A Preliminary Case For Chile Over Mexico

by: Ulysses de la Torre

If mainstream media hype is any indication of a market's peak, then Mexico (EWW) has got to be nearing its top by now. In just the past week, Tom Friedman of the New York Times wrote from northern Mexico, "U.S. companies are expanding here, which is one reason Mexico grew last year at 3.9 percent, and foreign direct investment hit record highs."

Two days before him, Toronto's Globe and Mail, in an article entitled, "With eyes on trade, Canada courts resurgent Mexico," quoted Canadian Foreign Affairs Minister John Baird as saying, "Mexico, in our lifetime, is going to be a top-10 world economy, and potentially in our lifetime, a top-five world economy."

To call either of these statements misleading would be polite. In the case of Friedman, foreign investment to Mexico last year was in fact negative, as I will discuss further in a moment. In the case of Minister Baird, if we assumed Mexico's 3.9% real growth last year were to continue into perpetuity (an overestimation, according to Economist Intelligence Unit forecasts), and we further assumed that every other economy presently larger than Mexico's experienced zero growth during the same period, Mexico would finally supplant India as the tenth largest economy in the world in 2026. For the sake of reference, India had real growth of 5.8% last year and is forecasted to average 6.4% real growth annually through 2030, (again, from the Economist Intelligence Unit). But even if India's real economic growth suddenly stopped at zero along with everyone else and held there while Mexico carried on with a generous 3.9% real growth forever, Mexico would eventually pass France in 2033 to be the fifth largest economy in the world.

Friedman and Baird are only the latest in a long line of well-meaning but ultimately overzealous well-wishers. In January, the Financial Times declared Mexico an "Aztec Tiger" while Chris Anderson, née of Wired Magazine promoted his new company on the New York Times' op-ed page in an article entitled, "Mexico: The New China," before them, countless others have been declaring Mexico to be the "new China," including Barron's, Zacks and even the Christian Science Monitor which apparently was way ahead of the curve in its September 11, 2008 article, "Is Mexico the New China?"

Putting aside for a moment the exhaustive use of "X is the new Y" to declare the next hot investment destination, a brief look at some basic macroeconomic indicators suggests that Chile (ECH) is at least as compelling an investment destination as Mexico, if not more so.

The most recent signal came last month in the form of the UN Conference on Trade and Development's (UNCTAD) Global Investment Monitor report, which showed that as of last year, Chile has surpassed Mexico to become the second largest recipient of foreign direct investment in Latin America after Brazil (EWZ):

UNCTAD FDI Inflows 2010-12

Note not just the absolute FDI numbers in the chart of $26.4 billion versus $17.4 billion but also the growth rate from 2011-2012: 52.7% vs. -16.5%.

The difference is even more pronounced on the following page of the report, in which Chile M&A net purchases grew more than 800% while Mexico's shrunk by 44%:

UNCTAD cross-border M&A

Since then, Chile's central bank followed up by announcing its own estimate that FDI in Chile reached a record US$28.152 billion, a 62.7% increase from the previous record of US$17.299 billion in 2011.

What's more is that Mexico's negative FDI was already evident by halfway through last year. The details of Mexico's economic merits at this point are so proliferate and frankly so loaded with caveats that I'm not going to spend a lot of time here dissecting what to believe and what not to believe. To newcomers looking for my basic view on the state of things Mexican, my July 3 article in Seeking Alpha is a good place to start, and I purposely wrote it with the longer term in mind, so I believe it remains as relevant today as it did then. For those seeking something more current, I would very strongly recommend Alejandro Schtulmann and Sergio Broholm in Economonitor with "Mexico s Tax Reform in the Works: Preview and Initial Considerations."

For more detailed background of Chile's economy, BBVA's recent economic outlook isn't a bad place to start (available here).

