NAFTA’s Overhaul: From Stability To Uncertainty – Analysis

By Gustavo Flores-Macías and Mariano Sánchez-Talanquer*

(FPRI) — As it approaches its 25^th year of existence, the North American Free Trade Agreement (NAFTA) faces its biggest challenge. Signed in 1992 by the governments of Canada, Mexico, and the United States to eliminate barriers to trade and investment, NAFTA has for more than two decades provided a workable framework for integration and exchange. Since entering into force in 1994, overall regional trade has more than tripled, with sectors like auto manufacturing and agriculture experiencing major transformation. Total foreign direct investment among member countries has grown from some $127 billion in 1994 to $972 billion in 2017, based on data from the U.S. Bureau of Economic Analysis. American machinery and foodstuffs have flooded the Mexican market, vehicle production in Mexican territory has boomed, numerous U.S. companies have developed unprecedented presence in Mexico, and Mexican avocados have become a staple of the American diet.

At the same time, NAFTA has remained a bone of contention in domestic politics for the unequal gains and social dislocations brought in its train. Although the agreement has bolstered the North American region’s competitiveness in global markets and average consumers in all three countries have benefitted from greater product diversity and lower prices, economic anxiety, when not outright political resentment, has accumulated among losers from the trade agreement, from small Mexican agricultural producers to manufacturing workers in the American rust belt. For those affected, the slow and uneven recovery from the global financial crisis of 2008 finished twisting the knife into an already hurting wound. Amidst the political mobilization of such discontent, NAFTA as we know it is on the brink of collapse.

Of course, not only NAFTA, but also core norms and institutions of the international order are under fire. The World Trade Organization (WTO), the United Nations (UN), and even the North Atlantic Treaty Organization (NATO) have become targets of harsh treatment and sharp criticism from the global hegemon. From an economic standpoint, the trade deficit—which, despite theory and evidence to the contrary, President Donald Trump considers an unequivocal sign of being taken advantage of—is bigger with China than with Mexico. Yet, NAFTA is arguably unique for what it evokes among certain sectors of American society: precisely the type of economic, cultural, and social-status (including racial) anxieties that fuel deep partisan polarization, and ultimately propelled President Trump to power. Symbolically, the agreement occupies a special place in the politics of scapegoating.

It is no coincidence that terminating NAFTA, which Donald Trump characterized as “the single worst trade deal ever approved” in the first 2016 presidential debate, was a key promise in his path to the presidency. The “American” way of being, living, and winning, so the argument goes, has been compromised by elite-imposed globalization, permeable borders, harmful trade deals, immigration, and unbridled sociodemographic change. Such abstract evils find corporeal expression in NAFTA, a trade agreement with Canada and none other than the United States’ still developing, low-wage, migrant-producing, violence-ridden, and Spanish-speaking southern neighbor.

Although many dismissed the fiery rhetoric as mere campaign strategy, the Trump administration has, in line with its promise, turned protectionism into practice. To date, measures include pulling out of the Trans-Pacific Partnership (TPP) in January 2017, adopting a series of tariffs on steel and aluminum on purported national security grounds, and engaging in a tariff back-and-forth with China, in what appears to be the early stages of a trade war. In May 2017, President Trump confirmed to Congress his intention to renegotiate NAFTA to reverse what he considered intrinsically unfair conditions in the agreement, or else pull out of it altogether.

More than a year after renegotiations officially started in August 2017, and having successfully split talks with Mexico and Canada into separate tables, the Trump administration and the Mexican government announced a preliminary bilateral understanding. The political clock, however, is ticking rapidly. Hasty negotiations with Canada, ongoing at the time of writing, must produce a deal by September 30 if a rebranded trilateral agreement is to be signed before Mexican President Enrique Peña Nieto steps down on November 30 to make way for Andrés Manuel López Obrador, the leftist-nationalist figure who won the Mexican presidency in July by a landslide.

Time is also critical for President Trump. With the U.S. Congressional midterm elections in November and a new—possibly more hostile—Congress sworn-in in January, the president is at risk of failing to deliver on one of his central promises. Where do things stand with the revised agreement, and how might the newly negotiated terms influence economic exchange in the North American region? What is the political logic driving NAFTA’s demise or overhaul?

Renegotiation in Context: Mutual Dependence, Conflicting Priorities

As the three governments sat at the negotiation table, they each faced the reality of deep economic integration and mutual dependence. However tempting, NAFTA could not be terminated with the stroke of a pen—at least not without inflicting significant economic self-damage and incurring political costs. In all three countries, important constituencies benefit from the current trade agreement.

