One year in and one tentative bilateral deal later, the hardest part of NAFTA negotiations still lies ahead. The U.S. and Mexico on Monday announced that they had resolved their differences and had reached an agreement on a trade deal. Canada has not been outright excluded from participating in the U.S.-Mexico deal, but nor is its inclusion a forgone conclusion. The conversation will now focus on the U.S.-Canada bilateral relationship – a relationship in which, contrary to U.S.-Mexico trade, the two players are on more equal footing. The intensity of negotiations will reflect this fact.
Trade deficits have been a battle cry in the U.S.-led trade wars, but the U.S. actually had a slight trade surplus with Canada in 2017. The U.S. trade deficit in goods with Canada was $17.1 billion (versus $71 billion with Mexico), according to the U.S. Trade Representative. (Both figures pale in comparison to the U.S. goods deficit with China and the European Union, which totaled $347 billion and $147 billion in 2016, respectively.) But when it comes to trade in services, the latest reports from the USTR show that majority U.S.-owned affiliates sold $121.3 billion worth of services to Canada in 2015 (the most recent year for which data is available), compared to $100 billion sold to the U.S. by majority Canada-owned firms. Canada also has greater foreign direct investment in the U.S. than vice versa ($453.1 billion to $391.2 billion), though it still trails the United Kingdom and Japan. All this gives Canada some leverage Mexico didn’t have.
This doesn’t mean Canada can easily walk away. Canada has been contemplating the effects of trade tensions with the U.S. for months now, and Ottawa is more than aware of its economic constraints. Exports account for approximately 31 percent of Canada’s gross domestic product, with 76 percent of those bound for the United States. In March, the National Bank of Canada published a special report on Canada’s exposure to U.S. protectionism. It identified 24 key Canadian exports to U.S. markets and divided them into three levels of risk. The lowest-risk industries were those with a high degree of dependence (i.e., 25 percent or more of exports) on U.S. markets; medium-risk industries were similarly U.S.-dependent and, without a free trade deal, would likely be subject to high tariffs under the most favored nation clause of the World Trade Organization; and high-risk industries were U.S.-dependent and added the condition that the U.S. had already put tariffs or had threatened them with tariffs. The report concluded that, in the event NAFTA was abolished and the U.S. followed through on threatened higher tariffs, up to 5.8 percent of Canada’s GDP would be at risk. (Note that this does not mean its GDP could drop by 5.8 percent, but that the at-risk industries the report identified make up 5.8 percent of Canada’s GDP.)
Of course, the impact won’t be felt equally across the Canadian economy. The initial exposure of listed goods, for example, was calculated at 11.5 percent but was then reduced, with the report saying that only goods with value added were truly at risk. The report also did not consider Canada’s oil and energy exports to the United States. These are Canada’s top exports by value – they account for 20 percent of the country’s total exports – and 91 percent of them go to the U.S. Last year, we concluded that the U.S. and Canada are mutually dependent in the oil trade. This will help discourage harmful actions in energy but it doesn’t make Canadian energy immune. Finally, some Canadian provinces would be hit harder than others. Manitoba, Quebec and Ontario would see 6.4 percent, 6.8 percent and 8 percent of their GDPs at risk, respectively. Quebec and Ontario are the most populated provinces and have the largest economies in Canada.
No country, even one as developed and diverse as Canada, would willingly risk up to a 6 percent cut in GDP. Canada has thus been working to diversify its trade away from the United States. Last year, it signed a free trade agreement with the EU that will give it access to a market comparable to that of the U.S. (All EU member states need to sign off, but provisional implementation of the deal is active.) Preliminary results indicate that Canada is slowly but surely making progress. From January to June, Canada’s exports totaled 301.65 billion Canadian dollars ($233.44 billion), according to the government stats agency Statistics Canada. The U.S. accounted for only CA$194.37 billion, or 64.4 percent, of the total – a 12 percent reduction from the same period in 2017. The EU ranked as the second-largest market, taking in CA$31.27 billion worth of exports (10.4 percent). China increased its share to 7.5 percent from 4.3 percent last year, while Mexico more than doubled its share to 3.5 percent from 1.4 percent. Canada is moving in the right direction, but it’s slow going.
In other words, Canada needs a deal. If even half as much of Canada’s GDP were at risk as the bank expects, it would create social and political upheaval. Canada has experienced three recessions in its recent history: 1981-82, 1990-92 and 2008-09. In the first of these, Canada experienced six consecutive quarters of contraction, with GDP and employment each falling by 5 percent, according to Statistics Canada. Recovery took three years. The second recession was milder – GDP contracted 3.4 percent over four quarters, and employment fell by 3.2 percent over two years. Recovery took four years. It was this recession that spurred Canada toward a trade agreement with the U.S. that quickly led to NAFTA. The 2008-09 recession was the mildest, with three quarters showing a 3.3 percent contraction in GDP and employment falling 1.8 percent. Recovery came in two years.
What this means is that in a worst-case scenario, the end of NAFTA would put Canada on the road to its worst recession in recent history. Even a 3 percent drop in GDP would have the country facing years of economic hardship and would leave voters questioning the government’s decisions that led to such hardship. Furthermore, the International Monetary Fund and the Bank of International Settlements have already warned that Canada’s debt situation makes it a prime candidate for a financial crisis. Ottawa will have to take into account its ability to deal with any shocks to the system, no matter how manageable they seem.
But the politics at home won’t be easy for Canada. So far, the government has been using NAFTA negotiations to show that it can be assertive with the U.S. and that it isn’t Washington’s puppet. It’s a message that has resonated with portions of the electorate: Beginning in July, some Canadians independently organized informal boycotts of select U.S. goods, using hashtags like #BuyCanadian, #BoycottUSProducts, and #BoycottUSA.
Talks won’t be as easy this time around for the U.S., either. The most controversial issues will be the dispute settlement mechanism (which Mexico agreed to throw out), the clause requiring regular reviews of the agreement, pharmaceuticals and intellectual property regulations, and Canada’s subsidized industries. Washington will be dealing with a government that seeks to score political points through hard bargaining, and the nature of Ottawa’s economic relationship with the U.S. gives it a bit more negotiating space. The United States’ awareness of these facts is what drove it to seek a deal with Mexico first. By sealing a deal with Mexico, the U.S. increased its leverage with Canada, but Washington’s apparent indifference toward Canada’s inclusion is part of the negotiation. The U.S. would have to be extremely aggressive for Canada to walk away from any type of trilateral agreement – the costs would be too high – but Ottawa won’t pass on the opportunity to score political points and press for the best deal it can get.