MEXICO: PROSPECTS FOR ECONOMIC POLICY SHIFTS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP86T00589R000300380001-3
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 23
• Document Creation Date: December 22, 2016
• Document Release Date: March 7, 2011
• Sequence Number: 1
• Publication Date: September 1, 1985
• Content Type: REPORT

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didential-
. Directorate of
Intelligence
Mexico: Prospects for
Economic Policy Shifts
ALA 85-10091
September 1985
Copy 360
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Directorate of Confidential
Intelligence
Mexico: Prospects for
Economic Policy Shifts
ALA,
This paper was prepared by Office
of African and Latin American Analysis. Comments
and queries are welcome and may be directed to
the Chief, Middle America-Caribbean Division,
Confidential
ALA 85-10091
September 1985
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Mexico: Prospects for
Economic Policy ShiftsF-7 25X1
Key Judgments Mexico appeared to rebound solidly from the economic crisis of 1982,
Information available judging from its announced 3.5-percent growth rate in 1984 and continued
as of 9 August 1985 success in negotiating international debt rescheduling agreements. This
was used in this report.
favorable record was underpinned, however, by unsustainable domestic
policies and Mexico City now is facing some hard decisions.
Key government officials began priming the pump in mid-1984 with
sharply higher public spending, even though it could cause rising prices and
overvaluation of the exchange rate. We believe the policy shift reflected the
leaders' belief that Mexicans would not accept more austerity as well as
their perception that it was necessary to make a strong showing in the July
1985 midterm elections.
Stimulation of the economy continued during the first half of this year,
pushing economic activity to expand at an annual rate of 6 percent. The
pickup in the economy, the growing overvaluation of the peso, and
declining oil prices, however, precipitated a sharp deterioration in the
balance of payments. This trend and the runup in the public-sector deficit
forced Mexico City to announce a devaluation and spending cuts soon after
the July elections.
Although some of the political imperatives for a stronger economy
temporarily eased and allowed new austerity measures to be imposed, in
our view the lure of more expansive policies will remain strong as President
de la Madrid gauges the public's willingness to accept further stringency.
Mexico City will still have to face more than a dozen gubernatorial
contests in 1986 and the beginning of the yearlong campaign for the
presidency in 1987. The greatest pressure for continued expansion is from
the 4 million Mexicans who are unemployed and the even greater numbers
who are unable to find full-time jobs. Moreover, given Mexico's demo-
graphic profile, the problem will only get worse before the end of the de la
Madrid term in 1988.
In 1986-88, at least conceptually, Mexico could achieve an annual growth
rate in the 4- to 5-percent range if relatively favorable global economic
conditions continued, including United States economic growth of about
3 percent annually, oil prices remaining near their present levels of $24 a
iii Confidential
ALA 85-10091
September 1985
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barrel, and international interest rates holding near their current average
level of 8 to 9 percent. However, foreign lenders would have to provide
some $6 billion annually, far above the amount they are presently willing to
lend.
In reality, an expansionary growth path would quickly run into a number
of key constraints. The budget deficit would rise to 12 to 15 percent of
GDP and by its very nature result in an easy monetary policy and high in-
flationary pressures throughout the period. Externally, Mexico's trade and
current accounts would also deteriorate further. By 1988, we project
Mexico's current account surplus would disappear. As expansive policies
take their toll, Mexico's ability to grow would become increasingly checked
by the severity of the country's foreign exchange situation.
Continued government expansion, even at present rates, is producing
unfavorable economic factors that we believe will inevitably force de la
Madrid to introduce belt-tightening policies similar to those imposed in
1983. If such policies were introduced in early 1986, we project economic
activity would be throttled back to about 1-percent annual growth.
Given Mexico's relatively sizable foreign exchange reserves and the intense
political pressure, the government could decide to postpone full imposition
of adjustments for a year or more. As delays continue, the inevitable
trauma would be even greater when the government tried to slow the pace
of the overheated economy.
The longer the delay, the greater the risk that the government will
overcompensate when it finally takes action and cuts back spending. Such
overreaction would be made even worse if the wrong policy signals sent to
the private sector result in spurred capital flight and a drain on invest-
ments. The effects of such a policy fiasco could be substantial. Not only
would Mexico enter the preelection period in a serious economic tailspin
but the new president would come into office facing a virtual replay of de la
Madrid's first six months in power.
From a political perspective, economic backsliding will strengthen the hand
of those in the government who favor more nationalistic, anti-US, and
protectionist policies. In our view, de la Madrid will find it more difficult to
continue building a consensus for liberalizing the economy, a policy lenders
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view as constructive. Economic hardship will exacerbate the competition
for limited resources among the traditional pillars of the Mexican political
system. The eroded confidence already evident in a large portion of the
citizenry could result in activities more damaging than mere discontent
should de la Madrid overreact by cutting too much. Support for opposition
parties would grow, we believe, with little realistic expectation that the
ruling party would open up the political system as an escape valve. In fact,
if pushed to the wall in a political crisis, de la Madrid would be likely to
employ violence-a technique used successfully by previous Mexican
administrations-to attempt to stem the tide. Short of a crisis, however,
fallout from a deteriorating economic situation could result in bolder, more
risky policy moves at home and a greater willingness to sacrifice recent
gains in the US-Mexican relationship abroad.
Under the best of circumstances, the de la Madrid government's present
policies risk undoing the gains of the last two years. Once the crunch
comes, we expect Mexico City to appeal to Washington to put pressure on
the IMF and international bankers to be especially lenient with Mexico.
