NAFTA and Domestic Policy Impacts: U.S. View

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1 NAFTA and Domestic Policy Impacts: U.S. View James M. Hansen and William H. Meyers Hansen is Research Associate, Department of Agricultural Economics, University of Arkansas Meyers is Professor of Economics and Interim Director of CARD, Iowa State University Introduction Mexico had been self sufficient in agriculture up until the mid seventies, at which time it became more dependent upon imports form the United States to support domestic consumption. The major imports have been corn, sorghum, wheat, and soybeans. The United States provided almost hundred percent of Mexico's imports for corn and sorghum, while the United States share of corn exports to Mexico has averaged 6 to 8 percent of total US corn exports. The share of US sorghum exports destined for Mexico have varied from a low of 8 percent in 1981 to more recent averages of 50 to 60 percent in the early nineties. The share of U.S. corn relative to domestic production in Mexico has decreased in the early nineties to average percent. Imports of U.S. sorghum relative to production has ranged from 75 to 125 percent in the early nineties. This indicates that corn and sorghum imports from the United States are quite important to Mexico, and the Mexican market is important to US producers. Wheat, barley, and rice exports to Mexico from the United States have increased since the mid eighties. The U. S. wheat exports to Mexico has usually ranged from one to two percent of total exports. During this same time period, Mexicos wheat imports from the United States have been 15 to 30 percent of Mexico's domestic production. Barley imports have not been as pronounced as wheat, but Mexico does import a greater share of the United States barley exports. Mexico only recently began importing rice from the United States, beginning in This has been 25 to 125 percent of Mexican production and accounted for 5 to 8 percent of United States total rice exports. Except for rice, Mexico has been importing a relatively large amount of grain since the late seventies. The above discussion and figures establishes the importance of grain trade

2 2 between Mexico and United States. But even with a large amount of trade, little price transmission has existed for these commodities between Mexico and United States, and therefore U. S. domestic agricultural policy has had limited affect on Mexican producers and consumers. In most markets with little government intervention, equilibrium or market clearing of supply and demand is achieved through the pricing system. In Mexico, the government has intervened in the market numerous ways. These included price support programs for agricultural commodities, input subsidies, import license controls, marketing subsidies, and direct consumption subsidies. These policies have separated the production and consumption sectors of these commodities and the price linkage does not facilitate equilibrium. Equilibrium in Mexico's agricultural market was achieved through controlled trade by the government. Producers received guaranteed prices above the international price, and marketing subsidies were passed on to the consumers. Prices were maintained at high levels by strict control of imports through import quotas. From the early 1950s until 1989 these commodities have been insulated form the international market through the use of price supports, guaranteed prices, for producers and subsidies for consumers. Mexico began liberalizing domestic economic policy in the early eighties and continued this process through the nineties. Tariffs and non-tariff barriers were gradually reduced beginning in In order to ensure acceptance into the General Agreement on Tariffs and Trade (GATT), Mexico began to phase-out non-tariff barriers in In August 1986 Mexico joined the GATT, and the liberalizing of economic policies increased. For example, quotas were reduced and substituted by tariffs, and these tariff rates were then further reduced. In 1987 the United States and Mexico negotiated an agreement called " A Framework of Principles and Procedures for Consultations Regarding Trade and Investment Relations" five different working groups were set up to review problems. In the late eighties the Mexican government established the economic reform plan for , called the Pact for Economic Stabilization and Growth (PECE). One of PECE's main objectives was to reduce government intervention in the private economy (Valdes, 1993). Many of the changes in government policies directly affected agriculture, such as the

