April 27, 2015 Mexico: Building the Foundation of a Solid ... sherven group... · Mexico: Building the Foundation of a Solid Economy Introduction Mexico has long struggled to overcome

April 27, 2015

Angelo Katsoras, Senior Associate - (514) 879-6458

Pierre Fournier, Geopolitical Analyst - (514) 879-2423 1

Mexico: Building the Foundation of a Solid Economy

Introduction

Mexico has long struggled to overcome a major image problem as a country

overwhelmed by massive crime and corruption. But over the last few years another much

more positive story has emerged, that of a country that is slowly but surely building the

foundation for long-term sustainable growth.

Key to the country’s brighter future are its notable successes in building a globally

competitive manufacturing sector, establishing an extensive global network of free trade

agreements, and recently, opening its energy sector to private investment and reforming

its tax collection system. Despite some continuing negative headlines, we feel that

Mexico is making progress, albeit slowly, in reducing crime and improving the rule of

law.

Economic outlook

In recent years, Mexico’s economy has outperformed those of many major South

American countries. Further, a recovering U.S. economy is good news for Mexico given

that it is the destination for 80% of its exports.1

Mexico’s GDP growth compared to its South American peers

Source: “World Economic Outlook,” IMF, April 2015

1 “Mexico’s economic gloom hard to crack,” The Financial Times, April 7, 2015

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A major challenge for Mexico has been the significant drop in the price of oil, which

accounts for about a third of government revenues. This has recently forced the country

to announce about $8 billion in budget cuts. These cuts could have been much worse had

it not been for the fact that the country locked in a price of $76.40 a barrel for much of its

2015 production (via hedging).2 It doesn’t have any price protection for next year

however.

The government passes important education and tax reforms

On the policy front, the government passed a law in 2013 to begin reforming Mexico’s

underperforming public-education system, in which teaching jobs are often handed down

through generations and are sometimes even sold. The reforms, among other measures,

required teachers for the first time to undergo regular evaluations. The ultimate aim is to

boost the quality of education in a country that gives children an average of 8.8 years of

study, versus 13.3 years in the United States.3

Effective April 2015, Mexico has also begun to require the whole country to start

adopting electronic invoicing in an attempt to reduce rampant tax avoidance.4 Mexico has

the lowest tax revenue in the 34-nation Organisation for Economic Co-operation and

Development, hurting its ability to fund infrastructure and social programs vital to

boosting living standards and growth.

Mexico’s globally competitive manufacturing sector

Unlike many other South American countries, Mexico has a strong manufacturing sector

to help cushion the blow of low commodity prices. Manufacturing accounted for roughly

17% of its GDP in 2013, versus an average of 12% for Latin America as a whole.5

Mexico’s manufacturing sector is poised to grow even more due to a recent wave of

investments.

The automobile industry is the best example of Mexico’s manufacturing prowess. Since

2009, about $20 billion in investments has been announced by automakers, according to

the Center for Automotive Research. Mexico is the world’s seventh largest manufacturer

of automobiles. Production increased by 27% last year over 2013.6 Industry analysts see

Mexico’s current annual production of 3.2 million cars and light trucks growing by over

2 “Oil's Slump a Blow to Mexico Amid Touted Energy Reforms,” Associated Press, Feb. 11, 2015

3 “Flunking the test,” The Economist, March 7, 2015

4 “Electronic arm-twisting,” The Economist, May 17, 2014

5 “Slowdown in China Bruises Economy in Latin America,” The New York Times, Dec. 16, 2014

6 “VW to spend $1 billion on Mexico assembly plant expansion for Tiguan,” Reuters, March 9, 2015

April 27, 2015



50% to five million by 2018.7 Mexico is the world’s fourth-largest exporter of

automobiles after Germany, Japan and South Korea. Over 80% of Mexico’s automobile

production is exported, mostly to the United States.8

“Why Auto Makers Are Building New Factories in Mexico, not the U.S.,” The Wall Street Journal, March 17, 2015

