Mexico: Solid fundamentals bolstering economic performance despite the shifting political landscape

• A new political era is taking shape under recently elected President Obrador.
• Controversial policy decisions are nurturing uncertainty.
• Strong macroeconomic fundamentals are bolstering Latin America’s second largest economy.
• Fiscal continuity is being sought while Mexico’s public debt dynamics remain sustainable.
• Credendo’s risk outlook for Mexico remains generally stable.

A new political era is taking shape

Left-wing nationalist and former Mayor of Mexico City Andrés Manuel López Obrador officially took over as Mexico’s President on 1 December 2018 after a convincing win in the July 2018 elections. For the first time Mexico’s President does not belong to either the Institutional Revolutionary Party, which ruled the country for almost a century, or the traditional opposition party, the National Action Party, which governed for 12 years. In fact, President Obrador’s Morena Party (the National Regeneration Movement) only registered as a political party in 2014, making this a brand new political era for Mexico. His electoral victory was no surprise, with him being the anti-establishment candidate, capitalising on voters’ anger over corruption scandals, Mexico’s record murder rate and pervasive inequality. 

On the legislative side, President Obrador’s coalition also sealed a majority in both houses of Congress, making him the most powerful president in decades and facilitating the smooth passage of legislation. The ruling majority in office since September 2018 could even increase to two thirds if small parties decide to vote with the coalition, enabling some critical reforms that require constitutional modification (energy, labour, telecommunications and tax) to go ahead. Despite the expected lack of opposition pressure, internal party division between members who desire pro-market reforms and those who prefer more state participation could complicate policymaking.

Controversial policy decisions are nurturing uncertainty

Since taking office, President Obrador has demonstrated great eagerness by quickly introducing reforms to curb corruption and fight crime (by creating a controversial National Guard under military control) while increasing social spending and presenting ambitious infrastructure projects. However, past reforms in energy and education introduced by his predecessor Peña Nieto could be reversed by the new administration. The newly elected president has accepted a deal with the USA and Canada to update NAFTA (the North American Free Trade Agreement) – referred to as the USMCA – which has seriously reduced uncertainty over trade ties with the USA. Although the new trade deal has been signed by the three respective leaders, it will need to be ratified by each country’s legislature before it can come into effect. Although the USMCA bears a lot of similarities to NAFTA, there are certain differences in areas like services and e-commerce and the USMCA introduces more stringent rules of origin requirements and tougher automotive rules.

President Obrador is seeking to govern through an unusual combination of congressional debate and direct democracy by putting many decisions to a people’s vote, which will marginalise the power-check of Congress. In October 2018, President Obrador organised a popular consultation on the cancellation of a huge airport under construction for Mexico City. The 1% of the electorate who took part voted to scrap the airport and President Obrador pledged to honour this result even though the project had already cost USD 5 billion (of a total of USD 13 billion) and was already 30% built. The financial markets were rattled, causing Mexico’s bonds and currency to plunge, which prompted the central bank to raise interest rates to up to 8.15% (the highest rate since 2008). However, the construction of the airport has continued in order to protect the state-owned airport trust from having to repay USD 6 billion of airport bonds when works are cancelled. To avoid a messy default, the government recently brokered a deal with the bondholders who bought USD 6 billion in airport bonds to fund the construction, buying back USD 1.8 billion of the bonds. For now, negotiations on contract termination are ongoing.

Following the airport debacle, policy uncertainty has threatened to hurt Mexico’s credibility in the capital markets, raising borrowing costs and reducing appetite for Mexican debt. Nonetheless, the presentation of the 2019 budget managed to reassure investors by showing general fiscal responsibility, which reinforced the peso again. In addition, the new administration has repeatedly promised pragmatism and stated its commitment to maintain Mexico’s strong policy framework and the independence of economic-policy institutions.

Strong macroeconomic fundamentals are bolstering Latin America’s second largest economy

Economic growth in Latin America’s second largest economy has remained resilient over the past 5 years and is projected to reach 2.1% GDP growth in 2019 and 2.2% in 2020. Inflation decreased to 4.8% in 2018 (from 6.8% in 2017) and is set to converge to 3% thanks to prudent monetary policymaking. The Mexican peso (which depreciated by less than 5% against the USD in 2018) follows a flexible exchange regime that has helped deal with external shocks.

