Outlook On Mexico Revised To Stable From Negative On Improved Debt #BBB+/A-2# Ratings Affirmed

Stocks and Financial Services Press Releases Wednesday July 19, 2017 09:24
S&P Global Ratings--19 Jul--S&P Global Ratings

On July 18, 2017, S&P Global Ratings affirmed its 'BBB+/A-2' foreign currency and its 'A/A-1' local currency long-term and short-term sovereign credit ratings on the United Mexican States. We have revised the outlook on the long-term ratings to stable from negative.

In addition, we affirmed our 'A+' transfer and convertibility (T&C) assessment.
RATIONALE

The change in outlook reflects diminishing risk that the government's direct debt burden, combined with our future assessment of potential contingent liabilities (especially from nonfinancial public enterprises), could materially worsen our overall debt assessment over the next 24 months. We believe that the prompt reaction of Mexican government authorities to recent negative shocks, such as the depreciation of the currency in late 2016, will diminish the recently rapid pace of debt accumulation and help stabilize the government's debt burden.

We expect that the general government debt burden will hover around 45% of GDP this year and next, absent an unexpectedly large depreciation of the currency, and remain below 50% for the next two years. Net general government debt exceeded 44% of GDP in 2016, up from around 40% in 2014. We project that general government debt will rise by just over 3% of GDP annually on average in the next three years, and the general government interest burden (interest to revenues) will remain below 10%.

We project that the general government fiscal deficit will be around 3.3% of GDP, or potentially lower, in 2017, down modestly from last year. The smaller deficit reflects constrained spending, as well as likely stable tax collections. It also reflects a dividend of 1.4% of GDP from the central bank (from its 2016 operational profits), which will provide a large contingency in case of a negative shock that hurts the economy and fiscal revenues. However, we expect the government's underling fiscal balance (excluding the central bank dividend) to improve in 2017 and remain stable in 2018, reflecting both the government's fiscal policies and continued (but modest) GDP growth. The government's decision to proceed with gradual de-control of gasoline prices toward world prices, in the face of strong public opposition early this year, was an important step in strengthening fiscal policy.

Earlier tax reforms have helped the government to largely absorb a substantial decline in oil-related revenues in recent years. During 2012-2016, tax revenues rose by 5.5% of GDP while public-sector oil revenues declined by 4.9% of GDP (to 4% of GDP last year from 8.9% of GDP in 2012). Oil revenues fell to only 16.3% of total public-sector revenues in 2016, down from more than 39% in 2012. The increase in tax revenues reflects both higher excise tax collections as well as income taxes.

Our forecasts assume broad continuity in economic policy following the July 2018 national elections (the new president takes office on Dec. 1, 2018). We also expect that the next Congress will remain divided, with no party enjoying a majority. The upcoming change in political leadership could result in different spending priorities, but we expect continued moderate fiscal deficits. The legal independence of the central bank and public support for the institution should result in continuity in prudent monetary policy. We also expect the current legal framework and private-sector activity in the

energy sector to continue.

Our base case is that the U.S., Canada, and Mexico agree on a new trade deal that largely preserves the cross-border links that underpin the North American economy. Negotiations over a new trade treaty could spill into 2018, despite political incentives for all governments to come to a conclusion as soon as possible.

The ratings on Mexico reflect its track record of cautious fiscal and monetary policies, which has contributed to moderate government deficits and low inflation, as well as moderate external debt. The combination of predictable economic policies and a flexible economy has allowed Mexico to adjust to changing global conditions, including a sharp drop in the price of oil and a depreciation of the local currency, while maintaining stable growth and low inflation, despite short-term inflationary pressures that we do not expect to continue. The ratings also reflect Mexico's per capita GDP of just below US$9,000 in 2017.

Mexican democracy has continued to mature as power is shared across party lines at the national and local levels of government. Democracy has brought stability and regular changes of government to Mexico but has not created economic dynamism or improved public security because of weaknesses in governance and perceptions of corruption. Mexico's system of political checks and balances has improved over the last decade but remains weak, as revelations of alleged corruption emerging during the transition of governorships in various Mexican states over the last two years demonstrate.

