MEXICO: When the wind blows
There’ll be no calm in Mexico after the damaging hurricane season is over: energy reform will be painful, and much depends on it
Mexico had an unexpectedly painful September. Two tropical storms, Ingrid and Manuel, battered its Atlantic and Pacific coasts respectively, triggering a flooding disaster in Acapulco, where tourists had to be evacuated in government planes, mudslides inland, and closing ports and oil rigs on its Gulf coast. The official death toll, of close to 100, was likely to rise further according to experts.
The disasters came towards the end of a quiet hurricane season. The response is a key test for the nations ruling Institutional Revolution Party (PRI), back in power since December, after 12 years in opposition. Mexicans tend to judge their authorities on their response to such disasters; the shaky response to 1985s deadly earthquake is widely viewed as the beginning of the end of 71 years of PRI power.
The government is also buffeted by economic storms, which began in the housing construction sector; again, remediation efforts will be crucial. A government success on energy reform which was launched earlier this year is seen as likely by most analysts, but it could easily be overshadowed if construction seeds a deeper malaise. Mexico is often touted as an example of how to keep the economy expanding even during headwinds, but growth is a long way from what officials and analysts expected at the start of 2013.
At the start of September, the finance ministry asked permission from the legislature to run a deficit of 0.3% of gross domestic product (GDP). During the second quarter, Mexicos economy shrank 0.74% versus a quarter earlier, following a stagnant first quarter.
"The PRI is at risk of being blamed because it happened on their watch," says Federico Estevez, a professor of political science at the Mexican Autonomous Technological Institute (Itam), a private college that has supplied many government ministers. "There are people who are making the argument that the economy is weak because the PRI didnt spend enough."
The finance ministry currently expects economic growth of 1.8% this year, having twice cut estimates from an initial 3.5%.
In an early September syndicated column, Jonathan Heath, HSBCs chief economist for Latin America, pointed out that state investment had declined by 4.6% in real terms during the first seven months of 2013, versus the same period of 2012. Spending by the communications and transport ministry (SCT) which focuses on infrastructure declined by 23.8%, the second sharpest fall among government departments.
Since that column was written, the finance ministry has signed a deal with regional governments for them to administer 2.8 billion pesos ($217 million) of public works directly. This is on top of 2.5 billion pesos for hospital equipment, 5 billion for road building and 2.5 billion for disaster relief. There was also 13 billion pesos ($101 million) for additional development bank lending.
In its minutes for the September 6 monetary policy meeting, the Bank of Mexico puts the blame elsewhere. "The unfavourable evolution was mainly due to a fall in construction sector activity levels," the meetings minutes said.
Construction firms Homex, Geo and Urbi, the three biggest in the nation, suffered a liquidity crisis through this year, and have now abandoned many half-built developments. The spark was news that the government planned to push homebuilders to build more flats in urban areas. The big three firms base their business on buying greenfield sites and building single-family homes, and such a shift would mean tying up their capital for months or years more than they are used to. In the spring of this year, news spread that Urbi had missed a loan payment, which led creditors to demand in the courts that state-run home loan giant the Infonavit pay them ahead of the developers.
By June, when the crisis was developing but had not fully bloomed, new construction was already 4.2% lower than a year earlier, while staff was down 5%. In July, two of the firms did not file second-quarter results, and were removed from stock exchange, the BMV. Since then, the finance ministry has issued a statement that it would bail the firms out.
All this is playing out as the nations legislators tackle a keystone energy reform formally launched in August. A PRI plan aims to reform the constitution to break the monopoly currently held by state energy company Petroleos Mexicanos (Pemex) over exploration and production. During the first seven months of 2013, oil-linked revenue represented nearly 34% of the governments 1.6 trillion pesos ($121 billion) in income. Most of this comes from just one source, the Ordinary Hydrocarbons Right (DOSH), which brought in 505 billion pesos ($39.5 billion) during the period. The DOSH is essentially a royalty of 71% charged on oil proceeds. The reform plans to reduce this to 60% during 2015 and 10% thereafter, as well as lifting the cap on Pemexs tax write off above $6.50 per barrel.
