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