The last Volkswagen Beetle rolled off the assembly line in Puebla, Mexico

For twenty years Mexico and Brazil, and eventually Mexico alone, were the sole producers of the people’s car. Production was halted the United States in 1977, after the car's air-cooled engine and no-frills design no longer met the updated safety and emissions standards. In the 20 years since production of the Beetle began in the city of Puebla, Mexico has grown to be one of the world’s largest car manufacturers.

The Beetle, formally known as the Sedán, is just one of a number of low-cost models available to the Mexican consumer. Surpassing Volkswagen, GM, Nissan and Ford now focus a significant percentage of their production and enjoy an increasing proportion of their sales in Mexico.² As new PT Cruisers and Pontiac Azteks are being shipped from Mexico to overseas markets, Mexico’s population of 105 million rely on the trusty green Sedán.³ While Mexico serves as low-cost supplier of automobiles to the world, its domestic market remains distinct, yet developed.

Brazil has seen similar recent success in the automotive industry.

After more than a decade of stagnation, Brazil's auto market has been booming. Total vehicle production grew by 30% in 1993 and another 14% in 1994, making 1994 the most profitable year in GMB's 69-year history.⁴

The recent recent rise of Mexico and Brazil as two of the world's leading auto exporting countries is directly tied to the lowering of tariff rates and other barriers to trade with the developed world. NAFTA and similar agreements with the EU have spurred investment in Latin America, most noticeably in its two largest, and arguably most prosperous nations. This appears be another success story attributed to the virtues of free trade.

However, Latin America's auto industry owes its successful establishment not to the forces of the open market, but to a planned and directed national industrialization program. Its existence is due entirely to the cultivation of a domestic market through specific state-directed policies. It owes its survival to government support and intervention. Although in the economy of today intervention is more of a hindrance than a help, government policies allowed the Mexican and Brazilian industries to flourish after their inception. Later, government interference allowed the industry to survive through disastrous economic turmoil.

Across Latin America the ratio of people to cars is 9 to 1, compared with 2 to 1 in developed countries.⁶ This gap has been narrowing constantly. However, the large discrepancies in income distribution endemic to Latin America have hindered growth and development of a domestic market. Political interests have often made foreign investment difficult, if not impossible. Financial crises have periodically threatened the survival of the industry. Nonetheless, Brazil and Mexico are well on their way to building highly developed, segmented automobile markets.

The automobile production industry in Latin America is comparatively young. Many well-established corporations in the United States and Europe had been operating successfully well before the decision to commence manufacturing in Latin America. Over half a century and more than 1500 miles separated Ford's perfection of the assembly line in Dearborn, Michigan from the development of an industry in Mexico.

Given the large economies of scale associated with the existing system of production centered around Detroit, there was no inherent reason for these companies to move a portion of their production to the developing world. For Mexico, as well as Brazil, the formation of a local industry was result of carefully designed government planning and economic intervention.

Not until the 1950s did the countries of Latin America begin to industrialize for the purpose of creating a homegrown consumer automobile industry. Due to the strict government controls and high trade barriers of the time, industries developed separately within neighboring countries. Each separate industry owes its birth and subsequent successes to the utilization of the policy of import substitution industrialization (ISI). While ISI proved eventually untenable, it was an important step in the development of the automotive industry.

The positions of Brazil and Mexico in regard to the industry were typical of the approach to import substitution as a policy. First, each country proposed a limit on the number of firms allowed to compete in the industry. Savings from economies of scale, that is, from increased efficiency due to mass production, are magnified as production increases.^ˆ† By endeavoring to limit the number of firms with access to the market they were assuring competitive prices and therefore higher potential sales. Secondly, these firms were then made to comply with a set of guidelines including limiting of makes and models and standardization of parts, further improving efficiency and lowering costs.

Lastly, each enterprise was to be majority owned domestically. Each car was to comply with a domestic content requirement. Every vehicle would have to be assembled with a certain amount of domestically-produced material. To furnish this material, a whole supply chain of local enterprises would necessarily need to be created. This focus on domestic ownership, production and control was the hallmark of ISI.

The aim of this proposal was to spur the creation of industry, resulting in a reverberating effect that would benefit the entire economy. Domestic parts suppliers would have a market in the new industry, as would all the attendant industries that grow in symbiosis with the creation of a market for automobiles: oil refining, steel, construction, service stations. As the local economy grew from the creation of a support network for the new industry, wages would rise and the market for finished vehicles would expand.

