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


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:

Recommendation 11

That the Government of Canada refrain from entering into any discussions on the establishment of a customs union with the United States.

B.  A Common Market

The introduction of a common market in North America would take economic integration to a point on the spectrum even further along than the customs union.  According to the normal definition, a common market would remove all barriers to the movement of goods, services, capital and people within the NAFTA market.  In Europe, as Armand De Mestral pointed out to the Committee, the free movement of those four entities is already guaranteed constitutionally.

A key advantage of the common market is the improvement in labour mobility that it would bring about.  As Bob Keyes reminded the Committee, there continues to be considerable unfinished business associated with the labour mobility chapter of the NAFTA (Chapter 16).  Immigration authorities are resistant to change, for example, and as a result, significant mobility barriers still exist.

Another key benefit of a common market is worth mentioning.  George MacLean (Professor, Political Studies, University of Manitoba) argued that the establishment of a common market would enhance Canada’s access to the U.S. market, especially if it included standard regulations for subsidies and competition between the two countries to curb the use of trade remedies.  He saw the North American common market serving as the basis for one that would eventually cover all of the Americas.  This does not mean that the NAFTA would disappear. 

Richard Harris felt that a common market with the U.S. would remove border and softwood-type problems, but that it would be a tough sell with the Bush Administration.  Having Mexico on board would help provide necessary leverage, but there was no guarantee of success.  While three years ago he had recommended a common market, the events of September 11 had completely changed the situation.  With the terrorist threat still in place, U.S. authorities would be unlikely to go along with what would essentially be the removal of the border.  Rolf Mirus, the keen proponent of the customs union, is also not recommending a move to a common market.  The Committee agrees that in the current situation, in which the Americans are extremely security-conscious, the notion of creating a common market in North America is not feasible.

 

C.  A Common Currency

Although very little testimony was received on this issue, witnesses appearing before the Committee indicated little enthusiasm for a common currency with the United States.  Kathleen Macmillan observed that while there were strong arguments on both sides of the common currency debate (e.g., a reduction in transactions cost on the positive side; a decline in monetary sovereignty on the negative side), the general consensus was that the time was not ripe for abandoning the Canadian dollar.  On balance, maintaining the status quo was the preferred option as far as she was concerned.

Minister Pettigrew remarked to Committee members that achieving a common currency regime would imply effectively adopting the U.S. dollar and giving up Canadian monetary policy, since it would be virtually impossible to convince the Americans to get rid of their currency.  Moreover, the domestic exchange rate’s capacity to absorb the adverse economic impacts that significant outside shocks (e.g., the Asian financial crisis) would have on this country would be lost. 

For his part, Perrin Beatty noted that the low Canadian dollar, while good for exporters, had also driven the costs of imports up.  However, it was important for Canadian policy-makers to focus on the productivity gap between the two countries, not the currency value gap.  Owing to the low value of the currency, there has been less investment in machinery, and as a result, Canadian SMEs have older machinery than do U.S. plants.

The Committee is concerned that the costs associated with abandoning the domestic currency would overwhelm any decrease in transactions costs that monetary integration could produce.  However, a more in-depth review of the single currency issue would need to be performed before any conclusions could be ventured. 

 

D.  Lessening Regulatory Duplication

Although market and production systems are becoming increasingly integrated in North America, businesses operating on this continent continue to face three separate sets of production standards (e.g., health and safety, packaging, electrical standards, emission controls, food testing, language), regulations and labelling requirements.  Owing to this regulatory situation, a product may have to be modified physically or relabelled or have its origin and components certified before it can cross an internal NAFTA border. 

This complexity, which stems from the fact that the marketplace has often moved ahead of the regulatory system under which it operates, can impose a tangible burden on firms conducting regional trade.  This can take the form of delays in shipping products throughout the NAFTA marketplace and resulting higher financial costs.  According to David Adams (Vice-President, Policy, Canadian Vehicle Manufacturers’ Association), true economies of scale can only be realized in North America if a manufacturer can produce a product designed according to a set of common standards.  This is especially important for a small country.  He urged the Committee to recommend that, where possible, standards and regulations among NAFTA countries be harmonized and mutual recognition agreements (see below) be adopted unless an extensive cost benefit analysis shows that separate standards should be kept.  Various witnesses from the agricultural sector also saw the merits of greater harmonization.

