Fitch Affirms Mexico at 'BBB+'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed Mexico's long-term foreign and local currency Issuer Default Ratings (IDRs) at 'BBB+' and 'A-', respectively. The issue ratings on Mexico's senior unsecured foreign and local currency bonds are also affirmed at 'BBB+' and 'A-' respectively. The Rating Outlooks on the long-term IDRs are Stable. The Country Ceiling is affirmed at 'A' and the short-term foreign currency IDR at 'F2'.

KEY RATING DRIVERS

Mexico's 'BBB+' ratings are supported by the country's diversified economic base and a track record of disciplined economic policies that has anchored macroeconomic stability and curbed imbalances. These strengths counterbalance Mexico's rating constraints, which include its historically moderate economic growth, structural weaknesses in its public finances, such as low fiscal buffers in the context of oil dependence of fiscal accounts, a relatively low level of financial intermediation and institutional weaknesses highlighted by the high incidence of drug-related violence and corruption.

Mexico has confronted significant shocks including low oil prices, reduced oil output, a lacklustre U.S. economy, and increased global financial volatility. Despite these headwinds, Mexico's economic performance has remained relatively resilient and the authorities have been taking measures to cushion the impact of these adverse developments on public finances and the broader economy. The strong credibility of the macroeconomic policy framework, the recent proactive and coordinated monetary and fiscal policy response in the face of the above-mentioned shocks, and continued implementation of structural reforms passed a few years ago support confidence in the ability of Mexico to navigate the current challenging external environment.

The economy grew by 2.5% in 2015 and Fitch forecasts growth to average 2.8% in 2016-2017. Competitive gains from the real exchange rate depreciation, continued growth in U.S. demand, and positive spill overs for investment and productivity from the ongoing implementation of reforms should enable growth to reach 3% by 2017. To attract private investment, the government has made some headway in conducting auctions for certain oil fields, although depressed oil prices will continue to present challenges for implementing the hydrocarbon reform. Downside risks to growth could stem from a prolonged weakness in U.S. manufacturing, further declines in oil production, public sector spending cuts, and an intensification of the challenging external environment.

Mexico's macroeconomic imbalances remain moderate. The current account deficit is expected to average around 3% of GDP during the forecast period, and should be predominantly funded by foreign direct investment flows. Inflation reached a historical low of 2.1% last year despite the peso depreciation although Fitch expects it to rise moderately during the forecast period. Notwithstanding the sluggish economic outlook, the central bank has increased interest rates, most recently in an extraordinary meeting in February to consolidate the convergence of inflation with the target and better anchor inflation expectations in the context of a weaker and volatile peso.

The central bank has sold significant international reserves (USD30.2 billion) since the beginning of FX intervention (rules-based and discretionary) in December 2014 to smooth volatility and ensure adequate liquidity in the FX market. The Foreign Exchange Commission recently suspended the rules-based mechanism, which could help preserve Mexico's external buffers but additional discretionary dollar sales cannot be ruled out given the high level of global uncertainties. Mexico's access to the IMF's Flexible Credit Line and the current adequate international reserves position supports the country's external shock absorption capacity.

Despite the severity of the oil income shock, the government remains committed to meeting its pre-established fiscal targets. Fitch believes that the oil hedge and the spending adjustments should allow the government to meet its federal government deficit objective of 2.7% of GDP in 2016, while the expected transfer of central bank operating surplus to the government should give it additional flexibility to cope with downside risks. Since Pemex is not covered by the oil hedge, the government recently announced that the company will be cutting MXN100 billion (0.5% of GDP) in spending (pending approval by the Pemex board) to cope with the oil price shock and to facilitate the achievement of the non-financial public sector deficit target of 3% of GDP. Inadequate public expenditure adjustments, weaker growth, and lower oil production represent downside risks to fiscal projections.

Fitch expects the government to implement further fiscal adjustments in 2017 as oil income will likely remain under pressure. In this regard, the government recently announced precautionary spending cuts of MXN32 billion (mostly at federal agencies), which should help smooth the needed adjustment for 2017.

Mexico's government debt burden has continued to increase in recent years, highlighting the erosion of fiscal space to confront shocks. Fitch currently projects that Mexico's general government debt burden should peak in 2016 and reduce gradually thereafter as fiscal consolidation proceeds and growth recovers. The debt trajectory will be influenced by the government's absorption of the pension savings secured by Pemex as a result of the pension reform deal the company secured with its union.

The government's excellent external market access and deepened local capital markets provide financing flexibility to the sovereign. The high participation of non-resident holdings in domestic debt (around 36%) represents a vulnerability in the context of U.S. Fed tightening and increased global investor risk aversion. However, so far these flows have remained relatively resilient.

RATING SENSITIVITIES

The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced. Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a rating change.

The main factors that individually, or collectively, could trigger a negative rating action include:

--Weak economic performance and fiscal deterioration leading to a worsening of government debt dynamics. Materialisation of contingent liabilities that undermine the sovereign's balance sheet;

--An inadequate macroeconomic policy response that dents confidence, flexibility, and credibility of the macroeconomic policy framework.

The main factors that individually, or collectively, could trigger a positive rating action include:

--Improved investment and growth prospects that help reduce Mexico's income gap with higher-rated sovereigns over the medium term;

--Reduced fiscal vulnerability related to oil income, fiscal consolidation and a reduction in government debt burden that boosts flexibility to confront shocks;

--Improvements in governance indicators that address Mexico's institutional weaknesses.

KEY ASSUMPTIONS

--Fitch assumes that continued economic growth in U.S. will provide support to the Mexican economy given the strong trade and financial ties between the two countries.

--Fitch assumes that oil (Brent) price averages USD35/bbl in 2016 and USD45/bbl in 2017.

--Fitch assumes that the Mexican government will adhere to its medium term fiscal consolidation plan with the narrow non-financial public sector deficit reaching a balanced position by 2017.

--Fitch assumes that the drug-related violence does not escalate significantly although it will continue to exact economic costs.

Additional information is available on www.fitchratings.com

Applicable Criteria

Country Ceilings (pub. 20 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869287

Sovereign Rating Criteria (pub. 12 Aug 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=754428

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1000078

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1000078

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst
Shelly Shetty
Senior Director
+1-212-908-0324
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Kelli Bissett-Tom
Associate Director
+1-212-908-0564
or
Committee Chairperson
Douglas Renwick
Senior Director
+44 203 530 1045
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Shelly Shetty
Senior Director
+1-212-908-0324
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Kelli Bissett-Tom
Associate Director
+1-212-908-0564
or
Committee Chairperson
Douglas Renwick
Senior Director
+44 203 530 1045
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com