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UNCERTAIN ACCESS:
THE CONSEQUENCES OF U.S. SECURITY AND TRADE ACTIONS FOR CANADIAN TRADE POLICY
(Volume 1)

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PART 3:

CANADIAN TRADE POLICY IN THE LONG TERM:
CLOSER INTEGRATION OR TRADE DIVERSIFICATION?

The Canadian and U.S. economies have become increasingly integrated over the past forty years, and the pace of integration has increased since the launch of the FTA in 1989.  How much of this increased integration, in the form of greater cross-border trade and investment flows, can be attributed to trade liberalization and how much to other factors such as exchange rate movements?  Would this integration have occurred even without the FTA and NAFTA?  Should measures be adopted to achieve even closer formal integration with the United States?  Alternatively, should an aggressive policy of trade diversification be pursued to lessen Canada’s vulnerability to U.S. security and trade actions?  These are questions that, we believe, must be given serious consideration by Canadian decision-makers.

 

THE DIMINISHING RETURNS FROM TRADE LIBERALIZATION

Discussions of free trade between Canada and the US relate to the period beginning with the launch of the Canada-U.S. Free Trade Agreement (FTA) in 1989.  The FTA certainly opened up new business opportunities and caused an industrial restructuring that exists to this day.  NAFTA’s impact on Canada-U.S. trade has been considerably smaller, and it is safe to say that the returns for Canada from trade liberalization have been diminishing.  Rather, the effects of NAFTA have been most widely felt on trade between Canada and Mexico. 

The North American Free Trade Agreement (NAFTA), involving Canada, the United States and Mexico, came into effect in January 1994.  Designed to expand trade and investment between the three member countries, the agreement took aim at both tariff and non-tariff barriers and contained provisions on how business was to operate within the free trade area.  Since NAFTA was largely modelled after the FTA, it did not significantly affect the trading relationship between Canada and the United States.  The tariff reduction schedule between the two countries was unchanged – tariffs on virtually all goods of Canadian or U.S. origin disappeared on January 1, 1998^[1] – and most elements of the earlier bilateral agreement were absorbed into the NAFTA.  One of the few significant exceptions to this was that NAFTA broadened the coverage of the FTA to include virtually all aspects of cross-border trade in services.  As de Mestral pointed out to the Committee, NAFTA has worked well in removing barriers to trade in services.

   

A.  The FTA and Trade Growth

Canada has witnessed an explosion in trade with the U.S. since the process of tariff elimination under the FTA was launched in 1989.  Exports to the U.S. grew by 250% from 1988 to 2001, while imports increased by 153% over the same period.

Supporters of the FTA, including the federal government, have frequently stressed that the agreement has been a resounding success for the two member countries.^[2]  They maintain that the agreement has promoted strong economic growth, led to increased investment and trade between Canada and the U.S. and contributed to historically low levels of unemployment.  According to Pierre Alvarez, the FTA and the deregulation of energy markets in the 1980s were very successful public policy initiatives and rival the Auto Pact in terms of impact.  Access to the U.S. market has resulted in a significant increase in sales.

It would be difficult to argue that the Canada-U.S. Free Trade Agreement has not had a positive effect on trade flows between the two countries.  Since the implementation of the FTA, Canada has seen a shift in economic structure and orientation.  The Canadian economy has become more export-oriented and at the same time has become more integrated into a collective North American economy.  As William Dymond (Executive Director, Centre for Trade Policy and Law) remarked to the Committee, entire Canadian economic sectors have been restructured on a north-south basis. 

John Helliwell, certainly no big fan of the bilateral agreement, informed the Committee that the FTA had caused north-south trade to expand twice as much as predicted by the model that he was using.  Industries that had been concerned about free trade (e.g., textiles and clothing, furniture, wine) ended up being big winners.^[3]

Other empirical work comparing trade growth in products liberalized by the agreement with trade growth in goods which were already exchanged tariff-free also supports the point that the FTA has contributed to an expansion of the Canada-US trade relationship.^[4]

   

B.  Other Factors Influencing the Canada-US Trade Relationship

This optimistic assessment of the FTA’s impact on trade must be tempered by the reality that a number of factors other than the trade liberalization brought about by the agreement have affected trade between the two countries.  Although there has been considerable growth in trade between Canada and the U.S. since the implementation of the FTA in 1989, it would be misleading to suggest that this growth was exclusively the outcome of the trade liberalization brought about by the FTA (and the NAFTA that followed it).  While agreements such as the FTA undoubtedly improve the conditions for trade by lowering tariff barriers and creating an environment of stability and security for trade and investment, they are only one of several factors that influence the exchange of goods and services between countries in any given year.

