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From NAFTA to the USMCA — A Canadian Perspective

Although it is still too early to say how investors to Canada will react to the USMCA, it does provide medium-term certainty to North American trade.

Location Canada 2020
On July 1, 2020, the United-States-Mexico-Canada Agreement (USMCA) came into force as a replacement for the longstanding North American Free Trade Agreement (NAFTA) between the same three countries. The new treaty is the result of over two years of negotiations between the three trading partners.

NAFTA was not the first agreement liberalizing trade between Canada and United States. The two countries have been parties to a free trade agreement predating NAFTA since 1988. Many of the conditions of the preceding agreement were included in NAFTA.

The effects of NAFTA on the Canada-United States trading relationship were significant. U.S. investments, which account for more than half of Canada’s FDI stock, grew from $70 billion to $368 billion between 1993 and 2013.In addition, exports from Canada to the U.S. grew from $110 billion to $346 billion, while imports grew by a similar amount.

NAFTA did not, contrary to some predictions, destroy Canadian manufacturing. However, Canadian manufacturing did not make productivity gains to bring it level with its American counterparts: labor productivity in Canada is at around 70 percent of U.S. levels.

Furthermore, Canada has become more heavily dependent on trade with the U.S. The Council on Foreign Relations points out that 75 percent of Canadian exports go to a single trading partner — the United States — while most high-income countries do not typically rely on a single other partner for more than 20 percent of trade.

Canada’s Trade Strategy
Since the turn of the century, Canada has been pursuing bilateral and multilateral trade strategies by ratifying treaties with a number of trading blocs and individual countries. This has been largely thanks to mainstream political consensus in the country, as all major parties have generally been supportive of free trade since the late 1990s. As a country with a market size dwarfed by its immediate neighbor, opening itself up to trade was an easy choice to make.

The past five years, in particular, have seen trade agreements with South Korea, the European Union, and 10 Pacific countries come into force. In effect, Canada is part of trade pacts that represent almost $50 trillion in GDP.

As the new treaties have only recently started to come into effect, it is still slightly early to study the specific aspects of liberalized trade with Europe and Japan, for instance. However, it is clear that Canada had successfully pursued this strategy, while its southern neighbor, traditionally at the forefront of international trade, had stepped back from being an enthusiastic supporter of globalization.

Canada began multiple negotiations in the mid- to late-2000s partly in order to diversify away from trade with the United States. This period coincided with strong raw material and energy prices, particularly oil. Canada was positioning itself as a commodities hub with a manufacturing industry capable of serving economies representing over half of the world GDP.

Rise of Uncertainty and “End of Globalization”
At the same time as Canada was opening new trade agreements, many high-income countries began to question globalization, including its own largest trading partner. As emerging powers, mainly China, challenged the post-Cold War order, political support for free trade has diminished in the United States.

To illustrate: neither of the 2016 U.S. presidential candidates supported the Trans-Pacific Partnership — which the United States had negotiated — and were critical of NAFTA.

Canada is part of trade pacts that represent almost $50 trillion in GDP. The current U.S. administration has imposed various sanctions against a large number of industries and trading partners, such as China and the European Union. Canada has also been on the receiving end of such sanctions. In 2018, the Trump administration invoked national security concerns (referred to as Section 232) in order to hit Canadian steel and aluminum with tariffs equal to 25 percent and 10 percent, respectively.

This situation has generated profound economic uncertainty for the Canadian economy and could, in turn, harm long-term trade and investment. It is in this context that the Trump administration sent a 90-day notification to Congress of its intent to open talks with Mexico and Canada to renegotiate NAFTA in May 2017.

Enter the USMCA
Between May 2017 and October 2018, the United States, Mexico, and Canada negotiated a new free trade agreement. As stated, the USMCA came into effect on July 1, 2020.

Canada was the third signatory to the pact and made some concessions to American demands. However, Canada did succeed in maintaining most of the NAFTA status quo, and some of the U.S. changes had originally been previously agreed to as part of the Trans-Pacific Partnership (TPP). Crucially, the new deal appears to have brought some form of stability to trading relations with Canada’s largest partner.

The Good: From Canada’s point of view, the USMCA is a modernization of NAFTA and not a complete revamping. In particular, the deal now ensures that certificates of origin can be submitted electronically, and the format will not be as strict as before. This should be especially important for exporting SMEs, or those that wish to participate in continent-wide supply-chains, as they will now face less bureaucratic burdens than previously.

Digital trade, which did not exist in 1993, and financial services are now part of the treaty, which will help trade in those industries. However, this would have been covered by the TPP to which Canada, Mexico, and the United States were signatories.

