Mexico
No Oil, No Problem?
February 24, 2009

By Luis Arcentales & Daniel Volberg | New York

For a public sector highly dependent on oil revenues such as Mexico’s, lower crude quotes appear to spell trouble. In 2008, crude represented 36.8% of total fiscal revenues, a figure marginally higher than the 36.4% projected in the 2009 budget. While the government hedged its oil price exposure during 2009, absent a sharp upturn in oil prices, the prospects of a meaningful fiscal deterioration in 2010 and beyond appears to top – along with Mexico’s tight link to the sputtering US economy – the list of concerns of Mexico watchers (see “Mexico: Fiscal Hedging Grace”, EM Economist, November 14, 2008).

But market concerns about the impact of lower oil prices on Mexico’s fiscal accounts appear overblown, in our view. These concerns, we suspect, come in part from a widespread misunderstanding of the interplay between crude prices and the exchange rate in a context of controlled domestic fuel prices. Indeed, even with the Mexican crude basket trading at current levels of near US$35 per barrel – half the 2009 budget assumption of US$70 per barrel – and the peso at 14.5, we find that the potential fiscal hole would reach just over 1 percentage point of GDP. If current oil market conditions persist, some fiscal adjustment in 2010 would be almost inevitable – be they higher taxes, an increase in domestic fuel prices and/or, more likely, a cut in expenditures. However, the shortfall generated by lower oil prices at around 1 percentage point of GDP seems quite manageable to us, especially compared to the increase in expenditures seen over the past couple years.

Overblown Oil Fears

At first sight, Mexico’s fiscal coffers appear to be facing prospects of a meaningful deterioration starting 2010. The argument made by some in the market is straightforward: oil revenues alone represent more than one-third of total fiscal receipts or 8.2% of GDP in the 2009 budget, which assumes that the Mexican crude basket will average US$70 per barrel – consistent with WTI around US$80 per barrel. With futures pointing to WTI averaging closer to US$55 per barrel next year – or roughly a third below the 2009 budget’s projection – then a major revenue crunch is in the cards that could be as big as 2.7% of GDP, even if Mexico manages to meet its oil output target. The math, however, is not as simple as many of the Mexico critics argue.

The potential fiscal deterioration in 2010 and beyond from lower oil prices appears quite manageable at around 1 percentage point of GDP, according to our calculations. This is far from the alarmist case made in some quarters, an argument that we believe does not take into account the interplay between lower oil prices and a sharply weaker peso against a backdrop of controlled fuel prices, which act as a stabilizer. Indeed, in 2008 Mexico generated relatively fewer benefits (M$185.5 billion or 1.6% of GDP) from each additional dollar of above-budget oil – prices averaged US$38.8 above last year’s US$49 per barrel budget assumption – due in great part to soaring fuel subsidies as international prices rose well above domestic fuel quotes (see “Mexico: Oiling the Fiscal Coffers”, EM Economist, June 6, 2008).

Controlled domestic fuel prices act as an important stabilizer in cushioning swings in oil prices. The lion’s share of the cushion comes from the excise tax on domestic fuels (known as IEPS). For example, in 2008, when crude prices soared to historically high levels, fuel subsidies became a heavy burden on the fiscal accounts as subsidies on gasoline and diesel ballooned to M$223.7 billion or a massive 1.9% of GDP from just 0.4% the year before. By contrast, even with the peso at 14.5 per dollar, if oil remains at US$40, taxes on fuels could generate as much as 1.1% of GDP this year in revenues, according to our calculations.

A weaker peso, in addition, represents a major tailwind for Mexico’s oil revenue inflows. The 2009 budget, for example, assumes an exchange rate of 11.7 on average, significantly stronger than current levels. Thus, even though 2009 net exports are hedged at the budget’s estimate of US$70 per barrel, the weaker peso should translate into a meaningful oil revenue windfall this year. Indeed, if the peso were to average 14.5 this year, we estimate that the windfall could reach some 0.7-1.0% of GDP.

