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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO D E C E M B E R 1992 N U M B E R 64 Chicago Fed Letter NAFTA and the auto industry: boon or bane? The recent successful completion of the North American Free Trade (NAF TA) talks raise serious questions about the potential economic, social and political ramifications of an agreement that may result in the world’s largest and potentially most prosperous com mon market. Among the industries that are likely to be affected, few are of greater concern to the Midwest than the auto industry. One critical ques tion is how the pact may alter trade flows of automotive products and consequently the location of jobs in North America. This Chicago Fed Letter summarizes the auto related agree ments on this issue and finds that the major impact of NAFTA, especially in the Midwest, may be simply to acceler ate a process that most likely would take place regardless of the treaty. However, the question may become whether the U.S. chooses to export goods or jobs. Existing auto trade and trade provisions To a greater extent than trade in most other products, the existing North American market for vehicles is already a highly integrated and growing mar ket where finished goods and parts transcend borders. Total North Ameri can trade in automobiles and auto components has almost tripled in the last decade to over $50 billion annually (see Figure 1). This integration re flects such developments as the explo sive growth of the Mexican domestic industry, further integration of U.S.Canadian production, and the pres ence of four major manufacturers in all three markets along with other manufacturers rapidly following suit.1 Furthermore, integration in auto parts has also occurred with two-way trade between the U.S. and Mexico more than doubling in the last decade to over $8 billion annually. In the aggre gate, trade in automotive products accounts for roughly one-fourth of all trade in North America. That level has accelerated since the mid-1980s and continues to grow substantially. Integration has been encouraged first and foremost by the economic benefits to producers in the respective markets. These benefits accrtie from cheaper inputs, especially labor in Mexico, and access to a burgeoning Mexican con sumer market, especially for U.S. pro ducers. As indicated in Figure 2, these elements were stimulants in the 1980s.Further integration, especially between U.S.- Canadian assembly and technical component facilities and labor inten sive facilities in Mexico, are widely ex pected to continue. Previous trade pacts and adjustments, which have attempted to liberalize the trading environment, are an additional impettis to integration. In the U.S. the most important provisions have includ ed the 1965 auto pact with Canada, the Free Trade Agreement (FTA) of 1989, Harmonized Tariff Rules (HTS) and the Generalized System of Prefer ences (GSP). The auto pact of 1965 between the U.S. and Canada began the process of duty free automotive trade in North Ameri ca. U nder the provisions of the agree ment, most new autos and auto parts could be shipped between the U.S. and Canada duty free. The exception to the rules included replacement parts, used cars, and some domestic content requirements. A loophole in the pact was the duty remission program of the Canadian government which did pro duce some trade distortion by encour aging some production in the Canadi an market. billions of dollars 60 ------------A utos and parts 1980 1985 1990 SO U R C E: U.S. Department of Commerce. The FTA of 1989 removed some of the distortions of the duty remission pro gram and solidified the provisions of the pact. The duty free status of prod ucts with a domestic content level of 50% was established between the U.S. and Canadian markets. Furthermore, the duty remission program was cur tailed by removing its provisions re garding trade with the U.S. and future extension of the program to nonU.S. producers. Consequently, since the mid-1960s, trade in automobiles and auto parts has been relatively unre stricted between the U.S. and Canada, with more than 95% of all trade in autos currently being tariff free. Far and away the most important cur rent provisions with respect to U.S. imports from Mexico have been HTS items 9802.00.60 and 9802.00.80. Un der these provisions, and within the GSP rules, a large portion of Mexican auto components enter the U.S. under limited and/or reduced tariffs. Specifi cally, the provisions reduce the applica ble tariffs levied to the amount of Mex ican value added to a product exclud- other production