January 1, 2004, marked the 15th anniversary of the implementation of the Canada-US Free Trade Agreement (FTA), which largely formed the basis of the North American Free Trade Agreement (NAFTA), including Mexico as a partner, that came into effect exactly five years later at the beginning of 1994.
Both agreements were seen as epochal and were the subject of intense scrutiny and debates in Canada (at least with respect to the FTA) and the United States and Mexico (at least with respect to NAFTA). In retrospect, they also must be put in context of the broader trend toward the increased liberalization of global merchandise trade, invest- ment, and flows of services and peoples after the Second World War, as well as technological changes affecting transportation and communications. These trends toward more deeply interconnected world economies called for new rules, beyond simply those affecting trade in goods at the border that had been the mainstay of the rounds of negoti- ations on the multilateral General Agreement on Tariffs and Trade until the 1970s. In some ways the FTA and NAFTA served as role models for the subsequent agreement on the Uruguay Round of multilateral trade negotiations.
Given that various proposals have recently surfaced to facilitate even further the exchanges between the US and Canadian economies, it may be useful to look back on what we know about how the FTA and NAFTA did or did not work and about economic integration in North America more generally, and to ask what questions remain or what les- sons can be drawn as we look to the future. To that end, this article reviews some of the recent analysis and data relevant to the evaluation of how the FTA and NAFTA have affected Canada, and attempts to draw some conclu- sions relevant to the future of Canada’s economic position in North America.
Economic integration is typically analyzed by looking at four broad types of cross-border flows: trade in goods, trade in services, investments and people. These distinctions are use- ful in terms of examining the breadth of North American integration across a range of activities. I summarize the evolution of these four variables between Canada and the other two NAFTA countries in table 1. The table compares data for the years 1988 (the year before the FTA came into effect), 1993 (the year before NAFTA came into effect), and 2002. For investment, I show the accumulated stock of foreign direct investment (FDI, as distinct from portfolio investments) in Canada by NAFTA nationals, and by Canadians in other NAFTA countries. A sub-category of services transactions called ”œcom- mercial” services, which excludes trav- el, transportation (which often reflects trends in goods trade) and govern- ment-provided services, is also shown. Commercial services include, for exam- ple, cross-border flows of royalties and licence fees, financial services, manage- ment services, and architectural, engi- neering and other professional services.
These data are, in a first block of rows in the table, expressed as a share of Canada’s GDP, except the data on temporary worker movement (only shown for 1993 and 2002), expressed as a share of Canada’s total employ- ment. The picture that emerges from these lines is unambiguous: all the key trade and investment cross-border flows with NAFTA countries, as well as the temporary presence of Canadians working in other NAFTA countries, have assumed a much bigger impor- tance relative to Canada’s economy since 1988.
These flows overwhelmingly rep- resent transactions with the United States. Canada’s merchandise imports from Mexico, Canadian direct invest- ment to Mexico, and two-way flow of temporary workers between Canada and Mexico have grown markedly faster than the corresponding transac- tions between Canada and the United States since 1988, but they did so from a very small base, and hence they have slightly reduced but not chal- lenged the dominance of US flows for Canada as far as intra-NAFTA relations are concerned.
These intra-NAFTA data can also be expressed relative to similar transac- tions between Canada and all coun- tries, and I have done this for trade and FDI flows in a second set of rows in the table. Of note here is how much more subdued, when not in fact sub- merged, the just-noted increased importance of intra-NAFTA transac- tions becomes, when compared to the increasing flows that Canada has also experienced with the rest of the world. Note however, that 2001 and 2002 were years of exceedingly slow growth for the United States economy, and also ushered in noticeable increases in the costs of transacting business across the US border due to the fallout from the September 11, 2001 terrorist attacks. (Total Canadian goods and services trade as a share of GDP are shown in figure 1.)
In other words, while our interde- pendence with NAFTA increased across all key indicators, Canada’s relation- ships with the rest of the world in some cases grew even faster, notably with respect to flows of Canadian direct investment abroad. Furthermore, even though Canada’s goods trade with its NAFTA partners rose much faster than that with the rest of the world, Canada has not actually increased its share of the total US import market during the period.
