Avoiding déjà vu in Mexico

Mexico faces an urgent need to do something about its productivity problem. What it needs today is a way to unleash the talent and energy that is bottled up in the traditional sector. It will take reforms—many of which are now in the pipeline—as well as some fundamental changes in business and regulatory practices, write Eduardo Bolio and Jaana Remes in Forbes.

This was not the script that was expected for Mexico. After a surprisingly weak 2013, when GDP growth declined to a dismal 1.1 percent, first-quarter 2014 GDP growth came in at 1.8 percent. The government trimmed its 2014 growth target from 3.3 percent to 2.3 percent and in June, the Bank of Mexico cut interest rates to a record low to re-ignite growth. Many longtime observers of the Mexican economy and a growing cadre of enthusiastic global investors had expected that by now Mexico would be on its way back to rapid growth, propelled by reforms and initiatives of the two-year-old government of President Enrique Peña Nieto and a strengthening recovery in the United States.

Unfortunately, this is a script that Mexico has seen before. The stars align for a great economic comeback, the global community gets excited about Mexico’s prospects, but reality disappoints. This has happened repeatedly since the “Mexican Miracle” ended in the 1980s. Even the North American Free Trade Agreement, which turned Mexico into a global manufacturing hub, was unable to lift GDP growth back to the level of developing-economy peers (and the government’s goal of 5 percent growth).

We are not prepared to say that Mexico’s moment has passed—that this chance to achieve a level of GDP growth that can once again raise living standards across the economy is over. What we can say is that for all the reforms of the past three decades, including those of the current administration, Mexico has not—and will not—revive growth until it deals with the source of its growth challenge: negligible average productivity gains—about 0.8 percent a year since 1999.

This productivity figure reflects Mexico’s fundamental growth challenge. There are, in effect, two Mexicos: a fast-growing, increasingly productive and globally competitive modern economy, with state-of-the art auto and aerospace plants, and traditional Mexico, a land of millions of small, often informal businesses that are the dominant type of enterprise in many industries, even auto manufacturing. These slow-growing, unproductive firms employ more than 40 percent of formal workers and much of the large informal labor force. They are the flipside of the gleaming, modern economy that has burgeoned under NAFTA.

While the largest modern corporations in Mexico have been raising productivity by a sizzling 5.8 percent per year (on average) since 1999, in traditional enterprises, productivity is plunging by 6.5 percent a year. And, because nearly half of job creation is in the traditional sector, more workers find themselves in low-productivity work. In between, in Mexico’s mid-size firms, productivity is growing by just 1 percent a year and their share of employment has fallen from 41 percent to 38 percent.

Low average productivity is not only a drag on GDP (economies such as India and China count on rising productivity for more than two-thirds of GDP growth) but also on wages and living standards. Wages in Mexican firms with ten or fewer employees, adjusted for inflation, shrank by 2.4 percent per year from 1999 to 2009. Per capita GDP in Mexico, which was 12 times that of China’s in 1980, is now only 25 percent higher, and, at current growth rates, China could surpass Mexico by 2018.

Now, Mexico faces an urgent need to do something about its productivity problem. The rapid growth of its labor force, which has provided more than two-thirds of GDP growth, will soon decline. Productivity will need to take up the slack and if it does not, Mexico could be headed for 2.0 percent GDP growth.

The most important priority, then, is to transform the traditional sector—by raising productivity of traditional firms and making it easier to launch formal, modern businesses. Productivity is so limited in traditional businesses today that even the simplest tools—point of sale computers in neighborhood stores, for example—can make an enormous difference. Joining together in buying consortia can help small stores and bakeries gain scale benefits and access to better inventory and ingredients, and small subcontractors that work for the modern auto sector can benefit from tighter ties with their customers. Some global auto parts makers are already providing technical assistance and financing to raise the capabilities of their small subcontractors.

To bring more small businesses into the modern economy will require policy changes that shift incentives and make it easier for small businesses to grow. Many of the tens of millions of Mexicans who run tiny traditional enterprises or are employed in them undoubtedly would prefer to join the modern sector, where they can earn more and contribute to a thriving sector of small and medium-sized enterprise (SMEs). But the path is not clear and policies create perverse incentives. For example, small businesses are able to buy electricity at consumer rates, which are 25 percent of commercial rates, and can also qualify for subsidies that range as high as 80 percent. Until this January, companies with less than MXN 2 million in sales could file taxes under a simplified system, instead of the corporate tax system that is so onerous that business owners would break their holdings into smaller units—essentially shells—to avoid it.

The incentives for companies to formalize, pay their taxes, and hire workers on the books also need to be more compelling. In Mexico, business owners cannot count on the key benefits of formality—being able to enforce contracts and gain access to financing. In Mexican courts, protections for creditors and parties in business disputes are not assured. And bank lending—a critical source of funding for SMEs—is limited. Mexico’s loans outstanding as a share of GDP are about one-fifth of the US level and on par with Ethiopia’s. We estimate that restricted SME lending accounts for three-quarters of an estimated $60 billion funding gap in Mexican business. Reforms such as bolstering the rights of lenders could help unleash badly needed capital.

We are optimistic about Mexico. What it needs today is a way to unleash the talent and energy that is bottled up in the traditional sector, the way that NAFTA helped turn Mexico’s leading companies into global competitors. It will take reforms—many of which are now in the pipeline—as well as some fundamental changes in business and regulatory practices. Mexico needs to become a place where it is clear that playing by the rules is how companies succeed, where violations of tax laws and other regulations will be punished, and where all Mexicans can aspire to a better life.

This article originally ran in Forbes.com.

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