May 2002
Federal Reserve Bank of Dallas

Will Mexico Become the Next Tiger?

In the past twenty years, Mexico has become a much more open economy. At the same time, Mexican authorities are beginning to display a true commitment to macroeconomic discipline. Given this progress, many observers have become enthusiastic about Mexico's prospects. In fact, one might wonder if Mexico is on the brink of an economic take off. Will Mexico become the next tiger? Will Mexico catch up to first world nations in twenty, perhaps thirty years, as Korea, Taiwan and other so-called tigers did in the last few decades?

In this presentation, I will argue that a lot of work remains to be done before Mexico can become the next development success story.

Mexico's transformation...
Let me first describe Mexico's economic transformation over the past twenty years. Until 1982, Mexico imposed stringent restrictions on foreign trade and investment in order to expand its domestic industrial base. But a severe financial crisis prompted Mexico to change tactics and open up.

In 1983, foreign investment limits were lifted in some sectors. But the big news came in 1985. Mexico announced it would join the General Agreement on Tariffs and Trade, which it did in 1986. Between 1985 and 1990, Mexico's maximum tariff fell from 100 to 20 percent. In 1989, most sectors opened to foreign investment, which paved the way for a successful wave of privatizations. By 1994, 80 percent of state-owned firms had been privatized.

The icing on the cake came in the 90s with the implementation of the North American Free Trade Agreement (NAFTA), which secured Mexico's access to North American markets.

... leads to an explosion of foreign investment and trade
These policy changes have paid off. Among developing nations today, only China receives more foreign investment than Mexico.

Figure 1shows the evolution of net U.S. direct investment in Mexico since the mid-60s. What has happened is nothing short of an explosion of U.S. investment in Mexico. The U.S., by the way, accounts for three quarters of all of Mexico's foreign investment.

Today, firms that receive some foreign direct investment account for 20 percent of all formal employment in Mexico. Of course, not all regions have benefitted equally from this boom. In border states like Chihuahua and Baja California, this employment share reaches 50 percent. But southern states like Chiapas and Oaxaca have largely been left out. In terms of economic sectors, manufacturing is the leading destination for foreign investment, followed by financial services. Within manufacturing, the maquiladora sector accounts for a third of all foreign investment.

Exports have surged as well. As Figure 2 shows, Mexico's exports/GDP ratio has quintupled since the 60s and has tripled since 1980. As Figure 2 also shows, manufacturing exports, fueled by foreign investment, account for most of the export boom. Manufacturing goods have replaced primary resources as Mexico's main export.

In passing, the 11th and 12th Federal Reserve districts are benefitting a great deal from Mexico's recent openness. Take, for instance, the states of California and Texas. Figures 3 and 4 show that for both states, exports to Mexico have grown faster than other exports. Today, Mexico is the destination of 15 percent of California's exports, and over 40 percent of Texas' exports.

There are also signs that Mexico's foreign trade/investment boom is beginning to translate into more economic growth. Between 1994 and 2000, Mexico grew faster than any other Latin American economy, faster even than the United States. Mexico has slowed since 2000 but despite that, it is now the largest economy in Latin America.

In light of all the good news, it is indeed tempting to ask whether Mexico is on the brink of becoming the next development success story.

Mexico is no success story yet
Unfortunately, Mexico's recent performance can't hide the fact that a lot of work remains to be done before it really begins to catch up with first world economies.

Figure 5 shows that real GDP per capita had almost doubled between 1960 and 1982. Back then Mexico was described as an economic miracle. But the downturn in oil prices and a series of financial crises brought the miracle period to an end. Mexico's real GDP per capita today is roughly what it was twenty years ago.

Learning from the tigers
Why haven't the tremendous policy changes made in the past twenty years enabled Mexico to pick up where it left off in 1982?

For a nation to grow in the long run, its productive capacity must grow. Nations can accomplish this by mobilizing more physical and human resources, and/or by becoming more productive by allocating existing resources more efficiently.

These principles are best illustrated by looking at the few economic development success stories that occurred in the 20th century. In Asia, several nations that were very poor in the 1960s caught up with industrialized nations in no more than two generations. These economic tigers include both small countries like Singapore, and fairly large countries, like Korea.

Mexico's recent performance pales next to what these tigers accomplished in the past forty years. Consider, for instance, Korea. In 1965, as shown on Figure 6, Korea's income per capita was half of Mexico's. Mexico kept up with Korea until the early 80s during its own miracle period. By the mid-80s however, Korea had overtaken Mexico. Korea's income per capita is now about twice Mexico's.

How did countries like Korea succeed? First, the amazing economic expansion of these tigers was marked in each case by an export boom. Figure 7shows that the export to GDP ratio has quadrupled in Korea since the early '70s. Manufacturing goods accounted for most of the trade expansion. In this respect, at least, Mexico does look like a tiger, with its own manufacturing export explosion.

But the key to becoming a development success, and the area where Mexico is falling short, is for a nation to find a way to quickly expand its productive capacity. MIT economist Alwyn Young is credited for establishing that on a basic level, the amazing economic performance of East Asian countries is no mystery at all. As he explained, Asian tigers grew as they did because they were able to mobilize physical and human resources at a mind-boggling rate.

Take, once again, Korea. Korea's investment to GDP ratio, shown in Figure 8, reached almost 40 percent in the late '80s, which is very large by international standards. Interestingly, foreign investment did not play a big role in Korea's investment surge. This surge was financed primarily through exceptionally high private and public domestic savings. Mexico's investment rate, in sharp contrast, and in spite of the foreign investment surge, has hovered around 20 percent for the better part of the past thirty years.

