DBRS Confirms United Mexican States’ BBB Rating and Revises Trend to Positive

DBRS Ratings Limited (DBRS) has today confirmed its ratings on the United Mexican States long-term foreign debt at BBB and long-term local currency debt at BBB (high), and changed the trend on both ratings to Positive from Stable. The BBB long-term ratings on the foreign and local currency securities are underpinned by the country's well-managed public finances with moderate debt ratios, well-engineered monetary easing with moderate and stable inflation, and a strong commitment to a flexible exchange rate regime. In addition, healthy external accounts anchored in solid FDI and portfolio inflows, a sound financial system and robust international reserves add to Mexico’s ability to weather financial volatility. DBRS has also confirmed the short-term foreign rating at R-2 (high) and the local currency rating at R-1 (low), revised the R-2 (high) trend to Positive from Stable, and confirmed the R-1 (low) Stable trend.

The revision of the rating trends to Positive reflects DBRS’s view of Mexico’s improved economic performance, proven track record of decisive and predictable macroeconomic management, which provided resilience during the international financial crisis and the improved prospects for longstanding structural reforms, particularly in the fiscal and energy sector, to raise growth potential.

The ratings are however constrained by relatively low GDP growth record vis-à-vis other emerging market peers, limited fiscal flexibility due to reliance on oil revenues, a relatively narrow non-oil tax base, lack of significant resources in the oil stabilization funds as well as structural weaknesses in certain sectors of the economy that continue to dampen economic activity.

Since 2010, the Mexican economy rebounded with real GDP growth making a strong recovery, averaging 4.5% between 2010 and 2012 after a steep fall of -6.2% in 2009. Robust growth brought output back to pre-crisis levels, boosted by the relatively good performance of the U.S. manufacturing sector and by the recovery of Mexico’s manufacturing exports sustained by a competitive exchange rate, greater FDI inflows and lower wage costs. A rebound in domestic demand supported by growth in employment and credit has helped sustain the momentum. The recovery was underpinned by Mexico’s sound public and private sector balance sheets, a strong prudential framework and the effective countercyclical fiscal policy response.

In particular, Mexico’s credit profile resilience is attributable to: i) disciplined public finances with moderate net general government debt (35.8% of GDP in 2012) and a well-managed debt structure, which provides fiscal flexibility and reduces debt vulnerability; ii) relatively low and well-anchored inflation providing room for expansionary monetary policy intervention and which allows the exchange rate to function as a buffer; iii) a small current account deficit fully funded by solid FDI and portfolio inflows; and iv) substantial international reserves of USD163.4billion as well as a USD73 billion contingent credit line with the International Monetary Fund (IMF).

DBRS believes that the strengthening of political institutions over the past decade has allowed for a smooth transition of power, with broad policy continuity following the election of President Enrique Peña Nieto in July 2012, expected to further anchor macroeconomic stability. The 2013 budget presented by the Peña Nieto administration does not depart from previous trends in terms of prudent fiscal management and is aimed at maintaining fiscal discipline and achieving a balanced budget of 2% in 2013 (0% excluding Pemex investment). After reaching 2.5% of GDP in 2011, the deficit rose in 2012 to 2.6% of GDP (0.6% excluding Pemex investment), given higher spending associated with the July election.

The Peña Nieto government is likely to try to address some of the shortcomings of the tax system, with a reform designed to boost revenue and streamline the excessively complex tax system, particularly for corporate taxes. Revenue collection is hindered by a low tax base (non-oil revenue accounted for 14% of GDP in 2012), and by high tax evasion and informality. DBRS believes that structural overdependence on oil revenue which accounts for around one third of government revenues is unlikely however to be tackled in the short term, even if the government pushes through plans to open up Pemex, the state-owned oil firm, to private investment.

Mexico’s modest growth record of 2.3% between 2001and 2011 and limited fiscal flexibility highlight the need for the country to implement some of the key structural reforms to improve the country's growth potential. The Peña Nieto government has outlined an ambitious and wide ranging programme of reforms which is expected to gather momentum in 2013, and formal proposals for energy and fiscal reform are expected in the third quarter of 2013, following the recently approved labour market and education reforms. If implemented, DBRS expects the proposed reforms to bolster Mexico’s annual trend growth and thereby spur the country’s convergence with other OECD economies. Furthermore, reduced dependence of government finances on oil revenues on the back of a broadened non-oil tax base and a smaller informal sector could improve fiscal flexibility and free funds for infrastructure investments and improved public services provision. The possible opening of the energy sector could substantially bolster FDI in the medium term. However, DBRS believes that the passage of these reforms is likely to be gradual and subject to implementation risk as a divided Congress might make the negotiation process challenging.

The risk of a slowdown in the United States or return to financial instability in Europe could weigh on the ratings and provide downside risk for Mexico. Importantly, a potential increase in global risk aversion could prompt a slowdown or reversal of foreign capital flows to Mexico. While Mexico cannot escape a global slowdown, its government does have some flexibility to mitigate external shocks through policy actions.

Public security issues, which could be acting as a drag on economic activity, are likely to dominate the political debate. The new administration’s public security strategy is not expected to differ greatly from that of its predecessor, focusing on combating violence by strengthening the Federal police and creating a national gendarmerie backed by the military and with close cooperation with the U.S. government. However, it will likely take several years for these initiatives to produce lasting results.

In spite of these concerns, DBRS takes comfort in Mexico’s long-term prospects. Decisive and predictable macroeconomic management during the crisis and the resilience of the economy have underpinned Mexico’s ratings. DBRS views Mexico as well-positioned among BBB-rated credits to weather a more adverse macroeconomic environment. Equally, DBRS could raise the ratings if Mexico's GDP growth were stronger than anticipated, facilitating better fiscal dynamics, if the outlook for the oil sector were to improve, or should the government implement further structural measures to strengthen its fiscal flexibility.

Notes:
All figures are in USD unless otherwise noted.

The applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include Secretaría de Hacienda y Crédito Público (SHCP), Banco de México, INEGI, the World Bank and the International Monetary Fund. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Giacomo Barisone
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 28 July 2006
Most Recent Rating Update: 17 December 2012

For additional information on this rating, please refer to the linking document under Related Research.