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Reforma school

President Fox and central bank chief Ortiz are desperately trying to educate Mexicans on the need for economic reform, even as recovery makes it appear less urgent.

The number was even grimmer than expected. On February 17 the Finance Ministry disclosed that Mexico's economy had grown only 1.3 percent in 2003. This meant that President Vicente Fox, midway through his six-year term, had presided over GDP growth of just 0.7 percent a year on average -- the worst record for a Mexican president during his first three years in office in almost two decades.

Fox, however, was quick to defend his record. Yes, growth was sluggish, he acknowledged, but it was "growth with quality": Mexicans were enjoying real increases in income because of low inflation and a stable peso. And he pointed to a pattern of improving growth (liberally rounding the numbers to emphasize his point): 0 percent in 2001, 1 percent in 2002, 2 percent in 2003 and a government-projected 3 percent in 2004. "We're nearing 7 percent little by little," Fox declared. That elusive number was the robust rate of growth that the president had promised for 2003­'06 during his spring 2000 election campaign.

But when Fox asserted on February 23 at a convention of the Confederación de Trabajadores de México, the huge labor union affiliated with the political opposition, that workers were actually better off despite the lackluster growth, because of the lowest inflation in 34 years, the president endured loud whistles -- a sign of disrespect in Mexico -- as newspapers gleefully reported the next day. Prominent economic columnist Enrique Quintana of the newspaper Reforma pointed out that Fox's public pledge that Mexico would achieve 7 percent growth during his term was flatly contradicted by his own government's budget forecast, which anticipates only 4.5 percent growth by 2006.

"It is as if the president were detached from reality," says Guillermo Valdés, director of political analysis for Mexico City think tank Grupo de Economistas y Asociados. "The Fox administration has a vision of the country and reality that is not shared by the majority of people, especially the most informed sectors."

That vision gap is becoming more and more glaring in Fox's dealings with Congress. Although still personally popular, with an approval rating in February of about 55 percent, the handsome and personable former Coca-Cola Co. executive -- the first president of Mexico in 71 years who is not from the long-dominant Partido Revolucionario Institucional (PRI) -- has been ineffectual at pushing critical economic reforms through Mexico's fragmented legislature. In the most damaging episode to date, Fox's sweeping tax-overhaul package was defeated in December for a second time, putting in grave doubt the government's entire agenda of structural reforms. The president has now been rebuffed not only on his plan to lower personal and corporate income taxes while imposing a value-added tax on food and medicine but also on his proposals to partially open Mexico's energy industry to private investment and to loosen restrictive labor regulations.

With key elections for ten of Mexico's 31 states imminent and the contest to succeed Fox in July 2006 all but under way, the government and Mexico both appear to be increasingly adrift. "Fox is not just a lame duck but a dead duck," says George Grayson, a professor of Latin American political studies at the College of William and Mary in Williamsburg, Virginia. "Nothing moves in Congress because of the elections."

Luis Rubio, president of the Center of Research for Development, a pro­free market Mexico City think tank, characterizes the country's situation this way: "In the past decade the sense of direction was totally lost, and this administration has not been capable of recovering it. The presidency no longer has the instruments that previous presidents had -- the marriage between the PRI and the government -- and Fox has demonstrated a lack of political skills. Moreover, he didn't have a proper strategy to begin with."

Mexico's current malaise, whatever its cause, makes the task of central bank chief Guillermo Ortiz all that much harder -- and all that much more vital. "His only real job -- and it's a very important one -- is to convey certainty to markets, to convey that monetary policy is not going to go astray," says Rubio. Adds Christian Stracke, head of emerging-markets research at CreditSights, an independent, New York­based financial analysis firm: "In a place like Mexico where political continuity is questionable, it is important to have institutional continuity. Ortiz provides that."

