Author: Denise Bedell
Despite uncertainty over the likely result of Mexico’s impending election, financial markets are showing remarkable stability. It’s a sign of their newfound resilience.

fe_noteMexico_foto01 Mexico is known for its banking and financial systems. The country has one of the most advanced financial infrastructures of any emerging market country, and the government has implemented serious reforms and maintained conservative fiscal policies to ensure it stays that way. But with a presidential election looming, there is growing concern over what impact a changed government—and possibly a left-wing leader—could have on the economic and financial stability of the Mexican market.
The country’s financial markets have undergone a transformation in recent years. From privatization of the banking system in 1982 through the currency crisis of 1994, Mexico has come out of it all with a strong financial infrastructure and a solid framework for future development. The strength of the banking system is demonstrated by the influx of foreign banking interests, which have bought up most of the major banking assets in the country. For example, Citigroup bought Mexican powerhouse Banamex in 2001, and Spain’s BBVA and Canadian group Bank of Montreal have both invested heavily in rival Bancomer.
How those banks do business has also changed considerably in recent years, as a number of regional and global market trends have had a big impact on financial institutions in the country. These trends have dramatically affected both the asset and liability sides of the major financial institutions in Mexico, according to Eugenio Garza, co-head of Mexico investment banking at Merrill Lynch. On the asset management side, says Garza, competition for domestic savings has grown dramatically, and players are now forced to offer more competitive asset management products. “On the lending side, the great acceleration of credit coming from non-banks has forced banks to come up the learning curve quickly—some organically and some through acquisitions—to be able to cater to this un-met demand that has been further accelerated by price elasticity in the new lower interest rate environment,” he says.
The increased competition has created an environment of lower rates and a broader array of tailored credit products, all with more term flexibility and thus greater creativity in credit uses. This has led to a growing disintermediation of the banking sector from heavy capital users. Says Garza, “The increased availability of long-term financing and structured financing in local currencies has added a wide array of products to the menu for large corporate and government entities and reduced their reliance on the balance sheet of financial institutions.”
As the capital markets have grown, banks have turned away from vanilla lending to more diverse product offerings in order to reach profit targets. This, in turn, has created a burgeoning market for interest rate, currency and credit derivatives, as capital users try to manage their liability exposure more proactively to achieve the lowest all-in cost in their desired exposure regardless of the funding source. “All in all, financial institutions now have the ability to be a lot more sophisticated in how they deliver capital to end users and have a lot more alternatives to manage their balance sheet more aggressively and maintain good levels of return-on-investment,” Garza says.

Coming of Age for Mexican Capital Markets

Mexico "has grown
from non-existent
to a significant
market on the
world scene in a
matter of years."
Felipe de Y’Turbe

According to Felipe de Y’Turbe, director general of Scotia Capital Mexico, there have been significant changes in the Mexican capital markets over the past five years: “They have grown dramatically, and we are seeing much more depth to the markets, especially on the debt side.” This has a lot to do with the government’s proactive approach to debt management. By pre-paying much external debt in recent years, the Mexican government has substantially reduced exposure to exchange rate risk. Neil Dougall, head of emerging markets economic research at investment bank Dresdner Kleinwort Wasserstein (DrKW), says, “By pre-financing well ahead on international capital markets—indeed, through until the end of 2007—the government has helped reduce vulnerability to any abrupt change in global liquidity conditions, either before or after the July elections.”
The activity of private pensions and institutional investors has buoyed the market beyond expectations. Says de Y’Turbe: “It has grown from non-existent to a significant market on the world scene in a matter of years. We are at the point where the Mexican government is issuing 20-year paper, which is just incredible.”
Within the credit space, the real standout development of the past year is the phenomenal growth of the local currency bond market. This market has been heating up and looks set to continue to grow. Global corporates and sovereigns have been taking advantage of local demand to tap the Mexican market regardless of whether their ultimate exposure is in pesos or not. Merrill Lynch’s Garza says, “These successes show the resilience not only of the debt markets but also the FX and interest rate derivative markets.”
The yield curve for domestic peso-denominated debt now extends to 20 years, but the Mexican authorities have signaled that they plan to launch a 30-year bond soon. DrKW’s Dougall says: “Conservative monetary and fiscal policies have ensured a stable macroeconomic backdrop. In turn, this has encouraged a steady rise in foreign participation in the local bond market.” Market growth has really been driven by the increasing appetite, from both local and international investors, for investment that yields higher-than-average returns for a given credit rating even when adjusted for currency risk, says Garza. “This is more manageable now with the development of the local IR and FX derivatives market,” he notes. And as local pension funds and mutual funds look to diversify their growing pool of investments into a broader array of issuers, this should also open the door for more structured products, such as securitization and other asset-backed deals from local and international issuers.


