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MEXICO - Taxing Times

Mexican Finance Minister Agustin Carstens tackles fiscal reform.

MEXICO'S VOTERS HANDED PRESIDENT FELIPE Calderón a poisoned chalice last summer. The July 2 election propelled the business-friendly, right-of-center Calderón into office, but only just: His margin of victory over the left's candidate, former Mexico City mayor Andrés Manuel López Obrador, was a whisker-thin 0.58 percent of the popular vote, prompting months of street protests by López Obrador's supporters. The disputed outcome seemed to promise a continuation of the political gridlock that had stymied Calderón's conservative predecessor, Vicente Fox.

Since taking office at the start of December, however, Calderón and his economic team, led by Finance Minister Agustín Carstens, have displayed some surprising agility. By combining an increase in social spending sought by the left, extra investment in infrastructure for the business community and a range of austerity measures -- including cuts in cabinet salaries -- the two men won unanimous congressional approval for the government's $208 billion budget for 2007 in record time. That early victory offers hope that Calderón may be able to appease the populist, antiglobalization sentiment that López Obrador whipped up without compromising his own market-oriented policies.

Now comes the real test. The government is preparing to launch its first structural reform -- a long-awaited overhaul of Mexico's cumbersome and inefficient tax system. The reform, which Carstens is spearheading, is vital to strengthening public finances in the face of declining oil revenues and to promoting growth and investment in an economy that has lagged behind more-dynamic competitors in Asia. "It's important to have a tax system that is efficient, with the least distortions possible, and one that gives legal security to investors," Carstens says in a recent interview with Institutional Investor (see box).

Winning Congressional approval for such a sensitive reform won't be easy. Mexico's perennially gridlocked political system and hidebound economy have conspired to keep the country mired in a cycle of weak growth and populist turmoil. In the wake of the narrow election outcome, Mexico seems even more starkly divided along class and regional lines -- most of Calderón's support came from the wealthier industrialized north, while López Obrador's base is in the poor, rural south.

But Carstens' strong technical background and savvy personal skills seem tailor-made for breaking the logjam. The 48-year-old University of Chicago­trained economist knows the concerns of international investors, having served as deputy managing director of the International Monetary Fund in Washington from 2003 to 2006. He also honed his skills as a backroom bargainer during stints as deputy Finance secretary in the Fox administration and treasurer of the Banco de México, the central bank, under former president Carlos Salinas. Those abilities helped him forge a consensus and win speedy approval of the 2007 budget. The secret, Carstens tells II, is "to listen and be patient."

The minister can afford to be patient, at least for now. The economy grew by 4.8 percent last year, largely as a result of high oil prices. That was one of the strongest growth rates of any major Latin country and compared with an average of just 2 percent a year between 2000 and 2005. The government forecasts that growth will ease back to 3.6 percent this year, reflecting the slowdown in the U.S. economy. Mexico attracted $18.9 billion in foreign direct investment in 2006, up from $17.8 billion in 2005, according to government figures. Mexico ranked third globally as a recipient of FDI, behind China and Hong Kong, in 2004, the latest year for which comparable figures are available, according to the United Nations Conference on Trade and Development.

Calderón came into office promising to attack Mexico's stark inequalities with liberal economic and trade policies. He traveled to the World Economic Forum in Davos, Switzerland, in January and proclaimed Mexico a proud member of the global economy that is committed to democracy and free trade, and determined to resist the economic nationalism of countries like Venezuela.

The president was immediately thrown on the defensive, however, by the government's first crisis -- a surge in the price of tortillas, a staple of the Mexican diet and culture. Growing demand for corn to produce ethanol in the U.S. has driven up the grain's price and had a knock-on effect on tortillas, prices of which have tripled in some part of Mexico. The increases have sparked a wave of protests in a country where nearly half the population -- some 50 million people -- lives below the poverty line.

Calderón initially lowered restrictions on corn imports; then in January he broke with his own free-market principles and imposed a price cap. But the cap was widely ignored by distributors and small tortilla shops, and government officials have resorted to denouncing hoarding and speculation by tortilla distributors.

Notwithstanding the political tensions, however, there are signs of a new willingness to compromise that was notoriously absent during the six-year term of president Fox. The leftist Partido de la Revolución Democrática (PRD), now the second-largest bloc in Congress after Calderón's ruling Partido Acción Nacional (PAN), has shown a new openness to deal making. Although the PRD's López Obrador continues to present himself as Mexico's legitimate leader, who was robbed of victory by a business cabal, his party lieutenants have begun to distance themselves from him. Felix Boni, director of research at Scotia Capital Mexico in Mexico City, says the two parties are responding to national fatigue from years of political gridlock and acrimony. "There is now an atmosphere in which all parties recognize the need to behave more responsibly," he contends.

