With economic recovery firmly established in Mexico, the government plans to consolidate its success in foreign debt markets and focus on the development of a peso-denominated yield curve. The immediate new horizon, though, is the presidential election due in 2000. The finance ministry is working overtime to overthrow the unfortunate Mexican tradition of capital flight and devaluations accompanying changes of administration. So current policy aims to clean house before the elections in both external and internal debt management.
The government largely completed its mission in external financing last year with a massive debt restructuring that included a $6 billion bond issue and a Brady bond exchange. As a result, government financing requirements have fallen dramatically. The United Mexican States (UMS) will borrow $1.5 billion next year, with a further $2 billion in maturities facing the state agencies, including some $600 million in bonds for development bank Nacional Financiera. This year the government concentrated on bonds that offered currency swap opportunities, particularly in lire and yen. The UMS also hit the market with two $1 billion issues.
Aside from refinancing, the government will continue to search for ways to reduce the cost of financing. Although the average cost of financing for the entire $70 billion in debt held by the UMS is still 6.5%, that includes Brady bonds and multilateral credit, which lower the figure. In general, finance ministry officials are confident the country’s debt will benefit from improving economic fundamentals. “If you weigh the high yield against the fundamentals, in the long term it’s the fundamentals that count. The technicals count in the short term,” says Martin Werner, general director of external credit at the finance ministry.
Setting debt goals
Werner and his team have completed Mexico’s dollar yield curve with benchmarks set from five to 30 years. Now the government will set its goals for fixed-rate debt. A five-year fixed-rate bond is in the pipeline. Other options include issues in local currencies from Portugal, Austria and Spain, among others, as well as maintaining a presence in the German and Japanese markets.
Now the whiz team that brought Mexico from the brink of collapse in the peso crisis will use its talents to create a peso yield curve. The government currently issues peso instruments in 28-day and three-, six-, and 12-month treasury certificates, or two-year bonds whose interest rates mature every 28 days (Cetes). As a start, the first long-term bonds will be denominated in the inflation-indexed UDI unit for five to 10 years. “As the US economic bloc becomes a reality, the peso market will be more compelling,” says Eduardo Cepeda, director at JP Morgan Mexico. “There is a tremendous potential in pesos.”
The recent pension reform is key to the evolution of local long-term instruments. In July, Mexico’s new privatized pension system opened its doors for the first time with overwhelming approval from the country’s workers. Some of the confidence in the new funds, known as Afores, derives from the workers’ well-earned mistrust of the former system, run by the ill-reputed Mexican Social Security Institute (IMSS). Not only are the funds out of government hands, but the management is shared with foreigners who lined up quickly to form joint ventures with the majority of the 17 funds.
By September next year, the pension system will command the equivalent of some $3 billion in funds. Given investment limitations, fund managers will be hungry for longer-term peso instruments. Starting this September, the pension funds were allowed to invest 65% of their liquidity in public securities with the remaining 35% in private-sector debt. Of the government paper they purchase, 51% must be based in the inflation-indexed UDI unit. They can also invest in Mexican government dollar instruments such as Bradys and UMS international bonds on a limited basis. “It’s just a matter of time until they force the creation of a liquid and diverse bond market,” says Richard Segal, head of fixed- income research at Santander Investment, who predicts there will be a significant difference perceived as soon as next year.
The government’s ongoing sales of banking assets will be another factor to accelerate local market instruments, particularly secondary market securities. In all, the government’s saving guarantee fund Fobaproa plans to sell some $40 billion in assets, of which 95% corresponds to bank portfolios and the rest to real estate. The first auction was a direct sale to buyers. Upcoming sales include a mortgage securitization and other bond issues, although these will take a while to develop.
“The market is still worried about the speed with which this is done given the large amount of assets,” says Eduardo Fernandez, president of the National Banking and Securities Commission (CNBV). “So Fobaproa will be careful not to depress the markets and to stretch out the sales for the next five years. If we look at the RTC [the US’s Resolution Trust Corporation], it took 10 years in a much more profound market.”
