The Changing Threshold of North American Supply Chains

Impacts from the COVID-19 pandemic cascaded across a range of industries and elements of the global economy, bringing important lessons for both the public and private sectors. Chief among them was that the reliance on long supply chains, ultimately dependent on production in a single country or factory, placed countries, individual companies, and the larger economy at risk. While this new understanding about the limits of extended supply chains did not begin with the pandemic, COVID-19 certainly accelerated US efforts to diversify, build resilience, and near-shore from Asia to North America.

Shifting tradewinds

Corporate interest in moving production from China received a boost from the Trump administration’s trade policy, which sought to reduce the US trade deficit with China by applying broad-based tariffs available under the 1974 Trade Act. This increased the cost of Chinese-made products, making them less competitive. Firms, which were already interested in shifting production to countries like Malaysia and Vietnam, were further inspired to move production of non-Chinese market goods elsewhere by Trump’s policies.

Even before it implements new policies, Mexico starts from a position of comparative advantage. This stems from the country’s proximity to the United States and the existence of advanced and complex supply chains linking the Mexican and US economies.

The Trump administration’s trade policy was not solely about China; nor was it about returning manufacturing and jobs to North America. The goal was to create jobs in the United States. One clear example of this was the initial inclusion of Mexico and Canada under the Section 232 steel tariffs, which imposed a 25 percent tariff on imports of steel from all countries except those that negotiated restraint agreements. Canadian officials took offense at the implication that their country represented a threat to the United States; Mexican officials expressed somewhat less offense in public but were no less concerned with the implications for North American trade. Canada’s greater offense may have stemmed in part due to existing US-Canada mutual defense commitments under NATO; the US and Mexico have no such defense agreement and are not “allies” in a military sense.

The Trump administration’s focus on US manufacturing jobs was reflected in Trump’s opposition to the North American Free Trade Agreement, or NAFTA, which he called “the worst trade deal ever made.” His opponent, Hillary Clinton, was also critical of that agreement, marking perhaps the first time in decades that both major parties nominated candidates who were not free traders. Trump’s threat to withdraw from NAFTA led to the negotiation of what became the United States–Mexico–Canada Agreement, referred to as USMCA. While the agreement retained important provisions that ensured North America’s competitiveness as a region, the agreement was the first ever signed by the United States that reduced market access through, for example, increasingly complex rules of origin for autos and auto parts. After ratification of the USMCA in July 2020, the Trump administration focused its attention on China.

The transition to the Biden administration in January 2021 brought some changes to US trade policy, though many of the “buy America” provisions and impulses remained. Biden, for example, has not sought renewal from Congress of Trade Promotion Authority, nor has he negotiated any new trade agreements. Nevertheless, trade within North America continues apace.

Implementation of the USMCA by Biden and President Andrés Manuel López Obrador of Mexico, also known as AMLO, was not the only way in which the two administrations sought to enhance their economic recovery from COVID-19. AMLO, who assumed office in December 2018 (one day after the USMCA was signed), was dealing with a negative growth rate; Biden, too, was facing economic challenges. Both sought to reinstitutionalize the US-Mexico bilateral relationship. One tool was to resurrect the US-Mexico High-Level Economic Dialogue, a mechanism dating back to the Obama administration, in which cabinet officers from both countries meet routinely to discuss policies and share best practices to promote economic growth and development. The forum was reestablished on September 9, 2021, and identified four distinct pillars for action.

Under pillar one, Building Back Together, the United States and Mexico committed to strengthen essential semiconductor and information and communication technology supply chains—which are centered in China and Taiwan—and promote trade between the two countries, in part by establishing the Supply Chain Working Group. Promoting investment in semiconductors in North America seems like a logical response to the overreliance on Asia. Moving from theory to practice is a bit more difficult.

The carrot and the stick

In simple terms, to promote or steer investment, governments can either create incentives or “force” industries to invest where the government wishes. The United States and Mexico have engaged in both approaches.

Under the Trump administration, coercive efforts included use of the above-referenced tariffs, threats to tear up the NAFTA, and “naming and shaming” companies that chose to move production or employment overseas. Trump’s public criticism of Harley Davidson is one such example. The Biden administration has adopted a more balanced approach, eschewing its predecessor’s public shaming strategy, as it seeks to implement what US Trade Representative Katherine Tai calls a worker-centric trade policy. Elements of the strategy, however, have retained a “Buy America” approach, causing some consternation in Mexico and in Canada.

