Electronic payments are paying off for Mexico

December 3, 2013, 9:11 PM UTC

FORTUNE–Advocates of electronic payments – everything from direct deposits to mobile banking – have argued that moving away from cash and checking for disbursing payrolls and even social welfare payments will produce much-needed cost savings to companies and governments by reducing paperwork, costly bank transfers and other inefficiencies. Turns out the pro-digital crowd is right, to the tune of billions of dollars.

The Better Than Cash Alliance, a non-profit organization backed by the Gates Foundation, a handful of corporations and others, is releasing a study today that shows the Mexican government’s shift to electronic payments is producing $1.27 billion a year in savings.  The report says dispersing federal funds through a centralized, electronic payment system has trimmed federal spending on wages, pensions, and social welfare payments by 3.3%  “It makes a huge impact in terms of savings,” Mexico’s treasurer Irene Espinosa Cantellano tells Fortune.

Such cost savings are sure to catch the attention of governments and other institutions that have been slow to make the transition to digital payments. But the Better Than Cash Alliance, which also counts USAID, the United Nations Capital Development Fund and philanthropic organizations as founding members, also has another motive in promoting electronic payments: Its research suggests eliminating cash and checks will empower poor citizens and promote economic development.

How? To many in the developed world, the concept of digital banking and mobile payments seems very much the purview of the financially savvy.  But advocates note that electronic payments, especially when governments get involved, create a virtuous economic cycle: Banks and other financial services groups will only create products (especially entry-level services) or accept electronic payments when there’s enough scale—such as millions of people receiving government paychecks or subsidies via direct deposit or on a prepaid card. “You are, in a sense, guiding a big part of the economy into being able to accept electronic payments,” says study author Guillermo Babatz, a partner at the advisory firm Atik Capital and the former head of Mexico’s National Banking and Securities Commission (CNBV).

And once citizens are engaged in the financial sector there’s an opportunity to educate them about financial health and also introduce them to additional services, such as savings accounts. “If we can do that cost effectively, in a way that’s transparent and secure, then we can really make a big difference, and that will lead to better savings, and expanding the financial sector to be inclusive,” says Goodwin-Groen, managing director of the alliance.

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Only about 27% of Mexico’s adults report using a bank account, according to the World Bank. (The total population is 120 million people.) Globally, some 2.5 billion adults are shut out of formal banking, according to the World Bank. The Mexico study is the first in a series of reports that will examine how countries in Latin America, Africa and Southeast Asia are adopting electronic payments across the public and private sectors.

In Mexico, that shift began gradually in the 1990s as successive finance ministers moved to standardize a system in which budget payments were carried out via hand-delivered paperwork and wire transfers. Banks profited from the float – cash that sat in accounts before being dispersed – and from the transaction fees. How individual agencies spent the funds was largely shielded from view.

Since 2007, efforts to improve efficiency and transparency have gained pace. The treasury department amplified its own IT platform, and contracted with Mexico’s Central Bank, which had developed a rapid, high-volume payments system. New laws also required federal agencies to establish strategies for moving to electronic payments.

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Today, 580,000 civil servants – about half of Mexico’s federal payroll – are paid through the centralized system, as are nearly all pensioners, another 3.4 million people, according to Espinosa.

In addition to better financial controls, the change to electronic payments has brought with it other benefits. Mexico’s commercial banks, for example, have had to cater to more types of customers, and diversify into offerings like loans and credit, rather than rely on the government’s business. “Commercial banks were one of the initial barriers to the shift,” Espinosa says. “And in the end I think they learned that they had to innovate, and see new areas of business.”

Other financial services companies are also starting to see the potential profit in such inclusion efforts. (Citigroup’s (C) Citi, MasterCard (MA) and Visa (V) are all funders of the Better Than Cash Alliance.) Companies see a chance to gain access to new customers, who, as they gain greater economic traction, can be “upsold” to fee-based services and products.

“The institutions you build to expand the financial sector are critical for business development and private sector development more generally,” Goodwin-Groen notes.

Based on his interviews and his own experience working in Mexico’s government, Babatz is also convinced that the adoption of electronic payments prompted many Mexicans to open bank accounts for the first time. “A lot of people who didn’t bank now have to bank — just because that’s the way they receive payments,” he says.

Still, the payment system has yet to reach the vast majority of social welfare recipients. With less than 4% of those payments ($258.4 million) being dispersed electronically, it’s the category of payments “that has proven by far the most problematic to centralize,” according to the study.

That problem is particularly acute in Mexico’s rural geography. “Having a network of points of access is still missing in rural, remote areas and that is necessary to really engage, and to have effective financial inclusion,” Espinosa says.

Babatz contends that government payments can change that equation. “All of a sudden it starts making sense for banks and other non-bank entities to start offering services to these individuals,” he says.