NAFTA and the Mexican Economy:

A Guide to the Winners, Losers, and Administrators of Free Trade

Jay Karimi

Presented at the MBA Student Forum Pepperdine University - April 9, 2013

This paper argues that the onslaught of Mexicos free trade agreements starting with the North American Free Trade Agreement in 1994 have had a positive net benefit on the economy. Although political pundits can denounce NAFTA as a failure by choosing to examine only one or two suffering industries in a vacuum, free trade will propel the country into the right direction for the 21st century. This paper seeks to defend this position by answering the following central questions: Has the sizable increase in post-NAFTA foreign direct investment had a positive effect on jobs in the Mexican manufacturing sector? Have other macroeconomic factors outside of NAFTAs control like Chinas emergence on the world stage deterred Mexicos economic performance? Can the criticism of NAFTAs shortcomings instead be shifted to the governments lack of reforms on labor and competition?

Jay Karimi is an MBA candidate at the Graziadio School of Business and Management at Pepperdine University in Los Angeles, California. You may contact him at ojan.karimi@pepperdine.edu.

NAFTA and the Mexican Economy: A Guide to the Winners, Losers, and Administrators of Free Trade

Introduction This paper argues that the North American Free Trade Agreement (NAFTA) was the correct for step for the Mexican economy, but that the government needs to do more to take full advantage of their new global partnerships. Specifically, privatizing the oil industry and

enforcing antitrust laws would allow capital and innovation flows into the key industries of energy and telecommunications. Reforms to labor would increase employment among the

nations young and counter enrollment in criminal activities. Beginning with the 1994 signing of NAFTA followed by the passing of 42 subsequent free trade agreements, Mexico has opened its domestic industries to unprecedented competition. Competition, by definition, means there will be winners and losers. This paper argues that even though free trade creates losers in the short run, and even if there are more losers than winners, the long run net benefit of free trade to Mexico is positive. NAFTA, with its abolishment of protectionist tariffs, has made a few things astonishingly clear: Mexican farmers cannot compete with the technologically advanced and heavily subsidized American agricultural industry; Mexican factory workers could not compete with cheap Chinese labor until very recently; and that Mexicos government policies aimed at increasing competition in domestic industries must supplement free trade agreements. It takes time for the factors of production to shift to their most productive uses and NAFTA, although it was ratified in 1994, was not scheduled to remove tariffs on the most significant goods and services until 2008. If supported by proper reforms,

capital and labor in Mexico will shift to industries in which Mexico offers a competitive advantage to the rest of the world. The Globally Connected Mexico Because of its geographical advantage of being located immediately south of the worlds largest economy, the United States, and due to its recent free trade agreements (FTA) with dozens of importing countries, Mexico has emerged as one of the most globally connected countries in the world. Mexicos total international trade, calculated by exports plus imports, by the beginning of 2012 was 69% of their GDP (The Global Mexican, 2012, p. 1). To put this in perspective, two of the most frequently discussed emerging economies of China and Brazil have ratios of 48% and 19%, respectively (1). After ratifying the North American Free Trade

Agreement (NAFTA) on January 1, 1994, Mexico has entered into 42 FTAs with the European Union, Japan and nearby Central and South American countries, making it the worlds most FTA-friendly nation (The PRS Group, 2012, p. 14). This dismantling of tariffs not only

increases the flow of goods shipped into and out of Mexico, but also significantly increases the inflow of capital. Mexicos foreign direct investment (FDI) was US$17.7 billion by the end of 2010, with the majority of that originating from the United States and the Netherlands1 (p. 33). Additionally, Mexicos sustainable external debt solvency ratios mitigate risk for many multinationals. Although Mexicos US$1.76 trillion economy (2012 GDP, PPP) ranks it 12th in the world, its per capita GDP is only about one-third of its NAFTA partners of the United States and Canada at US$15,300 (CIA World Factbook, 2013, p. 12). This gap is not expected to narrow

