USMCA is a solid opportunity for the middle market
The new North American trade agreement represents a solid opportunity for American middle market firms to expand their participation in the regional and global economies.
The pact, called the United States-Mexico-Canada Agreement, includes a chapter dedicated to small and medium enterprises – a first for a multilateral trade agreement – and also adopts a wide array of provisions from the abrogated Trans-Pacific Partnership trade treaty. Both of these provisions are major wins. Before the input of Democrats in the House of Representatives around labor, the environment and pharmaceuticals, language from the TPP represented close to three-quarters of the USCMA text.
In broader terms, the new agreement shows that all of the talk about the end of globalization is perhaps premature. Rather, one might say that we are headed toward an era of re-globalization featuring regional trade arrangements until the United States and China can reach accommodation on larger macroeconomic and security issues.
Despite some good provisions, the agreement will have costs, particularly when it comes to the auto industry.
The deal includes new requirements for improved labor practices, environmental policies, facilitating digital trade, cross-border trade in services, protecting intellectual property and reducing the role of state-owned enterprises. In our estimation, the chapters covering these substantial areas have created a positive framework and lay the groundwork for subsequent trade accords.
Despite those wins, though, the agreement will have costs, particularly for the auto industry.
The new treaty increases the required ratio of parts made in North America – known as the auto rules of origin — from 62.5% to 75% if the vehicle is to avoid import duties. It also requires that 30% of a car be made at a plant where workers earn at least $16 an hour to qualify for duty-free status. That ratio increases to 40% by 2023 if that auto is produced with 70% of steel and aluminum made in North America. In either scenario, the new requirements will result in higher prices on vehicles and their parts.
Put in dollar terms, these new requirements will erode the roughly $5,000 discount for all autos produced and purchased within the North American supply chain. And this, in turn, will ultimately lead to a modest roll back of the deep economic integration of the three economies organized around auto production.
While the inclusion of language from the Trans-Pacific Partnership is an undeniable positive, additional layers of costly regulation and a move toward managed trade as opposed to free trade in the North American auto chain will result in higher prices for all firms that participate. Most important, the burden of adjustment will fall squarely on the shoulders of middle market producers in the United States, Canada and Mexico, with firms in Mexico bearing a disproportionate share.
Also of interest is Section 32.10 of the agreement, which states that if any party enters into a free trade agreement with a non-market economy, the other parties would have the option of terminating the agreement. Essentially this represents a poison pill that will severely curtail the ability of Mexico and Canada to enter into trade agreements with China. This stems from the larger U.S. trade dispute with China and will most likely be part of other U.S. trade treaties going forward.
From a broader strategic standpoint, it is the first in what can be expected to be a long-term effort by the United States to constrain China’s ability to further penetrate the North American trade bloc and other critical U.S. economic and trade relationships.
The treaty, subject to language verification, is comprised of 34 separate chapters, 13 annexes and 13 side letters. The following is a quick summary and analysis of those chapters that have the biggest impact on the economy and middle-market enterprises.
Small and medium enterprises: Chapter 25
The text in the agreement on small and medium enterprises sets up a mechanism to increase trade and investment opportunities and ensure that large firms do not squeeze out smaller firms. It marks the first time that formal language ensuring fair participation in trade and investment for small and medium-size enterprises has been included in a multilateral trade treaty.
The treaty sets up cooperation among the three countries to support small business infrastructure including dedicated enterprise centers for small and medium businesses, incubators and accelerators, and export assistance centers. The goal is to create an international network that allows small and medium business to share best practices, exchange market research and promote participation in international trade, as well as promote business growth in local markets.
The oversight measures outlined in the chapter call for meeting at least once a year to discuss the experiences and best practices of small and medium businesses in supporting and assisting exporters. In addition, all three countries in the treaty will support and facilitate training programs, trade education, trade finance, trade missions, trade facilitation, digital trade, identifying commercial partners in other countries and establishing good business credentials.
Rules of origin: Chapters 4 and 5
The basic premise of current trade policy out of Washington, D.C., represents an audacious attempt to repatriate global supply chains back to the United States. On that account, the new treaty is likely to fall short of that lofty goal. The rules of origin chapters are the formal expression of that policy goal.
Unfortunately, those rules will result in higher costs for consumers and producers. The USMCA is the first trade treaty entered into by the U.S. that formally increases trade barriers rather than reducing them. In the end, it will result in a loss of auto production jobs across all three economies.
