Nov. 2 (Bloomberg) -- Mexico’s peso fell in New York as Fitch Ratings said the tax increases approved by congress are a “less optimal solution,” adding to concern the country will be downgraded for the first time since 1995.

The currency declined 0.1 percent to 13.2156 per U.S. dollar at 5 p.m. New York time, erasing a gain of as much as 1 percent. The peso has advanced 3.5 percent this year, the second-worst performer after Argentina’s peso among the major Latin American currencies.

Mexico’s opposition-controlled congress this weekend approved a permanent 1 percentage-point increase in the sales tax to 16 percent after rejecting President Felipe Calderon’s proposal for 2 percent consumption tax that would have generated more than double the revenue. Calderon is seeking to bolster tax revenue to offset a decline in oil production, which funds 38 percent of the budget.

The sales tax increase is a “less optimal solution” to rein in the deficit than the government’s proposal to create a consumption tax, Shelly Shetty, an analyst with Fitch Ratings, said today.

“The placement of that measure by increasing just the rate by one percentage point is a less optimal solution, however it does help in bringing in additional revenues,” Shetty said.

Fitch is waiting to see the spending side of the 2010 budget that congress approves before making a decision on the rating, Shetty said in a telephone interview from New York.

Both Standard & Poor’s and Fitch Ratings have Mexico’s BBB+ rating, the third-lowest investment grade rating, on outlook negative on concern the fastest drop in oil output since World War II will swell the budget gap.

Fitch’s comments about the 1 percent sales-tax increase were “not very positive,” RBC Capital Markets analysts led by Nick Chamie wrote in a note.

“Challenging”

Lisa Schineller, a Standard & Poor’s analyst, said the ratings agency is also waiting to see the final budget before deciding whether to cut the rating.

The difficulties lawmakers had on agreeing on tax increases shows that “the topic is quite challenging,” Schineller said.

Legislators approved some of Calderon’s measures, such as raising the income tax, increasing the duty on cash deposits and creating a telecommunications tax in the income portion of the 2010 budget that was approved this weekend.

They also raised the forecast for next year’s average oil price to $59 a barrel from $53.90 a barrel in the original bill, boosting projected revenue. Lawmakers have until Nov. 15 to vote on the spending side of the budget.

‘Second-Best Solution’

“It’s definitely a second-best solution,” said Edwin Gutierrez, who manages about $5 billion of emerging-market assets at Aberdeen Asset Management in London. “It does little to reduce Mexico’s structural dependence on oil for its revenue, which is what the ratings agencies wanted to see.”

While the tax increases reduce the chance of a downgrade, Gutierrez said he “wouldn’t be surprised if Fitch and/or S&P still pulls the trigger.”

The peso plunged 20 percent in 2008 and sank to a record 15.5892 against the dollar amid the global credit crisis in March, prompting Calderon to turn to the International Monetary Fund for a $47 billion credit line.

‘Positive News’

The income portion of the budget approved by congress has an estimated deficit excluding investment by state-owned oil company Petroleos Mexicanos, known as Pemex, of 0.75 percent of gross domestic product, up from 0.5 percent in the government’ original bill. The government’s proposed 2010 budget had projected a 2010 deficit, including Pemex investment, of 2.5 percent of GDP, up from 2.1 percent this year.

“Mexico is immersed in a very, very difficult economic situation,” said Alberto Bernal, head of emerging markets research at Bulltick Securities Corp. in Miami. “The fact that we got something, just on a pragmatic standpoint, it’s positive news.”

RBS Securities Inc. estimates the budget gap will equal about 2.8 percent of gross domestic product this year, the widest since 1989.

Credit-default swaps, contracts investors use to protect against non-payment of debt, show Mexico trading as high-yield, or junk -- placing it three levels below the nation’s BBB+ grade from Standard & Poor’s and Fitch Ratings -- on concern the tax increases will fail to stave off downgrades.

The cost of protecting Mexican debt against default for five years is 1.64 percentage points, according to data compiled by CMA Datavision. By comparison, it costs 1.66 points to protect securities issued by Colombia and 1.55 points to protect bonds sold by Panama, countries that S&P rates three levels below Mexico at BB+.

Mexican Bonds

A basis point equals $1,000 on a swap protecting $10 million of debt against default. Credit-default swaps, conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Mexico’s dollar bonds lost 2 percent last month, their biggest monthly decline since a 4.4 percent tumble in January, on speculation the government will fail to avoid a downgrade, according to JPMorgan Chase & Co.’s benchmark emerging-market index, known as EMBI+. The drop compares with a 0.5 percent slide for emerging-market debt overall.

The extra yield investors demand to own Mexican bonds instead of U.S. Treasuries has narrowed 1.85 percentage points to 1.91 points this year -- less than the average 3.69-point drop in the spread on emerging-market bonds, according to JPMorgan.

Mexico’s $1.09 trillion economy, the second-biggest in Latin America, shrank 10.3 percent in the second quarter and will contract as much as 7.5 percent this year as the U.S. recession erodes demand for the country’s exports, according to the central bank.

The peso isn’t trading today in Mexico, where financial markets are closed for the All Souls Day holiday.

To contact the reporter on this story: Catarina Saraiva in New York at asaraiva5@bloomberg.net

Last Updated: November 2, 2009 18:06 EST