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Cablegate: Mexico Faces Budget Challenge; Tax Hikes,

VZCZCXRO1933
RR RUEHCD RUEHGD RUEHHO RUEHMC RUEHNG RUEHNL RUEHRD RUEHRS RUEHTM
DE RUEHME #2537/01 2382318
ZNR UUUUU ZZH
R 262318Z AUG 09
FM AMEMBASSY MEXICO
TO RUEHC/SECSTATE WASHDC 8032
INFO RUEHXC/ALL US CONSULATES IN MEXICO COLLECTIVE
RHMFIUU/DEPT OF JUSTICE WASHINGTON DC
RUEHC/DEPT OF LABOR WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RHMFISS/CDR USSOUTHCOM MIAMI FL
RHMFIUU/CDR USNORTHCOM PETERSON AFB CO
RUEAHLA/DEPT OF HOMELAND SECURITY
RUEABND/DEA HQS WASHINGTON DC
RHEHAAA/NSC WASHINGTON DC

UNCLAS SECTION 01 OF 03 MEXICO 002537

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: PREL PGOV PHUM SNAR KCRM MX
SUBJECT: MEXICO FACES BUDGET CHALLENGE; TAX HIKES,
SPENDING CUTS LIKELY

Summary
-------

1. (U) The Calderon administration faces a formidable
challenge in preparing its 2010 budget. GDP contracted 10.3%
in the second quarter of this year, the fourth consecutive
quarter of decline. Weak tax collection, the recession, and
low oil production, prices, and exports has created a 2.7% of
GDP spending gap for 2010. The President plans to propose
austere measures which may include a combination of debt,
higher taxes, and lower spending. The Administration is
confident there are sufficient political incentives in place
to approve successful fiscal reform. Despite the GOM's
confidence, the outcome of the reform depends largely on the
willingness of the PRI to agree to these politically
unpopular tax changes. End Summary.


GDP Contraction in 2Q09
-----------------------

2.(U) On August 20, Mexico's statistics agency (INEGI)
reported a 10.3% GDP contraction in the second quarter,
compared to the same quarter last year. Hurt by a slowdown
related to the H1N1 flu outbreak and the Easter holiday, it
is the fourth consecutive quarter of declines in economic
activity. According to the agency, a 16.4 percent
contraction in manufacturing and a 9.2 decline in
construction led the quarterly decline. Commerce was down by
20.9 percent and transportation decreased by 13.7 percent.
The decline is slightly less than analysts, projections.
Undersecretary of Finance Alejandro Werner told the media
that the economy stabilized or touched bottom in June 2009;
he projects a recovery in the next quarter. Werner also
noted improving July data for car sales and unemployment
figures were the first evidence of a recovery. (Note: The
OECD reportedly advised Mexican policymakers to ensure the
economy stopped contracting before tightening fiscal policy.
Hasty moves to bring public finances back in balance could
aggravate the recession. End note.)

The Fiscal Challenge
--------------------

3.(U) The GOM must send its 2010 budget to Congress by
September 8. In preparing its 2010 budget, the GOM faces a
spending gap on the order of MX$300bn (approximately US$23bn
or 2.7 percent of GDP, assuming a 7.5 percent annual
contraction this year). The gap is due to continued:

-- Low oil production, prices, and exports. About 35-40% of
budget revenues depend on oil. Oil production has fallen by
almost 800,000 bpd (or 25%) since Calderon took office in
December 2006, with production at Mexico's main oil field,
Cantarell, down more than 50% since it peaked in 2004. Oil
revenues in the first 5 months of 2009 were down 24 percent
compared to the same period in 2008. The GOM also forecasts
an average export price of US$54/b in 2010, down from US$70/b
in 2009.

-- Weakness in collecting taxes. Non-oil taxes represent
less than 10% of GDP, compared to an average of 19 percent
internationally and 15 percent in Latin America. Tax
collection has historically been difficult in Mexico, and a
recent tax reform that raised taxes on business has
stagnated.

-- Decline in economic activity due to the recession. Fully
integrated into the U.S. economy, the Mexican economy is
reeling from the U.S. economic crisis, which takes over 80
percent of Mexico's exports. Mexico's trade was down by a
third in the first half of 2009, year-on-year. Last month
Secretary of Finance Agustin Carstens said that the economic
crisis had cut the GOM's revenues by MX$480bn (US$36.6bn).

