Call for Modesty
While there is still uncertainty over how far China will permit its currency to strengthen in the coming months, our China economist Qing Wang expects the pace to be gradual and the magnitude of the move to be modest (see Renminbi Exits from USD Peg and Returns to Pre-Crisis Arrangement, June 20, 2010). He is calling for a renminbi-to-USD move toward 6.60 by year-end 2010 and 6.20 by year-end 2011 - that would represent a gain in the dollar purchasing power of the renminbi of just under 10% over the next 18 months. It is worth noting that the last time the Chinese embarked on a crawling peg in July 2005, the authorities allowed the currency to gain roughly 20% over a three-year period.
It is worth keeping the magnitude of the projected path for the renminbi in context: it is very modest when compared with the much more abrupt move made by the US dollar against the euro in recent months. The dollar has already gained roughly 20% in just over the past seven months or twice the gains that that Chinese renminbi is expected to experience over the next 18 months.
Reducing the Tail Risk
Perhaps the most important impact of the move away from the peg is to reduce the risk of a trade spat between China and the US. That was never our central case, but was always a tail risk to our constructive view on Latin America in 2010 and 2011. While political pressure on China may continue in Washington, our emerging markets strategist Jonathan Garner argues that the chance of protectionist measures passing is reduced following China's decision and the strategy of not citing China as a currency manipulator appears to be bearing some fruit. I suspect that the fanfare from the recent announcement is likely to be greater in the political arena than in the economic arena.
A Sign of Confidence
The move to allow the renminbi to appreciate also represents an important sign that the Chinese authorities are comfortable not only with the outlook for the Chinese economy, but also with the outlook for the global economy. In recent months, we have seen a new round of concerns about the pace and the outlook for the global economy as investors have feared that the sovereign debt turmoil in Europe could morph into a larger problem. Those risks still remain in place. But the message from the announcement this weekend appears to be that the Chinese authorities are seeing strong enough support for domestic demand as well for external demand as to permit a resumption of a currency revaluation. The move may limit the need for interest rate hikes in China - indeed, Qing is removing any interest rate hikes from his 2010 forecast - as inflation pressures are better contained by imports. The flipside of course is that China could export more inflation; but that seems to come as a sign of relief for many who began to worry once again about the risks of deflation.
The Case for Commodities
To the extent that there is a direct or immediate impact on Latin America from China's move, the link is likely to come from commodity prices. Despite all of the talk that Latin America is producing new pockets of locally grown domestic demand, the region's growth trajectory still moves closely with the price of commodities. Indeed, there is evidence that the region has become even more closely tied to the commodity cycle as strong demand for commodities has boosted the share of commodities. The overall weight of commodity exports as a percentage of both total exports as well as GDP has been rising in recent years in Latin America - not surprisingly perhaps, given the strength of the commodity cycle. And while exports as a percentage of GDP remain low in Brazil - running currently in the mid-teens - it is not clear how germane that fact is. After all, the track record of Brazil's growth point suggests that output tends to move with the commodity price cycle. A similar cycle between activity and terms of trade can be seen throughout Latin America.
The Case for Mexico
But while the immediate impact, however large or muted, might be seen in commodity producers, the medium-term impact of the latest news from China is unambiguously positive for Mexico. While the ascension of China during the past decade has been welcomed in most of Latin America as a new source of demand for the region's commodities, Mexico has long viewed China warily as a threat to Mexico's low-cost manufacturing and assembly model. Indeed, I can recall a decade ago when many investors began to argue that China "would eat Mexico's lunch". The criticism of Mexico mounted in 2002 and 2003 as Mexico's market continued to slump even as China gained ground (see "Mexico: Convergence or Divergence?" This Week in Latin America, June 6, 2004). Within another two years, China had replaced Mexico as the leading trading partner of the US and we were being told that the Mexican model - built around its role as an outsourcing arm for the US manufacturing industry - was over.