Even before such a critical point, however, we believe Mexico City will
continue to look to Washington for special deals, perhaps a generous oil
sales arrangement. Barring a major change in the international environ-
ment, de la Madrid is unlikely to renege on Mexico's debt obligations,
however. In our judgment, any drift in this direction should be perceived as
a tactical attempt to gain leverage with international lenders. The period of
slow growth we foresee will lead to tensions in other areas because of the
increase in the number of Mexicans crossing the US border illegally in
search of jobs, the restrictions on resources available for fighting drug
cultivation, and mounting pressures on foreign investors.
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Key Judgments iii
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Figure 1. Administrative Units
.`San Luis( Victoria,
Sonora
Hermosillo
~L tr?w ~~,.,.o?w~~a~
I ti t \IVMoaterreT,
Saltillo. PFlluevol,
a Cu t~acdn? Durango a Leon
RA 0- IJ
lalisco`Maretia. "a}t
Toluc
co,.-,
Ii
uueri
Estados and their capitals have
the same name except where noted.
?,!" Distrito ~fdearell', ~?`(~?--~
coacn Cuernavaca 3
,J -` " Puebla
Mdrida J
Lucatdi' 7
2. U;,,nta!a
"hA`ahe moss
Chiapas
1. Hidalgo
2. Mexico
3. Morelos
4. Querdtaro
5. Tlaxcala
Boundary representation is
not necessarily authoritative.
Nicaragua
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Mexico: Prospects for
Economic Policy Shifts
Judging from Mexico's announced 3.5-percent growth
rate in 1984 and continued success in negotiating
international financial and credit agreements, the
country rebounded solidly from its economic crisis of
1982. Even so, this favorable record was underpinned
by a domestic policy program that is forcing the de la
Madrid administration to reassess its policy stance.
Whether fiscal and monetary policies announced sub-
sequent to the July elections become effective in the
next few months or are delayed until next year,
Mexico City still faces some hard decisions. F--]
statistics, the initial policy moves were quite substan-
tial. Mexico City cut public expenditures and domes-
tic credit by one-third during the period 1983-84.
Overall, the lower spending and greatly reduced
import levels allowed Mexico to end its debt mora-
torium, work out favorable rescheduling agreements
with its international creditors, and rebuild badly
depleted foreign exchange reserves. At the same time,
these measures cut Mexico's economic growth
performance over 13 percentage points between 1981
and 1983. This in turn worsened the country's already
growing employment problems, and seriously eroded
living standards and real wages.F_-]
Against this backdrop, this report examines the sus-
tainability of Mexico's current policies and the impact
of likely alternative policy choices. In doing this, we
evaluate Mexico's economic performance during the
first 32 months of the de la Madrid administration,
focusing on the effects of falling oil prices and other
constraints on Mexican economic policies and struc-
tures. Using an econometric model, we then analyze
alternative policy paths available to the Mexican
administration, examining the effects on the growth
of consumption and payments tradeoffs that are in-
volved. This study also analyzes how other possible
outcomes, which in essence involve government policy
miscalculation, could affect Mexican economic per-
formance as the country moves toward the end of
President de la Madrid's term in office in 1988.F-
The Impact of de la Madrid's Policies, 1982-84
When President de la Madrid assumed office in
December 1982, he implemented a series of tough
austerity measures that considerably eased the finan-
cial crisis he had inherited.' According to government
' For a more comprehensive evaluation of de la Madrid's economic
25X1 policies during the first half of his administration, see appendix A.
Priming the Pump
As the immediate effects of the financial crisis eased,
the Mexican Government began to reassess its eco-
nomic situation with an eye toward potential political
gain. We believe, on the basis of US Embassy reports
that key government
officials decided in mid-1984 that they had to speed
economic recovery even at the cost of rising prices and
overvaluation of the exchange rate. The shift in policy
direction reflected both Mexico City's belief that
Mexicans would not accept continued strict austerity
and the view that it was necessary to make a strong
showing in the important July 1985 local and guber-
natorial elections. All national legislative deputies and
seven state governorships were to be elected, and key
contests were viewed by party leaders as an important
barometer of public confidence in the de la Madrid
administration, according to the US Embassy.)
From an economic standpoint, the decision to prime
the pump was initially reflected in numerous moves to
bolster public spending.
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new government investment projects, particularly in
areas where the ruling party believed it would face the
greatest challenges. For example:
? The government announced in June it would spend
the $1.5 billion contingency fund set up under the
IMF program for special needs. This "readjust-
ment" of fiscal policy was necessary to spur eco-
nomic activity.
? The Federal District indicated in August that
200,000 temporary jobs would be created to contin-
ue construction of the Mexico City subway and to
repair the water system.
? The Bank of Mexico proclaimed a new program
that would provide nearly $300 million in credits for
housing.
Moreover, throughout the states of northern Mexico,
numerous new road projects were begun and other
highly visible construction projects-such as sewer
systems-were started. F__1
By the end of 1984, the economic effects of all of
these new spending efforts were beginning to be felt.
