The crystal ball tells all; possible fiscal scenarios for coming year evaluated.

Businesspeople in Mexico are operating in a new environment. Those who have been successful know how to make money in spite of high inflation and abrupt, massive devaluations. They've had a quarter century of experience at doing it, after all. While a return to those times can never be completely discounted, the odds are against it. Now, the challenge is a different, more difficult one: How to make money in an economy where inflation is low, growth negligible and competition intense.

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When the final numbers are in, they will show that 2003 was a year of macro-economic stability in which growth was largely absent, repeating the pattern of the first half of the President Fox sexenio. Inflation has been below 5% in each of the first three years of Fox's six-year presidential term. Interest rates have fallen to historical lows: the average benchmark one-month Cete rate has dropped from 21.4% in 1999 to an estimated 6.2% in 2003.

Neither has the balance of payments been a problem. The current account deficit in 2003 will be under 2% of gross domestic product (GDP), less than half its percentage of GDP in 1998 and well below the 4% rule of thumb that sparks concern and, often, devaluation. In absolute terms, the current account deficit will be a minimum of 27% smaller than in any year in the previous five.

Capital inflows have handily financed the current account deficit, building reserves up to unimagined levels in excess of US$53 billion and prompting the central bank to sell some to limit their accumulation. Direct foreign investment (DFI) will reach at least US$12 billion, more than double its annual average during the Salinas years (1988-1994) when DFI more than doubled the annual average of the previous administration.

THORNS ON THE ROSE

The flaws in the otherwise rosy economic picture are growth and employment. Growth during the first half of the Fox presidency virtually hasn't been, averaging a pitiful 0.7% a year (estimated). That's a performance on a par with the "lost decade" of the 1980s--hardly a record to aspire to.

Not surprisingly, job creation is a serious problem. Fewer than 300,000 new jobs in the formal economy (registered in the IMSSS as permanent employment) will have been created in three years in an economy that requires 1.2 million new jobs a year just to absorb new entrants into the labor market. The open unemployment rate (useful because it shows trends over time) had jumped to 3.9% in September, almost double its December 31, 2002, level and twice its level in December 2000.

THE YEAR AHEAD

Does 2004 look any better? This article will present three scenarios for 2004. One takes an optimistic view, another a pessimistic perspective, and then, there is the most likely case.

While the major figures forecast vary in the three scenarios, it is reassuring that most of the key numbers fall in a narrow range. The distinguishing characteristic of the three scenarios is the economy's growth rate. The critical influences are structural reforms, oil prices and the growth rate of the U.S. economy.

In all three scenarios, inflation remains under control, interest rates at historically low levels, the peso devalues by a bit more than the U.S.-Mexican inflation differential, the trade and current account deficits stay quite manageable and reserves are high. The major differences between the three scenarios are what happen to growth and to direct foreign investment (DFI).

THE PESSIMISTIC SCENARIO

How bad can it get? Bad enough, but it won't be a disaster and will be better than 2003. Next year should see a continuation of what we've seen so far in this administration: macro-economic stability with insignificant (2.0%) growth.

The pessimistic scenario is premised on the U.S. economy growing about 2.5% in 2004, more slowly than the projected 2.9% growth rate for 2003 and an average oil price (for a barrel of the Mexican crude export mix) of US$18, considerably lower than the estimated US$24.14 price in 2003. The price in the pessimistic scenario is still several dollars above the historical average price.

We assume no progress will be made on the structural reform front. There won't be an energy reform. There may be something called a "fiscal reform," but its objective will be simply to increase the government's revenues. Even if the government workers' social security and pension funds are put on a solid financial footing (with the consequent impact on the budget deficit), important as that is for the country's long-term financial health, it won't be the kind of reform that excites financial markets.

Weak growth will mean lower inflation and lower nominal interest rates. With the U.S. economy only plodding along, the Federal Open Market Committee (FOMC) will hold off longer on raising interest rates. Weak growth will also translate into smaller trade and current account deficits, as we've seen these last three years (2001-2004). Consequently, the peso will be stronger than in the most likely or optimistic scenarios.

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World economic activity and DFI flows will not be much stronger or larger, respectively, than they are this year. DFI will continue to finance 85% of Mexico's US$12.9 billion current account deficit. That's good. The bad is that Mexico won't be enhancing its attractiveness as a location for DFI: when DFI flows do pick up, Mexico won't be positioned to benefit.

A continuation of macro-economic stability with negligible growth means unemployment and underemployment will become more severe, underscoring Mexico's social tensions. Sustainable growth isn't possible without macro-economic stability, but macro stability alone isn't enough, as Mexico's economic policy-makers are well aware.

