EUROPEAN BUSINESS SCHOOL
International University Schloß Reichartshausen

Diploma Thesis

for the obtainment of the academic degree
“Diplom-Kaufmann”

Benefits and Costs of Regional Integration:
The Impact of NAFTA on the Mexican Economy

von

Karl-Günther Illing

Due Date: 20. Feb.2004

Contents

1 Introduction ... 1
1.1 A Decade of Debate  ... 1
1.2 Objective and Structure of the Thesis  ... 2

2 Regional Integration  ... 4
2.1 Definition, Forms and Objectives  ... 4
2.2 Welfare Implications ... 6
2.2.1 Static Welfare Effects  ... 6
2.2.2 Dynamic Welfare Effects ... 10
2.3 North-South versus South-South Integration ... 13
2.4 Spatial Inequality in the Integration Process ... 15

3 NAFTA as an Example of Regional Integration  ... 19
3.1 Mexico’s Way into NAFTA  ... 19
3.2 Design and Coverage of the NAFTA Provisions ... 22
3.3 NAFTA in the Light of Integration Theory: Expected Effects ... 24

4 NAFTA’s Impact on Mexico after One Decade  ... 28
4.1 Static Benefits  ... 28
4.1.1 NAFTA’s Impact on Trade ... 28
4.1.2 Trade Creation, Diversion and Mexican Terms of Trade  ... 32
4.2 Dynamic Benefits ... 34
4.2.1 NAFTA’s Impact on Foreign Direct Investment  ... 34
4.2.2 Dynamic Spillovers, Productivity and Growth ... 38
4.2.3 Catching Up with the North?  ... 41
4.3 Adjustment and Divergence ... 45
4.3.1 Growing Disparities and Intra-Mexican Divergence  ... 45
4.3.2 Migration – Adjustment Mechanism for the NAFTA-Neglected?  ... 49

5. Conclusions and Policy Implications ... 54
5.1 Summary and Discussion of Results ... 54
5.2 Policy Implications and Outlook  ... 57

Appendix ... 61

Figures
Figure 1: Trade Creation and Diversion in a Free Trade Area  ... 8
Figure 2: Exemplary Effects of the Formation of an FTA on Countries’ Industry Share and Welfare ... 18
Figure 3: Mexican Trade Flows, 1980-2002 ... 29
Figure 4: FDI Inflows to Mexico, 1980-2002 ... 35
Figure 5: GDP Per Capita Growth of Mexico and the U.S., 1993-2002  ... 42
Figure 6: Migration from Rural Mexico to the United States, 1980-2002  ... 51

Tables
Table 1: FDI Inflows as a Percentage of Gross Fixed Capital Formation  ... 36
Table 2: Poverty in Rural and Urban Areas, 1984-1994  ... 50
Table 3: Income from Household Remittances, 1996-2002  ... 53

Abbreviations
Art. Article
CET common external tariff
CGE computable general equilibrium
CUSFTA Canada-United States Free Trade Agreement
EEC European Economic Community
EFTA European Free Trade Association
EMU Economic and Monetary Union
FDI foreign direct investment
FTA free trade area
GDP gross domestic product
GNP gross national product
MFN most-favored nation
MNE multinational enterprise
NAFTA North American Free Trade Agreement
PRI Partido Revolucionario Institucional
p.a. per annum
R&D research and development
RIA regional integration arrangement
ROW rest of the world
TFP total factor productivity
TRIMS Accord on Trade-Related Investment Measures
U.S. United States

1 Introduction

1.1 A Decade of Debate

In January 1994, after two and a half years of negotiation, the North American Free Trade Agreement (NAFTA) came into force. The treaty between Canada, Mexico and the United States has created the largest economic area in the world, slightly surpassing the European Union in market size. But NAFTA is also outstanding in a second aspect: it has constituted the first major regional integration arrangement between two highly developed countries, the United States and Canada, and a developing country, Mexico. 

The North-South nature of North American integration has polarized the debate about NAFTA from the earliest stage on. On the one hand it was unclear how much the U.S. would gain from the agreement. Would it stabilize its southern neighbor and thus benefit the U.S. economically and politically? Or would it cause the “giant sucking sound” Ross Perot feared, drawing thousands of jobs from the U.S. over the border (Thorbecke/Eigen- Zucchi 2002, p. 648)? Regarding these concerns, Canada was at most a side-player, possessing neither intense trade relations nor geographical proximity to Mexico.

Mexico’s gains from NAFTA, on the other hand, seemed even more unsure. The agreement’s effects on the southern member state, whether positive or negative, were expected to be unequally greater than on the U.S. On the one hand, it seemed, Mexico could gain immensely through improved access to the North American market, increasing trade, attracting foreign investment, and importing growth and stability. On the other hand, some trade economists, such as Arvind Panagaria (1996, pp. 512-513) warned that Mexico could only lose when opening its market to its powerful northern neighbors, while receiving little in return that it would not have obtained anyway. Furthermore, would Mexico’s move towards regional integration hamper any further step into the direction of multilateral opening, after promising reforms had been started in the mid-1980s? 

Concerns also regarded the adverse effects of NAFTA within Mexico. These centered around large adjustment costs from sectoral restructuring and resource reallocation. This would occur if inefficient, partly subsidized Mexican industries declined after removing tariffs and non-tariff barriers, allowing the North American competition to enter the national market. In addition, would this hit mostly those Mexican regions that were poor anyway?

The Mexican government was convinced of the miracles of regional integration and acted as the main driver in the negotiation process between the three North American nations. Nevertheless, ten years after NAFTA’s start the debate about its benefits for the Mexican economy is more polarized than ever. On the one hand, NAFTA’s champions, such as the then Mexican minister of trade and industrial development, Jaime Serra, still argue forcefully in favor of NAFTA’s blessings regarding trade and investment (Serra/Espinosa 2002, pp. 60-62). On the other hand, many Mexicans appear disappointed by unattained social goals. In addition, activists from all over the world regard NAFTA as a prime example of the negative effects of free trade, denouncing working conditions in and the environmental impact of the maquiladora plants, essentially seeing Mexico on the ground after a race-to-the-bottom.

In the face of the controversy about NAFTA’s effects, it is important to establish an unbiased evaluation of the benefits and costs that regional integration has brought to Mexico after a decade. Not least because the outcome of the experiment of North-South integration is of considerable importance for other developing countries trying to liberalize, whether preferentially or multilaterally, and for which NAFTA may or may not serve as a model.

1.2 Objective and Structure of the Thesis

The question around which this thesis centers is, therefore, where and to what extent Mexico has gained from regional integration in the form of NAFTA and where it has experienced adverse effects and costs from it. These gains and losses can cover a large variety of issues, the examination of all of which would exceed the scope of any single thesis by far. The economic effects of trade liberalization are one possible area of investigation, another one would be the impact of NAFTA on Mexican politics, policy reform and political stability. Political economy approaches can explain the role of and the effect on interest groups in regional integration arrangements. Lastly, NAFTA’s environmental impact could be an issue.

This thesis focuses on the economic implications of NAFTA, leaving aside the other issues above. The problem is further broken down into three specific questions: First, what have been the traditional static gains from integration for Mexico? Second, which dynamic effects has NAFTA brought about, especially on foreign investment, its impact on productivity and growth, and have these led to economic convergence? And third, what have been the costs of adjustment resulting from the static and dynamic effects?

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