In a previous post, I discussed how informality may or may not weigh on Mexico’s economic performance. Here, I will look at foreign investment, with a particular focus on foreign direct investment (FDI). The issue of foreign investment is a good proxy for a broader discussion about liberalization – i.e., does liberalization of trade and investment generate strong and sustainable economic growth and development. In this regard, Mexico presents a vexing case for proponents of the liberalization approach to economic policy. This issue is significant given that the consensus approach to economic reform among Mexican economic and political elites is further liberalization. The consensus view is that the reforms will attract foreign investment – which they likely will – but with the implicit assumption that increased foreign investment is universally positive.
Some Context – Mexico’s Economic Openness Since 1982
Since the 1980s, Mexico has pursued an agenda of economic liberalization, particularly in the areas of trade and investment. The reforms fell into the following main categories:
- Trade Liberalization – starting with unilateral acceptance of the General Agreement on Trade and Tariffs (GATT) and culminating with the North American Free Trade. Agreement (NAFTA), Mexico can now boast having signed more free trade agreements than any other country.
- Investment Liberalization – in 1993, Mexico passed the Foreign Investment Act, which repealed and replaced the country’s existing framework adopted in 1973, and eliminated ‘anti-foreign investor’ provisions such as performance requirements, capital controls, and domestic content percentages. The 1993 Act also opened up some industries and activities to foreign investment – e.g., mining, secondary petrochemicals, ports, transportation, land development along Mexico’s coasts. In some cases the new law imposed conditions on such investments, such as requiring they be made via local entities. Moreover, the 1993 Act preserved longstanding policies of excluding foreigners from investing in certain industries (most notably, oil and gas).
- Privatization – in the 1990s, Mexico privatized whole swaths of the economy that had previously been entirely in the state’s hands, starting with the telecom and banking industries and followed by mining and air and sea transportation. From 1982-2003, the total number of Mexican State-Owned Enterprises (SOEs) dropped from 1,155 to 258, with 439 (38%) of the SOEs disappearing via privatization.
- Deregulation – Mexico also adopted several measures that deregulated certain industries. For example, the Mexican government deregulated the trucking industry to encourage competition, by reducing barriers to entry and eliminating tariff ceilings.
Results of Economic Liberalization
At a macro level, the reforms adopted over the 1980s-90s did not generate the level of economic growth expected and hoped for by the Mexican authorities, averaging just 0.76% annual GDP growth from 1996-2012. Moreover, Mexico was comparatively less-insulated from the 2008 financial crisis, during which it experienced a 7.7% drop in GDP per working age person.
Despite Mexico’s economic underperformance, it appears that the reforms did generally have their intended effect. On foreign investment, FDI grew by 1,125% between 1990-2007. Mexico also substantially improved on more substantive measures like economic diversification, technological specialization, and economic complexity.
Paradoxically, although the high levels of FDI in Mexico were associated with increased total factor productivity, they appeared to depress labor wages while increasing returns on capital. The disproportionate harm suffered by Mexico following the 2008 financial crisis was another likely effect of the success of the liberalization policies, as the country’s entire manufacturing sector is dependent on U.S. companies and consumers.
Good vs. Bad FDI
Mexico’s arguably net negative – and at best mixed – results from its liberalization efforts highlight the need for a more refined understanding of foreign investment than ‘yes vs. no’. The drawbacks of relying on FDI – including balance of payments problems at the national level – are not controversial. But the quality of FDI received can also benefit or damage the underlying development of an economy, beyond causing short-term fiscal or financial instability.
In Mexico, FDI was typically clustered in manufacturing activities at the end of a global supply chain, where all the high-value work is completed elsewhere. Mexico’s role in the supply chain is final assembly – e.g., before the car or TV is shipped to the US for sale. Such facilities are colloquially known as ‘screwdriver factory’ because the only tool needed to complete the job is simple like a screwdriver. The high-value work – design, programming,j fabrication, machining – is done in the USA, Germany, and East Asia.
Naturally, ‘screwdriver factory’ FDI generates jobs that are low-skilled and low-wage because their function is inherently limited to low-value assembly. Investment decisions in this area are dictated by labor costs at the low end of the spectrum, giving poorer countries a competitive advantage. But, this advantage will diminish to the extent that the workers at FDI-fueled jobs experience wage growth (i.e., enjoy the benefits of economic development). If labor costs grow above a certain point, the foreign investors will relocate to a different market with lower costs. In the meantime, the workers have not received any technical training and the host country has not received any meaningful technology transfers. You can get a sense of Mexico’s role in the global supply chain from this map of its 2008 exports (source).
Also, the map of Mexico’s export destinations is striking (source)
All of this is not to say, however, that all of Mexico’s inbound FDI was ‘bad’. Indeed, in industries like pharmaceuticals and medical devices, Mexico has received investments that are more permanent and add value and sophistication to the economy. But the few good investments won’t be enough to solve the problem.
Mexico faces the prospect of ‘premature deindustrialization’, whereby manufacturing will cease to be a growing source of employment as wages rise, but before Mexico is able to capitalize on the benefits of increased manufacturing. Before the supply chain became global and then ‘unbundled’, countries receiving FDI could count on manufacturers to remain in-country for an extended period of time. In that era, the manufacturers transferred skills and technology to foreign operations because the other, higher-value elements of the business and needed to grow organically near production facilities.
China exploited the era of ‘clustered’ manufacturing most shrewdly, typically requiring Western companies to invest via a minority share in a joint venture with Chinese SOEs. Eventually, foreign investors learned that their Chinese JV partners were not trustworthy, such as when the Chinese company would set up companies to compete against the same joint venture. The outright theft of intellectual property and corporate secrets by Chinese partners has been called “the greatest transfer of wealth in history” by Gen. Keith Alexander (fmr Dir. of the NSA).
But in the era of the unbundled global supply chain, manufacturers do not have to commit to putting all their operations in one location or region. And the liberalization of capital movement has made relocating low-value assembly facilities quite simple. Thus, it is unclear whether low-value manufacturing FDI contributes to overall economic development. Also, increased FDI of the type Mexico has received seems to have a net negative impact on wages, raising the question of low-value FDI’s purpose.
What Should Mexico Do Next?
Mexico’s lack of success with liberalization in the past does not mean that the Pact for Mexico reforms are doomed. The Energy Reform – which aims to attract foreign investment into Mexico’s oil and gas industry – differs from past liberalization efforts as it (i) does not relinquish ownership over the industry; and (ii) the investment would necessarily be of a ‘high-value’ nature with ample opportunity for the transfers of technology, skills, etc. Similarly, the Telecom Reform at the least undoes the failures of the Telemex privatization, which was done without an adequate pro-competition regulatory framework in place. Attracting investment to this sector will result in technology upgrades from which Mexico will immediately benefit.
While the money is flowing into Mexico, the country also needs to invest heavily in upgrading its infrastructure and education system, which could possibly result from Pres. Pena’s infrastructure spending program and the Education Reform.