The Teflon of Lyford
November 13, 2006
By Stephen S. Roach | from Doha
Our 22nd annual Lyford Cay investment conference was notable for lack of controversy and deep conviction on major investment themes. It was as if the assembled crowd were watching the world and the markets go by in slow motion. There was the usual hand-wringing over fat-tailed concerns -- especially credit risks, the dollar, and politics. But there was a nearly universal belief that an increasingly elastic and globalized world could cope with almost anything except the most extreme of disruptions.
The experience of the last four years certainly lends support to such hope. Despite all the angst over global imbalances, soaring oil prices, housing bubbles, and spread markets, the global economy never really skipped a beat. Instead, world GDP growth soared at a 4.9% average annual rate over the 2003-06 period -- the strongest four-year burst of global growth since the early 1970s. As the resident “Doubting Thomas,” my latest strain of cautious comments was received by the Lyford crowd with understandable indifference. The US housing downturn was not thought to be a particularly big deal, and even if it were, conviction was deep that there were plenty of alternative sources of growth -- either at home or abroad -- that could easily fill most of the void. We did a fair amount of interactive polling at this year’s conference in order to deepen our understanding of the macro assumptions held by the investors in attendance. Three conclusions jumped off the page: First, inflation was not perceived to be a major risk. Fully 45% of the group thought the core CPI would recede from its latest reading of 2.9% in September 2006 into the 2.4% to 2.8% zone over the next 12 months; another 30% felt core inflation would hold around current levels. That left only about a quarter of those in attendance with some inflation concerns, but most of that segment anticipated risk in the 3.1% to 3.5% range. In other words, those banking on a relatively sanguine outlook for core inflation outweighed those looking for deterioration by a factor of three to one. Nor was there much concern about the possibility of sharp further upward increases in oil prices. Fully 64% of the Lyford crowd expected WTI-based oil prices to hold in a $40 to $60 range, with more leaning toward the lower half of that range than the upper half. The tail on the oil price was skewed slightly to the upside, with 6% of the group fearing a breakout above $80 while no one thought oil would drop below $40 per barrel over the next 12 months. Second, there was little concern over the interest rate outlook over the next year -- very much consistent with the generally optimistic prognosis for inflation. The Federal Reserve was viewed as more likely to ease than tighten over this time horizon, with nearly 40% of the investors in attendance looking for the federal funds rate to fall from its current level of 5.25% into the 4.5% to 5.0% zone over the next year and another 10% thinking it could drop below 4.5%. Conversely, 6% thought the Fed would hike the overnight lending rate into the 5.5% to 6.0% zone, whereas just 3% feared a funds rate in excess of 6%. The biggest chunk of the Lyford crowd -- fully 42% of them -- thought the Fed would basically stay on hold and keep its policy rate in the 5.0% to 5.5% zone. In terms of the long end of the yield curve, there were a few more investors who thought rates would drift up rather than decline: Nearly 35% of the group expected yields on 10-year Treasuries to move up into the 5.0% to 5.5% range, and another 6% thought long rates could rise above 5.5%; by contrast, about 30% thought long rates could be slightly lower. When the expectations of long-term interest rates are combined with the Fed policy bet, the Lyford consensus is very much in the camp that the inversion of the US Treasury yield curve is likely to come to an end at some point during the next 12 months. In their collective view, the possibility of a back-up at the long end should generally outweigh expected moves toward policy accommodation at the short end. Third, we attempted to measure investment sentiment on the prospective state of the US business cycle by asking the assembled crowd where they thought the unemployment rate was headed over the next 12 months. Fully 77% of the group thought it was headed higher, whereas only 17% thought it could drift a bit lower. Of those looking for an upside drift in US joblessness, the majority thought any increases would be relatively modest, confined in the 4.5% to 4.9% range. This is broadly consistent with an opening up of thin margins of labor market slack that might result from a modest downturn in real GDP growth to the 2.5% to 2.75% range over the next 12 months. The scenario that emerges from our polling of the macro sentiment of the Lyford crowd is the quintessential soft landing -- a modest slowdown that leads to an equally modest easing of underlying inflationary pressures and a concomitant