Global Economics

Mexico Scrambles to Save Its Credit Rating


A soaring budget deficit and declining oil revenues are threatening the investment-grade rating on Mexico's sovereign debt

Mexico is not a fiscal basket case, yet its beleaguered presidency has prepared massive budget cuts to save the country's hard-won credit rating on its sovereign debt.

Countries the world over are engaging in deficit spending as they try to coax their economies out of recession. Mexico is no exception. Curious to see how Mexico compared, Jonathan Heath, chief Latin America economist for HSBC bank (HBC), compiled a list of 25 countries and their fiscal deficits: The U.S. is headed for a deficit equaling 15% of gross domestic product, Britain more than 13%. Russia went from a 4.1% surplus in 2008 to a deficit of 8.4% today. Even oil-rich Saudi Arabia went from a surplus of almost 32% of GDP to an expected deficit of 2.5% this year, Heath calculates.

Those gaps make Mexico's anticipated 2.3% fiscal deficit—up from a nearly-balanced 0.1% of GDP last year—look positively modest. There's a problem, however: Nearly 40% of the government's revenues come from oil taxes and royalties—and oil production and exports are steadily falling as the country's main reservoir in the Gulf of Mexico dries up.

Austere Fiscal Package

Lower world oil prices are revealing how dependent spendthrift politicians have become on the volatile commodity. Yet, there has been little political will to own up to the problem. "You can't just discover and start producing more oil overnight—it can take years," says Heath. "[Mexico is] facing a permanent problem that other countries don't have."

So Mexican President Felipe Calderón is starting to slash expenses: This week he announced the elimination of three government ministries, including one overseeing the country's important tourism industry. He ordered a freeze on federal government salaries and hiring. And on Sept. 7, he sent a budget bill to the opposition-dominated Congress calling for $13.1 billion in higher personal, corporate, and consumption taxes and $16.2 billion in spending cuts in 2010.

Even with what Calderón called "drastic and unprecedented" measures, Mexico's deficit is expected to widen to 2.5% of GDP next year. The gap rises to 3.1% if borrowing to cover off-balance sheet government obligations, such as a 14-year-old bank bailout, are included. And the deficit won't disappear until 2012. An HSBC report on the fiscal package called it a "reasonable way to muddle through these difficult economic times," but noted that the "highly politicized environment" in Congress makes approval uncertain.

That has some analysts concerned that Mexico's hard-won investment-grade credit rating, which it obtained in 2000, could be downgraded. In mid-term elections in July, the main opposition force, the Institutional Revolutionary Party (PRI), more than doubled its seats, to 49% of the vote in Congress, while Calderón's conservative National Action Party (PAN) lost nearly a third of its deputies.

Calling for Stimulus Spending

The center-left PRI has argued recently that the downturn—Mexico's economy is expected to shrink by 7.7% this year, the worst performance since the Great Depression of the 1930s—justifies stimulus spending and a larger fiscal deficit, not Calderón's austerity measures. Since the 1994 peso devaluation that caused a yearlong economic meltdown, the government has maintained fairly strict budgetary discipline, keeping the deficit as close to zero as possible. But PRI economists have argued that superfrugality has hampered economic growth.

"This is a pro-cyclical package that favors short-term financial equilibrium and caters to the ratings agencies, not to the serious social [development] problems the country has, and it runs counter to what other major countries in the world are doing," says Francisco Suárez Dávila, a former finance undersecretary.

From Standard & Poor's (MHP) and Fitch Ratings, Mexico currently has a BBB+ classification, the third-lowest investment-grade level. But both agencies have a "negative" outlook on the rating, signaling that a downgrade is possible. Moody's Investor Services (MCO) in August reaffirmed Mexico's Baa1 rating with a "stable" outlook.

The problem for Mexico is its addiction to oil revenues. Government spending has more than doubled over the past nine years, fueled by high world oil prices. The government used some of the windfall to pay off part of its foreign debt and create an oil stabilization fund, but as of June 30 that fund contained just $6.6 billion. "If you consider the amount of excess revenue we've had from oil exports and then look at the size of our oil stabilization fund, you say: 'Geez, we did a really poor job,'" says Heath. "Mexico basically spent all of its oil windfall."

For years Congress insisted that a big chunk of what's called the "excess revenue" from oil exports be channeled directly to state and municipal governments, ostensibly for infrastructure projects. But much of that money went to increase payrolls or build governors' vanity projects, such as sports stadiums and fancy government offices. "Most of it was spent on projects that might have made political sense to them, but not necessarily economic sense," says Luís Rubio, an political scientist who heads the Center of Research for Development, a Mexico City think tank.

'Feudal Lords'

When the PRI lost the 2000 presidential elections after seven decades in power, Mexico's government became more decentralized, and the country's 31 governors more powerful, "more like feudal lords than anything else," Rubio says. Yet, while federal spending has been extremely transparent since the country's 1995 financial crisis, with most data posted on the Internet, state finances "are a black hole," he says. And, with limited ability to levy taxes at the state level, the governors have become dangerously dependent on shrinking oil revenues.

The federal government is similarly dependent: Mexico has one of the lowest tax-collection rates in the hemisphere, taking in just 11% of GDP. As long as oil revenues were high, there was little incentive to raise taxes. Now, it has become imperative.

For the past 30 years, Mexico has been one of the world's top oil producers and exporters, thanks to a megareservoir of oil, called Cantarell, in shallow offshore waters. Engineers at Pemex, the state-run oil monopoly, have known for years that Cantarell's production would begin to decline this decade, but politicians who control Pemex's exploration budget and Finance Ministry officials who treated Pemex as a cash cow failed to take the decline seriously—until now. Last year, Mexico produced around 2.6 million barrels of oil per day, down 30% from its peak production in 2004; this year, production has slipped to 2.5 million. Unless major discoveries are made soon, the country's reserves will last for just nine more years.

And oil exports—the source of much of the oil revenue on which the Mexican Treasury depends—have fallen from 1.87 million barrels a day six years ago to just 1.25 million a day this year. Mexico is one of the top three suppliers of oil to the U.S., but some analysts believe the country could become an oil importer within the decade. That would wreak real havoc on Mexican finances.


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