04/08/2014 11:10 am ET Updated Dec 06, 2017

Mexico: What If the Reforms Fail?


The year is 2030. It has been 17 years since Mexico stunned even its staunchest pessimists by passing a series of landmark structural reforms designed to lift the country out of its historical lethargy and land it squarely within the ranks of the world's most dynamic economies. By now, the country is unequivocally middle class and although crime, poverty, and informality still blight the socioeconomic landscape, these have all fallen sharply and have ceased to be the scourges that they once were. Mexico not only broke well into the top 10 largest economies, but guaranteed the grand majority of its citizens a degree of security and prosperity that was for a long time believed to be unattainable.

But what if none of this happens? After initial euphoria over reforms, the economy sank into a stupor instead, growing at a paltry 2 to 3 percent on average (occasionally dipping into 1 percent territory); not enough to induce further confidence for the "Aztec Tiger" and help lift its millions of poor into the middle class. The PRI, which managed to secure a second straight electoral win in 2018, was unable to win a third after failing to convince the electorate that it had the skill and the will to turn the ship around. Unfortunately, the opposition couldn't either and legislative deadlock ensued. And with a demographic boom now largely gone, Mexico's last natural chance to break loose from the grip of underdevelopment faded away.

What went wrong in this hypothetical worst-case future?

Productivity and informality

Productivity is the foundation of long-term growth, and there is little disagreement over the fact that the main reason why Mexico has failed to live to its economic potential over the past three decades is a lack of measurable improvements in productivity. By most estimates, productivity growth since 1982 -- the year of the debt crisis- - has been nearly zero and has only been raised modestly (to less than 1 percent) since NAFTA was signed. Essentially, almost all of Mexico's growth since then has been attributed solely to the increase of the labor force, a demographic rather than an economic effect. It therefore becomes obvious that if the economy is expected to grow much beyond its labor force rate, the remainder must necessarily come from productivity.

One of the main reasons it is so low is the huge mass of informality, currently around 55-60 percent of the labor force and mostly composed of small "mom and pop" stores that proliferate on almost all Mexican streets. Mexico may be one of the richer Latin American economies in per capita terms yet informality is well above the regional average, a phenomenon which is partly explained by institutional factors such as high costs towards formalization and generally lax enforcement of tax collection which is exacerbated by an overly complex tax code for smaller firms.

In its "crusade against informality," the Peña Nieto government has set a target of reducing the share of informal workers by a third by the end of its mandate (to 40 percent). But is this achievable? On one hand, it is laudable that the labor market did not suffer much -- if any -- deterioration during 2013 despite dismal GDP growth. Evidence also shows that informality is indeed gradually falling, but at a snail's pace. On the other hand, however, very little emphasis was placed on the fight against informality in the fiscal reform as few of its measures towards simplification were specifically targeted at small and micro firms, many of which may actually see their fiscal burden increase instead. And doubts are growing over the viability of the government's plan to establish universal social security, which would effectively remove the cost of social protection from firms. This would be arguably the single most important factor in helping speed up formalization but the high cost of its implementation could be too much compared to what the fiscal reform is expected to bring in.

The lowest point in the chain

Unfortunately, the productivity problem doesn't end with informality: even the much vaunted export-oriented manufacturing sector has a crucial flaw which is that hardly any of it is actually Mexican. Since the liberalization of Mexico's economy began in the 1980s, this was not necessarily seen as a limitation. Investment, after all, is the same whether it is Mexican or foreign and the presence of large foreign firms provides the same amount of employment possibly even at higher wages and certainly with superior technology (both material and organizational). But the legacy of this strategy is that it has left the country at the lowest level of the value added chain: assembly.

For a nation of over 100 million people that borders the most technologically advanced on earth and which has received a flood of foreign investment since the 1990s, it is undoubtedly one of the great failures of economic policy that hardly any Mexican firm competes in the country's most successful and dynamic sectors. The ones that do are generally of a supportive nature, as is the case with the auto-parts or business process outsourcing industries. Yet Mexico's economic model continues to bank on the belief that attracting FDI without the simultaneous upgrade of domestic value added capacity is the end-all. A high-tech sweatshop is ultimately still a sweatshop, one that benefits from cost competitiveness (read: low wages, which is an anathema to higher per capita income growth) rather than in its ability to innovate and market its creations. Failure to construct proactive policies to move into these more profitable segments of the value chain will result in one of two outcomes: either Mexico will languish as a low-income (but high-tech) sweatshop, or get to the point that labor will be too costly to be a sweatshop at which point foreign companies will start looking elsewhere.

Breaking the grip

Then of course, there's the possibility that the secondary legislation (to be debated throughout 2014) may fail to meet the lofty standards of the constitutional changes that were passed in 2013. Not only could this significantly weaken the impact of the reforms, but the fact that this legislation requires only a simple majority in congress means that in theory it can be reverted just as easily as it was passed. Could the next government (or even this one later on) succumb to pressure from interest groups and undo many of the reform's gains? This is hardly unthinkable in an institutionally frail country like Mexico and is probably the single greatest risk for the reform agenda to fail in the short-run.

In the end, reality may not be as harsh as this counterfactual worst case scenario. But it would be far too naïve to assume that the work is done and that the country can now cruise towards progress and prosperity. The structural reform agenda of 2013 may have helped remove many of Mexico's bottlenecks to growth but it does not guarantee that this potential will be achieved. The government is smart enough to realize that productivity is a key to long-term success: "democratizing productivity" is a major axis of the 2013-18 National Development Program. But if Mexican history is any guide, promises and results can be vastly divergent when the efforts to achieve them are lacking.

Follow the EIU's Latin America team twitter feed @TheEIU_LatAm and the author @raguileramx