3 3 Economic Solidarity Pact (ESP), that was negotiated in 1987 with labor and business sectors. The ESP objectives were to maintain price stability and economic growth. This program accelerated trade liberalization and reduced government agricultural production subsidies. In 1989 the Mexican government further liberalized its agriculture sector all guaranteed prices were removed except for corn and dry beans, the main food stables, and replaced with agreement prices. Indirect subsidies were also reduced for many crops (Valdes, 1993). Agreement prices replaced guaranteed prices in order to facilitate transition toward a market economy (Grennes et al. 1991). CONASUPO was no longer required to purchase all of the domestic production. The international market was opened to private traders once all of the domestic supplies had been purchased. In 1992, a new land reform program gave communal farmers legal title to encourage investments. Mexico also put renewed emphasis on trade activity and began negotiating bilateral and multilateral trade agreements, mainly within the Latin American region. In 1991, Chile and Mexico signed a Free Trade Agreement. The North American Free Trade Agreement (NAFTA) between United States and Mexico was signed but had not yet been ratified in December NAFTA was subsequently ratified by the U.S. national legislators in December This would continue the process of liberalizing Mexico's economy. The recent free trade negotiations are unique, since this was the first time a Mexican President explicitly linked rural development and domestic food policy to trade policy (Valdes, 1993). On October 9, 1993, a new policy program for the Mexican farm sector, PROCAMPO, was introduced by President Salinas. This policy reform will gradually align domestic agricultural prices with international prices and decouple agricultural policy by providing income assistance to farmers not linked directly to farmers' production levels. PROCAMPO includes the following crops; corn, dry beans, sorghum, wheat, soybeans, rice, barley, and cotton. Due to Mexico's strong government intervention in the agricultural market at many levels, continued reform of agricultural policies will have a large impact on producers and consumers in Mexico. Changes in Mexico's agricultural policy, PROCAMPO, and continued liberalization of trade under GATT(WTO) and the NAFTA, with United States and Canada,

4 4 will have increasing affects on Mexico's agricultural production, consumption, and trade, especially trade with the United States. In particular, the shift from non-tariff barriers to tariff based protection will increase the transmission of external market impacts to the Mexican agricultural market. U.S. Policy Reforms The increased linkages between Mexican and external markets, especially with NAFTA partners, will make policy changes in the U.S. more significant to Mexico. Since 1985, the United States has been reducing the role of government in price stabilization and other forms of market intervention. The last significant step in this process was the adoption of the Federal Agriculture Improvement and Reform Act (FAIR Act) of Steps were taken to further decouple income support payments from production decisions and reduce the government's role in supply management and price stabilization. Deficiency payments, which were influenced by market prices, were replaced with contract payments over seven years that are invariant with respect to production decisions or market prices. Unlike PROCAMPO payments, however, the U.S. payments are per unit of output based on (historical) program yield and program acres. By coincidence, the average per hectare payments for corn are very similar in magnitude to the PROCAMPO payments. These payments are scheduled to decline over the next seven years to reduce the total payments from a high of $6.38 billion in 1997 to $4 billion in The annual set-aside program (acreage reduction program) was eliminated, so farmers no longer will be required to idle land when asked by the government as a condition to receive payments. The long-term Conservation Reserve Program (CRP) was continued but with increasing emphasis on environmental criteria rather than on supply management. The commodity loan program was continued but with loan rates low enough to insure that the government does not acquire commodity stocks. The Farmer-Owned Reserve (FOR) was suspended for the seven year duration of the FAIR Act, so that the sometime stabilizing effect of this program is also eliminated. The expenditure caps for the Export Enhancement Program (EEP) were reduced from the GATT-bound levels by more than 60 percent in 1996 and 1997 and by nearly 30 percent in 1998 and (Note, however, that credits for underspending of EEP in 1996 and

