Report No. 29920-MX Mexico Mexico's Challenge of Knowledge-based Competitiveness Challenges and Opportunities (In Two Volumes) Volume I: Executive Summary June 2006 Colombia and Mexico Country Management Unit Latin American and Caribbean Region Knowledge for Development Program, WBI Document of the World Bank Mexico's Challengeof Knowledge-basedCompetitiveness: ChallengesandOpportunities Table of Contents Page Acknowledgments 4 Boxes, Figures, Tables 5 Main Messages 6 I. ANeedforTransitiontoKnowledge-basedEconomy 7 1.New ChallengesandOpportunities 7 2. Benchmarking Mexico's Positioninthe Knowledge Economy 12 11. Major PolicyIssues 14 3. Transforming the Innovationand Enterprise Upgrading System 15 4. EnhancingEducation and Skills 16 5. Updating the ICT Infrastructure inMexico 17 111. ImplementationOptions 19 6. Toward NationalVision and Leadership 19 7. Regional Leadership inthe Transition to a Knowledge Economy 24 3 Acknowledgments The report was prepared by a team led by Carl Dahlman and Yevgeny Kuznetsov o f the World Bank Institute's Knowledge for Development Program (WBIKD). Team members included Guillermo Abdel Musik (Instituto Tecnol6gico Aut6nomo de Mkxico, Mexico City), Aimilios Chatzinikolaou (International Finance Corporation), Joost Draaisma (World Bank, Latin America and Caribbean Region, Economic Policy Sector), and Robert Stephens (IBRD-Global Information and Communications Technologies Department, Policy Division). Valuable contributions were made by Clemente Ruiz Duran (Universidad Nacional Aut6noma de Mkxico, Mexico City), Carlos Mancera (Valora Consultores), Mark Hagerstrom and Harry Patrinos (World Bank, Latin America and Caribbean Region, Human Development), Daniel Crisafulli (IBRD-Global Information and Communications Technologies Department, Policy Division), and Derek Chen (WBIKD). Administrative and editorial assistance was provided by Faythe Calandra (WBIKD). We express special thanks to participants o f a discussion with the government organized by the Presidency o f Mexico on January 17, 2005, particularly Alejandro Werner (Secretaria de Hacienda y Crkdito Publico de Mkxico), Guillenno Aguirre (Consejo Nacional de Ciencia y Tecnologia), and Bemardo Gonzalez-Arrechiga (Instituto Tecnol6gico de Estudios Superiores de Monterrey). Membersofthe Mexico country team, particularlyKrishna Challa and Anna Wellenstein (World Bank, Latin America and Caribbean Region, Finance, Private Sector and Infrastructure), provided guidance and advice. We would also like to thank Peter Scherer and our colleagues inMexico, particularly ReneVillareal (Centro de Capital Intelectualy Competitividad), Roberto Villareal (Office o f the President), Guillermo Fernandez de la Garza (US-Mexico Foundation for Science), and Hector Moreira (ITESM) for their useful insights. Peer reviewers are Jose Luis Guasch(Latin America and Caribbean Region, Finance, Private Sector and Infrastructure), Lauritz Holm-Nielsen (Latin American and Caribbean Region, HumanDevelopment, Education Sector), Alfred Jay Watkins (Europe and Central Asia Region, Poverty and FinancialSectors Development), and Fernando Clavijo (Analitica Consultores, Mexico). 4 Boxes, Figures, Tables Boxes Box 1. The Republic o f Korea's Transition to a Knowledge Economy: FromVision to Implementation Box 2. The Fundaci6n Chile Model andits Relevance for Mexico Figures Figure 1.GDP per Capita Growth inthe Republic o fKorea and Mexico, 1960-2003 Figure 2. Four Projections o fMexico's Real GDP per Capita, 2001-2020 Figure 3. Mexico's Knowledge Economy Index Figure4. Mexico's Performance on the Four Pillars ofthe Knowledge Economy Figure5. Virtuous Circle ofGrowth andReforms Figure6. Knowledge Index byMexicanStates Tables Table 1. FromNAFTAto a knowledge-driven(second generation) NAFTA Table 2. Transition to a Knowledge-based Economy: Four Types o f States inMexico and Policy Agendas 5 MainMessages The knowledge revolution offers unprecedented challenges and opportunities for Mexico. An ongoing knowledge revolution may allow Mexico to escape the low-growth trap and switch to higher growth. Other countries-among them the Republic o f Korea, Ireland, and Finland-have recently accomplished such a transformation. To take advantage o f new knowledge-based opportunities, Mexico must take concerted action now. The stakes are high.The NAFTA agenda needs to be deepened (Chapter 1and 2). Taking advantage of new opportunities is not business as usual. Mexico's reforms were founded on getting relative prices right..Although this is still anunfinishedagenda, a second-generation knowledge-driven policy agenda should focus on getting institutions right. More specifically, Mexico should create institutional capabilities through innovation and enterprise upgrading, improving education and skills, and updating its infrastructure for information and communications technology (Chapters 3-5). Momentumfor change mustcome fromthe bottomup andfromthe top down. A pragmatic way to move forward is to increase top decision- makers' awareness of the need for consensus concerning how to overcome key national obstacles. Mexico then can move ahead with concrete and manageable bottom-up approaches that promote national vision andleadership andbuildon past successes (Chapter 6). Concertedaction amongstakeholdersis vital for progress. States and champions in the private sector are important agents o f the transition to knowledge-based competitiveness. The heterogeneity o f agents can be an advantage. Alliances among dynamic agents at the regional level are the key to creating and benefitingfrom new opportunities (Chapter 7). 6 Mexico's Challengeof Knowledge-BasedCompetitiveness: Challengesand Opportunities I.ANeedforTransitiontoKnowledge-basedEconomy Knowledge and its application are now widely acknowledged to be key sources o f growth in the global economy. Driven by the rapid application o f new information and communications technologies, as well as by the application o f scientific discoveries to production in every sector o f the economy, the knowledge revolution has enabled countries to dramatically increase their competitiveness and to achieve rapid growth. However, it has also brought great challenges to countries that want to participate effectively in the knowledge-driven supply chains and markets that now dominate the global economy. If countries fail to position themselves properly in this global, knowledge-based marketplace, then competitiveness will be increasingly difficult to achieve. The term knowledge as used in this book is emphatically not just about high technology. Putting knowledge to work allows countries to improve everyday life for their people and opens new possibilities for developing regions o f Mexico, small and medium-size enterprises (SMEs) and other less-developed actors. Mexico's service sector (tourism and health services, for example) provides particularly fertile ground for the applicationo fknowledge. 