A study of labor productivity in four industries—steel, food processing, telecommunications, and retail banking—in the five largest Latin American economies—Argentina, Brazil, Colombia, Mexico, and Venezuela—finds that it is at only around 30 percent of world-class levels in three of the four cases analyzed (steel, food, and banking), but is much closer in telecommunications. The study also finds in all cases, except food, that labor skills do not represent obstacles to achieving higher productivity levels and that scale of production does so only to a low degree. Corporate managers in Latin America can close the huge current gap in productivity in the formal sector by adopting global best practice in the way they organize the functions and tasks of their companies. The structural factors that hinder productivity in the informal sector—much lower labor costs and lack of financing—will change only gradually. Thus, productivity increases in this large part of Latin American economies will be modest, and income disparity will probably increase.

During the past few years, the world has witnessed a radical change in the economic history of Latin America. After the fast growth of the 1960s and 1970s, the following decade brought the debt crisis, high inflation, recession, and decreasing standards of living. Today, the policies responsible—import substitution, protectionism, and heavy regulation—are giving way to genuinely market-oriented policies—albeit with varying speed and depth—in one country after another. At long last, privatization, deregulation, and lower trade and capital barriers have started to replace state monopolies, private cartels, mercantilism, and hyperinflation (Exhibit 1).

Latin America has, for example, become one of the most aggressive privatizers in the world. Per capita proceeds from the massive sale of state assets are bigger than in any other developing region of the world. Even when compared with industrial countries, privatization revenues in relation to the GDP are much higher. As a result, privatization is one of the key drivers of the modernization of these economies: it affects—and is fundamentally turning around—a significant share of each (Exhibit 2).

Economic reforms

In the past, Latin American countries have often been known for their lax monetary and fiscal policies. Big deficits were regularly financed by printing money, which inevitably led to high inflation rates and chronic devaluations. More recently, tight and responsible monetary policies have considerably reduced these formerly huge fiscal deficits (Exhibit 3). Not all the countries, however, are following the same path. Chile, Argentina, Colombia, and Mexico are consolidating their fiscal equilibrium and trimming down their inflation. By contrast, Venezuela and Brazil have, since 1992, reverted to substantial deficits that are again fueling inflation (Exhibit 4).

Trade

Another consequence of the current flurry of economic reform is that trade barriers have fallen dramatically, from an average of 50 percent "ad valorem" to less than 15 percent in the last 5 years (Exhibit 5). Non-tariff restrictions have also been substantially reduced. Not surprisingly, international commerce has surged in these formerly isolated economies. Imports have tripled and exports have doubled since the opening of economic borders (Exhibit 6). Exports of manufactured goods to the developed world have been growing even faster, changing the historical pattern of Latin America as a supplier of only raw materials (Exhibit 7).

Foreign direct investment

This "virtuous" behavior has allowed the region to capture a significant part of the increasing flow of capital to the world's emerging economies. Today, in fact, Latin America is receiving more money per capita than any other developing region (Exhibit 8).

Timing

Not all the countries in the region, of course, have implemented their reforms at precisely the same time or to exactly the same degree. Chile and Mexico led the way in the early 1980s, and today are more open and deregulated than their neighbor economies. Argentina and Colombia began the process later but tackled it aggressively. Brazil, the giant of the region, and Venezuela slowed down their reforms after a couple of years of rapid economic change due to political instability fueled by corruption scandals. In all these economies, however, there have been very positive changes that have—or soon will—show up in significant improvements in productivity.

A focus on productivity

We measure productivity as the ratio of the output of goods and services to the input of resources used to produce them. On the national level, productivity is an important indicator of economic strength: for any level of employment, the higher a nation's productivity, the higher its population's standard of living. At the company level, productivity is one of the key factors that fuels competitiveness. Productivity growth is the driver of economic growth and higher per capita incomes. It increases the goods and services provided by some workers and releases other workers to produce additional goods and services in the rapidly growing parts of the economy.

Objectives

Overall, productivity in Latin America lags far behind that of the developed world. GDP per capita in every country of the region is, in fact, much lower than in the OECD countries (Exhibit 9). The traditional economic literature, however, offers few explanations for productivity differences at the country level and even fewer recommendations on what, given structural differences, would be realistic goals for closing the gap. Accordingly, the McKinsey Global Institute set out to examine whether structural barriers constrain the "micro" performance of the Latin American economies now that their macroeconomic environment is healthier. In other words, we wanted to know if the region will be able to catch up with the best practices of the developed world and, thereby, significantly improve the standard of living of its population. We also wanted to know if Latin American corporations can realistically set their aspirations at global best practice levels.