TheNetherlandsroleinMexicosFDIisoverstatedin2010becausetheDutchcompanyHeiekenremitteda paymentofUS$5.2billionforthepurchaseoftheMexicanbeercompanyFemsa.
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any time soon with an a unimpres ssive expecte ed GDP grow wth rate of 4% (12). In nternational trade will have e to be suppl lemented wit th increased d intellectual property law w enforceme ent, legal ref forms to stimul late competition in key industries an nd the priva atization of t the state-run n oil compan ny for the count try to see rap pid economic growth tha at will narrow w the gap w with its NAFT TA partners. . Political Gesturing and a the Rise of Tariff Wa alls Although A the e United States S has long l been heralded as s the drivin ng force be ehind globaliza ation and fre ee trade, it was Americas anti-tra ade laws tha at led to a rapid world dwide increase in tari iffs during the middle decades o of the twen ntieth centu ury. Amid the econom mic and pol litical

nigh htmare that was the G Great Depre ession, Ame erican polit ticians were e quick to bla ame internat tional trade a as the culp prit. Desper rate times an nd political fervor led t to the swif ft passing o of the infam mous Hawle ey-Smoot A Act of 1930 0, which r raised tariff f rates on 845 import ts of man nufactured a and agricultu tural goods (The Batt tle of Smo oot-Hawley, 2008, p. 2). . Good suc ch as milk, b butter, sugar, liv vestock, app parel and hun ndreds of ot thers became e subject to new or incr reased duties s that led to ge eneral price increases of o about 6% % for import ted goods (p. 4). Because of its close proximity y, and therefore, depend dence on the e United Sta ates, Mexico o was most a affected by these tariffs an nd began to increase i its import i dutie es in retaliati ion. Not all l Americans s were in fav vor of the Haw wley-Smoot Act A as witn nessed by th he 1,028 eco onomist tha at signed a p petition plea ading

President Hoover to veto the bill2 (p. 3). The fact that President Hoover did not heed the warning of the days leading economists and sided with fellow politicians Reed Smoot and Willis C. Hawley suggests that tariffs are purely political and not responsive to sound economic reasoning. NAFTA Explained On January 1, 1994, the three member group of Canada, the United States and Mexico entered into the North American Free Trade Agreement, which would remove all duties and quotas of imports over a 14 year schedule. With 450 million people producing over US$17 trillion of goods and services, this free trade area represents the largest one in the world (ustr.gov, 2013). The aim of the agreement was to remove all artificial barriers of trade that had slowed the growth of all three economies. While the law seeks to ease the trade of all goods and services across borders, specific sub agreements for key industries such as agriculture, textile, and auto trade were drafted. Intellectual property enforcement, environmental policies and dispute resolution are also outlined in the accord (ustr.gov, 2013). NAFTA has been a lightning rod of controversy since it was first discussed by Ronald Reagan during his 1979 presidential campaign and, as it approaches its twenty year anniversary, its complete economic consequences are still inconclusive. The Mexican Farmer: the NAFTA-Induced Loser The biggest losers of NAFTAs dismantling of tariffs are the Mexican farmers who cannot compete with American agricultural technology and subsides. In the absence of

protectionist tariffs, these farmers are priced out of the market and lack the skills and

AmongthelistofeconomistswasPaulDouglasoftheCobbDouglasproductionfunctionfame,FrankTaussigwho headedthedepartmentresponsibleforloweringorincreasingduties,andIrvingFisher,thefamousmonetaristand perhapsthefirstcelebrityeconomist.

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professional networks to transfer to manufacturing and service sector jobs.

According to

NAFTA negotiator Luis de la Calle, maize (corn in Canada and the United States), which has been grown in Central Mexico for over 5,000 years, has become a recipe for poverty to Mexican farmers (Tariffs and Tortillas, 2008, p. 2). The hard fact is that because of its

