Long-term foreign currency raised upgraded to 'BBB'; local currency rating raised to 'A'; outlook stable, February 2005
Long-term foreign currency rating raised to 'BBB-'; local currency rating raised to 'A-'; outlook revised to stable, February 2002
Long-term foreign currency rating raised to 'BB+', outlook on local currency rating revised to positive, March 2000
Foreign currency outlook revised to positive, September 1999
Outlook revised to stable, October 1998
Outlook revised to positive, September 1997
Outlook revised to stable; short-term foreign currency rating of 'B' assigned, September 1996
Local currency ratings lowered to 'BBB+/A-2', outlook on foreign currency ratings revised to negative, March 1995
Foreign currency ratings lowered to 'BB'; local currency ratings lowered to 'A'; outlook on foreign currency rating revised to stable; outlook on local currency rating to negative, February 1995
(For complete history, see Sovereign Ratings History Since 1975, available on RatingsDirect, Standard & Poor's Web-based credit research and analysis system, at www.ratingsdirect.com, and on Standard & Poor's public Web site at www.standardandpoors.com.
Default History Since 1975
Default on commercial bank debt, 1982-1990
Year
2006
Population
107.8 million
Per Capita GDP
US$7,427
Current Government
President Vicente Fox is head of state and government.
Legislative branch comprises upper (Senate) and lower (Deputies) houses
Election Schedule
Presidential
Last, July 2006
Next, July 2012
Congressional
Last, July 2006
Next, July 2009
Major Rating Factors
Strengths:
Growing macroeconomic stability;
An improving debt profile; and
Improving external liquidity.
Weaknesses:
A lack of political consensus on economic policies;
The government's narrow nonoil tax base; and
A weak institutional framework that constrains growth prospects.
Rationale
The ratings on the United Mexican States are supported by:
Growing macroeconomic stability. Low inflation, a flexible exchange rate, and deepening financial markets give Mexico greater ability to adjust to negative shocks. Growing integration with the U.S. economy, as shown by the tight connection between industrial growth in the U.S. and GDP growth in Mexico, contributes to greater stability. That, in turn, sustains investor confidence despite little prospect of structural reform over the near term;
An improving debt profile. Monetary stability and growing domestic capital markets (especially pension funds) have facilitated the substitution of domestic for external debt in recent years by both the private and public sectors. More than two-thirds of the central government's debt stock is now in local currency and about 50% of its domestic debt is at fixed nominal interest rates of one year or longer, compared with only 14% in 2000. Low inflation, an independent central bank, and skillful debt management—including prefunding of external debt till 2007—insulated the government's liquidity from possible negative shocks during the 2006 election campaign; and
Improving external liquidity. The country's external financing gap (defined as the sum of the current account deficit, amortization of medium-term debt, and all short-term debt) is projected to approach 66% of its foreign exchange reserves in 2006, compared with over 120% three years ago. Net public sector external debt is projected to decline to 13% of current account receipts (CAR) in 2006 from 25% in 2002. Total debt service, including short term, is projected to decline to 20% of CAR in 2006 from 36% in 2002, well below the median level for 'BBB' sovereigns.
The ratings are constrained by:
The lack of political consensus on policies to boost growth prospects and strengthen the government's tax base. Political divisions on policies such as tax reform, along with energy sector liberalization, constrain the government's fiscal flexibility and the country's growth prospects. The lack of consensus on key reform, combined with modest per capita GDP growth in recent years, provides less durability to the current policy framework over the coming decade in the event of a major negative shock compared with most investment-grade sovereigns;
The government's narrow nonoil tax base, which is around 11% of GDP, and the resulting fiscal inflexibility. The government has been able to largely meet its fiscal targets in recent years, thanks in part to high oil prices. Oil-related fiscal revenue could approach 9% of GDP in 2006, nearly two percentage points of GDP above its historical average. Fiscal performance remains vulnerable to volatile oil revenue; and
A weak institutional framework that constrains GDP growth prospects. Shortcomings in the judicial system and in creditor and property rights, and perceptions of corruption, weaken the rule of law. Such microeconomic shortcomings, along with restrictions on private domestic and foreign investment in key sectors such as electricity and energy, constrain the competitiveness of Mexican firms and deny Mexico the full benefits of economic integration with NAFTA countries.
