Mexico’s Globalization Economic Model

A quest for competitiveness

After 45 years of maquiladoras, 17 years of NAFTA, 11 years of democracy, 4 years of war against crime and 200 years of U.S.-Mexico relationships, Mexico’s globalization economic model has mixed results. Mexico has accomplished macroeconomic and currency stability, electoral democracy, a growing middle-class and a constant flow of foreign direct investment.

But Mexico’s economic growth is sluggish, unemployment is high, income inequality grows and a high percentage of the population is below the poverty line. Mexico also continues to be a hostage of public and private monopolies, political parties and, as of late, organized crime.

In this article, we will review Mexico’s Economic Globalization Model. This model is a concept developed by MEXICONOW and its main objective is to explain in a nutshell the main elements affecting Mexico’s position in the global context. Mexico’s global issues are many and complex. In this editorial piece we will keep a bird’s view perspective and offer some general suggestions on how Mexico may improve its global competitiveness.

MEXICO’S GLOBALIZATION ECONOMIC MODEL

Mexico’s globalization economic model is built around its geographic proximity to the U.S. and its market. The extraordinary size of the U.S. market and its large demand for goods (both licit and illicit) and low-cost labor (both domestic and off-shore) has signi ficantly influenced Mexico’s position in globalization.

Mexico’s economy ranks in position #14 in the world at about US$1 trillion nominal GDP, and it is #60 in GDP per capita in the world at almost US$10,000. In comparison, the U.S. GDP is 14 times larger than Mexico’s and its GDP per capita is almost US$50,000.

With a 2,000 mile long border between the two countries and a huge economic difference, Mexico’s trade and migration trends have historically been northbound. And the U.S., particularly from the perspective of international companies, developed an interest in Mexico as a potential export market and a source of inexpensive labor.

During the last 5 decades, and as a result of mutual interests, Mexico and the U.S. conceived trade and customs arrangements to foster their business relationships. Exhibit #1 illustrates Mexico’s Globalization Economic Model. Please note the four cornerstones in the conceptual graph: Labor, market, maquiladoras and NAFTA.

A GROWING LABOR AND CONSUMER MARKET

Few global firms fail to value Mexico’s labor and consumer markets trends and potential. Mexico’s demographics and purchasing power of households is a rare and positive combination among emerging economies. Mexico’s “Demographic bonus” is a unique advantage shared by only a few other countries in the world such as India and Brazil.

While most developed and many emerging countries in the world are already experiencing a deficit of workers because of their aging population, Mexico has a surplus of potential workers to last at least for the next 50 years. About 40% of the total 115 million Mexicans are age 19 or younger. It is estimated that in the next three decades, the number of individuals in working age will reach 63 million, up from 43 million in 2010.

Furthermore, Mexico is one of the richest countries among emerging economies in terms of household consumption expenditure per capita, easily outpacing Brazil by 50%, Russia by 100% and China and India by 1,000%! A highly populated market with a relatively high income seems very compelling to global firms as a potential customer.

And according to World Bank estimates, Mexico will improve its economic size and will become the 7 th largest economy of the world by year 2050.

A WIN-WIN DEAL

To link demand and supply of low-cost labor, the U.S. and Mexico implemented reciprocal customs agreements in 1966 to create the “Maquiladora” industry, which has become the most successful production sharing program in the world.

The maquiladora regime practically converted all of Mexico’s territory in a free-trade zone for manufacturing. Equipment and materials freely enter Mexico, and after processing, the products exported back to the U.S. pay import duty (if any) only on the value added in Mexico.

Today, the maquiladora industry employs one out of three direct manufacturing workers in Mexico and accounts for about 65% of all manufactured goods exports.

From Mexico’s perspective, the maquiladora system was primarily designed to create jobs. In retrospect though, the arrangement failed to provide strong and effective basis for the development of a domestic supply chain.

Interestingly enough, before the Chinese implemented their production sharing programs to open their labor market, they carefully studied the maquiladora industry of Mexico. They soon identified the domestic supply development void in the system in Mexico and cleverly structured obligatory local supply development and joint venture commitments when China opened to foreign manufacturers.

Very much along the maquiladora program basis, Mexico has also developed special programs for certain industrial sectors such as the automotive, electronics and aerospace industries to facilitate foreign trade and investment and increase local content.

