This Selected Issues paper analyzes fiscal multipliers in Mexico. Estimates of fiscal multipliers--obtained from state-level spending--fall within 0.6-0.7 after accounting for dynamic effects. However, the size of multipliers varies with the output gap. The planned fiscal consolidation-under the estimated multipliers-is projected to subtract on average 0.5 percentage points from growth over 2015-20. However, there are offsetting effects. The positive growth impulse of lower costs on manufactured goods production is estimated to reach 0.5 percentage point in 2015 and 2016, largely offsetting the impact of fiscal consolidation on growth in the near term.

Abstract

This Selected Issues paper analyzes fiscal multipliers in Mexico. Estimates of fiscal multipliers--obtained from state-level spending--fall within 0.6-0.7 after accounting for dynamic effects. However, the size of multipliers varies with the output gap. The planned fiscal consolidation-under the estimated multipliers-is projected to subtract on average 0.5 percentage points from growth over 2015-20. However, there are offsetting effects. The positive growth impulse of lower costs on manufactured goods production is estimated to reach 0.5 percentage point in 2015 and 2016, largely offsetting the impact of fiscal consolidation on growth in the near term.

Corporate Vulnerabilities and Impact on the REAL Economy1

Nonfinancial corporate debt has increased in recent years, supported by easy access to global debt capital markets, ample global liquidity, and low interest rates. While this has contributed to a modest increase in corporate leverage, particularly for large firms, the ratio of corporate debt to GDP at the aggregate level remains low compared to other emerging market countries. Slowing economic growth and external headwinds could weaken firms’ debt-servicing ability. However, our sensitivity analysis suggests that most firms have adequate capacity to service debt, even in extreme shocks of a combined 30 percent depreciation in exchange rate, 30 percent increase in borrowing costs, and 20 percent decline in earnings. Banks’ buffers are sufficiently strong to withstand any associated rise in defaults. Nonetheless, these shocks could lower real GDP growth by 0.2–0.4 percent through lower corporate investments and bank credit supply.

A. Rising Corporate Debt

1. Nonfinancial corporate debt has increased in recent years. Total corporate debt, including state-owned enterprises, rose from 28 percent of GDP in 2010 to 32 percent of GDP in 2014, a relatively low level compared to other emerging countries (Figure 1). Since the Global Financial Crisis (GFC), easier access to debt capital markets has helped support corporate borrowing, particularly for large firms. Mexico is the second largest corporate bond issuer in the Latin American region, and around two-thirds of the net issuance is denominated in foreign currency. State-owned companies Petróleos Mexicanos (PEMEX) and Comisión Federal de Electricidad (CFE) accounted for one third of total foreign-currency corporate bond issuance, from 2009 to 2014.

Figure 1.
Figure 1.

Corporate Debt

Citation: IMF Staff Country Reports 2015, 314; 10.5089/9781513593432.002.A003

Sources: Bloomberg, L.P.; Orbis; and IMF staff calculations.

2. Along with the growth in bond issuance, corporate borrowing from banks had also increased modestly. Corporate bank loans grew at a compounded annual rate of 8 percent from 2008 to 2014. In 2014, domestic bank loans accounted for 23 percent of total corporate debt, while external borrowing and debt securities issued in the domestic bond market amounted to 57 percent and 20 percent of total debt respectively.2

3. The rapid increase in bond issuance has been, in part, used to reduce funding costs and increase the maturity structure of debt. The share of corporate bonds maturing in 2015 and 2016 is only 10 percent of total outstanding debt. The bulk of bonds mature in 2020 or later. It is worth noting that some of the new bonds were issued by the subsidiaries of large multinationals and used for expanding investments outside of Mexico, so they do not count as part of Mexico’s external debt in the national statistics.

4. As debts grew at a faster pace compared to equity, gross corporate leverage has increased, but after accounting for cash holdings, net leverage has risen only slightly (Figure 2). For large firms, in particular, the ratio of total debt to total equity has increased notably. On the contrary, leverage has declined slightly for small firms. Sectors with relatively high leverage ratios (excluding PEMEX and CFE) are telecommunications, construction, and metals and metal products. However, after accounting for cash holdings, net leverage—defined as total debt minus cash holdings to total equity—increased only 2 percentage points to 46 percent between 2008 and 2014.

