Roberto Cardarelli

Ten years ago, Canada, Mexico, and the United States launched the world’s largest free trade area under the North American Free Trade Agreement (NAFTA). This agreement represented a milestone in global trade policy, not just because of the size of the free trade area it created but also because of the comprehensiveness of the agreement. NAFTA covered merchandise trade as well as issues related to investment, labor markets, and environmental policies. In addition, it was the first comprehensive free trade agreement between advanced countries and a developing economy.

During the last decade, several papers have appeared that assess the impact of NAFTA on the economies of its members. This article briefly surveys recent IMF research on the effects of NAFTA on trade and financial flows in the region; on whether increased economic integration has resulted in a higher business cycle interdependence among NAFTA partners; and, finally, on whether free trade agreements have favorably affected growth performance of both Canadian and Mexican economies, and their catching up with the U.S. economy, over the past decade.

A large body of research shows that the North American free trade agreements have been followed by a dramatic increase in trade and financial flows among partner countries. Kose, Meredith, and Towe (forthcoming) and Cardarelli and Kose (forthcoming) show that the free trade agreements played a significant role in increasing Canadian and Mexican exports to the United States over the 1990s, and changed the composition of sectoral trade flows across these countries. In particular, both Canadian and Mexican exports have shifted toward manufactured goods, and vertical specialization—the amount of imported goods embodied in exports—and intrafirm trade among the NAFTA partners have increased substantially.

However, isolating the effects of NAFTA on its members is a particularly difficult task: NAFTA came after a series of other trade agreements signed over the 1980s, including the 1988 Canada-U.S. Free Trade Agreement. Moreover, other significant shocks that occurred over the past decade may have affected trade and financial flows in the region. Using a gravity model to analyze the impact of NAFTA on Mexico’s trade performance, Krueger (1999) finds that most of the increase in Mexican trade after NAFTA was driven by factors other than the agreement, including Mexico’s unilateral reduction of tariffs following its entry into GATT in 1986 and the collapse of the Mexican peso in 1994. Using a shift-in-share analysis, Krueger (1999, 2000) also finds that, over the 1990s, Mexican exports gained shares in both the United States and the rest of the world, suggesting that NAFTA was a trade-creating, and not a trade-diverting, agreement. As for Canada and the United States, Bayoumi and Klein (1997) find that, despite the trade agreement and the geographical closeness, the United States-Canada border remains a significant barrier, and that Canadian provinces’ trade balances respond much less to events in the rest of the world than they do to events within Canada.

A growing body of research assesses the extent to which business cycles in North America have become more synchronized. Studies that examine changes in the degree of correlation of business cycles across advanced countries have failed to reach a definitive conclusion, possibly because they use different data and methodologies. While Kose, Prasad, and Terrones (forthcoming) report that correlations of output and consumption fluctuations in Canada and the United States were higher in the “globalization” period (1986–2002) than in the Bretton Woods period of fixed exchange rates (1960–72), Helbling and Bayoumi (2003) do not find a statistically significant change in the correlations of the growth rates of GDP of Canada and the United States during 1973–2000.

Studies that analyze the relative importance of regional and country-specific shocks in explaining business cycle comovement have reached more uniform results. Kose, Otrok, and Whiteman (2003) suggest that the North American regional factor played an important role in driving macroeconomic fluctuations in Mexico, Canada, and the United States. Bordo and Helbling (2003) and Helbling and Bayoumi (2003) also find evidence that increased regional trade integration in North America led to an increase in synchronization of business cycles, and that common shocks are the dominant influence of the business cycle in the region.

Studying the impact of NAFTA on Mexican business cycles, Kose, Meredith, and Towe (forthcoming) show that output variability has declined in Mexico after the inception of NAFTA, and that business cycles within the NAFTA region have become more synchronized during the past decade. They also conclude that structural changes in the Mexican economy have decreased the role of country-specific shocks in driving the Mexican business cycle and led to a concomitant increase in the role of region-wide shocks. By studying a dynamic stochastic general equilibrium model, which is calibrated to reflect some basic features of the NAFTA economies, they also show that reductions in trade frictions that boost trade flows can cause a concomitant increase in business cycle interdependence. Similarly, Cuevas, Messmacher, and Werner (2002) find that business cycles in Mexico became more synchronized with the cycles in Canada and the United States after NAFTA.

Focusing on the changes in Canada’s business cycle under the free trade agreement, Cardarelli and Kose (forthcoming) conclude that the increase in vertical specialization and intra-industry trade between Canada and the United States has helped strengthen business cycle linkages between the two countries. However, inter-industry trade and differences in industrial structure remain considerable, implying that sector-specific shocks could still lead to divergence of cycles. For example, the fact that Canada experienced a shallower downturn and a somewhat stronger recovery from the 2000 recession than the United States can be partly ascribed to Canada’s smaller information technology sector. Focusing on the labor market, Prasad and Thomas (1997) also note that similar shocks in Canada and the United States could result in dissimilar labor market outcomes, both in the short run and in the long run, because of some differences in labor market adjustment mechanisms between the two countries.

The important role played by country-specific factors in explaining Canadian business cycles points to significant benefits associated with exchange rate flexibility. Arora and Jeanne (2001) argue that exchange rate flexibility has not slowed the pace of Canada-U.S. economic integration, and has been useful in isolating the Canadian economy from asymmetric external shocks.

Several papers address the impact of increased trade integration on the long-run growth prospects of Mexico and Canada. Kose, Meredith, and Towe (forthcoming) suggest that NAFTA may have favorably affected Mexico’s growth performance over the past decade. In particular, the paper shows a dramatic increase in the average growth rate of investment after NAFTA. Arora and Vamvakidis (2004) conclude that half of the increase in Mexico’s growth in the latter half of the 1990s was attributable to the growth performance of its NAFTA partners. However, they argue that it is difficult to assess the role played by NAFTA in accounting for output growth in Mexico, because Mexico and the United States had strong trade linkages even before the agreement.

As far as Canada is concerned, Cardarelli and Kose (forthcoming) find that increased exposure to trade has positively contributed to Canadian firms’ total factor productivity over the last two decades, and that the relationship has strengthened under the NAFTA period. However, the labor productivity gap between Canada and the United States has remained wide over the 1990s, partly because of differences in the industrial structure of the two countries. In particular, industry growth accounting shows that after 1995 Canada’s labor productivity performance has been as strong as that in the United States in many (non-information and communication technology (ICT) producing) manufacturing sectors, but Canada has lagged in some industries that have been intensively using ICT capital, especially in the service sector. Cerisola and Chan-Lau (2000) also show that Canadian firms have benefited from U.S. firms’ R&D activity by accessing their best technologies.

The analysis of the NAFTA experience illustrates that, while important barriers remain, large gains could be derived from further steps to deepen economic linkages among its members. For example, differences in regulatory frameworks impede trade and investment flows; security concerns, which have become critically important during the past two years, slow cross-border flows of goods; and rules-of-origin requirements also restrict trade flows. As an example of the potential efficiency gains from deeper economic integration, recent research quoted in Cardarelli and Kose (forthcoming) suggests that the removal of rules-of-origin requirements and the harmonization of external tariffs—which has been under discussion among the NAFTA partners—could increase NAFTA countries’ GDP by as much as 2–3 percent.