Mexico Rides Opposing Forces

Country is thorn between “Regionalization” and the “Culture of Franchising”

The world’s economy has been restructured.

Who would have thought, just a few months ago, that the world’s emerging economies are helping developed nations elude a “double-dip” recession? Advanced economies started 2010 with strong economic performances that soon dwindled to a mild and slow cruise. Even optimistic predictions do not place their economic growth for the year to reach far beyond the 2% mark.

But most emerging markets are in a roll. China will likely top 10% annual growth in 2010, along with India’s 8% and Brazil’s 7%. According to the International Monetary Fund, the developing economies of the world will average over 6% growth in 2010, and will likely sustain that pace into 2012.

In fact, the strong sales and earnings reports of many global corporations in Q3- 2010 cite that continuing economic growth in the developing world has been key to improving overall sales in 2010.

While most emerging economies have bounced back and are enjoying very healthy growth rates, Mexico faces continuing and new difficulties that prevent the country from being a top performer among developing countries.

In fact, in spite of having many competitive advantages on its favor, Mexico cannot unleash its full economic potential yet. At most, Mexico’s annual economic growth aspirations for 2010-2013 will be slightly above 4%.

Mexico continues to be thorn between opposing forces. In this article, we will review the two main forces that keep Mexico in the middle of the pack of global competitiveness rankings and economic growth rates.

REGIONALIZATION

The strongest positive force currently favoring Mexico’s growth is the economic phenomenon of Regionalization.

Conceptually, regionalization is globalization taking a step backwards. Indeed, the world is “deglobilizing” and Mexico stands to be one of the largest beneficiaries of this process.

Let’s recall that, in an economic sense, globalization refers to the reduction and removal of barriers between national borders in order to facilitate the flow of goods, capital, services, labor and technology.

The process of globalization has many positive aspects, such as the emergence of worldwide production and financial markets; and broader, less expensive access to a range of foreign products and services for consumers and companies.

On the other hand, globalization critics argue that the world is so interconnected today that the collapse of the subprime mortgage market in the U.S. led to the recent global recession. Other negative effects of globalization, critics mention, include the spreading of environmental degradation, diseases, drug trade and illicit manufacturing practices.

But, in a nutshell, globalization has been good for the world’s trade and economic growth, resulting in a significant increase in global middle-class population and a general improvement of the quality of life of developing nations.

Author Thomas L. Friedman analyses the progress and eventual dominance of globalization in his international bestselling book “The World Is Flat: A Brief History of the 21st Century”. He views the world as flat or level where all competitors have an equal opportunity and where geographical divisions are becoming increasingly irrelevant. All this, as a result of the internet, off-shoring, outsourcing, personal digital devices and other “world flatteners”.

But Nobel Prize winning economist Joseph Stiglitz said: “Friedman is right that there have been dramatic changes in the global economy; in some directions, the world is much flatter than it has ever been, but the world is not flat. Not only is the world not flat, in many ways it has been getting less flat”.

Indeed, the development of globalization had a major setback with 9/11, which triggered significant restrictions in the international flow of goods and individuals.

And recently, the great recession of 2008 helped to further reverse the process of globalization as developed nations activated domestic job protection and import restriction initiatives.

Since the advent of the new Century and into 2004-2005, when the price of crude oil started to spike, it became clear that globalization was receding and that world production value chains engaged in a process of restructuring their global footprints, leading the way to a new wave or order that we have labeled as “Regionalization”.

Regionalization is simply the trend of reordering production value chains to better serve regional markets. In this fashion, regional production and logistics supply chains are reshaping and restructuring in Asia, Europe and the American continents.

So what we will have in the long-term is manufacturing and logistics platforms to serve the different regional markets.

This is not to say that the U.S. imports from China will stop altogether anytime soon, but rather that we are going to see, for example, more Toyota, Hyundai and BMW plants opening in the U.S. to serve the North American regional market.

