Mexican industry has benefitted from NAFTA. Renegotiating the terms of the agreement could reverse or accelerate this progress. Negotiators from the United States, Mexico and Canada are each vying to secure production in their own countries but striking the right balance will be difficult.
President Trump dubbed NAFTA “the worst trade deal” for the United States, arguing that Mexico, and to a lesser extent Canada, are benefitting at the expense of their larger neighbor (Al Jazeera, 2017). After threatening to pull the US out of NAFTA entirely, President Trump agreed to renegotiate the terms in April 2017 with the goal of securing better terms for US firms and workers. The US is using the threat of withdrawal, coupled with new tariffs on steel and aluminum, to pressure Mexico and Canada into accepting its demands (Swanson and Tankersley, 2018). The Trump administration has put forth proposals intended to repatriate production to the United States. In theory, these policies would benefit American workers, but making the restrictions too tight could backfire.
The original NAFTA agreement significantly changed automotive supply chains in North America. Since it came into force in 1994, auto production in Canada has declined steadily, while production in Mexico has risen. The 2008 financial crisis and bail out of the US auto industry accelerated the migration of production from the US to Mexico (Setser, 2018). Shifting production to Mexico has led to an industrial boom in the north of the country, where upstream suppliers have sprung up or moved from elsewhere to create economies of scale. Mexico now has a strong industrial base along its Northern border and exports more cars to the US than it imports (Setser, 2018).
The Trump Administration aims to reverse this trend. Among the thornier issues being discussed in the NAFTA renegotiation are stricter Rules of Origin (ROO) for vehicles. Currently, 62.5% of the components of a vehicle must be manufactured in North American for it to qualify for the NAFTA no-tariff priority. If the car does not meet this standard, it is subject the World Trade Organization’s standard 2.5% import tariff for cars and 25% for trucks.
The US has proposes increasing the ROO from 62.5% to 75% and requiring that 70% of aluminum, steel and core parts like engines, transmissions, and batteries be made in North America. The US also wants to require that 40% of vehicle components be produced by workers earning $16 and above (Whelan, 2018). Origin requirements for core parts or high-paid labor are aimed directly at shifting production to the United States.
With the US pushing for stricter rules, Mexico is on the defensive. As a concession, it suggests an increase to 70% of car components being manufactured in North America, and some reports suggest that Mexican negotiators are pushing for a “check one of three” option, where a car would only need to meet one of the three new requirements proposed by the US in order to maintain the tariff priority (Leonard et al, 2018).
Canada has suggested that jobs off the production floor, such as R&D, accounting, and other administrative positions, be included in the 40% high-wage requirement (Economist, 2018). This would reduce the need to reshape supply chains to comply, as many of these jobs are concentrated in the US already. American brands such as Ford and GM would benefit more from this option than European and Asian brands, which tend to base these positions in their home countries.
The battle over wages and the global “race to the bottom” has plagued many global supply chains. Labor unions in developed countries bemoan the downward pressure that offshoring puts on wages in their own countries. Development economics theory posits that as more people become employed, companies will need to compete with each other for labor, causing wages to rise (Krugman, 1997). Many thought that NAFTA would bring about such a change in Mexico (Martin and Cattan, 2017). Nevertheless, slack in the Mexican labor market continues to hold down wages in the formal sector. In real terms, the minimum wage has fallen 43% since NAFTA came into force (Agren, 2017). Unions in the United States want to see a wage increase in Mexico, and some Democratic Senators are pushing for this (Mauldin, 2018). However, the current proposal is unlikely to bring wage increases to Mexican factory floors.
At first glance, one might think that the $16 USD per hour wage requirement would encourage Mexican factories to raise wages, which are currently around $4-$8 USD per hour. This is unlikely to be the case. Lower wages are a substantial part of Mexico’s comparative advantage. Firms choose to produce in Mexico because lower labor costs make it more affordable, despite higher transportation or other costs. Increasing wages above the market rate would diminish this comparative advantage. Some companies may pursue a strategy of eliminating other benefits offered to workers to offset the wage increase. Others may simply invest in automation across the supply chain.
Yet, the most likely outcome of the high wage requirement is that companies will relocate production or forego the NAFTA preference instead of paying for a wage increase. The Center for Automotive Research in Detroit finds that “Average wages in the Mexican automotive and parts industries fall so far short of the North American average that paying the [WTO 2.5% tariff] rate for Mexican exports will be the preferred strategy for nearly all manufacturers of vehicles that are not classified as trucks” (Dziczek et al, 2018).
