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Worldwide investment hotspots Mexico: rising star in North America, but for how long?

Executive summary

• Greenfield Foreign Direct Investment (FDI) as a percentage of GDP is still lower than before the economic crisis (Figure 1).

Fig 1 Global foreign greenfield investment (percentage of world GDP)*

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

* Announced investments (in nominal US$m) of which the value in some cases has been estimated. World GDP 2016 is an annualised figure sourced from IMF Source: UNCTAD, IMF, FDI Intelligence, ING calculations

• The United States is the most important destination for foreign greenfield investment into North America but Mexico shows the largest increase.

• Worldwide the US was the third-largest beneficiary of greenfield FDI in 2015 (Figure 2). In comparison to the average for the five years preceding the crisis, average annual greenfield investment into the US nearly doubled, to US$60bn.

• Within the US, Texas, California, New York and Louisiana are attracting the most foreign greenfield investments. The fastest growing sectors in these states are chemicals, renewables, and business services.

• By sector, most greenfield FDI flows into the United States are directed at business services, software and IT. In Texas and Louisiana greenfield FDI is concentrated in the chemicals industry and in the liquid fossil fuels sector.

• Although greenfield FDI in the US automotive sector saw a significant increase in absolute terms, Alabama, Indiana, and Michigan have disappeared from the list of top greenfield FDI recipients in the US, with the share of greenfield FDI into the automotive sector declining by 4%.

Raoul Leering Head of International Trade Analysis Amsterdam +31 6 133 03 944 raoul.leering@ing.nl

Timme Spakman International Trade Analysis Amsterdam +31 6 105 87 724 timme.spakman@ing.nl With special thanks to Marco Loomstra

Economic and Financial Analysis

Trends in cross border greenfield investments: winners and losers, part II 1 March 2017

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• In the post crisis years China has been by far the largest source country of foreign investments into the US, followed by the UK, India, Mexico and Canada. The Netherlands, traditionally a large foreign investor, stands in 11th place.

• Mexico catches the eye with, incoming greenfield investments that are on average 120% higher in the post crisis years than during 2003-07. Worldwide Mexico ranks sixth on the list of countries that attract most greenfield FDI (Figure 2). In the pre-crisis years the country did not show up in the top ten.

• Greenfield investments into Mexico mainly come from the US (35% of total incoming greenfield FDI), former coloniser Spain (11%), top European car producer Germany (10%) and Asian car giant Japan (9%).

• Greenfield FDI into Mexico strongly relates to offshoring of auto production. The automotive sector has attracted US$67bn from 2008 to 2016, about 30% of incoming greenfield FDI.

• Although back-shoring of production from Mexico and other low wage countries to the US has increased, indicators show that offshoring of US manufacturing has still been dominant in recent years.

• This could well change with the current US administration. Trump has pledged to bring manufacturing jobs back to the US and has already used his political leverage to arm- twist Ford and other companies into forgoing offshoring plans.

• Trump has many policy measures at his disposal. Not only can he hit offshoring companies with the stick (with import duties) but he can also try to seduce them with the carrot (lower taxes on profit and tax advantages for those American companies that repatriate stalled foreign financial assets).

• If Trump really implements his threat to impose a 35% tax on imports from Mexico coming from companies that offshored into Mexico f this , it will lead to a 5% decline in total US-demand for goods from Mexico.

Fig 2 Inward greenfield direct investment in 2016 (nominal US$bn)

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Source: FDI intelligence

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Introduction Many Western companies offshored or outsourced parts of their production to low wage countries in the 1990s and the first half of the 2000s. These products are subsequently shipped back to the developed world and sold on domestic markets. The offshoring trend has led to an increasing flow of foreign direct investments (FDI), not only in money value but also as a share of GDP (Figure 1). Especially China benefited from that trend, turning into the “factory of the world”.

Offshoring boils down to geographically splitting up the production process. In the years before the global financial crisis offshoring created many new global value chains. This led to much cross-border trade in intermediate products, resulting in fast growth in world trade.

