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MEXICO IN THE GLOBAL MARKETPLACE

Artist’s impression of the new Mexico City airport designed by Foster + Partners. Credit: Foster + Partners.

2 MACROECONOMIC OVERVIEW Still Mexico’s moment

6 INTERVIEW WITH THE DEPUTY FINANCE MINISTER Fernando Aportela says reforms are focused on the long term

8 MEXICAN SOVEREIGN BOND MARKETS ROUNDTABLE Stable sovereign standing out in a volatile world

17 THE ENERGY SECTOR Oil price casts shadow over ambitious energy reforms

22 CORPORATE BORROWERS’ ROUNDTABLE Corporates sitting pretty, but not complacent

31 BANKING SECTOR Intermediation and regulation hold the key for bank investors

33 INFRASTRUCTURE Looking to private sector for infrastructure solutions

37 EQUITY CAPITAL MARKETS Equity market looks to energy reform for growth spurt

39 AFORES Afores ready for next stage of evolution

001 Contents Mexico 2015.indd 1 09/07/2015 18:30

2 | July 2015 | Mexico in the Global Marketplace

MACROECONOMIC OVERVIEW

THERE ARE two Mexicos, accord-ing to a report published recently by McKinsey. “There is a modern Mexico, a high-speed, sophisticat-ed economy, with cutting edge auto and aerospace factories, multina-tionals that compete in global mar-kets, and universities that gradu-ate more engineers than Germany,” says the constancy.

“And there is a traditional Mexi-co, a land of sub-scale, low-speed, technologically backward, unpro-ductive enterprises, many of which operate outside the formal econo-my.”

Nowhere is the first Mexico more strikingly embodied than in its extremely successful auto indus-try, which in the last five years has leapfrogged oil and gas to become the largest source of exports to the US by some distance. Unlike most of the Mexican economy, the auto sector is also highly productive.

But the auto sector hardly consti-tutes the DNA of the Mexican econ-omy, as Alberto Ramos, head of Latin American economic research at Goldman Sachs in New York, points out. “The Mexico you see through the lens of the auto sector is enjoying record levels of invest-ment, production and exports, as well as efficiency levels that are comparable with some European manufacturers,” he says. “But this is not the whole story Mexico.”

The old or legacy Mexico is also a country in which bank credit is harder to come by than it is in Ethiopia, according to McKinsey. It is a country in which corrup-tion ranks as the single most prob-lematic factor for doing business, according to the World Economic Forum.

It is also a country which is famously unproductive, as Manuel Sánchez, deputy governor of the Mexico’s central bank, acknowl-

edged in a presentation delivered in Japan in March. Recognising that Mexico’s long term economic performance has been “less than stellar”, Sánchez conceded that “the key problem has been stag-nant total factor productivity”.

Economists agree. “Low produc-tivity has definitely been one of the main reasons Mexico has strug-gled to deliver sustainable growth rates,” says Lorena Domínguez, senior economist at HSBC Mexico.

The figures tell their own rue-ful story. McKinsey calculates that overall productivity fell from $18.30 per worker per hour in 1981 to $17.90 in 2012, with productiv-ity gains at the largest companies more than offset by falls in smaller

companies. Mexican manufactur-ing, says McKinsey, is 24% as pro-ductive as it is in the US.

Too many monopolies Jan Dehn, head of investment research at Ashmore Investment Management in London, puts some of this lack of productivity down to the monopolistic structure of the Mexican corporate universe. “One of Mexico’s most serious problems is that it has too many monopo-lies,” he says. “In principle, this should have cheapened labour, reduced production costs and made Mexican goods more com-petitive, pushing up growth rates. In practice, lower labour costs have been used to increase margins

While some of the shine has come off its reform programme, Mexico occupies a key position in the emerging market universe, with its highly respected central bank, finance ministry team and policy agenda lauded by the international investor community. Philip Moore reports on the country’s progress since President Peňa Nieto came to power in 2012 and the long term impact of the far-reaching and ambitious reform programme.

Still Mexico’s moment

Thumbs up: Mexico’s president Enrique Pena Nieto and wife Angélica Rivera

^

002-005 Mexico MacroEconomics.indd 2 09/07/2015 18:30



instead, making monopolies richer and workers poorer. That has been negative for competition and for Mexico’s balance of payments.”

The infuriating consequence, for a country sharing a 2,000-mile border with the largest consumer market in the world, is that Mexico has consistently failed to deliver on its economic potential. Under the presidency of Vicente Fox, between 2001 and 2006, its average growth rate was a modest 2.4%. During the term of his successor, Felipe Calderon, it hobbled along at an even weaker 1.9% per year between 2007 and 2012. Since the PRI was returned to power under President Peňa Nieto in 2012, things have improved. But not by much. GDP grew by a sluggish 1.1% in 2013, accelerating to 2.1% in 2014 and 2.5% in the first quarter of 2015.

Recognising that productivity growth will need to triple if Mexico is to reach an annual GDP growth target of 3.5% (according to McK-insey’s estimates), Peňa Nieto’s government unveiled a cocktail of structural reforms at the end of December 2013.

In simple terms, the Mexican reform initiative can be divided into three broad types. The first and the most newsworthy is the package of reforms in the energy sector, which at a stroke brings to an end more than 70 years of suffo-cating state control over oil and gas production as well as energy distri-bution.

This section of the reform agen-

da is also the sexiest in terms of the investment that the government is expected to attract as a result. Its official forecast is that the reforms will generate $50bn of new invest-ment by 2019.

The second type of change pushed through by the govern-ment’s package is decidedly less headline-grabbing fiscal measures which are a corollary of the ener-gy reform. About a third of gov-ernment revenues come from oil, production of which has dropped by about a quarter in the last dec-ade. So Mexico urgently needs to increase its government tax intake, which according to JP Morgan is 10.3% of GDP, compared with over 15% in Peru and Chile, more than 13% in Brazil and a Latin American average of 13.4%.

Mexico’s fiscal reforms target an increase in the government’s non-oil tax take of 2.8% of GDP over the next four years.

The third layer of reforms is the socio-economic corrective surgery that will take years — or even dec-ades — to bear any tangible fruit. These include reforms to areas like education and the labour market. They also include financial sec-tor reform aimed at addressing the chronically low levels of credit in the economy, which is less than 20% of GDP, compared with a Latin American average of 37%, accord-ing to JP Morgan.

Rating agencies onsideMexico’s government, which econ-

omists say has a history of over-promising and under-delivering, has made some gung-ho esti-mates about the likely impact of its reform agenda, believing it could boost annual growth to between 4% and 5%.

Analysts are generally more cau-tious about the growth potential generated by the reforms, but the initiative was warmly and deci-sively greeted by the rating agen-cies. Standard & Poor’s upgraded Mexico from BBB to BBB+ barely before the ink was dry on the presi-dent’s reform papers. Moody’s fol-lowed in February 2014, upgrad-ing Mexico from Baa1 to A3, saying the ratings action was spurred by the structural reforms’ capacity to “strengthen the country’s potential growth prospects and fiscal funda-mentals”.

Fitch, meanwhile, has rated Mexico BBB+ since May 2013, but Shelly Shetty, the agency’s New York-based head of Latin Ameri-can sovereign ratings, also views the reform programme positively. “One of the triggers for an upgrade is the ability to reduce debt and bridge the gap with higher rated sovereigns in terms of per cap-ita income,” she says. “To the extent that the reforms are well-implemented and encourage more investment and higher growth, they could be positive for Mexico’s creditworthiness going forward.”

Investors also seem prepared to give Mexico the benefit of the doubt. “Generally speaking, we are

constructive on Mexico,” says Gorky Urquieta, co-lead portfo-lio manager, emerging market debt, at Neuberger Berman. “It is one of the few bright spots in the emerging market universe which is committed to a pro-cess of structural reforms, and its spreads still provide decent value compared with other com-parably rated sovereigns.”

Ashmore’s Dehn is also posi-tive on Mexico, albeit with one or two caveats. “Some of the shine has come off the reform programme, in that there have been some setbacks on fis-cal reform and anti-corruption measures,” he says. “But Mexico occupies an important position in the emerging market uni-

Real GDP Growth Forecast (Banco de México)2015 Between 2.5 and 3.5%

2016 Between 2.9 and 3.9%

Real GDP Growth Expecta�ons of Private Sector Analysts

Median, %

Source: Banco de México Survey

2.50

2.75

3.00

3.25

3.50

3.75

4.00

4.25

4.50

Jan

Feb

Mar

Ap

r

May Ju

n

Jul

Au

g

Sep

Oct

No

v

Dec Ja

n

Feb

Mar

Ap

r

May Ju

n

Jul

Au

g

Sep

Oct

No

v

Dec Ja

n

Feb

Mar

2015

2016 2017

Mar

2013 2014 2014

Real GDP growth expectations of private sector analysts




verse, in that it has a very cred-ible central bank, finance minis-try team and policy agenda. So we feel comfortable holding Mexican debt.”

Many investment banking ana-lysts are also upbeat about the longer term impact of reform. “Potential GDP [growth] today is around 3%, and we expect it to rise to 4.5% or 5% by 2021, but only on a very gradual basis,” says Domínguez at HSBC in Mexico City.

Bank of America Merrill Lynch (BAML) echoes this view. It said in May that this is “still Mexico’s moment”, adding that “we are opti-mistic that the 11 reforms enacted since 2013 — energy in particular — will allow potential growth to increase to 4% from 2.8% in a few years.

Impact mañanaThat’s mañana. As for the immedi-ate outlook, analysts aren’t so sure. “Beyond the declines in electric-ity costs, I see no short term ben-efits arising from the reforms,” says Pablo Riveroll, fund manag-er in the emerging market team at Schroders in London. “The domes-tic economy has grown by about 2% a year over the last 10-15 years and I see no reason for that to change unless the energy reforms bring in a huge amount of FDI. If it doesn’t, why should Mexico grow any faster?” Riveroll adds.

“It didn’t accelerate when the US was in recovery mode in the last four or five years and it didn’t grow much faster when a big fiscal stim-ulus was introduced last year. With the government tapering public spending because of the fiscal cliff it is facing from lower oil prices, I see structural growth remaining at about 2% or 2.5%.”

At Goldman Sachs, Ramos agrees that the economic impact of reform is unlikely to match the govern-ment’s ambitious expectations, but that any progress should be wel-comed. He says that if the reforms lead to an increase in GDP of 0.5% or 1%, that will represent a signifi-cant achievement, but he adds that there are dangers in over-promis-ing, one of which is the political backlash that may arise if tangible benefits fail to filter through to the

microeconomy sooner rather than later, making it more efficient and flexible.

Others share this concern. S&P, for example, cautions in a recent update that drug-related vio-lence could constitute a challenge to President Peña Nieto’s leader-ship, “and, therefore, his ability to implement its economic agenda.” On balance, however, S&P believes that with most of the key reforms already passed, a reduction in the president’s popularity need not become critical.

Be that as it may, the politi-cal risk of the reform programme unravelling is why it is encourag-ing that a number of positive per-formance indicators are already coming through.

How many of these can be attrib-uted directly to the reforms is open to debate, but that does not make them any less welcome.

“Compared to its regional peers,” noted BAML in May, “Mexico has avoided the slowdown that has engulfed the rest of the region.” While retail sales have outpaced those elsewhere in the region, unemployment is falling in Mexico, while it is starting to rise in Brazil and Chile.

“Not surprisingly,” adds BAML, “consumer confidence has remained high in Mexico, while it has plunged in Brazil, Chile and, more recently, Colombia.”

Promising FDIFDI flows have also been promis-ing. 2013 was an unrepresentative year for investment into Mexico because the FDI total of $35.2bn included the whopping $13bn that Anheuser-Busch paid for the Mexi-can beer giant, Grupo Modelo. But 2014’s figure of $22.6bn was an impressive advance on 2012’s anae-mic $12.7bn.

This suggests that FDI inflows are not necessarily as sensitive to bad news about drug-related vio-lence in Mexico as the media some-times suggests. “In spite of some mixed reviews you hear in the news, if you look at the FDI com-mitments announced in the first quarter of 2015, they have been the highest for many years,” says Ale-jandro Díaz de León, head of public credit at Mexico’s finance minis-try. FDI reached $7.57bn in the first three months of this year, com-pared with $5.82bn in the same period in 2014.

Nevertheless, there are several reasons why economists are doubt-ful that reforms will deliver the sort of turbo-charged growth perfor-mance that President Peña Nieto’s very capable finance team is hop-ing for in the short term. The most obvious of these is that the fall in oil prices has already forced the government to recalibrate its fis-cal plans, cutting spending by 0.7% this year.

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0

5

10

15

20

25

30

35

40

45

2008 2009 2010 2011 2012 2013 2014 2015f 2016f 2017f 2018f 2019f

% of GDP$bn

Manufacturing Other Energy-related As a % of GDP (RHS)

Expected FDI inflows

Source: Banxico, HSBC estimates



MACROECONOMIC OVERVIEW MACROECONOMIC OVERVIEW

Another reason why the reforms are unlikely to translate into eye-popping growth numbers over the next few years is that many of the most important measures can, by definition, only hope to deliv-er material change over the very long term. Educational reform is one obvious example. Anti-corrup-tion initiatives are another. Labour reform is a third. “Giving employ-ers more flexibility with regard to hiring and firing is clearly posi-tive, but will take many several years to trickle down to the micro economy,” says Ramos at Goldman Sachs.

Reform will also take years, and possibly decades, to support the growth of a vibrant middle class in

Mexico, although Díaz de León says that rapid job creation is already helping to underpin its growth. “It is astonishing that job creation has been growing at almost twice the speed of overall economic growth in the last 18 months,” he says. “This reflects the success of a num-ber of programmes incentivising people to move from the informal sector to the formal sector.”

But a sustainable middle class is not something that can be built overnight. “Brazil doubled the size of its working class in 10 years but not in a sustainable way,” say Ramos. “It was driven by a boom in credit and fiscal transfers, and by overly generous increases in the minimum wage above productiv-ity growth, all of which led to the recession and erosion in disposable income that we’re seeing today.”

Ramos adds, however, that there are measures that could be imple-mented today to encourage the growth of domestic demand in Mexico. “The share of credit in GDP is still extraordinarily low in

Mexico,” he says. “There is plen-ty of potential to increase leverage in the SME and consumer markets which would encourage and sus-tain higher consumption levels.” An additional reason why the fruits of the reforms will not immediate-ly be visible in Mexico’s economic performance is that their influence is not all-encompassing.

Oil questionThere are several other external factors that will play a key role in determining growth as well as fiscal and monetary policy. One is commodity price volatility, although the recent fall in oil pric-es is perhaps not as perilous for Mexico as the size of its oil and gas

sector may suggest. “Lower oil prices are not criti-

cal, but are certainly a nega-tive shock to the economy — to real activity, the fiscal accounts and the external accounts,” says Ramos. “But it is important to remember that Mexico is mostly a manufacturing-based econ-omy, not a commodity-based economy like most South Ameri-can countries.” Maybe not. But a $10 decline in oil prices still shaves 0.3% off Mexico’s gov-

ernment revenues, according to Moody’s.

Another obvious influence on Mexican growth is economic per-formance elsewhere in Nafta, given that the US accounts for 80% of Mexico’s manufactured exports and for over half of its foreign port-folio liabilities and inflows of FDI. US monetary policy also inevita-bly has ramifications south of the border.

“Mexico is not particularly exposed to higher interest rates in the US given that it has a low to moderate current account defi-cit and contained external fund-ing needs,” says Ramos. “However, the authorities are mindful of the fact that there is around $150bn in foreign money invested in the local fixed income market and that these flows may be sensitive to US rates.” Too true: according to the IMF, a 100bp rise in 10 year US Treasur-ies translates into a 140bp increase in the Mexican 10 year sovereign yield.

Beyond its Nafta backyard, softer

global trade also has an impact on Mexico’s manufactured exports. The decline in the value of the peso is cushioning some of this blow, although the weakness of the Mexi-can currency has been a double-edged sword. As Ashmore’s Dehn says, the size and liquidity of the peso market has meant that the Mexican currency is used by inter-national investors as a proxy for the emerging market universe. That in turn has exacerbated vola-tility in the peso, which has not been supportive for bondholders.

The weakening peso has, howev-er, helped exports to hold up quite well in 2014 and the first quarter of 2015. According to data published by the Inter-American Develop-ment Bank, Mexican exports rose by 4.6% in 2014, compared to a fall for overall Latin American exports of 2.7%. In the first quarter of this year, while Latin American exports have fallen by 9.1%, Mexico’s were down by just 0.4%.

Economists say that in the long-er term, the resilience of Mexico’s exports reflects the efficiency gains its manufacturing sector has gen-erated relative to its competitors, especially those in China. “Mexico perhaps does not get enough cred-it for recapturing so much of the US market share it lost to China a decade or so ago,” says Urquieta at Neuberger Berman.

Although the focus of its export-ers is inevitably principally on its Nafta partners in general and the US in particular, economists add that Mexico’s success in forging trading links with Europe should not be belittled. “Ten years ago, the US accounted for 90% of Mexico’s exports, so there has been con-siderable success in diversifying exports,” says Domínguez at HSBC.

Trade between Mexico and the EU has gathered pace since a free trade agreement was signed between the two in 2000. But econ-omists say that more could be done to encourage closer integration. In May, BBVA published a report on EU-Mexican trade and investment, which recommended that “both economies could gain from the advantages of a revised agreement that, among other things, would eliminate import quotas on agricul-tural products by Europe”.

“To the extent that the reforms are

well-implemented and encourage

more investment and higher growth,

they could be positive for Mexico’s

creditworthiness”

Shelly Shetty, Fitch



INTERVIEW WITH THE DEPUTY FINANCE MINISTER

MEXICO’S GDP GROWTH may not have been spectacular since Presi-dent Enrique Peña Nieto took office in 2012, but it is not denting Dr Fernando Aportela’s faith in the government’s extensive reform agenda.

The government’s diagnosis of an underperforming Mexico when it came to power was not concerned with the recent whims of the econom-ic and business cycles, but with some 20 years of economic underachieve-ment. Peña Nieto’s government is pro-posing long term solutions for long term problems.

“Mexico’s low growth is funda-mentally a result of negative growth in productivity in recent years,” says Dr Aportela, who holds an econom-ics PhD from MIT, and was appointed undersecretary of finance and public credit in December 2012 when Peña Nieto took office.

“This problem goes beyond eco-nomic cycles; it is a structural prob-lem that requires deep transforma-tions.”

Dr Aportela points out that aver-age growth in the last two decades in Mexico has been just 2.5%, “low ver-sus other countries with which we can compare ourselves, like Brazil, Chile, Spain, South Korea and even China”.

Hence the government’s structural reforms are concerned with sustain-able benefits, rather than short term goals. This administration’s priority lies with “improving Mexico’s produc-tive capacity and encouraging com-petition and private investment”, Dr Aportela says.

Indeed, Mexico’s GDP numbers were — on the surface — not too dis-couraging before this government took power. The economy grew 5.1% in 2010, 4% in 2011 and 4% in 2012. But those numbers were partially a rebound from the 2009 crisis and belied an underproductive economy.

Indeed, as the eyes of the emerg-ing market investment world turned to Mexico — on the back of the not insubstantial fanfare that greeted President Enrique Peña Nieto’s reform programme — GDP growth dropped to just 1.4% in 2013.

Even with implementation of the reforms well under way as 2014 came to an end, there was restlessness among some observers as global head-lines began to focus more on social discontent than economic potential. Commentators asked if the reform momentum had lost steam.