According to Embassy reporting, public expenditures
for the year as a whole jumped far in excess of the
level agreed to in IMF targets. Indeed, the overall
public-sector deficit rose to 7.6 percent of GDP, a far
cry from the 3.5-percent target established in the
original Fund program for 1984. If anything, this
figure understates the full extent of government
spending. If, for example, arrears on public-sector
interest owed to the Bank of Mexico were known and
included, the deficit almost certainly would be in-
creased by a substantial margin.F__-]
Mexico's expansive economic policies were not simply
limited to the fiscal side. As the government deficit
began to grow, the administration allowed the money
supply to increase a hefty 60 percent in 1984, com-
pared with 40 percent the previous year. On the basis
of a review of government statistics, this increase in
the money supply appears to be basically an accom-
modation to the expansive fiscal spending that was
under way. While credit to the public sector, for
example, expanded rapidly, loans to private-sector
borrowers remained exceedingly tight, according to
press and Embassy reporting.F__-]
Even though official information for early 1985 is still
sketchy, the US Embassy indicates stimulation of the
economy continued at least through June. Not only
did Mexico City fail to meet some 1984 IMF targets,
but most observers report that public-sector spending
remained well above targeted levels during the first
half of the year. These spending trends contributed to
keeping inflation above the target level.F---]
Most Mexicans and foreign observers are waiting to
see whether the de la Madrid administration follows
through on its latest commitment to return to more
austere policies. The government announced once
again that it would cut the budget, this time by
reducing current outlays 1 percent. It also pledged
that it would tighten monetary policy, provide addi-
tional incentives for exports, and liberalize imports by
eliminating import license requirements for 37 per-
cent of imported goods. Over the next few months,
observers will be watching to see if the government's
recent decision to regulate the float of the peso
keeps exports competitive and whether measures that
cushion the negative effect of austerity on the popula-
tion are introduced.)
Given the size of the budget deficits and the lagged
impact of last,year's expansion of the money supply, it
seems unlikely that Mexico stands much chance in
even achieving the 45-percent inflation-rate target
agreed to with the Fund. Indeed, on the basis of the
25X1
25X1
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Figure 2
Mexico: Economic Indicators, 1979-84
performance of the first six months of 1985, we
project that prices will end up rising about 60 percent.
Value of Oil Exports
Billion US $
Merchandise Imports
Billion US $
Current Account Balance
Billion US $
Consumer Price Index
Annual percent change
Public-Sector Deficit as a
Share of GDP
Percent
Gross Domestic Product
Percent change
The Short-Term Effects
From an economic standpoint, last year's decision to
gear up the economy for the election paid off, at least
in the short run. After falling 5.3 percent in 1983,
GDP rose 3.5 percent in 1984, according to official
Mexican estimates. Government consumption ex-
panded almost 7 percent and the slide in public
investment ceased. Moreover, in response to the pick-
up in aggregate demand, private investment grew by
nearly 9 percent, a noticeable turnaround from the
large declines of the preceding two years. Even though
real wages continued to fall, private consumption
showed a slight rebound of 2.8 percent, in contrast to
last year's 7.5-percent fall.F__1
Results so far this year suggest the growth spurt has
continued. The US Embassy estimates that GDP
probably was growing at an annual rate of about
6 percent in January-June, while production of auto-
mobiles was up 25 percent during January-April, and
construction activity rose 25 percent in January-
March. Another indicator of the pickup in the econo-
my has been the sharp runup in imports that contrib-
uted to the deterioration in the trade balance. Indeed,
during the period January-June 1985, Mexico's trade
account surplus plummeted 50 percent to $4 billion.
This pattern, combined with large interest payments
on foreign debt, is likely to cause Mexico this year to
experience its first current account deficit since the
financial crisis of 1982.
From a political standpoint, a readout of election
results suggests that the de la Madrid administration
emerged relatively unscathed. The ruling Institutional
Revolutionary Party (PRI) captured all seven guber-
natorial seats and the vast majority of local offices.
Official results for the 300 congressional seats con-
tested and the 100 seats reserved for opposition
parties reflected reduced representation for the con-
servative National Action Party (PAN). The govern-
ment's decision to sweep the contests and to use such
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pump priming and irregularities as necessary to en-
sure victory provoked little violence from opposition
supporters. Voter turnout was lower than in previous
elections, however, indicating many Mexicans are
cynical about the democratic nature of the political
process,
With the July elections now over, some of the political
imperatives for a stronger economy will temporarily
ease. Even so, the lure of more expansive policies will
be strong. From a political standpoint, the de la
Madrid administration still has to contest more than a
dozen gubernatorial elections in 1986. Among these,
the races in the states of Chihuahua, Sinaloa, and
Durango will probably be particularly worrisome be-
cause of the growing appeal of the PAN to middle-
class voters in northern states. Moreover, in 1987 the
yearlong campaign for the presidency will begin.
In addition to the likely focus on difficult races, high
levels of concern remain over Mexico's willingness to
accept a return to greater austerity and disenchant-
ment with continuing high unemployment and declin-
ing real wages. Aside from bolstering party popularity
well before the 1988 presidential election, an active
government spending program also would help under-
score the government's pivotal role in guiding the
economy. If the recent past is any guide, Mexico City
will continue to see public-sector investment, state-
owned enterprises, and tight regulatory control of the
private sector as key ingredients in managing the
25X1 country's economic life. l
Perhaps the greatest pressure for continued expansion
is from the labor front. At present, we estimate that a
little over 4 million Mexicans-or roughly 17 percent
of the labor force-are unemployed and even more
are unable to find full-time jobs. Given Mexico's
demographic profile, this problem will only get worse
as an additional 4 million persons enter the labor force
before de la Madrid's term ends in 1988. We see this
surge as only the beginning. As things now stand,
The de la Madrid administration's concern over job
creation reflects the longstanding fear of Mexican
governments that growing unemployment and wide-
spread underemployment will eventually lead to so-
cial unrest. High birth rates of the past have created
the enormous task of providing jobs for a labor force
growing at nearly 4 percent a year, according to
government statistics. We estimate that just provid-
ing jobs for the I million people entering the labor
force each year in 1985-90 would require economic
activity to expand about 10 percent annually, at
current capital labor ratios.
