Mexico’s proximity to the world’s largest economy has been both a blessing and a curse. On one hand, Mexico enjoys easy access, with efficient trade routes, to an enormous market of wealthy consumers, particularly since the signing of the North American Free Trade Agreement. On the other hand, the allure of trade with such a market has made Mexico dependent on the U.S. for trade – and makes the Mexican economy more vulnerable to the trade war launched by the current U.S. administration. So far, Washington has pulled out of the Trans-Pacific Partnership, slapped tariffs on critical industrial goods like steel and aluminum and demanded that NAFTA be renegotiated. This approach is forcing Mexico to re-evaluate its own trade partnerships and strive for greater market diversification.
To be sure, Mexico has tried to diversify its export markets for years, in part by signing trade agreements with dozens of countries. In addition to joining the General Agreement on Tariffs and Trade, the World Trade Organization’s predecessor, in 1986 and NAFTA in 1992, Mexico has entered into 12 other free trade agreements that cover 46 countries, according to Mexico’s Economic Ministry. It also has trade and investment promotion agreements with several other countries. But despite these efforts, Mexico is still heavily reliant on the U.S. market: 80 percent of Mexico’s exports go to the United States.
And trade has become an increasingly important part of the Mexican economy. Over the past 25 years, exports have gone from 12 percent of Mexico’s gross domestic product to nearly 38 percent, according to the World Bank. This Deep Dive will look at Mexico’s prospects for diversification in its most important export industry: the auto industry. It will focus on five emerging markets and conclude that, although these markets can’t replace the U.S. completely, they can help reduce Mexico’s dependence on its northern neighbor.
Attracting export customers really comes down to establishing a comparative advantage. At a basic level, it requires a country to produce goods that other countries want to buy. But those goods must also be sold at a price that buyers are willing to pay. If potential customers can buy the same good – or one of similar quality – for a cheaper price elsewhere, they almost certainly will. There’s also the issue of delivery, which is affected by things like government regulations (which may limit access to certain markets) and infrastructure (which can affect how quickly goods can reach a market). Barriers to delivery can increase the cost of goods and therefore make them less competitive.
Just over 80 percent of Mexico’s total exports are manufactured goods, the vast majority of which do not qualify as high tech. In 2017, five sectors accounted for nearly two-thirds of Mexico’s total exports: vehicle and vehicle parts, furniture and bedding, optical and medical devices, machinery and mechanical appliances, and electrical equipment and parts. From 2013 to 2017, Mexico maintained or increased its global market share in all of these categories except electrical equipment and parts. In addition, among the world’s top producers, it ranked between fourth and 11th in each of these categories but only 13th in total exports. These indicators suggest that Mexico has a comparative advantage in these industries.
But it’s in the automotive industry that Mexico has really excelled. This sector accounts for roughly a quarter of the country’s total exports and is among the most promising industries in terms of value, growth and market share. It is also among the most vulnerable to the U.S. trade war. (Washington has threatened to slap 25 percent tariffs on all imported vehicles.)
Mexico’s comparative advantage in the auto industry is the result of a number of factors. First, labor costs in Mexico are relatively low, with the daily minimum wage at 88.36 pesos ($4.60). By comparison, the federal minimum wage in the U.S. is $7.25 per hour. Wages for an entry-level manufacturing job in Mexico can start as low as $2 per hour, with the average being $2.60 per hour. The cost of renting a production facility can be as low as $4 to $6 per square foot annually, while customized construction costs run about $27-$35 per square foot. Manufacturing is clustered in certain states, and infrastructure and supplier networks have developed in these areas to support manufacturing activity.
When it comes to the U.S. market, Mexico’s biggest advantage over other low-wage producers is its low transportation costs due to its proximity to the U.S. and established infrastructure connecting the two countries. But Mexico doesn’t want to rely so heavily on one market; even if there were a trade-friendly administration in Washington, Mexico would still be looking to increase trade with other partners.
Globally, vehicle sales are expected to increase this year, but slower than last year. At the start of the year, IHS Markit, an information services firm, reported that global light vehicle sales growth by unit is expected to be 1.5 percent in 2018, down from 2.4 percent in 2017. Emerging markets will drive growth while mature markets like Europe will see low growth rates. Sales in Western Europe are expected to grow by only 0.7 percent in 2018, and in mature Asian markets like Japan and South Korea they will increase modestly – by 2.4 percent and 2 percent, respectively. Even Chinese growth in demand is projected at only 0.2 percent, as tax breaks on cars are phased out this year. But sales are expected to increase by 11 percent in India, 15.9 percent in Russia and 12.5 percent in Brazil.
Moody’s projects similar global growth in vehicle sales for 2018. It estimates Western European sales will grow 2 percent this year before slowing to 0.5 percent next year. The exception may be Germany, which Moody’s expects to see above-average growth of about 4 percent in the next year or so as it phases out diesel vehicles. Japan is expected to see a decline in sales this year and low growth in 2019. The ratings company’s projections for China are more optimistic than IHS Markit’s: It anticipates China will have 2 percent growth this year and 2.5 percent in 2019.
