Special Economic Analysis
Wages have shot up so quickly in China in recent years that manufacturing labor costs are now within 7 percent of manufacturing labor costs in Mexico, creating, all of a sudden, an exciting opportunity for Mexico to displace China as the location of choice for U.S. outsourcing. Mexico has a particular advantage in bulky goods, which can take four to five weeks to ship from China. Already, most of the flat screen televisions sold in the United States are manufactured in Mexico.
The attractions of Mexico – a reform-minded government, an oil producer, a nation with low debt ratios and a low and stable inflation rate – have not been lost on bond investors. In the past three years, foreign capital inflows have surged as appetites for emerging market sovereign bonds have expanded in the global reach for yield. In recent years, the Mexican peso has held fairly steady in relation to the U.S. dollar, but fears are growing that additional inflows of direct investment could destabilize the currency and lead to a loss of competitiveness.
Unlike many emerging economies, notably Brazil, Mexico has suffered little of the destabilizing currency movements that followed monetary easing programs launched by developed economies since 2008. These programs contributed to an increase in global liquidity that has been reflected in portfolio entry flows and appreciating emerging market currencies. In turn, these have brought an unwelcome loss of manufacturing competitiveness and over-reliance on foreign portfolio flows to bridge the gap between expanding public sector budget deficits and declining revenues.
Over the course of 2012, Mexico encountered record levels of portfolio inflows. Figures 1 and 2 break these investment inflows down into acquisitions of debt instruments and corporate equities. It is clear that while acquisitions of private sector debt have increased, the greatest beneficiary has been public sector bonds, with investment rising by nearly 40 percent in the first three quarters of 2012, year-over-year.
At the beginning of 2013, Mexico tapped the U.S. debt markets with a $1.5 billion (19 billion Mexican pesos) offer in 30-year bonds. Orders for the issue came in at $3 billion, with the bonds selling at a yield of 4.19 percent -- the lowest rate ever recorded on a Mexican bond of this maturity. Inflows into Mexico’s equity market have also been significant, helping to bolster its IPC stock index above the broad MSCI Emerging Market index following years of in-line performance.
This deluge in overseas investment has heightened demand for the Mexican peso, putting upward pressure on its bilateral exchange rate. The relationship between increased liquidity and emerging market exchange rate fluctuations has been demonstrated in figure 3, using the United States and Mexico as examples. In the month following the announcement of the second round of quantitative easing by the U.S. Federal Reserve in September 2010, the Mexican peso appreciated against the U.S. dollar by 2.9 percent. This is represented by a downward sloping line in figure 3. This course of monetary easing, which commenced in November 2010 and concluded seven months later in June 2011, was accompanied by a Mexican peso appreciation of 4.5 percent. To date, the implementation of the third round of quantitative easing has bolstered the peso by 3.8 percent against the U.S. dollar.
Other favorable factors have also contributed to the influx of capital into the Mexican debt and stock markets, explaining their outperformance despite GDP and earnings growth rates that have been broadly in line, if not below, the emerging market average. One of its most attractive attributes is its proximity to the United States.
As China and other manufacturing hubs have suffered heightened wage inflation in recent years, Mexico has become significantly more competitive. A recent report by Reuters said that in 2007, hourly Mexican manufacturing wages were 238 percent higher than in China. By the end of 2012, this wage gap had narrowed to just 7 percent. With transport costs also rising, Mexico has successfully clawed back its percentage share of goods imported by the United States
As Asia’s competitive advantage continues to ebb, the localization of production processes is likely to grow in popularity. Some companies are even re-shoring production after the global financial crisis and a spate of natural disasters across Asia caused significant supply chain disruptions. As the preference for shorter and more nimble supply chains grows, Mexico will undoubtedly benefit. Its relatively high unemployment levels and large informal labor market will help restrain wage inflation, while its demographic composition is also favorable with an average age of just 26. Mexico has a particular advantage in bulky goods, which can take four to five weeks to ship from China. Already, most of the flat-screen TVs sold in the United States are manufactured there, with official government data claiming that Mexico is also the world’s largest exporter.
