NAFTA and the Trade
in Automotive Goods

Jon R. Johnson
Goodman & [Internationally Goodman Freeman Phillips & Vineberg] Goodman

CANADA, THE UNITED STATES, AND MEXICO have signed a North American Free Trade Agreement (NAFTA) with potentially major effects on the policy options open to the governments of each country. Reaching a common understanding for countries in such different circumstances was particularly difficult in the sensitive automotive sector.

The U.S. market for automotive goods is the largest of any country in the world. Historically, the U.S. market has been served by North American producers. However, in recent years, Japanese motor vehicle assemblers have made serious inroads into the market share of traditional U.S. producers. Concern with Japanese competition has driven U.S. policy with respect to its automotive sector with collateral effects on both Canada and Mexico. Certain elements in both the U.S. government and the U.S. automotive industry view Canada and Mexico as potential production platforms for Japanese and other third country producers to penetrate the U.S. market with lightly processed goods on a preferential basis. Consequently, controlling access to the U.S. market was a priority for the U.S. negotiators.

The Canadian and Mexican negotiators had different concerns. The Canadian and Mexican governments are well aware that the U.S. automotive industry is large enough to satisfy the entire Canadian and Mexican demand for automotive products. The assembling industry in both Canada and Mexico is foreign owned. The major assemblers in Canada are the U.S. Big Three (General Motors, Ford and Chrysler), together with Honda and Toyota (Japanese), Hyundai (Korean) and CAMI (a General Motors-Suzuki joint venture). The major assemblers in Mexico are the Big Three, Nissan (Japanese) and Volkswagen (German). Proximity to the United States coupled with high levels of foreign ownership have resulted in neither Canada nor Mexico being willing to rely on market forces to assure an adequate level of domestic automotive assembling or parts production. Both have relied on government intervention to achieve that end. However, the forms of government intervention and the fundamental philosophies underlying them have been quite different. The Canadian government decided in the 1960s to permit Canada's automotive industry to be integrated with the U.S. industry, and directed its automotive policy towards ensuring that an adequate level of the integrated Canadian/U.S. industry remained in Canada. While Mexico has also been concerned that assembly and parts production take place in Mexico, the Mexican government has endeavoured to achieve this result through import substitution and export promotion. While the current Mexican regime is turning towards market solutions, the existing Mexican government automotive regulations are still incompatible with the full integration of Mexico's automotive industry into the North American one.

Canadian and Mexican automotive programs are so different that the Canadian and Mexican negotiators did not have a common cause against U.S. demands that the programs in each country be dismantled. The Canadian negotiators shared the objective of their U.S. counterparts that the Mexican market for automotive goods should be opened to much greater participation by both U.S. and Canadian producers. While the Mexican negotiators may have accepted the inevitability of the eventual dismantling of their policies, they had little sympathy with Canada's position that Canadian automotive policies should be retained while Mexico's be scrapped.

The task of the NAFTA negotiators was to find a common ground among these conflicting concerns.

Canadian Automotive Policy and the Auto Pact

For the past thirty years, Canadian automotive policy has balanced integration of the Canadian and U.S. automotive industries with measures to ensure that an acceptable portion of the integrated industry remains in Canada. A productive Canadian automotive industry has been made possible through serving the larger U.S. market and continuing access to that market is a major Canadian policy objective. However, the by-product of integration is access by U.S. assemblers and parts producers to the Canadian market. Successive Canadian governments pursued a policy of making that access conditional on performance in Canada. The policy instruments used have been a relatively high tariff coupled with conditional duty remission.

Canada achieved both these policy objectives when it entered into the Auto Pact [The full name of the Auto Pact is the Agreement Concerning Automotive Products between the Government of Canada and the Government of the United States.] with the United States. The Auto Pact, which came into effect in 1966, combined duty-free access to the U.S. market based on origin with conditional duty-free access to the Canadian market based upon assemblers in Canada meeting performance requirements.

For automotive goods entering the United States, the Auto Pact is a sectoral free trade agreement with the sole criterion for duty-free entry into the United States being the origin of the goods. The focus on the Canadian side of the Auto Pact is not origin but the performance in Canada by the importing assembler. The Auto Pact itself applied only to assemblers producing vehicles in Canada during the Auto Pact base year (August 1, 1963 to July 31, 1964). Those assemblers were the Big Three and Volvo, which had established an assembly operation in Nova Scotia. Following the Auto Pact coming into effect, the Canadian government began conferring "Auto Pact status" by company specific duty remission orders on assemblers that met performance criteria similar to those contained in the Auto Pact.

To be eligible to import automotive goods duty free under the Auto Pact, the importer must be a vehicle assembler maintaining a prescribed ratio between the value of the vehicles it produces in Canada and its sales of vehicles in Canada, together with a prescribed level of Canadian value added in its Canadian production. The production-to-sales ratio has the effect of requiring that an assembler wishing to import vehicles on a duty-free basis for sale in Canada produce vehicles in Canada. However, the vehicles produced need not be the same as those sold. So long as the ratio is maintained, an assembler entitled to Auto Pact benefits is free to supply the Canadian market with vehicles imported from any other country. This flexibility permits specialization by allowing a U.S. assembler in Canada, such as General Motors, to limit the number of model lines produced in Canada and to supply the entire Canadian and U.S. markets for those model lines from Canadian plants. The Canadian value added (CVA) requirement ensures that Canadian production amounts to more than mere assembly. The production-to-sales ratio and the CVA requirement are the so-called Auto Pact safeguards. If the safeguards are met, the assembler can import new vehicles and original equipment parts duty-free from anywhere, without regard to origin. [Not quite anywhere. Under the Motor Vehicle Tariff Order, 1988, which covers the assemblers producing in Canada during the Auto Pact base year, the countries from which duty-free importations may be made are those entitled to the benefit of Canada's MFN Tariff. This includes most countries in the world. Tires and tubes are excluded. See SOR/88-71, Canada Gazette Part II, Vol. 122, No. 2, Jan. 20, 1988, p. 615.]

The Auto Pact served Canadian interests well. However, the arrangement was inherently unstable. At the time that the Auto Pact was entered into, the Big Three completely dominated the Canadian assembling industry. By the mid 1980s, the Asian transplants were becoming a significant factor in the North American automotive market. Toyota, Honda, Hyundai and CAMI were all in the process of establishing plants in Canada. In the mid 1960s, the disparity in the relative efficiencies of the Canadian and U.S. industries was so great that the need for safeguards for the Canadian industry in a sectoral free trade arrangement was obvious. By the mid 1980s, this disparity had disappeared, and so, from the U.S. perspective, had the rationale for the safeguards. U.S. interests were sceptical about the utility of a regime which provided for unqualified access to the U.S. market but conditional access to Canada, particularly when that conditional access was about to be extended to transplant assemblers.

Effect of the Canada-U.S. Free Trade Agreement

In the Canada-U.S. Free Trade Agreement (FTA), which came into effect on January 1, 1989, Canada surrendered its future ability to use duty remission as a means of ensuring performance in Canada in return for assurance that duty-free access to the U.S. market would continue. Like the Auto Pact, the FTA provides for duty-free access for Canadian automotive goods to the U.S. market based solely on origin, but replaces the Auto Pact origin rule with the FTA rules of origin. The proposition that the FTA would provide more secure access to the U.S. market is based on two factors. First, the U.S. government always regarded the Auto Pact and its safeguards as a transitional arrangement, whereas the FTA was viewed as a long-term arrangement. Second, the free trade arrangement under the FTA is bilateral and applies to all goods as opposed to being unilateral and sectoral as under the Auto Pact. Many sectors of the U.S. economy would acquire a vested interest in the continued existence of FTA, making its cancellation much more difficult.

However, the FTA weakened existing Canadian programs in respect to its automotive industry and foreclosed certain future courses of action. The Auto Pact functions through duty remission, and without duty to remit, there is no incentive to meet the safeguards. The bilateral elimination of duties on all goods under the FTA will be complete by January 1, 1998, following which U.S. automotive goods will enter Canada duty-free solely on the basis of origin and without regard to whether Auto Pact safeguards are being met. Also, while the FTA permits duty remission under the Auto Pact and Canada's Auto Pact based duty remission orders to continue in perpetuity, Canada surrendered its ability to extend the program. While an exception was made for CAMI, the other transplants in Canada, Toyota, Honda and Hyundai will never be permitted to receive Auto Pact status.

The FTA requires the elimination of export-based and production based duty remission orders which have been issued to various assemblers in Canada. Most notably, the production based duty remission orders granted to Honda, Toyota and Hyundai, which tie duty remission to CVA in domestic production of vehicles, must be eliminated by January 1, 1996.

Canada entered the NAFTA negotiations with its policy options curtailed by the FTA. However, the Auto Pact was still perceived as a significant element in Canadian automotive policy and the Canadian negotiators had a strong mandate to preserve it. [For a more detailed discussion of the effects of the FTA on the Auto Pact, see Jon R. Johnson, "The Effect of the Canada-U.S. Free Trade Agreement on the Auto Pact," in Maureen Appel Molot, ed., Driving Continentally.]

