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What does free trade mean to CFOs?

What does free trade mean to CFOs?

Free trade between the United States and Canada harbors a bright future for Arnold Miller, chief financial officer of the Illinois-based Quill Corporation. The mail-order company, which distributes office supplies from stationery to word processors across the U.S., will expand its list of potential customers by 10 percent with the opening of the Canadian market.

With paper mills in the U.S. running at 90 percent of their capacity, Miller cheered on January 1 of this year, when shopping at Canada's bountiful paper factories became as permissible as visiting Toronto or Montreal. Miller, who also imports a small amount of manufactured goods from Mexico, Asia, and Europe, believes the Free Trade Agreement (FTA) will benefit both Canadian and U.S. companies. "Our real costs used to be inflated by the intervention of tariffs," the CFO explained. "With the eradication of trade barriers, we are able to buy and sell in Canada just as if we were operating in the United States."

Miller hired an accounting firm, Laventhol & Horwath, to better his understanding of Canadian accounting methods. "We have to figure out how to manage the profits generated in Canada," he explained.

Equally enthusiastic is Gordon Cummings, CEO of National Sea Products Ltd., the largest fish processor in North America, headquartered in Halifax, Nova Scotia. National Sea Products, along with the rest of the Atlantic Canadian industry, spent $1.5 million (in Canadian dollars) in one year alone battling countervailing action suits launched by U.S. competitors. Newly appointed binational panels will now review each trade dispute--removing the biases that existed when either a U.S. or Canadian court passed unilatheral judgments over trade issues.

Cummings' financial strategy is clearly influenced by trade considerations. The company's first takeover of a retail outlet in the U.S. occurred in 1986, when Cummings acquired the Booth brand. With assets worth C$400 million, National Sea Products also acquired in November of 1988 the second largest shrimp processor in the U.S., Florida-based Treasure Isle. National Sea Products will be hiring 400 new employees to seize opportunities under free trade and will lower its production costs by processing more of its fish in Canada, close to the raw material. Before free trade, the company shipped raw fish to the U.S. for processing, which Cummings says was an expensive undertaking.

CEOs and CFOs on both sides of the border are quick to extol the virtues of free trade, even though a number of companies presently not involved in bilateral trade are adopting a "wait-and-see" attitude. Because firms in Canada feel they have much more to gain than their U.S. competitors, they have been quicker to prepare for free trade. Sixty-one percent of the large companies in the U.S. studied by the accounting firm Thorne Ernst & Whinney admitted to having no opinion on free trade, compared with only 37 percent in Canada.

The United States and Canada are the world's largest trading partners. Bilateral trade in goods alone amounted to $130 billion in 1987, and the "single market" established under free trade will create a $5 trillion North American economy.

About three-quarters of Canadian exports are shipped to the United States. Canada's trade surplus with its southern neighbor increased tremendously in the early 1980s, from $500 million in 1979 to $15.7 billion in 1984. This was due in part to the changing value of the Canadian dollar, which during the same period fell from 85 cents to 77 cents in U.S. dollars, enhancing the competitiveness of Canadian companies in the U.S. With the Canadian dollar still below 80 cents, Canada's trade surplus with the U.S. shrank slightly in 1987 to $13.1 billion.

Trade between the two nations already was liberalized before free trade. Seventytwo percent of Canadian exports to the U.S. crossed the border duty free in 1987--that's $53 billion out of $73 billion of Canadian exports. Similarly, 73 percent of U.S. exports to Canada were duty free in 1987, representing $45 billion out of $57 billion of U.S. exports to Canada. Fresh fruits, metal ores, and machinery were among the items the U.S. could export to Canada without dry; Canadian crude oil, electricity, and machinery bound for the U.S. were duty free.

The FTA, in effect January 1, 1989, will eliminate most of the remaining tariffs within 10 years. The agreement provides for consistent treatment of businesses in both countries and eliminates most performance requirements for investments. For example, U.S. bank subsidiaries in Canada, known as Schedule B banks, are no longer limited to holding less than 16 percent of all domestic assets of the Canadian banking system. U.S. insurance companies are now free to diversify into securities, trust, and banking activities in Canada.

The FTA, however, does not remove the limits imposed in the U.S. under the Glass-Steagall Act. The 50-year-old legislation prevents financial institutions from operating both commercial banks and securities underwriting firms in the U.S., and the potential repeal of Glass-Steagall has proceeded slowly since the October, 1987, market crash.