1. New ChallengesandOpportunities Where does Mexico aspire to be twenty years from now? And what will its industrial structure be? These questions are impossible to answer indetail, just as it was impossible to predict, given the debt crisis two decades ago, how truly dramatic Mexico's transformationwould be inthe aftermath o f the crisis. This book contends, however, that Mexico needs to embark on a no less dramatic transformation than the one that occurred after the 1980s. Although based on the main economic tenets o f NAFTA, the effort must go further by focusing on second-generation reforms. These reforms are about dramatic improvements inMexico's capacity to generate knowledge and transform it into wealth. Total factor productivity (TFP) is a proxy for a nation's ability to put knowledge to work. This capability to adopt, adapt, and create knowledge is critically dependent on countries' institutions, particularly investment climate andregulatory framework. It is often measured by a so-called residual inthe production function that cannot be explainedby factor inputs.' This ability to put knowledge to work produces a dramatic difference ina country's wealth. Figure 1compares the evolution o fper capita income o f Mexico and the Republic o fKorea from 1965 to 2002. While initially lower than Mexico's, Korea's per capita income increased more than a factor o f eight and i s now 'Because TFP is a very imperfect proxy, Figures 3 and 4 are merelyillustrative and serve to outline qualitative scenarios of development. 7 about five times that o f Mexico. The dashed line represents what would have been Korea's per capita income ifgrowth was just a matter o f the growth o f capital and labor inputs. The differencebetweenthe dotted line andthe actual percapita income for Korea i s due to its more effective use o fknowledgebroadly defined (both technical knowledge andpolicy knowledge). Korea developed learningcapacities inthe 1970sand 1980s. Mexico did not. Figure 1.GDP/capita growth inthe Republic o f Korea and Mexico, 1960-2003 between Poverty and Wealth... Knowledge makes the Difference Thousands oi 14% Conskitit US $ 14 Rep of Korea 12 10 8 j: 2 0 1965 1970 1975 1980 1985 1990 1995 2000 Source: Knowledge for Development Program, WBI 8 The four projections in Figure 2 suggest how Mexico may be able to utilize its knowledge capacity by the year 2020.2 As mentioned before, total factor productivity i s a proxy for national learning capability. Projection I plots the path o f real GDP per capita ifMexico's TFP growth rate followed its 1991-2000 average value (-0.13 percent per annum). Projection 2 plots the path of real GDP per capita given a 2 percent per annum TFP growth rate, which i s close to 1991-2000 decade average for the Republic o f Korea. Projection 3 plots the path o f Mexico's real GDP per capita given a 3 percent per annum TFP growth rate, which i s close to Finland's 1961-1970 decade average. Finally, Projection 4 plots Mexico's real GDP per capita given a 4.25 percent per annum TFP growth rate, which i s the approximate value of Ireland's 1991-2000 decade average. Figure2: Four Projections ofMexico's RealGDPper Capita, 2001-2020 1995 US$ 23,500 .. . ..... - ... __ . _ ... 7 -Actual 21,500 --.-.-. - ....................................... - Projection1: 0.13 YoTFP Growth - Projection2: 2% TFP Growth (South Korea) 19,500 ....... ............... -Projection - 3: 3% TFP Growth (Finland) 17,500 ....... Projection4: 4.25% TFP Growth (Ireland) ....................... 15,500 ..................................................................................................... . . . . . . 13,500 ............................................................................... I 11,500 .............................................. 9,500 ................. ........... 7,500 i 1995 2000 2005 Year 2010 2015 2020 Source: Based on historical estimates of variables. For more details on the methodology andsources of data, see Annex I of main report "TheoreticalFrameworkfor Growth Projections." Projection 1i s an inertial scenario; projections 2 and 3 are realistic; projection 4 is an optimistic yet not impossible scenario. The ability to transformknowledge into wealth, quite literally, makes the difference between poverty and prosperity. All things being equal, there i s an almost twofold difference inper capita GDP by the year 2020 between the realistically optimistic scenario 3 and the inertial scenario. * For all four projections, capital, labor, and humancapital were assumed to grow at the 1991-2000 average growth rates for Mexico-3.32 percent, 2.75 percent, and 0.92 percent, respectively. 9 Throughout this report, Mexico i s compared with the following set o f countries: United States, a main trading partner o f Mexico's and a paragon o f the knowledge economy. 0 The Republic o f Korea and Ireland, countries that about twenty years ago faced challenges similar to the challenges now facing Mexico and made meteoric progress toward knowledge-based competitiveness. We also make references to Finland's experience, particularly with regard to the political economy o f transition to knowledge-based development. 0 China, a new economic powerhouse, competitor, and opportunity. 0 Spain and Chile, two dynamic (although obviously very different) Spanish-speaking countries. Mexico's transformation in the next twenty years will be shaped by the ongoing knowledge revolution-a revolution that brings unprecedented threats and opportunities. The term knowledge revolution refers to the increased speed in the creation and dissemination o f knowledge. The ability to make effective use o f knowledge is becoming a fundamental determinant o f global competitiveness. One can already catch glimpses o f the prosperous, knowledge-based Mexico o f twenty years from now. The engineering centers o f GE, GM, and Delphi, employing hundreds o f high-skilled knowledge workers, can become springboards for innovation clusters. The provision o f health services to retirement communities in San Miguel de Allende or Cuernavaca indicates a potential for cluster communities o f highly value- added healthcare services and recreation. These two examples may seem worlds apart, butthey bothrelyon efficient knowledge organizations. To take advantage o f the ensuing knowledge revolution and assure the necessary productivity gains, Mexico needs to develop a strategy o f transition to knowledge-based economy. To take advantage o f the ensuing knowledge revolution and assure the necessary productivity gain, Mexico needs move up value chains by developing efficient education, innovation, and ICT systems. While first-generation NAFTA-related reforms were based on low-cost labor, second-generation reforms will be based on lower cost skilled labor (see Table 1). Skilled workers with highschool diplomas and engineers will need to become a major comparative advantage. The average income for engineers and researchers inthe United States is about 300 U.S. dollars per day, while inMexico it i s about 120dollars per day.3 R&D links with the United States and Canada-in venture capital and innovation, exchange of researchers and engineers-is at the center o f knowledge-based, second-generation NAFTA reforms. Data providedby CONACYT 10 Table1. From NAFTA to a knowledge-driven (second-generation) NAFTA I ResultsofNAFTA agenda Knowledge-driven (second-generation) NAFTA agenda Trade and FDI,particularly maquilas, as a major FDIand strategic alliances withknowledge capital flows: source o f employment organizations abroad as a source o fknowledge-based moving up higher-value addedjobs value chains Large stock o f accumulatedFDIwith 0 Attract knowledge-intensive FDI little linkages to the domestic 0 Promote spillovers from the existing FDIstock: economy supplier and cluster development 0 Promote strategic alliances with foreign universities, firms, technology and research organizations Labor flows: Migration and remittances as an Migration as a source o f entrepreneurship, knowledge maximizing escape valve and shock-absorber and capital for Mexico: benefits o f 0 Reach agreement to regularize low-skilled migration Remittances as a second source o f undocumented flows foreign revenues after tourism 0 Reduce transactions costs o fremittances transfer