Theodore Kahn on what 20 years of NAFTA have meant for Mexico

The New Year marked 20 years of NAFTA, the landmark free trade agreement among Canada, Mexico, and the United States that aimed to integrate the North American economy. The agreement has long been a lightning rod for controversy and a touchstone for the broader debate over the costs and benefits of globalization.

In the U.S. NAFTA spawned fears of a massive exodus of jobs, while in Mexico, the agreement was greeted with nothing less than an armed rebellion in Southern Chiapas state.

Two decades on, the results for Mexico are decidedly mixed. The economy managed only 2.6 percent average annual growth since 1994—compared with 3.1 percent for Latin America as a whole. Trade has increased dramatically, especially with the United States, and Mexico transformed itself into a manufacturing powerhouse over the past two decades. The economy currently produces and exports electric cars, aircraft systems, medical equipment and a range of other high-tech goods that would make Raul Prebisch smile.

But the trade boom has done little to help the worse off Mexicans. Poverty remains high: after decreasing through the middle of the 2000s, the percentage of Mexicans below the national poverty line increased from 42 percent in 2006 to 52 percent in 2012—the same level as 1994 when NAFTA entered into force.

While it is wrong to pin the country’s overall economic performance solely on NAFTA, the agreement has contributed to and perhaps accelerated three parallel trends in the Mexican economy: regional disparities between the rich north and the poor south, concentration of productive assets in a handful of firms, and individual income inequality. NAFTA has exacerbated divisions between two Mexicos: one modern and prosperous, the other backwards and poor.

Consolidating Mexico’s Economic Reforms: The Origins of NAFTA

NAFTA represented the culmination of a long process of economic reform in Mexico that began in the early 1980s. Like most of Latin America, Mexico pursued state-led industrialization policies for much of the 20th Century, which protected domestic businesses from competition behind high tariff barriers.

This strategy worked well until the 1970s when a constellation of external shocks and irresponsible policy choices at home roiled the Mexican economy, leading to cycles of unsustainable debt, capital flight, and currency devaluations.

In 1982, after its foreign debt jumped from $49 to $75 billion in one year, Mexico announced a moratorium on debt service, setting off Latin America’s debt crisis and sending the economy into a tailspin.

The debt crisis also sounded the death knell of state-led industrialization, and Mexico introduced market reforms in an attempt to restart growth. Part of the package was trade liberalization. Mexico joined the General Agreement on Trade and Tariffs (GATT) in 1986, unilaterally slashing tariffs and eliminating import licensing under president Miguel de la Madrid (1982-1988).

The initial trade opening led to an influx of imports that displaced many long-protected and inefficient domestic firms. The resulting trade deficits required Mexico to attract a steady stream of capital inflows—no easy feat for an economy that had spent much of the previous decade in recession.

Enter NAFTA. President Carlos Salinas de Gotari (1988-1994) first floated the notion of a free trade agreement with the United States in 1990 as solution to the foreign investment conundrum. The effect would be both practical and psychological. On the one hand, Mexico’s low-wage work force and unmatched proximity to the US market would give foreign producers a strong incentive to locate production in Mexico.

On the other hand, NAFTA would send a powerful signal to international investors that Mexico was a serious country—one that would repay its debts and not meddle in the operations of foreign firms.

In this way, NAFTA provided the lynchpin for a decade of economic reforms. Within Mexico, the deal represented the final triumph of the “modernizing” wing of the ruling PRI, which, in alliance with the pro-business opposition PAN, moved Mexico from statism to neoliberal orthodoxy. This alliance continues to reign supreme in Mexican politics, as the recent energy reforms, backed by the governing PRI and opposition PAN, demonstrate.

