Chinese Economics of the NAFTA Deal

NAFTA negotiations really targeting China

I am going to posit an unpopular opinion: the Trump administration scored a big win striking an agreement in their deal with Mexico. This is a win in a lot of different ways for them.

  1. Is it a win for free trade? No, not really but it is mixed. It is designed to increase intra-NAFTA trade while restricting the benefits to non-members. So it may or may not be a win for global free trade, but it is a win for NAFTA free trade (more about the diversionary impact later). However, by definition any regional trade agreement is not a win for global free trade.

  2. Is it going to materially impact growth? No, not really but it is mixed. There will likely be some reorganization of supply chains inside and outside NAFTA, but very little here suggests this will have a material impact on the macroeconomic picture.

  3. Why did Mexico agree to the deal? This is a great deal for Mexico. While most analysis focuses on the US and China as trade competitors, the reality is that Mexico and China compete much more on specific products than the US and China. The increased rules of origin along with the wage specifications, give Mexico a clear path to grab more business in key industries and move up the value chain. For most of the prohibitions or demands, Mexico simply does not factor significantly as a violator. While they will likely have to upgrade certain regulations or tweak some laws, it is unlikely to impose significant costs but deliver significant potential benefits.

  4. Why did Trump strike a deal with Mexico? The real target in this deal (which I will get to shortly) is not Mexico or Canada, but China. The Trump administration is trying to divert trade from China or trade that will come from China in the coming years, from China to Mexico/NAFTA. In reality, the deal is pretty straightforward in what you would expect to see with regards to many of the provisions that we have seen so far. The rules of origin requirements that are likely to divert trade to NAFTA members is a relatively small concession to Mexico but important to the larger goal.

  5. What happens to Canada? Canada got outflanked by the Trump administration. The Trump administration struck a good deal with Mexico that Mexico is happy with. Trump has framed the agreement, by that I mean, he is effectively giving Canada a take it or leave it agreement. Canada may be able to get some marginal changes but Canada cannot come in and demand any significant changes at this point without having to just walk away. Mexico and Canada received different benefits from the rules of origin requirement. By striking a deal with Mexico first, who received more benefit, Trump has backed Canada into a corner.

  6. What are the likely economics implications?

a. The big question about the impact will be the economic efficiency of the impact of trade diversion into NAFTA and away from other countries. By this I mean, what will be the impact of buying more parts intra-NAFTA rather than outside NAFTA and layering on top of that the low skill parts outside of NAFTA and the high wage parts intra-NAFTA? Here is what I suspect, and feel free to disagree respectfully of course. Assume there are currently, for simplicity sake, four parts needed to make a car. Each part costs $20, $15, $10, and $5 respectively. For simplicity sake, lets assume that currently the $20 and $15 parts are made inside NAFTA and the $10 and $5 parts are not. Under the new agreement, I think we can expect the $20 part to remain unchanged, the $15 part rise to a $16 part, the $10 part move to Mexico, and the $5 part stay outside of NAFTA. Again, this is a very simple model, but this would meet the general requirements before and after. What we see primarily is a diversion of trade to Mexico as the primary recipient with some increased work likely going to the US and Canada. However, the major question, which is very difficult to know with good foresight is the impact of trade diversion from the rest of the world to the trade agreement partners.

b. I suspect this will result in a boost of investment into Mexico making middle to high grade parts leaving all the $5 parts to the rest of the world. Think of Toyota investing in the US after the voluntary export restraints, we are likely to see companies looking to set up shop in Mexico. Furthermore, do not be surprised if a lot of the component manufacturing is in those products where wages would pay (round numbers) $12-16. Here is why: there are going to be a lot of car companies looking for manufacturers looking for suppliers that pay on average $16 an hour. That means high grade components, say products where the average wage is $25/hour in Canada and the US will be guaranteed business, but to meet the input requirements, there will also be demand for mid and mid to high grade components where the wage rate might be $15. If the average input for 40-45% of the car needs to earn $16 an hour, that means Mexico can make a lot of parts at $12-16/hour improving upon its current wage rates. Expect to see a boost to investment in Mexico targeting this type of work.

c. Expect to see a good amount of game playing to get to the $16 an hour average wage especially in Mexico. For instance, companies may elect to drop benefits but pay a higher hourly wage or include the benefits into how the hourly compensation is calculated. Anytime you see a semi-arbitrary number, you see people fiddle their numbers at the margins to get to the arbitrary number.

  1. Any losers from this new agreement? We have already mentioned Canada but what is notable is that the real target of this deal is China. Everything about this agreement says it was crafted with China in mind. Mexico went along because they are being given a big opportunity to take market share in key areas away from China due to trade diversionary rules of origin. Probably the biggest problem for China is not just the text of the agreement but whether China can start putting to bed all these unnecessary fires he started. If he can roll up a coalition of countries who are at least as frustrated with Chinese protectionism, starting with Mexico, this could be a real game changer in the bigger trade war.

  2. Any other winners? AFL-CIO must be over the moon that the Trump administration included wage levels in a trade agreement. This has been a major request for some time. For a Republican president to do this says just how much things have changed.

This is in a reality a not that important trade agreement as a measure of trade creating and minimizing trade diversionary distortions. It will have probably almost no impact on macroeconomic activity though maybe in Mexico. Its importance in what it sets out to achieve however, is very important.

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