Narco-security in Mexico – Fat Tail Downside Risk to Financial Markets

Potential changes in Mexico’s internal security situation pose both upside and downside risks to corporates, each with relatively equal, medium likelihood and medium-to-high impact. With relatively lower probability, an extreme deterioration poses substantial broad-based downside risks for currency, credit and equity markets.

To date, security issues related to organized crime in Mexico have posed some limited corporate risks for foreign investors, the bulk of violence being limited to roughly 80 municipalities and economic targets not predominating. Tourism numbers have recovered after a slump in 2008 which can now therefore attribute to the financial crisis rather than to the security situation.

Clearly, a sustained improvement in the security situation would lead to an improved business environment. Conversely, any significant deterioration, in terms of the range of targets or geographical spread of killings and kidnappings, would have a negative impact.

The situation is volatile, and both cases must be viewed as medium risk, with the former carrying a medium impact, the latter carrying potentially a much higher impact.

In extremis, there is also a relatively low probability of more broad-based market risks arising from a very severe escalation in violence. There are some limited parallels with 1994, but they should not be overstated.

In 1994, a leading Presidential candidate was assassinated, as was another leading member of PRI. Moreover, the Zapatista insurgency gave rise to significant insecurity in the southern Chiapas region. A critical distinction between 2012 and 1994, however, is that Mexico’s macro-economic fundamentals are now far stronger, and its financial markets less vulnerable to political shocks or triggers.

A severe retrenchment in portfolio investment FDI could presage a sudden stop in capital inflows, while the recently robust Mexican peso would face devaluation risk, sovereign debt risks downgrade and yield spikes, while the stock market could consequently see significant falls.

Downside risks therefore outweigh the potential upside in terms of impact, but the more extreme, market sensitive downside risks must be viewed as low probability (less than 10%).

In the short term, it is unlikely that we will see any significant change in government internal security policies, either before the elections in July, or before December when the new President will come to office.

Our baseline scenario indicates a two thirds probability that PRI’s Enrique Peña Nieto will win the Presidential election. While he has promised a shift away from the military-led strategy of Calderon (PAN), it is unlikely that such a profound shift could be executed in the short-term, if at all. In particular, his pledge to double the size of a police force riven with corruption is not credible. Moreover, Calderon’s military-led strategy is far from universally unpopular, particular in areas where violence linked to organized crime was endemic prior to 2006.

Implicitly and, to a limited extent explicitly, PRI is viewed as having a more conciliatory – if not symbiotic – relationship and outlook with organized crime elements. It is doubtful, but cannot be excluded, that Peña Nieto would adopt a more robust posture vis-à-vis organized crime groups than his predecessor.

A victory for Josefina Vazquez Mota, recently selected as PAN’s candidate, and polling second to Peña Nieto, could presage a more sustained commitment to Calderon’s confrontational military-led strategy. At this point, the approach of AMLO (PRD), who is polling third, to internal security, is less clear. It would not be unreasonable to assume that his stance lies between that of the two front-runners.

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