In 2017, GDP growth is likely to be just below 2% and rise to around 2%-3% during 2018-2019 (or just below 2% on a per capita basis). Real per capita GDP growth during 2011-2016 averaged 1.6%, slow for an emerging economy. Despite a framework of policies that has contributed to macroeconomic stability for more than 20 years, low economic growth has contributed to only modest improvements in living standards. Persistent low GDP growth will continue to pose a fiscal challenge for the Mexican government as it seeks to stabilize its debt burden. Our forecasts over the next two years assume continued stable growth in the U.S. and gradual increase in private investment in the Mexican energy sector. The impact of past reforms in the telecom, electricity, and oil and gas sectors should sustain private investment and contribute to lower costs for key inputs.

Financial-sector intermediation in Mexico is low but rising, but the banking system is solid. We place the Mexican banking system in our Banking Industry Country Risk Assessment (BICRA) group '4', with '1' being the lowest risk

category and '10' the highest one (see "Banking Industry Country Risk Assessment: Mexico," published Sept. 19, 2016). Commercial banks have capital adequacy of just under 15% and remain highly liquid. Nonperforming loans are just above 2% of total loans and are fully provisioned.

We view contingent liabilities from the financial sector and nonfinancial public enterprises as being limited. The combined debt (excluding pension liabilities) of prominent public-sector enterprises (including Pemex and Comisión Federal de Electricidad (CFE)) totals just over 10% of GDP (which the sovereign does not guarantee). We attribute an almost certain likelihood that the government will provide Pemex and CFE with timely and sufficient extraordinary support in the case of financial distress. Hence, the sovereign's long-term debt trajectory will partly depend on the ability of these enterprises to contain their own debt burden and improve their finances.

The country's independent central bank enjoys broad political support, based on its ability to maintain low levels of inflation. The bank conducts monetary policy under an inflation-targeting framework with a floating exchange rate. We expect inflation to peak in late 2017 and return inside the central bank's range of 3%, with a margin of plus or minus 1%, by mid-2018.

We expect that Mexico's external liquidity profile will remain stable in the coming three years. The Mexican peso is a floating currency and, by our definition, an actively traded currency, which eases the country's external financing needs. Our assessment of Mexico's external financing needs reflects the currency's international role.

The current account deficit (CAD) is likely to be around 2.4% of GDP in 2017, slightly lower than in the previous year. We expect the CAD to remain around 2%-3% of GDP in the next two years, reflecting a trade deficit around 1.5% of GDP on average. Our forecast is based on moderate income growth in the U.S. and the expectation that any potential changes to the North American Free Trade Agreement likely will not materially weaken trade and capital flows between Mexico and the U.S. We expect that world oil prices will rise modestly in the coming two years (see "S&P Global Ratings Raises Its Oil And Natural Gas Prices Assumptions For 2017," published Dec. 14, 2016, for our price assumptions).

We expect Mexico to have gross external financing needs (current account payments and public- and private-sector external debt due by remaining maturity) below 90% of current account receipts (CAR) and usable reserve in the next three years. We project that narrow net external debt will hover below 45% of CAR in the next couple of years (we include nonresident holdings of locally issued debt in our estimates of external debt as our methodology calculates external debt on a residency basis).

Our projections assume a stable level of nonresident holdings of Mexico's central government debt.
OUTLOOK

The stable outlook reflects our expectation of continuity in economic policies in the coming two years, along with fiscal policy that contains the general government debt burden. We expect broad continuity in economic policy

following the July 2018 national elections and continued implementation of recent economic reforms.

An unexpected disruption in Mexico's trade and investment links with the U.S. and Canada, or an unexpected negative change in fiscal or other economic policies after elections next year could harm the country's GDP growth prospects. Low GDP growth, combined with larger-than-expected fiscal deficits, could make it difficult for the government to stabilize its debt as a share of GDP over the next two years. Similarly, unexpected changes in energy-sector policies, including steps that weaken the financial health of Pemex and CFE, could enlarge the sovereign's potential contingent liabilities. The resulting gradual erosion of the sovereign's financial profile would raise the vulnerability of public finances to adverse shocks, leading us to downgrade the sovereign.

Over the long term, faster economic growth and better-than-expected fiscal consolidation could strengthen Mexico's external and fiscal profile. That, along with deeper domestic capital markets and a continued track record ofcredible monetary policy undertaken by the central bank, could reduce external vulnerabilities and lead us to raise the rating.


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