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Emerging Markets

Pesos and pragmatism

Savvy deal-making has set the tone for president Felipe Calderon’s administration. Finance minister Agustin Carstens discusses the gains following this year’s landmark reforms

Felipe Calderon has something to smile about. Barely 10 months into his six-year term, the 45-year-old president of Mexico has managed to perform a minor miracle: the ex-entrepreneur has pushed the country’s first major economic reform in a decade through a previously snarled-up Congress.

The passage of Calderon’s landmark tax reform bill – skilfully negotiated by Calderon and his finance minister, Agustin Carstens – marks an end to a legislative gridlock that had paralyzed a divided lower house since 1997. More than that, it demonstrates that Calderon’s administration – in stark contrast to his predecessor’s – has a realistic chance of building a coalition in Congress to advance its initiatives.

In a wide-ranging interview with Emerging Markets, Carstens explains the thinking behind the tax bill: “We will establish solid foundations so that Mexico can increase tax collections over time, and we can gradually substitute the taxes paid by [oil monopoly] Pemex with taxpayer revenues.”

The reform, says Carstens, promises gains on several fronts. It was designed to strengthen “four pillars of the architecture of public finance, making important advances in evasion and elusion, improving the quality of public spending, improving fiscal federalism and, of course, increasing collections,” he says.

The Calderon administration argues the reform would allow for spending hikes for social needs and up to $5 billion for infrastructure. “It will be a reform that contributes to improving the capacity for growth and generation of jobs,” Carstens says.

Mexico will gain an additional $10 billion in revenues from the reform next year, and an increase of 2.6% of GDP over the next five years – barely enough to keep the budget in balance, given growing pension and health care liabilities. The lion’s share of the new tax collections will come from the new alternative minimum tax on corporations, known as IETU, which set off cries of pain from big business and a stony silence from the leftist Party of the Democratic Revolution (PRD) as its long-standing demand for raising taxes on firms was co-opted.

Analysts single out the design of the IETU – the most sensitive measure in the package – for praise. “It is very creative because the flat tax automatically hurts sectors with special tax regimes and helps those that do not have (exemptions), all without singling out sectors,” says John Welch, senior Latin America strategist with Lehman Brothers in New York.

Give and take
For all its fanfare, the political deal-making came at a price: a compromise on electoral reform, which will shorten the presidential campaign period and will replace all the Federal Electoral Institute (IFE) officials who made the critical decisions for a razor-thin Calderon victory last year.

Still, the political deal-making showed that Congress is capable of forging agreements that span the three leading parties from right to left: the groups formed a bloc and passed an electoral reform as a precondition for the fiscal package.

“It’s a huge victory, given the constraints from the outset,” says Federico Estevez, a political scientist with the Instituto Tecnologico Autonomo de Mexico (Itam). The administration’s success lies in crafting a feasible reform that avoided imposing a VAT tax on food and medicines, he says, although he acknowledges that, in its detail, “it’s a minor reform – this is not redoing the tax system.”

Scepticism over the reform’s impact remains. “It’s a ‘lite’ reform – better than nothing, but it won’t bring changes or infrastructure,” says Jose Antonio Crespo, a political commentator. Most of the revenue gains are already committed to pensions, long-term debt, federal transfers and Pemex, leaving “very little for social works”, he says.

Carstens is quick to admit that the economic impact of the reform on a stand-alone basis will be limited. In 2008, the increase in revenues will add only 0.2% to Mexico’s expected growth of 3.5%. In subsequent years, the gain will be 0.3% annually. The reform will last “for two or three years”, Carstens says.

For Mexico to leap to robust growth of 5–7%, the country will need a series of reforms in the labour, telecommunications and energy sectors, Carstens says.

When the fiscal reform passed, the effects were immediate: country risk dropped as the sovereign spread tightened to 117 basis points above the rate on US Treasury bonds, and Fitch Ratings gave a 1-notch upgrade to Mexican bonds.

Stronger hand
The reform strengthens confidence in Mexico at a time of uncertainty in the global economy. Carstens believes that Mexico, like other large emerging economies, is well positioned to deflect external shocks.

“We do not face a problem of financing – that vulnerability cannot affect emerging markets including Mexico,” he tells Emerging Markets. Macroeconomic fundamentals remain by and large strong in developing nations, he adds.

But the risks posed by a US slowdown have scarcely diminished. The finance minister prefers to see a possible US slowdown as an opportunity. “This is an incentive for us to adopt policies that stimulate economic growth and make us less dependent on the growth of the US economy,” he says.

Whatever the limitations of the reform, it sets a strong precedent for the future and gives Calderon political momentum as he sets out to tackle other, momentous challenges such as labour, justice and energy reforms. The government now has more clout for advancing its agenda, and the signals are clear about the Calderon style of legislating. The administration can be expected to “go for piecemeal reforms that are doable – that is critical to Calderon’s leadership style – you’ve moved things off the dime,” says Estevez of Itam.

Mexico is going to need a lot more than this fiscal reform to fulfil the Calderon pledges to combat poverty, promote growth, create jobs and gain competitiveness so the country can hold its own in the global economy. Carstens points to the need for a more hard-hitting fiscal reform that would revamp the value added tax and an energy reform [see box].

Those initiatives will meet maximum resistance. Both opposition parties – the leftist PRD and the centre-right Institutional Revolutionary Party (PRI) – will challenge measures that impose the 15% VAT on food and medicines and throw open the nationalized oil industry to private investment and control.

The political stars were aligned well enough this year to achieve a moderate tax reform. But the constellations could be reshaped by the time the government takes a fiscal reform with teeth to Congress – or an energy reform that opens up segments of the petroleum sector.

The launch of those reforms is not expected until after the July 2009 mid-term elections that will renew the national congress. Calderon and his National Action Party (PAN) will battle to expand their bloc and secure a majority position. If PRI gains strength, it could prove a less reliable ally in Congress, especially on contentious proposals such as an extensive energy opening or expanding the VAT tax base.

New controls will be in place for ruling on the final outcome of those mid-term elections. The election reform passed with the fiscal reform in September puts in place a new set of officials at the IFE expected to create a more balanced representation between the PAN, PRD and PRI parties. The PAN will lose the powerful sway it held in the IFE last year.

The Calderon agenda is crowded enough between now and the time of those congressional races. The president may get moving on justice and labour reforms, and perhaps take action to reduce the monopoly power of leading companies in the telecommunications and cement industries.

The government will need to keep a constant watch on the bottom line, too. Although the fiscal reform provides for balanced budgets through 2012, external factors, including a US recession, lower oil prices and a drop in remittances, could cause the current account deficit to grow, warns Fitch Ratings.

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