In recent years some Western companies have re-shored parts of their production, either to their home country (back-shoring) or to cheaper neighbouring countries (near-shoring). Back-shoring leads to lower cross border

Although still a very important production location, China is one of the countries that has experienced the consequences of back-shoring, caused by the rise in Chinese wage costs. The value of greenfield FDI into China declined by approximately 20% between the pre-crisis and post-crisis years (Figure 3). This raises the question of where the lost production is moving to. Is another country or region replacing China as the “factory of the world”? We try to answer this question in a series of reports. The first report in this series focuses on Europe. In this report, the second in the series, we look at whether North America, and especially Mexico, is benefiting from the decreasing popularity of China. This report will be followed up with studies about the developments of greenfield FDI into Asia and the CIS countries.

Fig 3 Growth of incoming greenfield FDI flows 2008-2016*

< -75% 11 to 75% > 75%

-11% to -75% 10 to -10% No info * Average % change for 2008-16 vs the average for 2003 to 2007 Source: FDIntelligence

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A lack of sufficient comparable data about corporate decisions on production locations makes it difficult to measure off- and back-shoring precisely. We use data about greenfield foreign direct investments (FDI) as a proxy for developments in off- and back-shoring. Figure 3 shows that various regions have seen high growth in incoming greenfield FDI, while China is among the biggest losers.

It should be noted that greenfield FDI is not a perfect indicator for offshoring. Greenfield investments by foreign investors not only serve the purpose of setting up new offshore production locations, but are also made to sell products in local markets. This leads to fewer exports and less cross-border transport, with home country exports substituted by local production.

Nevertheless, data on greenfield FDI still contains valuable information about production offshoring. Many greenfield FDI flows to North American countries, especially those to Mexico are related to offshoring of production.

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FDI into North America North America’s share in worldwide greenfield FDI rose from an average of 9.3% over 2003-07 to 12.5% over 2008-16, mainly driven by the US and Mexico. From 2012 onwards this share has declined but is still well above the levels of 2007. Canada has lost ground significantly since 2011 (Figure 4).

The United States and Mexico together have attracted 85% of greenfield FDI flows into North America in the post-crisis years, amounting on average to US$100bn per annum. The United States and Mexico are among the top greenfield FDI destinations worldwide. In 2015 the US ranked second and Mexico sixth. Measured against the size of the economy (as a percentage of GDP), Mexico receives the most greenfield FDI. While US greenfield FDI inflows account for less than 0.5% of GDP in 2015, this stands at more than 2% for Mexico.

Fig 4 North America’s share in worldwide Greenfield FDI flows (nominal US$)

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

NAFTA Canada Mexico US

Source: FDi Intelligence, Calculations by ING

Mexico: popular offshore location but for how long? Mexico has been the rising star in North America and is a popular offshoring destination. The nominal average annual value of greenfield FDI projects into Mexico in the post-crisis years has risen by 120% relative to the period before the start of the crisis. Mexico’s share in worldwide greenfield FDI is also higher now than it was before the crisis.

With the exception of the fossil fuel sector, all large Mexican sectors have been attracting more greenfield FDI in the post-crisis years. The automotive sector is in the lead. Greenfield FDI flows into this sector over 2008-16 constituted 16% of total greenfield FDI inflows (Figure 5).

In addition to the automotive sector, communications, renewable energy and beverages have become important sectors for incoming greenfield FDI inflows. A large share of the greenfield FDI flows into the beverages industry has been driven by Coca Cola, which invested US$5bn into new bottling facilities in Mexico. In addition, Heineken and PepsiCo have together invested US$1.8bn into the Mexican beverages market.

Automotive, renewable energy, communications and the beverage market are the most important destination industries for Greenfield FDI flows into Mexico.

FDI into North America has on average been 2.3% higher in the post crisis years than in the pre- crisis years

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Fig 5 Mexican FDI inflows by sector*

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2003 - 2007 2008 - 2016 * Annual average sector FDI (nominal US$m) Source: FDIntelligence

Greenfield FDI flows into Mexico are sourced from all over the world. All the German car giants have set up plants in Mexico. Audi based a new plant in San José Chiapa as the global production location for the new Audi Q5. Recently BMW and Mercedes announced production moves of 3-series and C-class models to Mexico. Fiat Chrysler Automobiles (FCA) announced in 2016 that they will move all production, with the exception of SUVs and pick-ups, to Mexico. However, in 2017 FCA abandoned this plan after President Trump threatened companies that offshore production with a 35% import tax if they subsequently try to export those products to the US.

