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How has NAFTA affected the Mexican economy?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 2004
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IMFSurvey: What were Mexico’s key objectives entering into NAFTA?

Towe: Mexico wanted to accelerate economic growth by promoting trade and financial flows with its NAFTA partners, but, as we discuss in the paper, other considerations were also in play. Some observers have argued, for example, that Mexico was also keen to use the agreement to help secure the permanence and credibility of its economic reform program, thereby improving its risk profile and boosting foreign investment inflows.

IMFSurvey: Have these objectives largely been met?

Towe: This question is a little bit tricky to answer. As our paper emphasizes, isolating the effects of NAFTA on Mexico is difficult given the significant other shocks that occurred during this period. For example, Mexico suffered a severe financial crisis in 1994, and it is difficult to gauge how much of Mexico’s recovery can be attributed to cyclical causes rather than to NAFTA. Similarly, the global cyclical boom during the latter half of the 1990s and the more recent slump have also played an important role in driving growth and business cycles in emerging markets like Mexico. Nonetheless, our paper tries to disentangle some of these effects and concludes that NAFTA did help spur a dramatic increase in trade and financial flows between Mexico and its NAFTA partners, as well as economic growth in Mexico.

IMFSurvey: How has the agreement affected trade flows between Mexico and its NAFTA partners?

Kose: If you simply look at the statistics, there has been a significant change in trade flows since the inception of NAFTA. For example, Mexico’s exports to the United States and Canada more than doubled in dollar terms between 1993 and 2002 as Mexico’s trade (the sum of exports and imports) with NAFTA partners rose from 25 percent of its GDP in 1993 to 51 percent in 2000. The question, then, is whether this remarkable increase has been driven by NAFTA. Using various econometric methods, several recent studies have analyzed the impact of NAFTA on the growth of trade flows in the region. Some of these studies have used aggregate data, while others have employed sectoral series. In the paper, we provide a brief survey of these studies. I think it is fair to say that most of these studies have found that the agreement has had a positive impact on the growth of trade flows.

IMFSurvey: Has the nature of trade changed since NAFTA?

Kose: Yes, trade within the region has changed markedly since NAFTA. First, Mexico’s export base has shifted toward manufactured goods. Second, vertical trade—or the value of a country’s imports that are embodied in its exports—has increased among the NAFTA partners. The obvious example of this is the rapid growth of maquiladores, which import inputs from the United States, process them, and re-export them back to the United States. Third, intraindustry trade between Mexico and NAFTA partners has risen significantly. Moreover, NAFTA has resulted in a substantial increase in the variety of products traded between Mexico and its partners.

IMFSurvey: Have these changes in trade and financial flows affected business cycle developments in Mexico?

Kose: One of the main objectives of our paper is to examine how free trade agreements affect business cycles in member countries. This is a particularly important empirical question since the past 15 years has witnessed a significant increase in the number of these arrangements. Although these agreements have typically led to a substantial expansion of trade and financial flows among the member countries, economic theory does not tell us much about how this would affect the dynamics of business cycles. In the case of NAFTA, however, our results suggest that the increase in regional integration has had a substantial effect on business cycles. In particular, the agreement appears to have been associated with increased comovement of business cycles in Mexico and its NAFTA partners. For example, the output correlation between Mexico and its NAFTA partners rose from almost zero before NAFTA to around 0.75 during 1996-2002. Moreover, there has been a marked decline in macroeconomic volatility in Mexico. We argue that this decrease in volatility has reflected the encouragement that NAFTA provided to intraindustry and vertical trade, which has increased the importance of regional rather than country-specific shocks in driving business cycles in Mexico.

IMFSurvey: Have regional cycles changed?

Kose: Yes, regional factors have become more important in driving business cycles in Mexico since the advent of NAFTA. In the paper, we undertake a deeper analysis of the increase in business cycle comovement using a recently developed econometric model. We find that structural changes in the Mexican economy that have reduced the role of country-specific shocks in driving the Mexican business cycle have led to a concomitant increase in the role of regionwide shocks. In addition, we use a dynamic, multicountry model to analyze the importance of structural factors and find that reductions in trade frictions that boost trade flows lead to a concomitant increase in business cycle interdependence in the member countries.

IMFSurvey: Has NAFTA also affected Mexico’s growth performance?

Meredith: Our study examines a variety of factors that affect economic growth. We found, for example, that there has been a dramatic increase in the average growth rate of investment since NAFTA. In addition, contributions of investment and exports to GDP growth have sharply increased. Recent empirical studies suggest that NAFTA has significantly raised total factor productivity in Mexico and has been instrumental in improving macroeconomic as well as institutional policies in Mexico. We conclude that the agreement has favorably affected Mexico’s growth performance over the past decade, and our conclusion is supported by a broad range of studies, which we survey in the paper.

IMFSurvey: In recent years, Mexico has begun to face competitive pressures—particularly from China, but also from elsewhere in Latin America—at a time when U.S. demand has slumped. Looking to the future, what does this imply for Mexico?

Meredith: While stronger U.S. growth this year is also leading to cyclical recovery in Mexico, these longer-term developments underscore the importance to Mexico of designing proactive policies, particularly in the area of structural reforms, to raise international competitiveness. There are several areas in which reforms are critical. For example, Mexico’s energy sector suffers from a lack of investment and has not exploited new opportunities. Rigidities in several other markets also remain major obstacles to economic growth. To illustrate, Mexico has one of the most rigid labor market institutions in the region, discouraging development of the formal labor sector. Moreover, comprehensive tax reform is essential to reduce dependence on oil revenues and generate the resources needed to improve public infrastructure and education. The role of social objectives—which include giving higher priority to education and human capital development, combating corruption, and dealing with poverty issues—in advancing economic development is also critically important. Addressing these challenges will be central to recovering the growth momentum experienced in the latter part of the 1990s from membership in NAFTA.

IMFSurvey: What are the lessons for other countries in Latin America as the region works toward the Free Trade Area of the Americas (FTAA)?

Towe: The most important lesson is that countries should take early advantage of the boost to trade and financial flows that can result from free trade agreements and ensure that the necessary structural reforms are in place to sustain the benefits of these agreements. The NAFTA experience suggests that the FTAA could have potentially significant effects on the region’s developing country members. We should resist drawing too strong a lesson from Mexico’s experience under NAFTA, given that Mexico also benefited from a depreciated peso, the strength of the U.S. economy, and a common border with the United States. But that said, our analysis does suggest that the FTAA could boost economic efficiency, foreign investment, and trade flows, as well as help promote greater macroeconomic stability in the region.

Copies of IMF Working Paper No. 04/59, “How Has NAFTA Affected the Mexican Economy? Review and Evidence,” by M. Ayhan Kose, Guy M. Meredith, and Christopher M. Towe, are available for $15.00 each. Please see page 168 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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