Mexico
More Pain Ahead
January 27, 2009

By Luis Arcentales | New York

For well over a year, Mexico watchers have been cautious about the country’s growth prospects because of concerns from its strong links to the US economy.  These concerns are not misplaced: after all, Mexico ships 80% of its exports to the US, Mexicans working in the US send back home almost US$24 billion per year (2.4% of GDP) and, since 1999, the US has accounted for US$116 billion or 55% of total FDI inflows.  And of all the ties between the Mexican and US economies, the link is strongest in industrial production (see “Mexico: The Link is Alive”, This Week in Latin America, August 18, 2003).  

Even though Mexico’s industrial sector has been sluggish for most of 2008, we believe that conditions are set to get much worse before they get any better.  Indeed, incoming data indicate that there was a dramatic downturn in Mexico’s industrial sector in the final months of 2008, setting the stage for an important contraction in 2009.  Several factors underpin our cautious stance, above all evidence that export demand has suddenly dried up – particularly shipments to non-US partners – and concerns that the downturn in US industrial activity appears to be in a freefall.  In addition, manufacturing surveys in Mexico reflect a broad-based, sudden deterioration of alarming proportions.  Lastly, for all the fears Mexico watchers have expressed about the industrial sector, once the drag from mining is excluded, the industrial slump in Mexico is just getting underway. 

The Manufacturing Slump: More Pain Ahead

For Mexico’s industrial sector, the real slump only started in 4Q08.  At first sight, this may seem odd: after all, industrial output has posted annual declines for seven consecutive months through November and the manufacturing sector has been shedding jobs during most of 2008 (see “Mexico: Consumers: Nowhere to Hide”, EM Economist, January 23, 2009). However, the overall decline in industrial production (IP) – which includes manufacturing, construction, mining and utilities – has been heavily influenced by the drag from mining, which reflects in great part falling oil output from Mexico’s oil monopoly, Pemex (see “Mexico: Oil Output – Bottomless”, also in last week’s EM Economist).   Indeed, in the first three quarters of 2008, mining alone – which represents almost a fifth of IP – knocked off 1.5pp from total IP growth, leaving it essentially flat (+0.3%). 

But in the final months of 2008, the picture changed dramatically: in the three months ending November, IP ex-mining posted a 2.7% annual decline compared to -3.3% for overall IP as the weakness began to spread to construction (-3.2%) and manufacturing as well (-2.8%).  And seasonally adjusted data show that the impact of external weakness is spreading, with ex-mining IP contracting at a near 8% annualized pace between September and November.  

The deepening of the deceleration in Mexico’s industrial sector in late 2008 has coincided with a sharp worsening in US manufacturing.  Up until mid-2008, US manufacturing was being supported by strength in exports even as domestic demand was slowing, according to our US economists, David Greenlaw and Ted Wieseman.  Since then, not only has domestic activity deteriorated sharply, but exports are showing major weakness as well.  Indeed, the most recent batch of data from the US indicate that conditions for Mexico’s manufacturers are about to become much worse.  The ISM manufacturing index collapsed to 32.4 in December – a level only seen in a handful of months during the 1980, 1973-75 and 1948-49 recessions.  Echoing the grim results from the ISM survey, manufacturing output plummeted at a 19% annualized rate between August and December, while capacity utilization (73.6%) declined to close to a record low in 61 years of available data in December.

With the US industrial sector in the midst of one of its worst downturns ever, Mexican manufacturers are likely to see much more pain ahead.  And for Mexico watchers, there are few historical precedents in the post-NAFTA era to benchmark against.  For example, in the 2001 recession, when Mexican GDP contracted by 1.6% on average between 3Q01 and 1Q02, the US industrial slump turned out to be relatively modest in both magnitude and duration compared to what the current episode is likely to be. 

