Itaú BBA - Fiscal adjustment in the spotlight

Scenario Review - Mexico

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Fiscal adjustment in the spotlight

septiembre 8, 2016

Fiscal consolidation disappoints, while the current-account deficit peaks

Please see the attached file for all graphs. 

• In spite of the large dividend received from the central bank (1.2% of GDP), stemming from the 2.5% of GDP exchange-rate gains on international reserves, the government cut its target for the Public Sector Borrowing Requirements (PSBR, which is the broadest measure of the public-sector deficit) by only 0.5% of GDP. Shortly thereafter, Standard and Poor’s revised the outlook for Mexico’s sovereign credit rating to negative. While the government is promising to deliver more fiscal consolidation ahead (including a primary surplus next year), the recent episodes highlight the difficulties in adjusting the fiscal accounts amid lower oil prices, weak oil production and a challenging political environment. 

• The loss of oil revenues is also having a negative impact on the balance of payments, with the current-account deficit reaching 2.9% of GDP in the year ended in 2Q16. On a better note, recent trade data shows an improvement at the margin, as manufacturing exports recover and the energy balance stabilizes. We expect current-account deficits of 2.6% and 2.3% of GDP in 2016 and 2017, respectively.  

• The performance of the Mexican peso disappoints, and we see the currency as undervalued. We expect the Mexican peso to appreciate somewhat, ending this year and the next at 17.5 to the dollar.   

• In spite of low inflation and subdued growth, we expect Mexico’s central bank to raise interest rates in December (by 25 bps) together with the Fed. In 2017, our baseline scenario considers two further hikes, also in lockstep with the Fed. An earlier hike by the Fed (say, in this month's policy meeting) would bring an earlier response from Banxico.

Fiscal consolidation disappoints, while the current-account deficit peaks

In late August, rating agency Standard and Poor’s revised its outlook for Mexico’s sovereign credit rating (BBB+) from stable to negative, based on rising debt-to-GDP and low economic growth. This decision came just one day after the Ministry of Finance lowered its estimate of the broadest fiscal-deficit measure (public-sector borrowing requirements) for 2016 by only 0.5% of GDP (to 3.0% of GDP), in spite of the whopping dividend that the government received from the central bank this year (MXN 239.1 billion or 1.2% of GDP). In fact, the budget cuts trumpeted in February and June – amounting to 0.9% of GDP – are being watered down by a variety of expenditure increases (including clearing the arrears with Pemex suppliers). Although Moody’s also has a negative outlook for Mexico, its rating (A3) is one notch above those of S&P (BBB+) and of Fitch (which has a stable outlook), so the S&P decision is certainly harsh. 

The rating outlook revision highlights the difficulties of adjusting the fiscal accounts amid low oil prices. As oil accounts for a significant share of the government’s revenues, lower oil prices have widened the fiscal deficit and contributed to pushing the public debt upward (to above 45% of GDP, from around 35% of GDP two years ago). And the government's apparent lack of political support does not help to expand its capacity to adjust.

To preserve fiscal sustainability and the sovereign rating, the government will likely need to step-up its fiscal-consolidation efforts. Although the oil-price recovery seen recently could bring relief to public finances, oil production is failing to stabilize (it fell 5.1% year over year in July, after 13 consecutive quarters of negative growth). In this context, the government’s current target for next year’s PSBR (3.0% of GDP, unchanged from the revised number for 2016) will require a significant effort by the government, considering that it will not be able to count on the sizable dividend from the central bank of Mexico next year.

President Peña Nieto announced that Luis Videgaray stepped down as Finance Minister and appointed José Antonio Meade (former Finance Minister of the Calderón administration, 2006-2012) to replace him. Both Videgaray and Meade boast strong market credibility, which explains why the reaction of financial prices was fairly muted. We believe the appointment of Meade implies policy continuity, and expect the transition to be smooth. The Ministry of Finance would remain focused on the implementation of the fiscal consolidation program. 

