February 16, 2018
The United States, Mexico and Canada are in the midst of a contentious renegotiation of the North American Free Trade Agreement, the 24-year-old pact that lifted most trade barriers between the three countries. NAFTA has led to integrated supply chains across borders and is thought by economists to have been a very modest net contributor to US economic growth. However, a shift in manufacturing jobs from the US to Mexico in the ensuing years has made the agreement a political lightning rod. Given that NAFTA came into force before the dawn of the digital age, some revision clearly makes sense, with the now-shelved Trans-Pacific Partnership likely to serve as a template for modernization. But since commencing in August 2017, renegotiation talks haven’t yielded much progress. However, as any observer of complex, international negotiations probably recognizes, deals often come together at the last minute — and sometimes even later. Amid few tangible signs of progress, the heads of the three delegations have extended negotiations through the first quarter of 2018, and recent indications are that they may be extended further. With a Mexican presidential election in July and US midterm elections in November, negotiators are running short of time. Against that backdrop, let’s examine the main points of contention and what the fallout could be if the three countries fail to reach agreement.
What’s at issue?
The root of the problem, from the Trump administration’s perspective, is the approximately 30% drop in US manufacturing employment during NAFTA’s existence. Among the issues pushed to the forefront of the negotiations by the Trump administration are measures to reduce trade imbalances, particularly the imbalance in goods between the US and Mexico. The US also seeks to deter currency manipulation by trading partners. In addition, the US aims to eliminate a trade dispute mechanism that it says is an invasion of sovereignty and an incentive for companies to outsource to Mexico by guaranteeing them a venue to sue for unfair treatment. Rules of origin, which determine the national source of each product, are additional issues, and especially affect the auto sector as the US attempts to mandate increased American-made content. The Trump administration has called for requirements that vehicles, in order to escape tariffs, must be assembled from parts that are at least 85% sourced from NAFTA countries, and 50% of the content must be sourced from the US. That hurdle is quite high. So high that if a renegotiation of NAFTA is not agreed to, some observers expect automakers may opt to just pay the 2.5% tariff on autos built in Mexico. Others fear production could be shifted out of North America to Asia or Eastern Europe.
Among the most controversial US proposals is that a renegotiated agreement contain a “sunset” clause requiring that the pact be reapproved by the three signatories every five years. Critics say a sunset clause would be extremely counterproductive, as it would be a grave source of uncertainty for businesses. Some even say the proposal is, in reality, a “poison pill” designed to cause talks to fail and allow the US to claim that Mexico and Canada were inflexible negotiating partners.
The only certainty is uncertainty
If a renegotiated agreement between the three countries cannot be reached, what would happen next? According to the text of the NAFTA agreement, “a Party may withdraw from this Agreement six months after it provides written notice of withdrawal to the other Parties. If a Party withdraws, the Agreement shall remain in force for the remaining Parties.” So, in theory, President Trump could withdraw the US from the agreement merely by writing a letter to his NAFTA counterparts. In reality, however, a major constitutional question would remain. Since NAFTA was approved by Congress under an implementing law, some constitutional scholars suggest the president would need to ask Congress to vote to withdraw from the agreement. Others counter that under Section 125 of the Trade Act of 1974, Congress delegated to the president the power to terminate obligations under free trade agreements. Given that the US Constitution grants both Congress and the president powers to regulate foreign trade, any attempt to withdraw from the agreement would almost certainly end up in the courts. Still, some observers believe the president may pull the US out of the agreement purely as a high-stakes negotiating tactic, using the six-month notification period to pressure Mexico and Canada into making concessions.
Forecasting the potential economic impact of a US pullout from NAFTA is quite difficult. In fact, it is difficult to assess the net impact that NAFTA has had on the US economy during its 24-year history. An October 2017 study by the Council on Foreign Relations puts the added growth to the $19.7 trillion US economy from NAFTA at only several billion dollars annually. Since NAFTA was implemented during a period of rapid globalization and technological change, it is almost impossible to tease out the direct impact of the agreement on the US economy as a whole. Critics of the agreement point to the falling numbers of US manufacturing jobs, particularly in the auto sector, while Mexican employment in that sector has more than quadrupled. But proponents of the deal point to gains in the overall US economy owing to higher productivity and lower consumer prices. Plus, they note, the US has lost manufacturing jobs to many other countries as manufacturing employment has fallen across all developed markets, and has even begun to fall in China, too.
What would the economic impact of a NAFTA pullout be on the US, Canada and Mexico? For the bilateral relationship between the US and Canada, the impact might be quite small, on the hope — hope that some say is misplaced — that by ending NAFTA, the US and Canada would fall back on a pre-existing free trade deal put in place in 1988, though there are fears that the US could pull out of that agreement as well. Even if the 1988 pact were voided, a 1965 pact covering automobiles might come back into effect. To be sure, Canada, with which the US has a trade surplus when including services, is not the primary object of the Trump administration’s ire. However, as illustrated by the US's imposition of 20% countervailing duties on Canadian softwood lumber in April 2017, along with the recent Boeing/Bombardier dispute, Canada is unlikely to escape the “America First” trade policy unscathed.