Looking ahead, large emerging markets like India, Russia, China and Brazil will be the primary areas of growth for finished vehicle sales. According to a 2017 report by PwC Growth Markets Center, emerging markets will account for over 90 percent of the increase in demand through 2023. In addition, the report projects that emerging markets will produce just over 60 percent of vehicles by 2021, up from about 56 percent in 2017. Focus2move, a firm that tracks global auto trends, also suggests that emerging markets’ share in auto sales is increasing. According to the company, in 2017, car sales grew by 8.7 percent in India, 9.2 percent in Brazil and 11.9 percent in Russia. Though China’s growth rate is comparatively low (2.3 percent), it is the largest market for vehicle sales in the world, so in absolute terms the increase is still significant.
When evaluating Mexico’s potential alternative markets, we considered two factors: countries with promising growth in demand for both finished automobiles and auto parts, and countries that had existing trade agreements with Mexico. (Replacing suppliers for auto parts is more complicated than it is for finished vehicles because production processes in different countries may have different requirements.) In the analysis below, we focus on four emerging markets that show promising growth in this sector, as well as South America, a region with which Mexico has several trade agreements.
Mexico’s exports to India total $3.42 billion, and roughly three-quarters of those exports are oil. Mexico’s auto exports to India consist entirely of parts and accessories. But despite India’s size, its market for auto parts is limited and highly competitive. In 2017, Mexico exported just $56.1 million worth of auto parts to India, compared to $23.1 billion to the United States. India is unlikely, therefore, to replace the U.S. as Mexico’s main market for such goods anytime soon. In fact, India’s total imports of these components were worth just $4.3 billion. Even with vehicle sales expected to increase in India over time, its market is still less than a fifth of Mexico’s total sales to the U.S. In other words, even if Mexico were India’s sole supplier of these goods, it would still be only 20 percent of the value exported to the United States. Indian tariffs on auto components from Mexico are 10 percent – which puts Mexico on par with China, while other suppliers like Japan, South Korea and Thailand have lower tariff rates.
As for finished vehicles, India likely wouldn’t want to increase competition for its own domestic producers by importing cars from Mexico. The automotive industry now accounts for half of all manufacturing activity in India and about 7 percent of GDP. Some 85 percent of the cars produced in India are sold domestically. Mexico, however, is India’s top export destination for finished cars. India may not be interested in buying finished vehicles from Mexico, but it is interested in investing in Mexico’s automotive industry (along with pharmaceuticals and information technology). Even with the questions about NAFTA’s future, India still sees Mexico as a gateway to North, Central and South America, largely because of the many other trade agreements in those regions that Mexico is part of.
Bilateral trade between Russia and Mexico is quite low. Prior to the past couple of years, little effort was made to encourage trade between these two countries. Mexico’s National Association of Importers and Exporters opened an office in Moscow only this year. But now, both governments have their own reasons to want to boost trade with each other – Mexico wants to diversify its export markets as the U.S. trade war heats up, and Russia wants to revive its auto industry, which started declining a decade ago, and encourage economic growth after a recent recession.
Prior to the 2008 financial crisis, Russia was the second-largest car market in Europe. But after the crash, car sales slumped. There was a slight rebound in 2012, but it was short-lived. The steep drop in oil prices in 2014 exacerbated the problem, as the economy took a major hit and sales continued to decline through 2016. (Russia’s dependence on oil, a commodity whose price it can’t control, is another reason Moscow wants to increase production of value-added goods like automobiles.) It wasn’t until last year that Russian car sales and production began to finally show signs of recovery, along with the rest of the economy. In fact, the prolonged period of decline is one reason Russia has potential for growth in sales and production in the near and medium term.
Russia imported $255.6 million worth of goods, including $77.67 million auto sector goods, from Mexico last year. These imports consisted primarily of finished vehicles designed for the transport of people ($76.85 million) and parts and accessories ($823,000). Tariffs are only 1.65 percent on auto parts from Mexico but 16.52 percent on finished vehicles. But again, the question is, could Russia be a viable alternative to the U.S. market? Russia imported a total of $7.9 billion in parts in 2017, which is about a third the amount imported by the United States. Imports of finished vehicles totaled $6.7 billion, which is only about 23 percent of the U.S. market. But Russia, which has been the target of U.S. sanctions in recent years, also has political reasons to want to decrease its imports from the United States. For Mexico, Russia might not be able to replace the U.S. completely, but it has ample room for growth in sales.
The size of the Chinese market makes it an attractive alternative destination for Mexican exports. Since 2009, China has been the largest purchaser of finished vehicles in the world, buying up 28.2 million units in 2017. (The U.S. ranked second at 17.2 million units.) Over the past couple of years, Mexico and China have worked to increase bilateral trade, which totaled $80.86 billion in 2017, up 7.9 percent from the previous year. This figure is projected to rise to $90 billion in 2018. Mexico and China have expressed interest in signing a free trade agreement, and with both caught in the crosshairs of the U.S. trade war, they now have even more motivation to do so.
