Table of Contents

Page 3

USMCA Update

Michael Gregory, CFA, Deputy Chief Economist

The Importance of U.S. Trade with Canada

Page 7

National

Michael Gregory, Deputy Chief Economist

Sal Guatieri, Senior Economist

Page 11

Regional

Priscilla Thiagamoorthy, Economic Analyst

Page 14

Industrial

Aaron Goertzen, CFA, Senior Economist

USMCA Update

Introduction

On November 30, 2018, the leaders of the three North American countries signed the U.S.-Mexico-Canada Agreement (USMCA). So far, only Mexico has ratified the trade deal. To mark the upcoming one-year anniversary of the signing, we prepared this report, Making it Together: USMCA and U.S. Trade. It provides an update on deal-related developments and discusses the importance of trade with Canada for the U.S. economy.

Since last autumn, escalating U.S./China trade tensions, increasing risk surrounding U.S. and foreign trade policies, along with the consequences of these tensions and uncertainties for the U.S. and global economies, have pushed the USMCA to the backburner. But it’s against these developments that unencumbered access to North American markets becomes even more attractive for U.S. businesses. Total U.S. trade with Canada and Mexico, i.e., combined U.S. exports and U.S. imports of goods and services, was $1.4 trillion in the year ending June, with Canada alone at more than $720 billion, the most for any single country. This means about $2 billion of goods and services crosses the U.S.-Canada border every day. The USMCA should allow this to continue, and increase further.

Why USMCA?

Upon ratification in all three jurisdictions, the USMCA will replace the North American Free Trade Agreement (NAFTA) that has governed continental trade since 1994. NAFTA was due for modernizing, given how new goods and services have emerged in the past 25 years and the way digitalization has revolutionized commerce. Under the Obama Administration, the Trans-Pacific Partnership (TPP) was designed to update NAFTA and also expand it to other Pacific Rim countries [1]. The TPP was signed in February 2016, but Congress failed to ratify it by November. The subsequent election of Donald Trump marked a seismic shift in U.S. trade policy, with the new Administration interpreting the increasing U.S. trade deficit as the negative economic consequence of unfair practices by America’s trading partners, failure to enforce U.S. trade laws, and bad trade deals.

At the time of the election, the annual U.S. goods and services trade deficit totaled just above $500 billion or about 2.7% of nominal GDP. It has since widened to $656 billion (12 months ended July 2019) or around 3.1% of GDP (Chart 1). Interestingly, the trade shortfall has remained at a relatively stable share of GDP since early 2013, in a narrow 2.7%-to-3.1% range, after widening meaningfully in two waves. The first was after NAFTA came into force in January 1994 and the second was after China entered the World Trade Organization (WTO) in December 2001. Before the Great Recession (2006 Q3), the four-quarter deficit hit a record $778 billion or 5.7% of GDP, before shrinking massively. The latter emphasizes that, because of America’s propensity to import, the trade deficit tends to improve when domestic demand is weakening and deteriorate when demand is strengthening.

Although the total trade deficit has been relatively stable for six years, this masks extreme moves among the components. The U.S. ran a very large $244 billion surplus in services trade in the latest year (1.2% of GDP), with a record $900 billion deficit in goods trade (Chart 2). The latter, as a share of GDP (4.3%), was still not as bad as 2006’s nadir (6.2% in Q3). However, accounting for the steady improvement in the petroleum goods trade shortfall, the balance of trade in non-petroleum goods is currently at a record deficit both in dollar terms and relative to GDP ($858 billion, 4.1%).

A record non-petroleum goods trade deficit is not necessarily a bad thing because there are net economic gains from trade. However, the benefits are often diffused through the economy while the costs tend to be concentrated. Unfortunately, given America’s woefully inadequate trade-adjustment programs and alleged unfair trade practices by some partners (which the Trump Administration argues is particularly the case for China), the mounting goods trade deficit corresponded with a lengthening list of trade casualties that increasingly became a social and political problem. The response was President Trump’s “America First” trade-policy agenda, with its two key priorities of strictly enforcing U.S. trade laws (hence the proliferation of U.S. tariffs) along with negotiating new and better trade deals.

