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Impact of the North American Free Trade Agreement (NAFTA) on U.S.-Mexican trade and investment flows.

IN DECEMBER 1992, the presidents of Canada, the United States and Mexico signed the North American Free Trade Agreement (NAFTA), creating a free trade area in North America that would be the largest of its kind in the world, with a combined GDP in 1992 of $6.9 trillion and 368 million consumers. The treaty is scheduled to take effect in January 1994, subject to ratification by the legislatures of all three countries. A bilateral Canada-U.S. free trade pact has been in place since 1989. With respect to Mexico, the new accord formalizes and cements a growing commercial relation and a series of previous bilateral framework agreements with the United States, such as those signed in 1985 and 1987.

U.S.-MEXICAN TRADE AND INVESTMENT FLOWS

As a matter of fact, trade and investment relations between the U.S. and Mexico have expanded rapidly over the past few years. Mexican economic reforms and the prospect of NAFTA have been essential factors in this evolution. Between 1986 and 1991, U.S. merchandise exports to Mexico rose by 168 percent, from $12.4 billion to $33.3 billion. Mexico is now the third largest U.S. trading partner, and, given the present rate of growth of bilateral trade, Mexico can be expected to surpass Japan to become the second largest buyer of U.S. products by 1995 or earlier.(1) Mexico also is an important destination of U.S. foreign direct investment, accounting in 1990 for approximately 4 percent of total U.S. FDI, a fraction that is likely to increase significantly over the near future. Table 1 gives an overview of the development of bilateral economic relations since 1988.

This dynamic evolution of bilateral trade and investment flows would have been unthinkable without the economic reforms initiated in Mexico in 1982 during the administration of Miguel de la Madrid, subsequently continued and expanded by Carlos Salinas de Gortari.

IMPACT OF MEXICAN ECONOMIC REFORMS ON BILATERAL EXCHANGES

In 1981, the Mexican economy experienced two major shocks: a sharp fall in the price of oil, and a steep rise in interest rates on international capital markets. So began a period marked by high inflation, capital flight, and successive rounds of devaluation. In 1982, Mexico declared that it was no longer able to service its foreign debt. To confront the crisis, the government launched the Plan for Immediate Economic Recovery, containing a series of measures aimed at curbing inflation, reducing public spending, establishing a realistic exchange rate and promoting foreign investment.
Table 1
Evolution of U.S.-Mexico Trade and Investment Flows
in billions of current U.S. dollars
 1988 1989 1990 1991 1992(2)
U.S. Exports to Mexico(1) 26.2 31.5 37.6 44.3 48.5
U.S. Imports from Mexico 24.0 27.0 31.2 32.7 33.5
U.S. Direct Investment 1.4 1.6 2.3 2.4 2.8
in Mexico
Cumulative U.S. Direct 15.2 16.7 19.1 21.5 24.4
Investment in Mexico
Source: Banco de Mexico, U.S. Department of Commerce, U.S.
Embassy in Mexico City.
1 The figures regarding U.S. exports and imports to/from Mexico
include the value of flows in merchandise and services, as well
as investment income. It has been calculated from total Mexican
trade figures assuming that the U.S. share in Mexican trade is
equal to three-quarters.
2 Estimated


The Economic Solidarity Pact signed between the government, labor and the private sector in December 1987 represented another milestone in the government's efforts to implement economic stabilization and liberalization. An overview of the major economic policy reforms introduced in Mexico since December 1982 can be summarized as follows:

Tariff reductions. Starting in 1984, successive reductions were made in the maximum tariffs. By 1992, the average tariff was approximately 9 percent.

Accession to GATT. Mexico became a member of this organization in 1986.

Realignment of the foreign exchange rate. A system of regular devaluations was introduced in 1982, followed by managed floating in 1985, and a crawling-peg mechanism in 1987. There were also major devaluations in each of these three years. Under the present crawling-peg regime, the peso is allowed to devalue by a maximum amount of 40 centavos a day, or an annual rate of 5 percent.

Export promotion. Under the February 1984 National Program for Promoting Industry and Foreign Trade, exports were promoted in key areas such as automotive products, computers and pharmaceuticals. Import liberalization was designed to foster efficiency in the export sector through competition and cheaper inputs.

Refinancing and rescheduling of external debt. A turning point was the signing of the first "Brady Agreement" in 1989, which reduced Mexico's debt burden by one sixth.

Wage restraint. As a result of economic recession and the provisions of the Pact, by 1991 Mexican real wages were almost 40 percent lower than the corresponding 1980 levels.