A DANGEROUS COMBINATION

The U.S. and Mexico decided to further but gradually liberalized their borders by eliminating many of the tariff and nontariff barriers to trade. In 1994 the North American Free Trade Agreement (NAFTA) came into effect after a lot of controversy in all three participating countries.

It is well known that in the U.S. the opposition to NAFTA came from the labor unions in fear of losing jobs to Mexico. This debate has continued to spark antagonism towards the agreement, particularly during economic recessionary periods in the region and the world.

But through the years, and with the mixed experience of the U.S. manufacturing in China, even some labor unions and other challengers of NAFTA have recognized that Mexico’s lower manufacturing costs help many U.S. firms to remain competitive in the global markets and in some case, avoid extinction altogether.

Mexico has certainly benefited from NAFTA. The automotive, appliance, electronics and aerospace industries have experienced important production volume and technological growth. What it is not so well known, particularly in the U.S., is the high cost that the domestic industrial sector of Mexico incurred and has continued to suffer as the result of entering into NAFTA.

When NAFTA started, Mexican consumers were delighted. As the huge supply of imports from the U.S. arrived and developed in Mexico, consumers were able to get many more quality products at competitive prices and enjoy modern retailing, distribution and franchising by U.S. companies.

But, as imports from the U.S. soared into Mexico, literally thousands of Mexican mid-size and small industries went belly-up, unable to compete with the cheaper and better imported products. Whatever Mexico had at that time in terms of developing industry was devastated.

Mexico’s government possibly believed at the time that Mexican producers would be forced to become more competitive by the imports. Actually some industrial sectors were gradually or not fully liberalized immediately when NAFTA got started so as to give Mexican producers time to prepare for the tide of imports.

Also, the government had a plan to implement many structural reforms to help Mexican businesses to become more competitive through lower manufacturing costs, including energy, flexible labor and loans.

But the gridlock in Congress has prevented the passing of any significant reforms to support the competitiveness of domestic industry. As a result, other than a few large and competitive Mexican manufacturers, medium and small producers continue to struggle and do not participate in any significant form in the huge supply chain of foreign manufacturers in Mexico.

Indeed, the combination of a “toddler democracy” with an open market economy has proven to be a dangerous combination for many producers in Mexico. And worse yet, the lack of reforms continue to be an important obstacle to stronger growth of foreign manufacturers, consequently hindering the volume of employment of Mexican workers.

Since NAFTA, Mexico has continued to expand its network of free trade agreements. Today, Mexico boasts 44 trade agreements including treaties with the European Union and Japan, positioning the country to become a major manufacturing “hub” to serve the North American markets.

AND YET IT MOVES

In spite of the lack of structural and competitive reforms, Mexico’s Globalization model works. Let’s briefly review some of the other elements of support in the model in the conceptual illustration shown in Exhibit #1.

Thirty years ago firms starting manufacturing operations in Mexico literally had to wait for months before getting telephone or electrical service. Today, Mexico boasts modern industrial parks throughout most of its territory with readily available utilities.

In the main cities of Mexico, there are inventory facilities ready for occupancy. Mexico’s industrial and distribution real estate market ranks amongst the best in the world. Its high quality and cost competitive facilities provide a significant advantage to Mexico’s ability to attract Foreign Direct Investment.

As a result of many years of working under strict performance standards set by international companies, Mexico’s managers, service professionals and public authorities have actually developed U.S. like business practices and logistics procedures.

Almost two billion dollars worth of goods flow back and forth daily between the two countries. Although, compared to U.S. & Canada trade flows, there are still a lot of improvement opportunities in logistics in the U.S. & Mexico. But as more companies join the binational customs trusted programs and Mexico continues to improve its border infrastructure, trade flows continue to gain efficiency.

Petroleum exports are another key element in Mexico’s global economic model because they provide about 30% of Mexico’s federal income. But Mexico’s oil industry is plagued with problems. Production by Pemex has fallen 25 percent from its peak in 2004, while internal demand has climbed, sharply curtailing the amount of crude available for export.

Mexico is the third-largest supplier of foreign oil to the United States and could lose the capacity to export crude altogether within a decade without major new investments in exploration and production. Nevertheless, oil industry policy makers continue to stall possibilities of foreign investment in production and distribution.