technological superiority, American farmers yield nine tons of crops per hectare to six tons by their Mexican counterparts (Malkin, 2009, p.3). This comparative advantage leads to significant price differences. American farmers can produce, transport and mark up corn at a price that is 30% cheaper than Mexican farmers can even produce it (Tariffs and Tortillas, 2008, p. 2). A recent study by Mexicos Ministry of Agriculture estimated that only 6% of farms are highly efficient and profitable (Tariffs and Tortillas, 2008, p. 2). This finding led to the governments launch of the Procampo program aimed at providing a minimum income to each farmer, but the US$1.4 billion budget was quickly misappropriated to the largest agribusiness farms (p. 2). An estimated 80% of small farmers who should have received this government aid have not (p. 2). Instead of transferring wealth from middle and upper class citizens to subsidize the inefficient operations of small farmers priced out of the market by technological superior Iowan farmers, the Mexican government should use the resources to train displaced farmers to perform jobs in the manufacturing or service sectors of the shifting economy. NAFTAs Effect on the Mexican Economy While NAFTA has produced quantifiable economic benefits for Mexico, it has not propelled the country into the emerging economy class of China, India and Brazil as many predicted in the early 1990s. As stated in The Economists Tariffs and Tortillas article, Since 1994 Mexicos non-oil exports have grown fourfold, while the stock of foreign direct investment

has expanded by 14 times. Even the countrys farm exports to its NAFTA partners have risen threefold (p. 1). International trade theory predicts that capital and goods will flow across tariff-free borders easier than protectionist ones, so it should be no surprise that Mexicos FDI and exports have grown substantially since NAFTAs passing. However, are these the best metrics to use in evaluating Mexicos economic performance? The overall standard of living and the sustainability of the economic growth should be examined as well. Removing tariffs from a three country member US$17 trillion trade area means firms can exploit comparative advantages and price other less productive ones out of the market. By definition, competition means there will be winners and losers. As previously discussed, the small Mexican farmer has been the most observable loser of NAFTA. However, jobs lost in the agricultural sector of the Mexican economy have been replaced by jobs gained in the manufacturing one. The winners in this sectorial shift are Mexican factory workers and

transporters who are the direct benefits of the colossal increase in post-NAFTA FDI. In addition, the over 100 million Mexican consumers reap the advantage of cheaper food. American manufacturers, specifically automobile firms, have taken advantage of Mexicos relatively cheap labor long before NAFTA was conceived. In 1925, Ford opened their first factory in Mexico with General Motors and Chrysler following suit in the 1930s and 1940s (Hecht and Morici, 2000, p. 32-33). Ford became the forerunner of U.S. based firms that

opened macquiladoras assembly factories that sprouted up along the U.S.-Mexican border that employ tens of thousands of Mexican workers (p. 33). American-induced industry in

Monterrey, an industrial city in Northern Mexico, has reached such a high level that the Mexican government and private investors financed a US$2 billion transportation project called Interpuerto in 2010. (Bringing NAFTA Back Home, 2010, p. 1). The projects objective is to
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speed assembled goods back to American firms using a customs-clearing 150 miles rail line and motorway system (p. 1). Although FDI from the U.S. is reaching Mexicos northern borders, it is not staying there for long. Mexico firms are not capturing enough of the supply chain. Many of the parts that arrive in Mexican factories only depend on local labor to assemble them and ship them back to the U.S. Modern, robust manufacturing economies interconnect several related industries in the production of a final good (think of how an automobiles production needs glass for the windshields, rubber for the tires and fabric for the seats). In the case of Mexican manufacturing these related industries are lacking and the economy is suffering from an unusually low multiplier effect (Bringing NAFTA Back Home, 2010, p. 2). The article goes on to state: each export dollar [in Mexico] generates only $1.80 at home, compared to $2.30 in Brazil and $3.30 in the United States. The opportunity lost is magnified because exports make up some 28% of Mexicos economy, compared with 11% of Brazils (p. 2). Applying some basic math, it can be estimated that if Mexico could capture an extra $0.50 per export dollar to put them on par with Brazil, the net effect with be a US$137 million increase in GDP, or approximately 7.8%. In addition to the multiplier effects of capturing more of the supply chain, Mexican firms would secure more external markets. Of the dozens of free trade agreements Mexico has signed in recent years, most notably with the European Union, several mandate that a certain percentage of the manufacture of goods occur in domestic markets (Bringing NAFTA Back Home, 2010, p. 2). Many goods exported from Mexico do not satisfy this stipulation and are therefore not granted tariff restrictions. In order to take full advantage of its free trade agreements, the

