Forecast

• Diverging interests will prevent Canada and Mexico from putting up a united front against the United States on NAFTA, making two-track negotiations or direct bilateral talks likely.
• Canada will avoid antagonizing the Trump administration and focus on harmonizing regulatory environments.
• Mexico will try to raise the political cost in the U.S. Congress of supporting sweeping changes to the pact.

Analysis

Less than a year ago, the cordial spirit among members of the North American Free Trade Agreement reached a high-water mark at a plenum in June of its leaders dubbed the Three Amigos Summit. The next such meeting is unlikely to be as friendly. U.S. President Donald Trump has put NAFTA's foundations squarely in his crosshairs, and more than likely, the three sides will soon enter contentious negotiations over the structure of the trade deal — if it remains a trilateral pact at all.

Trump's calls to revamp the deal have stoked concern in Mexico and Canada, whose economies are deeply intertwined with that of the United States. But with Trump's most withering criticisms of NAFTA directed at Mexico, the negotiations will expose an underlying reality of the pact: NAFTA should be viewed not as a comprehensive trilateral economic union, but as a pair of bilateral free trade agreements — one between the United States and Mexico and the other between Canada and Mexico — governed by a common set of rules. As the three powers move deeper into negotiations, this dynamic will drive a wedge between the positions of each. The government in Ottawa will "put Canada first." Mexico City will "put Mexico first." In practice, NAFTA will not be anyone's top priority.

Trump's Theory of Trade

At its heart, Trump's criticism is centered on the notion that U.S. manufacturing — principally heavy manufacturing sectors such as automobiles — has been hollowed out by imports, either through trade agreements he deems unfair, such as NAFTA, or through unfair trading practices. This, he says, has bled the United States of manufacturing jobs. Employment in the U.S. manufacturing sector has certainly dropped, but the extent of the decline that can be directly attributed to NAFTA is unclear. It is likewise unclear whether renegotiating the pact would help reverse the tide.

Trump has pledged to launch a formal review of all existing trade agreements, starting with NAFTA, and determine a course of action by his 200th day in office. Backtracking on that plan seems unlikely. The main questions, then, are: What will the United States seek? And what form will a successor agreement to NAFTA take?

The Trump administration will focus on changes to NAFTA that can be portrayed, at least at face value, as creating or saving U.S. manufacturing jobs. This can be done in a number of ways. First, Washington will almost certainly seek to boost NAFTA's rules-of-origin requirements — the amount of a product that must be manufactured in a NAFTA country to be eligible for preferential tariff access — to as much as 90 percent, depending on the sector. The current requirement is generally around 50 percent for most products (or 62.5 percent for finished light vehicles).

This would help boost investment into NAFTA, but alone it would not address Trump's argument that Mexico unfairly benefits from the trade pact. Thus, Washington will also likely push for other measures such as import quotas or more stringent caps on foreign ownership of firms exporting to the United States as well as stronger requirements on how much of an imported product must be made in the United States in certain sectors. The Trump team will also likely seek to incorporate several components of the Trans-Pacific Partnership (TPP) deal into NAFTA, including strong requirements on issues such as labor regulations, intellectual property protections and environmental standards. The Trump administration accuses Mexico of keeping its standards weak in these areas as another way to siphon jobs from its northern neighbors.

Beyond the focus on weakening incentives to invest outside the United States, the Trump team will take the opportunity to revisit other problematic NAFTA mechanisms as well. Much of the attention will focus on NAFTA's Chapter 11 investor-state dispute settlement mechanism, which allows investors to sue foreign governments without first going through legal proceedings in that country. Also under the microscope will be Chapter 19, which allows members to request a binational panel review of anti-dumping and countervailing duty lawsuits. U.S. negotiators may also seek to make good on Trump's pledge to be able to terminate any new deal with 30 days' notice.

The United States has not pulled out of a trade agreement since Andrew Johnson was president in 1866. On NAFTA, it is somewhat legally ambiguous what Trump can do unilaterally and what would require congressional approval. Sweeping changes to the pact — which technically is a congressional-executive agreement, not a treaty — would likely require a sign-off from Congress. But in the interest of accelerating negotiations, Congress often grants the White House more authority to act on its own.

