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America is running a record $900 billion deficit in goods trade. China accounts for the largest share of the shortfall at 44.6%, followed by Mexico’s 10.8%, Japan’s 7.9% and Germany’s 7.6% (Table 1). Canada weighs in at 2.5% (10th), lifting the NAFTA share to 13.3%, which still falls under the total EU (20.0%). Indeed, China and the EU have accounted for the vast majority of the deterioration in the goods trade deficit since the shortfall hit its post-recession low in early 2010 (Chart 3).
Bilateral trade balances by themselves say little about the importance of trade for the U.S. economy—it’s the underlying trade flows that matter. For example, you can have two similar-sized deficits but one shortfall reflects lots of exports and imports (the latter obviously being larger) and the other reflects a lopsided situation of mostly imports with few exports. The former trade pattern would be more beneficial than the latter in terms of production and jobs tied to exports.
So, while the U.S. has its second largest trade deficit with Mexico, it’s anything but lopsided. Mexico is the second largest destination for U.S. exports and the second largest origin for U.S. imports. The ratio of imports-to-exports, a measure of lopsidedness, is 1.37 for Mexico, meaning U.S. imports from Mexico are 37% larger than U.S. exports to Mexico. For China, the imports-exports ratio is 4.72, meaning imports from China are 372% larger than exports to China. Therefore, while America’s trade deficit with China is about four-times larger than with Mexico, China’s shortfall is 10 times more unbalanced than Mexico’s. The goods trade deficit with Canada is the most balanced among major trading partners, with imports only 7% larger than exports. Canada is the largest destination for U.S. exports and the third largest origin for U.S. imports.
U.S. exports to Canada are dominated by transportation equipment, along with non-electrical machinery (Chart 4). U.S. imports from Canada are dominated by transportation equipment, along with oil and gas (Chart 5). Having transportation equipment as the biggest slice of both trade pies (it’s the same with Mexico) is a testament to the integration of the North American automotive industry, owing to NAFTA and the greater efficiency of continental instead of national supply chains. As the saying goes, “we make things together.” Indeed, Canadian goods shipped to the U.S. have, on average, around 25% American content.
In addition to being more balanced overall, NAFTA deficits are concentrated in just one sector (Table 2). Excluding vehicles and parts, the U.S. has a slight trade surplus with Mexico among all other goods combined; excluding oil and gas, the U.S. has a large trade surplus with Canada. This means that North American trade flows are mirroring comparative advantages, which is precisely what free and fair trade is supposed to engender. Through comparative advantage—Mexico’s abundant and low-cost labor, Canada’s ample natural resources and highly-skilled workforce, and the U.S.’s dynamic business culture and thirst for innovation—each country gains more from trade than simply earning export revenue. Greater efficiencies in production translate into lower-priced goods and real wage gains that, in turn, generate new demand and jobs. By providing access to larger markets and lowering the cost of intermediate goods, trade also helps U.S. small- and medium-sized firms grow.
U.S. business exposure to trade is best reflected in combined two-way trade flows (Table 3). In the goods space, Canada comes in a close second ($612 billion) to Mexico ($621 billion), with the NAFTA duo combined doubling up on China’s tally ($610 billion). One thing to note on imports, having spent the past 25 years integrating the North American economy through trade and investment (and the past 30 years for the U.S.-Canada economy), imports from Canada and Mexico matter more to the U.S. than those from other countries because the income generated from exports in these two countries is more likely to be re-spent on American goods and services given integration’s legacy—a high propensity to import from the United States. Keep in mind that Walmart and Costco are major retailers in both Canada and Mexico.
Two-way trade in services with Canada currently runs above $100 billion annually, which pushes Canada to the top of the table in terms of U.S. business exposure to total trade. The latter now tops $720 billion, more than any other single country. This means that about $2 billion per day in goods and services crosses the northern border. And amid these massive trade flows, America has maintained a total trade surplus with Canada in recent years (Chart 6). Of note, Canadian tourists spend about $17 billion each year in the U.S. and make many more trips to the U.S. than the other way around.
Besides trading in goods and services, investing directly in other countries is an important source of growth for U.S. companies. Establishing plants, warehouses and retail outlets abroad gives companies closer access to markets and suppliers, reducing transportation costs. Investing abroad can help North American firms better compete against China during the current trade war, say by operating plants in non-tariffed Asian nations that sell to China.
U.S. companies own fewer direct investments abroad (in the form of facilities or a controlling ownership in a business) than foreign investors own in the U.S. Direct assets held abroad totaled $8.2 trillion in 2019Q1, compared with liabilities of $9.4 trillion (Chart 7). The difference marks a reversal from the decade prior to 2016 when the U.S. had a positive net foreign direct investment position. This is partly because a stronger dollar has reduced the value of foreign-held assets. Following a weak 2018, U.S. purchases of foreign assets picked up in 2019Q1. Cross-country data are unavailable for 2018, but they show strong U.S. direct investment in China in the five years to 2017. Still, the U.S. invested more than twice as much in Canada ($93.9 billion) than in China ($42.9 billion) in this five-year period.