In 2001, US IP peaked in June 2000 and bottomed 18 months later after contracting by a little over 6%.  Though with a brief lag, Mexican production also contracted by just over 6% over a period of 16 months ending in January 2002.  In the current episode, the peak in US production took place in January 2008 – though it was essentially flat in 4Q07 – and, as of December 2008, it was already 8% lower. 

Though in Mexico the magnitude of the downturn over the same period has been about half as large as the US, with the link between both economies very much alive, we suspect that it may be only a matter of time until Mexico catches on. And the length of the downturn also matters as it still seems to have a long way to go: our US team doesn’t expect a bottoming in IP until 3Q09 for a total drop of roughly 11% from January 2008. 

From Tailwind to Drag

For most of last year, Mexico enjoyed robust demand for its exports, even after excluding oil.  Exports ex-fuel jumped 10.1% in the January-September period, even as global conditions deteriorated.  With concerns over the outlook for the US economy mounting in 2H07, we highlighted that Mexico’s non-US exports were decoupling from US exports and helping to soften the hit from the slowdown in the US (see “Mexico: A Decoupling of Sorts”, EM Economist, October 26, 2007).  At that time and through most of 2008, exports to non-US trading partners grew at multiples of the pace of US-bound shipments.  While the US still accounted for 80% of Mexican exports, Mexico’s export dynamic had become less US-centric.  Indeed, in 2007 and 2008, exports to non-US partners – which accounted for just 19% of total exports – contributed a disproportionate 47% of total export growth. 

In the last few months of 2008, however, demand from non-US partners quickly turned from a growth tailwind into a drag, in a sudden reversal of the encouraging ‘decoupling’ on the exports front.  After expanding by a robust 26.8% in the first nine months of 2008, non-oil exports to non-US partners grew just 1.0% in the last three months of the year.  And the average for 4Q masks a progressive deterioration: in October non-oil exports to non-US partners were up 18.2% from a year earlier (-7.2% to the US), while in December they plummeted 12.0%, exceeding the sharp 11.1% decline in US-bound exports. 

This re-coupling in export demand has important implications for Mexico – beyond the direct impact on Mexico’s export-oriented manufacturers – as it suggests that the US economy could remain weak for longer.  Sinking trade is a sign of the spillover to the rest of the world from sluggish US demand and the credit crunch, argues our US Economics team.  In turn, the global slowdown is likely to feed back to US exports, dragging US growth further (see Global Recession Aggravates the US Downturn, January 12, 2009). 

Aside from plummeting global demand, Mexican exports face another headwind, as their total share in the US imports market has been eroding for most of 2008.  This is in sharp contrast to the encouraging trend of modest yet steady inroads into the US imports market experienced between 2005 and early 2008.  Indeed, as of November 2008, Mexico’s share in the US import pie had declined to the lowest level in almost three years, based on our calculations. 

The loss in US market share is more than just a story of swings in oil prices.  Once we strip out oil, the picture looks similarly challenging, with Mexican manufacturing exports commanding their lowest market share since the end of 2005.  Indeed, the modest upturn in the share of manufacturing exports at the end of 2008 came entirely from the relative success of the Mexican automobile industry. In 2008, Mexico’s shipments of light vehicles to the US declined by just 2.4% in a market where total auto imports contracted by almost 9%.  Even if this trend continues, given the strong headwinds facing the automobile industry – most Mexican carmakers announced extraordinary technical stops starting mid-December due to falling demand – Mexican carmakers would only be increasing their presence in a significantly smaller US pie (our US team expects light vehicle sales to shrink by 22% to 10.1 million units during 2009).    

Manufacturing Gloom

Manufacturing surveys in Mexico are experiencing a sudden deterioration of unprecedented proportions.  The central bank’s monthly manufacturing confidence index – which dates back to 1998 – has collapsed to the lowest level on record.  In fact, whether measured in the absolute decline from the most recent peak or in percentage terms, the ongoing downturn eclipses the two previous major declines during the Asian Financial Crisis in 1998 and the recession of 2001. And the deterioration has been broadly based: once seasonally adjusted, measures of six-month forward business outlook, hiring intentions and capital expenditures all hit historical lows in 4Q08.  And though still far from the levels reached during the 2001 recession, the number of survey participants with excessive inventories of finished goods rose sharply in late 2008, pointing to a worsening inventory overhang. 