The first week in office, President Trump pulled the U.S. out of the TPP [2]. And having referred to NAFTA as the “worst trade deal ever”, the Administration informed Congress in May 2017 that it intended to renegotiate the North American deal. The first set of talks between the U.S., Canada and Mexico took place in August 2017. An agreement in principle was reached in the late hours of September 30, 2018, in time for the October 1 deadline [3].

A now-modern NAFTA

The USMCA achieves the goal of modernizing NAFTA, mirroring much of what the U.S., Canada and Mexico had already agreed to in the TPP [4]. Through its 34 chapters (NAFTA had only 22) and various annexes and side letters, the USMCA should facilitate even more trade in goods and services among the partners.

According to the International Trade Commission’s (ITC) required assessment published in April 2019, the USMCA should boost U.S. GDP by 0.35% and add more than 175,000 jobs [5]. This is arguably a modest gain from such a comprehensive trade deal. The ITC concluded that the various provisions that reduce policy uncertainty about international data flows, cross-border services and investment would have the most significant impact, along with the new rules of origin in the automotive sector. However, modeling how businesses would react to reduced uncertainty is fraught with uncertainty. The ITC employed a conservative assumption so there’s likely more upside here. Meanwhile, raising the North American and higher-wage vehicle content for tariff-free trade is estimated to boost U.S. automotive production and jobs. But, this would likely be offset by projected increases in vehicle prices that would hurt the broader economy via pared purchasing power [6].

Part of the appearance of a modest net economic gain from the USMCA reflects the fact that the three economies have already reaped much of the benefits of lowering tariff and non-tariff barriers to goods trade under NAFTA, and two-way services trade is still only around 11% of total trade. The ITC’s analysis was also done with U.S. Section 232 tariffs on steel and aluminum in place, along with Canada’s and Mexico’s retaliatory tariffs. However, these have since been removed. The ITC’s analysis also did not account for the added attraction for U.S. businesses to “re-shore” global supply chains in North America amid a flare-up of global trade tensions, not to mention the potential boost to business confidence after ratification of the USMCA.

Where the USMCA stands

The Mexican Senate ratified the USMCA on June 19, 2019.

In Canada, the Trudeau government introduced USMCA-implementing legislation on May 29, but it wants to move “in tandem” with the U.S. (unlike Mexico). The legislation made its way to the final stages of the approval process, awaiting the U.S., but the October 21 election call will require it to be reintroduced in the next session. By the time the next session begins, and given the usual year-end parliamentary break, it’s likely that Canada will only be in a position to ratify the USMCA by early next year.

U.S. Trade Representative Lighthizer sent a draft Statement of Administrative Action to Congress on May 30, which gave the Administration the option to submit to Congress (after 30 days) implementing legislation and the final USMCA text to be considered by Congress. This has yet to take place. Under the Trade Promotion Authority (TPA), once these documents are submitted—and there are no modifications permitted in this “fast track” process—the House has 45 session days to consider it, then another 15 session days to vote on it. The Senate then has 15 session days to consider it and another 15 session days to vote on it. The whole process could take 90 session days to complete. Congress doesn’t meet every calendar day, so 2019 passage is looking iffy. Given that the trade deal cannot be modified, the Senate could consider it concurrently with the House to expedite the process.

If the House is not pleased with the timing of the Administration’s submission, say, because it wants some changes made to the trade deal beforehand, the House can still circumvent TPA procedures. This was done with President Bush’s Colombia Free Trade Agreement, which, after being submitted in April 2007, failed to be ratified by the time he left office in January 2009 (the House had Colombian labor issues). It was eventually ratified in October 2011 after renegotiation with Colombia under the Obama Administration. “Fast track” is sometimes not so fast.

