Dallas Fed: Mexico’s productivity woes limit nearshoring, growth potential

DALLAS, Texas – Mexico’s real per capita GDP could grow 3.8 percent annually over the next ten years and 3.1 percent annually over the following ten years, according to a new report from the Federal Reserve Bank of Dallas. 

But such performance would require Mexico to reform in ways that enable it to break from its trend of flat to negative total factor productivity (TFP) growth, that is, how efficiently inputs are used in creating output — a primary driver of growth in most advanced and emerging economies.

The report is titled: Mexico’s productivity woes limit nearshoring, growth potential. It was authored by economists Jesus Cañas, Sewon Hur and Braden Strackman. Cañas is senior business economist at the Dallas Fed. Hur is principal research economist at the Dallas Fed. And Strackman is a research analyst at the Dallas Fed. The report was produced for the Dallas Fed’s Southwest Economy regional publication.

The key findings of the report include:

•           During 2000–22, domestic credit to the private sector in Mexico as a share of GDP averaged just 24 percent, compared with Chile, 99 percent; Brazil, 51 percent; and Korea, 131 percent.

•           In Mexico, the informal sector of mostly small businesses that are not taxed or regulated accounts for a staggering 24 percent of GDP and 55 percent of employment.  

•           Developments in nearshoring are unlikely to boost GDP per capita growth in a sustained way purely through capital accumulation because Mexico is already very capital abundant.

•           Little change is expected over the next 20 years in Mexico’s current hours per working-age person.

The report compares Mexican productivity, capital, hours worked and working age population with countries of similar economic backgrounds that made a leap forward, such as Korea and Japan. 

“Even if Mexico gains from the reorganization of global value chains and industrial production relocation via nearshoring, the country clearly needs to unlock its productivity growth potential in order to maximize its opportunities and ascend to the next level of development,” the report states.

Citing previous studies, Cañas, Hur, and Strackman discuss potential reforms such as promoting competition and taking antitrust actions, reducing barriers to finance and to market entry for firms, encouraging higher education and vocational training, and relaxing restrictions on investment, particularly foreign direct investment.

Cañas, Hur, and Strackman say Mexico’s economic gains have been disappointing for several decades, despite a series of reforms since 1986. These reforms included opening the economy to foreign trade and investment, achieving fiscal discipline, and privatizing state-owned enterprises.

“Mexico’s real (inflation-adjusted) gross domestic product (GDP) per capita grew on average 0.7 percent per year from 1980 to 2019, considerably below peer countries that started from comparable income levels. Over the same period, Chile averaged 3.0 percent growth and South Korea 5.3 percent,” the economists write.

“Low productivity gains explain this gap. Mexico’s economic growth has largely been driven by an expanding labor force and, to a lesser extent, by capital investment, reflecting Mexico’s long-time position as top U.S. trading partner. Yet, this progress has been offset by poor total factor productivity (TFP) gains, that is, how efficiently inputs are used in creating output. TFP is the primary driver of growth in most advanced and emerging economies.”

The Dallas Fed reports says Mexico can no longer solely depend on favorable demographics for economic expansion. The report points out that Mexicos’s fertility rate of 1.9 children per woman is below the replacement rate. In other words, the number of children needed to keep the population stable from generation to generation.

“Mexico’s demographic dividend—its disproportionately large increases in the working-age population—is expected to end by 2030,” the report states.

Mexico’s large informal sector does not help, Cañas, Hur, and Strackman state. This sector mostly operates outside government insight and has sidestepped policy reforms enacted a decade ago that were designed to draw it more into the formal economy.

Then there is the violence in Mexico.

“Mexico still struggles with persistent violent crime that remains outside the control of authorities. These factors complicate Mexico’s economic outlook and its attractiveness to investment,” the report notes.

“Taken together, to develop its economy, Mexico will need to increasingly rely on boosting TFP growth. To make this pivot, Mexico must renew its reform efforts. A comparison to countries with economic backgrounds that resemble Mexico offers insight, among them Korea, a one-time middle-income country that undertook reforms and successfully became a high-income country.”

How can Mexico reach its potential?

The last section of the report is titled: How can Mexico reach its potential?

It states:

“If Mexico aspires to make the transition from middle income to high income, it could look at reforms similar to those undertaken in Korea during the 1990s and early 2000s. When they were implemented, Korea was a middle-income country similar to Mexico today. A World Bank report characterized these reforms and the underlying goals as a transition to a knowledge-based economy.”

“Mexico has progressed in some areas, and policy research has outlined some additional steps the government can take to reverse the productivity gap of the past few decades. Recommendations include increasing competition in the telecommunications, energy, pharmaceutical and certain food industries, and incentivizing workers and firms to move to the formal sector. Also suggested are increasing protections for creditors and tackling the education quality gap, which leaves many workers with limited educational attainment.

“Even if Mexico gains from reorganization of global value chains and industrial production relocation via nearshoring, the country clearly needs to unlock its productivity growth potential in order to maximize its opportunities and ascend to the next level of development.”