Itaú BBA - Lower growth, controlled inflation...and higher interest rates?

Scenario Review - Mexico

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Lower growth, controlled inflation...and higher interest rates?

abril 7, 2015

We expect the hiking cycle in Mexico to start in September, in conjunction with the Fed’s liftoff

• Mexico’s economic recovery remains fragile, and we have reduced our growth forecast for 2015 to 2.6%.

• Inflation is still under control, as the impact of the peso’s depreciation on domestic prices is being absorbed by the negative output gap. We continue to expect inflation to be at the midpoint of the target range both at the end of this year and at the end of the next. 

• The exchange-rate commission announced additional currency intervention. Even so, we expect the peso to end the year at 15 pesos to the dollar (from 14.7 pesos to the dollar in our previous scenario), as we now expect a more gradual recovery of oil prices. 

• The central bank emphasized that activity is weak and inflation expectations are well anchored. Still, it has made clear that its actions will be mostly determined by Mexico’s monetary policy stance relative to that of the U.S. (and the resulting impact on the evolution of the exchange rate). Therefore, we expect the hiking cycle in Mexico to start in September, in conjunction with the Fed’s liftoff, but there is also a risk that the central bank will hike only after the Fed does.

• In a scenario of disappointing oil revenues, the government announced new expenditure cuts (this time for 2016).

A weak start to the year

The first indicators available for this year hint that the Mexican economy is losing momentum. Year-over-year growth in the working-day adjusted IGAE (a monthly proxy for GDP) was 2.5% in January, down from 2.6% in 4Q14. Sequentially, the seasonally adjusted index grew by 0.2% compared with December, which was not enough to offset the 0.4% contraction registered the previous month.

Supply-side factors affecting the oil sector continue to hurt industry, but manufacturing and construction activities weakened too. In January, oil and gas production fell by 3.3% compared with December and by 8.5% qoq/saar. Manufacturing and construction – which were driving Mexico’s expansion – both declined from December (by 0.1% and 1.5%, respectively). Furthermore, in February manufacturing exports contracted by 0.3% month over month and by 2.9% qoq/saar.

On the positive side, there are signs that consumption is improving. Retail sales expanded by a strong 2.1% month over month in January, posting a quarter-over-quarter (annualized) growth rate of 2.7% (up from -0.3% in 4Q14), helping to lift service activities (to 3% qoq/saar in January). Strong formal employment growth (4.6% year over year in February) and the drop in inflation are boosting the real wage bill (to 5.8% in January), supporting consumption.

We have reduced our growth forecast for this year to 2.6% (from 2.9%). For 2016, we still expect a 3.3% expansion. A worse carry-over and a more negative outlook for oil production are the factors behind the downward revision. Still, we note that our forecasts are still consistent with a recovery from 2Q15 on, supported by higher growth in the United States. In fact, the weakening of exports in Mexico came along with a deterioration in industry data from the U.S., which we view as temporary. The implementation of the energy reform will probably fuel Mexico’s recovery next year, both by reversing the decline in oil production and by stimulating investment.

Pass-through remains low

Annual inflation stood at 2.97% in the first half of March, the same level as in the second half of February, while core inflation came in at 2.42% (up from 2.38%). Prices for core goods increased by 2.63% (compared with an increase of 2.62% in the second half of February), confirming that pass-through has been low so far, and inflation for core services was 2.25% (up from 2.18%). Apart from lower telecom prices, inflation for services is benefiting from the negative output gap. Non-core prices slowed to 4.69% (from 4.79%) due to a smaller increase in agricultural and livestock prices, while energy and government tariffs rose by 3.40% (compared with 3.12% previously).

Our year-end inflation forecasts for both this year and the next remain at 3.0%. Inflation is still under control, hovering around the center of the target range, while core inflation is running below that threshold. In our view, the negative output gap will likely keep inflation around the target midpoint, in spite of the weaker peso.

