Risk drivers and outlook

Mexico enjoys manageable fiscal and current account deficits, agreeable levels of inflation and international reserves, and a diversified export base. Macroeconomic stability is furthered by a solid policy framework. Fiscal responsibility is entrenched by law, and the central bank credibly targets inflation and relies on a flexible exchange rate to serve as a first buffer to external shocks.

Add to that the tolerable level of short-term external debt, and this explains why Credendo Group assesses Mexico’s short-term political risk as limited (category 2 on a scale from 1 to 7). Looking further ahead, Credendo Group sees additional risk in the upward trending external indebtedness as well as some vulnerability with regard to adverse evolutions of oil prices and international financing conditions. Therefore, the MLT political risk assessment is somewhat less favourable (category 3).

In response to rather disappointing economic growth, both monetary and fiscal authorities recently loosened their policies. Along with the economic recovery in the US – Mexico’s all-important trade partner – this indeed boosted activity. What is more, President Peña Nieto’s impressive array of structural reforms stands to underpin investor confidence and, thus, investment inflows. All this makes for rather favourable growth prospects. Yet, as institutional quality remains to be improved, Credendo Group classifies the Mexican systemic commercial risk in its middle category (B on a scale from A to C).

Facts & figures

Pros

  • Prudent macroeconomic policies
  • International confidence
  • Diversified economy
  • Solid liquidity buffers

Cons

  • Large informal economy
  • Weak rule of law
  • Suffering oil sector
  • Prevailing insecurity

Main export products

  • Manufactures (65.3% of total current account receipts), petroleum and derivatives (12.5%), remittances (5.3%), tourism (3.0%)

Income group

  • Upper middle income

Per capita Income

  • USD 9,940

Population

  • 122.3 M

Description of electoral system

  • Presidential: 6 year term,presidency limited to one term,next election in July 2018
  • Chamber of Deputies: 3-year term,next election in June 2015
  • Chamber of Senators: 6-year term,next election in July 2018

Head of State and Government

  • President Enrique Peña Nieto

Country risk assessment

Drive for reform

The general elections of July 2012 saw the return to power of the once-dominant Institutional Revolutionary Party (PRI). Its presidential candidate, Enrique Peña Nieto, won 39% of the vote, thus defeating the contenders of the centre-left Party of the Democratic Revolution (PRD) and the centre-right National Action Party (PAN) of then incumbent President Felipe Calderón.

Since taking office in December 2012, President Peña Nieto has proven an agile politician. Lacking a congressional majority – the PRI and the allied Ecologist Green Party of Mexico together control only 48% of Lower House and Senate seats – he managed to secure PRD and PAN support to pursue an ambitious reform agenda. This ‘Pact for Mexico’ facilitated legislative change in the fields of education (to reduce the skills gap and help integrate a greater share of the labour force into the formal sector), the labour market (to increase flexibility and incentivise investment in human capital), telecoms (to foster competition), fiscal policy (see below) and the financial sector (see below).

Yet, the Pact subsided when the PRD opposed the more recent energy reform, arguably the most significant (see below) and certainly the most controversial of all. Even though the reform was still passed (PAN backing alone provided the President with the two-third majority required for constitutional change), the political consensus has waned further since then. This is mainly so because the implementation of reforms (general principles being transformed into concrete laws) clearly identifies winners and losers. This means all parties have an interest in protecting their constituencies, especially in the light of the upcoming legislative and local elections of June 2015. Still, opposition to reforms is unlikely to seriously threaten political stability.

Failed state?

For all the international praise about the President’s drive for reform, his domestic approval rating has not fared well. Though the still slow economy (see below) may be a partial explanation, widespread discontent about corruption and insecurity seems to be the main driving factor. The popular perception is that – so far – Peña Nieto has failed to deliver on campaign vows to reduce corruption, increase transparency and improve the rule of law. Indeed, Mexican cartels that control much of the drug trafficking from South America to the US continue to pose a substantial security risk, while undermining institutional quality and inflicting severe reputational damage.

Over the past decade, tens of thousands have been killed in turf wars between rival gangs and violent confrontations with security forces. Moreover, most cartels are involved in extortion of local businesses, kidnappings for ransom and people smuggling. Consecutive administrations have had limited success in re-establishing law and order, and 2012 saw the rise of heavily armed self-defence groups in the south-western states of Michoacán and Guerrero, highlighting the ‘failed state’ nature of the areas most affected by the violence. Most recently, the kidnapping and murder of 43 students renewed nationwide public outrage about the dire security situation, not least due to the direct involvement of local police with links to criminal groups.

