From The Sovereign's Credit Quality Perspective, What Are The Main Issues Facing The Next Administration?

The Sheinbaum administration will confront strained public finances, including a recently growing fiscal deficit and long-standing weaknesses in state-owned oil company PEMEX. In addition, the new administration faces the need to boost the country's rate of economic growth on a sustained basis to help address pressing social needs.

Mexico's general government deficit is slated to exceed 5% of GDP in 2024 from 3% last year, due in part to large capital expenditure (capex) to finish the construction of several large projects, including the Mayan Train and PEMEX's new oil refinery. As a result, net general government debt may increase to 48% of GDP this year from 45% in 2023. The outgoing administration of President Andres Manuel Lopez Obrador (AMLO) presented plans to make a substantial fiscal correction in 2025, reducing the public sector's borrowing requirements by nearly half. However, it remains to be seen if the Sheinbaum administration will adhere to the current administration's fiscal path when it presents its 2025 budget later this year. A potential weakening of public finances, leading to a higher debt burden, could hurt the sovereign rating.

Mexico's credit quality is constrained by its poor track record of economic growth in comparison with peers at a similar level of income. Growth has picked up recently, with GDP rising 3.1% in 2023 and likely to grow about 2.5% this year. Recent developments have raised hopes for sustained higher private-sector investments, including foreign direct investment, to build a larger supply chain to cater to the North American market and reduce reliance on China. Some recent economic data, especially rising non-residential construction activity, indicate brightening investment prospects. However, many years of under-investment, especially in infrastructure (such as energy and electricity), constrain the supply side of the economy. Poor physical infrastructure, shortage of water in some areas, and electricity capacity constraints (especially from non-thermal sources) pose limits to Mexico's growth prospects.

We expect a broad continuity in fiscal, monetary, and trade policies that should help absorb potential external shocks in coming years. However, such stability may not necessarily translate into greater economic dynamism. Like many Latin American countries, Mexico's economic output has been increasing due mainly to greater use of inputs like labor or capital rather than better labor productivity. While its population is on average relatively younger than in developed countries, Mexico is undergoing the same demographic shift (the rising average age and the slowing population growth rate) as other countries, especially advanced economies, have been experiencing. Hence, it's crucial for Mexico to create new and better-paying jobs for its still-growing workforce to take advantage of its current demographic dividend. However, while unemployment is low in Mexico, the productivity of workers is on average low, limiting the country's ability to prosper.

Addressing Gaps In Infrastructure Is Vital For The New Administration

During AMLO's administration, investments in infrastructure were primarily in its emblematic projects, such as the Olmeca refinery, the Mayan train, and the Felipe Angeles Airport. Meanwhile capex in other sectors, like transmission and power generation, was cut. In this context, we believe it will become a challenge for the new administration to "catch-up" on and to build new infrastructure, particularly in nearshoring-related sectors in order to unlock opportunities in this area.

For example, energy generations and transmission constraints continue to act as a drag on expanding manufacturing capacity. This is because state-owned utility Comision Federal de Electricidad (CFE) focused on the development of new combined-cycle gas turbine power plants, while lagging in constructing new transmission lines, while private investments only added about 4.5 gigawatts of new renewable capacity (mostly distributed generation) in the past three years. The newly elected president was vocal during her campaign about giving more room for private investment in the energy sector, and to foster new unconventional renewable capacity. Therefore, we expect the private entities' participation in the generation sector will increase, given that new net capacity is needed to increase by about 32% by 2030. Moreover, we believe that CFE has a limited financial room to bolster its generation capacity, while it needs to invest in strengthening transmission capacity to mitigate the number of blackouts, curtailments, and energy spills. Nonetheless, we will monitor how the new president's strategy will adhere with her intention of maintaining CFE's primary position in the energy sector.

The transportation sector should also be one of the priorities for the new administration, as greater and more efficient network (in the form of roads, ports, and airports) is needed to connect the country's economically robust regions, primarily Mexico City, Bajío, the Gulf Coast, and the northern states.

Finally, we believe the increased participation by private players is key to foster new and improve the existing infrastructure, given the sheer size (below 2% of the country's GDP between 2019 and 2023) of investments required to attend new nearshoring assets. Nonetheless, an important issue for the new president Sheinbaum and her team is how to regain confidence in the infrastructure regulatory framework. This is because it somewhat weakened during AMLO's administration following the cancellation of the new Mexico City Airport, the dispute with private gas pipeline operators, the intention to change the 2013 energy reform, changes to public-private partnerships for certain roads and prisons, among others.