The main drag on fiscal coffers from lower oil prices comes from export receipts, rather than domestic sales. But even in this revenue line, the relative swings are less drastic today due to the combination of the steady decline in Mexico’s oil exports and, due to insufficient refining capacity, an increase in imports of fuel (see “Mexico: Oil Output – Bottomless”, EM Economist, January 23, 2009). Of course, falling oil output – which declined 9.2% last year – represents one of Mexico’s most daunting challenges, one that the authorities began to address last year with the passage of the energy reform, which we believe represents a significant (and underappreciated) step in the right direction (see “Mexico: Energy Reform – The Final Stretch”, EM Economist, October 24, 2008).

Under current conditions, we estimate that the oil revenue shortfall in 2010 without the benefit of a hedge would be modest, ranging between 0.9% and 1.2% of GDP relative to the projections in the 2009 budget. In our exercise, we assume that oil (WTI) averages US$40 per barrel and the peso remains at 14.5 per dollar, while oil output and exports remain stable at 2009 estimated levels of 2.75mbpd and 1.336mbpd, respectively, despite recent disappointing production figures.

Given the wide perception gap among Mexico watchers about the potential oil-driven deterioration in Mexico’s fiscal accounts going forward, we decided to use two separate methodologies to estimate the oil revenue shortfall. First, we used a purely quantitative approach where we modeled total tax revenues as a function of GDP growth, inflation, the oil price (in pesos) and the real effective exchange rate. By applying different oil prices, we can test the sensitivity of the model-implied fiscal revenues to fluctuations in the price of oil. Our second methodology, rather than quantitatively, attempts to determine the revenue shortfall from an accounting approach. Using the aforementioned parameters, we calculate separately revenues from domestic and external sales, while another model estimates the revenues (or subsidies) from domestic fuel sales. Under current conditions, our estimates of the oil-related revenue shortfall range from M$115 to M$142 billion or 0.9-1.2 percentage points of 2009 GDP.

Little Savings for a Rainy Day

If a revenue shortfall were to materialize, the authorities have a series of stabilization funds which could be used to plug in any revenue shortfall. At the end of 2008, the main Oil Stabilization Fund (FEIP) had resources of M$85.8 billion or 0.72% of 2008 GDP; meanwhile, the States’ Revenues Stabilization Fund or FEIEF had M$30.3 billion (0.25% of GDP). In addition, Pemex’s Infrastructure Spending Stabilization Fund (FEIIPEMEX) contains M$29.0 billion or 0.24% of GDP; however, about half of the funds in the FEEIIPEMEX have been earmarked for the construction of a new refinery. Lastly, there is the sizeable Pensions’ Restructuring Fund (FARP) with M$63.7 billion and the Natural Disaster Fund (FONDEN) with M$19.4 billion. Although these last two funds are not stabilization funds in a strict sense, we believe that under certain circumstances they can be used.

The good news is that insofar as oil remains above US$22 per barrel, the Oil Stabilization Fund will continue to accumulate resources. Before 2006, the accumulation of resources in the FIEP was highly dependent on the oil price assumption in the budget and on actual prices exceeding this threshold. Since 2006, Pemex has paid a progressive tax (DSHFE) – up to 10% of the value of crude production – when the price of oil exceeds US$22 per barrel, which should allow for further accumulation in the FEIP even at today’s low oil prices. The FEIP also receives 40% of any excess revenues after a series of deductions take place such as covering for fuel subsidies and additional non-budgeted expenditures. In a repeat of the experience of last year when the first M$28 billion of the funds raised by the DHSFE were diverted to fiscal spending, in 2009 the amount should reach M$40.7 billion, thus reducing the potential accumulation of resources in the FEIP. Importantly, however, Congress approved as part of the stimulus package of last October an increase of 73% in the legal limits of the stabilization funds, which in the case of the FEIP stood at M$56.2 billion at end-2008.

While the slump in growth is likely to hurt tax receipts and thus require tapping the stabilization funds, the combination of the oil hedge and a weaker peso should lead to a sizeable oil revenue windfall when the receipts of the put options are received on December 1, 2009. The fiscal budget assumes an average exchange rate of 11.7 over the course of 2009; thus, if current peso weakness persists it will provide a major boost for the fiscal coffers. In turn, this could lead to a welcome replenishment, even if only partial, of the stabilization funds by year-end.