tilt toward easier Fed policy. A slight updrift in bond yields was the only real anomalous result of this exercise. By contrast, you would have thought a benign growth, inflation, and Fed policy outlook might have provided a modestly constructive climate for long rates. One development that might square this circle is a possible decline in the dollar. With 40% of the group looking for the yen-dollar cross rate to move below 115 over the next 12 months -- nearly double the 22% anticipating further dollar strength -- some concession on real rates could well be part and parcel of America’s long overdue current account adjustment. With Asian central banks speaking increasingly of the need for reserve diversification out of dollars, a modest currency-driven boost to longer-term US interest rates is not out of the question. But even in this case, the worst-case expectations of a back-up in long rates -- roughly in the 50 to 100 basis point range -- is hardly the stuff of a dollar collapse and a wrenching current-account adjustment. We did our best to stress-test this sanguine macro prognosis. I made a compelling case for the coming China slowdown and its important implications for the overdone commodity bet. The response was a great big yawn, with far more interest in a presentation of secular constraints on the supply side brilliantly articulated by my debating adversary, Wiktor Bielski, our European metals and mining analyst. Professor Niall Ferguson, who wowed the European version of this conference last June with his concerns over the fate of two globalizations -- the one that came to a sickening end in the early 20th century and the current strain with many eerie parallels -- grabbed the Lyford crowd with his “paradox of the newspaper.” Shouldn’t we make more of an effort, he argued, to reconcile the sickening content of the news section with the sanguine stories of the business section? “Nonsense,” said the Lyford crowd. Geopolitical angst paled in comparison to the main event -- globalization. A rapidly accelerating pace of cross-border integration of economies and markets should not be seen as a risk -- even as pro-labor Democrats stormed the US Congress. Instead, it was viewed as a one-way street to ever-greater prosperity by poor and rich countries, alike. Globalization was the glue that cemented the unflinching enthusiasm over BRICs and commodities that permeated our discussions at Lyford Cay this year. Instead, Niall Ferguson was seen as typical of the alarmists that I always seem to invite to this conference. There was actually a request by one of the more seasoned investors to dispense altogether with an outside speaker next year, and instead offer a screening of “Mary Poppins.” There was the usual hand-wringing over the credit explosion, as well as related angst over the explosion of credit derivatives, LBOs, and the levered loan market. But no one made a case why these trends couldn’t continue -- especially in the context of the relatively benign interest rate climate that most were expecting. Derivatives were not be feared, went the all-too-familiar refrain -- they were the new “killer ap” of financial markets that slices up risk and distributes it widely to the masses. With built-in shock absorbers like that, why worry? Over the years, I have learned to read the Lyford consensus very carefully -- and with great respect. Of course, we have the inside joke of the fabled “curse of Lyford Cay” -- i.e., that the strongest held view of the group usually turns out to be wrong. Sometimes that turns out to be the case -- the most recent such example was the dollar’s rebound in 2005 when, at the end of 2004, almost all of the crowd was lined up on the side of the boat that thought it would continue to decline. But far more often than not, the debate at this conference gets right to the heart of the major issues the markets are grappling with. Like most groups, the crowd is heavily influenced by recent trends. The US stock market has been on a tear in recent months, and the economy seems to be holding up just fine -- at least so far -- in the face of the bursting of another asset bubble. The election has come and gone, and while the outcome was a shocker to most, there were few concerns that shifting political winds might derail this Teflon-like scenario. In the end, the Lyford macro view all boiled down to a very simple observation: Liquidity was everywhere -- holding the system together, keeping many of the assembled investors heavily involved in spread markets and unlikely to challenge the widely recognized excesses of the credit cycle. As has been their wont, central banks were widely presumed to ride to the rescue in the event of any major disturbance in the credit cycle. In a low inflation world, this was not viewed as a moral hazard -- but prudent management by the most powerful stewards of the global economy and world financial markets. Literally nothing seemed to faze the Lyford crowd in November 2006. Did someone say Mary Poppins?
