Mapping uncertainty: what happens if NAFTA dies?

Since his election in late 2016, President Trump has made no secret of his willingness to withdraw the United States from NAFTA if his administration cannot obtain the changes to the agreement he wants.  In recent days, his position has become more nuanced, even though he indicated in a January 11 interview with the Wall Street Journal, “If we don’t make a fair deal for the United States and the United States taxpayer, then I will terminate it.” He followed up: “With that being said, I would rather be able to negotiate.  We’ve made a lot of headway.  We’re moving along nicely.  Bob Lighthizer and others are working very hard, and we’ll see what happens.”

The sixth round of negotiations will take place in Montréal January 23-28, and it is heading for a “make or break” set of discussions.  Canada has been under increasing pressure to respond substantively to the U.S. proposals released in October, preferring instead to point out to the Americans in subsequent meetings how unworkable and self-defeating those proposals are in Canada’s view.

On January 11, Canada’s Foreign Affairs Minister Chrystia Freeland signalled a coming change in negotiating strategy: “When it comes to the more unconventional U.S. proposals, we have been doing some creative thinking, we’ve been talking with Canadian stakeholders and we have some new ideas that we look forward to talking with our U.S. and Mexican counterparts about in Montreal.”

Following on the heels of the U.S. announcement of preliminary duties on Canadian newsprint imports on January 10, Canada released the details of a wide-ranging set of complaints it lodged on December 20 with the World Trade Organization over Washington’s use of anti-dumping and anti-subsidy duties.  The 32-page brief cites almost 200 examples of U.S. “wrongdoing” going back over many years, most of which relate to other trading partners, including the European Union, Brazil, China and India.

Foreign Minister Freeland said the complaint was launched in reaction to the “unfair and unwarranted” U.S. duties against Canada’s softwood lumber industry, although there is little more than a dotted line between the complaint and the stalled softwood negotiations.  No fan of WTO himself, USTR Lighthizer responded angrily, saying that “Canada’s claims are unfounded and could only lower U.S. confidence that Canada is committed to mutually beneficial trade.  Even if Canada succeeded on these groundless claims, other countries would primarily benefit, not Canada. Canada’s complaint is bad for Canada.”

The President has also received an earful from domestic stakeholders and their members of Congress, who are increasingly warning him about the perils of scrapping NAFTA.  Automakers and farmers, the two groups most likely to be hurt if the U.S. withdraws from the agreement, have put on a full court press to get the Administration to bargain more reasonably:

• Auto interests in the U.S. as well as Canada and Mexico all strongly oppose the American proposals on rules of origin—a 50 per cent U.S. content requirement, plus an increase in North American content from the current 62.6 per cent to 85 per cent, combined with an expansion of the tracing list of non-U.S. content.
• U.S. farmers and agricultural exporters are desperate to preserve the access NAFTA has provided them to Mexican markets for such products as corn, soybeans and wheat, and to avoid disruption to the complex cross-border agriculture supply chains that add value to the U.S. economy.
• In his January 8 speech to the American Farm Bureau in Tennessee, the President paused during his conversational and rambling speech to read a carefully-worded and non-threatening statement on NAFTA from his teleprompter, leading many U.S. observers to conclude he had “gotten the message” on agriculture, and now better understands the risks to the sector of a NAFTA withdrawal.
• Recently, several Republican Senators have pointed out to the Administration that a NAFTA withdrawal could jeopardise the stock market gains resulting from the tax bill successfully passed by Congress just before Christmas.

Mid last week, Bloomberg and Reuters reported that unnamed Canadian officials indicated Canada expected the President would move to terminate NAFTA soon.  These reports served to create a significant narrative in Canadian media and send the financial markets tumbling for a brief moment until Chrystia Freeland made a more tempered statement from the Cabinet retreat in London, Ontario.

The absence of similar coverage in trade media in the U.S. combined with the President’s comments last Friday that “I’m leaving it a little flexible because they (Mexico) have an election coming up. So I understand a lot of things are hard to negotiate prior to an election…” indicate that the threat to terminate the agreement may not be so imminent.  Still, many observers on both sides of the border believe that barring major progress in Montréal, President Trump will end the negotiations by issuing a notice of withdrawal from the agreement.

A Trump move to withdraw from NAFTA would trigger several possible scenarios, so it’s useful to explore how these might play out, starting with the fact that despite the directness of the President’s words to the Wall Street Journal, there are some initial strategic steps short of outright termination he could take first.

