Waiting game: Mexico depends more than ever on the U.S. economy. That's both good news and bad.

In January of last year the North American Free Trade Agreement (NAFTA) turned 10. Over the past decade the close relationship between the economies of Mexico and the United States grew even closer. Even though Mexico now has trade deals with 42 countries, nearly 90% of its exports go due north to U.S. consumers. The year ahead will be no exception; the Mexican economy is expected to grow at the same pace as its main economic partner.

Mexicans will begin the year facing two major trends, analysts say. "The good news is that there will be a certain economic stability, but the bad will be that the country will be standing still watching others race ahead," says Jonathan Heath, chief economist at Banco HSBC Mexico. Heath thinks the Mexican economy will increase by 3.8% in 2005, down from 4% growth this year.

Growth will track economic improvement in the United States and will be bolstered by high international prices for oil, of which Mexico is a major exporter.

The LATIN TRADE Consensus Forecast of investment banks is in line with Heath's view. It predicts 3.6% growth in 2005, down from 4.1% this year. "We have always had a relation with the economic cycle of the U.S. economy, but that has gotten stronger in recent years, so we're at the crossroads situation of seeing whether we grow or don't grow based on the strength of the United States," Heath says.

The world's 10th-largest economy could substantially reduce its economic dependence on the United States, thereby achieving more sustained growth and keeping up with its competitors in the race toward development, but big obstacles stand in the way: lack of structural reforms in the energy sector, on labor issues and on tax collection. "In order for the government to have resources, there has to be a profound government reform. On the other hand, if the private sector invests in energy, lots of resources could be channeled to infrastructure, but for that to happen there has to be energy reform," Heath says.

Getting reforms under way, one of the campaign promises of President Vicente Fox, will be hard to accomplish in the remainder of his administration, which ends in December 2006. The former Coca-Cola executive faces a Congress where his National Action Party doesn't hold a majority and has not managed to achieve the necessary consensus.

Holding back on reforms doesn't create just a competitiveness problem but also generates a climate of frustration, Heath says. "They know exactly the way to achieve all of these reforms, but they haven't found a way to do it," he says. In August, Mexico closed its National Finance Convention, a commission that includes state and federal governors formed to find alternatives to the current government-funding regime, but the outcome wasn't enough.

Fiscal reform and labor reform are important. But these reforms alone won't generate anything, says Gerardo Esquivel, a researcher at the Colegio de Mexico. Esquivel says that the Mexican economy would rebound if it could reorient the banking and credit sector, better spend its resources, and strengthen a domestic market of 100 million consumers; by reactivating private banking sector credit; and by managing to raise the tax collection rate to finance national development.

The Fox administration should focus on what the government really needs, which is a more efficient tax system, Esquivel says. Mexico collects just 11.4% of its gross domestic product (GDP) in taxes, the lowest rate in Latin America. Brazil collects 36.5%, while Chile collects 20.5%. In Mexico many simply don't pay taxes because they believe that the money will go into the pockets of corrupt bureaucrats or to pay for government overhead, not on social programs.

The country's other major challenge is increasing bank credit for the private sector. "This is an imperative measure which, if delayed, will make it hard for the domestic economy to be a significant factor in sparking growth, and we'll be dependent on the external sector," says Esquivel. Credit has fallen to its lowest level in history, and it hasn't yet been able to recover from the 1994 currency crisis. According to global development indicators published by the World Bank for 2004, Mexican private credit is just 11.4% of GDP, while Chile is at 30% and Brazil is at 60%. "Obviously, this slows economic development. It there is no credit, businesses can't invest and have to depend on their own resources. Banks don't lend because they have no incentive to do so, thus they prefer to put their money in government bonds or live on lees they charge," Esquivel says. Mexican credit in 1994 was 49% of GDP in 1994, falling to 15% by the end of 2003.

In order to understand why credit has not been able to rebound, one has to understand the risk that offering it implies, says Heath at HSBC. "During the 1994 crisis, we realized that the rule of law is very weak. Lending was much riskier than we thought, debtors didn't pay and nothing happened, and the financial system of the country collapsed," he says. "It's not that the banks didn't want to lend, but that there were problems in the legal system, which has to do with the government being out of control."

Consumer credit, housing credit and business lending has grown, although at varying rates. Consumer financing, for instance, has grown better than 30% annually. "The benefits of macroeconomic stability are being reflected, while low interest rates and the development of financial markets in the long term has permitted the development of mortgage lending in the private sector," says Alejandro M. Werner, head of the Economic Planning Unit of Mexico's Finance and Public Credit Ministry. But the figures Werner uses don't impress some private analysts. "Irrelevant," says Esquivel. "So small an increase in credit that it doesn't represent the magnitude of the country" in the race toward development where countries like China, Korea and Chile outpace Mexico.

In fact, one of the big demands of industry has been help getting credit. Cuahutemoc Martinez, president of the National Chamber of Industry Transformation, says that while other countries offer long-term credit and have interest rates between 1% and 5%, Mexican interest rates are at 15% and only extend to between 12 and 24 months. "In a globalized world, this is marginal," Martinez.

To poor credit availability one has to add the Mexican bureaucracy when it comes to creating new businesses. According to a World Bank study, Mexico requires 51 days and seven steps to register a business, while in Australia it takes two days and two steps. Werner says that efforts are being made to reduce the number of steps to open a business, those efforts must be redouble in order to catch up to the countries with which Mexico competes.

Industry nevertheless is expected to grow in 2005, fed by foreign demand. "Of total exports, between 80% and 90% are related to manufacturing, so we expect the industrial sector to grow relatively well." Sectors linked to the domestic economy, such as personal consumption and services, will grow less, analysts say.