The only problem with the "China eating-Mexico's lunch" view is that it stopped working five years ago. Since early 2005, Mexico's share of US imports first stabilized and then more recently has rebounded sharply. Luis Arcentales has written about this extensively (see "Mexico: More than Just Cyclical?" This Week in Latin America, June 14, 2010). Some argue that recent gains in market share are tied to Mexican peso weakness: an interesting idea but it does not seem to hold up well with a longer review of Mexico's market share in the US. Yes, the peso weakness has been associated with Mexico's recent gains in market share, but Luis can find plenty of examples where Mexico lost market share with a weak peso and periods where it gained shared with a strengthening peso in the past two decades. Some argue that Mexico's gains in 2006 were the lagged consequence of China's move to allow its currency to revalue beginning in mid-2005. Perhaps that played some role, but Mexico once again lost those gains in market share in early 2008 long before the Chinese stopped the currency's revaluation path.
Indeed, I would argue that a key driver for Mexico's export gains has been foreign direct investment and I would expect the most recent news from China to provide a boost for the outlook for investment in Mexico. Even before the latest news, the low-cost labor advantage that China had enjoyed over Mexico a decade ago was evaporating. And the reading from the recent currency move in China is likely to reinforce the message: whether through wage increases or through a stronger currency, or a combination of both, the days of China relying primarily on its low-cost status are likely over.
Bottom Line
If you are still in a funk that the globe is likely to slow and that the risk of a financial accident emanating from the turmoil in Europe is still present, I doubt that the news from China this past weekend is sufficiently powerful to challenge you. Still, the moves from the Chinese suggest that their reading of the global outlook is not nearly as dire. And meanwhile, week after week, Latin America continues to surprise on the growth front to the upside. Whether the latest move by the Chinese has a meaningful impact on commodity prices (and hence growth in Latin America) remains to be seen, but I suspect that it will prompt long-term direct investors to revisit their view of Mexico. Beyond the cyclical pop, something appears to be going on in Mexico. Despite the limited (virtually nil) progress of late on the reform agenda, Mexico's private sector appears to becoming more agile and flexible as a major manufacturing force in North America.
Mexico's recovery - up until now largely a reflection of the sharp bounce in industrial output and exports - now seems to be broadening as consumers benefit as well. Indeed, after several months of characterizing the recovery in private consumption as "weak" and displaying a "relatively low" pace of growth, Banco de Mexico in its most recent policy statement on June 18 pointed out that consumption "had shown some improvement of late". Incoming data validate the central bank's more constructive tone: even accounting for the World Cup's boost in May, ANTAD sales accelerated sharply, imports of consumer goods have been moving gradually higher through April and consumer confidence improved to a ten-month high in May, led by rising optimism about current conditions.
The ongoing improvement on the consumer front seems to be fundamentally driven, not just a reflection of one-off or seasonal factors. The pick-up in consumption has been essentially led by improvements in employment, which began in industry and that, by end-2009, had broadened into other sectors as well. Moreover, the recent downturn in inflation has both led to modest gains in real wages and, importantly, diffused early-year fears among consumers about runaway inflation due to higher taxes and administered prices. While credit and remittance inflows remain sluggish, we find reasons for optimism going forward on both fronts, particularly on the credit front.
Income Gains Driving Consumption
The main tailwind for consumption had been persistent job creation, which has led to gradual improvement in consumer incomes. And more recently, real wages have shifted from being a drag on consumption into a minor tailwind for consumers.
Put together, swings in employment and real wages seem to explain much of the recent improvement in retail sales, which according to the broad measure by Mexico's statistical institute, INEGI, have posted sequential gains in four out of the last six months through April. Indeed, when analyzed through this lens, we don't find much merit in the common concern among many Mexico watchers that there is something inherently wrong with Mexican consumers. While industry turned the corner in mid-2009, our measure of wage mass only began to trend higher in late 2009 - an improvement which coincided with a modest uptrend in retail sales.
Changes in the wage mass seem to explain not only the apparent ‘disconnect' between rising production and stagnant consumption observed during 2H09, but also consumption downturns during past recessions. During the 2001 recession, consumption - as measured by retail sales - was relatively resilient as job losses were offset by positive gains in real wages, as Mexico was in the midst of a multi-year disinflationary process. Industry, by contrast, did not recover until mid-2003. During the Tequila Crisis, the downturn in industry was short-lived - industry was back on its feet by 3Q95 - thanks to a weaker currency and strong global demand. Consumer incomes, however, were devastated by the one-two punch of massive job losses and severe real wage losses caused by the spike in inflation which peaked at 52.0% in December 1995.
