Itaú BBA - Congress Approves Energy Reform Bylaws

Scenario Review - Mexico

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Congress Approves Energy Reform Bylaws

August 11, 2014

Mexico’s IGAE (monthly proxy for GDP) was weak in May

• Manufacturing continues to perform well and will likely continue to lead Mexico’s growth. Recent data hint at a recovery of internal demand. We expect 2.4% growth in 2014 and 3.8% for 2015.

• Inflation breached the upper bound of the central bank’s target range in July and is expected to continue to edge higher (due to higher non-core food inflation). Headline inflation will likely fall back into the target range toward the end of the year. We see inflation at 3.7% in 2014 and at 3.2% in 2015.

• The minutes of the latest monetary policy decision confirm that interest rates will likely remain unchanged for some time. In our view, a new tightening cycle will likely start only in the last quarter of 2015, as Mexico’s output gap closes and the Fed starts to raise rates. We see the policy rate at 3.0% as of the end of this year and at 3.5% as of the end of 2015.

• The Mexican peso has depreciated more against the U.S. dollar than most major currencies have following the stronger-than-expected activity numbers in the United States. However, once markets start to price in the capital flows associated with the reform agenda, we expect the peso to perform better than its peers. We forecast an exchange rate of 13.2 pesos to the dollar for both the end of this year and the end of 2015.

• The telecommunication reform secondary laws were approved at the beginning of July, and the energy reform secondary laws were approved in Congress on August 6, after a heated debate. The energy bill will be sent for presidential ratification soon.

Manufacturing-Led Growth

Mexico’s IGAE (monthly proxy for GDP) was weak in May, but its sequential trend continues to improve. The index came in at 1.4% year over year in May (1.9% adjusting for calendar effects) after a strong 2.9% increase in April. Although the IGAE decreased by 0.1% month over month, it grew by 2.4% qoq/saar (vs. 1.2% in 1Q14).

Manufacturing production continues to show solid growth, influenced by the recovery of U.S. industry. In May, Mexico’s manufacturing output was up 9.2% qoq/saar, while manufacturing exports gained 19.3% qoq/saar in 2Q14, led by auto exports. Non-auto exports also performed well, rising by 16.8% qoq/saar.

Some indicators hint at an improvement in both consumption and investment. Imports of consumer goods excluding fuel were again strong in June, rising by 1.0% compared with May, and were up 43.8% qoq/saar for 2Q14. Although retail sales decreased slightly from April to May, they were up 4.7% qoq/saar. The improvement in consumption comes along with a 3.5% increase in formal employment in June, the highest such increase since May 2013, supported by a strong 5.4% increase in temporary employment (temporary job growth is a leading indicator of total employment). Meanwhile, gross fixed investment rose by 6.7% qoq/saar in May.

We are leaving our growth forecasts at 2.4% for 2014 and 3.8% for 2015. The positive evolution of the U.S. economy alongside loose monetary policy and expansionary fiscal policy in Mexico points to an acceleration of Mexico’s economy during the second half of the year. Indeed, the recent strong manufacturing ISM numbers in the U.S., coupled with the recovery in job creation in Mexico, suggest a bright outlook for Mexican exports and consumption. Finally, we believe that both strong public capital spending and the narrowing of the output gap will contribute to boosting investment.

Inflation Breaches the Upper Bound of the Target Range

Annual inflation breached the upper bound of the central bank’s target range in July, due to higher non-processed food prices – a factor which is likely to be temporary, in our view. Headline inflation reached 4.07% in July, up from 3.75% in June. Non-core inflation rose to 6.8% (from 6.0%), due to higher non-processed food prices. Meanwhile, core inflation stood at 3.20% (up from 3.1%), slightly above the center of the target range.

We expect headline inflation at 3.7% in 2014. For 2015, we expect 3.2%, as the effects of the tax hikes in the fiscal reform package fade away. Considering the negative output gap, the stable exchange rate and the low inflation rates abroad, headline inflation is likely to fall toward the end of this year, converging to the central bank’s target range. We maintain our inflation forecast of 3.7% for year-end 2014.

We See No Policy Rate Moves Soon

In July, the central bank left the policy rate unchanged at 3.0%. The statement announcing the decision was in line with the guidance provided in the previous decision: the rate cut in June was one-off. We do not expect any change in the policy rate in 2014. In our view, a tightening cycle will likely start in the last quarter of 2015, as the output gap of Mexico closes and the Fed starts raising rates.