In addition to new entrants to the labor force,
however, we estimate there are about 4 million
unemployed and about 9 million underemployed.
Indeed, of the 23 million Mexicans in the labor force,
we calculate less than half have full-time jobs earn-
ing the minimum wage or better. Under any economic
policy mix we envision de la Madrid putting in place,
unemployment and underemployment will rapidly
worsen; the President has only the choice of slower or
faster increases in the numbers of people without full-
time jobs at the minimum wages.
Mexico is likely to see its labor force nearly double to
as many as 40 million by the turn of the century.
An Expansionary Policy Path ...
We believe that Mexico theoretically could achieve an
average annual growth rate in the 4- to 5-percent
range during the period 1986-88.2 Such a growth path
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would, of course, require the continuation of relatively
favorable global economic conditions from a Mexican
perspective. Specifically, it would require that:
? GNP gains in the United States average around 3 to
3.5 percent a year over the entire period.
? Oil prices firm near or at the present average level
of $24 per barrel.
? International interests rates remain near their
present average level of about 8 to 9 percent.
In addition, such a growth path would assume that
lenders are willing to provide on an annual basis about
double the average of $3 billion we believe they will
grudgingly lend Mexico over the next three years, and
that their already shaken willingness to provide even
limited new funding would not be further eroded by a
major payments crisis elsewhere in the Third World
during this period.)
Even assuming such favorable conditions, Mexico
would only partially move down the road to full
recovery by 1988. A 4-percent growth path, for
example, would bring per capita income nearly back
to its 1982 level by the end of the de la Madrid term.
Even so, the number of new entrants to the labor force
in 1988 would still exceed the number of jobs created
by perhaps as many as 500,000 people. Indeed, at
present productivity levels, 10-percent growth for 20
25X1 years would be required to fully absorb Mexico's
labor force pool. F__1
25X1
... and Its Sustainability
In reality a recovery growth path anywhere near the
4- to 5-percent range would require much more than
just a favorable international environment. Indeed,
any attempt to stick to a growth path underpinned by
expansionary government policies would quickly run
into a number of key constraints. F___]
Internally, an attempt to grow at 4 percent a year,
while meeting de la Madrid's pledge to protect real
wages, would almost certainly require expansionary
money supply growth. Even if credit to the private
sector remains tight, simply accommodating govern-
ment budget deficits, which could equal 12 to 15
percent of GDP by 1988, would by its very nature
result in an easy money policy. This in turn would
mean that inflationary pressures would continue and
increases in the cost of living would remain high
throughout the period. In such a case, inflation would
be at least several times higher than the 20-percent
level that the government has targeted.F_~
Externally, an overly aggressive government-support-
ed growth path would almost certainly lead to a
deterioration in Mexico's trade and current accounts.
From the export side, assuming that Mexico City opts
for a slight but growing overvaluation of the peso
between now and 1988, the best that Mexico could
expect to see on its nonoil exports accounts is a 12-
percent rise in sales.' On the oil side, the picture is not
much brighter. Indeed, if consumption rises in line
with official Mexican estimates and production man-
ages to increase as planned, petroleum available for
export will rise only about 40,000 b/d annually during
1985-88. At present prices, this would represent $385
million in additional export earnings, an amount equal
to only 12 days' worth of merchandise imports at
current levels. Taking into account both the overall
export picture and the import needs associated with
government-supported recovery, we project that Mex-
ico's current account surplus would disappear by
1988.1
The need to finance existing debt will further strain
Mexico's external accounts. Even though recent debt
rescheduling operations have provided some financial
breathing room, they have not eliminated a heavy
loan repayment schedule. At present we see annual
public debt servicing exceeding $11 billion by 1988
under almost any plausible scenario, including one
where world interest rates remain at their present
levels until the end of the de la Madrid administra-
tion. Renegotiating Mexico's private debt under terms
similar to those being worked out with the public
sector would reduce overall debt service obligations by
an additional $1 billion each year through the remain-
der of the decade. Even with these new reschedulings,
we calculate that debt payments during the remaining
40 months of the de la Madrid term will reach $60
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Outlook for Nonoil Exports
As long as the Mexican Government remains unwill-
ing or unable to shift its policies toward external-
oriented development, its nonoil export prospects will
be constrained. Steps taken so far to spur foreign
sales, such as devaluation, new trade credit mecha-
nisms, and reduced regulation, have been only par-
tially effective and their impact is diminishing:
? Complex and unpredictable exchange rate policies
make business decisions difficult, while the increas-
ing overvaluation of the peso makes Mexican ex-
ports less competitive in world markets.
? Mexico's financial crisis has reduced the availabil-
ity of foreign and domestic credit for exporters.
? Orientation toward import substitution and protec-
tion for domestic industries boosts costs for
exporters.
Until both local and foreign businessmen become
confident that economic policies will be favorable and
steady, they will limit their investment in export
industries. Even so, we believe a 10 percent annual
growth between 1985 and 1988 is possible if-but
only if-the government keeps the peso competitive.
Growth would be driven largely by sales of automo-
tive parts and engines, electronic and mechanical
billion. Assuming the renegotiated payments schedule
is adhered to, the interest payments, coupled with the
import-boosting trade performance associated with
high growth, could end up pushing the current ac-
count into the red by $2-3 billion in 1988.F-7
As expansive government expenditure policies take
their toll on the country's external accounts, Mexico's
ability to grow will become increasingly dependent on
the country's foreign exchange situation. As things
now stand, official statistics show that Mexican fac-
tories rely on imports for 20 percent of their raw
materials, and the bulk of all machinery and equip-
ment needed for capital formation comes from
abroad. Even if Mexico ran down its $7 billion foreign
equipment, steel, processed foods, chemicals, and
telecommunication equipment.