In a similar vein, Asian car producers are actively moving automobile production to Mexico. In 2014 Mazda opened a factory in Mexico and Kia is currently in the process of doing so. Toyota and Honda are also planning to move production capacity to Mexico. However, Asian manufactures have been the target of Trump threats to tax companies that offshore production that is to be sold on the American market.

Fig 6 Level of overall unit labour cost in US$: China and Mexico

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Mexico China

Source: OECD data, unit labour costs indices (levels, internationally comparable)

Mexico is an attractive candidate for offshoring activities because it is close to the large US market, a market that, due to the North American Free Trade Agreement (NAFTA), can be entered without facing import tariffs. According to consultancy firm A.T. Kearney, the most important reason for automotive firms to invest in Mexico is low labour costs.

Low wage costs and proximity to the US make Mexico an attractive offshoring location. Automobile manufacturers from all over the world are moving production capacity to Mexico.

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In 2010 the price of one unit of labour in China exceeded the price in Mexico and since 2014 unit labour costs in Mexico have been decreasing rapidly (figure 6). While current unit labour costs in Mexico are 45% lower than in China, a large part of this is driven by depreciation of the Mexican Peso. Labour productivity driven by foreign exchange devaluation is less sustainable than when driven by changes in labour force fundamentals.

Besides labour costs, improved delivery times and quality control have also made Mexico more attractive.

Mexican government policies in recent years have facilitated incoming greenfield FDI as well. This is reflected in the World Bank “Ease of doing business” score for Mexico, which has been improving in the post crisis years. After the 2014 reforms, bankruptcy resolution significantly improved and access to credit and electricity improved as well.

Greenfield FDI in Mexico is mostly concentrated in the border regions with the US. The attractiveness of Mexico as an offshoring location has led to an export performance that is well above the world average (Figure 7).

Fig 7 Mexican export growth accelerates*

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World Mexico

* Cumulative growth in nominal US$ for Mexico and the World (2009 = 100) Source: UNCTAD, Calculations by ING

In recent years the press devoted increasing attention to back-shoring of manufacturing activities to the US. Although an increasing number of firms re-shored production from low wage countries to the US, according to A.T. Kearny back-shoring never overtook offshoring (with the exception of 2011).

This conclusion is consistent with those that can be drawn by looking at the share of Mexican manufactures in US consumption of manufactured goods. A rising share indicates that off-shoring dominates back-shoring. This is exactly what has happened in the post crisis period (Figure 8).

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Fig 8 Percentage of Mexican manufactured goods in US consumption*

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

* Imported Mexican manufactured goods as % of total manufactured goods consumed in the US Source: US Int. Trade Commission, U.S. Bureau of Economic Analysis, Calculations by ING

How will Trump’s attack on offshoring affect Mexico? President Trump has repeatedly pledged to bring back American manufacturing jobs and to impose a 35% import tariff on companies that offshore production to Mexico and subsequently sell it on the American market. If Trump really imposes such measures, this would definitely change the balance between back-shoring and offshoring.

However, recent experience seems to show that, only by threatening, Trump may have already affected greenfield FDI flows into Mexico. Although other factors were also relevant, manufacturers such as Ford, Chrysler and air-conditioning manufacturer Carrier (located in Indiana) abandoned earlier plans to offshore to Mexico after Trump threatened tax measures.

If needed, Trump has many policy measures at his disposal. Not only can he hit companies with the stick (import duties) but he can also try to seduce them with the carrot (lower taxes on profit and tax advantages for those American companies that repatriate financial assets held abroad).

Independent of the approach Trump chooses to implement, we expect it will result in less offshoring and more back-shoring of American production in years to come. There is little to suggest that Trump will stop arm-twisting enterprises to refrain from offshoring production. Tariffs only have to come into play if his “management by Twitter” approach becomes ineffective.