Capital Inflows Likely to Curb the Depreciation of the Peso

The trade balance for June is consistent with an easily financed current-account deficit. On a seasonally adjusted and annualized basis, the trade balance registered a USD 5.6 billion deficit in 2Q14, after a USD 9.0 billion deficit the previous quarter. The improvement from the previous quarter was due to non-energy trade (a USD 10.3 billion deficit in 2Q14, compared with a USD 13.9 billion deficit the previous quarter).

We see the exchange rate at 13.2 pesos to the U.S. dollar at both year-end 2014 and year-end 2015. Although we expect Treasury yields to continue to rise, we do not expect a further weakening of the peso. The approved structural reforms will likely start to attract significant capital flows, offsetting tighter financial conditions abroad. If the implementation of the reforms is carried out as planned, capital inflows could start coming as early as the fourth quarter of 2014.

Energy Reform Bylaws Advance

After the political and telecommunications reforms were approved, the formal debate on the energy reform bylaws began in the Senate. A total of 15 laws related to the energy sector, divided into six legislative packages, were approved by the Senate on July 21. The next day the Lower House of Congress received the legislation from the Senate and the energy commission approved the energy bylaws (in general terms) on July 28. The President is expected to ratify these laws by the second week of August at the latest.

One of the main issues addressed in the bylaws is the granting of permits and contracts for energy-related activities. The Ministry of Energy (SENER) will be responsible for granting permits for oil refining, natural gas processing and imports of hydrocarbons, liquefied natural gas, petroleum and petrochemicals. The National Hydrocarbons Commission (CNH) will be responsible for granting the contracts to explore and extract hydrocarbons onshore and offshore, through a bidding process. Three main contract types will now be permitted: profit-sharing contracts, production-sharing contracts and licenses. Finally, the Energy Regulatory Commission (CRE) will issue permits for the transportation, storage, distribution, compression, liquefaction, decompression, re‑gasification, commercialization and retailing of hydrocarbons, liquefied natural gas, petroleum and petrochemicals.

According to the bylaws, the bidding process of oil fields will be divided into rounds. In Round Zero, Pemex will be awarded oil fields that can be exploited at reasonable speed given its current budget and technology capacity. After Round Zero, Pemex may enter into joint agreements with private firms – the so-called “farm-out agreements” – through a bidding process. Round Zero is expected to take place in September. In Round 1, Pemex will compete alone or in partnership with private firms for oil field contracts. Different types of fields will likely be included in Round 1 in order to attract a diverse array of companies. Round 1 is expected to take place during the first half of 2015.

The third important area addressed by the bylaws is the new fiscal regime for the energy sector. Under the proposed law, Pemex’s fiscal burden will be reduced significantly to make it more competitive. At the same time, the new fiscal regime for private firms entering the oil industry will have no VAT and, in some cases, will allow up to 15 years to pay the direct income tax due to fiscal losses. As part of the financial restructuring of Pemex and the Federal Electricity Commission (CFE), the federal government will absorb some of pension and retirement liabilities of these two entities on the condition that the Federal Comptroller’s Office (ASF) audits their pension systems. Pemex and CFE will have to adopt austerity measures to reform their pension systems and will have one year to conform to these conditions. The total liabilities of Pemex and CFE are equivalent to around 12% of Mexico’s GDP, and around a third of that would be absorbed by the federal government. The government sees this proposal as an opportunity for Pemex and CFE to reform their dysfunctional pension systems.

Finally, the bylaws create the Mexican Oil Fund for Stabilization and Development, which will oversee all resources related to oil revenues and will be managed by the central bank. The fund will be responsible for guaranteeing that the Mexican government receives oil revenues equivalent to 4.7% of GDP every year and for setting aside savings from these revenues equivalent to 3% of GDP. Once savings in the fund exceed 3% of GDP, some of the extra resources would go to other funds (Universal Pension Fund, Investment Vehicle Fund, Scholarship Fund and a Project Innovation Fund). In addition, the bylaws stipulate that Congress may authorize the exceptional use of resources from this fund to offset a shortfall in government revenues. In that way, fiscal policy in Mexico will become more counter-cyclical.


João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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