On September 8th, Mexican IRS (SHCP by its Spanish initials) delivered the 2020 Budget to Congress. As expected, most of the fiscal discipline lines remained unchanged: 1) Fiscal surplus of 0.7% (although below 1.3% presented in the pre-criteria); 2) Lower expected growth for this year (0.9% vs. 1.6% of the pre-criteria); 3) Financial requirements of the public sector (RFSP) deficit without much change (2.6% of GDP by 2020); 4) Indebtedness (Historical balances of the RFSPs) at 45.6% of GDP by 2020 (0.5% above those published in the pre-criteria).
A precise estimation of these macroeconomic criteria is of vital importance since income and expenditure relay entirely on them. To err when estimating them could mean falling short to carry out the spending program that the government wants to execute.
An example of the above was announced in recent months, which was endorsed in the text of the 2020 Budget: the use of the Budget Income Stabilization Fund (FEIP, by its Spanish initials) for an amount of $ 129.6 billion (43.8% of the resources available in the fund) to alleviate the lower income received during 2019. This means that the government errs in making its calculations of macroeconomic variables and revenues in the 2019 budget will fall short. However, there is no problem, that is the intention of the FEIP: to be a "cushion" that allows to stabilize the budgetary income if the calculations fail.
However, the FEIP has a limit, and to err constantly might carry out the extinction of the fund, leaving public finances to the sway of global and local shocks. In this sense, after the “bite” that the government will give to the FEIP this year, the stabilization fund will be reduced by 2020 and will have a balance of $ 166.4 billion. Is this enough to face the risks of a sharp fall in income the following year? The answer is not so obvious.
The General Criteria for Economic Policy (CGPE, by its Spanish initials) presents a sensitivity exercise of income and expenditures to the different macroeconomic variables (Graph 1). Let's see how sensitive the numbers are to "realistic shocks" in the macro variables.
The relationship is quite direct. Greater economic growth means greater activity and, therefore, greater tax collection. In fact, for every 0.5% change in economic growth, revenues would move in the same direction $ 17,247.1 million.
I see a problem here. The SHCP is forecasting 2% growth of the economy by 2020, but I think that is a bit optimistic. In the latest Banxico survey, the forecast for 2020 is only 1.39%, and historically, growth forecasts have tended to fall as time goes by, which is not far-fetched to assume for the future if trade war problems continue. Therefore, for the purposes of this analysis, I will assume that next year's growth turns out to be 1%. This would imply a reduction in estimated revenues of $ 34,494.2 million.
If the price of a barrel increases by US$ 1, the oil-related revenue will increase by $ 13,775.80 million pesos. However, if we fall into an economic slowdown due to a slowdown in the US, prices will tend to fall. In fact, the government is assuming this could happen as they lowered the estimated price of a barrel from US $ 55 in the pre-criteria to US $ 49 in the 2020 Budget.
However, the downside risk should not be that worrisome because of the oil hedges that the government have bought this year. Now, if the exercise price of these hedges is at US $ 49 (same as the Budget), then the risk is minimal. If the strike price is lower, then there is a risk in which money could be lost if the price of the barrel falls.
For the purposes of this exercise, we will assume that the government has perfect coverage, and the estimated price of the barrel is what they will receive, that is, US $ 49. Therefore, this macroeconomic variable does not affect us for the calculation of sensitivities.
The exchange rate plays a double role in income / expenditure sensitivities. On the one hand, a depreciation (appreciation) of the exchange rate would increase (decrease) oil revenues; on the other hand, the same depreciation (appreciation) would increase (decrease) expenditures in the form of financial cost due to the interest that must be paid in foreign currency. What effect is stronger?
The effect related to oil revenues is greater, in fact, the size of the effect of the financial cost represents only 10% of the total effect of the change in oil revenues. Given this, that the exchange rate depreciates is positive for the 2020 Budget.
However, the estimated average exchange rate in CGPE is $ 19.9 per USD, slightly above that estimated by the market ($ 19.8 per USD). However, an appreciation greater than that estimated by the market is not difficult to imagine given the restrictive course the Fed has begun to follow. Remember that when the Fed cuts rates, emerging markets benefit. On the other hand, if the commercial war between the US and China continues, Mexico would benefit in terms of exports to the US, strengthening its currency.
In this sense, thinking of an average exchange rate of $ 19.5 per usd is not that difficult, so if we had an appreciation of $ 0.40 per usd in the peso, we would stop receiving $ 13,675.6 million.
I believe that this is one of the most critical parts of the assumptions made by the SHCP. The Budget assumes an increase in oil production of 224 mbd, which implies a growth of 13%. Given the current conditions of Pemex, it is difficult to think of an increase of that size.
The government argues that the rounds made during the last government will begin to bear fruit, however, it is likely that this will only stabilize the drop in production we have experienced month by month.
For the sake of the exercise, and being more pessimistic than in the other points, I will assume that production stabilizes, that is, it does not grow in 2020. This would imply a loss of 224 MBD, that is, a decrease of $ 73,012.35 million in the income of 2020.
The interest rate directly hits the expenditures, especially, the part of the local debt that is referenced at a variable rate: the higher the rate, the higher the interest-derived expenditure.
The budget assumes that the average nominal rate in the year will be 7.4%. In this area I believe that the government has been quite conservative. The consensus expects that Banxico rate to be 7.5% at the end of 2019, with the possibility of continuing to lower its rate. In fact, the consensus assumes that by the end of 2020 Banxico will have the reference rate at 7%.
Given the above, thinking about a lower rate makes sense. For this exercise I will assume that the average rate of the year will be 7.10%, so the expenses will be reduced by $ 5,843.37 million.
It should be remembered that the FEIP also serves to contract the oil coverages mentioned in the second point. These coverages have had an average cost of $ 16,000 million in the last 5 years, so we will assume that by 2020 this average cost remains.
We see that "small changes" in macroeconomic variables could bring a cost of $ 131,338.78 million in the 2020 Budget, which is no small matter. On the other hand, the balance of the FEIP will be 166,400 million, so, although it could help to alleviate the negative effects of a bad estimate in the Budget, it would leave the Public Treasury in a very precarious position to be able to take countercyclical measures in case the income decreases further.
The government is approaching a crossroads. Extraordinary measures to alleviate income shortfalls are limited and we are running out of them. In my opinion, the next logical step should be the implementation of a comprehensive tax reform that is not popular but is very necessary.
Column by Franklin Templeton México , written by Luis Gonzalí, CFA
Luis Gonzalí, CFA, is Portfolio Manager at Franklin Templeton Servicios de Asesoría México. He joined the company in 2013 and is responsible for the fixed income strategies of their funds.
In 2005 he joined Heyman y Asociados.
He is an ITAM graduate that holds certifications from the AMIB and CFA.