Running in place: the world's 10th-largest economy will grow this year, but it's slowing down.

Over the last three years, Microsoft Mexico posted average growth rates of 11%, and company executives expect a similar pace of expansion in the coming two years. "Everything indicates that the country will have a second year of reasonable economic growth. In our industry, the trend is heading that way; technology is on a steady path for 2005," says Felipe Sanchez, chief executive of Microsoft Mexico. There's good news for Mexico, too: The computer giant's outlook clearly reflects on what's happening today in the Mexican economy.

The service sector did well in 2004, especially tourism, which posted record-high foreign-currency income of US$10.84 billion, a 14.6% jump from the previous year. The economic recovery of the past year touched upon almost all sectors: Services grew 4.8%; agriculture up 4%; industry rose 3.8%. According to forecasts, Mexico's service economy should expand again by nearly 3.7% this year.

Francisco Gastelum, sales and services director for Eastman Kodak in Latin America, says Mexico's 100-million-strong consumer market will keep growing in the coming years, despite potential uncertainty as the 2006 presidential election approaches. "Election years always have an impact, but I think we're going to see no economic effects from that, given that we had a democratic change in 2000," he says.

Markets nevertheless remain wary of the pending change in government. President Vicente Fox's term will end in December 2006, and with mixed results. He'll likely leave the country in stable macroeconomic condition while having failed to fulfill two of his main campaign promises: annual gross domestic product (GDP) growth of 7% and progress on reforms needed to resolve the country's endemic problems, including poverty, unemployment, flagging competitiveness and poor infrastructure.

Following three years of stagnation, 2004 was finally a year of good news for Mexicans. The economy grew 4.4%. Nevertheless, GDP estimates for 2005 are more conservative; the Mexican government forecasts 3.8% growth. Last year's GDP increase was stimulated by world economic growth, exports of manufactured goods to the United States--Mexicos main trading partner--and high oil prices. High crude prices pushed state-run oil company Pemex's annual exports up to a record $21.23 billion.

No one is predicting big economic shocks for Mexico in 2005, but markets are nevertheless likely to become uneasy by year's end on the approach of what is expected to be one of the most contentious presidential races in the history of the country. Analysts say that the Mexican economy will manage to overcome any political noise, unless the mayor of Mexico City is blocked from running.

Polarized. Andres Manuel Lopez Obrador, a popular politician with the left-leaning Democratic Revolution Party and current mayor of Mexico City, has been accused of ignoring a judicial order to suspend construction of a road leading to a hospital. "I don't think the economy will be affected in the pre-election year," says Raul Feliz, an economist with the Center of Economic Research and Learning (CIDE). "But if the attempts to discredit Lopez Obrador are poorly managed, we run the risk of an illegitimate race that polarizes positions and generates uncertainty, similar to what happened in Brazil before Lula's election." One of the positive aspects of Fox's administration, Feliz says, is that it has allowed for certain civil liberties. "But this issue with Lopez Obrador is putting his legacy at risk," he says.

A study conducted in February by the U.K.'s Economist Intelligence Unit also suggests that discrediting Lopez Obrador, a leader so far in election polls, would be a step back in the country's transition toward greater democracy.

Despite the political fracas, the Mexican economy itself is on solid ground, says David Madero, undersecretary of financial planning for Mexico's finance ministry. "President Fox will leave behind an economy that's starting to show a much more consolidated domestic financial market and greater growth in personal savings," he says.

In fact, at the beginning of the year, both Standard & Poor's and Moody's raised their ratings on Mexico's long-term foreign currency denominated debt. Standard & Poor's credited Mexico's gradually improving economic stability as a result of good debt management, the accumulation of international reserves and a deepening of domestic financial markets.

Large companies, like U.S. shipping giant UPS, are optimistic. "Mexico is the most important Latin American market for us," says Luis Arriaga, chief executive of UPS Mexico. "We've been here 14 years already, and the country has advantages that we'd like to continue to exploit, like its various trade pacts with other countries."