Though still an attractive destination, foreign investors have been less willing to invest directly in the U.S. in the past two years, partly due to uncertain trade policies. After surging in 2016, investment from China all but vanished in 2017, perhaps in anticipation of the looming trade battle. Investment from Mexico also remained modest. In contrast, Canadian firms flocked to the U.S. from 2015 to 2017, in particular to buy energy companies due to a lack of domestic pipeline capacity and a less hospitable regulatory climate (Chart 8). In the five years to 2017, direct investment from Canada to the U.S. ($236.3 billion) was 2½ times larger than the other way around ($93.9 billion).
Trade is a crucial element to many regional economies. Sixteen states have total trade equivalent to more than one-fifth the size of its GDP, including Michigan (38%), Texas (35%), and Illinois (26%). Kentucky leads the pack with trade close to 42%, compared to the national average of 20% (Table 4).
USMCA partners make up almost 30% of total trade at the national level, compared to China's 15%, underscoring the degree of interdependence within North America (Table 5). On a regional basis, however, that interdependency is even more pronounced for many states. North Dakota tops the list with 82% of its total trade directed within North America alone, followed by Montana (77%) and Michigan (69%). North American flows also emphasize how closely imports (e.g. intermediate inputs) and exports (e.g. finished products) are inter-related and the complexities of global supply chains. In states such as Michigan and Ohio, cross-border trade almost entirely focuses on the automotive industry, where cars and parts are built via supply chains that send components across the border multiple times before completion.
Canada, in particular, remains a large trading partner for many states. In fact, 33 states have Canada as its top export destination, including most of the Midwest and northern regions (Chart 9). An additional 10 count Canada as its second largest exporting partner. Meantime, 19 states import from Canada the most, and the nation remains top-three to 17 other states (Chart 10). Most states in the Midwest run trade surpluses with Canada and Mexico. The exceptions are Illinois, Michigan and Missouri (deficits with both countries), Minnesota (deficit with Canada), and Ohio (deficit with Mexico).
The top-five states that trade with Canada account for 40% of the northern neighbor's total trade with the U.S., in dollar terms, led by Michigan, Illinois and Texas:
MICHIGAN is heavily dependent on Canadian trade, more so than any other state, thanks to its auto industry. Exports reached $56.9 billion in the 12 months to July; and, although slowing recently, still remain near record highs. Canada was the largest buyer for Michigan’s products at $23.0 billion. Mexico was the second-largest customer at $11.8 billion, and China was third at $3.3 billion. Auto-related exports represented nine of the state’s top-ten export categories and all of the state’s top-ten imports. Michigan’s combined exports and imports within the USMCA bloc totaled nearly $140 billion, representing more than two-thirds of the state’s international trade. The North American auto industry relies increasingly on deep, cross-border supply chains for parts, supplies, materials, and finished products, and Michigan is a key part of those continental supply chains.
ILLINOIS remains the transportation hub of America thanks to the sheer volume of exports and imports. Canada is Illinois' top-export destination. In the year to July, the state's companies shipped more than $16 billion worth of goods to and purchased over $37 billion goods from Canada. Topping that list was equipment and machinery, which accounted for 30%, followed by goods linked to energy and transportation.
TEXAS rounds out the top three in total trade with Canada. The Lone Star State has a highly globalized economy as a result of its proximity to Mexico and also because of its thriving oil and gas industry. Almost 10% of total exports were directed to Canada. The state's four largest export and import categories were energy-related, reflecting the all-important oil and gas industries.
Bottom Line: Economic activity at the state level, especially those regions that are automotive-, aerospace- or energy-intensive, is highly tied to trade. That link becomes even more pronounced with USMCA partners, as a large share of economic output and jobs remains hinged to North American trade flows. The dollar value of USMCA total trade in goods amounted to $1.2 trillion in the 12 months to July, almost 6% of U.S. GDP. But, for states like Michigan, total USMCA trade flows equated to almost 25% of its GDP, followed by North Dakota (16%), Texas (15%) and Vermont (12%). Manufacturing in transportation, including autos and aircraft, as well as energy are increasingly dependent on complex supply and value chains. Regional economies, particularly in the Midwest, have greatly benefited from intricate global networks of sourcing, production and distribution, providing consumers and businesses with access to the best products at the lowest price and greatest value.
Free trade has prompted a dramatic increase in cross-border trade and investment within North America since NAFTA took effect in 1994. U.S. trade1 in goods with Canada and Mexico now exceeds $1.2 trillion per year—roughly double the amount of trade conducted with China—and has increased more than 140% since NAFTA took effect (after adjusting for inflation). The rise in cross-border exchange has been driven by the core tenet of free trade: that dismantling trade barriers leads businesses to focus in areas of comparative advantage, export output more intensively, and import inputs that are expensive to produce domestically. The result has been an increasingly integrated continental supply chain, a reduction in overall production costs, and an increase in productive capacity relative to what would be possible in isolation. The USMCA represents an additional step in this direction.
