Mexico: A Rough Road Back

For President Ernesto Zedillo Ponce de Len, it was a rare occasion. In a mid-October state visit with President Clinton, his first since the U.S. brokered a $50 billion international bailout for his country, Zedillo basked in praise for his disciplined handling of Mexico's financial crisis. Not a year has passed since Mexico's botched peso devaluation plunged the economy into near-chaos. Yet exports are booming, and the country is borrowing billions again on the international markets. Raising a glass at a lavish White House dinner, Clinton complimented Zedillo on his "courage and determination."

South of the Rio Grande, however, the mood has been far from cheerful and the compliments few. Hardly a day has gone by without a business or labor group demanding that Zedillo let up on the harsh fiscal and monetary controls that he and Finance Secretary Guillermo Ortiz introduced last March. Their aim had been to give Mexico a dose of shock therapy to put it back on track to becoming what had been a dream within reach--a Latin tiger economy linked to the U.S. through the North American Free Trade Agreement.

MUCH PAIN. But as 1995 winds down, it has become increasingly clear that Mexico's recovery will be slower and rougher than anyone, from Zedillo to the most pessimistic analysts, anticipated. Catching a severe case of market jitters, the peso dropped 6.2% on Oct. 26, the worst one-day fall in the currency since January. In response, the government rushed to seal an economic pact with business and labor. Unveiled on Oct. 29, it offers tax incentives to spur investment and create jobs, and promises to target government spending on education, energy, and health in 1996. The peso recovered the next day by 2%, to 6.9 to the dollar, but then resumed its fall.

The Banco de Mexico was forced to raise interest rates again, to 43.3%, to shore up the currency. While some business leaders applaud the government's latest initiative, many voice skepticism that Asian-style expansion is in Mexico's reach anytime soon. Only modest growth is expected next year (charts). "I wonder if the government realizes the degree to which the industrial infrastructure is collapsing?" asks Stephen P. Knaebel, president of Cummins Engine Co.'s Mexico operation, whose engine sales have plunged. "How are they going to realize their dreams of growth with this virtual dismantling of the industrial base?"

While exports will be up 28% for the year--and now make up an impressive 25% of gross domestic product--companies that focus on Mexico's domestic market are hurting badly. Whole industries, such as truckmaking and construction, have virtually shut down. A million people have lost their jobs--and Mexico has no unemployment insurance to cushion the suffering. Banks, burdened by bad loans, are unable to lend to struggling companies. Austerity shrank the money supply by a painful 57% through August. And 1996 is likely to be another tough year. Mauricio A. Gonzlez, chief of Mexico City consultancy GEA Associates, says the best-case scenario is that domestic demand will be flat.

Beneath the devastation, however, there are signs that the pain of Mexico's economic upheaval will not be in vain. In fact, the crisis has accelerated key structural changes that were already under way and were making Mexico more attractive to investors. More Mexican companies are streamlining faster--making them more competitive in the world economy. Some are carving out new niches in such areas as high-tech manufacturing. And while the crisis has crimped foreign investment, it hasn't cut it off. Encouraged by NAFTA, U.S. and other investors are shifting work to Mexico--often to midsize cities that could become new growth areas.

No one doubts the high stakes involved in Zedillo's effort to steer Mexico further toward recovery. The strength of the rebound is sure to set the tone for the remainder of Zedillo's six-year term in office. Zedillo is presiding over a critical period in Mexico's history. He has to manage both the sweeping opening of the economy under NAFTA and the dismantling of a decades-old feudal political system.

LOST CHANCE? If Zedillo is set back by unrest arising from a prolonged recession--or if he fails to attract higher levels of foreign investment--Mexico could lose its chance to leap into the economic big leagues. Multinational companies are already warning that they might channel more investment to emerging markets such as Brazil if Mexico's domestic market doesn't revive. "Mexico runs the risk of losing the interest of foreign investors," says Philippe Mellier, chief of Ford Motor Co.'s operations in Mexico. Without foreign investment to boost the economy, Mexicans would have to postpone their dreams of prosperity, at least until early next century.

As Zedillo continues to steer Mexico toward recovery, he is attempting a difficult balancing act. On the one hand, he must maintain investor confidence by continuing a policy of financial discipline. On the other hand, he must be careful not to apply so much medicine that he kills the patient. Like their predecessors in the administration of President Carlos Salinas de Gortari, Zedillo and Ortiz oppose major government intervention in the economy. "There have been a lot of voices calling for higher public expenditures and looser monetary policy," says Ortiz, a Stanford University-educated economist. "I don't think that's the right approach. The recovery is going to be private-sector-led."

Ortiz may be right. The private sector is much more important than it used to be, accounting for 75% of economic output, up from 50% a dozen years ago. Ortiz' formula is to turn Mexico into an export platform by keeping the value of the peso low, making the cost of Mexican labor and products cheap (table).

BANKING WOES. At the same time, tight monetary and fiscal restraints aim to discourage the out-of-control consumer spending that helped run up a $29 billion current-account deficit in 1994. That policy worked this year: The current-account deficit is down to $1 billion, and inflation has been kept to 50%, lower than expected. Zedillo aims to bring inflation down to 20% next year. Nevertheless, unemployment is at a record high. And those who still have jobs have seen their real wages fall by 25%. A new proposed minimum wage hike of 21% through next April won't be enough to recover that lost purchasing power.

