From NAFTA to USMCA.
From Globalization to Regionalization.
Could a regional trade deal disrupt global supply chains?
Daniele Langiu, Managing Consultant & Blockchain Local Group Leader – IBM Italia – Global Business Services – Fabio Sdogati, Professor of International Economics – School of Management Politecnico di Milano.
Mr. Trump has been president of the US for nearly two years now, two years during which all and any kind of interpretations have been offered on his approach to trade policy (we write ‘his approach’ since in the US the president does not need a vote of confidence by Congress on such matters). We believe that despite tactical and strategic about-faces and a general sense of disorientation, it has become possible to identify the basic elements of a ‘stable’ strategy that will ‘make America great again’ – in the eyes of the beholder, of course. Our point is that the ‘stable’ strategy has emerged around the end of August 2018 with the demise of North America Free Trade Agreement and the launch of its substitute, USMCA (the interested reader can find here the United States-Mexico-Canada Agreement Text). We suggest that in order to comprehend the characteristics of the ‘final’ strategy we ought to follow the making of the ‘stable’ strategy in its three stages over the past two years.
1. The strategy roadmap
Strategy in the first stage
In the first stage, beginning at the end of electoral year 2016, the Trump strategy appeared to be aimed at that splendid isolation dreamt by nationalists the world over: that was the meaning of ‘make America great again’. Indeed, at different times or contemporaneously, country by country or groupings of countries at once, many countries went under attack by the US president: China was the first and most harshly attacked for its ‘unfair trade practices’, but then the EU came under fire, especially with respect to trade in automotive products; the focus shifted then more heavily on Germany, while at the same time showing a very cautious attitude towards the enthusiastic offers of cooperation by Ms. May, who believed that she had found a powerful economically just because Trump was saying that he liked people whose mother tongue is English; and, of course, frequent and often harsh have been verbal attacks against Mexico and Canada, the close associates of the US in the North American Free Trade Agreement since 1994. It is crucial to our point to emphasize that the attacks against the other two members of the agreement were encompassing all sorts of issues, from migration to trade in dairy products, and that those attacks appeared therefore to be really far-reaching and, at times, harsh. All in all, one could say that the first stage represented the triumph of words and verbal threats.
The second stage: implementation of a traditional restrictive trade policy
The threat-and-scream stage carried out on press conferences and interviews and through tweets, an operational stage has followed. The type of implementation we have observed did not introduce any relevant difference relative to that which we call here ‘traditional commercial policy’. In short, the most used among the tools of commercial policy was the one that appears as the most prominent in international trade textbooks: the import duty. What was notable from this point of view is that very heavy import duties were imposed not on imported final goods, but rather on intermediate products, and very important ones at that: steel and aluminum.
Such choice. This was a very surprising choice, in that steel and aluminum protection duties are expected, at least prima facie, to favor domestic producers by inducing an increasing domestic price for those goods. From the point of view of the economy as an aggregate the negative effects of such a duty are easily understood, and such more pervasive effect of an import duty imposed on intermediate goods used in a variety of production processes has already been emphasized by one of us. The point can be summarized as follows: an increase in the domestic price of products that are inputs to a very large number of domestic production processes, translates in increasing prices of the products using those inputs. The effects are several: one of them is that the duty is inflationary in most sectors; furthermore, the duty on imported inputs is also detrimental to the international price competitiveness of US-originated export products. It is ‘natural’ to think of the effects of the ‘indirect duty’ on those industries using steel and aluminum heavily such as house appliances, precision machinery, industrial and residential construction, infrastructure and, of course, one of the best examples is the automotive industry. In September,the Ford Motor CEO released information according to which steel and aluminum tariffs have cost the company about $1 billion in profits. Thus, it is not surprising that over the first half of 2018 the emphasis appeared to move away from traditional import duties towards the supply chains, while attention was focused on Canada and Mexico.
