Special Report on Mexico: Capital flows back as economy transformed: Mexico's fiscal situation is now better than that of the US. Colin Harding reports

IF MEXICO'S default in 1982 set off the Latin American debt crisis, its debt reduction (Brady) deal of 1989 signalled its return to international respectability and a way for other countries to follow suit.

In the intervening years Mexico joined the global movement towards free markets, joining the General Agreement on Tariffs and Trade (Gatt) in 1985 and initiating a tough stabilisation programme two years later. When President Salinas took office in 1988 he accelerated these trends, to much more telling effect.

The present government's stabilisation and structural reform policies have wrought a remarkable transformation of the economy. The budget last year was in surplus for the first time in the country's history, and inflation has come down from stratospheric levels to just over 10 per cent in four years. A fourth year of modest economic growth is expected this year (between 3 and 4 per cent), and foreign capital has been flowing into the country.

At the same time, the economic nationalism and state interventionism that characterised Mexico for 40 years has been jettisoned, and the leading role shifted decisively to the private sector.

The process was begun by President Miguel de la Madrid (1982- 88), who had the thankless task of trying to pick the prostrate economy off the floor in the wake of the debt crisis. Carlos Salinas de Gortari was Mr de la Madrid's budget director before succeeding him and, with the strong backing of the International Monetary Fund, Mexico's fiscal situation is now considerably better than that of the United States. At the same time he has pushed ahead with privatisation and deregulation of the economy, luring back capital and attracting interest from New York, London, Frankfurt and Tokyo.

Mexican economists generally agree that the general thrust of the Salinas government's economic strategy is correct, but lingering concern in many quarters over what might still go wrong. Criticism of the government's economic performance tends to revolve around two main points: the obstinate refusal of the inflation rate to fall to single digits as quickly as the government would like, and the huge and growing current account deficit. Inflation last year was 16.6 per cent, and the target of 9 per cent for this year is unlikely to be met.

'As long as the inflation level remains so much higher than the US's, the stabilisation programme in incomplete and the economy remains in transition,' according to Rogelio Ramirez de la O, an economic consultant. He puts much of the blame on the failure to deregulate quickly. Others think the inflow of capital - dollars 22bn last year - has not been adequately sterilised by the Bank of Mexico, and there is too much liquidity sloshing around.

This is not the official view. But all are agreed that inflation needs to come down further if the country is to benefit from free trade, particularly with the US. The trick, as ever, is not to apply the brakes so quickly that the economy comes to a halt.

As for the current account deficit, economists such as Jonathan Heath point out that while the government is using a fixed exchange rate to control inflation and attract foreign capital, a strong peso tends to hurt Mexican exports in the longer term while encouraging imports.

Again, the government is unperturbed. The trade deficit in the first quarter of this year was dollars 4.4bn, compared with dollars 2bn in the same period last year, but the Bank of Mexico's 1991 report argues that this deficit was more than covered by foreign capital inflows, including returning flight capital. The bank says the imports will ultimately generate more exports by modernising Mexican industry.

Some problems are those of success. The high productivity of the Mexican automobile industry, for example, has meant a 20-30 per cent annual growth in exports over the past several years, but in 1991 the industry actually ran a trade deficit because of the rampant growth of the domestic market, which Rogelio Ramirez expects to continue at 25 per cent a year for the foreseeable future.

Other critics point to future social difficulties. The failure of increasingly capital-intensive industries to create enough jobs, and of the education and training system to turn out enough workers of the right calibre, are among the most telling.

The political scientist Jorge Castaneda notes that the highly successful privatisation programme, Latin America's first and most extensive, has increased the oligopolistic nature of the Mexican economy. This programme has transferred 15 out of 18 leading banks, the telephone company, steel mills and now even toll roads to the private sector, while enabling the government to cancel much of its domestic debt in the process.