Uncertainty reigns in the era of Trump

If you are a US-Mexico international trader or investor looking for an antidote to relieve the stress and anxiety of a Trump administration, this article may be a good solace for consolation but it is warrantless.

We have researched and gathered expert opinions on the subjects critical to US-Mexico relationships, and at the time of this writing (December 15, 2016) we can offer what may be labelled as “Educated Speculation” about the things to come.

The subject matter –Trump’s policies in affairs with Mexico- is one of the most challenging, elusive and we must say “entertaining”, no pun intended, journalistic topics ever in Naftaland. Trump’s aggressive electoral rhetoric against Mexico has already damaged the country considerably. In the few post-election weeks, the peso lost 10% of its value versus the dollar, foreign and domestic investment projects that were in the planning stages stalled and a shroud of uncertainty and fear suddenly extended over everyone with a stake in Mexico. Not to mention that Mexico’s growth GDP for 2017has been degraded from 2.8% to 1.7% largely as the result of the U.S. elections.

This is the typical prelude of an economic recession, which can go from a mild downturn if the issues are resolved favourably and fast to a more drastic economic decline if negotiations are long lasting and adverse to Mexico.

Mexico’s sin is having most of its eggs in the U.S. basket. Mexico’s globalization and economic model is built around exports to the U.S. market through a web of free-trade agreements, availability of competitive workers and a reasonable cordial relationship with its northern neighbour. Up to now, it seems.

In this piece, we will go over some interesting data on the U.S. – Mexico economic relationship, the potential Trump trade negotiating options and the shield that protect the North American Free Trade Agreement, NAFTA; we will end with some recommendations that Mexico may consider in this process.

FDI flows both ways

Mexico “elected” Donald Trump.

Without the bombast on Mexico’s immigrants, trade gap, jobs outflow and FDI flight, President-elect Trump would not be.

In the campaign, Trump often used Mexico as a scapegoat or “chivo expiatorio” in Spanish. He certainly found the perfect country to blame for most of the economic ailments in the U.S.

Although some of Trump’s arguments against Mexico may be true, there are data that evidence that he short changed the benefits of the U.S.-Mexico economic relationship.

Take for instance the “Flight of Foreign Direct Investment (FDI) from the U.S. to Mexico” illustrated in Exhibit #1. During the last three decades or so, the U.S. has accumulated about US$110 billion FDI in Mexico. U.S. manufacturers from Ford and GM and Carrier are highly criticized for opening facilities in Mexico. But Mexico’s FDI of about US$18 billion in the U.S. is rarely the subject in the U.S. media or high-level political conversations.

And if you consider the relative size of the U.S. (US$18 trillion) and Mexico’s (US$1.2 trillion) economies, it turns out that Mexico is relatively more invested in the U.S. that the other way around!!

Indeed, with an economy 15 times smaller than the one of the U.S. Mexico FDI with its northern neighbour is only six times smaller. The point is that while “public knowledge” in the U.S. is that its factories, investment money and payrolls are headed south, the truth is that these flows are relatively balanced, or favour the U.S. if the size of their economies is considered.

According to the U.S. Bureau of Economic Analysis, Mexico’s FDI in the U.S. supports at least 123,000 jobs in facilities in the U.S. such as the 70 bakeries owned and operated by Bimbo, dozens of operations by Cemex and Gruma in the southwest and multiple plants of Mexican auto parts makers Rassini and Nemak in the rust-belt.

About Trade and Jobs

A study by the International Trade Administration concluded that almost five million jobs in the U.S. depend on exports to Mexico. This report breaks down those jobs by state as shown in Exhibit #2. Not surprisingly, California, Texas, New York and Florida top the list with over 1.5 million jobs combined. U.S. middle class workers, which represent Trump’s largest group of supporters, have not experienced a rise in their income in the last 20 years and many lost their jobs.

But why blame Mexico and NAFTA for all those lost jobs?

