Monday, April 24, 2017

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:

...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.

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