Trade agreements have a major impact on trade and investment worldwide. In fact, they are responsible for shaping business relationships among companies across the globe. In order to succeed in the international environment, small business exporters need to be aware of the impact trade agreements have had and will have on their businesses. Likewise, lenders must be familiar with trade agreements in order to better understand the needs and financial concerns of their customers. But why are trade agreements flourishing? The answer lies in their broad array of benefits.

Some countries have established free trade agreements and are in the process of expanding them, while other countries have established customs unions and common markets. This development is having a profound effect on small businesses worldwide.

A free trade area is formed when two or more nations establish preferential trade liberalization policies by eliminating or substantially reducing trade barriers among themselves. A customs union surpasses free trade liberalization policies by establishing a common external tariff for non-members. A common market goes even further. Members eliminate restrictions on the movement of labor and capital among each other. Additionally, members may harmonize national policies to some degree, including monetary, fiscal and social policies, and concede a degree of political and legal control to a single ruling authority.

Michael Porter, a contemporary trade theorist, explains that the principal economic goal of a nation is to produce a high and rising standard of living for its citizens. Porter contends that the ability to do so depends on the productivity with which a nation’s resources are employed. Productivity is defined as the value of the output produced by a unit of labor or capital. It depends on both quality and features of products and the efficiency with which they are produced. As such, the ability to export many goods produced with high productivity allows a nation to import many goods involving lower productivity. This is desirable because it translates into higher national productivity.

In pursuit of both increased productivity and international competitiveness, governments must promote trade without barriers — or free trade — without which the economic growth of a nation will be stunted. Free trade promotes the following:

  1. The creation of economies of scale;
  2. An increase in efficiency and competitiveness;
  3. A reduction of resources used in the production of goods; and
  4. A higher standard of living.

Most free trade agreements (FTAs) owe their success, at least in part, to prior reductions in trade barriers between the parties to the agreement. For example, integration and cooperation in the iron, steel, coal, and nuclear energy sectors set a precedent for Western Europe to tear down barriers in other sectors. The U.S.-Canada Free Trade Agreement was preceded in 1965 by the Automotive Products Trade Act (APTA), which allowed duty-free trade between the United States and Canada in almost all motor vehicles and parts. This resulted in extensive integration of motor vehicle production between the two countries. Likewise, many U.S. firms are taking advantage of Mexico’s maquiladora program and U.S. tariff provision 9802.00.80, demonstrated by the growing use of assembly operations in Mexico by these firms. The provision allows for the elimination of duty on goods co-manufactured in both countries.

The progeny of this marriage — Mexico’s maquiladora program and U.S. tariff provision 9802.00.80 — has resulted in more internationally competitive industries. This has made business and government leaders in both countries see that the elimination of remaining barriers through a U.S.-Mexico FTA would benefit each country even more. Canadian leaders, too, saw the advantage of access to low-cost Mexican labor for its producers and access to Mexico’s burgeoning market for its products. Consequently, Canada opted for the North American Free Trade Agreement (NAFTA).

The benefits of free trade already have been proven through a variety of pacts throughout the world. In 1983, New Zealand and Australia implemented an accord liberalizing trade between them. For the three years preceding the accord, Australian exports to New Zealand grew at an average of 10 percent each year. After implementation, through fiscal year 1985, exports rose 18 percent annually. New Zealand’s exports to Australia also increased as trade barriers declined.

Between 1959 - 1969, trade within the European Community (EC), the forerunner to the European Union (EU), rose by 347 percent. In contrast, trade outside the EC rose by only 130 percent. In this same period, U.S. global trade rose by 124 percent, while Canadian global trade rose by 130 percent. The value of Spain’s bilateral trade with Portugal increased more than 79 percent the first year the two joined the EC (1986). During the first 10 years of Britain’s membership in the EC (1973 - 1983), the U.K.’s exports to the other member states grew by 28 percent per year, while its imports increased by 24 percent. Trade with the rest of the world during this time period went up 19 percent per year.

The best example of free trade is the unobstructed trade among states in the United States. As a result, the United States is unquestionably the wealthiest single market and an extremely efficient producer of goods and services.

Small Business Benefits From Trade Agreements

Since 1992, trade agreements such as the Tokyo Round and the Uruguay Round of the GATT, and the North American Free Trade Agreement (NAFTA), as well as 200 other lesser-known trade agreements, have been negotiated and implemented by the United States. Small business has benefited from the resulting substantial reduction in foreign trade barriers. But obstacles still exist. For instance, high foreign duties have prevented many small U.S. firms from exporting. Large companies, however, often have circumvented these barriers by establishing a presence in the foreign country, achieving secure and competitive access. Small firms usually do not have the resources to do this. By the U.S. participating in trade agreements thereby reducing and eliminating foreign tariffs, small companies’ products can be more price competitive, enabling them to export more goods and create new jobs.

Foreign red tape or non-tariff barriers, such as import license requirements, also have prevented small companies from exporting. Large companies often either have the resources to hire consultants or the existing in-house expertise to work through these sometimes hidden barriers. Small companies don’t. By eliminating confusing red tape through trade agreements, small companies are put on a more level playing field and are better positioned to grow internationally. On the other hand, smaller companies often are able to respond faster to market changes than large firms. This can give them an edge as the pace of global change quickens. Importantly, as more “niche” market opportunities present themselves — which may be considered insignificant in size for large multinationals — small firms likely will find many of them very profitable and well worth the pursuit.

GATT and the World Trade Organization

The General Agreement on Tariffs and Trade (GATT), established in 1947 in Geneva, Switzerland, was responsible for governing approximately 90 percent of world trade. It sought to liberalize trade and thereby improve the world trading system through a code of rules and a forum in which negotiations and other trade discussions took place. Importantly, it played a major role in the settlement of trade disagreements among member countries. The founders of GATT believed that increased international trade would promote an economic interdependence between countries, making wars between trading partners unthinkable.

GATT was responsible for reducing the international tariff average from 40 percent in 1947 to 5 percent in 1990. These reductions have permitted international trade to expand enormously, national incomes to substantially increase, and international competition to flourish, resulting in higher quality, lower priced goods. The organization was very successful at reducing international trade barriers. However, many analysts have argued that it was not very successful at remedying less apparent forms of protection, such as non-tariff barriers. New protectionist tools, such as abusive uses of dumping legislation and environmental, labor and other issues, are becoming the new non-tariff barriers.

