Until the so-called “secondary legislation” in Mexico is finalized, it is not clear whether the energy reform will meet the high expectations of industry observers and financial markets.

BY ROGER F NORIEGA AND FELIPE TRIGOS

During the last three decades, most of Latin America has benefited from important gains in the consolidation of democratic institutions and implementation of orthodox economic policies that have tamed hyperinflation, reined in debt, and liberalized trade. Of course, Venezuela, Cuba, and other countries are dramatic exceptions to this regional progress. Even in countries that generally have chosen a more responsible course, however, recurring bouts of populist policies make it harder for them to reach their full potential.

For example, the region’s bellwether economies—Brazil and Mexico—are routinely hailed for their growth spurts and unquestionable potential. However, inconsistent policies have put sustained and substantial economic growth just out of their reach. A burgeoning middle class in both countries has increased the demand for more economic opportunity; better jobs; low inflation; and efficient, accountable government— raising the stakes for leaders hoping to meet these expectations.

In the long run, sound policies are good politics. Fresh evidence of failed statist models in neighboring countries in Latin America has reinforced the lesson that prosperity can be achieved only through responsible macroeconomic policies, fiscal discipline, and a growing and dynamic private sector. Unless elected leaders commit fully to policies that favor free market solutions, they will not be able to deliver the economic opportunities their people require.   (…)

BRAZIL: TRIUMPH OF HOPE OVER EXPERIENCE

For the last 20 years, economists have charted Brazil’s steady climb in the ranks of world economies. Under a series of democratically elected presidents, but beginning especially with former President Fernando Henrique Cardoso, who served from 1995 to 2003, successive Brazilian governments have implemented orthodox macroeconomic policies that succeeded in ending the country’s historical boom-and-bust cycles and taming inflation.

Growing opportunities swelled the ranks of middle-class consumers, and income-transfer programs have helped millions lift themselves out of poverty. In 2005, the country earned a seat at the then–G-8 (Group of Eight) dialogue and was hailed as an example for the developing world. Indeed, Brazil’s relative stability in the wake of the global financial crisis of 2007–08 appeared to validate the most optimistic forecasts for the country’s economic future.

The windfall from a commodity boom fueled by Chinese consumption and the discovery of vast deep-water oil deposits in 2007 buoyed the Brazilian economy, lowered unemployment, and filled the government’s coffers. The downside to the country’s apparently boundless prospects was that then-president Luiz Inacio “Lula” da Silva was under no pressure to invest his considerable political capital in a reform agenda that most experts say was needed to make Brazil more competitive and unlock its full potential.

Writing in the journal Americas Quarterly in mid-2012, University of Connecticut professor Peter Kingstone argued that Brazil had grown too dependent on the commodity boom. By 2012, he noted that Brazil’s commodity exports accounted for 14 percent of gross domestic product (GDP), compared to 6 percent in the 1990s.

Indeed, in 2012, the tide began to turn. Weakening Chinese demand for commodities and other raw material imports hit the Brazilian economy hard, with growth sliding from 7.5 percent in 2010 to 2.3 percent in 2013.

The slowdown also exacerbated contractions caused by the government’s more statist economic policies. Widespread urban demonstrations in June 2013, sparked by public transportation rate hikes and the government’s perceived indifference to the needs of most Brazilians, were a sobering reminder that Brazil’s economic trajectory continues to be a work in progress.    

Many economists have identified unfinished business in Brazil’s reform agenda, including improving government efficiency and accountability, taming costly public pensions, simplifying the labyrinthine federal and state tax systems, liberalizing the labor code, removing arbitrary obstacles to doing business, and attracting foreign capital and technology into the promising energy sector. Brazil’s political leaders would do well to renew consideration of these reforms to spur more robust growth.

The Brazil Economic Survey for 2013, published by the Organization for Economic Cooperation and Development (OECD), echoed the need for cutting public expenditures and debt, reforming the tax and labor codes, and continuing to manage inflation.

It also recommended education reform that focuses on improving overall quality as well as entrepreneurship and vocational worker training.

Yet, in reaction to slowing growth and popular discontent—and facing reelection in October 2014—current President Dilma Rousseff has pledged massive new government spending programs while eschewing the difficult but essential structural reforms needed to sustain long-term progress.

A dramatic example of the prime need for reform is the current management of state-owned oil company Petrobras. Even with the prospects for vast new oil deposits, Brazil’s petroleum sector has failed to reach its potential and is under unrelenting pressure from politicians to generate the revenue needed to fund the state’s social welfare programs. In recent years, Brazil has failed to attract the capital and technologies needed to exploit its resources because of the nationalist ground rules the government has imposed on investors. Domestic content rules and onerous requirements to enter into partnerships with Petrobras have discouraged many international oil companies from entering the Brazilian market.