Outlook
The stable outlook incorporates Standard & Poor's expectation that Mexico will maintain macroeconomic stability in the coming years. The new Administration, led by Felipe Calderon, will take office in late 2006 and is expected to remain committed to moderate budget deficits that are consistent with continued economic stability.
Mexico faces the risk of stagnation and ineffective government over the medium term if the new president is unable to pursue his agenda in another divided Congress. Over the short term, such a scenario would limit the possibility of a better sovereign rating by constraining any improvement in public finances and growth prospects. However, over several years, political paralysis would raise the risk of reduced creditworthiness if reform needed to sustain GDP growth is stymied or if stagnation interferes with the government's ability or willingness to take timely action to address possible fiscal pressures, reversing the sovereign's recently improving debt profile.
Comparative Analysis: A Healthy Banking System And A Declining Debt Burden
Political risk in Mexico is comparable with that in rated peers and generally lower than that in much of Latin America;
Mexico enjoys a similar level of fiscal flexibility as its rated peers but depends more upon volatile oil revenue for its fiscal budget; and
The level of external liquidity is modestly better than that of the median level for similarly rated sovereigns.
The level of political risk in Mexico is similar to that in other 'BBB' rated sovereigns such as the Republics of South Africa ('BBB+'; all ratings herein are long-term foreign currency sovereign credit ratings) and Croatia ('BBB) and better than in the Republic of Tunisia ('BBB') and The Russian Federation ('BBB+'). Political power is increasingly shared between an assertive Congress and a once-dominant presidency, as well as between more assertive state governments and the central government.
Mexico's three main political parties share a broad consensus in support of fiscal policies that sustain macroeconomic stability and maintain open current and capital accounts. These factors should help maintain policy continuity in coming years. However, the political parties are sharply divided on microeconomic policies, especially energy sector liberalization and tax reform. The lack of consensus on such policies, combined with modest per capita GDP growth in recent years, provides less durability to the current policy framework over the coming decade in the event of a major negative shock—unlike the situation in most investment-grade sovereigns (see table 1).
Table 1
Mexico Selected Indicators
--Year ended Dec. 31--
BBB Median 2006
2003
2004
2005
2006f
2007f
2008f
2009f
GDP per capita (US$)
7,003
6,177
6,635
7,099
7,427
7,464
7,539
7,634
Real GDP (% change)
4.7
1.4
4.4
3.0
4.4
3.5
3.5
3.5
Real GDP per capita (% change)
4.6
(0.0)
2.9
1.6
3.0
2.1
2.1
2.2
General government balance (% of GDP)
0.2
(1.2)
(1.0)
(0.8)
(0.9)
(1.2)
(1.6)
(2.0)
General government debt (% of GDP)
29.4
36.0
33.2
32.8
32.1
31.6
32.0
32.2
Net general government debt (% of GDP)
24.8
34.4
32.1
31.5
31.0
30.6
31.0
31.3
General government interest expenditure (% of revenue)
5.1
11.9
11.7
10.4
9.9
9.6
9.3
9.1
Domestic credit to private sector and NFPEs* (% of GDP)
55.6
15.4
15.0
15.8
17.7
18.7
19.8
22.2
Consumer price index (average % change)
3.8
4.6
5.1
3.6
3.5
3.5
3.5
3.5
Gross external financing needs (% of CAR and usable reserves)
108.2
104.5
98.2
95.8
92.6
91.3
92.1
91.5
Net public sector external debt (% of CAR)
(9.6)
22.8
21.3
13.7
14.8
15.3
15.1
15.0
Net banking sector external debt (% of CAR)
(0.6)
1.0
1.2
(0.4)
(0.7)
(1.0)
(1.2)
(1.3)
Net nonbank private sector external debt (% of CAR)
21.0
24.9
20.5
16.1
13.7
11.5
9.5
7.7
f-Forecast. *Standard & Poor's estimates that, in a reasonable worst-case scenario, the government's contingent liability from a banking crisis could amount to 10%-20% of bank credit; see "Global Financial System Stress Appendix 1", published July 8, 2004, on RatingsDirect, Standard & Poor's Web-based credit analysis system. NFPE-Nonfinancial public sector enterprise. CAR-Current account receipts.
