RATING PERSPECTIVE RATING PERSPECTIVE

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1 RATING PERSPECTIVE Mexico: The most closely contested presidential election in Mexico's history Its social and economic backgrounds and issues left to the next administration Since the inauguration of the Fox administration in 2000, Mexico's economic and fiscal structures have added to stability, which has led to gradual improvement of the country's creditworthiness. A favorable economic growth is continuing in 2006, with real GDP growth rate expected to surpass that in the previous year. The government restored a fiscal balance in 2005 and is likely to see a fiscal surplus expand in 2006 on high oil prices. The Mexican economy stays sound for the present. In the longer term, however, a host of problems remain be resolved. Under a favorable economic situation, presidential and congressional elections were held on July 2, Mr. Felipe Calderon of the ruling National Action Party (PAN) and Mr. Andres Manuel Lopez Obrador of the Party of the Democratic Revolution (PRD) locked horns with each other in one of the closest presidential races in Mexico's history. After a vote recounting, Mr. Calderon won by a razor-thin 0.6% margin. An unconvinced Mr. Lopez Obrador brought his complaint to the Federal Electoral Tribunal, which is expected to declare the final winner in early September. The close contest mirrored the pre-election situation in which the voters had been dichotomized in opinions over structural problems such as an income disparity, distortions in the labor market and tax reforms that have been left unresolved despite the stable economic and fiscal conditions in recent years. Both candidates take completely opposite approaches toward structural issues, with Mr. Calderon advocating market-driven reforms and Mr. Lopez Obrador favoring government intervention in the market. Whoever may emerge the winner, however, the impact on Mexico's creditworthiness would be limited since both are agreed on the need to maintain fiscal discipline and keep good relationship with the United States. JCR will closely watch whether the new administration can carry out effective policies in coordination with Congress. 1. A review of the Fox administration and issues left to the new administration 1.1 Economic development under the Fox administration ( ) During the six years of Fox administration that began in 2000, Mexico's economy and financial structures have become more stable than ever before. As indicated in Chart 1, the achievements of the Fox administration are prominent as compared with those of the former Zedillo administration of the Institutional Revolution Party (PRI) from 1994 to First, the real GDP growth rate that had averaged a lower 2.5% between 2001 and 2005 recovered to 4.2% in 2004 and 3.0% in 2005, and is projected at around 3.5% in The year-on-year consumer price inflation fell sharply from an average 22% during the Zedillo administration to an average 4.7% under the current administration, which cleared its own target of 3.0% plus or minus 1.0% in The unemployment rate has steadily declined, reaching 3.6% in 2005, one of the lowest on record. The central government's fiscal deficit, which stood at 1.1% of GDP in 2000, was slashed to 0.1% or close to a balance in In the medium term, the fiscal balance is expected to break even or register a surplus. During the same period, both the public debt and the external debt have been reduced, with significant improvement made on the current account balance (See Exhibit 1). The ruling PAN of President Fox lost a large number of seats in the lower house election held in The setback was due in part to the lower real GDP growth rates in the preceding years and due in part to the delay in structural reforms caused by the opposition in Congress. However, a comparison of the medium-term development plan formulated in the early days of the Fox administration and the current economic and fiscal situations indicates that his administration has achieved many of its targets (See Exhibit 2). Mexico experienced an economic crisis during the former administration. In order to recover its creditworthiness, the country had to put greater priority on economic and fiscal stability than on economic expansion. From that viewpoint, President Fox was right in pursuing tight fiscal and monetary policies. However, it should be noted that Mexico still has many structural problems as illustrated by the large support Mr. Lopez Obrador has drawn from lower-income voters who have hardly benefited from the country's stable yet moderate economic growth. 1.2 Structural problems left to the next administration Redressing income disparity The Fox administration has lowered the inflation rate under a tight monetary policy and brought about a sounder fiscal * * 6 JCR Ratings September 2006