The Canadian and Mexican Automotive Industries

The Canadian automotive industry is integrated with that of the United States. The Canadian industry has a strong assembling sector which is a consistent net exporter of finished vehicles to the United States. However, the Canadian parts sector is weaker, especially in high value added items such as engines, transmissions and body stampings.

The Mexican automotive industry is partially integrated with the North American industry. Many maquiladoras, Mexico's in-bond manufacturing plants, are owned by U.S. assemblers [See The Mexican Auto Industry: A Competitor for the 1990's, a study completed by the Automotive Parts Manufacturers Association in September, 1990 (the "APMA Study"). According to the APMA Study, General Motors owns 30 maquila plants with more than 30,000 employees. See p. 72.] and parts producers, and produce mainly low-cost labour-intensive items such as wiring harnesses and radios. Most of their production is exported to the United States or Canada. [Automotive parts production comprises about 39 percent of all maquiladora production. See The New North American Order-A Win-Win Strategy for U.S.-Mexico Trade, Clyde V. Prestowitz, Jr., Robert B. Cohen with Peter Morici and Alan Tonelson, p. 81. Maquiladoras are mostly foreign owned. While some maquiladora production can enter the Mexican market, most is exported to the United States.] While the maquiladoras are integrated with the U.S. automotive industry, they are not integrated with the rest of the Mexican automotive industry. Assemblers in Mexico produce engines in world-scale plants [James P. Womack, "The Mexican Motor Industry: Strategies for the 1990's," MIT International Motor Vehicle Program International Policy Forum, May 1989, p. 8.] for both the U.S. and Canadian markets. [Chrysler at Toluca and Saltillo, Nissan at Cuernavaca, Volkswagen at Puebla, Ford at Chihuahua and General Motors at Ramos Arizpe and Toluca. See APMA Study pp. 48-9, 51, 60, 71 and 72.] Export plants such as the Ford plant at Hermosillo achieve high levels of productivity. [Womack, J., D.T. Jones, and D. Roos (1990), The Machine that Changed the World, p. 265.]

However, assemblers' plants in Mexico are generally at least a decade behind plants in Canada and the United States, [Mark Scheinman, "Corporate Strategy, Globalization and the FTA: Mexico's New Role," a paper presented at a research workshop on "The Auto Industry: Responding to a Changing North American Trade Environment," sponsored by the Centre for Trade Policy and Law, Carleton University, October 3-4, 1991, p. 8.] and Mexican assembly costs are estimated as exceeding international costs by between 10 and 15 percent. [Miguel Angel Olea, "The Mexican Automotive Industry in the NAFTA Negotiations," a paper presented at a research workshop on "The Auto Industry: Responding to a Changing North American Trade Environment, sponsored by the Centre for Trade Policy and Law, Carleton University, October 3-4, 1991, p. 16. The figure given for trucks is 20 percent.] The assemblers cannot justify making the capital expenditures to upgrade because of the short production runs involved in serving the Mexican market and because the use of Mexican parts resulting from meeting content requirements makes the Mexican produced vehicles uncompetitive for export. [The Hermosillo plant was established under a provision of the 1983 Automotive Decree that permitted an assembler to produce a line of vehicles for export and imposed local content requirements on the basis of a sliding scale. For example, if 80 percent of the production was exported, the domestic content requirement was 30 percent (as opposed to the usual 60 percent required under the 1983 Automotive Decree). See North American Free Trade: Issues and Recommendations by Gary Clyde, Hufbrauer, and Jeffrey J. Schott, p. 217.] The Mexican auto parts sector is protected and generally not competitive. These sectors of the Mexican automotive industry have not been integrated into the North American industry.

The Auto Pact and the Automotive Decree Compared

Mexican automotive policy [For a good summary of the Mexican Automotive Decrees of 1962, 1972, 1977, 1983 and 1989 (the current Automotive Decree), see Hufbrauer and Schott, North American Free Trade-Issues and Recommendations, pp. 215-219.] has been implemented through a series of decrees commencing in 1962 and culminating in the current Automotive Decree, which entered into force on November 1, 1990. [The full name is the Decree for the Development and Modernization of the Automotive Industry ("Decreto para el Fomento y Modernizacion de la Industria Automotriz") (December 1989). See NAFTA Annex 300A, Appendix B, paragraph 1.] The Automotive Decree covers all vehicles except for tractors, buses and large trucks. [Gross vehicular weight exceeding 8,864 kilograms. See Article 2:IV of the Automotive Decree for the classes of vehicles covered.] These vehicles are covered by the Autotransportation Decree. [The full name of which is the Decree for Development and Modernization of the Autotransportation Vehicle Manufacturing Industry ("Decreto para el Fomento y Modernizacion de la Industria Manufacturera de Vehiculos de Autotransporte"). See NAFTA Annex 300A, Appendix B, paragraph 18.]

The Automotive Decree substantially liberalized previous Mexican rules governing the automotive industry. Domestic content requirements were reduced from 60 percent to 36 percent, and imports of vehicles were permitted for the first time in decades. However, the regulatory framework imposed by the Automotive Decree is considerably more restrictive than that created by Canada's Auto Pact based duty remission orders.

The Auto Pact and the Automotive Decree both require automotive assemblers to maintain a level of national value added in their domestic production of motor vehicles. [The calculation of CVA under Canada's Auto Pact duty remission orders is not comparable to the calculation of national value added under the Automotive Decree. In calculating CVA, only the cost of imported components count as foreign and virtually all other costs count as domestic. Under the Automotive Decree, only the domestic content of parts supplied by the auto parts industry and by national suppliers and of parts exported by these suppliers where the exportation has been promoted by the assembler count as domestic.] However, under the Automotive Decree, only parts supplied by members of the Mexican "auto parts industry" or "national suppliers" count in the calculation of an assembler's national value added. To be considered a member of the auto parts industry, 60 percent of a producer's total sales must be parts sold to the Mexican assembling industry. To be considered as a national supplier, the producer must be supplying the Mexican automotive industry with certain defined parts. Furthermore, for the parts supplied to be eligible for inclusion in an assembler's calculation of national value added, the supplier (whether a member of the Mexican auto parts industry or a national supplier) must maintain a 30 percent level of national value added in its own production. In addition, an auto parts industry supplier must be majority Mexican owned. [Hufbrauer and Schott state on p. 218 that a Mexican auto parts firm must be at least 60 percent Mexican-owned. However, see NAFTA Annex I-Mexico, p. I-M-33, which describes the relevant restriction as requiring 51 percent ownership.] A national supplier can be majority foreign owned, but not by the assembler it is supplying. [See Hufbrauer and Schott, p. 218.] Maquiladoras are neither members of the auto parts industry nor national suppliers, and parts produced by them cannot be included in the calculation of an assembler's national value added. Under the Auto Pact, the ownership of a Canadian parts producer and the content levels it achieves in its own production are irrelevant to determining whether the parts supplied to an assembler are to be included in the assembler's CVA calculation.

Under the Automotive Decree, assemblers must maintain positive trade balances. An assembler's trade balance is the sum of the foreign trade exchange value of exports of automotive products plus exports of parts and components that it promotes minus the value of direct and indirect imports of parts and components that a manufacturer incorporates into vehicles produced in Mexico for sale in Mexico. The formula is set forth in rule 9 of the Acuerdo que Determina Reglas para la Aplicación para Fomento y Modernización de la Industria Automotriz (the "Auto Decree Implementing Regulations").Note An assembler's ability to import new vehicles is determined by the amount of its extended trade balance (its trade balance modified by further adjustments, including a negative adjustment if the assembler fails to meet the content requirement Under the content requirement, the assembler's national value added from suppliers (i.e. the total invoicing to the assembler for parts and components supplied by national suppliers and the auto parts industry minus imports incorporated in parts and components acquired from national suppliers and the auto parts industry plus exports "promoted" by the assembler minus imports incorporated in exports promoted) (VANp) divided by the assembler's total national value added (i.e. the assembler's production in Mexico for sale in Mexico plus its trade balance) (VANt) must equal at least 36 percent. If VANp is less than 36 percent of VANt, the negative adjustment equals the excess of VANt over VANp/0.36. The other adjustments are transfers of trade balances from other assemblers plus net trade balances of maquiladoras controlled by the assembler (up to an amount equal to 20 percent of the assembler's direct and indirect imports) plus 30 percent of its investment in fixed assets plus its unused entitlement to import vehicles carried forward from previous years. The formula is set forth in rule 8 of the Auto Decree Implementing Regulations.Note). Currently, an assembler in Mexico needs two units of positive value in its extended trade balance to import one unit of value of new vehicles. For 1994 and years following, the two units of positive value in the trade balance are reduced to 1.75. Furthermore, imports of new vehicles can comprise only 15 percent of total number of vehicles an assembler sells in Mexico. For 1993 and years following, this percentage increases to 20 percent. Restricting imports to a certain percentage of vehicles sold in Mexico makes it impossible for an assembler in Mexico to specialize in the same manner as is possible under the Auto Pact for an assembler in Canada.