Bottom Line

Ultimately, Mexico would benefit it were to reduce its dependency on oil as its single-largest revenue source. Mexico’s fiscal oil addiction conspires to make fiscal policy even more pro-cyclical as oil revenue shortfalls loom precisely when non-oil sources of revenue come under the greatest stress. The current stabilization funds are too modest in scope and have not prevented Mexico’s fiscal stimulus from growing in recent years precisely when greater savings would have been in order. Nonetheless, while Mexico’s current oil policy mix is no substitution for the task of strengthening non-oil revenues, the authorities should have little difficulty resolving any fiscal shortfalls in 2010, even if oil prices remain unchanged from current levels.

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United States
Review and Preview
February 24, 2009

By Ted Wieseman | New York

Treasuries ultimately posted decent long-end-led gains over the past holiday-shortened week, as the market was buffeted back and forth day to day on the one side by increasing pessimism about the US and global economic outlooks and accompanying severe correction in stocks (and other risk markets to varying degrees) and on the other by heavy supply, both an unprecedented flood of Treasury coupon supply announced for the coming week and major corporate and agency issuance over the past week.  Investors remained disappointed with the efforts of the new Administration to address the turmoil as it wrapped up its first month in office.  The latest effort to loosen loan-to-value standards to refinance agency mortgages and an effort to lower mortgage payments for homeowners in danger of default because of extremely high payment to income ratios promised some hope.  The likely impact on consumer incomes of the loosened refinancing standards is minor, but mitigating foreclosures is particularly important at this point, as the ongoing correction in the homebuilding industry to a significant extent reflects the inability of new construction to compete with the flood of fire-sale-priced foreclosed homes hitting the market, and if the 3-4 million homeowners the plan claims it could aid proves accurate, it could have a big impact.  Like previous plans, though, important details still remain to be worked out.  Meanwhile, there’s only a week left in February and there’s still no TALF, though details do appear to be getting worked through, hopefully for a start before too long.  But as bank stocks slump to generational lows, there have been no indications that any imminent further announcements about the vague plan for a private sector-led bad bank are likely, and the fiscal stimulus bill that won’t have the bulk of its impact until 2010 isn’t looking any more promising a week later.  Economic data at this point are largely being ignored.  Investors realize that the economy is in a severe, deflationary recession, so economic data that confirm that outlook are as expected and those that don’t are considered temporary outliers.  Confirming data over the past week included another month of extraordinary weakness in housing starts and industrial production along with weak readings for jobless claims and the early regional manufacturing surveys that led us on a preliminary basis to forecast a 625,000 drop in February non-farm payrolls and a renewed decline in the ISM to 34.0.  Data going against the deflationary depression outlook included some mild upside in core inflation in both the CPI and PPI reports.  There is certainly no fear at all about inflation risks in an economy that is seeing the slump in nominal demand and operating rates that we are currently experiencing. 

For the week, benchmark Treasury yields fell 1-12bp and the curve flattened, with the 2-year yield down 1bp to 0.94%, 3-year 6bp to 1.30%, 5-year 6bp to 1.80%, 10-year 11bp to 2.77% and 30-year 12bp to 3.56%.  Despite upside in CPI and PPI inflation and oil prices (though other commodity prices were weaker), TIPS lagged, with the 5-year yield up 3bp to 1.10%, 10-year down 2bp to 1.62% and 20-year down 10bp to 2.21%.  Mortgages managed only small gains on the week, leaving MBS yields not far from the highs for year hit earlier in the month and above where they were when the Fed began its heavy MBS purchases at the beginning of January. 