NAFTA’s Economic Impact: The Story of Two Mexicos

Did Mexico’s NAFTA gambit work? The answer, as with most economic questions, is it depends. NAFTA did bring about a major expansion of trade between the U.S. and Mexico, which reached nearly $474 billion by 2012 from a starting point of $106 billion in 1994. Mexican exports accounted for the bulk of that gain: the trade balance with the U.S. went from a deficit of $3.6 billion in 1994 to a surplus of over 100 billion in 2012.

Foreign direct investment in the Mexican economy also skyrocketed. After averaging just over $4 billion a year between 1990 and 1993, Mexico attracted an average of $12.5 billion in annual FDI inflows from 1994 to 2000.

At the same time, the patterns of trade and investment that developed under NAFTA have done little to reduce poverty and inequality and aggravated gaping disparities between the prosperous North and backwards South. More problematic still, wages for Mexican workers have stagnated, despite what economic theory would have us believe.

Between 1970 and 1985, the GDP of Mexican states actually converged—the poorer states grew more quickly than the richer ones as the government channeled oil revenues towards investment in peripheral regions. Things began to change in the mid-1980s, coinciding with the country’s trade opening.

During this period, the fastest-growing states were the Northern border states as well as Mexico City, while the poor South stagnated, thanks in part to competition from US agricultural producers. This trend accelerated after NAFTA came into force, as FDI and technology-intensive industries clustered in states with existing advantages in human capital, infrastructure, and proximity to the US.

Over the past decade, states in the center of the country such as Aguascalientes, Queretaro, and Zacatecas have experienced fast growth and attracted major investments from multinationals, raising the prospects of NAFTA supply chains spreading to a broader swath of the country.

But the poorest states in the South—Oaxaca, Guerrero, and Chiapas—remain out of the loop. These three states grew at an average of 1.7 percent between 2003 and 2011, compared with a national average of 2.8 percent.

This concentration of wealth is mirrored at the firm and individual level. At the onset of Mexico’s reform period, state-owned enterprises were sold off rashly and with little oversight. This process created a stable of near-monopolies in industries such as telecommunications, chemicals, cement, and agribusiness.

Under NAFTA, these firms captured increasingly large shares of the Mexican market. In 1991, the sales of Mexico’s top ten private firms amounted to 7 percent of the country’s GDP; by 2009, their share had more than doubled to 15 percent.

Not surprisingly, NAFTA has done little to improve Mexico’s income inequality either. The country’s Gini coefficient, at 0.47 in 2010 according to World Bank, might be on the low end for chronically unequal Latin America, but it only declined by 0.02 points since 2002—a period when other countries in the region such as Argentina, Brazil, Colombia, and Peru achieved a much greater decrease in inequality.

Again, it is difficult to tease out the impact of NAFTA from factors such as the country’s broader structural reforms or changes in the global economy. The experience of Mexico does mirror that of most of Latin America, where trade liberalization in the 1990s tended to exacerbate the duality characteristic of the region’s economies.

In most sectors, a handful of leading firms, including multinationals, benefitted from increased market access, opening to foreign investment, and the availability of inputs and capital goods at world prices. These firms, already the most productive, absorbed high-skilled workers and managers, increasing the skills premium in most countries.

On the other side of the divide are the vast majority of relatively unproductive, often informal, small firms producing for the domestic market. This second group, which relies primarily on unskilled labor, suffered the brunt of import competition.

Throughout Latin America, leading firms reaped the benefits of economic integration while the larger majority struggled to compete and held out little hope of participating in trade. NAFTA likely exacerbated these trends by committing Mexico to rapid and far-reaching opening to trade and FDI that exposed many sectors, in particular agriculture, to fierce competition from US producers.

The Mysterious Case of the Stagnant Wages

This distribution of winners and losers is not entirely surprising given what we know about agglomeration effects and economic geography.

What is surprising is what has happened to Mexican wages—or more precisely, what hasn’t happened. A major selling point for Mexico was the belief (likely rooted in undue faith in economic theory) that NAFTA would cause wages to converge with the higher levels of its Northern neighbors.

