IX. Economic Integration in the Americas: Lessons from NAFTA1
1. In January 1994, Canada, the United States, and Mexico launched the North American Free Trade Agreement (NAFTA), creating the world’s largest free trade area. The agreement helped spur a dramatic increase in trade and financial flows among the NAFTA partners and has contributed to making North America one of the most economically integrated regions in the world. This chapter briefly reviews the effect of the agreement on trade and growth within the region and considers the extent to which it has also affected business cycle dynamics in North America. Some lessons for future free trade agreements are then drawn.2
A. NAFTA and Regional Trade and Financial Flows
2. NAFTA was the first comprehensive free trade agreement between advanced countries and a developing economy. The agreement aimed at eliminating all tariffs and substantially reducing nontariff barriers between the member countries. NAFTA also included provisions covering investment flows, financial services, government purchases, protection of intellectual property rights, mechanisms for settlement of disputes, as well as side agreements covering labor and environmental issues. The agreement eliminates the majority of tariffs and other trade barriers in its first ten years and phases out most remaining tariffs by 2008. Since Mexico’s tariffs were higher than those of other member countries, it implemented the largest reductions in tariff rates—the average Mexican tariff rate fell from 12 percent in 1993 to 1.3 percent in 2001, while U.S. tariffs on imports from Mexico fell from 2 percent to 0.2 percent during the same period (Figure 1).
Figure 1.United States and Mexico: Tariff Rates
3. Trade in the region has increased significantly since the inception of NAFTA. For example, Mexico’s exports to the United States and Canada tripled in dollar terms between 1993 and 2001, and Mexico’s trade (the sum of exports and imports) with NAFTA partners rose from 25 percent of its GDP in 1993 to more than 50 percent in 2001 (Figure 2). Over the same period, Mexico became the United States’ second largest source of imports, while U.S. exports to NAFTA partners climbed nearly 90 percent, twice the increase in its exports to the rest of the world. Total U.S. trade with its NAFTA partners increased by roughly half to reach almost 7 percent of GDP by 2001. Canada’s exports to its NAFTA partners increased by twofold since 1993, and Canada’s trade with other members reached more than 60 percent of its GDP in 2001.
Figure 2.Trade with NAFTA Partners
4. Recent studies suggest that the impact of NAFTA on the volume of trade in the region has been substantial. Using detailed commodity level data, Romalis (2002) finds that between 25 to 50 percent of the increase in U.S. imports from Mexico after 1993 was driven by NAFTA. The Congressional Budget Office (CBO) uses aggregate trade data and estimates that NAFTA boosted U.S. imports from Mexico by 8 percent in 2001 and raised U.S. exports to Mexico by just over 11 percent (CBO 2003).3 Krueger (1999, 2000) finds that NAFTA is not a trade-diverting agreement, suggesting that the expansion of trade was not at the expense of other countries.4 However, she also argues that most of the increase in Mexican trade after NAFTA was driven by other factors, including the collapse of the Mexican peso in 1994 and Mexico’s unilateral reduction of tariffs following its entry into GATT in 1986.
5. NAFTA has also significantly affected the nature of trade in the region. In particular, vertical specialization has increased, with member countries increasingly specializing in particular stages of the production process. The prime example has been the maquiladora trade along Mexico’s northern border, where firms import inputs from the United States, process them, and re-export back to the United States. Maquiladora firms grew substantially after the early 1980s, and the share of maquiladora exports in total Mexican exports rose from 15 percent in 1980 to roughly 50 percent in 2001 (Figure 3). After the inception of NAFTA, the growth of maquiladora industry accelerated, with employment in maquiladora firms surging by 86 percent during the first five years of the agreement, compared with 77 percent growth in the previous five years (Gruben, 2001 and Hanson, 2002).
Figure 3.Mexico: Maquiladora Trade
6. Foreign direct investment (FDI) flows also strengthened in the region after NAFTA. The agreement contained important provisions that improved the relative standing of foreign investors in Mexico and expanded the sectors in which they could operate. This helped boost FDI flows to Mexico from $12 billion over 1991–1993 to roughly $54 billion in the 2000–2002 period (Figure 4). The share of NAFTA partners in total FDI flows to Mexico increased from 50 percent in 1994 to roughly 80 percent in 2000 (Lopez-Cordova, 2002). Recent research suggests Mexico’s NAFTA membership raised its annual FDI inflows by roughly 40 percent (Waldkirch, 2003).
Figure 4.Mexico: Inflows of Foreign Direct Investment
7. NAFTA has changed the dynamics of economic growth in Mexico. Contributions of exports and investment to GDP growth have increased more than two-fold following the introduction of the agreement (Figure 5a). Schiff and Wang (2002) estimate that NAFTA increased total factor productivity in Mexico by 5.5–7.5 percent. As a result, Mexican GDP growth rose from an annual average of 2 percent in 1980–1993 to an annual average of roughly 4 percent in 1996–2002 (Figure 5b). Studies employing computable general equilibrium (CGE) models report that NAFTA has had a large impact on the growth performance of the Mexican economy. For example, Kouparitsas (1997) finds that the agreement increased Mexico’s steady state level of GDP by roughly 3.3 percent, consumption by 2.5 percent, and investment by more than 5 percent. CBO (2003) estimates that the NAFTA-induced increase in exports to the United States raised Mexico’s GDP by 1.7 percent in 2001. Compared with several other emerging market countries, the average growth rate of investment has been particularly impressive, as it rose almost eightfold during the period 1996–2002 (Figure 5c).