The Autotransportation Decree, which took effect on January 1, 1990 and covers buses and heavy trucks, is less restrictive. Assemblers are subject to trade balancing requirements, and during a transition period which expires for all vehicles by 1993, there is a 40 percent national value-added requirement. See Hufbrauer and Schott, p. 219.Note

The Mexican negotiators were well aware that both the U.S. and Canadian negotiators had as an objective the complete elimination of the Automotive Decree and the Autotransportation Decree over a period of time. The Canadian position was complicated by the strong mandate given to its negotiators to preserve the Auto Pact. The Mexican objective in the negotiations was not to preserve the Automotive Decree or the Autotransportation Decree, but to extend the elimination over as long a period as possible.

Provisions of NAFTA

NAFTA contains the following provisions affecting automotive goods.

1.Elimination of tariffs on all automotive goods by January 1, 2003.

2.New rules of origin.

3.Continuance of the Auto Pact and Canada's duty remission program based on Auto Pact principles.

4.Phasing out of the Automotive Decree and other Mexican restrictions.

5.Treatment of Mexican-produced vehicles as "domestic" under the U.S. Corporate Average Fuel Economy ("CAFE").

6.Elimination of restrictions on the importation of used cars.

Tariff Elimination under NAFTA

NAFTA will eliminate tariffs on all automotive goods traded among Canada, the United States and Mexico.

Complexities of Trilateral Duty Elimination

Tariff elimination under NAFTA will be more complex than under the FTA. Elimination of tariffs between the United States and Canada will continue on the FTA schedule to completion for all goods by January 1, 1998. However, tariff elimination on goods traded between Canada and Mexico and between the United States and Mexico will not commence until January 1, 1994 and, in the case of many automotive goods, will not be completed until January 1, 2003.

Many goods from Mexico are currently entitled to the benefit of Canada's General Preferential Tariff (GPT) and the U.S. Generalized System of Preferences (GSP). The Canadian and U.S. NAFTA tariff elimination schedules, as they apply to goods from Mexico, will use these rates as base rates.

Only "originating" goods will be entitled to preferential treatment under NAFTA. Origin will be determined in accordance with the NAFTA rules of origin. However, to be eligible for treatment under the FTA Schedule, an automotive good entering Canada will have to satisfy the NAFTA rules of origin applied as if Mexico were not a Party. See NAFTA Annex 302.2(4). Mexican value added of up to 7 percent of the transaction value of the good is permitted.Note Similarly, to be eligible for treatment under the NAFTA schedule based on Canada's GPT rate, an automotive good entering Canada will have to satisfy the NAFTA rules of origin applied as if the United States were not a Party. See NAFTA Annex 302.4(5). U.S. value added of up to 7 percent of the transaction value of the good is permitted.Note If the good satisfies the NAFTA rules of origin but neither of these conditions apply, For example, an auto part in a semi-finished condition could be sent from the United States to a maquiladora plant for finishing. Unless the Mexican value added amounts to less than 7 percent, the auto part will not be eligible for FTA duty treatment. This good might be called a "joint production" good.Note the good will receive either the less favourable of FTA or NAFTA GPT based treatment or, in the case of a few automotive goods, treatment under a schedule based on Canada's most-favoured-nation rate of duty. See NAFTA Annex 302.2(6).Note

U.S. Customs will distinguish between originating goods entitled to FTA treatment and those entitled to treatment under its NAFTA schedule. Rather than selectively applying the NAFTA rules of origin, the United States will distinguish between goods of Canada (eligible for FTA treatment) and Mexico (eligible for NAFTA treatment) on the basis of whether the good is eligible to be marked as a good of Canada or Mexico in accordance with the NAFTA marking rules. [See NAFTA Annex 302.2(10). Presumably the difference in treatment is because mixed U.S.-Mexican production will be a common occurrence while mixed Canadian-Mexican production will be relatively uncommon. While criteria for the marking rules are set forth in NAFTA Annex 312, the rules themselves have yet to be established.] There is no third category for joint production goods.

Elimination of U.S. Duties

Under NAFTA, tariffs on vehicles other than trucks and most automotive parts entering the United States will be eliminated forthwith upon NAFTA becoming effective on January 1, 1994. As a result, producers of these goods in Mexico will enjoy the same duty-free access to the U.S. market as Canadian producers, and Canadian assemblers and parts producers will no longer have this comparative advantage over their Mexican counterparts. The comparative advantage is not significant in respect to these goods. Passenger vehicles are subject to duties of 2.5 percent. Vehicles other than trucks are subject to low rates of duty. Most parts are subject to duties of 3.1 percent. There is no GSP rate for most vehicles entering the United States, and the MFN rate of 2.5 percent applies. There are some exceptions, such as public transportation type motor vehicles, which already enter the United States duty-free from Mexico under the GSP. Many parts from Mexico already enter the United States duty-free under the GSP.Note

U.S. tariffs on light trucks are being cut from 25 percent to 10 percent on January 1, 1994 and are then being reduced by 2.5 percent each year, with elimination complete by January 1, 1998. See U.S. tariff subheadings 8704.21 and 8704.31. These are trucks with a gross vehicle weight of under 5 tonnes.Note U.S. tariffs on heavy trucks See U.S. tariff subheadings 8704.22, 8704.23, 8704.32 and 8704.90.Note are being phased out in ten equal stages, with elimination complete by January 1, 2003. The comparative advantage that Canadian assemblers have over their Mexican counterparts is significant with these vehicles, because the U.S. tariff being eliminated is 25 percent. See U.S. tariff item 9903.87.00.Note

Canadian Duties on Mexican Automotive Goods

With a few significant exceptions, Canada will not be granting immediate duty-free access to Mexican automotive goods. Tariffs on passenger vehicles will be reduced immediately by 50 percent and the remaining tariff will be eliminated in nine equal annual stages, with complete elimination on January 1, 2003. Tariffs on trucks with a gross vehicle weight not exceeding five tonnes will be reduced by 50 percent and the remainder will be eliminated in four equal annual stages. Tariffs on other trucks, truck tractors, and buses, will be eliminated over ten equal stages.

Canadian tariffs on automotive goods from Mexico will be eliminated over a variety of time periods. Tariff elimination will be immediate on some parts, while tariffs on others will be eliminated over five or ten stages. Tariffs on a number of parts which were being eliminated in ten stages under the FTA for goods from the United States (with complete elimination by January 1, 1998) will, under NAFTA for goods from Mexico, be eliminated in five stages with complete elimination by January 1, 1999. For example: locks, distributors, starter motors, generators, lighting or visual equipment, cassette decks, junction boxes, car bodies, safety seat belts, body stampings, mufflers and exhaust pipes, steering wheels, steering columns and steering boxes.Note Producers of these parts in Mexico will be in a position vis ŕ vis the Canadian market which is substantially on a par with their U.S. counterparts, although the practical effect for these producers is negligible given that the vast majority of parts from both Mexico and the United States already enter Canada duty free under the Auto Pact. Tariffs on most engines will be eliminated immediately under the NAFTA schedule. Mexico is a significant exporter of automobile engines to Canada. In 1991, the value of engines imported into Canada under tariff subheading 8407.34 (engines, spark-ignition reciprocating, displacing more than 1000 cc) was $204,548,000, of which only $3,393,000 (or 1.66 percent) was dutiable. The remaining engines would have been subject to duty had it not been for the Auto Pact. Once NAFTA enters into force, engines from Mexico will enter Canada duty free under the NAFTA schedule. Unless imported under the Auto Pact, engines falling under this subheading from the United States will be subject to duty until January 1, 1998. There are a few other parts upon which complete duty elimination will occur under NAFTA on January 1, 1994 but not under the FTA until January 1, 1998. These include ball bearings and windshield wipers and defrosters.Note

Canadian tariffs on Mexican parts are not very high. For example, Canada's GPT rate on passenger automobiles is 6 percent. Under NAFTA, this will be reduced immediately to three percent, which will then be eliminated over nine equal annual stages. The base rate for most Mexican-produced parts will be in the 6 percent range.

Mexican Duties on Canadian Automotive Goods

The elimination of Mexican tariffs on vehicles imported from Canada will closely parallel the staging categories for the elimination of Canadian tariffs. Elimination of Mexican tariffs on Canadian parts will take place over a variety of time periods. In some cases, these will parallel those for the elimination of Canadian tariffs, but for many parts they will not. All tariffs will be eliminated by January 1, 2003. As Mexican duties are generally quite high, Canadian and U.S. produced vehicles and parts will be significantly more competitive in the Mexican market.

The New NAFTA Rules of Origin

As indicated above, controlling access to the U.S. market was a priority for the U.S. negotiators. The U.S. negotiators wished to limit duty-free access by tightening the rules of origin. The task of the Canadian negotiators was to place reasonable limits on the tightening. Given the experience with the FTA rules, the Canadian negotiators placed a high priority on limiting the scope for unilateral and arbitrary application of the rules by U.S. Customs.