In the early 1990s, GATT’s inability to eliminate non-tariff barriers had put the organization in jeopardy. Its incapacity to successfully remedy the U.S.-European Community disagreement over agricultural subsidies and complete the Uruguay Round on schedule had created doubt as to the organization’s ability to meet future challenges. Furthermore, the decreasing level of world confidence in GATT contributed to the speed at which countries have formed trading blocs. Since the successful conclusion of the GATT Uruguay Round Agreements, the degree of confidence in its successor organization, the WTO, has risen significantly. In fact, many believe it will enforce international trade rules and settle disputes among members to a better degree than its predecessor.

Eight rounds of multilateral trade negotiations were held since 1947 under the auspices of the GATT. The goal of each round was to reduce or eliminate tariffs, and in some cases, non-tariff barriers among the contracting parties. In September 1986, trade ministers met in Punta del Este, Uruguay, to launch a new and final round of trade talks aimed at strengthening the GATT — and expanding its coverage. This aspect added a different element from the previously negotiated Kennedy and Tokyo GATT Rounds, which focused primarily on tariff reductions. After seven long years, a landmark GATT accord was finalized.

While trade agreements have evolved and have helped small and big business alike gain secure access to foreign markets, trade blocs have emerged. Today, the major trade blocs include the European Union, chiefly involving West European countries and spreading eastward; the North American Free Trade Agreement, among Canada, the United States and Mexico and spreading south; and an informal bloc in East Asia, currently dominated by Japan, but soon to be dominated by China. Based on past trade patterns and policies, and anticipated policies, these blocs will continue to develop, gaining increased strength and influence.

In The Spotlight

Within each of the world’s trade blocs, small and large, free trade will continue to become more entrenched. Future trade between blocs is not so clear. Many fear that individual blocs will become inwardly focused and protectionist. Even if protectionism does not emerge outright, trade diversion could have a similar effect. Trade diversion occurs when members of a trade group buy more goods from each other due to the elimination of internal trade barriers, and displace non-member goods. For manufacturers and distributors, foreign market share may be at risk. In the dynamic international environment, all tools that offer U.S. firms a competitive advantage must be employed. And the ability to offer attractive export financing is becoming essential.

The European Union

The EU has come a long way in its development. On April 18, 1951, the European Coal and Steel Community was formed. Its success prompted the March 25, 1957 signing of the Treaties of Rome, creating the European Economic Community (EEC) and the European Atomic Energy Community. On April 8, 1965, the three organizations merged into the European Communities, simply referred to as the European Community or EC. On July 8, 1968, the EC formally established a customs union.

An economic decline in the 1970s, compounded by a recession in 1980, caused EC economies to stagnate. Declining confidence in EC policy and increased import competition from members and non-members alike resulted in individual EC countries establishing non-tariff barriers directed toward competitors, including other EC members. Consequently, industries became increasingly inefficient and less competitive with the United States, Japan and the newly industrialized countries of the Far East.

In an attempt to reverse this trend, in 1982, the European Council, composed of EC member nation heads, agreed that the completion of a unified market was a priority and requested that the EC Commission propose a timetable for removing all obstacles. In June 1985, the Commission released its White Paper detailing a timetable ending December 31, 1992, for the implementation of some 300 directives or measures intended to eliminate all physical, technical and fiscal barriers to intra-EC trade. Essential to its success was the enactment of the 1987 Single European Act that changed EC voting procedure. This body has matured into a common market. Policies include the elimination of barriers to labor and capital movements, coordinated monetary and fiscal policies, a common agricultural policy, use of common investment funds, and similar rules for wage and welfare payments.

In late 1992, a survey conducted in Germany yielded specific conclusions regarding the advantages of the single market. Reported by the Journal of Commerce on January 4, 1993, the advantages are as follows:

  1. A decline in unit costs as production runs are lengthened;
  2. A single EC-wide registration and protection of intellectual property;
  3. The harmonization of taxes, eliminating divergent tax systems that distort competition;
  4. Lower research and development costs due to lengthened production runs;
  5. Opportunity for longer product life span;
  6. Simplified inventory management no longer necessitating that individually tailored products satisfy different EC country standards;
  7. The elimination of border delays;
  8. Simplification of formalities, resulting from mutual recognition of approval procedures; and
  9. A reduction in product and service costs, resulting from greater product availability and competition.

As the EU expands, it will continue to gain greater economic and political strength, in addition to an enhanced level of global competitiveness. Should it look inward and establish protectionist measures, U.S. firms could be at a disadvantage. Or through trade diversion, it’s possible that EU members will purchase more goods from each other at the expense of non-member firms. On the other hand, a more economically viable Europe can mean more imports. And further integration among EU members, which creates one set of standards and regulations, can make the export process less complex.

In 1998, U.S. exports to Western Europe exceeded $150 billion, up by more than 30 percent from 1990, and far exceeded exports to Eastern Europe, which barely reached $7.5 billion. U.S. direct investment throughout Europe has outpaced exports. In fact, according to an Arthur Andersen report on international investment, Europe was the world’s largest recipient of foreign investment in 1995.

The European Union (EU) now encompasses 15 countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom. Many other countries are waiting for full membership. Turkey applied in 1987; Cyprus and Malta applied in 1990; Switzerland applied in 1992; and Hungary and Poland applied in 1994. Six countries applied in 1995: Romania, Slovakia, Latvia, Estonia, Lithuania, and Bulgaria. And the Czech Republic applied for membership in 1996. As the EU expands, it will continue to gain greater economic and political strength, in addition to an enhanced level of global competitiveness. Thus, should all Eastern European countries eventually become members of the EU, its numbers of consumers would swell to approximately 850 to 900 million.

Provided the EU does not look inward and establish protectionist measures, a more economically viable Europe should result in more imports. Further integration among EU members, creating one set of standards and regulations, could make the export process less complex for outsiders.

East Asia

In recent years, trade among East Asian nations has increased at a much faster pace than trade outside the region. Through the development of several trade agreements — such as the Association of Southeast Asian Nations (ASEAN), comprised of Malaysia, the Philippines, Singapore, Thailand, Brunei, and Indonesia — the region is becoming more trade-cohesive. However, economic integration is primarily influenced by Japanese investment in the region, creating an informal trade bloc. Even considering the Asian financial crisis that began in 1997, which will no doubt have a massive impact on regional developments and world growth, many predict that Asia will still become the world’s dominant region in the next decade.

