North America October 01, 2018 / 05:10 pm UTC

NAFTA Deal Removes a Major Risk

By Kevin Harris, Pedro Tuesta

Bottom line: The agreement reached between Canada and the U.S. in NAFTA talks means a major risk to the North American economies has been eliminated. Legislative review in each country could present difficulties, but that is unlikely. With an agreed text in hand, the investment environment is more certain. So is the monetary policy outlook. Only Mexico faces any medium-term difficulties from the deal. However, a new FX provision signals a new twist in U.S. trade demands for the rest of the world. We will further examine the deal in future reports.

Figure 1: NAFTA Area Currencies—FX Manipulation Now Part of the Deal

Source: Federal Reserve Bank of St. Louis, Continuum Economics

The big news about Sunday’s NAFTA deal between Canada and the U.S. is that the deal is done. Individual details pale in importance next to the fact that certainty about trade rules has been restored. The agreement keeps NAFTA (soon to be the United States-Mexico-Canada Agreement—USMCA) alive for at least another 16 years, and includes a method for further extension. That part of the agreement, which replaces the sunset provision demanded by the U.S., should lead to a pick-up in NAFTA-area investment. Reaching agreement also means central bankers in all three countries can remove one big uncertainty from their economic outlooks. 

The U.S.-Canada deal is more or less what has been expected all along. Delays were largely to do with the U.S. pushing for changes that Canada had made clear it would not stomach. U.S. negotiators settled for the inevitable on Sunday because the congressional calendar gave them no real choice. 

A Push for Enforceable FX Rules

One notable feature of the new NAFTA deal is an enforceable FX manipulation provision. Because both Mexico’s peso and Canada’s dollar are very responsive to conditions in the U.S., FX manipulation is unlikely to be an issue. Rather, the FX provision represents a U.S. goal in other trade deals. The recently-signed deal between South Korea and the U.S. also contains a pledge that neither country will intentionally devalue its currency for trade reasons, but that pledge is largely unenforceable. The U.S. is likely to keep pushing for enforceable FX manipulation provisions in trade talks, and the USMCA stands as a model.

Labor Rules Hit Mexico 

Mexico has given more ground than Canada. Wage rules for autos that are duty free under NAFTA raise costs for Mexico, but not for the U.S. or Canada. That represents a tacit cap on Mexico’s share of the market for NAFTA autos and auto parts. The new labor standards provision also mostly affects Mexico, further raising labor costs.

There is clearly room for interaction between the FX provision and upward pressure on Mexican wages. Unless productivity gains fully offset the rise in wages in the tradeables sector—and we have serious doubts the incoming administration will be able to create the environment for such a development—the natural response is for the peso to weaken. If the peso were to weaken, the U.S., especially under the current presidential administration, might accuse Mexico of currency manipulation without regard to the cause of peso weakness.

Dispute Settlement Unchanged

Dispute settlement provisions of NAFTA are unchanged in USMCA. Maintaining a balance of power in dispute settlement was one of Canada’s fixed goals for the new agreement, along with preventing the inclusion of a sunset provision. Here, too, certainty is increased, to the benefit of investment prospects.

Canada’s Big Dairy Concession

In return for avoiding the U.S.’s five-year sunset clause and maintaining the existing dispute resolution system, Canada agreed to drop a couple of rules from its dairy marketing system. That gives the U.S. industry improved access to about 3.5% of Canada’s dairy market.

Auto Supply Chains Will Shorten

Content rules for autos have changed, requiring a higher share of North American parts for autos to receive tariff-free treatment. That will disrupt supply chains for a time, and require new investment in North American parts production. This will raise costs, and may boost employment. 

Old NewsThere Has Been Progress

Mexico faces real difficulties as a result of the new agreement–labor costs will rise. That is problematic, but better than falling back to the level of just another WTO trading partner. 

Otherwise, it is easy to forget the progress that has been made because most of it was made during work-a-day negotiations over things like e-commerce early in the process. More trade has been brought under the open-trading NAFTA (USMCA) umbrella.

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Analyst Certification
I, Kevin Harris, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.