Dealing with Devaluation
January 20, 2010
By Giuliana Pardelli | Sao Paulo & Daniel Volberg | New York
When Venezuela devalued the Bolivar Fuerte just a little over a week ago, we suspect that it may have been yet another step in a slow dance of continued economic deterioration. The authorities devalued the currency from 2.15 bolivars per dollar to a new dual exchange rate scheme where essential goods, such as certain food and medicine, would be traded at 2.6 bolivars per dollar and non-essential goods would trade at 4.3 bolivars per dollar. The move to sharply devalue the currency, despite last year's continued pledges by the authorities to maintain the peg, is likely to have significant implications on fiscal, inflation and economic growth fronts. While a devaluation can often boost domestic activity, the first details from Venezuela's devaluation leave us concerned that it is unlikely to stop the steady deterioration in the business climate that we have seen in recent years.
Impact on Activity
A devaluation can often boost economic activity as it supports exports, while channeling resources to domestic industry which may gain the upper hand over now much more expensive imports. On the flipside, when the move is first announced, it may weaken confidence of local agents who fear that the devaluation from a fixed exchange rate regime represents a broken promise and may lead to concerns that additional policy moves could be announced, creating even greater uncertainty. In the case of Venezuela, we expect that the benefits normally associated with a devaluation - namely the realignment of relative prices and incentives for domestic producers - are likely to be limited, and hence we doubt that Venezuela's manufacturing base will see an important jump start in 2010 from the measures announced at the beginning of the year.
Our cautious stance on the Venezuelan economy is based on three reasons:
First, we suspect that current exporters are unlikely to get a significant boost from the devaluation. Venezuela's export basket is dominated by oil, whose production is unlikely to be helped significantly by the devaluation. According to the latest available data, Venezuela's exports were 94% oil in 2009. There is little currently being exported by Venezuelan manufacturers or from the agricultural sector.
Second, we suspect that any potential exporters may be deterred by the adverse business climate. In theory, local industry could use the devaluation to invest in building capacity for export-oriented production. But given the track record of the authorities - including regulatory pressure and expropriations - the risks associated with rebuilding industrial capacity may outweigh the short-run benefits of a more competitive exchange rate. It is no coincidence that Venezuela ranked 177th out of 183 countries in the World Bank's latest Doing Business survey that measured the hospitability of a country's business climate during 2009. Thus, we suspect that industry in Venezuela may not benefit from the weaker exchange rate, breaking one of the channels that often helps to boost activity in the aftermath of a devaluation.
Finally, we suspect that the negative impact of the devaluation on investment may prove to be a drag on activity. While we suspect that the devaluation may not bring industrial exports back to Venezuela, it is reasonable to expect that imports will be hurt. While diminishing imports can represent a positive contribution to growth as local production picks up the slack, we are most concerned by the potential negative impact on the imports of capital goods, a crucial component for domestic investment. Indeed, we suspect that to the extent that the devaluation makes capital and intermediate goods more expensive, it may harm existing industry further.
Could there be an alternative channel whereby the devaluation helps to strengthen activity in Venezuela? For that, we need to examine the fiscal impact of the devaluation.
Fiscal Impact
The devaluation significantly improves Venezuela's near-term fiscal outlook. The biggest boost to the fiscal accounts comes on the back of the higher local currency value of the state oil company's oil exports. After all, the authorities have dubbed the devalued exchange rate ‘the oil dollar' because state oil company PDVSA will receive 4.3 bolivars for every dollar sold to the central bank. On top of near doubling the local currency value of the oil revenues, an additional benefit to the state oil company of the two-tiered exchange rate regime is that imports of inputs are set at the new 2.6 exchange rate. And the benefits to the state oil company should also translate into an overall fiscal boost, given our estimate that 55% of all fiscal revenues are tied to oil. Indeed, all else constant, we estimate that the devaluation would reduce Venezuela's fiscal deficit to -2% of GDP from -7% of GDP. However, we suspect that all else will not be constant - we suspect the authorities may boost fiscal spending ahead of September's parliamentary elections.
We are revising our fiscal balance forecasts, respectively, for 2010 and 2011 to -3.2% of GDP (from -7.2% previously) and -2.0% (from -5.9% previously). While the authorities may boost spending ahead of parliamentary elections, we still expect the devaluation to significantly improve Venezuela's overall fiscal outlook, at least in the short run. The boost to fiscal spending could have a positive impact on economic growth, either through public works projects or higher public sector wages.