Origin under the Auto Pact

Under the old Auto Pact origin rule, the landed value of imported parts could not exceed 50 percent of the appraised duty value of the finished vehicle entering the United States. The test was applied on each vehicle with no averaging. The test required tracing of parts to the point that they were imported into Canada or the United States. Everything besides the landed value of imported parts included in the duty-appraised value counted in the producer's favour.

The FTA Rules

The Auto Pact origin test was never contentious so long as the only significant assemblers in Canada were the Big Three. However, at the time that the FTA was being negotiated, the Asian transplants had all established plants in Canada. The Auto Pact rule was seen as being too generous and the U.S. FTA negotiators pressed for a stricter rule of origin. The FTA content requirement counts only production costs and not other costs towards territorial value. The expression "territorial" is used to convey the idea of "domestic," as if Canada and the United States were a single entity.Note However, the FTA content requirement accounts for materials when acquired by the producer and no tracing of materials back through chains of suppliers is required. If the producer acquires a material that is originating (determined by applying the FTA rules of origin to the material), the producer receives territorial credit for its entire price, and the value of any imported sub-materials is "rolled up" into that price. Similarly, if the material is non-originating, its entire price counts as non-territorial, and any territorial value added it may contain is "rolled down. While the FTA test was unclear on the point, both Canadian and U.S. Customs authorities accepted the proposition that a vertically integrated producer could claim roll-up on an originating material which it produced itself. However, because of the cryptic wording of the FTA content requirement, the authorities in the two countries could not agree on the territorial credit to be allowed. In one of the rulings with respect to Honda, U.S. Customs allowed credit only for imported sub-materials whereas Revenue Canada would have allowed credit for all sub-materials. See U.S. Customs Ruling CLA-2:R:C:M 000131 JLV, dated December 12, 1991. See also Revenue Canada Customs and Excise Memorandum D11-4-12, Guidelines paragraphs 39-40.Note"

Problems with the FTA Rules

The FTA content requirement was viewed as unsatisfactory by both Canada and the United States. The U.S. Congress was unhappy with the threshold percentage of 50 percent and required the President to negotiate a 60 percent threshold. Manipulation of roll-up was viewed in the United States as a means whereby the transplants in Canada could export vehicles into the U.S. market which technically met the origin rule but in fact contained low levels of true Canadian or U.S. value added. U.S. concerns with the FTA rule of origin were aggravated by the huge U.S. trade deficit in automotive goods with Japan.

The Canadians viewed the matter differently. The administration by U.S. Customs of the FTA rules of origin was considered arbitrary. There were endless (and, from a Canadian viewpoint, needless) disputes over what costs counted as production costs. The Canadian perception of U.S. arbitrariness culminated in a ruling by U.S. Customs in respect to Honda that only the costs of assembling operations performed with respect to several major engine assemblies counted as territorial, while the cost of machining and other processing operations performed in Ohio did not count. See U.S. Customs Service rulings CLA-2 CO:R:C:M 000155 VEA and CLA-2 CO:R:I 000160 JLV. The particular version of the FTA content requirement upon which Honda was relying uses the expression "direct cost of assembling" rather than the more usual "direct cost of processing." See FTA Annex 301.2 Interpretation, paragraph 4. Although the two expressions are both defined to mean the same thing, namely production costs, U.S. Customs interpreted the defined expression "direct cost of assembling" as excluding processing costs. While in the author's view the U.S. Customs ruling was wrong, the unusual drafting technique of using two defined expressions to mean the same thing left the opening for the restrictive ruling.Note The United States was seen as trying to obtain through administration the 60 percent threshold that it had failed to obtain through negotiation.

The United States entered the NAFTA negotiations looking for a tougher content rule, through a higher threshold and restrictions on roll-up. These demands were coupled with a wide perception in the United States that Asian transplant operations in North America had to be forced to achieve higher levels of North American content. In Canada, the use of the rules of origin in this manner as an instrument of industrial policy was viewed with scepticism. The only effect of a more stringent rule of origin would be to divert transplant activity from Canada to the United States, where the U.S. domestic market could be served without complying with the rules of origin. However, the concept of a stricter rule of origin found considerable support in Canada among some constituents of the automotive industry, most notably the parts producers.

The NAFTA Rules

Goods containing imported materials are considered to originate in a country if the production of the good in that country has resulted in the "substantial transformation" of those materials into something new and different. Like the FTA rules, the NAFTA rules of origin define the required transformation primarily in terms of prescribed changes in classification, with some goods being subject to the additional requirement of a content requirement. Origin can be established by the content requirement alone in certain situations in which a change in tariff classification cannot occur.Note However, with vehicles and major automotive components, the required transformation is defined primarily in terms of the content requirement. The operation of the NAFTA content requirement has been described elsewhere in this book. The unique features of the content requirement applicable to automotive goods are tracing, averaging and phasing to higher thresholds.

Tracing

For passenger vehicles, small trucks and buses (together with those of their parts which are subject to a content requirement), roll-up is eliminated. The producer must trace all materials which are imported under specified tariff provisions. These tariff provisions cover a wide range of parts and components used in vehicles. See NAFTA Annex 403.1 for the specified tariff provisions. For these automotive goods, the numerator of the content requirement is the producer's "net cost" minus the value of all these imported materials. The denominator is the producer's "net cost." The contentious decision which denied Honda its processing costs in respect to engine assemblies could not occur under the NAFTA rules because there is no distinction made between processing and assembling costs. However, because of tracing, Honda will be applying the content requirement in a manner completely different from what it was doing under the FTA. While the rule in the FTA which used the expression "direct cost of assembling" has been modified to make it clear that there is no distinction between processing and assembling costs, Honda will no longer be relying on that rule to qualify its motor vehicles.Note Suppose that an assembler of passenger vehicles purchases an engine from a local supplier and the pistons in the engine were imported by an upstream supplier. The origin of the engine would be irrelevant. The assembler would have to ascertain the upstream supplier's transaction value of the imported pistons and that amount would count against the assembler, The specified tariff provision for the pistons is 8409 (parts of engines). (See NAFTA Annex 403.1.) If the metal from which the pistons were made was imported and the pistons were produced domestically, the tracing requirement would not apply, because the tariff provision under which the metal would be imported is not specified in NAFTA Annex 403.1. The transaction value is, essentially, the duty-paid value, and is subject to adjustment under certain circumstances.Note together with the transaction value of materials imported directly by the assembler under the specified tariff provisions. The tracing requirement applies to every component or assembly purchased by the assembler. This approach is very similar to the approach under the old Auto Pact test for origin.

The NAFTA rules adopt a less stringent version of tracing in respect to larger trucks and buses and specialty vehicles. Tracing is confined to the engines and transmissions and does not extend back to the stage at which materials are imported. NAFTA Annex 403.2 breaks down engines and transmissions into their constituent materials (such as, in the case of an engine, the cast block, the cast head, the fuel nozzle, the fuel injector pump, etc.). The producer must determine whether each of these materials is originating or non-originating by applying the applicable NAFTA rule of origin. Notwithstanding whether the engine or transmission itself is originating or non-originating, the value of those constituent materials which are non-originating count against the producer, along with the value of other non-originating materials contained in the vehicle. However, there is no roll-down of territorial value added contained in the engine or transmission if the engine or transmission itself is non-originating. Normal roll-up and roll-down apply with respect to other parts of the vehicle.

Consider the example above respecting the engine and the pistons, applied to a large truck assembler. The origin of the engine is irrelevant. Pistons are included in the list in NAFTA Annex 403.2, so the assembler must ascertain whether or not they are originating. If the upstream supplier imported the pistons, they would be non-originating and their value would count against the assembler. If the upstream supplier produced the pistons locally but they were non-originating, their value (or, if the assembler elects, the value of the non-originating materials contained in the pistons) count against the assembler. The assembler must obtain sufficient information from the upstream supplier to ascertain whether the pistons are non-originating and, if so, their value or the value of the non-originating materials they contain.

Averaging

Under the FTA, motor vehicle manufacturers were entitled to average their calculation over a twelve-month period on the same class of vehicles assembled in the same plant. The classes of passenger vehicles were broken down on the basis of size, with trucks and buses each forming their own class. [See FTA Article 1005(2) and the definition of "class of vehicles" in FTA Article 1006. The classes of vehicles were taken from the classes of vehicles for labelling purposes in the U.S. Corporate Average Fuel Economy regulations. See 40 CFR section 600.315-82, subparagraphs (a)(ii) to (ix).] The NAFTA rules retain averaging and extend its scope. The "class of motor vehicles" has been redefined into much broader categories. For example, all passenger vehicles are in a single class, regardless of size. A vehicle producer has a number of averaging options. The producer can average over the same model line within the same class produced within the same plant, or over the same class within the same plant, or over the same model line within one of the NAFTA countries. A special averaging rule permits CAMI to average with General Motors Canada. Averaging has been extended to automotive parts. Averaging is tied to the producer's fiscal year or, in the case of an OEM parts producer, to the assembler's fiscal year.

