Growth Interrupted

Seven years ago, the North American Free Trade Agreement came into effect, linking the economies of Mexico, the US and Canada. Trade across the US-Mexican border has risen at an impressive rate. Mexico may still be a Latin American country, but financial markets now see it as an integral part of the North American economy. This has helped Mexico attract foreign investment and expand its exports, but dependence on the US – which takes 85% of Mexican exports – does come at a price. A decelerating US economy has pushed Mexico into recession.

“The US is the engine and economic indicator for the world, and the Mexican economy is now extremely closely tied to it,” says Peter Cardinal, chief executive officer of Grupo Financiero Scotiabank Inverlat, Mexico’s fifth-largest bank.

However, the US link and Mexico’s sound economic policies have isolated the country from the effects of Argentina’s financial troubles, which have brought Brazil low and hurt Chile to a lesser extent. Indeed, emerging market investors these days view Mexico as a safe haven. The spreads on Mexican bonds have tightened 18% this year, while those on Brazilian bonds have risen nearly 50%.

Last year, Mexico’s economy steamed ahead, growing by 7%, and between 1995 and 2001, the country’s GDP growth doubled to $615.3 billion, today making it Latin America’s largest economy, surpassing even Brazil.

Economic reliance on the US means that Mexico’s industrial sector has been hit disproportionately hard by weak growth in the US, causing a drastic reduction in imports from Mexico. In just three months this summer, exporters saw foreign sales shrink 4.5%. During the same period a year ago, exports rose 22.4%.

Mexico’s trade deficit rose to $4.02 billion in the first six months of the year, up 60% from the same period last year, according to the Finance Ministry. By mid-2001, Mexico was in recession and in August, many believed that the economy would decline again in the third, and possibly the fourth quarter. “We tend to be overly conservative, but we are concerned. We do not think that we have seen the worst yet,” says Alvaro Rodríguez, vice president of administration and finance for Grupo Elektra, the country’s largest appliance retailer and consumer finance company. “We have been on the less optimistic side of things since the end of last year.”

Jonathan Heath, chief economist for LatinSource Mexico, a consultancy, says total fixed investment peaked in Mexico more than a year ago in July 2000 and the industrial sector began contracting shortly thereafter. Though the country’s commercial and retail sectors remained fairly active into 2001, by summer, even they had ground to a halt.

“We’re in a recession and it is not clear that we’ve touched bottom,” says Heath. If the US economy doesn’t soon return to strong growth, Mexico’s recession may intensify as consumers cut spending, much as companies did beginning last year. The slowdown in industrial production in Mexico this year led to a phase of layoffs; further job cuts would hit retail spending. The Mexican chamber of industry estimates that the country’s manufacturing industry is firing up to 20,000 people a month.

Companies, like glassmaker Vitro, have had to fire employees because of falling exports and domestic sales. In mid-July, Vitro said it planned to fire about 1,100 people to help boost profits. The Mexican government estimates that about 200,000 workers lost their jobs in the first half of the year. Many industrialists are blaming the central bank’s sound money policies for driving up the value of the peso, which has hit companies’ ability to maintain exports and defend their home markets from import competition.

Although growth has ground to a halt, a strong currency and political stability seem to be maintaining business confidence. President Vicente Fox is still very popular. He won Mexico’s first truly democratic election in July 2000, unseating the Institutional Revolutionary Party, which had run the country since 1929.The Mexican peso is one of the world’s strongest and most stable currencies (see story page 14).

Continuity in economic policy has added further confidence. Francisco Gil Díaz, the finance minister, is a notorious fiscal hawk. Guillermo Ortíz, president of the independent central bank, is an anti-inflation hardliner. The government has cut its budget deficit and debt load.

In March 2000, Moody’s Investors Service awarded the country a Baa3 investment grade rating. This cut the cost of capital for government and private-sector issuers and opened a new, far larger universe of institutional investors able to buy Mexican bonds. Previously, Mexico was off-limits to most US investment funds, which are barred from investing in sub-investment grade assets. Standard&Poor’s still rates Mexico a sub-investment grade BB+ rating. The agency says it will raise Mexico to investment grade only after Congress has approved unpopular tax measures extending a value added tax to food and medicines.

Stronger Banks
Mexico’s banking system, leveled during the peso crisis in 1994, has been recapitalized and restructured thanks to heavy government intervention and foreign investment. The total bill for straightening out the banking system is not in yet, but could hit $100 billion.

Mexico’s big banks are among the strongest and most profitable in Latin America. According to Economática, the financial data service, four Mexican banks – Banamex, BBVA Bancomer, Santander Serfin, and Inbursa – were among the top 10 Latin American banks ranked by net income in the first half. Among those, only Inbursa, controlled by Carlos Slim, the business magnate, is still in Mexican hands.

Foreign investment in local banks was banned until 1999. The government subsequently liberalized the industry, opening it up foreign investment. International banks have since spent $18 billion to take over Mexican banks. This year alone, Banco Bilbao Vizcaya Argentaria, bought Bancomer, Mexico’s largest bank, Citigroup bought Banamex Accival, the second-largest bank, and Banco Santander Central Hispano bought Serfin, the third-largest bank. Today, foreign banks control nearly three-quarters of Mexico’s bank assets. A year ago, foreigners held less than 20% of assets.

