Date: April 8, 1996
by Oliver Sukowski
How does Mexico respond to its biggest challenge in its recent history?
What are the reasons for the present difficult situation? How can Mexico recover?
"Every developing country in the world is trying to attract foreign direct investment. But there is not enough capital available to be invested. Therefore, Mexico is experiencing a strong competition for these limited resources." (Dr. Paul E. Adams Ragg, Queretaro, Mexico, personal interview, March 1, 1996).
Both the Mexican culture and economy are fascinating fields of study. Mexico's eventful history includes various influences, spectacular changes of governmental policies, and it offers a profound insight into the Mexican society.
In this essay, the current economical situation of Mexico will be examined. The first section focuses on the introduction of the main facts on Mexico in the fields of economical and political infrastructure. While the first section describes the state of being within the country, the second section places emphasis on Mexico's position in international trade. International treaties of major importance are reviewed.
With these information as a background, the following part focuses on incentives offered by the different levels of the Mexican government in order to attract foreign direct investment. Finally, with the basic understanding of the preceding facts, a perspective of the probable future development is given.
The Mexican economy experienced a continuos up and down over the last five decades. Interestingly, there exists a striking relationship between the economical situation and the change of the presidency. Every six years, with a new president being elected, the general economic policy changed radically. This of course brought along enormous consequences for the society and the economy. The most recent change of presidency probably also had the most important effect on the Mexican economy: the handover of governmental power from Carlos Salinas to Ernesto Zedillo in 1994.
In order to understand the reasons for the dramatic depreciation of the Mexican Peso one has to analyze the consequences of the economic policy under the presidency of Carlos Salinas (1988-94). The plummeting of the Peso was initiated by the 13.89% devaluation in December 1994. (http://www.cs.unb.ca/~alopez-o/politics/mexstats.html) The new president Ernesto Zedillo had to take this measure only a few month after he took over the government from his predecessor.
It was the result of an unfortunate policy by Carlos Salinas: while the government has traditionally been the major force for economic growth, financed by oil exports, the private sector did not develop adequately. The domestic savings rate, which is essential for the growth of an economy (see Appendix A), decreased to less than 16% in 1994. (Dornbusch, Rudi, "A strong peso is just what Mexico doesn't need", Business Week, November 20, 1995)
With the elimination of major trade barriers in 1987 as a result of the GATT membership, the demand for imported products grew overproportional. As soon as the major source of revenues for the public sector, the export of oil, did not provide enough capital anymore, the government still did not restrict its spending. (Dornbusch, Rudi, "A strong peso is just what Mexico doesn't need", Business Week, November 20, 1995)
Instead, Mexico borrowed the necessary funds from the world capital markets and issued short term bonds. This, in turn, led to an overvaluation of the Peso. Imported goods became cheaper and thus the current account deficit grew due to an excessive consumption. The trade deficit in 1994 totaled in $2.5 billion per month. (http://www.cs.unb.ca/~alopez-o/politics/thief.html). This required ever growing capital inflows and the government was forced to sell its currency back from the international market. It had to spend its foreign currency reserves and the revenues from privatizing state owned industries to finance the excessive appetite for consumption (see Appendix B).
There have been several attempts by the Salinas government to hide the hazardous trade balance situation: Until 1991, the performance of the "in-bond industry" where $95 worth of imported components were assembled for $5 of Mexican labor, was considered to be an export service, comparable to the tourism industry. In 1991, the Salinas government decided to change the definitions for "merchandise export". Now the same product was considered to be a $100 Mexican export!
In 1993, with the new definition for "merchandise export" the share of the "Maquiladora industry" accounted for $22 (!) billion of Mexican exports (http://www.cs.unb.ca/~alopez-o/politics/omc.html)
Carlos Salinas is also responsible for deliberately delaying the publishing of basic economic data in 1994. In the last year of his presidency the Mexican foreign exchange reserves, used to finance the trade deficit, dropped from $25 billion to $6 billion. This alarming development was obviously considered to be too bad to be pronounced in public.
Apart from that, president Salinas must have been aware of the consequences deriving from issuing excessive amounts of dollar indexed bonds ("tesobonos") with the apparent intention to generate short term capital to finance the trade deficit.
