Markets relieved there may be light at the end of the NAFTA tunnel

Markets relieved there may be light at the end of the NAFTA tunnel

On Monday morning, the U.S. and Mexico announced a renegotiated agreement on “key portions” of NAFTA, including rules of origin (on the automotive front), a softer version of the sunset rule (without expiration), the removal of dispute settlement panels and the preservation of steel and aluminium tariffs.

Markets reacted very positively to the announcement with U.S. stock prices rising 1 percent and the Mexican peso rallying 1.2 percent.

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However, while bilateral progress is encouraging, we know the devil often lies in the details of trade agreements, and Canada has yet to rejoin the talks. Once it does, Prime Minister Justin Trudeau will want to negotiate his own bilateral deal, as well as review the issues ironed out between Mexico and the U.S.

Talk of a bilateral Mexico-U.S. trade deal during the conference call between Trump and Pena Nieto is far-fetched as this would represent a new trade deal, which would require congressional approval and take at least 180 days.

Similarly, Trump’s intent to “terminate” the North American Free Trade Agreement (NAFTA) before the signature of a new trade deal appears unrealistic and dangerous.

What was agreed upon?

Intense bilateral trade negotiations between Mexico and the U.S. appear to have yielded a preliminary NAFTA agreement on “key portions” of the trade deal including:

  • Rules of origin: Increasing the share of a vehicle's components that should come from within NAFTA from 62.5 percent to 75 percent to be considered tariff-free. Adding that 40 percent of a car's final assembly will have to be done by workers with wages at or above $16/hour. Cars produced at existing facilities that don’t meet these requirements face a 2.5-percent tariff.
  • Sunset clause: Renewable 16-year life span with a 6-year review window and no automatic expiration of the trade dealy.

While markets have reacted positively to the announcement of a preliminary deal between the U.S. and Mexico, we note that this appears to be more of a relief rally: “no harm done.” By announcing progress on key portions of NAFTA, President TrumpDonald John TrumpSunday shows preview: Trump sells U.N. reorganizing and Kavanaugh allegations dominate Ex-Trump staffer out at CNN amid “false and defamatory accusations” Democrats opposed to Pelosi lack challenger to topple her MORE and President Pena Nieto signaled encouraging progress toward a fully negotiated NAFTA after months of stalled negotiations.

However, despite all the hype, much still needs to be done to finalize a new NAFTA deal, and the tone of the administration toward Canada remains very aggressive; something that has not worked well with Canada in the past.

As quoted in Reuters, PM Trudeau’s office said earlier on Wednesday, “[Canada & Mexico] leaders discussed the ongoing negotiation of NAFTA and shared their commitment to reaching a successful conclusion to this agreement for all three parties."

The NAFTA trade deal contains roughly 30 chapters that will need to be renegotiated. We know that earlier negotiations had yielded significant trilateral progress on issues such as sanitary standards for agricultural goods, transparency, anti-corruption, regulatory practices, the treatment of small and medium enterprises and telecommunication.

Further, recent bilateral talks updated the agreement to include fast-growing sectors, such as the digital economy and access to Mexico’s recently liberalized energy market. However much remains to be done.

First and foremost, Canada will have to rejoin the talks after its decision to take a step back from what it considered stalled negotiations.

President Trump’s talk of a bilateral U.S.-Mexico trade deal appears unrealistic given opposition by U.S. businesses and Mexico, as well as the need for Congress to approve a new trade agreement. That process would take a minimum of 180 days.

Second, many bilateral issues between Canada and the U.S. will have to be negotiated, including dairy and lumber trade. With the U.S. having imposed steel and aluminum tariffs on Canada, these negotiations will not be easy, especially since Mexico is said to have accepted new NAFTA terms despite tariffs not being lifted.

Threats Monday morning by President Trump to impose 25-percent tariffs on cars from Canada are sure to get Prime Minister Trudeau’s attention, but as stated previously, Canada has said it won’t be bullied into a trade agreement.

Third, many trilateral issues upon which Mexico and the U.S. have agreed will need to be approved by Canada. While Canada is likely to accept stricter rules of origin on the automotive front, it is likely to resist the softened sunset rules — a 16-year NAFTA deal renewable for another 16 years after a six-year review, and no automatic expiration — as it creates unnecessary business uncertainty.

Further, while Mexico is said to have agreed to scrap Chapter 19 rules on independent dispute settlement panels, this issue is central to Canada’s preoccupations.

Fourth, once all of the details have been ironed out, the deal will have to be ratified by the legislatures of the three countries. In Mexico, President-Elect Lopez Obrador will likely be the signatory — and his designated negotiator has been closely involved in the talks alongside Mexico’s current administration.

In the U.S., the president will need to notify Congress of an intent to sign a renegotiated deal. Congress would then proceed to a vote after 90 days. Importantly though, the final text would need to be presented to Congress at least 60 days before the vote and the International Trade Commission would have to submit its report.

As such, it appears increasingly likely the renegotiated NAFTA would be voted on by the newly-elected Congress. While the odds of passage are elevated, we cannot discount the possibility of Democratic resistance. If there is any certainty in Washington, D.C. these days, it is the omnipresence of political uncertainty.  

President Trump’s announcement that he will “terminate” the NAFTA deal in the near future to allow for the new trade agreement to take place should be taken with a grain of salt. Any pre-emptive move before the final deal is signed would carry significant risks for the three economies.

As Oxford Economics has estimated a unilateral U.S.-exit from NAFTA could reduce U.S. GDP growth by 0.5 percentage points in 2019, and the impact on Mexico could be twice as large.

Gregory Daco is the chief U.S. economist for Oxford Economics.