Prior to the Asian financial crisis, many Asian economies were growing at the fastest rates in the world. And, as the region emerges from the crisis, its purchasing power will again increase at favorable rates and provide a plethora of export and investment opportunities. According to a report published by the Asian Development Bank, economic recovery in affected economies to pre-crisis GDP growth rates and per capita income levels will take a number of years.

Many U.S. companies that have watched Asian economic developments closely over the last decade do not appear to be dissuaded. Thus, many are positioning themselves to take advantage of new opportunities, while establishing new strategies to mitigate risks caused by the economic crisis.

Numerous U.S. firms predict that as Asian trade barriers are reduced, expanding in the region will be less burdensome. However, many admit successful navigation through Asian distribution systems will continue to be difficult. Piracy of intellectual property continues to be an obstacle in many Asian countries, especially China. Numerous executives believe that vast cultural differences in Asia represent the biggest trade barrier of all. Without a doubt, close familiarity with Asian markets and a solid understanding of business customs are prerequisites to doing business there. Companies that take the time to become well-positioned are more likely to reap the trade and investment opportunities of the 21st century.

The Americas

The North American Free Trade Agreement (NAFTA) was implemented on January 1, 1994, creating a trade area of 360 million consumers and ensuring secure markets for U.S., Canadian and Mexican products. One of the primary goals of NAFTA is to encourage expansion of business partnerships among North American firms to promote greater efficiency and to counter fierce competition from the Far East and Europe. So far, NAFTA appears to be working. Since the Agreement’s implementation, there has been a proliferation of joint ventures and strategic alliances between U.S. and Mexican companies. Already strong ties with Canada also have prospered. The benefits derived from this teamwork will continue to make the United States, Canada and Mexico more globally competitive at a time when regional trade alliances are becoming increasingly important in the world economy.

In 1997, for the first time, Mexico followed Canada as the United States’ second largest export destination, pushing Japan into third place. And the proposed Free Trade Agreement of the Americas (FTAA) — in which all the benefits given to Mexico and Canada under NAFTA will be extended to the rest of Central and South America — further would increase cooperation among nations in the Western Hemisphere. Such an agreement would make the Americas one of the largest trading areas in the world, with a population of 750 million consumers.

Latin America and the Caribbean have come a long way in their economic and political development. The so-called “lost decade” of the 1980s is a fading memory. Less than 20 years ago, most Latin American countries were run by generals or dictators closely aligned to the military. Today, freely elected governments rule in almost every Latin American and Caribbean country. These once-closed markets have become dynamic economies that resemble the “Asian tigers” (Taiwan, Hong Kong, South Korea, and Singapore) during their development in the 1970s. The region’s more severe boom-and-bust cycles are starting to smooth out due to widespread economic reforms and better leadership. According to the Inter-American Development Bank, the region’s growth rate is vastly improved since the 1980s, when annual growth stagnated at 1.1 percent. At the end of 1996, average inflation in the region was approximately 10 percent, a remarkable turnaround from 550 percent in 1990.

Political and economic reforms in Latin America and the Caribbean are working well, and the middle class is on the rise. Like East Europeans, Latin Americans have learned that protectionist policies only result in an inevitable loss in standard of living. As a result, the region has a great deal more to offer the United States in terms of export markets, investment opportunities and a low-cost manufacturing base. U.S. exports to Latin America exceeded $142 billion in 1998. And U.S. direct foreign is up considerably. And that’s not all. According to former U.S. Trade Representative Mickey Kantor, by the year 2010, the United States will export more goods to Latin America than to Japan and Europe combined.

The North American Free Trade Agreement

On January 1, 1989, the United States and Canada implemented the U.S.-Canada Free Trade Agreement. On September 25, 1990, former President Bush notified Congress that the United States and Mexico intended to initiate free trade negotiations. On February 5, 1991, the United States, Canada and Mexico issued a joint communiqué formally proposing a North American pact that “would link our three economies in bold and different ways.” Formal NAFTA negotiations began on June 12, 1991, and were completed on August 12, 1992. The agreement was ratified by the U.S. House of Representatives on November 18, 1993, and two days later by the Senate, with formal implementation taking place on January 1, 1994.

Due to issues concerning wage differences and possible job losses along with environmental concerns, an unusual coalition of NAFTA opponents emerged that included labor and environmental activists. Supporters of NAFTA were equally diverse. The successful vote of 234 to 200 in the House of Representatives was primarily due to the support of Republican members. Former Republican Senator and 1996 presidential candidate Robert Dole played a vital role in garnering support for NAFTA. Prior to the vote, all former presidents came out to show bipartisan solidarity for the trade accord. In the final days before the vote in the House, President Clinton had to bargain hard to put together a majority vote.

The NAFTA agreement was voted on by the legislative bodies in all three participating countries. The Mexican Parliament readily supported the agreement. Although Canada’s newly elected Prime Minister Chretien had opposed NAFTA in his campaign, he eventually supported the agreement, and the Canadian Parliament voted favorably. Although trade with Mexico was not particularly significant for Canada at the time, the agreement offered long-term potential. Moreover, the Canadians did not want to be left out of efforts that were expected to lead to far broader open market agreements in the Western Hemisphere.

At that time, U.S. textile industry leaders, generally opposed to free trade, were out front campaigning for NAFTA. Except for executives in a few firms, the textile industry saw free trade with Mexico as the opening of a large market for its business. The textile mill products sector in Mexico was not well developed. Therefore, Mexico represented a potential 25 percent market increase for U.S. textile producers. In an effort to offset concerns over possible U.S. job losses, board members of the American Textile Manufacturers Institute (ATMI) pledged that they would not move their jobs, plants, or facilities to Mexico. The forceful support of textile leaders for NAFTA swayed some members of Congress from the major textile-producing states to vote in favor of the agreement.

NAFTA Expectations

Former President Bush and former Mexican President Salinas defined a U.S.-Mexican free trade agreement as a process of gradual and comprehensive elimination of trade barriers between the United States and Mexico, including: the full, phased elimination of import tariffs; the elimination or fullest possible reduction on non-tariff trade barriers, such as import quotas, licenses, and technical barriers to trade; the establishment of clear, binding protection for intellectual property rights; fair and expeditious dispute settlement procedures; and other means to improve and expand the flow of goods, services, and investment between the United States and Mexico.

