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AmericasMarch 1 2017

Nafta or not: Mexico’s economy in the balance

As US president Donald Trump takes aim at Nafta, which he calls “the worst trade deal ever”, Silvia Pavoni takes the pulse of Mexico’s business, banking and trade community, where hearts are thumping but heads remain cool.
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Kenneth Smith Ramos has one of the world’s most stressful jobs. As the Mexican Ministry of Economy’s man leading trade relations with the US, he has his work cut out. President Donald Trump’s administration wasted no time in calling for a revision or abandonment of Nafta, the North American Free Trade Agreement that binds the two countries and Canada. Nafta is “the worst trade deal ever”, according to Mr Trump. Mexico’s economy has grown to depend on it.

Yet, when The Banker called his office on Pennsylvania Avenue, a couple of blocks from the White House, Mr Smith Ramos discussed his activity in the capital with the energy and enthusiasm of someone about to embark on a promising negotiation.

“What we’re looking to do is to strengthen Nafta, to make it more efficient, to provide more competitive North American products that can compete successfully against products from other regions in the world,” he says. The 23-year-old agreement could include electronic commerce and a digital trade agenda, he adds, and it could upgrade intellectual property rights and promote the internationalisation of small companies. Everybody would win.

Trump talks tough

His optimistic line could not be further from that taken by the new US administration, which appears to focus on the country's trade deficit with Mexico, nearly $60bn in 2015, and takes issue with manufacturing facilities US corporates have sited south of the border. Mr Trump has threatened to slap taxes on businesses moving production and jobs abroad, and has taken it upon himself to publicly threaten – usually through his Twitter account – individual corporates investing in Mexico. Ford Motors directly tied its decision to cancel a $1.6bn plant planned for Mexico to policies championed by Mr Trump, and did so before the president had even been sworn in. It will instead invest $700m in a Michigan assembly plant.

Mr Trump had also threatened General Motors with taxes on car imports from Mexico and went as far as promising the same treatment for non-US companies: Japan’s Toyota, the world’s largest vehicle manufacturer, plans a new factory in Mexico to produce a model that is currently made in Mississippi and Ontario, Canada. “NO WAY! Build plant in US or pay big border tax,” tweeted the president.

The automotive supply chain is one of the most strongly integrated in North America, and Mexico is the main auto parts supplier to the US. A total of $131bn in cars and parts is traded between the two every year. The electronic goods market behaves similarly, with $143bn-worth of bilateral trade, while Mexico has grown dependent on US exports for certain agricultural products, such as corn.

Nafta has created a development path for Mexico’s economy; trade now accounts for almost two-thirds of the country’s gross domestic product (GDP), compared with 30% in the early 1990s according to government data. Despite the current administration’s view, the deal has created employment opportunities in the US too, although in retrospect most experts would agree that the transition to the free-trade model could have been handled better. Nevertheless, more than 4.85 million US jobs now depend on trade with Mexico, according to Washington-based independent researcher the Wilson Center.

Dissenting voices

The concern of many in the US should not come as a surprise. “US businesses are distraught,” says Michael Shifter, president of policy think tank the Inter-American Dialogue. “I talk to a few of them privately. They’re extremely concerned. That’s the basis for my hope, that at the end of the day this is not going to be a complete breakdown [of Nafta]. The cost would be so immeasurable for US businesses and jobs in the US. For all the things Mr Trump claims he wants to do and protect, it seems utterly at odds with what his agenda is.”

US businesses are beginning to address such concerns, says Mr Smith Ramos. “In the US, in this case, the stakeholders that matter the most are private sector companies and organisations that have been involved in Nafta and have seen the benefits of free trade in specific communities,” he says. “It is very important that the US National Association of Manufacturers, the US Chamber of Commerce, the American Farm Bureau Federation and others mobilise and talk to their congressmen and the new administration, in order to explain the benefits they obtain from Nafta and the losses they would incur if the US pulls out.”

But if corporate America is suffering palpitations, it is Mexico that risks a heart attack if Nafta is repealed. The effects would be devastating: the economy could sink into recession, many predict, making corporates and even municipalities insolvent and eating into lenders’ capital reserves.

Mexico’s consumer confidence index plummeted to a historic low in January as the new US president was sworn in, down nearly 20 percentage points to 68.5%. Levels of below 100 indicate pessimism, and this is by far the lowest figure since records began in 2001, below even 2009’s post-financial crisis results.

“It shows you what is going on here,” says one senior Mexican banker, who adds that his institution is preparing for the worst. “[A repeal of Nafta] would be bad for the US but for Mexico it would be a disaster. Nafta has driven the economy for the past 20 years.”

Leading Mexican banks

Bad to worse

Rising numbers of non-performing loans and limited growth prospects will press heavily on the balance sheets of Mexican banks already dealing with the Trump-induced peso dive and investor concerns over the emerging market’s creditworthiness. "Non-performing loans will have to go up. It has to happen,” says the senior banker. “Banks’ capital levels are good so that is something that would insulate them a bit, but they’re also dealing with instability in the foreign exchange and bond markets. It is really affecting banks.” However, data from The Banker Database shows that Tier 1 capital has been decreasing for most of Mexico’s large lenders over the past few years.

Mexico’s concerns do not end there. In February the country's central bank hiked the interest rate by 50 basis points to 6.25%, aiming to address inflationary pressures from rising fuel prices as well as currency depreciation. In the accompanying statement, it noted that “the balance of risks to growth has continued to deteriorate”.