After being criticised for apparent apathy (it took over a month before he met the students’ families), President Peña Nieto has sought to regain the initiative with proposals to – among other things – grant the federal government additional security-related powers, abolish municipal police in favour of state-level forces, and integrate vigilantes in official security units. His plans will not bear fruit in the short term, however, and even the longer-term impact remains very uncertain. On the one hand, that implies that the upcoming elections in June may well reduce the number of PRI-controlled seats in the Chamber of Deputies, thus complicating the three remaining years of Peña Nieto’s presidential term. Such prospect has moreover become more likely due to exposed links between a mansion owned by the First Lady and a Mexican company that has won hundreds of millions of dollars in government contracts. All the while, a proposed anticorruption reform has been held up in Congress since 2013. Yet on the other hand, the leftist opposition is divided, the centre-right PAN is experiencing internal strife, and both are suffering from public disenchantment with politics in general. The opposition may thus fail to take advantage of the PRI’s weakness.

Waiting for economic rebound

Mexico was strongly hit by the global financial crisis. Economic activity contracted by 4.5% in 2009, making it the first year with negative growth since 1995, when the ‘Tequila crisis’ caused a 6.8% drop in GDP. A rebound ensued in 2010 and 2011 – with growth rates of 5.1% and 4.0% respectively – but the economy slowed again from the second quarter of 2012 owing to weak external demand, mainly reflecting sluggish US industrial production. As of early 2013, the negative trend was compounded by domestic factors, with a decline in remittances and slow budget implementation by the new administration weighing on domestic demand, and gas supply bottlenecks hampering manufacturing. GDP growth fell from 4.0% in 2012 to a mere 1.4% in 2013 (see graph).

Graph1EN

More recently, economic activity has modestly picked up. Mexican GDP expanded by 2.1% in 2014, mainly as goods exports – supported by restrained labour cost evolution relative to China – along with tourism and remittance earnings benefited from the economic recovery in the US. A very accommodative policy mix has helped as well, though. To close the output gap, the central bank has lowered its policy interest rate by a full percentage point over the last eighteen months, to a historic low of 3%. And fiscal loosening has taken the form of accelerated investment spending. Looking at 2015 and beyond, the incipient recovery stands to promote employment and thus underpin household demand. Moreover, investment may boom if – as assumed – confidence is boosted by sustained political stability, credible inflation targeting by monetary authorities (anchoring inflation expectations within the 2-4% target range) and implementation of structural reforms. As such, GDP growth is expected to accelerate to 3.2% in 2015 and 3.5% in 2016.

Authorities seek to reduce informality and boost oil prospects

Mexico’s sound regulatory and supervisory framework furthers financial stability. Yet, despite adequate provisions and stabilised non-performing loan ratios, risk aversion among lenders has remained relatively high. Mexican banks only lend the equivalent of 22% of GDP, less than a third of the figures for Brazil and Chile (see graph). Hence the reform to facilitate access to credit: more competition among private banks is to bring down interest rates; development banks will be encouraged to lend more actively; and to do away with risk aversion, it will be made easier to seize assets from companies that default on repayments. To a large degree, the success of the reform will be determined by the extent to which it manages to foster financial inclusion, that is, to extend the benefits of financial services to the sizable informal parts of the economy.

Graph2EN

Public finance management has considerably improved since the 1995 Tequila crisis. As such, gross public debt – which stands to stabilise around a moderate 49% of GDP in the medium term – is judged sustainable by the IMF, even under severe shocks. That being said, weak monitoring of subnational public finances, high reliance on oil revenues (making up about a third of the government budget) and subpar tax collection have remained key weaknesses. With regard to the latter, again note the crucial role of luring a larger share of the economy into the – tax-paying – formal sector. Indeed, even if informal employment is losing ground, it remains bleak reality for some 60% of workers.

Fiscal authorities have recently sought to address the deficiencies. For one thing, a reform aims to increase tax revenues by 2% of GDP by 2018 (among other things by eliminating VAT exemptions and income tax deductions) and to phase out domestic gasoline subsidies. Moreover, the fiscal responsibility law (in place since 2006) was overhauled in order to curb pro-cyclical spending (by capping growth of current expenditures and creating a sovereign wealth fund to manage oil revenues) and prevent fiscal derailment (by requiring the government to commit to a fiscal plan consistent with the desired debt path). As a result, the public sector primary balance – showing a deficit of 1.5% of GDP in 2013 – is expected to turn to surplus by 2017. Even if this forecast may prove optimistic given the possibility of sustained lower oil prices, the risk of derailment is limited in the short term owing to the Mexican authorities’ annual purchase of put options that hedge against lower-than-budgeted oil prices.