Further exchange-rate intervention

Although low oil prices and declining oil production are depressing net energy exports, the weak internal demand and the exchange-rate depreciation are hurting imports enough to produce a low trade deficit. In February, the trade balance posted a USD 0.6 billion surplus, lower than the surplus of one year before (USD 0.9 billion). As a result, the 12 month-rolling balance registered a deficit of USD 2.9 billion, with the energy balance recording its first deficit in history (USD 0.7 billion), while the non-energy balance reached its highest level in almost two decades (a deficit of USD 2.1 billion). On a seasonally adjusted and annualized basis, the three-month deficit was USD 7.3 billion, improving from the USD 11.2 billion deficit posted in January.

The exchange-rate commission (integrated by members of the Ministry of Finance and the Central Bank) announced further intervention in the currency market. Specifically, the commission announced that the pace of international reserve accumulation will be reduced by 25% of the expected reserve growth over the next 12 months. Thus, the central bank will auction USD 52 million daily (with no minimum price) from March 11 until June 8. The auctions may be extended beyond June 8, according to the statement announcing the decision. The new auction mechanism comes in addition to the one put in place in December 2014, in which the central bank offers the market USD 200 million daily with a minimum price (1.5% above the exchange rate of the previous trading day). Reserves in Mexico currently stand at around USD 195 billion. Apart from high international reserves, Mexico can also count on a USD 70 billion stand-by credit line with the IMF (the so-called “flexible credit line”, which the IMF extends to countries with solid fundamentals without imposing adjustments as a condition for accessing the line). So, while the intervention now in place is no bazooka, the exchange-rate commission can intervene more strongly if necessary.

In spite of the additional intervention, we now expect a weaker currency by the end of the year, relative to our previous scenario. We project that the exchange rate will end this year at 15 pesos to the dollar (up from 14.7 in our previous scenario), as we now expect a more gradual recovery of oil prices. For 2016, we still expect a year-end exchange rate of 15 pesos to the dollar.

Waiting for the Fed

As widely expected Mexico’s central bank left the policy rate unchanged at 3.0%. In the press statement announcing the decision, the committee pointed to a deterioration in the balance of risks for activity. So, in spite of the weakening of the exchange rate, committee members think that the balance of risks for inflation has not changed since the previous meeting.

In the concluding remarks of the statement, the committee emphasized that activity is weak, inflation is low and inflation expectations are well anchored. Still, it made clear that its actions will be mostly determined by the Mexico’s monetary policy stance relative to that of the U.S. (and the resulting impact on the evolution of the exchange rate). According to the committee members, because Mexico’s economy is closely integrated with that of the U.S., the Fed’s decisions – through their impact on the exchange rate and inflation expectations – could affect prices in Mexico. In this context, members repeated the message introduced in the statement accompanying its previous decision: it is willing to take the necessary actions to ensure inflation convergence in 2015 and then to hold it at that level.

We currently expect Mexico’s central bank to start a tightening cycle in September (with a 25-bp move), in conjunction with the Fed’s liftoff. However, the output gap is negative, and its narrowing pace is far from impressive; inflation and core inflation are both at low levels; the pass-through in Mexico has been low; and authorities are willing to use dollar sales to contain depreciation pressures. These factors may lead the central bank to act several months after the Fed does.

Our year-end forecasts for the policy rate stand at 3.5% and 4.5% for 2015 and 2016, respectively.

Reacting to a new oil-price scenario

The Ministry of Finance announced that it is planning to reduce budget expenditures by 0.8% of GDP next year. According to the ministry, this measure is aimed at dealing with lower oil revenues without increasing taxes or indebtedness. Also as a result of lower oil revenues, the ministry had already reduced expenditures for this year by 0.7% of GDP and delivered a 4Q14 budget deficit that was smaller than the level approved by Congress.

Meanwhile, the government is also making the contractual terms for oil exploration more attractive to the private sector. The national hydrocarbon commission (CNH) announced that there will be an extension of the exploration timeline for the fields offered in Round One. The timeline will now allow exploration to last four years with a possible two-year extension (previously, the exploration period was set at three years and allowed for two one-year extensions). Pemex is also adjusting to the more challenging environment by seeking more private partnerships than originally expected.

João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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