Mexico - Manufacturing sector : situation, prospect and policies

A WORLD BANK COUNTRY STUDY PUB- 1671 MEXICO Manufacturing Sector: Situation, Prospects and Policies FILE COPY MARCH 1979   MEXICO Manufacturing Sector: Situation, Prospects and Policies This report is based on the findings of a mission which visited Mexico in October/Novem- ber 1976. The mission was composed of: A. Nowicki, chief J. Bergsman, deputy chief D. Keesing, export analysis T. Hutcheson, finance; import controls D. Cook, small and medium-scale industry J. Levitsky, small and medium-scale industry F. de la Balze, small and medium-scale industry J. Kendall, public sector enterprises H. Choi, capital goods sector S. Swayambu, capital goods sector. W. Oettinger, capital goods sector D. Weigel, private banking A. Tejano, statistical assistance Latin America and Caribbean Region The World Bank Washington, D.C., U.S.A.  The World Bank issues country economic studies in two series. This report is a working document and is, as such, part of an informal series based wholly on materials originally prepared for restricted use within the Bank. The text is not meant to be definitive, but is offered so as to make some results of internal research widely available to scholars and practitioners throughout the world. A second, more formal series entitled World Bank Country Economic Reports is published for the Bank by The Johns Hopkins University Press, Baltimore and London. Titles of these and all other Bank publications may be found in the Catalog of Publications, which is available free of charge from World Bank, Publications Unit, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. This report is a free publication. A small charge may be made if airmail postage is required. The views and interpretations in this report are the authors' and should not be attributed to the World Bank, to its affiliated organizations, or to any individual acting on their behalf. Copyright '() 1979 The International Bank for Reconstruction and Development/The World Bank The World Bank enjoys copyright under Protocol 2 of the Universal Copyright Conven- tion. Nevertheless, reproduction of any part of this report is hereby granted provided that full citation is made.  Preface This report is based on the findings of a World Bank mission that visited Mexico in Oetober and November of 1976. The report was completed by May 1977. Immediately before and since then rapid and profound changes in economi.: conditions and policies in Mexico have occurred. On September 1, 1976, one month before the mission visited Mexico, the exchange rate which had been in force since 1954 was abandoned. Incentives to manufactured exports were discontinued; indeed for a few weeks a tax was imposed on manufactured exports. A new Government was installed shortly afterwards. It rapidly designed and instituted administrative reforms, made adjustments in a number of policies which are discussed in the present report, and put other policies under review. Because of those relatively recent changes and ongoing reviews, it was not possible for the mission to evaluate (or even fully describe) Mexico's emerging policy framework. It was clear, however, that many of those changes were in the directions suggested by the mission's (as yet unfinished) analysis. Now, some two years later, many more positive steps have been taken to improve the situation analysed in the report. The grave economic situation of 1976 has been resolved; investors' confidence returned, equilibria on the external and fiscal account are in the process of being restored, and after a two-year recession the Mexican econonW has begun to grow rapidly again. In the manufacturing sector, the high bias against exports that prevailed in 1976 has been reduced by the reinstatement of the tax reimbursement program ("CEDIs"). Import liberalization is steadily progressing and over 5,000 out of the 7,455 tariff categories can be now imported without an import license. Free import categories comprise about one-third of the value of all imports, but when imports by government agencies of certain products with only nominal import control are added, over one-half of value of all imports enter free of any non-tariff restrictions. Efforts to cut costs and deficits in public sector enterprises, especially the Federal Electricity Commission, are underway. Various capital market reforms have helped to provide an adequate credit supply, and special funds for small and medium-scale firms and for exporters are in full operation. There is more flexibility in dealing with proposals for new foreign private investment, whenever they meet Mexico's development priorities. Pub'lic sector agencies are no longer permitted imports of capital goods on an import duty-free basis. Important measures to promote development of capital goods production are now being designed. The geographic incentives to develop certain regions have been greatly improved; the new scheme concentrates on four special ports and eleven regions with good growth potential. Investment incentives are less biased towards capital-intensive production processes than they were in the recent past, and special tax certificates related to the size of the wage bill are now being considered to tilt the choice of techniques towai-d higher labor intensity in production of capital goods. Finally, a ne,- industrial development plan is being formulated.  - 2 - This progress on so many fronts brings an assurance that other issues of Mexican industrial development policy will be also closely watched by the managers of the economic policy. These include the exchange rate, whenever the need to compensate for rising price levels in Mexico would warrant adjustments, the related problem of incentives for manufactured exports, the biases of wage taxes and surcharg , which militate against employment increases especially when combined with subsidies tied to equipment purchases, and financial deficits in many public sector enterprises. The many changes during the last two years have not altered but rather have strengthened the view of the authors of the report as to the importance of three basic objectives for manufacturing sector development, and of policies to meet those objectives. The present report was conceived precisely with this purpose in mind, and the decision to make it more widely available reflects the continued importance given to these objectives by the Mexican Government as well as the World Bank. The objectives, while economic in their nature, have important social ramifications. They are: rapid and efficient growth of production of the Mexican industry, which applies both to the non-petroleum as well as to the petroleum based branches of manufacturing, management of balance-of-payments related aspects of the manufacturing sector and, last but not the least, the creation of productive jobs for Mexico's rapidly growing labor force. It is recognized, of course, that Mexico has other objectives as well and that in some cases policies that would promote the goals indicated above perhaps cannot be put into effect immediately and in their "pure" form, because of the need to accomodate other objectives or constraints. It is hoped, however, that any such compromise can be reduced to a minimum, so that the three objectives stressed here can be met as fully as possible. Nicolas Ardito-Barletta Vice President Latin America and Caribbean Regional Office  Currency Unit: Peso (Mex$) Prior to September 1. 1976: US$1.00 = Mex$ 12.50 Mex$ 1.00 = us$0.80 Mex$ 1 million - US$80,000 On September 1, 1976 the fixed parity of the peso was abandoned. During 1977 the value of the peso has fluctuated in the range of 20-30 pesos per US dollar. As of March 1979 the values were: US$1.00 - Mex$ 22.87 Mex$ 1.00 - us$o.40 Mex$ 1 million = US$43,733 Fiscal Year: January 1 through December 31.   GLOSSARY OF ABRREVIATIONS AND ACRONYMS CANACINTRA Cgmara Nacional de la Industria de Transformaci6n National Chamber of Manufacturing Industries CEDI Certificado de Devoluci6n de Impuestos Indirectos Certificate of Reimbursement of Indirect Taxes CFE Comiai6n Federal de Electricidad Federal Electricity Commission CONASUPO Compaaia Nacional de Subsistencia Popular Public Corporation for distribution of low-priced basic food products FIDEIN Fideicomiso de Conjuntos, Parques, Ciudadea Industriales y Centros Comerciales Trust Fund for Industrial Parks and Cities and Co_ercial Centers FOGAIN Fondo de Garant!a y Fovento a la Industria Mediana y Pequenia Fund for Promotion of Smell and Medium-sized Industries FOMYX Fondo para el Fomento de la Exportaciones de Productos Manufacturados Fund for the Promotion of Manufactured Exports POUIR Fondo Nacional de Fosento Industrial Fund for Industrial Promotion FOhIP Fondo Nacional de Estudios de Preinversi6n Fund for Pre-investment Studieg FTE Free Trade Equilibrium (refers to exchange rate) xPES InStituto de Eatudion Politicos, Econ&icos y Social.. Institute of Economic, Political, and Social Studies (analytical arm of the PRI, Mexico's principal political party) IME Institute Mexicano de Comercio Exterior Mexican Foreign Trade Institute INFONAVIT Instituto del Fondo Nacional de la Vivienda para lo Trabajadores Workers' Housing Fund SIC Secretaria de Industria y Comercio Ministry of Industry and Co merce SICARTSA Siderurgia Lazaro Cardenas, Las Truchas, S.A. Lazaro Cardenas - Las Truchas Steel Company SmI Small and Medium Scale Industry All monetary values are expressed in US dollars, unless otherwise noted.   