Report No. 32288-LAC DR-CAFTA Challenges and Opportunities for Central America December 6, 2005 Central America Department and Office of the Chief Economist Latin America and the Caribbean Region Document of the World Bank LES Linear Expenditure System LSMS Living Standards Measurement Survey MCCA Central American Common Market MFN Most Favored Nation MERCOSUR Mercado Comtin Suramericano NAFTA North America Free Trade Agreement NGOs Non-govermental Organization NIS National Innovation System OECD Organization for Economic Cooperation and Development PROCAMPO Programa de Apoyos Directos a1 Campo (Mexico) PROGRESA Programa de Educacidn, Salud y AlimentaciBn (Mexico) R&D Research and Development RIA Regional Integration Aggrement RPS “Red de Proteccidn Social“ SAM Social Accounting Matrix SAT “Superintendencia de Administracidn Tributaria” SPS Sanitary and Phytosanitary TFP Total Factor Productivity TPL Trade Preference Level TRIPS Trade-Related Aspects of Intellectual Property Rights TRQs Tariff-Rate Quotas UPOV International Union for the Protection of New Varieties of Plants us United States USTR United States Trade Representative UNCTAD U.N. Conference on Trade and Development UNECLAC United Nations Economic Commission for Latin America and the Caribbean VAT Value Added-Tax WB World Bank WBI World Bank Institute WTO World Trade Organization Vice-president Pamela Cox Country Director Jane Armitage PREM Director Ernest0 M a y Sector Manager Mauricio Canizosa Task Managers Carlos Felipe Jaramillo Daniel Lederman “DR .CAFTA: CHALLENGES AND OPPORTUNITIES FOR CENTRAL AMERICA” Table of Contents Chapter I: Summary of Findings and Introduction ........................................... 1 1. Introduction ..................................................................................... 1 2 . I s DR-CAFTA the End o f the Road? Trade and Development in Central America Since 1990...................................................................................... 2 3. The Contents o f DR-CAFTA: Implications for Market Access and Domestic Reforms ......................................................................................... 3 4 . Economic Effects o f DR-CAFTA: More Art than Science ............................. 5 5 . Policy Approaches to Managing the Economic Transition: Ensuring that the Poor Can Benefit from DR-CAFTA: ........................................................ 7 6 . Macroeconomic Implications o f DR-CAFTA ............................................ 9 7 . Obtaining the Payoff from DR-CAFTA: Priorities for the Complementary Agenda 11 Chapter 1 1: I s DR-CAFTA The End of the Road?:Trade and Developmentin Central America since 1990 ................................................................. 13 1. Introduction...................................................................................... 14 2 . Trade Policies in Central America 1990-2003.............................................. 14 - Tariff and non-tariff barriers ................................................................ 14 - Export Promotion............................................................................ 16 - Integration Initiatives........................................................................ 16 - Caribbean Basin Initiatives ................................................................. 18 3 . The Result o f Trade Policies: Trade and Growth Outcomes .............................. 20 - Trade Openness..................................................................................... 20 - Trade Diversification ........................................................................ 23 - Growth ......................................................................................... 25 - Trade, Poverty and Inequality.............................................................. 28 4 . Summary and Conclusions ...................................................................... 29 Chapter 111: The Content of DR-CAFTA: Implications for Market Access and Domestic Reforms ............................................................................. 31 1. Introduction ...................................................................................... 32 2. Market Access for Goods ....................................................................... 33 - Agriculture ...................................................................................... 33 - Manufactures .................................................................................. 38 - Apparel and Textiles (“Maqui2a”) ......................................................... 40 3 . Services ........................................................................................... 42 4 . Other Provisions............................................................................... 44 - Investment Protection...................................................................... 44 - Intellectual Property Rights............................................................... 45 - Labor and environment..................................................................... 47 - Government Procurement and Corruption.............................................. 49 - Customs ........................................................................................ 51 - Dispute Settlement ............................................................................ 51 - Trade Capacity Building................................................................... 52 5 . Provisions to Deepen Regional Integration ................................................ 52 6. Conclusions .................................................................................... 53 Chapter IV: Economic Effects of DR-CAFTA: More Art than Science .................... 57 1. Introduction...................................................................................... 58 2. Trade Liberalization and the Static Gains from Trade ..................................... 60 3 . Complementary Policies and the Dynamic Gains from Trade ........................... 88 4 . Conclusions and Policy Priorities for the DR-CAFTA Beneficiaries.................... 105 Chapter V: Policy Approaches to Managing the Economic Transition: Ensuring that the Poor Can Benefit from D R X A F T A ................................................... 121 1. Introduction...................................................................................... 122 2. Liberalization o f Sensitive Agricultural Commodities under the DR.CAFTA ........ 123 3 . Framework for Analyzing Welfare Impacts o f the DR.CAFTA ......................... 125 4 . The Expected Impacts o f Liberalizing the Sensitive Agricultural Commodities: New Evidence from El Salvador. Guatemala and Nicaragua ........................... 133 5 . Alternative Approaches to Mitigating the Adverse Impacts o f DR.CAFTA ......... 146 6. Policies and Investment to Ensure the Poor Can Benefit from DR.CAFTA ......... 156 7 . Summary and Conclusions .................................................................. 158 Chapter VI: Macroeconomic Policy Implications of D R X A F T A ........................... 163 1. Introduction...................................................................................... 164 2. Potential Fiscal-Revenue Losses from DR.CAFTA ....................................... 164 3 . DR.CAlTA, Trade Structure and Business-Cycle Synchronization................... 169 4 . Summary and Policy Recommendations ................................................... 179 Chapter VII: Obtaining the Payoff from DR-CAFTA: Priorities for the Complementary Agenda ........................................................................ 183 1. Introduction.................................................................................... 184 2. Trade Facilitation................................................................................ 185 . Roads ............................................................................................. 185 . Ports.............................................................................................. 186 . Customs ......................................................................................... 190 3 . Institutions and Regulations.................................................................... 193 . Labor Regulations ........................................................................... 194 . Firm Entry ................................................................................... 195 . Administrative Corruption ................................................................. 196 - Regulations and Access to Credit......................................................... 199 4 . Innovation and Education.................................................................. 202 - Innovation: outputs, inputs and efficiency .............................................. 202 - Discovering new export products ......................................................... 205 . Education for Innovation and growth ................................................... 206 . Areas for action .............................................................................. 208 5. Summarizing priorities for countries ...................................................... 210 REFERENCES 213 ACKNOWLEDGEMENTS This study was led by C. Felipe Jaramillo, Lead Economist for the Central America Department (LCC2C), and Daniel Lederman, Sr. Economist, Office of the Chief Economist (LCRCE) and included a core team consisting of Andrew Mason, David Gould, Maurizio Bussolo, Ricardo Tejada and Norbert Fiess. Key responsibilities for chapters were as follows: Chapter I ;C. Felipe Jaramillo and Daniel Lederman. Chapter 1 1; C. Felipe Jaramillo and Daniel Lederman, Chapter I II; C. Felipe Jaramillo and Daniel Lederman. Chapter IV, Maurizio Bussolo, David Gould, C. Felipe Jaramillo and Daniel Lederman. Chapter V. Andrew Mason. Chapter VI. Norbert Fiess, C. Felipe Jaramillo and Daniel Lederman. Chapter VII; C. Felipe Jaramillo and Daniel Lederman. Excellent research assistance was provided by Ricardo Tejada (chapters I I,111, IV), Jorge Camacho (chapter 1 1, IV), Ana Maria MenCndez (chapter EI), and Ana Cristina Torres (chapter V). The peer Reviewers were JosC Manuel Salazar, Jack Stein and Antonella Bassani. In addition, the team benefited greatly from comments and conversations with colleagues including Helena Ribe, Paul0 Correa, Neeta Sirur, Pablo Fajnzylber, Amparo Ballivian, Manuel Sevilla, Carlos Arce, Francisco Pichh, and Dante Ariel Mossi. Desktop publishing was done by Sonia C. Molina. Elena Serrano and Alejandra Viveros were responsible for developing the dissemination strategy and Nicky Bowyer coordinated translation services. Rodrigo Jarque and Beatriz Prieto-Oramas provided proofreading and editing help. The report was prepared under the stewardship of Jane Armitage, Country Director and Guillermo Perry, Chief Economist. The report draws on the work of an extended team both within and outside the Bank. Background papers were written by Claus C. Portner (University of Washington) (on impacts in Guatemala), JosC Marques (Synthesis) (on impacts in El Salvador), Ricardo Monge and Florencia Castro-Leal (on impacts in Nicaragua), Ricardo Monge (CAATEC), Miguel Loria and Claudio GonzAlez Vega (Ohio State University) (on impacts on agriculture), Sergio Schmukler (on financial globalization), AndrCs Rodriguez-Clare (Penn State University) (on innovation and technology adoption), Caroline Freund (reciprocity in free trade agreements), J. Edward Taylor (U.C. Davis) (on trade integration and rural economies), Caroline Freund and Bineswaree Bolaky (University of Maryland) (on trade, regulations and growth), Maria del Pilar Londofio-Kent and Paul Kent (consultants) (on ports), Caglar Ozden and Daniel Lederman (on C B I versus FTA and other trade preferences), Norbert Fiess (on business cycle synchronization), Caglar Ozden and Gunjan Sharma (University of Maryland) (on textile and apparel trade), Anabel Gonzfilez (consultant) (on legal and institutional changes), Amy Angel (FUSADES) (on agricultural quotas). Most importantly, this report reflects a long process of interactive research and policy dialogue, originally launched in San JosC, Costa Rica, at a Round Table with Central American Ministers of Trade in December of 2002 -- one month before formal DR-CAFTA negotiations were launched. Preliminary findings of the study and background papers were discussed a month after the end of negotiations, at a Regional Conference in San Salvador, El Salvador, in February of 2004, co-sponsored by DFJD, in which stakeholders from all sectors of Central American societies were invited to participate. The report benefited from fruitful exchanges with a large number of citizens of all Central American nations, including government officials, civil society stakeholders and representative from other donor agencies. The authors would l i k e to acknowledge especially valuable conversations with Trade Ministers Albert0 Trejos, Miguel Lacayo, Mario Arana, and Norman Garcia and with negotiators Anabel Gonzalez, Enrique Ayala, Roberto Echandi, Yolanda de Gavidia, and Fernando Ocampo. Others who helped us with information and useful insights include Rebeca Grynspan (CEPAL), Jose Manuel Salazar-Xiriiiachs (OAS), Regina Vargo (USTR). Mary Ryckman (USTR), Alfred Schipke (IMF), Hans Peter Lankes (IMF), Diego Arias (IADB), Ennio Rodriguez (MDB), Amy Angel (FUSADES-E1 Salvador), Jose Marques (Synthesis-El Salvador) and Pablo Rcdas (ASIES- Guartemala). The team would l i k e to thank all of those who gave generously of their time to meet with the team and share their thoughts. Chapter I.Summary of Findings and Introduction 1. Introduction 1.1 A central factor in determining the future o f Central America w i l l be the ratification and implementation o f DR-CAFTA, the free trade agreement negotiated by Costa Rica, the Dominican Republic (DR), El Salvador, Guatemala, Honduras, and Nicaragua, with the U.S. This i s an important issue, not only because the U.S. i s these nations' major trading partner, but also because the treaty holds the potential o f increasing trade and investment in the region, which in turn i s key to lifting economic growth and improving the welfare of the people o f Central America and the DR, including those living in poverty. 1.2 This report provides a preliminary assessment o f DR-CAFTA, with particular attention to three key themes: (i) expected trade and non-trade benefits, ( ii)actions that Central American countries need to pursue to capitalize optimally on the new opportunities, and ( iii) identification o f the population groups that may require assistance to adapt to a more competitive environment. The report focuses on the developing countries o f Central America, namely Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua.' 1.3 Past experience demonstrates that predicting the precise effects o f any free trade agreement i s always difficult. However, this report draws upon a number o f different approaches and methodologies to reach the conclusion that DR-CAFTA i s likely to improve growth levels for the participating countries in Central America and the DR, due to the expected positive effects on trade and investment levels. Greater trade levels w i l l arise due to the removal o f virtually all tariff and quota barriers to trade among all parties, consolidating - and in some cases expanding - the preferential market access that Central American countries have enjoyed in US. markets through the Caribbean Basin Initiative (CBI) program. DR- C A F T A i s also expected to deepen regional trade integration (and increase trade levels) among the Central American nations themselves and with the Dominican Republic. DR- CAFTA should additionally promote greater levels o f foreign and domestic investment, by improving the certainty o f these countries' market access with the U.S., solidifying the broad economic reforms o f recent years and spurring further reform efforts. Investors should respond positively to the modernization o f key regulations in such areas as trade in services, government procurement and intellectual property rights, - including provisions for greater transparency in government regulations - which w i l l be made more credible under DR- C A F T A commitments. 1.4 At the same time, the report's analysis o f the gains from trade suggest that, as has been found with other trade agreements, these gains w i l l depend on the ability o f the Central American economies to successfully adjust to the changes that the agreement will bring (including changes in relative prices) and to handle effectively the ensuing restructuring o f the economy. Hence, the magnitude o f the benefits from DR-CAFTA will depend critically on the Analysis of the effects of DR-CAFTA on the economy of the Dominican Republic can be found in World Bank (2005a and 2005b). CHAPTER I : Summary of Findings and Introduction ability o f the Central American economies to pursue a complementary policy agenda, as the agreement’s benefits can lead to substantial developmental gains if i t i s accompanied by parallel efforts in areas like trade facilitation (e.g., ports, roads, and customs), institutional and regulatory reforms, and innovation and education. 1.5 The analysis presented in the report shows that the vast majority o f the population in Central America i s likely to experience welfare gains from implementation o f DR-CAFTA, even in the short run. At the same time, the removal o f trade barriers in sensitive agricultural crops could adversely affect a small share o f the population living in rural areas in Central America. Although provisions in DR-CAFTA w i l l allow for long timetables in reducing tariffs for most sensitive products, appropriate support programs may need to be designed. In addition, selective investments in education, rural infrastructure, rural finance, and technical assistance w i l l be required to ensure that the rural poor have the means to take full advantage o f the new opportunities arising out o f DR-CAFTA. 1.6 The rest o f this summary reviews the main findings o f the chapters o f the report in the order in which they appear. Chapter I1 places DR-CAFTA in the historical context o f the economic reforms that Central American countries have been undertaking since the late 1980s. Chapter I11provides a summary overview o f the recently negotiated DR-CAFTA, with special attention on the extent to which the agreement’s provisions would significantly change market access for Central American goods and services, and also on how far they could be expected to consolidate prior reforms. Chapter I V reviews various analyses that assess the potential impacts o f DR-CAFTA on the developing countries o f Central America. Chapter V focuses on the identification and quantification o f potentially affected populations from the easing o f trade restrictions in sensitive agricultural products and analyzes policy options to assist vulnerable groups. Chapter V I reviews evidence related to key macroeconomic implications o f DR-CAFTA, namely the potential revenue losses that might be produced by the removal o f import taxes and the treaty’s potential effect on the patterns o f business-cycle synchronization. Chapter VI1 reviews evidence from each Central American country in the areas of trade facilitation, institutional and regulatory reforms, and innovation and education, in order to identify key priorities for the complementary agenda for DR-CAFTA. 2. I s DR-CAFTA the End of the Road? Trade and Development in Central America Since 1990 1.7 Chapter I1 provides a description o f the wide-ranging unilateral and regional trade reforms that Central American nations have pursued since the late 1980s. Tariffs have been slashed and most non tariff barriers have been removed. Regional agreements have been revitalized and countries have engaged in the expansion o f trade markets through the negotiation o f bilateral trade agreements. The C B I preferences granted by the U.S. have also opened important opportunities, especially in the development o f new maquila exports. 1.8 However, these impressive achievements in the trade policy area have yielded mixed economic results. On the one hand, export volumes have increased, and some diversification has occurred, as demonstrated by the appearance o f new exports -- including the impressive growth o f maquila in most Central American countries and high technology goods in Costa 2 CHAPTER I: Summary of Findings and Introduction Rica. These are positive developments, because - among other considerations - exporting sectors have been shown to provide higher wages and improved working conditions compared to other areas of the economy. 1.9 At the same time, while trade has made a significant contribution to growth in Central America since 1990, i t s impact has not been sufficient to lift aggregate growth rates enough to transform these countries' economies and radically reduce poverty rates. Nor have trade opportunities by themselves served to offset some o f the constraints to progress in the region, such as the s t i l l inadequate progress in improving infrastructure, education and governance, or continuing vulnerabilities in areas o f macroeconomic and financial management that continue to add to investors' uncertainties in some o f the countries. Beyond this, the new maquila industries have only developed a limited degree o f integration with the local economies, while textile and apparel export prospects are s t i l l fragile due to the growing competition from Asian competitors. Although the diversification o f Central American countries' exports has increased, this tendency partly reflects negative trends during the period, such as the decline or stagnation in exports o f traditional commodities such as cotton, coffee and bananas. Ironically, while Honduras has achieved the highest degree o f trade openness relative to i t s level o f income, i t i s also the country with the weakest record o f growth in Central America since the early 1990s. 1.10 Why these mixed results? As noted earlier, trade policy i s unfortunately not the only determinant o f trade (or growth) outcomes. There are s t i l l many obstacles to further export growth and trade diversification in Central American nations, including poor infrastructure, weaknesses in labor skills, inflexible regulations, trade barriers in other markets, deficiencies in governance (e.g., corruption, inefficient customs), and macro-fiscal and financial market vulnerabilities. 1.11 DR-CAFTA certainly caps the decade and a half o f reforms in Central America, particularly in the trade area. I t offers a great opportunity to make further progress in fostering trade-led growth. Yet it should not be seen as a silver bullet. On the positive side, it i s a potentially more useful tool than the combination seen so far o f unilateral removal o f trade barriers and trade preferences, as i t effectively guarantees long-term market access to the largest trading partner and locks in the reforms o f recent years, boosting credibility and attracting investment. However, DR-CAFTA alone should not be expected to unleash radically higher levels o f trade and growth, for the same reasons that trade policies since the early 1990s obtained only limited results. Countries will need to accompany DR-CAFTA implementation with policies to address key constraints and bottlenecks in order to reap the full social and economic results o f t h i s initiative, as will be justified in more detail in Chapter I V o f this report and illustrated by the identification o f certain country-specific elements o f the complementary agenda in Chapter VII. 3. The Content of DR-CAFTA: Implications for Market Access and Domestic Reforms 1.12 Chapter I11 provides an overview o f the recently negotiated DR-CAFTA, concentrating on the extent to which the agreement's provisions would significantly change market access for Central American goods and services, and also on how far they could be 3 CHAPTER I: Summary of Findings and Introduction expected to consolidate prior reforms and/or spur further domestic reforms in Central American countries. The overall assessment presented in the chapter i s that, on both fronts, the answers are broadly positive, suggesting that D R - C A l T A should be expected to have a positive impact on trade flows and investment. 1.13 O n market access, DR-CAFTA would consolidate and expand the current generous access that Central Americans currently enjoy to the U.S. market, while extending broadly reciprocal access for U.S. goods to their own markets. The benefits offered under the C B I would be locked in for Central American countries, and some additional permanent duty free access would be obtained for goods that had been previously exempted from C B I preferences. Other significant results would include the flexibilization o f rules o f origin for textiles and apparel, as well as commitments to help producers meet sanitary and phytosanitary standards required for the entry into the U.S. o f promising non traditional agricultural exports. DR- C A F T A also includes reciprocal commitments on access to service markets, which consolidate domestic reforms that opened most o f these markets to private participation in recent years. 