Restoration of balanced public finances through cuts in subsidies, improved tax collection, increases in public sector prices, and privatization of state-owned enterprises.

Privatization of state-owned enterprises. As of February 1992, out of 1,115 state-owned firms, 921 had been privatized, raising $14 billion in the process. Hundreds of others had been closed.

Liberalization of foreign investment policy. The original law of 1973 was updated in 1984 and 1989, relaxing or fully removing restrictions on foreign investment in most sectors.

Modernization of the law on protection of intellectual property. A new law went into effect in June 1991. The legal regime in this area is now comparable to that of industrialized countries.

Reform of the Laws on Land Tenure. Approved in December 1991, it changes the legal status of the ejido system,(2) allowing private ownership of ejidos and their right to enter into associations with private domestic or foreign firms.

Lowering of tax rates in general.

As the extent and depth of the economic reforms show, the past two Mexican administrations have engineered a fundamental shift in trade and foreign investment policy, and a significant reduction of the role played by the government in the economy. As can be appreciated from Table 2, these changes in economic policy have been largely successful in achieving stable macroeconomic conditions and liberalizing the economy.

The majority of the reforms described above were started before there was any consideration of a FTA between Mexico and the U.S. By the time the idea of the FTA between both countries was proposed at the end of 1989, bilateral trade, and to some extent also investment flows, were already growing rapidly. It seems reasonable to conclude that Mexican measures regarding import liberalization, export promotion and relaxation of foreign investment regulations were the main factors responsible for the remarkable expansion of bilateral economic relations in recent years.

TABULAR DATA OMITTED

The implementation of economic reforms helped restore Mexico's international credibility, enabling many Mexican state and private institutions to return to international capital markets. One good example of this fortunate reentry was the listing in May 1991 of Telefonos de Mexico on the New York Stock Exchange, raising $2.2 billion in the process. As a result of renewed domestic and international confidence, the Mexican stock market has recently registered some of the world's highest returns, seeing its capitalization value rise to about $139 billion at the end of 1992, thus surpassing in size its Canadian, Italian, Spanish, or Swiss counterparts. Of total foreign investment in the Mexican stock market in 1991, about two-thirds came from the U.S., and approximately 72 percent of it was accomplished through the purchase of ADRs.(3)

A new phenomenon is the entry of Mexican firms into the U.S. market by way of acquisitions or joint ventures, a process that also had started before a bilateral FTA was in consideration.

IMPACT AND NET GAINS FROM NAFTA

As we have seen, U.S.-Mexican economic relations have expanded rapidly over the past few years. The main factor behind this evolution has been the implementation of a wide range of economic reforms by the most recent two Mexican administrations. Thus, one could ask, in the presence of an already lively and increasing level of bilateral exchanges, why is a formal FTA needed?

The importance of NAFTA lies in the fact that it would be regarded by economic agents as locking in the progress thus far achieved in the bilateral economic relations, preventing sudden changes in national trade and investment policies. NAFTA would become a guarantor of the irreversibility of those economic reforms,(4) which have been crucial for opening up the Mexican economy and for the dynamic expansion of cross-border exchanges in recent years. It would provide safer access for U.S. and Mexican goods in each other's market, eliminating the possibility of unilaterally imposed countervailing duties and antidumping sanctions, a factor all too often present in bilateral trade relations before the framework agreements of 1985 and 1987 were signed. NAFTA would introduce an element of predictability in bilateral economic relations, creating an environment based on clear rules where trade and investment flows can continue to develop and grow.

The major innovations introduced by NAFTA in relation to the current situation can be summarized as follows:

1. Elimination of tariffs and most nontariff barriers on regional trade within five, ten and, for some goods, fifteen years.

2. In a precedent-setting arrangement, bilateral trade in agricultural goods will be completely liberalized within a period of fifteen years.

3. Another precedent-setting disposition is the elimination of all tariffs and quotas in North America trade in textiles and apparel. However, the actual importance of this liberalization is diminished by the introduction of very strict rules of origin in the sector.

4. It liberalizes investment rules in the region, eliminating performance requirements on investment (such as local content and export performance requirements), and granting national status to regional investors.

5. It liberalizes regional trade in services, including financial services, within a framework of clear rules regarding intellectual property rights.

