrictions out of total imports. The source wass Gil Diaz F., Ibidem. The Rate of Net Domestic Credit Creation. Net domestic credit is obtained from the consolidated banking system balance sheet. Its rate of change is obtained as the annual change in the nominal stock of net credit divided by the nominal stock of monetary assets at the beginning of the year. The source was IFS, IMF,  - 29 - The Relative Price of US Capital Goods in Mes$. It is obtained as the product of the US producer price index for capital equipment and the index of the annual average of the controlled exchange rate, divided by the GDP deflator. The source for both components of the numerator was IFS, IMP.  - 30 - TABLE 3: MEXICO: Data Used In Estimating the Regressions (In Percent) obs p pf Y/K QRs 1960 102.9630 154.1193 43.43353 37.80000 1961 99.28571 149.0040 42.73182 53.80000 1962 97.22222 145.2433 44.09813 52.50000 1963 101.3513 141.6858 48.76482 63.50000 1964 96.81529 134.9514 49.17985 65.50000 1965 104.3478 133.2900 49.13813 60.00000 1966 103.5928 131.7626 50.38022 62.00000 1967 104.6512 132.0489 50.48351 65.20000 1968 109.6591 133.6898 51.53908 64.40000 1969 108.7432 132.7428 51.08719 65.10000 1970 97.04434 125.2992 50.97790 68.31000 1971 93.95349 123.1190 51.74186 67.70000 1972 92.98246 118.9657 52.74241 66.30000 1973 91.86047 108.7214 53.39858 69.60000 1974 90.15873 101.6703 48.90191 82.00000 1975 93.13187 101.4508 47.96574 86.50000 1976 93.33333 111.7171 47.94003 90.40000 1977 99.64602 134.0266 43.19328 67.70000 1978 99.69698 124.9216 46.96928 64.20000 1979 102.2814 li3.7006 47.80382 60.00000 1980 100.0000 100.0000 47.38810 76.00000 1981 95.63492 93.44348 46.32153 82.80000 1982 104.8817 141.1739 41.34202 78.30000 1983 124.7540 162.4675 30.65258 80.19000 1984 116.5826 145.8740 32.50785 78.40000 1985 117.6855 145.6892 32.12053 35.10000 1986 119.8642 202.7307 28.49463 17.90000 1987 110.8495 189.9779 24.07883 13.60000  - 31 - TABLE 3: MEXICO: Data Used In Estimating the Regressions (In Percent) obs r rf c (M/K) De 1960 1.731315 3.103034 NA 6.112343 NA 1961 3.718571 2.278718 8.333333 6.031656 -0.711747 1962 4.650061 2.476155 12.00000 6.954368 -1.523295 1963 5.354871 3.502887 10.34483 7.181367 0.636940 1964 2.480528 3.264979 8.823529 6.905303 -2.983721 1965 5.541052 2.042472 13.51351 7.118165 -0.745576 1966 4.396333 1.750047 7.317073 7.111777 2.253523 1967 5.398923 3.995866 -2.222222 6.519766 -2.571169 1968 6.101330 3.092682 6.666667 6.458S45 -0.848258 1969 4.632873 4.166810 32.65306 7.673700 0.950570 1970 -1.641672 3.420218 7.692308 7.355075 -1.506590 1971 2.677368 1.279894 2.816901 6.968513 0.000000 1972 1.951872 0.020779 25.00000 7.937831 3.250480 1973 -4.799815 -3.898387 28.57143 7.849524 -0.277781 1974 -11.80785 -7.001092 36.22047 8.180079 -2.228407 1975 -6.290481 -3.128493 24.13793 8.490438 -1.994308 1976 -9.473949 0.373911 19.26605 7.425216 4.941866 1977 -15.83482 -0.269532 129.5019 12.70240 10.71099 1978 -5.499469 0.139519 32.07907 13.28170 -4.920769 1979 -7.128217 -1.186579 35.16193 13.74147 -4.385965 1980 -6.897067 -0.673965 39.20993 13.20168 -8.256881 1981 -1.268714 6.643455 44.15266 13.12755 -9.300003 1982 -16.29402 10.04162 83.44542 9.974231 48.07057 19E3 -22.61354 7.735204 65.30278 8.678700 2.382723 1984 -14.30395 7.670287 64.34782 8.852296 -17.09091 1985 -1.410914 8.617634 56.74508 7.470602 -2.017547 1986 -0.254954 10.00894 95.04859 6.371425 30.61772 1987 -3.908425 3.884043 85.11198 6.456861 3.769706 ===X=w===ssssSS2== 0=======S==s=======S=s====  - 32 - TABLE 3: MEXICO: Data Used In Estimating the Regressions (In Billions of 1980 MexS) obs PRIV k PUI a m 1960 151.0791 2908.505 64.74820 44.44444 177.7778 1961 151.0792 2960.570 71.94245 35.71429 178.5714 1962 142.8572 2895.862 78.57143 41.66667 201.3889 1963 166.6667 3198.969 93.33334 54.05405 229.7297 1964 190.7894 3412.867 118.4211 50.95541 235.6688 1965 232.1429 3577.585 95.23810 43.47826 254.6584 1966 219.6532 3788.942 121.3873 47.90419 269.4611 1967 238.8889 4012.842 133.3333 