MEXICO?S ECONOMY HIT BY GLOBAL CRISIS; PLANE CRASH

UNCLAS SECTION 01 OF 05 MEXICO 003345

SENSITIVE, SIPDIS

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 FISK
STATE PASS TO USTR (EISSENSTAT/MELLE)
STATE PASS TO FEDERAL RESERVE (CARLOS ARTETA)

E.O. 12958: N/A
TAGS: ECON EFIN ENRG EINV PGOV MX
SUBJECT: MEXICO?S ECONOMY HIT BY GLOBAL CRISIS; PLANE CRASH
EXACERBATES FINANCIAL MARKETS? NERVOUSNESS


1. (SBU) Summary: Jitters over the depth of the global
economic downturn, the drop in oil prices, and foreign
investors? flight to quality have hurt domestic financial
markets. The financial crisis and the downturn of the U.S.
economy is adversely affecting the Mexican economy,
reflected in a decline in manufacturing exports, a slump in
remittances sent by Mexicans abroad, an expected drop in
tourism and FDI flows, a lower demand for Mexican oil
exports, and unemployment. The government has implemented
a series of measures to help relieve liquidity pressures,
stabilize the main economic variables, offset the oil
revenue shortfalls, and boost the economy. The timing and
effectiveness of the government?s countercyclical measures,
especially the National Infrastructure Plan (NIP),and the
passage of other economic reforms or will determine how
effectively Mexico will weather the economic recession. The
November 4 plane crash that killed the Secretary of
Interior, a close friend and advisor to President Calderon,
has contributed to a sense of uncertainty. While it is
premature to speculate on the causes of this tragic event,
the impact has shaken policy makers and markets. End
Summary.

REACTION TO SECRETARY OF INTERIOR?S SUDDEN DEATH
-------------- ---

2. (SBU) The Mexican stock market's index, the IPC, fell
5.05% and the peso depreciated 0.96% to 12.60 pesos to the
dollar a day after the U.S. elections and the plane crash
which killed Secretary of the Interior Juan Camilo Mourino.
Government officials and analysts had expected some relief
in financial markets after the U.S. elections, but poor
economic data in the U.S., rising jitters on the depth of
the global economic recession, and what analysts have
called a healthy profit-taking after a weekly gain of 28%
had negative effects on the stock market.

3. (SBU) Finance Secretary Agustin Carstens and the
Chairman of the Stock Market Guillermo Prieto maintained
that it was premature to speculate on the cause of the
crash which killed Mourino and on the long term impact on
the economy. Both asserted that Mexico's economic
fundamentals were solid and unaltered after the tragedy.
The government has been implementing a series of measures
to help relieve liquidity pressures and stabilize the main
economic variables. Carstens noted that Mexican financial
markets are "functioning adequately and will continue to".
Prieto acknowledged speculation about possible sabotage of
Mourino's airplane as a response to the government's
ongoing war against drugs, but stressed that until the
government releases the results of the investigation,
"investment plans and financial markets should not be
affected."

PLANE CRASH BRINGS BACK MEMORIES OF 1994
--------------

4. (SBU) The government's war against drugs, surging
insecurity levels and the Secretary of the Interior's
sudden death brought back unpleasant memories of the
assassination of Revolutionary Institutional Party's (PRI)
presidential candidate Luis Donaldo Colosio in 1994 and the
financial (?Tequila?) crisis that ensued. Most experts
consider these fears to be premature, and speculation
before the government announces the real cause of the plane
crash, could be risky. The government has undertaken a
thorough investigation of the crash, inviting aviation
experts from the U.S. and the U.K. to assist. The
government's communication strategy on the incident,
informing the media and the public step-by-step on the
process of the investigation and the level of cooperation
with foreign governments including the U.S., as well as
President Calderon's commitment to investigate the case
thoroughly have helped soothe concerns. While the
investigation is ongoing and may not be completed until
eleven months from now, all evidence uncovered to date
points to the crash being the result of an accident and

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non/not sabotage.

