The USMCA Rule of Origin for automotive products not only sets a high threshold of regional content to qualify for tariff-free treatment (75 percent, up from 62.5 percent in NAFTA) it also adds requirements specific to steel, aluminum, and labor value content. Auto companies protested when U.S. officials claimed a stricter formula for tallying content than the firms, the Canadian and Mexican negotiating teams, and many Members of the U.S. Congress had understood when the USMCA was approved. The U.S. position on the automotive rule of origin, if adopted and implemented, would require dramatic and expensive changes to current supply chains, and some companies argued that it would drive them to abandon the USMCA and bring components across the border paying the WTO bound tariff of 2.5 percent. In August 2021, the governments of Mexico and Canada formally requested consultations with the United States on the issue.
This dispute marks an important test of the USMCA and its mechanisms for resolution. Challenges to requirements could lead to disruption of the North American automotive industry. To highlight the importance of this dispute and the implications for coordinated economic policy, the Mexico Institute presents insight from our global fellows Christopher Wilson, Francisco de Rosenzweig, and Luis Rubio.
NAFTA was born out of a geopolitical imperative and its content, practices and interpretations fit that point of departure. USMCA was born out of a wish to restrict trade and investment across the US-Mexico border and that thrust, conceived of by Trump, has remained part of the Biden agenda. The issue is not whether there are differences of interpretation among respectable trading partners, but that these differences are taking place at an extremely sensitive moment in Mexican politics, just the scenario for which NAFTA was sought after in the first place.
NAFTA came into being with two contrasting objectives which sealed its fate. For Mexico, NAFTA was meant to be the end, the seal of approval as it were, for a series of reforms that had been carried out over the previous decade (mid-1980s to 1994). For the United States, the trade agreement was meant to be the beginning of a process of a thorough Mexican transformation (which never happened), but for which the US was willing to invest major political capital. It is no wonder that the results of greatly increased integration, as transcendent as they were for Mexico two decades later, were underwhelming for the US, which made it possible for Trump to call for its demise.
Mexico’s objective in NAFTA was to provide certainty to Mexicans and foreigners that there would be no unwarranted changes in the rules and no capricious expropriations, regardless of who governed Mexico in the future. The goal was to initiate a new era for the country, an objective with which the American government not only identified but saw as in the best interest of the US. A prosperous Mexico would be the best guaranty of a strong southern border.
The problem with NAFTA was that it was replaced with a very different type of trade arrangement, one devoid of the geopolitical thrust of the original, at the precise time in which Mexico’s government was taken over by a president who would rather distance Mexico from the United States and, to the extent possible, diminish trade and investment interactions.
The consultation on rules of origin for the automotive industry is a critical issue for Mexico, for it involves the largest share of the country’s exports, which themselves constitute the main engine of growth of the economy. A decision to accept the American interpretation of these rules would greatly affect exports and, in so doing would impoverish Mexicans. How such impact manifests itself would depend on the specific circumstances, but there is no question both nations would be harmed.
Where are the statesmen when they are most needed?
The USMCA Parties agreed to overhaul the NAFTA’s rules of origin for automotive goods, largely in response to the United States’ push to limit the amount of foreign content in vehicles that receive duty-free treatment. In addition to requiring that a higher percentage of a vehicle’s components originate in North America (75% under USMCA, versus 62.5% under NAFTA), the USMCA requires that a vehicle’s “core” components, such as its engine and transmission, qualify as originating in order for the vehicle to benefit from tariff preferences.
The dispute between the United States and Mexico concerns the interaction between these requirements. In Mexico’s view, when “core” components qualify as originating in North America, the entire value of the core component should count as originating when determining whether a finished vehicle meets the 75% threshold – even if the core component contains some content from outside the region. The United States considers that a core component’s foreign content should not count towards a finished vehicle’s regional value content, even if that core component contains enough North American content to qualify as originating itself.
These interpretations reflect divergent views about the optimal level of regional content requirement for promoting North American automotive production. Rules of origin must strike a balance between ensuring that an agreement primarily benefits regional producers and, on the other hand, providing enough flexibility that tariff preferences remain accessible, and that producers can manage their supply chains. The United States considers that its interpretation promotes regional economic activity by encouraging automakers to source core components made mostly or exclusively with North American content. Mexico and many industry stakeholders believe that this approach will have the opposite effect. That is, by penalizing the use of components that contain any foreign content (even if they are manufactured in the region primarily from North American content), the US interpretation will make it costly and difficult for vehicles to qualify for USMCA benefits. This may prompt some automakers simply to import core components, paying the relatively low most-favored-nation duty rates, rather than undertaking the complex sourcing and monitoring process that will be necessary to qualify for the USMCA tariff preference. Some may even believe that they can lower their costs by paying the import duties, rather than pay the higher prices for regionally sourced components.
The resolution of this dispute will have important implications for producers throughout the automotive supply chain, who may see demand for their products rise or fall depending on which interpretation prevails. More broadly, the outcome may affect the competitiveness of the North American industry as a whole, particularly when compared to Asian and European competitors whose trade agreements utilize more flexible rules of origin than the USMCA.
The normal US tariff (MFN rate) for car imports is just 2.5%. This affords the countries of North America very little room for error in the articulation and implementation of the new USMCA rules of origin for the auto sector. The rules are meant to encourage suppliers to beef up their supplier base within North America, but if the rules become too stringent—too complicated and expensive to meet—the opposite could easily happen. Once companies decide to forgo USMCA benefits and simply pay the 2.5% rate, they are free to grow their supply chains wherever they like, including Asia or Europe.
If there is little room for error in an economic sense, the same is true for the politics of the situation. The USMCA was groundbreaking in attracting union support for the trade deal, and U.S. unions are now holding the Biden administration’s feet to the fire when it comes to issues of compliance. The United Auto Workers union has voiced support for the stricter interpretation of the auto rules of origin put forward by the U.S. Trade Representative, making movement from its initial stance more difficult for the U.S. Government.
Despite the challenges, there are two main reasons to be optimistic. First is the timeline. The difference in U.S. and Mexican interpretations have to do with the calculation of regional content once the transition period ends in July, 2023. This gives the countries of North America ample time to find an amicable solution before turning to formal dispute resolution. The second and more important cause for hope takes us back to the economics of the situation. While we’ve grown accustomed to seeing the U.S. and Mexico haggle over rules and compete for investment in the auto sector in recent years, in a much more important way the U.S., Mexico and Canada are all on the same team. A smooth transition from NAFTA to the USMCA will encourage greater investment across North America and a more competitive North American auto sector, creating jobs and growing exports from all three countries.
Mexico Institute Advisory Board Member; Chairman, México Evalúa; Former President, Consejo Mexicano de Asuntos Internacionales (COMEXI); Chairman, Center for Research for Development (CIDAC), Mexico