In practice, this means that although Trump could conceivably announce a withdrawal from NAFTA without congressional approval, it remains unclear whether such a move would actually terminate Congress' original implementing legislation. At minimum, such unilateral action would face multiple court challenges. It is more likely — albeit far from a given — that Trump could raise tariffs on Mexico to the levels that Washington grants other countries with "most-favored nation" status under the World Trade Organization (though these tend to be far below the 20 to 35 percent levels the president has threatened to impose on Mexico). And Trump almost certainly has the authority to modify some rules of origin in an attempt to force North American manufacturers to rely more on materials or component parts sourced from within the bloc. Since any other substantial modifications would probably require some sort of congressional approval, Washington is likely to prioritize these aspects.

Two Discrete Trade Relationships

As the Trump team pursues these goals, the disparities of the NAFTA members' negotiating positions will become starker. This is, in part, because the economic integration furthered by NAFTA across the northern U.S. border looks vastly different than that to the south.

As in the United States, Canada's mid- and high-end manufacturing industries remain competitive, with most citizens employed in the services sector. As a result, the countries' bilateral trade relationship is robust and generally balanced. In 2015, for example, Canada and the United States conducted roughly $581 billion in trade, with the U.S. trade deficit amounting to just $21 billion. In fact, when ignoring the energy trade balance, the United States has enjoyed a small trade surplus with Canada every year since 2007. Moreover, the two are becoming more integrated in energy markets. Thus, while the shale oil boom has contributed to a decline in the U.S. energy trade deficit with Canada, it has not reduced Canada's own market share in the United States.

The United States and Mexico likewise enjoy a robust trade relationship exceeding $500 billion annually, but that's where the similarities to the U.S.-Canada partnership end. By contrast, though the United States and Mexico have also pursued energy integration, the energy sector has never been a core driver of the U.S. deficit with Mexico. In fact, the United States posted a substantial surplus in such trade in 2015. The main issue is Mexican manufacturing, principally of automobiles, electronics and related sectors. (The trade balance is a little bit misleading because of Mexico's position near the end of most U.S.-bound supply chains. Mexican manufacturing is heavily focused on assembly, meaning a larger share of its U.S.-bound exports are counted as high-value goods than other manufacturers'.)

Meanwhile, only scant trade takes place between Mexico and Canada, amounting to $20 billion to $30 billion annually. Accordingly, the disputes between the two countries have been relatively small, such as over visa regulations. The dearth of economic ties binding Mexico and Canada further underscores the awkward marriage of their respective trade relationships with the United States under NAFTA rules. It also means that neither has substantial interest in joining forces against the United States as it seeks to reformulate the pact. Just as Washington's criticisms against them differ, so too will their strategies and demands.

Canada Cozies Up to Washington

Compared with Mexico, Canada has been relatively open to renegotiating aspects of NAFTA. Historically, concern has been high in Canada about competition from the United States, and to a lesser extent Mexico, but protectionism has been subsiding gradually. Still, as in the United States, labor frustrations remain in Canada with the perceived loss of automotive and other manufacturing jobs to Mexico, making it worthwhile for Ottawa to side with Washington against Mexico on certain issues. For the most part, however, Ottawa has been signaling to Washington that it may be open to a two-track negotiation process — or even to sideline Mexico altogether with direct bilateral talks.

Notably, Canadian Ambassador to the United States David MacNaughton has emphasized that the Canada-U.S. free trade agreement that preceded NAFTA was never formally repealed but only suspended for as long as NAFTA remains in force. In the event of a breakdown of U.S.-Mexico negotiations over NAFTA, Canada could seek a quick and simple resurrection of the prior agreement or perhaps seek to update the pact to incorporate certain elements of TPP and NAFTA. In particular, Canada would like to introduce TPP-mandated reforms on environmental issues. And like the United States, Canada would like to weaken NAFTA's Chapter 11 investor-state dispute mechanism, which frequently has been used by foreign companies to skirt more stringent Canadian regulations, particularly environmental rules. Ottawa will also seek more favorable treatment for Canadian products in Trump's "Buy American" initiatives (though this is a long shot). The United States, meanwhile, may seek to revisit a long-standing dispute over British Columbia's exports of softwood lumber. A previous settlement on the issue expired in 2015, and Canada will likely be amenable to pursuing a permanent solution.

