Mexico's construction sector shifts toward more private sector involvement

Mexico’s construction industry is changing gears in 2017. After recording GDP growth of 1.8% in 2016, the sector faces some short-term challenges. Austerity in public sector budgets has reduced the value of infrastructure projects. There are some macroeconomic concerns including the prospect of higher inflation and tighter interest rates. The worry is that demand for building work across the economy will slow down.

Offsetting these concerns, however, are a number of positive signs in the medium- and long-term. A young, growing population and a rising middle class continue to drive demand for homes, shops, factories and offices. The infrastructure industry is preparing for a future where private sector funding takes over from the public sector and becomes the key engine of growth. Furthermore, profits at Cemex, Mexico’s multinational cement company, have reached record levels, and the project to build Mexico City’s new airport – which is now under way – is the biggest of its kind in Latin America.

Industry Background

According to the construction sector’s economic research centre (Centro de Estudios Económicos del Sector de la Construcción, CEESCO), the sector represents the fourth-largest value-added activity in the country. Ranked behind manufacturing, commerce and real estate services, it constitutes roughly 8% of GDP.

Construction is also the country’s second-largest source of employment, after agriculture, accounting for 15.7% of the workforce and creating 6m direct jobs. Moreover, CEESCO reports that the industry is closely linked with many other areas of the Mexican economy. For every 100 pesos spent on construction, 45 pesos goes towards purchasing goods and services from 176 of the economy’s other 262 productive branches.

Construction’s total market size was estimated at MXN2.4bn ($145m) in 2016, of which 77% was commissioned by the private sector and 23% was from the public sector. Of the private sector total, the highest areas of investment were residential spaces at 39.2%; commercial facilities, including shopping centres and warehouses, at 18.3%; and industrial spaces, such as industrial parks and factory shells, with 15.6%.

Smaller segments receiving private sector funding included non-residential building, tourism facilities such as the construction of resorts and hotels, and services including schools and hospitals. Within the public sector, 77% of activity related to federal government infrastructure contracts while the remaining 23% of funds was related to state governments.

National Infrastructure Programme

The government has published a 2014-18 National Infrastructure Plan (Programa Nacional de Infraestructura, PNI) that identifies six strategic priorities: transport and communications; energy; water; health; urban development; and tourism. Soraya Pérez, president of the government real estate entity INDAABIN, acknowledged that the state could use a new tactical direction in national plans such as these. “Historically, Mexico hasn’t been the most efficient in mediation and implementation procedures in the infrastructure planning process. Fortunately, authorities like INDAABIN nowadays are implementing new practices at an international standard with high levels of transparency and better coordination between all entities,” Pérez told OBG.

The value of the plan has been calculated at MXN7.7bn ($464m). However, this figure reflects only the public sector funding commitment and does not capture additional resources that will be mobilised through public-private partnerships (PPPs) and other mechanisms. In addition, the new Mexico City airport project – valued at over $13bn – is being developed outside the PNI. The airport will be partly self-funded through a PPP model, as well as using local tax and airport operating revenue.

Financing Partnerships

Public sector funding of infrastructure investment has been cut back due to falling oil revenues and the need for fiscal austerity. The 2017 budget, for example, envisions investment in physical infrastructure totalling MXN540bn ($32.5bn), a reduction in real terms of 27.2% from the previous year. On the other hand, there has been growing interest in the use of PPPs to leverage increased private sector involvement in infrastructure projects.

Fernando Fernández, LatAm general manager of USG, a lightweight construction materials firm, recognises this trend. “Recent lack in government income means there has been a shortfall of funding for many public services, especially construction projects. This is when PPPs are useful tools for developers, as they provide a much wider funding base and security of income for stakeholders,” he told OBG.

A law regulating PPPs was approved in 2012. In 2014 only one PPP, the construction of a hospital in Mexico City, was up and running. The number rose to two in 2015, 10 in 2016, and an expected 16 partnerships for 2017. Of the 2017 PPPs, seven are federal road upgrade projects, including highway links between Coatzacoalcos and Villahermosa, Querétaro and San Luis Potosí, and Texcoco and Zapatec. The other nine are hospital and medical centre projects. Total private sector investment mobilised through PPPs has almost doubled on the previous year to reach a planned MXN8.5bn ($512.3m) in 2017.

Industry Helper

Federico Castillo Sánchez Mejorada, chief credit officer at Grupo Financiero Interacciones, states that his company specialises in helping finance large public works projects, both PPPs and wholly publicly funded works. Even in 100% government-funded projects, private sector financial institutions have a role to play in bridging finance and monitoring project deliverables.

“Financing big construction projects in Mexico is not a simple matter and requires knowledge of local and federal legislation related to public works, the new law related to the financial discipline of states and municipalities, a deep understanding of the PPP model and public works, and a very serious evaluating process of the financial sources of funds and contractors,” Castillo told OBG. “The new Financial Discipline Law gives more certainty to banks and contractors about the source of payment for public works or PPPs, because it is mandatory that it be registered in the annual budget, and also requires that all participants have a clear understanding of this type of financing,” he added.

