How Canada’s auto sector can survive its terrible, no-good, very bad year

Andrei Sulzenko is a former head of the automotive directorate in the federal industry department and was a principal negotiator of the Canada-U.S. Free Trade Agreement.

With the U.S. imposition of tariffs on automotive imports, the North American-based industry faces a reckoning: the dismantling of the free trade in vehicles and parts that has prevailed for decades.

This means that instead of, say, one auto plant making 150,000 cars for North America, using parts from across the continent, we will see one plant in each country making some fraction of the total, using parts sourced mainly domestically.

This will result in production inefficiencies and higher costs. That will impair the competitiveness of North American automakers against low-cost, high-quality manufacturers, notably from China. Friday’s announcement of lower tariffs on Chinese electric vehicles add to the problem.

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A huge challenge for Canada, absent a change in the U.S. administration’s outlook, will be how to mitigate the consequences of this protectionist policy and forge a second-best outcome.

The stakes cannot be higher. Canada’s auto industry contributed $17-billion to the country’s economy in 2024. It employs more than 125,000 people directly and 427,000 indirectly. If the industry cannot compete, the impact will ripple to other parts of the economy and could well pave the path for a recession.

The pragmatic solution for the future may reside in the past, a time when Mexico was not yet in the picture. With the weekend’s news of preferential market access for foreign carmakers if they produce in Canada, it does seem that Ottawa is looking to this period for guidance. But the federal government is not thinking big enough.

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In 1965, Lyndon Johnson’s administration did Canada a big favour by agreeing to implement a bilateral treaty – the Automotive Products Trade Agreement, commonly known as the Auto Pact.

Before the Auto Pact, there were duties between the two countries, with Canada’s at 35 per cent. It was essentially the same situation that U.S. President Donald Trump is trying to bring about: Cars sold in one country were, for the most part, made in that country. Such manufacturing was done inefficiently and at a high cost.

The Auto Pact removed the tariffs. It allowed vehicle companies, mainly General Motors, Ford and Chrysler, to spread production between the countries. The companies could source parts and build plants in locations that made the most financial sense and benefited from economies of scale.

To ensure that Canada did not lose investment and jobs, the companies had to maintain minimum domestic production levels roughly equivalent to vehicle sales. For example, a company that sold 100,000 cars in Canada needed to maintain 100,000 cars’ worth of production levels in the country – though not necessarily for those 100,000 cars specifically.

Jobs were maintained, while auto companies were able to produce more efficiently, at scale, and grow, creating even more jobs. It was the best of both worlds.

The Auto Pact ushered in a wave of investment in Canada, largely in vehicle assembly; and bilateral trade exploded in both vehicles and parts. In the first dozen years of the Auto Pact, U.S. vehicle imports from Canada increased 11.4 times and Canadian imports from the U.S. increased 7.4 times, with trade largely in the overall balance.

Fairly quickly, participating companies far exceeded their production requirements in Canada and the Auto Pact requirements became redundant. It was eventually phased out, leading to unfettered duty-free trade under the North American Free Trade Agreement (NAFTA) and subsequently the current United States-Mexico-Canada Agreement, (with the main change from NAFTA coming from higher North American content requirements to qualify for duty-free trade).

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Over the last 60 years, Canada has benefited greatly from Auto Pact-induced investments, largely in southern Ontario, close to the U.S. Detroit-based production hub. General Motors, Ford, and Stellantis (originally Chrysler) production sites in Canada have been joined by Honda and Toyota. The enormous sustained contribution of the automotive sector to Canada’s GDP cannot be overstated.

Ottawa’s new plan, as reported by The Globe and Mail on Saturday, hearkens back to that earlier arrangement. But the plan tries to confine automakers’ production to Canada, which is inefficient. It does not offer benefits to the United States to try to preserve the integrated auto sector. Maybe, to truly save our auto industry, it’s now time for Canada to demonstrate generosity by returning the old Auto Pact favour in a time of perceived need by the U.S.

If the American objective is to claim self-sufficiency in the automotive sector, that is, having the value of American production equal to the value of vehicles sold in the U.S., then there is an alternative to erecting punitive tariff walls against foreign competition.

That alternative is to have an Auto Pact-like regime that essentially guarantees the equivalent outcome, but preserves many of the efficiency benefits of the current production distribution.

For example, if a participating company had sales of $500-million in Canada, it would need to generate the equivalent amount of domestic content in vehicle and in-house parts production, plus parts procurement from Canadian suppliers to qualify for duty-free imports of vehicles and parts. Their U.S. operations would have mirror obligations.

If that company underperformed by contributing less domestic content than sales, for example only $400-million, then it would need to pay duties on the $100-million shortfall.

Such a system would incentivize companies manufacturing in the U.S. and Canada to arrange their business practices with a view to minimizing duty penalties, and in doing so, to balance trade. It would also provide an incentive for companies manufacturing in the U.S. but not in Canada, for example Nissan, Subaru, BMW and Hyundai, to invest in Canadian operations in order to qualify for duty-free trade.

Once the basic principle is accepted, the main resulting negotiation between governments would centre on duty rates at the margin for non-compliance by participating companies, the higher the rate, the greater the incentive to match production to sales. Companies that choose not to participate in the scheme would pay full duties on bilateral trade.

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It is not clear how Mexico could fit into this formulation. Currently Mexico has a disproportionate level of vehicle production relative to its domestic sales – about four to one. That situation would be ameliorated using domestic content as the measure, since final assembly constitutes only about 20 per cent of the value of a vehicle.

This is not to say that a three-way deal is impossible. Indeed, it would be preferable in terms of not overly disrupting longstanding supply chains. It could, as well (notwithstanding numerous existing bilateral free trade agreements by all three partners) lead to a potentially constructive discussion about a common external tariff on competitors from Asia and Europe that do not manufacture in North America.

The priority, however, should be to come to an agreement with the U.S., as Mexico is of marginal importance to Canada’s industrial base. Further, there are ongoing ruminations among senior U.S. officials about switching to bilateral agreements with Canada and Mexico.

For Canada, the new arrangement would not be far off the status quo ante, as historically the value of automotive production here has been more or less equivalent to the value of our vehicle market. The bonus could be new investment by Asian and European companies seeking to take advantage of duty-free trade between partner countries.

For the Trump administration, the benefit would be to enshrine the principle that the value of production in the U.S. is equivalent to the value of the market, a powerful talking point for its protectionist base.

The world of second best in which we find ourselves offers few choices beyond the default position of outright protectionism. Managed trade as outlined here, using the defunct Auto Pact as a model, may be the least bad option that serves both countries’ needs.

Prosperity’s Path