May 12 (Bloomberg) -- Mexico’s credit rating may be cut as soon as the third quarter as the global recession exposes the government’s failure to raise taxes and ease its dependence on oil income, according to Credit Suisse Group AG and UBS AG.

“Mexico was very complacent over the past decade,” Alonso Cervera, a Latin America economist at Credit Suisse, said in an interview from New York. The country “didn’t really move in a meaningful way to accomplish the reforms that it needed,” he said.

Standard & Poor’s lowered Mexico’s rating outlook yesterday to negative from stable, signaling it’s considering the first reduction since the aftermath of the 1994 peso devaluation. New York-based S&P rates Mexico BBB+, the second-highest grade among major Latin American countries after Chile. Fitch Ratings, which also assigned the government’s debt BBB+, or three levels above junk, gave the country a negative outlook in November.

Nine years after the North American Free Trade Agreement buoyed growth and propelled the country to its first investment- grade rating, the Mexican economy is in a recession that has highlighted the government’s inability to cover up its fiscal “vulnerability,” Cervera said.

State-owned oil monopoly Petroleos Mexicanos contributed 37 percent of government revenue last year. The 60 percent plunge in oil prices from a July record helped swell Mexico’s budget deficit to 149 billion pesos ($11.3 billion) in the 12 months through March. The government had a 3.3 billion peso surplus in the previous 12 months, according to the Finance Ministry.

Swine Flu

The economy will contract 4.1 percent this year, Finance Minister Agustin Carstens said last week. The deadly outbreak of swine flu in Mexico last month exacerbated the slump as the government ordered businesses and schools shut to prevent the disease from spreading and tourists canceled trips.

While President Felipe Calderon won approval in 2007 for legislation to close corporate tax loopholes, he and his predecessor Vicente Fox were unable to gather support for broader tax increases on items such as food and medicine.

Mexico’s tax revenue equaled 20.5 percent of gross domestic product in 2007, the lowest among the members of the Organization for Economic Cooperation and Development, an October study from the OECD showed. The country’s income tax revenue equaled 5.7 percent of GDP, the second-lowest among OECD members. Only Turkey’s income tax revenue was lower.

‘Aware of the Problems’

“There has been budgetary dependence on oil for quite some time,” Lisa Schineller, an analyst at S&P in New York, said in an interview. “The vulnerabilities that are in Mexico’s fiscal account are being heightened under the current context.”

Rodrigo Brand, the Finance Ministry’s spokesman, said the government’s position “coincides with S&P.”

“We must work to strengthen the fiscal position in 2010,” Brand said. “We will do so when we present the economic package for next year.”

Cervera said he expects more than one company will lower Mexico’s credit rating “over the next few quarters.” Moody’s Investors Service rates Mexico Baa1, also the third-lowest investment-grade rating. Mauro Leos, an analyst at Moody’s, said at an event yesterday in New York that the ratings company is “aware of the problems but at the same time we think there are other factors that compensate for them.”

Riskier Than Brazil

Mexico is already trading in the credit-default swaps market like a riskier credit than Brazil, a country rated two levels lower by S&P and three levels lower by Moody’s.

Five-year credit-default swaps tied to Mexico’s bonds trade at 2.56 percentage points, according to data compiled by Bloomberg. That means it costs $256,000 a year to protect $10 million of Mexican debt from default for five years. It costs $227,000 to protect Brazilian debt.

Credit-default swaps, which are used to hedge against losses or to speculate on a country’s ability to repay its debt, pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent.

Gabriel Casillas, an economist at UBS in Mexico City, said the first downgrade may happen in the third quarter.

“Mexico’s government is now going to have to face reality,” Casillas said. Fox “wasn’t up to the task as president,” he said. Calderon has made more of an effort to implement reform, “but the circumstances haven’t helped him,” Casillas said.

PRI’s Advance

The economy shrank 1.6 percent in the fourth quarter and likely contracted 7 percent in the first quarter, according to the Finance Ministry. The recession is eroding opposition parties’ willingness to support unpopular tax increases, Casillas said.

The Institutional Revolutionary Party, or PRI, the country’s second-biggest opposition party, is poised to take the highest number of seats in mid-term congressional elections in July, making it tougher for Calderon to pass legislation, according to a poll by El Universal newspaper published yesterday.

The PRI has the backing of 33 percent of voters for the elections to replace all members of the lower house. Calderon’s National Action Party, or PAN, has 27 percent backing, while the Party of the Democratic Revolution, or PRD, the biggest opposition party, is poised to take 10 percent of the vote, the poll showed.

The PAN currently holds 41 percent of the seats in the lower house, the PRD holds 25 percent and the PRI holds 21 percent. The El Universal poll surveyed 1,157 people between May 1 and May 5, and has a margin of error of 3.4 percentage points.

S&P highlighted concern about the mid-term elections in its statement yesterday.

“It’s the limited room for maneuver that is a key component of the negative outlook,” Schineller said.

To contact the reporters on this story: Valerie Rota in Mexico City at vrota1@bloomberg.net; Carlos Manuel Rodriguez at carlosmr@bloomberg.net

Last Updated: May 12, 2009 16:32 EDT