Austerity Package on the Way
--------------------------

4. (U) In a bid to keep a lid on next year's budget gap,
President Calderon recently indicated the GOM's intention to
launch a "very severe austerity plan which will probably

MEXICO 00002537 002 OF 003


include adjustments to the very structure of the government."
The GOM's proposal may include a combination of debt, higher
taxes, and lower spending. Other possibilities include
expanding the tax base to the informal sector, changing
current energy pricing policies, and simplifying the tax
system. (Comment: The proposal to selectively expand the
value-added tax (VAT) on medicines and food is controversial.
End Comment.) The GOM has already cut spending twice this
year (a combined 0.7 percent of GDP) and also plans to use
profits on dollar/peso operations and oil and state-revenue
stabilization funds to plug the gap for 2009.


Prospects for Fiscal Reform
---------------------------

5. (SBU) The Finance Secretariat and the central bank (BOM)
remain confident that there are sufficient political
incentives in place to approve a successful fiscal reform.
Despite this confidence, the outcome of reform efforts
depends greatly on the willingness of the opposition and
lower house majority coalition (PRI-PVEM) to agree to these
politically unpopular tax changes. In a meeting with a
group of visitors from the Office of the Comptroller of the
Currency on August 19, Victor Herrera, the chairman of
Standard & Poor's (S&P) in Mexico, expressed his doubt that
any major fiscal reform would be approved. Taking a
lame-duck view of the last half of Calderon's term, he said
some small reforms would be passed, but nothing significant.
He explained that it was not in the PRI's interest to make
Calderon look good. At the same time, the PRI needs to show
that it is being somewhat cooperative by passing small
reforms, but nothing that will have a major impact. Other
observers say the PRI wants to build on its 2009 electoral
victory and get credit for improving the economy before the
2012 Presidential election.

6.(SBU) Herrera also implied, but did not explicitly state,
that S&P will probably downgrade its rating for Mexico. The
line that gave it away was when Herrera described Moody's
recent rating affirmation as &bold and aggressive.8
Nevertheless, the downgrade is unlikely to have a &negative
outlook8 attached. In S&P's opinion, the economy will
improve by 2012. (Comment: Before the economic crisis hit,
Fitch put Mexico on a negative watch last year. Given that
the economy has deteriorated since then, Fitch will downgrade
as well. End Comment.)


Security Spending Constant
--------------------------

7. (SBU) Calderon's top priority is the counternarcotics
campaign; in spite of potential expenditure cuts in other
areas, Standard & Poor's Victor Herrera said security
spending would remain constant in the GOM's proposal. (Note:
GOM Cabinet members have confirmed this steady state
security spending in multiple conversations with the Charge.)
He emphasized to Econoff in a meeting that funding to states
and municipalities would be cut before security. When
questioned whether the PRI would try to negotiate for more
funding to states and municipalities in the run-up to 2012,
Herrera responded that the PRI has a reputation of being the
most infiltrated by the cartels so they would not want to
take any actions -- like cutting security -- that would hurt
their presumed candidate's (State of Mexico Governor Enrique
Pena Nieto) squeaky clean image. Sigrid Artz, Former
Technical Secretary to Mexico's National Security Council,
echoed a similar view to Econoff last month ) but said the
PRI would try to negotiate a change in the composition of
security spending, with more resources going to state and
municipal public security programs such as SUBSEMUN (a
federal grant to municipal law enforcement entities).

Comment
-------

8. (SBU) Recession and falling oil production have put the
GOM's fiscal accounts in a vulnerable position. One-off
measures will allow the GOM to maintain fiscal control during
2009. However, there will be a fiscal gap of 2.7 percent of

MEXICO 00002537 003 OF 003


GDP in 2010 -- 4-5 percent of GDP including Pemex
infrastructure investment -- unless the Calderon
administration reaches a substantive fiscal restraint
agreement with the new Congress. It is unclear whether
domestic investors, particularly international capital
markets, would be willing to finance this without a
significant premium.

9. (SBU) Meanwhile, PRI Mexico State Governor and possible
Presidential contender Enrique Pena Neto told the Charge on
August 21 that, while the PRI was considering how it might
collaborate with the government to solve the country's dire
economic crisis, it was carefully considering the &political
costs8 of such cooperation. Pena Nieto made clear that the
PRI was ready to cooperate, but intends to secure significant
compromises on its priority issues. The GOM's challenge )
far more difficult than it concedes ) will be to structure
its economic measures in a way that will bring the PRI on
board. End Comment.
Visit Mexico City's Classified Web Site at
http://www.state.sgov.gov/p/wha/mexicocity and the North American
Partnership Blog at http://www.intelink.gov/communities/state/nap /

FEELEY

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