A recent research by Ball State University indicated that during the period of high manufacturing job losses in the U.S. (2000-2010) 87% were caused by technological production improvements and increases in productivity while only 13% of the losses were trade related. And China was the main sucker, not Mexico. It is common knowledge among Global firms, and even guardedly accepted by some large U.S. unions, that low wage jobs in Mexico actually support higher paid workers in the U.S.

For many firms in the U.S. their factories in Mexico are vital; without them they would not survive in the highly competitive international marketplace. By relocating low-cost labour production to Mexico, global firms are able to grow and expand. For instance, cardiac devices maker Merit Medical’s CFO Bernard Birkett recently said: “We move high-volume, labour-sensitive to Mexico to benefit from lower costs, then in turn we fill the emptied capacity in our U.S. factory in our U.S. factory with innovative products from our own R&D or by acquiring new product lines.”

The principle of “Production Sharing” by which the making of parts and components and final assembly are conducted in the most competitive location is fundamental for global firms to keep their competitive position.

In the case of NAFTA, the ability to share production processes between the three countries has truly made the region the most competitive and efficient manufacturing platform in the world! Mexico and the U.S. are not job competitors; they are manufacturing partners, building things together for the benefit of the companies and the consumers.

Alter this arrangement and many firms will succumb to international competitors even triggering a recession in the U.S.

But worse yet, the U.S. would be doing China and a great favour, as the huge Asian dragon would quickly gain an even larger share of the global markets across all industrial sectors. China already ships nearly 25% of all world exports.

Trump’s Mexico Trade Paths

Up to mid-December President-elect Trump continued to threaten with slapping a 35% tariff on all imports from Mexico and possibly withdrawing from NAFTA.

The minimum and imminent action by the new administration will be a renegotiation of NAFTA. But the term “renegotiation” in itself is vague and may have a very broad spectrum of items to cover.

We can divide Trump’s NAFTA options in three potential as shown in Exhibit #3.

The first, which would be considered a “Soft-landing” would be to renegotiate NAFTA within the existing parameters of the treaty and the World Trade Organization (WTO). After all, NAFTA is 23 years old and is due for revisions that were supposed to be made annually.

In this path, the agreement could be kept in its original structure, and changes could be made by using protocols or other forms of side agreements.

A longer and more complicated option is to re-write the agreement completely if the number of changes is overwhelming. But in either case U.S. and Mexico’s Senate approvals are required, along with Canada’s of course.

Some trade industries would be analysed and even selectively targeted with punitive duties. There are plenty of other issues of renegotiation including for example rules over E-commerce, which was inexistent when the original agreement came into effect in 1994.

More openness by Mexico in the telecommunications and media markets should be a priority item for the U.S. and one that would be cheered by consumers in Mexico.

Mexico also has qualitative or “virtual” barriers to imports by requiring myriad compliance documentation for many imported goods and farm products; U.S. negotiators would likely ask for more import facilitation on the part of Mexico.

And there are of course the “Rules of Origin” which the Chinese use to route clothing to Mexico via the U.S. or cheap auto parts to the U.S. by first “naturalizing” or “naftalizing” the products in Mexico. Evidently, the rules of origin need much stronger enforcement.

Other subjects such as labour and environmental practices, intellectual property protection and even corruption practices, among other issues, may be revisited in a NAFTA renegotiation process.

It is a complex renegotiation and it would take time, but if soft-landing were the path of choice, no major damage would be made to the U.S. economy. Mexico’s economy would suffer because of the negotiations outcome uncertainty and the time they may take, but it will be OK, not KO.

In the “Hard-landing” scenario, Trump would impose a duty of anywhere from 3% to 35% across the board on all imports from Mexico.

This is a tough option and it hurts all parties. Retaliation by Mexico would be inevitable and quick.

Besides disrupting all supply chains, the U.S. would be shooting itself on its foot, as American consumers would be “taxed” with higher prices.

Furthermore, according to the Peterson Institute, this action, at the higher tariff of 35%, would ripple through the American economy by hitting private sector employment by 4.8 million and possibly activating a recession.

Although under special circumstances such as a war or an emergency, the U.S. President can indeed impose import duties, but the new administration team, is or should be, a lot smarter to not opt for tariffs that would eventually backfire.

