OREANDA-NEWS. September 15, 2015.  Mexico's proposed budget would lower spending and maintain a path of fiscal consolidation despite downward pressure on oil revenues, Fitch Ratings says. Overall, we believe Mexico's proactive response to lower oil income is prudent, especially in light of the difficult external environment and continued weakness and volatility in the oil markets. The proposed budget cuts are in line with our expectations and growth is forecast within the range projected when Fitch affirmed Mexico's rating with a stable outlook in July.

The proposed budget sees Mexico's 2016 growth rate in the range of 2.6%-3.6%. Fitch forecasts 2.5% growth in 2015; we believe it could pick up to average above 3% in 2016-2017 on stronger external demand, real exchange rate depreciation, and some progress in implementing economic reforms. Downside risks to growth remain and could emerge from higher domestic financial volatility due to US Fed tightening, further contraction in oil output, and failure of investment and confidence to recover materially.

Spending cuts are central to the proposed budget and the government has been working toward implementing a zero-base budgeting approach to improve operational efficiency and reduce costs. The budget includes a cut of MXN133.8 billion (around 0.7% of GDP) in 2016. These cuts come on top of the MXN124.3 billion (0.7% of GDP) spending cuts in 2015, highlighting the government's commitment to adjust to the new economic environment. However, implementation risks remain.

The proposed budget includes a 0.5% reduction in the nonfinancial public sector (NFPS) deficit, compared to the estimated results for 2015. In our view, this is in line with a gradual fiscal consolidation embedded in the government's medium-term fiscal targets. The non-financial sector deficit including investment outlay of productive state enterprises is forecast to decline to 3% of GDP in 2016 from an estimated 3.5% this year. Excluding such investments, the NFPS deficit is targeted to reach 0.5% of GDP in 2016, compared to 1% in 2015.

The budget projects that overall revenues will fall by 0.2% in real terms in 2016 (compared to the 2015 budget) as oil income contracts and is largely offset by the expected growth in non-oil revenues. No new taxes are proposed. Oil revenues are projected to fall by 30% in real terms compared to the 2015 budget due to the dual headwinds of low oil prices and reduced oil production. The budget assumes oil production platform of 2.25 million barrels per day, down from 2.4 million assumed in the 2015 budget.

A faster drop in oil production remains a risk. The oil price assumption included in the budget is USD50 per barrel for the Mexican oil mix and the federal government has hedged its net oil exposure at USD49 per barrel using put options costing around USD1 billion. The remaining difference of USD1 per barrel is covered with a secondary account of MXN3.7 billion within the oil stabilization fund. As such, the oil hedge combined with resources in this secondary account protect Mexico's federal government revenues from lower than budgeted prices.

Mexico's economic growth continues to constrain its credit profile as it remains relatively weak compared to its rating peers and some large emerging markets. In addition, the government's narrow revenue base, heavy though declining dependence of public-sector revenue on oil income, and limited fiscal buffers are the main structural weaknesses of the country's public finances.