Figure 2.
Figure 2.

Corporate Leverage

Citation: IMF Staff Country Reports 2015, 314; 10.5089/9781513593432.002.A003

Sources: Bloomberg, L.P.; Standard Chartered Bank; Orbis; and IMF staff calculations.

B. Vulnerabilities

5. Legacy issues from a sharp economic slowdown in 2013 may partly explain a decline in profitability in 2014. Firm-level data suggests that the median returns on equity (ROE) ratio continued to decline in 2014, driven mainly by large firms (Figure 3). Slower growth in Mexico and other countries in which these firms have operations can explain this trend. The pattern is in line with other emerging market countries, where corporate ROEs also weakened in 2014 compared to five-year averages. The decline in corporate profitability in 2014 was broad-based.3

Figure 3.
Figure 3.

Corporate Credit Metrics

Citation: IMF Staff Country Reports 2015, 314; 10.5089/9781513593432.002.A003

Sources: Bloomberg, L.P; Worldscope; Orbis; and IMF staff calculations.

6. Lower earnings weakened corporate debt servicing capacity somewhat, although it remains strong for most firms. Interest expense grew at a faster pace compared to earnings from 2008 to 2014, particularly for large firms. Together with the recent weakness in earnings, this has lead to a decline in the interest coverage ratio (ICR), though the median ICR across firms remained strong and sufficient to cover debt interest payments.4 It is worth noting that while large firms’ median ICR had been declining, small firms’ median ICR had improved in 2014 due to improvement in earnings and a reduction in leverage. Sectors with low ICRs tend to be those that have relatively high leverage (telecommunications, construction, and metals and metal products).

7. The authorities are actively improving monitoring of corporate risks. In Mexico, the Stock Exchange and CNBV require listed firms to disclose information on their derivative positions on a quarterly basis to enable the identification of risks. In addition, Banco de Mexico has detailed information on derivative transactions where the company’s derivative counterparty is a domestic bank or a domestic broker-dealer. In this context, Banco de Mexico conducts foreign currency risk analysis for the nonfinancial corporate sector using available information. Notwithstanding these improvements, access to comprehensive firm-level data on foreign currency risks remains a challenge for Mexico and many other emerging market economies.

C. Stress Tests

8. To gauge the resilience of firms to a combination of exchange rate, earnings and interest rate shocks, we conducted a stress tests analysis on a sample of firms, based on available balance sheet information.5 The shocks were derived from the following “severe but plausible” assumptions:

  • A 30 percent increase in borrowing costs, similar to the average of median changes in corporate borrowing costs across major emerging market countries during the GFC.6 In Mexico, the median increase in firm’s borrowing costs was 10 percent during the GFC.

  • A 20 percent decline in earnings, similar to the median changes in firms’ EBIT across major emerging market countries during the GFC. In Mexico, the median decline in firm’s earnings was also 20 percent during the GFC.

  • A currency depreciation against the U.S. dollar of 30 percent, similar to trends observed in late 1990s, and 15 percent depreciation against the Euro, reflecting a divergence in the monetary policy stance between the U.S. and Euro area. In Mexico, the peso depreciated close to 30 percent against the dollar during the first six months of the GFC.7

9. We also took into consideration natural and financial hedges that could mitigate corporate exposure to exchange rate risk. We made the following assumptions:

  • Natural hedges were proxied by the ratio of foreign sales to total sales, as data on foreign currency revenues is not available’8 The median foreign sales to total sales ratio was 23.4 percent in 2014.

  • Financial hedges were derived based on a simple assumption that 50 percent of FX debt interest expense is hedged through derivatives. This takes into consideration the availability and effectiveness of the hedges.9

10. The results show that a combination of these three shocks would weaken firms’ debt servicing capacity, but the corporate sector would remain resilient. Corporate earnings are largely sufficient to service interest obligations under the stress scenarios (Figure 4, panel 2). With natural and financial hedges, the median ICR would decline from 3.7 in 2014 to 2.3. Without hedges, the median ICR would decline by around 2 percentage points, to 1.9. This is in line with the decline in median ICR observed during the GFC (from 5.4 in 2007 to 3.3 in 2008) where the shocks to corporate earnings, borrowing costs, and exchange rate were close to the levels used in this exercise.

