For more than two decades, foreign investment in Mexico has been gaining ground as firms with an eye to the U.S. market seize the opportunity to set up a manufacturing base next door.

Since the launch of the North American Free Trade Agreement (NAFTA) in 1994, U.S. direct investment in Mexico has risen more than sixfold to $92.8 billion in 2015, led by carmakers and other manufacturers, according to the U.S. Bureau of Economic Analysis.

Over the same period, Mexican exports to the U.S. have surged more than sevenfold to $294.6 billion, U.S. Department of Commerce and the U.S. International Trade Commission (ITC) data show.

The increases make sense. Mexican labor costs are lower than in America, trade is tariff-free, and it’s a short distance to move goods to the U.S., the world’s biggest consumer market.

But could this change if the new U.S. administration pursues a proposal to review the NAFTA free trade agreement between its country, Canada and Mexico or to implement a border adjustment tax of up to 20 percent on Mexican goods in an effort to protect American factory jobs and narrow the U.S. trade deficit?

This poses obvious concerns for companies, and as a result foreign investment has dropped by up to a quarter in Mexico this year from 2016, says John Price, Managing Director of Americas Market Intelligence.

Since the changeover in the U.S. government, General Motors has said it would move production of pickup axles from Mexico, creating 450 jobs in its home state of Michigan. Other firms have said they would create new jobs in the U.S. without necessarily downsizing in Mexico. Walmart, for one, plans to ramp up investments in Mexico by 19 percent in 2017, including building new retail stores.

The biggest concern is the border tax, which the analyst believes could hit U.S. consumers with higher prices by triggering a trade war.

“For the average car built in the U.S. or Canada for example, the average part crosses the border seven times before that car is sold,” he says. “If one of those countries imposes a border adjustment tax, it is pretty impossible for the other countries to not match that tax.”

Even so, over the longterm experts say the prospects for growth in Mexican manufacturing and trade is promising, thanks largely to the benefits NAFTA has brought U.S. companies.

“NAFTA was designed by U.S. corporations for U.S. corporations,” says Walter Molano, Chief Economist at BCP Securities, a Greenwich, Connecticut, investment advisor. “Most of the exports that come out of Mexico and into the U.S. are intracompany exports.”

Paul Ganster, a social scientist with a specialty in Latin America at San Diego State University, says many U.S. jobs depend on Mexico far more than on China, another hotspot for outsourcing manufacturing. Goods made in China contain 5 percent U.S. inputs, while those from Mexico contain 40 percent, he says. 

“If we stop Mexican products from coming in, then we are killing a lot of U.S. jobs,” says Ganster.

Tough negotiations

Instead of doing away with NAFTA, the partners are likely to try to bring it up to date, says Duncan Wood, Director of the Mexico Institute at the Wilson Center, a nonpartisan policy forum in Washington D.C.

Mexico, for example, wants to include energy in the deal and modernize the NAFTA visa categories so North Americans can work anywhere in the region, making it possible, for example, to attract Americans and Canadians to key sectors like technology “to move innovation forward,” says Wood.

This would feed a growing IT industry in cities like Guadalajara, where startups have created a sensor brace for the blind and cost-cutting technology for solar power. More than a dozen universities around there are supplying the brains for such ventures and the satellite offices of multinationals like Dell, Intel and Oracle.

As part of the negotiations, Mexico may have to accept short-term tariffs or voluntary export constraints on manufactured goods shipped to the U.S. If structured well by Mexico, these would have little impact on the economy.

A 25 percent weakening of the peso against the U.S. dollar during 2016 means exporters can handle a 10 percent tariff, for example. Or Mexico could play tough and say it wants to restrict shipments of auto parts to the U.S., a move that would push up car prices in the U.S., damping sales.

“Mexico could go that route as a way of saying, ‘Well, if you want to mess around with trade, then U.S. consumers are going to pay the price,’” Wood says.

Faster growth

NAFTA aside, Mexico may be poised for faster economic growth, in part thanks to U.S. President Donald Trump. His policies, such as heavy infrastructure spending, are expected to fuel economic growth in the U.S., says Molano. While this could stoke inflation and higher interest rates there, investment should return to the U.S. from emerging markets, except Mexico. This is because about 80 percent of Mexico’s GDP growth is tied to its economic relations with the U.S., making it an attractive investment, he says.

To be sure, while investment has slowed in Mexico, Price says manufacturers there “are running their factories at full tilt and selling everything they produce” to meet U.S. consumer demand as U.S. factories run at high capacity utilization rates.

At the same time, Mexican consumer demand is growing as a shift to smaller, two-income families and improving access to credit increases purchasing power in spite of the weaker peso.

“Domestically, Mexico is still a growth story. And that is where you will see investment this year, in financial services, healthcare services, medical products and consumer goods,” Price says.

Lower costs

Geography is a big advantage for Mexico in trade.

A shipment from Shanghai to a U.S. port takes 31 days, whereas it takes three days overland from Mexico City to Dallas, sometimes less.

“Mexico can supply a reorder very quickly when products are missing or selling well,” says Eric Gantier, Managing Director, DHL Global Forwarding, Mexico.

The country also has cost advantages in production. A boom in shale oil and natural gas production in the U.S. has created a surplus that is being piped to Mexico, slashing energy costs there.

Logistics and transportation is also comparatively cheaper in Mexico, accounting for about 6 percent of COGS (cost of goods sold), compared with 15 percent in Brazil and 25 percent in Colombia and Peru, Price says.