Mexican public institutions are stronger than those of many Latin American countries but weaker than those in the Republic of Chile ('A'), the only other Latin American sovereign with an investment-grade rating. The political consensus on economic policies is weaker in Mexico than in Chile. Perceptions of corruption, and a weak and largely unreformed legal system, contribute to a lower quality of governance in Mexico than in many sovereigns in the lower ranks of investment grade.
The country's trend GDP growth rate of around 3.5% is below the level in rated peers, and slightly worse than that in Tunisia and in Russia. The levels of domestic savings and investment (just above 22% and 23% of GDP, respectively) are similar to the median level for rated peers. Mexico depends more on U.S. growth than do most countries. NAFTA provides an external anchor to the U.S. economy, stabilizing Mexico's economic policies and sustaining exports, foreign direct investment (FDI), and long-term growth prospects. Thanks to NAFTA, the trajectory of a substantial segment of Mexican industry is firmly tied to U.S. industrial growth (see chart 1).
The dynamism of Mexico's nonoil export sector is reflected in the fact that manufactured goods comprised more than 80% of the country's exports in recent years, compared with less than 50% for the rest of Latin America and the Caribbean. The oil sector is less important in Mexico than in other large oil exporters. Oil exports accounted for just over 4% of GDP in 2005 compared with 15%-20% for the Republic of Ecuador ('CCC+'), the Kingdom of Norway ('AAA'), Russia, and the Republic of Trinidad and Tobago ('A-'); and 30%-50% for the Bolivarian Republic of Venezuela ('BB-'), Algeria (not rated), the Federal Republic of Nigeria ('BB-') and the Kingdom of Saudi Arabia ('A'). (See chart 2.)
Nevertheless, the level of domestic competition is poorer than in most investment-grade peers. For example, the persistence of public sector monopolies (as in oil) and the large public sector presence in key sectors such as gas and electricity—combined with a perceived low level of competition in other sectors (such as telecom) reduces prospects for investment and growth. Compared with most investment-grade sovereigns (including the People's Republic of China ['A']), Mexico depends largely upon higher inputs of labor instead of labor productivity for most of its growth. The extent of "dualism" in the economy is higher than in most similarly rated sovereigns, given the contrast in productivity between competitive, export-oriented sectors (autos) and protected sectors (corn, oil, gas, and electricity).
Mexico's per capita GDP of over US$7,000 is higher than the median level for rated peers. However, its social welfare indicators, such as literacy and nutrition levels, are more comparable to Latin American and Caribbean countries as a whole than to Organization for Economic Co-operation and Development (OECD) countries. Mexico suffers from the sharp regional differences found in speculative-grade countries, with entrenched poverty in the south and a modern export-oriented economy in the north. Mexico's relatively easier access to the U.S. relieves pressure on poverty by facilitating emigration. As a result, the inflow of workers' remittances to Mexico is higher than that for any Latin American country and is estimated to be second only to that for the Republic of India ('BB+') globally.
Mexico enjoys a similar level of fiscal flexibility as its rated peers, better than higher-rated China, but worse than Russia. The public sector deficit, hovering around 2% of GDP, is similar to the level in rated peers. Total central government revenue (including that from oil) is much lower than in most investment-grade and OECD countries. Nonoil tax revenue, at around 11% of GDP, falls below the levels in similarly rated sovereigns. Mexico earns less revenue from consumption taxes compared with other Latin American countries. VAT collections are lower as a share of GDP (after being adjusted for the different tax rates) than in much of Latin America. The government estimates that tax exemptions and special breaks cost more than 5% of GDP in foregone revenue (see chart 3).
Both the general government and public sector debt burdens (projected at 32% and 48% of GDP, respectively) are similar to the median levels for similarly rated sovereigns (Standard & Poor's adds contingent liabilities incurred under the Pidiregas investment plan to public sector debt). However, Mexico relies upon a narrower tax base than its peers and on volatile oil revenue to service that debt. The public sector has been borrowing more domestically and leaving external markets for private sector borrowers in recent years. Subnational government debt is less than 2% of GDP.
Like many other energy exporters, Mexico has an oil stabilization fund. However, it is a weak policy tool for reducing fiscal volatility. It has allowed the government to cut spending in bad years, but not to save much in good years (as much of the "excess" oil revenue is devoted to investment). The fund is a political compromise: Congress accepts automatic spending cuts by the Administration in bad years in return for more spending in good years. The mechanism will likely remain effective if oil prices fall rapidly over the next two years (see chart 4).
