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NAFTA Negotiations: Canada Steps up to the Plate

On Monday, the U.S. and Mexican NAFTA discussions resulted in an announcement of a bilateral trade agreement. This agreement includes augmented rules of origin for autos, strengthened intellectual property protections, guarantees of a more level playing field for financial services, and enhanced protections for labour and the environment. (A more complete list of achievements can be found on the Office of the U.S. Trade Representative website.)

The agreement is far from complete, as both sides still have to hash out details. Most importantly, a lot of what has been agreed upon still requires approval by the Canadian government in order for the trade pact to remain trilateral, and roughly 10 of the 30 chapters in NAFTA remain incomplete. Given that it took about 2 months to achieve the current U.S.-Mexico terms without Canadian participation, the August 31st deadline imposed by the U.S. Trade Representative is likely unachievable. However, it’s in the economic interest of all three political leaders to forge an agreement, even if it’s only one in principle against the short political timeline.

Trying to expedite the process by proceeding with a bilateral trade deal to the exclusion of Canada at this juncture also comes up against a big hurdle. The current Trade Promotion Authority (TPA) granted to the U.S. President allows for fast-tracked approval relates only to the current trilateral agreement (i.e. NAFTA). Pushing for a bilateral agreement would likely require a procedural time lag through the dissolution of NAFTA and advance notification to both Congress and trade partners. At the same time, any new bilateral agreement(s) would require at least 90 days, and up to 180 between notification and consideration by Congress.

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Therefore, unless Canada is pleased with what’s on the table and can proceed at a rapid pace of negotiation, it will likely be difficult for the current sitting U.S. Congress to pass any agreement before elections in November. That said, there can still be “agreements in principle”. Doing so, however, does not remove the risk of the ball being placed onto the field of incoming new governments in Mexico and the U.S.

Until then, NAFTA will remain in effect in its current, unrevised form, leaving time for consideration by Canadian Parliament. Although the U.S. administration may threaten to pullout from NAFTA, a complete nullification of the agreement would require Congressional approval, something that may be unpopular within states that have strong trade inter-dependence with Canada, particularly in the lead-up to U.S. midterm elections this fall.

Some wins for Canada in the new agreement

The augmented rules of origin for the auto industry are considered a win for manufacturers located in higher cost jurisdictions such as Canada and the U.S. The changes include requiring that 75% of auto content be made in the U.S. and Mexico, and that 40-45% of auto content be made by workers earning at least U.S. $16 per hour. Importantly, there is much wider breadth in the products that qualify as North American auto content, including all components of the vehicle, company headquarters and research and development facilities. This should make for an easy hurdle for Canadian manufacturers to surpass, with a large share of U.S. and Canadian manufacturing facilities (and products) already meeting these new requirements.

Concerns of a ‘sunset clause’ have been alleviated and this is a positive development. The agreement will be reviewed every six years. At that time, if one or more parties expresses a desire to alter the trade pact, there would be a ten year window to resolve issues before the agreement would end. There is a key difference in the incentive structure that is created by a sunset clause versus the current review period proposal. The former is typically structured as an “opt-in” clause that requires all three countries to formally confirm their commitment to the trade pact, otherwise it would automatically be dissolved over some specified time period and process.

The initial U.S. sunset clause proposal was on a very short time frame of 5 year cycles, which would create far too much business uncertainty. In contrast, a review period reflects an “opt-out” approach. A country needs to deliberately provide notice to terminate the trade pact, otherwise it continues in its current form. In addition, even in the event that a country raises this possibility, the ten year window for resolution offers far more line-of-sight to businesses.

However, not all progress is for the better

Although the auto agreement purports to benefit higher cost manufacturers in Canada and the U.S., consumers are likely to be the losers. The higher cost of parts and assembly will likely be passed onto consumers. Moreover, at the moment higher cost North American producers are not shielded from lower cost foreign producers, where business models may dictate that the lower cost option remains to simply pay the current 2.5% tariff on non-North American auto parts and vehicles in order to remain in full compliance to the new rules of origin. This incentive structure could cause the U.S. to revisit a higher tariff imposition for other countries, via Section 232 on grounds of national security. In turn, this would keep trade wars front and center for other countries, with the consumer ultimately holding the bill at the end of the day.

To this end, there are reports that the U.S. and Mexico have negotiated a side agreement imposing a quota on Mexican auto exports. The imposition of quotas on Canadian vehicles entering the U.S. would be a negative outcome. Avoiding it may be difficult. The U.S. can use the threat of additional tariffs, including the previously threatened 25% tariff on autos and auto parts, or non-tariff barriers in an attempt to strong-arm Canada to come to an agreement sooner rather than later.

Indeed, with the U.S. Commerce Department due to deliver the results of its Section 232 investigation into auto and parts imports (the same grounds used to impose steel and aluminum tariffs), this side agreement may represent a template for U.S. negotiations with Canada and other major auto exporting nations, like Europe.

Strengthened intellectual property laws to the U.S. standards of 75-year copyright and 10-year data protection for biologicals, may be deemed as a threat to certain Canadian industries, such as the thriving Canadian generic pharmaceuticals industry.

Many questions remain

The ultimate status of the current dispute resolution mechanism remains in limbo. Under the U.S.-Mexico agreement, some U.S. industries will remain fully protected by the current dispute process, such as energy, infrastructure, transportation, and telecoms, but others may face a more limited dispute resolution process. Canada would prefer that the current or improved dispute resolution mechanism remain in place, with international panels preferred to local courts. Interestingly, under the current system, U.S. businesses have been the top users of this mechanism (Chart 1).

The path forward for agricultural sectors is also an open question. CETA, which saw Canada agree to an expansion of dairy import quotas, may provide a template for negotiations. It remains to be seen how Canadian negotiators balance the sensitivities of dairy and other protected agricultural industries against potential impacts on auto manufacturing and other sectors. Should the Canadian government feel it necessary to cede on dairy supply management in order to mitigate risks elsewhere in the trade pact, they would likely be able to provide direct support to the industry, as is typically done within the U.S.

Access to U.S. government procurement for Mexican and Canadian firms remains uncertain.

Not much impact yet for monetary policy

News of progress on NAFTA and Canada’s rejoining of negotiations appears to have lifted some of the trade-related uncertainty, based on markets’ positive reactions. The loonie gained more than 1% on the news of a U.S.-Mexico agreement, even with Canada not having been part of the talks! This speaks to the market confidence that a broader deal is at hand. The TSX has risen about 0.2% since news broke last Friday of a potential agreement this week.

The impact of these developments for the Bank of Canada’s policy interest rate path is likely neutral in the near term (2018), and slightly hawkish in the medium term (2019-2020). The Bank has incorporated a drag on economic growth from trade policy uncertainty that kept the level of GDP about half a point lower than it would otherwise have been by the end of 2020. To the extent that this uncertainty is lifted, a stronger forecast will be the result, and this can lead to a quicker pace of monetary tightening.

However, we are not out of the woods yet, and uncertainty is likely to prevail in the near term. While progress on negotiations will be welcomed by Governor Poloz and company, we do not expect any significant change in the path of monetary policy or the communication thereof at this juncture. This has not increased the likelihood that they’ll raise rates at the upcoming September meeting (market implied odds have in fact fallen since the weekend). The most probable timing for the next hike remains October.

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