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Mexico WatchReform course on the right track
Group EconomicsEmerging Market Research
Malte Kalsbach
Tel: +31 20 638 0518
8 August 2013
In December 2012, the Institutional Revolutionary Party of the new president Enrique Pena Nieto took over after 12
years in opposition. Together with the two major opposition parties president Nieto was able to introduce the “Pact for
Mexico” which embraces a variety of reforms ranging from social security and education, to competitiveness,
employment and fiscal reforms. This broad-scale reform is a step towards improving Mexico’s competitive position as
well as preparing the country for future growth. In the recent years, the economic resilience achieved has allowed
Mexico to navigate the external challenges with relative success. Despite several risks and problems in the area of
economic development and structure, the government is currently tackling the right problems with its reform agenda.
Although GDP growth fell back from 3.2% yoy in Q4 2012 to only 0.8% yoy in Q1 2013, we expect activity to stabilise
and Mexico to recover during the second half of the year in line with the improved outlook for GDP growth in the US.
Introduction
The Institutional Revolutionary Party (PRI), which held power
for 72 years after the Mexican revolution in 1929, returned to
power under the new president Enrique Pena Nieto after being
in opposition for 12 years. Aware of the country's current
problems and future challenges, the government introduced a
comprehensive reform package to guarantee the
competitiveness of the economy and make the public
institutions more accountable to the people. Since the
government missed an absolute majority with only 41% of the
vote, Nieto sought and managed to achieve a cooperation with
the two major oppositional parties PAN and PRD to form the
“Pacto por Mexico” (Pact for Mexico). An analysis of the
course of reform requires consideration of both internal
challenges and external influences. Before taking a closer look
at the proposed reforms, we will evaluate economic
developments after the currency crisis in 1994 as well as major
structural challenges with a focus on the labour market.
More ups than downs
The Mexican economy has experienced several boom-bust
cycles in the past years following the Peso Crisis in 1994.
Although the country has strengthened its economic structure
and adopted sounder policies, the high vulnerability to external
shocks has frequently taken a toll. Throughout its history, the
development of the Mexican economy has been highly
influenced by events in the US. A constant export share to the
US of around 80% over the last 15 years combined with high
levels of remittances, tourist receipts and foreign direct
investments continue to make Mexico extremely dependent on
developments in the US economy. Indeed, when looking at the
trend of economic growth, Mexico closely follows its major
trading neighbour in the north. Although up as well as
downswings were more pronounced in Mexico compared to
the US, in the time span from 1995 till 2012 Mexican average
GDP growth was equal to the growth in the US with 2.5 % a
year.
GDP growth
% yoy
Source: EIU
Once again, in the aftermath of the financial crisis, a dip in
GDP growth of -6% in 2009 highlighted Mexico's strong
external vulnerability. After a fast recovery marked by average
growth rates of 4% between 2010 and 2012, the economy
seems to have cooled down a bit in 2013. Growth fell from
3.2% in Q4 2012 to only 0.8% yoy in Q1 2013 due to the
slower recovery in the US and weak global demand. We
expect this dip to be temporary, thanks to good growth
prospects for the US economy, robust government action and
a loose monetary policy. In fact for 2013, GDP growth is
expected to reach 3% followed by 4% in 2014.
Achieving sound macroeconomic policies
In the shadow of its northern neighbour, Mexico made
considerable progress in creating sound economic policies.
The monetary environment was stabilised in several steps.
After the central bank of Mexico became independent in 1994
it introduced a number of policies. These included the inflation
targeting of 3%, with a band of 1% implemented in 2003, which
helped to stabilise the inflation level. Although the target is
sometimes overstepped, the targeting has helped to keep the
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rate constantly below 8% since 2001 after years of average
inflation of 20% in the 1990s.
Inflation close to central bank’s target
% yoy
Source: EIU
Furthermore, the introduction of a floating exchange rate after
the Mexican peso crisis has made the country somewhat more
robust against external shocks. Current account deficits below
-1% over the past four years further underline the less
vulnerable external situation. With stable government and
foreign debt levels, the fiscal side is also relatively strong. The
government has been able to keep its debt level below 40% of
GDP over the last 15 years following the currency crisis.
Nonetheless, the country's high dependency on oil is still
problematic. Since earnings from the oil industry generate
around one-third of government revenue, unstable world
demand as well as changes in the oil price could put pressure
on the government budget.
