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 is far from cheerful and the compliments are few. Hardly a day goes 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's becoming increasingly clear that Mexico's recovery will be slower and rougher than anyone, from Zedillo to the most pessimistic analysts, anticipated. While modest growth is expected next year (charts), executives voice mounting skepticism that Asian-style expansion is in Mexico's reach anytime soon. "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 are down 98%. "How are they going to realize their dreams of growth with this virtual dismantling of the industrial base?"

While exports are up 32% this 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. 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.

Faced with this realization, the markets have recently caught the jitters. The peso, which has been steady at about 6.2 to the dollar since June, fell to 6.7 in late October. Banco de Mexico was forced to raise interest rates by 10 points, to 41.8%, to shore up the currency. The stock market, which had rallied to predevaluation levels in peso terms, sputtered through October.

But beneath the devastation, 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 key areas such 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 continuing to shift work to Mexico--often to midsize cities that could become new growth areas.

But it's not yet clear that these sweeping changes will produce the growth Mexico needs. Businesspeople, who had given Zedillo credit for restoring financial confidence, are calling on him to promote growth through government spending and tax incentives. Austerity, they complain, shrank the money supply by a painful 57% through August. "The government will have to play a more important role in stimulating the economy than the authorities are willing to admit," says Felix Boni, an analyst at James Capel Research Mexico. Adds Julio A. de Quesada, director general of Citibank Mexico: "We need long-term sustained economic growth."

LOST CHANCE? No one doubts the high stakes in this debate over how 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. Most observers agree that 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.

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. And 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. So far, he and Ortiz are facing down pressure from the markets and business to loosen up their economic policies. Calling for patience, they argue that their approach will bring solid growth if given time.

Like their predecessors in the administration of President Carlos Salinas de Gortari, both men oppose government intervention in the economy. "There have been a lot of voices calling for a reactivation of economic activity, for higher public expenditures, and for 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 cost 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. Nevertheless, unemployment is at a record high. And those who still have jobs have seen their wages fall by 25% so far this year in real terms.

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. "If negative growth continues for three or four more quarters, we'll see real problems," Quesada says.

More important, some executives 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 amounts of investment 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, the million Mexicans coming into the workforce each year won't find jobs. Social unrest may increase, and the economy won't have the resources to make itself competitive--as Mexico's membership in NAFTA demands.

By turning Mexico into an export platform, 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 January, 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 new export strategy will put money in enough people's pockets to create robust growth. A small group of big Mexican companies and subsidiaries of international companies dominate exports. Many of these companies have been trimming staff over the past few years--and layoffs have accelerated since the crisis. A senior executive of a major Mexican conglomerate reports that in the past eight years, his company has reduced its workforce from 30,000 to 23,000 while doubling unit volume.

Such textbook streamlining may make Mexico more competitive, but it may not be the right answer for a country with a fast-growing work- force 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 Boni. "But if labor is cheap and plentiful, there is no reason to go for reducing it."

Critics say the government's technocrats should throw away their Ivy League economic formulas and write a homegrown recipe for Mexico's development. Indeed, the government's policies have done little to help the small and midsize companies that employ most workers. They have been left to sink or swim as officials eliminated subsidies and slashed tariffs. A few big companies dominate industries such as cement and glass, swallowing up and driving out competitors. A new antimonopoly commission established in 1993 is widely criticized as ineffective.

The government approach to growth is also too passive, critics say. As big exporters establish themselves, the hope is that smaller suppliers will spring up around them. But Zedillo and Ortiz, opposed to government intervention in industry, are reluctant to push a strategy to bolster small business. With no guidance or incentives from the government, small companies say they are left guessing what their role in the future economy will be. Under these conditions, it is hard to see how Zedillo will persuade Mexican businesses to invest.

Despite this year's setback, Mexico is still far better off than it was 10 years ago. As Mexico opened up its highly protected economy, many Mexican companies and the subsidiaries of American, European, and Japanese companies spent heavily to modernize. DuPont Mexico's President, RaPound l Muoz, says this process began at his company as early as 1985. Anticipating changes in the business environment, DuPont gradually pared back staff by about 25% and invested to bring operations up to international standards.

A CUSHION. The effort paid off this year. Although DuPont's domestic sales have slumped by 35%, it has narrowed the gap by exporting some 60% of its products. "You have a much bigger market to think about," Muoz says. "We won't necessarily have Mexico as our chief market."

While small and midsize companies were hit hard by this year's 8% to 10% plunge in domestic demand, NAFTA provided a cushion for 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, CEO 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.

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 also attract billions in investment. Ending Telefonos de Mexico's monopoly on long-distance communications has reaped commitments for at least $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 peso debacle, 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 a bolder strategy 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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