By Jack Deino
As a longtime investor and former resident of Mexico, I cannot recall any time when expectations have been so high. President Enrique Peña Nieto has leveraged his newfound political capital and ability as a political kingmaker to approve seven structural reforms in a little more than one year. As a result, investors have flocked into Mexican assets - from equities to local currency government bonds to real estate. While much of this enthusiasm may be justified longer term, we believe that short-term expectations are quite lofty and that reforms may take a while to materially impact Mexico's economy.
During a recent trip to Mexico, we met with multiple companies and government officials. We remain constructive on Mexican assets - we believe the aggressive reform agenda has the ingredients to make Mexico a compelling destination for both portfolio and direct investment in a sustained environment of reduced global liquidity and increased competition for every marginal cent. However, we also see risks to these investments that, from our perspective, require consistent monitoring.
Fiscal reform: The right medicine at the right time … almost?
We believe fiscal reform is an obvious necessity to de-bottleneck growth. In recent years, tax revenues have accounted for less than 20% of Mexico's gross domestic product (GDP) versus an average of about 34% for all countries in the Organization of Economic Cooperation and Development. Reform would shift the increasing burden from those few Mexicans paying taxes to the country's sizeable informal economy, which comprises about 60% of GDP. Nonetheless, politicians' bias toward "playing it safe" before negotiating monumental energy reforms resulted in a watered-down version that makes little headway.
An originally proposed expansion in value added taxes would have cast a much wider fiscal net by expanding VAT to food and medicines. However, that proposal has been diluted by a bill that focuses on increasing taxes mostly on Mexican corporations of all sizes as well as the middle class, who are already disproportionately and heavily taxed. According to Mexico's National Alliance for Small Businesses, small mom-and-pop businesses that form the backbone of the Mexican economy have experienced a year-on-year fall in sales of around 15%, depending on location, mainly attributable to the impact of reforms. Given this, many companies have held off on investments in hopes that major revisions (which President Peña Nieto is trying to avoid) may come soon.
Energy reform: A short-term fix?
The Mexican oil industry is operated by state-owned Petróleos Mexicanos (Pemex). In 2013, President Peña Nieto proposed reforms that would offer private companies profit-sharing contracts. However, there are several risks. The most immediate is if the privatization legislation were to be delayed further or be structured in a way that makes it unappealing for foreign companies to invest. The current expectation is that the legislation will be done by the end of June 2014 and that it will largely be conducive to foreign investment; however, nothing is finalized yet.
The other near-term risk, and perhaps a more likely concern, is if Pemex were to keep the vast majority of the quality assets, leaving a relatively poor set of assets for bid by the private sector. Also, will the actual bidding process for assets be transparent and fair? Given the track record of Pemex and the Mexican government, this is far from certain. Finally, as we look out over the next few years, Pemex will face strong competition from foreign entrants for its best employees who are familiar with the geology and operating environment in Mexico. It is uncertain as to whether Pemex can provide the necessary incentives to retain its top talent. Nevertheless, Pemex is systematically important to the Mexican economy, from an employment basis to a tax-revenue generating basis, with worldwide name recognition, and therefore will remain well-supported in the market.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy resources. Short-term fluctuations in energy prices may cause price fluctuations.
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