Business leaders fear that if high interest rates continue, more companies will collapse. That could create new troubles for banks, which the government has already spent billions of dollars to bail out. Some executives also worry that by leaning too far to please financial investors, the government could set back Mexico's chances of attracting direct foreign investment. The country needs huge investments in manufacturing and infrastructure--something on the order of $10 billion a year--just to achieve 3% to 4% growth. If that doesn't materialize, unemployment and unrest may increase, and the economy won't have the resources to make itself competitive--as Mexico's membership in NAFTA demands.

By making Mexico more of an export economy, Ortiz believes he can get the economy growing at 3%, even if companies that don't export perform poorly. But longer term, he says, growth must come from foreign investment, greater productivity, and higher internal savings. Ortiz wants to energize investment on the home front by introducing private fund management to the creaky government social security scheme. The aim is to raise domestic savings from the present 16% of GDP to 24% over five years.

A government task force is drafting a law to create mandatory, privately managed, individual pension plans. "It won't make much difference in the first year," says an official familiar with the plan. "But in two or three years, you will see a substantial pool of savings."

Any tinkering with the sacrosanct social security system faces an uphill fight in Congress, but officials hope pension funds can be introduced by early 1997. Already, international banks with big presences in Mexico, including Citibank and Spain's Banco Bilbao Vizcaya, are planning to offer their own pension-management plans if foreign banks are allowed to participate.

Will all this be enough to sustain the growth Mexico needs? There are broad concerns about whether Mexico's export strategy will put money in enough people's pockets to create robust growth. Big Mexican companies and subsidiaries of international companies dominate exports. Many have been trimming staff in recent years--and layoffs have accelerated since the crisis. One Mexican company, for example, has cut 8,000 jobs in eight years while doubling output.

Such textbook streamlining may make Mexico more competitive, but it may not be the right answer for a country with a fast-growing workforce and no social safety net. Indeed, a debate is growing about Mexico's model for economic growth. Taking advantage of a peso that was overvalued until last year, Mexican companies invested heavily in machines from Europe, Japan, and the U.S. that are designed to save labor. Now, some argue that Mexico's best hope may be its cheap labor. "People think labor-intensive manufacturing is unproductive," says Felix Boni, an analyst at James Capel Research Mexico. "But if labor is cheap and plentiful, there is no reason to go for reducing it."

Despite all the setbacks, Mexico is still far better off than it was 10 years ago, before it began opening up. Companies such as DuPont Co. have spent heavily to modernize and pared staff to bring their Mexican operations up to international standards. Although DuPont's domestic sales have slumped by 35% this year, it has narrowed the gap by exporting some 60% of its products. "You have a much bigger market to think about," says DuPont Mexico President RaPound l Muoz. "We won't necessarily have Mexico as our chief market" in the future.

While small and midsize companies were hit hard by this year's 8% to 10% plunge in domestic demand, NAFTA provided a cushion for many larger companies and multinational subsidiaries. When Cummins Engine saw domestic sales of its heavy-duty truck and bus engines in Mexico fall 98%, to 45 units, it switched a production line from Brazil to Mexico. Cummins is also bringing used engines from the U.S. to be rebuilt and sent back north. That helps minimize layoffs.

Ford's new North American strategy, based on NAFTA, has also helped shield the company's Mexican subsidiary from a slump. Exports are up, and the company gave the go-ahead to expand an engine plant and start a new component line in Mexico. "I don't know what we could have done without NAFTA," says Ford's Mellier.

The more open economy is having a profound effect on Mexican companies. Many were family-run and insular, and lacked professional management. Now, as they try to raise capital and take on foreign partners, they are being forced to be more accountable. "Having outside people on the board is foreign to them, but it's going to have to happen," says Claudio X. Gonzlez, chief executive officer of Kimberly Clark de Mexico and head of the Mexican Business Council. "We're going to be a capital-importing country for quite a few years."

The government is going through a similar transformation. Zedillo is supporting a democratic opening that will curb the near-authoritarian powers of Mexican presidents and introduce real debate on government policies for the first time. Congress has won new powers to oversee government spending. And the government now releases economic information weekly on the Internet--rather than revealing its foreign reserves just three times a year.

SOBERING OUTLOOK. Such changes will likely make Mexico more attractive for outside investors. Some investment funds are already flowing in. Banco Bilbao has paid $476 million for a 70% stake in troubled Mercantl Probursa. And other buyouts are in the offing.

The government's plans to privatize ports, railroads, and some petrochemicals and to allow private companies to build natural gas networks, will attract billions in investment. Ending Telefonos de Mexico's monopoly on long-distance communications has reaped commitments for $5 billion in investment. Foreign direct investment is expected to rise next year after plunging by 44%, to $3.5 billion, in 1995.

Nearly a year after the peso crisis, Zedillo can take credit for restoring financial stability to Mexico. But the country's outlook is much more sobering than it was when he took power last December. Before the devaluation, Mexico seemed well on its way to becoming an economic powerhouse. It had even joined the Organization for Economic Cooperation & Development--the club of industrialized economies.

The biggest question facing Mexico is whether, after six years of rising expectations--and one year of seeing them horribly dashed--the country is destined to remain just another emerging market, or whether it still has the potential to become a First World economy.

In coming months, Zedillo will have to prove that he can be much more than a technocrat, or "Manager of the Nation," as one newspaper sarcastically dubbed him. Without abandoning financial discipline, he may need an even bolder strategy than his recent economic pact to jump-start the domestic economy. "Zedillo is very convincing when he meets with foreign officials and investors," says one trusted adviser. "But he hasn't yet succeeded in convincing Mexicans that there is a bright future ahead of them." Zedillo must show that he not only has a vision for Mexico's future but the political skills necessary to make it happen.

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