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MEXICO: Heat of the moment

Jul 1, 2012

Rebounding growth and the promise of reform have turned many bullish on Mexico’s prospects – not least relative to Brazil’s. Separating hype from reality has scarcely been more important

By Ben Miller

Mexico is in for big change - or so say the optimists.

Enrqiue Peña Nieto's July 1 victory in the presidential polls will herald a new era, they say; his government will not resemble the Institutional Revolutionary Party (PRI) of old, but will instead consist of a competent bunch of technocrats who will hasten the passage of critical reforms to the judiciary, energy sector and fiscal system that have long eluded bickering and divisive legislators.

US growth, say the hopers, will also rebound, pulling Mexico's economy with it. And an IPO of Pemex will eventually follow, reversing the fortunes of the bloated state producer, and spurring others to join it in deeper capital markets.

So far things have not quite gone to plan: Peña Nieto won with a 7 percentage point lead, a less resounding result than many had expected; and his party fell short of an absolute majority in Congress, complicating his ability to push through reforms. The election result was also swiftly challenged by runner-up Andrés Manuel López Obrador of the leftist PRD, who, alleging fraud, demanded a recount. Although the PRI candidate is still expected to emerge victorious, his win is likely to have had some of the force knocked out of it.

Optimists will nevertheless take comfort in an economic narrative that for the past 18 months has defied expectations, lending some credence to their belief that Mexico has turned the corner.

Although this is hardly the first time followers of Latin America's markets have encountered such optimistic predictions, over the past 10 years they have also witnessed a handful of undeniable success stories. None has been as well publicized as that of Brazil - the economy many are now predicting that Mexico will replace as the favorite for investors over the next decade.

Riding favorable commodity prices, extraordinary Chinese growth and an expansion in consumer credit, Brazil had captured many of the easiest gains over the past decade. But continuing to do so, especially in the absence of tough economic reforms, will prove much harder as demand from China - a significant factor behind Brazil's surge - slows and consumer borrowing hits its limit, dragging growth with it.

Mexico, by contrast, stands to gain from a Chinese slowdown - a fact which could boost the country's competitiveness and, in particular, support the outlook for its manufacturing sector. Its close economic links to the US -an unwelcome weight during the crisis in which other Latin American economies were relatively less affected - could mean there is some upside in the event of a sustained US recovery.

"Mexico is in a unique position, and as a result in the next five years it will do better than Brazil," says Benito Berber, an analyst at Nomura. "This has to do with first-unit labor costs continuing to go down, which makes the manufacturing sector very competitive. More reforms could push it even further ahead." He expects Brazil's GDP growth to land at about 3.5%, Mexico's could reach 4.5% from 3.5 % now.

Others analysts have similar expectations. HSBC sees growth hitting 3-4% this year, after 3.9% last year. The bank says without any reforms, the trend should be 3.5% to 4.0%. With significant reforms, though that could be 4.5%.

Fundamental shifts

Regardless of Peña Nieto's victory or whether or not he can deliver the promised change, several trends point to an improving Mexican growth story. Last year, the country's economy grew faster than Brazil's, 3.9% versus 2.7%, and it looks set to outpace its larger Latin rival again in 2012. Manufacturing could grow by even more, as the US appears to be poised to be the only G3 economy to grow, in contrast to the widening slowdown across Europe. Mexico can also point to 17 years of macroeconomic stability, low inflation, manageable debt, sophisticated financial systems, an open economy and increasing global competitiveness.

Brazil's advantage in the last decade has in effect been little more than a terms of trade shock, and it has not taken advantage of a favorable backdrop to undertake tough structural reforms.

"Even with the overall lack of reforms, the government has made some reforms that have made Mexico more competitive than Brazil," Berber says. "In terms of no restrictions on lending and open capital accounts, the model is Mexico, not Brazil."

Berber says there are stronger fiscal rules, a lower fiscal deficit, more flexible labor and capital markets. There are "no surprises" in the fiscal accounts, and the government is not intervening with the rates and foreign exchange markets to the extent that Brazil's government is.

