Will Mexico’s new president target banks?

While most of the focus on post-election performance has been on the peso’s roughly 10% fall, the country’s banks have been trading as if they were being re-rated by investors.

Shortly before the election in mid May, Mexico's bank composite forward price-to-earnings and price-to-book multiples showed a 9% discount and 1% premium respectively, compared with long-term mean averages. Following the presidential election, these banks’ P/E and P/B multiples are now big 28% and 20% discounts.

The first question is: why have assets moved so strongly, given that the election result was so widely forecast?

Mexican bankers explain it by saying that while Claudia Sheinbaum's victory was expected, the scale of the electoral win was not.

Sheinbaum’s strong polling meant that she almost claimed a super-majority and will govern from a position of considerable strength. This means she will be able to consider more radical policies to address the increasingly urgent fiscal challenge. The country’s public deficit is forecast to hit 6% of GDP this year – its highest since 1998.

The prospect of an unfettered Sheinbaum administration caught the markets – which were dominated by long peso positions – off guard.

The fiscal issue also explains a large part of the downward lurch in share prices, because Mexico's banks have been enjoying strong profitability in recent years. According to recent research from Citi, over the last 20-plus years, the Mexican banking system’s return on equity has averaged 15.2%; in the past couple of years, the banks have reached record profit levels, with RoEs between 18% to 20%.

This could put a target on the industry’s back when the government is searching for additional revenues.

Some bankers think that investors’ fears over more taxes are overdone. They argue that the banks have already been paying higher rates in recent years: the system’s effective tax rate has gone from 21.6% in 2003 to 26.6% in the first quarter of 2024. Banks’ income taxes have grown at a faster pace too, with a compound annual growth rate of 12.7%, compared with a CAGR of 11.7% in pre-tax profit.

Banks have also made outsized fiscal contributions, with the aggregated income tax for commercial banks relative to GDP going from 0.11% to 0.31% during the same period.

But a counter argument can be made from this too: the government may decide that if banks have been able to pay increasing taxes while also growing profitability, why not accelerate this trend?

Investors clearly see that risk.

Citi’s analysis – meant to downplay the risk of rising bank taxes – can also be used to back the government’s possible case. Assuming an increase in the effective tax rate to 35% by 2026, the impact on RoE is around 170 basis points, which doesn’t sound too drastic and could increase banks’ fiscal contribution to around 0.46% of GDP – a tempting source of funds.

However, the strong profitability of Mexico's banks recently has been materially driven by higher rates – it is not a new structural norm. And taking 170bp of RoE at the heights is very different to taking the same amount at lower levels of profitability.

Mexican bankers will be hoping that the government will overcome the temptation to squeeze the banks and that it will see the industry’s pivotal economic role and decide not to push too far on profitability.

But with such a big fiscal hole to fill, the temptation may be too great.

Which leads to second-order risks for Mexico’s banks, which are arguably larger than any potential new tax regulation. Will business confidence be knocked to such an extent that the macroeconomy will deteriorate, impacting financial results?

There are already initial reports of softening corporate loan demand. Total loan demand has been falling in the country since the middle of 2022, despite the talk of nearshoring.

There are no concrete proposals from the incoming administration for changes to taxes that will directly impact the banks – and it is also far too soon to assess the second-order impacts on Mexico’s financial system. But that hasn’t stopped investors deciding the future has just got harder for the country’s banks.

And they may well be right.