It is more accurate to say that it had not even started yet. Any Latin American investors — perhaps spoilt by years of eye-popping growth from Mexico’s commodity-driven peers like Colombia and Peru — expecting excitement around Mexico to trans-late into similarly impressive numbers were misguided.

The slowdown in growth at the start of Peña Nieto’s government was a clear sign that, no matter the scale of the reforms, change would not

come overnight. But then overnight change was hardly the purpose of the reforms, and Dr Aportela highlights that the central objective of the reform programme is to enable “sustained growth in productivity”.

Moreover, the reforms are not just about economic growth. The govern-ment wants to enable Mexico to reach its potential in a “broad” sense, says Aportela.

“The vision we have is to enable Mexico to reach its full potential, including human development, sus-tainable gender equality, the pro-tection of natural resources, and improving health, education, political participation and security.”

Tangible improvementIn any case, 2015 numbers are finally showing some promise. The first quar-ter’s 2.5% growth may not be spectac-ular, but Dr Aportela points out that it was the country’s second best result since the end of 2012, and was ahead of certain previously flying neigh-bours like Chile (2.4%) and Peru (1.7%).

“In a complex and volatile environ-ment, the Mexican economy is grow-ing at a faster rate than last year, beat-ing analysts’ expectations and doing so in a balanced way,” he says.

Beyond growth numbers, across the economy the reforms have already provided other tangible benefits that may not be visible to a casual observ-er.

The average Mexican, for exam-ple, is “already seeing positive effects in the form of lower electricity and telephony tariffs, more available and cheaper credit, and rapid job creation, with the advantages that entering the formal economy can give,” Aportela highlights.

He says that Mexico is now “one of the countries with best prospects for growth, attracting investment and

As Mexico finally, if modestly, starts to outperform much of Latin America in growth, deputy finance minister Fernando Aportela tells Oliver West that the structural changes the government is making will have significant medium and long term effects.

Finance ministry stays focused on structural change as reform benefits become visible

Fernando Aportela: curing productivity problem requires deep transformations

006-7 interview.indd 6 09/07/2015 18:31


INTERVIEW WITH THE DEPUTY FINANCE MINISTER

generating jobs”.In the past 12 months energy tar-

iffs have fallen by as much as 26.3% for the industrial sector, up to 10.3% for the commercial sector, and up to 10.3% for the domestic sector, thanks to the energy reform.

The telecoms reform has ended extra charges for long distance phone calls within Mexico and cut by 11.2% the costs of mobile phone calls from May 2014 to May 2015, among other reductions, says the deputy minister.

And the financial reform has brought an increase in domestic credit to the private sector as a percentage of GDP from 25.7% in 2012 to 30.9% as of March 2015. Finally, the tax reform brought 9.7m more tax contributors from December 2012 to March 2015 — or a 25.1% increase, according to Dr Aportela.

Indeed, when asked which of the 11 reforms that make up the Pact for Mexico has passed by most unjustly unnoticed amid the headline-grab-bing energy reform, he immediately talks up the financial reform.

This reform “catalyses the other structural reforms by enabling more credit to be granted, and this is key to generating investment in every sector of the economy”.

Some of the most significant effects of the reforms, however, are in how Mexico’s economy is perceived. For-eign direct investment has hit $75bn in the first nine quarters of this administration, says the deputy min-ister, the “highest ever figure for an equivalent period”.

And he highlights an AT Kearney FDI confidence index published in April that saw Mexico climb three places in a year to be the ninth most attractive investment destination in the world.

Domestic confidence “has also strengthened”, he says, pointing to an index from INEGI, the national sta-tistics agency, which shows consum-er confidence up 1.4% to 92 points in May this year.

Solidity firstBut if Mexico has begun to differenti-ate itself during a tumultuous period for emerging markets, it is thanks to its ability to stand strong in the face of the commodity price and US mon-etary policy-related market volatility that is afflicting many emerging mar-kets, says the deputy minister.

And this is perhaps just as much a question of macroeconomic prudence as of exciting reforms.

“Mexico has stood out by achieving an orderly adjustment to an uncer-tain and volatile panorama,” says Dr Aportela. “The Mexican market is one of the emerging markets in which the exchange rate, interest rate and sov-ereign risk have been least affected by the recent financial volatility.”

Regarding monetary policy north of the border, Dr Aportela says he expects any improvement in the US economy — required for the US Fed-eral Reserve to tighten rates — to have “a positive effect on Mexico’s econo-my, mainly in manufacturing and the sectors most closely linked to external commerce”.

The deputy minister highlights that Mexico’s stability amid volatility has come from its flexible exchange rate regime, international reserve accumu-lation, diversified and deep debt mar-ket access and a flexible IMF credit line.

Yet if these are policies and meas-ures that most sophisticated emerging market finance ministries have devel-oped in recent years, Mexico’s level of preparation for the oil price tumble is something more special.

Therefore Dr Aportela appears calm in the face of oil losing nearly half its value in less than a year. He predicts that “the trajectory of the fiscal adjust-ment will be gradual and orderly, maintaining the responsible manage-ment of public finances and macroe-conomic stability”.

The Finance Ministry is estimating a spending cut of just 0.7% of GDP in 2015 (Ps124bn), and based on a pre-liminary estimate of crude oil being at $55 a barrel — or $24 below 2015’s budget — an additional 0.7% cut in 2016 (Ps135bn).

This is “around half of the spend-

ing adjustment that would have been necessary if the adjustment had not begun at the start of 2015,” Dr Aporte-la says.

Not only did Mexico soften the blow by hedging its exposure to oil, but Dr Aportela estimates that the tax reform approved in 2013 has saved the coun-try from an even tougher adjustment.

He highlights that tax income reached its highest ever level of 15.3% of GDP in the first quarter of 2015, and that this has helped oil revenue fall from 39.4% of government income in 2012 to 16% in Q1 2015.

Energy reform still shining brightBut the most common question that the oil price fall has provoked is how the effects of the energy reform — arguably the most transformative of all the reforms and certainly the most commentated on — could be damp-ened.

Again, the deputy minister gives a measured response.

“Despite the new market condi-tions that caused changes in the ref-erence prices of crude oil, we do not expect that the objectives of the ener-gy reform’s first round of procurement will be affected,” he says.

The first round remains an attrac-tive option for investors, even with oil at depressed prices, he says, because a significant part of the areas included in the first round of bidding are shal-low water or onshore oil fields that have low extraction costs and existing infrastructure.

Secondly, the deep water fields in the first round may have higher costs but also have “medium term cost-ben-efit horizons, meaning their attrac-tiveness is less sensitive to short term fluctuations in the oil price”.

In Dr Aportela’s opinion, “projects in the oil sector are investments ana-lysed over the long term, which must be evaluated beyond merely today’s temporary situation”.

Whether the effects are more grad-ual than some anticipated or not, per-haps the most pertinent question to ask is what kind of challenges Mexico could be facing, had it not introduced the reform programme.

“Mexico is facing up to the complex international environment as one of the countries with the most notable agendas of structural transformation,” says the deputy minister.

If Dr Aportela is correct, this is what should save Mexico from the malaise that is drifting over the rest of emerg-ing markets.

Aportela: oil price fall should not hinder energy reform

006-7 interview.indd 7 09/07/2015 18:31

8 Mexico in the Global Marketplace

Mexican Sovereign Bond Markets Roundtable

: Let’s begin with a panorama of Mexico’s funding situation. How are funding conditions, how has your financing strategy developed and do you see anything changing?

Alejandro Díaz de León Carrillo, Ministry of Finance: If I could just start with an update on our objectives and how we pursue them. Like any issu-er, we want to obtain permanent sources of finance with low cost and low risk — and by permanent I mean always having a long term horizon and having permanent market access.

As the sovereign, we are concerned with develop-ing a liquid yield curve in both local currency and in the countries where we have decided to issue. We believe the sovereign has a strategic role in develop-ing a liquid yield curve to provide a reference point for other issuers — be they other public sector issu-ers or from the private sector. In our transactions both locally and abroad we are constantly trying to meet those goals. Of course our cornerstone is local funding: we carry out 80% of our funding in local

markets and 20% abroad. This mix shifted rapidly as our local market developed, but the 2009 crisis also reminded us that it was a good idea to have access to markets beyond the local market. That is why we have developed, and continue to develop, our pres-ence in the dollar, euro, sterling and yen markets.

For this particular year, we have already covered our external financing needs. Given how debate and attention has gathered around the potential lift of interest rates in the US, and the potential volatility that this may entail in financial markets, we have tried to complete this funding a little bit earlier on in the year.

I would also like to highlight that in the last six or eight months there has been an increase in risk premiums, mainly affecting emerging markets. A combination of external factors have driven this, including the difference in GDP growth between the eurozone and the US, and the depreciation of the euro that started around August and September last year. On top of that, there has been lower growth from China, commodity prices have fallen, and

Participants in the roundtable were:

Alejandro Díaz de León Carrillo, director of public credit unit, Ministry of Finance and Public Credit, Mexico

Richard McNeil, co-head of investment banking for Latin America, head of Latin American financing group, Goldman Sachs

Juan Claudio Fullaondo, managing director, capital financing, Mexico, HSBC

Luis Eduardo de la Cerda Quiñones, CIO, Afore Sura

Jaime Lázaro Ruiz, CEO, BBVA Bancomer Asset Management

Leonardo Pin, deputy CEO, Seguros Banamex

Oliver West, moderator, GlobalCapital

Stable sovereign standing out in a volatile world

In local and international bond markets the Mexican government has led the way in recent years, demonstrating the importance of a proactive and innovative debt management strategy. This has allowed the country to calmly navigate periods of volatility in emerging markets. With such volatility likely to persist until after the Federal Reserve �nally raises interest rates, GlobalCapital sat down with the country’s debt chief and leading bankers and local investors in Mexico City to �nd out what Mexico does and needs to do to achieve such stability.

008-016 Mexico Sovereigns RT.indd 8 09/07/2015 18:31


Mexico in the Global Marketplace 9

dynamics in the oil market has changed, all of which have presented real challenges to emerging markets.

Amid this, here in Mexico we have tried to keep two goals in mind: to try to maintain our macroeco-nomic policies in order and consolidate that with some fiscal measures; and to try to fast forward the implementation of the structural reforms. This, I think, has allowed us to have good market access and positive conditions in financial markets; both our local and external yield curves have performed relatively well vis à vis other emerging markets in the last few months.

: As Alejandro says, there are many external challenges but at the same time significant progress in Mexico with the reform agenda. What is your impression as to how the world is seeing Mexico right now, Richard?

Richard McNeil, Goldman Sachs: Alejandro began talking about the principles and underlying strat-egy of Mexico’s debt management, and as an initial point I would highlight that Mexico’s approach to debt management is very well understood in the markets. It is an important point to make, given something else Alejandro said — that we’re facing some uncertainty regarding the timing of Fed hikes and the potential spill-over effects therefrom. Mexico benefits from being very predictable. I think people understand the Mexican policymakers’ reaction func-tion. Therefore, although these uncertainties certain-ly are out there and have to be dealt with, I haven’t seen any evidence that people have any particular concerns regarding Mexico.

Juan Claudio Fullaondo, HSBC: I would add that we should take into account that Mexico is the jewel in the crown among Latin American countries. One of the best votes of confidence the country has received comes from the large amount of money that the international community has invested in the Mbonos, the government’s local debt curve. Around 60% of the money in the curve comes from abroad, which clearly shows that foreign investors have con-fidence in the currency — especially at the long end of the curve.

: This sounds great, but I want to ask the Mexico-based investors if they share this optimism. One thing I’ve heard several times this week is that

Mexicans themselves are not as bullish as foreign-ers: would you agree Leonardo?

Leonardo Pin, Seguros Banamex: In general terms, I would say yes. We see a little bit more optimism outside Mexico than inside. However I would high-light that Mexico has been doing its homework for several years. There will definitely be some tur-moil caused by the lift-off of rates, and the periods of volatility in the markets will no doubt impact the Mexican curve. But this impact will come on much better terms for us than for other countries. Furthermore, the money and investments that for-eigners have brought into this country will stay here, I believe, because the turmoil will be in every part of the world — not only in Mexico.

: Let’s talk about the significant holdings of foreign investors in the Mexican curve. What are the advantages and disadvantages for you of this characteristic of the Mbonos curve?

Díaz de León, Ministry of Finance: Being a very open economy, both in terms of trade and capital flows, is at the core of Mexico’s strategy. There are occasion-ally approaches followed by other emerging econo-mies that try to play with capital regulation in order to increase the flows that they like and decrease the flows that they dislike. Mexico has been very disci-plined in allowing for all types of flows, and though you could argue it is not the same if they buy a 30 year bond versus a 28 day instrument, at the end of the day, I think the country has benefited from the openness of the capital account.

It has improved the price discovery process, leav-ing us with a very well functioning yield curve, which is important because this now reflects the risk appetite of both local and global investors. Is this always, in any scenario, positive? Well the 2009 crisis reminded us that extreme scenarios with ‘black swans’ do happen, and we could imagine any num-ber of scenarios. However, it is specifically for those scenarios that we have built up international reserves and have the flexible credit line with the IMF, which provides additional resources in case a very extreme and unlikely scenario materialises. Moreover, the very fact that we have these reserves as well as the IMF line itself reduces the probability that we will ever be in that situation.

To sum up, having international investors express-ing their view on our local yield curve is clearly part of the strategy, something from which we have benefited tremendously, and we have put in place sufficient backstops in case they are needed. I would also point out that we have seen a different type of foreign investor in the market. In the early 1990s we had ‘on and off’ investors, but now we are seeing that the investor community in emerging markets has evolved. The space is dominated by institutional investors dedicated to EM, and we have fewer cross-over investors and significantly fewer mutual funds. That says a lot about the resilience of the market, as does the fact that we have been able to withstand — for example in 2013 with the taper tantrum — very significant episodes of volatility with more or less stable flows.

McNeil, Goldman Sachs: I don’t want to say that

Alejandro Díaz de León Carrillo, MINISTRY OF FINANCE AND PUBLIC CREDIT, MEXICO




the composition of ownership is irrelevant, but I do think sometimes people make too much of an issue out of it. When you consider the recent eco-nomic history of Latin America, you find multiple examples of balance of payments crises, capital con-trols, and the need to rescue financial institutions. If you focus in on why those capital controls were imposed, or on why you sometimes saw deposit freezes, it hasn’t been because foreigners had onshore bank accounts from which they were mov-ing funds abroad, it was because domestic deposi-tors were doing that. If there is a situation in which the country’s debt sustainability comes into ques-tion, foreigners and locals are not going to behave all that differently.

There are certain regulatory requirements that may cause domestic investors to behave in a certain way, but to me it seems that historically, bank runs have been motivated by local behaviour. Based on my experience with Mexico, I’d say some of the points that Alejandro has made about the maturity of the debt stock and putting the debt burden on a sustain-able footing are a much bigger deal than the compo-sition of foreign versus domestic ownership.

: Luis, would you agree that local inves-tors generally behave just like foreign investors?

Luis de la Cerda Quiñones, Afore Sura: Foreign investors are here because they like Mexico, not because they are forced to be here. Mexican pension funds invest in the Mbonos for the same reasons: we have never had controls on where to invest as long as we comply with our investment regime and what our investment committee approves. In the context of global emerging markets, Mexico is a manufactur-ing country that could benefit from growth in the US, has had more or less stable debt to GDP ratios, and has responsible fiscal policies. That tells me that foreign investors are here because they like it, and the bulk of this foreigner investor base is going to be here for a long time. Generally, they are not invest-ing because they see some movement in the short run; they have allocated into Mexico because it is a good country to be invested in.

: Has the more permanent presence of international investors in the curve changed in any way the behaviour of local players?

Pin, Seguros Banamex: Definitely.

De la Cerda, Sura: I think so. For a start it makes the price discovery more efficient. There are more views going into the curve, and you have a yield curve that more effectively prices people’s expectations about the future of Mexico.

Jaime Lázaro Ruiz, BBVA Bancomer Asset Management: I agree totally. First of all the presence of foreigners here has helped local investors to take more of a global perspective. They have started to see Mexico’s fundamentals on both absolute and relative terms, as the global perspectives tell you how you are performing against other benchmark countries. We should not see this presence of foreigners as a threat to the Mexican economy, because we can be confi-dent in having better fundamentals and better yields than many countries. In this sense, the mentality of the locals has changed when it comes to bond invest-ing; we have realised that we have to understand our fundamentals better and compare ourselves to other countries. At the end of the day the presence of foreigners in the yield curve has helped to provide liquidity, making the market more efficient in valua-tion terms. This is not something that should concern us. Only if we see that our fundamentals become worse on a relative basis should the presence of for-eign investors be a source of concern.

De la Cerda, Sura: …or on an absolute basis.

Lázaro, Bancomer AM: Indeed.

Fullaondo, HSBC: Another positive thing about the evolution of our solid domestic yield curve is that it has expanded to the corporate level. We have seen some issuers like América Móvil, Televisa and Pemex start to tap international investors for pesos. That is an extremely good thing for the market because it helps to appropriately price the bonds taking into account broader demand from a larger investor base. This trend will evolve with time and allow compa-nies to start printing money in local currency in a far more efficient way.

Díaz de León, Ministry of Finance: As I said at the beginning, our objective is not only to get local fund-ing at low cost on an ongoing basis but to develop the markets. We believe that the sovereign yield curve has really strong external effects on the rest of the market. You could also highlight that it is good to have a well functioning yield curve that allows savers and investors in the economy to make good choices and to transact at a lower cost. For us, developing the corporate market is definitely a key goal, and I would just highlight one very concrete example of that.

Mexico’s government bonds have been Euroclearable and on Clearstream for over a decade, which has been a key element in making it easier for foreigners to invest in Mexico. We have recently carried out some fine-tuning in regulation and tax criteria that apply to corporates, which has allowed local corporate bonds to be Euroclearable. In January we saw the first Euroclearable security issued by Pemex, which is the first step in the right direction. I believe that the government public debt market has been internationalised, but we are lagging on the

Luis Eduardo de la Cerda Quiñones, AFORE SURA




corporate side. Some of these actions and decisions are being put in place to address that.

McNeil, Goldman Sachs: Just to give you a sense of how important this is, I would like to tell a story from many years ago, when I first got out of busi-ness school. I was working in the Latin American M&A team at the firm I was at, and my colleagues were getting ready to carry out their valuations for an impending transaction. They had to work out what the 10 year risk-free discount rate in pesos, was, and because there was no benchmark, it was a completely hypothetical exercise. Today, with a fully developed yield curve, there are readily observable benchmarks. When you think about what this does, not necessarily just in terms of financial market activ-ity, but in terms of the effect on real business and investment decisions such as M&A, it is an extremely important development.

Pin, Seguros Banamex: If I could make a further comment: as Alejandro was saying, the diversifica-tion of investors from outside Mexico is very impor-tant. On top of that, although obviously there is a large number of US investors, they are not the only foreign investors. There are lot of investors from very different places, backgrounds and economic sit-uations, investing in Mexican pesos. This also helps stabilise prices in the Mexican curve.

: Now to turn to the Mexican investors. Local institutional investors have grown significant-ly over the years, and begun to diversify away from government securities into more risky asset classes. How has this affected your appetite for Mbonos?

De la Cerda, Sura: If I could just give a quick recap on the development of pension funds in Mexico. In 2007 more than 86% of our portfolio was invested in government securities, nearly 10% was in corpo-rate debt, and less than 5% was in public equities — all of them Mexican names.

Right now the industry is much more diversified and the investment regime has evolved to give a bet-ter risk-adjusted return to our clients, the workers of Mexico.

