After USMCA, Taking Aim at China?

11 October 2018

After years of describing NAFTA as “the worst trade deal in history”, the Trump Administration along with Canada and Mexico signed the US Mexico Canada Agreement (USMCA). The White House, naturally, hails the accord as a historic triumph for American workers and farmers. Critics view the deal as a simple rebranding of NAFTA —  NewFTA or NAFTA 2.0, if you will. Mexico and Canada, meanwhile, just seem relieved the negotiations are over, realising it could have been worse. What is the truth about USMCA’s impact? Can we draw any lessons about the future of the Trump trade agenda?  Two important conclusions appear to be coming into focus. If the aim of trade negotiations is to benefit the overall US economy, the US trade agenda needs to focus more on economics and less on domestic politics. And, a showdown with China is becoming increasingly likely.

USMCA: NAFTA 2 or Something New?

Key features of USMCA include:

  • Greater access for American farmers to Canada’s dairy market
  • Inclusion of the digital economy in the negotiations
  • Raising the local content requirement — to 75%  from 62.5% — in order to receive tariff-free status.
  • Requiring that 40% of products’ value added comes from factories paying workers more than $16 per hour.
  • Limiting the 3 nations’ ability to enter FTAs with non-market economies: that is, China.

Do this changes represent an improvement compared to NAFTA, e.g. more trade, lower prices, more jobs?  On the positive side,  most observers agree that NAFTA needed an update. For example, the digital economy barely existed 25 years ago, so its inclusion in USMCA  is beneficial. Likewise, liberalisation of Canada’s dairy market will benefit some American farmers. However, the sums are so small, estimated at $70 million, that they will have no impact on the US economy overall.

On the other hand, the other features have the potential to produce less trade, fewer jobs, and higher prices.  The increase in local content requirements is meant to impeded the trend towards including components from lower-cost third parties, usually China and Asia. In practice, rather than upsetting existing supply chains, North American manufacturers are more likely to pay the additional tariff (on average only 2.5%), and attempt to pass the cost to consumers.

Of course, the requirement that 40% of value added comes from factories with high labour costs is aimed at boosting US jobs, especially in the auto sector (at the expense of Mexico). While that may happen, it is also possible that manufacturers will simply pay the additional tariffs.  In either case, the result will be higher prices. Alternatively, consumers may simply buy cars produced in cheaper, non-USMCA regions of the world (especially as import duty on cars is only 2.5%).

What can we learn from the USMC experience that will help predict the outcome of trade talks elsewhere? First of all, America’s external deficits will not be corrected as long as the Trump Administration continues its focus on bilateral issues, and ignores the macro factors causing the US trade deficit. In particular, America’s external shortfall reflects the nation’s low savings rate, which has been made worse by the rising US budget deficit. In 2018,  for instance, despite excellent export performance, America’s trade deficit has widened 15%, as imports have surged. Chart 1 illustrates that the twin deficits are projected to expand in tandem in coming years.

In addition,  there is a pattern emerging. In both the USMCA and the recent Korean trade agreement, the Trump Administration talks tough, but ultimately settles for deals  involving only minor changes. While the outcome is welcome, this sort of tactical brinkmanship causes business uncertainty, and may reduce US credibility in future negotiations.

Furthermore, the Trump Administration’s focus seems to be on the impact on domestic politics rather than economics. It is not overly cynical to observe America’s focus on the auto and dairy sectors, with the voters in Wisconsin and the rust belt in mind. A new plan is needed. To maximize the benefit to the overall economy, US negotiators should seek to liberalise trade in sectors in which demand is strong and the US enjoys a comparative advantage, e.g. services, technology, health care, media, etc. (Although it is true the US is very competitive in agriculture, and  faces protectionism virtually everywhere).

Also, the next Chart illustrates that trade imbalances with Canada and Mexico were never big problems: their Export/Import ratios were not out of line with America’s trading partners world-wide. Does the Chart provide clues as what to expect, as US trade policy turns elsewhere?

Europe: Germany Should Act More Boldly

Although Europe is the America’s top trading partner, the Trump Administration has promised to take action against the region’s mercantilist policies which, he believes, have led to a $100bn bilateral  deficit. As with North America, however, the Chart above illustrates that Europe’s export/import ratio is not out of line with other American partners.  Macro-imbalances appear to explain most of the bilateral deficit. Specifically, US domestic demand has been far stronger than European spending in recent years.  American negotiators should pressure EU nations to boost spending.

Europe also points out that when the activities of multi-national corporations (MNCs) are included (sales by US firms operating in Europe and EU firms in the USA), the United States actually enjoys a surplus with the European Union!

US trade performance with individual Europe nations is also revealing. The USA runs deficits with 21 of the 27 EU members, which highlights the macro causes of the imbalance.  Moreover, roughly 2/3 of the US deficit emanates from just two countries: Germany and Italy.

Germany must act more boldly to reduce its unacceptably large current account surplus (through more expansive fiscal policies) in an attempt to avert a transatlantic trade war. Italy, meanwhile, must implement reforms aimed at lifting productivity, which will boost incomes, spending and imports.

As in NAFTA, American negotiators overly focus on trade in food and automotive sectors. Unfortunately, however, the EU is unlikely to agree to major changes in agricultural policies. And, European automakers have already called on EU leaders to cut tariffs on US car imports. Instead, America should focus on sectors in which future demand will be strong. As one example, EU  imports of US services  could be much higher, especially in Germany, France and Italy (Chart). Liberalisation of Europe’s service sector — where America enjoys a competitive edge — would create vast opportunities for US firms.

Japan: Aging Gracefully?

