Itaú BBA - An Unbalanced Recovery

Scenario Review - Mexico

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An Unbalanced Recovery

noviembre 1, 2013

The end of the easing cycle, a successful energy sector reform and the economic recovery will likely support the Mexican peso next year.

•    Mexico’s lower house introduced positive changes in the tax reform bill submitted by Peña Nieto’s government. The senate approved most of the changes. A political reform is likely within the next weeks, which would make way for the debate on energy reform.

•    The economy is recovering during 3Q13, but growth composition has been unbalanced, with exports up and internal demand down. We expect the economy to grow by 1.3% this year and 3.6% in 2014.

•    Tax hikes will likely keep inflation above the target center (but within the target range) next year. We now expect 2014 inflation at 3.7% (3.5% in our previous scenario).

•    The central bank reduced the policy rate by 25 bps but closed the door on new rate cuts.

•    The end of the easing cycle, a successful energy sector reform and the economic recovery will likely support the Mexican peso next year. The postponement of the tapering will also help in the short term. We continue to expect the peso to end 2014 at 12.0 to the dollar, from 12.8 at the end of this year.

Tax Reform and, Last, but Not Least… the Energy Reform

Mexico’s lower house approved a modified version of the tax reform bill sent to congress by Peña Nieto’s government. The house voted 317-164 to approve the bill, as the left-wing PRD supported the initiative and the PAN opposed to it. The bill approved doesn’t include VAT on private education tuition, mortgages, home rentals or sales, which were contained in the initial version of the bill. However, the top income-tax rate for individuals was raised to 35% from a proposed 32%. In addition a 5% tax on high-fat foods was created. The new tax regime for PEMEX will be discussed, together with Energy sector reform. Among the proposals from the initial version that were included in the approved bill are: equalization of the VAT rate on the border with the one charged in the rest of the country; taxing sugar beverages at MXN 1 per liter; a 10% tax on capital gains from the stock exchange and on dividend payments; and a 7.5% Mining Royalty tax. The senate later approved the bill with few changes, so the tax reform is now back to the lower house for final approval. The PAN refused to participate in the senate voting session.   

According to the government, the approved bill would add around 1.1% of GDP in fiscal revenues in 2014 (versus 1.4% in the previous version of the bill). To offset the lower revenues next year, legislators raised the oil price forecast (a key variable for the budget). Finance Minister Videgaray, however, estimates that the reform will add 2.8% of GDP in revenues by 2018 (slightly below the Finance Ministry’s estimates before the modification of the bill). 

Apart from the new tax code, the congress approved the fiscal responsibility law. This includes the government’s proposal to create a sovereign wealth fund to save part of the “excess” revenues during good times. In addition, the lower house included in the bill a cap of 2.5% for real current expenditure growth in 2015 and 2016. From 2017 on, real current expenditure growth is capped at the potential growth rate of the economy. 

In our view, the changes introduced by the congress are positive because they limit the risks to growth next year and make more credible the fiscal 0% medium-term public deficit target (excluding PEMEX investments). By removing the government’s proposed taxes on the Housing sector, congress has avoided hurting an already fragile Construction sector. In addition, caps on current public expenditures will leave the fiscal accounts less vulnerable to political conditions.

The PAN and the PRD each presented its own versions of political and electoral reforms. The PAN initiative was presented in the senate, while the PRD sent its reform proposal to the lower house. The debate is significant for the macro outlook because PAN has made its support for Energy sector reform conditional on approval of political and electoral reforms, and without the PAN, the PRI would not be able to pass far-reaching energy legislation.

According to political analysts, the PRI and the PAN will be able to find common ground on political reform, so an energy reform before the end of this year is likely. In this context, the secondary laws regulating the new framework for the energy sector could be approved during the first quarter of 2014. Still, the clashes between the PAN and the PRI during the tax reform debate show that there is the risk that the PRI could meet resistance from the PAN to approve the energy reform.

