DBRS Confirms United Mexican States at BBB (high), Stable Trend

DBRS has confirmed Mexico’s long-term foreign currency issuer rating at BBB (high) and long-term local currency issuer rating at A (low). DBRS has also confirmed the short-term foreign and local currency issuer ratings at R-1 (low). The trend on all ratings is Stable.

Mexico continues to face a challenging external environment characterized by low oil prices, weak demand from key trading partners, and tightening global financing conditions. These factors have dampened Mexico’s recent growth performance. After expanding just 2.3% in 2014 and 2.6% in 2015, the economy is expected to decelerate to 2.1% in 2016. However, the confirmation of the ratings reflects DBRS’s view that Mexico’s credit fundamentals remain intact. The strong policy framework is facilitating a relatively smooth adjustment to less favorable global conditions, the fiscal consolidation plan is proceeding gradually and on schedule, the banking system remains well-capitalized, and structural reforms passed under the Peña Nieto administration should boost growth over the medium term.

The principal risk to Mexico’s growth outlook stems from the threat of protectionism. U.S. President-elect Donald Trump has suggested he would renegotiate or withdraw from the North American Free Trade Agreement (NAFTA), impose tariffs on Mexican imports, and penalize U.S. companies that move operations to Mexico. In the near term, uncertainty over the future of U.S. policy could delay investment decisions and lead to tighter financing conditions. In DBRS’s view, however, a temporary slowdown is unlikely to change Mexico’s credit fundamentals. On the other hand, the implementation of protectionist measures or a prolonged period of uncertainty would constitute a more durable supply-side shock for Mexico, with adverse implications for investment and productivity over the longer term.

The Mexican economy has been hit by a series of external shocks. Over the last two years, manufacturing exports have performed poorly amid weak industrial production in the United States. Investment has been negatively affected by budget consolidation and uncertainty surrounding the U.S. election. More recently, funding conditions have become less favorable due to higher U.S. Treasury yields and tighter monetary policy by the central bank of Mexico.

Despite weak economic conditions, further fiscal tightening is required in order to put public finances in a sustainable position. The deficit is expected to narrow from 4.1% of GDP in 2015 to 3.0% this year, albeit supported by some one-off factors. The government aims to reduce the deficit to 2.5% by 2018. While the consolidation plan appears to be on track, fiscal pressures could emerge, particularly with declining oil production and rising pension costs.

Primary deficits, peso depreciation and the assumption of pension liabilities from state-owned enterprises have led to a substantial increase in public debt. From 2012 to 2016, public debt-to-GDP rose from 43% to an estimated 56%. The debt ratio is expected to peak in 2017 and then gradually decline as fiscal consolidation advances and the effects of peso depreciation recede. However, weaker-than-expected growth or deviations from the fiscal consolidation plan could raise public debt ratios significantly above the baseline trajectory, potentially putting downward pressure on the ratings.

Despite challenging external conditions and heightened political risks, Mexico’s sound macroeconomic policies are facilitating an orderly adjustment and DBRS believes that the supply-side reforms passed in 2013 and 2014 will increase growth over the medium term. Tighter fiscal policy is being accompanied by reforms at Pemex to improve operational efficiency and strengthen the company’s financial position. Inflation is close to the central bank’s target of 3% and inflation expectations remain anchored around the target. Furthermore, Mexico’s banking system is profitable, well-capitalized, and in a strong position to support the economy.

Mexico’s external accounts appear sound from a flow and stock perspective, even as international risks weigh on the outlook. Exchange rate flexibility is helping to cushion the economy from external shocks without putting excessive stress on the banking system or corporate balance sheets. The current account deficit has stabilized at a moderate level and external financing is primarily provided through net foreign direct investment. While monetary tightening in the U.S. could generate some capital flow volatility, the central bank holds substantial reserves and a Flexible Credit Line from the IMF in order to provide FX liquidity if necessary. The net international liability position is at moderate levels, and though external debt ratios have increased over the last decade, they remain relatively low.

Furthermore, several trends in the domestic economy signal that Mexico’s structural reforms are starting to have a positive impact. The 2013 energy reform, which opened the market to private capital, has fundamentally changed the outlook for the oil and gas sector. Results of the December 5th auction are encouraging. The labor market is also performing well. Formal jobs increased by 4.1% year-over-year in November 2016. New competitive forces in the telecommunications sector are attracting greater investment and lowering consumer prices. In addition, credit is expanding at a robust pace, highlighting greater competition in the banking sector, the resilience of credit demand, and advances in terms of financial deepening. While the combined effect of these reforms should boost potential growth, generating higher rates of productivity may also hinge on Mexico’s ability to meaningfully address corruption and strengthen the rule of law.

RATING DRIVERS
In the coming months, DBRS will assess the policy intentions of the incoming Trump administration. If U.S. policy actions materially weaken Mexico’s medium-term growth outlook, the ratings could come under downward pressure. Weakened political commitment to fiscal consolidation could also have adverse implications for the ratings. Conversely, if the risks to Mexico’s economy stemming from protectionism recede and deficit-reduction plans proceed on schedule, the ratings could remain at their current level. DBRS does not foresee upside pressure on the ratings in the near term.

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 at http://www.dbrs.com/about/methodologies.

The sources of information used for this rating include Secretaría de Hacienda y Crédito Público, Banco de México, INEGI, Pemex, Sociedad Hipotecaria Federal, U.S. Energy Information Administration, Chicago Mercantile Exchange, IMF, OECD, United Nations, United Nations Development Programme, Tullet Prebon Information, Bloomberg, The Conference Board Total Economy Database, Banco Central do Brasil, Banco Central de Chile, Banco de la República, World Bank/NRGI/Brookings, BIS, Haver Analytics and DBRS. 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: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 28 July 2006
Most Recent Rating Update: 15 June 2016

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