Hey Canada, stay in your self-made sandbox

December 15, 2021

Canada has a policy problem with dairy. On the one hand, the country has a very prosperous export sector. In 2019 Canada exported $769 billion (Canadian dollars) in energy products, motor vehicles and parts, consumer goods, metals and minerals, forestry products, and other products including agriculture. Their economy is clearly dependent on trade, and they need to participate in trade agreements. But they also want these trade agreements sans any hint or mention of dairy. Canada’s dairy industry, located in the politically powerful provinces of Ontario and Quebec, puts enormous pressure on the Canadian government to hold the line. So, with a handshake with international trade negotiators, and a “wink-wink” to Canadian dairy farmers, the Canadian government signs the paperwork and then never fully implements, and at times, violates the deal (as in export subsidies under the WTO). For more recent examples, just look at CPTPP, CETA, and USMCA. The Canadian government basically wants it both ways. YES to state planning in the form of milk quotas and more global exports, and NO to any dairy imports. But Canada must make a choice. As in the letter from Thomas Howard, 3rd Duke of Norfolk to Thomas Cromwell in 1538, “you can’t have your cake and eat it too.”

Canadian problems with dairy hail from the 1970s when they first implemented a supply management system for dairy and poultry. Back then a number of countries veered towards expensive socialist government policies to offset market impacts to agriculture. For Canada, the objective was to control the milk supply and stabilize the farm gate milk price. And just like the Biden Administrations “Build Back Better” plan, the program was expected to impart tremendous benefits with no costs. That same message was touted during the USMCA negotiations in the Canadian press regarding their superior dairy policy. Basically, the U.S. just didn’t understand the complexities of their supply management program what with hectoliters, exchange rates, etc. But we all know that nothing is free. In the case of dairy production quotas, they do restrict milk production and raise internal milk prices. But the system only works if imports are constrained, and domestic supply is perfectly balanced with demand. The program creates an artificial entry ticket to market milk that costs roughly $30,000 Canadian dollars per cow (the market value of the quota). Finally, who pays these higher milk prices? Yes, Canadian consumers. It’s an implicit tax on Canadian dairy consumption. So, many consumers pay to the benefit of a few producers. Since the “target” price of milk each year (calculated by the Canadian Dairy Commission) is based on a cost of production survey, it goes up each year. That means the “spread” between Canadian milk prices and world prices has nowhere to go but up, year after year. In the appendix of chapter 6 of my new textbook, I calculated that Canadian farm gate milk prices are almost 60% above U.S. milk prices. Those are some of the highest milk prices in the world.

Canada has gone to extremes to protect their fragile yet politically sensitive dairy sector from competition from global trade agreements. Under the GATT, Canada implemented import quotas and claimed exemption under Article XI due to enforcement of their internal milk supply quotas. The idea was “we’re not impacting the global markets, so leave us alone.” Later, under the WTO, signed in 1994, all countries were required to convert non-tariff barriers (i.e. their import quotas) to bound tariffs. That is where Canada came up with over-quota tariffs of 298.5% for butter and 245.5% for cheese. Canada also agreed to small import quotas for fat, cheese, blended dairy powder, and whey. In terms of exports, under the WTO Canada agreed to strictly limit the use of export subsidies and later, at the Nairobi Ministerial Conference in 2015, to end them altogether, as did all WTO member countries.

But the Canadian dairy industry was not happy with the elimination of export subsidies in the WTO. It limited their ability to export surplus byproducts of their strict quota system. Surpluses accumulated because their milk production quotas were based on milkfat, not total dairy solids. So as Canadian demand for fat in fluid milk, creams, cheese, etc. grew, and they expanded the milk production quota, it generated surplus byproducts of skim solids. Looking back, one of the first disputes under the new WTO was brought by the U.S. and New Zealand against Canada in 1997. The dispute claimed that Canada was exceeding their reported export subsidy commitments. Canada was using low-cost producer milk to subsidize their exports. In their milk pooling they raised some class prices, lowered the one for exports, and on average maintained their farm milk price. The WTO panel eventually ruled in favor of the U.S. and New Zealand. And there were other disputes with Canada that followed surrounding this issue of export subsidies.

During NAFTA negotiations in the early 1990s, Canada basically said leave dairy out. However, later, after signing the NAFTA agreement, Canada realized they had a problem with their domestic food processing sector. U.S. produced pizza or croissants could enter Canada duty free. Because similar Canadian food products contained expensive Canadian dairy ingredients, these businesses were no longer competitive. So, to avoid Canadian food companies from shutting down, the government came up with the Special Milk Class Permit Program (SMCPP). This allowed Canadian food processors to buy Canadian dairy ingredients at lower U.S. prices. Later, Canada also realized a problem with non-Chapter 4 imports from the U.S. Specifically, NAFTA created low Chapter 35 duties which allowed U.S. high tech milk proteins (such as ultrafiltered milk and milk protein concentrate) to flow across the border to Canadian cheese processors. The last thing Canada wanted was to import globally competitive milk proteins from the U.S.

When negotiations for USMCA began in earnest, things got really interesting. First, when President Trump learned that Canada imposed an average 270% duties on U.S. imports of dairy products, he reportedly was shocked and expressed that it was “not fair to our farmers!”. He robustly expressed his views at the Group of Seven summit in June 2018 in Canada. That set the stage for very tense negotiations for USMCA between the U.S. and Canada. Class 7 pricing also became a lightening rod for the Administration when U.S. exports of milk proteins from Wisconsin and Western New York into Canada were suddenly cut off. When the USMCA was finally signed, Canada agreed to 1) phase in greater U.S. market access over a 19-year period, 2) end Class 7 pricing, 3) improve pricing transparency, and 4) set export thresholds for milk protein concentrates, SMP, and infant formula. Yet, despite looking our trade negotiators in the eye, shaking their hands, and signing the agreement, Canada once again found ways to avoid fully implementing the new deal.

