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NAFTA modernization: Why it matters to the middle market

INSIGHT ARTICLE  | 

In the June 8, 2017 issue of The Real Economy, RSM's Chief Economist, Joe Brusuelas, explains why NAFTA represents a major opportunity for middle market companies. The following is an excerpt from that issue. For more information, read the full edition of The Real Economy.

On May 19, U.S. Trade Representative Robert Lighthizer sent a letter notifying the U.S. Congress of the Trump administration’s intent to renegotiate the North American Free Trade Agreement (NAFTA).

In our estimation, the notification is more sound than fury and isn’t a step toward U.S. withdrawal from NAFTA. Rather, renegotiation and modernization will likely lead to increased opportunities for middle market businesses as the administration seeks to operationalize important updates to the recently-abrogated Trans Pacific Partnership (TPP) trade treaty.

It is important to put NAFTA in perspective. NAFTA was created as a legal and institutional framework for trade and investment flows between the trilateral partners (United States, Canada and Mexico) to promote production, efficiency gains and productivity. The result of the past quarter of a century since its inception has been the development of an economic bloc area that accounts for about $1.3 trillion in trade per year, approximately $3.6 billion in trade per day.

NAFTA featured an unparalleled development of an integrated continental auto supply and value chain, which even today has resulted in a net reduction in the cost of an automobile assembled in North America by $4,300 per car. Of course, NAFTA isn’t solely about automobiles and auto parts. The trade relationships for goods and services has evolved into a robust ecosystem.

While the looming discussions around NAFTA will likely be the largest renegotiation of the treaty in its nearly quartercentury lifespan, it isn’t without precedent. During NAFTA’s 23-year lifespan, it has been modified 20 times.

Moreover, new areas of trade, such as online commerce and other forms of intellectual property rights, didn’t even exist at the time of the treaty’s original formulation and implementation. That alone warrants a new look at modernizing the agreement. During the first four months of the Trump administration, we’ve noted a modest evolution in trade policy with respect to NAFTA. Originally, we expected a more rigid stance organized around tighter rules of origin requirements in the auto industry and perhaps tighter labor rules that essentially targeted trade with Mexico. That did not materialize. From our vantage point, this creates an opportunity to preserve and reinforce existing NAFTA supply and value chains as well as opening up space for middle market businesses to gain share within the North American economic bloc. 

During the first four months of the Trump administration, we’ve noted a modest evolution in trade policy with respect to NAFTA. Originally, we expected a more rigid stance organized around tighter rules of origin requirements in the auto industry and perhaps tighter labor rules that essentially targeted trade with Mexico. That did not materialize. From our vantage point, this creates an opportunity to preserve and reinforce existing NAFTA supply and value chains as well as opening up space for middle market businesses to gain share within the North American economic bloc. 

More importantly, it appears that the new approach selected by the administration is complementary to our Canadian and Mexican trade partners, and the table is being set to reshape the agreement to create new forms of North American economic integration and improved economic efficiency, which should help lower prices and create valueadded productivity.

NAFTA modernization and the middle market

Statements by Commerce Secretary Wilbur Ross, as well as other members of the administration, have pointed to using the abrogated TPP as a template for modernizing NAFTA. For middle market firms, this represents a major opportunity to take advantage of trade innovations that didn’t exist in 1994 when the original treaty was implemented. 

MIDDLE MARKET INSIGHT:
A modernization of NAFTA will need to be organized around the middle market for it to be acceptable to a North American business community highly attuned to overall fairness in trade. 


Most importantly, embedded inside the TPP was section 24 which was dedicated to carving out space for small and medium enterprises (SMEs) to fully participate in global trade, while reducing tariff and nontariff barriers that previously hindered their participation.

This approach includes government-sponsored information available online for SMEs to ensure that these businesses have access to detailed data and opportunities that will permit them to better participate in international trade. This would also include government oversight to ensure that the benefits of trade won’t disproportionately flow to large multinational firms.

This innovation stems from the 2012 U.S.-Korea Free Trade Agreement that was designed to include SMEs and help them gain access to a greater share of global trade. This innovation was noticeably successful. Trade, through the end of 2013, for SMEs in the beverage and tobacco industries increased 25.5 percent; leather and allied product manufacturing firms posted a 10.8 percent increase; textile exports climbed 3.9 percent; and transportation and equipment manufacturing increased 3.5 percent. In the lucrative services sector, SME trade increased by 8.4 percent, or $13.3 billion, compared with the same period two years earlier. Royalty and licensing fees jumped 23.4 percent. Travel increased 10 percent.

