It has been a difficult period for all emerging markets (EMs). Just today, Moody’s downgraded Mexico’s sovereign debt outlook from “Stable” to “Negative”. Since 2014, due to the falling oil prices, international risk aversion has risen considerably, affecting first EMs. It coincides with the Chinese economy slowing down and the divergent monetary policies of the US, UK, Japan and the European Union.
Emerging markets have suffered from falling oil and commodities prices, decreasing trade flows and by capital outflows, which have created currency depreciation and accelerating inflation. Oil prices have gone from more than $100/b in mid-2014 to the current $40/b, albeit a $10/b rebound over the last weeks. Taking June 2014 as the month of reference, the IMF all-commodity price index has fallen 45.8%, while emerging market currencies in dollar terms have fallen 73.4% as of February 2016.
This risk aversion can be seen in the portfolio capital flows to emerging markets, which now have become negative. Last year, $750 billion in assets flowed out of emerging markets—almost $700 were from China alone.
Source: LATAM PM with data from IIF
In relative terms, Mexico has been resilient. The peso does have depreciated by 34% since June 2014, but that has not translated into second-round inflation. On the contrary, the 2.13% annual inflation of 2015 was one of the lowest for the country’s recent history.
Mexico has not seen significant capital outflows either. Non-resident holdings of peso-denominated government securities (36% of the total) have remained relatively constant at MXN$2.27 trillion.
So far, the drivers of the Mexican economy are private consumption—up 3.5% YoY— and the services sector—up 3.7% YoY. Both have benefited from low inflation levels and an expanding formal sector, which have increased the real purchasing power of the middle class. These trends have been reinforced by remittances, which reached $24.8 billion in 2015—up 4.8% YoY.
Source: LATAM PM with data from INEGI (Mexico’s stats agency)
This does not mean that the country is exempt of risks. The pass-through to inflation coming from the peso depreciation could manifest this year. The core component of inflation rose to 2.89% YoY in mid-March.
Additionally, oil prices have put pressure to Pemex, which last year reported a net loss of $30 billion. Despite the recent $10 rally in the price of oil, the state-owned behemoth will face a challenging year. It cut CAPEX again in February, which compromises production in the medium to long terms; and announced a downward adjustment of 100,000 barrels a day in its 2016 production. Debt is also becoming an issue, as it increased 30% last year and for 2016.
Mexican fiscal revenue still depends in 20% from Pemex. But this year, instead of transferring significant resources to the Mexican government, the oil company is likely to be capitalized. Pemex needs more than $20 billion in financing. The oil company will have to tap international capital markets in a context in which its credit risk premium jumped from 250bps at the end of 2015 to 350bps this March (it reached 450 in February).
Another major risk for the Mexico is that the US economy does not take off. Mexico’s manufacturing production, the bulk of the economy, is strongly correlated to US economic cycle. After having reached an annual growth of 4% in 4Q14, US manufacturing production currently grows at 1.5%. Such a rate is not sufficient for Mexican exports to grow; instead, these are currently contracting at a 0.5% YoY pace.
The current risks that EMs are currently facing are the reason why Mexican officials have highlighted the importance of differentiating Mexico from its EM peers through structural reforms and fiscal and monetary policy. On February 17, Banxico (Mexico’s central bank) and the Ministry of Finance announced a 50bps hike in the interest rate and a federal budget cut of 0.7% of GDP, which prolonged the fiscal consolidation initiated in 2015. However, given that other emerging economies are implementing similar policy, recent structural reforms differentiate Mexico at the moment. Thus, an accurate and swift implementation of these reforms becomes crucial to boost growth and attract foreign capital.
LATAM PM’s Take: Mexico remains resilient given the huge attention that government officials have given to safeguard the macroeconomic framework; however, the economy is still vulnerable to external shocks.
We consider that the main risk is a significant outflow of foreign holdings of MXN-denominated government debt. Recent volatility and the Fed’s tightening cycle initiated last December add pressure to a potential outflow and should continue to be a major concern for policy makers. The peso’s liquidity and the volume of short positions and carry trades threaten to affect the real economy through a depreciating exchange rate and public USD-denominated debt. This is the reason why investors should continue to follow closely the actions of the government regarding the implementation of the reforms, in addition to more fiscal and monetary policy measures, which are not expected for the time being.
Analyst: Fernando Posadas
LATAM PM is an independent consultant firm based in New York and Mexico City.
LATAM PM provides consultancy services for firms and governments.
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