Emerging Markets:
The Political Dimension
Emerging Market Risk Reports
Mexico Briefing - March 2003
The prelude to conflict in the Middle East kept markets around the globe in a state of uncertainty for several months. The war, especially if it is protracted, will likely stall Mexico's economic recovery. The positive news is that the economy has shown signs of growth during the first quarter. On the other hand, inflation has exceeded the government's target rate in the first weeks of March. The government party's design on a majority in the lower house of Congress has also suffered a setback.
The Economy
In January, economic activity grew at a rate of 2.0 percent year-on-year (y-o-y). The economy was paced by service sector growth of 2.9 percent and an increase in agricultural production of 1.7 percent. The industrial sector grew 0.3 percent, with all components registering gains except manufacturing, which fell 0.5 percent. The monthly indicator measures approximately 96 percent of the economic activity covered in the quarterly gross domestic product data. The fishing and forestry sectors are excluded.
Preliminary data indicate a $US 65 million trade surplus in February. International oil prices near $US 28 per barrel reversed an expected trade deficit for the month. Total exports grew 8.6 percent y-o-y, with petroleum registering an increase of almost 110 percent. Non-petroleum exports grew a meager 1.4 percent. Weak external demand resulted in slowed growth of manufactured goods as well as imports (2.6 percent) compared to February 2002.
The Bank of Mexico's mid-March announcement that it plans to cap the accumulation of international reserves (by selling dollars) bolstered the beleaguered peso. The exchange rate improved from an historic low of 11.225 (pesos/$US) to 10.767 by the end of March. The decision to cap international reserves was prompted by the anticipated pace of accumulation for the current year and the projected costs of an increasing balance versus yields from liquid and high credit investment instruments. A daily auction of dollars will commence on May 2.
Consumer prices rose 0.39 percent in the first half of March, nearly doubling monthly estimates of 0.2 percent. The government has set a target of 3 percent inflation for the year. The higher than expected inflation rate can be attributed to a spike in agricultural prices and the increased cost of electricity and gasoline. A weaker peso also contributes to inflation as companies raise prices on imported goods and services. The peso declined over 12 percent against the US dollar in 2002 and 3.9 percent this year.
In a related development, Mexico's central bank reduced overnight lending on March 27 to stem inflation. Citing uncertainties regarding the war in Iraq, the bank cut lending to banks by $US 7 million. This marked the fourth time since December that the bank has scaled back loans in an effort to raise the 28-day inter-bank lending rate. The bank increases/decreases overnight lending to influence interest rates rather than setting a benchmark rate. The inter-bank lending rate had declined to 9.1 percent from a high of 10.8 percent earlier in the month. Tighter credit will undoubtedly help the peso and check inflationary trends. On the other hand, higher interest rates may snuff out an economic recovery.
January retail sales rose 3.3 percent over the same month last year. Wholesale sales declined 1.1 percent y-o-y for the month. Both indicators exceeded analyst forecasts. The increase in retail sales suggests growing consumer confidence. (INEGI, the Mexican statistics institute, will initiate a consumer confidence survey later this year.) In contrast, the unemployment rate increased to 2.8 percent in January, up from December's figure of 2.13 percent. The February jobless rate remained virtually unchanged at 2.79 percent. While the January figure was down from the same month a year ago (2.98 percent), the February rate increased 0.09 percent y-o-y. These statistics indicate that the economy remains sluggish, unable to create expanded employment opportunities.
Mexico's benchmark stock index, the IPC, generally moved in concert with Wall Street, particularly during the past two weeks. The market closed down 0.2 percent for March and is off 3.5 percent for the first quarter of the year.
Despite mixed economic news, Moody's raised its outlook for Mexico's credit rating from stable to positive. The change reflects optimism regarding the government's ability to manage $US 150 billion in debt and weather the economic slowdowns of trading partners. Moody's currently rates the country two levels above investment grade, at Baa2.
The Political Front
As reported previously, the Institutional Revolutionary Party (PRI) made gains in the local elections in the state of Mexico. The results signal diminished support for President Fox's National Action Party (PAN). Elections in this state (which surrounds the nation's capital) provide an indicator of public sentiment with respect to the mid-term legislative elections scheduled for July. Despite a strategy of cooperation and conciliation over the past two years, the administration has been unable to garner PRI support for key legislation in Congress. As a result, the government's reform agenda has withered on the vine. Furthermore, the sluggish economy (0.9 percent growth in 2002) is a far cry from the 7 percent annual growth rate promised by Fox in the 2000 presidential campaign.
The PAN currently holds 218 seats in the lower house of Congress (Chamber of Deputies) and 46 of the 128 seats in the Senate. All 500 seats in the Chamber will be contested in the upcoming election. (Three hundred deputies are elected in single-member districts and 200 members are elected by proportional representation from multi-seat constituencies.) The PAN had high hopes of capturing a majority in the lower house, thus enhancing the administration's ability to enact legislative reform in the areas of labor, energy, and tax administration. The early vote in the state of Mexico suggests this will not occur. The PRI will most likely retain its plurality (currently 60 members) in the Senate, with only a portion of the seats contested in the mid-term election.