At the moment — and these are rough numbers — between 45%-50% of our portfolio is made up of government securities, around 30% in public equi-ties, around 15%-20% is in corporate debt, and 5% is in structured products in the shape of private equity,

private infrastructure investments, or Mexican real estate.

I think that this is positive for the Mexican market and the pension system as a whole, but it does not necessarily affect our appetite for the Mexican curve, as this diversification has happened over the same period as a doubling of pension funds’ assets under management. We have therefore been more or less constant in terms of our holdings of Mexican gov-ernment securities. Diversifying away from govern-ment bonds is not a question of not liking like them, just of exploring newer investments that can provide higher returns to our clients.

Lázaro, Bancomer AM: In the mutual fund industry we have experienced growth in many products. It is a product-based industry. Given where short term interest rates are, clients that for years invested only in short term securities are now diversifying their portfolios into long term debt and national and international equity products. From our perspec-tive, there is therefore a lot more appetite from the Mexican investor pool as a whole not only for Mexican government bonds but to increase the dura-tion in their portfolio. That said, we’ve experienced growth all over: there is more appetite to go into equity-based portfolios, absolute return, alternative investments and international equities. In our indus-try, the losers in terms of assets under management have been short term mutual funds and money mar-ket funds, in favour of more medium and long term fixed income and equities funds.

Pin, Seguros Banamex: Across the whole investor base, but especially where I work on the insurance side, the biggest evolution we have seen in the last 10 or 15 years in the market is a much greater pro-fessionalism and knowledge of credit and risk man-agement. This means the appetite to diversify into securities other than government bonds is definitely there. However, we should also mention that in our case, as an insurance company, our investment deci-sions should be more based on our liabilities — and not every insurance company has the same liabilities in duration and convexity.

: Looming large across all markets, including Mexico, is the prospect of US rates rises later this year. Alejandro, could you expand on your outlook and how it’s affecting your daily goings on?

Díaz de León, Ministry of Finance: Before I go into that, I feel it is important to point out that in recent years we have seen a major structural change in terms of how global capital moves around the world.

Many years ago, I would read papers and articles saying global investors were under-diversified. For various reasons, push and pull factors have allowed for this diversification to take place in the last years.

On one hand emerging markets have been show-ing better macro numbers and developing their own markets, while the financial crisis of 2008-09 led to a compression in yields in the developed world. I think this is a structural change and it will not be the case that the Fed will raise interest rates and then we will be back to pre-crisis dynamics, although it is hard to tell with accuracy just how much of that is structural and how much is cyclical.

Richard McNeil, GOLDMAN SACHS




By and large, I think that what we have already seen in terms of foreign diversification into the EM space is mainly structural and any cyclicality will be seen as rates go up, if there is a reallocation of funds or outflows.

This is a very peculiar business cycle, which means there are no data points to compare and extrapolate from and it is very hard to accurately forecast how much and how soon interest rates increases will take place. Before the crisis, you could very easily say that a certain rate rise or movement in short term interest rates would trigger a rise in 10 year Treasury yields by so much. Now the situation is completely differ-ent. In addition, the depreciation of the euro and the weakness in the large economic blocks like Europe, Japan and at the margin, China, has put less pressure on the Fed. If the US economy was performing very well and the other large economies growing strongly that could have pushed the Fed towards more signifi-cant rate hikes.

You can debate timing issues and so on, but the 2013 episode — when expectations were not adequately managed in May and then very carefully managed in December — was a very powerful lesson for the lift-off of rates that we have ahead of us. I do hope that that will be the case and that we will have an orderly adjustment in the market.

: Is the buyside confident of an orderly adjustment?

Pin, Seguros Banamex: We are not expecting a large or permanent movement in any way, and I think there will be a certain order. But I would not go as far as to say it will be completely orderly; at the beginning we will see some discomfort or radical movements within the market. I also think that the rates lift-off will take a lot of time, not in terms of the first move but in terms of the moves that follow. It will not be a cycle in which the Fed increases rates every meeting or every couple of meetings. In our view the Fed will take time between one hike and the next, which will give more order to the price set-ting for longer term bonds.

De la Cerda, Sura: I agree that the Fed will take a lot of time to raise rates, and the potential GDP growth of the US has probably diminished somewhat after this huge crisis. This lift-off has been telegraphed since 2013, and people have been talking about it for a long time. Therefore it is already on our minds, which means the movements will probably come as people expect, unless we see a huge pick-up or downturn in GDP growth in the US.

Having said that, I think that the best way to shield the Mexican bond market is for us to have GDP growth. Mexico has to deliver some growth and all investors are waiting for this. They are wait-ing not only for Mexico to be pulled by the US, but for Mexico to capitalise on all that it has done on paper and implement all the reforms that have gone through Congress. Whether the Fed moves fast, slowly, or not at all, I think that GDP growth is the best way to shield Mexico from the effects.

McNeil, Goldman Sachs: I’d just add that the word ‘disorderly’ can encompass a wide range of out-comes. As a measure to set a base, let’s go back to

the Fed’s rate hike in 1994 — we all know what hap-pened in Mexico at the end of that year. There is a reason why the market reaction was so disorderly: a certain percentage of the Mexican debt stock was in dollar-linked instruments that were due to mature in one year. If you look at any of the indicators — such as the reserves with which Mexico ended 1994 — it becomes clear that there was a very logical reason why capital markets participants were alarmed at the potential effects on the economy. I’m not saying this interest rate increase is going to be completely smooth sailing, but — within the realm of disorderly — if you look at where we are today and take any of those measurements the reaction should be calmer than what we’ve seen in the past. There are some very fundamental reasons for this.

Fullaondo, HSBC: Exactly. If you look at the mar-kets today, the vast majority of investors are wait-ing for yields to pick up, with most of them doing carry trades in India, Russia or Brazil for example. Everybody is expecting this increase in interest rates, and it will of course cause some volatility in the market, but if you analyse Mexico — the levels of reserves, how solid the curve is, the number of investors in the Mbonos market — it is undoubtedly one of the best prepared countries for this scenario.

Lázaro, Bancomer AM: Some of this is already priced into the slope of the curve. We are living in a very steep yield curve environment. When the Fed gave its previous hint of the start of a tightening cycle, the market reacted aggressively and during the initial movements Mexico moved pretty hard alongside many countries — both in the fixed income and the currency market. However, after a few days it started to become clear that Mexico is a different story as the country’s markets started to behave a little better than other emerging markets. I think this could hap-pen again. As has been said, the pace of the move-ment is going to determine just how volatile the environment becomes, and it’s difficult to envisage a very aggressive pace of tightening right now given there is QE in Japan and Europe. I think the pace is going to be slow and we are therefore not going to experience a very sharp movement at the beginning of this.

: You said earlier that in 2013, Mexico differentiated itself because of the positive story

Juan Claudio Fullaondo, HSBC




behind it. But if growth doesn’t materialise will investors still be as patient?

Lázaro, Bancomer AM: Growth is needed, but the main issue for a bond investor is the ability of the issuer to pay, and I think that is very well anchored in Mexico where there are both local and foreign investors. That is the primary reason for an investor to go into the fixed income market, and in that sense we are in a better position than many countries. Of course, if growth does materialise then fundamentals will improve, increasing confidence in investing in these bonds. But the premium investors are receiving in the Mexican yield curve is good enough to com-pensate for the risk.

Díaz de León, Ministry of Finance: Just a quick comment on growth. I think it is fundamentally important that Mexico is one of very few emerging markets that is so tightly linked to the US. It means that our business cycles tend to be more correlated — even though there have been occasional differ-ences in the past — than other emerging markets. If we look at some of our Latin American peers, we find that their economies are following the opposite trend to the US economy. For them the challenge is going to be double, because they will have weakness in the domestic economies and will therefore need lower rates, but will find a higher interest rate envi-ronment. I think the fact that our business cycles are more synchronised is going to reduce the stress level and trade-off in terms of growth that comes with higher rates.

Lázaro, Bancomer AM: Growth, just to comple-ment my earlier point, helps to improve the fiscal stance of Mexico. If the income side of government is performing better, that also gives investors more confidence that the ability of a country to fulfil its obligations is strong.

Fullaondo, HSBC: On this subject, I would also like to add to Alejandro’s comments: we must not forget to mention the energy reforms. When the effects of these reforms start kicking in and the price of oil recovers, we will be in a much stronger position than many countries around the world.

: On the subject of the oil price, has it affected Mexico’s borrowing, perhaps requiring the shortfall to be made up in the debt markets for the quasi-sovereigns, for example?

Díaz de León, Ministry of Finance: For many years now the Federal government has had a policy of hedging, in international financial markets, our net oil price exposure. That has several advantages. One of them is that whenever the budget is approved by Congress, before the year starts, we already know that the exposure of the budget to changes in oil prices is non-existent. That avoids having to ask the question of whether to raise the deficit or not. It means that you will not need to raise extra financing from either local or international markets. Therefore the oil hedging strategy has clearly provided very positive results in how it insulates the yearly budget from swings in oil prices.

Nonetheless, this particular contraction of oil

prices was very strong and probably had more permanent than transitory components, which is why even as early as January the government had announced a spending reduction. The idea here is basically to adjust gradually, by trying to smooth out the expenditure adjustment that you have to under-take when you say goodbye to a world of $100 a barrel of oil. In this sense, the hedge that is in place for this year has allowed the government to spread the expenditure adjustment by carrying it out over a two year period. There was a budget cut announced in January, and the most recent figures presented to Congress for next year have an additional budget cut. Each is more or less similar in magnitude at around 0.7% of GDP. This is more or less how we have been able to cope with lower revenues coming from oil. On the debt side we have not been pressured into issuing more or adjusting our funding plans, thanks to this hedging mechanism.

McNeil, Goldman Sachs: When we started this con-versation I was talking about the predictability of Mexico’s behaviour. This is a clear example.

: Has the lower oil price had an effect on appetite in the Mbonos market?

Lázaro, Bancomer AM: It depends on how you han-dle the lack of revenue you will face compared to previous years. Our first impression was to wonder whether Mexico would try to handle this situation by issuing more debt or if they would reduce the spending budget. So far the government has taken the approach of undertaking some spending cuts and trying to maintain debt ratios. That is good for us as investors and is the approach that we wanted. In that sense if the debt ratios do not deteriorate it’s not a matter of concern.

: People appear very excited about the energy reforms — perhaps none more so than Moody’s, which granted Mexico an A3 rating last year. Does Mexico have a deliberate strategy to win a clean sweep of A ratings or are ratings just a side-effect of good work?

Díaz de León, Ministry of Finance: I would start by highlighting that in Mexico there have been two major waves of structural reforms in the last 30 or 40 years. The first one, in the early 1990s, basically

Jaime Lázaro, BBVA BANCOMER ASSET MANAGEMENT




had two objectives. At that stage we were coming off the boom and bust cycles of the 1970s and 1980s, so a wave of reforms was designed on one hand to increase macroeconomic stability through measures such as the independence of the central bank. But the other key part was Nafta, which was basically designed to redefine Mexico from a relatively closed and commodity-based economy towards an indus-trial economy with a very open trade sector. That gave a lot of weight and adequate incentives for mar-ket discipline to the tradable sector of the economy. However, we had a lag in the non-tradable and other key inputs markets, and this is basically the common denominator of the reforms that have been enacted in the last two years: labour, education, telecoms, financial and energy.

Previously, it was constitutionally the sole respon-sibility of the federal government to exploit energy. The objective of these reforms is to complement other sources of growth, because clearly we have been too dependent on the US for growth. This is because the domestic sources of growth have not been fully exploited, in part by these non-tradable and key inputs markets that have significantly lagged and were neither very attractive to investment nor very productive. This is precisely the objective of the reforms: to eradicate some of the things that made Mexico quite bizarre, such as being an energy-rich country but not fully benefiting from that position.

That is going to take time. Nafta took several years to have a transformational effect that changed the economy; Mexico is now one of the few emerging markets that is not commodity-based. The effects of Nafta are long lasting, and these reforms will also have very long lasting and meaningful effects on the economy.

Of course there are low hanging fruit that the implementation of the reforms tries to obtain, and round one is going according to plan. For example, one of the benefits of being so late to open up the energy sector is that there are still old technology oil fields like shallow water available for invest-ment, and this is something from which we’ll try to profit. In the future I do believe that this is going to increase investment opportunities in Mexico; we are already seeing that, and next year the rate of GDP growth is expected to continue its recovery phase. All this is going to be a strong argument in favour of additional upgrades. We tend not to target upgrades as an end in themselves but more as a reflection of the state of the economy. It is very positive that we already have an A rating and hopefully we will have more soon.

: Juan, has the A rating changed in any way the conversations you’re having with fixed income investors about Mexico?

Fullaondo, HSBC: To be honest, people were already very optimistic about the country, and the amount of money people have been putting into emerging markets for the last two months has been positive: you can see that in the spreads. Unfortunately we don’t have more paper available. Given the scarcity of emerging market paper — especially from Brazil — there is a lack of new paper in the market. There is a huge appetite from the investor base to step into Mexico in any currency: dollars, euros or pesos.

Hopefully we’ll see more activity in that regard.

McNeil, Goldman Sachs: I’d suggest that we compare where we are today to, for example, when Mexico got its first investment grade rating. Back then, I perceived a very deliberate strategy on the part of Alejandro’s predecessors to obtain that investment grade rating, and that investment grade rating had a very profound effect. The effect wasn’t so much on the nature of the conversation that you were having, because the macroeconomic developments taking place and the evolution of policymaking were part of a process, but rather on whom you could have that conversation with. Getting to investment grade really meant a step change in the number of investors that were looking at Mexico. These developments that Alejandro is describing are great, but my sense is that we aren’t seeing the sort of profound shift that happened back then.

: Could another couple of A ratings make a step change in the investors you could talk to?

McNeil, Goldman Sachs: I don’t think so. I see it more in terms of a continuum than a step. I hope I’m not contradicting Alejandro here.

Díaz de León, Ministry of Finance: No, I agree with Richard. One transaction that exemplifies this was the recent 100 year trade in euros. The names in the book — including European central banks — and the size of the book say a lot and exemplifies that point. Mexico has proven itself to have unique market access.

Fullaondo, HSBC: If you look at the quality of inves-tors that usually get their hands on Mexican paper, they tend to be buy-and-hold investors.

: These 100 year trades grab a lot of attention. Is this part of your motivation? Or is it just a cold calculation of price versus maturity?

Díaz de León, Ministry of Finance: We evaluate every transaction on how it meets our strategic objectives. We have funding needs, and we have diversification needs. For the ultra-long instruments in particular, there is usually a specific niche of investors that is willing to buy at that maturity. I don’t think any of the players in a 100 year bond would substitute that to buy one of our 10 year bonds. So part of the motivation is to cater for a niche of investors willing to put their money in an ultra-long instrument — a unique niche.

The other motivation is to diversify the investor base, and we saw very clearly in the sterling cen-tury bond that there were insurance and annuities companies that would not have participated in other Mexico issuances. Of course, these deals also reduce refinancing risk. Sometimes we tend to only think about duration, and it is true that the extension in duration is not that large, but the difference in refi-nancing risk is very substantial.

Finally, there is the question of what these deals convey to the market. Mexico is trying to build a bridge from the emerging markets to the developed world, and one way of consolidating that is to have a strong presence in these markets even including 100




year bonds. There are some preconditions required in order to issue a century bond, including regular presence in a given market and having a significant yield curve in those markets. Not every EM country — for different reasons — has been developing its presence in dollar, euro, sterling and yen markets like Mexico has. This puts us in the position to carry out that extension at good levels, but getting to that position takes some time. I would add that in terms of rating and the credit quality you should have a good track record and outlook.

McNeil, Goldman Sachs: To give an example of how I see this, I would highlight that one of Mexico’s 100 year deals was brought in the aftermath of the US credit rating downgrade. As we all will remem-ber, the downgrade coincided with a really tense situation in US Congress regarding the debt ceiling. My sense was that there were a lot of people in the capital markets who were not really quite sure what to expect, whether in terms of what would happen if Congress did not reach an agreement, or what the downgrade’s effect would be. In carrying out the 100 year transaction, Mexico accomplished two things on the signalling front that I think were really important. The first one was the calmness and deliberation right in the aftermath of such an event that Mexico showed by stepping into the markets to do a transaction of that nature. It really told market participants something about Mexico’s decision mak-ing and rationale. The second aspect is a bit more subtle. Often times when you are doing a bond deal, although market participants can observe the vari-ous announcements related to the transaction, most investors are not actually speaking to each other about a deal while it is happening. Consequently, one of the end results once a transaction is priced is to reveal to each investor how other people are looking at the credit. In the aftermath of the UMS’s 100 year getting successfully executed, I think a lot of investors — who were themselves willing to com-mit to the order book but perhaps did not have a very strong sense of what the rest of the market was thinking — immediately found that the confidence they had in their own view of the credit was bol-stered. I believe that when you have an issuer that can, in times of uncertainty, step into the market boldly, it is quite a profound thing. I think people overlook that sometimes.

: Do you consider Mexico to be closer to developed countries?

Díaz de León, Ministry of Finance: Emerging markets are countries that are under construction. In Mexico there are stories of things that have worked well, and stories of things that have not been working well and require much more work. That is precisely what we are trying to do. Our approach has been to have a very open economy very integrated to the global economy, and to try to play a role in develop-ing our markets and economy through the channels of market interaction. That interaction is in the debt and equity markets, and of course we have things to improve on and develop, but the overall approach has been to try to construct that bridge.

: What do local investors feel? Is there a

sense here that you are living in one of the leading emerging market countries?

De la Cerda, Sura: We have mixed feelings, because yes we read the newspapers and see some bad local stories, but then we look at what is happening out-side Mexico and realise that the same things happen in lots of countries. I don’t think that affects our investments, as we look more at the economic fun-damentals of Mexico and how it compares to other emerging markets. It is all about how Mexico com-pares with other markets. Where is the growth com-ing from? Is it from manufacturing and being linked to the US? Or does it come from a being commodity producer? If it’s not the latter, then we should do OK.

: There are plenty of positive economic headlines about Mexico in the international press. Despite the bad local stories you mention, do you feel Mexico is a leader in emerging markets?

De la Cerda, Sura: We are seeing a lot of companies coming to invest in Mexico, and a lot of internation-al private equity managers trying to invest in Mexico looking for real estate yields or infrastructure yields. For example a Canadian pension fund has bought toll roads from ICA. That tells you how Mexico is seen, and we have to look at the economy on a non-sentimental basis. We can see newspapers and read bad stories, but at the same time see that Mexico is providing an opportunity. You can read bad news in any country.

: So the international enthusiasm rubs off because you realise you’re in a good place?

Pin, Seguros Banamex: Obviously the international enthusiasm rubs off on local investors. But I actually think that it is a pro to be a local investor here as news from here — and I mean social, not economic, news — is often magnified outside Mexico. As Mexicans we may realise that some of these develop-ments are exaggerated outside the country. On the other hand, sometimes on the macro front interna-tional investors tend to see things on a higher level than we see them. So yes, the international enthusi-asm helps, and being local has pros and cons.

McNeil, Goldman Sachs: Maybe this is heading a little off topic, but I think it is a natural part of the

Leonardo Pin, SEGUROS BANAMEX




democratic process that the people who’ve elected politicians have a different set of expectations and place different demands on them than people who haven’t. This is not unique to Mexico. For example, around 2008, in the aftermath of the Lehman default and disruption in the capital markets, I was on a business trip to another Latin American country. I met with a client who said that he actually found it reassuring that T-bills traded at negative yields that morning. He said it was a sign everything was going to be OK, as he put it because when such turmoil occurred ‘in our country, the last place you would put your money would be the government bond market’. I don’t imagine there were too many people in the US at that time expressing satisfaction that the world was a safe and orderly place. To have such dif-fering expectations and different measures of success is a natural thing, I think.

