Mexico-Brazil FTA: Still a Dream?

Is free trade between Mexico and Brazil still just a dream?

LBC SPECIAL
Knowledge@Wharton  

When Mexican president Felipe Calderon met with Brazilian president Luiz Inacio “Lula” da Silva in Cancun in 2010, the leaders of Latin America’s two largest countries announced plans to begin negotiations on a comprehensive free-trade agreement between Brazil and Mexico. A few months later, a delegation of Brazilian officials traveled to Mexico to begin preparatory work for a hypothetic reduction of tariffs on all goods traded between the two countries. “We want to partner with Brazil,” Calderon said. “The strongest economies in Latin America are Brazil and Mexico. Imagine what we can do together; imagine if we complement each other.” 

Two years later, that sort of optimism has been drowned out by a dispute over the fate of “ACE 55,” the Economic Complementarity Agreement that established rules for gradually deregulating automotive trade between Brazil and Mexico back in 2003. Succumbing to protectionist pressure by Brazil, Mexico agreed this March to revise the ACE 55 agreement so that it limits surging car exports to Brazil to an annual average value of about US$1.55 billion over the next three years. Mexican automotive exporters will take a major hit: Last year, Mexican auto exports to Brazil reached 134,000 units, worth a total of $2.1 billion, up from a total of only 53,000 units to Brazil in 2009.

Over the first seven years of the agreement (2003-2009), Brazil ran an automotive surplus with Mexico worth a total of about US$10 billion, according to the Mexican government. “Brazil was happy when Brazil had a trade surplus with Mexico, but over the last three years, Mexico has had the surplus” so the Brazilians have pushed Mexico to restrict its exports, notes Barbara Kotschwar, research associate at the Peterson Institute for International Economics.

BRAZIL’S DISADVANTAGE

According to Brazilian sources, automotive imports from Mexico increased by 40% in 2011, at the same time that Brazil's exports of vehicles to Mexico declined by the same percentage, resulting in a Brazilian deficit of nearly US$1.7 billion in the sector. (Mexican sources provide a lower figure of nearly US$700 million.) Last year, Mexican cars accounted for almost 20% of the more than 850,000 autos and light commercial vehicles imported into Brazil -- a 66% increase from 2010, according to the Mexican Automobile Industry Association. A key reason was the growing price differential: Because of higher local taxes, the stronger Real and the lower economies of scale of Brazilian plants, retail prices of Brazilian-made cars like the VW Jetta are much more expensive than their Mexican equivalents -- despite the cost of transportation and delivery from Mexico. “Brazilian trade policy generally tends to be one of ‘managed trade’ deals, such as [the ACE],” says Kotschwar. Such deals set limits on trade volumes -- unlike genuine free-trade agreements that lower or remove duties and let market forces determine the total volume and value of trade, she adds.

These kinds of "managed trade" deals “are normal for Brazil but a little troubling” for Mexico, Kotschwar points out. Unlike Brazil, Mexico has enacted bilateral free-trade pacts with numerous trading partners, including agreements with Bolivia, Chile, Peru and Uruguay. Mexico has also expressed interest in participating in the ambitious new Trans-Pacific Partnership pact (TPP), which will include such countries as the U.S., Canada, Australia, Malaysia, New Zealand and Vietnam. (Because it has no Pacific borders, Brazil is not eligible for membership in the TPP.)

HEDGING RISKS

For Mexico, which is highly dependent on the U.S. economy, Brazil’s rapidly growing domestic markets could help reduce the kinds of risks that Mexican companies were exposed to during the latest global recession. For Brazil, Mexico’s economy could offer a tempting platform from which Brazilian companies could enter vast markets in the United States and Canada, via duty-free access courtesy of NAFTA (The North American Free Trade Agreement). "Mexico can be a strategic partner as [these companies] enter the North American market,” says Wharton management professor Felipe Monteiro.