THE “SUPERPESO”

You may recall that the Mexican peso was one of the most battered currencies in the world during 1970-2000. The peso actually had to be demoted by 1,000 in that time period to simplify transactions.

Thereafter, during 2000-2008, as a result of the country’s macroeconomic stability, the peso gained strength and traded at about $10.50 to US$1.00. It was during this period that the Mexican currency earned the nick name of “Superpeso”, sustaining for eight years what seemed to be an endless overvaluation.

When the global financial crisis exploded in October, 2008, the peso experienced an overdue correction to about $12.50 per dollar, bringing back a much needed competitive exchange rate to Mexico’s exports. Since, because of the uncertain financial markets, the peso has fluctuated in a band of plus or minus 10% from $12.50 per dollar.

PAISANOS IN THE U.S.

About 11 million Mexican expatriates living in the U.S. are an important part of Mexico’s global model simply because they provide close to approximately US$30 billion in annual remittances to their families back in Mexico.

This amount of money is larger than the value added by maquiladoras or tourism income and will soon rival oil exports. Although official figure place foreign remittances at about US$25 billion, the amount is greater because a good part of it is transferred by hand in cash.

This flow of money is a great support to the Mexican economy, the stability of the peso and the level of Mexico’s foreign exchange reserves. But it doesn’t come without side effects for separated family members and Mexico’s international relations.

Indeed, one of the most difficult subjects between Mexico and the U.S. is the looming issue of the approximate 5 million undocumented Mexican workers. The problem is highly complex and charged with politics. The recession and the increased unemployment in the U.S. have resurged opposition for further immigration and flat out opposition to current undocumented workers in some southern states such as Arizona and Alabama.

But many feel the U.S. economy needs the labor Mexicans contribute in agriculture and other lower skilled trades. The issue is certainly not a favorite of U.S. policy makers as they have been avoiding to firmly tackling it for years. It would seem plausible for the U.S. to establish some form of registration and temporary visa programs for future Mexican workers coming to the U.S. In this manner, through employment market forces, the newly documented workers would displace the undocumented ones, while also forcing many of the latter to regularize their immigration status.

THE MISSING LINKS

In the conceptual illustration of Mexico’s global economic model, please notice 14 red elements at the bottom. These are the missing links in the model. Mexico would be a much more competitive economy in the world and reach annual growth rates of 7% or greater if its policy makers enacted initiatives to incorporate the missing links into the model.

Tax incentives for capital investments and R&D expenditures need to be signi ficantly upgraded. Competitive loans for domestic suppliers are essential to develop supply chains. Industrial policy and fiscal rules should be clear and permanent. And the English language should have a significant role at all levels of education.

We need a lot of space beyond this article to analyze in depth all of the missing links. Please read the related articles on competitiveness and security in this edition of MEXICONOW: “The Good, The Bad and The Ugly… page 30, and “Surgical strikes in the drug wars… page 45.

UNDERSTANDING THE STRUCTURAL REFORMS

Following is a brief explanation of the main “Structural Reforms” that Mexico urgently needs to improve its global competitiveness.

STATE REFORM
Politics need to be reformed in Mexico, for example: Mexico has 200 unelected house representatives and 32 senators too many in Congress. Of the 500 total lower house representatives and the 128 senators only 300 and 96, respectively, are elected. The rest, are appointed directly by the parties, who get seats allocated by law based on their proportional representation in the general vote. Mexico does not need such a large Congress.

City mayors and all congressmen should have the ability to be reelected, so that their interest belongs to their constituents and not just to their political party. Without reelection, these public officials spend their time preparing their next political move, and give little time working on their assignment. In addition, the no reelection rule precludes Mexico from having experienced politicians.

Mexico has over 700 elections in a given 6-year term. Why not, for example, reform the schedule to limit city, state, congressional, presidential and other elections to 40 dates? It would also be wise to shorten the campaigning cycles. These changes would certainly save money, time and effort.

ENERGY REFORM
Mexico’s energy policy is highly restrictive. The powerful federal monopolies, controlled by the unions and sheltered by a popular nonsense notion of “National pride”, preclude foreign investors from producing and marketing energy. Opening the doors of Mexico’s energy supply chain to foreign investors with a level competitive set of rules would undoubtedly drive energy prices down.

