Summary

The Mexican economy has been making headlines of late, and, generally speaking, not for positive reasons. Following Moody’s lead, credit rating agency Standard & Poor’s recently lowered Mexico’s long-term outlook from stable to negative due to its growing public debt. Furthermore, the peso’s value has dropped to historic lows, sparking fears of inflation in local economies. U.S. presidential candidate Donald Trump has also threatened that the United States will leave the North American Free Trade Agreement (NAFTA) in the future, and the upcoming U.S. elections create a great deal of uncertainty for Mexico. Despite these factors, the country’s economic future is not as bleak as the headlines suggest. There will be some difficulties ahead, but they will be relatively minor, especially in comparison to some of the challenges facing many of Mexico’s peers that are also considered “emerging” markets. The most telling sign about the future of Mexico’s economy will be the performance of the U.S. economy.

  • Mexico’s economic evolution over the past 35 years has put it in a fundamentally stronger position to deal with debt and a weaker currency.
  • Cross-border trade between the U.S. and Mexico will continue regardless of U.S. election results. While the U.S. president could technically withdraw from NAFTA the political costs that come with such a move make this very unlikely to happen.
  • Mexico’s debt-to-GDP ratio is much lower than other countries in the region or countries of similar economic size. In terms of how it compares to emerging markets, Mexico is much more stable politically and economically.
  • The performance and future of the Mexican economy is closely linked to the United States. In the coming months and years, Mexico will not be able to rely on exports to the U.S. as a strong source of growth. The U.S. is likely to have a cyclical recession in the next year or two; if and when this happens, Mexico is likely to fall into a recession as well.

Introduction

Within our geopolitical framework, Mexico is seen as a key emerging geopolitical power with the potential to one day be North America’s dominant power. When we use the term “emerging,” we refer to long-term processes that will come to fruition over the course of decades. That said, it is necessary — from the standpoints of both intellectual rigor and commitment to accuracy — to periodically evaluate the trajectory of these long-term forecasts. The course of current events has prompted us to conduct such a re-evaluation. Ultimately, our forecast for Mexico still holds firm. However, the accuracy of this long-term forecast does not preclude cyclical recessions along the way, and Mexico is likely to have one such cyclical recession in the next couple of years.

First, we must recognize that Mexico is no longer the country it was 20 or 35 years ago because it now exhibits many characteristics of a developed economy. With 80 percent of its population living in urban areas, Mexico has a high urbanization rate, which is a reflection of developed industrial activity. In addition, services account for 62 percent of the country’s GDP, which indicates that Mexico already has a well-developed industrial base. This is confirmed by the fact that value-added industrial activity accounts for 34.5 percent of Mexico’s GDP, and leading exports — vehicles, electronic equipment, machines/engines and medical equipment — are all high-value-added manufactured goods.

Equally important is that other countries recognize and treat Mexico as a significant world economy. Mexico’s total GDP is the 15th largest in the world, similar in size to Spain and steadily climbing the ranks. In terms of GDP and purchasing power parity, Mexico ranks 11th in the world, wedged between France and Italy. Most recently, the Mexican economy was also included on a list of “big-league” players in the U.S. Commodity Futures Trading Commission’s latest project to broaden the scope of interest rate swaps that must be cleared through a central organization. The U.S. seeks to align its rules with requirements consistent with those found in Australia, Canada, the European Union, Hong Kong, Mexico and Singapore. Mexico’s inclusion among a list of major economies conducting financial transactions with the U.S. and others signals that Mexico is being taken more seriously by the world’s major economies and is gaining their respect.

Issues Facing the Mexican Economy

An accurate long-term forecast does not give us free license to ignore the headlines or dismiss them as inconvenient. However, further examination of some of the main issues facing the Mexican economy — U.S. elections, the falling value of the peso and public debt levels — reveals that they are not as threatening as media headlines make them out to be.

Upcoming U.S. Elections

Let’s start with the upcoming U.S. presidential election. The uncertainty and concern revolves entirely around the potential victory of Donald Trump, who, among other things, said he would consider leaving NAFTA. Roughly 80 percent of Mexico’s exports go to the United States, and the removal of a free trade agreement with Washington would complicate and slow trade (though it’s impossible to stop cross-border trade altogether). Even without NAFTA, World Trade Organization regulations would still apply.

mexico-exports-by-region
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We have previously written on the legal ambiguity surrounding the U.S. president’s power to leave NAFTA. While the action is technically possible, the political cost and risk would be extraordinary, making it incredibly unlikely to happen. Leaving a free trade agreement is not an instance where Trump could yell “you’re fired” and expect the agreement to immediately walk away.

