DBRS Confirms Mexico at BBB (high), Stable Trend

DBRS Inc. confirmed the United Mexican States’ (Mexico) Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high) and Short-term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The ratings reflect a balance between Mexico’s long track record of sound macroeconomic policymaking and the country’s deep governance and growth challenges. In recent years, the Mexican economy has demonstrated a high degree of resilience to adverse shocks, in large part due to its strong macroeconomic policy framework – comprised of exchange rate flexibility, prudent fiscal management, and a credible inflation-targeting regime. On the other hand, significant structural challenges in the Mexican economy weigh on the credit profile. Poor education outcomes, widespread informality, and far-reaching governance problems have led to decades of weak growth.

Uncertainty over the policy direction of the new administration presents risks to the credit outlook. President López Obrador (AMLO) has pledged to run sustainable fiscal policy, respect the independence of the central bank, and support the trade agreement reached by President Peña Nieto’s administration with the U.S. and Canada. The market reforms enacted under the previous administration have had a positive impact on the economy, which could improve growth prospects if the new administration continues to implement them. AMLO is backed by majorities in both houses of Congress, which gives him wide-ranging power to address critical challenges, such as strengthening the rule of law. However, recent announcements raise concerns about the emerging policy direction under the new administration. The postponement of oil auctions, the cancellation of a new $13 billion airport, and the decision to change Pemex’s business strategy suggest that the AMLO administration may be reorienting policy in a manner that ends up constraining private investment and stressing public finances.

RATING DRIVERS

The likelihood of a rating action is low in the near term, although medium-term risks are slightly skewed to the downside. The broad policy direction of the new administration will be key in determining the evolution of the ratings. The ratings could be upgraded if (1) fiscal policy is tightened sufficiently to put debt dynamics on a firm downward trajectory, and (2) Mexico’s economic performance strengthens on the back of increased investment. On the other hand, the ratings could be downgraded if (1) the commitment to fiscal discipline deteriorates, or (2) policy actions materially weaken medium-term growth prospects.

RATING RATIONALE

The New Administration Has Wide-Ranging Power to Impose Its Agenda

Mexico’s July 2018 general election produced a decisive victory for AMLO and his coalition Juntos Haremos Historia. In addition to AMLO winning the presidential election by a wide margin, his coalition won a majority in both houses of Congress as well as control of more than half of the state legislatures. The consequence is that AMLO has substantial power to pass legislation and coordinate policy with subnational governments. Although the pro-AMLO coalition falls short of the qualified majorities needed to amend the constitution, the governing coalition is in a strong position to reach the 2/3 threshold by building congressional alliances, suggesting that some previously passed reforms, such as the education reform, could be repealed.

One of the critical challenges facing Mexico is strengthening the rule of law. According to the Worldwide Governance Indicators, Mexico scores poorly on issues of corruption and rule of law relative to peers in Latin America. Corruption and cronyism, which are perceived to be entrenched and widespread, constrain economic growth by encouraging rent-seeking behavior and misallocating resources. Elevated levels of criminality and violence weaken the investment climate. In DBRS’s view, generating sustainably stronger economic growth could depend on the new administration’s ability to meaningfully address corruption and improve public security.

Rollback of Market Reforms Would Constitute a Missed Growth Opportunity

Structural reforms passed during the Peña Nieto administration aimed to break Mexico out of its history of lackluster growth. For more than two decades, Mexico failed to make progress in converging toward advanced economy income levels. This relative stagnation is explained by Mexico’s weak labor productivity growth. In the wake of the 2013 structural reforms, however, several encouraging economic trends are visible: strong formal job creation, substantially lower consumer telephone prices, and increased investment in the electricity sector. Furthermore, the energy reform has attracted private capital and expertise to the sector, which is needed to reverse 14 years of declining oil production. If the AMLO administration implements the previously enacted structural reforms, DBRS believes that the economy could outperform Mexico’s modest growth expectations.

However, some early decisions by the AMLO administration point to a shift in policy direction. With regards to the energy sector, the new administration suspended oil auctions for three years and announced plans to build a new $8 billion refinery. Other decisions by the administration also look costly and inefficient, including the cancellation of a partially-built $13 billion airport in Mexico City. Such actions could ultimately end up lowering much-needed investment and dampening growth.

External risks to Mexico’s economic outlook have recently diminished but adverse global developments could still create a challenging environment. The recently reached United States-Mexico-Canada trade agreement reduces uncertainty regarding the North American trading relationship. The agreement is important because the three North American economies are deeply integrated, with cross-border supply chains in sectors such as automobiles, electronics and textiles. However, passage of the new trade deal could end up facing opposition in the U.S. Congress. In addition, Mexico could face escalating global trade tensions or increased market volatility amid U.S. monetary policy normalization, which could adversely affect growth through trade and financial channels.

