MEXICAN ECONOMY SLOWS IN FIRST QUARTER

UNCLAS SECTION 01 OF 03 MEXICO 002670

SIPDIS

SIPDIS
SIPRNET

STATE FOR A/S SHANNON
STATE FOR WHA/MEX, WHA/EPSC, EB/IFD/OMA, AND DRL/AWH
STATE FOR EB/ESC MCMANUS AND IZZO
USDOC FOR 4320/ITA/MAC/WH/ONAFTA/GERI WORD
USDOC FOR ITS/TD/ENERGY DIVISION
TREASURY FOR IA (ALICE FAIBISHENKO)
DOE FOR INTERNATIONAL AFFAIRS KDEUTSCH AND ALOCKWOOD
NSC FOR DAN TOMLINSON, RICHARD MILES, DAN FISK
STATE PASS TO USTR (EISSENSTAT/MELLE)
STATE PASS TO FEDERAL RESERVE (CARLOS ARTETA)

E.O. 12958: N/A
TAGS: ECON EFIN PINR PGOV MX
SUBJECT: MEXICAN ECONOMY SLOWS IN FIRST QUARTER


--------------
Summary
--------------


1. (SBU) The Mexican economy is showing signs of slower
growth, with the forecast for real GDP growth around 3.2% for
2007, down from 4.8% last year. In the first quarter of the
year, the Mexican economy grew at its slowest rate in more
than a year, in part due to the slower pace of the U.S.
economy. Most economists agree that Mexico can weather a
gradual U.S. slowdown, at least temporarily, but that its
economy is too closely linked to that of the U.S. for it to
escape unscathed. Slower growth in the U.S. weakens demand
for Mexican goods in the U.S. -- the destination of 85% of
Mexico's exports. In the fourth quarter of last year and the
first quarter of 2007, export growth to the U.S. tailed off
from the double-digit quarterly growth rates registered from
the beginning of 2004 until the third quarter of 2006. The
weakened demand is most notable in the manufacturing sector,
which accounts for more than 80% of Mexico's total exports.
The automobile sector in particular has suffered, with
vehicle production down 12.4% in the first quarter compared
with the first quarter of 2006. Finance Secretariat
officials have said that Mexico is better positioned to
weather a U.S. slowdown than it was in the past because of
stronger macroeconomic fundamentals and domestic demand.
While this is true, it is the Calderon government's ability
to diversify the economy and tackle much-needed economic
reforms that will determine the country's future success.
End Summary.

--------------
U.S. Slowdown Dampens Growth...
--------------


2. (U) The Mexican economy is showing signs of slower
economic growth, with the forecast for real GDP growth around
3.2% for 2007, down from 4.8% last year. In the first
quarter of the year, the Mexican economy grew at its slowest
pace in more than a year, largely because of a drop off in
automobile output and construction. Real GDP expanded 2.6%
from a year earlier, down sharply from the 4.3% growth
registered in the fourth quarter of 2006.


3. (U) A key factor behind this subdued performance is the
slower pace of the U.S. economy, which only grew 1.3% in the
first three months of the year. Most economists agree that
Mexico can weather a moderate, gradual U.S. slowdown, but
that its economy is too closely linked to that of the U.S.
for it to escape unscathed. Slower growth in the U.S.
weakens demand for Mexican goods in the U.S., the destination
of 85% of Mexico's exports, according to Mexican trade
statistics. In the fourth quarter of last year and the first
quarter of 2007, export growth to the U.S. tailed off to 8%
and 2%, respectively, over the same quarters a year before.
These rates compare unfavorably with double-digit quarterly
growth rates from the beginning of 2004 until the third
quarter of 2006. The weakened demand is most notable in the
manufacturing sector, which accounts for more than 80% of
Mexico's total exports. Industrial production rose only 0.2%
in March, after growing 0.1% in February and 1.5% in January.
The automobile sector in particular has suffered, with
vehicle production down 12.4% in the first quarter compared
with the first quarter of 2006. April saw a rebound of 11%
over the same month in 2006, but it is still too early to
project the beginning of a complete recovery. That said,
auto output is expected to increase over the next 5 years as
Asian companies continue to grow and efficiency pressures
push the Big 3 (Ford, GM, and Chrysler) to expand production
in Mexico. However, a decrease in the U.S. demand for
automobiles produced in Mexico would hurt the already
weakened manufacturing sector.


MEXICO 00002670 002 OF 003


-------------- -
...But Mexico More Resilient Than in the Past
-------------- -


4. (SBU) Finance Secretariat (Hacienda) officials have said
publicly and privately that Mexico is better positioned to
weather a U.S. slowdown than it was in the past because of
stronger macroeconomic fundamentals and domestic demand.
Mexico's fiscal deficit and public debt ratios are down, and
inflation has fallen to around 4%. Bond spreads are at
record lows, and the current account deficit is manageable.
Reynoso told econoff that the floating exchange rate has
helped, but he noted that the real difference is that now a
depreciation of the peso does not hit wages.


5. (SBU) Marco Oviedo Cruz, Hacienda's Director of Financial
Planning (strictly protect),told econoff that domestic
growth will act as a counterweight to the expected decline in
exports. While domestic demand cannot permanently stave off
a downturn, Oviedo Cruz said it can act as a buffer for 2-3
quarters. He added that the increase in credit to the
private sector, particularly loans to homebuyers, and the
likely decline of domestic yields would help propel domestic
consumption. The Managing Director to the President on
Strategy at the Mexican Stock Exchange, Alejandro Reynoso
(strictly protect),added that another important factor is
the government's ability to maintain a modest fiscal deficit.
Oviedo Cruz and Reynoso both said a prolonged U.S. slowdown
would be more harmful to Mexico than a short, steep downturn.



6. (SBU) Oviedo Cruz and Reynoso agreed that a decline in oil
prices would not have a significant impact on Mexico's
economy. Oil only represents a small component of total GDP,
and revenue shortfalls could be covered by slightly
increasing the deficit and reducing government spending.
Oviedo Cruz said that oil prices are more of a concern for
public finances, which would eventually affect domestic
growth. HSBC's chief Mexico economist noted that he is more
concerned about the impact of falling oil production than he
is about oil prices.

--------------
Comment
--------------


7. (SBU) A stronger, more dynamic economy will help Mexico
weather the U.S. slowdown, but the Calderon administration's
ability to diversify the economy and pass much-needed
structural reforms are key to the country's international
competitiveness and future success. The government is overly
dependent on volatile oil prices and must to find ways to
direct more investment into the state-owned energy company to
keep production levels from falling. Bank lending has
increased, but financing for agriculture and small- and
medium-sized businesses remains scarce. To improve Mexico's
competitiveness, foreign investors and many experts on Mexico
also have called on the government to reform the labor code,
improve respect for rule of law, encourage competition in
sectors dominated by only a few firms, and improve the
quality of the educational system.


8. (SBU) On the positive side, prospects for economic reform
have improved since the Calderon administration took office
last December, due largely to the President's political
dexterity and the Finance Secretary's strong negotiating
skills. The government passed a major pension reform for
public sector workers earlier this year, and fiscal reform is
in the works. Separately, Hacienda officials expect the
economy to pick up pace in the second half of the year as the
U.S. economy recovers. End Comment.



MEXICO 00002670 003 OF 003


Visit Mexico City's Classified Web Site at
http://www.state.sgov.gov/p/wha/mexicocity and the North American
Partnership Blog at http://www.intelink.gov/communities/state/nap /
BASSETT