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Six Markets to Watch: Mexico

Viva las Reformas

Author: Shannon K. O'Neil, Senior Fellow for Latin America Studies
January/February 2014
Foreign Affairs

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Just over a year ago, as President Enrique Peña Nieto started his administration, the domestic and international press were touting "Mexico's moment" and the rise of "the Aztec tiger." Now, the naysayers have returned. Their pessimism stems in part from disappointing economic results: Mexico's GDP growth has fallen, from nearly four percent in 2012 to around an estimated one percent in 2013. The negativity also reflects the impatience of pundits and markets, as the economic dividends from Peña Nieto's ambitious economic reform agenda have yet to appear.

Today's vocal disappointment discounts the positive changes Mexico has undergone and continues to make. Over the last three decades, Mexico has made the transition from a commodity- and agricultural-based economy to one dominated by manufacturing and services. It is also finally moving forward on a host of overdue domestic reforms. Internationally, the country is firmly situated within North American supply chains, augmenting its global competitiveness. And these advantages should only grow with Mexico's involvement in both the Trans-Pacific Partnership (TPP) and the Pacific Alliance, two of the most dynamic free-trade negotiations of this century. If Mexico is able to make its legislative changes stick and harness its geostrategic potential, the country will excel over the next five years, benefiting its people and making it a good bet for investors.

ONCE UPON A TIME IN MEXICO

As the North American Free Trade Agreement (NAFTA) celebrates its 20th anniversary, many forget just how much Mexico has changed in the last two decades. Once hidden behind high tariffs, quotas, subsidies, and hundreds of state-owned enterprises, Mexico's economy is now one of the most open in the world. Mexico boasts free-trade agreements with over 40 countries and a trade-to-GDP ratio -- a common measure of economic openness -- above 60 percent, surpassing the United States, Brazil, and even China. And whereas oil once represented over 75 percent of Mexico's exports, today it is manufactured goods that produce three out of every four export dollars.

This transition has not been easy. In fact, Mexico's openness was for many years seen as a weakness. Relentless international competition threatened new companies and otherwise promising industries, giving them little time to climb the learning curve. Particularly after China's 2001 entrance into the World Trade Organization, the search by CEOs and their boards for lower-cost and more flexible producers led many east, decimating several of Mexico's manufacturing sectors, including textiles and apparel.

This trend is now reversing. The low-skilled, low-paid jobs are likely gone from Mexico for good. But rising wages in China, combined with higher Mexican productivity; increasing energy costs, which make shipping more expensive; the proximity of Mexican factories to the United States, reducing delivery times; and worries about intellectual property rights, have led a number of manufacturers to choose Mexico over China. Others have brought back production once sent across the Pacific. In advanced manufacturing industries such as aerospace and automotive, Bombardier, Embraer, Honda, Nissan, and Volks­wagen have invested billions of dollars in Mexico and made the country a vital leg of their global supply chains.

As Mexico's economy has changed, so, too, has its society. Alongside a few of the world's wealthiest individuals and tens of millions who are still poor, a growing middle class has arisen. Depending on how one measures this group, it now comprises anywhere from 40 million to over 60 million Mexicans -- either way, a large percentage of a population of 116 million. These individuals and their families own cars, houses, and every modern appliance, as well as new cell phones. A growing number use their newfound disposable incomes to send their children to private schools.

Such increased consumption shows up in aggregate GDP numbers and on companies' balance sheets. Providers of electronics (Elektra), air travel (Interjet, Volaris), basic goods (OfficeMax, Walmart), cars (Ford, GM), credit cards (American Express), and high-end coffee (Starbucks) are just some of the firms that have seen their sales and profits rise.

THE PRESIDENT'S PLAN

The current government under Peña Nieto has kicked off its six-year term with an ambitious reform agenda. Working with Congress even before he donned the presidential sash, Peña Nieto helped pass a labor reform to reduce the size of the informal sector by making it easier for businesses to hire and fire employees (among many other changes). Once in office, his administration, working with all three major political parties, passed an educational reform to make the system more transparent and merit-based, introducing evaluations and performance tests. Next came telecommunications and the media, with new legislation creating a more powerful regulator and opening up the broadcast spectrum in an attempt to break up the current monopolies. Recent fiscal reforms should increase government revenue while also redistributing the tax burden, raising rates on the wealthiest, taxing capital gains and dividends, and creating universal pensions and unemployment insurance for those in the formal sector.