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Inflation Objectives and the Bond Market
November 13, 2006
By Richard Berner | New York
The Fed is not an inflation-targeting central bank and, as I noted in an earlier report, has yet to articulate a “numerical objective for price stability” (see “A Higher Inflation Objective?” Global Economic Forum, August 11, 2006). Yet it is widely presumed that Fed officials implicitly aim at core inflation measured by the personal consumption price index (PCEPI) excluding food and energy in a range of 1-2% — the famous “comfort zone” for inflation. That may now be changing. By all reports, the Fed is now actively considering the adoption of an explicit numerical objective for price stability, following in the footsteps of other central banks. What will be the outcome of these deliberations and what would be their implications for investors? First, why do it? An explicit numerical inflation objective, which falls short of inflation targeting, would likely accomplish three goals. First, it would better communicate policy objectives. To be sure, the Fed’s dual mandate — to balance maintaining price stability and achieving maximum growth in employment — is clear in principle. But with “core” inflation measured by the PCEPI lingering above the Fed’s presumed “comfort zone” for the third straight year, some officials are concerned that uncertainty over the Fed’s inflation preferences may erode hard-won credibility. On the other hand, if disinflationary shocks re-emerged as in 2003, the Fed’s inability to lower rates below the so-called zero lower bound would make explicit inflation preferences even more important. And as Fed Chairman Bernanke reasoned in a 2003 talk, when inflation is low it’s less obvious what the Fed wants, and “uncertainty about… [Fed inflation preferences] …may translate ….into broader economic and financial uncertainty” (Remarks at the 28th Annual Policy Conference: Inflation Targeting: Prospects and Problems, Federal Reserve Bank of St. Louis, St. Louis, Missouri, October 17, 2003). A second and related goal is that specifying an explicit objective could further anchor market participants’ and the general public’s inflation expectations. Put simply, if the public knows the goal and how the Fed will act (and react) to achieve it, the chances of achieving that outcome are better. Finally, a common, agreed-upon objective would enhance the quality of the Fed’s policy deliberations. Currently, a range of inflation preferences among FOMC members may obscure the reasons some advocate different policies. The merits of an explicit objective are thus clear in principle, and several Fed officials have declared their allegiance. Until recently, however, opponents argued that monetary policy had been highly successful without specifying an objective — so why fix it? Moreover, empirical evidence from other countries’ experiences suggests that the benefits are not quantitatively substantial. And, given the Fed’s dual mandate, concern lingered that adoption would invite Congressional insistence on an explicit employment objective. But a softening on both sides of the debate, and the shared understanding that the Fed’s communication strategy needs more than a patch, seems to be swinging the argument towards adoption in principle. However, the debate over how to do it is far from settled. Rather than merely converting the “comfort zone” into an explicit objective, officials likely will want to vet thoroughly several key issues. First, is the midpoint of that range the right level? Second, should the Fed pick a number or a range for the objective? Third, what inflation metric should be the standard, and should the objective refer to core or headline inflation? Finally, should officials specify a time period over which they should be accountable for achieving their goals? Let’s examine each in turn. The 1½% midpoint of the current “comfort zone” seems to have arisen from two rules of thumb: First, many — including former Fed Chairman Greenspan at a 1996 FOMC meeting and current Chair Bernanke in his 2003 talk describing the optimal long-term inflation rate — think that 2% is a reasonable level for a medium- to longer-term inflation objective. It seems low enough to affirm the Fed’s commitment to price stability and high enough to allow a cushion for disinflationary shocks and for upward measurement bias (about 0.6% in the case of the CPI and about half that in the case of the PCEPI). Second, officials wanted to frame the objective in terns of core inflation to get at the trend, and preferred the core PCEPI with its smaller weight on housing and reduced “substitution” bias. An historical average gap of about ½ percentage point between the core CPI and the core PCEPI seemed to indicate that, for the latter yardstick, 1½% was the right number. But Fed officials and staffers seem increasingly uncomfortable with that level. Although they can symmetrically specify their inflation objectives around it, actual policy responses have been asymmetric, connoting more tolerance for higher inflation and creating just the uncertainty about inflation preferences officials would like to avoid. On one side, the policy response required to avoid a feared deflation in 2003 in hindsight seemed too aggressive. In contrast, over the past three years, the Fed has been content to let inflation drift above the upper end of the zone. And both today’s low inflation rate and the belief in a flatter Phillips curve seem to be behind the Fed’s forecast of a slow decline in inflation next year. A higher level for the objective would remove some of that