and create conditions for productive use o f remittances 0 Utilize Mexican professionals abroad: create "brain circulation" and venture capital networks Services: Mexico as a major tourist destination Knowledge-intensive services as a major source o f repositioning employment: Mexico's 0 Move to higher-brand tourism nature and Develop engineering and other highvalue culture professional services r 0 Develop high-quality health services to attract retirees and healthtourists from OECD countries 0 Capitalize on Mexico's history and culture: I promote investment into media, movie industry, etc. Source: World Bank Staff World-wide experience shows that such a strategy can b e developed in three steps. First, a benchmarking framework i s introduced to measure country's initial conditions and progress towards knowledge economy. Second, core issues of knowledge economy: necessary reforms o f innovation, education and ICT systems are analyzed. This i s a question of what should b e done (Part I1of the report). Third, implementation issues o f the knowledge strategy are considered. These implementation issues include political economy considerations, investment climate and other issues. Although not analyzed in detail, they are touched upon to discuss what could b e done in terms of transition to knowledge-based competitiveness given the constraints Mexico faces. (Part I11 of the report). 11 2. BenchmarkingMexico's Positioninthe KnowledgeEconomy As a first step to articulate a strategy for moving forward, we disaggregated the knowledge-based economy and competitiveness into four functional areas: 0 Economic incentive and institutional regime that provides incentives for the efficient use o f existing and new knowledge and the flourishing o f entrepreneurship; 0 Effective national innovation and enterprise upgrading system: a system o f research centers, universities, think tanks, consulting firms, and other organizations that can tap into the growing stock o f global knowledge, assimilate and adapt it to local needs, and create new knowledge; An educated and skilled population that can create and useknowledge; 0 A dynamic information infrastructure that can facilitate the effective processing, communication, and dissemination o f information. On the basis o f these four pillars, we developed an aggregate knowledge economy index and other scorecard indicators for Mexico (see Figure 3).4 Figure 3. Mexico's Knowledge Economy Index Global View: Knowledge Economy ltidex 0 2 3 4 5 7 8 9 1995 Source: Knowledge for DevelopmentProgram, WE31(www.worldbank.org/kam) Source :Knowledgefor Development Program, WBI- Knowledge Assessment Methodologv (KAM) (wnit ~t.orlo'barrk.or.e/ko,r,). Note: The distancefrom 45 degree line indicates the improvement (above the line) or deterioration (below the line) of the selected countries between 1995 and most recent(generally2002). 12 Economic incentive regime: strong openness to competition, but weak on regulation Institutional regime: improving on property rights, but weak on corruption and government effectiveness Education: weakest pillar in the longer term, with big challenges in access and quality Innovation: very weak for an economy o f its size ICT: laggingbehindleaders inLatinAmerica. Figure 4 presents Mexico's comparative performance against the four pillars o fthe knowledge economy framework over time. It shows the relative changes inperformance between 1995 and the most recently available data. Mexico has shown some improvement inthe pillars o f economic incentive regime and education, while in innovation and informationinfrastructure the country has lost some ground. I t is important to note, however, that the changesthat occurred are quite insignificant. The improvements in particular are quite small, especially when compared to China, the Republic ofKorea, or Ireland. Figure 4. Mexico's Performance on theFour Pillars of the Knowledge Economy Mexico[most recent3nd WE),NormalizationGroup: All Ecm. IncentiveRegime Innovation -- RegulatoryQuality -EconomicNontariff Incentive Regime Tariff & Barriers Researchersin R&D per mil pop. & JournalArticles per mil pop. Ruleof Law --- Scientific USPTO patents per mil pop. InformationInfrastructure --- Computersper 1,000 Information Infrastructure Telephones per 1,000 persons persons -- Adult Literacy Rate - Tertiary Secondary Enrollment Internet users per 10,000persons Enrollment Education most recent - 1 - 1 1 1995 Source :Knowledge for Development Program, WBI KAM(WMV. wor.lrlban~.or.r/kam) - 13 11. Major Policy Issues Drawing on the previous analysis, we can now summarize the strategy to move forward as follows: Finalize broader economic reforms to enhance revenue mobilization and create an evenplaying field andmore contestable markets Upgrade and improve the three key hnctional pillars o f the knowledge economy: education, innovation andenterprise upgrading, and ICT systems. Getting institutions right-creation o f organizational capabilities-is central to bothprongs. Unlike "stroke o f the pen" reforms, these efforts are often time consuming. Much like learning inthe sphere o f technology, organizational learning relies on adaptation of worldwide best practices to local conditions. Given existing weaknesses, Mexico faces a challenging policy agenda. We distinguish between long-term actions (what should be done) and the more immediate agenda (what could be done given Mexico's institutional rigidities and constraints). Recommendations for the short term are informed by Mexico's Competitiveness Agenda (coordinated by the President's Office). These recommendations tend to be more specific than for the long term. The agenda inthe area o f institutional regime and governance i s quite large and has beenthe object o fmuch analysis. This book does not dwell on it indetail. Reforms in this area are critical to improve Mexico's overall performance, as well as to provide the appropriate context for the more structural reforms ineducation, innovation, and ICT. To ensure transition to the knowledge economy, it is particularly important that Mexico provide adequatepublic resources and enhance the incentive framework for the transition. Inthe short run, there is significant roomfor better use o fexistingpublic resources through continuous evaluation o fprograms andpolicies and a better link between performance o f public programs and the amount o fresources allocated to them. Inthe long run,however, the transformationto aknowledge economy, particularly reform o f innovation and education systems, will require more public resources; this creates urgency for tax reform. Inthe longrun,inorderto enhancethe framework for transitionto aknowledge economy, the following actions are required: Create an even andbusiness-friendly playing field by enhancing competition, improving the regulatory framework, and focusing inparticular on reduction o f costs (including logistical costs) o f entry, exit, and doing business. Strengthen major factor markets,particularly labor, the financial markets, and the energy market (electricity, gas, petroleum). 0 Improve public governance, with a more transparent rule o f law, efficient judiciary system, andrespect for intellectual property rights. 