PRESS RELEASE

S&P: Mexico Outlook Revised To Negative On Potential For Lower Growth Prospects

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Monday, March 4, 2019

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MEXICO SOVEREIGN ​RATINGS

Foreign Currency: BBB+/Negative/A-2

Local Currency: A-/Negative/A-2

For further details see full release.

OVERVIEW

  • We expect the López Obrador Administration to pragmatically implement economic policies that balance social priorities with the need for macroeconomic stability in Mexico.

  • However, a recent shift in government policy to reduce private-sector involvement in the energy sector, along with other developments that have diminished investor confidence, could contribute to higher contingent liabilities for Mexico and lower its GDP growth prospects.

  • We are revising our outlook on the long-term ratings on Mexico to negative from stable, and we are affirming our 'BBB+/A-2' foreign currency and 'A-/A-2' local currency sovereign credit ratings.

  • The negative outlook reflects our view that potentially higher contingent liabilities and lower GDP growth prospects could weaken the sovereign's financial profile, which could lead to a downgrade.

RATING ACTION

On March 1, 2019, S&P Global Ratings revised its outlook on the long-term ratings on Mexico to negative from stable. At the same time, we affirmed our 'BBB+/A-2' foreign currency and 'A-/A-2' local currency sovereign credit ratings on Mexico. We also affirmed our 'A+' transfer and convertibility (T&C) assessment.

OUTLOOK

The negative outlook indicates an at least one-in-three possibility of a downgrade over the coming year.

The outlook reflects the risk that a recent shift in government policy to reduce private-sector involvement in the energy sector, along with other developments that have led to a decline in investor confidence, could contribute to higher contingent liabilities for the sovereign and lower its GDP growth prospects.

The resulting weakening of the sovereign's financial profile could lead to a downgrade.

The new strategy for the energy sector places an added burden on the already highly indebted government-owned energy company Petroleos Mexicanos (Pemex), which has a legacy of poor operational and financial performance and technical capacity constraints. Pemex continues to bear a heavy fiscal burden, despite a recent change in its taxation policy that modestly improves its cash flow.

Based on past policies, as well as on more recent steps (such as a budgeted capital injection in 2019), we assume that the government will continue to provide financial and other types of support to Pemex. We continue to assume an almost certain likelihood of extraordinary government support, which equalizes our ratings on Pemex with those on the sovereign. The combination of Pemex's weak financial profile and a more active role in the energy sector could raise the risk of higher contingent liabilities for the sovereign.

There is also a risk that lower private-sector investment could reduce GDP growth prospects, weakening Mexico's economic resilience. That, in turn, could contribute to fiscal slippage and financial market uncertainty, potentially worsening the sovereign's financial profile and leading to a downgrade.

Conversely, effective economic management that maintains moderate fiscal deficits, encourages investment, and raises investor confidence would strengthen GDP growth prospects and help maintain stable public finances. That, along with steps to contain the potential contingent liability posed by Pemex, could avoid an erosion of the sovereign's financial profile. We could revise the outlook to stable over the coming year in that scenario.

RATIONALE

The ratings on Mexico reflect its moderate economic growth thanks to many years of cautious fiscal and monetary policies, and a floating exchange rate regime that has maintained stability despite many adverse global trends. They also reflect its independent central bank, which has broad political support thanks to its credible inflation-targeting monetary policy. Our institutional assessment incorporates strengths and weaknesses in Mexico's democracy, which has brought political stability and regular changes of government over the last two decades but has not created economic dynamism or improved public security.

The Mexican peso is a floating currency and, by our definition, is actively traded, which eases external financing needs. According to the Bank for International Settlements' (BIS) Triennial Central Bank Survey, the peso is bought or sold in more than 1% of global foreign exchange turnover. The peso accounts for one side of 2%-3% of global currency transactions, according to BIS data, the highest share for any emerging market country. In addition, Mexico has access to the International Monetary Fund's (IMF) Flexible Contingent Credit Line for up to $74 billion, boosting the sovereign's external liquidity. Our ratings reflect the country's projected per capita GDP of about US$9,600 in 2019 and its moderate external position. They also reflect expected moderate current account deficits (CAD) in coming years, containing the growth in external debt.

We expect the new administration of President Andres Manuel Lopez Obrador to implement pragmatically its economic policies, balancing economic and social priorities with the need for macroeconomic stability. We expect that the general government fiscal deficit will remain around 3% of GDP in the next two years, little changed from recent years. We expect the net general government debt will increase around 3% of GDP over the next three years. A combination of moderate economic growth and cautious fiscal policy should keep the net general government debt burden below 45% of GDP over the next couple of years. The ratings currently incorporate limited contingent liabilities. Institutional and economic profile: More centralization and a bigger economic role for the government

  • A strong electoral mandate sets the stage for the Lopez Obrador Administration to reform Mexico's economic and social policies.

  • We expect continuity in monetary, exchange rate, and trade policies under the new administration and moderate changes in fiscal policy.

  • We expect GDP growth in 2019 to be 1.8%, led by consumption and constrained by weak private investment.