This is no less true for the United States, the party who forced the others into the re-negotiation. With a dynamic domestic economy, international trade only represents about a quarter of U.S. gross domestic product (GDP), yet, in raw numbers, the country is still among the largest exporting economies in the world, only second to China. This simple fact implies that the economic fortunes of a large share of the American workforce and their employing companies depend on access to foreign markets. NAFTA’s contribution is anything but trivial: Canada is the United States’ first export market, and Mexico the second. The Department of Commerce estimates that U.S. exports to Canada and Mexico supported 2.8 million jobs in 2015, one out of every four export-supported jobs in the country.

The reestablishment of pre-NAFTA trade barriers would not only make certain goods more expensive for consumers—a burden that falls more heavily on the economically disadvantaged—but also hit several politically sensitive sectors harshly. Exports to Canada and Mexico in the agricultural and food industries, for instance, have more than quadrupled under NAFTA. Not surprisingly, the warnings of the Secretary of Agriculture appear to have been crucial in making President Trump reconsider the exit option. After all, despite his general antagonism toward free trade—and particular distaste for NAFTA—the president would not want to alienate members of his own electoral coalition.

The constraints entering into the negotiations were even tighter on Mexico. According to the World Bank, international trade reached a whopping 78% of the Mexico’s GDP in 2017, up from some 30% pre-NAFTA. Yet, despite free trade agreements that span economic relations with 46 countries, more than 80% of the country’s exports have the U.S. market as their destination. More than a choice, healthy commercial relations with the northern neighbor are a necessity for governments of all stripes. The incoming administration of López Obrador, once a sharp critic of NAFTA, rushed to send signals of moderation and goodwill, in fact working jointly with President Peña Nieto’s team in the final negotiations in Washington, D.C.

Mutual dependence notwithstanding, Mexico and the United States thus approached negotiations with varying degrees of concern regarding NAFTA’s termination. For President Trump, the reality of economic integration imposed limits on impulsive action, but he has become invested in the promise of restoring manufacturing jobs and bringing purported foreign freeloading to a halt, all of which requires a tall wall—physical, but above all symbolic—along the border with the southern neighbor. NAFTA as we know it had to go.

For Mexico, the American threat of withdrawal risked a grim economic scenario. To add complexity to an already delicate matter, the combination of a leftist president-elect—who will enjoy a congressional majority for the first time in the history of Mexican democracy—and a long lame duck period further raised concern and uncertainty among investors. Put shortly, the country found itself drawn into a high stakes renegotiation it had not asked or wished for, and which would reach its defining moments during the sensitive period of transfer of executive power. Under these circumstances, preserving the agreement became the top priority for Mexican negotiators, who were willing to make major concessions—for critics, too willing.

Renegotiation: American Demands, Mexican Concessions

The original U.S. position pushed for significant changes to NAFTA, including adopting a sunset provision and modifying rules of origin for the automobile industry—the most dynamic sector in the agreement and, politically, at the core of the promise of reviving American manufacturing. In particular, the U.S. sought to increase the minimum North American content in the auto industry to reach duty-free privileges from 62.5 to 85%, with an additional requirement that 50% of auto content must be made on U.S. soil. Further, the U.S. pursued the elimination of NAFTA’s chapter 19, the dispute settlement mechanism which allows expert international panels to adjudicate controversies without resorting to domestic courts. Finally, the U.S. demanded that the new agreement include a clause mandating the automatic termination of the agreement every five years, unless the three countries explicitly decided to ratify it.

Although both Mexico and Canada initially deemed these controversial proposals unacceptable because they would disproportionately favor the U.S., Mexico eventually agreed to a modified version of the White House’s requests in the bilateral negotiation. On August 27, the two countries announced that a “preliminary agreement in principle” had been reached, putting Canada in the spotlight. While the details of the agreement have not been made public, the terms of the deal appear to skew heavily toward the United States’ original demands. Rather than risking the end of NAFTA, the Mexican government seems to have accepted some version of the main changes proposed by the Trump administration, without obtaining much in exchange.

One view is that Mexico’s heavy economic dependence on the U.S., President Trump’s open hostility to NAFTA, and the power asymmetry between the two countries would inevitably result in worse terms for Mexico. Further, with the looming inauguration of a leftist government and in the event of U.S. exit, circumstances could conspire to materialize a nightmarish scenario of capital flight, speculation, sudden depreciation of the peso, and full-blown economic crisis. With such high stakes, Mexican negotiators understood the current deal as a way to accomplish the immediate goal of avoiding major economic damage, regardless of the outcome of negotiations between the U.S. and Canada. In their view, Mexico may have paid a high price, but it bought itself an insurance policy in the face of severe risk and pending the return of more politically auspicious times, when a new U.S. administration could reconsider the current protectionist drive.

