International business assignment

NAFTA's Impact Effects on fhe U.S. and Mexican Economies

Free trade agreements are supposed to enhance the wel-fare of participating countries, so evaluating their eflFects is a valuable exercise. The North American Free Trade Agree- ment (NAFTA) is particularly relevant to the bilateral trade agreements being considered by the United States today because it was the first trade agreement in a nonmultilateral setting between a developing and two developed countries.

This report focuses on U.S.-Mexico issues, not because Canada is unimportant, but because the U.S.-Canadian firee trade agreement predates NAFTA, is less controversial in the eyes of most trade critics, and is less relevant (because it entails trade between two developed countries) to the pend- ing trade agreement with Latin America. Further, because trade between Canada and Mexico remains very small, the trilateral trade agenda is still only emerging, although there is growing interest in analyzing immigration, security, and other issues within this trilateral framework.

This report evaluates four studies produced by the Con- gressional Budget Office (CBO), the World Bank, the Carnegie Endowment for International Peace, and the United States International Trade Commission (USITC). These assessments of NAFTA, by and large, are analytical in nature, use established methodologies, caveat their own work to reflect limitations of the research, and draw on academic rather than special interest research. The details of their methodologies are not reproduced here, but it is im- portant to note that they faced similar research challenges. These include:

• Isolating the effects of NAFTA from other economic policies and forces at play.

• Using sufficiently long timeframes to separate out pre- and post-NAFTA trends and effects.

• Comparing NAFTA over time and across countries to provide relative measures of the importance of any ob- served or inferred change.

From the Library of Congress, Congressional Research Service report NAFTA at Ten: Lessons fi-om Recent Studies, Febru- ary 13, 2004.

The lessons outlined below reflect conclusions of the reports, but not all addressed each of the issues. When analy- ses overlap, agreements and differences are identified, and other sources are cited when needed to clarify or expand on a certain theme. Conclusions regarding NAFTA's effects are not drawn relative to expectations espoused prior to its implementation. For political and other reasons, many of the claims made about NAFTA in the early 1990s, both good and bad, were less than credible. Details below pro- vide a sense of NAFTA's economic success or failure rela- tive to its effect on trade, investment, economic growth, productivity, employment, wages, and immigration.

• Trade and Investment EfiFects

NAFTA is a broad agreement, but improved market access, including tariff reductions on merchandise trade, was the major U.S. goal. After 10 years, most tariffs have gone to zero, except for some very sensitive (mostly agricultural) goods that have limited protection for up to 15 years. Clearly, U.S.-Mexico trade and investment have grown sharply over the past decade. From 1994 to 2003, U.S. ex- ports to Mexico rose 91 percent, compared with 41 percent to the world. U.S. imports increased by 179 percent, com- pared with 89 percent from the world. This surge, however, began prior to NAFTA, so the question is, how much of the post-1994 growth can be attributed to NAFTA?

NAFTA Had a Modest Effect on U.S.-Mexico Trade Growth. The CBO, World Bank, and USITC approached the problem differently, but all found that NAFTA had a modest effect on U.S.-Mexico trade grov/th. The CBO model of U.S.-Mexico trade estimated that 85 percent of the U.S. export growth and 91 percent of U.S. import growth would have occurred without NAFTA. Although the effect was modest, it accelerated over time, accounting for a 2 percent marginal growth of U.S. exports and imports in 1994, up to 11 percent, and 8 percent marginal growoJi of U.S. exports and imports in 2001.

As a percentage of economic activity, the increased trade was more pronounced for Mexico than for the United States.

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Separately, the World Bank makes the point that NAFTA has reinforced existing trends in trade growth and estimates that Mexico's global exports would have been 25 percent lower without NAFTA.

The USTIC analyzed tariff preferences by sector to iso- late the effects of NAFTA on U.S.-Mexican trade. It esti- mated that NAFTA tariff preferences accounted for one-third of the growth in U.S. import shares from Mexico (higher among textile and apparel goods) and 13 percent of growth of U.S. exports to Mexico.

