By Robin Emmott and Jason Lange
MEXICO CITY, Oct 1 (Reuters) - Mexico is struggling to contain escalating drug violence against a backdrop of a slow economic recovery and declining oil output, posing a threat to investor confidence in Latin America's second-largest economy.
President Felipe Calderon is under increasing pressure to show that his war on drug gangs is working, almost four years after he sent thousands of troops across Mexico. Calderon, a former lawyer, has put hundreds of drug gang leaders in jail and captured major drug lords including Edgar "La Barbie" Valdez in recent months, winning praise from Washington.
But Mexicans and some investors are concerned that the drug war is backfiring, sparking horrific levels of violence and threatening to cloud Mexico's reputation as stable oil exporter and haven for U.S. and European tourists.
More than 29,000 people have been killed in drug violence since the conservative Calderon took office in Dec. 2006. While most of the dead are hitmen and corrupt police, violence has spread from dangerous border regions and is a serious problem in many areas, including the norhern industrial city of Monterrey.
Suspected drug hitmen have killed five mayors in recent weeks as cartels attack elected officials in towns along smuggling routes and use new intimidation tactics, like explosives planted in cars. [ID:nN2999688]
The escalating violence prompted U.S. Secretary of State Hillary Clinton on Sept. 8 to compare Mexico to Colombia at the height of its fight against cocaine-smuggling rebels in the early 1990s. [ID:nN08125068]
U.S. President Barack Obama played down those remarks but his administration is clearly worried by the escalating violence.
Many analysts believe Mexico cannot win its fight against drugs without an end to weapons smuggling from the United States and reforms to Mexico's police, judicial and prison systems.
The drug war has not yet become a major drag on Mexico's peso <MXN=> <MEX01> or bond yields, and foreign firms are so far not a target for drug gangs.
But some U.S. firms are rethinking investment plans in northern Mexico [ID:nN08113364] and some analysts are gauging whether the violence may start weighing on the peso.
Credit Suisse said in a recent report that Mexico's problems of organized crime have become a clear threat to the strength of its economic recovery.
Finance Minister Ernesto Cordero said on Sept. 1 that drug gang violence is likely weighing on the economy, adding that countries with crime problems can see 1.2 percentage points sliced off their annual GDP growth. [ID:nN01192854]
What to watch:
-- More targeted political killings or more attacks that kill civilians.
-- Foreign or local companies scaling back investment plans due to security concerns.
-- Broad protests or signs that violence is seriously eroding Calderon's support.
RISKS TO RECOVERY
Mexico is limping back from one of the world's worst economic contractions last year, but growth is slowing in factory exports as the U.S. economy cools.
Most analysts think the weak economy will keep the central bank from raising interest rates until well into 2011.
A top central banker said on Sept. 28 that the bank is still focused on the threat of inflation, which appeared to play down speculation in a few corners of the market that policymakers could cut rates next. [ID:nN28206642]
The economy is expected to grow around 4.5 percent this year, not enough to make up for last year's 6.5 percent contraction.
While the employment rate has improved in recent months, consumer spending remains anemic, further threatening the recovery. [ID:nN21152296] [ID:nN23144362]
What to watch:
-- Any drop in exports.
-- Weak consumer demand.
-- Any darkening of the central bank's growth or inflation outlooks.
Calderon's window may have shut for passing major reforms to boost the country's tax take, relax labor laws and boost investment in its declining oil sector.
Calderon, who has never had a majority in Congress, started his presidency looking nimble as he built support in Congress for a landmark pension overhaul and modest fiscal and energy reforms. But party relations in Congress have soured in recent months as politicians eye the 2012 presidential election.
Mexico has Latin America's second largest economy but the lack of reforms has been a drag as growth takes off in Brazil and Chile. Already, political deadlock on reform led Wall Street rating agencies to downgrade Mexican debt last year. Fighting between the main parties could keep economic reforms on ice even beyond 2012. [ID:nN26226254]
Calderon is fighting just to keep on track his modest plan to significantly cut the budget deficit by the end of his term. [ID:nN27274513]
What to watch:
-- Details of the eventual deal for the 2011 budget, which will set the deficit level in 2011.
-- Revisions to credit outlooks from rating agencies.
After Mexican oil production slumped by nearly a quarter between 2004 and 2009, output has stabilized in recent months.
But there have been few signs production will return to the 2004 peak and the government says output will hold steady at 2.6 million barrels per day in the medium term. [O/MEXICO1] [ID:nN29163813]
Some analysts fear another decline this year if output at state oil firm Pemex's flagship Chicontepec project remains sluggish.
A top exporter to the United States, Mexico relies on oil for a third of the federal budget. The output decline was a major factor behind last year's debt rating downgrades.
A 2008 law was supposed to open the door to lucrative new contracts to bring foreign oil companies into Mexico's oil industry to boost deepwater exploration.
But Pemex's chief executive Juan Jose Suarez says the reform is overly complicated for the company and that it still needs fine tuning. [ID:nN12217398]
Suarez aims to boost the profitability of the company and Pemex is studying a plan to import higher quality foreign crude oil for the first time in more than 30 years to improve the performance of its refineries. [ID:nN20205847]
Pemex hopes to issue up to 14 incentive-based contracts by the end of the year to get private sector assistance to develop the Chicontepec project [ID:nN03221138], although one Pemex board member recently suggested fewer contracts may be offered this year due to a shift in strategy. [ID:nN23176167]
What to watch:
-- Any resolution to a court case challenging the validity of the proposed new contracts.
-- Any improvement in the performance of Chicontepec.
-- Any deep sea oil finds by Pemex, which has yet to confirm forecasts of deepwater reserves.
-- Further declines in monthly oil output figures.
(Additional reporting by Robert Campbell; editing by Missy Ryan and Kieran Murray)