THE OPTIMISTIC SCENARIO

2004 won't be the year in which Fox's campaign promise of 7% growth becomes a reality, even under the optimistic scenario. With growth of 4.7%, it will, however, be the best year by far than we've seen under this scenario and on a par with or better than 1998 and 1999.

For the most optimistic scenario to become a reality requires important structural reforms. A fiscal reform would have to include significant advances in transparency and simplification. Increasing government revenues would be a byproduct, not the sole purpose, of fiscal reform. The energy reform would have to be sufficiently attractive to the private sector to prompt companies to invest in energy projects. Judging by the results of the first auctions in the Burgos basin, the multiple service contracts on which the administration had pinned its hopes are not an attractive vehicle.

Helping to boost Mexico's growth rate to nearly 5% would be a faster growing U.S. economy: U.S. GDP is premised to rise 4.1% in this scenario, with manufacturing doing as well. Finally, world oil markets would be propitious to Mexico's trade balance and fiscal accounts: this scenario anticipates a US$21.50/barrel average price for Mexican crude.

Growth this strong would mean larger trade and current account deficits, although the latter would be less than 3%, well below the 4% "trigger" and one still three-quarters financed by DFI. Larger deficits would produce a slightly weaker peso. Inflation would be higher because of higher demand. Stronger demand would also allow companies to pass on to their customers some of the cost increases they have had to absorb these last few years.

The fiscal reform, if it includes assessing value-added tax on food, medicine and education, would have an additional inflationary impact, one that could well push the inflation rate above 5% but that would play out next year. Higher inflation would translate into higher nominal interest rates, but still quite low by historical standards.

If the conditions assumed in the optimistic scenario come to pass, it not only sets the stage for good growth in 2004, it also guarantees a more positive evolution of the economy through the remainder of the sexenio and beyond. The key, of course, is structural reform. Meaningful structural reform, by definition, would dismantle some of the major political obstacles to enhancing competitiveness and living standards in Mexico.

THE REALISTIC SCENARIO

The most likely scenario is one in which minor progress is made on the reform front--some moves toward simplification and transparency of the tax system with most progress made in terms of increasing government revenues. An "electricity lite" reform would essentially legalize "facts on the ground," the co-generation projects. In this scenario, growth would pick up to 3.2%, which, by this point, would be a major accomplishment.

What would make a growth rate in excess of 3% possible would be solid growth in the United States (3.5%), untroubled by fears that the U.S. economy would slow down or fall back into recession in 2005. The U.S. manufacturing sector would be in a definite recovery, growing at about the rate of the overall economy. Mexican oil prices, while still lower than the highs of 2003, would remain high. At US$19.50/barrel, they would be well above their historical average.

Under this scenario, Mexico would see macro-economic stability with more growth--not enough, but better. DFI would be on a par with what we've been seeing and enough to finance 85% of the projected current account deficit, which would be about 2.4% of GDP.

Inflation would be within the 3%, plus or minus 1%, target the central bank has defined as meeting its goal of price stability. The exchange rate would depreciate by a bit more than the U.S.-Mexican differential, nominal interest rates would be slightly lower than this year (2003), and reserves would be higher than in either of the other two scenarios.

It's not a bad scenario, but neither is it very promising for the long term. If the domestic market is to drive growth that is faster and sustainable in Mexico, the country's governing officials must successfully transform the underlying barriers to growth that now obstruct competitiveness and development. In this most-likely scenario, little progress is made, keeping the country from realizing its growth potential until the government tackles those issues.

A CEO once told me he uses the best-case scenario to set his employees' goals, the pessimistic scenario goes to his bosses, and the most-likely scenario he keeps in his desk drawer.

There are a number of readers, especially those in manufacturing, who will think the pessimistic scenario is the most likely, if not the best, that can be expected in 2004. That could be the case for manufacturing, particularly sectors in which low wages are essential to their ability to compete in world markets. Companies reporting in euros or for which imported European goods comprise an important component of their cost structure will also face a tough situation. However, other manufacturers should see a 2004 that is definitely better than 2003. Why?

The U.S. economy is forecast to grow close to 4% next year. That doesn't translate into a boost to growth from exports, as we've seen this year. What will make the difference is that the U.S. manufacturing sector is finally showing signs of life. According to the Chicago Purchasing Managers' Index, U.S. manufacturing was expanding for the fourth consecutive month in October, the most recent month for which data was available at press time. Mexico's growth rate this decade will not benefit from the recovery of the U.S. manufacturing sector to the extent it did in the 1990s.

Some growth in the market and an exchange rate at a more comfortable level don't mean that 2004 will be a year in which it's easy to meet one's hurdle point for an acceptable return on capital. Competition will continue to be stiff but some growth should, at last, allow firms to move beyond focusing on cost cutting.

Dr. Deborah L. Riner is AMCHAM'S chief economist.