Endnotes:

[1] The other countries were Australia, Brunei, Chile, Japan, Malaysia, New Zealand, Peru, Singapore, and Vietnam. A third motive for the TPP was to check the expanding global influence of China. ^

[2] Only Japan and New Zealand had ratified the TPP by then. After the U.S. pulled out, the remaining 11 countries agreed to a modified TPP called the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, which came in force on December 30, 2018 after the minimum six countries ratified it (a group which included Canada and Mexico). ^

[3] This was a deadline because, under the Trade Promotion Authority (TPA), there had to be a 60-day review period after signing the preliminary deal, and the term of Mexican President Enrique Peña Nieto ended on December 1. ^

[4] For the text of the USMCA, see https://ustr.gov/trade-agreements/free-trade-agreements/united-states-mexico-canada-agreement/agreement-between ^

[5] See “U.S.-Mexico-Canada Trade Agreement: Likely Impact on the U.S. Economy and on Specific Industry Sectors”. https://www.usitc.gov/publications/332/pub4889.pdf ^

[6] Technically, all of the net benefit of the USMCA is estimated to come from the provisions that reduce policy uncertainty. Not including them at all generates a 0.12% loss in GDP, which means the conservative assumption is adding 0.47%. A less conservative assumption would at least triple this impact. ^

The Importance of U.S. Trade with Canada

National

America is running a record $900 billion deficit in goods trade. China accounts for the largest share of the shortfall at 44.6%, followed by Mexico’s 10.8%, Japan’s 7.9% and Germany’s 7.6% (Table 1). Canada weighs in at 2.5% (10^th), lifting the NAFTA share to 13.3%, which still falls under the total EU (20.0%). Indeed, China and the EU have accounted for the vast majority of the deterioration in the goods trade deficit since the shortfall hit its post-recession low in early 2010 (Chart 3).

Bilateral trade balances by themselves say little about the importance of trade for the U.S. economy—it’s the underlying trade flows that matter. For example, you can have two similar-sized deficits but one shortfall reflects lots of exports and imports (the latter obviously being larger) and the other reflects a lopsided situation of mostly imports with few exports. The former trade pattern would be more beneficial than the latter in terms of production and jobs tied to exports.

So, while the U.S. has its second largest trade deficit with Mexico, it’s anything but lopsided. Mexico is the second largest destination for U.S. exports and the second largest origin for U.S. imports. The ratio of imports-to-exports, a measure of lopsidedness, is 1.37 for Mexico, meaning U.S. imports from Mexico are 37% larger than U.S. exports to Mexico. For China, the imports-exports ratio is 4.72, meaning imports from China are 372% larger than exports to China. Therefore, while America’s trade deficit with China is about four-times larger than with Mexico, China’s shortfall is 10 times more unbalanced than Mexico’s. The goods trade deficit with Canada is the most balanced among major trading partners, with imports only 7% larger than exports. Canada is the largest destination for U.S. exports and the third largest origin for U.S. imports.

U.S. exports to Canada are dominated by transportation equipment, along with non-electrical machinery (Chart 4). U.S. imports from Canada are dominated by transportation equipment, along with oil and gas (Chart 5). Having transportation equipment as the biggest slice of both trade pies (it’s the same with Mexico) is a testament to the integration of the North American automotive industry, owing to NAFTA and the greater efficiency of continental instead of national supply chains. As the saying goes, “we make things together.” Indeed, Canadian goods shipped to the U.S. have, on average, around 25% American content.

In addition to being more balanced overall, NAFTA deficits are concentrated in just one sector (Table 2). Excluding vehicles and parts, the U.S. has a slight trade surplus with Mexico among all other goods combined; excluding oil and gas, the U.S. has a large trade surplus with Canada. This means that North American trade flows are mirroring comparative advantages, which is precisely what free and fair trade is supposed to engender. Through comparative advantage—Mexico’s abundant and low-cost labor, Canada’s ample natural resources and highly-skilled workforce, and the U.S.’s dynamic business culture and thirst for innovation—each country gains more from trade than simply earning export revenue. Greater efficiencies in production translate into lower-priced goods and real wage gains that, in turn, generate new demand and jobs. By providing access to larger markets and lowering the cost of intermediate goods, trade also helps U.S. small- and medium-sized firms grow.

