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Mexico: The hope of a nation

Jan 1, 2013

The government of Enrique Peña Nieto has staked its political future on a big bet that it can push through radical economic reforms. Without quick successes, its gamble could unravel fast

In his first full day in office last December, Enrique Peña Nieto performed a feat that had long eluded politicians in Mexico: the country’s 46-year old new president managed to forge a broad agreement across all three major political parties for what the government hopes will be a sweeping set of economic reforms.

That Peña Nieto had on day one proposed in his so-called "Pact for Mexico" an ambitious list of measures was bold enough.

But that he had won endorsements for his government’s 95-point plan from across the political divide was entirely new – and was orchestrated for one chief purpose: to signal that Mexico’s new leader has what it takes to overcome the political paralysis that has prevented previous administrations from tackling Mexico’s fundamental economic problems.

In a masterful piece of political theater that day, the former state governor – who had just returned his centrist Institutional Revolutionary Party (PRI) to power after 12 years in opposition – had also sought to hammer home the point that he is prepared to shake things up to bring about the vital reforms needed to turn Mexico into one of the world’s high-growth emerging markets.

Though these are early days yet, Peña Nieto’s fledgling administration at the start of its six-year term has so far surprised even the most hardened cynics across the political spectrum. And his election has lent vigor to an already upbeat mood in Latin America’s second largest economy.

Mexico’s economy rebounded in 2010 from recession the year before, growing by 5.5%, its fastest expansion in a decade. In the two years since, it has reported higher GDP growth than Brazil. Its expected 4% expansion last year was spurred on in part by US export demand that has helped insulate Mexico from ill winds from Europe and a slowdown in Asia and other emerging markets.

"The conditions are all there for growth: there is huge potential," says Gerardo Rodríguez, a deputy finance minister in the last administration. "Credit penetration has doubled in the past decade and has the potential to double again the next decade."

He adds: "Mexico finds itself placed very well between high yielding countries that as an investor you don’t really want to hold and the low yielding countries that offer less return. That makes it very appealing to investors."

On the up

Financial markets have taken heart. In early January, Mexico’s IPC stock index was breaking record highs; the sovereign, meanwhile, was able to sell $1.5 billion in 30-year global bonds at the lowest ever cost, with a yield of 4.19%. And the country’s Purchasing Manufacturers’ Index (PMI), a measure of business sentiment, itself reached a new record in December of 57.1.

The improving mood predates the elections: Mexico had already won praise in recent years for having achieved relative economic stability and growth in the midst of a protracted global slump. This followed a decade in which its average growth had languished at 1.7%. A major part of the apparent turnaround has been a boost in relative competitiveness with China, given a rise in latter’s labor costs and as Mexico’s own manufacturing sector has moved up the value chain.

But the speed of last year’s uptick in sentiment also caught many off guard. "Everyone was taken by surprise by the reversal in perceptions," says Alonso García Tamés, head of public sector at Grupo Financiero Banamex. "Fiscal and financial conscientiousness is paying off, the value of having an open economy and vibrant financial market is paying off."

He adds: "The stars are aligned for Mexico to become more successful, all the elements are there to have a period of solid growth."

Many now believe that Mexico has a good shot at boosting its growth by some two percentage points a year so long as key reforms, including of the tax system and energy sector, succeed.

Opportunity knocks

In an exclusive interview with LatinFinance in December – his first with any international or domestic print media since taking office – Mexico’s finance minister Luis Videgaray says that the Pact represents "an opportunity" to finally push ahead with critical reforms.

"It’s an opportunity because it’s a broad political agreement to carry out some significant changes in public policy, particularly in economic policy, to make some changes that we all know need to be made: on the fiscal side, in energy and in competition."

"The mandate is very clear," he adds. "It is to do all the things that we need to do to have faster growth, stable growth and for that growth to be something that is not only evident in the macro variables but in the households and the domestic economy."