Mortgage securitization is particularly sticky since there is little standardization in the diverse portfolios Fobaproa has bought from the banks in the last two years. Since the loans converted into the UDI unit form the most uniform portfolio, UDI mortgages are the most likely securitization candidates. Of the entire $40 billion, $5 billion corresponds to mortgage portfolios formerly held by the then three largest banks – Banamex, Bancomer and Serfin.
Investors normally buy short-term peso instruments because of their relatively high yields. Proven economic stability is expected to bring more non-traditional investors across the border. “Mexico is the natural market to attract non-traditional investors because it’s close to home and part of the Nafta [North American Free Trade Area] bloc,” says Cepeda at JP Morgan. “We’re seeing an arbitrage in nominal ratings. They’re better returns for the buck with the same risk profile, which is a healthy trend. We’ll be seeing even more capital flows into Mexico in the next two years.”
With that in mind, earlier this year the Mexican government established one of the first long-term economic programmes in Latin America, known as Pronafide. For this year, the plan targeted GDP growth at 5% and inflation at 15% with external borrowing limited to $5 billion and a current account deficit equivalent to 3% of GDP. Economists such as Ernest Brown at Morgan Stanley Dean Witter are even more optimistic about growth. Brown recently increased his forecast for 1997 from 5.2% to 6.2% and for next year from 4% to 5%.
The economy has started to recover in various sectors this year, most notably in construction and manufacturing. The Mexican economy grew 8.8% year on year in the second quarter. Construction is expected to lead the recovery after an increase in capital goods imports during the first quarter. The increased activity should be reflected by the third quarter in better margins for such companies as Cementos de Mexico (Cemex), ICA and Bufete.
Earlier this year services picked up, with 7.7% growth in the second quarter, as manufacturing hit levels higher than pre-crisis in 1994. Services account for nearly 60% of all aggregate supply and are a significant employer. However, compared with pre-devaluation figures, construction and services are still underperforming while tradable goods show steady progress. Overall, aggregate GDP is already above the 1994 peak.
In response, consumption is slowly accelerating. Analysts believe two consecutive months of year-on-year retail sales growth are an indication of this. Second-quarter data show 11.7% growth in commerce and an 11.2% jump in transport and communications. New sales growth at Elektra, the retailer which serves the low-income sector, is indicative of a nascent recovery in domestic consumption. Supermarket chain Cifra showed its first real sales increase since 1995. Overall, department store sales grew 8% in May. Meanwhile, investment spending increased 18% in the second quarter and is expected to continue growing next year.
The financial sector is also reaping the benefits of economic growth and lower interest rates. Credit activities have started to recover in the peso-denominated commercial area, notes Jose Garcia Cantera, Salomon Brothers’ Latin banking analyst. However, growth in other areas, such as consumer and mortgage loans, is stagnant.
Past-due mortgage portfolios still comprise the overall risk in the banking sector. In response, the government has announced various tax schemes to help the banks create new programmes. The government’s first debt-support programme for mortgage holders was not a great success. As many as 20% of the debtors did not choose to convert their mortgages into the inflation-indexed UDI unit, which postpones the large principal payments. As a result, although the government originally assumed the cost of the UDIs, it later also assumed the cost of the unused UDIs.
The new aid programme for mortgage debtors recently created by the largest private bank, Banco Nacional de Mexico (Banamex), could become the prototype for the entire system. Banamex offers mortgage holders who are current repayers a 20% discount and those who have made consecutive payments for the past year another 5%. Although the bank will lose significant interest payments, the programme will be worth the effort if it prevents further erosion in the portfolio and thereby cuts provisioning.
Overall, Garcia Cantera does not expect a recovery in the mortgage market until two or three years down the road. “In the meantime, without loan growth and greater competition, the banks face weak profitability,” he warns.
When the banks eventually resume lending at full strength, investors can expect much stricter supervision from the CNBV, although the Fobaproa savings guarantee net is shrinking. The banking commission plans to limit Fobaproa’s guarantees starting in 1998 on “sophisticated” debt, although smaller, riskier debt, such as subordinated notes, will still fall under its protective wing, says the CNBV’s Fernandez. As it reduces its paternalistic role, the commission expects the market to increase its regulatory role in the banking system with regular ratings.