Even though Japan has the third largest deficit with the USA (and is its 4th largest trading partner), they have managed to remain out of the limelight.  Geopolitics have been important, as the United States relies heavily on Japan regarding North Korea.  And, America hopes Japan can play a role in curbing China’s regional influence. However, as formal talks are about to commence, there should be much to discuss, especially as Japan’s very low export/import ratio suggests impediments to bilateral trade exist (see earlier Chart).

What can we expect?  First of all, unlike USMCA partners, Japan will not be pressured to limit its deepening trade ties with China.  While exports to China only account for 3% of foreign sales for Mexico and Canada,  they represent 20% for Japan. And, the Chart shows China will soon be Japan’s top trading partner.

The following Chart illustrates that Japanese tariffs on manufactured goods are extremely low, and are not a factor in its bilateral surplus.  However, Japan’s trade surplus increases further when activities of MNCs are included, which suggest strong non-tariff barriers exist (earlier Chart).

How to reduce the imbalance? First of all, an earlier Chart shows Japanese domestic demand has been even weaker than European spending in recent decades. However, Japan confronts formidable impediments to higher spending. Higher government debt, for example, rules out fiscal expansion (in fact, tax hikes are planned for 2019). Moreover, demographic trends — the dramatic shrinking and aging of the population — will continue to dampen demand (Chart). As in much of Europe, deregulation and reform aimed at boosting productivity are crucial to lifting incomes, spending, and imports.

Understandably, the USA will want to focus on automobiles and agriculture. Even though Japan is America’s largest foreign market for agricultural products, and food already  accounts for nearly 20% of US sales to Japan, very high tariffs suggest that considerable trade expansion remains possible. While Japan is likely to offer similar concessions provided in its FTA with the European Union, wholesale liberalisation is unlikely.

Amazingly, motor vehicles account for virtually all of the bilateral trade deficit ($53bn of the $57bn total). The motor vehicle industry is hugely important in Japan:  the industry accounts for 9% of employment and 20% of factory output.  Exports, especially to the USA, are critical — 50% of domestic production is sold abroad, half of which heads to the USA. Even though Japan imposes no import tariffs on autos, the domestic market is heavily protected. American automakers are not alone, vehicles represent only 3% of Japanese imports.  US demands for greater access are understandable, but would face serious political resistance. Alternatively, Secretary Ross urges Japan to produce more cars in the USA.  However, Japan’s US production is already twice as large as its exports to this vital market. Indeed, the Chart shows that production in the USA has increased 60% since 2000, and Japan already accounts for roughly 30% of vehicle production in the United States.

American should also pressure Japan to boost import of US services — the earlier Chart shows that sales in this key sector are a fraction of their potential. Focus also on sectors demanded by an aging population, e.g. health care, robotics, AI, etc.  Currencies could be a talking point, as the Chart illustrates that the Japanese yen is quite undervalued (as are the Mexican peso and Canadian dollar).

China: Too Big to Fail?

With North America resolved and Japan too vital on North Korea and other regional issues, US trade policy increasingly will take aim at China.  In an earlier blog entitled “Three Sides to Every Story“,  I expressed hope that mutual interests would prevail, and the world’s two largest trading nations would strike a deal. I still believe that the relationship is too big to fail, but worrisome patterns have emerged.

Firstly, the bilateral trade balance continues to deteriorate. Through August, America’s deficit with China expanded 8%, largely as imports expanded another 9%.  Unfortunately, I expect this will continue. This year’s expansion in US fiscal policy is further depressing the national savings rate with direct links to the trade balance.

Second, China’s economy continues to decelerate, reflecting the ongoing transitions in the domestic economy and trade tensions.  I anticipate China’s underlying GDP growth is slowing towards 4-5%. This could make China less willing to make large concessions.  In response, the PBOC has eased monetary conditions, and the CNY has depreciated — much to the chagrin of the Trump Administration. Reflecting these uncertainties, China’s foreign reserves have slipped in recent months. So far, the pace of outflows does not match 2014/15, but watch this space.

Third, the Trump Administration is  attempting to add pressure by persuading third nations not to sign FTAs with China. Canada and Mexico, surprisingly, have agreed. Japan will not, as China has become a vital trading partner. Likewise, European leaders view the US administration as unreliable, and are building relationships elsewhere, e.g. FTAs with Canada and Japan. Likewise, China is responding by attempting to improve relations with Russia, India and others.

In addition, China appears to be hoping that a poor result for the Republican party in upcoming US mid-term election will shift American public opinion on this trade dispute. This is a miscalculation. To be sure, Americans love Chinese consumer products, but there is a strong consensus that China is not playing by the rules, e.g on technology transfer, state subsidies, and IP theft. This issue will not go away.

Finally,  in a recent speech US Vice President Pence outlined a more assertive approach to America’s overall relationship with China.  China got the message. In such an environment, the likelihood of a deal may have declined. At this stage, I expect additional tariffs on Chinese exports at the beginning of 2019.

Nevertheless, I am remain hopeful mutual self-interest will prevail eventually. There is simply too much at stake. And, frankly, there are so many steps China can take which would both be in their own interest and appease the USA. To be sure, this bilateral relationship will remain competitive and contentious, and likely will become ever more complicated in coming decades. Commercial ties will develop incrementally, let’s hope the first step is taken during the next 6 months.

Strategic Implications

  • MXN and CAD are both undervalued. I expect both to rally, especially the Mexican peso.
  • The Japanese yen, likewise, is cheap. However, strong US economic growth points to additional USD appreciation in coming months (criticism of the Fed notwithstanding).
  • Rising US bond yields pose risks to global equity markets –See my 2019 Strategy blog.
  • Trade tensions and Fed rate hikes will pressure EM markets for at least six more months.