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In the 20 years since the North American Free Trade Agreement went into effect, Mexico has become a global manufacturing leader and a prime destination for investors and multinationals around the world. Yet the country’s economic growth continues to disappoint, and the rise in living standards has stalled. The root cause is a chronic productivity problem that stems from the economy’s two-speed nature. A modern, fast-growing Mexico, with globally competitive multinationals and cutting-edge manufacturing plants, exists amid a far larger group of traditional Mexican enterprises that do not contribute to growth. These two Mexicos are moving in opposite directions. The largest companies are raising productivity by an impressive 5.8 percent a year, while the productivity of small, slow-growing enterprises is falling by 6.5 percent a year (exhibit). And with employment growing faster in the traditional Mexico, more labor is shifting to low-productivity work.

[[exhibit 1]] [[audio two mexico]]

This problem explains why GDP growth has risen by only 2.3 percent a year, on average, since 1981 and Mexico lags behind countries whose GDP per capita it once surpassed, despite more than 30 years of market-opening measures. The country has an urgent need to reconcile the two Mexicos because its demographic dividend—the rapid labor-force expansion that has contributed more than two-thirds of GDP growth—is about to fade. Unless Mexico can nearly triple productivity growth from the recent 0.8 percent a year average, the country could be headed toward 2.0 percent annual GDP growth rather than the 3.5 percent goal the Bank of Mexico estimates for 2014.

This is the central finding of A tale of two Mexicos: Growth and prosperity in a two-speed economy, a new report from the McKinsey Global Institute and McKinsey’s Mexico office. The report concludes that the country can meet the productivity challenge and raise GDP growth to the 3.5 percent target. But that will happen only if Mexico can raise productivity in traditional small businesses, move more businesses and workers into the modern sector, and continue to raise the productivity of large, modern corporations. Policy changes will be required to remove both perverse incentives that discourage small companies from growing and barriers to launching and expanding businesses. In addition, Mexico will need to invest in broad enablers, such as reducing the cost of energy, expanding infrastructure, and improving labor-force skills.

Transform the traditional sector

Traditional, low-productivity businesses are pervasive across the Mexican economy and often constitute the majority of establishments in a given sector. For example, more than 90 percent of the baking industry is made up of small local shops, which have, at best, one-fiftieth of the productivity that the largest top-performing industrial bakeries achieve. In auto parts, 80 percent of all enterprises have ten or fewer employees. These firms provide low-cost assembly work to suppliers working directly for Mexico’s seven global auto manufacturers and are only about 10 percent as productive as these large suppliers. This reduces the sector’s overall productivity to just 21 percent of the US average.

The report examines how to raise productivity in small, low-productivity enterprises in three sectors: the manufacture of food, the manufacture of auto parts, and the retailing of food and beverages. These measures include investments in technology—even adopting simple tools (such as point-of-sale terminals) in mom-and-pop stores could have significant effects. Many small companies have not invested to raise growth and productivity, because they lack access to reasonably priced financing.

Policy changes

Mexico has instituted many reforms to open markets and promote competition, but significant obstacles to growth remain. Special tax breaks for small enterprises, intended to protect traditional businesses, encourage companies to stay small, informal, and unproductive. Mexico can also streamline regulatory processes to make compliance easier and examine the remaining labor-law inflexibilities that discourage full-time hiring. Most important of all, to discourage informality the country can redouble its efforts to enforce tax laws and other rules; today, informal businesses employ more than half of nonfarm workers. Mexico needs to become a place where formal, compliant companies grow and prosper—and inspire others to emulate their success—and where companies that do not play by the rules suffer the consequences.

Access to capital

Between Mexico’s largest, most productive corporations and the millions of small, traditional, and unproductive enterprises there is an increasingly stressed group of midsize companies. While some are pushing innovation and generating well-paying new jobs, their productivity has been growing by only about 1 percent a year and their share of employment has fallen from 41 percent in 1999 to 38 percent in 2009. The World Bank estimates that Mexico’s financial industry underserves 53 percent of these midsize firms, and we calculate that this problem accounts for roughly three-quarters of the estimated $60 billion credit gap across Mexican businesses. Additional reforms to enforce lenders’ rights, including rules for tracking movable collateral (such as office equipment and vehicles) can help.

We believe that with the right measures, Mexico can accelerate its productivity and raise GDP growth to 3.5 percent a year or even higher. Reaching this goal depends on crafting the right approaches, enlisting the aid of the private sector, and translating broad agreements into detailed policies and legislation, as well as implementing them throughout the country.