Free trade ; Canada ; International trade - Canada

Hang-Sheng Cheng

English

Research Papers in Economics

FRBSF
February 10, 1989 WEEKLY LETTER
U.S.-Canada Free Trade
The U.S.-Canadian Free Trade Agreement be-
came effective on January 1. It brought to a close
120 years of intermittent attempts at dismantling
trade barriers between the two nations. By the
end of this century, nearly all existing barriers to
trade and investment between the two countries
will have been removed, thereby creating the
largest internal market in the world and ushering
in a new era of accelerated integration of the two
economies.
As with all arrangements aimed at achieving re-
gional economic integration, the purpose ofthis
Agreement is to stimulate economic growth and
enhance consumer welfare in the two countries
through more efficient resource allocation. In this
instance, the Agreement also represents the first
major reversal of a rising tide of protectionism in
the u.s. during the last decade. Moreover, like
the European Community's (EC) plan to achieve
economic integration by 1992, the U.s.-Canadian
Agreement sets up a concrete model for lowering
barriers to international trade in services and in-
ternational investment. This Letter discusses the
principal features and limitations of the Agree-
ment, and analyzes the likely impact of this
important step forward in freer international
trade.
Internal tariffs
Over a ten-year period beginning on January 1
of this year, the Agreement phases out all tariffs
between the two nations. The existing tariffs are
classified into three groups: those in the first
group (five percent of dutiable imports for the
u.s. and 13 percent for Canada) were abolished
on January 1, 1989; those in the second group
(60 percent of dutiable imports for the u.s. and
34 percent for Canada) will be abolished on
January 1, 1994; and the remainder will be abol-
ished on January 1, 1999. Thus, during the final
year of this century, all tariffs between the two
nations will have been reduced to zero.
Non-tariff barriers
The Agreement lowers the' threshold value re-
quiring open, cross-border competitive bidding
on government procurements from $171,000 in
the General Agreement on Tariffs and Trade
(GATT) code to $25,000 for bidders from the two
nations. It commits both nations not to impose
quantitative restrictions, norto use discrimina-
tory pricing, on either imports or exports in their
bilateral trade. In concrete terms, the commit-
ment assures U.s. industries uninterrupted access
to Canadian oil and gas, an important commit-
ment since this access was interrupted during the
decade after the 1973 oil shock. It also binds
Canada immediately to eliminate its discrimina-
tory pricing for liquor and to phase out over
seven years its restrictions on wine imports.
Services
The service industry has been the most rapidly
expanding sector in both national economies,
now acounting for 47 percent of national output
in the U.S. and 60 percent in Canada. Competi-
tion in services between the two countries has
been hampered not so much by explicit national
prohibitions as by the absence of provisions that
would enable or facilitate it.
The bilateral agreement breaks new ground by
setting up a framework in which national treat-
ment regarding the establishment of branch of-
fices and licensing and certification procedures
is accorded to cross-border service businesses.
Lawyers, accountants, architects, engineers,
computer-system designers, and telecommunica-
tion networks, to name only a few, will all find
the new rules helpfulin expanding their busi-
nesses across the national border.
Subsidiaries of u.s. banks in Canada will be
exempt from the existing Canadian laws and reg-
ulations that limit foreign banks' market share (to
16 percent of the total banking assets in Canada)
and expansion of capital. All U.s. financial insti-
tutions will be allowed to acquire securities firms
or federally-regulated insurance and trust compa-
nies in Canada. They will also welcome Canada's
abolishment of the "10/25 rule;' which limits
ownership in Canadian financial institutions to
10 percent for any individual nonresident, and 25
percent for all nonresidents together.FRBSF
Investment
Besides freeing trade in goods and services, the
Agreement also lifts most of the existing restric-
tions on direct investment across the national
border between the two countries and provides
for national treatment in most cases. Canada
agrees to eliminate screening requirements for
the establishment of new businesses in Canada
by U.S. investors, and to ease screening require-
ments for u.s. acquisition of existing businesses
in Canada. By 1992, the screening requirements
will apply only to the 600 largest firms in Can-
ada. Moreover, Canada also binds itself noUo
impose new requirements on the sourcing of in-
put and exporting of products by u.s. businesses
in Canada. In the past, these have discouraged
u.s. investments in Canada. These provisions re-
move the threat of Canada's return to the strongly
interventionist policy towards foreign investment
it has followed in the past.
Trade and investment disputes
The Agreement sets up procedures for notifica-
tion, consultation, and resolution of trade and
investment disputes in an expeditious manner,
avoiding judicial appeals which usually drag
on for years. To implement the procedures, a
Canada-U.S. Trade Commission will be formed to
resolve most bilateral trade and investment is-
sues; these disputes will be resolved through
binding arbitration. Aseparate consultative
mechanism, involving the two national Treas-
uries, will be set up to handle disputes relating
to financial services.
Major limitations
Although the U.S.-Canada Agreement moves
these two countries closer to economic integra-
tion, it does not provide for complete integration.
Barriers will remain under this Agreement even
after 1998. The more far-reaching EC plan serves
as a useful benchmark for comparison. (See Let-
ter of August 12, 1988, for discussion of the EC
plan.)
The scope of the U.S.-Canada Agreement is
much less ambitious than that of the EC plan in
several respects. First, hidden barriers to trade
and investment arise because of differences in
national policies regarding taxation, commodity
specification standards, and product-testing cer-
tification, among otherthings. The EC plans to
eliminate these barriers by standardizing or har-
monizing all such policies. The u.S.-Canada
Agreement, in contrast, contains no such provi-
sions. Similarly, the EC already has a Common
Agricultural Policy providing for unrestricted
agricultural trade among member nations, while
Canada and the u.s. have decided each to retain
