DBRS Morningstar Downgrades Mexico to BBB, Trend Remains Negative

DBRS Inc. (DBRS Morningstar) downgraded the United Mexican States’ (Mexico) Long-Term Foreign and Local Currency – Issuer Ratings to BBB from BBB (high). At the same time, DBRS Morningstar downgraded the United Mexican States’ Short-Term Foreign and Local Currency – Issuer Ratings to R-2 (high) from R-1 (low). The trend on all ratings remains Negative.

KEY RATING CONSIDERATIONS
The downgrade reflects the sharp deterioration in Mexico’s immediate growth outlook due to the global outbreak of the Coronavirus Disease (COVID-19), as well as DBRS Morningstar’s view that Mexico’s medium-term growth outlook has weakened. The government remains committed to a sound macroeconomic policy framework, but the severity of the shock combined with weaker recovery prospects will have a materially adverse impact on public finances. In DBRS Morningstar’s Building Block Assessment, the downgrade reflects the deterioration in “Economic Structure and Performance” and “Fiscal Policy and Management.”

The coronavirus pandemic is having a severe impact on the Mexican economy. Non-essential businesses have been closed across the country until at least May 17th, global demand for Mexican goods and services has declined precipitously, and financing conditions have tightened amid heightened risk aversion globally. At a minimum, the combination of these shocks will have a deeply negative impact on economic activity the first half of this year. The government is working with the United States and Canada to coordinate a reopening of sectors that are essential to North American supply chains. However, a broader resumption of activity in the second half of the year will likely be gradual and uneven. Some sectors might be able to quickly recover lost output as social-distancing policies are relaxed, but other parts of the economy will likely experience longer-lasting damage. The IMF forecasts Mexico’s GDP to contract by 6.6% in 2020 and then partially recover with 3.0% growth in 2021.

Mexico’s medium-term growth outlook has also weakened, in DBRS Morningstar’s view, due in large part to policy actions by the López Obrador (AMLO) administration. Poorly-targeted infrastructure spending, reduced reliance on private capital, and less predictable policymaking will likely end up constraining investment and dampening productivity 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. The modest fiscal response to the pandemic so far could also prove to be insufficient to support the supply side of the economy, in DBRS Morningstar’s view, as firms may close permanently due to the shutdown. The broad policy orientation of the AMLO administration, in our view, will likely contribute to a comparatively slow economic recovery.

The BBB 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, responsible fiscal management, and a credible inflation-targeting regime. 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.

The Negative trend reflects DBRS Morningstar’s view that risks to the economic and fiscal outlook are skewed to the downside. There is a high degree of uncertainty over the magnitude and duration of the COVID-19 shock. While the incidence of confirmed COVID-19 cases is lower in Mexico than in other countries in the region, testing thus far has been relatively limited. Output losses could be substantially greater than anticipated if strict containment measures need to be extended or reinstated later in the year. At the same time, underlying pressures in the fiscal accounts are building. Absent corrective measures, this could lead to a deterioration in public debt dynamics beyond what is currently anticipated.

RATING DRIVERS
The ratings are unlikely to be upgraded in the near term. However, over time the rating could be upgraded if (1) the government revitalizes the reform agenda in a manner that materially strengthens Mexico’s investment outlook and (2) public debt dynamics are put on a firm downward trajectory over the medium term.

The ratings could be downgraded if the outlook for public debt sustainability deteriorates substantially more than expected. This could be because the spread of the virus takes longer to contain than anticipated, thereby resulting in a greater economic shock, or fiscal outcomes materially weaken. The ratings could also be downgraded if there is a weakening in the country’s macroeconomic policy framework.

RATING RATIONALE

The Coronavirus Presents A Large Shock To The Mexican Economy And The Recovery Will Likely Be Slow

With the coronavirus outbreak, Mexico’s 2020 growth outlook has markedly deteriorated. Strict social-distancing measures, combined with weaker labor market conditions and a likely decline in remittances, will adversely affect consumption. The outlook for investment is also poor, due to the domestic shutdown and weak business confidence. On the external side, supply chain disruptions and depressed global demand will negatively impact exports, including auto manufacturing and tourism services. In addition, limited fiscal support from the government could dampen the pace of the recovery, in our view, possibly due to greater firm destruction on the supply side of the economy and weaker aggregate demand once the restrictions are lifted.

Policy actions by the AMLO administration have also set the stage for slower growth over the medium term, in DBRS Morningstar’s view. The government’s decision to postpone energy auctions and limit cooperation between Pemex and private firms, cancel a partially-built airport in Mexico City, renegotiate private contracts related to several natural gas pipelines, and the recent decision to revoke permits to build a beer manufacturing plant, have reduced policy predictability and damaged business confidence. Even as the pandemic-related restrictions are eased, projected levels of investment over the next five years are expected to be materially lower than we had expected two years ago. Moreover, the one area where public investment is expected to increase is energy, where resources appear to be being misallocated, in our view. 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. The market reforms passed under the previous administration aimed to break Mexico out of its 25-year record of lackluster growth. DBRS Morningstar upgraded Mexico’s ratings in March 2014 to BBB (high) on the expectation that 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 actions by the AMLO administration, the anticipated growth benefits are unlikely to materialize. The coronavirus shock and the reassessment of the medium-term outlook have led to a negative adjustment in the “Economic Structure and Performance” building block assessment.

