Mexico's Economy Slumps, Dragged Down by U.S.

By DAVID LUHNOW and ANTHONY HARRUP MEXICO CITY -- Mexico's economy shrank 5.9% in the first quarter from the fourth quarter of last year -- showing the economy in its steepest decline since the depths of the country's 1995 peso crisis. That translates to an annualized quarter-on-quarter drop of 21.5%. Compared to a year ago, gross domestic product fell by 8.2%, the country's statistics office said on Wednesday. The worst may not be over for Mexico, which faces a dramatic fall in tourism because of the recent outbreak of A/H1N1 flu, on top of slumping demand from the U.S. Mexican Finance Minister Agustin Carstens on Wednesday revised down the government's forecast for full-year GDP to a contraction of 5.5% from the previous 4.1%. Mexico during the past 15 years has depended in large part on demand for goods from a supercharged U.S. economy. About a fifth of Mexico's economy depends on manufacturing exports to its neighbor, and the dramatic drop in demand has hit Mexico hard. During the first quarter, Mexican auto production slid 41% compared to the same period the year before, an historic decline. The second quarter doesn't look much better, economists say. Exacerbating the downturn, the outbreak of A/H1N1 flu caused Mexico City to largely shut down for business for about a week earlier this month. The weak outlook is particularly bad news for a country that has made gains against poverty in the past few years, but struggles to create jobs for its young and to fight powerful drug cartels. Because many flu cases abroad were initially found in people who had traveled to Mexico, the country's reputation as a travel destination has suffered. Grupo Mexicana, Mexico's leading airline company, said this week that after a strong first quarter, passenger traffic will likely drop substantially as a result of the flu outbreak. Adolfo Crespo, Grupo Mexicana's vice president for corporate communications, said that this month has been "very sad and dreary" following the outbreak in Mexico of the new influenza strain that slowed the flow of foreign travelers to Mexico. Mr. Crespo said that while domestic travel has started to pick up "very slowly," international traffic remains weak. Foreign visitors may generate $4 billion less in revenue this year than the $13 billion last year, says Tourism Minister Rodolfo Elizondo. The travel industry, Mexico's third biggest source of foreign income, employs 2 million. View Full Image Associated Press A waiter at an empty restaurant in Cancún, Mexico. The swine flu outbreak has dealt a blow to the tourism industry in the country. Hotels in the resort town of Cancún are running at 29% occupancy during May compared to the usual average 74%, according to the regional hotel association. "Our business has dried up. We sit around with nothing to do," says Margarita Ruiz, the 44-year-old co-owner of the travel agency Travel Center in Mexico City. She recently laid off the company's messenger boy. Even if the U.S. economy begins to recover, American consumers may continue to spend less of their incomes. "Our base-case scenario has to be that the U.S. consumer won't come back as strong," deputy finance minister Alejandro Werner said in an interview. "That means we need to redouble efforts to pass economic reforms that generate higher growth." Even if the U.S. economy pulls out of the doldrums, Mexico may lag. "Mexico and the U.S. economies have been synchronized for years. This time around, Mexico was synchronized on the downturn but maybe not as quickly on the upturn," says Damian Fraser, head of equity strategy at UBS. Because Mexico's economy is less leveraged than the U.S., lower interest rates are less effective in jump-starting the economy, he notes. Mexico also can't afford to run as big a budget deficit as the U.S. because investors won't give it as much leeway. Since North American Free Trade Agreement took effect in 1994, Mexico hasn't managed a big overhaul of its economy to keep ahead of rivals like China, India and Brazil. Much of the economy, from oil to telecommunications, is dominated by state or private monopolies that stifle competition and create high costs. Labor laws make hiring and firing difficult. Standard & Poor's put Mexico's credit rating on review last week, citing the country's heavy reliance on oil revenue and doubts about the political will of the government to boost non-oil tax revenues despite sliding crude output. This week, Mexican central bank chief Guillermo Ortiz called on politicians to come together after July mid-term elections and agree on a tax overhaul to raise the country's paltry tax revenues. "It is really urgent that once we are through the elections that a medium-term fiscal program be designed and passed," Mr. Ortiz told a conference. "Mexico isn't going to be a basket case like Argentina or Venezuela, but it's not going to rebound from this crisis like Brazil, China or India either. That could mean years of sub-par growth," says Mr. Fraser at UBS. Write to David Luhnow at david.luhnow@wsj.com and Anthony Harrup at anthony.harrup@dowjones.com