75 years, 107 days, and Mexico’s Reform Agenda

mexicoToday marks the 75th anniversary of the nationalization of Mexico’s oil industry, exactly one week after President Enrique Peña Nieto celebrated his first 100 days in power.

Mexican Presidents are elected for a single six year term, taking office in December. In modern times, regime change has been associated with economic and political upheaval.

Felipe Calderon’s razor thin victory in 2006 gave rise lengthy street protests and an aggressive militarization of government anti-drugs efforts driven, at least in part, by the newly-elected President’s attempt to assert his authority and establish legitimacy.

2000 saw the election of Vincente Fox, ending the PRI’s (Institutional Revolutionary Party) 71 year vice-grip on the Presidency – an end to the so-called ‘perfect dictatorship’.

PRI’s hegemony was shattered not least by the disastrous legacy of it’s final Presidential succession. The controversial sexenio of Carlos Salinas de Gotari drew to a close amid political assasinations, armed rebellion of the Zapatista movement and ultimately unsustainable macroecomomic imbalances. In December 1994, Ernesto Zedillo took up the reins only to be faced with immediate economic and financial crisis, bank bailouts and a currency devaluation.

This time was different.

A slick, professionaly orchestrated campaign saw PRI seize back the Presidency in decisive fashion in July 2012 with a young, telegenic and sometimes underestimated candidate with a strong track record as governor of Estado de Mexico. Enrique Peña Nieto (EPN) has proved himself to be a shrewd political operator, with the confidence to surround himself with smart advisors, not least of which is Luis Videgaray, his Finance Minister.

Even before his December inauguration 107 days ago, EPN sought to reach across the aisle, working with Calderon’s lame-duck administration to usher meaningful labour market reforms through Congress. Tri-partisanship – bringing on board his political opponents, Calderon’s right-leaning PAN and the left-leaning PRD which was by now descending into disarray – would be an early hallmark of his tenure.

Within days of assuming office, the government hammered out an published, to the surprise of many, the Pacto por Mexico, 95 policy commitments signed up to by the government and opposition alike. Certainly, these commitments are often vague, taking the line of least resistance to secure broad political support. A new innovation in Mexican politics, the pact is not without its sceptics, but it serves a useful purpose while the loose coalition holds together, allowing the Presidency to drive deep reforms, first in areas of broad consensus.

The early results are encouraging.

With labour reforms already under his belt, EPN moved quickly to education, introducing sweeping changes aimed at improving teacher standards, undermining the power of the teachers’ union in the process. While implementing legislation has yet to be adopted, the power of the National Union of Education Workers, Latin America’s largest trade union, to water down reforms has been hobbled by the jailing of its leader, Elba Esther Gordillo, on corruption charges. Gordillo, herself a former PRIsta, has long been one of Mexico’s most combative, controversial and powerful political figures. Her jailing was a powerful statement of intent by the new President, building up a store of political capital which he clearly intends to spend delivering on his reform agenda.

For his next trick, barely 100 days in power, EPN took aim at another of Mexico’s most powerful men, and the world’s richest: Carlos Slim, owner of America Movil, which dominates fixed and mobile telephony in the country. Proposals for wide-ranging communication sector reform promises more competition, better regulation, lower prices, increased foreign investment and two new TV stations. For the first time, foreign investors will be permitted majority ownership in Mexican telcos. The new regulatory authority – the Federal Telecommunications Institute – will be given the power to break up phone and TV providers controlling more than a 50% market share, and apply to them more stringent ‘asymmetric’ regulatory criteria to stimulate competition.

Perhaps the toughest nut to crack, and that watch most closely by potential foreign investors, is energy reform. Since PRI President Lázaro Cardénas nationalized the Mexican oil industry in 1938, founding state behemoth PEMEX and expropritating foreign investors in the process, state control of natural resources has been a constitutionally protected national badge of honour.

However, oil production in Mexico, one of the world’s top ten producers and one of the United States’ top three sources of imports, has fallen precipitously from its 2004 peak of 3.4m bpd to the current level below 2.6m bpd at which it appears to have stabilized.

With a small tax base, oil revenue covers one third of government revenue, declining production thus poses risks to long-term fiscal sustainability, even with relatively high crude prices. This further complicates the reform agenda, as any change that involves a reduced government yield from PEMEX will necessitate simultaneous fiscal reforms to replace revenue.

Chronic underinvestment and lack of modern technical proficiency undermines Mexico’s ability to explore and extract more of its still significant reserves (estimated at 44.5bn barrels ‘possible and probable’, of which 13.9bn are classified as ‘proven’). Much of these reserves lie in as-yet-unexploited and difficult-to-extract fields under the deep water of the Gulf of Mexico. Without significant advances in extraction capacity, Mexico could become a net oil importer within a decade as reserves in mature fields such as Cantarell are depleted.

