What Ails Mexico’s Economy?

A lack of capital to finance business startups, for one.
By William P. Kucewicz
Mexicans illegally cross into the U.S. in the knowledge that there’s a ready market for their labor at wages that represent a premium over what they can earn in their homeland. But why is it that Mexico can’t generate sufficient jobs at high enough wages to stave off this massive flight of labor capital?

Under the North American Free Trade Agreement, Mexico has evolved into two economies, in effect: an externally oriented one, where wages and job opportunities have risen, and the domestically oriented one, which suffers, inter alia, from a lack of capital availability to finance business startups and thus create new jobs.

The lack of adequate financing is especially galling because Mexicans are tremendously enterprising. Mexico consistently ranks among the top of various lists of countries with the most self-employment and entrepreneurship. This proclivity indeed seems to carry over into Mexican self-employment rates in the U.S. for those migrants who are here legally, according to a University of California study.

The economic improvements of the past decade have been largely confined to border states adjoining the U.S. or to areas around major shipping centers. While NAFTA, which took effect in January 1994, has boosted trade, GDP, and foreign direct investment, Mexico’s more isolated inner and southern regions haven’t kept pace. Hindrances include longer distances to international markets, low education and skill levels, limited access to credit, and less foreign direct investment.
“Not all regions within Mexico seem to be equally linked to the international economy,” Daniel Chiquiar of Banco de México stated at a recent Dallas Federal Reserve conference. “Overall wages in general and unskilled wages in particular increased in regions that exhibited stronger links with the U.S. market.” As a result, he said, regional wage differentials have widened as “workers with similar characteristics fared differently in response to Mexico’s trade liberalization, depending on their geographical location.”

Near the U.S. border, a new industry has prospered — namely, maquiladora assembly plants, which account for roughly half of Mexico’s exports to the United States. In fact, studies show the more maquila-intensive a region is, the more connected it becomes to the U.S. economy and the less tied it is to Mexico’s domestic economy. Maquiladoras and similar operations in other countries are said to be “chronically volatile” because they “act as shock absorbers for manufacturing operations in industrial countries,” according to a Dallas Fed report. Perhaps more accurately, such operations resemble “peaking” plants in the electric power industry — plants that come online to supply power at times of peak demand. Either way, maquiladoras operate on the margin, meaning swings in U.S. economic activity, up or down, have disproportionately large effects.

Then there’s the China factor. In terms of comparative advantage in manufacturing and other labor-intensive sectors, Mexico has discovered that even its low wages are high compared with those of China and some other Asian nations. In 1999, for example, Mexico made about 70 percent of all U.S. television-set imports; five years later, the figure had dropped to 45 percent, with China and other Asian exporters making up the difference. Mexico has also lost export market share to Asian competitors in such labor-intensive areas as textiles, apparel, and leather goods.

Labor capital flight from agrarian areas has seen the percentage of male Mexicans aged 25 to 65 employed in agriculture drop from 22 percent to 13 percent. Most of this migration has gone into the service sector, where the percentage of male workers employed has risen from 45 percent to 52 percent, while manufacturing employment overall has been flat at between 21 and 22 percent, according to Bank of Mexico data.

In skill-scarce Mexico, education is as critical as geography. “Wage gains [under NAFTA] were largest for more educated workers living close to the United States and were smallest for less educated workers living in southern Mexico,” according to Gordon Hanson of the National Bureau of Economic Research of Cambridge, Mass.

Low education levels characterize the vast majority of Mexican migrants to the U.S., according to a recent Instituto Tecnológico Autónomo de México study. In the period 1992-2002, 79 percent of all Mexican migrants and 78 percent of illegal immigrants from Mexico had eight years or less of formal schooling, with 11 percent of both groups having no education and 33 to 34 percent having only one to four years of schooling.

