The Importance of NAFTA

With Canada, Mexico and the United States renegotiating the 1994 North American Free Trade Act (NAFTA), a look at the trade balance between the three nations is in order, particularly trade between Canada and the United States and Mexico and the United States.  For the purposes of this posting, I am sourcing the trade data from the United States Census Bureau with the Canadian trade data sourced here and the Mexican trade data sourced here.

Let's start with Canada.  According to the Office of the United States Trade Representative, we find the following:

- United States exports to Canada are up 165 percent from 1993 (pre-NAFTA).

- United States exports to Canada make up 18.3 percent of America's overall exports (2015)

- two-way trade in goods with Canada totalled an estimated $544 billion in 2016, making Canada the largest goods trading partner with the United States. 

- in 2016, the U.S. goods trade deficit with Canada was $12.1 billion and the services trade surplus was $24.6 billion resulting in an overall trade surplus of $12.5 billion for the United States.   

- the U.S. Department of Commerce estimates that American exports of goods and services to Canada supported an estimated 1.6 million jobs in the United States in 2015 (latest data available)

- the top exports to Canada include vehicles, machinery, electrical machinery, mineral fuel and plastics.

- the top imports from Canada include vehicles, mineral fuels, machinery, special other items and plastics. 

Here is a graph showing what has happened to the net value (exports minus imports) of American goods exported to Canada since NAFTA was signed:

As you can see, the Great Recession had a profound impact on the American long-term trade deficit with Canada and, in fact, at just under $11 billion, the trade deficit with Canada in 2016 was the smallest since before NAFTA was signed.  In fact, in April 2016, the United States ran a trade surplus of $1.13 billion with Canada, the largest monthly trade surplus by a wide margin since prior to 1985. 

   

Now, let's look at Mexico.  Again, according to the Office of the United States Trade Representative, we find the following:

- United States exports to Mexico are up 455 percent from 1993 (pre-NAFTA).

- United States exports to Mexico make up 15.9 percent of America's overall exports (2015).

- two-way trade in goods with Mexico totalled an estimated $525.1 billion in 2016, with Mexico being America's second largest export market and second largest supplier of goods imports in 2016.

- in 2016, the U.S. goods trade deficit with Mexico was $63.2 billion and the services trade surplus was $7.6 billion resulting in an overall trade deficit of $55.6 billion for the United States.

- the U.S. Department of Commerce estimates that American exports of goods and services to Mexico supported an estimated 1.2 million jobs in the United States in 2015 (latest data available).

- top exports to Mexico included machinery, electrical machinery, vehicles, mineral fuels and plastics.

- Mexico is the third largest market for U.S. exports of agricultural products.

- top imports from Mexico include vehicles, electrical machinery, machinery, optical and medical instruments and furniture and bedding.

- Mexico is the largest supplier of agricultural products imported into the United States.

Here is a graph showing what has happened to the net value (exports minus imports) of Mexican goods imported into the United States since NAFTA was signed:

As you can see, the Great Recession put an end to the substantial growth rate of the U.S. - Mexico trade deficit; since 2007 when the deficit peaked at nearly $75 billion, the deficit has ranged from a low of $47.7 billion in 2009 to a high of $64.5 billion in 2011.

By way of comparison and to put the data for Canada and Mexico into perspective, let's look at trade with China.  Again, according to the Office of the United States Trade Representative,  we find the following:

- United States exports to China are up 504 percent and imports are up 353 percent from 2001 (pre-WTO Accession).

- U.S exports to China make up 8.0 percent of America's overall exports (2015).

- two-way trade in goods with China totalled an estimated $578.6 billion in 2016 with China being America's America's third largest export market and largest supplier of goods in 2016.

- in 2016, the U.S. goods trade deficit with China was $347 billion and the services trade surplus was $37.4 billion resulting in an overall trade deficit of $309.6 for the United States.

- the U.S. Department of Commerce estimates that American exports of goods and services to China supported an estimated 911,000 jobs in the United States in 2015 (latest data available).

While there have been some trade imbalances, trade disagreements and unintended consequences to the implementation of the NAFTA deal, overall and particularly in the case of Canada, the trade situation between the three nations readjusted during and after the Great Recession with the trade deficit with Canada shrinking markedly and the significant annual growth rate of the trade deficit with Mexico levelling off.  In any case, it is quite clear that the United States is not suffering from its trade relationship with Canada and Mexico to the same degree that it is experiencing trade imbalance with China whose trade surplus with the United States is 5.5 times that of Mexico.  My suspicion is that trade with China will be next on Washington's agenda.   

Who Is Really Benefitting from Freer Trade?

