Strong fundamentals in Mexico allow manufacturing sector to grow despite challenges

In 2016, as many other sectors of the economy experienced a slowdown, the Mexican manufacturing sector achieved annual growth of 1.3%. Since the enactment of the North American Free Trade Agreement (NAFTA) in 1994, the country has cemented itself as one of the world’s industrial powerhouses, providing parts and products for a range of industries, from food and beverages to automotive and aerospace. Accounting for 16.8% of GDP, the manufacturing sector is the largest contributor to the national economy, according to the National Institute of Statistics and Geography (Instituto Nacional de Estadística y Geografía, INEGI).

In recent years, a concerted effort by the government and the private sector to attract top manufacturing firms and train the country’s workforce has seen Mexican production move up the value chain and become increasingly crucial as a supplier for North American firms. Manufactured goods now account for nearly 90% of Mexican export earnings. Given the sector’s economic weight, the November 2016 election of US President Donald Trump has created a shadow of uncertainty over the Mexican economy. However, such is the dependence of US industry on Mexican imports that drastic measures look unlikely. Additionally, Mexico is one of the world’s most open economies and continues to build ties with a wide variety of global markets.

The Mexican Edge

Not long after the signing of NAFTA, it seemed that Mexican industry was going to lose out to a distant competitor. The opening of the Chinese economy during the 1990s and first decade of the 21st century offered manufacturers the chance to outsource production to the Asian economy at bargain labour costs. In 2003 Mexican manufacturing wages were 188% higher than those of China, according to data from Bank of America Merrill Lynch. However, more than a decade of rapid economic growth in China has seen earnings rise in tandem. Meanwhile, Mexico’s minimum wage has grown modestly to MXN80 ($4.82) per day, but the depreciation of the Mexican peso means that 2016 manufacturing wages in dollar terms were roughly where they were in 2003, making Mexican labour 40% cheaper than its Chinese equivalent as of January 2016, according to media reports.

For Hire

The attractiveness of labour markets rests on more than hourly wages, however. Under former President Felipe Calderón, who envisaged Mexico as a country of engineers, the number of engineering graduates tripled to 71,300 between 2008 and 2012, during which time 120 higher education institutions dedicated to science and engineering were inaugurated, according to a September 2016 report by industry media. This growth in engineering graduates was the highest registered across OECD countries during the period and placed Mexico among the top-five major economies by percentage of total university students studying engineering at 26%, according to a September 2016 report by the Royal Academy of Engineering. Benefits have also accrued to the private sector. “The country has an incredibly talented pool of engineers, especially women, who represent over 50% of employees at many levels of certain companies,” Raúl Baz y Harvill, director-general of Grupo Petroquímico Beta, told OBG. “Overall, Mexico has the talent, but it has to be developed and nurtured to meet the economic needs of the country, which is undoubtedly a shared responsibility among government, industry and academia.”

The availability of qualified workers has allowed Mexican manufacturers to move up the value chain. “The country’s industrial sector has proven to be resilient and capable of attracting some of the largest global players,” Mauricio Toache, director-general of electrical and engineering solutions provider SEL, told OBG. “Future growth in the automotive, aerospace and energy industries will be fuelled by a high level of human capital available in the country of talented and creative engineers and technicians. Further gains in labour productivity will enhance the country’s image as an attractive centre for advanced manufacturing.”

The influx of leading international firms has also had a positive effect on labour productivity. A 2014 report by consultancy McKinsey found that productivity – measured as average hourly output per worker – had increased at an average rate of 5.8% per year at large, modern Mexican companies since 1999, although a fall in productivity at smaller firms tended to obscure these improvements in overall productivity. However, the push to boost engineering graduates has left gaps in other segments that government education policy is now looking to fill. “Mexico lacks qualified mid-level technicians, making it crucial to build a stronger relationship between the private and public sector,” Francisco Santini Ramos, director-general of automotive parts supplier Ripipsa, told OBG. “It is important to build links with universities in order to develop centres where technical training meets theoretical learning.”

