DBRS Confirms Mexico’s Sovereign Ratings on Strong Economic Policies

DBRS has today confirmed the ratings on the United Mexican States’ (Mexico) Long-Term Foreign Currency securities at BBB and Long-Term Local Currency securities at BBB (high), and maintained Stable trends on both ratings. The Stable trends balance the steady momentum Mexico has maintained in its structural reform agenda with the severe economic downturn and financial market instability underway.

“In spite of the direct impact on Mexico of the collapse in U.S. manufacturing – causing the steepest decline in Mexican industrial production since the Tequila crisis – we take comfort in Mexico’s longstanding record of sound economic management,” says Fergus McCormick, DBRS’s Mexico analyst. “Steady progress on structural reforms under President Calderón provides further evidence of good policymaking. These policies create a promising outlook and provide strong evidence to support our confirmation of Mexico’s sovereign ratings at this time.”

The government is providing well-targeted counter-cyclical fiscal stimulus, although the exact effect on employment and economic activity is not clear. Most of this spending is in new investment in Petróleos Mexicanos (Pemex). DBRS supports this effort and believes that once the recession ends the government will work to reduce the deficit, which will be at least 1.8% of GDP in 2009.

Financing the deficit appears to be manageable given Mexico’s liquid domestic capital markets, successful bond issuance in international capital markets and access to multilateral loans. This year, Mexico will also enjoy a hedge on oil prices worth $9.6 billion. The Bank of Mexico’s inflation-targeted monetary policy is supporting the fiscal effort by lowering interest rates, providing liquidity to credit markets and sustaining the money supply. The U.S. Federal Reserve has made additional liquidity available in swap transactions with the Bank of Mexico in case of need.

Complementing these measures is Mexico’s steady progress on passing reforms, which have brought important results during the first half of President Felipe Calderón’s administration. These include a more efficient corporate tax, public pension reform, a more equitable judicial system, higher standards of teaching through the Alliance for Educational Quality and easier access to credit and homeownership. In late 2008, the government approved an energy reform that should lead to some efficiency gains in the energy sector.

However, market instability and concerns that the U.S. recession will further curtail U.S. dollar flows to Mexico have resulted in downward pressure on the peso, and this is having a number of adverse effects. Currency depreciation appears to be passing through to domestic core prices, although this is likely to be temporary. A weaker peso has also led to episodes of corporate debt refinancing due to out-of-the-money currency hedges by Mexican companies. A large private debt overhang in 2009 and 2010 may pose additional financing issues. Finally, prospects that the weaker currency will lead to an export-led recovery are unlikely in the near term given falling global demand.

Since 2008, uncertainty has further increased from a rise in drug-related homicides. Drug traffickers have intimidated and in some cases infiltrated local governments, and the violence is likely acting as an additional drag on economic activity. The government has organized a military offensive against the narcotics trade, and in spite of retaliations, DBRS views the offensive as appropriate. However, it will take time to produce lasting results.

Low oil prices, Mexico’s links to the weak U.S. manufacturing cycle, and a steep drop in global demand are driving the Mexican economy into recession. The 2009 growth outlook remains clearly to the downside, and a deeper recession in the United States could translate into a more severe recession in Mexico. Over the coming months, a continuation of adept crisis management will be critical to preserving macroeconomic stability and the Stable trend on the ratings.

In spite of the recession, DBRS takes comfort in Mexico’s longer-term prospects. The recent energy reform has helped to stabilize Mexico’s ratings. In fact, Mexico’s key vulnerability lies in the structural barriers to higher productivity growth. The more progress Mexico makes in reducing bottlenecks, the greater its ability to raise potential growth, which is still too low to produce a substantial upward trend in per capita incomes or redress income and regional inequalities. Looking beyond the gubernatorial and legislative elections of July 2009, creditworthiness would improve if the government widened the value-added tax base, increased labor market flexibility and introduced competition in key sectors of the economy, including energy and telecommunications.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.

This is a Sovereign rating.