With these examples of abusing trades statistics as instruments of politics, Carlos Salinas' candidacy to become the president of the World Trade Organization (WTO) appears in a different light. (http://www.cs.unb.ca/~alopez-o/politics/omc.html)
Mexican's new president Ernesto Zedillo introduced a sharp turn in economic policy compared to his predecessor, Carlos Salinas. Since the Zedillo government experienced the consequences of the former consumption driven economic policy, it is no wonder that Mr. Zedillo favors a very restrictive monetary policy. The devaluation in conjunction with the following depreciation of the peso to less than half its former value significantly helped to reverse the fatal trade deficit to become a small surplus in 1995 (http://www.shcp.gob.mx/english/info/html/mex08b.html)
A major variable for evaluating the economical situation of a country is the savings rate of its population. As described in appendix B, a continuous, substantial trade deficit will eventually lead to a devaluation of the currency. However, a high domestic savings rate can, to some extend, help to provide necessary capital for the economy.
Compared to other emerging markets, the savings rate in Mexico is rather low. While the Asian Tigers maintain savings rates ranging from 30% in Indonesia up to almost 50% in Singapore, the Mexican internal capital source constantly remains below 20%. The main reason for that is the low level of personal income in Mexico and the high unemployment rate. The average wage in Mexico in 1993 for production workers in manufacturing was $2.61 per hour. (http://stats.bls.gov/pub/special.requests/foreignlabor/hcreport.txt)
The constitution provides for a daily minimum wage, which is applied to some 14% to 18% of the registered workers. The daily minimum wage ranges -- depending on the area -- from $2.59 to $3.06, including a 14% supplemental fiscal subsidy. The common daily wage for workers however is usually three to four times higher. (gopher://dosfan.lib.uic.edu:70/0f-1%3a23367%3amexico)
About 22% of the Mexican population enjoys first world living standards, while some 27% face extreme poverty. Mexico's basic demographic figures reveal the essentiality of substantial growth and development: More than half of Mexico's population is younger than 25 years and there are approximately 11.5 million people considered illiterate (http://www.cs.unb.ca/~alopez-o/politics/mexstats.html)
It is the enormous unemployment rate that allows for a very low average wage to last. The official unemployment rate in Mexico January 1996 was about 6.4%. (http://www.shcp.gob.mx/english/info/html/mex16b.html). But this figure is misleading. As virtually every country in the world, Mexico also has its own definitions when it comes to publish the unemployment rate. In this statistic, nobody who works at least for one hour per week is considered to unemployed. A more reasonable estimation that would comply with international definitions claims the unemployment rate to be at 20% to 25%. (Eichelmann, Jorge E. Gomez, Queretaro, Mexico, "Mexico Economic System" (lecture), Februaury 26, 1996)
Considering the above mentioned dramatic changes in the governmental policy with each succeeding president, it appears to be obvious that each president plays a very strong role within the governmental process of decision making. The more recent history seems to support the disposition of the current president that a concentration of too much power into one person is not advantageous for a country. President Zedillo thus pleads for the transfer of substantial parts of authority from the president towards the state and municipal political leaders.
The government of the United States of Mexico is divided into three branches:
Only recently, beginning in 1989, the major opposition party, the center right Nation Action Party (PAN) won elections in four states and several bigger cities. Or, as some observer put it, the PAN was allowed to win some elections. The reason for this imputation are reported manipulations of elections. (gopher://dosfan.lib.uic.edu:70/0f-1%3a23367%3amexico%20country%20G)
The political power of the third major party, the leftist Party of Democratic Revolution (PRD), currently appears to be diminishing, despite the fact that it almost won the last presidential election August 21, 1994.
For decades, Mexico's perspective on international trade was lead by the belief that import restrictions can effectively protect the domestic economy. In order to maintain a basically closed economy, Mexico imposed high tariffs on goods, quotas and non-tariff barriers. Non-tariff barriers included bureaucratic burdens, subsidies for domestic industries, and difficulties for companies to expatriate profits or even to purchase land in Mexico.
