Special Encore: Will US Tariffs Drive Mexico Closer to China?

Original Release Date November 22, 2024: Our US Public Policy Strategist Ariana Salvatore and Chief Latin America Equity Strategist Nikolaj Lippmann discuss what Trump’s victory could mean for new trade relationships.

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Andrew Sheets: 2024 was a year of transition for economies and global markets. Central banks began easing interest rates, U.S. elections signaled significant policy change, and Generative AI made a quantum leap in adoption and development.

Thank you for listening throughout 2024, as we navigated the issues and events that shaped financial markets, and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world. This week, please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January. From all of us on Thoughts on the Market, Happy Holidays, and a very Happy New Year.

Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore, Morgan Stanley's US Public Policy Strategist.

Nikolaj Lippmann: And I'm Nik Lippmann, Morgan Stanley's Chief Latin American Equity Strategist.

Ariana Salvatore: Today, we're talking about the impact of the US election on Mexico's economy, financial markets, and its trade relationships with both the US and China.

It's Friday, November 22nd at 10am in New York.

The US election has generated a lot of debate around global trade, and now that Trump has won, all eyes are on tariffs. Nik, how much is this weighing on Mexico investors?

Nikolaj Lippmann: It’s interesting because there's kind of no real consensus here. I'd say international and US investors are generally rather apprehensive about getting in front of the Trump risk in Mexico; while, interestingly enough, most Mexico-based investors and many Latin American investors think Trump is kind of good news for Mexico, and in many cases, even better news than Biden or Harris. Net, net, Mexican peso has sold off. Mexico's now down 25 per cent in dollar terms year to date, while it was flat to up three, four, 5 per cent around May. So, we've already seen a lot being priced then.

Ariana, what are your expectations for Trump's trade policy with regards to Mexico?

Ariana Salvatore: So, Mexico has been a big part of the trade debate, especially as we consider this question of whether or not Mexico represents a bridge or a buffer between the US and China. On the tariff front, we've been clear about our expectations that a wide range of outcomes is possible here, especially because the president can do so much without congressional approval.

Specifically on Mexico, Trump has in the past threatened an increase in exchange for certain policy concessions. For example, back in 2019, he threatened a 5 per cent tariff if the Mexican government didn't send emergency authorities to the southern border. We think given the salience of immigration as a topic this election cycle, we can easily envision a scenario again in which those tariff threats re-emerge.

However, there's really a balance to strike here because the US is Mexico's main trading partner. That means any changes to current policy will have a substantial impact.

So, Nik, how are you thinking about these changes? Are all tariff plans necessarily a negative? Or do you see any potential opportunities for Mexico here?

Nikolaj Lippmann: Look, I think there are clear risks, but here are my thoughts. It would be very hard for the United States to de-risk from China and de-risk from Mexico simultaneously. Here it becomes really important to double-click on the differences in the manufacturing ecosystems in North America versus Southeast Asia and China.

The North American model is really very integrated. US companies are by a mile the biggest investor. In Mexico – and Mexican exports to the US kind of match the Mexican import categories – the products go back and forth. Mexico has evolved from a place of assembly to a manufacturing ecosystem. 25 years ago, it was more about sending products down, paint them blue, put a lid on it. Now there's much more value add.

The link, however, is still alive. It's a play on enhancing US competitiveness. You can kind of, as you did, call it a China buffer; a fender that helps protect US competitiveness. But by the end of the day, I think integration and alignment is going to be the key here.

Ariana Salvatore: But of course, it's not just the direct trade relationship between the US and Mexico. We need to also consider the global geopolitical landscape, and specifically this question of the role of China. What's Mexico's current trade policy like with China?

Nikolaj Lippmann: Another great question, Ariana, and I think this is the key. There is growing evidence that China is trying to use Mexico as a China bridge.

And I think this is an area where we will see the biggest adjustments or need for realignment. This is a debate we've been following. We saw, with interest, that Mexico introduced first a 25 per cent tariff and then a 35 per cent tariff on Chinese imports. And saw this as the initial signs of growing alignment between the two countries.

However, Mexican import from China never really dropped. So, we started looking at like the complicated math saying 35 per cent times $115 billion of import. You know, best case scenario, Mexico should be collecting $40 billion from tariffs; that's huge and almost unrealistic number for Mexico. Even half of that would go a long way to solve fiscal challenges in that country.

