Itaú BBA - Exchange-Rate Intervention Returns

Scenario Review - Mexico

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Exchange-Rate Intervention Returns

diciembre 10, 2014

The lower dynamism of economic activity led us to reduce our GDP growth forecast to 2.2% from 2.4% previously.

• Mexico´s GDP expanded by 2.0% qoq/saar in 3Q14 – a moderation from the 3.6% growth rate recorded in 2Q14 – as both Services and the Industrial sector slowed.  The lower dynamism of economic activity led us to reduce our 2014 GDP growth forecast to 2.2% from 2.4% previously. 

• While we still expect a recovery led by solid growth in the U.S., expansionary fiscal and monetary policies and by the implementation of the structural reforms, we also reduced our 2015 GDP forecast to 3.5% (from 3.8%). 

• Annual inflation has started to fall as the effects that are lifting non-core prices are gradually easing. Core inflation remains tame, close to the target center. We expect inflation to converge to the target range by year-end, reaching 3.9% in December. For 2015, inflation will probably fall substantially as fuel prices adjust to expected inflation, telecom tariffs are reduced and the tax hike effects from this year fade. We expect inflation at 3.2% by the end of 2015.  

• The continued strengthening of the U.S. dollar and the recent drop in oil prices has weakened the Mexican peso, leading the exchange-rate commission (formed by members of the central bank and of the Ministry of Finance) to announce an intervention program. The central bank will sell up to USD 200 million daily whenever the peso weakens by at least 1.5% from the previous day. Still, we now see the exchange rate at 14.0 pesos per dollar at the end of 2015 (from 13.6 in our previous scenario and an estimated 14.2 by the end of this year).    

• The central bank left the policy rate unchanged, at 3.0%, in its last decision of the year. The central bank sounded more concerned over the outlook for activity (“the balance of risks for activity has deteriorated”) but sees higher risks for inflation due to the exchange-rate developments. In all, the board did not signal any intention to move the policy rate soon. We still see the interest rate at 3.50% by the end of 2015, with rate hikes starting only by the end of 2Q15.  

• The impact of lower oil prices on the economy is contained for next year. In the medium term, there are greater concerns.

• After the sustained civil protests over the disappearance of 43 students (presumed dead) in the state of Guerrero, in which local authorities seem to have participated, President Peña Nieto announced 10 measures that aim to tackle the security concerns in Mexico.

The Economy Slowed in 3Q14

The lower dynamism of economic activity led us to reduce our GDP growth forecast to 2.2% from 2.4% previously. Mexico’s IGAE (monthly proxy for GDP) came in at 2.9% year over year in September, therefore bringing third-quarter GDP growth to 2.2%. Sequentially, the IGAE declined 0.1% from August, the second consecutive drop. With this result, the GDP expanded by 2.0% qoq/saar in 3Q14 – a moderation from the 3.6% growth rate recorded in 2Q14 – as both Services (2.0% qoq/saar vs. 3.8% in 2Q14) and the Industrial sectors (1.7% in 3Q14 vs. 3.6% in 2Q14) slowed. We also note that declining oil production has weighed on the industry, as Mining contracted 5.9% qoq/saar in 3Q14, after falling by 3.2% and 3.3% in 2Q14 and 1Q14, respectively.  

A number of indicators suggest that external and internal demands are set to evolve favorably. Manufacturing exports expanded strongly in October (5.4% from September), after two monthly contractions, posting a robust 9.9% qoq/saar expansion. The positive figures for U.S. industry (the ISM manufacturing PMI continues at very high levels) indicate that the good momentum for Mexico’s exporting sector will likely continue. Also, the evolution of employment suggests that consumption will continue to perform well. Formal employment grew 4.2% year over year in October, while temporary employment grew a strong 8.1% (temporary employment is a leading indicator of total employment). In spite of high inflation, the real wage bill (in the formal labor market) was up by 4.5% in September, and if deflated by the less volatile core inflation the real wage bill expanded 5.4% from one year before. Looking forward, the expected fall in inflation will improve labor income further. On the investment side, considering that public capital expenditures continue to expand notably (19% in real annual terms for the first 10 months of the year), we believe that infrastructure investment will add to the ongoing housing recovery (residential investment expanded 9.3% qoq/saar in August).   

Although we continue to expect that the U.S. economic recovery, the expansionary fiscal and monetary policies and the structural reforms will increase growth in 2015, we have reduced our growth forecast to 3.5% (3.8% previously) due to a less favorable carry-over.  

Inflation Starts to Moderate

Annual inflation has started to decline as the effects lifting non-core inflation are gradually easing. On a year-over-year basis, headline inflation fell to 4.17% in November, from 4.30% in October. Meanwhile, core inflation stood at 3.34% (from 3.32%), close to the center of the target. Non-core inflation reached 6.78% (from 7.51%) due both to lower agricultural and livestock inflation, at 7.04% (from 8.46%), and regulated tariffs, at 6.62% (from 6.93%).

