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Trump, Trudeau, Tariffs, Trade, Tijuana - The asymmetric impact of tariffs between the NAFTA partners

Special

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  • The Trump administration decided to impose tariffs on aluminium and steel on Canada, Mexico and the EU. By imposing retaliatory tariff packages that are more or less in line with the absolute export value targeted by the US, Mexico and Canada argue that their measures are proportionate. In reality, however, the macroeconomic impact of the recently announced measures deviates to a substantial degree, with the smaller NAFTA partners getting the worst of it. This suggests that the bargaining position of Mexico and Canada is weaker.
  • However, the US can push its neighbours only so far. With the key obstacles remaining firmly in place, with more aggressive rhetoric being fired north of the border, and with a potential new government south of the border, it is certainly not a stretch to suggest that the odds of a renegotiated NAFTA are declining.
  • Our simulations show that a NAFTA breakdown would slow down all three economies, with the Canadian economy almost coming to a standstill in 2019. In case of a full-fledged global trade war, all three economies could face a recession in 2019, with Canada hit the hardest.

The current trade spat between the US, Mexico and Canada could have negative implications for the economic outlook in North America. In this Special, we take a closer look at the direct impact of the recently announced and implemented protectionist measures, the possible implications for the renegotiations of the North American Free Trade Agreement (NAFTA), the impact on specific Food & Agri product groups and a scenario where things get really messy: a hard NAFTA breakdown or a full-fledged global trade war.

Trade hawks seem to have the upper hand

The past couple of months the US administration seemed willing to de-escalate the tensions over trade. Pending US duties on steel and aluminium from Canada, Mexico and the European Union (EU) were postponed on several occasions and South Korea even got a permanent exemption. Moreover, there were positive signals that progress was made in the renegotiations of NAFTA and a deal would be possible in the short term. And on 20 May, the framework agreement between the US and China resulted in a statement by Treasury Secretary Steven Mnuchin that the “trade war was put on hold”.

However, over the last few weeks the US president’s rhetoric on trade has changed remarkably. On 29 May, the White House announced that is still planning to put a 25% tariff on USD 50bn of Chinese goods that contain industrially-significant technology. On 1 June, the Trump team chose to press ahead with the installment of 25% steel and 10% aluminium import duties on Canada, Mexico and the EU, despite initially suggesting that Canada and Mexico would remain exempt as long as NAFTA negotiations continued. In the aftermath of the G7 summit and President Trump’s rejection of the communique, Canada and the US ended up in political mud-throwing, so it doesn’t take a leap of faith to suggest that NAFTA negotiations will be even more fraught going forward. Moreover, President Trump has tweeted that his team is looking at tariffs on automobiles shipped to American shores. This refers to the section 232 national security investigation into auto imports which is due February 2019 and could serve as a basis to authorize tariffs in the automotive industry. US tariffs on auto imports would be far more damaging than the current steel and aluminium tariffs. Escalation would in particular pose problems for Germany, as the US is its largest auto export market. On 15 June the White House will release a list of Chinese products subject to tariffs under the already announced USD 50bn worth of goods.

It is unclear why the Trump administration radically hardened its stance on trade with allies, but it might be related to the domestic backlash and criticism in the US media and in US Congress following the framework deal struck with China. The influence of Peter Navarro and national security advisor John Bolton seem to be on the rise as the president is becoming tougher on trade. Navarro and Bolton are the most hawkish advisors within Trump’s team of foreign policy advisors. We may be coming closer to the point that it becomes difficult for either side to back down. The current trade spat could result in a situation similar to the Smoot-Hawley act, which probably exacerbated the Great Depression of the 1930s. The Smoot-Hawley act raised US tariffs on over 20,000 imported goods. Led by Canada, America’s trading partners retaliated, which resulted in a plunge of 61% in United States exports from 1929 to 1933. Although the exact damage of Smoot-Hawley on the global economy is disputed, there is universal agreement that no one ‘won’ that trade war and it only resulted in a sharp reduction of trade in the 1930s. This pushed negotiations towards multi-lateral trading agreements that would prevent similar situations in the future. If the tit-for-tat strategy we are seeing at this moment transforms into a similar situation to that was seen in the 1930s, the current integrated global trade system could start to disintegrate.

What will be the economic impact of the new tariffs?

Tariff packages

On 1 June, the Trump administration slapped 10% duties on aluminium and 25% on steel imports from Canada, Mexico and the EU. With these tariffs, the US targets roughly USD 18bn worth of Canadian steel and aluminium exports, which is approximately 7% of total exports to the US (figure 1). The duties on Mexico encompass roughly USD 8bn worth of Mexican steel and aluminium exports, which are around 3% of total exports to the US (figure 2).