The government supported the kinds of policies that encouraged concentration of wealth. Low-interest, long-term government-backed loans together as well as low income taxes were upheld for the express purpose of creating an internal market for goods. By allowing citizens and businesses to keep a larger portion of their earnings, they could promote the beginnings of a consumer economy. Despite low per capita income as a whole, Brazil and Mexico were able to cultivate a managerial and professional class able to afford these newly produced automobiles.

Motivated by different politics, economics and geography, the two countries drifted apart in their implementation of the methods of import substitution industrialization and in their styles of promoting overall industrial development. Mexico followed a less stringent approach

Mexico, as the southern neighbor of the United States, was much more popular with American companies. Under heavy pressure from business and political interests, Mexico took a less regulated and more interconnected approach to import substitution. The transportation costs for imported parts was lower, and the transfer of technology and expertise much simpler due to Mexico's proximity. American firms' ability to expand into the market was greatly aided by these factors. Ford and General Motors, along with Chrysler, the Big Three of the U.S. car industry, were among the first to gain a foothold.

The Japanese gained entry to the market due to an unlikely source: the cotton trade. In 1963, cotton exports to Japan accounted “for foreign exchange earnings of $196 million, over 20 percent of the total ... about 70 percent of these exports went to Japan, Mexico's most important trading partner after the United States.”⁷ In this way, the creation of the multinational auto industry within Mexico owes its beginnings not to the creation of trade ties, but the strengthening of existing interconnectedness.

“The Japanese government,” rather underhandedly, “used its position as Mexico's major cotton buyer as a lever to support Nissan: it threatened to cut cotton imports if the Nissan proposal was not approved. The threat proved successful.”⁸ This “capitulation” weakened the resolve of the Mexican government to resist the demands of other multinationals, as well as domestic producers that wished to enter the market.

Competing firms followed a “follow-the-leader pattern of defensive investment,”

'Rival firms within an industry ... counter one another's moves by making similar moves themselves,' seeing this as a risk-minimizing strategy. ... Thus while it may not have been in the interests of the firms taken individually to commence manufacturing operations in Mexico, they were prepared to do so rather than risk the possibility of that market being conceded to a competitor.⁹
For this reason, “In total, ten firms were approved to manufacture in Mexico, far more than the [government] NAFIN report has recommended and far more than the size of the Mexican market warranted.” This number was twice as high as the amount calculated to be efficient within the Mexican market.

The government “pinned its hopes on competition to winnow down the industry over the next few years.”¹⁰ However, the foreign multinationals were able, because of their size, to cross-subsidize production in order to maintain their respective market shares. That is to say, they would transfer profits between branches in different countries in order to weather the ups and downs of demand in the developing world.

In order to ensure the success of the Mexican firms against their large, well-equipped foreign competitors, “a system of production quotas was introduced which limited the production of each firm, and thus ensured a market share for the Mexican firms.”¹¹ On the question of product differentiation and the proliferation of makes and models, the U.S. companies won out. They were allowed to keep their system of changing models every year.

The Mexican government lost out on the majority of contended claims in their bargaining agreement. However, two of the most important claims were left standing. Mexico's law requiring 60 percent domestic content, by price, was not struck from the agreement. At sixty percent domestic content, inexpensive mass-produced parts were able to be imported from abroad, while still allowing for a significant amount of production and assembly to be centered in Mexico.

The multinationals were “limited to the machining of the motor and the final assembly of vehicles.”¹² This clause gave rise to the creation of a domestic parts industry, creating more jobs and anchoring the Mexican industry firmly in place. Multinational firms were led to take on the complex task of assembly and engine production while the individual parts were contracted out locally. This specialization led to an efficient division of labor within the industry as a whole.

The Brazilian government was much more exacting in its demands on the multinational corporations allowed to enter its market. It pursued a much more rigid approach to import substitution. It imposed strict regulations, “requiring 90 to 95 percent domestic content by weight within a period of three and a half years [beginning in 1956].”¹³ This decree had the effect of essentially prohibiting imports, lending an incentive to firms already in the market and willing to compete. It also had the effect of raising prices considerably. In 1967, it cost 158 percent more to produce a light truck in Mexico than in the United States and 180 percent more to produce the comparable truck in Brazil.¹⁴