Trump’s third option to deal with NAFTA is to “Crash-land” the deal by withdrawing with six-month prior notices, something that the U.S. President can do “without” approval from the senate.

The grammatical preposition “without” is in quotes because although it says so in the NAFTA document, this Presidential prerogative would be highly contested by the Senate itself and other interested parties.

The issue would be highly litigated at many court levels and it could become so entangled that even a constitutional crisis in the U.S. would be possible.

The prolonged litigations and uncertainties would cause significant damage to both the U.S. and Mexico’s economies.

But there is more.

Terminating NAFTA would only transfer Mexico from a 0% import duty to about a 3% tariff under the most favoured nation according to WTO rules.

This is something that would certainly not satisfy the author of the “Art of the Deal” book, so now he would need to withdraw from WTO, a 21-year-old entity with 164 country members that encompass 98% of total world trade and that the U.S. promoted to found.

That would be a suicidal “Crash-landing” that would alter all global economies.

The U.S. Trade Deficit with Mexico

The talk about NAFTA and global trade is dominated by its negative, and highly misunderstood effects, but its benefits are for the most part unknown, unseen or taken for granted by most in the U.S.

But U.S. consumers would immediately take notice if suddenly, under a Trump extreme anti-trade/fully-made-in-America scenario, auto prices jumped 15% or more at dealerships, smart phones became 40% more expensive, and trivial goods such as clothing doubled their sticker prices in stores.

The trillions (with a T not a B) of dollars that U.S. consumers save every year courtesy of free-trade are spent back mostly into the U.S. economy creating literally millions of jobs in the services industry, high-tech firms and even manufacturing.

The U.S. economy is shifting from being a manufacturing economy to a services one. Millennials do not want to work in an auto factory; their goal is a job at Google, Apple or other high-tech or service firm.

By virtue of the consumers and the huge market they represent, the U.S. became a gargantuan importer.

Please see Exhibit #4 from the U.S. Census Bureau where China represents roughly 50% of the U.S. goods trade deficit, Mexico is at about 8% and the rest of the world accounts for 42%.

Notice in the graph that in the early 90’s the U.S. actually had a surplus or even trade with Mexico. Few remember that when NAFTA started, Mexico lost hundreds of thousands of jobs and thousands of companies as the country got inundated with a huge wave of U.S. goods, retailers and franchises. But Mexican consumers were very, very happy to buy American goods at competitive prices.

So, President –elect Trump sees foreign trade as a Zero-sum case, meaning that trade between two nations should be even. Well, in the case of Mexico it appears that Trump, without doing anything, could get his wish, not in two or three years, but maybe in about 10.

The main product categories traded between the neighbours are shown in Exhibit #5. The most important item is automotive; please note that even if motor vehicles U.S. imports from Mexico continue to rise, the offset is the U.S. auto parts exports to Mexico, since finished light vehicles assembled in Mexico contain about 40% of U.S. manufactured parts.

The other important category to look at is Oil and Gas, where Mexico’s exports to the U.S. will continue their fast fall, while U.S. exports to Mexico, on the contrary, will rise fast in just a few years.

Consider that U.S. shale natural gas exports to Mexico will increase from the current 3-billion cubic feet per day to about 15-bcfd in the mid-term.

As the multiple natural gas pipelines continue to be built from Texas to Mexico, the U.S. is set to gain quite a bit of ground in its trade with Mexico.

And if we include the trade in the services sector, where the U.S. has the upper hand over Mexico by US$10 billion, with other things being equal, all of a sudden, the US$60 billion U.S. deficit with Mexico would be cut in half in just a few years. Please see Exhibit #6, for a probable “Pro-forma” scenario in 2020.

And as trade moves forward in the next decade, services, natural gas and other energy products from the U.S. to Mexico will continue to rise at a faster pace than goods and services coming the other way, to possibly reach even or near-even trade in the middle or end of the next decade.

Mexico’s and NAFTA Shields

At US$1 million per minute, U.S. trade with Mexico is no small business. Altering, terminating or even modifying the trade deals between the two countries would have enormous economic consequences.