Figure 1: Canadian steel and aluminium export constitutes roughly 7% of total export to the US
Figure 1: Canadian steel and aluminium export constitutes roughly 7% of total export to the USSource: OEC, Rabobank
Figure 2: Mexico steel and aluminium exports constitutes 3% of total exports to the US
Figure 2: Mexico steel and aluminium exports constitutes 3% of total exports to the USSource: OEC, Rabobank

In response to these tariffs, the Canadian and Mexican government immediately announced retaliatory tariffs. On 1 July, Canada will impose tariffs targeting 12.8bn worth of US goods, including steel (25%),aluminium (10%), yogurt, coffee, motor boats, sailboats, whisky, washing machines, shaving cream and even toilet paper. The protectionist measures by Canada targeting US household and food & agri (F&A) products by 10% are especially designed to hurt manufacturers geographically located in states where Trump received much support during the last election. Mexico has implemented tariffs which became effective on 5 June and target USD 2.9bn worth of goods, including steel (15% to 25% dependent on type of steel), whisky (25%) and a wide set of F&A products (mostly 20%) such as pork, cheese, apples and potatoes. The US is relatively vulnerable in the field of F&A, which constitutes USD 18.4bn and USD 17.8bn of export (7%) to Mexico and Canada, respectively. Moreover, Mexico is the largest market for US pork exporters (see box 1). Lastly, the EU responded to the US steel and aluminium tariffs by implementing a 25% tariff package targeting USD 3.2bn worth of goods, which will be effective on 20 June. In addition, two additional tariff packages covering 2.6bn (against on average 27%) and 1.2bn (against 10%) of goods in 2021 were announced.

Figure 3: US F&A and steel exports to Canada are important
Figure 3: US F&A and steel exports to Canada are importantSource: OEC, Rabobank
Figure 4: US F&A export to Mexico constitutes 7% of total exports
Figure 4: US F&A export to Mexico constitutes 7% of total exportsSource: OEC, Rabobank

Direct economic impact

To assess the direct economic impact of these protectionist measures on either side, ideally one would like to use a general equilibrium trade model, such as Global Trade Analysis Project (GTAP), which has incorporated tariff and non-tariff barriers for different product groups. However, for the purpose of just an indication of the direct economic impact of the current relatively small package of protectionist measures, we will create a more straightforward back-of-the-envelope calculation using export elasticities by Imbs and Mejean (2010). These elasticities are used to calculate the potential negative impact on the volume of exports as a result of higher export prices caused by the implied tariffs. We need to make a number of assumptions. First, we abstract from export substitution effects. This means that, for instance, Canadian steel exporters are not able to make up for export market losses instantly by exporting abundant steel to other parts of the world. Second, we do not assess the economic damage as a result of disrupted integrated supply chains, which are to a highly extent intertwined between the NAFTA partners (see Erken and Tulen, 2017). Third, we do not know the exact breakdown of the Canadian and Mexican tariffs packages into different product groups. For simplicity, we use the share of different product groups within total bilateral trade volumes to break down the total targeted export tariff package into different targeted aggregated product groups. Consequently, we relate the targeted product group’s value to the decreasing export market size to assess the decline in total exports of a country due to higher tariffs. The lower export values are subsequently used to calculate the impact on gross domestic product (GDP), by using a simple breakdown of GDP by expenditure components. Fourth, we do not take into account the mitigating effect of currency depreciations due to the protectionist packages. In reality, a depreciation of the Canadian dollar and the Mexican peso would mitigate some of the negative impact on export market shares due to higher tariffs and, hence, export prices. Finally, we only distinguish between three product groups: steel, aluminium and F&A, whereas we know that, for instance, Canada is also targeting household products. However, it is important to keep in mind that most of these other product groups are all targeted at a 10% rate, which determines the extent of losses of export market shares. In the end, the label of the product group does not determine the impact on the macro figures. In Table 1 we show our calculations.

Table 1: Impact of tariff packages on GDP
Table 1: Impact of tariff packages on GDPSource: Trademap.org, OEC, Imbs and Mejean, Department of Finance Canada, European Commission, WTO, Bloomberg, Rabobank.
* Estimate based on the rough shares of the different product groups within total exports to the US

The impact of the steel and aluminium tariffs is especially large for Canada. According to our calculations, the 25% duties could essentially wipe the entire US market share of the Canadian steel sector. This is due to the fact that the export elasticity in Canada are relatively large (up to almost 4). This could result in a 12.7bn decline of Canadian exports to the US, which comes down a GDP loss in 2018 of -0.7ppts. Mexico’s steel exporters could lose 75% market share due to the American tariffs[1], hurting total Mexican exports (steel and aluminium) by USD 5.1bn, which is equal to -0.4ppts of GDP.

