(Shutterstock)
(Shutterstock)

In May 2017, Donald Trump’s administration triggered the launch of the renegotiation of the North American Free Trade Agreement (NAFTA). This was no surprise, since during the 2016 US presidential election campaign Trump repeatedly promised to either tear up or renegotiate the agreement. In tweets and speeches he frequently singled out the automotive sector, threatening to impose a tariff on automotive products entering the United States if automakers did not repatriate automotive investment and jobs. Although Mexico was his primary target, Trump’s threats sent shockwaves through the entire North American automotive industry. While having populist appeal for workers in states such as Michigan and Ohio, Trump’s rhetoric displayed a woeful lack of understanding of how integrated the industry has become under NAFTA.

In the 23 years since NAFTA came into force, automakers have constructed the most highly integrated supply chain of any manufacturing industry in North America. The cross-national integration of automotive production enabled the sector to remain globally competitive by improving productivity and efficiency. This benefited carmakers, lowered vehicle prices for consumers, attracted billions of dollars of domestic reinvestment and new foreign direct investment by Japanese, German and Korean-owned automakers, and secured hundreds of thousands of jobs. Any disruption to this complex system of integration caused by new tariff restrictions on the free flow of vehicles and parts among the three countries would have significant ramifications for automakers, suppliers, consumers and workers in Canada, Mexico and the United States alike.

Canada’s automotive industry grew substantially during the 1990s, reaching an annual production peak of 3.06 million vehicles in 1999. After 2000, the industry experienced challenges culminating in a precipitous drop in production and employment during the 2008-2009 financial crisis and recession. Following the recession, automotive production in the United States rebounded and vehicle production in Mexico surged. In contrast, recovery of the industry in Canada was muted. Vehicle production and employment in Canada has stabilized, with just over 2.3 million vehicles built in each of the last four years (about the same level of production as in the early 1990s).

Automotive trade under NAFTA reflects a high level of regional specialization and intra-industry trade. Canada and Mexico rely heavily on access to the US market for their automotive exports but also register large volumes of automotive imports, especially parts, from the United States (Canadian automotive imports from Mexico rose sharply in the last decade but still pale in comparison to imports from the United States). Canada currently runs a modest automotive trade surplus within NAFTA — a positive balance with the United States generated by vehicle exports outweighing a smaller negative balance with Mexico. In 2016 over 84 percent of the vehicles built in Canada were exported to the United States, accounting for over 97 percent of Canada’s almost CDN$63 billion of total vehicle export trade. A substantial proportion of the parts and components in vehicles assembled in Canada are imported from the United States, especially from plants in Michigan, Ohio and Indiana. Conversely, 70 percent of the CDN$21 billion of automotive parts exported from Canada are destined for those same states.

For the automotive sector, rules of origin (ROOs) and regional content-value (RCV) requirements are key features of any liberalized trade agreement. ROOs influence firm strategies shaping what, where and how automotive products will be produced within the area covered by a regional trade agreement. For a vehicle or component to qualify for preferential tariff treatment under NAFTA, it must “originate” in the United States, Canada or Mexico and contain a specified minimum level of RCV. Currently, the NAFTA RCV requirement for vehicles, engines and transmissions measured on a net cost basis is set at 62.5 percent, and at 60 percent for other automotive parts. Vehicles built in the United States and Mexico that fail to meet the NAFTA RCV and vehicles built outside the NAFTA bloc incur a non-preferential tariff of 6.1 percent when imported into Canada. Automotive parts destined for assembly plants in Canada have entered duty-free since the late 1990s. The corresponding non-preferential tariffs levied by the United States are 2.5 percent for cars, 25 percent for pickup trucks and 3.1 percent for automotive parts.

