Flash Fixed Income Report /
Mexico

Mexico: Five more dark clouds for the economy

    Rafael Elias
    Rafael Elias

    Director, Latin America Credit

    Tellimer Research
    30 September 2019
    Published by

    We recently discussed the thoughts on the Mexican economy of Dr Carlos Urzua – AMLO's first finance minister, who resigned in July.

    Today, we discuss his second and third contributions to Mexican newspaper El Universal, published on 23 and 30 September, respectively. (We provide translations of the articles below.)

    Urzua continues to raise valid concerns about the economy, with the most important being the need for a fiscal regime that increases tax revenues for the federal government.

    He also delves deeper into the mismanagement of state oil firm Pemex (and the risk that it represents to the economy, given the possibility of a sovereign downgrade), criticising the strategic error to progress with the construction of the refinery at Dos Bocas. 

    In contrast to his initial thoughts, though, we regard the "dark clouds" that Urzua discusses below as less immediately worrying for the sovereign ratings. However, investors in Mexico must remain attentive to what happens with the 2020 budget and the growing unfunded liabilities that the country will face in just a couple of years. 


    Dark clouds for the economy, part two

    "In light of the Economic Package for 2020, delivered to the Lower House, in the previous article we began to list the dark clouds that can unleash, eventually, storms over the Mexican economy. The first is the dark outlook that the government itself has on growth during this administration, similar to that of the Fox, Calderon and Peña Nieto's. The second dark cloud has to do with the impossibility to contain in the medium term the financial burden of the public debt. And the third is the fall in public investment for 2020, especially regarding national infrastructure. But, unfortunately, the list does not end there – we continue with another dark cloud that relates to the third item.

    4) Despite the lack of money, the construction of the Dos Bocas refinery will continue in 2020. In 2019, MXN50bn pesos were allocated to this project and, in 2020, cMXN41bn is being earmarked for this item. This, regardless of the fact that the project shows several problems. First, according to experts in refineries, both the times and the costs have been underestimated: Dos Bocas will not be ready by mid-22 and will not end up costing US$8.5bn, but rather, with a lot of luck, 57% more.

    Second, it is a mistake to choose this specific project, given that Pemex could develop other projects in the exploration and production areas that would be much more profitable.

    The third problem is that most of the investment in Dos Bocas will not have a multiplying effect on the economy, given that the allocated moneys have to be transferred to the few foreign firms that can adequately supply the machinery, equipment and technical expertise.

    Finally, given the sizable amount of money that will have to be allocated under pressure over the remaining months of the year, there is a chance that corruption will increase significantly.

    5) The next dark cloud is the payment of pensions, which always represents a headache (not only for Mexico, but for every country). In 2020, MXN965bn will be allocated to the payment of pensions to the retirees of the Federal Government, the Mexican Institute for Social Security (IMSS), the Institute for Social Security for Public Servants (ISSSTE), Pemex and the Federal Electricity Commission (CFE), among others. These pensions are labelled "contributions", since, in the beginning, the pensioners had to contribute throughout their labor lives to pay for them. But, unfortunately, this has not always been the case; for example, until just a few years ago, Pemex workers did not contribute at all to their pensions. Moreover, given the ageing of the population, the fiscal load for this typically grows faster than the economy itself. In fact, the payment of pensions in 2020 will grow by more than 6% in real terms relative to 2019.

    And if this problem were not complicated enough, next year there is a plan to spend MXN139bn for the payment of non-contribution pensions, in particular those corresponding to the program for seniors. In total, if we add up the payments for all the pensions mentioned, we reach an amount close to 4.2% of GDP, which is equivalent to a little under one-third of the total fiscal revenue at the federal level. In fact, tax collections in 2020 from VAT, that ever-present VAT, would not be enough to cover the payment of all those pensions.

    In our third and last article on the dark clouds on the economy, we underscore the importance of implementing significant fiscal reform in Mexico. But, as it is clear from what has been said before, there will also be a need for pensions reform, of even more depth than the fiscal reform."


    Dark clouds for the economy, part three

    "The two previous articles warned of five big dark clouds that could end up as storms affecting the Mexican economy. But these are not the only ones – in this final article, we list three more that are equally troubling. The first is partially responsible for the final two.

    6) As opposed to the municipalities, that for starters count on revenues from property taxes, the state governments have very few ways of collecting taxes. Among these, state governments can collect payroll taxes, which is the case for many entities, as well as tax vehicle ownership, charged in just a few states (those few that have had governments with a particular vision for the future). This means that the state coffers depend overwhelmingly on "federal participations" and contributions, both of which are regulated by the so-called Fiscal Coordination Law. These participations can be used freely by the states and are assigned according to a formula (erroneous, by the way, as we have argued in other venues), while the contributions are assigned mostly to education and health services.

    As one might assume, there are a dozen states in the Republic where the federal participations are no longer sufficient. Aside from the typical problems of inefficiencies and large government payrolls, all these states in a critical situation have a common denominator: excessive state debt. In light of the global recession of 2008-09, the federal government, facing the impossibility to compensate the states for the drop in their participations, literally left them free and allowed them to raise debt themselves in a manner that would seem irrational. And, in fact, this was the case in the eyes of the inhabitants of those states, although not under the eyes of their corrupt governors (think of what happened, for example, with the cases of Duartes in Chihuahua and Veracruz).

    7) It is well known that basic education in Mexico is a complete disaster in some states, especially in the south. This is not merely our judgement, but rather, an empirical fact that has been very well documented for decades by both Mexicans and foreigners. This factor has constituted and will continue to constitute one of the major obstacles for Mexico to develop. What can we, the citizens do to improve this worrisome, draconian and unjust situation that the Mexican children suffer? The answer to that question is not clear at all, if there even is one. But there is yet another problem that is also not easy to solve: in some states, the sum of the education budget and the federal contributions are no longer sufficient to even cover the education payroll.

    8) In the case of those Mexicans who do not benefit from a formal institution, the provision of health services, if it exists, is through hospitals dependent on state governments. These are financed by the federal government via the program known as the "Popular Insurance", which, according to many Mexicans, is neither insurance nor popular. Most of the public health services fall very short, in a similar way to the education services; only, in this case, the consequences are even more worrisome and in some cases, deadly. In addition, again, in some states, the local and federal budgets allocated to health are insufficient. 

    We have identified in this article and in the previous two eight worrisome dark clouds that hover over the Mexican economy, dark clouds that from one day to the next could become strong storms. One common factor to all of them is the lack of budgetary funds. There is no longer a choice. In 2021 at the latest, there will need to be a pension reform and the fiscal regime will have to be redesigned in order to secure more fiscal revenue."