The U.S. election conversations have framed leaving NAFTA as an economic question, but pulling out of the agreement is primarily a political one. For certain segments of the American economy, such as the automotive sector, NAFTA helps to stimulate cross-border trade and economic growth in localized areas of the U.S. where these industries are strong. Secondly, campaign promises are rarely fulfilled. They are designed to address voters’ concerns, not geopolitical imperatives and constraints confronting the nation. At worst, they are carefully crafted lies to win votes; at best, they are well-intended goals that are often impossible to execute in reality. No one really expects a candidate running for office to keep all of his/her campaign promises, and in this sense, Trump would be no different.

Falling Value of the Peso

As for the peso, the Mexican currency’s value dipped to historic lows at the end of September, momentarily breaking the 20:1 barrier against the U.S. dollar. At this time last year, the peso was trading at 16.79 to the dollar; at the time of writing, the peso is at 19.87 to the dollar. This signifies a decline in the peso’s value of just over 18 percent over the last twelve months. The Mexican peso has also weakened against other global currencies like the euro, yen and franc. That said, there is no exact correlation between currency prices and economic behavior, and there are numerous theories to explain why the peso has weakened. What we can do, however, is examine any impacts observed thus far.

mexico-peso-us-dollar
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The down side of a weaker peso is that it becomes more expensive for Mexico to service debt denominated in dollars and the cost of imports rise. (When we speak of imports, we are talking about both finished products and input materials for value-added manufacturing that takes place in Mexico.) Local Mexican manufacturers have already expressed concerns about the peso remaining below the value they calculated in their business plans for the year (18.5-19 to the dollar). As a result, they are facing tighter profit margins than expected, though there have not yet been rumblings about major losses or factory closures on the horizon.

Increasing import costs also stimulate fears of inflation, which has been kept at bay thus far. Since May 2015, the Mexican government has managed to keep inflation below its 3 percent target. In June, 12-month inflation registered at 2.54 percent; it then accelerated slightly to 2.65 percent and 2.79 percent in July and August respectively. Financial press has attributed this acceleration to government-approved increases on some energy prices. Nevertheless, in a pre-emptive move against short-term market volatility and inflation Mexico’s central bank rose interest rates by half a point to 4.75 percent on Sept. 29.

On the flip side, a weaker peso makes Mexico’s exports cheaper, increasing their competitiveness in foreign markets. Increased competitiveness is essential at a time when global consumption rates are slowing. World exports are in a downward cycle, and a weaker peso will not be enough to counter declining global demand. Although a weaker peso cannot force a buyer to purchase more goods, it can make the remaining buyers more attracted to Mexican goods. This can help cushion the blow of slowed consumption.

Increased exports also help to limit unemployment. For now, the peso’s low value does not significantly affect the trajectory of the Mexican economy, nor does it pose any challenge to Mexico’s potential emergence as a geopolitical power.

Increasing Public Debt

This leaves us with the question of Mexico’s national debt. The warning bells surrounding the debt were sounded not so much because of the actual size of Mexico’s public debt but because of the speed at which that debt accumulated in recent years. This also triggered memories of the 1982 sovereign debt crisis and the 1994 peso crisis (also known as the “tequila crisis”). However, the conditions leading up to these previous crises are different from those observed today.

mexico-evolution-of-debt-gdp
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In the years leading up to the 1982 crisis, the Mexican government strongly pursued fiscal expansion. Inflation was as high as 20 percent and budget deficits registered as high as 10 percent of the GDP. About three-quarters of interest rate payments on public debt were tied to the London Interbank Offered Rate (LIBOR), which reached a high of 16.7 percent in 1981. For a brief time in the late 1970s, Mexico adopted an International Monetary Fund stabilization program. This program was abandoned in 1979 with the discovery of oil reserves at a time when oil prices were at record highs. Sustained heavy borrowing and devaluation of the peso resulted in the Mexican government spending international reserves to a point where the reserves only covered three weeks’ worth of imports. The debt repayment crisis ensued.

The 1982 scenario differs notably from Mexico’s situation today. The country’s inflation rate remains below 3 percent, and the budget deficit for this year is 3 percent as well. While this year’s interest payments on public debt are equivalent to 2.7 percent of the country’s GDP, the LIBOR rate is 0.53 for one month and goes as high as 1.55 for one year. In other words, the interest rates being charged on the current debt principal are significantly lower than the rates that were charged leading up to the 1982 crisis. Moreover, Mexico’s current international reserves stand at about 3.4 trillion pesos, or approximately five months’ worth of imports. Additionally, the Mexican government is now pursuing a more prudent fiscal policy than it did in 1982. All of these factors converge to indicate that Mexico is unlikely to enter into another financial crisis.

