With global oil prices remaining well below expectations and the Mexican peso experiencing severe weakness over the last few months, the Mexican government and central bank joined forces on Wednesday last week in a show of force to tackle growing fears of rising inflation, greater fiscal deficits, and a fast-depreciating Mexican peso. Finance minister Luis Videgaray announced budget cuts of 137 billion pesos, while central bank president Agustin Carstens increased the benchmark interest rate by 50 basis points. These preventative measures will help cement Mexico’s position as a bulwark of macroeconomic stability, but will yield significant negative implications for the market’s short-term economic prospects.

A largely preventative set of measures

The preventative budget cuts (amounting to 0.7%) were enacted to avoid further increases in public debt and a need for tax increases that may undermine private investment and domestic consumption. These cuts compound the more austere budget put in place for 2016, and fall predominantly on PEMEX (cuts amounting to US$5.5 billion on the state-owned oil company). The rest of the cuts will affect federal government spending, with the finance minister promising that cuts will largely be applied to current spending rather than to investment spending.

The increase in interest rates is a clear demonstration that the recent increase in inflation led to growing concern that the pass-through impact from currency depreciation would be much higher than what Mexico experienced last year. The private sector, which loathes price increases, has confronted an unexpected further depreciation of the peso since the beginning of 2016. Now companies are choosing to increase prices to compensate for rising import costs. Inflation has crept up quickly so far this year, though it remains below Banxico’s 3% target.

Impact on multinationals

• Pressure on the peso will recede momentarily, but volatility will persist: While these pronouncements have helped strengthen the Mexican peso recently, multinationals should not expect the global volatility that has hammered the Mexican peso to recede. The Mexican peso will continue to face severe pressure (largely due to the currency being among the most liquid emerging market currencies), and further depreciation towards a 20 MXP/USD exchange rate at some point this year remains likely. Multinationals need to plan accordingly
• Interest rates will continue to rise: While Mexico has been able to keep interest rate increases lower than other Latin American markets, the unexpected increase in inflation coupled with likely persistent volatility for the Mexican peso almost certainly mean that Banxico will need to increase interest rates later this year. Tightening credit conditions are likely to mute consumer credit demand and investment appetite, which will impact overall economic growth
• Government spending cuts will dent overall growth: Confirmation that the government will not increase taxes as part of future adjustment measures should hearten multinationals across B2C and B2B industries, but the impact on investment from spending cuts, particularly on energy investment by PEMEX, will be dire for the economy’s short-term performance. PEMEX will see a 20% budget cut this year, likely impacting production this year

Mexico’s prospects are dimming, but the market’s stability remains solid

Multinationals will need to quickly adjust their expectations for the Mexican economy’s performance this year. Economic growth is now likely to fall closer to 2.2-2.3% in 2016, down from a forecasted 2.8% earlier this year (although electing not to proactively tackle the adjustment would be worse, as we have seen in Venezuela and across other emerging market petrostates). Mexico remains an oasis of stability within an increasingly volatile and adverse global economy.

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Photo Credit: Geraint Rowland