Fullaondo, HSBC: Any country has its challenges, and here the press has magnified them to a large extent. As an investor, if you analyse Mexico versus the other countries in the region you realise that there are very few regions in the world that offer you that opportunity. Just take the country’s sound economic policy, the exchange rate and free flow of the cur-rency, the population demographics, the closeness to the US, the manufacturing industry and the infra-structure the country is building, for example.

Díaz de León, Ministry of Finance: How foreign investors perceive the country versus how local investors do is all linked to their respective bench-marks. For foreigners the benchmark is a world where things are getting more volatile, EM countries are sliding down from their peak, there is a reverse in fortunes for commodities, and we are seeing the end of very rapid rates of growth. Mexico in this sense can tell a different story, thanks to manufactur-ing and the link to the US as has been mentioned. However, for locals the benchmark is probably how much the economy and their businesses grew last year and the year before and why things are not kicking in. But the structural reforms are so pro-found in what they are changing that it will take time for some of them to settle and really get invest-ment going. This year we’re starting to see that.

: Returning to this idea of bridging this gap, people now have great expectations of Mexico’s capacity to carry out novel trades, despite being an emerging market. One of these new ideas that has been reported was a potential Sukuk deal. Is this still on your radar?

Díaz de León, Ministry of Finance: Our external funding, as I have said, complements our local fund-ing and is thus a relatively small share of our financ-ing. We only have a few transactions to execute every year and therefore have to be judicious in committing to markets where we believe it is use-ful to develop a long term presence, well function-ing yield curve and useful reference point for other potential Mexican issuers. That is how we have decided on the four markets in which we issue on a regular basis (dollar, euro, yen and sterling).

Opening a new market is something that we are willing to consider and for which we evaluate the

pros and cons. The sukuk market is particularly challenging. Mexico is co-chair at the G20 of an investment working group alongside Indonesia and Germany, with Germany being responsible for look-ing at the sukuk. It is not something that should be taken lightly and requires a lot of work and commit-ment. Given that it is so focused on the real asset component, other Mexican issuers would probably be better suited to the instrument than the sover-eign. It is something that other public sector issuers can look into.

Fullaondo, HSBC: As Alejandro has commented, there are some corporates that would be able to tap that market. It’s a great market that is highly linked to the dollar, it represents a whole new potential investor base, and I think you can become a frequent issuer. The only issue is that by Islamic law you have to comply with a lot of internal regulation and the amount of work you would have to put in is quite complex, for example with pledging some assets. I certainly think that eventually we will get there with some Mexican institutions, and that would be a very useful path to take and a very good way to reach another investor base.

Díaz de León, Ministry of Finance: I have one further question for investors: are you feeling lower liquid-ity as a result of the regulation that has been put in place in recent years? This is very important for the dynamics of the bond markets and I wondered if these changes in regulation are already being felt?

De la Cerda, Sura: There are people writing about this and we’ve certainly seen some diminished liquidity in the bond markets — but liquidity is dropping in all markets. It is a different size to the Mexican market but even US Treasuries have become less liquid than they used to be. Right now it’s not affecting us, but we know that the issue is there and is something to be addressed in the future.

Lázaro, Bancomer AM: For me, the crisis and the subsequent reduction of the balance sheets of many banks have had a really large impact on the liquidity of the Mexican market.

De la Cerda, Sura: Exactly, I was talking about Dodd Frank and the fact that banks have more capital requirements and smaller balance sheets.

Díaz de León, Ministry of Finance: This is one of the challenges we are trying to address, so we are trying to work out exactly how it is affecting the ecosystem. We will probably see the marketplace less dominated by the large market making banks, with institutional investors likely to take on a larger role and presence and fostering liquidity. We are trying to gauge how to cope with these new challenges and adapt to them so that the levels of liquidity are maintained or enhanced.

: In that sense, is Mexico in a privileged position having such large foreign holdings in its debt curve?

Díaz de León, Ministry of Finance: Having more stakeholders in our yield curve clearly benefits liquidity.



THE ENERGY SECTOR

WHEN MEXICAN Congress passed a constitutional amendment in December 2013 opening the energy sector to private investment for the first time since the industry was nationalised by President Lázaro Cárdenas in 1938, it represented what Standard & Poor’s described as a “watershed moment” for the country.

The world’s largest infrastructure investors agree. “Clearly the energy reforms are transformational not just in the context of the Mexican economy but also in a global con-text,” says Jon Walbridge, managing director of Macquarie Infrastruc-ture and Real Assets (Mira) Mexico.

“By oil, gas and shale reserves, proven and unproven, Mexico is in the top 10 countries in the world. But for more than 70 years prior to these reforms, it had also ranked among the 10 countries in the world whose energy sector has been most closed to private sector investment.”

The changes to the energy regime are the cornerstone of the broader Mexican reform programme, and invite private partners to partici-pate in the oil and gas sector, pri-marily through joint ventures in the form of profit-sharing agree-ments and production-sharing con-tracts.

Pivotal to the reforms is the transformation of the state-owned petroleum company, Pemex, which is the world’s eighth largest oil pro-ducer, by making it a “state-owned productive group” enjoying much more independence from the gov-ernment. The Federal Electricity Company (CFE) also enjoys great autonomy as a result of the reform.

The change to Pemex’s legal sta-tus also relieves it of some of its pension liabilities and reduces its tax liability. According to Pemex’s latest investor presentation, the

reforms will reduce its total tax burden from 70% today to 65% in 2019.

Analysts regard the reforms as a breath of fresh air for Pemex. “The passing of the energy reform is the first step in what we believe will be a series of steps that will change Pemex from a slow-moving state-owned oil and gas monopoly to a more dynamic energy compa-ny,” wrote Bank of America Merrill

Lynch soon after the announce-ment of the reforms.

The changes at Pemex have had no impact on its rating, with Moody’s noting last year that the company will remain “closely linked to the government of Mexi-co, which will continue to provide strong support, given the compa-ny’s importance to the government budget, to the oil sector and to the country’s exports.”

Mexico’s energy reforms are a game-changer, with some saying oil and gas output could be doubled over the next 10 years, meaning the country could become one of the top five producers in the world, rivalling the likes of Iraq and China. However, the oil price needs to recover first for the ambitious programme to be fully realised. Philip Moore reports.

Oil price casts shadow over Mexico’s ambitious energy reforms

Analysts think Mexico’s energy reforms will bring a breath of fresh air to Pemex

017-20 Mexico Energy Sector.indd 17 09/07/2015 18:32


THE ENERGY SECTOR

Sweeping reformsThe government initially forecast that its sweeping energy reforms would attract inflows of some $12.5bn a year over a five year peri-od, adding 1% a year to GDP over the same period, which analysts reckoned was attainable. As Ernst & Young put it in a report published last year, “given Mexico’s sub-stantial reserves and the interest among international energy com-panies, including many from the US, these objectives are definitely within reach.”

Other independent forecasters have been equally upbeat about the possible impact of the reform pro-gramme on the Mexican oil and gas sector. According to a client brief-ing published by law firm Fresh-fields Bruckhaus Deringer, the US Energy Information Administration (EIA) has calculated that the reform could yield a 75% increase in Mexi-co’s long term oil production.

BAML, meanwhile, puts the long term potential of Mexico’s energy revolution into perspective, saying that some estimates suggest that oil and gas output could be dou-bled over the next 10 years. “Should this occur,” says BAML, “Mexico could become one of the top five oil producers in the world, rivalling the likes of Iraq and China.”

This promising outlook, says E&Y’s report, is because Mexico’s decline in oil production over the last two decades has been princi-pally a product of lack of invest-ment and technology, rather than a result of geology. This was in turn a function of the state’s asphyxiating control of the oil and gas sector.

Mira’s Walbridge says that the motivation for relaxing this con-trol is two-fold. “First, it’s about improving the government’s fiscal

position, given that a third of its revenues come from Pemex, which has seen its oil production decline by more than 20% over the last 10 years,” he says. “Mexico urgently needs to arrest the decline in pro-duction, which is why the reforms are aimed at attracting private sec-tor expertise and best practice as well as cost-competitive capital.”

“Second,” says Walbridge, “although Mexico has a very pro-ductive manufacturing sector, it remains hampered by the high costs of energy in the domes-

tic market. So the second leg of the reforms is aimed at increas-ing the share of gas in Mexico’s overall power generation mix and improving the efficiency of its domestic generation, transmis-sion and distribution.”

Not before time. According to numbers published by JP Mor-gan, as of the end of 2014, indus-trial and commercial costs of elec-tricity were 40% and 88% higher respectively in Mexico than in the US, while costs for residen-

tial users were 28% cheaper south of the US-Mexican border. That still left the total average cost 13.5% higher in Mexico than in the US, which has obvious implications for Mexican competitiveness.

Dismantling the state control over Mexico’s energy sector may look like a rational enough way of arresting the headlong decline of the sector, which has seen crude oil production fall continu-ously since 2004. But as a work-ing paper published last year by the Americas Society/Council of America Energy Action Group advises, “there is virtually nothing in the Mexican political and histori-cal context more politically fraught than energy, and the difficulty of reform cannot be overstated.”

Colourful proof of that has been provided by Mexico’s fiery leftist leader, Andrés Manuel López Obra-dor. In 2013 he issued a belligerent hands-off warning to internation-al oil companies, reportedly say-ing that foreign investment in the industry would be tantamount to “piracy”, and writing to the CEO of ExxonMobil to warn as much.

Breaking the monopolyThe majority view, however, is that

energy reform is a necessary and brave initiative. “Breaking the pub-lic sector’s monopoly on upstream and downstream activities in the oil industry is clearly a very posi-tive development,” says Alberto Ramos, head of Latin American economic research at Goldman Sachs in New York. “It has created the opportunity to engage private capital in a sector that was very inefficient on all counts.”

That may be. But this opportu-nity also comes at an unfortunate moment for the global oil indus-try. “Investors have not respond-ed in the way the government had hoped,” says Jan Dehn, head of investment research at Ashmore Investment Management in Lon-don. “But this has nothing to do with the reform programme itself and everything to do with the fact that the oil price collapsed just at the time that the new invest-ment environment was supposed to be attracting investment.” From a high of more than $100 a barrel, the price of Mexican export crude oil reached a low of below $40 early in 2015.

Economists agree that the weaker oil price is one factor that makes the government’s forecasts of like-ly investment flows into the sec-tor over the next five years look optimistic. “The government may have to delay some of the projects announced before the dramatic fall in the oil price, in particular those related to shale oil and shale gas,” says Lorena Domínguez, economist at HSBC in Mexico City. “Even in the US, there have been some pro-ject cancellations in the shale oil and shale gas sectors.”

Specifically, Dominguez says that HSBC expects the reforms to gen-erate investment of $30bn by 2019,

“Breaking the public sector’s monopoly

on upstream and downstream

activities in the oil industry is clearly

a very positive development”

Alberto Ramos, Goldman Sachs

“The oil price collapsed just at the

time that the new investment

environment was supposed to be

attracting investment”

Jan Dehn, Ashmore Investment

Management



THE ENERGY SECTOR

rather than the $50bn originally forecast by the government. HSBC is also forecasting that the reforms will underpin a rise in potential GDP of between 1% and 1.5%, but only by 2021 — not by 2018, as it originally estimated.

In light of the oil price decline, the progress that has been made in bringing investors into oil and gas projects in Mexico has been impressive. “There have been some minor delays, which I would have expected in a process so complicat-ed,” says Pablo Riveroll, fund man-ager in the emerging market team at Schroders in London. “But the reduction in oil prices has not real-ly changed the government’s agen-da with regard to energy reforms.”

Round ZeroThe first stage in this process, known as Round Zero, allowed Pemex to bid for rights to fields where it could demonstrate that it had sufficient technical and finan-cial capability to develop inde-pendently or in joint ventures with the private sector. The results were announced in August 2014, and allowed Pemex to retain 83% of Mexico’s proven and probable resources and 21% of its prospec-tive resources. Pemex’s entitle-ments over these areas allow it to carry out exploration and develop-ment, with or without joint-venture partners.

That paved the way for round one of the bidding process, the first stage of which was announced in December 2014 and invited bids for shallow-water exploration. This attracted a Who’s Who of interna-tional energy giants to the newly liberalised Mexican market, with the likes of ExxonMobil and Chev-ron among the 19 companies select-

ed to bid for the first auction of 14 oil blocks. “The first two tenders in round one, which involve produc-tion and extraction of oil in shallow waters, attracted very strong inter-est from local as well as interna-tional investors,” says Domínguez at HSBC. “This reflects the fact that Mexico remains very com-petitive in the production of oil in shallow waters.” The cost of shal-low water production, she says, is about $20 per barrel.

Analysts say it is not just the relatively low costs of Mexican shallow water production that are appealing to international oil com-panies (IOCs). “The US side of the Gulf of Mexico has become satu-rated by decades of open market exploration activity,” says Lucas

Aristizabal, senior director of cor-porate ratings at Fitch Ratings in Chicago. “The companies that have been operating in this crowd-ed market for years now have the opportunity to deploy their oper-ating knowhow across the border, in an area that remains relatively unexplored.”

Schroders’ Riveroll says that the bidding process for round one of the oil block auctions may, if any-thing, be moving faster than the private sector had expected, leav-ing some prospective bidders under-prepared.

“The authorities are keen to have the bidding rules for all the phas-es published this year,” he says.

“According to the authorities, some of the bidders are even asking the government to slow down because they want more time to analyse the projects and put their consortiums together. At this rate we may have all the shallow water and semi-shallow water production projects awarded by the end of this year.”

Unconventional projects hitThe bidding process for the remaining stages of round one, cov-ering unconventional shale oil and gas and deep water fields, is less straightforward. This is the area that appears to have been most immediately impacted by the weak-ness in the oil price, with Pemex already having announced the postponement of a number of deep water projects. S&P cautions in a recent update that “non-conven-tional operations, whose bids were supposed to take place no earlier than 2016, might be at risk if the currently low oil prices persist.”

Ramos at Goldman Sachs points out that it is important to distin-guish between the different types of oil plays that have been the focus of most investors’ attention. “The most interesting short term pros-pect appeared to be shale oil and gas which shares similar geologi-cal characteristics to formations in the US,” he says. “But anything that could have produced an immedi-ate dividend from the reform is not going to be possible in this oil price

“The opportunity set for equity investors

in the oil drilling sector is still small”

Pablo Riveroll, Schroders

Electricity tari�s in Mexico

Source: Ministry of Energy

0

5

10

15

20

25 USD cents per kWh

Residential Commercial Industry

1999 2002 2005 2008 2011 2014

Electricity tari�s in Mexico

Source: Ministry of Energy



THE ENERGY SECTOR

environment. If oil prices recover, or if technological progress reduces the cost of shale oil and gas pro-duction, we will see substantial investment in the sector. But this won’t happen in the short term.”

The long term potential of Mexi-can shale oil and gas is certainly compelling. According to BAML’s research, with 545tr cubic feet and 13bn barrels of recoverable shale gas and oil resources, the US Department of Energy estimates Mexico is the world’s sixth largest holder of shale gas and the eight largest source of shale oil.

Offshore deep water projects, meanwhile, continue to look prom-ising over the long term, according to Ramos. “Lifting costs are such that deep water development in the Gulf of Mexico remains viable even at current prices,” he says. “But developing a new offshore frontier takes four to six years.”

With about 29bn barrels, which is the equivalent of more than half of Mexico’s total oil resources, lying in deep water fields that have been almost untouched by Pemex, it is unsurprising that their long term potential should remain appealing to developers with the necessary technology to explore them. “In the case of deep water exploration, there could be interest from major operators, as they base their deci-sions on a medium term perspec-tive,” notes HSBC’s Domínguez. “Energy experts estimate that the cost of production in deep water fields could oscillate around $32 per barrel.”

The government takeFitch’s Aristizabal cautions, how-ever, that lifting costs and the glob-al oil price are not the only inputs that go into IOCs’ calculations in their assessment of the econom-ics of exploration and production in Mexico. “Another component that is as important, if not more so, than oil price is the government take,” he says. “Mexico has been used to charging Pemex extremely high royalties or duties on oil pro-duction. During the past five years, Pemex’s transfers to the govern-ment have averaged 53% of sales. For production sharing contracts, Mexico offered during the first round a sliding scale royalty sys-

tem with a floor of 7.5% for oil and condensate when prices are below $48 per barrel and increasing as a function of price thereafter. This, in addition to the profit share for the government that depends of the project’s complexity, will rep-resent the government take.”

The investment opportuni-ties arising from Mexico’s far-reaching energy liberalisation have attracted the attention of investors at a number of levels. At a broad FDI level, economists say that they make Mexico a more attractive destination for manu-facturers. This is because allow-ing the private sector to compete in generation and marketing of electricity is expected to lead to a dramatic reduction in costs for industry. “The creation of a com-petitive environment for CFE will force it to revise the cross-subsidy scheme which benefited residen-tial consumers at the expense of commercial and industrial electric-ity users, which will lead to more competitive tariffs,” says Fitch’s Aristizabal.

Electricity costs are also expected to come down as a result of reforms allowing the state-owned Feder-al Electricity Commission (CFE) to invest in the gas sector.

“According to the CFE,” notes HSBC’s research, “the company aims to reach 65% of electricity power generation through natural gas, which is expected to reduce electricity tariffs.”

Infrastructure opportunitiesThe liberalisation of Mexico’s ener-gy market also opens an abundance of opportunities for the world’s leading dedicated infrastructure investors. They don’t come much larger than Macquarie, which is licking its lips at the prospect of building its exposure to the Mexi-can market. “We are prioritising opportunities in midstream areas ranging from power generation to oil and gas transportation, power transmission and oil storage,” says Mira’s Walbridge. “This represents a very big sector in any energy resource-rich country such as Mex-ico and we would expect opportu-nities to increase further as Mex-ico begins to meet its aspirations regarding increased output on the

upstream exploration and produc-tion side.”

Among institutional investors, exposure to opportunities aris-ing from energy reform may be limited in listed equity markets. “Although a number of the con-struction companies in some of the bidding consortiums are open to investment, the opportunity set for equity investors in the oil drilling sector is still small,” says Riveroll at Schroders. “But there are other ways to get exposure to the impact of energy reforms, such as through the petrochemicals sector as well as some of the Mexican suppliers to the oil production projects, which will benefit from local content requirements.” According to HSBC, these national content minimums will start at 25% in 2015, gradually rising to 35% by 2025.

Nevertheless, the limitations on opportunities in listed equities is one reason why Mexico’s private pension funds (Afores) are eager to up their allocation to infrastruc-ture via exchange-listed Certifica-dos de Capital de Desarollo (CKDs), investment trusts that give them access to illiquid asset classes such as private equity, real estate and infrastructure. According to the industry regulator, Consar, as of mid-2014 the funds had invested $5bn in CKDs, meaning that they had regulatory capacity to invest a further $20bn.

This capacity is likely to dimin-ish rapidly, given the Afores’ appe-tite for exposure to infrastructure in general and energy in particular. “We’re very excited about the ener-gy reforms and we believe we will be increasingly important players in the sector,” says Tonatiuh Rod-riguez, director at Mexico’s largest private pension fund, Afore XXI-Banorte.

“The government may have to delay

some of the projects announced before the dramatic fall in the oil price, in par-

ticular those related to shale oil and

shale gas”

Lorena Domínguez, HSBC Mexico City


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Mexican Corporate Borrowers’ Roundtable

: Mexico is accounting for more than 60% of Latin American bond issuance this year. Is this going to be the new norm and has the way fixed income investors are seeing Mexico changed?

