How can Mexico boost its growth?

When Mexico’s then-President Carlos Salinas de Gortari and his American counterpart, Bill Clinton, signed the North American Free Trade Agreement (NAFTA) more than 20 years ago, the hope was that the Mexican economy would be swept forward by a rising wave of globalization. By many measures, that hope has been amply fulfilled.

Mexico’s foreign-trade volume (exports plus imports) climbed steadily after NAFTA entered into force, roughly doubling, to more than 60% of GDP. Net foreign investment inflows relative to GDP tripled. Though Mexico is an oil exporter, its manufactured exports have led the way, as the economy has become ever more tightly integrated into North American supply chains. The automotive and steel industries, once inefficient and kept alive by protectionist trade barriers, are now highly productive and thriving.

Like so many other countries, Mexico was initially hit hard by Chinese competition in global markets, particularly after China became a member of the World Trade Organization at the end of 2001. Nonetheless, Mexico’s proximity to the US market and its conservative monetary, fiscal, and labor-market policies have provided significant protection.

Dollar wages, moreover, have grown much more slowly than in China; As a result, labor is now some 20% cheaper in Mexico in relative terms. Taking productivity trends into account, unit labor costs have also risen less than in China and other major competitors, allowing Mexico to recover since the mid-2000s some of the market share it had previously lost.

The gains have come not only on the external front. Remarkably, Mexico’s exceedingly high levels of inequality have begun to fall since 1994, thanks in large part to reforms in social policy and educational improvements.

Mexico’s success shows up everywhere, except where it counts the most over the long term: overall productivity and economic growth. In both areas, there has been disappointment galore. Incredible as it may seem, average growth in total factor productivity (TFP) – a measure of the efficiency with which the economy’s resources, human and physical, are used – has been negative since the early 1990s.

As a result, living standards in Mexico have fallen further behind the US and most emerging-market economies. Probably no other country in the world presents a starker contrast between external success and domestic failure.

What lies behind the apparent paradox is the phenomenon of “the two Mexicos,” the McKinsey Global Institute’s evocative term for the extreme dualism that characterizes Mexico’s economy. Large firms, oriented toward the global economy, have done quite well, whereas traditional, informal firms – exemplified by the ubiquitous neighborhood tortillerías – have performed poorly while continuing to absorb the bulk of the economy’s work force. The successes of the former have been nullified by the drag exerted by the latter.

But excitement about Mexico’s prospects is on the rise. President Enrique Peña Nieto has launched a new wave of reforms, spearheaded by liberalization of the energy sector, which will allow foreign investment in oil exploration and production. The state-owned oil company Pemex, a monopoly for three-quarters of a century, will finally face domestic competition. Even an observer as sober as Harvard University’s Martin Feldstein gushes about Mexico, declaring that Peña’s reforms position the country to become “Latin America’s economic star in the coming decade.”

Yet Mexico’s NAFTA experience should make us extremely cautious about such prognostications. We have seen even more comprehensive reforms falter. Will the energy reforms produce another false dawn?

Policymakers need to bear in mind two lessons from Mexico’s frustrating encounter with globalization to date. First, external trade and foreign investment on their own cannot lift an economy in the absence of the simultaneous development of productive capabilities at home.

The reason that East Asia’s export superpowers – Japan, South Korea, and China – experienced growth miracles was that their governments worked on both fronts at once. Yes, they pushed their firms toward global markets. But they also engaged in a broad range of industrial policies to ensure that these firms were growing and diversifying into new product lines.

In fact, domestic producers were often protected from foreign competition at home to ensure that they remained profitable enough to undertake the requisite investments. Countries like Mexico can no longer revert to import protection. So they will have to experiment with alternative strategies of support for domestic enterprises.

The second lesson is the need for pragmatism in policy design. For too long, Mexico’s economic policies have reflected the view that the real economy will take care of itself once the “fundamentals” (macroeconomic stability, openness, and basic regulations) are in place. In the words of the Mexican economist Enrique Dussel Peters, this is the “macroeconomist” mindset , which is very different from the problem-solving “engineer” mindset that has traditionally characterized Asian policymaking.

Mexican officials will need to develop a broader dialogue and partnership with the private sector in order to diagnose and remove the sector-specific obstacles faced by domestic firms. Such collaboration is especially important for the medium-size firms at the cusp of breaking into the big leagues. They will need to act less like “macroeconomists” and more like “engineers.”

Mexico’s failure to grow remains a puzzle, for which there is no simple explanation. It is unlikely that a single grand strategy – whether it is opening up the oil sector, improving access to finance, fighting informality, or, for that matter, altering industrial policy – can unlock the gates to rapid, broad-based growth. This uncertainty underscores the need for an agile, responsive government that can move on diverse fronts simultaneously, learn about the problems confronting the real economy, and respond pragmatically.