U.S. business exposure to trade is best reflected in combined two-way trade flows (Table 3). In the goods space, Canada comes in a close second ($612 billion) to Mexico ($621 billion), with the NAFTA duo combined doubling up on China’s tally ($610 billion). One thing to note on imports, having spent the past 25 years integrating the North American economy through trade and investment (and the past 30 years for the U.S.-Canada economy), imports from Canada and Mexico matter more to the U.S. than those from other countries because the income generated from exports in these two countries is more likely to be re-spent on American goods and services given integration’s legacy—a high propensity to import from the United States. Keep in mind that Walmart and Costco are major retailers in both Canada and Mexico.

Two-way trade in services with Canada currently runs above $100 billion annually, which pushes Canada to the top of the table in terms of U.S. business exposure to total trade. The latter now tops $720 billion, more than any other single country. This means that about $2 billion per day in goods and services crosses the northern border. And amid these massive trade flows, America has maintained a total trade surplus with Canada in recent years (Chart 6). Of note, Canadian tourists spend about $17 billion each year in the U.S. and make many more trips to the U.S. than the other way around.

Foreign Direct Investment

Besides trading in goods and services, investing directly in other countries is an important source of growth for U.S. companies. Establishing plants, warehouses and retail outlets abroad gives companies closer access to markets and suppliers, reducing transportation costs. Investing abroad can help North American firms better compete against China during the current trade war, say by operating plants in non-tariffed Asian nations that sell to China.

U.S. companies own fewer direct investments abroad (in the form of facilities or a controlling ownership in a business) than foreign investors own in the U.S. Direct assets held abroad totaled $8.2 trillion in 2019Q1, compared with liabilities of $9.4 trillion (Chart 7). The difference marks a reversal from the decade prior to 2016 when the U.S. had a positive net foreign direct investment position. This is partly because a stronger dollar has reduced the value of foreign-held assets. Following a weak 2018, U.S. purchases of foreign assets picked up in 2019Q1. Cross-country data are unavailable for 2018, but they show strong U.S. direct investment in China in the five years to 2017. Still, the U.S. invested more than twice as much in Canada ($93.9 billion) than in China ($42.9 billion) in this five-year period.

Though still an attractive destination, foreign investors have been less willing to invest directly in the U.S. in the past two years, partly due to uncertain trade policies. After surging in 2016, investment from China all but vanished in 2017, perhaps in anticipation of the looming trade battle. Investment from Mexico also remained modest. In contrast, Canadian firms flocked to the U.S. from 2015 to 2017, in particular to buy energy companies due to a lack of domestic pipeline capacity and a less hospitable regulatory climate (Chart 8). In the five years to 2017, direct investment from Canada to the U.S. ($236.3 billion) was 2½ times larger than the other way around ($93.9 billion).

The Importance of U.S. Trade with Canada

Regional

Trade is a crucial element to many regional economies. Sixteen states have total trade equivalent to more than one-fifth the size of its GDP, including Michigan (38%), Texas (35%), and Illinois (26%). Kentucky leads the pack with trade close to 42%, compared to the national average of 20% (Table 4).

USMCA partners make up almost 30% of total trade at the national level, compared to China's 15%, underscoring the degree of interdependence within North America (Table 5). On a regional basis, however, that interdependency is even more pronounced for many states. North Dakota tops the list with 82% of its total trade directed within North America alone, followed by Montana (77%) and Michigan (69%). North American flows also emphasize how closely imports (e.g. intermediate inputs) and exports (e.g. finished products) are inter-related and the complexities of global supply chains. In states such as Michigan and Ohio, cross-border trade almost entirely focuses on the automotive industry, where cars and parts are built via supply chains that send components across the border multiple times before completion.

Canada, in particular, remains a large trading partner for many states. In fact, 33 states have Canada as its top export destination, including most of the Midwest and northern regions (Chart 9). An additional 10 count Canada as its second largest exporting partner. Meantime, 19 states import from Canada the most, and the nation remains top-three to 17 other states (Chart 10). Most states in the Midwest run trade surpluses with Canada and Mexico. The exceptions are Illinois, Michigan and Missouri (deficits with both countries), Minnesota (deficit with Canada), and Ohio (deficit with Mexico).