The third stage: Trump understands the importance of global supply chains, does not extend import duty policies any longer, and emphasizes instead production relationships as a terrain on which to implement commercial policies.
Rather unexpectedly, at the end of August 2018 we found out that the North America Free Trade Agreement, signed in 1994, was being phased out and replaced with a United States, Mexico and Canada Agreement (USMCA). We believe that the USMCA represents an important novelty in the way commercial policy will be implemented in the years to come, and the way it will affect the global character of supply chains.
NAFTA was a free trade agreement among the three countries. A ‘traditional’ agreement, therefore, whose scope was to ensure the free movement of goods and services and therefore the renunciation from each participant to use import duties. Moreover, ‘North America’ gave the impression that the parties to the agreement were ‘thinking big’, and use of the word ‘Agreement’ indicated the will to think, at least tendentially, less and less individually and more and more like an association where all the participants have the same importance. USMCA shows, instead, that the approach has changed, even though there is no consensus as to the directions in which the changes have occurred, or their impact. For instance, the Peterson Institute appears to make the point that USMCA is nothing but the old NAFTA, and the differences between the two Agreements are mostly of a cosmetic nature.
This is not our interpretations. Two articles of the Agreement appear to us revealing of the non-cosmetic, substantial nature of the changes introduced through USMCA.
2. The third stage strategy applied to the automotive industry
We are interested in the way the text of the Agreement documents a shift of attention away from the traditional tools of commercial policy, that is mostly import duties and quantitative restrictions, towards using directly changes in supply chain conditions to bring about desired (by the US government) changes in trade flows and location of productive activities. We show that scaling down his strategy from a ‘US alone matters’ to a ‘North America matters, so long as the US dictates the rules’, will result in a shift from multilateralism and globalization to bilateralism and regionalization. We are not interested here in the details of other parts of the agreement, and indeed we pay little or no attention to industries affected by the agreement other than automotive. We do not want to discuss the entire text of the Agreement, as we want to focus on the two most consequential changes from NAFTA. The biggest changes include higher rules-of-origin requirements for the auto sector, marginally greater US access to the Canadian dairy market, and a scale-back of the investor-state dispute settlement rules. The first change is the introduction of two measures pertaining to the auto industry to avoid tariffs: 1) Starting in 2020, 75% of an automobile’s content will have to originate within North America – an increase from 62,5%; 2) by 2023, 40-45% of production will have to come from workers earning on average at least $16 per hour.
Rules of origin requirements
Stricter rules of origin applying to parts and components for the automotive industry are by far the most important USMCA element affecting how firms will organize their supply chain over the coming years. Why? Because as early as the mid-seventies US companies have been fragmenting internationally their production process looking for productivity gains as well as new markets. Freer trade, guaranteed by NAFTA, and other factors have reduced the cost of shipping intermediate product cross-border and contributed to the fragmentation of the automotive industry supply chain: this means that some auto parts are produced in the US, then shipped to Mexico for assembling into finished vehicles; then some of these finished vehicles will be exported to the US market. It is shown that 74 percent of all the foreign parts used by vehicle assemblers in Mexico that export to the US are imported from the US itself. NAFTA was already requiring that 62,5% of an automobile’s content originate within North America. Accordingly to Nomura figures, most of the important automotive manufacturers were complying with this requirement. In short, their activities have created value mostly (at least 62,5% per cent of the assembled vehicle) in North America.
