If you have followed our coverage of Mexico and Pemex, Fitch’s downgrade of Mexico’s sovereign rating to BBB from BBB+ yesterday should come as no surprise. Neither should Moody’s lowering of the A3 sovereign rating outlook to negative from stable.
As far back as 15 April, we stated that government support for Pemex would not solve the company’s fundamental issues, highlighting that, “to protect the sovereign ratings” [new emphasis], the authorities needed to “modify the company’s business strategy…to refocus on exploration and production.” The 5 June rating actions reflect a failure to do that.
We do not believe a change in direction is on the horizon for Mexico. At today’s daily press conference, President Andrés Manuel López Obrador (AMLO) dismissed the rating actions and criticised Fitch and Moody’s, saying they continue to use “the same ratings methodologies that have been in place for decades, that have a ‘neoliberal’ bias, and that don’t consider the fight against corruption, making their assessments wrong”.
We worry the administration is in denial, and what worries us even more is that many investors remain confident on Mexico and are long on the country, mostly given that the rates paid by the sovereign are among the highest in the universe of sovereigns at similar ratings.
We believe Mexico’s high rates are part of a strategy to prevent capital flight (particularly portfolio investments) and MXN from weakening. We are also convinced that Mexico’s fiscal and macroeconomic situation is unlikely to improve, that risks are rising and that, eventually, the rates that Mexican sovereign instruments pay will be seen as inadequate compensation for the risk and the deteriorating creditworthiness.
In conclusion, we remain bearish on Mexico, apparently against the market consensus. However, we believe the Fitch and Moody’s rating actions support our theses and that time will prove us right.
Moody’s on Mexico
Moody’s said its action has been prompted by “ongoing challenges related to weak growth rates, weaker-than-peers institutional strength and a large informal sector, weak growth rates, and weaker-than-peers institutional strength.”
The agency stated that factors that could persuade it to downgrade the rating include: “increasing fiscal deficits that cause the debt trajectory to shift upward, whether due to financial support to Pemex or for any other reasons.”
Additionally, Moody’s said that “the horizon over which these trends might materialize is uncertain” and that “while policy action or inaction could lead Moody's to conclude that these risks will crystallize, a period of up to 18 months may be needed to assess the credit consequences of the uncertainties and tensions inherent in government policy and their interaction with investor sentiment.”
Fitch on Mexico
Fitch, meanwhile, defined its key rating drivers as “a combination of the increased risk to the sovereign’s public finances from Pemex’s deteriorating credit profile together with ongoing weakness in the macroeconomic outlook, which is exacerbated by external threats from trade tensions, some domestic policy uncertainty and ongoing fiscal constraints.”
The agency added that “the impact of the contingent liability represented by Pemex weighs increasingly heavily on the sovereign credit profile” and that “the fiscal cost of that support to date represents .02% of GDP to the budget in capital injections and lower effective taxes”. In Fitch’s view, that is “not sufficient to provide a long-term solution or prevent continued deterioration in Pemex’s credit profile.”
Fitch stated that “Pemex’s tax bill (oil accounted for 2.3% of GDP in federal government revenue in 2018) exceeds its FCF, preventing it from investing sufficiently to maintain production and reserves” and that it “expects oil output to contract by 5% in 2019 and 2020”.
However, the agency also said that: “as our base case expectation is that ongoing sovereign support will be extended to Pemex over the medium term through a combination of a lower tax burden and/or further capital injections, our assessment of the sovereign’s public finances is weaker than indicated by the headline gross general government debt to GDP ratio of 42% at year-end 2018.”
In addition, Fitch noted that “Mexico's growth continues to lag that of the more developed U.S. economy to which it is closely linked. Fitch expects growth to accelerate from 2Q but despite this it will reach only 1% in 2019” and that “the energy sector, characterized by a trend of falling production at Pemex, and weaker investment levels, reflecting lower business confidence, will continue to weigh on growth. The suspension of private sector bidding rounds that had been scheduled as part of the energy sector reforms is unlikely to help investment sentiment.”