However, we suspect that, while positive, the effects of improved fiscal position on economic activity will remain limited. Indeed, if history is any guide, the relationship between fiscal spending and economic activity may not be robust. In the past few years, we have observed periods of joint fiscal and economic expansion, fiscal expansion without growth and growth without fiscal expansion. The lack of a clear historical relationship does not mean that it does not exist, but it does make us less comfortable in our assessment of the likely impact of any fiscal expansion. As for public works - that impact is more uncertain, given the issues with efficiency of execution of any planned projects.
Financing Needs
While the fiscal improvement may have limited growth effects, we expect it to help with Venezuela's financing needs. Markets have penalized Venezuela during the global recession, but we suspect that Venezuela's debt service obligations will remain manageable during 2010 and 2011. We estimate that Venezuela should have US$6.2 billion in financing needs this year and US$4.7 billion in 2011. To finance that gap, the authorities can rely on international debt markets or internal sources, such as the US$35 billion in international reserves or US$25.1 billion in other assets. To the extent that the fiscal improvement translates into stronger capacity for debt service, we suspect that the near-term effect of the devaluation should be positive for the markets. Indeed, our colleagues in EM Strategy believe that the dollar-denominated debt in the short end of the curve will see the great part of the benefits of the higher fiscal cushion and manageable financing needs (see "Venezuela: The Rally and The Risks", EM Strategy Update, January 12, 2010).
Inflation Impact
The short-term impact of the devaluation may be the improved fiscal position and strengthened position to service debt, but in the longer term, the key challenge for Venezuela in the aftermath of the devaluation is likely to be inflation. Despite the announcement by the authorities that they will expropriate businesses found raising prices in the aftermath of the devaluation, we suspect that inflation pressures may rise in the months ahead.
We are most concerned that Venezuela may see a significant increase in imported inflation. Venezuela is highly reliant on imports for a range of goods, from food to cars. The country's largely underdeveloped agricultural and manufacturing sectors historically have suffered a paucity of investment, as the majority of internal and external capital was focused on developing the energy industry. With such a high reliance on imports, the devaluation of the currency should, over time, have a significant impact on the price of consumer goods in the domestic market.
We expect the devaluation to raise inflation by nearly 10pp during the course of 2010. To fully assess the inflation impact of the devaluation, we have to consider the details of the multiple exchange rate regime in Venezuela. We estimate that near 56% of Venezuela's imports in late 2009 were made at the parallel exchange rate. For the goods that continue to trade at the parallel exchange rate, the devaluation has no inflationary impact. However, the goods that were imported at the official 2.15 exchange rate - roughly 44% of all imports - will now be imported at the 2.6 rate for essential items or the 4.3 rate for non-essential goods. For non-essential items, the great majority of items that are traded at the official rate, the devaluation means that the local currency price of these goods should double. Of course, the pass-through is usually less than 100%, but anecdotal evidence from local businesses suggests that in Venezuela the pass-through could reach as high as 50%.
To better summarize the inflation impact of the devaluation, we built an effective exchange rate using import shares as weights for the parallel exchange rate and the official exchange rates. We find that the devaluation and the continued depreciation of the parallel exchange rate mean that the effective exchange rate has weakened by near 20%. With 50% pass-through from exchange rate to inflation, we expect this move to add nearly 10pp to headline inflation in 2010. We are now forecasting inflation to reach 45.0% in 2010 versus 38.5% previously.
Of course, our initial work on the inflationary impact is fraught with difficulties. There is significant risk that many goods may continue to be imported at the parallel market rate (currently above 6.0). There has been talk that the authorities will reduce the amount of dollars they make available at the official exchange rate - perhaps as much as a 40% reduction in dollar sales according to some local news accounts - potentially pushing some imports from the official rate of 4.3 into the parallel market with clear inflationary consequences.
Bottom Line
There is little doubt that Venezuela's fiscal accounts will be a major beneficiary of the devaluation announced at the beginning of the year. While increased spending ahead of key elections scheduled for September may erode some of the initial fiscal improvement from the devaluation, the new exchange rate should provide a much-needed boost to the public sector. Whether this has any positive impact on real economic activity will turn in part on the magnitude of the inflationary increase. Our greatest concern is that, aside from the boost to nominal government spending, the other traditional channels that allow a devaluation to improve economic activity are largely absent. With a tiny non-oil export sector and an adverse business climate, we doubt that the new exchange rate regime will do much to boost exports or spur investment in domestic industries. Without a revival of private investment and with the specter of still higher inflation, we think the devaluation is unlikely to do much to reverse Venezuela's path of continued macro deterioration.
