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Emerging Markets

Shadow of a doubt

Mexico is plagued by an increasingly violent drugs war, a US slump, which is pushing its economy into recession, and a fragile governing party, which faces a punishing mid-term congressional election that will likely diminish its support

Mexico is plagued by an increasingly violent drugs war, a US slump, which is pushing its economy into recession, and a fragile governing party, which faces a punishing mid-term congressional election that will likely diminish its support.

At the centre of this maelstrom, president Felipe Calderon is clinging onto still healthy approval ratings. But the challenges are piling up as the hallmarks of his first three years in office – tight fiscal management and a balanced budget, the promise of deep structural reforms and the militarization of the narco war – are under threat, while the effectiveness of his government is increasingly called into doubt.

“Mexico is looking to investors like a wounded animal: under two administrations it has tried to make progress on structural reforms and has not gotten very far; oil production dropped 10% last year and oil prices have crashed; violent crime is rising and some are wondering if Mexico could become a failed state,” says Arturo Porzecanski, distinguished economist-in-residence at American University in Washington, DC.

The US financial crisis is wreaking havoc on Mexico’s economy, with key indicators falling sharply: the economy contracted at a 2.41% annual rate in December. The Bank of Mexico, the independent central bank, projects negative growth of 1.8% for the year. On March 9, finance minister Agustin Carstens finally lowered his forecast for the year to zero growth. “It’s like we’ve been hit by a tsunami,” Carstens said earlier this month. “The shock is tremendously strong.”

But the recession could be more severe yet: Standard & Poor’s rating agency predicts a 2% contraction, while Ecanal business consultancy in Mexico City puts the number at 2.5%.

Indeed, few countries are as vulnerable as Mexico to the turmoil originating in the United States: automobile exports (which make up 20% of manufacturing output) fell by 57% in January 2009 from the previous year; the trade balance for 2008 ended up $2.1 billion in the red; the average price for Mexico’s oil mix sank to a low of $30.52 per barrel last December, a drop of nearly $100 in five months; and remittances fell by 3.6% for the year, a loss of $930 million.

Meanwhile, unemployment is rising sharply. In the last quarter of 2008, 348,000 formal sector workers and 104,000 informal sector labourers lost their jobs. Manufacturing industries eliminated 336,000 jobs during 2008, about 10% of the sector’s total work force. During 2009, approximately 300,000 workers across Mexico are expected to be thrown out of work.

The peso has lost 45% of its value since last July, with the Bank spending some $19 billion in reserves in a bid to prop up its value. The Bank still has over $80 billion, plus a swap line of $30 billion from the United States Federal Reserve which it has not used.

But as Rogelio Ramirez de la 0, president of Ecanal consultancy in Mexico City, puts it: “The economy is falling into the same trap of the dollar exchange rate, depleting reserves, all are revisiting us. It amuses me in a morbid way.”

Against the wind
The government is trying to lean against the economic cycle with expansionary fiscal and monetary policies. On January 16 the Bank of Mexico cut its benchmark interest rate by half a percentage point (to 7.75%). It was the first cut since April 2006, but will not be the last.

Calderon has also launched a bold fiscal stimulus package, which includes cuts in energy prices, extra investment in roads, railways and oil wells, and measures to extend medical cover, welfare benefits or temporary jobs to the unemployed. This is in addition to an expansionary budget for this year, and a previous fiscal stimulus last October (which included extra payments to poorer Mexicans). In total, the government is injecting about three percentage points of GDP.

Officials can do this in part because of Mexico’s move last November to lock in future oil sales at higher prices – a deft manoeuvre that will shield public finances when government spending will be important for pushing back against a slowing world economy. The world’s sixth biggest oil producer hedged almost all of this year’s oil exports at $70, at a cost of about $1.5 billion through derivatives contracts. Without the hedge, the recent price falls could have been calamitous for Mexico. The sharp devaluation of the peso (the currency was trading at 15.27 to the dollar mid-March, down from a high of 9.93 in August) now also means that dollar oil revenues will go further in pesos.

Mexico also benefits from a swap line of $30 billion from the United States Federal Reserve, which, according to Gerardo Rodriguez, head of public credit at Mexico’s finance ministry, the sovereign is likely to use soon. “We are definitely considering using this, and it may happen soon. The central bank is exploring ways of doing this with the Fed,” he tells Emerging Markets. “We are working on a plan to target specific sectors since it is useful to provide finance to the financial sector.”