Peña Nieto's administration has focused on major political and energy reforms, which are intended to take on two of Mexico's most sacred political cows: the reelection of politicians and foreign investment in energy, both of which have long been banned. The government has also pursued financial reforms that would encourage lenders to extend credit beyond just a fortunate few. Although all the reforms entail compromises, many represent real changes. If fully implemented, they have the potential to chip away at Mexico's many barriers to broader, more inclusive growth.

With a stronger domestic economic base and a richer society, Mexico can take advantage of its greatest potential, which lies in its deepened ties to two developing economic blocs: North America and the Pacific Alliance. The most important region for Mexico is and will be North America. The continent is a global economic powerhouse, with Canada, the United States, and Mexico together boasting around 470 million citizens and an economy totaling some $19 trillion -- nearly equaling the EU in population and outpacing it in production.

A large part of North America's economic dynamism stems from its interdependence. Since NAFTA entered into force, intraregional trade has multiplied, from around $290 billion in 1993 to over $1.1 trillion in 2012. Roughly half of this trade crosses the U.S.-Mexican border each year. The nature of this back-and-forth has also changed, as new supply chains have taken root throughout the region. A study by the National Bureau of Economic Research found that on average, 40 percent of the content of the products imported by the United States from Mexico actually comes from the United States, reflecting the degree to which Mexico and the United States now make things together.

The recent boom in North American energy could further deepen regional ties. Ten years ago, North American analysts worried about a growing energy deficit as demand rose and supply diminished. Today, with the rise of shale oil and gas production in the United States, oil sands in Canada, and the potential opening of Mexico's energy sector, many experts are talking about the possibility of the continent's becoming self-sufficient. For Mexico, greater access to stable and affordable gas from the United States also stands to boost the country's competitive edge in manufacturing.

Still, challenges remain. Limited infrastructure investments, higher security hurdles, and duplicate regulations and bureaucratic procedures have increased border delays, raising costs for many North American operations. Studies show that the added time costs billions of dollars -- eating away at profit margins and hurting companies and workers on both sides of the U.S.-Mexican border.

After a decade of stagnation, the United States is finally taking steps to improve and facilitate economic ties between itself and Mexico. In September 2013, the two governments began the U.S.-Mexico High Level Economic Dialogue, led by U.S. Vice President Joseph Biden and Mexican Finance Secretary Luis Videgaray and Mexican Foreign Secretary José Antonio Meade. From customs forms to border crossings, product testing to standardized regulations, teams in both countries are beginning to work to reduce the current obstacles to freer trade, to the benefit of regional manufacturing and production.

NOT JUST NAFTA

Mexico also now forms part of the United States' most ambitious international trade effort, the TPP. Bringing the NAFTA partners together with Chile and Peru in the Western Hemisphere and Australia, Brunei, Japan, Malaysia, New Zealand, Singapore, and Vietnam across the Pacific, the bloc would represent one-third of the world's trade and 40 percent of global GDP. The TPP is intended to transcend traditional free-trade agreements and address such issues as regulatory coherence, e-commerce, and how to encourage small and medium-size businesses to trade internationally, all of which would increase competition and deepen production chains.

But even as Mexico is reaching out to the north, it is also actively looking south. In 2012, it became a founding member of the Pacific Alliance, alongside Chile, Colombia, and Peru (Costa Rica and Panama are expected to join soon, too). These like-minded globalizing countries are working to eliminate tariffs, allow the free movement of people, share diplomatic embassies overseas, and combine their stock markets into a joint trading platform. Although trade and investment flows among the members of the Pacific Alliance remain modest, the bloc offers a space for rapid growth.

By laying the groundwork for deeper regional supply chains, these blocs could represent a boon to manufacturers, distribution and logistics companies, construction businesses, and service providers. Taken together, they could help Mexico compete with, and benefit from, a rising Asia.