The 44-year old Videgaray, who is widely considered the president’s right hand man and who headed the transition team before being given the finance portfolio, served previously as the State of Mexico’s finance minister during Peña Nieto’s five-year tenure as governor, from 2005.

In that role, he was highly regarded for his management of public finances: he was instrumental in helping the state win an investment grade rating, having slashed public debt by 20% and having boosted state revenues through a successful fiscal reform – although, he stresses, revenues were doubled without tax increases. "This was all about revenue efficiency," Videgaray says. "It’s just as important as having a good fiscal reform to have true efficiency in revenue collection."

Boosting tax revenues and increasing competition in the energy sector are two key priorities of the new administration. Mexico has the smallest non-oil tax take of any OECD country: at 11% of GDP, it is on par with Pakistan and compares unfavorably to Brazil, at 34%, or even the Latin American average of 18.5%. Oil revenues, which account for a third of the budget, are in decline.

Fiscal first

Videgaray says the fiscal reform must fulfil three goals: it must be simple and enable competitiveness; it must be fair; and it must encompass all levels of the state as a whole, including states and municipalities. "The agreement is for this to happen in the second semester [of this year]," he says.

The reform aims at improving the efficiency and fairness of the tax spending systems, to make public finances more transparent, and to boost domestic savings and investment, and – so it’s hoped – Mexico’s growth potential.

"Clearly this is not just a marginal twist in the fiscal regime. We need to do a true overhaul of our fiscal structure in order for this to be possible," he says. The government has said it will review all taxes as part of a comprehensive reform, though Videgaray has said no new taxes will be introduced this year.

The Pact also includes a sweeping proposal for broadening social security. "It’s based on the belief that we need to create a more equal society," he says.

Indeed, part of the rationale for the fiscal reform is to raise funds to pay for the new programs under the Pact, including universal healthcare. "We need to give budgetary support for this to happen and that’s where the fiscal reform comes into play. We need to create a basic safety net to make sure that all Mexicans have a minimum base of benefits."

The vision is bold. As Luis de la Calle, managing director at consultancy De La Calle, Madrazo, Mancera, and a former undersecretary for international trade, puts it: "They’ve essentially said, 'let’s build a welfare state with our budget.’" But, he adds, "the question is: how will they pay for it and how much will it cost?"

Videgaray says it’s too soon to talk numbers. The government is "not releasing any figures because it will all depend on many components that are yet to be defined," he says.

Some anecdotal estimates put the cost of such reforms – creating a social safety net – at between 3-5% of GDP. The Center for Economic and Budgetary Research (CIEP), a think tank, puts that figure at closer to 6% of GDP.

Vito Tanzi, a former head of the IMF’s fiscal affairs department, says there is no relevant historical precedent for what Mexico is setting out to achieve; only the US and Sweden have set up welfare systems from scratch, one in the midst of the Great Depression, the other in the context of a highly homogenous society. "Mexico is a very long way from where they need to be if they want to have a welfare state, even one like the US. They will have to have a major tax reform," Tanzi says.

Too much to handle?

Tax reform is the key to getting the broader set of proposals in the Pact done. The finance ministry has estimated that revenue losses from special tax preferences, exemptions and deductions averaged more than 5% of GDP annually in the 2003 – 2010 period.

While there is consensus that a tax reform could prove a significant boost to Mexico’s economy, experts worry both about the aim of using the proceeds to fund a broadening of social security and the chances of success of the fiscal reform itself.

Peña Nieto’s administration has, in effect, wagered its political future on getting its broader set of reforms done. Videgaray himself points out that 44 of the goals in the Pact are "explicitly subject to a fiscal reform happening." But the fear is that given the new government’s dense legislative agenda, if one item falls short others could falter – and turn a hopeful proposition quickly into a losing bet. The risks, experts say, are not trivial, given a modern history littered with fallen dreams.