The expected decrease in offshoring to Mexico and/or back-shoring from Mexico is bad news for cross-border transport because it means less transport of (intermediate) goods exported from Mexico to the US. With Trump’s agenda unclear, it is difficult to quantify the size of this effect. If Trump chooses to stick with “management by Twitter”, will he only target those companies that come up with new offshoring plans and will he limit the arm twisting to larger, and higher-profile, companies? Or will he target all companies that plan to offshore? And what about US- companies that are already producing in Mexico for the US market? Will he leave them alone, or is he going to follow up on his campaign promise ”to bring back jobs to America?”

If Trump actually takes steps to implement his threat of a 35% import tax on imports resulting from the offshoring of production from the US to Mexico, it becomes a bit easier to quantify the effect of his policy on the transport sector. A conservative estimate of the size of this effect shows that a 35% import tax on these Mexican goods

Back-shoring brings production back home, near-shoring brings production closer to home.

Offshoring accounts for 40-50% of Mexican exports to the US

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would lead to 11% less demand for these goods by American end users (see: Trump and Trade). Knowing that US offshoring accounts for 40- 50% of Mexican exports to the US, the imposition of a 35% import tax will diminish the US-demand for Mexican by approximately 5% (see annex).

Aside from the effect on American imports from Mexico, these policies will lead to less offshoring to Mexico and more back-shoring to the United States. Currently, 55% of accumulated foreign direct investments in Mexico, measured in nominal US$, are investments by US companies. This has led to significant growth in exports and substantial job and income growth in Mexico. A tariff of 35% will make producing in Mexico to service the American market less (or un) profitable. Although it is not possible to calculate how many companies will withdraw from Mexico or refrain from new investments, the height of the tariff means that substantial effects are to be expected. The fact that just the threat of imposing the 35% tariff has contributed to companies such as Ford, Fiat Chrysler and Carrier deciding to cancel investments into Mexico, indicates that Trump’s tariff policy would do serious harm to Mexico’s status as a rising star for greenfield FDI inflows.

FDI into the United States: still going strong The US is by far the largest recipient of Greenfield FDI in North America. In 2016 it ranked third worldwide, after India and China, with an annual inflow of US$48 bn.

The primary reasons for foreign investors to invest into the US are market expansion and clustering. Foreign firms invest to service American and Canadian consumers or seek to exploit spillovers from locating close to American and Canadian companies that have a relative competitive technological or innovative edge over foreign companies. For instance, firms may decide to locate in the Sillicon Valley or Austin clusters to profit from the linkages and structure of the environment in which American champions such as Apple, Google and Intel operate. Data on greenfield FDI at the sector level seems to confirm this. Business services, software and IT services, and electronic components are among the fastest growing sectors for greenfield FDI into the United States (Figure 9). Comparing the pre-crisis years to the post-crisis ones, these have shown average annual greenfield FDI inflow growth rates of 100% to 300%.

Cheap energy has become another reason for choosing the US as a production location. The shale gas revolution is particularly beneficial for firms with energy-intensive production processes - the chemicals sector has seen a 10% increase in annual greenfield FDI flows since 2010.

A 35% (mutual) import tax on production offshored to Mexico will lead to a 5% decline in demand for Goods imported from Mexico to the US.

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Fig 9 The top 15 US sectors for incoming greenfield FDI *

01,0002,0003,0004,0005,0006,0007,0008,0009,000

2003 - 2007 2008 - 2016 * Annual average sector greenfield FDI in nominal US$m Source: FDi Intelligence, Calculations by ING

Real estate is one of the fastest growing sectors for incoming greenfield FDI. According to Deloitte, the United States and Canada have become popular destinations for Chinese investors. While Chinese real estate investors accounted for no significant amount over 2003-2007, they have accounted for 33% of the average annual greenfield FDI flows into the real estate sector in the post crisis years.

Although greenfield FDI into the US automotive sector has increased in absolute terms, the share in total greenfield FDI has declined.

