Will Cyprus start the dominos falling?

Greece didn't drop the Euro but there's a new threat to the common currency -- Cyprus. The country with a tiny economy (one about the size of Scranton, Pennsylvania) may abandon the Euro, thanks to the uproar caused by the "Troika's" (the European Central Bank, the European Union and the IMF) plan to force depositors to fork over a percentage of their fully guaranteed bank deposits to help finance the rescue of the country's banks.

The proposal, which isn't prospering, would have had savers take a haircut to pay bond holders 100 cents on the dollar. If implemented, it would toss aside the hitherto sacrosanct principle that a government guarantee of bank deposits is a hell or high water guarantee.

If ever there was an incentive to move money out of the banks of weaker countries (like Cyprus, Greece, Spain, Italy, etc.) into the banks of strong ones (like Germany), this is it. What a recipe for capital flight and for a death spiral for weak banks!

The problem is that there's still no other solution and Cyprus faces a March 25 deadline. Stay tuned for the result of the frantic negotiations that will undoubtedly be occurring over the weekend.

Quantitative easing: not without risk...

In his testimony before the Senate Banking Committee several week ago, Fed Chairman Ben Bernanke said as clearly as central bankers ever say anything that the Fed will NOT tighten monetary policy in the near future. He recognized that the Fed’s policy experiments carry risks but he deemed them manageable or worth taking. 

There are three broad risks associated with the Fed’s QE programs. One is the inflation risk, which the Fed is confident it can manage. The Governors believe the Fed has the tools to tighten monetary policy when necessary. In any case, inflation is not a problem now and inflationary expectations are low.

A less obvious risk is to the federal budget. The Fed earns interest on the assets it has purchased. Between 2009 and 2012, the Fed sent the Treasury on the order of US$290 billion, roughly triple its pre-QE remittances. When the Fed implements an “exit strategy” from its QE program, the interest earned and, consequently, the remittances to the Treasury will fall. Mr. Bernanke expects that even after the exit, the Fed’s remittances to the Treasury will be above pre-crisis levels. A recovering economy, a pre-condition of the exit, generates higher tax revenue, which would more than compensate for the decline in Fed remittances.

A third risk is to financial stability. With US interest rates so low and liquidity flooding the system, portfolio managers may “reach for yield” by taking on riskier credits, greater leverage or lengthening their exposure. The extraordinary inflow of portfolio investment directed to Mexico over the last three years exemplifies how low interest rates and ample liquidity in the US can affect other economies. Mr. Bernanke recognizes that investors may pile on risk in the search for higher returns but believes the benefits of stronger growth and job creation in the US justify the risk. 

The cost-benefit analysis for this last risk -- to financial stability -- may be different for the US and the recipients of massive portfolio inflows, like Mexico. Yes, Mexico will benefit from a stronger US economy. But, the vulnerability to the movements of foreign investment in fixed income obligations and equities is much greater for Mexico than for the US. Time will tell...

At work on immigration reform...

After the votes were counted in the US last November, immigration reform became a hot issue in Washington. That one of the top items on Mexico's agenda in the bilateral relationship is center stage in American politics has everything to do with American politics.

The "Group of 8" (four Republican and four Democratic Senators) are thrashing out a legislative proposal that stands a chance of passage. According to today's Washington Post, the "8" are discussing redistributing visas: fewer family members would receive priority so that more visas could go to qualified workers. The Migration Policy Institute says that about 65% of legal immigrants are admitted for family reasons. Only 14% of legal immigrants are admitted for employment.

The discussion is centering on who should qualify as "family" for visa purposes. Presently, spouses and minor children have first priority. Unmarried children older than 21 are next, followed by married adult children and siblings. An idea being floated is to eliminate the latter two categories, which would free up about 90,000 visas a year. Those visas could go instead to qualified workers. Married adult children and siblings could still apply for a visa but they would need other qualifications (such as highly technical skills) to get a green card. 

