Mexico’s reformation remains on track

Sophia Whitbread, Newton Investment Management

Mexico's reformation remains on track

When developed world investors think of Mexico, their minds tend to jump back to the 1994 ‘Tequila crisis’ – when the Mexican peso plunged by around 50% versus the US dollar in just six months, causing the local-currency value of the government's large US dollar-linked debts to swell enormously and send the country into a deep recession. “Nearly 20 years on, the crisis may be a distant memory but its effects remain,” explains Whitbread. “For example, the financial sector still looks very different to its regional peers: private debt as a percentage of GDP is around 28% (Brazil’s is over 65%).1 Mexico has not witnessed the surge in consumer credit which some other emerging markets have seen – this leaves room for further growth. Furthermore, there are no Mexican state banks – to put this in context, around half of Russian loans come from state banks – so there is limited risk of state intervention in the financial sector. A perennial underachiever, the country is now in rude financial health,” she adds.

“We are positive on Mexico given the strong fundamentals of the Mexican economy and the prospect for game-changing reforms of the oil, gas and electricity sectors, which should increase foreign direct investment inflows. The long-term outlook is bright based on a reform agenda that has the potential to boost Mexico’s long-term growth rates, especially owing to energy and fiscal reform,” she says. “The country’s external and fiscal accounts are largely in balance, while core inflation remains at benign levels. The outlook is for credit to grow at strong rates from the current low levels of penetration. There are many reasons to be positive on the long-term case for Mexico.”

Teething pains

Like much of the developing world, however, politics provides a seemingly ever-present stumbling block. The government’s proposed energy reforms are a case in point. President Enrique Peña Nieto announced plans for a ground-breaking energy overhaul last summer aimed at breaking up the country’s 76-year old energy monopoly, Pemex. “This would allow scope for multinational oil majors to invest in Mexico’s oil industry. The creaking Pemex is very inefficient and is estimated to employ three times as many people than needed. Reforming and streamlining the company could have a big effect on the overall economy as a significant proportion of the country’s revenues come from Pemex,” according to Whitbread. Indeed, the Mexican energy minister, Pedro Joaquin Coldwell, has suggested such energy reform would add 1% to annual GDP growth during this government term and 2% in the next.

However, towards the end of April and just days before the reforms were due to be approved by the Mexican Congress, it was revealed the plans had yet to be presented and that approval would have to wait until September – Congress moved into recess at the end of April – when it reconvenes. There is the possibility of the energy reform being addressed during special legislative sessions before then but time is already against such an eventuality. “This is, of course, a blow to the government but we shouldn’t forget the transformational potential of such reform. It should allow Mexico to unlock vast potential in the sector and we believe more than ample political capital has been expended to ensure it is successful,” she adds.

Crossed wires

The government’s plans for reforms in the telecoms sector have also hit trouble. “The most important element of the proposed telecoms reform is that it will establish a new institutional framework to regulate the sector,” explains Whitbread. “It extinguishes the previous regulator, Cofetel, and replaces it with a constitutionally autonomous regulator, Ifetel. This institutional framework should give the regulator authority to pursue its objectives of increasing competition, increasing access to services and improving service quality. The law mentions specifically several tools that will be at the regulator’s disposal to achieve these goals, such as unbundling, oversight of spectrum allocation, and asymmetric rates.” Yet critics are concerned the police and authorities will be able to monitor internet traffic, restrict access in the event of popular unrest and enable widespread censorship. These concerns have been taken on board and an amended bill has been presented to the Senate.

Labour reform was one of the first areas of focus for the president after the outgoing Felipe Calderón administration had prepared the ground before leaving power towards the end of 2012. “Mexico has historically had very rigid labour laws; a ‘hire-for-life’ culture made it difficult to get rid of workers and therefore made companies reluctant to hire,” explains Whitbread. “This has resulted in a grey/black labour market made up of workers who aren’t formally employed and, as such, are harder to tax. The reforms are improving the ability of companies to hire and fire, while the government has also cracked down on union power and corruption.”

Movement on Mexican tax laws is also gaining traction, she adds. “Tax rates are currently very low in Mexico relative to other markets – 20% of GDP in 2012, according to the OECD. Indeed, Brazil’s tax revenues stand at 36% of GDP while the OECD average is 35%; greater tax revenues are required if it wants to genuinely compete. For example, a new tax on sugary drinks (one Mexican peso per litre) was passed in October 2013 aimed at bolstering the coffers and battling the cost of obesity-related illness.”

Heading in the right direction

Mexico is one of the emerging markets set to benefit from its own demographic dividend. During the past six decades the population of Mexico has more than quadrupled to around 120 million people. “Over this period, there has been a reduction in the dependency ratio due to a smaller number of elderly people at the top of Mexico’s population pyramid relative to the rest of the country’s youthful population, and falling fertility rates reducing the number of small dependent children at home,” says Whitbread. “This phenomenon results in increased disposable income for consumption but also improved access to better education, something which is set to improve Mexico’s productivity.

“With revamped energy and telecoms sectors and progressive tax and labour laws, the country is well set to firm up its position as Latin America’s leading light,” she concludes. The future certainly looks bright.

1. The World Bank, June 2014

This is not investment advice. Regulatory Disclosure