Brazil vs Mexico

Infoamericas - Tendencias

Noviembre 2001

Clash of the Titans: Brazil vs. Mexico

by Jan Smith

jsmith@infoamericas.com

Four years ago, Brazil was the first choice among companies seeking to establish a regional presence in Latin America beyond an export-manufacturing platform. In 1997, with a GDP of US $800 billion growing at nearly 3 percent annually, Brazil was the darling of foreign investors. Between 1997 and 2000 they poured in more than US $100 billion in FDI, betting on both the largest domestic market in Latin America and the export opportunities through Mercosur.

Today Brazil is no longer seen as the most obvious choice, and many companies are now focusing on Mexico. FDI inflows into Brazil will fall by 50% from 2000 levels to US $17 billion in 2001. While Brazil repeatedly stumbled, Mexico recovered from its 1995 financial crisis, took advantage of its membership in NAFTA, and turned itself into an attractive base for regional operations. But Mexico is still far from an investor's Eden, and Brazil has not yet lost all of its charm. Companies contemplating new or expanded Latin American operations must weigh a variety of factors to choose between them. Depending on whether they intend to export to the region or to invest in manufacturing facilities, they need to consider such issues as economic performance, market access, trade agreements, currency characteristics, infrastructure, export competitiveness, and ability to adopt new technologies and products.

Economic Performance

The choice between Brazil and Mexico would be easy if the issue came down to a simple comparison of economic scorecards. Mexico outperforms Brazil on nearly every front. Over the last five years, Mexico's GDP grew at an average annual rate of 4.5%, twice as fast as Brazil's. Meanwhile, Mexico's industrial GDP expanded by an average 7.5% annually since 1997 compared to 2.3% in Brazil. Mexico's robust performance resulted from both strong domestic demand and soaring exports. In five years, Mexican non-oil and non-maquila exports doubled - transforming the country into the region's export powerhouse. Moreover, sustained economic growth, combined with a 120 percent devaluation of the Brazilian real since 1998, allowed Mexico to displace Brazil as the largest economy in Latin America during 2001.

In reality, however, the comparison of the Mexican and Brazilian economies is not quite as simple as indicators expressed in US dollars might suggest. In dollar terms, Brazil's economy is half of what it was in 1998. But with a population of 170 million, (compared with Mexico's 100 million) Brazil still has the most primary urban centers in Latin America. It continues to be the largest regional market for many products and services. Furthermore, the fact that Brazil's export markets are well diversified gives it better insulation from the downturns in the US economy that have plagued Mexico. Indeed, in the aftermath of the September 11th attacks, few economies outside the US have been more adversely affected than Mexico. It has suffered from declining US demand, a sharp drop in tourism revenue and cutbacks in foreign investment. Brazil, on the other hand, expects the economy to grow by at least 1.8% during 2001 and exports are already up by 6%.

BRAZIL ECONOMIC OUTLOOK

Indicator 2000 2001f 2002f

GDP (USD Bn) $599 $536 $538

real GDP Growth 4.5% 1.9% 2.8%

Inflation 6.0% 6.3% 4.8%

Interest Rates (annual average) 17.3% 17.2% 16.5%

Fiscal Balance (% of GDP) 4.6% 6.2% 4.0%

Exports (USD Bn) $55.1 $58.7 $63.1

Imports (USD Bn) $55.8 $57.9 $59.4

Trade Balance (USD Bn) ($0.7) $0.8 $3.7

Current Acct (USD Bn) ($24.5) ($25.3) ($23.0)

Current Acct (% of GDP) (4.1%) (4.7%) (4.3%)

Foreign Direct Inv. (USD Bn) $32.8 $17.0 $13.0

FDI/Current Acct Deficit (%) 134% 67% 57%

Foreign Reserves (USD Bn) $33.0 $31.4 $33.6

Foreign Debt (USD Bn) $238 $238 $244

Foreign Debt (% of GDP) 39.73% 44.40% 45.35%

real/USD (end year) 1.96 2.58 2.7

Source - InfoAmericas, Business Monitor, GEA, Economist

MEXICO ECONOMIC OUTLOOK

Indicator 2000 2001f 2002

GDP (USD Bn) $563 $593 $563

Real GDP Growth 6.9% (0.5%) 2.0%

Inflation 9.0% 5.6% 6.5%

Lending Rates 15.0% 11.0% 10.0%

Fiscal Balance (% of GDP) (1.80%) (0.80%) (0.40%)

Exports (USD Bn) $165 $169 $179

Imports (USD Bn) $173 $179 $191

Trade Balance (USD Bn) ($8.0) ($10.0) ($12.0)

Current Acct (USD Bn) ($17.5) ($19.0) ($20.0)

Current Acct (% of GDP) (3.11%) (3.20%) (3.56%)

