EMTA Annual Meeting: Deputy Finance Minister Werner Discusses Actions Taken By Mexico To Counter Global Slowdown
Mexican Undersecretary for Finance and Public Credit Alejandro Werner delivered the keynote address at EMTA’s Annual Meeting, held on December 4, 2008 in New York City. In his address, Dr. Werner reviewed the measures taken by Mexico to promote economic growth during the global financial crisis. The event attracted over 300 market participants and was hosted by Citigroup.
In his introductory remarks, EMTA Executive Director Michael M. Chamberlin noted that although many in the audience had worked in the market during several business cycles, “none of us has been around long enough to experience anything like this.” However, he added, the actions taken by governments around the globe offered some hope that the current economic situation would stabilize.
At the outset of his address, Dr. Werner recalled that, during the first half of 2008, the global slowdown started to affect Mexican exports and growth indicators, although the country’s financial markets remained stable. Once financial contagion became an issue in the fall, the Ministry began to promote stability by adopting a countercyclical fiscal policy (taking advantage of recent years of fiscal discipline and an improved debt to GDP ratio) and by providing liquidity cushions. Spending was increased, with new infrastructure projects and additional transfer payments to lower-income families approved.
Dr. Werner listed the many ways the credit crunch has been felt in Mexico: (1) it has reduced consumption, investment and aggregate demand, (2) valuations in the financial markets have fallen, (3) the peso has depreciated, (4) long-term interest rates have risen, (5) credit has contracted, and (6) markets, such as the commercial paper market, have been disrupted. Additionally, the contraction in world trade has hurt Mexican exports, notably those in the non-oil sector. FDI and tourism are also expected to decline.
Government actions have helped to mitigate the effects of the current crisis, Werner underscored. Hedging will, as it has for years, reduce the country’s vulnerability to market fluctuations. In addition, an approximate one-percent-of-GDP cushion in its Oil Stabilization Fund will allow Mexico to “smooth out whatever adjustment might be needed.” Such proactive measures would allow Mexico to implement its 2009 budget “without any problem,” he stated.
In addition, remittances have been “choppy but overall flat in the past ten months,” Werner observed, after having grown by double digits in the recent past and having previously boosted domestic consumption. (Regional vulnerability to remittances varies, he pointed out, with such funds accounting for as much as 50% of disposable income in certain areas.)
Werner spoke on the implications of lower demand for exports on the Mexican economy. Weakness was being felt most dramatically in the mining sector, although the US auto sector slowdown has had repercussions on Mexico’s industrial export sector as well. Werner expected manufactured goods to decline in a “close to one-to-one correlation” with their US counterparts in the foreseeable future. In contrast, the service sector has proven somewhat more resilient because of government policies. Werner forecast a rebound in the construction sector in 2009, boosted by increased infrastructure spending and development bank funding which will substitute for private sector investments which have been disrupted because of the crisis.
Werner attributed the depreciation of the peso to several factors: the change in the terms of trade, the “much deeper recession that is expected in the world economy,” and an overshooting due to the unwinding of derivative positions that had previously been attracted by Mexico’s high interest rates. The government has intervened in the foreign exchange markets to “smooth out” the demand for foreign exchange (as it has also intervened in the local bond market).
“All of these measures have proven to be successful in generating a relatively more stable peso market; at the same time we changed the structure of our public sector debt auctions, moving it to the shorter-term,” Werner asserted. The government has also given “regulatory breathing room” to institutional investors, thus preventing a vicious circle of forced sales. Mexico has also engaged in discussions with the IADB and the World Bank for additional loans in order to boost investor confidence.
In addition to these short- to medium-term policies, Mexico continues work on its structural reform agenda, according to Werner. The country’s major success in 2008 was the approval of the Energy Reform Law, which “we believe is much broader and deeper than many analysts have described.” Passage of the law will allow PEMEX to work more efficiently with the private sector in deep water energy explorations (as well as drilling in more complex geographical areas), and to broaden the scope of potential projects over the next five years. Corporate governance reform in PEMEX, including a more market-oriented incentive structure, will result in the company being “increasingly managed like a commercial firm and less as a government ministry.”