On the other hand, appreciation of the peso could
reduce the growth of nonoil exports to less than 10
percent annually. Mexican officials are reluctant to
devalue the peso fast enough to keep it competitive
because they want to break the public's inflationary
expectations, to restore imports of capital goods for
domestic industries, and to keep the private sector's
debt repayment burden manageable.
Besides its own policy constraints, the government's
prospects of expanding nonoil exports are limited by
external factors:
? The large, oil-generated trade surpluses Mexico
has with many industrial countries limits these
countries' willingness to expand purchases of other
Mexican products.
? Many Mexican exports face stiff competition from
industrial country and Third World producers.
? Other LDCs are reeling from their own financial
difficulties and have had to restrict imports.
exchange cushion to $1 billion by 1988, this would
only buy a few months' worth of foreign exchange
relief.
Beyond these pressures, the key international con-
straint Mexico will face will be the level of net new
foreign lending. Our calculations indicate Mexico
could continue to support economic growth in the 4-
to 5-percent range through 1988, but only if bankers
were willing to provide $6-7 billion annually in new
funding. We believe the prospects for such an injec-
tion are highly doubtful. Even given Mexico's rela-
tively favorable situation today, we believe that the
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Dealing With Foreign Banks
The tough austerity measures that sharply reduced
inflation have impressed foreign bankers, and al-
lowed Mexico City to catch up on debt arrears and to
work out favorable extended repayments terms with
its creditors. Financial authorities are rescheduling
public debt in two steps. In September 1983, after
more than a year of difficult negotiations, $23 billion
in public debt coming due between August 1982 and
December 1984 was rescheduled over seven years. In
June 1984, Mexico City went back to its more than
500 foreign creditors asking for the refinancing of
$48.5 billion of its $65 billion public debt. The
proposal included the debt rescheduled in 1983,
commercial loans taken in 1983 and 1984, and
obligations not earlier rescheduled and coming due
before 1990. After months of tough negotiations,
Mexico reached agreement in March with creditor
representatives to reschedule $23.6 billion in public-
sector debt due in 1982-84 on concessionary terms,
including lower interest rates and a 14-year payback
period with one year's grace. Later this year, Mexico
City expects to reschedule on similar terms the
remaining $25.1 billion in public-sector debt due
after 1984.F__-]
Mexico's $28 billion private-sector debt has proved
more difficult. While progress has been made in
catching up on some interest arrears, much of this
debt is in technical default. Only $12 billion in
private debt was registered in October 1983 with the
Bank of Mexico when the bank closed access to a
trust fund set up to finance rescheduled private debt.
Now, nearly two years after the program was set,
only a small number of those private debtors have
negotiated rescheduling agreements with their credi-
tors. Details on the other $16 billion of private debt
are sketchy, although we believe much of it consists
of suppliers' credits and other short-term instruments
that may not require multiyear rescheduling. In any
event, we believe that a sizable portion of this debt
has been or will be written off as uncollectible. The
peso devaluations have aggravated debt problems,
causing unprecedented financial problems for many
private-businesses that depended on imports.
prospects for new loans exceeding $3 billion annually
are quite low. Bankers' willingness to go even this
high would certainly be tested if Mexico came seeking
money at a time when government policy had already
run down reserves, fueled inflation, distorted the value
of the peso, and further weakened the private sector.
The financial ramifications of continued government
expansion strongly suggest that sooner or later un-
favorable economic factors will inevitably force de la
Madrid to introduce belt-tightening policies similar to
those imposed in 1983. Such a shift would cause
Mexico City's economic policies to aim primarily at
fighting inflation and maintaining a sustainable bal-
ance-of-payments position. In these circumstances,
real wages and the incomes of most Mexicans would
be hit again as the government moved to keep spend-
ing in line with revenue and other financial resources.
From a practical standpoint, such a policy shift would
likely entail a number of individual moves. For exam-
ple, Mexico City could opt to:
? Slow the growth in government wages, which pres-
ently account for 17 percent of current
expenditures.
? Hold down new hiring both in the government itself
and in the wide array of state-owned firms.
? Slow outlays on subsidies that account for 15 per-
cent of government spending.
? Pare the growth in investment spending in state-
owned industries such as oil, steel, railroads, mining,
and utilities.
Even with spending restraints, we project that, for
political reasons, the large public-sector deficit could
only be reduced gradually and most credit would
continue to go to the public sector. Credit to private
business would remain tight. To shore up the external
accounts, Mexico would have to keep the peso com-
petitive by stepping up depreciation in line with
inflation.)
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If such belt-tightening policies were introduced
sooner rather than later-say early 1986-we project
economic activity would be throttled back to about
1-percent annual growth through 1988 to avoid run-
ning into major international payments constraints.
Growth at this rate would not be enough to make up
for the domestic purchasing power losses of the last
few years, and at the end of de la Madrid's term per
capita income would remain about 12 percent below
1982 levels. Moreover, unemployment and underem-
ployment would grow more rapidly than if Mexico
City had been able to sustain high government spend-
ing, and as many as 800,000 more Mexicans could
find themselves out of work. Weak demand and wage
restraint would allow Mexico to slow increases in the
cost of living, but we believe inflation would remain at
25X1 levels considered far too high by most Mexicans.
