Is the Magic Starting to Fade for Manufacturing in Mexico?

Rivals threaten the country's appeal as a high-tech hub

It's not quite Silicon Valley, but it's as close as you'll get in Mexico. Over the past 25 years, dozens of technology companies, including IBM (IBM ) and Hewlett-Packard Co. (HWP ), have flocked to Guadalajara, in the central state of Jalisco. They were joined in the 1990s by huge contract manufacturers, such as Flextronics (FLEX ), Solectron (SLR ), and SCI Systems (SCI ). Those companies built factories to churn out everything from laptops to Palm Pilots and cellular phones, plus all manner of electronics components. The city's attractions: its proximity to the U.S. and its abundance of cheap labor.

But Guadalajara's appeal as a high-tech hub is losing some of its luster. Local electronics exports, which totaled $10.4 billion in 2000, were down more than 16% in the first quarter. And the industry shed some 15,000 jobs in the first half of the year--a figure equal to almost 20% of the electronics workforce. Many of the layoffs are due to the slowdown in the U.S., the main market for Mexican exports. More worrisome, though, is the fact that high-tech companies have begun shifting production of such price-sensitive products as printed circuit boards and low-end printers from Mexico to China and Malaysia.

What have these countries got that Mexico doesn't? Plenty, it turns out: wages as low as 60 cents an hour, tax incentives, better infrastructure, and less red tape. Flextronics, which pays its Mexican workers two to three times what its Chinese workers make, already makes most of its low-margin items, such as cellular phones and computer mouses, in China. Other contract manufacturers are moving that kind of work to Asia. "I'm an absolute believer in this country, but anything that is really price-sensitive is considering moving, lock, stock, and barrel to Asia," says Charles N. Parks, executive vice-president for Latin America at SCI Systems Inc., which employs 10,000 workers in Guadalajara.

Wait a minute. Isn't there something wrong with this picture? It's certainly not the image Mexico boosters like to paint. They depict an economy that has grown 28% in the past seven years, thanks in large part to the North American Free Trade Agreement, which is eliminating all tariffs on trade between Mexico, the U.S., and Canada. Since the agreement has been in effect, Mexico's exports have tripled, to $166.4 billion, and foreign investment has tallied $85 billion. Many in Mexican government and business circles are confident that NAFTA, along with a decade's worth of economic reforms, is enough to ensure the country's future success.

Yet Mexico may be reaching its day of reckoning. The country has long suffered from problems of its own making--poor schools, rampant corruption, and outmoded infrastructure, just to name a few. Multinationals put up with these shortcomings because of the potent combination of free trade, proximity to the U.S. market, and low wages.

PESO PROBLEM. But for some companies, that trade-off is no longer looking like such a good deal. Although they fell sharply in the wake of the 1994 peso devaluation, wages in Mexico have been rising faster than inflation for the past two years. Wage increases for union labor have averaged 10.4% so far this year, four full points ahead of the expected inflation rate. And since the peso has strengthened almost 5% against the dollar since January, Mexico-based exporters are seeing local production costs increase. To make matters worse, China is about to enter the World Trade Organization, which will confer new trade benefits on manufacturers there. China isn't the only threat. From Southeast Asia to Eastern Europe, other nations are aggressively courting multinationals with tax breaks and other incentives.

All those factors threaten Mexico's manufacturing base. "I'm very worried," says Luis Berrondo, who heads Grupo Mabe, a Mexican appliance manufacturer that is 48%-owned by General Electric Co. "Mexico has become an important manufacturing center with a big number of foreign companies setting up operations, but I have my doubts that this will continue." Mind you, Mabe isn't hurting: The company, which is aiming for $2 billion in sales this year, churns out all of the gas ranges and most of the electric stoves GE sells in the U.S., as well as side-by-side refrigerators. Yet a year ago, GE transferred production of low-margin minibar fridges to China.

The single most important thing Mexico can do to boost its own competitiveness is to upgrade the skills of its labor force. "Mexico has been very successful up to now," says Jeffrey D. Sachs, director of the Center for International Development at Harvard University. "But many countries get stuck at this stage of development, and there's no guarantee that Mexico can get beyond it." Indeed, in the annual Global Competitiveness Report that Sachs and his associates at Harvard compile, Mexico ranks a lowly 42 out of the 58 countries surveyed. Mexico also lags behind most other nations in areas such as math and science education. Mexican President Vicente Fox has promised to boost public spending on education from 5% of gross domestic product to 8% by the end of his six-year term. Still, it could take as long as a generation for Mexico to see any real improvements.

BUREAUCRACY BOG. Education isn't the only area where Mexico comes up short. Companies must contend with deficient infrastructure: Telephone penetration is among the lowest in Latin America. The judicial system is prone to corruption, and the bureaucracy is cumbersome. Even government officials acknowledge it takes on average 112 days to set up a new business in Mexico, compared with just one day in Canada.