"The acceleration
of credit coming
from non-banks
has forced banks
to come up the
learning curve."
Eugenio Garza

However, with the election coming up, the debt capital markets are slowing down and will probably continue to lose momentum as election day approaches. De Y’Turbe says: “We will see some issuance, but perhaps less so than last year because the big Mexican names have already cleaned their balance sheets. Many Mexican issuers went into the market last year in anticipation of the electoral process.”
Equities have shown less vigor, although recent regulatory changes should help jump-start the market, according to market participants. One factor that had been a deterrent in the development of the equity market was the outdated and unfriendly regulatory environment. But securities markets and banking law reforms passed at the end of last year have signaled a sea change in the markets.
According to Dougall at DrKW, the passage of the new securities law was an important step in the progress of the market: “It should help Mexico to secure larger amounts of private equity capital. Up until now, Mexico has captured only a small proportion of total equity flows entering Latin America and an even smaller share of global flows.” This is despite the fact that the country has been successful in attracting comparatively large amounts of foreign direct investment. “The new securities law should help overcome some of the disincentives to equity investment—for example, by strengthening the rights of minority shareholders,” he says. “In turn, this should lead to a steady rise in stock market capitalization—currently a relatively lowly 25% of GDP.”
Garza notes that pension funds are still underweight in the Mexican equity market compared with their mandated maximum levels. “Fund managers have been cautious in stepping in with a lot of exposure with valuations at all-time highs,” he says. A number of new companies, however, have gone public in the past year, and more are expected to do so in 2006. “What has been proven is that once again the Mexican stock market is providing a viable source of capital for new, up-and-coming companies that are breaking new ground in their respective fields,” he says.

Election concerns

The new securities
law "Should help
Mexico to secure
larger amounts
of private equity
Neil Dougall

Mexico will hold presidential elections on July 2 this year, and some observers are concerned about the impact the elections might have on the financial markets. According to Ian Craig, treasurer at Coca-Cola Femsa in Mexico, the full impact is likely to be relatively small, though. “There might be some volatility, at most three months prior to the election, and we will probably see the local capital markets shut down for that period,” he says.
The worst-case scenario for the markets would be a close and disputed result. This would result in adjudication by the independent electoral institute—the IFE—and could lead to a prolonged period of uncertainty. Notes Craig, “If either candidate wins by a small margin and there is a tight outcome, there might be some noise within the markets.”
Throughout most of the run-up to the elections Andrés Manuel López Obrador of the leftist Partido Revolucionario Democrático—PRD—has had a clear lead in most opinion polls over his nearest rival, conservative Felipe Calderón from president Vicente Fox’s Partido de Acción Nacional—PAN. While some market participants may feel uncomfortable with a left-wing president, Neil Dougall, head of emerging markets economic research at investment bank Dresdner Kleinwort Wasserstein, counters that it is unlikely that a López-Obrador-led government would risk triggering macroeconomic instability by shifting dramatically away from responsible fiscal policies. “We therefore believe the short-term market reaction to a López Obrador win would be fairly muted,” he says.
Steve Sullivan, corporate finance manager at Coca-Cola Femsa, adds that it is very unlikely there would be a problem in the market. “Outside the presidential race, not all of congress is up for election in the executive branch,” he notes. “Even if there is a new president from a different party, that party is not going to share the same majority in congress.”
Dougall adds, “Compared with previous end-of-session episodes, we are expecting both the run-up and immediate aftermath to the elections to be relatively smooth for financial markets.”

Denise Bedell