Katia Bouazza, HSBC: Mexico accounts for such a large percentage of Latin American issuance because Brazil issuance has been low in 2015. We would like to see Mexico make up 60% of issuance in normal market conditions. With the reform agenda, a lot more supply was expected from Mexico, but — simi-lar to other countries in the region — investors have not seen as much new paper as they would like.

There is a strong appetite for Mexican issuers across the board, whether it’s local currency, dollars, euros or private placements, but there is not enough supply. Regular issuance from the frequent borrow-ers like UMS and Pemex has taken place and has been extremely well received but that’s not enough. We’ve seen a few corporates come to market but the market would like to see more, and indeed investors are asking for more.

Richard McNeil, Goldman Sachs: To me 60% is just an arbitrary figure. I think it’s much more about find-ing out what needs companies have and where they find the most efficient financing levels. Katia’s points about investors having a positive attitude towards Mexico are absolutely correct, though we’ll see what happens later in the year when the Fed decides to hike.

: Pemex has been the greatest contributor to this year’s supply, issuing in great volumes and at good prices. Carlos, as a Mexican borrower, have you ever enjoyed funding conditions as attractive as today’s?

Carlos Caraveo, Pemex: Well I’ve been in the job for three or four years, Gerardo was in the job before me.

Gerardo Vargas, Fibra Uno: No, I definitely never had conditions as good as this!

Caraveo, Pemex: Conditions are very positive, but

Participants in the roundtable were:Carlos Caraveo, associate managing director of finance, Pemex

Richard McNeil, co-head of investment banking for Latin America, head of Latin American financing group, Goldman Sachs

Katia Bouazza, head of capital financing, Latin America, HSBC

Gerardo Vargas, vice-president of finance, Fibra Uno

Daniel Odriozola, corporate treasurer, Grupo Alfa

Tania Dib Rodríguez, deputy treasurer, Grupo Bimbo

Carlos Enrique Ochoa Valdés, chief financial officer, Crédito Real

Oliver West, moderator, GlobalCapital

Mexico’s corporates sitting pretty, but not complacent

Mexico could hardly enjoy a better reputation among emerging market investors right now, with companies in the country revelling in their new role as darlings of the capital markets. GlobalCapital met leading borrowers and banks in Mexico City to discuss how far-reaching the e�ects of the energy reforms will be, and the prospects for peso-denominated funding amid the government’s attempts to entice international buyers into the domestic corporate debt market.

022-30 Mexico Corporates RT.indd 22 09/07/2015 18:33



we’ve still had some challenges explaining the change in Pemex’s DNA as it has moved from being a state oil company to being a productive state enterprise. In 2014, we had to do a large consent solicitation with bondholders to authorise a change in our DNA that means we will no longer have a monopoly on the energy sector in Mexico. Now that’s done, I have found a very good market, with very attractive rates that allowed us to raise $6bn in dollars at the begin-ning of the year and recently tap the euro market for €2.2bn.

Pemex is always looking for market opportunities, but now the issue is that we are finding we can be opportunistic in all markets, so we want to be com-mitted to just three international markets. First there is the dollar market, because Pemex has 98% of its rev-enues in dollars, produces a commodity that is linked to dollars, and has three quarters of its costs in dollars. Secondly, we are also committed to the euro market. Where in the past we were just an opportunistic bor-rower in euros, now the idea is to have a very defined curve. Thirdly, we are also pursuing a Samurai deal. This is difficult after the change in Pemex’s DNA that I was talking about, which might have shifted the way Japanese investors think about our relationship with the government, so we have to work very hard with them.

Finally, we have the Mexican peso denominated market, which though I wouldn’t say has been tough, has certainly been more complicated because we always want to look for longer maturities. These mar-kets are there to pursue because the rates are attractive. I remember when we were in London at a roadshow last year and everybody was talking about rates being hiked imminently as there had been a very fluent speech from the FOMC. But here we are and rates are still attractive. It is certainly a good opportunity for other issuers to be prepared to issue.

: You mentioned that the perception of Pemex’s relationship with the government has changed in the eyes of Samurai investors. How has your investor base elsewhere taken the change in DNA you talk about? Do they see it as a good thing for Pemex?

Caraveo, Pemex: That is a good question. One of the challenges we had after the consent solicitation was to explain the changes inside Pemex to investors and to make the benefits of the energy reform clear. We have been all over the world explaining this change in DNA to investors. Losing the monopoly is not in itself a bad thing, as the link between the government and

Pemex remains very important since we provide about a third of the government’s income. Moreover, when Pemex was a state-owned monopoly it was responsible for providing oil and gas products to the most remote places in Mexico. Sometimes these activities are not that profitable, or may even be loss-making. I always like to give the example of Cancun airport, to which we have to deliver jet fuel. Doing this requires moving the product by truck from the port facility at Progreso in Yucatan, all the way through Mérida to Cancun, which costs us about $7 per barrel. If we put together a pipeline it will bring costs down to around $1.50 per barrel. With the energy reform, somebody else can build this pipeline, which is not that expensive, in order to get the jet fuel to Cancun. That would help us a lot.

Our bookrunners have always recommended that we explain everything we know to investors and do not hide anything, so we have very fluent conversa-tions with our lenders — from the banks to the bond-holders.

Another thing that has helped us in a certain way has been the events surrounding Petrobras. As we are in the same region and sector, investors were asking us about differences between us and them. We could give very detailed responses about our controls, how we do our business, and how our procurement procedures work.

: A last point on Pemex: how have your bond investors reacted to the slump in oil prices?

Caraveo, Pemex: Since the last quarter of 2014 the oil price has been the first thing investors want to talk about. But we have to realise that there are two distinct sources of income at Pemex: on one hand the exploration, production and export of crude, which is very linked to the oil price; but also the capacity to sell all hydrocarbons in Mexico — via pipelines, refiner-ies, gas stations and the 76 years of assets we have built up. At the end of the day the impact of the fall in crude oil was more on the government of Mexico, which is why Pemex does not hedge its exposure to crude oil.

The bigger question we have been answering con-cerns our production and the future of Pemex. Two days ago, the Minister of Energy announced round one of bids, and we are participating. One advantage we have is that we can capitalise Pemex’s assets to be operated by someone else. We can make more money out of those assets, and move it into exploration and production. Now we can migrate our reserves. We can carry out joint ventures, which was impossible before the energy reform. The scope of our sovereign immu-nity, which prevented us from getting rid of certain assets, has been reduced substantially. Just think about it: we could potentially sell, say, 50% of a refinery in order to capitalise and somebody else can operate it. So we have a lot more flexibility than before, which allows us to be less affected by the price of crude oil, and you can see that in the balance sheet.

: On the subject of energy reform I’d like to open up the debate. The positive momentum around Mexico has been in large part driven by this reform, but is there a knock-on effect for companies beyond Pemex?

Daniel Odriozola, Grupo Alfa: Alfa is involved in the energy sector and thus directly exposed to the energy

Carlos Caraveo PEMEX




reform, although maybe not to the same extent as Pemex. As we’ve said before publicly, we are inter-ested in the sector. We believe we are well positioned to capitalise on potential opportunities going forward. So I’d say there is a direct impact on Alfa.

Vargas, Fibra Uno: We’re coming from a very different sector, not exposed at all to energy. But our view is that it’s one of the questions on everybody’s minds. Every time we meet with investors we get ques-tions about our view on energy reform. I guess there are two factors. One is everybody was expecting an investment boom when oil prices were very high, and with energy reform happening there was an expecta-tion of tons of new investment heading to Mexico. We get asked about that.

But then you have to look through this slump in energy prices and look back to Nafta (the North American Free Trade Agreement signed in 1994), which came just a year before the Tequila crisis. Even worse than that, a few years later China joined the World Trade Organization, which was like dropping an atomic bomb on Mexico’s economy. Despite that, if you compare Mexico’s economy today versus the beginning of the 1990s you find it is totally different. Energy reform is a bit like that: the benefits are going to be seen mainly in the long run as more sources of capital are put to work in hydrocarbons.

Furthermore, everybody is forgetting about the effect on power, which is really one of the biggest drivers of the economy because we are a manufactur-ing country. We all get asked the question, and I think it’s a very positive thing. If executed right this will be a game changer for Mexico.

McNeil, Goldman Sachs: I emphatically agree with that point. Having lived through the Nafta experi-ence, Gerardo makes a very astute observation. We also talked earlier about the Petrobras situation, and of course there are a lot of idiosyncrasies there, but if you just take a step back and look at the structural reform agenda in Brazil for the last few years versus what’s happened here in Mexico, there are some important differences. I agree energy reform is a game changer, and I think market participants see it that way. Now that doesn’t necessarily mean, given where spot prices are and the oil price outlook, that you’re going to see an immediate investment boom. But my sense is that the point of structural reforms to a large extent is to improve the efficiency of the economy. I believe, therefore, that we could see something quite profound happening.

Caraveo, Pemex: Yes just to return to Gerardo’s point, even if he thinks Fibra Uno is not exposed to the energy reform, it certainly is.

Vargas, Fibra Uno: Yes, we will see the effects.

Caraveo, Pemex: The really big point is power. Energy is just going to be cheaper. We worked on a pipeline that will come from Texas all the way to Guanajuato in central Mexico in order to provide cheap energy to Mexico. This region has a lot of industry and right now they are paying $15 for a mil-lion BTU of energy, which is roughly what China is paying for natural gas. With the pipeline we will be able to transport energy so that it costs around one dollar for a million BTU. These manufacturers in the centre of Mexico, which is a very industrialised place, will become very efficient. The people at this table — Alfa, Bimbo — will benefit in the same way: they will buy efficient energy. It’s not going to be a boom. We were talking about it with economists of some large banks and they’d say, ‘GDP in Mexico will be 6%’. I don’t know where they come up with these numbers, it won’t be so black and white, but it will be reflected in everyone’s work.

Vargas, Fibra Uno: Exactly, everything will be affect-ed. Industrials will want to put more factories in Mexico, and that will affect consumption. Everybody at the table will be impacted.

Caraveo, Pemex: For sure. At the time of the Tequila crisis we just were building car parts. Now we build more cars than Detroit. Imagine the possibilities now that energy will get even cheaper. Today Mexico is making aeroplane parts, soon we could be making aer-oplanes — all because of cheap energy. That is going to happen. Previously, because of regulators, it was impos-sible for anybody else to do anything in the energy sec-tor. But now Pemex will not always be the provider.

: Tania, are your experiences similar? Do investors ask Bimbo, a food group, about energy reform?

Tania Dib Rodríguez, Grupo Bimbo: Yes, of course, though Bimbo’s case is quite different. I’m sure it will have an impact on consumer spending, which will benefit us, but Bimbo’s story has been about growing a lot and diversifying our revenue base. Now around 60% of our revenues come from outside of Mexico, and that’s the story that we have been telling. Bimbo has been trying not to depend as much as in the past on Mexico. So although we will benefit and the country will benefit, we are also focusing outside of Mexico. Canada and the US are now strong markets for us after we worked a lot trying to reorganise our operations in the US.

: Given Richard and Gerardo’s remarks about the energy reform being a game changer for Mexico, are there any benefits for Bimbo in terms of how investors perceive Mexico?

Dib, Bimbo: Yes, for the past three years or so we have been trying to achieve this — in the sense that we do not want investors to think of us as a purely emerging market credit any more.

: Have you been successful?

Daniel Odriozola GRUPO ALFA




Dib, Bimbo: I would say so.

Bouazza, HSBC: You can tell they have been successful because when Mexico was going through several big challenges the company did a bond offering and was still able to achieve very tight pricing. This was due to the way Bimbo has positioned itself and the way the story was presented to investors. Although Mexico now has a lot going for it and investor sentiment is very positive, spreads of its counterparts in North America are still much tighter. Therefore a borrower still wants to associate itself with North American comparables if it can, and Bimbo has done very well in that respect.

: Are other investment grade issuers discovering more interest from non-EM buyers, or is that only for companies that have operations abroad?

Bouazza, HSBC: Companies do not need to have operations abroad, but in the case of Bimbo it was a repositioning of the credit. I’d say that the gradual migration of the investor base from EM specialists into investment grade buyers has, for a lot of the people sitting at this table, been happening for the past three years. It continues today.

McNeil, Goldman Sachs: I agree with what Katia just said but would say that the process is even longer term than that. I’m simplifying drastically, but just imagine an issuer walking around Boston waving a prospectus and trying to interest bond investors: if the issuer sits in a single-B country, the number of investors who will take a look is smaller than if the issuer sat in a single-A country. As Mexico has gone through this process of improvement, gradually the universe of potential buyers has expanded.

In addition, I think that there was something of a step-change as we went through the crisis in 2008. Investors started to realise, to a greater extent than they had previously appreciated, just how battle-test-ed an average CFO in Mexico or an emerging market country is. 2008 was the first time in my professional lifetime that you’d ever seen creditworthy compa-nies from the Midwestern United States having huge liquidity issues and having trouble with their banks and so on. If you’d cut your teeth south of the border, so to speak, that was not necessarily a regular occur-rence but it happened relatively often. I think one of the things that resonated with a lot of investors who had not grown up in EM was that, as they dig in to the asset class, realise the challenges and meet the people, they realise just how expert the people are. That’s had a hugely positive effect and I feel as though there’s been something of a step-change coming out of the crisis.

Dib, Bimbo: To return to Carlos’ point, we have also done a lot of work trying to be as transparent as we can with investors, explaining what has been hap-pening with Bimbo, because the name is still that of a Mexican company and trying to position Bimbo as something different requires a lot of work. We have been doing a lot of work in investor relations explain-ing the story. That is something that all the corporates should be extremely focused on, regardless of the energy reform.

: Let’s turn to Crédito Real, the only high yield issuer at the table.

Carlos Enrique Ochoa, Crédito Real: Not only that but the only firm that has nothing to do with the energy reform at this point.

: Although we’ve heard that everyone is affected somehow?

Ochoa, Crédito Real: As most of the people on the table have said, we are going to see benefits eventu-ally. We are a microfinance company and we will get to see benefits when ordinary people start seeing ben-efits. We are operating all over the country.

Proceeds from the reforms from the 1990s began to be seen pretty much in the last decade, and I’m sure that our customers and we will notice the benefits of the energy reform in the next few years. What is really good for us is that despite being a lending com-pany and high yield issuer, when we are on the road people ask us about the energy reform instead of ask-ing all kinds of other questions they could ask about Mexico. That’s a pleasant side-effect.

In some ways it’s a new story for the country as a whole and I agree it will be a game changer. We will see proceeds in the growth of our customer base.

: Last year you did two successful international bond deals, but in general high yield conditions have not been so strong recently. How do you evaluate investor appetite right now?

Ochoa, Crédito Real: In my experience, corporate new issue volumes have been so low this year that investors are looking for opportunities. Therefore we’ve seen a lot of people in the past few weeks and months wanting to give us money. In that sense we are very confident and comfortable. We have all the ingredients needed to diversify our funding and try to do something new for the company. We are not as mature as the companies on this table are but we are working on that one.

: Katia, are all high yield issuers having this same experience of investors lining up at their doors, offering financing?

Bouazza, HSBC: I must say that a high yield borrower from an A rated country is very attractive. Obviously it depends a lot on the credit and sector, but we have not seen a lot of high yield issuance and there is — with interest rates still very low — decent appe-tite for higher yielding products. There has not been any issuance from Brazil, and appetite for high yield

Carlos Enrique Ochoa CRÉDITO REAL




out of Brazil would be very different to appetite for Mexican high yield, but we were even involved in a well received high yield issue from Argentina earlier this year. Though it may be selective, the appetite is there and for a healthy company from Mexico there may well be plenty of demand.

Odriozola, Alfa: Out of all the bonds Alfa has out-standing at the subsidiary and holding company lev-els, most of the reverse enquiry requests we receive are for Nemak, which is rated non-investment grade.

Bouazza, HSBC: This is due to investors looking for a pick-up in yield. They can either go out to the 30 year end on more established names, or turn to the high yield sector.

McNeil, Goldman Sachs: What I’d say about the demand for Nemak is that a lot of it is a real infatua-tion with the credit. I don’t mean to sound too casual, but people like the management and the story a lot. So of course there is this reach for yield and what-not amid quantitative easing and easy central bank policy, but my sense is that as you go down the credit spec-trum, people start to pay more attention to the idi-osyncrasies of each story, and of course the sectorial dynamics. There are differences between high yield auto parts companies versus high yield energy busi-nesses versus high yield consumer credits, and those are the dynamics that investors look at when consid-ering opportunity cost in the high yield space.

: On the subject of opportunity cost, let’s look at the issuer perspective. Daniel, Alfa has issued at subsidiary and holdco levels. What do you take into consideration when tapping the bond market?

Odriozola, Alfa: Traditionally our model has been to have our subsidiaries rated independently and financed on a standalone basis with no parent sup-port. Before we issued the bond at the Alfa level, our strategy was not to have any leverage at the holdco and have all the debt at the subsidiary level. The $1bn bond issue we did at the holdco last year was an exception driven by our strategy of looking to capitalise on energy opportunities. We have an energy subsidiary called Newpek, but it doesn’t have the size or financial muscle yet to raise the amount of resources needed, so we decided to issue at the Alfa level. Our expectation is that in five or seven years time, Newpek will be a much bigger subsidiary and can finance its own projects on a standalone basis like

the rest of our subsidiaries.

: To sum up, conditions in dollar markets have been very good. But soon we’ll face a US interest rate hike. Gerardo, Fibra Uno has issued in the dollar market but more recently has been more active in local markets — are dollar market conditions becoming comparatively less attractive as rates rise?

Vargas, Fibra Uno: That’s not why we’ve been issuing in pesos; it’s more a question of how we view the company. Most of our rents are in pesos; therefore we like our debt in pesos. We like peso rents because we sense there is going to be convergence. If conver-gence does happen, then our rents in pesos — which are inflation-linked — are in the long run going to end up being higher than dollar rents. That’s what convergence means: Mexicans become relatively wealthier compared to the world, so in real terms the currency should appreciate.

We went to dollars because there is a constraint in the local markets caused by the Afores having rela-tively limited allocations for non-government named issuers. In that same bucket they put equity and debt, so we’re constantly wondering if there is enough room for us to issue in pesos.

What we like with the dollar market is that it’s relatively easy to execute long term deals. As Richard was saying, all of us at the table have gone through very extreme cycles, and we’re in a cyclical business, so we try to manage that part of our balance sheet and not to minimise interest cost. That means we like to issue long term and do fixed rate financings, and as long as that is available in Mexico we would rather issue in Mexico. But if not, we will issue in US dol-lars and swap proceeds back to pesos. We do have dollar income — around 25% of our revenues — but right now we have a coverage ratio of $1.70 of rents coming in for every dollar that we spend in interest expenses, and we want to keep it that way.

Odriozola, Alfa: But can you achieve the same tenors in the Mexican peso market versus the US dollar mar-ket?

Vargas, Fibra Uno: In our debut deal in the dollar market we issued 30 year debt, which I think would have been impossible in Mexico, where if we reach 10 years that is very good result.

Bouazza, HSBC: And you have to take into account size, too.

Vargas, Fibra Uno: Indeed, sizes are smaller in Mexico.

Caraveo, Pemex: The thing is you have fewer inves-tors here, the investor base is highly concentrated in the Afores.

Dib, Bimbo: Yes, and local bonds are a lot less liquid.

Vargas, Fibra Uno: Well yes, bonds in general don’t trade much, but in Mexico they trade even less.

: Finally on the US rates question. Tania, as a company with a need for dollars, is Bimbo taking any specific measures to protect itself from an increase in interest rates in the US?

