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NAFTA 2.0 – Mexico Left with Little Choice but to Renegotiate, and Fast

Over the years, NAFTA has been one of the most contentious FTAs that have ever been inked, especially for the USA. While the treaty and its merits (or mostly alleged lack of them) featured in political campaigns of a few previous US presidential candidates, NAFTA’s shape and scope have never been revisited in its many years of existence – until now. Mexico, along with Canada, wishes to maintain the NAFTA as is, however US president Donald Trump has strongly condemned the treaty and, though earlier threatened to walk away from it completely, has agreed to attempt a renegotiation. Any possible changes to the shape of NAFTA might have profound impact especially on Mexico, however, the country has little choice but to renegotiate. Some of the negotiation objectives, such as tougher ‘rules of origin’, can be greatly damaging to Mexico’s several sectors, including the automobile industry. The upcoming elections in Mexico in July 2018 may further complicate matters – if the renegotiations are not completed by then (which is a highly probable scenario), they may be brought to a standstill, especially if the government changes. This presents a great deal of uncertainty for companies that have investments in Mexico.

The North America Free Trade Agreement (NAFTA), which came into force in 1994, removed trade tariffs and duties on most goods for trade between the USA, Mexico, and Canada. While the deal has been mostly considered a positive in Mexico and Canada, its benefits have often been debated in the USA. The main reason behind this remains the high US trade deficit with Mexico (which stood at around US$64 billion in 2016) and the loss of several US manufacturing jobs to the south of the US border.

The NAFTA issue also found itself at the center of Donald Trump’s 2016 presidential campaign, as he called the treaty one of the worst trade deals ever signed by the USA and talked about withdrawing from it once he came to power. Although several previous presidential campaigns also involved talks of renegotiating NAFTA (including campaigns of both Democratic candidates – Barrack Obama and Hilary Clinton, in 2008), none has been as strong-worded as Trump’s campaign. Therefore, with Trump coming to power in 2016, revisiting the 23-year old treaty became largely inevitable.

Chapter 19

Initially threatening to back out from NAFTA, Trump agreed to renegotiations, which according to him would ensure bringing jobs back to the USA. However, a few aspects on the renegotiation agenda are a hard line for Mexico. Firstly, the USA wishes to eliminate Chapter 19 of the treaty, which encompasses a dispute settlement mechanism wherein dispute resolution (in cases such as anti-dumping and countervailing duty disagreements) is undertaken by independent and binational panels instead of domestic courts. This prevents NAFTA countries from putting unfair duties on products from other NAFTA countries to protect their own industries. While the USA is trying to disregard this clause, Mexico is largely opposing it, as without Chapter 19, it would become much easier for the USA to implement protectionist policies and duties that would inherently threaten free trade. However, Mexico is not alone in pushing back this change as Canada also strongly opposes any change in the dispute settlement mechanism.

Impact of NAFTA on Mexico

NAFTA Minimum Wage

Another negotiation objective (where Canada stands in support of the USA), is to incorporate some kind of standardization for trade-related labor issues and wages, by introducing a minimum wage across the three NAFTA participants. This will be greatly damaging for Mexico, which has for long benefited from lower wage rates that have incentivized several industries, such as automobiles, to shift base to Mexico to reduce costs and maximize profits. Stating that wage-related policies are an internal matter, Mexico has strongly opposed any such amendments and may make this a non-negotiable aspect.

Rules of Origin

However, one of the most dampening renegotiation objectives, especially for Mexico and in particular for its the automobile industry, are the restrictive changes to the rules of origin. As per the current NAFTA rules, for a car to qualify for a tariff-free entry in the NAFTA region, 62.5% of the value of the car must have originated in NAFTA countries. Thus, over the years, automobile manufactures have perfected their value chains, wherein auto components such as body-works, engines, gear panels, etc., are manufactured in various parts of NAFTA countries, and then assembled in another part of the region, to attain greatest benefits in terms of costs and quality. However, the current US administration is proposing changes to these rules, which may wash away a great deal of efficiencies and synergies attained by global automobile manufacturers under the current rules. As per the proposal, the US government aims to increase the US content in the finished vehicles to 50% for these products to attain tariff-free entry into the USA. In addition to going against the basic fabric of a free-trade agreement, this will jeopardize the competitiveness of the North American auto industry, which has greatly depended on integrated supply chains that also have deep roots in Mexico. This definitely spells bad news for Mexico, as the economy has significantly benefited from investments made by global automobile manufacturers in the country.

Moreover, apart from increasing the share of US content requirement to 50%, the US administration has also proposed raising the regional content requirement for NAFTA to 85% as against the current 62.5%. While this may seem to be a positive amendment for the region in general, analysts call it largely counter-productive as not all components can be competitively sourced from the North American region. If brought into action, automobile companies would have to spend huge sums to try to source/produce most components in the North American region at competitive prices. However, if they fail to accomplish that (which is quite likely) and as a result are unsuccessful in qualifying for tariff-free entry into NAFTA, they would shift to suppliers outside NAFTA and pay WTO tariff of 2.5% to access the North American market (which they will pass onto the consumers). Such developments might mean that by increasing regional content requirements, the region may end up pushing automobile players away from the region rather than encouraging them to continue and intensify their operations. This will be catastrophic not only for the Mexican automobile sector, but also for the US and Canadian auto market. To make matters tougher, the new proposal asks for technology-based automotive parts, electric vehicle batteries, etc., that are currently not included in the origin tracing list (as they did not exist when the NAFTA was originally negotiated). Most of these products are now sourced from Asian markets.

Due to the US president’s known cold sentiment towards NAFTA, the onus of ensuring the treaty remains unterminated is on Mexico and Canada. While Mexico (along with Canada) has previously mentioned that the American demands to change the rules of origin are unworkable with and unacceptable, the Mexican government is working on a compromise proposal to toughen the rules of origin clause in hope to meet the USA somewhere half-way. As per the proposal, Mexico is willing to accept the extensive tracing list and is also willing to negotiate on the 85% North American content requirement in exchange for the USA withdrawing from the 50% US content provision. The tracing list proposal will be drawn in a manner ensuring that low-cost technology-based components that are currently sourced from Asian countries would be sourced from within North America, especially Mexico. However, the proposal, which is not finalized yet, is not expected to be presented in the current (fifth) round of talks.