Fiscal Discipline is Needed to Keep Public Debt Ratios on a Sustainable Trajectory

The AMLO administration’s inaugural budget appears prudent and credible but questions remain about the multi-year strategy. The 2019 budget aims to increase the primary surplus to 1.0% of GDP next year, which should keep public debt ratios on a stable trajectory. The macroeconomic assumptions underpinning the budget are in line with market expectations. Nevertheless, there are still concerns over how the administration will fulfill campaign promises to spend substantially more in subsequent years on priority programs, such as pensions, education, and infrastructure, while maintaining primary surpluses, particularly given AMLO’s pledge not to raise taxes in the first half of the administration. A deterioration in the underlying fiscal position would weigh negatively on the ratings.

Public debt dynamics appear sustainable but highlight the importance of tight fiscal management. Gross public debt declined from its peak of 57% of GDP in 2016 to an estimated 53% this year, primarily due to fiscal consolidation efforts advanced by the Peña Nieto administration and the use of windfall revenues from the central bank to pay down liabilities. If the AMLO administration sustains primary surpluses proposed of about 1.0% of GDP, debt dynamics look stable over medium term. However, in an adverse scenario characterized by weaker growth, fiscal slippage, and higher real interest rates, public debt levels could rise significantly, thereby requiring a sizable fiscal adjustment to stabilize public finances. The outlook underscores the importance of maintaining a sustainable fiscal strategy that is credible and affirms market confidence.

Strong Policy Frameworks Support the Economy’s Resilience in a More Turbulent Global Environment

Mexico benefits from a credible inflation-targeting framework and limited financial stability risks. Inflation climbed well above the central bank’s 3.0% target in 2017 and 2018 due to a series of transitory shocks. The central bank responded by substantially tightening monetary policy in order to anchor inflation expectations and contain second-round effects. Inflation is now trending down. Despite upside risks, the easing of supply shocks and peso stabilization should reinforce the disinflationary process. In addition, the financial system is well-regulated. The banking system is profitable and well-capitalized, with low levels of non-performing loans. Exchange rate fluctuations have not adversely affected banks’ balance sheets nor have they resulted in a deterioration in asset quality in the corporate sector. Household leverage is also low, with limited foreign exchange exposure.

Mexico’s external position does not exhibit any clear imbalances. The current account deficit is modest and fully financed by net foreign direct investment. The net international liability position is moderate and relatively stable. While the highly integrated nature of the Mexican economy leaves Mexico exposed to capital flow volatility, the country’s sound macroeconomic policy framework enhances the economy’s resilience to bouts of market turbulence. In addition, the central bank holds substantial reserves and a Flexible Credit Line from the IMF in order to provide foreign exchange liquidity if necessary.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A – BBB (high) range. The main points discussed during the Rating Committee include the objectives of the new administration, the broader political environment, and the fiscal outlook.

KEY INDICATORS

Fiscal Balance (% GDP): -1.1 (2017); -2.5 (2018F); -2.5 (2019F)
Gross Debt (% GDP): 54.3 (2017); 53.1 (2018F); 53.2 (2019F)
Nominal GDP (USD billions): 1,151 (2017); 1,228 (2018F); 1,294 (2019F)
GDP per capita (USD thousands): 9.3 (2017); 9.8 (2018F); 10.3 (2019F)
Real GDP growth (%): 2.1 (2017); 2.1 (2018F); 2.3 (2019F)
Consumer Price Inflation (%, eop): 6.8 (2017); 4.4 (2018F); 3.1 (2019F)
Domestic credit (% GDP): 42.8 (2017); 42.5 (June-2018)
Current Account (% GDP): -1.6 (2017); -1.7 (2018F); -1.8 (2019F)
International Investment Position (% GDP): -48.0 (2017); -46.8 (June-2018)
Gross External Debt (% GDP): 37.8 (2017); 36.7 (June-2018)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 307% (2017); 301% (June-2018)
Governance Indicator (percentile rank): 42.3 (2017)
Human Development Index: 0.774 (2017)

Notes:

All figures are in US dollars unless otherwise noted. Public finance statistics reported on a public sector basis; this excludes state and local governments but includes state-owned enterprises and public development banks. The Fiscal Balance is the Public Sector Borrowing Requirement. Gross External Debt comprises external public debt (including local currency debt held by non-residents) and external private debt. Projections are based on IMF Country Report No 18/332. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Secretaría de Hacienda y Crédito Público, Banco de México, INEGI, Pemex, IMF, OECD, UNDP, BIS, Bloomberg, Tullet Prebon Information, World Bank, NRGI, Brookings, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Michael Heydt, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: 28 July 2006
Last Rating Date: 7 December 2017

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.