Morgan Stanley: In Search of Mexico's Slowdown

There is a great deal of disagreement over how Mexico will react to the economic troubles seeping out from over its northern border. Gray Newman and Luis Arcentales, writing in Morgan Stanley's latest Global Economic Forum, side with neither extreme view: a brutal Mexican slowdown that will force local interest rates down; or that Mexico's fiscal stimulus will overcome whatever ills may spill over from the U.S.

Mexico announced a fiscal stimulus package last week, and this prompted the slowdown camp to conclude that the situation must be worse than the authorities declare, and that a monetary stimulus would not be far behind. The de-linkers, as Newman and Arcentales call them, believe that the stimulus package will suffice to help Mexico decouple from the U.S. in its times of trouble. The Morgan Stanley analysts find fault in each school of thought, but do agree that Mexico's economy will decelerate in 2008:

We have long argued that the link between the Mexican economy and the US is alive and that it cuts both ways. Of course, a nuanced view is in order. Mexican exporters have taken the first steps to reduce their dependence on the US. Last year, as the US economy began to falter, Mexican exports to the rest of the world grew by 28% compared with a pace of only 5% to the US. That lopsided shift in demand has helped to offset the slowdown in US demand for Mexico’s manufactured products. While non-US-bound exports accounted for just under one-fifth of all Mexican exports, the rapid growth meant that its contribution to export growth nearly equaled that of all US-bound shipments. Meanwhile, with services rather than manufacturing now the key driver of growth and employment in Mexico, the economy is likely to be less vulnerable to weaker US demand than it was during the 2001 US downturn (which followed a manufacturing-led upturn in Mexico).

Morgan Stanley expects the Mexican economy to grow by 2.6% in 2008, which had previously been considered a pessimistic forecast, but is now only slightly below the consensus. Newman and Arcentales do however find some particular points of argument with the slowdown camp: They see no sign of rapid deceleration, and in fact see some signs of a turn-up - retail activity, for example, remains robust; softening in demand is unlikely to prompt any interest rate cut by the Banco de Mexico, as inflation pressure has been supply-led; and the inflation dynamic - pressure from commodity prices - is likely to continue from last year.

As for the de-linkers, Morgan Stanley regards the latest Mexican fiscal stimulus package as "modest at best and likely to dwarfed by the cyclical pressures from the US."

At the end of the day, the evidence is inconclusive either way. Newman and Arcentales summarize:

We expect Mexico’s economy to be tested in 2008 as the US recession unfolds. Our US economics team continues to review its GDP forecast and warns of more weakness ahead. That clearly puts downside risk to our Mexican forecasts in 2008. But we subscribe neither to the camp arguing that the slowdown will be brutal and force Banco de Mexico’s hand to begin to cut interest rates soon, nor to those who argue that Mexico’s fiscal efforts can fully offset the weakening growth dynamic from the US. We would advise caution if investors begin to swing too far to either of these camps.