If Mexico falls, dont punish Brazil…

2009/01/16 in BRIC - emerging markets, currency, macro trends

Mexico is facing a severe economic crisis, with falling oil prices, decreased exports to the US, and a falling currency.  Brazil has its own challenges, but they are different (outlined in GloboTrends here), and should be distinguished from Mexico´s for foreign investors.

Many foreign investors simply lump Latin America together, and assume that their economies behave similarly.  They do not.  Even when looking at the two biggest economies in Latin America, Brazil and Mexico, its clear that their economies are responding differently to the global economic crisis.

Judging by the way currency traders have been trading the Real and Peso, however,  it appears as if traders are not properly distinguishing between the two.  When a crisis hits (as one did in September 2008), it seems as if traders sell Latin American together first, then ask questions later.  Take a look at the following currency graph from yahoo finance..

Chart for USD/MXN (MXN=X)

The Challenges for Mexico:

The macro economic challenges confronting the Mexican economy are quite serious.

I recently read an excellent (although slightly negative) analysis of the challenges facing Mexico from the source ´RGE monitor` (here).  In this article, the economist  Walter Molano outlined the following challenges (summarized here):

summary of points:

  • The decline in oil prices will hit Mexico hard. The Mexican government will soon face a gaping hole in the fiscal accounts. Oil represents about a third of government revenues.  Unfortunately, the decline in the valuation of crude coincides with a plunge in oil production.
  • Drop in metal prices will weigh heavily on the mining regions, particularly in the north.
  • dramatic fall in remittances expected as the US slows (especially construction)
  • Slow down in the automobile industry is forcing some Maquiladoras to close factories and furlough workers.
  • The current account gap may exceed $24 billion in 2009.
  • This shortfall will be larger if remittances collapse. (which might fall by 50% due to contraction in the US)
  • the capital account will not provide any solace. Foreign direct investment will also decline, due to the downturn in manufacturing. There is a chance that the portfolio flows will be negative, as investors flee the emerging markets.
  • the peso will have to devalue…the Mexican currency could lose another 20% to 25%, which could put it above 17 to 1 against the USD
  • corporate defaults expected; No Mexican CFO is prepared for such a scenario, which could lead to despair on the corporate front. Hence, we could be in for a wave of unexpected defaults.
  • social situation could become explosive. The lawlessness caused by the burgeoning drug trade undermined local institutions, such as the press, judiciary and law enforcement.
  • author:  Walter Molano | Dec 18, 2008

This may be the extreme view to the negative side, but it does throw up the red-flag, and warn investors about the potential for crisis.  Investors should be careful, however, to recognize that Mexico has some unique characteristics that should be highlighted, so that investors dont reflexivly sell `Latin America` on bad news in Mexico.

Brazil is different:

While Brazil and Mexico do share a bond as commodity-exporting Latin American nations, there are some critical differences that investors should keep in mind.

Nearly 80% of Mexicos exports go to the USA, but only 17% of Brazils exports head for North America (Canada, Mexico, and USA included).  This makes Brazil much less export dependent upon the US manufacturing sector (who´s slowdown is driving the slump in Mexico).

Another big difference is that Mexico´s major commodity export is oil, which has dropped from $130+ per barrel, down to $30.52 last week.  Brazil´s exports of commodities are much more food-based and therfore should have support even if the recession turns to depression and lasts longer than analysts predict (so there is less long-term risk for Brazil, as people will continue needing to eat, even if production of material goods doesnt come back for a while).

Also, remittances play a much smaller role in Brazil´s economy than in Mexico´s.

My point is that even if you agree with his analysis (as many traders do), it would be unwise to lump all of Latin America together, and to not distinguish some of the unique characteristics that its economies have.  My fear is that investors seem to lump bad news in Latin America together, and punish all commodity exporting countries together whenever one of them shows signs of weakness.

On the other hand….(or, how Mexico could surprise Mr. Molano!)

