Canada's Next Move: NAFTA or TPP?

Canada has spent the last year enjoying the spotlight as a globalization leader. Ottawa waited patiently last fall as the tiny Belgian region of Wallonia briefly, but seriously, threatened to scupper its newly signed trade deal with the European Union.

The first 10 months of the Trump administration have also posed their own special challenges. The Trudeau government has had to withstand repeated public berating from a populist American president on issues such as softwood lumber and dairy. And Canada has been forced to respond diplomatically to a Trump administration that has made highly regressive proposals in the North American Free Trade Agreement (NAFTA) renegotiations.

Canada has remained a bulwark until the recent Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) talks in Da Nang. The CPTPP was being pitched as a successful rebuke to President Trump withdrawing the United States from the original, 12-country TPP agreement that President Obama had signed in 2016. In Da Nang, the Trudeau government reportedly held up the final new Pacific deal partially out of concern for its auto industry, the main Canadian manufacturing export.

The situation now facing Canada is being framed as a stark choice: play the good global actor and stand up for the international order, or succumb to more narrow self-interest? Even worse, some have indicated that the holdup was a tactical move to deal with its NAFTA renegotiations with President Trump.

The unfortunate truth is that Canada was never in love with the TPP. And now, Canadian interests in the new Pacific agreement depend heavily on whether NAFTA remains in place. Given the uncertainty of the Trump administration, efforts to finalize a CPTPP that includes Canada may be hard.

Canada is playing it safe and keeping CPTPP warm while renegotiating NAFTA.

Canada's automakers and workers opposed the original TPP that included America. They have enjoyed duty-free access in their big southern neighbor for decades and were not enamored with suddenly sharing that market with efficient producers from Japan. (Canada's dairy sector had also opposed TPP, but the TPP negotiations had left much of their protection intact.)

Canada's auto sector already underwent a tremendous period of adjustment when faced with increased competition from Mexico, especially in the US market, starting in the mid-1990s under NAFTA. Worried about a repeat of this experience, Canada was hesitant to take a seat at the original TPP negotiating table, but with the United States in TPP, Canada had no choice but to join.

During negotiations, Canada's main concern for were the auto rules of origin. The rule negotiated in the TPP is that 45 percent of the value of a car must be made in the region to be traded freely. The corresponding rule in NAFTA is currently 62.5 percent. To protect its role in the North American supply chain during the TPP negotiations, Canada pressed for a stricter rule to make TPP preferences for Asian suppliers harder to achieve.

The irony is that President Trump's decision to pull the United States out of the TPP actually helps Canadian auto production, as the US market remains protected from Asian competition. Other major CPTPP countries like Japan, Vietnam, and Malaysia will not enjoy the same zero-tariff access to the US market for autos and parts. The big Japanese auto companies, like Toyota, which are already heavily engaged in Canada, are likely to invest even more with both CPTPP and NAFTA in place.

A CPTPP would result in Canada reducing its import tariffs on the Pacific countries. Because the big car companies invest in Canada primarily to export to the United States through NAFTA, the tariff cuts are unlikely to lead to a major displacement of Canadian automotive content by new Asian parts. And the higher rule of origin in NAFTA protects them because content must be US, Canadian, or Mexican to receive duty-free access. Since car companies in Canada export more than 80 percent of their production, they are unlikely to start to procure substantially more content from Asia with the CPTPP.

The problem for Canada is that its attractiveness as a manufacturing hub depends heavily on NAFTA remaining intact. What happens if NAFTA disappears?

While Canada would still be a convenient location to reach the vast US market, some of the financial attraction would dissipate. Thus, without NAFTA, Canada might find the CPTPP even more important as a tool to help diversify its exports away from America.

But if NAFTA is dead, Canada may also want a somewhat different kind of TPP deal.

For example, Canadian-made cars—which are produced with significant US content—are unlikely to meet the 45 percent rule under CPTPP.

Because US-based automotive content is so deeply embedded in the North American supply chain, the CPTPP would offer little new market access to Canadian producers.

The longer the NAFTA talks drag on, the more likely that Canada will need to make a call on whether to go forward with the CPTPP.

With NAFTA in place, this is no big deal—nothing would change, as Canada's auto exports already go almost entirely to the United States. But, without NAFTA, a Canada that is seeking to expand and diversify its exports may want lower rules of origin in its new CPTPP.

Compounding matters is the very concern, repeated frequently by the US administration, that illicit Asian content is somehow finding its way into the United States via the NAFTA backdoor. If Canada ratifies CPTPP, the duty-free access offered to Japanese auto parts companies could provoke politically a US administration already preoccupied with rules of origin and concerns with Asia.

With the bulk of Canada's exports going to the United States, it is therefore no surprise that the top concern from Ottawa is NAFTA. How the Trump administration will react to Canada embracing the 11-country CPTPP during the NAFTA renegotiations is anyone's guess.

At this point, Canada is playing it safe and keeping CPTPP warm while renegotiating NAFTA. This strategy makes sense. The ongoing Trans-Pacific Agreement discussions may even potentially offer them some leverage during NAFTA negotiations.

But the longer the NAFTA talks drag on, the more likely that Canada will need to make a call on whether to go forward with the CPTPP. Given a desire for export diversification and its vocal support for globalization, Ottawa should go all in. With or without NAFTA, Canada has much to gain from greater integration with Asia.

And politically? With its southern neighbor falling asleep at the wheel, ratification of the new CPTPP trade deal would project a Canada that punches well above its weight on the global stage.

Follow @ChadBown and @CarolineFreund on Twitter.