Market Perspectives: In the News

The Day After NAFTA: Economic Impact Analysis

Freight Train
Douglas Porter BMOCM
Douglas Porter
Chief Economist
BMO Financial Group

The following report was originally published by BMO Capital Markets. To view the full report, click here.

Executive summary

The growing threat to NAFTA, and all the uncertainty that possible termination entails, has prompted a myriad of questions on what this would mean for the North American economy, financial markets and monetary policies. This report delves into those issues, and explores the impact by sector and by region, looking at where the greatest vulnerabilities lie.

Our overriding conclusion is that while the termination of NAFTA would clearly be a net negative for the Canadian economy, and a mild negative for the U.S. as well, it is a manageable risk that policymakers, businesses, and markets would adjust to in relatively short order. It is critical to note that policy would not stand still in the event of a negative outcome for NAFTA. Monetary policy would be looser than it would otherwise be, the Canadian dollar would adjust lower, trade policy would be aggressively aimed at securing new arrangements, and even fiscal policy would potentially adjust. All of these factors would work to mitigate the economic damage. Over the span of five years, we estimate that real GDP would be up to 1% smaller than it otherwise would have been. That’s a relatively moderate impact on an economy that is expected to expand by close to 9% over that period.

U.S. macroeconomy

With Canada and Mexico accounting for a combined 26% of U.S. goods and services exports, or 3.1% of U.S. GDP, the direct impact of the tariff on exports is modest at just over 0.1% of GDP. However, given some likely strengthening in the U.S. dollar (versus the C$ and the peso), the adverse impact on exports could be somewhat larger. Imports from Canada and Mexico account for an equally modest share of U.S. imports (24%) and GDP (3.4%). Therefore, the reduction in imports from the two countries stemming from the tariff amounts to less than 0.1% of GDP. In fact, it could be zero assuming a stronger greenback and sourcing of products from other countries. Thus, the U.S. trade deficit would likely widen modestly as exports weaken while imports hold relatively steady. Still, the net drag from trade is unlikely to amount to much more than 0.1% of GDP.

American spending power would be little affected by the tariffs. The tariff on imports from Canada and Mexico would lift prices by less than 0.1%, having a negligible effect on the purchasing power of households and businesses.

Provincial Exposure to US ExportsThe more material impact on the U.S. economy would emerge from potentially lower productivity due to disruptions to supply chains, the need to transform business processes, and a likely shift of resources into tariff-protected (but less productive) industries. Though difficult to quantify, the reduction in productivity could have a material impact when accumulated over long periods of time.

The main message is that the U.S. economy would slow modestly without NAFTA, likely by around 0.2%. U.S. business competitiveness would take a hit, possibly worsening its trade deficit with Asia and Europe. Employment losses (assuming half the hit is absorbed through lower productivity) would be around 0.1% of payrolls, lifting the jobless rate slightly.

For the Fed, the uncertainty for businesses would likely encourage an even more cautious approach to normalizing policy, likely precluding at least one of the three rate hikes we have penciled in for 2018.

U.S. industry

Industries with significant vulnerability

The transportation equipment industry is judged to be among the most exposed. Although auto exports to Canada and Mexico are small in comparison to the U.S. domestic market, both countries are crucial contributors to the continental manufacturing network. As a result, even modest tariffs on North American trade could raise costs substantially across the production chain—especially given the tendency of parts and assemblies to crisscross the border multiple times during the production process.

U.S. manufacturers of textiles, clothing & leather would face among the most burdensome trade barriers if North America were to revert to WTO rules, with tariff rates expected to reach nearly 13% for exports to Mexico and 8% for exports to Canada. This would represent a significant headwind for U.S. manufacturers, as the combined Canadian and Mexican markets account for a not-inconsequential 15% of total sales.

Industries with moderate vulnerability

Two U.S. manufacturing industries and the crop sector are judged to have moderate sensitivity.

Of all U.S. industries, computer & electronics producers and appliance & equipment manufacturers rely most heavily on NAFTA members for sales, with combined exports to Canada and Mexico accounting for over 20% of receipts. And, while WTO-level tariffs would not be especially high, at less than 2% for the Canadian and Mexican markets, the resulting tariff bill could prove material in these low-margin industries.

U.S. crop producers would also be materially affected, as they would face tariffs averaging nearly 4% on exports to Canada and a lofty 11% on exports to Mexico. Although the industry is not especially reliant on NAFTA members for sales, with Canada and Mexico accounting for around 7% of industry receipts, dramatic climate differences across North America mean that import substitution is likely to be relatively limited.

Industries with low vulnerability

U.S. financial institutions would face similar, if more moderate, challenges to those in Canada. Remaining U.S. industries are judged to have limited vulnerability to NAFTA termination. Generally, these industries have not integrated their production processes across the Canadian and Mexican borders, and have little reliance on sales to other NAFTA members.

U.S. regional

Selling Mostly to Canada and Mexico - Largest Goods Export Trading Partner by StateThe U.S. regional impact of a NAFTA termination would be spread across many states, but those near the borders, and with high exposure to industries with tightly-integrated supply chains, would face the biggest fallout.

The vast majority of U.S. states count Canada or Mexico as their top export market for goods. Canada is the top destination for exports from 32 states, including nearly the entire Midwest and Northeast regions. An additional 6 states (including the Border States from California to Texas) rely on Mexico as their top market.

Some states would certainly feel a significant impact from a trade disruption. Michigan looks the most at risk thanks to a tightly-integrated auto-sector supply chain. Elsewhere, auto-sector exposure plays a key role in driving state exposure, with Alabama, Indiana, Kentucky and Ohio all seeing vulnerable exports account for more than 1% of GDP.

North Dakota relies on Canada and Mexico for a hefty 84% of exports, but oil accounts for the bulk of shipments, an industry we deem low risk, and thus the state looks relatively sheltered in our analysis.

Illinois and Wisconsin both have relatively high export shares to Canada and Mexico (more than 40% of total exports for each state), while the share of exports to these countries that are in sectors deemed vulnerable is above the state median. Indiana’s exposure to the auto sector leaves it vulnerable, while Minnesota’s diverse economy appears to be in the middle of the state pack.

Arizona’s relatively high exposure comes on the back of computer products and electronics, a burgeoning industry in the state.

Finally, while not as severe as states tied more significantly into the auto sector, Missouri and Kansas would face a significant challenge given elevated export levels in agriculture, as well as significant factory activity in transportation equipment.

Access the full report for more details on the U.S. and Canada macroeconomies, industries and regional/provincial impacts:

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