Certainly, much of the bilateral trade had already been liberalized before the agreement was implemented.  When the FTA was signed in 1989, many products were already being traded between Canada and the U.S. in a tariff-free environment, most notably automobiles and parts, which were liberalized by the Auto Pact in 1965.  In addition to automobiles and auto parts, tariffs on aircraft and related parts, pulp, paper and wood products, and crude oil, petroleum and natural gas – some of Canada’s most significant export products – were unaffected by the FTA.  In all, it has been estimated that a full 35% of Canada-U.S. trade was tariff-free prior to the implementation of the FTA.^[5]  Other tariff lines were at low levels owing to successive rounds of GATT tariff reduction.

As Tim O’Neill (Executive Vice-President and Chief Economist, BMO Financial Group) told the Committee, the FTA was the culmination of the trade liberalization between Canada and the U.S. that had been going on over a forty-year period.  The reduction in tariffs arising from the FTA was, in the overall scheme of things, actually rather small.  It stands to reason that a significant part of the growth in bilateral trade since 1989 could be attributed to the improved trading environment that had already been established prior to the launch of the FTA.  In his brief to the Committee, Jim Stanford noted that two “liberated” sectors alone – energy and automotive – accounted for a full 40% of export growth under the FTA.  In neither of these sectors did the FTA enhance access to the U.S. market.

While the FTA improved Canada’s access to the U.S. market, two macroeconomic factors independent of the trade agreement also affected trade between Canada and the U.S. in the post-FTA period.  They not only influenced growth in trade between the two countries during the 1990s, but also had a significant effect on the balance of trade.  Much of the growth in exports to the U.S. since the onset of NAFTA can be attributed to (a) weakness in the exchange rate between the two countries, and (b) higher growth rates experienced south of the border (higher growth in the U.S. absorbed our exports).

The first of these factors is the performance of the Canadian dollar, shown in the above chart.  After rising sharply in the year immediately preceding the launch of the FTA in 1989 – the dollar’s value rose to the 85 cent mark in that year – the currency continued to appreciate relative to the US dollar, rising to almost 89 cents in 1992.

Between 1992 and 2002, however, the Canadian dollar fell steadily, which lowered the price of Canadian export products in the U.S. market and at the same time made U.S. goods more expensive to purchase in Canada.^[6]  This placed downward pressure on import growth in Canada while at the same time making Canadian products more competitive in the U.S. market, which pushed exports to higher levels.

John Helliwell informed the Committee that the U.S. strong-dollar policy during the 1990s has been the most significant influence leading to the rise in Canadian exports to the U.S. during that decade.  The share of our exports going to the U.S. has risen from 77% before the FTA to 87% now, the change in the exchange rate being the major factor.  O’Neill concurred, pointing out that if one examines the change in the volume of trade in the 1990s, the big effect would have been the dramatic decline in the value of the Canadian dollar from a near 90-cent dollar to a 65-cent dollar.  Fred McMahon also argued that the devaluation of the Canadian currency was the principal reason for the large trade surplus between Canada and the U.S.

Adding to the effect of the Canadian dollar was the fact that following the recession of the early 1990s, the U.S. entered one of the longest periods of uninterrupted economic expansion in its history.  A combination of factors, including productivity growth, falling commodity prices, equity market gains and a strong U.S. dollar, allowed the economy to expand, creating jobs, raising incomes and attracting investment, all without triggering inflationary pressures.  As Americans’ wealth increased, so too did consumption levels, buoying demand for Canadian goods.  Since the Canadian economy did not perform as well, Canadian demand for U.S. goods did not grow as quickly, and as a result, Canadian exports to the U.S. outpaced imports from that country.

