NEWS ANALYSIS : Mexico Walking on Tricky Ground With Rate Hikes : Economics: Officials hope to keep capital in the country. Political, social and economic goals are inextricably entwined.

In a bid to keep Mexico’s economy on track during increasingly perilous times, the Mexican central bank over the past month has embarked on a policy of dramatic interest rate hikes.

Policy-makers seem to be betting that raising rates will be only a short-term tool to halt the flight of foreign capital and prop up the value of the peso. But the higher rates could, if prolonged, choke off Mexico’s economic recovery and exacerbate the political problems that have gathered force in recent weeks, according to economists knowledgeable about Mexico.

In recent months, interest rates have been inching up to achieve various economic goals in many nations, including in the United States. But Mexico took drastic action last week, lifting rates on its bellwether 28-day treasury bills to 18%, up 3.42 percentage points from the previous week and up from 8.8% a month previous. The rate hike caused a steep drop in Mexico’s stock market, though prices rebounded Thursday and Friday.

Mexico’s policies over the past month provide a grim reminder that in times of trouble, Third World countries have to take unusual measures to keep things from falling apart.

And those measures pose risks for foreigners who until recently were investing $2 billion a month in Mexican factories, equipment and securities, attracted by President Carlos Salinas de Gortari’s economic plan and buoyed by the optimism surrounding the North American Free Trade Agreement.

But optimism has waned in recent weeks. The assassination of presidential candidate Luis Donaldo Colosio on March 23 is still, in most Mexicans’ minds, unsolved. The government is holding peace talks with Chiapas peasant rebels, but no resolution is in sight.

The Aug. 21 presidential election is looming--and inviting all sorts of potentially explosive scenarios, whoever wins. Among the most dreaded for investors is a deep devaluation of Mexico’s currency similar to those that have occurred around past elections.

Increasing nervousness among foreign investors since the assassination has caused a huge outflow of foreign capital as investors have cashed out of Mexican stocks and bonds. Rogelio Ramirez de la O, an economist with ECANAL a Mexico City-based think tank, estimates that outflow at $8 billion.

Fearing that its carefully crafted economic recovery could unravel, Mexico had no choice but to raise short-term rates on its treasury bills and other securities, said Ramirez de la O.

“There are serious political problems, and the price to be paid for these political problems is what’s unwinding in the market now,” said Scott Kalb, a Mexico analyst at Smith Barney Shearson.

The sharply higher yields are meant to compensate for the greater risk now associated with Mexican investments, making the treasury bills more attractive to the foreigners who typically buy up half of them at weekly auctions.

Mexico desperately needs to make those sales and collect foreign currency so it can fund its internal growth. There is not enough domestic capital to finance the ambitious private and public works spending now under way, said Arturo Acevedo, director of research at Vector Casa De Bolsa, a Mexico City brokerage firm.

“We are engaged in an ambitious modernization program, and to compete globally we need to import capital equipment for petrochemical plants, automobile assembly lines, household appliance manufacturing and so on,” Acevedo said.

Mexico’s other important objective in raising rates is to maintain the stability of the peso. Mexico is hoping to avoid a mad rush of foreign investors cashing out their Mexican securities and converting pesos to dollars. That kind of peso selloff would cause the currency to rapidly lose value against the dollar, upsetting Salinas’ economic plan.

The Mexican central bank has spent up to $8 billion of its $28 billion in federal reserves to buy pesos over the last month in a bid to stabilize the market. “By doing this, the Mexicans are saying, believe us, we’re defending the peso, give us your money, don’t get out of Mexico,” said Geoffrey Dennis, a Mexico analyst at Bear Stearns & Co.

Maintaining the peso’s stability is important because foreign and domestic investors need confidence in a stable currency. During the 1970s and 1980s when inflation went as high as 160%, foreigners stayed away from Mexico. Droves of wealthy Mexican citizens took money out of their country to preserve their holdings, which depleted Mexico’s capital resources.

Salomon Bros. economist Lawrence Goodman sees only a small chance the 1980s-style inflation will return because Salinas has eliminated its root causes: Mexico’s habitual deficit spending and the closed economy that worked to artificially inflate consumer prices.

But the Mexicans will pay for the higher interest rates if they persist. High rates raise the financing costs of Mexican companies and ultimately cut corporate profits. That, and the generally disappointing corporate profits that Mexican companies have reported this year, are two big reasons Mexican stock prices have plummeted.

Last but not least, the higher rates will eventually filter down to Mexican citizens in the form of higher prices for consumer goods and services and higher consumer loan rates. In cutting consumers’ buying power, the prolonged higher rates could stunt the recovery of Mexico’s economy which, when Colosio was murdered, was just beginning to improve after last year’s recession.

“The problem with higher rates is companies stop borrowing and investing in their businesses and consumers stop borrowing and spending on consumer goods,” said Kalb of Smith Barney Shearson. “The money tends to stay in the bank and the economy just slows.”

The result, then, of a longer period of higher rates could be economic stagnation, which would intensify the social conflicts already sharpened by Salinas’ six-year austerity program. Although few analysts expect the worst, many have already scaled back their estimates of Mexico’s economic growth from as high as 4% to as low as 2%.

“The risk of high interest rates in an economy that is not growing is that it is feasible for only a short period of time,” said ECANAL’s Ramirez de la O. “Over time, investors are going to be perceptive to the diminished potential for growth resulting from the high rates, as well as to the political tensions that may be exacerbated.”

Kalb expects the Mexicans to lower interest rates in three to four weeks after they have achieved the result of calming foreign investors’ fears. “Even if rates go higher in the U.S., we don’t expect them to in Mexico,” Kalb said.

Dennis at Bear Stearns sees a rocky road ahead, perhaps even another rate hike on treasury bills. “Unfortunately the fear of a deep devaluation is so embedded now that it may take more than this one move to 18% to calm those fears,” he said.