The structure of the agreement when it comes to the auto supply chain most likely serves as an incentive for firms to make further investments closer to the global growth areas in China and India. Moreover, with respect to the internal dynamics within the North American supply chain, the wage floor included in the modernization will almost certainly result in a greater use of automation and robotics inside an auto supply chain that is already among the most technologically advanced in the world.
While there may be a reduction in auto exports from Mexico into the United States, especially at the lower end of the price spectrum, and price hikes across the industry over the medium term, further automation is highly probable as firms adjust to politically managed rather free trade. The result will be higher prices and loss of competitiveness for middle market firms that feed into the North American auto supply chain.
In our estimation, rather than moving supply chains back to the United States, firms like Volkswagen that export affordable autos to the United States and Canada will most likely opt to pay the 2.5% tariff. If a household chooses to purchase a VW Atlas SUV, the current base price of $30,750 would increase by roughly $768. That would result in a net 15% reduction in the average $5,000 discount to those who purchase an auto produced in the United States. This does not include any impact from higher costs of production implied by the treaty, which will surely reduce that discount further.
Then there are the demographic headwinds.The United States has not breached 18 million sales of autos on an annual basis over the past 20 years. It makes little sense for automakers to bring production back home to a market that, in population-adjusted terms, is falling. Instead, they will almost certainly look to make new investments closer to the growth markets of Brazil, China and India.
On the second point, consider if a firm produces glass in Mexico that feeds into the North American auto and housing supply chains. It faces a difficult choice. Either lift wages to meet the new wage floor or choose to move toward 100% automation. A firm like this will most likely choose to focus on retaining higher-value-added employees, release lower-paid workers and then move to automate with the end game resulting in falling costs of production and retaining access to the wealthy American and Canadian markets. The result of the agreement will be greater reliance on robotics in auto production for all three economies.
The result of the agreement will be greater reliance on robotics in auto production for all three economies.
One of the more disappointing aspects of the new agreement is that it appears to be designed for an American industrial economy that is slowly shrinking relative to the fast-growing new economy organized around sophisticated technology. With most products used in auto production crossing the border an average of six times, it is virtually impossible to place a value on origin. Ultimately, the expectations on production and job gains in the auto sector are not well-aligned with empirical reality. More important, the agreement does not appear to have considered the impact of advances in the use of data, artificial intelligence and machine learning in the production of autos and other manufactured goods.
Textiles and apparel: Chapter 6
The chapter on textiles and apparel is vague and will require further interpretation once the agreement’s language is verified. But it does promote a greater use of American-produced fabrics and yarn while using enhanced customs enforcement and trans-shipment of goods produced outside of the agreement through third parties. This does represent a roll back of market pricing and will over time most likely increase the probability that non-market barriers to trade will be put in place. Ultimately, that increases the overall costs of production and consumption.
The text appears to reduce the ability to use non-USMCA inputs, which if implemented, will certainly result in higher costs of production and thinner margins for those dependent upon the textile and apparel supply chains along the U.S-Mexican border. To gain preferential treatment under the new trade agreement requires that unspecified inputs be incorporated into finished products and be made in the same region as that finished product. There is specific language that applies to coated fabric, narrow elastic bands, pocketing fabric and sewing thread. To put this in context, a dress shirt produced in Mexico must use goods made in the United States, Canada and Mexico.
Chapter 6 is one of the most technical in the agreement and will require an in-depth investigation to provide greater clarity on its impact in the apparel and textile supply chains.
Chapter 6 is one of the most technical in the agreement and will require an in-depth investigation to provide greater clarity on its impact in the apparel and textile supply chains. But one thing is clear: The importation of goods from outside the North American trade bloc will face higher duties and will increase the cost of production. This is in line with the overall efforts of the administration to limit the ability of Chinese exporters to make further inroads in the North American economy.
Modest changes in other chapters like the much-hyped access for U.S. dairy farms to the Canadian market were simply an adoption of what had already been agreed upon inside the TPP. While it does reduce some market distortions on the Canadian side of the border, the increase in total dairy exports from the U.S. to Canada will be quite small and in line with the TPP.
De minimis thresholds that apply to low-value shipments were reduced while there was nothing in the treaty that encouraged an increase in energy market trade, which is a conceivable future point of further liberalization within the treaty. More problematically, the aluminum and steel tariffs put in place on both Canada and Mexico were not removed despite the update of the trade agreement. The increased costs associated with that specific set of policies will continue to offset any gains in the agricultural sector linked to greater market access for U.S. firms.
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