asymmetry. Moreover, policymakers now understand that “best practice” for an explicit inflation objective probably involves a point rather than a range. It is simple, enhancing communication. It is unambiguous, strengthening both the anchor for inflation expectations and the quality of the policy discussion. A single point may to some connote unachievable precision for the Fed’s goal, but everyone will understand that it is a medium-term objective. Given that medium-term time horizon, policymakers can specify the objective in terms of overall inflation, both because changes in relative prices like energy will reverse and because — if they don’t — officials should count them as part of the trend. Likewise, over that horizon officials might elect to use the better-known CPI rather than the PCEPI, although that choice isn’t clear-cut. Meanwhile, a range is important for a different purpose, namely monitoring the Fed’s progress toward that objective over a shorter time horizon. In that context, officials could follow the Bank of Canada model and specify the range in terms of core inflation. Officials might also choose a wider range than +/- 50 bp to allow for short-term inflation fluctuations. Indeed, former Philadelphia Federal Reserve Bank President Santomero suggested a 1-3% monitoring band around a 2% objective. The wider band has major advantages over the unrealistically low 2% upper bound for the comfort zone. Policymakers can point to the 3% upper bound as a “harder” edge that would elicit a strong policy response and still allow for the flexibility the Fed needs in the day-to-day conduct of policy. A higher value for the objective coupled with a wider monitoring range could thus meet two needs. First, the higher objective would allow a larger cushion for disinflationary shocks and reduce the asymmetry now implicit in policy responses to them. Second, a wider range but with “harder” edges would still allow for short-term fluctuations in inflation and the flexible and pragmatic approach to policy that enables the Fed to aim at both parts of the dual mandate while reinforcing its commitment to price stability. What does the outcome of this debate imply for financial markets? In my view, the specifics may surprise market participants. For example, given the considerations discussed above, the Fed could decide on a medium-term objective of 2% for overall inflation measured by the CPI, but with a 1-3% range specified in terms of the core rate for monitoring how the Fed is doing over a shorter time horizon. At this point, I don’t believe that a change in the level of the objective from today’s presumed 1½% would erode Fed credibility. Once officials announce and explain it, I think market participants and the public would quickly adapt to a slightly higher inflation objective, possibly measured by the CPI, than the current midpoint of the presumed comfort zone. Indeed, the Fed has enormous credibility with market participants despite the latter’s apparent widespread anticipation, judging by inflation compensation in the TIPS market, that the objective may be higher than 1½%. Similarly, were the Fed to take longer to realize the objective, in recognition of a loose relationship between slack in the economy and inflation, it need not reduce credibility. But the transition may nonetheless be bumpy: In today’s less-constrained context, the longer the Fed allows inflation to remain at current levels or to edge higher, the more the yield curve is likely to steepen from current levels. The complexity of these issues hints that the debate over implementation of a numerical objective could be protracted, potentially creating uncertainty over the Fed’s preferences. But having created market expectations that a more explicit numerical objective is coming, it seems unlikely that the Fed would defer the decision for more than a few months.
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AXJ: Revising Up Our Forecasts for the AXJ Currencies
November 13, 2006
By Stephen Jen | London
Aligning our forecasts with our bullish view With the recent resumption of net equity inflows into AXJ, we have become more confident that the risk-reduction phase that began in May this year has come to an end. In this note, we announce some forecast revisions to reflect the constructive outlook for the AXJ currencies that we expressed in Asian Currencies to Lead the Break-out of the Ranges (November 2, 2006). In short, we started out the year looking for the Asian currencies to dominate, and indeed they did until May. Now, we are calling for a resumption of that trend. Why we are bullish on the AXJ currencies The US economy is slowing; the question now is whether this will be a soft or a hard landing. We firmly believe that we will witness a very benign rotation of growth away from the US and toward the rest of the world. Global growth will remain robust, even with a soft landing in the US economy. The global economy is likely to decelerate from around 5.0% this year to 4.5% or thereabouts in 2007 — making it the fifth consecutive year of global growth above 4.0%. Having been a ‘high-beta’ region in recent decades, Asia should, in theory, be sensitive to short-term swings in global growth. However, we believe, on balance, that AXJ economies will be able to weather the short-term volatility in global demand and its currencies will outperform both the dollar and European currencies in the year ahead, as long as global growth remains robust, i.e., above 4.0%. We make the following points. • Point 1. AXJ’s exports are a function of global, not US, demand. We must draw a distinction between the US economy and the global economy. One