But Korea's fastest growing resource has been human capital. Figure 9shows that in the 60s, almost half of Korea's labor force had not completed primary education. Today, 70 percent of working Koreans have completed secondary education. Unlike tigers', Mexico's educational achievements remain dismal. A third of the working population has not completed primary education. In fact, Mexico roughly stands where Korea was forty years ago.

Making a tiger out of Mexico
Of course, the big question remains: Why are nations like Mexico unable to achieve results similar to Korea's? As Nobel laureate Robert Lucas puts it, "If we know what an economic miracle is, we ought to be able to make one." In other words, why can't Mexico simply replicate what the tigers did?

In a sense, the answer is simple. Several factors that contributed to the performance of these East Asian countries are nearly impossible to replicate. For instance, the savings rates that they achieved, sometimes through repressive methods, and the sacrifices that those high savings rates entail, may not be achievable, or even desirable, for most emerging nations.

But all emerging countries can learn from certain aspects of the East Asian experience. Tigers provided several conditions conducive to the accumulation of productive resources. In most cases, they committed early on to monetary and fiscal discipline. This is conducive to the accumulation of resources because it provides predictable macroeconomic conditions to domestic and foreign investors. They also provided investors with fairly efficient, stable institutions, such as a well-functioning legal system.

As for human capital, tigers made a tremendous effort to provide basic, universal education and basic health services to their population during early stages of their catch-up period. I will now argue that Mexico has a lot of work to do in all of those areas.

Fiscal uncertainty
Take macroeconomic discipline first. Since the 1994 financial crisis and the International Monetary Fund bailout, Mexico has made quite a bit of progress on this front. Monetary authorities have managed to bring inflation down to the lowest levels recorded in thirty years. On the fiscal side, the government has spared no sacrifice to keep fiscal deficits below 1 percent of GDP.

But Mexico's government continues to depend on unpredictable oil sales for a third of its revenues. When oil prices are low, budget cuts become necessary, even in the middle of a recession like the current one. Recently, the government has been able to cut spending when needed but in the long run, a credible commitment to fiscal and monetary discipline demands that Mexico reduce its dependence on oil revenues.

Why is it so difficult for Mexico to find more reliable sources of public revenues? Mexico's tax rates are not low by international standards. The problem is that many individuals and corporations are able to evade taxation altogether. In other words, the base for income taxation is small. In Mexico, the untaxed sector accounts for an estimated 50 percent of employment.

The result is shown in Figure 10. Mexico's tax to GDP ratio is markedly below Korea's, or the United States'. In fact, it is low even by Latin American standards.

Bad Institutions
Ill-functioning institutions add to the uncertainty of Mexico's business environment. First and foremost, property rights are not effectively enforced in Mexico, due to a particularly inefficient legal system. As Figure 11 shows, collecting on a bad check takes five times longer in Mexico than in the U.S. or Korea. Resolving more complicated contractual disputes can take several years.

This poor legal environment has many negative consequences. Maybe the most detrimental for growth, and a key reason why investment has stagnated in Mexico, is the impact on the financial sector. Mexican banks are very hesitant to lend in an environment where contracts are not properly enforced. Figure 12 shows the ratio of loans to the private sector to GDP over the past forty years in the U.S., Korea and Mexico. Mexico's financial sector is very small and, if anything, getting smaller.

Put another way, Mexican firms and households have limited access to external sources of finance. In a recent survey by the World Bank, over half of Mexican firms described their access to outside financing as "severely limited". In the U.S., 15 percent of firms are similarly constrained. In Singapore (Korea did not participate in the World Bank survey), only 10 percent of firms say that they are severely financing-constrained.

To make matters worse, even when they can somehow secure the financing they need, entrepreneurs must still face Mexico's regulations and notoriously inefficient bureaucracy. It takes over sixty-five days on average to simply declare a firm in Mexico, compared to four days in the United States.

On the educational front, Mexico's bad performance is not due to low spending. Instead, it is largely due to Mexico's failure to do what the tigers did early on, namely emphasize basic education.

Figure 13 shows Korea's early commitment to basic education. In 1970, two-thirds of Korea's educational spending was allocated to basic education. As recently as ten years ago, only a third of Mexico's education budget was allocated to basic education. Thankfully, this share has increased to one-half lately, but it will take a generation for these efforts to begin paying off, provided Mexico can stick to its new strategy.

A partial agenda for long-term growth
In conclusion, let me ask again: what will it take for Mexico to start growing like a tiger? First, Mexican authorities must find a way to diminish their reliance on oil revenues. One specific suggestion would be to emphasize consumption taxation instead of income taxation, since income taxation has failed. Consumption taxation has already shown tremendous potential in Mexico. When a limited value-added tax was introduced in 1978, Mexico's tax/GDP ratio rose by five percentage points in two years.

Next, as I mentioned, Mexico must continue fighting its human capital deficit by targeting basic education.

Finally, the most daunting task: improving Mexico's institutions. Here, too, Mexico can learn from the tigers. Tigers had quite a bit of success in improving the performance of their civil servants by 1) making recruitment and promotion merit-based and 2) making pay competitive with the private sector.

None of this, of course, is easy, but the potential benefits are enormous.

—Erwan Quintin

About In Depth This article is based on a presentation by Erwan Quintin, senior economist, Research Department, Federal Reserve Bank of Dallas. The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System.