The United States had several fundamental objectives in pursuing a free trade agreement with Canada and Mexico. These included the promotion of the following:

  1. U.S. exports to Mexico, designed to increase the number of well-paying U.S. jobs;
  2. Ongoing Mexican trade and investment reforms, especially intellectual property rights which would generate substantial new opportunities for U.S. firms;
  3. More efficient uses of natural and human resources in North America, structured to promote U.S. world competitiveness; and
  4. Mexican economic growth and prosperity, an increase in the Mexican standard of living and a reduction of the number of undocumented Mexican immigrants in the United States.

Both Mexico and Canada wished to initiate a free trade agreement (FTA) with the United States for several reasons. In January 1990, Mexican President Salinas visited Europe to promote foreign investment that would support the Mexican trade liberalization process. He found the Europeans preoccupied with Eastern Europe. It became apparent that Europe would not be a sufficient source of investment and exports. Mexico would have to depend upon U.S. investment and markets to increase productivity, exports and wages. Through a U.S.-Mexico FTA, President Salinas hoped to stimulate Mexican economic growth through increased trade and investment. President Salinas also saw that an FTA likely would prevent future Mexican presidents from deviating from his economic policies, which he believed were essential to provide the stability necessary to promote long-term economic growth.

The expected benefits to Mexico of economic integration included the following:

  1. Greater and secure access to U.S. and Canadian markets;
  2. Achievement of international credibility and increased foreign investment;
  3. Improved domestic confidence in Mexico’s economic future and the return of flight capital;
  4. Access to U.S. and Canadian technology and expertise;
  5. The development of economies of scale to achieve greater productivity;
  6. A movement toward greater specialization;
  7. An increase in jobs and wages, resulting in a higher standard of living with a more equal income distribution;
  8. Improvement of working conditions; and
  9. A reduction in the so-called brain drain or the loss of educated workers through migration.

Canada expected to benefit in ways very similar to the United States, including:

  1. Better access to Mexico’s large and growing market;
  2. Establishment of guarantees protecting intellectual property rights;
  3. Enhanced competitiveness at home and abroad;
  4. Establishment of long-term guarantees protecting Canadian direct foreign investment;
  5. The development of economies of scale to achieve greater productivity;
  6. A movement toward greater specialization; and
  7. Availability of less-expensive products.

Elimination of Trade Barriers

NAFTA provides for the progressive elimination of all tariffs on North American goods through four staging categories defined as A through D. Duties on goods in category A, which had the fastest tariff phase-out, were eliminated entirely on January 1, 1994. According to the U.S. International Trade Commission, this represents 31 percent of U.S. goods exported to Mexico (based on goods traded in 1990). Duties on goods in category B were removed in five equal annual stages beginning on January 1, 1994. This represents 17.4 percent of goods exported to Mexico. Duties on goods in category C are phased out in 10 equal annual stages — representing 31.8 percent. Duties on goods in category C+ are eliminated in 15 equal annual stages — representing 1.4 percent of U.S. goods exported to Mexico. And duties on goods in category D will continue to be duty free. This represents 17.9 percent of U.S. exports to Mexico.

Thus, approximately 50 percent of all U.S. exports to Mexico were completely duty-free on the day NAFTA entered into force and approximately 66 percent were made duty-free within five years. Products included in this category include: aerospace equipment; semiconductors; computers and parts; telecommunications and electronic equipment; medical devices; rail locomotives; many auto parts; machine tools; and paper products. Pre-NAFTA Mexican duties on these products ranged from 10 to 20 percent. All Mexican duties will be eliminated on U.S. goods within 10 years with the exception of corn and beans, which will become duty-free within 15 years. Duty rates will be phased out based on the applied rates in effect on July 1, 1993.

Without NAFTA, Mexico would have the right under international law to raise most of its duties to 50 percent. Under NAFTA, Mexico is prevented from raising its duties above current rates. In addition, should the United States and Mexico agree, tariffs on U.S. exports to Mexico may be eliminated at an accelerated pace. This has been successfully accomplished several times between the United States and Canada under the U.S.- Canada FTA and NAFTA.

Mexico eliminated many of its import licenses upon NAFTA’s implementation date. Other licenses will be eliminated over a 10 year period. These include items such as pharmaceutical inputs and used equipment, including computers, tractors and industrial machinery. In addition, enhanced intellectual property rights under NAFTA have better protected American technology. Consequently, U.S. exporters of R&D-intensive goods that require a high level of patent protection have benefited because, in the past, inadequate protection has held back U.S. sales to Mexico.

Rules of Origin

In an attempt to confine NAFTA benefits to North America, rules of origin have been devised to define the origin of a particular product. Only products that originate in North America are accorded free trade status — allowing them to enter the United States, Mexico or Canada at a reduced duty or duty-free. Under these rules, as duties are phased out, the incentive to use North American goods increases. NAFTA rules strengthen, clarify, and simplify rules contained in the U.S.-Canada FTA.

Most NAFTA rules are based on simple, predictable tariff classification principles. New U.S. Customs provisions set out documentation, record keeping, and origin verification procedures, and provide for advance rulings, review and appeal of customs origin determinations. U.S.-Canada FTA rules are superseded by NAFTA and are compatible with the General Agreement on Tariffs and Trade.

Concerns that non-North American companies will use Mexico as an export platform are addressed in NAFTA. For example, if two Japanese components are shipped to Mexico, undergoing “simple assembly” there, and then are exported to the United States, under the NAFTA rules of origin, the finished product would not be classified as a Mexican product. Instead, it would be classified as a Japanese product because the value added in the assembly was too small to cause the required transformation. As a result, U.S. Customs would assess the same duty as if the product were shipped directly from Japan to the United States.

Under these origin requirements, products wholly obtained in North America, such as minerals extracted from the ground, undeniably satisfy these rules. However, products that embody overseas parts or materials must be substantially transformed in North America in order to satisfy the transformation requirements stipulated in NAFTA.

For example, live chickens imported from Europe into the United States enter under a particular U.S. harmonized code, HS 0105. If processed in the United States into chicken cutlets, the product then takes on an entirely different tariff code classification, HS 0207. Thus, the cutlets would have been sufficiently transformed to be considered a U.S. product. If exported to Mexico, the cutlets would then qualify for duty-free treatment.