Werner listed other reasons for confidence: (1) Last month Congress approved President Calderon’s October budgetary amendment which further boosted government spending, focusing on security, social expenditures and infrastructure; (2) Mexican development banks have been prompted to make up for financing shortfalls caused by the departure of commercial banks and foreign financing; and (3) PEMEX has been freed from the balanced budget rule, allowing for it to make additional investments (which would be evaluated and approved according to the guidelines at private firms). The 2009 government budget includes a 5.1% increase in expenditures, and Werner took pains to highlight the “huge increase” in public sector investment under President Calderon compared with the previous administration. Werner credited Mexico’s policy of hedging its oil exposure at US$70 per barrel in 2009, as well as federal, state and PEMEX Oil Stabilization Funds, as making this possible.
“We will continue our efforts to strengthen the structural determinants of growth in the economy, adding to some key reforms,” he pledged, and named as a priority the reform of the pension system for state employees which will cut government expenses while serving to deepen the country’s financial markets (as Mexican civil servants are moved to a capitalization system of individualized accounts). Judicial reform will include a speedier resolution of conflicts. Educational reform will include incentives for teachers, and new jobs will be awarded on merit and not “let’s say, on union privileges.” These measures will compliment changes in the financial, fiscal and energy sectors.
Werner acknowledged that the official 2009 growth projection of 1.8% was subject to revision in light of international economic developments, but suggested a wait-and-see attitude was appropriate until conditions become clearer. He acknowledged that private sector forecasts were lower at 0% to 0.8% growth. “This signals our projection has a significant downward risk,” he recognized.
“The actions we have implemented in our domestic financial markets have been well-received by the market, and we will remain vigilant…to provide a relatively smooth adjustment to the new financing conditions that we are facing,” Werner concluded. Following his formal presentation, Werner took questions from the audience on topics such as the possibility of additional loans from multilateral banks, details on Mexico’s oil hedging operations, the role of international banks in the domestic banking sector and the effects of a potential bankruptcy of a major US automotive firm on the Mexican manufacturing sector.
Sell Side Panel: “We’re Down But Not Out”
"We are all in the same boat, down but not out,” JPMorgan’s Joyce Chang affirmed as she introduced the event’s sell-side panel. Ms. Chang offered some thoughts on the lessons learned in 2008 – first, “the audacity of having hope,” which she defined as the additional downside that investors witnessed each time it had appeared the markets might stabilize, and second, the interconnectedness of markets in such a dramatic downturn.
Chang displayed a slide detailing economic forecasts for key economic variables in 2009, noting that broad consensus existed on many EM statistics, in contrast to a wider variation on developed market predictions. Chang drew attention to bullish forecasts for EMBI+ returns in 2009, which implied a 20% return on the EM debt asset class. However, Chang noted that corporates were, in general, more vulnerable than sovereigns during a period of a prolonged new issue shutdown.
Chang polled panelists on which sovereigns were most vulnerable and how much more deleveraging was still to come. Credit Suisse’s Kasper Bartholdy opined that the EM industry has identified as most vulnerable countries with high current account deficits. However, this sort of analysis “hasn’t actually been particularly helpful in explaining the cross-country differences in spreads or to explain the differences in behavior of the exchange rates in recent months.” He specified that countries such as Argentina, Venezuela and Russia trade at wide spreads while having low funding needs; while Poland and Chile trade at comparatively tighter spreads, yet have greater funding needs. Analysts have been focusing on the needs of the banking sector, largely as a result of the recent Iceland crisis. The loan to deposit ratios in a country’s banking sector actually “works pretty well” in explaining the differences in spreads according to Bartholdy, if one excludes Argentina and Venezuela from the analysis. Using this focus instead, Russia, South Africa, Ukraine and Indonesia look cheap, while Kazakhstan, Colombia, Peru and Brazil look expensive.
Deutsche Bank’s Anne Milne, who served as the panel’s corporate specialist, warned that the weakest performance in 2009 could come from Argentine corporates (due to potential foreign exchange controls in 2009) and their Ukrainian counterparts (because of illiquidity in the banking system and necessary government support). In addition, smaller Russian banks which aren’t on the Central Bank’s priority list could be of concern, and surprisingly Chilean corporates have more short-term debt than liquidity, although she doesn’t anticipate a payments problem.