Corporations Are In A Sound Financial Position And Government Will Continue Supporting PEMEX

In general, the corporations we rate are well positioned to navigate through the upcoming government transition given their low leveraged capital structures and adequate liquidity levels. We forecast the performance of these entities to remain stable. This is because 90% of corporate ratings in Mexico have a stable outlook and a liquidity assessment of adequate or better. This is the result of several companies' refinancing their debt before the election year.

Several of the corporations we rate have benefited from the USMCA agreement (the trade agreement with the U.S. and Canada), which will be reviewed in 2026. While we do not anticipate significant changes in the trade relationship between Mexico and the U.S., an unexpected setback could impact Mexican corporations, as they have benefited from their relationship with the U.S., which serves as the destination for many of their products.

We expect the consumer products, retail, and building materials sectors to continue posting healthy results due to a solid labor market, high remittance volumes, access to credit from well-capitalized financial institutions, and the country's favorable demographic trends that have strengthened the purchasing power of consumers. We believe that the industrial real estate sector will continue to boom thanks to nearshoring and increasing e-commerce. Meanwhile, office properties are likely to face ongoing structural challenges due to hybrid work models. We anticipate stability in the current housing policy, suggesting that housing starts will likely stay near historically low levels, at least in the short term. We will continue to monitor Instituto del Fondo Nacional de la Vivienda para los Trabajadores' (Infonavit) plans regarding its possible initiation of home construction and the potential impact for the sector.

We expect continuity in the Mexican energy sector's strategy. PEMEX will continue to play a central role in the national energy policy, and we expect the government will continue providing extraordinary support. The AMLO administration has supported PEMEX through capital injections, the reduction of the profit-sharing duty (DUC) to 30% from 65%, and the funding of almost all of PEMEX´s 2024 amortization payments, among other forms of support. PEMEX will have debt maturities of about $6.8 billion and $10.5 billion in 2025 and 2026, respectively. We will continue to assess the mechanisms in which the new administration will provide support to PEMEX.

For other sectors such as metals and mining, telecom, and airlines, we are not envisioning any major reforms in terms of regulatory changes or concession revisions. These sectors have benefited from stable commodity prices and a strong demand for their services, allowing them to maintain their creditworthiness.

We believe nearshoring represents an opportunity to attract more investments to the country, which could benefit various corporate sectors. To maximize benefit from this trend, the new government would need to address the obstacles in terms of infrastructure, energy, and water supply, among others.

How Will Mexican Banks And Insurers Fare?

During the election campaign, Claudia Sheinbaum has committed to maintaining the country's existing economic policy based on preserving fiscal discipline, maintaining the autonomy of the central bank, and guaranteeing the stability of the public debt. In our opinion, these pillars would generate stable business and operating conditions for the Mexican banking and insurance sectors. The new administration aims to pull more individuals and companies into the financial sector and support micro, small, and medium enterprises, which would shrink the still large informal sector. In our view, these factors could expand access to credit and insurance products. Moreover, if Sheinbaum's administration focuses on addressing Mexico's long-standing weaknesses--income inequality, a large informal sector, weak rule of law, corruption, and crime--investments and consumption would jump. This in turn would bolster banks and insurers' growth and performance.

S&P Global Ratings believes that the new administration will start its term with a sound financial system. Banks' credit fundamentals remain solid. Despite high interest rates, the banking sector has increased its credit portfolio through conservative lending policies. This is reflected in moderate credit growth rates, healthy asset quality metrics, and solid profitability that have allowed banks to continue strengthening their capital positions. In addition, the banking sector benefits from sound liquidity and a large share of low-cost deposits in the funding base. We do not expect significant changes in the banking system, in terms of competitive dynamics, once the new administration takes office. We expect commercial banks to remain the main provider of credit in the country (45%-50% of total lending), and we believe these entities' loans will expand at 4%-5% in real terms in the next 12-18 months.

Under the new administration, we expect development banks (which provide about 20% of total credit in Mexico, if we include Infonavit and Fovissste's mortgages) will regain strength and serve as a lever for economic development in the country. In our view, development banks will play a key role financing Sheinbaum's infrastructure and investment proposals. These lenders would serve economic sectors that commercial banks usually don't. Once these sectors develop, commercial banks would be encouraged to start lending to them, generating a virtuous circle.

