Itaú BBA - Calibrating the monetary policy response

Scenario Review - Mexico

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Calibrating the monetary policy response

December 8, 2016

Mexico’s economic activity accelerated in 3Q16

Please see the attached file for all graphs. 

We expect GDP growth to slow down from 2.6% in 2015 to 2.1% in 2016 and to 1.8% in 2017. The “Trump shock” is likely to perpetuate uncertainty about protectionism (particularly harmful for investment in Mexico’s manufacturing). Higher growth in the U.S. (due to fiscal stimulus) is a buffer.

A prolonged period of uncertainty over U.S.-Mexico trade relations will likely keep the Mexican peso at week levels. We see inflation at 3.7% by the end of next year (up from an upwardly revised 3.4% in 2016).  

As the central bank switched its focus to the pass-through from the Mexican peso depreciation (instead of the Mexican peso itself), we expect rate hikes to move in lockstep with the Fed. That is, three 25-bp rate hikes before the end of 2017.

The fiscal accounts have shown signs of improvement in early 4Q16, which is why we have lowered our public deficit forecast for 2016 to 2.7% of GDP (from 3%). Fiscal consolidation is making headway.

Activity was cyclically firmer when the “Trump shock” hit

Mexico’s economic activity accelerated in 3Q16, supported by strong growth in the service sector and an incipient pickup in manufacturing output. The monthly GDP proxy (IGAE) expanded by 1.6% year over year in September, leaving the GDP growth rate of 3Q16 at 2% year over year (consistent with the previously released flash estimate). Adjusting for calendar effects, GDP growth was also 2% year over year – up from 1.4% in 2Q16 – thereby marking an acceleration. In fact, at the margin GDP advanced 4.1% qoq/saar (from 0.2% qoq/saar in 2Q16).

Growth is uneven across sectors, with mining and construction contributing negatively to activity. Working-day adjusted figures show that the growth of services picked up from 2.5% year over year in 2Q16 to 3.4% in 3Q16, while industrial production growth slipped to -0.8% year over year (from -0.6% previously) during the same period. Looking at the breakdown of Industrial sectors, however, we highlight that manufacturing output improved (0.7% year over year in 3Q16, from 0.4% in 2Q16), which is consistent with the acceleration of manufacturing exports in the trade balance data. Conversely, mining output (-7.4% year over year in 3Q16 vs. -4.9% in the previous quarter) and construction activity (0% in 3Q16 vs. 1.2% previously) worsened, probably dragged down by the fiscal consolidation of the government (whose budget cuts are concentrated in PEMEX’s capex).

We expect GDP growth of 2.1% in 2016, but our forecast for 2017 implies a deceleration, to 1.8%, in response to the “Trump shock.” In 4Q16, manufacturing output will likely continue gaining traction, helped by the pickup in U.S. industrial output and a competitive exchange rate. But the prospects for 2017 have deteriorated, considering that the uncertainty over protectionism will take a toll on investment in the Manufacturing sector. For the service sector, we expect a moderate slowdown as inflation increases (eroding real wages) and tighter fiscal and monetary policies have a negative effect on consumers.

Inflation is fueled by depreciation

The outlook for the exchange rate is contingent upon the course of U.S. policies – on issues such as trade, immigration and remittances. As uncertainty over these issues is expected to diminish only gradually,our exchange rate forecasts for 2016 and 2017 are 20.5 MXN/USD and 19.5, respectively. The real effective exchange rate looks undervalued, but a prolonged period of uncertainty over U.S.-Mexico trade relations can exert protracted pressure on the MXN, keeping the currency far away from fundamentals.

We have increased our inflation forecast for 2016 (to 3.4% from 3.2%) and maintained the forecast for 2017, at 3.7%. Exchange-rate pass-through and the increase of non-core inflation have been more significant than we expected. However, we note that part of the recent increase in year-over-year inflation is attributable to the reversal of a base effects associated with the telecom reform. As of October 2016, we estimate that mobile telephone costs (falling by 28.5% year over year) were subtracting 31 basis points from annual inflation, but this negative contribution shrank to 18 basis points in the first half of November (and would fall to 14 basis points in December, assuming mobile telephone prices remain constant from November). For 2017, we believe that the lagged effects of the sharp peso depreciation triggered by the U.S. presidential election, and to lesser extent the liberalization of gasoline prices, will exert upward pressure on consumer prices.

Central bank calibrates its policy response

The Trump electionhas been a game-changer for the Central Bank, whose discourse has changed by acknowledging that the economy is facing a “real shock,” rather than just volatility, which makes a difference in the calibration of the appropriate policy response. During the presentation of the quarterly inflation report, Governor Carstens argued that the uncertainty over Mexico’s economic outlook warrants real exchange-rate depreciation, stressing that the latter acts as shock absorber and represents the “most efficient” adjustment mechanism under these circumstances. The takeaway is that the central bank will be less reactive to potential new currency sell-offs (at least if linked to protectionism developments), and that its focus is on preventing second-round effects on inflation (from the weakening currency).

