Assessing Mexico’s Economy at a Historical Milestone: Structural Reforms and Challenges

Mexico is, without question, already an economically attractive country. With a population of 118 million and 2013 GDP of USD 1.26 trillion, it is the largest emerging economy after the BRIC countries. Mexico is Latin America’s most important player after Brazil, accounting for over a fifth of the region’s gross domestic product (GDP). In terms of economic policy, Mexico has reached an interesting point in history.

At the outset of President Enrique Peña Nieto’s term in 2012 he signed the Pact for Mexico, an agreement with the major political parties to jointly move forward with the most sweeping reform agenda in two decades. Throughout 2013, President Peña Nieto pushed through most of the agenda, and his administration is now focused on ensuring that the secondary legislation (containing all by-laws) is passed successfully in order to fully implement the reforms. The overhauls to communications, education, energy, finance, fiscal policy and even elections and politics are expected to lift potential economic growth in 2015 and beyond.

Consequently, most economic analysts surveyed by FocusEconomics are cautiously optimistic about Mexico’s economic outlook in the near term. Last year, the economy grew a disappointing 1.1%, which was the worst result since 2009. Yet this year, private sector analysts expect economic growth to rise to 2.7% and then to pick up to 3.9% in 2015*.

FocusEconomics participants also agree that, although the President’s initiatives are important, their impact should not be overestimated, particularly in the near term. The energy reform, which aims to open the energy sector and break up the monopoly that Mexico’s state-owned Pemex has held for 76 years, is expected to reverse Mexico’s decline in oil and gas production, although this would not occur before the end of the decade. Education reform lays down the foundation for improved academic performance, but its impact on progress and, particularly, on the economy, will be gradual. Finally, the financial and fiscal reforms were disappointingly modest—market participants had expected more ambitious overhauls.

Overhauling the Energy Sector

The Mexican Congress approved the energy reform in December 2013. The ruling PRI party (Institutional Revolutionary Party) and the right-wing PAN party (National Action Party) voted for a bill that opens up the energy sector to private investment from domestic and foreign investors. The general consensus among analysts and investors is that the reform is transformational and that the principle of opening the oil, gas and electricity sectors remains in place, despite fierce opposition from the left-wing PRD party (Party of the Democratic Revolution).

In the oil sector, one key objective is to boost the production of crude oil. Pemex’s oil production reached a peak in 2004, totaling 3.4 million barrels per day (bbl/d) and output has been on a downward trend ever since. In 2013, oil production reached 2.5 million bbl/d and output could decline rapidly in the coming years with the depletion of fields that are now operated solely by Pemex. Oil production in Ku-Maloob-Zaap, currently the largest field, is expected to decline sometime around 2017. Experts have confirmed that Mexico has significant deep offshore resources in the Gulf of Mexico, in addition to shale gas potential in the northern region near the border with Texas.

However, Pemex has neither the resources nor the expertise required to harness that potential. The energy reform is designed to attract investment from both foreign and domestic firms and, to allow private sector involvement in attractive unconventional fields, to provide licenses, profit-sharing and production-sharing contracts as well as services contracts to be granted by the government, either directly or in association with Pemex. Pemex should continue to have priority for operating the fields, but could join private firms under profit sharing or production sharing agreements. Alternatively, Pemex could decide to operate the field, in which case a license could be awarded to a private investor. The arrangement would be close to a production agreement and the state would maintain ownership of petroleum resources. In economic terms, licenses are no different from concessions and firms would be able to report the expected benefits of a contract for accounting and financial purposes, even though they could not, in practice, book reserves.

The energy overhaul will provide foreign companies investment opportunities in exploration—particularly in the offshore deep-water fields and onshore shale resources—which are currently beyond the state-owned firm budget. In addition, the opening in the down-stream industry, specifically gasoline sales at retail level, will provide businesses the opportunity to enter a growing market of fuels, although competition in gas stations will be introduced gradually, so private businesses will not be able to compete with PEMEX in retail right away. Mexico will also need massive investments in infrastructure development of pipelines, roads and ports. Moreover, the proposed legislation confirms the government’s intention of transforming PEMEX into a “productive state enterprise” meaning that the government will gradually lower the tax burden on the company from 80% to around 65% a decade from now. In addition, PEMEX will have budgetary and management autonomy from the federal government and the new law also contemplates the creation of a sovereign wealth fund from excess oil revenue, which will be constructed step by step and which the government will not be able to tap until it reaches 3.0% of Mexico’s GDP.

Overall, oil and gas production could indeed be boosted by the energy reform, although analysts agree that there are some caveats. Investor confidence may remain stymied by concerns over the actual interpretation and application of the new reforms. Legal uncertainty could still be a potential hurdle, even though the by-laws provide a legal framework for investment. Opinion is mixed on how Mexico’s courts will interpret the laws when conflicts arise and ambiguity remains regarding the possibility of recourse to international arbitration. Physical security could also be an obstacle as many shale resources are situated in the violent northern and northeastern parts of the country.

