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The U.S. Coughs--and Mexico May Catch a Cold

Being the U.S.'s second-largest trading partner is both a blessing and a curse. Since the North American Free Trade Agreement began on Jan. 1, 1994, Mexico's exports have tripled, and 88% of them go to the U.S.

But now that the U.S. economy is slowing, Mexico is feeling the pain. Its real gross domestic product grew 6.9% in 2000, but the Central Bank expects growth of just 3% this year. Industrial output fell 3.7% in the year ended in February (chart), while analysts had expected a 1% rise. Manufacturers are cutting back output at dozens of Mexican plants, especially in the export-oriented northern states.

At the same time, Mexico's peso is the world's second-best-performing currency, appreciating about 3% so far this year, to 9.28 per U.S. dollar. That's due in part to an influx of foreign cash lured by the 13.92% rate for Mexico's 28-day treasury bills.

Foreign investment in the money market at the end of March totaled $2.25 billion, up 26% from December, 2000. The Central Bank has kept interest rates high to reduce inflation to 6.5% this year, with an eye toward reaching the target of U.S.-level inflation of 3% by 2003. But the strong peso has exporters howling that they're losing competitiveness just as U.S. companies are seeking to lower their production costs.

So far, there are no real danger signs in Mexican finances. The country has $38.9 billion in international reserves. And the government is on track to have a fiscal deficit of less than 1% of GDP this year, thanks to still-high oil export prices.

But an economic slowdown will impact tax revenues, possibly making it difficult for Mexico to meet its budget goal of a deficit of 0.65% of GDP. Mexico collects just 11% of GDP in taxes, and a tax reform bill now before Congress may not pass before October. Some legislators object to a 15% value-added tax on food and medicine. They argue the tax would hurt Mexico's 40 million poor, but President Vicente Fox says it's the most efficient way to raise needed revenue. By Geri Smith in Mexico City

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