There are mounting positive signs suggesting that the upturn in hiring has further room to go. First, the ten-month sequential stretch of positive formal job creation has been gaining breadth. In the early stages of the recovery - formal employment bottomed last July and by May 2010, Mexico had recovered over 95% of the formal positions lost during the recession - job creation was centered exclusively on industry, but by late 2009, it had broadened into other areas of the economy as well. Indeed, by April of this year, non-industrial formal employment reached a historical high, topping the previous October 2008 peak. While improved external demand has translated into strong job gains in tradable sectors - which have expanded at an average sequential pace of 6.2% annualized so far in 2010 - non-tradable sectors like construction, retail and leisure have been adding workers at a 3.9% annualized clip.
Second, the relative importance of temporary jobs is gradually declining as businesses are adding more permanent positions. Temporary workers, which represent just 12% of all formal employment, accounted for a disproportionate amount of job growth (41% of the total) between August and December last year. By contrast, since January of this year temps represented 34% of all new jobs which, though still relatively high, represent a substantial decline from the figures between August and December. In our view, this positive trend suggests that businesses are becoming more confident about the sustainability of the ongoing economic recovery.
Last, surveys are showing that industry is turning increasingly constructive about the prospects for hiring ahead. For example, in 3Q10, 24% of participants reported intentions to add workers whereas only 7% plan to let workers go - the best net result in two years - according to Manpower's most recent survey. Once adjusted for seasonality, net intentions to hire for 3Q10 were not far from pre-crisis levels.
Though consumers have started to enjoy modest real wage gains, the outlook depends heavily on the trajectory of labor markets, in our view. Contractual wage increases have averaged 4.6% this year - virtually unchanged from 4.5% over the same period in 2005 - despite the early-year inflation spike caused by the tax reform and higher administered prices. Even though inflation and inflation expectations have moved lower recently, slack in labor markets is likely to maintain contractual wage increases range-bound this year.
Credit and Remittances: Turning the Corner
A turnaround in credit and remittances remain two missing pieces in the consumer story, but even in these two areas we find some reasons for optimism. The slump in consumer credit is subsiding and guidance from banks is turning more constructive. Remittances, meanwhile, appear to bottom out in late 2009 and have improved since in USD terms; the relative strength of the Mexican peso, however, has offset part of the improvement.
Mexico's economic recovery seems to be giving way to increased credit demand, argues Jorge Kuri from our Latam financials team. Given the evident retrenchment of the banks last year, Jorge points out, pent-up demand for credit at the corporate and SME level is high, and should translate into strong lending recovery over the next 12 months. On the consumer side, credit is on the mend, but the pace of recovery is modest still. As improvement in employment and, to a lesser extent, real wages continues, it is likely to lead to stronger demand for consumer credit. Conversations with banks point to a noticeable acceleration in the pace of recovery since April, particularly in vehicle financing and credit cards. Indeed, Jorge and team see consumer credit growing by 20-25% over the next 12 months.
Even though inflows from remittances have stabilized, gains in the exchange rate relative to 2009 levels have hurt recipients of remittances, who do their spending in pesos. Since bottoming at the end of 2009 at a seasonally adjusted pace of around US$1.65 billion per month, remittances have moved up, topping US$1.75 billion per month by April. Though in April, remittances posted their first annual gain (+0.2%) since October 2008, the stronger exchange rate meant that they posted a meaningful annual drop of near 9% from a year earlier once translated into pesos. The good news is that even if the peso were to strengthen to 12.0 versus the dollar, on their current improving path annual remittances growth would turn positive during 2H10.
Bottom Line
Mexico's external-led recovery seems to be finally leading to a more tangible improvement in the backdrop for consumers. Prospects for further employment growth remain favorable, while the recent downshift in inflation has led to modest real wage gains; meanwhile, credit and remittances, though still weak, appear to have turned the corner as well. Incoming data ranging from the sharp upturn in May retail sales to the uptrend in imports of consumer goods and confidence suggest that Mexico's two-tier recovery is gradually becoming more balanced and hence more sustainable.
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