Itaú BBA - A Bolder Energy Reform Is Back on the Table

Scenario Review - Mexico

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A Bolder Energy Reform Is Back on the Table

diciembre 4, 2013

A political-electoral bill will likely be approved over the next few days.

•    A political-electoral bill will likely be approved over the next few days, clearing the way for energy reform. Politicians have hinted that the energy bill would be more aggressive than the PRI’s original proposal.

•    The economy rebounded during 3Q13 and is up 3.4% qoq/saar after a 2.2% contraction in the previous quarter. The economy will likely grow 3.6% next year, following a weak 1.3% expansion in 2013.

•    Inflation has begun to rise, although core inflation fell and continued below the center of the target. We see inflation at 3.6% by the end of this year, lifted by base effects. For 2014, tax hikes will hold headline inflation around the same levels (we expect 3.7% by the end of 2014).

•    In an environment of higher interest rates abroad, the Mexican peso has depreciated, even with the positive news on energy reform. We now see the peso ending 2014 at 12.5 to the dollar (12.0 in our previous scenario), from 13.0 by the end of this year (12.8 previously). 

•    The minutes of the last monetary policy meeting reaffirmed that additional rate cuts are unlikely. In addition, the document showed that concerns over the wide public deficit announced for 2014 influenced the policy guidance. We do not expect interest rate moves at least until the beginning of 2015.

A Busy Congressional Calendar

A political-electoral bill will likely be approved over the next few days. If approved, the draft bill currently under discussion would allow the reelection of senators for up to one additional term and federal and state legislators for a total tenure of up to 12 years. The bill also introduces the reelection possibility for mayors. Furthermore, the foreign minister will need to be ratified by the senate, while the minister of finance will require ratification by the lower house. The threshold of votes for party registration would increase from 2% to 3%. According to the bill, the president would take office on October 1 (instead of December 1), so the transition between governments would be faster. A National Electoral Institute (INE) would replace the Federal Electoral Institute. Some controversial items of political-electoral reform were not included in the draft bill. Among them, a second-round vote for presidential elections and changes in the political status of Mexico City.   

Politicians from the PAN and the PRI confirmed that energy reform would be discussed and approved in congress as soon as the political-electoral bill is approved. Thus, a constitutional reform to allow private-sector participation in all the segments of the Energy sector is likely before the end of the current ordinary session of congress (December 15). Importantly, the energy reform bill will likely be closer to the PAN’s proposal, which is bolder than the profit-sharing scheme previously announced by the PRI. Specifically, the reform would remove the constitutional constraint for granting concessions. Still, the final framework for energy will only be known when the secondary legislation is approved, which is expected in the first quarter of 2014.    

The PRD left the Pact for Mexico. The PRD’s departure was in protest against developments in the energy debate and, to a lesser extent, the political-electoral bill. The PRD’s decision to leave resembles the PAN protest against the tax reform bill. It seems that instead of moving to the center on both reforms, the PRI decided to endorse a tax reform that would please the PRD and an energy reform that matches the PAN’s. We recall that the PAN and the PRI have enough seats in congress to approve both the political and the energy reforms.    

The Economy Rebounds During 3Q13

Activity was weak in September but solid in 3Q13 as a whole. The IGAE (monthly proxy for GDP) fell by 0.4% between August and September, as the three supply-side components saw month-over-month contractions: Agriculture, Industry and Services were down by 1.2%, 1.15% and 0.4%, respectively. Activity in September was likely hurt by the severe storms that affected Mexico during the month. In 3Q13, Mexico’s economy expanded by 3.4% qoq/saar, after a 2.2% contraction in the previous quarter (revised upward from -2.9%), with both Services (5.3%) and Industry (3.6%) rebounding.

The GDP figures are consistent with our view that Mexico’s economy would recover from the weakness seen in the first half. However, growth continues to be too dependent on external demand. While the demand-side data for GDP is yet to be released, the available indicators suggest that both consumption and investment remain too weak. In fact, retail sales contracted by 2.4% qoq/saar during 3Q13 – the fourth consecutive quarter of negative growth. In August, gross fixed investment was down by 6.9% qoq/saar.

We reaffirm our GDP forecast for this year at 1.3% and at 3.6% for 2014. We also expect that the decoupling of external demand from internal demand will not last long, so we see a more balanced recovery ahead. Next year, the economy will likely be helped not only by stronger growth in the U.S. economy, but also by the full or partial reversal of the negative shocks that have impacted the economy this year (gas supply disruptions, financial strain for homebuilders, slow public expenditure growth). 