Still, Petrobras remains the government’s cash cow. Even as its profitability and stock prices have declined, Petrobras is required to finance growing social spending. For example, the Brazilian Congress recently passed a law earmarking 75 percent of oil royalties for education and 25 percent for health care. In addition, Petrobras also is required to divert revenue to import foreign oil to satisfy domestic consumption.

Although Brazil’s social welfare programs—such as the Bolsa Familia cash transfers—have helped 50 million people out of poverty, they have added to Petrobras’s financial burden. They also exact a significant and growing portion of the national budget. According to the Financial Times, a 2012 study by the Brazilian government found that the number of young people (aged 15 to 24) not working or in school has increased since 2009, leading some to ask whether government transfer programs have contributed to a culture of dependency. The Times piece also reported that the slowing economy even led some to question the 11-year-old Bolsa Familia program.

Another significant drain on the government’s finances is its pension fund, which entitles persons over 54 years of age to receive a pension of 70 percent of final pay. Brazil spends 3 percent of its GDP on survivors’ pensions, although OECD countries spend an average of less than 1 percent for such benefits. Furthermore, Brazil spends a staggering 11.3 percent of GDP on public pensions, a percentage just below that of Greece.

Brazil’s public education programs present another serious problem. The government spends 5.6 percent of GDP on public education—more than the average of OECD countries—yet the quality of education ranks very low. Although education outcomes have proven to be unsatisfactory, Rousseff’s election-year agenda proposes to increase education spending to 10 percent of GDP, the highest rate of any nation in history.

Inadequate infrastructure is another obstacle to Brazil’s growth. Much attention is being paid to Brazil’s costly renovation and construction of venues and other facilities that will host the 2014 FIFA World Cup and the 2016 Summer Olympics. These expenditures stand in stark contrast to the significant infrastructure deficit countrywide that inhibits key sectors of the economy. In contrast to the global average of 3.8 percent, Brazil spends only 1.5 percent of GDP on infrastructure.

This underinvestment has resulted in inadequate transportation networks and inefficient ports, which have hampered commerce; raised shipping costs; and undermined the profitability of agriculture, mining, and other industries that depend on the export market.

Overcoming these obstacles is essential for Brazil to sustain healthy growth rates and realize its aspiration of becoming a global economic power. High current account deficits, high inflation, and possible devaluations could further complicate Brazil’s predicament. A Bulltick Capital emerging markets research analyst warns, “Interventionist and erratic policymaking, capital controls, fears of China’s deceleration, and declining commodity prices have affected the Brazilian economy.”

Whoever wins Brazil’s October 2014 presidential election will be expected to tackle the politically tough challenges to gradually liberalize the Brazilian economy to produce broad economic growth to take the country to the next level.

MEXICO'S MOMENT?

Unlike other countries in the region, Mexico’s robust economic growth in recent years was not heavily dependent on the commodities boom. Instead, it has resulted from the  economic policies implemented during the administrations of Presidents Ernesto Zedillo (1994–2000), Vicente Fox (2000–06), and Felipe Calderón (2006–12).

After decades of devaluations, high current account deficits, excessive inflation rates, and deficit spending, Mexico was finally consolidated as one of the most stable economies in the world; for example, international reserves increased from $35 billion in 2000 to $163 billion in 2012. Throughout the last decade, Mexico signed 44 free trade agreements (more than any country in the world) and established itself as one of the world’s leading exporters of manufactured goods and the third most important commercial partner for the United States.

In the final year of Calderón’s administration, the economy grew 3.9 percent. During 2013, the first full year under president Enrique Peña Nieto, Mexico’s economy contracted and grew only 0.9 percent. Most of this slowdown came in the first half of 2013 and could be attributed primarily to sluggish US growth. However, Peña Nieto’s populist campaign and initial budget proposals may have sent negative signals on crucial taxing and spending issues. In his first year, Peña Nieto steered important education and energy reforms through a divided Congress, but his tax reform plan imposes a disproportionate burden on the productive sectors of the economy and will not likely generate sufficient revenue to cover significant new social spending.

Furthermore, although Mexico’s economy attracted more than $33 billion in foreign direct investment in 2013, reports from Mexico’s Central Bank (BANXICO) suggest that this figure is expected to decrease by 22 percent in 2014. Also, according to BANXICO, between January and September 2013, Mexico experienced a capital outflow of $26 billion, which accounts for 15 percent of Mexico’s international reserves. The outflows are apparently due to investor uncertainty about whether Peña Nieto will vigorously implement his ambitious reform agenda to liberalize key sectors of the economy.

