Mexico Tariffs on U.S. Goods: Managing U.S. Tariffs In The Manufacturing Environment

June 27, 2018

The uncertainty surrounding the Trump administration’s position on global trade and its U.S. tariff strategy has made it difficult for manufacturers, especially in the United States, to understand and prepare for the impact it will have on their companies. From exiting the Trans-Pacific Partnership to the disregard of NAFTA, U.S manufacturers need to ready for anything. Recently, we’ve seen the Trump administration impose high tariffs on steel and aluminum; with the recent 25% tariff on foreign steel, 10% tariff on foreign aluminum, $50 billion dollars of other imported goods from China and the threat to increase that number to $250 billion, it is now clear that manufacturers need to prepare to operate in this new reality, taking into consideration trade tensions which have led to retaliatory tariffs. Just days after President Trump announced the steel and aluminum tariffs, Mexico responded with tariffs on U.S. goods such as pork, apples, cheese, steel and others.  Whether or not a full international trade war will break out between the U.S. and its trading partners around the world remains to be seen but regardless, most business owners and economists agree that new U.S. tariffs will increase the cost of raw materials and components, even if they are purchased from U.S. suppliers.

The primary intent of applying a tariff on raw materials is to help domestic producers of such materials be more competitive with their global counterparts, thus creating (or protecting) domestic jobs. And while this strategy can certainly help domestic producers compete with countries who can produce the same product at a lower cost, it will virtually always result in higher prices to the end user.  Historically speaking, domestic suppliers of goods protected under a tariff policy will often increase their prices higher than would otherwise be necessary to compete globally, prior to the imposed tariff.  Manufacturers who rely on these materials to produce various components and finished goods are therefore forced to pay higher prices, whether via a tariff or from a domestic supplier. In turn, manufacturers must either lower their margins (profits) or pass along the increase to their customers, which inevitably raises the cost to the consumer.

It is impossible for manufacturers to control (global) political environments or predict the long-term effect of tariffs on their businesses. However, having a global manufacturing footprint can often mitigate some of the risks associated with domestic tariff policies. By having factories in different countries, manufacturers can shift production from one factory to another, depending on the lowest total cost of production.  The cost of raw materials, however, is just one factor manufactures must consider.  Other costs, such as labor and logistics, could have an equal or greater impact.

For example, a U.S. automotive supplier who requires steel may currently be sourcing it from outside of the United States and almost overnight saw their raw material cost on steel increase by 25%.  Their option is to pay the tariff or find a U.S. steel supplier to replace their current supplier, which is often difficult to do quickly due to quality control requirements, certifications and other factors. Also, there is no guarantee the U.S. supplier will offer a significantly lower cost.  If, however, this manufacturer had a factory outside of the United States, such as Mexico or Canada, that was capable of manufacturing the same product, it could send import the steel directly to that facility, tariff-free, produce the finished good and then send that finished product to the U.S., avoiding the 25% tariff.

While manufacturing in Mexico is just one example, many manufacturers from virtually all industries have been expanding to Mexico due to lower labor costs, its proximity to the United States and the Mexican government’s continued effort to attract foreign investment despite the recent tariffs on Mexican imports/exports. Also, Mexico enjoys free trade agreements and treaties with over 40 countries, making it less expensive to import most raw materials from around the world, tariff-free.

The unintended, but historically significant, consequences of imposing an aggressive tariff policy can lead to higher inflation, retaliatory tariffs from trading partners, lower GDP and ultimately the risk of recession.  Many economic historians believe the Smoot-Hawley Tariff of 1930, one of the broadest tariff hikes in the history of the United States, increased the length and severity of the Great Depression.

Being that approximately 70% of the U.S. economy (GDP) is comprised of consumer spending on goods and services, it is no surprise that higher prices on manufactured goods can result in less spending, which is often a catalyst for layoffs and ultimately a recession.  Most economists agree that economic growth is by far the most effective long-term solution to create new jobs and that the short-term effect of protecting jobs using tariffs is far less beneficial.

China is currently being targeted by the Trump administration with regard to broad-based tariffs.  Being that more than half of the United States’ global trade deficit, which is currently close to $600 billion, is with China, it makes them the obvious target. Trade deficits, however, are not always a bad thing.

The economic theory behind free trade is to enable businesses to purchase goods and services from countries that can offer them at the lowest cost.  This strategy can help bolster consumer spending, which in turn grows the economy and creates jobs.

In China’s case, it is able to produce many of the manufactured products Americans want and need at much lower costs than U.S. suppliers can produce domestically. By spending less on manufactured products, Americans have more money to spend in other areas, such as eating out, cable television and vacations, which is why the U.S. economy has shifted from a manufacturing to a service economy.  As such, the U.S. tends to run trade deficits with most of its trading partners. Some policymakers feel that countries without a strong manufacturing base are at great economic risk; however, the U.S. has thrived over the last 30 years, all while its manufacturing contribution has dwindled from 35% down to 12% of GDP.

Free trade, however, is not a perfect system. The World Trade Organization was developed to help monitor and enforce free trade rules and regulations among member countries but it is not always successful.  Government intervention can disrupt an otherwise “stable” system by subsidizing domestic production of certain products.  One example is China’s steel industry, which is primary state (government) owned.  China is notorious for producing low-cost steel and “dumping” it into foreign markets to force its global competition out of business.  Being that the Chinese government owns these businesses, they can afford to sell the steel for a period of time below their cost to produce it.  While this practice was supposed to stop after China was accepted into the World Trade Organization, there is evidence it still happens.

Due to the numerous and uncontrollable variables that can impact manufacturers around the world, the best solution to mitigate their risk is to diversify their manufacturing footprint. By having factories in different countries, manufacturers can shift production from one to the other, depending on the lowest total cost to produce their product. While this strategy carries its own set of challenges and risks, which include capital investment, overcapacity, cultural differences and knowledge transfer capabilities (training), it is being implemented by many manufacturers in the United States and other developed countries.

North American Production Sharing, Inc. is the leading expert in helping manufacturers from around the world expand to Mexico.  Please contact us for more information about Manufacturing in Mexico or to speak with one of our executive managers.