1.14 Central American countries also agreed to grant reciprocal tariff-free access to their markets to U.S. products. Certain sensitive agricultural crops would be subject to extended transition periods (up to 20 years), in order to allow for gradual adjustment and to respond to domestic sensitivities. Central American countries secured access to flexible safeguard mechanisms to prevent sudden surges in imports or declines in prices. 1.15 Commitments embedded in DR-CAFTA would gradually erode current protection levels for various products that have retained high protection in Central American economies, during earlier efforts at easing trade restrictions in the past. The gradual decline expected in prices o f basic food staples as a result should prove positive for the vast majority o f Central Americans who are net consumers o f such goods and whose welfare will be increased by lower prices. This said, not all sensitive products are included, in response to cultural and political factors, and these limitations - together with the agreement's s t i l l excessively restrictive rules o f origin for the entry o f textile products to the U.S. - represent barriers to trade that w i l l continue to foster some inefficiencies in the deployment o f domestic resources both in the U.S. and Central America. 1.16 On the questions related to domestic reforms, DR-CAFI'A commitments promise to lock in a number of the policy and regulatory changes implemented in recent years for the opening o f competition in previously protected sectors (e.g., telecoms, financial services, energy) and the modernization o f key norms and procedures in areas such as government procurement, intellectual property rights and the treatment o f foreign investment, by locking in current levels o f access o f investors (and bidders) from the U.S. 1.17 Costa Rica i s the only country that will be required to make significant legislative changes to adapt policies and regulations to i t s commitments under DR-CAFTA, allowing access to significant portions o f i t s telecom and insurance markets. These reforms had been long postponed and should further foster the modernization, efficiency and competitiveness of these areas o f the Costa Rican economy. 4 CHAPTER I: Summary of Findings and Introduction 1.18 Aside from consolidating and spurring further reforms, the treaty should strengthen commitments to upgrade enforcement levels o f domestic legislation. This represents a significant challenge in areas like labor, environment and intellectual property rights, which w i l l require decisive efforts and resources to modernize and boost the capacity o f public agencies. The net impact o f these efforts should be positive, as investment i s likely to be attracted to environments with effective institutions. However, while DR-CAFI’A w i l l put pressure on the modernization o f these institutions, i t will not by itself create such modernization. Countries will need strong independent plans o f action and sufficient dedication o f implementation capacity and resources. 1.19 The agreement includes cooperation accords to boost standards and enforcement levels in areas such as labor, environment, customs and other areas. I t also offers proposals to develop further cooperation and “trade capacity building”, which should aid in the mobilization o f human and financial resources required for key reforms and institutional actions required to implement the agreement and the broader developmental challenges. 1.20 Finally, a welcome side effect o f the negotiation o f DR-CAFTA has been the advancement o f regional integration efforts. The decision to make the provisions o f the agreement apply multilaterally among Central American countries and the Dominican Republic w i l l deepen regional integration efforts in the region and facilitate the creation o f a Central American Customs Union. 4. Economic Effects of DR-CAFTA: M o r e Art than Science 1.21 Chapter I V reviews various analyses undertaken to assess the potential impacts o f DR- C A F T A on the developing countries o f Central America. I t begins by highlighting that standard theoretical treatments o f the gains from trade indicate that such gains depend on an economy’s capacity to change i t s productive structure. Otherwise, the gains are limited to the gains on the consumption side, which allow domestic agents to consume a bundle o f goods that i s larger in economic value than the one without trade reforms. The gains from productive transformation can be substantially higher than the gains from enhanced consumption alone. These conclusions refer to static analyses o f the gains from trade. 1.22 Regarding empirical analyses o f the potential static gains from trade, the evidence reviewed in the chapter highlights two key complementary factors, namely, the infrastructure that affects international transport costs and the regulatory environment. There i s strong evidence suggesting that exports to the U.S. market will benefit from the shift from unilateral preferences (CBI) to a free trade agreement, but perhaps more importantly, international transport costs (freight, insurance) have a robust and large effect on the value o f exports, regardless o f the type o f preferential treatment. Also, the evidence reviewed suggest that the gains from trade in terms o f increases in GDP per capita i s intermediated by the regulatory environment that determines how quickly firms and workers can change their sectors o f operation and employment. Thus a complementary agenda to enhance the impact o f the DR- C A F T A should consider these factors, even when concerned about the static gains from trade. 5 CHAPTER I: Summary of Findings and Introduction 1.23 Partial equilibrium analyses o f the potential sectoral effects o f DR-CAFTA suggested that the main short-term winners o f the agreement would be concentrated in the apparel industries, abstracting from any impact o f the elimination of world quotas in this sector. Nevertheless, these analyses suffer from an inability to capture the potential effects on sectors that are relatively small, since the effects predicted b y these models are proportional to the initial level o f exports. In addition, they have difficulty dealing with technical issues such as the restrictiveness o f rules o f origin. Furthermore, such partial-equilibrium models do not consider the effects o f the trade reforms in the economy as a whole since they do not consider inter-sector interactions through factor and goods markets. 1.24 This chapter also presents the simulation results from a so-called “Computable General Equilibrium” (CGE) model for Nicaragua linked to household data. The simulation relates the macroeconomic results o f the model to changes in the returns to unskilled labor to poverty outcomes. Indeed, under a restrictive set o f conditions (e.g., segmented labor markets, no dynamic effects, effective transmission o f tariff reductions to relative producer prices, and no further unilateral trade reforms) DR-CAFTA could have an overall modest positive effect on Nicaragua’s welfare (income per capita) but with a very small (positive) effect on poverty, and the potential for poor rural households to be negatively affected. Thus, as with the other static analyses, these results further support the contention that DR-CAFTA might not be enough to reduce poverty, although these results need to be interpreted with caution, as they are obviously limited by key theoretical and empirical assumptions. 1.25 The rest of the chapter i s dedicated to understanding the potential dynamic gains from DR-CAFTA. The first part covers evidence concerning the potential effect o f free trade agreements (FTAs) - and trade more generally - on foreign investment, corruption, and innovation. Existing evidence suggests that FDI responds to FTAs indirectly, by enhancing the effect o f exports and GDP on FDI. The evidence also indicates that trade might not have a direct effect on corruption, and thus we should not expect large dynamic gains from DR- C A F T A to come from the impact o f international trade on the quality o f public institutions. The process o f democratic consolidation seems much more important, although certain aspects o f DR-CAFTA that put pressure on governments to improve the enforcement o f their own laws could also be helpful. The existing literature on innovation and economic discovery suggests a mixed picture. On the one hand, innovation efforts might not be related to the incidence o f international trade. On the other hand, the probability o f observing episodes o f “economic discovery” seems to be positively correlated with overall export growth. 1.26 This chapter also reviews the econometric challenges and results by investigating the empirical link between FTAs and subsequent economic growth in a large sample o f countries. The main result i s that the growth rate o f GDP per capita i s positively associated with a country’s participation in FTAs. This finding i s robust to the inclusion o f various control variables and econometric methods. Unlike the evidence presented in previous work, the new evidence reviewed does not find that the increase in GDP growth o f about 0.6 percent per year was sensitive to the type o f partner in the FTA. In contrast, a previous empirical study using a different set o f control variables and specifications o f the empirical models, did find that access to larger markets has a larger effect on growth than FTAs with smaller partners. In any case, there seems to be substantial evidence that FTAs might help accelerate the pace o f 6 CHAPTER I: Summary of Findings and Introduction economic development, at least for the first five years subsequent to implementation. In the long-run, the steady-state level o f income w i l l be determined by a plethora o f other factors and as economies get richer, their pace o f growth w i l l tend to decline. Consequently, there does not seem to be a silver bullet, and DR-CAFTA i s unlikely to be the solution to all development challenges faced by Central America. 1.27 The evidence reviewed should make clear that ex-ante analyses o f the potential effects o f DR-CAFTA (and trade reforms in general) remain an art rather than a science, since the results are highly sensitive to theoretical assumption and empirical methods. Chapters V, V I and VI1 of this report provide more guidance regarding the “complementary agenda”, which includes policies that can help DR-CAFTA beneficiaries overcome the challenges posed by the adjustment process as well as the long-term challenge o f economic development in the context o f DR-CAFTA. 5. Policy Approaches to Managing the Economic Transition: Ensuring that the Poor Can Benefit from DR-CAFTA 1.28 While the vast majority o f people in Central America are expected to benefit from DR-CAFTA in the medium to long-term, there are at least some people who are at risk o f bearing the costs o f trade-related economic adjustment in the short-to-medium term. Specifically, although the Central American economies are already relatively open, due to unilateral efforts at lowering barriers to trade undertaken in the 1990s (Chapter I I)a,handful o f sensitive agricultural commodities (e.g., maize, beans, dairy, and poultry) s t i l l have significant levels o f protection. Chapter V focuses on quantifying the size o f the potentially affected population and the magnitude o f the potential effects. I t additionally examines alternative policy approaches on how to best assist vulnerable groups to ensure that they can benefit from emerging opportunities arising out o f the DR-CAFTA. 1.29 Given current levels o f protection, the introduction o f more trade competition for sensitive agricultural commodities under DR-CAFTA can be expected to lead to lower domestic prices for sensitive commodities in each country - in some cases significantly lower prices. For t h i s reason, DR-CAFTA includes a wide range o f provisions (described in Chapter 111) for dealing with the easing o f trade restrictions on sensitive goods, including grace periods for initiating the removal o f tariffs, extended phase-out periods for tariffs, interim quotas and/or phase-downs o f tariff-rate-quotas, as well as special safeguard measures to protect local farmers from undue harm. Indeed, the Agreement includes extended timetables for reducing protection on sensitive agricultural crops. Phase-out periods are, for some commodities, as long as 20 years and, at least for a few countries, white maize, an important staple crop produced by the poor, was exempted from the commitments to eliminate tariffs. These provisions in themselves represent important protections for producers o f sensitive crops, giving them an extended timeframe over which to undertake the necessary economic adjustments. 1.30 Given this, what might policymakers expect to be the impacts o f removing barriers to trade in sensitive agricultural commodities under the DR-CAFTA? Three new empirical studies using nationally representative household survey data f r o m Nicaragua, Guatemala, 7 CHAPTER I: Summary of Findings and Introduction and El Salvador help shed light on this and related policy issues. All three studies apply a comparable net consumer-net producer framework to assess likely first-order impacts on household welfare of eliminating quotas and reducing to zero tariffs on several sensitive agricultural products, including maize, beans, milk, poultry meat, bovine meat, apples, pork, wheat, and rice. Despite the phasing out o f trade protection negotiated under the DR-CAFTA, these analyses examine expected impacts as if all tariffs and quotas were going to be removed completely and immediately under the DR-CAFTA. The approach provides useful insights into the first-order impacts o f introducing more competition in the markets for sensitive commodities. I t also provides a useful baseline from which to examine policy options - including some important policy trade-off implicit in the gradual approach to easing trade barriers negotiated under the Agreement. 1.31 This analysis on Nicaragua, Guatemala, and El Salvador indicates that the vast majority o f households in these countries stand to gain from the price changes associated with removing trade barriers for the "sensitive" agricultural commodities. More specifically, 90 percent o f Nicaraguan households, 84 percent o f Guatemalan households, and 68 percent o f Salvadoran households, respectively, were found to be net consumers o f the basket o f sensitive agricultural commodities, and as such, can be expected to benefit from DR-CAFTA- related price changes. Only about 9 percent o f Nicaraguan households, 16 percent o f Guatemalan households, and 5 percent o f Salvadoran households were found to be net producers o f the basket o f sensitive commodities and, thus, would be expected to experience welfare losses. For El Salvador, a further 27 percent were estimated to remain unaffected due to their essentially negligible gains or losses. Even though potential losers are thus relatively small minorities, nonetheless appropriate attention needs to be paid to ensure that anticipated losses do not harm the poorest and most vulnerable groups, for which targeted programs aimed at those that may suffer significant welfare losses may be justified. 1.32 While DR-CAFTA has built into it considerable grace periods and extended phase-out periods for eliminating tariffs and quotas that provide reasonable protection to producers o f sensitive crops over a prolonged adjustment period, t h i s approach i s not without i t s own economic and social trade-offs. While phasing o f reforms provides producers an extended period to make the necessary economic adjustments, i t also deprives consumers for that same extended time period o f the benefits associated with lower prices for important agricultural staples. In this context, an alternative (and some might argue more efficient) approach might involve a shorter period o f removal o f trade barriers for the sensitive commodities, coupled with transfers targeted to those adversely affected by DR-CAFTA in the short-term. In principle, a shorter liberalization period combined with targeted transfers i s more efficient economically than phased removal of barriers, as consumers do not have to wait up to 20 years to reap the full benefits o f lower prices. Coupling well-targeted transfer programs with quick easing o f trade restrictions could thus enhance households' welfare in the short-term on the consumption side while providing producers with a reasonable period o f support to make the economic transition. 1.33 Regardless of whether the DR-CAFTA countries in Central America choose to pursue this alternative approach, i t i s important to understand the broad options that policy makers can use to mitigate potential income losses arising from declines in commodity prices if a CHAPTER I : Summary of Findings and Introduction extended phase-outs and safeguards are deemed insufficient: (i) “decoupled” income support payments to farmers o f sensitive crops (e.g., as in Mexico’s PROCAMPO program), ( ii) technical assistance programs to farmers o f sensitive crops, ( iii)conditional cash transfers (CCTs) to rural families, effective only as poor families make investments in their children’s education, health, and nutrition, and (iv) provision o f public goods (e.g., economic infrastructure, basic education, rural financial services, technical assistance) targeted to households and/or regions that are either expected to be particularly affected by DR-CAFTA. 1.34 These options can be viewed from two different perspectives. The f i r s t i s the institutional sophistication required to implement support programs, recognizing that different approaches w i l l tax the implementation capacity o f Central American countries to different degrees. T h i s criteria recognizes that effective programs w i l l require, inter alia, a viable method o f targeting vulnerable populations, a minimum degree o f know-how among the civil servants o f the implementing public sector agency, the creation o f new government organizations (or transformation o f old ones) and a minimum degree o f independence to ensure the application o f technical criteria and avoid political interference. The second dimension i s related to whether the program provides incentives (or other support) for broad production diversification, including strengthening the capacity o f families to exploit new income opportunities for off-farm and/or non agricultural activities - which may be critical to ensure greater economic mobility among poor households. 1.35 The classification i s useful to assess the requirements and objectives that may be relevant in each country, as the choice o f which type o f support program would be more appropriate should be made on the basis o f country-specific factors. Decoupled transfers require relatively low institutional sophistication but offer few incentives for farmers to seek new income opportunities, as demonstrated by the PROCAMPO experience in Mexico. Technical assistance programs place a greater burden on the capacities o f government agencies, while giving incentives for productive diversification (or upgrading), but only within agriculture. Public goods programs require less institutional sophistication by relying on existing institutions for program delivery, while creating conditions for rural inhabitants to diversify economic activities -although programs o f this type may require a strong regional concentration o f potentially affected poor households in order to make economic sense. CCTs require relatively sophisticated new institutional capacity (especially in countries where programs o f t h i s type are not currently being implemented, such as in Costa Rica, Guatemala and El Salvador), although by strengthening families’ human capital, they offer broad support for production diversification. 6. Macroeconomic Policy Implications of DR-CAFTA 1.36 Chapter V I reviews evidence related to two macroeconomic policy issues. The f i r s t concerns the potential revenue losses that might be produced by DR-CAFTA’s removal o f import taxes. The other topic i s related to the treaty’s potential effect on the patterns o f business-cycle synchronization (BCS) that could be affected by changes in the structure o f international trade. 9 CHAPTER I: Summary of Findings and Introduction 1.37 The fiscal losses that DR-CAFTA i s likely to create need to be compensated in all Central American countries to avoid further deterioration o f public finances. At present, all Central American countries with the exception o f Guatemala exhibit relatively high debt indicators and require tight fiscal stances to maintain or decrease indebtedness. However, relatively s m a l l losses in the f i r s t years allow for some flexibility in the timing o f the fiscal response in some of the countries -particularly as some time may be needed for adequate political conditions to emerge. 1.38 A more comprehensive fiscal response to DR-CAFTA requires efforts to raise revenues above and beyond fiscal losses, as some o f the key measures needed to optimize i t s effect require increases in public investments (e.g., infrastructure, education, institutional strengthening, and transitional adjustment programs). While some o f these expenditures may be temporary and could arguably be financed by greater indebtedness, this may be difficult in practice due to high current debt levels. 1.39 The fiscal response to DR-CAFTA should be adapted to the fiscal situation o f each country. For the cases o f El Salvador and Guatemala, where tax revenue ratios are l o w (below 13 percent o f GDP), the ideal fiscal response would be actions that go significantly beyond recovering direct losses, in order to finance additional social and infrastructure investments that are needed to boost growth and that are made more urgent and productive by the opportunities o f DR-CAFTA. In Costa Rica, where the tax ratio i s higher but s t i l l short o f the level needed to guarantee debt sustainability, the ideal response should also involve going beyond compensation for the relatively low projected losses, making improvements in the efficiency and allocation o f public expenditures, as well as attracting private financing to fund some o f the most significant infrastructural needs. Honduras and Nicaragua, which have benefited recently from the Heavily Indebted Poor Countries Initiative (HIPC), will likely require additional fiscal revenues, improvements in expenditure efficiency and attraction o f private financing to respond to the opportunities o f DR-CAFTA. In all countries, an essential element o f efforts to improve fiscal performance should include the institutional strengthening of tax agencies and their collection capacity, as well as the elimination o f exonerations from VAT and income taxes. 1.40 DR-CAFTA implementation should also be used to deepen regional coordination efforts in the realm o f tax policy. Going forward, a regional coordination agenda should include gradual harmonization o f VAT and excise rates, fiscal incentives for foreign investors, information exchange for tax enforcement efforts, double taxation treaties and transference prices. 1.41 Regarding the prospects for macroeconomic policy coordination among Central American countries and perhaps with the U.S., business cycle synchronization within Central America i s quite low compared to NAFTA and EU, but not when compared to MERCOSUR. In fact, synchronization in Central America i s highest between Costa Rica and El Salvador, El Salvador and Guatemala, El Salvador and Nicaragua and Honduras and Nicaragua. Costa Rica and Honduras have a higher degree o f co-movement with the U.S. than with any other Central American country. Yet synchronization with the U S i s s t i l l below the levels among NAlTA and even MERCOSUR members. 10 CHAPTER I: Summary of Findings and Introduction 1.42 Furthermore, unlike NAFTA, EU and MERCOSUR, trade in Central America i s not predominantly intra-regional. The U.S. i s by far Central America’s most important trading partner. With the exception o f Costa Rica, there i s virtually no evidence o f intra-industry trade between Central America and the U.S. The level o f intra-industry trade within Central America i s comparable to that of MERCOSUR, but below the levels o f NAFTA (Canada and the US) and the EU (Germany and France). Finally, the degree o f business cycle synchronization seems only weakly related to trade intensity and trade structure (intra- industry trade), although the relationship between intra-industry trade and synchronization i s slightly stronger, which i s consistent with existing international evidence. As such, the gain in synchronization through trade expansion could be modest. 