Phasing to Higher Thresholds

The threshold percentage in the NAFTA content requirement is being increased over a phase-in period. The applicable percentage for small trucks and buses, together with their engines and transmissions, will be 50 percent until the producer's fiscal year The tie-in to the producer's fiscal year is because of averaging, which has been discussed above.Note beginning on the day closest to January 1, 1998, 56 percent from then until the producer's fiscal year beginning on the day closest to January 1, 2004, and thereafter 62.5 percent. The applicable percentage for tractors, larger trucks and buses and specialty vehicles together with their engines and transmissions, as well as most parts for all types of vehicles will be 50 percent until the producer's fiscal year beginning on the day closest to January 1, 1998, 55 percent from then until the producer's fiscal year beginning on the day closest to January 1, 2004, and thereafter 60 percent. Notwithstanding the foregoing, the applicable percentage remains at 50 percent for any five-year period for a vehicle not previously produced by the producer which is produced in a new plant, and for two years following a refit. The applicable percentage for other automotive goods is 50 percent.

As the NAFTA content requirement as applied to automotive goods is so different in concept from the FTA content requirement, the threshold percentage of 62.5 percent or 60 percent under NAFTA is not directly comparable with the 50 percent FTA threshold.

General Observations

For passenger vehicles, the NAFTA rules are a return to the old Auto Pact tracing concept. The difference will be in the manner of enforcement. The Auto Pact rule was never rigorously enforced. U.S. Customs was vigorous in its enforcement of the FTA content rule as against transplant operations in Canada. There is no reason for believing that they will be any less rigorous in the enforcement of the NAFTA rules.

The Canadian parts industry was strongly in favour of tracing, and they achieved this objective in the NAFTA rules. However, much of the burden of tracing will fall on parts producers, as they will have to provide much more detailed information to their assemblers. In one sense, this should not present a problem to parts producers in Canada because they provide similar information to assemblers in Canada which are entitled to Auto Pact benefits. However, the information they compile for Auto Pact purposes is audited by Revenue Canada. The tracing information that they will be compiling for NAFTA purposes will be audited by U.S. Customs. Mexican parts producers also provide tracing data to assemblers under the Automotive Decree.

The NAFTA rules of origin represent a compromise. An excessively strong rule of origin would have been a disincentive to the transplant assemblers to continue manufacturing for the U.S. market in Canada. The NAFTA origin requirements are more stringent than those under the FTA and, as such, represent a tightening of access to the U.S. market. However, the NAFTA rules are not nearly as stringent as some in the negotiations were demanding, See, for example, Prestowitz, et al. supra at p. 69. While the threshold percentage that they recommended of 60 percent is not higher than that ultimately agreed to, the only costs which would have counted as territorial were labour and materials. Ford and Chrysler were pressing for threshold percentages in excess of 70 percent.Note and there is a substantial phase-in period before the final threshold percentages apply. The NAFTA rules should also be more predictable and less open to contentious interpretations. Producers in Canada may be better off with more stringent rules that are less capable of being capriciously administered. The extent to which this will be achieved depends largely upon the degree of effort made by the NAFTA parties in ensuring that the Uniform Regulations which are to be completed by the time that NAFTA enters into force are precise and workable.

One concern with the NAFTA rules of origin as applied to automotive goods is their complexity. The FTA had one version of the content requirement. NAFTA has four. Transaction value method (cannot be used for automotive goods), normal net cost method for non-automotive goods, full tracing net cost method for passenger vehicles, etc., partial tracing net cost method for trucks, etc.Note Applying these different methods and auditing their application (particularly the tracing requirements) could be very difficult, especially for producers producing goods with a variety of end uses.

Effect of NAFTA on the Auto Pact and Other Policy Options

NAFTA contains provisions similar to those in the FTA prohibiting duty waivers which are conditional upon satisfying performance requirements. See NAFTA Article 304. See also FTA Article 405, which is incorporated by reference in NAFTA Annex 304.2(c) to apply as between Canada and the United States as regards measures predating NAFTA entering into force.Note However, Canada and the United States are expressly permitted to maintain the Auto Pact, as modified by the FTA, and Canada is permitted to maintain the Auto Pact duty-remission orders which have been issued to the recipients listed in FTA Annex 1002.1 NAFTA has, in effect, preserved the status quo insofar as the Auto Pact and Canada's Auto Pact duty-remission orders are concerned. The two tier system is perpetuated, with the Big Three and CAMI continuing to be entitled to Auto Pact benefits and the transplants not being permitted to receive such benefits.

Effect of Duty Elimination with Mexico

An Auto Pact assembler's sole incentive to meet the Auto Pact safeguards is duty remission. If there were minimal or no duty to remit, there would be no incentive to meet the safeguards and the Auto Pact would, for practical purposes, cease to exist. Duty remission on automotive goods will continue to be relevant for automotive goods imported from the United States until 1998 and from Mexico until 2003 for most vehicles and until 1999 or 2003 for many other automotive goods. As discussed above, engines are a significant exception.Note However, once duty elimination under NAFTA is complete, Mexico will be added to the United States as a country from which automotive goods can be imported into Canada duty free without meeting the safeguards. The question is whether free trade with both the United States and Mexico will reduce the benefits of duty remission so significantly that the Auto Pact safeguards will be ignored.

The continuing incentive to comply with the safeguards will be to save duty on vehicles and parts imported from third countries. Assemblers entitled to Auto Pact benefits will continue to have duty-free sources of new vehicles and parts other than the United States and Mexico. This advantage cannot be made available to their counterparts in the United States or Mexico so long as these countries choose to maintain external tariffs. How meaningful this advantage is depends on the volume of vehicles and parts imported from third countries, as opposed to the United States and Mexico, and Canada's level of external tariffs. Consider the following figures for the period January to December, 1991.

Click here to view Table: Imports of Automotive Goods into Canada under selected HS Subheadings Period January-December, 1991 (CDN $'000s)

Canada's published import statistics do not identify the basis for the duty-free treatment. Accordingly, the following analysis is based on several arbitrary assumptions. It is likely that most of the duty-free imports from the United States and Mexico were made by the Big Three. Therefore, it is assumed that these imports have been made under the Auto Pact. However, a significant portion of the duty-free imports from Japan would have been made by Toyota and Honda under their production-based duty-remission orders. Some of the duty-free imports from from third countries would have been made under Canada's export-based remission orders. In the absence of better information, it is assumed that 50 percent of the imports from Japan and 75 percent of the imports from other third countries were made under the Auto Pact. Based on these assumptions, the breakdown is as follows:

Click here to view Table: Assumed Duty Free Imports under the Auto Pact (CDN$ $'000s)

Of the foregoing items, 88.96 percent came from the United States, 5.86 percent from Mexico and 5.18 percent from third countries. Of these items from countries other than the United States, 53.11 percent came from Mexico and 46.89 percent came from third countries.

Based on the foregoing, it is apparent that without free trade with the United States and Mexico, the incentive to comply with the safeguards is overwhelming. Assuming a rate of 9.2 percent, duty saved on $24,136,391,000 is $2,220,547,970. Even assuming a rate of 6.0 percent (Canada's GPT rate on many automotive goods), the duty saved would be $1,448,183,460.

Removing the United States and Mexico still leaves $1,249,308,000 of Auto Pact imports. Assuming a duty rate of 9.2 percent, the duty saved is $114,936,340. Assuming a rate of 6.0 percent on all the non-Japanese imports, the duty saved is $93,104,590. On the basis of these figures, it would appear that there is still a considerable incentive to earn the duty remission by meeting the safeguards. As the automotive industry in Canada evolves and expands, sourcing from third countries may increase, which would strengthen the incentive. The scope for increased third country sourcing is limited by the need to satisfy CVA and NAFTA rules-of-origin requirements.Note However, diversion of sourcing from third countries to Mexico would weaken the incentive. The incentive would also be weakened by Canada lowering its external tariff. If the tariff on parts were lowered to correspond to the U.S. MFN rate on most parts of 3.1 percent, the duty saved on the 1991 volume of third-country imports would be only $38,728,550.

To the extent that the foregoing assumptions underestimate duty-free imports of automotive goods being made under Canada's production and export-based duty-remission programs, the foregoing estimates of duty saved are overstated. However, there are many other tariff subheadings under which goods for use in automotive production are imported besides the subheadings used for the above tables. These were not used because they include goods imported for non-automotive purposes. Therefore, the figures in the table understate the volume of imports of automotive goods and to that extent, the above estimates of duty saved are understated.

If Canada becomes the highest cost NAFTA producer and the additional cost to an Auto Pact assembler of complying with the safeguards by assembling vehicles and sourcing parts in Canada (as opposed to assembling vehicles and sourcing parts in the United States or Mexico) exceeds the duty saved through compliance, there will be no incentive to comply.