However, with increasing international trade in the rest of the world, Mexico eventually decided to liberalize its economy. In the last decade (starting in 1983) Mexico opened its markets to imports and foreign investors. In addition to that the Mexican government initiated a program to reduce the role of the public sector in the economy by privatizing about 80% of its former 1,155 governmental controlled companies, with only 216 state owned enterprises remaining at the end of 1994. The Mexican leadership intends to continue the process of privatization. By 1997, another $12-$14 billion are projected to be generated from privatizations. (gopher://dosfan.lib.uic.edu:70/0f-1%3a23367%3amexico%20country%20G)
The General Agreement on Tariffs and Trade (GATT) was signed in 1947 by 24 countries. The main purpose has been the reduction of tariffs and the promotion of
international trade among its member countries. Apart from that, establishing conflict settlement procedures always has been a major objective of GATT. >From the first agreement in 1947, GATT's goals evolved in several steps negotiated in the Tokyo and the Uruguay Round to primarily improve dispute settlement mechanisms. Currently, 119 nations are members in the World Trade Organization (WTO) "which will supervise and adjudicate GATT agreements and encourage future negotiations" (http://gatekeeper.unicc.org/wto/memtab2_wpf.html) (Czinkota, Ronkainen, "International Marketing", The Dryden Press, 1995, page 26)
One of the most important steps for Mexico towards a liberalized, open market for international trade was to become a member of GATT in 1987. The decision has likely been affected by the realization that import restrictions result in retaliation measures imposed by other countries, which, in turn, hinder the own export industry.
As a result of GATT, Mexico reduced its tariffs on goods significantly. However, despite GATT trade barriers, particularly non-tariff barriers, remained to restrict imports to Mexico. For example, in 1992 import licenses for 269 product categories were required. And foreign ownership of Mexican companies was restricted. For example, the foreign ownership of auto parts manufacturing companies was limited to 40%. In like manner, foreign ownership of insurance or telecommunications companies was limited to 49%. (U.S. Department of State, "Country Reports on Economic Policy and Trade Practices)
Mexico eliminated the major part of these obstacles of international trade with its most important trading partner, the U.S., with the formation of NAFTA.
One of the most important developments in international trade over the last five decades is the formation of regional trade alliances. These regional groupings based on economics try to withstand the increasing competition in the world markets by forming huge areas of free trade. The three major blocks in Europe, Asia, and North America each embrace some 300-400 million people who produce a GNP of around $4 to $6 trillion each. (Czinkota, Ronkainen, "International Marketing", The Dryden Press, 1995) The North American alliance is a free trade area; this is the least restrictive form of economic integration. NAFTA is an agreement to allow all goods and services to be traded freely without barriers between member countries. Every individual member country may set its own policy regarding trade with nonmember countries.
Mexico joined the already existing alliance of the US and Canada in 1994, after two years of difficult bargaining. As a result of the introduction of the North American Free Trade Area (NAFTA), trade barriers among the three countries were substantially reduced. In the first year after signing the treaty, trade between the U.S. and Mexico increased by 24%. As a result, more than 60% of U.S. goods exported to Mexico enter the third largest trading partner of the U.S. duty free. (gopher://dosfan.lib.uic.edu:70/0f-1%3a23367%3amexico%20country%20G) And this percentage is agreed upon to reach 100% until January 1, 2003. (http://the-tech.mit.edu/Bulletins/ Nafta/tariff.doc) The alliance between U.S. and Mexico also goes beyond mere trade cooperations. A recently signed "tax exchange information system" agreement is
designed to enforce taxation more efficiently in both countries and at the same time to prevent double taxation of companies acting transnationally.
Despite the formal restriction of NAFTA towards trade partnership, some experts believe that in the long run a more advanced integration, comparable to the European Union, will eventually become an objective for the members of NAFTA. (Ragg, Dr. Paul E. Adams, Queretaro, Mexico, personal interview, March 1, 1996)
In the preceding chapters and the appendices the necessity for a country to open its financial markets to international capital has been discussed. In the case of Mexico, it is estimated that it takes some $10 billion of investments a year to achieve 3% to 4% growth. (http://www.businessweek.com/1995/46/b46cov.htm) However, this does not take into account that the population grows at a comparable rate. Hence a growth rate of only 3% would result in an overall unchanged level of development.