14 3. Transformingthe InnovationandEnterpriseUpgradingSystem Mexico's strategic objective should be a dramatic increase in productivity through knowledge-based integration into global value chains and participation in knowledge networks. To achieve this, Mexico would require reform o f its system o f national innovation and enterprise upgrading. A dynamic and flexible innovation system must be led by private demand, and it must respond to private sector needs. Strong academic- industry linkages are an important part o finternational knowledge networks. Inthe short term the policy agenda should focus on formulating a cohesive strategy, improving incentives, and increasingthe role o fthe private sector inpublic programs. Formulating a CohesiveStrategy The government has created myriad policies and policy instruments for scientific research, technological development, and innovation. Diffuse mandates, overlapping functions and bureaucratic considerations have complicated strategy formulation and policy coordination. There i s a need to centralize innovation policy and assignment o f funding. Currently, Consejo Nacional de Ciencia y Techologia (CONACYT) manages about 36 percent o f the funds for public R&D and technology upgrading. Out o fthese funds, less than a thirdis for productive innovation. Both figures should be increased significantly, making CONACYT a hub for interorganizationaland private-public alliances. As a first step toward greater cohesion, the government should make a thorough evaluation, preferably using cluster analytical concepts, o f its policies, programs, and funding. This audit by domestic as well as international experts should be o f high technical caliber, independent in order to avoid capture by vested interests; and representative through collaboration o f important Mexican stakeholders. The audit should include the locus for effective decision making and alignment o f management responsibilities with accountability for results. The budgetingprocess should bebased on clear priorities. Improving Incentives To improve incentives for innovation, linkages between business and R&D can be strengthened in four ways. First, the government should restructure intellectual property rights. (Mexico remains the only OECD country where the researcher on a public institution does not have a legal mechanism to claim the upside potential of his or her invention. Second, public institutions should reward staff for success in productive research projects and linkages with the productive sector. Third, rules for the allocation o f public funding for R&D should be introduced that favor consortiums between universities and private firms, and between private firms and SMEs. Finally, funding should be targetedto sectors known for excellence and strategic value. Increasing the Role of the Private Sector Private sector participation inthe design and implementationo fpublic programs must be increased. Although the situation i s improving, Mexico's private sector role, both in financing and execution o f research and development, i s below the standards o f comparable countries. The private sector takes a comparatively passive stance on using 15 product and process innovation as a strategic tool for business development. The reasons for this seem to be weaknesses on the supply and demand sides. Drawing on Conacyt's AVANCE and other programs, the government could enhance its catalytic function by (i)supporting research and training linked to joint ventures between international and domestic technology companies; (ii) prompting international technology companies to create research teams in Mexico through staff exchange schemes; (iii) moving science and technology researchers from government institutions to companies 'through specific public-private incentive programs; (iv) leveraging innovation spillovers from FDI through targeted investment promotion; and (v) expanding programs supporting innovation start-ups with matching grants through private venture capital firms and incubation assistance. '4. EnhancingEducationandSkills Given the level of current educational expenditures, Mexico should be achieving better results for its students in both qualitative and quantitative terms. Among OECD countries, Mexico spends nearly as much on education as a share o f its gross domestic product (4.42 percent) as Australia (4.49 percent), Germany (4.64 percent), Italy (4.55 percent), and the United Kingdom (4.47 percent), but these OECD countries produce students with more average years of schooling, higher literacy, and lower rates o f repetition. Inthe longer term, Mexico needs to achieve consensus to reform its education system ina way that would eliminate institutional rigidities and limit self-interest, such as the power o funions. A reformed education system would be based on principles o f lifelong learning and would incorporate successful new approaches and pilots in pedagogy into an integrated system of lifelong learning at the national level. It would also tap private sources to finance the expansion and improvement o f educational opportunities. By providing multiple pathways to learning, Mexico will enable its people to learn continuously through life. Its subsystem o f tertiary education would have multiple qualified service providers and sources o f financing. In the medium term, actions should focus on three major areas: increasing coverage and quality in basic and secondary education; expanding access to higher education, making it more demand-driven and responsive to the needs o f the Mexican economy and labor market; and accelerating the transition to lifelong learning. A minimum standard o f achievement in basic and secondary schools must be ensured and access to upper secondary and vocational education expanded. Through promising programs such as the Escuelus de Culidud program, Mexico can improve the years inschool and skills o f its labor force. Strengthening incentives to expand enterprise training and to enrich adult education, particularly at the secondary level, will reduce the undereducated adult population. To expand access to higher education, a dramatic change i s required in how the government finances its universities, giventhe highper student spending at this level and 16 the regressive and distributional effects that this policy has had on the entire education system. Greater reliance on private financing o f higher education could be achieved through income-contingent loan schemes inwhich repayment i s linked to the borrower's income. Mexico also should strengthen university-industrypartnerships and linkages; introduce higher education programs that are flexible and part-time, thus allowing students to leave or re-enter the system as needed; and scale up initiatives at the state and national levels that grant greater autonomy to tertiary schools in managerial, financial, and pedagogical issues. To accelerate Mexico's transition to life-long learning, distance education models and pedagogy pilots at the local level should be diversified. Many promising initiatives inthis areamustbe evaluated inorder to scale up and spread loc,alinnovations. As anext step, we recommend bringingkey stakeholders together to design the architecture o f an integrated system o f lifelong learning. Standards must be developed concerning certification, accreditation, testing, and evaluation, as well as recognition o f prior learning. Policy actions should focus on an overhaul o f the curriculum and institutional models that are usedin adult education, creation o f a transparent systemthat can retrain workers for re-entry into a changing marketplace, introduction o f clear regulations and accreditation procedures for long-distance learning programs, and the creation o f a coherent and nationwide quality assurance system. 