Fitch Affirms Mexico at 'BBB+'; Outlook Stable

Fitch Ratings has affirmed Mexico's long-term foreign and local currency IDRs at 'BBB+' and 'A-', respectively. The issue ratings on Mexico's senior unsecured foreign and local currency bonds are also affirmed at 'BBB+' and 'A-' respectively. The Rating Outlooks on the long-term IDRs are Stable. The Country Ceiling is affirmed at 'A' and the short-term foreign currency IDR at 'F2'.

KEY RATING DRIVERS

Mexico's IDRs reflect the following key factors:

Mexico's ratings are supported by the country's disciplined economic policies, well-anchored macroeconomic stability and low imbalances, and an adequately capitalised banking sector. If properly executed, the wide-ranging economic reforms that are in the process of implementation under the Pena Nieto administration bode well for medium term competitiveness, investment and growth prospects. These strengths sufficiently counterbalance Mexico's rating constraints, which include structural weaknesses in its public finances, relatively low financial intermediation and institutional weaknesses highlighted by the high incidence of drug related violence and corruption.

Mexico's economic policy flexibility is facilitating an adjustment to the changing external environment of lower commodity (oil) prices and the withdrawal of monetary stimulus in the U.S. The currency has been allowed to weaken to absorb external shocks and the Mexican Foreign Exchange Commission has employed a rules-based FX intervention to ensure proper liquidity and functioning of the FX market. The increased foreign participation in the domestic government securities market represents a source of vulnerability. However, enhanced international reserves buffers since 2008 and access to the IMF's Flexible Credit Line provide adequate support for continued external resilience. Macroeconomic stability is further bolstered by a relatively moderate inflation rate (4.1% at the end of 2014), which is expected to decline further in 2015 and moderate current account deficits, which are projected to deteriorate slightly, averaging just over 2% of GDP during 2015-2016.

The Mexican economy is projected to grow at 3% in 2015, up from 2.1% in 2014 owing to the expected acceleration of the U.S. economy and the easing of certain factors that weighed on confidence and growth last year. Higher confidence and greater investment flows related to the implementation of structural reforms passed in recent years should be supportive of growth in 2016 and beyond. However, lower oil prices, fiscal spending cuts and international volatility related to the prospective tightening of U.S. monetary policy represent downside risks for Mexico's economic performance in the near term. If the current weakness in oil prices is sustained, it could delay and/or reduce potential investment flows to the oil sector, especially related to deep-water fields and unconventional sources.

The implementation of revenue-enhancing measures in 2014 proved to be timely as it helped in offsetting the lower oil income last year and will continue to contribute positively to revenues in the coming years. The decline in oil prices and reduced oil production platform represent challenges for the Mexican economy, especially for the fiscal accounts. Near-term vulnerability of the fiscal accounts is mitigated by the government's decision to execute an oil hedge to protect the federal government oil income from materially lower-than-budgeted oil prices and the recently announced spending cuts. The pre-emptive spending cuts (amounting to 0.7% of GDP for the public sector) demonstrate the commitment of authorities to maintain fiscal stability in the face of lower oil prices and a sluggish economic recovery. Further fiscal adjustments will likely be required for the government to meet its medium term fiscal consolidation goals especially if the low price environment is sustained and/or if oil production fails to increase as per expectations. Fiscal buffers in the form of oil stabilization funds to confront a structural oil price shock are relatively small.

The government is planning to gradually consolidate its fiscal accounts in the coming years which should result in broad stability of the government debt ratio. However, downside risks for fiscal and government debt trajectories could emerge from subdued oil prices over a longer period of time, adverse oil production trends and lower economic growth. Mexico's effective liability management, favourable currency composition of debt and excellent market access mitigate risks.

Certain high profile corruption scandals and the continuing incidence of violence appear to have dampened domestic confidence and highlight some of the institutional weaknesses of Mexico. The country ranks relatively poorly on governance indicators related to the rule of law and control of corruption. Fitch expects progress on these institutional weaknesses to take time and foresees violence to remain regionally concentrated although economic costs related to it will remain for the foreseeable future.