Pemexs director-general, Emilio Lozoya, said in September that the change expected in 2014 could have added the equivalent of $10 billion to Pemexs investment budget, had it been applied last year. Pemex will still have to pay substantially into government coffers from 2015 onwards: it will pay income tax of 30% on profits and a dividend of the same amount. Crucially however, these will be changed on profits, not income. The DOSH system frequently pushes Pemex into net losses even when oil prices are high.
"Assuming the reform is passed this year, Pemex is going to pay fewer royalties, but all of its profit will be paid to the government via dividends," Araceli Espinosa, who covers the company for Scotiabank Inverlat, says. "The decoupling of Pemex from the government will not be immediate. The government does not have the capacity to substitute all of Pemexs resources so quickly."
The reforms impact will enter into force from 2015 onwards, taking at least five years, Espinosa estimates. Although the reforms intentions are clear, there are a lot of details to be worked out.
It is not yet clear how much new participants will pay in royalties, how they will obtain blocks for development, how much tax they will pay, whether there will be special regimes for technologies that Mexico seeks to develop including shale gas and deep-water exploration. It is clear, however, that the government does not want to lose ownership of the underlying hydrocarbons, opting to share profits, not production or reserves. The treatment of reserves could be a problem, as finance companies prefer to invest in projects where assets can be put up as a guarantee.
In September, the government launched a fiscal reform designed to close longstanding revenue loopholes and special exemptions. This focused on extending taxes to school fees, mortgages and pet food, as well as raising the top rate of tax on individuals by two points to 32%. It also featured a tax on soft drink sales, responding to reports that in some regions 42% of residents are overweight or obese.
"They have chosen to raise tax on the middle class, where they have the potential to do so, in the short term, but this is not enough to compensate for Pemex," says Duncan Wood, director at the Wilson Center in Washington DC. "The government does have the chance to bring in more oil income in the medium term, and one way to bridge the gap is going to be grandfathering the changes."
The fiscal reform makes clear that Pemex will not be able to pay less than 30% of profits as a dividend to the government, as its only shareholder. But the obligation will lower gradually to zero in 2026, when the firm will be able to set payment levels independently, assuming the plans go through in their current form.
Mexicos president, Enrique Pena Nieto, promoted the reforms as having the potential to "raise and transform all Mexicans quality of life" adding that it could trigger growth "such as Mexico has not seen in decades".
Much of this hope is pinned on one technology: shale gas. According to the US Energy Information Administration, Mexico has the worlds sixth-largest shale gas reserves with 545 trillion cubic feet. But, in stark contrast with Texas, just over the border in the United States, Mexican states which share the same geology are producing virtually no gas. "It will have an impact in the supply of gas, which has suffered from scarcity. That in turn impacts electricity and the petrochemicals industry," Nieto said.
An increase in the amount of generation and reliability of supply would certainly be welcome for industrialists whose production was threatened by a series of power cuts during the latter half of 2012. But this happy outcome, if it does come to pass, could be the better part of a decade away.
There seems to be little doubt that the PRI will get their way in the legislature. It holds 213 seats in the 500-seat lower house, where opposition is most likely to be present, and can also count on the support of the pro-business National Action Party (PAN), which holds a further 114.
Demonstrations planned by leading figures in the left-wing Revolutionary Democratic Party (PRD), are unlikely to impact decisions in the chamber. The recent sit-in by teachers in the main square of Mexico City, whose messy eviction made headlines around the world, was not widely supported domestically and showed politicians that the government would continue with its main ideas.
But right now, the economy has to battle a domestic housing crisis, and its main trading partner, the US, continues to send mixed signals on growth. Few expect this to derail critical policymaking this year, but economic optimism felt just six months ago now feels very distant.