The seasoned central banker, who was confirmed for a second term as head of the Banco de México by Mexico's Senate on December 11, has done a masterful job so far. Ortiz, who has a Ph.D. in economics from Stanford University, has reduced Mexico's rampant inflation from about 18 percent when he took over the bank in January 1998 to less than 4 percent. Fox's claim that Mexican workers are faring better because their raises aren't consumed by soaring prices is not entirely wrong. The Banco de México sits atop a record $58 billion in foreign reserves to back up both the peso and Mexico's creditworthiness -- which has reached the coveted investment grade under Ortiz. Currency stability has returned to a country that suffered six wrenching devaluations in 18 years. Meanwhile, working in tandem with Ortiz to establish a sound underpinning for the economy, Finance Minister Francisco Gil Díaz has reduced the country's budget deficit from 0.65 percent of GDP to 0.50 percent (this year's target: 0.30 percent), while paring foreign debt to a manageable 13.4 percent of Mexico's GDP.

"We in Latin America have written the textbook on failures, but we have also written the textbook on successes, and we have learned a lot," Ortiz tells Institutional Investor. "The country has made enormous advances in many fields. It is much more resilient to external shocks. It's very significant that we were given investment grade in the midst of an economic recession in the U.S. and Mexico. Not long ago we placed a 20-year bond. In 1995 we had difficulty placing 20-day bonds." Nevertheless, he adds bluntly, "we have to move a lot faster in all those elements that make the economy more flexible and agile to respond to future external shocks."

To Ortiz, the case for sweeping reforms has long been compelling (see interview, page 56). In speech after speech he has catalogued a backlog of problems besetting the Mexican economy: The country hasn't carried out any fundamental economic reforms in six years; it doesn't properly exploit its vast natural-gas reserves; the government can't raise enough tax revenue to support education, health and social services or infrastructure development; excessive labor regulation deters job creation; too much of the federal budget is devoted to current expenditures and not enough to energy, social initiatives and roads.

"Thank God Ortiz is out there pounding the table, saying we're losing competitiveness," exclaims Jack Sweeney, executive vice president of the American Chamber of Commerce of Mexico in Mexico City.

Ortiz often speaks about Mexico's deep-seated economic problems with a frankness that can be startling. No doubt this is in part a measure of how much the role of Mexican central bank boss has changed since the institution was granted autonomy in 1994. But it also reflects Ortiz's firmly held conviction that as head of the bank he has a duty to comment on economic issues, letting the chips fall where they may.

"It's certainly not my intention to be constantly pointing out problems," Ortiz asserts. "What we try to do is to make a realistic diagnosis. All central banks in the world do this."

In November it was by no means clear that Fox would renominate Ortiz to another six-year term when his current one expired on December 31. Some members of the president's conservative Partido Acción Nacional (PAN) charged Ortiz -- who happens to be a member of the rival PRI -- with mishandling Mexico's big mid-1990s bank bailout when he was Finance minister.

The rescue remains a contentious issue. Ortiz, as undersecretary of Finance, had presided over the controversial 1991­'92 privatization of Mexican banks, unwinding their 1982 nationalization. The peso crisis of 1994­'95 rocked many of these newly private banks. Observes Ortiz: "With the nationalization of banks in 1982, a generation of bankers disappeared. There wasn't sufficient experience and administrative capacity. As a result, when the peso devaluation came, it set off a full-blown financial crisis."

Named Finance minister a few days after the calamitous December 20, 1994, peso devaluation, Ortiz promptly helped Mexico secure an emergency $50 billion loan from Washington and the International Monetary Fund to prop up the currency and meet debt payments. He also imposed an unpopular austerity regime that postponed government investments, raised tariffs and squeezed subsidies. Ortiz predicted ­2 percent growth in 1995; instead, it was ­6.5 percent, though a brisk recovery began the following year.

Turning his attention to the banks, Ortiz put together a mammoth $90 billion bailout package in 1996­'97 that resolved the immediate crisis but prompted angry legislators from the then-opposition PAN to demand that the Finance minister be put on trial. Many in the Chamber of Deputies disputed the administration's rationale for the bank rescue, and they commissioned an audit that found that the government had absorbed several "irregular" loans that were made to bank board members or lacked proper collateral. (One such loan was for $2 billion.)