Areas of emphasis

Beyond the detailed inclusion of sections in the TPP dedicated to improving middle market participation in the global economy, any modernization of NAFTA will, by necessity, be organized around products and services favorable to middle market businesses. We anticipate new provisions designed to address rapid changes in digital trade and electronic commerce, regulatory cooperation and intellectual property rights will receive the lion’s share of attention in the renegotiation.

For Canada, these discussions will likely be organized around “Buy American” provisions, dairy products and softwood lumber. For Mexico, it will be organized around discussions of security, immigration and trucking provisions within the United States.

With respect to the United States, the major objective will be to ensure the balance of rights and obligations for businesses that produce and engage in trade in the digital economy, and to preserve intellectual property rights. This area represented a major breakthrough in terms favorable to the United States within the TPP. Similarly, we anticipate this will get done during this 2017-2018 round of NAFTA talks.

On electronic commerce, the TPP provided a template for protecting cross-border data flows, reducing barriers to cross-border digital trade while setting up a framework to ensure data privacy and security. Given the recent problems in global computer hacking, this would potentially be a major win for all three trading partners in any modernization of the agreement. 

MIDDLE MARKET INSIGHT:
One area to watch out for is whether rules of origin arise as a potential impediment to an agreement. This could hurt the middle market with SMEs potentially losing market share to foreign competitors.


The rules of origin issue wasn’t included in the renegotiation letter and likely won’t play a major role in renegotiations. If it does arise as an impediment during negotiations, the trilateral parties could reduce the current threshold to 50 percent from 60 percent of regional value content using the transaction method, or to 50 percent of regional value using the net cost method. The problem is this could be counterproductive to the middle market with SMEs potentially losing market share to foreign competitors. A more efficient method of resolving rules of origin issues would be a construction of a North American customs union, which would involve harmonizing tariffs for the entire North American industrial supply chain. But that will likely be left for future modernization.

Critical need: Do no harm

Thus far, the Trump administration has slapped tariffs on Canadian soft lumber—that figure to be addressed during negotiations. Meanwhile, widely anticipated tariffs on steel imports from Mexico have yet to materialize. Thus, we are optimistic that an agreement can be reached during the next year.

The negotiations will be wide-ranging, and we anticipate that all parties will want to wrap up proceedings prior to the Mexican presidential election in mid-2018. We expect that all three parties will proceed with the mantra of “do no harm to the North American automotive supply chain,” especially with rules of origin rules that underscore the entire agreement. Keep in mind that, with respect to the North American supply chain, about 40 percent of content imported from Mexico was originally made in the United States.

As Mexican Central Bank President Agustin Carstens recently noted, “[T]he fragmentation of production through global value chains is the most-recent manifestation of the process of economic integration… global supply chains imply that this process occurs primarily through trade in intermediate goods and joint production agreements… global value chains foster specialization, improve efficiency and increase welfare through the same mechanisms that induce gains for international trade in final goods.” In other words, attempts to repatriate supply chains back to the United States are likely counterproductive for the American economy and its North American trade partners.

Other areas of focus should revolve around the following:

Agricultural, sanitary and phytosanitary
This area of the negotiation figures to revolve around opening agrifood markets and harmonization of trade rules across the three parties. Without a doubt, the most notable area of potential disagreement is likely to revolve around Canadian agriculture and dairy products. Given that Arizona, Mexico, Kansas and Missouri export over 90 percent of their corn crops to Mexico, there is likely an urgency to consolidate gains of the past and create opportunities for further growth. Also, given the fragile state of the NAFTA agricultural supply chain and the agreements within the sector in the TPP, one would anticipate that this could be one of the major growth areas for middle market firms post modernization.

Government procurement
While the Canadian and Mexican parties to the agreement would like to gain greater opportunity to bid on U.S. government procurement projects given the current state of domestic American politics, one should not expect much progress made here. Given the "Buy American" preferences of the administration and Congress, any further economic integration via government procurement projects will have to wait for subsequent rounds of modernization.

Investment protection
Inside the TPP was an innovation that provided additional protection to private firms discriminated against in such a way that it confers substantial advantages to foreign stateowned enterprises, national champions or other favored firms by forcing investors to favor foreign technologies. Essentially, this results in an investment environment where state-owned enterprises cannot take actions on behalf of governments against foreign investors and argue that they are not covered under past trade agreements, which often provided such a fig leaf. Given the extensive liberalization of state-owned enterprises in Mexico over the past six years and the need to attract global capital to finance the construction of a modern energy distribution infrastructure, this looks like one area of progress that serves the interest of the trilateral parties.

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