The level of monetary flexibility in Mexico is modestly better than in rated peers and better than in most Latin American countries. A flexible exchange rate, high foreign exchange reserves, and a growing domestic debt market is allowing Mexico to move away from the "original sin" of most speculative-grade Latin sovereigns, namely the inability to raise fixed rate, long-term debt in the domestic market in the local currency. The Mexican peso is the most traded Latin American currency in financial markets.
Inflation has fallen in recent years but is mildly higher than in most rated peers. At 17% of GDP, domestic credit to the private sector and the nonfinancial public sector is lower than in most rated sovereigns, a legacy of a past major banking crisis. Monetary policy is largely insulated from political forces, thanks to an independent central bank that has gained greater credibility in recent years. The level of pass-through from exchange-rate depreciation into inflation is low and declining. However, the transmission mechanism of monetary policy is sluggish compared with most investment-grade sovereigns.
The Mexican banking system poses less of a contingent liability to the sovereign compared with its peers in other countries. It is healthier than its counterparts in many rated peers thanks to high levels of capitalization and good asset quality. Over 80% of Mexico's banking system is owned by foreigners, compared with around 50% in the Republic of Argentina ('B'), 42% in Chile, and 27% in the Federative Republic of Brazil ('BB'). (See chart 5.)
A declining debt burden and impressive debt management have improved Mexico's external liquidity. Net public sector external debt is projected at 13% of CAR in 2006, compared with a median level of 6% for rated peers. Net nonbank private sector external debt is projected at 20% of CAR in 2006, almost equaling that of the median level for rated peers. The banking sector's net external position is likewise similar to that of the median level for rated peers. Total debt service, including short-term debt, is projected to hover around 20% of CAR, below the 30% median level for rated peers. Reserves are projected to exceed 250% of short-term debt in 2006, above 160% median level for the peer group. Mexico's gross financing gap (defined as the current account deficit plus short-term debt and amortization of other debt) is projected to fall to 66% of CAR in 2006, about half that of the median level for rated peers (see charts 6 and 7).
Political Environment: Disputed Presidential Election Will Affect Calderon's Ability To Implement His Policies
The bitterness over the results of the 2006 presidential elections will affect the ability of the Calderon Administration to reach political consensus on its economic agenda.
The election campaign and the close results revealed the deep divisions within Mexico on key economic issues, as well as a growing regional division between north and south; and
Mexico's credit rating will, to a large extent, depend upon the ability of the Calderon Administration to implement reform to sustain GDP growth and contain long-term fiscal pressures.
The close results of the July presidential elections, in which Felipe Calderon of the conservative Partido Accion Nacional (PAN) defeated Mr. Andres Manuel Lopez Obrador of the Partido de la Revolucion Democratica (PRD) by less than 1% of the votes, will affect the course of Mexican politics in the coming years. The narrow margin of victory led Lopez Obrador to file legal challenges against the results, as well as to undertake public demonstrations and street blockades in Mexico City to protest against alleged fraud. After the electoral authorities ruled in favor of Calderon, Lopez Obrador declared his unwillingness to accept defeat and has promised to continue protests and other measures designed to hinder Calderon from governing.
The election campaign showed that Mexico is divided on key issues, such as how to raise investment in the energy sector (whether to rely on public sector investment or liberalize laws to allow more scope for private sector investment). There is little consensus on crucial microeconomic policies that affect long-term growth prospects, such as tax reform, amending labor laws to remove rigidities, and on public sector pension reform.
Felipe Calderon is seen to be a politically more agile leader than his predecessor and may be more successful in negotiating with other parties in Congress and with the governors (who exert a strong influence over the congressional delegations from their states). Moreover, PAN has gained more experience in power over the last six years, possibly helping it to use its stronger position in Congress (where it won a plurality in both houses but still fell short of a majority) to negotiate with other parties.
The long-ruling Partido Revolucionario Institucional (PRI) is now the third party in Mexico, at least at the national level. It will undergo a change in leadership, with more powers flowing to PRI governors—whose command of resources at the state level will increase their influence over the national leadership. PRI may be more open to working with the Administration to approve reform, especially if the measures help the governors. PAN and PRI together comprise a solid majority in both houses of Congress.
