Mexico & Nafta - March 2011 (ISSN 1741-444X)

On 21 February the official Instituto Nacional de Estadí­sticas y Geografí­a (Inegi) reported that GDP growth in the final quarter of 2010 was 1.3%, quarter-on-quarter and 4.6% year-on-year. This brought annual real growth to 5.5% for 2010.

It's unclear whether economic confidence in the economy is strengthening or has peaked. Our guess is that confidence has peaked, even though retail sales figures have been strong. The Inegi's Indicador Global de la Actividad Económica de México (Igae) for December was up only 0.07% on November.

The final quarter growth figure of 4.6% was substantially better than the consensus forecast of 3.9%. The main reason for the overperformance was a pick-up in exports to the US. On the other hand, the quarter-on-quarter figure was a bit less than the 1.7% consensus forecast.

The growth rate in 2010 was the highest annual rate since the Partido Acción Nacional (PAN) first won the presidency in 2000. In 2000 (all but one month of which was managed by President Ernest Zedillo Poncé de León's economic team) the economy grew 6% annually. In 2009, real GDP contracted 6.5% year-on-year. This was originally put as the worst contraction since the Great Depression, but subsequent revisions now put it as the second worst, behind President Zedillo's first full year (1995, -6.3%).

It's worth noting that the economy has done much better than most commentators (us included) expected. The consensus this time last year was for 4% real annual growth in 2010. The consensus forecast for 2011, co-incidentally, is also 4%. We think Mexico will be doing well to hit that.

In December, the best performing sector was agriculture (where output rose 12.5%). The chill in northern Mexico in January and February means that the agri sector will do badly in the first part of 2011. The winter maize crop in Sinaloa has been devastated and at least half of it will be lost.

The industrial sector registered decent output growth in December, rising 4.9% year -on-year overall, and the growth was pretty broadly based. Services were the comparative laggard in December, rising only 3.3% year-on-year.

Long term, we are bears on Mexico. The two PAN administrations in office since 2000 have failed to introduce the structural reforms (to the labour market, the pension system and to the state energy monopoly, Petróleos Méxicanos [Pemex]) that are so manifestly needed. Notably, the Mexican press has lately been full of complaints about a lack of prescription medicines at the Instituto de Seguridad y Servicios Sociales de los Trabajadores del Estado (ISSSTE), which handles welfare for state employees. The government pushed through a reform of the ISSSTE in 2007, arguing that unless it reformed the ISSSTE the organisation would run out of medicines. The growing belief that the ISSSTE reform has achieved little or nothing undermines the government's other claims (never believed by us) that it has also pushed through transformational reforms in other areas. 

One revisionist view of the presidency of President Carlos Salinas de Gortari (1988-1994) is that his economic reform initiatives, principally the introduction of the North American Free Trade Agreement (Nafta) in 1994, which meshed Mexico into the US supply chain, laid the basis for the fast growth of the Zedillo years. Although 1995 was a write-off (thanks to a devaluation in December 1994), the economy bounced back and recorded the best postwar rate of GDP growth, 7.2%, in 1997.  Stripping out 1995, the average annual rate of growth in Zedillo's six years was 5.3%. Since 2000, Mexico's average annual growth rate had struggled to get above 1.5%.

Mexico's economy is horribly vulnerable to what happens in the US. Between 1995 and 2000, manufactured exports (of which up to 85% go to the US) increased by an average of 16% a year. In 2010, they were up 29.5%, compared with 2009.
In January 2011, exports rose 28% year-on-year to reach US$24.59bn. This is the highest figure for any January since records began. The year-on-year rate of growth was the highest since September 2010.

It is highly unlikely that exports to the US can keep on rising at the 2010 rate. There are two reasons for this. The first is that the winds behind the US economy have become gustier, so growth there may be a bit worse than it was in 2010. The second is that the security situation in northern Mexico, especially in the heavily industrial state of Nuevo León, has deteriorated over the past 12 months. Mexican companies, let alone US companies, are starting to avoid doing business in Monterrey, the increasingly violent state capital and the industrial heart of northern Mexico.

This problem, and its effects on investment decisions, could have long term implications for Mexico. The maquiladora belt, along the US border, has long been the best performing part of the economy, thanks to the appetite of US importers. Mexican economic policymakers had hoped that the maquilas' links to US end-users would enable them to gradually source more of their components and intermediate products from Mexican suppliers. This has barely happened. Most of the components used in Mexican manufactured goods are still imported from the US. Without a responsive Mexican supply chain, the Mexican maquilas can only really compete on price and convenience. Both selling points are now vulnerable. The violence is also a major threat to convenience.

The Mexican peso has been one of the strongest currencies in the region this year, trading at between M$12.1 and M$12.2 to the US dollar. That currency strength hurts Mexican competitiveness.

Tax breaks: On 14 February President Felipe Calderón infuriated the opposition Partido Revoucionario Institucional (PRI) by stealing one of their tax plans: the right to charge off education costs against income tax. The break is backdated to 1 January 2011, and so will provide a bit of boost to consumption.

The reform sets maximum annual deductions of M$14,200 (US$1,180) for pre-school payments, M$12,900 for primary school payments, M$19,900 for high school payments, M$17,100 for vocational studies payments and M$24,500 for undergraduate level payments. The government reckons that the move will help 3.3m students in the private education sector.

The opposition parties criticised the government's populist move on two fronts. The first was that by issuing a decree of a budget issue, the government was undermining congress, whose lower house vets public spending. The second line of attack was that the measure was unaffordable, as tax revenues will fall.

Inflation: The consumer price index was 0.49% in January. This was better than most local economists had expected. The 12-month inflation rate was 3.78%, down from 4.4% in December.

The good data also prompted the Banco de México to lower its inflation forecast for the first quarter of 2011 and to raise its GDP growth estimate for the year to a range of between 3.8% and 4.8%.

There must be some doubt, however, about whether inflation will remain low. The cold weather in northern Mexico in January has seriously damaged crops: the state of Sinaloa, a major maize producer, has reported that 500,000 hectares of maize may have been destroyed by the cold. Surprisingly in January, given the cold, the price of many fresh vegetables fell.     

Speculative flows: On 25 February, the Banco de México reported that financial inflows exceeded foreign direct investment (FDI) in 2010. This was the first time in 17 years that speculative inflows (which the central bank put at US$23.8bn) exceeded foreign direct investment (FDI, of US$17.2bn, according to the central bank). The inflow has contributed to a strengthening peso, which has appreciated 5.5% against the US dollar in the past 12 months.  Businessmen in Mexico fear that the peso strength is pricing them out of export markets. They note that while the peso appreciated, the Brazilian Real has barely budged against the dollar over the past 12 months, while the Chilean peso and the Peruvian Sol have both fallen marginally.

Local economists claim that the financial inflows have mostly gone to support domestic bank liquidity, so if the money were to be yanked out, some Mexican banks could face problems. The other potential economic danger is that inflation could jump in Mexico if the capital flows reverse and the peso comes under pressure.

Historically, the final two years of the six-year Mexican presidential administrations have created economic problems which either detonate before the elections (1982) or immediately after (1994). The next scheduled elections in are in July 2012.

FDI: In 2010 FDI was US$17.7bn, up 17% over 2009, according to preliminary figures from the Secretarí­a de Economí­a. The 2009 figure is also 53% higher than previously reported: the ministry's earlier estimate was US$11.4bn.