Inflation Starts to Rise, but Demand-Side Inflationary Pressures Are Absent

In the first half of November, headline inflation increased, while core inflation fell. Headline inflation on a year-over-year basis increased to 3.51% (from 3.45% in the second half of October), above the center of the target range. The increase was due to higher non-core inflation (7.01% from 6.51% previously), which was led by a 275-bp gain in inflation for non-processed food items. Meanwhile, core inflation fell from 2.49% to 2.43%. Although the exchange rate weakened over the past few months, inflation for core goods continued to fall, to 2.02% (core goods ex-food inflation is below the lower bound of the target range, at 1.37%). Core services inflation went up but remained low (at 2.77%, from 2.62% in the second half of October), highlighting the lack of demand-side inflationary pressure in Mexico.

We expect Mexico’s inflation to end this year at 3.6%. For 2014, we see inflation at 3.7%. Unfavorable base effects will contribute to higher annual inflation by the end of the year. Meanwhile, tax hikes are expected to lift prices in 2014, which will likely keep inflation above the target center but within the target range.

A Wider Current-Account Deficit

Driven by a deterioration in the income balance, Mexico’s current account deficit widened during the 3Q13. The current account gap came in at USD 5.5 billion, up from a USD 1.9 billion deficit one year before. As a result, the four-quarter rolling deficit widened to USD 24.9 billion (or 2% of GDP), from USD 21.3 billion (1.7% of GDP) the previous quarter and USD 14.6 billion in 2012 (1.2% of GDP). The deficit widening was mostly due to higher investment income remittances (the four-quarter rolling income balance reached USD 29.1 billion, up from USD 25 billion the previous quarter).

In spite of higher yields in the U.S., foreign flows to Mexican fixed income securities were strong in 3Q13. During the period, foreigners invested USD 17.6 billion in Mexican securities. However, this time around flows to bonds issued abroad took center stage (USD 10.9 billion), while investment in domestic bonds was USD 3.0 billion and flows to the stock exchange were USD 3.7 billion. Over the last four quarters, net portfolio flows (that is, excluding Mexican portfolio investment abroad) totaled an impressive USD 56.7 billion, though lower than the USD 65.4 billion of the previous quarter. Meanwhile, direct investment continues to be subdued. Foreign direct investment was USD 3.4 billion during 3Q13, while Mexican direct investment abroad was USD 2.1 billion, putting net direct investment at a low USD 1.3 billion. Net direct investment flows accumulated over the last four quarters continued to be high relative to the recent past (USD 18.4 billion), but this is only due to a large one-off transaction that took place in 2Q13.   

We expect the Mexican peso to appreciate next year, reaching 12.5 to the dollar by year-end (12.0 in our previous scenario), from 13.0 at the end of 2013 (12.8 in our previous scenario). With the reform agenda evolving, capital flows to Mexico will continue to be robust over the next few years, supporting the exchange rate (the composition of flows will likely shift from portfolio to direct investment, also considering that monetary policy abroad will be tighter). Still, we now see a more limited upside for the peso next year, taking into account that, amid higher interest rates in the U.S., the recent positive news on energy reform couldn’t prevent the peso from weakening further.   

Reaffirming That There Will Be “No Additional Rate Cuts in the Foreseeable Future”

According to the minutes of the latest monetary policy meeting, the decision to lower the interest rate by 25 bps was unanimous. This is in contrast to the previous decision, when the central bank reduced the policy rate by 25 bps, but two board members voted to keep it unchanged. In our view, the two dissenting board members likely decided to vote in favor of a cut due to the other members’ “commitment” to end the easing cycle. In fact, there was a unanimous agreement within the board that additional rate cuts would not be advisable in the foreseeable future, and that the central bank should communicate this message to the market.

The minutes of the latest meeting revealed the reasons for closing the doors on additional rate cuts. Board members continued to be very concerned with economic growth and sounded comfortable with the inflation outlook. They see decreased (but still-high) downside risks for the economy relative to the previous meeting. The output gap is likely to remain wide within the relevant monetary-policy forecast horizon. In addition, most board members see an improved balance of risks for inflation. Still, the board doesn’t think that there is room for additional rate cuts. First, because it expects a narrower (though still wide) output gap ahead. Second, the real interest rate is already too low (specifically, the central bank cites the short-term ex ante real rate, which is close to zero) and a new rate cut could generate risks to financial stability. Finally, the higher public deficit announced for 2014 is also weighing on monetary policy guidance. However, this is not because of the positive impact of public spending on growth or because of the transitory impact of tax hikes on inflation. It is because there is the risk that the government will fail to bring the public deficit (excluding PEMEX investments) back down to zero over the next few years. In fact, one board member referred to the potential negative impact of the higher public deficit announced for 2014 on expectations. In the concluding remarks of the most recent inflation report, the central bank again highlighted the importance of solid public finances by pointing out that besides a successful reform agenda, strengthening Mexico’s fiscal accounts is key to supporting growth in the medium term.  

We don’t expect any policy rate moves soon. In our scenario, the central bank will remain on hold throughout 2014, so the policy rate would likely end both 2013 and 2014 at 3.5%.   

João Pedro Bumachar

Forecasts: Mexico

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