To control the building process and manage cash flow, Grupo Financiero Interacciones sets up project-specific trusts and continuously monitors performance against objectives, triggering the release of funds from the commissioning entity only on the audited achievement of project milestones. “One of our clients won the PPP project to build 120 km of highway between Querétaro and San Luis Potosí, and we are involved by monitoring 18 separate deliverables across 16 road segments,” Castillo explained.

Airport Plans

The plan to build a new international airport in Mexico City (Nuevo Aeropuerto Internacional de la Ciudad de Mexico, NAICM), valued at over $13bn, is by far the largest infrastructure project in Mexico, and among the largest of its kind in Latin America. While the current government has had to cut back spending and projects because of fiscal austerity, President Enrique Peña Nieto is widely seen as deeply committed to NAICM, partly as a legacy project that represents his ambitions to modernise Mexico, and to turn the capital city into a major international gateway.

It has been clear for a number of years that Mexico City needs new airport capacity. An attempt to build a new airport during the presidency of Vicente Fox ( 2000-06) eventually had to be abandoned because of concerted opposition from local farmers at the intended site, who were resisting the prospect of losing their land through compulsory land purchase orders. Since then, two successive Mexican governments have incrementally purchased almost all of the land at the new intended site. It will be located a few kilometres away from the current airport, just outside the city limits in the municipality of Texcoco, Mexico State.

Local residents have been promised jobs in the new development, meaning that political opposition to the project has been largely overcome. Nevertheless, the project still faces a wide range of technical challenges. The entire Mexico City area is built on a former lakebed, meaning much of the ground is muddy and subsiding very slowly. In addition, some of the site was used for landfill purposes. An engineering solution has been found to ensure that any subsidence in the area is evenly distributed across the runways.

It has also been decided that, because of limited flight path availability, there will be a hard switchover between the old and new airports, with all flights transferring at 7:00am on October 20, 2020 – the time when NAICM is scheduled to be up and running and when the current airport will cease operations. Therefore, project managers face every pressure to meet the very specific completion deadline. The airport will begin with three runways upon completion, one of which will be reserved for military use. In a later phase the facility can expand to a total of six runways. The new airport will have the capacity to handle up to 120m passengers per year.

Project Composition

The airport project is being run as a PPP by a specially formed entity, Grupo Aeroportuario de la Ciudad de México (GACM). For the design component, GACM approached nine international architectural practices and asked them to submit bids, on condition that each was made in partnership with Mexican architects. The winning bid, announced in 2014, was submitted by Foster + Partners of the UK, led by architect Norman Foster, in association with Arquitectos Romero, led by Fernando Romero. Civil engineering contracts to build the main terminal were won by ICA and Grupo Carso as part of a consortium with other partners, including Acciona and FCC Construcción of Spain. The contract for the terminal is worth approximately $4bn.

The approach of a consortium is not a new idea, but one that has become popular as a means of completing large-scale projects. Mario Rosado Fuentes, director at real estate development firm MARQ, told OBG, “The financing aspect of the very largest projects is extremely difficult to manage and only very few companies have the true capacity for this. Therefore, a consortium of investors or partners is often needed to ensure the quality and efficiency of the planning of construction is maintained.” Furthermore, the OECD has been asked to take part in auditing the project.

Linked Developments

The construction of the new airport is expected to act as a catalyst for other connected developments. In early 2017 it was reported that GACM was due to receive a feasibility study from Spanish consultancy IDOM on a major urban development known as Airport City (Ciudad Aeropuerto). This would be built on a 910-ha site close to the current airport, and would include shopping centres, residential units, a hospital, hotels, convention centres and industrial parks. The area would be similar in size to the existing Santa Fé shopping centre to the west of the city that occupies 931 ha (see Real Estate overview).

There is also ongoing discussion of transport links to the new airport. Initial plans imagined only an improvement in road links. Yet in March 2017 Jorge Gaviño Ambiz, director-general of the Mexico City Metro system, said two options were under investigation. One would involve building a link between the airport and the Río de los Remedios station on Line B of the metro system; the other would involve building an elevated express rail link into Mexico City.

Industry Performance

According to the Chamber of Commerce for the Mexican Construction Industry (Cámara Mexicana de la Industria de la Construcción, CMIC), uncertainty regarding the impact of the US elections on the Mexican economy led to a 53.8% drop in foreign direct investment in the construction sector in 2016, taking it down to $1.83bn. Reductions in domestic government spending linked to the fiscal austerity programme may also have discouraged some foreign investors, CMIC suggested. Other signs of uncertainty were visible in early 2017. According to the consultancy Bimsa Reports, the index of construction industry confidence (Índice de Confianza del Constructor, ICOCO) had fallen to 47.95 – its lowest level since 2011. Whenever the index falls below 50, it means that construction companies are expecting growth to decelerate. The National Institute of Statistics and Geography (Instituto Nacional de Estadística y Geografía, INEGI) reported that construction GDP growth eased from 2.6% in 2015 to 1.8% in 2016. José Antonio Hernández, manager of the CMIC’s Construction Economic Studies Centre, says that relatively slower growth in the construction sector reflected a medium- to long-term change that was taking place in the industry. “The economic growth paradigm for the construction sector is shifting,” he told OBG. “In the old model, growth was led by the public sector. In the new model, it is the private sector that will be the main driver. What we are seeing now is a transition.” Industry growth is now closer to GDP, whereas before it had been in excess of GDP. In his view, it is going to take time for the industry to adapt to the changing landscape of the sector, understand the new sources of funding and get comfortable with assuming a greater degree of business risk.

