Macroeconomic Overview: the year ends with some challenges The Mexican Government faces a complex scenario for 2015, including dealing with three outstanding economic concerns from 2014; the ongoing fall in oil prices and its effects on economic performance, pressures on the Bank of Mexico to adjust its monetary policy in the near future, and a weak recovery during 3Q2014.
The current fall in commodity prices has changed the economic outlook for all emerging markets; Mexico has not been excluded. Since October, the price of Mexican oil barrel has been decreasing day by day. The monthly average price of the mix fell 20% from October to December. The consequences of cheaper oil prices can be seen already in the Mexican exchange rate and in Government revenues. However, the impact of these has been much reduced by the Government’s foresight due to its policy of ‘hedging’ the price it buys/sells oil. It has had this policy in place in 2011 and hedged the price from the second half of 2014 at USD$79, protecting Government from the biggest shocks, but meaning that the Government will not receive any revenue surpluses from high oil prices for the foreseeable future.
The capital outflow from emerging markets is not arbitrary: it is focused mainly on oil producers, and it is closely related with the fall in oil prices. From the beginning of September to the end of 2014, in comparison with the US dollar, the Mexican peso depreciated 11.1%, the Brazilian real 15.2%, the Norwegian kroner 16.9%, and the Russian rouble 35.5%. As Graph 1 shows, there is a close relationship between both variables, and only the intervention of the Mexican Central Bank to auction USD200m on 12 December smoothed the depreciation rate of the currency. Agustin Carstens, Governor of the Bank of Mexico, justified this intervention by stating that this volatility in capital markets could cause exchange rate overshooting and therefore could affect price stability. The correlation between daily exchange rate and the price Mexican oil barrel for the 4Q2014 is -0.98 and statistically significant.
In addition, government revenues have been affected by the fall in prices. As Graph 2 shows, some of the impact of the fall in oil revenues has been offset by two policies: the hedging of the oil prices (which prevented a larger decrease in revenues in 2H2014) and new tax revenues brought by the fiscal reform. Hedging oil revenues has been a sensible decision, however if this trend in prices remains in 2016, public debt could increase significantly. Moreover, if oil companies perceive this negative trend as something that will be maintained in the long term, the energy reform could attract less investment than expected, since the expected profit margin would decrease and projects for deep water and shale require a significant amount of initial investment. In order to remain as an attractive destination for foreign investors, the Mexican authorities would need to check its tax scheme for profit sharing contracts in order to offer better conditions to maintain the interest. However, this will mean less government revenues, which was the original purpose of the reform.
The Bank of Mexico has also take into account short term depreciation into its inflation targets. Even when evidence suggests that the exchange rate pass-through is low for the general price level, yearly inflation is already over the benchmark established by the Bank (3 +/-1%) as it could reach 4.07%. Most of the increase is due to non core inflation caused by recent increases in petrol and livestock prices. Paired with an imminent increase in interest rates in the US for 1Q2015, the Bank will have to discuss its interest rate target, set in 3%.
Not all the effects of this depreciation will be negative: the depreciation of the exchange rate, paired with good economic performance of the American economy for the last quarter of 2014, could boost exports in the short term. This will help the weak recovery of the economy. The recovery started back in April 2014, but it hasn’t been strong enough to drive the economy to its potential. According to the latest survey from Bank of Mexico, the expected GDP growth rate is 2.2%.