ANALYSTS THINK GOM FUNDAMENTALS ARE SOLID
--------------

5. (SBU) Banamex-Citigroup's chief political and economic
analyst Sergio Kurczyn told us that if the investigation
concluded that sabotage was the cause of the plane crash,
financial variables would undoubtedly be affected. But,
more than these variables the strongest impact would be on
the credibility and strength of the country's institutions.
Kurczyn said he thought the pillars of public institutions
had already been weakened by the tight 2006 presidential
election and Andres Manuel Lopez Obrador's protests
claiming electoral fraud, as well as the removal of the
Federal Electoral Institute's counselors by the Congress.


6. (SBU) Banamex analyst Kurczyn told us he did not think
Mexico would relive the political and economic crisis of
1994 and 1995. Echoing the government's views on the
economic and financial situation, he noted that the
economic and financial conditions are very different now
from what they were more than a decade ago: Mexico has
lower foreign debt (equivalent to 2.4% of GDP),high
foreign reserves, a fixed exchange rate, a low inflation
rate compared to other countries, well-capitalized banks, a
lack of risky structured instruments, low private sector
leverage, etc. Moreover, the financial crisis did not
originate in Mexico this time. For Kurczyn, international
confidence in Mexico's fundamentals was reflected in the
Federal Reserve Bank's recent 30-billion swap line to the
Bank of Mexico and the International Monetary Fund's
decision to double borrowing limits for emerging-market
countries. Goldman Sachs Director General in Mexico and
former Finance Under Secretary, Martin Werner echoed
Kurczyn's confidence in the strength of the financial
institutions saying that Mexico learned its lesson and that
banks are stronger. The only impact on financial
institutions would be the cut in annual profits because
they will be forced to increase their preventive reserves
to face the rising non-performing consumer loans.


7. (SBU) Financial authorities and Hacienda officials have
repeatedly denied the risk of a collapse of the banking
system thanks to the regulations implemented since the
1994-1995 so-called "Tequila crisis", which have
strengthened financial institutions. Banks have
dramatically changed the way they report their accounting
and their balance sheets are available to investors'
scrutiny. An exception though was the exposure of some
companies to foreign exchange derivatives, which made the
peso depreciate to over 14 pesos to the dollar in October.
The peso depreciation led to the bankruptcy of a major
Mexican retail store and left other major Mexican
corporations shaky. The Finance Secretariat asserted that
the demand for dollars has been supplied and that most of
these operations had been closed.


8. (SBU) Corporations? failure to disclose their exposure
to such operations made authorities realize the need for
stricter supervision. The National Banking and Securities
Commission (CNBV) stepped up by conducting an investigation
on the companies' compliance to their obligation to report
significant financial information. Lawmakers are preparing
an initiative to increase disclosure of derivative
positions and their potential risk. The Finance
Secretariat is currently working on a specific bankruptcy
law and is also looking into incorporating further controls
based on the U.S. subprime experience.

CREDIT CARDS AND CONSUMER LOANS
--------------

9. (SBU) The increase of non-performing consumer loans, in
particular credit cards, has raised concerns about bank
solvency. The National Banking and Securities Commission

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(CNBV) reported that the delinquency index, which measures
delinquent loans as a percentage of total loans, rose from
2.82% to 3.03% during the third quarter of the year. This
figure is still low compared to 16.3% in 2001. The
delinquency index in consumer loans, including credit cards
and automobile loans, rose from 6.92% to 7.69%. Within it,
the delinquency index for credit cards grew from 8.18% in
the second quarter to 9.41% in the third quarter, and from
3.9% in December of 2005. The delinquency index for
housing and business loans rose from 3.05% to 3.34% and
from 1.05% to 1.09%, respectively.


10. (SBU) Banks have raised their preventive reserves due
to the increase in credit cards? overdue payments.
Currently, coverage for non-performing loans is 157%, which
means that for each peso owed, banks have 1.57% to cover
it. Banks' current capitalization index or the capital-to-
asset ratio is 15%, which is way above the required 8% by
domestic and international standards. The private sector's
current leverage is equivalent to 22% of GDP ? which
comparies favorably to 201% in the U.S. The recent
increase in credit card interest rates from an average of
34% to 42% is worrisome, especially when there is a
potential risk of a higher unemployment rate in the coming
months. To offset this risk, banks have reduced the
issuance of credit cards and are being more careful with
their credit origination procedures, both for credit cards
and mortgages. The Bank of Mexico, the Finance
Secretariat, other financial authorities, and banks have
created a coalition to improve financial education for
consumers.