Dib, Bimbo: Almost all of our debt is fixed rate; we

Katia Bouazza HSBC




really try not to speculate on rates or currencies. We generally try to balance our assets and our liabilities and match them all the time. This means that even when we issued in local currency, as we did for the George Weston acquisition, if the assets are in dollars we swap the liabilities to dollars. We always try to rid ourselves of that risk, and it’s the same with the rates: almost all of our debt is fixed. I know that we might be leaving some money on the table but we’d rather not run any risks.

: How are other issuers preparing for rate rises?

Bouazza, HSBC: Well, for three years or more we’ve been seeing a lot of front-ended funding. But you have to look at things on a relative basis. Even if rates go up they’ll still be relatively low. Some people here will remember the old days when the rule of thumb was that if a Mexican company could borrow at under 8% they took all they could get.

Dib, Bimbo: We should talk about spreads as well because even though base rates are so low, inves-tors are looking for greater spreads, so I’d guess that if Bimbo were to issue today we have to be careful because spreads have widened.

: Do we think spreads will tighten again soon?

Bouazza, HSBC: It’s hard to tell on spreads by them-selves. We could maybe see all-in yields stay stable if rates go up and spreads don’t widen. But investors have definitely required compensation for low rates and even credit investors that traditionally just look at the spread now have an eye on the all-in yield as well.

Vargas, Fibra Uno: It will depend on how the overall macro picture is managed: how many outflows we see, what happens to the currency, what happens to interest rates. The general macro environment will affect all of us as issuers because it’s going to affect the perception of Mexico.

Bouazza, HSBC: The borrowers at this table are savvy. Most have broadened their investor base and explored different markets, meaning they have the advantage of being able to issue opportunistically, whether in the local market and then swapping it to dollars or the other way around. Some have also explored the euro market, where there could some-times be arbitrage between the different currencies. Furthermore, companies that have operations in Europe and thus don’t need to swap back into dollars or pesos can get tighter coupons in euros.

I’d say that since 2009, when Bimbo was in the middle of its acquisition, companies have learned their lessons: you cannot rely on one market or one product. There’s also the loan market, which is very much available for corporates here and has been used by several companies to either bridge between markets or take advantage of competitive loan rates. You’re sitting in a country where you have domes-tic liquidity in both the bond and the bank market, and you have access to different markets abroad. We should highlight that this has not been an overnight process. Several of these names have been around the globe and educated investors on not just their credit

story but also on Mexico. Now they’re benefiting from all this legwork, all those long flights and late nights.

Caraveo, Pemex: We have a saying at Pemex that dur-ing a roadshow if you see bread you have to eat it even if you’re not hungry, because sometimes the bread won’t be there.

Dib, Bimbo: To complement that, I’d add that when you are issuing you shouldn’t only be thinking about the present, but also about your next issuance. By that I mean it is important to be fair with the market, to do things the right way, and to take care of all your markets. You need to think about what will be next, because if you don’t, next time investors will charge you for that.

Bouazza, HSBC: I will remind you guys about that next time.

Caraveo, Pemex: Especially when you’re calculating the new issue premium!

Vargas, Fibra Uno: I’d say it’s very difficult to be total-ly prepared for an interest rate increase. We all might be saying, ‘oh I have 70%, or 100% of my debt in fixed rate’, but you have to be looking at your maturi-ties too. Tania is exactly right: what is coming up next is important.

Dib, Bimbo: And of course, you have to think about what the proceeds are for.

McNeil, Goldman Sachs: To my mind that is the most salient aspect of this. There is nothing magic about a 2% rate, or 3% or 4% rate, for US Treasuries. It’s really a question of the macroeconomic context. One thing is having a 3% rate in an economy growing at 5%; a totally different thing is to have 2% rates in an economy that’s shrinking by 1%. The real questions are what you’re going to use the money for, what is the income that you will generate, and what that capex does for your bottom line. To go back to the reform, if we’re in a macroeconomic environment in Mexico in which economic productivity is increas-ing, that puts this economy in a position to withstand interest rate rises or spread increases much better than an economy where you don’t have this produc-tivity increase with the spillover effects into growth.

: Carlos, you made history earlier in the

Tania Dib Rodríguez GRUPO BIMBO




year with your Euroclearable Cebure (ECC), the first Mexican domestic bond sold by a corporate that international investors could buy. A lot of people are interested to see how this product will develop. How did you decide to do it and what was the reaction from investors?

Caraveo, Pemex: Actually it comes from what Tania was saying regarding use of proceeds. As we increase exploration and production activities, we require a lot of capex financing. For some context: last year, we had total capex expenditures worth 30% more than all the other companies in the Mexican stock exchange. This means using all the sources of money you can get all over the world. That includes our local mar-ket, and we want to follow the ministry of finance in bringing liquidity to the Mexican peso curve.

Our restriction was just what Gerardo said: the capacity of the Afores to buy our securities — because the law has long stated that they have to consider us under the corporate debt limits and not as sovereign debt. This means only the government can raise bil-lions and billions of pesos in the local markets. We want to have the capacity to hit longer tenors in pesos, as 10 years — even for us — is getting difficult.

Bearing that in mind and trying to enhance liquid-ity in the local market, we had to do something to bring international investors into Mexican pesos. We started the process with GDNs, global depositary notes, which haven’t worked that well. They are a lit-tle like ADRs, but with bonds instead of shares. The problem with GDNs is achieving liquidity and price friction. We then closely watched América Móvil’s idea of having Europeso notes but under both US law and Mexican law. However, the problem there is that you wind up having two types of curves — in New York and Mexico — so you don’t achieve price ten-sion.

The challenge was to put two types of investors — the Afores and international investors — together in the same market. With the help of the ministry of finance we began talks to get over certain issues like the withholding tax, and achieved that. We have only done one issue, but the context is promising: in our GDNs, for each Ps10bn raised, just Ps1bn usu-ally came from investors abroad. With the ECCs, we raised Ps10bn in the Mexican market at a 10 year maturity and Ps8bn of that money came from inter-national investors. Clearly we have work to do and things to learn, but it was a very positive experience because now the Afores know that they have compe-tition.

: Did you find there was a pricing benefit?

Caraveo, Pemex: Not on this trade, but more impor-tant for us was what we learned. In international mar-kets, there are syndicate desks, a team of people who receive calls from investors saying ‘I need this thing at this price’. In Mexico there isn’t the same structure, for now. There is no syndication desk. But we are working towards building this system and having a syndicate desk and open books. Of course, everybody tells us it’s very expensive, because you have to pay for attorneys and other things when doing an SEC 144A deal. Not everybody has the capacity to do an SEC-registered issue but you could do a private place-ment, or something similar. My recommendation is that big issuers, starting with Mexican development banks, go to this market.

Vargas, Fibra Uno: Was it fully registered?

Caraveo, Pemex: It was fully registered. You have to register it to be able to reach retail investors, and to have a pricing mechanism that works well you have to have a strong book. We received calls from local investors who thought they were our only client, and now all of a sudden we can pitch them against for-eign buyers. In general, Mexican investors are more bearish than international ones, who have a different perspective. International buyers see that Mexico has growth, the capacity to be more productive, is very close to the US and has the energy reform. International investors also have an alternative view-point because they are playing the FX rate, as these bonds pay in pesos. They see us as sovereign risk with added spread, which means a corporate Mbono market is perfect for us. This time we saw only three investors, and all three participated. Next time we’ll do a full roadshow.

We will form a market-making programme, and these market makers will have to explain not only the credit but how the mechanism works. We have received calls from surprised accounts asking if they can really buy it through Euroclear. Well yes, yes you can. And eventually we want to go to Clearstream and other clearing houses to enhance liquidity. Liquidity remains the challenge and we will learn from the ministry of finance’s experience in creating the Mbonos curve. My recommendation for other issuers is to go to the peso market. Take Alfa, for example. Say you need pesos and are comfortable with peso bonds, because you know you are paying less today than you would in the States, go to the local market and do what you can to enhance the liquidity.

: Is this an encouraging development for other issuers?

Vargas, Fibra Uno: Yes, we are following it very close-ly and are very interested in the development. We think Pemex did a very successful first deal, although we don’t think we will be the first corporate to issue under this structure because it would be right for a company that has already issued in pesos internation-ally, like América Móvil, to try it first. There are still issues. Under what law should I issue, New York law or Mexican law?

Caraveo, Pemex: Mexican law.

Vargas, Fibra Uno: You say that but Pemex is a spe-

Richard McNeil GOLDMAN SACHS




cial case. How would the appetite be for a normal corporate under Mexican law? It is a very interest-ing development because it would allow us to have larger size in the tenors that we like, and from the issuer perspective it’s great. The question for me is: are the investors there? Are they committed? If they are and the banks are committed too, I think that liquidity will come.

McNeil, Goldman Sachs: I agree with the signifi-cance of this development, and I’m optimistic as well. But regarding the investor base there is a something of a structural issue to be overcome with time. As a simplified illustration of what I mean: if you were to consult investors sitting in the north-eastern United States that take currency risk, you’d find that they tend to take this risk in the govern-ment bond markets. And if you were to consult investors who take credit risk in emerging markets and ask them in what currency and law they want their risk, they’d tend to say in US dollars under New York law. The number of people who take credit risk in local currency, just as a matter of what is in their fund’s mandate, is more limited. Even if you were to look back say the last 20 or 30 years in capital markets, I’m going out on a limb here, I think that the best example of growth in local currency bond markets was in the run-up to the creation of the euro. But in that case people were playing convergence. It wasn’t that they were saying ‘oh I think country X or country Y is a magnificent credit’.

Vargas, Fibra Uno: No one was saying ‘oh I love the peseta’ or ‘I just love the lira’.

McNeil, Goldman Sachs: Exactly. They just believed that interest rates were going to come down stag-geringly during that period of time. I think that you may see this development in Mexico, but it will take time.

Caraveo, Pemex: I don’t agree that much with Richard here. Look at the Mbono experience. They are Mexican law bonds, and just look at the amount of money that is in there.

Bouazza, HSBC: That’s because of the liquidity these bonds have.

Caraveo, Pemex: Yes, but we at Pemex will work a lot on the liquidity and will force our market mak-ers to create it. I understand Richard’s point, but regardless of whether it is New York or Mexican law — and there is of course a benefit for foreign inves-tors to having it under New York law — if you do it under separate different jurisdictions, like América Móvil, then you will create different curves and cre-ating liquidity will be even harder. With the help of the Ministry of Finance we are following the story of the Mbonos. We have to go to see those guys who buy the Mbonos and say ‘put together tickets for us’. They sometimes find it hard to believe they can go to a screen and buy a Pemex peso bond, but we say ‘yes you can, see you there with the custo-dian’.

Vargas, Fibra Uno: Look at where the govern-ment has got to today. We tend to forget the story. The first five year issuance was not too long ago,

and at the time there were questions as to whether there would be demand. In 15 years we’ve gone from no foreign buyers of bonds to a full curve, and it is very encouraging that there is now a lot of interest outside Mexico for the government curve. The next step is to do the same thing for us cor-porate issuers. What you guys are doing is great. I don’t think it’s going to be immediate but to the degree that the buyside thinks there is value in get-ting exposure to both currency and the credit, it is a big game changer.

Caraveo, Pemex: We encourage other issuers to fol-low in Pemex’s tracks. Pemex was the first corporate to issue long term bonds, the first to issue perpetual bonds. The government has put a lot of things together to enhance liquidity, we follow them and someone else follows us. Maybe the development banks will be the next step because they have the full government guarantee. The issue is liquidity but liquidity will come to Mexico.

Vargas, Fibra Uno: Do you know if your peso bonds trade?

Caraveo, Pemex: Yes, a lot. Those specific bonds do trade. They are in good hands now so maybe not as much as at first, but the idea is to issue frequently to enhance the liquidity. We have to be reliable in order to ask for things. We like our investors a lot, but we have to treat them well. If we receive a call from an investor, we step aside from a meeting — even if it is with the CEO — and take the call.

Another thing that you have to be good at is pre-paring for the market. You have to be very strong accounting wise, documentation wise, with a strong legal department and risk manager.

: Daniel, is it interesting to you too?

Odriozola, Alfa: Yes, it is something that we would explore, although I’m not sure if we are ready to issue in that market. We would rather see more issuers like Pemex and América Móvil, for example, develop the market further. It may be an attractive market especially for frequent issuers. For a one-off borrower I don’t know if the cost-benefit makes sense. We are constantly evaluating different financ-ing alternatives and markets, and at some point we might consider the ECCs as an alternative.

: Some senior debt bankers in Mexico City

Gerardo Vargas FIBRA UNO




have told me that in the long term there are three prospective stages for the ECC market. First, state-owned companies will issue, then investment grade corporates will come, and finally the market will open for high yield borrowers. Carlos, could ECCs end up being an attractive option for Crédito Real?

Ochoa, Crédito Real: You can always speculate. It will probably come but I don’t see it happening soon. Right now we are on the sidelines trying to learn from the experiences of other corporates. It would definitely be attractive to have a broader base of investors at the company. At the moment we have diversified as far as we can in terms of peso funding and in that sense we are always looking for new options.

: So is it overly optimistic to think the ECCs could be a high yield instrument in the future?

Bouazza, HSBC: Markets can surprise you. The story has been a slowly progressing one in high yield, so it is not imminent, but we are definitely seeing more traction in terms of international investors in pesos. This is a journey that started with América Móvil in 2007, followed by Televisa. It is progress-ing now and thankfully we are now past the GDNs, which will simplify all our lives. We need to have more stability around the Mexican currency and Mexico’s role as an EM country, because in times of heightened volatility local currency bonds are the type of instruments whose liquidity dries up very fast. Investors can’t get out of their positions in these times of stress; that has been a complaint we have received. We’re doing our part and issuers are doing their part to make sure all the embedded ele-ments are there to make it more liquid. As dealers we have to provide more liquidity to the markets, but it is also a story that will work with the stability of Mexico as foreign participation in the local mar-ket increases.

Vargas, Fibra Uno: In terms of high yield, the first thing we need to see is local institutions playing a bigger role, whether it’s dollar or peso denominat-ed. They need to get their credit teams up to speed.

: As international investors enter the local market could they find themselves in a posi-tion where they have to change their behaviour?

Caraveo, Pemex: Well it could create price tension. They have to be more aggressive in price. Now they will have to compete; at the moment the Afores don’t compete with anybody. But they are strug-gling to match assets and liabilities, so they are ask-ing us ‘why don’t you sell me a platform, a module, a jack-up so we can get a better yield?’. We say ‘but why don’t you go to the high yield market?’ It just requires good credit analysis. We cannot give them the rates they need.

: To wrap up, will the positive economic outlook lead to the increase in issuance volumes that bankers would like to see?

Bouazza, HSBC: We certainly would like to see it.

Odriozola, Alfa: I think part of the reason you’re not seeing a lot of issuance this year is that corporates

have done their homework in the previous two to three years. In our case, we’ve been actively refi-nancing our debt, diversifying our funding sources and extending our debt maturity profile. Five years ago we relied heavily on bank debt. Around 70% of our debt was bank debt. Nowadays most of our debt is in longer term bonds.

Like many other corporates in the last couple of years, we’ve been terming out our debt with longer tenors and attractive rates. That’s probably why you don’t see a lot of issuance this year. That said, with the energy reforms, one would expect more funding needs going forward.

Bouazza, HSBC: One of the elements of growth in issuance will come when you start seeing the need for project finance, whether it’s through bank fund-ing or through project bonds. We are seeing an increased need for project finance. It is a trend that we have been seeing throughout Latin America, whether it’s drilling platforms, ports, or railroads — everything you need around improving infrastruc-

ture to generate growth. And that is another element we are yet to see

realised in terms of what reforms can really bring to the table. But it is understandable, this is a process and we’re at the beginning.

: Richard, I know you’ve done some interesting infrastructure deals. Do you agree that supply will come gradually?

McNeil, Goldman Sachs: I think Katia is right: there are lags between when the reform happens in the legislature and when, say, a new infrastructure pro-gramme is launched; and then again until when con-tracts are awarded and financing finally is needed.

: Do other issuers feel they will begin to issue more frequently?

Ochoa, Crédito Real: Hopefully we will. At this point we have the resources we need, however in the next few months we will be focusing on both organic and inorganic growth and this may lead to us needing to tap the markets.

Dib, Bimbo: It’s a difficult question. You never know with Bimbo. Most of the companies in Mexico have done their homework for the past 18 months or so but as long as there’s a good reason, we will be active in the market.

Oliver West GLOBALCAPITAL



BANKING SECTOR

IT’S A strange paradox, with multi-ple angles. Ask any Latin America coverage banker and they will tell you that demand for Mexican bank assets is off the scale.

That might seem strange, given Mexican banks’ issues with corrup-tion in the not too distant past. But the dynamics of Mexico’s economy and the particularities of its mostly foreign-owned banking sector are not conducive to bond issuance by banks. Options in equity are scant as well, with only four of the coun-try’s major financial institutions (Banorte, Santander Mexico, Banco Inbursa and Banco Interacciones) listed.

“Everyone has very high hopes for the Mexican economy,” says Francisco Hernandez, head of Mexico debt capital markets at Deutsche Bank. “It’s supposed to be the darling of the emerging mar-kets, so getting exposure to the Mexican banking system is some-thing that lots of investors are very keen to do.

“If you want to play the Mexi-can economy, you want to play it through the banks — either through equity or through debt. But there are only four banks that are listed, and in terms of debt, there is bare-ly any issuance, so there are few options.”

The paucity of choice between the financial sector’s major play-ers is to some extent mirrored in the Mexican corporate bond mar-ket, which is dominated by well known names like telecoms giant América Móvil and state-owned oil company Pemex.

But the corporate market at least has some issuance, which is more than can be said for the financial sector. Aside from a smattering of subordinated bond issuance over the past couple of years and a handful of local cur-

rency senior unsecured issues, Mexican banks have given few gifts to investors wanting exposure to the country’s success.

“In terms of bond issuance, there are more opportunities on the cor-porate side,” says Tito Labarta, a director in Latin America equity research at Deutsche Bank.

“The banks issue some bonds but not a lot. They don’t need to use wholesale funding as much, because they have enough deposits to cover their needs. And compared to wholesale funding, deposits are much lower cost and you don’t have to worry about liquidity crises. It’s stable, low cost funding.”

Typically, a Mexican bank may take some 6% of its funding from interbank loans, around 5% from subordinated debt, and less than 1% from senior unsecured bond issu-ance, he says. Deposits more or less take care of the rest.

Plentiful depositsSomewhat ironically, one factor that has helped to keep banks’ loan-to-deposit ratios low — most of the country’s major lenders run an LTD ratio of around 100%, according to investment bank research — is the increasing disintermediation in the corporate financing market that has provided domestic and internation-al fixed income investors with a rel-ative bounty of corporate bonds.

Loan growth at Mexican banks has been slow over recent years, dropping from around 15.5% in June 2012 to a trough of just over 8% in October 2014, according to data from Comisión Nacional Ban-caria y de Valores and UBS. The general economic background is partly to blame for that, but the strong presence of capital-con-strained foreign-owned banks in Mexico could also be a factor.

“In the past, bank lending was perhaps somewhat constrained by a lack of interest in Mexican growth from global banks that were present in Mexico,” says a Latin American bank analyst. “Santander, for exam-ple, had capital constraints at home so it had tighter standards across its subsidiaries in terms of lending.”

However, that slow loan growth could be changing, with UBS ana-lysts reporting a “clear inflection point in credit demand” after a recent field trip to the country.