Volkswagen and Fábrica Nacional de Motores (FNM), who both already owned moderately developed firms, were the first to indicate their willingness to follow through with increased investment, even before enactment of the regulations. In their wake followed all of the existing assembly firms, as well as three new entrants.¹⁵ The federal government, in its role as promoter of domestic production “provided the firms with a host of fiscal and foreign exchange incentives, which drastically reduced actual investment costs. In essence the state underwrote the whole venture.”¹⁶

The government policies induced a surge in investment projects in both the parts and terminal sectors of the industry ... These investments in turn propelled an enormous increase in output, with production jumping from 600 vehicles with approximately 43 percent local sourcing in 1956 to 133,000 with over 95 percent local content in 1960.¹⁷

As evidence, Brazilian auto sales over the period 1960 to 1968 rose by an average of 14 percent.¹⁸ Over the period 1968-1974 they rose an average of 21 to 22 percent. However, in the following six years, from 1974-1980, industry output stagnated at a 4.3 percent pace. This drop in productivity “can only be understood in relation to the deterioration of Brazil's position in the international capitalist economy.”¹⁹

In the early 1970s, the Brazilian government sponsored another round of expansion in the industry in response to the incredible growth in demand. This exacerbated the problem of an increasing current account deficit, as well as building excess capacity within the industry. The government was disproportionately borrowing large sums of money, leading to high inflation and high interest rates as banks began to doubt whether the money would be repaid. As growth of demand waned from record levels, plants were supplying an excess of vehicles. To compound the problem, the Oil Crisis of 1973 sent fuel costs soaring.

Responding to this crisis, the government tightened consumer credit and increased gasoline prices, effectively raising the cost of owning a vehicle. In addition, firms were exempted from the system of price controls then in place, freeing them to reduce production and raise their per unit profits. With tariffs in place, this assured the survival of the industry while punishing the consumer. Firms were subsequently encouraged to export through a system of incentives and credits in an attempt to even the current account balance. Thus the early 1970s marked the end of import substitution industrialization as a viable policy in Brazil.

In Brazil, high inflation and interest rates plagued national industry throughout the 1980s until the passage of market-based reforms in the mid-1990s. This situation led Roger Smith, GM's Chief Executive officer of Roger and Me fame, to disparagingly refer to Brazil as a “black hole,” for its propensity to suck up cash with no hope of a return.²⁰

Mexico suffered a similar fate during the late 1970s and throughout the early 1980s. Under import substitution both countries managed to create an eventually disastrous situation for foreign investment and economic stability by investing state funds and providing subsidies to inefficient, protected industries. Millions of dollars in subsidies were paid out to businesses while millions in potential gain to consumers was lost due to inefficient local production methods, quotas, and barriers to automobile imports.

An economic downturn in the United States as well as poor economic policy on the part of many Latin American nations led to economic stagnation. What arose out of the crisis was a series of decisions that benefited the industrializing borderlands of Northern Mexico and Baja California, as well as the industrial base of Brazil.

The increased competition from inexpensive Japanese automobile imports that was battering GM and Ford eventually led to cost-cutting, economizing, restructuring, and the moving of facilities. In 1986, in a cost-cutting move, Ford relocated one of its U.S. production units to Hermosillo, Mexico.²¹ Efficient, modern facilities were constructed. Workers were paid only a fraction of the cost of a unionized automobile worker in Michigan or Pennsylvania. A new era in the history of the car industry began.

The most recent series of policy decisions to affect wholesale change in the automobile industry are the series of free trade and tariff reduction agreements embodied in GATT, the WTO, Mercosur in South America, and most notably, NAFTA. Here, we once again see a policy decision directly influence automotive industry investment. January 1^st, 1994 marked the beginning of a new epoch in the history of the economy of the Americas as virtually duty-free trade commenced between Mexico, the United States, and Canada.

Opening the market to international trade and investment produced the effect of bolstering already existing production facilities. Well before the advent of NAFTA this expertise in automobile production, regardless of its inefficiencies, formed a basis from which to develop more modern, export-focused platform. Production externalities, gains from the clustering of automotive knowledge and a trained labor force, were integral in chasing U.S., European and Japanese investment to Mexico.

Free trade simply multiplied the benefits by allowing for the utilization of inexpensive labor without a tariff penalty. While workers were dismissed from their jobs in the United States' car industry, the Mexican car industry was expanding throughout the 1980s and 1990s, leading to unprecedented growth, and a reversal in the fortunes of Mexico's stagnant economy. In the period 1985-2000, roughly coinciding with the construction of Ford's plant in Hermosillo, automobile production roughly quintupled, from 398,000 units to 1.92 million by 2000. This placed Mexico as the world's eighth-largest producer, ahead of the United Kingdom, Italy and Brazil.