China, for instance, knows well that its booming years of attracting manufacturing and export capacity will soon be over. So, China has already started a “going-out” industrial policy by establishing value chain platforms outside of its mainland in other Asian regions and farther abroad.

Not surprisingly, China’s new global industrial strategy contemplates Mexico as an ideal logistics passage and manufacturing hub for reaching the North American regional market.

This is evidenced by Lenovo’s largest investment outside of China in Monterrey, in a 260,000 ft2 manufacturing plant with a 5 million PC annual production capacity in 2008.

Earlier, Lenovo had bought IBM’s ThinkPad PC division, and the plant in Mexico “will be contributing to a more streamlined and efficient regional supply chain”.

The savvy Taiwanese electronic goods contractors learned of the benefits of regionalization earlier. They started to significantly regionalize their operations in the NAFTA region in 2003-2004, by taking literally millions of square feet of light manufacturing space in Ciudad Juarez and Reynosa primarily to serve the U.S. market.

“Time-to-market” has been a strong driver in regionalization. Consumers not only demand custom built products but also prompt deliveries. Taiwan’s Foxconn, Asus, Wistron and Tatung along with other international electronics manufacturing contractors such as Flextronics, Sanmina- SCI and Elcoteq learned some time ago that competitive manufacturing costs and adequate time-to-market logistics for the U.S. market were impossible to be attained from Asia, but were quite efficient from locations in Mexico.

Inventory holding costs alone tell that serving North America from Asia is not viable. The Taiwanese were the first to do the hard math to calculate how longer lead times and higher variability associated with those lead times affect inventory.

Big numbers include static and in-transit storage costs and, especially, capital and interest costs to service those long supply chains from Asia that tie up inventory, and money, in transit.

The supply chains from Mexico to the U.S. and Canada are evidently shorter, less risky and have a lower “Landed Cost” than those from Asia and Eastern Europe.

The cost of inventory alone has played an extremely important role in the regionalization of the countries of NAFTA as well as those of the European Union.

Extensive traveling and mid-night business phone calls have slowly broken the resilience of many managers and engineers of international firms. Staying closer to home and operating during normal business hours is a growing preference in the minds of many executive and technical U.S. and Canadian workers, and another reason in favor of regionalization.

Even the masters of round-the-clock work shifts are recognizing this fact: Indian outsourcers Tata Consulting Services Ltd.

and Infosys Technologies Ltd. have established Information Technology services and BPO (business process outsourcing) operations in Mexico, in line with the strategy of many Indian outsourcers to deliver services to customers from locales in nearby time zones to better serve their regional markets.

Currency exchange rates have also played a very important role in the wave of regionalization. This is one of the main reasons behind the remarkable growth of the aerospace industry in Mexico in the past few years, which has gone from about 50 companies in 2004 to over 300 in 2010.

France’s Safran, Zodiac and Manoir, U.K.’s Triumph, along with Spain’s Aernnova have substantial investments in Mexico, representing over 25% of the jobs of Mexico’s young and strong 35,000- workers aerospace industry.

As the Euro gains strength over the dollar, many European aeronautical supply firms that have dollar denominated contracts are ailing with higher manufacturing costs in Euros. These corporations know that relocating to Mexico, gives them the advantage of a low-cost manufacturing platform as well as the benefit of shifting their costs to a “dollarized” region.

Many global players are realizing that the world continues to be round. Their perception will gradually shift from offshore to near-shore and new windows of opportunity will open for Mexico.

THE CULTURE OF FRANCHISING

In spite of all the advantages Mexico has, many wonder why it continues to grow at a subpar pace when compared to other developing economies in the world. Why are Chile, Brazil, the Czech Republic and even Vietnam and Sri Lanka, not to mention China and India getting well ahead of Mexico in the global developing race? For the last 30 years, Mexico has undergone an impressive process of economic openness and trade liberalization leading the world in free trade agreements. Over the last decade, in particular, Mexico has accomplished macroeconomic stabilization and even real democratization and averted extreme currency devaluations, excessive inflation and acute fiscal deficits.

