Itaú BBA - A tighter budget

Scenario Review - Mexico

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A tighter budget

octubre 5, 2015

Reacting to lower oil revenues.

Please see the attached file for all graphs. 

• With oil revenues falling short of expectations (due to both weaker production and lower oil prices), the government announced on September 8 – when it submitted its 2016 budget proposal to Congress – expenditure cuts worth 97 billion pesos (or around 0.5% of GDP) for next year. This year the government is spending 124 billion pesos (0.65% of GDP) less than the amount approved by Congress.

• Mexico’s IGAE (monthly proxy for GDP) grew at a weak pace in July. The manufacturing sector has been weak, in spite of the depreciation of the currency and the recovery of the U.S. economy. On the positive side, internal demand continues to perform well and oil output is stabilizing. Although we expect growth to pick up, we are reducing our 2015 GDP growth forecast to 2.2% from 2.4% in our previous scenario. For 2016, we still expect a 2.8% growth rate.

• With the currency still under pressure, the Exchange Rate Commission (made up of representatives of the central bank and the finance ministry) rolled over the two intervention programs that were set to expire in September 30. As a result, the central bank will continue selling USD 200 million daily without a minimum price and another USD 200 million every day when the exchange rate weakens by at least 1%. We still see the currency ending this year at 17.0 pesos to the dollar and ending 2016 at 17.5 pesos to the dollar.

• Given the weaker currency, inflation for core goods rose somewhat in September. Even so, headline inflation and core inflation remain below the center of the target range. We now expect inflation to end this year at 2.8% (down from 3.0% in our previous scenario). For 2016, we see inflation at 3.0%.

• Mexico’s central bank left the policy rate unchanged at 3.0% in September. In the concluding remarks of its statement, the board again highlighted the economy’s weak cyclical conditions, as well as the low inflation rate and well-anchored inflation expectations. Still, the future actions of the U.S. Fed remain a key concern. As both growth and inflation have been low, we still believe that rate hikes in Mexico will come only in 1Q16, after a hike by the Fed in December and once it has become clearer that Mexico is benefiting from the U.S. recovery.

• The second phase of Round One oil auction came according with government and market expectations. Three out of five fields were awarded. The looser terms of contracts have contributed to attract more bids than in the first phase.


 

Reacting to lower oil revenues

On September 8, when it submitted its 2016 budget proposal to Congress, the government announced expenditure cuts worth 97 billion pesos (or around 0.5% of GDP) for next year. This year the government is spending 124 billion pesos (0.65% of GDP) less than the amount approved by Congress. Public investment (including Pemex) is being hit particularly hard by the budget cuts.

The tighter budget is a response to lower oil revenues. In 2015 through July, oil revenues declined by 35.9% in real terms. There are some offsetting factors: excise tax revenues are growing strongly, as domestic gasoline prices are above international levels, and by the end of the year, the government will exercise an oil price hedge of 76.4 dollars per barrel. For next year, however, oil revenues were hedged at a lower oil price (49 dollars per barrel), so there will be more downward pressure on government revenues in 2016.

The government is targeting budget deficits of 3.5% of GDP this year and 3.0% of GDP in 2016.

In all, the 2016 budget proposal signals a commitment by the government to maintain fiscal stability, but there are challenges ahead. The economic acceleration that the government is expecting for next year (to the 2.6%-3.6% range) may be optimistic. Also, as Pemex’s investments are negatively affected by the budget cuts and lower oil prices add uncertainty to future oil field auctions, there is considerable risk associated with the forecasts for oil production and, consequently, government oil revenues.

Manufacturing remains weak, while internal demand is recovering strongly

The economy entered 3Q15 on a weak footing. The IGAE increased by a modest 0.1% from June to July. On a quarter-over-quarter (annualized) basis, the index rose by 2.6% (from 2.5% in 2Q15).

In spite of the depreciation of the peso and the recovery of the U.S. economy, Mexico’s manufacturing sector has been weak. In July, manufacturing output fell by 0.5% from June and by 1% qoq/saar. Manufacturing exports contracted sharply between July and August (-7.2%), erasing much of the solid gain seen over the previous two months. Both auto and non-auto manufacturing exports were weak.