Inflation is likely to converge to the target range of the central bank before the end of this year due to more favorable base effects. We expect inflation to reach 3.9% in December. For 2015, we expect inflation to end at 3.2% because of lower increases in gasoline prices, the elimination of some telecom tariffs, a negative (though narrowing) output gap and the dissipation of the effects of the tax hike implemented at the beginning of this year.

The proposal to increase the minimum wage gains momentum. President Peña Nieto stressed the need to improve labor conditions for the population and sent to Congress a proposal to delink the minimum wage from fines, payments and other measures.  Minimum wage hikes and the sustained weakening of the currency are upside risks for inflation next year. 

A Strong U.S. Dollar and Low Oil Prices Weaken the Peso, and Intervention Is Announced

The current account deficit narrowed in 3Q14, remaining low. The current account deficit reached USD 2.7 billion in 3Q14, lower than the deficit of USD 5.8 billion one year before. As a result, the four-quarter rolling deficit stood at 2.0% of GDP, down from 2.2% in 2Q14, largely due to an improvement in the income balance. In the capital account, foreign direct investment (FDI) came in at USD 3.1 billion in 3Q14, leaving the flows accumulated in four quarters almost unchanged, at USD 24.4 billion. Foreign portfolio investment amounted to USD 4 billion, sharply down from USD 23.5 billion in the second quarter of the year (the reduction was mostly due to limited flows into public sector bonds) and reached USD 56.1 billion over the last four quarters (from USD 70.5 billion in 2Q14). 

Due to the persistent decline in oil production and lower oil prices next year, we are now adjusting our current-account deficit forecasts for 2015 to 2.2% of GDP (previously: 2.0%). In fact, in October the energy trade surplus reached its lowest level since January 2009, when oil prices were collapsing.

A stronger U.S. dollar and the sharp decline in oil prices have contributed to the weakening of the Mexican peso. 

As a response, the Exchange Rate Commission, made up of three members of the central bank and three members of the Ministry of Finance, announced that it will start auctioning USD 200 million on a daily basis if the spot price weakens at least 1.5% from the previous day. The last time the Exchange Rate Commission announced a similar mechanism was on November 29, 2011 (during the euro-zone crisis), when the central bank started auctioning USD 400 million daily, if the spot price weakened 2% from the previous day. The mechanism was withdrawn only on April 9, 2013, but it was little used when it was in place (the central bank sold less than USD 1 billion during the period). 

Mexico has around USD 192 billion in international reserves, and it also has a stand-by credit line with the IMF (the so-called Flexible Credit Line) worth USD 70 billion. So the exchange-rate commission has room to intervene more aggressively if necessary. However, considering the pro-free floating stance of Mexico’s policymakers, we think it is unlikely that a major intervention will be announced.

Even with the intervention, we now see the exchange rate at 14.0 pesos per dollar at the end of 2015 (13.6 in our previous scenario), almost flat with year-end 2014 (we see the peso averaging 14.2 to the dollar in December 2014). Amid higher interest rates in the U.S., the Mexican peso will likely outperform other currencies in the region due to the prospects of capital inflows associated with the reforms and Mexico’s close trade ties with the U.S.

Rates On-Hold in the Last Monetary Policy Decision of 2014

The central bank left the policy rate unchanged, at 3.0% in December, as expected. The board highlighted in the press statement that the dollar strengthened globally on expectations of a tighter monetary policy in the U.S., the deceleration of the global economy and the terms-of-trade deterioration in many countries. In the case of the Mexican peso, the board declared that the depreciation was “orderly.”

In spite of concerns over the exchange rate, the board delivered a neutral message. According to the statement, the balance of risks for activity deteriorated, but the risks for inflation have increased due to exchange-rate developments. In the concluding remarks, the board did not signal any intention of moving the policy rate in any direction soon.

We do not expect rate moves in Mexico soon. In our view, a tightening cycle will likely start in the second quarter of 2015 in tandem with the Fed’s move.

Oil Prices and Security Still in the Spotlight

Mexico’s energy balance is only USD 6 billion (or 0.5% of GDP), and even this small amount was already hedged by the government next year. However, in the medium term, Mexico has much to lose from the recent fall in oil prices: one-third of fiscal revenues comes from oil, and the investments associated with the energy reform would be at risk if the outlook for prices deteriorates much further.

In the aftermath of protests over the disappearance of 43 students presumed dead, in which local authorities of the state of Guerrero apparently participated, President Peña Nieto addressed the nation, announcing ten reforms that aim to improve security in Mexico. Among the main initiatives announced by President Peña, we highlight the most significant: 1) the creation of unique state police forces that would eliminate municipal police forces; 2) a constitutional change (which has to be approved by congress) that offers power to the executive branch to dissolve local governments accused of collusion with organized crime; 3) a unique ID for all citizens; 4) the deployment of the federal police force to the most affected States (Guerrero, Michoacán, Jalisco and Tamaulipas); and 5) a special national phone number for emergencies. He also announced tax breaks for businesses in the poorest regions of the country, loans from development banks at subsidized rates and the investment in infrastructure projects to foster growth in these regions. We believe that these initiatives are a step towards improving security in the country.


João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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