Beyond a Dual Downgrade - Mexico

November 18, 2009 By Gray Newman, Luis Arcentales & Daniel Volberg New York After a tumultuous turn in recent weeks, Mexico's congress is putting the final touches to the federal government's 2010 budget. This year, however, the budget is likely to receive greater scrutiny than in most years for one reason: the potential threat that at least one of Mexico's three principal rating agencies will downgrade the country's sovereign credit rating. Investors have been parsing the public comments from the rating agencies, particularly from the two that have Mexico on negative outlook. We find the focus on Mexico's rating a bit surprising. After all, it was only a year ago that the rating agencies were (rightly or wrongly) under considerable attack from many in the investor community. Imagine you had taken a part of the year off from looking at markets: you'd likely be very surprised to see just how important the verdict of the rating agencies now appears to be, at least in Mexico. Faced with the uncertainty surrounding the next decision by the rating agencies, as well as the precise timing of any move, our advice is two-fold. First, we think Mexico watchers should start with the assumption that both of the two rating agencies that have Mexico on negative outlook will downgrade the sovereign's foreign debt rating from BBB+ (three notches above the cutoff for investment grade) to BBB. We usually shy away from making calls on what a rating agency will do. But after exploring the rationale by both of the agencies in question, as well as reviewing the evolution of the liquidity and solvency ratios of Mexico relative to its peers, we think that a dual downgrade (that is, a downgrade by two agencies) is the most likely scenario. Second, we would encourage investors to look beyond today's ratings debate. Whatever the outcome in the coming months - and our sense is that changes, whether in the form of a downgrade or a move back to stable outlook, are likely to take place in the near term - investors should not lose sight of the long-term challenge facing Mexico, which is to boost potential GDP growth. Behind the commendable management of Mexico's public debt, behind the torturous political negotiations to approve some form of tax measure this past month to help patch up a growing public sector deficit, and behind the public sector's overdependence on pro-cyclical oil revenues, is one overarching challenge: Mexico needs to do much more to boost its sustainable growth path. Boosting potential growth is no easy task. It is very easy for armchair analysts in New York or London to dole out policy advice from the comfort of their posts. But in reviewing Mexico's growth record, we cannot help but believe that the economy would be returning to a stronger and more sustainable growth path if more was done in three areas: address shortfalls in human capital through a thorough rethinking of education policy; strengthen the laudable recent steps in funding infrastructure; and finally, ensure that a regulatory environment is in place to promote competition and foster a thriving entrepreneurial base throughout all sectors of the economy. Why a Downgrade? Our reading of the rating agencies suggests that they remain concerned that Mexico policymakers have not done enough to address three concerns: an excessive budgetary dependence on oil revenue (the flipside to a low non-oil tax base), limited fiscal savings (virtually wiped out by 2010), and insufficient progress in boosting long-term growth. While the authorities have made progress in the 2010 budget negotiations to boost non-oil tax revenues, it is not clear that the actions taken to date have been sufficient to trigger a move by the two rating agencies back to a stable outlook from the current negative outlook. In the case of one of the rating agencies, the negative outlook was first announced in November 2008 amid enormous financial market uncertainty. Since then, the global economy has improved and the turmoil in financial markets has subsided. Neither Mexico's external accounts nor the financial stress experienced by some Mexican corporations at the time - both raised as concerns a year ago - have proved to be significant issues. But, the bar is much higher in the case of the rating agency that announced in May 2009 that it was putting Mexico on negative outlook. By May of this year, financial markets had stabilized, the US and Mexican economies were no longer showing signs of a worrisome downward spiral and yet Mexico's outlook was moved from stable to negative, largely on concerns that Mexico would not adequately reform its fiscal policy. Whatever the benefits derived from Mexico's recent budget process for fiscal year 2010, it is not hard to imagine that the rating agencies will decide that not enough has been done to address Mexico's "underlying structural fiscal vulnerabilities" - excessive reliance on oil revenues, lack of significant fiscal savings and a low non-oil tax base. The rating agencies can also make an additional element: the move is not solely about Mexico. Since the global turmoil accelerated just over a year ago, most of Mexico's peers (those in the broader BBB class including BBB+, BBB and BBB-) have either experienced a downgrade in rating or a deterioration in outlook. For Mexico to maintain its current rating, it would need to show that it had outperformed its peer group (even if that meant its deterioration was more modest than others). Yet, work by Daniel Volberg, using the most common solvency and liquidity ratios, suggests that Mexico has remained in a similar position of disadvantage relative to it peers during the past year - a position of disadvantage relative to a group that has seen its average rating downgraded. (For the purposes of Daniel's work, he has used the ratings of the group of broad BBB credits as rated by Standard & Poor's in 3Q08 and then compares them with the latest available data in mid-2009.) The Timing of the Downgrade We suspect that the first downgrade could come later this month or next following a review of the fiscal measures approved in their finality by Mexico's congress on November 15. However, a downgrade by a second agency seems more likely set for late in the year or early next year. What seems clear to us is that both rating agencies feel certain pressure to move away from the ambiguity of a negative outlook. The real choice is either a move to a stable outlook or a downgrade by one notch to BBB. The actions taken by the authorities in recent months (the budget, the lifting on the caps for the oil stabilization funds, as well as the move to takeover the power company, Luz y Fuerza del Centro) are set to be judged