6. It extends the innovative and so far successful dispute-settlement procedures of the Canada-U.S. FTA to Mexico.

Regarding the economic impact of NAFTA, the majority of a large number of different studies(5) find that implementation of the agreement would have a positive net effect on the participating countries, with a significantly larger impact on the Mexican economy, given its smaller relative size. The approach taken in these studies is often based on simulations involving either computable general equilibrium models or macroeconomic forecasting models. Some of these models are static while others are dynamic. The number of sectors included in the analysis vary, as do the assumed market structures, and there are variations in the specific types of imperfect competition assumed. Some of the studies assume economies of scale, while others assume constant returns to scale. Lastly, there is a wide variety of sources of growth specified by the different authors.

Most of these models find aggregate gains in each country in terms of welfare, trade expansion, production, employment, and wages, even though the sectoral distribution of the benefits within each economy may vary widely. Given the historical approach taken, and the simplicity of its projections, one of the best known among these studies is probably the work of G.C. Hufbauer and J.J. Schott (1992)(6) of the Institute for International Economics. In this study, a free trade agreement in North America would result in 1995 in the net addition of 130,000 jobs in the U.S. and 609,000 jobs in Mexico. Mexican imports from the U.S. would reach $58.6 billion and an additional $9 billion improvement would occur in the U.S. bilateral trade balance. Positive but relatively small net gains in U.S. employment (in the order of 60,000 over ten years) were estimated by a U.S. Department of Labor study (1990),(7) and in an analysis by KPGM Peat Marwick (1991).(8) Losses in U.S. jobs are predicted under specific scenarios by Hinojosa and Robinson (1991).(9)

A major effect of NAFTA would be the reallocation of resources among sectors, with the largest dislocations occurring in those branches of the economy that were more protected before the FTA and thus would be most affected by the removal of trade barriers. Among the sectors in the U.S. economy expected to show the largest gains in exports to Mexico are: the capital goods industry; the transportation equipment sector, both finished automobiles and components for assembly; chemical intermediate goods and pharmaceuticals; the agricultural sector, mainly field crops (corn, wheat, soybeans) and processed food; and the metals sector, in which trade gains are expected in both directions. Among the sectors in the Mexican economy expected to increase exports to the U.S. are: fruits and vegetables; the tourism industry; textiles and apparel; durable goods, an area in which two-way trade is expected to expand, including transportation equipment, machinery and electronic components; and oil exports.

Regarding the impact of NAFTA on U.S. wages, some studies predict wage gains by workers in high-wage categories while seeing a decline for those in the low-wage segments of the work force.(10) Other authors predict wage deterioration for the unskilled labor segments.(11) These results are disputed by works finding that the increase in the trade volume will be such that the wages of all types of workers will rise as a result of the FTA.(12) Given the lower level of Mexican wages relative to those in countries such as Hong Kong, Korea, Singapore and Taiwan, as well as the proximity and preferential access to the U.S. market, NAFTA is also expected to lead to the relocation of production sites and to trade diversion from these and other Asian countries to Mexico, especially in areas where Mexican production already has achieved a competitive level, such as electrical machinery, apparel and EDP equipment.(13)

RULES OF ORIGIN PROVISION AND OTHER NAFTA PROVISIONS

Among the NAFTA provisions having the most far-reaching effects for foreign direct investment in the area is the "Rules of Origin" requirement, mandating a minimum level of local content in production. This provision is of special importance for the automotive and electronic industries. In 1991, approximately one-quarter of bilateral U.S.-Mexican trade was in the automotive sector. The 62.5 percent local content required in the final version of the FTA represents a challenge for prospective new manufacturers in the area because they will be forced to increase local sourcing or production in order to be classified as North American and qualify for duty-free treatment.

This requirement will also have an important impact on the future of the mainly U.S.-owned Maquiladora plants, which at the beginning of 1992 numbered about 2,200 and employed 560,000 workers in Mexico. Under present regulations, production from these plants can enter the U.S. duty-free under the Generalized System of Preferences of GATT if at least 35 percent of the inputs are deemed to be of Mexican origin and if the goods fall into certain trade categories. More important for Maquiladoras than this concessional treatment are the currently applicable benefits stemming from sections 9802.00.60 and 9802.00.40 of the Harmonized Tariff Systems of the United States. Under these sections, duty is levied only on the portion of the product corresponding to the value added in Mexico and on the components of Mexican or third-country origin. In the future, output from these facilities would have to meet the new conditions on local components or pay duties on the entire value of the product.

