Itaú BBA - A more conservative fiscal policy

Scenario Review - Mexico

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A more conservative fiscal policy

Fevereiro 11, 2015

The Finance Ministry announced expenditure cuts worth 124 billion pesos, or 0.7% of GDP.

• Mexico’s recovery continues, led by exports. While private consumption has been weak, real labor income will likely lift it ahead. Still, fiscal-expenditure cuts for this year, disappointing oil production, potential delays in the implementation of the energy reform and the recent weaker-than-expected U.S. industry data led us to reduce our growth forecasts to 3.2% this year (from 3.5% in our previous scenario) and to 3.5% next year (from 3.8% previously). 

• Inflation fell sharply in January, due to lower telecom prices and a more-favorable comparison base. Core inflation is currently running below the target center. We now see inflation at the target center by the end of this year (from 3.5% in our previous scenario). 

• While exchange-rate volatility continues, we still expect to see an appreciation of the peso by the end of this year, to 14.0 to the dollar, supported by export growth, the recovery of oil prices, higher domestic policy rates and the capital inflows associated with the structural reforms – factors that, in our view, will more than offset the interest-rate increases in the U.S. 

• The Finance Ministry announced expenditure cuts worth 0.7% of GDP. The cuts are a preemptive measure in a more challenging scenario for the fiscal accounts, which includes lower oil prices, lower oil production, higher borrowing costs and potential delays in the energy reform. 

• Mexico’s central bank decided to maintain the policy rate at 3% in January, as expected. According to the statement, the balance of risks for inflation remained unchanged from the previous meeting, in spite of the sharp decline of inflation, and the central bank again highlighted the evolution of the exchange rate as a key concern. We believe that the monetary-policy debate on when to hike continues, and we still expect the central bank to raise interest rates by the end of 2Q15, together with the Fed. However, the sharp fall of inflation and the announced public expenditure cuts may lead the central bank to postpone the tightening cycle. 

The government announces expenditure cuts

The Finance Ministry announced expenditure cuts worth 124 billion pesos, or 0.7% of GDP. According to officials, this is a preemptive measure to deal with a more-challenging international scenario. Most of the cuts (65%) will come from current expenditures while the remaining adjustment will affect investments. For example, the Mexico City-Queretaro and the Yucatan train projects have been suspended. Although we don’t see significant funding pressures for the government this year since the revenue exposure to oil prices is hedged, risks for fiscal accounts next year are on the rise. Besides the uncertainty over oil prices, risks include lower oil production, potential delays on the energy reform and higher borrowing costs. Overall, the fiscal adjustment announced for this year signals the commitment of the government to maintain fiscal stability.

In fact, fiscal consolidation began even before the budget-cut announcement. The 2014 fiscal deficit stood at 3.2% of GDP, lower than what was approved by Congress (3.6%), though higher than in 2013 (2.2%).

The recovery continues, but we reduced our growth forecasts

The IGAE (monthly proxy for GDP) came in at 2.0% year over year in November and, adjusting for working days, it grew a solid 2.9%, from 2.8% in October. Sequentially, the IGAE increased 0.5% from October after a 0.7% gain. So, its sequential trend improved to 2.9% qoq/saar (from 1.7% in October). Sluggish oil output continues to be a significant  drag on the economy, so the mining output fell 6.4% qoq/saar in November. In fact, the non-commodity sectors – whose short-term growth is more linked to demand conditions – are evolving better. According to our calculations, the IGAE excluding agriculture and mining grew by 4.0% qoq/saar.

The U.S. economy continues to benefit Mexico. Nominal manufacturing exports expanded by a solid 10.1% qoq/saar in 4Q14, after a 10% increase the previous quarter. In November, manufacturing production increased by 5.2% qoq/saar.

Gross fixed investment is gradually recovering. In November, it expanded by 5.7% qoq/saar, from 4.7% in October. Investment in machines and equipment accelerated to 9.4% qoq/saar, while construction investment slowed moderately to 4.6% (from 5.7% in October). Within construction investment, housing is performing strongly (6.7%), but non-residential construction contracted 0.3%. The weakening of non-residential construction shows that the strong expansion of public capital expenditures made last year hasn’t impacted growth yet.