Figure 5.Mexico: Economic Developments Pre- and Post-NAFTA
8. NAFTA’s effect on U.S. trade has been small but significant, reflecting the size of the U.S. economy compared with its NAFTA partners. The CBO (2003) estimates that the boost to U.S. exports was only around 0.12 percent of GDP in 2001. Moreover, NAFTA raised imports by about 0.1 percent of GDP, broadly in line with estimates of the ITC (1997) and Gould (1998). The potential long-term increase in the level of U.S. GDP due to NAFTA has been estimated in the range of 0.02 percent to 0.5 percent (CBO, 2003).
B. NAFTA and the North American Business Cycle
9. NAFTA appears to have been associated with significant changes in North American business cycle dynamics. For example, the agreement appears to have fostered an increased synchronicity of business cycles among its members.5 This can be seen from the marked increase in cross-country correlations of the major macroeconomic aggregates, including output, consumption, and investment (Figures 6a and 6b).6
Figure 6.NAFTA Members: Indicators of Economic Integration
10. Macroeconomic volatility in Mexico has also declined markedly after the inception of NAFTA. This can be seen in the uniform and sizeable decline in the variance of several macroeconomic aggregates between the 1980–1993 and 1996–2002 periods (Figure 7). As discussed above, the decreased volatility may have been partly a result of vertical specialization in the NAFTA period but may also have reflected the increased importance of more stable regional factors in driving the Mexican business cycle, as well as the imported stability of domestic macroeconomic policies.
Figure 7.Mexico: Volatility of Macroeconomic Aggregates
11. Staff estimates of a dynamic factor model suggest that regional factors have become more important in driving business cycles in Mexico with the advent of NAFTA. Using the methodology described in Kose, Otrok, and Whiteman (2003), the model seeks to capture the dynamic comovement in output, consumption, and investment among the NAFTA partners. Macroeconomic fluctuations are decomposed into: (1) a regional factor that is common across all variables/countries; (2) country-specific factors, which are common across the main aggregates within a country; and (3) factors specific to each variable. The results indicate that the proportion of output volatility explained by the regional factor rose from less than 1 percent in the period 1980–1993 to more than 19 percent in 1994–2002 period, while the variance of investment accounted for by the regional factor increased almost tenfold during the same period (Figure 6c). The regional factor has also played a more important role in explaining the volatility of manufacturing and industrial production over time (Figure 6d).
12. To illustrate the channels through which trade agreements can lead to business cycle spillovers among its participants, a dynamic stochastic multi-country business cycle model was also constructed.7 In the model, imports from Mexico are used as intermediate inputs to produce final consumption and investment goods in the United States and Canada. The impact of NAFTA is simulated by changing the level of trading frictions between the member countries, which are assumed to proxy for tariffs as well as non-tariff barriers among participants. Pre-and post-NAFTA simulations illustrate the substantial increase in Mexican exports that results from the lowering of tariffs after the advent of the agreement. The results also demonstrate that Mexico’s output and investment respond much more strongly to temporary supply shocks in partner countries during the post-NAFTA period than they do in the pre-NAFTA period (Figures 8a and b).
Figure 8.Mexico: Impulse Response Functions
13. As many authors have noted, it is difficult to quantify the impact of NAFTA on its member countries, especially given the other shocks they experienced. For example, following the agreement, the U.S. economy experienced a major boom, followed by the 2000 stock market collapse and subsequent recession. The Mexican economy also suffered the tequila crisis and recession in the mid-1990s, which led to a substantial decline in foreign investment. Subsequently, the devaluation of the peso and the strength of the U.S. economy played an important role in boosting Mexican exports.8
14. Nonetheless, the discussion above suggests that NAFTA had an important effect on growth and business cycle dynamics among its members. Mexico, in particular, benefited from a substantial increase in the volume of international trade and financial flows, as well as stronger growth. In addition, business cycles among the NAFTA partners became considerably more synchronized, with a substantial increase in the degree to which Mexican output volatility was driven by regional versus domestic factors.
15. This experience suggests that the Free Trade Area of the Americas (FTAA) could have potentially significant effects on its developing country members.9 Care is undoubtedly needed in drawing too strong a lesson from Mexico’s experience under NAFTA, given that Mexico benefited from the depreciated peso, the strength of the U.S. economy, and a common border with the United States. Nonetheless, the analysis above does suggest that, in addition to boosting economic efficiency, the increased foreign investment flows and deeper trade and financial linkages under an FTAA could also help promote greater macroeconomic stability in the region.