5. Updatingthe ICT InfrastructureinMexico A strategic objective is creating a flexible ICT infrastructure with price and quality o f services comparable to those in the United States and Western Europe. This would require creation o f a contestable marketplace and incentives for new entrants that would reduce the dominance o f Telmex, the main provider o f IT services. Legislation to transform Comisih Federal de Telecomunicaciones (COFETEL) into a more independent and effective regulator will also be necessary. Inthe shorter term, the policy agenda for the information and communications technology infrastructure should focus on the following three areas: (i)creation o f an even playing field by accelerating institutional changes; (ii)elimination o f entry barriers and efforts to foster competition and promotion equity, and (iii) greater access to ICT infrastructure, particularly in poor areas. Createan evenplayingfield Rebuildingthe credibility, effectiveness, independence, andtransparency ofthe Comisi6n Federal de Telecomunicaciones should be a first priority. Despite a promisingbeginning, the commission is a weak regulator that does not inspire the confidence new entrants needto makeinvestments inthis sector. This, along with the filings ofamparos, have become the single most important barriers to ICT growth inMexico. Congress, which has been debating amending the Federal Telecommunications Law for nearly two years, 17 should focus on adopting amendments to the that would make COFETEL as independent andtransparentas the Comisi6nFederal de Competencia (COFECO). Congress should set aside amendments over more technical issues, such as interconnection, tariff, and unbundling-issues that couldbe better addressedby a more effective andindependent COFETEL. The amendments to the Federal Telecommunications Law should also remove the ability o f the Secretaria de Comunicaciones y Transportes (SCT) to review or oversee COFETEL and, equally important, mandatethat COFETEL immediately adopts and follows transparent and accountable procedures indecisionmaking. COFETEL should have the power to develop andimplementits own regulations and not simply be responsible for implementing those developed and approved by the SCT. The COFETEL chairmen and commissioners, nominatedby Congress, should be appointed for fixed terms and should be removedonly for gross ethical violations. To send a dramatic and clear signal that there is an institutional break with the past, Congress could direct COFETEL to report to the Secretariat of Economy. This could have an added benefit o f increasingcoordination between COFETEL and COFECO-the telecommunications and competitionregulators. Congress should also make sure that COFETELhas adequate financial resources: the commission should be able to finance itself through fines and license fees. It should also be accountable to the Congress for its annual budget.Making COFETEL a more effective regulatory agency with increased autonomy andtransparency will not only strengthen the commission, but itwill also reduce the ability o f disaffected parties to misuse thejudicial system to reverse or delay implementation o f equitable decisions. Eliminate Entry Barriers and Foster Competition Mexico should put inplace incentives for competitors to grow and increase investments. In particular, it could simplify and streamline the licensing regime, eliminate requirements to register contracts with COFETEL for all but companies with market power; and eliminate voice-centric regulation. We recommend automatic review o f regulations every two to three years with the goal o f fostering competition and increased access. Promote Equity and Increase Access There are numerous ways inwhich Mexico could promote equity and increase access. It could encourage broadband deployment and reduce local loop costs through competition from cable T V and wireless operators; implement an effective and better coordinated universal access program; eliminate cross-subsidies and complete tariff rebalancing; buildon the success o f e-Mexico Fidecomiso; landimplement output-based aid pilots to foster provision o f infrastructure inunderservedareas. Elimination o f the 10percent tax on mobile operators is advisable. A universal access hnd and tax (a 1to 2 percent tax on operators) could be administered by an independent and transparent authority (either COFETEL or a new ICT agency). 18 111. ImplementationOptions 6. Toward NationalVision andLeadership To move forward, Mexico needs to implement major reforms and develop a national vision o fMexico as a knowledge-based economy. The reform agenda is as challenging as the institutional impediments to reforms. The economic agreements (Los Pactos) o f the 1980swere good examples o fpragmatic institutions to carry out economic liberalization andcontain inflation. The new reform agendabuilt around a concept o fknowledge needs a similarly far-reaching mechanism. For lack o f a better title, we can call this a Knowledge Economy Pact. It would include consensus on the need to move forward as well as a rankingo fpriorities and a planfor monitoring progress. Such an agreement would evolve gradually over time 'and would entail a combination o f top-down and bottom-up policies. Finland, Ireland, and the Republic o f Korea are the best-known, best-practice examples -of countries that have engineered successful transitions to knowledge-based economies. In all these cases, national economic crises compelled diverse actors to define and implement a new agenda through explicit or implicit national agreements on goals and mechanisms to move forward. The crises also promptedpolicymakers and private sector leaders to lengthenthe time horizon o f the policies adopted. Thus, Nokia-Finland's first mover toward an innovation-based economy4ramatically increased R&D investments. Finland responded by increasing public R&D and transforming the innovation system to fit business needs. Members o f parliament took courses and went on study tours to demonstrate the need for the new agenda. National public innovation organizations played a crucial role by transforming technology into businesses and ensuring a critical mass o f demonstration cases. Ireland also exemplifies a successful attempt to pursue both top-down and bottom-up policies. It invested in education and R&D infrastructure in the 1980s and implemented drastic policy changes beginning in 1987. To complement its top-down policies, Ireland instituted pragmatic bottom-up programs-regional partnerships to mitigate high unemployment and a program to expand national-supplier linkages from foreign direct investment (FDI). The Republic o f Korea's powerful and shared national vision was followed by effective government coordination (see Box 1). A private sector champion provided the crucial impetus for change. 