On NAFTA, Uncertainty is Our Enemy

By Ian Russell

The prospects for global growth have brightened in recent months as the strengthening recovery in Canada and the U.S. has been matched by promising momentum in Europe and Asia. But, amid more broad-based growth, optimism is tempered by uncertainties and downside risks. The specter of protectionism looms large and geopolitical tensions could flare up at any time. Rich asset valuations raise the possibility of a financial market correction, which could dampen growth and confidence.

In Canada, lingering uncertainty over the future of the North American Free Trade Agreement (NAFTA) is weighing on business investment decisions and gnawing at the flow of foreign direct investment into the country. There have now been six rounds of talks to renegotiate NAFTA, with the seventh round taking place February 25 to March 5. The negotiations could culminate in some re-working or modernization of the Agreement or, in the worst-case, a U.S. withdrawal from NAFTA, which President Donald Trump has called “the worst trade deal ever.”

President Trump can unilaterally pull out of NAFTA by giving Canada and Mexico six months’ notice (i.e. trigger Article 2205). He can do so because the executive branch has exclusive authority over foreign relations. However, Congress has the power to regulate commerce with foreign nations and, therefore, has a say. Congress ratified and implemented NAFTA provisions through legislation and would have to repeal the statutory provisions. Legislative action would be required to implement new trade regulations. The potential conflict over executive and legislative powers could trigger a prolonged period of uncertainty, marked by legal wrangling over the U.S. Constitution’s broad language about executive powers.

The longer NAFTA uncertainty drags on, the more Canada’s capital markets and economy are vulnerable to set-back.

Impact of U.S. trade policy

Overall, NAFTA underpins $1.2 trillion in annual trade between the three member-countries, a three-fold increase since it came into force in January 1994.

Three-quarters of Canada’s merchandise exports are destined for the U.S. market, accounting for 22% of Canadian GDP. Canadian exports to Mexico are small in comparison, representing less than two% of total exports and 0.5% of GDP.

Behind the trade numbers is an integrated web of cross-border supply chains that enhance the competitiveness of all three countries.

NAFTA has also contributed to enhancing Canada’s attractiveness as a destination for foreign investment, while providing opportunities for Canadian businesses to invest south of the border. In 2016, U.S. direct investment in Canada was $392.0 billion, up from $90.6 billion in 1993, just before NAFTA came into effect. Foreign direct investment from Canada to the U.S. totaled $474.4 billion, up from $67.7 billion in 1993. Mexican direct investment in Canada surged to $1.7 billion from $154 million in 1993. Canadian direct investment in Mexico increased dramatically, reaching $16.8 billion in 2016 compared to $530 million in 1993.

A fair dispute resolution system

The current dispute settlement mechanism, part of Chapter 19 of the NAFTA, allows Canada to by-pass judicial review and go to an independent, binational panel of five arbitrators to resolve disputes over anti-dumping and countervailing duties. The U.S. has proposed that Chapter 19 be scrapped entirely, a clear non-starter with Canadian officials. Without Chapter 19, disputes would end up in national courts, or before the WTO, a very onerous and time-consuming process that can last for years.

The NAFTA Chapter 11 investor-state dispute settlement process provides investors from NAFTA countries timely recourse to an impartial arbitration tribunal to settle disputes with, and bring claims against NAFTA governments for infringement of investor rights. Investors of NAFTA countries must be accorded no less favourable treatment than that accorded to domestic investors and to investors of any other country.

The U.S. prefers a system where nations opt in to NAFTA’s Chapter 11. Canada is willing to compromise in this area (in return for concessions in other areas), likely because it has lost several Chapter 11 suits. Canada could work with Mexico on a bilateral investor dispute settlement system, still under NAFTA.

Foreign investors have used Chapter 11 to challenge a wide range of state actions, including environmental regulations, that disrupt their investment expectations. While additional clarifications and possible reforms of Chapter 11 may be in the cards, it is important they do not encumber the flow of investment within North America. Canadian investors need assurance their long-term investments are protected through high standards of treatment and effective dispute resolution mechanisms.

A world without NAFTA

Currently, tariffs are 0% for most goods under NAFTA. In its absence, trade would be governed by World Trade Organization (WTO) rules, and WTO-level tariffs would apply. Canadian exporters would face an average WTO tariff in the U.S. of 3.5%; U.S. exporters would face an average WTO tariff in Canada of 4.2%; and Canadian exporters would face an average WTO tariff in Mexico of 7.1%.

Reverting to WTO-level tariffs would leave Canada unequivocally worse off than under NAFTA. WTO-tariff levels would negatively impact export-oriented industries that rely heavily on the U.S. marketplace for sales, and industries that rely on imported inputs for a high percentage of their production. The Canadian auto sector comes to mind. Not only is it heavy reliant on exports to the U.S., it also imports parts and raw materials. Indeed, some components cross the border up to six times over the course of vehicle production. Tariff-free trade allows North America’s integrated supply chains to operate relatively seamlessly. Without NAFTA, businesses will need to incur higher costs, time and resources to address the trade barriers.

Sectors such as oil and gas are not expected to face direct tariffs, should NAFTA be dissolved, owing to the U.S. administration’s desire to preserve access to secure energy.

The services sector would be impacted. Without NAFTA, cross-border movement of professionals would be more restricted, given the U.S. Administration’s stance on immigration and jobs. Additionally, services now comprise a large share of Canada’s exports. A wide range of manufacturing industries rely on services, such as finance and insurance, research and development, accounting, legal and other business services, to bring their goods to market.

Potentially, the U.S. could ignore WTO rules and WTO-level tariffs (to reaffirm its sovereignty over trade policy, as some U.S. officials have stated) and impose punitive tariffs on Canadian exports. This would have more serious repercussions for Canada’s capital markets and economy. It could precipitate tit-for-tat, leaving consumers and investors on both sides of the border considerably worse off.

In the meantime

The uncertainty associated with the NAFTA renegotiations is weighing on the outlook for business investment and exports. Both the Bank of Canada and Canada’s Minister of Finance have said that Canadian businesses that export to the U.S. are increasingly more hesitant to invest in machinery and equipment and plant expansion.

Additionally, the Bank of Canada notes that greenfield foreign direct investment into Canada has declined since mid-2016, especially from Europe but also from the U.S., possibly because of the uncertainty around trade policy.

Even if NAFTA stays put, Canada has limited fiscal maneuverability to match the corporate tax reductions under the recent U.S. tax reform legislation. Canadian businesses may decide to redirect investment spending from Canada to the U.S. to benefit from lower corporate taxes. Increased capital flows to the U.S. would likely bid up the U.S. dollar.

The partial or complete dismantling of NAFTA will likely spark near-term financial market volatility, further weighing on business and consumer confidence and economic growth. Investors in Canadian equities (i.e. in Canadian companies that are part of the NAFTA supply chain) will likely pull back given all the uncertainty on the export and investment front. More money will pile into safer assets, putting downward pressure on interest rates. Against this backdrop, the Canadian dollar would weaken, making Canadian goods more competitive abroad, providing some offsetting benefit to Canadian exporters.

Ian C.W. Russell is President and CEO of the Investment Industry of Canada and Past-Chair of the International Council of Securities Associations