Mexico Could End Up as a Failed State

Includes: EWW, FXM, SMK, UMX
by: Russ Winter

Money transfers from expats now represent Mexico’s no. 2 source of revenue after proceeds from oil exports. Many Mexican households depend on remittances to meet normal living expenses. Unfortunately for Mexico, however, there has been no U.S. economic recovery that has shown up in the external dinero import numbers. Last year, remittances were down 1.5 percent compared to 2009 and down around 20% from the 2006-07 peak. If human services start to get the serious ax in the U.S., this figure could be quick to drop even further. (See Calif. Budget Cuts to Affect Poor and Immigrant Families.)

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Mexico's government depends on Pemex oil production for 35% of its tax revenue, which it also uses to subsidize its citizens. Production has long since peaked and is in a steady, steep decline- with 2010 keeping in line with 2009. Mexico's oil exports have largely eroded away, making benefits from being a net exporter increasingly problematic, even with high energy prices. Further, the government has hedged oil sales at US$57/barrel in 2010.

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Mexico's government engages in a lot of subsidizing of food prices as well. Tortilla makers supposedly have been active buying corn and grain futures to hedge against the kind of tortilla crisis seen in 2007-2008. This is fortunate for Mexico, but is really a zero-sum game. It also serves to bid up prices in general for others in the market.

Here is a report that Mexico has been buying corn calls lately, a strategy that at some point might result in losses. This is a real live-by-the-sword, die-by-the-sword way to run a key element of one's economy. Adding insult to injury, the corn and vegetable crop in northern Mexico was damaged and impacted by cold weather and frost. This will result in additional food inflation, both in Mexico and the U.S.

Through fortunate trading and heavy handed intervention, and by using its declining oil revenue, Mexico can give the false impression of being stable. Or at least, relatively so. To do so, the country needs to have all the moving parts working perfectly. Of late, some of this has been wearing off as tortilla prices started spiking by a few percent. In the short run, Mexico may have dodged this bullet, but may also be a candidate for trouble on the downside of the commodity and oil depletion roller coaster.

The influence of Mexico's other large industry, drug trafficking (see The Economist: Kicking the Hornets Nest), is a wild card in terms of Mexico's economy. Although there are large sums of dinero entering the country and supporting some regions, much of this causes untold negative externalities on the decent part of Mexican society and corrupts its political system. Much of this drug cartel money ends up in the rat lines and ultimately goes out of Mexico. I have no hard evidence to judge the overall economic benefit, pro or con to Mexico, but intuitively I chalk it up as another negative. For the U.S., it goes without saying that this trafficking is very costly.

Mexico is another of the many inflated, darling emerging markets out there. In reality, I consider it a good candidate to end up as a failed state, which will have tremendous repercusions for the U.S. My actionable advice is to hold the double inverse ETF SMK, of the underlying MWW Mexico index.

Disclosure: I am long SMK.