1.43 In sum, at present neither Central America’s trade structure nor i t s degree o f business cycle synchronization make a compelling case for macro coordination within Central America or between Central America and the U.S. Clearly, trade integration i s a dynamic process and as trade intensities and compositions o f trade flows change so will business cycle patterns. To fully assess the consequences o f closer trade integration for the conduct o f macroeconomic policies, information about the future evolution o f trade structures in DR-CAFTA are needed. I f trade becomes more intra-industry (vertical or horizontal), business cycles are expected to become more similar and independence o f macro policy will be less o f a concern. However, if trade integration takes the form of higher inter-industry trade then business cycles are likely to diverge from current levels and the ability to conduct independent macro policies w i l l grow more important. In the meantime, other factors that are not directly related to the structure o f international trade will remain more important considerations for the design o f macroeconomic policies over the business cycle in Central America. One important consideration, for example, i s the extent o f dollarization o f financial assets and liabilities. Hence the macro agenda in the light o f DR-CAFTA should remain focused, at least in the short-run, on fiscal consolidation. 7. Obtaining the Payoff from DR-CAFTA: Prioritiesfor the Complementary Agenda 1.44 Chapter VI1 reviews recent evidence in the areas o f trade facilitation, institutional and regulatory reforms, and innovation and education, in order to identify key priorities for the complementary agenda for DR-CAFTA. The main challenges identified for Costa Rica include improving road quality, port and customs efficiency, boosting financial depth, and improving the quality and coverage o f secondary education. For El Salvador, priorities focus around increasing road quality, reducing shipping costs, and tackling governance challenges, as well as improving the quality and coverage o f secondary education. Both countries need to devote more public resources to R&D (with monitoring and evaluation efforts put in place to assess results over time), strengthen public private partnerships for innovation, and enhance the institutional capacity to enforce intellectual property rights laws. In addition to tackling weaknesses in the areas identified for Costa Rica and El Salvador, Guatemala also needs to continue to build on recent accomplishments in improving customs administration, coverage and quality o f primary education, and road density, as well as devoting some attention to fostering the development of new export products. 11 CHAPTER I: Summary of Findings and Introduction 1.45 The challenges for Honduras and Nicaragua are likely to encompass a broader set o f policy issues, as they face more limitations due to their lower development level. Both countries need to address governance, and work on improving the coverage and quality o f primary education, improving the operational efficiency o f ports and increasing the quality o f roads and their density. They also need to improve their capacity to absorb knowledge from abroad, strengthen institutions in charge o f innovation policy and increase linkages between public R&D programs and the needs o f the private sector. Honduras also needs to upgrade customs administration and reduce the costs and time to establish new business ventures. 1.46 All Central American countries share a regional economic agenda which needs to focus urgently on achieving a Customs Union, which i s critical to reduce transaction costs to trade within the region. In addition, efforts should be deepened to coordinate the development o f infrastructure that benefits from a regional perspective, including major road networks, and the development of ports. Mechanisms to formulate a common regional trade policy need to be strengthened, to ensure coherence o f future bilateral, regional and global commitments with the new framework provided by DR-CAFTA. In addition, improved coordination o f key regulatory policies (e.g., financial supervision, competition, fiscal incentives) may be needed to establish the basis o f a deeper and more integrated regional market in the future. 1.47 All o f the elements o f the complementary agenda mentioned here are also components o f the broader agenda to boost economic growth in the region. Recent analytical work produced by the World Bank to prioritize actions for broad-based growth in the nations o f Central America has highlighted the high return that would be obtained from improvements in the areas o f infrastructure, education and governance. DR-CAFTA enhances the social return to these actions and makes them more urgent. Hopefully, this important agreement serves as a useful tool to rally support for consolidating policy reforms o f recent years and pushing forward with new energy in the areas in which weaknesses remain, in order to boost the pace of growth and poverty reduction across Central America. 12 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: Chapter 11. I s D R - C A F T A The End Of The Road?: Trade And Development In Central America Since 1990 Abstract 2.1 Central American countries have implemented wide-ranging unilateral and regional trade reforms since the late 1980s. These achievements in the trade policy area have yielded mixed results. They have produced significant growth in trade volumes, some trade diversification, and the emergence o f new exports including the large growth o f maquila goods and high technology goods from Costa Rica. Greater trade volumes have also made a significant contribution to growth in Central American in the 1990s, although their impact has not been sufficient to compensate for less dynamic factors, including l o w levels o f education, weak governance, lagging infrastructure, and weaknesses in macro policies and financial sectors. From t h i s perspective DR-CAFTA can be seen as offering an important opportunity for further progress in consolidating trade-led growth, but i t needs to be complemented by addressing key bottlenecks that can maximize i t s trade, investment and growth impact. 13 CHAPTER II. Is DR-DR-CAFTA The End Of The Road?: 1. Introduction 2.2 Negotiations for a free trade agreement between the U.S. and the nations o f Central America follow a long process o f trade and broad policy reforms that have been undertaken in the region since the late 1980s. While reforms were associated with an initial growth spurt, the slowdown in most of the economies o f the region in the late 1990s and early 2000s has yielded some disappointment. In some quarters, DR-CAFTA has been received as the missing piece o f the puzzle to jumpstart economic activity in Central America, while others see the treaty as an opportunity for improving growth which requires complementary policies to obtain i t s promise. 2.3 This chapter sets the background for DR-CAFTA’s appearance in the scene in Central America. T o better understand the context for t h i s treaty in the region, this chapter provides a broad review o f the progress in trade liberalization and integration policies that have taken place in Central America since the early 1990s, and the results obtained in the areas o f trade flows, trade diversification and overall growth. The analysis o f the potential effects of D R - C A F T A for Central American economies i s left for a later chapter. 2.4 The next section summarizes the most significant changes in trade policy since 1990 in the Central American region. In the third, the results obtained in trade performance are reviewed along with an analysis o f i t s impact on overall growth. The fourth section presents a summary and some thoughts on the results that can be expected from DR-CAFTA for the Central American economies. 2. Trade policies in Central America 1990-2003 2.5 Over the past decade and a half, Central American countries have put in place ambitious reforms aimed at invigorating economic activity by shifting away from the old inward-looking pattern o f development to one that i s more reliant on market forces and private initiative. The reforms have included trade liberalization, privatization o f infrastructure services, removal o f exchange controls, opening up to FDI and efforts to boost the efficiency o f government programs. 2.6 A key aim o f the reforms has been to increase trade openness and the outward orientation of the economy. Reforms in this area included unilateral liberalization o f trade barriers, removal o f exchange controls, opening up to foreign investment flows, and increased participation in global, regional and bilateral trade agreements. In order to encourage trade flows, these policies were complemented with more flexible foreign exchange arrangements and selected actions in other fronts (e.g., improved infrastructure, customs reform). Tariff and non tariff barriers 2.7 Central American countries began to reduce tariffs unilaterally starting in the late 1980s or early 1990s. By the mid-l990s, average tariff levels in Central America were among the lowest in the L A C region. For the five D R - C A F T A members, average import duties fell 14 CHAPTER 11, I s DR-DR-CAFTA The End Of The Road?. from 45 percent in 1985 to 14.1 percent in 1990 and to 7.1 percent by 1999 (See Table 1). By 1999, Costa Rica exhibited the lowest average tariff at 3.3 percent and Nicaragua the highest at 10.9 percent. Table 1: Average Tariffs 1985-2000 I 1999- 1 1999- I * Data for 1989. Source: L o r a (2001) and IDB (2004). 2.8 The reduction o f tariff levels has also been accompanied by a reduction in tariff dispersion levels. This process has been aided by harmonization efforts in the context o f the Central American Common Market (CACM) to gradually converge to a four-tier common tariff ranging between 0 and 15 percent for most goods imported into the region.' Within the region, El Salvador stands out with the most parsimonious tariff structure, with only 5 tariff levels (0, 5, 10, 15 and 20) and dispersion levels among the lowest in LAC. At the other extreme, despite boasting a l o w average tariff, Costa Rica exhibits a relatively high dispersion due to the persistence of a number of additional tariff levels beyond 20.* 2.9 Most countries s t i l l exhibit a few tariff peaks (e.g., ad valorem rates over 20 percent), protecting sensitive areas of the economy. While the l i s t varies somewhat from country to country, sensitive activities typically include maize, poultry meat, rice, sugar, and dairy products. The continued protection afforded to these products has been explained by the strength o f small, highly organized producing groups coupled with urban sympathy to some farming groups who may have difficulties in facing international competition (Monge et al, 2003; Arce and Jaramillo, 2005). 2.10 To complement the reduction o f tariffs, Central American nations also removed most non tariff barriers, which had been widely used prior to the reforms. As a result, prohibitions and quantitative restrictions are today mostly limited to sanitary or technical standards grounds. However, specific complaints o f the use o f non tariff barriers - often using . ~ addition, some phitozoosanitary arguments - continue to be reported with some r e g ~ l a r i t yIn 1 This common tariff structure consist of rates o f 0 percent for goods not produced in Central America; 5 percent for primary and capital goods produced in CA; 10 percent for intermediate and capital goods produced in C A and 15 percent for final goods. * Costa Rica's tariff levels beyond 20 percent currently include: 30, 35,40,45,50,65 and 150 percent. 3 Allegations of arbitrary use of non tariff barriers for sensitive agricultural products in some Central American countries have been common at the WTO and other fora. Honduras, for example, has been accused in recent years o f the arbitrary use of sanitary and phytosanitary measures in agriculture, particularly in reference to imports o f poultry, dairy products, pork, feed grains and rice (U.S Embassy Honduras, 2003). 15 CHAPTER II, I s DR-DR-CAFTA The End Of The Road?: countries continue to require importers to purchase part o f the local crop o f some sensitive commodities before issuing import permit^.^ Figure 1: Average Tariffs - Selected Latin American Countries 0 1987 W 1998 02001 1 I Source: Lederman et a1 (2002) with data from WITS, USITC and IADB. Export Promotion 2.1 1 As part o f the trade reforms o f the early 1990s, Central American countries also restructured their approach to promoting exports. Direct fiscal subsidies gradually gave way to the recognition that the removal o f traditional import protection eliminated the anti-export bias o f traditional policies. Incentives to attract and facilitate the development o f export ventures were granted through Export Promotion Zone (EPZ) regimes which exempted f i r m s from import, sales and income taxes. Most countries in the region also introduced regimes that allowed for the tax free importation o f inputs (raw materials, semi-processed goods, machinery and equipment) for use in the production o f goods and services intended for export. In conjunction with trade preferences granted by the U.S., EPZ and temporary importation o f import regimes have greatly facilitated the expansion o f exports throughout the region since the late 1980s. Integration initiatives 2.12 In addition to unilateral liberalization efforts, trade developments in Central America were significantly influenced by other trade initiatives in the 1 9 9 0 ~ ~ including the active pursuit by Central American nations o f multiple trade negotiations in what has been termed a three-tiered strategy (Salazar, 2002). At the global level, a l l countries participated actively in the Uruguay Round (1986-1994) and those that were not already members joined the GATT- Under these schemes, producers and processor negotiate a reference price for these products. Once the domestic supply to these grains has been exhausted, a quota i s introduced that allows processors to import these products at a preferential rate, often duty free. 16 CHAPTER 11. I s DR-DR-CAFTA The End Of The Road?: WTO. At the regional levels Central American countries revitalized the C A C M under new principles (see below) and participated actively in the negotiations for the Free Trade Area o f the Americas. At the bilateral level, all countries actively engaged in negotiations o f bilateral or subregional FTAs to expand markets and attract investment. 2.13 On the latter front, Costa Rica pioneered independent FTA negotiations with Mexico (1995) and finalized agreements with Chile (2000), Dominican Republic and Caricom (2000) and Canada (2002). C A C M members jointly negotiated FTAs with the Dominican Republic (1998), Chile (2001) and Panama (2002) and are currently participating in talks to establish the Free Trade Area o f the Americas (FTAA). The Northern Triangle (Honduras, Guatemala and El Salvador) subscribed an FTA with Mexico in 2000.5 This strategy o f “open regionalism” has been the subject o f some controversy (see IADB, 2002, Chapter 2). On the one hand, i t has created a multiplicity o f agreements that may have high administration costs and can lead to confusion about application as well as information costs - related to what i s known as a “spaghetti bowl”. O n the other hand, these agreements have opened new trading opportunities, improved the capacity o f national trading teams to participate in regional and global negotiations and may have served as building blocks to reach negotiations with the large market represented by the U.S. In any case, the literature suggests that these agreements are useful inasmuch as they do not generate trade diversion nor hamper efforts for broader global negotiations. 2.14 The revitalization o f the Central American Common Market (CACM) also merits mention, as it i s responsible for a resurgence o f intra-regional trade in recent years. Created in 1961 as the first regional trade agreement in L A C under the inward looking strategy o f industrialization as a Customs Union with l o w barriers to intra-regional trade and high barriers to imports from third countries, i t faced growing obstacles to i t s consolidation since the late 1960s and suffered from the macroeconomic and political upheavals that were present in the region in the 1980s. I t was significantly restructured and re-launched in the 1990s with a lower common external tariff structure and deeper integration disciplines in areas such as investment, intellectual property and technical standards (Salazar-Xiriiiachs, et al, 2001). Revitalization occurred through the 199 1 Tegucigalpa Protocol and the 1993 Guatemala Protocol, aimed at eliminating the remaining trade barriers, working towards a customs union, and promoting integration in other areas beyond trade. Trade negotiations spurred by these protocols led to rapid progress in reduction o f trade barriers among members and in harmonization o f tariffs towards extra-regional partners. Lower trade barriers as a result o f the new version o f the C A C M have yielded an impressive resurgence o f intra-regional trade, which has grown at rates that are more than double those o f extra-regional trade between 1990 and 2004. While intra-regional trade averaged only 21 percent o f all trade in Central America in 1990, by 2004 these flows had increased to 38 percent. 2.15 Despite the progress made, there are some issues that need to be tackled to meet fully the trade liberalization objectives o f the CACM. Intraregional trade s t i l l faces tariff and non n addition, El Salvador Guatemala, Honduras and Nicaragua are jointly negotiating an FTA with Canada. The I five countries are in the early stages of ETA talks with the European Union. In addition to FTAs, several Central American countries have signed partial scope trade agreements with Colombia and Venezuela. 17 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: tariff barriers, in products such as non-roasted coffee, cane sugar, wheat flour, and ethyl alcohol. For the C A C M to become a fully operating customs unions, further progress will need to be made in the harmonization o f external tariffs. As o f early 2004, s t i l l 8 percent o f tariff lines required harmonization, including some inconsistencies arising from the differences in some o f the bilateral agreements that were not negotiated by the five countries jointly. A well functioning customs union w i l l also require upgrading o f the rules o f origin framework, to bring them to the same level o f formality as the rules o f origin that w i l l be agreed for trade with the U.S. within DR-CAFTA. 2.16 Aside from trade, Central American countries have embarked on deeper regional integration efforts. The new regional integration agenda has included macroeconomic, political, legal, social, territorial and environmental agreements. However, many o f the non- trade commitments have had few practical consequences and regional institutions in other areas are s t i l l weak. Clearly, trade stands out as the area where most substantive achievements have been made. A noteworthy development o f the past decade i s the significant growth o f cross border investment within the region, which has gone hand in hand with greater regional trade flows. The expansion o f intra-regional FDI flows (highlighted by investments in the financial sector and retailing from El Salvador and other countries) has been changing private sector relationships and may be heralding the beginning o f a deeper phase o f integration. Caribbean Basin Initiative 2.17 Since 1983, Central American countries have enjoyed trade preferences to the U.S. market under the Caribbean Basin Initiative (CBI). T h i s initiative allows duty-free access to the US. market for a substantial number o f products. In 1986 the coverage was extended to include apparel assembled from fabric formed and cut in the U.S., a key factor behind the birth o f the maquila production o f apparel in the region. In 2000, the U.S. Trade and Development Act extended the benefits o f the CBI by granting trade concessions similar to those enjoyed b y Mexico under NAFTA for apparel, and lowered tariffs for other products previously excluded from the Initiative (e.g., footwear, canned tuna, petroleum products, watches and leather goods), granting duty free access to almost 75 percent o f all Central American exports to the U.S. 2.18 The new access provisions approved in 2000 permitted the incorporation o f more value added from the region in textile exports. In particular, i t eliminated duties and quotas from apparel cut and assembled in the region from U.S. made fabric, whereas previously tariffs were levied on the value added and products could not be cut in the region. New provisions also allowed for duty-free entry o f items made from knit fabric made in the region from U.S. yarn, although subject to an annual quota. I n addition opportunities for greater regional value added were granted by allowing for some finishing processes to be performed in the region (Le., dying, perm pressing and printing) as well as for the use o f some inputs (i.e., findings and trimmings) o f non U.S. origin. 18 CHAPTER II, Is DR-DR-CAFTA The End Of The Road?: 2.19 The C B I has brought considerable benefits for trade expansion to Central American nationse6All have become significant exporters o f apparel to the U.S., with the largest export volumes coming from Honduras, El Salvador and Guatemala - w i t h the former achieving substantially greater exports over the others as a result, inter alia, o f its logistics advantages in accessing East Coast destinations from the relevant urban center (Le,, San Pedro Sula). Success has come despite rules o f origin restrictions which have limited the development o f greater linkages with the local economy as well as greater flexibility in the sourcing o f input^.^ Besides apparel and textiles, Central American countries have used C B I preferences to export traditional export goods (bananas, coffee, sugar) free o f duty as well as for the development o f a number o f growing non traditional agricultural exports and some light manufactures. On the other hand, studies o n the hurdles that have remained to further expansion o f exports despite C B I preferences reveal the continued existence o f non tariff barriers for agricultural products in the U.S. (e.g., sanitary and phytosanitary restrictions, standards, labeling), complex rules o f origin for some sectors such as textiles as well as the high costs o f transport and the lack o f economies o f scale (Monge, Loria and Gonzalez Vega, 2003). Figure 2: Textile and Apparel Imports into the U.S. 2,500,000 2.250,ooo 2.000,000 1,750,000 I % I / 1.500.000 1,250,000 1,000,000 750,000 500,000 250,000 +CostaRica -USalvador +Guatemala +Honduras +Nicaragua -Panama Source: Office o f Textiles and Apparel, US. Department o f Commerce. The expansion in trade and FDI associated with C B I preferences is also the result o f complementary actions by Central American governments, including export promotion and investment attraction policies. The latter included the active role o f specialized agencies (CINDE in Costa Rica, FUSADES in El Salvador and FIDE in Honduras) which played an important role in designing incentives, policies and actual promotional work. Rules o f origin restrictions explain why a significant o f apparel exports to the U.S. do not qualify for C B I duty free treatment. For 2002, the share o f apparel exports which were able to enter duty free were 65 percent for Costa Rica, 63 percent for El Salvador, 73 percent for Honduras and only 29 percent for Nicaragua (World Bank, 2005e). 19 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: 3. The results of trade policies: Trade and growth outcomes 2.20 The ultimate test of success o f trade policies i s significant growth and diversification o f trade flows. However, simple assessments using these criteria are problematic as improvements in trade are usually determined also b y a number o f different policy and exogenous issues. Nevertheless, in this section we attempt a preliminary assessment o f trade policies by examining recent trends in trade flows, trade diversification and growth in Central America. The evidence on growth i s also reviewed in an attempt to evaluate if trade policies o f recent years may have contributed to overall economic performance since the early 1990s. Trade openness 2.21 Table 1 displays a common measures o f trade flows (also known as trade openness, defined as exports plus imports as a share o f GDP) for Central American countries and other LAC countries for 1990-91 and 2000-01.8 The figures indicate that in the early 1990s, trade volumes in the region (47 percent on average for the five DR-CAFTA countries) were somewhat lower than the L A C average (51 percent). However, the figures for the early 2000s indicate that Central America led the region in the growth o f trade volumes, along with Mexico. Between the early 1990s and the early 2000s, the Central American average grew by 29 percentage points to 76 percent. Expansion o f trade volumes was most impressive for Honduras (62 ppts) and Nicaragua (40 ppts) and less so - but s t i l l quite significantly -for El Salvador (17 ppts), Costa Rica (14 ppts) and Guatemala (13 ppts).’ * While trade openness has been used in the literature as a common proxy o f trade policy, strictly speaking i t i s an outcome variable that reflects a broad array o f policies and other structural features o f an economy (Le., area, landlocked situation, oil exporter). The indicators o f trade volume presented in t h i s section include the best available information for all trade, including all imports and exports related to free trade zones and maquila activity. One o f the reasons for the apparent large trade openness (and gains) magnitudes as a share o f GDP obtained for Honduras and Nicaragua i s the potential underestimation o f their gross domestic product figures. 20 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: Table 2: Trade Openness* (Percent of GDP) I 1990-91 12000-01khanrrel * Exports and imports of goods, including rnaquila (gross). Source: World Bank with data from Central Banks and private sector sources. 2.22 Between 1991 and 2001, growth in trade volumes in all countries o f Central America was larger for imports (16.9 percentage points for the Central America average) in comparison to exports (10.2 percentage points) (see Table 2). The disparity i s mostly due to the resumption o f capital flows (including € 31, aid and public and private indebtedness) which allowed for the financing o f larger trade deficits than was possible in the 1980s. For countries such as El Salvador, Guatemala and Honduras, the significant secular growth in remittances have also contributed to financing trade deficits. On the export side, growth can be explained in great part due to the surge in maquila exports (mainly textile and apparel), and the development o f non traditional agricultural exports (particularly in Costa Rica, Guatemala and Honduras). Traditional exports have stagnated (coffee, bananas, sugar) or declined (cotton) as a result o f heavy supply competition and slow demand growth, which have led to declining prices. Costa Rica’s outstanding performance i s related also to success in developing new manufacturing lines o f export, including high technology exports (e.g., Intel microchips) and a wide array o f other manufacturing products. 21 CHAPTER II. Is DR-DR-CAFTA The End Of Re Road?: Table 3: Trade Openness, Exports and Imports" (Percent of GDP) I ] 1991 I 2001 I Change Guatemala 0.39 0.50 0.11 Exports 0.18 0.19 0.01 Imports 0.21 0.31 0.10 El Salvador 0.42 0.57 0.15 Exports 0.14 0.21 0.07 ImDorts 0.29 0.36 0.08 * Exports and imports of goods, including naquila (gross). Source: World Bank with data from Central Banks and private sector sources. 2.23 Although trade volumes have grown impressively in Central America since the early 1990s, there seems to be scope for further trade increases in the future. To evaluate this potential, i t i s useful to compare their trade outcomes with those o f other economies in similar situations. Figure 3 show the results of a simple benchmarking exercise o f trade openness indicators for a sample of 124 countries by per capita income, controlling for factors that may affect trade but are unrelated to government policies (i.e., area, population, access to coast, o i l exports)." In t h i s light, the positive performance o f trade since 1990 can be reinterpreted as catching up from significant initial deficits, relative to international norms. By 2001, Honduras was the only Central American country that performed beyond international comparators, due in great part to the huge success o f maquila exports. For the remaining countries, only Nicaragua managed to cut the deficit significantly since 1990, although the other countries are among the top in Latin America in terms o f progress achieved in this loAccounting for the factors mentioned i s done so that we do not unfairly attribute to trade policy what is merely the result of structural country characteristics. We follow here the corrections included in Loayza et al (2002). 22 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: front. l1 However, the fact that most o f the countries continued to exhibit shortfalls by the early 2000s in relation to international comparators i s a likely result o f continued constraints in transportation costs, port bottlenecks and other behind the border weaknesses. Figure 3: Trade Openness as a percent of GDP: Deviations from Predicted Values by Level o f Income 6o 3 I T lggo 2001 60 80 Source: Own calculations. Trade diversification 2.24 Another important measure o f the success o f trade policies i s the degree o f diversification o f exports. I t i s well known that countries that rely heavily o n a few goods for i t s exports, are more vulnerable to swings in market conditions than those that enjoy a diversified export basket. The importance o f this point was highlighted recently in a study by Lederman and Maloney (2002) which found that countries that exhibit a high concentration o f exports in a few products tend to exhibit less growth. 2.25 The export basket for most Central American countries has exhibited significant changes since 1990. A clear structural transformation i s evident, with the share o f traditional commodity exports declining in favor o f light manufactures. The case o f El Salvador i s representative. Traditional exports f e l l from 50 percent o f total exports in 1990 to 15 percent in 2002. In the same period, the shares o f non traditional exports and net maquila exports went from 48 percent to 58 percent and from 3 percent to 28 percent, respectively. *'The reductions in the deficit for El Salvador, Guatemala and Costa Rica seem small by comparison to achievements in Honduras and Nicaragua, but the latter may be overestimated due to the undervaluation o f GDP. 23 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: Despite the structural change in the composition o f exports, conclusions about their diversification are not as sanguine. For El Salvador, Honduras and, to a lesser extent, Nicaragua, the Herfindahl index o f export revenue concentration (calculated at the two digit level) deteriorates sharply since the early 1990s, as the concentration in a few traditional commodities has been replaced by a new concentration o f exports in maquila manufactures (Figure 4). Results for Guatemala show unchanging diversification levels until the late 1990s, followed by increasing concentration levels in recent years. Costa Rica displays a diversification trend that ends abruptly in 1999, when the sudden surge in exports o f high-tech products produces a new concentration trend. 2.26 Interestingly, if the analysis excludes maquila and high technology products, strong diversification trends become evident for all countries with the only exception o f Nicaragua. This demonstrates that aside from the disproportionate success o f maquila products and microprocessors - industries that are s t i l l not fully integrated into the local economies --, exports in Central America have shown significant diversification, particularly into non traditional agricultural goods, processed foods and other light manufactures. Figure 4: Export Diversification Index 0.6 ,- 5 A m U 0.3 5 8 0.2 0.1 - J 0 : 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 -Costa Rica El Salvador +Guatemala -.e-. Honduras +Nicaragua Without textiles or Intel 0.350 0.300 i - E - 0.250 5 0.150 j 0.050 I I ~ 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1-Costa Rica -El Salvador +Guatemala ---e--- Honduras --Nicaragua Source: Own calculations. 24 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: Growth 2.27 Table 4 presents growth figures for the five Central American countries starting in 1990. While there i s substantial disparity in annual growth rates per country, i t i s possible to detect three distinct phases. The first i s o f relatively high growth rates between 1990 and 1995. The second i s one o f mixed results between 1996 and 1999. Poor economic results are more prevalent in the third which starts at around 2000. The only country that seems to deviate from the general trend i s Nicaragua, which exhibited l o w growth until 1994 and a boom situation in 2000 induced by aid flows after Hurricane Mitch. Table 4: GDP Growth, 1990-2004 2002 2.9 2.1 2.2 2.5 1.o 2.2 2.5 2003 5.6 2.0 2.1 3.2 2.3 3 .O 3.2 3nnAn 'ww-y, ?9 71 7 6 A .? A? I ? A I 27 d . , I I .I I I." I I a I I .d & . I d .I I Source: Central Banks of Central America and World Bank projections. 2.28 An important question i s whether the expansion o f trade flows described above had an influence on growth results. Generally, correlations and scatter plots do not display simple bivariate relationship between trade volumes (or growth in trade volumes) and economic growth. Figure 5 illustrates t h i s point with data from a large sample of countries. Can we conclude then that the positive trade results o f recent years had no discernible impact on growth? 25 CHAPTER II. I s DR-DR-CAFTA The End Of The Road?: O.lo0 1 0 I 0 0 0 .. 0 0.040 t 0 : 0 . 0 0 0 0 0 0 . * . 0 0 0.020 0 *O ,* . 58,550 = >I17,100 Sub-Federal Level = >477,000 = >650,000 * Other Entities = >250,000 = >538,000’ For Construction Services. All levels = >6,725,000 => 8,000,000* 50 CHAPTER 111. The Content of DR-CAFT’4: Implicurions Customs 3.59 DR-CAFTA includes obligations aimed at strengthening, improving and modernizing the operation o f customs in order to facilitate trade among signatory parties. Provisions seek to facilitate customs procedures and reduce room for discretion. I t includes rules of origin that are designed to be easier to administer. I t also requires transparency, procedural certainty and efficiency in administering customs procedures, including DR-CAFTA rules of origin. Central American countries committed to a l i s t o f actions within three years to accomplish goals such as the publication of all norms and regulations in the Internet, the automatization o f the clearance procedures, the electronic presentation of certificates o f origin and the implementation o f management and risk evaluation systems. All signatories also agreed to share information to combat illegal trans-shipment o f goods. A program o f technical assistance was agreed to support Central American countries in carrying out their commitments in this area. Evaluation 3.60 Customs related issues have posed significant barriers to trade in Central America, due to complex and lengthy procedures, inefficiencies and opportunities for fraud and corruption. In many surveys conducted among private sector f i r m s , complaints against customs procedures and officials usually top the list. The clarifications and simplifications of some procedures with respect to verifying rules o f origin are o f value but unlikely to be enough to end deep seated problems. Central American nations w i l l need to push ahead with strong reforms (independent o f DR-CAFTA) if they are to reap the full benefits of trade for development. Dispute settlement 3.61 DR-CAFTA provides for all core obligations to be subject to a bilateral dispute settlement panel with high standards for openness and transparency. I t includes monetary penalties to enforce commercial, labor and environmental obligations. Evaluation 3.62 The dispute settlement section o f any FTA i s where key incentives are laid out for parties to get serious about compliance with provisions and strengthening domestic norms and institutions. DR-CAFTA sets appropriately high standards for openness and transparency in settlement procedures. While monetary penalties were included - a first for any FTA signed b y Central American countries - they would only be used after long consultation periods and tests for non compliance. For Central American countries, having a reciprocal dispute settlement mechanism i s a significant gain with respect to the C B I regime, in which no recourse was provided to unilateral actions b y the U.S. 51 CHAPTER Ill. The Content of’DR-CAFTA: I?nplicufions. Trade capacity building 3.63 The agreement includes a Committee on Trade Capacity Building for the first time for any FTA involving the U.S. or any o f the Central American nations. Also the creation o f the Institute for Trade Capacity Building, in New Orleans, which w i l l focus on developing capacity for support programs for small and medium enterprises. In addition, a coalition o f U.S. companies came together to support the creation and strengthening o f trade capacity in Central America. Evaluation 3.64 While i t i s too early to evaluate results o f these provisions that have not been included in other U.S. free trade agreements, the Committee could be o f use for the coordination of actions b y donors, NGOs and the private sector for the improvement o f institutional capacity, adjustment to new liberalization commitments and sensitive enforcement challenges. 5. Provisions to deepen regional integration 3.65 Central American countries took a momentous decision in making D R - C A F T A a treaty that would be applied multilaterally. Initially, i t was thought that the treaty would be so markedly different to the norms that have governed trade among Central American Common Market members - aside from including many areas that are not included in that agreement - that i t would only apply bilaterally between the U.S. and each Central American member, in what i s known in the literature as the classic “hub-and-spoke” model. However, during negotiations i t was agreed that the treaty’s commitments would be applied to trade and investment relations among all parties, including the Dominican Republic, as reflected in the agreement’s Article 1.1. This important decision should have great impact in a number o f areas, most significantly in facilitating further trade and deepening regional integration efforts. 3.66 The multilateral application o f D R - C A F T A w i l l make more goods qualify for free trade between Central American countries than current norms.26 Under D R - C A F T A all goods made with inputs from any o f the parties o f the agreement w i l l qualify as meeting the rules o f origin - in the Central American Common Market regime, input accumulation was not possible and inputs from the U.S. or the D.R. could not count towards meeting origin rules. In addition, DR-CAFTA disciplines w i l l allow free trade in goods produced in Export Processing Zones, as long as they meet origin requirements. As pointed out b y Gonzhlez (2005), firms w i l l enjoy an expanded set o f input sourcing options when producing for exports to DR-CAFTA members, reducing the distortions that are created b y the existence o f multiple parallel FTAs. However, to avoid confusion, i t may be important to modernize some o f the existing Central American instruments which are not superseded b y DR-CAFTA, in order to ensure that they are consistent with the treaty and more up to date with recent international trends. 26 Some o f the arguments presented here draw from the excellent analysis o f the application of D R - C A F T A among Central American countries and the Dominican Republic o f Gonzfilez (2005). 52 CHAPTER Ill. The Content oJ’DR-CAFTA: Implications 3.67 In addition, DR-CAFTA w i l l not contribute to the “spaghetti bowl” syndrome associated w i t h the administration of multiple treaties, particularly costly in terms o f the administration of multiple sets o f complex rules of origin regulations. Instead, i t i s likely to foster an atmosphere conducive to finalizing steps for a Customs Union between C A C M members, a task which only requires a few additional administrative steps to ensure that imports into the region can stop only once at the port o f entry into the region, and then proceed to move freely across the region’s borders.27 3.68 Multilateral application o f DR-CAFTA also deepens regional integration efforts. The over forty years of history in such efforts among Central American nations had yielded a very advanced set of rules for trade in goods. Yet virtually no legal instruments exist for applying a common set o f norms among Central American countries in the other areas of commitments included in DR-CAFTA.** DR-CAFTA w i l l now provide modern rules and disciplines for relations among Central American countries and the Dominica1 Republic in the areas o f trade in services, investment protection, and government procurement - including financial services, telecoms and e - ~ o m m e r c e Moreover, .~~ i t w i l l allow the use o f dispute settlement mechanisms in novel areas such as IPR, labor and environment. The new regional rules and disciplines are likely to strengthen regional ties and set the stage for even deeper integration efforts among Central American countries and the Dominican Republic in the future. 6. Conclusions 3.69 This chapter provides an overview o f the recently negotiated DR-CAFTA, concentrating on the extent to which the agreement’s provisions would significantly change market access for Central American goods and services, and also on how far they could be expected to consolidate prior reforms and/or spur further domestic reforms in Central American countries. The overall assessment presented in the chapter i s that, on both fronts, the answers are broadly positive, suggesting that DR-CAFTA should be expected to have a positive impact on trade flows and investment. 3.70 On market access, DR-CAFTA would consolidate and expand the current generous access that Central Americans currently enjoy to the U.S. market, while extending broadly reciprocal access for U.S. goods to their own markets. The benefits offered under the C B I would be locked in for Central American countries, and some additional permanent duty free access would be obtained for goods that had been previously exempted from C B I preferences. Other significant results would include the flexibilization o f rules of origin for textiles and apparel, as well as commitments to help producers meet sanitary and phytosanitary standards required for the entry into the U.S. o f promising non traditional agricultural exports. D R - CAFTA also includes reciprocal commitments on access to service markets, which ’’ Arrangements would need to be made during the transition period to free trade for different tariff phase-out periods and for the specific country commitments that were made for tariff rate quotas in sensitive goods. ’*Negotiations in recent years among Central American countries had yielded general texts for draft treaties on Investment and Services and on Government Procurement. Detailed country-specific annexes were still under negotiation when D R - C A F T A discussions started. 29 I n government procurement, Central American countries applied much stronger commitments to each other than they allowed with the US., b y eliminating minimum thresholds or exemptions to any government agency in purchases o f goods or services (Gonzhlez, 2005). 53 CHAPTER Ill. The Content ojDR-CAFTA: ltizplications consolidate domestic reforms that opened most of these markets to private participation in recent years. 3.71 Central American countries also agreed to grant reciprocal tariff-free access to their markets to U.S. products. Certain sensitive agricultural crops would be subject to extended transition periods (up to 20 years), in order to allow for gradual adjustment and to respond to domestic sensitivities. Central American countries secured access to flexible safeguard mechanisms to prevent sudden surges in imports or declines in prices. 3.72 Commitments embedded in DR-CAFTA would gradually erode current protection levels for various products that have retained high protection in Central American economies, during earlier efforts at easing trade restrictions in the past. The gradual decline expected in prices o f basic food staples as a result should prove positive for the vast majority o f Central Americans who are net consumers ‘of such goods and whose welfare w i l l be increased b y lower prices. This said, not all sensitive products are included, in response to cultural and political factors, and these limitations - together with the agreement’s s t i l l excessively restrictive rules o f origin for the entry o f textile products to the U.S. - represent barriers to trade that w i l l continue to foster some inefficiencies in the deployment o f domestic resources both in the U.S. and Central America. 3.73 On the questions related to domestic reforms, DR-CAFTA commitments promise to lock in a number o f the policy and regulatory changes implemented in recent years for the opening o f competition in previously protected sectors (e.g., telecoms, financial services, energy) and the modernization o f key norms and procedures in areas such as government procurement, intellectual property rights and the treatment o f foreign investment, b y locking in current levels o f access o f investors (and bidders) from the U.S. 3.74 Costa Rica i s the only country that w i l l be required to make significant legislative changes to adapt policies and regulations to i t s commitments under DR-CAFTA, allowing access to significant portions of its telecom and insurance markets. These reforms had been long postponed and should further foster the modernization, efficiency and competitiveness o f these areas o f the Costa Rican economy. 3.75 Aside from consolidating and spurring further reforms, the treaty should strengthen commitments to upgrade enforcement levels o f domestic legislation. This represents a significant challenge in areas l i k e labor, environment and intellectual property rights, which w i l l require decisive efforts and resources to modernize and boost the capacity o f public agencies. The net impact o f these efforts should be positive, as investment i s likely to be attracted to environments with effective institutions. However, while DR-CAFTA w i l l put pressure on the modernization of these institutions, i t w i l l not b y itself create such modernization. Countries w i l l need strong independent plans o f action and sufficient dedication o f implementation capacity and resources. 3.76 The agreement includes cooperation accords to boost standards and enforcement levels in areas such as labor, environment, customs and other areas. I t also offers proposals to develop further cooperation and “trade capacity building”, which should aid in the 54 CHAPTER 111. The Conrent (fDR-CAFTA: Iriiplicurions mobilization of human and financial resources required for key reforms and institutional actions required to implement the agreement and the broader developmental challenges. 3.77 Finally, a welcome side effect o f the negotiation o f DR-CAFTA has been the advancement of regional integration efforts. The decision to make the provisions o f the agreement apply multilaterally among Central American countries and the Dominican Republic w i l l deepen regional integration efforts in the region and facilitate the creation o f a Central American Customs Union. 55 CHAPTER Ill, The Content oj’DR-CAFTA: Ittiplicutions.. 56 CH.4PTER IV. Economic Effect oj' CAFTA: More Arr Than Science Chapter IV. Economic Effects o f DR-CAFTA: M o r e Art than Science Abstract 4.1 Estimating the effects of trade reforms i s in general more art than science due to the need to use highly restrictive assumptions when applying various analytical methods. Standard analyses of the gains from trade suggest that these gains depend on the ability of economies to successfully adjust to changes in relative prices. This entails the restructuring o f the economy. The international evidence suggests, however, that FTAs with the U.S. are associated with greater exports and foreign direct investment. There i s also some preliminary evidence that FTAs are associated, on average, with transitory improvements in economic growth. But the benefits from DR-CAFTA w i l l depend on the ability o f Central American economies to pursue a complementary policy agenda, because DR-CAFTA by itself i s unlikely to lead to substantial developmental gains without parallel efforts in institutional and regulatory reforms, infrastructure, and innovation and education. 57 CHAPTER IV. Econonlic Effect of’CAFTA: More Art Than Science 1. 