Though China imported an impressive $79.2 billion worth of vehicles and automotive parts in 2017, Mexico supplied only $1.24 billion worth of these goods. Germany is China’s top supplier, accounting for 27 percent of these goods, while Japan came in second at 21 percent and the U.S. third at 19 percent. The U.S. sold $12.7 billion worth of finished vehicles to China and $1.8 billion worth of parts. Meanwhile, Mexico exported only $826.66 million worth of finished cars and $413 million worth of parts to China last year. Mexico would not be able to take over the Chinese market completely, but it certainly has room to increase its sales there, particularly in finished cars. Mexico also stands to benefit from increased Chinese investment in Mexico’s auto industry. This year, the Beijing Automotive Industry Corp. announced plans to build its first factory in Mexico, with construction slated to begin in 2020. The company wanted a production facility closer to its supply base and to avoid paying tariffs on supplies.
China is protective of its domestic market and producers but has become more flexible in the auto industry due to its desire to increase foreign investment and mitigate the effects of the trade war. In July, the Chinese Finance Ministry reduced import duties on passenger cars from 25 percent to 15 percent. Similarly, auto part duties that ranged from 8 percent to 25 percent were reduced to 6 percent. The government also announced plans to ease restrictions on foreign investments in China. There are also plans to reduce the amount of local content required in Chinese-produced vehicles, which currently stands at 50 percent. This could open the door for Mexico, which produces higher-quality parts and input materials than China at competitive prices.
Brazil and Mexico have long-established trade frameworks. Both countries are part of the Latin American Integration Association, which provides a flexible framework for the development of economic agreements between member countries. Specifically, members can use the Economic Complementation Agreement mechanism to establish import quotas for certain goods with reduced tariffs. These agreements can eventually evolve into formal free trade agreements between two countries. Mexico and Brazil are currently using this mechanism to try to establish duty-free trade in the auto sector.
Nonetheless, trade between the two countries is relatively small. Brazil imports only $3.68 billion worth of goods from Mexico, of which about a quarter is related to the auto industry ($788 million worth of finished vehicles and $616.9 million worth of auto parts). This accounts for about 12 percent of Brazil’s auto imports, which totaled $11.2 billion in 2017. Only Argentina exported more auto goods to Brazil – about $3.7 billion worth. Argentina and Brazil have a complicated trade relationship, particularly in the auto sector, which has led to trade disputes in the past. Mexico wouldn’t want to undermine their relationship because it could disrupt trade for the region, but it does have an opportunity to increase its market share in Brazil. Mexico’s strategy includes trade agreements that encourage integrated production models and purchases of other goods from Brazil such as grains to balance Mexican auto sales. This would help Mexico diversify not only its automotive exports but also its grain imports, which largely come from the U.S.
South American markets are small but they’re growing, and to Mexico’s advantage, it already has trade agreements with many of them. Some of the fastest growing markets in terms of vehicle sales last year were Argentina (28.7 percent), Chile (17.9 percent) and Ecuador (61.7 percent). Mexico has a free trade agreement with Chile and Economic Complementation Agreements with Argentina and Ecuador. The Mexican auto industry has also promoted the idea of diversifying exports by looking to members of the Pacific Alliance, a trade bloc formed in 2011 by Chile, Colombia, Mexico and Peru. All members have bilateral free trade agreements with one another and have already eliminated tariffs on 92 percent of goods traded within the bloc. The Pacific Alliance also wants to become more active in global markets, particularly in East Asia, as reflected in efforts to strike a deal through the Comprehensive and Progressive Agreement for Trans-Pacific Partnership.
Barriers to Diversification
In its efforts to decrease its dependence on the U.S. market, Mexico will face many challenges. First, the United States is the world’s largest economy, and it’ll be difficult to replace it with any other market. With the potential exception of China, none of the major emerging economies identified here can on their own consume as much as the U.S. Mexico, therefore, must pursue multiple markets at the same time, which is actually a good strategy considering that it wants to diversify its trade relations. Russia and China – both of which have had their share of problems with Washington recently – may be particularly motivated to do business with Mexico.
Second, these large markets all have their own burgeoning auto industries, and imports are in direct competition with domestically produced goods. (This is more a concern for finished vehicles than for auto parts, since imported parts can be used by domestic producers and don’t necessarily limit sales of domestically made cars.) Governments often protect domestic industries by putting up trade barriers such as tariffs that increase the price of imported goods, making them more expensive and thus less competitive.
Then there’s the issue of time. Major shifts in a country’s export markets don’t happen overnight, yet Mexico could see new U.S. tariffs on the auto sector soon. Plus, to remain competitive, Mexico will need to continue to attract multinational firms that can produce goods at low prices. This will be more difficult as its access to the U.S. market becomes more uncertain. (This is, after all, one of Mexico’s biggest selling points.) But regardless of what happens in the NAFTA talks, or whether the U.S. government decides to impose new tariffs, Mexico knows it needs to diversify its trade partners. It’s a question of when, not if.