Analysis: Mexico's creaky economy to test Pena Nieto's ambitions

MEXICO CITY Mon Jul 2, 2012 3:37am EDT

Supporters of Enrique Pena Nieto, presidential candidate of the Institutional Revolutionary Party (PRI), celebrate at the party headquarters in Mexico City, July 1, 2012. REUTERS/Edgard Garrido

Supporters of Enrique Pena Nieto, presidential candidate of the Institutional Revolutionary Party (PRI), celebrate at the party headquarters in Mexico City, July 1, 2012.

Credit: Reuters/Edgard Garrido

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MEXICO CITY (Reuters) - Mexico's creaky domestic economy, riddled with monopolies and inefficiencies, makes the next government's goal of boosting growth to rates last seen in the 1970's seem like a pipe dream.

The return to power of the Institutional Revolutionary Party, or PRI, in Sunday's presidential election may be a chance for the most significant economic remodeling in a generation.

But the checkered history of reforms in Latin America's second-biggest economy, producing failure as often as success, underscores the size of the challenge.

Enrique Pena Nieto, who won with about 38 percent of the vote according to a quick count by electoral authorities, aims to lift growth to 6 percent a year by making labor markets more flexible, boosting tax revenues and allowing more private companies to enter the oil industry.

If implemented in full, the reforms would be the deepest since Mexico embraced privatization, bank deregulation and free trade in the 1980s and 1990s. Those reforms culminated in Mexico's 1994 entry into the North American Free Trade Agreement (NAFTA) with the United States and Canada.

Pena Nieto's chance of success hinges on whether the PRI secures more than half the seats in Congress, which was not clear on Sunday night, and whether it can bring on board PRI-affiliated but independently powerful labor unions for reforms which will hurt many of their members.

"Reforms won't be automatic and most likely will still require political negotiations with opposition parties and the unions," said Fitch sovereign ratings analyst Shelly Shetty.

NAFTA helped turn Mexico into a major exporter of computers, cars and fridges for foreign markets. Exports are almost double 1990 levels at 32 percent of gross domestic product, or GDP.

But that dynamism stands in stark contrast to a sluggish and archaic domestic market. The two-speed economy has taken Mexico further from its goal of joining the emerging-economy A-list and competing with countries such as India and Brazil.

A lack of competition stifles innovation and means Mexicans are overcharged billions of dollars a year for basic services.

High business costs drive similar sums into the informal economy, depriving the government of valuable tax revenue and crimping investment in education, infrastructure and research and development, vital building blocks for future growth.

Economic growth has languished at an average 2.6 percent annual rate over the last two decades, compared to 7 percent in India and 10 percent in China, partly due to the meager trickle of reforms. In recent years, a fierce drugs war has raised security fears and put off some investors.

Productivity is lower now than in 1981, the year before a debt crisis that ended a golden era of three decades of 6-percent-plus average annual growth. Income inequality has worsened and investment has stagnated at half the rate of that in China.

The last round of major reforms, book-ended by the 1982 debt crisis and another deep financial crisis in the mid-1990s, did succeed in cutting government debt to levels Europe would now be proud of and wrestling inflation down from a 1987 peak near 150 percent to around 4 percent now.

But the reforms have not boosted Mexico's potential growth rate, the top speed possible without fanning inflation. At about 3 percent, it is less than half that estimated by the International Monetary Fund for the emerging economies of Asia.

"The reforms that were made in the 1980s and 1990s were there to prevent a dying patient from dying but that doesn't necessarily mean it's going to bring him to good health," said Economist Intelligence Unit analyst Rodrigo Aguilera.

"We had a heart attack in 1982 and another one in '94, I guess those reforms saved us from ending up worse but they didn't necessarily generate a more dynamic economy."

One quick way for Pena Nieto to boost growth would be to increase lending to the private sector via a proposed new state bank. At 20 percent of GDP, lending is half the level of Brazil and small firms who turn to boutique lenders complain of paying interest of 50 percent-plus.

Another could be giving competition regulators more teeth against opposition from family-run oligopolies which control industries such as cement, bread making and communications, the home turf of Carlos Slim, the world's richest man.