MEXICO MANUFACTURING SECTOR: SITUATION, PROSPECTS AND POLICIES TABLE OF CONTENTS Page No. SUMMiARY ....................................................... 1 ANALYSIS . ................................................ 9 I. FOH(ElGN TRADE POLICIES. 9 Exports .10 Imports and protection .15 Net protection and export incentives ............ 18 Choices for the Future .21 Conclusions .28 II. PUBLIC AND FOREIGN-OWNED ENTERPRISES .9 Public Sector Enterprises .29 Conclusions. 34 Foreign-Owned Enterprises .36 Conclusions .39 III. INDUSTRIAL FINANCING .41 The Financial Situation .41 Conclusions .43 IV. TECHNOLOGICAL AND SECTORAL ISSUES. 45 Employment and Wage Policy .45 Small and Medium-Scale Industry (Summary) 148 Cal,ital Goods (Summary) .4 Regional Development. 8 Annex I: Tables and Charts .66 Annex IT: Technical Note: Free Trade Equilibrium Exchange Rates ............................. 83 Annex III: Mexico's Industrial Structure. 2 Annex IV: Small and Medium-Scale Industry .102 Annex V: Capital Goods ........... ....... 122   SUM4ARY 1. Over the last several decades, manufacturing has grown rapidly in Mexico and today plays important roles in employment, import substitution and exports, and through its large impact on the economy as a whole. In 1970, the last ;ear for which complete census estimates are available, manufacturing accounted for approximately 23 percent of GDP and employed 17 percent of the labor force. In 1975 the share of GDP was still 23 percent. 1/ Growth in the volume of manufactured output was 9 percent per year during the 1960s, con- siderably more rapid than the 7 percent per year growth in GDP. During 1970-1975 manufacturing growth slowed to 6.2 percent per year, only slightly over the annual GDP growth rate of 5.7 percent. Development of the sector has followed a pattern common to several other large LDCs, with import substitu- tion almost complete in consumer goods (both durable and nondurable), less so in intermediate goods and least well advanced in capital goods. (See Table 1.1 and Annex III. For more details on Mexican industrialization, see Aspra, 1977; Nacional Financiera, 1971; Solis, to appear; and Villarreal, 1976.) 2. Efficiency, measured by international price comparisons, presents a mixed picture. Average price levels for manufacturing as a whole were 17.9 percent above international levels in 1960, 15.6 percent above in 1970, and 19.0 percent above in 1975. 2/ (These figures are net of estimated peso overvaluation of 6.0, 2.8, and 18.4 percent in the three respective years. Realized nominal protection of manufactured goods, based on prices converted at the official exchange rate -- i.e, including peso overvaluation -- is estimated at 25.0, 18.8 and 40.9 percent. See Annex II.) Thus the average efficiency of the sector compares well with other large import-substituting LDCs, where protection has been considerably higher, but not so well with the more open, specialized economies. Moreover, the averages in Mexico hide a fairly wide variation; many processes are highly inefficient, as shown both by price coumparisons and by plant visit analysis. In a comparison of prices of 394 products in 1975, 52 products (13 percent) had prices more than 50 percent above international levels and 26 of these (7 percent of the total) were priced at more than double the international levels. (These price differen- tials also are net of overvaluation, estimated at 18.4 percent in 1975.) This scattered inefficiency is protected by an import licensing system which virtually ignores price differentials in its usual refusal to permit the private sector to import goods that are produced domestically. 1/ Data on the different variables are not collected on a consistent basis and hence the estimates of shares may not be accurate. 2/ Throughout this report, measures of protection are based on estimates of how much Mexican prices exceed international prices. The quantity measured therefore reflects how much Mtexican producers actually take advantage of various protective devices. Estimated changes over time in protection may be biased downwards because the 1960 study made more adjustments for quality than did the 1970 one, while the 1975 study made none. Thus protection may have increased somewhat more over time than the estimates indicate.  -2- 3. Export performance of manufacturing has also been mixed. In 1975, the value of manufactured exports (including total value of export sales of assembly industries -- maquiladoras -- which accounted for half of the total) amounted to $2,090 million. At 12.50 pesos per dollar this was equivalent to 2.6 percent of GDP and 6 percent of gross valuec tf domestic production of manufactures. (Exports were depressed in 1975 because of the -ecession in the United States and the overvaluation of the p-su. In 1974 exports had been somewhat higher.) Manufactured exports g-;ew very rapidly in the 1970-74 period -- about 26 percent per year in real terms -- but the level they at- tained is still Ic'. for a country at Mexico's stage of development. Most of these exports came about in response to special situations such as the in- crease in assembly plants of US firms, or special programs such as the auto- motive parts exports that are required of the Mexican automotive industry. The rapid growth in manufactured exports occurred in spite of Mexico's over- all policies which, except for these special cases, implicitly discriminated against manufactured exports. In 1975, disincentives to manufactured exports included the overvaluation of the peso estimated at 18.4 percent, as well as the higher cost and lower quality of inputs (owing to protection and to sales taxes on inputs), as well as sales taxes on exports. These disincen- tives together are estimated to have been equivalent to an implicit tax on exports of some 26 percent. Positive incentives including sales tax reim- bursements under the CEDI scheme, low-interest export financing by FOMEX, and somewhat better-than-average access to import permits for inputs, are estimated to have been equivalent to only about 16 percent of what sales revenue would have been in the absence of any incentives or disincentives, even when the value of CEDIs are increased to reflect that they are not subject to income tax. Thus net incentives for manufactured exports in 1975 were negative, about minus 10 percent. 4. The situation as of mid-1977 is somewhat better, as a more realistic exchange rate plus restored CEDIs reduced net disincentives to close to zero. Mexico appears to have great potential as an exporter of manufactures, with her advantages of natural resources, abundant labor, growing industrial sophistication, and closeness to the large market of the United States. This potential is suggested by the growth in manufactured exports that has already occurred, and is confirmed by the mission's analysis. Better policies would help to develop this potential. 5. In recent years, the whole package of Mexico's foreign trade policies (protection, export incentives and disincentives, and the exchange rate) has not been fully appropriate either for promoting sustained and efficient growth in output and employment or even for managing the balance of payments. Policies that give greater promise of meeting these goals incluae (a) a higher real 1/ exchange rate (in terms of pesos per dollar) than in the past, maintained at a stable real level by reasonably stable prices if possible or otherwise 1/ Throughout this report, "real" means net of any effects of inflation, i.e., in terms of constant prices. Keeping the exchange rate stable in real terms therefore means adjusting it in proportion to any changes in the ratio of Mexican prices to international prices.  - 3 - by frequent adjustments, and (b) low import protection and commensurately adequate net export incentives for manufactures, with low dispersion among products. Since September 1976 the exchange rate has moved in this direction. As to import policy, low and more uniform protection could only be achieved by substantial liberalization or complete removal of the import licensing system, since this system affords potentially very high protection and thus can be used to shelter very great inefficiencies where they exist. For exports of manufactures, the cancellation of sales tax reimbursements under the CEDI scheme, and price increases, have offset the positive effects of the higher exchange rate; as of December 1976 net export incentives for manufactures are estimated at minus 14.0 percent, which is even more negative than in 1975. Export profits for most Mexican manufacturers were still too low to motivate sustained growth in a wide range of exports. The restoration of CEDIs announced on April 1, 1977 will wipe out most but not all of the net negative incentives. 