Turning on the Credit Supply

Strange things are happening in Mexico. In late July, the government raised $100 million in 10-year peso bonds at a fixed rate of 10.9%, or only 150 basis points over 28-day local instruments. A few weeks later, Scotiabank Inverlat announced it was slashing interest rates on its 20-year mortgages to 14% a year from 19%.

The drop in interest rates in Mexico is being felt throughout the country. If these low rates are sustainable, and many think that they are, the change could revolutionize the country’s financial markets, boosting borrowing and investment, and improving liquidity of the capital markets. Bank financing in turn should serve as a key factor in supporting economic growth.

This would be a remarkable change. Interest rates in Mexico in 1995 hit 49% and although they fell over the following years, benchmark rates still averaged a punishing 27% since then. Low inflation, a small budget deficit and a strong currency have brought rates down to single figures. However, at 7% a year in real terms, they are still high. Nonetheless, a recapitalized banking system is ready to resume lending to the private sector after nearly five years during which it lent almost exclusively to the government.

“We expect that the sharp reduction in government rates will feed throughout the financial and capital markets and lead to cheaper financing in the long term, primarily for corporations but also for individuals,” says Miguel Palomino, chief Latin American economist at Merrill Lynch. “This will contribute to stronger GDP growth, particularly as foreign direct investment flows continue to rise.”

While lower interest rates in Mexico will squeeze banks’ profitability in the short term, even they see the decline in interest rates as beneficial. “With the levels of interest rates that we are seeing, [banks’] financial margins of 3% are more in line with the US,” says Manuel Medina Mora, chief executive officer of Banamex, the country’s largest bank. He adds that, “With those levels you should see a resumption of lending both to consumers and to businesses.”

Medina Mora says the key question is how sustainable low interest rates are. He says that if rates stay low, “We will see a credit surge unlike anything we have seen in eight or nine years.”

The change cannot be overemphasized. Credit just about died out in Mexico after the 1994-95 peso crisis. Until then, the country gorged on easy loans from recently privatized banks that had only rudimentary credit controls. “Those asking for loans were not really aware of the risk they were taking and those making loans were not really aware of the risk they were taking. [Regulatory] supervision was very poor,” says Othón Ruiz, chief executive officer of Banco Mercantil del Norte.

“There has been a tremendous consolidation of the system, supervision has improved substantially and banks have implemented better infrastructure to manage risk,” says Ruiz. “There is a substantial reduction of systemic risk. The environment is very different.”

Declining inflation in Mexico should also help resurrect a credit culture. The government’s July bond sale, its longest-ever peso issue, was more than three times oversubscribed, an indication of the market’s growing comfort with the country’s inflation levels. Prices rose 9% last year and rose 2% through July 2001.

“It was the first time the government was able to place a bond in pesos with a maturity that long,” says Carlos Peyrelongue, senior country analyst for Merrill Lynch. “What this is telling me is that the market believes Banco de México’s inflation targets. It tells me that the bank has gained credibility.”

Peyrelongue says that in the past, the markets had little confidence that the country’s independent central bank could reach its annual inflation targets or that it wasn’t merely a political pawn of the government. “But now, the markets do believe that it is an independent central bank and will do anything it needs to make its inflation target of 3% by 2003,” he says.

The implications of low inflation and interest rates run deep. For the consumer, the mere availability of reasonably priced loans will allow them to buy more big-ticket items. “Banks are aggressively getting back into the market, with mortgage and car loans and credit card debt,” says Peter Cardinal, chief executive officer of Scotiabank Inverlat, which was the first Mexican bank to lower consumer interest rates below 20% earlier this year.

Cardinal adds however, banks are evaluating risk much more carefully than in the past. “We have very rigid loan-to-value policies as well as payment capacity requirements. The lending is a lot more prudent.”

Expanding loans to companies may take longer. They are expected to borrow more and begin to issue new debt in 2002 as the cost of borrowing in pesos continues dropping. It is still cheaper for Mexican companies to issue bonds in US dollars, but the peso market will be especially attractive for companies that don’t export and want to avoid currency mismatches. Borrowing in pesos also makes sense for companies that are not large enough to access the international capital markets.

“Corporates are going to start thinking about borrowing in pesos instead of in dollars,” says Peyrelongue. “It is a way for those companies that don’t export to reduce risk on their balance sheet. Yes, they many have to pay a bit more than they would in dollars but it is in the same currency that they have their actual sales.”

The Mexican broadcast company Televisa was an early mover in peso issuance. In a major debt restructuring in January last year, the company reduced the annual cost of its debt from an average of almost 14% to slightly over 8%, and perhaps as important, altered its profile, says Alfonso Angoitia, Televisa’s chief financial officer.

“Before [the restructuring] we had 90% of our debt in dollars and 10% in pesos. Now we have 60% in dollars and 40% in pesos,” says Angoitia. “Most of our revenues are in pesos and we also wanted to take advantage of the strong peso by moving the dollar debt into pesos.”

Increased peso issuance would also broaden the range of investment opportunities in the local bond market, still dominated by low-priced government paper. Declining interest rates should also give the equity markets a boost. With deposit interest rates falling and bond market yields declining, investing in shares, bearing an attractive equity premium, will start looking more attractive.