19 Box 1. The Republic of Korea's Transitionto a KnowledgeEconomy: FromVision to Implementation In1998, inthe wake o f a financial crisis, the Republic o fKoreaofficially launcheda national strategy to become a knowledge-basedeconomy. The initial impetus came from the private sector-the Maeil Business Newspaper-which concluded in 1996,even before the crisis, that there was an urgent need for a more coherent vision o f the future o f the Korean economy. This newspaper launched the "Vision Korea Project" as a national campaign inFebruary o f 1997, and it developed the first Vision Korea Report. Eventually, the government-the Ministryo fFinanceandEconomy-became the mainchampion o fthe policy agenda for the knowledge economy. The Korean Development Institute, a so-called system integrator, coordinated the work o f a dozen think tanks. A joint report by the World.Bank and the Organization for Economic Cooperation and Development (OECD) outlined concrete steps for reforms in the various policy domains. Progress was monitored closely. As a result, inertia or resistance was identified and addressed. Korea's knowledge strategy o fApril 2000 evolved into a three-year action plan for five main areas: information infrastructure, human resources, knowledge-based industry, science and technology, and elimination o f the digital divide. T o implement the actionplan, Korea established five working groups involving nineteen ministries and seventeen researchinstitutes, with the Ministry o f Finance and Economy coordinating the implementation. Source: The authors. Three lessons are relevant for Mexico. First, simple institutional recipes applicable to all countries do not exist. Mexico will need to devise its own recipe for a knowledge economy. Because o f Mexico's great regional diversity, regional and state- level policy initiatives would be a key entry point for a knowledge-based economy. Mexico has already advanced quite significantly inthat direction. Subnational initiatives (such as the Monterrey Knowledge Technopolis) are important springboards for more systemic reform agendas. Second, even when crises call for urgent economic transitions, countries must "prepare the bases." The experiences o f Korea and Finland teach this valuable lesson. The essential preparatory stage can be seen inthe initial Vision Korea Report. It also is seen inFinland's major effort to facilitate and accelerate business R&D. Third, although major reform efforts from the top are vital, they may not provide the all-important impetus for transformation. Concerted effort must evolve. Bottom-up experiments in Mexico, which are already well under way, must mature. These transitional stages then proceed to concerted efforts. (Korea's knowledge strategy i s one example.) Drawing on a diversity o f best practices, we suggest that Mexico construct a Knowledge Economy Pact in three stages: the immediate agenda, medium-term agenda, and long-term agenda. The art and craft o fpolicymaking are about sequencing the various horizons o f a policy agenda ina virtuous circle o f growth and reforms (see Figure 5). 20 Figure5: Virtuous Circle of Growth andReforms IMMEDIATE AGENDA MEDIUM-TERM AGENDA Demonstrationprojects CRITICAL MASS OFCHANGES LONG-TERM AGENDA Source : World Bank staff Immediate Agenda Buildingawareness o fthe need for innovation; developing a system to monitor progress, and implementing new pilot projects are the main tenets o f the immediate agenda. Mexico i s already engaged in significant new initiatives on innovation, education, and ICT. Because o f the sheer diversity o f new programs, priority should be given to monitoring and evaluation. Evaluation should be viewed as a valuable management tool to help improve performance, not a way to assign blame for failures and problems. Such forward-looking evaluations are crucial to proceed to the next stage o f consolidation when diverse pilot projects are aggregated at the regional and sectoral levels. Bottom-up initiatives must be complemented with top-down efforts. A massive campaign should be launched to raise awareness o f the urgent need for reforms and the high pay-offs that can follow. The government can champion a search for pragmatic, step-by-step reform strategies and ways to monitor progress and set priorities. Global strategic consultancies could be contracted to lend additional credibility to these efforts. They can helpadapt global best practices to Mexicanreality. Medium-term Agenda The agenda at this stage focuses first on pragmatic actions not requiring parliamentary approval that can yield results in the medium term. Mexico's Competitiveness Agenda elaborated by the government i s comprehensive and well thought out. It addresses the 21 knowledge economy fi-om this medium-term perspective. Particularly in the areas o f education and innovation, government programs that have received positive evaluation yet have remained relatively small could be scaled up and consolidated. Incollaboration with federal ministries and state governments, CONACYT has established a diversity o f sectoral and regional funds.. These funds could be consolidated with clearly specified priorities and operating procedures. Interorganizational and private-public projects are to be particularly encouraged. A good example in this context is Tekes, the National Innovation Agency o f Finland. It funds industrial projects, as well as projects inresearch institutes, and especially promotes innovative, risk-intensive projects. In education, promising programs include Escuelas de Calidad, Consejo Nacional de Foment0 Educativo (CONAFE). Income-contingent loans can facilitate private financing o f higher education and life-long learning initiatives. The government also should bring key stakeholders together to design the architecture o f an integrated national system o f life-long learning. Issues to be addressed include the following: accreditation of multiple providers, certification o f prior learning, vocational qualifications, vocational counseling and information on career paths and earning streams, quality o f different public and private providers, and financing mechanisms. The successful transitions in Ireland, the Republic o f Korea, and Finland (see Chapter 3) indicate that actions designed to yield immediate results should be complemented by longer term efforts. . These actions prepare the bases for a major concerted effort-an effort that articulates a shared vision o f Mexico as a knowledge- based economy, an effort that has a visible and tangible demonstration effect by consolidating existing initiatives. "Preparing the bases" recalls the Japanese proverb: "A vision without an action i s a dream. An action without a vision is a nightmare." Collaborating with private sector champions and civil society, the federal government can begin to formulate a compelling yet realistic vision o f Mexico as a knowledge-based economy. Its objective i s to shift gears fi-om business as usual to a more urgent concerted action. Buildingawareness would create a vivid image o f what i s at stake for every Mexican-the poor, the middle-class, and members o f national industrial groups and multinational corporations. The experience o f Korea (which has a centralized economy) exemplifies how a shared vision can emerge from outside the government as the result o fbyprivate sector champions and the media (see Box 6.1). Piloting a national knowledge agenda at the state level is important. National private-public collective projects can serve as springboards for Mexico as a knowledge economy. For instance, a private-public bridge organization, Foundation Mexico, could scan new opportunities and put them into practice. One model for such an organization is Fundaci6n Chile (Box 6.2). For Monterrey's leading industrial groups, a vibrant and commercially successful Foundation Mexico could become a flagship organization o f knowledge economy, just as the Monterrey Institute o f Technology, created in 1943 by Monterrey's industrialists, was at that time a symbol o fMexico's industrialization. 