In one of the most promising ventures for bilateral cooperation, the Inter-American Development Bank recently approved a US$300 million loan to Braskem-Idesa S.A.P.I., a joint venture between Brazil’s Braskem SA and Mexico’s Grupo Idesa, to develop, build and operate an integrated petrochemical plant in the Mexican state of Veracruz. The complex will comprise one ethane cracker and three polymerization plants with a nominal annual capacity of approximately 1,050 kilo tons of polyethylene -- a key input for plastic manufacturing. PEMEX Gas y Petroquímica Básica of Mexico will supply the ethane that will be used as feedstock for the plant, which will allow Mexico to leverage Brazilian know-how and state-of-the-art technology to modernize its production methods for polyethylene. The complex is expected to create as many as 9,800 jobs during construction and 3,000 direct and indirect jobs when the plant begins operations in 2015.

Nevertheless, Mexico and Brazil “really don’t trade with each other” all that much, notes Mauro Guillén, a Wharton management professor and director of the Lauder Institute.  In 2010, Mexican exports to Brazil amounted to only US$3.78 billion, or about 1.3% of total Mexican exports of US$298 billion. That’s almost exactly the same total (US$3.76 billion) as Mexican exports to Colombia, a much smaller nation, that year. Mexico’s imports from Brazil amounted to US$4.3 billion, slightly lower than 1.5% of Mexico’s total imports of US$301.4 billion. As Guillén notes, Mexico trades a great deal with the U.S. but far less with Europe and Latin America. Brazil’s leading trading partners are China, followed by the United States, Argentina and such European nations as Germany and the Netherlands.

Mexico’s leading exports include oil, autos, minerals, electronics and agriculture. Like Mexico, Brazil exports agribusiness, minerals, and oil. “They are not really complementary,” Guillén points out. While Mexico has bet its future on having “the tightest possible” integration with the U.S., “Brazil will never agree to make a free-trade agreement with the U.S. Brazil wants to go its own way. Their complementarities are not very great.”

Monteiro adds that because Mexico is not one of Brazil’s leading trading partners, its strategic importance is not so great for Brazil. He contrasts that with the importance of Brazil’s strategic relationship with neighboring Argentina. According to Monteiro, “Brazil and Argentina have to find a way to get a friendly trading relationship” because both countries belong to Mercosur, the regional trading bloc that plays a major role in South American trade.

When it comes to the automotive sector, emblematic of industrial development, neither Brazil nor Mexico has its own automotive companies. The two countries depend on foreign multinationals to assemble vehicles, although both have local component manufacturers. In both countries, “any decisions about making autos will be made by companies like Ford, GM and VW,” notes Guillén. On the other hand, Mexico’s automotive sector is export-oriented -- with over 50% of its output sold to North America. Brazil’s automotive output is sold largely in the country’s own domestic market, which is very large and growing rapidly. 

Apart from high-value electronics, most automotive components used in Brazil’s plants are produced very close to the assembly location, where they can be delivered to meet the needs of the “just in time” manufacturing model. NAFTA made it possible for Mexican-based multinationals to build highly efficient plants that were scaled to serve much larger markets than simply Mexico’s domestic market, note Guillén and Monteiro.  For Mexico-based vehicle exporters, the new caps imposed by Brazil may be a hard pill to swallow. “No other market in Latin America can compare with Brazil,” says Monteiro. “No other market has the same appetite. But Mexico will try to find a way to work with the restrictions and the [higher] local content requirements” that are part of the revised agreement. “The Mexicans accepted the caps because something is better than nothing.”

BETTING ON THE LONG TERM

According to Christopher Wilson, an associate of the Mexico Institute at the Woodrow Wilson Center, “By agreeing to limit exports of cars to Brazil for a three-year period, Mexico is betting on the long-term competitiveness of its car industry, and is aiming to convince automakers to continue investing in Mexican production.” Last year, Nissan, Mazda, VW, Honda, Chrysler and GM all announced investments aimed at increasing their production capacity in Mexico, with the goal of serving markets in both North and South America. “Mexico is accepting a short-term loss to protect its auto agreement with Brazil, hoping the new investments will ultimately bear fruit while Mexico regains its tariff-free access to the growing Brazilian market,” said Wilson.