A big sell-off in stocks led a bad overall week for risk markets, with commercial real estate also doing particularly badly.  The S&P 500 fell another 7% on the week to bring the year-to-date loss to 15%.  Financials, as usual, led the weakness, with the BKX banks stock index plunging another 17% to its lowest level since 1992 after another 51% drop so far this year on top of last year’s 50% drop.  Credit was softer on the week but continued to hold up much better than equities even amid heavy issuance.  In late trading Friday, the investment grade CDX index was 13bp wider on the week at 212bp.  The S&P 500 is now only 2% above the low hit November 20, while the IG CDX index remains well below its wide of 280bp hit then.  High yield credit has performed a lot worse than IG in recent months but did relatively well in the latest week.  The HY CDX index was only 13bp wider on the week at 1,487bp through Thursday, though the index was trading down about another half point Friday.  The wide close for this index was 1,546bp on November 21, and it has weakened substantially since improving off that level to end 2008 at 1,146bp.  After some brief stabilization a couple of weeks ago, the leveraged loan LCDX index continued falling, widening 211bp on the week through midday Friday to 2,229bp, not far from the all-time wide of 2,327bp hit December 15 after a nearly 800bp widening just so far this month.  Meanwhile, the commercial mortgage CMBX market was a complete disaster zone.  A 54bp widening on the week by the AAA index to 700bp was a relatively strong showing compared to the lower-rated indices, holding a way below the all-time wide of 848bp hit November 20.  Every other index, however, moved to a series of record wides through the week, with the junior AAA widening 189bp to 2,044bp, AA 336bp to 3,049bp, A 437bp to 3,670bp, BBB 823bp to 5,019bp, BBB- 807bp to 5,206bp and BB 848bp to 6,816bp.  It was nowhere near this extreme, but the subprime ABX market also saw significant further weakness as bad bank hopes faded, with the AAA index falling nearly 3 points to 32.33, a low since early December.

Economic data released the past week showed continued extraordinary weakness in the housing market and the industrial sector along with some upside, though almost certainly only temporary, in core inflation.  Housing starts dropped 16.5% in January to a record-low 460,000, having now collapsed 39% in just the past three months.  Single-family starts fell another 12% to another record-low of 347,000, such a low enough level of new homebuilding that if the flood of foreclosed homes hitting the market could be slowed, inventories of unsold homes could be worked down steadily.  More striking recently has been plunging multi-family starts, which fell 28% in January to 119,000, matching an all-time low after an 85% annualized drop over the past six months.  The breakdown in the securitization market for commercial real estate loans and resulting severe tightening in credit availability has likely played a substantial role in the slump in multi-family building.  Industrial production plunged 1.8% in January even with a significant weather- related boost from utility output (+2.7%).  The key manufacturing gauge plummeted another 2.5% in January for a 21% annualized decline over the past six months, one of the worst-ever drops over such a period.  Weakness in manufacturing production was broadly based, but a 23% collapse in motor vehicle and parts production was a particularly big contributor as vehicle assemblies fell to an all-time low.  The recent collapse in high-tech production also continued.  The manufacturing capacity utilization rate tumbled 1.7pp to 68.0% – an all-time record low.  There is huge slack building up in the industrial sector that will badly constrain pricing power going forward.

On the inflation front, the consumer price index rose 0.3% in January, the first increase in six months, for no change on a year-on-year basis.  A partial rebound in gasoline prices (+6.0%) after a collapse over the prior few months led a modest 1.7% uptick in energy prices that boosted headline inflation.  Meanwhile, the core CPI gained 0.2%, the highest reading since July but still resulting in the year-on-year pace falling another tenth to +1.7%.  Minor upside relative to recent trends in a number of components, including owners’ equivalent rent (+0.3%), clothing (+0.3%), new motor vehicles (0.3%) and medical care (+0.4%), caused the slight acceleration in the core in January after it had risen at only a 0.5% annualized pace over the prior four months.  We continue to look for core CPI inflation to fall to 1% by year-end.  The producer price index rose 0.8% in January for a 1.0% decline from a year ago, boosted by a rebound in energy prices (+3.7%) as wholesale gasoline prices recovered.  Meanwhile, the core PPI gained an elevated 0.4% (+4.2%Y).  A 0.5% rise in capital equipment prices accounted for much of the upside in the core, with notable gains in telecom equipment, aircraft, heavy trucks and ships.  Some consumer categories also showed sizable upside, especially drugs, though inadequate seasonal adjustment was probably to blame.  Early-stage readings pointed to continued deflation in cost pressures.  The core intermediate index fell 1.1% after a record 2.9% drop in December, while core crude prices were flat for a -28%Y plunge.

