Canada Must Decide: It’s Either a Nafta Deal or a Smaller Economy

By Anonymous

OTTAWA—The consensus is unequivocal: Canada can’t afford to be shut out from the North American Free Trade Agreement.

Uncertainty over the future of the three-nation trade pact has already taken a toll on the country’s economy and contributed to the Bank of Canada’s cautious approach to raising interest rates. Business investment slowed in the second quarter, according to data released this week, a move analysts partly attribute to potential trade disruptions. Bank of Canada Gov. Stephen Poloz has warned that some domestic companies are dialing back investment plans, while those with U.S. operations are choosing to expand in that country to hedge against Nafta risks.

After more than a year of negotiations, Nafta talks are coming to a head this week, with Canadian and U.S. negotiators rushing toward a U.S.-imposed Friday deadline. As of Friday morning, officials remained apart on some key issues, such as agriculture and how to resolve disputes over tariffs.

The risk of being shut out of Nafta comes as Canada’s economy was starting to hit its stride after dealing with a painful slowdown in recent years that was fueled by the slump in global commodity prices.

“The Canadian economy would be smaller than where it is today without Nafta,” said Karl Schamotta, chief market strategist at foreign exchange firm Cambridge Global Payments. The latest economic data put the size of the Canadian economy at 1.878 trillion Canadian dollars ($1.446 trillion), or 10th largest in the world. “The lack of access to the U.S. under a free-trade pact would have a long-term deleterious effect on the Canadian economy.”

Three-quarters of Canadian exports, or the equivalent of one-fifth of Canada’s gross domestic product, are U.S. bound.

The effect of uncertainty over Nafta talks was visible this week in an otherwise strong second-quarter report on Canada GDP. While the economy grew 2.9% annualized, business investment in the three-month period—dominated by heightened U.S.-Canada rhetoric on trade—decelerated to 0.4%, or its slowest pace of growth since late 2016.

Of the three countries in Nafta, Canada stands to lose the most from its potential demise, economists say. The Bank for International Settlements said in a report last week a complete revocation of Nafta would cause a 2.2% decline in Canada’s GDP, while Mexico’s GDP would fall by 1.8%. U.S. GDP, in contrast, would sustain a relatively meager 0.22% hit.

Mexico reached a deal with the U.S. earlier this week, and officials from both countries have warned they are prepared to move forward with a bilateral pact if Canada doesn’t sign on.

A failure to reach a breakthrough on Nafta, along with the threat of further U.S. tariffs, could disrupt the Bank of Canada’s plans to raise interest rates to more normal levels, after keeping them rock-bottom for years in the aftermath of the financial crisis.

Ultralow interest rates fueled a housing craze in Canada, helping to push household debt to one of the highest levels among advanced economies.

As it stands, Canada’s central bank is expected to keep its key interest rate on hold next Wednesday amid uncertainty over the outcome of Nafta negotiations. However, market participants widely anticipate the central bank will lift the key rate by a quarter of a percentage point at its following policy announcement in October, bringing it to 1.75%, due to solid economic indicators and rising inflation. That view could change if Nafta talks falls apart.

A full termination of Nafta, combined with more tariffs by the U.S., “would hurt the economy relatively quickly,” Bank of Montreal chief economist Doug Porter said. “I think the Bank of Canada would, at least for a while, move to the sidelines,” he said, adding rate cuts could then be a possibility.

The Bank of Canada estimated in July that trade uncertainty, coupled with existing U.S. tariffs, will subtract about 0.7% from the level of GDP by the end of 2020. The central bank hasn’t weighed in on the possible impact of a Nafta revocation or U.S. auto tariffs.

Write to Kim Mackrael at [email protected] and Paul Vieira at [email protected]