NO COUNTRY FOR OLD WAYS

For all of Mexico's strong positioning, the country still faces many daunting hurdles, which, if unaddressed, will hold it back. The biggest one is security. Crime remains stubbornly high -- not only homicides but also extortion, kidnapping, and petty crime. Corruption and impunity only compound the problem. Mexico's police have often proved unwilling or unable to stem the bloodshed of the country's violent drug wars. The judicial system has also failed, with just two percent of all crimes leading to convictions. Without the basic rule of law, citizens and investors cannot hope to thrive over time.

The most immediate bellwether for investors is whether Peña Nieto's government will use the political will and influence so ably wielded in the economic realm during its first year to reform security policies in its second. Perhaps the first important step will be fully implementing Mexico's justice reforms. Passed in 2008 under President Felipe Calderón, they aim to fundamentally transform Mexico's judicial system, moving it from one of written evidence to one of oral trials; redefining the roles of judges, prosecutors, and defense attorneys; and even altering the de facto assumption of guilt. Although the changes are not a panacea for all of Mexico's criminal ills, they would move the country toward a more transparent and accountable system of justice.

Mexico's political reforms are just as important for its future. If the country actually allowed reelections, elected officials would have incentives to keep their promises to voters rather than their promises to their party bosses, whom they currently rely on for their next posts. This shift would not only empower citizens but also encourage politicians to invest in public goods that take more than one term to be fully realized, such as professionalized police forces and reformed court systems.

Economically, weak infrastructure holds the nation back. According to the World Bank, less than 40 percent of Mexico's roads are paved, and much of its railways were laid over a century ago. Investments in ports, airports, and highways have not kept pace with the growing economy or its increasing northward orientation. In the energy sector, underinvestment in pipelines has left half the country unconnected and caused gas shortages that reduce its competitive advantage as part of North America.

Finally, Mexico still struggles with uneven playing fields in business and in its citizen's daily lives more generally. For companies and entrepreneurs, the monopolies and oligopolies across various sectors both box out healthy competition and new ideas and raise the basic costs of doing business. As a result, according to estimates from the Organization for Economic Cooperation and Development, the average Mexican pays 40 percent more than necessary for everyday basics. Mexicans also have unequal access to health care and basic household services and face huge disparities in educational opportunities. These obstacles make it difficult for poorer Mexicans to climb up the economic ladder and, in the process, keep the country stuck in the "middle-income trap," with not enough highly skilled, educated workers or innovative jobs to boost productivity and grow its burgeoning middle class.

MADE IN MEXICO

Despite these barriers, many companies have found a way to thrive. The automotive, aerospace, electronics, and appliance industries have all seen both investment and returns grow quickly over the last decade. In other sectors, Mexico's obstacles could turn into economic opportunities. The unevenness of public education opens up space for for-profit schools and universities. The infrastructure deficits, combined with the current government's ambitious five-year investment plan and advantageous public-private partnership laws, create possibilities for profitable private investment in ports, railroads, airports, roads, and border crossings. Recent reforms have also opened up at least the possibility of competition in long-closed sectors and markets; for instance, Virgin Mobile has already announced new investments in telecommunications.

Consumer sectors more broadly remain promising, especially if the proposed financial reforms are adopted, expanding credit in the country, which currently lags behind that in not just the United States but also Mexico's emerging-market peers, such as Brazil, China, and India. Hotels, retail outlets, clothing lines, restaurants, cinemas, pharmacies, and thousands of other businesses stand to gain.

Although Peña Nieto recently made a show of going to China and promoting bilateral economic ties, Mexico competes with, rather than complements, China's rise. It provides few natural resources to the Asian behemoth, and its own factories have faced the threat of low-cost Chinese production. But with its growing trade links to the United States, Mexico now looks increasingly attractive; investing in Mexico remains, in essence, an anti-China play.

For the moment, the idea that the next iPhone or iPad will be built in the Western Hemisphere from beginning to end seems far-fetched. Few believe that the continent has the capacity, the skill, the supply chains, or the competitive pricing to compete with China or the rest of Asia. But the TPP and the Pacific Alliance represent the best and most promising paths to making this a reality -- and Mexico stands at the heart of both.

What Mexico already has is a stable economy, a strong banking system, a democratic government, favorable demographics, globally competitive manufacturing sectors, and preferential access not just to the world's largest market (the United States) but also to many others through its growing trade alliances. If Mexico is able to get beyond its current limitations and capitalize on these benefits, investors and Mexican citizens alike will come out far ahead.

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