Some question the logic of the government’s approach. "I would not have put the general principle of universal social security as one of the first reforms to do," says Claudio Loser, a former director of the Western Hemisphere department at the IMF. "The problem is that the costs are significant. And if it’s not done with a tax reform that is major, then I would say this is a very dangerous game

"As a broad plan it sounds great if they do the fiscal reform on the revenue side, but it is an extremely dangerous course of action. This could be a major disappointment if they don’t manage it well."

Others cast doubt on the presumed need to sell a high-stakes fiscal reform that risks substantial amounts of political capital up front and at a time when the macro picture appears relatively sound.

Indeed, in recent years, Mexico had already strengthened its fiscal framework, boosting the credibility of public finance management – a fact that, among other things, has also contributed to bringing down public debt to 36% of GDP.

"Mexico doesn’t have an urgent need to do a fiscal reform to address a fiscal problem," says Rodríguez. "Mexico doesn’t have a fiscal problem."

But there is also the practical reality of trying to get a deal through Congress and winning the buy-in of opposition parties when push comes to shove. Any major tax reform would also demand confronting vested interests head-on while expending much political capital in doing so. Experts, including Tanzi, say there are simpler ways to boost revenue, such as increasing taxes on gasoline, political resistance notwithstanding.

Moreover, with the oil price hovering between $90-$100 per barrel, the urgency for pushing the tax reform may be naturally diminished.

Change in climate

Videgaray points out that the political climate has changed markedly with PRI’s return to power. "The political environment I think is very constructive. It’s a major innovation to have the opposition parties approach the government and seal a pact to work together on important and difficult matters."

The agreement on the Pact between the ruling PRI, the conservative National Action Party (PAN), which governed for the past 12 years, and the left-wing Party of the Democratic Revolution (PRD), is widely seen as significant.

But Peña Nieto’s achievement in winning the support of the other two major political parties may prove to have been the easy part: the bulk of the document’s proposals were seen as relatively uncontroversial in broad form.

"All the problems that the government wants to solve have long been seen as serious problems for Mexico. In this sense, agreement on these points is almost a no-brainer," says Loser. The hard part, he says, will be "fighting on the details."

"The task ahead is enormous," he adds.

De la Calle agrees: "When you start tampering with special interest groups, that’s when you can run into problems."

Mexico has struggled in recent years to make any meaningful progress in fiscal reform. Although ironically, it was Peña Nieto’s own party that was most obstructive over its 12 years in opposition to the very reform agenda his government is now pushing.

Says Luis Rubio, president of CIDAC, a consultancy in Mexico City: "I have no doubt that the administration will come up with ambitious reforms. The question is whether they will have the power to push them through. It is the PRI and PRI-related interests that have long been the issue.

"The PAN has been trying for 20 years to raise VAT but failed. Will the PAN now play the same role today as the PRI has played for the past decade, that is, to block reform? What’s in it for the opposition?"

He adds: "It was Peña Nieto that blocked many of the reforms himself. He dominated the Lower House [of Congress]. Will it now be payback time?"

Nevertheless, a growing consensus is that Peña Nieto’s PRI might now be willing to back some of the measures it obstructed when in opposition, including extending the VAT to food and medicine.

Political ammunition

Moreover, the government has already notched up some legislative successes and may yet have the wind in its sails.

In the run up to the inauguration, congress passed a key labor reform bill, steered by Peña Nieto. The government then had a major success in December with the passage of an education reform bill. The sweeping overhaul of the country’s substandard educational system grants the government, rather than the union, the power to hire and fire teachers. But the development could also set the government on a collision course with the unions.

Some have suggested the PRI’s failure to secure a majority in Congress will stymie the reform agenda. But Rubio says: "Peña Nieto’s greatest asset is the fact that he doesn’t have a majority, so he will have to convince people, he will need the support of the opposition."

Energy overhaul

At the same time the government is pushing ahead with plans to overhaul the energy sector and specifically state oil company Pemex, which funds nearly a third of the federal budget.