The remaining growth in trade would have occurred anyway, and was influenced more by factors such as the 1994 peso devaluation and existing preferences provided Mexico under the Generalized System of Preferences (GSP) and production-sharing {maquiladora) programs. The U.S. benefit from NAFTA may also be seen in Mexico's slow re- sponse to the 1994 peso crisis, which was to raise tariffs against non-NAFTA partners. (In another report, the USITC noted that there was also an increased variety of goods traded and a rise in the average price of Mexican imports, suggesting new and upgraded goods being im- ported from Mexico.)

There Is Little Evidence of Trade Diversion. A key con- cern of trade analysts is whether a free trade agreement re- sults in trade shifting from nonmember countries to members of a trade agreement because the tarlfFpreferences have allowed them to become the lower-cost producers. This has the effect of switching trade from more to less efficient trading partners. The World Bank study found no signifi- cant evidence of trade diversion in NAFTA, particularly with respect to textile and apparel producers in neighboring Cen- tral America and the Caribbean. This is consistent with a majority of studies done earlier.

NAFTA Did Not Cause the Widening U.S. Trade Defi- cit with Mexico. Form 1994 to 2002, die U.S. trade defi- cit with Mexico grew from -$1.3 to $37.1 billion. These studies found that trade deficits are largely macroeconomic phenomena, in this case predominantly attributed to the re- spective business cycles in Mexico and the United States. Strong U.S. growth in the 1990s, combined with Mexico's deep recession caused by the December 1994 peso crisis (de- valuation), were the main factors cited for the large deficits. Importandy, none of the studies attributed the peso crisis to NAFTA, but to structural misalignments in the Mexico economy combined with political events.

NAFTA Helped Increase Bilateral Foreign Direct Invest- ment (FDI). From 1994 to 2002, U.S. FDI in Mexico rose from $16.1 billion to $58.1 billion, or 259 percent. Mexi-

can FDI in the United States increased 244 percent to $7.9 billion, albeit from the much smaller base of $2.3 billion. FDI in Mexico (mostly U.S.) grew on average from 1.1 percent of gross domestic product (GDP) in 1980 to 1993 to 3.0 percent of GDP in 1994 to 2001. The World Bank noted that NAFTA was one of numerous factors directing FDI and estimated that it led to a 40 percent annual in- crease in FDI to Mexico, without diverting FDI from other countries. The CBO and USITC studies basically agreed, finding that NAFTA's investment and trade liberalization worked together to reduce risk and improve profitability, and so observed that NAFTA helped to increase total in- vestment flows to Mexico.

• Domestic Economic Effects

The various studies reached different conclusions with re- spect to the macroeconomic effects of NAFTA. Choice of methodology and depth of research varied and likely explain many of the differences.

NAFTA Slightly Increased Growth in Output and Pro- ductivity. The CBO study, which had a limited model for estimating the trade effects on GDP, found that NAFTA increased annual GDP growth in the United States by no more than .04 percent, and for Mexico, no more than 0.8 percent. Similarly, the USITC cited other literature suggest- ing that U.S. GDP could grow by an additional 0.1 per- cent to 0.5 percent once NAFTA is fully implemented. The World Bank study, which undertook a more elaborate modeling effort, concluded that Mexico's economic perfor- mance was similar to the rest of Latin America prior to NAFTA. After NATA went into effect, Mexico's per capita GDP converged increasingly toward that of the United States, although a large discrepancy still exists.

Estimates of the rate of convergence s u r e s t that with- out NAFTA, Mexico's per capita GDP growth would have been 4 to 5 percent lower by 2002. The World Bank also suggested that NAFTA contributed to "a substantially faster rate of productivity convergence than in previous years." For example, Mexican manufacturers were able to halve the time needed to adapt U.S. technological inno- vation. The Carnegie study also notes that productivity rose dramatically afier NAFTA in both the United States and Mexico, and suggests NAFTA "likely played a signifi- cant role."

NAFTA Had Little or No Impact on Aggregate Employ- ment. NAFTA is at the heart of a longstanding debate over the employment effects of trade because of fears that trade

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with developing countries causes U.S. job losses and that trade deficits equate to higher unemployment. None of the reports attributed changes in aggregate U.S. or Mexican employment levels to NAFTA, but the author of the first chapter of the Carnegie study suggests that changing the assumptions of a USITC model would allow for a net gain in U.S. employment over the past decade of between zero and 270,000 jobs, a small increase.