However, another view considers that despite the sound and fury, the negative consequences for U.S. business sectors of ending NAFTA and the pressure to deliver on an agreement before the November midterm elections significantly constrained the White House, whose tough rhetoric should have been interpreted as the standard negotiation tactics of the times. For critics, the negotiation team made a strategic mistake in submitting to President Trump’s divide-and-conquer strategy, instead of joining forces with Canada and vindicating the three-sided spirit that has characterized the agreement since its inception. More importantly, Mexico could have leveraged the strong dependence of certain U.S. industries on NAFTA—many in Republican territory—and Trump’s rush to tout the deal’s overhaul before the midterms to extract at least some concessions.

In addition, the timeline for President Trump to score a legislative victory with a new agreement is tight at best, a constraint Mexico could have taken advantage of to maintain the status quo. On August 31, President Trump notified Congress of his intent to sign an agreement with Mexico—and Canada “if it is willing”—under the Trade Promotion Authority (TPA), which grants the executive the power to (re)negotiate trade agreements and hold them to an up-or-down congressional vote with no amendments. From that date, the President has 30 days to present the final text (hence the September 30 deadline to incorporate Canada) and 90 days to sign the deal—that is, by the end of November, just before executive power changes hands in Mexico. Yet, there are additional roadblocks. Under TPA law, the U.S. International Trade Commission has up to 105 days after the President enters into a trade agreement to submit a report on the likely economic impact of the agreement (see section 105(c)(2)-(3)). U.S. Trade Representative Robert Lighthizer has urged the ITC to issue its assessment “as soon as possible after the agreement is signed,” presumably to settle the matter before the end of the year. Within the 105 days deadline, however, exactly when to do so is at the ITC’s discretion.

Then, there are additional procedural and political hurdles that relate to Canada, who found itself having to rush back to the negotiating table to try to reconcile its own interests with the terms negotiated between the U.S. and Mexico. President Trump has expressed his willingness to proceed without Canada, which in principle limits Prime Minister Justin Trudeau’s room to maneuver—he will have to decide whether he considers the current terms better than no deal, contrary to what he had stated.

Should negotiations with Canada fail, President Trump would like to proceed with the U.S.-Mexico deal as NAFTA’s replacement. But, his May 2017 notice of intention to Congress invoked TPA to initiate talks with Canada and Mexico to renegotiate the trilateral pact, not to enter into a new bilateral agreement. As a result, the very applicability of the current TPA process to a deal that excludes Canada is in question. And politically, it is at best unclear whether such an agreement would meet the required legislative support. Strong opposition is likely to emerge among legislators from states for whom Canada is the main trading partner, regardless of partisan affiliation.

What all these technicalities add up to is that to enter into effect any new deal and associated changes in legislation will most likely need to go through the next U.S. Congress, where President Trump could be hostage to Democrats should they win control of the House in November. His administration could reignite the threat of unilaterally withdrawing from the agreement and unwinding North American free trade if Congress does not go along, but a Democratic Congress could itself fight back. In the meantime, the current NAFTA would continue to live. Critics of the Mexican government’s strategy thus consider that, given President Trump’s time constraints and key Republican districts’ dependence on continued trade with Mexico, negotiators surrendered the advantages of multilateralism and submitted to pressure all too quickly.

While the counterfactual is difficult to establish, Mexico may have indeed missed an opportunity to call President Trump’s bluff and reach a more balanced deal. Under the preliminary bilateral understanding reached at the end of August, 75% of automobile content must be sourced in North America (up from 62.5%), and between 40% and 45% of content must be produced by workers earning at least $16 an hour. This change is aimed at shifting part of the automobile production back to the U.S. (and potentially Canada, should an understanding be reached). Thus, the North American auto sector, now reliant on less-demanding requirements and frictionless cross-border flows that allow for intra-industry efficiencies, risks losing competitiveness at a global scale—and thus market share and jobs, making President Trump’s victory pyrrhic, at least in economic terms.