On the positive side, these policies would enable
Mexico to post a sustainable external account per-
formance. As long as oil prices remain steady, nonoil
exports grow at least gradually, and weak demand
holds down imports, we believe Mexico could continue
to generate the trade surplus it needs to help meet the
country's debt service payments. As long as interna-
tional bankers were accommodating and lending to
Mexico totaled at least $3 billion annually, Mexico
City would not be forced to draw down its accumulat-
ed international reserves and, indeed, could increase
25X1 them slightly in keeping with current IMF targets.
Given Mexico's relatively strong foreign reserve posi-
tion, it is of course possible that the political realities
of the situation could force de la Madrid to postpone
adjustments for a year or more. If the shift to
economic adjustment is indeed delayed, the inevitable
trauma would be even greater as the government tried
to slow an even more expansive economy later in de la
Madrid's term. We calculate, for example, that, if
adjustment was held up a year, growth would have to
be cut an additional 1 to 2 percentage points in 1987
and 1988 in order to bring the country's financial gap
in line with the maximum level of new lending we
believe is possible. Aside from the higher economic
costs, the delay in action would risk serious political
consequences since a more severe downturn would
occur even closer to the 1988 elections-a time when
pressures for new pump-priming measures will almost
certainly be on the rise. F__1
While delay would be costly, most short-term pres-
sures will argue for holding off on adjustment for as
long as possible. Aside from the normal concerns over
pork barreling for next year's elections, there will be
political debts to be paid for this year's victories.
Moreover, even if timely retrenchment is begun, the
combination of sharply rising unemployment, continu-
ing inflation, and declining per capita income will
bring intense political pressure on the government to
ease austerity measures before the 1988 campaign
gets into full swing. From a political standpoint,
government officials would almost certainly worry
that the opposition National Action Party (PAN)
would capitalize on adverse economic conditions and
shift even more voters away from the fold. Such
concerns would only be intensified if the PAN made a
good showing in the 1986 gubernatorial contests. On
balance, it then seems likely that, given the political
realities in Mexico, a general austerity approach
marked by fits and starts is the most likely outcome.
Some inevitable variation of a stop-and-go policy
approach is not the only possible outcome, however.
Indeed, given the need for austerity and the policy
pressures to delay it, there is a risk that Mexico City's
economic policy community could misjudge the need-
ed degree of correction and accidentally overshoot. If
anything, the longer adjustment is delayed, the great-
er the risk the government will overcompensate by
excessively cutting back public spending. F__1
If the past is any guide, overreaction is a real
possibility. The long period of temporizing by the
Lopez Portillo government in 1981-82 necessitated
the introduction of harsh austerity policies by the de
la Madrid administration in 1983. Although the
policies were carefully developed, no one envisioned
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the severe economic consequences that followed from
efforts to cut government spending, reduce inflation,
and curb imports. The plan called for reducing growth
to just 1 to 2 percent for 1983. Instead, economic
activity plummeted 5.3 percent, from nearly 8 percent
in 1981, while imports plunged to $7.7 billion, from
$24 billion in 1981. Even under these circumstances,
the sharp devaluations of the peso contributed to
keeping inflation relatively high. The cost-of-living
index rose 80 percent in 1983, down 20 percentage
points from the previous year. 0
Any overreaction this time around could be made
even worse if, in addition to reduced federal outlays,
the wrong policy signals were sent to the private
sector. As economic constraints became increasingly
severe prior to a shift toward austerity, for example,
the odds increase that the government could make a
number of moves that would be interpreted as a tilt
even further away from the private sector. For exam-
ple, Mexico City could:
? Change the current trend, allowing the peso to
become increasingly overvalued to help reduce infla-
tionary pressures domestically. This would not only
discourage exports but also encourage imports-
both of which hurt domestic business interests.
? Show a greater unwillingness to use dwindling
foreign exchange reserves on private-sector import
needs.
? Try to project the image of a job creator by
reconfirming a commitment to maintain or even
strengthen the role of the government in the econo-
my, especially by underwriting inefficient and fi-
nancially costly state-owned enterprises.
? Revising guidelines on foreign investment to recon-
firm the case-by-case review process and further
limit areas in which foreign investors could become
involved in the Mexican economy.
? Try to protect lower class income levels by publicly
pledging not to renege on government support for
subsidies and price controls.
If such moves came on the heels of a growing
defection of businessmen from the PRI, the percep-
tion of anti-private-sector sentiment would only be
intensified. Regardless of the actual intent, such
policy moves in their totality would only attract
additional funds that otherwise could have been used
by private businessmen to finance badly needed in-
vestments.F__1
The risks of misperception at a time of policy change
are only increased by the recent record of the de la
Madrid administration. In numerous speeches de la
Madrid and other Mexican officials have pointed out
that economic recovery will require substantial pri-
vate investment as long as public outlays are con-
strained. Even so, this rhetoric to date has not been
matched by clear action even at the margin. Indeed,
the US Embassy reports that recent moves to
strengthen the private sector by boosting tax credit
and cutting red tape have been more than offset by
reduced peso credit to the private sector, continued
official antibusiness rhetoric, and increased govern-
ment regulation. F__-]
If private-sector confidence-both domestic and in-
ternational-were to be dashed, overly aggressive
government austerity, along with a push to meet IMF
exchange reserve targets, could cause a steeper de-
cline in economic growth. We calculate that the
decline could be 2 to 3 percent if, for example,
austerity sparked:
? A drop in private investment activity to 1983 levels.
? Capital flight at roughly twice the estimated 1984
level.
? Banker unwillingness to lend net new funds in
excess of $1 billion.
