| After 12 years in opposition, the Partido Revolucionario Institutional [PRI], which until 2000 had ruled the country for over 90 years, will return to power on December after winning the presidential elections in July. However, the PRI failed to gain a majority in Congress in the parliamentary elections, and this will make it harder to pursue his policy agenda, including structural economic reforms. Escalating violence is harming the business environment One major issue for the new government will be internal security. Violence has flared up considerably and security conditions have deteriorated since the end of 2006, when President Calderóns government stepped up its battle against the well-organised drug mafia. Since then, more than 50,000 people have fallen victim to this struggle. With violence escalating despite the efforts of the police and security forces, and no end to the conflict in sight, public support for the governments actions has waned. The worsening security situation has had an impact on the business environment, discouraging foreign investment that would otherwise flow into Mexico. Moreover, the profitability of many businesses is suffering from threats and violence against the business owners, including the kidnapping of their family members. Rebound from the 2009 recession continues Mexicos economy deteriorated dramatically as a result of the credit crisis - and due to its close links to the US business cycle, the deep US recession. Real GDP growth decreased by 6.3% year-on-year in 2009 because of diminishing industrial exports [down 14%], lower workers remittances [the funds that expatriate workers send back to Mexico], a liquidity crunch with scarcer bank credit and external finance, and the outbreak of swine flu. Domestic demand also took a turn for the worse, with less consumer spending and business activity. As a result, unemployment rose sharply. However, since 2010 the economy has rebounded, thanks mainly to a resurgence of exports - as demand from the US has picked up again - and increasing domestic demand. GDP grew by 5.8% year-on-year in 2010 and 3.6% in 2011. Slower growth in Q2 of 2012 Growth continued into 2012 - by 4.5% year-on-year in Q1 - but slowed to 4.1% in Q2 [up 0.9% from the previous quarter], according to the National Statistics Institute INEGI. This was in line with decreasing growth in the United States [up by 2.2% in Q2 after 2.4% growth in Q1]. Mexican export growth slowed to just 3.8% in Q2 after an 11.6% rise in Q1. Gross fixed investments increased 8.3% year-on-year in the period from January to the end of May 2012. Manufacturing activity grew by 4.9% year-on-year in the first half of the year while construction output increased 5.0%. Despite the resurgence of business confidence seen since the end of 2009, consumer confidence remains subdued, although it has improved in recent months. Mexicos banks are, in general, well capitalised and liquid, with limited exposure to foreign currency risks. However, they are performing below potential [bank assets as a percentage of GDP stand at just 46%], constraining the credit growth needed to give more stimulation to private consumption. A rather cautious lending policy is also restricting financing options for small and medium-sized enterprises. Solid short-term economic policies Overall, Mexicos current budgetary and monetary policies are healthy, with an acceptable public sector financial position. The budget deficit continues to improve: from 3.4% of GDP in 2010 and around 3.0% in 2011 and 2012, it is expected to reach around 1.5% of GDP in 2013, while public debt constitutes at approximately 35% of GDP. However, additional fiscal consolidation is urgently required to compensate for low tax revenues, as Mexico has a narrow tax base of only 10%, and the structural decrease in oil revenues, which represent almost a third of public sector income. Generally, Mexicos monetary policy faces the challenge of finding the right balance in the movement of interest rates that will curb inflation while maintaining the countrys competitive position. While higher interest rates help to contain inflation and attract short-term portfolio capital inflows, leading to a currency appreciation, an overly strong peso may damage Mexicos export competitiveness with other emerging markets. The key interest rate was gradually lowered in the first half of 2009, to 4.5%, and has remained unchanged since then, not least because of stable inflation [3.9% in the first half of this year]. However, this still rather high interest rate is attracting short-term portfolio capital inflows. Recently consumer prices increased to 4.4% in July 2012 due to higher food and cereal prices, breaching the central banks 2%-4% target range. Lack of structural reforms impedes stronger growth Despite a solid short-term economic policy, the Mexican economy suffers from structural weaknesses, as poor reform results are still impeding economic efficiency and longer-term GDP growth: GDP-increases are hardly ex- ceeding population growth, leaving the GDP/capita ratio more or less on the same