their own agricultural policies, including do-
mestic farm subsidies and import quotas. They
defer attempts at lowering agricultural trade bar-
riers to the ongoing GATT negotiations. More-
over, the EC already has achieved unrestricted
movement of labor among member nations; U.s.
and Canadian nationals, in contrast, will con-
tinue to be treated as aliens under each country's
labor laws.
In addition to these broad differences between
the EC plan and the U.s.-Canada Agreement,
there are specific limitations in the Agreement,
which reflect the special concerns of the two na-
tions. In direct investment, for instance, the
Agreement preserves the Canadian energy sector
and "culture industry;' including broadcasting,
newspaper, and film, for exclusive Canadian
ownership, and as already noted, places restric-
tions on U.s. acquisition of Canada's 600 largest
firms.
A particularly troublesome area in U.s.-Canada
trade has been each nation's anti-subsidy and
anti-dumping laws that provide for imposition of
duties on imports found to be subsidized by gov-
ernments or priced below cost of production in
the originating nations. Since 1980, Canada has
imposed duties on imports from the u.s. in 24
such cases, and the U.S. on imports from Canada
in 15 cases, although the total value of affected
imports is larger on the u.s. side.
Resolution of these issues has been difficult
because of disagreement on what constitutes a
subsidy and on what subsidies are "distortive"
and "unfair" trade practices. In a broad sense,
because Canada has socialized medicine and
other social welfare programs not available in the
U.s., Canadians have been concerned that u.s.
industries might invoke these programs as an in-
direct subsidy to production in Canada, and call
for countervailing duties against imports from
Canada.
More specific concerns have to do with trade
in particular products. For instance, a counter-
vailing-duty case has been brought against U.S.
lumber imports from Canada on the ground thatthe stumpage fee for logging in public forests in
Canada is significantly lower than that in the U.s.
Although the U.s.-Canada Agreement does not
preempt such future disputes, it does establish
an expeditious procedure for resolving future
disputes, including binding arbitration.
Another major limitation arises from the two
nations' Constitutions, which limit the federal
government's power on each side in domestic
regulatory matters. An illustration stems again
from the lumber industry. Building codes are a
matter of local regulation in both countries. The
U.s. lumber industry has complained that build-
ing codes in certain Canadian provinces require
plywood of a certain grade which precludes u.s.
export, and in one case, lumber is required to be
cut from Canadian logs. By its Constitution, the
Canadian Government could only, and did,
agree to try to persuade the local governments
concerned to change such codes, but it had no
power to order changes.
Benefits
Since the Agreement provides for a ten-year
phase-in, its immediate impact on the two na-
tional economies is likely to be small. In the long
run, however, adjustments will inevitably bring
about changes in both nations' economic struc-
tures, expanding production in some industries
and causing shrinkage in others in each nation.
Consumers in both nations are bound to benefit,
as wider choice of goods and services will be
available at lower prices. In time, the benefits of
economic integration and the losses associated
with the remaining trade and investment obsta-
cles may become more apparent, and the two
nations may decide to seek more complete eco-
nomic integration along the lines of the EC.
Studies suggest that U.S. exports to Canada now
subject to Canadian import duties are likely to
rise by 18 percent, while U.s. dutiable imports
from Canada should rise by only five percent
because of the higher average Canadian duty (10
percent) than the average U.S. duty (3 percent)
on imports from each other. However, since du-
tiable imports accounted for only about one-
quarter of the bilateral trade between the two
countries in both directions, the direct impact of
tariff elimination is likely to be small.
Far more significant are the effects of the non-
tariff provisions of the Agreement, which should
increase productivity, as business firms on both
sides of the border take advantage of the reduced
trade and investment barriers to achieve greater
economies of scale and to redirect their resour-
ces to more competitive uses. Estimates of the
total effects of the Agreement suggest that it will
raise real income in Canada by 2.5 to 3.5 per-
cent, and increase U.s. real income by less than
one percent. The considerably larger proportion-
ate benefit to Canada is attributed to Canada's
gaining access to a market 10 times its size and
to the significantly higher restrictions on trade
and investment Canada has erected in the past
and has now bound itself to remove under the
terms of the Agreement.
Another benefit is the assurance that no future re-
strictions will be placed on trade and investment
between the two countries. The rise of protec-
tionism in the U.S. in the 1980s posed a serious
threat to Canada, as the U.s. market accounts for
three-fourths of Canadian exports, and Canada's
exports to the u.s. account for more than 20 per-
cent of Canadian national output. The Agree-
ment reduces this risk to Canadian businesses.
Although exports to Canada account for 24 per-
cent of total U.S. exports (far larger than the 11
percent accounted for by Japan, our next largest
trading partner), th~se exports are only about 1.6
percent of u.s. national output. Nevertheless, as-
sured access to Canadian markets and to the
supply of resources such as oil, gas, and elec-
tricity mean a lot to specific U.s. sectors and
regions.
Finally, because it lowers the bilateral trade bar-
riers between the two nations but leaves their re-
spective trade barriers against others unchanged,
the Agreement is bound to lead to some diver-
sion of trade from other nations. However, to the
extent that the Agreement fosters bilateral eco-
nomic integration, it will stimulate economic
growth in both countries and expand the market
for third nations' exports. Consequently, the net
impact may not be detrimental to the rest ofthe
world..
Hang-Sheng Cheng
Vice President, International Studies
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San Francisco, or of the Board,of Governors of the Federal Reserve System.
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U.S.-Canada free trade

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U.S.-Canada free trade

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