THE COSTS Of NON-NAFTA

It is difficult to determine whether and to what extent the prospect of NAFTA has caused the current rapid growth in bilateral trade and investment. Perhaps asking a different question might help shed some light on this issue: What would be the cost of failing to implement NAFTA? The answer must necessarily consist of several parts.

Failure to implement NAFTA would jeopardize the continuation of the current dynamic trends in bilateral economic relations and the survival of many of the economic policies implemented in Mexico over the past decade. It would imply a significant decline in the projected short-term rate of growth in Mexico and a major reduction in U.S. exports to its third largest and fastest growing foreign market. The high level of imports of real resources needed in Mexico for development purposes leads to increasing trade and current account deficits, financed mainly through inflows of foreign investment. This latter item amounted to approximately $12 billion in 1992. A large fraction of this sum, about three-quarters, consists of portfolio investment, a flow easily reversed when conditions are judged unfavorable. Failure to implement NAFTA would negatively affect the expectations of international investors, causing at least a partial withdrawal from the Mexican market. This would lead to serious cutbacks in imports and to a significant decline in economic growth in Mexico.

NAFTA would be seen as a precursor of future FTAs between the U.S. and other countries in Latin America or elsewhere in the developing world, and also as a model for GATT negotiations, given its ground-breaking approach in areas such as rules of origin, intellectual property rights, trade in services, textiles and agricultural products, foreign investment regulations, government procurement, etc. In the absence of an agreement, these innovations would have limited development in the international arena.

Although most of the integration structures in Latin America predate the conception of NAFTA, the proposed accord is perceived in the region as a possible first step towards some form of integration involving all countries of the Western hemisphere. This prospect has led to renewed efforts aimed at consolidating or creating subregional integration plans as a possible preparation to merge into wider configurations. Among these initiatives are:

1. Mercosur. Signed in 1988 by Argentina and Brazil, and extended in 1991 to include Uruguay and Paraguay, it is supposed to lead by 1995 to a free market in goods, services, capital and labor, i.e., a common market.

2. Successor or Andean Pact. Signed in December 1991, it is a free trade agreement including Colombia, Venezuela and Peru. Bolivia and Ecuador joined the group later. It is expected to introduce common external tariffs by 1994, thus becoming a customs union.

3. Successor of Mercomun. Established in 1991, it consists of the five country signatories to the original Central American Common Market. It should usher in the formation of a common market by 1994.

4. Free Trade Agreement. Mexico has signed or is in the process of signing free trade agreements with several countries in Latin America. It signed a FTA with Chile in 1991 and it is soon expected to finalize the free trade negotiations started in October 1991 with Colombia and Venezuela, the two other members of the so-called "Group of Three." Free trade talks are being held with Bolivia. In 1992, Mexico signed a framework agreement with the five Central American countries aimed at creating a free trade zone by 1997. A final agreement is expected in 1993.

5. An enlarged free trade zone. Preliminary contacts regarding the possible inclusion of Chile in NAFTA took place in 1992 during the Bush administration. Negotiations would be expected to take about two years. Other nations in Latin America and also from outside the area have expressed their interest in becoming a member of an enlarged North American free trade zone.

6. The "Group of Three," composed of Mexico, Colombia and Venezuela, is playing an important role in free trade initiatives in the region, acting as a bridge between South, Central and North America. Mexico is part of the proposed NAFTA, while Colombia and Venezuela are members of the Andean Pact, and these three countries are also working since October 1991 to finalize a free trade agreement among them by 1994. Mexico has agreed to extend automatically all concessions to Ecuador and Peru, leading to a de facto Mexico-Andean Group free trade agreement. The Group is also negotiating the inclusion of the five Central American countries into a regional trade pact.

In the light of these events, and the expectations created by the June 1990 "Enterprise for the Americas Initiative" (EAI) of President George Bush, a setback in the integration efforts in North America would deal a severe blow to the idea of promoting increased liberalization and integration in Latin America, including some form of association with the United States.(14) It would almost certainly mark the end of the EAI.

NAFTA would strengthen the bargaining position of the U.S. at multilateral trade negotiations such as the ongoing Uruguay Round of GATT negotiations. At a time when the European Community is about to expand through the inclusion of a round of new members (Austria, Finland, Sweden and Norway), and East Asian nations' interdependence is growing, the United States seems unable to capitalize on the opportunities for a closer trade association with natural economic allies. Reservations about NAFTA in the U.S. contrast sharply with the European Community's willingness to forge closer trade links with countries outside the region, as witnessed by the recent EC offers to negotiate free trade agreements with the Russian Republic and Morocco.