Within Fox's own party, resentment of Ortiz has lingered. As his renomination deadline drew near, some PAN senators objected to the very idea that a holdover from the long-dominant PRI like Ortiz (another: Finance Minister Gil Díaz) would remain in a pivotal position in a PAN government. As if those weren't grievances enough, Ortiz's strict monetary policies, while undeniably taming inflation and stabilizing the economy, were blamed by many businesspeople -- PAN's natural constituency -- for the economic stagnation of the past three years.

Ortiz responds: "Of course the Banco de México is worried about economic growth -- all central bankers are. But we think that the best contribution that we can make to economic growth is to provide economic stability. But stability is not sustainable without growth."

Fox's lobbying on Ortiz's behalf -- and the central banker's indisputably sound record of monetary management -- overcame the resistance to his second term. Ortiz now has a fine forum for pressing the administration and Congress for reforms.

He has said publicly on many occasions that Mexico must embrace significant structural initiatives to remain competitive and achieve sufficient growth to accommodate population growth and ameliorate grinding poverty. As Ortiz told II early this month: "We are approaching economic stability, meaning low interest rates and relatively low inflation. And now that external demand is picking up, we're seeing the economy grow again. But this doesn't mean that we are meeting the challenges that a more competitive world environment implies. To sustain this cyclical recovery, we need to do structural reforms."

Fox's coordinator of public policies, Eduardo Sojo, has put a price on what the administration regards as Congress's -- and the opposition PRI's -- intransigence on reforms. The government and most analysts reckon that the U.S. recovery, coupled with higher earnings from oil exports, should allow Mexico to resume passable 3 percent GDP growth this year. But Sojo calculates that if Fox's fiscal, energy and labor reforms were in place, growth would be more than 5 percent -- maybe not the 7 percent the president promised but enough to begin to absorb the 1.3 million new entrants into the labor pool each year. "Despite U.S. economic growth," says José Antonio Crespo, a political scientist at the Centro de Investigación y Docencia Económica in Mexico City, "Mexico without reforms is falling behind in competitive terms."

Fox's reform policies will be subject to an indirect referendum in the state elections, which are considered a dress rehearsal for the presidential election. (Mexican presidents serve a single six-year term.) In last year's midterm races, Fox's PAN sustained a severe blow when it not only lost 50 seats in the 500-seat Chamber of Deputies -- one fourth of its total -- but also gave up the governorship of the state of Nuevo León, which encompasses Mexico's industrial capital, Monterrey, and is a longtime PAN bastion.

The loss of Nuevo León was both an insult and an injury to PAN. State governors have grown in national power ever since Fox wrested the presidency away from the PRI in a sweeping political realignment three years ago. Increasingly, governors are seen as pivotal to ensuring that legislators from their states vote along party lines in Congress.

Starting in July and running through November, governors' races will take place this year in states that are home to 43 percent of Mexicans. PAN and the center-left Partido del la Revolución Democrática (PRD) have agreed in principle to back a coalition slate in Chihuahua and Oaxaca, which have been PRI strongholds. In five of the six other states holding elections -- including oil-producing Veracruz and Tamaulipas and agribusiness center Sinaloa -- the PRI looks unshakable. PAN, however, is expected to win in small Aguascalientes, where it already holds the governorship. Overall, the state elections are widely expected to give a boost to the PRI's efforts to regain lost political ground.

Meanwhile, the positioning for a presidential election that is still 27 months away has already begun. During the week of January 19, no fewer than six politicians -- including Fox's wife, Marta Sahagún de Fox -- let it be known that they would like to run for president or at least that they hadn't ruled out the possibility. The six didn't even include the three most likely, and most credible, candidates: Interior Minister Santiago Creel for PAN, Mexico City Mayor Andrés Manuel López Obrador for PRD and party head Roberto Madrazo for PRI. None will say officially that he's seeking the nomination.

Mexico's first lady has since become the campaign's first dropout. In mid-February a growing controversy over her supposed use of her personal charity to promote her candidacy, combined with relentless media attention, had created such a public uproar, and such a headache for her husband, that she renounced her presidential ambitions.

