Credit FAQ:

How Mexicos Proposed Tax And Energy Sector Reforms Could Affect The Sovereign Ratings
Primary Credit Analyst: Lisa M Schineller, PhD, New York (1) 212-438-7352; lisa.schineller@standardandpoors.com Secondary Contacts: Sebastian Briozzo, Buenos Aires (54) 114-891-2120; sebastian.briozzo@standardandpoors.com Roberto H Sifon-arevalo, New York (1) 212-438-7358; roberto.sifon-arevalo@standardandpoors.com

Table Of Contents
Frequently Asked Questions

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Credit FAQ:

How Mexicos Proposed Tax And Energy Sector Reforms Could Affect The Sovereign Ratings
On Oct. 10, 2013, Standard & Poor's Ratings Services affirmed its 'BBB' foreign currency and 'A-' local currency long-term sovereign credit ratings on Mexico and kept a positive outlook on the ratings. We've received questions regarding Mexico's low economic growth and the Pea Nieto Administration's proposed tax and energy sector reforms. Here, we address those questions and the potential impact on our ratings.

Frequently Asked Questions

Why has Mexico's growth been so low this year and how does that affect the ratings?
We've revised our forecast for Mexico several times this year and now expect real GDP growth of only 1.5% in 2013, down from our initial expectations of 3.5% at the beginning of the year. In our opinion, lower demand from the U.S. for Mexican exports, among other factors, accounts for the slower economic growth. The lower projection also reflects a drop in government expenditure in the first and second quarters, as the new Administration was slow to execute spending after coming to office. In addition, the government changed its policy on residential construction, which hurt activity in that sector. Mexico's economy could also suffer this year as a result of the recent storms and potential ramifications of the U.S. government shutdown. However, we expect the country's growth to pick up in 2014 to 3.2%, as the U.S. economy improves and assuming the Mexican government makes progress on comprehensive structural reforms to boost investment. From a ratings perspective, it's not one quarter or one year of growth that matters, but the broader, medium-term trajectory. At about US$10,500 in 2012, Mexico's level of per capita GDP puts it in line with many of its 'BBB' rated peers. Mexico's real GDP per capita growth over the past decade, at an average of 1.4%, is on the lower side for emerging markets and many, but not all, of its peers. This track record, absent the effects of substantive reform, does not suggest a rapid improvement in the country's standards of living vis--vis its peers.

How does Standard & Poor's view Mexico's recent tax reform proposal?
The recent tax reform proposal addresses one of the key constraints on the ratings: a low non-oil tax base that limits fiscal flexibility. The legislation aims to raise tax revenues by 1.4% of GDP in 2014 and by 2.9% by 2018. The proposal overhauls the corporate tax regime through the elimination of various loopholes (exemptions and special regimes). But, at the same time, the removal of IETU (an alternative minimum tax) almost entirely offsets the gain in revenues. The proposal raises the value-added tax (VAT) for some goods and services, such as education and those sold at the border, although taxing food and medicine, a politically controversial concept that may have generated more revenue, was not included. A key component is the phasing out of the gasoline subsidy and introduction of a carbon tax. The government expects these two measures combined to generate more than half of the new revenue through 2018. The proposal also plans to facilitate higher taxation by local governments on property taxes, though revenue gains from this measure don't appear to be included in the government projections.

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Credit FAQ: How Mexicos Proposed Tax And Energy Sector Reforms Could Affect The Sovereign Ratings

In our view, the actual increase in tax revenue is likely to be somewhat less than the official estimates. Many of Mexico's previous tax reforms failed to generate the anticipated revenue increases, given the problems with tax collection. We also expect some watering down of the proposal during congressional negotiations. What Congress ultimately approves will provide a firmer basis for revenue projections.

What are other key components of the fiscal reform package?

In addition to its low non-oil tax base, Mexico's budgetary dependence on oil revenues (one-third of total revenues), without an effective stabilization fund, also greatly limits the government's ability to smooth its fiscal accounts through economic and commodity cycles. To that end, the proposed reform endeavors to strengthen the fiscal framework by revamping the stabilization funds (which currently total only 0.3% of GDP) and establishing a sovereign wealth fund that considers longer-term savings objectives. The proposal includes a "structural" budget rule. By establishing expenditure caps, the rule would promote additional savings during an economic upswing. If passed and implemented effectively, this reform could be an important step in reducing revenue volatility; the exact rules would be set via secondary legislation, probably next year. In addition, the government is introducing more transparency into the deficit targets by considering the public-sector borrowing requirement, a broader measure than the "traditional" narrower budget target. This would represent a more realistic budgetary assessment because while Mexico's fiscal responsibility law targets a balanced budget, when evaluated as a whole, the full public sector runs a deficit.

How important is energy reform?

We think it's very important. Mexico's oil production has declined by about 25% over the past decade because state-owned oil company Petroleos Mexicanos (Pemex) lacks technical expertise and the financial capability to broadly develop the country's vast oil resources. Although key for the government's budget, oil accounts for a small portion of GDP, at about 5%. However, tapping into Mexico's vast oil potential could energize investment and growth throughout the economy. Oil sector reform that adds dynamism to the economy and buoyancy to the fiscal accounts would also be a positive for the ratings. The government's proposed energy reform aims to achieve those goals by raising oil production by 1 million barrels a day (mb/d) over the next 10 years from current levels of 2.5 mb/d. To do so, it lifts restrictions precluding private, including foreign, investment by amending two key articles of the Mexican constitution. If passed, this change is likely to attract significant investment. The executive's proposal, which envisions profit sharing agreements, is less ambitious than PAN's (National Action Party) proposal for greater participation of the private sector via concessions, but more ambitious than the PRD's (Party of the Democratic Revolution). Further negotiations in Congress will ensue before all parties vote on any constitutional amendment (requires approval by two-thirds of both houses, followed by two-thirds of the states' legislatures). The opening up of the oil sector with changes to the constitution, if approved, could entice large-scale private investment. However, few oil companies are likely to act until the adoption of subsequent so-called secondary or enabling legislation that would follow passage of the amendment, according to industry experts. In addition, the reform aims to strengthen corporate governance at Pemex while maintaining 100% government ownership of the company. It also opens up private investment in the electricity sector, though preserving Comision Federal De Electricidad's (CFE) monopoly on distribution and transmission.