Portfolio investment: more than ever

Portfolio investment poured into Mexico in 2012. The US$56.68 billion in portfolio investment last year more than doubled 2011’s record high. Foreign investment in Mexican stocks came to US$10.04 billion in 2012, a contrast to the US$6.57 billion outflow in 2011.  The US$46.64 billion of foreign investment in fixed income instruments was 47.4% more than in 2011.

Portfolio investment was the driver of Mexico's US$46.88 billion 2012 capital account surplus. Over the last three years, the surplus has averaged US$46.93 billion. The closest the country has ever come to surpluses of this magnitude was in 1993, when, thanks to portfolio investment, the capital account registered a US$32.34 billion surplus. In 2010 and 2011, portfolio investment comprised, respectively, 52.8% and 43.5% of the capital account surplus. In 2012, portfolio investment was 120.9% of the capital account surplus. In 1993, the proportion was 56.0%.

Forget about portfolio investment fleeing the country, as it did in 1995, the last quarter of 2009 and the first quarter of 2012. If portfolio investment diminishes substantially or ceases, the capital account surplus will plummet.

Direct foreign investment: a disappointment

Last year, incoming FDI last year was a paltry US$12.66 billion, the lowest amount since 1996 and 41.1% less than in 2011. In part, the figure was so low because of the sale of shares by a financial institution with foreign ownership. The US$4.11 billion sale appears in the balance of payments as an outflow of FDI. Foreigners purchased US$3.94 billion of the shares sold, which then are accounted for as portfolio investment. If the sale of shares is excluded, FDI would have been US$3.20 billion in Q4 instead of the US$0.91 billion outflow actually registered and FDI for the year would have come to US$16.77 billion. It is worth noting that even excluding the sale of shares, last year’s FDI would have been on a par with that of 2009, which was the lowest since 1999.

Net FDI equals foreign direct investment (FDI) in Mexico minus FDI by Mexican companies.  Last year, net FDI was negative.  FDI by Mexican companies, one of the components of the assets held abroad account, was US$25.60 billion, double incoming FDI.  FDI will jump this year if US regulators approve AB InBev’s purchase of the 50% of Grupo Modelo shares it doesn’t yet own. Depending on the conditions imposed if the deal is permitted to go ahead, the FDI it represents could well be less than the US$20.1 billion announced at the end of June 2012.

Another take on "informal" employment...

INEGI publishes a quarterly analysis of unemployment in Mexico. Since 2005, INEGI has been publishing statistics on the percentage of the economically active population (PEA, in Spanish) employed in the informal economy. That percentage ranged between 27% and 29%.

The figures for the fourth quarter of 2012 present a different take on employment in the informal economy, an approach officially published by the International Labor Organization (OIT, in Spanish) on October 31, 2012. The new methodology, adopted in December by INEGI, includes categories of workers who weren't counted in the existing measure of employment in the informal economy. The new definition counts household help, "non-protected" agricultural workers, and employees working in formal businesses who weren't registered in the Social Security Institute (IMSS).

So, what's the percentage of people employed in the informal economy? The old methodology says 27.9% of the working age population in the fourth quarter of 2012. Under the new methodology, the percentage is more than doubled - to 59.9%. Definitions matter.  

Public sector debt...

Mexico’s public sector finances were much stronger in 2012 than those of the US. In fiscal year 2012, the US federal government’s deficit came to 6.9% of GDP. Mexico’s was 2.6% of GDP. Adding in states’ debts, Mexico's debt ratio is still below that of the US, which, by the way, doesn’t include state debt either. Excluding investments by Pemex, the deficit was 0.6%. 

Mexico’s debt to GDP ratio is low but there are some troubling signs. Expenditures grew more rapidly than income (respectively, +3.8% and +3.3%, discounting inflation). Oil income, which accounted for a hefty 33.8% of public sector revenues in 2012, was up 3.7% while tax revenues were only 1.4% higher – in a year in which the economy grew close to 4%. A substantial 28.5% jump (again, excluding inflation) in “other” non-tax revenues left total non-tax revenues 16.6% higher than in 2011. The increase in non-tax income accounted for 15.5% of the increase in public sector revenues last year.