Weakness in computer output in the IP report pointed to weaker business investment in 1Q, and we cut our forecast for business investment in equipment and software to -17.5%.  Note that this would be significantly weaker if not for a sharp likely post-strike rebound in aircraft investment.  CPI inflation, however, was lower than we expected, leading us to boost our estimate of January real consumer spending a bit, raising our 1Q consumption forecast to -1.2% from -2.0%.  Netting these impacts, we boosted our 1Q GDP forecast to -5.0% from -5.2% after an expected downward 4Q revision to -5.4%.

Looking ahead to the key early round of February economic data to be released in a couple of weeks, data released over the past week pointed to another month of terrible numbers.  Continuing jobless claims surged to another record-high in the latest report and the four-week average of initial claims during the survey period for the employment report surged to another new high since 1982.  We look for February non-farm payrolls to plunge 625,000, which would be the biggest drop yet in this recession, and for the unemployment rate to rise another half point to 8.0%.  Meanwhile, the early regional manufacturing surveys remained dreadful, indicating that the recent collapse in the factory sector extended into February.  On an ISM-comparable weighted average basis, the Philly Fed survey fell from 36.1 to 33.8, the worst month in the 40-year history of the survey, while the Empire State was little changed at a depressed 40.4.  After posting a modest rebound last month, our preliminary forecast (which we will update as the rest of the regional reports are released in the coming week) is for the national ISM to resume sinking, falling to 34.0 from 35.6. 

Main focus in the Treasury market in the coming week will be on taking down an unprecedented US$94 billion in coupon supply, with a US$40 billion 2-year auction Tuesday, US$32 billion 5-year auction Wednesday and US$22 billion 7-year auction Thursday.  Ahead of the supply, Fed Chairman Bernanke will give his semi-annual monetary policy testimony to the Senate on Tuesday and then appear again before the House on Wednesday.  It seems unlikely that much news will come out of the testimony following Chairman Bernanke’s speech and the release of the minutes from the January FOMC meeting the past week.  Economic data releases due out include consumer confidence Tuesday, existing home sales Wednesday, durable goods and new home sales Thursday, and revised GDP Friday:

* We expect the Conference Board’s measure of consumer confidence to fall to 35.0 in February.  The Conference Board index is already well into record-low territory, while the University of Michigan gauge is still hovering a little above its 1980 lows.  This divergence probably reflects the fact that the former places a greater weighting on labor market conditions.  With the job market continuing to show significant deterioration, we look for another downtick in the Conference Board survey.

* We forecast January existing home sales of 4.80 million units annualized.  In December, resales posted a decent bounce off the November low.  Based on the latest gain in the pending home sales index, we look for activity to edge up another 1.3% in January, with support coming from low mortgage rates and a further rise in foreclosure sales.

* We look for a 4.0% plunge in January durable goods orders.  The ISM orders gauge posted a modest rebound from an extremely depressed level in January.  This points to a continued decline in core order activity, albeit not at as rapid a pace as in December. Moreover, a plunge in motor vehicle production – as many automakers extended their normal holiday shutdowns well into January – points to a very sharp decline in bookings for cars and trucks.  Finally, company data suggest that the volatile aircraft category should be little changed this month.

* We forecast January new home sales of 330,000 units annualized.  Sales of newly built residences have plummeted in recent months – including a 15% drop in December.  The homebuilder sentiment survey pointed to continued softness in January.  So, we don’t expect to see any noticeable improvement despite the drop in mortgage rates.

* We expect 4Q GDP growth to be revised down to -5.4%.  Several data reports that have been released since the initial Commerce Department estimate of -3.8% point to a significant downward revision.  In particular, lower inventories should subtract nearly a full percentage point.  Also, exports, construction and consumption are likely to be marked lower.

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Mexico
The Policy Dilemma
February 24, 2009

By Gray Newman | New York

When Banco de Mexico cut policy rates by 25bp on Friday, February 20, it seemed unlikely that it thought it would unleash a new debate over the direction of policy, and indeed the direction of Mexico’s economy. After all, the central bank had only begun to cut rates with a 50bp move in January and had warned then that future moves would be data-dependent. The authorities had made no promise that the future policy rate cuts would be of the same magnitude.