From a macroeconomic point of perspective, the current protectionist measures are nothing more than a pinprick for large economies, such as the US and the EU. For the US, the total set of protectionist measures by Canada, Mexico and the EU together would shave off 0.03ppts of GDP. In a same fashion, we have stated in an earlier report (in Dutch), that US steel and aluminium tariffs would go at the expense of 0.02ppts of EU GDP. This small impact does not mean that individual sectors, states and branches (see Box 1) do not feel the pain of the current measures, but from a macro perspective, the impact is hardly worth mentioning.

Given the large differences in economic impact, Canadian Foreign Affairs Minister Chrystia Freeland’s statement that “Canada has announced a perfectly reciprocal measured dollar-for-dollar retaliation response” is rather debatable. Mexico and Canada chose to launch a retaliatory tariff packages that are more or less in line with the export value in absolute terms. If these small countries would like to reciprocate the inflicted economic damage, however, it would make more sense to impose tariffs targeting a much larger volume of US trade. Of course, the most important reason for Canada and Mexico to refrain from such desperate measures is to prevent the situation from getting out of control. In the end, these economies are far more dependent on the US economy than the other way around.

Box 1: The impact of Mexican pork tariffs

The new pork tariffs introduced by the Mexican government as a retaliatory response to US tariffs on steel and aluminium has left Mexico and US in a difficult situation. The US currently accounts for 89% of Mexico’s total imports of pork with products like hams and shoulders being the main primal cuts imported. While there exists the possibility of some imports from other countries to increase, this will most likely come at a higher cost.

Mexico imported a total of 1,083 thousand tonnes in 2017 and is expected to import 1,200 thousand tonnes in 2018. Under the new tariffs, Mexico has allowed to import 350 thousand tonnes of duty-free including ham, shoulders and other cuts for the remainder of the year 2018. Considering through March imports at 275 thousand tonnes (CWE) plus 470 thousand tonnes of duty free imports (converted to carcass weight equivalent), yields a total of 745 thousand tonnes (CWE) with 450 thousand tonnes (CWE) subject to a 20% tariff.

The tariff free quota will help reduce the impact on the domestic market with only 38% of the imports being subject to tariff. Given that tariffs will take two stages, first, imposing a 10% tariff on pork imports effective June 5th, and on July 5th, adding the remainder 10% to a total of 20% tariff, industry will take advantage of increasing imports in June to avoid the full 20% tariff.

If the tariff is extended to 2019, Mexico will have to seek the possibility to reach potential deals with other countries, which might come at a higher cost. Canada being the closest, with the potential to export to Mexico chilled pork, will be the cheapest and the most preferred product as Mexico buys mostly fresh pork. However, transportation cost will be significantly higher. 

The US runs the risk of reduced demand from Mexico that could potentially decrease the prices of primal cuts that are exported to Mexico. While the US might find markets to export, cut-out values for pork will find downward pressure given increased stocks of hams and shoulder.

Second-order impact

Figure 5: Especially the MXN slid after protectionist measures were announced
Figure 5: Especially the MXN slid after protectionist measures were announcedSource: Macrobond, Rabobank

Besides the direct impact as estimated above, the NAFTA partners could be affected via different more indirect ways. Tariffs can have an impact on the economies by negatively affecting the sentiment among consumers and investors. Especially investors might delay their plans when they are insecure about further trade-restrictive measures. This could reduce investment in the involved countries, which hurts consumers by lower job growth. The exchange rate is the second channel that could have an indirect effect. Exchange rates will most likely depreciate when countries are hit by tariffs that have a negative impact on their economies, through less exports and higher import prices for consumers and producers. A depreciating currency makes imports even more expensive resulting in more inflation. The higher domestic prices will weigh on domestic consumption. Exporters that import intermediate goods also face higher prices and become less competitive. Although the Canadian dollar (CAD) barely budged after announcements by the Trump administration to press ahead with the steel and aluminium tariffs, the Mexican peso (MXN) showed some weakness. It is difficult to determine whether this weakness should be attributed to the US-Mexican trade tensions or to rising concerns relating to the upcoming Mexican presidential elections and it is important to note that it occurred against a backdrop of broad-based emerging market currency selling as well.