Also to be resolved is the issue of Canadian institutions establishing banks in more than one state in the U.S., given the current upsurge in nationwide banking. Since the implementation of the U.S. International Banking Act in 1978, Canadian banks have been prohibited from opening branches in different states. Under the FTA, Canadian banks already operating in more than one state will not have to curtail their operations, but the U.S. made no promises to emulate Canada and deregulate the industry.

There are notable exceptions to the agreement, such as the shipping industry, which the U.S. exempted for national security reasons. U.S. long-distance telephone companies were not granted access to the Canadian market, although communication gear can flow through freely. Politically sensitive industries, notably textiles, steel, and agricultural products, will continue to be protected during the first 10 years.

The bottom line, according to Al Jameson former CFO of IBM Canada and now head of the Financial Executives Institute of Canada, is a more complex working environment for CFOs. "Financial officers will now have to understand market conditions in California as well as the 10 Canadian provinces. Profits should improve because of the expanded markets," he reasons, "but not all companies will succeed in recognizing opportunities and dealing with new competitors."

The only major constraint free trade introduces is on manufactured goods. To qualify for duty-free status, about 50 percent of the manufacturing content of a traded good must originate in either the U.S. or Canada. Keeping track of the manufacturing process can be easily integrated into companies' accounting procedures, notes the Conference Board of Canada. The so-called "content rule" should prove worrisome only for companies very close to the 50-percent threshold.

Pricing and economies of scale

The immediate impact of the removal of tariffs will be a surge in cash flow. Procter & Gamble Co. expects to save upwards of $50 million a year, which will allow for new investments and expansions in both the U.S. and Canada. Based on a survey of 75 Canadian and U.S.-owned companies operating in Canada, the COnference Board of Canada reported that "free trade has the potential to cause a redirection of available capital funds."

The capital funds influx will stem from Canada's closer ties to the U.S. marketplace, which the Board predicts will attract foreign investors and boost Canada's capital accounts. This should improve Canadian productivity and encourage exports, which in turn may offset Canada's deficit in services and investment income.

Not only will tariffs be removed, but higher export sales and possibly higher margins will boost company revenues and encourage investments in both countries. By 1997, business investments can be expected to rise 4 percent above what they would have without free trade, estimates the Conference Board of Canada.

The removal of tariffs brings up the issue of pricing. Economic principles state that the price of tariffs is passed on to consumers, and so the eradication of tariffs should be reflected in lower prices.

This has been the experience of the North American automobile industry. Under the aegis of the U.S.-Canadian Auto Pact of 1965, U.S. manufacturers have enjoyed the benefits of tariff exemption--as long as 60 percent of the labor and parts is Canadian. According to Oren Shaffer, the CFO of Ohio-based Goodyear Tire & Rubber Co., whose $9.9 billion in worldwide sales in 1987 were almost entirely attributed to automotive products, prices are set in each marketplace. The key factor in free trade is the elimination of tariffs, which in the long run will translate into greater competition at the local level.

The new free trade rules uphold the benefits of the Auto Pact for North American producers and do away with Canada's used-car embargo. Other car manufacturers will be tariff-exempt within five to 10 years, though, in order to qualify, at least 50 percent of the value of the product must originate from North America. A Japanese car maker, therefore, will not be able to bypass the U.S. import quotas by arranging minor assembly in Canada and shipping the cars to the United States.

Dofasco Inc., the largest steel producer in Canada and based in Hamilton, Ontario, does a significant volume of selling to the automotive parts industry. While the company already benefits from the Auto Pact rules, it hopes to expand its production of appliance steels and tubular steel products for the oil and gas industries as steel tariffs are gradually reduced to zero in 1999.

Dofasco plans to compete and help its customers compete by relying on economies of scale. According to the company's CFO, Thomas Van Zuiden, Dofasco set the process in motion as early as July of 1988 by acquiring, for C$560 million, Algoma Steel Corp. of Sault Ste. Marie, Ontario, and thus jumping the firm from eighth to fourth in steel output on the North American continent. The current thrusts are modernizing facilities, upgrading employee skills, and tightening quality control.