Nonetheless, by slowing the pace of monetary easing, the central bank may have unwittingly prompted the very “financial turbulence” turmoil that it was trying to prevent. Many market participants are concerned that Banco de Mexico has misunderstood the link between currency moves and interest rates. Many believe that smaller policy rate cuts put the currency under even greater pressure and hence the move by Banco de Mexico on February 20 to slow the pace of rate cuts may actually provoke a weaker currency, which in turn may further jeopardize the central bank’s efforts to cut interest rates. Indeed, the intra-day peso trading on February 20 appears to support such a contention: the Mexican peso weakened from 14.78 to 14.99 following the decision. The peso recovered, to 14.82, only after Banco de Mexico once again intervened in the currency markets with discretionary dollar sales.

The disconnect between the debate at the central bank and the discussion within the market is cause for concern. We don’t believe that it is the greatest policy dilemma facing Mexico, but it could complicate the outlook for Mexico’s financial markets in the months to come.

Two Ships Passing in the Dark

What, you may ask, has prompted the disconnect? On the one hand, Banco de Mexico remains as focused on inflation as ever. The central bank recognizes that it cannot guarantee where the Mexican peso will trade or how deeply the economy will contract in 2009. Nor does the central bank interpret its mandate of preserving the ‘purchasing power’ of the peso (price stability) slavishly: it has shown little interest in engineering a hard landing in an attempt to offset an adjustment in relative prices from a weakened peso. Nonetheless, the central bank does believe that it provides some anchor to economic agents by assuring that it will strive to ensure that inflation trends towards its 3% target.

At the beginning of the year, Banco de Mexico appeared to believe that the bulk of the currency’s weakness was behind it. The shocks and near-sudden stops of mid-September, October and November had triggered a derivatives sell-off in Mexico and produced some tension within the domestic mutual fund industry. While it remains difficult to handicap the duration or the magnitude of the global downturn, the central bank appeared to believe that Mexico’s peso had already taken the brunt of the hit early on, given the strong link between US and Mexican economic activity. Another negative surprise for Mexico was always possible, but it seemed plausible that Mexico – at least relative to other economies – had seen the worst.

The potential for pass-through from the currency to domestic inflation has re-emerged as a source of debate both within Banco de Mexico and at other central banks, particularly in emerging economies. At the beginning of the year, however, Banco de Mexico appeared to have concluded that the peso’s weakness was likely to be largely offset by lower import prices from the drop in commodity prices.

Since January, Banco de Mexico’s view on pass-through has faced two challenges. First, the peso’s further weakness has raised concerns that the equilibrium achieved between currency weakness (putting upward pressure on prices) and lower imported dollar prices (putting downward pressure on prices) may not hold. Second, some imported prices in dollar terms have begun to rise (such as wheat, due to droughts in Argentina and Brazil). Faced with these risks, and particularly through the impact on processed foods, Banco de Mexico decided to warn in its February 20 communiqué that although the risks to growth seemed greater than the risks to inflation and although it believed that inflation had peaked in December, nonetheless it was concerned that peso weakness (“financial turbulence” in its words) could begin to jeopardize the expected continued improvement in inflation.

Meanwhile, many market participants feel that larger interest rate cuts are currency-positive and smaller cuts are currency-negative. The rationale is that larger rate cuts should help to temper the magnitude of the downturn and reduce the risks for both fiscal policy and broader policymaking from a severe downturn in economic activity. The example of Chile is often cited. Chile’s move to surprise the markets with a larger-than-expected 250bp cut on February 12 actually helped to drive the currency stronger. Carry, the old driver of near-term currency movement, appears to have lost much of its luster, given the volatile swings seen in currency markets of late. Instead, market participants are looking for signs that the authorities recognize that the risks associated with a downturn in economic activity are significantly greater than those associated with inflation.

We question just how much monetary policy will be able to accomplish in Mexico, or in Brazil, or in much of the emerging markets space for that matter. Our fear is that the under-intermediated nature of most of the economies in the region and throughout emerging markets will limit the traction gained by monetary policy. And we are concerned that the impact of monetary policy is asymmetric: hiking interest rates to cool an overheated economy is likely to be much more effective than cutting interest rates when demand has weakened and the overhang of oversupply is weighing on activity. Nonetheless, we fear that Banco de Mexico’s actions and communications have contributed to the very market turbulence that the central bank hopes to avoid.

A Currency Target?