Effect of the Elimination of Duty Drawback

The elimination of duty drawback under NAFTA will have opposing effects on the incentive to comply with Auto Pact safeguards. On the one hand, elimination of duty relief through drawback will provide an added incentive for Auto Pact assemblers to earn duty remission through complying with the safeguards. On the other hand, the elimination of duty drawback will increase pressure to lower the external tariff on automotive goods to U.S. rates.

Under the FTA, duty drawback on exports to the United States was to have been eliminated on January 1, 1994. NAFTA postpones this until January 1, 1996. Elimination of drawback for exports to Mexico from both the United States and Canada will commence January 1, 2001. Unlike under the FTA, Canadian exporters of goods to the United States will still be entitled to drawback of the Canadian duty up to an amount equal to the duty paid on the finished goods entering the United States. There will be U.S. duty payable on goods which are in FTA staging category "C," for which duty elimination is not complete until January 1, 1998, and on goods which do not satisfy the rules of origin.

The elimination of duty drawback for exports to the United States will adversely affect the transplant assemblers in Canada. The postponement of the elimination of duty drawback by two years will be helpful, but each transplant will still be receiving some duty relief under its production-based duty waiver. Under the FTA, these must be terminated by January 1, 1996, which coincides with the NAFTA deadline for the elimination of duty drawback for exports to the United States.

The NAFTA provision allowing drawback of Canadian duty on imported parts up to the amount of U.S. duty on the exported finished good could act as a disincentive for the transplants to satisfy the rules of origin. If the Canadian duty paid on parts exceeds the U.S. duty paid on the finished vehicles going into the United States, an exporting transplant will be in the same economic position whether its goods satisfy the rules of origin or not. This is possible because U.S. MFN rates for all vehicles, except trucks, is 2.5 percent while Canadian MFN rates on most parts is 9.2 percent. This seems a perverse result, given that the whole point in having a more stringent rule of origin is to increase North American sourcing by transplants.

The only way that the Canadian government can assist the transplants when drawback is eliminated is to lower external tariffs to U.S. levels. However, as indicated above, this will further weaken the incentive for Auto Pact assemblers to comply with the safeguards.

Other Policy Options

NAFTA is much more comprehensive than the FTA in its effects on policy options open to governments. For example, the NAFTA investment chapter prohibits conferring benefits on an investor (which could be an assembler or a parts producer of any nationality) which are conditional upon meeting performance requirements. See NAFTA Article 1106(3). The prohibited performance requirements are those related to purchasing domestic goods, achieving levels of domestic content, trade balancing requirements and export requirements. However, NAFTA Article 1106(4) expressly permits conditions relating to location of production, providing a service, training and employing workers, constructing or expanding particular facilities, or carrying out research and development. The provision is silent on world product mandate requirements.Note In the past, Canadian governments have granted subsidies to automotive firms for the construction of plants or the development of new products. These subsidies have been conditional on meeting a number of requirements, such as achieving levels of Canadian content. These policies are precluded under NAFTA.

The Effect of NAFTA on Mexican Automotive Policies

The U.S. and Canadian negotiators achieved their objective of dismantling Mexican automotive policies, but only after lengthy phase-in periods.

The Automotive Decree

NAFTA will eliminate the Automotive Decree by 2004. Up to that time, the Automotive Decree remains in effect but a number of its restrictions are eased or eliminated.

Trade Balance

In calculating its trade balance, the assembler will be required to include only a percentage of the imported parts and components in vehicles sold in Mexico rather than the entire amount. The initial percentage will be 80 percent for 1994 and will be phased down in more or less equal annual amounts to 55 percent in 2003. The percentages are: 80 percent for 1994, 77.2 percent for 1995, 74.4 percent for 1996, 71.6 percent for 1997, 68.9 percent for 1998, 66.1 percent for 1999, 63.3 percent for 2000, 60.5 percent for 2001, 57.7 percent for 2002 and 55.0 percent for 2003.Note This provision will enable assemblers to import more parts and components. For example, in 1999, when the applicable percentage is 66.10 percent, the importation of 1513 units of parts and components would have the same impact on the assembler's trade balance as the importation of 1000 units under the present rules. 1000 is 66.10 percent of 1513.Note Thus by 1999, an assembler's entitlement to import parts will have increased by 51.3 percent.

New Vehicle Imports

The limitation on annual imports of new vehicles to a prescribed percentage of vehicles sold in Mexico will be eliminated. In determining the total value of new vehicles that an assembler may import, the assembler will be permitted to divide its extended trade balance by the aforementioned percentages rather than by 1.75. NAFTA Annex 300-A.2(14).Note In 1994, the applicable percentage will be 80 percent. Dividing the extended trade balance by 0.8 rather than 1.75 will increase the ability of an assembler to import vehicles by 219 percent. In 2003, the last year of the transition period, the applicable percentage is 55 percent (or 0.55) and the ability to import new vehicles will have increased by 318 percent over what would have been the case if 1.75 had been used.Note The value of the extended trade balance (upon which the ability to import new vehicles is based) is also enhanced by the more generous trade balance calculation just described.

Content Requirement

The 36 percent national value-added requirement will be reduced to 34 percent from 1994 to 1998, to 33 percent in 1999, to 32 percent in 2000, to 31 percent in 2001, to 30 percent in 2002 and to 29 percent in 2003. Existing producers that did not satisfy the 36 percent content requirement for the 1992 model year may use the percentage that they did achieve for that year until that percentage is higher than the prescribed percentages. Thus if the percentage achieved for the 1992 model year was 32 percent, the assembler may use that percentage until 2001. Only Ford achieved the required percentage in the 1992 model year. The percentage which this relieving provision permits an assembler to use is calculated on a basis which includes purchases from independent maquiladoras. Under the current Automotive Decree, these are excluded but, as indicated below, under the NAFTA rules they will be included.Note

For existing assemblers, the basis for calculating the percentage of value added is the higher of the assembler's Mexican production for sale in Mexico plus its trade balance (the current basis for the content calculation, or "VANt") and the assembler's reference value for the year that the calculation is being made. NAFTA Annex 300-A.2(5).Note The reference value is the lower of the assembler's current year domestic sales, and the average of its sales for the 1991 and 1992 model years (adjusted for inflation) plus a prescribed percentage of the excess of sales in the current year over that average amount. See NAFTA Annex 300-A.2(8). "Base value" is defined in NAFTA Annex 300-A.2(27). The prescribed percentage is 65% for 1994-97, 60% for 1998-2000, and 50% for 2001-03.Note The trade balance is not included in the reference value. However, the sales include imported vehicles and not just those produced domestically, so that the reference value could be higher than VANt. If this occurs, the assembler will require a higher level of domestic Mexican value added to satisfy the content requirement than would be the case if VANt is used. This provision affords some protection to the Mexican autoparts industry, given the more lenient trade balancing requirements and the significantly enhanced capability to import new vehicles. This more stringent rule will not apply to new assemblers. Those beginning production of vehicles after the model year 1991. (See NAFTA Annex 300-A.2(5).)Note

The national value added required of the auto parts industry and national suppliers will be reduced from 30 percent to 20 percent. A maquiladora can now qualify as a national supplier, provided that it is not owned by the assembler that it is supplying.

Other Requirements

The ownership restriction on enterprises of the auto parts industry is to be eliminated for investors of Canada and the United States, and their subsidiaries in Mexico, by 1999. Parts produced in Mexico by suppliers owned by such investors will be eligible to be counted in the determination of national value added. An enterprise's status as an investor of Canada or of the United States is based on its having substantial Canadian or U.S. business activities and not on ultimate ownership. Thus, Canadian and U.S. transplant enterprises, as well as those of the Big Three, have status as investors of Canada or the United States.

The restriction imposed on the sales of maquiladora production into the Mexican domestic market is to be phased out over seven years. One year after NAFTA enters into force, a maquiladora may sell up to 60 percent of its previous year's exports into the domestic market. This percentage will increase in five percent increments to 85 percent in the sixth year. The restriction will be completely removed in the seventh year.

Following January 1, 2001, the NAFTA drawback rules will apply to the maquiladoras. Duty deferred on materials imported from countries other than the United States or Canada will have to be paid at the time that the goods are exported to the United States or Canada. This will have little effect on U.S. owned maquiladoras but will have a substantial effect on maquiladoras owned by investors in third countries such as Japan or Germany.

Mexico is obliged to eliminate immediately its Autotransportation Decree, which covers larger trucks and buses. However, until 1999, there will still be restrictions on the importation of these types of vehicles. Mexico may restrict the number of vehicles imported by an assembler to 50 percent of the number of vehicles produced in Mexico, See NAFTA Annex 300A, Appendix B, paragraph 20. Note that the imported vehicles must be originating.Note and the importing assembler must satisfy a 40 percent national value added requirement in its Mexican production.

NAFTA contains a general prohibition of import permit systems. However, Mexico is permitted to require import permits in respect to all types of vehicles. For vehicles covered by the Automotive Decree, the permit system may continue in force for ten years, and for vehicles covered by the Autotransportation Decree, the permit system may continue for five years.