From a political perspective, we believe economic
backsliding in the next year or two would aggravate
existing policy conflicts within the government,
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strengthening the hand of those who favor more
nationalistic, anti-US, and protectionist policies. In
effect, it would make it more difficult for de la
Madrid to continue building a political consensus for
liberalizing the economy in ways that Washington
and the Western financial community view as con-
25X1 structive.l
At the same time, economic hardship would make it
harder for the government to satisfy the growing
demands of organized labor and other influential
members of Mexico's so-called revolutionary family,
which generally have endorsed de la Madrid's poli-
cies. While Mexico's major trade unions almost cer-
tainly will remain in the government camp for the
foreseeable future, the planned retirement in Febru-
ary 1986 of labor kingpin Fidel Velazquez-who has
dominated the unions for close to 50 years-could
result in a modest relaxation of labor discipline. More
generally, the popularity the ruling party has enjoyed
since coming to power in 1929 has derived in large
25X1 part from its ability to bring greater material benefits
to the Mexican people. F__]
The austerity measures imposed since the 1982 eco-
nomic crisis have already eroded a significant portion
of the confidence the average citizen has in the
government to rule effectively, according to Embassy
reports. While there are no signs of a system break-
down yet, continued worsening economic conditions
could result in activities more damaging than mere
discontent. We believe these could take the form, for
example, of more strikes by workers and land grabs
by peasants. F__~
Opposition parties, notably including the relatively
conservative PAN, almost certainly would try to
exploit the government's economic failings. We know
from US Embassy 0 reporting that the PAN
has the strongest appeal among middle-class, urban
professionals in northern Mexico, many of whom have
been exposed to US culture and values. While the
PAN stands virtually no chance of displacing the PRI
on the national scene in the next decade or two, in our
judgment, it probably would pick up additional popu-
lar support if economic conditions worsened. F - - - I
Growing popular sympathy for the PAN and, to a
lesser extent, for Mexico's factionalized and largely
feckless leftist parties, would, in our view, elicit a
strong response from the government and ruling
party. Members of the governing elite,
almost certainly would
argue that the ruling party should preserve its politi-
cal power at all cost, and they probably would favor
more repressive policies to accomplish this end.
With economic revenues already strained,
however, it would be more difficult to satisfy local
needs, especially if many demands were made at once.
With his back up against the wall, de la Madrid
probably would employ force-a policy used success-
fully by previous Mexican administrations-in an
effort to stem the tide.
Even if the economic situation does not generate a
political crisis, there will still be domestic political
ramifications. De la Madrid could be tempted to
adopt somewhat bolder and riskier policies, much as
his immediate predecessors did shortly before leaving
office. In the waning days of his administration, Luis
Echeverria expropriated a number of large farms in
northern Mexico. Jose Lopez Portillo at a similar
point in his term nationalized the banks. In an effort
to deflect domestic criticism from his administration
and to appeal to nationalist sentiment, de la Madrid
could conceivably move more aggressively to pursue
collectivist solutions to the Latin American debt crisis
or more overtly blame external conditions for Mexi-
co's economic woes.)
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25X1
Implications for the United States
Under the best of circumstances, the de la Madrid
administration's present policies of economic stimula-
tion risk undoing the gains of the last two years. The
government clearly decided, however, that it was
politically necessary to sacrifice the fight against
inflation in order to avoid social unrest and to aid the
ruling party's chances in the midterm elections in
1985. To some extent, Mexico's policy stance also
probably reflects the President's hope that private
investors will rescue the economy in time to prevent a
renewed clampdown. With the present emphasis on
nationalistic economic policies, however, we do not see
investors being particularly responsive. Moreover, we
expect foreign bankers to be unwilling to lend the
amounts necessary to maintain stimulative policies for
an extended period. Once the crunch comes, we
expect Mexico City to appeal to Washington to put
pressure on the IMF and international bankers to be
especially lenient with Mexico in keeping open credit
lines and encouraging new debt rescheduling exer-
Mexico City has recently an-
nounced it is reconsidering its international trade
posture and its position on such areas as GATT
membership. Nevertheless, because domestic opposi-
tion to such a move is high, for now we see these
gestures largely as an attempt to placate the interna-
tional financial community and gain concessions from
trading partners. F_~
Mounting domestic political pressures, falling oil
prices, and rising interest rates conceivably could
force Mexico to abandon the rules of the game. Such
a response could include a debt moratorium, negotia-
tion through an international debtors cartel, or a
scheme to tie debt payments directly to export per-
formance. On the basis of Mexico's need to keep
borrowing lines open, reliance on trade with creditor
countries, and desire to improve relations with the
United States, however, we deem this highly unlikely
and see any drift in this direction as a means to gain
leverage with international lenders rather than as a
serious threat to renege on debt obligations.
The period of slow economic growth that we project
for Mexico will lead to greater tension in other areas.
We expect continued growth in the numbers of Mexi-
cans crossing the US border illegally in search of
work. Indeed, we estimate that in 1983, following de
la Madrid's initial austerity program, an unprece-
dented 1.5 million undocumented Mexicans entered
the United States, up from the annual average of
800,000 to 1.1 million in the years of the economic
boom. The flow will be increasingly representative of
the Mexican population, including more urban dwell-
ers, women, and families. Continued budget stringen-
cy will restrict the resources available for fighting
drug cultivation, while the economic incentives for
increasing production will be higher. These factors
will reduce the effectiveness of any Mexican eradica-
tion program. Moreover, as economic difficulties
mount, we expect greater pressure on foreign investors
to export a greater share of their products or to make
special concessions to be allowed to invest in Mexico.
