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Part I: Introduction
The United States-Canada-Mexico Agreement (USMCA) entered into force on July 1, 2020, after a long and arduous journey that began in 2017 with multiple U.S. threats to terminate the North American Free Trade Agreement (NAFTA). Its journey effectively ended when the Trump administration and the Democratic Congress agreed in December 2019 on a series of amendments to the original text signed on November 30, 2018.
For purposes of this paper, it suffices to note that while much of NAFTA has been carried over into the USMCA, extensive modernization and innovation were accomplished, reflecting the passage of 28 years since NAFTA was originally negotiated in 1991-92. Overall, the most significant changes directly affecting regional trade are those that impact the auto industry, particularly the requirements that autos and light trucks benefitting from the zero tariff status granted under NAFTA must, after three years, increase their regional value content from 63.5% to 75%, and that 70% of the steel and aluminum used in automotive production must originate in North America (the steel, after seven years, must also be melted and poured in North America).
These provisions in themselves will require significant modifications to the supply chains utilized by the dozens of auto plants operating in North America, keeping in mind that NAFTA created the regionalization of automotive supply chains nearly 30 years ago. Simultaneously, several other factors are forcing North American manufacturers, including but not limited to those in the automotive industry, to radically adjust their supply chains, creating a veritable “perfect storm” of pressures to decouple with China (and reduce dependence on other non-North American sources) for materials and components. This has led to an already significant decoupling of the U.S. and Chinese economies in the first quarter of 2020. Although this is not the place for a full discussion of the U.S.-China relationship, it is notable that a high official of the Trump administration has argued for an end to “blind engagement” with China and criticized U.S. allies for not taking action to address the prospect of “a Chinese century.”
Nor is this reshoring limited to the United States. The Japanese government has promised $2.2 billion to bring production back to Japan and in July announced that 87 companies had been paid to shift production either back to Japan or into other Southeast Asian nations. Here, as presumably will be the case with the United States, the departures from China are not simply to Japan, but to preferred locations where low-cost labor is available, such as Vietnam.
The United States-China trade war, discussed in Part II of this paper, is the most important of the pressures for altering the long-existing supply chains. The trade war, despite the conclusion of the “Phase One” agreement between the U.S. and China on January 15, 2020, permits the United States to continue to impose tariffs of 7.5% to 25% on $370 billion worth of goods imported from China. Many observers, myself included, believe that these penalty tariffs, imposed originally to pressure China to improve its protection of intellectual property, will be in force for the foreseeable future. Given the unpredictability of both the Trump administration and the Chinese leadership, the tariff levels could be increased without much warning, or the $150 billion or so of U.S. imports from China that are not currently subject to penalty tariffs could be taxed as well; this was threatened by the Trump administration in the fall of 2019 when the Phase One agreement was under negotiation.
Thus, in many respects, North America will become the most attractive option for sourcing many parts and components for manufacturing and for supply chain management more broadly, even if the logistics and other complexities of more extensive decoupling from China require an extended period (three to five years) for manufacturers of complex products.
Beyond the purely economic impact of higher tariffs, U.S. relations with China have deteriorated. Primarily based on national security concerns and on efforts to hold China responsible for originating the COVID-19 pandemic, it is possible that further penalty tariffs, export restrictions, and limitations on Chinese investment in the United States will be imposed.
At minimum, it may become impracticable for publicly traded U.S. enterprises to continue to source certain goods from China even if they continue to produce goods in China for the Chinese market. The dislocations will not be limited to U.S. importers, since American firms—such as semiconductor producers Qualcomm and Intel, as well as Boeing, who all count China as one of their most significant markets—are likely to lose partial access to that market either because of export controls or as retaliation against U.S. tariffs on Chinese exports to the United States.
Initial concerns arose some years ago, well before the coronavirus became a world-wide catastrophe, and before the U.S. and other governments placed blame on China for concealing the seriousness of the outbreak in a manner that has made it difficult to react promptly and effectively to the associated health and economic threats. The pandemic has further reinforced the determination of the president, his key advisers, and many in Congress to greatly reduce or eliminate the supply chain links between U.S. manufacturers and China, through “reshoring” production either to the United States proper (as the administration would seemingly prefer) or, more likely in the case of labor-intensive products, “nearshoring” production to Mexico. It is evident that the process, stimulated by most of the factors addressed herein, is already taking place. In 2018, the U.S. market imported $0.131 of production from low-cost Asian producers for every $1 worth of domestic manufacturing output; currently the ratio has fallen to $0.121.
A year or two ago, this process would have been even more difficult because of the uncertainty surrounding the replacement of NAFTA. Most potential investors, otherwise inclined to create or expand manufacturing activities and related employment in North America, were simply not willing to do so while NAFTA and its potential USMCA replacement were in doubt. Although some new investment has largely been postponed because of the pandemic, the entry into force of the USMCA has greatly reduced this particular source of investor uncertainty. In time, probably within several years, most businesses operating within North America will have become comfortable with the USMCA’s new rules of origin, and thus will feel more confident in expanding their operations in North America under generally reliable and transparent rules of the game. The timing of any investment surge will depend, in part, on how quickly the U.S. and Mexico recover from the recession brought about by COVID-19, the unemployment it has caused (nearly 15% as of the second quarter of 2020 and a predicted 10.1% for 2021), and the massive reduction in U.S. gross domestic product (GDP). Given that both Mexico and Canada depend on the United States to take 75% or more of their exports, once the U.S. economy begins to recover, Mexico and Canada will hopefully not be far behind.
Much of the public discussion of supply chain reorientation suggests that when U.S. enterprises reduce or eliminate dependence on China for their materials and components, the United States should be substituted for production processes that can be highly automated and/or are subject to severe national security concerns. However, products, as well as parts and components that remain labor intensive, should logically be produced in Mexico, where average hourly manufacturing labor costs are still only about 15%-20% of those in the United States.
Moreover, and of particular importance for those who seek to relocate all manufacturing to the United States rather than North America, it is notable that goods produced in Mexico for export to the United States typically contain about 40% U.S. content (25% from Canada), while for those sourced in China, the U.S. content is only about 4%. Other advantages (as well as disadvantages) of producing in Mexico are discussed later in this paper. Even if enterprises decide that they should not be dependent on single-source suppliers ever again, North America remains the most attractive means of hedging bets.
The remainder of this paper is organized into five parts. Part II briefly describes the pressures on enterprises producing goods in North America to move materials and component sourcing to North America from China because of the U.S.-China trade war. Part III reflects on the additional pressures that national security concerns are placing on the sourcing of Chinese parts and components, particularly in high-tech areas such as 5G telecommunications. This section also discusses what some term a new “cold war” developing between the U.S. and China. Part IV discusses similar pressures arising out of the USMCA, particularly the automotive rules of origin, which offer a dual benefit through avoiding penalty tariffs and assuring zero tariffs and quotas for USMCA-originating goods. Part V addresses related pressures resulting from both COVID-19 and carbon footprint concerns to reduce or eliminate long supply lines, particularly regarding medical equipment, pharmaceutical products, and personal protective equipment. Part VI provides a short conclusion and predictions for the future.
This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.