Improving Core
Mar 01, 2006
Gray Newman (New York) and Heloisa Marone (New York)
The news from Mexico’s inflation front keeps getting better. Core inflation hit a new record low of 2.93% in the first half of February, while the headline uptick in inflation at the beginning of the year appears to have peaked and should dissipate in the coming months. The only holdout appears to be expectations which in late January reversed their downward trend and bumped up a bit. While expectations for headline inflation in 2006, 2007 and for the average of 2007 through 2010 moved up, expectations for core bucked the upward trend and fell again in late January to 3.2% for 2006 from 3.27% in the previous monthly survey.
Perhaps the biggest obstacle to our forecast that overnight interest rates are likely to reach 6.75% this year is the recent language from the central bank. After cutting interest rates by 50 basis points to 8.25% in December and then by another 50 basis points in January to 7.75%, the central bank warned that its space for further easing in the coming months was “limited.” The central bank repeated the language of “limited” space in its February communiqué when it cut by 25 basis points. After reading the January communiqué, we first thought that a pause was in the works, possibly as early as March. However it now seems that Banco de Mexico intended to send a much more nuanced message in January. It now appears that the central bank was simply trying to signal that unlike the 200 basis points of cuts that took place between the peak in overnight interest rates at 9.75% and the six-month decline to 7.75% in January, agents should not expect the authorities to cut interest rates by another 200 basis points in the coming six months. In some ways, it is unfortunate that the central bank did not adjust the language of “limited” space in the February communiqué, but we would argue that it should be read with care. After all, “limited” space is still space to cut. And as long as the language remains, the market will continue to price in at least one more cut in interest rates. We suspect that the absolute floor established by the “limited” space language is likely somewhere near 6.25-6.5% which would represent an additional 100 to 125 basis points of cuts from here. That is also in line with what our Taylor Rule modeling suggests for the year end. The risks
Of course, risks to our call that overnight interest rates can fall below 7% are present. First, if the Fed were to hike the Fed funds rate above 5%, it is unlikely that Mexico’s central bank would be comfortable reducing overnight rates below 7%. Second, if Mexico suffers from a more severe bout of peso jitters than we are expecting — either because US growth falters or because political tensions in Mexico flare, Banco de Mexico may prefer to hold off on further interest rate easing to ensure that a much weaker currency does not reignite inflation expectations. Finally, a reduction in global risk appetite thanks to a geo-political event or a significant reduction in liquidity thanks to the Bank of Japan could also cut short the easing cycle in Mexico. None of these events currently form part of our US or Japanese forecasts. Absent an external shock from the Fed or from the BOJ and absent sudden peso weakening, Mexico’s inflation picture looks quite benign. The decline in core goods inflation, thanks to a more competitive retail space and from pressure from imports of Chinese goods, is unlikely to stop. From consumer goods to steel (which has an impact on the housing component of Mexico’s CPI), China has helped to produce lower inflation in Mexico. Service inflation appears a bit more sticky, but even there we expect to see some declines as agents realize that lower overall inflation is here to stay. Bottom line
The good news in Mexico is that not only is inflation not showing any signs of coming back from the dead, but it appears to well on its way to the central bank’s long-elusive headline target of 3%. As we saw in December, January and early February, Mexico cannot escape supply shocks, especially given the heavy weight of rainfall-sensitive produce in its consumer basket, but a credible central bank can help expose those supply shocks as little more than transitory events with little relevance for price setting. This year should be yet another year to congratulate Banco de Mexico. But we will have to cut the celebratory remarks short because tackling inflation simply isn’t Mexico’s greatest challenge. Instead, as we have argued repeatedly, Mexico needs to move forward on a series of much-needed reforms to boost both public and private investment to deal with its loss of competitiveness. On that front, we are concerned that there is little to celebrate.
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January Current Account Widens More Than Expected
Mar 01, 2006
Deyi Tan (Singapore) and Denise Yam, CFA (Hong Kong)
Current Account Widened Due to Strong Net Services and Transfers: The released BOP data showed exports expanding 14.5% YoY and imports weakening to a 0.4% YoY pace in January. Trade balance widened to -US$388mn from -US$176mn in December. Net services and transfers was strong and rose US$893mn (higher than the usual January average of US$540mn). This brings January current account balance to US$504mn. Trade Details: From the custom-based data for which trade details are released, exports are seen strengthening on the back of segments such as crude materials (+24.7% YoY & 1.3%-pt), mineral fuel & lubricants (+87.3% YoY & 3.1%-pt) and machinery (+27.6% YoY & 11.5%-pt). On the other hand, imports weakened due to slower machinery (+13.8% YoY & 5.5%-pt) and crude materials (-21.0% YoY & -0.8%-pt). Details for net services & transfers are not available on a monthly basis. However, extrapolating from the data we saw in 4Q05, the strong number is likely due to continued travel receipts normalisation in what is now the peak tourism period in the aftermath of the tsunami. Infrastructure Project Delay Might Spell Smaller Current Account Deficit: The dissolution of the Parliament means that bidding for the infrastructure projects which was due in April will be delayed until 2H06 if the snap election occurs. As such, there is a possibility that the actual current account deficit could turn out smaller than our forecast of -3.8% of GDP.
