Strength lies within: strong 2003 performance predicated on domestic structural reform in the face of world volatility. (Spotlight).

Mexico opened its economy to the world in time to enjoy the unprecedented decade-long expansion of its principal trading partner, the United States. Starting in 2001 and continuing through 2003, the Mexican economy is living the downside of the world business cycle and there's no doubt about it -- the upside is more fun. The future of the Mexican economy is inextricably bound with the evolution of the world economy and, especially, because of trade, capital and labor flows, with the ups and downs of the U.S. economy.

COPING WITH THE WRONG SIDE OF THE BUSINESS CYCLE

For Mexico's policy-makers, to cushion the country's future growth prospects against the downside of the international business cycle, Mexico must continue down the path of structural reform. A vibrant internal market can provide a counterpoint to the negative impact of a slowdown in the world economy, but that growth in the domestic market must be based on more productive workers, whose compensation reflects the increases in productivity. Governments rely on two principal policy tools to manage the level of activity in the domestic economy, fiscal policy and monetary policy. U.S. policymakers have brought both fiscal and monetary policy into play to pump up the economy: Beginning in 2001, taxes were cut, government spending on defense climbed and the U.S. Federal Reserve slashed interest rates.

However, when-as is the case in Mexico-the fiscal deficit is over 3% of gross domestic product (not including upcoming major drains on the public purse in the form of pension payments for government, state and local workers) and bringing inflation down to developed world levels will be neither easy nor guaranteed, expansive fiscal and monetary policies are simply not sustainable. Boosting government spending (cutting taxes faster than the reductions approved with last year's budget isn't a seriously considered option) will create a still larger government deficit, increasing the cost of financing the deficit and taking resources away from the private sector, which could be invested productively.

The days in which Mexico paid triple digit rates of interest and, even so, obtained foreign financing only with great difficulty aren't that far away. If further reminder of the dangers of a large government debt are needed, look south to Brazil or Argentina. An expansive monetary policy will temporarily create a sense of wellbeing and a thriving domestic market but, very quickly, it will unleash an inflationary spiral, leading to the vicious inflation-devaluation cycle with which we are all too familiar.

Paying for the sins of the past precludes Mexico's policymakers from adopting expansive fiscal and monetary policies at a time when they could be most useful. The inflationary legacy and fiscal burdens it inherited from the 1960s and 1970s leave policymakers no choice but to forego the easy policy response and take on the hard one of adopting the structural reforms that will remove longstanding obstacles to growth. As key sectors of the economy are forced by structural reforms to become more competitive, the domestic market will become more able to offset declines in foreign demand, protecting Mexico's growth prospects against the inevitable dips of world business cycles. It's not just a more dynamic internal market that will result from structural reform. Mexican products will be more competitive in world markets as well if the country has more efficient and less expensive power, fuel and telecommunications, better infrastructure, a banking sector that intermediates more at more competitive rates, a judicia l system that works as it's supposed to in theory, an equitable tax system, effective but not extensive regulation and an educational system that gives students the skills they need in the modern workplace.

Unfortunately, the prospects for significant structural reform in the near future are not bright. Two of the reforms the Vicente Fox administration has most emphasized, fiscal and energy, are facing tough battles. There is some hope Congress may approve in the next six months a version of the electricity reform proposed by the president. However, the resistance to the proposed fiscal reform that would reduce the government's dependence on oil, which accounts for 30% of public sector revenues, has been so strong the administration has decided to wait until 2003, after the mid-term elections, to renew its effort to get a fiscal reform approved. AMCHAM's scenario for 2003 assumes there will not be any high-profile structural reforms approved.

2003: NOT THE TYPICAL THIRD YEAR OF THE SEXENIO

When Mexico was a closed economy and its business cycles were easily predicted by the timetable of the sexenio, the third year of the six-year presidential term was typically one in which the economy was showing good growth.

That won't be the case in the first sexenio in which the Institutional Revolutionary Party (PRI) hasn't controlled the presidency. Growth in the first three years of the sexenio will be very weak, averaging about 1.5% a year. Neither is growth likely to average the 7% heralded in the campaign in the second half of the Fox administration. With U.S. growth in the next several years unlikely to recover its unusually rapid 4.5% of the last part of the 1990s and with the dim prospects of further significant structural reform in Mexico, the Mexican economy in the second half of the Fox's historic term will most probably grow at an average rate of 4% to 5%. Next year, 2003, the third year of the sexenio, should see growth nearly double this year's meager rate, but Mexico's GDP is still likely to fall a bit short of 3%. If there is a deep, double-dip recession in the United States, then even the 2.8% growth AMCHAM is projecting for Mexico in 2003 would be too optimistic.

Growth in 2003 won't be what Fox and his advisers had hoped, and neither is inflation likely to decline to the 3% the central bank and government have targeted. After three years of beating the official annual inflation objective, 2002 will see inflation again exceed the target. The overshooting won't be by much-about half a percentage point-but, when inflation rates are at low levels, as they are now in Mexico, it's a more significant figure than when inflation was in double digits. Hikes in public-sector prices have been the main driver of inflation in 2002. The administration's proposal to limit price increases for key public-sector goods to the projected inflation rate will help to control that source of inflationary pressure. However, it will hardly be surprising if, in the future, the Finance Secretariat announces additional reductions in subsidies for key public sector goods, as it did with electricity in February 2002, which would have the same inflationary effect as raising prices by a larger percen tage. The remarkable stability of the peso since 1999 has played a key role in the reduction of inflation. The weakening of the peso since early April 2002 has not yet fed through to prices, but the latest monthly inflation figures suggest that companies are beginning to pass on to their customers at least a part of the increase in their costs due to the peso's depreciation. As demand recovers in 2003, companies will try to pass on more of their cost increases, making it more difficult to reduce inflation to 3%. While AMCHAM expects inflation to exceed the official objective by 1.5 percentage points, it is still a great success for Mexico to keep inflation to a low single digit.