CENTRAL BANK ACTIONS TO ADDRESS THE CRISIS
--------------

11. (SBU) To shore up the peso and tackle liquidity
pressures, the central bank has engaged in daily U.S.
dollar sales (USD 13.1 billion of its $84 billion foreign
exchange reserves) in an attempt to break a dangerous cycle
of currency weakness begetting turmoil. Foreign exchange
reserves continue to be high despite this dollar injection
(USD 76 billion). Other central bank policy actions
include: paying interest on dollar deposits held with the
central bank; repurchasing up to 150 billion pesos of
Savings Protection Bonds, which is expected to help in the
sterilization process in order to reduce the amount of
dollars auctioned by the central bank; establishing an
interest rate swap mechanism via which local banks will be
able to exchange exposure to long-term fixed interest rates
for short-term variable rates; and, establishing a USD 30
billion swap facility with the U.S. Federal Reserve.


12. (SBU) The government announced it will reduce the
supply of its long-term securities in its fourth quarter
2008 auction program and the weekly issuance of Savings
Protection Bonds. The GOM will temporarily permit
financial institutions to buy and sell government
instruments from investment funds that are part of the same
financial group. The government is providing guarantees on
commercial paper via development and mortgage banks. The
most recent measure announced by the Finance Secretariat is
the buy-back of up to USD 3.2 billion of debt (bonds with
maturities between 10 and 30 years) in an effort to drive
down long-term yields. The government expects liquidity
pressures to stabilize during the first quarter of 2009,
but will extend these measures if needed.


13. (SBU) On Oct. 8th, President Calderon announced his
Program for Growth and Employment aimed at mitigating the
impact of the global economy's deterioration and credit
crunch. The Program for Growth and Employment focuses
boosting the economy by increasing public spending on
infrastructure projects. The elimination of Pidiregas
(long-term debt for infrastructure projects),included in
the program will enable the government to convert Pidiregas

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liabilities into public debt and exclude Pemex's capital
expenditures from the balanced budget. This measure will
give the government an additional USD 6 billion to spend on
infrastructure. The initiative will also allow Pemex to
use its current stabilization fund of approximately USD 923
million to build a refinery.

OIL PRICE AND THE RISK OF REVENUE SHORTFALLS
--------------

14. (SBU) Due to the deterioration of the global economy,
the government had to submit revised economic projections
to the Congress. GDP growth, the Mexican oil mix price,
the exchange rate were revised downward from 3% to 1.8%,
from USD 80.3 to USD 70 per barrel, and from 11.20 pesos to
the dollar to 11.70 pesos to the dollar, respectively. The
1.8% GDP growth seems too optimistic given the depth of the
global financial crisis and the sharply downgraded outlook
for the U.S. economy. In its World Economic Outlook 2008,
the IMF projects a GDP growth of 0.9% in 2009 from the
previous projection of 1.8%. There are growing concerns
that lower economic growth and the decline of international
oil prices could lead to a revenue shortfall next year.


15. (U) The Finance Secretariat assures that it will not
have to cut spending next year particularly in
infrastructure projects, security, and social development
as it has a cushion of USD 4.3 billion in the Oil
Stabilization Fund. The government is also confident that
a weaker peso will compensate for the oil price fall. The
stabilization fund would be sufficient if the Mexican oil
price falls from the USD 70 per barrel set in the budget to
USD 60 per barrel. However, the Mexican oil mix price
keeps on falling and on November 5 it closed at USD 43 per
barrel. The government might have already hedged a chunk
of its oil exports, according to analysts, although it is
unlikely that the Finance Secretariat will acknowledge this
fact. The Finance Secretariat continues to gradually
eliminate the gasoline subsidy.