As a final point, the FTA may have caused some of the existing Canadian trade to be diverted from other destinations to the U.S. market.  Exports may have been rerouted from other countries to the U.S., and trade between Canadian provinces may have been deflected to the United States.  As Helliwell pointed out to Committee members, some of the gains in north-south trade have occurred at the expense of trade with the rest of the world, and there was no gain for Canada in that development.  Whereas the creation of trade yields economic benefits for Canadians, the diversion of trade from other countries in response to differential tariff rates may simply lead to economic inefficiencies.^[7]

   

C.  The Diminishing Gains From Trade Liberalization Under the NAFTA

It is also worth noting that the gains in tariff reduction between Canada and the United States, by far the two largest economies within NAFTA, were realized not under NAFTA but rather under the FTA.  By the time NAFTA came into force in 1994, tariffs between Canada and the U.S. were already low or non-existent. 

Thus, it should not come as a surprise that there was no NAFTA-induced explosion in bilateral trade.  Indeed, a 1997 U.S. report on NAFTA’s economic impact revealed that total U.S. trade with non-NAFTA countries increased by about the same percentage immediately following the agreement’s implementation (11% rise in 1994; 14% in 1995; 5% in 1996) as did total Canada-U.S. trade (15% in 1994; 12% in 1995; 7% in 1996).^[8]

As this same report further concluded, “Most of the international specialization that could have been expected from trade liberalization had already occurred when the NAFTA went into effect.”^[9]  While the agreement did stimulate some further cross-border specialization in manufactured products, it should be properly viewed as an incremental step forward in the process of North American economic integration that was occurring anyway.  Indeed, most of the gains to Canada from freer trade in North America were achieved following the introduction of the Canada-U.S. Free Trade Agreement, the NAFTA having added little since then. 

ASSESSING THE MERITS OF CLOSER INTEGRATION

If the economic returns from integration have already been largely exploited, as the previous chapter of our report suggested, why is closer integration being contemplated?  The Committee received a mix of views on the merits of adopting closer formal economic ties with the Americans.  This Chapter reports on the evidence heard and assesses a number of distinct policy proposals that have been put forward.

John Helliwell informed the Committee that the argument to get closer to the Americans hinges on obtaining more per capita income from the relationship.  However, this will not occur as there is simply not much left to be tapped.  In addition, the subjective well-being research that he has conducted suggests that Canada’s separateness and independence produces greater subjective well-being.  Therefore, he predicts that there would be net costs to the adoption of policies that would increase the intensity of the bilateral linkage.  Helliwell also thought it dangerous to think that because we have not been able to get what we want – namely to obtain easier access to the U.S. market and to be exposed to less danger from U.S. trade remedy action – we should go further along the integration path to get to where we want to be.

Theodore Cohn (Professor, Department of Political Science, Simon Fraser University) was of the view that Canada should emphasize multilateralism in its trade relations with the U.S. since (a) it emphasizes the rule of law and therefore limits the ability of larger partners to seek side payments; (b) the U.S. will only be willing to make changes in agricultural trade and contingent trade measures (countervail, anti-dumping) in those multilateral venues; and (c) Canada benefits from the existence of a range of plurilateral groups such as the Quad.

Bob Keyes (Vice-President, International, Canadian Chamber of Commerce) felt it was unrealistic to expect that any of the proposed models of integration along this continuum (convergence and harmonization, customs union, common market, total economic integration, dollarization, expansion of NAFTA, a new North American governance framework, and continental political institutions) would happen right away, as they raise political and sovereignty issues.  This was a view heard with some frequency during our hearings.  At the same time, he thought that this extensive menu of integration proposals was worthy of analysis and discussion. 

Other witnesses thought that closer ties with the U.S. would help lower the risk associated with U.S. security or trade actions.  Rolf Mirus, while agreeing with John Helliwell that most of the gains from trade liberalization have already been realized, was nevertheless concerned that the economic gains from North American integration may be at risk if another terrorist attack occurs on U.S. soil or if the Americans become even more inward-looking.  Therefore, it was important to sit down with the Americans, work together on common interests (e.g. security, natural resources) and move forward along the integration path (e.g., customs union).

