the Beatty Blog

Some stray thoughts from the front line of the trade war

Timing is everything

The 2024 sales numbers for North America are in and they revealed more of the same for Canada and a surprising breakthrough in the United States.

In Canada, the Ford F-150 was once again the number one selling vehicle. In the United States, however, the Ford was overtaken by the Toyota RAV4, which grabbed the number one position for the first time.

Talk about timing. The RAV4 is primarily built in Canada and exported to the US. Meanwhile the Ford is built in the US and shipped to Canada. One offers the US a platform for demanding further tariffs against auto imports and the other becomes a leading target for Canadian countervailing duties. In both cases it will be North American drivers, whose preference for these vehicles made them leaders in the two markets in the first place, who will ultimately pay the price if tariffs are imposed. That market disruption will kick off a ripple effect through North American supply chains for the two companies (and all the others about to be impacted by proposed tariffs).

How would President Trump’s proposed tariffs impact the Canadian auto industry?

Actually nobody really knows. Before you can do the calculation, you first need to know the rules and those have not been spelled out by the US. With the rules in hand, you would have to factor in the different business structure of each of the Automotive OEMs currently manufacturing vehicles or powertrain components in Canada. Those differences mean that each OEM will be affected differently by these tariff rules.

For example, Ford doesn’t currently assemble any vehicles in Canada but does have an engine plant in Windsor. According to a Ford spokesperson, the company sources some 90% of its steel from the US and 10% from Canada. Since everyone including the White House seems to use the word steel as a short form covering both iron and steel, I am going to apply the same logic to Ford operations in Canada. As things stand, the 25% duties that are supposed to kick in against imports from Canada would apply to engines made in Canada. That would certainly have a cost impact on a truck built in the US but would be a fraction of the value of the finished vehicle. And if future 232 tariffs are applied to engines as an extension of the steel and aluminum order, the logical thing for Ford to do (until it has an alternative source of engines is to substitute US metals for Canadian ones), thereby avoiding any additional tariffs.

While Canada may impose countervailing duties of its own, the Canadian government will not increase manufacturing costs if it doesn’t have to. It is therefore reasonable to assume that drawback will apply any dutiable metal that was subsequently reexported in the form of a finished engine.

In a case like this, the countervailing duties that the Canadian government might apply to finished vehicles could have a much greater impact on Ford’s bottom line. A 25% increase in the landed cost of an F-150 would significantly impact the company’s Canadian business. Ford sold 1.96 million vehicles in the United States in 2024. In Canada, the company notched sales of over 279,000 vehicles. Of course, popular vehicles like the Maverick and Escape are built in Mexico so are unlikely to be caught by countervailing duties. But, for simplicity, let’s imagine that all of their Canadian sales were affected by duties. That means that over 12% of Ford’s combined sales in Canada and the US would be hit with a 25% price increase (at today’s level of threatened duties). On the other hand, there are Canadian, Mexican, European or Asian substitutes for Ford products that would continue to be available to Canadians on a duty free basis. This would significantly alter the competitive balance in Canada.

Similarly, roughly 85% of the over 530,000 vehicles produced in Canada by Toyota last year were destined for US customers. A 25%, tariff-induced price increase in the US would put those Canadian vehicles at a significant disadvantage against US-built vehicles or other imports that were not subject to the same, high tariffs. The Canadian market is simply not large enough to compensate for losses in the United States. Something would have to give.

You can run a similar analysis for each of the OEMs and come to a rough assessment of the impact a potential trade war would have on those companies. I would expect that each one, once the final tariff package on both sides of the border is known, will beat a path to Washington and Ottawa to seek concessions.

While 232 tariffs in the US are not eligible for waivers, Canada’s tariff regime is much more flexible. Both industry and government need to be doing a bottom line analysis and be prepared to trade investment guarantees for market access in Canada. This isn’t just about manufacturing. Since services are not subject to tariffs, someone should be thinking about how to rebuild head office functions, engineering and software development and connected services in Canada. Those functions are not as “sticky” as bricks and mortar investment in manufacturing but they are critical to building next generation competitiveness for Canada.