With the main goal to achieve a healthy growth, the Mexican leadership has to determine on how it would like to obtain the necessary funds for investment in the country's infrastructure.
Basically, there are three different ways to finance an expansive economy:
The main problem for a country receiving large amounts of portfolio investment is the fact that investment houses and mutual funds -- the main investors of very large amounts of money -- expect "nearly instant returns on their investments" (http://www.cs.unb.ca/~alopez-o/politics/thief.html) If, however, the investment climate for some reason such as political instabilities or economic decline becomes less attractive, the capital will immediately abandon the country again. In the case of Mexico, political instabilities occurred while interest rates in the U.S. rose.
Table D.1 (http://www.shcp.gob.mx/english/info/html/mex21b.html) shows the quantities of investments in Mexico before and after the devaluation of the Peso: Interestingly, the foreign direct investment (FDI) flow into Mexico decreased significantly, however it remained positive. In contrast to that, there was a huge capital outflow out of Mexico in terms of portfolio investment.
Unfortunately, there is little the government can do about that mechanism. It might consider to restrict the capital outflow of short term money by appropriate laws. A restricting measure like that, however, would most certainly prevent this kind of capital to flow into the country in the first place. Currently, there are no restrictions on capital and investment transactions. (gopher://dosfan.lib.uic.edu:70/0f-1%3a23367%3amexico%20country%20G)
resources." (Ragg, Dr. Paul E. Adams, Queretaro, Mexico, personal interview, March 1, 1996). This competitive situation for foreign direct investment requires the government to offer incentives to investors:
There are several possible ways the Mexican government promotes direct investment. For that, all three levels of the government are involved:
In the race for FDI, the three levels of Mexican government tried to lure foreign capital into the country. However, since the domestic firms were hit hard by the devaluation of the Peso and the subsequent recession, incentives for foreign capital is sometimes considered to be discriminatory for domestic companies.
One goal in the governmental effort to promote businesses will certainly be appreciated by both domestic and foreign companies: the reduction of bureaucratic burdens.
Many foreign companies, particularly from the U.S. and Asia, benefit from the "in-bond" program offered by the Mexican government. Initially, this program was restricted to only a small area along the borders of Mexico. However, over the time this area was successively expanded. The advantages of the "in-bond" program are now available almost everywhere in Mexico. These program includes very attractive conditions for foreign investors:
The maquiladora industry, which consists mainly of plants just south of the U.S.-Mexico border, is exempt from paying tariffs on imported raw materials and components provided the final product is exported. (http:// dch.mty.itesm.mx/ ~mbanda/news/ ap110395_ maquiladora.html)
The benefits for the Mexican economy, however, are limited. Although the maquiladora industry had on average 641,900 workers in August 1995, an 8 percent increase from 594,100 employees a year earlier, these workers are often paid the minimum wage, since the jobs offered do not require highly qualified workers. In the last two years the situation improved due to the increasing demand for unskilled labor. But still the share of Mexican labor and semi-finished products usually remains below 5% of the total value of the manufactured good.
A prognostication of the future Mexican development is difficult due to the abundant number of important aspects which might change the course dramatically. One of the main obstacles on the way to long term prosperity appears to be the immeasurable degree of corruption within the Mexican administration system. As a result of the one party ruling during the last 66 years, the PRI accumulated a great amount of power which
is frequently used by official representatives to achieve personal benefits. In an international survey on subjectively perceived corruption in 41 countries around the world, Mexico was placed 32nd, with a score of 3.18 out of 10 (with 10=clean).
There is a chance that Mexico can overcome corruption. If the transition to a multi-party society takes place without severe instability, increased public interest might be able to fight back corruption and the influence of the money coming from drug cartels. At the same time, president Zedillo's tight money control policy has yet to prove to be successful.
This appendix intends to display the relationship between the savings rate and economic growth. This is done in two steps: first, the link between the savings rate and domestic investment is described. Subsequently, it is shown how domestic investment transforms into higher national income (=economic growth).
