Mexico: Embracing trade as a source of economic growth Global Economic Outlook, Q1 2017

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​Over the last 20 years, Mexico has completely embraced free trade, having signed various trade agreements around the world. Now that its GDP is heavily dependent on exports, it is not surprising that the nation is concerned over Donald Trump’s campaign promise to renegotiate NAFTA.

Introduction

The Mexican economy has left behind its days of protectionism and industrial substitution to fully embrace trade as a strategy for sustained economic growth. While 2016 was a particularly volatile year for international financial markets and trade, Mexico will continue to bet on commerce as a major driver of economic growth.

Mexico was not always a beacon of free trade. For many years of the past century, Mexico’s economic development strategy followed a model that shielded national industries from foreign competition through hefty tariffs on imports. This protectionist strategy coupled with a monopoly on oil production, refinement, and distribution resulted in an economy that was vulnerable to fluctuations in international commodity prices and overly reliant on a single export good. After several economic crises and repeated currency devaluations, Mexican authorities fundamentally changed their approach to trade.

After several economic crises and repeated currency devaluations, Mexican authorities fundamentally changed their approach to trade.

The signing of the North American Free Trade Agreement (NAFTA) between the United States, Canada, and Mexico in 1994 marked a pivotal moment for the Mexican economy. Since then, Mexico has ratified 11 more free-trade agreements (FTAs) with 46 countries, and it is among the countries with the most FTAs in the world.1 As a result, exports of goods and services contribute to more than one-third of the GDP, up from just 11.0 percent in 1980 (figure 1).

Exports of goods and services as share of GDP

Over the last 20 years, trade has become a critical part of Mexico’s growth strategy. It is therefore not surprising that authorities and economic stakeholders have shown concern over the campaign promise of President Donald Trump to renegotiate NAFTA. Although concrete actions have yet to be announced, press reports suggest that some of the largest automotive manufacturers in the country have already halted or canceled investment projects.2 However, a drastic alteration in the trade terms of NAFTA can also create major disruptions in the United States, since Mexico is the largest export market for Texas, California, and Arizona, and the second-most important market for another 20 states.3

A healthier approach to trade

The 1970s saw an economic boom in Mexico. This was a consequence of high international oil prices and newly discovered oil production sites, which resulted in unprecedented growth for Mexican exports. Between 1970 and 1985, exports of oil and other petrochemical products registered double-digit compound growth rates.4 However, the large profits from the export frenzy did not translate into higher productivity in these sectors. By the time oil prices started to fall in the 1980s, the Mexican government was facing enormous pressure due to a rising public deficit, financed largely by international debt, and a falling currency. The drop in oil prices and the poor management of public finances—which from 1973 to 1981 led to the external debt of Mexico’s public sector growing at an average annual rate of more than 30 percent—resulted in a crisis that rocked the foundations of the Mexican economy.5 Between September 1981 and December 1982, the Mexican peso depreciated 222.0 percent against the US dollar, while the economy contracted 0.5 percent in 1982 and 3.5 percent in 1983.

In response, Mexican policymakers started a series of reforms aimed at liberalizing the economy and opening it up to international trade. In 1986, Mexico joined the General Agreement on Tariffs and Trade, the precursor to the World Trade Organization, and, in 1994, it signed NAFTA. FTAs with Colombia, Nicaragua, the European Union, Japan, and other countries followed. Today, Mexico’s FTAs touch over a billion consumers, and Mexican companies have access to a market that makes up about 60 percent of the world’s GDP.

Today, Mexico’s FTAs touch over a billion consumers, and Mexican companies have access to a market that makes up about 60 percent of the world’s GDP.

The new-found openness of the Mexican economy has resulted in a more diversified basket of goods exported and has contributed to the generation of clusters of industrial activity in higher-value-added industries. For example, in 1989, mineral products and fuel (oil) accounted for 33.8 percent of exports; by 2015, the category accounted for less than 10.0 percent of exports, while machinery and transport equipment represented more than 60.0 percent of exports (figure 2). The diversification of the Mexican economy was positively impacted by trade agreements, particularly NAFTA.6

Selected Mexican exports

Mexican and US global value chains

The diversification of Mexican exports was in part driven by an increase in intra-industry trade, where similar firms specialize in different segments of a supply chain and trade inputs used in the creation of a final product. Contemporary trade is no longer a mercantilist zero-sum game but rather a complex set of economic relationships where many of the imports into a country have a significant amount of domestic value added.7 For example, a car manufactured in North America crosses the border eight times before being shipped as a final product.8 While trade between Mexico and the United States increased 128.0 percent between 1995 and 2000, trade in shared industries such as miscellaneous manufactured articles grew 145.5 percent, and machinery and transport equipment expanded 158.7 percent in the same period. There is strong evidence that NAFTA caused the fast intra-industry trade growth.9

A car manufactured in North America crosses the border eight times before being shipped as a final product.

This close economic relationship has resulted in a trade relationship that focuses on similar types of products and industries. For example, machinery and transport equipment is the single largest type of commodity traded between Mexico and the United States, accounting for more than half of Mexican exports to the United States (figure 3) and 45.8 percent of the exports from the United States to Mexico (figure 4). It is therefore not surprising that out of every 100 dollars that Mexico trades with the United States, 40 dollars are actually American value added.10 While the automotive industry epitomizes the impressive network of trade between Mexico and the United States, other clusters of industries have also emerged as sources of growth for both nations.

Mexican exports to the United States in 2015

US exports to Mexico in 2015

While Mexico has done a good job of diversifying the variety of goods it sells abroad, when it comes to services, it is still heavily reliant on tourism as its single largest service export. In 2015, tourism accounted for 77.0 percent of all exports, a higher share than in 2000. In this particular industry, the United States accounts for more than three-quarters of Mexico’s travel and tourism exports.

A bumpy Q1 2017

While trade continues to be one of the brightest spots of the Mexican economy, the weakness of the peso, rising energy prices, and high levels of public expenditure create risks for economic prospects in coming months. The background of low growth—the economy has not grown above 2.5 percent since 2012—makes these risks more problematic.

The exchange rate of the peso versus the US dollar reached a new low in December 2016, when the dollar cost $20.5 pesos, a 20.7 percent depreciation compared with December of the previous year (figure 5). The depreciation of the exchange rate is already producing some inflationary pressure. In November 2016, core inflation reached a two-year high at 3.3 percent, slightly above the 3.0 percent target established by Banxico. The weaker peso has also affected energy prices, particularly the price of gasoline. During the first weeks of 2017, the government increased gasoline prices between 14.0 and 20.0 percent. The increment was driven by lower oil production and the need to cover a deficit in tax revenue. The rise in prices was accompanied by multiple demonstrations across multiple cities in the country.11

Exchange rate of Mexican peso to US dollar

The protests were in part fueled by major corruption scandals involving the party of the president, the most salient being the fleeing of the former governor of Veracruz, Javier Duarte, under investigation for the embezzlement and mismanagement of dozens of millions of dollars destined for social programs.12 The former governors of Chihuahua and Quintana Roo are also under investigation for systematic corruption under their administration. It is not surprising that, as result of corruption scandals, the approval rate of President Pena Nieto is below 30.0 percent.

Given the limited tools available to control international economic shocks and the uncertainty regarding the future of NAFTA, the Mexican government will need to concentrate on policies that address the sluggish economic growth, among them ensuring the rule of law and fostering productivity. While fighting corruption may not address long-term economic maladies, it is a necessary step to calming social unrest and restoring a favorable business environment.