The industry’s massive downsizing has evoked great concern on both sides of the border, with hand-wringing about unbeatable Chinese competition and the imminent demise of Mexican apparel operations. The situation isn’t that grim, though.

Mexico’s textile and apparel export industry isn’t going to disappear, although it has shrunk in response to market realities related to trade policy changes. What’s happened reflects a facet of trade liberalization little understood by the general public: trade diversion. Coined by economist Jacob Viner, the term describes how discriminatory tariff policies can undermine the benefits of free trade, leading to inefficient allocation of resources and higher costs for consumers. [1]

Before joining the European Union, for example, Britain imported most of its lamb from New Zealand, the cheapest producer. Adopting the common EU tariffs made New Zealand lamb more expensive in Britain, opening the door for producers in member countries, particularly the French. For exporting nations, trade diversion can lead to dramatic ups and downs in sales—which is just what occurred with Mexico’s textiles and apparel.

When the North American Free Trade Agreement took effect in 1994, its proponents emphasized the pact’s efficiency and growth effects. Their arguments rested on the findings of long-dead economists whose writings still ring true. Adam Smith, David Ricardo and others had shown that increased international trade would allow economies to direct resources toward what they produced relatively efficiently, exporting what they didn’t consume at home and importing what their trading partners could produce more effectively. World efficiency would increase. Products would be cheaper. Everyone would be better off.

To achieve these mutual gains from trade requires a world in which all economies are open and each nation treats all others the same. While regional free trade agreements like NAFTA do lower prices for their members, they are quite different from universal free trade.

By their very nature, regional accords lower tariffs and regulatory burdens for members, giving them an edge over nonmembers. Trade diversion occurs when these preferential trade agreements encourage higher-cost imports of member countries to replace the lower-cost imports of nonmembers.

Where trade diversion exists, economic theory suggests that all good things must end—at least for those that have benefited from the trade preferences. As an industry’s imports increase under a regional trade deal, resistance to opening markets falls off. At the same time, those excluded from the preferential arrangement lobby for the same benefits. More countries receive such deals and then even more do. This result suggests that a little bit of trade opening can lead to a lot.

When the importing countries extend preferential trade benefits to more nations, the boom from the original diversion may be followed by a bust as new trading patterns emerge and the world’s low-cost producer regains its advantage. This may not always occur, but it’s exactly what happened with Mexico’s textiles and apparel. With the erosion of Mexico’s NAFTA edge, China increased U.S. sales. Mexico lost market share—and as a result, employment fell in the textile and apparel maquiladoras.

Mexico’s Experience

Comparing the trends in U.S. apparel imports from Mexico, China and countries that eventually became part of the Dominican Republic–Central American Free Trade Agreement suggests that trade diversion was behind the boom-and-bust cycle in Mexico’s textile and apparel maquiladoras.

In the early 1990s, China topped Mexico in apparel exports to the U.S. (Chart 2). A shift toward Mexico began with NAFTA’s signing in 1993 and accelerated with implementation in 1994.

Under NAFTA, Mexican apparel enters the United States duty-free, provided all its components from the thread forward are made in the United States, Canada or Mexico. This provision was included in the agreement to benefit not only Mexican apparel manufacturers but also U.S. textile and fiber companies.

When NAFTA lowered U.S. barriers, Mexican producers could compete in the huge market north of the border, even though other countries could produce textiles and apparel more cheaply. By the late 1990s, Mexico was picking up market share so rapidly against China that it briefly became the No. 1 apparel supplier to the U.S.

With NAFTA in place, Mexico also began to increase its U.S. sales more rapidly than the Central American nations. The gains continued until 2000, when the U.S. offered low-wage Caribbean and African countries some of the same benefits it had bestowed on higher-wage Mexico under NAFTA. Last year, the United States signed a broader preferential trade agreement with DR-CAFTA.

Meanwhile, China had developed highly competitive apparel export industries, helping it become the world’s low-cost producer. In 2001, China joined the World Trade Organization, just as the group was dismantling the Multifiber Arrangement, the textile and apparel quotas rich countries had maintained to protect their industries from imports. On a leveled playing field, China regained market share at the expense of both Mexico and Central America.

About the Author
Gruben is a vice president and senior economist at the Federal Reserve Bank of Dallas.

Notes
1. The Customs Union Issue, by Jacob Viner, New York: Carnegie Endowment for International Peace; London: Stevens & Sons, 1950.
About Southwest Economy

Southwest Economy is published six times annually by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.