The Hidden Costs of a Possible U.S.–Mexico Trade War

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In the race for the White House, both Republican Donald Trump and Democrat Hillary Clinton have incorporated skepticism about free-trade pacts into their presidential campaign platforms. While Trump has attracted more attention than Clinton by arguing that the U.S. should seriously consider pulling out of the three-nation North American Free Trade Agreement and the 164-nation World Trade Organization, both candidates have criticized the impact of NAFTA on U.S. jobs growth, and opposed U.S. membership in the Trans-Pacific Partnership (TPP) on the grounds that the 12-nation free-trade bloc, yet to be enacted, would have a harmful impact on U.S. economic growth and job creation.

In the case of the United States and Mexico, what are the hidden risks and costs of making such a radical change in U.S. trade policy? The patterns of U.S.-Mexico economic and social interdependence are often overshadowed by dramatic rhetoric about job losses in the United States.

Nevertheless, last year Mexico was the United States’ third largest goods trading partner with $531 billion in two-way goods trade during 2015, surpassed in volume only by Canada and China. Since NAFTA’s enactment in 1994, trade and investment between the U.S. and Mexico have mushroomed at a spectacular rate. U.S. exports to Mexico have risen from $41.58 billion in 1993, the last year before NAFTA, to $235.7 billion in 2015 — an almost six-fold increase.

Over the same period, U.S. imports from that country have risen from $39.91 billion in 1993, to $296 billion in 2015, an increase of more than seven-fold. Since NAFTA was enacted, Mexico’s exports to the U.S. and Canada have grown more than five-fold from $53 billion to $319 billion in 2015.

The stock of U.S. Foreign Direct Investment in Mexico has also increased, from a cumulative total of $17 billion in 1994 to $101.5 billion in 2013, an almost six-fold increase, because of the NAFTA-related liberalization of Mexico’s restrictions on foreign investment in the late 1980s and the early 1990s. Over the same period, the cumulative stock of Mexican FDI in the United States increased eight-fold, from a mere $2.069 billion in 1994 to $17.6 billion in 2013.

On the other hand, the growing interdependence of the U.S. and Mexican economies makes both countries more vulnerable to the impact of anti-trade (“protectionist”) measures imposed from either side of the U.S.-Mexico border. On balance, Mexico would be more susceptible than the U.S. to damage from any sustained trade war between the U.S. and Mexico, notes Daniel Villegas, an economist at UNAM, the Mexican national university. Villegas says, “Trump has threatened that the United States could leave or renegotiate [its membership in] NAFTA because he considers that agreement unfair for his country, and he believes that only Mexico and Canada have benefitted from that agreement.” However, he adds, “one of the main goals of [NAFTA] is to create a free flow of goods” between the three countries, so that “consumers benefit by getting the best products at competitive prices” in all three countries. Nevertheless, he adds, “The agreement has been more important for Mexico [than for the U.S.], because more than 95% of Mexico’s exports to NAFTA countries have been [shipped to] the United States,” rather than to Canada, notes Villegas.

For Mexico, whose governments were long noted for their protectionist trade politics, membership in NAFTA and multiple other free trade agreements has become a cornerstone of its national economic policy. According to ProMexico, the country’s investment promotion agency, Mexico has a network of 10 free-trade agreements with 45 different foreign countries; 32 Reciprocal Investment Promotion and Protection Agreements (RIPPAs) with 33 countries; 9 trade agreements within the Latin American Integration Association (ALADI). Not to mention, Mexico has signed on to the Trans-Pacific Partnership Agreement, and is an active member of the WTO, and the OECD. So while Mexico is banking more than ever on free-trade, the U.S. may be turning in the opposite direction.