Canada’s auto sector has been particularly hard hit by the rise of Mexico

In 2014, Mexico accounted for 20% of light vehicle production in North America, up

from only 3% in 1985. This share is projected to rise to 25% by 2022.9 In stark contrast,

Canada’s share of vehicle production in North America fell to 14% last year, its lowest

level since 1987. Since 2001, Canada has lost 20% of its jobs in vehicle assembly and

auto parts.10

7 “Why Auto Makers Are Building New Factories in Mexico, not the U.S.,” The Wall Street Journal, March

17, 2015 8 “Toyota to Invest $1.4 Billion to Meet Growing U.S., China Demand,” The Walls Street Journal, April 15,

2015 9 “Ford investment highlights Mexico’s booming car making sector,” The Financial Times, April 16, 2015

10 “Made in Mexico: An emerging auto giant powers past Canada,” The Globe and Mail, Feb. 17, 2015

April 27, 2015



Source: “Made in Mexico: An emerging auto giant powers past Canada,” The Globe and Mail, Feb.

17, 2015

The chart below shows that Mexico now attracts an even higher percentage of the

global foreign direct investment of the auto industry than even China, a trend that

looks set to continue for at least the next few years given the recent surge of announced

investments.

Source: “Mexico steals a march on China in car manufacturing,” The Financial Times, April 21,

2015

April 27, 2015



As the following graph highlights, the strength of Mexico’s manufacturing extends

well beyond the auto sector.

Stratfor: “In Mexico, a Resilient Manufacturing Sector Thrives,” Stratfor, April 7, 2015

The strength of Mexico manufacturing sector is underpinned by low

wages and a web of free trade agreements.

Average hourly labour costs in Mexico excluding benefits can be as low as $8 to $10. By

comparison, Ford, General Motors and Fiat Chrysler pay an average of $48 to $58 an

hour in their U.S. factories. 11

11 “Ford investment highlights Mexico’s booming car making sector,” The Financial Times, April 16, 2015

April 27, 2015



“Ford investment highlights Mexico’s booming car making sector,” The Financial Times, April 16, 2015

Mexico also has a wage advantage over China. Average manufacturing labour costs in

Mexico are now almost 20% lower than in China. This is a radical change from 2000

when Mexico's labour costs were 58% higher than China's.12

Another crucial element is free trade. Mexico has many free-trade arrangements

encompassing 45 countries, including all EU members. In contrast, the United States has

free-trade agreements with 20 mostly smaller countries such as Chile, Jordan and

Panama.13

These trade agreements give Mexico the huge competitive advantage of

having duty-free access to markets that contain 60% of the world’s economic output. For

example, European car companies are hit with a 10% duty on each car they ship to

Europe from its U.S. plants. For a $50,000 vehicle, that works out to a tariff of $5,000.14

The same car shipped from a Mexican plant can enter the EU tariff-free due to a trade

pact signed between Mexico and the EU. Negotiations between the United States and EU

over signing a free trade deal are still in the early stages.

12 “Mexico's Manufacturing Sector Continues to Grow,” Stratfor, April 6, 2015

13 “Toyota to Invest $1.4 Billion to Meet Growing U.S., China Demand,” The Wall Street Journal, April 15,

2015 14

“Why Auto Makers Are Building New Factories in Mexico, not the U.S.,” The Wall Street Journal, March 17, 2015

April 27, 2015



A turning point for Mexico’s energy sector

Since 2004, Mexico's oil production has dropped to around 2.3 million barrels per day

from about 3.4 million barrels. One of the main reasons for this decline is the fact that the

state-owned oil company, Pemex, has been unable to invest in new production because

most of its revenues have been transferred to government coffers. Despite this decline,

Mexico remains one of the 10 largest oil producers in the world, and the third largest in

the Americas after the United States and Canada.

Source: “Pemex prepares to expand oil production after decade of decline, The Financial Times,

April 21, 2015

In an attempt to reverse the decline in oil production, the government passed a landmark

energy bill last December that would for the first time in 75 years allow private

companies to drill for oil and gas. To date, more than 40 oil companies have sought

access to geological data under Mexico’s first oil auction in eight decades - a clear

indication that interest in the process is holding up despite the drop in oil prices. The

auctions for oil blocks will begin in July and run to the end of the year.15

The government

has set a goal of increasing oil production by 500,000 barrels a day by 2018.