Step I: Savings rate \ Investment
The relationship between savings (S) and business investment (I) can be described by the Keynesian model, where the national income (Y) is the sum of consumption expenditures (C) plus S: Y = C + S. Total expenditures on national product are C plus I: Y = C + I. Combining these two equations yields the following: Y = C + S = C + I. Subtracting C on both sides of the equation yields: S = I
The relationship S=I indicates that the savings of a country equals the investments of a country.
Step II: Investment \ National Income
The more money is saved by the households in a country, the more money is available for investments. Investments, in turn, accelerate the growth of an economy. With the Keynesian model, it is possible to calculate a factor that describes the relationship between every additional dollar invested and the resulting increase of national income.
Additional savings result in additional investment: dS = dI (from step I). With dS = s*dY
where s represents the marginal propensity to save, we get: s*dY = dI. Division of both s on both sides of the equation gives us the investment multiplier: dY=1/s*dI.
This relationship indicates that every additional amount of money invested (dI) results in a multiplied (1/s) increase of the national income (dY).
However, one has to take into account that the consumption rate decreases at the same rate as the savings rate increases. Thus, a desired increase of the savings rate inevitably leads to a reduced consumption rate and hence to decreased domestic demand. (Carbaugh, Robert J., "International Economy", South-Western College Publishing Co., Cincinnati, Ohio, 1995)
This appendix displays the possible ways to finance a trade deficit:
A trade deficit appears in the balance of payments (BOP) in the current account. It results from the difference between imports (I) and exports (E) of goods. The capital account of the BOP shows the capital flows into (CI) or out of (CO) the country. In a system of fixed exchange rates, the government has to intervene to maintain the exchange rate by selling or buying its domestic currency from or to the world market, respectively. For that, it uses its foreign exchange reserves (FXR). As the name of the BOP already implies, the international capital flows have to be balanced out:
(E - I) + (CI - CO) + FXR = BOP = 0. Rearranging of this equation yields:
(I - E) = (CI - CO) + FXR.
In the case of Mexico, (I - E) reached some $ 29 billions in 1994; in order to balance the international capital flows, CO had to decrease and/or CI and FXR had to increase accordingly. However, Mexican's foreign exchange reserves (FXR) already diminished over the last few years in which Mexico experienced a trade deficit. The capital inflows were no longer sufficient to finance the trade deficit.
Eventually, in December of 1994, the government devalued the Peso by 13.89% and allowed the exchange rate to float freely. In a system of free floating exchange rates, an excessive amount of currency leads to a loss of value. This mechanism explains the subsequent significant depreciation of the Mexican Peso. (Eitemann, Stonehill, Moffett, "Multinational Business Finance", Addison Wesley, 1995)
Carbaugh, Robert J., "International Economy", South-Western College Publishing Co., Cincinnati, Ohio, 1995
Czinkota, Ronkainen, "International Marketing", The Dryden Press, 1995
Eitemann, Stonehill, Moffett, "Multinational Business Finance", Addison Wesley, 1995
Anonymous, "Tequila freeways", The Economist, December 16, 1995,
Banks, Howard, "Who gets the foreign direct investment", Forbes, April 10, 1995
Dornbusch, Rudi, "A strong peso is just what Mexico doesn't need", Business Week, November 20, 1995
Multiple authors, "Viva Amexica", The Economist, October 28, 1995
Nystrom, Dwight D., "Foreign investment and NAFTA", Southern Economic Journal, October 1995
Smith, Geri, "Mexico, a rough road back" Business Week, November 13, 1995, page 106
Summers, Lawrence, "Ten lessons to learn", The Economist, December 23, 1995