An Unbalanced Recovery

On one hand, the IGAE (monthly proxy for Mexico’s GDP) increased 0.22% from July to August, bringing quarter-over-quarter growth to 2.6% (annualized). The number confirms that Mexico’s economy is recovering gradually from a very weak first half. Manufacturing activity grew 7.1% qoq/saar, consistent with a recovery in external demand (in fact, manufacturing exports gained 11% during 3Q13).

On the other hand, retail sales grew by only 0.1% in the same period, hinting that private consumption continues to be sluggish. In addition, construction activity (down 7.0% qoq/saar in August) and imports of capital goods (down 9.5% during 3Q13) point to another contraction in gross fixed investment.

We expect Mexico’s economy to continue its gradual recovery over the next quarters. U.S. growth will likely continue to lift Mexico’s export sector, which should support internal demand. We expect the economy to grow 3.6% next year, following an estimated 1.3% expansion in 2013.

Headline Inflation Falls Further, While Core Inflation Continues Below the Target Center

Headline inflation fell to 3.27% year over year during the first half of October, close to the center of the target range. The decrease was due to both a reduction in non-core inflation (to 5.85% from 5.96% previously) and in core inflation (to 2.46% from 2.5%). While the exchange rate weakened over the past few months, inflation for core goods fell further, to 2.47% (core goods ex-food inflation is below the lower bound of the target range). Meanwhile, core services inflation is at 2.46%, highlighting the lack of demand-side inflationary pressures in Mexico. Within non-core prices, non-processed food inflation is running at a low 0.71%, while inflation for regulated prices increased to 9.15% (previously 8.97%), influenced by the removal of gasoline subsidies.

We expect inflation to end this year at 3.6%. For 2014, we expect inflation at a similar level (3.7%). Unfavorable base effects will likely drive headline inflation higher in November and December. Next year, the fiscal package will likely sustain inflation above the target center, but within the target range. In our previous scenario, we were expecting inflation at 3.5% by year-end 2014.

No More Cuts

Mexico’s central bank reduced the policy rate by 25 bps in October, bringing it to 3.5%. This was the second consecutive meeting in which the board decided to lower rates. Although the tone of the press statement shows that the board is still concerned about the recovery of the economy and very comfortable with the inflation outlook, the central bank makes clear that it does not intend to cut rates further (“additional reductions of policy rate are not advisable in the foreseeable future.”)

The board classifies the domestic economic recovery shown by some indicators as “incipient.” Also it still sees “considerable” slack both in the labor market and in the overall economy. Although the board expects a narrower output gap in the monetary policy forecast horizon, it still expects a lot of slack for a long time to come.

The central bank considers that the balance of risks for inflation has improved. Board members once again noted that core inflation is hovering around record-low levels, while non-core inflation is falling as the temporary shocks that were lifting it in recent months fade. In addition, they highlighted that the severe storms that hit Mexico in September have not impacted inflation at this point. Inflation expectations for 2014 increased in response to the likely tax hikes next year, but inflation expectations for the longer term continue stable. Economic growth is the key downside risk for inflation. While financial-market volatility and tax changes were cited as upside potential, the board downplayed each of those factors.

We do not see policy-rate moves at least until 2015. In our scenario, Mexico’s economy continues its gradual recovery throughout the rest of this year and the next. So we see the policy rate unchanged at 3.5% both by the end of 2013 and by the end of 2014 (from 3.75% in our previous scenario).

A Stronger Peso Ahead

Although the Fed will likely start the tapering during 1Q14, we see room for the Mexican peso to appreciate. Our exchange-rate forecasts are unchanged at 12.8 to the dollar by year-end 2013 and 12.0 to the dollar by year-end 2014. A successful energy reform will be crucial to drive the currency stronger. The ongoing economic recovery and the end of the easing cycle will also help to strengthen the peso. 

João Pedro Bumachar

Forecasts: Mexico

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