McKinsey Global Institute

Briefing note
In the 20years since Mexico signed the North American Free Trade
Agreement, creating a single market with the UnitedStates and
Canada, it has become one of the worlds leading manufacturing
exporters. Seven global automakers have plants in Mexico that
now produce more cars each year than come out of Canada.
Mexican universities turn out more engineers than Germany. Market-
opening reforms that began before NAFTA have continued and
have helped create a cadre of globally-competitive Mexican-based
multinationals. And with its scal stability and news of a broad
reform agenda, Mexico is once again in the sights of global investors
and multinationals.
Yet there is another side to the Mexico story. Its GDP has grown
by just 2.7percent a year on average since the beginning of the
1990s and since 1981 has averaged just 2.3percentvery slow by
emerging-economy standards. More than two-thirds of the growth
has come from expanding the labor force; productivity and living
standards have been stagnant. Indeed, because of slow growth,
Mexico now lags countries in GDP per capita that it once surpassed.
China, which had one-twelfth of Mexican GDP per capita in 1980,
could pass Mexico by 2018.
What holds Mexico back? The answer, we nd, is that there are,
in effect, two Mexicos: There is a modern Mexico, a high-speed,
sophisticated economy with cutting-edge auto and aerospace
factories and there is traditional Mexico, a land of sub-scale, low-
speed, and unproductive enterprises, many of which operate outside
the formal economy. Mexicos disappointing growth record is the
result of the two Mexicos pulling in opposite directions: while the
largest modern corporations (those with more than 500 employees)
have been raising productivity at a brisk paceby 5.8percent
a yearproductivity among the small traditional businesses has
been plunging by 6.5percent a year and the proportion of workers
employed in these enterprises is rising. In between is a shrinking
cohort of mid-sized businesses, whose productivity is rising by just
1percent a year. So, between the plunging productivity of small
traditional companies and the weak gains of mid-sized employers,
the gains of Mexicans modern productivity champions are all but
eliminated (Exhibit1).
A tale of two Mexicos: Growth and prosperity
in a two-speed economy
March 2014
Whats new?
Mexican growth has averaged only
2.3 percent per year for three decades
due to low productivity growth.
Stagnant productivity reflects the
central challenge facing Mexico:
reconciling the two Mexicosthe
traditional Mexico of small-scale,
unproductive enterprises and the
modern Mexico of highly productive
large corporations.
Small, traditional businesses represent
the majority of establishments
across sectors, including in auto-
parts manufacturing.
Companies remain small and informal
because there are incentives to
do so (special tax breaks for small
companies, for example); they remain
informal because there is little risk of
being caught.
Incentives to formalizeto qualify
for financing and be able to enforce
contractsare not compelling for
Mexican small business owners today.
By raising productivity of traditional
enterprises, shifting companies and
workers to the modern sector, and
enabling continuing productivity
improvements in the modern sector,
Mexico can reach its growth target.
Mexico would also have to invest in
growth enablers, such as improving
the cost and reliability of the electric
supply, upgrading infrastructure,
and improving public education and
vocational training to prepare workers
for modern-sector employment.
Briefng note 2
McKinsey Global Institute

Falling productivity in traditional firms that account for
42 percent of employment offset gains by modern firms
SOURCE: Censos Econmicos 1999, Censos Econmicos 2009, Instituto Nacional de Estadstica y Geografa; McKinsey
Global Institute analysis
Exhibit 1
1999
2009
Compound annual
growth rate,
19992009 (%)
Value added per occupied person
$ thousand, constant 2003 $
25
13
7
44
14
4
10 11500 >500 Number of employees
42 38 20 Share of employment,
2009
%
39 41 20 Share of employment,
1999
%
-6.5
+1.0
+5.8
Mexico now faces an increasingly urgent productivity imperative since its
demographic dividendthe rapid labor-force growth that has contributed
more than two-thirds of GDP for three decadesis fading. In the coming
decade, labor-force growth is expected to fall from about 2percent a year
to about 1.2percent. Without a strong boost in productivity growth, Mexico
could be headed toward 2percent GDP growth, rather than the 3.5percent
rate that the central bank has estimated and that global investors and business
leaders anticipate.
Our research nds opportunities for Mexico to raise productivity by the required
amount to achieve desired GDP growth. This will entail transforming the
traditional economy and removing barriers that hold back growth of the modern
economy. To reach the goal, large modern corporations also must continue
to raise productivity and Mexico will need a series of policy changes and
investments to improve the business environment and make compliance simpler.
