NEW YORK (KWR) -- We regard Mexico's credit outlook as stable and the inauguration of its new president, Felipe Calderon, as a net positive. After narrowly winning the July 2006 elections, he has brought together a solid cabinet and proposed a balanced budget for 2007, which also seeks to meet some of the country's needs for greater social spending. In addition, we like his appointment of Jesus Reyes Heroles to head Pemex, the state-owned company, a move that indicates a firmer intention to reshape the oil company's finances and operations. Mexico is rated Baa1 (stable)/BBB (stable).

Mexico Economic Data

Appointing the Cabinet: On December 1, 2006 the country's new president, Felipe Calderon, assumed office. Calderon is only the second non-PRI president, following Vincente Fox, who won the historic 2000 elections ending over 70 years of rule by the PRI (Institutionalized Revolutionary Party). While Fox's major role was to be the man who presided over democratic change of Mexican politics, he largely failed to enact many of the needed economic reforms with a notable exception of improving the country's debt profile.

It is now the task of Calderon to consolidate pluralistic politics and equally important, to move ahead with a generally stalled reform process. Central to Mexico's future economic well-being are reforms pertaining to pensions (a bill is currently under consideration in the Congress), simplifying the tax structure, and energy. The last encompassed electricity and Pemex, the heavily-indebted state-owned oil company. Despite the slowing U.S. economy -- Mexico's largest trade partner -- and a militant opposition built around presidential loser Andres Manuel Lopez Obrador or AMLO, Calderon appears to have an excellent grasp of both the economic and political landscape.

Calderon's first action as Mexico's leader was the appointment of his cabinet. By most accounts, he selected a strong team, based on technical expertise, supplemented by a handful of more political figures for less sensitive posts. The new president turned to Agustin Carstens, a former high-ranking IMF official, to head the Ministry of Finance (Hacienda). Calderon also made a good decision in keeping Alfredo Elias Ayub at the head of the state-owned utility Comision Federal de Electricidad (CFE). Elias Ayub was originally appointed in the late 1990s and presided over an improvement and expansion of services.

Dealing with Pemex...

To head up Pemex Calderon turned to Jesus Reyes Heroles, an economist from Mexico's ITAM university. He was also a former ambassador for Mexico to the United States (1997-2000) and energy minister from 1995-1997 under President Ernesto Zedillo. In the last-mentioned post, Reyes Heroles promoted a number of changes in the sector - pushing through a reclassification of petrochemicals to encourage greater private investment in the industry and working to encourage private involvement in natural gas transmission and distribution.

The future of Pemex is a major concern, considering the decline in the company's main oil field Cantarell and strong opposition to any privatization of the sector. Pemex is producing around 3.2 million barrels a day of crude oil and 5.6 billion cubic feet a day of natural gas. This has helped generate a considerable flow of revenue, most of which has flowed into government finances and not back into re-investment in exploration and production. Oil and related taxes account for more than a third of federal revenue. In November, Pemex indicated that output from Cantarell is expected to decline at an average of 14 percent a year between 2007 and 2015 and that the company needs to invest $18-20 billion a year in exploration and production. Pemex invested $14 million in 2006 and plans to invest $16 billion in 2007. The company has $5.5 billion in debt coming due in 2007.

Considering the challenges facing Pemex, Reyes Heroles is an excellent choice. Having served under a PRI president, he has solid ties to that party as well as to Calderon's PAN. This is critical if he is to pass any changes in Mexico's oil laws. Thus far, Reyes Heroles has not announced any push for privatization. This would no doubt stir up the opposition, but he is expected to start by pursuing Calderon's campaign planks of allowing Pemex to form technological alliances with private companies to exploit potential reserves in the deep waters in the Gulf of Mexico. This includes refining joint-ventures in Mexico such as the one Pemex established with Royal/Dutch Shell in Deer Park, Texas.

Other Challenges and the 2007 Budget

Calderon does face other challenges - crime and corruption, the need to boost economic growth above the 2.2 percent average growth rate over the past six years, and to open up the telecom sector to more competition. The chief opposition party, the PRD, is more militant than moderate and Calderon's PAN will be forced to rely on a fickle PRI to press legislation. The new president did include one PRIista as a member of his cabinet.

While the appointment of the cabinet was a positive signal, Calderon gave his new administration further momentum by proposing a balanced budget for 2007. At the same time, the budget contained some gains for social programs. The key assumptions for the budget are as follows:

• The budget assumes real GDP will slow to 3.6 percent in 2007 form 4.7 percent in 2006;
• Average oil prices will be $42.50 a barrel for Mexico's crude mix;
• The currency is expected to average 112 pesos per dollar in 2007;
• Annual inflation is expected to fall to 3 percent for 2007.

The main thrust of the budget for 2007 was:

• Government spending will be more tightly controlled, including a cut in the President's and other high-ranking management in the government, worth around $2.5 billion.
• Spending will be increased to fight poverty and crime by increasing the salaries of the lower paid ranks of police, army and navy.
• Spending on education will be increased by 4.2 percent and on health programs by 9.3 percent.
• Spending will be increased on Pemex by 32.5 percent as well as for CFE by 15.3 percent.

We take three things from the proposed 2007 budget. First and foremost, Calderon incorporated much of AMLO's social agenda into his budget, hitting on the themes of cutting salaries of high-ranking officials, upping social spending and improving pay for the lower-ranked police. Going ahead, AMLO will find it more difficult to attack a Calderon government for being socially insensitive. Second, the budget should assure business and foreign investors that the new government is serious about maintaining Mexico's fiscal prudence. Third, the proposed budget is a start on addressing Pemex's problems, though considerably more work is required.

Conclusion: Mexico has begun a new phase under President Calderon. While outgoing President Fox was generally well-liked, he was unable to aggressively push ahead with badly needed reforms. Part of this was related to his inability to forge lasting alliances in the Congress, where his PAN was a minority. PAN remains in a minority, but it is increasingly likely it will find the PRI a workable ally - in part due to Calderon's ability to have that party represented in the cabinet and to strike deals. Although this does not eliminate the vulnerability of PAN in Congress, it does mean that chances of more meaningful reform being passed over the next six-year presidential term.