Mexico & Nafta - October 2006 (ISSN 1741-444X)
ECONOMY: Central bank starts to fret
The Banco de México indicated that it is considering cutting interest rates. It made this signal by taking out a standard line from its monthly report on monetary conditions in Mexico. The standard line, that was dropped, after the bank's monetary policy meeting on 22 September, was that the bank did not see any room for interest rate cuts in the immediate future. The markets were quick to see the implication of an interest-rate cut. Interest rates have been stuck at 7% for the past four months.
Most local economists say that the central bank has changed its view because of what is happening in the US economy. The US economy appears to be slowing quite sharply, though the US Federal Reserve Board is not panicking. On 20 September the Fed decided to hold interest rates at 5.25%. The Fed's next interest rate meeting is in late October, just before the mid-term elections in the US.
The Banco de México's announcement did not entirely surprise the financial markets even though the last move in Mexican inflation had been upwards. In August the headline inflation rate hit a seven-month high of 0.51%. This was almost twice the rate of July (0.27%). The August rate pushed up the headline inflation rate for the past 12 months to 3.5%. The Banco de México prefers to track what it calls core inflation. This strips out volatile food and energy prices. On this measure, inflation in Mexico in August fell from 0.28% in July to 0.12% in August.
Unlike the US Fed, the Banco de México has under its constitution to deliver only price stability. The US Fed has to promote employment (and therefore economic growth) as well. So the expectation in Mexico is that any pick up in inflation precludes the chance of a looser monetary policy. The central bank argues that what matters is the core inflation rate not the headline rate, which is often affected by the weather (producing shortages or gluts of particular foods) and international politics (which can inject a fear premium into energy prices).
What happens in the US economy is crucial to Mexico. Two of the most dynamic elements in Mexico's economy are non-oil exports and capital investment, principally by companies that want to increase their exports to the US. If the US economy tanks, non-oil (as well as oil) exports to the US will fall and investment in Mexico will diminish as well.
In 1990-91 when the US economy contracted by 1.3% over two quarters, US imports of goods and services fell by 5.4% over three quarters. In 2001, when the US economy contracted by 0.2% over three quarters, imports of goods and services fell by 8.2% over five.
The big worry for Mexican policymakers is that a US slowdown occurs simultaneously with a slide in the international oil price. This looks as though it will happen. The export price of Mexican oil fell sharply at the end of September. On 26 September the price of Mexican oil was US$48.12 a barrel. This was 26% lower than the record price, hit on 7 August, of US$64.85 a barrel. Oil export revenues in the first eight months of the year were up by 38%.
Even the 26 September price is still 32% higher than the price in the 2006 budget. The finance ministry is forecasting that the price in 2007 will be US$37.50. This looks conservative, given OPEC countries reluctance to see the price of their oil fall below US$50 a barrel.
Mexico's total exports are equivalent to about a third of the country's GDP. That is comparatively high for a Latin American economy. What keeps Mexican economic policymakers awake at night is the narrowness of Mexico's export markets: 85% of Mexico's exports go to the US. Only Malaysia and Canada are more susceptible to the effects of a slowdown in the US.
The current state of the US economy gives these same Mexican policymakers a nasty turn of déjí vu. In 2000, the US economy began to turn down in the second half of the year and was heading towards recession by the time President Vicente Fox took office on 1 December.
The effects of leads and lags meant, however, that President Ernesto Zedillo went out on an economic high, with growth of 7% in 2000 and record levels of employment. President Fox's first year produced a near recession in Mexico and a savage fall in employment: at least 700,000 people working in the formal economy lost their jobs in Fox's first two years.
Two things preserved the Mexican economy from a slump. The first was the strength of the oil price. The other was the mix of monetary and fiscal policies in the US which encouraged US consumers to keep spending.
The oil price produced revenues that provided a safety net that allowed the government to keep spending. Mexico's economy only started to generate jobs and grow again from 2003, when the US started to recover. Even so, it took until September 2005 for the employment situation to get back to where it was when President Fox took office. By June this year the government was claiming that it had created 740,000 new jobs since Fox took office. This time, Calderón will not have the prop of rising oil prices.
