Mexico, destined to always underachieve?

By Eduardo Bolio and Jaana Remes

Since the 1980s, both national and international observers have predicted time and again that economic growth in Mexico is just about to take off. But it hasn’t, and others have quickly gained ground and overtaken Mexico. In 1980, for instance, Mexico’s GDP per capita was almost double South Korea’s and 30 per cent higher than Taiwan’s. Today, South Korean per capita GDP is twice Mexico’s and Taiwan’s is almost three times as much. China, which had one-twelfth of Mexico’s GDP per capita in 1980 could surpass Mexico by 2018.

Since the 1980s, both national and international observers have predicted time and again that economic growth in Mexico is just about to take off. But it hasn’t, and others have quickly gained ground and overtaken Mexico. In 1980, for instance, Mexico’s GDP per capita was almost double South Korea’s and 30 per cent higher than Taiwan’s. Today, South Korean per capita GDP is twice Mexico’s and Taiwan’s is almost three times as much. China, which had one-twelfth of Mexico’s GDP per capita in 1980 could surpass Mexico by 2018.

The important factors that stoke rapid growth in emerging economies exist in Mexico: a young and growing labor force, abundant natural resources, and access to export markets (in Mexico’s case a strategic location next to the United States and membership in NAFTA provide uniquely privileged access). In addition, Mexico has opened up its economy to trade and foreign investment, installed extensive reforms. Since 2000, it has also been able to boast sustained macroeconomic and fiscal stability.

Yet year after year, rapid growth remains elusive. GDP expanded by just 1.1 per cent in 2013 and probably came in between 2 and 2.5 per cent in 2014. That’s less than the 3 per cent plus global average and far below the 5 per cent-plus rate of fast-growing developing economies.

Government economists and foreign investors are once more calling for GDP growth rates of 3 to 4 per cent this year, and some project even higher rates after that. But can Mexico do it this time? There are reasons for optimism. The United States is enjoying a robust recovery, raising demand for cars and other goods that flow from Mexican factories.

US auto sales topped 16m units in 2014 and could break 17m in 2015 — and more than 10 per cent of these cars are Mexican imports. At the same time, rising wages in China and a search for simpler supply chains make Mexico more attractive.

What could hold Mexico back? The same force that has hampered Mexican growth since 1980—extremely weak productivity growth.

The productivity problem

Many factors have gone into the decline of economic growth and progress in GDP per capita, including the effects of oil shocks and fiscal crises. But the biggest factor has been stagnant productivity.

Since 1990, output per worker has grown by only 0.8 per cent per year — 70 per cent of GDP growth has come from more workers entering the labor force. Today, the output of the average Mexican worker is no more than it was in 1980 and has fallen from half the US rate in 1964 to a third in 2014.

Behind Mexico’s productivity problem is the divergent nature of the economy — what we have been calling “The Tale of Two Mexicos.” On one side is a vibrant, modern economy, with highly productive large establishments — both domestic and foreign-owned — and a traditional economy of small, often informal enterprises with low-skill workers and very poor productivity. And the productivity gap between the two is widening rapidly.

Since the North American Free Trade Agreement was signed, large Mexican producers and locally owned operations of multinationals have invested in modern plants. In Mexico, the plants of the world’s leading autos and auto parts makers are as productive as many US plants and, we estimate, that productivity across all large modern enterprises has risen by 5.8 per cent a year since 1999.

In stark contrast, in traditional enterprises productivity is falling by 6.5 per cent a year. A decade ago, Mexican small businesses were, on average, 28 per cent as productive as the large companies; now they are less than 10 per cent as productive. In between are mid-sized companies—a mix of traditional and modern establishments whose productivity growth has been close to flat, at about 1.0 per cent a year.

Complicating the productivity challenge is the rise in employment in less-productive parts of the economy. The traditional segment has accounted for 48 per cent of job growth since 1999. Large modern enterprises are expanding, too, but their 20 per cent share of employment has not risen. The share of workers employed in mid-sized companies dropped from 41 per cent in 1999 to 38 per cent in 2009, making Mexico’s employment increasingly polarized between two extremes.

Until the productivity problem is addressed, Mexico will continue to fall short of its growth potential. And that challenge is growing because of changing demographics. Labor force growth is expected to fall from 2 per cent annually to 1.2 per cent through 2025. To reach GDP growth of 3.5 per cent a year under those conditions, productivity would have to nearly triple to 2.3 per cent per year.

The path to growth

Can Mexico manage such breakthrough productivity gains? We believe it is possible if Mexico helps traditional enterprises evolve into modern, formal small and medium-sized enterprises (SMEs); expand access to capital, particularly for SMEs, and continue to make Mexico a place where world-class companies prosper.

Businesses remain small and informal because they have incentives to remain so and lack access to the capital that would enable them to operate formally and grow.

Policies that were intended to help small businesses survive now provide perverse incentives to stay small. These range from tax exemptions and electricity subsidies to zoning rules that keep modern operators out, insulating Mom and Pop businesses from modern competitors that would force them to become more productive.

Even if companies want to operate in the formal economy, they face barriers and prohibitive costs. The cost of registering a company (in terms of annual income) is seven times the US cost. Required social security contributions average around 28 per cent of salaries, and labor laws make it costly to dismiss workers, discouraging formal hiring. Weighing these costs against the unlikely possibility of being caught and prosecuted for operating informally, companies choose to stay informal and enjoy higher margins than their formal peers.

Addressing some of these core issues would give Mexico the opportunity to raise productivity growth to as high as 4 per cent a year. This would put Mexico on track to actually hit its GDP goals. To unleash productivity and growth, longstanding political, judicial, and regulatory practices need to be modified and ingrained institutional practices must be replaced.

Mexico needs to enforce a rule of law that allows lenders to trust that they can collect on their loans and ensures that businesses have a fair opportunity to reap the benefits of their investments.

Most important of all, Mexico needs to become a place where those who do not play by the rules will be penalized and where formal, compliant companies are free to go as far as the energies and talent of their workers can take them. This cannot happen overnight, but will take a sustained effort for many years.

This article originally ran in Financial Times.