The energy company in recent years has experienced sharp drops in output at its largest fields. Official estimates suggest oil output will stagnate at 2.8 million barrels per day (bpd) over then next decade without substantial new investment.

But Pemex remains protected by a constitution that does not allow private investment in the state monopoly.

Duncan Wood, director of the Mexico Institute at the Woodrow Center, says that despite output having stabilized in recent years, without fresh investment it could nevertheless decline to 2.5 million bpd by the end of the decade, at a time when domestic oil consumption is inching towards 2 million bpd.

"You’re looking at a very dangerous situation as the largest oil field enters decline in the next few years. If you don’t get mechanisms in place to replace those fields, you’re looking at losing potentially another half a million barrels per day," he says.

"It’s not a question of Mexico lacking oil, it’s a question of Mexico not being able to exploit the oil it has," adds Wood. "Pemex is ill equipped to deal with the challenges of the modern energy sector." Such challenges include tapping unconventional hydrocarbons, including oil in Mexican deep waters and shale gas – a prospect Wood and others say would prove a huge boost to the competitiveness of Mexican manufacturing.

"The consequences of not achieving this reform are quite dramatic," says Wood.

Peña Nieto’s predecessor Felipe Calderón was unable to garner support to reform Pemex, but nevertheless began the process of opening the state-run industry to private investment.

Peña Nieto has said publicly that he is pursuing a constitutional reform to allow for private investment in the oil sector. Videgaray also acknowledges that foreign capital and expertise are urgently needed to develop the sector, though, like the president, he rules out privatization. "Pemex needs to team with other players in the international energy arena that can bring capital and expertise," he says. "That’s the key of the reform, to allow Pemex to partner with such players."

Wood is confident the government will push hard for a meaningful constitutional reform. "I’m more optimistic than I’ve been in 17 years in Mexico that something meaningful is going to happen. I’m absolutely 100% sure they’re going for an ambitious reform. There’s a better chance of them getting there at the current political juncture than at any point over the last 20 years."

But he concedes that ultimately legislative success on other fronts will be key. "Peña Nieto and the government need to keep having legislative success in order to keep going. If there is a hiccup, that will damage the future possibilities."

Yes we can

Videgaray, like his boss, is adamant that both fiscal and energy reform will be tackled in the coming year and he insists his government is best placed to succeed where others have failed.

Asked whether he thinks his government can convince its own party to drop historical opposition to reforming Pemex and opening up the energy sector, Videgaray says: "absolutely, otherwise we wouldn’t be doing it."

Similarly, on fiscal reform, he says the case is unambiguous. "All of us are alert to the importance of doing this and to the cost of delaying a fiscal reform. The consensus is much broader, that this is something that needs to be done," he says.

He adds that the political environment today is "very constructive." "It’s a major innovation to have the opposition parties approach the government and seal a pact to work together on important and difficult matters," Videgaray says. "The political environment will help significantly."

"It’s not only the opposition, it is society as a whole that needs to understand why we need to enhance the financial capacity of the government," he says. "It’s not just 'we need to tax more because we’re taxing more.’ It’s that we need to do things that are good for Mexico and the Mexican people. One of the tools will be the tax reform. It’s not an end in itself."

What’s at stake

If Videgaray and Peña Nieto are right and the political cards are stacked in their favor, the fruits of a successful economic reform could be significant.

Loser says it would mean the difference between Mexico growing at 6% a year and reaching advanced income status in thirty years or facing annual growth of roughly 2% and wallowing in mediocrity for a generation to come.

Ultimately, though, the administration is likely to only have one shot at the reforms. "Peña Nieto and the PRI know it’s their last chance. If they want to stay in power, they will have to get the reforms done," says Rubio. "I’m convinced that they will undertake many reforms but then they will crash against the wall at some point. Then we’ll see what they’re really made of." LF

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