Mexico’s Infrastructure Challenge

 

A Story of the Struggle in Construction Productivity

By Sergio L. Ornelas
MexicoNOW Editor

Infrastructure?

 

Who wants to read about this dull Mexican subject of steel, concrete, logistics, construction and corruption?

 

You do!

Because if you are a taxpayer working in Mexico, there is a very high probability that you already own a piece of that infrastructure through your retirement savings account. And if you think infrastructure is a boring theme, think again because this tongue rattling word represents many important things in your life, including your safety, productivity and comfort when you are out of your home. Countries need infrastructure to achieve economic growth. Look at China’s impressive pace on the heels of dozens of new airports, special economic zones, maritime ports, intermodal logistics hubs and state-of-the-art telecommunications. Developed European countries are role models for infrastructure. If you live in London, you can have a complete same day work agenda in Paris on a round trip by train, automobile or air across the English Channel. In spite of what seems to be a well-planned effort by the current administration, Mexico is still a laggard in infrastructure. In this article we will review the macroeconomic status of the infrastructure industry in Mexico, the reasons behind its failure and the possible actions that may improve it in the future.

 

By the Numbers

 

“Infra” means “below”, so the infrastructure is the “underlying structure” of a country and its economy, the fixed installations that it needs in order to function. These include roads, bridges, dams, the water and sewer systems, electric power, railways and subways, airports, harbors and telecommunications. According to the World Economic Forum 2018 Competitiveness Report, Mexico ranks in position #71 among 137 countries in the quality of overall infrastructure, down two places from the same report in 2017. Please see Exhibit #1 showing Mexico’s ranking in nine categories of infrastructure compared to other selected countries. Notice that Mexico is “in the middle of the road” in most of them. One of President Pena Nieto administration flagships is the National Infrastructure Plan (NIP) launched in 2013. The NIP has 3,600 jobs and the main projects include building fifty-two 4-lane highways and eighty 2-lane roads for a total of 6,500 km (4,000 miles), the construction of the Mexico City new international airport (NAIM), doubling the maritime ports capacity from 260 to 520 million tons and the construction of the interurban train Mexico City-Toluca, the electric train in Guadalajara and the #3 Monterrey Metro line. According to the Communications and Transport Ministry (SCT) the original budget of about US$97 billion had a progress of 81% by the end of 2017, and has created over a million jobs in five years. In the two-page spread forward in this piece you may see some of the most prominent NIP works covering most of Mexico’s landscape. But as impressive as NIP looks, the effort is well short of what the country actually needs. According to the Global Infrastructure Hub, a G-20 initiative, to have adequate overall infrastructure over the long-term of 33 years (2007 – 2040) Mexico needs to spend US$1.1 trillion, or about US$33 billion per year. At the current trend of infrastructure investment, Mexico is set to reach US$522 billion in that long-term period, an average of US$16 billion per year, yielding an investment gap of US$544 billion, which represents a bit over half of the real need. A current investment level of US$16 billion per year in infrastructure represents about 1.6% of Mexico’s Gross Domestic Product (GDP). This figure is a galaxy away from the 7% to 8% of GDP that Asian countries invest in infrastructure development.

 

The Hurdles

 

And then, Murphy’s Law shows up out of nowhere in the form of unfavorable economics, Teutonic plates movements and political circumstances. Macroeconomic head winds are pilling up challenging the completion of the NIP with many projects at risk of not making it to the finish line, at least not during the current administration. Public works are suffering under a shrinking federal budget, oil prices have no fully recovered, interest rates are on their way up, the peso is devalued and inflation on building materials is on the rise. Then, the September 2017, 8.1 and 7.1 Richter scale magnitude earthquakes that trembled the states of Chiapas, Oaxaca, Puebla and Morelos required the attention and budget of the SCT to support the affected population and rebuild housing, bridges and roads. Government reports indicate the loss at over 250 souls; and 184,000 households, 175 health facilities and 16,000 schools damaged or destroyed. Over 2 million people were affected by the natural disasters. Six months after the tragedy, SCT continues to be active rebuilding houses and schools as thousands are homeless and most children are still unable to attend classes. On another front, the looming presidential elections of July 1, 2018 bred a controversy over the NIAM’s fate among the presidential candidates. Andres Manuel Lopez Obrador (AMLO) is the voters preferred candidate in most recent polls, with about 10 percentage points over second place conservative Ricardo Anaya (PAN), the official candidate (PRI) Jose Antonio Meade is at a distant third place, 20 percentage points behind AMLO. AMLO’s political platform includes cancelling and terminating the NIAM in lieu of expanding Mexico’s main military air base of Santa Lucia, 30 kilometers north of Mexico City. There is plenty of space in that location for commercial and military purposes. The latter includes a relative low number of operations, mostly practice drills.