Sunset Clause

Mexico and Canada’s openness to negotiate can also be gauged by their willingness to work around the sunset clause proposed by the US administration during the fourth round of negotiations. As per the proposed clause, the treaty will expire every five years unless the member countries agree to keep it in place. While the remaining two parties refused to accept this clause when proposed, they have softened their stance on the matter during the current negotiations and counter-proposed a five-yearly review system. This showcases Mexico and Canada’s keen desire to ensure NAFTA is preserved and their willingness to work around USA’s fixed stance. While the review proposal may be a better option compared with the sunset clause, purely from a business or investment point of view, it still leaves room for a great amount of uncertainty for companies looking to invest, as five-year horizon is too short for several heavy-investment industries such as automobiles.

2018 Mexican Elections

Lastly, it is extremely critical that the negotiations are completed by the set date of March 2018 as any delay will result in their overlap with the 2018 Mexican elections and that will further complicate the matters. NAFTA has not only been instrumental in providing Mexico with economic stability, but has also played a significant political role, especially in terms of economic policy. The basic framework of the treaty has ensured protection for investments and, to an extent, economic equity as over the years it restricted the government from granting protections, incentives, and subsidies to a set of companies or industries, while discriminating against others. The termination of NAFTA would allow the future government to modify the current economic framework of the country, and this will directly impact Mexico’s attractiveness as an investment destination. This becomes all the more relevant in case the leftist candidate, Lopez Obrador, comes to power in 2018.

Mexico’s Contingency Plans

While Mexico is certainly hopeful and is working towards retaining the NAFTA, it is not putting all its eggs in that one basket alone. Mexican government is looking at deepening Mexico’s ties globally and reducing its dependence on the USA. Mexico is currently negotiating with the EU to modernize its existing FTA which is expected to be completed by the end of 2017. Moreover, it is looking at Argentina and Brazil as alternative sources of agricultural imports to replace those from the USA. In a similar move, Mexico’s foreign minister, Luis Videgaray, met with his Russian counterpart in Mexico to discuss Mexico’s openness to do business with nations other than the USA. In November 2017, Mexico participated in a meeting of the nations that were formerly a part of the Trans-Pacific Partnership (TPP), which ceased to exist in its previous form in early 2017 (we talked about it in our article TPP 2.0 – Minus the USA in May 2017). This meeting resulted in an official announcement that the TPP nations will negotiate a new deal, without the USA, and that it will be called the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). The creation of CPTPP will provide a much-needed cushion to Mexico’s automobile industry in case NAFTA fails. Also, in case NAFTA toughens its rules of origin but the CPTPP relaxes them, Mexico may continue to be part of the global automobile supply chain (this time in combination with CPTPP members such as Japan, Canada, and Chile – instead of the USA).

EOS Perspective

It is safe to say that Mexico and its automobile industry have a lot riding on the NAFTA negotiations. While Mexico along with Canada are working hard to ensure NAFTA stays, US president’s tough stand on several aspects and his willingness to walk out of the deal in case his demands are not met, complicate the negotiations greatly. It is uncertain how the situation is going to develop, and even if NAFTA continues, new provisions that might find their way into the revised treaty may not offer a great deal of benefits for companies to invest and for intra-regional trade to flourish.

The pressure of upcoming elections in Mexico in 2018 makes the situation even tighter. If the negotiations are not completed before the elections, all progress made up till then can easily go in vain in the event of the government change. Therefore, companies are extremely cautious about investing/expanding in Mexico at the moment, and are likely to wait at least up till mid-next year. They may find respite in the fact that the Mexican government is trying to do its best – both in terms of being flexible during negotiations as well as diversifying its export markets and import sources – but this respite might just not be enough to ease investors’ minds and businesses’ worries over the operating and trade environment within the North American region.

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UK Airlines Expected to Face Turbulent Times with Brexit on the Horizon

As the UK heads towards a hard Brexit, one of the industries that could be facing the maximum heat is the airline sector. The country’s aviation sector has for long enjoyed the perks of UK being an EU member, as its business greatly benefits from two of the EU’s four fundamentals of freedom of movement – freedom of movement of people and of cargo/goods (with the other two being freedom of movement of capital and of services). However, with UK triggering Article 50 (divorce clause) of the EU treaty, the European Commission has warned British airlines about several restrictions that are likely to be imposed on their EU routes in case the UK and EU fail to reach a new agreement. This has left the airline sector in a state of high uncertainty. While several airlines, such as EasyJet, have already started working on a contingency plan, others chose to follow a wait-and-watch approach.

Airlines industry has definitely been one of the key beneficiaries of the UK being an EU member. As per the EU’s Open Skies Agreement, all EU members are allowed to fly anywhere across the EU states. This rule gave the British airlines access to fly not only from London to Paris but also from Milan to Paris, expanding the airlines’ passenger base.

However, with Brexit being an absolute certainty, UK airlines fear losing access to the EU’s single aviation market which they have for long promoted and championed. Since the EU-UK divorce seems to be a rough one, airlines have little hope for a continued Open Skies Agreement. The sector’s worries have been further deepened by the fact that British PM, Theresa May, has clearly expressed her inclination to end the authority of the European Court of Justice (ECJ) over the UK matters. Since ECJ (which is the highest court in the EU in matters of European Union law) also presides over European Aviation Law and in turn the Open Skies Agreement, the end of its authority over the UK will automatically result in the removal of UK’s aviation sector from the Open Skies Agreement.

Moreover, within days of the UK triggering Article 50 of the EU treaty (i.e. formalizing the exit process that needs to be completed over two years), the European Commission has sent out warnings to British airlines about several compliances they must adhere to, to continue flying intra-EU post Brexit. In order for these airlines to continue flying on these routes, they must comply with EU’s strict ownership rules, which state that airlines operating intra-EU flights must be based in an EU state and their majority stake must be owned by EU citizens. Failing to abide by these regulations will result in the UK losing its rights to fly intra-EU flights. Alternatively, as a counter to EU’s regulations on UK airlines, it is well expected that the UK will put similar stipulations on EU-based airlines that wish to fly intra-UK flights.

These two-sided restrictions will affect several airlines such as British EasyJet, Irish Ryanair, and IAG-owned airlines – Irish Aer Lingus as well as Spanish Iberia and Vueling, which derive a great deal of their business from flying within the EU countries and UK cities. While some of these airlines have preemptively started deploying a contingency plan, others are still waiting for some more clarity and are hoping for a positive outcome in the form of an agreement similar to Open Skies.