Foreign Direct Inv. (USD Bn) $13.0 $23.0 $12.0

FDI/Current Acct Deficit (%) 74.29% 121% 60.00%

Foreign Reserves (USD Bn) $34.0 $33.0 $32.0

Foreign Debt (USD Bn) $168 $165 $161

Foreign Debt (% of GDP) 29.8% 27.8% 28.6%

Peso/USD (end of period) 9.6 9.4 10.4

Source - InfoAmericas, Business Monitor, GEA, Economist

Country Risk

Latin America is more exposed to external risk than any region in the world. The region is largely a commodity exporter, earning dollars with products with volatile and gradually declining prices. Moreover, despite relatively prudent governance over the last 8-to-12 years, Latin America is highly indebted, in currencies other than its own. Therefore fluctuations in US or European interest rates have a huge impact.

Foreign capital and portfolio investors who operate in emerging markets tend to group countries by risk, within the general category of Latin America or Asia, etc. Though Brazil benefits from a relatively protected domestically focused market, this year proved how vulnerable it is to Latin American contagion. Economic stagnation and political ineptness in Argentina has hurt both Brazil's and Chile's currencies, the 2nd and 3rd weakest global currencies respectively in 2001. Mexico has been largely unhurt by Argentina's difficulties. It also escaped the contagion of the Samba effect in 1999 when the pegged real was floated and when Ecuador defaulted on a foreign loan, sparking capital flight throughout South America. Most investors now view Mexico as part of North America. This has helped Mexico raise its S&P rating on long-term sovereign debt from BB to BB+ with a positive outlook. Brazil, on the other hand is rated BB- with a negative outlook by S&P. Brazil must pay more than Mexico when borrowing money.

Currency

The Brazilian real lost 30% of its value in the first 10 months of 2001, mainly because of investor fear over Brazil's important links to Argentina's teetering economy. Reduced food commodity prices and continuing low oil prices hurt Brazil's balance of trade, which should have improved as the real slid. To offset capital flight, the government obtained US $4.7 billion from the International Monetary Fund (IMF) in late September, and issued US $13 billion in government bonds through the Central Bank. Declining interest rates in the US did not translate into lower Brazilian rates because of the Central Bank's efforts to strengthen the real.

The Mexican peso appreciated during most of 2000 and 2001. But lower oil prices, falling exports, handicapped tourism, sharply reduced economic growth and shrinking investor confidence will weaken the currency starting in 2002. Next year, the peso will fall by 10-to-13%.

Weaker currencies will hurt purchasing power in both countries, particularly Mexico, which imports a large proportion of its consumer goods and industrial inputs. Brazil still enjoys relatively robust consumer spending and demand for locally manufactured consumer and capital goods. Higher government spending in the lead up to the October 2002 elections will boost consumer spending and drive construction sector growth next year. The exit of President Cardoso and uncertainty concerning the next President will delay politically sensitive foreign direct investment plans.

In contrast, Mexico's political environment remains stable, which encourages mid-to-long term investment to continue flowing into the country. Domestic demand will suffer throughout 2002 as Mexico waits for the US economy to rebound. Exports to Mexico will begin to slow after two years of blistering growth.

Trade Agreements and Export Competitiveness

Weaker currencies will make both countries' exports more attractive in global markets. But the current slowdown of the US economy, exacerbated by the September attacks, will slow trade flows for both of them during the next 6-to-9 months. In the near term, Brazil will be less affected than Mexico because only 24 percent of its exports are destined to the US, compared with nearly 90 percent for Mexico. In the longer term however, Mexico is better poised to take advantage of recovering demand for exports. Mexico enjoys free trade agreements with 35 countries, giving it virtually unfettered access to three-quarters of the global economy, including the US and the European Union.

Brazil's weaker currency provides it with a relative advantage in pricing, but in most sectors Brazil is still less competitive than Mexico as an exporter. Mexico's business laws are more business friendly with fewer onerous contract rules and its tax and labor systems are not as bureaucratic. Mexico's trade agreements allow manufacturers to import industrial inputs and capital equipment at global prices whereas Brazilian industries must rely on protected 1st and 2nd tier local suppliers for support. The great exception is Brazil's large-scale agri-food sector, which is a global competitor. In contrast, Mexico is burdened with an antiquated agricultural system that limits the size of farms, and the nation cannot even feed itself. On the other hand, Mexico's decision to embrace free trade weeded out uncompetitive mid-size family owned companies while creating publicly traded powerhouses like Cemex, Bimbo, TMM and other flourishing global enterprises. Brazil's relatively protected economy is home to dozens of large-scale businesses, but they remain reliant on the domestic market, and have not yet been forced to pursue new markets abroad.

For its part, Mexico is working to offset the disadvantages of a smaller domestic market by expanding exports to Brazil. Such exports are already getting easier, as a result of the ALADI agreement, which commits the signatories to reduce import tariffs by four percentage points on most products. Mexican exports to Brazil have grown by 70% since 1998. And now the two countries are exploring a bilateral trade agreement.

