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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2 Mexico Watch – ECB steps up guidance – 8 August 2013

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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3 Mexico Watch – ECB steps up guidance – 8 August 2013

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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4 Mexico Watch – ECB steps up guidance – 8 August 2013

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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