How China is eating Mexico's lunch: the Maquiladora system's comparative advantage is being challenged head on.

• Author: Rosen, Daniel H.
• Position: China

Mexico's Maquiladora system, a darling of the 1990s and sometimes referred to as a template for special economic zone programs in other emerging economies, suffered a double whammy over the past two years. The first whammy, U.S. economic weakness, has a built-in light at the end of the tunnel: there is a question of timing, but the downturn in U.S. demand from competitive export processors abroad won't last forever, and somebody will be a winner on the upswing. But the second whammy is competition from China, and if there is light at the end of that tunnel, it is more likely from raging wildfires than soothing rays of daylight. As a result, direct investors are hesitant; speculators are pondering a bet against the peso that might pay off if exports and Mexico-bound direct investment don't recover; and financial officials are concerned about the bilateral and systemic risks that could eventuate if a turn-around doesn't come.

Mexico's comparative advantage lies in lower labor costs than the United States, proximity to developed North America, and--for some industries--somewhat lower costs due to different regulations on areas associated with high per capita income economies such as environmental protection. On the other hand, comparative disadvantages include an intrusive bureaucracy that is sometimes corrupt, sometimes simply hostile to the private sector; poor utilities and transportation infrastructure; under-investment in human development; and a less than dynamic industrial structure reflecting imperfect financial intermediation and residual statism. "Clustering" of the right industries doesn't always take place, and demonstration effects from vibrant new industries are too few, despite successes. Maquiladoras were a strategy for maximizing the comparative advantages and protecting investors from the disadvantages, thus tipping the scales and making it attractive for U.S. and other multinationals to come on down.

And come they did. Today there are 3,288 Maquiladora plants in Mexico employing over one million citizens, and accounting for half of the country's exports (see Table 1). But Maquiladora exports have fallen with the U.S. recession and rising Chinese competition. More than two hundred plants closed last year, and hundreds of thousands of jobs were lost. Most went to Asia--primarily China.

What is going on here? Mexico's comparative advantage over the world in its Maquiladora-intense sectors, as revealed by changes in share of...