Despite hedges on the price of oil, Mexico’s government still risks a drop in tax revenues this year if the economy falls further. The economic downturn could mean fiscal revenues fall by $15 billion, or 1.6% of GDP, though the shortfall will be compensated in part by the oil stabilization funds that total $11 billion, or 1.2% of GDP.

Analysts, however, say the fiscal stimulus is inadequate – and will hardly prevent recession. “The stimulus package is really small, there is no real increase, no expansion over the 2008 budget, which was relatively high,” says Raul Feliz, an economics professor at the Centro de Investigacion y Docencia Economica in Mexico City.

“The problem at heart is that Mexico has no space for (funding) a counter-cyclical policy,” says Feliz.

Moody’s ratings agency analyst Mauro Leos says the impact of the additional spending will be limited. “It won’t be enough to reverse declining indicators,” he says.

But Rodriguez is adamant that the fiscal outlook, though challenging, is stable. “There may be a perception that external accounts will be receiving pressure, but this is very manageable.”

“We have the oil price hedge in place in 2009, so we have some currency revenue in our capital account to cover the deficit in our current account. So our fiscal situation this year is very manageable.”

Nevertheless, he admits problems lie ahead. “2011 is where the real issues are. We are having discussions about a 1–1.5% fiscal adjustment, and there are several ways to achieve this.” Officials are discussing several options, including higher taxes, an increase in domestic fuel prices and a cut in expenditures, Rodriguez says. Moreover the stabilization fund, with 1.8% of GDP, has yet to be spent.

Finance minister Carstens argues that Mexico’s fundamentals remain sound. “Intrinsically, we have a healthy economy, public finances are in order, we don’t have a problem of over-indebtedness, our banking system is strong, monetary policy of the Bank of Mexico is oriented toward lowering inflation and maintaining stability in financial markets, and to a great degree has achieved that,” he said this month.

Shelly Shetty, senior director of sovereign ratings with Fitch in New York, agrees that officials are taking tough measures. “Their policy framework has not been undermined significantly,” she notes.

Failed state?

But in many ways, the bigger test is governance. According to Ecanal’s Ramirez de la O, a former economic adviser to opposition leader Andres Manuel Lopez Obrador, “The capacity for countries to emerge from this crisis depends not only on resources but on the quality of leadership and the capacity of government to manage situations.”

Standing down a recession is a tall order for any politician – but add to that a drugs war, and the situation becomes nearly intolerable. After the July elections, Calderon will be called on to battle on both fronts with a weakened party and an emboldened PRI opposition, the power-thirsty former ruling party that governed Mexico for 71 years straight up to 2000.

The deaths from narco violence exceeded 6,000 in 2008, and the death toll will likely rise further this year. Expanding lawlessness and security threats are raising the spectre that the government response may not be up to the task.

Meanwhile, a debate is emerging that defines Mexico as a failed state. As historian and political columnist Lorenzo Meyer puts it: “If Mexico is not already a ‘failed state’, it increasingly seems to be, and it’s not apparent that those in charge are up to addressing the problem.”

Meyer’s list of ills spans the gamut. Mexico, he says, is failing to protect its citizens from crime and violence; the government is unable to employ 7 million people, who instead seek work in the United States; the nation ranks 43 out of 57 countries in literacy; economic growth averaged only 0.87% per year between 1983 and 2006; and wealth is so heavily skewed that the poorest 20% of the population receive 3.1% of output.

As that debate gains traction, Calderon faces a more immediate challenge to his ability to govern – and his grip on power. After the July mid-term congressional elections his National Action Party (PAN) looks set to be overtaken in the Chamber of Deputies by the former ruling party, the Institutional Revolutionary Party (PRI). According to polls in February, the PRI will double its seats in the powerful Chamber of Deputies, which decides the federal budget.

The need for compromise raises the odds that legislation will be watered down. This happened once before with Calderon’s tax reform bill, which closed loopholes but did not broaden the tax base, and with an energy reform that fell short of opening exploration and production of the national oil monopoly, Petroleos Mexicanos, to private investment.

The setback in the legislature for PAN could prove a drag on Calderon and needed structural reforms such as greater labour flexibility, a deeper tax reform and an opening of the petrochemical sector to private investment.

“The risk of gridlock is high, we don’t anticipate anything in reform for the rest of the term,” says Leos of Moody’s.

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