Introduction

The automotive industry is being deeply transformed by new technologies, government regulation, and consumer preferences. Information and communication technologies (ICTS) are impacting manufacturing, and vehicles are becoming autonomous, connected, electric, and shared (ACES). Regulation is promoting green electric cars, and a social trend has emerged to share vehicles instead of buying them. In addition, coronavirus disease (covid-19) caused a global economic crisis leading to plant closures for months, affecting sales, production, and profits, and breaking global value chains.

The automotive industry in North America also faces other challenges due to the July 2020 entry into force of the United States-Mexico-Canada Agreement (USMCA), which introduced four critical new rules of origin (ROO) for the automotive industry: (a) increase of regional value content (RVC) requirement for vehicles; (b) a hike in the auto parts RVC depending on their classification (core, principal, and complementary); (c) a first-time regional labor value content (RLVC); and, (d) an RVC for steel and aluminum.

According to the United States International Trade Commission (^{USITC, 2019: 85}), these changes will increase production of parts and employment in the U.S. and Canada and prevent offshoring. Additionally, as the USMCA region imports more vehicles and parts than it exports, the difference may provide an opportunity to substitute imported parts with regional products (^{INA, 2020}). However, these assertions may oversimplify the possible consequences of the industry’s new ROO. At this moment, the interpretation of how to calculate the parts’ RVC, later added to the car’s overall RVC, is in dispute among the partner countries.

The USMCA went into effect a year ago, and studies analyzing the effects are scarce. In this article, I investigate how the new ROO are impacting the automotive industry in Mexico, paying particular attention to explaining how specific car models are affected. Since governments assumed that the agreement would favor parts import substitution, I analyze regulated parts trade trajectories. This article proposes that the companies’ response to the new USMCA rules will be heterogeneous, depending on their product strategies, how far they are from meeting the new RVC threshold, and the tariff imposed.

Analysis of specialized literature allowed me to reconstruct industry participation in globalization and regionalization processes. I developed a theoretical framework on localization factors and free trade in order to characterize ROO, and explain companies’ responses. Other data reviewed were mandatory reports from the American Automotive Labeling Act, government official documents, and research literature. Trade Map database was used to analyze trade growth trajectories of regulated auto parts.

The article is organized in four sections: (a) a description of auto industry globalization and regionalization processes along with some conceptual background on FDI location, relationship, and Foreign Trade Agreements (FTA); (b) a succinct analysis of the impact of the North American Free Trade Agreement (NAFTA) in the industry as a precedent for the USMCA; (c) implementation of the new ROO and changes observed in the first year under the USMCA; and (d) discussion of the data and conclusions.

Globalization and Regionalization of the Automobile Industry

Globalization gained momentum in the late 1970s through restructuring of the capitalist system. Financial deregulation, trade liberalization, and privatization increased capital and trade flows. For twenty years, world trade increased and multinationals became relevant actors, creating facilities in countries where spatial proximity was critical (^{Dunning, 1998: 47}).

Around 1995, regionalism accelerated, and the number of free trade agreements (FTAS) increased.¹ The economic blocs of the European Union (EU), the Asia-Pacific Basin, and North America consolidated; high- and low-cost countries were integrated, benefitting from comparative advantages; for example, North America incorporated two high-cost countries (the United States and Canada) with one low-cost country (Mexico). As globalization and free trade have been associated with inequality, protectionism became relevant in these years. All this was complicated by the covid-19 pandemic, which exacerbated trends in anti-globalization (^{Curran and Eckhardt, 2020}).

The automotive industry is at the center of the globalization and regionalization process. Companies’ strategies led to creating productive geographic spaces, the international division of labor, and the generation of global value chains. Mergers and acquisitions consolidated the industry and allowed companies to increase the product spectrum and access new markets and technologies. Automakers promoted the internationalization of firms and designed global cars and platforms, although this was not successful. Toyota used a policy of products targeting regional markets, achieving better results (^{Lung and Van Tulder, 2004}).