UK Airlines Expected to Face Turbulent Times

EasyJet

One of the first movers with regards to an action plan has been EasyJet. Being a UK-based company deriving a large part of its revenue from low-cost intra-EU flights, EasyJet will be one of the airlines hit the worst. Since losing its intra-EU business is not an option for the carrier, it has already set up a European sister company in Vienna, EasyJet Europe, in July 2017. About 100 planes have been assigned to the subsidiary and the total cost of the project is about US$13 million.

EasyJet does not face a major hurdle with regards to ownership requirements for EU airlines. It is currently 84% owned by EU citizens, a stake that will fall to 49% post Brexit provided that the shares of its owner, Stelios Haji-Ioannou, who is a dual UK and EU citizen, are accounted as EU citizen-owned. However, since the 49% ownership is going to be only slightly below the required mark, the airlines will not have much issue in meeting the requisite ownership requirement.

With these two aspects settled, the EasyJet is likely to be able to continue operating its international and domestic flights across the EU states.

Ryanair

Ryanair, unlike EasyJet, does not need to move its base as it is already headquartered in Dublin, Ireland. However, the airline faces ownership pressure as the shares owned by EU citizens will fall from 60% to 40% after Brexit. To ensure compliance with the ownership rule, as a first step, the airlines could possibly ask the fund managers holding their stock to switch the funds in which the shares are held from their UK-based funds to Dublin-, Milan-, Frankfurt-, Ireland-, or Luxembourg-based funds. However, if that does not work, the company does have extraordinary provisions in its articles of association to force non-EU investors to sell their stake to ensure major control and ownership by EU nationals.

However, the airline might be facing a larger threat looming on the horizon. In case the UK replicates similar flying barriers on EU-based carriers, Ryanair might be negatively affected, as the UK is an important domestic market for the airline. To ensure smooth operations in the UK, the company will need to apply for a domestic UK Air Operator Certificate (AOC) which will let it continue its operations without major changes.

IAG-owned Airlines (British Airways, Aer Lingus, Iberia, and Vueling)

IAG-owned British Airways is likely to remain among one of the least Brexit-affected airlines as is does not fly intra-EU flights. Moreover, the group’s other airlines including Spanish Iberia and Vueling, as well as Irish Aer Lingus already are based in the EU and therefore can continue flying within the EU. However, the group has refused to comment on its shareholding structure which will be required to be majority EU-based for the latter three airlines to continue intra-EU operations. As per industry experts, IAG, which also has extraordinary provisions for force sale in their articles of association, may need to divest some of their non-EU-based stake and replace it by stake held by EU nationals.

EOS Perspective

While there is a significant uncertainty about the fate of the airline industry post Brexit, there is a common consensus that the sector is likely to be hit hard by the divorce. The UK and EU markets aviation sectors are largely inter-dependent, whether it is about air traffic or employment in the sector, and potential lack of regulations similar to the Open Skies Agreement will be detrimental to the industry in general as well as its consumers. This makes it vital for the Brexit negotiators to try to develop a mutually beneficial deal for the sector in general.

Having said that, it is clear that the airlines must prepare for the worst as the UK and EU seem to be heading for a hard divorce. Brexit process was formally started in March 2017 and the UK has two years to conclude all procedures and negotiations leading to the EU exit, which also puts the same timeframe for the sector to develop contingency plans. Some players, such as Ryanair hope that some form of Open Skies Agreement will be replicated, and continue to put pressure on their government for such a similar agreement to be negotiated. Other players, such as EasyJet, seem to take a more proactive approach, already investing resources in ensuring their smooth operations even if the worst case scenario materializes. Such an uncertainty about shifts in the operating environment is never favorable for any sector, UK airlines included, and as the future developments of the operating framework lie largely in the hands of negotiators, the industry players hold rather limited control over the future changes.

by EOS Intelligence EOS Intelligence No Comments

OBOR – What’s in Store for Multinational Companies?

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One Belt One Road (OBOR) Initiative, also known as Belt and Road Initiative (BRI), is part of China’s development strategy to improve its trade relations with countries in Asia, Europe, the Middle East, and Africa. OBOR envisions to not just bring economic benefits to China but to also help other participating countries by integrating their development strategies along the way. It has the potential to be one of the most successful economic development initiatives globally. Opportunities are countless for investment along this route. Multinational companies are looking to make the most out of this project, however, capitalizing on this opportunity will not be easy. To benefit from this initiative, companies need to understand that assiduous research and effective long-term planning is crucial, as the nations involved, though offer economic growth, will also present a series of geopolitical risks and challenges.

Chinese President Xi Jinping unveiled OBOR in 2013, aiming to improve relations and create new links and business opportunities between China and 64 other countries included in the OBOR. The initiative has two main segments: The Silk Road Economic Belt (SREB), a land route designed to connect China with Central Asia, Eastern and Western Europe, and the 21st-Century Maritime Silk Road (MSR), a sea route that runs west from China’s east coast to Europe through the South China Sea and the Indian Ocean, and east to the South Pacific. These two routes will form six economic corridors as the framework of the initiative outside China – New Eurasian Land Bridge, China-Mongolia-Russia Corridor, China-Central Asia-West Asia Corridor, China-Indochina Peninsula Corridor, China-Pakistan Corridor, and Bangladesh-China-India-Myanmar Corridor.

OBOR brings opportunities and challenges

Multinational companies will have a plethora of opportunities to explore along these economic corridors – for instance, trading companies can take advantage of these routes for logistics, while energy companies can use these corridors as gateways for exploring new sites of natural resources such as oil and natural gas. Along with dedicated routes, OBOR will require huge investment which is proposed to come from three infrastructure financing institutions set up as a part of this initiative – Asian Infrastructure Investment Bank (AIIB), The Silk Road Fund (SRF), and The New Development Bank (NDB).

The development of OBOR opens up a range of opportunities for overseas businesses. However, with the initiative being launched by the Chinese government and all the six corridors running across the country, it is clear that China will play a major role in most of the business collaborations. Thus, multinational companies investing in OBOR can prefer to partner with Chinese companies and leverage the partnership to access projects and assignments in other countries. Companies are also likely to be able to access new routes to sell products cheaply and efficiently, but looking for opportunities across OBOR would definitely involve initial partnerships between multinationals and Chinese state-owned enterprises.