But since pictures tend to speak louder than words, I think a preliminary case for Chile over Mexico can best be made with some comparative charts. All data to follow is from the Economist Intelligence Unit except where noted and all data points post-2012 are forecasts. The way I've broken this down is to first look at the main economic indicators pertaining to absolute size so that we all begin with some reference point of who's bigger than whom. For me, this means nominal GDP and central bank reserves:

Latam Nominal GDP 2008-17

Latam CenBank Reserves 2008-17

Notable here is that Peru (EPU) has the smallest economy of the five and yet has a greater central bank reserves stash than Chile or Colombia (GXG). This obviously speaks to a relatively larger engagement of, or dependence on, or involvement in commodities. Also worth noting is that Mexico's economy is almost five times larger than Chile's.

After nominal GDP and central bank reserves, everything else I look at is about controlling for the size variable so that we can better compare apples to apples. Since we just finished looking at central bank reserves, let's consider import cover, which measures how many months of imports can be covered by those central bank reserves. This filters out the absolute size of an economy by assessing the relationship between central bank reserves and trade balance. In plain English, what we're measuring here is a country's ability to weather a rainy day that winds up lasting longer than one day - that is, if Armageddon hits and a country stops generating revenue and has to live by spending its savings on imports, approximately how long can it survive before the money runs out?

Conventional wisdom dictates a minimum of three months' import cover for countries not overly dependent on commodity exports. Major commodities exporters, because they sell so much product priced in dollars, can run an import cover well above 12 months (to give you an idea of the high water mark, Saudi Arabia's import cover last year was 32 months; by contrast, the last time the United States had an import cover above ONE month was 1995, but that's a conversation for another day). Here's how Latin America's main five break down:

Latam Import Cover 2008-17

Brazil and Peru consistently maintain a minimum of 12 months' import cover, which is to be expected. Chile and Colombia are comfortably above the 3-month mark. The main story on this chart is that Mexico, given its known oil stash, not to mention sizable remittances inflows, is behaving like it has no natural resources of note. Mexico's oil policy is widely known to be in desperate need of reform, and the likelihood of an effective reform happening still remains very much up in the air. This isn't a death knell in and of itself, but something to keep in mind as we proceed.

It's hard to talk about Chile without talking about copper (CU). Copper makes up half of Chile's exports and China is Chile's top export market. Last year, China accounted for just over 20% of Chile's total exports, about equal to the second and third export destinations, Japan and the US, combined. So that we have this fully accounted for, the following chart, taken from the BBVA report mentioned above, shows where copper has been since 2008 and where it is forecasted to go.

Copper price forecast

Bear in mind that the price of copper has an approximately inverse relationship to the value of the US dollar, which brings us to our next chart, relative currency performance, with the dark days of October 2008 taken as the starting point (source: Oanda.com).

Latam FX performance Oct 2008 - Jan 2013

Obviously an appreciating currency is not automatically good or bad. However, in the global market environment we've been subjected to in recent years, the Chilean Peso's resilience above its counterparts is notable.

Generally speaking, a declining currency value is viewed as a warning flag for rising inflation since it implies more local currency needed to pay for imports. As we see below, starting in 2009, Chile has managed its inflation better than Mexico and is forecasted to continue doing so:

Latam Inflation 2008-17

A natural segue from inflation is how it affects economic growth. Below we have economic growth after accounting for inflation. I've also looked at this very same data on a per capita basis and the look of the chart is practically identical. Chile consistently beats Mexico, past, present and future.

Latam Real GDP Growth 2008-17

I once had an economics professor who preached that the truest test of a country's economic policy is not when times are flush, but when times are hard. Of all the data points in the real GDP growth chart above, the most striking to me is that the widest gap between Mexico and Chile came in 2009, when everyone everywhere was having a hard go of it, though the fact that Peru and Colombia still managed to sustain net positive growth that year is also notable.

Of all the lessons that we should have learned over the past decade, somewhere near the top of the list, if not the very top, would undoubtedly have to do with public debt management. So here's what public debt as a percentage of GDP for these countries looks like.