1. Introduction 4.2 Like many Latin American countries, the economies o f Central America that recently signed the Central America Free Trade Agreement (DR-CAFTA) underwent a period o f dramatic trade reforms in the early 1990s. These reforms were implemented in an era when academics, political leaders, and various civil society organizations from throughout the globe were questioning the merits o f trade liberalization. For example, Rodriguez and Rodrik (2000) criticized influential academic papers on the relationship between trade and economic growth on the grounds that the literature had not adequately addressed the key issue o f measuring trade policy, as opposed to other factors that might affect the incidence o f international commerce on national economies. In the public domain, traditional defenders o f free trade are now questioning i t s benefits in the context o f international capital flows (Roberts and Schumer 2004). In fact, a recent World Bank report on the impact o f the North American Free Trade Agreement (NAFTA) concluded that this controversial agreement had been moderately positive for the Mexican economy, but that i t was certainly not enough to spur fast long-term economic development in Mexico (Ledennan, Maloney, and ServCn 2005). 4.3 This chapter highlights various analytical arguments and their limitations in favor o f trade reforms and contrast them with the findings o f various analyses undertaken to assess the potential impacts o f the DR-CAFTA on the developing countries o f Central America, namely Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. 4.4 Assessing the impact o f any public policy before i t i s actually implemented i s admittedly difficult. Indeed, Kehoe (2003) points out that popular ex-ante general equilibrium analyses o f NAFTA written in the early 1990s turned out to be quite off the mark relative to their predictions about the structural (in terms o f industry-level growth) effects o f N A F T A on the Mexican economy, mainly because such models are generally incapable o f predicting dynamic effects o f trade reforms and Free Trade Agreements (FTAs). The problem, however, i s not necessarily particular to the general-equilibrium- simulation approach, for all methodologies have advantages and disadvantages, and most provide some useful elements for policy discussions. Ex-ante analyses, either partial- or general-equilibrium simulations have the advantage o f focusing on the effects o f the FTA on the beneficiary countries. But, since the agreement has not been implemented, these analyses are thus limited b y a broad set o f assumptions required to make such predictions before the policies are implemented. In contrast, statistical analyses o f the impact o f international trade and FTAs already in operation have the advantage o f using real-world experiences, but are not strictly related to the D R - C A F T A countries themselves. Hence these econometric exercises need to be controlled for an array o f variables in an attempt to identify the average effects o f FTAs, independent o f other country characteristics. In the end, understanding the effects o f DR-CAFTA prior to i t s implementation remains more art than science, but the technical aspects o f the various approaches to some extent determine the results obtained from each. For this reason, this chapter provides a wealth o f technical discussions of methodologies. Non-technical readers are encouraged to browse the various results and proceed to the other chapters. 58 CHAPTER IV. Econotnic Eflecr of CAFTA: More Arr Than Science 4.5 This chapter applies two broad approaches for estimating the potential economic effects o f trade agreements, namely static and dynamic approaches. The static approach includes efforts to simulate the impact o f DR-CAFTA on each country’s structure o f trade, returns to factors of production, and on the structure of production itself. This approach includes both partial and general-equilibrium modeling attempts. These simulations are also complemented with statistical evidence from global data that highlight how country- specific characteristics might affect the outcomes o f DR-CAFTA. Two such characteristics are transport infrastructure and the regulatory environment that affects the ease with which workers and firms can take advantage o f new opportunities. 4.6 The dynamic approach includes statistical analyses o f the impact o f trade in general and FTAs in particular on factors such as investment and institutions. The underlying idea i s that for trade to have dynamic effects, these should operate through factors that affect long-term economic growth. Consequently, the final section o f this chapter reviews new estimates o f the impact o f FTAs from throughout the world on the rate o f growth o f GDP per capita. 4.7 The evidence reviewed herein supports three key conclusions. First, DR-CAFTA i s likely to have positive effects on economic growth in Central America, by increasing foreign and domestic investment, and increasing both exports and imports, which might help speed up the transfer o f technology from abroad. Preliminary evidence, from econometric estimates that control for the possibility that economic conditions themselves determine the probability o f signing an FTA (Gould and Gruben 2005), suggests that economies that sign Free Trade Agreements tend to increase their annual growth rates b y about 0.6 in the five years following i t s implementation. Moreover, there i s evidence that FTAs offer better market access opportunities to the U.S. than this country’s existing unilateral preferential programs, such as the C B I in spite o f i t s recent modifications. The evidence based on data from 2001 and presented b y Lederman and Ozden (2005) suggest that, after controlling for various country and industry characteristics, FTAs with the U.S. are associated with higher exports that can be several multiples o f the exports of otherwise similar countries that do not benefit from any commercial preferences. Likewise, exports from FTA members are higher than those from C B I beneficiaries, after controlling for industry and country characteristics. Also, the econometric evidence from Cuevas et al. (2002), which was also reported in Lederman, Maloney, and ServCn (2005), suggests that FTA members temporarily attract FDI than non-members, by increasing the responsiveness o f FDI to a country’s economic performance. 4.8 Second, the magnitude o f these positive effects and how they are distributed within the national economies o f Central America w i l l depend crucially on each country’s ability to take advantage of the opportunities offered b y the agreement, particularly because the gains from trade depend on each economy’s ability to change i t s production and employment patterns and to adopt foreign technologies. M o r e specifically, the evidence suggests that institutional reforms and public investments in innovation and infrastructure w i l l affect the magnitude o f the impacts on foreign direct investment, technology transfer, and international commerce. 59 CHAPTER IV. Economic Ejjecr of CAFTA: More Art Than Science 4.9 Third, the agreement w i l l undoubtedly have differential effects within countries. Perhaps more importantly, the overall benefits o f DR-CAFTA for these countries w i l l depend on their ability to help the sectors, especially workers that w i l l be negatively affected b y the expected changes in relative prices. In other words, the implementation o f efficient adjustment programs w i l l help not only the workers that w i l l face important adjustment challenges, but w i l l also affect the magnitude o f the overall gains from D R - CAFTA. 4.10 The rest o f this chapter provides an analytical overview o f both the intuition and empirical evidence that suggest why DR-CAFTA and other trade reforms might not be enough to help Central America enhance i t s prospects for rapid economic development. The following Section 2 reviews the theory and corresponding literature concerning the so- called “static” gains from trade. Section 3 examines the theory and evidence concerning the “dynamic” gains from trade. The final Section 4 concludes b y summarizing the main findings and highlighting broad policy implications, most o f which are discussed in more detail in other chapters. 2. Trade Liberalization and the Static Gains from Trade A. Background 4.1 1 The standard textbook theories that predict gains from international commerce do so usually b y comparing the welfare o f consumers in a country without trade to that same country after full trade liberalization. At the center o f these arguments l i e s the idea o f “comparative advantage” whereby certain countries can produce some products at lower relative costs than other goods. The gains from trade for small economies come in two parts2: those related to the increase in the level o f consumption for a given level and structure o f production, plus the gains derived from the reallocation o f labor and other factors o f production towards the sectors with the lowest relative costs o f production (or higher relative prices o f the relevant goods). The technical appendix at the end o f this paper reviews some o f the basics and shows why the gains from trade have never been thought to be automatic. 4.12 A finding o f particular relevance for Central America i s that the gains from trade are unambiguously positive only if the structure o f production changes as a consequence o f the trade reform. This requires that labor move to those sectors where labor productivity i s relatively higher. That is, the gains from trade are feasible as long as economies are able to adjust efficiently to the new set o f relative prices after trade liberalization by maintaining a constant level of employment. The static gains from trade w i l l make all citizens better o f f only i f workers that w i l l bear the costs o f adjustment b y having to change their economic activities are compensated for their efforts. The term “small” i s used here to refer to any economy that cannot affect international prices o f goods and services. 60 CHAPTER IV. Economic Effect (f CAFTA: More A r t Than Science 4.13 More generally, the potential gains from trade exist in most contexts: when comparative advantage i s caused b y differences in factor endowments (the Hecksher-Ohlin framework), technologies (the Ricardian model), tastes, the size of domestic markets (in the presence o f increasing returns to scale), and even in the presence o f trade costs, such as transport and transaction costs. Interestingly, there are gains from trade for small countries even when the sectors o f comparative advantage are unknown in the sense that i t depends on how (at what price) one measures comparative advantage (Deardorff 2003). But in all these settings, the static gains from trade might not be realized if the adjustment process produces significant and persistent unemployment or if the structure o f production does not change. 4.14 Some observers have argued that even this conclusion i s tenuous in the presence o f international capital flows. The argument seems to be that capital w i l l go to countries where, for example, labor standards and wages are lower. Free trade in turn makes these multinational production decisions more profitable, but leaves workers in some countries worse off. While theoretically plausible, substantial independent reviews o f the empirical literature suggest that there i s no systematic evidence o f increased trade leading to the deterioration of wages. Moreover, Figure 1 shows that there i s actually no statistical relationship between the incidence o f international trade and unemployment rates across countries, thus suggesting that there i s no long-term relationship between international commerce and unemployment. As w i l l be discussed in detail below, there might be short- term effects as economies adjust to changes in trade policies and thus the public sector has a role to play so as to facilitate a socially and economically efficient adjustment process. Indeed, there's also no evidence that trade or multinational production i s associated with the worsening o f environmental outcomes (Stern 2003; Brown et al. 2003; Dean 2001 on environmental standards; Copeland and Taylor 2003 on the environment). Figure 1: Unemployment and the Incidence of International Trade in the Long-Run I I I 2 4 6 8 io 12 14 16 18 20 Unemployment rate ("4) 1 OLAC countries .Rest of the World i Source: D e Ferranti, Perry, Lederman, and Maloney (2002, Figure 5.2) 61 CHAPTER IV. Economic Efject of CAFTA: More Art Thun Science 4.15 However robust i s the international evidence about trade, wages and unemployment, critics o f trade agreements often focus on the so-called “core” labor standards. These have to do with the legal rights of workers to unionize or restrictions imposed on child labor or female worker discrimination rather than with economic outcomes, such as wages and unemployment. Busse (2004) finds that overall exposure to international trade (measured b y the ratio o f trade flows to GDP) i s actually negatively correlated with female-labor discrimination and child labor, thus suggesting that international trade does not promote discrimination against female workers or child labor. But Busse does find that trade i s negatively correlated with an indicator o f c i v i l liberties (which in turn appears correlated with OECD indicators of union rights). In another article, Busse (2002) presents partial correlations between female labor participation rates, child labor participation, and an index o f collective bargaining rights and allegedly labor-intensive exports as a share o f total exports. Greater female labor participation actually increases the share o f labor-intensive exports, as does the participation o f children (ages 10-14), whereas the OECD’s index o f unions rights tends to reduce comparative advantage in labor-intensive manufactures. This latter study can be amply criticized on various technical grounds, including, as the author notes, that the econometric estimates suffer f r o m endogeneity biases, and that the data did not permit the inclusion o f all relevant labor-market variables. More importantly, Busee (2002) i s silent with respect to the impact o f trade reforms and FDI on domestic labor- market outcomes. 4.16 Jones (2000) i s perhaps the most comprehensive treatment o f issues related to international commerce in the presence o f international capital flows. The main theoretical conclusion with respect to the potential gains from trade i s that the presence o f international capital flows, or even international migration o f labor, does not change the basic finding that trade reforms are potentially beneficial for all countries involved in trade. This i s so even under various assumptions regarding the sector-specific use o f such international capital or labor. The main intuition behind this result i s that international flows o f factors o f production w i l l reinforce the incentives to specialize in the production o f goods and services where a given country has a relative productivity advantage. However, international capital or labor flows do make i t more difficult to predict in which sectors an economy w i l l specialize, but this ambiguity does not mean that there no gains from trade. The technical appendix discusses analytical issues related to how capital flows can affect both the gains from trade and the pattern o f specialization. 4.17 The Mexican experience with NAFTA highlights how an economy adjusts and changes i t s pattern o f trade and employment, which in turn allowed i t to benefit from the agreement. Figure 2 shows the evolution o f Mexico’s pattern o f net exports, covering ten broad commodity groups. The implementation o f NAFTA in 1994 was associated with the rise o f this country’s share o f net exports o f machinery (e.g., vehicles and parts, telecommunications equipment, and computers). D e Ferranti, Perry, Lederman, and Maloney (2002) showed that this change in Mexico’s pattern o f trade with respect to the U.S. became apparent b y 1993, just prior to the implementation o f the trade agreement. Thus N A F T A had structural effects even prior to the formal implementation o f the treaty, possibly related to changes in the pattern of foreign direct investment (FDI). Figure 3 shows 62 CHAPTER IV. Econotnic E#ect of CAFTA: More Art Than Science the evolution o f formal employment in agriculture and manufacturing maquilas (and do not include other manufacturing establishments), many of which produce the aforementioned machinery products. This evidence i s representative of the structural change experienced b y the Mexican economy, which, given that overall unemployment was not higher after NAFTA (except for 1995 during the so-called Tequila crisis), represents a healthy structural shift. Figure 2: Mexico: Structure of N e t Exports, 1981-1999 100% 80% 60% 40% Machinery 0 Capital-Intensive 20% W Labor-Intensive OCereals .Animals 0% WTropical Agriculture bSl Forestry ORaw Materials -20% PPetroleum -40% 60% -80% 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Source: De Ferranti, Perry, Lederman, and Maloney (2002, Figure A.7.) 63 CHAPTER IV. Economic E#ect ojCAFTA: More Art Than Science Figure 3: Mexico: Registered Agricultural and Maquila Workers, 1983-2003 1.1w 7 550 -- 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1898 1999 2000 2001 2W2 2003 1-Maquilas (left axis) Agriculture (nght axis) I Source: Lederman, Maloney, and ServCn (2005, Chapter 4, Figure 9). 4.18 In fact, the international evidence suggests that long-term development around the world i s characterized by structural economic changes whereby the share o f agricultural employment and production decline as economies grow (see, for example, Bravo-Ortega and Lederman 2005; Martin 2002). Although this does not necessarily mean that the absolute number o f jobs in agriculture declines with development, the absolute number tends to decline in the most developed economies. 4.19 The structural change experienced b y Mexico under NAFTA i s thus consistent with gains from trade, but i t i s likely that public policies can help Central American economies ensure that DR-CAFTA w i l l deliver on i t s promises o f economic development. The following paragraphs review some of the policy sensitive areas that might affect the capacity of Central American economies to adjust to the new trade regime and thus affect the magnitude o f the potential static gains offered b y DR-CAFTA. B. Static gains from trade under various conditions - the role infrastructure and the labor adjustment process 4.20 Theory dictates that international trade can provide significant opportunities for development, but these depend on the ability o f an economy to prevent unnecessary declines in overall employment as the economy adjusts to a new set o f relative prices. Here we cover three related issues - infrastructure and trade facilitation, and labor adjustment - that seem to be important determinants of an economy’s capacity to successfully adjust to a new more open trade regime. 64 CHAPTER IV. Economic Effect of'CAFTA: More Art Than Science Infrastructure and trade facilitation 4.21 As mentioned above, the restructuring o f an economy i s crucial for taking advantage o f the economic opportunities offered b y trade agreements. A successful adjustment entails the avoidance o f substantial job losses, and thus might require that labor literally move to regions that have attracted new investment and that exports o f activities with the highest labor productivity can overcome transport and transaction costs. In both instances, an economy's infrastructure i s critical for helping this process. I f national infrastructure, covering both the movement o f people and goods, i s not adequate then exports w i l l not rise as much and labor might thus be stuck in the l o w productivity areas, thus reducing the gains from trade. Indeed, empirical evidence suggests, for example, that for a given economy (in terms of size and geographical location) the international costs of international freight, insurance, and customs procedures affect the value o f exports to the U.S. Table 1 reports various econometric estimates b y Lederman and Ozden (2004) concerning the impact o f each additional dollar in transport and transaction costs on the value o f exports to this market. Regardless o f econometric technique, the impact of these costs seems to be quite high. Although the empirical analyses b y Lederman and Ozden do not cover all types o f infrastructure, logic dictates that telecommunications or the provision of basic services to emerging sectors can also help the economic transformation promised b y DR-CAFTA. Chapter VI1 o f this report provides some guidance regarding the types o f infrastructure needs, if any, that should be prioritized in the complementary agenda of the DR-CAFTA beneficiaries. Explanatory TOBIT Model TOBIT Model Treatment Model Heckman Variables (Preferences (Preferences (Preferences as Selection Model represented by represented by dummies) (Preferences as dummy variables) utilization rates) utilization rates) (1) (2) (3) (4) GSP -0.14 -1.46"" -0.10 -0.52 FTA 1.60"" 1.05"" 1.59"" 1.75"" CBI 1.55"" 1.35"" 1.12"" 0.53"" Transport Costs I -5.97"" -5.98"" -5.60"" -5.83" * Table 1 Notes: A 11 models were estimated with a data set that covers over 150 countries and 98 product categories, and all included the following (unreported) control explanatory variables: Product dummy variables: log GDP and log GDP per capita for each country: log distance in kilometers to the US.; log area in squared kilometers o f each country; dummy variable for membership in the WTO; dummy variable for English-speaking countries; dummy variable for islands; and variables for the A G O A and Andean trade preferences. In specifications 1 and 3, each preferential trade scheme i s represented by a dummy variable so that each product from a beneficiary country takes a value o f one for each program. In specifications 2 and 4, the use o f preferences by each exporting country i s captured by the percent o f each sector's exports that entered the U.S. market by utilizing the preferential program. Results for specification 2 were unaffected when country dummy variables were included instead o f the country characteristics listed above. In models 3 and 4, the variables that determine the probability of being beneficiary o f U.S. preferential treatment were log distance to the U.S., dummy variable for political alliance with the US., U.S. aid inflows per capita, and a dummy for sharing a border with the U.S. (Canada and Mexico). All levels o f significance were derived from robust standard errors: ** significant at 5 * percent; significant at 10 percent. 65 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science 4.22 Other relevant results from the estimations by Lederman and Ozden concern the effect o f FTAs on exports to the U.S. market, especially when contrasted with the effects o f unilaterally provided preferences such as the Generalized System o f Preferences (GSP) and the so-called Caribbean Basin Initiative (or the Caribbean Basin Economic Recovery Act, CBERA). In the authors’ preferred estimations listed under columns (3) and (4) in table 1, the effect of FTAs are larger than the estimates for the unilateral preferences. Only in model 2 i s the C B I effect larger, but since the average product-country utilization rates o f FTAs (58 percent) i s significantly higher than those of C B I (36 percent) in the year o f analysis (2001), even this estimate suggests that the average effect (as opposed to the marginal effect) had been much higher for FTA beneficiaries than for C B I beneficiaries, while holding a plethora o f control variables constant in the regressions (see Table 1 Notes at the bottom of the table). The data and the coefficients in regression 2, therefore, suggest that DR-CAFTA could raise the value o f U.S. b y almost 11 percent relative to the benefits offered b y the CBI.3 If we take the more generous results under column 4, these benefits in terms o f exports increase to over two times C B I benefits. In any case, the exact magnitude o f the contribution o f moving to an FTA from unilateral preferences offered through the C B I (and GSP) i s less important than the general finding that there are additional gains in terms o f access to the U.S. market. These gains are probably due to a combination o f factors, including the fact that the utilization o f the FTA preferences might be easier due to less restrictive rules o f origin (see Chapter I11on the contents o f DR-CAFTA) as well as the fact that FTAs provide more secured market access rules that entrepreneurs can rely on to make long-term business investments, which would then be reflected in rising exports to the U.S. Labor and the adjustment process 4.23 Another regulatory area concerns labor markets and the ability o f f i r m s to enter new markets and the ease with which uncompetitive firms exit other markets. The restructuring o f an economy, whereby factors o f production migrate from one economic activity to another, requires the disappearance o f some firms and the emergence o f others. Likewise, i t requires workers to find new employment opportunities. Edwards and Edwards (1994) had previously reviewed various theoretical settings where lack o f labor mobility could reduce the gains from trade and even turn them negative. Consequently the regulatory environment in these areas could be a crucial element in allowing the economies o f Central America to take advantage of the opportunities offered by DR-CAFTA. 