System-wide loan growth rebounded to 13.1% in April 2014, the analysts found. “From discus-sions with both policymakers and banks, the recovery in loan growth also appears to be broadening, from infrastructure lending to SME loans to payroll loans and mortgages,” they wrote. “The one segment that has been lagging is credit cards, but even here green shoots of recovery appear to be emerging.”

Is ABS an option?That backdrop could in theory point to better prospects for the Mexican asset-backed securities market. But securitization doesn’t make sense as a funding tool for banks when they can use deposits.

“Securitization has the potential to grow in Mexico but more on the non-bank side of the market,” says Hernandez. “The formal banking sector can fund itself more cheap-

Mexico is seen as a bright spot in the emerging markets, and investors are hungry for assets — whether equity, senior bonds or subordinated debt. But while disintermediation has provided plenty of fodder in corporate funding markets, the banking sector has yielded far less issuance. Could an increase in lending tip the scales? Will Caiger-Smith reports.

Intermediation and regulation hold the key for bank investors

“Compared to wholesale funding, deposits are much lower cost and you don’t have to worry

about liquidity crises”

Tito Labarta, Deutsche Bank

031-32 Mexico Intermediation.indd 31 09/07/2015 18:34


BANKING SECTOR

ly on balance sheet. Banks are well capitalised without many capital constraints, so I don’t see the bank-ing sector being active in securiti-zation. But for the non-banks, that could be their main source of fund-ing in the wholesale market.”

The issuance of subordinated debt by Mexican lenders has been a source of some business for Latin American teams at investment banks. But again, there are limita-tions on the growth of this market.

Most investors in Mexico can-not buy sub debt, or cannot buy it in sizes meaningful enough for the market. Pension funds, for exam-ple, have limited buckets for sub debt. Some retail deals have been done, but they are marginal. Cross-border issuance can help, but even then there is a supply problem at the issuer end as well.

“The other factor limiting subor-dinated bond issuance by Mexican banks is that in the Mexican bank-ing regulations there is a limit of around $200m on how much subor-dinated funding a bank can have if its stock is not listed,” says a Latin American DCM banker in New York. “So that basically scratches everyone but the four listed banks off the list of potential issuers.”

Regulatory incentiveBut, when you couple the growth in bank lending with the regula-tory backdrop, the deposit funding model ceases to be quite so com-fortable. “Over time, especially as the economic recovery resumes or

strengthens a bit, we will see, start-ing this year, Mexican bank lend-ing growing in double digit territo-ry,” says Alejandro Garcia, a senior director in Fitch Ratings’ Latin American financial institutions team. “That will increase the need for different funding alternatives.

“There have also been some regu-latory changes focused on liquidity requirements. It is good that banks use deposits, because they are sta-ble and resilient, even in times of stress. People have confidence in the stability of the Mexican banking sector. But one constraint to depos-it funding is that, as in most emerg-ing markets, deposits are very short term in nature. Typically they are not beyond one to three months.”

This tendency towards short term deposits means a funding mismatch arises, which will only increase if the growth in bank lend-ing continues.

“The asset mix is shifting,” adds Garcia. “You’ve got an increase in mortgages and commercial and cor-porate loans. With the new regu-lations, regulators are trying to make banks more aware of those tenor mismatches and seek to reduce them, so we expect banks to increasingly tap the markets.”

At least to begin with, sen-ior unsecured bonds would be the cheapest and most efficient funding tool for banks looking to increase the tenor of their fund-ing. But subordinated debt could also be an attractive option. Gar-cia points out that even though sub

debt and hybrid issuance is more expensive, it has the double benefit of being regulatory capital as well as long term funding.

Foreign dominanceThe small scale of the banking sys-tem in Mexico presents a multitude of opportunities, market partici-pants say.

“An important structural factor [limiting debt issuance by Mexi-can banks] is that, among emerging markets, the Mexican banking sys-tem is among the smallest relative to the size of the economy,” says Garcia at Fitch. “There is there-fore the potential to accelerate this loan growth over the coming years to increase the levels of financial intermediation.”

Lending is increasing, but there are some who believe it could have grown faster if the government was more involved in the banking sec-tor — or if, at the very least, there were more truly Mexican banks in the market. “After the crisis, we saw that the Mexican government real-ised that it didn’t fully control the Mexican banking system, and that it couldn’t push the banks to lend more because they were all owned by for-eign entities. The government would definitely be interested in having a strong, locally owned bank.”

As of April 2015, Spanish-owned BBVA Bancomer had 22% of the market by total assets, with Citi-owned Banamex next at 15%, tieing with Santander Mexico. Bancomer also dominates in loans, with 24%

of the market. Banamex takes 15%, with Banorte and Santand-er Mexico tied at 14%.

Regardless of the lack or presence of political will, it is tough for challengers to arise. As one banker puts it: “You would have thought that the smaller banks would steal busi-ness from the larger ones, but the big ones just keep getting bigger.”

Foreign banks aren’t going anywhere anytime soon and for local competitors, building market share is a big challenge. “It’s hard to enter a market that is highly concentrated, with the top five banks controlling close to 80% of assets,” says Labarta at Deutsche Bank.

An inflection point in Mexico’s loan growth

Source: CNBV; UBS

6%

8%

10%

12%

14%

16%

Jan

12

Mar

12

May

12

Jul 1

2

Sep

12

No

v 12

Jan

13

Mar

13

May

13

Jul 1

3

Sep

13

No

v 13

Jan

14

Mar

14

May

14

Jul 1

4

Sep

14

No

v 14

Jan

15

Mar

15

An inflection point in Mexico’s loan growth

Source: CNBV, UBS

031-32 Mexico Intermediation.indd 32 09/07/2015 18:34


INFRASTRUCTURE

THE VOLKSWAGEN plant in Puebla, 120km southeast of Mexico City, is the biggest of its kind in the Americas. Spread over three million square metres, in 2013 the facility employed almost 16,000 people and churned out 516,000 vehicles and 786,000 engines.

The factory is, however, not big enough to satisfy North America’s voracious demand for Volkswagen cars. Having already invested $8bn in its Mexican operation between 1964 and 2014, in March 2015 Volk-swagen announced that it was investing another $1bn in its Puebla factory.

Volkswagen is by no means the only auto giant that is invest-ing heavily in Mexico. Between 2010 and 2014, according to num-bers published by Congressional Research Services, exports of motor vehicles from Mexico to the US rose from $27.5bn to $46.4bn. Over the same period, exports of motor vehi-cle parts increased from $23.6bn to just over $40bn.

America, it seems, can’t get enough cars and car parts from Mexico, and the world’s largest auto manufacturers have been respond-ing accordingly. According to the Center for Automotive Research, a US-based think tank, since 2009 eight new assembly plants have been announced in Mexico, com-pared with none in the US or Can-ada.

The snag, say economists, is that Mexico’s crumbling infrastructure may soon be unable to cope with the demands of the country’s export-ers. In 2013, the government fore-cast that cargo travelling through Mexico’s ports would increase by 80% during its administration, from 282m to 508m tonnes. At that rate, it is only a matter of time before bot-tlenecks build up at Mexico’s major ports, slowing export growth.

It’s not just Mexico’s ports that are in urgent need of rehabilita-tion. Road density is just 0.11km per square kilometre, compared with 0.4km in China and 0.67km in the US, while fewer than 40% of Mexi-co’s roads are paved.

Road blocksThe country’s inadequate roads and railways, together with its congest-ed airports and run-down power facilities, are a major contributor to Mexico’s unflattering and deterio-rating position in the World Eco-nomic Forum’s global competitive-ness rankings. Having ranked 53rd in 2012-13, and 55th in 2013-14, Mex-ico slipped to 61st in 2014-15, which is below Panama and Costa Rica. While Mexico was positioned 53rd in the macroeconomic ranking, it was a lowly 65th in the league table for infrastructure.

It is not just that Mexico’s trans-portation infrastructure is in a seri-ous state of disrepair. Mirroring the

broader structure of the economy, its quality differs markedly from region to region, which has impor-tant implications for investment, productivity, wealth distribution and social stability across Mexico.

“Five to 10 years ago, it was main-ly the border states which saw inflows of investment, which is unsurprising, given how much they benefited from Nafta,” says Alejan-dro Díaz de León, head of public credit at Mexico’s finance minis-try. “We’re now starting to see more FDI coming into some of the cen-tral states, but there is still a big gap between the north and the south in terms of productivity, which we need to address through infrastruc-ture improvements.”

He adds: “Although we’re still focusing on improving the efficien-cy of highways, ports and cross-ing points with the US, we also face a significant challenge in terms of better integrating the regions and the country as a whole, which is

Finance Minister Luis Videgaray’s decision to cut annual infrastructure spending by $1.15bn in his January 2015 budget was unfortunate considering how much needs to be spent on the country’s inadequate roads, railways, ports and power facilities. Philip Moore reports on whether the private sector can help fill the infrastructure finance gap.

Mexico looks to private sector for infrastructure solutions

Volkswagen’s Puebla plant is the biggest of its kind in the Americas

033-36 Infrastructure Mexico 15.indd 33 09/07/2015 18:38


INFRASTRUCTURE

where infrastructure investment needs to play a key role.”

As an example of an area where infrastructure investment could enhance economic integration and attract new inflows of FDI, Díaz de León points to the Istmo region, which is the largest in the south-western state of Oaxaca. He says this can be described as Mexico’s third border, as it covers the southern part of the isthmus of Tehuantepec, which is the narrowest point in the country between the Atlantic and Pacific oceans.

“Of course the most efficient way to transport goods from the Atlan-tic to the Pacific is via the Panama Canal,” says Díaz de León. “But we believe that the Oaxaca/Veracruz region could be a viable alternative. We also think it’s worth encouraging some investment into maquila oper-ations (manufacturing operations in the free trade zones) in this region targeting the US East coast, because if you’re planning to ship goods to New York or Boston, it is cheaper and quicker to do so from Veracruz than from the border region. For this to happen, we will need to recon-struct the railway that President Diaz built 100 years ago linking the Atlantic and Pacific coasts.”

NIP nippedThe response of President Enrique Peña Nieto’s government to the humbling and uneven state of Mex-ico’s infrastructure has been the announcement of an unprecedent-ed, all-guns-blazing National Invest-ment Programme. This calls for total investment between 2014 and 2018 of $596bn, or more than 8% of GDP, in almost 750 projects. Energy accounts for just over 50% of the total, followed by urban develop-ment and housing (24%), and com-munications and transport (17%).

This may need to be just the beginning of a multi-year infra-structure investment programme if Mexico is to deliver on its ambi-tious longer term growth objec-tives. Assuming a GDP target of 3.5% per year, McKinsey estimates that it would take $923bn to build the infrastructure necessary to support economic growth between now and 2025.

Already, some of the wind has been taken out of the investment

AS ANYBODY who has had the misfortune to travel through Benito Juaréz airport recently will testify, the sooner Mexico City opens a new international airport, the better. According to Mexico’s Secretaría de Comunicaciones y Transportes (SCT), annual passenger and cargo growth between 2009 and 2013 was 5.4% and 5.2% respectively, comfortably ahead of GDP growth over the same period of 3.5%.

It’s not just that the congestion at Benito Juaréz airport is a source of such discomfort for its beleaguered users. The sub-standard facility means that Mexico is increasingly missing out on the economic poten-tial created by the region’s plentiful transit passengers. According to SCT’s data, Panama’s airport now handles twice as many transit pas-sengers as Mexico City.

The result of the airport’s increas-ingly visible inadequacies, the SCT recognises, is that it “limits Mexico’s growth potential as one of the 15 larg-est economies in the world”.

Little wonder that a new airport is the showcase project in Mexico’s ambitious infrastructure investment programme.

X-shapedThe first development phase will see the construction of three runways and a X-shaped terminal, increasing the airport’s annual capacity to 50m passengers. In a subsequent phase, three more runways will be added, bringing total annual capacity to 120m passengers.

According to SCT, the new airport will call for a total investment of Ps169bn (almost $11bn), of which Ps98bn will come from the national government with the remaining Ps71bn provided by private sector in-vestors. The lion’s share of this total, Ps127bn (just over $8bn), is earmarked for the airport’s core infrastructure. Of the balance, Ps20.5bn is for design, engineering and project manage-ment, with Ps16.4bn earmarked for hydraulic works and Ps4.7bn for social works.

While some market participants

question whether the project will go ahead as originally planned, most are ready to accept Finance Minister Luis Videgaray’s public pledge that the airport will not be affected by spend-ing cuts of 0.7% of GDP announced in this year’s budget.

“I don’t believe the project will be scaled back,” says Adrian Javier Garza, analyst at Moody’s in Mexico City. “The government has confirmed the project will be built. The financial structure might change though, to increase private participation.”

The first phase of the financing was a $1bn loan arranged by BBVA Bancomer, HSBC, Citigroup and Banco Inbursa backed by the airport usage tariff generated by the existing airport. The longer term funding plan calls for this to be refinanced through a series of long dated bond issues.

This financing blueprint is one that could be replicated across large swathes of Mexico’s infrastructure programme, says Alejandro Díaz de León, head of public credit at Mexico’s finance ministry. “There is a lot of potential in using mature pro-jects and securitising some of their income flows to generate funding for greenfield developments,” he says. “This is precisely the model that is being used for the new airport, where landing fees and other resources are being leveraged to support the greenfield project. We’re now in the evaluation phase to see how other mature projects directly or indirectly in the public domain can be used to finance new infrastructure.”

Mexico City’s new airport: X marks the spot for financing blueprint

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INFRASTRUCTURE

programme’s sails by the fall in the oil price. At the end of Janu-ary, Finance Minister Luis Videga-ray announced Ps18.1bn ($1.15bn) of infrastructure spending cuts as part of a broader fiscal retrench-ment in the federal government’s 2015 budget. Probably the high-est profile casualty of those cuts was the Ps44bn ($2.8bn) project to build a high speed 210km train line between Mexico City and Queretaro, which had also been beset with con-troversy and allegations of corrup-tion. Another passenger rail project, the proposed Yucatan line linking Merida and Cancun, has been sus-pended.

Bankers say that projects such as these are unlikely to be the last to be cancelled or scaled back. “I’m not sure that all the projects in the National Investment Programme will make it to market,” says Ricardo Cano, former head of DCM at BBVA Bancomer who is now principal at the Miami-based Gateway Capital Advisors. “I would expect a higher rate of success in the energy sector than in some of the others where the economic rationale of some of the projects may be less compel-ling or financing may be tougher to obtain.”

Others agree. “We are in a period of transition at the moment as the government re-evaluates where to spend its money and where to prior-itise the promotion of private sector

investment,” says Eugenio Mendo-za, president and CEO of the Mexico City-based Latam Capital Advisors (LCA). Mendoza describes LCA as a UK-style merchant bank which is focused chiefly on providing debt, equity and M&A advisory services in the infrastructure arena, covering all areas ranging from oil and gas to toll roads and airports.

Private sector opportunitiesEven though the overall National Investment Programme may need to be scaled back, its sheer size dic-tates that there will still be abun-dant opportunities for investors, as well as for developers and sup-pliers of all sizes — and for their financiers. “Whenever major pro-jects are auctioned you usually see a handful of the largest companies involved,” says Cano at Gateway in Miami. “But behind those large construction companies are doz-ens if not hundreds of mid-sized suppliers, which don’t have such easy access to capital.” Identifying funding options for these compa-nies, he adds, will provide challeng-es and opportunities for boutique firms like Gateway.

Mendoza says that despite the pressures on the federal govern-ment’s budget, there is no short-age of international and domestic liquidity attracted by opportunities in the Mexican infrastructure sector. That is just as well, because bank-

ers think that the government may need to reappraise its original plan of providing 63% of the funding for the infrastructure programme, with the private sector stumping up the remaining 37%, or some $220bn.

Already, there are a number of indications that the private sec-tor is prepared to step up to the plate in the Mexican infrastructure market. Among domestic inves-tors, fast-growing private pension funds (Afores) see infrastructure as a promising way of enhancing returns, increasingly as co-inves-tors with international infrastruc-ture specialists in Certificados de Capital de Desarollo (CKDs). Regu-lated by Comisión Nacional Bancaria y de Valores, the financial regulator, and traded on the Mexican Stock Exchange, CKDs are trust certifi-cates designed to allow pension funds to invest in assets perceived to be illiquid such as real estate, pri-vate equity and infrastructure.

Opportunities for them to do so will increase as more international infrastructure specialists establish and expand their footprint in the Mexican infrastructure market.

One recent entrant is Canada’s Caisse de Dépôt et Placement de Quebec (CDPQ), which has formed a joint venture with Mexico’s larg-est infrastructure company, Empre-sas ICA, which will initially oper-ate four toll highways. Díaz de León says that the CDPQ also plans to co-

invest with a local partner in a new infrastructure-focused CDK.

One of the most successful of the existing CDKs is the Macquarie Mex-ican Infrastructure Fund (MMIF), which was launched at the end of 2009, raising Ps3.4bn from seven local pension funds. This gave the Afores an initial 66% interest in MMIF, whose other investors are

Railway projects are the highest profile casualties of spending cuts

“As the National Investment Plan

progresses and the energy reforms come through, I

expect the weight of international capital

to become more dominant”

Jon Walbridge, Mira and MMIF



INFRASTRUCTURE

Macquarie and the national infra-structure fund, Fonadin.

Macquarie Infrastructure and Real Assets (Mira) Mexico is the largest institutional manager of real assets in the country, with some $2bn of equity assets under management and a team of about 40 local profes-sional staff, according to Jon Wal-bridge, managing director of Mira and CEO of MMIF.

Mira’s principal focus in Mexico is on opportunities in the energy sec-tor, but it also has holdings in sever-al other infrastructure assets ranging from highways to telecommunica-tions, according to Walbridge.

“Within Mira Mexico, we are cur-rently focused on equity invest-ment,” says Walbridge. “While we’ll look at instruments such as mezza-nine and preferred, the bulk of our holdings in infrastructure assets are in ordinary equity, where our participation ranges from 100% investments to significant minor-ity holdings with negative controls. The size of our holding is driven by our perception of the risk profile of each investment on a project-by-project basis, and where execution risk is high we look for strong stra-tegic partners such as construction or energy companies, or major local developers to come in alongside us.”

Walbridge says that he is com-fortable with the legal and regulato-ry regime governing infrastructure investment in Mexico. “Generally speaking, the contractual frame-work of the legal system is good,” he says. “Archaeological, environ-mental and land ownership laws are for the most part similar to those in developed markets. But when we’re structuring a project, especially on the greenfield side, we do a lot of work with our advisors to under-stand risk allocation between key counterparties.”

“The risk profile of institutional investors like ourselves, interna-tional pension funds and sovereign wealth funds probably still dif-fers slightly from some of the local vehicles,” Walbridge adds. “Over time, as the National Investment Plan progresses and the energy reforms come through, I expect the weight of international capital to become more dominant, purely by virtue of the size of some of these transactions. Then we’ll probably

see greater alignment in terms of risk profile.”

New and improved PP lawOther market participants say that Mexico’s new PPP law is a substan-tial improvement on previous ver-sions. According to a briefing pub-lished by the law firm, White & Case, the four key changes in the new law are “a thorough, transparent bid-ding process”, minimum mandato-ry terms, clearer rights for investors and dispute resoluion via arbitra-tion.

The new law, adds White & Case, is “well structured, based on prov-en models from other jurisdictions, and there is momentum and appe-tite to ensure the success of the new regime.”

The result of this more robust legal framework, twinned with deeper and more mature capital markets, is that the structure of project financ-ings put forward today is an incalcu-lable improvement on the formu-la used in the toll road programme introduced in 1989. The good news, for Mexico, was that the highway concession programme doubled the length of the country’s toll high-ways between 1989 and 1994. The bad news was that many of the roads were empty and loss-making.