At this early juncture, the smart money is on the charismatic López Obrador (Institutional Investor, September 2003), who recently held a 20-point lead in the polls, although breaking scandals involving two of his former aides threaten to taint his squeaky-clean image. Though a founder of the leftish PRD, López Obrador has been conspicuously friendly to big business, offering companies incentives to create employment and to invest in renovating downtown Mexico City. He opposes local tax increases and has imposed anticorruption and austerity measures that have sharply trimmed bureaucrats' perks.

At the same time, López Obrador has introduced measures to help the poor through cash transfers to single mothers, the elderly and needy children. And he is building a massive freeway system in Mexico City whose eventual impact on the municipal budget remains to be determined. Some political analysts criticize his ostentatious populism, but as well-known social commentator Carlos Monsivaís tells II, "All Mexican politicians are populist because the majority of the country is poor." López Obrador has given no real indication of how he stands on the market-oriented reforms of Fox or on the disciplined monetary regimen of Ortiz.

The prospect of an electoral free-for-all lasting for more than two years so worries leaders of the three main parties that in late January they all issued calls for restraint and a focus on national issues. Nonetheless, presidential politics, premature or not, are bound to weigh on everything the Fox government attempts to do from now on -- including pressing for reforms.

Fox insists that he will squeeze his fiscal reforms through the Chamber of Deputies on the third try. Few on the left or right dispute that the government desperately needs to raise more revenue through taxes: Mexico collects the equivalent of only about 12 percent of its GDP through corporate and personal income taxes and VAT, one of the lowest proportions of any country, developing or developed. Ortiz calls fiscal reform "my first priority," pointing out that Mexico needs "many more resources to upgrade its infrastructure -- human capital, social development, poverty-alleviation, education, technology and so on."

Even after adding the contribution from Petróleos Mexicanos, or Pemex, the state oil and gas monopoly, to the revenue pot ($5.3 billion, or 37 percent of the federal budget, in 2003), the government finds it hard to finance such basic infrastructure projects as building and maintaining a decent highway system. Fox's latest tactic is to relaunch his fiscal reforms -- including the unpopular value-added tax on food and medicine -- through the National Fiscal Convention, a body of federal, state and municipal authorities that the president convened last October and which is meeting from February to July to hash out fiscal policy and make a blanket proposal to Congress. The Fox team hopes to build a consensus for its existing reforms with state governors and political parties. His coordinator of international information, Agustín Gutiérrez Canet, contends, "It's practically automatic that the convention's recommendation will be approved in Congress."

Perhaps, but many skeptics point out that the convention is ultimately a political debating club not a legally constituted entity charged with fiscal reform and that its conclusions are not binding on either Congress or the administration. In an election year, they add, governors have scant incentive to approve measures that would raise their constituents' taxes.

Moreover, Fox appears to be as inflexible on the tax issue as Congress is. Gutiérrez Canet acknowledges that "Fox maintains the same objectives" on tax reform as he did before Congress twice defeated his proposals and is merely "changing strategy."

The president has proposed lowering corporate income taxes from 35 percent to 30 percent by 2005. Domestic and foreign companies complain that the federal tariff on corporate profits is burdensome, especially because an additional 10 percent of gross profits must be distributed to workers under profit-sharing tax legislation. Fox has proposed lowering the top personal income tax rate from 35 percent to 30 percent.

The controversial centerpiece of Fox's reforms, however, remains the 10 percent value-added tax on most foods and drugs. Seen simply as an expedient way to raise taxes, it is projected to yield an additional $7 billion in revenues, slightly more than 1 percent of GDP. Fox has defended the VAT, saying it would permit more social spending on the poor.

The PRI, striking a populist stance, fiercely objects to a regressive tax on either medicine or food. The party also opposes the Fox tax because of a PRI campaign promise not to raise levies. The party's control of close to half of the seats in the Chamber of Deputies gives it tremendous bargaining power. The 95-member PRD bloc in the chamber has also stood firm against the VAT measure, arguing that it would hurt the poor.

