TPP: Renegotiating NAFTA, By the Back Door

For years, trade and justice activists have proposed renegotiating the North American Free Trade Agreement to address some of the deal’s most damaging features: for example, by removing the anti-democratic investor-state dispute settlement provisions of Chapter 11, linking trade benefits to genuine protections for human and labour rights (all the more important given the deteriorating democratic situation in Mexico), and establishing a continent-wide strategy for auto investment and production.  We were always told that renegotiating NAFTA was a pipe dream: it would not be possible to open the text and get all three countries on board with reforms, no matter how legitimate the concerns.

So imagine our collective surprise to see that the Trans-Pacific Partnership talks, behind closed doors, have jumped right into the deep end of NAFTA: undertaking a wholesale renegotiation of what is by far Canada’s most important trade relationship.

The TPP would include 12 countries, several of which Canada already has free trade agreements with.  For Canada, the most important new free trade relationship would be with Japan.  Opening up bilateral free trade with Japan poses many risks to Canada, similar to issues critics have raised regarding the CETA and the bilateral FTA with Korea.  Our bilateral relationship with Japan starts from a position of deep quantitative and qualitative imbalance: we incur chronic trade deficits with Japan, since our imports of high-value manufactured goods vastly outweigh our exports to Japan (which consist mostly of natural resources).  Bilateral tariff elimination with Japan will therefore boost our imports far more than our exports (since our imports are bigger, and our resource-based exports do not face large Japanese tariffs).  The working of Japan’s state-directed economy, reliant on nuanced and multidimensional interventions to support and protect strategic domestic industries, and boost net exports, will not be fundamentally altered by the restrictions of a trade deal.  There is little prospect that Canada’s value-added exports to Japan would significantly grow under bilateral free trade; in the important case of automotive products, there is no upside at all (right now, the bilateral trade flow is effectively one-way: $5 billion in imports from Japan last year, versus just $33 million in auto exports to Japan).  So liberalization with Japan can only reinforce Canada’s structural disadvantage as a resource supplier.  This point has been made in previous critiques of the Harper government’s free trade strategy.

Indeed, this negative structural evolution is already visible under our new free trade agreement with Korea, which has only been in place since January 1.  Korea and Japan share similar economic structures, and have followed similar state-directed policy strategies, so the analogy to the effects of a Canada-Japan trade deal is strong.  Based on the most recent data from Industry Canada’s Strategis database, Canadian exports to Korea declined 7% in the January-July period (compared to year-earlier levels), Canadian imports from Korea grew 8%, and the already-large bilateral deficit widened by another 29%.  We are on track to post a $4 billion bilateral trade deficit with Korea this year, the largest on record, contributing significantly to Canada’s record trade deficits.  (I know that DFATD spokespeople have argued that trade deficits don’t matter, so long as Canada harvests the “efficiency gains” from mutual free trade specialization; this argument is impossible to sustain in conditions of chronic unemployment and inadequate aggregate demand.)  The big “winner” for Canada under the Korea deal was supposed to be our beef and pork exports.  Yet six weeks after the FTA came into effect, Korea once again banned Canadian beef (because of a BSE scare), and the FTA has been useless in reversing that decision.  The bilateral Korea FTA is already proving to be a fiasco for Canada.

The TPP talks, however, have opened a Pandora’s box that is potentially much worse than simply the expansion of free trade to include Japan (an expansion which would, itself, be significantly damaging to Canada).  Because it would include all 3 members of NAFTA, the TPP rules would in effect supplant NAFTA’s rules on all sorts of issues: from rules of origin, to dispute settlement, to intellectual property.  The TPP talks therefore amount, in practice, to the complete renegotiation of NAFTA.  TPP-inspired changes to NAFTA’s rules could have major impacts on Canadian trade, investment, and employment outcomes, quite separate from the effects of the TPP experienced via new trade partners (like Japan).  For this reason, the TPP discussions should be conducted with far more public consultation, dialogue, and caution than has been the case so far.  This risk has been exacerbated by Canadian politics: the Harper government would love to be able to brandish a signed TPP before the October 19 vote, as “proof” of its economic “leadership.”  It has broken with tradition (according to which active policy decisions do not take place after the write has been dropped), and has instructed negotiators to keep working full speed in search of a deal before October 19.

(Never mind that the last blockbuster trade deal trumpeted by the Conservatives, the CETA with the EU, is still stuck in political limbo, nearly two years after a gaudy signing ceremony attended by Mr. Harper in Brussels.  The CETA has foundered on strong European opposition to investor-state measures of the sort pioneered by NAFTA’s Chapter 11.  Never mind, either, that Canada’s exports have performed worse under the Harper government, despite the several trade deals it has signed, than any other government in Canada’s postwar history.  Real exports of goods and services grew just 0.3% per year between 2006 and 2014, and have fallen this year; details are provided on p.19 of Unifor’s comprehensive evaluation of the Harper government’s economic record.)

One important example of this back-door renegotiation of NAFTA rules has been the government’s apparent willingness to accept a substantial watering down of the rules-of-origin provisions governing trade in automotive products.  When NAFTA was negotiated in the early 1990s, Canada insisted on strong regional content rules for this vital industry: to qualify for NAFTA’s tariff-free preferences, an auto part had to include 60% North American content, and a vehicle had to contain 62.5% North American content.  These rules were negotiated because Canadian officials understood well that NAFTA would eliminate most of the economic power of the Canada-U.S. Auto Pact (by giving any North American product free access to Canadian markets, whether or not the producing company had any production facilities in Canada).  These relatively ambitious regional content rules were intended to reinforce the stability of the Canadian industry (including auto parts producers, which employ twice as many Canadians as auto assembly plants) in the wake of that huge policy shift.

