Canada: Free trade and the United States Global Economic Outlook, Q2 2017

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​Canadians may have thought that the long-standing debate over free trade with the United States was over. But the United States might reopen this issue, which dominated Canadian political debate for much of its history.

What’s at stake for Canada in NAFTA

Just when Canadians thought that the question of trade relations with the United States had been resolved, the whole issue may come up for debate once again.

One of the great issues that consumed Canadian politics from the beginning of the Confederation was the economic relationship with the United States. Both countries debated the wisdom of free trade across Canada’s southern (and the United States’ northern) border. After the Second World War, agreement that open borders were best started to take hold. In 1965, the two countries decided to free trade in automobiles and parts and, by the 1980s, had agreed to negotiate a more comprehensive agreement, together with Mexico.

At the time, opposition to the North America Free Trade Agreement (NAFTA) in the United States mainly focused on Mexico, while Canadians expected to be left alone (aside from some disputes around certain products such as lumber). The main debate in Canada involved the size of the potential gains to the country from opening trade with the United States. The signing of the final treaty looked like it put to rest one of the great debates of Canadian history. From now on, Canada and the United States would operate as a single economy, with Mexico included as a kind of unseen bonus (from the Canadian side).

But US policy may be changing—which could potentially restart the old debate in Canada. Even without major changes in Canada, the Canadian government will have to determine how to manage the new relationship. What’s at stake is really the entire Canadian economy, since 75.0 percent of Canadian goods exports go to its southern neighbor.1

US policy may be changing—which could potentially restart [an] old debate in Canada.

Canadian exports to the United States, 2015

Canada’s position in the North American economy has changed since NAFTA came into place. Figure 1 shows Canada’s exports by type in 2015. Mineral products (almost entirely oil) are the largest category, making up over one-third of all Canadian exports to the United States. Despite the close relationship between the Canadian and US auto industries, and the importance of the auto industry for Ontario and Quebec, just one-fifth of exports were transportation goods. Even in manufactured products, the focus appears to be as much on commodity items such as metals and chemicals than on parts and machinery farther down the supply chain.

Canada as the mining supplier for the United States is not really what anybody expected when NAFTA was negotiated. That’s because Canada’s trade picture at that time was quite different. Figure 2 shows Canadian exports in 1995, not long after NAFTA was signed. The difference is striking.

Canadian exports to the United States, 1995

The Canadian economy at the dawn of NAFTA was, to a certain degree, an extension of the US automobile industry. Canada was also a supplier of primary products to the United States, but exports of mineral products such as oil were smaller than exports of wood products (an important industry, especially for British Columbia).

This is a huge change in the structure of the Canadian economy and in its relationship with the United States. What happened? Tar sands and other oil exploration happened—but also, surprisingly, so did NAFTA. As figure 3 shows, Mexico did not really take vehicle production from the United States, as some have claimed. It took production share from Canada. In 1993, Canada produced over 2 million vehicles, compared with just a bit over half a million in Mexico. In 2016, US production had fully recovered from the impact of the financial crisis, and Mexico produced a record 3.5 million vehicles—and Canadian production was 20 percent lower than it had been in 1999.

North American vehicle production by country

While there are disadvantages to being a primary producer, there are advantages as well. Prime Minister Justin Trudeau hasn’t seemed too worried about the United States’ desire to renegotiate NAFTA. Perhaps that’s because he knows that so much of Canada’s exports to the United States are primary products that don’t have US competitors and don’t represent a lot of US employment. Canada is perhaps less vulnerable to the new US trade regime than it might seem at first glance.

Canada is perhaps less vulnerable to the new US trade regime than it might seem at first glance.

Canada’s budget: Deficits as far as the eye can see?

Canadian budget projections run until 2021. The government’s new budget forecasts a modest deficit of about 19 billion Canadian dollars in that year. It’s not a lot by international standards—less than 1.0 percent of GDP. But for Canadians who are proud of their fiscal rectitude learned in the 1990s, it’s still a bit unsettling. That may be why this year’s budget really isn’t very different from the first Liberal budget last year. The government has made its move, and is willing to see how things turn out.

With no major changes in priorities, and a relatively unchanged point of view about the economy and the deficit, attention is likely to turn to some relatively minor points.

First, there is the increase in defense spending. This is despite the current US focus on the relatively low defense expenditures of many North Atlantic Treaty Organization (NATO) partners. While NATO rules require that members attempt to keep defense spending at 2.0 percent of GDP, Canada’s is just under 1.0 percent.2 This may become a source of friction in the future.

Second, the attention-grabbing “Uber tax” should provide Canadian headline writers a way to draw eyeballs to budget articles. This is really a technical matter, since Canada’s goods and services tax is supposed to cover all transactions. From an economics point of view, there is no reason to exclude ride-sharing services from the tax. However, given Uber’s role as a well-known disrupter, just about anything related to it is likely to draw some attention.

Otherwise, there is a grab bag of initiatives that are small in the context of the entire budget, although potentially important to specific groups. For example, the budget includes a bit more money than before for indigenous communities and an argument that the budget will help improve gender equality. But the truth is that this is a rather boring budget. Boring is not a bad thing, as Canada’s neighbors and peer countries can testify.

Is the economy picking up steam?

Early 2017 saw some positive economic news. January GDP was up 0.6 percent, and average employment grew by over 35,000 in the three months to February. Monthly GDP growth over the previous 12 months has been around the 2.0 percent mark since September—a contrast to the less than 1.0 percent level recorded earlier in 2016. It all certainly suggests that the Canadian economy is beginning to pull out of the slower growth of the recent past. That likely reflects the moderate strength of the US economy in the past few months. A significant slowdown in the US economy remains a key risk for Canada, as do the housing situation and consumer debt.

Total consumer price index (CPI) inflation was 2.0 percent in February, at the Bank of Canada’s target. However, the bank does not use the total CPI. In October, as part of the renewal of the bank’s agreement with the Government of Canada, it adopted three inflation measures as a kind of joint target.3 Each measure uses a different method of removing volatility from the inflation number. All are currently under the 2.0 percent inflation target, and one (CPI common) is at just 1.3 percent. Most observers therefore expect the Bank of Canada to maintain an accommodative policy in the near future.