Thomas d’Aquino has adopted a similar approach to risk management, while abandoning any new formal integration arrangements such as a customs union.  This approach is embodied in the NASPI proposal already discussed in the report’s chapter on border issues.  In order to prevent the Americans from imposing their security needs (e.g., Code Red alert at the border), d’Aquino concluded that Canada should develop a North American strategy that takes the national interest into account and then attempt to sell that strategy to the U.S.  He recognized that strong political leadership and a firm national consensus would be required. 

Still others argued that closer integration would be in Canada’s best interests regardless of any risk assessment.  The Honourable Perrin Beatty (President and Chief Executive Officer, Canadian Manufacturers and Exporters) advocated the development of a vision of what a new North American community could look like.  There are many items to consider in developing such a vision:  trade remedies, softwood lumber, agriculture, the simplification of rules of origin, regulatory cooperation, the need for intergovernmental cooperation to keep terrorists from entering North America, the planning of continental trade corridors to speed up the transportation of products to their markets and the protection of the continental environment.  Beatty concluded that stronger North American integration was bound to happen in any event, either by default or by design, and that now was the time for Canadians to engage in this discussion.

Richard Paton (President, Canadian Chemical Producers’ Association) also arrived at the same conclusion: integration of the North American economy is inevitable.  The question for Canada is whether to position ourselves to benefit from it or lose out on investment and growth opportunities.  A strategy on North America is required.  Fred McMahon suggested that a key element of a longer-term integration strategy was the development of a deeper bilateral trade agreement with the U.S. that would have a more certain and quicker dispute settlement mechanism. 

The Committee has carefully considered the competing arguments presented on the question of closer Canada-U.S. economic integration.  We have indicated that the management of risks at the land border would be best dealt with through existing mechanisms (i.e., the Border Action Plan) and that “strategic bargains” would not be in Canada’s best interest.  We have concluded that Canada has already faced diminishing returns from past efforts to integrate and are swayed by John Helliwell’s position that the gains to be had from even closer economic integration with the U.S. are rather limited.  Accordingly, we believe that any attempts to develop closer formal Canada-U.S. ties in the form of a customs union, common market or single currency should be resisted.  Efforts to cooperate on regulatory matters and to deal incrementally with other concerns in the bilateral trade relationship could be assessed, however.

   

A.  The Customs Union Option

At the present time, many goods circulating within the NAFTA economic space are either produced wholly or in part outside the free trade area, and rules of origin are needed to determine what is free of duty and what is not.  Without these rules, firms would have an incentive to route imports into the integrated North American marketplace through the country possessing the lowest external tariff.

Rules of origin impose an administrative and compliance burden on business.  With all three NAFTA countries having different tariffs with the rest of the world, goods shipped across internal NAFTA borders must be extensively documented so that each country can apply its own tariffs to products generated outside NAFTA.  It has been estimated that reducing the need for border inspections and lowering the amount of paperwork required could result in efficiency cost savings of a not inconsequential 2% to 3% of NAFTA GDP.^[10]  The potential cost savings are meaningful, since over 85% of Canada’s exports flow to the United States.  An added advantage is that border resources now devoted to goods inspection could be freed up to enhance cross-border security. 

Minister Pettigrew has recognized the need to realize additional liberalization in the NAFTA rules of origin, to make it easier for firms to comply with the rules in the case of certain products.  In a recent speech to a Canadian-American business gathering, in which he outlined a six-point agenda for North America, he stressed the need to accelerate Canadian efforts “to further reduce transaction costs and make it easier for companies to do business and benefit from our integrated economies.”^[11]

Another option would be to remove these rules of origin entirely, through the creation of a customs union.  Under this option, participating countries undertake to eliminate all restrictions on mutual trade and adopt a common external tariff for outside countries.  Rules of origin are dispensed with since imports into the customs union would face the same tariffs anywhere in the union.  Once the item had been cleared for entry into the North American economic space, it could then be shipped between participating countries without the need for complex customs inspections.  Removing these rules of origin should result in administrative cost savings at the border and efficiency gains, although Tim O’Neill cautioned the Committee that the increased economic benefits from a customs union narrowly defined as a common tariff structure might not be all that substantial.  Moreover, inspecting items crossing the border for security purposes would still likely be required. 

