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Investment Opportunities in Mexico

"The aftermath of this event is known to us today as the "Tequila Effect."

Raoul Rodriguez-Walters

Opportunities Exist, But Do Not Bet the Ranch When Investing South of the Border

It's hot in Mexico again: Moody's, a top credit rating service, raised its rating on Mexican government debt to investment grade last year and word has it that Standard and Poor's is seriously considering to do the same this year. The Mexican economy is expected to continue to grow despite a slowdown in the US and inflation is well under control. The tight money supply has kept Mexican interest rates high, especially as compared to those that can be found in the US. As a result, I am witnessing a substantial increase in investors who are willing to seek greener pastures on the "other" side of the fence. This is a summary of the good (opportunities), the bad (pitfalls), and the ugly (taxes) as relates to investing in Mexico.

The Good - The Opportunities

Mexican markets have been very profitable over the last 15 years. This is true even after we factor in currency devaluations and market crashes. From 1985 to 2000 the IPC (the stock market index) has delivered negative returns only thrice: 1994, 1998 and 2000. The average annual return, in U.S. dollar terms, from 1985 to 1999 has been a very respectable 27.7% per year1.

Just last year, Money Magazine selected two Mexican companies, out of eleven non-U.S. companies, as international blue chips2. The article illustrates that an investment of $10,000 USD in Cemex (a cement multinational) fifteen years ago would be worth $970,000 today!

The good times have not been limited to the equity side of the equation. Mexican government bonds and money markets have also provided attractive returns to the investor. The Mexican equivalent to U.S short-term treasuries are called CETES. The 91 day CETE has averaged a real rate of return of 4.19% compared to the three month U.S. T-Bill of 2.30% over the last 15 years3. Sovereign debt, government bonds sold outside of Mexico, usually denominated in dollars or euros, has also provided attractive returns in the 8-10% range over the last few years.

You see these numbers, do a little research, maybe you live in Mexico, and you decide that you would like to rope in some of these gains. The problem is that you do not speak Spanish, at least not well enough to feel confident interpreting brokerage contracts, reading prospectuses, and so forth. No problem. You can "purchase Mexico" by using the U.S. markets.

The most conservative option would be to purchase mutual funds that specialize in Latin America, or conversely, that invest only in Mexican securities. Another option would be to purchase the Mexico World Equity Benchmark Shares (WEBS) that quote on the American Stock Exchange, (symbol EWS). The Mexico WEBS are passively managed and try to replicate the performance of the Mexican stock index. Still another option is to purchase stock of individual Mexican companies that quote in the U.S. by way of American Depository Receipts (ADRs), most of which quote on the New York Stock Exchange.

If it is fixed income that you are interested in, Mexican sovereign debt caries an investment grade, can be found in U.S dollars and pays interest in the same currency. The bonds known as "UMS" are currently yielding around 8%.

Finally, if you feel confident enough, you may want to consider opening an account at a Mexican banking institution or brokerage and pursue your investments here.

The Bad - The Pitfalls

Looks good, but do not be tempted to put all of your money into the Mexican markets. Mexico is still a developing nation, political changes have not been consolidated, and the country is still too dependent on the U.S. economy. You need to approach these investments with your eyes open or you might get trampled, not by the bull, but by the bear.

Volatility and currency fluctuations will continue to be feature of this market. If you cannot wait 5 to 10 years to see results in the equity markets, stay away. For shorter time horizons stick with the fixed income alternative, especially money market instruments, which are currently paying about a 15% return in pesos.

If you are still tempted to put a sizable percentage of your portfolio here, you might not remember 1995. At the end of 1994 Mexico was the darling of the world. NAFTA and been signed, the economy was taking off, investments were pouring in. The world was shocked in December of that year when the peso had to be sharply devaluated. The repercussions were severe enough to be felt around the world. The aftermath of this event is known to us today as the "Tequila Effect."

Much has changed in 6 years, but it is advisable to consider your Mexican investment in light of your overall international exposure and risk tolerance.

The Ugly - Taxes

Actually, the situation is not as ugly as it sounds, that is if you are not an American, Filipino or Eritrean buckaroo.

The truth of the matter is that in Mexico there is no capital gains tax on the sale of shares, anywhere in the world, as long as the transaction takes place on the "floor" of a recognized exchange. That is a huge advantage for the Mexican resident.

Another advantage is that dividend income paid by Mexican companies to residents in Mexico usually does not need to be reported on your Mexican return. Further, interest paid by the bank or by money market mutual funds are paid net of taxes, so you do not have to worry about reporting these payments on the Mexican return either.

Most countries of the world tax people based on residence, not so the three countries listed above. The U.S taxes people based both residency and nationality. If you are an American, this is where things can get down-right U-G-L-Y. Americans need to report their worldwide income regardless of its source. If you are an American, and a Mexican resident, you may need to file two returns, one for each country. And while Mexican law exempts gains on the stock market from taxes, the Internal Revenue Service will take its share of your worldwide transactions, Mexican ones included. Ditto for dividends and interest

Worse yet, if you invest through an equity mutual fund in Mexico (or any other foreign country) you are subject to the Passive Foreign Investment Company (PFIC) rules. Forget the 20% long-term capital gains tax! The effective rate of taxation on an investment which you have held for 4 years has been calculated at 46% of your gain, 56% if you leave it there of 8 years and 84% if you have invested for 15 years4! It is best to play it safe and stay away from equity mutual funds.

Conclusion

Call me biased, but I think we should all have a little bit of the Mexico in our lives, whether you are a resident of Mexico or not. If you can ignore the noise and can stay in the saddle for the long-term, you can round up some nice profits. Do not go overboard with the spice, a dash will do, and be careful not to alienate the tax man.

***

1 Source: Acus Consultores, S.C. (www.acus.com.mx)

2 Adrienne Carter, Pablo Galarza, et al, "The New Global Blue Chips," Money Magazine, August 2000, 81-87.

3 Using data provided by Acus Consultores, I averaged 13 of the last 15 years of real returns. I threw out the highest and lowest of the real returns when making my calculations

4 Tracy Byrnes, "Global Tax Forum: Tax Laws Make Foreign Funds a Bad Investment," The Street.com,, October 6, 1999.

March 2001

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