NAFTA renegotiations

When we looked at the economic impact of a (partial) NAFTA breakdown back in January we noted that “negotiations are currently set to conclude before the end of 2018Q1”. “Currently” proved to be the operative word as (soft) deadline after (soft) deadline came and went. At the start of the year, Canada, Mexico and the US all highlighted the importance of concluding negotiations in time for the US Congress to approve before the November mid-term elections and before the July 1st Presidential elections in Mexico. That will not happen now. Indeed, since that juncture, President Trump stated that “I told the Mexicans we can negotiate forever”. As far as he is concerned, uncertainty mainly impacts investment in Mexico and that is just fine from Trump’s point of view. Unfortunately for Mexico, he is probably right and investment does continue to suffer south of the border. Canada has also lost some of its edge in terms of relative attractiveness as an investment destination in the aftermath of the US corporate tax cuts. We still hear of optimism with Canada’s Minister Freeland stating that a win-win-win outcome is absolutely possible, but at the same time Freeland herself noted that it will “take as long as it takes”.

Going forward, the negotiations are no longer studded with deadlines and the main storyline reflects a familiar theme; NAFTA is close but major obstacles remain. Indeed, the market seems to be experiencing NAFTA fatigue with CAD and MXN seemingly less sensitive to NAFTA headlines than earlier in the year. Given that there has been little progress on the key topics this is somewhat understandable. So what are those key topics now? The answer to that is the same as when we wrote our analysis back in January, namely the sunset clause, dispute panels, and rules of origin. These remain the three main hurdles holding up NAFTA negotiations. Although the nuts and bolts of negotiations seem to have hit a wall, rhetoric has certainly intensified recently. As we highlighted earlier, the G7 summit early June ended with some rather choice words from the Trump administration about Canada’s Prime Minister Trudeau. On 9th June Trump tweeted: “PM Justin Trudeau of Canada acted so meek and mild during our @G7 meetings only to give a news conference after I left saying that, “US Tariffs were kind of insulting” and he “will not be pushed around.” Very dishonest & weak. Our Tariffs are in response to his of 270% on dairy!”. Trump’s trade advisor, Navarro followed up saying: “A special place in hell for any foreign leader that engages in bad faith diplomacy with President Donald J. Trump and then tries to stab him in the back on the way out the door.” “And that's what bad faith Justin Trudeau did with that stunt press conference. That's what weak, dishonest Justin Trudeau did, and that comes right from Air Force One.” Strong words indeed and hardly a positive sign when it comes to NAFTA negotiations.

South of the border, events could soon complicate negotiations from Mexico’s side as well. Back in January, López Obrador (AMLO) of the MORENO party was leading the polls but now that lead has surged substantially and at 50.8% (according to Bloomberg’s poll of polls) he is currently polling more than double the next highest polling candidate, Anaya, of the PRN (24.8%) and Meade of the PRI (21.6%). Although it is not a foregone conclusion, it is fair to say the likelihood of an AMLO victory in the July 1st Presidential election is very high. The recent Parametria poll also showed that voter intentions imply the MORENA-PT-PES coalition may achieve 37% of seats in the Lower House and 39% of seats in the Senate. PAN are polling at 16% and 17% respectively, while PRI stands at 14% and 12% respectively. Polls are notoriously poor at predicting the outcome of seats in both houses, and even if accurate this time it does not imply an outright majority for AMLO’s party, but it does point to the possibility of that being achieved and does certainly imply that the coalition may attain a significant number of seats. It is fair to say AMLO is of the left-leaning populist ilk. During this election cycle he has moderated his tone and moved closer to the center but one can argue that a leopard does not change his spots and we could still see a more dramatic shift to the left if he wins. So what has AMLO said about NAFTA? Trade with the US is vital to the Mexican economy given that in recent years Mexican exports to the US have counted for around 25-30% of Mexico’s total GDP and AMLO has not suggested he wants to destroy NAFTA noting that "we are not looking for a bilateral agreement with the U.S. or Canada. The trilateral agreement is what we want,” That said, AMLO has been clear that over-reliance on the US is not how he envisages Mexico’s future and he would like to redirect the economy towards the internal market. In his own words: “I am going to suggest that the treaty remains, but (the end of NAFTA) cannot be fatal for Mexicans, our country has a lot of natural resources, a lot of wealth,” and “no NAFTA is better than a bad NAFTA”. In short, while adding to uncertainty surrounding NAFTA negotiations, a potential new government come July 1st does not provide a kiss of death to negotiations.