6. Placing greater reliance for both protection and export incentives on a higher exchange rate and keeping that rate constant in real terms could help increase both import substitution and exports. This, in turn, would increase growth in total production and employment. tMoreover, growth under this strategy would be more efficient, because incentives would be more equal among products. Manufacturing as a whole still would, and should, be promotes, but the strategy would induce somewhat more specialization within the sector in those products that can be produced most efficiently. The strategy would also permit fuller utilization of capacity, greater scale of production, ai1d hence reduced costs. Gains in quality would also result from reduced procec- tion and greater exposure to export markets, and thus Mexican consumers would benefit in terms of both price and quality. 7. The possibility of greatly increased exports of petroleum and petrochemicals opens up a new option for Mexico's foreign trade policy. The increased revenues from these exports can be used to relax constraints on domestic demand and investment, and hence to facilitate faster growth of GDP and employment. To do this, the peso/dollar exchange rate must be maintained at or near its present level in real terms, and other export incentives must also be maintained (or strengthened). Then not only petroleum products but other exports will grow, the total increase in foreign exchange earnings will be larger, GDP and employment will increase and the additional foreign exchange can be used to pay for the additional imports that will be demanded. The danger to avoid is allowing incentives to increase other exports to weaken. This weakening would occur if the increased foreign exchange earnings from petroleum induced the authorities to allow the dollar value of the peso to appreciate in real terms, to reduce CEDIs, etc. Such actions would reduce the profitability of other exports, with the net effect of substituting petroleum for other exports with no gain in GDP or employment. 8. Employment and wage policy, in this report, are analyzed only from the viewpoint of the manufacturing sector. In this limited context, the most effective measure to increase employment would be the foreign trade policies just mentioned. These policies would promote both import substitution and  - 4 - exports of products Mexico can produce efficiently, which should imply much greater use of Mexico's abundant supply of labor. Another complementary ap- proach would be to improve support of small-scale industry, through greater access to credit and technical assistance as well as the improved access to material inputs that would result from liberalization or abolition of import licensing. .lso, fringe benefits that are financed from taxes or other charges that are proportional to wages add as much as 50 percent to basic wage costs. These burdens, combined with other labor laws that make firing or laying off workers very difficult, greatly increase incentives for employers to substitute equipment for labor. Shifting the financing of some fringe benefits to taxes on value added or on income, in place of taxes or other charges that are proportional to wages, would reduce the cost of labor to potential employers. This would increase employment, and through it, equity, as the relatively high-paying jobs typical of the manufacturing sector become available to a greater part of the Mexican labor force. Finally, the large wage increases of 1976, which were far above price increases and productivity growth, could rapidly erode Mexico's competitiveness if repeated in the future. 9. Fiscal policy is treated only partially in this report, but is important for the objectives dealt with here. (Fiscal policy will be dealt with in greater depth in the report being prepared by the economic mission that visited Mexico in April/May 1977.) Large public sector deficits have fueled inflation, which in turn has made Mexican exports less competitive, has led to greater use of import licensing to counteract the fall in the real peso price of imports, and has negatively affected saving and financial intermedia- tion in Mexico. Moreover, to help finance the growing public sector deficits of recent years, credit has been withdrawn from the private sector. Thus inadequate fiscal discipline in the past has reduced industrial investment and growth, efficiency of production, and exports. Reversing these trends is important for the future. Moreover, the adoption of foreign exchange policies to increase output, exports, and employment (as summarized in paragraphs 5-7) would increase the need for managing public finances in a non-inflationary manner. Analysis of the details of a sound fiscal policy is beyond the range of this report, but one important aspect could be improving the management of public sector manufacturing enterprises, especially requiring them to cover a fixed share of their current expenses and investment requirements, so as to increase their incentives to cut costs and to adjust prices to cover reason- able costs more fully. 10. A return to steady industrial growth requires controlling the infla- tion that has been accelerating for the last few years, contributing to the climate of uncertainty that had brought domestic private investment in Mexican manufacturing to a virtual standstill. The Mexican government is now taking steps to reduce inflationary pressures. The mission's analysis of the manufac- turing sector suggests that an approach to price stability involving restraint by government, management and labor should consider: (a) A sound fiscal policy, as mentioned in paragraph 9. (b) Reduction of the high protection for some products permitted by import licensing, combined with tariff revisions to  rationalize the system, would benefit consumers by doing away with the shelter- ing of the few highly inefficient producers that take advantage of the licens- ing system to pass on their high costs by raising prices in the domestic market. (c) Changes in taxation to tax away some of the increased profits that could result from the changes in foreign trade and wage policies, and to increase motivation to re-invest most of the rest of such profits. (d) Not allowing real wage increases to exceed productivity gains, especially for the next year or two. 11. Many public sector enterprises in Mexico function well. However, some others are a significant drain on public resources because of high pro- duction costs and low product prices. As a whole, public sector manufacturing enterprises have been incurring losses of 2 to 4 percent of net worth in each of the last few years. To increase the contribution of public sector enter- prises to Mexico's development, the management situation which permitted this should be reviewed, and the recent Mexican Government reorganization seems designed, at least in part, to do this. Another important aspect of the performance of public sector enterprises is their virtually unlimited access to duty-free imports, especially of capital equipment. This is one of the principal causes of lagging development in capital goods production in Mexico. These policies are also responsible, in part, for the large debts that some public sector enterprises have accumulated. Equity contributions by the government would be useful to restore financial health to enterprises that are basically productive, while increased fiscal discipline as required by the recent administrative reform and other laws and regulations should guard against repeating these problems. 12. Private foreign investment has played a growing and useful role in Mexican development, and can continue to do so in the future. The restriction on foreign ownership to 49 percent of equity (less in some branches of industry) is sometimes relaxed if the investment is in a sector or region judged particularly important to the country's development. Explicit public notice of such relaxation in specified conditions, rather than by ad-hoc implementation, might help to make the policy more effective. Also, the strategy now being pursued of promotion of tripartite joint ventures, by public, domestic private, and foreign capital, offers many advantages and should be strengthened. 13. Mexico's well-developed system of financial intermediation has been badly set back during the last few years. Credit available to private indus- try has been doubly squeezed, by a drop in the mobilization of savings and by a rise in the share of total credit going to the public sector. These trends have reduced credit outstanding to the private sector as a whole from 22 or 23 percent of GDP during 1970-73, to 15 percent of GDP in 1976. The private industrial sector has been squeezed even further, as agriculture and commerce have maintained their shares of the total. Credit outstanding to manufactur- ing enterprises dropped from 36 percent of value added in manufacturiie in 1969 to 32 percent in 1975; in 1976 it appears to have continued to fail, at an even faster rate. This credit squeeze could be reversed by reducing the public sector deficit, restoring reasonable real interest rates paid to depositors, and managing foreign trade policy so as to increase confidence in  -6 - the peso. The Bank of Mexico seems to be aware of the need to provide ade- quate working capital to help firms affected by the adjustments to higher exchange rate, price increases in public services, etc., and that the situation requires careful monitoring and prompt action to avoid unnecessary and costly failures. 