The Bell Tolls On NAFTA - So What Are The 'Known Unknowns'?

by: Patrick M. Crowley

Originally published April 1, 2018

Donald Rumsfeld, the U.S. defense secretary in the George W. Bush administration, once stated (back in February 2002) that "there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know". At present, the situation with whether NAFTA (North American Free Trade Agreement) exists this time next year is one of these "known unknowns". In fact, the date for deciding whether NAFTA will exist next year is about a month away, due to mid-term elections north of the border and the Presidential elections south of the border, which will hamper any further progress in the negotiations beyond May. Not only that, but some decisions are to be taken also before May on the extent of the tariffs to be taken against China, in addition to the ones already announced.

Larry Kudlow - Speaking at CPAC 2015

With the new tariffs on steel and aluminium, plus the resignation of Gary Cohn as the head of the National Economic Council and President Trump's top economic adviser, there is little now to stop the advance of US economic nationalism in the US administration. Even the new appointment of Larry Kudlow as Cohn's replacement is unlikely to change things on the trade front, as Kudlow clearly sees the bigger picture and wants to keep his new appointment and much greater political influence than he has pontificating on CNBC. Plus, in the grand scheme of things, these tariffs are not that important compared to the regulatory rollback favored by Kudlow and his ilk.

In general, though, the US media seems to be at a loss to understand why President Trump is pushing ahead with this agenda and is predicting doom and gloom with the potential for trade wars to emerge, rolling back the advances made towards a fully globalized trading system. But they do not seem to understand what is at stake here, and nor do they seem to understand the economics surrounding globalization and how financial markets are to a certain extent tied to the fate of globalization over the next month or so. The way I tended to view the President's stance on tariffs was that it was mostly a case of "bluster" to prompt other countries to yield on their trade positions so as to obviate the need to implement tariffs. But recent events have proved that position to be wrong - President Trump is indeed willing to bypass the WTO, and implement tariffs, particularly on China (there is a good article on the growing irrelevance of the WTO from the FT here)

But the President's position on NAFTA is a little different. President Trump was partially elected on his campaign promise to either repeal or renegotiate NAFTA, and so far, the re-negotiation has been hung up on various of the US demands, most notably: i) rules of origin for autos - 85% NAFTA and 50% US for those autos sold in the US; ii) scrapping of the investor-state system, where investors from another NAFTA country can sue the government of that country if they are treated differently from how they would be treated in their own country; iii) scrapping of the trade dispute settlement mechanism whereby a panel of experts decides which country wins a particular trade dispute case; iv) an end to Canada's agricultural supply management system; v) the introduction of a sunset clause whereby all 3 countries have to renew NAFTA every 5 years.

So, what is likely to happen here, and what are the potential "known unknowns" here? First, how far is President Trump likely to want to compromise to save NAFTA. Well, so far, the negotiations have been making slow progress, but as one might imagine, some of the US demands are proving difficult for the other NAFTA countries to accept and/or compromise around. The investor-state system has been updated, and as the US wants it scrapped, Canada and Mexico have decided to just make it apply to them, effectively giving the US an optout from the system. Recent news from the talks in Mexico City appear to show that the US has now dropped all its demands on auto content (see here), which was also a major sticking point. While that seems like a reasonable compromise, there are still other issues like the trade dispute mechanism and the sunset clause, where it is hard to see how the different parties can come together in a deal, despite what is at stake.

The Mexican border at Yuma, AZ

As the President stated in a Reuters interview last year:

"A lot of people are going to be unhappy if I terminate NAFTA. A lot of people don't realize how good it would be to terminate NAFTA because the way you're going to make the best deal is to terminate NAFTA. But people would like to see me not do that".

