Itaú BBA - The Economy Offers a Negative Surprise

Scenario Review - Mexico

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The Economy Offers a Negative Surprise

August 30, 2013

Enrique Peña Nieto announced the government’s reform proposal for the energy sector.

•         Enrique Peña Nieto presented the government’s energy reform proposal, which, as expected, was less bold than that of the main opposition party, but significant nonetheless.

•         The economy performed in 1H13 was much worse than expected. We now project a 1.3% growth rate this year and maintain our 3.6% forecast for 2014.

•        Core inflation reached a new record low, while headline inflation is within the target range. Our year-end inflation forecasts are unchanged, at 3.6% for 2013 and 3.5% for 2014.

•         Higher U.S. yields led to a sharp depreciation of the Mexican peso recently. The persistent downward activity surprises and uncertainty regarding the final energy reform could also be weighing on the exchange rate. Although we continue to expect the peso to reach 12.0 to the dollar before the end of 2014, we now see the peso at 12.8 by the end of this year (12.2 in our previous scenario).

•         Despite the slower growth and tamed inflation, we believe the tighter monetary policy stance in the U.S. will prevent interest-rate cuts, and foresee an unchanged policy rate throughout our forecast horizon.

The Government Unveils Its Energy Reform Proposal

Enrique Peña Nieto announced the government’s reform proposal for the energy sector. The proposal is less bold than the bill presented by the PAN (Mexico’s main opposition party), but it is still much more aggressive than expected a few months ago. According to the government’s proposal, Mexico’s constitution would be changed to allow private investment in all segments of the energy sector. The private sector would gain access to Mexico’s oil industry through profit-sharing agreements. This is a key difference from PAN’s proposal, which establishes a concession scheme to attract private firms. Because concessions usually offer a more aggressive risk/return relationship than profit-sharing agreements, oil companies are likely to find the former more attractive. The government’s proposal would also make PEMEX more competitive, given the easing tax burden that would free up the company’s resources for investment. Moreover, the company would be split into two, so that one company could focus only on exploration and production activities.

In our view, the proposals from both PAN and the government are close enough that the parties should be able to reach an agreement.The energy-reform debate in the Mexican congress will begin in September. Given that these two parties have enough combined congressional seats to change the constitution, the left-wing PRD (which is currently proposing an energy reform that does not require a change in the constitution) will not need to be on board.

We expect a positive outcome in the congressional debate on energy reform.Because changing the constitution to allow the private sector to engage in energy activities involves a large political cost, we do not believe that either the PAN or the PRI would push for a constitutional change that is not attractive enough for private investment. We therefore expect the PRI to reshape its proposal – if necessary – to ensure that oil companies have an incentive to invest in Mexico’s energy sector. 

Still, we acknowledge that there are substantial risks to the energy reform.The PAN is demanding changes in the political system before voting on the energy reforms, and if it insists on proposals such as election runoffs or the adoption of a semi-parliamentary system, the chances of reaching an agreement with the PRI will be reduced. Furthermore, the reform may face opposition from the PRI itself, particularly from those with close connections with the PEMEX union. Finally, Lopez Obrador (Mexico’s main left-wing leader, who left the PRD after the last presidential election) is calling for protests against the reform.  

A Much Weaker-Than-Expected Economy in 2Q13

Mexico’s GDP contracted 2.9% qoq/saar during 2Q13, following a downwardly revised 0.1% expansion in the previous quarter. The Industrial sector fell 4.3% during the second quarter of the year, following a 2.6% loss in the previous quarter. The Service sector shrank 1.7% (vs. +1.3% during 1Q13). The small, volatile Primary sector rose 5.0%, after a 9.5% drop in 1Q13. The June IGAE (monthly GDP proxy) was also weak (0% mom).

We now expect Mexico’s economy to post a 1.3% grow this year. Given the weak 2Q13 activity reading and the downward growth revision in 1Q13, the statistical carry-over for this year has become very unfavorable. Our new forecast still calls for strong economic growth in the second half of the year, boosted by higher growth in the U.S.; we expected a 2.3% expansion previously.

We continue to expect a 3.6% expansion in 2014. In addition to the higher growth in the U.S., Mexico’s economy will also benefit from the positive impact of reforms on activity next year.

