By: Beatriz Leycegui
Beatriz Leycegui leads the international trade practice at SAI Law & Economics in Mexico City (“SAI”). She served as undersecretary of the Ministry of the Economy from 2007-2011 where she negotiated numerous international trade and investment agreements. She is the legal editor of The SAI Report, a comprehensive briefing report on NAFTA which is published and distributed by SAI on a monthly basis to a wide range of subscribers.
NAFTA was implemented in January, 1994. Almost 25 years later, it is still unclear as to whether it has fulfilled the promises that the Mexican, U.S. and Canadian governments made prior to its enactment. Negotiations for the modernization of the treaty between the three countries, which started in August 2017, continue and resolution of the most substantive matters of discussion is still pending.
That NAFTA reshaped North American economic relations is not under discussion: i) it drove an unprecedented integration between Canada and the U.S., (developed economies) and Mexico (a developing economy); and ii) it encouraged a more than tripling of regional trade and cross-border investment between the three countries. Yet, debate persists regarding NAFTA’s legacy on other issues, such as its effect on employment, wages, growth and inequality. This article focuses on this last matter: income inequality. Studies suggest that Mexican states that benefited most from trade openness are also the ones in which income inequality decreased the most, contrary to recurring opinions which state that NAFTA has sharpened inequality issues in the country.
NAFTA’s direct effects
Shortly after the implementation of NAFTA, the effects of economic integration between the three member countries were apparent. After just two years, Mexico had doubled its open economy index, measured as exports plus imports as a share of its GDP. Today, that index is equivalent to 74.2%, meaning that Mexico’s openness more than tripled in 20 years (see Graph 1). Also during this time, Mexico, the U.S. and Canada did not remain oblivious to the transformation of trade brought about by the revolution in information technologies. Throughout the years, they evolved from trading partners to production associates, creating productive synergies so relevant that, today, several industries could not prevail without the input produced by other industries in the region. Besides, the negotiation of the original NAFTA served as a model for the negotiation of several subsequent free trade agreements (FTA).
Graph 1. Mexico’s Open Economy Index (measured as Exports plus Imports as a Share of its GDP)
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Therefore, the transition to an open economy scheme, first with NAFTA and then with subsequent FTAs, increased the dynamism of the Mexican external sector and the influx of investments in the country from different parts of the world (see Graph 2).
Graph 2. Mexico’s Exports and FDI Evolution
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As shown in the graphs above, foreign trade and investment flows in Mexico increased after NAFTA. This, along with the strengthening of economic institutions (the most important being granting of autonomy to the Central Bank, i.e., the Bank of Mexico or “Banxico,” in 1994) made macroeconomic variables in Mexico converge to similar levels as its regional partners, finally leaving behind the extreme volatility and high susceptibility to economic crisis endured in the previous decades.
Graph 3. Convergence of macroeconomic variables to stable levels
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Has NAFTA aided in reducing income inequality in Mexico?
Certainly, macroeconomic conditions have improved in the last 20 years for many reasons, perhaps the most relevant being the transition to an open economy model and the strengthening of Mexican economic and financial institutions. Nevertheless, debate persists on whether NAFTA’s benefits have reached the whole population. Many have stated that NAFTA’s benefits in areas such as employment, wages, growth and inequality have been meagre at best.
Plenty of studies and press releases state that Mexico’s GDP per capita growth has been very low, and that the effect of NAFTA on the reduction of the wage gap between Mexico and the U.S. has been nil. However, GDP per capita sustained growth cannot be solely attributed to one FTA: Agustín Carstens, former governor of the Bank of Mexico and specialist of the Mexican economy, states that “[…] to hold NAFTA responsible for overall growth in Mexico is putting too much weight on NAFTA. It’s a very important element, but Mexico needs to take care of many different assignments in other areas to make the Mexican economy more productive and really exploit its capacities to grow”.
The following graph shows the evolution of the GDP per capita in Mexico from 1990 to 2016. GDP per capita grew 33.8% during this period, at a meager average annual growth rate of 1.1%.