Under AMLO’s airport plan, the existing Mexico City airport would be used for domestic flights and the Santa Lucia airport would handle international flights. That would not had been a bad idea before the time the NIAM went from paper to ground breaking. Today, the NIAM construction is likely at a no return point because of the committed building contracts, in all likelihood cancelling the project would be cost prohibited. The NIAM has a construction budget of US$10 billion and is expected to be completed by 2020. (Read the article “NIAM in the air” in this edition of MexicoNOW.)

AMLO is also keen on scraping or modifying the energy reform, which has multi billion commitment contracts mostly with foreign investors for oil and gas exploration, drilling, refining, transporting and even retailing fuels. Another hurdle for the NIP is the timeline to advance and complete project construction jobs before the presidential election and the change of the guard come December. Finishing the main three train projects before the election is a big challenge to the administration, because they really weigh on voters’ animosity. Our take is that they would be completed in 2018, but not before the presidential election. The above and other hurdles linger on the confidence of foreign and domestic investors, particularly about the uncertainty of AMLO’s moves if he does make it to the presidency. And as far as hurdles are concerned, did we mention President Trump? And NAFTA under scrutiny?

Do not expect any dull moments for Mexico in 2018.

 

Helpful Buoys

 

The private sector plays an important role in supporting infrastructure development in Mexico. The helping hands come from various sources. Industrial parks have been a long-time sponsor of infrastructure growth. They have big investments in utilities, roads and facilities. For many years The Electric Federal Commission (CFE), Pemex, Telmex and other communications providers, railroads, municipal water and sewer departments and other utilities have heavily relied on funds from industrial park developers to expand their infrastructure to service park tenants. Unlike the practice in the U.S. whereby utilities reach the user with their infrastructure and are happy to recover their investment through demand in the years to come, in Mexico, any industrial installation is required to pay for the infrastructure cost needed by the utility provider to reach its location. In 2018, Mexico’s industrial parks and stand- alone facilities total approximately 750 million square feet under roof and their contribution to infrastructure is north of US$5 billion over the past 25 years. Two capital markets tools have also been instrumental in supporting infrastructure by attracting foreign and domestic funds: FIBRAs and CKDs. Mexico’s real estate investment trusts (REITs), aka FIBRAs in Mexico (Fideicomiso de Inversion en Bienes Raices) are listed in the Mexican Stock Exchange and they target stabilized income-producing properties in Mexico. The leading FIBRAs specialize in industrial, logistics and commercial properties and their contribution has been invaluable to consolidate and solidify real estate investments in Mexico. And as of late, in the past few months, at least 3 infrastructure FIBRAs have been issued in Mexico. The latest one, called FIBRA E is for the construction of the new airport. In fact, the NAIM raised about US$1.6 billion, which includes US$730 million from 4 Mexican retirement investment funds (AFORES). FIBRA E will start compensating the investors with some of the income of the existing airport and in the future it will rely on NAIM inflows. The Certificates of Capital for Development known as CKDs are financial instruments in the Mexican Stock Exchange meant to finance infrastructure and other long-term projects. CKDs have been active since 2009 and were initially established as investment vehicles for the AFORES.

To date, there have been about 80 CKDs emissions worth approximately US$6 billion for investment projects in electricity and other utilities and real estate developments among many others. According to the Global Infrastructure Hub, the private sector has invested in Mexico US$12.2 billion in the last five years. Private Public Partnerships (PPP) represent another structure through which the private sector participates in infrastructure investments. Unfortunately the number of PPP infrastructure projects has been declining. For Mexico, the World Bank reports a peak of 30 PPP macroprojects in 2013, down to only 13 in 2016. The Mexico-Toluca Interurban train and the NAIM are two of the largest PPP projects in process in Mexico today.

The Construction Industry

The subject of infrastructure cannot be properly analyzed without a brief look at the state of the construction industry in Mexico. The construction sector is not doing well in Mexico. It has been battered by a double-digits percentage reduction in the public investment budget since 2016 and the recent interbank interest rate hike to 7% by the Bank of Mexico. According to the Mexican Chamber of the Construction Industry (MCCI), the sector is expected to grow marginally at less than 1% in 2018 after suffering a contraction in 2017. According to MCCI, the sector’s annual market is approximately US$130 billion with a 77% private market share and 23% government participation. Private works have kept the construction industry afloat during the past few years. Construction of industrial, commercial, tourism, high-end residential building, office buildings and mixed-use development projects are relatively healthy.