key assumption we make, as mentioned above, is that the rest of the world should be able to de-couple from the US if the US only soft lands — soft enough not to thwart the recovery in the rest of the world and soft enough not to undermine global asset prices. A relatively isolated soft-landing in the US should not hurt Asia much, in our view. There are early signs of economic weakness in some AXJ countries (e.g., weak IP and export growth in Malaysia, a sharp slowdown in Taiwan’s exports in October and Korea’s disappointing export performance in October). We discount, but do not dismiss, this weakening trend. The soft patch in 2Q and 3Q in both the US and Japan must have had some effects on AXJ’s exports. We suspect that, with a 3-4-month delay, these effects should be felt in AXJ. But this weakness should not be interpreted as the beginning of a trend, as we believe that the global economy will do just fine in 2007. Further, AXJ is increasingly reliant on non-OECD countries. The rise in intra-regional trade in Asia is well-documented and familiar to most investors. Growth in the non-OECD countries has become an increasingly important source of demand for the AXJ economies. The outperformance of AXJ’s export growth in mid-2003 and again in mid-2005 are reminders of this idea. We are not saying that OECD growth isn’t important anymore. Rather, we stress that the sources of Asia’s external demand are much more diversified now than they were in the 1980s or the 1990s. • Point 2. The ‘beta’ is not a constant. We talk about AXJ being a ‘high-beta’ region. But this ‘beta’ is far from a constant. First, in addition to the ‘direct trade’ channel, there is also a ‘financial channel’ that affects the ‘beta’. In 2001, the world looked ‘tightly coupled’ (i.e., a high measured ‘beta’), as it fell into recession in synchronism. But this was due primarily to IT bubbles bursting in synchronism. This time around, it is not clear whether a US housing market in recession will trigger a global equity market collapse, and therefore the stress the US economy may place on the rest of the world is likely to be much more muted. Second, general confidence could alter the ‘beta’. As long as the economic agents in Asia are not disturbed by the soft-landing in the US, consumption and capital expenditure may remain buoyant. • Point 3. No more large-scale, level-defending interventions. We have been arguing for the past year that virtually all of the Asian central banks have more than enough foreign currency reserves for liquidity purposes. This includes China. Under the management of Mr Watanabe of the MoF, Japan has refrained from intervention since March 2004. Similarly, despite the angst regarding the low JPY/KRW cross, Korea has limited its intervention activities to smoothing purposes. We believe that the Asian central banks will no longer engage in level-defending, large-scale one-sided interventions as they have in the past, because they are already saturated with reserves. If USD/JPY and USD/CNY correct, as we believe they will, we believe that the AXJ central banks will allow the dollar to weaken against their currencies. Already, the policy makers in Korea and Thailand have begun to talk down their currencies, arguing that they are either too strong or are appreciating at too rapid a rate. Our view is that any resistance that the AXJ economies put up will be modest and certainly much less aggressive than in 2004. Finally, with a Democratic US Congress, aggressive interventions would almost certainty trigger a response from the US. • Point 4. A race against the dollar. In forming our forecasts on the AXJ currencies, we don’t just look at the absolute export or GDP growth rates of the AXJ economies. Rather, we aim to assess the likely relative performance of these currencies/economies vis-à-vis the dollar/US economy. We have long argued that if the market’s expectations become more in accord on the likelihood of a soft landing for the US and the US does in fact soft-land, the dollar should weaken, from a cyclical perspective. In this scenario, which is our central case, the dollar should weaken against most currencies, including the AXJ currencies. Our forecast changes Exhibit 1 in the full report (available on ClientLink) summarises our new forecasts for the AXJ currencies. The changes are in bold face. While there are important country-specific idiosyncratic factors that will lead to disparities in the trajectories of the various AXJ currencies, the key message we are trying to convey is that the general trend in USD/AXJ that we expect to see in the coming year is downward, except for USD/HKD. USD/CNY’s down-trend is definitive and determined; we are only witnessing the beginning of a multi-year trend. USD/KRW is very heavy, despite incipient signs of a slowdown in some economic indicators. We expect USD/KRW to breach below 900 in the coming year. TWD, in our view, is under-appreciated by investors. Low yields and political uncertainties have clearly been TWD negatives since this summer. However, we believe we may be nearing a situation where, following the military coup in Thailand, developments regarding President Chen’s tenure could trigger a sharp rally in the TWD, much as the nuclear test in North Korea had an impact on the KRW. Bottom line As the US economy soft-lands while the rest of the world de-couples from it and continues to grow, USD/AXJ should resume the down-trend that was interrupted in May. We align our forecasts with the constructive outlook we have for the AXJ currencies.
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Is the Manufacturing Motor Starting to Sputter?
