Can Mexico Stay on the Road to Prosperity?
Mexico has maintained a strong commitment to macroeconomic stability for well over a decade. Since 2003, inflation has averaged 4.2% while the fiscal deficit has averaged 2.6% of gross domestic product (GDP). In 2013, the public debt was less than 50% of GDP. While that ratio has fluctuated over time, the public debt accounts for the same amount of GDP as it did in 1996 and still compares favorably to the 106% average in developed economies. Mexico also allows its currency, the peso (MXN) to float freely, and has enjoyed low foreign exchange (FX) rate volatility and a manageable current account deficit.
This macroeconomic stability has led to better debt ratings and a sharp decline in the spread between Mexico’s government bond yields and those from developed nations with similar maturities – a widely used measure of risk perception. That spread now stands at its lowest historical level. The government has been able to issue fixed-rate peso-denominated debt at longer maturities of up to 30 years, and extend average public debt maturity to almost eight years, a threefold increase since 2004.
This stability allowed Mexico to issue £1bn (US$1.7bn) in a 100-year bond earlier this year – four years after a US$1bn issuance in 2010. For households and companies, increased financial certainty has meant lower borrowing costs and better financing conditions. Between 2002 and 2014, the number of credit cards in use jumped from just over 6m to more than 27m, while non-financial corporate bond yields have been halved over the last decade.
In the mid-Eighties the country began developing a strong and diversified export sector, which mushroomed after the signing of the North American Free Trade Agreement (NAFTA) between the US, Canada and Mexico in 1992. Today, Mexico has free trade agreements with 45 countries – more than any other nation in the world – and its manufacturing export volumes are more than the rest of Latin America combined. In 2012, the country reached a significant milestone when it became the top exporter of transportation equipment to the US. It is now one of the top 10 automakers in the world, and this year it is likely to surpass Japan to become the second-largest auto exporter to the US market. If these trends continue, Mexico will surpass the number one exporter, Canada, in 2016.
The aerospace industry is also strengthening its presence in Mexico. Today, the country produces almost all components for jetliners and helicopters, including jet engines and fuselages. That helps generate demand for high-skilled workers, such as engineers and specialised technicians, and prompts the development of research and training centres. Other industries that have experienced significant growth include electronics, food, appliances, petrochemicals and metallurgy.
Shared Border Advantages
Mexico’s shared border with the US bestows advantages that clearly boost trade and the business cycle. Its proximity reduces transportation costs and simplifies the integration of production chains. Shipping times to the US could be about 16 days from China, for example, while it takes 48 to 72 hours to move goods from Mexico. Clusters of US manufacturing firms and foreign companies wishing to tap the US market have popped up and are now well-established in the country. Mexico’s close ties to the world’s biggest market also helped insulate it from some of the global financial turmoil in 2008-09, while the recent economic recovery in the US will no doubt provide strong support to Mexico’s business cycle.
The fast pace at which policymakers have implemented major reforms has revived expectations for the Mexican economy, causing investors to recalibrate their views on its growth potential and its degree of attractiveness both as an export base and as a growing internal market. Much of the attention has been focused on the energy reform, with the ending of a 75-year state oil monopoly that kept a tight grip on the industry. Inefficiencies are evident across all segments of production, making the state-owned company Petróleos Mexicanos – better-known as Pemex – a source of bottlenecks rather than a growth engine.
The energy reform could attract an additional US$15bn to US$20bn per year in foreign investment, mainly for shale and ultra-deepwater projects, which would help build up infrastructure, capacity and production. Mexico, which began producing shale gas in 2011, will have about 175 shale wells by the end of 2014 – albeit a small number compared to more than 13,000 shale wells just in Texas, but still significant for a country that started the year with far fewer.
Better technology will increase efficiency in a country where electric power transmission and distribution losses are three times higher than those of China. Increased energy supply, meanwhile, will reduce costs for industries and households that currently pay electricity rates twice as high as those paid by their neighbours to the north. This reform could increase potential growth by more than one-half of a percentage point, assuming that it is implemented efficiently and without the shortcomings that have doomed previous reform efforts.
The telecommunications sector also has been targeted for major reforms by policymakers intent on improving competition and its aging infrastructure. Consumers pay about $15 billion in excess costs for phone and internet services. Among Organisation for Economic Co-operation and Development (OECD) countries, Mexico has one of the slowest broadband internet speeds and the lowest per capita public investments in telecommunications.
Structural Reforms
Besides taking important steps to fortify public finances and reduce dependency on oil, which accounts for more than 30% of total revenues, Mexico’s government also set out to improve the public education system, which has widened income inequality and confined millions of people to poverty or forced them to leave the country altogether.
Among OECD countries, Mexico has the largest resource gap between advantaged and disadvantaged schools, and the lowest graduation rate at the secondary and tertiary levels. In addition, despite spending similar shares of GDP in education, test scores in maths, reading and comprehension show an enormous gap with most other OECD countries, which could take several decades to narrow in the absence of significant improvements.
To help carry out its structural reform efforts, the government has tried to polish the tarnished political and institutional frameworks that have impeded its previous efforts. This will not be an easy task, as Mexico suffers from high levels of corruption, crime and violence, government bureaucracy, inefficient regulation, and labour market failures. It also lacks adequate infrastructure, an educated workforce and a strong judicial system and rule of law. Not surprisingly, labour productivity has stagnated for more than a decade, the informal – and untaxed – economy still claims six in 10 workers, and investment as a share of GDP has remained flat for several years, settling at one-half the ratio seen in developing countries in East Asia and the Pacific.
A successful implementation of the reform agenda, in a stable and open economy that borders the largest market in the world, opens an unparalleled window of opportunity to foreign investors and residents. All would like to succeed and are capable of doing so in a more competitive and transparent environment. Mexico’s solid demographics amplify the opportunity. The country has a population of almost 120m – ranking it as the 11th largest in the world – with a median age much lower than most developed countries and many other large emerging markets. This implies a growing working age population, in contrast to an ageing population in many developed countries.
If the reforms increase labour productivity and result in a more efficient allocation of resources, real wages could rise rapidly, increasing purchasing power and domestic consumption. In the next five years, if per capita GDP were to increase at twice the speed it has in the past 10 years, the economy would grow by around US$1 trillion. Wealth could expand at an even faster pace if the increase in real incomes led to a burst of activity in the banking industry, with new financial services facilitating the acquisition of big-ticket items with high spillover effects, such as housing, new vehicles, and high-value-added services. A growing middle class would generate a positive feedback loop, as an expanding internal market would be attractive to even more foreign investment.
Mexico’s track record on reforms has been disappointing though, leaving the realities on the ground daunting: The minimum wage is only $5 per day, and about half the population lives below the poverty line. The income disparity is extreme, with only a tiny sliver of the population as wealthy as the world’s richest individuals. Success requires the reforms to be implemented in a competent and transparent manner to guarantee their benefits are broadly shared and lead to higher living standards, particularly among the most vulnerable households. This would set the country on a path of prosperity and build a strong national consensus around a long-term strategy, supported by genuine democratic institutions.