2 structure by curbing budget expenditures. On the other hand, the country's average real GDP growth rate in the last five years was below that for the Latin American region. It was only 0.3% higher than the average growth rate among the OECD member countries. Mexico's growth rate was too modest to give a boost to the income levels of the poor. A comparison between Mexico's per capita GDP and those of other Latin American countries and its closest rival shows that Mexico's Gini coefficient is relatively higher, which means that its income disparity is wider (See Exhibit 3). As Exhibit 4 shows, more than 55% of Mexico's wealth is concentrated in the highest income group that accounts for 20% of the population. This means that only a handful of wealthier people have benefited from the economic growth while most people in the lower income bracket have not. Furthermore, while the poverty rate in the urban area has declined that in the rural area has not fallen much, with 47% of the total population still living below the poverty line of less than US$4 per day (See Exhibit 5) Improvement of labor market structure Mexico's unemployment rate is extremely low. It stood at 3.6% in Some pundits argue that the rate is kept low because many of the jobless (more than 6% of the total labor force) work abroad. Looking at the unemployment rate by educational background, rates become higher as education levels go up (See Exhibit 6). Considering that the agricultural sector accounted for 16% of the total work force on the annual average between 2000 and 2004, which is not much higher than those in other countries, that is either because Mexico has few highly-developed industries that employ highly-educated people or because many of such industries are run by foreign businesses and employ foreigners to assume senior managerial posts. Various structural reforms such as the development of diversified and sophisticated domestic industries, an enhancement of labor productivity and improvement of the employment practices need to be carried out in order to redress these employment distortions on the labor market Structuring stable revenue base Despite the balanced budget, the country's revenue structure is not constantly stable. More than 30% of the annual total revenues are oil-related income which is apt to be affected by crude price fluctuations. Tax yields are one of the lowest among the OECD countries (equivalent to 10% of JCR Ratings September

3 GDP and 43% of the total revenues). It is important for the government to expand its tax base through higher economic growth while reviewing both direct and indirect taxes with a view to implementing tax increases where necessary. Unless drastic tax hikes are carried out, the share of oilrelated income may go up as oil prices will stay high in the foreseeable future. However, the new administration will have to take some swift actions to improve the situation since oil production from the existing plants will taper off in the longer term and there seems to be no prospect of new oil field development. 2. Economic and fiscal policies of both candidates and their possible impact on credit rating Behind the disputed July 2 presidential election between Mr. Calderon and Mr. Lopez Obrador lie the above-mentioned structural problems such as the income disparity, labor market distortions and the need of tax and energy-sector reforms that have utterly divided the voters in two. This chapter examines the effectiveness of the two candidates' economic and fiscal policy agenda centering on structural problems. 2.1 Differences between Mr. Calderon and Mr. Lopez Obrador in economic and fiscal policies As shown in Exhibit 9, the candidates seek to pursue completely different policies, with Mr. Calderon favoring a market-oriented approach and Mr. Lopez Obrador emphasizing government intervention in the market In case of Calderon's presidency: The point is whether he can develop and diversify the economy through expansion of investment In general Mr. Calderon who represents the current ruling party is supported by the business circles. He puts priority on improvement of the business environment through promotion of free trade, deregulation and induction of private capital into the energy sector with an aim of accelerating inward investment. He expects that these measures will help stimulate the economy and expand employment. Under his administration, budget expenditures will be curbed since he has pledged to follow the Fox administration's sound and restrained fiscal policy based on market principles. Redressing income disparity As reviewed in Chapter 1.2, the income disparity has hardly narrowed under the Fox administration's market-oriented policy. If investment increases and the economy grows faster than under the Fox administration as envisaged by Mr. Calderon, employment may start expanding to the benefit of the lower income group. On the other hand, if the slower economic growth continues, more than a third of the voters who supported Mr. Lopez Obrador may turn disaffected, possibly leading Mexico to political and social instability. To 8 JCR Ratings September 2006

