Mexico - Economic Briefing November 2003

Recovery in Sight as U.S. Manufacturing is Rebounding But Shadows Remain

Even though the U.S. economy expanded at the fastest pace in almost two decades, the Mexican economy continues to ail along. Rather than depending on the U.S. economy as a whole, Mexican growth hinges on the U.S. manufacturing sector, which is lagging behind the overall economy. However, recent data suggest that the U.S. manufacturing sector is beginning to recover more notably, which should provide a backdrop for a more improvement of the Mexican economy but full recovery will be undermined by rising competition from China.

Economy deteriorates further in August
In August, economic activity dropped 0.7% over the same month last year, according to the global indicator for economic activity (IGAE, Indicador Global de la Actividad Económica). The actual reading was well below last month’s Consensus Forecast, which had the economy growing at an annual rate of 1.2%. Moreover, the reading represents the weakest performance since April this year and according to seasonally adjusted data, the economy even contracted 0.46% over the preceding month, the worst performance since May 2001. All sectors performed worse than in the preceding month. Agriculture contracted at an annual rate of 1.6% (July: +0.4% year-on-year) and services added only 0.6% over the same month last year (July: +2.0% yoy).

Industry leads decline in economic activity
The industrial sector dropped 2.9% over August 2002 (July: -1.9% yoy). The development in the manufacturing industry is particularly worrying as the sector remains entrenched in a deep recession despite the record growth observed in the United States. In the third quarter, the U.S. economy expanded by robust 7.2% according to preliminary data, the fastest pace in almost 20 years (details see Latin American overview at the beginning of the publication). When Mexico entered into recession in 2001 in the wake of slumping demand from the United States, it was generally anticipated that the economy would leave recession behind with a rebound in the United States. However, despite the record growth in the U.S. economy, Mexican economic activity remains subdued. The reason for the diverging trends in the two closely linked economies is in part due to increased competition. Since the inception of NAFTA (North American Free Trade Agreement), Mexico experienced a massive export boost as many U.S. and Canadian firms relocated their production facilities to Mexico, in order to take advantage of cheap labour. Mostly, these production plants were set up as in bond manufacturing facilities along the US/Mexico border, in the so-called maquiladora industry. In the recent past, however, competition from China has increasingly challenged Mexico’s role as a production base for the US market, particularly since the country joined the World Trade Organization (WTO). According to recent estimates, China's manufacturing wages average 61 cents an hour compared with US$ 2 in Mexico. With this competitive edge over Mexican labour costs, many multinational companies are relocating production facilities to China and new investment projects in Mexico are becoming increasingly scarce.

Recovery of maquiladora industry could be imminent, as U.S. manufacturing is recovering at rapid pace
However, increased competition only in part accounts for the sluggishness of the Mexican economy. Another reason is the subdued demand for manufactures in the United States, which lag behind the overall economic recovery. Nevertheless, latest data suggest that the troubled US manufacturing sector is beginning to recover notably. The monthly Institute for Supply Management (ISM) index of manufacturing activity rose from 53.7 in September to 57.0 in October, the highest reading since December 1999. Robust growth in new orders and production constituted the main drivers behind the October increase, suggesting that manufacturers are responding to growing demand observed this summer. Inventories continued to contract in October and the inventories-to-sales-ratio has now dropped to levels widely considered as being unsustainably low. If U.S. businesses increasingly opt to replenish their historically low stocks, demand for Mexican manufactures should increase in the short term. Nevertheless, a recovery to pre-recession output levels in the maquiladora industry will take time. With output contractions of 9.5% in 2001 and 8.7% in 2002, the sector will need more than a year of solid demand increases for a full-scale rebound.