A key piece of legislation designed to encourage investment in semiconductors in the United States is the Creating Helpful Incentives to Produce Semiconductors Act, otherwise known as the CHIPS Act. The act’s objective is to transform investments through research, development, and manufacturing. It established a tax credit for all new investments of semiconductor manufacturing in the US. Furthermore, it established the International Technology Security and Innovation Fund, which provides the State Department with $100 million annually to support secure semiconductor supply chains as well as the development and adoption of secure telecommunications networks. The State Department has indicated that the funds “will help deepen efforts with key allies and partners”; Mexico presumably could be a recipient of these funds. The Build Back Better legislation—which ultimately was not approved by Congress—had tax incentives for electric vehicles produced in the United States, excluding production in USMCA partner countries, despite the deep integration of the auto industry. However, the Inflation Reduction Act, which was adopted by Congress, establishes tax credits for electric vehicles and batteries produced in North America. This minor provision in the larger bill is an important demonstration of congressional support for North American economic development and one that may encourage additional investment in the region.

AMLO’s reforms, intended to reverse those implemented by President Pena Nieto in 2013, have shaken investor confidence and prompted the United States—and subsequently Canada—to seek dispute resolution under the USMCA to address threats to roughly $10 billion in foreign direct investment.

It is also important to understand that corporate investment decisions are driven by competition and internal analysis of market dynamics, which may or may not be driven by federal policy. For example, Honda and LG Energy Solution announced plans to build a new battery plant in the United States before passage of the CHIPS Act, echoing plans announced by competitors Ford, General Motors, and Stellantis. Tesla also announced plans to expand operations in Mexico.

Advantage Mexico

Even before it implements new policies, Mexico starts from a position of comparative advantage. This stems from the country’s proximity to the United States and the existence of advanced and complex supply chains linking the Mexican and US economies. NAFTA facilitated deep integration, especially in the automotive and agricultural sectors. This has created important incentives for companies to invest in Mexico, almost despite further government action. Even so, the AMLO administration, led by its secretary of the economy, has actively engaged with the private sector to better understand its needs and concerns, including recent discussions with US investors to showcase Mexico’s advantages and explore incentives that coincide with US efforts to promote reshoring semiconductor production.

In addition to the new focus on supply chains, pillar 4 of the High-Level Economic Dialogue focuses on workforce development. This reflects awareness in both capitals of the need to train workers in the necessary skills to operate increasingly advanced manufacturing facilities. The two governments have met with representatives of labor, industry, and academia to identify potential tripartite pilot projects to develop cost-effective training programs. The involvement of labor organizations is also critically important, both to the economic and political objectives of the countries and to meaningful skill-building efforts.

These advantages and efforts are especially fortunate now because AMLO is opposed to using public funds to cover costs while private firms reap the profits. Several firms have announced plans to expand their operations in Mexico over the past few years, citing proximity to the US market and the availability of skilled labor.

Significantly, a number of investment decisions were based not on recent policy decisions but on conditions developed over two and half decades of free trade and economic integration. This suggests that the ability of governments to take actions to attract investment quickly, at all three levels of government, is limited. At the end of the day, companies will invest where they find the greatest return on investment and the lowest risk. The AMLO administration’s adoption of measures that will undermine Mexico’s comparative advantages and complicate decisionmaking in corporate board rooms is cause for concern.

These measures include the cancellation of the Mexico City airport project started by AMLO’s predecessor and the withholding of a permit to construct a brewery near the US-Mexico border after claims that scarce water resources would be misused. Beyond actions affecting specific companies, of great concern is AMLO’s proposed electricity reform, which favors production and distribution by the state-owned Comisión Federal de Electricidad over private generation, much of which is through renewable energy. AMLO’s reforms, intended to reverse those implemented by President Pena Nieto in 2013, have shaken investor confidence and prompted the United States—and subsequently Canada—to seek dispute resolution under the USMCA to address threats to roughly $10 billion in foreign direct investment.

AMLO continues to assert that USMCA Chapter 8 permits Mexico to retain the right to manage its natural resources—particularly hydrocarbons—and insists that the trade relationship with the United States cannot come “at the cost of our dignity.” Chapter 8 solely refers to the hydrocarbon sector; the dispute initiated by the US and Canada primarily focuses on the electric sector, which is not included in Chapter 8. If a panel were to side with the US, punitive tariffs against important Mexican exports (likely agricultural) will have an impact on those who AMLO most focuses on helping—the poor and marginalized—while undermining Mexican competitiveness and ultimately increasing prices for consumers. Compliance with treaty obligations is essential to foster a welcoming investment climate; failing to do so undermines the very advantages provided by the agreement.

The challenges ahead

Despite new investment, the picture is not all rosy. Corporations such as General Motors have made clear that investment decisions will be affected by access to reliable electricity supply. As the automotive industry moves toward a fully electric future—as soon as 2035, in California—Mexico will need to adapt. Mexico’s foreign secretary, Marcelo Ebrard, recently climbed on board the electric vehicle bandwagon, noting in response to California’s 2035 target that [this is] “the most important thing that happened at the North American Leaders Summit… Now we have a shared vision in many areas, and this is one of them.”

Shorter supply chains and regionalization are likely to be two of the most important trends coming out of the COVID-19 pandemic.

