Mexico: Tempering the Link

For the first time since 2001, Mexico will face a severe external shock as the US economy falls into an outright recession in 2008. Courtesy of the housing slump and the spillovers from tighter credit conditions, the US economy is likely to remain flat through the third quarter of next year. Given the strong links between the two economies, Mexico’s ability to insulate itself from the US business cycle is limited.

Against this difficult cyclical backdrop, however, several tailwinds are coming into play to temper the impact on Mexican growth from the coming US recession. Among these positive factors are soaring Mexican non-US-bound exports, an ambitious public investment plan, and expanding credit. And even as Mexico’s growth performance may once again be among the poorest in the region, Mexico’s recent success on the reform front raises the possibility of further progress in 2008, with positive implications for competitiveness and long-term growth.

The link between the Mexican and US economies is alive — and it cuts both ways. Indeed, time after time Mexican manufacturers have followed the ups and downs of their US counterparts, usually with only brief lags. But unlike the downturn in 2001 that was more capex led and thus hit US manufacturers hard, the coming recession will be characterized by weakness in construction and consumer outlays. Indeed, while US industrial activity was contracting at a 6% annual clip at its trough in late 2001, our US team expects industrial production to continue growing next year at a modest 1.5% clip.

Accordingly, we are trimming our 2008 GDP forecast to 2.6% from 3.2% previously, a mild adjustment considering the severity of the decline during the last US recession in 2001.

While the US remains by far Mexico’s largest trading partner, Mexico’s export dynamic is less US-centric today than at any point in the recent past in terms of both market share and growth contribution, thanks to a weakened dollar and hence a more competitive peso. While non-US bound shipments have been growing faster than exports to the US since 2004, it is remarkable how well they have held up so far this year. After jumping 15% in 2006, exports to the US are up just 3% in the first nine months of the year; meanwhile, growth in shipments to the rest of the world has averaged 24% in 2007, unchanged from last year’s pace (see “Mexico: A Decoupling of Sorts” in WIB, October 29, 2007). Over the same period, Mexican exports bound for Europe and Latin America — although making up only 12% of total Mexican exports — have accounted for nearly as much of the total growth in exports as those destined for the US. Meanwhile, Mexico has been gaining market share in the US, which should help even as the growth pace of the US pie slows. And in terms of employment, manufacturing has played only a minor role, contributing only 13% of total job growth this year, a far cry from its 30% share in the year 2000

Moreover, the oil windfall accumulating in recent months should help to boost fiscal spending — particularly by states — in the first months of 2008, even as the federal government ramps up an ambitious program of infrastructure spending. Courtesy of additional funds from the fiscal reform approved last September, the approved amount of total investment promoted by the public sector could top $50 billion (5% of GDP) in 2008 alone.

And mortgage and consumer credit, which combined were still on a declining path in 2000 and 2001, have shown a significant upswing in recent years thanks to improved credit affordability and significant pent-up demand, both of which suggest that Mexico’s credit expansion can carry on largely independent of the US credit cycle. Moreover, as our homebuilding analyst Jorge Kuri argues, the turmoil in markets for asset-backed securities and a slowdown in Mexican growth and remittances are unlikely to dent Mexico’s secular homebuilding and mortgage lending stories.

Given the still low level of financial penetration, credit alone is unlikely to prevent the Mexican economy from feeling the pinch from slower US growth; however, combined with strong non-US-bound exports and the most ambitious public investment plan in two decades, we suspect the Mexican economy could surprise in its relative resilience next year. Indeed, whereas we suspect that most of the downside is built into our Mexican forecast, the rest of the region seems at greater risk of further downward revisions as our global team works through the implications of a downshift in US consumption.

The Ultimate Decoupling

The most important development for Mexico in the year ahead will not be its potential resilience to a US slowdown, but its progress on the reform front. The passage of the public pensions and, more recently, the fiscal reforms point to an administration capable of breaking through the political gridlock that characterized Mexico’s past decade and raises the possibility of further reforms, with positive implications for competitiveness and long-term growth. Not only does progress on the reform front represent a break from Mexico’s past, but it also stands in welcome contrast to most emerging markets where the abundance of recent years has produced a significant degree of complacency.

In particular, we suspect that moves on the energy and telecom fronts could come next year. A meaningful set of reforms designed to boost the efficiency of spending by Mexico’s public oil company, Pemex, as well as constitutional changes that would allow private investment to complement public investment in the energy sector, could detonate an outpouring of investor interest in Mexico and reverse the ongoing decline in oil output. Moreover, moves to produce a more competitive environment in Mexico’s telecommunications space could help reduce costs, boost innovation and serve as a powerful signal of the importance of fostering a thriving entrepreneurial base in Mexico.

By Luis Arcentales and Gray Newman New York
Morgan Stanley
December 16, 2007