BRAZIL

Mercosur

Argentina, Uruguay, Paraguay

Andean Pact

Peru, Ecuador, Venezuela, Colombia

Partial Accords

Mexico, Bolivia

Exploring with

MEXICO

NAFTA (USA, Canada)

EU (Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, UK)

G3 (Venezuela, Colombia)

Chile

Costa Rica

Panama

Israel

Bolivia

Nicaragua

Central American Pact

Partial Accords

Brazil, Argentina, Uruguay, Paraguay

Exploring with

Japan, Switzerland, Iceland, Norway, Lichtenstein, and Singapore

Infrastructure

As with other factors in location analysis, the importance of transportation infrastructure depends greatly on the purpose of the enterprise under consideration, especially whether the venture will focus on exports, the domestic market, or both.

About 30 percent of Mexico's roads are paved, but local transportation is still seriously underdeveloped. Some 20 percent of the country's roads were built for the specific purpose of transporting cargo to the US border. As a result, it can be up to 17 percent more expensive to ship goods from the State of Sinaloa to Mexico City than it is for the similar distance from Sinaloa to the northern border. Of Mexico's 238 airports, 28 are capable of clearing or storing international shipments. But air shipments between Mexican cities usually cost twice as much on a weight-distance basis than cargo movements between Mexican and US cities. Mexican ports are benefiting from more than six years of privatization, which has in some cases reduced costs and demurrage by 25% since 1997. But up to 80 percent of port shipments are international.

In Brazil, only about 10% of the roads are paved, and most of them are corridors connecting the industrial centers of Sao Paulo and Rio de Janeiro with Salvador in the north and Porto Alegre in the south. Brazil has only one road link to Venezuela and limited road connections with Peru and Colombia. Trade with Argentina is predominantly shipped by sea, since there are only three major land crossings. Air shipments are 13 percent more expensive than in Mexico. Only now are rail links between Brazil and its Mercosur partners Uruguay and Argentina being connected. As traditional rivals in grains and other food commodities shipped by rail, each country stopped its rail lines just short of the border to prevent easy market penetration by the others.

Energy infrastructure also differs considerably between the two countries. Brazil has a very limited energy supply. Electricity has been rationed recently as a result of inadequate rain that failed to fill reservoirs at major dams, combined with a shortage of hydroelectric generators. This is holding back industrial expansion and production. Brazil is also a net importer of natural gas, oil and petrochemicals. In contrast, Mexico is a net exporter of energy with three times as many industrial parks using energy from mineral fuels as Brazil.

In both countries, current infrastructure and planned developments play on their respective strengths rather than address their weaknesses. In Mexico, port, rail and highway development is focused mainly on expediting shipments to the US, rather than on developing local markets. The opposite is true in Brazil where the priority is to develop more efficient road and waterway transportation to reduce internal transportation costs.

Developing an Entry Strategy

A comprehensive market entry strategy for Latin America necessarily involves doing business in both Brazil and Mexico. But the choice of where to locate manufacturing facilities, distribution centers, and other assets depends greatly on the product involved and the company's long-term objectives.

A foreign company considering an export strategy for Latin America will look first to issues of market access, domestic demand and growth, currency strength, and consumer tastes, especially the propensity to adopt new products.

An enterprise seeking to invest in manufacturing faculties in the region, on the other hand, is more interested in political and economic stability, currency risk, export competitiveness, and infrastructure, as well as domestic demand.

Either way, a careful comparison of the business environment in both countries, factor by factor, is more important now than it has ever been. For now, Mexico is generally the more attractive choice for export-oriented production, while Brazil offers larger domestic opportunities. But both countries are changing rapidly and profoundly, and choices that may have seemed relatively clear in the past now require careful analysis. Much will change over the next five years, particularly if the Free Trade Agreement of the Americas (FTAA) moves ahead. By the end of this period, the Mexican market will likely be large and strong enough to merit direct investment for domestic production of many products, with or without an export strategy. For its part, Brazil will probably have a free trade agreement in place with the European Union (and perhaps others) and it will once again be an attractive base for exporting to the rest of South America, especially Mercosur. So in the long run, the question is not how to chose one or the other, but how to set up in both.

MEXICO AND BRAZIL

Comparing the Titans

Mexico Brazil

Attractive for export oriented production Attractive for domestic oriented production

Imports can supply many sectors Imports are often uncompetitive or face local competition

Production costs average Production costs average

International logistical costs average International logistical costs high

Domestic logistical costs high Domestic logistical costs average

Trade agreements favor exports Not easy to trade with

Growing domestic market Large domestic market

Domestic economic recession with export led growth in late 2002 Weak currency. Increased growth in election year ahead, especially construction.

Source: InfoAmericas

Jan Smith

jsmith@infoamericas.com

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