OBOR – What’s in Store for Multinational Companies

Oil, gas, coal, and electricity

OBOR has the potential to open up opportunities for collaboration in the areas of oil, gas, coal, and electricity. Several energy opportunities may emerge with the OBOR initiative, and these energy-related investment projects are likely to be an important part of OBOR. For instance, the Gwadar-Nawabshal LNG Terminal and Pipeline in Pakistan includes building an LNG terminal in the Balochistan province and a gas pipeline between Iran and central Pakistan. Estimated at a total value of US$46 billion, the project was announced in October 2015 along the China-Pakistan Economic Corridor.

Energy projects along OBOR include initiatives largely by Chinese companies due to funds coming in from China-led financial institutions. In another investment, General Electric, an American corporation, signed a pact with China National Machinery Industry Corporation (Sinomach), in 2015, to offer project contracting (for supply of machinery and hardware tools) for developing a 102-MW Kipeto wind project in Kenya. The project aims to set up 2,036 MW of installed capacity from wind power by 2030. Kipeto wind project was originally a part of US president Barack Obama’s ‘Power Africa’ initiative, but with Sinomach joining in hands, it is clear that more initiatives like this can be expected to come up in the near future as a part of OBOR.

Logistics

Players in the logistics industry can also benefit from the improved infrastructure along the OBOR. In 2015, DHL Global Forwarding, providing air and ocean freight forwarding services, started its first service on the southern rail corridor between China and Turkey, a critical segment of China’s OBOR initiative. This rail corridor is expected to strengthen Turkey’s trading businesses along with benefiting transport and freight industries of Kazakhstan, Azerbaijan, and Georgia. Logistics companies can also initially partner with local postal or freight agencies to set up new business in these regions. OBOR can provide fast, cost-effective, and high-frequency connections between countries along the route. Improved infrastructure, reduced logistics costs, and better transport infrastructure will also contribute to driving e-commerce businesses in the regions.

Tourism

Tourism is expected to also see a major boost as a result of OBOR initiative. As connectivity between countries improve and new locations become easily accessible, the tourism industry is expected to see positive growth in the coming years. To support tourism, Evergreen Offshore Inc., a Hong Kong-based private equity firm, in 2016, launched a US$1.28 billion tourism-focused private equity fund called Asia Pacific One Belt One Road Tourism Industry Fund to boost relations between China and Malaysia by investing in tourism sector. The company invested in Malaysia as the country is considered an ideal investment destination for a long-term gain. This is in sync with the long term vision of OBOR to promote tourism sector in countries and regions along the MSR.

As OBOR develops, new markets along the routes are likely to open to business. The already existing routes will experience business diversification as infrastructure and connectivity improves. Trade barriers will most likely reduce as developing countries become more open to international investment which brings new jobs, better infrastructure, economic growth, and improved quality of life. There is bound to be growth in consulting business, professional services, and industrial sectors apart from trade and logistics.

EOS Perspective

While OBOR initiative assures opportunities for multinational companies, the path may not be smooth for all. Investing in these new geographies, companies will come across various economies with different legal and regulatory frameworks. Political stability is also a matter of concern – some regions may have sound political structures while others may be dealing with ineffective government policies. In fact, political instability and violence are some of the key challenges in the development of OBOR. Weak government policies and lack of communal benefit lead to political instability including terrorism and riots. These factors influence the availability of resources, negatively impact the setting up of businesses locally, thus resulting in financial losses for multinationals. Local investments need policies and investment protection backed by the governments to facilitate growth which is far more difficult to achieve in case of political and economic instability. Taking advantage of the opportunities associated with OBOR may be of strategic importance, but the companies need to be cautious about the obstacles associated with it.

While OBOR initiative assures opportunities for multinational companies, the path may not be smooth for all. Political instability and violence are some of the key challenges in the development of OBOR.

Local competitors will also present obstacles to multinational firms. The competition is stiff for international players as local companies can operate better in riskier environment at low operating costs. Not only will regional companies pose a threat for survival of multinationals, in many scenarios, partnering with Chinese companies will also be a massive challenge. Many Chinese companies do not implement a clear structure while partnering with other international companies. Decision making and profit sharing is often not properly documented. Lack of clarity in business dealings give these state-owned enterprises an upper hand.

Complexity and lack of transparency in local regulatory framework for setting up a new business is also a hindrance for investments in many geographies along the OBOR. Absence of clear policies and delays in decision-making processes can prove too challenging for companies to adapt to which may even lead to financial losses or failed attempts to establish local operations. Issues such as corruption, challenges associated with supply chain security, and financial risks are some of the other obstacles that companies are likely to face while setting up businesses in new countries along the OBOR route.

Complexity and lack of transparency in local regulatory framework are a hindrance for investments in many geographies along the OBOR.

OBOR is still in the initial years of implementation. The initiative offers great potential for developing regions in need for improved infrastructure and economic growth but what this really means for multinational companies is still somewhat unclear. It encourages participation from international companies to turn the initiative a success, but there are no clear guidelines on how these investments would be integrated into the OBOR. With a major part of investment coming from China-based institutions, dominance of Chinese companies in major projects cannot be avoided. While the underlying aim of the initiative is to reduce China’s industrial overcapacity and to strengthen its economy, there are concerns about the part being played by multinational companies. To what extent would they participate, who would be the main investor (Chinese company or multinational companies), and how much share and what say would the multinational company have in a project, etc., are some of the questions that still remain unanswered.

With major part of investment coming from China-based institutions, dominance of Chinese companies in major projects cannot be avoided.