PRD has now become the second-largest party in the country, a remarkable rise from its previously distant third place. Hence, it will come under more scrutiny by voters and under more pressure to demonstrate that it is ready to govern at the national level. The refusal of its candidate, Lopez Obrador, to recognize the official results and to continue with public demonstrations will continue to polarize Mexico. Some members of PRD may gradually abandon Lopez Obrador over time, pursuing a more pragmatic course that could enhance their chances for victory in future elections.
The elections showed a growing regional gap, with most of the northern half of Mexico voting heavily in favor of PAN while the PRD won all the southern states (with the exception of Puebla and Yucatan). PRD maintained its dominant position in the heart of the country, in both the Federal District and the surrounding State of Mexico. PRI failed to win a single state, despite governing in 19 states.
The recent political polarization will force Calderon to seek agreement with other political parties on key policies. His ability to reach such an agreement (perhaps with PRI) in the coming months would be an important signal about the course of economic reform in Mexico in the coming years.
The potential risk for Mexico's credit rating over the medium term is one of stagnation, especially if Calderon proves to be as unsuccessful as his predecessor, Vicente Fox, in implementing his agenda through a divided Congress in the face of public hostility from followers of Lopez Obrador. A key test for the new government will be fiscal management, especially when oil prices eventually decline.
The new Administration will have to cope with rising drug-related violence in several parts of the country connected with gang violence. The country's political leadership, cutting across all parties, has been unable to assuage rising public anger at the government's perceived inability to deal with crime. In addition, growing tensions with the U.S. on immigration issues, including Mexican opposition to efforts in the U.S. Congress to restrict immigration, will complicate Mexican politics in coming years.
Economic Prospects: Economic Growth Has Been Disappointing
GDP growth is likely to exceed 4% in 2006;
Economic growth in Mexico remains highly correlated to the rate of U.S. industrial growth; and
The level of economic flexibility is constrained by low investment in energy, electricity, physical and human infrastructure, and lack of credit for small and midsized enterprises.
Macroeconomic stability has helped improve living standards modestly in recent years, but has not injected dynamism into the economy. Economic growth has been disappointing in Mexico in recent years, despite good international conditions. GDP growth was only 3% in 2005, hurt by poor farm output, hurricane damage in major tourist spots, and weak demand from U.S. industrial sectors. Several Mexican manufacturing sectors (especially labor-intensive industries) that compete directly with Chinese producers in the U.S. market also suffered from the growing competitiveness of their Asian rivals.
GDP growth is likely to exceed 4% in 2006, with private investment growth outpacing consumption growth by a slight margin. Industrial growth should also rise moderately, with formal sector employment rising by 5%, similar to the rate in 2005.
Recent years of stability and modest growth have led to slowly improving social welfare indicators (e.g., the infant mortality rate), helped by some targeted government social programs that have boosted health and education for the very poor. Low interest rates have spurred the housing sector, creating more new homes for middle- and lower-middle-class people. The government was able to pass legislation in 2005 to boost local capital markets, including steps to strengthen the rights of minority shareholders. The measure should contribute to financial market development, reinforcing a trend that has contributed to stability in the economy.
Poor microeconomic foundations prevent Mexico from enjoying a better macroeconomic performance despite tight integration with the U.S. in goods, services, capital, and even labor markets (about 10% of the Mexican workforce is estimated to be working in the U.S., legally and illegally). Mexican economic growth remains highly correlated with U.S. industrial growth. The link is stronger in the auto industry than in high technology sectors (e.g., computers and communications equipment). Autos, auto parts, and related equipment constitute more than 25% of total Mexican exports, exceeding petroleum and related products. Economic integration has stabilized the Mexican economy, but has not resulted in higher growth rates on a sustainable basis (see table 2).
Table 2
Mexico Economic Indicators
--Year ended Dec. 31--
2003
2004
2005
2006f
2007f
2008f
2009f
Nominal GDP (bil. US$)
639.0
696.0
755.0
800.6
815.5
834.6
855.7
GDP per capita (US$000s)
6.2
6.6
7.1
7.4
7.5
7.5
7.6
Gross domestic investment (% of GDP)
22.3
23.3
24.1
24.0
23.8
23.6
23.5
Gross domestic savings (% of GDP)
20.9
22.3
23.3
23.2
23.0
23.0
22.7
Real exports (% change)
2.7
11.5
5.4
6.5
6.5
6.5
6.5
Mexico's long-term growth prospects (around 3%-4% over the medium term) appear to be modest, especially in light of the country's pressing social needs and its growth potential from the close links it enjoys with the world's largest economy. Recent years of good oil revenue have facilitated more public investment in physical infrastructure (capital spending by the government has risen to 3% of GDP from around 2.5% three years ago) and in the energy sector, sustaining growth prospects. Nevertheless, investment levels remain modest (around 22% of GDP) and are unlikely to increase rapidly absent policies to liberalize the telecommunications sector and labor markets and to modernize the legal and judicial systems. Despite the lack of reform in the energy sector, such steps could sustain growth prospects for several years.
