January 30, 2009

1. Mexico — Co-opete with China • A Supply-Chain Perspective Leon Bian (SDM’04) — Esteban Guerrero (LFM’03) Leaders for Mfg and System Design & Mgmt Web Seminar January 30, 2009 Mexico—Co-opete with China

2. Co-opetition = Cooperation + Competition Mexico—Co-opete with China

3. Preamble – Mexico seems unable to compete with China • China has taken over as the 2nd largest exporter to the US and has even flooded Mexico’s internal market with all kinds of products. As more companies find it harder to stay afloat in the face of Chinese competition, it seems inevitable that Mexico cannot compete anymore. China surpasses Mexico as the 2nd largest exporter to the US. China’s exports to the US sharply increased in 2001. Source: US Census Bureau Mexico—Co-opete with China

4. China’s cheap labor and vertical integration NAFTA and maquiladoras’ waning advantages Mexico’s unrealized advantage: proximity Three factors contribute to the gloomy picture, from a supply-chain strategy perspective Mexico—Co-opete with China

5. China’s cheap labor and vertical integration – China moves up the Value Chain Population: 1.3B Area: 9,600,000 km2 GDP: USD 4.222T GDP Growth: 9 % FDI Inflow (2007): US$75 B Foreign Exchange Reserve: US$2T Export: US$1.465T Import: US$1.156T • Low labor cost (fully loaded): $1 per hour (China) vs $3 per hour (Mexico) • Joined WTO in 2001 • Exchange rate advantage • Investment in fundamentals Data source: 2005 Ministry of Commerce Mexico—Co-opete with China

6. The advantages provided by NAFTA and the maquiladora strategy faded away • Scarce labor in the less populated north contributes to the rise in labor costs • Moving factories south is not necessarily attractive from a logistics point of view • NAFTA’s Article 303 reduces the tax benefits for maquiladoras Population: 110M Area: 1,972,550 km2 GDP: USD 1.143B GDP Growth: 2 % FDI Inflow (2005): US$17.9 B Foreign Exchange Reserve: US$91.9B Export: US$294B Import: US$305.9B Mexico—Co-opete with China

7. Mexico’s biggest advantage — proximity to the US — has not been fully exploited • On occasion, it is faster to build and ship goods from China to the US market than it is from Mexico • Transparent truck/trailer crossing — warranted by NAFTA — must be fully realized Mexico—Co-opete with China

8. China’s cheap labor and vertical integration NAFTA and maquiladoras’ waning advantages Mexico’s unrealized advantage: proximity Benefit from China’s low labor costs through “co-opetition” Prepare the country for this new scheme: people & logistics Utilize the one advantage that no other developing country has … but Mexico can adopt a different strategy to tackle the issues: Mexico—Co-opete with China

9. a) China-US vs. Mexico-US b) China-Mexico-US US-Mart US-Mart Benefit from China’s low labor costs through “co-opetition”— an alternative to direct competition • A careful supply-chain modeling exercise can reveal that not everything is cheaper in China, and Mexico need not compete with China in all instances. In certain cases, a more profitable alternative to a China-US value chain is a China-Mexico-US value chain. Mexico—Co-opete with China

10. Mexican Tariff (%) Chinese Content (L+Mat’l), (%value) CH-US weight = 5kg constantly Component Material Weight from China to Mexico (kg) A China-Mexico-US supply-chain model • CH-MX-US is more profitable, the lower the labor content. So CH-MX-US is more suitable for capital-intensive products or if more of the transformation is done in Mexico. • Mexico would have to provide more material than China (either in weight or value). • Adding more material content in Mexico improves profitability more than reducing Mexican labor content. • If Mexican Import Tariffs increase, however, decreasing overall Chinese content (both labor and material) by a similar rate tends to cancel the effect. Mexico—Co-opete with China

11. …supply-chain model (2) Total MATERIAL Value Mexican tariff (%) Total Chinese Content (L+Mat’l), (% total value) Mexico—Co-opete with China

12. Prepare the country for this new scheme: people (increase skilled-labor supply) • Further train the local population in the north • Attract skilled labor from the south • Move more factories south Mexico—Co-opete with China

13. Prepare the country for this new scheme: logistics. And, 3, fully exploit Mexico’s proximity to the US. • Improve customs processes to reduce or eliminate border-crossing time • Develop a secure, high-speed railway system that can bring products from anywhere in Mexico across the border in one day — and more cheaply Mexico—Co-opete with China

