DBRS Confirms Mexico at BBB with Stable Trends

DBRS has today confirmed its ratings on the United Mexican States’ long-term foreign currency securities at BBB, long-term local currency securities at BBB (high), and maintained Stable trends on both ratings. The Stable trends reflect Mexico’s resilience and strong policy response to the shock from the global financial crisis, and balance concerns over long-term fiscal and growth prospects.

The international financial crisis and a steeper-than-expected decline in Mexican oil production had a profound effect on the Mexican economy and public finances. The collapse in U.S. manufacturing caused the steepest decline in Mexican industrial production since the 1994-95 Tequila Crisis, as real GDP fell by 6.5% in 2009. Given Mexico’s budgetary dependence on oil revenues, the decline in oil production required a significant fiscal adjustment to offset lower oil revenues. As global risk aversion accelerated, capital outflows from Mexico resulted in currency depreciation and sporadic liquidity pressures on corporates. An outbreak of the H1N1 virus added to the drag on economic activity. Risk perceptions increased further with a deteriorating security situation.

“In spite of the shocks that Mexico experienced over the last three years, we maintained Stable trends on Mexico’s ratings, anticipating that the economy would rebound along with that of the United States, and that Mexico’s record of sound and predictable macroeconomic management would materialize in a strong policy response. This is exactly what has happened,” says Fergus McCormick, DBRS’s Mexico analyst.

During the crisis, the government approved a tax reform, well-engineered monetary easing, targeted assistance to financial intermediaries, and interventions in the foreign exchange market. Contingent financing from U.S. Federal Reserve swap lines and an IMF Flexible Credit Line supported these measures, as did rapid reserve accumulation by the Bank of Mexico, strengthening Mexico’s external resilience.

“This action provided the backdrop for an economic rebound, currently underway, manageable public finances and expectations of lower debt ratios as of 2011,” adds Mr. McCormick.

Mexico has complemented these measures with slow but steady passage of economic reforms and improvements in microeconomic management under President Felipe Calderón. These reforms have brought important results that include a higher value-added tax, a more efficient corporate tax and greater electricity sector efficiency with the liquidation of Luz y Fuerza del Centro, a state-power supplier. Other measures include corporate governance improvements at Petróleos Mexicanos (Pemex), the state-owned oil company, and public pension reform that has reduced medium-term contingent liabilities. Most of these initiatives should help raise productivity growth over the medium term.

The ratings remain constrained by overexposure to the U.S. economy and by structural weaknesses that dampen economic activity. The most important of these are inefficient public companies, especially Pemex, whose oil production has declined more than expected, from 3.4 million barrels of crude oil per day in 2004 to 2.5 million in June 2010. Lower production has resulted in a sharp decline in oil revenues as a percentage of total revenues, from 36% in 2008 to 28% in 2009. Although this effectively lowers fiscal dependence on oil, the gap in the budget required immediate tax hikes. It appears that oil production has stabilized between 2.5 million and 2.6 million barrels per day. However, DBRS stresses that if oil production declines further, additional fiscal measures will be necessary to prevent Negative trends being assigned to the ratings over the medium term.

In recent months, security has become a central concern and is likely acting as a drag on economic activity. DBRS commends the government on its military offensive against the narcotics trade, but it will likely take several more years to produce lasting results. Drug traffickers have threatened local governments and approximately 28,000 people have perished in the conflict since 2006, including the gubernatorial candidate of the State of Tamaulipas in June 2010.

In spite of these concerns, DBRS takes comfort in Mexico’s long-term prospects. Good and predictable macroeconomic management during the crisis and the resilience of the economy, as evidenced in the strong economic recovery underway, have stabilized Mexico’s ratings. DBRS’s greatest concern is in the structural barriers to higher productivity growth, especially in the oil sector. On the other hand, the more progress Mexico makes in reducing infrastructure bottlenecks and improving social services, 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. Creditworthiness would improve in the near term if the government implements the 2008 Pemex reform that makes oil contracts more flexible, further widens the value-added tax base, increases labor market flexibility and introduces competition in key sectors of the economy.

Notes:
The applicable methodology is Rating Sovereign Governments, which can be found on our website under Methodologies.