As yet, foreign direct investment in Mexico is not indicative of a mass re-shoring phenomenon. Nevertheless, Mexico’s proximity to the United States and improved competitiveness suggest that it has the potential to become a beneficiary of this growing trend.
Another factor deemed favorable by investors is Mexico’s new reform agenda, ushered in by President Enrique Pena Nieto. Despite commencing his six-year term only in December, Enrique Pena Nieto’s PRI party has already enacted important labor and education reforms. During a speech at the OECD headquarters in Paris in October, he detailed five major goals that Mexico should focus on achieving in order to overcome weaknesses. The first of these was public security, directed at a reduction in violence and crimes of homicide, kidnapping and extortion. This reform is considered essential, since serious security threats have almost certainly deterred foreign direct investment into the country.
Other objectives involve reducing inequality, improving education and enhancing Mexico’s global presence. Under the heading of sustained growth, there were two particularly important reforms -- energy reform and fiscal reform. Some experts believe that if Mexico’s national oil producer PEMEX was reformed appropriately, its economy could grow at a 5-6 percent for several years. The estimated growth for 2012 was 4 percent.
Fiscal reform is focused on promoting the economy and fostering employment in order to increase Mexico’s tax revenue. Without fiscal reform, Mexico’s government will struggle to finance its objectives without generating a deeper current budget deficit and mounting public sector debt burden. Although spreads over developed economy securities of similar maturities are near historical lows, over-dependence on foreign capital investment is highly undesirable.
Having successfully gained cross-political party agreement on these reform and growth initiatives, the PRI should have considerable momentum in the early days of Pena Nieto’s administration.
At present, Mexico’s public sector finances are relatively sound. Its budget deficit compares favorably to other countries and is expected to be just below 2.5 percent of Gross Domestic Product for 2012 as a whole. Total outstanding public sector debt was equivalent to 31 percent of GDP in the third quarter of 2012, well below the United States’ 86 percent, Brazil’s 66 percent and Malaysia’s 46 percent. Accordingly, investors perceive Mexican public sector debt to have a relatively low risk of sovereign default.
Other factors encouraging the entry of foreign capital flows include Mexico’s monetary pause at 4.5% since June 2009 and stable inflation within the targeted 2%-4% range.
Ironically, portfolio inflows of the magnitude currently encountered by Mexico typically result in currency appreciation. Unless efficiency gains can be made, resulting in lower unit labor costs, export heavy industries are vulnerable to a loss of competitiveness and a narrowing of profit margins. If, for example, the goods are priced in Mexican Peso terms, they will cost an American importer relatively more due to the depreciation of the US dollar. In order to retain competitiveness, therefore, the Mexican retailer would have to reduce its selling price.
Although the peso has remained reasonably stable within the 12-14 peso per dollar range, Mexico’s export growth has been decelerating. Since approximately 80% of Mexico’s exports are destined for the US, the health of the US economy is fundamental to Mexico’s economic performance. It is likely that uncertainty surrounding the US fiscal cliff negotiations toward the end of 2012 hampered import demand a little, although it should be noted that Mexico’s share of total US imports has also nudged lower.
Should the Peso appreciate further, causing additional economic instability, Mexico’s central bank could help alleviate its relative strength. One method would be to conduct foreign exchange intervention, purchasing other country’s currencies in exchange for its own. Another tactic, advocated by Kazumasa Iwata (a potential candidate to replace Bank of Japan Governor Masaaki Shirakawa in March) is the acquisition of foreign debt instruments.
So far, the only action taken by the Bank of Mexico has been to threaten to lower the official rate of interest from 4.5% at its January monetary policy meeting. It is unlikely that this was anything more than a threat, however, since economic growth has been healthy and inflation, although within target, has been towards the top end of its specified range.
Surging inflows to Mexico’s debt and equity markets could soon be augmented by US direct investments, seeking to take advantage of Mexico’s inexpensive labor costs. Such inflows, were they to appreciate the currency, could undermine Mexico’s cost advantage. Ironically, it is Mexico’s potential to benefit from the re-shoring of production processes that has made it such an attractive destination for portfolio investment. A loss of competitiveness not only compromises foreign direct investment, but also threatens a destabilizing reversal of portfolio flows.
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