In some cases, a product must satisfy both transformation and content requirements. For example, hairdryer parts imported into Mexico from Japan and South Korea will arrive under parts classifications. When assembled with North American parts, the sum of the parts becomes a hand-held hairdryer. At this point, tariff transformation rules have been satisfied, but percentage content requirements must now be met.

Value content may be calculated using either the transaction value, based on the selling price, or the net cost method, based on the cost of goods. In general, if the North American value content is less than 60 percent using the transaction value, or 50 percent using the net cost method, the product will not be considered a North American product.

NAFTA rules of origin improve upon current requirements in U.S.-Mexican trade and requirements under the United States-Canada Free Trade Agreement. NAFTA implements stricter transformation requirements and content requirements not previously imposed on U.S. imports from Mexico. Consequently, NAFTA origin requirements encourage more North American components to be used in North American trade, while discouraging use of non-North American components.

In addition to improving upon current origin requirements, NAFTA ensures that non-North American countries will not use Mexico as an export platform to achieve preferential access to U.S. markets. In fact, in order to qualify for NAFTA tariff treatment, automotive goods and vehicles entering the United States from Mexico must contain at least 62.5 percent North American content, based on the net cost formula. This encourages the usage of North American auto parts. According to the U.S. International Trade Commission, the resulting increase in U.S. production of auto parts will increase U.S. competitiveness.

NAFTA Update

On January 1, 1994, the day NAFTA was implemented, approximately 50 percent of all U.S. exports to Mexico became duty free, accelerating trade flows. During that year, U.S.-Mexican bilateral trade rose 22 percent, up from $81.5 billion to $100 billion. U.S. exports to Mexico increased at about the same rate — and almost four times faster than U.S. exports to the rest of the world. Mexico even edged up on Japan, competing for the United States’ second largest trade partner status.

Since NAFTA was implemented, there has been a proliferation of joint ventures and strategic alliances between U.S. and Mexican companies. According to a survey conducted in May 1994 by KPMG/Peat Marwick, a leading consulting firm, nearly 40 percent of 1,000 U.S. companies said their industry has already benefited in some way by the Agreement’s passage. The American Chamber of Commerce in Mexico conducted a survey of its members in spring 1994. Of the 224 executive officers who responded, most expressed confidence that NAFTA would be beneficial to their company’s productivity and profitability.

Coopers and Lybrand, another leading consulting firm, interviewed executive officers of 410 of the fastest-growing U.S. product and service companies. According to the report issued, for growth companies, NAFTA has meant export opportunities, not job relocations. NAFTA opponents who predicted a mass exodus of U.S. jobs south of the border have been proven wrong by the facts. NAFTA contributed significantly to the success that U.S. manufacturers encountered in Mexico in 1994. In the auto industry, for example, the value of U.S. car exports to Mexico decreased 6 percent from 1992 to 1993. With the implementation of NAFTA, however, car exports increased a whopping 685 percent in 1994 to over $437 million, according to the U.S. Department of Commerce. From January 1 to October 5, 1994, Ford Motor Company exported 18,000 cars to Mexico. This represented a huge increase from its 1,700 cars and trucks exported there in 1993. U.S. exporters of textiles and apparel also performed well. The increase in U.S. textile exports to Mexico from 1993 to 1994, the first full year of NAFTA, was 130 percent more than the increase from 1992 to 1993.

The question often arises: how can Mexican consumers buy U.S. products when their incomes are so low? The answer is simple. In general, Mexican consumers feel that U.S. goods are superior in quality, not only to European or Japanese goods, but to Mexican goods as well. As a result, Mexican consumers have a strong demand for U.S. goods. For example, in 1992, two years prior to the implementation of NAFTA, production workers in manufacturing industries in the European Community (referred to as the European Union since 1993) received 748 percent more in hourly compensation than manufacturing production workers in Mexico; Japanese workers received 588 percent more. Nevertheless, on a per capita basis, Mexicans bought more goods from the United States than from the European Community or Japan. In 1992, Mexicans spent $440, or 44 percent more, per capita, than European Community citizens ($305) and almost 15 percent more than the Japanese ($384) on U.S. goods.

Even when calculations omit the amount of exports to Mexico that were re-exported back to the United States or to other countries, Mexicans still consumed more than Europeans. According to the U.S. International Trade Commission, in 1992, about 21 percent of U.S. exports to Mexico were re-exported back to the United States. Many of these goods were components shipped back to the United States after being assembled or improved in some manner. If 21 percent of U.S. exports to Mexico were omitted from calculations, Mexicans still consumed $335 worth of U.S. goods per capita, 10 percent more than Europeans.

The numbers today are even higher. Thus, despite much lower income by comparison, in 1998, Mexican consumers bought more goods from the United States, on a per capita basis, than did German consumers. That year Mexicans consumed about 2.5 times more than the Germans. As purchasing power continues to increase in similar developing markets, and the perception of American products continues to improve, the demand for U.S. exports will continue to rise.

The Economic Crisis

On December 20, 1994, on the verge of entering the second year of NAFTA, the situation drastically changed. An attempted currency adjustment by the Mexican government, that some say should have occurred earlier but at a more gradual pace, accelerated out of control. The Mexican government expanded its exchange rate band by 15 percent in an attempt to allow the peso to adjust downward. Within two days pressures mounted — currency reserves used to prop up the peso were quickly dwindling. As a result, the peso was allowed to float freely. Shortly thereafter, it nose-dived.

From December 20, 1994 to March 1995, the peso dropped about 40 percent in value as compared to the U.S. dollar. Like falling dominos, what began as a short-term liquidity crisis, turned into a full panic. The Mexican stock market dropped precipitously. Most investors whose money came due did not reinvest in the country. As the value of the peso declined, the Mexican government was forced to raise short term interest rates by a dramatic amount to prevent a massive outflow of capital invested in Mexico and to fight inflation. At the time, a significant percentage of Mexican debt was in the form of tesobonos, securities denominated in dollars but paid in pesos. Tesobonos were designed to attract foreign capital by shielding foreign investors from exchange rate risk. Approximately $774 million worth of tesobonos matured on December 28, 1994; another $5.2 billion came due mid-February 1995. A total of approximately $28 billion in dollar denominated debt came due in the first half of 1995 — an amount which had to be paid out in order to maintain some semblance of stability.

