Itaú BBA - Out of the woods?

Scenario Review - Mexico

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Out of the woods?

marzo 9, 2017

Mexican peso has been supported by perception of lower protectionism risk and Central Bank intervention

Please see the attached file for all graphs. 

We expect Mexico’s GDP growth to slow in 2017, to 1.6%. Higher inflation (eating through real wages), tighter monetary and fiscal policies, and the uncertainties surrounding trade relations with the U.S. will weigh on internal demand, while exports will be a buffer. 

The current account deficit narrowed around year-end, driven by an improvement of the non-energy trade balance. We expect further narrowing in coming quarters as the economy rebalances its sources of growth (with weaker domestic demand partly offset by firmer exports).

The Mexican peso has appreciated recently, helped by an easing of the perceived risk of protectionism in the U.S. and the announcement of a USD 20 billion intervention program. In this friendlier environment, we expect the central bank to slow the pace of rate hikes, raising rates by 25 bps in March (matching the move by the Fed that we expect for this month). But it is too soon to decree the MXN is out of the woods.

Fiscal consolidation is ongoing. All nominal fiscal deficit indicators narrowed in January. Although helped by transitory factors (e.g., another sizable central bank dividend), it is likely that the Mexican government will meet its fiscal targets for 2017, potentially averting a rating downgrade.

The economy pulls off a solid 4Q16

In spite of the uncertainty shrouding the future of trade relations with the U.S., Mexico’s economy was solid in 4Q16. The monthly GDP proxy (IGAE) rose by 2.1% year over year in December, bringing the 4Q16 GDP growth rate to 2.4% year over year (and beating the 2.2% flash estimate announced three weeks before). At the margin (seasonally adjusted), GDP grew by 2.9% qoq/saar in 4Q16.

Growth was uneven across sectors in 4Q16: the overall figure was propped up by services activity and industry’s contribution was muted. Calendar-adjusted figures show that services activity rose by 3.4% year over year in 4Q16, the same rate as in 3Q16. This is consistent with solid consumption growth (the monthly indicator for private consumption showed a 3.3% increase in the period). Meanwhile, industrial production growth was nil in 4Q16. Among the industrial sectors, we highlight that mining and construction were weak, while manufacturing production picked up (up 2.2% year over year in 4Q16, from 0.6% growth in 3Q16), in line with the pick-up in manufacturing exports.

Looking ahead, we expect the economy to weaken starting in 1Q17, as higher inflation (eating through real wages), tighter macro policies (higher domestic rates and fiscal consolidation) and the uncertainty surrounding future trade relations with the U.S. weigh down internal demand. However, stronger growth in the U.S. will likely continue to act as a buffer by boosting Mexico’s manufacturing exports. We expect 1.6% growth in 2017 and then a moderate recovery to 2.1% growth in 2018.

Smaller external imbalances

The current account deficit narrowed significantly in 4Q16 on the back of an improving trade balance and a pick-up in remittances. Mexico’s current-account deficit came in at USD 3.4 billion in 4Q16, which reduced the four-quarter rolling deficit to USD 27.9 billion (2.7% of GDP) from USD 32 billion in 3Q16 (3% of GDP). Looking at the breakdown of the last four quarters, we note that: the trade deficit bottomed out; transfers are improving (driven by a more dynamic U.S. economy and, possibly, advance transfers due to fears of taxation on remittances); the services deficit is small and stable; and net income payments are not decreasing (even in dollar terms) in spite of a weaker exchange rate.

On the funding side, foreign direct investment is now almost enough to finance the entire current account deficit, and portfolio flows firmed up in 4Q16. Net direct investment totaled USD 4.9 billion in 4Q16 and the four-quarter rolling total was USD 27.5 billion. Net portfolio investment recorded inflows of USD 16.3 billion in 4Q16 (with the four-quarter rolling measure increasing from a USD 22.4 billion net inflow in 3Q16 to a 30.7 billion inflow in 4Q16). Importantly, there were significant inflows into domestic government bonds for the second consecutive quarter, showing that so far price volatility and potentially negative headlines have not been accompanied by outflows.

