How Do You Spell Relief? U-S-M-C-A
The new NAFTA 2.0, the United States-Mexico-Canada Agreement, remains to be ratified. But the specifics of the deal are now known and no one is better qualified to outline the details and implications than BMO Financial Group Chief Economist Doug Porter.
While the new USMCA disperses the cloud of uncertainty over the Canadian economy, it doesn’t change the fundamental factors driving the longer-term outlook. The initial financial market reaction to the deal was one of relief, but the positive vibrations didn’t last long, given that it didn’t move the needle on Canada’s broader economic outlook. As well, there is the nagging reality that the new agreement must still be ratified by all three
legislatures, including a new U.S. Congress. Finally, the conventional wisdom in markets was always that a deal would eventually get done, and the only uncertainties were around timing and the details—so the deal ultimately had little lasting impact on markets or consensus projections.
WHAT’S IN THE DEAL AND WHY IT MATTERS
• Lifespan: The United States-Mexico-Canada Agreement, or USMCA, will last for 16 years, with a review to be made at the six-year mark. At that point, the three countries can extend the agreement or begin formal negotiations to fix any irritants. However, as before, any party can still decide at any time to exit the agreement after six months’ notice.
• The dispute settlement mechanism for countervailing and antidumping duties (Chapter 19) in the original NAFTA and not part of the U.S.-Mexico deal, is retained. This was a Canadian red-line issue and was the sticking point in the original FTA negotiations in 1987.
• The state-to-state dispute resolution mechanism (NAFTA’s Chapter 20) was already retained in the U.S.Mexico deal. The investor-state dispute settlement mechanism (NAFTA’s Chapter 11) will be eliminated between Canada and the U.S.
• Supply management: U.S. dairy farmers will get access to just under 3.6 per cent of Canada’s protected market. Canada has agreed to eliminate its Class 6 and Class 7 milk categories within six months. Given that Canada’s dairy market is growing by roughly 1 per cent per year, and that the import quotas will be phased in over six years, Ottawa believes that the industry can adjust to the changes. Even so, the federal government intends to compensate dairy farmers. Poultry and egg producers are also relinquishing market share, with poultry opening up by almost 5 per cent over a six-year period and egg producers ceding 1.3 per cent with no phase-in period. It’s debatable whether consumers will ultimately see much impact from these adjustments. Note that dairy prices are already on track to drop this year for the fifth time in the past six years, according to the Consumer Price Index.
• Autos: Automotive production will be subject to higher North American content provisions for duty-free shipments across the three countries, with a minimum 40 per cent coming from USMCA jurisdictions that pay workers at least US$16 per hour. There’s a “side letter” guarantee that potential U.S. Section 232 tariffs on automotive products will not be applied to Canada or Mexico up to a certain limit. Canada agreed to a 2.6 million passenger vehicle duty-free limit per annum and US$32.4 billion in parts (light trucks are exempt). These are not binding constraints as Canada currently produces just under two million light vehicles for its domestic and export markets, and currently exports just over C$23 billion (or roughly US$18 billion) in parts. Effectively, this portion of the agreement is a safeguard that Canada will not become a high-volume producer in the future; given that Canada’s vehicle production has trended lower since 1999, this had a low probability. We judge the overall effect of the auto agreement as a net positive for Canada.
• U.S. steel and aluminum tariffs: These remain in place, as do Canada’s retaliatory tariffs. A quota system is a possible replacement, but this issue may not be settled until the agreement is officially approved by all three nations. A broader concern is that the deal does not limit the U.S. Administration from imposing Section 232 tariffs on other Canadian industries, apart from autos.
• De minimis thresholds: The threshold value of imported goods purchased online from the U.S. that qualify for duty-free access for Canadians rises from C$20 to C$150. Imported goods valued at less than C$40 will also be exempt from sales taxes. The higher thresholds have both benefits (to consumers and some small businesses) and costs (to retailers). Canadian consumers will enjoy lower prices and faster delivery times due to less customs processing, but this puts yet more pressure on a retail sector that already faces many deep challenges.
