DBRS Upgrades Mexico to BBB (high), Stable trend

DBRS, Inc. (DBRS) has today upgraded the United Mexican States’ long-term foreign and local currency issuer ratings to BBB (high) from BBB and to A (low) from BBB (high), respectively. DBRS has also upgraded the short-term foreign currency rating to R-1 (low) from R-2 (high), while the short-term local currency rating has been confirmed at R-1 (low). The trend on all ratings is Stable.

The upgrade reflects the significant progress made by Mexican authorities on a broad range of reforms over the past 18 months, particularly in the areas of energy, telecommunications, competition, fiscal policy and the financial sector. The cumulative impact of these reforms is likely to be significant, initially leading to increased investment and stronger public finances. In addition, the reforms could boost Mexico’s potential growth rate by up to 2.5 percentage points within 5 years. Other important reforms, particularly in education, could have supportive long-term effects on labor productivity and social mobility.

With the upgrade, DBRS has changed the trend from Positive to Stable to reflect our view that the full impact of the reforms will not be evident for several years. Nonetheless, strong implementation of reforms combined with continued adherence to Mexico’s sound macroeconomic policy framework could lead to further upgrades. In particular, DBRS will monitor evidence of significant increases in investment and competition, which are likely to contribute to lower domestic costs and higher productivity growth. In contrast, if reforms are rolled back or if vulnerabilities arise from a lack of continued fiscal discipline and conservative management of oil revenues, the ratings could come under downward pressure.

Since the 1994 peso crisis, Mexico has made significant strides in establishing a sound macroeconomic policy framework. In spite of relatively weak growth performance, openness to trade has enhanced the competitiveness of Mexican manufacturing and other key sectors of the economy. Disciplined public finances have kept debt at manageable levels, with net general government debt of 38.5% of GDP in 2013. Mexico’s well-managed debt structure provides fiscal flexibility and reduces vulnerability to shocks. Relatively low and well-anchored inflation provides room for expansionary monetary policy and allows the exchange rate to function as a buffer. Finally, Mexico’s external accounts are resilient, featuring a small current account deficit fully funded by foreign direct investment, substantial international reserves of USD180.9 billion, and a contingent credit line of USD73 billion with the International Monetary Fund (IMF).

The 2012 Presidential election ushered in a reform-oriented government that has brought the major parties together to address a broad range of challenges. These include an inadequate non-oil tax base, low levels of investment into the state-dominated energy sector, and a lack of competition in key sectors of the economy. The combined impact of the reforms is potentially transformational and could nearly double Mexico’s rate of economic growth from a lackluster 10-year historical average of 2.6%. Although the magnitude of the impact from these reforms remains highly uncertain, DBRS believes that the reforms will bolster Mexico’s annual trend growth and accelerate the country’s convergence with high-income OECD economies.

Mexico’s primary challenges include a lack of fiscal flexibility and weak productivity growth. Although the administration’s reform agenda is generally well-designed and targeted to address these specific problems, the full impact of reforms will not be evident for several years. Meanwhile, weaknesses in implementation could limit the impact of reforms in some areas. Mexico may fail to attract a significant increase in foreign investment if violence persists and if a lack of adequate infrastructure and skilled labor prove to be a deterrent. Efforts to empower regulators to monitor the prices and policies of dominant companies could have a limited impact if the legal and lobbying efforts of regulated firms undermine their capacity to enforce changes. Finally, improving the quality of Mexico’s education system has only just begun, and opponents of the reforms could still significantly undermine the recruiting and promoting of the most qualified teachers.

Even taking recent reforms into account, fiscal flexibility remains low due to Mexico’s structural overdependence on oil revenue and high levels of tax evasion and informality. A prolonged decline in oil prices or further declines in oil production would increase the burden of fiscal adjustment. In this context, rising social demands may make it difficult to manage expenditure pressures and to maintain consensus behind reforms. Nonetheless, DBRS takes comfort in Mexico’s favorable demographics and the government’s track record of gradually expanding the size of the formal sector.

The external environment may also pose challenges. A renewed slowdown in global growth would likely result in a recession in Mexico and increased risk aversion toward emerging markets generally. Additional financial instability in Europe is likely to have a limited direct impact on Mexico, though the health of the large Spanish banks with Mexican subsidiaries would need to be monitored carefully. Given the improving U.S. economic conditions associated with a slowdown in the pace of asset purchases by the U.S. Federal Reserve and subsequent monetary policy normalization, DBRS believes the transition to higher global interest rates will be manageable for Mexico.

Notes:
All figures are in Mexican pesos (MXN) unless otherwise noted.

The principal 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, Banco de Mexico, INEGI, IMF, BIS, OECD, IBRD, and IADB. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

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: Thomas R. Torgerson
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 28 July 2006
Most Recent Rating Update: 18 February 2013

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