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No Harm, No Charm
Mar 01, 2006
Chetan Ahya (Mumbai) and Mihir Sheth, CFA (Mumbai)
A Lackluster Budget Budget F2007 was one of the most unexciting budgets from a policy reform perspective. As we have been arguing, over the last few years, the importance of budget has indeed been diminishing. First, a large part of the major tax rate changes (key function of budgets in the early 1990s) have been accomplished; second, coalition dynamics make it difficult for the Finance Minister to announce path-breaking reforms in the budget before arriving at a consensus with the coalition partners. The focus of Budget F2007 was to not initiate anything politically sensitive, which could be difficult to implement. Not surprisingly, there was little opposition to the budget presentation in the parliament. From a macro standpoint, typical budget measures can be classified into three broad areas – broad policy reforms, tax measures and fiscal management. (1) Policy reforms - avoiding tough measures: From the reforms perspective, we believe that for ensuring a sustained growth trend of 8%, there is a need to kick-start some tough reforms. We believe that there are three key areas in which the government could have conveyed its intention to take the reforms process forward including ‘PFI’ — Privatization, FDI and Infrastructure. There was no mention of the word ‘privatization’. There was a cursory mention on FDI with no indication of any fresh measures being taken up. For the infrastructure sector, the budget has only reaffirmed some of the earlier projects, which we believe will continue to help increasing infrastructure as percentage of GDP gradually over the next three years. The only major new investment announced in the budget was the government’s plan to get bids for five ultra mega power projects of 4,000 MW each with an intention to award these projects before December 31, 2006. However, we are less optimistic on the government being able to abide by the timeline and even attract private players to invest in such large projects. The key challenge in attracting investment from the private players is that the counterparties purchasing the electricity generated by these power projects are likely to be loss-making government owned distribution companies (SEBs). (2) Tax revenue mobilization and structure – minor tinkering, no surprises: The government’s ability to increase tax collections by hiking tax rates has been limited by its decision to open up the economy for global competition. Hence, the government is largely dependent on overall economic trends to increase tax revenues. For instance, according to the budget documents, the tax changes announced are likely to contribute to only 11% of the increase in tax collection projected in F2007. In Budget F2007, most of the tax rate changes are minor with no major implication on tax to GDP. Changes in direct taxes were minimal and we believe the key focus was reducing and removing exemptions. For instance, the corporate minimum alternative tax rate has been increased to 10% from 7.5% and income tax exemption for co-operative banks has been removed. The key indirect tax related measures initiated in the budget are follows: Minor changes to excise and customs tax on goods: The peak customs tariff was cut further to 12.5% from 15%. A small cut has been announced in excise and customs duty for various products such as small cars, aerated drinks, alloy steel, non-ferrous metals, mineral, ores, man-made & filament yarn and bulk plastics. Services tax rate increased to 12% from 10% and scope services tax has been expanded by including a few more services in the tax net. Broad timeline for transitioning to country-wide goods and services tax (GST): The Finance Minister indicated that the government should target to move to GST from the current multiple levels for separate state and central goods and services tax by F2011. This is about two years behind our estimate of F2009. The delay to F2011 is also a concern given that the term of the current government is likely to end in May 2009. (3) Fiscal management — Cyclical correction in deficit supported by higher tax to GDP: On the face of it, there appears to be an improvement in fiscal management by the central government. The government has been able to cut its fiscal deficit from the recent peak of 6.2% in F2002 to 4.0% of GDP in F2005 and maintain it at 4.1% in F2006 (versus budget estimate of 4.2%). However, a large part of the reduction has been due to a higher ratio of tax to GDP. The rest of the decline is explained largely by a decrease in interest cost, due largely to a fall in interest rates (not a lower debt burden). We believe the improvement in tax to GDP is largely cyclical; reflecting a leveraged, consumption-driven growth cycle supported by global liquidity and low real interest rates. For a structural reduction in the deficit, we believe that the government will have to initiate expenditure reforms but there was no sign of this being taken up in the budget. Although, we do not have full expenditure classification for F2007 BE, the trend in Central government’s expenditure until F2006 as per official classification into development and non-development expenditure is not inspiring. The only positive news in the F2007 budget from expenditure mix appears to be a minor increase health and education expenditure to US$8.1 billion (0.92% of GDP) in F2007 from US$ 6.2 billion (0.79% of GDP) in F2006. Bottom-line As expected, the annual budget statement has brought small changes related to individual sectors but has not produced any major macro surprises. The challenge of coalition politics has continued to weigh on the government’s efforts on policy reforms generally and more specifically on expenditure reforms, a measure we believe is critical for a sustainable reduction in deficit. Glossary Fiscal Deficit = Government Revenues (ex borrowings) - Government Expenditure Revenue Deficit = Government’s revenue receipts (in the form of tax and non tax revenue) less Government’s revenue expenditure Primary Deficit = Fiscal Deficit - Interest Payments Consolidated National Deficit = Centre’s fiscal deficit + State fiscal deficit - Inter-governmental transfers Plan Expenditure = Refers to the expenditure based on total plan provisions of various ministries under the Central Government and assistance provided to the State Governments. The plan provisions are based on recommendations from the planning commission. Non-plan expenditure = All government expenditure not included under the plan expenditure head. The expenditure under this head is usually obligatory in nature (interest payments, pensions) or is related to essential expenditure (defense and internal security). Debt Swap Scheme = The Union Budget F2004 announced a Debt Swap Scheme which enabled the State Governments to substitute their high cost loans from the Central Government with fresh market borrowings and a portion of small savings transfers. The total amount of debt swapped by state governments was Rs. 137.7 bn (US$ 3.1 bn) in F2003, Rs. 462.1 bn (US$ 10.4 bn) in F2004 and Rs. 436.8 bn (US$9.9 bn) in F2005.
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