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The Industrial Fiesta
January 20, 2010
By Luis Arcentales, CFA | New York
Mexico's rebound in economic activity, which got underway during 3Q, gained ground as the year closed. Some of the factors that boosted growth in 4Q are likely to continue providing support for a stronger-than-expected recovery during 2010. That, in turn, is likely to produce further upward revisions to 2010 GDP and provide for a positive boost toward investor sentiment.
This past week we saw numerous reports indicating that Mexico's industrial recovery continued to gain steam as the year ended. November industrial production declined just 1.0% from a year earlier - handily exceeding consensus estimated for a 3.8% drop. Meanwhile, industrial exports have been on a steady uptrend since June and December's auto production approached pre-crisis levels.
Given industry's strong performance in late 2009 and good prospects from early 2010, consensus expectations for 2010 industrial growth seem too low, in our view. The market is looking for 3.6% growth in industry during 2010, according to the latest survey by Banco de Mexico. Though December industrial production figures won't be available until February 11, even in the unlikely case that output were to stall in December, the carryover into 2010 would approach 2.5pp. Accordingly, the consensus' current growth view - well below our expectations for industrial growth to top 5% in 2010 - would imply nearly no sequential growth over the course of 2010, a view that seems at odds with the growth prospects for the US and global economies. The consensus, moreover, also seems to ignore the constructive 1Q outlook from US manufacturing, based on automakers' assembly schedules and the supportive inventory backdrop.
An important feature of the ongoing industrial revival is that it has coincided with employment gains in the sector. The current episode stands in sharp contrast to the recovery that followed the 2001 recession, which was largely jobless. With today's industrial rebound already translating into job creation, albeit modest, we expect this externally driven upturn to translate into a broadening of the recovery into domestic-focused sectors over the course of 2010.
So Far, So Good
Incoming data from Mexico's industrial sector indicate that production has been on a steady recovery, echoing the pick-up in US manufacturing since mid-year. After a wrenching contraction since late 2008, activity finally bottomed in June. The most recent November production report extended industry's run of sequential gains to three consecutive months during which output expanded at a 7.1% annualized pace - the strongest gain over such period since early 2007. Industrial exports, once seasonally adjusted, were almost a quarter higher in November than at their mid-year trough, with strength in shipments to both US and non-US partners. Not surprisingly, Mexico's captains of industry are turning increasingly constructive about the outlook for activity.
During this recovery phase, the automobile sector has staged a remarkable V-shaped rebound. After soaring at a sequential pace nearing 120% annualized in 3Q, our calculations suggest that light vehicle production accelerated to almost 180% annualized in 4Q09. Indeed, light vehicle production in the December quarter was just 9% below the historically high figure achieved during 3Q07, based on our calculations. Encouragingly, the auto sector's spectacular run is unlikely to be over just yet: thanks in part to the success of the cash-for-clunkers incentive program in the US, the automakers' assembly schedules for 1Q10 indicate further gains compared to late 2009 levels as production still has some catch-up to do (and vehicle inventory levels in the US are still somewhat supportive).
While the automotive sector - which represents around 15% of total manufacturing - has been the main driver of the turnaround, other industrial sectors have also participated in the recovery. Indeed, by November manufacturing activity stood 9% above its depressed mid-year trough, with the auto sector contributing with just over half of the total growth over that period. In terms of exports, once seasonally adjusted, the auto sector - which accounted for 17% of total exports in January-November - contributed with just over a third of the total increase in industrial shipments over that period.
And Mexico's industrial recovery has been accompanied by important share gains in the US imports market, where Mexico ships 81% of all its exports. Whether we look at all imports, manufactured goods and even excluding autos, by end-2009 Mexico's share of US imports stood at the highest level since early 2002 and just shy of the most recent peak from late 2001. Various factors may have contributed to this encouraging development, including the devaluation in the real exchange rate and the relatively large share of intermediate goods - around half of the total - in Mexico's export mix. The reasons behind this gain notwithstanding, the implication is important: if the late 2009 market share level is sustained, Mexico's 2010 exports would be around 3pp of GDP higher than if the country's market share had remained steady at late 2008 levels.