The current-account deficit has widened, reaching 2.9% of GDP (USD 31 billion) in the four quarters ended in 2Q16 (vs. 2.0% of GDP one year earlier). Deterioration of the current-account balance is largely due to weaker net energy exports (-1.1% of GDP vs. -0.4% in 2Q15), which brought the trade balance near to its lowest levels since the Lehman crisis. On the other hand, remittances climbed 0.5% of GDP in the period. The remaining components of the current account have been more stable over the past year, in spite of the sharp weakening of the Mexican peso. 

On the funding side, portfolio flows into the domestic bond market (a key source of financing) are scarcer, while direct investment is not enough to fully fund the deficit. In the four quarters ended in 2Q16, adding the current account deficit (2.9%) to net FDI (2.1%) leaves a gap of 0.8% of GDP. More concerning is the fact that net portfolio investment recorded outflows of USD 4.8 billion in 2Q16 (with the four-quarter rolling measure decreasing from net inflows of USD 31.7 billion in 1Q16 to 16.3 billion in 2Q16). Importantly, there were meaningful outflows from the domestic government bonds (USD 7 billion in 2Q16), and over four quarters, foreign investment in these securities was negative by USD 11 billion (a sharp contrast with the record USD 46.6 billion inflows in 2012).

We expect the current-account deficit to narrow to 2.6% and 2.3% in 2016 and 2017, respectively, as a recovery of U.S. manufacturing supports Mexico’s industrial goods exports and the weak real exchange rate weighs negatively on import growth. In fact, in July the trade balance already recorded a significant improvement at the margin, with the three-month average deficit narrowing to USD 12.1 billion (annualized), the lowest level since April 2015, and the non-energy balance reaching one of the highest values on record (helped by a pick-up in manufacturing exports).

In all, we see Mexico’s fiscal and external accounts as manageable. Still, the worsening of macro fundamentals seen recently is partly behind the poor performance of the Mexican peso. We hold to our view that the exchange rate is substantially undervalued and that it will appreciate going forward (we see the peso at 17.5 to the dollar by the end of 2016 and 2017). Amid supportive external conditions for emerging markets, the improvement of external accounts, a more credible commitment to fiscal consolidation, Mr. Trump’s (still) likely defeat in the elections and a further recovery of oil prices are the many potential triggers for the appreciation.

The central bank waits for the Fed

We expect Mexico’s GDP growth to slow from 2.5% in 2015 to 2.1% in 2016. However, for 2017, we see a modest recovery, to 2.4%. As U.S. industry performs better, Mexico’s manufacturing exports will continue to recover, with significant spillovers to the rest of the economy (given its openness) more than offsetting the negative impact of fiscal consolidation.

Inflation is trending up, but we expect it to stabilize around the 3% target in 2016 and 2017. The Mexican peso’s sharp depreciation and firmer oil prices have put upward pressure on consumer prices, with CPI running at 2.80% year over year in the first half of August. The lagged effects of the exchange-rate depreciation, coupled with unfavorable base effects related to the telecom reform, would drive inflation up slightly from current levels.

Consistent with our forecasts, the Central Bank of Mexico (Banxico) published the third quarterly inflation report of 2016, with a reduction in GDP growth forecasts (down to ranges of 1.7%-2.5% in 2016 and 2%-3% in 2017). Previously, Banxico’s official GDP growth forecasts for 2016 and 2017 stood at 2%-3% and 2.3-3.3%, respectively. Moreover, the report tweaked the inflation outlook, by stating that end-of-period and average CPI inflation would come in “close to” and “below” 3% in 2016, respectively, rather than “above” and “close to” (as they expected previously). The inflation forecast for 2017 remains unchanged at 3%.

Still, the stance of Mexico’s monetary policy remains unchanged: it will continue closely monitoring the evolution of the exchange rate and the Fed’s decisions, focusing less on the short-term dynamics of growth and inflation. Our view is that Mexico’s central bank will likely raise interest rates in December (by 25 bps) together with the Fed, and then tighten monetary policy again in 2017 in lockstep with the U.S. Depending on the evolution of the currency, the central bank may raise interest rates more than the Fed does, as has been the case so far this year. If the Fed decides to bring forward its rate hike, Banxico probably will as well.


João Pedro Bumachar
Alexander Andre Muller


Please see the attached file for all graphs.  



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