The automotive industry is subject to unique and complex NAFTA rules related to the calculation of RCV, the most significant of which is “tracing.” Tracing ensures greater accuracy in calculating the RCV by tracking the value of specified automotive components and sub-assemblies imported into the NAFTA region, so that their non-originating value can be accurately reflected in the RCV calculation of the vehicle or component into which they are incorporated. For components subject to tracing, any non-originating (non-NAFTA) value remains non-originating through all stages of assembly to the time of calculation of the RCV of the vehicle or component. For example, if a seating manufacturer uses a non-originating motor in the production of a seat it sells to a vehicle manufacturer, the non-originating value of the assembled vehicle must include the value of the non-originating motor.

So what’s at stake for Canada’s automotive industry in the NAFTA renegotiations? The uncertainty generated by Trump’s trade rhetoric has already caused carmakers to be cautious about making future investment and production commitments, especially for their Canadian and Mexican operations, until the US administration’s agenda for the renegotiation comes into sharper focus. Such commitments are essential to ensure that Canadian assembly plants can update production processes and machinery on a regular basis, to improve efficiency and productivity and remain competitive within North America. Assembly plant investment is also critical for sustaining the diverse network of southern Ontario parts and components manufacturers, a crucial source of competitive advantage for Canada’s automotive industry.

The biggest fear is that Trump, in a misguided effort to force increased domestic automotive production, will impose a tariff on vehicles, parts and components entering the United States from Canada and Mexico. The Republicans have also floated the idea of a border adjustment tax (BAT) as part of their plan for broader tax reform. Such a tariff or BAT would disrupt existing automotive supply chains, undermine the global competitiveness of the North American auto industry and impact negatively on all three countries. Canada (and Mexico) would likely experience reduced vehicle and parts exports to the United States with an attendant loss of production and jobs throughout the automotive supply chain. short-term impact in the United States would be severe and result in higher vehicle prices and lower sales volumes. A recent study by the Boston Consulting Group for the Motor & Equipment Manufacturers Association estimated that a 15 percent BAT or a 35 percent tariff would add US$1,000 or US$1,200, respectively, to the average US production cost of a vehicle.

There is little currently unused assembly capacity in the United States, and building a new assembly plant is a multi-year project. Vehicles imported to the United States from Mexico and Canada contain significant levels of US-made parts (40 percent and 25 percent, respectively). Thus, curtailing vehicle imports would have an immediate negative impact on workers at US parts manufacturers, especially in the “red states,” such as Ohio, Indiana and Michigan, that were so crucial to Trump’s electoral victory. If a tariff was only applied to automotive imports from Mexico and Canada, the likely winner would not be the United States but China, Japan, South Korea and the European Union, which would increase their automotive exports to the United States.

Given the potential negative impact on the United States of either an automotive tariff or a BAT, it is likely that cooler and wiser heads in the Trump administration will prevail and that such drastic measures will not be introduced. It is more likely that the United States will seek a tightening of the NAFTA ROO and RCV requirements. If a renegotiated NAFTA were simply to increase the NAFTA RCV requirement or expand the range of components subject to tracing, Canadian-based parts and components suppliers could conceivably benefit, as the change would reduce the non-NAFTA content allowed in vehicles and components. On the other hand, if the United States were to insist that vehicles and components contain a certain level of US content in addition to NAFTA RVC, it would limit opportunities for Canadian parts suppliers. Large Canadian-owned suppliers with existing production facilities in the United States, such as Magna and Martinrea, would be less affected than Canadian companies that primarily produce parts in Canada and export.

In summary, NAFTA currently ensures that the North American automotive industry remains globally competitive, by allowing automakers to take advantage of best-cost production and manage supply chain risk. Any change to the automotive rules and requirements in a renegotiated agreement must be sensitive to the nuances and complexities of the existing North American automotive supply chain. If it is not, it will jeopardize the competitiveness of the automotive industry — and the livelihoods of thousands of the industry’s employees — in Canada, Mexico and the United States.

About the Authors

Brendan Sweeney is Project Manager for the Automotive Policy Research Centre.

John Holmes is Professor Emeritus at Queen’s University.

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The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.