Mexican government needs to create a more attractive environment for either foreign or
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domestic firms to produce these early supply chain operations within their borders, the economy would feel the multiplier effect and be afforded the benefit of cheaper prices in external markets, including the highly profitable European Union. Despite the political rhetoric to the contrary, increased FDI has had a positive effect on manufacturing jobs in Mexico. In Andrea Varellas and Rene Cabral Torres Harvard Working Paper, 25 manufacturing industries were examined in the periods directly before and after NAFTAs ratification. The variables of levels of employment, capital stock and production were observed using vector autoregression (p. 17). They concluded that increases in capital

fluctuations have a positive effect on employment [that] implies that labor and capital are complements in manufacturing, and the relationship in stronger in the post-NAFTA sample (p. 14-15). Finding that there is a strong positive relationship between increased capital stock (FDI) and employment in the manufacturing sector of the Mexican economy in the post-NAFTA era, suggests that manufacturing has been a NAFTA winner. Mexico v. China: The Battle for Globally Mobile Manufacturing and High Tech Jobs Mexico was the last of the then 44 World Trade Organization (WTO) members to approve the accession of China into the assembly (Polanski, 2004, p.2). coincidence. This was not a

Mexico and China offer the world the similar product of a large surplus of

relatively cheap labor. Under NAFTA, Mexico was the first country to benefit from tariff-free pricing to external markets in the United States and Canada, but with the passing of each subsequent free trade agreement this benefit has been diluted. Specifically, NAFTA cut tariffs on Mexican-produced manufactured, textile, apparel, petrochemical, electricity and automotive goods and information technology services. With Chinas entry into the WTO, Mexican now

had a competitor in the highly labor l intensi ive industrie es of electro onics and tex xtiles. More eover, China ha ad a distinct advantage that t trumped d the geograp phic one tha at Mexico en njoyed. In 2 2001, Mexicos s manufactur ring wages were w four tim mes higher t than China ( (The Globa al Mexican, 2 2012, p. 1). The T inabilit ty for the Mexican M economy to a attract and retain a gr reater number of

manufact turing jobs was w not due e to NAFTA A, but instea ad because o of the powe erlessness ag gainst rock bott tom priced Chinese C labor r during the late 1990s a and the early y years of the e 21st century y. In n recent year rs, foreign firms f deman nd for manu ufacturing an nd high tech labor has st tarted to turn away a from China C and ba ack towards s Mexico. A As China co ontinues its rapid ascent t to a mod dern econo omy, labor and envi ironmental reform have

push hed manufacturing wag ges to roug ghly the sa ame as Mex xicos (The e PRS Grou up, 2012, p. . 32). In a addition to i increased w wages, push hing out f foreign bid dders, ener rgy costs (o oil) make Mexico an increasin ngly attra active

dest tination for firms located in the western n hemisp phere,

cifically the e United S States spec (Bringin ng NAFTA Back Hom me, 2010, p. p 2). Altho ough China s membersh hip in the W WTO excepts it from certai in tariffs and d quotas, it does d not enjo oy the level of subsidy t that Mexico does. For exam mple, Chine ese tiles and d paving ston nes are chea aper than Me exican ones, , averaging $ $5.20
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per square meter against $5.29, but after paying an 8.5% tariff they end up more expensive. The same is true of cloth, glassware, chemicals and much else (p.2). As illustrated by the graph labeled Gaining Ground, Mexico has gained significantly in the lucrative U.S. imports market since 2005, and specifically at the expense of China. Intellectual property, the protector of information technology firms research and development expenditures and their well-paid high tech jobs, is thought to be safer in Mexico than China (Bringing NAFTA Back Home, 2010, p. 2). In their 2012 Country Risk Report of China, the PRS Group summarizes foreign investors intellectual property protection concerns in China as: China acceded to the World Intellectual Property Organization (WIPO) Copyright Treaty and the WIPO Performances and Phonograms Treaty in 2007. China is also a member of the Paris Convention for the Protection of Industrial Property, the Berne Convention for the Protection of Literary and Artistic Works, the Madrid Trademark Convention, the Universal Copyright Convention, and the Geneva Phonograms Convention, among other conventions. China has updated many of its laws and regulations to comply with the Agreement on Trade-Related Aspects of Intellectual Property (TRIPS). However, in 2009 a WTO dispute settlement panel found that some aspects of Chinas IPR regime are inconsistent with its obligations under TRIPS. Industry associations representing software, entertainment, and consumer goods continue to report high levels of piracy in China. Trademark and copyright violations are widespread. During its Special IPR Campaign from October 2010 through June 2011, China emphasized criminal prosecutions against IPR violations, particularly in the copyright area. In general, however, criminal penalties for infringement are seldom applied. Administrative sanctions are typically nontransparent and are so weak as to lack a deterrent effect. While litigation awards in recent years have been larger than in previous years, civil sanctions against infringement tend to be of limited effect. (2012, p. 61).