15 “Oil Companies Show Active Interest in Mexican Energy Tracts,” The Wall Street Journal, March 31,

2015

April 27, 2015



Source: “Mexico Moves to Open Its Energy Sector,” Stratfor, Dec. 17, 2014

The competitive advantages of Mexico’s oil sector

From the perspective of energy companies looking for projects in which to invest, low oil

prices could push energy companies to lose interest in more costly projects in other

countries in favour of investing in Mexico. The breakeven point for developing

conventional onshore and shallow water fields in Mexico is less than $40 per barrel.16

It

is $40 to $80 per barrel for Mexico’s deepwater oil, and $50 to $80 per barrel for shale

oil, according to Boston Consulting Group.17

16 “Low Oil Prices Have Silver Lining For Latin America’s Heavy Crude Producers,” Oil Price.com. Jan. 17,

2015 17

“The Promise of Mexico’s Energy Reforms,” Boston Consulting Group, April 9, 2014

April 27, 2015



Political stability also works to Mexico’s advantage. Despite Mexico’s crime-related

challenges, the country is still much more stable than, say Iraq or Nigeria. Further, in

contrast to Venezuela and Argentina, which are saddled with reputations for constantly

changing rules and reneging on contracts, Mexico has an investment climate that is

viewed as much more welcoming. A greater respect for contract law is a key point in the

country’s favour.

In another plus for foreign investors, only 13% of equipment and supplies must be

purchased locally. This rises to 25% in the development phase and will reach a high of

35% by 2025. In comparison, the local content requirement for Brazil can be as high as

85% with no grace period. Local content requirements are a significant concern for

international oil companies because being forced to overly rely on local industry that has

not yet developed the capacity to produce required equipment has been a major source of

cost overruns in the past.18

The game-changing potential of Mexico’s natural gas sector

Similar to oil, natural gas is especially plentiful in Mexico. The U.S. Energy Information

Administration ranked Mexico’s reserves of shale gas alone as the world's sixth-largest

after China, Argentina, Algeria, the United States and Canada. Despite these abundant

resources, a lack of investment in natural gas production has forced Mexico to meet its

own energy needs in part by importing natural gas. Worsening matters further, inadequate

pipeline connections to the United States have meant that Mexico has often resorted to

importing liquefied gas that can cost three times as much as piped-in gas from the United

States.19

(Mexico has about 5,500 miles of natural gas pipelines, while Texas alone has

more than 58,000 miles of natural gas pipelines.20

) Further, about 20% of the country’s

electricity is generated with dirty and expensive fuel oil (versus 1% in the U.S). The

cumulative impact of all these factors means that the cost of electricity for industrial users

is 75% higher in Mexico than the United States.21

However, plans to first increase pipeline connections from the United States then, over

time, to increase domestic natural gas production will boost Mexico’s economic

performance over the next few years. Cheaper natural gas and electricity will

significantly strengthen Mexico’s already very competitive manufacturing sector.

Billions of dollars of pipelines projects have already been announced this year involving

such companies as BlackRock and Kinder Morgan.

18 “Mexico Moves to Open Its Energy Sector,” Stratfor, Dec. 17, 2014

19 “U.S. Natural-Gas Exports Fuel Mexican Manufacturing Boom,” The Wall Street Journal, Sept. 7, 2014

20 “Mexico’s emerging infrastructure opportunity,” Ernst & Young, April 2014

21 “A new Mexican revolution,” The Economist, Nov. 15, 2014

April 27, 2015



Mexico biggest challenge: the rule of law

While Mexico faces many challenges, including dealing with an uncertain global

economy and successfully implementing its recent economic reforms, its biggest

challenge by far is trying to establish the rule of law. This is absolutely necessary in order

for the public to have greater confidence that the government is acting in the public

interest, and thus give its economic reforms a greater sense of legitimacy.

