Mexico: Lower Growth To Pressure Ratings But Prudent Banxico Should Support Peso

Weaker economic activity and a dovish shift by the Federal Reserve now point to a cut at the 15 August Banxico policy meeting. That said, a prudent course and the high rate differential with the US should remain stabilising factors, keeping USD/MXN trading in a 19-19.5 range.

As a crucial element in Mexico’s energy policy, investor focus has recently been on PEMEX. The recently presented business plans have been largely met with scepticism, with the consensus looking for further downgrades. This could have substantial ramifications should PEMEX lose investment grade status (currently rated currently Baa3/BBB+/BB+), probably triggering forced selling of more than US$10 billion in bonds and weighing on future financing costs of the company and the sovereign. Among the drivers that could see PEMEX losing investment grade status, a sovereign-induced downgrade at Moody’s (from A3 to Baa1) by year-end would have an almost certain knock-on effect on PEMEX being cut to Ba1 (from Baa3).

Energy policy drives concerns with regard to investments and PEMEX

President López Obrador (pictured) took office with a focus on re-orienting private and public-sector relationships and redefining the roles each would play in the coming years. So far, the focus has been on questioning existing agreements and a preference for state ownership in the systemically important energy sector, after the brief opening overseen by the previous administration.

Among the chief initiatives announced since taking office were the termination of the construction of the new Mexico City airport, the cessation of future rounds of oil exploration auctions, the announcement of fiscal support to PEMEX, and the decision to seek arbitration remedy against gas pipeline owners, in hopes of better terms for the state-owned power utility.

The consequences of these actions were: the deterioration in the outlook for private investment and GDP growth, financial market instability and credit rating downgrades for the sovereign and for PEMEX, due to the weaker fiscal stance and perception of misguided corporate strategy.

The recent abrupt resignation of Finance Minister Carlos Urzua also served to highlight the growing divergence of opinions inside the cabinet, with energy policy appearing a particular source of contention. Known for his commitment to sound fiscal policy, Urzua’s exit highlighted the risk that ideology is prevailing over pragmatism, raising the risk of unpredictable and heavy-handed domestic policy decisions, dampening the outlook for business sentiment and fiscal policy in the foreseeable future.

Getting energy policy right is crucial because it affects all major aspects of Mexico’s macro outlook. Over the past five/six years:

1)  oil production has fallen by 34%, exacerbating the drop in PEMEX’s contribution to the government’s budget, which fell by almost 40% (in real terms)

2)  output from PEMEX’s refineries has dropped by almost 50%, dragging industrial activity sharply down over the period

3)  the oil-sector external trade balance has deteriorated by more than US$30bn in annual terms, moving from a US$9bn surplus to a US$24bn deficit, damaging the outlook for external accounts.

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Without private sector investment in energy, it’s unclear the government and PEMEX would have the resources to alter this landscape in any meaningful way, without jeopardising fiscal sustainability. In fact, market reaction to the recently-announced business plan and government support for PEMEX, suggests that widespread scepticism continues to prevail.

According to its business plan, the government will support PEMEX with a total of close to 1% of GDP in tax breaks and capital injections during 2020-22. According to the company, this should help expand crude production at a double-digit rate annually, starting next year. As a result, PEMEX would completely reverse the output drop seen in recent years by the end of the AMLO administration, in 2024. The company also plans to keep debt levels stable and, after posting financial losses in recent years, the aim is to generate profits starting in 2021.

By relying completely on PEMEX, the government severely restricts the energy sector's potential to generate investment and, as a result, the risk is that Mexico’s macro outlook will continue to deteriorate gradually. This reflects the greater downside to economic activity, and to the outlook for fiscal and external accounts, the latter also due to diminished prospects for foreign direct investment.

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The information does not constitute investment recommendation, and nor is it investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. more

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