This new attitude was evident during the prebudget wrangling. Carstens won grudging respect from PRD legislators who presented him with their populist demands for pension increases, reinstatement of funding cuts to universities, increases in funding for government services to indigenous peoples and improved infrastructure for Mexico's backward rural regions. After several weeks of haggling over a budget based largely on the work of the outgoing Fox administration, Carstens won Congressional backing for a package that will boost spending and revenues by 10.7 percent in real terms and keep the overall budget in balance, which the minister considers a bedrock of macroeconomic stability. The increased spending will be financed by a variety of cutbacks -- including salary reductions for the president, ministers and senior officials -- designed to save $2 billion.

The opposition was satisfied with the result, even if the spending increases were less than it had sought, says Javier González Garza, leader of the PRD bloc in the lower house Chamber of Deputies. "In those discussions, I was treated respectfully," the legislator tells II. Referring to Carstens, González Garza says, "He didn't ever deceive me, and that's important."

The budget also reflected Calderón's emphasis on fighting crime and drug trafficking, with salary hikes for the lower echelons of the police and military forces. Since December he has ordered sweeps in four states by more than 5,000 police and army troops to arrest traffickers, seize arms and eradicate drug crops.

Luis Rubio, president of the Centro de Investigación y Desarrollo (Cidac), an independent think tank in Mexico City, credits the Finance minister for keeping his eyes on the big picture. "Carstens was much more concerned about the aggregates than the details on what each ministry spends," he says.

If the deal-friendly atmosphere continues, Carstens believes he will be able to tackle some of the country's major economic dysfunctions. His first target is the tax system, which generates a meager 11 percent of GDP in revenues. Among countries in the Western hemisphere, only impoverished Haiti raises less in tax revenue.

Mexico traditionally combined high tax rates with weak enforcement. The Fox government slashed rates to a single level of 28 percent from its previous 35 percent for business and 40 percent for individuals, but efforts to actually collect taxes showed little improvement. A 15 percent value-added tax introduced during the government of president Ernesto Zedillo is also widely flouted. Some 50 percent of Mexicans work in the informal economy in jobs ranging from street vendors to construction workers, according to World Bank estimates, allowing many of them to avoid the tax rolls. Tax revenue has declined as a percentage of GDP in four of the past seven years.

Revenues from state-owned Petróleos Mexicanos -- which will finance more than one third of the federal budget, or some $47 billion, in 2007 -- have enabled the government to dodge tax reform for years, but Pemex's output and revenues are set to decline soon.

"Fiscal reform is our major challenge," Carstens says during an interview in his Spanish colonial­style office in the block-long Palacio Nacional, which houses the government's financial bureaucracy as well as the president's office.

Carstens has been vague so far about how he intends to confront that challenge, and for good reason. The president campaigned on a job-creation platform emphasizing competitive tax rates that favor investment, whereas the PRD wants to shift a greater share of the tax burden onto business. "We are going to maintain a very open attitude," Carstens says.

An open attitude, perhaps, but he is still guarded about the details, promising only to incorporate the ideas of other parties into the government's tax reform package. All the parties agreed in principle to launch fiscal reform in the first half of 2007, and Carstens kicked off talks with opposition leaders in mid-January. But by mid-February the government had not yet indicated when it would set out its proposals. Cross-party deal making seems to be the reigning mantra for Calderón, a former leader of the PAN legislative bloc. And that is where Carstens' skills may prove particularly useful.

As undersecretary of Finance from 2000 to 2003, Carstens gained a reputation as an affable and effective political operator when he shepherded financial reforms through a divided Congress. The reforms included an overhaul of the pension fund system to grant pension administrators more leeway in investing, the adoption of incentives for banks to increase their capitalization and a consolidation of rules to allow foreigners to take full control of local banks. The latter two reforms helped the banks finally emerge from the wreckage of the financial crisis in the mid-'90s. "He was patient, going over the financial details carefully with legislators," says John Welch, a senior vice president for sovereign strategy at Lehman Brothers in New York who followed the government's financial reform process at the time.

Carstens proved similarly adept at navigating the political backrooms when he was at the Banco de México, where he worked alongside Mexico's lead debt negotiator, Angel Gurría, in developing the Brady plan in 1990. His tenure as one of three deputy managing directors at the IMF from 2003 to 2006 gave Carstens a "finger on the pulse" of international financial issues and close contacts with senior policy makers in the U.S. and other major countries, says Riordan Roett, director of the Program in Latin American at the Johns Hopkins University School of Advanced International Studies.