Regional Disparity

There are significant regional variations within the country. Construction in 2016 grew at double-digit percentage rates in ten states including Quintana Roo, Zacatecas, Aguascalientes and Mexico State. On the other hand, there were single-digit contractions in a seven states including Michoacán and Jalisco, and double-digit contractions in a further eight states including Morelos, Tabasco and Tlaxcala. The states where construction was weak in 2016 included many in the poorer southern region of the country, states where low security and high levels of crime have been discouraging investors, and some where the downturn in the oil and gas industry had a negative effect on local economies.

In contrast to the subdued national trend, the authorities in Mexico City claimed that the value of construction activity there had surged ahead by 14.7% during 2016. Using INEGI data, CEESCO broke down nationwide construction activity by type in the first 11 months of 2016. In that period, overall construction GDP grew by 1.9%, led by specialised works (9.3%) and building by the private sector (4.2%). In contrast, civil engineering by the public sector contracted 9.1%, in part a reflection of the effects of fiscal austerity.

Cost Challenges

There is concern surrounding the impact of higher fuel prices on construction activity, particularly after the increases announced in January 2017, which were in the 14-20% range. More generally, the depreciation of the Mexican peso during 2016 is seen as having a significant impact on the price of construction materials. A study by ratings agency Moody’s in early 2017 suggested that Mexican construction companies might encounter lower revenue growth because of increased heavy machinery and transportation costs, along with higher prices for cement and steel. CMIC president, Gustavo Arballo, estimated that the combined effect of higher fuel prices, the peso depreciation, and higher interest rates have raised construction company costs by an average of 12%.

Cemex

Mexico has a number of global construction companies, one of which is Cemex, which has been following a programme of cost reductions and asset sales across its global operations. The results were hailed as very positive when the company announced a $750m profit for 2016, the highest level since 2007, and 10 times what it recorded for 2015. In the fourth quarter global cement sales were down 4% at 15.9m tonnes, with ready-mix concrete sales 1% lower at 37.7m tonnes. In Mexico, however, sales improved 4% in the last quarter of 2016, buoyed by what the company said were increases in residential, industrial and commercial construction. The company used asset sales to reduce total debt, which fell by $2.3bn to end 2016 at $13.1bn.

Cemex generated some domestic political controversy in early March 2017 when executives said it would, if asked, provide estimates for the cost of supplying cement for US President Donald Trump’s proposed US-Mexico border wall. While the wall is deeply unpopular in Mexico, with cost estimates ranging between $15-20bn, it could be one of the largest infrastructure projects in North America. Cemex is reported to have six cement plants and over 40 ready-mix plants within a 200-mile corridor on either side of the border.

Marco Medina, an analyst at Mexican bank Ve por Más, said that the negative effect on Cemex’s domestic reputation and sales from participating in the construction of the wall would likely outweigh any profits to be made. He suggested the company avoid any involvement with the border wall and instead focus on other upcoming profitable investment projects in the US.

Ica

In contrast to Cemex’s year of record profits, 2016 was a difficult year for ICA, Mexico’s largest construction company. The company has been struggling with a heavy debt load and was hard hit by the reduction in public sector construction work. It last reported a profit in 2013. In the second quarter of 2016 it reported a loss of controlling interest of MXN3.4bn ($202.5m), over five times more than the loss recorded in the same quarter of 2015. In December 2015 it defaulted on a $1.4bn international bond repayment, the largest default by a Mexican company since the 1990s. In November 2016, following the death of its CEO Luis Zárate, the company appointed Guadalupe Phillips as the new CEO with a mandate to carry out a financial restructuring. In March 2017 it was reported that ICA readied a bankruptcy filing as a precaution, in the case the company cannot restructure its debt with creditors outside of court.

Outlook

Despite some concerns over the potential economic impact of protectionist headwinds from the US and rolled-back government participation in the sector, Mexico is still enjoying a “demographic bonus” – a young and growing population that is boosting demand for housing, energy, communications and foodstuffs, all of which require support from construction activity.

Arballo of CMIC expects construction growth to slow from about 2% in 2016 to 1% in 2017, partly because foreign investment is on hold, waiting for uncertainty over Mexico-US relations to clear. However, he argues that the outcome of any renegotiations of the North American Free Trade Agreement will ultimately have little long-term impact on the sector, where demand for infrastructure is set to continue driving growth.