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Economics & StrategyLatin America MexicoMexico InsightsMonthlyThe external sector passes the torch tothe domestic sector9 October 2012Sergio MartinChief EconomistHSBC Mexico, S.A.abcGlobal ResearchFeatured article: Labor reform andtransparency law: steps forwardThe domestic economy holds upQE3 and structural reforms momentumsupports a flatter yield curveImproving the Federal Labor Law and makinguse of public resources more transparentThe Institutional Revolutionary Party (PRI), the Green Party(PVEM), and the National Action Party (PAN) reached anagreement to advance most of the proposed amendments tothe Federal Labor Law (FLL). In our view, the amendmentsrepresent a step toward a more-flexible labor market. Thenew FLL provisions promote productivity, improve laborconditions, regulate outsourcing practices, and createcontracts involving payment by the hour. In addition, theupper house passed the General Law on GovernmentAccounting (GLGA), which seeks to improve transparencyof spending at all levels of government. The measure nowgoes to the lower house.A weaker economy in sight+52 55 5721 2164Lorena DominguezSenior EconomistHSBC Mexico, S.A.+52 55 5721 2172Claudia NavarreteEconomistHSBC Mexico, S.A.+52 55 5721 .mxWhile we maintain our position that the economy willweaken over the second half of 2012, we see some delay inits materialization. Indeed, domestic demand has taken thetorch from the external demand and gives the extra mile tothe economic strength observed in 2012. We expectpressures on inflation to take it above 4.0%, although wealso expect a decline in 2013. The MXN continues to besubject to the external environment and technical constraints,Alejandro Martinez-CruzFixed Income Strategistbut we estimate an appreciation path. We may have noisypolitics in the struggle to pass structural reforms, butHSBC Mexico, S.A.+52 55 5721 .mxperspectives on this front look positive.Receive 10Y TIIELocal rates have been supported by QE3 and the structuralView HSBC Global Research at: http:/reforms momentum. The 10Y sector of the TIIE curveremains more appealing than the 5Y sector as investors willIssuer of report:HSBC Mxico, S.A., Institucin de Bancabe looking for duration. Thus, we remain engaged in our 10yMltiple, Grupo Financiero HSBCDisclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of itTIIE receiver position (target: 5.60%, stop: 6.20%). Forthose interested in MBonos, we recommend that investors golong MBonos June 2022.UnitedCanadaUnitedIrelandSwitzerlandAustraliaIcelandIsraelNewJapanSlovakDenmarkHungarySwedenItalyKoreaPolandAustriaOECDNetherlandsCzechFinlandEstoniaGermanyBelgiumChileNorwayGreeceSpainFranceMexicoPortugalLuxembourgTurkey4.03.02.01.00.0Economics & StrategyLatin America Mexico9 October 2012Increased labor flexibilityand transparency forpublic resourcesThe lower house approved the Federal Labor Law; the upperhouse also may pass it in October after revising itThe upper house approved the transparency law, which goes tothe lower house for any revisions and approvalWe see strong prospects that local curve could flatten on laborreform approvalabcThis section is a reprint of our 5 October 2012report, Mexico Economics & Strategy: Laborreform and transparency law: steps forward.More flexible labor marketThe lower house approved most of the economicproposals contained in the labor reform measuresent by President Felipe Calderon. The FederalLabor Law (FLL) enacted in 1970 is one of themost rigid among member states of theOrganization for Economic Cooperation andDevelopment. Thus, in our view, the amendmentsthat were advanced would allow the country toHere are the main aspects of the labor reform:Promotes different types of employmentrelationships. It regulates six different types oflabor contracts, such as specific job, determinedperiod of time, seasonal job, and undeterminedperiod of time, probation period and initialtraining. All these categories have access tosocial security, wages, and other benefits. Inour view, this generates proper incentiveseither for enterprises to generateemploymentor for employees to be more productive.Strictness of employment protectionSergio MartinChief Economist+52 55 5721 .mxLorena DominguezEconomist+52 55 5721 .mxAlejandro MartinezFI Strategist+52 55 5721 .mxhave greater flexibility in its labor market,promote productivity, improve labor conditions,and facilitate hiring and firing of workers.However, effects of the reform would take time tomaterialize, as enterprises and workers wouldhave to adapt to new practices and regulations.Source: OECD2Economics & StrategyLatin America Mexico9 October 2012Creates contracts involving payment by thehour, considering that calculation of the hourlyrate should not be less than the correspondingvalue of a full working day. It would createconditions for young people and women tofind part-time jobs, promoting formalemployment and making the labor marketmore flexible. This might