Chambers & Partners
Ritch, Mueller, Heather y Nicolau, S.C.
The year 2018 began with mixed reactions from investors and bankers to the expectations generated by the elections held on 1st July and the renegotiation process regarding the North American Free Trade Agreement (NAFTA). Many decided to press forward with their transactions with a view to closing prior to the general election. Another subset of investors opted for a more cautious approach and put some transactions on hold pending the electoral results. Although Mexican fundamentals were consistent with those of years past, these factors, along with the prospect of potential social instability, resulted in exchange rate fluctuations aimed at discounting the potential risks well in advance of the elections and the conclusion of the NAFTA renegotiation process.
On 1st July 2018, Mexicans went to the polls in one of the largest electoral sessions in recent history, with the presidency, the federal congress, and many state and municipal governments up for grabs. A record number of voters decided in favour of the “Fourth Transformation of Mexican Public Life” touted by Mr. Andrés Manuel López Obrador in his presidential campaign, which focused primarily on eradicating corruption. Mr. López Obrador was also victorious in that the voters granted a majority of seats in both chambers of congress to his MORENA party and a number of state governments, resulting in a landslide victory for Mr. López Obrador’s left-leaning agenda.
In a transition period during which Mr. López Obrador and his team were permitted to take up much of the spotlight, a public consultation process with the participation of approximately one million participants resulted in a majority supporting the cancellation of the Mexico City airport project in Texcoco, which had raised financing and reached approximately 35 per cent completion. This consultation process, held prior to the new administration having even taken office, has been the subject of much debate and criticism.
Another similarly criticised public consultation process among a similar number of participants resulted in majority preferences for ten additional campaign proposals put forward by Mr. López Obrador. This process was held a few days prior to the transfer of power on 1st December and resulted in a majority supporting proposals regarding: reforesting southeastern Mexico and building two railroads and an oil refinery in the same region; increasing and guaranteeing pensions for senior citizens; granting scholarships to students and paid apprenticeships to young unemployed individuals; granting pensions to disabled individuals; guaranteeing access to medical attention to populations that currently have no such access, including medicine and treatment free of charge; and free internet access throughout Mexico.
On 30th November 2018, the outgoing administration signed a substitute to the North American Free Trade Agreement (NAFTA), now named the Mexico, United States and Canada Trade Agreement (T-MEC in Spanish), which retains many of the key features of its predecessor and has modified many politically charged concepts. The newly signed agreement is still subject to congressional approval in Canada, the United States and Mexico.
The public consultation processes, the conclusion of the T-MEC negotiations and other initiatives by the Mexican congress, including a proposal to impose strict limits on banking fees, have resulted in stock market dips and significant short-term exchange rate fluctuations.
The expectation continues to be that the Mexican economy will maintain its competitive edge with respect to other Latin American economies, primarily due to its legacy of macroeconomic stability, skilled labour (particularly in the manufacturing sector) and an open economy that is highly integrated with the United States. However, the much-publicised and largely positive reforms passed by the outgoing administration are under significant scrutiny in congress and by the new administration. Such scrutiny may result in ill-advised changes to these newly issued reforms and, in some instances, outright repeals, with a legislative outcome that may be difficult to predict.
Considering that many of the structural reforms were passed at a constitutional level, the new administration may be unable to obtain support for the supermajority required to repeal such constitutional reforms. However, it is still possible to introduce changes to such reforms through secondary legislation or limit their application through administrative inactivity and delay. This has already been announced as the new administration has indicated that it will suspend the public tender process for oil exploration and production contracts for at least three years under the argument that the results of the energy reform remain unclear. The fourth long-term power auction has also been suspended by the office of the president until further notice. The current expectation among participants is that it will resume during the first quarter of 2019 once the new administration has come to terms with the new wholesale electricity market.
Similarly to other parts of Latin America, corruption continues to be a critical issue in Mexico, and was influential during the 2018 elections. The NAFTA renegotiation process, implementation of anti-corruption policies by international financial institutions participating in the Mexican market and the recent reforms and enactment of the laws governing the "Mexican anti-corruption system" are clear signs that legal services regarding compliance with such anti-corruption laws and policies are likely to be in high demand in the near future.
2018 Sector Trends
Transactional activity in 2018 varied greatly across sectors.