In view of these risks and challenges, we believe it is too early to estimate the scale of potential monetary benefits for companies wanting to invest along the OBOR route to expand their businesses. It will surely not be easy for multinational companies to compete for benefits from OBOR in an environment heavily dominated by Chinese companies. Developing business policies and financing schemes through related institutions can help the multinational firms to benefit from this initiative in the long run. There is no doubt that OBOR has the potential to open new markets for doing business by redrawing the global trade map, however, with no clarity and transparency on the role MNC’s as part of OBOR initiative, companies need to correctly identify the best opportunity by accessing the right market and find effective ways to mitigate a wide range of associated risks. For now, the future role of MNC’s in this environment is uncertain. They will have to wait and watch to work out a stable business arrangement. But in current times of global geopolitical turbulence, such a harmony is never guaranteed.

by EOS Intelligence EOS Intelligence No Comments

GCC to Introduce VAT: What It Means for Businesses, Economy, and People

The Gulf Cooperation Council (GCC) countries are gearing towards rolling out a 5% Value Added Tax (VAT) starting January 1, 2018. Economies of GCC countries are highly dependent on the oil and gas sector revenues, which account for about 80% of the GCC governments’ budgets. The recent volatility in oil prices have battered GCC nations’ revenues, which motivated the governments to initiate a reform in the form of indirect taxation with a goal to diversify income sources. VAT is a measure that will impart more stability and robustness to the governments’ income considering the outlook for crude oil still remains volatile, while diversified revenue sources will cushion the GCC economies in times of financial crisis.

A standard rate of 5% will be applied on most products, except specified food items, domestic public transportation, and healthcare, education, and financial services. The proposed VAT rate is much lower in comparison with rates in most European countries, China, and Australia. Nonetheless, the GCC countries still stand to gain in income with the tax implementation – for instance, the UAE is forecast to generate US$3.27 billion revenue during the first year of VAT introduction.

Industries such as construction and automotive are likely to benefit from VAT implementation, while retailers might feel a pinch due to dwindling margins. The sentiment among the citizens is wary to say the least – for instance, according to a survey conducted by CFA Society Emirates, citizens of the UAE did not seem quite optimistic towards the economic impact of VAT across certain parameters such as price inflation, cost of doing business, and inflow of foreign direct investments (FDI).

GCC to Introduce VAT

EOS Perspective

Introduction of VAT could empower the GCC economies by bolstering revenue generation, aiding infrastructure development, and improving productivity levels. While some may believe that VAT implementation could tarnish GCC countries’, particularly the UAE’s, competitiveness and tax-free haven status, it is important to consider that GCC markets’ attractiveness goes way beyond only the tax benefits. GCC’s appeal also lies in developed infrastructure, competitive labor costs, lower trade barriers, and proximity to the developing Asian and African markets – implementation of a new tax reform will not change this favorable business environment.

There have been some discussions regarding the negative implications of VAT, considering residents and businesses have grown accustomed to high incomes and low deductibles for a long time. Post VAT implementation, businesses are expected to incur certain additional costs related to administrative expenses, upgrading IT systems, and training staff members, among others.

Also, highly competitive industry sectors, or those operating with thin margins are likely to witness cash flow burden, as they will be required to meet the VAT costs on purchases before they can be reclaimed from the government – in certain scenarios, when the businesses end up paying more as VAT to suppliers as compared to the VAT collected from customers, the difference can be reclaimed from public funds. The way businesses operate is likely to fundamentally transform once VAT is applied, however, with adequate preparation businesses should be able to introduce systems and processes to avoid unnecessary cost implications as well as smoothly align themselves with the new tax system.

The way businesses operate is likely to fundamentally transform once VAT is applied, however, with adequate preparation businesses should be able to introduce systems and processes to avoid unnecessary cost implications as well as smoothly align themselves with the new tax system.

VAT is not expected to have much impact on a common man, as vital household expenditure items will be exempted from it – this includes about 100 varieties of staple food items and essential services such as healthcare and education. However, for a section of the population with an appetite for luxury goods, services, and lifestyles, as well as for tourists (along with VAT, they will have to pay duty tax again on some goods in their country of origin) the brunt of new taxation is likely to be felt.

Nonetheless, a modest tax rate of 5% will ensure that certain social-economic distortions often associated with VAT are minimized. Also, the decision to exempt a few vital sectors (basic food items, and healthcare, financial, and education services) will ascertain that they are not affected by the tax reform.

VAT imposition is expected to become an essential part of GCC regions’ economic reforms and the taxation policy will immensely aid in diversification of revenue sources. Further, the pre-implementation period should be used by the GCC countries to develop a modern tax administration system that ensures compliance, so that once VAT is implemented, businesses and residents are able to smoothly adapt themselves to the new taxation policy.

by EOS Intelligence EOS Intelligence No Comments

Brazil – Long Road Ahead

Sentiments regarding economic recovery in Brazil rose high when Index of Economic Activity of the Central Bank (IBC-Br) recorded growth in January and February this year, only to be dampened by the March data, which showed 0.44% decline in the index. Hope of economic revival was hinged on good show by service sector, coupled with anticipation of improvement in agriculture and industrial sectors in the first quarter of 2017.

Fluctuations in IBC-Br, which is considered as a preview of Brazil’s GDP performance, indicate the fragile condition of the country’s economy, shaken by two back-to-back recessionary years. Downturn of 2015 and 2016 was uncommon in the country’s recent economic history, which had not seen the GDP declining for two straight quarters on more than four occasions since 1996. Brazil was among the few countries that were able to withstand the global financial turmoil of 2008-2009.

Reasons behind the deterioration of the Brazilian economy seem to be clear. Reliance on commodity exports for growth and high consumer debt were among the key factors that burst Brazil’s economic bubble. Unless these issues are addressed, Brazil’s long-term economic recovery will remain doubtful. Hence, it is imperative to look where the country stands with respect to each of the factors that contributed so considerably to the deterioration over the past two years.

EOS Perspective

In near term, commodities are likely to retain high share in Brazil’s external trade, as increasing the export share of finished or semi-finished goods would require significant efforts that Brazil currently is unlikely to be capable of making. Commodity prices are expected to remain volatile in near term, with soybean, sugar, and wheat likely to continue registering decline in prices (as witnessed year on year, April 2016 – April 2017). Therefore, unless the domestic demand picks up, commodity export is unlikely to assist significantly in boosting the Brazilian economy in the near future.

Keeping interest rates low is one of the ways to boost spending, and the country’s falling inflation, which in April 2017 plummeted to 4.08% (below the market forecast of 4.1%), has enabled the central bank to slash interest rates from 12.25% to 11.25%. This is expected to reduce the cost of credit for households, thereby boosting spending (amid fears of debt burden ballooning up again).