In July it was reported that Japanese and U.S. negotiators had secretly agreed to reduce those content rules to just 30% for parts, and 45% for vehicles, under a TPP.  Thus a vehicle could be imported tariff free to North America even if a majority of its content was produced outside of the TPP (say, in China, Thailand, or Indonesia).  The Japanese automakers are strongly committed to this watering down, because their own supply chain is heavily oriented around imports of low-cost parts (for Japanese assembly plants) from those low-wage non-TPP countries.  U.S. negotiators accepted the demand, despite fierce criticism from U.S. auto parts, steel, and other input industries.  (The U.S. is interested in the TPP mostly for geopolitical reasons, to counter China’s growing influence in the Pacific Rim economy, and perhaps that explains President Obama’s willingness to make such a concession to keep Japan on-side.)  Canada and Mexico were not even consulted.  This sparked fury on the part of Mexico, and embarrassment on the part of Canada.

Remember, these new rules would not just make it easier for Japanese automakers to import vehicles tariff-free to North America, even if they contain a majority of non-TPP content.  (This alone would damage Canada’s auto sector considerably, by squeezing out market share from North American producers, and reducing the incentive for Toyota and Honda to assign future products to their Canadian plants.)  Even worse, the new watered-down rules would apply to the existing North American auto supply chain (since the former NAFTA rules, which have underpinned the geography of auto production for a quarter-century, will disappear).  Companies that have nothing to do with Japan could now outsource a substantial portion of their existing parts and input purchasing to non-TPP countries, thus gaining more access to the same low-wage labour (in China, Thailand, Indonesia, etc.) that is already tapped by Japanese automakers.  (That benefit for Japanese automakers, until now, has been offset by the fact they must face modest tariffs to bring those products to North America.  But that countervailing factor would disappear under a TPP.)

The weakening of auto content rules would facilitate the offshore outsourcing of about one-quarter of the total value of a finished vehicle by North America’s auto industry.  The parts content rule would be reduced by 30 percentage points (from 60% to 30%), and the finished vehicle rule by 17.5 points (from 62.5 to 45).  Given that the auto parts industry in Canada presently employs about two-thirds more workers than the assembly sector (about 70,000 in July, versus just over 40,000 in assembly), this works out to a weighted-average content reduction of 25 percentage points: one-quarter of the car!

Another way of calculating the proportional reduction in the content rule, is to consider the combined effect of the two thresholds.  An auto part can qualify as TPP-made with just 30% TPP content.  A vehicle can qualify as TPP-made if 45% of its content originate within the TPP — including auto parts which only had minority TPP content in the first place.  This “double jeopardy” effect means that the theoretical minimum regional content for a finished vehicle to qualify for TPP trade preferences would be only 13.5% (equal to 30% of 45%).  That is a theoretical minimum; in practice, true content will be higher than that (in part because the deal would require final assembly within the TPP to qualify for tariff-free status).  The equivalent value for NAFTA is 37.5% (60% of 62.5%), hence the weighted average reduction in the regional content threshold is 24 percentage points.

By either method, the industry could outsource approximately one-quarter of the value of its existing value-added activity to jurisdictions outside of the TPP, yet still preserve its made-in-the-TPP trade preferences.  Applying the lower of these two weighted-average calculations (24 percentage points) to Canada’s existing automotive manufacturing footprint (and assuming that the dislocation for Canada’s industry is only proportional to the overall North American shrinkage, an assumption which is probably optimistic), allows us to generate an estimate of the potential scale of economic loss if the U.S.-Japan rules were implemented.  Canada could lose 24,600 jobs (ie. 24% of existing automotive manufacturing employment), $6 billion in parts shipments, and a large chunk of its assembly footprint as well.  This loss would be experienced over several years, as automakers and suppliers alike adjusted their investment and location decisions to take advantage of the new freedom afforded them under the watered-down content rules.

These seem like large predicted changes, but the methodology seems reasonable, and they are consistent with equally alarming predictions made by the Mexican auto parts sector.  For example, Oscar Albin, Executive President of Mexico’s National Auto Parts Industry Association, has estimated his sector would lose $23 billion (U.S.) in shipments over ten years if the U.S.-Japan rules were implemented (Inside U.S. Trade, August 26, 2015).  We have already seen in North America how the geography of auto production can experience tectonic shifts in response to trade policy and other determinants (with the migration of investment to Mexico in the wake of the NAFTA and Mexico’s attainment of critical mass in this sector).  The dramatic change in NAFTA’s content rules, negotiated without Canada even being at the table, could certainly unleash equally dramatic effects.

Of course, there are many other problems with the TPP proposals, and indeed other concerns relating to the auto industry (including the need for protections to ensure that automotive trade with Japan and other TPP countries becomes meaningfully two-way, and measures limiting the use of active currency manipulation as a means of achieving advantage in trade competition).  The auto content issues have suddenly made TPP a political hot potato, however, because of the vocal opposition of important industry leaders in all three NAFTA countries.  Expect Conservative politicians to try to “manage” this issue in the remaining weeks of the campaign, perhaps with some incremental changes to the final content rules (although we will have to be cautious to read the fine print of future language; if an increase in the headline threshold is accompanied by concessions in the methodology used for calculating regional content, then we would be no further ahead).  And I hope that the current debate sparks Canadians to take a much harder look at these trade talks, which — by renegotiating the NAFTA — would have a much bigger impact on our economy than “just another trade agreement.”