In general, Mexico’s markets flourished in the first six months of this year. The peso was strong, the stock exchange rose 45% and interest rates dropped by six percentage points. Given Mexico’s positive growth outlook for the next two years, such progress could continue, although the shadow of US treasury rate increases still hangs over Mexico’s markets. A US rate hike notwithstanding, analysts predict interest rates for the benchmark 28-day Cetes could fall as low as 17% by the end of the third quarter.
The peso is expected to hit turbulence towards the end of the year given a variety of fundamental and political factors including signs of a trade deficit and the national budget debate. Meanwhile, Mexico’s principal stock indicator, the IPC index, should continue its upward swing, hitting 4,900 by the year-end.
“The economics for the region as a whole are as good as they’ve been since the 1970s. In general, Latin America is an under-owned region,” says Robert Pelosky, Latin American strategist at Morgan Stanley Dean Witter. “We believe Mexico will be leading the market in the second half of the year.”
In the first half of this year, investors held back on Mexico because of concerns about the federal elections in July, says Pelosky. “Now investors’ attention will shift back to the fundamentals.” He believes interest rates will decline and the peso will remain relatively stable for the remainder of the year. “Stock prices will do quite well in that environment and will bring in local investors who were previously on the sidelines as well as non-dedicated investors who have figured out a risk-reward basis,” he says. Currently Mexican stocks trade at 15.1 times the generally forecast 1998 earnings.
Given the postponements and the renewed investor interest, new issues will line up for the second half of the year and into next year. “The IPO market will be hot. Any new company which has a reasonably good story has a good chance,” says Isauro Alfaro, head of Mexican corporate finance at Salomon Brothers. “Investors are looking for a decent uptick in earnings.”
The biggest equity news out of Mexico so far this year is a mixed primary/secondary offer for $605.1 million from media company TV Azteca. Bear Stearns was the global coordinator with Salomon Brothers and Allen & Co, and SBC World Group as co-arrangers. Co-leaders were Bear Stearns and Merrill Lynch with Serfin handling the brokerage and Inbursa on the local tranches. Azteca is considered a good buy compared with the mighty Televisa conglomerate, given its streamlined management. The company has won a good chunk of Televisa’s traditional advertising base. Later this month, Cintra, the holding company for the Mexicana and Aeromexico airlines, is issuing some $300 million.
Fixed-income activity is expected to pick up as well, although less dramatically. Overall, it is still cheaper for companies to organize bank loans than to head for the capital markets. At current spreads, top-level corporations are borrowing at rates well below the crisis, even though there is still room for more compression in the bond market. Many analysts believe these differentials are not sustainable over time.
Among the upcoming corporate refinancings, the market can expect reappearances from tobacco conglomerate Empresas La Moderna, conglomerate Desc, construction company ICA, corn-meal producer Gruma, supermarket chain Comercial Mexicana, and the Bancomer and Mexicana financial groups.
In a regional comparison, Mexican debt fares well. Brazil, for instance, still has large imbalances, with a large public debt and a current account deficit that is slowing down the economy. And Mexico’s corporate debt offers more choice to investors compared with the smaller Argentine universe. “We’re seeing more sacrificing of credit quality in Argentina than we are in Mexico,” says Jim Garvey, corporate bond analyst at Santander Investment.
Bigger playing field
“There’s a definite corporate yield curve which was established before the peso crisis,” says Matthew Peck, head of emerging market corporate debt research at Salomon Brothers. Companies such as TMM, Cemex and Televisa helped establish a curve that was more diverse at the time than those in Brazil and Argentina, he adds. “Post-devaluation there is a much bigger playing field than we’ve ever had.” New players, such as Azteca and tourism group Coparmex, helped create a wider universe.
