FACTBOX-Key political risks to watch in Mexico

MEXICO CITY, June 1 (Reuters) - Raging drug violence, a tepid economic recovery, flagging momentum on economic reforms and declining oil output are all risks to watch for this year in Mexico, which needs to keep up investor confidence to maintain its debt ratings and emerge from recession.

DRUG WAR

Since President Felipe Calderon came to power in late 2006 and launched an army-led campaign against drug traffickers, he has had some success in removing cartel leaders, but turf wars between rival gangs have spun out of control, worrying Mexicans, foreign investors, tourists and the U.S. government.

The drug war death toll since Calderon took power now stands at more than 23,000 and the violence is intensifying. Almost 4,000 people have been killed in drug violence so far this year, the deadliest period of Calderon's rule, and a jump in civilian deaths is hurting support for his crackdown.

Drug gangs have launched a campaign of intimidation ahead of state and municipal elections across much of Mexico on July 4, recently killing one candidate from Calderon's ruling National Action Party in a small town in northeastern Mexico.

Some politicians in states along the U.S. border have been forced to ditch their candidacies after receiving death threats from hitmen, while others are accused of drug gang ties.

In May, police arrested the mayor of the Mexican beach resort of Cancun for allegedly laundering money and protecting drug gangs, one of the highest-ranking public officials to be swept up in Mexico's crackdown on traffickers. [ID:nN26217189]

U.S. President Barack Obama strongly backs Calderon's drug war and is providing Mexico with more than $1 billion in funding to train police and buy anti-drug equipment and helicopters. But Calderon is also impatient for a U.S. ban on assault weapons that he says fuel the drug violence. In a speech to the U.S. Congress on May 20, Calderon urged lawmakers to reinstate the ban. [ID:nN20162558]

The drug war has not hit Mexico's peso or bond yields and despite daily reports of daylight shootouts, beheadings, and even terrorized border towns [ID:nN25214985], polls show voters are more concerned with economic issues than drug crime.

However, some foreign companies are starting to reconsider future investment plans, [ID:nN25249751] and Mexico's key tourism industry is also under pressure. [ID:nN13234162]

A month ahead of elections in nine states, Calderon's popularity is near the lowest levels of his presidency and his party is trailing the opposition Institutional Revolutionary Party, or PRI.

Most Mexicans support the drug war and Calderon told Reuters recently that he is sticking to his military strategy [ID:nN13221622]. But the longer the bloodshed goes on, and the worse it gets, the weaker Calderon looks and the more he risks losing support.

Recent incidents where groups of minors were killed sparked street protests blaming Calderon for failing to curb the violence. Calderon admits that whoever wins the presidential election in 2012 will still be facing off with drug gangs.

What to watch:

-- Any escalation in intimidation tactics such as murders of senior officials or deliberate attacks on the public.

-- Companies scaling back investment plans because of security concerns.

-- More protests or signs that Calderon is losing support.

FEEBLE ECONOMIC RECOVERY

Mexico is rebounding from a deep recession last year that saw the economy contract 6.5 percent and force the government to cut public spending and raise taxes.

Mexico's export-driven factories are now booming but its consumers are lying low due to a drop in incomes and scarce credit. [ID:nN18147767] Consumers have also been hit with tax hikes and increases in government-set prices for items such as gasoline. [ID:nN20376241]

A chief risk to 2010 economic growth forecasts is the mood of Mexican households worried about jobs and wages.

The unemployment rate rose unexpectedly in April, another factor that could give the central bank more room to leave interest rates low to support the economy. [ID:nN25130750]

Analysts worry that Mexico's recovery will be slowed if the U.S. economy -- which buys most of Mexico's exports -- falters. Mexico is already lagging behind the likes of Brazil, whose economy is more balanced around commodity importers like China and benefits from stronger domestic demand.

Mexico is still bruised from getting sovereign debt downgrades last year from two credit ratings agencies, leaving Mexico only one notch above the lowest investment grade. Fitch and Standard & Poor's said they were concerned about Mexico's public finances given declining crude oil output and dismal prospects for passing any far-reaching fiscal reforms.

The central bank kept its key interest rate at a 6-1/2 year low to help the economy and warned Europe's crisis presents a new risk, which suggested it might hold off on rate hikes for longer than previously expected. [ID:nN21171735]

What to watch:

-- Signs of consumers continuing to lay low, or starting to spend again.

-- Any dimming of the central bank's growth outlook.

STRUCTURAL REFORMS

Investors are impatient for Mexico to pass significant reforms to boost its low tax take, relax labor laws and allow more foreign investment in the state-controlled oil sector.

Calderon looked nimble on the legislation front early in his term, passing moderate pension, fiscal and energy bills, but since his party lost mid-term elections last year he is seen unlikely to be able to push anything substantial through the opposition-led Congress for now.

Investors want to see deep overhauls to energy laws and reforms to weaken monopolies in other industries. The antitrust proposal, however, may struggle in Congress. [ID:nN12134584]

Since last year's credit rating downgrades by Fitch and Standard & Poor's, the government is under pressure to do something to boost investor confidence for the year ahead.

What to watch:

-- The details of any government tax reform proposal and how the opposition-led Congress receives it.

-- Signs of opposition parties taking lead on new reform initiatives in order to benefit should they win power in 2012. -- Any revisions to credit outlooks from rating agencies.

FALLING OIL OUTPUT

Mexico's oil production, a boon for the country in the 1980s and 90s, has slid drastically in the last few years, with output down nearly a quarter from 2004 peaks, due mainly to a lack of new projects to replace the flagging Cantarell field.

Output fell for the fifth straight year in 2009, and while it has stabilized in recent months, production fell in April. [ID:nN21199999]

The government says it will pump an average 2.5 million barrels per day in 2010 and can keep output steady through 2012. But some analysts fear another decline this year if output at state oil monopoly Pemex's flagship Chicontepec project remains sluggish. Government regulators have urged Mexico to cut its Chicontepec oil and gas reserves forecasts by a third. [ID:nN16157981]

Mexico's prospects for quickly starting production in the crucial deepwater oil sector look dim. [ID:nN11209249]

A top exporter to the United States, Mexico relies on oil to fund around a third of the federal budget. The decline in output and exports was a key factor behind last year's debt downgrades.

A 2008 law was supposed to open the door to lucrative new contracts to bring foreign oil companies into Mexico's oil industry for the first time in decades, to boost deepwater exploration efforts and output for unconventional fields.

But Pemex's chief executive Juan Jose Suarez says the reform is overly complicated for the company and that it still needs fine tuning [ID:nN12217398].

Carlos Morales, the head of Pemex's upstream oil and gas production arm, is optimistic that the company could issue up to 14 incentive-based contracts by the end of the year to get private sector assistance to develop mature oil fields as well as the Chicontepec project [ID:nN03221138].

What to watch:

-- Any resolution to the court challenge to new contracts

-- Any improvement in the performance of Chicontepec

-- Any deep sea oil finds by Pemex, which has yet to confirm forecasts of deepwater reserves.

-- Further declines in Pemex's monthly oil output data or bleaker government forecasts for the coming years. (Reporting by Robin Emmott in Monterrey and Jason Lange and Robert Campbell in Mexico City; Editing by Kieran Murray)