Because McKinsey's previous work on productivity within the OECD had showed that industry-level case studies were needed to explain observed productivity differences in terms that were helpful to policymakers and managers, we chose the five biggest economies in the region (Argentina, Brazil, Colombia, Mexico, and Venezuela), which account for 75 percent of its total population and more than 80 percent of its GDP, and conducted four industry-specific case studies (steel, food processing, telecommunications, and retail banking). The goal in each was to compare their performance with that of the world's best in the US, Germany, and Japan and to build an understanding of the reasons for the aggregate productivity differences. Mostly, we focused just on labor productivity, but in telecommunications, we calculated total productivity. However, because labor productivity is not a complete measure, we have also paid attention to capital intensity and its impact on labor productivity.

The cases were selected so as to cover:

• Services industries (telecoms, banking) and manufacturing (food, steel).
• Industries that are monopolies (telecoms), concentrated (steel, banking), and fragmented (food).
• Industries that are private (food), state-owned and recently privatized (telecoms, steel), and mixed private/state-owned (banking).

We analyzed these industries in three phases to:

1. Understand the performance of the industry in Latin America relative to that of its counterparts in the developed economies.
2. Identify the causes of the differences observed.
3. Draw implications for public policy and corporate strategy.

Results

Our productivity measurements are summarized in Exhibit 10. Except for telecommunications, we found that labor productivity is very low in all the countries studied. (The relatively high productivity levels of the telecommunications industry in every Latin American country are largely explained by the relatively low performance of—and the comparatively low competitive intensity faced by—US carriers.) On a country-by-country basis, we found that:

• In steel, Brazil outperformed the rest of the region, reaching 44 percent of the US level. The tiny steel industry in Colombia came in with only 15 percent.
• In food processing, Argentina emerged as the regional leader at 52 percent of the US level.
• In retail banking, Argentina's 19 percent represented the worst performance in the region.

In the three cases where such measurements were possible (see Exhibit 11), we tracked the evolution of labor productivity as countries shifted toward more market-oriented economies. The relative improvements in the steel and telecommunications industries are especially striking, considering that the US has also aggressively increased productivity there. No major gains, however, occurred in the food processing industry. In retail banking, although it was not possible to find comprehensive historical data on physical output, stable employment levels and some indicators of stable output suggest that productivity has not changed a great deal. On balance, most countries reveal a similar pattern of improved performance after liberalization. The one exception is Venezuela, which had declining relative productivity in telecoms, processed food, and steel.

The productivity gap

In almost all of these Latin American countries, protectionism and regulation have prevented competition. Managers have not, for the most part, felt either the pressure to improve performance or the risk of going out of business. Moreover, other external factors, such as low wages and cheaper raw materials, have allowed them to stick with quite labor-intensive processes. Consequently, organizations are often unduly large and hierarchical, filled with needlessly complex processes and unnecessary tasks. The existence of very inefficient state-owned participants has exacerbated this phenomenon. The good news is that many of the factors that hindered productivity in the past are now disappearing, although in varying degrees and at varying rates across the region's industries and countries (Exhibit 12). In addition, managers have proven that, once the right incentives are in place, productivity gains can be realized at an astonishing speed.

Implications for policy

Economic liberalization has had an immediate, beneficial impact on productivity

The economic liberalization that the region has recently experienced has had an immediate, beneficial impact on productivity in the formal sector. The privatization of state-owned steel and telecommunications firms provides the most striking example of the potential improvement that can be achieved simply by adopting a new management approach. The lowering of import barriers has increased consumer choice and, thus, forced domestic producers to lower their prices and improve the quality of their products and services. Though in its initial stages, the deregulation of retail banking has stimulated the expansion of the services delivered and increased the capital available to consumers and companies.

However, we do not foresee such fast improvements in the food processing industry. Very low labor costs and lack of access to capital hold back consolidation and modernization. If our case findings can be generalized, these economies will witness two different paths of development. The formal sector will rapidly close the gap with the developed world as the right incentives are put in place. This process, however, will occur more slowly in the large informal sector.

These possible diverging paths will likely result in larger income disparities. Policymakers should, therefore, attempt to diminish the impact of structural factors on the informal sector by aggressively attacking upaid mandatory benefits and making the capital markets as efficient as possible for lending to that sector.

