Mexico became a manufacturing mecca thanks, in part, to its inexpensive labor and proximity to the massive U.S. market. But there is a new reality on the ground in that country these days: a surge in violence tied to the war on drug cartels that Mexico’s President Felipe Calderon mounted after his election in 2006. The result has been a wave of kidnappings, extortion and murder that is threatening the country’s economic health and causing multinationals to examine closely how they operate and invest in Mexico.

“A failure to attract new capital is a major risk,” warns Wharton marketing professor Jerry Wind, director of the SEI Center for Advanced Studies in Management. “If [the violence] continues, a lot of talented people might leave the country.”

The cost of Calderon’s war on the cartels has been steep. Since he took office four years ago, the government estimates there have been more than 28,000 deaths tied to the conflict. And each day seems to bring new horrors — the recent discovery of 72 murdered migrants in a mass grave and the subsequent disappearance of two government officials investigating the crime, a bombing in the tourist hotspot of Cancun, and evidence that the cartels may be gaining expertise in car bombs.

Just as troubling has been the increase in attacks in the modern and once-safe city of Monterrey. While violence along the U.S.-Mexico border — the route for drug traffickers to transport narcotics into the United States — has not been a surprise, the problems in Monterrey, 130 miles south of the border, have been an unexpected nightmare. Home to manufacturing operations of large companies like General Electric and Whirlpool, Monterrey has seen politicians and citizens murdered and roadblocks set up throughout the city by roving gangs, a tactic apparently aimed at showing the gangs’ power and also disrupting police activity. “The violence [in Monterrey] is bordering on obscene,” says Daniel Johnson, senior chief of kidnap response at ASI Group, a Houston, Tex.-based global risk management firm. “It is a major concern for companies operating there.” 

To date, the impact of these security issues on the country’s economy has been overshadowed by the severity of the global recession. Last year, Mexico’s gross domestic product declined 6.5%, a painful contraction exacerbated by an outbreak of the swine flu and a slump in oil prices. This year, Rafael Amiel, director for Latin America at IHS Global Insight, an economic and financial analysis firm, expects Mexico’s GDP to grow 5.1%.

At the same time, Amiel says there are no signs of a major exodus of foreign dollars from the country. Foreign direct investment averaged $1.6 billion per quarter in the four quarters ending March 2010. While there was a surge in the second quarter to $6.1 billion, Amiel says that uptick was driven by one deal, an acquisition by Heineken. Excluding that, foreign direct investment in Mexico remains weak, although he notes that this is a function of the stresses on the global economy, not Mexico’s challenges with the drug cartels. “Employment growth is about what you would expect at this point in the recovery and we don’t see firms moving out of Mexico due to the violence.” Still, Amiel warns that if the situation on the ground in Mexico worsens, this could change. He figures a major escalation in the violence could shave half a percentage point off GDP growth.


How the drug-related crime in Mexico ultimately impacts the country depends in part on how multinational firms respond. For now, experts like David Robillard, managing director in the Mexico City office of risk consulting firm Kroll, say there are no signs that big multinationals are considering pulling out of Mexico. But Robillard does know some firms that have decided to put additional investment in Mexico on hold for now. And he notes that other firms that are looking to set up operations in Mexico for the first time are considering locations further south in the country, away from the crime hotspots. In addition, more corporate boards are asking management to take a hard look at their companies’ exposure to risks in Mexico. Finally, some U.S. government workers in Monterrey have moved their families back to the U.S. following a drug-related shooting near their children’s school.

“Not a day goes by that we are not asked by our multinational clients about a specific threat to their company [in Mexico],” notes Fred Burton, vice-president of counter-terrorism and corporate security at global intelligence firm Stratfor. Some firms are quietly doing what he called “gameboarding”– studying other places to shift their operations to in case the situation in Mexico reaches a crisis. “Companies are still making money there but the cost of production is increasing,” Burton says. “That doesn’t bode well for the country.

The way companies handle those decisions — whether they relate to Mexico or any other location around the globe — comes down to an analysis of the risks and rewards. Erwann Michel-Kerjan, managing director of the Risk Management and Decision Processes Center at Wharton, says companies often break these issues down into a matrix. First, they will come up with a rundown of the top 10 or 15 risks they may face in a certain region. Then they gather information on how likely those risks are. The task at that point is to figure out how, if at all, the risks can be mitigated or controlled. This may involve changes in security processes at a plant, increased insurance against certain events or setting up back-up operations in case one location becomes disabled. “Ideally, you want to prevent every problem,” Michel-Kerjan points out. “But in reality you don’t have the resources to do that.”