Despite the larger scale of its economy, the U.S. has benefited meaningfully from continental free trade. Canada and Mexico, while small next to the American juggernaut, nevertheless represent almost US$3 trillion per year in economic activity—roughly equivalent to California, which is by far the largest state economy. Since the advent of free trade, many U.S. industries have grown to rely significantly on Canada and Mexico as both sources of inputs and as important end-markets for their products. Economic integration within North America has also better positioned U.S. industries to compete more effectively in a world that has become characterized by regionally integrated trading blocs, most notably in Europe and Asia. U.S. industries would find it significantly more challenging to compete against overseas production networks without the benefits stemming from cross-border specialization.
Manufacturing has become especially integrated across North America, with a wide variety of intermediate goods crisscrossing national borders during production. Across the U.S. manufacturing space as a whole, exports to Canada and Mexico account for 8.2% of total sales—a considerable portion given the divergent scale of the three economies—and total trade is now equivalent to 16.9% of industry sales, or more than $1 trillion annually (Table 6). Importantly, the most integrated manufacturing subsectors tend to be high value-added industries with complex multi-stage production processes where tariffs would compound quickly in the absence of free trade.
Leading the pack on integration is electrical equipment and appliance manufacturing, where trade within the USMCA bloc is equivalent to 47% of sales, and computer and electronics manufacturing, where trade within the bloc equates to 43% of sales. Both subsectors see substantial continental trade in intermediate components, with wiring, semiconductors, fuel cells, instruments, and a myriad of other parts moving back and forth across the border as they are incorporated into more complex products. The cost reduction associated with continental integration in these industries has been particularly welcome amid cut-throat competition from low-cost producers in Asia, which has weighed on prices and margins. These competitive challenges would be amplified without free trade in North America.
Motor vehicle and parts manufacturing is also highly integrated in North America. Across U.S. automakers, trade with Canada and Mexico is equivalent to 36% of sales and accounts for 51% of overall industry trade, while for upstream parts manufacturers, trade within the bloc equates to a similar 36% of sales and over 60% of total trade. As in other industries, free trade has bolstered North American automakers’ competitiveness on the global stage. In 2018, automakers across the USMCA bloc produced 17.4 million units, up nearly 15% since free trade was established in the mid-1990s, whereas Japan produced 9.7 million units, down almost 5% over the same period. And although free trade has seen aspects of production shifted from some U.S. regions toward Mexico, the USMCA addresses these concerns with more stringent wage requirements and labor standards, which will help to better balance the overall framework. The USMCA also incorporates an explicit (albeit somewhat technical) assurance that tariffs will not be erected within the North American auto sector. Auto tariffs had been threatened during trade negotiations and, if implemented, would have had acted as a significant drag on continental competitiveness.
Canada and Mexico also account for a disproportionate share of U.S. trade in many resource and resource-processing sectors. In the energy space, the USMCA bloc accounts for 43% of U.S. trade in oil and gas, reflecting the expansive network of pipelines that now spans the continent. U.S. energy trade within North America now amounts to over $100 billion per year, with Canada and Mexico serving as both valuable export markets and geopolitically desirable sources of imports. And, while the United States is a net importer of unprocessed oil and gas within North America, it is also a significant net exporter of refined petroleum and coal products back to Canada and Mexico, to the tune of $27 billion per year.
In the metal and minerals space, the high bulk-to-value of most quarried products constrains international trade in unprocessed resources, but there is extensive continental trade in downstream processed goods. In the primary metal products industry (which produces usable metals from raw metal ores) nearly 35% of total U.S. trade takes place with Canada and Mexico, while the downstream fabricated metal products industry (which shapes and welds metals into more functional products) conducts 31% of trade within the bloc. The cancellation of steel and aluminum tariffs imposed during USMCA negotiations last year represents a favorable development for further integration on this front. Non-metallic mineral products, including construction materials like cement and glass, are also traded significantly within the bloc, with Canada and Mexico accounting for 28% of total industry trade.
Continental trade in agri-food products is also considerable, with Canada and Mexico accounting for 36% of U.S. trade in crops, livestock, and processed food products. Agriculture is an industry where climate can create extreme differences in comparative advantage, making free trade particularly beneficial. Not only has free trade helped to reduce the cost of agri-food products within North America, it has contributed to a wider array of food options across all three member countries (avocado toast is thankfully not as expensive as it once was). The USMCA will allow U.S. dairy producers to gain additional tariff-free access to the Canadian market and will see Canada raise its pricing for milk protein concentrates in line with the United States. Canada will also begin grading all U.S. grain on an equal footing to domestic product.
The axis of global trade has undergone a monumental shift over the past two decades, with the tri-polar framework of the United States, Japan, and Europe disrupted by the rapid emergence of China and developing Asia. In this shifting landscape, the establishment of a North American economic zone some 25 years ago was a strikingly forward-thinking development. The USMCA represents a further advancement of this framework and will help to ensure that U.S. and North American industries are well positioned to meet the challenge of ever-increasing global competition.
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Michael Gregory is Deputy Chief Economist and Head of U.S. Economics for BMO Capital Markets. He manages the team responsible for forecasting and analyzing the No...(..)View Full Profile >
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