The cost of electric power in Mexico is among the highest in the world. In Mexico you will be charged for an industrial average kilowatt-hour at about US$0.05 compared to about US$0.03 in the U.S. Mexico charges premium prices for gasoline and natural gas compared to other oil and gas producing nations.

Domestic and foreign competitors are precluded from participating in the energy market. Basically, the unions of Pemex (Mexican Petroleum) and CFE (The Federal Power Commission) have blocked any efforts that may “endanger” their position.

TELECOMMUNICATIONS AND MEDIA REFORM
Just as the unions control the two federal energy monopolies, private monopolistic companies control and exercise a siege over media and communications in Mexico. The TV and telecom industries in the country have one dominant player and at best only one more real competitor. Every time a telecommunications reform initiative starts to take form in the aisles of Congress, counter forces rapidly make it disappear.

Evidently, what are needed are competitive, long-term rules so that other players, foreign and domestic, are able to invest capital and enter the telecom and media markets. The current rules do not provide potential competitors the possibility of a return on their investment.

FISCAL REFORM
Although Mexico has a relatively strong international financial position in terms of debt to GDP and foreign currency reserves, the country must address important domestic affairs and the lack of longterm fiscal rules for foreign investors.

In general, Mexico’s income is insuf- ficient and risky and the expenses are high and lack accountability. Tax revenue from US$40 billion oil exports support over a third of the federal budget, were it not for the current high price of oil, Mexico’s finances would suffer drastically.

Mexico needs to tax over 20 million individuals and informal businesses that do not currently pay any taxes, while at the same time significantly simplify tax regulations and payment procedures. Mexico must also eliminate many special low-tax or no-tax regimes and universally, not selectively, apply the sales tax (IVA) to consumption.

In addition, Mexico must end the practice of announcing new tax rules and changes practically every year, leaving business planners (domestic and international) in the dark. Mexico must positively define its tax structure with clear and permanent rules.

EDUCATION REFORM
Unquestionably the most needed reform in Mexico is in education. Although not widely recognized as such, education reform is really the long-term, fundamental platform that Mexico needs for sustained competitiveness.

China is the second largest economy in the world and India is poised to become #3 in a couple of decades. They are leveraged by an admirable academic/training strategy for their young. Mexico’s quality of education is well below average in the world.

Before aspiring to reach excellence in education, Mexico first needs to restructure the powerful teachers’ union. The union has huge influence in national politics as well as strong regional positions throughout all of the Mexican States. A basic requirement for the teachers union should be to install fundamental transparency and accountability measures.

The academic programs should be brought up to international competitive standards, most noticeably in public schools. English language instruction and progress in proficiency should be required at all levels.

LABOR REFORM
Labor reform is important because in a flexible labor market, the most productive workers obtain the best paying jobs; while in a rigid labor market, the productivity of workers is not directly related to their salaries. In essence, labor rigidity is a signi ficant drag for productivity growth.

Mexico’s labor law is a relic. It is cumbersome, complicated and highly protective of workers and unions. Mexico needs a flexible labor law in accordance with global competitive practices.

In order to compete, employers need a labor law that allows flexibility for temporary employment, hiring, firing, working schedules and multi-task work. As it stands today, it is mandatory that employment be permanent and for an indefinite time period. Three months severance pay applies for unjustified layoffs. Mexico needs to create labor structures that link productivity and workers’ pay.

In addition, to further boost employment, Mexico needs to reform its Social Security policy. This can be done by increasing the costs of informal workers, reducing the cost of formal enrollment and allowing and streamlining the transfer of pensions and other social fringes between employers and between different social security regimes.

CONCLUSION

For the past decade, Mexico’s economy has only grown at about 2% per year. Mexico has great global attributes and an enviable manufacturing base with the potential to achieve much higher growth.

But Mexico seems to continue to be its own worst enemy. Most of Mexico’s problems are fixable from within. What is Mexico waiting for?

Sergio L. Ornelas has 30 years of experience in international trade and direct foreign investment. He has business degrees from Babson College, Southern Methodist U. and Harvard; he was head of the State of Chihuahua Industrial Promotion Agency in 1980-5 and General Director for Intermex Industrial Parks through 2000. He is MEXICONOW’s editor.
He may be contacted at: editor@mexico-now.com