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Credit FAQ: How Mexicos Proposed Tax And Energy Sector Reforms Could Affect The Sovereign Ratings

How do the fiscal and energy reform proposals affect the ratings on Mexico?
As we stated on March 12, 2013, when we revised the outlook on the long-term sovereign credit ratings to positive from stable, the revision reflected our opinion that there was a greater than one-in-three chance that the government would first, put forward a combination of meaningful fiscal and energy reform and, second, be able to garner passage given its high degree of political capital. In our view, it's a combination of fiscal and energy reform that can bolster the economy and fiscal accounts. Passage of these reforms could mitigate some of the key constraints on the ratings: lackluster growth and limited fiscal room for maneuver. We could raise the ratings based on our evaluation of how much the reforms reduce the public finances' vulnerability to sharp drops in oil revenues and enhance the country's long-term growth prospects. Alternatively, we could revise the outlook to stable if the government fails to obtain approval for its policy proposals, or if the reforms are insufficient, in our view, to materially strengthen public finances and contribute to greater economic resilience.

Aren't the other reforms important to the ratings besides fiscal and energy?
The government has an extensive reform agenda with the goal of improving Mexico's trend rate of growth. At the end of the Caldern Administration, the PRI worked with PAN to pass labor reform. Since coming to office and formulating the Pacto for Mexico, the Pea Nieto Administration has passed legislation aimed at reforming education and the telecommunications industry. In addition to the proposals for fiscal and energy reform described above, the executive is in the process of negotiating reforms of the financial sector and of fiscal rules for the states. If approved, along with supportive secondary legislation and appropriate implementation, this aggressive legislative package should play a role in supporting growth. The government estimates that taken together, its reforms will push trend growth above 5% of GDP, which we believe could be optimistic. While there is no doubt that the totality of these reforms would boost Mexico's growth rate, we believe that the fiscal and energy reforms are particularly important. The impact of each of the reforms on actual growth is subject to uncertainty and likely to occur gradually. However, energy reform has the most scope to be transformative. It can uniquely reshape and buoy private-sector expectations and animal spirits. Opening up the oil sector creates the greatest opportunity to attract new investment and to lower costs across the economy. Its success should also play an important role in increasing the dynamism of Mexico's fiscal accounts through greater overall oil and non-oil revenues. Fiscal flexibility could be enhanced, especially if oil revenues are more effectively saved. Hence, while all the reforms are important, the fiscal and energy measures have the potential to mitigate some of the more binding constraints on the ratings on Mexico.

What about the countercyclical and social security spending components of the 2014 budget and the growing deficit?
We'll consider the larger deficit and higher permanent social spending in the context of the outcomes of the proposed fiscal and energy reforms since they will determine medium-term growth trends and buoyancy in government revenues. Given the weak performance of the Mexican economy and the wider negative output gap, the government proposes to run a larger fiscal deficit for several years to be phased out no later than 2017. While the deficit in 2014 is now expected to be higher than we initially anticipated, it looks to be lower this year than expected given the slow execution on spending. The government also proposes to establish a universal pension for Mexicans aged 65 and older, making permanent the current government program started by former President Caldern and expanded by

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Credit FAQ: How Mexicos Proposed Tax And Energy Sector Reforms Could Affect The Sovereign Ratings

President Pea Nieto. The government estimates this program at an annual cost of 0.7% of GDP, which could be an underestimation.

When does the government plan to pass its fiscal and energy reforms?
The government aims to pass the core of both its fiscal and energy reforms this year. The fiscal reform is incorporated in the 2014 budget proposal, and as such, has set dates for passage. The entire budget (the separate revenue and expenditure laws) must be passed by Nov. 15. However, there are no set dates for voting on the energy reform, though the government will work to pass the reform by the end of 2013. Any slippage on this timetable will likely generate a negative reaction in the financial markets. Market participants have high expectations for the government's reform agenda and view energy reform as the crown jewel of the Pea Nieto Administration. Slippage would raise questions about the government's commitment to reform following market disappointment about the content of fiscal reform (since it did not raise the VAT on food and medicine and increased the budget deficit). A delay would also signal an inability to negotiate the most politically challenging and high-profile legislation within PRI and across party lines (with PAN and PRD). A reduction of the president's political capital with five years remaining in his term would raise questions about his ability to move forward with the passage and effective implementation of secondary legislation for both fiscal and energy reforms, both of which are likely to be presented in 2014.

When does Standard & Poor's plan to resolve its positive outlook?
For investment-grade entities (those rated 'BBB-' or higher), our outlook generally covers up to a two-year time horizon. When we revised the outlook on Mexico in March 2013, we indicated it referred to a 12-18 month period. This time frame provides scope for both presentation and passage of reform, including possible slippage in the government's timing. It also allows for the potential need for additional clarification or passage of secondary legislation. We are currently within this time frame. Given the high likelihood that the content of reforms will change as they are discussed and negotiated in Congress, we'll await at least partial approval of the fiscal and energy reforms to assess the ratings implications.

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