In the face of mass opposition, not least from the PRI, former President Calderon abandoned an attempt to win support for constitutional change in 2008, settling instead for less ambitious – and to date only moderately successful – mechanisms to attract private investment into the oil and gas sector. In his election campaign, EPN pledged to modernize the sector, mobilizing the private sector investment, technology and know-how necessary to exploit Mexico’s reserves. Recognizing the sensitivity of the issue in the Mexican psyche, he has been more ambivalent on the possibility for privatization, although Petrobras is often invoked as a model for reform and as a potential partner.

Critical for foreign investors is the issue of constitutional change, notably to article 27, which currently prohibits private sector ownership or part-ownership of hydrocarbon reserves. Understandably, investors are reluctant to provide their technology and know-how without securing an ownership stake in potential returns.

By progressing ambitious reforms on the basis tri-partisan consensus, EPN has built up significant momentum for structural change, with impressive early results. Whether the broad and loose coalition underpinning the Pacto por Mexico can hold together on more controversial issues, such as energy reform, is open to debate. The honeymoon is unlikely to last forever.

Constitutional change requires a two-thirds congressional super-majority and approval by a simple majority of state legislatures. Displaying an impressive command of his own PRI, EPN recently secured a change to the party’s platform which saw dropped their historic opposition to both article 27 and to the application of sales tax to food and medicine – twin-prongs of a potential fiscal-energy reform nexus.

Given that PAN is broadly supportive of constitutional change, and given the relative success to date of the tri-partisan arrangement, it is not unreasonable at this point to suggest that they will remain supportive as the shape of proposed reforms become clear. There is, moreover, more realism and less reflex opposition to reform in Mexico than at any time in recent history.

The PRD, itself riven by faction fighting since its failed two-time Presidential candidate, Andres Manuel Lopez Obrador (AMLO) challenged again the election results citing irregularities, is historically among the most trenchant opponents of changes to article 27. If the wider left were to ditch tri-partisanship and revert to an oppositional stance, as seems increasingly likely, it would require very strict cooperation and discipline among the PAN, PRI and the latter’s Green Party allies in Congress to achieve the required two-thirds majority.

As I wrote (here and here) prior to the 2012 election, the most likely outcome is still significant reform, including better terms for private sector investors, but falling short of constitutional change. EPN’s shrewd post-election stewardship, demonstrable commitment to reform, and willingness to take on vested interested have all increased the likelihood of more far reaching energy reform, up to and including constitutional change, but this holy grail may remain tantalizingly out of reach.

Even if this proves to be the case, however, taken together the labour, education and telecom reforms, coupled with measures to boost private sector involvement in the Mexican energy sector would make for a fine first year and a handsome down payment on the structural reforms needed to boost the country’s economic growth rate towards EPN’s targeted 6% per annum.

Mexico’s relatively open economy was hit hard by the global financial crisis, GDP falling 6.3% in 2009, before bouncing back strongly on the back of industry, exports and record tourist numbers, even despite its well documented security issues. With the wage gap with China having narrowed significantly, Mexico is well poised to continue reaping the benefits of NAFTA membership and close proximity to the world’s largest economy.

In a sense, Mexico as an emerging market play can be considered as a leveraged bet on US economic prospects given that it accounts for fully 80% of Mexican exports. The US’ relatively robust recovery – compared to other developed markets – thus bodes well for Mexico’s near-term prospects. In the longer term, the benefits of structural economic reforms can boost the economy’s potential growth rate, while its significant shale gas reserves should come in to play beyond 2020.

As Brazil’s star has waned after a decade of out-performance, Mexico has come back into vogue as the darling among LatAm investors. EPN’s early success in delivering on his reform agenda has further whetted appetites. While Mexico may well out-perform Brazil economically in the second decade of the 21st century, talk of eclipsing an economy still twice its size is more hubris than reality.

Where Mexico does eclipse Brazil, however, is in terms of sound, predictable fiscal and monetary policy. EPN shows every sign of continuing the PAN legacy for responsible management of the public finances, targeting a balanced budget for 2013 (when PEMEX investment is stripped out). Augustín Carstens, moreover, is one of the world’s most credible and predictable central bankers, operating an orthodox foreign exchange regime with minimal intervention, low inflation and a relatively transparent communication policy. The recent 50bp cut in the central bank policy rate actually gave rise to a stronger rather than a weaker peso, as would usually have been expected, such is the bullishness surrounding Mexican assets.

While over-bullishness among investors and the eventual withdrawal of monetary stimulus by the US Fed give rise to the risk of sharp corrections, long-term trends must favour Mexican assets.

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