Still, not all of the Mexican economy is due to grow in 2005. According to CIDE predictions, industrial ventures are due to suffer a slight slowdown, led by the automotive industry. Mexicans bought a record 1.09 million new vehicles last year, up 12% from 2003. However, exports of cars assembled in the country declined by 6.5% as some manufacturers retooled plants for new models. The Mexican auto industry association, AMIA, though, insists that 2005 will indeed be a good year for the car business, with domestic buying rising at least another 10% and export volumes improving by 15%. "For 2006, we don't expect that the change of government will affect us much," says AMIA President Cesar Flores.

Car sales might not be enough for the world's 10th-largest economy. Just keeping up with the other two North American economies, Canada and the United States, is not enough, either. Mexico needs to clock an annual rate of better than 5% for several decades just to cut poverty and unemployment. Fox promised while campaigning to reach annual GDP growth of 7%; however, CIDE reckons that the Mexican economy will expand by between 3.7% and 4% in 2006.

The country hasn't fared too well on the employment front, either. Just 350,000 jobs were created in the formal economy last year, very low considering that 1 million people enter the workforce each year. In order to generate enough jobs to satisfy demand, the economy would have to post annual growth of better than 6%. CIDE predicts that 370,000 new jobs will be created in 2005, while another 400,000 workers will enter the informal labor pool, untaxed, while another 400,000 people will head to the United States in search of work. Last year, Mexicans living abroad sent a record $16 billion back to relatives, an increase of 24% over 2003. Remittances to Mexico are expected to reach $18 billion this year.

Consumer credit, meanwhile, is seen growing by just 3.6%, despite good performance last year. Business credit, meanwhile, is still an immature market, currently just 10% of GDP. Even though it's growing fast, there's not enough credit out there to meet the demand; experts figure 30% of GDP is a healthier figure. This has hurt the performance and competitiveness of small and medium-sized companies, says Jaime Yesaki, president of the National Agriculture Board.

Just 15% of economic output is financed through banks in Mexico, Yesaki says, while in the United States it's 85%. "We would be better off if we were more competitive, but we lack the structural reforms," he says. "We're in the middle of globalization, we have trade accords with 43 countries, but we don't have the ability to take advantage of these agreements."

Another problem for the Fox administration has been the lack of consensus on energy, fiscal and labor reforms in a Congress where the president's National Action Party is in the minority. Fox is likely only to partially move reforms forward before the end of his term, observers say. Although passing reforms is not the Fox administration's responsibility alone, in the end he has lacked the political leadership needed to win over the opposition and build coalitions. Energy and fiscal reforms would put more money into government coffers for infrastructure as would boosting tax collection, which in Mexico represents just 11% of GDP. Countries like Chile and Brazil have collection rates of 36.5% and 35.45%, respectively.

Recent high oil prices have made up for these deficiencies, but analysts warn that the situation is unsustainable in the long-term. One of the objectives of the energy reform calls for giving greater autonomy to Pemex. Heavy taxes on the state-run entity have limited for more than 20 years its ability to invest in infrastructure.

Divided. Regardless of who wins in 2006, the country still will have a divided Congress. The next president will have to search hard for a way to boost tax collection and open the energy sector to private investment.

Macroeconomic control, one lasting achievement of the Fox administration, coupled with eventual progress on the various reforms needed, should allow Mexico to benefit from increased competitiveness and economic growth. Specialists recommend that the country take advantage of its geographical position in one of the world's highest-growth regions, as well as the Mexican population living in the United States.

As for debt, Fox has taken some pressure off the country by extending foreign debt maturities and arranging lower interest payments while increasingly filling funding gaps with domestic financing. Although inflation in 2004 shot past the Central Bank's 3% target, coming in at 5.19%, the bank plans to try even harder this year to control rising consumer prices. Oil income and remittances are expected to help slow inflation in the second half of the year, holding price increases to around 3% in 2005. Political nervousness, slower economic growth and higher U.S. interest rates should push the peso up to 11.90 per U.S. dollar in the second half of the year, from 11.08 at press time.

Although Mexico's public finances are healthy, politics could destabilize the country. To avoid economic shocks, J.P. Morgan economist Alfredo Thorne says Lopez Obrador should be allowed to run for president. "The best thing for Mexico is to maintain the rules of Democracy," says Thorne. "Let Lopez Obrador seek office and participate in a free contest because this is the only way, even if he loses the election, that the country will win. The pressure is heading in this direction."