4.24 One way o f examining the role o f regulations in determining the gains from trade i s to look at how regulations affect the magnitude and sign o f the correlation between the incidence of international trade on the domestic economy and the level o f development, measured by the value o f Gross Domestic Product (GDP) per person. Bolaky and Freund (2003) provided Figures 4a-c, which show the aforementioned correlations for a large sample of countries, for the sub-sample o f countries exhibiting the lowest regulatory This calculation comes from the fact that the model i s estimated in log-log form. Thus the effect of FTAs relative to CBI i s equal to the ratio of exponential o f the product of the FTA coefficients reported in Table 1 multiplied times the average utilization rate divided by the CBI coefficients times the average CBI utilization rate. 66 CHAPTER IV. Economic Ejfect of CAFTA: More Art Than Science burdens, and those with the highest regulatory burden. The index o f regulatory burden combines ratings on labor regulations and on the bureaucratic procedures that are required to start new business. The data come from the World Bank database on Doing Business (see World Bank 2004~).Figure 4a shows that trade openness i s positively correlated with the level o f development in a sample of 75 countries. However, the correlation i s flatter and statistically not significant for the 25 countries with the worst regulatory environment, thus suggesting the gains from trade might not materialize in perverse regulatory environments. Bolaky and Freund (2003) provide further discussion of these important issues, but i t i s worth noting here that a plethora of econometric estimations support the basic intuition reflected in these graphs - that a heavy regulatory burden can seriously reduce the gains from trade. Figures 4a-c: Trade and Levels of Development: The Regulatory Environment A: All countries. I In(Real per capita GDP at PPP) = 9.80 t 0.88 In(Trade/GDP) T statistic 8.26 L k 11 4 i T 1 .i i . nl + it E -B - ~ 05 1 I I -4 -3 5 -3 -2 5 -2 -1 5 -1 -0 5 0 In(TradelGDP at PPP) 67 t CAFTA: More Art Than Science CHAPTER 1V. Econoniic E ~ e c of Matters I B: One-thirdleast regulated countries. In(Rea1 per capita GDP) = 9 90 + 0 92 In(Trade/GDP) I E T statistic 5 22 T ; l2 11 r * * . - a ___--- B il ** *---*- _- .- 0 i *,--ma-- I g I - & Z - 8 t -3 -2 5 -2 -1 5 -1 -0 5 0 05 1 I 15 In(Trade/GDP at PPP) C: One -third most regulated countries. I In(Real per capita GDP) = 9 31 + 0 49 ln(Trade/GDP) ![ T statistic 2 11 c k B * U .- 9 a .- - - - *-a- - - 3 9 Source: Bolaky and Freund (2003, Figure 1A-1C). 4.25 Upon comparing the regulatory environment in Central American countries with those in other Latin American and other developing countries it becomes evident that regulatory reform should be a key priority in the complementary agenda.4 The major ways for improvements are in reducing the number of days for entry procedures and reforming employment laws or any other regulations that impede the intersector labor mobility. 4.26 Even the best and most flexible regulatory framework cannot ensure that people w i l l automatically change jobs or that capital w i l l instantaneously reallocate to the most productive activities. Moreover, some workers could experience income losses greater than the gains in terms o f lower prices o f consumption goods. As highlighted b y L6pez (2002), since the marginal utility loss for the poor from a given loss of real income i s greater than for the richer workers, then a countries’ overall national welfare w i l l also depend on the El Salvador i s covered i n the World Bank regulatory database and thus we leave to the interested reader to undertake the necessary evaluation o f this country’s regulatory burden. On the other hand, the data reviewed i n Chapter VI1 o f this Report suggests that this country might not suffer from excessive regulations more generally. 68 CHAPTER IV. Economic Efect of CAFTA: More Art Than Science ability of the economy to provide greater adjustment assistance to the poor, rather than the middle and upper echelons o f the labor market. 4.27 Thus there i s a role to be played b y the public sector in terms of aiding the adjustment process. In the case o f the DR-CAFTA countries, which have already undergone a substantial process of economic adjustment over the past decade and a half, this intervention by the public sector does not need to be characterized b y excessively large adjustment assistance programs. Rather, i t i s likely that any pro-adjustment program can be contained b y targeting workers and small farmers that are most vulnerable to the relative price changes expected from DR-CAFTA. Monge and GonzBlez-Vega (2003) have identified some key sectors in agriculture that would fall in this category. Moreover, the distinction between net producers and net consumers o f the sensitive commodities i s also an important ingredient for designing efficient adjustment programs, as argued in Chapter 5. C. Simulations from partial-equilibrium models 4.28 To quantify the potential short-term effect o f the elimination o f U.S. tariffs on Central American exports, results o f partial equilibrium simulations based on market- specific elasticities are reported in summary Table 2 (specifics in Tables A 1 to A5).5 The simulations suggest that trade gains from DR-CAFI'A would amount to a short-term increase in exports ranging from 21 (El Salvador) to 47 percent (Guatemala). As expected, most of the estimated gains for Central American economies would be concentrated in the textile and apparel sector. Smaller absolute gains would also be expected for other made up textile articles, footwear, articles of leather and cotton. Nicaragua could see gains in some processed foods (vegetable oils, processed beef) while Honduras and Guatemala may see significant increases in tobacco products. ~~ Simulation results calculated with S M A R T software, using tariffs that are corrected b y the 2001 utilization rates o f the CBTPA preferences (Le., the share o f U.S. imports f r o m El Salvador that actually enjoy the zero tariff treatment upon entry for each item). Results reflect a scenario where all C A C M countries gain zero-tariff access to the U.S. simultaneously. 69 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science Table 2: Central America - Changes in exports as result of US tariff elimination (%) Source: See Annex Tables A I to AS 4.29 The partial equilibrium results reported above need to be interpreted with caution. While the employ o f utilization rates of trade preferences i s an improvement over traditional analysis o f potential apparel gains, simulations cannot easily deal with the complicated structure o f export restrictions associated with rules or origin requirements that are likely to be in place in DR-CAFTA. 4.30 For most countries in the region, the greatest potential for expanded Central American apparel exports resides in the loosening up o f the rules o f origin that govern current tariff preference rules. As explained in Chapter 1 11, D R - C A F T A w i l l facilitate apparel goods to qualify for duty free treatment b y allowing for unlimited use o f regional inputs, accumulation o f origin with regional partners, exceptions for specific types o f apparel, and temporary quotas for goods that do not need to meet strict rules o f origin for Costa Rica and Nicaragua. Some o f these gains should attract investment into yard spinning, fabric making and other textile processes into Central America that could greatly increase local value added in this sector. Similarly, Central American countries are also likely to benefit from the more flexible “short supply” provisions included in DR-CAFTA, which allows for duty-free exports with inputs f r o m third countries that are not widely available in the U.S. 70 CHAPTER IV. Economic Ejject of CAFTA: More Arr Thun Science 4.31 Hopes for expanded apparel exports from the Central America region depend on how the U.S. market responds to the end o f the global textile quotas in January 2005. While there has been a noticeable spike in imports into the U.S. market from China in the first few months o f 2005, strong import growth from Central American countries in the same period suggest that other traditional exporters are bearing the brunt of Chinese shipments. I n part, this may be explained since Central American countries continue to enjoy a significant tariff advantage (Le., zero tariffs vs. 10-30 percent MFN tariffs in apparel categories) over Asian competitors, an edge that i s likely to continue once DR-CAFTA enters into force. In addition, gains made in the flexibilization o f rules o f origin may be retroactive, in the sense that imports that qualify for zero tariff under DR-CAFTA rules (but not under the current tariff preferences) could be allowed to claim refunds for tariff payments. Also, Central American countries benefit from a distance advantage which provides them with a competitive edge in markets where fashion trends change rapidly and just-in-time deliveries and rapid supply response are important. These factors together with the ‘know how’ capabilities developed and the specialization on “full package” services b y Central American apparel exporting firms should create significant opportunities for development of local linkages for this cluster, beyond the pure assembly model associated with maquila. 4.32 Partial equilibrium results do not reveal significant short term export gains aside from maquila products, as this technique traditionally underestimates the supply response to FTAs. Available estimation methods cannot anticipate new exports aside from those for which positive export levels exist prior to the implementation o f the FTA. Simulations made for Mexico before NAFTA also underestimated the expansion o f new export categories for the same reason. Before NAFTA, Mexican exports to the U.S. were concentrated in primary products, including oil. After NAFTA, Mexico’s export base broadened substantially, with manufactures largely surpassing traditional primary products, as mentioned above. 4.33 Regarding the possible impact o f tariff elimination on U.S. imported products to Central American economies, Tables A 6 to A10 show there w i l l be trade increments in a wide range o f manufactures, following the same partial equilibrium model methodology. The higher absolute increases w i l l be concentrated for most of the countries in vehicles, mineral oils, furniture, electrical machinery and textiles. The import aggregated increase w i l l vary from 10 per cent to 12 per cent in Nicaragua, El Salvador and Guatemala, and up to 26 per cent in Honduras. D. A Simulationfrom a General Equilibrium Model for Nicaragua6 4.34 This section describes the main features o f the CGE model and household survey micro-simulation module that were applied b y Bussolo and Niimi (2005) to study the sectorial and national effects o f further unilateral trade liberalization and DR-CAFTA on Nicaragua. Unlike the previous partial models, these CGE simulations consider the interactions across industries and factors o f production (labor and capital). Since Nicaragua i s a relatively poor country for Latin American standards and even relative to the other DR- CAFTA beneficiaries, i t i s worthwhile to look at this case in detail from a poverty This section draws heavily from Bussolo and Niimi (2005). 71 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science perspective. Nevertheless, at this point i t i s worth highlighting that other studies that use similar CGE simulations suggest that the overall static gains for DR-CAFTA countries are on average well above 1 percent o f the region’s GDP (or GNP, depending on the study) as a whole (see, for example, Hilaire and Yang 2003; Hinojosa-Ojeda 2002 as cited in Pauvonic 2004; and Brown et al. 2004). Here our focus i s on understanding the distributional effects o f DR-CAFTA and compare them with what could be obtained (under the same restrictive assumptions) with further unilateral trade reforms. The Nicaragua general equilibrium model and its data 4.35 A 2000 Social Accounting Matrix (SAM) has been used as the initial benchmark equilibrium for the CGE model. The SAM, which includes 39 sectors, 39 commodities, 3 factors (skilled and unskilled labor and one composite capital), an aggregate household account, and other accounts (government, savings and investment, and rest o f the world), has been assembled from various sources incorporating data from the 2000 Input Output table and the 2001 L S M S households survey. Since the quality o f the initial dataset represented by this SAM directly influences the quality o f the model results, particular attention has been devoted in estimating the value added, the trade, and tariff components o f the SAM.7 The C G E model we use i s based on a standard neoclassical general equilibrium model, which i s virtually identical to other CGE simulations, including Hilaire and Yang (2003) in terms o f the underlying economics concerning constant elasticities o f substitution on the production side. The Nicaragua analysis i s unique, however, in i t s treatment o f issues related to income distribution, international trade, and factor markets. Income Distribution and Absorption 4.36 Labor income and capital revenues are allocated to households according to a fixed coefficient distribution matrix derived from the original SAM. Notice that one o f the main advantages o f using the micro-module i s to enrich this rather crude macro distribution mechanism. Private consumption demand i s obtained through maximization o f household specific utility function following the Linear Expenditure System (LES). Household utility i s a function o f consumption o f different goods. Once their total value i s determined, government and investment demands8 are disaggregated in sectoral demands according to fixed coefficient functions. International Trade 4.37 In the model we assume imperfect substitution among goods originating in different geographical areas.’ Imports demand results from a CES aggregation function o f domestic and imported goods. Export supply i s symmetrically modelled as a Constant Elasticity o f Transformation (CET) function. Producers decide to allocate their output to domestic or foreign markets responding to relative prices. As Nicaragua i s unable to influence world prices, the small country assumption holds, and i t s imports and exports prices are treated as exogenous. The assumptions o f imperfect substitution and imperfect transformability grant a certain degree o f autonomy o f domestic prices with respect to foreign prices and prevent ’For more details on the S A M see Bussolo (2004). Aggregate investment i s set equal to aggregate savings, while aggregate government expenditures are exogenously fixed. See Armington (1969) for details. 72 CHAPTER IV. Economic Effect of'CAFTA: More Art Than Science the model to generate corner solutions; additionally they also permit to model cross-hauling a feature normally observed in real economies. The balance of payments equilibrium i s determined b y the equality of foreign savings (which are exogenous) to the value for the current account. With fixed world prices and capital inflows, all adjustments are accommodated b y changes in the real exchange rate: increased import demand, due to trade liberalization must be financed b y increased exports, and these can expand owing to the improved resource allocation. Price decreases in importables drive resources towards export sectors and contribute to falling domestic resource costs (or real exchange rate depreciation). Thus, this modelling exercise i s subject to at least a few caveats. First, i t assumes that tariff reductions at the border are directly transmitted to domestic relative prices as viewed b y producers. This i s a strong assumption given that reported tariffs are not always effective due to the fact that many products, including agricultural commodities, enter Nicaragua (and other Central American markets) through informal channels and often through formal channels as in the cases o f zero-duty imports allowed to stem rising prices or for specific uses (e.g., feed grains for poultry in Nicaragua). Moreover, changes in border policies do not necessarily mean that producer prices in the interior o f Nicaragua w i l l change due to the natural protection offered b y distance to markets. Thus all results from this simulation exercises need to be treated with great caution. Factor Markets 4.38 Labor i s distinguished into two categories: skilled and unskilled. These categories are considered imperfectly substitutable inputs in the production process; moreover, some degree o f market segmentation i s assumed: composite capital i s sector specific, and labor markets are segmented between agriculture and non-agriculture, with labor fully mobile within each of the two broad sectors, but fully immobile across them. These restrictive conditions are imposed on the modeling framework so that i t mimics in the best possible and least contentious way what would be the short term impact o f trade reforms on the Nicaraguan economy. One could certainly introduce dynamic features, market imperfections, and other complications, however the debate would then move towards assessing what are the links between trade policy and growth and, although important, this i s a much more contentious issue. Finally, the segmented version o f the model also facilitates linking the macro results o f the CGE model to the household survey micro- model, where households are not allowed to respond to price changes b y migrating, increasing their human capital endowments, or even changing their consumption choices. 4.39 The labor market specification i s a key element o f our model and an important driver o f poverty and distributional results. Therefore, i t s specification calls for some clarification and justification. The labor market s k i l l segmentation" has become a standard assumption in CGE modeling and i t i s easily justifiable for the case o f Nicaragua, where inequalities in terms of educational endowments and access to education support this assumption. However, the assumption that the market for labor i s further segmented into agricultural and non-agricultural activities i s more controversial. T o test i t s validity, Bussolo and Niimi (2005) conducted an econometric exercise of wage functions to assess whether Nicaragua exhibits wage gaps across these two sectors after controlling for the individual characteristics o f workers. They concluded that the possibility that agricultural loSee Taubman and Wachter (1986) for a general discussion o f labor market segmentation. 73 CHAPTER IV. Econotnic Effect of CAFTA: More Art Than Science workers have different wage from similar workers in other industries cannot be rejected. Although this finding i s not conclusive, because the estimated wage gap might have various interpretations and be caused b y other factors that were not included in the analysis, it might be sufficient to justify the assumption o f segmented labor markets in the CGE simulation exercise. The micro module: linking household surveys to the CGE model 4.40 Poverty effects o f trade reforms are estimated using a top-down approach. Initially the CGE model calculates the new equilibrium (Le. new relative prices and quantities for factors and commodities) following a trade shock. Then prices are transferred to the micro module to estimate a new income distribution, and finally poverty effects are calculated. No feedback from the micro module to the macro model i s explicitly accounted for in this version. The following equation' represents the core o f the micro module: ~ I, , labor income remittances profits , consumption t a r 8 revenue The relative gains or losses (W represents welfare), for each household (h) depend on: (a) changes in prices for purchased goods (Pg, where a dot represents percentage change) and the initial share o f expenditure on each good (6&); (b) changes in factor returns (w stands for returns to skilled and unskilled labor, and 7c i s returns t o capital) and the shares o f total initial income b y source (0; and By ); (c) remittances and other transfers which depend on the wage rate and the government revenues. Income b y source i s calculated for each member o f the household, and the above equation, to keep notation simple, shows results after aggregating incomes for each individual in the same household. Once the changes in welfare are calculated, a new distribution of income i s generated and this counterfactual distribution i s then compared to the initial distribution. 4.41 The main advantage o f this approach i s that i t takes into account important sources o f heterogeneity across households given that the structure o f income b y type and the composition o f consumption b y commodity, the various 8's in the above equation, are household specific. A large literature on trade and povertyI2 has shown that changes in the distribution of income (or consumption) might differ considerably across different groups of households and that predetermined groupings may not capture the whole spectrum o f possible outcomes. Poor households themselves are poor for different reasons and designing compensatory policies that are targeted to the right recipients can be greatly facilitated b y having at disposal a whole new counterfactual distribution. In the new distribution, households, as well as individuals, can be identified according to the full set o f socio-economic characteristics recorded in the survey. I t i s thus easier to identify a specific characteristic - such as region o f residence, employment status, gender, education, age, etc. " The formal derivation o f this equation i s presented in the annex o f Bussolo and N i i m i (2005). '* See Winters et a1 (2004) for an excellent survey. 74 CHAPTER IV. Economic Ejject of CAFTA: More Art Than Science - that may strongly correlate with larger than average losses from the trade policy reform and then use this information in targeting compensatory measures. Clearly how this new counterfactual distribution i s generated i s rather important. The above equation only considers first order effects and excludes important second order mechanisms that may account for large income changes. Specifically movements in and out of employment or across sectors o f production are excluded as well as substitution in consumption, although not accounting for the latter does not normally result in large errors. This approach i s better suited to estimate short run impacts and i t may overestimate the effects o f a trade shock, given that quantity adjustments and substitutions are ruled out. Knowing these limitations, i t s main advantage though i s i t s transparency and low, in terms o f data and time, implementation costs. 4.42 Equation (1) implies that, for each household, individual incomes can be readily imputed to the relevant factors of production, namely the two labor types and the composite capital. This i s fairly straightforward for urban wage-workers; however for a large group o f the Nicaraguan population this imputation i s not obvious. As explained in the next subsection, disaggregating income for the self-employed workers in the farm sector can be a laborious and error prone procedure: the labor and capital components are often not easily separable. For households whose heads belong to this group o f workers, an approach that bypasses this imputation has being used. This i s represented b y the following equation: r as before, the relative change in welfare i s represented by a change in consumption (the last t e r m in the left hand side of the equation), b y a change in explicit wage earnings, and by the profit generated b y the activity run b y the household (the term in squared brackets). This i s estimated as the difference between sales (holding constant the quantity shares o f the different goods sold t9jo) and input costs (again without changing the structure o f input quantities 0 ) ; . 