As Claude Carrière informed the Committee, Canada could examine ways to reduce differences in standards and product regulations while continuing to meet the regulatory objective (e.g., safety standards).  Cooperating on regulatory matters could facilitate intra-industry trade, lower transaction costs for shippers, reduce the disincentives for investors, lessen the scope for disputes, and provide benefits to Canadian consumers.  It should be recognized, however, that establishing closer cooperation in the regulatory area would reinforce Canada’s dependence on the U.S. market, which is almost everyone’s current concern.

There are essentially three ways to resolve this problem:  common policies, harmonization and mutual recognition.  The first of these options is self-explanatory:  the three NAFTA partners would adopt common regulatory policies.  While this option would achieve the most certainty for business, it is doubtful that it would receive much support in the three countries in question.

Second, the countries could begin to harmonize their regulatory approaches in such sectors as transportation, telecommunications, financial services, energy, agriculture and pharmaceuticals.  While the policies would not be identical, in contrast to the first option, exporters, importers and businesspeople in general would face a considerably more predictable regulatory environment.  As in the case of common policies, however, political support for this option may be lacking.

That leaves mutual recognition as perhaps the regulatory option with the most potential.  Under this option, if a good met the standards of Country A, then it could enter Country B without restrictions, as long as Country A also accepts goods produced according to the standards of Country B.  Appearing before the House of Commons Standing Committee on Foreign Affairs and International Trade during its hearings on North American integration, a representative from the Canadian Chamber of Commerce saw the advantages of mutual recognition as follows:  “it requires us to say we recognize your standards as appropriate standards and you recognize our standards as appropriate standards.  That doesn’t mean you have to change your standards or we have to change our standards.  I think that is potentially much more politically feasible, and it doesn’t require us to harmonize to the U.S. standard.  That’s a potential way of moving this relationship forward and ensuring more secure access to the U.S. market while avoiding this issue of requiring harmonization.”[12]  Mutual recognition of laboratory accreditation, approvals or certification could lower the cost of regulation.

The adoption of mutual recognition is not without precedent.  In Europe, for example, efforts to harmonize regulations were found initially to be expensive and inefficient.  They were replaced with an agreement that each government would recognize the regulations put in place by the other governments. 

Here at home, Minister Pettigrew recently advocated greater regulatory cooperation between the three NAFTA members, arguing that in many areas the three countries had “similar regulatory systems that work for similar goals and produce similar results.  Yet each country often demands that products imported from the other go through costly testing procedures to meet domestic requirements.  Why not acknowledge the similarity of our systems and agree that once these products are tested in one country, they are acceptable in the other?  Can we not move to the principles of mutual recognition and the elimination of duplication?”[13]  In his appearance before the Committee, he noted that any examination of mutual recognition would have to be done on a sector-by-sector basis.

During his appearance before the Committee, Bob Keyes suggested that Canada and the U.S. should examine their own regulatory processes and standards.  He observed that the existence of parallel, overlapping, duplicate systems of regulatory approval leads directly to delays and an increase in business costs and that regulatory cooperation would not mean simply adopting U.S. standards.  Two or three sectors could be targeted to start the process of moving to mutual recognition. 

Richard Paton also advocated the adoption of mutual recognition, with agreement on testing criteria approaches.  However, it would be difficult to get an agreement with the Americans on the development of common testing procedures since our market is so much smaller than theirs.  There would be no incentive for them to change since they are the larger entity.  One way to deal with this problem is to reach a bilateral agreement on the lower-risk areas and keep decision-making separate in the higher-risk areas.

The Committee questions why, in view of the integrated nature of the North American market and the similarities in many product standards, there continues to be a need for a duplication of approval and testing processes in all areas.  We recommend:

Recommendation 12

That the Government of Canada carefully investigate the impact that regulatory differences with the United States have on the Canadian economy, and release its findings to the public.  The government should seriously examine the concept of mutual recognition of each country’s regulatory standards and procedures, under which standards would be tested and inspection and certification would be carried out only once within the Canada-U.S. market.  Moreover, the government should identify those sectors in which the U.S. and Canadian regulatory systems are similar and the mutual recognition approach could be applied. 

THE NEED TO DIVERSIFY CANADA’S TRADE

The federal government has attempted to promote hemispheric, transpacific and transatlantic free trade in order to diversify Canada’s trade.  Minister Pettigrew told us that much of this country’s trade promotion effort is aimed at markets outside the U.S., the objective being to strengthen Canada’s trade position around the world.  The use of Team Canada and other, more modest trade missions was cited as proof that the current government takes the trade diversification objective seriously.