Winters, Cecilia Ann, "Growth and disaggregated capital flows", Southwest Journal of Business and Economics, Spring 1992
Eichelmann, Jorge E. Gomez, Queretaro, Mexico, "Mexico Economic System" (lecture), Februaury 26, 1996
Ragg, Dr. Paul E. Adams, Queretaro, Mexico, personal interview, March 1, 1996
World Wide Web articles:
http://www.businessweek.com/1995/46/b46cov.htm, Business Week: November 13, 1995, Department: Cover Story, By Geri Smith, Stanley Reed, and Elisabeth Malkin in Mexico City,"Mexico: a rough road back"
http://www.gwdg.de/`uwvw/ranking.htm>Ranking 1995>, Institute for Management Development, Lausanne, "International Corruption Ranking 1995"
http://the-tech.mit.edu/Bulletins/ Nafta/tariff.doc, Massachusetts Institute of Technology, The Tech, "NAFTA tarrifs"
http://www.cs.unb.ca/~alopez-o/politics/econindicator.html, U.S. Department of State, "Country Reports on Economic Policy and Trade Practices"
http://the-tech.mit.edu/Bulletins/nafta.html Massachusetts Institute of Technology, The Tech, "NAFTA"
http://wmw.com/gatt/, World Market Watch, "GATT"
http://www.cs.unb.ca/~alopez-o/politics/thief.html, "Heritage of a Thief", Counter Punch, Vol 1. No. 21, December 1, 1994, Published by the Institute for Policy Studies, Washington, D.C. 20009
http://www.cs.unb.ca/~alopez-o/politics/mexstats.html, "Statistical Information". Mexico, Documents on Mexican Politics, Edited by Alex López-Ortiz, University of New Brunswick, firstname.lastname@example.org
ftp://stats.bls.gov/pub/special.requests/foreignlabor/hcreport.txt, U.S. department of labor, Bureau of Labor Statistics, "labor report", June 1995, Government printing office
http://gatekeeper.unicc.org/wto/memtab2_wpf.html, WTO's World-Wide Web Information Server (located at Geneva, Switzerland), "World Trade Organization"
http://www.shcp.gob.mx/english/info, "Official Economic Information of México", Coordinated by Secretaría de Hacienda y Crédito Público
gopher://dosfan.lib.uic.edu:70/0f-1%3a23367%3amexico, U.S. Department of State, March 1996, "Mexico Human Rights Practices"
gopher://dosfan.lib.uic.edu:70/0f-1%3a23367%3amexico%20country%20G, U.S. Department of State, 1996, "Mexico Country Commercial Guide"
http://www.shcp.gob.mx/english/info/html/mex16b.html, Basic Economic and Financial Data, Instituto Nacional de Estadística, Geografía e Informática, "Unemployment Rate"
http://www.shcp.gob.mx/english/info/html/mex08b.html, Basic Economic and Financial Data, Instituto Nacional de Estadística, Geografía e Informática, "Trade balance, year to date"
http://www.shcp.gob.mx/english/info/html/mex21b.html, Basic Economic and Financial Data, Instituto Nacional de Estadística, Geografía e Informática, "Balance of Payments, 1994-1995"
http://www.cs.unb.ca/~alopez-o/politics/maq101.html, "Maquiladoras 101", R. Bruce Sinclair, Mexico Direct Business Services,4307-F5 N.10th St. #16-162,McAllen, TX 78504
http://www.cs.unb.ca/~alopez-o/politics/economics.html, The Sciences, "economic data", Sept/Oct 1994, Documents on Mexican politics, Robert Dorfman, Harvard University
http://www.cs.unb.ca/~alopez-o/politics/omc.html, Documents on Mexican politics, "Salinas, trade and Mexico's currency devaluation", George Baker
http://www.cs.unb.ca/~alopez-o/politics/whatsnext.html, Documents on Mexican politics, "Mexico: What's Next?", Remarks by Christopher Whalen 1,Council on Foreign Relations,New York, N.Y., March 6, 1995
http://www.shcp.gob.mx/english/info/html/mex03b.html, "Basic Economic and Financial Data", Secretaría de Hacienda y Crédito Público Federal government finances, January - December,
http://www.shcp.gob.mx/english/info/html/mex07b.html, Basic Economic and Financial Data, Secretaría de Hacienda y Crédito Público Federal government finances, "Trade Balance, by month"
http:// dch.mty.itesm.mx/ ~mbanda/news/ ap110395_ maquiladora.html, "Mexico's maquiladora industry expanded 24% in August", Eduardo Garcia, 1995 Bloomberg Business News, Mexico City, Nov. 3, 1995
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