High oil prices in recent years have helped alleviate the government's budgetary pressures, but have not had much direct positive impact on either economic growth or the trend performance of the external current account. Both of these variables are more influenced by developments in the U.S. market (where high oil prices contribute to slower economic expansion). Failure to invest more in the energy sector could eventually reduce Mexican oil production. The greatest stress from such a scenario would appear on fiscal balances, given the economy's successful diversification away from oil in recent decades.
Mexico has limited capacity to stimulate growth from domestic sources, relying heavily on external demand. Exchange-rate flexibility and an independent central bank give scope for limited monetary stimulus through low interest rates. However, the limited extent of domestic credit constrains the effectiveness of low interest rates in spurring consumption and investment. Similarly, fiscal flexibility is low given the desire to maintain investor confidence by containing budget deficits.
Fiscal Flexibility: Public Finances Remain Tied To Oil Prices
High oil prices and, to a lesser extent, a higher volume of petroleum product and petrochemical output, should result in a very modest public sector deficit in 2006;
Public finances remain vulnerable to a potentially sharp fall in oil revenue; and.
Improvements in debt management have reduced the government's vulnerability to market turbulence during an election year.
High oil revenue reduced the public sector borrowing requirement (PSBR) to below 2% of GDP in 2005, and reduced the "narrow" government deficit to near zero. Tax efficiency also improved, with VAT revenue growing 7.5% in real terms and personal and corporate income taxes growing by 7%. The consolidated public sector ran a primary surplus of 2.5% of GDP in 2005, similar to the level in 2004.
High oil prices should keep the PSBR below 2% of GDP in 2006. The "narrow" government deficit is likely to be close to balance this year (The "narrow" official balance includes privatization and other nonrecurrent revenue, excludes part of the interest costs of indexed bonds issued to rescue banks, and delays the recording of investment projects under the Pidiregas investment program until the debt is serviced. The PSBR corrects for these omissions and other quasi-fiscal activities and excludes one-time revenue).
The new Administration will eventually face the challenge of managing growing pressure on its budget once oil prices decline. Mexico's improving fiscal performance in recent years has benefited from high oil revenue, which averaged 7.6% of GDP in 2001-2005 compared to 6.8% in 1998-2000. Fiscal revenue from the oil sector was around 8.7% of GDP in 2005, and could be similar in 2006. Oil revenue could fall toward 7% of GDP over the medium term. Nonrecurrent revenue (mainly privatization and recovery of collateral backing the Brady bonds) averaged 0.7% of GDP in 2001-2005 and will also decline in coming years. On the expenditure side, public sector pension spending by the government equaled around 2.2% of GDP in 2005 and could reach 2.8% by 2009. The net present value of the pension deficit is estimated at 116% of 2003 GDP. (see table 3).
Table 3
Mexico Fiscal Indicators
--Year ended Dec. 31--
(% of GDP, unless otherwise indicated)
2003
2004
2005
2006f
2007f
2008f
2009f
General government revenue, of which:
19.5
19.5
20.3
20.3
19.7
19.1
18.5
Central government*
18.5
18.6
19.4
19.4
18.8
18.2
17.6
General government expenditure, of which:
20.7
20.5
21.2
21.2
20.9
20.7
20.5
Central government
19.6
19.7
20.2
20.2
20.0
19.8
19.5
General government balance, of which:
(1.2)
(1.0)
(0.8)
(0.9)
(1.2)
(1.6)
(2.0)
Central government
(1.1)
(1.0)
(0.8)
(0.9)
(1.2)
(1.6)
(1.9)
General government interest payments (% of revenue)
11.9
11.7
10.4
9.9
9.6
9.3
9.1
Consolidated public sector balance¶
(3.2)
(2.5)
(1.7)
(1.6)
(2.3)
(2.8)
(2.8)
Public sector gross debt
51.5
48.6
47.6
47.4
47.7
48.5
49.2
General government debt§, of which:
36.0
33.2
32.8
32.1
31.6
32.0
32.2
Central government debt
34.2
31.5
31.1
30.4
29.9
30.3
30.6
Public sector net debt**
49.9
47.5
46.3
46.3
46.6
47.6
48.3
f—Forecast. N.A.—Not available. *Central government revenue includes social security and excludes privatization and other nonrecurrent revenue. ¶Restricted balance adjusted to include the cost of bank restructuring, PIDIREGAS, and other off-budget expenses. §Includes local government and IPAB debt. **Net of government deposits and other government assets.