The top-five states that trade with Canada account for 40% of the northern neighbor's total trade with the U.S., in dollar terms, led by Michigan, Illinois and Texas:

1. MICHIGAN is heavily dependent on Canadian trade, more so than any other state, thanks to its auto industry. Exports reached $56.9 billion in the 12 months to July; and, although slowing recently, still remain near record highs. Canada was the largest buyer for Michigan’s products at $23.0 billion. Mexico was the second-largest customer at $11.8 billion, and China was third at $3.3 billion. Auto-related exports represented nine of the state’s top-ten export categories and all of the state’s top-ten imports. Michigan’s combined exports and imports within the USMCA bloc totaled nearly $140 billion, representing more than two-thirds of the state’s international trade. The North American auto industry relies increasingly on deep, cross-border supply chains for parts, supplies, materials, and finished products, and Michigan is a key part of those continental supply chains.

2. ILLINOIS remains the transportation hub of America thanks to the sheer volume of exports and imports. Canada is Illinois' top-export destination. In the year to July, the state's companies shipped more than $16 billion worth of goods to and purchased over $37 billion goods from Canada. Topping that list was equipment and machinery, which accounted for 30%, followed by goods linked to energy and transportation.

3. TEXAS rounds out the top three in total trade with Canada. The Lone Star State has a highly globalized economy as a result of its proximity to Mexico and also because of its thriving oil and gas industry. Almost 10% of total exports were directed to Canada. The state's four largest export and import categories were energy-related, reflecting the all-important oil and gas industries.

Bottom Line: Economic activity at the state level, especially those regions that are automotive-, aerospace- or energy-intensive, is highly tied to trade. That link becomes even more pronounced with USMCA partners, as a large share of economic output and jobs remains hinged to North American trade flows. The dollar value of USMCA total trade in goods amounted to $1.2 trillion in the 12 months to July, almost 6% of U.S. GDP. But, for states like Michigan, total USMCA trade flows equated to almost 25% of its GDP, followed by North Dakota (16%), Texas (15%) and Vermont (12%). Manufacturing in transportation, including autos and aircraft, as well as energy are increasingly dependent on complex supply and value chains. Regional economies, particularly in the Midwest, have greatly benefited from intricate global networks of sourcing, production and distribution, providing consumers and businesses with access to the best products at the lowest price and greatest value.

The Importance of U.S. Trade with Canada

Industrial

Free trade has prompted a dramatic increase in cross-border trade and investment within North America since NAFTA took effect in 1994. U.S. trade [1] in goods with Canada and Mexico now exceeds $1.2 trillion per year—roughly double the amount of trade conducted with China—and has increased more than 140% since NAFTA took effect (after adjusting for inflation). The rise in cross-border exchange has been driven by the core tenet of free trade: that dismantling trade barriers leads businesses to focus in areas of comparative advantage, export output more intensively, and import inputs that are expensive to produce domestically. The result has been an increasingly integrated continental supply chain, a reduction in overall production costs, and an increase in productive capacity relative to what would be possible in isolation. The USMCA represents an additional step in this direction.

Despite the larger scale of its economy, the U.S. has benefited meaningfully from continental free trade. Canada and Mexico, while small next to the American juggernaut, nevertheless represent almost US$3 trillion per year in economic activity—roughly equivalent to California, which is by far the largest state economy. Since the advent of free trade, many U.S. industries have grown to rely significantly on Canada and Mexico as both sources of inputs and as important end-markets for their products. Economic integration within North America has also better positioned U.S. industries to compete more effectively in a world that has become characterized by regionally integrated trading blocs, most notably in Europe and Asia. U.S. industries would find it significantly more challenging to compete against overseas production networks without the benefits stemming from cross-border specialization.

Manufacturing has become especially integrated across North America, with a wide variety of intermediate goods crisscrossing national borders during production. Across the U.S. manufacturing space as a whole, exports to Canada and Mexico account for 8.2% of total sales—a considerable portion given the divergent scale of the three economies—and total trade is now equivalent to 16.9% of industry sales, or more than $1 trillion annually (Table 6). Importantly, the most integrated manufacturing subsectors tend to be high value-added industries with complex multi-stage production processes where tariffs would compound quickly in the absence of free trade.