A number of witnesses told the Committee that because of the vulnerable position that Canada is in regarding possible U.S. security and trade actions, it makes sense to diversify trade as much as possible.  To mention but one example, Dennis Laycraft noted that the Canadian cattle industry has already formulated a long-term objective to export 50% of its products outside the U.S. by 2010.

Meeting the diversification challenge will require considerable effort.  Kathleen Macmillan reminded Committee members that although efforts to diversify Canada’s trading patterns have been made over the years, our dependence on the U.S. economy has continued to rise.  She pointed to a number of reasons for the close Canada-U.S. relationship: geographic proximity, language, similar institutions, and a good understanding of each other’s market.  Tim O’Neill cautioned the Committee not to set its expectations too high concerning diversification.

Other witnesses, however, noted that Canadian efforts to diversify its trade could be improved.  Bob Keyes argued that Canada appears to be entering into trade agreements and trade liberalization agreements primarily with smaller countries and regions, such as Costa Rica, Central America, the Andean Community and Singapore.  He noted that these are small markets and that some of the trade agreements are being entered into for political rather than trade reasons.  Other countries such as Mexico have been considerably more aggressive in seeking out expanded trade relationships with larger entities.  Many witnesses pointed to Europe and Asia as regions where Canada has not enjoyed much success in terms of forging a closer trade connection.

John Wiebe (President and Chief Executive Officer, Asia-Pacific Foundation of Canada) thought that the Canadian focus on the U.S. had had the unintended consequence of diverting our attention from other, important regions of the world.  The Canadian government should be encouraging other free trade agreements to enhance our overall trade relationship.

Finally, Bruce Campbell (Executive Director, Canadian Centre for Policy Alternatives) called on the federal government to examine past efforts to diversify, determine why they failed, and attempt to design an improved strategy to achieve a different outcome.  He placed considerable emphasis on the achievement of a genuine trade agreement with the European Union (EU). 

The Committee is convinced of the importance of a strong trade relationship with the U.S. but is also of the view that Canada would be better off if its trade dependence on its single largest market to the south was reduced.  This does not mean that our trade with the U.S. should stop growing but rather that trade with other countries should expand at a higher rate.  The Committee is struck by the current efforts of other countries to enter into bilateral trade agreements and encourages the Government of Canada to aggressively seek out comprehensive free trade agreements in Europe and Asia.

 

A.  Achieving a Comprehensive Free Trade Agreement with Europe

While the European Union is Canada’s most important trade and investment partner after the U.S., our trade is not increasing as quickly with that area as with other parts of the world, and the EU’s share of our total exports and imports has been declining over the past decade.  Merchandise exports now total $21.2 billion, or 5.2% of Canada’s total exports, while imports equal $36.1 billion.  The figures for services are $9.9 billion and $10.6 billion respectively.  Moreover, several bilateral trade issues stand out:  market distortions in the agricultural sector stemming from export subsidies and domestic support; protective tariffs in certain sectors; and EU import bans and restrictions, especially in the agriculture and natural resource sectors, for health, environmental and consumer protection reasons.

Whereas trade has been declining (in percentage terms), the real success story regarding Europe has been the two-way investment relationship.  The stock of Canadian investment in the EU was $99.9 billion in 2002, and the Europeans had invested $94 billion in Canada.

In view of the deteriorating trade situation with Europe, it is regrettable that Canada has not yet been successful in entering into a comprehensive free trade agreement with the EU.  The planned addition of ten new countries by May 2004 will turn the EU into a single market of over 480 million people and a GDP of around $13.7 trillion, compared with NAFTA’s 412 million and roughly $15.7 trillion.  Europe is a continent clearly on the move, and yet Canada is only one of eight economies worldwide that does not have some form of preferential trading relationship with the EU.  The Committee heard that seeking closer formal economic ties would be a positive development.  Donald Barry informed the Committee that a study carried out by the Department of Foreign Affairs and International Trade showed that a Transatlantic Free Trade Agreement (TAFTA) would generate significant gains on both sides of the Atlantic.  Both the EC and DFAIT agreed to undertake surveys of the business community on free trade.  The Canadian survey, released in November 2002, was positive, but the European survey has not been released.  The EU Trade Commissioner (Pascal Lamy) seems to have changed his tune on the merits of a TAFTA:  previously he was willing to consider the business case, but now he maintains that market access issues need to be resolved in the WTO Doha Round.  Barry also pointed to the inertia within the European Commission on this topic.  The Commission appears to view Canada as a small market with few benefits for the EU.

