We will have to look east

ASPEN, Colorado - It looks very much as though North America will become a free trade area at the beginning of next year. Late last week trade negotiators for the United States, Canada and Mexico announced they had reached agreement on the environmental and labour issues that had been holding up the deal. The particular concern in the US had been that the agreement would simply encourage US companies to shift even more investment (and of course jobs) to Mexico, encouraged by lower wages and social security contributions and by lax pollution controls.

Without some agreement the administration felt it could not get the deal through Congress. Now, on paper at least, there is agreement that Canada and Mexico will fit in with US provisions, though in different ways. Canada will have an independent panel to impose fines on companies that do not abide by US practice, while in Mexico non-compliance would result in trade sanctions.

This might sound like a lawyers' paradise, and it probably will be. Even seasoned watchers of international trade talks find this set byzantine. In any case the deal still has to get through Congress. But if the US trade representative, Mickey Kantor, calls the agreement 'historic', as he did last week, maybe it should be given the benefit of the doubt. In any case - and this has attracted less attention on the UK side of the Atlantic - economic integration along the Mexican border has been so fast for the past seven or eight years that it almost does not matter whether there is a free trade agreement or not.

It suits Mexico to bring down its tariffs (the average has fallen from 29 per cent in 1985 to 10 per cent today) to put pressure on its own industry to become more efficient. As for US trade barriers, with the exception of some agricultural products, tariffs are 2.5 to 4 per cent, not much when Mexican wages are little more than a 10th of those of the US.

This process of economic integration between the US and Mexico is charted in an article in the current Harvard Business Review ('Managing Risks in Mexico', Laurence Hecht and Peter Morici, HBR July/August 1993). The authors point out that all has not been plain sailing for US companies that invested in Mexico.

While the experience of the big three car manufacturers was that quality at their best Mexican plants was at least as good as in many US ones, companies met many problems they had not encountered before. One company, Nytronics, found it had labour turnover of more than 100 per cent per year, compared with 12 per cent at its Connecticut headquarters, with the result that the plant was not fully staffed. It had to set up a bus service to bring people to work simply to run its plant.

Training costs, partly as a result of high labour turnover, are far higher than in the US, but spending money on training may cut labour turnover and hence help improve quality, as Ford has found at Hermosillo, now ranked as one of the best plants in North America. There are many other problems. The communications are poor, road freight costs high, and the telephone networks often unable to handle data transmission.

The central point here is that, even without the North American Free Trade Agreement and without these problems, US companies have accumulated an enormous amount of experience of how to run plants in Mexico. This puts them in a quite different position from their counterparts in Europe, though not in Japan.

Japan, like the US, has a series of relatively near neighbours which are industrialising rapidly, and to which it exports manufacturing expertise. The higher the yen goes the greater the pressure to shift production abroad - last week's currency movements would have given the process further impetus.

The opening up of Mexico to US investment gives American companies an alternative to the Far East: they do not need to shift production to the far side of the world to take advantage of cheaper labour, for they have it on their doorstep. Assuming that Nafta does go through, they will have an advantage that even Japanese companies lack: no legal or financial barriers between a rich and a middle-income country.

As a result US companies will find it easier to fit their activities to the 'right' level of economic development. They will continue to do their design and marketing in the high- wage US, but then have great freedom of choice of where they actually make their products.

European companies naturally follow the same pattern. Buy a pair of Hi-Tec sports shoes and it says on the front of the tongue 'Designed in Britain'. You have to look inside for the tiny label that says the shoes were made in Indonesia. But shifting production to the Far East probably means sub-contracting it; the logistics are too difficult otherwise. If, on the other hand, you can make them nearby, you have the option of running your own factory, as US companies have been doing in Mexico.

Europe does not have this option of shifting production to a low-wage country near home. Or rather it has only just begun to see this opportunity, for with the EC the equivalent of Mexico is Eastern Europe.

Up to now most of the talk about enlarging the EC to include the former Soviet bloc has been in terms of charity: that it is the moral duty of the rich West to buy the goods of the poorer East. But if Nafta is truly successful, European businesses will see that it is in their interest to find the equivalent of a Mexican production base. The EC may need Eastern European countries as members of a free trade area if Europe is to be a more successful competitor against North America.