North American Free Trade Agreement Bilateral Trade Effects

I. INTRODUCTION After several years of debate, the U.S. Congress on November 17, 1993, narrowly ratified the North American Free Trade Agreement (NAFTA), which went into effect January 1, 1994. The agreement links the United States with its first and third largest trading partners and creates a single market with over 360 million consumers and six trillion dollars in annual output. By immediately reducing and eventually eliminating the barriers to trade, the NAFTA has the potential to significantly affect trade between the three countries. The NAFTA is an expanded version of the U.S.-Canada Free Trade Agreement (FTA) signed in January of 1988. That agreement liberalized trade and investment in goods and services between the two countries. The NAFTA extends the agreement to Mexico, requiring it to implement the same degree of trade and investment liberalization with the United States and Canada. The NAFTA goes beyond the U.S.-Canada FTA by improving such aspects as intellectual property rights and rules against distortions to investment and by addressing other issues omitted from the U.S.-Canada FTA. These issues include subsidies, countervailing and anti-dumping duties, transportation services, and side agreements concerning labor and the environment. The NAFTA provides for phased elimination of tariff and most non-tariff barriers among the three countries within 10 years and includes a 15 year transition period for a few import sensitive products. Phasing out tariffs between the United States and Canada will continue in accordance with the terms of the U.S.-Canada FTA and will be complete by January, 1998. The benefits of the NAFTA arise from reducing and eventually eliminating trade barriers. The United States will benefit from expanded trade with a large and growing Mexican market. Mexico will benefit from increased access to the U.S. market, which accounts for three-quarters of Mexico's exports. For Canada, the NAFTA reinforces and strengthens its FTA preferred position in the U.S. market and provides equal access to Mexico's market. Examining recent trade flows between the United States and Mexico and between the United States and Canada confirms the benefits of trade liberalization. Before the NAFTA signing, Mexico and the United States agreed on a series of bilateral trade pacts, lowering trade barriers between the two countries. In 1986, Mexico joined the General Agreement on Tariffs and Trade (GATT), further reducing tariffs and import licenses. Since 1987, U.S. exports to Mexico have more than tripled to over $40 billion, making Mexico the fastest growing export market for U.S. products. The U.S. trade balance has shifted from a $5.7 billion deficit in 1987 to a $5.4 billion surplus in 1992. Trade between the United States and Canada also has experienced continued growth. Since implementation of the U.S.-Canada FTA, U.S. exports to Canada have increased 27 percent, exceeding $100 billion in 1993. This study determines, within the context of a vector autoregression (VAR) model, NAFTA's effects on the U.S. economy. In particular, it estimates changes in bilateral trade that likely will result from continued trade liberalization between the countries. The VAR model, which takes each explanatory variable and relates it to its own past value and to past values of all other variables in the system, allows flexible and dynamic analysis of trade flows. II. METHODOLOGY To determine trade flows between the United States and its major trading partners, Canada and Mexico, the analysis estimates import demand and export functions. It uses a VAR model to examine the interaction of the major variables related to international trade among the United States, Canada, and Mexico. In a VAR model, prior information guides the selection of variables to be included, but theoretical restrictions, such as exogeneity, are not imposed a priori. VAR models allow complete flexibility in specifying the correlations between past, present, and future realizations of the system variables and thus facilitate flexible and dynamic analysis of trade flows. …