If successful in broadening the tax base, the fiscal reform will clearly benefit the Mexican state-owned petroleum company Pemex. That is because the high tax burden that the company currently faces has crowded out investment. As a result, production fell by nearly a quarter since 2004. To reverse the downward trend, the government has also decided to turn back the clock on the 1938 hydrocarbon nationalisation and open up the Mexican oil sector to much-needed finance and technological know-how of foreign oil majors. Though highly controversial for that reason, the energy reform is anticipated to significantly benefit economic growth. The hope is that foreign involvement and increased Pemex autonomy will improve efficiency, thus making for increased production and in turn reducing the Mexican energy cost disadvantage vis-à-vis the US.

External resilience

Mexico has strong ties with the global economy. Above all – and certainly since the North American Free Trade Agreement (NAFTA) took effect in 1994 – its economy hinges on trade with the US and on investment and remittances inflows from that country. Roughly half of imports and foreign direct investment (FDI) flows into Mexico originate from the US. The other way round, almost 80% of total Mexican exports go to the US, and these represent about 12% of total US imports (where China accounts for some 23%). Growth in Mexican bilateral trade with China has been unbalanced. A boom of the Chinese share in Mexican imports from 2.4% in 2001 to 15.3% in 2012 went unmatched by exports, thus making for a bilateral trade deficit of almost 3% of Mexican GDP.

Apart from representing a key strength of the Mexican economy, close international integration also makes for vulnerability. In this context, note that the peso is the most actively traded emerging market currency in the world, making Mexico especially susceptible to rapid capital outflows in periods of financial turbulence and risk-averse market sentiment. Sure enough, talk of ‘tapering’ – the gradual coming-to-an-end of extremely accommodative monetary policies in the US – as of May 2013 caused a fall in portfolio investment inflows and initially did herald currency depreciation (reversing the appreciation seen from June 2012). All in all, the peso has weathered the financial storm quite well, however. It has outperformed many other emerging market currencies since July 2013, even if the recent drop in oil prices renewed downward pressure (see graph). Moreover, net capital inflow into Mexico remained largely unchanged and the share of local currency-denominated public debt held by foreign investors has risen to 37%. This resilient appetite for Mexican assets illustrates investor confidence in the policy framework (the flexible exchange rate rather than international reserves serving as a first buffer to shocks) and optimism about recent reforms.

Graph3EN

Solid liquidity, limited financial risk

On the back of weak oil production, the current account deficit grew from 1.3% of GDP in 2012 to 2.1% in 2013. No reduction of the deficit is in the cards for the coming years either, as reforms are expected to lead to a surge in capital imports – barring a worse-than-expected impact of lower oil prices that is – and only in later stages to benefit competitiveness and generate additional exports. That being said, Mexican reliance on manufactured exports limits vulnerability to commodity price volatility, and this makes that the current account deficit is not projected to surpass 2.5% of GDP. Furthermore, the external imbalance is expected to be largely covered by non-debt-creating FDI inflows, even if these are relatively limited in terms of GDP (see graph).

Graph4EN

Because external financing needs have always been amply met in recent years, Mexico has been accumulating international reserves. As such, it has a structurally adequate liquidity position, with reserves covering almost five months of goods and services imports. The country is also in an excellent position to honour its short-term external debt obligations, especially so given the confidence it enjoys in international financial markets. That confidence was further underpinned in November 2014, when the IMF renewed Mexico’s two-year Flexible Credit Line for USD 70 billion.

Considering the medium-term financial risk, it is apparent that Mexican external debt has increased substantially in recent years. While total external debt comprised less than 20% of GDP at the end of 2008, it stood at 35% at the end of 2013. The evolution up to now almost exactly mirrors that of private sector external debt, which rose from little over 8% of GDP in 2008 to more than 21% in 2013. Yet, despite the increase, Mexico’s financial risk remains moderate as total external debt is forecasted to stabilise around a still tolerable 38% of GDP from 2016 onwards. Besides, favourable international financing conditions have eased debt servicing obligations, which are not expected to rise above 20% of current account receipts.

Analyst: Sebastian Vanderlinden, s.vanderlinden@credendogroup.com