NAFTA: Should we stay or should we go now?
Clash of trade treaty ideals holds dramatic implications
THE REAL ECONOMY |
Despite an improved outlook, it is possible that the U.S. political authority will trigger a six-month review period for exiting the North American Free Trade Agreement (NAFTA) sometime during the next 90 days. At stake is more than $1 trillion in cross-border trade and more than 14 million jobs across three economies. While Mexico has the largest exposure to such an event—in the case of a hasty exit, its economy could contract 2.9 percent in 2019—both the United States and Canada have significant direct and indirect exposure to such a radical policy shift. We expect this to subtract 0.3 to 0.5 percent from United States gross domestic product (GDP) between 2019-20 and Canada to take a 0.5 percent hit to growth over that same time.
MIDDLE MARKET INSIGHT: Middle market businesses across the three economies, and a number of specific industrial ecosystems, face direct risk from potential disruptions of supply and value chains built up during the past generation.
Given the increase in overall trade volumes globally, particularly for the United States, the potential for a policy shift toward NAFTA would be ill-timed. U.S. exports are up 5.6 percent on a year-ago basis with a trade volume of $195.9 billion dollars. Given the tail winds behind a global economy that we expect to grow by 4 percent in 2018, the particular timing of such a drastic policy shift is problematic. By effectively imposing a series of taxes across a large universe of goods, withdrawing from NAFTA would partially negate the positive impacts in store for businesses and households due to the recent Tax Cuts and Jobs Act signed into law by the administration.
The impact will be asymmetric throughout middle market ecosystems and the North American economy. The striking degree to which value chains will be disrupted, especially in individual states and industries that significantly add value to finished goods sold domestically and abroad via imports, will be quite noticeable upon any potential enforcement.
Moreover, if the United States pulls out of the treaty, it will likely trigger a series of unintended consequences and indirect economic effects that will negate any short-term positive changes. Substitution effects would quickly be outweighed by the overwhelming shift in costs, losses in competitiveness, rising prices for consumers and widespread disruption to the mature North American supply chain.
Under the status quo, tariffs—which are better understood as taxes on imports and exports—are zero. Once the United States withdraws from the treaty, they would reset under current World Trade Organization rules, to 3.5 percent, whereas in Canada and Mexico, they would reset to 4.2 and 7.1 percent, respectively on average. The major problem that will generate massive uncertainty, and harm overall capital expenditures and capital flows, is that tariffs will increase in an asymmetric fashion for a variety of goods and service exports for U.S.-based firms.
For example, U.S. exports to Mexico of chicken and potatoes would be 75 percent, whereas apparel exports to Canada automatically increase to 18 percent and sales of beef would face a tax of 27 percent. Moreover, the integrated North American supply chain confers a savings of roughly $4,000 to each consumer who purchases an auto produced across the continental economy. That would quickly unravel and would act as a direct tax on all who purchase autos produced in North America in 2019. Most importantly, assuming neither Canada nor Mexico withdraws from the treaty and remains members of the Trans Pacific Partnership treaty, all other major competitors in that treaty will have access to both Canadian and Mexican markets at a zero tariff rate, while U.S. businesses will not.
There are a large number of states with exposure to NAFTA (see page 8), many of which are just starting to expand at a quicker pace, following the recovery from the 2007-09 recession. For example, Michigan has 366,000 jobs at risk that produce $35 billion worth of exports, with 56 percent of value-added imports from its NAFTA trade partners with the motor industry and parts ecosystem at greatest risk. Other states face similar risks with respect to jobs, exports, value-added imports and industries such as manufacturing, agriculture, construction, pharmaceuticals and energy. A deeper dive indicates producers and importers of aluminum, nonferrous metal products, mining, engineering series, finance, insurance, resins, synthetic rubbers and coal products will also face risks.
There is a belief that erecting tariff barriers to trade will result in economic growth and job gains. However, based on the evolution of trade regimes since the end of the second World War, and the data we have evaluated here, that is simply not true. Our discussions with trade representatives in Washington D.C. all point to one unmistakable conclusion: that after a generation of constructing a dense network of production across three countries, firms are not going to bring jobs and supply lines back to the United States. Rather, they will simply accept the new tax and tariff regime and pass those costs along to producers and consumers downstream. Perhaps more onerously, many industry players whose production chains are deeply embedded in NAFTA have indicated that they would look seriously at offshoring production in the aftermath of any decision to exit NAFTA.
The data point to the outcome of such a policy shift as neither welfare enhancing nor economically beneficial.
12 most dependent states on the NAFTA economy
A quick look at U.S. states that are overly dependent on the NAFTA economy (see infographic on page 12 of this month's issue) indicates that 3.95 million jobs are at risk, and $249.5 billion in trade has exposure to a potential withdrawal of the United States from the treaty regime.
Canada is the largest destination of exports for 30 out of the 50 states with risk spread out across the geography of the United States.
States hit hardest by NAFTA exit
There are 12.5 million U.S. jobs at risk among 50 states linked to the integrated North American economy. Perhaps more surprisingly is that among the 50 states, the average value added due to NAFTA imports is 68 percent. This implies that there will be a potential asymmetrical price shock to middle market firms whose supply and value chains depend upon imports. (See full details on page 13 of this month's issue).
Tariffs and costs by industry
It is hard to understate the negative impact on industry due to a potential U.S. withdrawal from NAFTA. There would be roughly a 3 percent economic drag on exports that would impact $15.5 billion in goods and services sold abroad. Food products, auto exports, textile and apparel, and chemical exports will bear the disproportionate burden of that adjustment. (See infographic on page 10 of this month's issue).
Export dependent and growth counties
Too often economists and policymakers focus on the macro impact, while focusing on the large important economic and financial areas of the economy. One inescapable finding from our analysis of the data, is how withdrawing from NAFTA will negatively impact small cities and counties that are depending upon the growth opportunities from exporting to Canada and Mexico. (See infographic page 14 of this month's issue).
Mexico and NAFTA
In our estimation, Mexico will take the largest hit of the three economies that make up the NAFTA trade regime. In the event of a radical policy shift from the United States, Mexico’s economy would contract by 2.9 percent in 2019 due to an 18 percent decline in exports and 16 percent decline in imports. Direct investment would probably fall 11 percent and the current account deficit would fall by 1 percent. Under such a scenario, we would anticipate the peso to depreciate to 21.5 against the U.S. dollar and inflation as measured by the Mexican consumer price index (CPI) to increase to 5 percent by the end of the year, with Banco de Mexico lifting the policy rate to 8 percent. The lagged impact of a depreciating peso would partially mitigate the negative impact of the Washington-induced policy shock and create the conditions for a return to growth in late 2020.
Canada and NAFTA
While Mexico will fall into a recession should the United States withdraw from NAFTA, Canada will take a large hit north of 0.5 percent on GDP in 2019. Canada receives roughly $392 billion in foreign direct investment from the United States each year that accounts for 47.5 percent of all foreign direct investment annually. With 1.2 million Canadian workers employed by U.S. firms, a disruption to commerce in a context where the United States purchases 72.6 percent of total Canadian exports, there are significant risks to the overall economy. The Canadian auto industry would face a particularly large shock with truck exports facing a 25 percent tariff in contrast with the 2.5 percent applied to auto exports. Overall Canadian exports would likely decline by $23 billion or roughly 3 percent.