Tue | Sep 19, 2017

Walter Molano | Mexico: Free trade bravado

Published:Friday | September 9, 2016 | 9:00 AM

Republican nominee Donald Trump and former Democratic candidate Bernie Sanders are full of bravado when they threaten to abrogate the North American Free Trade Agreement (NAFTA).

At first light, it looks like Mexico would be the big loser. Exports and imports represent 64 per cent of GDP. Exports are 31 per cent of GDP, and 77 per cent of these embarkations go to the United States.

There is no doubt that the end of NAFTA would be a blow. However, according to the Office of the United States Trade Representative (USTR), the US stock of foreign direct investment (FDI) in Mexico was US$107.8 billion in 2015, while the Mexican stock of FDI in the US was US$17.7 billion.

The interesting thing is that the stock of FDI is valued at historical levels. The current market value is probably much higher. Therefore, which country is going to be the big loser? The answer is not Mexico.

Looks are deceiving

These two candidates point to the huge amount of Mexican exports that enter the US, but what they don't explain is that much of this trade is intercompany. In other words, Boeing's plant in Queretaro sells airplane components to the company's main assembly facility in Everett, Washington.

The exports appear to be Mexican, but they really belong to Boeing, an American firm. Indeed, many US companies are competitive on a global scale, thanks to low-cost Mexican operations which provide essential components for their high-tech products. Losing these inputs would make these US firms uncompetitive, thus leading to the loss of high-paid jobs.

What Trump and Sanders don't say is that US firms have been the main beneficiaries from the vast array of trade treaties.

The US automotive industry was one of the main drivers behind NAFTA. The concept was born out of the Automotive Products Trade Agreement (APTA) that was signed with Canada in 1965.

Although labour productivity and the education levels of these two countries are similar, Canada had been gravitating towards universal health care during the early 1960s. By moving labour-intensive activities north of the border, US automobile companies were able to slash costs - given that the Canadian government had assumed responsibility for the provision of health benefits.

Soon, the Big Three automotive groups were the most powerful lobbyists fighting to support Canada's universal health-care programme. Unfortunately, the auto sector suffered an expensive setback during the early 1970s, when US President Nixon passed legislation enacting the Environmental Protection Agency.

The new agency introduced sweeping regulation to clean up the environment, which became an onerous burden for many industries. This created an impetus for the Big Three to move the environmentally challenging parts of the manufacturing process to friendlier locations.

Fortunately, Mexico was close by and ready to welcome the factories. Once the operations relocated south of the border, the companies took advantage of other favourable factors, such as cheap labour costs, compliant unions and lower health/pension benefits.

US the big winner

Hence, US companies have been the winners from the various trade agreements and they will have the most to lose if they are abrogated.

Mexican factories are fully integrated with US industry. The end of NAFTA will deliver a debilitating blow to these operations, triggering a massive downgrade of earnings and a punishing writedown of assets.

What Trump and Sanders fail to understand is that bringing back a handful of low-paying jobs will not justify the debilitating blow that will be delivered to the US economy.

At the same time, Mexican businessmen will have a unique opportunity to buy top-of-the-line facilities, with cutting-edge technologies and well-trained employees at cut-rate prices. It would also be an opportunity for Mexico to delink itself from the US and open its trade relations with the rest of the world.

Less than a decade ago, the Mexican economy was pushed into an unnecessary recession because of the collapse of the US housing bubble, even though there was nothing wrong at home.

There is a saying among Mexican economists that when the US sneezes, Mexico catches pneumonia. Delinking itself from the US would allow Mexico to diversify across a wider spectrum of trade partners where it is no longer considered to be a second-class citizen.

There is no doubt that the end of NAFTA would be painful, but the floating exchange rate regime would mitigate the blow. Therefore, the US should be careful what it wishes for, because it might just come true.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com