Mexico’s financial system stability board, the CESF, is also concerned. It attempted to head off an economic downturn by requesting lenders to add a Trump scenario to their annual stress testing exercise before the US presidential elections in 2016. The CESF includes representatives from the Ministry of Finance, the central bank and banking regulator CNBV. Most lenders would have prepared action plans but few would act before loan books begin to suffer, worries the Mexican banker. “The main worry now is consumer confidence, but you don’t see anything else,” he says. “The Mexican economy is going to get bad in the second half of the year, and [then] especially [so] in 2018.”

All economic sectors in the country are being braced for the worst. “Nobody could quite believe that we would voluntarily blow up supply chains between the US and Mexico,” says Eric Farnsworth, vice-president of the Council of the Americas and the Americas Society. “But you increasingly hear businesspeople and government leaders in Mexico saying: ‘Well, we simply can’t take this for granted, we need to lay the groundwork.’”

Percentage pressure

Indeed, the Mexican government launched a 90-day consultation period with the private sector. The country's deputy chief negotiator for Nafta at the time of its creation, Jaime Zabludovsky Kuper, has taken on the role of principal adviser to businesses as part of this national consultation. He also led negotiations on the free-trade agreement with the EU from 1998 to 2001, and is now president of Conmexico, the Mexican council on industry and consumer products, and the founder and vice-chairman of advisory firm IQOM Inteligencia Comercial.

Nevertheless, years of experience could not prepare Mr Zabludovsky Kuper for today’s atmosphere of confrontation. “Even when we were dealing with protectionist forces both in Mexico and the US, particularly with unions, the arguments were completely different,” he says. “What we are facing today is a complete rejection of what we thought was the accepted doctrine of free trade.”

He offers his view on what negotiations might centre around in a less toxic scenario. The rules of origin are one area of contention. These determine the regional or national content that products must have to qualify as admissible under a certain free-trade agreement. So if a rule of origin stipulates that 50% of a TV set must come from products of countries that are part of the agreement, appliances with a higher percentage of foreign components would not qualify for preferential treatment when crossing borders. According to official Mexican data, there is currently a 40% US value added on Mexico’s exports to its northern neighbour: those Mexican products sold in the US are 40% made in the US.

“In their nationalistic and protectionist approach, the US might be willing to negotiate on higher regional and domestic content in the goods produced in North America and traded between the three countries,” says Mr Zabludovsky Kuper. “We might be able to have negotiations on rules of origin. For example, if today you need a 50% value-added among the three countries on a certain product so that product would receive the preferential access in these three markets, we might have a discussion so that we can raise that number to 60% or 65% and see if individual producers in those sectors can get supplies regionally. What happens is that in many cases they just have to import from other countries [outside North America] because those products do not exist anymore in North America. It’s not that we don’t want to buy locally.”

The complexity of rules of origin would require detailed and technical negotiations on hundreds of products and individual parts, and deal with international supply chain reality whereby a certain component of a certain TV set might no longer be made in the US or even North America but have to be imported from, say, South Korea.

Looking east

The possible collapse of Nafta has also revived other tensions, for better or worse.

The potential loss of preferential treatment with a trade partner so tightly linked to the domestic economy has reinvigorated discussion over diversification. Mexico already has free-trade agreements with 46 countries, but lacks depth in many, partly because of geographical distance. Now is the time to act, says Enrique Garcia, president of development bank CAF, particularly when it comes to other economies in Latin America. “There have been too many speeches. This is the time Latin America improves regional integration,” he says. Indeed, Mexico’s government has begun discussions with Brazil and Argentina over potential replacements for US agricultural supplies, says Mr Smith Ramos.

But the biggest opportunity, both in terms of trade and investment, is likely to come from fast-growing Asia, where so far Mexico has secured a free-trade agreement with only Japan. China might be interested in Mexico’s plentiful energy sources, but discussions would require the Mexican government’s full attention and top team, both currently occupied with the attempt to soften Mr Trump’s stance.

“There’s going to be lots of criticism saying Mexico made a mistake by hitching its fate to the US to the extent it did; it probably would have been very hard not to given the geography. I think it’s going to be hard to make that switch,” says Mr Shifter. “They’re going to try to build new relations with China and other partners but that will take a long time to yield any results, in even the best scenarios.”

Political scuffle

Another side effect could be the revival of nationalist sentiment in Mexico.

Presidential elections will take place in 2018 and political discourse has started to shift back towards protectionism and disdain for the US. “The relationship between the US and Mexico has been historically fraught. The past 20 to 25 years have really been an anomaly,” says Mr Farnsworth. “Nationalism in Mexico is never that far from the surface. [Mr Trump could] return to Los Pinos, Mexico’s White House, a populist who is anti-US and whose mandate is ‘Mexico first’.”

Mr Shifter adds: “[President Enrique] Peña Nieto’s campaign for 2018 is going to start very soon, [but] I can’t see him having much energy, [as Mr] Trump is wearing him down. Whoever wants to be Mexico’s president now will have to have an anti-Trump agenda.” Maverick leftist politician Andrés Manuel López Obrador may have better prospects this time around after his previous campaigns in 2006 and in 2012, when he was a close runner-up to Mr Peña Nieto. “I can see the Chinese starting to talk to [Mr López Obrador] directly – no commitment to the US, only to China,” says the senior Mexican banker.

Whether Nafta is renegotiated or scrapped, this will be one of the most pivotal years in Mexico’s recent economic and political history. It will not be one for the faint hearted.

Mexican loan books

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Silvia Pavoni is editor in chief of The Banker. Silvia also serves as an advisory board member for the Women of the Future Programme and for the European Risk Management Council, and is part of the London council of non-profit WILL, Women in Leadership in Latin America. In 2019, she was awarded an honorary fellowship by City University of London.
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