First, when implementing USMCA, Global Affairs Canada (GAC) came up with the requirement that only Canadian citizens can apply for an import permit (a permit that allows a U.S. manufacturer to import dairy products to Canada under a specific USMCA quota). So, a U.S.-based fluid milk, cheese, or butter manufacturer cannot legally apply. That is very odd. Second, a Canadian importer must have prior experience marketing the product in Canada. So new entrants such as brokers importing packaged fluid milk or branded butter need not apply. Third, GAC used the trade language “up to 85%” to allocate the most quota to Canadian manufacturers. Hmm, why would a Canadian butter or cheese manufacturer go to all the trouble of importing those products from the U.S. when they have access to provincial milk and have hired labor and a plant at their disposal? Fourth, part of the allocation is to “further processors,” which means imports can only be used to manufacture food products that contain dairy products (like soups). So this requirement would in effect act to block sales of retail dairy products from the U.S.. Fifth, the GAC rules for the butter and cream powder TRQ went off the rails from the agreement and further restricted the possibility that retail branded butter would find its way into Canada. Oh, and I’m not done yet.

The USMCA agreement also has a few structural issues that make enforcement of the U.S. understanding of the agreement difficult. Yes, Canada did end Class 7 pricing, which provided low-cost Canadian milk ingredients to Canadian protein processors. But the new agreement provided a formula that all but guarantees that the new cost of Canadian nonfat solids will always be cheaper than the U.S. Class IV price of nonfat solids. Plus, the Canadian government is providing these manufacturers with subsidies that will enable them to invest in new protein processing facilities. That means subsidized Canadian protein exports will continue to undercut U.S. exports to key dairy markets in Asia and elsewhere. Also, the agreement does have caps or “thresholds” on protein and infant formula exports, but the caps are very specific to certain HS codes. Canada knows they can simply sprinkle a little sugar or starch on their SMP to evade the caps, or focus on manufacturing bulk high care ingredients used to can retail ready infant formula in China.

So, what are my conclusions?

First, Canada needs to be held accountable to their trade agreements. They agreed to U.S. quotas under USMCA, so GAC should implement policies to ensure that those quotas can be filled. A U.S. dairy manufacturer should be able to apply for an import permit. It’s ridiculous that they cannot. And yes, that means that over time, branded U.S. dairy products will have access to the Canadian market. That’s how trade agreements work. That’s the whole idea of the original GATT and now the WTO. More trade!

Second, Canada should not be exporting ANY dairy products beyond their borders as long as they operate a production quota. None, zero! If Canada pays their dairy farms almost 60% above the U.S., but allows for Class 4a pricing to Canadian protein manufacturers at a price BELOW the U.S. Class IV nonfat solids price, then clearly an export subsidy is being used. In 2020 Canada exported CAD 486.43 ($379.6 million) in dairy products. That included 39,011 mt of SMP, 73,280 mt of whey products, and 9,549 mt of MPC. If Canada wants to operate a milk quota system, they should stay in their sandbox. Otherwise, they will contribute to distorting world trade. And that was a big part of implementing the WTO.

Third, allowing Canada to use a nonfat solids formula (called class 4a) that prices Canadian nonfat solids below U.S. nonfat solids not only acts as an export subsidy, but also effectively blocks any U.S. protein imports. That is exactly what happened under Class 7 pricing that made U.S. exports of high value proteins uneconomical. Thus potential U.S. exports to Canada are displaced. The new class 4a in Canada is well below the price of other Canadian milk classes that are themselves protected by the high tariff wall, and the final blend price to farmers, which includes class 4a, is still almost 60% above U.S. farm gate prices.

Fourth, the U.S. should open up a new WTO case against Canada for violating their agreement to end the use of all export subsidies. Canada wants to export their surplus onto the world market, depress prices for a “thin” global protein market, and create market distortions. The WTO has teeth in it, and there are already settled cases that clearly link actions by the Canadian government, dairy policy, and the use of export subsidies. Seeking consultations and filing a case may not require millions of dollars and three to four years to settle. It’s likely it would immediately have a chilling effect on further expansion of their subsidized protein processing capacity. That’s what occurred with their new infant formula plant when the U.S. required an end to Class 7 pricing under USMCA. Time for the U.S. to take firm action with Canada!

Dr. Ken

Notes: CETA = a trade agreement between the EU and Canada called “EU-Canada Comprehensive Economic and Trade Agreement”; CPTPP = trade agreement called “Comprehensive and Progressive Agreement for Trans-Pacific Partnership; GATT = General Agreement on Tariffs and Trade; MPC = milk protein concentrate; SMP = skim milk powder; WTO = World Trade Organization.

For a detailed review of Canadian dairy policy, USMCA, and the Canadian dispute under the WTO, see Chapters 5 and 6 of my textbook “Dairy Economics: Pricing, Policy, and Risk Management.”

Source for Canadian exports: https://agriculture.canada.ca/en/canadas-agriculture-sectors/animal-industry/canadian-dairy-information-centre/dairy-statistics-and-market-information/exports