Arturo C. Porzecanski, an economist-in-residence at American University, agrees that it makes little sense to anticipate that Mexico and Brazil will negotiate a full-fledged bilateral free-trade agreement. “I am highly suspicious [of an FTA ever taking place] because Mexico is inextricably linked to the U.S.” The fundamental problem for Mexico, he adds, is that the country "is very tied into the North American market, and Brazil has trade issues with the U.S. It is impossible for Mexico to sign an agreement with Brazil without complicating the U.S.-Mexico relationship. In addition, Brazil has taken a hard line on the U.S. dismantling [its] agricultural subsidies. [So] it would be very hard to reconcile Mexico-Brazil commercial interests unless you bring down the rhetoric in the U.S.-Brazil relationship.” Nevertheless, Porzecanski believes that it may be possible for Mexico and Brazil to conclude some small-scale reciprocal agreements, such as in the automotive sector.

Why, then, do the leaders of both Mexico and Brazil keep alive the dream of an eventual free-trade pact between the two countries? Guillén notes that Mexican president Calderon, who will end his six-year term this year, may be motivated by a desire “to do something big” before leaving office, rather than be remembered foremost as the man who raged a long – and possibly unsuccessful – battle against gangs of violent drug dealers in his homeland. “He would go down in history as having engineered a big deal with Brazil,” says Guillén. “On the Mexican side, it’s about Calderon and his legacy.”

Kotschwar argues that with Enrique Peña Nieto, the presidential candidate of Mexico’s PRI party, likely to take office later this year, Mexican trade policy could take a new direction from those pursued by Calderon, leader of the conservative National Action Party (PAN).  How much Mexican policy will change under the next president “will depend on which arm of the PRI takes over” after Calderon leaves office -- either the populists or the pragmatists. “I don’t imagine that Mexico will go back to protectionism” after the country is once again ruled by the PRI, which ran Mexico for seven decades until it lost power in 2000, she adds.

When news of the revised agreement was announced, some Mexican trade analysts criticized their own government for being much too quick to cave in to Brazil’s demands for the restrictive new export caps. In the Mexican newspaper El Universal, columnist Alberto Barranco wrote, “At the same time that the United States, in one of its protectionist moves, is about to impose extraordinary [anti-dumping] duties on imports of refrigerators coming from [Mexico] and South Korea, Mexico is surrendering on all points to the demands of Brazil in order to maintain the ACE [Agreement on Economic Complementarity]. The punitive taxes against Mexican-made Electrolux and Mabe, and Korean-made LG and Samsung refrigerators will likely be imposed by the U.S. government in response to a petition by Whirlpool Corp. (...)

POLITICAL CALCULATIONS

Meanwhile, Brazilian president Dilma Rousseff is having her share of political troubles at home. The Brazilian economy has recently slowed down, and eight of Rousseff’s ministers have resigned from office, including the ministers of cities, defense, transportation, agriculture, tourism, sports and labor. If Brazil were to conclude a major trade deal with Mexico, it would not only send a signal that Rousseff, who met with President Obama in the White House in mid-April, is a visionary leader, but that “Brazil is a big player” that can take bold new initiatives, says Guillén.

“Brazil wants to play a stronger role in the G20, the IMF and the World Bank,” adds Monteiro. “The more Mexico becomes a strategic partner for Brazil,” the stronger the image they both might project as leaders of an alignment bloc of emerging markets. If you look simply at the numbers that measure the Mexico-Brazil bilateral trade and investment relationship, “you are not very inspired,” adds Monteiro. “But if you think ahead, and assume that Brazil will continue to be a key player in the region, then Mexico can be a very important partner for Brazil. Most observers agree that Mexico is a very important player because of its size and its proximity to the United States.” In the mass media, Mexico’s importance is often ignored because of negative publicity about its domestic drug wars, as well as the fact that Mexico is not an official member of the so-called "BRIC" group of emerging markets. However, he adds, “There are a lot of fundamentals that will be there,” working in favor of Mexico over the long run.

Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the Wharton School of the University of Pennsylvania