DBRS Confirms Mexico at BBB (high), Stable Trend

DBRS, Inc. has confirmed the ratings on the United Mexican States long-term foreign and local currency debt at BBB (high) and A (low), respectively. DBRS has also confirmed the short-term foreign and local currency ratings at R-1 (low). The trend on all ratings is Stable.

The confirmation reflects the continued but gradual progress made by Mexican authorities on implementing reforms in the areas of energy, telecommunications, competition, fiscal policy and the financial sector. The cumulative impact of these reforms is likely to be significant, in spite of the decline in oil prices and somewhat diminished near-term expectations for investment in the energy sector. The reforms are still expected to provide a considerable boost to Mexico’s potential growth rate, though the full effect will not be evident for several years. Other important reforms, particularly in education, could have supportive long-term effects on labor productivity and social mobility.

Strong implementation of the 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 deterioration in 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 41.8% of GDP in 2014. The central government’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. Moreover, Mexico’s external accounts are resilient, featuring a modest current account deficit funded largely by foreign direct investment, substantial international reserves of USD195.3 billion, and a contingent credit line of USD66.6 billion (SDR 47.3 billion) with the International Monetary Fund (IMF).

The 2012 Presidential election ushered in a reform-oriented government that was able to bring 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 significantly increase 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 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 limited fiscal flexibility and weak productivity growth. Although the administration’s reform agenda was well-designed and has made progress in addressing 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 sufficiently 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 promote competition. Improving the quality of Mexico’s education system will require a sustained political commitment, and opponents of the reforms could undermine the recruitment and promotion of qualified teachers.

Even taking recent reforms into account, fiscal flexibility remains limited due to Mexico’s structural overdependence on oil revenue, and high levels of tax evasion and informality. The decline in oil prices during 2014 forced the state-owned oil company (Pemex) to cut investment and prompted precautionary reductions in mostly current spending at the Federal Government level. On the positive side, oil revenues for 2015 are protected via hedging from a decrease in oil prices below 79 dollars per barrel. Furthermore, DBRS takes some comfort in Mexico’s favorable demographics and the government’s track record of gradually expanding the formal sector. A prolonged period of low oil prices could nonetheless pose challenges for Mexico. Rising social demands may make it difficult to manage expenditure pressures and to maintain consensus behind reform implementation.

The external environment may also pose challenges. Mexico benefits strongly from its deep economic linkages with the United States, but a renewed slowdown in U.S. growth would likely result in a recession in Mexico and could increase 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 should 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 a transition to higher global interest rates will be manageable for Mexico, even if exchange rate volatility remains high.

Notes:
All figures are in U.S. Dollars (USD) 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, UN, 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: Roger Lister
Initial Rating Date: 28 July 2006
Most Recent Rating Update: 2 April 2014

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