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MONTERREY, Mexico (Reuters) - Mexico is struggling to avert a collapse of law and order along its northern border in a region that generates a quarter of its economic output, with two states already facing the threat of criminal anarchy.
Even after four years of dramatic military sweeps, drug cartels in Chihuahua and Tamaulipas are extending their control over large areas and the state governments seem powerless to stop them.
Mass jail breaks, abandoned police stations, relentless killings and gangs openly running criminal rackets such as gasoline stolen from pipelines are the new reality in regions once at the forefront of Mexico's efforts to modernize and prosper under the North American Free Trade Agreement.
Gunmen killed as many as 18 people near Tamaulipas' state capital Ciudad Victoria on Sunday night, attacking a passenger bus and shooting up government buildings, although no word of the violence appeared in local newspapers and TV stations, which are too afraid to report or are paid off by the cartels.
Police found the severed head of a two-month-old baby dumped in the town of Delicias in Chihuahua earlier this month in one of the cruelest revenge attacks to scar the state.
"The criminals are hollowing out police and local governments' capacity to uphold the law," said Kevin Casas-Zamora, an analyst at the Brookings Institution in Washington and a former vice president of Costa Rica. "There is an explosion of robbery, extortion and kidnapping."
Violence is well away from the white beaches that draw millions of tourists, but Mexico risks losing control of parts of the country to drug cartels -- fears expressed by a senior Mexican official in October 2009, according to U.S. State Department documents made public by WikiLeaks in December.
Back then, Deputy Interior Minister Geronimo Gutierrez, who has since left his post, said the government had 18 months to show voters it was beating drug gangs or see President Felipe Calderon's army-led offensive abandoned after the next presidential election in 2012.
The lawlessness in Tamaulipas is spreading to the neighboring border state of Nuevo Leon, home to Mexico's richest city Monterrey, as the Gulf cartel's war with the Zetas gang spreads across the region.
Coahuila, another frontier state, is seeing a surge in violence in one of its main cities Torreon. The calm in Baja California, where the government boasts a fall in violence, may not hold. The state has already seen 80 drug murders this year, a 70 percent jump compared to the same period in 2010.
Mexico's six border states generate one-quarter of gross domestic product but close U.S. links are a double-edged sword as drug traffickers fight to control the strategic region.
Extortions, one of the scourges that prompted Calderon to go after the cartels, have become so bad in Chihuahua's biggest city Ciudad Juarez that many small businesses have stopped paying their social security, and hitmen have warned government tax collectors against trying to chase up those in arrears.
"Restaurants, bars, delicatessens, shoe shops, everyone is paying extortion money," said a business man with an car dealership who has been extorted by drug gangs and declined to be named. "And if you can't pay both extortion fees and your taxes, you tell the gangs and they sort it out for you."
Mexico and the White House play down the threats posed by the cartels but U.S. Secretary of State Hillary Clinton said last year that Mexico faces a drug cartels insurgency and U.S. Undersecretary of the Army Joseph Westphal was recently forced to retract similar remarks.
The drug gangs have not launched major terror attacks like Colombian traffickers, who set off powerful car bombs in busy streets and killed 107 people in bombing a commercial airliner in 1989. But hitmen have killed at least 14 mayors across Mexico over the past year, have detonated explosives in vehicles, and on Sunday night murdered a Nuevo Leon police chief in Monterrey.
More than 34,000 people have died in drug violence since Calderon launched his crackdown in December 2006.
Taking no chances, Tamaulipas' new Governor Egidio Torre, a last-minute substitute for his brother who was killed by hitmen while campaigning last June, is heavily guarded at all times by soldiers. A third of the state's 1,200 police work full-time as bodyguards for officials and their families, said Tamaulipas' police chief, himself an army general.
The cartels, meanwhile, continue to defy troops.
Gunmen claiming to represent the Zetas have threatened oil contractors working at isolated natural gas fields in the Burgos basin in Tamaulipas and Nuevo Leon.
Rivals working for the Gulf cartel in the nearby cities of Reynosa and Rio Bravo are openly selling gasoline siphoned off from pipelines or from hijacked trucks owned by state energy monopoly Pemex, residents and police sources say.
On a recent day in Reynosa, a young man casually smoking a cigarette and holding a wad of peso notes sold gasoline in plastic jugs with a 35 percent discount compared to legal gas stations.
Last year, a man in Rio Bravo who couldn't pay a ransom fee to free his kidnapped eight-year-old daughter was forced to watch as cartel hitmen chopped her into pieces in front of him, a family member told Reuters, breaking down as he spoke.
"There's no hope here, only fear," said the man, a local bus driver. "These gangs have complete power over us."
Reporting by Julian Cardona in Ciudad Juarez and Tim Gaynor in Phoenix; Editing by Kieran Murray