It could be tempting to conclude on that basis that North American free trade has had little overall impact, and that most of the explosion in trade is due entirely to the booming American economy for much of the period and attendant rise in US imports (figure 2). But this would not likely be the correct conclusion. We cannot expect North American integration to proceed in isolation from other rapidly evolving global trends and events, and the broad numbers may hide significant shifts on the ground. For example, while Canada has not gained share in total United States imports, it has in fact done quite well, relative to many traditional competitors, since the FTA. If one excludes the emergence of Mexico on the US market since NAFTA (and the 1994 peso devaluation), and the huge progress that a rapidly mod- ernizing China is making in the world’s major markets (including Canada, where China has displaced Japan as the number two importer), Canadian producers have done well relative to the rest of the field (see table 1). Indeed, early signs clearly had shown that by 1995 Canada-US trade was booming specifically in those sec- tors that were liberalized by the FTA, and relative to trade with other coun- tries, suggesting a positive impact on trade flows from the trade agreement.
This is not to say that subsequent competition from Mexico or China is to be taken lightly. On the contrary, it is important both to understand who the competition is and to adjust our strategies accordingly, a point to which I will return below.
A similar observation applies with respect to FDI. China and other large and promising markets have opened themselves up to foreign investors since the FTA came into effect. It is not suprising that these new and fast growing markets exert a profound attraction on global firms, including Canadian ones, leading to a neglect (but only a relative one) of markets that in any event are already well ”œmined” by foreign investors, such as Canada’s.
Another factor might be at play in the Canada-NAFTA investment rela- tionship. Foreign direct investment used to be, in part, the means by which foreign firms could ”œjump” over a country’s tariffs and access its mar- ket. With tariffs between Canada and the United States falling to zero for the vast majority of products, some of the increased cross-border trade could have substituted for products that might have otherwise had to be made locally by a subsidiary. In other words, trade reduced the need for FDI as a means of accessing markets, which would be consistent with the increas- ingly standard finding that investment is now in large part a complement to trade, not a substitute for it.
Having said this, there appears to have been a structural shift in Canadian investments in the United States toward services industries rather than goods production. During the first year of the FTA, in 1989, 33 per- cent of Canadian FDI in the United States was in services. Today, that ratio is close to 65 percent. This shift, which seems to be continuing with recent announcements of substantial Canadian acquisitions of US firms in the insurance and retail sectors, including Manulife’s purchase of John Hancock, may be a sign that many Canadian services companies are pur- suing, through investments, the verti- cal integration achieved through trade by their colleagues in manufacturing. Indeed, Statistics Canada has shown that, relative to manufacturers, Canadian service providers tend to serve their foreign clients more through majority-owned affiliates in foreign countries (Marth 2003). In part, this is because the nature of cer- tain services makes it difficult to pro- vide them without having a significant physical presence in the market. Having said this, the US services mar- ket remains more open to Canadian services exports than most others around the world.
Clearly, vertical integration (coun- tries specializing in various stages of production in a wide range of prod- ucts, as opposed to each country spe- cializing in different industries) has been more intensively pursued than specialization by industry between the NAFTA partners. Indeed, a key trend there has been the increased use of imports from each other as inputs into our exports to each other. Thus, the typical Canadian export was made up of 33 percent imported goods and serv- ices in 1999, up from 26 percent in 1988, according to Statscan in 2002. This increased ratio ”” evident across resources, manufactured goods and commercial services exports ”” under- lines the greater sensitivity of North American production to potential bor- der disruptions, as well as the increas- ingly self-defeating nature of protectionist measures between coun- tries. A similar phenomenon has sprung up from more open trade between Mexico and the United States.
The temporary movement of people for economic reasons has also experienced a significant leap during the period. Here again, one may spec- ulate that these temporary exchanges of talent may well be the sign of more vertically integrated economies and are often supportive of Canadian exports or Canadian investments.
