How to stay nimble as USMCA tensions heat up

By Michelle Stokes

All investments come with risk, that’s a given. But when considering long-term investments of hundreds of millions or even billions of dollars in the establishment of a production facility, one wants some degree of reassurance that the basic value proposition of the investment will hold firm.

Uncertainty, like that which befell North America between 2017 and 2019 when the North American Free Trade Agreement (NAFTA) was put on the table for renegotiation, is precisely the sort that puts a chill on the investment climate. Take Mexico as a case in point. In 2016, the year before renegotiation of NAFTA began, America’s southern neighbor saw $38.9 billion in foreign direct investment (FDI) inflows. By 2019, the second and final year of negotiation, those inflows had dropped to $29.9 billion. That a 23% drop in two years. Once all three leaders signed the deal at the close of 2019, things began to perk up. Even in the midst of a global pandemic, FDI inflow in Mexico grew to $31.5 billion in 2020 and has been rising steadily since.

In Canada, the recovery was much quicker. The country’s 10-year average of FDI inflows went from $47.8 billion in 2016 to $29.6 billion in 2017, a drop of 38% in a single year. But those flows shot right back up in 2018 to $48.8 billion, eclipsing the 2016 figure.

The key message here is that investors didn’t particularly like the uncertainty wrought by the often-public renegotiation of NAFTA, which was characterized by threats of Washington pulling out of the deal entirely. If you were an automaker looking to set up a multi-billion-dollar manufacturing plant in Mexico with the goal of avoiding the 25% tariff on light trucks by leveraging the trade deal, you likely put any significant investments on pause.

A new trade landscape

But that was then. Today, NAFTA’s successor, the United States-Mexico-Canada Agreement (USMCA) is the bedrock by which trade takes place in North America. In fact, since the agreement took effect in July 2020, intraregional trade within North American has soared. U.S. exports to Canada and Mexico went from $468 billion in 2020 to $680 billion in 2022. Mexican exports to USMCA partners spiked 40% and Canadian exports to its southern neighbors surged to 58%. It should be noted, however, that these figures are amplified by the fact that the deal was launched when trade activity had plummeted to dramatically low levels due to the pandemic.

But there’s more to the picture than just the certainty brought about by the signing of the USMCA and the natural boost in trade levels that followed the pandemic. Global companies saw their risk exposure shift quickly from the volatility of the NAFTA negotiations to the widespread disruption to supply chains brought about by production shutdown in Asia during the pandemic. Suddenly, North American production was looking a lot safer than cheaper overseas production, especially since Washington and Beijing’s trade war saw no signs of waning.

Many of those multinationals began their shift away from a just-in-time supply chain to a just-in-case model that involved stockpiling inventory stateside and diversifying suppliers to reduce reliance on China. Mexico became a sanctuary for many as did Canada where there’s an abundance of high-skilled workers and a relatively harmonized regulatory environment and business culture.

Given the rapid acceleration of North America’s regional integration there is little likelihood that the leaders of the three countries will do anything to put the USMCA in jeopardy. But that doesn’t mean there’s an absence of risk.

Cause for conflict

While the private companies have been betting consistently on North American regionalism in recent years, it’s important not to be too pollyannish about the fate of the continent’s trade. The reality is that many of the conflicts that were emblematic of the fraught NAFTA renegotiation are still very much present.

Washington continues to express its dismay over Mexico’s nationalized energy sector and its exclusionary policies towards foreign investors. Canada’s approach to USMCA compliance in the dairy sector has been called out by the U.S. dairy industry as obstructive, and Washington continues to argue it is so despite a dispute panel having already ruled that Canada is in compliance.

Both Canada and Mexico continue to practice the so-called roll-up mechanism to calculate regional value for automobiles, a method Washington has opposed in favor of more accurate reporting that automakers decry as far too onerous. Again, a dispute panel has already ruled in favor of America’s neighbours, but Washington has yet to indicate definitively whether or not it will accept a roll-up calculation.

There are also lingering disputes between the U.S. and Mexico over agriculture and between the U.S. and Canada over softwood lumber. Individually, none of these disputes are likely to prompt any USMCA party to do away with the deal. But doing away with the deal isn’t necessary to scare away investors. There need only be the possibility the deal gets shelved. That possibility will become increasingly prevalent as the USMCA’s first tripartite review takes place in 2026. That’s where the outcome of the election becomes critical.

The politics of the USMCA

The initial renegotiation of NAFTA was held at the behest of the U.S. government. Led by the Trump administration, the goal of the renegotiation was to get a better deal for the U.S. and, more specifically, U.S. workers. In essence, the Trump team viewed NAFTA as giving the U.S. the short end of the stick and robbing its economy of much needed jobs in the manufacturing sector. This populist positioning resonated well with the electorate and the renegotiation was widely supported.

In the end, the USMCA didn’t represent a significant departure from NAFTA save for new rules in auto sector trade and some small gains for the U.S. in accessing Canada’s dairy market. The other key changes were mostly administrative, such as a new dispute-resolution system, simplifications to how goods are certified and resolutions to disputes around steel and aluminum. That didn’t stop the U.S. government from claiming the USMCA as a victory for the American worker.