Furthermore, even Fox's comparatively feeble performance on job creation may be overstating the actual position. The official statistical agency, Inegi, reports that manufacturing employment is still nowhere near where it was when the Tequila Crisis hit in 1994. Its manufacturing employment index takes 1994 as 100: it currently stands at 85. In 2000, the index had recovered to 100. Maquiladoras, which export to the US, still employ almost 10% fewer people than they did when Fox came to power in 2000.
Just as in 2000, the Mexican economy appears to be hitting a cyclical peak this year. GDP growth in Mexico at the moment is running at just over 5%. If the US does suffer a hard economic landing in 2007, Mexico will be shaken by the bump.
It is President-elect Felipe Calderón Hinojosa's misfortune that the US authorities are unlikely to respond as they did in 2000 and 2001 by cutting US interest rates to their lowest levels for 45 years and launching recklessly expansive fiscal policies. That mix of US policies allowed the Banco de México to lower its rates as well without triggering capital flight.
The Mexican government, crucially, could keep its social programmes going because of the booming oil revenues. Ironically, Josefina Vázquez Mota, Calderón's campaign manager in the presidential elections, managed these programmes, when she ran the government's great spending ministry, the Secretaría de Desarrollo Social (Sedesol).
The problem for Calderón's economic policymakers is first, that the US is unlikely to fight a recession in the same way that it did in 2000 and second, that the oil price is heading lower. From 2000 to 2003, the US Federal Reserve, with its expansionary monetary policy, and the government through its fiscal policy, which verged on the irresponsible, produced a consumption boom in the US. The problem with this boom is that it sent the US economy out of kilter. Household savings are now negative and if property prices slide further, US financial markets could see withdrawals, depressing both consumption and the economic mood yet further.
To be fair the boom in the US appears to have transformed US corporate balance sheets. The macro-economic situation created by the boom is that two of the three elements in the US economy (households and the government) need to rebuild their balance sheets and reduce their indebtedness. When these two elements are hunkering down, it is hard to see the third element, the corporate sector, deciding that now is the appropriate time to increase its consumption and thus ramp up investments.
What all this will mean for Mexico is that there will be less demand for Mexican goods, and equally importantly, services. We analyse the economic effects of a slowdown in the US on Mexican immigration in the Nafta Report. Here, we will only note that while 500,000 Mexicans successfully join the US labour force every year, fewer than 150,000 find jobs in Mexico.
A significant change in immigration trends (either fewer migrants going to the US or more US migrants returning home) poses a major economic and social threat to the Calderón administration
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Calderón's economic plans |
| The president-elect, Felipe Calderón, emphasised in the election campaign that he wanted to cut income taxes. He even flirted with the idea of switching to a flat rate tax system. To do this he will need to introduce a fiscal reform, which in turn means that he will have to have a majority in congress to approve it.
It is not clear what level of income tax Calderón has in mind. The current rate of personal and corporate income tax is 29%; Calderón has not said publicly that he wants a 25% rate, but he did not deny this target when it was suggested to him in an interview. Local economic analysts reckon that Calderón will need around M$60bn (US$5.8bn) in extra revenues to deliver his campaign promises. This figure looks way too low, given the bleak outlook for oil prices. As oil prices slide, the government will have to choose between cutting spending and raising taxes. Mexican governments, historically, only cut spending when economic disaster strikes. If Calderón is to cut income taxes he will have to raise indirect taxes. President Vicente Fox failed to convince congress of the wisdom of doing this. Calderón is likely to face equally bitter dissent. It is worth noting that the government's total revenues are still tiny: 16.4% of GDP. This, though, is up by 1.1 percentage points of GDP of the average for the administration of President Zedillo (1994-2000). It is also worth noting that Fox's proposed tax reform would not have produced much more in the way of revenues. The increase in the tax take under Fox is almost entirely due to the surge in oil prices. Even so, the rise in spending under Fox has led, according to government figures, to average expenditure per school child rising from M$13,900 (US$1,275) under President Zedillo to M$19,200 now. That is a rise of 22%. What is not clear is whether this spending actually filters through to the classroom. There is little evidence that Mexican children are achieving more; indeed a lot suggest that achievement has actually deteriorated. The money has, probably, gone to teachers and administrators. |