Mexico: Latin America S Uncertain Bright Spot

Issues in International Political Economy

March 2002, Number 27

Mexico: Latin America’s Uncertain Bright Spot

Sidney Weintraub

William E. Simon Chair in Political Economy  Center for Strategic and International Studies

1800 K Street, N.W.  Washington, D.C. 20006  Tel: (202) 775-3292  Fax: (202) 775-3199 

William E. Simon Chair in Political Economy  Center for Strategic and International Studies

1800 K Street, N.W.  Washington, D.C. 20006  Tel: (202) 775-3292  Fax: (202) 775-3199 

The three major economic rating agencies have accorded investment grade status to Mexican government obligations, thereby making this paper eligible for inclusion in many pension funds. The ratings are a testament to Mexico’s solid macroeconomic management. When projected revenue declines, Francisco Gil-Díaz, the finance minister, does not hesitate to cut budgeted expenditures. In recent years, the Mexican peso has appreciated against the dollar—which, in large part, is a reflection of the conservative management of monetary policy by the Bank of Mexico. The ratings from Standard & Poor’s, Moody’s, and Fitch, however, are based more on a snapshot—the macroeconomic solidity of the moment— than a sophisticated analysis of the future.

By most reckonings, 2001 was not a good year for Mexico. Gross domestic product GDP), which had grown solidly for the previous five years (i.e., after recovery from the disastrous economic decline in 1995), fell in 2001 by 0.3 percent. The main reason for the economic decline was the drop in exports to the United States, which had its own economic slowdown. The United States is the destination for 85 to 90 percent of Mexico’s exports. This, however, was not the only reason for export problems. Industrial productivity declined in most sectors last year and unit labor costs rose. The high value of the peso in relation to the dollar was surely a drag on exports. GDP growth is expected to grow this year by only about 1 percent.

If these were the only economic indicators, a dynamic analysis might lead to the judgment that the problems of 2001 were merely a temporary hiatus in Mexico’s successful march to a more prosperous future. Foreign direct investment is holding up (the total in 2001 was $25 billion, which includes the CitiBank purchase of Banamex) which implies that long-term investors have reached this conclusion. Other features must be taken into account, however. Perhaps the most important is that Mexico’s export growth rate of some 20 a percent year in recent years is unlikely to be sustained in the future, particularly if the United States does not grow as rapidly as it did in the halcyon years of the latter 1990s. Ever-growing exports to the United States in those years were the main engine for Mexico’s economic growth, but this engine is likely to slow.

There were other disappointing developments in Mexico last year. The tax reform proposed by the government—whose central feature was to raise the value-added tax on food and medicines to 15 percent, thereby making the VAT rate uniform—failed miserably. Some reform was achieved in the income tax, but this was counterbalanced by a complicated luxury tax that most Mexican economic analysts hope can be discarded quickly. Other structural reforms have gone nowhere. These include making the labor market more flexible, simplifying investment in electricity generation, opening natural gas exploration to private investors, reforming the telecommunications structure, and altering the judicial system, especially as it applies to mercantile law. The electricity rate structure for consumers was altered in early 2002 and this change raised the cost to middle-class ratepayers by 25 to 50 percent.

Mexico’s net domestic savings rate remains low, in the neighborhood of 17 percent, and tax collections as a percent of GDP are about 11 to 12 percent, low even by Latin American standards. This throws a heavy burden on Pemex, which picks up much of the revenue shortfall, thereby shortchanging its ability to invest in oil and gas exploration and exploitation. Because Pemex is the only source for investment in the oil industry in Mexico, this translates into inadequate investment in this vital sector.

Polls indicate that the popularity of President Vicente Fox is declining steadily; it is now below 50 percent and seems to slide further in each successive poll. The economy is in the doldrums and this diminishes the president’s popularity.

Many Mexicans lost jobs last year and, in addition, there was a 300,000-person shortfall in job creation for the one million new entrants in the labor force. Fox and his team were seen as inept negotiators with the legislature on taxes and the budget. Democracy, including an independent legislature dominated by the opposition, is a relatively new phenomenon in Mexico and the political class is still learning how to deal with this.

Some of the problems of 2001 and early 2002 may be manageable in the months and years ahead. The Institutional Revolutionary Party has just chosen a new leader, Roberto Madrazo, and he may show a willingness to negotiate structural issues with the government. The peso, which is probably overvalued, may decline in value during the coming months; the peso is not being propped up by active intervention or high interest rates. Mexico needs considerable investment in infrastructure and funds for this should be available from the international development institutions. The learning curve for dealing with an opposition-led legislature may speed up.

Other issues, however, require more complex solutions. These include the main structural impediments to growth, raising the low savings rate and thereby reducing the large reliance on capital inflows, and dealing with the growing lawlessness in many Mexican cities. Efforts to deal with these matters have not succeeded in the past, including when the PRI ran both the executive and the legislature. The capacity to deal with these structural issues is really at the heart of Mexico’s economic future. If the export engine is slowing, supplementary measures are needed.

The mood in Mexico is one of disillusion. President Fox is not meeting the expectations aroused by candidate Fox. The problems are not necessarily his entire making, but his watch is a historic one after 71 years of PRI domination. This mood of disappointment, especially from middle-class voters who supported Fox, was the dominant impression I took away after a recent visit to Mexico. Mexico has a solid macroeconomic foundation, and this impresses Wall Street and foreign investors, but makes little impression on those Mexicans who expected more tangible progress under a new, non-PRI administration.

The year 2001 was only the first of a six-year term, and there is plenty of time to turn around negative impressions. A U.S. recovery, even if modest, will help, and a sustained U.S. recovery will help even more. A less confrontational atmosphere between the congress and the presidency would help alter the mood of helplessness, which informed Mexicans now take for granted when it comes to innovation in public affairs. Fox’s cabinet, which has been replete with internal quarrels, does not have a good reputation in Mexico and some changes will probably occur—although not in the economic sphere. What is needed most of all, however, are structural reforms that will convince Mexicans and foreigners alike that Mexico is prepared to confront its problems head on. The nature of these reforms has already been cited.

What role can the United States have in helping to turn around what I found to be current pessimistic mood in Mexico? The most important action is to run the U.S. economy well because the growth in U.S. GDP is the key determinant of Mexico’s exports. In this respect, keeping one number in mind is useful: exports to the United States comprise 30 percent of Mexico’s GDP.

The two countries (three, if Canada is included) are in the ninth year of an integration process that has come a long way since NAFTA was first proposed, and the relationship has been transformed beyond anyone’s expectations a decade ago. The integration process, however, still has a long way to go—in facilitating trade, promoting investment, intensifying official and informal contacts, and stimulating knowledge of each other’s cultures. Bringing the two countries even closer in the years ahead requires a prosperous and self-confident Mexico, and not a country that looks to its neighbor to the north as an escape valve for its impoverished population. This kind of economic advance will not come without structural changes—and these are needed sooner rather than later if the Fox administration is to be a successful one.

CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author.

William E. Simon Chair in Political Economy  Center for Strategic and International Studies

1800 K Street, N.W.  Washington, D.C. 20006  Tel: (202) 775-3292  Fax: (202) 775-3199 