Brazil needs to create more assets to increase productivity and to create more income sources. Capital formation (a measure of investment) as a share of GDP was at about 15.5% in 2016 (fourth quarter) as compared with the high of 23% in 2013 (first quarter). The country needs to invest more, and one way to unlock funds for this would be through reforming the pension scheme (bill related to pension reforms was passed in lower house of Congress in May 2017 amid protests), which is the primary reason behind Brazil’s fiscal deficit. Brazil currently spends more than 10% of its GDP on pensions. Reforms seek to fix minimum retirement age at 65 for men and 62 for women. At present, many Brazilians qualify to retire in early to mid-fifties, and this not only impacts the productivity but also puts pressure on the government coffers.

There is a general consensus that Brazil will come out of recession in 2017, registering a modest sub-1% growth. However, to sustain this recovery, it will require a political will, fiscal discipline, and a vision for long-term growth.

by EOS Intelligence EOS Intelligence No Comments

Japan Hopes to Get a Slice of Mercosur Opportunity Cake as LATAM Exports to USA Decline

In early May 2017, representatives from Japan and Mercosur, a sub-regional alliance consisting of Argentina, Brazil, Paraguay, and Uruguay, met to discuss trade and investment between the nations with the aim to promote free trade and fluid movement of goods. Over the past years, business between Mercosur and Japan has been badly affected mainly by outdated trade policies that have not been revised in a long time. To improve economic relations between Japan and member countries of Mercosur, trade policies need to be renewed and new sectors of investment should be explored.

In 2016, Japan exports to Mercosur nations reached US$3.5 billion and imports from Mercosur totaled US$7.6 billion. Both exports and imports drastically reduced since 2012, taking a hit of 52% and 42.8%, respectively.

Japan and Argentina

After a decade of slow business dealings, trade relations between Japan and Argentina are showing signs of improvement. The number of Japanese companies operating in Argentina reduced from 120 in the 1990s to 54 by the end of 2007. However, the interest of Japanese businesses in the Argentinian market has started to return since the last quarter of 2015, with 78 companies currently in operation in Argentina, and Japan aims to have a minimum of 200 Japanese companies operating in the coming years. According to Japan External Trade Organization (JETRO), in 2016, Japanese exports to Argentina stood at US$630 million, primary exports being machinery and electronics. Imports to Japan were worth US$762 million in the same year.

In order to boost Argentina’s economy, president Mauricio Macri has focused on reviving infrastructure projects in the country. Taking an advantage of this opportunity, Japanese trading companies are keeping a close watch on upcoming rail contracts. Marubeni Corporation, Mitsubishi Corporation, and Mitsui & Co., three of the largest trading companies in Japan, are interested in sales of passenger rail cars in Argentina and planning on submitting bids as part of the new proposed projects. Japanese companies plan to invest between US$6 billion and US$9 billion in Argentina during 2017-2020. The investments are likely to be made across various sectors including mining, energy, and agriculture, among others. With more sectors now open to investment, Japan hopes to boost trade in the broader Latin American market.

Japan and Brazil

Brazil is a large investment market for Japan. With close to 700 Japanese companies currently operating in Brazil, the commercial and industrial opportunities the country offers are unquestionable. In 2016, Japan imported goods worth US$6.7 billion from Brazil, a drop by 10.6% over the previous year when the imports stood at US$7.5 billion. Japan and Brazil are now partnering to strengthen trade and investment between the two countries to spur increase in trade.

Brazil offers Japan a considerable investment opportunity in infrastructure projects. After the Cooperation Agreement for the Promotion of Infrastructure Investments was signed in October 2016, investment in areas such as transportation, logistics, information technology, and energy is expected to increase. At the same time, Japan is a large market for Brazilian agricultural products such as soy, corn, and cotton, but Brazil is also interested to enter the fruit and beef market in Japan. While discussions and negotiations regarding the entry of Brazilian products in the Japanese market are still under way, issues related to hygiene and sanitary standards still need to be addressed.

Japan and Paraguay

Paraguay is one of the least explored countries in terms of trade by Japanese firms. Between 2011 and 2014, only some 10 Japanese companies established operations in Paraguay. Japanese exports to Paraguay stood at US$77.5 million in 2016 while imports from Paraguay were reported at US$41.6 million during the same year. Japanese companies plan to invest in Paraguay to improve business and generate revenue in sectors such as infrastructure, agriculture, and energy, which are seen as areas of opportunities in the future.

Japan and Uruguay

In January 2015, the countries signed a Japan-Uruguay Investment Agreement – the first investment agreement between Japan and any member of Mercosur. Uruguay has become an attractive destination for Japanese investors mainly due to the country’s economic and political stability, low level of corruption, and easy inflow of FDI in the country. Additionally, Japanese companies are provided with the same opportunities and conditions as domestic firms. Uruguay offers the benefit of being able to serve as a distribution hub and boasts of good logistical services to other Mercosur countries – Japanese companies are likely take this as an opportunity to develop an overseas base to strengthen business ties within the region. Uruguay largely depends on natural resources such as wind, water, solar, and biomass to produce energy, making the renewable energy sector in the country another attractive area for investment by Japanese companies in the coming years.

EOS Perspective

The arrival of Trump’s administration leading to USA’s withdrawal from Trans-Pacific Partnership and focus on encouraging domestic industrialization by limiting imports from countries across Latin America, have resulted in several LATAM countries’ attempts to improve and tighten friendly trade relations within their own region as well as with new partners globally, including Asia – we wrote about it in our article Trump In Action: Triumph Or Tremor For Latin America? in February 2017. Japan appears to be willing to use this situation to its advantage by renewing trade and investment policies with Mercosur nations as well.

In the past five years, exports and imports value have declined continuously between Japan and Mercosur nations, and to reverse this declining trend and to revive trade, Japan started to build new trading relationships with Mercosur countries. If successful, this initiative is likely to serve two purposes – firstly, Mercosur countries can reduce dependence on the USA and move towards new markets to look for new opportunities, and secondly, through increased investment in Mercosur, Japan can become a prominent player in the region to reap benefits from engaging in business with several emerging countries.

by EOS Intelligence EOS Intelligence No Comments

TPP 2.0 – Minus the USA

The Trans-Pacific Partnership (TPP) is a regional trade agreement involving twelve countries on the Pacific Rim: Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the USA, and Vietnam. TPP was to be the largest regional trade agreement as the countries involved accounted for 40% of the world’s GDP and 26% of global trade by value. TPP differed from usual trade partnerships as the agreement, along with focus on free trade, also promoted intellectual property protection, enhanced labor standards, and environmental protection, as well as took into account the needs of a digitized global economy – setting new standards for 21st-century global trading environment.