These advances in competitiveness come at a time when the low-cost attractiveness of China and other Asian manufacturing nations is fading in labor terms. Real wages are poised to go up 6.1 percent in Asia in 2017, the highest globally, according to a study by consulting firm Korn Ferry Hay Group. In Mexico, they are set to rise 4.6 percent, helped in part because a large young workforce, while not growing as fast as in previous years, has kept a lid on pay increases.

Mexican labor productivity is also improving, surpassing China 1.8-fold in 2015 in terms of GDP per employee, according to the Organization for Economic Cooperation and Development. Mexico still lags behind the U.S. by 2.7 times in terms of overall productivity, but at cutting-edge manufacturing plants, productivity has been growing at 5.8 percent per year, according to a recent report by the McKinsey Global Institute. While overall manufacturing productivity in Mexico is just 24 percent of the U.S. level, the leading plants exceed the U.S. average, according to McKinsey.  

“NAFTA pushed companies to train workers to produce high-quality products,” says Agustín Croche, CEO, DHL Supply Chain, Mexico. For carmakers, for example, “the quality of worker training is the same in Mexico as in the U.S. or Europe,” and labor productivity has got so good that it has helped to attract the German luxury brands Audi and BMW to make vehicles there, he says.

Croche expects Mexico to sustain its competitive advantage and continue luring foreign manufacturers as part of a national policy for growing the economy over the long term. “Mexico is still a young population, so a lot of young people will need those jobs,” he says.

Infrastructure

Infrastructure investments have brought world-class ports, highways and railroads as well as free trade zones, inland ports and industrial parks, thereby helping to provide an integrated supply chain and trade links to the world, and to keep up with economic growth. A new airport is scheduled to open in Mexico City in four years, and there are plans for more ports like in Tuxpan in Veracruz on the Gulf of Mexico.

PLANT LIFE: Productivity in Mexican factories and plants is rising.

More investment is planned, as the country pursues a goal of ranking in the top 20 percent of the World Economic Forums Infrastructure Competitiveness Index, according to a logistics report by PwC.

This has been helping to drive aerospace, electronics, food processing and other advanced manufacturing companies such as the U.S. aircraft makers Honeywell and Textron to set up in Mexico.

American manufacturers have also worked closely with logistics companies to slash costs for moving inputs and finished products between their factories in Mexico and their Canadian and U.S. customer and supplier bases. The result? “Crossborder logistics in Mexico today are arguably the most efficient anywhere in the world because of the scale of the manufacturing that was moved there,” Price says.

Encouraged, Mexican companies have also outsourced everything from trucking to inventory and supply chain management, he adds.

There is more to be done, of course. “At times of peak demand, there are constraints in getting goods to market,” says Croche. “Consumption is growing but the number of truckers on the road is not keeping pace.”

Improvements in trade logistics could come from building more east-west transport capacity to take advantage of access to the Atlantic and Pacific. This would make it easier to expand exports to the rest of Latin America, its second-biggest market, as well as to Asia and Africa.

“Mexico is very dependent on the U.S. economy, and so the NAFTA negotiations could be an opportunity to become less dependent,” Gantier says.

While the government could try to widen the country’s trade ties, it is down to companies to step up sales beyond NAFTA.

For cars, planes and white goods, that may not make sense. The added cost for long-distance shipping would make it harder to compete with goods from markets closer to the customer.

For computer motherboards, mobile phones and other light products, however, a company can supply the world from one factory. Asia is the leader in these industries, and for Mexico to lure investment its infrastructure and logistics efficiency still needs to get better.

“Mexico will have to improve its competitiveness, in particular with better air infrastructure,” Price says. “The ability of Mexican airports to clear customs and move inventory in and around the airports is still a decade behind much of Asia,” he says. “Its port infrastructure is better, but its ability to move cargo domestically is not as competitive as it needs to be if you want to compete with Southeast Asia or China.”

The IT supplier base, too, would have to be convinced to move to Mexico from Taiwan, Thailand and Korea.

“This doesn’t happen overnight,” Price says. “If we have a resolution between Mexico and the U.S. [on NAFTA], we could see it happen. But not until then.”

While foreign investment in Mexico has increased over the past two decades, so have concerns about doing business there, such as a lack of well-trained engineers and steady reports of violent murders in states like Baja California, Chihuahua and Tamaulipas.

On security, Steven Dudley, co-director of InSight Crime, a Washington D.C.-based foundation that studies organized crime in Latin America, says Mexico is “relatively safe.”

The biggest risks are not from the big drug cartels, but the smaller criminal groups focused on contraband, kidnapping and theft. These groups, however, go after easy targets, not the larger companies with private security, he says.

Education-wise, graduation and literacy rates are reasonable in Mexico, Price says.

The problem is that universities “are not well equipped to produce graduates who are employable in the manufacturing sector,” he says.

To get around this, the automotive industry has banded together to form training centers for which the government is providing students with a subsidy for low-cost entry.

“Now Mexico produces a lot of mid-level technicians in the automotive industry as well as engineers, which is what they lacked in the past, and that was one of the greatest limitations of Mexico’s ability to grow in that sector,” Price says.

Could other sectors follow suit and bolster Mexico’s growth prospects for manufacturing? Price thinks so.

 “I suspect that as other industries gain critical mass they will repeat that model,” he says. “After aerospace, the first that could probably do this is medical equipment, and then the IT sector.”     — Charles Newbery

Published: May 2017

Images: REUTERS/Daniel Becerril, Adobe Stock, Sollina Images/Getty Images