According to the White & Case briefing, the programme of 52 toll roads was plagued by problems which included “errors in traffic-

volume estimates, relatively short 15 year concessions and poor project planning.” As a consequence, adds White & Case, many were unable to meet their US dollar denominated debt payments and were rescued by the federal government agency, Farac, which has since re-privatised some of them on a much sounder financial footing, generally on 30 year concessions with peso denomi-nated debt.

These more robust structures, says Díaz de León, attest to how far the Mexican capital market has devel-oped over the last 25 years. “In the late 1980s and early 1990s Mexico had a fixed exchange rate regime and its history of financial instabili-ty meant that it was almost impossi-ble to raise long term local currency debt,” he says. “We’ve now had two decades of stability and nine years of issuing 30 year bonds in pesos.”

Díaz de León believes the capital market could certainly play a more active role in financing infrastruc-ture in Mexico — as it could around the world. “Capital and liquidity ratio requirements are making life increasingly hard for traditional pro-ject finance lenders,” he says. “This is creating an opportunity for insti-tutional investors to plug what we call the infrastructure financing gap, but the challenge is to find ways of making instruments appealing to institutions in terms of risk and return.”

Finance Minister Luis Videgaray



EQUITY CAPITAL MARKETS

MEXICO’S EQUITY capital mar-ket, which hit an inflection point of growth in 2012, may be about to reach another one. The expected trigger is the country’s energy reform, which will liberalise the oil and gas and elec-tricity sectors.

Progress is not fast enough for eve-ryone — awarding licences to explore for hydrocarbons and build new oil and gas transport systems and power infrastructure is taking time.

But the finance ministry and Comisión Nacional Bancaria y de Valores, the financial regulator, have begun working on a Mexican version of the US’s master limited partner-ships — tax-advantaged, listed vehi-cles that own energy infrastructure such as pipelines.

The forecast boom, however, will probably not begin until 2016. For now, the equity capital market is going through a slow period of issuance. Leaving aside a €3bn bond issued by América Móvil, which was exchange-able into shares of a Dutch company, KPN, and hence not really a Mexican ECM deal, there has been less than $1.2bn of issuance this year.

This tempo echoes the long quiet period in the early years of this cen-tury, when there were only $2bn-$3bn of deals a year.

Then in 2012, capital raising sud-denly took off, with $9bn that year and $12bn the next. “Two things hap-pened,” says Ian Taylor, managing director in equity capital markets at Goldman Sachs in New York. “One was that economic growth in Brazil slowed rapidly.”

International investors that had relied on owning Brazil to get their LatAm exposure suddenly had to look elsewhere — and Mexico was the next largest and most liquid market.

At the same time, Taylor says, “Some companies, which had histori-cally been able to fund themselves with local debt, needed to look exter-

nally to grow, and wanted to raise capital.”

América Móvil and Cemex have famously bought companies in many other countries; just this summer, Alfa Group, the Mexican conglomerate, is buying Campofrio, the Spanish meat company.

These growth dynamics are still in place, though the number of compa-nies listed in Mexico has actually fall-en, to 140. This is a fraction of Brazil’s total, as is the daily trading turnover, of only $400m-$500m.

One reason, bankers say, is that Mexican industry is more oligopolistic — there tend not to be as many play-ers in each sector. Another is that the institutional investor base is smaller and less sophisticated than Brazil’s.

A cloud called YellenMarket participants are worried, too, about the impact of a US interest rate rise. “It is an issue, because inves-tors will take their resources to fixed income instead of ECM, and to a more secure currency,” says Paulina Ezquer-ra, head of equity capital markets at Actinver in Mexico City. “Because we

are so close to the US we suffer a lot. There have already been outflows, and you can see it also in the currency exchange rate.”

The peso has fallen 18% against the dollar in the past year — yet the Mexbol stockmarket index is still only 2.7% off the record high it reached last August.

David Noble, head of ECM for the Americas at HSBC in New York, says Mexico’s Fibras — real estate invest-ment trusts — will be in the front line when rates rise, because investors see them as yield stocks.

“But it should be relatively priced in,” he adds. “In general, I don’t think there will be flows out of Mexi-can equities when US rates rise. The underlying economy is strong, and so is the US. Mexico is a bit of a geared play on the US — if the US grows 2.5%, it grows 3.5%.”

Ezquerra says that after the initial shock of the first rate rise, the market should regain stability.

Property partySupporting issuance in the last three years have been regulatory changes,

Larger companies needing growth capital have a useful source in Mexico’s stockmarket, where demand in roughly equal quantities from domestic and foreign investors has supported a strong rise in issuance. It is going through a dip this year — but as Jon Hay reports, if Mexico delivers on reforming energy markets, there will be plenty of deals to come.

Mexico’s equity market looks to energy reform for growth spurt

0

2

4

6

8

10

12

14 $bn

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

IPO Follow-on Convertible

Mexican ECM issuance — recent boom has run out of steam

Source: Dealogic

037-38 Mexico in the Marketplace.indd 37 09/07/2015 18:36


EQUITY CAPITAL MARKETS

notably the introduction of Fibras.“Mexico’s equity market has

become one of the most prominent in Latin America, and banks like our-selves are putting resources into it,” says Katia Bouazza, head of capital financing for Latin America at HSBC in New York. “The country is well reg-ulated, with high standards of trans-parency and corporate governance.”

Since Fibra Uno’s difficult Ps3.6bn ($300m) IPO in 2011, which failed to win much international support and had to be shrunk, the sector has bloomed. Nine more Fibras have floated, and Fibra Uno has grown to a market cap of $8bn, as the sector has attracted a global following, mainly of Latin American-focused funds.

The most recent one to float, in June, was Fibra HD, which raised Ps1.1bn. This deal, like the IPO of Fibra Monterrey in December, differed from all those before in one way. “The last two were only placed in Mexico,” says Ezquerra.

Since the deals were quite small they did not need international demand, so could skip the costs of an international roadshow and lawyers to prepare US SEC documents.

“Sooner or later, when they get big-ger, they will make international offer-ings,” Ezquerra says. In the mean time, foreign investors can buy in the secondary market — and Ezquerra says there has been interest.

These deals show that local demand is deep enough to swallow smaller transactions whole.

The down side is that the domestic bid — which usually takes 40%-60% of any Mexican equity issue, up to $1bn — is very concentrated.

There are some mutual funds, bro-kerages and family offices, but the lion’s share of demand comes from the 12 Afores, or pension funds. “Only a handful of these control the vast majority of assets, so the ability to drive appropriate price tension into transactions is critical,” Taylor says.

When there are five or six key inves-tors, an issuer has little pricing power.

In most deals, the Afores pro-vide reliable, fairly price-insensi-tive demand — they want a chunk of almost every issue. But international investors take the lead in price discov-ery and are more vigorous secondary traders.

This partly explains why, although there are not many equity deals in

Mexico, those that do happen are usu-ally quite substantial.

International investors are reluc-tant to buy deals under $200m, judg-ing them not worthwhile and illiquid. Issuers do not want to bring a smaller deal, and have to rely only on the few big local funds.

This suggests the market may not be meeting the needs of smaller com-panies.

Bolsa Mexicana tries to promote IPOs to midcap firms, Ezquerra says, but the regulatory concessions it has made are not enough: a minimum of 150 investors instead of 200, and two years’ financial statements instead of three.

A big barrier is that Mexico now obliges listed companies to publish accounts under IFRS. This is costly for smaller companies, as not all Mexican accountants are suitably trained.

Still, the flourishing of the Fibras shows that when there is a local investment opportunity, and interna-tional appetite, Mexico’s capital mar-ket can put them together, and inves-tors’ interest will deepen with time.

Energy for growthThat may be about to happen again. “The energy reform being imple-mented now and the size of invest-ment needed in the sector are the next leg that will push the market in the next five years,” says Martin Werner, country head for Mexico at Goldman Sachs.

Since 2011, $16bn of capital has been raised on Bolsa Mexicana for real estate. Werner reckons the energy

need could easily be $20bn-$40bn. So far, remarkably, only one ener-gy company is listed: gas transport group IEnova, which floated in 2013. But there could be 10-15 more in a few years’ time, from oilfield support to pipelines to power generators.

Ironically, the energy reform has coincided with depressed global oil prices, damping investment. Never-theless, the private capital set to be deployed in the next few years should pep up the economy.

Growth has been stable, but under-whelming for years — but Werner is convinced things are starting to pick up. “The supply of natural gas in Mex-ico is changing, and with labour at Mexican costs and gas at US prices, it makes Mexico more attractive for manufacturers,” he says. “You can see that in how the industrial parks are growing.”

Bankers are excited by deals such as Rotoplas, a family-owned company that started out making water tanks and has diversified into exporting water equipment across the Americas. It floated in December for Ps4.2bn, even attracting specialist thematic investors focused on water.

Just launched is the IPO of Nemak, a car parts maker with $4.6bn of sales and plants all over the world. The company's products include engine blocks made of aluminium, which is lighter than steel.

“Auto sales have been growing,” says Noble. “Mexico has become a real producer of auto parts, compet-ing head to head with China, and cars. There’s been massive investment by the Japanese, US, European and Kore-an automakers.”

Nemak’s IPO could reach $900m — as could the possible listing of another Alfa Group subsidiary, Sigma Foods.

Follow-on offerings are usual-ly done on a fully marketed basis, though the regulator has allowed the timeframe to be reduced from about 10 days to more like five. But in November, Goldman and JP Morgan did the country’s first one day accel-erated bookbuild, selling a Ps3.9bn ($290m) position in toll roads group OHL Mexico.

Its Spanish parent Obrascon Huarte Lain was particularly keen to avoid market risk, after a rough experience in 2013, so the sale was done entirely outside Mexico — while the market was closed for a public holiday. Source: Dealogic

Mexican ECM issuance since 2005: a big hole for energy

Sector Deal value No of ($m) dealsReal estate 12,500 22

Finance 9,300 11

Construction 5,200 10

Telecoms 3,400 1

Chemicals 2,300 3

Food and beverage 1,400 2

Retail 1,400 3

Transport 1,100 4

Dining and lodging 1,100 5

Utility and energy 600 1

Automotive 87 1

Leisure 62 1

Forestry and paper 62 1

Insurance 59 1

Total 38,500 66

037-38 Mexico in the Marketplace.indd 38 09/07/2015 18:36


AFORES

MEXICO’S PRIVATE pension funds (Afores) have come a long way since legislation was passed in 1997 allow-ing for the replacement of the pre-vious pay-as-you-go system. Under Mexico’s defined contribution sys-tem, which is based on the high-ly successful Chilean blueprint, all employees are required to save 6.5% of their salaries into one of the coun-try’s 11 Afores.

This has underpinned a sharp rise in the funds’ assets under manage-ment (AUM) which have expanded by 16.73% annually over the last 10 years, according to data published by the industry regulator, Consar. By April 2015, some 51 million Mexicans contributed to private pension funds, whose AUM had reached just under Ps2.5tr, which equates to 23.28% of domestic savings, or 14.9% of GDP.

Although this is a marginally larger share than in Brazil, it still makes the Afores small by international stand-ards. The OECD average is 37% and in Chile, the poster-boy for the indus-try in Latin America, private pension funds’ assets under management are equivalent to more than 60% of GDP.

Today, the Afores face two for-midable, related challenges. The first is their projected turbocharged growth, driven by Mexico’s demo-graphics. With 47% of the popula-tion under the age of 25, and with the reform programme expected to

encourage many workers to migrate from the informal to the formal sec-tor of the economy, the Afores’ assets are forecast to continue growing at an explosive rate. According to Con-sar’s estimates, which the regulator describes as conservative projections, the funds’ total assets will reach close to Ps3tr by December 2018.

The second challenge the funds face is their stretched resources and relative lack of expertise, both of which are understandable given the youth of the Afores sector. “Given the amount of money they manage, the Afores clearly have too few capable people,” says one analyst. “It’s not uncommon to have the same indi-vidual doing Mexican stock selection, being part of the global asset alloca-tion team and participating in fixed income investment decisions.”

It is equally understandable that the funds’ relatively scarce resources have meant that their performance has been modest, although the short-age of competition in the indus-try may also have been a dampener on performance, given that the four largest Afores account for almost

70% of the funds’ total AUM.

Deteriorating performanceMore surprising is that the perfor-mance of the Afores appears to be deteriorating, rather than improv-ing. “Despite being the year with the largest contributions on record ($7.8bn), 2013 was the worst year in terms of performance, as Afores’ AUMs grew only by 6.2% (local cur-rency terms),” says a recent JP Mor-gan report. “Performance picked up in 2014 to c16%, yet still below the

historical average.”The Afores’ undistinguished per-

formance track record may be a reflection of the restrictions that have historically governed their asset allocation. When they were original-ly launched, Afores’ exposure was

concentrated almost exclusively in the domestic government bond mar-ket — with good reason, as Alejan-dro Martinez, senior Latin Ameri-can fixed income strategist at HSBC in Mexico City, explains. “When the Afores were launched in 1997, the only government nominal-rate secu-rities in the market were Cetes, or bills with maturities of between one month and one year,” he says. “So the government’s strategy when it passed legislation allowing for the creation of private pension funds was both to increase the domestic savings rate and to support the development of the peso fixed income market.”

Both objectives have been met. Between 1993 and 2014, accord-ing to Consar’s numbers, total sav-ings in Mexico more than doubled, from 32.6% of GDP in 1993 to 68.2% in 2014.

In the domestic fixed income uni-verse, meanwhile, the robust demand that the Afores legislation created at the short end of the market in the late 1990s allowed a liquid and well diversified yield curve to take shape over the next decade. “Three years after the Afores were launched the government issued its first nomi-nal fixed rate bond, with a three year maturity,” says Martinez. “In 2001 it introduced five and 10 year bonds. Finally, in 2006 the government added a 30 year bond.”

As well as underpinning the extension of the yield curve, strong demand for government bonds from Afores provided an investor base that helped draw foreign investors into the market, adds Martinez. This has in turn allowed the pension funds to extend their exposure at the longer end, satisfying their natural demand for longer dated assets and enhanced returns. “About 60% of the peso fixed rate market is now held by foreign investors, but their holdings are con-centrated in the belly of the curve,”

Mexico’s private pension funds (Afores) have played a key role in supporting the growth of the domestic capital market since the late 1990s. Now it’s time for them to diversify, writes Philip Moore.

Afores ready for next stage of evolution

“International diversification is an

important part of our agenda, and

given the speed with which our assets are

growing, we think the 20% limit is too

tight”

Tonatiuh Rodriguez, Afore XXI-Banorte

039-40 Mexico Afores.indd 39 09/07/2015 18:37


AFORES

he says. “The longer end of the curve is the preserve of Afores and insur-ance companies.”

Relaxing restrictionsThe development of a liquid govern-ment bond market supported by a diverse range of local and interna-tional investors has been one fac-tor allowing for the restrictions on the pension funds to be relaxed. “We are continuously adding new instruments and new risk measures to allow the Afores to expand their investment horizons,” says Gaston Mejia, of Consar’s financial planning and economic studies department.

This relaxation has, however, been a tortuously slow process. In equities, for example, it was not until Febru-ary 2005 that they were allowed to expand from ETFs into single stocks. Even in the domestic equity market, however, the Afores remain modest players, with a little over 7% of their assets in Mexican listed equities as of February 2015. “The Afores aren’t large enough to explain the premium that the Mexican market commands,” says Pablo Riveroll at Schroders in London.

It is this premium that has encouraged the Afores to slim down their exposure to the domes-tic equity market. “After the reform agenda announced soon after the 2012 election, there was a signifi-cant re-rating of the Mexican stock market,” says Jaime Aguilera, equi-ties strategist at HSBC in Mexico City. “Very quickly, the market P/E ratio which used to average between 13 and 15 rose to 19 times based on 12 month forward EPS. This encouraged the Afores to add to their internation-al holdings, mainly in the US market, where their returns were enhanced by the strength of the dollar against the peso.”

Consar’s Mejia says that the Afores now have ample opportunities to build well diversified portfolios in the domestic market. He points out that since 2005, other asset classes have progressively been added to the list of securities eligible for invest-ment by the funds. In 2007 they were permitted to invest in fideicomisos de inversión en bienes raíces (Fibras), stock exchange-listed investment trusts similar to Reits with a mini-mum of 70% invested in real estate.

In the same year they were also

allowed to expand into private equity certificados de capital de desarollo (CKDs), cashflow-based trusts simi-lar to US-style master limited part-nerships, which now give investors access to illiquid asset classes such as infrastructure and real estate, as well as private equity. Today, about 90% of CKDs are held by domestic pen-sion funds.

Further liberalisation of the invest-ment regime for Afores followed in 2011, when they were allowed to expand into commodities, and in 2013, when Reits and swaptions were added to their repertoire of eligible holdings. The result, says Mejia, is that supply of eligible asset classes now comfortably exceeds the Afores’ demand. “For example,” he says, “Afores have been allowed to invest in commodities for several years, but so far only one fund has chosen to do so.”

Diversifying overseasMejia says, however, that one area where Consar would like to see the Afores diversify more is into overseas markets. In 2004, as part of the pro-gressive liberalisation of the indus-try, the pension funds were allowed to invest up to 20% of their assets in overseas markets. More recently, they have been allowed to contract invest-ment mandates to international third-party managers, with Schroders winning the first of these man-dates from Afore Banamex, a whol-ly-owned subsidiary of Citigroup, in August 2013. It was a successful arrangement, with the $200m global segregated account returning 23% on an annualised basis between August 2013 and April 2014. This track record prompted Banamex to award a sec-ond mandate to Schroders last April.

Mejia says that although both Con-sar and the funds themselves would

like to see the limit on the Afores’ international exposure increased, this would require legislation to be passed by Congress, which is not yet on the agenda.

Legislative change can’t come soon enough, say the Afores. “Internation-al diversification is an important part of our agenda, and given the speed with which our assets are growing, we think the 20% limit is too tight and should be reviewed,” says Tona-tiuh Rodriguez, director at Mexico’s largest private pension fund, Afore XXI-Banorte.

It is in infrastructure CKDs, how-ever, that the Afores are understood to have identified the greatest poten-tial for diversification — largely by virtue of the huge requirements for private sector capital called for in the government’s $596bn 2014-18 Nation-al Investment Programme. Certainly, the regulator is eager for the funds to recycle more of the nation’s sav-ings into infrastructure, although Mejia emphasises that they will only be permitted to do so when they can demonstrate conclusively to Consar that they have the appropriate ana-lytical and risk management capacity to do so.

“Afores can and must play a main role in infrastructure projects and private equity,” said Consar in a pres-entation delivered last summer. The combination of the funds’ strong liquidity and the government’s huge-ly ambitious infrastructure invest-ment plans mean that this, according to the same presentation, is a “histor-ical moment for Afores”.

It is an opportunity the Afores are clearly eager to grasp. At Afore XXI-Banorte, Rodriguez says that his firm is aiming to lift its investment in infrastructure via CKDs to about 5% of total AUM, focusing principally — but not exclusively — on energy to begin with. “We believe the Afores can be significant take-out providers of funding for some of the infrastruc-ture assets that Pemex is looking to sell,” he says. “So we will be looking for ways in which we can team up with other investors to participate in brownfield projects through special-ised CKDs with a long-term invest-ment horizon.” Rodriguez says that Afore XXI’s targeted annual peso returns on infrastructure-focused CKDs would be in the range of 15%-17%.

“Foreign investors are concentrated in the belly of the curve. The longer end of the curve

is the preserve of Afores and insurance

companies”

Alejandro Martinez, HSBC

039-40 Mexico Afores.indd 40 09/07/2015 18:37

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