4 avoid such risks, Mr. Calderon will need to act to redress the income disparity and pay due consideration to the vulnerable. Improvement of labor market structure Mr. Calderon aims to get the domestic industries sophisticated and diversified through promotion of investment. Mexico's labor cost is higher than those in China and other emerging markets. But it has an advantage in heavy industries such as automobile that can capitalize on the shorter distance to the United States. This, in particular, applies to assembly plants which need to employ a large number of blue-collar workers. In fact, many automakers made massive investment in 2005 and 2006 to expand their car assembly plants in Mexico. In contrast, Mexico will find it harder than other emerging markets to lure investment in highlydeveloped industries characterized by lower product shipment cost, such as information technology and other electronics industries. In this situation, it is unclear how far Mexico can go in creating jobs through industrial diversification and sophistication. Structuring stable revenue base Mr. Calderon aims to increase tax revenues through an expansion of the value added tax, which the Fox administration could not realize, while carrying out tax reductions to promote investment. It is necessary to examine the new administration's actual budget plan to see whether the tax base can be eventually expanded or not. As a means of increasing oil-related income, another main source of government revenues, Mr. Calderon proposes development of deep-sea oilfields through induction of private capital into the country's oil monopoly PEMEX. The proposal is surely a short cut to securing an increased oil production. However, infusion of private capital into PEMEX would require an amendment of the Constitution. With no single party emerging from the July election with a parliamentary majority, whether and how Mr. Calderon is going to win a constitutional amendment remains to be seen In case of Lopez Obrador's presidency: The point is whether he can maintain fiscal discipline by expanding the tax base while seeking to increase expenditures to benefit lower income group. In general Mr. Lopez Obrador won high reputation for his fiscal management and social care as mayor of the City of Mexico. During his election campaign, he hammered out an economic policy in favor of more government intervention in the market. Specifically, he underlined the need to care for the socially vulnerable, create jobs for the lower income group, spend more on social welfare and public works projects, nationalize the energy sector and renegotiate protection of farm products (such as maize) under NAFTA provisions. Redressing income disparity Mr. Lopez Obrador focused on the income disparity, one of the issues left unresolved by the current administration. The gimmick won him a large number of votes in the election. Judging from what he did during his mayoralty, he may be able to produce some good results in terms of care for the poor and vulnerable. His emphasis on job creation through public works could inevitably inflate expenditures. It is necessary to see whether his administration can maintain fiscal discipline in the longer term and whether it can push ahead with effective tax reforms. Improvement of labor market structure Mr. Lopez Obrador has been less specific about possible solutions to the higher unemployment rate among white- JCR Ratings September

5 collar workers and brain drain. Increased care for the poor and enlarged public works projects alone would be not enough to bring about strong economic growth and massive employment expansion. While basically underscoring the importance of the relationship with the United States, he has pledged to protect the interests of farmers through NAFTA renegotiations. Too much emphasis on this matter might give rise to friction in talks on trade terms for other products and on other crucial issues such as illegal Mexican immigrants in the U.S. Structuring stable revenue sources On the fiscal front, Mr. Lopez Obrador also gives priority to the need of a balanced budget, a policy advocated by the Fox administration. His policy agenda call for reinvigorating corporate activities through lowered energy prices and carrying out tax reforms with an aim of increasing tax revenues from businesses so that the administration can expand expenditures. However, it will be difficult to expand the revenue base to cover increased expenditures without relying on oil price hikes. As to reforms on the oil sector, which is a key revenue source, he rejects possible introduction of private capital. He insists separating PEMEX completely from the Ministry of Finance to allow it to make its own decisions on investment plans. However, it is doubtful how far the separation would boost PEMEX's efficiency and whether it would enable the oil monopoly to expand investment in an effective manner. Since oil is an important resource not only for government finance but also for economic growth, a larger-scale development of the resource would seem inevitable in the long term. 2.2 Impact of the new administration on credit rating A comparison of the policies advocated by both candidates gives the impression that they take completely different approaches. However, JCR considers that their differences would have little impact on Mexico's creditworthiness. In the first place, both candidates are committed to fiscal discipline and pro-american lines. Secondly, the absence of a majority party necessitates political adjustment over implementation of reforms, which would make any drastic policy shift extremely difficult. Thirdly, the economy is stable amid a steady expansion of both domestic and external demand and high oil prices. Upon inauguration of a new administration, it is necessary to keep an eye on whether it has practicable economic and fiscal policies in place and whether it will be slow to carry out necessary structural reforms by staying complacent with the abundant revenue gains brought by favorable economic growth and high oil prices or by getting stuck in the mud amid difficult policy adjustment in Congress. 10 JCR Ratings September 2006