22 Box 2. TheFundacibn ChileModel and its Relevancefor Mexico One o f the most successful attempts in the Latin American region to establish national "antennae" for new technologies i s Fundacih Chile, originally ajoint effort between the Chilean government and the U.S.firm ITT, but now largely autonomous. Fundacion Chile uses four main techniques in its technology transfer and dissemination work: (i) it captures and disseminates technologies to multiple users though seminars, specialized magazines, and project assistance; (ii) it develops, adapts, and sells technologies to clients inthe productive and public sectors, both in the country and abroad; (3) it fosters institutional innovations and incorporates new transfer mechanisms; and (iv) it creates innovative enterprises, almost always in association with companies or individuals. The creation o f demonstration companies by Fundacion Chile has had a mixed record with some successes and some failures, but overall the companies have been effective in disseminating new technologies. The companies are transferred to the private sector once the technologies have been tested in practice, and their economic profitability has been established. One o f the most successful cases exemplifies the successful development o f a knowledge cluster. The salmon industry,ina period o ften years, grew to become a dynamic export sector. In the Mexican context, one can think about "Fundacion Monterrey" as part of the Monterrey Knowledge Technopolis championed by the state government and private sector leaders. For Monterrey's leading industrial groups, a vibrant Fundacion Monterrey could become a flagship organization for a knowledge economy, much as Monterrey Institute o f Technology, created in 1943 by Monterrey industrialists, was at that time a symbol o f Mexico's industrialization. Source: World Bank staff The central objective o f the "preparing the bases" stage is to package isolated efforts to achieve a tangible and visible demonstration effect. At the state level, a knowledge-based competitiveness initiative can be seen as a package o f four components: 0 Enterprise upgrading; facilitation o f clusters and value chains; 0 Humancapital upgrading, with an emphasis on vocational training, higher education, and life-long learning; 0 An investment climate characterized by deregulation and lower administrative barriers; 0 Infrastructureinvestment to reduce logistical costs Monterrey Knowledge Technopolis is an initiative championed by the state government and private sector leaders to transform Monterrey into a knowledge-based economy. The Monterrey Knowledge Technopolis already meets three important prerequisites as a crucial pilot o f the knowledge economy agenda: highly promising institutional experiments in many areas; a sense o f urgency for change, and private sector and public sector leadership. The current focus o f the Monterrey Knowledge Technopolis is on infrastructure; there are plans, for instance, to create technology parks for companies. While infrastructure is important, so is building an environment for knowledge-based entrepreneurship by improving in the quality and private sector orientation o f education systems and facilitating innovation networks between Mexico and the United States. Cross-border ties can be strengthened through research, 23 technology, and education consortia. Promotion o f Diaspora networks can encourage successful Mexicans living abroad to invest and/or set up shop at home. Long-term Agenda Economy-wide changes at this stage lead to a national accord on the knowledge economy. As we discussed earlier, Mexico requires major reforms in education, innovation, ICT infrastructure, energy, labor, and the financial markets. The reforms will need to create an evenplaying field to ensure efficient entry and exit o f diverse service providers. Strong regulations are needed to maintain service and guarantee conformity with minimumstandards. The agenda includes curbing the power o fthe teachers' unions; creating greater incentives to reward educational quality; improving standards on certification, accreditation, testing, andevaluation, as well as recognizing students' prior learning. ICT infrastructurereforms would create a more open marketplace and develop incentives for new entrants, reducing the dominance o f Telmex. Labor market reforms would ease employment protection provisions, establish revenue support systems inthe case o fjob loss, and modernize the collective bargaining framework. Implementation o fthis agenda requires a major concerted effort. The challenge here i s to proceed with major reforms and create a new governance structure for private- public collaboration. A knowledge economy accord (Pacto) can be seen as a postcorporatist agreement facilitating cooperation betweenthe national government, the private sector, and subnational entities. 7. RegionalLeadership inthe Transition to a Knowledge Economy To capture diverse regional agendas for the transition to a knowledge-based economy, we performed a modified knowledge assessment and constructed a knowledge economy index for each state.5 According to this index (which is closely correlated to the state's GNP),we dividedMexican statesinto four groups (see Figure 6): "Fragile leaders": the most advanced states incentral and northern Mexico, many o f which are loosing their competitiveness. "Emerging leaders": central states with less-developed knowledge infrastructures than the fragile leaders butnonetheless advancingrapidly. "Dormant potential" states: below average states but higher than the lagging states. Lagging states: southern states that are the worst three performers. 'Theknowledge assessmentmethodology and a construction o f an aggregate index follow the national methodology o f four pillar framework. It is based on 30 variables such as adult literacy and secondary enrollment for education pillar; patents for 1,000 people for innovationpillar, telephones lines per 1,000 people for ICT pillar. Yet it differs from it intwo features. We omitted the incentive regime pillar mainlybecause we lackedrelevant data. We added the economic performance pillar which includes such variables as GDP, FDIper capita, humandevelopment index, manufacturing productivity and numbero fbusinessesper 1,000 people. As innationalknowledge assessment methodology, variables are not weighted. Annex 6 provides more detailed description o f the variables. . 24 Figure 6: Knowledge Index by Mexican States Source: Staff calculations. Most recent year refers to 2001. Note: The distance from the 45-degree line indicates the improvement (above the line) or deterioration (below the line) o f the selected Mexican states between 1995 and 2001. The more advanced regions are concentratedtoward the northeast quadrant ofthe graph.. 25 Table 2 presents the regionalpolicy agendas for each type o f state. All four agendas have in common the need to marshal existing knowledge assets (such as universities and research centers) to develop technology and technical assistance for addressing local needs and opportunities. Table 2: Transition to Knowledge-based Economy: Four Types of States in Mexico and Policy Agendas Type of state Source of growth Promising Major issueor Policyrecommendations Entry pointsa institutions threat Fragile Nationalbig Monterrey as an industrial A threat from low- Two-prong strategy: Develop 1eaders business hubofMexico cost countries : To take advantage o f Monterrey as a (northern concentrated in exodus o f geography (proximity to the knowledge states) mature industries: Monterrey Institute o f footloose United States and Canada) technopolis maquila industry Technology as a model o f businesses improve infrastructure and andmultinationals. private sector-driven decrease logistics costs; Supplier higher education and life- Increase the knowledge development long learning content o f exports by programwith big developing effective national business educational, innovation and andmultinationals enterprise upgrading institutions Emerging Major Guadalajara as education, Exhaustion o f cost- Make a major