Exponential Existentialism

Absent a trade agreement, the method generally used to determine the origin and classification of a good is the concept of substantial transformation. The US Department of Commerce defines substantial transformation as follows: “Substantial transformation means that the good underwent a fundamental change in form, appearance, nature, or character. This fundamental change normally occurs as a result of processing or manufacturing in the country claiming origin. Additionally, this change adds to the good’s value at an amount or percentage that is significant, compared to the value which the good (or its components or materials) had when exported from the country where it was first made or grown.”

A trade agreement between two or more countries may introduce more complex rules of origin designed to achieve specific policy outcomes. For example, the USMCA automotive provisions outline three separate rules of origin (regional value content, regional value thresholds for certain parts, and a labour value content rule) each of which must be met, in order for a vehicle to receive duty-free status. These types of rules vary between different free trade agreements.

The recent announcement by the Trump Administration that the US would apply reciprocal tariffs to its trading partners, taken at face value, effectively outsources US tariff policy to other countries. In this scenario, if a trading partner applies a different tariff to US goods than the US currently applies to imports from that partner, the US would adjust its tariffs to match.

Douglas Irwin, a Dartmouth University professor, has calculated that, with roughly 200 countries in the world and 13,000 separate tariff lines, the US would end up with some 2.6 million specific tariff rates by product and country of origin.

The takeaway from all of this is that the individual tariff adjustments may or may have a significant impact on prices as many countries have free trade agreements with the US or apply lower average rates of duty than the US does. However, the sheer complexity of the system is likely to cause a breakdown of the US trading system. This complexity is not a big deal for simple products, say a baseball bat made from American hickory. But for complex products like automobiles that may have tens of thousands of individual components, managing duty costs will be a significant barrier to doing business.

Add the possibility of special tariffs on intermediate inputs such as steel and aluminum and the cost reduction task becomes formidable. Some duties on goods imported to the US for further processing or assembly can be refunded to the importer if those goods are subsequently exported, others cannot. So effective management of input costs will not only be a task of correctly identifying the origin and applicable rate of duty but also managing business logistics in a way that ensures that duty costs don’t get baked into goods as they cross borders in North America.

Take the enormously overhyped example of an auto part that crosses a border multiple times through to its eventual incorporation in a finished vehicle. If both the raw material used to produce the part and one of its intermediate stages were subject to Section 232 duties, where no US duty drawback is permitted, you would want to build a process flow where the only time that the product crossed the US border was when it would attract the lowest rate of duty. This may or may not align with companies’ current supply chain dynamics.

The implication of all this is that companies will need to make greater use of free trade zones and shipment in bond in order to prevent goods from accidentally attracting US duty. On top of that, the potential for enormous complexity means that companies, brokers and national customs agencies will have to develop and deploy smart systems that can more accurately trace and classify goods.

We are moving ever closer to the day when a digital passport for goods will be required — a kind of goods “genome project” where all of the relevant data on a product would follow it through the supply chain. This type of digital fingerprint is needed not just to handle the problem of a 2.6 million line tariff code but also the additional requirements that governments are imposing on goods to address problems such as child and forced labour.

Of course this doesn’t just apply to inputs to manufacturing. OEMs have centralized much of their parts distribution system in North America, including for repair and service parts. Parts logistics systems need to be rethought to avoid unnecessary tariff costs. An OEM that allows US tariffs to impact their catalogue price in Canada will be at a disadvantage against aftermarket players such as retail chains that import directly to Canada.

A Thought for Mark Carney: Taxes Aren’t Better Than Tariffs

As everyone in federal politics has taken great pains of late to distance themselves from consumer carbon taxes, Mark Carney has introduced a new wrinkle. In a speech in Halifax a couple of weeks ago, Mr. Carney made it clear that he favoured the introduction of Carbon Border Adjustment Measures (CBAMs).

The theory behind CBAMs is that countries with carbon taxes, or those that have invested to measurably lower their carbon footprint, should level the playing field by taxing imported materials or goods that come from countries that have not similarly reduced their carbon footprint. Europe proposes to introduce CBAMs on certain materials and precursors such as steel, aluminum, cement, electricity and hydrogen in 2026. Essentially, this is just a tariff masquerading as a tax but is defended as a measure to level the playing field between trading partners with differing carbon prices/footprints.