Mexican insurers are also enjoying solid credit fundamentals, and we see growth opportunities stemming from the nearshoring trend and the greater use of customer data analytical tools. We expect insurers will maintain their conservative risk management and underwriting policies, along with sound capitalization and sufficient liquidity. We forecast real life gross premiums written (GPW) growth will slip to 10% in 2024 and 8%-9% in 2025, as interest rates fall and economic pressures crimp households' purchasing power and savings capacity. For the nonlife segment, we expect real GWP growth to slow to 9% in 2024 and 7% in 2025 on a weaker economy and expectations of lower vehicle sale volumes.

Could Structured Finance Grow During The Next Administration?

Despite historically low issuance amounts that we have observed in recent years, we believe Mexico's securitization market infrastructure is robust, providing a solid foundation for growth. However, it will take some time to regain investor confidence in the sector following the nonbank financial institution (NBFI) sector woes in the past two years and absence of residential mortgage-backed securities (RMBS) issuance over the past few years. Moreover, still-high interest rates continue to represent a significant challenge in the market.

Asset-backed securities (ABS) could regain momentum, although some obstacles persist. Financing for small and midsize enterprises (SMEs) remains insufficient. In our view, many originators, most of which are NBFIs, could find an opportunity in this sector, which has been shunned by commercial banks. However, access to accessible funding sources will remain one of the main impediments. In our opinion, the support provided by the government through development banks in providing accessible funding to SMEs will play a fundamental role in the development of the market.

We anticipate that ABS transactions backed by equipment loans and leases will continue to dominate new issuances, although we believe that conditions will remain choppy due to events associated with some market participants.

The housing strategy of the new administration will influence the prospects for new RMBS issuances. The president-elect proposed building 1 million homes in order to address the current housing deficit. In our view, this signals that new-home starts will remain low and RMBS issuance volumes will be limited.

Nearshoring could bring considerable opportunities for the development of the market. We continue to expect that nearshoring could act as a significant catalyst for new issuance activity. In our view, commercial mortgage-backed transactions could serve as an alternative source of financing for industrial real estate players. Demand for industrial properties is increasing, which will require additional equipment for construction, manufacturing, and logistics, which in turn could be used as collateral in ABS transactions. Additionally, increased employment in the north of the country could bolster demand for housing in that area and could accelerate the use of RMBS transactions in the long-term.

Regional Economic Disparities Will Persist Among Local Governments

According to preliminary elections results, the ruling Morena party and its coalition members won seven out of nine contested governorships, and control 24 out of 32 governorships. Morena and its allies are also likely to have the supermajority in both chambers of Congress, which is needed to pass constitutional amendments. Overall, we expect broad continuity in Mexico´s National System of Fiscal Coordination, which distributes tax and oil revenue collected by the federal government to local governments.

Mexico's trade openness has primarily benefited central northern and northern states because of their proximity to the U.S., while southern and southeastern states continue to have lower incomes and subdued growth rates. In this regard, Mexico has the widest regional economic disparities among OECD members, and closing the gaps is a task that no administration has been able to successfully tackle. Strategy to develop and diversify growth in the south of the country could strengthen local investment sentiment.

Mexican subnational governments' exposure to PEMEX, as measured by the share of oil revenue in federal transfers, has declined in the past decade. We expect it to remain relatively low. In the past 15 years, various reforms to Mexico's federal fiscal framework affected the revenue constituting the distributable federal income (Recaudacion Federal Participable), along with a decline in PEMEX's oil production. The reforms have raised the non-oil federal revenue collection, which more than compensated for the decline in oil revenue.

That said, volatility in oil revenue vis-a-vis budgeted transfers, even at this lower level, can affect local government finances, whether from swings in market prices or from federal policies to support PEMEX, such as a lower DUC or postponed payments. In recent years, such volatility and economic shocks led to leveraging local governments' stabilization funds to offset some loss in expected budgetary transfers. In general, we expect local governments with greater own-source revenue to be more resilient.

On average, 90% of states' and 75% of municipalities' operating revenue relies on federal transfers. This underscores the opportunity for local policies to enhance own-source revenue collection and strengthen the resilience of local budgetary performance to external shocks.