Mexico at War


The state of Mexico – “so close to the United States, so far from God”, as one old expression has it – presents a due diligence dilemma for risk takers. Belying the nihilism of that old saying, macro numbers generally are quite good. Mexico is also an integral part of the USMCA trade agreement, and therefore the enormous North American trade and commercial block with the United States and Canada. That would seem to bode very well for country prospects, and hopefully those prospects will be borne out.  Institutional fragility however impairs the body politic, and seems to hinder more robust growth.

Ongoing pressure on Mexico’s social, political and economic institutions leaves open the possibility of “metastasis risk”, where general conditions enervate quickly and pervasively. Mexico – a large economy and market, and a critical ally to the US – therefore presents for the investor the task to hedge against local conditions that could worsen – when and how are difficult to ascertain, but fragility is notable.

Again, Mexico is a large economy and an engaged trading partner through its USMCA association – itself, a bonanza situation for the country. That said, risk insurance, perhaps booking options/derivatives, which are significantly cheaper and clearly out-of-the-money, along with the local funding of local assets, will complement risk exposures in a “sorta kinda” stable, yet delicate political risk environment.  

This past November, Mexico did have a pretty good check-up. The periodic review which the International Monetary Fund (IMF) convenes for each of its member states – the Article IV reviews – showed Mexico in pretty good macro-economic standing. In its report, the IMF notes that economic growth has moderated somewhat, slowing from an annual rate of 4.8% in 2021 to an estimated annual rate of 2.1% in 2022. Annual GDP growth is forecast for 1.2%, a slower pace still, through 2023.

Inflation remains somewhat elevated, increasing from an annual rate of 7.4% in 2021 to an estimated annual rate of 8.5% this past year, before moderating slightly to a forecast 6.3% for 2023. Foreign exchange reserves are at roughly the USD200bln, and are expected to remain roughly at this level through this year and into the next.

Maintaining a floating exchange rate regime for the peso will reinforce the country’s external liquidity position, precluding any FX management-style mishap of the sort that catalyzed the “Tequila Crisis” in the mid-1990s. Moreover, the re-shoring and supply-chain shortening trend in the global economy may be playing to Mexico’s advantage, as global corporates increasingly exit from China and seek to locate manufacturing facilities in Mexico.

Things do seem to be aligning for greater country prosperity. In the concluding Article IV remarks, the IMF economists pointed to a solid bedrock, noting that, “The directors agreed that Mexico is well placed to navigate the (economic) challenges, owing to its very strong macroeconomic policies and policy frameworks…”

And right there is the rub. Perhaps the technocratic aspects are in line, but for the global lender and risk-taker there are other things to consider.

On its face, the current government of President Andres Manuel Lopez Obrador and his majority Morena party should be benefitting wholly from the emergence from Covid and from the dividends accumulating from the “strong macroeconomic policies and policy frameworks” the IMF has cited. We would note, though, that there is much work still to do.

The Economist magazine puts Mexico’s GDP per capita at USD11,650 (USD23,120 on a PPP adjusted basis), which places Mexico within the ranks of what the World Bank describes as “middle-income countries”, countries with GNI per capita levels (a close proxy for GDP per capita) ranging between USD4,046 and USD12,535. These countries fall short of the advanced economy standing. Often, it’s a question still of internal development, institutions and allowance for market forces that elevate an economy into the ranks of advanced economies – those with per capital wealth levels substantially higher than the bracketed middle-income countries.

So, Mexico – a USMCA signatory, a country endowed with natural resources, a large domestic population and market – why isn’t it among the “advanced” economies, its OECD status notwithstanding? Why isn’t it wealthier?

Maybe for its residents – its citizens – the discretion to save, to transact, to own, and to engage freely in the public space, one defined by laws that are clear and robust, may not really be there – or that discretion may not be as manifest as it should be. The World Bank updates annually, but with a two-year lag, its World Governance Indicators (WGI). These reflect survey work the World Bank compiles on the state of country institutions. The six measures reflect surveyed resident perceptions on Government Effectiveness (GE), Regulatory Quality (RQ), Rule of Law (RL), Control of Corruption (CO), Voice and Accountability – i.e. Freedom of Expression (VA) and Political Stability and Absence of Terror (PV).