The 1994 crisis, like the 1982 crisis, occurred during a period of expansionary fiscal policy that contributed to large-scale deficits in the current account. To help fund these deficits, the Mexican government began selling short-term debts in pesos with repayment in U.S. dollars. As part of this plan, the peso was pegged to the U.S. dollar, which ultimately led to the peso being overvalued. The pegging was intended to curb inflation as imports increased. At the same time, political instability took hold in Mexico when a presidential candidate was assassinated, and there was also violent unrest in the south because of conflict between indigenous peoples and farmers. Between the currency peg and political instability, investors began to lose confidence in the economy and capital flight ensued. The government was eventually forced to lift the currency peg and allow the peso to float, which resulted in a strong devaluation of the peso. While the peso has recently declined in value, it is free floating rather than pegged; this, in turn, helps protect its value and prevent market fluctuations. The Mexican government has not taken strong measures to artificially sustain the currency like it did in the early 1990s. On a political level, Mexico is also more stable than it was in 1994. There are still scandals, protests and party rivalries, but they take place within the normal scope of political life in Mexico and do not rise to the level of assassinations or coups. For all of these reasons, the current situation is quite different from the situation in 1994; therefore, a similar financial crisis is improbable.

The Mexican government is already taking action to slow the speed at which debt as percent of GDP is growing, with the aim to eventually reverse the debt. Mexico’s proposed 2017 budget calls for an overall spending cut of approximately 1.7 percent of GDP and has a primary surplus of 0.4 percent of GDP. Reductions to state oil company Pemex’s budget account for just over 40 percent of the total budget cuts, with the company receiving $5.4 billion less in 2017 than it received in 2016. The budget also includes a 23.7 percent reduction in public investments to states, some of which will see cuts as high as 52 to 83 percent. National-level ministries will also see large spending cuts. The Secretariat of Economy is one of the hardest hit with a 52 percent cut to government-sponsored support programs for industry, investment and small and mid-sized businesses’ foreign trade.

The Mexican government has responded to the accelerating debt problem with a sense of urgency. Augustín Carstens, governor of Mexico’s central bank, publicly recognized that changes in government spending could not have been postponed. His evaluation of the 2017 budget is that the government has less room in its fiscal policy and that debt is reaching its reasonable limit. Finance Minister José Antonio Meade agreed on the lack of maneuvering room and acknowledged that next year will put the federal government to the test in terms of funding government spending without increasing taxes.

There is concern in the business world that reduced government funding will damage economic growth. The Confederation of Industrial Chambers of Mexico said that 2017’s government budget cut will affect private sector behavior, investment, growth and wealth generation. To minimize the impacts, resources should be reduced on product lines that do not generate value-added products and are not competitive. The confederation also said that so far in 2016, reduced public investment has caused a 16 percent contraction in real terms. In the area of small and medium-sized businesses, the government is hoping to use administrative measures to support entrepreneurship rather than subsidies or funding. While a more austere budget will likely hinder next year’s growth prospects, the proposal does appear to include feasible plans and means to curb the rising public debt. The proposal also marks the first steps toward lowering Mexico’s public debt as a percentage of GDP.

The Rest of the World

When looking at Mexico’s economic performance and public debt levels, we must also view them within the larger global economy. Throughout the year, the exporters’ crisis has been unfolding to the point where it appears that a worldwide recession is beginning. Global economic growth forecasts have been lowered multiple times throughout the year. Additionally, worldwide trade growth has been lowered to an estimated 1.7 percent this year, down from the 2.8 percent projected early in 2016, and 2017 forecasts do not inspire much confidence of recovery, ranging from growth of 1.8 to 3.1 percent at best.

The table shows different economic regions or groups with which Mexico is associated. When we look at Mexico’s debt as a percent of GDP, we see that it ranks on the lower end compared to its peers. From a geographic perspective, Mexico belongs in North America, which is reflected in its NAFTA membership. There is also a group of economies typically labeled as “emerging” by mainstream media, and this group includes Mexico. Finally, a number of major European economies are close in size to Mexico’s economy, as mentioned above.

mexico-public-debt-comparison
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From multiple angles, Mexico’s situation is comparatively positive. For instance, Eurasia is currently in crisis with political, economic and social turmoil spread across the Eastern Hemisphere. However, Mexico’s placement within North America helps to shield it from this chaos and offers a level of stability not seen elsewhere.

Among the media’s favorite “emerging” markets, Mexico fares better than its counterparts. Russia’s economy has been hit hard by the drop in commodity prices, and there are already reports that Russian food prices are becoming further out of reach for the average person. Credit agencies have questioned Turkey’s political stability due to its July 15 coup attempt. Additionally, drought is affecting South Africa’s food supply, while its economy weakens due to lowered commodity prices and the erosion of power for the ruling African National Congress party. China’s economic expansion is also decelerating to levels that will prompt severe unrest. Compared to its peers in the emerging market category – countries facing crises that threaten the core of their political system and/or economy – Mexico’s challenges are much less threatening and do not bring into question the status of the government or economic collapse.