"The story may be still somewhat under-appreciated," says Alonso Cervera, an economist at Credit Suisse. "There is a focus on negative events, and many have heard talk of reforms many times before, only to be disappointed by the result."

Investment is already returning to Mexico. Some $10 billion has been ploughed into the auto sector over the last five years. Nissan, Mazda and Honda have all announced plans to build new plants in Mexico, and further new investment in industries including aerospace and electronics are expected soon.

The automotive sector represents 28% of total manufacturing exports or 7% of GDP. Mexico's exports have grown more diverse, however, and it has attracted significant foreign direct investment. It is the world's first exporter of refrigerators and the second largest supplier of electronic products to the US market, computer equipment and parts, and telecommunications.

Mexico had struggled as Chinese-made products replaced its goods in the US, which buys about 80% of Mexico's exports. But a Chinese slowdown could mean less demand for Brazilian commodities, and so less competition for Mexican manufacturing.

The faster rate of wage increases in China than in Mexico suggests that the cost advantage China once enjoyed is fast dissipating, according to Nomura. Chinese labor rates were 33% of Mexico's in 1996, yet now they are close to or even higher than those in Mexico, the bank notes.

China-US transportation costs have also gone through the roof, and Mexico could further extend the advantage if the government is successful in lowering the costs of production.

Another point in Mexico's favor is the shale gas revolution in North America that has come on the back of improvements in hydraulic fracturing, a process also known as "fracking." Mexico and the US are sitting on one of the largest shale reserves in the world. Mexico has a strong manufacturing base which uses natural gas as a raw material for production, adding another competitive advantage over China.

"This will drive the manufacturing in many industries, not only commodities, but everything, the whole manufacturing base will be more competitive just on the natural gas advantage," says Ramon Leal, chief financial officer of Alfa, whose Alpek unit is among those companies standing to benefit.

The exchange rate also paints a favorable picture for exporters. A weaker dollar relative to the world's major currencies, means more competitive exports in the US which will help Mexican suppliers.

The global downturn could also boost Mexico's tourist sector, which stands to benefit from its proximity to the US. Faced with tigher budgets American holidaymakers will be reluctant to spend more on long-distance vacations and could instead choose destinations, such as Mexico, closer to home.

Foreign direct investment (FDI) flowing into Mexico should be $22 billion to $23 billion this year, according to HSBC, and the country is able to make the most of its flows. Mexico gets $14 of exports for every $1 of FDI, says Sergio Martin, an economist at HSBC. This compares to $9 in China and $4 in Brazil.

These advantages are striking when considering the lack of obvious reforms in Mexico during the 12 years of National Action Party (PAN) presidencies. To capitalize on these fundamental shifts, experts say Mexico must make large improvements in the energy, fiscal, labor and education sectors.

Reforms finally?

Much of the hype in the first half of 2012 over change was down to the fact that Peña Nieto's calls for a new direction were the loudest of the three major candidates.

Followers of Mexican history may find it odd that the PRI - which for seven decades restrained Mexico with its tough grip on democracy, the economy and many facets of life - is the party now poised to spearhead much-needed changes. Supporters claim that Peña Nieto represents a changed party, and point to a strong track record as governor of the state of Mexico. Skeptics fear a return to the old ways.

"There is a new wave of PRIstas, younger and more modern, who are surrounding Peña Nieto," Cervera says. "The PRI gets it and wants to stay in power for more than six years. The only way to do this is to deliver. This is Mexico's golden opportunity."

The list of reforms is the same and almost all of the politicians are agreed on them, Cervera says. He expects the PRI to be more focused, and to avoid trying to control everything, as it aimed to do before.

Peña Nieto strived to campaign for himself rather than the PRI, presenting himself as a pro-market candidate that would continue the process of liberalization. There are in fact many strengths to point to during his governorship. His government renegotiated debt efficiently and introduced innovative means of funding, as well as oversaw several infrastructure projects based on the public-private partnership (PPP) model.