Mexico Libre

In addition to inexpensive and qualified labour, a major attraction for firms eyeing Mexico as a manufacturing hub is the country’s open trade policy. Mexico is a signatory to 12 free trade agreements (FTAs) with a total of 46 countries. “Mexico’s FTAs enable companies in the sector involved in manufacturing to import the necessary inputs, enter new markets and sell locally made products,” Christian Romeroll, director-general of air-conditioning manufacturer Daikin, told OBG. “The treaty with the EU and NAFTA are of particular importance to companies in the value-added chain that require advanced components to complete their manufacturing process in Mexico.”

In 2015 the country exported a total of $380.6bn in goods and services, up from $214.2bn a decade earlier, placing it just outside the world’s top-10 exporting nations. The US is by far its largest trading partner, accounting for around 80% of Mexican exports, or $294.15bn in 2016, according to figures from US Census Bureau, and $230.96bn worth of imports. Canada, the other member of NAFTA, is the second-largest market for Mexican goods, receiving $10.55bn in exports in 2015, according to World Bank figures. The primacy of NAFTA has been the basis of the development of Mexico’s maquiladoras, or relatively low-value-added assembly plants in border areas. These plants began as a government-backed, cross-border manufacturing programme in the northern states, but have since been adopted as a model across the country.

Mexico also has FTAs with major economies such as the EU and Japan, as well as many of its regional neighbours. Along with Chile, Colombia and Peru, Mexico is part of the Pacific Alliance, a Latin American trading bloc that has ambitions to become as significant as the Southern Common Market, known by its Spanish acronym Mercosur, with discussions about potential integration between the two blocs already on the table. The country is also a member of the Trans-Pacific Partnership, although the future of this agreement among a dozen states is in jeopardy following President Trump’s January 2017 decision not to ratify the treaty.

Mexico was the best performing Latin American country in the World Bank’s ease of doing business index in 2017, ranking 47th out of 190 countries. It ranked 61st for trading across borders, 40th for enforcing contracts and fifth for access to credit, creating an attractive environment for manufacturers. “Mexico has been committed to making ease of doing business a priority,” Bernd Schreiber, director-general of industrial control and automation firm Festo México, told OBG. “Better regulations and fast-track Customs processes make investment in the country more attractive.”

Clusters

A third major advantage for manufacturers, and one that is increasingly important, is the development of major industry clusters across Mexico. Around many original equipment manufacturers (OEMs), numerous supply and support industries have sprung up, often backed by state government incentives, cutting transport and logistics costs, and incubating knowledge transfer between firms. “Mexico benefits from the experience of multinational companies operating in the country,” said Toache. “In terms of certifications and quality of processes, these firms often have advanced quality control mechanisms and mature management structures. This knowledge can be passed on to local companies.”

The automotive segment was one of the first to develop a vibrant cluster culture, initially in the northern states but then spreading to states such as San Luis Potosí (see analysis). The aerospace industry has at least four major clusters, with the largest in Querétaro, thanks in part to the growth of a university focused on aeronautical engineering. Baja California and Jalisco – home to Guadalajara, which is called the Mexican Silicon Valley – have also become centres for software and IT development. Clusters have also exposed local firms to the importance of gaining international certifications for their products. “Quality, safety and performance certifications allow Mexico to demonstrate the high level of work that can be done in the country,” Hermann Saenger, managing director of certification and consultancy firm SGS México, told OBG. “Foreign investment and trade continues to increase, with more and more companies in Mexico achieving the highest levels of certification in their respective industries.”

In 2016 the government published a map of the country’s industrial clusters on INEGI’s website. It made evident the need to expand clusters to more areas of the country, particularly in the south. Frédéric Garcia, president of the Executive Council of Global Companies, told OBG, “Clearly, there are two Mexicos, with the north and the south exhibiting hugely different growth rates. However, with adequate investment in infrastructure, in education, in rule of law and the implementation of special economic zones in these poorer areas, there is a possibility this development gap will start to close.”