Figure 4.
Figure 4.

Corporate Sensitivity Analysis

Citation: IMF Staff Country Reports 2015, 314; 10.5089/9781513593432.002.A003

NOTE: Excludes PEMEX and CFE.Sources: Bloomberg, L.P.; Haver Analytics; Worldscope; Orbis; and IMF staff calculations.

11. A combination of the three shocks would increase debt at risk—mostly at large firms—but it would remain relatively moderate compared to other emerging market countries (Figure 4, panel 3 and panel 4). The simultaneous shocks would raise the corporate debt at risk to 38–40 percent of total debt (5.2–5.4 percent of GDP), from 27 percent of total debt (3.7 percent of GDP) in 2014 (Box 1).

Interest Coverage Ratio and Debt at Risk

Interest Coverage Ratio

A firm’s capacity to service debt hinges on its interest coverage ratio (ICR), computed as Earnings/Interest Expense, where Earnings is measured by earnings before interest and taxation (EBIT)1. The lower the ratio, the more the company is burdened by debt expense relative to earnings. An ICR of less than 1 implies that the firm is not generating sufficient revenues to service its debt without making adjustments, such as reducing operating costs, drawing down its cash reserves, or borrowing more. This analysis uses EBIT as a measure of earnings instead of EBITDA (earnings before interest, taxation, depreciation and amortization) to account for the need to replace assets and reinvest to ensure going-concern.

Debt at Risk

By the time a firm’s ICR dips below 1, it may already be in distress. As an early warning signal of potential corporate difficulties ahead, analysts often use an ICR of 1.5 as a threshold. An ICR of below 1.5 also flags potential vulnerability to funding risks, particularly when market liquidity thins in turbulent times. During the Asian Financial Crisis, countries whose corporate sector with median ICR below 1.5 were more vulnerable.2 Accordingly, we define debt at risk as the debts of firms with ICR below 1.5. The debt at risk for each country is computed as:

ΣDebtofFirmswithICR<1.5ΣDebtofFirms

The share of debt at risk shows how much of these outstanding debts are vulnerable due to the weak debt servicing capacity. A relatively high share of debt at risk shows that the country may be more susceptible to corporate distress from macroeconomic and financial shocks.

Caveat

It is worth noting that the coverage and representativeness of the sample obtained from the Orbis database vary across countries, and therefore sample selection bias can be a problem.

1. Also known as operating profit/loss2. The median interest coverage ratio in Korea, Thailand and Indonesia were below 1.5.

12. Some of the largest firms have high leverage and low interest coverage. Among the top ten largest companies (by asset size), four of them had total debt to total equity ratios above 100 percent, and three of them had ICRs below 1.5 in 2014 (Figure 4, panel 5 and panel 6). Our stress tests analysis shows that a fourth firm would see its ICR decline below 1.5, bringing the number of firms with ICR below 1.5 to four. The total debt of these four firms is around 3 percent of GDP.

D. Impact on the Banking Sector

13. Commercial lending comprise a large share of total bank loans, but banks have adequate buffers to absorb shocks in the corporate sector. Lending to nonfinancial corporations account for half of total bank loans. Total gross nonperforming loans (NPL) in the banking sector reached around 3 percent of total loans in 2014, slightly higher in larger banks compared to smaller banks.10 Loss absorbing buffers comprising Tier 1 capital and excess of provisioning over NPLs are strong, at 15 percent of risk-weighted assets. Our stress tests analysis, which assumes a default probability of 15 percent for corporate debts with ICR below 1.5, suggests that the gross NPL ratio could increase by 1.5 percentage points to 4.5 percent in a scenario where the corporate NPLs are fully written-off (figure 5). In this scenario, the ratio of banks’ loss absorbing buffers to risk-weighted assets would decline from 15 percent to 13.7 percent, still above Basel III’s minimum Tier 1 capital ratio requirement of 8.5 percent.11 It is worth noting that commercial banks may be exposed to funding risks in the stress scenario due to potential large deposit withdrawals, particularly from corporations that are facing weaker financial positions.

