The US president made it through Davos and the State of the Union address without increasing his anti-NAFTA rhetoric, but the threat to withdraw from the trade organisation still looms if progress is not made at the next two negotiating rounds ahead of a self-imposed end March deadline.
Around one third of US trade is with Canada and Mexico. Manufacturing unions blame NAFTA for sending US jobs abroad and President Donald Trump campaigned to reverse the offshoring of recent years. But would withdrawing from NAFTA be of economic benefit to the US? There is no doubt that NAFTA is in need of reform. It was originally set up in 1994 before the digital and e-commerce era. The US has produced a list of negotiating objectives. The top priority is to reduce the trade deficit with NAFTA members, though this is somewhat bizarre since trade is currently almost in balance.
Most of the US trade deficit is with China. The other priorities initially seemed reasonable and read more like an aspiration to move towards a single market with the harmonisation of rules. However, the US then made some additional demands around US content shares in autos, access to public works contracts, reducing the role of the dispute mechanism and dismantling Canada’s supply management system for dairy and poultry. While these were initially deemed as unpalatable by Canada and Mexico, the two countries appear reluctantly to be moving towards a compromise.
However, can the president withdraw from NAFTA without the approval of Congress? At a minimum he has to give six months’ notice and even this could be subject to legal challenge. This period of uncertainty would probably be used to strike a deal. But what would be the cost if the US did withdraw?
In this case, tariffs would be introduced in line with the 'most-favoured nation' principle. Under World Trade Organisation (WTO) agreements, this principle states that countries cannot normally discriminate between their trading partners who are WTO members. This implies an average tariff of around 3.5% on US imports, but weighted by the share of trade actually covered by NAFTA and the types of goods, the effective tariff would be not much more than 2%.
So the static cost appears relatively small, but this probably understates the damage given the potentially negative impact on US exports and disruptions in cross-border supply chains.
There is a serious risk that talks slip beyond the March deadline and get stuck in a pause ahead of the Mexican presidential election on July 1 and the US congressional elections. President Trump could issue the notice to withdraw from NAFTA at any point, but this would most likely be part of an aggressive negotiating strategy. This could lead to some further concessions from Mexico and Canada as ultimately falling back on WTO rules is in no country’s interest.
In addition, given the economic hit would be more severe in Mexico and Canada (as they have extremely high trade shares with the US), both their exchange rates could be liable to weaken against the US dollar, wiping out any incentive to move production back to the US. The bigger danger is what the US approach to NAFTA implies for the US handling of wider international trade issues. The world's largest economy has already imposed tariffs on some specific product areas (solar panels, washing machines) and is looking into aluminium and steel. While this followed a process, the main worry is the potential for the US probe into Chinese intellectual property practices to trigger trade sanctions, which could then spark a trade war.
In the meantime, talking down the US dollar could help President Trump meet some of his objectives, even if eventually it only ends up delivering higher inflation and interest rates.