Steel

In 2016 increased low-cost imports of Chinese steel, brought about by an oversupply in China’s domestic market, continued to impact Mexican steelmakers. The country is the second-largest steel producer in Latin America, behind Brazil, producing 18.3m tonnes in 2015, a 3.7% decrease from the previous year, according to figures from the International Trade Administration at the US Department of Commerce. However, total apparent steel consumption increased by 7% in 2015 and imports rose by 9.4% to 9.9m tonnes, meaning that by 2015 local production met just 62.5% of domestic demand, compared to 65.7% in 2014. However, in the first half of 2016 Mexican imports slowed somewhat. Between January and June 2016, 4.7m tonnes were imported, which was a 4% year-on-year (y-o-y) decrease. The sector remains very sensitive to the weakening peso. “One of the main concerns in the sector is the continued depreciation of the peso, which would begin to push up the price of steel in Mexico,” Juan Pedro Martín Navarro Cota, CEO of Grupo Ameristeel, told OBG. “Increasing exports can alleviate some of these concerns by diversifying revenue streams.” This sentiment was echoed by José Antonio García, CEO of Si Vale, who told OBG, “Due to the high volatility of the peso, companies importing raw materials from the US are seeing their costs significantly increase, which clearly impacts their competitiveness.”

Looking Up

Following a production record of 4.65m tonnes of steel in 2016, Altos Hornos de México has announced plans to invest $1bn in 2017 and 2018 in the construction of processing plants in Coahuila and Durango states to increase its production of special steel for the automotive industry from 150,000 to 400,000 tonnes per annum (tpa). Media also reported in January 2017 that Japan’s second-largest steelmaker, JFE Holdings, will move ahead with plans to build, in partnership with US firm Nucor, a 400,000-tpa galvanised sheet steel factory in Mexico for an estimated $270m. Company officials confirmed that the project would proceed despite doubts over US trade policy, with completion expected in 2019. According to a 2016 research report by BMI Research, Mexican steel production is on track to grow by 9.3% annually between 2017 and 2020, the fastest rate in the Americas.

Cement

Both steel and cement producers have benefitted from the continued strength of the Mexican construction sector, which expanded by 1.8% in 2016, according to INEGI. In 2015 the country produced 44.9m tonnes of cement. The market leader is local firm CEMEX, which holds an estimated 50% market share, with the rest split among Grupo Cementos de Chihuahua, Cementos y Concretos Moctezuma, LafargeHolcim, Cruz Azul, Holcim-Apasco and Cementos Fortaleza.

Food & Beverage

Mexico’s food segment grew by 2.6% in 2016, while the drinks and tobacco industries expanded by 5.3%, according to INEGI. In a May 2016 report, US investment bank US Seale & Associates reported that the packaged food industry, which registered total sales of MXN802bn ($48.3bn) in 2015, is expected to grow at a compound annual growth rate (CAGR) of 3.3% through to 2020, when it will reach sales of MXN909bn ($54.8bn). While the packaged food segment is exceptionally diverse, with Grupo Bimbo, the market leader, holding just 12% of the market, the non-alcoholic beverage industry is more consolidated. The three largest players, Coca-Cola, Danone and PepsiCo, hold a combined 41% of the market. With 2015 sales totalling MXN559bn ($33.7bn), the beverage market is forecast to grow at a 4.1% CAGR through to 2020 to MXN650bn ($39.2bn).