By 2002 the industry had thoroughly assimilated the regionalization process. EU production added to NAFTA’s accounted for more than half their world output, and, adding Mercosur, the Association of Southeast Asian Nations (ASEAN),² and the Commonwealth of Independent States (CIS),³ it reached 70 percent (^{Lung and Van Tulder, 2004}). By 2020, production regionalization was maintained while changing its epicenter to Asia. The share of the EU and the USMCA region decreased 34.97 percent. Even adding Mercosur, ASEAN, and cis, production reached only 46 percent, losing 30 percentage points in twenty-eight years (^{OICA, 2021}). The decrease was due to China’s participation, which increased from 5 percent to 32.5 percent in twenty years.

^{Freyssenet (2017)} points out that market globalization and harmonization of automobile demand never occurred. On the contrary, globalization generated different “growth modes” and income distribution.⁴ Thus, carmakers had to keep using differentiated strategies and failed to reduce the number of platforms worldwide. Even without market globalization, the industry increased its internationalization: between 1990 and 2005, its transnational index (TNI) rose from 36 percent to 56 percent, approaching the world industrial average of 60 percent (^{Jetín, 2017}). Regional automotive production is the dominant pattern; however, globalization transformed the industry by promoting a highly complex inter-regional value chain with flows of intermediate goods, information, knowledge, and money between geographical production spaces (^{Sturgeon et al., 2010}).

De Gortari points out that “in GVC [global value chains], intermediate input suppliers produce specialized inputs that are only compatible with specific subsequent uses, and manufacturing companies in Mexico that export to the U.S. use relatively more U.S. inputs than those exporting to other destinations” (2017: 1). He estimates that the automotive industry’s integration in the two countries is so deep that the U.S. accounts for 74 percent of foreign inputs embedded in vehicles assembled in Mexico and sold in the U.S. market. In contrast, the U.S. accounts for only 18 percent of the inputs embedded in a car built in Mexico and sold on the German market.

Published studies on determinants of manufacturing and FDI are plentiful. Still, determinants like access and market size, GDP, GDP per capita, and cost factors have been consistently mentioned over time and also fulfilled in USMCA. Labor issues such as low wages, the number of skilled and unskilled employees, and the number of engineers are also widely mentioned (^{Hurley, 1959}; ^{Dunning, 1998}). Also analyzed are agglomerative spatial economies and local service (^{Dunning, 1980}; ¹⁹⁹⁸), transaction costs (^{Williamson, 1979}), strategies in the automotive value-added chain (^{Sturgeon et al., 2010}), infrastructure development and regional innovation capabilities (^{Csíki, Horvath, and Szász, 2019}). I focus on free trade agreements and ROO that influence investment location and supply-source decisions.

Free trade agreements (FTAS) help partner countries reduce barriers to imports and exports between them: tariff and non-tariff trade barriers may influence companies to locate facilities or investment in a country when increasing the market size or allowing access to a population with higher per capita GDP (^{Dunning, 1980}; ¹⁹⁹⁸; ^{Sturgeon et al., 2010}). ^{Reinsch et al. (2019)} indicate that FTAS have contributed to configure global value chains by favoring industry linkages and protecting producers from rivals external to the region. However, FTA ROO define features of a product to be considered originating in a region in order to receive preferential treatment and may not always benefit GVCS. ROO impose barriers for companies and countries outside the economic bloc and can motivate producers to locate production facilities within the countries, partly to take advantage of preferential treatment. On the other hand, complicated ROO can increase transaction costs, and companies may choose to pay the tariffs rather than comply with them.

Strict rules may force companies with low-cost sources of supply outside of FTAS to seek supply sources within the region and thus receive preferential treatment, despite the fact that the inputs may be of higher cost or lower quality. This may happen when the preferential margin is wide enough to incentivize the change of supplier. ROO may support protectionist goals for inputs and final products in the region. Governments can use them to encourage investment and create well-paying jobs (^{Estevadeordal and Suominen, 2003}).

Background of the USMCA Free Trade Agreement

The automotive sector has existed for more than ninety years in Mexico, contributes 3.8 percent to national GDP and 20.2 percent to manufacturing GDP, generates 1.8 million jobs, manufactured 3.9 million vehicles in 2019, and is the world’s seventh-largest vehicle producer (^{AMIA-INEGI, 2018}). The sector has twenty-two complete car assembly plants, more than 2,000 suppliers, and thirteen private engineering and design centers. This explains the concern of developed countries about the relocation of design services and research and development.