The big problem for President Trump is not Canada, although the Canadians have taken issue with the US position here (see this recent article in their national newspaper, The Globe and Mail here), but on the other hand, Mexico is seemingly the biggest problem as far as President Trump is concerned, and largely because of the trade deficit that the U.S. runs with Mexico. Even, just this morning, on his way to Church, the President stopped by reporters to announce that as well as there being no DACA deal that he was still considering pulling out of NAFTA (see here) if border security did not improve. So, this is clearly a huge "known unknown", and if President Trump appears not to be able to get his cherished wall on the Mexican border by a deal with the Democrats on DACA, then this appears to be the President's next best hope - allowing Mexico to remain in NAFTA, only if it pays (in part or wholly) for the new border wall. It also perhaps is a signal that the President was not happy with the concession that his negotiators made in regard to the trade in autos.

U.S. Trade Representative Lighthizer's comments at the conclusion to the 7th round of talks in Mexico City were also revealing. He stated "As President Trump has said, we hope for a successful completion of these talks, and we would prefer a three-way, tripartite agreement. If that proves impossible, we are prepared to move on a bilateral basis, if agreement can be made."

Texas is very much involved now in trying to save NAFTA - as Canada's Financial Post pointed out in an article this week (see here), but, clearly, the President is not keen to compromise on NAFTA without there being some quid pro quo in the case of Mexico.

But what is at stake is probably bigger than any talk of tariffs with China, as although China is a large trading partner, the embedded nature of the trading relationships with both Mexico is far reaching. The actual size of the trading relationship with both Canada and Mexico can be seen in the figure above, which shows the flows of trade in and out of the country for 2016. Now of course the trade relationship with Canada is unlikely to be threatened, as President Trump will likely revert to what was known previously as CUFTA (the Canada-US Free Trade Agreement), but for US States along the border with Mexico, the implications are much more serious if Mexico is prohibited from continuing in NAFTA. The figure below shows the exports by State to Mexico, and it is clear that although all the border States would be hit by any new trade restrictions introduced between the US and Mexico, it is Texas that would suffer by far the most of any State.

Now, it is likely that the US has a surplus on services which should likely redress some of the imbalance on the trade in goods (i.e. a trade deficit). The latest figures we have for the U.S. Services exports were $33.3 billion; services imports of $26.3 billion, giving a U.S. services trade surplus with Mexico of $7.0 billion in 2017. This figure also seems small to me, considering how many Mexicans come on vacation to the U.S. and also considering the dominance of the internet by U.S. multinationals, but in any case, those benefits would likely mostly flow to one U.S. State: California.

So what are the possible outcomes here?

i) First, the worst scenario, with a complete withdrawal from NAFTA. No special trade relations with either Mexico or Canada. This is now extremely unlikely, but the effects on the North American markets would definitely be highly negative if it were to occur.

ii) Second, a more likely scenario would be a withdrawal from NAFTA while, at the same time, an invitation to Canada to continue negotiating on a CUFTA deal. This I think is highly likely if no concessions are made by Mexico regarding border security, and in particular, some funding for the wall. Clearly, Mexican markets would take a big hit if this were to occur, and the Texan economy in particular could potentially be badly hit. In the U.S., the auto sector and the energy sector would be particularly vulnerable.

iii) Third, another possible scenario which has just appeared due to the President's retreat from doing a DACA deal with Democrats, that of the NAFTA being successfully concluded due to a side deal that the President does with the Mexicans such that they partially agree to some unspecified payments so that the President gets a partial victory. Although unlikely, due to Mexican opposition to any acquiescence on the wall, it is possible and would likely have no effect on the U.S. markets but would see a relief rally in Canadian and Mexican stock markets.

iv) Fourth, a successful conclusion to NAFTA without any side agreement, but with some of President Trump's signature demands embedded into the agreement, notably reformed dispute settlement mechanism and a sunset clause on the agreement, subject to a review and further revisions at some point in the future. A relief rally in all 3 participant countries would likely occur on such news.

If I were forced to choose, I would say that outcome ii) and iv) are most likely, but in fact, I think for electoral reasons, President Trump's instincts will be to withdraw from NAFTA, unless certain key concessions are won.