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Emerging Markets

Vision failure

President Felipe Calderon’s ambitious reform agenda looks set to flounder amid mounting political opposition. This is yet more bad news for Mexico’s browbeaten economy

He vowed to supercharge Mexico’s stable but tepid economy through key reforms, but with three years left in power, conservative president Felipe Calderon is reeling from the one-two punch of a stinging recession and a mid-term election that put Congress in the hands of the opposition.

For now, his government must focus its attention on diffusing the immediate threat of a fiscal crisis that could lead to a ratings downgrade. The radical tax and energy reforms Mexico needs to compete with its emerging market peers seem a long way off, and as the odds pile up against him, few observers believe Calderon will have the time or political capital needed to push them through.

“We’ve always been extremely sceptical with regard to reforms in Mexico,” says Mauro Leos, a sovereign credit analyst with Moody’s Investors Services. “With this new Congress we’re not expecting anything.”

From the day he took over as president from Vicente Fox in December 2006, the former lawyer from Mexico’s centre-right National Action Party (PAN) has never had it easy. Aides had to smuggle him into a brawling Congress through a back door so he could take his oath, while tens of thousands of leftists marched through the streets screaming that his razor-thin victory was a fraud.

As protests by supporters of his leftist opponent and former poll favourite Andres Manuel Lopez Obrador finally fizzled out, however, Wall Street breathed a sigh of relief. Instead of having a wild-card firebrand at the helm, Mexico was in the hands of another conservative, who promised to continue a trend of market-friendly financial stability.

But while investors had yearned for a stable hand at Mexico’s tiller during the turbulent 1980s and the tumultuous 1994 Tequila Crisis, now expectations are much higher: stability alone is no longer enough.

Without a major overhaul of Mexico’s energy sector and tax system, the country has only managed insipid growth. It has trailed behind the rest of Latin America.

Many who had helped guide the country out of its previous mess are dismayed at how one of Latin America’s most celebrated economic success stories has fallen flat, and worry about its future.

“We have performed well from the point of view of the credit ratings of the country and debt indicators,” Inter-American Development Bank vice-president Santiago Levy tells Emerging Markets. “I don’t want to minimize that at all. It’s a major achievement, but it’s clearly insufficient.” The remarks are particularly poignant given Levy was Mexico’s deputy finance minister between 1994 and 2000.

Towards a political solution?

“They came from nowhere. In 1994 and 1995 everyone thought that the country would collapse, and they worked it out,” says Claudio Loser, who headed the IMF’s Western Hemisphere department during the Tequila Crisis. “They did tremendous things and had the best economic bureaucrats and technicians – they still do – but if the political class does not come up with a solution, I’ll be totally disappointed.”

In July finance minister Agustin Carstens announced Mexico had a 480 billion peso ($36.6 billion) revenue gap, saying it was probably the country’s biggest ever decline in revenues. Ratings agencies Fitch and Standard & Poor’s changed the outlook on Mexico’s investment-grade rating to negative, with S&P citing a “challenging fiscal outlook over the next number of years”.

The news that a country long commended for its financial stability was in dire fiscal straits came as a shock, but the crisis was a long time in the making.

Mexico’s particularly heavy dependency on exports to a struggling US economy had dealt it the toughest recession in Latin America – the government estimates the Mexican economy will shrink nearly 7% this year. But the foundations for this crisis were laid long before the US sub-prime meltdown – they are rooted in Mexico’s addiction to oil export revenues and a 70-year-old ban on foreign participation in its energy sector.

State oil company Petroleos Mexicanos (Pemex) has historically provided Mexico with a third of public revenues, so successive governments have made relatively little effort to collect tax. The country has one of the lowest non-oil tax takes in Latin America.

As vice-minister of finance Alejandro Werner admits: “Because we had oil, and oil income that supported the government budget, our tax-raising efforts have historically been weak. Oil allowed us to keep on spending despite having a very weak tax base.”

There had long been talk of the need to wean Mexico off its unhealthy dependence, but with crude gushing from the country’s massive Cantarell oil field since the late 1970s, there was no rush to reform. Cantarell has started running dry, and Mexican crude production has trailed off, but rising oil prices compensated for the decline, even allowing Mexico to pour money into a rainy-day oil stabilization fund.

Now, however, in a mix lethal to the fiscal health of an already sputtering economy, global prices have fallen along with production. Mexico could only control the latter, and the country’s constitution stood in its way.

Most experts agree Mexico could ramp up output by tapping extensive deep-water deposits known to lie in the Gulf of Mexico. But exploring and drilling that deep takes money and expertise Mexico doesn’t have.

One option would be to reach out to foreign oil companies for help in drilling and extracting, giving them a share of their discoveries. But such deals were banned in Mexico when the country expropriated foreign oil company assets in 1938. The country is fiercely proud of its oil wealth, and any politician who suggests foreigners should have a share, does so at their own peril.

The government passed a moderate energy reform last year that allowed it to award performance-based service contracts to private companies. The bill stopped well short of allowing foreigners a share in oil discovered or drilled, but even so, thousands of Lopez Obrador militants poured on to the streets to protest at what they called the privatization of Mexico’s oil industry, while his supporters in Congress mobbed the podium to try to stop it being passed into law. Analysts say this constitutional rigidity lies at the root of all Mexico’s economic problems.