In addition to reducing regulatory friction, Mexico needs to enforce the rule of
law, guaranteeing that debts can be collected and contracts will be honored.
Mexico should become a place where it is clear that those who do not play by
the rules will be penalized and where formal, compliant companies grow and
prosperand inspire others to emulate their success.
Specic policy changes are needed to transform the traditional sector by
removing perverse incentives such as special tax breaks that today encourage
traditional companies to stay small and informal. Small modern rms need a
level playing eld on which to grow and Mexico can make it easier to start and
grow a businessincluding by expanding access to capital. Finally, Mexico
can support faster growth across the economy by taking steps to make
electricity less costly and more available, updating infrastructure, and continuing
improvements in education and vocational training to prepare workers for
formal-sector employment.
Briefng note 3
McKinsey Global Institute
We recognize that identifying strategies and policies to unleash productivity
growth is the easy part. Carrying them out requires changes in longstanding
political, judicial, and regulatory practices, which cannot happen overnight. Yet
our analyses strongly suggest that there is no alternative: to return to sustained
long-term growth, Mexico must raise productivity and get the two Mexicos
moving forward together.
Transform the traditional sector
We nd that traditional businesses are pervasive across sectors of the Mexican
economy and often represent the majority of establishments, even in industries
that have attracted large global players. In auto manufacturing, 60percent of
output is parts, which global players build for export or to supply the large auto
assemblers in Mexico. These global parts makers depend on a network of low-
skill local assemblers with ten or fewer employees, which make up 80percent
of parts manufacturing enterprises. These rms account for 40percent of sector
employment but are only 10percent as productive as the large suppliers for
which they work, reducing overall sector productivity to just 21percent of the
US level.
The long tail of unproductive traditional enterprises is an even greater factor in
food manufacturing, which is the largest employer in the manufacturing sector.
Half of the value added in the baking industry is generated by the 0.5percent of
employees who work in the very large, highly productive corporations. But the
vast majority of bakers work in traditional neighborhood panaderias (bakeries)
and tortillerias (small-scale tortilla factories), and their productivity is, at best,
one-ftieth of workers in the most efcient modern baking company.
The third major sector we analyze is food and beverage stores, the largest
subsegment of the retail industry and another major employer. Since the industry
was opened to competition in the 1990s, modern-format stores (supermarkets,
hypermarkets, and convenience stores) have ourished and now account for
65percent of sales. Yet traditional mom-and-pop stores, market stalls, and
counter stores continue to proliferate. They employ 84percent of workers in
food and beverage retailing, yet have only 20percent of the productivity of
modern stores.
Our case studies in auto and food manufacturing and in food and beverage
retailing uncovered many ways to raise productivity in both traditional and
modern rms. If applied broadly across the economy, the measures we identify
can enable Mexico to realize the productivity gains it needs to raise its growth
trajectory to the desired level. This would involve operating improvements, such
as creating buying consortia for small bakers and retailers to gain access to
better supplies and goods at attractive prices. In the auto sector, tighter links
with major suppliers and co-location in Mexicos many industry clusters would
enable traditional subcontracting rms to adopt more advanced methods and
raise productivity. Some global auto parts makers are already helping their
subcontractors to improve their operations, including by providing nancing for
investment in machinery.
Briefng note 4
McKinsey Global Institute
Policy changes to enable growth of a modern SME sector
Policy actions should focus on reversing two unwelcome trends: the falling
productivity of the traditional sector and the rise in the share of workers who are
employed in these low-productivity, low-wage activities. Nearly half of job growth
has been in traditional businesses while employment by the modern sector has
remained level, at about 20percent of the labor force, despite rising output. In,
effect, Mexican labor is shifting from high-productivity to low-productivity work,
the opposite of what any economy wants. The impact is reected not only in
productivity data, but also in falling wages: in traditional enterprises with ten or
fewer employees, pay (adjusted for ination) fell by 2.4percent per year from
1999 to 2009. In Mexicos largest companies, wages have remained at.
Policy changes, backed up with strong enforcement, are needed to remove
perverse incentives that reward companies for remaining small and informal.
Today, small companies benet from a series of regulatory preferences that
inadvertently discourage companies from investing in growth and productivity
improvements. These include tax breaks for small retailers and the ability to
purchase electricity at residential rates (and with subsidies that can range as
high as 80percent). Most importantly, government needs to address informality.
An estimated 54percent of nonfarm workers are employed informally and
according to World Bank estimates, informality is growing. Informality is a
problem across the economyeven some of the largest companies hire
informally to avoid requirements of Mexicos labor lawsbut it is rampant in the
traditional sector where business owners know that there is little chance of being
caught for not registering their businesses and paying workers on the books.