Applied between Canada and the US, the theory would hold that, because Canada has a cleaner electric grid and also applies industrial carbon taxes, an adjustment tax should be added to imports of commodities such as steel from the US. That would be in addition to any countervailing duties in effect at the time of import.

It’s easy to imagine that this would create a feedback loop in the proposed US reciprocal tariff policy. If so, the cost of trade in both directions would rapidly spiral out of control. Calculating and remitting those taxes would create another level of administrative burden for companies in Canada. Remember, costs borne by industry ultimately have to be passed through to the marketplace. Hopefully Mr. Carney will rethink his platform if he wins the leadership and the eventual, next general election.

Save Us From The Well-Intentioned

Flavio Volpe, President of the Automotive Parts Manufacturers Association penned an article for the Toronto Star last week (https://www.thestar.com/opinion/canada-didn-t-steal-the-auto-sector-from-the-u-s-we-built-it-together/article_211386e0-e97a-11ef-beb6-7f57cf38beca.html?utm_medium=social&utm_source=copy-link&utm_campaign=user-share).

In that opinion piece, Mr. Volpe points out that the Canadian and US auto sectors grew together and that Canada helped build the industry alongside the US, implying that Trump tariff actions are therefore unnecessary. By way of example, he cites the fact that just one year after its founding, the Ford Motor Company made Canada the “first global outpost of American auto manufacturing”. The unfortunate truth however is that move only happened because Canada maintained a high tariff wall that required Ford to manufacture here rather than exporting from Detroit. In turn, tariff access to the Commonwealth encouraged Ford to make Canada the headquarters of its international arm for a period of years. This anecdote doesn’t do much to combat the Trump narrative that Canada stole US manufacturing.

As a further defence of the importance of Canada to the North American auto industry, Mr. Volpe goes on to note that over half of the vehicles produced in Canada are built by non-US headquartered companies. Again, unfortunately that just plays into protectionist hands in the United States, who are already concerned about the possibility of its North American trading partners becoming a “back door” into the US market.

Whether true or not, sometimes it is better just to keep certain arguments out of the public debate.

Tariffs and the Collapse of the EV Market

In all of the fuss and furor over the sudden collapse of consumer purchase incentives for electric vehicles in Canada last month, one thing that was overlooked was the fact that the zero emission vehicle (ZEV) marketplace in Canada is governed by ZEV regulations at the federal level and in Quebec and BC. Those regulations include an adjustment mechanism where companies that oversell the percentage of ZEVs required in a given year are able to sell that surplus in the form of credits to companies that have underperformed against their target requirements.

Tesla, by virtue of being an EV-only manufacturer has been a net generator of those credits. Other companies have purchased credits to meet their regulatory requirements. Without getting into the minute details, a credit at the provincial level has a capped value of roughly $20,000 (the penalty cost applied per credit by the provinces), while the federal system is allowed to float. The credits always sell at a significant discount because manufacturers would rather pay a penalty to the government than subsidize a competitor if the price of a credit is equal to the penalty.

Here’s what happens next: if tariffs are applied on vehicles on both sides of the Canada-US border, any EV sales decline to date will be compounded by a sudden, larger tariff cost increase on US-made electric vehicles, the vast majority of which are Teslas. One would expect that massive price inflation of Teslas over a very short period of time would cause their Canadian sales to collapse.

As that happens, the ZEV credit market will also collapse, causing other manufacturers to have to quickly reconfigure their sales strategies across Canada. At a $20,000 per credit penalty, no manufacturer can sustain a strategy of missing its ZEV sales ratio. Deep manufacturer subsidies to support additional ZEV sales (difficult to do given tight margins on these products) or sharp reductions in sales of other vehicles are the only options available to companies in this scenario.

Here’s a prediction: if the tariffs come to pass, it won’t take long before the federal and provincial governments suspend their ZEV mandates. Unhappy consumers forced to pay more on average for vehicles to pay government fines or facing vehicle shortages in local showrooms will quickly become unhappy voters. Incumbent governments will ignore that mood at their peril.

We live in interesting times here on the front line of the trade war.