Foreign observers say his background gives him advantages his predecessors never had. "He saw the failure of fiscal reform when he was in the Fox government and has probably taken a lot away from that experience," says Douglas Smith, chief economist for the Americas at Standard Chartered Bank in New York. Carstens, displaying self-confidence behind his unassuming demeanor, says simply, "I know the legislative process."

Carstens' skills have been recognized by opposition parties. During the budget discussions in December, Carstens' efforts to find a consensus "left a good taste in everyone's mouth," reports PRI legislator Jorge Estefan Chidiac, chairman of the finance committee in the Chamber of Deputies. That could be taken literally: The hefty Carstens, who understands the importance of the schmooze in getting things done in the capital, is often spotted dining tête-à-tête with legislators. One night in early February -- just after flying back from a grueling series of meetings in Washington with Treasury Secretary Henry Paulson, Federal Reserve Board chairman Ben Bernanke, Homeland Security Secretary Michael Chertoff and World Bank and Inter-American Development Bank presidents Paul Wolfowitz and Luis Alberto Moreno -- the indefatigable Carstens went to dinner at a Mexico City restaurant with Emilio Gamboa, leader of the PRI legislative bloc and a crucial swing vote in Congress.

"He likes to eat, but he uses lunch as a way to talk with people," says Cidac's Rubio. "He likes small talk, and that makes him attractive to politicians." That also makes him a welcome change after the imperiousness of previous Finance ministers. Carstens' immediate predecessor, Francisco Gil Díaz, was seen as an orthodox economic bureaucrat whose occasionally biting humor didn't play well in Mexico's often rough and rowdy political circles.

Tax reform is closely related to another structural issue that previous governments have occasionally talked about but never addressed: namely, the constitutional monopoly on oil production held by Pemex. With the country's proven oil reserves in decline, Pemex forecasts that output -- of which roughly half is exported -- will slip to 3.2 million barrels a day this year from 3.3 million in 2006; the company needs to invest $10 billion to15 billion a year for the next six years just to keep production from falling further. Lower output, combined with the budget's forecast that the average price of Mexico's heavy crude will fall to $42.80 a barrel this year from $53.20 in 2006, implies a sizable drop in export revenues.

The weakness of such an important cash cow threatens Mexico's fiscal stability. At Davos, President Calderón dangled the possibility of allowing private investment in Pemex -- but that is likely to meet stiff resistance from legislators, many of whom consider unimpeded national control of oil reserves sacred.

Pemex is not part of Carstens' portfolio, but he is well aware that its future health will influence everything else on his agenda. "Pemex will continue to be the most important company in the country," he says. The government will maintain efforts by the Fox administration to ease Pemex's tax burden, he says. The $15 billion in investment spending this year will be financed by tax savings adopted in 2005 that are aimed at encouraging deep-water explorations.

Carstens says that in the long run the government wants to reduce its dependence on Pemex. That is music to the ears of some opposition leaders. "We have to stop depending on oil already," says PRD bloc leader González Garza.

A failure to implement fiscal reform and adjust for the decline in oil revenues, as well as mounting pension liabilities, would be felt in nearly every sector of national life. According to official projections, the budget is expected to slip back into deficit, reaching 3 percent of GDP, by the end of Calderón's term in 2012. Such a deterioration would threaten the hard-earned stability that Mexico achieved by tightening public finances after the 1994 peso crisis.

Most Mexican observers believe that tax reform must tackle the privileges and tax breaks that Mexico's business elite have long enjoyed, such as accelerated depreciation schedules and provisions that allow holding companies to use losses in subsidiaries to reduce their tax payments. The eight parties in the Chamber of Deputies have pledged to introduce a fiscal reform package within six months, but an air of skepticism remains. "How will Calderón tax the [business] groups that brought him to power?" wonders Mario di Constanzo, the senior financial adviser to López Obrador.

Achieving fiscal reform would allow Carstens, and the government, to focus on other pressing challenges for Mexico: increasing growth and improving competitiveness. Even a stellar record of foreign direct investment has failed to generate enough well-paying jobs to stem the flow of hundreds of thousands of illegal immigrants across the U.S. border each year. Carstens concedes that ensuring macroeconomic stability and healthy public finances "are necessary but not sufficient conditions" for stimulating growth.

One answer, he says, is to channel more public funds into large-scale infrastructure projects in labor-intensive sectors such as housing, tourism and agriculture. The 2007 budget includes double-digit spending increases on infrastructure, law and order, communications, agriculture and tourism, while education and antipoverty programs receive smaller rises. The government also will encourage banks to extend more credit to small and medium-size businesses. Carstens says measures could include tax breaks for public-private partnerships involved in new infrastructure projects and incentives for banks to grant loans at favorable rates to small exporters.