stride in Deepening and leaders: multinationals and culture and manufacturing based FDI : coverage and quality o f strengthening o f their value chains center o f Mexico transition to higher education knowledge-based Emerging cluster-based clusters (central- knowledge and Technology development growth Accelerate cluster processes north: service-intensive centers o f General Motors by enhancing academia- Querktaro, clusters inToluca, IBMin industry linkages and Jalisco, etc.) Guadalajara, GE in efficient `bridge' Queretaro and Motorola in organizations Puebla Dormant Natural resources "Transformando Volatility and (in Diversify the economy and Develop Potential (inparticular Campeche" as a private- states such as increase value added o f infrastructure for a (states of mineral wealth) public effort to move up Zacatecas) decline natural recoursesby retirement Zacatecas, value chains andbring associated with the improving investment community (health Michoachn, knowledge-intensive reliance on mineral climate services and Hidalgo, business resources and engaging in investment leisure industry) Campeche) promotion and linkage Little pressure to promotion initiatives Utilize remittances grow and reform for community reasonably infrastructure and educated labor micro-enterprise migrates to the development United States. Lagging Tourism Tourism development Increasingly Four-prong strategy: Develop viable states Isolated industry disintegrating from Strengthen the rule o f law local suppliers for (Southern enclaves Fondo Chiapas as a the rest o f Mexico and increase credibility o f a public sector and States) controversial but public sector; large private firms; promising attempt o f Strengthen local public eco-tourism based concerted action institutions through training on cultural heritage and twinning arrangements; andnatural beauty Improve quality o f basic endowments; education and reduce rezago Exploit the educativo; potential o f Accelerate local pockets o f counter cyclical vitality through careful tropical agriculture private sector-driven interventions. 26 Fragile Leaders Growth during the past ten years has come from firms taking advantage o f NAFTA, usingMexico as an export base to sell to the North American market. However, Mexico has been losing its preferential trade status vis-a-vis other low labor-cost countries. As a result, many o f the firms, particularly in the electronics and garment sectors, have been emigrating to countries with lower costs. Fragile leaders (mostly northern states and Distrito Federal) face the challenge o f reinventing themselves in the context o f growing global competition. They have the most advanced knowledge endowments o f any states inMexico, but some ofthem are losingtheir competitive edge. Border stateshave grown on the basis o f low labor costs and proximity to the United States. As the result o f growth, they face congestion and higher wages. The exodus o f maquilas to China signifies erosion o f traditional competitive advantages and calls for a two-prong approach: take advantage o f geography (proximity to the UnitedStates and Canada) by improving infrastructure and decreasing logistics costs; 0 increase the knowledge content o f exports by developing effective educational, innovation, and enterprise upgrading institutions. Emerging Leaders The states categorized as emerging leaders fall into two categories. The states in the first category, such as Jalisco, Guanajuato, Puebla and Queretaro are located in the center and center-north o f Mexico. They are characterized by high education and knowledge endowment, yet they face a lower level o f industrial and urban congestion than do the northern states. The emerging leaders signal Mexico's future, as exemplified by the technology development centers o f major multinational corporations: General Motors inToluca, IJ3M inGuadalajara, GE inQueretaro, andMotorola inPuebla. To take advantage o f the presence o f these MNCs, the government should put at the forefront o f the policy agenda the facilitation o f innovation clusters. This implies major advances in the coverage and quality o f higher education, and the enhancement o f academia-industry linkages andefficient bridgingorganizations. Second category is the states such as Quintana Roo, Yucatan and Morelos which have both relatively high educational level and significant natural endowments. Those states were able to capitalise on its endowments by attracting investments into service sector (tourism), agricultural processing and maquila investments. "Dormant Potential" States States with dormant potential are the most enigmatic and challenging. The challenge for themis to unlock a virtuous cycle o f growth similar to that o fAguas Calientes. "Dormant potential" states depend almost exclusively on low-value added natural resources. The resources can be abundant, and the states relatively prosperous (such as Tabasco, Campeche, and Veracruz), or indecline (such as mininginZacatecas). As a consequenceo ftheir relative decline, Zacatecas and Michoacan are characterized byvery 27 highlabor migrationto the UnitedStatesandveryhighpercapitaremittances. Diversificationo f local economies to move to higher value-added exploitation o f natural resources, services, andmanufacturing is a main policy objective inthose states. LaggingStates Analysis o f knowledge endowments shows three southern states (Oaxaca, Guerrero, and Chiapas) to clearly be lagging states. The states face the most basic agenda o f building robust institutions. To that end the following four-pronged strategy is recommended: 0 Strengthen the rule o f law and increase the credibility o fthe public sector; 0 Strengthen local public institutions through training and twinning arrangements; 0 Improve the quality o f basic education and reduce the "rezago educativo" (educational gap); Accelerate local pockets o f vitality through careful private sector-driven interventions. Inthese states, the issue ofleadership, bothprivate andpublic, looms as themost significant challenge. The ChallengeToday Building on a diversity of innovative local initiatives, Mexico should institute a robust federal mechanism to facilitate, monitor, and scale up those initiatives. The challenge of new governance structures is not unique to Mexico. OECD economies such as Ireland, Finland, or Korea (and emerging economies such as China) are exemplars o f so-called pragmatic agendas that put governance innovations at the center o f policymaking. One pillar o f the new pragmatism is to create a favorable climate for institutional innovation. The creation o f evaluation and monitoring tools also is essential. These capabilities will help the government detect early on which programs are succeeding and which are failing. It then can begin to scale up successes as appropriate. The transition to a system o f new capabilities and institutions, consistent with the knowledge-driven NAFTA, is an open-ended process. It involves diverse institutional innovations designed to generate credible commitments among stakeholders. It would be impossible to describe every detail o f the second-generation NAFTA architecture. An exciting ifpragmatic agenda lies ahead for Mexico. Such an agenda can only be developed by Mexico itself. This Executive Summary informs the evolving debate by calling attention to the high stakes for Mexico, the major issues needingresolution, andthe progress already made. The challenge now is to transform the many promising initiatives into a critical mass o f changes that will trigger Mexico's rapid transition to a knowledge-based economy. 28