Some influential Mexicans are starting to sound the alarm. "It's one thing to compare the Mexico of today with the Mexico of 1990," says Rogelio Ramírez de la O, an economic consultant to several major multinationals. "But if you compare its advances in productiv-ity and competitiveness relative to China and Singapore, Mexico's achievements are really nothing to write home about." Manufacturing productivity grew at an average of 6% a year in the 1990s, thanks largely to the privatization and deregulation of large swaths of the economy. But that growth slowed to just 1.8% in 2000 and by March of this year was down to zero, according to José Manuel Suárez Mier, an economist affiliated with the Center of Investigation for Development, a Mexico City think-tank.

Without another round of structural reforms, companies may find it increasingly hard to squeeze productivity gains out of their Mexican factories. The tire industry is on the verge of extinction because of inflexible labor contracts that make production costs at least 30% higher than in the U.S. or Europe, industry executives say. Over the past nine months, Michelin and Goodyear Tire & Rubber Co. have shut down their Mexican tire plants, laying off 2,800 workers. In July, Bridgestone/Firestone Inc. persuaded its workers to accept pay cuts to avoid shutting down its Mexico City truck tire plant.

Mexico's garment industry is also being squeezed. Under NAFTA, garment exports grew fivefold, with Mexico overtaking China to become the top clothing supplier to the U.S. But with the strong peso and reduced U.S. demand, many operations are transferring production to China and the Caribbean, eliminating around 22,000 Mexican jobs so far this year. As unskilled Mexican workers become more expensive in comparison with the Chinese, it's harder to overlook their inefficiencies. "The idea that this country is a haven of cheap labor is a fallacy," says Victor M. Herrera, head of Standard & Poor's in Mexico. "If you look at absenteeism, quality, and returns, it really hurts."

BASIC MATH. Big companies must often invest in intensive training for Mexican workers, who average fewer than seven years of schooling, compared with about 10 for Koreans and Poles. At Mabe's new refrigerator plant in Celaya, new hires--mostly young women from the countryside--are put through eight weeks of training that covers topics such as proper hygiene in addition to basic math. The state government covers half of the cost of the training program--which averages $350 per worker--but it's up to Mabe to design and administer it. Small Mexican companies don't have the resources to offer such training.

Mexico has long refused to offer tax breaks and other incentives to foreign investors to compensate for the varying quality of its workforce. The government argues that the country's location next door to the world's biggest consumer market makes such inducements unnecessary. Yet countries such as Malaysia and Singapore charge next to nothing in corporate taxes on electronics assembly, while China and Ireland levy very low rates of around 10% to 15%. Mexico's tax is 34%. "We've been working with the government to achieve a more competitive fiscal policy, but they give absolutely nothing," complains Jaime Reyes, general manager of Hewlett-Packard's Guadalajara site and head of the western chapter of the National Association of the Electronics, Telecommunications, & Informatics Industry.

Jaime Parada, who heads the government's National Council on Science & Technology, is lobbying for new tax breaks to encourage companies to spend more on research and development. Today, Mexican government and business together spend just 0.33% of gross domestic product on R&D, compared with Korea's 2.8%. Parada would like to see R&D spending more than double. Only a dozen companies maintain R&D centers in Mexico, and most of them are foreign-run. "Mexico should be known for more than just low wages and maquiladoras," Parada says.

Some top Mexican officials are keenly aware that the country is at a crossroads. Says Eduardo Sojo, Fox's chief economic strategist, "We have to identify the niches that allow us to stand apart from the other emerging market countries." In some cases, that may mean watching some industries wither while nurturing others with more promise. That's already happening in the state of Guanajuato, home to some 1,000 shoemakers, from Mom and Pop outfits to sophisticated large-scale operations. The industry is rapidly losing market share, both at home and abroad, to rivals in China and Brazil.

So Guanajuato officials now are working with business to lay the foundations for a new industry. At the center of this effort is GMatrix, a Mexican software design outfit that boasts KPMG and Compaq Computer among its clients. The three-year-old company, with just $1 million in 2000 sales, caught Fox's eye when he was governor of Guanajuato. He asked its founder, Massachusetts Institute of Technology-trained engineer Roberto Solis, to help set up seven other software companies. With $700,000 in annual state funding and help from Microsoft Corp., 12 universities are training 1,000 software design engineers a year. Now, Fox wants to create software clusters in other Mexican states. "If we work with more than 100 universities, within two years we could be graduating 10,000 software developers a year," Solis says.

Yet India already graduates 37,000 software engineers each year and exports some $6 billion annually in software. It's hard to see how Solis can hope to play catch-up. Then again, Mexico needs ambitious goals if it is to prevail in the contest of nations.

By Geri Smith in Mexico City

    Before it's here, it's on the Bloomberg Terminal.