Itaú BBA - Fiscal and Monetary Policies Come to Help

Scenario Review - Mexico

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Fiscal and Monetary Policies Come to Help

octubre 2, 2013

Mexico's government presented the tax reform bill with its proposed 2014 budget.

•         Mexico's government presented the tax reform bill with its proposed 2014 budget. With the reform, both revenues and the fiscal deficit would increase next year. The reform was less ambitious than expected, because it didn’t expand the VAT base to include food and medicines.

•         Although we left our inflation forecasts unchanged, exchange-rate depreciation (which is lasting longer than we previously expected), tax increases and weather-related supply shocks are upside risks to our inflation outlook.

•         The central bank surprisingly cut the policy rate by 25 bps in its most interest rate decision. We don’t expect further cuts, even considering the FOMC decision to postpone the removal of monetary stimulus in the U.S., because of the expected rebound of the economy and some upside inflation risks.

•         After a very weak first half, activity data in Mexico and U.S. industrial-sector data suggest better growth momentum. Our GDP forecasts (1.3% this year and 3.6% in 2014) are unchanged, despite the recent storms. In our view, the looser fiscal and monetary policies reduce downside risks to our 2014 forecast.

Higher Taxes and Higher Fiscal Deficits

Mexico's government presented the tax reform bill with its proposed 2014 budget. With the reform, policy makers aim to increase tax revenues by 1.4% of GDP next year and by 2.9% of GDP by the end of 2018. The aim of the reform is to depend less on Pemex revenues, allowing the company (and the economy) to invest more and, hopefully, generate growth. The new tax regime for Pemex would reduce the tax burden and give more budgetary autonomy to the company.

The bill creates a series of tax increases and new taxes as well. The top income-tax rate for households would increase to 32% (from 30%). A new 10% tax rate on capital gains and dividends is proposed. The bill also seeks to eliminate the VAT exemption on private education services, mortgage credits and rents. Finally, the bill includes a 7.5% royalty on the mining sector and a tax on sugar soft drinks (to fight obesity). The special tax regime that was applied on the border was eliminated. Some incentives for informal workers to formalize were introduced in the bill.

Although revenues would rise with the reform, the government proposes to increase the fiscal deficit to 0.4% of GDP in 2013 (previously the government was targeting a zero deficit for this year) and to 1.5% of GDP in 2014. Including Pemex investments, the fiscal deficit could reach 3.5% of GDP next year. The deficit would return to zero (excluding Pemex investments) by 2016. Thus, with the bill the government is also seeking to stimulate the economy through fiscal policy.

The reform proposes a Sovereign Fund to save the income windfall in good times. Under the proposal, 75% of excess revenues (versus budgeted) would be deposited in the fund and spent during years in which revenue growth disappoints. Thus, fiscal policy would become more counter-cyclical.

The reform was less bold than expected, because it didn't expand the VAT base to include food and medicines. The decision to leave the VAT exemption on food and medicines unchanged is intended to avoid controversies at a time that the government is already facing a number of protests due to the rest of the reform agenda. In our view, a less ambitious tax reform saves the government some political capital (by avoiding more protests) to be spent on a meaningful energy reform. Still, opposition parties are already demanding changes to the bill, so it is unclear at this point what the final shape of the tax reform will be.

Recovery Signs Emerge

After a very weak first half, Mexico’s economy surprised positively in July. The IGAE (monthly proxy for GDP) came in at 1.7% year over year. Sequentially, activity increased 0.5% from June. The service sector was up by 0.56%. As shown in the previously released industrial production statistics, industry fell by 0.1% but with good performance of the manufacturing sector. On a quarter–over-quarter basis, the IGAE increased 1.1% (annualized), following a contraction during 2Q13.

Data from August hints that external demand is picking up. Manufacturing exports increased by 2.3% from July, as the auto component grew 2.5% and the non-auto component was up by 2.3%. On a quarter-over-quarter basis, manufacturing exports gained 10% (annualized), led by a 21% increase in auto exports. The data adds to positive news on the U.S. industry: the ISM manufacturing index came in at 56.2 in September.

We expect 1.3% growth this year and 3.6% next year. In our view, the recent activity numbers are consistent with our view that the economy will pick up from the second half of this year on, lifted by better growth in the U.S. The recent storms that are affecting Mexico create downside risks for the economy in the short term, while looser macro policies reduce downside risks to our 2014 forecast. 

Upside Risks to Inflation Emerge

Headline inflation increased slightly in the first half of September, lifted by core inflation. Non-core inflation fell to 6.4%, with non-processed food inflation down sharply to 3.4% (4.5% previously). Core inflation increased, as inflation for both services and goods picked-up, but continued below the center of the target.

Our inflation forecasts are unchanged at 3.6% this year and 3.5% for 2014. Still the risks for our forecasts are tilted to the upside: the peso is taking longer to appreciate than we previously thought (even after the Fed’s decision to postpone the withdrawal of monetary stimulus); there could be effects from supply-shocks associated with storms and tax increases as well. 

Another One-Off Rate Cut?

In its September decision, Mexico’s central bank surprised both the market consensus and our expectations and reduced the monetary policy rate by 25 bps (to 3.75%). The press release announcing the decision justifies the reduction with the worsening domestic activity during the second quarter. The central bank (like us) expects a rebound in the second half of the year, but activity growth during full-year 2013 would be considerably lower than estimated in the latest Inflation Report. The historically low level of core inflation also influenced the decision to lower rates. The minutes of the meeting revealed that the decision was not unanimous. Two out of five board members voted for leaving the reference rate unchanged, as they wanted to wait for the Fed’s decision, to get a more precise view of how the financial market reacts. In addition, those who voted against the cuts continue to be uncomfortable with the fact that inflation and inflation expectations are persistently above the target center.

In the concluding remarks of both the press statement and the decision, the board doesn’t provide any hint that new rate cuts will come. Board members pledged to monitor both activity and the monetary stance of Mexico vis-à-vis other countries in the upcoming meetings.

We expect rates to remain unchanged throughout our forecast horizon. While we acknowledge that the Fed’s decision to postpone the beginning of the withdrawal of monetary stimulus increases the odds of a new interest-rate cut, we think that the better activity numbers in Mexico and in the U.S. manufacturing sector will lead the central bank to hold rates, especially considering that the policy rate is already low. 

João Pedro Bumachar

Forecasts: Mexico

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