Paulo Leme concurred that corporates were more vulnerable than sovereigns, but added that corporate instability could quickly lead to a sovereign crisis. Bulgaria, Hungary, the Baltics, Romania and Turkey are among the most exposed with the largest financing gaps. He listed Ukraine, Argentina and South Africa as other potential concerns.
Merrill Lynch’s Daniel Tenengauzer, making this first appearance at the Annual Meeting, was watching monetary policy easing very closely, and looking for countries which are acting most dramatically to revive growth. He agreed that CEMEA was the most vulnerable region, and added the Philippines to the list of potential trouble spots.
Chang next addressed the countercyclical policies being adopted in many emerging countries. What other measures should be taken that haven’t already been adopted? Leme replied that, in general, EM countries have responded swiftly to the economic downturn, but that not all countries can enact sustainable countercyclical policies to mitigate against recent shocks. In addition, there might be permanent changes in the economic landscape. Those countries with large reserves and sound fiscal balance sheets should be better able to tackle the global rebalancing problem by boosting demand, increasing fiscal spending and freeing exchange rates, or by letting currencies depreciate. In general, the financing needs are “staggering,” Leme asserted, so he was “not convinced that many countries can drink the Kool-Aid of countercyclical policies.”
Leme suggested that multilaterals could work on improving their credibility and transparency and avoiding any policy flip-flops. He urged that they take a more proactive stance in anticipating problems rather than reacting to them. The US can help by making outright purchases of risky assets by the Fed or using the TARP, as well as actions to lend more aggressively to address the housing problem.
Tenengauzer disagreed with Leme, affirming “there is huge firepower that never existed before.” The market was forcing Central Banks to start using reserves despite prior reluctance. He added that there remained room for interest rate reductions.
Brazil, Mexico and Russia had the greatest scope to support their corporate sectors, according to Milne. She expected Russian support to its banking and corporate sector to continue throughout at least 2009, and referred to the efforts described earlier by Undersecretary Werner to support corporates with temporary liquidity issues.
Prompted to discuss some of the lessons that could be learned from the credit crisis, Tenengauzer opined that “policymakers probably waited too long before they launched the apparatus to fight market volatility.” Bartholdy feared that many countries might perceive the importance of cash-hoarding as an important lesson, as those with growing reserves and current account surpluses have been faring relatively well. Countries might also conclude that one of their goals should be to curb credit growth to avoid banking crises. As for FX regimes, countries such as Russia and Ukraine will realize they would have had less difficulty if they had maintained more flexible exchange rate regimes. “Most other countries learned that lesson a long time ago…during the Asia crisis,” he observed.
The dilemma for corporate issuers was that most of them have to borrow in foreign currency to meet their financing needs, noted Milne. She offered as a possible improvement for the future increased disclosure of short-term debt, and perhaps policymaker monitoring of short-term foreign-currency exposure of their corporate issuers.
A comparative lack of appropriate regulations, capital requirements and supervision in countries with less experience with capital flows hurt some EMEA nations, noted Leme. Having transparent, well-capitalized exchanges such as BM&F and Bovespa was also important, and “is something we should have had in the CDS markets.”
Asked for a summary of the prognosis for EM corporates, Milne believed that these bonds would continue to follow the trends in the US market. When US issues recover—and Milne recognized that 2009 spread forecasts indicated that this was not expected in the near-term—she saw LatAm as being the first outperformers, while Eastern European and Russian names would be laggards. “On average, high-quality Latin corporates have much better credit quality than high-yield indices. Leverage levels are lower, costs of production on commodity companies is lower, many of them have been through crises before, they have clear amortization schedules and they don’t have a lot of short-term maturities coming due,” she stated.
Historically, Latin corporate default rates were lower than in the US market. Deutsche’s forecast of a 4% EM default rate was “fairly aggressive” as no Latin default is expected except perhaps in Argentina. Chang agreed that EM default rates would be low in 2009, noting that much of the borrowing was from quasi-sovereigns or state-supported banks.
The largest risk to the asset class was that the actions taken to restore growth don’t work in 2009 according to Bartholdy who suggested that profits could be made from short-term rate Brazilian and Mexican rates (most panelists agreed), as well as short-term CDS on Russia. For those with longer-term time horizons and willing to sacrifice liquidity, “going out on a limb, Argentine unrestructured external debt looked attractive,” Bartholdy ventured.
