US Trade Wars and Trade Deals

Following a long re-negotiation process between the US and Mexico, the two countries managed to reach a mutually beneficial agreement yesterday. The new agreement, while maintaining the absence of tariffs which existed in the original NAFTA deal, also entails stricter rules for Mexican car exports to the US, including a higher content of the cars produced in North America as well as a higher content made by higher-earning workers. Both clauses aim to discourage US manufacturers from relocating to lower-wage Mexico, even though this appears rather unrealistic. On top of that, today, Canada is expected to face a take-it-or-leave-it situation, as the Trump administration has said that automotive tariffs will be placed on imports from Canada if talks are unsuccessful. Under this scenario, commentators suggest that a “bad deal is worse than no deal”.

The Trump administration appears to have understood that it does not pay to have too many fronts open. Since Trump took over the administration, the US has imposed tariffs on Europe, China, and, by abandoning previous trade agreements, on Canada and Mexico, in an effort to reduce the US trade deficit. The US likely feels that is in a position of pushing tariffs without much harm being inflicted upon it, given that it has market power over several of these countries, precisely as a result of higher imports. Picture it this way: suppose that you are selling sandwiches for $3 and one of your loyal customers purchases half of your production each day at that price. If a tax now forces your price at $3.20, and you know that your customer will reduce his consumption as a result of the higher price, wouldn’t you be willing to absorb some of the cost and reduce the price to, say $3.10 so that you prevent a large reduction in your sales quantity?

In a similar setup, Mexico exports approximately 74% of its goods to the US, meaning that a large part of Mexico’s exporting sector is heavily dependent on the US. If the US imposes a tariff of, say 20%, on Mexican products, this means that their price will increase by that amount, making Mexican goods less price-competitive. Note that the proceeds from US tariffs will belong to the US government. Given the standard inverse relationship between price and quantity, higher prices usually mean that a smaller quantity of goods is expected to be sold. To avoid this, Mexican exporters would likely be willing to absorb some of this increase and reduce their profits, perhaps even to an extent where the new price will be quite close to the old one. This would, in theory, force Mexico to lose some of its profits as they will be transferred to the US.

However, reality can be different: approximately 40% of the parts of a typical Mexican exports originate in the US, according to the US Commerce Department. This can also be observed from the Balance of Payments data: US is a major investor in Mexico, with about 44% of total foreign direct investment in country originating from the US. The US automotive industry has actually built 10 factories in Mexico, compared to 8 factories built by all other automotive companies, while US steel companies also operate plants in Mexico. As Primary Income data suggest, much of the income generated from these investments returns to its country of origin in the form of dividends.

The benefits for US companies operating in Mexico are straightforward: lower operating costs, a result of lower wages, allow companies to achieve higher profit margins and hence improve their overall performance. Allowing for free trade between the two countries would mean that goods and services which are better and more efficiently produced in one country can move freely across the borders, also allowing US and Mexican companies access to a much larger consumer base, compared to operating just within their national markets. All of these benefits would have been lost for both countries if an agreement was not to be reached. While the trade deficit is important, the US would have most likely been hurt if an agreement was not achieved.

What the above analysis aims at suggesting is that both countries stood to lose if the agreement was not reached. US trade advisers appear to understand this, with Peter Navarro, the person leading the National Trade Council commenting that: “The tariff is not an end game, it’s a strategy – a strategy to renegotiate trade deals”. Overall, this strategy suggests that the US would likely aim to continue reaching trade deals which, given its size in the world economy, would be beneficial to them. The markets have also been clear about understanding what is good for business, as the US500 index jumped 0.5% upon the announcement, discounting future higher profits from its constituent firms. The Mexican Peso also gained on the Dollar upon the announcement, however most gains dissipated during the day.

What should be kept in mind from the above analysis is that the response is not only related to the case of the US and Mexico. In the near future, a positive response should also be expected when the US reaches other trade deals, unless some other economic developments shadow such a development. More generally, trade deals which eliminate trade barriers, promote the exchange of goods and services, and enlarge the potential market for companies in all the countries which participate and usually tend to boost the stock market as well as the currency. As such, market participants should keep abreast of new developments in such areas in order to be able to correctly navigate their strategies and adjust their risk management practices accordingly.

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