Emerging fiscal pressure over the medium term could be alleviated through spending cuts of 1%-2% of GDP, especially since public spending increased in 2005 and 2006 thanks to above-budgeted oil revenue. Moreover, the budgetary formula for allocating excess oil revenue provides some flexibility to the government in reducing spending if oil prices fall. Added fiscal compensation is possible through raising the excise tax on gasoline. The government-controlled domestic retail price of gasoline has risen only at the pace of inflation in recent years—but less than the rise of world prices. This has been accomplished partly through reducing the excise tax on gasoline, which generated around 0.4% of GDP in 2005 compared to 0.7% in 2004 and 1.8% in 2002. The combination of spending cuts, higher excise taxes, and modest increases in VAT collections could alleviate the impact of falling revenue, absent tax reform to widen the tax base.
Prudent debt management has reduced the government's vulnerability to external risk. The government has issued all net new debt in the local market since 2005, and established internal performance benchmarks for debt management while continuing to issue long-term, fixed-rate debt in the domestic market. The duration of government's market debt (referring to the "narrow" government and excluding other types of debt like Pidiregas and Instituto para la Proteccion al Ahorro Bancario) was just under three years at year-end 2005, and is likely to rise to 3.8 years in 2006 (compared with one year in 2000).
Congressional approval of a new budget law in 2006 is an encouraging sign that all three main parties favor a better framework for fiscal policy. The law sets more transparency in allocating funds and in setting the budgeted oil price. Fiscal policy could be more effective if it is embedded into a medium-term framework that reduces the chances of fiscal volatility from sudden changes in oil prices.
Part of the pressure for additional central government spending may be absorbed by encouraging states to raise more money on their own, containing the pressure for transfers from the national government. A few states have started to use their new authority to impose a 2%-5% tax on the base of the federal income tax, and more are likely to follow. Just over half of primary (noninterest) spending by the national government went to subnational governments, either directly as transfers or through various spending programs. This share should increase in coming years.
Monetary Policy: Falling Inflation And Greater Credibility Equal Increased Stability
The rising credibility of the statutorily independent central bank gives Mexico more monetary flexibility than in the past;
The healthy banking sector is beginning to lend more, mainly for consumer credit; and
The use of a reference overnight rate to conduct monetary policy should strengthen the effectiveness of the central bank's inflation targeting policy.
The combination of low inflation, growing private sector pension funds, and modest budget deficits has allowed Mexico to unwind the "original sin" of many Latin sovereigns that are unable to borrow long term in the local currency at fixed interest rates. Monetary stability has improved in recent years due to falling inflation and the central bank's greater credibility in the market. Headline inflation closed at 3.3% in 2005, the lowest level since 1968, and core inflation was just above 3% (within the 1% official range around the 3% target). As a result, the central bank was able to cut its base rate in 2005 and again in early 2006. The bank's statutory independence and its good track record in recent years have buttressed stability during an election year. Inflation should remain around 3% over the near term.
The Bank of Mexico is gaining room to run modestly countercyclical monetary policy to cushion the impact of a cyclical downturn. The bank stopped tightening in mid-2005 and followed a different trend from the U.S. Federal Reserve Bank. In 2005, the bank supplemented the settlements balance (the "corto")—the level of overdraft by the banking system from the central bank at a penalty rate of interest—as its near-term operational target, with a reference overnight interest rate to signal monetary policy. The pursuit of inflation targeting using the corto, a quantitative approach, has worked in absorbing exchange- and interest-rate volatility while allowing market forces a greater role in determining interest rates. The cost of this approach has been less transparency and more volatility in short-term interest rates.