14. How this strategy changes in light of the current worldwide economic slowdown: • Lower fuel cost  lower transportation cost • Worsening economic condition  lower labor costs in both countries • Lower demand  cost is more important (JIT, etc) • Large investment projects (e.g. new plants)  delayed  Some of these changes are temporary, but the need for Chinese exporters to assemble closer to their markets will remain  The benefit of leveraging a particular supply chain depends on the nature of the product, and it should be considered on a case-by-case basis Mexico—Co-opete with China

15. Summary: Mexico – Co-opete with China • Take advantage of China’s low labor cost while leveraging the tariff advantage provided by NAFTA • Increase skilled-labor supply to be able to assemble capital-intensive products • Fundamentally change the roles of China and other emerging economies in a Mexico-led value chain into the US • Engage the rest of the country through improved logistics Mexico—Co-opete with China

16. Thank you Esteban Guerrero esteban@sloan.mit.edu Leon Bian Motorola Inc lbian@sloan.mit.edu Paper: http://www.mexico-now.com/index.php/contents/editions/No33.html Mexico—Co-opete with China

17. backup Mexico—Co-opete with China

18. Detailed observations (1) Chinese Content (L+Mat’l), (%value) Mexican Tariff (%) Observations: All else being equal---while P.cu stays constant… 1. ...as WT ex-CH (+) grows, P.cxu (-) drops [i.e. the more WT gets loaded in MX, the less overall freight, because MX-US FRT < CH-MX FRT]; e.g. 2x WT.c ---> 20~25% drop in P.cxu 2. ...as im.c-x (+) grows, P.cxu (-) drops [i.e. as it gets more expensive to import CH components into MX, MX cost increases, thus reducing overall profitability]; e.g. 2x im.cx ---> -10% P.cxu 3. ...as CH% (+) grows, P.cxu (-) drops, and makes the effect of im bigger [i.e. as more of the product is produced in MX, the effect of a higher MX DL Rate can be felt]; e.g. 2x CH% ---> -10% P.cxu 4. If im, CH% and WT remain the same, as DM (+) grows, P.CXU (-) drops a bit, but P.CU (-) drops a lot [i.e. the more DM value gets loaded in MX, the less the effect of MX DL (which is higher than CH DL), thus reducing P.CXU a bit; but greater DM vs. DL obviously increases costs tremendously in a CH-US chain, thus reducing P.CU by a lot] Conclusions: 1. CH-MX-US chain works better for low labor-intensive products (i.e. a higher DL% is better suited for the CH-US chain) 2. Adding more material to the product in MX in WT (and to a lesser extent in value) has a greater effect on profitability than trying to reduce MX Import Tariffs 3. If Tariffs increase, though, decreasing CH content by a similar % cancels out the effect CH-US weight = 5kg constantly Component Material Weight from China to Mexico (kg) Mexico—Co-opete with China

19. Detailed observations (2) Observations: All else being equal… 1. ...as CH DM (+) grows, P.cxu and P.cu (-) drop (respectively by 2~10% [dropping with CH%(+) ] and 11~15% [ (-) with DM (+) ]; i.e. more DM means fewer profits overall, but if more DM gets loaded in MX, more DM gets a lower tariff, so P.cu will be more sensitive to the greater amount of DM overall 2. For DM.c < 50% value, as CH% (+) grows, P.cxu (+) grows, while for DM.c > ~50%, Pcxu (-) drops... 3. ...but only for higher values of DM.c is P.cxu > P.cu... 4. As WT ex-CH (+) grows, P.cxu (-) drops; e.g. 2x WT.c ---> P.cxu drops by 20% 5. And as WT ex-CH (+) grows, because P.cxu (-) drops, the DM range and the CH% range for which P.cxu > P.cu, shortens [i.e. DM has to be closer to 100% (or >>DL) and CH% has to be closer to 0% (or <<MX%) for P.cxu to remain > P.cu] 6. As im.c-x (+) grows, P.cxu (-) drops [i.e. if MX Tariffs on CH products get higher, MX costs increase, which reduces overall P.cxu]; e.g. 2x im.c-x ---> P.cxu drops by 3~24% (the higher the CH%, the higher the P.cxu drop, but this drop is less sensitive to DM drop; e.g. DM(+) ---> P.cxu(-) <=> CH% >>0) Conclusions: 1. For CH-MX-US to be profitable, more material (in WT or $) has to be loaded on the MX leg 2. DM in general has to be high and CH% low, which means CH-MX-US is better for lower labor-intensive products and if more of the transformation is done in MX 3. Adding more WT to MX has a greater effect than reducing DL.x Total MATERIAL Value Mexican tariff (%) Total Chinese Content (L+Mat’l), (% total value) Mexico—Co-opete with China