Recently, Central Bank Governor Agustín Carstens resigned from his position, but we do not expect this event to have negative implications for governance nor for the credibility of Mexico’s monetary policy. Agustín Carstens presented a resignation letter to President Peña Nieto and will leave Banxico in July 2017 to lead the Bank for International Settlements (BIS). In our view, Carstens’ successor will be another technocrat with strong academic and professional credentials, just like every other member of the board, so it is unlikely that the quality of monetary policymaking will change. Banxico has built strong credibility over the past decades, which is reflected in the taming of inflation (significantly down from the 1990s), well-anchored inflation expectations and low exchange-rate pass-through. The inflation mandate guarantees discipline, and governance is already strong.  

Looking ahead, our call is that Banxico will hike rates in lockstep with the Fed. The short-term interest rate differential between Mexico and the U.S. is mentioned in the policy documents as a major variable to be monitored. We expect Banxico to hike by 25 bps in December, assuming the Fed makes a similar move, and then deliver two similar hikes next year (also following the Fed), bringing the reference rate to 5.5% and 6.0% by the end of 2016 and 2017, respectively. In fact, according to the minutes of the last board meeting, one deputy governor highlighted that, under current conditions, Banxico has little room to decouple from the Fed.

External and fiscal imbalances will likely narrow

The current account deficit remained stable in 3Q16 (rolling 4Q: 2.9% of GDP), in spite ofa narrower trade deficit (which was offset by a deterioration in the income balance). Manufacturing exports are recovering, and the weaker currency is hitting non-energy imports. A downside risk, nevertheless, is the extent to which the fiscal consolidation plan of the government will affect the energy balance (by cutting PEMEX’s capex and hence oil output).

Funding of the current account deficit is challenging: net FDI (rolling 4Q: 2.2% of GDP) is not enough to fully fund the deficit. Overall, FDI has held up well, but flows into the domestic bond market (a key source of financing) are scarcer. The price action of financial assets, after the U.S. election (and the sharp peso depreciation), suggests there were outflows of portfolio investment.

We expect the current account deficit to narrow – from 2.9% of GDP in 2015 to 2.8% in 2016 and to 2.4% in 2017 – as the substantial real exchange-rate depreciation and slower growth of the Mexican economy will likely affect the demand for imports. At the outset, we expect manufacturing exports to accelerate, driven by a pickup in U.S. industrial output and a competitive exchange rate, and domestic demand to weaken. From a funding perspective, the risk of protectionism could be another drag on foreign direct investment (especially to the tradable sectors), while higher U.S. treasury yields could mean further outflows from the domestic bond market.

On the fiscal front, there are signs of improvement in early 4Q16. The 12-month public deficit narrowed from MXN 450.1 billion (2.4% of GDP) in 3Q16 to MXN 369.5 billion (approximately 1.9% of GDP) in October. In fact, the Treasury (SHCP) has narrowed its estimate for the primary deficit for 2016 from 0.4% of GDP (estimate presented in September’s budget) to 0.3% of GDP, although it still expects public sector borrowing requirements of 3% of GDP. Given these better-than-expected results, we have revised our estimate of the public deficit for 2016 to 2.7% of GDP (from 3%). It is also worth noting that the net debt of the public sector decreased from 47.6% of GDP in 3Q16 to 46.8% of GDP in October. Nevertheless, net debt is expected to increase significantly in the last months of 2016, considering the increase in the local currency value of foreign debt (as a result of the sharp peso depreciation) and the federal government’s purchase of the National Electricity Company’s (CFE) pension liabilities for up to MXN 160 billion (0.8% of GDP). Looking ahead, a large dividend from the central bank (due to exchange-rate gains on international reserves) could be a windfall for fiscal accounts in 2017.

Finally, we highlight that the Mexican government successfully carried out the fourth set of oil field auctions (“Round 1.4”) of the energy reform, which represents positive news for economic activity, capital inflows and fiscal sustainability in the medium-term. “Round 1.4” can be considered a success in the sense that it awarded 8 of the 10 blocks auctioned (without counting PEMEX’s Trion project), thereby doubling the goal set by the Ministry of Energy (SENER). Indeed, the Energy Minister, Pedro Joaquín Coldwell, had said that awarding 4 of the 10 blocks would be a positive outcome. Given these results, foreign direct investment commitments from “Round 1.4” would add up to approximately USD 43 billion (around 4% of current GDP) over time. Notably, the first three rounds (1.1, 1.2 and 1.3) only got investment commitments of USD 7 billion. So this marks a more important milestone towards the liberalization of the energy sector (whose market has been historically captive for state-run monopolies). Moreover, PEMEX’s partnerships with private firms aim at improving the profitability of the firm, and hence its financial soundness, which will have positive implications on Mexico’s fiscal position.


João Pedro Bumachar
Alexander Andre Muller

Please see the attached file for all graphs.  


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