5 can be used until 1999.) All of these changes contribute to the reduction of the government role in market intervention and stabilization. The new provisions of the FAIR Act, coming as they do in a tight market situation with historically low world grain stocks and high and volatile prices, increase the likelihood of significant price shocks in international markets. The European Union also has implemented a reform of the Common Agricultural Policy (CAP) in 1992, which reduced government market intervention for grains and by 1995 led to much lower stock levels. Under these new policy regimes in the United States and the EU, it is expected that world grain stocks in the medium term will remain relatively low by historical standards. This means that both seasonal and year-to-year price variability are expected to be greater than during the past decade or two. For this reason, farmers and other agricultural related businesses in the United States are looking more carefully at risk management strategies to deal with this increased price and revenue risk. To provide an example of the potential impact of such increased price volatility, we analyze the impacts on the Mexico corn market of price shocks originating in the U.S. market. Methodology The econometric model consists of an agriculture sector and a livestock sector. The agriculture products modeled include corn, wheat, dry beans, sorghum, rice, barley, and soybeans. The livestock sectors include pork and chicken. The production and consumption sectors are modeled independently because government policies, guaranteed prices for producers and subsidies for consumers, eliminated price linkages and equilibrium between producers and consumers. The production and consumption sectors are modeled independently based on the government prices, with trade accounting for the difference of production and consumption, which is similar to other models of Mexico (Rempe, 1992; Hueth et al., 1993). Simulation beyond the historical period incorporates new policies so the two sectors are solved together to obtain an equilibrium condition, and then trade will be determined. The presentation of the crops sectors will be presented in stages of production, consumption, and trade.

6 6 The econometric model was estimated in SAS proc model, using the OLS estimator, and simulated. Production, consumption, and trade data is from United States Department of Agriculture PS&D. Price data is obtained from Mexican Agriculture Databook, (Hall and Livas-Hernandez, 1991) and numerous USDA, Foreign Agricultural Service reports prepared by the Agriculture Affairs Office in Mexico City. Macroeconomics data is obtained from the International Financial Statistics. Production Production is determined by yield and area harvested. The yield and acreage harvested of a specific crop are estimated with OLS. Producers respond to real prices in decisions such as application of fertilizer, herbicides, and insecticides which affect yields. Therefore yields will be a function of prices and past yields. The prices used are guaranteed prices or farm prices (Fprice ) where i represents the different commodities. i Yield = Y(FPrice, Yield ) i i i,t-1 Acreage decisions are based on expected profits among competing crops. Therefore area harvested is affected by domestic prices of substitute crops, own price, interest rate (InteR), and fertilizer cost (FertC). Production (Prod ) is derived from an identity of yields i times area harvested. AreaH = H(FPrice, FPrices, InterR, FertC) i i s Prod = Yield * AreaH i i i Production relationships are similar for all crops; corn, dry beans, wheat, sorghum, and soybeans, but differ with respect to crop substitution for harvested area; and soybeans has additional equations accounting for meal and oil production. Food and Feed Demand Corn, wheat, barley and soybeans provide food for human consumption and feed for

7 livestock. Dry beans and rice are only utlized as food for human consumption. Sorghum is utilized only as animal feed. The per capita food demands (FoodPc ) include corn, wheat, i barley, rice, and soybean oil. Food demand is a function of retail price (Rprice ), subsititute i prices, and per capita income (INC). Total food consumption (FoodC ) is derived from an i identity of population (POP) times the per capita food consumption. 7 FoodPc = OF(RPrice, Rprice, INC) i i s FoodC i = FoodPc i * POP The feed demand includes sorghum, corn, wheat, barley, and soybean meal. Feed demand depends upon prices of own feed and feed substitutes, plus the level of production in the hog and poultry industries. A ratio of feed grain utilization to pork and poultry meat production was used to represent feed utilized by the pork and poultry industry. For example, sorghum utilized as feed with eighty percent in the current year and twenty percent last year divided by the sum of pork and poultry production for consumption in metric tons in the current year. The feed grain production ratio (FeedRto ) is estimated by OLS as a function of i own farm grain price and substitute feed prices. Time trend is used to capture the technological changes in feed rations and increase in efficiency for rates of gain by pork and poultry producers over the time period of estimation. The feed demand, FeedU, is derived i from an identity of feed grain utilized to meat production ratio times pork and poultry produced for consumption. Feed demand is derived for corn, wheat, barley, sorghum, and soy meal, which provides the link for livestock producers demand for grains and grain producers. FeedRto = (.8*FeedU +.2*FeedU )/(PorkPr+PoulPr), i i i,t-1 FeedRto = R(FPrice, FPrice, Time) i i s FeedU i = FeedRto i * ( PorkPr + PoulPr) International Trade Prior to the early nineties, the Mexican government purchased crops at the guaranteed price and then subsidized processors, with the lower cost being passed onto consumers, such