In the near term, we do not see Mexico becoming the
dynamic market for US exports or investment that it
was before 1982.F__1
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Appendix A
Recent Financial and
Economic Performance
Legacy of Neglect
For several years before de la Madrid came to power,
foreign and many Mexican economists had argued
that policies of expanding public investments, increas-
ing producer and consumer subsidies, and propping up
the peso to take the heat off domestic prices could not
last much longer. Dedication to these policies, to-
gether with the optimism generated by new oil wealth,
had led the previous President, Lopez Portillo, to
defer adjustments until it was too late.
According to the US Embassy and our analysis, to
keep this bundle of policies intact in 1981 when the
world oil market was weakening, Mexico borrowed
$30 billion abroad, the major portion in short-term
money. When Mexico City ran out of foreign ex-
change in August 1982 and suspended payment on
$2 billion per month in debt service, the whole world
became aware that Mexico had squandered much of
its oil wealth through premature consumerism,
stifling state controls over economic activity, and the
exactions of a corrupt bureaucracy.
Thus, when de la Madrid came to power in December
1982, most analysts believed the Mexican miracle of
four decades of rapid economic growth, rising living
standards, low inflation, and a strong peso was over.
Controlling the Financial Crisis
To avoid debt default and regain foreign exchange
liquidity, de la Madrid embarked on a tough, IMF-
sponsored stabilization program. We believe his quick
devaluation of the peso was designed to slash imports
and rein in foreign payments deficits. According to
our analysis, maintaining IMF financial support and
working out new debt repayments schedules required
tough steps to slash public spending, wages, and
domestic credit.
During 1983, and to a lesser extent during 1984, the
austerity results were remarkable, according to offi-
cial statistics, Embassy reports,
? State-negotiated work contracts cut real wages
20 percent during 1983 and another 10 percent
during 1984. While this disillusioned organized
labor, workers generally accepted de la Madrid's
explanations for the need for austerity because they
were more concerned over protecting jobs.
? Government spending was reduced 25 percent in
1983 and held steady at the reduced level in 1984.
Public works and investment were cut one-third, the
impact falling heavily on oil development.
? Outlays for both consumer and producer subsidies
were lowered 24 percent in 1983 and another 10
percent in 1984. Producer subsidies were marked
down 40 percent. Consumer subsidies fell much less,
as political pressures kept price hikes for public
transportation and most government-supplied sta-
ples well below the inflation rate.
? Peso credits, in real terms, plunged one-fourth in
1983 before growing only 4 percent in 1984.
The most visible aspect of Mexico's austerity has been
the turnaround in its foreign payments situation. By
halving its import bill in 1983, while exports remained
steady, Mexico City engineered a $10 billion swing in
the current account balance, according to government
statistics. The $5.5 billion surplus on current account
was the first surplus of any size since 1955.
Depressed imports during 1984 kept the balance of
payments strongly in surplus, according to Mexican
Government reports. While imports increased a bit,
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they still amounted to only about 80 percent of the
corresponding 1982 level and less than half the 1981
level. Stimulated by the dynamic US economy, ex-
ports of goods and services during 1984 also rose. In
particular, sales of petroleum products and manufac-
tures were higher and income from tourism and cross-
border assembly industries increased. This enabled
Mexico to have a current account surplus of $3.9
billion,
The strong trade position and new bank loans associ-
ated with debt rescheduling allowed Mexico City to
substantially rebuild foreign exchange reserves. Dur-
ing 1984, we estimate that bank loans more than
offset rescheduled debt principal payments, allowing
foreign exchange reserves to increase nearly apace
with the current account surpluses. While capital
flight persisted, it was substantially below earlier
levels. By yearend, net foreign reserves had risen from
a negative $1 billion when de la Madrid assumed
office in December 1982 to a comfortable $8.5 billion,
according to published statistics.
The Whipsawed Domestic Economy
Despite the progress on foreign financial accounts,
government deflation and the steady decline in
private-sector investment hit the domestic economy
hard. Jobs and living standards during 1983 and 1984
also suffered severe setbacks, according to our
analysis.
The Crunch in Production. During 1983, according to
official estimates, government deflation resulted in a
5.3-percent decline in GDP. Economic activity fell as
investment plunged one-fourth and utilization of ex-
isting plant capacity dropped to 65 percent overall. In
some industries it fell to 40 percent. Industrial pro-
duction slipped 10 percent, as manufactures declined
7 percent and construction 14 percent. Weak demand
caused services to decrease markedly, most noticeably
in commerce where activity fell 9 percent. Agriculture
bucked the trend, growing somewhat in 1983 as
favorable weather ended two years of drought
conditions.
During 1984, the depressed demand caused by lower
consumer purchasing power, a deteriorating invest-
ment climate, and government deflation prevented an
early economic rebound, according to our analysis.
Official statistics, however, show that the economy
bottomed out during the first half of 1984, as the
government began to boost spending. Overall, the
economy grew about 3.5 percent
Manufacturing during 1984
increased 4.7 percent, led by small gains in metal
industries and mineral products. While the plunge in
government investment was halted in 1984, private
investment jumped nearly 9 percent.
Sharp Job Losses. During the past two years, job
losses-particularly among unskilled labor-have
been severe. In our estimation, the rate of unemploy-
ment has edged up to near 20 percent, higher in many
urban areas. Official statistics indicate that the aver-
age number employed in modern manufacturing fell
12 percent between 1982 and 1984. A recent private-
sector survey indicates that, during the first half of
1984, 47 percent of large businesses in the Mexico
City area reduced their work force, as did 30 percent
of medium businesses and 23 percent of small busi-
nesses. Government employees did the best; we be-
lieve some increases in defense and internal security
slots offset losses in other public-sector positions.
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