The poor aren't the only ones feeling the economic pain in Mexico. Tampico-based businessman Adolfo Hellmund, who manages a private equity fund with interests in hotel chains, retailing and industry and is a shareholder in a textile business, recently attended the 25th reunion of his class at the prestigious Tecnológico de Monterrey, which is patterned on the Massachusetts Institute of Technology and trains high-level technocrats to run businesses. The reunion weekend was to cost $400 per person, including lodging and meals; only 12 signed up. So the event was "reengineered" to cost $200, Hellmund says, and 30 people ended up going. "For a good number of people," he says, "$200 was the difference between going and not going after 25 years of working." Between 30 and 40 percent of his class of '78 are out of work, many the victims of cutbacks at Mexico's biggest companies, including Alfa, Cemex, Vitro and banks.

Today Mexican business is experiencing a triple whammy: the final phasing out of most of its protective tariffs under the Nafta regional trading agreement; China's extraordinary evolution into a low-cost manufacturing powerhouse; and the emergence of a massive global labor pool that competes for both skilled and unskilled jobs.

"The comparative advantages of Mexico are eroding," admitted Jaime Serra Puche, former minister of Trade and Industrial Promotion and Mexico's chief Nafta negotiator, at a conference last fall. In an interview with Spain's El País newspaper, Finance Minister Gil Díaz noted sardonically, "We depend on the U.S. no more than 99 percent." But he added: "We'd like something more diversified. In any case, it is not possible to think that the Mexican economy is going to delink from the U.S., because that is something that has no remedy."

"Nafta is not enough," says World Bank senior economist Daniel Lederman. "The gains from Nafta don't come close to what some of its promoters still claim." Nonetheless, his bank stated in a draft report on Nafta this year that the trade accord "has brought significant economic and social benefits to the Mexican economy." The report also said, however, that Mexico would be unlikely ever to reach more than 50 percent of U.S. GDP per capita if Nafta is not followed by a deepening of trade ties and additional policy reforms by Mexico. More pessimistically, the Carnegie Endowment for International Peace concluded in a study issued last October that Nafta did not bring job growth to Mexico and that real wages for the country's workers were actually lower now than at the time the deal was signed.

With Nafta, Mexico set itself up as an assembly and manufacturing platform for the U.S. Today that strategy is in doubt. Entire sectors of the Mexican economy, such as toy makers, textile and clothing manufacturers and shoemakers, have been all but wiped out. Fierce competition from China, compounded by the U.S. recession, has cost Mexico more than 430,000 mainly manufacturing jobs since 2000. In 2003, China overtook Mexico to become the U.S.'s second-largest trading partner after Canada.

"Competitiveness based on labor cost reductions is basically over for Mexico except perhaps in southern Mexico," asserts Lederman. The agreement failed to stimulate domestic research and development and primarily drew multinationals wanting to assemble goods made elsewhere. He argues that Mexico, like developed countries, must shift toward growth driven by productivity gains and by knowledge and innovation.

Unfortunately, Mexico ranks next-to-last among the 27 nations in the Organization for Economic Cooperation and Development in years of schooling: nine on average. Only about 9 percent of Mexicans aged 20 to 29 are studying at the college level. "In some Asian countries," points out Ortiz, "all education and human development indexes were considerably lower than those of Latin America 30 years ago, and today they're considerably higher. This should be a benchmark" for improvement.

The harsh realities of the global marketplace seem to have stunned Mexican companies. "During those ten years [of special trade treatment under Nafta], many issues which relate to competitiveness of industrial firms were not done," says Luis Téllez, a former Energy minister and onetime executive vice president of industrial conglomerate Desc who was recently named one of two Mexican representatives of Washington venture capital firm Carlyle Group.

Foreign multinationals fault the Fox government for a lackadaisical attitude toward attracting investment. "The government has not understood what it has to do, because its neighbor is the U.S.," maintains Steve Knaebel, president and general manager of the Mexican subsidiary of U.S. engine maker Cummins. "They haven't benchmarked; there's no hustle."