Mexico’s oil production has been following a downward trend – going from 2.5 million barrels a day in 2013 down to 1.9 in 2018 – largely explained by years of underinvestment in the heavily indebted state-owned petroleum company Pemex and outsized levied taxes. The financial health of Pemex continues to be a great concern. Moreover, Pemex reportedly loses USD 3 billion annually due to fuel theft, mainly by local gangs and drug cartels. In a recent attempt to combat fuel theft by shifting distribution from vulnerable pipelines to tanker trucks, the government provoked a major fuel shortage across the country after just three weeks in office. Unless it drags on over the coming months, the impact on economic growth is expected to remain limited while in the longer term these efforts could strengthen fiscal accounts. Mexico also imports large amounts of petroleum and since 2015 the hydrocarbon balance has turned negative. It is expected to remain a ‘net oil importer’ at least until 2022 despite President Obrador’s plans to increase production and raise the domestic refinery capacity. Unlike many oil-producing countries, the Mexican economy is not overly dependent on exporting petroleum products (5% of total export receipts) given that manufactured goods like machinery, electronic appliances and automotive products represent the lion’s share of the country’s exports (70% of total export receipts). 

The manageable currentaccount deficit has fluctuated around 2% of GDP since 2013 and is expected to continue doing so in the years ahead. Mexico attracts significant amounts of foreign direct investments and large yet volatile portfolio investment inflows. However, large sums of capital also flow out of the country, leading to episodes of limited financing shortages on the external balance of payment in 2015, 2016 and 2017, explaining the drop in foreignexchange reserves to a still adequate 3.8 months of import cover (September 2018) after years of stable liquidity levels of around 4.5 months.

Fiscal continuity is being sought while public debt dynamics remain sustainable

The new administration has managed to temper market uncertainty by presenting a responsible 2019 budget. Since 2016, prudent fiscal policies have tempered the primary fiscal balance (excluding interest payments) into a tight surplus, moderating the overall fiscal deficit from 4% of GDP in 2015 to 2.8% in 2016 and 1.1% in 2017. As of 2019, the fiscal deficit is expected to remain confined at a manageable 2.5% of GDP owing to improved tax collection (reducing tax evasion and avoidance) and reduced current spending. The government’s total debt stock peaked in 2016 at 56.8% of GDP and is expected to stabilise around a reasonable 53% in 2018 and the years ahead. Half of government debt is held externally yet only a third is denominated in non-local currency while most is issued at fixed interest rates with relatively long maturities. The total external debt stock (1/3rd private sector debt) has stabilised at around 40% of GDP since 2016 and is set to stay at this level in the years to come. Debt services are also at a modest level. Consequently, both Mexico’s external and public debt dynamics are generally judged as being sustainable.
 

Fiscal dependence on the oil sector (20% of total public revenues) and significant exposure to an economic slowdown in the USA are likely to remain structural weaknesses. Moreover, tightening financial market conditions, escalating global trade tensions and a reversal of capital flows from emerging markets pose major risks to Mexico’s open economy. Domestically, imprudent policy decisions could increase market uncertainty, possibly affecting Mexico’s refinancing conditions. On the upside, the risk of sudden alterations in Mexico’s major trade relations distressing its vital manufactured exports has been appeased by the USMCA deal, which has improved the general economic outlook. However, delays in the ratification of the USMCA trade agreement cannot be ruled out due to renewed diplomatic disputes between Mexico and the USA, for example over the construction of the border wall or due to political polarisation in the US Congress blocking ratification. This could lead to renewed pressure on the Mexican peso and higher inflation, as witnessed when Trump was elected.

Credendo classifies Mexico in short-term political risk category 2/7 with a stable outlook. The country enjoys a low level of external short-term debt while foreignexchange reserves are adequate. The medium-/long-term political risk is in category 3/7 with a stable outlook. Mexico’s modest risk rating reflects its moderate external debt and debt service ratios, maintainable currentaccount deficits, sound public finances and the country’s economic diversification despite its great reliance on the US economy.

Analyst: Louise Van Cauwenbergh – l.vancauwenbergh@credendo.com