Before completing this article, I believe its important to first challenge some of Mr. Molano´s assertions…

In response to his article, however, I would say that Mr. Molano forgets to mention that the Mexican government has locked-in oil prices at $70 per barrel throughout 2009 (by purchasing $1.5 billion in derivatives contracts).   source: Ft.com

Another factor that Mr. Molano fails to mention is the huge warchest of reserves that Mexico has built up…

`The central bank has accumulated more than $90 billion in foreign currency reserves since Mexico’s own 1995 financial crisis, allowing it to auction off at least $15 billion to prop up the battered peso last year`.  source Ft.com

In the mean time, however, I agree with Mr. Molano´s analysis that Mexico will be challenged by a mixture of reduced demand of oil exports, lower level of orders for its manufactured goods, and a reduced level of remittances from abroad, especially from the USA.  The danger is that oil prices may stay low beyond one year, at which time, Mexican budget could be serverly challenged.

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3 responses to If Mexico falls, dont punish Brazil…

  1. Brasi has better spread of buyers for it’s products. This was a good move by the Brasilian government. In the long term it will play well.

    However, what is not mentioned is the whole world is declining as a place to export to. Even a 17% drop to the USA will be hard on Brasil and R$. You can not leave out the EU as a buyer. They are in recession also and will not come back to heavy importing till the USA resolves it’s economic problems.

    Brasil will survive better than Mexico but that is little comfort considering that Brasil is slipping into a recession.

  2. Sorry to burst your bubble, but Walter Molano is more than just a little biased, he foolishly predicted “revolution” in Mexico simply because it occurred every 100 years and they were about due, and this ridiculous story was relayed in various media outlets online (including, I believe, the LA Times). If his plan is to recommend his clients buy Mexican stocks for long-term growth, than scaring down prices would make sense, as he is a paid analyst this would not be a surprising strategy.

    A serious analysis points out the benefits to the weakening peso relative to the US dollar as more American tourists decide to travel to relatively more affordable (and closer) destinations in Mexico, which is made even more affordable by the weak peso… which supports foreign exchange supplies and the Mexican economy in general.

    Even though manufacturing by Mexico will suffer, Mexico’s economy has made a strong shift to services, it should be hurt as much as many other industrialized nations, which is still a significant, but average, hit.

    Oil prices are hedged for the year as your article pointed out (which Molano should know but seems to gloss over that fact), whereas other countries in Latin America have been benefiting for years from other commodity prices which they did not hedge. Unfortunately for such countries, the commodity prices will fall dramatically as part of the support for their prices relies on expectations of growth in developing China and Asia, where growth rates have plummeted along with that of the rest of the world. Asia’s bust will soon be Latin America’s bust, but less so for Mexico next year, allowing it to buy time to continue instituting pro-growth reforms.

    Unlike many other Latin American nations, Mexico has been instituting tough reforms to its pension plans, its oil industry (which should help stem declines in production), and its tax scheme (expanding collections). It has also eliminated a major drain of funds by cutting its former subsidy of gasoline. It is now able to stem declines with counter-cyclical policies and its many reforms should point to an improvement of future prospects for Mexico. This is partly reflected in the markets, as Mexico’s stock market (even after adjusting for currency depreciation) holds up better than most of Latin America and the world (only Chile in Latin American boasts a more resilient major Latin American stock market). This market is forward looking, and points to a future in Mexico of real growth with continued improving prospects as reforms are have not seen an end. I don’t blame the market, which is a entity full of increasingly savvy investors… as Mexico’s relative performance is expected to improve in relation to its Latin-American neighbors.

  3. It should be mentioned furthermore that the weak Peso benefits Mexico’s manufacturing sector, as shows by recent anouncement of new car plans that were started in Mexico years ago now going online even in this tough environment, as Mexico has become relatively stronger than other countries for manufacturing.

    Not only are more car plants moving or expanding in Mexico for the long-term rather than to China or Brazil, but they are benifitting from many reforms to pension, oil, etc.

    Look at Walmart’s expansion in Mexico and Best Buy’s entry to Mexico.

    Look at Canadian company’s entry into and expansion in Mexico including Bombadier and Scotiabank.

    South America has relied on commodities sales to Asia for too long, and they will soon be looking to Mexico’s strengthening manufacturing and services sectors with envy.

    By the way, as to inflation, look at which countries have been growing despite having lower inflation and continuing to lower inflation. This disinflation is normally a tradeoff to growth in the short term, but in the long term battles inflation expectations. It appears that the Mexican government understands this better than a lot of Latin American countries that are pushing their not-as-independent central banks to cut interest rates as a knee-jerk reaction. Patience is a virtue that will lead to long-term growth.