Brazil, with the election of President Lula da Silva, witnesses a period of high interest rates and soaring unemployment, which reached 13 percent by August 2003. International automakers “were counting on emerging markets like Brazil to rev up profits in the coming decades. The market's potential seemed limitless in the early- to mid-1990s.”²² The reason for the recent troubles within the industry is explained by João Batista Simão, president of the GM distributors' association, "While people are afraid of losing their jobs, they won't change their car."

While Mexico increasingly pointed itself towards a more open market approach to automobile production, Brazil has reformed, yet remained relatively protectionist. In the early 1990s, then-President Collor de Mello fulfilled a campaign promise to open the Brazilian market to imports. In an effort to keep Brazilian firms competitive, he then reduced the domestic content requirements from 90 percent to 70 percent.²³

Tariffs on auto imports have remained, ranging from a moderate 20 percent to prohibitively high 70 percent tariff in response to a widening trade imbalance.²⁴ Likewise, government taxes on Brazilian-made vehicles have remained high. From 22 to 45 percent of a vehicle's cost passes directly to the State.²⁵

In contrast, Mexico's acceptance of the terms of NAFTA has led to less regulation of the economy, especially in the automotive sector. With decreased regulation has come increased foreign investment. Free trade has encouraged an export-based system to arise within Mexico. In all fairness, Brazil is a member of a free trade association, Mercosur. However, Paraguay, Uruguay and Argentina have never been the economically powerful neighbors that the U.S. and Canada are to Mexico.

As long as the multinational firms are secure in their faith in the North American economy as a whole, the car industry in Mexico will remain prosperous. Since the majority of Mexico's greatly increased production is devoted to supplying the U.S. and Canadian markets, their fates are intertwined to a point. Mexico has successfully liberated itself from the cycle of debt and deficit that characterized the inwardly-focused import substitution period.

Brazil's industry, due to its large production numbers and strong emphasis on domestic demand, is tied inseparably to its internal market. If the Brazilian economy takes a turn for the worse, the local automotive industry takes a plunge. Worse yet, if the Brazilian economy is expected to face trouble in the future, it will have to pay enormous costs to continue production in the form of high-risk, high-premium loans.

While Mexico was able to extricate itself from the import substitution system successfully in order to transition to the future, Brazil is still stuck within the system. Mexico, through a series of trade agreements, has become the labor-saving solution to the difficulties of the American automotive industry. Investment and jobs have flown south, while exports from Mexico have risen. In 2004, on the strength of automotive exports, Mexico ran a trade surplus of over $45 million with the United States, its largest trading partner.²⁶ Since the implementation of NAFTA in 1994, trade with the U.S. and Canada has tripled.²⁷

Mexico is fast becoming the location of choice for new production. Volkswagen manufactures its popular New Beetle in only one location, Puebla, MX. Expertise in producing the old Beetle, as well as labor cost savings, led Volkswagen to shift the entire production line. Volkswagen benefits from low labor costs, while still in close proximity to the United States, a market in which it has worked hard to establish itself.

Brazil, due to its isolation as the dominant force in the South American market, never developed an export-based system. Yet its internal market has been enticing enough to lure foreign investment, despite the uncertainties of relying on domestic demand in a developing country. However, with recent reforms exports have been growing, marking a move away from domestic production towards greater global interconnectedness. With an industry-wide capacity of over 3.2 millions vehicles, Brazil has the potential to become one of the world's largest automotive suppliers.²⁸

The future is bright for the integration of the Latin American car industry. Brazil, even without a comprehensive export policy, is the eleventh-largest auto manufacturer in the world. If its production was equal to its capacity, it would be the fifth-largest producer in the world, behind only the U.S., Japan, Germany, and France.²⁹

Mexico is eighth in the world, bolstered by its foothold in both the domestic and export markets. With integration comes reliance on international demand. This is not necessarily a discouraging development. Demand for low-cost, quality vehicles will remain relatively stable internationally. ^{Investment flows to the automobile industry will be based on fulfilling international rather than local demand. Engaging the larger world market means that these countries will be able to continue growth possibilities, even while weathering economic problems at home. Increased international integration, in trade and in finance, solved the problem of sustainability that has plagued the Latin American car industry since its inception.}