High Spirits

Home to globally recognised brands of beers, tequila and mezcal, the Mexican alcoholic drinks market was valued at $35.7bn in 2015. The beer market accounts for the majority of sales and has traditionally been dominated by two local players now under foreign ownership: Grupo Modelo, which produces the Corona, Modelo and Pacifico brands, and was bought by Belgium’s Anheuser-Busch InBev Group for $20.1bn in 2013; and Cuauhtémoc-Moctezuma, whose brands include Sol, Dos Equis and Tecate, and was purchased by Heineken in 2010. Constellation Brands, the beer importer and distributor of a range of Mexican brands in the US, including Modelo and Corona, announced in January 2016 that it was building a new brewery in Mexicali at a cost of $1.5bn. Scheduled to begin production at a rate of 500m litres by the end of 2019, the facility will produce Mexican beers for the Californian market. Production will be ramped up to 1bn litres, with the possibility to expand to 2bn litres in the future.

The Mexican spirits industry continues to post strong growth, particularly in the luxury segment. According to IWSR, a leading provider of data on the alcoholic beverages market, in 2014 tequila sales in Mexico totalled $1.14bn; however, between 2010 and 2014 sales of standard and value tequilas grew at a rate of 1.7% and 2.8%, respectively, while sales of super- and ultra-premium brands rose by 8.4% and 46.5%, respectively. In March 2015 UK drinks maker Diageo bought Tequila Don Julio, one of the leading brands in premium tequila, and pledged to invest $400m in expanding production facilities. “The liquor sector in Mexico is currently characterised by an increasing appreciation for premium products,” Carlos Álvarez, managing director of Bacardi México, told OBG. “Therefore, the trend is towards an increased non-price competitiveness based on vigorous marketing campaigns,” he added.

However, the food and beverage segment faces a number of challenges regarding taxation and the informal market. Mexico, along with South Korea and Chile, are the only OECD countries that utilise an ad valorem taxation system for alcoholic drinks, which levies alcoholic drinks on the basis of price rather than alcohol content. As a result, spirits are taxed at 53% of price and beer at 26%. With such high rates, incentives for untaxed, black market spirits are high, and Euromonitor International estimates that 43% of spirits consumed in the country are illegal. “The liquor industry is threatened by an informal market that does not pay taxes and resells products at a lower price,” said Álvarez. “With the sector being heavily taxed by the Special Tax on Production and Services at a rate of 53%, it becomes difficult for brands to compete. It is in the best interest of the government to drive forward reforms in order to eliminate illegal liquor trafficking and thus increase tax collection.”

Plastics Production

Across Latin America, underinvestment in the petrochemicals industry and delays in planned projects have led to a regional polyethylene deficit of 1.5m tpa by 2015, according to a November 2016 report titled “Latin America’s Petrochemical Dilemma” by S&P Global Platts. That deficit is expected to grow to 2m tpa by 2025. However, Mexico broke the trend in 2016 by inaugurating the Etileno XXI project, a 1.05m-tpa ethylene cracker built in the state of Veracruz by Brazilian company Braskem and Mexico’s Grupo Idesa (see analysis). The success of the project was due in no small part to the decision to allow private enterprise to buy long-term feedstock contracts from state energy company Petróleos Mexicanos (Pemex). Nevertheless, there is a push in the plastics industry to do more to liberalise the segment.

The availability of cheap, locally produced feedstock will be a boon to the country’s plastics manufacturers. In 2016 the Mexican plastics and rubber industry grew by 3.2%, according to INEGI figures. Over 4000 companies, two-thirds of which are micro-firms or small and medium-sized enterprises (SMEs), make up the Mexican plastics industry and are often located in states with clusters for automotive, aerospace or electronics industries. Approximately 40% of plastics production is exported directly. According to World Bank data, in 2015 Mexico exported $10.93bn worth of plastics and rubber goods, $8.35bn of which was sent to the US. However, imports of plastics for the same year reached $28.93bn, with the US providing $18.57bn, meaning Mexico’s plastics deficit with the US was more than $10bn. As with many other Mexican industries, the fortunes of plastics are tied to market movements north of the border. “Business opportunities to manufacture products in Mexico are linked to how much installed capacity there is in the US for the same products,” Carlos Sierra Von Roehrich, director-general of Japanese chemicals and plastics manufacturer Kuraray México, told OBG. “When installed capacity for a specific process is fully utilised in the US, Mexico will be an attractive location for new investments.”