We expect the current-account deficit to narrow – from 2.7% of GDP in 2016 to 2.3% in 2017. The slower growth of domestic demand coupled with a weak real exchange rate will likely affect imports. At the same time, we expect manufacturing exports to remain strong, supported by the pick-up of U.S. industrial output and a competitive exchange rate, as long as protectionism doesn’t materialize substantially. From a funding perspective, we still see the situation as fragile in spite of the benign financial account data reported in 4Q16 - the threat of protectionism will likely be a drag on foreign direct investment this year, while higher U.S. treasury yields could have negative effects on portfolio inflows (even considering the sizable rate hikes implemented by the central bank).

Mexican peso appreciation puts the brakes on rate hikes

Mexico’s FX commission, a joint entity representing the central bank and the Ministry of Finance, in February announced the creation of a USD 20 billion FX swap facility. In the first auction, all of the USD 1 billion in volume tendered was placed. Since the announcement of the program, the Mexican peso has outperformed LatAm peer currencies meaningfully, although we note that an easing of the perceived risk of protectionism could also be behind the appreciation.

We continue to expect an exchange rate of 20.5 pesos to the dollar at the end of this year. Higher interest rates in the U.S. and the uncertainty surrounding future U.S. trade policy are likely to weaken the peso from current levels.

The central bank continues to focus on the potential second-round effects of higher gasoline prices and exchange rate depreciation. In the latest inflation report, the central bank explicitly mentions a “further increase of inflation expectations” as one of the factors that could drive inflation higher. This contrasts with the previous few inflation reports, which reinforced the notion that short-term inflation expectations have increased but long-term tenors remain well-anchored.

However, the central bank now highlights its view that hiking rates to fight short-term inflation shocks can be “inefficient and costly in terms of economic activity”. This was arguably the most significant twist in the language of the latest inflation report. Moreover, in a recent presentation, Deputy Governor Javier Guzmán mentioned that the latest measures announced by the exchange rate commission could contribute to more balanced policies (which we read as a less aggressive monetary policy).

We still expect Banxico to take the reference rate to 7.0% in 2017, through three 25-bp rate hikes that follow respective moves of the same magnitude by the Fed. We expect the Fed to raise interest rates as soon as its March meeting, so we see the next Banxico hike coming by the end of this month. Heightened concern about activity coupled with higher inflation expectations mean that additional tightening is likely, but at a more moderate pace than before. The better exchange-rate behavior, if sustained, will also play in favor of slowing the pace of rate hikes.

Fiscal picture is improving in 2017

Nominal fiscal deficit indicators narrowed in January on the back of a significant increase in oil revenues. The rolling 12-month public sector borrowing requirements (or PSBR, the broadest measure of the fiscal deficit) narrowed to MXN 544.5 billion in January 2017 from MXN 556.6 billion in December 2016 (2.9% of GDP), with the public deficit shrinking to MXN 485.1 billion (from MXN 503.7 billion, 2.6% of GDP) and the primary balance posting a MXN 12.8 billion surplus (from a 24 billion deficit, -0.1% of GDP) in the same period.It is worth clarifying that in order to calculate the PSBR, the Mexican government makes adjustments to certain public-deficit figures – specifically, the accounting of extraordinary profit/losses from public-sector financial operations, the net profit of development banks, the net profit of the deposit insurance agency (IPAB) and infrastructure investment with deferred financing (PIDIREGAS).

However, public debt remains high. The gross debt and net debt of the public sector increased to MXN 10,131 billion (from MXN 9,934 billion, 51.2% of GDP) and MXN 9,817 billion (from MXN 9,693 billion, 50% of GDP), respectively, between January and December of 2016, compared with 35.2% of GDP and 34.3% of GDP when President Peña Nieto took over in December 2012. According to the fiscal consolidation plan, the government is looking to stabilize the public-debt-to-GDP ratio this year, after nine consecutive years of increases.

In our view, it is likely that the Mexican government will meet its fiscal targets for 2017, potentially averting a ratings downgrade. The government is targeting a primary surplus of 0.4% of GDP and public-sector borrowing requirements of 2.9% of GDP for 2017. We believe that higher oil revenues (in spite of lower oil output) and a large dividend from the central bank (possibly around 1.5% of GDP, resulting from exchange rate gains on international reserves) will be crucial if the government is to meet this goal. However, the government’s recent decision to smooth gasoline price variations through the adjustment of the excise tax introduces a new element of risk. Specifically, this means that any depreciation of the exchange rate will have a smaller positive effect on fiscal flows.


João Pedro Bumachar
Alexander Andre Muller

Please see the attached file for all graphs.  


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