Scenario 1: The NAFTA renegotiation talks reach a stalemate and are paused

A pause in the negotiations could come about in several ways:

• The three partners could proactively agree to a pause in the talks to accommodate 2018 elections in Mexico and the United States;
• The three sides could agree to suspend the talks but continue informal discussions that do not involve the Ministers/Secretaries;
• The President could claim that no progress is being made in the negotiations, and suspend them.
• The President could give notice of withdrawal, but stop short of implementing it.

With respect to the latter two options above, it should be noted that last October, President Trump told a group of Republican Senators that he believed the U.S. would need to trigger a NAFTA withdrawal as a negotiating tactic to push Canada and Mexico to bargain more seriously.

During a pause in the talks, to raise the stakes on Canada and Mexico, the President could also initiate Commerce Department studies potentially leading to tariffs on sensitive industries, such as Canadian supply-managed exports to the United States and Mexican trucking companies that move goods between Mexico and the U.S.

Such steps would put pressure on Canada and Mexico to “negotiate or else” and provide “red meat” to the President’s base, while deferring a substantive decision.

Scenario 2: President Trump declares the renegotiation talks a failure and triggers termination

NAFTA Article 2205 provides that “A party may withdraw from this agreement six months after it provides written notice of withdrawal to the other parties.”

All experts agree this would be a journey into uncharted territory.  The reason is that while the president can initiate an end to the agreement, it is doubtful he can complete the withdrawal process on his own without Congress, or how long that process might take.

The U.S. Constitution grants the executive branch clear authority over foreign relations, including treaties, but it also gives Congress the power to “regulate commerce with foreign nations.”  It was Congress that ratified and implemented the existing agreement through the NAFTA Implementation Act in 1993.

As the Congressional Research Service wrote in its May 2017 report, “Despite the president’s ability to withdraw from the agreement, the repeal of statutory provisions implementing NAFTA would likely require congressional assent.”

If the President invokes Section 2205 to terminate NAFTA, Congress would have options:

• Concerned at the fallout from terminating NAFTA, Congress could refuse to act, which would maintain the existing implementation legislation, and the agreement would continue in force;
• Congress could pass legislation repealing NAFTA, and agree to the “snapback” to the Canada-US Free Trade Agreement (CUSFTA) by renewing it.;
• Congress could pass legislation removing the U.S. from both NAFTA and CUSFTA; or
• Legal action over the respective powers of the President and Congress would very likely cause paralysis while the courts sorted out who can do what, and nothing would happen until those issues were resolved.

After NAFTA… What comes next?

Should President Trump signal the U.S. intent to leave NAFTA, he might also concurrently signal what he wants to come next on the trade file vis-à-vis Canada and Mexico.  The three options are:

• Double bilateral agreements between the U.S. and both Canada and Mexico;
• Bilateral agreements with Canada, but not Mexico, or Mexico but not Canada; or
• No bilateral agreements with either country.

Given the Trump Administration’s stated preference for bilateral trade deals as opposed to multilateral ones, it is more probable that they would go the bilateral route. That presents some options:

Scenario 1: The U.S. could accept a “snapback” to the U.S.-Canada Free Trade Agreement (CUSFTA), reject it, or seek renegotiation towards a new Canada-U.S. FTA.

When NAFTA came into effect in 1993, it succeeded the Canada-U.S. Free Trade Agreement The CUSFTA was not terminated but merely suspended by Congress; therefore, in the absence of NAFTA, the FTA could return to be the legal framework governing trade and investment between the U.S. and Canada.  It is, however, unclear whether reverting to the CUSFTA would require an act of Congress.

Given that the Trump Administration’s complaints about NAFTA vis-à-vis Canada would not have been resolved in the NAFTA talks, it is likely that the President would insist on a renegotiated FTA. However, if the U.S. retained the key demands it has tabled in the NAFTA talks, it would be just as difficult for Canada agree to them in a revised FTA negotiation.

As Prime Minister Trudeau told Global news on December 21, “We’ve successfully communicated to the administration that triggering a termination isn’t going to have them be able to negotiate a better deal with Canada.”  Therefore, it is not inconceivable that Canada could reject a proposed renegotiation of the CUSFTA.

The reverse is also true.  American anger with Canada’s December 20 complaints to the WTO about how the U.S. conducts trade might cause the U.S. to punish Canada by refusing to pursue both the snapback to the CUSFTA or an attempt to renegotiate it.

Scenario 2: The U.S. would either seek to negotiate a free trade agreement with Mexico or not.