Yet, Mexico’s economic growth continues to be unsatisfactory and the country has failed to increase the standard of living of its population comparatively to other emerging economies of the world.

Mexico needs to grow at an annual rate of 7% to be able to employ about one million new job seekers per year. That level was reached only once in the past 25 years, in the year 2,000. Since then, Mexico’s average annual growth rate for the last decade is only about 1.5%.

A number of significant flaws continue to afflict Mexico’s economic growth, including inefficient government bureaucracy, overly rigid labor markets and poor educational systems. This is coupled with still inequitable income distribution, social tensions, rampant crime and corruption, an inefficient legal framework and low levels of citizens’ trust in politicians and the police force.

Low spending on R&D, the unavailability of scientists and engineers, the emigration of highly qualified professionals, the unavailability of loans and venture capital and the enormous cost of electricity and telecom services are among other main variables hindering Mexico’s GDP growth and business competitiveness.

Every stakeholder in Mexico’s public and private life is well aware of Mexico’s shortcomings, as well as their possible and likely solutions. However, like everywhere else in the world, there are positions of strength and individual interests that oppose change for the benefit of the people.

But unlike most everywhere else in the world, those special interests with positions of strength in Mexico are particularly mighty, very mature and extremely dominant.

HOW DID THIS HAPPEN?

The answer can possibly be traced back to the mid 60’s. At that time, the dominant political force in Mexico, the Institutional Revolutionary Party (PRI) had been in power for over thirty years. But changing global social and economical forces started to threaten its position.

What ensued in the late 60’s were intense political negotiations inside the PRI, between the President and leftist and rightist groups and between Mexico and the U.S. and other developed and developing countries.

These conditions provided an extremely fertile ground for a peculiar phenomenon to mushroom: political and economical franchising.

The culture of franchising had been part of the PRI since its beginnings, but it was rather discrete. Political franchising goes beyond political favors and reciprocity. It is rather a long-term, empowering, often times hereditable, political or economical position of strength granted by the system to an individual or group to use for his or their benefit.

Mexico’s major political, social and economic developments have been widely franchised. This explains, to a large extent, why Mexico has extremely powerful union leaders, public and private monopolies, bureaucratic corruption, police corruption and even organized crime.

It also explains in part why structural reforms, badly needed to enable a faster growth in Mexico’s GDP, are so difficult to pass in Congress.

Political and economical franchising is now deep and spread out in the Mexican way of life; it is part of the Mexican culture.

Franchising in Mexico takes its own relative shape in the different levels of the “food chain”. This culture is practiced from Mexico’s political and economical helm all the way down to the street policeman, rural teacher, public office receptionist and customs official.

When those holding a franchise, the “franchisees”, get to “work” and exercise their franchise for their benefit, they actually do not think they are doing something wrong. The empowering franchise is an “earned right”, and even if it is used for technically illicit purposes or situations, since society tolerates such behavior, the franchisees, generally, do not actually experience any remorse.

Franchising in Mexico is somewhat like intellectual property in China.

The world rages China for its unstoppable copying and infringement of intellectual and industrial property rights. But for the Chinese, there is nothing wrong with copying somebody else’s design.

For the Chinese, everything belongs to the people and copying is fair, it is part of their culture. Most technical universities in China actually include in their curricula “Reverse Engineering” courses, and some even offer master degrees on this subject major.

When the conservative National Action Party (PAN) won the presidential elections in 2000, after 70 year of ruling by the PRI, the majority of the people of Mexico voted for a “change”. In their minds, the voters placed a ballot in favor of eliminating the culture of franchising.

Unfortunately, after ten years in power, and except for a few cases, the conservatives have been unsuccessful to carry out this mandate.

One example of a top franchise in Mexico is the one held by the leader of the powerful national teachers union.