However, we note that the initial activity indicators for 3Q13 do not yet indicate an economic rebound. Manufacturing exports were flat in July, relative to the previous month, while the Manufacturing PMI and its main subcomponents stood below 50. Formalemployment slowed to 3.2% year over year (vs. 3.5% in June and 4.0% in May).

Core Inflation Continues to Edge Lower  

Headline inflation increased on a year-over-year basis during the first half of August, to 3.54%. The higher inflation was due to a sharp increase in non-core inflation (to 7.34% from 6.58% previously), which is a very volatile component of the CPI.

On the other hand, core inflation fell to a record-low 2.38%, below the target’s center. The decrease in core inflation was driven by the goods component (now at 2.51%), likely influenced by the delayed impact of exchange-rate appreciation. Meanwhile, core service inflation remains low, falling further to 2.27% (vs. 2.35% previously) and helped by the lower activity growth.

We expect Mexico’s inflation to end the year at 3.6%. Year-over-year inflation is likely to fall in the next few months, until it starts a base-effect induced temporary upward trend in November. The risks to this forecast are balanced, in our view. On one hand, the exchange-rate depreciation (if sustained) could pressure tradable prices. On the other hand, activity has been more sluggish than previously expected. Our inflation expectation for 2014 also remains unchanged, at 3.5%.

Ongoing Exchange-Rate Volatility

Mexico’s current account deficit is widening, but remains at a moderate level. The current account deficit came in at USD 6 billion in 2Q13, up from a USD 1.3 billion deficit one year before. As a result, the rolling four-quarter deficit reached USD 22 billion (or 1.8% of GDP), from USD 14.2 billion in 2012 (1.2% of GDP).

Foreign direct investment (FDI) was very strong during 2Q13 due to temporary factors, while foreign portfolio investment weakened. FDI came in at USD 18.3 billion during the quarter, boosted by the USD 13.2 billion acquisition of a brewery company. Excluding this transaction, foreign direct investment remained moderate. Net direct investment (that is, foreign direct investment minus Mexican direct investment abroad) stood at USD 16.5 billion during 2Q13 and at USD 16 billion (1.3% of GDP) over the last four quarters. Foreign portfolio investment fell to almost zero, given that foreign investors have withdrawn USD 4.9 billion from Mexican equities and investments in public bonds fell to USD 2.0 billion (from USD 11.9 billion in 1Q13). However, Mexicans repatriated USD 8.3 billion through the portfolio account, leading to a strong net portfolio investment of USD 8.3 billion during 2Q13 and USD 66.3 billion over the past four quarters. Although the current-account financing continues to come predominantly from the portfolio account, we expect the reforms, together with higher U.S. yields, to cause a shift in capital flow composition ahead, meaning that direct investment would gain a larger share in Mexico’s foreign financing.

We now see the peso at 12.8 to the dollar by the end of this year. We continue to expect the peso to reach 12.0 to the dollar before the end of 2014. Higher U.S. yields led to a sharp recent depreciation of the Mexican peso. The persistent downward activity surprises and uncertainty regarding the final energy reform could also be weighing on the exchange rate. In our view, the Mexican peso will resume an appreciation trend once it becomes clear that there will be a positive outcome to the energy-reform debate and the economy starts to show convincing signs of a rebound.

Lower Growth and Tamed Inflation are Unlikely to Lead to Lower Interest Rates

The central bank’s latest inflation report reaffirmed that higher interest rates abroad is an important variable in Mexico’s monetary-policy debate. In its concluding remarks, the central bank repeats the message delivered in both the minutes and the statement accompanying the monetary policy decision: for the next few meetings, the board will pay particular attention to the developments in economic activity, to potential second-order effects from relative price adjustments, and to the Mexico’s monetary policy relative to that of other countries.

We expect the central bank to keep rates on hold throughout our forecast horizon. The activity numbers following the inflation report suggest that growth will remain below the lower bound of the range forecasted by the central bank for this year. However, the increased exchange-rate volatility over the past few weeks is likely to keep the central bank on the sidelines.

João Pedro Bumachar
Economist

Forecasts: Mexico



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