In terms of economies of similar size, we can look to Spain, France, Italy and the U.K. in Europe. Europe is fraught with financial and economic crisis and has been plagued with high public debt for years. Italy is on the verge of a banking system collapse, and Germany’s banking system may not be too far behind. Furthermore, Spain still hasn’t managed to curb its budget deficits in the wake of the 2008 crisis. France is also now questioning EU budget deficit rules and saw its economy contract by 1 percent in the second quarter this year. The Mexican economy stands out from its peers not only for its low public debt levels but also for the absence of major social and economic turmoil experienced by other nations. Mexico has a program in place to cope with low oil prices, there are no expectations of bank failures, food supplies and availability are not a major concern, and the political system remains intact with no challenges that could interrupt the government’s term. All of these factors point to a positive outlook overall.

The United States

Mexico’s economy is intimately linked with the United States’ economy, and how Mexico weathers the exporters’ crisis will be determined by U.S. exposure to the crisis. Mexico’s exports account for 35.3 percent of GDP, with approximately 80 percent of these exports going to the United States. As the saying goes, when the U.S. catches a cold, Mexico gets pneumonia.

The U.S. has minimal direct exposure to Italy’s banking crisis. However, it does remain vulnerable to a potential French or German banking crisis, which explains recent efforts by the U.S. Department of Justice to settle a $14 billion dispute with Deutsche Bank. As for exports, they only contribute to 12.6 percent of the U.S. GDP, which helps create a buffer against declines in global trade. Other countries, such as Germany, where exports account for 45 to 50 percent of GDP, will experience strong economic consequences with much smaller fluctuations in global trade.

While the U.S. is fairly well positioned to face both the exporters’ crisis and the European financial crisis, it does not make the country immune to global economic trends. There are three trends emerging in the U.S. economy that will be problematic for the Mexican economy in the medium term. First is slow growth and potential stagnation; U.S. economic growth is forecasted to be a mere 1.6 percent in 2016 while Mexico’s economic growth will be approximately 2 to 2.6 percent. Little or no growth of the U.S. economy means, at best, little or no growth for Mexican exports, and Mexico will be unable to rely on its largest export market for growth and will be hard pressed to fully compensate this loss with other trade partners.

Secondly, U.S. demand for imports from some major economies — namely China and Germany — has started to decline. Given that the U.S. is the world’s largest economy and accounts for nearly a quarter of global GDP, this will exacerbate the exporters’ crisis. It also means that, at the very least, Mexico should not count on increased U.S. imports as a source for economic growth. According to the United States Census Bureau, the U.S. imported $196.2 billion worth of goods from January to August 2015. During that same period in 2016, U.S. imports from Mexico totaled only $193.7 billion. So far this year, this reflects only a minor decline in U.S. imports from Mexico and reinforces the idea that Mexico cannot depend on strong U.S. demand as a way to increase its exports.

Lastly, there is reason to believe that the U.S. is due for a cyclical recession in the next year or two. Since World War II, the U.S. economy has averaged a corrective, cyclical recession every six years, although the time between recessions was a bit longer between 1990 and 2008. While there has been a U.S. recovery since the 2008 recession, the speed and intensity of the U.S. economy is still slow compared to its pre-crisis performance. The U.S. recovery started around 2010; according to historic patterns, this means a corrective recession is very likely next year or the year after. A recession in the United States would mean Mexico is also likely headed for a recession.

Conclusion

While the credit outlook for Mexico changed from stable to negative, it should be noted that the country’s credit rating itself did not change. Meanwhile Brazil, Turkey and the U.K. all had their credit ratings cut by agencies this year. Italy’s credit rating is currently facing review by Europe’s DBRS, and there are concerns this rating will be lowered. Though smaller than the main U.S. credit rating agencies, the European Central Bank takes DBRS ratings into account when grading collateral for its liquidity operations. Additionally, Germany’s iconic Deutsche Bank saw its unsecured senior debt rating reduced to Baa2 from Baa1and its long-term deposit rating reduced from A2 to A3.

Our 2016 forecast for the European economy outlined a banking crisis in Italy and how this could potentially unravel the entire eurozone’s financial system. The downgrade of Deutsche Bank is symptomatic of the German economy failing under the stress of the exporters’ crisis. At the same time, the U.K. is redefining its relationship with Europe, and both Brazil and Turkey are recovering from political crises (an impeachment and attempted coup respectively). In contrast, Mexico is not facing any existential threat.

Mexico has already begun taking action to avoid any major debt or currency crisis, which should help to address the business world’s immediate concerns. While Mexico did not successfully evade debt and currency crises in the past, its economy today bears little resemblance to its economy decades ago and is now better prepared to weather the challenges that come its way. We expect to see these challenges arise in the next year or two as the exporters’ crisis plays out and the U.S. economy likely experiences a cyclical, corrective recession.