US Tariffs and Canada: A Looming Economic Reckoning

Key Takeaways:

I. The automotive and forestry sectors, highly integrated with US supply chains and representing a significant portion of Canadian exports, face substantial contraction under potential US tariffs, with cascading effects on related industries.

II. Canada's trade diversification efforts through CETA and CPTPP, while positive in the long term, have not generated sufficient export growth to offset the potential losses from increased US protectionism, highlighting the need for a more targeted approach.

III. Canada's lagging innovation performance, measured by R&D spending and business dynamism, exacerbates its vulnerability to external economic shocks, demanding urgent policy interventions to enhance competitiveness.

Bank of Canada Governor Tiff Macklem's recent statements regarding increased trade frictions with the United States, particularly through tariffs, represent a significant understatement of the potential economic consequences for Canada. While "structural changes" are anticipated, the reality is a potential cascading crisis across multiple sectors, driven by Canada's deep economic integration with, and dependence on, the US market. In 2024, Canada's merchandise exports to the US accounted for 77% of its total exports, a figure that underscores the magnitude of the risk. A hypothetical 10% across-the-board tariff on Canadian goods could translate to a direct reduction of over $50 billion in Canadian exports, based on 2024 export values, with far-reaching implications for GDP growth, employment, and investment. This is not simply a matter of adjusting to a 'new normal'; it's a fundamental challenge to Canada's economic model, requiring a comprehensive and proactive response.

Sectoral Impacts: Quantifying the Damage of US Tariffs on Key Canadian Industries

The automotive sector, a cornerstone of Canada-US economic integration, faces severe disruption from potential US tariffs. In 2024, automotive products constituted approximately 12% of Canada's total exports, with a staggering 85% destined for the US market. A 25% tariff on Canadian-made vehicles and parts, as previously threatened, could translate to a direct cost increase of over $20 billion annually, based on 2024 export figures. This would severely impact the profitability of Canadian automakers and parts suppliers, leading to potential plant closures and job losses, concentrated primarily in Ontario, which accounts for over 90% of Canadian auto production. The highly integrated nature of North American supply chains means that even smaller tariffs can have a disproportionately large impact, disrupting just-in-time inventory systems and increasing production costs.

The ripple effects of automotive tariffs would extend to related industries, including steel, aluminum, plastics, and electronics. Canadian steel and aluminum producers, already subject to previous US tariffs, face renewed pressure. In 2024, approximately 50% of Canadian steel exports and 80% of aluminum exports were destined for the US. A 10% tariff on these materials, coupled with reduced demand from the automotive sector, could lead to a combined revenue decline of over $5 billion for Canadian producers, according to industry estimates. This interconnectedness highlights the vulnerability of Canada's manufacturing base and the potential for widespread economic damage.

The forestry sector, particularly softwood lumber, remains a perennial target for US trade action. Despite the CUSMA agreement, disputes persist, and the threat of renewed tariffs looms large. In 2024, approximately 70% of Canada's softwood lumber exports, valued at over $10 billion, were shipped to the US. A 20% tariff, similar to those imposed in the past, could reduce Canadian lumber exports by an estimated $2 billion annually, disproportionately impacting British Columbia, which accounts for over 60% of Canadian lumber production. This would lead to mill closures, job losses, and economic hardship in resource-dependent communities.

The agricultural sector, while seemingly protected under CUSMA, faces ongoing challenges and potential non-tariff barriers. Dairy and poultry, subject to supply management in Canada, remain contentious issues. While CUSMA provides some market access for US dairy products, the potential for increased US pressure to dismantle Canada's supply management system remains a significant threat. Furthermore, stricter sanitary and phytosanitary regulations, or other non-tariff barriers, could be used to restrict Canadian agricultural exports to the US. In 2024, Canada exported over $30 billion in agricultural products to the US, representing a significant portion of total agricultural output. Even a 5% reduction in exports due to non-tariff barriers could cost Canadian farmers over $1.5 billion annually.

Diversification Challenges: Assessing the Limitations of CETA and CPTPP in Mitigating US Trade Risks

The Comprehensive Economic and Trade Agreement (CETA) with the European Union, while offering potential long-term benefits, has not yet delivered significant trade diversification to offset the risks of US protectionism. While CETA has eliminated tariffs on 98% of goods traded between Canada and the EU, the utilization rate of CETA preferences by Canadian exporters has been uneven. A 2023 report by the Parliamentary Budget Officer found that while some sectors, such as agri-food, have seen increased exports to the EU, others, particularly in manufacturing, have lagged behind. In 2024, Canadian exports to the EU represented only about 8% of total exports, a modest increase from pre-CETA levels, highlighting the challenges of penetrating new markets and overcoming established trade patterns.