US FDI outflows Although a significant part of US offshoring is addressed towards Mexico, Asian countries are also popular offshoring destinations. Figure 10 supports this, clearly showing that a larger fraction of manufactured goods has been imported from Asia in recent years.

Fig 10 Asian manufactures in US consumption*

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* Imported Asian manufactured goods as % of total manufactured goods consumed in the US Source: U.S. Int. Trade Commission, U.S. Bureau of Economic Analysis, Calculations by ING

The trend towards more offshoring is also visible in US greenfield FDI outflows. When looking at US outflows between 2008 and 2016, low wage countries received 65% of the total (Mexico, China, “Others low wage” and India in Figure 11). While most of the investment in high income countries is market seeking, greenfield FDI in low wage countries is more often related to either the exploitation of natural resources or to the

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offshoring of labour intensive production. However, one should be aware that these greenfield FDI outflows to low wage countries tell only part of the offshoring story, since cross border outsourcing to local producers in low wage countries does not generate greenfield FDI flows.

Fig 11 US greenfield FDI Outflows by destination, 2008- 2016*

China12%

UK7%

India7%

Mexico7%

Canada6%

Others (High-wage) 22%

Others (Low-wage)39%

* Percentage of total greenfield FDI outflows (nominal US$m) Source: FDi Intelligence, Calculations by ING

FDI into Canada: not as bad as it looks Canada has attracted less greenfield investments in recent years. Annual greenfield FDI flows into Canada have been on average US$15 bn over 2008–2016, 18% lower than in 2003-2007.

This bad performance is due to the fossil energy sector. Greenfield FDI into this sector nosedived from an average of US$7.8bn per annum for 2003-2007 to US$2.2bn per annum over 2008-2016. The primary reason for this decline is low commodity prices, which reduced the profitability of extraction projects. When looking at greenfield FDI inflows excluding fossil fuels, Canada has attracted on average 23% more in greenfield FDI inflows during the post crisis years. The fastest growing industries for greenfield FDI inflows are communication, software and IT services, and metals.

Fig 12 The 15 most important sectors in Canada for greenfield FDI*

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* Annual average sector greenfield FDI in nominal US$m Source: FDi Intelligence, Calculations by ING

Bulk of greenfield FDI flows still to low-wage countries.

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Conclusion North America is an important destination for greenfield FDI flows. The main insights of this report are:

• The United States is the most important destination for foreign greenfield investment in North America. Greenfield FDI flows into the United States are mainly directed at the oil & gas industry, renewables, chemicals, and real estate.

• Mexico is the rising star of North America. Greenfield FDI flows into Mexico were on average 120% higher in the post crisis period than over the 2003-2007 period.

• Mexico is a popular offshoring and near-shoring destination, with most greenfield FDI directed into the automotive sector.

• Although back-shoring of production from Mexico and other low wage countries to the US has increased, offshoring of US manufacturing has still been dominant in recent years, indicators show.

• As President Trump pushes for more re-shoring and less offshoring, we expect less greenfield FDI flows into Mexico in the years to come.

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Annex 1: Effects of a mutual imposition of 35% import tariff by the US and Mexico 1) Effect on US imports from Mexico

- Share of Mexican exports subject to the US import tax: 45%

- Pass through of the tariff costs to the market price: 30%

- Price elasticity of American demand for Mexican goods: 1.0

So the imposition of a 35% tariff by the US on offshore production would lead to 5% less demand for Mexican goods:

0.45*35%*0.3*1.0 = 5%

2) Effect on Mexican imports from the US

- Share of US exports subject to the Mexican import tax: 45%

- Pass through of the tariff costs to the market price: 60%

- Price elasticity of Mexican demand for US goods: 1.5

So the imposition of a 35% tariff by Mexico would lead to 13% less demand for US goods:

0.45*35%*0.6*1.5* = 13%)

Sources: 1. J.W. Mason (2016), Trump’s tariffs, A dissent, post on blog Slackwire

2.Dallas FED, 2011, working paper 1106, Offshoring and volatility: more evidence from Mexico’s Maquiladora Industry

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