Beyond economic factors such as reliable energy or confidence in Mexico’s compliance with USMCA obligations, other key aspects also inform investment decisions. One of the most important is security. If firms do not believe that their employees and their facilities are safe or can be made safe at a reasonable cost, they will invest elsewhere. In announcing the decision to add the state of Zacatecas to the State Department’s “no travel” list, US ambassador to Mexico Ken Salazar tweeted that “without security it is not possible to have prosperity” and “investment in security and justice foment investment and creates jobs.” Ambassador Salazar’s comments doubtless reflect his conversations with business leaders over the past year.

Thoughts for the future

For Mexico to capitalize on the opportunity offered by near-shoring, government officials must recognize their limitations. Governments can establish incentives for investment and can create positive conditions, but ultimately business decisions are based on a complex series of calculations and projections. These decisions are made over time and do not occur in a vacuum but amid global developments that are not always controllable. The timing and scope of the COVID-19 pandemic could not have been predicted; however, it is important that governments anticipate and plan for the inevitable. There are several steps that the AMLO administration, and its successor beginning in late 2024, can take to ensure that Mexico remains an attractive investment destination.

• Mexico must clarify its energy policy and ensure reliable generation and distribution of electricity for industrial development. For electricity consumers, the system’s ownership may be less important than its reliability and cost competitiveness. For those who invest in renewable energy—past, present, or future—the calculation is different. Companies are also increasingly concerned about the environmental impact of their activities. To meet their environmental, social, and governance commitments, many have adopted carbon-neutral policies. This may mean that production in Mexico will depend not only on cost and reliability but also on the cleanliness of the fuel source. If production is “dirtier” due to reliance on fossil fuels for electricity generation, a global manufacturer might be forced to reduce or even eliminate production in Mexico to ensure its overall carbon footprint meets investor expectations.

• Investors must feel confident that the rule of law is being adhered to and in the government’s commitment to meet its international obligations, especially those under USMCA. The AMLO government’s decision to break contracts (for example, the Mexico City airport) and to change the long-standing rules of the game (for example, Talos’s dispute with Pemex) undermine investor confidence not only in the affected sectors but more broadly. Further, AMLO’s reaction to an unfavorable USMCA dispute panel decision will serve as a critical signal to investors of his commitment to comply with Mexico’s USMCA obligations. Ignoring the decision and politicizing the US response (presumably with additional tariffs) will have implications beyond the electricity sector.

• Security for people and facilities must be addressed. The perception among many both inside and outside Mexico that sizable portions of the country are not under federal government control must also be addressed. The movement of drugs—chiefly fentanyl and other synthetics and precursor chemicals—into and through Mexican ports is cause for concern. While drug trafficking control is not a uniquely Mexican responsibility, the perception that this government is not willing to confront the cartels suggests an increasingly risky environment from which to operate.

• On a more positive side, continued engagement with industry and academia to ensure that Mexican students graduate with marketable skills to meet current and future demands is essential. For example, Mexico’s secretary of the economy, Tatiana Clouthier, and her team have focused on this issue, and it has been addressed within the context of the North American Leaders’ Summit. Mexico is making good progress in this area, but more needs to be done.

• Mexican government officials at all levels must be realistic about their ability to gain investment. For example, not every state in Mexico can or should have a semiconductor fabricator, any more than should every US state. Government officials should continue to engage with private-sector representatives to understand their needs while simultaneously taking a clear-eyed look at their own opportunities and limitations. Some Mexican and US states alike will require more help to create conditions conducive to investment and should be realistic about what they can accomplish in the short, medium, and long terms.

Shorter supply chains and regionalization are likely to be two of the most important trends coming out of the COVID-19 pandemic. The USMCA updated and codified the “rules of the game” (including labor and environmental practices), while the High-Level Economic Dialogue provides a forum to strategically address mutual challenges. In combination, they offer Mexico this moment to achieve the job creation, poverty reduction, and enhanced equality envisioned under AMLO’s Fourth Transformation. But moments are fleeting and are easily missed without sound policy to capitalize upon them.

Andrew I. Rudman is the director of the Woodrow Wilson Center's Mexico Institute. Before joining the Wilson Center, Andrew was managing director at Monarch Global Strategies, a boutique strategic advisory firm with a focus on government relations and market entry/access for companies interested in doing business in Mexico and other Latin American countries. He began his career as a tenured Foreign Service officer at the US State Department (1991–2001), followed by time at the Department of Commerce (2001–6), where he was director of the Office of NAFTA and Inter-American Affairs. 

The author wishes to thank Mexico Institute graduate intern Marisol Hernandez for her research assistance with this article. 

Cover photo: Mexican President Andrés Manuel López Obrador, right, speaks during a meeting with President Joe Biden, left, and Canadian Prime Minister Justin Trudeau, center, in the East Room of the White House in Washington, Thursday, November 18, 2021. AP Photo/Susan Walsh.