Overall, with the Trump administration focused primarily on Mexico, and with the Canadian economy so dependent on U.S.-bound exports, Ottawa cannot afford to antagonize Washington. For Canada, the thrust of the issue is about more than just preserving preferential access to U.S. markets. Rather, it also includes harmonizing the regulatory and non-tariff trading environment with the United States as much as possible.

Mexico Looks for Leverage

Mexico has been backed into a corner, both economically and politically. Structurally, Mexico is exceedingly dependent on its access to the U.S. market. In 2015, an estimated $309 billion of its $381 billion in exports went to the United States. Moreover, the business models of dozens of companies that have invested in Mexico, especially foreign ones, are contingent on the ability to either sell products directly to U.S. consumers or to produce component parts for U.S.-bound products manufactured elsewhere. Without that access, a substantial share of foreign direct investment into Mexico would likely dry up, curbing Mexican economic growth for years and threatening the country's social stability.

There are some factors working in Mexico's favor. Despite Trump's criticism, the U.S.-Mexico trade relationship is actually one of the United States' most balanced. On average, imports account for 60 percent of total U.S. global trade. With Mexico, this figure is 56 percent. Meanwhile, Mexico is the second-largest U.S. export destination and a crucial market for the U.S. energy and agricultural sectors. Moreover, finished Mexican products exported to the United States often consist of component parts made in the United States. These trade linkages are heavily concentrated in certain U.S. states, many of them Republican-dominated ones such as Texas, giving their elected leaders a stake in preserving the status quo. Mexico's automotive industry illustrates these patterns. The U.S.-based Center for Automotive Research argues that ending NAFTA and instituting tariffs of 35 percent could cost the United States 31,000 jobs in the automotive sector alone.

Mexico City will pin its negotiating strategy on these areas of mutual dependence and focus on where it can inflict concentrated pain on selected segments of the U.S. economy. In fact, the country has taken those actions in previous disputes. In 2009, Mexico responded to a disagreement over U.S. cross-border trucking regulations by slapping targeted tariffs on around 90 agricultural products, affecting 40 states. Moreover, there have been some signs of a backlash against U.S. companies in Mexico and growing calls for boycotts of their products.

Already, clear signs of this strategy have begun emerging from Mexico City. On Feb. 1, after starting a 90-day consultation period with key business leaders, Mexico announced that its priority was to preserve unhindered access to the U.S. market and that it would not accept higher tariffs or new import quotas. On Feb. 23-24, Mexico's National Council of Governors will meet with the U.S. National Governors Association in Virginia, an attempt by Mexico to build grassroots support for maintaining the status quo on trade and potentially make it difficult for Trump to get congressional approval for a full repeal of NAFTA — or even a substantial renegotiation through a fast-tracked implementation process.

The longer negotiations drag on, the more domestic political complications both sides are likely to encounter. Trump's failure to win the national popular vote adds fragility to his governing coalition. As voting blocs dependent on trade with Mexico head to the ballot box during the U.S. midterm elections in 2018, lawmakers who might otherwise support changes to NAFTA could abandon ship. Trump's broader popularity will also affect those calculations. The potential knock-on implications of changes in NAFTA in rural, agricultural-focused states, as well as in key border states, will become particularly important to watch. In an unfavorable political environment, Trump could have little choice but to settle for relatively minor adjustments to NAFTA.

Mexico's July 2018 presidential elections will also affect the negotiations. Mexican President Enrique Pena Nieto and his Institutional Revolutionary Party are already under major political duress. The harder the United States presses Pena Nieto on trade, the more a nationalist candidate such as the Party of the Democratic Revolution's Andres Manuel Lopez Obrador may gain in popularity. From the White House's perspective, negotiations thus likely need to be fast-tracked to avoid the risk of a more hard-line government taking power in Mexico — one with an electoral mandate to show even less flexibility in the NAFTA talks or to walk away from them altogether.