Roy MacLaren identified the EU as the top priority in any Canadian diversification strategy, and favoured the pursuit of a Transatlantic Free Trade Agreement (TAFTA) with the EU and one with the European Free Trade Association (EFTA), which consists of Norway, Switzerland, Iceland and Liechtenstein.  Regarding the EU, he speculated that the Europeans would prefer to deal with the U.S. as opposed to us and commented on the doubtful success of the WTO Doha Round, on which the Europeans have pinned all their hopes.  On EFTA, he is disappointed that Canada’s shipbuilding subsidy program has been allowed to disrupt free trade negotiations.

Other witnesses also pointed out additional roadblocks to a TAFTA.  Theodore Cohn stressed that no economically developed country outside Europe has a free trade agreement with the EU.  One can have an associate agreement with the EU only if one is a developing or European country, neither of which applies to Canada.  Cohn was not optimistic that Canada would obtain a special link with the EU.

Richard Harris noted that since formal trade barriers between Canada and Europe are not high, there is not much to eliminate.  In addition, the trade that we now have with the U.S. (time-sensitive delivery in intermediate goods and manufacturing) will just not happen between Canada and Europe.  Canada will be trading in energy, natural resources, finished products, and agriculture instead.  He is optimistic that there could be some improvement in that trade, but it certainly will not be an engine of economic growth for Canada, even if a TAFTA were to be signed. 

Rolf Mirus thought it would be unproductive for Canada to negotiate with the Europeans, especially since the trade negotiations are so complex (e.g., we try to export agricultural products there and they erect barriers).  He did not foresee any gains for Canada in negotiating with the Europeans separately (i.e., separately from the Americans).

Thomas D’Aquino identified three problems with Europe:  we are not important to the EU and they are preoccupied with expansion; they see us as tied to the Americans; and there is the thorny problem of agriculture to resolve.  He doesn’t think a deal with Canada would be entered into unless the Americans were also part of it.   Support for such a trilateral approach to transatlantic trade liberalization, with Canada and the U.S. facing joint market access barriers in Europe, was expressed to the Committee in Washington by both William Lash III and Representative Earl Pomeroy.

Bob Keyes argued that Canada should forget about its comprehensive free trade proposal and move forward in a practical way to remove non-tariff barriers such as regulatory impediments to trade.  At any rate, the Europeans are waiting for progress at the WTO.

Claude Carrière informed the Committee that Canada and the EU are currently working to define the content of a Canada-EU Trade and Investment Enhancement Initiative.  Though not as comprehensive as a TAFTA, this important new initiative should prove useful in harmonizing or cooperating on technical standards, labelling requirements and the certification of professionals; this will improve the existing regulatory framework governing the two-way movement of goods and services.  

Minister Pettigrew has started consulting with Canadians on what should be in the new agreement and the barriers to the European market that should be addressed in the WTO negotiations.  The plan is for the two sides to propose designs for the new agreement in December 2003 and then negotiate the deal in 2004, with the targeted completion date to be established once the results of the Doha Round are known.

The Committee has, for many years and with limited success, advocated the implementation of a comprehensive free trade agreement with Europe.  Such an arrangement, apart from significantly improving access to the European market, would send a strong signal to business on both sides of the Atlantic that a less restrictive trade and investment climate was in place for transatlantic commerce.  While any initiative to enhance the Canada-EU relationship should be viewed as a positive development, the long-term goal of achieving a broadly-based free trade deal should remain intact.    The Committee recommends:

Recommendation 13

That, noting the valid objective of engaging in regulatory cooperation with the European Union within the proposed Canada-EU Trade and Investment Enhancement Initiative, the federal government retain as a goal the successful negotiation of a comprehensive Transatlantic Free Trade Agreement.

 

B.  Strengthening Trade Ties with Asia-Pacific

During his appearance before the Committee, John Wiebe made a compelling case to expand Canada-Asia-Pacific trade.  This section largely presents the evidence that he provided.

Why Asia-Pacific?  Because it is recovering from the 1997 financial crisis, because it accounts for two thirds of the world’s population and 40% of the world’s trade, and because it has the fastest growing economies in the world.  Canada’s trade with Asia-Pacific totals $70 billion annually, second only to trade with the U.S. However, we run a $30 billion deficit with that region, so there is a considerable economic opportunity there.  On the negative side, Canada is losing market share in Asia as trade growth is not keeping up with economic growth in the region.  In the short term, the current SARS situation may also serve to dampen the economic relationship.