Figure 5.
Figure 5.

Impact on the Banking Sector

Citation: IMF Staff Country Reports 2015, 314; 10.5089/9781513593432.002.A003

Sources: Bankscope; Haver Analytics; and IMF staff calculations.

E. Impact on the Real Economy

14. While stress tests reveal that corporate balance sheets appear strong enough to withstand large shocks, there could still be an impact on the real economy. The stress scenarios discussed in the previous section reveal that widespread bankruptcies as a result of the assumed shocks are unlikely. However, the median firm can still decide to retrench investment to rebuild buffers if faced with shocks. Furthermore, firms outside the sample—if financially weaker—could still default and may trigger higher NPLs at banks, which in turn, can curtail credit supply.

15. The median firm could lower investment up to 1.2 percentage points of the capital stock in the most severe stress scenario. To derive the implications of the shocks for leverage, we assume that total debt increases by the valuation loss on the proportion of debt denominated in foreign currency due to the currency depreciation. Using estimates from Li, Magud, and Valencia (2015)—relating investment rates to net leverage—the resulting increase in leverage would lead to a reduction in investment rates between 0.3 and 1.2 percentage points of the capital stock. These authors report an elasticity of real GDP growth to investment rates—measured in percent of a firms’ capital stock—of about 0.1. This elasticity implies that the reduction in investment rates could lead to lower real GDP growth in 0.03 to 0.12 percent.

Stress Scenarios and Impact on Corporate Investment Rates

article image
Source: IMF staff calculation.

Li, Magud, and Valencia (2015), coefficients estimated in a panel of 11,000 firms from 38 emerging markets, including Mexico, relating investment rates—defined as capital expenditure divided by the capital stock—to net leverage, defined as total debt minus cash stocks divided by total equity.

16. Additional real effects from lower supply of bank credit could arise if weaker firms default. Firms in the above analysis are relatively large corporations with access to international financial markets. Lacking firm-level data for the whole corporate sector, we assume—rather conservatively—that firms outside the sample default with a 15 percent probability. This default rate corresponds to Moody’s historical estimate for firms with ICR’s below 1.5. We extrapolate this default rate to the whole portfolio of bank loans to the corporate sector. The resulting increase in NPL’s is treated as a bank capital shock.12 Additional real effects could then arise from a reduction in the supply of bank credit in response to this capital shock. To estimate this effect we ran simple regressions relating bank lending growth to the equity-to-assets ratio, which as the table below shows, gives an estimated coefficient of around 2, similar to estimates for U.S. banks.13

17. Higher NPL’s at banks could reduce growth by up to 0.3 percent through a reduction in the supply of credit. Empirical studies find elasticities of real GDP growth to bank credit growth ranging from 0 to about 0.4, so a 1 percent reduction in credit growth leads to 0–0.4 percentage points decline in real GDP growth.14 In times of severe recessions, the elasticity tends to be closer to the upper limit, whereas during normal times it tends to be closer to zero. The elasticity depends also on the degree of credit deepening. Given Mexico’s low credit deepening and the absence of a deep recession, the elasticity would tend to be low; therefore, we assume a value of 0.15. The estimated response of bank lending to the assumed shocks (between 1.4 and 1.7 percent) would reduce growth between 0.2 and 0.3, depending on the stress scenario.

Stress Bank Lending Response to Bank Capital Shocks

article image
Source: IMF staff calculation.Note: Fixed effects regressions with robust standard errors in parenthesis. Size denotes the lagged value of the natural logarithm of total assets; Equity/Assets denotes total equity divided by lagged total assets; currency depreciation measures the percentage change in the exchange rate of the Mexican Peso vis-a-vis the U.S. Dollar; Inflation denotes the percentage change in the CPI. * p<0.1; ** p<0.05; *** p<0.01

18. Altogether, the assumed shocks could reduce growth by 0.2–0.4 percent, but in combination with other shocks could lead to larger effects. The total effect reflects the impact of the assumed shocks exclusively through a financial channel, operating both through lower investment by firms in the sample in response to increased leverage and lower supply of bank credit—from impaired loans to firms outside the sample. However, if the assumed shocks happen in conjunction with other shocks—for instance, a negative growth surprise in the U.S.—the effects could be much larger.