For nearly two decades, successive administrations have maintained generally stable public finances, low inflation, and modest economic growth. Presidential power has alternated smoothly over the past 19 years between the center-left Partido Revolucionario Institucional (PRI), the center-right Partido Acción Nacional (PAN), and now to the leftist Movimiento Regeneracion Nacional (Morena) without substantial changes in macroeconomic policy.

The 2018 national elections signal changes in both economic and political trends. The new center-left President, Andres Manuel Lopez Obrador (AMLO), a longtime politician and former member of the long-dominant PRI, favors a shift in the focus of economic policies with a larger role for the state and greater emphasis on social policies. AMLO has a strong electoral mandate and high levels of popular support, having won with more than half the popular vote. Morena also has a majority in both chambers of Congress and controls 19 of the total 32 state Congresses (and Federal District). This should facilitate passing legislation, including constitutional changes that require a two-thirds majority. AMLO's solid mandate gives him greater political capital than presidents in the last two decades.

We expect broad continuity in trade, exchange rate, and monetary policies, but we expect some changes in the focus of fiscal policy (amid contained deficits). AMLO has expressed his support for central bank autonomy and has supported a renegotiated trade deal with the U.S. and Canada (the United States-Mexico-Canada Agreement). The administration has focused on strengthening social programs, enlarging the public sector's role in the energy and electricity sectors. It has also aimed to keep the size of the fiscal deficit little changed from recent years by, among other things, introducing austerity measures upon the public sector. This includes capping public-sector salaries at the level of the president's salary. It has initiated a drive against fuel theft from Pemex, which suffers around $3 billion annually in such losses.

Several recent steps by the administration have hurt private-sector confidence and could put downward pressure on investment and growth prospects over the next couple of years. These include the cancellation of existing private-sector contracts for the construction of a new airport to replace the current, at capacity, airport that serves Mexico City.

In addition, the administration plans to change the law on public consultations (which requires a Constitutional change) to allow for more frequent public votes on a wider variety of issues, potentially injecting greater uncertainty about policies. The introduction of new federal coordinators to oversee the allocation of federal transfers to subnational governments introduces further changes in fiscal federalism. We expect that Mexico's democracy, large middle class, close economic integration with the U.S., and its institutions will provide a measure of stability and predictability in coming years as the AMLO Administration pursues its ambitious social, economic, and political plans. However, there is a risk that poorer-than-expected economic growth and greater centralization of political decision-making could weaken macroeconomic stability amid difficult policy trade-offs and potentially affect institutional effectiveness.

We expect trend GDP growth is likely 2%-2.5% (and per capita growth around 1%-1.5%). Many years of only moderate private-sector investment, low public-sector investment in infrastructure, relatively poor quality of education, and judicial uncertainty constrain Mexico's long-term growth prospects. Real per capita GDP growth during 2014-2018 averaged 1.5%, partly reflecting a contraction in the oil sector, compounded by recent investor uncertainty about Mexico's trade deal with the U.S. and Canada and national elections in 2018.

Non-oil GDP has grown around 3% in the last four years. Mexican oil output fell to 1.8 million barrels per day (mbpd) in 2018 from 3.4 mbpd in 2004, and it may decline again in 2019. We expect that the oil sector could gradually stabilize, based on stable world oil prices (see "S&P Global Ratings Lowers Brent And WTI Oil Price Assumptions For 2019 Through 2020; Natural Gas Price Assumptions Are Unchanged," Jan. 3, 2019, for our price assumptions). We expect GDP growth in 2019 to be 1.8%, down from 2% last year. Solid consumption, steady exports to the U.S., and robust remittances should sustain growth. The labor market remains strong, with higher real wages in recent years.

The administration's growth strategy includes an enlarged role for Pemex and Comision Federal de Electricidad (CFE) in the energy and electricity sectors and the merger of some government-owned development banks to create new institutions to promote development finance. It also plans to boost growth in the impoverished south, including through new trains for freight and tourism, as well as agroforestry projects. Failure to ensure effective public-sector management, and to avoid discretion in lending (including through targeted lending policies), could result in poor investments and bad loans. It could also result in diminished GDP growth over the coming two to three years. Flexibility and performance profile: Moderate increases in debt burden and effective monetary policy

  • We expect Mexico's external profile will remain stable in the coming three years.

  • The Mexican economy showed its resilience in recent times, based on a flexible exchange rate and credible monetary policy that targets inflation.

  • The combination of moderate economic growth and cautious fiscal policy should keep the net general government debt burden below 45% of GDP over the next couple of years.

We expect Mexico's gross external financing needs (current account payments and public- and private-sector external debt due by remaining maturity) to hover around 90% of current account receipts (CAR) and usable reserve in the next three years. We project that narrow net external debt (gross debt net of liquid external assets) will hover below 40% of CAR in the next couple of years. (We include nonresident holdings of locally issued debt in our estimates of external debt because our methodology calculates external debt on a residency basis.)

The current account has adjusted to contain external vulnerability despite a decline in terms of trade since 2014 due to lower oil prices. The CAD was a