programs, tariffs on assembled vehicles and parts are elimi nated for Firms which maintain a cer tain level o f production in Canada. Consequently, due to the presence of firms with facilities in both Mexico and Canada, the programs have removed many banders to the Canadian market. hourly compensation in dollars 24 ----------------------- J___________________ I____________________I____________ 1980 1985' 1990 SOURCE: U S. Department of Commerce. ing U.S. components and, therefore, reduce the overall effective tariff rate on products. Estimates of tariffs on auto parts alone indicate that perhaps over half of all parts imported from Mexico are favorably impacted by reduced tariffs under these terms. Trade in this environment, especially Mexican exports to the U.S., has been encouraged, as indicated by the fact that three-quarters of Mexican auto mobile exports are destined for the U.S. The favorable trade provisions have also been a stimulus for the maq uiladora program. Maquiladoras are facilities established for processing an d /o r assembly of imported compo nents which are then re-exported to the original component producing market, usually the U.S. The original program was created in 1965 to assist displaced Mexican migrant workers who had been adversely affected by cessation of a seasonal migrant worker program (the bracero program) in the U.S. Canadian imports from Mexico also have been influenced by preferential trade terms. The duty remission pro gram allows for waiver of all tariffs on many imports from Mexico. The third party provisions of the program have long been an area of contention be tween the U.S. and Canada. However, the program has been a plus to the Mexican auto industry. Under the terms of the remission program and Of course, the Mexican market is still not completely open in terms of trade provisions, and specific external barri ers in the U.S. and Canada may be relatively high. For instance, corporate average fuel efficiency (CAFE) stan dards, countervailing duties, and quo tas for autos still exist. Furthermore, within North America, Mexico still has aggressive trade restrictions which distort the trading environment. Al though the 1989 auto decree brought a realignment and movement toward more progressive policies, the provi sions prior to NAFTA have been rather stringent. After 1989, for instance, the following standards were established: 1) A local content level of 36% was established as a minimal level for all vehicles sold in the domestic market. 2) Vehicle manufacturers must main tain an export to import ratio great er than 1. An initial target of $2.50 of exports to $1.00 of imports was established for 1991 and the sched ule slides down to $1.75 by 1994. 3) The total number of import vehicles sold in the domestic market is re stricted to 15% of the market. 4) Duties of 20% and 13%, respective ly, are imposed on vehicles and auto parts. Undoubtedly, the distortive effects of these terms have been severe, especial ly in light of the robust growth in the Mexican market since the mid-1980s. More importantly, current trade re strictions give strong incentives to U.S. producers to locate in Mexico to have access to Mexico’s rapidly growing consumer market. However, even in the case o f Mexico, many of the provi sions have been weakened substantially in the last decade and the movement to make further modifications has become stronger recently, as evi denced by the willingness of President Salinas' government to participate in the NAFTA talks. Changes under NAFTA NAFTA will impact the North American market by reinforcing underlying trends and altering some aspects of the market, primarily the rules for domestic content levels, duties, and trade balanc ing procedures. According to the agreement, domestic content levels for duty free and/or reduced duty provi sions will be set at 62.5%, which is above the existing U.S.-Canadian level of 50%. This provision would be phased in over eight years, with a reduced level of 60% for auto parts and other vehicles. Upon implementation of NAFTA, the U.S. would eliminate its duty of 2.5% on cars and cut its 25% duty on trucks to 10%. The truck tariff would then be phased out over a five year period. The significance of this agreement is dimin ished by existing HTS rules, which have already liberalized the trading environ ment. In conjunction with these revi sions, Mexico would immediately cut in half its existing duties and phase the remainder out over a ten year period. Finally, Mexican officials have also agreed to phase out the trade balancing rules and its domestic content rules over a 10-15 year period. The impact