In a U.S. economy marked by price deflation in several consumer product categories, companies operating on razor-thin margins could face further price pressures and vulnerability if the U.S. withdraws from the North American Free Trade Agreement.
A U.S. withdrawal from NAFTA could cost retailers and manufacturers billions of dollars if it forces them to shift long-standing supply chains to more distant production areas including in Asia.
The squeeze on margins does not give companies much leeway to raise prices, particularly in a period of long-term deflation. But termination of the 23-year-old trade deal, considered a distinct possibility heading into 2018, is presenting a set of new challenges for companies that might be forced to absorb those costs or raise consumer prices and risk losing customers.
U.S. companies produce an array of goods in Mexico and Canada before they import them back into the states, including automobiles and parts, as well as denim and other consumer goods.
Those products cross the border, both ways, duty-free under NAFTA, saving companies billions of dollars annually in additional costs along the supply chain.
According to the Congressional Research Service, imports of textiles from Mexico and Canada could face U.S. tariffs as high as 20% under a NAFTA exit, while imports of apparel would face rates of up to 32%.
On the clothing front, foreign trade consultant International Development Systems estimates that 81.9% of all apparel imports under NAFTA were duty-free for the year ending Oct. 2017. For that same period, 94.9% of the 40.75 million square meter equivalents, or SME, of apparel imports from Canada were duty-free, while 81.2% of the 680.61 million SME of apparel imports from Mexico were exempt from tariffs.
Apparel brands and retailers are already caught in a bind because of consumer expectations that prices will remain low, said Julia Hughes, president of the U.S. Fashion Industry Association. Hughes said that without NAFTA, tariffs could reach as high as 32% for synthetic fiber garments, while cotton would generally reach somewhere in the 15%-to-16% range.
"It's a tough consumer environment versus what it used to be," Hughes said in an interview. "Wages are going up and prices are going up, which makes NAFTA pretty important."
Should the Trump administration withdraw from NAFTA, the U.S. could revert to "most favored nation" tariffs, which would be the lowest possible duty assessed by countries under the World Trade Organization.
Gary Hufbauer, senior fellow at the Peterson Institute for International Economics, estimated that should the U.S. revert to most favored nation tariff status with Mexico, the cost of imports from the southern neighbor would rise on average roughly 3%, however he noted that those tariff-related costs would rise by roughly 12% for clothing imports.
"Because of competition both from other suppliers and Amazon.com Inc., either Mexican suppliers or U.S. retailers will have to eat most of the higher tariffs," Hufbauer said in an interview. "My speculation is that Mexican suppliers will absorb at least two-thirds of the impact."
Companies would be forced then to either absorb those costs, or turn to other countries, including those in Asia or those that are part of the Central American Free Trade Agreement, to produce or assemble products. This could mean extra transportation costs and lag time for an already competitive retail industry. President Donald Trump can pull the U.S. out of the agreement by giving Canada and Mexico six months' notice, which would give companies limited time to develop new supply chains.
According to an S&P Global Market Intelligence analysis of the CPI index produced by the U.S. Bureau of Labor Statistics, several consumer goods products, including toys, footwear, televisions, household furnishings and supplies, and personal computers and peripheral equipment, have seen prices fall by at least 2% between October 2016 and October 2017. This leaves retailers with little pricing power, effectively forcing them to absorb the costs associated with losing the duty-free savings on products made in Mexico and Canada.
"The short message is if the U.S. withdraws, apparel supply chain retailers who generally use the agreement are going to look for other ways to enter the market that are more cost-effective," said Josh Teitelbaum, counsel for Akin Gump Strauss Hauer & Feld LLP in Washington. "This could involve going to an Asian supply chain. That's a risk that the U.S. needs to take into account in trying to conclude an agreement like this."
Big-box stores as well as grocery stores would also be forced to raise prices, predicted Rajeev Dhawan, director of the Economic Forecasting Center at the Robinson College of Business at Georgia State University.
"Whether you are at a grocery or at Wal-Mart Stores Inc., there's going to be an increase in cost," Dhawan said. "I doubt that Wal-Mart and other retailers can absorb it, and it will be passed on to the customer."
Dhawan said a nominal tariff of 1% to 2% can be absorbed, but a tariff of 5% or more, especially if product components cross a tariff border multiple times throughout the production and distribution process, can eventually add up.
"I don't think anyone has a 5% profit margin to give away," Dhawan said. "No company can survive like that. They have to raise the price. And then the demand goes down for that product."
Scott Hoyt, director of Moody's Analytics, said that he believes the impact on companies would be minimal because the increase in tariffs on most goods would be relatively modest.
"As long as there is a relatively amicable breakup of NAFTA, the increase in tariffs with both Mexico and Canada will be relatively small," Hoyt said. "Although there would be some impacts on costs, it wouldn't be huge and I'm not convinced it would necessitate a major re-shifting of supply chains."
He said there could be some impact because of intensifying competition in the retail industry coupled with the already high value of the dollar, but he expressed more concern in the event a trade war arises.
But especially vulnerable from a withdrawal is the U.S. automobile industry, Dhawan said, which relies heavily on parts sourced from Mexico. Unlike apparel and the broader consumer goods industry, the domestic auto industry would be the hardest hit by losing that duty-free access in Mexico because of the numerous border crossings throughout the production phase, which would make cost increases unsustainable, he added.
According to the Center for Automotive Research, NAFTA saves the U.S. automotive sector roughly $4.7 billion each year.
"That supply chain has no alternative," he said. "In the short run, there is no alternative for either the U.S. or Mexico. That is why the viability of our automakers and their profitability comes into question big time."
The Commerce Department declined a request for comment.
Where the talks stand
U.S. Trade Representative Robert Lighthizer has previously stated his intent to have talks wrapped up by the end of 2017 or January 2018, but that seems increasingly unlikely following a contentious fourth and a fifth round that concluded with the U.S. trade representative saying he has "seen no evidence" that either trading partner is "willing to seriously engage on provisions that will lead to a rebalanced agreement."
The next round of talks is scheduled for Jan. 23-28 in Montreal, where trade negotiators from the three countries may look to reconcile differences encountered in the first five rounds of talks. Canada and Mexico firmly rejected several U.S. proposals, including an American content requirement in North American-produced vehicles.
The U.S. countered by saying it was necessary to rebalance the trade deficit that currently exists with its NAFTA partners, followed by further strong rhetoric exchanged by all three nations.
Hughes from the U.S. Fashion Industry Association said as much as companies would like to prepare in the event of the six-month notice to withdraw, it simply is too hard to at this point.
"It's hard for companies to make the decision to change their sourcing strategy because they just don't know," Hughes said. "Is something going to happen next month? February? March? We just don't know."