52.32558 261.6279 1968 248.7047 4310.642 145.0777 56.81818 278.4091 1969 286.4322 4628.684 140.7035 54.64481 355.1913 1970 355.3300 4755.270 162.4365 54.18720 349.7537 1971 376.2376 5072.652 118.8119 65.11628 353.4884 1972 372.6415 5414.887 174.5283 74.56141 429.8246 1973 392.4051 6271.057 236.2869 69.76744 492.2481 1974 482.3944 6752.759 257.0423 60.31746 552.3810 1975 463.1268 7053.831 312.6844 57.69231 598.9011 1976 460.5911 8080.573 298.0296 50.57471 600.0000 1977 483.1262 8035.553 273.5346 -0.530972 1020.708 1978 530.3951 8630.012 316.1094 -8.333333 1146.212 1979 583.6431 9432.747 411.4003 -6.717368 1296.198 1980 727.0000 10499.42 487.0000 -42.89999 1386.100 1981 797.5102 11686.32 595.0208 -85.71429 1534.127 1982 580.6299 15103.02 474.3771 -295.3649 1506.410 1983 487.9618 14753.65 282.0673 -182.2890 1280.425 1984 524.8465 15316.92 292.1552 -81.20423 1355.899 1985 622.3652 16582.56 292.6184 -168.4484 1238.817 1986 487.5311 19905.28 240.4868 -214.6600 1268.250 1987 540.4833 19981.49 220.5079 235.8072 1290.177 = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = == = = = =  PPR Working Paper Series Title Author Date Contact .,5160 Evaluating the Performance of Public Enterprises In Pakistan Mary M. Shirley March 1989 R. Malcolm 61708 WPS161 Commodity-indexed Debt in International Lending Timothy Besley March 1989 J. Raulin Andrew Powell 33715 WPS162 Ups and Downs In Inflation; Argentina Since the Austral Plan Miguel A. Kiguel WPS163 The Impact of Infrastructure and Financial Institutions on Agricultural Output and Investment In India Hans P. Binswanger March 1989 J. Arevalo Shahidur R. Khandker 30745 Mark R. Rosenzweig WPS164 Intersectoral Financial Flows in Developing Countries Patrick Honohan March 1989 W. Pitayetonakarn Izak Atlyas 60353 WPS165 Developing Countries' Exports of Manufactures: Past and Future Implications of Shifting Patterns of Comparative Advantage Alexander J. Yeats WPS166 Achieving and Sustaining Universal Primary Education: International Experience Relevant to India Nat J. Colletta March 1989 M. Philiph Margaret Sutton 75366 WPS167 Wage Determination In Rural Bangladesh: The Welfare Implications Martin Ravallion WPS168 Technological Change from Inside: A Review of ireakthroughsl Ashoka Mody March 1989 W. Young 33618 WPS169 Financial Sector Reforms In Adjustment Programs Alan Gelb Patrick Honohan WPS170 General Training Under Asymmetric Information Ellakim Katz Adrian Ziderman WPS171 Cost-Effectiveness of National Training Systems in Developing Countries Christopher Dougherty March 1989 C. Cristobal 33640  PPR Working Paper Series Title Author Date Contect WPS172 The Effocts of Peru's Push to Improve Education Elizabeth M. King March 1989 C. Cristobal Rosemary T. Bellow 33640 WPS173 Staffing and Training Aspects of Hospital Managoemnt: Some Issues for Research Julio Frenk Enriquo Ruelas WPS174 Trade Restrictions with Imported Intermediate Inputs: When Does the Trade Balance Improve? Ramon E. Lopez March 1989 M. Aweal Dani Rodrik 61466 WPS175 An Intograted Model of Perennial and Annual Crop Production for Sub-Saharan Countries Robert 0. Weaver WPS176 Credit Rationing, Tenancy, Productivity, and the Dynamics of Inequality Avishay Braverman Joseph E. Stiglitz WPS177 Cash-Flow or Income? The Choice of Base for Company Taxation Jack M. Mintz April 1989 A. Bhalla Jesus Sea:,e 60359 WPS178 Tax Holidays and Investment Jack M. Mintz April 1989 A. Bhalla 60359 WPS179 Public Sector Pricing In a Fiscal Context Christopher Heady April 1989 A. Bhalla 60359 WPS18O Structural Changes In Metals Consumptlon: Evidence from U.S. Data Boum-Jong Choe April 1989 S. Lipscomb 33718 WPS181 Public Finance, Trade and Development: What Have We Learned? Johannes F. Linn April 1989 M. Colinet Deborah L. Wetzel 33490 WPS182 The Experience of Latin America With Export Subsidies Julio Nogues April 1989 S. Torrivos 33709 WPS183 Private Investment in Mexico. An Empirical Analysis Alberto R. Musalem April 1989 L. Spear 30081