As the U.S. election of 2024 draws nearer, there is good reason to believe some of these sentiments are likely to resurface. While the Biden administration has generally taken a hands-off approach to the USMCA, preferring to allow the dispute-resolution process to carry out its due diligence, the return of a Trump administration and its trade czar Robert Lighthizer may bring USMCA disputes to the fore. How and when that happens might make investors antsy, though likely not nearly as much as the nail-biting days of the NAFTA renegotiation.

Not the only game in town

There’s no question the USMCA offers significant gains to the businesses that use it. Those that trade in high volume and who make use of regionally or globally integrated supply chains, save tens of millions of dollars in duty outlay by making use of the trade deal. Even with the often burdensome administration of the record keeping, certification et al that come with using the USMCA, it’s in the interest of any business that trades with North America to make use of it.

But as the still fledgling agreement finds itself back in the spotlight, supply chain managers and the investors who line their pockets may want to hedge their bets by diversifying their use of free trade beyond the USMCA.

Many U.S. firms have production facilities located in Mexico and Canada. These supply-chain points often receive inputs that come in from other parts of North America. That’s sound supply chain logic. But the other option is to leverage the many free trade agreements both Canada and Mexico share with countries around the world. For example, Canada has a free trade deal with the European Union called CETA that offers just as much duty exemption as the USMCA. Mexico holds more than 40 free trade agreements with countries around the world. And both Canada and Mexico are signatories to the Comprehensive and Progressive Agreement for Trans-Pacific Partnership or CPTPP (try saying that fast 10 times). The CPTPP, an agreement between 11 Pacific Rim countries and, most recently, the UK, offers the opportunity for significant duty savings. As an example, a companies could use Vietnam as an alternative production base to China and bring goods into either Canada or Mexico duty free through the CPTPP. The trick, however, is to ensure those goods are transformed substantially before they make their way into the U.S. or Canada. Exactly what that means isn’t always clear, which is where a firm’s compliance manager tends to step in to ensure all the required boxes are checked. The other critical factor is adherence to the Rules of Origin, which set out exactly what qualifies for duty exemption and often demand a certain percentage come from within North America.

Importing into North America without importing into North America

For companies that have overseas markets, one of the most under-utilized mechanisms of trade are free trade zone (FTZs). These small geographic areas adjacent to airports and seaports are hubs of manufacturing activity. They see goods come into the U.S., Canada or Mexico and sent directly to a production facility within the FTZ. As long as the goods remain within the FTZ, they’ve not technically entered the official commerce of the country. The goods then undergo a degree of transformation before being re-exported outside the country.

The FTZs could be particularly advantageous where goods originate in a CPTPP or CETA country but require an element of manufacturing in the U.S. (perhaps advanced manufacturing that requires rare technical expertise) before making their way to Canada. Leveraging the USMCA may not be an option if the percentage of North American content is minimal. But using a U.S. FTZ for eventual re-export to Canada allows firms to avoid duty in the U.S. while the CPTPP allows for duty exemption in Canada.

Like free trade deals, FTZs come with their own set of administrative headaches, including import and export licenses, certifications, regulatory requirements and more. But the monetary savings are well worth those headaches.

How to know when to use USMCA alternatives?

Knowing when and how to use the USMCA depends on a number of factors that firms need to consider when evaluating global supply chains. Here is a non-exhaustive list of those considerations:

  • What are the Rules of Origin (ROO) and Regional Value Content (RVC) requirements for my product and to what extent can I include content from outside North America?
  • Where is my end market and is there an opportunity to make use of free trade agreements held by Canada and Mexico?
  • If my end market is outside of North America, to what extent does it require North American production input?
  • How many border crossings are involved in my supply chain and can I leverage free trade agreements or free trade zones to reduce my duty outlay?
  • Does my company have the internal expertise and human-resource capacity to navigate the complexities and administrative burden of using one or more free trade agreements?

Hedging bets

As noted above, there is little likelihood that investors should be fearful over the fate of the USMCA, despite some of the politicking that may take place during and after the upcoming U.S. election. But diversification is the rule of the day. Just as my colleague, Jamie Adams, wrote about nearshoring diversification; FTA diversification should be given equal weight.

The end goal is to prevent overdependence on any single process, agreement or supplier. Investors and supply chain managers have learned all too well the dangers of over-dependence on China. The supply chain of the future is one that can flex, and scale as needed to meet shifting market conditions and threats and/or disruptions that may stall production processes. Some food for thought for those looking past the upcoming election.

Michelle Stokes is the Senior Director of Global Trade Consulting for Canada at Livingston International. She has led and implemented business strategies with free trade agreements, valuation, import tariffs, trusted trader programs, cross-border security initiatives, and e-commerce solutions.  Her global expertise includes multi-country projects with a focus on customs compliance, improved flow of goods across international borders and predictability and stability in new markets.