Given the US decision to pull out of the Trans-Pacific Partnership trade deal, it was inevitable that the North American Free Trade Agreement would have to be re-opened. The Obama Administration had anticipated that the TPP would have modernized the 24-year old continental trade pact.
Given the size of the borders, the uneven development, (GDP per capita from the IMF 2017, US $59.5k, Canada $45.1k, and Mexico $9.3k), and the respective endowments (labor, resources, and capital), one can imagine the basis of all sorts of tensions. Yet the economic integration of such a disparate continent, through trade, tourism, worker remittances, and direct investment, was previously embraced as an important achievement.
It is the sheer dominance of the US that has pacified the region. Nary a word is spoken about the large territory the US took from Mexico in 19th-century wars. The idea that the US was bamboozled and is being victimized by incompetent US negotiators and crafty Canadian and Mexican officials in NAFTA ring hollow to many.
The economies were becoming more integrated before NAFTA. The treaty codified, accelerated, and shaped the integration. For example, under the agreement, Mexico opened up its agriculture sector. This hit rural Mexico, especially the corn-growing region. The dislocation that resulted led to many people and families being disgorged, fleeing to the US.
In some ways, the nationalist regime on the Potomac may help facilitate the election of a nationalist one the Rio Grande. It had been hoped that NAFTA agreement could be achieved before Mexico's election on 1 July, though an agreement was initially targeted for the end of last year.
We suggested there were a few timing considerations from the US side. There is the deadline for the Trade Promotion Authority that will automatically be renewed in July unless either chamber of Congress objects. Although Congress had curtailed the executive's power to soften certain sanctions against Russia, it is unlikely to take action now, when Trump's public support is on the rise, and the mid-term elections draw near.
The legislative process once a new agreement is reached is quite extensive. It can take a little more than 200 days, and that is before the up-down vote (no amendments) permitted under the Trade Promotion Authority. The Speaker of the House said an agreement must be reached by May 17 or this Congress will not vote on it.
There seems like there is some flexibility because after the election, what is dubbed the Lame Duck session, is held before the newly elected Congress takes office in January. Also, although many pundits are talking above a wave election, where the Democrats score large and broad victories, the recent primaries warn against ignoring Aesop and counting the eggs before they are laid. And the power of incumbency is particularly strong. It may not be much of an exaggeration to suggest that the re-election rate of the US House of Representatives is higher than the re-appointment rate of the Central Committee of the Chinese Communist Party.
The other consideration is that the Trump Administration may think it needs a victory ahead of the November election. The agreement struck with South Korea was under duress, and in any event, the leverage it had does not appear to be scalable. The consequences of the US unilateral withdrawal from the agreement with Iran will not be clear for some time, though the price of oil continues to rise and new four-year highs are being recorded.
Trump's economic adviser Kudlow linked NAFTA and China, noting that an agreement on NAFTA would demonstrate that the US can avoid a trade conflict with China. The subtext here is that a NAFTA agreement would show Trump's tactics work and if there is trade conflict with China, then it is China's fault. For the US to take on the world, Europe, Japan, China, Russia, Iran, Venezuela, and North Korea, it needs to protect its flanks, and that means a trade agreement.
We suspect Canadian Prime Minister Trudeau was right when he reportedly told US President Trump that a deal would be imminent if he (Trump) would drop the controversial demands. The demands are not simply controversial. They are also contradictory. The US demands on domestic content will force companies to re-create the extensive and complex supply chains, which, of course, will be costly. Then the US demands a sunset clause that dissolves the pact in five years unless each of the parties affirms the pact. This pushes companies in the other direction.
Canada and Mexico both dismissed the significance of Ryan's deadline. They implied negotiations can resume shortly. This seems to be the most likely scenario, fanning hopes of a deal by the middle of next month. The Trump Administration created a venomous atmosphere through nativist rhetoric and liberal use of superlatives, and violated a precept of strategic thinkers since Sun-Tzu: do not let your adversaries unite. Canada and Mexico are coordinating their positions. This explains Trump's preference for bilateral agreements when the full force of US power can be brought to bear.
Then there are the steel and aluminum tariffs. Canada and Mexico (and the EU) were given exemptions until June 1. The exemptions may end. The stark choice is between forms of US restrictions: tariffs or quotas. Some countries may prefer quotas to tariffs on a cost-benefit analysis. Quotas in the form of voluntary export restrictions on Japan in the 1980s shifted exports to higher profit-margin vehicles, for example, as well as the building of production facilities within the protectionist walls.
Without an agreement in hand, Trump may renew his threat to announce the US withdrawal from NAFTA. The risk that he actually withdraws from it should not be dismissed lightly. Domestically, it would strengthen though not broaden his base. It would likely boost volatility in the peso and Canadian dollar. It could be a sufficient enough of a shock for the market to push out expectations for a Bank of Canada rate hike. Since so many industries have organized themselves on a continental basis, volatility in the equity markets would also rise.
Using IMF data for last year, the US economy is 12-times larger than the Canadian economy, which is 50% larger than the Mexican economy. Yet the breakdown of NAFTA, which requires six-month notification, would threaten to hit the US economy as evidence of late-cycle behavior continues to accumulate. Disruptions in trade also could be inflationary.
The bottom line is that a re-negotiated agreement is not a lost cause. The near-term window likely extends for a few more weeks. Various forces encourage an agreement. The lack of agreement, however, is not lethal, unless the US signals its withdrawal. There is a general recognition that at the very least the treaty needs to be updated to include such things as the internet, which did not exist when NAFTA was signed. Despite the rhetoric, a withdrawal would still be disruptive for investors and businesses.
Still, long before NAFTA, the US absorbed the bulk of Canada and Mexico's exports. The movement of goods in Canada is so dominated by north-south flows that eastern provinces import Brent instead of getting much oil from the west. Just like the WTO sets a still high bar for trade behavior between the UK and the EU after Brexit, so too do WTO rules provide a sort of safety net for the dissolution of trade agreements, like NAFTA.
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