News Analysis December 14, 2009, 9:37PM EST

For Want of Higher Taxes, Mexico's Debt Is Downgraded

Mexico's bid for limited financial austerity in hard times fails to keep S&P from cutting its credit rating, although Moody's sees stability

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For years, Mexico's policymakers have avoided taking the tough medicine the country needs to boost its tax revenue and reduce its singular dependence on oil revenues. Congress had a chance recently to push through meaningful fiscal reform during a debate over the 2010 budget, but legislators balked at raising taxes in a year when the economy is set to shrink about 7.5%.

Now the country is paying the price: On Dec. 14, Standard & Poors (MHP) became the second ratings agency in three weeks to downgrade Mexico's foreign-currency debt rating, reducing it from BBB+ to BBB. (Fitch Ratings downgraded Mexico on Nov. 23.) While Mexico maintained its investment-grade status with both agencies, the downgrades reflected concern that the country's failure to fix its tax system will hurt economic growth for years to come.

In announcing the downgrade, S&P chief credit analysts Lisa M. Schineller and Joydeep Mukherji said that the "prospects for substantial fiscal reform or other measures to enhance [gross domestic product] growth in the second half of the Calderón Administration are…diminishing." The downgrade had been expected by many in the market, so the announcement had little effect on Mexico's Bolsa or the peso, both of which rose slightly. The country's benchmark peso bond yields were unchanged.

The downgrade comes as Mexico is suffering through the worst recession since the 1930s, spiraling drug-related violence, declining oil production, and political gridlock—plus the aftermath of this year's outbreak of H1N1 flu, which dealt the country's vital tourism industry a serious blow. The severe U.S. economic downturn has hit especially hard, as Mexico sends 80% of its exports north of the border.

rising deficits, reluctance to tax

Ever since Mexico became a major world oil producer in the mid-1970s, with the discovery of the super-giant Cantarell offshore field, the country has depended heavily on petroleum revenues to fund government spending. Today Pemex, the state-run oil monopoly, provides more than one third of the government's total tax take. But oil production has dropped by nearly 30% in the past five years, the result of insufficient investment to replace Cantarell's dwindling reserves. Mexico's crude oil reserves will be depleted in only nine years, according to projections.

To reduce the Treasury's dependence on oil taxes, President Felipe Calderón tried to push through a new, 2% consumption tax in the 2010 budget, which was approved in November. He was rebuffed by Congress, which approved only a smaller, 1% hike in the country's value-added tax. The VAT increase will provide limited, short-term compensation for the drop in oil revenue. Government spending more than doubled over the past nine years, fueled by high world oil prices. For most of the past decade, Mexico had kept its fiscal debt as close to zero as possible. But as oil revenues dropped and spending continued to rise, the deficit has grown. Even with the recently approved tax increase, Mexico's deficit is expected to widen to 2.5% of GDP next year, and that gap rises to 3.1% if borrowing to cover off-balance-sheet government obligations, such as a 14-year-old bank bailout, are included.

When he took office for a six-year term in 2006, Calderón promised to boost economic growth and create jobs, but he has been frustrated by the U.S. recession and by the opposition-dominated Congress' refusal to approve anything more than incremental reforms. In mid-term elections in July, the president's center-right National Action Party lost nearly one-third of its seats in the lower house of Congress while the main opposition force, the Institutional Revolutionary Party (PRI), more than doubled its seats, to 49%. That put Calderón at a disadvantage in the recent budget negotiations.