Mexico: Out of the Shadows

Investing Daily Article of the Week

by Ben Shepherd, Investing Daily

Since the North American Free Trade Agreement (NAFTA) came into effect in 1994, Mexico has been undergoing an accelerating industrial revolution.

Two decades ago, the majority of Mexico’s manufacturing base was located along the US-Mexico border and produced mostly low-end consumer goods. These items were easy and cheap to produce and didn’t require a highly educated workforce. Mexican workers would pull 12-hour shifts, churning out toilet paper, knickknacks and cheap textiles for pennies an hour.

Since then, free trade agreements such as NAFTA and other deals have catalyzed rapid economic growth in Mexico. While the US is still Mexico’s largest trading partner, thanks to improved highway and rail infrastructure and increasingly sophisticated seaports, Mexico is now a major commercial player.

Aided by the adoption of NAFTA, Mexican “maquiladoras” continue to thrive. These are manufacturing operations located in a free trade zone, where factories import material and equipment on a duty-free and tariff-free basis for assembly, processing, or manufacturing and then export the final products. About 1.3 million Mexicans are employed in about 3,000 maquiladoras.

However, Mexico now also produces higher-end goods such as automotive parts and electronics and sophisticated equipment such as aircraft engines and assemblies. Over the past decade, textile exports have plunged by 43 percent while automotive and electronic exports have grown by 152 percent and 73 percent, respectively.

Not only is the character of Mexican manufacturing changing, it’s undergoing a radical geographic switch as well. The value of industrial output continues to grow in some states situated near the US border, such as in Coahuila and Nuevo Leon. However, the most rapid growth is occurring in the Mexican heartland region, in such states as Mexico, Jalisco, Guanajuato and Puebla.

This geographical shift places higher-end factories closer to Mexico’s better-educated workers, because most major academic institutions are located in and around the Distrito Federal and Mexico City. It also provides a buffer zone between those factories and the worst of the narcotics-related violence that is still largely confined to the border region.

In the State of Mexico, which surrounds the federal district, manufacturing output grew by about MXN400 billion in 2011 while it grew by about MXN250 billion in Jalisco and Guanajuato. By contrast, output grew by only about MXN100 billion in the border states of Baja California, Sonora and Chihuahua—traditionally Mexico’s largest manufacturing areas—and didn’t grow at all along the country’s southern borders with Guatemala and Belize.

To help encourage that shift, both state and federal governments have been investing heavily in Mexico’s heartland. While the total length of Mexico’s rail system has remained relatively static for decades at about 16,000 miles, the rail network in the central region has been upgraded to accommodate intermodal traffic, as has the length of railroad running along two-thirds of Mexico’s Pacific Coast.

The government has also been investing heavily in its seaports, particularly the ports of Manzanillo and Lazaro Cardenas, which now handle about 25 million tons and almost 30 million tons of freight annually. Lazaro Cardenas has also become the fastest growing port in North America.

This Pacific development is reflective of Mexico’s deepening trade ties with Asia and a growing relationship with China. Historically, the two countries have been intense competitors, with each seeking to lure low-end manufacturing away from the other.

However, China’s economic linkage with Mexico have been strengthening, thanks to China’s thirst for natural resources. While China isn’t likely to ever invest in Mexican manufacturing, it is certainly eager to get involved in Mexico’s natural resources sector.

That relationship is clearly important to Mexico. One of Mexican President Enrique Peña Nieto’s first state visits after taking office in December was to Beijing. China has offered to invest in developing a high-speed rail network in Mexico and is a major supplier of component parts used by Mexican manufacturers. Nieto’s effort to court China is likely behind the ambitious reform package he and his party is pushing.

Nieto and his Institutional Revolutionary Party (PRI) have taken aim at Mexico’s monopolies, seeking to bust them up while liberalizing the country’s labor laws and pushing privatization of its energy sector. These moves will not only increase the efficiency of the Mexican economy, they also will open the door to greater foreign investment from countries such as China.

While that reformist agenda hasn’t been particularly well-received by the average Mexican—periodic protests have become a fact of life in Mexico—it is helping to make the Mexican economy one of the most vibrant in the region.

It has also helped push Mexico into the unfamiliar territory of being one of the top-performing equity markets in Latin America. As you can see from the chart below, Brazil has been falling from grace over the past year. Brazil has taken a much more interventionist approach to its economy, while Mexico has come into favor thanks to its push for privatization and liberalization.

Consequently, while Mexico’s trust busting is playing hell with the value of companies such as America Movil (NYSE: AMX), the country’s newfound reformist bent is creating huge opportunities elsewhere in its markets. It also requires that Mexico play a greater role in global portfolios.