Northeastern Asia (China, Korea, Japan) accounts for the bulk of Canada’s commercial interactions with Asia-Pacific.  Add India for its economic potential and one would have a short list of where Canada’s priorities ought to be.

China is the one economy that is worthy of close examination; Canada ignores it at its peril.  China’s economy, the sixth largest in the world, is undergoing a thorough transformation that is affecting the entire NE Asia region.  Its growth rate, officially 8%, is very high (see the graphs below on GDP growth rates in selected countries), and it continues to specialize in low-wage manufacturing.  China has also become a significant consumer and has now surpassed the U.S. as the world’s leading destination for investment ($53 billion).  Canadian trade with China has been rising at an annual rate of 10% to 15%.

Japan is Canada’s second largest trading partner and is still the number-two economy in the world (with 13.5 % of the world’s GDP), even though its economy has been stagnant lately.  Its potential as a consumer economy is still enormous, although it is not opening up as much as China.[14]  Wiebe believes that Japan is on the verge of a major transformation, both economically and politically, one that will be important for Canada.

Two other Asian countries are worth mentioning.  Korea has rebounded strongly following the financial crisis of the late 1990s.  Per capita income last year exceeded US$10,000, and the country is becoming an opportunity for Canada.  Canada’s current trade with India is only $2 billion but is growing quickly – it was $900 million in 1991.  Services are the most dynamic sector there for Canada to exploit.

According to Wiebe, Canada needs to do the following.  First, Asia is becoming increasingly inward-looking regarding trade, and it behooves Canada not to be left out of the action.  Like the U.S. and Mexico, which are both trying to negotiate FTAs there, we should be actively engaged in bilateral discussions with key countries in the region.

Second, Canada should promote investment in Asia.  Assets are cheap there now (discounted from the 1997 crisis), so it is a good opportunity to buy.  Opportunities for trade will be created if we invest there (i.e., trade follows investment). 

Third, Canada needs to develop a better “brand” (i.e., image) in the region.  We are viewed as a friendly, clean country with lots of clean natural resources and a willingness to tolerate diversity.  We are not seen as a high-tech company or provider of high-quality industrial goods and services.  Here, reality does meet perception, as our exports are dominated by natural resource products and unfinished goods.

Finally, government leadership is required for trade facilitation, tariff reduction, the signing of mutual recognition agreements and other initiatives.  Coordination and cooperation between governments, communities and businesses will be required for trade with Asia to grow.

To maximize economic opportunities in Asia, Canadian trade policy will have to become more focused on that region and more aggressive and innovative in its approach.  Like the U.S. and Mexico, which are both trying to negotiate free trade arrangements there, Canada should be actively engaged in bilateral discussions with key countries in the region.  The federal government should also find new ways to augment the awareness of Asian economic opportunities within the Canadian business community, assist firms in improving direct business ties with Asian companies and develop a better “brand” for its products.  The Committee recommends:

Recommendation 14

That the Government of Canada make free trade with Asia a priority and initiate trade-liberalization negotiations with  China, Japan, South Korea, India and members of the Association of Southeast Asian Nations (ASEAN).  The federal government should also develop new strategies to increase the interest of Canadian businesses in Asian markets, help Canadian firms construct durable partnerships with Asian companies and establish a better image for Canadian products in Asia.

C.  The FTAA and Hemispheric Trade Ties

Canada, along with the 33 other democratic countries of the hemisphere (excluding Cuba), is negotiating a Free Trade Area of the Americas (FTAA); the conclusion date is set for January 2005.  If one excludes our NAFTA partners, the FTAA region pulls in $3.8 billion of our exports and $67.4 billion of our direct investment, which represents 17.3% of Canada’s total foreign direct investment. 

The Committee did not receive a great deal of evidence on strengthening hemispheric economic ties.  George McLean, the most active proponent of the witnesses we did hear on this matter, called for Canada to seek out an enhanced role in the hemisphere.  However, Canada needs to maintain a balance between paying close attention to bilateral relations with the U.S. and moving the hemispheric agenda forward.  Nevertheless, it is his belief that Canada’s commitment to economic multilateralism in the hemisphere benefits its strategic trade relationship with the United States.

McLean is of the view that the FTAA appears to be a logical offshoot of the NAFTA.  He prefers the FTAA approach in that it brings together 34 different countries into a single entity.  Increased integration in the hemisphere could provide benefits to FTAA members while offsetting regionalism in other parts of the world.  Canada may not benefit much economically, but being a part of the deal may protect the NAFTA benefits we already have.