Ortiz sees "flexibility" as a large part of the solution to Mexico's plight: "We have to move much more quickly to [adopt] elements that make the economy more flexible and agile -- flexibility of labor markets, flexibility in goods markets, deregulation, more agile legal and judicial procedures." All these, he says, form "the spinal column of how a market economy should function."

The financial system that he helps to oversee might not be a bad place to start. Mexico's bank lending remains wholly inadequate for industry, despite growing by 11 percent in 2003. Fernando Sánchez Ugarte, the head of Mexico's competition commission, has slammed the banking system for being too concentrated and charging excessive interest rate spreads and fees. "We need to stimulate competition in the financial sector to guarantee that financing flows to the productive sector," he declared in a report last November.

Ortiz gives this assessment: "It is the responsibility of the central bank to watch over the healthy development of the financial sector, and given its concentration, structure, etc., this should entail more accountability, more transparency, better corporate governance and more responsiveness [by foreign-owned banks] to local needs."

Like other multinationals in Mexico, Cummins mostly steers clear of local banks for financing; instead, it relies on GE Capital to underwrite its joint-venture generator-rental operations. "A big obstacle in this country is the banking sector; it moves slowly, it's risk averse, and the money it provides is very costly," says Cummins's Knaebel. Half of all lending to industry in Mexico comes from suppliers, not banks.

It's not hard to understand why. The laws favor borrowers. Banks, meanwhile, can collect generous rates on government bank-rescue bonds and, until interest rates fell, on federal certificates of deposit. So they have little incentive to go out of their way to lend to any but the biggest, safest companies. Recent bankruptcy "reforms" intended to make it easier for lenders to recoup losses are too halfhearted to induce banks to lend to business with any great enthusiasm. Mexico must "really, really reform and have judicial system support for laws built around credit and repossession," says Bill Meyers, managing director of shipping company Case Mexico.

Ironically, in one of the world's great petroleum producers, energy policy needs urgent reform. Demand for energy is outstripping supply, blackouts occur frequently, and high energy prices hinder industry and hurt consumers. Gasoline and diesel fuel as well as electricity are all more expensive in Mexico than in the U.S. and Canada. A liter of regular gas costs 61 cents, or $2.58 per gallon.

"Mexico should take advantage of its natural resources to give business an energy platform," says Ortiz, warming to his subject. "One way to compete with China is in energy. We have immense reserves of natural gas that we are barely beginning to measure. We know there's a lot, but we don't know how much exactly. Why? Pemex will invest $14 billion in 2003, and the greatest part of it goes to oil, some to refining, very little to gas. From the point of view of Pemex, it's very logical because extracting oil is much more profitable than extracting gas. But there's no other product more profitable in Mexico after oil than natural gas. So we are in the paradox of importing gas from a country with a deficit in gas [the U.S.]. If we could organize ourselves so the private sector could be working natural gas in sufficient quantities -- and it takes many billions of dollars -- Mexico could offer an energy platform at lower prices than the U.S."

Mexico's 1917 constitution, however, mandates that energy remain the province of state-owned and -operated companies. The results are predictable. Growth in demand for both natural gas and electricity is expected to exceed the increase in supply throughout the next ten years. "We can't go on having a monopoly providing hydrocarbon fuels in an economy of $700 billion -- either we buy from Pemex or we buy from Pemex," says former Energy minister Téllez. For his part, Ortiz strongly favors opening electricity generation and natural-gas exploration to private investors, including foreign ones.

When power is readily available in Mexico, it can be prohibitively costly. For industrial users, electricity runs 50 percent higher per kilowatt hour in Mexico than in the U.S. Pemex has set a price of $4.50 per thousand BTUs for natural gas over a three-year contract; the same quantity of gas in Japan would run about one third less.

High energy prices may hurt business and consumers, but they happen to serve the short-term needs of the Fox administration. "The government has not been able to collect enough taxes -- the only way to balance the budget is to charge more for natural gas, electricity, gasoline," explains Eugenio Clariond of Grupo Imsa, a steel and battery conglomerate.