Wages are generally lower in poor countries than in richer ones for a simple reason: the availability of financial capital. It’s the ratio of financial capital — spent on technology, plant, and equipment — to labor capital that determines labor productivity, and labor productivity in turn determines a nation’s overall wage and salary structure and its standard of living. Indeed, capital equipment and technology can even help to offset a country’s inferior educational levels by allowing minimally trained workers to perform relatively complicated tasks. The availability of financial capital thus becomes the key to rising economic growth, labor productivity, personal incomes, and living standards.

Financial capital can be generated internally within a country, borrowed from abroad, repatriated from abroad, or invested from abroad. Other than foreign aid and criminal proceeds, those are about the only sources of financing available to a developing economy. U.S. direct investment in Mexico (on a historical cost basis) has risen fivefold under NAFTA from $13.7 billion in 1992 to $66.6 billion in 2004 (the latest available data). As a percentage of all U.S. direct investment abroad, Mexico’s share has expanded from 2.7 percent to 3.2 percent over the same period.

Government indebtedness to commercial banks has been on the decline in the past two years or more, thanks to heftier oil-related revenue. Reduced government reliance on bank loans, as well as the phasing out of a contingency fund dating back to 1990, means that commercial banks in Mexico have more capital to lend to the private sector — and most of this freed-up capital has gone toward increased consumer lending.

Commercial bank lending in the 2005 fourth quarter increased by 42.9 billion pesos, or about $4 billion, from the third quarter, a 3.7 percent gain. Compared with year-earlier levels, total fourth-quarter lending was up 76.3 billion pesos, or $7.2 billion, a 7.1 percent increase. Consumer credit has been on a tear, up 32.1 billion pesos (or $3 billion) in the fourth quarter, a gain of 12.4 percent from the prior quarter and a 52.9 percent increase from a year earlier. However, lending to businesses was up 23.2 billion pesos (or $2.2 billion), a quarterly gain of 5.6 percent and a year-on-year rise of 8.9 percent.

Soaring oil prices have boosted fiscal revenues, with income from the state oil monopoly Petróleos Mexicanos (Pemex) reaching 21.1 billion pesos in February, up a whopping 236.3 percent from a year earlier, and all oil-related revenue (including royalties) adding up to 67.1 billion pesos, a year-on-year gain of 41.4 percent. Total public-sector tax revenue in February was 65.2 billion pesos, 7.4 percent above a year earlier. Income taxes were 29.2 billion pesos, up 3.9 percent, while the national value-added tax (VAT) brought in nearly as much at 27.7 billion pesos, representing a gain of 30.1 percent from a year before. As a percentage of GDP, Mexico’s total public-sector income was equivalent to 24 percent of GDP at the end of 2005, although federal tax revenue equaled just 9.3 percent of GDP.

Besides low education levels and poor skill sets, a number of additional factors account for Mexico’s inability to reap the full benefits of free trade: Its legal system is slow and unreliable; contract law requires fixing, as does contract enforceability; Mexico’s corporate structures lack adequate financial transparency and accountability; the country’s low-paid judiciary is open to charges of inefficiency, incompetence, and corruption; and vital institutions, such as property rights, need considerable improvement.

Inadequate infrastructure, including transportation, power, and communications, plagues the nation. Supply-chain gaps in areas like freight and repair services are a major problem. The banking system, though expanded and improved, still needs more modernization, and pension and insurance reforms are also lacking. As for the cost of credit, unnecessarily strict banking regulations add significantly to borrowing expenses. It’s estimated, for instance, that if Mexico’s restrictions on banking activities were on a par with those of South Korea, its interest-rate margins would be a full percentage point lower than they are today. And Mexico is still insufficiently hospitable to venture capital.

Crime and corruption, which act like a tax, present serious impediments to new investment, both direct and portfolio. One study estimated that corruption, a lack of financial transparency, an inferior legal system, and other institutional inadequacies add 5 percent to the cost of doing business with Mexico versus the United States. Another analysis found Mexico’s level of government corruption has the same negative effect on inward foreign direct investment as raising the marginal tax rate by 42 percentage points.