A major concern is the security of business operations in a country that still struggles

with the problem of lawlessness in certain regions. The recent theft of $10.7 million

worth of gold from McEwen Mining Inc.’s El Gallo mine in Sinaloa State has refocused

the spotlight on this risk. This armed robbery follows several other large mine robberies

in the past five years, including multimillion-dollar heists at Pan American Silver and

First Majestic Silver Corp.22

The oil sector also suffers from theft. Pemex, Mexico’s

state-owned oil company, estimates that 9.3 million barrels of oil and gasoline were

stolen in 2013, roughly 1% of Pemex’s total annual output and a 13% increase from the

previous year.23

Last year president Enrique Peña Nieto introduced a 5,000-strong police

force tasked specifically with providing security for the natural resource sector.

Mexico’s struggle with violent crime and corruption was back in the spotlight due to two

recent events which have inflamed public opinion: 1) the murder of 43 students by drug

gangs in Guerrero state, allegedly with the involvement of the former local mayor and

police working with the cartels, and 2) a series of conflict-of-interest scandals involving

high-ranking politicians, particularly one centred on the home owned by the first lady and

built by a state contractor that has won many lucrative public contracts.

This low confidence in Mexico’s government institutions is further exemplified by the

fact only 10% of crimes are reported due to lack of trust in the police force.24

The

government has promised to reform policing by placing locally controlled forces under

federal control, and when necessary dissolving corrupt local forces altogether. Even

under the best of scenarios, this will take several years to fully implement.

22 “Canadian miners grapple with security risks in Mexico”, The Canadian Press, April 19, 2015

23 “Drug Cartels Will Challenge Energy Investors,” The Wall Street Journal, Dec. 18, 2014

24 “Mexico: lawlessness undermines reforms and economic progress,” The Financial Times, March 3, 2015

April 27, 2015



On a positive note, rising anger over corruption and crime in Mexico is attributable to a growing tax-paying middle class that is beginning to hold its political leaders to higher

ethical standards. The middle class represents about 39.2% (44 million) of the country's

total population, an increase of 11% over the last decade.25

Boston Consulting estimates

that Mexico’s middle class will increase by 3% annually over the next several years.26

Over the long term, such pressure will force the government to become more efficient

and honest.

It is also important to note that while Mexico has a reputation for being one of the

world’s most violent countries, it has a relatively low national homicide rate when

compared with many other Latin American nations.

25 “Emerging Markets: Mexico, The Neighbor Next Door,” NASDAQ, Nov. 11, 2014

26 “Mexico: lawlessness undermines reforms and economic progress,” The Financial Times, March 3, 2014

April 27, 2015



Source: “Global Study on Homicide,” United Nations, April 2014

The murder rate in Mexico has fallen for two years in a row. In 2013, there were 22,732

murders equivalents to 19 per 100,000 inhabitants. This is down from 21.5 murders per

100,000 inhabitants in 2012 and 24 homicides per 100,000 in 2011.27

Conclusion

Over the last few years, despite its struggle with violent crime, Mexico has begun to build

a foundation for long-term sustainable growth. This has included creating a globally

competitive manufacturing sector, establishing a worldwide network of free trade

agreements, opening its energy sector to private sector investments and reforming its tax

collection system. The country’s strong manufucaturing sector means that Mexico has a

much more diversified and stable economy than many of its commodity-dependent peers

whose manufacuturing sectors have, in many cases, been hollowed out by Chinese

compeition. Finally, we feel that Mexico’s growing tax paying middle class will over the

long term be a positive force in pushing the government to become more efficient and

honest. Mexico’s declining murder rate over the last few years, while still too high, is a

leading indicator, in our opinion, of growing social stability.

27 “Mexican Homicide Rate Fell 12.5% in 2013, Statistics Agency Says,” The Wall Street Journal, July 24,

2014

April 27, 2015



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Documents

April 27, 2015 Mexico: Building the Foundation of a Solid ... sherven group... · Mexico: Building the Foundation of a Solid Economy Introduction Mexico has long struggled to overcome