Heavily Invested in Integration

Separating U.S. firms from their partnerships in Mexico may be a much riskier task than many supporters of protectionism yet realize. Integrated supply chains now link Canada, the United States and Mexico, so much of what is produced in each of these NAFTA members has content previously imported from its neighbors, notes Gary Clyde Hufbauer, senior fellow at the Peterson Institute for International Economics. For example, about 70% of the value of any Honda CR-V built in Jalisco, Mexico, comprises inputs imported into Mexico from the United States and Canada. To establish these supply chains, private firms in all three countries have invested heavily in their neighbors: U.S. companies have invested about $387 billion in Canada and $108 billion in Mexico. Canadian firms have invested $348 billion in the United States and $14.8 billion in Mexico.

Further investments are needed to enhance the competitiveness of NAFTA as a whole, and generate more of the kinds of high-quality jobs that NAFTA’s critics crave, Hufbauer notes.

“Each of the three governments must enhance its country’s economic competitiveness by domestic reforms in areas such as education, infrastructure and tax policy. But by cooperating” – with one another, rather than trying to protect their markets from foreign competition – “they can spur the entire North American economy.” Most major firms are aware of the opportunities ahead. According to Kirk Sherr, president of Clearview Strategy Group, a Virginia-based energy consultancy, “For most U.S. large businesses that produce any kind of tangible goods, the likelihood that they have a significant presence in Mexico is very high. Most of them have tremendous investments [there], and it is frequently the case that their Mexican factories and their Mexican production are among their most profitable.”

Moreover, if the next U.S. president moves to leave NAFTA, such a decision might lead the government of Mexico to take retaliatory measures that would have significant negative costs for the U.S. economy and for the large number of U.S. corporations that do business in Mexico.

In one possible scenario, argues Hufbauer, the next U.S. president could try to use the six-month termination clause in the NAFTA agreement to negotiate enough concessions from Mexico to preclude the U.S. from actually having to leave NAFTA.

“My thinking is that it is a three-way negotiation between the Mexican government, Trump or his new trade czar, and U.S. companies,” Hufbauer explains. “What [Trump] really wants to do is to create some story line where jobs are created in the United States. There are a lot of companies in the U.S. that use Mexico as part of their supply chain, which is critical for what they are producing. Presumably, he would lean on those companies to enlarge their factories in the U.S.; to build new factories in the U.S.; to do something that would give some visible headline numbers for new employment in the U.S. as the price for not putting tariffs or new tariffs on those particular products.

I can imagine Trump doing this and hoping to get a lot of companies [in the U.S.] to pledge to build in the U.S.”

That sort of very direct bargaining approach may sound tempting, in part because it has never before been tried by a U.S. government, notes Hufbauer, a former professor of international finance diplomacy at Georgetown University. However, “if it goes to the next step of actually cutting off U.S. imports from Mexico, what will surely happen [after that] is that Mexico will cut off imports from the United States. It will be a tit-for-tat story, and how far it goes is hard to guess.”

History has shown, Hufbauer says, that “successive Mexican governments – including those of [presidents] Zedillo, Fox, and Pena Nieto – do retaliate.” For example, although the charter of the NAFTA established a schedule that would have opened the border states of the United States to competition from Mexican trucking companies in 1995, and all of the United States to this competition in 2000, the full implementation of these provisions was delayed due to concerns about the safety of Mexican trucks and drivers. The delay resulted in much frustration for Mexico, which ultimately implemented retaliatory tariffs on products imported from the United States. Recalls Hufbauer, “They have done other retaliations for the COOL – Country of Origin Labeling – that the U.S. did.”

Warns Hufbauer: “Mexico is not just a pushover. And further, that whole Trump program is going to tap into a deep wellspring of Mexican pride.” He argues that any Mexican government that did not retaliate [against the U.S.] “would be very unpopular in Mexico. I don’t think it could survive politically. Whatever the retaliation might cost, for reasons of national pride, Mexico will do it. What that will mean, in turn, is that there will be very specific factories in the U.S. or plants that sell stuff to Mexico that are going to find their sales dry up. And the Mexicans have good negotiators – and they will pick out products that are very harmful to the politicians who support Trump” and put a tariff on them, or a quota to make it difficult for them to compete. “They can do that game. So I think the enthusiasm for this approach now, which is basically founded on the thought that you are going to bring back a lot of manufacturing jobs to the U.S. at no cost for the U.S. economy, would quickly fade as the reality played out.”