Chemicals Sector

The Mexican chemicals industry, in contrast, posted a weak performance in 2016, declining by 2.8%, following a 16% drop in 2015, according to INEGI figures. As with the plastics industry, one of the principle challenges facing chemical firms in Mexico is access to Pemex feedstock. “Mexico’s challenge is that its internal capacity to supply many chemicals is not enough to satisfy local demand,” Roberto Bischoff, former CEO of Braskem-Idesa, told OBG. “It is an importer of all four families of ethylene derivatives: glycols, polyethylene, vinyl and polystyrene. The market is growing at 4% y-o-y – the precise reason why investments in large projects, such as Etileno XXI, are needed.”

In recent years domestic chemical companies have focused on international acquisitions. Mexichem, the country’s largest chemicals firm, invested over $2bn in the US between 2011 and 2016, and in November 2016 it purchased Compounds Holdings, a UK-based vinyl producer with annual sales of $40m. The next biggest Mexican chemical company, Alpek, also made international acquisitions in 2016, buying up Petroleo Brasileiro’s stake in two polyester plants in Brazil, increasing its polyester production capacity by 30%. Meanwhile, foreign firms continue to find niches for chemical production in Mexico. In September 2016 US firm Chemours, a spin-off from DuPont, inaugurated a 200,000-tpa titanium dioxide production line at its Altamira plant in the state of Tamaulipas. Indeed, the development of the Etileno XXI project – along with the downstream industries it is expected to foster – looks set to have a transformative effect on the Mexican chemicals and plastics industry. “The petrochemicals industry is a truly globalised industry, as polyethylenes are easily tradeable across the world,” said Bischoff. “In the long term Mexico should, at some point, be exporting to the US, Europe, Central and South America. In spite of this relevant export market for polythene, the primary focus in the short to medium term should be on addressing the domestic Mexican market.”

Strength To Change

While Mexico’s many strategic advantages helped manufacturing achieve healthy growth in 2016, industrialists face some challenges in the coming years, though some solutions are within their control. Poor connectivity between cities and regions adds extra costs to firms working in production chains that require products from outside their cluster. In the World Economic Forum’s “Global Competitiveness Report 2016-17”, Mexico ranked 51st overall out of 138 economies. The country’s infrastructure rankings, such as 58th for quality of roads, 59th on quality of railroad infrastructure and 57th for quality of port infrastructure, are below the overall score and have trended downward in recent years. “Clearing Customs in Mexico has become a fast and easy process for most companies,” Von Roehrich told OBG. “Nonetheless, the country’s infrastructure, and in particular its highways, need significant investment to facilitate trade and commerce in the country.” Recently, the Mexican government has embarked on a policy of building and modernising 133,000 km of highways, 27,000 km of railways and 68 container ports.

Another shortfall of the current Mexican cluster system is that, while well represented with OEMs and tier-1 and 2 companies, the development of tier-3 suppliers has been slow. One key problem is access to finance for those firms that spot a niche in the market and need capital to set up shop. “Even though financing opportunities for SMEs are improving, it is still difficult to get a loan from private financial institutions,” Santini told OBG. “Moreover, the lack of trust towards banks leads companies to find alternate sources of funding.”

Given the high energy consumption of manufacturing jobs, electricity prices are also a major factor in investment decisions. The liberalisation of the Mexican energy market has deepened price differentials between regions. According to the US Energy Information Administration, wholesale energy prices in Tijuana averaged $23 per MWh in the first six months of 2016, but rose to over $60 per MWh in the Yucatán and southern Baja California peninsulas. “Despite government efforts to bring down prices, energy costs remain high in Mexico,” said Romeroll. “Prices are not competitive compared to other Latin American markets, forcing industries to absorb significant costs and increasing the attractiveness of energy-efficient products.” Ricardo Cardiel, director-general of metal services firm Latin American Rainmakers, added that this could lead to uptake of green power. “Mexico is still an emerging country, so green energy is not a top priority for many companies or individuals. That being said, costs are declining every few months, which bodes well for the future of green energy in the country,” he told OBG.