CAFE Rules

The U.S. CAFE rules impose fuel economy requirements on vehicles sold in the United States. The rules split the fleet of each assembler into a domestic fleet and imported fleet. As to whether a car line is domestic or imported depends on its meeting a 75 percent content test. See 40 CFR Ch.I (7-1-89 Edition), Section 600.511-80.Note The two fleets are treated exactly the same but the calculations for each fleet must be made separately. For the purposes of the test, Canadian production is considered domestic but Mexican production is considered imported. NAFTA requires that Mexican value added count as domestic, just as Canadian presently does. This rule will not commence for existing assemblers (producing before model year 1991) in Mexico, the United States or Canada until after 1997, and these assemblers may elect whether to have the rule apply until 2004, at which time the rule must apply. However, for assemblers establishing in Mexico after 1991 (including assemblers such as Honda with existing operations in Canada or the United States) and assemblers not operating in North America, the rule applies from the time that NAFTA comes into force.

Prior to the completion of the NAFTA negotiations, a number of commentators suggested that the Big Three would benefit from Mexican production being treated as "domestic" for CAFE purposes. This view was based on the fact that Mexican produced cars tend to be smaller and more fuel efficient entry level vehicles. If treated as "domestic," the lower fuel consumption of these vehicles would help offset the higher fuel consumption of U.S. and Canadian produced vehicles. See APMA Study, pp. 113-4.Note Ford undergoes several contortions to comply with CAFE. Its Crown Victoria, assembled in Ontario, has sufficient Mexican content to be considered imported while the Escorts manufactured at Hermosillo have sufficient U.S. content to be considered domestic.

The Big Three themselves did not advocate the change in status of Mexican production to domestic. In their letter to Carla Hills dated September 9, 1991, they stated, ". . . we wish to make it clear to the U.S. that our companies do not seek such a change in status of the CAFE designation of Mexican produced autos in NAFTA. The text of this letter is reproduced in a Special Report dated September 23, 1991 of Inside U.S. Trade, An Inside Washington Publication. (See p. S-5.)Note"

The terms of NAFTA change the status of Mexican production, but only after a fairly lengthy lead time for existing assemblers in Mexico. This result is consistent with their wishes. Ford needs a period of time to adjust its sourcing practices in respect to vehicles such as the Crown Victoria and the Escort. Volkswagen is content that its fuel efficient Mexican-produced Golfs and Jettas count as "imported" for a number of years to offset the less fuel efficient Audis which it imports into the United States from Germany.

Used Cars

Canadian restrictions on used cars from Mexico will be phased out over ten years starting 2009. Mexican restrictions on used cars from Canada and the United States will be phased out over the same time period. In their September 9, 1991 letter to Carla Hills, the Big Three recommended that the Mexican embargo on imports of used cars be maintained to protect Mexico's new vehicle industry. See September 9, 1991 letter, p. S-5, item #7.Note The fifteen year lead time in NAFTA gives a substantial time period for the Mexican new vehicle industry to adjust. The rationalization of the North American industry which will result from NAFTA should be complete by that time.

There is still no rule for determining origin of used cars. While the North American versus foreign distinction may be obvious with older vehicles, the distinction may not be so clear with later model vehicles. Consider a used car that was produced by a transplant in the United States for the domestic U.S. market. No certificate of origin would have been issued for the car when it was new because it was not exported. The car may contain a high level of non-North American content. It is not obvious that this car is North American. The exporter of this car will not be able to obtain the information necessary to satisfy the NAFTA content requirement.Note

Conclusion

NAFTA sets the stage for the full integration of the Mexican automotive industry into the North American automotive industry. Assemblers in Mexico will no longer have to satisfy Mexican demand with locally produced vehicles and will be able to specialize. The distinction in the Mexican parts between the maquiladoras and the auto parts industry will disappear. Subject only to the constraints imposed by the NAFTA rules of origin, assemblers in Mexico will be able to source parts from wherever they choose.

Assembling

James Womack suggests that Mexico could become an effective source of cheap entry-level vehicles for the U.S. and Canadian markets. James P. Womack, "The Mexican Motor Industry: Strategies for the 1990's," MIT International Motor Vehicle Program International Policy Forum, May 1989, p. 19.Note Womack and others draw an analogy with the entry of Spain into the European Community. Following its entry into the European Community, European assemblers used Spain as a source of entry-level vehicles, and Spanish production increased dramatically.

Some predict that Mexico will become the favoured low-cost production location for both North American and Japanese producers and that the Spanish experience will be replicated in Mexico. Ford's experience at Hermosillo has demonstrated that cost-effective production of vehicles is possible in Mexico. Some assemblers are currently making very large investments in new production capacity. Nissan is planning a "state of the art" facility at Aguascalientes for the production of 200,000 vehicles by 1995. See APMA Study, p. 51.Note Volkswagen is increasing the capacity at its Pueblo plant to 300,000 vehicles a year from its current capacity of 150,000 vehicles. See APMA Study, p. 59.Note

As to whether the dramatic increase in Mexican vehicle production depends on Mexico becoming an effective low-cost producer, Mexico has advantages in its lower labour costs, and Mexican workers have proven to be very effective at plants like Hermosillo. However, labour only represents about 10 to 15 percent of assembling costs. Miguel Angel Olea, p. 14.Note Mexico does not have other cost advantages and, because of the lower quality of its infrastructure, has some real disadvantages. Cost effective vehicle production in Mexico depends not only on the willingness of assemblers to make large capital expenditures to upgrade existing plants and significantly increase their scale of operation, See Miguel Angel Olea, p. 17. Olea attributes part of the 10 to 15 percent cost disadvantage of Mexican assembling plants to inadequate scale of operations. He suggests that the scale of operations would have to reach 2.5 million units per year (roughly a four fold increase) or 500,000 units per assembler for assembling costs to be competitive.Note but also on the willingness of the Mexican Government to solve infrastructure problems. Unless vehicle production becomes cost effective in Mexico, North American assemblers will serve the Mexican market from plants in Canada and the United States.

If Mexico becomes an effective low-cost producer and vehicle production expands dramatically, what will be the effect on vehicle assembly in the United States and Canada? According to the Womack scenario, Mexico would specialize in cheap entry-level cars and trucks for the entire North American market. Mexican small truck production for the U.S. market will become feasible with the elimination of the 25 percent U.S. tariff. See Womack et al. (1990) p. 266, where he states that "... some way must be found around the 25-percent American tariff on pickup trucks." NAFTA will eliminate this impediment for assemblers in Mexico.Note Plants in Canada and the United States would specialize in larger more expensive vehicles and would increase exports to the expanding Mexican market.

This optimistic scenario depends first upon the Mexican market being opened and second upon it growing significantly. NAFTA will open the Mexican market. Increased Mexican domestic demand for cars and trucks depends on whether the current policies of the Mexican government, including entering NAFTA, are successful in significantly raising the living standards of its 85 million people. Measures of the performance of the Mexican economy in recent years have been very positive, and projections of current growth rates suggest significant future improvement. Womack et al. predict that the Mexican market could expand from its current level of about 500,000 units to 2 million units by the year 2000. Womack et al. (1990), p. 266. See also Mark Scheinman, p. 4, who predicts that Mexican domestic sales of cars and trucks will probably surpass Canada's sometime between 1996 and 1998.Note However, some economists are very critical of the current Mexican government's export oriented policies, and suggest that the success of such policies depends on repressing wages, which in turn represses demand. See, for example, David Barkin, Distorted Development: Mexico in the World Economy, 1990), pp. 113-115.Note

If neither Mexican demand nor production capacity increases significantly, the effect of the integration of Mexico's automotive industry will have minimal effect on assembling in the United States and Canada. If Mexican production capacity increases dramatically but Mexican domestic demand does not, some of the excess production may be exported to the European Community and Asia. However, most of it will enter the North American market, with possible adverse consequences for assembling in both the United States and Canada.