Newly introduced surveys show a consistently gloomy picture in manufacturing.  Last year, Mexico’s statistical institute (INEGI) unveiled a series of detailed, comprehensive diffusion indices inspired by the survey from the Institute of Supply Management in the US.  Mexico’s aggregate index of manufacturing orders, for example, plunged to 41.5 in December, well below the 50 ‘neutral’ threshold and the lowest since inception in 2006. 

Meanwhile, the confidence survey’s capex intentions component collapsed to 14.1 in 4Q08, a whopping 26.9 points below its level in 4Q07.  With fixed investment in machinery – up 14.6% in the January-October period – as one of the few bright spots in an otherwise sluggish Mexico growth story of last year, the deterioration in capital expenditure intentions seems particularly worrisome.  

Bottom Line

Even though Mexico’s industrial sector has been sluggish for most of 2008, conditions are set to get much worse before they get any better during 2009.  Indeed, in the final months of 2008 it seems that the downturn intensified in Mexico’s industrial sector, as the US manufacturing slump worsened and demand from non-US exports partners dried up. 

For well over a year, Mexico watchers have been cautious about the country’s growth prospects, because of concerns from its links to the US, mainly in industry but also via remittances and capital flows.  And those fears are only likely to intensify in the coming months due a deepening in the production slump and further retrenchment of consumers, both of which set the stage for a larger-than-expected recession this year.

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Singapore
A Constructive Budget
January 27, 2009

By Deyi Tan, Chetan Ahya | Singapore & Shweta Singh | Mumbai

What’s New?

The government announced the F2009 budget yesterday evening, bringing it forward from the usual February timetable in light of the severity of the macro downturn. Overall, the budget is constructive and expansionary, in our view. The government expects a fiscal deficit of -3.5% of GDP for F2009 (versus -0.8% of GDP for F2008). For basic balance (which excludes top-ups to endowment & trust funds and net investment income/returns revenue), it expects -6.0% of GDP (versus -1.0% of GDP in F2008). Specifically, government revenue is expected to fall from 15.1% of GDP in F2008 to 13.4% in F2009. Total expenditure (including special transfers) is expected to increase from 17.2% of GDP to 20% in F2009. In terms of size, the budget announced is in line with our overall expectation of a 3% fiscal stimulus (i.e., increase in expenditure) (see Singapore Economics: The Need to Bring on Mr. Keynes, January 13, 2009). We maintain our view of -3.5%Y GDP growth for 2009 and +3.0%Y for 2010. 

Doing the Necessary

In terms of measures, we believe that the investors should ask the question of what the government can and should do. As we highlighted in our previous note, the budget needed to address two broad objectives, in our view: 1) supporting demand and preventing adverse social impact of a slowdown from income compression and unemployment; and 2) easing credit conditions and reducing the systemic risks of asset market price corrections and corporate credit failures on the banking sector. In this regard, we believe that the centre-piece of the budget, a S$20.5 billion package (8.2% of GDP) (not all are new spending or costs), focused on measures of the right nature. Broadly speaking, the emphasis is placed along the following lines:

a)         Job preservation through a job credit scheme which helps employers to reduce costs by providing cash grants up to 12% of the first S$2,500 of employees’ wages, skill-upgrading programs and course subsidies. This totals S$5.1 billion (2% of GDP).

b)         Easing credit conditions through measures such as a special risk-sharing initiative under which the loan quantum for the Bridging Loan Program for Working Capital will be increased from S$500,000 to S$5 million and the government’s risk share from 50% to 80%. This totals S$5.8 billion (2.3% of GDP).