Negotiations on the deal were concluded in October 2015 and representatives from each country signed the agreement in February 2016. TPP was to come in effect after approval of the agreement by each country’s legislature. Before the deal could materialize, the newly elected president of the USA, Donald Trump, issued an executive order in January 2017 withdrawing the country from the process – leaving remaining member-countries in a lurch.

As per the terms, TPP could come in effect only if ratified by six countries accounting for 85% of the group’s total GDP. Since the USA accounted for about 60% of the groups’ total GDP, its withdrawal killed the deal in a literal sense. However, the remaining eleven countries are still clung to the idea of TPP and are reluctant to throw away years of negotiation. This leads to a question – can TPP survive without the USA? We take a look at the countries’ take on a newly proposed TPP agreement involving the group of eleven countries, without the USA.

Japan to lead the pact

When the USA opted out from TPP, the first reaction of the prime minister of Japan reaffirmed that the trade deal was meaningless without participation of the USA – the largest market in the group. Soon Japan realized that even through eleven-member TPP it can still yield net economic gains in medium-sized markets such as Australia and Vietnam. Moreover, this deal was essential to reduce the dominance of China in the region. Since TPP has been an integral part of the Japanese government’s growth strategy, the country took a U-turn from its previous stance and took the lead in pushing forward the relaunch of TPP involving eleven member countries.

Australia, New Zealand, Singapore, and Canada still in favor of the deal

Australia and New Zealand, being advocates of trade liberalization, were among the first few countries to express their intention to continue with TPP without the USA. Through the eleven-country TPP, Australia and New Zealand aim to gain access to new markets such as Canada, Mexico, and Peru, with which these countries do not have any trade agreements. Moreover, New Zealand expects to gain about two thirds of the US$2.7 billion in estimated annual benefits (after 15 years) if the eleven-member TPP is implemented with terms similar to original deal. This indicates that TPP would result in net economic benefit for the members even without participation of the USA.

Singapore, being an export-oriented economy, strongly favors multilateral trading system especially with like-minded trading partners and thereby the country is likely to support eleven-member TPP.

In a bid to strengthen its economic ties with the pact, especially with Japan, Canada has also shown interest in renegotiating the TPP with remaining eleven countries and urges other nations to join the trade deal.

These countries believe that it would be better to have a weakened TPP without the US participation than to have no TPP at all.

Latin countries sense distinct opportunity

Mexico has enjoyed free access to markets of its largest trading partners – the USA and Canada – since 1994 through North American Free Trade Agreement (NAFTA). As Trump administration turns unfriendly and hostile towards Mexico, threatening to renegotiate or even withdraw from NAFTA, Mexico is looking to diversify its trading options to counter the effect. Under such circumstances, Mexico is more than willing to pursue an eleven-member TPP that will open new markets for the country.

Smaller countries such as Chile and Peru are also keen on going ahead with the proposed eleven-member TPP so as to gain access to Asian markets.

Some Asian countries may lack enough incentive to continue with TPP in absence of the USA

Without participation of the USA, it seems difficult to lure countries such as Malaysia and Vietnam that agreed to change rules on state-owned enterprises and deregulate key sectors such as finance, telecommunications, and retail in anticipation of gaining access to the US market. Both the countries signaled waning enthusiasm for TPP in absence of their largest target market – the USA. For instance, through the twelve-member TPP, Vietnam was expecting its textile exports to increase by 40%, primarily due to free access to the US market at 0% tariff. Thus, without the USA, the expected economic benefits of TPP would drastically reduce for Vietnam as well as Malaysia.

In such a scenario, these countries might give preference to alternative trade agreements such as Regional Comprehensive Economic Partnership (RCEP) that includes seven of the TPP members (i.e. Malaysia, Vietnam, Brunei, Singapore, Japan, Australia, and New Zealand). Launched in 2015 and backed by China, RCEP is the proposed trade agreement aimed to economically integrate 16 countries in Asia and Oceania region, however, this trade deal lacks the elements of intellectual property protection or labor and environment laws that TPP is set apart with. Brunei, the smallest economy in the pact, is actively involved in further discussions, however, its final take on eleven-member TPP is still unclear.

EOS Perspective

While the twelve-member TPP is effectively dead, the new TPP, if at all formed and implemented in future, would be very different from the original one. Being the largest economy in the group, the USA had great negotiation power in development of the original TPP. With the USA’s exit, the power dynamics have changed and the remaining member countries might want to reconsider certain terms that they agreed upon only under the pressure of the USA. For instance, Malaysia could demand change in TPP’s rules that restrict the country to offer preferential treatment to ethnic Malays in government contracts. Such difference in power dynamics might indicate that the eleven-member TPP negotiation process is unlikely to be as simple as just striking ‘the USA’ off the 5,000+ page agreement. It might take years of discussions and renegotiations before the member countries could reach a consensus.

Furthermore, increasing participation from other countries is one way to fill the void left by the USA. TPP members have extended invitation to several countries, including China and UK. China immediately rejected the proposal stating that the TPP is very complex and the country is rather focused on RCEP. In the meantime, UK is yet to confirm its intent. UK is looking to deepen ties with other countries to boost trade after Brexit, thus, joining the TPP might be a good decision, as this might possibly allow the country to have direct access to the markets of the current eleven member countries. However, UK would need to objectively weigh in the estimated benefits of joining TPP as against the stringent requirements of the deal.

At this stage, the future of TPP is uncertain. In the end, all countries act in the best interest of their own economies as well as own political aspirations. Though the ambitious TPP proposal laid out a strong vision for international rules-based trade and investment system for global digital economy, it is far from implementation unless it ensures satisfactory benefits for all the countries involved.

by EOS Intelligence EOS Intelligence No Comments

Trump In Action: Triumph Or Tremor For Latin America?

Donald Trump commenced his presidency by announcing ‘America First’ policy, thus casting a dark shadow on trade and exports from other countries to the USA. Trump’s protectionist and neo-isolation policies are accepted with gritted teeth across the world, particularly by the USA’s southern neighbors. The renegotiation of trade treaties, more stringent migration policies, as well as strong focus on encouraging domestic industrialization by pruning imports might contribute to a slowdown in economic growth of a few Latin American countries. The policies set by the new president may result in economic malaise across Latin America, where people are uncertain and apprehensive towards the alarming strategies laid down by the USA.