“The capital and experience that the foreign banks bring reduces in a significant manner the risk that Mexican depositors have faced over the last few decades,” says Scotiabank’s Peter Cardinal.

Recapitalization should enable Mexico’s banks to increase lending to corporations and consumers alike. Interest rates and inflation are at historic lows, and banks say they are revving up lending (see story, page 12).

‘Great Opportunities’
Local companies are confident that Mexico faces years of sustained growth. Cesareo Fernández, chief executive officer of WalMart de México, says Mexico’s large proportion of young people make the country especially attractive. He says that 78% of the country’s population of 100 million is under 40 years of age. Young people spend more and save less than older ones do. They also marry, begin families and start a lifetime of purchasing, from cars and homes, to dishwashers and hairdryers. Fernández says: “We continue to grow, foreign companies continue to come here and every day the banks are stronger and more important in this country. [This] is a country of great opportunities.”

Prudent fiscal policies, initiated in the mid-1990s by the previous government under President Ernesto Zedillo, have laid the foundations for steady growth. Although growth has petered out, the country’s sound economic fundamentals mean that it should be able to bounce back quickly from recession.

The country’s external debt load, once a critical weakness, has fallen sharply. Mexico has reduced its debt burden to 39% of GDP, from 115% of GDP at the onset of the Latin debt crisis 20 years ago.

In the first half of this year, the government placed $6.5 billion in the international bond markets at a time when few other Latin American sovereigns were able to come to the market, and none were able to do so on favorable terms. In August, the government sold a $1.5 billion, 30-year bond in a matter of hours, priced at just 335 basis points over US Treasurys.

With only $2 billion to $4 billion in external debt scheduled to mature in any given year through 2004, the government is no longer particularly vulnerable to the volatile international bond markets, and can afford to pay down or refinance maturing debt as it pleases. Mexico has further improved its debt profile through a series of liability management exercises over the years, aimed mainly at reducing its stock of expensive Brady debt.

However, the country’s poor tax collection record is one of the economy’s main weaknesses. Mexico’s tax base has shrunk over the last 20 years, as governments conceded numerous tax exemptions and failed to crack down on the growth of the informal economy. Personal income tax receipts have decreased to 1.9% of GDP today from 3.2% of GDP in 1980. Governments have cut debt by reducing expenditure on infrastructure. Merrill Lynch says public infrastructure spending has dropped to 1.9% of GDP from 12% in 1980.

Boosting Revenues
One of Fox’s greatest challenges is to enact a comprehensive reform of Mexico’s tax system that would widen the tax base by drawing the large informal sector into the economy and eliminate loopholes. That would simplify enforcement of tax laws. He also wants to extend value added taxes to food and medicine, which he says would affect middle and upper class Mexicans far more than the poor. The proposed reforms aim to increase tax collection and put fiscal policy on a sustainable footing. They would enable Fox to keep his promise to expand government spending on education, social programs and infrastructure. The government says the reforms would increase tax collection by 1.5 percentage points of GDP in the short term and another 1 to 1.5 percentage points within five years. This would raise the tax take to 14.5% of GDP from a current level of 11%.

The controversial reforms are also needed to ensure that the government can meet its budget deficit target of 0.65% of GDP this year. Without the reform, the deficit could rise to 1.5% of GDP.

The Mexican government has traditionally depended on transfers from Pemex, the national oil company, for more than a third of the budget. During the next decade, oil revenues are expected to stay constant in real terms, so the government needs to increase its tax revenues just to maintain its current level of public sector revenues. The government also needs to reduce its reliance on Pemex for its own sake, since it needs to cut spending when oil revenues fall. The Finance Ministry earlier this year implemented $367 million in budget cuts in response to declining oil exports. First quarter oil revenues sank 41% compared to the same period last year.

Cutting the Pemex Lifeline
Using transfers from Pemex to shore up the budget deprives the company of resources it needs to spend on increasing its oil and gas reserves or upgrading its refineries (see story on page 9). Demand for energy is growing at 4% annually, but oil and gas reserves are declining because Pemex has not invested enough in exploration and development. The private sector is not allowed to do so, because oil reserves are state property.

Mexican executives complain that they are paying a high price for the government’s failure to improve the quality of public services. Eugenio Clariond, chief executive officer of Grupo Imsa, a steel company based in Monterrey, complains that, “The roads and infrastructure are not there. The legal system is not efficient. The quality of electricity [supplies] is poor. We are flooded with natural gas but cannot extract it because drilling for it is so expensive. These are all things that force us to continue to be a third world country.”

Perhaps, but Mexico has made huge strides in modernizing its economy and reforming its political system. Much remains to be done, but it continues to move in the right direction. It no longer seems outlandish to imagine that in a generation or two, Mexico could attain standards of living similar to those of Spain or Portugal. They too, were backward, marginal states until they were integrated into the European in the 1980s when they joined the European Union.