Mexico's Energy Regulatory Commission estimates that $55 billion is required to build facilities to meet domestic power needs over the next ten years. In addition, according to the ERC, Mexico must invest a further $10 billion to efficiently explore for and extract natural gas from Mexico's promising fields, strategically located along the Gulf Coast and in the north of the country near the U.S. market.

Fox's energy proposals -- which he plans to resubmit to Congress later this year -- seek to amend Mexico's constitution to more fully facilitate private participation in power generation and natural-gas production, though not in oil production. Government officials reckon that these energy reforms alone could add as much as 2 percentage points to Mexico's GDP growth.

Nevertheless, both the PRI and the PRD, which between them control 76 of the 128 seats in the Senate -- where energy bills are first debated -- have been reluctant to relinquish control over any aspect of what they consider Mexico's national patrimony. Strong showings in the upcoming state elections would no doubt fortify their resistance to reforms. For Fox's bills to pass, suggests David Shields, an independent energy analyst in Mexico City, "something would have to happen that would move the opinion of senators who are saying the law won't be changed -- serious blackouts or a grave shortage of gas."

If electricity generation and natural-gas exploration are eventually opened to private interests, Mexico could attract an additional $20 billion in foreign direct investment between 2004 and 2009, predicts Alfredo Thorne, Latin America economist at J.P. Morgan in Mexico City. That would be a good beginning, especially if it were followed by infrastructure and legal reforms making it easier to do business in Mexico.

Fox may be wandering in a political wilderness as bleak as Mexico's Sonoran Desert. Yet the country's economy is beginning to recover nicely. Mexico City's IPC stock index broke through the 10,000 barrier last month, following last year's 43 percent gain. "We have financial stability -- low inflation, no crisis and no expectation of a crisis, either," says the Center of Research for Development's Rubio. Central banker Ortiz deserves much of the credit for that.

And yet, in a way, it's a shame that Mexico is doing better at all. Recovery dissipates the urgency for vital reforms. "This is a society that is refusing to adjust," sighs Rubio. And while Mexico dithers, China develops.

Ortiz: Why reform matters

For more than a decade, Guillermo Ortiz has been a pivotal, and often controversial, figure in Mexican finance. As undersecretary of Finance in 1991­'92, he led the privatization of Mexico's banks, unwinding their ill-conceived nationalization a decade earlier. Named Finance minister days after the calamitous peso devaluation of 1994, Ortiz played a key part in implementing austerity measures and finding foreign assistance so that Mexico could recover, albeit painfully. He also put together a still-angrily-debated $90 billion bank rescue package for the very banks that he had helped to privatize. As governor of the Banco de México since 1998, Ortiz has had remarkable success controlling inflation -- the central bank's prime mandate. Some, however, say the price has been economic stagnation. Ortiz, 55, who has a doctorate in economics from Stanford University, is an ardent champion of economic reforms. He spoke in March with Institutional Investor Contributing Editor Lucy Conger.

Institutional Investor: Mexico is recovering nicely. Why are economic reforms important?

Ortiz: Precisely to sustain the recovery. We are approaching economic stability, meaning low interest rates and relatively low inflation. And now that external demand is picking up, we're seeing the economy growing again. But this doesn't mean we are meeting the challenges that a more competitive world environment implies. To sustain this cyclical recovery, we need to do structural reforms.

What's the most important reform right now?

Fiscal reform is the key. If you solve the fiscal problem, you can do countercyclical fiscal policy. Second, you lessen your dependence on oil revenues. Third, by definition you have many more resources for upgrading infrastructure -- human capital, social development, poverty alleviation, education, technology and so on. We're talking only about increasing government revenues by a few percentage points of GDP; this is perfectly achievable starting from as low a tax base as we have. Mexico has a chronic problem of very low taxation -- not necessarily because tax rates are very low but because of gigantic tax evasion. That's correctable, but you have to start with changing the tax structure because there are a lot of loopholes that lend themselves to evasion. The Ministry of Finance just published estimates that evasion in value-added taxes is about one half of the total theoretical intake. You have a big hole there.