If the U.S. opts to try to do a deal with Mexico but not with Canada, it is almost certain that the Canadian-Mexican common front would shatter.  The level of economic integration between Canada and the U.S. would demand a formal arrangement between the two countries if one were available.  If it is not available, and Mexico gets a bilateral deal while Canada does not, that would be seen as a huge loss for the Trudeau government.

Scenario 3: The NAFTA talks fail and there are no bilateral deals among the three countries, so the trilateral trade relationship is governed by existing WTO rules.

This outcome is a long-shot but still within the realm of possibility.  It assumes that the NAFTA negotiations have ended without success, and that the United States, Canada or Mexico have either rejected bilateral deals or that they could not be successfully negotiated.  In that case, the fallback would be that the trilateral trade relationship would be governed by WTO rules.

Impacts of the scenarios on Canada

What are the potential economic impacts on Canada of losing NAFTA or the other scenarios identified above?

In recent months, there have been numerous media reports on the potential impacts of a termination of NAFTA.  A problem with most of these reports is that they focus on what would be lost if the agreement were folded, without addressing what would replace it.  The reality is that something would replace the current agreement.  It might be the currently suspended CUSFTA brought back to life, a renegotiated CUSFTA or the World Trade Organization tariff regime. To obtain a clear understanding of impacts, it is necessary to compare what NAFTA currently provides with whatever trade regime might replace it, and with the exception of a WTO tariff regime, this cannot be done until one knows what those possibilities are.

As a result, most of the bank and research institute models compare the advantages of the current NAFTA arrangements to what would occur in comparison to the WTO tariff regime.

The first possibility is a termination of NAFTA, and it is essential to consider both the immediate and longer-term impacts of such a move.

Immediate impacts on Canada of U.S. withdrawal/notice of withdrawal
(Note that reaction to suspension of talks would be similar but less pronounced)

The immediate but hopefully short-term impact of a withdrawal or notice of withdrawal would be serious, and would likely include:

• There would be a devaluation of both the Canadian and Mexican currencies, and the stock markets in all three countries would drop, with the automotive sector being hardest hit;
• Huge concerns within trade-sensitive industries and companies would be expressed, as well as from trade-dependent provinces and U.S. states;
• There would be a further chilling of investment intentions and decisions in Canada and Mexico among businesses in trade-dependent sectors, and if the uncertainty dragged on, Canadian and Mexican investments would be pulled towards the U.S. as a “safe-haven”;
• Lending by capital markets to Canadian and Mexican companies in exporting sectors would likely be tightened or curtailed;
• In the early days following a withdrawal, border “incidents” in which shipments of Canadian goods or the temporary cross-border movement of Canadian professionals working in the United States are stopped or delayed at the U.S. border should be expected;
• Lobbying efforts by Canada and Mexico to rally their supporters within Congress would be redoubled, as well as among various industry groups in the U.S. and with trade-friendly governors and state legislatures to influence Congress to block the termination;
• There would be legal challenges to the termination, very likely from the U.S. Chamber of Commerce, the auto and auto parts sectors and U.S. agricultural producers and companies, and also possibly from some individual states.
• Many U.S. observers believe these legal challenges would ultimately reach the Supreme Court, leading to the possibility that the six-month notice period might be extended until the various courts have ruled, which would lengthen the period of uncertainty.

Many of these impacts would be short-term and fade as the realization dawned that nothing specific would happen to NAFTA for at least six months, and likely, for a much longer period.

Longer-term impacts: a potential “Zombie NAFTA”

Even if Congress were to repeal the law that implemented NAFTA, a further complication looms that adds even more time and uncertainty to the situation.

As Steven Globerman and Christopher Sands have pointed out¹, after NAFTA was negotiated in 1992, “the completed agreement was implemented (in the United States) by statutes giving executive branch agencies authority to adjust hundreds of regulations and procedures to give effect to US commitments conducted under normal rule-making procedures.”

They argue that in the event of a NAFTA termination, these rules would remain in effect until they were undone and replaced, “but such changes would also need to be undertaken through formal rule-making,” a process that would take months if not years to complete.

All of this raises the spectre of a “Zombie NAFTA,” in which the U.S. is no longer a member of the pact, but the rules and regulations that implemented it remain in place for a lengthy period.  Moreover, since many individual U.S. departments and agencies would be involved in the dismantling process, it would be piecemeal in nature, leading to even greater uncertainty sector-by-sector.  It also means that Canada would have significant time to adjust to life after NAFTA.