14. Taking a long-run view, Mexican industry has been growing and much of it is reasonably efficient. However, in the last few years the situation has been considerably less favorable. Compared to most of the past few decades, the 1974-76 period has seen increasing inflation, declining invest- ment, restricted access of the private sector to credit, and wage increases that were more rapid and less related to productivity growth. Since August 31, 1976 the abandonment of the peso-dollar parity of 12.50 to one, and subsequent instability in the exchange rate, prices and wages, had produced confusion and a crisis of confidence in the months that followed. Mexico needed a new set of policies that both in fact and in appearance confront both the short-run problems and the longer-run needs of the economy, providing a return to healthy growth. This confusion and air of crisis seem now to have passed, as the basic soundness of the economy, the tradition of good perform- ance in the past, and many of the actions the new Government has already taken or has declared its intention to take increase confidence in Mexico's future. 15. One of the problematical aspects of the situation when the mission visited Mexico in November 1976--perhaps difficult to avoid in that transi- tional period--was the lack of a coherent set of policies. Would wage and price increases be allowed to erode the hoped-for benefits of the devaluations of the peso? How can the competing claims of workers, public sector enter- prises, private business, and the government itself be resolved in a way that reduces inflation and allocates resources to where they are needed and where they would be most productive? How can the words and the actions of the government help to increase confidence, continue to attract both domestic and foreign saving, and invigorate investment? Any report must, necessarily, discuss policy measures in sequence. But the measures are dependent on each other for success, and must be so designed. The sequential nature of the exposition should not be mistaken for a lack of interrelations between the individual items. 16. Text Table 1 presents a brief overview of the policies discussed in this report. The three overall objectives that orient our analysis are listed across the top: efficient growth, balance of payments management, and employment. From top to bottom are the major policy areas studied: the exchange rate, import controls, export incentives, prices, wages and labor policy, public sector enterprises, private investment both foreign and domestic, and industrial credit, as well as the two more narrowly defined parts of the manufacturing sector that were studied in more depth: small and medium scale industry, and capital goods. Entries in the table summarize the measures suggested for consideration, and their likely effects. 17. Text Table 1 contains several examples of the interdependence of policies. To cite just one here: Removal or substantial liberalization of the import licensing system would probably increase imports to some extent.  -7- Text Table 1 MEXICO: OVERVIEW OF POLICIES SUGGESTED FOR CONSITDERATION O B J E C T I V E S Policy Areas Efficient Growth Balance of Payments Employment and Income hanagament Distribution Exchange Rate: Keep rate at or near equilibrium Creates export incentives Restores confidence and Promote exports and import in order to substitute for most and protection against brings both capital and substitution in all activi- protection and export incentives imports )hile avoiding current accounts more ties; thus increasing em- and to manage balance of payments price distortions and need toward balance even at ployment. Available income at a high GDP growth rate; keep for import controls that higher growth rates. increases and its distribu- real value more or less constant would otherwise lead to Eliminates implicit tax tion becomes more equitable, in future. A level in the range inefficiency and lagging on exports that stemmed based on real contributions of 20 to 22 pesos per dollar, at productivity; increases from overvalued peso, and to growtb rather than on December 1976 prices, could be import capacity enabling thus increases exports. distorted incentives. appropriate with other measures growth to accelerate. suggested here. Import Controls: Dismantle or greatly liberalize Strengthen role of prices Probably increase imports. Limit price increases and licensing system in a phased in resource allocation; However, higher exchange thus help to maintain con- sequence starting with inputs spur to increased efficien- rate and tariffs will limit sumers' purchasing power. into producer goods. Rational- cy. Improve access of these, and greater exports ize tariff system to provide manufacturers to inputs will more than pay for protection averaging, perhaps, at reasonable cost and them. 10 to 15 percent for manufac- quality. turing. Eliminate waivers of public-sector tariff payments. Create an administratively ef- fective system of drawbacks on import duties for exporters. Export Incentives: Fquilibrium exchange rate plus Exports would be products Reverses two negative as- Increased demand for labor somewhat stronger CEDIs; main- which are produced effi- pect of past policies, by in manufacturing and in all tain incentives indefinitely. ciently. making export profitabi- export activities; indirect Since import substitution lity (a) high and (b) nearly effects further increase opportunities are becoming equal to that of domestic employment throughout tne limited, and Mexican manu- sales. Enables balance of economy. facturing is maturing, a payments equilibrium at shift toward export markets higher growth rate and with is both natural and neces- more capacity to import. sary for continued rapid growth. Prices: A sound macroeconomic policy, Relative prices allowed to Helps to keep exchange Limit price increases and beyond the scope of this report, move closer to relative rate roughly constant, thus help to maintain con- is essential. Within such a costs (through liberaliza- in real terms at least. sumer's purchasing power. policy replace spotty price con- tion of imports and reduc- Maintains Mexico's compe- trols and below-cost provision tion of implicit tax on titiveness in both domes- of goods and services from some exports that stemmed from tic and foreign markets. public sector manufacturing overvalued peso); will enterprises with economy-wide increase efficiency and real price restraint, with target growth. level consistent with a modera- tely restraining fiscal and monetary policy. Wages and Labor Policy: Limit increases to productivity Reduce incentive to substi- Maintain Mexico's advantage Encourage employment ex- growth during stabilization tute capital for labor; of lower labor costs vis- pansion both by use of labor period. Replace annual renego- reduce costs of negotia- a-vie major trading part- as a substitute for labor- tiations with 2 or 3 year agree- tions and uncertainty. ners; induce expansion of displacing capital equip- ments providing for automatic ad- Greater use of available exports and of efficient ment and through greater justment. Replace financing of supply of labor will in- import substitution. growth; improve income some benefits from wage taxes crease output. distribution mong workers by financing from general reve- dsrbto mn okr nues. flnanc from general reve-by increasing the number of jobs in industry (which are relatively high-paying in comparison to the rest of the economy).  