There are checks, balances and interested parties in protecting a stabilized U.S.-Mexico trade environment. First, it is the U.S. new federal administration itself and the rational approach that its economic team may assume towards Mexico and NAFTA.

Political rhetoric aside, the likes of Wilbur Rose, Secretary of Commerce nominee and Steve Munchin, Secretary of Treasury nominee and the names floated so far for U.S. Trade Representative and the Council of Economic Advisers Chair are all highly capable business people with ties across many industries and international experience. They are not out to destroy or boldly interfere with business.

And there’s actually a potential great ally, the former Governor of the State of Texas, Rick Perry, Secretary of Energy nominee. He knows the importance of trade with Mexico (37% of Texas exports go to Mexico) and he certainly wants to cash in big on that natural gas export potential headed to produce electricity in Mexico.

And there is of course, the pro-trade Republican Party and its Congressmen, who need to listen to U.S. consumers. According to Gallup, a pollster, 58% of Americans think foreign trade is an opportunity for economic growth while 34% see it as a threat to the economy from foreign imports.

There are also all the interested parties that would legally oppose extreme actions because they have important affairs based on free trade and NAFTA. These include U.S. exporters and importers, which are well organized and influential such as the auto industry and the energy sector.

Even U.S. States such as California, Arizona and Texas would probably raise their hand and engage their courts and legal counsel to defend NAFTA.

But the strongest protective covering for NAFTA is that it just makes great business and economic sense. Nobody in its right mind would want to derail the deep and complex supply chains across most industries that support their competitiveness in global markets.

What Should Mexico Do?

#1…Be calm.

There is no reason to overreact. Serenity and patience on Mexico’s side are of the essence in this process.

#2…Have dignity, self-worthiness and be prepared.

Dignity is defined as the state of quality of being worthy of honor and respect.

Mexico has not violated any rules nor has it played dirty in dealings with the U.S. It has sustained a law compliance policy in international trade and does not deserve verbal abuse or bashing.

Mexico’s negotiating position is by no means weak, but Mexican negotiators must be ready to grant some concessions. For example, opening the Mexican markets dominated by monopolies would be a win-win for both countries.

#3…Educate.

Only the negative voices are heard in the talk of NAFTA. According to Gallup, over 50% of the U.S. population feel that they cannot vote for or against NAFTA because they do not know enough about it. Mexico and its affiliated and pro-trade institutions in the U.S. need to educate the American public and business about the benefits of free-trade and NAFTA.

#4…Diversify.

This is an old cry that is fundamental. As long as Mexico continues to concentrate on the comfortable market of the U.S. it will continue to suffer huge surprises.

Mexico needs to broaden its export markets. Maybe it is time to make a free-trade agreement with China.

#5…Focus inward.

By the same token, the domestic market in Mexico has great potential.

If Mexico straightens its act and incorporates the current 60% of the work force that is economically informal and does not pay taxes and doesn’t have credit or even a bank account, the need to export goods would decrease.

Brazil for example is an inward economy.

#6…Corruption.

Getting rid of corruption at all government levels should be at the top of the list. Corruption in Mexico is the root cause of all of the country’s problems.

Countries fail because they have failed institutions. Mexico’s public institutions are corrupt and a failure. Mexico should take the conjuncture of NAFTA at hand as an opportunity to straighten its institutions by truly getting rid of corruption.

#7…Fasten your seat belt.

Mexico needs to brace for an imminent economic slowdown in 2017.

Conclusion

It is most likely that the threats Trump has made to slap a high tariff on Mexican imports or to withdraw from NAFTA are just bargaining chips to renegotiate the agreement.

The big problem is of course that the lengthy renegotiation will take quite some time. The wheels of governments do not move faster than a snail.

For Mexico, the uncertainty of the outcome means lower growth, lower employment, less FDI and other economic sacrifices. It will be similar to a recession, hopefully not too drastic.

Our prediction is that we will have a “soft-landing”, but the runway will not be paved.