In the aggregate, wages did increase from 1996 to 2000, as the economy bounced back from the disastrous 1995 peso crisis and experienced its fastest growth of the past two decades.

Since then, however, wages have stagnated. Average wages barely rose over the course of the past decade, reaching a paltry $2.50 an hour in 2013 according to numbers from Bank of America. Even higher estimates (the U.S. Bureau of Labor calculates an average of $ 4.45 an hour) have the Mexican worker earning around two-thirds of his Brazilian counterpart.

Low wages are great news for multinationals looking to produce for the U.S. market. Foreign manufacturers in sectors such as automobiles, aerospace, and medical equipment have poured money into Mexico recently, including some who abandoned the country for China in the early 2000s.

But the fact remains that Mexico is increasingly becoming a country of first-world manufacturing and third-world wages. Mexican economist Luis de la Calle, a NAFTA negotiator, recently acknowledged that Mexico “needs to increase wages to become a truly modern country.”

What is behind the country’s wage problem? Mexico’s ridiculously low minimum wage—around 60 cents an hour—certainly doesn’t help. In addition, productivity gains have been meager, growing only 16 percent from 1992 to 2012, compared to 30, 57 and 113 percent in Brazil, Chile, and Peru respectively.

A slack labor market—despite low unemployment, an estimated 31 million Mexicans work in precarious conditions without a formal contract—further reduces pressure on wages.

The bottom line is that the presence of prestigious foreign firms and cutting edge manufacturing sectors has not spilled over into broad-based productivity gains. Foreign investment tends to exist in enclaves, relying heavily on imported inputs.

The percentage of foreign value added in Mexico’s manufacturing exports has been estimated to be around two-thirds—a trend that is not limited to the maquila sector along the U.S. border. As a result, linkages between large multinational and domestic exporters and the mass of small, local firms that employ the vast majority of Mexicans remain weak.

The dualistic nature of Mexico’s productive structure has not changed much since 1994.

How to Bridge the Gap

The challenge for Mexico is to create the conditions for more workers, firms, and regions to participate in NAFTA’s trade and FDI linkages. More foreign investment will help, but the Nissans, Siemens, and Bombardiers of this world, powerful as they may be, cannot build factories in every Mexican municipality.

What is needed are deliberate policies to promote productivity among small domestic firms and help forge linkages between them and the relatively small group of exporting firms. Improving the quality of human capital is an important step towards this end, and the current government has undertaken a much-needed education reform, but overhauling Mexico’s school system represents a long-term proposition.

As anyone who has traveled in rural Mexico knows, infrastructure represents a major barrier to economic activity in many parts of the country. Better road and rail links from the Southern states to key ports and hubs such as Mexico City would help firms in the country’s poorest region participate in the global economy.

A recent study by the Inter-American Development Bank put some numbers on this obvious intuition. Using plant-to-port data, the report estimates that for Southern Mexico, a 1 percent reduction in transport costs would translate into a 5 percent increase in exports.

Policymakers could also take more direct action to foster links between exporters and domestic firms. In the auto sector, Japanese carmakers, who account for around 30 percent of the auto production in Mexico, have participated for several years in public-private partnerships to build capacity in the domestic auto parts sector and help devise curricula in technical schools.

While NAFTA prohibits the performance requirements on foreign investors that have been used to (with considerable success) to promote linkages in China and other East Asian economies, the Mexican government could do more to promote these voluntary public-private arrangements.

After 20 years, the low-hanging fruit has been plucked. In order to realize the full potential of NAFTA, Mexican leaders need to bridge the gap between the Mexico that is thoroughly integrated in the North American economy and the Mexico that has been left behind.

Theodore Kahn is a PhD candidate at the Johns Hopkins School of Advanced International Studies. He has consulted for various international organizations and NGOs in Latin America and in Washington DC and previoulsy worked as a reporter in Argentina and Chile. Follow him on twitter: @TheoAKahn

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