Mexico: Flirting With Recession

In Spanish, the word “obrador” can be interpreted to mean “doer.”

But despite owning that last name, Mexico’s new President Andrés Manuel López Obrador faces a slew of challenges to spurring economic growth, including winning the confidence of foreign investors worried about his country’s future.

The populist leader, known informally as AMLO, has pledged to steer Latin America’s second-biggest economy toward a 4% annual growth rate. But as his administration, recently shaken by the sudden departure of Finance Minister Carlos Urzúa, marks its 10th month in power, that goal is looking increasingly difficult to achieve. Meanwhile, the crises over drug cartel violence and the use of Mexico as a corridor for Central American migration continue to absorb much of the new government’s attention.

Erratic policymaking and the debt woes of state-owned oil giant Pemex are prompting a pullback in foreign investment, denting consumer confidence, triggering credit downgrades—Pemex bonds are now classified by Fitch Ratings as junk—and fueling a debate as to whether the biggest trade partner of the US will slip into recession this year.

In this volatile environment, some banks could begin cutting credit, further squeezing small to medium-sized enterprises and individual Mexicans, more than half of whom are unbanked. Credit growth has bounced back only modestly from near a five-year low in February. While it expanded 5% last year, that is down from a 15% annual expansion between 2015 and 2017, says Charles Seville, a credit analyst following Mexico for Fitch Ratings.

The economy shrank 0.2% between January and March, surprising economists who had expected an expansion and adding to a sluggish fourth quarter when manufacturing, mining and construction projects ground to a halt. The Bank of Mexico’s latest economic survey forecast growth at 0.8% this year, down from an earlier 2.1%; the second-quarter data reveal a half-year of sluggish growth.

Yet growth of just 0.1% beat the expectations of Bank of America Merrill Lynch, whose analysts had, in a June client note, predicted a second consecutive quarter of contraction, which would have put the country in a technical recession.

Pemex on the Edge

It was deeply satisfying for Urzúa’s successor as finance minister, Arturo Herrera, who blames the slowdown on weakening global growth. “We are very, very far from thinking that we are close to a recession,” Herrera says.

Some analysts cautiously agree. Miriam Acuña, chief economist at Mexican financial-services group GBM (Grupo Bursátil Mexicano), says a recession is not looming and argues that Mexican risks are trending down. The so-called gasolinazo—or gas crisis—of rising prices exacerbated by fuel shortages stemming from a rash of Pemex pipeline thefts earlier this year, and lower infrastructure growth were one-time events that won’t be repeated in the second quarter, she says. Manufacturing growth, albeit sluggish, is offsetting sagging oil production, she adds.

Although the central bank has kept the benchmark steady at 8.25% since December, some economists expect the Bank of Mexico to cut its overnight funding rate by 50 basis points in a two-step operation, with half of the easing coming in November and the other half in December, in order to stimulate growth. The Finance Ministry plans to cut more than $6 billion from the budget, paying for new spending in part via government austerity and crackdowns on corruption. AMLO himself has given up half his salary and sold the presidential plane.

Pemex’s continuing problems and strategic stumbles—its latest business plan drew criticism as insufficient to lift its fortunes—could offset some of these moves, however. Its $105 billion debt load is said to top any global rival’s.

“Production continues to shrink, and there has been a pretty steep decline in the fields they operate,” says Seville, adding that the firm’s restructuring could take longer than expected.

The president and his deputies insist Pemex is not headed for a financial crisis, that its heavy tax burden will be reduced, its financing problems will be resolved, and annual oil output will eventually rise above its current 10-year low.

Pemex’s inability to cut debt could squeeze some of the country’s marquee lenders, however, including BBVA, Santander and Citibanamex, Seville adds. The former two repatriate a big chunk of their profits to their headquarters in Spain, so a protracted crisis at the state-owned Mexican company could negatively impact their operations.

“There is a risk for banks with high exposure to Pemex,” Seville concludes. “Their capital costs could eventually increase.”

Washington Jeers

Pemex’s headaches are not the only ones afflicting Mexico. Mexico City’s opaque infrastructure agenda also portends bad news, analysts say, leaving global and domestic developers at sea over how to participate in future public works initiatives.

“There is no clear pipeline of projects,” says a senior ratings analyst in Mexico City, adding that López Obrador’s decision to move ahead with the Dos Bocas refinery project using Pemex after no foreign construction firm bids met project requirements, along with the cancellation of a slew of renewable energy projects, will depress this year’s project-finance market.

But trade relations with the US, the destination for the bulk of Mexico’s goods, are the greatest source of angst; much hangs on ratification of the United States-Mexico-Canada Agreement (USMCA), the trilateral trade deal intended to replace NAFTA. And while President Trump dialed back his threats to impose tariffs of 5% to 25% on Mexican goods after López Obrador demonstrated progress in halting migrant flows, the threats could be renewed if the stream picks up again.

The trade drama has thus far spared the cross-border supply chain; as maquilas in the key automotive sector maintain production, and other US industries that source in Mexico—such as textiles and apparel—refrain from tweaking their strategies.

“Auto manufacturers and suppliers continue business as usual, pending the ratification of the USMCA,” says Steve Brown, a corporate-finance analyst at Fitch Ratings. “Most manufacturers say the cost [to shift production] would be so high that it would be a waste of money to do anything until there is more clarity.”

GM and Fiat Chrysler would be worst hit by a sudden hike in US import tariffs. “GM builds 40% of full-size pickups in Mexico,” he adds. “Fiat makes heavy-duty ones, and both make a smattering of other vehicles.” To put the potential impact into perspective, Brown says a 25% tariff—the level to which Trump said tariffs could have risen if Mexico had not bent on migration—would have added $10,000 to the price of a four-wheel-drive model in the US, based on an average $40,000 sticker price.

In the textiles-and-apparel sector, meanwhile, where Mexican maquilas sew more than $2.5 billion of exports annually for US fashion labels, Trump’s threats are also being shrugged off.

“They had no effect,” says industry consultant Miguel Angel Andreu, founder and director of industry consultancy Cedetex, who notes that the voluble US president, whose threats to build a border wall have made him Mexico’s most hated person, would not have been able to levy tariffs on Mexico without facing fines under NAFTA. “He was pressing for Congress to sign the USMCA, but then he decided to impose new tariffs? This is a contradiction.”

Export Concerns

Apparel makers—and others—are now closely watching the progress of USMCA approval in the US. The deal was initially expected to win passage before Congress began its summer break on July 26, but approval could now be postponed until fall or even 2020. The impasse stems from Democrat demands that the Trump administration make changes in labor, environmental and intellectual property provisions. Mexico ratified the treaty in June.

While clothing manufacturers on both sides of the border have not moved to rearrange their supply chain strategies, USMCA’s longer-than-expected ratification could further dent the $22 billion Mexican apparel industry’s growth, already facing a 50% contraction this year. Mexican consumers are tightening their belts to cope with the downturn, while US clothing demand is slowing—adding to Mexico’s export-market losses. Textile and apparel exports to the US have fallen by half in the past decade.

Should trade disputes suddenly intensify, Andreu says, Mexico would continue to lose export market share—not just to China but to emerging Asian powers such as Vietnam, as well as Central America, where countries including Guatemala, Nicaragua and El Salvador have garnered US sales.

Like many Mexican business executives, Andreu is anxious about the future.

“So far, we have a stable economy without growth, but consumer confidence has fallen strongly and abruptly,” he says. “If the president continues making mistakes, we could have a problem next year. We could fall into a recession.”