Country report Mexico
Economic growth has slowed as a result of low oil prices and tax hikes, but going forward external demand and investment will support growth. Oil reform will further induce foreign direct investment. Meanwhile, the security situation in some region remains challenging.
Strengths (+) and weaknesses (-)
(+) Sound and prudent fiscal policy
For almost two decades, Mexico has been running a small budget deficit, accompanied by a low level of public debt and a fiscal rule targeting a balanced budget.
(+) Strong competitiveness
Mexico’s proximity to its main export destination (the US) combined with relatively low labor costs results in a good competitive position, augmented by rising labor and transportation costs in China.
(-) Narrow income base of the government
Mexico’s government income base is narrow, which is reflected by the fact that almost 60% of the workforce is not registered in the tax payment system. Furthermore, 30% of the government’s income is oil sector related, whereby the country’s oil production has been decreasing gradually.
(-) Widespread corruption hinders the business environment
Widespread corruption in all layers of society has a negative impact on the business environment and makes the fight against drug cartels difficult.
1. Macroeconomic headwinds but good seamanship
Mexico’s economic prospects have worsened in recent months, lowering economic growth estimates to 2.4% y-o-y in 2015. This decline is largely associated with the sharp decline in oil prices, which precipitated harsh austerity measures implemented by the Mexican government, as 40% of total government income is oil related. The public oil receipts are largely hedged this year, but will weigh on the budget deficit next year. To preserve its good reputation for fiscal governance, the government has cut spending, which has led to the cancellation of some investment projects. This weighs on growth and also reduces consumer confidence. Low consumer confidence and only modest employment growth are keeping the brake on consumption growth. With the depreciating peso, which has lost 19% of its value in a year’s time, exports are set to increase, though, which will cushion some of the pressure of domestic demand on economic growth.
Looking forward, investment in the oil sector as a result of the recent oil reforms (see next paragraph) will raise GDP growth. Moreover, the almost concluded Transpacific Partnership could further intensify trade flows with the US (and other countries) and lead to increased FDI into Mexico. A rate hike in the US is a key economic risk, as it would likely induce capital outflows and put pressure on the Peso.
2. Oil reforms have rocky start but an improvement is expected
After approval of an extensive reform package last year, this year Mexico has started with the implementation of the reforms. The most notable reform is the energy reform, which necessitated a constitutional change. The 75-year state monopoly for PEMEX, Mexico’s national oil giant, was ended and foreign competitors will be allowed to bid for extraction and exploration of oil fields in the coming years. This reform was followed up by the Five-Year Hydrocarbon Exploration and Production Plan which was released in July 2015. The plan outlines the extraction and production plans for the 2015-2019 period. New fields will be opened in four bidding rounds in which 670 exploration areas (68bn barrels of oil equivalent, boe), and 244 production areas(39 boe) will be on offer. Despite the ambitious plan, the first bidding round which took place in July was perceived as a failure on many accounts. Firstly, only 2 of the 14 blocks were assigned and only 9 of the 26 companies that were prequalified took part in the bid. The failure can partly be explained by the fact that the fields on offer were (less attractive) shallow water fields. More minor issues like fiscal terms, uncertainty over contract sanctity and required guarantees may also have reduced appetite. The failure has increased pressure on the government to make the second round a success. Mexico needs a large influx of foreign technology to shore up the dwindling oil production, which account for over 40% of total government revenue.
3. Security situation remains challenging
Since the start of 2015 homicides have been on the rise again, increasing by 7% y-o-y in the first five months of the year. This goes against the downward trend that was visible during the current Presidents administration, in which the government cracked down on drug gangs. The recent increase can, however, partly be explained by the policy pursued by the government; the crackdown has led to a weakening of drug cartels, which has created a power vacuum. New groups, often more violent than their established predecessors, struggle for control in transport routes of drugs in regions like Guerrero and Michoacan. In other regions cartels are diversifying their activities away from drug trafficking. Meanwhile, the second escape of drug lord ‘El Chapo’ from a maximum security prison is a major embarrassment for the current government, as it signals the involvement of high level officials in the security apparatus. It also highlights how difficult it will be to realize improvements in the security situation, especially at the local level.
Mexico has a long history of both debt and financial crises. The last crisis, which took place in 1994/95, triggered a political landslide. The Institutional Revolutionary Party (PRI), which had run Mexico for almost the entire 20th century, lost its absolute majority in the lower house in 1997. Since 2000, Mexico twice elected presidents from the National Action Party (PAN), a business-friendly and conservative party. The PAN, however, did not succeed in implementing the necessary (economic) reforms. The PRI through Peña Nieto regained the presidency in 2012, with the opportunity to reform the country, especially since PAN is taking a pragmatic approach to being in the opposition. Another heritage of the crises is that Mexicans are cautious about entering into debt. Mexico’s political relation with the US is currently rather good, especially since both economies have become more and more integrated. Political themes are migration, security, energy, drugs and the environment, and do sometimes lead to small disputes. The strong economic ties are reflected by the trade agreement (NAFTA) and the fact that the US is Mexico’s main export partner. Mexico’s cheap labor is used to produce manufactured goods, which are then exported to the US. This type of business is typical for the northern part of the country, where the business climate is more developed than in other parts of the country, save the Yucatán peninsula. However, the north is also the battleground for the country’s war of drugs, which is hampering primarily socio-political, but also economic progress.