Auto industry results in Mexico after twenty years of NAFTA have been controversial. Benefits include increased production, contribution to total and manufacturing GDP, and job creation. However, the pull to grow other industries, to integrate national suppliers in global value chains, and to raise research and development capacities have been insufficient (^{Álvarez, 2014}).

Automotive industry growth in Mexico is explained by drivers-of-location decisions of FDI, including low wages, cheap and skilled labor, a broad base of international suppliers, agreements with several countries that trade with preferential tariffs with Mexico, proximity to the U.S. market, government support to attract foreign investment, agglomerative spatial economies, local services, and a devalued currency that decreased production costs. Infrastructure problems still exist, such as limite d natural gas and high prices for electricity supply (^{Álvarez and González, 2015}; ^{Álvarez and Carrillo, 2017}; ^{Dussel-Peters and Gallagher, 2013}; ^{Covarrubias, 2019}; ^{Martinez and Carrillo, 2019}; ^{Klier, 2019}).

NAFTA’s results partly explain the new ROO and the protectionism behind them. It was necessary to recover production spaces and jobs and improve the opinion of workers and citizens of the United States about regional agreements and the benefit they can represent for that country.

The USMCA’S New Rules of Origin for Light Vehicles and the First Impacts

The USMCA trade agreement imposed new ROO, increasing the regional value content requirements so that products not originating in the region pay tariffs for commercial exchange. To avoid taxes, which range from 2.5 percent for light vehicles to 25 percent for light trucks, carmakers must meet the mandatory RVC and, if necessary, reconfigure the region’s models and range of cars traded.

Regional Value Content for Auto Parts

The agreement mentions three types of auto parts: core, principal, and complementary. Together, they represent sales for US$294.86 billion, making up 11.55 percent of the total imports in the USMCA region in 2020.

Core parts for passenger vehicles and light trucks (Figure 1). The RVC requirement for core parts is 75 percent using the net cost method and 85 percent using the transaction cost method.⁷ Core parts are about 40 percent of the vehicle cost. The seven core parts (engines, transmissions, body and chassis, axles, suspension systems, steering systems, and advanced batteries) must be manufactured in the region to be considered original. Rubenstein and ^{Klier (2019)} point out that most core parts installed in vehicles manufactured in North America are produced by the automakers or by their Tier 1 suppliers in facilities located within the USMCA region. Therefore, companies may not expect a significant impact, except for some transmissions of German and Asian carmakers and several of the motors that are produced outside the region.

Source: Developed with data from ^{Trade Map (2020)}, Data Base, Table A.1 Core parts for passenger vehicles and light trucks, seventeen tariff items, and USMCA (n.d.).

Figure 1 USMCA CORE PARTS IMPORTS 

One of the purposes of ROO is to decrease region core-part imports, which grew an AAGR of 4.03 percent in twenty years. In 2020, the region imported US$113 billion, or 16.2 percent less than the previous year; most of the imports (61 percent) are made by the U.S. The drop in imports is a world trend that began in 2019 and grew during the covid-19 crisis. However, it is not yet possible to identify whether the drop in imports is the beginning of the expected trend related to USMCA (see Figure 1).

Core parts include seventeen tariff items,⁸ where heading 850760, “Lithium-ion accumulators,” is remarkable as it grew at an AAGR of 20 percent between 2012 and 2020. The USMCA region accounts for 14.8 percent of total world imports of lithiumion accumulators, and the U.S. imported US$2.099 billion from China, which represents half of these imports. The agreement requires advanced batteries to be original, and this rule is intended to incentivize new investments in the U.S. or Canada. ^{Arteaga, Marcial, and Ortiz (2021)} argue that the agreement tries to increase industry competitiveness vis-à-vis China and restrict its presence in the U.S. market. They supposed that competition forced an RVC increase in the most dynamic parts segments to contain China.

