Itaú BBA - Reforms and Cyclical Rebound Should Sustain Growth in the Short and Medium Run

Scenario Review - Mexico

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Reforms and Cyclical Rebound Should Sustain Growth in the Short and Medium Run

agosto 5, 2013

Mexico’s PAN (the largest opposition party) has presented an aggressive energy reform bill.

•           Mexico’s PAN (the largest opposition party) has presented an aggressive energy reform bill. The PRI (the ruling party) will send its proposal for the reform soon. Both proposals seek to change the constitution. 

•           We have revised our growth forecast for 2013 to 2.3%, as the economy remains weak. We expect a rebound during the second half of this year due to stronger growth in the United States.

•           Reforms and lower volatility in financial markets will likely lead to exchange-rate appreciation. Our year-end forecasts for the peso stand at 12.2 to the dollar for 2013 and 12.0 to the dollar for 2014.

•           Inflation fell sharply in the first half of July, while core inflation reached a new record low. Inflation will likely end this year at 3.6%.

•           Although the central bank is concerned with the weak activity numbers and comfortable with the inflation readings, we do not expect rate cuts in our forecast horizon. 

The Debate on Energy Reform Starts

The PAN (Mexico’s largest opposition party) has presented an aggressive energy reform bill.  Although divisions within the PAN remain deep, even after the party won the governmental elections in Baja California (on July 7), it seems that the party members are on the same page when it comes to energy reform. The bill, if approved, would change Mexico’s constitution to allow domestic and foreign private investment in every area of the energy industry (exploration, refining, transportation, etc.) through a concession scheme, although foreign participation in oil blocks would be capped at 75%. The bill would also open the way for the listing of a “small amount of PEMEX shares”. Union leaders would be removed from PEMEX board, which would likely make PEMEX a company more attractive to investment.

Mexico’s PRI (the ruling party) is expected to submit an alternative energy bill within the next few days. While there aren’t many details available on the PRI proposal at this point, it is already known that it will also seek to change the constitution. So the alternative proposal will probably be seen as positive by the markets too. In our view, the PAN and the PRI will likely find enough common ground to pass a meaningful reform.

The PAN and the PRI together have enough seats in Congress to change the constitution. So even though the left-wing PRD is opposing constitutional changes, a far-reaching energy reform stands a good chance of passage. Still, the risks facing the energy reform effort cannot be dismissed. The PAN is demanding changes in the political system before it votes on the energy reform. At the same time, Lopez Obrador, who recently left the PRD, is calling for a protest campaign against the energy reform beginning on September 8. History has shown that Obrador’s ability to bring supporters out into the streets should not be underestimated.

A tax reform bill is also expected to be submitted to Congress soon. As with every single reform sent to Congress over the past few months, details will not be released until shortly before the bill is submitted. Still, the imposition of a VAT on food and medicines is one likely outcome and remains part of our base-case scenario.

Expecting a Better Second Half

The IGAE (monthly proxy for GDP) for May hints that growth during 2Q13 was even lower than in the first quarter of the year. The index gained 0.45% from April, following a 0.7% decrease, bringing quarter-over-quarter growth close to zero. The number’s breakdown reveals that the Service sector grew by 0.34% from April (vs. -0.54% the previous month), while the Industrial sector grew by 1.4% month over month (following a 1.8% drop the month before). Finally, the small and volatile Agricultural sector fell 0.26% (vs. +8.6% in April). The demand-side indicators available so far hint at weak consumption and investment during 2Q13. Imports of capital goods contracted during the second quarter. Although retail sales increased by 0.8% from April, the result comes after a 0.8% month-over-month drop, highlighting that the trend remains weak at the margin. On the other hand, the trade balance figures hint that external demand is gradually picking up: manufacturing exports were up 12% qoq/saar during the 2Q13 (vs. -5.3% for the previous quarter). Primary fiscal expenditures also picked up after a sharp contraction in the previous quarter, suggesting stronger public sector demand.