The same reports that predicted Brazil’s takeoff also noted that Mexico was headed toward becoming the seventh largest economy in the world. Under its two previous administrations, these positive assessments were substantiated by financial discipline, deft management of the 2007–08 global financial crisis, responsible monetary policies, robust trade policies, and historic levels of foreign direct investment. It remains to be seen whether these healthy economic conditions can be maintained if Peña Nieto gives into the demand for traditional populist formulas that look to the state for solutions and increased social spending.

To his credit, Peña Nieto came to office promising comprehensive reforms that would improve Mexico’s long-term economic performance. Under El Pacto por México (the Pact for Mexico), the president and leaders of the country’s three major parties agreed to implement a series of important initiatives, including reforms of the education, telecommunication, financial, and energy sectors. The ability of this administration to win approval of so many reforms from a fractious Congress is impressive, particularly in light of the groundbreaking nature of most of these reforms. Of particular importance are the tax overhaul and energy reform.

The fiscal reform adopted last fall is not without its critics. In addition to raising taxes on the wealthy to help finance increased social spending, the new tax regime will extract more revenue from the productive, salaried middle class. Worse yet, the new taxes will not keep up with new spending—the equivalent of 4 percent of GDP—that was adopted to compensate for the economic slowdown. The combination of high taxation and rising government expenditures could threaten the steady growth that Mexico had achieved in recent years.

One renowned expert on the Mexican economy, Raúl Aníbal Feliz of the Center for Research and Teaching in Economics, criticized the tax reform as “mediocre” and warned that it would undermine Mexico’s economic stability.

He noted that the reforms do not improve the efficiency of tax collection and that taxes remain too high for an economy the size of Mexico’s. He predicted that the government would have to either cut spending or revisit the tax structure in the near future.

Another economist, Hector Villarreal, director for the Center for Economic Research and Budget in Mexico, recently warned, “The government is increasing its debt and disregarding economic growth, and this, in the long run, may end up in a deficit of 10 percent of GDP at the end of this administration.”

On the other hand, Peña Nieto’s energy reform took specific aim at the long-standing “third rail” of Mexican politics: opening up the oil sector to foreign investment. Although the president’s original proposal was cautious, the ensuing legislative process produced a transformational package. The ruling Institutional Revolutionary Party (PRI) and the center-right National Action Party (PAN) approved a substantial, sweeping plan for restructuring Mexico’s poorly managed energy sector. The language also proposes to reduce the influence of the powerful oil workers union by eliminating its representation on the company’s board.

In addition to improving performance, other reforms seek to improve the financial management of the state-run oil company Petróleos Mexicanos (PEMEX). For example, a key provision will reduce the amount of revenue that PEMEX funnels into the government’s budget from more than 50 percent of its revenue to no more than 4.7 percent. This will allow PEMEX to reinvest what it needs in exploration, operations, and maintenance to improve profitability.

Moreover, a “Mexican Petroleum Fund” will channel funds to a sustainable pension fund for PEMEX employees, provide a reliable source of funding for infrastructure (30 percent of revenues), and invest in PEMEX’s human capital (10 percent of revenues) to encourage postgraduate education and specialization for the company’s workers.

Although the privatization of Mexico’s oil industry was never seriously considered, significant opportunity exists today for improving the sector’s performance. If implemented thoroughly, energy sector reforms can be transformational in fueling Mexico’s economic development and making the country into an energy powerhouse. The next several years will be pivotal in assessing whether PEMEX will succeed in adopting modern policies and practices, particularly by welcoming private investment, reducing government interference and taxes, and taming the influence of powerful and corrupt labor unions.

Until the so-called “secondary legislation” is finalized, it is not clear whether this energy reform will meet the high expectations of industry observers and financial markets. Implementation of the laws and regulations, which will determine the depth and breadth of the energy reforms, is still being hammered out between the PRI and the PAN. For example, the secondary legislation would define the management structure and the terms for the exploration, exploitation, refinement, and transportation of oil and gas. It also will establish the parameters for private investment and for the collaboration of private companies in ventures with PEMEX. Unfortunately, recent partisan rancor has delayed negotiations on this critical legislation.

Roger F. Noriega is a former assistant secretary of state for Western Hemisphere affairs (Canada, Latin America, and the Caribbean) and a former U.S. ambassador to the Organization of American States. He coordinates the Latin America program of the American Enterprise Institute (AEI). This column is based on an excerpt from a recent AEI Latin America Outlook report.