The Canadian automotive industry and certain supply industries will also receive heavier protection from lower-wage competition from Mexico. Content rules now require that 75 percent of a vehicle (up from 52.5 percent) be manufactured within North America in order to be tariff-free. In addition, a minimum wage of $16/hour must be paid to workers in the industry. This will benefit Canadian and U.S. workers in the automotive sector.

Steel and aluminum also received guaranteed minimum content requirements, equal to 70 percent, for North American manufactured vehicles. In addition, the Canadian automotive industry would be exempt from any future tariffs invoked for reasons of national security, as steel and aluminum were facing during negotiations. However, this does not stop individual tariffs on certain goods to be re-imposed for national security reasons. The Trump administration did just that on August 16 by imposing a 10 percent tariff on Canadian aluminum.

The Canadian dairy industry will be easier to access for American producers with an opening of the quota system equal to 3.6 percent of the market. Whether this is good or bad depends on whom you ask: food product manufacturers see it as a gain, while dairy producers see it as another breach in the stability of the quota system.

From Canada’s point of view, the fact that the agreement maintains a dispute resolution system (NAFTA Chapter 19), which the Trump administration wanted to eliminate, is viewed as a significant gain for Canada, even though it does not change the status quo. However, the real benefit of the new agreement is lifting the veil of uncertainty. The uncertainty brought on by the renegotiation has been a major question mark over the Canadian economy, and following its signature, BMO Capital Markets expected the Canadian economy to grow faster than its own 2 percent forecast for 2019.

The Bad: The automotive industry, which appears to have gained the most, may in fact regret the amount of protection within its own regional trading bloc. The changes to the treaty are expected to make the wider North American industry more vulnerable to competition from overseas manufacturers. In addition, Canada’s strategy of being a trading hub is now limited because of the increase in North American content rules.

On a macro-economic level, the results of the renegotiation are expected to have a slightly negative effect on the GDP of all three trade partners. The CD Howe Institute, a Canadian think tank, estimates that real GDP will be 0.4 percent lower for Canada than under NAFTA. Mexico’s GDP will be impacted by 0.79 percent and U.S. GDP will be 0.1 percent lower than under NAFTA. FDI will be expected to be only marginally lower (-0.024 percent) in Canada under the new agreement.

From Canada’s point of view, the USMCA is a modernization of NAFTA and not a complete revamping. The implementation of the new treaty will likely serve to erode competitiveness for the entire region versus China, the rest of Asia, and Europe.

The Ugly: Beyond the basic uncertainty generated by the renegotiations of a longstanding treaty, the new pact signals a desire by the U.S. government to pull out from international trade and protect certain industries (automotive) at the expense of productivity and competitiveness. The new treaty has not totally alleviated uncertainty either, as illustrated by the Trump administration’s re-imposition of tariffs on Canadian aluminum on August 16.

However, perhaps the worst aspect of the new treaty is that it contains a sunset clause that will terminate the agreement automatically after 16 years (although a renewal mechanism is in place). This moves the clock forward on the next period of uncertainty when the treaty will come up for renewal or relapse. Foreign investors may ignore this aspect of the new pact for the moment, but the next round of negotiations has simply been pushed down the road. The USMCA’s predecessor brought stability to the trading relationship and certainty for investors; the new treaty will not be as effective.

In the end, the short-term threat to Canada’s economy was averted and most of NAFTA stayed in place.

How Does This Affect Investors to Canada?

It is still early to tell how exactly investors will react to the new treaty; most of the expected results are speculation and based on economic modeling.

The USMCA may encourage further investments in automotive manufacturing in Canada because wage increases in Mexico will make it less competitive. Other sectors, because they were not the focus of negotiations, will neither be harmed nor helped by the new treaty.

USMCA does not change Canada’s overall trading or investment strategy: it actually creates an incentive to open trade with as many partners as possible and be as open to foreign investment in order to be integrated into global, rather than just regional, supply chains.

The Canadian government is touting the treaty as a “win” in order to remind investors that the negotiations are over and, even with a sunset clause, there is now medium-term certainty to trade in North America. As Lewis Coughlin, Consul, Head of Office and Senior Trade Commissioner at the Consulate of Canada in Guadalajara noted, “The agreement brings stability and certainty to trade in North America by retaining what worked about NAFTA and updating it.”

In the end, Canada can now enjoy several years of stability within North America rather than be concerned with the renegotiation of what had been a generally positive agreement with its closest neighbors.

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