Dofasco's approach of improved efficiency and lower costs reinforces a trend in Canada, where a marketplace of 25 million people has often been too small for companies to implement economies of scale. The Conference Board of Canada noted that, "For many companies, rationalization and specialization provide the strategy for the adjustment to the new trading environment."

Such strategy may work best for companies that already have a strong foothold in the continental market, such as automobile manufacturers in the U.S. and the pulp and paper industry in Canada. Canada's Abitibi Price, the largest producer of pulp and paper in the world, has initiated a major modernization program to increase the volume of paper its plant can produce. Since there were no tariffs levied on pulp and newsprint prior to the FTA, the company has already sampled the benefits of free trading and views economies of scale as a logical strategy for any business aspiring to become a major player on the continent.

Sourcing strategies and

the exchange rate

One of the most important aspects of asset management--sourcing--will be directly affected by free trade. The CFO's chief responsibility under sourcing is to ensure the optimum use of the company's resources. Other crucial considerations are labor costs, skills, and productivity. Such factors vary from industry to industry between the U.S. and Canada and will determine where a product is manufactured.

Sourcing was already part of the CFO strategy for companies that operated factories in both countries before free trade. General Foods Inc., for instance, already supplies its Canadian branches with beverages, desserts, and a substantial share of sugar-based products. Free trade simply will enable General Foods' Canadian vice president for finance Gerry Lord to obtain a potentially different set of quotes from U.S. and Canadian plants on a variety of other goods to help determine which to produce in Canada and which to buy in the U.S.

Likewise, Lord sees an opportunity for General Foods factories in Detroit and Chicago to import additional products from Canadian plants. "At least one member of your financial team must become an expert in bilateral trade to fully benefit from free trade," the vice president noted.

Campbell Soup Co. Ltd. of Canada also expects a change in sourcing strategy. "A lower-cost access to markets and a broader array of product sourcing alternatives pose some transition challenges for us," says CFO Robert Hiller, "but they also promise ultimate benefits. And consumers can look forward to increased choice and value as costs reduce and competition intensifies."

Many of the sourcing and pricing decisions CFOs are called upon to make will be influenced by the exchange rate. The Canadian dollar rose against the U.S. dollar during most of 1988, many believe in anticipation of free trade. This followed a three-year period during which the Canadian dollar had been below 80 cents in U.S. currency, enabling many Canadian firms to become competitive with their U.S. counterparts.

If the Canadian dollar continues to gain value, Canadian firms will find it difficult again to compete, and labor costs may deter U.S. companies from branching out in Canada. According to Gilles Rheaume of the Conference Board of Canada, concerns about the U.S. trade deficit are tending to boost the Canadian dollar and have more impact on currency flow than the FTA. "Foreigners would have more confidence in the United States if its trade deficit shrank," Rheaume pointed out, "which would help bring the Canadian dollar below the U.S. equivalent of 80 cents."

This situation is exemplified by Nova International, a medium-sized company launched in 1972 out of Toronto, Ontario. The company produces cutting tools and milling machines for U.S. customers such as Boeing and GM. After attending New York City and Chicago trade shows to ferret out new clients under free trade, president Peter Kolovski was ready to accept a lower profit margin simply to gain a foothold in the United States. The rise in the value of the Canadian dollar hampered Nova's expansion, however, and Kolovski is now simply looking into purchasing low-cost items in the U.S.

Free trade may stimulate both economies by inducing a fall in interest rates, triggered by the drop in inflation. Not only will elimination of tariffs lower prices initially, but increased productivity resulting from economies of scale will keep down future price increases.

The situation created by the FTA is thus one of general confidence and dynamism, which most CFOs in the U.S. and Canada see as bringing about business expansion. The drop in inflation and increase in productivity will encourage more sales, generating profits that can boost both wages and demand. It is this scenario that bolsters CFOs' support for free trade and may well unshackle the North American economy.

PHOTO : Silver, gilt-lined tureen, Russia, 1766. A dramatic nautical container, embossed with Russia's double-headed eagle and the monogram of Catherine the Great

PHOTO : Silver ladle, United States, c. 1785 From silversmith Paul Revere, with the tip of the handle engraved with the semiscript "UR"

PHOTO : A tureen of the tin-enameled earthenware, France, c. 1760 An example of high-quality faience, a type of earthenware used in Europe in the 17th and 18th centuries
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Author:Beaudan, Eric Yann
Publication:Financial Executive
Date:May 1, 1989
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