DBRS Morningstar Confirms Mexico at BBB (high), Trend Changed to Negative

DBRS Inc. (DBRS Morningstar) confirmed the United Mexican States’ (Mexico) Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high) and changed the trend to Negative from Stable. At the same time, DBRS Morningstar confirmed the United Mexican States’ Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low) and changed the trend to Negative from Stable.

KEY RATING CONSIDERATIONS

The Negative trend reflects DBRS Morningstar’s view that Mexico’s medium-term growth outlook has weakened, due largely to policy action by the López Obrador (AMLO) administration. DBRS Morningstar considers poorly-targeted infrastructure spending, reduced reliance on private capital, and less predictable policymaking could end up constraining investment and dampening productivity growth over time. While the government is committed to sustainable public finances, the reorientation of policy, particularly in the energy sector, could ultimately leave the government with fewer resources to address its core objectives of reducing poverty and improving economic opportunity. The deterioration in DBRS Morningstar’s building block “Economic Structure and Performance” was the key factor for the trend change.

The BBB (high) ratings balance Mexico’s long track record of sound macroeconomic policymaking with the country’s deep governance and growth challenges. The economy has demonstrated a high degree of resilience in recent years, due in large part to its strong policy framework – comprised of exchange rate flexibility, prudent fiscal management, and a credible inflation-targeting regime. These pillars of macroeconomic policy are unlikely to change under the AMLO administration, thereby setting the stage for continued macroeconomic stability. The financial system is also well-regulated, and the country’s external position appears broadly consistent with economic fundamentals. However, significant structural challenges weigh on the credit profile. Poor education outcomes, widespread informality, and far-reaching governance problems have led to decades of weak economic growth. Some of the potentially growth-enhancing structural reforms put in place during the previous administration have not been fully implemented and are in some instances being unwound.

RATING DRIVERS

The Negative trend reflects DBRS Morningstar’s view that risks to the ratings are skewed to the downside. The trend could return to Stable if (1) the government revitalizes the reform agenda in a manner that materially strengthens Mexico’s investment outlook, and (2) public debt dynamics remain on a stable trajectory over the medium term.

On the other hand, the ratings could be downgraded if (1) the broad policy orientation under the AMLO administration continues to suggest weaker medium-term growth prospects, or (2) the government’s commitment to fiscal discipline deteriorates.

RATING RATIONALE

Policy Actions Have Materially Weakened Medium-Term Growth Prospects

Policy actions by the AMLO administration have set the stage for slower economic growth, in DBRS Morningstar’s view. The government’s decision to postpone energy auctions and limit cooperation between Pemex and private firms, invest in the Dos Bocas refinery, cancel a partially-built airport in Mexico City, and renegotiate private contracts related to several natural gas pipelines, have reduced policy predictability and damaged business confidence. Projected levels of investment over the next five years are materially lower now than 18-24 months ago. Moreover, one area where public investment is expected to increase is energy, where resources appear to be being misallocated. Lower and poorer-quality investment point to weaker growth over the medium term.

The rollback of reforms constitutes a missed opportunity, in DBRS Morningstar’s view. For two and a half decades, Mexico’s growth record has been poor, with GDP growth averaging just 2.4 percent. The market reforms passed under the previous administration aimed to break Mexico out of its lackluster performance. DBRS Morningstar upgraded Mexico’s ratings in March 2014 to BBB (high) on the expectation that the reforms would lead to higher levels of investment and productivity. This was never fully realized, in part due to a less supportive external environment, but also because reform implementation remained incomplete. In light of the early actions by the AMLO administration, the anticipated growth benefits are unlikely to materialize. This reassessment of the outlook has led to a negative adjustment in the “Economic Structure and Performance” building block.

External risks to the outlook have recently diminished, but adverse global developments could still create a challenging environment. The United States-Mexico-Canada trade agreement looks set to be ratified in early 2020, which would eliminate a major source of uncertainty regarding the future of the North American trading relationship. On the other hand, the threat of tariffs by the Trump administration could continue to weigh on investment. Other risks include a sharper-than-expected economic slowdown in the U.S. or increased risk aversion toward emerging markets generally, which could adversely impact Mexico through trade and investment channels. With regard to the potential escalation of U.S.-China trade tensions, the effect on Mexico would likely be mixed: Mexico could face weaker global demand, but it would also likely benefit from trade diversion.

The AMLO Administration Is Committed To Fiscal Sustainability But Pressures Are Building

The AMLO administration has thus far delivered on its commitment to sustainable public finances. In the first 10 months of the year, revenue shortfalls – which were driven by weaker-than-expected growth and oil production – have been offset by cuts in primary spending. For the year as a whole, the government will likely achieve its primary surplus target of 1.0% of GDP. Moreover, prudent fiscal policy looks set to continue next year. The 2020 budget maintains a broadly neutral fiscal stance with a primary surplus target of 0.7% of GDP.