Principal parts for passenger vehicles and light trucks (see Figure 2). The RVC requirement for principal parts is 70 percent as estimated by the net cost method or 80 percent if the transaction value method is applied.⁹ Principal parts imports grew up at an AAGR of 4.6 percent in twenty years. However, in 2020, the region imported US$116.45 billion, 15.3 percent less than the previous year because of the covid-19 crisis. Most of the imports went to the U.S. (66.7 percent) and Mexico (18.7 percent). Principal parts include thirty-eight tariff items (^{DOF, 2020: 219}). Two tariff items stand out, which together represent 34 percent of total imports: heading 870829, “Other parts and accessories of bodies, including cabs of motor vehicles (excluding body stampings),” imported US$21.318 billion. This was followed by heading 870899, “Other parts and accessories of motor vehicles of headings 87.01 to 87.05 (excluding chassis frames),” which imported US$18.382 billion.

Source: Developed using data from ^{Trade Map (2020)}, Database Table B, Principal parts for passenger vehicles and light trucks thirty-eight tariff items, and ^{USMCA (n.d.)}

Figure 2 USMCA PRINCIPAL PARTS IMPORTS 

Complementary parts for passenger vehicles and light trucks (see Figure 3). The RVC requirement for these parts is 65 percent applying the net cost method, and 75 percent applying the transaction value method.¹⁰ Imports of these parts grew at an AAGR of 4.5 percent in twenty years. In 2020, the region imported US$65.409 billion or 14.08 percent less than the previous year, because of the drop in production related to the covid-19 crisis, and the U.S. imported 67.7 percent of the total. Complementary parts include twenty-seven tariff items (^{DOF, 2020: 221}). Together, heading 854430, “Ignition wiring sets and other wiring sets of a kind used in motor vehicles,” and heading 842139, “Catalytic converters,” represent 26 percent of the total. However, this trade is mainly intraregional from Mexico to the U.S.

Source: Developed with data from ^{Trade Map (2020)}, Database, Table C Complementary parts for passenger vehicles and light trucks, twenty-seven tariff items, and ^{USMCA (n.d.)}

Figure 3 USMCA COMPLEMENTARY PARTS IMPORTS 

Automakers that cannot comply with the new ROO, but do comply with NAFTA’s rules (62.5 percent of RVC), may pay the most-favored-nation rate that will not exceed 2.5 percent for light vehicles and 25 percent for light trucks, limited to a total of 1.6 million units (^{DOF, 2020: 48}). However many doubts have yet to be resolved. On August 20, 2021, Mexico requested a formal consultation with the United States. It is a non-contentious stage of a dispute resolution mechanism provided for in Chapter 31 of the agreement. The interpretation of calculating the RVC of auto parts and later adding to the overall car’s RVC is in dispute. These kinds of problems may wear down the industry and increase transaction costs (^{Automotive News, 2021}).

The Regional Labor Value Content (RLVC)

The regional labor value content (RLVC) requirements for vehicles did not exist under NAFTA. Now, for a passenger vehicle to be considered originating, it is necessary to certify that workers who received at least US$16/hour made 40 percent of the net cost of the vehicle.

The RLVC is made up of three stipulations (^{DOF, 2020: 213}). Twenty-five percent will be accredited for high wages related to materials or manufacturing. Compliance is gradual, to reach the total three years after the trade agreement enters into force: 15 percent by 2020, 18 percent by 2021, 21 percent by 2022, and 25 percent by 2023 (^{DOF, 2020: 213}). Ten percent more will be accredited for high salaries related to research and development and information technology, and five percent will be certified for high wages related to assembly. Compliance is mandatory as soon as the trade agreement goes into effect. Five percent of assembly wages are contemplated as long as the plants have the capacity for 100,000 motors, 100,000 transmissions, or 25,000 lithium batteries.

Initially, it was thought that the treaty renegotiation would lead to higher wages; however, in the end, the work of the Mexican labor force was reduced to participating in only 60 percent of the total value of the automobile. This rule may increase employment in the U.S. and Canada. However, it will hardly improve stagnant wages in the USMCA region because US$16/hour is below the average hourly wage paid by the auto industry in these countries.