This situation, coupled with the assassination of Luis Donaldo Colosio, the Institutional Revolutionary Party (PRI) presidential candidate and former Secretary for Urban Development and Ecology, raised questions among foreign investors as to Mexico’s political stability. The assassination of Francisco Ruiz Massleu, a senior ranking PRI official, added to this uncertainty. These events, combined with unrest in the southern state of Chiapas, further fueled investor skepticism. Mexican fallout quickly spread to Brazil and Argentina, whose stock markets fell, along with those in other developing countries worldwide. Investors received what some have referred to as a “wake-up call,” reminding them that political and economic instability can largely affect growth prospects in developing countries.

Many large Mexican companies were hit hard by the crisis. Teléfonos de Mexico, the giant phone company, reportedly incurred a $862 million loss in foreign exchange in the fourth quarter of 1994. Cemex, an extremely large cement company by world standards, reported a $127 million foreign exchange loss. And Televisa, Mexico’s media conglomerate, lost $142 million. Mexican banks were experiencing default rates of 9.5 percent before the devaluation. Not long after December 20, 1994, default rates rose to more than 18 percent. Consequently, Mexican banks were told to increase reserves to 60 percent of past-due loans and 4 percent of total loans. This severely restricted their ability to lend.

According to a report issued by Salomon Brothers, an investment banking firm, in early 1995, the economic crisis negatively affected the Mexican banking industry. The report cited several banks at the highest risk of default. These included Serfin, Banpais, Comermex, Centro, Banoro, and Oriente. Interest rates charged on most Mexican loans and credit cards fluctuated monthly. By mid-1995, Mexican home mortgage interest rates had risen to 80 percent annually, while credit card holders were being assessed an annual rate of 100 to 120 percent.

Exports of consumer goods were expected to be most affected by the devaluation. And Mexican retailers feared that the industry would not bounce back for several years. Other retailers were not as pessimistic, but delayed expansion plans contingent on the speed of the economic recovery. For example, JC Penney was scheduled to open stores in Monterrey and Leon in March 1995. The retailer rescheduled the expansion as a result of the devaluation. Footlocker also announced delays in the opening of new stores. Dillards, which operated 227 stores in the United States at the time, and Saks Fifth Avenue did not open stores in Mexico as scheduled. Wal-Mart, the largest U.S. retailer, reportedly held off on adding 24 new stores in Mexico.

The Food Marketing Institute, in cooperation with the Asociacion Nacional de Tiendas de Autoservicio Y Departamentales, A.C., conducted a survey in Mexico in January 1995, just after the peso crisis began. The report’s survey results reflected the harsh economic burden affecting the Mexican people and their buying habits. Stated in the report, “Clearly, the economic pressures faced by the Mexican food shopper are having a major effect on the food industry.” The report continued to say that Mexicans are thinking more about how they spend their food pesos, and are concerned about the maintenance of food quality and their ability to pay the same or less for what they need.

According to the survey, 69 percent of Mexican shoppers interviewed indicated that their personal circumstances would either become “somewhat worse” (36 percent) or “far worse” (33 percent) as result of the economic crisis. Women, to a much greater extent than men, were more pessimistic. Sixty-seven percent of the oldest age category surveyed (over 65) believed their circumstances would be “far worse.” On the other hand, 12 percent of survey respondents indicated they believed their situation would stay “about the same,” 12 percent felt it would become “somewhat better,” and 4 percent said it would become “far better.” These respondents tended to be younger.

When shoppers were asked what they believed was the single most important issue facing Mexico, 45 percent pointed to inflation, 16 percent said the peso devaluation, 10 percent indicated the North American Free Trade Agreement, 10 percent said the government/PRI, 8 percent said poverty, 7 percent said unemployment, and 4 percent indicated the economy.

The Mexican Economic Recovery

President Clinton’s announcement on January 31, 1995, to provide Mexico with approximately $50 billion in U.S. and international loans and loan guarantees was met with considerable relief in Mexico, as well as in the U.S. business community. After receiving the news, the peso gained value and Mexican interest rates on 28-day government treasury certificates fell. Although economic indicators fluctuated to some extent after the announcement, greater stability was achieved. The package included a $20 billion credit line from the United States, $17.759 billion from the International Monetary Fund, $10 billion from the Bank of International Settlement, $1 billion from Canada, $1 billion from Latin American countries, and $3 billion from the International Commercial Bank.

On March 9, 1995, Guillermo Ortiz, Mexico’s Minister of Finance, announced an economic program designed to restore financial stability, strengthen public finances and the banking sector, regain confidence, and reinforce the groundwork for long-term sustainable growth. The measures called for an increase in the national value-added tax from 10 to 15 percent and the elimination of some exemptions, reductions in government expenditures to 1.6 percent of GDP for fiscal year 1995, a rise of 35 percent in gasoline prices and 20 percent in electricity rates, a continuation of the floating exchange rate, and a 10 percent hike in the minimum wage (which was bumped to 12 percent).

As time progressed, Mexico demonstrated increasingly strong signs of rebounding from the financial crisis. Its large trade deficit turned around, the peso stabilized, inflation dropped, and investment returned quicker than expected. International financial observers offered praise for this progress.

It should not be forgotten that while Mexico chose to follow the right path, it also was a difficult path. Mexico redoubled efforts to modernize its economy and has imposed tough short-term hardships to get its financial house in order. This was a courageous course for a developing country in the midst of extreme economic hardship and shouldn’t be underestimated. All one has to do is look a little further south — to a country like Venezuela — to see what might have been. After a brief economic boom earlier this decade, Venezuela was hit by a severe downturn from which it has yet to recover. High interest rates and political turmoil in 1993 precipitated a crisis that caused foreign investment to flee. Unfortunately, Venezuela’s populist, yet protectionist response only made the situation worse. Investment continued to slump; inflation and interest rates remained sky-high.

The picture for Mexico is much different. Despite the severity of the recent crisis, indicators continue to point to a surprisingly strong turnaround. Why is Mexico on the road to recovery while Venezuela stagnates? Both have vast natural resources and had similar economic profiles going into the 1980s — large public sectors and a dependence on oil exports. And both had resorted to protectionism and nationalization in times of crisis.