against a bar that looks at Mexico's longer-term challenges of fiscal flexibility and growth. What it Means for Markets We suspect that the pace of recovery of the Mexican economy will be much more important for equity markets and investors watching local rates in the coming year than a rating change from investment grade BBB+ to investment grade BBB status. While our Mexico economist, Luis Arcentales, expects a modest recovery in 2010 and consensus estimates for next year's GDP growth are near 3%, Gray Newman has a bias that the recovery could be stronger. Gray argues that the significant decline in 1H09 should make for a very easy base and hence boost Mexico's GDP reports at the beginning of 2010. And Mexico's peso weakness, which stands in sharp contrast with the rapidly appreciating currencies of many of Mexico's emerging market peers, should also benefit Mexico's manufacturing base and feed through to the Mexican consumer. So far, the data seem to be going in Luis's favor: the recovery in 2H09 has been modest despite the benefits that a weaker currency might provide, and concerns abound over the strength of the recovery in the industrial plant in the US, Mexico's dominant trading partner. The greatest impact from a downgrade would appear to come in debt markets or perhaps in the currency market, but even there many market participants argue that a downgrade by at least one rating agency is already priced in. Mexico's credit default swaps, while rallying of late, remain wide to credits such as Brazil (BBB-), which has a current rating two notches below that of Mexico (BBB+). Some participants argue that debt and currency markets have not fully priced in a downgrade to BBB by two of the three rating agencies. We'll leave that discussion for our strategy team, but would add one observation. Although it is difficult to argue that a dual downgrade (that is, a downgrade by two agencies) is positive for the pricing of Mexican assets, we would suspect that the downgrades would be accompanied by a return to a stable outlook. The current position in which two rating agencies have Mexico's outlook set at negative (since November 2008 in the case of Fitch Ratings and since May 2009 in the case of Standard & Poor's), may have raised the bar, making it more difficult for investors to build a case to buy Mexican debt instruments, given the concern over the timing of a single- or dual-downgrade. Once the downgrades take place and the outlook has changed to stable, investors should be able to focus on the relative strength of Mexico's credit fundamentals with less concern about the timing of a possible rating change. We feel strongly that if a downgrade takes place, Mexico's outlook will be moved to stable. In our review of the metrics being used by the rating agencies, we could find little evidence to support Mexico being reclassified as a BBB- credit, the lowest investment grade rating. Indeed, public comments by an official at one of the rating agencies suggested that a ‘two-notch' downgrade from BBB+ to BBB- is not being contemplated. A move to BBB with a negative outlook would, from our perspective, be viewed too close to a move to BBB-, and this does not appear to be the signal that the rating agencies wish to send. The Debate in 2010 The real debate in 2010 is likely to depend on the strength of growth in the Mexican economy. If economic activity surprises on the upside (which is Gray's initial bias), then we suspect that investors will begin to shift their attention away from our long-term concerns that revolve around Mexico's limited progress in boosting potential GDP and the public sector's oil addiction, which tempers Mexico's ability to engage in counter-cyclical fiscal policy. But whether Gray's biases play out or Luis's view of a modest recovery in 2010 turns out to be a more accurate forecast, we agree that the challenges for Mexico's long-term growth prospects remain much the same as they were before the turmoil that engulfed the globe last year. Growth in 2010 could surprise to the upside, but we would caution against confusing a statistical rebound after the significant fall seen in 2009 with a stronger, long-term growth path. And without stronger growth, as Luis Arcentales and Daniel Volberg have argued repeatedly this year, Mexico is likely to find it challenging to improve its fiscal house (see "Mexico: Zipping Up the Fiscal Straightjacket", EM Economist, October 30, 2009). Despite all of the focus on Mexico's oil dependence, Luis and Daniel forcefully argue that GDP growth assumptions matter even more. Luis and Daniel find that, assuming trend GDP growth of 3% and expenditures rising at roughly half the pace of recent years in real terms (about 3.6%), in the absence of tax reform Mexico was headed for a fiscal deficit of 3.6% of GDP in 2015. In contrast, the authorities' original proposal would have been of significant help - Luis and Daniel estimate that if it had been adopted, the fiscal deficit would have largely stabilized, heading towards 2.6% of GDP. Instead, the final bill was watered down when Congress removed the 2% ‘anti-poverty' consumption tax (that would have included food and medicine) and instead raised the VAT tax (excluding food and medicine) by 1%. Luis and Daniel find that the revised tax reform means that, under the same 3% GDP growth and 3.6% real expenditure conditions, the fiscal deficit may be heading towards 3.2% of GDP. And the risks are much higher if growth disappoints. For example, if you work with growth at half their initial assumption (only 1.5%), then the fiscal deficit would approach or even go beyond 5% of GDP under all scenarios. Of course, in those circumstances we would expect the authorities to cut expenditures - but the exercise is designed to show just how sensitive Mexico's current fiscal situation is to growth. Bottom Line Be ready for renewed focus on Mexico's rating, especially if - as we suspect - both rating agencies currently with a negative outlook move to downgrade. That move could create a near-term jolt to investor sentiment. But we suspect that much of the handwringing will subside if growth returns stronger in 2010. In a way, we think that would be a mistake: our concern is that even with stronger growth in 2010, Mexico has not made much progress in tackling what needs to be done to strengthen its long-term growth profile. Mexico's fiscal dilemma is largely just another symptom of the underlying shortfall on the potential GDP growth front. Out of crises often taboos are broken and reforms are born; that does not appear to be the case in Mexico in the aftermath of the severe downturn of late 2008 and 2009. Instead, we fear that another opportunity has been largely lost.