For Mexico, it concludes that "the sum of the effects of the trade pact to date has not been a strong net gain in overall employment." The second chapter (different author) argues for zero net growth in U.S. jobs. The USITC study dem- onstrates, contrary to some popular opinion, that U.S. trade deficits tend to occur during periods of low employment, and "vice versa." This evidence supports well-established economic theory that would suggest both the U.S. trade deficit with Mexico and U.S. employment levels over the past decade were responding to economic growth, not each other.

NAFTA Contributed to Employment Shifts Among Sec- tors. The Carnegie report observes a shift in Mexican em- ployment away from agriculture toward services and manufacturing. It attempts to correlate this shift with NAFTA-induced trade balances in agriculture (deficit) and manufacturing (surplus) goods, but concludes that it is impossible to establish precisely how much of the jobs shift can be attributed to NAFTA. The World Bank points to productivity growth in irrigated agricultural lands and the lack of opportunity in subsistence agriculture as alternative reasons for these shifts.

In the United States, employees who lost jobs because of NAFTA are eligible for NAFTA trade adjustment assis- tance. The Carnegie report notes that at the end of 2003, some 525,000 workers have been certified under this pro- gram, heavily concentrated in manufacturing, especially apparel. Over a period of 10 years, this represents a small portion of the aggregate workforce, many of whom are al- ready reemployed. Nonetheless, it is among the most sa- lient adjustment issues related to trade, along with the possible need for a larger "social safety net." The USTIC and World Bank also show that structural shifts in both countries had been affecting long-term employment pat- terns as well.

NAFTA Has Had a Small Effect on Real Wages. The USITC, in summarizing the vast literature on the observed rising U.S. income gap between more-skilled and less-skilled workers, suggests that while estimates varied, trade in gen- eral has contributed to no more than 10 to 20 percent of the wage gap. Economists generally consider the w ^ e gap

problem to be a ftinction of skill-based technological change that causes an employment bias toward more highly edu- cated or trained workers. Increased trade of intermediate goods using outsourcing or production-sharing arrange- ments has also been linked in recent research.

For Mexico, the Carnegie Endowment and the World Bank note that real wages are lower than when NAFTA began, but conclude that it was not the cause. Decompos- ing the trend shows that Mexico experienced a 25 percent fall in real wages after the 1994 peso crisis. Real wages be- gan a steady recovery in 1997 and are approaching 1994 levels. Interestingly, the World Bank study showed that those Mexican states tied to FDI, exports, and maquilas had higher and faster-growing wages than other states.

Immigration Patterns Were Not Aflfected by NAFTA. The long-term trend in legal and unauthorized worker migra- tion fiom Mexico to the United States continued and ac- celerated after NAFTA was implemented. The trade agreement, however, was found to be largely irrelevant. The Carnegie Endowment study points to many factors that outweigh any effect a ftee trade agreement can have on mi- gration patterns. Mexican workers have been drawn to the United States by big w ^ e differentials and the high demand for low-skilled workers. They have been encouraged to leave Mexico by the burgeoning workforce that cannot get ab- sorbed and the strong migration networks in place.

Periodic financial crises (1982, 1986,1994) exacerbate the problem. These cause huge losses in formal sector jobs, large declines in real wages relative to those in the United States, and failing confidence in the Mexican economy, all of which encourages emigration. The World Bank found that Mexican emigrants had higher levels of education and earned more than nonemigrants, and so migration may have contributed to Mexico's growing wage gap.

NAFTA Has a Minor Role in Mexico's Rural-Urban Mi- gration. The first chapter of the Carnegie Endovraient study argues that the observed trend of migration fiom rural ar- eas of Mexico to urban centers, along with the attendant problems of unemployment, family disruption, and poverty, is direcdy the result of agricultural liberalization linked to NAFTA. This is contradicted by a second chapter (differ- ent author) that argues that such migration patterns have been in place since 1960, when over 50 percent of the workforce was agricultural, compared with 36 percent in 1980 and with less dian 25 percent in 1995. NAFTA ap- pears at most to have affected at the margin an established trend that economists long have argued is common in the development process of most countries.

