United Mexican States FC And LC Ratings Lowered By One Notch; Outlook Stable

Despite recent tax increases and steps that could bolster growth prospects, we expect that Mexico's fiscal challenges will persist over the coming years.


In addition, the prospects for substantial fiscal reform or other measures to enhance GDP growth in the second half of the Calderón Administration are, in our view, diminishing.

As a result, we have lowered the foreign-currency sovereign credit rating on Mexico to 'BBB/A-3' from 'BBB+/A-2' and the local-currency rating to 'A/A-1' from 'A+/A-1'.

The stable outlook reflects fiscal and external indicators that are consistent with the 'BBB' median, the absence of macroeconomic imbalances in the Mexican economy, and the Mexican government's longstanding commitment to macroeconomic stability.

Standard & Poor's Ratings Services said today that it lowered its foreign-currency sovereign credit rating on the United Mexican States to 'BBB/A-3' from 'BBB+/A-2' and the local-currency credit rating to 'A/A-1' from 'A+/A-1'. Standard & Poor's also said that it lowered the transfer and convertibility assessment on Mexico to 'A' from 'A+'. In addition, Standard & Poor's affirmed the mxAAA/Stable/-- national-scale rating. The outlook is stable.

"The downgrades reflects our assessment that Mexico's recent steps to raise non-oil revenues and improve efficiencies in the economy will likely be insufficient to compensate for the weakening of its fiscal profile," explained Standard & Poor's credit analyst Lisa Schineller. "This weakening stems from a combination of modest GDP growth prospects and diminished oil production over the coming years." The revenue measures approved in the 2010 budget should address immediate concerns about fiscal vulnerability to volatile oil revenues. However, the inability to widen the tax base substantially, along with a low likelihood of major tax reform in the next several years, suggest that Mexico's debt profile will remain more in line with that of its 'BBB' peers.

Mexico's net general government debt has recently increased and is projected to remain at about 34% of GDP during 2009-2011, which is line with the projected 'BBB' median for this same period. Its GDP growth prospects over the next several years are also projected to remain moderate at 3%-4%, limiting the upside to fiscal dynamics. Notwithstanding the efficiency gains associated with the closure of Luz y Fuerza del Centro (the main supplier of electricity in the central region of Mexico), new management of its assets, and forthcoming telecommunications concessions, we believe that Mexico's strong links with the U.S. economy will limit its growth prospects given our diminished expectations for growth in the U.S.

In the midst of the deepest contraction in real GDP (estimated at 7%) in decades, the Mexican Congress passed a number of tax increases, including raising the controversial VAT. The measures replace lost oil revenue in the short term. However, the government's forecasts are for overall public-sector revenues to at best hold steady at about 22% of GDP; this is consistent with general government revenues of 19% of GDP and is much lower than the 35% for the 'BBB' median. Oil-related revenues have averaged about 35% of total budgetary revenues.

The government's inability to broaden the tax base meaningfully and address the many loopholes and exemptions in the tax regime weakens its capacity to contain fiscal pressures from diminished oil production--even if oil output declines more slowly than in recent years. General government deficits are projected to average 3% of GDP (2009-2011), which is comparable with that of the 'BBB' median. Projected deficits are higher than the deficits Mexico ran during the years of buoyant oil prices, when investment-grade credits with significant budgetary reliance on commodity revenue ran surpluses.

The ratings on Mexico are supported by its track record of and commitment to macroeconomic stability, as its prudent macroeconomic management, which political parties at the national level support, demonstrates. The ratings also reflect conservative management at the Finance Ministry, a formally and operationally independent central bank, and recent steps to improve tax administration at Servicio de Administractión Tributaria, the national tax-collection agency.

In addition, Mexico's external accounts do not, in our view, pose the same risk to its credit profile as they do in some other peer 'BBB' category credits. Mexico's external debt, net of liquid assets, is in line with the 'BBB' median of about 31% of current account receipts. Despite the fall-off in oil revenues, the current account deficit declined to an estimated 0.8% of GDP this year from 1.5% in 2008. Although we expect that the deficit will widen over the forecast horizon toward 1.4% of GDP in 2011, this is below the projected 2%-2.5% for the 'BBB' median for 2009-2011. The absence of imbalances feeds into comparatively strong external financing needs vis-à-vis peer credits. Mexico's gross external financing needs as a percent of current account receipts and usable reserves average 93% in 2009-2011 versus the 'BBB' median of 114%.

"The stable outlook reflects our expectation that cautious macroeconomic policies should contain the rise in Mexico's debt burden in coming years," Ms. Schineller added. The government's commitment to maintaining macroeconomic stability, combined with recent changes in taxation, should contain the slippage in Mexico's fiscal and external indicators and keep them at levels that are consistent with the 'BBB' median.

"The ratings could come under downward pressure if fiscal dynamics were to deteriorate, such as if the recently passed tax measures fail to generate sufficient revenues to offset lower oil revenue," Ms. Schineller notes. "The ratings could benefit from stronger-than-expected GDP growth prospects that facilitate better fiscal dynamics or other measures that enhance fiscal flexibility."
RELATED RESEARCH
"Sovereign Credit Ratings: A Primer," May 2008.

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