PAN senator and former Pemex refining head Juan Bueno said news of a giant deep-water find in the Gulf of Mexico by oil major BP at the beginning of September, made him sick to the stomach. “It hurts,” he said. “It hurts to see 160 or 170 wells in production on the other side of the border while we have five. Practically the whole Gulf of Mexico belongs to us, but we can’t drill there because we haven’t implemented the necessary constitutional reform.”

“The main reform Mexico needs is to better allow private-sector capital to participate in its energy matrix,” says Alberto Bernal, head of research at Bulltick Capital Markets in Miami. “If that were to happen, everything would slowly but surely fall into place.”

No one seriously expects Mexico to default on its debt. “We’re seeing a negative outlook on an investment-grade rating, but that rating is three notches into investment grade,” says Lisa Schineller, S&P’s main analyst for Mexico.

Nevertheless, the government has to make a tough choice to avoid slipping into deeper water. “They have to solve at least one of the two issues, either the tax reform or the Pemex energy reform,” says Loser. “If they don’t move on either of them, then that is a very serious problem.”

The Calderon challenge

Observers credit Calderon with rising to the challenge as best he can. “Profound change is our best and only hope,” he told the country in his state of the nation speech at the beginning of September. “Time and resources are running out, and people are needier by the day.”

A week later he sent an unexpectedly bold tax reform proposal to Congress along with his 2010 budget bill. The bill seeks to scrap three minor ministries to save cash, boost income tax, and take on a fiscal deficit of 0.5% of GDP, but the backbone of the proposal is an extra 2% sales tax on all items, including food and medicines, which are exempt from VAT.

Werner, the vice-minister of finance, says that along with a moderate reform already passed in 2007, it would “represent the biggest fiscal effort we have seen by any modern administration”.

Analysts, however, doubt the proposal was far-reaching enough to stave off a downgrade, and in any case, whether the reform sees the light of day depends not on the government, but on its greatest political rivals.

In 2000, Calderon’s conservative National Action Party made democratic history in Mexico when former president Vicente Fox beat the Institutional Revolutionary Party (PRI) out of power, ending 70 years of one-party rule. Since then, however, the PRI – a vast political empire with tentacles in nearly every area of Mexican life – has been gaining strength on the sidelines.

With the Mexican left bitterly splintered following its 2006 poll defeat and many voters blaming the PAN for economic hard times, the PRI trounced all other parties in mid-term congressional elections in July, securing 237 out of 500 seats in the lower house, close to an absolute majority.

The party is also the favourite to win the 2012 presidential election. Enrique Pena Nieto, the young, media-savvy governor of populous Mexico state, which rings the capital, leads in the polls.

Analysts say this is all bad news for Calderon’s reform agenda. First, they say, the PRI is unlikely to back any broad tax measures that would hurt the poor and offend the new supporters it has drawn away from the left. Second, they may simply choose to block any proposals that could help lift the government’s fortunes ahead of the 2012 vote.

“Although any type of major fiscal reform was going to be difficult, it became even more difficult after the elections,” says Allyson Benton, a politics professor at Mexican think-tank CIDE. “Now the PRI is emboldened. It thinks it can win the 2012 presidential elections or at least that it has a very good chance of winning, so now this party should be even more risk averse in how it thinks about the political effects of any major fiscal reform.”

The PRI says the idea that it would get in the way of change simply to make the government look bad, is absurd. “That’s totally false: the PRI, by definition, is a responsible opposition,” PRI deputy Sebastian Lerdo de Tejada tells Emerging Markets. “We’re not going to do anything at all that would hurt the country,” he says. “We just want things to work. We don’t put forward proposals just for the sake of criticizing the government.”

Prospects for the fiscal reform passing in its current state, however, were not initially promising. The day after the bill was sent, the PRI’s ranks were eerily quiet, leading some analysts to wonder whether the government might have reached a deal with the party beforehand.

When PRI lawmakers did speak out, however, it was in a damning chorus attacking the government’s economic policies and accusing it of fiscal terrorism. The prospect of months of bickering over the bill sent bond prices tumbling. “Seldom has Felipe Calderon been as alone as now,” said a grim editorial in El Universal, one of Mexico City’s largest dailies.

Waiting for a rebound

Mexico’s finance ministry expects the economy to begin bouncing back next year, and predicts 3% growth. As evidence of recovery emerges in the US, Wall Street, too, is largely confident that Mexico will get past its immediate financing crunch. “The reason Mexico fell so much is because of the US, and the US will get out of this one,” says Bernal. “Mexico’s problem is going to be Mexico’s boom next year.”

Calderon also remains upbeat and determined. The same week he sent his tax bill to Congress, he vowed also to propose a new energy reform – a highly ambitious move given the opposition’s reaction to his fiscal proposal.

Juan Bueno, the ruling party senator, hopes that people will receive the energy proposal with an open mind, and give foreign companies an incentive to help Mexico tap its mineral wealth. “There are people who think this national treasure should stay underground despite the poverty you can see above ground every day,” he says. “It’s time to be reasonable. It makes sense that others should do what the Mexican state can’t do anymore.”

Reflecting on the tough political climate Calderon faces, he says the seeming inability of Mexican politicians to agree on fundamental changes was perhaps to be expected in a country only recently emerging from seven decades of one-party rule.

“The old system hasn’t quite died and the new system hasn’t quite been born,” says Bueno. “There are wounds that haven’t healed and scores people still want to settle. We’re stuck in the middle, and it’s frustrating and painful for everyone. “It’s a new democracy and we’re still trying to make it fit.”

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