Comparative advantage considerations imply that an economy should engage in those production activities where it is relatively more efficient. In the case of the U.S., this precept suggests specializing in the production and export of knowledge-intensive goods and services,(15) while importing those involving a high degree of low-skilled labor. Free trade would foster specialization along these lines in North America, with the U.S. providing high-technology goods and Mexico, for a transitional period, furnishing labor intensive ones. It would also foster the cost-competitiveness of U.S. firms, which could use their Mexican subsidiaries as low-cost providers of needed components. For Mexico, free access to the U.S. market and increased flows of U.S. direct investment would assure and accelerated pace of structural change, stimulating the development of a modern manufacturing base and the assimilation of state-of-the-art technology in many sectors of the economy.

A successful trade and industrial strategy in a highly developed economy such as that of the United States cannot be based on the preservation at all costs of declining production sectors, especially when this is attempted against the dictate of the markets. It should rather hinge on the enhancement of those high value-added productive activities where the U.S. is most efficient: information and knowledge-based provision of goods and services. Mexico, on the other hand, needs to modernize its economy rapidly in order to raise the standard of living of large segments of the population now living in poverty. Failure to implement NAFTA would mean giving up a unique opportunity to move both economies to a higher level of efficiency and welfare.

FOOTNOTES

1 Over the same period U.S. exports of goods and services to Japan increased by 80 percent from $26.6 to $48.1 billion.

2 The word "ejido" means common land. It is a community of farmers who have the right to use and bequeath the land, but they cannot own it, rent it or sell it.

3 InverMexico, 53rd Meeting of Economics and Securities Research, Mexico City, May 1992. ADRs stands for American Depository Receipts, which are dollar-denominated equity-based financial instruments backed by a trust containing stocks of non-U.S. companies, in this case Mexican firms. ADRs may be traded directly among U.S. investors, with clearance and settlement handled by the custodian bank in the United States. See Finance and Development, The World Bank/IMF, March 1992, 38-41.

4 Mexico's membership in the OECD, currently being negotiated, would lend additional credibility to the claims of irreversibility of its policy reforms.

5 For a summarized description of many of these studies involving the use of mathematical analysis, see "Economy-Wide Modeling of the Economic Effects of a FTA with Mexico and a NAFTA with Canada and Mexico," USITC Publication 2516, May 1992, United States International Trade Commission.

6 G.C. Hufbauer and J.J. Schott, 1992, "North American Free Trade: Issues and Recommendations," Institute for International Economics, Washington, DC.

7 U.S. Department of Labor (1990), "Industrial Effects of a Free Trade Agreement between Mexico and the USA," Washington, 15 Sept.

8 KPMG Peat Marwick (1991), "Analysis of Economic Effects of a Free Trade Agreement between the United States and Mexico," Washington: U.S. Council of the Mexico-U.S. Business Committee.

9 Hinojosa-Ojeda, R. and S. Robinson (1991), "Alternative Scenarios of U.S.-Mexico Integration: A Computable General Equilibrium Approach," Working Papers 609, Oakland: Dept. of Agricultural and Resource Economics, University of California.

10 R.K. McCleery and C.W. Reynolds, 1991, "A Study of the Impact of a U.S.-Mexico Free Trade Agreement on Medium-Term Employment, Wages, and Production in the United States. Are New Labor Market Policies Needed?" Stanford: Americas Program, Stanford University.

11 Leamer, Edward E., 1991, "The Probable Effects of a U.S.-Mexican Free Trade Agreement on U.S. Wages and Manufacturing Output," Los Angeles, Anderson Graduate School of Management and Department of Economics, University of California, Los Angeles.

12 Internal U.S. International Trade Commission Memorandum, 8 March 1991.

13 DRI/McGraw-Hill, "Implications of NAFTA for Asian Low-Cost Producers," World Market Focus, April 1992.

14 There are precedents of successful FTAs between industrialized and developing countries, as witnessed by the FTAs between the EC and Spain, Portugal and Greece as well as the EC and Israel and between the U.S. and Israel.

15 U.S. service exports accounted in 1992 to approximately 44 percent of total exports, producing an annual $67 billion trade surplus. Since 1988, the growth in the services trade surplus has accounted for one-third of the rise in real GDP in the U.S.

Juan R. Espana is Professor, International Management Division, Monterey Institute of International Studies, Monterey, CA. This paper is based on one presented at the 34th Annual Meeting of the National Association of Business Economists, Dallas, TX, September 1992.
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