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Tuesday, December 20, 2016

Mexican Tariffs and the Auto Industry

Michael Smitka
Economics, Washington and Lee University

During the election campaign Trump promised to levy a 35% tariff on trade with Mexico. Under both Section 201 and Section 301 of US trade law the President has power to impose unilateral trade measures without going through Congress. So he could, if he chose, impose tariffs on January 21st. He's also promised to tighten up the border. What would those two policies do to the industry?

...there's a silver lining in Wilbur Ross as Commerce Secretary...

Automotive trade within NAFTA is huge. During January-September 2016, the US exported $2.6 billion in vehicles and $21.7 billion in parts to Mexico, a total of about $25 billion. At the same time, it imported $41.7 billion in parts and $17.1 billion in vehicles, for a total of over $80 billion. Trade with Mexico is thus double the $39 billion in cars and parts imported from Japan during the same period, and 40% more than the $48 billion of the light trucks, cars and parts the US imported from Canada. Those US exports represent a lot of jobs, and those imports support a lot of jobs.

What does this trade consist of? Some reflects the logic of comparative advantage. A modern car may have two miles of wiring, assembled into harnesses by a factory full of workers standing at pegboards, laying out wire according to pattern and then bundling them together with special tape and fasteners. This process has proved immune to automation, and so is labor intensive, but is relatively unskilled work. A higher wage leads directly to higher costs. But doing it right is critical. Fixing wiring problems has long been one of the most costly and most intractable source of new car warranty claims. Skills may not matter, but experience does, and having a plant with management systems and maintenance personnel and knowledgeable foremen in place is critical. Moving factories thus risks skyrocketing warranty costs and much higher labor costs. In addition, it's not clear where in the US you would find sites with thousands of unemployed yet highly motivated workers. Worse, at present there is almost no harness production in the US – or similarly in Japan. (I don't know about Europe.) You have to build a whole new plant, not just scale up an existing one. Doing that, and ramping up production gradually to keep quality in line, means that any shift would require at least two years, and moving the whole sector would require several more years, to train new managers and maintenance staff – unless Trump grants the current factory teams in Mexico work visas. So a higher tariff would result in higher costs, not more jobs.

But how much higher? Let's do a sample calculation using round numbers for a part that costs ₱320. In early 2016, when the Mexican peso was at ₱16 per dollar, that part would thus cost US$20. But because of worries about protectionism, among other factors, the peso has since depreciated to under ₱20 per dollar. (Again, I keep numbers round, the actual rate at 4:24 EST on 20 Dec 2016 was 20.4562.) So today it costs only US$16. Add a 35% tariff and the net cost jumps to $21.60. That's 8% more than the start of the year, painful when repeated across many parts (and wire harnesses are one of the most expensive purchases a car company makes, only seats run more). But it is not an immediate disaster.

This however is an underestimate. For Delphi, the wire is imported from a highly automated plant in Warren Ohio that draws wire from copper bars, twists them into a bundle (even the smallest gauge automotive wire is multi-strand, for flexibility and robustness to defects) and then adds insulation. Automotive sheet steel comes from US mills. Many other specialized components come from a single factory – that economies of scale thing – and many parts include elements that have crossed the US-Mexican border more than once. Indeed, on average imports comprise 40% of the cost of what Mexico exports.

So let's revisit the tariff calculation, using 50% imported content for clarity. So initially we have the same ₱320 part, where US$10 (₱160) was imported from the US and ₱160 consists of Mexican value added (wages, overhead, profits). Now we still have ₱160 in local costs, but the imported portion now runs ₱200. So total cost is ₱360, and at ₱20/dollar the pre-tariff cost is now $18. Add the 35% and it now runs $24.30. That's 21% price hike, and no longer trivial. Furthermore, the more the Mexican peso depreciates, the worse the impact, because half the tariff is on the unchanging cost of Made in USA content. Of course this increase in the costs of imported parts will make automotive exports from the US less competitive. The bigger bottom line is that it will be a big tax on American consumers: car prices will go up, but very few jobs will return.

...car prices will go up, but few jobs move...

How about cars themselves? Ford will build the Fiesta in Mexico, not the US. Audi will make the Q-series there, too. The reason is Mexico's FTAs (free trade agreements) with 45 countries, far more than the US has, and including Europe, Japan and China. Cars exported from the US to Europe incur a 10% tariff; cars exported from Mexico enter free. And many of Mexico's trading partners – absent their FTA with Mexico – have automotive tariffs far above 10%. That's a big deal, and is what drives assembly plants to locate to our south. Labor may be a little cheaper, but that's not the driver, because even in developed countries it's less than 10% of the ex-factory cost of a car. Cheaper labor saves a few percent. Lower tariffs save 10% or more.

Furthermore, boutique firms such as Audi aside, Mexico makes small cars. Now much of the Fiesta output will be exported, but only some of that will be to the US. We don't buy small cars, so if production were moved to the US midwest, much of output would still need to be exported. But add a 10% tariff and it can't be sold in Europe. Add higher tariffs, and it can't be sold in South America. Moving production to the US would make it impossible for the Fiesta to be profitable, not because of expensive labor, but because Ford wouldn't be able to run the plant at capacity without the FTAs in place that enable exports. (In this particular case, Ford doesn't in fact have idle capacity. Building a new assembly plant would take years, and mean that the Fiesta would lose even more money.)

But there's another issue that lies in the background: logistics. Trump has promised to tighten things at the border. Because of NAFTA, however, we don't collect a lot of tariffs and so have no need for a large customs staff in Laredo and at the other major crossings. But the automotive supply chain operates on a just-in-time basis. There's only 3-5 days inventory in the pipeline, and even less for Toyota's plant in Texas, which is remote from the midwest supply base and so relies more heavily than most on parts plants in Mexico. Close the border for a week, and every assembly plant in the US and Canada will be forced to shut down, and parts plants with them. That's hundreds of thousands of jobs, a disaster for the economy and something even Trump would have a hard time spinning positively – plus layoffs would be concentrated in the region that gave him his electoral college victory.

There is a silver lining in Trump's naming of Wilbur Ross as his Commerce Secretary. Ross owns International Automotive Components (IAC), which concentrates on making interior parts, door panels, headliners and the like. Many of the components in IAC's portfolio are labor intensive, and it's a competitive segment with thin margins. So since Ross put together IAC in 2005 from a group of failing and bankrupt parts companies, IAC has opened numerous plants in Mexico and in China as a matter of strategic survival. Ross understands very well what tariffs would do to the industry. Furthermore, Trump trusts him – Ross was instrumental to Trump surviving the bankruptcy of his Atlantic City casinos. But it's the silver lining to a dark cloud: Trump may not bother turning to Ross for advice.