level as in 2008 [around US$ 10,000]. Tax collection is very low, the labour market is inflexible and the energy sector is monopolised by the state. The energy sector in particular - including the electricity network and Pemex monopoly - needs to be overhauled. While Pemex, the state-owned petroleum company, was granted more financial and managerial autonomy by the Mexican Senate in October 2008, a comprehensive reform of the oil industry is still the most pressing issue, due to dwindling production and the fact that oil accounts for more than 30% of fiscal income. Until recently, efforts at reform have often failed because of a lack of political will at the top or of a lack of support from opposition parties in Congress. President Designate Nieto has promised to tackle reforms but it remains to be seen how the new government will put this into practice. Energy sector: oil production is decreasing Mexico is the sixth largest crude oil producer in the world, but proven reserves have shrunk from 34 to 14 billion barrels since 1998, and will last for only 10 more years. Current production has dropped from 3.4 million barrels per day [b/d] in 2004 to 2.5 million b/d, and is expected to decrease further: to 2.1 million b/d in 2015. Although offshore oil fields are said to be twice as large as land-based oil fields, Pemex currently lacks the knowhow and resources to invest in exploration and production, mainly because it pays 90% of its revenues to the state budget. Pemex therefore urgently needs permission to cooperate with private [foreign] investors for joint exploration, refining and distribution, but such a move is still met by fierce political opposition. The main hurdle is the fact that Mexicos constitution stipulates that the oil industry must remain under state control. External economic situation: Good solvency and liquidity indicators Mexicos short and medium term external economic position is robust. Its international liquidity is good, with enough foreign exchange reserves to cover imports for more than four months: even more so as this figure excludes the huge liquidity potential from a precautionary IMF credit line of US$ 72 billion on which Mexico can draw in times of adverse global credit conditions, and which has been extended until April 2013. Solvency is also good, foreign debt ratios are quite low and the debt service ratio has declined to around 20%, including short-term debt. The massive drop in imports and exports in 2009 was fully offset by 2010s strong rebound in foreign trade, leaving the current account balance more or less unchanged. Current account deficits are easily financed by capital imports, especially FDI and incoming short-term portfolio capital. Outlook: Principally good, but reforms are urgent President Designate has promised to swiftly pass those reforms which until now have been blocked in Congress, i.e. more flexible labour laws, an improvement in tax laws and a reduction of government control in Pemex. However, the latter would need a two-thirds majority in Congress. For the other reform projects, he needs working majorities/opposition support, neither of which is guaranteed as the PRI lacks a majority in Congress. Before losing power in 2000, PRI gained a reputation for cronyism, corruption and even making deals with the drug cartels. It remains to be seen how the New PRI will act and how will tackle the internal security problem. Slightly lower growth in 2013 Growth is expected to continue in 2013, albeit at a slightly lower level than in 2012 [3.5% compared to 3.7%]. However, structural GDP growth will remain below the regional average due to some unfavourable factors: poor infrastructure, inadequate education, corruption and the lack of structural reforms. Inflation will increase slightly in the second half of this year and into 2013. The biggest risk to Mexico remains a potential slowdown in the US, as it remains highly dependent on the economic performance of its northern neighbour. With nearly 80% of exports destined for the US, together with tourism and remittances, the US is Mexicos main source of foreign exchange. Currently, the US economy is expected to grow by 2.0%-2.3% in 2013 after around 2.0% growth in 2012. Stable solvency and liquidity despite some downside risks Solvency and liquidity indicators will remain stable. It is expected that the current account deficits will increase again in the coming years, while FDI will comfortably finance these shortfalls. However, if domestic violence continues to escalate, it could have more negative consequences for FDI inflow and the whole Mexican business environment. Another factor that has to be monitored is the behaviour of short-term portfolio capital that has been invested in Mexican assets and which can be easily withdrawn or reversed. Nevertheless, even in a worst-case scenario, the country should be able to cope without major financial problems. While the currency regime is considered to be stable, there is always a potential devaluation risk, which could cause major problems as happened after the Lehman crisis in September 2008. | 