The conclusions reached in an economic analysis of the possible effects of a NAFTA on the auto industry by Florencio Lopez-de-Silanes, James R. Markusen and Thomas F. Rutherford Florencio Lopez-de-Silanes (Harvard University and NBER), James R. Markusen (University of Colorado, Boulder and NBER) and Thomas F. Rutherford (University of Colorado, Boulder), The Auto Industry and the North American Free Trade Agreement: Employment, Production and Welfare Effects, First Draft, September 1992. Their model distinguishes between parts, engines and finished cars and between the Big Three and foreign firms. The analysis reports on three scenarios: (1) a free trade area with no content requirements and elimination of Mexican trade balancing requirements; (2) a free trade area with a content provision that must be satisfied for cars to be freely traded within North America; and (3) a free trade area with the content requirement and retention of the Mexican trade balancing requirement. The second scenario is closest to the terms of NAFTA and the conclusions reached by Lopez-de-Silanes et al. referred to in this chapter are those arising from the second scenario.Note suggest that this negative scenario will not materialize. Lopez-de-Silanes et al. conclude that assembling by the Big Three in Mexico will almost double, but that assembling in Mexico by foreign firms will decrease by almost 25 percent. This conclusion is not consistent with the extensive investment plans made by Nissan and Volkswagen, referred to above.Note Assembling by the Big Three will increase slightly in the United States and decrease slightly in Canada. However, assembling by foreign firms will increase by about 25 percent in Canada and decrease by about 35 percent in the United States. See Lopez-de-Silanes et al. pp. 31-32 and Tables IX and X on pp. 37-38. One would have thought that the relatively stringent rule of origin would have had the opposite effect on foreign (i.e. transplant) assembling in Canada and the United States. It is not clear from the Lopez-de-Silanes et al. analysis whether it is assumed that the content requirement must be satisfied for all vehicles produced in the NAFTA free trade area, or just by those intended for export from one NAFTA country to another. U.S. transplant produced vehicles destined for the U.S. market do not have to meet the NAFTA rules of origin. Except for trucks, Canadian and Mexican produced transplant vehicles destined for the U.S. market which do not satisfy the rules of origin are only subject to a 2.5 percent duty.Note

Parts

As with assembling, significant increases in Mexican parts production depend upon Mexico becoming a low-cost producer. The Mexican auto parts industry is particularly vulnerable to the integration that will take place under NAFTA. These producers have been protected for a long time and they are not efficient. As the NAFTA provisions are phased in, they will be squeezed by the maquiladora parts producers operating in the domestic market and by the increasing volume of imported parts that will be permitted during the NAFTA phase-in period. When the ownership restrictions are eliminated in 1999, the existing Mexican auto parts industry will also face competition from foreign-owned domestic parts producers.

If the Mexican assembling capacity and domestic demand increase as much as some predict, there should be a substantial new market for parts produced in the United States and Canada. Given the emphasis on just-in-time inventory practices in modern vehicle assembly, the principal beneficiaries of this market will probably be U.S. parts producers located in California, Texas and other states bordering Mexico. Parts producers in Canada are a long way from assemblers in Mexico and Canadian-produced parts have to cross two borders to reach the Mexican market.

Lopez-de-Silanes et al. predict that Mexican production of parts will increase by about 22 percent but that Mexican production of engines will decrease by about 28 percent by the Big Three and by about 68 percent by foreign firms. Lopez-de-Silanes et al., Tables IX and X, pp. 37-38. Overall they predict net employment losses for Mexico but net welfare gains, mainly resulting from lower prices for vehicles.Note They suggest that the predicted decrease in Mexican engine production is consistent with the view that investment in engine production in Mexico was largely because of Mexican content and trade balancing requirements. Lopez-de-Silanes et al. p. 32. Note, however, the observation made by Prestowitz et al. at p. 81, that the General Motors Ramos Arizpe engine plant can deliver a V6 engine to an American assembly plant at a cost saving of $200 compared with an identical engine from GM's American engine plants.Note According to the analysis, parts production will decrease only marginally in Canada and increase only marginally in the United States. Engine production by North American firms will increase by about 7 percent in the United States and by about 15 percent in Canada.

The Transplants

Given some of the positions advanced during the NAFTA negotiations, the transplants did not fare too badly. However, in some significant respects, they will be operating at a disadvantage vis ŕ vis the Big Three.

The NAFTA rules of origin are the same for all assemblers. However, the burden of compliance will fall most heavily on the transplants (which, in the case of Mexico, include one European manufacturer, Volkswagen) because of their ties to suppliers in third countries (Japan, Germany, Korea). Strict compliance with tracing could be difficult for all assemblers, and U.S. Customs can be selective in its enforcement practices. Over-zealous enforcement by U.S. Customs of the rules of origin against imported transplant vehicles could discourage transplant expansion in Canada and Mexico, but will not solve the Big Three's problems in the U.S. market with Japanese competition. As indicated above, precise and workable Uniform Regulations will narrow the scope for arbitrary enforcement.

The elimination of drawback will also affect the transplants more adversely than the Big Three. Both Mexico and Canada will have to significantly lower their external tariffs if their transplant assemblers are to be competitive with their U.S. counterparts.

The two tier structure continues in Canada, with only the Big Three and CAMI being entitled to Auto Pact benefits. However, the two tier structure proposed by the Big Three for Mexico, with a more favourable phasing out of Automotive Decree restrictions for existing assemblers (including Nissan and Volkswagen) did not materialize. See the Big Three letter to Carla Hills dated September 9, 1992, referred to above.Note Nonetheless, transplants that do not already have operations in Mexico will suffer some disadvantages. Until the Automotive Decree is phased out completely, only assemblers with operations in Mexico will be entitled to import new vehicles into Mexico. Honda has a motorcycle plant in Guadalajara and is the transplant most likely to establish assembly operations in Mexico. See APMA Study, p. 81. The definition of "vehicle" in paragraph 4 of NAFTA Annex 300-A specifically excludes "motorcycle" so that Honda would not be considered as an "existing producer of vehicles." Para. 1 of NAFTA Annex 300-A requires each Party to treat existing producers no less favourably than new producers. Thus, if Mexico offered a favourable arrangement to Honda to induce it to invest, it would have to offer the same arrangement to the existing producers.Note The Automotive Decree (as modified by NAFTA) would apply to a new Honda Mexican assembly operation in the same manner as to those of existing assemblers, except that the calculation of content would not be based on a reference value. This would be advantageous to Honda.Note A new Honda assembly operation in Mexico would be able to import new vehicles into Mexico because a portion of its investment in new plant and equipment would be credited to its extended trade balance.

Lopez-de-Silanes et al. predict that the foreign firms will be the big losers as a result of a NAFTA. The principal reason is because the Big Three, which rely very heavily on North American parts and engines, will benefit from rationalization of their North American operations significantly more than foreign firms, which are much less dependant on North American engines and parts. Lopez-de-Silanes et al. p. 35.Note According to this analysis, the negative effect on foreign firms is considerably aggravated by the content requirement. With the content requirement, Lopez-de-Silanes et al. predict that foreign firm vehicle production will drop by about 25 percent and that foreign firm engine production will drop by almost 55 percent. See Lopez-de-Silanes et al., p. 40, Table XII. In a North American free trade area without a content requirement, the analysis predicts that foreign firm vehicle production would drop by only about one percent and foreign firm production of engines would drop by about 38 percent. The validity of these conclusions depends on how the assumptions made in the analysis respecting the content requirement compare with the requirement actually imposed by NAFTA.Note

Canada's Position

The effect on Canada of the integration of the Mexican automotive industry into the North American one depends on whether Mexico succeeds in becoming a low cost producer of vehicles and parts and whether the dramatic increase in the Mexican domestic demand for vehicles predicted by some occurs. If Mexico does not become a low cost producer of vehicles and parts, the effect on Canada will be minimal. If Mexico becomes a low cost producer of selected products (such as entry-level vehicles and labour-intensive parts) and the Mexican demand for vehicles expands dramatically, the Canadian assembling and parts industries could benefit. However, U.S. parts producers located in the southwest United States will be in a much better position to benefit from increased Mexican demand than their Canadian counterparts.

The least attractive scenario for Canada occurs if Mexico becomes an effective low cost producer of vehicles and parts but a dramatic increase in Mexican demand does not take place. So long as Canadian parts producers are competitive with Mexican, Canadian parts producers will continue to be in a better position to serve assemblers located in the northeast United States. However, if Canadian costs of parts production are significantly higher than Mexican costs, new investment in parts production will be made in Mexico, at Canada's expense. The substantial protection given by the NAFTA investment provisions to investors from NAFTA countries will remove some concerns about investing in Mexico. In a reversal of past policy, Mexico has accepted the principle of prompt, adequate and effective compensation at fair market value in the event of an expropriation. See NAFTA Article 1110. The NAFTA investment provisions also contain investor/state dispute settlement procedures which will permit a U.S. or Canadian investor to bypass the Mexican judicial system in pursuing NAFTA rights.Note

The conclusions of the Lopez-de-Silanes et al. analysis are mildly positive for Canada. They predict a small overall employment gain for Canada with a zero effect on welfare. Lopez-de-Silanes et al., p. 31.Note

Other things being equal, the Auto Pact will continue to provide an incentive for assemblers entitled to its benefits to meet the safeguards by assembling vehicles in Canada and purchasing Canadian parts. However, if Canadian costs become greater than those in the United States and Mexico by any amount that is more than marginal, the incentives provided by Auto Pact duty remission will not prevent assembling and parts production from leaving Canada for the United States or Mexico.

Canada cannot prevent the integration of the Mexican automotive industry into North America by refusing to ratify NAFTA. Some suggest that the integration of the Mexican industry into the North American is well under way in any event and that NAFTA will merely facilitate the process. See Michael Hart, A North American Free Trade Agreement (1990), pp. 118-119.Note If Canada refuses to ratify NAFTA, the United States and Mexico will probably proceed with a bilateral free trade arrangement. If this occurs, Canada will be exposed to the down side of NAFTA with none of its potential benefits.

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