Latam Public Debt 2008-17

And because this statistic has played such an integral role in the global economy being where it is today, I think it's worth taking a moment to view these countries in a broader context. Public debt as a percentage of GDP and accompanying domestic credit growth last year in the world's largest economies versus our Latin American five:

Public Debt v Domestic Credit Growth

A few quick observations from these two charts:

  • Public debt is inversely proportional to credit growth.
  • In the broad scheme of things, Mexico isn't doing too badly on this front. But Chile is still managing lower public debt than Mexico and is forecasted to continue doing so.
  • Not only is Chile once again surpassing Mexico, but Chile last year had both the lowest public debt as a proportion of its GDP and the healthiest credit growth of any of these countries, aside from Russia, which is an entirely separate conversation.
  • I don't want to get off topic, but it's worth briefly noting that one unwritten rule has it that domestic credit growth exceeding 20% for five consecutive years is one sign that the economy is likely overheating. Russia has registered credit growth far in excess of 20% every year since 2006.

To recap, Chile has had and is forecasted to continue having better central bank reserves management, inflation, real GDP growth, public debt management and currency strength than Mexico. Other common economic indicators I did not include here: trade balance as a proportion of GDP, current account balance as a proportion of GDP and budget balance as a proportion of GDP. I looked at every one of them, and the differences were negligible. On paper, Chile consistently posts healthy economic indicators relative to the other investable countries in the region, and particularly against Mexico.

Given no shortage of hype surrounding Mexico's rise, one would think that Chile surpassing Mexico on the foreign investment rankings would be a story worth telling. Yet Chile's ETF performance to date lags Mexico's:

Latam ETFs from Oct 2008

Latam ETFs from June 2009

Where the starting point should be here was a toss-up: some country ETFs bottomed out in mid-October 2008 and others bottomed out around March 2009. I've chosen the first date for the sake of including more data points. In the case of Latin America, Brazil, Chile and Mexico were the only three country ETFs available at that point. Colombia came on board in February 2009 and Peru in June 2009, hence the second chart for a reference point that included them.

How is it that Chile's ETF lags Mexico's?

One reason might have to do with volume - EWW routinely turns over two to three million shares daily, sometimes reaching as high as seven million. Meanwhile ECH has broken the one million mark only seven times since October 2008, otherwise averaging volumes under 200,000. One upshot of low liquidity is that prices can remain unnaturally depressed due to disaggregated bid/ask spreads. The flip side of the same coin is that a less liquid share price doesn't need a lot of transaction activity to see upward movement.

We know that EWW has been weighted to reflect the Mexican equity market and ECH the Chilean equity market. Perhaps the issue here is to what extent either of these countries' ETFs reflect actual economic activity. In the case of Mexico, Morgan Stanley's Ruchir Sharma pointed out in his recent book "Breakout Nations" that the 10 wealthiest families in Mexico account for more than a third of its total stock market value, one of the highest concentrations among all emerging market economies. This very well known disparity would partly explain how Mexico's equity market, as represented by EWW, can outperform Chile's, while Mexico consistently lags Chile on every other economic indicator considered.

What else are we not seeing here?

There are those who claim FDI is a lagging indicator. If that's the case, then that would imply Mexico's negative FDI last year is a reaction to its economic health in the years preceding it. If so, this might mean Mexico's negative FDI last year was just an aberration, and the obvious exclusion from this figure of the US$20.1 billion AmBev (ABV) paid for Grupo Modelo would indeed suggest a positive inflow when this transaction is presumably counted for 2013. But the fact that Mexican FDI leans so heavily on this one-off transaction does not bode well for broader economic health.

Regardless, the new government in Mexico has, as of this writing, yet to do anything beyond talk to prove it will actually manage Mexico's economy in a materially different way than its predecessor.

There must be more to this story.

The big earthquake in Chile, which claimed some 525 lives, was in February 2010. Nothing in any of the above charts indicates that this event had a substantive effect on any of Chile's broader economic indicators.

I know social scientists who argue that Chile's social turmoil is holding it back from reaching more of its economic potential. It's a fair point, but at the risk of sounding reductionist, each of Latin America's five most investable economies has some huge non-quantifiable social or political risk holding it back. Suggesting that these qualitative risks all cancel each other out might be a bit presumptuous, but certainly the extent to which any of them would affect investment performance is completely subjective and impossible to measure.

How about this: maybe we're not missing anything. Maybe Chile bridging the foreign investment gap with Mexico last year was just the beginning.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ECH over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.