Industrial Estates

An important segment in industry involves the construction and operation of industrial parks. To some extent the parks are a logical development of a long historical process of economic integration between the US and Mexico, evolving from the maquiladora industry that was developed in the 1960s to more sophisticated, higher-value-added areas such as automobiles, pharmaceuticals, electronics, aerospace and medical equipment, among others.

Catering to the needs of this near-shoring industrial property sector, the Mexican Association of Industrial Parks (Asociación Mexicana de Parques Industriales, AMPIP) was set up in 1986 and now represents 56 corporate members that manage over 250 industrial parks, renting some 20m sq metres of space to 2500 domestic and foreign companies, and directly employing 1.7m people. Claudia Avila, executive director of AMPIP, told OBG that her members offer international firms a kind of plug-and-play service, where they can start up local operations efficiently and rapidly. Parks offer attractive locations with close links to freight transport terminals, pre-connected utilities, and class-A industrial space.

Parks are designed to meet manufacturers’ need to be located in a cluster with key suppliers. A major automobile company, for example, will want to purpose-build its own main assembly plant, but it is likely to do so adjoining, or actually inside of, an industrial park. This then allows it to be surrounded by component suppliers who rent factory space so they can operate a just-in-sequence production model, which minimises warehousing costs. Tier-1 companies deliver entire component parts to the main assembly plant, such as engines or car seats, while tier-2 suppliers deliver smaller components to tier-1 plants, and so on.

On The Rise

Industrial parks have grown at a steady and sustained rate, in step with near-shoring. Suppliers of industrial park space include four types of organisations: private sector property developers; Mexican and international property funds, which often buy a stake in individual units; state governments; and a local version of real estate investment trusts. More than 50% of AMPIP’s membership is composed of private developers. While the involvement of state governments was initially seen as unfair competition, motivated by a desire to attract employment, states began to offer free factory space to foreign firms, often with insufficient basic services. However, AMPIP turned state governments into business partners by working to convince them of the need for basic quality levels.

One of the key questions facing the sector is whether demand for factory space will slow. As of early 2017 developers had committed $7bn worth of investment in new parks for 2017-18. The pipeline of prospective clients remained intact, although some were waiting to assess the market. Future growth in the industrial park sector will depend in part on whether any tariffs are applied to US-Mexico trade and the level at which they are fixed. If NAFTA is renegotiated, the process would take some time, up to four years, but stakeholders business believe companies will be able to adapt.

Policy Shifts

While government and industry can work to rectify internal inefficiencies, they have limited influence over a key external factor: US trade policy. President Donald Trump has criticised NAFTA and a renegotiation of the treaty is possible. In this respect there are positive signs. In the weeks following Trump’s election, President Enrique Peña Nieto brought together an advisory team comprising private sector figures from the country’s major industries. Given the harmful effects the annulment of NAFTA would have on both economies, one possible scenario is a renegotiation of some of the treaty’s finer points. “There are some areas of NAFTA, such as the digital economy, that were not adequately addressed in the original treaty,” Carlos Noriega Arias, president of the education commission for the Confederation of Industrial Chambers, told OBG. “Another area of potential compromise is over terms of transport. Renegotiation does not frighten Mexico; we believe that we can strengthen NAFTA against the real threat to North American jobs: China.”

Outlook

While the near-term outlook for manufacturing remains uncertain, its success over the last 20 years demonstrates an ability to navigate the changing tides of global trade. Since the introduction of NAFTA, the government and private sector have successfully developed globally competitive clusters across a range of industries and moved into added-value products. While manufacturing has become the most important pillar of the economy, energy reforms have also created opportunities for heavy industry. Whether through a refocus on the domestic market or a diversification of export destinations, Mexican industry has preserved the fundamentals on which it can continue to prosper.