At MMD, we’ve developed a Political Risk Curve that plots four WGI indicators a country exhibits against the four average WGI indicator percentiles recorded for countries which have “defaulted” – in this case, accelerated a claim on political risk insurance due to a political risk event, and the average for those countries which have never tripped or accelerated a claim, i.e. have “never defaulted”. The information on realized political risk claims was drawn from work done by Zurich Insurance.

For three out of four of the plotted WGI indicators, Mexico’s percentile levels fell significantly below benchmark levels for both “defaulted” and “never defaulted” countries, highlighting low resident confidence and the apparent fragility of Mexico’s institutions.

We have also developed a logit regression model, which again, uses four of the WGI measures as independent variables against the dependent binary variable of country default status vs non-default status; that is, in this instance, whether a country registers at least one sovereign default episode over a set multi-year period or not. The SIRE model (Solvency Institutional Resilience Estimate) generates the probability that a country will not have registered at least one sovereign default episode.

By this measure, Mexico’s risk profile has been poor and declining. The SIRE model generated probability posted at only 14.1%, given 2012 WGI data. That model probability has steadily declined since then, falling to just 6.7% as of 2019 data. This of course implies the weakness of Mexico’s institutions, at least as they relate to estimated sustained external solvency over time.

And so, poor or fragile institutions have real consequences – not only from the commercial or financial perspective but also for the experience of daily living and stability. In November 2019, MMD posted the blog entry, “We Pray for Mexican Sovereign Residence…”. In that entry, we commented on the then recent massacre of a contingent of Mexican/American dual nationals, who were living in Mexico and were members of an off-shoot Mormon community. We wrote:

“Official commentary from Mexico points to a heinous mistaken identity situation, where the innocent travelers were confused with rival drug cartel combatants and attacked. Other reports point to an intentional cartel move to intimidate the Mormon community, who had resisted various extortion efforts. The Mormon community had also apparently undertaken its own initiative to ensure local security, the remit that generally rolls up to the sovereign authority. In any event the pervasive and controlling drug cartels mean that in reality Mexico’s sovereign writ does not seem to extend as fully as it should. That’s bad news for Mexican citizens and really for anyone else finding themselves there…”

The lack of unassailable sovereign authority residence (the sovereign authority is recognized and has monopoly use of force) has meant that large non-state actors, such as the narcotics cartels, can and do exercise discretion and force to achieve their aims. They compete with the sovereign authority over the monopoly use of force, which ideally should only be invested in the sovereign through a representative government reflecting the consent of the governed.  When the state no longer exercises a recognized monopoly on the use of force, then questions can arise – who says that a bona-fide contract must be honored? Who says laws must be complied with?

And just so, the UK paper the Guardian ran an article this January, “Sinaloa Cartel Launches Violent Response as Mexico Re-Captures El Chapo’s Son”.  In the article, reporters describe how the drug cartel essentially laid siege to Culiacan, a city in Sinaloa state with a population of close to 900,000.

The cartel undertook the action in response to the incarceration of Joaquin “El Chapo” Guzman’s son, Ovidio Guzman, by the state authorities.

The Guardian comments, “…all major roads into the city were blocked with burning vehicles, and (cartel) gunmen attacked a military air base and Culiacan international airport…”

The UK paper then quotes the State of Sinaloa’s public security chief, who offered, “We continue to work on controlling the situation…” as of the reporting of the article.

The presence and operation of salient non-state actors exercising de facto sovereign power in Mexico limits the sovereign writ. The absence of that writ probably does much to weaken public institutions. For residents and non-residents, this is consequential, even with the economic clout Mexico has as a USMCA signatory.

We would say as well that nothing stands still. As Herb Stein, Richard Nixon’s chief economist, once observed, “If something can’t last forever, it won’t.”

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