The Day After NAFTA
Douglas Porter, CFA, Chief Economist, BMO Financial Group
The growing threat to NAFTA, and all the uncertainty that possible termination entails, has prompted a myriad of questions on what this would mean for the North American economy, financial markets and monetary policies. This report delves into those issues, and explores the impact by sector and by region, looking at where the greatest vulnerabilities lie.
Our overriding conclusion is that while the termination of NAFTA would clearly be a net negative for the Canadian economy, and a mild negative for the U.S. as well, it is a manageable risk that policymakers, businesses, and markets would adjust to in relatively short order. It is critical to note that policy would not stand still in the event of a negative outcome for NAFTA. Monetary policy would be looser than it would otherwise be, the Canadian dollar would adjust lower, trade policy would be aggressively aimed at securing new arrangements, and even fiscal policy would potentially adjust. All of these factors would work to mitigate the economic damage. Over the span of five years, we estimate that real GDP would be up to 1% smaller than it otherwise would have been. That’s a relatively moderate impact on an economy that is expected to expand by close to 9% over that period.
To estimate the economic cost of a NAFTA breakdown, we need to make a number of assumptions. For the purposes of this report, we assume a “bad-butnot- worst-case scenario”, where the former Canada-U.S. Free Trade Agreement (CUSFTA) is not revived, and all parties revert to WTO-level tariffs. Underlying this assumption is the expectation that Canada would reject a U.S. requirement that the dispute settlement mechanism be eliminated or significantly weakened. Other sticking points could be U.S. demands for a sunset clause and the termination of supply management in Canada’s agricultural sector. U.S. demands for minimum automotive content and procurement in public projects would also impede a CUSFTA revival.
For purposes of this report, we will not delve into the implications of a ‘Zombie NAFTA’, where the U.S. Administration attempts to terminate the agreement, but opposition within Congress and by business/industry groups stalls the process. Indeed, the legal mechanics for withdrawal from the agreement are uncertain because NAFTA itself does not contain guidelines for withdrawal and there is no precedent for the U.S. exiting an international trade agreement that has come into force. While there is scope for unilateral action by the President in initiating the withdrawal process, there is also clearly a role for Congress because of the need to implement legislation to enact, amend, or replace trade agreements. Nevertheless, the President does have levers at his disposal were he determined to take actions to undermine or frustrate the intent of NAFTA. If such a scenario were to come to pass, the prolonged uncertainty on the part of consumers and business, not to mention legal challenges, would likely result in weaker-than baseline medium-term growth in investment, productivity and real GDP across all three countries.
In our assumed scenario, there will be the ongoing risk to any sector from trade actions by U.S. industry, with Canada no longer afforded the (limited) protection of the dispute resolution mechanism. However, we also assume that the Bank of Canada would cease tightening, and that the Canadian dollar would accordingly adjust quickly, with roughly a 5% depreciation (to about $1.35, or 74 cents US).
Importantly, it is arguably the consumer that would be the biggest net loser from the termination of NAFTA, in all three partner countries, and not any one industry or sector. For instance, we expect consumer prices in Canada to be roughly 0.8 percentage points higher, due to the weaker exchange rate and modestly higher tariffs. Business capital spending would also be lower than otherwise would be the case, partly due to the uncertain trade climate as well as the weakened growth outlook generally. Meantime, we would expect both exports and imports to weaken notably, but net trade to be broadly unchanged—with the Canadian dollar depreciation acting as a partial buffer for Canada.
In Canada, the sectors we judge the most vulnerable are listed in the accompanying table, including most notably the transportation equipment industry, clothing and textiles, and food & beverages.
By region, we judge Ontario to be the most susceptible province by far to NAFTA disruption, both due to its specific industry weighting and to its tight linkages with the U.S. economy.
In the U.S., we judge the macroeconomic impact to be less severe—in the vicinity of a 0.2% net reduction in real GDP from what it otherwise would be over the next five years. Even so, we still believe it would be worse off without NAFTA, and the transportation equipment and textile industries in particular would be significantly vulnerable. On a regional basis, we view some of the border states and those with heavy agriculture exposure as the most vulnerable.
While North America’s economies would ultimately adjust and adapt to a world without NAFTA, our conclusion is that the agreement has been a net positive for all three economies and it is deeply unfortunate that we are even considering this possibility. Ironically, even if the U.S. does eventually achieve its stated goal of reducing its trade deficit with the NAFTA partners (a deficit that was less than 0.5% of GDP last year), there is the very real possibility that this, in turn, would be offset by an even wider gap with Asia and Europe.
Regarding the U.S. merchandise trade deficit, it should be noted that positive or negative balances are not necessarily reflections of the success of trading relationships. Rather, they depend upon a myriad of factors, including: a country’s stage of development, attractiveness to foreign investors, fiscal and monetary policies, currency level, and domestic savings rate. None of these are primarily influenced by features of trade agreements.
For instance, household plus government spending, as a share of GDP, is considerably higher in the U.S. than
in other advanced-economy nations. In part, this reflects the fact that the U.S., unlike most other countries, does not have a national value-added tax, which would result in lower consumer spending relative to GDP, higher savings, and likely increased exports. With a lower domestic savings rate, the U.S. requires net inflows of capital from abroad, the flip side of a current account deficit.
To read the full report, visit BMO Capital Markets.