Greater integration has had a posi- tive effect on Canada’s produc- tivity performance. The importance of productivity (producing more or better goods and services with a given amount of resources) is hard to over- state as a key underpinning of well- being, regardless of whether one thinks that standards of living are suf- ficiently approximated by GDP (economic output) or not.
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A number of micro-economic studies show that greater trade integra- tion with the United States has been positive for Canada’s productivity per- formance. They suggest, simply, that free trade fulfilled its mission by rais- ing the productivity of Canada’s man- ufacturing industry beyond what it would have been otherwise. A by-now classic reference is Dan Trefler’s 2001 paper ”œThe Long and Short, of the Canada-US Free Trade Agreement.” In the same vein, a more recent 2003 Statistics Canada study by John Baldwin and Wulong Gu concludes Canadian manufacturing plants that have increased their exposure to export markets accounted for three- quarters of manufacturing productivi- ty growth in the 1990’s, even though they accounted for less than 50 per- cent of manufacturing employment.
While Canada’s manufacturing employment continued on its secular downward trend relative to total employment, its decline since the FTA was nothing like the decline in manu- facturing employment that character- ized the US economy during the same period. The establishment survey conducted by the US Bureau of Labor Statistics shows that US manufacturing employment now stands at less than 12 per- cent of total US employment, compared to 17 percent in 1988. Canada appears, relative- ly, like a manufacturing power- house, with average weekly earnings in manufacturing (including overtime) rising by five per- cent in Canada since the free trade agreement, relative to earnings in other sectors of the economy. Furthermore, the structure of Canada’s goods exports under the FTA has shifted markedly away from the traditional resource base, and toward non-resource exports, now accounting for some 55 percent of all exports, and no longer absolutely dom- inated by automobiles (see figure 3).
To be sure, there are serious clouds on the horizon. As useful as free trade has been in helping Canada shed its image of hewer of wood and draw- er of water, there are dangers in the position that Canada finds itself in. It is clear that the low Canadian dollar during much of the period has also been a very significant factor in sus- taining the Canadian manufacturing success. The recent rise in the Canadian dollar is now testing the basis of this success. And in a way this will be a good thing, for as Mexico is finding out, low costs are not a sus- tainable basis for competitiveness in the face of emerging economies. If Canada is to sustain its penetration of the US market, it will have to be on the basis of innovative products and supe- rior quality.
Having said this, as is widely known, and in spite of the boost pro- vided by free trade, Canada’s overall productivity performance did not keep pace with that of the United States. OECD statistics show that labour pro- ductivity in the business sector increased by 26.5 percent in the United States since 1988, or 1.7 per- cent per year, compared with 20.3 per- cent or 1.3 percent per year in Canada. This result runs explicitly against the hope that, thanks to free trade, Canada’s productivity could catch up to that of the United States.
What went amiss on that score, then? Recent studies point to two pos- sible explanations: a rise in self- employment, and a lack of innovation. Rather than reaping huge economies of scale from free trade as some had predicted, Canada’s produc- tivity initially increased through the shedding of workers in non-competi- tive firms, according to a 2003 Statscan analysis. To be sure, workers remaining in industries that modernized in the face of foreign competition, and the myriad consumers benefiting from lower prices and greater choice, were ”œwinners” from free trade. But, as the table shows, this was also a period of high unemployment due not only to those initial losses to liberalized imports, but to other factors that made it hard for employment to gain trac- tion at the time, such as the punish- ingly high level of the Canadian dollar at the beginning of the 1990s, undermining export efforts in the short run, and the beginning of serious fiscal retrenchment in the public sector.
This period coincided with an extraordinary mushrooming of self- employment, with the self-employed not having the level of productivity as those remaining in the incorporated business sector. This factor alone can account for most of the productivity differential between Canada and the United States, according to a Statscan analysis.
Another, possibly complementary, explanation focuses on innovation. Kais Dachraoui and Terek Harchaoui in anoth- er 2003 Statscan analysis found that while there was a revival of Canadian produc- tivity after 1992 relative to US levels, this revival was due to the progressive adop- tion of best-practice existing technology in Canada, presumably in the face of greater international competition. However, while Canada was copying best practices, the United States was able to keep its lead by pushing the innovative frontiers in new industries.