As a result of these apprehensions regarding Chinas intellectual property enforcement and because of Mexicos proximity to lucrative markets in the Americas, many high tech companies including IBM, Motorola, Solectron, Flextronics, SCI, Siemens have operations in
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Mexico (Bringing NAFTA Back Home, 2010, p. 2). In the case of German company Siemens, management decided on Mexico over traditional favorites China and India because, as General Manager Claude Steffen Raab explans, We are moving towards local hubs [with] the idea to respond more quickly to each of our markets (Thomson, 2012, p. 1). Siemens is just the latest example of the slow shift of manufacturing and high tech jobs meandering from China to Mexico in recent years. Although the intellectual property protection laws in Mexico are friendlier for the foreign investor, there is still room for growth. According to the PRS Groups appraisal, Mexicos federal authorities offer weak enforcement of the at least fifteen international treaties they have signed pledging to protect intellectual property (The PRS Group, 2012, p. 44). Because of these shortcomings, rampant piracy and counterfeiting around found throughout the country (p. 44). In order lure more high tech jobs from China, the Mexican government must ensure weary foreign investors that their cities are safe haven from intellectual property theft. The Governments Role in the Plight of the Mexican Economy NAFTA may not have delivered on all of the lofty promises it made nearly twenty years ago, but to blame it for an underachieving Mexican economy would be a difficult argument. Instead, one can look to the failures of the Mexican government in the areas of promoting competition in key industries, privatizing an outdated state-run oil company and curbing corruption and violence that weaken political and social institutions. Pemex, the countrys only oil producing company, has been nationalized by constitutional decree since 1938, which means that it can only be privatized by a two-thirds vote from a congress very vested in its tax generating powers (The PRS Group, 2012, p. 15). Like