While the degree of economic and trade impact will vary across LATAM countries, the strongest distress is likely to be witnessed across Cuba, Mexico, and Venezuela. On the other hand, Brazil might partially benefit, while the impact is unlikely to be significant on other larger economies such as Argentina or Chile.

The wall between Mexico and the USA

Mexico is facing the worst of Trump’s wrath. The country is highly dependent on the USA for trade – most importantly for duty free exports. These are likely to witness a tremendous setback with Trump imposing 20% import tax on goods from Mexico to finance a wall that he intends to build to safeguard USA’s border from illegal immigrants.

Renegotiation of the North American Free Trade Agreement (NAFTA) and withdrawal from the Trans-Pacific Partnership will further tarnish Mexico’s trade with the USA. Trump intends to renegotiate terms of NAFTA, focusing mainly on moving away from the zero trade barrier policy. By imposing tariffs on imports from Mexico, the cost of goods will increase as they enter the USA, which is likely to boost domestic production of those goods, but it will surely have a negative impact on Mexican production. Another key driver for Trump’s plans to put a break on Mexican imports is the concern over trade deficit that the USA faces with Mexico – approximately, US$ 50 billion in 2015. Hence, Trump wants to encourage domestic production to reduce imports from Mexico.

Further, Trump’s administration has also endangered billions dollars of remittances, one of the largest sources of foreign capital in Mexico, received from Mexican citizens working in the USA. Trump has threatened to tax the remittance transfers if Mexico does not support the trade and immigration limitations imposed by the USA.

Another major issue is the possibility of implementation of strict migration policies which can result in deportation of millions of undocumented migrants, most of them being Mexicans. Several other countries such as Haiti, Dominican Republic, El Salvador, Guatemala, Honduras, and Cuba also stand to suffer due to the change in migration policies. Mass deportation will increase unemployment in these migrants’ home countries and reduce remittances in foreign currency.

Amid the USA-Mexico tension, the Mexican peso has already witnessed a slump, almost nearing its all-time low – declined by 5% since the beginning of 2017 and by 20% since Trump came into power.

Trump’s crackdown on Cuba

The relationship between Cuba and the USA is predicted to get frosty under Trump’s administration. Cuba has struggled for several years under the USA-imposed isolation until president Obama negotiated to re-establish diplomatic relationship between these two countries. However, in his campaign, Trump threatened to reverse the restated diplomatic relationship – including easing of travel and remittances between Cuba and the USA – if Cuba does not agree to a “better deal” which Trump left undefined. Moreover, the US president has announced that he was against the Cuban Adjustment Act, which permits any Cuban, who reaches the USA to stay there legally and apply for residency.

Venezuela, not far from Trump’s radar

Trump has already turned hostile towards Venezuela considering the recent sanction imposed by his administration in February 2017 on the Vice President Tareck El Aissami, accusing him of playing a significant role in international drug trafficking. Relationship between these two countries has already turned sour amidst the deep economic and political crisis that exists in Venezuela.

Further, Venezuela’s oil exports to the USA might suffer due to Trump’s decision to revive the Dakota Access Pipeline – an oil pipeline project that can reduce country’s need to import crude oil. Presently, Venezuela exports 792,000 barrels a day of its crude oil or 38% of total crude exports to the USA, and any additional access to oil for the USA could have a deep impact on Venezuela’s oil exports.

Trump could be good news for Brazil

It appears that the only silver lining for Latin America, while Trump hovers with his protectionist policies, is Brazil’s opportunity to strengthen its ties with Pacific and European nations. Brazil’s Minister of Foreign Trade predicts new trade opportunities for Brazil, as the country aims to expand trading relations with other countries, while the USA withdraws and renegotiates key trade agreements. Moreover, Brazil (as a member of Mercosur – consisting of Argentina, Brazil, Paraguay, and Uruguay) is already pursuing free trade agreement with the European Union, with next round of negotiations lined up for March 2017.

However, a few setbacks that Brazil could suffer include deportation of many of the 1.3 million Brazilians immigrants living in the USA, whose stay in the USA remains undocumented. The deportation is likely to adversely impact the remittances received by Brazil. Further, Trump’s focus on implementing higher import tariffs is likely to impact the Brazilian exports to the USA – approximately 13% of Brazilian exports are directed to the USA.

 

EOS Perspective

USA’s withdrawal from Trans-Pacific Partnership and aim to renegotiate NAFTA is driving Latin American countries to break dependence on the USA, establishing friendly trade relations with other countries and strengthening intra-regional ties. Latin American countries are focusing to redirect trade and investment towards countries such as China and Russia, as well as Europe and Africa.

China is already a key trading partner for Latin America – with trade between the two regions growing from US$ 13 billion in 2000 to US$ 262 billion in 2013 – and USA’s withdrawal from Trans-Pacific Partnership is likely to further deepen the ties between them. China aims to increase investment and trade in LATAM to US$ 250 billion and US$ 500 billion, respectively, by 2025.

China is moving swiftly to strengthen relationship with Latin American countries. Soon after Trump’s win, the Chinese President visited LATAM aiming to deepen economic cooperation, and to promote social and economic development in the region. During the visit, Ecuador and China agreed to a new economic Free Trade Agreement, focused to grow production and investment across energy, infrastructure, and agriculture sectors. An extension of China-Peru free trade agreement was also signed to promote bilateral trade and investment between the two countries. A closer association between China and Latin America is likely to reduce USA’s dominance and supremacy in the region.

Further, with USA’s plans to increase import tariffs, Latin American countries are slowly focusing on expanding intra-regional trading relationships, which till now have not been developed to their full potential due to dependence on the USA for trade and exports. Present circumstances are optimal to slowly start building an intra-regional trade force in Latin America, and the region’s countries should work towards strengthening existing trade and integration blocs, such as the Union of South American Nations (UNASUR) and the Community of Latin American and Caribbean States (CELAC).

Trump’s policies are likely to have a diverse impact on different Latin American countries. The region has already slowly started forging new trading relationships to reduce dependence on the USA, which proves that LATAM might be able to divert the negative repercussions of USA’s new policies and turn them into new opportunities (at least to some extent).

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