Graph 4. GDP per capita Evolution in Mexico
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In the next graph, inequality is measured using the Gini Index. This index is often used to estimate the income inequality that exists in the population of a certain territory. Its value ranges from 0 to 1, with 0 representing maximum equality (all citizens earn the same income), and 1 representing maximum inequality (all income is owned by only one citizen).
Inequality in income has certainly decreased since the beginning of the ‘90s, particularly in the post-NAFTA era. As can be observed in the following graph, the Gini Index decreased from a level of 0.50 in 1992 to a level of 0.43 in 2016, approaching to the world’s average level of 0.36.
Graph 5. Gini Index Evolution in Mexico
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The question is whether NAFTA had any impact on GDP per capita and on inequality. The graphs that follow analyze the relationship at a Mexican-state level between trade openness and GDP per capita, on the one hand, and inequality, on the other hand. States were ranked according to the average penetration of exports into their economies (trade openness is measured as the share of exports in GDP), for the period for which there is information available, and then compared according to the change in the GDP per capita and the Gini Index in the last two decades.
If NAFTA had a positive effect on the reduction of inequality, it would be expected that the GDP per capita would have increased more in the states with a higher degree of trade openness, and the Gini Index would have decreased more as well. The analysis below indicates that NAFTA economic spillovers helped to increase income while also reducing income inequality in Mexico.
Graph 6 shows the change in the GDP per capita by state from 1993 to 2010, ordered by its trade openness ranking (states are ordered from the least to the most open). The size of the circles represents the GDP per capita at the beginning and at the end of the period. As can be observed, the most open states increased their GDP per capita in greater proportion than the least open states. Moreover, in the least open states GDP per capita remained almost unchanged, and even decreased in the case of the Mexican state of Campeche.
Graph 7 shows the same exercise as Graph 6 but with the change of the Gini Index from 1990 to 2010, instead of the change in the GDP per capita and, as shown, the most open states show the highest reductions of income inequality. Besides this general result, it is worth mentioning two additional facts: (i) the Gini Index decreased in all of the 32 Mexican states during this period, which means that the reduction in income inequality at the national level was driven by reductions in income inequality in the most open states; and, (ii) states with higher trade openness were not the most equal at the beginning of the period (as shown by the size of the blue circles), but were certainly the most equal states, in terms of income, at the end of the period (they have the smallest size of the purple circles).
Both previous situations controvert the common allegations regarding NAFTA’s meagre results on the improvement of income inequality.
Of course, this does not imply that trade openness is the sole factor motivating economic growth and income equality, but we can infer from the data that states that have been more open to trade grew proportionally more and reduced inequality more than the states that experienced less penetration of exports.
Graph 6. Trade Openness Ranking (Exports as % of GDP) and its Relationship with GDP per capita Growth
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Graph 7. Trade Openness Ranking (Exports as % of GDP) and its Relationship with Income Inequality
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There are many other factors other than trade that have placed certain states in a much less favorable position in terms of income and inequality. Nevertheless, the relationship between trade and income and its distribution among the population is clear: local economies with higher trade integration have higher income levels and a better distribution of that income. From Mexico’s perspective, the challenge ahead is how to integrate poorer states, specifically the ones in the Southeast of Mexico, into the global value chains and thus decrease the remaining gaps between more and less developed states.
NAFTA triggered foreign trade and investment in Mexico in the last 20 years, which, along with the strengthening of institutions, led to an improvement in macroeconomic stability. Some claim this is not enough and argue that NAFTA’s outcomes have not benefitted the most vulnerable. Yet, specifically for income inequality, data suggests that an inverse relationship exists between trade openness and income inequality: the more trade openness of a certain state the less inequality. Not everything can be attributable to NAFTA, positive or negative; certainly, several actions need to be implemented to achieve the reduction of inequality, as well as a more dynamic economic growth, job creation and poverty reduction. Nevertheless, trade integration seems to be a very good and even necessary first step, and NAFTA is certainly part of the solution, not part of the problem.