Consumption remains sluggish, but an improved labor market will probably lead to a recovery. The monthly private-consumption indicator produced by INEGI (the official statistics institute) grew by a modest 2.1% qoq/saar in November, while retail sales slowed to 0.6% in the same period. Meanwhile, formal employment grew by 4.3% year-over-year in December, which combined with the sharp decline in inflation in January (discussed below) will lift the real wage bill growth. Remittances are boosting purchase power too. They grew by 18.8% year-over-year in December (31.7% if converted to pesos) and by 9.5% in 4Q14 (16.8% in pesos).

While Mexico’s recovery continues broadly on-track, we reduced our growth forecast for this year to 3.2% (from 3.5% in our previous scenario). The recently announced fiscal-expenditure cuts for this year, disappointing oil production, potential delays in the implementation of the energy reform (due to lower oil prices) and the recent weaker-than-expected (though still solid) U.S. industry data are the reasons behind the revision. Even so, the economy would still grow significantly more than the 2.2% estimated for 2014. For next year, we now see growth at 3.5% (from 3.8% in our previous scenario).

Inflation falls sharply, helped by lower telecom prices

Inflation fell much more sharply than expected in January. Annual headline inflation came in at 3.07% in January (down from 4.08% in December), and is standing now very close to the target center. Core inflation stood at 2.34% (from 3.24%), significantly below the target center. Within core items, prices for goods increased by 2.43% (compared with an increase of 3.50% in December), and inflation for services fell to 2.26% (down from 3.03%), led by the elimination of long-distance telecom tariffs (telecom prices fell 14.71% year-over-year). Meanwhile, non-core prices rose 5.34% (versus an increase of 6.7% previously) as inflation for both regulated items and non-processed food slowed. Besides lower prices for telecom items, a more-favorable comparison base (due to the fading effects of the tax hikes introduced one year before) also contributed significantly to bringing inflation down.

We now expect inflation to end this year at 3.0% (from 3.5% in our previous scenario), meaning that inflation would reach the target center before we had been expecting. A negative output gap throughout much of the year will likely neutralize the impact of the weaker exchange rate. For 2016, our expectation remains at 3.0%.

Robust trade balance amid declining oil exports

While the peso continued to trade between 14.5 and 15.0 to the dollar over the past month, we continue to expect appreciation ahead. Policy-rate hikes, the recovery of oil prices later in the year, strong export growth and capital inflows associated with the structural reforms will likely drive the Mexican peso towards 14.0 to the dollar by the end of 2015. For 2016, we see the currency at 13.6 to the dollar.

The trade-balance figures continue consistent with a low and easily financed current-account deficit, in spite of a sharp weakening of net energy exports. On a seasonally adjusted and annualized basis, the trade balance registered a USD 1.3 billion deficit in 4Q14, down from a USD 3.4 billion surplus in the previous quarter. The decline was due to energy trade, which registered a USD 6.3 billion deficit in 4Q14, down sharply from the USD 2.7 billion surplus in 3Q14 and the lowest level on record. On the other hand, there was a USD 5.0 billion surplus in the non-energy balance in 4Q14, its highest historical value. As a result, the trade balance stood at a deficit of USD 2.4 billion in 2014 (up from a USD 1.2 billion deficit in 2013), as the energy surplus shrank to USD 1.5 billion (USD 8.6 billion in 2013), while the non-energy trade deficit fell to USD 3.9 billion (from USD 9.8 billion in 2013). Thus, a weaker exchange rate, strong demand in the U.S. and moderate internal demand growth are offsetting much of the impact of lower oil output and lower oil prices.

Together or after the Fed?

The central bank kept the policy rate unchanged at 3.0% in its first decision of the year, as expected. In the press statement announcing the decision, the board did highlight the recent decline of inflation, but that wasn’t enough to change members' mindset. According to the document, inflation is evolving in line with the bank’s expectation, and the balance of risks for inflation is unchanged from the previous meeting, as concerns over exchange-rate volatility remain.

In our view, the debate within the board on when to hike continues, and additional monetary easing is off the table. In our baseline scenario, Mexico’s central bank will start the tightening cycle in June, the same month in which we expect the Fed to raise rates. However, the sharp decline of inflation recently may lead the central bank to start removing stimulus after the Fed does, especially if the Fed’s first hike is not accompanied by excessive volatility. The announced budget cuts also support the postponement of rate hikes. In fact, some board members have expressed concern over the path of public finances, highlighting the need for fiscal prudence given the current global scenario.



João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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