There might still be a silver lining for Mexican firms. Another component of economic transformation predicted by development economic theory is diversification into higher-value production that requires higher-skilled labor. South Korea and China have followed the path from garments to low-grade electronics, to complex manufacturing. The majority of Mexican production in the auto industry has been in manufacturing less-complex parts or assembly. Ironically, the rules of origin requirements for core parts proposed by the US may encourage firms to shift production of engines and transmissions to Mexico as well. Following Canada’s suggestion of including R&D and administrative positions in this calculation could also encourage firms to base these jobs in Mexico. This could help Mexican suppliers to move further up the production value chain, bringing more (relatively) high-paid jobs.
Stricter rules of origin are risky. As with higher factory wages, the administrative burden of complying with stricter rules of origin for materials and parts is expensive. If compliance is too costly, companies may choose to pay the tariff instead (Weissman, 2017). Twenty percent of drive-axles and 25% of radiators are already sold without NAFTA benefits that they are technically entitled to (Economist 2018). Firms that decide to pay the tariff rather than comply with the new wage or sourcing requirements will be free to source more parts outside of North America. Such an outcome would be the opposite of that intended by negotiators. The parties must strike a delicate balance to ensure that new regulations do not drive production out of the region instead of drawing it back in. Once a deal is made, the potential benefits to Mexican, American and Canadian workers will hang in the balance of corporate budget sheets.
Agren, David. Center for International Governance Innovation. The View From Mexico on NAFTA: It’s Complicated. Oct. 12, 2017. https://www.cigionline.org/articles/view-mexico-nafta-its-complicated
Al Jazeera. What is NAFTA and Why Does Trump Want It Renegotiated? Aug. 19, 2017. https://www.aljazeera.com/news/2017/04/nafta-explainer-170427005642970.html
The Economist. Cars Block the Road to a Renegotiated NAFTA. Feb 1, 2018. https://www.economist.com/finance-and-economics/2018/02/01/cars-block-the-road-to-a-renegotiated-nafta
Dziczek, Kristin, Michael Schultz, Bernard Swiecki and Yen Chen. Center for Automotive Research. NAFTA Briefing: Review of Current NAFTA Proposals and Potential Impacts On the North American Automotive Industry. April 2016. https://www.cargroup.org/wp-content/uploads/2018/04/nafta_briefing_april_2018_public_version-final.pdf
Krugman, Paul. Slate. In Praise of Cheap Labor. March 21, 1997. http://www.slate.com/articles/business/the_dismal_science/1997/03/in_praise_of_cheap_labor.html
Leonard, Jenny, Josh Wingrove and Eric Martin. Mexico Offers NAFTA Compromise on Car Content, Wages. May 8, 2018. https://www.bloomberg.com/news/articles/2018-08-14/maduro-to-end-cheap-gasoline-for-all-venezuelans-this-week
Martin, Eric and Nacha Cattan. Bloomberg Businessweek. The US-Mexico Wage Gap is Actually Widening Under NAFTA. November 28, 2017. https://www.bloomberg.com/news/articles/2017-11-28/nafta-s-ugly-reality-u-s-mexico-wage-gap-is-actually-widening
Mauldin, William. Wall Street Journal. In NAFTA Talks, U.S. Pushes Mexico to Raise Wages for Its Auto Workers. May 7, 2018. https://www.wsj.com/articles/u-s-pushes-nafta-partners-to-accept-a-wage-floor-in-auto-sector-1525685401
Setser, Brad W. Council on Foreign Relations. Oil Production Has Moved North, and Auto Production South. July 26, 2018. https://www.cfr.org/blog/oil-production-has-moved-north-and-auto-production-south
Swanson, Ana and Jim Tankersley. New York Times. Mexico, Hitting Back, Imposes Tariffs on $3 Billion Worth of U.S. Goods. June 5, 2018. https://www.nytimes.com/2018/06/05/us/politics/trump-trade-canada-mexico-nafta.html?rref=collection%2Ftimestopic%2FNorth%20American%20Free%20Trade%20Agreement
Weissman, Rich. Supply Chain Dive. How Changes to NAFTA Rules of Origin Could Threaten Supply Chains. Sept 25, 2017. https://www.supplychaindive.com/news/NAFTA-rules-of-origin-supply-chain-effects/505712/
Whelan, Robbie. Wall Street Journal. Mexican Auto Industry Opposes Latest US Proposal on NAFTA Rules. April 30, 2018. https://www.wsj.com/articles/mexican-auto-industry-opposes-latest-u-s-proposal-on-nafta-rules-1525123237?mod=article_inline