However, when we started looking at the actual tax collection from Chinese imports, it was closer to $3 billion, as we highlighted in a note with our Mexico economist just recently. There's just multiple discounts and exemptions to effective tariffs at neither 25 per cent nor 35 per cent, but actually closer to 2.5 [or] 3 per cent. I think there's a problem with Chinese content in Mexican exports, and I think it's likely to be an area that policymakers will examine more closely. Why not drive-up US or North American content?

Ariana Salvatore: So, it sounds like what you're saying is that there is a political, or rhetorical at least, alignment between the US and Mexico when it comes to China. But the reality is that the policy implementation is not yet there.

We know that there's currently nothing in the USMCA treaty that prevents Mexico from importing goods from China. But a lot has changed over the past four years, even since the pandemic. So, looking forward, do you expect Mexico's policy vis-a-vis China to change after Trump takes office?

Nikolaj Lippmann: I think, I certainly think so, and I think this is again; this is going to be the key. As you mentioned, there's nothing in the USMCA treaty that prevents Mexico from buying the stuff from China. And it's not a customs union. Mexican consumers, much like American consumers, like to buy cheap stuff.

However, the geopolitics that you refer to is important. And when I reflect, frankly, on the bilateral relationship between the two countries, I think Mexican policymakers need to perhaps pause and think a little bit about things like the spirit of the treaty and not just the letter of the treaty; and also about how to maintain public opinion support in the United States.

By the end of the day, when we see what has happened with regards to China after the pandemic, it has been a significant change in political consensus and public opinion. When I think Americans are not necessarily interested in just using Mexico as a China bridge for Chinese products.

During the first Trump administration, the NAFTA agreement was renegotiated as the US Mexico Canada agreement, the USMCA, that took effect or took force in mid 2020. This agreement will come under review in 2026.

Ariana, what are the expectations for the future of this agreement under the Trump administration?

Ariana Salvatore: So, I think this USMCA review that's coming up in 2026 is going to be a really critical litmus test of the US-Mexico relationship, and we're going to learn a lot about this China bridge or buffer question that you mentioned. Just for some very brief context, that agreement as you mentioned was signed in 2020, but it includes a clause that lets all parties evaluate the agreement six years into a 16-year time horizon.

So, at that point, they can decide to extend the agreement for another 16 years. Or to conduct a joint review on an annual basis until that original 16 years lapses. So, although the agreement will stay in force until at least 2036, the review period, which is around June of [20]26, provides an opportunity for the signing parties to provide recommendations or propose changes to the agreement short of a full-scale renegotiation.

We do see some overlapping objectives between the two parties. For example, things like updating the foundation for digital trade and AI, ensuring the endurance of labor protections, and addressing Mexico's energy sector. But Trump's approach likely will involve confronting the auto EV disputes and could possibly introduce an element of immigration policy within the revision. We also definitely expect this theme of Chinese investment in Mexico to feature heavily in the USMCA review discussions.

Finally, Nik, keeping in mind everything that we've discussed today, with global supply chains getting rewired post the pandemic, Mexico has been a beneficiary of the nearshoring trend. Do you think this is going to change as we look ahead?

Nikolaj Lippmann: So, look, we [are] still underweight Mexico, but I think risk ultimately biased with the upside over time with regards to trade.

We need evidence to be able to lay it out, these scenarios; Mexico could end up doing quite well with Trump. But much work needs to be done south of the border with regards to all the areas that we just mentioned there, Ariana.

When we reflect on this over the next couple of years, there's a couple of things that really stand out. Number one is that first wave of reshoring or nearshoring, which was really focused on brownfield. It was bringing our manufacturing ecosystems where we already had existing infrastructure.

What is potentially next, and what we're going to be watching in terms of sort of policy maker incentives and so on, will be some of the greenfield manufacturing ecosystems. That could involve things like IT hardware, maybe EV batteries, and a couple of other really important sectors.

Ariana Salvatore: And that's something we might get some insight into when we hear personnel appointments from President-elect Trump over the coming months. Nik, thanks so much for taking the time to talk.

Nikolaj Lippmann: Thank you very much, Arianna.

Ariana Salvatore: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen, and share the podcast with a friend or colleague today.