8 that excess demand existed. The government would issue import licenses, after harvest was known, to make up the difference between production and consumption. This allowed the production and consumption sectors to exist separately, and the government adjusted for the difference through the international market mainly with the United States. This supply adjustment determines quantity of imports or exports to maintain the fixed guarantees and 8 consumer subsidies. The data, except for recent years, represents this and can be modeled by a net imports identity (ImportN ) with the realization that the imports are determined not from i market equilibrium, but by the government. The net import equation also closes the model. A net import demand for the grain from the United States, ImportUS is derived as function of i, net imports, price of the grain at the border plus transportation, and trade policy instruments are incorporated. This allows policy instruments to be incorporated which provide a transition to a market driven economy. Imports from the rest of the world (except the United States) is derived from an identity of net imports minus imports from the United States. ImportN = FoodC + FeedU + Estk - Prod - Bstk i i i i i I ImportUS = M( ImportN PriceUS, Tariff ) i i, i i ImportROW = ImportN - ImportUS i i i Pork and Poultry The system of equations in the Mexican pork model is determined by the biological and economic nature of the pork industry. Pork production consists of four equations, sow ending stocks, number of pigs born, slaughter, and pork production. The pork per capita consumption is a function of income, carcass price for pork, beef price and chicken price. Pork net imports are derived through an identity of consumption minus production. Imports are 6 to 8 percent of production, and exports are less than one percent. An import function for pork is derived in order to incorporate the special safeguard tariff rate quota. Imports are a function of pork carcass price, U.S. barrow and gilt prices, and lagged pork imports. Pork exports are derived from pork imports minus net imports, which is quite small and provides a check on the pork import equation with respect to total production and consumption. Poultry production is derived from an egg production and layers equation. Efficiency

9 9 in poultry production has greatly increased as producers increasingly utilized current technology and feed rations over the past 15 years. This is captured through an egg production to number of layers ratio. Poultry net imports is a function of United States broiler price, domestic poultry price, domestic consumption, and lagged exports. The model is closed through an identity for ending stocks, and poultry price is solved by the market conditions. Prices During the estimation period, domestic prices are used with no price margin between producer and retail price because of government policy intervention. United States border prices are used in import equations. Mexico is assumed to be small in the world market and a price taker for imports and exports. The United States price is given as the international price, since most of Mexico's imports and exports are with the United States. In the simulation for the forecast period Mexico's farm prices are linked to the United States border prices. A transportation cost margin is incorporated as well as a margin for border price and retail price is given, which is maintained throughout the forecast. Import equations include NAFTA policies. Policy Instruments In the Mexican crop production sector, the main policy instruments and the degree of use have varied depending upon the crop. For example, the main staples, which include corn and dry beans, had the most government intervention (Mielke, 1989). Mexico producers are now adjusting to international agreements, GATT and NAFTA, and beginning to make production decisions based on prices more closely aligned with the international markets. Producers will no longer view government prices as the primary indicator of price movements, but will begin to respond to international market forces which affect prices. This movement toward liberalization of agriculture markets will be observed by producers as permanent and the adjustment as transitory Production decisions and investments should reflect this behavior. Since many crops, such as wheat, soybeans, and sorghum were partially

10 10 liberalized in 1989 by moving to an agreement price instead of the government guaranteed price, producers have already begun to respond to market prices and to anticipate the international effects of an open market (Grennes, et. al. 1991; Sanderson, 1993). The only domestic polices incorporated are guaranteed and reference prices. NAFTA policy instruments are incorporated, tariffs are included for wheat, rice, and soybeans, which are phased out over 10 years. Tariff rate quotas are included for, corn, dry beans, barley, and poultry. A special safeguard tariff rate quota is applied to pork imports.