4.43 Finally, i t should be noted that auto-consumption has been explicitly excluded from the computations in both equations (1) and (2) given that price changes - in the short run, and those o f the order of magnitude considered here - do not affect it. In terms o f equation (2), this means that not only final consumption needs to exclude auto-consumption but also that input costs have to be netted of those costs that relate to production for auto- consumption. Poverty effects of trade policy reforms This section first presents the results o f the general equilibrium model and then the poverty estimations obtained b y linking the changes in the macro variables to the household surveys. Policy scenarios 4.44 The DR-CAFTA agreement has recently been at the center of attention o f trade ministers in the Central American region: this agreement should provide almost full free access to one of their major markets, i t should assist the implementation o f additional 75 CHAPTER IV. Economic Effect of’ CAFTA: M o r e A r t Than Science domestic market reforms, and, b y requiring reciprocal opening, i t should produce significant efficiency gains due to resource reallocations towards more competitive sectors. However, as brilliantly illustrated b y the Chilean multi-pronged strategy o f trade liberalization, DR-CAFTA i s just one o f the many trade options that the Central American countries can pursue, and probably the best way to evaluate the opportunities offered b y such regional agreement i s to compare i t with a benchmark case o f full liberalization. T w o main scenarios are considered: (a) DR-CAFTA, and (b) a unilateral non-discriminatory liberalization. The potential advantages and disadvantages o f the reciprocal liberalization entailed b y the regional scenario are illustrated b y further decomposing the D R - C A F T A scenario into two separate unilateral liberalizations: first Nicaragua liberalizes vis-&vis the U.S., which does not reciprocate, and then the U.S. unilaterally liberalizes vis-&-vis Nicaragua. Although not being a realistic policy choice, the full unilateral liberalization provides a useful yardstick against which DR-CAFTA can be evaluated. 4.45 In all the simulations only tariffs are modified and eliminated in single sweep. Likewise, each o f the simulations i s based on a comparative static framework with n o capital accumulation, no changes in labor supply or skill levels and factor market segmentation. Consequently, as happened with the early- 1990s CGE modeling attempts o f the Mexican experience under NAFTA, the results from the simulations might be quite o f f the mark since dynamic effects might overwhelm the static effects predicted b y the simulations even i f the assumptions regarding the key parameters (Le., elasticities o f substitution on the demand and supply sides for each o f the 28 industries) were realistic (see Kehoe 2004 for an ex-post review o f the accuracy o f NAFTA CGE models). Trade reforms: macro results 4.46 In a general equilibrium model all relative prices and quantities are determined simultaneously, however to disentangle the trade policy reform effects o n the economy i t i s helpful to describe the adjustment process as i f i t were sequential. First, tariffs are reduced, this then has an impact on import flows, these, in turn, displace domestic production and generate resources reallocations; these shifts interact with factors’ supply and demand, and determine factor prices, these, together with new goods prices, finally affect households’ real income level. Then, changed households’ incomes feedback into the system through changes in consumption choices and the process continues until a new equilibrium i s reached. Three main elements determine the position - i.e. the values o f the endogenous variables - of the new equilibrium: a) the starting level o f some key variables in the initial equilibrium, i.e. the prices and quantities implicit in the initial SAM; b) the functional forms o f the model’s behavioral equations; and c) some key parameters, namely substitution elasticities among factors in the production process and, for a trade reform analysis, the elasticities o f substitution in demand between domestic and imported commodities and the elasticity o f transformation in supply between domestic and foreign markets. A broad consensus as emerged as long as the functional forms are concerned and, as described above, the model used here i s in l i n e with this consensus. The values for the different elasticities have been borrowed from the available econometric literature, however, depending on the estimation methods as well as on the period or country considered, these values show considerable variation, and this has caused heated controversies among supporters and skeptics o f this type o f models. Systematic sensitivity 76 CHAPTER I V . Economic Effect of CAFTA: M o r e Art Than Science analysis, where all elasticities are randomly changed and results are presented with accompanying confidence intervals, has been proposed as a solution to these controversies; however, even this rather computationally intensive proposal has i t s problems and we do not attempt i t here. 4.47 The bottom line i s then that results presented here are indicative of a likely response to the analyzed shocks. In most cases, the sign and relative, if not absolute, magnitude of the model’s results - for example, a finding that gains for unskilled labor are larger than those for skilled labor - should be reliable. 4.48 Major advantages o f this type o f model are that i t represents the whole economy in a consistent and theoretically sound framework and that the structural features of the country investigated strongly influence the final results. Table 3 shows these features for Nicaragua in terms of sectorial shares o f gross production, imports, exports and private demand; the middle panel details, for each sector, the U.S. weight in total trade; the right panel shows Nicaraguan tariffs against the U.S. and other partners and the U.S. tariffs against Nicaraguan products. For convenience, the bottom panel o f the table reports measurements for aggregate macro sectors, although the model’s actual 28 sectors are shown in the top panel. In commenting the results o f the policy simulations, we w i l l be referring to data in this table repeatedly. 4.49 The initial import protection, both in i t s level and sectorial variability, i s among the key elements determining the simulation outcomes. Three key features are highlighted b y the tariff data: a) the overall trade-weighted protection rate i s rather low, b) i t s dispersion i s high with a clear bias against agricultural imports and c) tariffs against the US. are generally above the trade-weighted average o f tariffs against the Rest o f the World. 4.50 Table 3 also highlights that domestic Nicaraguan agricultural producers may be facing strong competition vis-&vis imports from the US, which, notwithstanding significant levels o f protection, enjoy a large share o f total imports o f agricultural commodities (41 percent). Anticipating the results shown below, i t i s likely that a liberalization o f U.S. imports, which basically consists of reducing an anti agricultural imports bias, may lead to an increase of competition in the agricultural sectors with a potential initial negative shock for households strongly dependent on farming incomes. Clearly this potentially negative outcome may be exacerbated b y the level of sector aggregation used in the model. I t may be that at finer sectoral levels, one finds that imports and domestic products are complements rather than substitutes; however, agricultural products are normally fairly homogeneous, and thus substitutable, and the risk o f negative impacts should not be completely ruled out. 77 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science Table 3: Nicaragua’s economic structure (2000) Notes: in the left panel, Xp represents the sectoral output as a percentage o f total output, M the sectoral total imports, Ex the exports shares, X c the private consumption shares; in the middle panel, M US the initial share of imports coming from the US over total imports, Ex U S the initial share of exports going to the US; in the right panel there are tariffs: N i c - US and Nic - ROW are Nicaraguan tariffs against U S and other partners imports, respectively, and U - S N i c are U S tariffs against Nicaraguan exports. Source: Nicaragua SAM estimated by the author. Unilateral liberalization against all trading partners 4.51 As outlined above, the adjustment process caused b y this reform i s initially described in terms o f sectoral demand and supply changes, as shown in Table 4. Consider f i r s t the demand/imports side. Initial tariff rates tm13 are highest in the agriculture and food processing sectors - in particular in Basic Grain, Meat and Fish Products, Sugar Products and Dairy - accordingly these sectors could experience the largest inflows o f import volumes once protection i s removed, assuming o f course that the border-price changes are fully transmitted to domestic consumers throughout the Nicaraguan economy and that the model parameters concerning the responsiveness o f domestic demand to such price changes are accurate. The model predicts an increase in import volumes (AM) of 23 percent with l3Note that column tm in Table 4 i s the trade weighted average o f the Nicaraguan tariffs against U.S. and the Rest o f the World (which are separately shown i n Table 3). 78 CHAPTER IV. Economic Effect o j C A F T A : More Art Than Science respect to their initial levels for agriculture and 6 percent their pre-liberalization levels for food processing. Nevertheless, imports do not represent a large share o f local demand ( M D ) in agriculture or food processing. Thus, even with a high (presumed) elasticity o f substitution between local production and imports (= 3), the impact o f increased imports on sales o f domestic goods (AS) i s l o w in these sectors. In fact, the model predicts that other manufacturing sectors suffer slightly bigger domestic sales contractions due to their larger initial share o f import dependency despite their lower initial level o f protection. Reflecting Nicaragua’s dependency on foreign production of capital goods, intermediates and energy, imports are well above 50 percent o f total local demand for other manufacturing and just below that threshold for energy and mining. For the other manufacturing sectors, cheaper imports displace up to almost 3 percent o f domestic production. Table 4: Sectorial effects of full unilateral trade liberalization Notes: tm represents initial tariff rates, AM the percent variation in total import volumes with respect to the initial levels, M/D the ratio of imports to domestic demand (the sectoral import dependency, calculated using pre-liberalization levels), AS the percent variation in the volumes o f domestic sales of domestic output, AF’d the percent variation i n domestic prices for local sales, AEx the percent variation i n the voiumes o f exports, ExlXp the ratio of exports to domestic output (the sectoral export orientation), AXp the percent change of domestic output, APx the percent change o f output prices. 4.52 For the economy as a whole, these l o w or moderate domestic market share losses are reflected in small declines o f producers’ prices for local sales (APd). Some o f these 79 CHAPTER IV. Economic Ejfecr of CAFTA: More Art Than Science effects are larger when disaggregated sectors are examined, and complementary analyses considering very disaggregated sectors of production may be needed to identify specific sensitive c ~ r n m o d i t i e s . ’ ~ 4.53 These demandhmports side effects are linked to the supply response to which we now turn. For producers o f exportable goods, the reduction o f prices in local markets (APd) combined w i t h unchanged export prices creates incentives to increase the share o f sales destined to foreign markets. This export response ( E x ) varies across sectors and it i s linked to the pattern o f Nicaragua’s comparative advantage, which, according to the exports sectoral distribution (column “Ex” in Table 3) and the export orientation (Ex/Xp in Table 4), i s within three main sectors: CofSee, Meat and Fish Products and Textiles and Clothing. For these sectors rising export sales more than offset the reduction o f domestic sales and lead to an overall increase in sectoral production (AXp). In other sectorst5, with lower export orientation, the change in sectoral production i s roughly equal to the change in local sales (AS). Sectors enjoying export led growth also record output price reductions (APx) that are smaller than those of domestic sales prices (APd). This i s because output prices are a combination (CES prices) o f fixed export prices and domestic prices. 4.54 In summary, trade liberalization, even if consists o f the elimination o f a relatively low economy-wide protection (3 percent), entails considerable sectorial adjustment.I6 Within agriculture, Basic Grain i s the only sector registering a contraction due to i t s high tariffs and l o w export orientation; whereas, among others, Coffee and Other Agricultural Products enjoy significant export-led growths. Similarly in the non-farm portion o f the economy, import competing sectors contract and release resources that move towards sectors which were less protected or that produce for foreign markets. Considering the aggregate averages, the macro-sector Food Processing i s recording positive output changes, whereas the other non-farm macro sectors’ outputs experience moderate contractions. 4.55 Changes in factors’ remuneration, shown in Table 5, are another important aspect o f the structural adjustment caused b y trade reform. Changes in wages and capital return are linked to changes o f goods prices through the production technology and the functioning of the factor markets. Different production technologies are approximated by different factor’s and intermediate inputs’ intensities across sectors, as shown in Table 6, and factor markets function so as to mimic short term adjustment possibilities: capital i s sector specific, and l4 Usually these analyses consider data at a very fine degree o f disaggregation, namely the tariff line. Although trade data at this level may be available, production, consumption and other important variables are unavailable. l5 Due to the sectorial classification, some sectors i n Table 4, notably Tobacco and Machinery and Equipment, appear to be both import and export intensive. The apparent export intensity in these sectors results from dividing low levels o f exports (probably re-exports) by even lower levels o f domestic production. Exports o f Tobacco and Machinery and Equipment jointly account for just 2 percent o f total exports. l6Due to the closure rule o f the external account, namely the fixing o f foreign savings, and the full employment assumption, the larger expansion o f the volumes o f exports, with respect to import volumes i s compensated with a real exchange rate depreciation which originates from falling domestic resource costs. In other words, exporting sectors expand by employing resources whose relative prices have declined because o f their falling demand from the contracting import competing sectors. 80 CHAPTER 1V. Economic Ejject of CAFTA: More Art Than Science the farm and non-farm sectors constitute two segmented markets for the skilled and unskilled labor. Table 5: Factor price changes due to full trade liberalization Skilled Labor Unskilled Labor 0.6 2.9 Farm Segment: Skilled Labor I -4.0 I -1.6 Sk/Unsk wage gap 2.5 Non Food Price Index -1.5 I CPI -2.4 I Sources: author calculations from model results. Notes: the first column, AP, represents the percent variation o f the price of each factor with respect to the initial levels; A(S/CPI) i s the percent variation o f the price deflated by the Consumer Price Index: 4.56 In the farm segment (which corresponds to the macro-sector Agriculture in the previous tables), capital (including land) records a positive real price change and skilled and unskilled labor experience reductions. The agricultural expanding sectors - shaded in Table 6 - are those which use capital relatively more intensively than Basic grains, the contracting sector. Indeed combined together, CofSee, Other Agricultural Products and Livestock, the largest output gainers, use almost 70 percent of the total farm capital value added. On the other hand, because o f the contraction o f the unskilled labor-intensive sector, Basic grains, unskilled labor records a greater reduction than skilled labor. 4.57 Turning to the non-farm segment and considering the bottom panel o f Table 6, i t i s easy to see that Food Processing, the sector with the largest output expansion, i s relatively intensive in the use o f capital, and, in terms o f number o f workers (rather than value added which includes wage differential biases), i s the sector that uses most intensively unskilled workers. Other manufacturing, the sector experiencing the largest contraction, uses unskilled labor to a large extent but not as intensively as Food Processing. This relative intensities in the use o f labor combined with initial levels of protection and output changes explains the observed wage movements. 81 CHAPTER IV. Economic Effect of CAFTA: M o r e A r t Thun Science Table 6: Value added and employment by sector and factor, and sectoral intermediate uses Notes All the values in the table except in the last column are calculated from values in the initial equilibnum, highlighted (shaded) rows are those corresponding to expanding sectors Sectoral intensity sum to 100 percent in each sector, Sk represents skilled labor, Usk and K&L unskilled labor and capital and land respectively, Xint i s the share o f intermediate inputs in total output, AXp i s the percent change o f domestic output due to full trade liberalization 4.58 The combination o f the trade shock with this production structure explains why unskilled labor i s the largest gainer in the non-farm segment, followed b y skilled labor and capital as shown in Table 5. These results are consistent with the comparative advantage o f Nicaragua, a country with abundant unskilled labor, which specializes in the production o f agriculture derived products, and i s import dependent for capital goods and intermediates, which are normally produced b y sectors using skilled workers intensively. 4.59 Even with segmented labor markets, the farm and non-farm sections o f the economy have strong interconnections that determine the final results. These inter segment links are illustrated in Table 7 for the Agricultural and the Food Processing aggregate sectors. l7Both l7These two sectors account for a third o f total production and for almost 40 percent o f total employment. 82 CHAPTER IV. Economic Effect of CAFTA: More A r t Than Science sectors face the largest average drops in tariff protection and large inflows of imports; however, they are also enjoying the largest aggregate output gains. This i s achieved b y significant structural shifts that are qualitatively different for these two sectors. 4.60, For Agriculture, the main adjustment consists o f a reduction o f one single sub-sector and a specialization towards export oriented sectors. Prices for imported intermediate goods are reduced by the removal o f tariffs, however due to the moderate use o f intermediates (35 percent o f total input value), cost savings needed to compete with cheaper imports in domestic markets and to increase competitive advantage in export markets have to be realized b y factor price reductions, and this also explains why labor wages are reduced in Agriculture. 4.61 For Food processing, the inflow of imports does not entail large sectoral contractions because producers can s t i l l compete in domestic markets b y enjoying reduced production costs due to their use o f cheaper intermediates, which represent on average almost 3 quarter of total input value. In fact, most o f these intermediate inputs come from agriculture whose prices following the trade shock are reduced. Table 7: Inter-sectoral links between Agriculture and Food processing 4.62 Factor price changes as well as the mentioned inter-sectoral intermediates costs savings also help explain why certain sectors record a reduction or almost no increase o f imports following tariff abatement. For instance, the absence o f imports surge for Livestock, after the market opening, i s explained b y the increased domestic sales of local producers who can produce at lower costs and are able to gain market share. A partial equilibrium framework where tariff reduction can only lead to increased imports and lower prices could never account for these types o f inter-sectoral linkages. DR-CAFTA bilateral trade liberalization 4.63 The full unilateral trade liberalization serves as a benchmark against which the DR- CAFTA regional agreement can be compared. Table 8 reports sectoral results for the simulation o f this regional free trade area. This policy b y discriminating between import origins has trade diverting effects which may or not be compensated by trade creation. However, as shown below, this geographic discrimination i s not the most relevant aspect to be considered in an evaluation o f this policy option. 83 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science 4.64 Nicaragua’s liberalization o f U.S. imports affects just one quarter of total imports (as shown Table 3) and, thus, has a smaller aggregate impact; however, the overall structural adjustment and inter-sectoral resource reallocation i s quite significant. This i s due to the large U.S. weight in some crucial sectors - such as the 72 percent o f Basic Grain imports and the 26 percent of exports for both of the top two exporting sectors in Nicaragua, CofSee and Meat and Fish Products. The DR-CAFTA agreement obviously includes increased market access for Nicaraguan products in the U.S. market, however as shown more clearly in the next section, this reciprocal liberalization amounts to a positive but rather small shock. In the model, the implied increased market access i s accounted for b y increasing border prices for goods exported to the US., implicitly assuming that Nicaraguan exporters do not influence domestic prices in the U.S. and that they can enjoy the full rents provided b y the initial U.S. tariffs.’* Given the initial l o w level o f U.S. tariffs, these rents are not very significant. A regional multi country model that includes the whole U.S. economy, rather than the current single country model, would be better suited to account for all the direct and indirect effects o f a liberalization of U.S. tariffs. However the approach used here, namely to model the U.S. simply as one of Nicaragua’s trading partners, can be considered as a reduced form o f a more complete multi country model which, although theoretically more appealing, has much higher data intensity and empirical implementation costs. 84 CHAPTER IV. Economic Efect ojCAFTA: More Art Thun Science Table 8: Effects of the DR-CAFTA agreement on Nicaragua's economic sectors Notes: tm represents initial tariff rates, M the percent variation in total import volumes with respect to the initial levels. M D the ratio o f imports to domestic demand (the sectoral import dependency, calculated using pre-liberalization levels), AS the percent variation i n the volumes o f domestic sales of domestic output, Al'd the percent variation in domestic prices for local sales, A E x the percent variation in the volumes of exports. ExlXp the ratio of exports to domestic output (the sectoral export orientation). U p the percent change of domestic output, APx the percent change o f output prices. 4.65 A preferential bilateral agreement with the U.S. shows some relevant divergences from a full liberalization, especially with respect to factor price changes. Firstly, the overall price deflation resulting f r o m partial trade reform i s roughly equal to one quarter o f the deflation induced b y complete tariff abatement (see the bottom right panel of 10). Secondly, a DR-CAFTA agreement entails a liberalization that i s geographically and sectorally concentrated. Consider again the shares of imports originating f r o m the U.S. in Table 3: the economy-wide average share i s 24 percent, however imports o f U S agricultural goods represent more than 40 percent o f total imports in that macro-sector, with peaks o f 7 2 percent for Basic Grain, which i s also the most protected sector. Additionally, tariffs against U.S. imports are slightly higher than those against other partners (in the data used for these simulations, which correspond t o the year 2000). Thus, the DR-CAFTA agreement-induced imports surge o f agricultural goods i s equal to 9 4 percent o f that induced by a full unilateral liberalization, whereas the economy-wide average stands at 7 6 percent. These sectoral distortions explain why factor returns in the f a r m segment undergo changes that are very close to those experienced in a full liberalization scenario; actually the 85 CHAPTER IV. Economic Effect of’CAFTA: More Art Than Science unskilled labor real wage contraction i s the same in the two cases, whereas factor returns in the non farm sector record a smaller percentage o f the full liberalization shock. AP A(PICP1) % ofFull Liberalization Non-Farm Segment: Skilled Labor 1.2 60 Food Price Index -1.4 I 39 Non Food Price Index 0.0 I -1 4.66 In summary, the impact on factor remuneration o f the examined trade reforms, full liberalization and DR-CAFTA agreements, should be positive for urban workers, both wage-employed or self-employed with physical capital, but i t may, at least temporarily, be negative for rural wage earners (but not necessarily negative for subsistence farmers). For agricultural households receiving part o f their income from capital and land, or even f r o m non-farm activities, the unfavorable farm wage changes should have smaller effect. Notice also that the wage gap between skilled and unskilled workers does not significantly change with this kind o f trade reform.” Decomposing the DR-CAFTA scenario 4.67 In order to distinguish the effects o f market access from those o f own-tariff liberalization, the simulated reciprocal D R - C A F T A trade agreement has been decomposed into two separate reforms: in the first, Nicaragua unilaterally eliminates all tariffs against U.S. imports, and, in the second, the U.S. unilaterally responds, Le. i t preferentially liberalizes imports from Nicaragua.20 This outcome may not hold under a different production specification where skilled workers, for example, are modeled as a complement to capital, rather than as substitutes. 