Mexico: When Oil Is Too Much of a Good Thing

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Mexico: When Oil Is Too Much of a Good Thing Gray Newman (New York)

While Mexico's role as a major oil exporter in Latin America might suggest that it should benefit from high oil prices, we are concerned with the impact that continued high oil prices could have on both the real economy and the policy measures proposed by Mexico's incoming administration. In our view, the revised oil prices announced by our global economics team, with Brent crude oil prices fluctuating in a $30 to $35 range over the next six months before falling to near $24 by year-end 2001, represent a case of "too much of a good thing" for Mexi co.

Our first concern is the impact that continued high oil prices could have on the fiscal front. We fear that the presence of high oil prices is likely to complicate much-needed fiscal reform. Currently, Mexico derives approximately one-third of its total budgeted revenues from oil-related activity, leaving the federal government vulnerable to swings in the price of oil. While the incoming administration of President-elect Vicente Fox is committed to reducing the role that oil plays as a revenue source, any attempt at reducing the dependency is likely to include a combination of higher tax rates, additional taxes, and greater tax compliance. (It is worth noting that Mexico's fiscal problem is not one of excessive government spending, but rather one of inadequate tax revenues. Indeed, Mexico's tax-to-GDP ratio, near 11% in recent years, is below that of all major Latin America countries.) And while raising taxes is never an easy measure for a new government, especially when faced with an opposition-controlled congress, the task facing Mr. Fox is complicated even further by the current oil windfall. Faced with an abundance of oil revenue, we fear that meaningful measures to enhance non-oil tax revenues will not fare well in Congress. The complications that high oil prices pose for the authorities are already being seen this year. While the Finance Ministry admitted to Congress in its second quarter report on public finances that it had excess revenues due to higher than expected oil prices, it has declined to spend those revenues. The macro-economic justification for declining to spend excess revenues when the economy is in a robust phase is clear; the legal grounds for the Finance Ministry's decision, however, have been questioned by the some members of Congress, who are calling for charges to be brought against the current Finance Minister, Jose Angel Gurria. As long as oil prices remain at lofty levels, the principal fiscal battle in Mexico is likely to involve attempts by the administration to limit spending, rather than seek new sources of non-oil revenues.

Our second concern with high oil prices is the impact on the exchange rate, which has been too strong for too long now. We are concerned that the presence of above-normal oil prices has artificially strengthened the peso. During the first half of the year, domestic demand growth (10%) was outstripping GDP (7.8%) at an unsustainable rate. While there has been some improvement in recent months, the accumulated gap between domestic demand and production continues to grow at a worrisome rate. Normally, such a wide divergence would lead to a growing trade and current account deficit. But the presence of high oil prices has masked much of the deterioration in the external accounts and limited the peso's movement.

One caveat to our concern: While high oil prices have artificially boosted the value of the peso, we are not arguing that the peso is woefully overvalued. We estimate that the current account, which at mid-year was running just under 3%, would be near 4% if oil prices were to fall back to near $20 (a level viewed as normal at the beginning of 2000). It is hard to argue that Mexico cannot finance a current account deficit near 4% of GDP. Still, there can be little doubt that high oil prices are delaying an eventual adjustment to the peso. The longer that oil prices stay at current lofty levels, the greater the risk of a more serious peso correction.

Our third concern with high oil prices is the impact on the US economy and the indirect effect on Mexico growth. Our US economists Dick Berner and David Greenlaw now believe that the risks for growth in the United States are shifting to the downside and have cut their US GDP growth forecast in 2001 to 3.4% (from 3.7%). They argue that uncertainty over the price of oil is likely to weigh on business confidence and investment outlays and is likely to compound the lagged effects of Fed tightening, which are still working their way through the US economy. While we have adopted an out-of-consensus view that the impact of a slowdown in the US on Mexico's real economy is likely to be less serious than most analysts argue (more on that in an upcoming note), there would be some impact. We are in the process of revisiting our Mexican growth forecasts, but would expect to see quarter-on-quarter real GDP growth (seasonally adjusted) slow from its current pace of near 2% (over 7% for the full year 2000) to closer to 1% (near 4.5% for the year of 2001).

Bottom line: Mexico is facing a quandary at the present. If oil prices remain high, Mexico faces the risk of a more serious US slowdown; while an abrupt adjustment to oil prices would likely hit the peso and trigger a tightening from Banco de Mexico to limit the inflationary impact. Sometimes, a period of high oil prices can simply be too much of a good thing.

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-- Martin Thompson (mthom1927@aol.com), October 06, 2000


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