11 Table 1: Mexico's Import Trade Policy for U.S. Agriculture Products before and with NAFTA. Commodities Trade policy before NAFTA Trade policy with NAFTA Corn Import license required Tariff rate-quota applied Dry beans Import license required Tariff rate-quota applied Sorghum 15% seasonal tariff Eliminate immediately Wheat Import license required License eliminate immediately 15% tariff 10 year phase out Soybeans 15% seasonal tariff Reduced to 10% immediately 10 year phase out Soybean meal 15% tariff 10 year phase out Soybean oil 10% tariff on crude oil 10 year phase out 15% tariff on refined oil Rice 20% tariff on brown & milled 10 year phase out 10% tariff on rough & broken Barley and Malt Import license required Tariff rate-quota applied 5% tariff Live cattle 15% tariff Eliminate immediately Beef 20% tariff on fresh beef Eliminate immediately 25% tariff on frozen beef Pork and 20% tariff Special safeguard tariff-rate quota slaughter hogs applied 11 Poultry Import license required 10% tariff Tariff rate-quota applied Source: USDA, International Agriculture and Trade Reports, NAFTA, Situation and Outlook Series, WRS-95-2, May 1995.

12 Table 2: Tariff Rate Quota System for Mexico's Imports from the U.S. Commoditie Within Tariff-rate Quota Over Tariff-rate Quota s 12 Corn Duty-free quota of 2.5 million Initial over-quota tariff of 215% metric ton Tariff is reduced 24% in first 6 years Quota increases 3% per year and eliminated in 15 years Dry beans Duty free quota of 50,000 metric ton Initial over-quota duty is 139% or Quota increases 3% per year $480/ton Largest duty is imposed on imports Duty is reduced 24% in first 6 years and eliminated within 15 years Barley Duty free quota of 120,000 metric Over-quota tariffs of 128% to 175% ton Tariffs are eliminated over 10 years Quota increases 5% per year Pork Special safeguard tariff-rate quotas Over-quota tariffs of 20% eliminated 120,000 metric ton over 10 years Within-quota tariff of 20% eliminated over 10 years Quota increases 3% per year Poultry Duty free quota of 95,000 tons Quota increases 3% per year Over-quota tariff of 133% to 260% Eliminated over 10 years Source: USDA, International Agriculture and Trade Reports, NAFTA, Situation and Outlook Series, WRS-95-2, May 1995 Scenarios We're interested in the affects on Mexico's production, consumption and trade as domestic prices become aligned to the international market and current polices are in effect, such as NAFTA. We have assumed that the United States border prices will have the dominate effect on Mexico's prices, especially under NAFTA. Variations in United States border prices will continue to have a greater affect on Mexico's producers and consumers. To see the effects of price variation in the United States on Mexico's agriculture we used the

