This week, trade talks between the United States and Mexico came to an agreement. It was called the United States-Mexico Trade Agreement, replacing the North America Free Trade Agreement (NAFTA) name, though much of the agreement includes updates on provisions about the digital economy, automobiles, agriculture and labor unions. Negotiations with Canada also took place this week, and it's expected they are likely to join the agreement soon. The main focus of having zero tariffs for American companies operating in Mexico and Canada remains intact, and hence there is a sigh of relief among international investors.
What is interesting is that there is a foreign exchange provision in this agreement, where the U.S. and Mexico will commit to maintaining transparency about how they manage their currencies. Plainly speaking, a country cannot unreasonably make their currency weaker to help their exports become cheaper.
Understandably, exchange rates matter. For instance, the USD index has risen by 5 percent since May of this year — that's a material rise in USD-denominated goods costing that much more within three and a half months. A certain percentage of tariff increase or reduction seems minimal compared to these magnitudes of FX rate fluctuations.
It's difficult to call countries with flexible exchange rates “currency manipulators," since it is not the central bank but the supply and demand of the FX market participants that decide the value of a currency. The central bank can only indirectly affect the value by their monetary policy, though the central banks' mandate is not targeting exchange rate bands but inflation and employment. And while the MXN has had a history of weakening during the past few years, the Banco de Mexico this year has been active in raising rates to curb inflation, resulting in the MXN actually outperforming many of the major currencies.
So for the NAFTA countries, this currency provision should not be an issue. In fact, Mexican Economy Minister Ildefonso Guajardo enforced this clause saying that they are committed to transparency in currency matters.
My View: The stronger currency clause for the NAFTA replacement may be part of the preparation for the eventual trade negotiations with China, as China still holds a quasi-fixed exchange rate. Fixed exchange rate regimes are typically held by less developed countries whose currency values may be under attack anytime because they are small and have a current account deficit that needs to be funded by foreign capital. China's economic picture is completely the opposite (where they have always had trade surpluses), and they are no longer a small nation.
President Trump has not been shy about calling China a "currency manipulator." Tougher language on currencies may potentially give more leverage to the U.S. in future trade negotiations.
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