In recent days, there has been increasing speculation that President Fox will turn the midterm congressional elections into a de facto referendum on his government. A 'make or break' effort to capture a majority in the Chamber of Deputies is extremely risky. While this type of strategy was utilized successfully by President Bush in the 2002 US mid-term elections, Fox does not have a 'war on terrorism' to anchor a patriotic vote. Instead, he is faced with a stalled legislative agenda and an economy struggling to emerge from recession. A campaign of 'finger pointing' will likely come off as little more than political grousing. In putting his prestige on the line in this atmosphere, the President risks losing substantial political clout if his party fails to achieve the objective. The outcome would likely be three years of political paralysis.
In the foreign policy realm, the President offered belated and tepid support for US military intervention in Iraq. While this underscores Mexico's (and the region's) new independence relative to earlier decades, it also signals a cooling of relations between the two countries. This is further reflected in strained trade relations (e.g. transportation provisions covered in NAFTA that have yet to be enacted) and work exchange programs which the Bush administration has failed to move on.
Outlook
The short-term outlook is influenced by the course of the US-led military effort in Iraq. A protracted conflict extending months rather than weeks will slow an economic recovery in the US, further eroding (US) consumer confidence, which fell to a nine year low last month.
Demand for Mexican exports, almost 90 percent of which are destined for the US market, will remain suppressed. This will undoubtedly have a negative impact on manufacturing, particularly the maquiladora sector. Mexico's maquiladora plants, located along the Mexican-US border, import materials and parts and turn them into finished goods for export. This sector has recently shown signs of recovery from a two year economic downturn. Employment rose in both December (0.3 percent y-o-y) and January (0.4 percent y-o-y) following a contraction of approximately 10 percent for the whole of 2002. This sector is a key component in the country's economic recovery.
Heightened security along the US border will exact a toll on the Mexican economy as well. While these measures may not cut into export volume, one or more sectors are likely to incur increased costs associated with transportation delays and accelerated production schedules. The 'protracted war' scenario will also keep pressure on the currency, with the central bank periodically acting to stabilize the peso and curb inflation. This will result in higher interest rates and limited new domestic investment over the short-term. Employment statistics are likely to remain largely unchanged. The economy will stall, with recovery delayed well into the second half of the year. The upside in this scenario is the continued benefit of higher oil prices. Mexico will generate a trade surplus based on oil export revenues and a shrinking demand for imported consumer goods.
The US economy will experience a post-war bounce should the hostilities in Iraq come to a swift conclusion. Despite the certainty of an extended reconstruction process, public interest will quickly shift to more routine pursuits. Consumer confidence (US) will tick higher in the months following the war, accompanied by increased spending. In this scenario, Mexico's economic recovery will proceed, albeit at a sluggish pace. The 'war factor' will come into play in Q2 with the lag in export demand. Furthermore, petroleum export revenues will decline, dependent upon the timing and volume of Iraqi oil introduced on the world market. The trade balance will subsequently register a deficit.
First quarter growth will likely come in under the government's 3 percent annual projection, in the range of 2.6 to 2.7 percent. This figure will be artificially inflated by as much as 1 percent due to the variable nature of the Easter holiday week, which occurred during March in 2002. This year's Q1 y-o-y growth rate will include an additional week of economic activity. Conversely, the religious calendar adversely effects Q2 growth. Combined with the war effect, look for growth of approximately 2 percent in the second quarter.
Over the medium term, the economic recovery in the US will pick up steam and serve as an engine for Mexican growth. Stable foreign direct investment will also contribute to the upturn. Growth will not be robust nor will it be uniform across sectors; 2.6 and 2.8 in Q3 and Q4 respectively. Mexican banks will continue to keep a tight rein on lending, thus generating little in the way of domestic investment. GDP growth in 2004 is projected at 3.5 percent. The US will be engaged in the Middle East for the foreseeable future and thus focus little attention on neighbors to the south. New trade initiatives are unlikely until 2005.
Mid-term congressional elections will take place following a quarter of slow economic growth. In this atmosphere, the PAN faces a daunting task in gaining majority status in the Chamber of Deputies. Regarding speculation that President Fox will fashion the election as a referendum on his administration: it is a high risk strategy with limited upside. Instead, watch for a more traditional political approach in which the PAN will attempt to solidify its core while expanding its base of support. This might include advance funding for a variety of existing programs prior to the election, wage increases or additional benefits for federal employees, or legislation targeting a broad sector of society which could contribute to electoral success. In any case, new initiatives will be fashioned in such a way that makes it difficult for the PRI to generate widespread opposition.
We continue to rate Mexico a moderate risk based on sound economic fundamentals and a stable political system. The government continues to service debt in a timely fashion, the Central Bank has taken an aggressive approach in controlling inflation, and there is room for optimism regarding economic growth in the medium term. The forthcoming election underscores the transition to a meaningful multi-party democratic system.
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