Helping businesses surmount Mexican red tape and petty corruption is an even tougher job. Here again, Carstens says he has ambitious goals. He promises a fresh look at the country's regulatory structures and says that, along with his counterparts in the Economy, Energy, and Communications and Transportation ministries, he will "modernize the regulatory framework of different sectors."

Such promises have been made -- and left unfulfilled -- before. The PRI's long political dominance allowed the creation of privileged preserves throughout the economy. Mexican regulatory authorities are historically weak, and big companies have typically short-circuited efforts to crack down on monopolistic or oligopolistic practices by obtaining an amparo -- equivalent to a court injunction -- that can paralyze proceedings for years. Many of the country's leading businessmen supported Calderón in hopes of fending off the threat from a resurgent Mexican left, and it remains unclear whether the government will take on its business allies on competition issues. In remarks made during the World Economic Forum in January, Calderón complained that the country's big banks were holding back growth by their failure to provide credit at competitive rates.

All in all, it's a daunting agenda that Calderón and Carstens have set for themselves, and their window of opportunity is tight. The president serves a single six-year term, and traditionally the first 15 months are the make-or-break period for a government. The budget deal was a good start, but the new team in Mexico City will have to produce bigger results soon. Carstens, who has spent much of his career helping to restore Mexico's economy from the ravages of the 1994 crisis, knows this better than most.

"Economic confidence takes a long time to recover," he tells II, "but is lost very easily." Carstens is determined that Mexico won't lose it on his watch.

Interview Agustín Carstens

A consensus builder

Agustín Carstens has maintained a low profile despite being one of the most experienced players in Mexico's policymaking establishment. At Banco de México he helped negotiate the refinancing of the country's debt under the Brady plan in 1990 and the U.S. Treasury­led bailout during the Tequila crisis in 1995.

Now the 48-year-old economist is firmly in the limelight. As Finance minister, Carstens hopes to promote ambitious tax reforms aimed at fostering growth.

His orthodox background provides reassurance to financial markets. He is a firm believer in fiscal discipline and free trade, having earned his economics Ph.D. at the University of Chicago; his thesis adviser was Michael Mussa, who went on to become chief economist at the International Monetary Fund, where Carstens also later worked.

Carstens discussed his agenda recently with Institutional Investor Contributing Editor Lucy Conger in his Mexico City office.

Institutional Investor: How have you been working with Mexico's divided congress?

Carstens: We've established a solid relationship based on a very open, very frank dialogue. President Calderón was president of the PAN legislative bloc in the Chamber of Deputies, so he knows the legislative process very well. He's instructed us to work closely with Congress, and the Finance Ministry has looked for ways to consider the concerns of the different parliamentary groups and seek consensus. That formula has already produced very good results.

But will there be a different atmosphere now that really difficult proposals like fiscal reform are on the table?

We are going into this with an open attitude. We want to listen to the parties' proposals. Obviously, we are also developing our ideas, and we will seek a consensus that allows us to strengthen public finances.

What can you do to make Mexico grow solidly?

We must reduce poverty and increase employment and growth. Preserving macroeconomic stability and having sound public finances are necessary conditions, but not sufficient. It's important to have a tax system that is efficient, with the fewest distortions possible, and one that gives legal security to investors. Spending must be more efficient and transparent, and at the margin, funds must be channeled to projects that can most support private productive activity.

Are there other factors that would enhance growth?

Improving public safety not only provides social benefits but also helps the economy. Insecurity in Mexico generates costs, and to the extent those costs are reduced, our industry will be more competitive. We are looking to promote sectors that can create employment, such as tourism and housing. We will also dedicate more attention to the rural sector, specifically agriculture.

What can Mexico do to confront competition from China and take advantage of the North American Free Trade Agreement?

Mexico's geographic proximity to the U.S. and the working cooperation between Mexican and U.S. companies offer many advantages. I'd like to see greater economic integration over time between Mexico and the U.S. Better regulation, better infrastructure and better-trained workers can provide Mexico with comparative trade advantages. We have to look for ways to distinguish ourselves from China and turn China into an opportunity.

Why are populist leaders appearing again across Latin America?

What has distinguished Latin America from other countries is its proclivity for crises. This has left social conditions lagging behind, and a cycle has been created that feeds desperation and then leads to the emergence of leaders who seek the easy way out. Perhaps the most important problem is that after the various crises, the efforts begun by many countries to stabilize their economies were not continued. Economic confidence takes a long time to recover, but is lost very easily.

What worries me most is that we are not strengthening our institutions enough. Some countries have been moving in the opposite direction, toward the destruction of institutions.