Proponents of a customs union apprised the Committee of the benefits that such a policy measure could generate.  Armand De Mestral stressed the importance of removing customs barriers to the free movement of goods at the border.  David Adams informed the Committee that the elimination of the tracing requirements (i.e., tracing of the origins of certain products) would be very useful for the automotive industry.  Rolf Mirus, with the most detailed presentation on the customs union concept, envisaged its implementation as lowering the significance of the internal border for the commercial movement of goods and services between the two countries (Mexico might be added later).  Cumbersome rules of origin would be phased out, agriculture and other sensitive sectors set aside and transition periods established.  According to Mirus, a customs union with zero common external tariffs as trade liberalization at the WTO continues could be accomplished in an incremental way without redoing NAFTA. 

Other witnesses advocated the creation of sectoral customs unions within those sectors of the economy that are highly integrated already.  For example, David Goffin (Secretary-Treasurer and Vice-President, Business and Economics, Canadian Chemical Producers’ Association) argued that the rules of origin are quite complex for chemicals and that his group would favour movement towards a sectoral customs union.  However, it was pointed out by Peter Clark that these sectoral arrangements would not be WTO-consistent. 

The trade-off for the economic gains that might be realized is the loss of policy independence that additional linkages with the United States would entail.  In a customs union, the participating nations have to surrender policy freedom – by adopting a common external tariff and a common external trade policy – to achieve economic benefits associated with the elimination of the need for rules of origin. 

With respect to tariffs with the rest of the world, Canada’s external tariffs are, on average, nearly double those of the United States.  Adoption of a synchronized tariff schedule with the U.S. would thus probably imply lowering Canadian tariffs to American levels.

The second aspect of the sovereignty issue to consider is the harmonization of external trade policy between the members of the customs union.  In the European Union (EU), the European Commission (EC) represents EU members in international trade negotiations such as the WTO and FTAA.  It seeks European consensus to do so, an often difficult task.  Like the EU, a Canada-U.S. customs union (or one encompassing all three NAFTA countries) would probably also operate as a bloc in future international trade negotiations.  Under this scenario, Canada and the U.S. would have to arrive at internal consensus on positions for trade negotiations, or at least achieve a substantial reduction in their differences, and make adjustments in their existing trade arrangements (e.g., bilateral free trade agreements).  A member country’s ability to act independently in its external trade policy would therefore be affected.

As witnesses informed the Committee, the question then becomes to what extent would Canada be able to influence the direction of the region’s trade policy.  Another way to state this is precisely how much of this trade policy – in particular, the establishment of the external tariff code – would be set in Washington.  It is difficult to imagine at this point that Canada’s interests would dominate in any regional trade discussions or negotiations.  Moreover, Gilbert Gagné wondered what would happen to multilateralism in Canadian foreign economic policy if Canada were to move beyond free trade.

While there may be economic benefits to be derived from movement to a customs union (e.g., reduction in border transactions resulting from the removal of rules of origin), the costs (e.g., adopting U.S. tariffs on products from third countries, having trade policy made in Washington) are too onerous for closer integration to be considered.  Moreover, several witnesses expressed doubt about the feasibility of a customs union, particularly in view of U.S. reluctance to enter into such an agreement.  For example, Thomas d’Aquino’s group decided, after three years’ effort, that it was no longer tactically desirable to formally advocate the idea.  Even Mirus noted that the size discrepancy between Canada and the United States would reduce the prospects for negotiating the customs union. 

It is also hard to imagine, as a number of witnesses also concluded, that the U.S. would give up its cherished access to trade remedies within such a customs union.  Keyes also noted that other issues such as non-tariff barriers in the form of health inspections and safety requirements and restrictions on the cross-border movement of people would remain untouched.

After seriously examining both sides of the issue, the Committee has concluded that upgrading NAFTA to a customs union would not be in Canada’s best interests.  We are not prepared to make the sacrifices in Canadian sovereignty that would be required to realize the economic benefits of a customs union, and recommend: