Mexico's year of far-reaching reform is a good beginning

(c) 2013, Bloomberg News.

The following editorial appears on Bloomberg View:

Spare a thought for Mexico's President Enrique Pena Nieto. After engineering an ambitious reformist pact among Mexico's three major political parties, he whirled through his first year in office rewriting laws on everything from energy to television and education to elections. Yet Mexico's economic performance in 2013 was disappointing, and Mexico's businesses and foreign investors aren't exactly exuberant. It's enough to damp a reformer's spirits.

These are early days for Pena Nieto's new policies, and the reforms he's achieved so far will take time to show results. A little patience is justified — but not too much. There's a lot of unfinished business.

The achievements of the past year are real. Most notably, Pena Nieto shattered a 75-year taboo on foreign investment in Mexico's oil fields with legislation passed this month. He opened Mexico's airwaves to more competition overseen by a tougher regulator. A new tax law has reduced Mexico's reliance on oil revenue. More people can get bank loans. Mexico's teachers are being held to account, and the corrupt leader of their powerful union has been jailed.

Yet in 2013, says the International Monetary Fund, Mexico's gross domestic product grew by only 1.2 percent, down from 3.6 percent a year ago. Foreign investors were skittish, with portfolio investment dropping sharply from the previous year. Mexico's peso bonds headed for their biggest yearly decline since 2008. Consumer and business confidence have sagged. Only in December, with the passage of energy reform and Standard & Poor's ensuing decision to upgrade Mexico's debt rating, have expectations begun to improve.

Several factors have dulled the immediate effects of Pena Nieto's reforms. Mexico has faced a year of financial uncertainty, held hostage to the Federal Reserve's decision making on when to cut monetary stimulus. The peso is the most actively traded emerging-market currency, and foreigners own 35 percent of its government securities, so Mexico is unusually sensitive to shifts in global capital flows. Higher taxes levied as part of the government's fiscal reforms have clouded the short-term outlook for growth. And further changes to laws and regulations will be needed to put Pena Nieto's groundbreaking changes into effect.

Over the coming year, the reforms will start to be noticed — especially in the energy sector, which could attract as much as $20 billion in additional foreign direct investment by 2015. To reap the full potential, though, the government needs to maintain its reformist zeal and press on. Three issues stand out.

First, Pena Nieto needs to bring more Mexicans into the formal economy. Mexico has more than twice as many "informal" nonsalaried workers as formal salaried kind. This lowers productivity because gray-market companies tend to be less efficient. It also narrows the tax base, requiring those who actually pay taxes to pay more. Case in point: Just-enacted fiscal reforms increase the tax burden on formal workers, which will make the economic distortion worse and continue the vicious circle. What's needed is unified social insurance — financed in a way that doesn't give informal labor an advantage.

Although Mexico's fiscal reforms will reduce its reliance on oil taxes (which fund a third of the federal budget) and increase tax revenue, Mexico will still collect proportionately less in taxes than any other developed nation. Despite being one of Latin America's most active tax reformers, Mexico has maintained a consistently low tax share of GDP — not a good thing when pressing needs for public spending are going unmet. Mexico has the lowest life expectancy in the Organization for Economic Cooperation and Development, spotty health-care services, and an uneven educational system.

Above all, Mexico needs to strengthen the rule of law. Pena Nieto has understandably sought to turn the news media's Mexico narrative away from drugs and violence and toward jobs, investment and progress. But facts, and criminal cartels, are stubborn things. Kidnappings and extortions are on the rise. Mexico's police forces and criminal justice system are underfunded and corrupt. There's a culture of impunity: Only 2 percent of crimes lead to convictions. In some states, vigilante groups are filling the vacuum.

Although some local reforms of the police and judiciary have shown success, rule-of-law reform needs the kind of national commitment and political savvy that yielded the advances of Pena Nieto's first year in office. Indeed, those advances are in jeopardy, too, unless Pena Nieto follows through. He has time: The next presidential election isn't due until 2018. Between now and then, Mexico's radical new president needs to keep at it.

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