"We will not believe these reforms until they are passed, but there is a clear need to pass, and this is the view among all parties, even the PRD," Berber says. "Yes, there can be a disappointment. But at the same time there seems to be much more clarity about the need to pass reforms."

The indications were that Peña Nieto supports key reforms, such as the privatization of Pemex, and might even push for political reforms including the reduction of the number of senators and federal deputies. However, the election results seemed to suggest that the PRI would not get the legislative majority that many had expected, complicating its ability to pass multiple reforms.

"This lowers the optimism about the passage of reforms," says Berber. "They are going to need alienaces with the other parties. That is going to reqire some manouvring."



The PAN opposition creates an interesting dynamic copmpared to what was seen in the current administration, with the PAN in the presidency and the PRI in opposition, Berber says. In the current setup the PAN has proposed pro-market reforms that, if passed, could still be watered down before passage. With Peña Nieto in Los Pinos, Mexico's presidential residence, proposing the pro-market reforms he promised in the campaign, the opposition PAN would be likely, if anything, to push to make them even more pro-market. All this suggests to Berber that, if Peña Nieto puts forward the reforms he promised, their passage would be a binary question - a strong reform or nothing - rather than the potential for watering-down seen during Calderón's time.

"Peña Nieto has the economic team, the political team, and the right connections," says HSBC's Martin.

Peña Nieto is on good terms with the unions - often a source of pushback in previous attempts to reform areas including energy and education - and may be in the best position to deal with them, Martin adds.

"Even without a majority in congress, you can push ideas if you negotiate," he says. "[Former presidents] Zedillo, Fox, and Calderón all had the right ideas, and knew what needed to be done, but they didn't have the political teams to push through the ideas."

Mexico's need for a more flexible labor market is most evident at a company like Pemex, but needs less union invention and more freedom to hire and fire workers across the board. Competition is also an important issue in many industries. This has notably played out in telecommunications, where some feel domination by Carlos Slim companies has led to higher prices.

"We haven't heard, at least in public speeches from the two most important candidates that they are likely to address that issue, says Alfa's Leal. "Everybody knows that Telmex is a monopoly and there is a lot of room for improvement in the telecommunications sector. We'd like to see the sector being more competitive and open for FDI. Any improvement would be beneficial for us, and for the industry."

But where to invest?

Alfa's Alpek unit raised 10.44 billion pesos ($794 million) in a April IPO, the country's first since the previous July. For years Mexicans have been hoping for more activity in the public equity markets, but the consensus is that the public companies are concentrated and not fully representative of the wider array of quality businesses in Mexico. Even if investors have a positive view on the county and want to express it, they can't make plans to.

"Most stocks in Mexico remain quite expensive," says Matt Hochstetler, portfolio manager at Janus. "In general, it's harder to find world-class companies at the same valuation that we're seeing in Brazil. The ability to find ways to express a positive view is more limited than in deeper, more liquid markets such as Brazil."

Hochstetler sees the reforms discussed by the candidates as positive if completed, but says that undertaking them presents a formidable challenge.

"We think Mexico is the place to be," says Christian Egan, global head of equities at Itau. It offers more liquidity than Colombia, Peru or Chile, he says, though the lack of investable names is a problem.

In many ways there is easier access to the capital markets versus other markets in the region. Bonds are Euroclearable, and there no IOF-type controls that are vexing investors in Brazil. The local bond market could be deeper - as could all domestic markets in LatAm - but has kept up steady issuance in the first half of the year while corporate issuers in places like Chile and Colombia have stalled. Private equity also has room to maneuver.

"Headlines in Mexico are a cause of concern over security. Structurally, the country is here to stay," says Martin Díaz Plata, head of LatAm at private equity firm Capital International. "Structurally, it is going in the right direction. Mexico is one of the top in terms of rule of law, and that is what is key for us."