At the same time, barriers to growth for formal companies, such as zoning
preferences that protect small shops and limit the growth of modern stores,
need to be reviewed.
The result of these changes should be to encourage small business owners
to join the formal economy and become part of a thriving SME sector that can
create higher-quality jobs. Incentives to formalize must be clear: Mexico needs
to become a place where contracts are enforced and where businesses that
play by the rules prosper. Changes to level the playing eld between traditional
and modern companies should allow for the continuing expansion of the modern
sector. Further reforms in labor regulation are also needed to encourage formal
hiring by modern companies of all sizes. Despite labor reforms, many companies
continue to hire informally to avoid obligations such as mandatory prot-sharing.
Access to capital at reasonable costs is needed for all growing rms.
Investing in broad enablers
To sustain the productivity gains of modern Mexican corporations and create
conditions for growth across the economy, Mexico can also address obstacles
to growth such as high electricity costs and inadequate infrastructure. A critical
enabler is improved access to capital. Mexicos large corporations can obtain
nancing in global markets at rates comparable to what top US companies pay.
But rates for mid-sized rms carry rates of 20 to 25percentif banks are lending
to such companies at all (Exhibit2). The World Bank estimates that 53percent
of medium-sized rms are underserved by Mexicos nancial industry and we
calculate that this accounts for three-fourths of an estimated $60billion credit
gap across Mexican business. Additional measures to enforce lender rights,
such as rules for tracking moveable collateral such as ofce equipment and
vehicles can help raise lending volumes.
Briefng note 5
McKinsey Global Institute

Corporate bond rates in Mexico are comparable to US rates;
SME loans and microcredits are much more expensive
SOURCE: Bloomberg; Banco de Mexico; McKinsey Global Institute analysis
~815
X
~2
BBB-rated 10-year
corporate bond
1
34
34
Consumer credit
Microcredit
Housing mortgage
Small and medium-sized
enterprises (SME) loan
10-year corporate bond
~70
~2762
~8
~2025
~3-4
~12
~3
~5
1 PPL Energy Supply LLC in the United States and Banco Santander de Mxico in Mexico.
Exhibit 2
Interest rates of different forms of debt
% per year
United States
Mexico
~60
p.p.
Costly electric supply is also a barrier to growth that can be reduced.
Commercial customers in Mexico pay 73percent more for power than US
companies and the World Economic Forum ranks Mexico 79 out of 144
countries for the cost and quality of its industrial electricity supply. An important
step will be to raise the share of electricity generated with natural gas, which
is now limited by pipeline constraints. In addition, Mexico can become more
energy efcient in transportation, through expansion of bus rapid transit,
for example. To support a goal of 3.5percent GDP growth, Mexico will also
need to upgrade infrastructure; we estimate that Mexico would need to
spend $923billion through 2025 to support expected growth. This spending
can be reduced by as much as 40percent, however, through infrastructure
productivity measures.
* * *
Our research nds that with the right measures, Mexico can accelerate
productivity improvements and raise GDP growth to 3.5percent a year or
even higher. Mexico needs to nd ways to unleash the energy and talent of the
traditional economythe way that NAFTA spurred Mexicos leading corporations
to become successful global competitors.
Key findings
Mexican labor productivity
growth has never recovered from
steep declines in the 1980s, and
in 2012 output per worker was
$17.90 an hour (in purchasing
power parity) compared with
$18.30 per hour in 1981.
Productivity has grown by
5.8 percent a year in large,
moderm firms since 1999, but has
been plunging by 6.5 percent a
year for small, traditional firms.
Mexicos mid-sized companies
are being squeezed; their share
of employment has fallen from
41 percent to 38 percent, and their
productivity growth averages
just 1 percent per year. Mid-sized
manufacturers are feeling the
pressure of imports.
Nearly half of job growth has
been in the traditional sector,
while the share of employment
by large modern companies has
been stable at about 20 percent of
the labor force. In effect, labor is
shifting from high-productivity to
low-productivity work.
Even in Mexicos most cutting-
edge industries, traditional
firms are a major presence.
In auto manufacturing,
80 percent of enterprises have
10 or fewer employees; in food
manufacturing more than
90 percent of employment is in
traditional shops. And 80 percent
of Mexican food shops are
traditional, even though modern
stores now account for 65 percent
of sales.
To reach GDP growth of
3.5 percent a year as labor-force
growth slows, the productivity
growth rate would have to rise
by almost three-fold from the
0.8 percent per year seen that has
prevailed since 1990.
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