Global Competitiveness Index Mexico
Rank (1-144)
Domestic market size 11
FDI and technology transfer 15
Soundness of banks 33
Macroeconomic environment 40
Business sophistication 44
Health and primary education 78
Institutions 92
Labour market efficiency 102
Hiring and firing practices 113
Total tax rate 115
Business costs of crime and violence 135
Organised crime 139
Overall rank 53
Source: World Competitiveness Index 2012-2013
Strengthening its competitive position
The progress Mexico has made over the years gets obvious in
international comparisons. On the 2012 Ease of Doing
Business index, Mexico jumped from a ranking of 74 (out of
185) in “Starting a Business” to 36. Furthermore, Mexico ranks
53rd on the “Global Competitiveness Index”, up from 58th last
year and 66th the year before. Meanwhile, the various trade
agreements, combined with its geographical position, helped
Mexico gradually increase its share in US imports to 12% in
2012 despite China’s increasing role in world trade. Since
1993 (pre-NAFTA), US imports from Mexico have risen by
almost 600%. Around 80% of these exports are manufactured
products, primarily produced in the “maquiladora” free trade
zone factories near the US border
Cheap labour boosts competitiveness…
When considering Mexican competitiveness, one relevant
factor which must be considered is its labour market.
Compared to other labour-intensive countries such as China,
Mexico has been able to keep its wages low. Since 2000, the
rise in unit labour costs (ULC) was quite small compared to its
main competitors. Thanks to the improvements in its
competitive position, Mexico has attracted a variety of
international firms. In the automobile industry in particular, the
country has emerged as one of the world's major producers.
Almost all major auto manufacturers have invested heavily and
reallocated their production facilities to Mexico, or have plans
for investments in the near future.
Unit labour costs
USD per hour
Source: EIU
… but structural challenges persist
While there were improvements in the competitive position, in
order to fully understand this trend one must consider
productivity developments. This area remains weak compared
to other countries in similar stages of development. In most
other large emerging markets, especially China, the increase
in ULC has been offset by a large and permanent increase in
labour productivity. Mexico is the weakest performer in
comparison to other major emerging markets, and has in fact
shown negative development in the broadest measurement of
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productivity. Although average hours worked per year is
among the highest in the world, productivity development has
remained a key problem in recent years. The unfavourable
development of economic productivity is one of the major
obstacles preventing the country from reaching its government
aim of potential GDP growth of 5%.
Productivity growth
% yoy
Source: EIU
There are a number of inefficiencies behind these
unfavourable developments, especially in the labour market.
The problems become particularly obvious in international
comparisons. On the Global Competitiveness Index, Mexico
ranks 102nd in labour market inefficiencies. The country
performs especially poorly in categories such as hiring and
firing practices (113rd) and flexibility in wage determination
(108th). Labour reforms approved in November 2012 under the
prior president Felipe Calderon already aimed at reducing
these rigidities. The new Federal Labour Laws were introduced
in order to boost flexibility and create incentives to join the
formal sector, which is essential to enable Mexico to tap its full
economic potential. The labour reform measures include laws
allowing hourly wages, temporary hires, subcontracting and
employment trial periods of up to six months.
In addition, there is still a major gap in the quality of education
compared to most OECD countries. In the OECD better life
analysis Mexico ranks among the bottom three countries in
categories such as years of education, student skills or
educational attainment, all variables which measure both the
quality of higher education and participation rates. This
disadvantage compared with developed countries leads to a
relatively low uptake of new technology by businesses to spur
productivity improvements and innovation (75th out of 144) and
needs to be addressed so that Mexico can catch up further in
the near future. It is therefore not surprising that education
reform is an important part in the government's plan to improve
Mexico’s competitiveness in future.
The education reform aims to improve the quality of higher
education, which will support acquiring knowledge and the use
of highly developed innovations. Part of the reform focuses on
boosting autonomy and accountability in schools. This involves
imposing tougher oversight of teaching standards through the
introduction of a national evaluation system. Creating full-time
schools and broader access to higher education are further
pillars of the education reform. These measures will take a
long time to yield fruit but are inevitable if the catch-up process
is to be successful. As stated by the EIU, the “poor educational
performance, even once the education reform is implemented,
will take years to improve, constraining long-term growth and
eroding the benefits of Mexico’s on-going demographic boom”.
