Canada

NAFTA modernization: A mixed bag for Canadian middle market

INSIGHT ARTICLE  | 

NAFTA modernization represents something of a mixed bag for middle market businesses. The new treaty, dubbed the US-Mexico-Canada Trade Agreement (USMCA), includes an important chapter dedicated to small and medium-size enterprises and a wide array of provisions from the abrogated Trans-Pacific Partnership (TPP) trade treaty, which represent major wins for the middle market.

It also includes requirements for improved labour practices, environmental policies, facilitation of digital trade, cross-border trade in services, protection of intellectual property and a reduced role of state-owned enterprises. In our estimation, the chapters covering these substantial trade areas have created a positive framework for future modernization and a precedent for subsequent trade accords.

However, these gains are countered by other stipulations that may directly affect middle market businesses: they include renegotiation of so-called auto rules of origin up to 75 per cent from 62.5 per cent, and the imposition of a wage floor of US$16 dollars per hour on 30 per cent of autos produced.

The production amount rises to 40 per cent of vehicles by 2023 if an auto is manufactured with 70 per cent steel and aluminum produced in North America. Those wage production thresholds will result in higher vehicle and parts prices, as well as a subsequent erosion of the existing discount of roughly US$5,000 per vehicle for all autos produced and purchased within the North American supply chain. In addition, we will see a modest roll back of the deep economic integration of the Canadian, U.S. and Mexico economies organized around auto production.

The inclusion of almost all modernization agreed upon during the Trans-Pacific Partnership negotiations, which was abandoned by the United States in early 2017, is an undeniable positive; however, additional layers of costly regulation and a move toward managed trade rather than free trade inside the North American auto chain will result in less efficient allocation of scarce resources and higher prices for all businesses that participate. Most important, the burden of adjustment related to production will fall squarely on the shoulders of middle market producers in Canada, the United States and Mexico, with those firms in Mexico bearing a disproportionate burden.

Section 32.10 of the agreement pinpoints the U.S. strategic position with respect to global trade; it states that if any party in the new trilateral agreement enters into a free trade agreement with a non-market economy, other parties in the existing agreement would have the option of terminating the agreement. Essentially this represents a ‘poison pill’ that will severely curtail Canada and Mexico from entering trade agreements with China. This limitation is part-and-parcel of the larger ongoing trade dispute between the United States and China, and likely indicates that future trade treaties will contain similar constraints as the United States attempts to curtail the ability of the world’s second-largest economy to further penetrate the North American trade bloc.

The full treaty, subject to language verification, is comprised of 34 separate chapters, 13 annexes and 13 side letters. The following provides a quick summary and analysis of those chapters that most impact the middle market economy.

Dairy provisions

Modest changes in other chapters, including the inclusion of U.S. President Donald Trump’s much-hyped access for U.S. dairy businesses to the Canadian market, represent the adoption of provisions already agreed upon under the TPP. While these provisions do reduce some market distortions on the Canadian side of the border, the increase in total dairy exports from the United States to Canada will be quite small and in line with the TPP. Canada will eliminate certain price classes in its dairy support program, and will allow new market access for U.S. dairy products. The United States will make similar market access allowances for Canadian dairy products.

New tariff rate quotas for U.S. dairy exports to Canada

Under the USMCA, tariff rate quotas will increase to a certain level by year six of the agreement, then by a set percentage in later years.

De minimus

De minimis thresholds that apply to low value shipments were reduced. Meanwhile, nothing in the treaty encouraged an increase in energy market trade, which is a conceivable future point of further liberalization and modernization of the agreement. As mentioned above, the aluminum and steel tariffs put in place on both Canada and Mexico earlier in 2018 were not taken out. These tariffs will continue to offset any gains associated with giving the U.S. agricultural sector greater market access.

Small and medium enterprises: Chapter 25

The text regarding small and medium enterprises sets up a mechanism to support efforts to increase trade and investment opportunities for businesses of this size, and a formal oversight to ensure that large firms do not squeeze them out as they pursue participation in the global economy. It marks the first inclusion in a multilateral trade treaty of formal language ensuring fair participation in trade and investment for small and medium-size enterprises. A similar provision in the U.S.-Korea Free Trade Agreement (KORUS) spurred exporting across a variety of sectors in the middle market economy.

The treaty also sets up co-operation among parties to support small business infrastructure, including dedicated SME centres, incubators and accelerators, export assistance centres and other centres as appropriate. In addition, it creates an international network for sharing best practices, exchanging market research and promoting SME participation in international trade, as well as business growth in local markets.

The oversight within the chapter intends to set up an ongoing dialogue with representatives meeting at least once a year to discuss SME experiences, and best practices in supporting and assisting SME exporters. In addition, all three parties to the treaty will support and facilitate training programs, trade education, trade finance, trade missions, trade facilitation, digital trade, identification of commercial partners in other parties, and the establishment of good business credentials.

Rules of origin: Chapters 4 & 5

The predominant driver of current U.S. trade policy is an attempt to repatriate global supply chains back to the United States. The modernization of NAFTA is likely to fall short of that goal. However, the rules-of-origin chapters represent its formal expression. Unfortunately, they will likely result in higher costs for consumers and producers in both Canada and the United States. Their inclusion denotes the first trade treaty entered into by Canada that formally increases trade barriers, rather than reduce them, and ultimately will result in a loss of auto production jobs across all three economies.

The structure of the agreement as it pertains to the North American auto supply chain likely serves as an incentive for firms to make further investments closer to global growth areas in China and India. Moreover, with respect to the internal dynamics within the North American supply, the wage floor stipulation will almost certainly result in a pulling forward of automation and robotics within the region’s auto supply chain, which is already among the most technologically advanced in the international economy.

In our estimation, rather than moving supply chains back to the United States, companies such as Volkswagen, which export affordable autos for many Canadian and U.S. households in the lower and middle-income strata, will simply pay the 2.5 per cent tariff, and pass the cost on to the consumer.

Auto suppliers will face difficult choices under the new agreement. Consider a firm that produces glass in Mexico and feeds its product into the North American automotive and housing supply chains. The company must either lift wages to meet the new wage floor or choose to move toward 100 per cent automation. A business such as this will likely choose to focus on retaining higher-paid, value-added employees, release lower-paid workers and then move to automate, resulting in lower production costs and the ability to continue supplying the wealthy Canadian and U.S. markets. The result of the agreement will be greater automation and a reliance on robotics in all three economies, with respect to the productions of autos and automotive parts.  

Textiles and apparel: Chapter 6

The chapter addressing textiles and apparel is vague and will require further interpretation, subject to language verification. This provision represents a rolling back of free trade and market-derived pricing; it will over time likely increase the probability of the erection of non-market barriers to trade that will increase overall costs of production and consumption.

Chapter six is one of the most highly technical of the entire treaty and will require an in-depth investigation to provide greater clarity on the impact of the apparel and textile supply chains. One thing that is clear—goods imported from outside the North American trade bloc will face higher duties, thereby increasing the cost of production.

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