The cost of leaving the WTO

Hidden costs would also be involved if the next U.S. administration were to renounce its membership in the World Trade Organization. Mauro Guillen, director of Wharton’s Lauder Institute, notes that the WTO, established in 1995, has been a strong force in favor of rules-based trade pacts, and against protectionist, anti-competitive measures imposed by nations worldwide. Guillen cautions, “The WTO is a multilateral agreement, and the U.S. has been its most important supporter since the end of WWII,” when the organization began as the GATT (General Agreement on Tariffs and Trade). “If the U.S. weakens its support for multilateral trade agreements, it would have a strong effect on global trade and ultimately on global economic growth. But it is also important to note that in recent years, currency manipulation has become a key way to protect.” All such practices are “scary,” Guillen adds. “Trade restrictions made the Great Depression worse. Let’s hope it does not happen this time again.”

In part because of weaker global economic growth, protectionist measures have recently become increasingly commonplace. According to a report by the WTO’s Trade Policy Review Body, an average of 22 new trade-restrictive measures were initiated by WTO members each month during the mid-October 2015 to mid-May 2016 review period. “This constitutes a significant increase compared to the previous review period, which recorded an average of 15 measures per month, and is the highest monthly average since 2011,” announced the WTO in a statement. Explains Guillen, “There has been a rise in instances of protectionism through anti-dumping measures and also through administrative controls or other types of actions that cause delay at the border. I interpret these as attempts by governments to protect without being seen as contravening WTO rules.”

As for the potential impact of leaving the WTO, Jeffrey J. Schott, a senior fellow at the Peterson Institute for International Economics, notes that if the U.S. were to leave the WTO, U.S. exporters would lose critical market access worldwide. “One of the major risks of leaving the WTO would be the loss of ‘most-favored nation’ (MFN) rights in 163 [other] countries; other exporters could replace some of U.S. exports in those markets,” he said, adding that this would mean job losses in America’s most competitive and profitable companies.

Most crucially, he adds, the United States would face the very real risk of losing MFN trading status with every foreign country worldwide. The United States currently has free trade agreements (FTAs) with only 20 countries, which means that U.S. firms enjoy preferential access to these countries’ markets at mostly zero or low import tariff rates, with very few exceptions. However, U.S. FTAs combined cover only 40% of total U.S. two-way goods trade; the remaining 60% of U.S. trade is with non-FTA partners. “In order to access these markets, the United States relies on nondiscriminatory MFN tariffs, pacts that countries agree to under the auspices of the WTO. Thus, if the United States pulled out of the WTO, every country in the world would no longer have to apply its MFN tariffs to U.S. exports and could raise such tariffs to whatever levels they choose. Thus, a pullout from the WTO and other U.S. trade agreements would reduce US companies’ access to 96% of the world’s customers.” Clearly, that would have a negative impact on U.S. exporters to most of the world, and on employment in those firms.

Finally, other economists have pointed out that if the U.S. were to leave the WTO, the U.S. would give up its right to defend the rules-based system that it helped to create, losing access to an important forum for resolving trade disputes. The WTO has been criticized for sluggish progress in recent trade negotiations, namely the Doha Round, “but its dispute settlement function has been widely acknowledged as its crowning achievement,” according to Chad Brown, another PIIE senior fellow.

Although most WTO disputes have revolved around subsidies and anti-dumping provisions, many members have “also challenged various tariff regimes, food safety measures, commitments in services schedules, labelling and packaging rules, animal welfare measures, and environmental schemes,” according to a recent statement by the WTO. Thus, “of the 500 cases filed, just over half have reached the litigation stage, suggesting that the system’s requirement for the members concerned to try to find a solution by consulting with each other helps to avoid many cases entering the litigation phase.”

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