Reforming state-owned oil company Pemex
One of the most ambitious reforms tackles the inefficiencies in
the energy sector, with a focus on the state-owned oil
company “Pemex”. As stated above, oil currently plays an
essential role in the country's fiscal policy since around one-
third of revenues are generated by taxes and duties on the oil
industry. A lack of refinery capacity, low rates of investments
and production inefficiencies, along with a decline in reserves,
has led to a gradual decline in oil production over the last eight
years. In comparison with other Latin American state-owned oil
companies such as Petrobas (Brazil) or Ecopetrol (Columbia),
Pemex's investment rates are by far the lowest. Since most of
Pemex's oil revenues are spent by the government, it lacks the
resources to invest in more efficient technology and take
advantage of other energy sources. Mexico has huge shale
gas as well as deep water oil reserves, which are not tapped
because of a lack of investments. The new reform process
therefore aims at fostering investments by enabling
cooperation between private (foreign) firms and Pemex. Such
cooperation is needed in order to finance these investment
projects. Still, while foreign investment should be allowed in
the form of shared contracts, for example, the monopolistic
role of Pemex should not be changed.
Oil production
Source: EIU
Other reforms coming
In addition to the controversial energy reforms, fiscal reforms
are also on the agenda. Both are crucial for the further
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financing of ambitious programs planned by the government.
These include a programme to fight poverty and a plan to
introduce a universal social security system. It will be a
challenge for the government to gain approval for the fiscal
reforms. Still, unpopular tax increases as well as a widening of
the tax base will be necessary to close the fiscal gap, which
will be created by lowering duties on the oil industry.
Further challenges
Along with the inefficiencies in the labour market and risks
associated with the dependency on the US as a trading partner
and oil as an income source, Mexico must solve several other
problems primarily related to institutional inefficiencies. The
economy is still plagued by high costs due to a lack of security,
weak public institutions and the business community's low
level of trust in politicians. Major problems arising from this are
linked to high levels of corruption and the influence of drug
cartels throughout the country. In the Corruption Perceptions
Index (rankings ranging from 1-176) Mexico's position is 105th.
In addition, the Ease of Doing Business survey, which explores
the most problematic aspects of doing business, reveals that
the categories of corruption and crime received the worst
scores. The ongoing drug war, which started in 2006, further
complicates the crime reduction efforts and is not predicted to
end in the near future. Aside from the disruptive impact these
developments have on Mexican society, tourism is also
affected and investors which might be discouraged to inject
huge amounts of money into the economy in the near future.
One of the new president's promises is to further enforce
efforts to gain control over the ongoing crimes and violence
associated with the drug war by introducing security reform.
Part of this reform involves the introduction a National Security
Plan. This plan includes the creation of a 10,000-strong
National Gendarmerie and continuation of an infiltration of the
police force which has already started. Since economic growth
has slowed, a further increase in violence would undermine the
government's political standing and it is therefore essential that
it be reined in. Still, it will be very difficult to combat the drug
war and associated crimes, while their future development is
extremely difficult to predict.
Potential risk affecting course of reform
There is a risk that reforms may come to a halt. Within the
main opposition party PAN, first internal disputes occurred and
disagreement about the cooperation with the government is
widening. Some members of the opposition already doubt the
decision to foster close cooperation since most of the
successes benefits only the popularity of the ruling president
and his PRI party. These developments are dangerous in light
of the PRI government's lack of an absolute majority. The
government relies on the support of other parties for passing
upcoming reforms dealing with the reformation of the energy
sector or the fiscal reforms, which are controversial topics
within the coalition. Furthermore, initial demonstrations against
reforms that have already passed prompted teachers to rebel
against education reform. The road ahead will be a bumpy
one, but we expect most reforms included in the Pact for
Mexico to go through.
Outlook remains positive
Despite several risks and problems facing the future course of
economic development, the country has considerably
strengthened its macroeconomic fundamentals and is tackling
the right problems with its reform plans. While reforms such as
those related to education and energy may take some time to
prove successful, they are inevitable in order to guarantee
future economic growth.
The energy reforms and fiscal restructuring still need to be
pushed through congress but they have great potential for
boosting the economy by attracting new investments. This will
especially be true if new inflows of capital can be used to
temper the full potential of the deep water oil and shale gas
reserves. Experts estimate that this would potentially increase
GDP growth by 0.5% to 1.5%.
Current weaknesses, such as the dependency on the U.S. and
the excessive reliance on oil revenues, represent challenges.
However, the government is keen to deal with them in order to
decrease the country’s external vulnerability. A trend towards
more diversified exports can already be seen, supported by a
number of new trade agreements with China and Brazil and
the creation of the Pacific Alliance with Chile, Colombia and
Peru. Although it will be a challenge to continue on the right
path and tackle internal as well as external burdens, we see
Mexico on the right track towards achieving a higher growth
trajectory in the coming years.
Outlook
Source: EIU
5 Mexico Watch – ECB steps up guidance – 8 August 2013
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