Updated September 2018

With the NAFTA talks dragging on endlessly, a look at why freer trade seems to be so important to the corporate world is key to understanding who gains and who loses in a more open environment.  Obviously, a regular part of Donald Trump's "raging against the machine" is his views on international trade, particularly how the United States comes out as the losing party in many of the trade deals that form part of the move toward globalization.  In actuality, as recent research has shown, there is one clear winner and it might not be particularly surprising when you find out who is the clear winner.

A 2017 paper by Wolfgang Keller and Willian Olney looks at a comprehensive data set that explains this trend:

As most of us are aware, compensation for the top one percent of earners in the United States has risen at far greater rates than compensation for all other earners, a trend that has led to increasing income inequality.  In fact, the vast majority of the growth in income inequality has been driven by income gains among the top 1 percent of earners.  The authors look at the role of one key factor that may have caused this earnings growth; the growth in exports, particularly the growth in exports that is unrelated to decisions made by company executives and management, that is, globalization.

There is no doubt that globalization increases access to foreign markets; this results in an increase in  sales as well as a reallocation of market share from less productive companies to more productive companies.  That said, over the past two and a half decades, there have been other factors at work that have increased exports, particularly improvements in computing power,  investments in capital goods including automation, improvements in communication and improvements in transportation, all factors that have relatively little to do with who resides in the upper floor corner offices in Corporate America. 

Since there are actually many other factors that could influence both executive compensation and exports, it is important to understand whether one trend creates the other (i.e. are more highly compensated executives more successful at promoting exports?).   As such, the authors looked at data for the years between 1992 and 2015, looking for a causal relationship between export growth and executive compensation.  For the purposes of the study, the authors used a dataset which included total compensation information (i.e. salary, bonuses, non-equity incentives, value from exercised stock options, deferred compensation etcetera) for 44,000 top executives at 3,500 publicly traded U.S. companies.  The data for the top five executives in each company is included in the study and all companies must have data for all of the years in the sample (1992 to 2015).  The trade data, both export and import, is taken from the United States Census Bureau with nominal trade flows converted to real U.S. dollars using the Consumer Price Index.  The two data sets are then merged to create a complete analysis of each firm.  As well, the authors were able to use the data to ascertain insider board relationships, a variable that may indicate whether an executive at a given firm serves on a committee that makes executive compensation decisions at their own firm or at another firm which has an executive serving on the board of their company.  When these data are combined, the dataset included 3,821 executives from 191 firms over 21 years for a total of 19,788 observations.

Now, let's look at the results.  The authors found that four factors had a positive impact on executive compensation:

1.) insider board relationships

2.) firm size

3.) technology

4.) trade 

The authors found that exports are just as important in driving executive compensation as technology, firm size and insider relationships.  Even after controlling for firm characteristics like assets and sales, exports still have a significant positive impact on executive compensation.  In fact, the authors found that a ten percent increase in exports leads to a two to three percent pay increase for executives that work in that industry.

In closing, let's look at a graphic which shows how average executive compensation for the top five executives and exports levels have risen in lockstep over the past 25 years:

Here is a quote from the author's conclusion:

"The results of this paper suggest that globalization is playing a more central role in rising top incomes than previously thought. The importance of globalization in explaining the growth of top incomes is often dismissed using basic comparisons across countries and occupations. Instead we use a comprehensive data set and rigorous empirical analysis to show that globalization has played an important role in the growth of executive compensation.

Identifying why top incomes are increasing so quickly is an important step forward. However, we remain cautious about interpreting these findings as a rational to restrict international trade. Globalization has generated enormous benefits that likely dwarf the distributional consequences highlighted here. In addition, the rapid increase in executive compensation, while startling, seems to be at least partly driven by the increasing difficulty of the job in a global economy. Instead policy makers concerned about these distributional implications, should think more carefully about how to ensure that the gains from trade are more equitably distributed."

At least now you know who is really benefitting from all of those freer trade deals that governments around the world, particularly the United States, are so anxious to make.

Donald Trump and the Repercussions of Renegotiating Trade Deals

Updated August 2017

One of Donald Trump's biggest concerns seems to be international trade, particularly the free trade deal that was negotiated between the United States, Canada and Mexico back in 1994.  Here's what he had to say about NAFTA shortly after taking control of the Oval Office:

His recent announcement that he is not going to scrap NAFTA at this time, merely renegotiate to ensure a "better deal" as shown here:

I received calls from the President of Mexico and the Prime Minister of Canada asking to renegotiate NAFTA rather than terminate. I agreed..

— Donald J. Trump (@realDonaldTrump) April 27, 2017

...subject to the fact that if we do not reach a fair deal for all, we will then terminate NAFTA. Relationships are good-deal very possible!