The primary focus of US dissatisfaction is Mexico, which enjoys a substantial overall trade surplus with the US, meaning Mexico undoubtedly has the most to lose if the US were to pull out of the agreement. But in a worst-case scenario where the US scuttles NAFTA, passenger vehicle exports from Mexico to the US, given Mexico’s most-favored-nation trade status, would incur only a 2.5% tariff rate. While that could be a headwind for automakers' profit margins and might result in higher prices for US consumers, ending NAFTA would likely not be a large enough inducement to cause firms to shut down Mexican production and move it to the US. The imposition of the tariff clearly could restrain future investment in Mexican plant and equipment, perhaps benefiting the US in the long run, but it could possibly send future investment to lower-wage destinations in Asia or Eastern Europe instead.
A recent study by Moody’s Analytics suggests that none of the economies of the NAFTA signatories would be thrown into recession if the pact were to collapse. Mexico would be hardest hit, according to Moody’s, though potential supply chain disruptions would ripple through all three economies. Uncertainty would likely prove a headwind for the first few years after the agreement’s demise. Foreign direct investment in Mexico has already decelerated as a result of uncertainty, and could slow further if the deal were unwound. Contributing to the slowdown would be the loss of the international arbitration mechanism built into NAFTA, which presently shields US and Canadian investors from Mexico’s legal system amid questions surrounding Mexico’s commitment to the rule of law. NAFTA-driven uncertainty has already caused a slowdown in business investment in Canada.
To be sure, a NAFTA pullout would result — at least in the short to intermediate term — in winners and losers. The US agricultural sector would be a clear loser, with tariffs on US farm exports jumping to as much as 150%, according to a Stratfor analysis. Mexican heavy truck exports to the US, which account for 7.5% of US imports from Mexico, would face 45% tariffs, according to the same report.
Beware unintended consequences
Investors will need to be mindful of the unintended consequences of these policy shifts and the resulting opportunities that may present themselves. For instance, if NAFTA disintegrates, the Canadian dollar and Mexican peso might depreciate, and perhaps could fall enough to offset newly imposed tariffs. It is not hard to imagine a scenario where the US runs larger trade deficits, both bilaterally and at the headline level, as a result of NAFTA's demise.
A NAFTA pullout by the US could inflame anti-American sentiment in advance of July’s Mexican presidential election. That could boost the fortunes of left-wing populist Andres Manuel Lopez Obrador, popularly known as AMLO, who leads in early opinion polls. History — most recently illustrated in the 2016 presidential election — has shown that free trade is rarely a vote getter. Mindful of that, AMLO, a NAFTA skeptic, claims the pact has devastated Mexican farmers.
Whatever the outcome of the NAFTA renegotiation, it’s clear that the path toward ever freer global trade is becoming bumpier. After decades of tearing down barriers to trade, a backlash against globalization has triggered a move toward the reimposition of trade obstacles. The free flow of labor and capital across borders that we’ve come to take for granted in recent decades is no longer a given, as Brexit should remind us. Indeed, after abandoning the Trans-Pacific Partnership, playing hardball with South Korea over an existing bilateral trade agreement (Trump favors bilateral trade deals to multilateral agreements, arguing he can negotiate better deals that way) and potentially scuttling NAFTA, the US may increasingly be seen as tearing down the post-WWII global architecture. The Trump administration’s “America First” policy mix is real, and it is being put into action.
However, while Brexit and an uptick in US trade concerns illustrate some of the fault lines that have slowed globalization’s momentum, progress continues elsewhere. China is looking to fill the leadership void left by the US’s TPP pullout. It has spearheaded the creation of the Regional Comprehensive Economic Partnership (RCEP) of 16 Asian nations as a counterweight to what was the US-led TPP. And the 11 remaining TPP members are working toward wrapping up negotiations for a deal that is expected to come into force in 2019. Over the longer term, these actions could make the US a less attractive place for capital and labor, and could undermine the international role of the US dollar.
Markets are unlikely to be shocked by a failure of NAFTA renegotiations, given President Trump’s well-known antipathy toward multilateral agreements. And recent signs suggest that the administration may be becoming a bit more measured in its trade approach in response to pressure from congressional Republicans from states that Trump won in 2016; many of those states would be disadvantaged should the US leave NAFTA.
More concerning to many investors is the future of the US–China trade relationship. A much more consequential clash between the world’s two largest economies has been brewing for some time and has the potential to be more deeply economically destabilizing than would a NAFTA stalemate. NAFTA may turn out to be a harbinger of bigger trade conflicts to come, confrontations that could have significant global ramifications.
The views expressed are those of MFS and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.