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Excerpted from World 3.0: Global Prosperity and How to Achieve it by Pankaj Ghemawat. Reprinted by permission of Harvard Business Review Press. Copyright 2011, Pankaj Ghemawat. All rights reserved.
From Canada with Candy
Let's dig deeper into the mystery of the missing trade by returning to the U.S.-Canadian border and focusing on a specific business trying to sell products across the border. Despite the general fascination with markets, businesses are, in many respects, the visible hand of trade. As international economist Edward Leamer observes (in the course of a critique of World 2.0): There are very few exchanges that are mediated by "markets" . . . Most exchanges take place within the context of long-term relationships that create the language needed for buyer and seller to communicate, that establish the trust needed to carry out the exchange, that allow ongoing servicing of implicit or explicit guarantees, that monitor the truthfulness of both parties, and that punish those who mislead. Many exchanges occur between colleagues who work for the same firm. Indeed, about 40 per cent of US imports are carried out internal to multinational enterprises.
In other words, 40 per cent of U.S. imports have the same business firm at both ends of that cross-border exchange. It's pretty clear, then, that the majority of U.S. imports have a firm - not necessarily the same one - at both ends of such an exchange, and an even larger proportion have a business firm involved as either the importer or the exporter.
To explore what might lie behind border effects, let's look not just at a specific company, but at a smallish one; large companies often have a lot of infrastructure, capabilities, and experience that make it comparatively easy for them to cross national borders. (Note that the largest companies are much more globalized than markets in general: in 2008, the world's one hundred largest nonfinancial companies had roughly 60 per cent of their assets, employees, and sales outside their home markets, up 10 to 20 percentage points from 1990 levels.) A company that fits the bill is Ganong Brothers, Canada's oldest candy maker and a firm roughly one-thousandth Google's size. While chocolates comprise its principal product line, what has really attracted attention are the company's attempts to sell jelly beans in the United States. Because of free trade agreements, there are no tariffs on jelly beans, and one might expect them to flow freely across the U.S.-Canadian border. And Ganong would seem well-positioned, literally, to serve the U.S. market: the state of Maine is just 1.8 kilometers away (1.1 miles for Americans) and visible from the offices of company president David Ganong. But it's not so simple.
Take labeling as an example. In Canada, nutritional labels read "5 mg," with a space between the number and the unit of measure. Yet Ganong's jelly beans can't get into America unless the nutritional label reads "5mg," without the space. Likewise, the two countries calculate daily nutritional values differently. His packages of jelly beans for American consumers need to state what percentage of an American's daily allotment of iron, say, the product provides, even if this percentage varies only slightly from that provided to a Canadian (e.g., 4 per cent of the daily allotment of iron as opposed to 2 per cent).
Such bureaucratic differences may seem trivial, but their effects are not. To comply with U.S. labeling laws, Ganong has to produce jelly beans in separate runs for its American and Canadian markets; this means that production runs for each are smaller and less economical.
Separate bags for the two countries elevate the costs of packaging, and the company needs to spend more money and devote more warehouse space to storing separate inventories of bagged jelly beans for the United States and Canada.
Lest it seem that the United States is unilaterally unreasonable, it's worth adding that Canada ties up trade in red tape as well. According to the Canada Border Services Agency, commercial importers into the country must register their businesses by obtaining a fifteen-digit business number. They must also create an accounting package for their shipments consisting of two copies of a "cargo control document," two copies of an invoice, two copies of a Form B3 ("Canada Customs Coding Form"), any other required permits or forms, such as health certificates, and in many cases, a "Certificate of Origin" form. Once shipments are reported to the government, they are granted a unique fourteen-digit transaction number before they are released by customs and any duties or taxes are paid. To handle all this red tape, American exporters usually hire an export agent, who contracts with a shipper or carrier, who in turn deals with a clearing and forwarding agent in the destination country, who in turn deals with the buyer. Bank letters of credit are often required, as is insurance on the part of the exporter. Of course, none of this counts the documentation that is required on the American side to export goods.
Since September 11, 2001, the barriers to trade have increased further due to the application of new layers of security and more complex rules and regulations. Processing time to enter the United States from Canada by truck (the principal mode of transportation) now takes an estimated three times as long. Delays have become such a problem that the Canadian government now has a Web site devoted to tracking them in real time.