On the positive side, the recovery of internal demand continues. Retail sales grew at a strong pace of 4.7% qoq/saar in July. Consumption has been supported by the labor market, low inflation and consumer credit. In August, formal employment grew by 4.5% year-over-year, the three-month average unemployment rate (seasonally adjusted) fell to 4.34% and low inflation continued to boost real wages. In fact, the service sector expanded by a robust 3.9% qoq/saar in July (in spite of a month-over-month contraction). Also, imports of capital goods and construction activity hint that the investment recovery is also on track.

Finally, oil production – a major drag on growth during the first half of the year – has stopped declining. Mining activity (mostly oil output) increased by 0.5% from June, the third consecutive month of growth.

Although we continue to expect growth to pick up, we have reduced our 2015 growth forecast to 2.2% (from 2.4% in our previous scenario). For next year, we still see growth at 2.8%.

Interventions continue

With the currency still under pressure, the Exchange-Rate Commission (made up of members of the central bank and the finance ministry) announced the extension of the two intervention mechanisms currently in place. The central bank will continue selling USD 200 million daily without a minimum price and another USD 200 million every day when the exchange rate weakens by at least 1%.The mechanisms were extended to November 30 (they had previously been set expire on September 30).

The trade balance deteriorated in August, dragged down by a worsening energy balance. Mexico’s trade balance posted a USD 2.8 billion deficit in August, larger than the deficit from one year before (USD 1.2 billion). As a result, the 12-month rolling balance stood at a deficit of USD 9.5 billion, with the energy balance deteriorating to a deficit of USD 7.7 billion. Meanwhile, the 12-month non-energy deficit improved to USD 1.8 billion from USD 2.2 billion in July. On a seasonally adjusted and annualized basis, the three-month deficit stood at USD 17.1 billion (annualized), worsening from the USD 15.9 billion deficit in July due to a lower balance for energy products. On the other hand, the non-energy balance showed a USD 3.5 billion deficit for the past three months (annualized), improving from a deficit of USD 9 billion for the three months through July.

We still see the exchange rate ending this year at 17.0 pesos to the dollar and at 17.5 pesos to the dollar at year-end 2016. A further appreciation of the U.S. dollar will likely lead to a (small) additional weakening of the peso.

Inflation remains low

Inflation remains at low levels, as core inflation is well below the center of the target range. Headline inflation was 2.53% for the first half of September (same as in the second half of August). Meanwhile, core inflation came in at 2.34% (up from 2.31%). Prices for core goods increased by 2.5% (compared with an increase of 2.39% in the second half of August), showing some pass-through from the currency depreciation, and inflation for core services was 2.21% (down from 2.24%). Non-core prices rose by 3.13% (vs. an increase of 3.25% in the second half of August).

We now see inflation ending this year at 2.8%, down from 3.0% in our previous scenario. We expect inflation to remain under control as the negative output gap curbs both the demand-side and currency-depreciation pressures on inflation.

Still on hold, waiting for the Fed

Mexico’s central bank left the policy rate unchanged at 3.0% at its September meeting, matching both our expectations and those of the market consensus according to Bloomberg. However, up until the Fed’s rate decision the previous week, most analysts expected a rate hike in September. In the statement announcing its decision, the board noted that the balance of risks for both activity and inflation had not changed since its previous meeting. In its concluding remarks, the board again highlighted the economy’s weak cyclical conditions, as well as the low inflation rate and well-anchored inflation expectations, in spite of the peso’s recent depreciation. Still, the future actions of the U.S. Fed remain a key concern.

We still believe that rate hikes in Mexico will come only in 1Q16, after a hike by the Fed in December and once it becomes clearer that Mexico is benefiting from the U.S. recovery. The downward revisions in our growth and inflation forecasts for this year are consistent with our views on the policy rate.

Phase two of the Round One succeeds

The second phase of Round One (September 30) came according with government and market expectations. A total number of 3 out of 5 extraction fields were awarded. According to government estimations, investment from these fields totals USD 3 billion with peak output of 90 thousand barrels per day. Following a disappointing first phase of auctions, the government moved to make contractual terms more attractive.

The National Hydrocarbon Commission (CNH) approved Pemex’s request for first four farmouts. Pemex has proposed private partnerships in nine projects, which will be tendered by the CNH. The Ministry of Energy will determine the type of the contracts (production sharing or license) and the Ministry of Finance will define the fiscal requirements.

João Pedro Bumachar

Jesus Gustavo Garza-Garcia


 

 



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