Text Table 1 (cont.) 0 B J E C T I V E S Policy Areas Efficient Growth Balance of Payments Employment and Incose Management Distribution Public Sector Manufacturing Enterprises Partly replace financing of defi- Motivates greater effi- Reduced inflation will make cits and expansions through ciency in operation and balance of payments manage- Treasury funds by revenues of keep prices from falling ment easier. the enterprises. Remove waiver below costs; reduce defi- on import duties for inputs. cit of public sector. Reduced demand for credit from public sector will increase supply to private sector. Private Investment Replace subsidies through cheap- Restore incentives to in- Increases employment by er access to equipment and vest in efficient sectors reducing incentives to imported inputs, by temporary through (a) better access substitute capital for income tax relief (where to imported inputs, (b) high- labor and further by in- subsidies are warranted); chan- er export profits, (c) ten- creasing investment. nel employer's gains from porary corporate income tax, Promote equity by discoura- wage restraint and export prof- relief in areas where sub- ging luxury consumption. its into productive uses sidies are needed and (d) through interest rate, tax and wage restraint: these credit policies that favor measures compensating for savings and reinvestment while higher costs of some equip- discouraging luxury consumption, ment and other current in- puts. Alleviate credit squeeze. Foreifn 1pvestment: Apply 49% participation limit Continue to attract needed Maintain or increase with flexibility; mske permis- capital and technology, foreign capital inflow; sible relaxation explicit in facilitate purchase of cases such as investment in technology where needed priority sectors or regions. (e.g. in capital goods). Continue to promote tripartite Motivate investment for joint venture with domestic export markets. Improve private and public investors. access to export markets. Industrial Credit: Hieher real interest rates and Restore flow of savings to Maintain output; expand Maintain and expand em- stable real value of peso. Reduce financial system; restore investment for export ployment in efficient public sector deficit. Assure share of private sector in production and efficient enterprises that would adequate flow of credit for work- access to savings; maintain import substitution; otherwise fail for lack ing capital, output by avoiding squeeze reduce new foreign in- of credit; promote equity on working capital. debtedness by expanding the by allocation of credit the flow of finance from based mainly on efficien- within Mexico. cy and future potential, rather than existing wealth or foreign connec- tions. Small and Medium Scale Industry: Increase access to credit and Remove constraint to growth Provide increased employ- technical assistance, especially of small-scale sector. ment and increased rewards for smaller firms. Liberalization of import to small-scale entrepre- licensing will also move neurs. in this direction. Capital Goods: Eliminate privileged access of Move towards Mexico's compa- Substitute for imports Expand production in a public sector to imports; provide rative advantage in this where domestic production sector with a relatively high moderate tariff protection; sector, is not too costly; increa- labor/output ratio. analyze growth possibilIties sed specialization should for intermediate inputs and end also increase exports. products; promote new projects and assist existing firms ac- cordingly.  - 9 - However, avoiding overvaluation of the peso, eliminating large-scale exemp- tions from paying tariffs, and providing moderate tariff protection for products where tariffs are now low or zero because of reliance on refusal of import licenses could contain any increases in imports within safe levels. The same exchange Late policy plus restoration of CEDIs at an adequate level could increase exports by more than enough to pay for the increased imports. This policy package would induce growth in output in efficient enterprises (and in particular could provide part of an appropriate environment for promotion of efficient import substitution and exports of capital goods). At the same time, the import liberalization could help to restrain unreasonable price increases and help maintain consumers' purchasing power in the face of wage restraint, and is in itself needed to cut costs and provide access to inputs of good quality and reasonable price, in order to promote exports. ANALYSIS I. Foreign Trade Policies 18. This set of policies includes the exchange rate; import tariffs, permits, and other regulations; and export incentives and disincentives. It is assumed that the important goals to be met are (a) in the short run, helping to increase confidence in the peso and in the economy, and (b) in both the short and the longer run, managing the balance of payments and in- ducing efficient growth in output and in employment. 19. The key themes of the mission's suggestions on foreign trade policy are increasing generalized incentives for exports of manufactures, and general- izing and rationalizing the already strong but uneven incentives for import substitution. Mexico's manufactured exports have been growing rapidly, but are still only a very small share of Mexican manufacturing production. The country has great potential for continued growth of exports of manufactured goods, which could be realized by better exploiting its growing know-how, abundant labor, natural resources, and proximity to the US market. A stronger export orientation for all Mexican manufacturing could serve many important purposes. (a) More exports are needed for managing the balance of payments, including the severe debt service burden of the next few years. Even import substitution that is efficient in the long run will not help much in the next year or two because most remaining opportunities for import substitution in Mexico would themselves require considerable imports of equipment and some current inputs. (b) More exports are needed to provide employment; exports provide markets for additional production and many export products that would appear under generalized incentives would be more labor-intensive than manu- facturing on the average. (c) Finally, such exports almost by definition are goods which Mexico produces efficiently and thus they would contribute to a greater growth of output in real terms. 20. Mexico's present system of protection through licensing provides potentially very high protection to many manufactured products, and less to  - 10 - others. The system insulates Mexican producers from motivation to cut pro- duction costs or to increase quality. This allows considerable inefficiency in domestic production, most of which could be eliminated if motivation were sufficient. Some of this inefficiency consists of producing goods in which, at least at present, Mexico cannot be competitive. But by far the largest part of the inefficiency consists of higher costs and/or lower 1uality that could be improved upon if the producers had to compete with imports or if export incentives made competing in export markets more attractive. To induce greater efficiency, Mexico could increase access to imported products where domestic costs are unreasonably high, and also increase the profitability of exports. This would permit more Mexican producers to increase volume and profits through successful competition in international markets. Increases in competition as well as more efficient specialization could induce faster growth. Past Policies 21. The exchange rate was kept constant at 12.50 pesos per dollar from 1954 until September 1976. Price increases in Mexico stayed about equal, grosso modo, with those of the United States and others of Mexico's trading partners until the early 1970's; protection against imports, as well as export incentives, also did not change very much. Around 1971-73 this behaviour changed. Prices rose faster in Mexico than in her principal trading partners. Mexican authorities chose to allow the peso to become overvalued, and to com- pensate for the overvaluation by increasing apparent protection and apparent export incentives. 22. In any process of increasing overvaluation of a currency, with com- pensating increases in protection and export incentives, the true change in protection (or in export incentives) is the net effect of the two opposite events: increasing overvaluation decreases protection (or export incentives) while the explicit measures such as more restrictive import licensing or tax rebates for exports provide compensating increases. For this reason, in this report we refer to the explicit measures as "apparent" protection or "apparent" export incentives, while the effects after estimated overvaluation has been netted out are referred to as "net." 23. Exports: M4exico's manufactured exports have grown rapidly from a low base. Over the five-year period 1971 through 1975 they grew by 30 percent per year, of which about 12 percent per year was attributable to price in- creases and 16 percent per year represented real growth. Text Table 2 sum- marizes this growth.  - 11 - Text Table 2 Mexico: Manufactured Exports, 1970-1975 /a (million dollars) "Maquiladora" Year Assembly Plants Other Total 1970 218.8 353.5 572.3 1971 270.0 454.2 724.2 1972 426.2 574.9 1,001.1 1973 651.2 837.9 1,489.1 1974 1,032.9 1,242.9 2,275.8 1975 1,020.6 1,069.3 2,089.9 /a The figures exclude primary nonferrous metals, sugar and petroleum products. The full value of product of assembly plant exports are reported, making them com- parable with other exports. 24. In relative terms these industrial exports are still rather small -- only 3 to 8 percent of those of European countries with populations roughly comparable to Mexico's but whose income is three to six times as much (West Germany, United Kingdom, France, Italy), and also very much smaller in per capita terms than manufactured exports from successful LDC exporters such as Taiwan, Hong Kong, The Republic of Korea and Singapore. However, Mexico's industrial exports, including assembly products, are roughly double those of Brazil in per capita terms. 25. Nearly half of Mexico's manufactured exports come from plants that assemble products for the US market based at least in part on inputs imported in bond from the United S-i.ates, taking advantage of special provisions in the US tariff that limit import duties for such products to value added outside the United States. About two-thirds of assembly-plant exports consist of items such as electronic parts, television and communications equipment; clothing is a distant second. 