MEXICO ECLIPSES BRAZIL.

STRAIGHT THROUGH TOUGH TIMES, MEXICO HAS BECOME THE LEADING ECONOMY IN LATIN AMERICA. CAN IT STAY ON TOP?

Brazil has almost 70 million more people and more than four times the land mass of Mexico but, as 2001 draws to a close, Mexico appears poised to pass Brazil on a number of economic fronts:

GROSS DOMESTIC PRODUCT: Even as it enters a recession, the Mexican economy will likely finish this year with a total value in excess of US$600 billion, compared to Brazil's roughly $500 billion economy. While the strong Mexican peso largely explains this year's power shift, analysts forecast that Mexico's continuing integration into the U.S. economy will allow the country to pull away from the South American giant in the next few years.

Trade: Years ago, Mexico sped ahead of Brazil in exports, imports and total trade. Unarguably, the North American Free Trade Agreement gave Mexico unique access to the world's largest single market. "In the measure that the United States signs free trade agreements with other countries, Mexico will lose its preferential treatment," says Eduardo Javier Soils Sanchez, head of foreign trade and investment promotion at Mexico's Economy Ministry.

Foreign Direct Investment: Mexico will likely record more than $20 billion in foreign investment in 2001--about the same as Brazil- although much of Mexico's boost will come from a single deal: Citigroup's $12.5 billion acquisition of financial group Banamex-Accival. Due to its close ties with the United States, Mexico may take a bigger hit than Brazil on declining international capital flows to emerging markets this year and next. "Brazil has been largely shut out of international capital markets for the last six months, so it is hard to see how things could get worse," says Ernest W Brown, bead of fixed income and economics research for Santander Investment in New York. "Mexico has had full access and now it may not."

To remain the lead economy of Latin America, Mexico will need to overcome a tough economic climate. At home, the country is heading at best into flat growth and most likely a recession. Mexico's central bank, Banco de Mexico, only recently began to loosen monetary policy, and the Fox administration is still struggling to get approval of its tax increase. Meanwhile, the country will face stiff competition for international cash from exports and investment from countries like Brazil in the depressed U.S. market.

Brazil and Mexico have long been rivals for investments dollars and export markets. Mexico has tended to approach Brazil in terms of the value of output in dollar terms due to exchange rate swings, but Brazilian production volumes have traditionally been larger than those of Mexico-not anymore.

Brazil continues to handily out-produce Mexico in steel and computers. But data from the Mexican and Brazilian automotive associations shows the two countries produced roughly the same number of cars and trucks during the first seven months of 2001.

Exports are making all the difference. Mexico's ongoing integration into the United States is changing the country's industrial landscape. And Mexican officials hope to use trade to build an even bigger economy. "We have to take advantage of our free trade agreements with the European Union and other countries to divert trade through Mexico and convince companies to invest here," says the Economy Ministry's Solis. "Wherever the United States exports, that's where our opportunities are."

Mexico, for example, is the only the country in the world to have free trade agreements with five Central American countries, yet Mexico exports only $1.2 billion annually to the region. That compared to U.S. and Canadian exports of $8.3 billion and European shipments worth $1.6 billion. Mexico wants to convince its Nafta partners to relocate to Mexico and get Central Americans to buy more Mexican goods. "The other countries pay full tariffs and we don't," says Solis. "All we need is to divert just a little portion of the trade," He makes the same argument about diverting trade between the United States and Europe through Mexico, citing tariff treatment for a long list of products like pharmaceuticals, autos and textiles.

VW hits the brakes. While logical, that brazen pitch won't necessarily succeed. Foreign investors have a growing list of concerns in Mexico, Volkswagen recently announced it may cancel investments of $1 billion following a bitter labor dispute that ended with a 10% nominal raise for workers, equal to a 4% real wage increase. Volkswagen Vice President Francisco Bada said the planned investment may now go to China or Brazil instead. "The strike leaves the company with deep wounds and creates a lack of confidence in the company among would-be investors," Bada said at the time of the settlement.