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

The government’s initial fiscal response to the pandemic is a mix of targeted support and fiscal austerity. Compared to other countries in the region, the scale of the response is small. Measures announced so far include accelerating some social transfer payments, extending low-interest credit to SMEs and households, and moving ahead with previously announced large infrastructure projects. Part of the additional spending will be offset by reduced expenditure on non-priority items as well as wage cuts for high level public officials. As a result, the government expects the fiscal deficit to increase from 2.3% of GDP in 2019 to 4.4% in 2020 and 4.0% in 2021.

However, we view the risks to the fiscal outlook as skewed to the downside. Of key concern is Pemex’s business strategy, which in DBRS Morningstar’s view, is unlikely to improve operational efficiency or rebuild its reserve portfolio. Consequently, Pemex could increasingly weigh on public finances, either by crowding out other fiscal priorities or contributing to higher deficits. Oil-related government revenues are largely hedged for 2020 at the budgeted price of $49/bbl (Mexican mix), thereby providing some cushion to the recent price collapse. Nevertheless, a sustained period of low oil prices would start impacting revenues next year. Given the elevated levels of uncertainty around the economic outlook, budget assumptions regarding GDP growth and oil production also pose downside risks. Finally, significant cuts in civil servant salaries, if sustained, raise concerns about the quality of public administration, in DBRS Morningstar’s opinion. Based on our view of the risks to the fiscal outlook, we have made a negative adjustment in the “Fiscal Management and Policy” building block assessment.

Given the government’s spending commitments, tax reform could be needed to put public finances on a sustainable path. The recessionary shock this year will lead to a higher public debt-to-GDP ratio. Stabilizing debt dynamics at this higher level will depend on the government’s ability to consolidate fiscal accounts once the public health crisis is over. An adjustment of 1-2% of GDP would likely be required. The government has already raised the possibility of a tax reform after 2021. If consolidation measures are not pursued and the primary fiscal balance remains close to the projected 2021 level, public debt ratios would rise over time, and thereby putting further downward pressure on the ratings. The outlook underscores the importance of putting in place 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.

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 influences positively our “Political Environment” building block assessment.

Strong Policy Frameworks Support The Economy’s Macroeconomic Resilience

Mexico benefits from a credible inflation-targeting framework and a well-regulated financial system. Amid mounting risks to the growth outlook over the last two months, the central bank cut the policy rate by 100 basis points from 7.0% to 6.0%. The easing cycle, which started in August 2019, has shifted the monetary stance from restrictive to broadly neutral. However, additional easing is likely, which will mean that monetary policy will provide greater support to the economy going forward. The next scheduled meeting is May 14th. In addition to lowering the policy rate, the central bank has provided a series of liquidity measures to ensure financial markets operate smoothly.

The financial system appears well-positioned to weather the recession. The banking system is well-capitalized with low levels of non-performing loans, although asset quality will likely deteriorate in the near term. 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. 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 can also provide foreign exchange liquidity, if necessary. In addition to $186 billion in reserves, the central bank has a $60 billion swap line with the Federal Reserve and a $61 billion Flexible Credit Line from the IMF.

ESG CONSIDERATIONS
Resource & Energy Management (E), Human Capital & Human Rights (S), Bribery, Corruption & Political Risks (G), Institutional Strength, Governance & Transparency (G), and Peace & Security (G) were among key drivers behind this rating action. Management of the energy sector remains a potential vulnerability to the Mexican economy and to public finances, with oil-related revenues accounting for 15-20% of government revenue. Similar to other emerging market economies and many of its regional peers, per capita GDP is relatively low, at US$10.1k (US$20.9k on a PPP basis). According to World Bank Governance Indicators, Mexico ranks in the 19th percentile for Control of Corruption, the 46th percentile for Voice & Accountability, the 28th percentile for Rule of Law, and the 48th percentile for Government Effectiveness. Mexico is trying to address violence and criminality issues through reform, but still ranks low (26th percentile) on Political Stability and the Absence of Violence/Terrorism. These considerations have been taken into account within the following Building Blocks: Fiscal Management and Policy, Economic Structure and Performance, and Political Environment.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at https://www.dbrsmorningstar.com/research/357792

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/360721

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 fiscal balance is the Public Sector Borrowing Requirement.

The principal methodology is the Global Methodology for Rating Sovereign Governments (September 17, 2019): https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments

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.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883

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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