The Organisation for Economic Co-operation and Development estimates that Mexicans, who pay on average $90 a month for broadband internet access compared to $55 in Chile, have been overcharged $13.4 billion a year for communications services.

FIX THE FOUNDATIONS

Mexico watchers see a holy trinity of labor, fiscal and energy reforms as vital to bringing the economy into the 21st century and even narrowing the income gap with the United States, which is about three times wealthier than Mexico in terms of per-capita GDP.

Energy reform is the most important of the three. It centers on opening the state-run oil industry to more private investment, either via the sale of a stake in state monopoly Pemex or constitutional change to grant oil concessions to private companies, which would attract much-needed investment.

Oil production has fallen by a quarter since a peak in 2004 to around 2.55 million barrels per day. Pemex believes there are up to 29 billion barrels of crude equivalent in the Gulf of Mexico, more than half Mexico's potential resources, but Pemex lacks the technology or expertise to tap the riches on its own.

HSBC and BNP Paribas estimate that opening the oil sector could boost Mexico's potential growth by as much as one percentage point.

Elsewhere in Latin America, Colombia's state-run Ecopetrol and Brazil's Petrobras have both sold some shares. However, the EIU's Aguilera said Pemex would need a major overhaul to be an attractive buy.

At the same time, the new government plans to cut Mexico's dependency on oil revenue, which makes up a third of the federal budget, one reason cited by rating agencies for capping Mexico's credit rating at the current BBB/Baa1, below Chile at A+/Aa3.

Mexico's narrow tax base is half the size of many European countries, and the IMF estimates government revenue at 22 percent of GDP this year, versus 36 percent in Brazil.

Pena Nieto's campaign chief and possible finance minister, Luis Videgaray, told Reuters in March that ending a value-added-tax exemption on food and medicine, as long as a way could be found to compensate the poor.

An economist educated at the Massachusetts Institute of Technology, Videgaray is part of a new generation of PRI technocrats whom analysts consider well-qualified to keep Mexico's finances healthy.

Dismantling all tax exemptions would add more than 4 percent of GDP to fiscal revenues, according to economists at Citigroup, and this would allow more investment by the state in sorely needed infrastructure such as schools and hospitals.

Another way to raise more taxes, and tackle the massive problem of low productivity, is to entice some of the estimated 14 million people working in the black economy into formal employment, using a new social-security system as a carrot.

Firms are loath to hire, partly because of labor and social security costs that are almost double the Latin American average, according to the World Bank's 2011 Ease of Doing Business survey. Former IMF official Claudio Loser estimates informal workers cost Mexico $10-$15 billion in lost taxes every year, enough to cover up to two years of the federal health budget.

Having so many workers in low-paid, low-skill informal jobs has helped depress Mexican productivity and means it lags well behind the similarly sized economies of Australia and Korea on measures such as GDP per hour worked.

SIX PERCENT "UNREALISTIC"

Mexico's central bank governor, Agustin Carstens, whose six-year term runs until the end of 2015, has said a full palette of reforms could boost annual growth to 5 percent or more, but most economists see the PRI's promise of 6 percent as unrealistic.

"That's a bit ambitious," said Edwin Gutierrez, portfolio manager with Aberdeen Asset Management, which has $295 billion under management or advice.

"It's going to be a slow grind. It would be great if we got there but let's crawl before we walk. Getting to 4 percent would be great, 5 would be fantastic."

Moody's Investors Service analyst Mauro Leos said a one-percentage-point boost to trend growth would cut the jobless rate and attract investment.

But even a best-case scenario will not necessarily guarantee Mexico the A-grade credit rating that has eluded it so far.

"If you think of what is a typical A-rated country, the countries that come to mind are the Czech Republic, Poland, Korea - countries that have a very balanced structure in every respect," Leos said, noting that Mexico also has to boost its rule of law, judicial system and other institutions.

"For us, what is really relevant are the next six years, more than the next six months," he said.

(Additional reporting by Daniel Trotta and Rachel Uranga; Editing by William Schomberg, Kieran Murray and David Brunnstrom)

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