The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), while offering access to new markets in the Asia-Pacific region, is a long-term strategy that provides limited immediate relief from US trade pressures. The CPTPP eliminates tariffs on a wide range of goods and services among 11 member countries, including Japan, Australia, and Vietnam. A 2022 study by Global Affairs Canada estimated that the CPTPP could increase Canada's GDP by $4.2 billion annually in the long run. However, realizing these benefits requires significant time and effort for Canadian businesses to establish new supply chains, adapt to different regulatory environments, and build relationships with new customers. In 2024, Canadian exports to CPTPP countries represented approximately 10% of total exports, indicating that while progress is being made, it is not sufficient to offset the potential losses from a major trade disruption with the US.

While the WTO provides a rules-based framework for resolving trade disputes, relying solely on this mechanism is insufficient given the current US administration's skepticism towards multilateral institutions and the lengthy dispute resolution process. Canada has a strong track record of using the WTO dispute settlement mechanism, and has successfully challenged unfair US trade practices in the past. However, the WTO process can take several years, and even successful rulings do not guarantee immediate compliance. Furthermore, the US has, at times, blocked appointments to the WTO's Appellate Body, undermining the effectiveness of the dispute settlement system. This necessitates a multi-pronged approach that combines WTO litigation with direct bilateral engagement and coalition-building with other like-minded countries.

Engaging with US state and local governments, as well as business groups, can be a valuable supplementary strategy, but it cannot replace strong federal-level engagement. Many US states, particularly those bordering Canada, have significant economic ties with Canadian provinces and are more receptive to maintaining open trade relations. Building relationships with governors, state legislators, and industry associations can help to create a counter-narrative to protectionist policies at the federal level. However, the ultimate authority to impose tariffs rests with the US federal government, limiting the influence of state-level actors. Therefore, while sub-national engagement is important, it must be complemented by a robust and proactive federal strategy.

Competitiveness Gaps: Addressing Canada's Internal Deficiencies to Enhance Resilience

Canada's lagging innovation performance, as measured by research and development (R&D) spending, weakens its ability to compete in the global economy and exacerbates its vulnerability to external shocks. In 2023, Canada's gross domestic expenditure on R&D (GERD) as a percentage of GDP was 1.6%, significantly lower than the OECD average of 2.7% and far behind leading innovators like South Korea (4.9%) and Israel (5.6%). This underinvestment in R&D translates to a weaker pipeline of new products, processes, and technologies, hindering Canada's ability to move up the value chain and compete in high-growth sectors. Addressing this requires a multi-faceted approach, including increased government funding for research, incentives for private sector R&D investment, and policies to foster a more vibrant innovation ecosystem.

Attracting and retaining investment, both domestic and foreign, is crucial for building a more resilient and diversified Canadian economy. Canada's business investment climate has faced challenges in recent years, with declining business confidence and concerns about regulatory uncertainty. To address this, the government needs to create a more stable and predictable policy environment, streamline regulatory processes, and invest in infrastructure to improve productivity and competitiveness. Furthermore, targeted incentives for investment in strategic sectors, such as clean technology, advanced manufacturing, and digital industries, can help to attract capital and drive economic growth. A proactive approach to attracting foreign direct investment (FDI), showcasing Canada's strengths and addressing investor concerns, is also essential.

A Call to Action: Building a More Resilient Canadian Economy

The potential economic consequences of increased US protectionism for Canada are substantial and multifaceted, demanding a comprehensive and proactive response. Addressing the immediate threat of tariffs requires a combination of strategic engagement with the US, targeted support for affected industries, and a renewed commitment to trade diversification. However, long-term resilience requires addressing Canada's underlying competitiveness gaps, particularly in innovation and investment. This necessitates a fundamental shift in mindset, from a reactive approach to trade disputes to a proactive strategy focused on building a more dynamic, diversified, and innovative economy. This includes significant investments in R&D, skills development, and infrastructure, as well as reforms to the regulatory environment to foster business dynamism and attract investment. The challenge is significant, but the stakes are even higher. Canada's economic future depends on a bold and decisive response to the challenges and opportunities that lie ahead.

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Further Reads

I. Seven Charts Showing How Canada/Mexico Tariffs Would ...

II. Trump’s 25% tariffs on Canada and Mexico will be a blow to all 3 economies

III. Evaluating the potential impacts of US tariffs - Bank of Canada