Notwithstanding signs of budget discipline, fiscal pressures are building. Maintaining primary surpluses over the coming years could be difficult given the downside risks to budgeted growth and oil production, as well as the promises to spend substantially more on priority programs. The significant cuts in civil servant salaries and public investment that have already been implemented also raise concerns about the quality of public administration and future economic growth. In addition, Pemex’s new business strategy is unlikely to improve operational efficiency or rebuild its reserve portfolio. Consequently, Pemex could continue to weigh on public finances, either by crowding out other fiscal priorities or contributing to higher deficits.

Public debt dynamics appear sustainable but highlight the importance of tight fiscal management. If the AMLO administration achieves its primary surplus targets of 1% of GDP, gross public debt is likely to remain stable at around 55% of GDP over the medium term. However, in an adverse scenario characterized by slower economic growth, some easing of the fiscal targets, higher real interest rates and a weaker exchange rate, government debt levels could rise significantly, thereby requiring a sizable fiscal adjustment to stabilize public finances. The outlook underscores the importance of maintaining a sustainable fiscal strategy that is credible and affirms market confidence.

Strengthening The Rule Of Law Is A Critical Challenge

The most significant challenge facing Mexico’s credit profile relates to governance. According to the Worldwide Governance Indicators, Mexico scores poorly on the rule of law relative to emerging market peers, both globally and in Latin America. Corruption and cronyism, which are perceived to be entrenched and widespread, constrain economic growth by encouraging rent-seeking behavior and misallocating resources. Elevated levels of criminality, combined with perceived deficiencies in the judicial system and law enforcement, also weaken the investment climate.

Early efforts by the AMLO administration to address corruption and improve public security have focused on poverty alleviation schemes, budgetary cuts for programs perceived to be subject to graft, and the creation of a National Guard to replace the Federal Police. Although it is still early to draw conclusions, it is not clear, in DBRS Morningstar’s view, that the strategy will yield any benefits in terms of strengthening the rule of law or improving the country’s institutional quality.

The 2018 general election produced a decisive victory for AMLO. In addition to winning the presidency by a wide margin, AMLO’s coalition won a majority in both houses of Congress as well as control of more than half of the state legislatures. The result is that AMLO has substantial power to pass legislation and coordinate policy with subnational governments. One source of credit strength has been the broad political support through the electoral cycle for Mexico’s sound fiscal and monetary policy frameworks. This has enhanced the economy’s resilience to shocks and led to a positive adjustment in the “Political Environment” building block.

Strong Policy Frameworks Support The Economy’s Resilience In A Turbulent Global Environment

Mexico benefits from a credible inflation-targeting framework and a well-regulated financial system. Inflation converged to the central bank’s 3.0% target in November 2019, down from 4.7% (yoy) one year earlier. The decline was driven by falling energy prices, while core inflation has remained close to the upper band of the 2-4% target range despite a widening negative output gap. The central bank has started to ease monetary policy, with three 25 basis point cuts in the policy rate from August to November, but the overall stance remains restrictive. DBRS Morningstar expects the easing cycle to continue in 2020 as long as inflation expectations remain anchored around the target.

Financial stability risks are limited. The banking system is profitable and well-capitalized, with low levels of non-performing loans. Exchange rate fluctuations have not adversely affected banks’ balance sheets nor have they resulted in a deterioration in asset quality in the corporate sector. Household leverage is also low, with limited foreign exchange exposure.

In addition, Mexico’s external position does not exhibit any clear imbalances. The current account deficit is modest and fully financed by net foreign direct investment. The net international liability position is moderate and relatively stable. While the highly integrated nature of the Mexican economy leaves Mexico exposed to capital flow volatility, the country’s sound macroeconomic policy framework enhances the economy’s resilience to bouts of market turbulence. In particular, Mexico’s flexible exchange rate helps the economy adjust to external conditions. The central bank also holds substantial reserves and a Flexible Credit Line from the IMF in order to provide foreign exchange liquidity in the event of global market volatility.

For more information on the Rating Committee decision, please see the <a href="https://www.dbrs.com/research/355026/" target="_blank">Scorecard Indicators and Building Block Assessments</>.

Notes:
All figures are in U.S. dollars unless otherwise noted. Public finance statistics reported on a public sector basis; this excludes state and local governments but includes state-owned enterprises and public development banks. The Overall Fiscal Balance is the Public Sector Borrowing Requirement.

The principal methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The primary sources of information used for this rating include the Secretária de Hacienda y Crédito Público, Banco de México, INEGI, BIS, OECD, IMF, World Bank, UN, Tullet Prebon Information, and Haver Analytics. DBRS Morningstar 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 for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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