16. (SBU) The elimination of Pidiregas will allow the
government to have a fiscal deficit of 1.8% of GDP, which
will help the government funnel resources to
countercyclical measures, such as the development of
infrastructure projects. Next year, the government will
spend USD 10.6 billion against the USD 18.5 billion
disbursed in 2008. The government also requested the
Congress to increase its indebtness levels and incur in
foreign debt of USD 5 billion with multilateral financial
organizations. The Finance Secretariat is confident that
if required it will have access to those loans since the
Mexican government prepaid USD 9 billion of its foreign
debt in 2006. Leftist economist Rogelio Ramirez de la O
and other critics strongly believe the government should
cut its current expenses and bureaucrats' salaries to help
offset the revenue shortfalls.

HOW THE CRISIS AFFECTS MEXICO?S REAL ECONOMY
--------------

17. (SBU) Tourism, oil and trade. The financial crisis and
the downturn of the U.S. economy is having an adverse
impact on the Mexican economy through various channels: a
decline in manufacturing exports, a slump in remittances
sent by Mexicans abroad, a drop in tourism and FDI flows, a
lower demand for Mexican oil exports, and unemployment.
About 85% of Mexico?s foreign trade is tied to the U.S.
economy. The exports value of manufactured goods declined
by 3.8% yoy in August. Non-oil exports to the U.S. fell by
6.6% and with them, automobile sales to the U.S. dropped by
16.4%. From January thru June, foreign direct investment
dropped 24% and tourism inflows are expected to slow next
year.


18. (SBU) Migrants and remittances. The lower remittances
will likely have a negative impact on domestic consumption

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and housing construction. From January thru September,
remittances have fallen by 3.7%. In July alone, they
dropped by 7%. The potential return of thousands of
Mexicans who have lost their jobs in the U.S. construction
sector will put pressure on Mexico?s job creation.
Mexico?s official unemployment rate reached a record of
4.25%.


19. (SBU) Financial markets. Jitters on the depth of the
global economy, the drop in oil prices, and foreign
investors? flight to quality from peso-denominated bonds to
U.S. Treasuries have hurt Mexico?s financial markets. The
stock market's main index, the IPC, has plunged and the
peso has suffered a major depreciation against the dollar
during the past months. The peso has lost 33% from its
strongest level of 10 pesos to the dollar last July and the
IPC has fallen 31.5% during the year. The country-risk
premium closed at 405 basis points on November 7 from 141
basis points in December 2007. The yield of the 30-year
bond reached 11.30% on October 24 before the government?s
actions to address liquidity problems, but by November 4 it
had fallen to 8.8%. Short-term yields? performance will
continue to depend on the inflation, which reached 5.78% in
October on higher gasoline and electricity prices. The
central bank?s benchmark overnight lending rate is 8.25%.
The Bank of Mexico expects the inflation to begin to recede
in the second quarter of 2009. Foreign currency flows have
also declined. The Bank of Mexico is projecting a current
account deficit of between 1.6% and 2% in 2009. One of the
most pessimistic projections is that from Banamex with a
2.8% deficit.

COMMENT
--------------

20. (SBU) Comment: The government's war against drugs, the
deteriorating security situation and the Secretary of the
Interior's sudden death raised fears here that Mexico would
experience another ?Tequila? crisis, much like the one
which ensued after the assassination of PRI presidential
candidate Luis Donaldo Colosio in 1994. Experts, however,
caution against jumping to such conclusions. The
government has made extraordinary efforts to soothe worried
investors by constantly referring to Mexico?s well-ordered
finances and macroeconomic variables, but Mexico?s
integration with the U.S. economy will undoubtedly impact
the country?s economy. On the financial front, the Finance
Secretariat and the Bank of Mexico seem to have been
reacting promptly to tackle liquidity pressures and the
financial crunch. The timing and effectiveness of the
government?s countercyclical measures, especially the
National Infrastructure Plan, and the passage of other
economic reforms will determine not only how well Mexico
weathers the economic recession, but also how fast the
country will succeed in its insertion into the global
economy. End Comment.

GARZA