OP-ED

by Eric Miller Thomson

Reuters
February 17, 2017

NAFTA: Impact and Discontents

After more than 20 years in force, the North American Free Trade Agreement (NAFTA) is back at the center of United States trade policy.

Throughout the 2016 presidential campaign, candidate Donald Trump attacked the agreement among Canada, Mexico and the United States as a “disaster” and vowed to renegotiate it. Now President Trump is moving to make good on his promise.

NAFTA was highly controversial when it was negotiated. Critics alleged that there would be a “giant sucking sound” of jobs moving to Mexico. Its proponents, including the Clinton White House and the business community, countered that the agreement would expand the pie for everyone. Congress was persuaded and NAFTA entered into force on January 1, 1994.

NAFTA created an integrated market for goods, services and investment among the three countries. Consequently, many firms began not only selling in the United States, Mexico and Canada, a market of more than 400 million, but extending their production networks across the continent.

The auto industry was at the vanguard of this integration. While the 1965 Auto Pact integrated the U.S. and Canadian vehicle industries, NAFTA brought Mexico fully into the North American auto production system. Mexico’s share of light duty vehicle production has grown from 6% in 1990 to 20% today.

The competitive forces unleashed by NAFTA pushed the auto companies to streamline costs and supply chain organization to an ever-finer degree. Consequently, major parts and sub-assemblies often cross the U.S.-Canada and U.S.-Mexico borders up to six times before they are installed in a finished vehicle.

While NAFTA has created a finely tuned system in which goods move seamlessly across to continent, opposition to the agreement endured in the American heartland. In many communities, NAFTA became synonymous with the ills of globalization and the downsides of trade. With no meaningful trade adjustment assistance to help those displaced by trade and no sustained counter-narrative in support of the agreement, the table was set for the “Trumpian” critique.

Re-Negotiating NAFTA

So what do we know about the NAFTA renegotiation?

On day one of his presidency, Mr. Trump stated that he would seek an agreement that gave “American workers a fair deal”. If Canada and Mexico refuse, the U.S. will notify its intent to withdraw from NAFTA. Wilbur Ross, the incoming Commerce Secretary, will lead the negotiations for the United States. Mr. Ross declared before the Senate “all aspects of NAFTA will be put on the table”.

For their part, Canada and Mexico are beginning to prepare their negotiating strategies. Each government has engaged the Administration. Mexico also has launched formal consultations domestically on what it should pursue in the agreement.

There are strong indications that the U.S. may seek to split NAFTA into Mexican and Canadian agreements. It is unknown how much of the original trilateral deal would survive under this scenario. Bilateralism could be beneficial in that it would allow Canada and Mexico to pursue distinct solutions on particular issues with the United States. A full de-coupling of the Canada and Mexico agreements however would have profound supply chain implications.

The Trump Administration tends to see trade as a zero-sum game with the relative trade balance between the U.S. and the other countries as the only scorecard that matters. Senior White House advisor Peter Navarro has also stated that the “unwinding and repatriating of international supply chains” is a top priority.

Given the relatively balanced trade between the U.S. and Canada, the Trump Administration has indicated that it does not see Canada as “problematic”.

By contrast, Mexico has a significant trade surplus. The Trump Administration wants to close this gap by shifting investment from Mexico to the United States, using means such as threatening the imposition of border taxes. Smaller suppliers would be particularly vulnerable to disruptions in North American supply chains. On average, 40% of what Mexico exports to the United States is U.S. content.

According to the terms of the U.S. Trade Promotion Authority, President Trump would be required to notify Congress of his intent to re-negotiate NAFTA no less than 90 days before initiating. The President has enormous authority to impose tariffs without congressional consent, but modifying other areas of agreement clearly implicates the legislative branch.

The negotiations are likely to take several months to truly get rolling. Many key U.S. officials are not yet confirmed and key strategic decisions remain to be made.

Implications for the Auto Sector

The auto sector has a massive stake in the re-negotiation of NAFTA. The three countries are preparing to make decisions that could significantly change the rules underlying the North American vehicle production system and the trajectory of future investment and supplier decisions.

So what might change?

• Higher North American content requirements: The mildest scenario seems to be that the Trump Administration would significantly raise the level of North American content required for a vehicle to be considered originating. At present, the regional value content requirement for light-duty automobiles is 62.5%. If this were to be raised to, say, 75-80%, one would expect fewer inputs from Asia and higher component and finished vehicle costs. This would place pressure on the profit margins of both OEMs and suppliers.

• “Trifurcation”: If the Trump Administration converts NAFTA from a single trilateral agreement to three separate bilateral agreements – U.S.-Canada; U.S.-Mexico; and Canada-Mexico – would the rules of origin be entirely separate and unconnected? If so, each agreement would have separate value content requirements, raising the risk of necessitating companies to shift production in order to continue to qualify.

• Market Access: The prevailing assumption is that Canada will secure duty-free, quota-free access to the U.S. market in whatever agreement it negotiates. The situation is less clear for Mexico. The Administration has repeatedly threatened border taxes on companies that invest in Mexico and export their output to the United States. This raises questions about whether the U.S. will demand tariffs or quotas for some manufactured goods.

• Compliance: The original NAFTA had rigorous tracing rules that were designed to provide visibility to the automotive supply chain. Many auto companies had hoped these requirements would be relaxed. Given the narrative about foreign countries “cheating” on trade, the compliance complexity is only likely to grow.

Conclusion

Much policy change is on the horizon for the North American auto industry. Companies would be wise to develop their own NAFTA re-negotiation strategies with a view to advancing their interests. It is rare that the rules governing commerce across an entire region are re-made. Assemblers and suppliers alike must seek to “own” the changes to come and ensure that the new post-NAFTA framework is ultimately workable and even advantageous.