This organization, unequivocally blamed for the low level of education in Mexico, wastes billions of dollars in the political positioning and life style of its leaders and a huge bureaucratic staff and substandard educators.

Mexico is destined to fall behind in the global competition to attract value chains and investment unless this union is dissolved or at least drastically restructured.

But this is easier said than done, because the leader of the national teachers union was instrumental in supporting the election of President Calderon.

Many other examples of franchising in Mexico can be found by tracing the practice of bribery or “mordida”.

Traffic cops, public utilities’ clerks and inspectors, customs officials, buyers of public and private institutions and others have made this practice popular in Mexico to bypass the law or “get things done”.

And this is at the “Consumer” level; imagine what happens at the high-end political spheres where billions of dollars are at stake in contracts, or where powerful criminal organizations seek protection from the law for their underground activities.

The above is not to say that everybody in a position of power or in possession of a franchise is at fault in Mexico. There are millions of honest workers that keep things working normally.

But the situation is very bad. This is evidenced by the ranking The World Economic Forum’s Global Competitiveness Report 2010-2011 assigned to Mexico in the following categories out of 139 countries surveyed: Organized crime #136, Reliability of police services #132, Irregular payments and bribes #91, Diversion of public funds #98, and just to make sure everybody visits the franchisees for one reason or another: Burden of government regulation #116.

WHERE IS MEXICO HEADED?

The culture of franchising affects Mexico’s GDP and its growth because it reduces the country’s competitiveness and it scares away foreign and domestic investors.

Franchising also makes goods and services more expensive for Mexican consumers because suppliers have to factor in “hidden” costs, not to mention the severe economic damage public and private monopolies exert over households and businesses.

There is no scientific data to support and quantify the damage franchising does to Mexico’s economic growth. A not so wild and conservative guess would be that franchising reduces Mexico’s growth by at least 3% every year.

But Mexico continues to get a boost from regionalization and other sources.

Undoubtedly, the single factor that contributes the most to keeping Mexico above water is its labor force. The young workers and technicians employed in manufacturing and service firms get great marks from international and domestic firms for productivity and competitiveness. And from a cost standpoint Mexico’s labor is getting more competitive.

Exhibit #1 shows the average monthly salaries of direct labor in various countries. Interestingly enough, the study from the Boston Consulting Group shows that China’s developed regions’ salaries are now about even with Mexico’s.

Exhibit #2 shows a summary of a KPMG study of industries comparing Mexico index cost versus the U.S. base index of 100. This index includes all of the operating costs of typical manufacturing or service facilities for each of the industries.

Notice that Mexico’s overall operating costs savings range from a low of about 12% in the auto, electronics and aerospace industries to over 50% in the case of back office operations.

Exhibit #3 shows a historical summary of Mexico’s main economic performance indicators for 2000-2009 and an outlook for 2010-2012. This information was sourced from HIS-Global Insight. This global leading economic forecasting firm is predicting that Mexico’s real GDP growth will turn positive, to an annual average of 4.2% for the remainder of the current administration.

HIS-Global Insight’s forecast exchange rate shows a strengthen peso in a range of between Mex$12.50 and Mex$12.70 per US$1.00. This is sustained by a moderate annual inflation forecast of just over 4% and a restrained negative export/import current account annual balance under US$11 billion.

These numbers show a moderate recovery under a remarkable continuing economic and fiscal stability, but still will fall short of providing sufficient employment and an improved income for Mexico’s population.

President Calderon is running out of time to implement much of his intended reform agenda. It looks like the reforms to improve Mexico’s labor market, energy costs, telecommunications and media competitive environments, educational structures and political election practices will continue to wait.

Furthermore, Calderon’s problems do not seem to go away: In the eyes of many voters, he has by now failed in his stubborn fight against crime with a death toll unprecedented in Mexico since the revolution in 1910.

And yet, somehow, Mexico works.