Mexican Security: The True Casualty of Low Oil Prices
By: Analysis | Stratfor.comJanuary 21, 2016

Forecast

  • As global oil prices fall, Mexico may have to make cuts to sensitive areas, including to security funding, which would delay essential anti-crime reforms.
  • The manufacturing sector, which primarily supplies the United States, will remain crucial to future economic growth.
  • Increasing energy trade between the United States and Mexico will make energy supply in Mexico more reliable, contributing to growth in the Mexican manufacturing sector.

Analysis

Mexico has long had a privileged position in Latin America. Its proximity to the United States — the largest consumer economy in the world — has contributed to the growth of a robust domestic manufacturing industry, which has become the bedrock of the Mexican economy. Manufacturing has made Mexico the third-largest U.S. trading partner and has propelled its economy to the rank of second largest in Latin America. Still, as in all oil-producing countries, the drop in global oil prices will hurt the country's financial position, possibly jeopardizing its security reforms. But overall, the country will manage the price drop relatively well.

Despite relatively low growth compared to previous years, Mexico will continue to make economic progress and will lead in regional manufacturing for the foreseeable future, largely because of its close economic ties to the United States. Nearly 80 percent of Mexican exports are destined for U.S. markets, and almost half of these exports are higher-value products, such as vehicles and electronic goods. Manufacturing growth is sustained by rising natural gas flows from the United States, which have propelled the rapid expansion of Mexico's electric grid by making energy availability more reliable.

Unsurprisingly, the commercial linkages created between the two countries over the decades, particularly since the passage of the North American Free Trade Agreement in 1994, have also accelerated capital flows into the country. Mexico received about $28.5 billion in foreign direct investment in 2015. The same year, remittances from Mexican nationals working in the United States totaled nearly $22 billion — the most since 2009. During the current Mexican president's term, the country has also opened additional avenues for foreign investment into sectors formerly closed to large inflows of foreign capital, and it has made major changes to its regulatory regime in the hydrocarbons and electricity sectors to break state monopolies, many of which have become costly and uncompetitive.

But Mexico's public finances are still strained, the victim of the steady decline of the price of oil and the taxes oil generates, which has reduced government income and forced Mexico City to find options for covering the budgetary shortfall. Its economic and energy reforms will not have tangible benefits for several years as well. For now, the financial burden posed by the two state enterprises that dominate the energy and electricity sectors — Petroleos Mexicanos (Pemex) and the Federal Electricity Commission, respectively — will remain. Pemex reported a loss of some $10 billion in the third quarter of 2015 — a bleeding of revenue that is expected to continue as oil prices drop even further. It is clear: No matter Mexico City's past prudence, if oil prices stay low, they will eventually hurt the government's bottom line.

Still, Mexico has enough revenue that any future challenges will not pose an existential threat to the country's financial stability. Its already healthy manufacturing base will expand to fulfill steadily rising U.S. consumer demand. Moreover, because of an oil hedge secured last year, Mexico's oil exports for 2016 are guaranteed at $49 a barrel — well above current prices. But the hedge is not permanent insurance. If oil prices remain low, any future hedge will likely be lower, reducing oil revenue further. Stripped of that revenue, which accounts for 20 percent of the federal government's income, Mexico City will be forced to find ways to make up the difference, selling debt abroad or even auctioning assets from state-owned enterprises, including Pemex.

Any challenges the government faces in the near term will arise not from acute political or economic instability, but from making these unpopular decisions to remain solvent. Mexico City could even cut security spending further, which would delay key parts of its security plan. Some security cuts have already been made: Federal security funding to states was cut by $160 million in 2016 — nearly a fifth of the total the year before. If more funding is cut, it could harm Mexico City's attempts to create lower-level institutions to deal with insecurity, an important component of the long-term security strategy to shift from using the army and federal police to deal with crime. It is increasingly unlikely that the federal budget will create additional forces anytime soon, even on the national level.

Overall, Mexico's next few years will be quite bright. Its economy will continue benefiting from foreign investment to fund manufacturing initiatives to supply the U.S. domestic market. The growing energy trade between the United States and Mexico will also ensure secure electricity supply that will further drive manufacturing growth. But security concerns will persist, as funding for anti-crime measures becomes less reliable.

This article originally appeared on Stratfor.com

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