DBRS Confirms Mexico at BBB (high), Stable Trend

DBRS has confirmed Mexico’s long-term foreign and local currency ratings at BBB (high) and A (low), respectively. DBRS has confirmed Mexico’s short-term foreign and local currency ratings at R-1 (low). The trend on all ratings remains Stable.

The confirmation of the ratings reflects Mexico’s strong macroeconomic framework and DBRS’s expectation of gradual improvement in economic performance. Structural reforms undertaken in energy, telecommunications, competition, tax policy and the financial sector are likely to provide a significant boost to Mexico’s potential growth rate. Recent growth performance, on the other hand, has been adversely affected by a negative terms of trade shock, with lower oil prices resulting in less investment and fiscal tightening. The price shock and continued production declines have also exposed Pemex’s financial weaknesses, forcing the government to inject additional capital and press for further spending cuts. Ultimately, DBRS believes that reforms at Pemex will likely help to reduce the government’s long-term liabilities, while the energy reform removes constraints on private investment into the oil and gas sector.

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 in spite of recent setbacks, with net public sector debt projected to peak at 48.6% of GDP this year. The public sector’s well-managed debt structure 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. Recent tightening appears to be a sign of Banxico’s commitment to anchor inflation more firmly at the midpoint of the target range for inflation of 2-4%. Moreover, Mexico’s external accounts are resilient, featuring a current account deficit largely funded by foreign direct investment, substantial international reserves of USD178 billion, and a contingent credit line of $88 billion from the 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 2.4%. Although the magnitude of the impact from these reforms remains uncertain and recent growth performance has been negatively affected by temporary factors, DBRS believes that the reforms will bolster Mexico’s trend growth and accelerate the country’s convergence with high-income OECD economies.

Mexico’s primary challenges include weak productivity growth and limited fiscal flexibility. Although the administration’s reform agenda was well-designed, weaknesses in implementation could limit the impact of reforms. Mexico may fail to boost investment if violence persists or 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 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 dependence on oil revenue. The decline in oil prices during 2014 and 2015 forced Pemex to cut investment and prompted precautionary reductions in mostly current spending at the Federal Government level. While oil revenues for 2016 are guaranteed via hedging at 49 dollars per barrel, a prolonged period of low oil prices could 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 from its deep economic linkages with the United States, but a renewed sharp slowdown in U.S. growth would likely result in a recession in Mexico and could increase risk aversion toward emerging markets generally. Given the improving U.S. economic conditions associated with monetary policy normalization by the Federal Reserve, DBRS believes a transition to higher global interest rates will be manageable for Mexico, even if exchange rate volatility remains high. Statements by U.S. presidential candidates are somewhat worrisome and could, if converted into policy, have negative implications for trade and investment across North America.

RATING DRIVERS
Strong implementation of the reforms combined with continued adherence to Mexico’s sound macroeconomic policy framework could lead to an upgrade. In particular, DBRS will monitor evidence of significant increases in investment and productivity, which are likely to be accompanied by lower domestic costs and increased competition. Early evidence shows progress and helps account for lower price pressures in the economy. In contrast, if reforms are rolled back or if fiscal discipline weakens, the ratings could come under downward pressure. In addition, if protectionism in the United States increases following the November 2016 elections, this could have adverse implications for Mexico’s economy and the ratings.

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. These can be found on www.dbrs.com at:
http://www.dbrs.com/about/methodologies

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 was not initiated at the request of the rated entity.

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

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: 29 May 2015

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