also help reducethe number of “neets,” short for “not inemployment, education, or training,” in thecountry. According to the OECD, Mexicohas the third-highest number of “neets”among OECD member states.Favors productivity and labor skills as the maincriteria to promote workers, in contrast to theinitial law that forced enterprises withcollective agreements to promote workersbased on their labor seniority. It acknowledgestraining as most important factor to increaseproductivity and considers creation of aNational Committee for Productivity. This, inour view, represents a significant step toincrease productivity, which is the best wayto create economic wealth.Limits to one year unpaid wages duringjudiciary decisions. We believe that thisprovides legal certainty and avoids abusesof labor court procedures that in manycases take small enterprises to thebankruptcy proceedings.Regulates hiring by intermediaries. It forcesemployers or intermediaries to provide socialsecurity benefits to employees.Improves labor conditions for mining, rural,and domestic workers, and provides for fivedays of paid paternity leave.However, the amendments that were aimed atforcing labor unions to become more transparentin their functioning were not approved, becausecongressional representatives that belong tounions vetoed them.Government accounting: thenext step to strengthentransparencyThe upper house approved and sent to the lowerhouse the General Law on GovernmentAccounting (GLGA) sent by President Calderon,which seeks to strengthen transparency ingovernment spending at all levels of government.Here are the main aspects of this measure:All levels of government would be required topublish all financial information in uniformformats and update information onexpenditures of public funds. This wouldallow making comparisons, whichfacilitates finding irregularities andfighting corruption.State revenue laws and state budgets wouldbe reduced to a minimum in a uniformmanner across the country. This wouldprevent states from excess borrowing andavoid fiscal problems at the federal level.The main audit body, the Supreme AuditOffice, would have more powers.More severe penalties would apply whengovernment officials failed to fulfill the law,including higher fines and prison terms aslong as seven years. This might improveaccountability of public officials and helpavert corruption.Structural reforms momentumThe PRI, the Green Party (PVEM), and the PANreached an agreement and approved a substantialnumber of amendments to the FLL, as well as theGLGA sent to Congress by President Calderon on1 September.abc350-5-10-15-20Economics & StrategyLatin America Mexico9 October 2012In the lower house, the labor reform was approvedwith 351 votes in favor: 209 from the PRI, 114from the PAN, and 28 from the Green Party.Votes against all came from leftist political partiesand totaled 128: 100 from the Party of theDemocratic Revolution, PRD, 13 from the LaborParty (PT), and 15 from the Social MovementParty (SMP). There were 10 abstentions from theteachers union political party, PANAL.The GLGA was advanced with 104 votes in favor,3 against, and 3 abstentions in the upper house,which is composed of 128 senators.These two reforms are evidence that the PRI andthe PAN can reach agreements and set conditionsfor the next presidential administration to functionproperly and advance terms of pending structuralreforms. The party of President-elect Enrique PeaNieto, who will take office on 1 December, did notwin majority in Congress, and thus needs thePANs support for passage of important reforms,such as on fiscal and energy issues. Hence, thepolitical incentives from both political parties arealigning for passage of pending reforms.What does labor reform meanfor FI markets?To answer this question, first we have to ask whetherlabor reform could help to reduce the mainvulnerabilities of Mexico established by creditagencies following the 2008-2009 global financialcrisis. These are: a) a low economic growth rate, b)public finances that are highly dependent on oilrevenues, c) limited room to undertake fiscalApproval of key structural reforms regardingfiscal and energy issues would contribute to GDPgrowth to attract more private investment, bothforeign and domestic, and to increase non-oil taxrevenues. All these together would contribute toreduce the vulnerability of the country to externalshocks. The sharp impact of the 2008-09 globalcrisis on Mexico was explained by its strongdependence on the US economy and vulnerabilityof fiscal accounts to a global slowdown.Fixed income markets deteriorated sharply in2008-09 and reflected the weakness of theMexican economy. Thus, the latest structuralreforms would contribute to lower the country riskpremium. If that were to happen, we could see areduction in Mexicos credit default swaps levels,tighter spreads between Mexicos hard-currencybonds and developed-market bonds, and a flatterlocal yield curve.CDS market: Little room for compressionThe 5Y