Chapter 23 of the USMCA free trade agreement (^{DOF, 2020: 496}) seeks fairer treatment for workers. It aims to prevent partner countries from not properly enforcing labor laws that protect their workers in order to attract more investment or increase trade: this problem has already arisen in Mexico. The trade agreement also promotes the commitment to comply with the Declaration on Rights at Work and the Declaration on Social Justice for a Fair Globalization of the International Labor Organization (ILO).

It also eliminates all forms of forced or compulsory labor, including child labor. It obliges all three partner countries to comply with acceptable working conditions regarding hours, occupational safety and health, and minimum wages. Obligations include complying with each country’s labor laws to provide benefit payments such as profit sharing, bonuses, retirement, and health care, eliminating discrimination in employment, and promoting equality for women at work (^{DOF, 2020: 497}). Workers and unions must be able to exercise their rights free from violence and threats. Independent institutions for conciliation, union registration, collective bargaining agreements, and labor courts must be guaranteed (^{DOF, 2020: 504}).

Monitoring compliance with Article 23 will be the function of the Labor Council overseeing rules and procedures specified in the agreement itself. In addition, the USMCA Implementation Law, Section 731, states, “The United States Congress will establish the Independent Board of Labor Experts of Mexico for monitoring and evaluating the implementation of labor reform” (^{IMLEB, 2020: 1}).

The Mexican government has taken advantage of the commitments made in the agreement and promoted long-pending labor reforms. As a result, changes to the National Labor Law passed in May 2019 include (i) gradual replacement of the functions of the Conciliation and Arbitration Boards by labor courts in the hope of decreasing resolution delays; (ii) the creation of a Federal Center for Conciliation and Labor Registration to register unions and collective bargaining agreements in Mexico; and (iii) the establishment of new mechanisms to guarantee freedom of association. The previous labor law regulated the right to organize unions, but was never enforced (^{STPS, 2019}). Of note are the rules prohibiting “covering up a labor relationship with simulated legal acts to avoid compliance with labor and with social security obligations, and also registering a worker with a lower wage than s/he receives,” both widespread practices in Mexico.

There is also confusion about how to calculate this content. The business community indicated that the agreement has some flexibility in its application since RLVC will be calculated for the entire corporation, adding the results of the different facilities in each of the three partner countries.

Regional Value Content for Steel and Aluminum

The agreement states that “a passenger vehicle, light truck, or heavy truck is originating in the region if, during the fiscal or calendar year before export or export quarter, at least 70 percent in value of corporate purchases of steel or aluminum were made in the USMCA region” (^{DOF, 2020: 213}). This rule of origin will only have to be reported by carmakers, as they purchase large quantities of steel annually for themselves and for their suppliers to achieve lower prices per ton of steel.

The trade agreement also states that after the seventh year, the steel purchased must have been melted and processed in the USMCA region (^{INA, 2020}). This rule affects companies that import steel from Asian or European countries. It will favor only the United States and Canada because Mexico does not produce steel for the automotive industry. Similarly, the RVC requirement for aluminum may favor Canada and the United States, which occupy the fourth and ninth places in world production (^{Statista, 2020}). Again, Mexico imports bauxite, as its aluminum production is limited.

Finally, the USMCA presents some options to help in the transition. Ten percent of a company’s total annual production of passenger vehicles or light trucks is eligible for a transition period that ends five years after the entry into force of USMCA, as long as they comply with the following: (a) 62.5-percent automobile RVC; (b) 62.5-percent RVC for core parts; (c) the steel and aluminum RVC requirement shall be fully met unless all three countries agree to modify it; and, (d) RLVC cannot be reduced by more than five percentage points for high wages in materials and manufacturing expenses, unless the three countries agree to modify it (^{DOF, 2020: 215}).

Conclusions

Companies will probably comply unevenly with the new rules of the agreement depending on their product strategies, how far they are from meeting the new RVC threshold, and the tariff imposed. I found that product strategies and the problem of meeting the new RVC are essential factors.

The impact was not the same for carmakers in Mexico: Ford, GM, and FCA were favored by the increase in the RVC because most of the vehicles they manufacture in Mexico and sell in the U.S. were already built with parts made in the area; three Nissan vehicle models were also in the same circumstances. The Mazda 3 and The Audi Q5 comply with the RVC, although transmissions came from Japan, Thailand, and Germany.

