One of the most attractive emerging markets in the world

Enrique Pea Nieto has just been elected president of Mexico.

It's not what you'd describe as a dream job.

Mexico's problems put all our worries in the UK over government debt and restive youth into sharp perspective.

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The most tragic and visible of these woes is the violent drug war. The war against the cartels (as well as infighting between cartels) has left 55,000 people dead over the last five years. It's easy to see why most investors give the country a wide berth.

But they're making a mistake. Behind the gory headlines lies a country with strong economic growth and surprisingly prudent management. Here's why Mexico could be one of the most attractive emerging markets in the world.

Mexico is enjoying a manufacturing boom

This may surprise you, but Mexico has become a formidable export power. Manufacturing accounted for just 2% of GDP in the 1980s. Now it's 24%.

The boom began when the North American Free Trade Agreement (Nafta) was signed in 1994. Over the last ten years, the weak peso has given the sector a further boost.Healthy demographics - with a large and growing work force - also checks wage inflation and makes Mexican goods more competitive.

The gap between Chinese and Mexican wages has narrowed sharply from 260% in 2006 to just 10% today, notes HSBC's Sergio Martin. Taking into account travel costs, Mexican factories now beat Chinese ones on cost for many goods. That explains why 12.5% of America's imports currently come from Mexico. That's the highest in a decade, and second only to China.

Of course, with so many of its exports going to one place, Mexico's fortunes are tightly tied to America's. But that's not necessarily a bad thing, as David Rees at Capital Economics points out: "With America growing at around 2%, Mexico's economy should grow at between 3% to 4%." It's "not spectacular", but it beats plenty of other parts of the world.

More importantly, while Mexico is still growing its share of the US market, it's also increasing sales to its Latin American neighbours. In the last six years, the share of Mexican exports going to the US has fallen from 90% to 80%. Meanwhile, the overall value of exports, which currently stands at $700bn, is expected to double within the next eight years.

Mexico is also moving up the value chain'. "More jobs, more energy, [and] more foreign investment are going into more advanced applications", says Scot Overson, boss of chipmaker Intel's Mexican division. These include "technology and aerospace", or "advanced manufacturing, not just simple unskilled manufacturing. Those aspects of Mexico economy seem to be accelerating."

The country has also been wise enough to avoid squandering the proceeds of the boom. Public debt stands at 35% of GDP and falling (even using the most forgiving measures, Britain's is well over 60%). Inflation, historically a bugbear, is hovering around 3.8% - below the upper band of 4% targeted by the central bank.

It helps that central bank governor Agustn Carstens is seen as a safe pair of hands. As finance minister, he hedged Mexico's entire oil output just before the oil price tanked in late 2008. It saved the nation $8bn and - so the joke went - made him "the world's most successful, but worst-paid, oil manager".

The three biggest challenges facing Mexico

Despite Mexico undergoing one of its best-ever periods of growth and economic stability, its main stock index, the MEXBOL, doesn't look too expensive. The price/earnings (pe) ratio of 14 is pretty much in line with the index average since its 1978 inception.

The main drag on the country is the drug-related violence. Any long-term solution can't be down to just Mexico. Consumer countries (such as the US) need to alter policies too. That won't happen in the near future.

However, there's plenty of room for improvement. Mexico's murder rate has tripled to 22 per 100,000 people far higher than other Latin American countries with similarly powerful narco gangs. If any progress could be made here, Mexico's other attractions would become far more apparent to investors.

Pea Nieto has promised to halve deaths by changing tactics. Instead of using the army to take on the cartels, he will use the police to minimise civilian deaths. He has also recruited the Colombian police chief credited with helping to stem that country's problems. Even Nieto's critics think he can halt the violence - although admittedly that's because they think his party, PRI, will do a secret deal with the gangs.

The second big problem is Mexico's falling oil output. Mexico has plenty of oil, especially offshore. The trouble is that while state-owned Pemex has exclusive rights to the country's oil, it lacks the capital and expertise to develop new fields. Production has fallen from 3.4 million barrels per day (bpd) in 2006 to 2.5 million today. It's expected to slip to 2.2 million by 2016.

So Pea Nieto has proposed partial privatisation. This won't be easy: Pemex's position is enshrined in the constitution. However, Eduardo Gonzales, a lawyer with Mexican firm Creel, believes it can be done. "Private equity funds are already raising the finance to take advantage of it."If he can pull it off, Capital Economics reckon it would add almost 1% a year to Mexico's GDP.

The final challenge is Mexico's uncompetitive domestic economy. Many markets are dominated by local oligopolies that rip off the people and block new entrants. Inflexible labour laws and a tiny tax base are also a problem: Mexico's total tax take is about 22% of GDP, far less than the 36% raised in Brazil.

The oligopolies look safe for now. Many supported PRI, and Pea Nieto is unlikely to attack them in his first term. Instead, he will probably focus on freeing up the labour market and reforming tax, says Rees. "Strong exports will keep the economy ticking over but if the domestic economy could be reformed then we would see exceptional growth."

How to invest in Mexico

Be warned. Mexico is definitely a risk-on trade': when investors get nervous they will jump ship indiscriminately. However, in the long run, it has great potential. Put it this way if you've been thinking of allocating capital to the BRIC countries, I'd suggest looking at Mexico as an alternative.

So what's the best way to invest? Siding with the oligopolies is not a bad bet. A cheap way to do that is through the iShares MSCI Mexico Investable Index ETF (US: EWW), which has an annual charge of just 0.5%. It is skewed towards the large consumer stocks that will continue to benefit as Mexico grows.

From next month we'll be broadening the focus of our free MoneyWeek Asia email to cover other exciting emerging market stories including Latin America. James will be regularly joining our current editor Lars Henriksson, so if you've not signed up for it already, do so here .

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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