The countrys sovereign risk premium has jumped but Mexico is profiting from its historically clean debt profile and array of funding sources for now. Sid Verma reports.
Mired in the deepest recession since the 1930s, engulfed in political gridlock over fiscal tightening and faced with threats of a credit downgrade. Mexico is Latin Americas whipping boy in the global credit crash. Vanishing revenues, plummeting dollar bond returns and diminishing foreign investor confidence are battering Latin Americas second biggest economy.
But the country has some protection from the storm in the form of minimal foreign debt and deep pools of domestic liquidity. So as it wallows in recession, external and domestic markets have left the door open for government borrowing. Its worth remembering that this stands in stark contrast to the late 1990s when sovereign debt crises swept through the region.
Mexico (Baa1/BBB+/BBB) is reaping the rewards of its astute debt management strategies in recent years. The country has aggressively sought to develop its domestic capital markets since 2004 by swapping foreign currency debt with local currency bonds and courting foreign investments in peso-denominated government bonds. Thanks to these reforms, Mexico now finances itself primarily from domestic capital markets.
As a result, the country has banished the demon known as "original sin": the foreign exchange risk triggered by large-scale dollar borrowing in emerging markets. This liability would have caused Mexicos debt servicing costs to jump to perilously high levels upon the onset of the global crisis as the peso slid downwards and foreign investors took fright.Thats because investors have been offloading Mexican dollar bonds this year in anticipation that the country will be downgraded by rating agencies. The governments dollar bonds have returned 7.1% in 2009, compared with the 24% return in JPMorgans EMBI+ index. The countrys investment grade rating is in jeopardy as investors sound the alarm over its 2010 budget gap, estimated at 2.8% of GDP. On November 23, Fitch lowered Mexicos BBB+ rating to triple-B, two notches above junk status, due to falling oil production. Moodys and Standard & Poors have threatened similar action if the government fails to tighten the budget. However, Gerardo Rodríguez, general-director of public credit at the Mexican treasury, dismisses the prospect of egregious new issue premiums for the international borrower in its hour of need in the event of further downgrades. "Markets, in general, do not pay that much attention to specific ratings actions anymore so I dont think a ratings action will be a significant price mover on bond yields," he tells EuroWeek. In June, Mexico sold a $750m tap of its $1.5bn 6.05% 2040s in a deal that demonstrated the return of investor appetite for long-dated paper. This marks a break from February this year when the country was forced to abandon a 21 year issue due to risk aversion. Mexicos international capital raising this year amounts to around $4bn.
Next year, the government faces $2.45bn of amortizations on external bonds that need to be refinanced. However, as dark clouds hover over Mexico which is reeling from an estimated 7% economic contraction this year will the country return to bond markets for balance-of-payments support?
Rodriguez quashes such suggestions. "No," he says We have been and will continue to focus on external borrowings for refinancing purposes." But there is thin line between raising cash for amortizations and deficit financing since, after all, money is fungible. Bankers expect Mexico to raise several billion dollars in global markets in 2010 despite pre-financing this year.
The country is a flexible and opportunistic issuer, swooping in when markets are hot thanks to its well developed secondary curve and its strong investor base.
Diversity: the financial remedy
"In the current environment, investor preferences are changing a lot so the lesson is to be more flexible," says Rodriguez. The debt management office is also diversifying the countrys international issuance away from US dollar markets despite the traditionally higher premium with yen and potentially, euro issues.
"In this environment, what you would like as an issuer is more options than less," says the public credit official.
The US dollar market is the most liquid source of external financing and home to the largest number of fund managers focused south of the US border. As a result, Latin American sovereigns have issued in euro and yen markets to diversify their investor base but have shunned large-scale issuance due to the higher cost of financing.
However, Rodriguez takes comfort from Pemex, the countrys state-owned oil firm, when it priced in September a Eu1bn 10 year bond at 250bp-255bp over mid-swaps.
"If you look at the Pemex transaction, they got a more attractive cost of funds than their dollar cost of funds, so I think [the foreign currency premium relative to dollars] depends on the market situation."Mexico along with Chile has one of the most developed domestic government bond markets and, unlike its South American counterpart, relies heavily on foreign investment. But immediately after the collapse of Lehman Brothers, foreign holders in government debt fled en masse. This triggered a sharp jump in bond yields, principally at the longer end. As a result, the government reduced inflation-indexed instruments with longer maturities and issued short-dated paper.
However, this development was largely a blip rather than a harbinger of a longer term structural trend, says Rodriguez. In the fourth quarter, Mexico was back on track on track after reducing Ps500m of issuance in five and six month format and increasing 10 and 20 year auctions by the corresponding amount. This assuages concerns that Latin governments now face the threat of tight repayment calendars after swapping foreign debt in favour of short-term domestic debt in recent years.
Point of no return
In Mexicos case, medium and long duration instruments provide the bulk of net funding while paper up to one year in maturity is the regular debt stock that is rolled over and bought by the mutual fund industry. Surprisingly, foreign buyers in domestic bonds have defied predictions that they would repatriate all their capital homewards. Indeed, they still represent 12.5% of the total market, mostly in the belly of the domestic yield curve, compared with 15% before the onset of the September 2008 crisis. At the height of the bull run, this stood at 25%.
The stability of foreign investment in Mexico is partly down to the availability of credit derivative products, such as interest rate swaps as well as currency forwards and swaps. These instruments allow investors to hedge or replicate currency and interest rate exposures to local currency bonds although no credit default market exists for local bonds.
Nevertheless, the dearth of market makers and divergent bid/ask spreads for derivative products from trader to trader has undermined liquidity. "We have well developed government bond market but we dont have a well developed credit market yet," laments Rodriguez. "This should develop in the coming years. The crisis halted that process. It is starting to come back but it is from a very low base."
If foreign investors tiptoe out of domestic bonds on the back of the countrys waning economic prospects, the government can bank on its faithful base of mutual funds and pension asset allocators that are hungry for high quality paper. Not surprisingly, local pension funds have proved to be more stable investors than foreigners and have increased their exposure by around 15% since early 2008.
This trend may intensify amid the populist clamour for financial protectionism. The government recently imposed a 20% cap on capital outflows of pension funds to boost the peso and domestic sources of government financing. This signals an abrupt reversal of the trend in recent years to liberalise capital outflows of local pension funds.
The domestic government bond market in Mexico, then, has survived its first big stress test since it became the chief financier for the government. Whats more, the country still has plenty of sources to finance its deficit, both locally and globally helping to reduce macro-economic shocks as plunging trade to the US batters the public finances.Ironically, Mexicos smooth ability to finance its budget deficit is a double-edged sword since it may delay belt-tightening measures before its too late.