Commentary: Mexico Isn't Investment Grade Yet

The economy has improved, but there is still potential for political upheaval

The news caught many by surprise: On Feb. 2, Moody's Investors Service announced that it was contemplating granting Mexico investment-grade status (Baa1) for its foreign currency debt. The move has sparked a debate among Mexico watchers over whether the country is really ready to join the select group of investment-grade nations. In Latin America, only Chile is now a member of that club.

Is Moody's rushing to judgment? It seems so. The upgrade could come as early as April, just months before the presidential election in July, which promises to be the most open and hotly contested in history. The rub is that in Mexico, every presidential transition for the past quarter century has been accompanied by a steep devaluation and economic collapse.

PESO PROBLEM. Although chances are good that the country can avoid an economic crisis this election year, it's by no means certain. And while the economy is in fine shape, it's still vulnerable. The peso is a touch too strong. And there is still potential for political upheaval, such as an assassination or a guerrilla uprising--events that helped precipitate the peso crash of 1994.

All these reasons support the decision by other rating agencies to wait. Duff & Phelps Credit Rating Co., which rates Mexico one notch below investment grade, has indicated that it will hold off until after the elections and maybe until next year before considering an upgrade. So has Standard & Poor's Corp., which rates Mexico two notches below investment grade. S&P, like BUSINESS WEEK, is part of The McGraw-Hill Companies. Moody's, for its part, denies that it is jumping the gun. "We have never said that nothing will happen," says Luis Ernesto Martinez-Alas, vice-president and senior credit officer of Moody's sovereign risk unit. "We're saying that even if something happens, the risk that the Mexican government will default on its bonds is less than it was before." Martinez-Alas is also confident the elections will not significantly alter the course of economic policy in Mexico. "We believe reforms will go forward," he says.

True, Mexico has come a long way since the Dec. 1994 devaluation. After shrinking 6.2% in 1995, the economy has averaged annual growth of 5.1%. The current-account deficit was a manageable 2.8% of gross domestic product at the end of 1999. And with oil prices at $30 per barrel, the government is sure to meet this year's budget deficit target of 1.25% of gross domestic product.

But Mexico is not completely in the clear. Its economy is still far too dependent on the U.S., which takes in 85% of its exports. So a slowdown north of the border would hit Mexico hard. The country is also vulnerable to fluctuations in the price of oil, which provides more than 30% of all tax revenue.

An even bigger Achilles' heel is the banking sector. Despite a $100 billion government rescue, Mexican banks are still not lending. That will dampen economic growth for years to come. What's more, the government has not yet put the cost of the bailout on its books. If it did, S&P estimates that Mexico's fiscal deficit would be closer to 3.5% of GDP.

Last but not least, there is the peso. Allowed to float freely since 1995, it appreciated by some 14% against the dollar last year. Mauricio Gonzalez, an economist at Grupo de Economistas y Asociados, a Mexico City consultancy, fears that a Moody's upgrade could draw billions of dollars into Mexico from U.S. insurance companies and pension funds that are allowed to hold only investment-grade paper. These inflows could strengthen the peso further, setting the stage for an abrupt correction in the event of a political or economic shock.

Moody's move has raised the question of whether Mexico is ready for prime time. The overwhelming conclusion among veteran Mexico-watchers is that it's not. "We still have a lot to prove as a country before we merit an investment-grade rating," says Jonathan Heath, a Mexican economist with LatinSource, a network of independent analysts in Latin America. It's one thing to recognize the great strides Mexico has made in the five years since the devaluation. It's quite another to tell American retirees that their money is completely safe in Mexico.

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