Mexico: ‘Tequila’ Sunrise?

Mexico: ‘Tequila’ Sunrise?

The incoming Mexican government’s costly plan to cancel the new Mexico City airport has fueled concerns that President-elect Andrés Manuel López Obrador will enact a populist agenda and squander the country’s sound financial position.

Local stocks, bonds and the peso tumbled after last month’s announcement to halt construction on the $13 billion project, which followed a referendum called by López Obrador (AMLO), who has criticized the new airport as a waste of taxpayer money and rife with corruption. However, canceling it will be costly since the project is already well underway.

The plan to scrap the airport highlights the risk that AMLO may implement some of his more costly campaign promises, possibly by using similar popular referendums without official legal status. This would, in turn, raise serious questions about the rule of law and would risk undermining credibility with investors.  Yet even if AMLO’s term as president proves to have negative implications for Mexico’s creditworthiness, as we expect, the airport referendum is no harbinger of crisis, in our view.

Populist or pragmatist?

Ahead of July’s presidential election, no one was certain which AMLO would emerge as president: the righteous autocrat or the thoughtful pragmatist.

As Mexico City mayor, AMLO showed elements of both: Against a sound fiscal track record (including paring down social programs he had promised to implement), AMLO enacted several “popular referendums” to justify measures that went against the spirit, if not the letter, of the law.

AMLO’s record suggests he’s not the typical Latin American populist of decades past, and accordingly, we think investors should take a nuanced view of how his presidency will affect investment opportunities in Mexico.

No Tequila sunrise

The Tequila crisis in 1994‒1995 followed a period of excess that led to a massively overvalued exchange rate, large external financing needs, and currency and maturity mismatches in the financial system. AMLO’s presidency will start with no such macro imbalances and significantly larger buffers against shocks. Foreign exchange reserves are in line with IMF recommendations; the currency serves as a credible adjustment mechanism in response to shocks, without destabilizing the domestic debt market; and the central bank has established its credibility over time in its pursuit of price stability.

However, there are material downside risks to the Mexican credit story, most notably the state-owned oil company, Pemex. Plans to build a costly refinery and to constrain private investment in the oil sector, if pursued, could result in the company’s loss of investment grade status. Not only would this serve to undermine the government’s objective to increase energy independence, but it would raise the specter of faster sovereign credit deterioration.

After the costly decision to cancel the Mexico City airport, the burden of proof falls on the incoming government to prove its respect for contracts and institutions, and to acknowledge the financial constraints to its social policy promises. 

The government’s first budget, to be announced in early December, will be the acid test on the administration’s commitment to a primary budget surplus. Also key will be the recurrent nature of social spending commitments that could destabilize debt sustainability in future years. A solid 2019 budget would alleviate some of the fears from the decision to scrap the new airport.

To avoid a further loss of investor confidence, AMLO must stick to his campaign promise to protect central bank independence. He should also seek to retain the IMF’s approval around its macroeconomic policies by extending the current $88 billion Flexible Credit Line beyond 2019.

Investment implications

We suspect that the market’s tendency to pigeonhole AMLO as a profligate leftist populist will offer interesting investment opportunities for a sovereign that remains on reasonably solid financial foundations.

The delivery of a coherent 2019 budget plan on December 15th, targeting a continued primary surplus, would validate our sense that the market has over-extrapolated the risks to Mexican creditworthiness stemming from AMLO’s campaign pledges on social and infrastructure projects.

Valuations are now much more attractive for investors: Sovereign external credit is already priced for a two-notch credit rating downgrade to BBB−, the cusp of investment grade status. Domestic real one-year interest rates, at 4.8%, are at 13-year highs and are the second-highest among major emerging markets, based on our analysis. On a comparable basis, the Mexican peso is the cheapest asset of all, over two standard deviations below its long-term average, according to our estimates.

For our broader views on emerging markets, please see “Opportunities and Value in Emerging Markets.”

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Gene Frieda is a global strategist based in PIMCO’s London office and a regular contributor to the PIMCO Blog.

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