26. Exports other than those of assembly plants are more diversified. Exports of non-electrical machinery, electrical machinery, and transport equipment industries have grown considerably, to $270 million (25 percent of non-assembly-plant manufactured exports) in 1975. Most of these exports consist of parts or components, led by automobile engines and parts, and most go to the United States. However, automobile parts exports are required of the automotive industry, and may not all be produced at internationally competitive costs (see paragraph 28). Chemical exports ($204 million in 1975 -- 19 percent of non-assembly manufactured exports) are largely based on  - 12 - natural resources such as sulphur, lead, zinc, and barbasco (used to produce hormones); these go mostly to the USA and LAFTA countries. Textile exports, based on locally produced henequen and cotton, and food product exports, led by molasses and simply preserved fruits and vegetables, are also important. In spite of the concentration of exports in a f.w sectors, _. _r . .* sectors exporting 10 percent or more of their output in 1974 (the last year for which these comparative data are available) were basic chemicals, fertil- izers, and pharaceuticals--all principally based on natural resources. (Large food product exports were mostly sugar, not treated here as a manu- factured export.) (See Tables 1.2, 1.3, and 1.4 for more details.) 27. Manufacturing exports have been inhibited by a number of serious disincentives. The most important of these negative elements have been (a) the progressively more overvalued exchange rate that prevailed through the 1970s, until the floating of the peso in September 1976, and (b) problems of high cost, low quality and unreliability of manufactured inputs, mainly owing to indiscriminate protection by the import licensing system. The overvalued exchange rate squeezed export profit margins, as the peso value of exports was kept from rising while peso costs of wages and other domestic inputs rose. At the same time, some of the intermediate inputs produced in Mexico and protected by refusal to grant licenses to import competing products were too expensive or not good enough in quality to permit their use in competitive export pro- ducts. Other disincentives include (c) the inflexibility of some of the labor laws: high costs of discharging workers and difficulties in achieving tempo- rary layoffs discourage investors from expanding their labor forces; (d) high costs and delays of shipping through the main Gulf ports of Veracruz and Tampico; and (e) heavy use of discretionary measures in policies affecting exports: "deals" offered and rules applied vary greatly over time, and even among firms in the same industry. A potential exporter cannot be sure what incentives he will get, whether he will be able to import certain inputs, etc. The uncer- tainty that results is a great discouragement to investments to produce exports. Restrictions on imports, on the part of countries which would other- wise be buying more Mexican goods, are also an inhibiting factor. 28. Many exports that appeared in spite of these disincentives have been brought into existence by special policy measures. For example: (i) Automobile manufacturers are required to achieve either exports or increased domestic content in specified ratios to imported inputs in order to raise the numbers of vehicles they are allowed to produce each year. At least two-fifths of the exports are required to come from parts manufacturers. Accord- ing to one study, in 1974 Mexico's motor vehicle industry achieved $154 million worth of exports, consisting mainly of automobile engines and parts, compared to $498 million worth of imports. (Vazquez Tercero, 1976) To the extent that these exports are not produced at competitive prices, the costs of subsidizing both exports and domestic manufacture are borne by Mexican consumers.  - 13 - (ii) Costs that processors have to pay for many natural resource inputs are reduced, by various means such as export taxes, export restrictions, or price controls that hold prices in Mexico below the world market price. The coverage of these measures has varied; at one time or another they have extended to most potential agricultural and mineral exports, including industrial inputs varying from zinc and sulphur to citrus and strawberries. In the case of babasco, used to manufacture hormones, exportation has been prohibited outright. Such measures, by lowering the costs of raw materials relative to the market value of exports, contribute importantly to Mexico's exports of manufactures based on natural resources. Costs are borne by primary producers whose sales prices are controlled or whose exports are taxed or restricted. (iii) Industrial exports under accords with LAFTA countries--to which Mexico exported over $125 million of manufactures, narrowly defined, by 1973 (see Table 1.4)--are based on mutual waivers of protection, giving these goods privileged access in markets such as Brazil or Argentina. Costs are borne indirectly by Mexican consumers, who must pay high prices for other products imported from Mexico's LAFTA partners in exchange. (iv) Low-interest financing by FOMEX has been a significant help to many exporters of manufactures. The advantage to exporters who receive these loans, which are available for virtually all manufactured exports and without excessive administrative diffi- culties, is on average equivalent to an additional 2 percent of export prices. (v) Many enterprises consider it good policy to export to increase their chances of being allowed imports, and many others export modest quantities at prices that may be well below average costs, in order to achieve fuller utilization of capacity. Some exports remain unprofitable in the long run but are continued because they cover variable costs; thus some of the exports in recent years are a lagged effect of investments undertaken earlier when conditions were more favorable. (vi) Finally, the most important of the incentives that were generally available to exporters of manufacturers were reimbursements for payment of indirect taxes--CEDIs. 29. CEDIs, in effect from 1971 to August 1976, were the single most important incentive to manufactured exports. These tax rebate certificates were temporarily eliminated after the fixed parity of the peso was abandoned in August 1976, were later reinstated on a selective basis for industries that could demonstrate a "need" for them (this is an example of the ad-hoc applica- tion of incentives, which is much less effective than automatic across-the- board procedures), and were reinstated generally just as this report was  - 14 - completed in April 1977. While CEDIs were in effect before August 1976, the producer for export received certificates worth 11 percent of the sales price of exports if the domestic content (material inputs made in Mexico plus value added) of his product was 60 percent or more; these certificates could not be negotiated or transferred, but could only be used to pay taxes. This tax rebate was not subject to income tax (which is generally 42 percent for corporations) so that for many recipients the after-tax effect was equivalent to a 19 percent increase in their sales price. However, some exporters pay little or no income tax. In calculations for this report the mission has assumed that two-thirds of all CEDIs went to companies with sufficient income tax liability, so that on average the value of CEDIs was equivalent to a 16 percent increase in the sales prices of exports. Under the old system, CEDIs helped exports considerably but had some shortcomings. For exporters whose product consists mostly of purchased inputs and only very little of value added, CEDIs increased profit margins enormously, while for others with a different cost structure or with low tax liabilities, their value was small. The system did nothing to compensate producers of inputs that were incor- porated into exports by other producers, and the CEDIs given out bore very little relation to the net contribution of each export to the balance of payments, since the reward was the same whether domestic content was 60 percent (which could mean much less in international prices) or 100 percent, and regardless of the extent to which the export used exportable inputs or imported capital equipment. 30. Under the new CEDI system decreed in April 1977, the value of the reimbursement varies from 25 to 100 percent of indirect taxes paid, depending on (a) how much of the gross value of product represents value added (as opposed to purchased raw materials and intermediate goods); (b) the domestic content of the product, and (c) whether the exporter has increased his exports in the last year. For example, if the product has only 30 percent domestic content, and the value added by the exporter is relatively low, the CEDI is only 25 percent of the taxes paid. More domestic content means higher CEDIs; at 80 percent or above the exporter receives 50 percent of taxes back. Similarly, higher value added means higher CEDIs; high value added and 80 percent or more domestic content earns the exporter 80 percent of his indirect taxes. Finally, export increases can earn up to an additional 20 percent. To receive reimbursement for all of his indirect taxes, the exporter must have 80 percent or more domestic content, high value added, and a 15 percent annual increase in his exports. 