The Risk of Contagion of a full-blown Mexican crisis is far greater today than it was during the Tequila Crisis 22 years ago.
By Don Quijones, Spain & Mexico, editor at WOLF STREET.
Things are rapidly going from bad to worse in Mexico. Hundreds of people were arrested and a handful of people killed over the past week as peaceful protests against the government’s hike of gasoline prices (by as much as 20% in some states) descended into widespread looting and rioting. The mood on the street was hardly helped when Mexico’s deeply unpopular president, Enrique Peña Nieto, tried to defend his actions by asking the public, “What would you have done?”
For a lot of people, the answer’s clear: a lot of things, very differently. Right at the top of the list would be launching an all-out war against the endemic culture of corruption plaguing virtually all levels of government. But now, time is fast running out as Mexico now faces a hideous constellation of threats and challenges, all at the same time.
There are few bigger threats to Mexico right now than the President Elect Donald Trump, who last week announced the appointment of Robert Lighthizer as the United States’ new Trade Representative. Lighthizer, a trade lawyer and vocal supporter of protectionist policies, is expected to play a leading role in the renegotiation of NAFTA, which helped transform Mexico into a low-cost industrial powerhouse while also shackling its economic fate to its northern neighbor:
The U.S. accounts for 80% of Mexico’s exports, 49% of its imports, and 60% of all its foreign direct investment.
Now that is all at risk. In the extreme event that NAFTA were cancelled, imports between Mexico and the U.S would be governed, at least on paper, by World Trade Organization rules. To access the U.S. market, Mexico would have to pay a tariff of up to 2.5% on all the vehicles it exported and as much as 6.4% on all its agricultural exports. As for the U.S. it would have to pay tariffs of 7.7% and 38.4%, respectively, in order for its industrial and agricultural products to reach the Mexican market.
The ramifications of such a sea change in trade relations are almost unimaginable. According to a report by Bank of America Merrill Lynch, cited by the Spanish daily El Economista, if Mexican exports to the U.S. fell by 25%, Mexico’s annual GDP growth could shrink by over one percentage point. The contraction could be as much as 3 percentage points if Trump were to seize the nuclear option of completely cutting off trade relations between the U.S. and Mexico. Whatever Trump decides to do, one thing is clear: Mexico’s industrial base is likely to suffer.
The biggest problem facing Mexico’s much diminished oil giant, Pemex, in 2017 will be finding a way to service a growing debt pile of over $100 billion – most of it denominated in foreign currency – from the proceeds of a continually shrinking revenue base. According to Mexico’s Business Coordinating Council, Pemex doesn’t just have temporary short-term liquidity problems, as the company’s senior management and Mexico’s Finance Ministry contend, but is suffering from a structural deterioration that poses a serious threat to its long-term viability.
This deterioration is the result of “decades of bad management, lack of vision, negligence, abuse and in many cases, corruption.” The Mexican daily La Jornada went further, arguing that the company has been systematically “plundered” during successive administrations, including, of course, the current one.
If Pemex is unable to service its debts, Mexico’s increasingly debt-burdened government will have to step in, again. The problem here is that Mexico’s government is also struggling to rein in its own addiction to debt, with some states already on the verge of bankruptcy. One state governor, Javier Duarte of Veracruz, did so much fiduciary damage during his mandate that he’s now on the run after allegedly misappropriating vast sums of public funds.
By the end of 2016 Mexico’s total public debt is expected to have reached 50% of GDP for the first time in decades. In 2008 it was just over 20%. Some of this debt is denominated in dollars, euros, yen, and other currencies, which will become difficult to service as the peso comes unglued.
At the end of last week, the peso tumbled to its lowest level ever, prompting the central bank, lovingly called Banxico, to step into the FX market by selling about $1 billion USD spot in a desperate bid to halt the peso’s relentless depreciation against the dollar, or, as the central bank market operations manager put it, “strengthen the peso.”
But as was the case with the central bank’s previous interventions, developments beyond Mexico’s borders, in particular in Washington and New York, would ultimately dictate the movement of Mexico’s currency. All it took to undo the desired effects of Banxico’s $1 billion intervention was one Tweet from Trump threatening to impose tariffs on Toyota if it chose to expand its production operations in Mexico.
Banxico stepped in again during the late hours of Thursday evening with an as-yet undisclosed amount of dollar sales – enough to steady the currency for at least a day or two.
The potent combination of a slumping peso and the Mexican government’s recent hike in gasoline prices is almost certain to fuel inflation, which is already above the central bank’s target rate of 3% annual. In January alone it’s expected to surpass 1% on a monthly basis, its highest level since the year 2000. Meanwhile, Banxico’s desperate bid to tame inflation, by hiking interest rates, risks further constraining internal demand, which in turn places even further pressure on retail companies that are struggling to pay off their increasingly costly dollar-denominated debt.
As Goldman Sachs notes, the last time the peso’s Real Effective Exchange Rate (REER) was weaker than it is at present was in the wake of the 1994-1995 “Tequila” economic and banking crisis, which unleashed destabilizing effects across the whole Latin American region and put at risk some of Wall Street’s finest, including, ironically, Goldman Sachs itself. Things got so serious that the IMF and other international financial entities felt duty bound to engineer a massive bondholder bailout.
Capital Flight, Part II
Now, much as then, there is a pronounced risk of capital flight from Mexico. As Professor Javier Santacruz of Spain’s Institute of Stock Market Studies (IEB) warns, if Trump does launch a trade war against Mexico, it risks triggering capital flight from Mexico toward the U.S, which risks being further exacerbated by the rapid appreciation of the U.S. dollar and an exodus of investments toward other Latin America countries, which currently offer greater growth potential than Mexico.
But it’s not just Mexicans that should be worried. The risk of contagion of a full-blown Mexican crisis is far greater today than it was 22 years ago. As author and former investment banker Nomi Prins points out, Mexico has the largest concentration of foreign bank ownership of any country in the world (mostly thanks to NAFTA stipulations).
And the world has never been so invested in Mexico as it is today. As we reported a couple of weeks ago, foreign investors hold around $100 billion of Mexico’s local-currency government debt, the most for any emerging market economy. By Don Quijones, Raging Bull-Shit.
The Mexican government had used Pemex as an endless ATM, but now the oil company is stewing in a toxic mix. Read… Shrinking Oil Giant Pemex Starts 2017 on Wrong Foot