The effectiveness of this type of evaluation depends in large part on who does it. Daniel Wagner, managing director of political and economic risk consulting firm Country Risk Solutions, suggests that it is critical for firms to have an independent group to assess the true risks of operating in a specific location. “If you rely on local management to tell you what is going on, you may not get good information,” warns Wagner. “You do not want to make a decision based on the feedback from someone whose bonus depends on whether headquarters invests more money in his or her region.”

The risks, of course, will vary depending on the type of operation a company is running as well as the country in question. Wharton marketing professor David Reibstein says that violence of the sort seen in Mexico is only one of the many risks corporations may face. “The risk might be to management [in the case of violence] but it could also be political unrest or an economic policy change. If you are thinking of investing in China, for example, there is always the question of whether at some point the Chinese government might prevent firms from taking funds out of the country.”

The tolerance for those risks, of course, is hardly uniform. Some industries deal with high risk situations every day, says Michel-Kerjan. “Almost by definition, due to where oil is found — in deep wells in the Gulf of Mexico or in countries like Iraq — oil companies are accustomed to high risk,” he notes. Mining operators are also comfortable with operating in difficult locations. Kroll’s Robillard points out that other firms in industries such as high technology, which have more flexibility in where they manufacture, will be less tolerant of threats.

Competition in Low-cost Manufacturing

According to Wind, the potential problems in Mexico are numerous. “To what extent are executives operating in the country at risk for being kidnapped or killed?” Wind asks. “There is also the risk of property loss. And if you rely on that country to supply other factories, what is the risk that you can’t deliver if it is attacked?”

Those risks are all leading to higher costs from heightened security. ASI Group’s Johnson says firms need to consider things like better physical security, lighting and fencing for facilities. Many U.S. companies also do not allow U.S.-based personnel to stay in Mexico overnight, he adds. Instead, they will fly or drive in and out in one day and use a security-trained driver while getting around. There are regular check-in procedures as well so employers can keep track of everyone who is in Mexico on business.

Higher security costs are not the only unwelcome consequence of Mexico’s problems. Increased complexity in the form of more outsourced work is another likely result. Stratfor’s Burton notes that some companies have passed more work off to subcontractors in Mexico to reduce the amount of personnel they need to keep on the ground there. Wind says this strategy is common in high-risk parts of the world. “There is some advantage to being a local, to knowing the people and the customs.” Reibstein suggests another option: to run the business in Latin America from a spot in the U.S., such as Miami. Yet that can be what he calls a “compromise position” — not necessarily the optimal way to operate.

The issue for Mexico is at what point those added headaches and higher costs make a serious dent in the advantages companies see in operating there. The key advantages include a good, inexpensive workforce and lower transit costs into the U.S. With many markets relying on just-in-time inventory systems, the ability to deliver goods quickly to many points in North America is a critical one. But Reibstein warns that when it comes to low-cost manufacturing, Mexico faces growing competition. “There are much less expensive places than Mexico,” he notes. “Vietnam, China, Pakistan and India are all viable alternatives without nearly the risk.” That reality is not lost on Mexico’s business leaders: An August 2010 survey of nearly 400 Mexican executives by Deloitte found that 57% believed the violence there was the biggest threat to the economy, up from 22% at the end of 2009. 

Wind argues that Israel provides an interesting contrast to Mexico. “Israel has been in various stages of war for the last 60 years,” Wind says. “Yet the country has high levels of foreign direct investment and venture capital, and major companies like Intel, Motorola, Microsoft and Cisco have [big] manufacturing or R&D centers there. The reason is that the perceived reward of the technology know-how and innovation far outweighs the risk.” Mexico, he notes, does not have that edge. “If you have longer lead times, then Bangladesh, Vietnam and Indonesia are all attractive. Low-cost manufacturing is a commodity and is not a sustainable long-term advantage.”

Despite all the dire headlines, however, some observers believe that the campaign against the cartels may be working. “The recent deaths and arrests of certain cartel leaders shows there is progress,” Kroll’s Robillard points out. “And you can see progress in the fact that the tenure of leadership in cartels is now measured in weeks, not years. But, unfortunately, the path to weakening the cartels is one of violence.”

If the Mexican government can succeed in making inroads against the cartels, observers say it needs to take on several other major challenges as well. Amiel suggests that among those are energy reform and tax reform. Indeed, the country’s failure to bring outside capital into the energy business in Mexico, which is dominated by PEMEX, is a major drag on the economy. At the same time, he says, tax evasion is rampant in Mexico, resulting in tax receipts that are just 10% of GDP — far short of the 50% figure in the developed world.

Other countries have faced similar challenges with success. Reibstein points to Colombia, which suffered from decades of violence. “Colombia has made huge strides,” he notes. “But that took a lot of patience and courage.”