Industrial output, too, will grow in line with the U.S. economy, experts say. The sector shrank 0.8% in 2003, while manufacturing shrank 2%, and next year they will grow 4% and 3.5% respectively. "A rebound of the global economy and, mainly, of the U.S. economy, is pulling up Mexican industry, especially the automotive sector, which from growing 1% in 2003 will in the first quarter of this year grew 10%," says Martinez. He adds that U.S. automaker Ford expects to invest $1.5 billion in the country, General Motors $1.2 billion and Nissan $1.8 billion during the coming two years. According to the National Chamber of Industry Transformation, the Mexican auto industry in 2003 exported more than $31 billion. In addition, in 2005 the auto industry will increase exports, and construction will recover too, bringing new business to no less than 40 sectors of national industry.

Even though the manufacturing sector will grow, it isn't expected to create jobs; however, the service sector will, analysts say. In the first half of the year Mexico gained 225,000 jobs, and it is forecast to close the year ahead between 350,000 and 400,000 new positions, a number it will likely repeat in 2005. Although the country is recovering, there will be a jobs deficit since Mexico annually adds 1 million people to its workforce. Nearly half work in the unregulated, informal economy.

That's one of the reasons Mexicans will continue to migrate to the United States. Remittances from the United States back to Mexico also will continue to be a constant source of hard currency. In 2003 remittances totaled US$13.27 billion, more than entered the country as direct foreign investment and equal to 79% of the country's oil exports. The flow of remittances has been enhanced by measures taken by the Fox administration to lower the cost of sending money from abroad, and the income from remittances in 2005 is expected to reach $14.00 billion.

Nevertheless, although analysts believe Fox will not meet his 3% to 4% inflation goal for 2004, it's a much better figure than in the 1980s, when inflation regularly hit 100%.

One big brake on the Mexican economy is the deterioration of its competitiveness. Other items on the wish list, analysts say: Financing, better ports infrastructure, highways and railways, all of which would reduce costs of doing business.

If for the biggest sectors in the economy competitiveness is a significant problem, for small and medium-sized businesses it can mean the difference between living and dying, above all in an environment with practically zero credit. It's imperative to train owners of small businesses so that they too can join the wider, globalizing world, says Manuel Tron, president of the Mexico City National Chamber of Commerce. "We have very tough competition from Asian products, which offer an enormous price difference, and now we are a country with practically no tariffs to defend us," says Tron.

Transition. With nearly two years left to serve, the current administration has a several outstanding problems to solve. What's certain is that without more sustained economic growth, the country will have little room to maneuver to solve those problems. "Growth in 2005 will not be enough to face up to the challenges, nor defeat poverty," says Gladis Lopez, senior economist at the World Bank. Just the same, analysts believe that the restrictions that Fox feels when it comes to enacting reform are the same as any other president facing a divided Congress in a young democracy, one formerly operated by a single party for 70 years.

"Mexico has no experience being a democracy, and this is something new for us," Heath at HSBC says. "There should be rules, an understanding of how the system works and agreements on many subjects. We want to be a democracy, and we are paying the price for this transition."

CONSENSUS FORECAST

              '03 GDP     '03 GDP      '03             REAL GDP
            US$ billion     per     POPULATION         % change
                          capita     million
                            US$

                                                 2003   2004E   2005F

ARGENTINA      129.7       3,339       38.9       8.7    7.4     3.8
BRAZIL         497.9       2,690      185.0      -0.2    3.8     3.5
CHILE           72.1       4,476       16.1       3.3    5.0     4.8
COLOMBIA        77.8       1,718       45.3       3.9    3.9     3.7
ECUADOR         27.1       2,082       13.0       2.7    4.8     4.0
MEXICO         626.1       5,978      104.7       1.3    4.1     3.6
PERU            60.6       2,201       27.5       4.1    4.2     3.8
VENEZUELA       84.9       3,250       26.1      -9.2   10.5     3.3

                 INFLATION            EXCHANGE RATES
                  % change             end of period

            2003   2004E   2005F   2003    2004E   2005F

ARGENTINA    3.7    7.5     8.4     2.91    2.95    3.04
BRAZIL       9.3    7.1     5.6     2.89    3.13    3.29
CHILE        1.1    2.4     3.0      599     621     630
COLOMBIA     6.5    6.1     5.4    2,778   2,781   2,949
ECUADOR      6.1    3.7     3.3     1.00    1.00    1.00
MEXICO       4.0    4.1     3.8    11.24   11.48   11.80
PERU         2.5    3.0     2.6     3.46    3.50    3.56
VENEZUELA   27.1   27.0    24.3    1,598   2,096   2,657

              CURRENT ACCOUNT         INT'L RESERVES
                  % of GDP             US$ billion

            2003   2004E   2005F   2003   2004E   2005F

ARGENTINA    6.3    4.0     1.6    14.2   17.6    17.9
BRAZIL       0.8    0.7    -0.1    49.1   50.6    49.9
CHILE       -0.8    1.3     0.5    15.8   16.6    17.1
COLOMBIA    -1.9   -1.9    -2.0    10.8   11.5    11.7
ECUADOR     -1.6    0.5     0.0     1.2    1.4     1.7
MEXICO      -1.5   -1.7    -2.2    57.4   60.3    60.6
PERU        -1.7   -1.2    -1.2    10.2   10.7    10.9
VENEZUELA   11.2   10.4     8.6    21.0   23.6    26.3

E = ESTIMATE

F = FORECAST

SOURCE: Banamex, BBVA, Bear Stearns, CS First Boston, Goldman Sachs,
J.P. Morgan Chase, Merrill Lynch, Morgan Stanley, Santander Central
Hispano Investment, Salomon Smith Barney, UBS Warburg, LATIN TRADE

MARISOL RUEDA * MEXICO CITY