CDS of Mexico has been consistentlytrading through the average level of the LatAmlow betas (Brazil, Colombia, Panama, and Peru)since 1Q11. Following the July presidentialelection, this spread widened even more, but it hasshrunk recently. Thus, if structural reforms wereto materialize in the coming months, we believethere is room for this spread to widen again.The credit spread between LatAm “BBB”countries and Chile, the only country in the regionMexico 5Y CDS vs average LatAm “BBB” ex-Mexico 5Y CDSabccountercyclical policies, d) low foreign directinvestment (FDI) as a share of GDP, and e) lack ofagreements to undertake structural changes. There isno a direct link between labor reform and reductionof the vulnerabilities, but approval of labor reformcould become a game-changer to unlock the10bpstructural reforms agenda that has been stuck for theJan-2011 May-2011 Sep-2011Jan-2012 May-2012 Sep-2012past 12-15 years.4Source: BloombergMex vs Latam Low Betas8070605040302010060%50%40%30%20%10%0%Economics & StrategyLatin America Mexico9 October 2012with “A” rating, has compressed throughout thisyear. Yet since 2Q12, the Mexico 5Y CDS hastightened faster than the rest of LatAm “BBB”credits. Indeed, the spread reached a level of 10bpjust a few weeks ago. Thus, it seems the ambitiousreform agenda of the incoming administration haspartly been incorporated by the CDS market.5Y CDS Mexico vs Chile & LatAm BBB ex-Mexico vs Chilebpfaster. Now AUM grows at an annual rate between15-19%, much faster than economic growth andlocal debt issuance growth. Also, these growthrates would continue in the next 10-15 years due toa demographic bonus, as more young people willbe sufficient to support the pension system. Thus,if the growth rate accelerates due to higheremployment levels, demand for local bondscoming from Afores would increase, in particularthat of long-term bonds, of which Afores hold49% of the total amount outstanding. Yet, if theinvestment regime that applies to Afores changesand allows them to increase investments overseas currently there is a limit of 20% of AUM theeffect of the labor reform in the long end of theabcJan-2011 May-2011 Sep-2011Jan-2012May-2012 Sep-2012curve should be milder.Mexico vs ChileLatam BBB ex-Mexico vs ChileAll in all, we believe that momentum for local ratesSource: BloombergGlobal Bonds: Something has been priced inWe believe there is more room for UMS spreadsto tighten. As we look at current spread levels oflow betas relative to the tightest levels of the EMsovereign index, Mexico sticks out by being onthe wide end of the range. The 10-year UMS Z-spread has been tightening by 90bp since mid-June. Yet it still trades wider than the 10yBrazilian global bonds. Also, Mexico has beenunderperforming other high betas in the past fewweeks. Thus, although it seems that some of thereforms approval is priced in, we believe there isstill some room for UMS bonds to tighten withrespect to US Treasuries.Local rates: We see a flatter yield curveThe impact of the labor reform on local ratesremains favorable, supported by a bunch of globalliquidity, lower US yields, and local structuralreforms momentum. Moreover, the potentialdemand for local bonds coming from Aforesfollowing labor reform approval would contributeto flatten the curve. To reflect this favorablemomentum, we are still recommending investorsreceive 10Y TIIE (target: 5.6%, stop: 6.2%).Distribution of 20Y and 30Y MBonos holdingsshould be positive in the following ways: 1) TheAforesForeign inv estorsOther local inv estorsstructural reforms momentum may increase theappetite for duration and, for instance, flatten theSource: Banxicolocal curve. 2) If labor reform increases jobcreation, more people would enter the pensionsystem, and assets under management (AUM) bylocal pension funds, the Afores, would increase5Economics & StrategyLatin America Mexico9 October 2012Economic outlookThe expected weakening for the Mexican economy may bedelayed thanks to a strong domestic sectorPressures may keep pushing inflation above the upper bound ofthe 2-4% targetIn spite of looser monetary policies abroad and inflation concerns,Banxico may keep its rate on hold for a long timeabcA domestic fighterBottom line: While we maintain our positionthat a weaker economy is in sight, we see somedelay in its materialization. Indeed, domesticdemand has taken the torch from the externaldemand and gives the extra mile to theeconomic strength observed in 2012. We seepressures on inflation that may take it above4.0%, although we may also expect a decline in2013. The MXN continues to be subject to theexternal environment and technicalconstraints, but we estimate an appreciationpath. We may have noisy politics in thestruggle to pass structural reforms, butperspectives in this front look positive.Global economic perspectives remain challenging.The US may grow slightly above 2.0%, whileEurope is expected to remain in recession againin 2013. Emerging countries are holding upbetter. Therefore, monetary