NAFTA regime vs a return to CUSFTA

A recent C.D. Howe Working Paper² projects the impacts of a “snapback” to the Canada-U.S. Free Trade Agreement, and its conclusions are decidedly positive for Canada.  Between now and 2023, “Canada comes out ahead, in part due to gaining some market share in the United States at Mexico’s expense.  The value of Canada’s GDP rises by about $3.6 billion, boosted by price effects; real GDP edges up by 0.0028 percent….”³

As noted above, in the event of the termination of NAFTA, a return to the CUSFTA must be considered unlikely, given that if the United States opted for a bilateral arrangement with Canada, it would almost certainly want the CUSFTA to be renegotiated.

NAFTA regime vs WTO tariff regime

RBC’s “Life after NAFTA” analysis published in November 2017 provides some useful guideposts on broad impacts on the Canadian economy, suggesting that “an effective hike in tariffs up to WTO levels could lower Canadian GDP by a total of about 1% over 5 to 10 years.  And while job losses are difficult to tally, it’s likely that a minority of the half-million Canadians working in highly trade-sensitive areas would be affected.”

RBC also notes that “the U.S.’s most-favoured-nation tariffs aren’t that high. U.S. tariffs under the WTO aren’t much higher than NAFTA’s preferential rates—its average most-favoured-nation tariff in 2016 was 3.5%, below Canada’s 4.1%.”

That said, RBC suggested several additional considerations to the transition from NAFTA to WTO rules:

• “Small tariff hikes can have a big impact on trade-sensitive industries,” particularly for those industries with tightly-knit production chains.
• “Though the auto sector gets cited the most often, tariff hikes would hit numerous other sectors: (S)ectors with trade with of at least double their Canadian footprint make up roughly 6% of Canadian GDP and about 5% of Canadian employment.”
• “Even under the WTO, tariffs in some sectors would be higher,” for example, clothing products, and some agricultural and petroleum products.
• “The impact would be concentrated in a small number of highly trade-sensitive sectors,” that represent employment totalling more than 500,000 people (see Annex 1). “The end result might be a slow decline in these sectors, rather than an immediate disruption.”
• “Services could be constrained,” and the “biggest would appear to be restrictions to the cross-border movement of professionals.”

The C. D. Howe study also looked at the impacts of Canada-U.S. trade reverting to a WTO tariff regime. Again, projecting impacts to 2023, the report suggests the following macroeconomic impacts on Canada:

• “Taking into account the redirection of Canadian exports to third parties, total exports would decline by about US$20 billion or 2.8 percent.
• Canada experiences a decline in household income of $15 billion and a loss of real GDP of 0.55 percent. These negative impacts would be abated only moderately (about $3 billion less income decline and 0.08 less of a decline in real GDP) if Canada and Mexico continue under NAFTA or retain free trade under the Comprehensive Progressive Agreement for Trans-Pacific Partnership (CPTPP).
• Job losses could be in the 25-50 thousand range due to long-term worker exit from the labour force, even after full employment in the post-NAFTA economy has been re-established. Temporary unemployment during a possibly long adjustment period could add very significantly to these losses. Retaining free trade with Mexico would reduce these losses by 4-8 thousand.
• Industrial products in the chemicals, rubber and plastics complex and automotive sectors experience large declines in bilateral exports to NAFTA partners; these losses are partly compensated by re-orientation towards third markets and to the domestic market, in part filling gaps resulting from declining bilateral imports. Total sales of these sectors fall by $3-4 billion.”

Conclusion

As Globerman and Sands conclude, “if NAFTA cannot be successfully renegotiated, it would not be economic Armageddon for Canada.”⁴  The impacts on Canada of reverting to WTO trade rules noted by the C. D. Howe study above, are significant but would be absorbed over a six-year period, meaning that their impact would be gradual and allow time for adjustment.

That said, there are so many alternative outcomes resulting from a termination, many of which turn on likely legal proceedings in the American system, that Canada should expect a period of extended uncertainty until NAFTA’s future is resolved and a successor trade regime is determined and adopted.  Such a period would chill business investment and heighten apprehensions about Canada’s most important trade relationship—with the United States.

ANNEX 1: 

¹Steven Goberman and Christopher Sands, The Fate pf NAFTA: Possible Scenarios and their Implications for Canada, The Fraser Institute, p. 7

²Dan Ciuriak, Lucy Ciuriak, Ali Dadkhah and Jinglang Xiao, The NAFTA Renegotiation: What if the US Walks Away?, The C.D. Howe Institute, 2017

³Ciuriak et al, p. 11

⁴Globerman and Sands, p. iii