For Mexico, the point of departure came after the 1982 debt crisis, which precipitated a period of protracted economic stagnation. At that time, Mexico imposed many of the same policies Venezuela follows today — nationalizing banks, imposing capital controls and keeping itself closed behind stiff trade barriers. The result was years of negative per capita growth.

Learning a hard lesson, Mexico rejected the state-managed model and opened itself to free markets and liberalized trade. Now, most of Mexico’s economy has been privatized, and has a diversified, competitive export sector. Where oil was once the primary export, it now represents only about 10 percent of exports — and manufactured products have surged to account for about 80 percent. The success of its export sector reflects Mexico’s efforts to hold fast to its program of modernization rather than return to the protectionism of the past. When the recent crisis hit, Mexico’s President Ernesto Zedillo Ponce de Leon’s Administration maintained its determined commitment to free-market policies.

Over the last decade, Mexico has been an important test case for the free market/free trade model of development. This model was envied and largely adopted by developing economies throughout Latin America and the world. But the alternative of protectionism and closed doors sometimes lurks in the shadows. Unfortunately, in December 1994, a test case for the dangers of economic integration in the new world of volatile international capital markets emerged. Capital that flowed in quickly showed a disturbing predilection to flow out even quicker when spooked by signs of political and economic trouble.

Fortunately, Mexico chose a path out of crisis based on steadfast adherence to free markets — while also pressing ahead with important legal, judicial and political reforms. This commitment, with help from the U.S.-led international financial package, laid the foundation for a remarkably quick rebound. Mexico’s recovery remains very much in the U.S. interest. Alternatives to continued economic partnership and integration, wisely, have not been seen as realistic options.

As part of its new economic program to promote investment and raise capital, the Mexican government began undertaking its third major round of privatization since the 1980s. And in a clear demonstration to the world that Mexico is not wavering from the path of economic liberalization, President Ernesto Zedillo has further opened up sectors to foreign investment that have been partially privatized over the last few years. This has presented a number of significant opportunities to U.S. investors.

From the 1980s through 1994, approximately 1,000 of the 1,155 state-owned Mexican businesses were sold to private entrepreneurs, merged or closed. This generated $14 billion in revenue and savings. These businesses included hotel chains, steel producers, mining companies, insurance providers, airlines, banks, and telecommunications companies. With an additional $14 billion expected to be generated from the new round of openings, Mexico’s ability to raise capital appears undaunted by the recent financial crisis.

Over the years, privatization of companies has not always benefited Mexico to the degree anticipated. For example, in the past, many state-owned enterprises were sold to domestic investors only, not allowing sometimes more qualified and cash-strong foreign investors to even bid. Many analysts believe that this policy restricted competition, and did not always push new owners to become as efficient as they could have been under more competitive, open market conditions.

For instance, in 1991 the Mexican government began selling the 18 largest banks it had seized back in 1982 — but restricted experienced foreign banks from bidding. The sale of the telephone company and two airlines, Mexicana and Aeromexico, were no exception. As time progressed, some of the newly owned and managed companies seemed to be in little better position than when controlled by the government. Under new rounds, open bidding to both domestic and foreign investors and greater scrutiny to ensure an ability to meet financial requirements have minimized the problems caused by past practices.

Under the NAFTA, Pemex, the Mexican state-owned oil company, was not opened to investment as many U.S. companies had hoped. However, while the production of natural gas remains the domain of Pemex, several activities related to getting the product to market have been, for the first time, opened to foreign investment. Continued privatization and further opening of Mexican sectors to foreign investment continues to substantially enhance economic progress and speed recovery in Mexico. Just as important, as the short-term economic crisis abates, U.S. investors in Mexico now have the chance to establish a strong new foothold in Mexico that will benefit them well into the future.

During the week of October 9, 1995, Mexican President Zedillo met with several organizations in the United States. Following a meeting with U.S. business leaders, several key U.S. participants announced direct investment plans for approximately $12 billion in Mexico over the following several years. This was a clear sign of continued growing confidence in the Mexican economy.

The Mexican manufacturing sector has continually attracted the most foreign direct investment, 40.5 percent; followed by the service sector, 31 percent; transportation and telecommunications, 8.5 percent; and financial services, 8.5 percent. Industries slated to receive the $12 billion include manufacturing, financial services and telecommunications sectors. Other industries receiving this investment — not considered major destinations in the past — include energy, transportation and distribution of natural gas, environmental services, agriculture and food processing, and real estate. Some of these had been announced earlier.

When President Zedillo met with President Clinton at the White House in October 1995, he brought the first $700 million installment to begin repaying the United States with interest. This early repayment of a portion of the $12.5 billion that Mexico borrowed from the United States was yet another indication that the Mexican economy was bouncing back. Stated by President Clinton, “Today’s decision sends a positive signal to the financial markets that the tough financial measures Mexico has taken are succeeding and the American taxpayer is being paid ahead of schedule.”

In January 1997, President Zedillo announced the Mexican government was repaying the United States $3.5 billion earlier than scheduled — the last installment of the $12.5 billion. Mexico also announced it was prepaying $1.5 billion to the International Monetary Fund (IMF). The Mexican government’s plan to finance the repayments with funds raised in international bond offerings reflects the renewed confidence that international investors have in the country’s economic policies.

The Mexican economy is continuing to grow, recovering from the peso crisis that struck the country in December 1994. This, combined with tariff reductions and other benefits derived from NAFTA, has resulted in a healthy increase in U.S. exports there. Thus, in 1998, U.S. exports to Mexico exceeded $79 billion, considerably up from the pre-NAFTA 1993 U.S. exports of $41.6 billion.

Other Trade Agreement in the Western Hemisphere

Since 1990, some 27 bilateral, trilateral, or multilateral free trade agreements have been signed in Latin America, according to the Inter-American Development Bank. These agreements, although significant within themselves, are today playing a more important role in providing vital foundation blocks for the building of a Free Trade Area of the Americas (FTAA) by the year 2005. The goal of the FTAA, which builds on the achievements of NAFTA, is to establish a free trade area covering the entire Western Hemisphere by the year 2005. With U.S. participation, the Americas will be the largest trading area in the world, with a combined gross domestic product of more than $9 trillion and a market of more than 750 million consumers.