Leading the pack on integration is electrical equipment and appliance manufacturing, where trade within the USMCA bloc is equivalent to 47% of sales, and computer and electronics manufacturing, where trade within the bloc equates to 43% of sales. Both subsectors see substantial continental trade in intermediate components, with wiring, semiconductors, fuel cells, instruments, and a myriad of other parts moving back and forth across the border as they are incorporated into more complex products. The cost reduction associated with continental integration in these industries has been particularly welcome amid cut-throat competition from low-cost producers in Asia, which has weighed on prices and margins. These competitive challenges would be amplified without free trade in North America.

Motor vehicle and parts manufacturing is also highly integrated in North America. Across U.S. automakers, trade with Canada and Mexico is equivalent to 36% of sales and accounts for 51% of overall industry trade, while for upstream parts manufacturers, trade within the bloc equates to a similar 36% of sales and over 60% of total trade. As in other industries, free trade has bolstered North American automakers’ competitiveness on the global stage. In 2018, automakers across the USMCA bloc produced 17.4 million units, up nearly 15% since free trade was established in the mid-1990s, whereas Japan produced 9.7 million units, down almost 5% over the same period. And although free trade has seen aspects of production shifted from some U.S. regions toward Mexico, the USMCA addresses these concerns with more stringent wage requirements and labor standards, which will help to better balance the overall framework. The USMCA also incorporates an explicit (albeit somewhat technical) assurance that tariffs will not be erected within the North American auto sector. Auto tariffs had been threatened during trade negotiations and, if implemented, would have had acted as a significant drag on continental competitiveness.

Canada and Mexico also account for a disproportionate share of U.S. trade in many resource and resource-processing sectors. In the energy space, the USMCA bloc accounts for 43% of U.S. trade in oil and gas, reflecting the expansive network of pipelines that now spans the continent. U.S. energy trade within North America now amounts to over $100 billion per year, with Canada and Mexico serving as both valuable export markets and geopolitically desirable sources of imports. And, while the United States is a net importer of unprocessed oil and gas within North America, it is also a significant net exporter of refined petroleum and coal products back to Canada and Mexico, to the tune of $27 billion per year.

In the metal and minerals space, the high bulk-to-value of most quarried products constrains international trade in unprocessed resources, but there is extensive continental trade in downstream processed goods. In the primary metal products industry (which produces usable metals from raw metal ores) nearly 35% of total U.S. trade takes place with Canada and Mexico, while the downstream fabricated metal products industry (which shapes and welds metals into more functional products) conducts 31% of trade within the bloc. The cancellation of steel and aluminum tariffs imposed during USMCA negotiations last year represents a favorable development for further integration on this front. Non-metallic mineral products, including construction materials like cement and glass, are also traded significantly within the bloc, with Canada and Mexico accounting for 28% of total industry trade.

Continental trade in agri-food products is also considerable, with Canada and Mexico accounting for 36% of U.S. trade in crops, livestock, and processed food products. Agriculture is an industry where climate can create extreme differences in comparative advantage, making free trade particularly beneficial. Not only has free trade helped to reduce the cost of agri-food products within North America, it has contributed to a wider array of food options across all three member countries (avocado toast is thankfully not as expensive as it once was). The USMCA will allow U.S. dairy producers to gain additional tariff-free access to the Canadian market and will see Canada raise its pricing for milk protein concentrates in line with the United States. Canada will also begin grading all U.S. grain on an equal footing to domestic product.

The axis of global trade has undergone a monumental shift over the past two decades, with the tri-polar framework of the United States, Japan, and Europe disrupted by the rapid emergence of China and developing Asia. In this shifting landscape, the establishment of a North American economic zone some 25 years ago was a strikingly forward-thinking development. The USMCA represents a further advancement of this framework and will help to ensure that U.S. and North American industries are well positioned to meet the challenge of ever-increasing global competition.

Endnotes:

Written with contributions from Alex Koustas, Senior Economist.

[1] Including both imports and exports—a broad measure of economic integration. ^