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Moody's affirms Aaa.mx rating of the Government of Mexico
Moody's de México, S.A. de C.V. (Moody's) has today affirmed the issuer rating of Aaa.mx on Government of Mexico's National Scale Rating. At the same time, Moody's Investors Service affirmed the issuer rating of A3 on its global scale for the Government of Mexico. The outlook remains negative.
The key driver of the decision to affirm Mexico's rating is that the risk that contingent liabilities from PEMEX will crystalize has decreased significantly in the period since the last rating action. In addition, the authorities have made progress in achieving structural fiscal consolidation despite subdued economic performance.
However, the decision to retain the negative outlook reflected newly emergent concerns regarding the possibility that external shocks stemming from changes in US trade policies negatively impact economic activity and undermine the fiscal consolidation process.
RATIONALE FOR AFFIRMING THE RATINGS AT A3/Aaa.mx
Moody's decision to affirm Mexico's sovereign ratings is due to the government's progress on fiscal consolidation and the significantly reduced likelihood that contingent liabilities from state-owned oil producer, PEMEX, will crystalize given its improved financial performance.
Government tax revenues expanded 11.9% in real terms in 2016, still benefiting from: (1) the effects of the 2013 tax reform, (2) differed tax payments that became due in 2016 and (3) increased formalization of workers and businesses. These increased tax revenues more than offset the decrease in oil-related revenues such that overall federal government income rose 9.1% in real terms last year. On the expenditure side, current spending increased by a low 1.4% in real terms due to expenditure restraint and lower goods and services purchases, while physical investment declined strongly.
The overall headline federal government deficit remained virtually unchanged at 2.9% of GDP in 2016, but this was due to a 0.4% of GDP transfer of federal funds in December to state-owned entities (excluding PEMEX) as a match for improving their actuarial pension balance as stipulated under the 2013 energy reform. The transfer constitutes a one-off given that the matching program for pension savings has now expired. Absent this one-off transfer, the underlying fiscal balance improved 0.3% of GDP relative to 2015, reaching 2.5%. This highlights that structural fiscal consolidation was attained despite a weaker-than-expected economic performance than what the budget had assumed. Moody's believes that although gradual, fiscal consolidation will continue in 2017 and will lead to a stabilization of debt-to-GDP in 2018. At least 70% of the upcoming transfer of extraordinary 2016 profits from the central bank to the sovereign totaling 1.5% of GDP, will be used to reduce debt in 2017 and, potentially, to stabilize the debt to GDP ratio.
PEMEX's financial position has strengthened since last year due to: (1) higher oil prices, (2) the implementation of an expenditure reduction program, and (3) liquidity support in 2016 from the government. As a result of this, Moody's believes that PEMEX will not require government assistance in 2017 and 2018, although there is a possibility that it might require a small amount (0.2% of GDP) of liquidity support in 2019 absent any liability management operations due to a spike in PEMEX's debt amortization schedule. This is in contrast to the more challenging outlook in early 2016 when Moody's believed that the state-owned oil producer would require government support in order to meet its financing needs every year through 2019.
RATIONALE FOR THE NEGATIVE OUTLOOK
Moody's view is that the renegotiation of NAFTA seems increasingly likely lead to moderate changes to the treaty. It seems likely that the US administration will pursue limited changes to the overall agreement focused mainly on adjusting thresholds for rules of origin and dispute resolution mechanisms such that the overall effect to Mexico's economy and its fiscal accounts is contained and credit metrics are not materially affected.
Nevertheless, it remains possible that more extensive changes, including trade distortions or a withdrawal of the US from the agreement, could be adopted with negative implications for Mexico's macroeconomic and fiscal performance. A highly adverse scenario in which the integrity of the treaty was compromised could lead to a material deterioration to Mexico's credit metrics. Mexico's economy has underperformed relative to expectations when the rating was upgraded to A3 in 2014 and is expected to continue to do so. That underperformance heightens the vulnerability of the sovereign's credit profile to further confidence shocks. The negative outlook on the sovereign's rating captures the possibility that negotiations go awry and that a scenario different from Moody's baseline, in which growth falls still further and debt ratios do not stabilize by 2018, materializes.
The negative outlook also reflects that an increase in investor risk perception in advance of the final agreement in late 2017 or early 2018 could compromise macroeconomic and financial stability and - directly or indirectly - reduce growth below even the relatively low levels expected over the next two years.
WHAT COULD CHANGE THE RATING UP/DOWN
Moody's would consider changing the outlook back to stable if the renegotiation of the trade agreement leads to changes that have only limited impact on Mexico's medium-term economic and fiscal prospects, leading to a significant reduction in investors' risk perception
Upward pressure on Mexico's rating could result from higher than expected growth driven by continuing structural reform efforts, which would result in the creation of sizable fiscal buffers by the government, and a significant decrease in government debt metrics.
Conversely, downward pressure on Mexico's rating could result should a major overhaul of trade agreements with the US cause macroeconomic instability, further undermine growth forecasts and jeopardize the ongoing fiscal consolidation program such that debt stabilization is not attained. Strong indications that trade flows with the US are likely to decline to an extent that causes materially lower GDP growth and potential financial market disruption could also prompt a downgrade. In this regard, a notice of intention by the US to cancel NAFTA would, by itself, be unlikely to be viewed as a decisive indication, since such a notice could nevertheless be a prelude to renegotiation or replacement of NAFTA rather than to its elimination. In the event this were to happen Moody's would assess the likelihood of a new agreement being put in its place and its likely impact on US/Mexico trade.