A closer look at some of the already existing Latin American trade pacts offers insight on just how close the countries in the Western Hemisphere are to achieving a Free Trade Area of the Americas:

The South American Common Market, known by its Spanish acronym Mercosur or Portuguese acronym Mercosul, is the largest emerging preferential trade agreement in Latin America. The accord provides its four members, Argentina, Brazil, Paraguay, and Uruguay, with duty-free trade on more than 8,700 products. Mercosur presidents continue to make significant decisions related to tariffs, addressing unfair trade issues, and free trade areas with other Latin American countries.

The Andean Pact, established in 1969, received new life in 1994 with the creation of a customs union among Colombia, Venezuela and Ecuador. As of February 1996, common external tariffs ranged from 5 to 20 percent. Exports within the pact reached $3.2 billion in 1994, up more than 10 percent from the previous year. The Andean countries have significantly liberalized their trade and investment regimes largely through coordinated efforts under the auspices of the Andean Pact. The Andean Pact passed several decisions on intellectual property rights protection, which established a common regime on patents and trademarks, new plant varieties, and copyrights.

The Caribbean Economic Community (Caricom), created in 1973, includes 14 Caribbean countries. Caricom also has signed free trade agreements with Mexico, Colombia, and Venezuela. In August 1995, 25 countries of the Caribbean Basin established the Association of Caribbean States (ASC) with the aim to create a free trade area.

The Case of Closer Economic Integration and the Textile Industry

U.S. textile manufacturers are one group that illustrate the benefits from closer economic integration with Latin America. As such, the United States is one of the world’s largest and most efficient producers of textile mill products. However, over the years, textile manufacturers’ output has dropped, primarily due to a reduction in apparel production in the United States — the single largest market for the U.S. textile industry. East Asian producers of apparel have become major suppliers to the United States. Unfortunately for U.S. textile producers, the East Asian apparel manufacturers source their textiles in East Asia, not in the United States.

In an attempt to sustain remaining domestic market share, U.S. apparel producers have expanded their production-sharing operations in Mexico and the Caribbean — benefiting from the lower wages and tariff preferences. And under a free trade agreement of the Americas, more U.S.-controlled apparel production will move to Latin America from East Asia. As this occurs, U.S. textile mills likely will supply Latin apparel producers, who in turn will export their products to the United States and overseas. Over time, this product flow will likely displace Asian apparel exports to the United States. This activity directly benefits the U.S. textile industry. Numerous other U.S. industries also stand to benefit. Thus, a free trade agreement of the Americas will secure Latin American market share for U.S. firms in many industries in place of European and Asian firms.

Increased North-South integration also will have a very positive impact on the standard of living in Latin America, which will likely result in more imports from the United States. Closer relations with Latin America also will foster an environment of improved political cooperation. Another advantage is U.S.-Latin American proximity. A problem with U.S.-Asian joint production is the great geographical distance between the United States and Asia, which can result in quality control problems. Yet, Mexico and the rest of Latin America are much closer than East Asia, which also means shipping costs are less expensive.

The Importance of Fast Track Negotiating Authority

Since 1974, when fast track legislation was first implemented, U.S. trade agreements have opened foreign markets to U.S. goods and services worldwide. This significantly has increased U.S. exports; they rose 670 percent between 1974 and 1997. Trade with these more accessible markets has impacted the level of growth and prosperity of the United States. This would not have happened without fast track negotiating authority.

Fast track legislation requires Congress to pass or reject trade agreements — without making any changes. Without it, foreign governments are reluctant to make agreements and concessions that could be changed later.

Since 1992, trade agreements such as the Tokyo Round and the Uruguay Round of the GATT and NAFTA, as well as 200 other lesser-known trade agreements, have benefited the United States by substantially reducing foreign trade barriers. Since its implementation in 1994 and despite a Mexican recession, NAFTA is fulfilling its promise. U.S. trade relations with Canada and Mexico are better, prices on consumer goods are lower, the region is more competitive with fast-expanding trade blocs in Europe and Asia, and trade and investment throughout North America has increased. In fact, from 1993 through 1997, U.S. exports to Mexico increased 70 percent, despite a steep contraction in Mexican domestic demand. What’s more, for the first time in 1997, U.S. exports to Mexico exceeded exports to Japan — a country with an economy 12 times larger than Mexico’s.

To the disadvantage of the United States, fast track has not been renewed in several years. As a result, the United States has not been able to successfully negotiate new trade accords and is losing out to countries that have. For example, since fast track has not been renewed, Canada and Chile forged a trade agreement that created freer access to each others’ markets. This has hurt U.S. companies and workers, especially in the telecommunications and fresh fruit sectors. Numerous other trade pacts, some involving European and Latin American countries, are in negotiations or have been finalized without U.S. involvement.

A large segment of the U.S. Congress continues to believe that trade agreements are not in the interest of the United States and will result in the loss of U.S. jobs. Ironically, through trade agreements, the exact opposite will occur. Many policy makers still cling to the beliefs that the United States cannot compete in an increasingly competitive global economy and suggest isolating the country from the rest of the world by erecting trade barriers. This ignores the disastrous lessons of the past. The Smoot-Hawley Bill, signed by President Hoover on June 17, 1930, raised U.S. tariffs on imports. American trading partners retaliated by closing their markets. The result was a steep decline in international trade, which significantly contributed to a U.S. unemployment rate of 25 percent in 1930 and a severe depression.

When the President of the United States is able to negotiate with other countries under fast track authority, a strong signal is sent that the United States is committed to promoting economic stability globally through trade. It is also a statement on how we, as a nation, will conduct ourselves in the new post-Cold War era.

A primary economic goal of the United States is to maintain a high and rising standard of living. In order to achieve this, the United States, which accounts for only 4 percent of the world’s population, needs to sell to the other 96 percent. The proposed Free Trade Agreement of the Americas and other economic integration accords not only open foreign markets to U.S. goods and services, but also encourage the expansion of small business exports to developing countries whose economies are growing three times faster than the United States’ economy.

This appeared as Chapter Seven in the book Trade and Finance For Lenders, 1999.
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John Manzella
About The Author John Manzella [Full Bio]
John Manzella is a world-recognized author and speaker on global business, emerging risks, and the latest economic trends. He's also founder of both the ManzellaReport.com and Manzella Trade Communications, Inc. His latest book is Global America: Understanding Global and Economic Trends and How To Ensure Competitiveness.




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