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NAFTA Impact U.S.-Mexico nade Continued from page 137

Outlook

The four studies discussed above point to three broad themes. First, by most a^regate measurements, NAFTA has had only a modest, but positive, effect on the U.S. and Mexican economies, and tends to reinforce long-term trends already evident by its inception. This is in keeping with what is widely understood about trade and trade agreements; they work at the margin of economies, and their effect can be easily confused with much more powerful factors such as long-term structural change and short-term volatility (e.g., financial crises). Such confusion is seen in the reluctance of many supporters and opponents of NAFTA to engage in a more nuanced debate on trade.

Second, adjustment problems related to trade liberaliza- tion present the greatest challenge to policymakers. For ex- port firms and sectors, the adjustment is positive and provides evidence of the winners fi-om trade. For import- competing sectors, displacement can have devastating effects on communities and raises the question of whether to fight fi-eer trade or attempt to adjust to it as part of the larger glo- bal integration process.

The World Bank report argues that trade agreements can do more by improving distorting rules of origin, tak- ing on the hard tasks of antidumping and countervailing duty measures, and tackling adjustment problems. The Carnegie Endowment study argues that trade agreements should address trade-related adjustments issues through longer tariff reduction schedules, use of special safeguards, removal of agricultural subsidies, and provision for region- ally funded trade adjustment assistance and social safety net programs.

Third, two studies address a common call for better in- tegration of trade policy into a country's overall develop- ment program by coordinating and supporting it with domestic reforms. The Carnegie study argues for more at- tention to agricultural, environmental, immigration, tax, and labor rights protection policies, among others. The World Bank study prioritizes institutional reform (especially rule of law and anticorruption efforts), educational devel- opment (to promote technology transfer), other innovation- supporting policies, and labor reform that facilitates transition among industries and sectors. In the end, these reports do not provide easy answers to trade-related policy problems, but do attempt to explain how the gains from trade may be enhanced by understanding and responding better to adjustment challenges all countries face. •

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growth was not smooth: A year after NAFTA took effect, exports dropped by 21.4 percent in just over two quarters, before they resumed their climb. U.S. imports of goods from Mexico almost tripled between late 1982 and late 1993 and then more than tripled again by the third quarter of 2000, at which point they, too, fell back during the recession. Even with exports and imports expressed as percentages of GDP, growth was substantial (see figure above).

The growth was sufficiently large and rapid that Mexico's share of U.S. trade with the world rose considerably. At the end of 1982, exports destined for Mexico represented 3.7 percent of all U.S. exports of goods. In the last quarter be- fore NAFTA went into effect, that figure stood at 8.8 per- cent, and it reached 14.2 percent by the end of 2001. Similarly, imports from Mexico rose from A.G percent of all U.S. imports of goods at the end of 1986 (the end of a de- cline resulting from a crash in crude oil prices) to 7.1 per- cent just prior to NAFTA and then to 11.8 percent by the end of 2001. Before NAFTA, Mexico was the third-largest market for U.S. exports and the third-largest supplier of U.S. imports. By 2001, it was second in both categories.

• Changes in the Trade Balance

The balance of trade in goods with Mexico has declined sub- stantially since NAFTA went into effect. Its descent actu- ally started almost two years before NAFTA, but the balance did not decline much until a year after the agreement went into force. It recovered slightly from 1995 through 1998, before resuming its descent.

The United States also experienced a growing deficit in trade in goods with the world as a whole during that period and for many years beforehand; Mexico's share of that defi- cit has been smaller than might be expected from the country's size as a U.S. trading partner. Indeed, for almost all of the past 17 years, Mexico's share of the U.S. trade deficit with the world has been smaller than its shares of U.S. exports and imports (the only exception being the seven quarters from the beginning of 1995 through the third quarter of 1996). Correspondingly, Mexico's ranking on the list of trading partners with which the United States has the largest deficits has been lower than its rankings on the lists of top U.S. ex- port markets and import suppliers. Nevertheless, the large decline in the trade balance since NAFTA took effect has led critics to suspect that the agreement significantly worsened, if not caused, the trade deficit with Mexico. •

160 International Debates • May 2005