Also, the upturn in production will be slow as the impact from new capacity—subject to the timing of contract negotiation, exploration, as well as construction of infrastructure—is expected to start no earlier than 2018. According to Pemex, the state-owned firm is likely to be able to return output to 3.0 million bbl/day in 2018 on improved operations in existing fields. However, uncertainty persists that Pemex is capable of doing so and that this objective would have a minor impact on the economy because, at the moment, the link between the oil sector and the rest of the economy basically runs through the government’s budget. In 2013, oil revenues amounted to just a third of total consolidated public sector revenues, or 7.8% of GDP. An increase in oil production by Pemex is, accordingly, expected to increase public sector revenues. However, keeping everything else constant, analysts estimate that for a 20% increase in oil production, revenues would rise by around 1.5% of GDP, not taking into account that the cost of producing an additional 20% would exceed the cost of current production. This could result in a bit more fiscal easing, but is not a structural change per se. It is likely that there are major unexploited oil and gas reserves in the northern part of the country and in the Gulf of Mexico. However, it will take time before these resources are online and thus they will have no significant macroeconomic impact before 2020.

Limited fiscal reforms

The fiscal reform, meanwhile, which was pushed through by the PRI party in conjunction with the left-wing PRD party, came as a disappointment when it was approved in October 2013. The market had expected a more ambitious tax reform and thus received the proposed overhaul with some dissatisfaction. The fiscal reform contains two main elements: First, a series of tax increases and new taxes in areas which were previously exempt from levies. The most notable increase is in the income tax rate (ISR) for high-income brackets, which will increase from 30% to 32%. New taxes include a 10% tax on capital gains from the stock market, a new levy on sugary soft drinks (to combat obesity) and a new carbon tax. Furthermore, exemptions on private education services and mortgage loans will be eliminated. Second, the tax structure for businesses was simplified by eliminating both the IETU, or corporate alternative minimum tax, and the IDE, a tax on cash deposits.

The fiscal reform is aimed at increasing the tax take by 1.4% of GDP in 2014. The hope is that it will increase revenues by nearly 3% of GDP by 2018. Investors’ disappointment with the reform was justified in some cases, but mistaken in others. First, the reform lacked the ambition to broaden the tax base. The burden is still imposed on those who cannot escape taxation, namely the economically active population in the formal sector. The government argued that broadening the tax base was not possible as it finds it difficult to tax the informal sector.

The counterargument came from economic analysts who studied government revenues as percentage of GDP for 2013. Of all countries whose long-term government bonds were rated Baa by the credit agency Moody’s, Mexico had one of the lowest ratios of government revenues to GDP, with 17.2% in 2013 compared to the median figure of 30.5%. Only the Bahamas, Colombia, Costa Rica, Indonesia and the Philippines had lower ratios. The conclusion was that the informal sector in Mexico could not be less accessible to taxation than that of Turkey (38%), Brazil (36%) or Romania (34%).

The second reason is that the Mexican government has failed to broaden the tax base because it sees no reason to do so. After the economic collapses of 1982 and 1994, Mexico had to follow fiscal orthodoxy, which became an anchor to economic policy after the country implemented the fiscal rules according to the principles laid out by the Washington Consensus, controlling mostly public expenditures.

Analysts and investors were mistaken, however, in their disagreement with the fact that basic foods and pharmaceuticals are still not subject to the value-added tax (VAT). Proposing a tax on these items would have been unrealistic, as the PRD would never have voted for the reform., A regressive tax on the consumption of basic necessities (for which the poor spend a much greater share of their income than the middle or upper classes) would have been a tough sell and difficult to justify.

Informal sector weight

While there is no doubt that Mexico is economically attractive, the impact of the structural reforms is not clear. The government, as well as some analysts and investors, agree that this comprehensive reform agenda should help address many of the country’s economic weaknesses, including lack of competition, inefficiencies and poor performance in the sectors that the reforms target. In addition, the successful passage of the by-laws, combined with a gradual recovery in the U.S. economy, should support stronger economic growth in Mexico in 2015 and beyond. However, other experts and investors see that the impact of the reforms will only be felt in the long term, while they still believe that questions remain regarding the country’s overall development model.

Mexico experienced a long period of mediocre growth between 2001 and 2013, when the economy grew at an average rate of 2.1%. This contrasted the so-called post-NAFTA boom—the period between 1996 and 2000—when the economy grew 5.1% on average. Analysts argue that the mediocre growth rates registered in recent years mainly reflect the country’s informal sector that continues to occupy a large proportion of the labor force that weighs down on the formal sector characterized by modern and globally-competitive industries.

In order to catch up with other advanced economies, Mexico will need to foster its more productive formal sector. The structural reforms promise to do that and will therefore help transform the Mexican economy. However, their impact will be felt only in the long term rather than manifest as a short-term panacea to improve growth.

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