of the accord will be influ enced in a number of ways by the exist ing environment. First, general integra tion in North America will continue as domestic producers in particular strug gle to maintain market share, reduce costs, and improve profitability. These efforts will likely include movement of some production facilities to lower cost environments in Mexico, closure of surplus capacity in some market seg ments (mostly in the U.S. and Canada) and increased production of some goods to capture a growing market in North America and abroad. These trends are in large measure indepen dent of NAFTA and are being driven by global economic and social factors. Additionally, it should not be assumed that movement of production and fu ture expansion as a result of NAFTA will take place only in Mexico. Quality , efficiency, and labor productivity are important elements in the production decision, and U.S. and Canadian sup pliers may have an advantage in certain areas. Mexican parts suppliers, for instance, have been sheltered from competition under existing rules. Lib eralization of trade terms in Mexico will also open up the Mexican market to imports for the first time, and this may dampen some of the movement of production facilities as well. Under current trade rules, auto producers must have Mexican production facili ties (domestic and export oriented) to sell in the growing Mexican market, a key restriction which in large measure is removed by the agreement. In addition, U.S. and Canadian exports of certain products and parts will likely receive a boost from the opening of the Mexican domestic market. A con sumer market of 83 million is currently underserved and sales are growing rapidly. Thus, liberalization will help to increase exports in this growing market. Still, it is likely that investment flows into Mexico, given the current envi ronment, will accelerate under NAF TA. This inflow will boost labor pro ductivity and the question then be comes whether or not wages keep pace. How much growth in Mexican production displaces U.S. production will be determined by relative growth in productivity and wages. If Mexican wages remain low relative to their pro ductivity growth in this environment, then displacement may occur to a greater degree than if Mexican wages rose quickly. One source of displacement may in volve domestic producers, especially transplants, switching from overseas suppliers to North American suppliers. As written, the pact gives greater pref erence to Mexican suppliers than oth er producers. Consequently, there may be displacement of Asian a n d /o r other overseas suppliers. A substitu tion of North American for overseas suppliers could then produce an over all gain in production and employ ment for industries, like autos, throughout North America. Nev erthe less, it must be remembered that the phase-in period is extended to 10 to 15 years, thus minimizing any shock to formerly protected markets. Conclusion In the North American market, the existing trade terms and recent modifi cations of autos and auto parts trade have further accelerated the integra tion of the market across national borders. Undoubtedly, further liberal ization will intensify these trends, espe cially with regards to vehicle sales and production in the growing Mexican market and will result in fundamental changes in the Mexican and Canadian markets. But in the U.S., for the most part, it will merely accelerate the pro cess of integration already begun. Thus, while the U.S. market will make adjustments, the immediate signifi cance of the accord will be m uted by the existing liberal trading rules o f the U.S. and the gradual phasing in o f the treaty ’s provisions over 10 to 15 years. This analysis does not mean to deemphasize the importance of the trade pact, or minimize concerns over dis placement of labor and other harsh effects like downsizing. These are very real and important issues. However, the pact itself is not the sole cause of liberalization of auto trade in North America, nor will it radically alter the composition of the industry. To say otherwise would be to understate the economic and political changes which have been occurring absent the agree ment. The industry in North America is already highly integrated and al though the environment is not com pletely unrestricted trade, restrictions have been minimized throughout the last 25 years. Furthermore, it should be stressed that the major modifica tions of the pact involve changes in access to the domestic Mexican m ar ket, which has been highly restrictive for foreign producers. The existing restrictions, given the recent