Mexico: Reforming for Growth

Investing Daily Article of the Week

by Ben Shepherd, Investing Daily

Reform is never easy, and Mexico has been no exception.

On Monday, as Mexican President Peña Nieto delivered his first state of the nation speech in which he lauded his package of education, taxation, energy and financial reforms, massive street protests blanketed Mexico City.

The protests were led by teachers from the poorest Mexican states who feel they’re being blamed for the substandard quality of many schools, although protesters ranged from opponents to energy reform to anarchists.

Given Mexico’s history and a heavy dependence on the state, that’s all understandable.

After Mexico gained its independence from Spain in 1810 following centuries of exploitation by foreign powers, a distrust of foreign entities became ingrained in the Mexican psyche. And despite the fact that Mexico is generally considered an upper-middle income country with the second-largest economy in Latin America, according to data from the World Bank more than half of the population lives in poverty.

The US Central Intelligence Agency ranks Mexico as the 21^st most impoverished country in the world.

As a result, many Mexicans are dependent on what amounts to a massively inefficient, bloated bureaucratic state for subsistence and are generally suspicious of any sort of reform that might threaten that support. While none of the reforms thus far are seen as directly attacking social safety nets, many view them as a step in that direction.

On top of that, the Mexican peso recently nosedived to a one-year low against the dollar as the currency, which is extremely liquid and widely held, has sold off along with the rest of the emerging markets.

The Mexican economy also contracted by 0.74 percent in the first quarter— the first contraction in four years  — and grew by just 1.5 in the second quarter. That weaker-than-expected gross domestic product (GDP) growth forced Mexico’s central bank to cut its 2013 growth forecast in half to 1.8 percent.

So far, reform efforts don’t appear to have played a role in the slowdown. Lackluster global demand is largely to blame, helping to slow demand for services. Industrial production also dropped off a bit, but keep in mind, economic growth was calculated using a new methodology desig n to conform with international norms.

Slowing growth aside and despite the political and economic upheaval created by the reforms, the need for change is glaringly apparent.

According to data from the Organization for Economic Co-operation and Development, less than 1 percent of Mexican students reach advanced levels in math proficiency versus about 10 percent in the US. That’s little surprise, considering that in some of the country’s poorest states, classes are held outside for lack of even the most basic facilities, including drinkable water.

Teacher hiring and promotion is also almost entirely in the hands of powerful teachers’ unions, which makes those decisions largely based on seniority and patronage. Low-quality education is a significant hurdle to economic development.

Under Nieto’s reforms, the state will essentially take back control of the schools while hiring and promotion decisions will be based on student performance metrics.

But most important of all for immediate economic growth is energy liberalization.

While Mexico is the world’s ninth largest oil producer, production has been steadily falling over the past few years as state-owned Pemex has plowed little of its profits back into technology, exploration and production. Over the past six years alone, Mexican oil exports to the US have fallen from 1.7 million barrels a day to just 900,000, thanks to declining production.

By opening Mexico’s energy patch to private and foreign investment, it’s estimated that production could jump by as much as 20 percent to 50 percent in the coming decades, while adding as much as 2 percent to annual GDP growth. It would also level the playing field, allowing Mexican oil and natural gas to compete at the same level as Canada and the US in the global markets.

Reshaping a nation’s economy, and by extension the very fabric of society, is a painful process. However, it’s often very necessary — just ask China. In the case of Mexico, radical reforms in both its energy and education sectors would not only serve to bolster economic growth today, but ensure stronger growth down the road. So while President Nieto is clearly stepping on some well-entrenched toes, his roadmap of reform will do lasting good for his country.