While many of the studies of the impact of free trade just mentioned have focused on manufacturing wages and employment, there is no doubt that services were also profoundly affected. This was not necessarily due to any liberalization that was con- tained in the FTA or NAFTA, since many trade and investment restrictions remained in the service industries under these two agreements. Rather, the need to serve customers who were themselves coming under greater com- petitive pressure provided the back- drop for changes in the Canadian services sectors. CN is the prime exam- ple of this, having reoriented its entire rail and service infastructure from being geared to east-west trade to being able to serve north-south trade. While CN did shed workers in the process, there is evidence that free trade favoured employment and earnings of workers in trade-related services indus- tries ””those services most linked to both export and import activities.
This exploration of the impacts of the FTA on the nature of North American integration and on Canada’s economy, while short and inherently incomplete, raises a number of questions moving forward.
Thanks to more open trade, Canada has improved and in many cases real- ized its potential to become a more pro- ductive economy overall than would otherwise have been the case. Thanks in part to the low Canadian dollar relative to its US counterpart, it has certainly been competitive in NAFTA. But, as I have sketched out, the world is moving rapidly, and simply holding the line on competitiveness is not sufficient.
Mexico provides a sobering object lesson in this respect. Quite apart from the difficulties that had been predicted and that have sadly come true with respect to Mexico’s newly liberalized agricultural sector, with attendant social and migration and environmental prob- lems, the Mexican economy faces for- midable emerging competitors. Yet Mexico has not fully taken advantage of the opportunities afforded by NAFTA to transform itself into a dynamic econo- my that could, among other things, provide better employment for dis- placed agricultural workers. The main lesson there is the role that domestic policies do or do not play in ensuring that economies can properly compete under conditions of more open transac- tions with the rest of the world. In the Mexican case, an energy sector strug- gling for capital under state ownership, and a poor tax structure and tax collec- tion that in turn starve the public sector of much needed funds for infrastructure and education, seem to be key culprits.
The point made above concerning the productivity travails of the Canadian economy under free trade also suggest some lack of flexibility and innovation domestically, preventing the capture of potential benefits from the larger market. It is remarkable that innovation has been such a buzzword of public policy for so long, and that governments at all levels have pro- duced countless studies and strategies aimed at improving Canada’s innova- tion performance, and that we still find ourselves with a major shortcoming on that score. Yet there are strong reasons to think that the larger and richer the markets in which we operate, the greater the returns to innovation and, conversely, the lower the relative incomes of those who do not have the skill or talent to innovate. In that light, every policy area and major public investment, from health care to cultural policies to the subsidies being sought by the automobile indutry, should be reviewed to ensure that it does not stifle or discourage innovation. Similarly, the case is strong that some elements of Canada’s tax mix are out of synch with building a more innovative and pro- ductive economy in the context of open trade, notably our relatively strong reliance on income-based rather than consumption-based taxes (note that this is not necessarily a question of the overall tax levels needed to fund public services).
The emphasis I have just put on bringing domestic policies more in synch with the more open economy does not mean that we should not address the many flaws and unfinished business of exist- ing trade agreements. But it is important to take the time to do this right, because the experience of the FTA and NAFTA also shows that par- tial liberalization has a cost, and indeed can corner participants into clearly sub- optimal situations. For example, the incomplete liberalization of transporta- tion services is a major element prevent- ing the full realization of the benefits of trade in goods, as noted by Mary Brooks in her 2003 paper, ”œMapping the New North America.” This is just one illustra- tion of the fact that it makes less and less sense to discuss strictly goods trade liber- alization (for example, under a customs union), without also considering how we can improve the cross-border relationship more generally (for example, concerning dispute avoidance and settlement) or address complementary flows of services, investments and peoples.
Thus, while NAFTA remains a major asset in Canada’s economic arse- nal, the lessons from our own experi- ence and elsewhere is that the world keeps moving, and that continued adaptability, as well as taking greater account of the complementarity of policies in various areas, is the name of the game.
