Dou­glas Porter

How Do You Spell Re­lief? U-S-M-C-A

Policy - - In This Issue - Dou­glas Porter

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).

Adam Scotti photo

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.

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