NAFTA: Negotiations Ongoing, Risks Remain

NAFTA, the 23-year old trade pact between the US, Mexico and Canada, remains on the negotiating table at the direction of US president Donald Trump. While some will argue that times have changed and the agreement is due for a review, the proceedings, however acrimonious they may or may not become, do pose risks to all parties involved, particularly should the entire agreement be dismissed and come to an end.

Mark Zandi, chief economist of Moody’s Analytics, spoke with Emerging Market Views about the current state of trade as well as where the risks may lie within the US economy. “There is also a risk posed by the expected normalization of US monetary policy,” says Zandi, as Federal Reserve chair Janet Yellen remains on a path to hike interest rates. “Financial markets and the Federal Reserve appear to have very different perspectives on the normalization process.”

What exactly is at stake right now for Mexico and the US?

Mark Zandi: For the U.S., at least in economic terms, not much. A new NAFTA that does narrow the trade deficit with Mexico – the primary objective of U.S. negotiators – would not bring back many jobs, since the deficit itself is not very large relative to the total volume of trade between the two countries.

On the other hand, If NAFTA talks fall through, the tariffs that would take effect in its place are not very high. Assuming there are no further protectionist measures, the impact on the U.S. economy from a NAFTA exit would not be very large. In contrast, the stakes are much higher for Mexico. Over three-fourths of Mexican exports are sent to the U.S., so a NAFTA exit would strike at the heart of Mexico’s export-oriented growth model. More than half of total FDI received by Mexico comes from the US.

Do you see any major risks to the US economy if things go awry? If so, what sector(s)?

The risks to the U.S. economy from a NAFTA exit or termination are largely sectoral and would not deal a major setback to the broader economy. US agricultural exporters would face a small markup from new tariffs, but this would not substantially threaten their competitiveness. The auto industry would suffer a bit more. The US does not export many cars to Mexico, but Mexico is a large source of auto parts and plays a crucial role in automakers’ supply chains. Still, the industry would adjust. The likely depreciation of the peso in case of a NAFTA exit would offset the costs of higher tariffs. In short, main sectors affected in Mexico will be: automotive, electronics, and banking to some extent (in case of taxing remittances).

What do you think the main macro risks are over NAFTA for the US? And for Mexico?

The risks for the US at the macro level stem not so much from a termination of NAFTA itself, but of further protectionist measures that could follow. If the U.S. both exits NAFTA and imposes even higher tariffs, this could trigger retaliation by Mexico. Depending on the degree of escalation, the US economy could slow significantly and possibly tip into recession. For Mexico, the consequences of escalation would be much more severe. Financial markets would hammer the peso, and pass-through from the currency to inflation would likely force the Mexico’s central bank to raise rates, compounding the economic shock. Mexico would face a situation of recession with financial instability, increased unemployment and deterioration of social wellbeing.

What is the current growth driver in Mexico now and do these NAFTA renegotiations pose a risk to it?

Mexico’s economy is highly dependent on the U.S. business cycle given trade and investment links, and as such, manufacturing exports are its primary growth engine. In the case of a new or revamped NAFTA that narrows the U.S. goods deficit, this still wouldn’t change. The US aims to increase its exports to Mexico but will not limit imports. On the other hand, a termination of NAFTA would put Mexico’s entire growth model at risk. The Mexican economy could ride out near-term volatility provided that no additional protectionist measures are imposed. However, should trade tensions escalate, however, causing the US economy to slow, this would mean less demand for all Mexican exports, and in particular, autos and parts. It is hard to believe that Mexican industry could find a replacement for US demand in the near and even medium term. This means less foreign direct investment, and ultimately, lower long-run growth.

Moving to the US, do you see any risks now in the domestic economy in the US and if so, why? And will these NAFTA talks have any influence on these risks?

The US economy is on strong fundamental ground, and it would be difficult to derail it, at least in the near-term.  The key immediate threat to the economy is related to potential political brinksmanship over increasing the Treasury debt limit by late September and the need to fund the government at the start of the fiscal year in October. There is also a risk posed by the expected normalization of US monetary policy, as financial markets and the Federal Reserve appear to have very different perspectives on the normalization process.

If investors are forced to adjust significantly higher their expectations for future interest rate hikes to be more consistent with the Fed’s expectations, this could result in significant volatility in markets. Longer-run, the main risks to the U.S. economy center around foreign immigration and global trade.  If the US turns away from the global economy, then our long-run growth prospects will be significantly diminished.