 

Dishonesty

 

It is common knowledge in Mexico that many public construction contracts at the federal, state and city levels have some sort of illegal payments built in. Indeed, governments have rules for transparency and accountability in the construction jobs bidding processes, but favoritism and inside information may tilt a contract to a preferred vendor. In addition, construction contracts have many ways of generating additional artificial costs in the form of change orders, scheduling extensions and cost overruns. Marginal funds are even budgeted for in the original quote in various forms such as supervision charges, consulting fees or indirect costs. The marginal money is then paid back to the persons in collusion. Sometimes the pay-off may be done in kind such as a real estate property, an expensive vacation trip or jewelry. This practice is not unique to Mexico or even just public contracts. Construction contracts corruption runs rampant all over the world in private and public entities. You might have heard of the Odebrecht case in Brazil, Vinci in France or OHL in Mexico. Exhibit #2, sourced from consultancy McKinsey Global Institute, pretty much explains Mexico’s tragedy of construction corruption. The graph is labeled World Construction Labor Productivity and it measures on the vertical access labor productivity indicated in US Dollars per hour worked. Notice that the U.S., Canada, Japan and many European countries are well above the US$25 dollar per hour international average, which is the horizontal line through the middle of the chart. On the horizontal axis we have labor productivity annual average % change for the 20-year period of 1995-2015. All the way to the right you have China, improving its labor productivity by about 7% every year! Notice the vertical line rising from the zero % change point, evidently, those to the left of that vertical line have negative labor productivity growth through the years. The lines mentioned form quadrants: in the upper left hand quadrant you have “Declining Leaders”, those with high productivity but declining growth; in the lower right hand quadrant you have the “Accelerators” with low productivity but positive rate of growth; in the upper right hand quadrant you have the stars or “Outperformers”, the ideal position, representing those with both high productivity and positive growth. And in the lower left hand quadrant you have the “Laggards” with very low productivity and shrinking or negative growth. This is not a soccer game, but you probably already noticed that Mexico and Brazil are competing to be the worst. In conclusion, this chart shows that the effectiveness of the monetary investments in construction is awful in Mexico simply because there are unrelated interests that bite off portions of the construction budgets.

Actions to Improve

 

Corruption is the leading reason behind Mexico’s laggard condition in infrastructure. But there are plenty of other reasons; we will briefly address some of the opportunities to improve Mexico’s infrastructure. Roads. – Mexico must focus on building and expanding highways and roads. According to the Global Infrastructure Hub, Mexico’s main infrastructure gap is in roads, actually 85% of the total gap, or US$464 billion is in the category of land transportation as shown in Exhibit #3. Indeed, 55% of cargo transportation and 96% of passengers in Mexico move by land over very limited and logistics inefficient roads (Exhibit #4). Auto OEM’s struggle to get their vehicles to the northern border and maritime ports and they claim that further expansions of production capacity are severely threatened by their ability to move production to their export markets. Planning. – In Mexico, infrastructure transportation works are oftentimes programmed to serve a particular region or the political moment. In other words, infrastructure development projects are fragmented; they lack intermodal planning and an overall functionality and coordination. There is not an Infrastructure Master Plan to anchor states, cities and the federal government in the same frequency when planning roads, railways, harbors and intermodal stations.

Mexico needs an Infrastructure Master Plan. Continuity. – By the same token, there must be an independent body or council and mechanisms that regulate the continuity of infrastructure works in order to keep them safe from politicians’ alternations in office. The NAIM is a huge case in point, but hundreds of small and mid-size truncated infrastructure projects plague Mexico’s landscape. For example, the independent regulatory councils could be formed at the state level and they would report to a federal master council. Infrastructure works and their funding may also be placed in a trust that would shield them from political turnover. Enforcement. – Mexico would save billions of dollars if building codes were enforced. Governments in Mexico spend large amounts of money just repairing and rebuilding works such as housing, buildings and roads that were built with subpar specifications or on unsuitable locations. Violations to structural requirements and zoning regulations are very frequent in Mexico; they are usually discovered when Mother Nature reminds developers that a building permit obtained through corruption is not such a good idea after all. More PPP. – The Mexico Projects Hub is a recent and nice Internet platform by Mexico’s federal government to inform potential domestic and foreign investors most everything they need to know to bid on projects in partnerships with the government, projects offered under a license and through concessions. Over 80% of the projects listed in the website are for the electricity and hydrocarbons sector under the energy reform and only 10% are transportation related.

In the transport section, there are just 16 highway related projects under a PPP format, and only one, the Las Varas-Puerto Vallarta Highway, which is a US$392 million investment up for grabs since 2015 is a complete design-build-operate project, the other 15 projects are “Maintenance and Conservation” of highway sections. Investors complain that the nature of the road related projects is the same, that there are not new project opportunities and that the regulations are complex. Mexico should be more innovative and launch a large amount of highway related PPP projects; there is plenty of geography and a huge need, especially for 4-lane “horizontal” highways oriented East-West. And last but not least:

Get Rid of Corruption. – Really?

Following is the unfortunate true in the words of Alan Greenspan, the former (1987-2006) Chairman of the U.S. Federal Reserve:

“Corruption, embezzlement, fraud, these are all characteristics which exist everywhere. It is regrettably the way human nature functions, whether we like it or not. What successful economies do is keep it to a minimum. No one has ever eliminated any of that stuff.”