We do not believe that Banco de Mexico or the finance ministry has a particular exchange rate target. Nor do we believe that what triggered the decision on February 4 to permit discretionary intervention in the currency markets was that the peso began to trade at the edge of some ‘tolerance range’. We accept the view from the central bank and the finance ministry that the new form of currency intervention was designed to reintroduce a more normal distribution of possible peso outcomes after it had been skewed by some market participants trying to game the results.

But Banco de Mexico’s decision in February to reduce the pace of rate cuts so soon after starting with a 50bp rate cut in January raises the specter that a particular currency level is being targeted. Given Banco de Mexico’s cautious stance on inflation, we would have preferred (and indeed were forecasting) that the central bank would begin its rate-cutting cycle with 25bp in January and continue with a 25bp pace during 2009. Instead, Banco de Mexico began with a 50bp cut. Once it started down the path with a particular pace, it should adjust the pace with great care. To reduce the pace so quickly raises serious questions about how much the currency is driving monetary policy. In the four weeks since the January 16 50bp cut, Banco de Mexico had more hard evidence that the economy was in a sharp decline. January auto production fell by 51%, December industrial output was off 6.7%, producing a 10.7% sequential decline for 4Q, and job losses by the end of the year had exceeded one million. On the other hand, the risk of pass-through from the currency was just that – a risk, although the processed foods data are of some concern. Indeed, the currency’s weakness since mid-January has been modest in light of the sharp downturns we have seen in financial markets.

Banco de Mexico further complicated its position by suggesting in the communiqué that the central bank would be willing to resume its previous pace of 50bp cuts once “financial markets” presented greater stability. Although the central bank added that it wanted to see the stability translate into “reduced” risks on the inflation front, it was easy to see market participants read the communiqué as a sign that the currency’s level is now directly driving monetary policy.

The Greatest Dilemma

However, Mexico’s greatest dilemma is to explain not only how Mexico will fare during the current downturn – a downturn whose duration and magnitude are still unknown – but also what the Mexican model represents. Much attention has been placed on Mexico’s fiscal needs in 2010 once the oil hedge is terminated (see Mexico: No Oil, No Problem). Luis Arcentales rightly argues that the size of the gap and the options available to fill it are not that daunting. Moreover, we would not be surprised to see Mexico announce a new version of the blindaje or ‘armor-plating’ with a large increase in the quota with the IMF to provide additional financing that Mexico could draw on if needed to complement funding from the Federal Reserve, the World Bank and other IFIs. We believe that these announcements might help to bolster the Mexican peso in the near term.

Ultimately, however, Mexico needs to address whether it has implemented the structural reforms necessary to produce strong enough growth to erase concerns over the sustainability of the current policy mix. It has become commonplace to hear the comparison drawn between Mexico’s growth record during the past five years with that of Brazil. We regularly hear that Brazil knew how to take advantage of the emergence of China and saw its growth rate soar during the ‘era of abundance’; Mexico’s growth record remained modest. It is an article of faith among emerging market participants that China will return as a powerhouse – perhaps later this year, perhaps not for another one, two or three years, but it will return. When China does return, it is argued, Brazil appears to be ready to benefit as well. In contrast, Mexico’s role remains much less well-defined. Will its status as a low-cost manufacturing provider for the US survive the re-emergence of China, or is Mexico’s primary role a service provider based on tourism and baby boomers in search of a retirement alternative? What will it take to boost Mexico’s growth from the modest record achieved during the past five years – the five years of the strongest consecutive global growth seen in more than four decades?

Bottom Line

It is easy to blame the latest actions of Mexico’s central bank for contributing to the peso’s recent currency turmoil. By slowing the pace of rate cuts and suggesting that the currency’s recent weakness in part drove the decision, the authorities may invite those who are willing to bet that the currency weakens even further. But that criticism would be unfair and deficient, in our view.

Mexico faces a much more serious structural challenge – to convince investors that it has adopted the policies necessary for long-term, strong, sustainable growth. No one is demanding that Mexico grow in 2009 in the midst of a severe global downturn, but many wonder whether Mexico’s policy mix – from investment in education and healthcare, to its competitive policies designed to foster entrepreneurial spirit – is sufficient. On that count, we remain concerned.

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