policy has becomeloose for longer.This weak global scenario is moderating theMexican exports growth rate and will likely hitthe rest of the economy sooner or later. However,domestic demand has helped offset this reduction,6keeping the economy growing at 3.6% or evenhigher in 2012, while we estimate a reduction to3.2% for 2013.Domestic demand explains the vigor in theeconomy thanks to higher credit availability,wage mass increases, and an improvement inconsumer confidence.Additionally, we expect FDI and portfolio inflowsto prevail this year and next, as conditions abroadand domestically could keep attracting investors;consequently, we believe that the accumulation ofreserves will continue.On inflation, food price increases abroad anddomestically combined with pressures from themerchandise component may have an unfavorableimpact. Consequently, we expect inflation tomaintain its upward trend before receding to 4.1%at end-2012, but slowdown to 3.6% in 2013.In the meantime, the MXN continues to behostage to external events and technicalconstraints; we estimate MXN13.5/USD at end2012 and MXN12.9/USD for 2013.Moreover, in spite of a context of globaldeceleration and looser monetary policy abroad,Sergio MartinEconomist+ 5255 5721 .mxLorena DominguezEconomist+5255 5721 .mxClaudia NavarreteEconomist+5255 5721 .mx(USDm)28,00026,00024,00020,00016,00014,000Economics & StrategyLatin America Mexico9 October 2012Banxico has adopted a neutral stance because ofNon-oil exportsabcinflation pressures and uncertainties in Europeand the US that might trigger risk-off episodesthat might impact negatively the MXN.22,000While we are positive on Mexican perspectives, wesee risks because of the negative externalenvironment and that the left opposition may alsobecome an important obstacle for structural reforms.18,0002006200720082009201020112012The electoral year is over, but political strugglewill continue around efforts to pass structuralSource: INEGINon-Oil ex ports SATrendreforms in Congress in 2012-2013; concurrently,security concerns continue.Alejandra Marquez contributed to this report.Ms. Marquez is employed by a non-US affiliate ofHSBC Securities (USA) Inc., and is notregistered/qualified pursuant to FINRAregulations.Monthly focusExports moderation: Latest trade results have been showing some weakness, particularly in exportsof manufactured goods excluding automobiles. However, the positive performance that auto exportshad been posting was contributing to offset to some extent the mentioned moderation. Nonetheless,August reading posted worrying signs as it confirmed a moderation in automobile exports. Thisthreatens the future performance of exports and confirms that Mexico is not immune to a weak globalpanorama.Domestic demand: Domestic demand remains strong, supporting vigorously economic growth for2012. However, we believe the expected deceleration in the industrial activity should translate slightlyto the domestic sector. As a result we remain attentive to some signals confirming this translation.Structural reforms: As a new presidential period is about to begin, we will pay close attention to anysign of possible structural reforms promoted by the new team, as well as, the income budget.7(USimportsfromMexicoas%oftotalimports)(as%oftotalimports)(%ofnonmanufacturingimports)(%ofmanufacturingimports)(%ofdurablegoodsimports)(%ofnondurablegoodsimports)Economics & StrategyLatin America Mexico9 October 2012Analyzing Mexico-US trade relationshipabc1) We have previously stated that Mexico has recentlygained some market share in US imports,12.512.011.511.010.510.09.59.02) which has made it the third most important country fromwhich the US imports goods, behind China and Canada201816141210864202006 2007 2008 2009 2010 2011 2012Mexico2008China2009CanadaJapan2010Germany20118Source: US Department of Commerce3) The main source for this increase comes basically fromexports of manufactured goods12. 512. 011. 511. 010. 510. 09. 59. 02005 2006 20 07 2008 2009 2 010 2011Source: US Department of Commerce5) Moreover, within manufactures, durable goods exports arethe main contributor to the increase in market share16. 015. 014. 013. 012. 011. 010. 02005 2006 2007 200 8 2009 2010 2011Source: US Department of CommerceSource: US Department of Commerce4) Since non manufactured goods have remained practicallywith the same share they held 5 years ago.12. 011. 511. 010. 510. 09. 59. 02005 2006 20 07 2008 2009 2010 2011Source: US Department of Commerce6) In contrast, non-durable goods have actually decreasedcausing to lower the gain5.85.65.45.25.04.84.62005 2006 2007 2008 2009 2 010 2011Source: US Department of Commerce(%oftransportequipmentimports)(%oftransportequipmentimports)(%ofcomputer&electronicequipmentimports)(%ofcomputer&electronicequipmentimports)(%ofelectricequipment&appliancesimports)(%ofelectricequipment&appliancesimports)Economics & StrategyLatin America Mexico9 October 2012An
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