The stability of the peso over the last four years has been nothing short of astonishing in a country where, typically, the currency has only depreciated. AMCHAM believes the strong peso is here to stay. We expect the peso to depreciate modestly in 2003. The days when companies invested in Mexico because labor was so cheap or when exporters competed on the basis of an undervalued exchange rate are, thankfully, behind us.

The trade account deficit will rise next year, as is typical when the pace of growth picks up. While both exports and imports will accelerate in 2003, AMCHAM projects imports will grow about 0.8 percentage points more rapidly than manufactured exports, adding about US$2.4 billion to the trade account deficit. World interest rates should remain very low through the first half of next year, only beginning to inch up in the second half of the year. That, combined with the modest trade account deficit, will keep the 2003 current account deficit to an easily financed 2.8% of GDP.

AMCHAM expects that direct foreign investment, the most stable source of financing, will equal about three-quarters of the projected current account deficit, an enviable situation. With reserves at a historical high of over US$45 billion at the beginning of November, two-and-a-half times the expected 2003 current account deficit and more than twice the money supply, it's hard to see how anything short of a major meltdown in the international financial system, a coup in Mexico or putting Cuauhtemoc Cardenas in charge of the Finance Secretariat could cause a major devaluation.

The government's cost of one-month funding has risen about two percentage points from its historical lows of under 6% in April. Given all that has happened in the last six months, it's impressive that the benchmark one-month Cetes rate is still under 8%, a rate that by historical standards is very low both in nominal and real terms. While AMCHAM projects interest rates will inch up in 2003, we expect the one-month Cetes rate will remain low by historical standards, oscillating in a narrow range around 8%. Although we expect inflation to decline, the increase in the average nominal one-month Cetes rate will keep the real interest rate in pesos fairly constant and at historically low levels.

OMC OR "OUT OF MY CONTROL": THE U.S. AND BRAZIL

Two exogenous factors--the U.S. economy and Brazil--will play a decisive role in determining the evolution of the Mexican economy in 2003. Mexico's policymakers can not control the rhythm and course of the U.S. recovery or the decisions new Brazil President Luiz Inacio Lula da Silva and his government make, but the policies Mexicans follow will determine the extent to which Mexico benefits or is hurt by developments elsewhere. The budget sent to Congress by the Fox administration on Nov. 5 represents a sound fiscal policy. The central bank's monetary policy, while similarly not the ideal, is also a realistic one that strikes a reasonable balance between controlling inflation and recognizing the demands for growth. It is reassuring that policy is basically sound and premised on an understanding of economic principles. That is not a statement that can be taken for granted in Mexico.

The indicators point to a slow, sluggish recovery in the United States. The economy has been doing better than profits, explaining the disconnect between economic indicators pointing to growth averaging 3% in 2002-2003 and stock markets that have been 40% off their 2000 highs. War with Iraq could push the U.S. economy back into recession. So could business pessimism, household debt levels, skittish consumers, another terrorist attack or deflation. Nothing is certain, but the most likely scenario is that the U.S. economy grows slowly in a low inflation, low interest rate, relatively stable exchange rate environment. Profit growth will remain constrained, as companies find themselves with less room to raise prices than they're used to in an economic recovery. The debate over whether stocks are fairly valued, overvalued or undervalued will continue. Equities won't repeat their spectacular appreciation of the 1990s.

The concern that Brazil's new government will brush aside orthodox economic policies has heightened the level of risk in the international financial system. If Brazil were to follow the lead of Argentina, implementing profoundly misguided policies, the world economy, not just Mexico, would feel the consequences. A Brazilian default or near default would not cripple the world economy or international financial system, but it would raise the cost of capital and reduce its availability. Neither would be good for Mexico.

CONCLUSION

The coming year, 2003, won't be the best of years in Mexico, but neither will it be the worst. Modest growth, low inflation, interest rates in single digits, a quite manageable current account deficit largely financed by direct foreign investment, and a floating exchange rate that depreciates more or less in line with Mexican--U.S. inflation differential are, all things considered, a positive performance. Progress on the structural reform front, if it can be made, will set the stage for a stronger rebound when the growth rate of the world economy eventually picks up in 2004.

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PROJECTIONS AMERICAN CHAMBER/MEXICO

                        2002      2003         2003         2003

                               MOST LIKELY  PESSIMISTIC  OPTIMISTIC

GDP growth rate         1.3%      3.0%         1.9%         3.7%
Inflation (annual)      5.2%      4.6%         5.0%         4.1%
CETES (Average annual)  7.2%      7.9%         8.9%         7.0%
FX (Average annual)     $9.69     $10.34       $10.40       $10.33

* projected November 15, 2002

Dr. Deborah L. Riner is the chief economist at the AMERICAN CHAMBER OF COMMERCE OF MEXICO.