c)         Easing cash flows through 40% property tax rebates, foreign-sourced income tax exemption, loss carry-back relief system and rebates & concessions on transport-related fees. This totals S$2.6 billion (1.0% of GDP).

d)         Cushioning disposable income through measures such as goods and services tax (GST) credits, 20% personal income tax rebates, rental and service & conservancy charge rebates. This totals S$2.6 billion (1.0% of GDP).

e)         Strengthening infrastructure by bringing forward deferred government projects, investing in healthcare, infrastructure and other sustainable development initiatives. This totals S$4.4 billion (1.8% of GDP).

How Effective Are The Measures?

We have the following thoughts on the impact of the budget:

1) In terms of top-line GDP growth – budget is not ‘stimulatory’ but defensive: For Singapore, the nature of the economy (high import leakage) and type of measures that has to be undertaken implies that the multiplier effect, by default, is likely to be relatively lower. In the case of China, the Rmb4 trillion infrastructure stimulus package is expenditure outlays that contribute directly to final demand. In the case of Singapore, the domestic economy is small and subject to leakage. The global macro environment is the single most important factor affecting economic outlook, which is why the economy is high-beta. Hence, using the government’s balance sheet to create final domestic demand directly (such as through government construction plans) to plug the global demand shortfall cannot be the key focal point. Moreover, Singapore has an ample infrastructure base to begin with. We believe that this is why Singapore budgets have tended to be ‘defensive’, focusing on the sustainability of households/corporates’ balance sheet via cost reductions/income enhancements to counter the blow of the external slowdown. Inevitably, part of this would be saved. Indeed, we do not expect the fiscal budget to enable the Singapore economy to buck the downtrend but merely to cushion the overshooting on the downside.

2) In terms of economic sectors, SMEs and low/semi-skilled consumers are greater beneficiaries: Small-to-medium sized enterprises (providing 60% of Singaporeans with jobs) and corporates with a higher percentage of low-to-semi-skilled workers on their payrolls will be greater beneficiaries of key measures such as the risk-sharing initiative and job credit scheme, in our view. Fiscal resources are not infinite, and the budget has targeted measures to cast the widest ‘safety net’ to where it is most needed. Although banks’ capital adequacy ratios are comfortable, loan growth contracted 1%M in November 2008 (after 23 consecutive months of positive sequential growth), suggesting some credit tightening at the margin due to risk-aversion. The increase in government risk share, coupled with the initiative to allow banks to price the loans, should tilt the risk-reward profile and predispose banks to more lending at the margin. Despite the commitment of government capital to such a scheme, the procedural difficulties of loan applications have been commonly cited as an impediment. In terms of execution, the enforced simplification of application procedures would perhaps serve to better unlock the credit flow. Separately, due to the cap of S$2,500 on monthly wages, the cost savings for the job credit scheme are more compelling for lower-to-semi-skilled workers, thereby incentivizing the employers of such workers. Continued lacklustre global demand and the ability to rehire semi-skilled workers relatively easily in an upturn pose the concern that SMEs could still cut the manpower pool to the bare minimum to maximize cost savings. This could undermine the effectiveness of the scheme. However, we believe that the scheme should at least mitigate the depth and the speed of such developments. 

Scope for More Pump-Priming

Although the government has enough surpluses from past budgets within this parliamentary term (which started in 2006) to fund the full deficit, it will tap into past reserves to finance the Job Credit scheme and the Special Risk-Sharing Initiative to ensure ample financial flexibility to respond quickly to changing conditions going forward. Indeed, we believe that the scope for further fiscal pump-priming remains. Macro conditions will deteriorate from here, in our view, and the risk profile to our -3.5%Y 2009 GDP is still skewed to the downside. Fiscal pump-priming is unlikely to be just a one-off, and the possibility of off-budget packages is high. As an aside, recall that two off-budget packages were announced in both 1998 and 2001.

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