All this said, with the key obstacles remaining firmly in place, with more aggressive rhetoric being fired north of the border, and with a potential new government south of the border, it is certainly not a stretch to suggest that the odds of a renegotiated NAFTA are declining and the potential move to bilateral agreements is steadily increasing.

The messy scenarios: termination of NAFTA and a global trade war

Although the economic impact of the current trade spat from a macro perspective is limited for the US, it does not take much imagination to see how things could evolve into a more messy situation. In two earlier Specials we have calculated what would be the economic impact on North America in case of a NAFTA breakdown or if the US would end up in a full-fledged global trade war with its main trading partners. Here we recapitulate the most important results for the NAFTA partners.

United States

Figure 6: US trade war would result in a 2019 recession
Figure 6: US trade war would result in a 2019 recessionSource: NiGEM, Macrobond, Rabobank

If the current trade spat would result in the termination of NAFTA, we can expect the US economy lose out on 1% of GDP growth over five years’ time (figure 6). In 2019 growth in US would slow to 1.7%, instead of the 2.3% growth that we would expect with NAFTA still intact. Things could take a turn for the worst if the current round of tariffs are the opening shots for ongoing tit-for-tat protectionist measures. In case of a global trade war scenario[2], the US would face a recession in 2019 and, ultimately, would lose out on 6% of GDP up to 2024 vis-à-vis our baseline.

Mexico

Figure 7: Mexico’s economic recovery from a NAFTA breakup or trade war would take a long time
Figure 7: Mexico’s economic recovery from a NAFTA breakup or trade war would take a long timeSource: NiGEM, Macrobond, Rabobank

Mexico has much more to lose in case NAFTA would not live to see another day. Our calculations show that the total cumulative GDP loss vis-à-vis the baseline would be 2.6ppts up to 2025. In that sense, López Obradors’ remarks that the end of NAFTA would not be fatal for the Mexican economy is backed by the numbers, but nevertheless it would be painful. A global trade war would inflict much more damage. Especially up to 2021, the Mexican economy could be facing -5.3ppts of missed economic growth. One could question why a global trade war scenario the US is facing a deeper recession than the smaller, exporting Mexican economy, especially since we argued in this Special that the smaller NAFTA partners are the more vulnerable ones. This can be explained by the fact that in our global trade war the US is facing retaliatory tariffs from all its trading partners, whereas Mexico only has to cope with 20% additional tariffs by the US.

Canada

Figure 8: Canada would be hit severely in either messy scenario
Figure 8: Canada would be hit severely in either messy scenarioSource: NiGEM, Macrobond, Rabobank

The stakes for Canada are high to prevent being caught up in any of the two messy scenarios. In case NAFTA gets terminated, Canadian economic growth would almost grind to a halt in 2019 (0.2%). In case of a global war, the situation even brings back memories to the global economic meltdown in 2008 and the economy could shrink by 2.7% in 2019. This might also explain why Canadian officials are reluctant to retaliate the US steel and aluminium tariffs with a more extensive package of protectionist measures.

Conclusions

Our calculations show that the economic impact of recent US tariffs on aluminium and steel imported from Canada, Mexico and the EU, and the retaliatory measures taken by the trading partners, is asymmetric. While GDP growth in the large US economy is hardly affected, the negative impact on Canada and Mexico is more substantial. While the Canadian and Mexican retaliatory measures are proportional in absolute terms, the impact is asymmetric in relative terms due to the larger size of the US economy. This response reveals the weaker bargaining position of Canada and Mexico as they stand to lose more in case of escalation of the trade conflict.

However, remarks by Trudeau and López Obrador suggest that the US can push its neighbours only so far. This makes it increasingly likely that we could see the end of NAFTA. A breakdown of NAFTA would have a negative impact on all three economies. US GDP growth would slow down moderately, but the impact on Mexico and Canada would be more substantial. The Canadian economy could even come close to recession in 2019. However, a further escalation into a full-fledged global trade war could push all three countries into recession. Again, the Canadian economy would be hit the hardest.

Footnotes

[1] For Mexico, we use the export average elasticities of Indonesia and Portugal as a proxy.

[2] In our trade war scenario we have added an additional import tariff of 20 percent on all US imports and assume that US trading partners will install retaliatory additional tariffs of 20% on all imports from the US.

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Author(s)
Hugo Erken
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 52308
Christian Lawrence
Rabobank KEO
Philip Marey
RaboResearch Global Economics & Markets Rabobank KEO
+31 (30) 2169721
Andrick de la Payen Diaz Vega
Rabobank KEO
Koen Verbruggen
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 1297 3956

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