We now expect Mexico’s economy to grow by 2.3% this year. Previously, we were expecting 2.5% growth. In our scenario, Mexico’s economy grows at a strong pace from the second half of this year on, boosted by the (expected) recovery in the United States. Our low forecast for GDP this year is mostly due to the unfavorable carry-over effects produced by the disappointing growth figures of the first half of the year. For 2014, our growth forecast is unchanged, at 3.6%. In our view, next year Mexico’s economy will benefit not only from a cyclical recovery in the U.S. but also from structural factors linked to progress made on the reform agenda.

Headline Inflation Falls Within the Target Range, While Core Inflation Reaches a New Record Low 

Mexico’s consumer price index was flat over the first half of July, far below the market consensus estimate of 0.11% inflation. Core inflation came in at 0.04%. The low headline inflation was due to lower prices for both core goods (-0.06%) and non-core food items (-0.78%). Non-core food prices are now down 5.5% from the peak reached in the first half of April. As a result of both low sequential inflation and favorable base effects, headline inflation fell substantially on a year-over-year basis, to 3.53% (from 3.93% in the second half of June), and now stands firmly within the target range. The fall was mostly due to a sharp decrease in non-core inflation (to 6.62%, from 7.83% previously), which is typically very volatile. However, core inflation also fell substantially, to 2.57% (from 2.74% previously) – below the midpoint of the target range and a new record low. The decrease in core inflation came mostly from the goods component (now at 2.75%), likely influenced by the lagging impact of exchange-rate appreciation. Meanwhile, inflation for core services remains low, at 2.41%.

Our year-end inflation expectations remain at 3.6% for 2013 and 3.5% for 2014. Annual inflation will likely continue to fall before resuming an upward trend in November. Next year, the tax reform will likely lift consumer prices, as the government is expected to introduce a VAT on food and medicines. In our forecast, we are assuming that the government will introduce the VAT on these items only gradually.

Weaker Internal Demand Improves the Trade Balance 

On a seasonally adjusted basis, the trade balance posted a USD 9.4 billion (annualized) deficit for 2Q13, down from USD 12.3 billion in the previous quarter. The result was led by a decline in the non-energy deficit (to USD 15.3 billion from USD 20.1 billion the previous quarter). Exports increased by 0.8% from May to June, bringing growth in 2Q13 to 4.5% qoq/saar. Imports fell by 1.2% month over month and increased by a modest 1.1% qoq/saar (vs. 8.6% in 1Q13).

We expect the Mexican peso to end this year at 12.2 to the dollar. For year-end 2014, we expect an exchange rate of 12.0 pesos to the dollar. As the market becomes less volatile and positive news on the reforms come, the Mexican peso will likely resume an appreciation trend. Apart from idiosyncratic factors, the Mexican peso will likely outperform the other LatAm currencies because of the relative performance of the U.S. economy vis-à-vis China’s.

Monetary Policy: Concerned About Growth, Comfortable With Inflation, but Unwilling to Cut

Downside risk to both growth and inflation. As widely expected, the board of Mexico’s central bank unanimously voted to leave the policy rate unchanged, at 4.0%, in July. However, both in the press statement that accompanied the decision and in the minutes of the meeting, board members expressed a lot of concern over the recent weak activity numbers. Most board members agreed that the downside risks for Mexico’s activity have intensified, even though they recognize the positive developments in the United States. In addition, the central bank again sounded confident that inflation was high due to transitory factors (the meeting took place while headline inflation was still above the upper bound of the target range), emphasizing the low core inflation readings.

Still, we do not expect rate cuts in our forecast horizon. The minutes of the meeting revealed extensive debate among the board members over the possible reduction in the Fed’s asset-purchasing pace and its potential impact on Mexico. In their concluding remarks, the board members once again made clear that monetary policy abroad, in particular in the U.S., will be an important variable in its future policy moves.

João Pedro Bumachar

Forecasts: Mexico

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