November 13, 2006
By Elga Bartsch | London
This week, weaker-than-expected manufacturing orders and industrial production data for the month of September have given rise to concerns that, despite soaring merchandise exports over the same period, the German export machine could start to sputter. Signs of the German manufacturing motor sputtering would be a real reason for concern because companies and consumers are currently bracing themselves for a three-percentage-point increase in the VAT in January and an overall fiscal tightening of around 0.75% of GDP. Indeed, September manufacturing orders dropped sharply by a non-annualised 2.5%M, despite sizeable bulk orders boosting the numbers, according to the Economics Ministry. Less spectacular, but also below market expectations, industrial production contracted by 0.3%M in September. The correction in manufacturing indicators is not changing our estimates for 3Q GDP — we are still looking for a respectable 0.7%Q to be reported in the flash estimate. If our estimates are confirmed by official GDP data, the third quarter would have seen gradual moderation in GDP growth from the 0.9%Q recorded between April and June. Substantial upward revisions to construction output in the first half of the year suggest that there is a distinct possibility of past GDP data being revised up. A further pick-up in construction output growth between July and September and other coincident construction indicators suggest that the sector’s multi-year recession is now over. The correction in manufacturing orders and, to lesser extent, output suggests that the manufacturing sector seems to be losing some steam as it enters the fourth quarter. The sharp decline in order demand recorded in September puts the sector onto a negative ramp in the final quarter of this year. This holds in particular for foreign orders placed with German manufacturers. A steep 6.2%M fall in September foreign orders gives a statistical underhang of 2.9%Q going into the fourth quarter. Hence, sizeable monthly gains are needed just to get back to the third quarter average, not to mention to rise above it. The correction in foreign order demand is driven by a plunge in orders from non-euro area countries. However, the sharp correction in foreign order demand is at odds with rebounding export expectations of German manufacturers polled by the Ifo Institute. Companies’ export expectations are now back to levels close to their historical highs, after a temporary correction in early summer. We would therefore expect a rebound in overseas order demand going forward. Contrary to foreign demand, domestic order growth has been gaining pace during 3Q and is entering 4Q with considerable momentum. The strong momentum is concentrated in the capital goods sector, suggesting that investment spending on machinery and equipment is set to expand at a rapid rate. Despite the widespread expectations of advance purchases ahead of the January VAT hike, orders placed with German consumer goods producers have stalled after the World Cup. On the whole, manufacturing orders hint at robust industrial production growth. Note, however, that the order data could be painting too rosy a picture because the cancellation of several big orders in the aerospace industry is not taken into account. But a continuation of robust manufacturing growth is also signalled by various business survey tallies. Peering into the final quarter of 2006, the Ifo business climate has been holding up well and even the ZEW investment sentiment, which had nose-dived earlier, seems to have stabilised now. We and the consensus have even factored in a small rebound in the November number to be released this coming week. With the biggest VAT hike in post-war history just around the corner, advance purchases ahead of the tax change will likely be key in shaping the quarterly growth momentum in the final quarter of 2006. Historically, broad retail sales (including cars) have gained a cumulative 4.8% in the last three months ahead of a VAT hike. And even narrow retail sales (excluding cars) have gained 2.3% on average over that period. Thus far, retail sales provide little evidence of advance purchases, at least not on the headline numbers. Only the breakdown of retail sales hints at a shift in spending towards big-ticket items such as furniture and cars.
