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Mexico's economy has been mentioned frequently in the press lately, and the news stories have been downbeat. A recurring theme is that Mexico's manufactured exports to the U.S. are being systematically supplanted by China's. One well-known real estate economist recently asserted that, "one-third of maquiladora factories have closed down [during the past two years] on the back of businesses moving to China." It's a startling, albeit misleading, assertion.

Whether Mexico's exports are less competitive today than they were two years ago is arguable. In any event, there is no imminent crisis, contrary to the recent shrill headlines. Mexico's economy appears to have held up well during the synchronized global macro-economic slowdown of 2000-03 and is poised today for an economic recovery. Here's how the well-respected Organization for Economic Co-operation and Development (OECD) has summed up Mexico's near-term prospects: "A pick-up in exports to the United States is expected to be the main driver of a recovery which has been delayed by the weakness of the US manufacturing sector" [OECD, December 2003, p. 95].

Yet many other observers remain convinced that a crisis is brewing and will cripple the "main driver" of Mexico's incipient recovery — i.e., manufactured exports to the U.S. China's market share of those exports to the U.S., it is claimed, will continue to expand in coming years — and will do so at the expense of Mexico's market share. China, say these pundits, has begun to eat Mexico's lunch.

Let's be clear about what the issue is. It is not whether China's manufactured exports to the U.S. will continue to grow rapidly. They most likely will. Rather, what's at issue is whether those exports will grow primarily at the expense of Mexico's market share. This is by no means a foregone conclusion.

The Sky Is Falling!

Observers who believe that China's exports to the U.S. will supplant Mexico's usually cite one or more of the following facts:

Some observers also like to point out that foreign direct investment flows (mostly from the U.S.) into Mexico's manufacturing sector have tumbled 50% from what they were in 1999 and 2000.

With China's labor costs amounting to just one-third to one-half of Mexico's, many analysts, commentators, and reporters have jumped to the conclusion that China's exports to the U.S. must inevitably grow at the expense of Mexico's.

When the U.S. Sneezes, Mexico Catches Pneumonia

Facts may be indisputable, but their interpretation is not.

Consider, for example, the parallel expansion paths traced out by China's and Mexico's exports to the U.S. from 1990 until 2003. (See Exhibit 1.) Not only did Mexico's exporters hold their own vis-à-vis their Chinese rivals during 1990 to 2000, but they actually outpaced the Chinese by a slim margin. Moreover, during that entire decade, Mexico's labor costs remained substantially above China's, and the disparity in relative wages appears to have widened.

Since 2001, however, Chinese exporters to the U.S. appear to have gained the upper hand over their Mexican rivals. Mexico's non-oil exports to the U.S. have leveled off since 2000. China's exports to the U.S. also leveled off in 2000 — but then surged ahead 50% during the next two years. Evidently, if there is a problem with Mexico's competitiveness, it has materialized just during the past two or three years.

Mexico's maquiladora plants have been hard-hit. They laid off hundreds of thousands of workers during 2000-01. (See Exhibit 2.) Maquiladora employment bottomed out early in 2002 and has meandered along the bottom since then. The total number of those jobs is still 22% (or 300,000 jobs) below the cyclical peak attained in mid-2000.

The past two years have also been stressful for the United States. First came the dot-com "bust" that began in late 2000.

Soon afterwards came the U.S. recession that began in March 2001 and then lingered until mid-2003.1 The economic slowdown in the U.S. dampened Americans' appetite for imports, but all of its trading partners should have been affected equally, barring systemic shifts in exchange rates. In fact, the value of the Mexican peso has fallen 20% vis-à-vis the U.S. dollar (to which the Chinese yuan is pegged) during the past two years.

We suspect that recent U.S. macroeconomic events go a long way toward explaining the recent plunge in Mexico's maquiladora employment. The output of maquiladora plants is linked to U.S. manufacturing through intricate production-sharing arrangements. Virtually all of the output of maquiladora plants is exported to the U.S., where it is either sold directly to American users or manufactured further and then sold.

Thanks to those production-sharing arrangements, Mexico's maquiladora plants serve, in effect, as shock absorbers for U.S. manufacturers. They function in much the same way that auto parts suppliers do for the major auto assemblers.

Cyclical swings in U.S. manufacturing are thus echoed by magnified swings in maquiladora production. (See Exhibit 3.) Statistical estimates suggest a ratio of roughly four-to-one [GAO, 2003, p. 59]. A 1% increase (decrease) in U.S. industrial output corresponds to a 4% increase (decrease) in maquiladora operations. Mexico's recent maquiladora woes have been an offshoot of the protracted U.S. recession.

But the U.S. recession of 2001-03 accounts for only part of those woes. As important, if not more so, was the extraordinary U.S. economic boom that climaxed during 1999-2000. Real GDP growth in the U.S. reached blistering rates not seen in 35 to 40 years.

And so did the growth in U.S. industrial production.

The run-up in U.S. industrial output during 1999-2000 spurred an even frothier frenzy among maquiladora factories. The number of maquiladora jobs also ballooned, and so did foreign direct investment into Mexico's manufacturing sector. (See Exhibit 4). With the benefit of hindsight, it is clear that industrial capacity and payrolls at Mexico's maquiladoras swelled to unsustainably high levels during 1999-2000. Consequently, having soared during the boom years, Mexico's maquiladora factories were whipsawed when the U.S. economy slipped into recession in 2001.

1 Although the U.S. recession officially ended November 2001, most business people we know believe that the subsequent recovery didn't get started until mid-2003.