- Newcomer Party MORENA is likely to win elections
- Outcome of the NAFTA renegotiations still uncertain
- Economic growth picks up in first quarter
- Financially, Mexico is in good shape
Roll back of recent economic reforms unlikely
Elections are due to be held in Mexico on 1 July and are likely to result in a new government. The country’s political arena is dominated by the centre-right PAN, the centrist PRI party and the PRD, a left-wing offshoot of the PRI. The PRD, in turn, is being torn apart by internal disputes. Members and voters are defecting in droves to MORENA, a party set up in 2012 by Andrès Manuel López Obrador (AMLO for short) after he left the PRD. The polls suggest AMLO is on track to win and take over the presidency from Enrique Peña Nieto. The popularity of Nieto’s PRI has suffered from the country’s security problem and the taint of self-interest and corruption clinging to the party. MORENA wants to reverse the PRI’s recent liberalisation of the telecom, energy and financial sectors but this will be difficult, as the party is unlikely to achieve the majority required for such drastic action. Nevertheless, the financial markets are nervous as investors anxiously await the election outcome.
Increase in government spending ahead of elections
In 2017, GDP growth slackened from 3% (yoy) in the first half year to 1.5% in the second half. This was due to the moderation in growth in consumer spending, public expenditure and business investment. GDP growth picked up in the first quarter of 2018 to 2.3%. One driver is consumption. Families have more to spend thanks to the reviving labour market and the fact that high inflation is no longer evaporating their wage increases. The government is also spending more, partly to win the voter’s favour. Businesses, by contrast, have put investments on hold. They are uncertain about the election result and the future of the NAFTA, the trade agreement with Canada and the US that president Trump wants to review. However, judging from the industrial output volumes, rising capacity utilisation rates and improved export competitiveness (thanks to the cheap peso), businesses are likely to gradually step up their investments in the years ahead. All in all we project GDP to grow by 2.5% this year.
Current account deficit is small and easily financed
The decline of the peso means that goods exports will rise faster than imports in the coming years, leading to a decreasing trade deficit. The inflow of income transfers will also gather pace, though Trump’s plan to finance his coveted border wall with a tax on remittances that Mexican workers send home is a risk and mounting safety concerns pose a threat for tourism income. Nevertheless, a decline in the current account deficit is not on the cards. That said Mexico has little trouble financing its relatively modest current account deficit, which stood at 1.6% of GDP in 2017. Direct investments from abroad are more than sufficient to close the gap. The cautious opening-up of the oil sector to foreign investors will give a fresh impulse to the net direct investment inflow in the coming years.
Uncertainty around NAFTA pushes Mexico to expand horizon
One uncertain factor regarding international trade concerns the NAFTA talks. This trade agreement between Mexico, the US and Canada dates from 1994 and is currently being renegotiated. Trump wants to narrow the US trade deficit with Mexico, partly by adjusting the so called ‘rules of origin’. A change in these rules will particularly affect the automotive sector, which has a large share in the country’s exports. Also on Trump’s wish list is a ‘sunset clause’, providing for NAFTA renegotiations every five years and requiring Mexico to raise its minimum wage. Reduced access to the US market, the destination of 80% of Mexico’s exports, would be severely detrimental. A further differentiation of export destinations is therefore imperative. It is not for nothing that Mexico recently successfully concluded its trade agreement negotiations with the EU and became the first country to ratify the Trans Pacific Partnership.
Central bank improves transparency
Amidst the uncertainties over the elections and NAFTA and against a backdrop of monetary normalisation in the US, the central bank is extra alert. This year it raised the official interest rate further to 7.5%, despite inflation (which soared after the fall of the peso in late 2016) declining from 7% (yoy) in December to 4.5% in April. The drop in inflation confirms the absence of second round effects in the form of higher wages to compensate for loss of spending power. However, with the current unrest surrounding Argentina, the central bank is not yet confident that the lower inflation and stable peso will be lasting. This is why it is playing safe and is even keeping the option of a further rate hike open. If inflation continues to fall and exchange rates remain stable and the election and NAFTA outcomes are favourable, interest rate cuts may come back on the agenda. In the meantime, the central bank is seeking to build confidence in its monetary policy framework through measures to provide more transparency.
Lending grows fast but credit risks remain limited
Financially, Mexico is in good shape. Lending to households and businesses is growing rapidly, albeit from a modest level. Outstanding household credit is currently the equivalent of 16% of GDP. This debt is almost entirely denominated in local currency. Non-financial sector corporate lending represents a value of 25% of GDP. Only 25% of this is denominated in Mexican Pesos and 60% in USD. The banks are well-capitalised and have healthy credit portfolios with few payment arrears and ample provisions to cover any losses. The government is promoting digital banking to encourage households to maintain larger deposits with banks, making them less dependent on wholesale funding. The public debt amounts to 47% of GDP, a number that will probably rise slightly given the expected modest budget deficits. Despite the tax reforms in 2013, public revenue remains strongly dependent on oil income. If the government wants to improve public services, it must raise extra funding by widening the tax base and improving the tax collection system.