Impact of Higher NPLs on Credit Supply

article image
Source: IMF staff calculation.Note: scenarios treat the increase in NPLs as a bank capital shock.

Coefficients correspond to those on the Equity/Assets ratio shown in Table 2.

F. Summary and Conclusion

19. While corporate credit metrics have weakened somewhat as of 2014, particularly among large firms, the corporate sector remains resilient and bank sector buffers are strong. The stress test analysis suggests that most firms have adequate capacity to service debt in a scenario which combines a 30-percent exchange rate depreciation against the dollar, 30-percent increase in borrowing costs, and 20-percent decline in earnings. Under these circumstances, banks’ buffers remain strong and are sufficient to withstand the shocks in the corporate sector.

20. Notwithstanding the resilience of the corporate and banking sectors, the shocks could still affect the real economy through lower investment and bank credit supply. Faced with these shocks, firms could retrench investments to rebuild buffers. Weaker firms may default, thus triggering higher NPLs, which could lead to a reduction in bank credit supply. Corporate data disclosure requirements have been strengthened, but data issues still present a challenge for monitoring risks.

Appendix I. Methodology for Corporate Sensitivity Analysis

A. Analytical Approach

A firm’s capacity to service debt hinges on its interest coverage ratio (ICR), computed as EBIT/Interest Expense, where EBIT is earnings before interest and taxation1. The lower the ratio, the greater the debt payment burden of the company. An ICR of less than 1 implies that the firm is not generating sufficient revenues to service its debt without making adjustments, such as reducing operating costs, drawing down its cash reserves, or borrowing more. This analysis uses an ICR threshold of 1.5, which is a benchmark used widely by analysts as an early warning signal. Firms with ICR below 1 may already be in distress.

B. Data Source

The analysis is based on annual firm-level balance sheet information from Orbis. This database has 123 Mexican firms with good data points, covering US$678 billion of assets (52 percent of GDP) and US$359 billion of debt (28 percent of GDP). It includes public and private, large and small companies.

C. Estimating Corporate Debt

As the breakdown of firm-by-firm foreign currency borrowing is not available through Orbis and other in-house databases, FX debt is estimated at the aggregate level, by external debt statistics and other sources as follows:

article image

While external debt could be in foreign or local currency, most foreign holdings of corporate debt are in hard currencies.

Aggregate corporate debt is estimated as:

  • External Debt + Loans from Domestic Banks + Borrowings from Domestic Capital Markets

D. Estimating Potential Exchange Rate Losses from Foreign Currency Debts

Potential exchange rate losses from foreign currency debt interest payment due in the current year is estimated as:

Share of External Debt xBorrowingCostxTotalDebtx[(ShareofUSDxNominalExch.RateDepreciationvsUSD)+(ShareofEURDebtxNominalExch.RateDepreciationvsEUR)]

The currency breakdown of external debt assumes that the share of EUR-denominated debt is similar to the share of exports to the Euro area (18 percent) while the rest are denominated in US dollar.

E. Accounting for Natural Hedges

FX losses from interest expense and revaluation of foreign currency debt principal and are offset by FX gains from overseas earnings, computed as:

Share of Foreign Sales xEBITx[(ShareofUSDRevenuexNominalExch.RateDepreciationvsUSD)+(ShareofEURRevenuexNominalExch.RateDepreciationvsEUR)]

Assumptions underlying this estimation:

  • Foreign sales are assumed to be in foreign currencies.

  • The share of FX revenues is derived from the country trade weights.

  • The multiplication by EBIT (operating profit) effectively takes into account foreign currency costs, as it assumes that the share of these costs are in proportion to foreign currency income.

It is worth noting that the effectiveness of natural hedges is an approximation as it may fall short of expectations. Past episodes have demonstrated that overseas revenues could decline in tandem with the depreciating currencies during turbulent periods.

F. Accounting for Financial Hedges

Currency hedging of foreign currency debts could also mitigate potential FX losses. Offset from financial hedging of foreign currency debt principal and interest is computed as:

HedgeRatioxFXlossesfromforeigncurrencydebtinterest

As information on financial hedging is sparse, this analysis assumes that at least 50 percent of foreign currency debts are hedged, on aggregate basis.