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Oil Spending Spree
November 13, 2006
By Luis Arcentales | New York
The introduction of Pemex’s new fiscal regime has raised questions among Mexico watchers about the flow of oil and the fiscal accounts. In the past, we have argued that Pemex’s new fiscal regime represented a step in the right direction, albeit a modest one, in its seemingly uphill battle to keep up oil output (see “Mexico: The Slippery (Oil) Slope” in This Week in Latin America, July 10, 2006). However, these timid yet positive changes — which have enabled Pemex to keep more resources for its significant investment needs — have had implications for Mexico’s fiscal coffers. In the following lines, we try to address some of the common questions we have received about Mexico’s oil windfall. Despite record crude prices, the public sector’s oil windfall has not been out of line with those of the past few years. In the first three quarters of this year, Mexico’s excess revenues from oil amounted to M$54 billion or about 0.7% of GDP. This is roughly unchanged from the same period last year and about half the windfall of 2004 (as a share of GDP). Of course, ‘excess revenue’ is a function of the budget estimate for the Mexican oil basket. But this year crude has been roughly US$18 above budget, higher than the spread of 2005 (US$15) and 2004 (US$10). The flipside has been an improved financial performance by Pemex, whose bottom line rose 166% in the first half of the year versus 2005 on a 21% increase in revenues. This is an encouraging development, given that Pemex has reported net losses in each of the last eight years. Contrary to popular belief, the bulk of the revenue abundance has come from non-oil receipts, exceeding M$150 billion (or 1.5% of GDP) in the first nine months of the year. With economic activity running at its strongest pace in six years — exceeding government forecasts — and superior compliance, part of the improvement should come as no surprise. Interestingly, authorities reckon that part of the upward surprise in tax collections has come from the ‘formalization’ of the economy in the form of an increasing share of Mexican consumers buying durables on credit at fast-growing mega retailers. Mexico’s provinces provide a good example of the abundance of non-oil receipts. Of roughly M$70 billion in above-budget receipts, over M$40 billion has been derived from revenue-sharing agreements (participaciones), which can be spent with a high degree of discretion. In addition, some M$14 billion represents earmarked transfers (aportaciones) to cover excess spending in areas like education and healthcare. The remainder, some M$12 billion, represents the transfers earmarked for the states’ infrastructure projects funded by excess revenues from oil exports. The lion’s share of the public sector’s oil take comes from the ordinary hydrocarbon duty (DOSH), which replaced the previous 60.8% tax on Pemex’s top line. The new system allows for some investment-focused deductions and contains different tax rates depending on the observed prices for oil and gas. Whether prices are high or low, however, the public sector’s take is guaranteed to be extremely high. When revenues from the DOSH exceed budget estimates, they are combined with the non-oil tax windfall and then channeled to the natural disaster fund, to fund energy subsidies and any above-budget increases in expenditures. If any of the windfall is left after these deductions, then it is split between Pemex (50%), the Oil Stabilization Fund (25%) and to improve the public sector finances (25%). Since its creation in 2000, the Oil Stabilization Fund (FIEP) has failed to achieve critical mass. It is hard to determine what the proper size of the FIEP should be, and there is a strong case against the accumulation of substantial assets, given Mexico’s significant development needs in areas such as education, healthcare and infrastructure. And to be fair, as the experiences of 1998 and 2001 clearly show, the Mexican fiscal authorities have been very effective at tightening their belts when faced with oil-related revenue shortfalls. Yet, given the public sector’s high dependence on volatile oil revenues, the potential impact of the FIEP — whose balance currently stands at about 0.20% of GDP — in smoothing the adjustment to a protracted drop in oil prices appears limited at best. This year, a transitory measure — reminiscent of the move in 2002 that nearly depleted the FIEP — has channeled a significant share of the FIEP receipts towards infrastructure spending. While today’s favorable backdrop means that accumulation of assets for a rainy day is not an imperative, such a short-sighted move underscores the risk that the ongoing abundance could hamper the political will to move forward on the structural reform agenda. Defining the ‘windfall’, namely the difference between budgeted revenues and expenditures based on oil price assumptions and actual revenues, is set to change this year. When the new administration — scheduled to take office on December 1 — begins budget negotiations next month, a new law will be used to set the reference oil price under a formula looking at a combination of historical and future prices. Depending on precisely how the timeframe is defined, the reference oil price for Mexican crude is likely to be near US$42 per barrel, guaranteeing that the spending spree will carry into 2007. The 2007 reference price is higher than the US$36.5 used in the 2006 budget — a price set after negotiations with Congress, which resisted the executive branch’s initial proposal of US$31.5 per barrel. What is more important, of course, than the narrowly defined ‘windfall’ each year as oil prices have exceeded ever-rising budget assumptions, is the magnitude of the increase in oil-related revenues. Compared with 2004 and 2005 — when the budgets contained oil at US$20 and US$27, respectively — a reference price of US$42 would translate into a budget some US$20 billion larger (or about 2.5% points of GDP larger). Against this backdrop, it is surprising to hear voices in Mexico calling for a small deficit in 2007; instead, Mexico should be running a surplus, given the unusual nature of its sudden oil wealth. Bottom line Mexico needs to boost public investment in areas like infrastructure and human capital. Yet, to the extent that these programs require long-term funding commitments, it seems unwise to rely on unpredictable sources of financing like oil. With Mexico’s current non-oil tax take among the lowest in the region, and absent a comprehensive tax reform, the scope to boost investment funded by permanent sources of revenue is limited. The challenge for the next administration, therefore, is to avoid the complacency caused by the ongoing abundance of inflows and work towards reversing the public sector’s over-dependence on oil.
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