German and Asian automakers were the most affected by the ROO. Twenty-two of their vehicles had an RVC lower than required when the agreement came into force. One year later, they reported a slightly lower RVC for some cars, so these automakers are not adjusting to the new rules and some of these vehicles may not be brought into compliance, ending sales in the U.S.

Premium brands follow a quality and niche strategy, and they are not abiding by these rules. As a result, the carmaker may decide that it is costly or bad for quality to substitute suppliers of core auto parts and choose to pay the duty, more so if the vehicle has a very low RVC. BMW, Mercedes Benz, and Audi are in this situation, as their engines and transmissions come from Hungary and Germany. Furthermore, opening a new internal combustion engine plant in the USMCA region does not make sense because of the technological change towards electromobility. Therefore, paying a 2.5-percent tariff and increasing the car’s price may be an option for them. Also, BMW is already deploying a market diversification strategy.

Companies with strategies based on economies of scale or emphasis on cost reduction will seek to comply with the rule of origin, especially if they are close to the RVC threshold. The Mazda 2; the Honda HR-V; Nissan’s Sentra and the QX50 of its luxury brand Infiniti; Toyota Tacoma; and Hyundai-Kia will probably choose to comply.

Volkswagen had the lowest RVC, and the company is pursuing a mixed strategy: on one hand, it ended the production of some products such as the Golf for the U.S. market, and on the other hand, it kept the SUVS. It also announced engines will be manufactured at the Guanajuato, Mexico facilities. Cars made in Mexico have a higher RVC average from Mexico (52.70 percent) than from the U.S. and Canada (24.17 percent); this could help comply with the RLVC, limiting Mexican labor’s value to 60 percent of the value of the car. In addition, all gm engines are manufactured in the U.S., while all Nissan and Hyundai-Kia are made in Mexico.

The FTA is increasing transaction costs because of the burden of applying the ROO. The rules are already causing controversy, and it will take more time for results to be observed. For now, some automakers have applied for an alternative transitional regime.

Inexpensive labor is a widely known location factor and will change in Mexico. The new government increased the stagnant minimum wage for three years in a row and installed a new labor regulation along with mandatory mechanisms. Chapter 23 of the free trade agreement may help improve workers’ conditions, especially for multinationals that export within the USMCA region, since a commission will supervise companies to avoid non-compliance with labor laws.

The RVC requirement for steel and aluminum favors the United States and Canada. At the same time, Mexico is not affected since it does not produce steel for the automotive industry, and aluminum production is limited.

I analyzed changes in imports from the three groups of auto parts regulated that represent 11.55 percent of total imports in the USMCA region in 2020. Four elements stand out among these changes: a) The covid-19 crisis negatively affected imports of core, principal, and complementary parts, which decreased on average 15 percent from 2019 to 2020; b)The United States was the partner country that imported more auto parts: 65 percent of the total; c) U.S. imports of lithium accumulators come from China, the world’s leading producer. This is important because the future of the automotive industry is electromobility, which depends on lithium batteries and, therefore, imports should be replaced shortly by batteries produced in the USMCA region; and, finally, d) The intraregional trade of complementary auto parts includes “ignition-wiring sets,” which are at the top of the list in Mexico’s production and exports to the U.S.

By 2020, there was a general decline in production, regional trade, foreign direct investment, and employment related to the covid-19 crisis that complicates the interpretation of changes since the agreement’s entry into force.

Finally, changes will only affect companies located in the USMCA region, taking advantage of the free trade agreement. Reasons to manufacture in Mexico and export to other countries or regions will continue to be inexpensive skilled labor, trade agreements with other countries, government support for industry, agglomeration advantages, and a devalued currency. However, lessons learned from this process lead to insisting on giving greater importance to manufacturing in Mexico. It is necessary to replace inexpensive labor and a devalued currency as the main reasons to manufacture in the country. Mexico must implement an industrial policy that inserts the country into the wave of technological change and be aware of the possibility that an import-substitution process may be very favorable.