October 29, 2013 No 175 Nordine Naam Juan Carlos Rodado

The BRL/MXN: an structural bet

The BRL/MXN has been one-directional since the beginning of the year. The cross strengthened 17.5% between March and mid-August before correcting 10.5% since its low point. We take a look at its rationale in 2013 and try to assess its future evolution and risks. All in all, the MXN should outperform the BRL in the coming months (5.60 for the BRL/MXN) as: the BCB will limit the rollover of currency swaps for the BRL, Mexican reforms have a serious chance of being approved notably the fiscal reform by the end of the year, growth momentum will be in better shape in Mexico over Brazil, high inflation will persist in Brazil, investors have become more selective with macro stories, commodity prices will remain sluggish and structural challenges (cost competitiveness, infrastructure bottlenecks) will not be solved in the short term in Brazil.

1/ A very hard start of the year for the BRL The BRL suffered until August from the deterioration of Brazils fundamentals (growth revisions, high inflation, worsening twin deficits) despite a rate hike cycle that started in April. Investors were disappointed with President Dilma Rousseffs erratic economic policies (intervention on prices, credit) and the lack of predictability of the BCB.

markets against the USD declining by 20% between mid-May and mid-August (vs. 8% for the MXN).

2/ Saved by the Fed But this changed since mid-August. The BRL benefited more than the MXN from the non-tapering news (lower UST10y) and the US fiscal debate (shutdown and debt ceiling) as it suffered from a massive selloff in Q3 2013 (chart 2a-2b).

As a consequence, Bernankes Fed tapering speech (May st 21 ) which led to higher borrowing costs in emerging markets, hit the BRL harder than the MXN (chart 1a-1b). The BRL was the worst performing currency among emerging

Meanwhile, Mexicos growth and reforms disappointed investors. The GDP growth rate suffered strong adjustments in July (chart 3b). Banxico even cut by 25 bps the key rate to 3.5% last week after 25 bps in September but we expect them to remain on hold for the rest of the year. Reforms on the other hand were not as ambitious as they should have been, but have a serious chance of being approved notably the fiscal reform by the end of the year.

Beyond domestic woes (contraction of public spending, slowdown in construction), the recent US fiscal debate weakened the MXN. The ties between both economies are strong due to tight financial, trade and migration flows. Indeed, the US is Mexicos main trade partner (3/4 of total exports). This explains why the 30 days rolling correlation between the MXN and the S&P 500 is most of the time close to 90% (chart 4).

The BCB also made its strategy more clear. It announced in September 60 Bn USD in FX swap interventions (500 Mns daily from Monday to Thursday and a 1 Bn Repo on Friday) adding to the 40 Bn already in place since the beginning of the year. The Brazilian GDP for 2013 began to be revised upwards in September (chart 3a). This helped to reduce the BRL volatility.

Bottom line: The real has appreciated aggressively with non-tapering news (lower UST10y). But it already gained 11% since August 21st against the USD while the MXN only 2.0% during the same period. Both currencies could weaken in the short run with bad NFP and retail sales numbers for the MXN and speculation on the fact the BCB will limit the rollover of currency swaps for the BRL. At the current levels it is although easier to find arguments to see the USD/BRL at 2.30-2.35 than a USD/MXN at 13.7-14.0. It is quite consensual that

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fundamentals (public debt, current account balance) are in better shape in Mexico than in Brazil. 1. Growth discrepancy: Mexican growth should gradually recover while Brazilian growth will disappoint in H2 2013 (chart 5a). This is story will be even more true in 2014 as the BCB is hiking interest rates while Banxico should remain on hold after reducing them. Growth should be around 2.2% next year in Brazil and 3.2% in Mexico. The upside and the downside risks for Mexico are well known: the US economy. 4.

could benefit from the reform momentum even if its materialization will take time. Commodity prices: when we look at LatAm currencies in terms of Real Effective Exchange Rate (REER), the BRL is overvalued compared to the MXN (chart 6). Brazils REER has followed commodity prices and has been affected by rising labor costs while Mexico has maintained its competitiveness. We expect more convergence between the REER of these two currencies in coming months. In particular, the BRL should remain under pressure as commodity prices are expected to remain stable in coming quarters and this should lead to a further fall of its terms of trade (chart 7). Structural issues: Brazil is struggling due to its lack of competitiveness while Mexico has managed to increase the share of its industry by keeping its production costs low and benefiting from its role in the US supply chain. The share of the manufacturing sector is increasing in Mexico while it is decreasing in Brazil. It is also well known that Brazil is suffering from strong bottlenecks due its poor infrastructure system.

5.

2.

Inflation differential: inflation is under control in Mexico at 3.4% in September (chart 5b). We expect this level of prices to limit the extent of rate cuts without weakening to much the currency. Meanwhile, Brazil is struggling to maintain inflation within its target range (4.5% +/-2%). Even if the currency appreciation is an important relief, prices will remain high in 2014 (World Cup effect).

chart 7 USDBRL & CRB index

500 450 400 350 2,0 300 2,5 250 200 150
Sources : Bloomberg

0,5
CRB index (commodity prices index) USDBRL (RHS inverted)

1,0 1,5

3,0 3,5 4,0 00 01 02 03 04 05 06 07 08 09 10 11 12 13

100

3.

Perception: investors are becoming more selective with macro stories and at this point Mexico outperforms Brazil. The lack of predictability of Brazil economic policy is a major drag on investors confidence. Moreover, rating agencies could downgrade the country if weak growth and bad fiscal numbers persist. The MXN and Mexicos rating

Nevertheless, the MXN could be penalized by the US th budget (January 15 ) and debt (Mid-March) ceiling woes. After this, the cross should continue its long term trend as it is hard to believe Brazil will correct its structural and economic challenges in the near term.
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Strategy: given that the BRLMXN is closely correlated to the USD/BRL, its trend should follow the BRL. As we expect the BRL to underperform in coming months towards a level of 2.35 versus the USD, this suggests that the pair BRLMXN (currently at 5.90) could fall back towards 5.60 in the coming months (chart 8).
chart 8 BRLMXN & USDBRL
8,0 7,5 7,0 6,5 6,0 5,5
Sources : Bloomberg

BRLMXN

USDBRL (RHS inverted)

1,4 1,6 1,8 2,0 2,2 2,4 2,6

5,0 08 09 10 11 12

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