Work to be done

Despite the impressive improvements already achieved, Latin American economies are still highly bureaucratic and regulated, a situation that often continues to reward small special interest groups rather than society at large. To redress such inequalities, policymakers will need to:

• Privatize inefficient state-owned steel companies in Venezuela, telecommunications companies in Brazil, and retail banks in both Brazil and Argentina.
• Lower import tariffs. Current tariffs are higher in Latin America than in many developed or developing countries. In addition, bureaucratic inertia and the proliferation of non-tariff barriers make international commerce difficult. If regional pacts, such as Mercosur and the Andean Pact, introduce high, common outer tariffs or strict rules of origin, the participating countries run the risk of converting national monopolies into regional oligopolies.
• Stem tax evasion, which is still common in Latin America and which indirectly subsidizes "unofficial," less productive sectors. This means "formal" firms have to bear an unreasonably heavy fiscal burden.
• Set economic prices. Generous tariffs, set by the regulatory bodies in the telecommunications industry, for example, reduced the urgency felt by managers to improve productivity. Governments must be cautious when setting price policies for newly-privatized utilities in order to keep tariff levels consistent with an efficient cost structure.
• Foster an efficient labor market. Liberalization and decentralization of salary negotiations is one path to such an objective. More flexible job categories would also help managers in the reallocation of human resources to enhance productivity.

Employment

These economies have been able to create an extraordinary number of new jobs, which more than offset the effects of the rationalization process

The far-reaching restructuring process that Latin America is orchestrating has triggered huge layoffs, both at newly-privatized and at formerly protected private companies. The evidence, however, does not suggest that total employment has plummeted because of these big labor reductions. Quite the contrary. Total employment has actually grown in at least three of the countries analyzed (Argentina, Colombia, and Venezuela). Such growth shows that these economies have been able to create an extraordinary number of new jobs, which more than offset the effects of the rationalization process as well as help absorb the natural growth of the laborforce.

The low penetration of basic goods and services in the region presents growth opportunities that will be the source of the new jobs needed to maintain and increase employment. To nurture these opportunities, governments must be careful not to over-regulate in hope of preventing layoffs. The relatively good job creation performance of these countries suggests that market forces can—and do—work well. For each of these countries, there is probably an optimal degree of job security, which is high enough to reduce resistance to innovation and productivity increases, but not so high as to make innovation unprofitable or impossible. This balance point may be difficult to define precisely, but the important idea is that both extremes are undesirable.

Implications for corporations

Managers in Latin American corporations should set themselves high aspirations. By significantly improving productivity at their firms, they can improve their competitive position, their growth prospects and their profitability. This means, however, they must adopt world-class best practices in organizing the functions and tasks of their organizations.

Every country studied is capable of implementing best practices in productivity improvement with its current workforce

These best practices can readily be transferred to all the Latin American countries studied because their laborforces possess the basic skills and motivation necessary. We observed dramatic productivity improvements once the workforce was reorganized in a more efficient fashion—for instance, by telecommunications carriers in Argentina and steel producers in Mexico. We have also seen huge management-based productivity differences between companies in the same country, such as those between the public and private telecom carriers in Brazil. All the evidence suggests that operations in every country studied are capable of implementing best practices in productivity improvement with its current workforce.

Even so, closing this gap may not be easy for some Latin American managers. The skills and strategies that ensured success in the past will sometimes not suffice in the new, more competitive environment. Formerly, managers needed to excel in operating under high inflation, navigating in and through a tight web of government regulations, dealing with volatile financial markets, compensating for price controls and abrupt changes in government policies, and managing a fine-tuned treasury system. Unfortunately, these skills are now not enough. Today's reality demands, in addition, building an understanding of consumer desires, improving productivity, establishing efficient relations with suppliers and distribution channels, seeking out the most suitable technologies, and dealing effectively with banks and financial markets.

Today, Latin America is challenging executives to adapt to a wholly new operating geometry. This shift is anything but trivial. Willingness to change is the most difficult step. But only the first step. Companies must then focus on developing the critical new skills needed to carry out the process. For companies that are unwilling or unable to improve productivity, survival in a globalized Latin American marketplace will become exceedingly difficult: the environment of protected markets, high import barriers, price controls, and lavish government subsidies is mostly a thing of the past.

World productivity leaders should look at Latin America as a growing region where their managerial know-how can be transferred in a profitable way

For world productivity leaders, the relevant message is that they should look at Latin America as a growing region where their managerial know-how can be transferred in a profitable way and results in more productive, higher paying jobs for local workers. The current wave of acquisitions of local companies by multinationals points exactly in this direction. So does the recent flurry of minority investments, joint ventures, and licensing arrangements.

For local managers, the message is that they should aggressively benchmark their operations against the leading global companies, not just their domestic competitors. History shows that few companies are really aware of the extent of their productivity disadvantage until new players begin competing in their home markets. Or until they begin to transfer managers from one country to another, as is now happening in the newly-privatized telecommunications companies in Latin America. Overall, we believe that the improvement of management practices will be the most critical factor for success in this vital region of the world.