Despite the uncertainty raised by the NAFTA renegotiations, seizing the opportunity to update a 23-year-old trade agreement can be a positive development. Notwithstanding the significant benefits that NAFTA has provided its three members in recent decades, the agreement no longer reflects many important intervening economic and technological developments. To name a few key areas, NAFTA rules of origin (which determine whether goods qualify for North American tariff preferences), labour and environmental standards, intellectual property rights, investor-state dispute settlement, and government procurement rules could all be updated and improved.
Modernizing NAFTA could also advance Canada’s interests in services and internet commerce — areas that would also support U.S. jobs and innovation. Fortunately, recent negotiations on next-generation trade agreements, such as the Canada-European Union Comprehensive Economic and Trade Agreement (CETA), can be a model for NAFTA renegotiations in key areas. So too could the Trans-Pacific Partnership (TPP), even though the U.S. has withdrawn from it.
NAFTA’s eroding benefits
There are three main reasons that NAFTA’s benefits have eroded over time. The first relates to the era in which the agreement came into force in 1994. At the time, the World Trade Organization concluded the Uruguay Round negotiations that reduced “most-favoured nation” (MFN) tariffs for many countries, across many sectors. As a result, the tariff preferences enjoyed by Canada and Mexico relative to other countries in the US market shrunk over time. It’s not surprising, then, that NAFTA utilization rates (i.e., the share of firms that seek tariff preference when exporting to another NAFTA country) have fallen, since many NAFTA preferences are no longer big enough to offset the cost of demonstrating compliance with NAFTA rules of origin (requirements to qualify for NAFTA’s preferential tariff rates instead of the MFN rate).
Second, the U.S. has subsequently signed new trade deals with 20 other countries (including with Australia, South Korea, and countries in Central and South America), and the tariff preferences that were extended to these countries further dilute the notion of ‘preferred’ market access for the original NAFTA partners.
Canada’s preferred access to the US market has been further eroded by a third development: enhanced security measures introduced after the terrorist attacks of 2001, which have thickened the Canada-U.S. border. There’s little chance that the U.S. under Trump would relax its security measures, but NAFTA renegotiation might offer a chance for fresh talks between Canada and the U.S. that would combine the issues of trade and security, as part of a win-win strategy. In effect, Canada could offer a security deal to the U.S. in return for a better trade relationship.
For instance, Canada might propose a North American ‘security perimeter’ in exchange for a Canada-U.S. custom union. Such an approach could establish a common external tariff (i.e., a common Canada-US tariff policy with respect to other countries). This would define a clear external trade perimeter, on which an external security perimeter could be imposed. This could, at least theoretically, be designed so as to liberalize (i.e., to remove) the post 9/11 security measures and decongest the Canada-U.S. border while possibly shifting these security measures (and associated direct administrative costs) at the external border for relations with the rest of the world. Decongesting the Canada-U.S. border would encourage production and foreign investment in the U.S. (and Canada) — something that President Trump would welcome.
In previous research, Marcel Mérette and I estimate that liberalizing the 9/11 security measures at the Canada-U.S. border would increase trade between Canada and the U.S., coming at the expense of American trade with the rest of the world. It seems that firms located in North America, and especially in the U.S., reacted to additional security requirements by shifting some of their exports away from Canada to the rest of the world. Liberalizing security measures at the Canada-U.S. border would help reverse this pattern.
U.S. security measures may also have incented Canadian firms to shift their production directly to the U.S., instead of manufacturing at home in Canada, and then exporting to the US. Thus, we might also expect to see some economic activities repatriated to Canada, from Canadian multinationals now located in the U.S. Finally, U.S. multinationals located in the rest of the world might also reinvest in the U.S. and in Canada, thereby raising continental production.
That said, developing a North American security perimeter would involve trade-offs, with enhanced trade coming at the cost of a potential erosion of Canada’s sovereignty over things such as intelligence data sharing, joint law enforcement and migration procedures, as well as pre-screening of foreign imports and travellers. It remains to be seen whether Canadians and Americans could cooperate more fully on these controversial, but important issues.
Renegotiating NAFTA Rules of Origin
In the NAFTA renegotiation, the U.S. is likely to seek changes to rules of origin (ROO). It may seem strange that the U.S., which is the country with the most liberal most-favoured nation tariffs in NAFTA, also insists on strict ROO. This dynamic reflects the outcome of intense lobbying by interest groups. Trade negotiators (in the U.S. and elsewhere) have consistently sought narrow benefits that they could offer stakeholders and key industries in exchange for their support for trade deals. In some cases, rules of origin have fit the bill to offer those benefits, and this game will no doubt continue in NAFTA renegotiations. Several groups will lobby against liberalizing rules of origin, as these rules have helped them secure a market for their intermediate products in Canada and Mexico, and have forged continental supply chains. But other forces will also lobby to prevent excessive new restrictions on trade, such as any withdrawal of the U.S. from NAFTA, because this would disrupt their supply chains, raise their production costs, and might eliminate rules of the game that have been advantageous for them.
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If rules of origin are renegotiated, then Canada’s strategy should be to seek more consistency between the new NAFTA rules and those recently negotiated under CETA. It would be much better for Canada to avoid having two separate rule books to deal with when our firms seek preferential treatments — one when they export to U.S., and one when they export to the EU. (The best way forward here might be to propose a process similar to the “diagonal cumulation” system implemented by the EU to simplify life for businesses across its numerous FTAs.)
More fundamentally, traditional rules that assign origin to only one country are getting harder and harder to apply in practice given globalized production. Canada could help to develop next-generation rules based on the idea (first expressed by Australian scholar P.J. Lloyd) of designating goods from multiple origin countries. Value-added tariff rates would increase with the proportion of the value that is added outside of the free trade area, and shrink to zero when the value is entirely from the FTA.
Diversify away from the US over the long-term
The overarching challenge in NAFTA renegotiations will be finding ways to maintain and enhance Canada’s access to North American markets. Over the longer-term, however, our strategy must be to continue to diversify our geographical trade patterns since North America is destined to become a smaller share of the global pie. From this perspective, CETA is helpful, but it’s not enough. We need to look beyond slower-growing advanced economies to realize the benefits in emerging markets, such as China and India, which are among the most dynamic producers and major consumer markets around.
My previous research, which focuses on demographic differences across countries, suggests that Canadians would tend to lose from a diversification scheme that simply shifts its trade away from the US, towards other advanced economies such as the EU or Japan. This result is due to the fact that the latter regions are undergoing even faster population ageing than the U.S., so this shift in trade could actually strain Canadian firms’ competitiveness, because the prices of EU or Japanese inputs are likely to increase relative to prices in the U.S. On the other hand, diversifying our trade away from the US, but towards India, China and the rest of the developing world is much more appealing proposition, and would tend to raise Canadians’ long-term per capita consumption possibilities.
Ironically, the recent and dramatic shift towards protectionism in the U.S. may actually reenergize stalled trade negotiations at the World Trade Organization, as some reluctant countries may refocus their efforts on supporting a global trading system that is now under threat. The current turmoil only strengthens the case in favor of the WTO and its relevance.
But Canada cannot sit idly by. Our negotiators should advance the non-preferential trade agenda at the WTO to the benefit of all countries. Meanwhile, we should also engage with large emerging countries such as China, India, Brazil, and the ASEAN countries. The scale and growth potential of these markets is huge, not just as a destination for Canadian goods, but also as a more efficient way for Canadian firms to exploit global supply chains.
This article is part of the Trade Policy for Uncertain Times special feature.
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