Bearish Industry Is So Last Year
Given industry's good rebound in late 2009 and decent prospects for early 2010, consensus expectations for industrial growth seem overly bearish, in our view. According to the central bank's December survey, Mexico watchers are looking for just 3.6% industrial growth - following an expected -8.1% plunge in 2009 - well below our expectation for industrial growth to top 5% this year. As the market recognizes the base effects and the relatively constructive outlook for industry this year, we expect that consensus will move closer to our forecast, which assumes a steady, moderately paced normalization from very depressed levels rather than an aggressive snapback.
First, the consensus seems to be underestimating the powerful base effect at play in 2010 following the sharp contraction in industry last year. Even in the unlikely case that industrial output were to stall in December (the report from INEGI will be released on February 11), the carryover would still approach 2.5pp for 2010, based on our calculations. Accordingly, the consensus' current 3.6% growth view would imply nearly no sequential growth over the course of 2010.
Second, the consensus view for a modest industrial expansion seems at odds with the prospects for moderate US and robust growth in emerging markets this year, as well as with the still-supportive inventory backdrop. Indeed, the most recent batch of US data seems supportive of further gains in manufacturing output in early 2010. December's ISM manufacturing index (55.9) posted its best reading since April 2006. A sharp jump in the orders index - which rose to a new five-year high - was responsible for much of the upside; however, increases in production, employment and vendor deliveries also contributed. Our US economists, Dave Greenlaw and Ted Wieseman, point out that the customers' inventory index reached another new all-time low (35.0), with 37% of respondents indicating that their customers' inventories were too low compared to only 7% who reported they were too high. The low inventory backdrop should help sustain the recent pick-up in new orders and production, according to our US team. And though December's manufacturing output report showed a pause after a strong run since July, the unusually cold weather that negatively impacted job growth probably had broadly negative temporary economic impacts, including on manufacturing activity to some extent, according to our US team. Last, automobile assembly plans point to a further ramp-up in output during 1Q, in line with the 4Q09 gain of about 40% annualized. Indeed, if Mexico's auto production in 1Q were to match the expected jump in US auto assemblies, it would lead to an increase in auto production of almost 70% compared to 1Q09, contributing 10pp to manufacturing growth and 6pp to total industrial production, according to our calculations.
Jobless Industrial Recovery? Not This Time
An important feature of the ongoing industrial revival is that it has coincided with employment gains in the sector. Today's episode stands in sharp contrast to the recovery that followed the recession in 2001, which was largely jobless. After shedding 17% of all jobs between December 2007 and July 2009, industry has hired workers in each month since August. By 4Q09, industry was adding workers at a 5.6% annualized sequential pace. And though the series are somewhat bumpy, industry began adding temporary workers in July, coinciding with the first pick-up in production following a slump that lasted nearly a year-and-a-half (temporary workers account for a just a tenth of all formal industrial jobs). By contrast, the upturn in industrial production from the 2001 recession was largely jobless. Between mid-2003 - when industry finally bottomed out - and the end of 2007, industrial output rose 16% and manufacturing exports rose over 60%; however, employment was stagnant.
The ongoing pick-up in industrial hiring has at least two important implications, in our view. First, it speaks of a more flexible industrial complex in Mexico, which adapted quickly to the deterioration in global demand and particularly US manufacturing conditions. In the current cycle - in contrast to the previous recession - employment adjusted aggressively and almost in tandem as demand dried up, as well as rebounding with the first signs of a pick-up in exports and output.
Second, today's manufacturing rebound is leading to immediate job creation with positive potential implications for income and consumer spending. It is important to note that job creation is picking up even as overall levels of industrial activity remain deeply depressed. Given our outlook for a moderately paced but steady pick-up in industry going forward - which should lead to further hiring - we expect this externally driven upturn to eventually start broadening into a recovery in domestic-focused sectors over the course of 2010. Indeed, December's formal employment report suggested that the recovery may be starting to broaden: after nearly a year of modest job losses, the economy began to hire permanent workers in areas beyond manufacturing and construction.
Bottom Line
Mexico's industrial rebound gained steam as the year ended and, unlike the last recession, the ongoing recovery hasn't been jobless. With industrial jobs rebounding in tandem with the first signs of a pick-up in exports and output - with positive implications for income and consumer spending - we expect this externally driven upturn to start to broaden into domestic-focused sectors over the course of 2010, translating into a stronger-than-expected recovery this year.
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