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Mexico: A Stable Credit in an Unstable Time

By Jonathan Lemco

From an investor’s point of view, Mexico has made tremendous economic and political strides in recent years. Economic growth has surged, in part because Mexico has benefited from its membership in the North American Free Trade Agreement. Mexico’s crippling debt load of the 1980s and early 1990s has been reduced substantially. Employment is at an all time high with unemployment at only a 3.1% level in September. Inflation has been contained at approximately 4.9% year-on-year. Education levels are slowly improving. And President Fox was elected in the freest vote in Mexico’s modern history.

As a consequence of this improvement, Mexico’s interest rate spreads have narrowed throughout 2002, unlike several other Latin American sovereign credits. Furthermore, the credit rating agencies rate Mexico at investment grade levels (Baa2 with “Moody’s” and “BBB-“ with Standard & Poor’s). As of December 2002, only Chile is higher rated in the entire Latin American region. As its credit fundamentals have improved, Mexico has become an investor darling, and has issued well-received debt throughout this past years. We expect the sovereign, Pemex, Telmex, Cemex and other Mexican issuers to return to the marketplace in 2003.

There are problems along the way of course. Mexico’s economic future, more than ever before in its history, is intimately tied to the United States. As the US economy slows at year-end, so has Mexico’s such that earlier growth economists’ forecasts for the year have been recently reduced from 1.7% GDP growth to 1.2% GDP growth. This deceleration, not surprisingly, is directly related to a decline in export-oriented industrial production. Ironically, one of the consequences of the improvement in recent years is that Mexico is now having trouble competing with certain lower wage sites. Most notably, there have been several media stories recently noting how Mexican industry and jobs in selected low-tech industries are leaving for lower wage China. We think that this is a natural development in a rapidly modernizing economy however. Mexican industry will have to adapt to worker demands for higher wages and improved benefits, but there will be an economic cost to this as well as lower wage countries compete effectively.

It is also worth noting that the structural reform agenda of the Fox Administration is hindered by a tense relationship between the executive branch and the PRI, the main opposition party. Structural reforms in the areas of electricity, labor and education are needed to improve competitiveness and to promote economic growth.

In the next month, investors should pay attention to the political wrangling associated with the next federal Budget. We think that the Budget, when it is finally passed by year-end, will include fiscally prudent provisions. Although President Fox’s administration is assuming a 3.0 % growth rate in Mexico in 2003, it is also proposing a modest 1.9 % real increase in expenditures. Overall revenues are expected to outpace expenditures slightly. Also, projected oil revenues, which are critical to the Mexican economy, are based on a $17.00 per barrel price for the Mexican oil basket. This is almost $5 below the estimated average for 2002. Currently, the Mexican oil mix is hovering near the $20 level. Unless prices collapse, which is unlikely given the uncertainty surrounding a potential war in Iraq, it is difficult to imagine hat the average oil price in 2003 will be substantially below the budget assumption.

Further, we think that the 2003 Budget will include a provision whereby the deficit target will be increased to 0.65% from 0.5%. This slight increase should not be alarming to investors. Away from the budget, investors will also be focused on electricity reform negotiations. If these discussions go well in the next few months, this will send a very positive sign to the financial community.

In short, we expect that Mexico will continue to grow at a steady pace while maintaining fiscally prudent policies. President Fox will have to expend political capital to pass much needed structural reforms, but we think that he will be able to do so. The 2003 Budget assumptions are conservative and achievable. At a time of economic and political uncertainty in much of Latin America, Mexico stands out as a positive model.