Why do Mexicans and other Latin Americans lag behind Asians in years of schooling?

It's a combination of factors. One is very rapid population growth in Latin America, particularly through the 1970s and '80s. Second, public resources are always insufficient. And priorities have been wrong. Governments in many Latin American countries embarked on the ownership of productive entities. Mexico in the late '70s or early '80s owned more than 1,200 state enterprises. Instead, we should have been focusing on the role of the state in education, social and human development, poverty alleviation -- capital-deepening in both the physical and human sense.

Is a poor infrastructure, from roads to telecommunications, holding Mexico back?

Asia in general and China in particular are not competing with us on the basis of low-wage jobs; they're competing on the basis of first-rate infrastructure. Parts of China that are growing quickly have high educational standards, good training programs, investment in technology and research. This is what we ought to be doing. This is the only basis for future competitiveness.

Where do energy reforms fit in?

I was in Monterrey today reading about projects to build terminals to import liquefied gas -- several have been approved already. That makes sense in the short term because Mexico has a shortage of natural gas. Yet, it's paradoxical that Mexicans cannot extract this gas from their own enormous underground reserves because a state monopoly is the only one authorized to do it, and it lacks the financial and the technical resources to extract the gas needed to satisfy demand. So here we are stuck with high natural-gas prices, high electricity prices, in a country that is energy rich.

What else does Mexico require to make it more of a developed country?

We have to strengthen our institutions. The transition to democracy has been extremely successful in electoral terms; fair elections are the norm and not the exception. But [that transition] has made life difficult in other ways with a divided Congress. Although the Supreme Court is independent and widely respected, we still have a long way to go to implement the rule of law and on all the microeoconomic issues. Clarity in the rules of the game in business and in the enforceability of contracts is an essential part of the institutional framework of a mature economy.

What about banking reforms? Some business people complain that they have to pay too much for loans.

As interest rates have come down, so have [commercial] lending rates but not at the speed one would expect. It's true banks in Mexico face higher regulatory costs than in other countries, but there's also probably not sufficient competition in the banking sector. To stimulate competition, we publish a Web site giving information regarding all the charges that banks have for services. We are trying to make this information comparative and available to consumers. And I've proposed that banks list a portion of their capital on the stock market, so that they are subject to market discipline. After all, Banco de México is the lender of last resort of a financial system that is primarily foreign-owned. We have to work on ways to make banks that are affiliates of large foreign banks more responsive to the needs of the Mexican economy. Healthy development of the banking sector, given its concentration, structure, etc., should entail more accountability, more transparency, better corporate governance and more responsiveness.

Mexico is already in a campaign mode, although the presidential election is two years off. What can you do to ensure economic stability amid all the political tumult?

This is not only up to the Banco de México. Central to economic stability is fiscal discipline, which this government has exercised and which Congress has sanctioned. We have had a divided Congress for more than seven years, yet fiscal responsibility has been maintained. Both Minister of Finance Francisco Gil Díaz and President Vicente Fox have been key in maintaining fiscal discipline, and the market is aware of that.

Some businessmen complain that your tough monetary policy has put a damper on growth.

Inflation has come down substantially, and that has contributed to reducing interest rates to historically low levels. And although the yield curve has flattened quite a bit lately, long-term rates have not risen. This provides a platform for access to finance, an important ingredient of growth. Of course, Banco de México is worried about growth. All central bankers are. But the best contribution we can make for economic growth is to provide economic stability.

So what does Mexico need to do now?

We have achieved a degree of economic stability. But stability is not sustainable without growth. We need growth and employment, and the way to get on that path is by increasing productivity and increasing the flexibility of the Mexican economy so that it's able to adapt to changing world conditions. First, we have to take stock of where we are today, identify what needs to be done, and then get political consensus so that the modernization agenda of the country becomes its political agenda. The diagnosis is clear -- we don't have to go through a lot of soul-searching to know the direction in which we should go. And a lot of people in all sectors, including political parties, share this view. What needs to be overcome is the implementation part. You have to get down to it.