• Prescription drugs: Canada will extend the patent protection for certain prescription drugs (biologic drugs) from eight to 10 years. This is part of the deal that is a clear negative for Canada, since it will add to drug costs with little upside in return.
• Cultural: Previous protections for Canadian cultural industries are retained. However, Canada made concessions on copyrights (out to 70 years after death, from 50 years currently).
• Restrictions on Canada’s ability to forge free-trade deals with “non-market” countries: The deal gives the U.S. and Mexico the right to review any trade deals that Canada forges with non-market countries (read China), and to abrogate the USMCA with six months’ notice if unsatisfied. While opinions differ wildly, it’s clear that the current U.S. administration would loom heavily over any possibility of a broad deal with China.
• Establishing a Tri-nation Macroeconomic Committee: The Committee will consult to prevent each USMCA member from embarking on a perceived “competitive devaluation”. Since Canada has long abandoned the practice of using foreign exchange intervention to “manage” its currency, this might not be a big deal. Still, it could see the Bank of Canada second-guess policy decisions given the potential impact on the loonie. While the Committee seems innocuous, it may have challenged the Bank of Canada’s rate cut in early 2015 (during the oil shock).
• Eliminates the “Proportionality” clause in energy production: The elimination of this clause is favourable for Canada’s energy industry, as
it had the potential to limit its ability to reduce shipments to the U.S. and hence diversify sales to other faster-growing regions, such as Asia. The rapid rise in U.S. oil production in the past decade made this clause from the original FTA all but redundant from a U.S. perspective.
IMPLICATIONS FOR MARKETS AND THE ECONOMY
• The economy: This deal was mostly about minimizing the negative impact on Canada from the harshest U.S. demands. While Canada made some concessions, the biggest positive from this deal is that it will remove a massive cloud of uncertainty for policymakers and businesses. We had been assuming that an agreement would eventually be reached, but the deal heavily reduces uncertainty surrounding our 2019 outlook. There is now upside risk to our call of 2.1 per cent GDP growth next year.
• The Bank of Canada: NAFTA and broader trade uncertainties have been a key issue for the BoC over the past year. Looking beyond the October 24 rate decision, a major downside risk has been cleared. Governor Stephen Poloz has stressed the “gradual” rise in rates, but that narrative may well change with a deal in hand. We are now anticipating three rate hikes in 2019 (January, April, and July). This would bring the overnight lending rate to 2.5 per cent, the low end of what the Bank considers to be neutral.
• The Canadian dollar: The currency initially appreciated moderately on news of the deal. This was more or less the market scrubbing out risk of a negative outcome, but Canada continues to struggle from a competitiveness perspective and the USMCA doesn’t change that. Prior to the deal, we were looking for 78.5 cents ($1.275) for the end of this year and 80 cents (or $1.25) for the end of 2019. We remain generally comfortable with that call, although persistent weakness in Canadian oil prices has been a drag on the loonie.
• Stocks: A limited TSX reaction to the deal likely reflects the fact that much of the index was never all that exposed to a negative NAFTA outcome to begin with (we often argue that the index is not an ideal reflection of the underlying Canadian economy). And, the deal does little to address other weights, such as the record oil-price differential and slowing credit growth. The bigger picture is that Canadian equities are relatively cheap versus their U.S. peers, with the forward earnings yield gap recently trending around the widest level of the cycle—if the trade deal improves sentiment toward Canada more broadly, it could help eventually narrow that gap.
• Government finances: Ottawa made it immediately clear that it will offer some support to dairy, poultry and egg producers as an offset to the concessions made in the deal. Look for an announcement in the Fall Economic Statement or Budget 2019. The good news is that Ottawa’s finances are tracking somewhat better than expected in the current fiscal year (running $4.5 billion ahead of last year in the first four months of FY 18/19).
Prime Minister Justin Trudeau and Foreign Minister Chrystia Freeland in the PM’s Centre Block office, reviewing the new U.S.-Mexico-Canada Agreement before their press conference announcing the new deal on October 1.