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other monopolists, the company lacks technology, expertise and financial resources and the solutions lie outside of its borders (p.15). In addition to the constitutional powers securing its monopoly, it has the peoples support to stay nationalized. Oil is one of those basic resources that become the source of national pride and independence. It becomes political and not a commodity that is to be sold to the highest foreign bidder. However, in order for Mexico to modernize its oil producing processes, it must privatize and reap the benefits of the worlds capital and technology. In addition to oil industry, market leaders in other key industries have been allowed to squeeze out competition at relatively unchecked level. Carlos Slim, the worlds richest man, owns holdings such as telecommunications company Telmex that have up to 90% market share (Coster, 2009, p. 1). Some critics are outraged that one mans net worth is equivalent to about 7% of the entire countrys economic output (p. 1). Some of Mexicos other corporate giants such as Grupo Bimbo (baked goods), which purchased Americas Sara Lee bakery arm to penetrate the U.S. market, Cemex (the largest seller of cement in the U.S.), and Alfa (gas drill manufacturing titan) have also been accused of abusing oligopolistic powers to raise the money for such enormous acquisitions (The Global Mexican, p. 2). When market share begins to consolidate to a single supplier, innovation is crowded out. The Mexican government needs to enforce anti-trust legislation to ensure competition and thus innovation, especially in key industries like energy and telecommunications. Labor reform is also needed as Mexican firms are usually too slow to hire workers because it is excessively difficult to fire underperforming workers (The PRS Group, 2012, p. 21). Difficulty finding jobs for the young can have a devastating effect on levels of violence in a country already known for murderous drug cartels. Growing income disparities can also lead to
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a rise in criminal activity (The PRS Group, 2012, p. 24). While multinational executives are not usually the target of the 2,000 annual kidnappings in Mexico (second only to Columbia in Latin America), foreigners are at risk (p. 24). Most alarming is that local and federal police are sometimes the culprits or criminal activity (p. 24). Criminals operating within a countrys law enforcement agencies are usually a sign of weak political institutions and high corruption. During its most recent presidential elections, reports of thousands of voters admitting that they received gift cards for votes were rampant (The PRS Group, 2012, p. 5). Even those these claims were never substantiated, public perception of the elections integrity has plunged (p. 5). Corruption in the corporate sector has also been in the news. The Wal-Mart scandal of early 2012 accused the American retail giant of using proxies to bribe local officials and speed up the permit-granting cycle (The Global Mexican, p.2). According to the World Banks Doing Business In index, Mexico ranks 152 and 141 out of 185 economies in getting electricity and registering property, respectively. These delays suggest that local officials may often delay basic services in an effort to extort bribes from a company. Conclusion Was NAFTA good for Mexico and Where They Go from Here? Concentrating only on the small farmer or textile worker in Mexicos post-NAFTA years will give a skewed view for evaluating the effectiveness of the 1994 free trade agreement. It is true that many Mexican farmers could not compete with American agricultural technology that was supplemented by enormous government subsidies when protective tariffs were removed. However, the farmers plight should not be viewed in a vacuum. Consider the net effect in combination with the marginal benefits to all Mexican consumers when the price of tortillas

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decreased because of cheaper American corn. Additionally, the one theme all modernized economies share, whether it was England in the 18th century, the United States in the 19th or China over the past 30 years, is shifting jobs out of agriculture into manufacturing and then ultimately into the service sector. NAFTA has thrust this process forward for Mexico. Political pundits may point to Mexicos sluggish economic performance over the past two decades in attempt to prove that NAFTA was a failure, but the governments shortcomings in establishing competitive markets and not curbing corruption and violence is the true culprit. Reforms to labor would increase employment among the nations young and counter enrollment in criminal activities. Privatizing the oil industry and enforcing antitrust laws would allow capital and innovation flows into the key industries of energy and telecommunications. Ratifying NAFTA and then a subsequent 42 other free trade agreements were the correct initial steps to propelling the Mexican economy into the 21st century, but the government must now do more to open their domestic industries to foreign capital, technology and expertise to take full advantage of these global partnerships.

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References Bringing NAFTA Back Home, The Economist. 28 Oct 2010. Web. Accessed 24 Mar 2013. Central Intelligence Agency. "Mexico" cia.gov. Central Intelligence Agency, World Factbook Web. Accessed 24 Mar 2013. Hecht, Laurence and Pater Morici. (1993). Managing Risks in Mexico. Harvard Business Review. July 1993. Web. Accessed 22 Mar 2013. Malkin, Elizabeth. (2009). Naftas Promise, Unfulfilled. The New York Times. 24 Mar 2009. Web. Accessed 22 Mar 2013. Mollick, Andre Varella and Rene Cabral Torress. (2007). Productivity Effects on Mexican Manufacturing Employment Before and After NAFTA. Harvard Working Papers. Office of United State Trade Representative. NAFTA. Ustr.gov. Web. Accessed 24 Mar 2013. Tariffs and Tortillas, The Economist. 4 Jan 2008. Web. Accessed 24 Mar 2013. The Battle of Smoot-Hawley, The Economist. 18 Dec 2008. Web. Accessed 24 Mar 2013. The Global Mexican, The Economist. 27 Oct 12. Web. Accessed 24 Mar 2013. The PRS Group, Inc. (2012). China: Country Report. East Syracuse, NY. Web. Accessed on 24 Feb 2013. The PRS Group, Inc. (2012). Mexico: Country Report. East Syracuse, NY. Web. Accessed on 24 Mar 2013. Thomson, Adam. (2012). Mexico: Chinas Unlikely Challenger. Financial Times. 19 Sep 2012. Web. Accessed 7 Apr 2013.

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