31. Other export incentives are: (a) Administration of import and in- vestment licensing by SIC favored export activities. Requests for import licenses were more likely to be granted, and were sometimes granted more quickly, if the need for the import was justified by a need to compete in export markets. (b) In general there was increased official concern over manufactured exports, as evidenced by various promotional activities such as those of IMCE. (c) The Banco de Mexico appears determined to direct financing to export-oriented firms in the present credit squeeze. 32. With proper policies, Mexico appears able to become a major exporter of industrial products, on a scale many times as large as today, provided that its industries are encouraged to specialize in what they can produce best.  - 15 - This achievement would speed the nation's advance into the ranks of the indus- trial countries, not only through the exports themselves but also because the types of policy environment and managerial and technical efficiency needed to meet this challenge are also what Mexico requires to improve its production for the domestic market, to raise income and to increase employment. 33. Mexico's comparative advantage in manufactured exports appears to lie especially in two broad areas. First, some manufactured exports can be and are based on local primary raw materials; progress in these industries depends heavily on the associated primary producing sectors. Second, there is an especially promising future in exporting products to the US that com- bine two features: substantial requirements for manual labor, and moderate transport costs and/or need for fast delivery. In products for which trans- port costs are too high, Mexico cannot compete with US producers; where transport costs are very low, Mexico cannot compete on even terms with Asian countries as a source of cheap labor. Mexico does enjoy special advantages in an enormous variety of exports subject to moderate transport costs, such as some building materials, furniture, other household items, a wide range of metal products and parts and assembly activities, perishable food products, and fashion-sensitive clothing requiring rapid delivery. While some of these exports may be specialty items produced in small batches, many other opportunities depend on mass production of goods in which Mexico has a poten- tial cost advantage vis a vis the United States. To realize such advantages requires specialization within each industry, so that high volumes of output can be achieved. Examples where early success can be expected include motor vehicle parts, components for machinery and transport and electronic equipment, assorted simpler metal products, and glass products. However, specification of the precise items is difficult to predict. The best approach may be to adopt generalized incentives and let the market indicate just where Mexico can best compete and, more, to make the market stimulate the potential exporters to come up with better and with new export items. 34. Mexico's potential can be realized rapidly by embracing a strategy that has been followed in periods since World War II in a number of coun- tries, with excellent results -- West Germany, Italy, Japan, Austria, Fin- land, Norway, Greece, Taiwan, Korea and Singapore would be leading examples. The essence of this strategy is to create a stable policy environment with a strong government commitment to expand exports and keep them profitable. This requires giving producers access to the inputs and other help they need to be competitive, and having an exchange rate, relative to domestic wages and other costs, at a level where local prices appear low and the country becomes a really attractive place to invest and expand output. In this strategy the exchange rate becomes the main source of protection against imports as well as of export competitiveness. By compressing the foreign currency value of incomes, non-essential imports can be kept in check and, since export earnings grow swiftly, the country can afford whatever imports of capital equipment and intermediate inputs are necessary. 35. Imports and protection: Mexican manufacturing has developed rap- idly and has diversified to a wide gamut of products during the last two or three decades. By 1969 imports contributed only 10 percent of total supply of  - 16 - manufactures in Mexico. Of non-durable consumer goods, imports were less than 2 percent of total supply; for intermediate goods the share was 11 percent and for durable consumer and capital goods together the share was 29 percent. (Nafinsa 1971). The share of manufactured imports as a whole increased in the early 19709, but this was due to the overvaluation of the peso and to inventory speculation in anticipation of possible devaluation. Looking at sectoral detail, by 1974 imports were significant only in basic chemicals, capital goods, synthetics and plastics, and the miscellaneous category. (See Table 1.1). 36. This development was promoted in large part by a conscious policy of import substitution during the last few decades. Control of imports has relied more on quantitative controls than on tariffs. The percentage of products for which import permits are required has risen steadily over the last 20 years; from about 33 percent in the late 1950s, the percentage rose to 50 percent in the early 1960s, reached 75 percent in the early 1970s, and in November 1976 was about 85 percent. The percentage by value of actual imports that required licensing also rose, although less rapidly, from 28 percent in 1956 to 74 percent in 1974. 37. The general principle of operation of the system is that imports that compete with locally produced goods are not allowed. In some extreme instances of high cost of the domestic product, the authorities have granted import permits. But as a rule they were prepared to allow substantial mar- gins of inefficiency - as reflected in the prices -- to protect goods pro- duced in MIexico. Of course domestic competition, the possibility of smug- gling and the increase in the size of the domestic market reduced inefficiency in many established industries. Nevertheless, the erratic levels of protec- tion generated by the licensing system are reflected in the wide dispersion of rates of protection, already noted in paragraph 2. Imports, moreover, have been subject to numerous exemptions from tariffs, most notably imports by the public sector and some imports of capital goods, so that tariff collections were only 6.5 percent of total merchandise imports. More than one-half of imports (33 percent of private sector imports and 89 percent of public sector imports) paid no tariff at all in 1975. 38. Actual protection as measured by international price comparisons, however, was higher. The apparent average level of protection of manufac- turing was 25 percent in 1960, 18.8 percent in 1970, and 40.9 percent in 1975. The pattern of protection is typical: primary production receives low rates, traditional industry higher rates and "modern" consumer durables still higher rates. Unfortunately, the two-digit industrial classifications that were used in studies of protection aggregate products with widely dif- ferent levels of protection in Mexico, and therefore impede analysis of appropriate groupings of products. For example, the two-digit sectors enjoy- ing the highest protection, on average, in 1975, were textiles, beverages, basic chemicals, synthetics and plastics, and cosmetics. However, the really high protection is only evident at higher levels of disaggregation. High protection is scattered throughout most manufacturing sectors, usually for a few products in each. This is the result of the licensing system which grants protection with little or no rationale, other than to pro- tect domestic production, and with little or no regard for relative costs.  - 17 - 39. While protection did help to induce industrialization in Mexico, and industrialization has been a key element in raising incomes, diversifying and increasing exports, and modernizing Mexican society, there have been signi- ficant costs associated with protection in Mexico. One way to estimate some of these costs, a- presented in Bergsman (1970), is to view protection as leading to higher prices owing to three different factors: (a) higher costs that are unavoidable, in which case protection is sheltering industries which, at least at the time, cannot be efficient in Mexico; (b) higher costs that could be reduced, in which case the industries could be efficient in Mexico but the producers are using protection to relax their cost-reducing efforts; and (c) monopoly returns, in which case the industries are efficient in Mexico but the producers use protection to charge higher prices. Reducing protec- tion would reduce all three effects, in the first case by replacing domestic production by imports while in the second and third case domestic production would continue but prices would be reduced. Estimates for 1960 place the size of the first effect at 1.5 percent of value added in manufacturing, and the second and third combined at 11 percent of value added in manufacturing. This means that Mexican manufacturing could have produced much more output if distortions induced by protection had been absent, with only very small replacement of domestic production by imports. Changes since 1960 suggest that the allocative costs may have risen; the total of these effects may be esti- mated currently at about 15 percent of value added in manufacturing, or over 40 billion pesos. 40. Indiscriminate protection behind an import licensing system is also a major hindrance to manufactured exports. Such protection not only increases the costs of intermediate inputs but in many cases results in lowering their quality. Experience in other countries suggests that real success in export- ing manufactured goods virtually requires that exporters have access to inputs at world market prices. 41. Another kind of cost of protection is that incurred by the govern- ment in administering the licensing system and by the private sector in dealing with it. Administratively, the licensing system causes some prob- lems for many importers but not in all cases. In general, if the import is permitted its quantity is not limited. Thus, firms can import without restric- tion certain inputs or machinery which by no stretch of the imagination are produced in Mexico. In other cases, firms resign themselves to using the domestic input even if it is more expensive or of lower quality, adapt their production processes to the situation, and pass the price or quality differ- ence on to the consumer. Administrative problems arise when it is not clear whether the domestically produced good is "really" the same as the imported product. For these cases some firms and trade associations maintain staff of "expediters" and "public relations experts," and invest a substantial portion of the time of top management to "cultivate" the import licensing authorities. The Ministry of Industry and Commerce in turn employed about one thousand persons and substantial computer time in the process of granting permits and other matters regulating imports. Of course firms that are too small or too far away from the capital to become involved in the import permit process have to buy from distributors, often at a substantial premium, or do without  - 18 - imports entirely. Controlling imports by licensing discriminates against small-scale entrepreneurs because they have less access to imported inputs and less ability to insure protection of their products by influencing the authorities to deny licenses for competing imports. Capital goods production is also very sensitive to the negative effects of licensing, because most capital goods are made of literally hundreds of parts which must meet certain tolerances or other quality standards. Uncertainty as to availability of imports and mistrust of protected domestic suppliers lead producers of end- product capital goods to produce more of such parts themselves, at smaller production volumes than is economical. 42. Net protection and export incentives: The combined forces of export incentives and disincentives, protection, and exchange rate policy can be summarized in numerical terms. Measures of many of the relevant variables are available only for 1970 and-1975, which is sufficient to show what happened: 1970, very roughly, is representative of the period 1960 through about 1971; changes from 1970 to 1975 show the trend from 1972-73 through August 1976. The analysis is summarized in Text Table 3 and Chart 1.1. The estimates for all incentives and disincentives are expressed in terms of equivalent effect on sales prices, so as to be comparable with each other and with changes in the exchange rate. For example, a 6 percent increase in input prices would be expressed as (6) (.62) - 3.7 percent, if inputs were 62 percent of product price. 43. From 1970 to 1975, apparent protection to Mexican manufacturing (as measured by price comparisons) rose from 18.8 to 40.9 percent. On the export side, the apparent effect of all incentives and disincentives taken together was changed from an implicit tax on manufactured exports of 12.0 percent in 1970 to an apparent subsidy of 7.1 percent in 1975. This apparent subsidy consisted of the positive effects of CEDIs (16 percent) and other incentives (3 percent), offset by the effects of sales taxes (8 percent) and higher input costs due to protection (5 percent). (See Annex II for details.) 44. As noted earlier the apparent increases in both protection and ex- port incentives were in large part compensation for an increasingly over- valued peso. Mexican prices were rising, relative to prices in her principal trading partners. Moreover, Mexico's balance of payments deficit was increas- ing. Both of these required devaluation or some substitute; the Mexican authorities chose to increase protection and export incentives as an alterna- tive to devaluation. As a result, the apparent increases in protection and export incentives were in large part illusory. 45. To make more meaningful estimates of levels of protection and of export incentives, the mission has estimated "free trade equilibrium" exchange rates for 1970 and 1975. These are the exchange rates at which Mexico's bal- ance of payments would have been at or near equilibrium if all protection, export incentives and disincentives were removed. Details of the methodology are explained in Annex II. Estimates of protection or export incen- tives relative to this exchange rate, referred to as "net protection" or "net export incentives," measure the net effects of all of Mexico's foreign trade policies, relative to a situation in which imports and exports are neither  - 19 - promoted nor discouraged. These net estimates can also be compared over time -- because the effects of any changes in overvaluation of the peso have been removed, the estimates measure net or true changes in protection or export incentives. Changes in net protection or net export incentives can also be approximated by changes in real effective exchange rates, as shown in lines 4 and 5 of Text Table 4, on page 25. 46. The estimated free-trade equilibrium exchange rate depends on what other policies are in force. For example, it would be increased by greater governmental spending or by faster growth; it would be decreased by more conservative macroeconomic policy or by increased exports of petroleum. Thus it is not necessarily the "right" exchange rate (this latter depends on the objectives of policy) but simply the rate at which Mexico's balance of pay- ments would be in equilibrium given a particular set of other policies. 47. Overvaluation is estimated by this method at 2.8 percent in 1970 and 18.4 percent in 1975. 1/ When the apparent levels of protection against imports of manufactures (18.8 percent in 1970 and 40.9 percent in 1975) are reduced to net out overvaluation, they fall to 15.6 percent in 1970 and 19.0 percent in 1975. On the export side, net export incentives for manufactures are negative in both years: -14.4 percent in 1970 and -9.5 percent in 1975. 48. These policies kept Mexican export profitability low, and certainly much lower than the profitability of sales within Mexico. In 1975 a typical manufactured product worth, say, $100 in the world market, could be produced and sold in Mexico for the peso equivalent of $118.40. 2/ The same Mexican producer would receive the peso equivalent of only $90.50, however, if he exported his product. If his profit margin on the domestic sale was 20 percent, exports would have implied a loss of $4.22 per unit. 49. These conditions were not much better as of December 1976. For exports, the depreciation of the peso added about 60 percent to unit revenue, but the loss of CEDIs plus labor and materials cost increases since 1975 were equivalent to an even greater drop in unit revenue. Net export incentives were still negative, at about -14.0 percent. On the import side, net realized protection was about the same as in 1975, 3/ as was the potential protection I/ The estimated overvaluation is slightly less than other approaches have calculated. Reasons for this are explained in Annex II. Briefly, the two main reasons are that the estimates take into account the (im- portant) effect of protection on raising costs of inputs (an effect that would be removed in free trade, and thus increase exports) and also the effect of structural changes such as import substitution and export growth in sectors such as petroleum and tourism. 2/ Valuing the peso at its estimated equilibrium level. 3/ Approximated by changes in wholesale price indices.  - 20 - Text Table 3 Mexico: Exchange Rates, Protection and Export Incentives: 1970, 1975, and December 191b (in current prices) 197