In Washington, William Lash III expressed optimism regarding the prospects for a hemispheric trade deal.  He noted that people have tended to underestimate the new Brazil and that the U.S. and Brazil, two of the key countries in the FTAA negotiations, are now actively communicating with each on important trade issues.

On the negative side of the ledger, McLean admitted that enthusiasm for the FTAA had dimmed and that countries had adopted strategies aimed at achieving bilateral trade liberalization.  His pessimism was shared by Kathleen Macmillan, who observed that the FTAA negotiations were not showing much promise of reaching a meaningful outcome, and Roy MacLaren, who suggested that prospects for the FTAA have deteriorated as economic problems persist in South America.  He thought that this development had made it hard for Brazil to negotiate (as part of MERCOSUR) from a position of strength.  A somewhat pessimistic view was also expressed by Gwyneth Kutz (Counsellor and Alternate Representative of Canada to the Organization of American States), who remarked that the 2005 FTAA target had been made more difficult to attain by U.S. action on farm subsidies and steel imports and by the lack of readiness on the part of the countries in the hemisphere for comprehensive trade liberalization.

 

STRENGTHENING FEDERAL LONG-TERM ANALYTICAL CAPACITY

While in Vancouver, the Committee heard compelling evidence that, with the elimination of the Economic Council of Canada (ECC) in the 1980s, the federal government lost its capacity to undertake medium- to long-term analyses of key economic issues such as those considered in this report. 

Richard Harris pointed out that the demise of the ECC left research on long-term economic issues in the hands of “think tanks”, which have their own agenda, and the rather limited academic community.  John Helliwell observed that the ECC had been a net contributor to Canadian economic thought, while Theodore Cohn suggested that the ECC had provided critical long-term, comprehensive analysis that is currently missing.

It is difficult to disagree with the informed views of these august experts.  The Committee recommends:

Recommendation 15

That the Government of Canada establish a Trade and Investment Council to conduct comprehensive analytical research on external trade and investment issues.


[1]       Exceptions include certain Canadian supply-managed farm products (e.g., dairy and poultry) as well as American goods such as sugar, dairy products, peanuts, and cotton.

[2]       See, for example, Canada, Foreign Affairs and International Trade Canada, NAFTA at Seven:  Building on a North American Partnership. 2002.

[3]       On the negative side, per capita income increases were smaller than anticipated, as the large economies of scale that had been expected did not materialize.

[4]       This methodology was employed in Schwanen, Daniel.  Trading Up:  The Impact of Increased Continental Integration on Trade, Investment and Jobs in Canada. Commentary 37.  C.D. Howe Institute, Toronto, 1997a.

[5]       Marcel Côté, "Is Free Trade Good for Canada? Ten Years Later the Balance is Positive," Cité Libre, April/May 1998, p.48.

[6]       In 2003, the Canadian dollar has rebounded sharply owing to pronounced weakness in the U.S. currency.

[7]       There is an extensive debate in the economic literature over whether regional free trade agreements are beneficial to the long-run goal of global free trade.  Proponents of regional agreements maintain that agreements like the FTA and NAFTA simplify multilateral negotiations by reducing the number of players at the global level.  Critics believe that regional agreements are artificially trade-distorting because they may divert trade from outside the regional bloc to within the bloc for non-economic reasons.

[8]       Arlene Wilson, “NAFTA’s Effect on Canada-U.S. Trade and Investment,” CRS Report for Congress 97-889, 26 September 1997

[9]       Ibid., p. 5.

[10]      Richard G. Harris, North American Integration:  Issues and Research Agenda, Micro-Economic Policy Analysis, Industry Canada, Discussion Paper Number 10, April 2001, p. 11.

[11]       Department of Foreign Affairs and International Trade, Notes for an Address by the Honourable Pierre Pettigrew at the 8th Annual Canadian-American Business Achievement Award and International Business Partnership Forum, "The Canada We Want In The North America We Are Building", Toronto, October 16, 2002, p. 6.

[12]      House of Commons Standing Committee on Foreign Affairs and International Trade, Evidence, 7 May 2002, Meeting No. 77, p. 94.

[13]      Foreign Affairs and International Trade Canada (2002), pp. 4-5.

([14])    Japan’s two-way trade is only 16% of GDP vs. Canada’s 60% and China’s 40%.


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