Following steel, auto tariffs can be the next to hit NAFTA. Would comparative disadvantage work for the US?
The North American automotive industry is highly integrated. Vehicles are built on shared platforms, enhancing the whole supply chain across the region. Robust demand in the regional automotive industry attracted all major global OEMs to the region which created fierce competition and sophisticated network of OEMs and auto parts suppliers. This enables them to source auto parts from not just within the region but also from different parts of the world.
NAFTA remained the lifeblood of the today’s North American automotive industry and attracted multi-billion investments to the region on the back of emerging Mexican market, sophisticated US consumers and matured Canadian market. The three tariff-free trading partners also allowed regional carmakers to benefit from the comparative advantage. Manufacturers have repositioned themselves and shift their production to Mexico to benefit from the low costs of labour. This also enables them to become more competitive and make low-end light vehicles more affordable.
Looking at the current structure of the North American automotive industry, US and Canada are market leaders in producing the high-end vehicles compared to Mexico where it is increasing production of low-end vehicles such as B and C segments. Automakers are very keen on keeping the cost down for low-end vehicles which make Mexico an ideal place for making such vehicles. Majority of these vehicles are exported to the US where they are finally sold with small margins on the top. Most of the auto parts and car bodies used in these vehicles are imported from the US and benefiting the country auto supply chain.
NAFTA has supported the integration of regional automotive industry and any change to trading patterns would result in severe implications for OEMs and auto parts suppliers across the region. Moving production to low costs locations is a vital part of the North American automotive industry which resulted in higher efficiency and productivity. So far, the comparative advantage has kept vehicle prices restrained and improved margins.
The automotive industry in North America is supported by domestic and near-shore production to save on transportation costs. The near-shore production in NAFTA region has evolved into the interdependent supply chain in Canada, Mexico and the US which is supporting the regional automotive industry. Having said that, it has affected Canada and the US industries to an extent, while benefitted the Mexican market un-proportionally. But examining it on the economic principals, it was inevitable for the OEMs to shift their production outside Canada and the US to keep the costs down and prices affordable. The near-shore policy remained more effective in choosing Mexico rather than embarking on the offshore investment where production could move to Vietnam or other South East Asia markets. In such circumstances, the US and Canadian supply chain and consumers would not be that much benefited. It could also be hard for the US OEMs and automakers to penetrate in the Asian markets and compete with Japanese and Korean companies.
Given the changes in the US politics, automotive industry may also see some implications. How beneficial is the automotive industry to the region is no longer matter. What is now matter is to create more jobs and bring back the automotive industry to the US. Would that change be on the cost of high vehicle prices to the US consumers or high marginal costs to suppliers may become irrelevant. The US President Donald Trump is committed to renegotiating the NAFTA agreement and committed to imposing a heavy duty on imported vehicles.
Under the current US Administration, there is a high risk that NAFTA would be renegotiated which would disturb the regional trading pattern. We will see automotive investments to slow down or put on hold in short to medium term in North America if NAFTA agreement is renegotiated or border tax enforced. We have already seen some reactions to Mr Trump rhetoric by some companies cancelling their automotive investment in Mexico. There are also few investments announcements in the US automotive industry, though it would not be likely to have ribbon cutting ceremonies soon for these projects. It would not be that easy to restrict imports and increase exports through playing with border taxes/ tariffs. It is just a small part of the jigsaw puzzle and investors should assess the long-term risks and opportunities.
Commodity Inside automotive analyst John Stanmore writes “the strong dollar and weak peso can also offset any trade measures for Mexican exports. Moreover, it is likely that Mexican and Canadian governments will follow a tit for tit strategy and can limit the US auto and parts supply. The consequences can be unequivocally severe for the US companies as Mexican vehicles are made of around 40% US made-parts.”
There is not enough explanation available that how the US President would approach the NAFTA negotiations. In case of just walking away would not be the right solution and could have severe consequences for the US automotive industry and its supply chain. We understand that the US companies would be able to benefit from any deficiency created by the lack of Mexican and Canadian exports due to low spare capacity and probably high marginal costs. This will also support keeping unemployment rates low. However, on the other said it would result in higher vehicle price, lower returns on capital and smaller product mix.
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