Backus, D.K., P.J.Kehoe, and F.E.Kydland,1994, “Dynamics of the Trade Balance and the Terms of Trade: The J-Curve?,” American Economic Review, Vol. 84, No. 1, pp. 84–103.
CBO (Congressional Budget Office), 2003, “The Effects of NAFTA on U.S.-Mexican Trade and GDP,” Washington D.C.
Cuevas, A., M.Messmacher, and A.Werner,2002, “Macroeconomic Synchronization between Mexico and its NAFTA Partners,” World Bank.
Gould, D.M.,1998, “Has NAFTA Changed North American Trade?,” Federal Reserve Bank of Dallas Economic Review, First Quarter, pp. 12–23.
Gruben, W.C.,2001, “Did NAFTA Really Cause Mexico’s High Maquiladora Growth?,” Federal Reserve Bank of Dallas Working Paper No. 0301.
Hanson, G.H.,2002, “The Role of Maquiladoras in Mexico’s Export Boom,” University of California at San Diego.
Kose, M.A., C.Otrok, and C.Whiteman,2003, “International Business Cycles: World, Region, and Country Specific Factors,” American Economic Review, forthcoming.
Kose, M.A., and K.Yi,2003, “The Trade-Comovement Problem in International Macroeconomics,” International Monetary Fund Working Paper, forthcoming.
Krueger, A.O.,1999, “Trade Creation and Trade Diversion under NAFTA,” NBER Working Paper No. 7429.
Krueger, A.O.,2000, “NAFTA’s Effects: A Preliminary Assessment,” The World Economy, Vol. 23, No. 6, pp. 761–75.
Kouparitsas, M.,1997, “A Dynamic Macroeconomic Analysis of NAFTA,” Federal Reserve Bank of Chicago Economic Perspectives, Vol. 21, pp. 14–35.
Lopez-Cordova, J.E.,2002, “NAFTA and Mexico’s Manufacturing Productivity: An Empirical Investigation Using Micro-Level Data,” Inter-American Development Bank, mimeo.
Romalis, J.,2002, “NAFTA’s and CUSFTA’s Impact on North American Trade,” University of Chicago GSB.
Schiff, M. and Y.Wang,2002, “Regional Integration and Technology Diffusion: The Case of NAFTA,” World Bank.
USITC (U.S. International Trade Commission), 1997, “The Impact of the North American Free-Trade Agreement on the U.S. Economy and Industries: A Three-Year Review,” Investigation No. 332–81, USITC Publication No. 3045.
Wall, H.J.,2003, “NAFTA and the Geography of North American Trade,” Federal Reserve Bank of St. Louis Review, Vol. 85, No. 2, pp. 13–26.
Waldkirch, A.,2003, “The New Regionalism and Foreign Direct Investment: The Case of Mexico,” Journal of International Trade and Economic Development, forthcoming.
Prepared by Ayhan Kose.
The United States has recently signed free trade agreements with Chile and Singapore in 2003. It has also begun free trade agreement negotiations with Morocco; five nations in Central America (CAFTA); five nations in the Southern Africa Customs Union (SACU); and Australia. The most ambitious one among these agreements is the Free Trade Area of the Americas (FTAA), which would include the United States and 33 other countries in the Western Hemisphere in one of the world’s largest free trade areas by progressively eliminating barriers to trade and financial flows. Market access negotiations have begun with the objective of concluding no later than January 2005.
Other studies employing aggregate trade data also document large changes in regional trade flows driven by NAFTA. For example, Wall (2003) estimates that NAFTA played an important role in boosting Canadian exports to the United States and Mexico by 29 percent and 12 percent, respectively, during 1993–1997. Gould (1998) and USITC (1997) report that the impact of NAFTA on trade flows in the region was significant.
To analyze the impact of NAFTA on trade flows, Krueger studies the changes in trade patterns and volumes between different groups of commodities and among NAFTA partners and the rest of the world using the data at the one-digit SITC level for the period 1990–1996. She concludes that the categories in which Mexican exports to the United States registered the largest increase overlap with those in which they rose most rapidly with the rest of the world, implying that the agreement was trade-creating. By contrast, Romalis (2002) uses more disaggregated data series, over a longer time period, and finds that NAFTA produced substantial trade diversion.
This finding is consistent with the general increase in the degree of business cycle comovement in the G-7 countries in recent years (see Chapter VIII).
In most cases, the increases in correlations are statistically significant. Cuevas, Messmacher, and Werner (2002) also study the impact of NAFTA on the degree of business cycle synchronization in the region.
The model extends the two-country, free trade, complete market model by Backus, Kehoe, Kydland (1994) by having three countries, trading frictions, and allowing for international financial autarky. For details, see Kose and Yi (2003).
Mexico had joined the General Agreement on Tariffs and Trade (GATT) in 1986 and began reforms to liberalize its trade regime. A comprehensive privatization and deregulation program was also undertaken during the period 1988–1994.
Chapter X contains a more detailed discussion of recent U.S. free trade agreements.