Since the onset of the credit crisis several events have highlighted just how little a rating reflects market reality. Brazil’s and Mexico’s credit default swap spreads are a case in point. Since January, Mexico’s five-year CDS have been trading wider than Brazil’s, even though Mexico is rated BBB+ by Standard & Poor’s, two notches higher than Brazil’s BBB–.
In normal times, Mexico’s fundamentals stand out from Brazil’s. Mexico has a higher GDP per capita ($14,200 compared with $10,100), a more open economy (55% compared with 24% exports plus imports as a proportion of GDP) and lower public-sector indebtedness. Mexico has better trade policies, more developed institutions, higher savings rates and lower interest rates. These factors help support S&P’s position and explain why Brazil’s five-year CDS spreads traded at more than double Mexico’s two years ago.
But in late 2008 the FX derivatives crisis hit Mexican companies, nearly taking out jewels such as Vitro and Comerci. Cemex has hit the rocks too as its over-ambitious acquisition programme in 2006 and 2007 caught up with it. In March, the Mexican peso fell to historically low levels against the dollar as capital inflows fell and interest rates were slashed. By April 17, Mexico’s five-year CDS traded at 285 basis points while Brazil’s stood at 270bp. On April 20, a 75bp cut in interest rates by Banixco left Mexico trading at 305bp, whereas Brazil’s spreads were at 290bp.
Is it really a fair judgement that Mexico is more likely to default than Brazil? The US crisis is expected to have an adverse impact on Mexican exports. However, in the fourth quarter of 2008 Mexican growth slowed by 2.7% whereas in Brazil it was down by 3.6%. In addition, even though Mexico has more trade links with its troubled northern neighbour, Brazil has a greater financial exposure to the US.
The bank credit to GDP ratio is 38% in Brazil compared with Mexico’s 12%. In Brazil, the five-year cumulative real credit growth rate is 66% compared with Mexico’s 17%. Again Brazil looks weaker.
Another issue is the balance of payments – external debt to exports in Mexico is 53%. In Brazil the reported figure is 86%. Brazil has a more closed economy than Mexico, which in turn will render it less able to generate foreign currency to pay its debts even though it has less debt than Mexico.
So what is driving Mexico’s CDS spreads wider? The short answer is oil. Oil accounts for nearly 40% of Mexico’s revenues but with a barrel of Brent crude trading at $49 and global demand showing few signs of picking up, the country faces testing times ahead.
The next biggest concern is external private sector debt. This year, maturing foreign debt obligations include $27.7 billion from the non-financial sector and $7.7 billion from the financial sector.
Included in the non-financial debt is $10 billion for trade finance. This has been fully accounted for since the $30 billion US Federal Reserve swap line was put in place to support any trade-financing difficulties. On April 22 Mexico accessed $3 billion of the swap line.
Although this Fed line runs out in October, it will be renewed. Of the remaining $17.7 billion, $6 billion has already been rolled over.
Clearly Mexico has long-term structural issues to resolve. Still, the price for protecting against a Mexican sovereign default is more onerous than it deserves to be.