Interest in the development, acquisition and financing of projects in the power sector increased during 2018, due in part to the successful auctions for long-term contracts for clean energy, certificates, and capacity. An increased number of projects awarded in the first and second long-term auctions reached financial closing in 2018 and others are in the process of financing, with both international and domestic lenders showing interest in funding such projects.Auctions for exploration and exploitation of oil resulted in several private entities participating in this sector, at a slow but continued pace. In the midstream sector, pipeline development continues, but several of the projects under construction have faced interruptions due to social problems which remain unresolved. Such unfinished pipelines are now the subject of increased scrutiny by the Mexican government, which has indicated that it will commence an audit of gas transport contracts issued under previous administrations. The continued liberalisation of the fuel distribution market and increased opening of service stations under private brands has progressed to an incipient differentiation in pricing, with the market now looking to expand into liquid storage facilities and multimodal transport projects throughout Mexico.
Commercial real estate benefited from stronger demand from a growing services sector, while increased rents and lower vacancies were seen in the retail and office markets. A robust manufacturing and logistics sector made demand strong for industrial real estate. Private equity investors from Mexico and abroad continued their trend of investment in real estate projects. The real estate industry was challenged by currency volatility and an increase in interest rates. Nevertheless, lenders continued to fund most real estate asset classes.
Except for a temporary pause at the beginning of the year, M&A continued to be strong, particularly in terms of mid-market transactions. Private equity and sector-specific funds (including those focusing on energy and real estate) were particularly active, in some cases as a result of investment periods for funds raised during the initial surge in CKD fundraising nearing expiry.
Issuers continued to approach the market with potential equity and debt deals. Local institutional investors remained dominant in the market. Efforts to increase retail investors' participation in market offerings remain one of the challenges. The creation of a new stock market was expected to increase competitiveness in 2018, with lacklustre initial results. Activity was consistent through the different asset classes, including debt, equity and quasi-equity products.
Despite the volatility and uncertainty, we have seen a boost in activity in respect of banking and finance transactions seeking to secure access to long-term financing and hedge the risks posed during 2018. In addition to traditional financial institutions, new local lending players have continued to emerge through CKDs and other investment vehicles which seem intent on focusing on small and medium-sized transactions. This has led to an increase in financings involving borrowers with less access to traditional bank financing.
Litigation is still complex in Mexico, as form over substance continues to encourage lengthy and inefficient processes. Even advances in judicial training and the sophistication of local and federal courts have been recently overshadowed by a “human rights” approach to the interpretation of commercial transactions, which has, in a handful of visible cases, undermined structured transactions. Most practitioners and business participants view the Mexican legal system as a robust set of laws that provide clear and adequate protection to persons engaging in business within Mexico, although the training and expertise of judges need to improve.
Mexico is no different from its Latin American peers with respect to taxes and it maintains a high corporate income tax rate of 30 per cent. However, Mexico is still among the countries in the region that collect the least tax as a percentage of GDP. This is due to generalised tax evasion that in many ways is the product of the existence of a very large informal economy, but most importantly, the result of the abuse by the formal economy of various questionable and even illegal tax schemes. This environment forced the Mexican tax authorities to put in place a very sophisticated digital tax administration platform that is yet to produce its desired effects.
The current administration has announced an aggressive public investment programme. The administration has announced that CFE and Pemex will receive significant investment to aid them in their respective core activities. The administration has also signalled the construction of the Maya Railroad, the Trans-Isthmic Railway and Port Project and the Dos Bocas Refinery, along with the overhaul of Mexico’s six existing refineries, as the key infrastructure projects of this six-year term. Needless to say, all of these projects will require significant investment and funding and, these large-scale investments may stress an already overstretched federal budget and lending limit. In particular, the funding strategy announced in principle by the administration leaves significant room for doubt, since the proposed strategy of eradicating corruption, government austerity and cutbacks in other sectors of the federal budget would seem not to suffice. The administration maintains that resources will suffice and it will not be necessary to raise taxes, incur additional debt or tap into the central bank reserves.
The ultimate outcome in relation with the cancellation of the Mexico City airport may well set the tone for infrastructure and project financing transactions having a government sponsor and may have a knock-on effect on private projects and the continued development of industry and the Mexican market. The course of the Mexican economy and levels of transactional activity for 2019 will largely be dictated by the ability of the Mexican government to continue to foster private investment by providing certainty and a stable legal and economic platform.