In principle, automobile companies could opt for assuming the costs of “most-favored nation” tariffs on autos, currently set at 2.5%, if they find the new regulations too difficult to comply with, instead of relocating production and readjusting supply chains. However, the U.S.’ invocation of “national security” considerations to impose tariffs on steel and aluminum—which have already thrown the World Trade Organization into crisis—would foreclose this circumventing path, as the U.S. could unilaterally raise tariffs on automotive imports on the same grounds. In fact, the U.S.-Mexico deal reportedly includes a side agreement that caps duty-free imports from Mexico to 2.4 million vehicles and $90 billion on auto parts per year. Beyond these levels, Mexican auto exports would, as those of other countries, be subject to punitive national security tariffs of up to 25 percent—should the U.S. government decide so.

The Mexico-U.S. agreement would also eliminate dispute settlement panels for some industries (although it appears that they will be preserved for energy and infrastructure companies). On the U.S. demand for a five-year sunset clause, a compromise appears to have been reached: the agreement would remain in effect for an initial 16 years, yet subject to review after six years.

Whether Canada will finally join the deal, and how the terms of the agreement might change in the process, remains to be seen. Dispute-settlement mechanisms, increased access to Canada’s market for U.S. dairy products, and culturally protected industries remain among the main sticking points in the negotiations.

Steps toward De-institutionalization

In the midst of this uncertainty, three things are clear. The first is that the terms of the agreement seem to have missed important opportunities to modernize NAFTA. The preliminary Mexico-U.S. deal includes areas neglected in NAFTA’s original text, including energy, information technology, intellectual property, digital trade, and more advanced environmental regulations. Mexico also agreed to strengthen legislation to protect workers’ rights, which—if enforced—may increase labor costs but help moderate sharp inequalities in the economic returns to capital and labor, with the latter appropriating only about a quarter of national income (compared to a declining, but still substantially larger 60% in the U.S.). However, there appear to be setbacks to liberalization in areas such as government procurement, land transportation, and rules of origin for textiles. And rather than contributing to shared prosperity, the net effect of changes to the automobile sector on jobs could be negligible or even negative, as increased production costs, reduced competitiveness, and higher prices—or instead an even stronger shift toward automation—could well place a cap on the return of manufacturing jobs to the U.S.

Second, NAFTA has also become much less predictable, eroding a key objective of trade agreements. Beyond tariff reductions, perhaps the main contributions of trade deals are stabilizing expectations for economic actors and limiting cronyism in trade policy. Under clear and common rules embedded in a stable institutional framework, firms know what to expect and need not engage in constant politicking to secure favorable treatment. In contrast, the new NAFTA, if enacted, will make it more difficult for investors to plan for the medium to long terms precisely because of the increased uncertainty about the permanence of the rules of the game. Worst of all, they may become more dependent on friendly relations with political powerholders. Permanent influence-peddling and arm-twisting could become the new normal in trade politics.

Further, without the mechanism of dispute settlement panels, firms will also find it riskier to invest in certain contexts where domestic courts would rule on cases of unfair trade practices. Workers in export industries could also face less job security. Overall, the agreement’s shorter time horizon makes the rules more vulnerable to short-term political calculation by whoever happens to hold the levers of power in each country, each time.

Arguably, the hardball tactics and capriciousness during the renegotiation itself have already eroded the very stability and predictability that trade agreements are meant to provide. As of today, the preliminary deal remains vulnerable, its definitive content unofficial, and even the number of members uncertain. In all, the new rules and ways represent steps toward the de-institutionalization of North American economic relations.

As a result, both Canada and Mexico will likely look to reduce their exposure to NAFTA by cultivating alternatives. Although their economic dependence on the U.S. does not allow for major departures in the short term, the rational strategy is to strengthen economic ties with other countries and regions, including the European Union and China, and resort to other avenues such as the TPP.

Finally, should a final agreement be reached along the lines of the preliminary deal with Mexico, President Trump will take home an important political victory. In the campaign leading to the November elections, he will be able to relay to voters that his administration has fulfilled a central campaign promise by rejecting the original NAFTA, extracting concessions from Mexico (and potentially Canada), and reasserting U.S. dominance. Although the new deal will not necessarily benefit American consumers and might even hurt them through higher prices and layoffs, the renegotiation is consistent with the protectionist message that was central to President Trump’s successful presidential campaign. While reassuring for some, the weakening of NAFTA is yet another manifestation of the increasing precariousness of the liberal international order, which, paradoxically, the U.S. had underwritten since World War II.

*About the authors:
Gustavo Flores-Macías is an Associate Professor of Government at Cornell University.

Mariano Sánchez-Talanquer is an Academy Scholar in the Harvard Academy for International and Area Studies at Harvard University

Source:
This article was published by FPRI