What would be the effect of a stricter rule of origin? The business case can be easily outlined: if the cost of reshuffling the supply chain is higher than the cost of the 2,5% tariff that will be in effect on parts coming from outside the USMCA area, USMCA firms may decide to pay the tariff costs and keep the supply chain as it is. But, we suggest that the first-round effect will be a higher degree of integration of the automotive supply chain within North America. A regional agreement, such as USMCA, will create even stronger bounds among North American firms aiming at free access to the US market. And these stronger trade bounds will be based on firms’ specialization decisions: most capital-intensive production tasks will be based in the US and most labor-intensive ones in Mexico. These will create a higher volume of intra-industry trade among US and Mexico. Of course, there is the risk that firms may start sourcing vehicle parts outside North America to further reduce the cost of cars production and cover tariff costs through this efficiency increase. But we think this could be a second-round effect, since it requires an even more complex supply chain reshuffling due to distance (not only geographic one). Trade theory states, in fact, that more similar and geographically closer two countries are, the more likely it is that they trade with each other. Since firms located in Mexico and Canada are better “positioned” than those located in other countries to trade with US partners, expect an increase in tasks specialization among US, Mexico and Canada and a regionalization of trade inside North America.
Traditional commercial policy does not regard factor costs in a country as a terrain of intervention by foreign countries. Indeed, we have been hearing plenty of gripes about countries taking advantage of low labor costs to enhance the price competitiveness of their own products, but we have never seen what we are seeing with USMCA. The Agreement mandates that by 2020 between 40 and 45 per cent of the content that goes into vehicles must be made by workers earning at least US$16 an hour. This is designed to keep manufacturing in the US by raising the wages of Mexican workers until wage differentials with US workers becomes immaterial. The intention here is that such rule is discourages US firms from moving their production of components away from the US, rather than sourcing parts from Mexico. Another clause in the agreements will see manufacturers forced to buy steel and aluminum from inside North America, with the aim of increasing output at US steel mills. This rule is trying to define the automotive production technology: stating how much workers should be paid can drive the labor content car production share. US automakers have benefited from labor-intensive activities taking place in Mexico, and Mexican producers have benefited from US capital-intensive activities. Overall, the North America automotive industry has benefited from the specialization in task by increasing the overall efficiency and improving North America automotive industry international competitiveness.
Since Trump has begun his presidential campaign, the slogan “Make America great again” has been claimed for many and several policy areas, from climate change to international trade. Regarding international trade, beginning on the first quarter of 2018, Trump has introduced standard protectionist measure (import duties) that would prove damaging in a scenario of global supply chain where intermediate products are internationally sourced and contribute to US companies’ competitiveness. But it seems that something has changed with the USMCA signature. We think USMCA represents the stable strategy through which the share of global supply chain value originated inside North America will be boosted. This could cause a regionalization of trade where US companies will try to source their products in Mexico or Canada and investment will be growingly regionally, rther than globally, directed. We have contributed to develop a theory that by scaling down his strategy from a ‘US alone matters’ to a ‘North America matters, so long as the US dictate the rules’, will result in a shift from multilateralism and globalization to bilateralism and regionalization. Enhancing regional trade relative to global trade can disrupt global supply chains if companies involved in automotive supply chain find a more efficient way to specialize their production activities among US, Canada and Mexico in order to abide to the rules of origin and labor costs requirements. Sholuld such be the case, over the next few years North America could become an even more important automotive supply chain hub and firms located in the Mexico, Canada and, above all, the US, could increase trade with regional supply chain partners.
Degree in Management Engineering at the Politecnico di Milano achieved in 2013 with a thesis in the field of International Economics about deindustrialization of high per capita income countries. He has been working as a consultant in the Global Business Services division of IBM Italia for 4 years and he is currently responsible for the blockchain area for the aforementioned consulting division.
Degree in Political Science from the University of Rome, and a Master of Science and a Ph.D. (Economics) from the University of Wisconsin-Madison. He joined the Politecnico di Milano and Mip in 1990. He teaches Economics, Monetary Economics, and International Economics at both the undergraduate and the graduate level. His research interests span from the determinants of firms’ international competitiveness to the role of reserve currencies, from unconventional monetary policies to exchange rate determination. His research has been supported by a number of bodies including the Italian national research Council, the European Commission, the Ente Einaudi in Italy, the Miles Fund in the United States. He joined Mip managing Committee in 2006 and was in charge of Mip Open programs first and Corporate Education then. At present he is in charge of Public Lectures events.