Mexico's financial system has strengthened in recent years, but remains smaller than its counterparts in other investment-grade sovereigns. Bank credit to the private sector is likely to continue growing around 20%-30% in 2006, thanks to more competition and the better ability of creditors to enforce their collateral. Nonbanks, especially rapidly growing pension funds and mutual funds, are playing a bigger role, and now account for over 20% of total assets in the financial system. Both banks and other lenders substantially boosted credit for consumer and mortgage financing in 2005, a trend that continues in 2006. The availability of 25-year, fixed-rate mortgages is spurring rapid growth in middle- and low-income housing.
The growth of long-term domestic funding for both the public and private sectors is an encouraging sign for creditworthiness. The public sector borrowing requirement consumed less than 15% of the annual flow of domestic financial savings in 2005 and 2004, compared with nearly 70% in 2000—releasing more resources for private sector borrowers. Total funding for the nonfinancial private sector has increased steadily by 0.75% of GDP annually since 2000. However, market debt issued by private firms now accounts for just less than 3% of GDP, about twice its level in 2000 but still modest. Pension funds (titled Afores in Spanish), which can invest in derivatives, equities and external assets, now allocate just under 20% of their money to nongovernment assets, compared to less than 15% in 2002. Despite some regulatory easing, the funds largely hold sovereign debt and have not diversified very much.
Most of the banking sector (and much of the nonbank financial sector) is foreign-owned after a period of consolidation and privatization. Nonperforming loans for commercial and development banks combined are below 3% of total loans, and are fully covered by loan-loss provisions. The commercial banks enjoy good profitability on the whole, and have capital adequacy of around 14% of assets.
External Finances: Mexico's External Position Is Strengthening
Improved debt management and growing recourse to domestic funding have improved the sovereign's external profile;
Mexico's external position has strengthened in recent years due to the stabilizing impact of growing trade integration with the U.S., steady remittances and FDI inflows; and
Prefunding of all sovereign external debt through 2007 reduces the vulnerability of public finances to adverse external shocks in the coming year.
Mexico's external liquidity continues to improve gradually. Foreign exchange reserves rose by nearly US$10 billion in 2005, bolstered by high oil exports. The volatility of the balance of payments has fallen due to greater synchronization between U.S. and Mexican business cycles and greater correlation between Mexican imports and exports (both largely with the U.S.). Open capital markets and monetary stability have helped to deepen financial market integration. External liquidity is also sustained by the nearly US$20 billion in remittances sent home by Mexicans in the U.S.
The current account deficit fell to around 0.7% of GDP in 2005 from 1% in 2004, more than covered by FDI inflows. Growing remittances largely compensated for the moderate increase in the nonoil trade deficit. Strong FDI and portfolio investment contributed to a large surplus in the capital account in 2005, offsetting growing borrowing by public sector firms under the Pidiregas program and by the nonbank private sector.
Both the trade and current account deficits are likely to increase modestly in both 2006 and 2007, especially as growth accelerates. The trade deficit may rise toward 1.5%-2% of GDP, but growing remittances should stabilize the current account balance at around 1%-1.5% of GDP. The integration of industrial production across the U.S.-Mexican border provides a solid anchor to external flows, creating greater harmony between export and import trends and stabilizing the trade balance. For example, the maquiladora sector (export–oriented industry enjoying duty-free access to inputs) accounted for 45% of total exports in 2005, despite the rise in petroleum exports. The modest current account deficits that result from deep integration with the U.S. market are likely to be fully funded by FDI inflows in coming years, sustaining or even strengthening the balance of payments and external liquidity.
The combination of a credible inflation-targeting monetary policy and a floating exchange rate (with a transparent, rules-based policy for the central bank to accumulate reserves from oil exports and sell them in auctions) should maintain macroeconomic stability, despite any potential disturbances in external markets. External debt management policies have also boosted stability. The government prefunded all external debt maturing through 2007. It also issued US$2.5 billion in warrants in 2005, an innovative scheme to allow investors to exchange certain dollar-denominated bonds issued abroad into fixed-rate peso bonds. In addition, it tendered up to US$5 billion in global bonds in February 2006, complementing prior repurchases of external debt with foreign exchange reserves and by issuing new debt that improves the overall maturity profile of sovereign debt. As a result, public sector debt has shifted to the domestic market, with net external debt falling toward one-third of total debt in 2006, compared with over 50% in 2000 (see table 4).