— Donald J. Trump (@realDonaldTrump) April 27, 2017

...could result in significant negative impacts for Corporate America.  With NAFTA renegotiations taking place right now, the information in this posting could prove to be key to the success of a new deal.

 A recent analysis on the Liberty Street Economics website by Mary Amiti and Caroline Freund at the Federal Reserve Bank of New York shows us the interesting relationship between U.S. exporters and the current tariff levels on products sent to Mexico and suggests that things may well be better off for American companies if Mr. Trump were to leave well enough alone.

As we know, countries often impose or raise tariffs on imports to discourage consumers from consuming imported goods, a methodology used to protect domestic industries.  The imposition of tariffs on goods often leads to international appeals of trading unfairness/protectionism to various trading organizations such as the World Trade Organization.  The WTO has set up a Dispute Settlement Body to resolve trade disputes as shown here:

Here is a screen capture showing some of the recent trade disputes that the WTO is dealing with:

Let's look at some background data first to help us put the trade issue into perspective.  Since the three nations signed the North American Free Trade Agreement (NAFTA) which became effective on January 1, 1994, the U.S. share of trade with Mexico has done this:

Mexico's share of trade has risen to 14 percent of total imports and exports, with imports and exports looking like this in 2016:

Here is what the share of trade with Canada looked like in 2016:

By way of comparison, the share of trade with China in 2016 looked like this:

While there is a trade deficit with Mexico totalling $63.19, the trade deficit with China is nearly 550 percent higher at $347.04 billion.  As well, the U.S. trade deficit with China is 3087 percent higher than the trade deficit with Canada which totalled only $11.24 billion.  So, as you can see, there are far bigger "fish to fry" when it comes to international trade fairness issues. 

Let's go back to the Liberty Street analysis.  The authors note that there are significant benefits to U.S. companies under NAFTA.  For instance, NAFTA grants duty-free access to the Mexican market for U.S. exporters in exchange for duty-free access to U.S. markets for Mexican importers.  To compare, exports from World Trade Organization nations that do not have free trade access to Mexico or the United States are subjected to "most favoured nation" (MFN) status.  If NAFTA didn't exist and most favoured nation tariffs were applied, the average tariff on Mexican exports to the United States would be 3.7 percent whereas the average tariff on U.S. exports to Mexico would be 7.4 percent.  As well, about 25 percent of U.S. exports to Mexico would be subject to tariffs above 5 percent compared to only 15 percent of Mexican exports to the United States.  Keeping in mind that American exporters would rather see lower tariffs on their exports, it's pretty clear that U.S. companies are benefitting from NAFTA.  

As well, without NAFTA, Mexico would be able to raise tariffs more easily than the United States because, under the WTO, the maximum rate or bound tariff rate at which Mexico can impose tariffs is well above its applied MFN rates.  In the case of the United States, tariffs are bound at applied rates so they are already at their maximum (i.e. the United States cannot raise tariffs on imports any higher than they are now to protect imports from less advanced economies).

Let's look a bit further at bound tariff rates.  In the case of Mexico, their average bound rate is 35 percent.  Were it not for NAFTA, more than 90 percent of U.S. exports to Mexico are in products with bound tariff rates above 30 percent as shown on this graphic:

The large gap between the applied tariff rates and the bound tariff rates is known as the "binding overhang" which means that Mexico could raise tariffs significantly without breaking international rules.  NAFTA prevents this occurrence.  In the past, Mexico has significantly increased tariffs; the nation's average tariff rose from 13 percent in 1995 to 18 percent in the early 2000s with significant increases in tariffs on car parts, textiles and apparel.  This increase in tariffs for imported goods eventually created consumer preferences for products manufactured within NAFTA, most particularly , the United States even when the United States was not the lowest cost producer.

Let's close by looking at the final two paragraphs of this analysis:

"In another example of the potential harm to U.S. interests, it is worth recalling that NAFTA's liberalization of U.S. corn exports was strongly opposed by Mexican growers twenty-five years ago.  The bound rate on corn - one of the largest U.S. exports to Mexico and a crop considered to be a national heritage in Mexico - is 37 percent.  Thus, Mexico could raise its tariff on U.S.-grown corn to 37 percent without breaching any international rules. (if NAFTA were rescinded)

Put simply, Mexico has a lot of room to raise tariffs, up to its bound rate of about 35 percent.  In contrast, the United States has less room to adjust its tariff rates without breaching WTO rules because the U.S. MFN tariff rates of about 4 percent are already at their bound rates.  Thus, for U.S. exporters, NAFTA offers a valuable insurance policy against Mexican tariff hikes." (my bold)

Sometimes the evil that you know is better than the evil that you don't.  Re-opening or discarding NAFTA could prove to be far less beneficial to Corporate America and American workers than it may appear on the surface.