growth and potential future growth of the Mexican market, have encouraged the movement of facilities—and with them jobs—from the U.S. and Canada in order to access this market. With the agreement, however, necessary chang es will be made to allow easier access to the Mexican economy. Consequently, job displacement directly attributable to the trade agreement should be mini mal and, with the potential grow th in the Mexican market, there may even be job growth. In sum, NAFTA, along with other fac tors, will encourage further restructur ing in the industry” however, indepen dently of these other factors, it will likely not fundamentally change the motor vehicle industry in the U.S. and North America. —Paul Ballewr and Robert Schnorbus 'C urrently, G eneral M otors, Ford, C hrys ler, an d Volkswagen have significant pres ences in all three m arkets. Jap an ese n a m e plates (i.e., all brands p ro d u ced by a p ar ticular m aker), in particular Nissan a n d Toyota, have begun to e n te r the M exican m ark et aggressively. -Total labor costs are affected by p ro d u ctiv ity in addition to wage rates. Also, access to th e grow ing M exican m arket is an im p o r tan t incentive fo r establishing p ro d u c tio n facilities because the existing trad e restric tions m ake it very' difficult for M exico to im p o rt significant quantities o f vehicles. _ Karl A. Scheld, S en io r Vice P re sid en t a n d D irecto r o f Research; David R. A llardice„ Vice P re sid en t an d A ssistant D irecto r o f R e search ; Carolyn M cM ullen, E ditor. Chicago Fed Letter is p u b lish ed m o n th ly b y th e R esearch D e p a rtm e n t o f th e F ed eral R eserve B ank o f Chicago. T h e views e x p ressed aue th e a u th o rs ’ a n d are n o t necessarily th o se o f th e F ederal Reserve Bank o f C hicago o r th e F ed eral Reserve System. Articles may b e r e p r in te d if th e source is cred ited an d th e R esearch D e p a rtm e n t is provided with co p ies o f th e reprints. Chicago Fed Letter is available w ith o u t c h a rg e fro m th e Public In fo rm atio n C e n te r, F e d e ra l Reserv e Bank o f C hicago, P.O. Box 8 3 4 T C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Motor vehicle production, millions (saar) 9 ----------------------------------- Manufacturing output index (1987=100) Sept. Month ago Year ago MMI 109.0 110.9 110.6 IP 109.4 109.8 108.9 Motor vehicle production (millions, saar) Oct. Month ago Year ago Autos 5.5 5.6 5.9 Light trucks 4.2 3.6 4.2 ■ Purchasing Managers’ Surveys: production index Oct. Month ago A / V / ^ Light trucks ' Year ago MW 58.4 64.1 57.5 U.S. 54.3 52.6 60.2 1 ------------------------------------------------------------------------------------------------------------------------------ _______________________________________________________ I I « 1 « I I 1 1 I I t 1 I I 1 1 t 1 1 1 I 1 1 1 1- 1— I--L 1 1_1__L I I I 1 I 1 l__i_ I -1-1 -LI i- 1 NOTE: Dotted lines are estimated production 1990 1991 The Midwest manufacturing sector could be feeling the strain of keeping its own and the nation’s recovery moving forward. Both the MMI and the Purchasing Managers’ Survey in recent months has been indicating a slowing of momentum. But most disturbing has been unexpected weakness in car production, following lower than expected sales. Domestic car producers cut assemblies in the third quarter to a 5.6 million unit annualized rate—half a million below the second quarter rate. Fourth quarter production plans call for virtually no change in assemblies in the fourth quarter. Light trucks , so far, are expected to provide an offset by increasing production to a 4.3 million rate this quarter from 3.7 million last quarter. 1992 1993 SOURCES: T h e M idwest M a n u fac tu rin g In d e x (M M I) is a com posite index o f 15 in d u strie s, based on m onthly ho u rs w orked a n d kilo w att h o u rs. IP rep re sen ts the FRBB in d u strial p r o d u c tio n index for the U.S. m a n u fa c tu rin g se c tor. A utos an d light trucks are m e a su re d in a n n u alized physical units, using seasonal a d ju s t m en ts developed by the F ederal R eserve B o a rd . T h e PMA index for the U.S. is th e p ro d u c tio n c o m p o n e n ts from the NPMA survey a n d fo r th e M idwest is a w eighted average o f th e p r o d u c tion co m p o n e n ts from the C hicago, D etro it, a n d M ilwaukee PMA survey, with assistance from B ishop Associates a n d C om erica. III£-S6£ (oIS) H'80-06909 s!o u lllI ‘o S b d iio F£8 xoH O d ja u ia ^ u o u e iu j o j u j o n q n j OOV3IHO 40 3NYH 3A33S33 TY33Q33 jdtpt paq oSuaxqo
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