The Mexican government dealt another blow to investor confidence with the expropriation of 27 of the nation's 60 sugar mills. Officials say the move was taken to collect unpaid taxes and debt, but caught in the action was Chicago real estate baron Sam Zell, an investor in leading local sugar concern Grupo Azucero. What particularly incensed investors is that the government squeezed mills with its controls of raw and refined sugar prices-setting raw product prices above those of refined sugar prices elsewhere in the world, according to Wilbur Ross, a wellknown bankruptcy adviser and investor. Ross says that the expropriation violates the North America Free Trade Agreement.

Whether the delay in fiscal reform plus these conflicts will prevent Mexico from getting investment-grade rating is unclear, but the country will have to continue to open the economy to attract major amounts of capital. No sector will be more important than electricity. In the last five years, installed power capacity has grown at an average rate of less than 2%; the country now needs expansion at more than 7% to power growth. To meet that need, Mexico requires investment of about $6 billion a year.

Brazil's recent experience can provide a guide. It sold state-run companies to attract billions of dollars to its electricity sector. Poor rules on pricing of Bolivian natural gas--the principal ingredient for most modern power plants--stymied many major projects. Then the drought took the huge hydroelectric dams out of the equation and rationing became necessary.

In contrast, Mexico's Constitution reserves all energy--oil, gas and power--for the government. The Fox administration will likely seek to change the Carta Magna to allow the privatization of state-run Comision Federal de Electricidad; in the meantime, it has begun playing at the edges with a green light for private independent power producers to import natural gas.

Alejandro Werner, director of economic studies at Banco de Mexico, cautions that a key element for power investment promotion will be a clear regulatory framework. In the past, independent power companies had difficulty negotiating long-term pricing contracts with the state-run electric company. We need reasonable rates that allow producers to compensate for sunk costs," he says.

An added attraction for Mexico will be the possibility of selling power to energy-squeezed California for dollars. Two major projects are underway and two more are coming in northwestern Mexico. The government hopes these, together with others--including the Royal Dutch/Shell Group and El Paso Corp. plan to build a $300 million power plant in Altamira--will bring in enough bucks to keep the economy humming.

Growth will be a tall order given the current backdrop. All indicators show that while the U.S. economy slowed, Mexico's crawled. "The deceleration in GDP, consumption and private investment was much more pronounced in Mexico than the United States," says Werner. Now that the United States is headed into a recession, Mexican policymakers will have to use their wits to avoid a major slowdown. Says Werner: "In this environment, Mexico has to deepen its structural reform to achieve high and sustainable growth."

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MEXICANS HEAD SOUTH

Amidst the battle for Latin American leadership, Mexican companies invade Brazil.

America Movil, the leading Mexican cellular operator, has quietly become one of Brazil's largest cellular phone carriers through alliances and acquisitions. The former Telefons de Mexico subsidiary was spun off to form Telecom Americas, a joint venture with Canada International and SBC Communications. America Movil also acquired a stake in Brazilian phone company ATL and is considering an alliance with local operator BCP to gain a foothold in Sao Paulo and northeastern Brazil.

Grupo Bimbo, the top Mexican bread maker, bought Brazilian baker Plus Vita for US$63.5 million earlier this year. The Mexican company plans to invest another $210 million to revamp its Brazilian subsidiary.

Jugos del Valle, the Mexican fruit juice company, has been plowing money into its Brazilian subsidiary, Sucos del Valle. The company expects an increased emphasis on exotic flavors to boost sales some 50% this year in the South American country Corporacion Interamericana de Entretenimiento (CIE), the Mexican live entertainment concern, has upped its ownership to 100% of Stage Empreendimentos. The company paid $9 million to buy the remaining 30% of the Brazilian company. Stage owns and operates several entertainment venues in Silo Paulo, including the Credicard Hall, DirecTV Hall, Teatro Opera and Teatro Jardel Filho.

Sanluis Corporacion, the Mexican mining and autoparts concern, moved into Brazil some five years ago via subsidiary Rassini Autopartes. The Mexican group together with Japan's NHK Spring Co. acquired Brazilian coil-spring maker Industrias C. Fabrini and combined it with NHK-Cimebra Industria de Molas Ltda.

Mike Zellner