Itaú BBA - Reducing the fiscal deficit

Scenario Review - Mexico

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Reducing the fiscal deficit

May 4, 2016

While Mexico’s net public debt is rising to less comfortable levels, authorities are taking action to stabilize it.

Please see the attached file for all graphs. 

• The Mexican economy continued to grow at a moderate pace in 1Q16, boosted by consumption, while exports remained weak. We expect the economy to grow by 2.5% this year – the same rate recorded in 2015.  

• Inflation remains very well-behaved, below the center of the target. We expect 3.0% inflation at the end of both this year and the next. Although inflation is projected to increase from current levels, it is likely to remain low. 

• We forecast an exchange rate of 17.5 pesos to the dollar, both by the end of this year and by the end of 2017. The more supportive external environment for EM currencies is likely to keep the Mexican peso at around the current levels.

• When presenting the guidelines for the 2017 budget, the government announced new expenditure cuts. As a result, while Mexico’s net public debt is rising to less comfortable levels (45% of GDP by the end of 2015), authorities are taking action to stabilize it.

• We expect no rate hikes in Mexico this year, even though we see two rate increases in the Fed fund rate during the second half of 2016.

Uneven moderate growth

Mexico’s economy continued to grow at a moderate pace in 1Q16. The IGAE (monthly GDP proxy) showed a gain of 4.1% in February, helped by the leap-year effect. Looking at the data beyond calendar effects, the IGAE adjusted for working days grew at a moderate 2.8% year-over-year pace, following gains of 2.9% in January and 2.6% in 4Q15. Sequentially, the IGAE increased 2.8% qoq/saar. The flash estimate for the 1Q16 GDP stood at 2.7% year-over-year.

Growth was again led by services, at 3.9% year-over-year in February (adjusted for working days), up from 3.6% in January, reflecting the strength of domestic consumption. In fact, retail sales posted a notable 5.4% growth (working-day adjusted), following a 5.9% gain in January. Robust formal-employment growth, low inflation, remittance expansion (converted to pesos) and credit have helped consumers.

Meanwhile, industry continued to perform poorly, hurt by weak oil output and sluggish manufacturing exports. Industry adjusted for working days gained only 0.8% in February (after a weak 1.6% expansion in January), as mining production contracted 5.0% and manufacturing rose by a weak 1.8%. If it wasn’t for the consumption performance, manufacturing would have grown even less: manufacturing exports (measured in current dollars) contracted 14.4% qoq/saar in 1Q16, with both the auto and non-auto component falling.

We expect Mexico’s economy to grow by 2.5% this year – the same rate recorded in 2015. We anticipate a recovery in U.S. industry, leading to an improvement in manufacturing exports and offsetting the negative impact of the fiscal consolidation on construction and oil production and some loss of momentum in consumption (Antad same-store sales data shows some moderation in sales in March). For 2017, we forecast a modest recovery to 2.7%.

Inflation remains low

Inflation remains well-behaved, below the center of the target. Annual inflation reached 2.6% in the first half of April, slightly up from the 2.49% recorded in the second half of March. Core inflation stood at 2.79%: despite the past depreciation of the Mexican peso, core goods inflation is at 3.26%, while the negative output gap has contributed to low core service inflation of 2.4%. Non-core inflation is hovering near the lower bound of the target, as the volatile prices for agricultural items moderated (5.0% year-over-year vs. 5.7% in the second half of March) and inflation on regulated items picked up to a still low 0.14% year-over-year (helped by low oil prices).

We expect inflation of 3.0% by the end of both this year and the next. Given our projection of a recovery in oil prices, regulated inflation is unlikely to remain so low. Furthermore, annual service inflation is likely to rise due to base effects related to the telecom reform. That said, although we expect inflation to rise from the current levels, it is likely to remain low.

Trade deficit continues to rise

Weak manufacturing exports and a deteriorating energy balance have led to worsening external accounts. The 12-month rolling trade deficit widened to USD 16.3 billion in 1Q16 (from USD 14.5 billion in 2015) – the largest deficit since July 2009. The energy balance registered a deficit of USD 10.6 billion (the worst reading on record), while the non-energy trade deficit stood at USD 5.7 billion (widening from the USD 4.6 billion registered in 2015 but still at a historical low). The trade deficit also widened at the margin (on a seasonally-adjusted basis), to USD 21.4 billion (annualized) in 1Q16 (from USD 15.1 billion in 4Q15), although the energy balance actually improved from 4Q15, to a deficit of USD 10.3 billion (down from USD 11.6 billion in 4Q15). The non-energy deficit increased significantly, to USD 11.1 billion in 1Q16 from USD 3.4 billion in 4Q15.

Looking ahead, we expect some improvement in the trade accounts as the more competitive exchange rate and higher U.S. industry output (the ISM index recently rose above 50) generate a recovery in manufacturing exports. Still, we now expect a wider current-account deficit of 2.5% of GDP for this year, versus our previous scenario of 2.2%, but narrower than the 2.8% recorded in 2015.

We expect an exchange rate of 17.5 pesos to the dollar by the end of both this year and of 2017. The more supportive external environment for EM currencies is likely to keep the Mexican peso at around the current levels.

New measures to stabilize public debt

Moody’s rating agency kept Mexico’s sovereign rating at A3, but changed the outlook from stable to negative. According to the press statement announcing the decision, the revised outlook took into account the fiscal-consolidation risks coming from “subdued economic performance and continued external headwinds” and “contingent liabilities in the form of possible government support for Pemex.” The agency added that “over the coming one to two years, it will evaluate the progress achieved on fiscal consolidation and the implementation of expenditure cuts at Pemex to confront liquidity pressures,” indicating that a rating downgrade in the near term is unlikely.

In response, the government announced new expenditure cuts together with the guidelines for the 2017 budget. In order to ensure a deficit reduction path amid lower oil revenues (due both to lower oil prices and lower oil production), the government announced expenditure reductions of around 0.9% of GDP for next year, relative to the 2016 budget (which was cut by 0.7% of GDP in mid-February).

The Central Bank also announced a dividend of 239 billion pesos (slightly more than 1% of GDP) for the federal government. Following the transfer, the government is likely to lower the fiscal deficit target for this year, which is currently at 3.0%.

As a result, while Mexico’s net public debt is rising to less comfortable levels (45% of GDP by the end of 2015), authorities are taking action to stabilize it. Our expectation of a recovery in oil prices will also help the country to preserve its sovereign ratings.

No rate hikes this year

The Central Bank left the policy rate on hold in March, following a surprise hike in February. The recent exchange-rate appreciation in an environment of moderate growth and low inflation makes rate hikes in the near term unlikely.

We expect no rate hikes in Mexico this year, even though we see two rate increases in the U.S. during the second half of 2016. Fed hikes are now less likely to lead to a strong depreciation of the Peso, as the Fed seems to have moderated its reaction function to avoid triggering significant financial strains. Other recent developments in the global economy (including the recovery in oil prices) should also help to contain exchange-rate depreciation pressures. Fiscal consolidation is another factor conducive to looser monetary policy. Finally, only the threat of Mexican policymakers using their firepower to prevent a sell-off in the exchange rate is likely to discourage short positions in the Mexican peso. Based on the minutes of the previous policy decision, only one board member explicitly stated that the short-term interest rate differential with the U.S. should not narrow. Our perception is that most board members are unwilling to commit to a pre-set response to the Fed.


 

João Pedro Bumachar


 

Please see the attached file for all graphs.  


 

 



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