Díaz Plata's fund looks at other emerging markets as well, and doesn't have a specific allocation for Mexico.

Overall, a weaker peso relative to the dollar may be helpful to attracting FDI and repatriating investment. Local rates are also low, Cervera says - a possible boon for the long end of the yield curve.

"International banks' lending capabilities will be diminished, and the capital markets will be an additional source of funding," Leal says. "Now that the Afores [pension funds] have more exposure to capital markets and specifically to stocks, you are more likely to see more [equity] issues in the near future."

Domestic investors represented 50% of Alpek's sale, and Leal says it could have been 100%.

"Despite international investors reacting to volatility, there will be windows in which Mexican companies will have a good shot at leveraging the ample Mexican base of investors and getting IPOs done," Leal says.

A $700 million-equivalent follow-on from the Fibra Uno real estate trust in March was the year's other notable deal. Investors have high hopes for the new Fibra asset class, of which Fibra Uno was the first. However, plans for a second fund have yet to materialize. In June the equity market awaited a follow-on from infrastructure firm Pinfra and an IPO from industrial property developer Vesta, though these have been put off until after the elections.

The big jewel would be the long-awaited IPO from Santander Mexico, which could raise more than $2 billion as the bank's Spanish parent looks to continue plugging holes in its balance sheets. Deutsche Bank and UBS have been hired to manage the offering, along with Santander.

The sale is expected by the end of the year, and would give a boost to the IPO market in Mexico. However, with financial exposure already available in the public equity market, the deal would not necessarily herald the diversification of the equity market that investors are seeking. The real stuff of bankers and investors dreams is the floating of state-owned energy giant Pemex.

The Pemex Question

Faced with declining reserves, more Mexicans than ever seem to think that Pemex, the once-sacred property of the state, could do with some outside help. Models in the region such as Petrobras and Ecopetrol suggest that floating part of the company would raise funds, improve practices and make the company more transparent and efficient. Those content with a few baby steps at first see at a minimum more opportunity for foreign partnerships and outside know-how.

"[Partial privatization] would bring foreign direct investment into the country, and bring foreign technology into Pemex," says Alfa's Leal. "It will professionalize Pemex in certain areas, and that is going to make Pemex competitive in certain products. There are also large reserves of shale gas that have not been exploited because Pemex does not have the resources to do so." Leal expects Pemex to open up in some form during the next six-year term.

There remain a number of problems that could keep Mexico from realizing the potential of the positive trends and derail reform plans. The biggest is perhaps the security situation. It remains to be seen what a PRI administration might do differently than the PAN.

That said, in 2009 and 2010, the most violent years in the drugs war, foreign portfolio investment averaged $22.4 billion, HSBC says, compared to a $3.4 billion average for the previous 10 years. Though the increase was mostly due to liquidity, the bank says the investment shows confidence in Mexico's sound macro framework.

The external backdrop will also remain challenging. Mexico can't count on a strong US recovery materializing. Despite economic indicators inspiring confidence earlier in the year, the US has posted weaker numbers in recent months.

Trouble could also come from other regions. Moody's expects Mexican corporate credit to remain stable. However, the sovereign debt crisis in Europe combined with the slowdown in China could ultimately add pressure to Mexico's economic performance, which could in turn result in corporate credit quality deterioration, the ratings agency says.

Social unrest is always on the back burner if parts of society feel they are being excluded from gains elsewhere. Mexico needs to ensure there are mechanisms to lift people up from the bottom. Real wages haven't increased, says HSBC's Martin, and Mexico has more people than work.

Martin, however, considers as low the odds of discontent that could shift the government - historically, change has been muted even in the midst of far more severe social pressure. "Social conditions are not such that we will see a revolution," Martin says.

A more likely result is simply that politicians will fail to seize their moment, and the country's growth languishes at 3% or less. Here, too, they have only to look to Brazil to see what happens when tough decisions are put off when the going looks good. LF



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“The crisis has been a setback for reserve diversification."

Jan Dehn, Ashmore Investment Management