Up to now, bond issuance has all been condensed within 10 years. However, following the UMS lead, the corporate yield curve should start to stretch out to longer maturities, says Peck. However, the ever-widening corporate universe makes accurate risk evaluation more imperative than ever. US rating agency Standard & Poor’s threw a spanner in the system when it decided to rate some Argentine corporate debt above the sovereign ceiling.
“Given the sovereign-ceiling polices of the major rating agencies, current ratings may not be an accurate reflection of credit quality among corporate issuers,” notes Garvey, adding that S&P’s alteration of its sovereign debt ceiling to allow for higher ratings among private corporates than the government only heightened confusion. Such moves, as well as the increasing number of companies which issue, are forcing the market to develop more precise methods properly to compare the credits.
As a whole, Mexico is edging closer to investment-grade criteria, although some risks still linger. On the economic side, the trade surplus will transform into a deficit by the second half of the year. Although the mere idea of a Mexican trade deficit might make some investors who remember the tequila crisis rather nervous, most observers are not worried at the moment.
Indeed a trade deficit should help correct a peso which has appreciated almost 30% since 1995. While some analysts have suggested that Mexico is ready to move back to a floating-peg regime, Pronafide established the current floating one for at least the next three years. As some sectors argue that a 5% to 10% depreciation would increase their competitiveness, the finance ministry pleads that it can do nothing. Although finance officials always cry innocence, in reality there are some options. Both finance ministry and central bank officials decide the peso’s fate on a Foreign Exchange Commission that could press for lower interest rates later this year.
“At this stage of the game, it is probably a waste of time to worry about the overvaluation of that pesky Mexican peso,” notes Morgan Stanley’s Brown, adding that the central bank is likely to continue selling deposits and repos to sterilize the inflow of reserves.
On the political side, the upcoming presidential elections are the highest risk. The federal elections held in July resulted in the opposition gaining control of the House of Deputies as well as winning the mayoral election in Mexico City. It appears the ruling Institutional Revolutionary Party (PRI), which has governed Mexico single-handedly for almost 70 years, might have some competition in the 2000 elections. “The PRI was the devil you knew, the next time we could see a president of any political stripe,” says Santander’s Segal.
The elections of 11 state governors next year will give some indication of the likely direction of the presidential elections. The management of relations with the new congress will also provide insights into Mexico’s future. Although the PRI lost its majority in the House, it lacks only nine votes. The question is how crucial these turn out to be in various votes, particularly during the national budget debate.
“The 1998 budget will be the first real test,” says Salomon’s Alfaro. “Mexican officials have said that the electoral reform was the biggest negotiation problem, so if they could do that, they can handle a budget,” he adds.
Opposition offensive
In August the four opposition parties made their first advance when they put aside differences to form a voting bloc to elect the speaker of Mexico’s House of Deputies and to control the influential rules committee. These parties are pushing the government to decrease value-added tax, currently levied at 15%. A modest VAT reduction would not be too detrimental to revenues – because of economic recovery the VAT take increased 13% in real terms in the second quarter.
Other key issues include the government’s investigation of the 1994 assassination of PRI presidential contender Luis Donaldo Colosio and the president’s discretionary funds.
Despite some peso volatility, however, analysts are not worried that the congressional budget battle will drastically affect economic policy or radically increase the budget deficit, which is estimated at around 1.4% of GDP.
The influence of drug money in politics could be another source of volatility in the longer term, adds Segal. Given this year’s drug-related scandals, some analysts worry that political anxiety in the US Congress about Mexico’s increasing reputation as a major drug player could transform certification into an uphill battle next year.
Certification is a tool of the US government to punish drug-trafficking countries and reward their endeavours to curb the trade. When Colombia was decertified after a year of political upheaval about the ties between drugs and the country’s power structure, fears of a loss of US funding and restrictions on trade paralyzed economic growth and investment, believes Segal.
If news of how drug dealing reaches the upper echelons of the Mexican government or contributes to political campaigns continues to proliferate, congressional pressure to decertify the country could translate into serious market volatility as well. “Most investors will recall what happened at the last decertification” in Latin America, warns Santander’s Segal.