13 13 Food and Agricultural Policy Research Institute (FAPRI) 1996 U.S. Agricultural Outlook conducted in April before spring planting and an updated Outlook conducted in August, The April Outlook is used as the baseline. The scenario uses the year 1996/1997. It is assumed that under the current trade policies of Mexico, tariffs are fixed and price increases are transmitted completely to the domestic market and influence both demand and supply in calendar year The focus of this analysis is on the Mexican corn and sorghum markets, since corn is the major food commodity and both corn and sorghum are major feed commodities and major imported commodities. Table 3. FOB Gulf Prices for 1996/97 in the FAPRI April Baseline and August Outlook. Corn Wheat Sorghum Soybean Soymea Rice Barley l US$/mt April Baseline August Outlook Percent Change Results and Implications The updated prices increased for all grains and soybeans and products, with increases ranging from 20 percent for barley to 12 percent for soybeans. The corn price in Mexico is estimated to increase by nearly 16 percent, with a slightly smaller increase in sorghum price (14.4). Corn production increases only slightly, but sorghum production increases more (Table 4). Corn food demand decreases by about one percent, which is 1.5 kg/person, since the price elasticity of demand for food is very small (Annex Tables A1 and A2). Feed demand, on the other hand, is much more price sensitive so the main impact of the price increase is a reduction of feed demand by 1.34 million metric tons (about 15.5 percent), while sorghum feed use increases only slightly. The combined effect of the increased production and reduced domestic use is a reduction of corn imports by nearly 1.6 million metric tons and a slight reduction of 191 thousand tons for sorghum. The decline in total feed use seems

14 large, but it indicates an implied demand elasticity of about unity. 14

15 Table 4. Impact of Price Shock on Mexico s Corn and Sorghum Markets, 1997 Commodity Farm Price Production Food Use Feed Use Imports percent thousand metric tons Corn Sorghum A major caveat to this analysis is that if the transition to full reliance on tariff measures is not yet complete, actual impacts may be smaller than those estimated here. Looking at data for 1995, when Gulf Port grain prices increased significantly from the previous year, it appears that prices in Mexico also increased but by a smaller percentage. This moderation of price impacts could be the result of government action, evidence of imperfect functioning of markets, or some combination of these factors. In any case, it is clear that the transition from an insulated market to a market driven primarily by price linkages to the world market is not yet completed. Thus, analysts need to look more carefully at the various factors that could moderate the degree of price transmission into the Mexican market and how these are likely to change as policy reform continues. Also, with increasing links to the global market and especially to the U.S. market, global and U.S. price shocks are now transmitted to Mexico, so farmers and agribusiness firms in Mexico need to be seeking more risk management tools in adjusting to this new market environment. Bibliography Grennes, Thomas et. al. An Analysis of United States-Canada-Mexico Free Trade Agreement. Commissioned Paper No. 10. International Agricultural Trade Research Consortium. November, Rempe, Jay R. The Implication of a North American Free Trade Agreement for the Mexican Corn, Wheat, and Sorghum Markets. Masters Thesis, Univ. of Nebraska, Lincoln. July, Mielke, Myles J.(1989). Government Intervention in the Mexican Crop Sector. USDA, ERS, Staff Report No. AGES September Sanderson, Steven. "Mexican Public Sector Food Policy Under Agricultural Trade

16 Liberalization." Policy Studies Journal, Vol. 20 No.3(1992): Hueth, Brent M., Gerald T. O'Mara, and Richard E. Just. NAFTA: Implications for Selected Crops and Livestock of a Free Trade Agreement Between the U.S. and Mexico. Sept. 24, USDA. Agriculture in a North American Free Trade Agreement: Analysis of Liberalizing Trade Between the United States and Mexico. USDA, ERS, FAS. July Valdes, C. Mexico. International Agriculture and Trade Report, Western Hemisphere Situation and Outlook Series, USDA, ERS, RS June Valdes, Constanza M., and Kim Hjort. Potential Effects of the NAFTA on Mexico's Grain Sector. International Agriculture and Trade Report, Western Hemisphere, Situation and Outlook Series, USDA, ERS, RS June 1993.

17 17 Annex Table A1: Acreage Elasticities. Variable Corn Wheat Sorghum Soybean Rice Barley Dry Beans Corn price Wheat price Sorghum price Soybeans price Rice price Barley price Dry beans price Table A2: Food Demand Elasticities. Variable Corn Wheat Rice Dry Beans Corn price Wheat price Rice price Dry bean price Income