These changes have directly affected Ganong Brothers: as David Ganong related, his firm had a candy shipment delayed for five weeks so that the American government could analyze whether the yellow food coloring used in the product had been FDA approved. For four weeks, the government wouldn't reveal why the shipment was being held, what they were checking into, and what it would take to get it released. With Ganong's American customers expecting just-in-time delivery, surprise hold-ups such as this leave them looking elsewhere for more reliable sources.
Jelly beans aren't even the industry hit most by red tape; other sectors with more complex production chains fare far worse. Take cars, whose production chains crisscross the U.S.-Canadian border with parts and subassemblies being shipped back and forth. A business advocacy group calculates that a typical shipload of four thousand cars imported into North America faces a single customs transaction, while an equivalent number of cars produced and sold within North America faces a staggering twenty-eight thousand customs transactions! The red tape has prompted some efforts at reform. In 2005, the U.S., Canadian, and Mexican governments launched the Security and Prosperity Partnership (SPP) of North America to tackle issues such as regulatory harmonization-to supplement the nine hundred pages on the topic in the NAFTA treaty-as well as alleviate the impact of border controls. But progress has been slow, partly because of domestic political resistance that taps into a rich vein of suspicion and resentment of the United States. Thus, as one Canadian think tank put it, "SPP regulatory harmonization is a policy straightjacket [sic]that tightens with each new agreement, narrowing Canadian regulatory policy flexibility as it conforms to the dominant US regime."
David Ganong, of course, finds all this very frustrating. And Canadian prime minister Stephen Harper shares his exasperation: "Is the sovereignty of Canada going to fall apart if we standardize the jelly bean? I don't think so."
As if administrative barriers weren't enough, Ganong faces other hurdles in selling to the United States. One is geographic. While the company is located right on the border, it does have to deal with distance within the United States. The U.S. state that it abuts from the north, Maine, is about the size of Portugal but has only 1.3 million people. It is more than 500 kilometers to Boston and nearly 900 kilometers to New York, over roads where the hazards include moose and snow. The dearth of nearby demand matters because sugar confectionery (given its relatively low value-to-weight ratio and limited scale economies) tends not to be shipped very far compared to, say, chocolate.
And then there is the economic constraint implied by currency exchange rates. Over the last few years, the U.S. dollar has hovered at around 1.1 Canadian dollars, compared to a level of around 1.5 in the late 1990s and early 2000s. From Ganong's perspective, this represents more than a 25 per cent drop in the value of each U.S. dollar the company receives. Given that the profitability of the typical business in the United States or Canada is about 5 per cent of sales, this kind of exchange rate realignment would be more than enough to wipe out export profits for the average company. Unsurprisingly, Canadian sugar confectionery exports to the United States have stagnated in U.S. dollar terms since 2005, the last time the average exchange rate exceeded 1.2; in terms of Canadian dollars, they have declined.
What has nonetheless kept Ganong and other Canadian sugar confectionery manufacturers interested in the U.S. market is the staggering amount of protection afforded the U.S. sugar industry. Since 1812, the U.S. government has used a maze of tariffs and quotas to set artificially high prices for domestically grown sugar and prevent the import of sugar grown elsewhere. While this is often rationalized as protecting the U.S. customer from the roller coaster of world sugar prices, this protection is achieved by setting domestic prices so high that the roller coaster never risks running into them.
As a result, U.S. domestic sugar prices are typically two to three times as high as world prices, and the multiple has ranged as high as seven! In this respect, the U.S. government actually seems kinder to foreigners than to its own. It subsidizes the export of products containing expensive U.S. sugar, effectively softening the effects of high U.S. sugar prices for foreign but not U.S. consumers. And it hurts U.S. sugar confectionery manufacturers by elevating their costs, but without affecting Canadian (and other) manufacturers' costs.
But U.S. sugar growers make out like bandits and have been creative in finding ways of sharing some of the gains with the political establishment, which in turn looks set to carry the torch of U.S. protection of this sector into its third century.
The United States, by the way, is not alone; the European Union and Japan also keep domestic sugar prices very high. Canada is actually the only major developed country to allow free importation of sugar. This discussion as well as the earlier discussion of regulatory harmonization suggest that the potential gains from opening up merchandise trade are still very large.
Pankaj Ghemawat is the Anselmo Rubiralta Professor of Global Strategy at IESE Business School in Barcelona. He is the author of five books including the award-winning Redefining Global Strategy. For more visit: www.ghemawat.com