During the ‘tequila crisis’ of 1994-95, Mexico came close to financial collapse. But a $50 billion bail-out organised by the US together with a boost from enactment of the North American Free Trade Agreement (NAFTA) shortly before, helped Mexico to rebound. In the years since, the country has become more tightly integrated with its NAFTA partners – the US and Canada – and has gained a reputation for credible marco economic policy management. However, tighter NAFTA integration is a mixed blessing: unhelpfully at present, the business cycle now moves in lock step with the US. The country faces other headwinds: a political structure resistant to reform and tenacious organised crime groups unafraid to use violence.

Mexico outranks its Latin American peers on three important dimensions – business climate, per capita income and creditworthiness - but its growth rate lags the regional average (Chart 1). Indeed, average annual growth since 2000 has been a disappointing 1.9%, considerably lower than the 3.2% racked up by Brazil or the regional average of 3.1%.

Exporters and investors face three main risks in Mexico: high business cycle and currency risks as well as a high degree of difficulty enforcing contracts. Mexican GDP growth has recently experienced a large bust and rebound; the peso can be a volatile currency; and enforcing contracts can be time consuming and expensive (Chart 2).

Rapid per capita income growth isn’t the only thing Mexico can claim credit for since the tequila crisis. There has also been an impressive decline in inflation and an improvement in creditworthiness.

NAFTA integration means that more than three quarters of Mexico’s exports now go to the US and production structures are tightly linked across the three NAFTA countries. This means that economic weakness in the US is quickly transmitted through trade and financial channels to the Mexican economy.

Though Mexico defaulted on external debts in 1982, had three debt reschedulings (Paris Club and Brady Plan) during the 1980s and experienced a financial crisis in 1994, it now has an investment grade sovereign credit rating BBB from S&P and Fitch and Baa1 from Moody’s.

Mexico’s close integration with the US saw the economy take a hammering in 2008-09, when the collapse in US industrial production quickly transmitted itself to Mexico. As a result: GDP contracted by around 6.5% in 2009; exports of manufactured goods and oil fell sharply, turning a string of current account surpluses into a steep deficit; and foreign capital outflows surged, which put pressure on the peso and foreign reserves. As a precaution, Mexico sought a Flexible Credit Line (FCL) from the IMF, which was subsequently renewed earlier this year.

The economy has begun to show signs of life and GDP is expected to expand by about 4.4% in 2010. However, longer term challenges loom, notably the need to address structural problems in the economy’s labour and product markets, fiscal policy and the petroleum sector. The petroleum sector is particularly problematic – the constitution effectively rules out private sector involvement, even through production sharing or service agreements. The net result is: inefficient production, declining proven reserves and limited technical capacity to prove up challenging potential ‘deep water’ reserves.

Mexico is officially a multi-party democracy, with three main parties, six year presidential terms and a bicameral legislature.

However, the reality is far more complex, with one party, the Institutional Revolutionary Party (PRI), exerting outsized political influence. For much of the 20th century, PRI governed the country and maintained a near dominance on public office. This political dominance was based on the creation of a network of politicians, landowners and other interest groups bound together by patronage and fear of political exclusion. The PRI’s political dominance was dented by the 2000 election of Vicente Fox Quesada of the National Action Party (PAN) as president and then the election of another PAN candidate, Felippe Calderon, in 2006.

But despite no longer controlling the presidency, the PRI remains a significant force in Mexican politics, holding 19 governorships and frequently playing a central role in forming coalitions in Congress where it holds 49% of the seats. It is pursuing a policy of non-cooperation with President Calderon, which has stymied his ambitious reform agenda, most notably proposals to amend the constitution to permit private sector involvement in the petroleum sector.

The stage is set for a difficult two year political standoff in the run up to a 2012 presidential election. The PRI appears to be re-positioning itself to reclaim office and the other two political parties’ – National Action Party (PAN) and Party of the Democratic Revolution (PRD) are unlikely to be able to sustain the cooperation they showed by fielding common candidates in recent elections.

Despite Mexico’s political complexities it manages to rank in the second top quartile on ‘government effectiveness’ in the governance indicators produced by the World Bank and outrank the Latin American regional average. However, Mexico ranks in the bottom quartile on ‘political stability’ and just inside the second bottom quartile on ‘voice and accountability’ (Chart 5).

Mexico historically has a reputation as a difficult place to do business. However, the reality today is much more nuanced. It’s true that the business environment is politicised, dominated by large conglomerates and lacks a strong legal framework. But this is rapidly changing as the government and private sector are becoming less insular over time – while selective, the government is increasingly drawing on international frameworks and the private sector is stepping up its cross border activities. At the same time, the economy welcomes foreign involvement (outside the petroleum sector) and access to international arbitration is guaranteed by law and by free trade agreements such as NAFTA.

The complexity of the business and investment environment is reflected in the variation in Mexico’s rankings on the World Bank’s ease of doing business gauge, which attempts to measure ‘regulation and red tape relevant to a domestic small to medium-size firm’. On ‘ease of doing business’ and ‘protecting investors’, Mexico ranks in the second top quartile, but in the bottom quartile for ‘hiring/firing workers’ (left hand panel, Chart 6).

On factors that matter most to foreign investors, such as controlling corruption, rule of law and regulatory quality, Mexico’s rankings are similarly variable (right hand panel, Chart 6).

As an ‘upper middle income’ country with a per capita GDP of US$8,200, Mexico has living standards on par with Malaysia, Brazil and Russia (Chart 7). But this high level obscures large regional disparities, with the sizeable urbanised and manufacturing areas in the country’s north and around Mexico City out earning their more rural and southern counterparts by a wide margin.

Poverty is long-standing problem in Mexico and while estimates of poverty vary, World Bank data suggest that 8% of the population live in moderate poverty (less than $2 per day). The government’s Opportuniades program, similar to Brazil’s Bolsa Familia, is designed to address some of the underlying causes of poverty, notably differences in human capital.

Mexico is a major recipient of remittances, sent mainly from the US. They average around US$20 billion a year, and fell for the first time in 2009 (but maintained their purchasing power thanks to a decline in the value of the peso against the US dollar).

Violent crime – primarily drug related – is a widely reported problem. The Calderon government has stepped up its enforcement against the drug cartels, which as well as fighting government forces are now fighting one another for dominance. Among the casualties have been several assassinated politicians and security officials.

According to estimates reported by the US State Department, nearly 23,000 have been killed in drug related violence since President Calderon took office in December 2006.

*All 2009 figures unless specified

**The HDI is composite measure of human development: long & healthy life (life expectancy), education (literacy & education enrolment) and income (GDP per capita)

***Expressed as % of GDP unless specified