In the corporate arena, Milne’s favorites were generally quasi-sovereign and which lead their fields. Conservative picks included Petrobras and Globo, Televisa, Petronas, Gazprom and Lukoil; aggressive names included Argentine oil firms with no prior defaults. Milne would avoid Ukrainian banks.
Leme agreed that, for the short term, receiving rates from Mexico and Brazil was picking the low-hanging fruit. At some point in 2009, being long EM currencies would be attractive after an anticipated overshooting on the weak side. Ecuador was best avoided and Argentina was “perfectly priced” at current levels.
Tenengauzer recommended long Brazilian real positions and shorts on the rand. As for external debt, he would short Russia, Mexico, Colombia and South Korea while buying Indonesia, Brazil and Ukraine.
Finally, Chang noted that Russia was her biggest underweight and agreed that the rand and some CIS currencies were vulnerable. She pointed out that 2010 will be an interesting year, with 35 scheduled EM elections, in a time of growing political tensions and social pressures and slower growth.
Investors Remain Convinced of EM Story in Longer Term
Don Hanna (Citigroup) led the event’s final panel of leading EM investors. Jim Barrineau of Alliance Capital noted that it was difficult to make the argument for significant value remaining in EM, both local and external debt, given current spreads on US high-yields and US investment-grade corporates. “We have significant pockets of money that is non-dedicated which just won’t get into the EM markets right now, except for some minor amounts for diversification, because of a view that the Fed will be able to unlock credit markets, which will benefit US markets.”
Bladex Investment Management’s Tulio Vera warned that the worst was still likely to come, yet agreed with his former sell-side colleagues that there were opportunities in rates. EM equities were probably best played on the short side, and he also leaned towards the short side on FX. “I am relatively agnostic on credit, but I do think credit will be the first to turn,” he concluded.
The argument for EM as a diversification tool has been somewhat discredited, according to Dave Rolley of Loomis Sayles, who underscored the strong correlations as EM tumbled downward with other global markets. However, there remain other strong reasons to be in EM, Rolley argued, citing the forecasts displayed during the first panel which showed expectations for lower EM default rates than in the US.
Hanna asked if longer-term, EM investment might lose some of its appeal because intermediation costs will be higher (as a result of banks needing to reserve more capital) while risk premiums will also rise. Would these combined factors serve to hurt investment and slow growth?
Rolley remained convinced of the EM story. “I would point to the advantages of technology transfer to areas where you can have very high pay-offs,” he responded. Rolley highlighted the extension of the Mexican curve, which had gone from 90 days when he started in EM to its current 30 years. “Mexico went through agony 15 years ago, they moved heaven and earth to rebuild their capital markets, and it worked!”
Vera observed that optimism was much more justified in the Latin markets. However, he warned that, unlike previous crises, the amount of global wealth destruction had been so great that it could be a while before there are inflows into the EMs.
Hari Hariharan of NWI Investment Management specified that the wealth destruction described by Vera totaled almost $50 trillion, including equities and housing price declines, equal to one full year’s worth of GDP. According to Hariharan, the main issue was that there was no discretionary capital left, no proprietary funds left at banks, to take advantage of any opportunities.
What policy decisions would encourage capital inflows into EM? Barrineau acknowledged he remained “massively bullish” on the long-term EM story and pointed out that EM governments were not the ones making “huge policy mistakes,” which he described as allowing Lehman to fail, discretionary changes on the US’ TARP, etc.
As for which countries were doing the best job limiting the external damage, Vera believed it was probably too early to a make a final judgment, but those with the soundest policies were the same last year and this year, e.g. Brazil, Mexico and Chile, while some emerging European countries were “stumbling.”
Rolley’s expressed concern that export-oriented Asian countries might “go old school” and engage in competitive devaluations (a concern later amplified by Barrineau). The potential departure of “hot money” from China was also worth monitoring, as well as the number of closing factories.
Hanna closed the event by inviting speakers to discuss what the sell side was doing well and where it could improve. “Of course everyone will axiomatically say we need more liquidity in the market,” Barrineau stated, while acknowledging that was a tall order in the current environment. Outside-of-the-box thinking is of great value, he added, especially as investors have greater sources of information than in the past, such as economist blogs. Vera encouraged greater factoring in of liquidity when research ideas are proposed.