G. Projecting the Increase in Nonperforming Loans

The increase in corporate nonperforming loans is projected from the after-shock corporate debt at risk as follows:

Increase Corporate NPL=Increase in Corporate Loan at Risk×Probability of Default×Loss GivenDefault
  • Increase in Corporate Loans at Risk: This is derived from extrapolating the risk of default of firms with ICR’s below 1.5 to the entire portfolio of bank loans to the corporate sector. The implicit assumption is that non-listed firms are financially weaker than listed firms.

  • Probability of default: This is assumed to be 15 percent based on Moody’s default probability for corporate debts with interest coverage ratio of 1.5 over a three-year horizon(based on data from 1970-2012).

  • Loss Given Default: This is computed as an average of 45 percent (Basel II Foundation Approach for senior claims on corporates, sovereigns and banks not secured by recognized collateral2) and country-specific LGDs from The World Bank’s data on “Resolving Insolvency”3 (Appendix 1).

The ability of banks to withstand losses will depend on their loss absorbing buffers, which comprise Tier 1 capital and the excess of provisioning over the stock of NPL. The after-shock loss absorbing buffers can be computed as:

Tier  1capital+Loan Loss ReservesExisting Stock of NPLProjected Increase in NPLRisk  -Weighted Assets

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1

Prepared by Julian Chow and Fabian Valencia. The authors thank Dora Iakova, Pascual O’Dogherty, and seminar participants at the Central Bank of Mexico for insightful comments and suggestions and Alexander Herman for outstanding research assistance.

2

This is estimated from a combination of sources that include Financial Soundness Indicators (FSIs), Bloomberg and Quarterly External Debt Statistics (QEDS). See Appendix 1.

3

Based a sample from the Orbis database with 123 firms (total assets of 52 percent of GDP and total debts of 28 percent of GDP). The sample was selected based on firms with at least one known value for the financial variables from 2006–2014, and firms with no recent financial data are excluded.

4

ICR is computed as EBIT divided by interest expense; where EBIT (also known as operating profit) is earnings before interest and taxation.

5

The sample consists of 123 firms from the Orbis database. See Appendix 1.

6

These countries include China, India, Indonesia, Malaysia, Thailand, Philippines, Brazil, Mexico, Chile, Argentina, Peru, Russia, Turkey, Poland, Hungary, Bulgaria and South Africa.

7

The Peso has registered a year-over-year depreciation of 25 percent against the U.S. dollar as of September 2015, very close to the exchange rate shock used in the stress test.

8

The information is sourced from the IMF Corporate Vulnerability Utility database which uses data from Worldscope.

9

While FX hedging instruments and markets are more developed now than during the late-1990 crises, it is important to note that some of these instruments are complex. For example, some currency hedges would terminate when the exchange rate depreciates beyond a certain “knock-out” threshold, thus rendering the hedge worthless. Moreover, firms are exposed to liquidity and rollover risks when these contracts expire.

10

These include NPLs from households and the corporate sector.

11

This includes capital conservation buffer of 2.5 percent.

12

The increase in NPL’s would affect capital in the same period only to the extent that they exceed loss loan reserves. However, even if loan loss reserves are enough to cover the increase in NPL’s, banks may wish to rebuild buffers.

13

Hancock and Wilcox (1993, 1994), Bernanke and Lown (1991), Berger and Udell (1994), and Peek and Rosengren (1994), Berrospide and Edge (2010) conducted studies with U.S. data and found coefficients ranging from 0.7 to 2.8, in a variety of specifications.

14

Estimates vary depending on whether the regressions focus on normal times or periods of financial distress. For instance, Driscoll (2004) finds no statistically significant effects, while Calomiris and Mason (2003) who study the real effects of credit supply shocks around the Great Depression find an elasticity of 0.4.

1

EBIT (also known as operating profit/loss) is used as a measure of earnings instead of EBITDA (earnings before interest, taxation, depreciation and amortization) to account for the need for investment and replacement of assets.

2

See section 287-288 of Basel II Accord (http://www.bis.org/publ/bcbs128.pdf)