20 This decomposition i s not exact given that the sequence in which these reforms are carried out matters for the final results. However in this particular case, given that the magnitude o f the shocks, especially the reduction of US. tariffs against Nicaraguan products, are not too large, the order in which the two simulations are carried out i s almost indifferent. 86 CHAPTER IV. Economic Ejjecr of CAFTA: More Art Than Science 4.68 As already anticipated, the opening of the Nicaraguan market corresponds to almost the full DR-CAFTA shock: the unilateral liberalization achieves roughly three quarters or more of the variation in imports, exports, and domestic output recorded b y the reciprocal case. As shown in Table 10, in the case of unilateral U.S. liberalization, effects on imports and local sales are more or less muted, and the most visible effects consist of some additional specialization in exports of food processing products. Table 10: Decomposing sectoral effects of DR-CAFTA Notes: AM represents the percent variation in total import volumes with respect to the initial levels, AS the percent variation in the volumes of domestic sales of domestic output, AF'd the percent variation in domestic prices for local sales, AEx the percent variation in the volumes o f exports, AXp the percent change of domestic output, AF'x the percent change o f output prices. 4.69 The two unilateral liberalizations are consistent in their sectoral output effects. Both induce additional growth o f agricultural and food processing sectors and, in this sense, helps Nicaragua exploit i t s comparative advantage. Although the U.S. already granted preferential access to Nicaraguan exports in the past, the remaining current U.S. tariffs seem to inhibit potential growth in some key sectors in Nicaragua, and obtaining full access to the U.S. markets may then bring some advantages. Table 11: Decomposing - - factor price - changes - due to DR-CAFTA Nicaragua Unilateral Liberalization I U.S. Unilateral Liberalization AP I A(P/CPI) I % of CAFTA 0 AP I I A(P/CPI) % of CAFTA Sources: author calculations from model results. Notes: the first column, AF'. represents the percent variation o f the price o f each factor with respect to the initial levels; A(S/CPI) i s the percent variation o f the price deflated by the Consumer Price Index; the column, percent of DR-CAFTA,shows the percent ratio o f the real price changes i n the unilateral liberalizations with respect to the bilateral DR- CAFTA case. 87 CHAPTER IV. Economic Effect of CAFTA: More Art Thun Science 4.70 As long as factor markets effects are concerned, Table 11 suggests that the non- reciprocal removal o f Nicaragua’s tariffs causes factor prices o f the non-farm segment to vary almost as much as with the DR-CAFTA scenario, leaving a small contribution to the full price change to the U.S. unilateral response. Interestingly, the two unilateral liberalizations have contrasting prices effects for factors in the farm segment. In the case o f U.S. liberalizing i t s tariffs, factor prices go up due to the increased export demand and this inflationary effect i s not counterbalanced b y inflows o f cheaper imports. However, these inflows explain why factor prices tend to contract with the unilateral liberalization o f Nicaragua, thus showing that access to the U.S. market mitigates the potentially negative shocks to farm incomes associated with the liberalization o f Nicaraguan agricultural markets. Finally, since these simulations predict small effects on factor returns, then the corresponding effects on Nicaragua’s poverty indicators (the Headcount poverty rate and the poverty gap) decline under both scenarios b y rather small amounts, as reported b y Bussolo and Niimi (2005). But these authors’ reported poverty-reduction effect of D R - C A F T A alone i s slightly lower than the predicted poverty effect o f a full unilateral reform b y Nicaragua. That is, Bussolo and Niimi predict that Nicaragua’s percent of poor families would fall b y 0.3 percent under DR-CAFTA but b y 1.6 percent under the full-liberalization scenario.21 3. Complementary Policies and the Dynamic Gains from Trade 4.71 The scientific literature on trade and economic growth provides various reasons explaining why trade reforms and trade agreements might have “dynamic” effects, as opposed to the previously discussed static gains. This latter t e r m i s used to refer to the impact o f trade policies on factors that can affect the long-term growth rate o f developing economies, namely aggregate investment, technological progress, and the quality o f public institutions. The following sections review relevant literature and empirical evidence concerning these channels o f influence. A. Dynamic gains from trade through FDI, innovation, and the quality of institutions Foreign direct investmed2 4.72 A specific aspect o f D R - C A F T A relevant for investment location decisions was the adoption of rules o f origin for the determination o f the goods that could benefit from the preferences established b y the treaty. These rules, which vary across goods (see Chapter 111), provided new incentives for the location o f investments in the NAFTA region in general and Mexico in particular, in those industries where existing levels of regional integration were below the threshold levels determined b y the rules. 4.73 But the effect o f FTAs on the perceived riskiness o f investment - the so-called ‘credibility effect’ -- can be even greater than the profitability effect. While the term 21 These numbers were calculated with respect to a national poverty rate o f 49.8 percent, which was used as the initial level of poverty in Bussolo and Niimi (2005). 22 This section appears i n Chapter 4 o f Lederman, Maloney, and ServCn (2005) and the econometric analysis was undertaken by Cuevas et al. (2002). 88 CHAPTER IV. Economic Eflect oj CAFTA: More A r t Than Science ‘credibility’ i s somewhat vague, in the present context i t encompasses three different things:23 (i) the FTA’s locking-in effect o f trade policies; (ii) the locking-in effect of broader reforms (ranging from regulation and competition policies to property rights, contract enforcement and macroeconomic stability); and (iii) the guarantee of access to partners’ markets.24 4.74 Different preferential trade arrangements entail different combinations of (i), (ii) and (iii). For example, EU accession i s viewed b y a majority of observers as having significant effects in all three dimensions, and particularly in the broader area (ii),as the single market entails a common regulatory framework for all members (leaving aside even broader issues of political unification). In the case o f a RIA such as NAFTA, the main effects should in principle accrue through the ‘secured access’ channel and the locking-in o f Mexico’s commitment to trade opening initiated in the late 1 9 8 0 ~ as ~ treaty entails , ~ the fewer automatic repercussions than the EU in the broader policy environment. Nevertheless, many analysts have expressed the view that NAFTA’s risk-reducing effect could also be very large, but i t i s virtually impossible to know with certainty given that Mexico suffered a major financial crisis during the first years o f NAFTA and relatively little time has transpired since then.26 4.75 T o gauge the effect o f NAFTA on FDI flows, and disentangle i t from that of other factors affecting FDI, we turn to an econometric analysis of the influence o f FTA membership on direct investment flows. We then use the empirical estimates to quantify the relative contribution o f regional integration, globalization, and other factors to the evolution of FDI in Mexico. This analysis should shed light on what can be expected in DR-DR- C A F T A countries. 4.76 The approach i s described in detail in Cuevas et a1 (2002), so here we provide only a summary. The analysis focuses on aggregate FDI flows to 45 countries over 1980-2000.27 This sample includes the same FTAs studied b y Frenkel and Wei (1998).28 The framework assumes implicitly that North-North, North-South and South-South FTAs are all the same in terms o f FDI effects. This i s worth noting because NAFTA i s the only North-South FTA in the period studied b y Cuevas and his coauthors. The empirical model relates FDI to various explanatory variables. The most relevant ones for this report are FTA-related 23 The various effects that would fall under ‘credibility’ are spelled out i n Whalley (1996) and Fernfindez and Portes (1998). See also Schiff and Winters (1998). 24 Note that even though FTAs do not necessarily preclude the imposition o f antidumping duties, they nevertheless do offer formal mechanisms for dispute resolution. In this sense, they do provide a guarantee of uninterrupted market access. See Fernandez and Portes (1998). 25 This locking-in i s emphasized by Kehoe and Kehoe (1994). 26 See for example Learner et al (1995). Mexico has not suffered a major financial crisis since the 1994-95 “Tequila” crisis, but i t i s not clear that the absence o f a crisis i s due to NAFTA. 27 This i s in contrast with other recent papers focusing instead on bilateral FDI flows or stocks, which often use empirical models based on gravity variables. See for example Levy-Yeyati, Stein and Daude (2001). 28 Specifically, ASEAN, EFTA, what today i s the EU, NAFTA, the Group o f Three, the Andean Group i n i t s recent revival, Mercosur, and COMESA (which i n the analysis i s included only as an expected FTA). 89 CHAPTER IV. Economic Efj'ect of CAFTA: More AI? TIzun Science variables, which comprise a dummy indicating FTA membership o f the host country (FTAMEM) and another capturing the anticipation o f future membership (EXFTAMEM).29 In addition, we include a measure o f the extended market size o f the FTAs to which the host country belongs, given b y members' total GDP (FTAGDP). These variables should be expected to carry positive signs if FTAs encourage FDI to member countries. Finally, to explore FTAs' potential investment diversion effects, a measure o f the degree o f trade integration o f other countries (INTEGRATION) i s used; this i s basically a weighted sum o f the GDP o f all the sample countries participating in FTAs, with the weight o f each country's GDP given b y the fraction o f worldwide GDP covered b y i t s FTA arrangement^.^' 4.77 Table 12 reports empirical estimates o f the determinants o f FDI obtained from this . ~ ~ variants are reported, with different combinations o f the FTA-related s p e ~ i f i c a t i o n Four variables and the institutional variables. On the whole, the explanatory power o f the empirical equations i s quite satisfactory given the samples employed. The results concerning the variables capturing FTA membership support the notion that joining a trade block leads to higher FDI inflows. The expectation of joining a free trade area (EXFTAMEM) has a positive impact on foreign investment. The coefficient consistently exceeds one-third, indicating that announcement of an imminent entry into a larger regional market raises FDI in that proportion. The fact that the free trade area dummy has a statistically insignificant coefficient reflects the inclusion in the equations o f a more direct measure o f integration, extended market size (FTAGDP), which i s always significant. The elasticity o f FDI with respect to this variable i s between one tenth and one seventh, implying that if a country joins a free trade area five times as large as the country itself, i t should expect FDI inflows to rise b y fifty percent or more. In contrast, we find no significant effects o f the variable capturing investment diversion (INTEGRATION), perhaps due to the rudimentary nature of this measure. 29 The results below correspond to the case when FTA membership i s anticipated two years ahead of i t s occurrence. Alternative time horizons were used too, without any substantial changes in results. 3" Thus, an increase in INTEGRATION holding FTAGDP constant would imply a reduced FDI appeal for the host country in question. Note that this variable has only time-series variation. 31 The dependent variable i s net FDI inflow. All variables with a monetary dimension are measured in constant dollars and expressed in logs. Country fixed effects were added in al the regressions. Endogeneity i s potentially an issue, especially in the case of GDP growth. However, specification tests could not reject its exogeneity. Additional experiments are reported in Cuevas et al (2002). 90 CHAPTER IV. Economic Effect o j CAFTA: iMore Art Than Science Table 12: Fixed-EffectsRegressions of the Log of FDI against Membership in a Free Trade Area and Other Variables Note: Standard errors appear i n italics under the corresponding coefficients. 4.78 As for the global variables, world growth carries in all cases a negative coefficient, close to 10 percent significance. This i s in agreement with the findings reported b y Albuquerque et a1 (2002) on the role of global factors in FDI flows: other things equal, faster growth in the rest o f the world reduces a country’s appeal for international investors. 91 CHAPTER IV. Economic Eaect of CAFTA: More Art Than Science In turn, the international interest rate i s generally insignificant. Finally, world FDI flows are strongly significant and positive, as should be expected.32 4.79 Among the local factors, the elasticity o f FDI inflows with respect to exports i s about 0.7 and significant in all models, suggesting that openness i s a major attractor o f FDI.33 Host country growth i s also consistently positive and significant, likely reflecting the positive impact o f profitability on FDI, and again consistent with Albuquerque et a1 (2002). Inflation has a generally negative effect on FDI, as expected, but not statistically significant. Likewise, local market size, as measured b y GDP, carries a consistently positive but insignificant coefficient. In turn, the negative coefficient on the current account balance in all regressions seems to reflect financing need (likely driven b y domestic investment) rather than an unstable macroeconomic environment. Finally, the measure o f relative per capita income (RELGNIPH) always carries a significant negative coefficient. If, as already argued, per capita income differentials proxy for relative wages, the result implies that ceteris paribus countries with lower labor costs attract larger FDI inflows.34 4.80 The last two columns in Table 3 add the institutional quality variables. They carry significantly positive signs, as one should expect, with the exception o f the quality o f the bureaucracy indicator, which fails to be significant. O n the whole, the coefficients on the other regressors show only modest changes relative to the previous specifications. 4.81 The key result from this analysis i s the positive effect o f FTAs on FDI inflows to member countries. This agrees with earlier empirical studies o f the impact o f FTAs based on a variety o f methodological frameworks ranging from structural model simulations (e.g., Baldwin, FranCois and Portes 1997) to gravity-based studies of bilateral FDI (Levy-Yeyati, Stein and Daude 2002). However, i t i s notable that the estimated impact o f FTAs i s much less than what proponents of NAFTA, for example, have argued (e.g., see the USTR’s web site) since FDI to Mexico increased b y much more than 40 percent (the effect o f NAFTA implied b y the aforementioned results). Moreover, the results suggest that i t i s the interaction o f FTA membership with other economic outcomes that really has an impact, rather than an FTA b y itself. Finally, the variables representing the quality o f public sector institutions have strong and independent effects on FDI, thus again suggesting that quality institutions are key for attracting FDI, not just for improving the allocation o f factors o f production (labor and capital) for productive uses, as discussed in the previous section on the static gains from trade. 32 The fact that the coefficient on global FDI i s less than unity likely reflects the fact that increasingly important FDI recipients are excluded from the sample due to lack o f complete data. Our measure o f total FDI inflows i s not the sum o f the inflows into the sample countries, which are obtained from a World Bank database, but a worldwide total reported by UNCTAD’s World Investment Report. 33 While this result i s consistent with expectations and previous results concerning the role o f openness, simultaneity i s a potential concern, as FDI may target traded sectors and lead to stronger export performance. However, there i s likely a long gestation period between new investment and exports, which reduces the risk o f simultaneity. 34 Albuquerque et a1 (2002) report this result using direct measures o f real wages for a reduced country sample. 92 CHAPTER N. Economic E#ect of CAFTA: More Arr Than Science 4.82 There can be little doubt that FDI increases the host country capital stock and contributes the technology embodied in that capital. But the evidence on technological spillovers i s sparse, and pessimistic. L6pez-Chdova (2002) finds a negative direct impact o f FDI on the same industry’s TFP. This i s consistent with numerous other studies.35 The early cross-sectional work by Blomstrom and W o l f f (1994) found that both the rate o f local firms’ labor productivity growth and their rate of catch up to the multinationals were positively related to the industry’s degree o f foreign ownership. They point out, however, that i t i s difficult to distinguish a rise in within-firm productivity from simply increased competition forcing out less efficient firms thus raising the average rate o f growth. 4.83 The macroeconomic evidence regarding the role o f FDI in spurring TFP growth i s also pessimistic. First, most studies o f the causality between investment and growth indicate that investment follows growth (see, for example, Loayza et al. 2002). Calderh, Loayza, and ServCn (2002) find that in developing countries FDI also follows national growth. Finally, Carkovic and Levine (2002, abstract) conclude that “the exogenous component o f FDI does not exert a robust, independent influence on growth.” Thus there seems to be a need to consider the potential role of national innovation and education policies, since we cannot assume that fast-paced growth w i l l automatically result from FDI inflows. Innovation and education 4.84 The most talked about channel through which international trade can raise long-term productivity growth i s through the importation o f foreign technologies in the form o f capital goods (Keller 2001 and 2002; Eaton and Kortum 2002; Trejos and Cavalcanti 2003; among others). For the case of Mexico under NAFTA, Schiff and Wang (2003) present empirical evidence suggesting that capital goods imports from the U.S. had huge impacts on industrial productivity in Mexico. Interestingly, these authors’ econometric estimates imply that a marginal increase in the imports of R&D-weighted capital goods from the U.S. lead to a 5.5-7.5 percent increase in the level o f Mexican industrial total-factor productivity, whereas capital imports from the Europe or other industrialized countries had negligible 35 Lipsey (2002), i n a comprehensive review o f the literature argues that the evidence i s vast that foreign firms tend to be at least as productive as domestic firms and hence their presence pushes up average productivity. The evidence on positive productivity spillovers from foreign firms i s ambiguous. The majority of papers that find these effects employ cross sectional data and thus do not control for unobserved country characteristics. Those using firm level panels frequently find insignificant or, even negative effects (e.g., Aitken and Harrison (1999) for Venezuela). Van Pottelsberghe de la Potterie and Lichtenberg (2001) find that investing i n a relatively more technologically advanced country and hence adding foreign production to domestic production increases productivity in the home country. But the reverse case of investment i n a technologically less advanced country has insignificant or negative results for the host, developing country. Baldwin, Braconier, and Forslid (2000) find mixed results for seven OECD countries and using panel firm level data from Sweden, Braconier, Ekholm, and Midelfart Knarvik (2000) find no spillovers from incoming FDI on productivity and the only variable i n their sample affecting TFP is own country R & D. Xu (2000) using panel data on technological transfer from U S finds a technology transfer effect by U S multinationals only for advanced countries although a competition effect does appear to increase productivity. Kinoshita (2000) found, for example, little evidence at the firm-level of positive effects o f FDI i n the Czech Republic from 1995-1998. Smarzynska (2002) finds no direct impact of FDI i n Lithuania on firms i n the same industry although there was an impact on affiliated upstream suppliers. 93 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science effects. These results are consistent with estimates provided b y Keller (2002). This author finds that the productivity gains due to the importation o f foreign capital goods declines with geographic distance o f the trading partners. This result alone should shed some doubt on the channel of influence, since geographic distance should affect the quantity o f trade but not necessarily the marginal effects of capital imports. Thus i t i s likely that the dramatic effects captured b y Schiff and Wang for Mexico under NAFTA are due to greater business interactions and learning via contacts rather than through the magic o f capital imports. 4.85 Recent work in innovation stresses that adopting existing technology i s not without cost. Firms and countries need to develop an “absorptive” or “national learning” capacity which, in turn are hypothesized to be functions o f spending on research and development .~~ ( R ~ L D ) Though often considered relevant only for basic science dedicated to expanding the knowledge frontier, Cohen and Levinthal (1991) among others stress learning -- knowing where the frontier i s and figuring out what adaptations are necessary -- as the “second face” o f R&D. In fact, Pavitt (2001) argues that investment in pure research i s also important for developing countries. First, those most familiar with the frontiers o f basic science w i l l best train the applied problem solvers in the private sector. Second, even basic research does not flow easily or costlessly across borders so developing countries cannot simply rely on what i s being generated in the advanced countries. Finally, Lederman and Saenz (2003) present econometric evidence suggesting that innovation outcomes, namely patents per capita, are an important explanation of the levels o f development observed around the world. 4.86 L o w rates o f investment in R&D can be due to l o w private and social returns to R&D in developing countries, although Lederman and Maloney (2003) estimate that the economic returns to R&D and to licensing for countries o f Costa Rica’s level of income are high at around 65 percent. Further statistical analysis by Lederman and Maloney suggests that financial depth, protection o f intellectual property rights, ability to mobilize government resources, and the quality o f research institutions are key determinants o f R&D effort across countries. Notably absent as a robust predictor o f national R&D effort in the preliminary analyses presented b y these authors was the incidence o f international trade. That is, after controlling for the aforementioned variables, international trade does not seem to be a crucial factor in determining how much each country invests in R&D. 4.87 L o w levels o f innovation outcomes may also arise from inefficiencies in the way in which existing innovation-related resources are utilized through the NIS. One way o f estimating the efficiency o f a N I S i s b y examining how R&D investments translate into commercial patents and how the “elasticity” o f patents with respect to R&D investment compares to the world average.37 Chapter VI1 includes a review o f the efficiency o f R&D expenditures in Costa Rica, El Salvador and numerous other countries. For the case o f L A C as a whole, econometric exercises described in Bosch, Lederman, and Maloney (2005) show that the main explanation of the region’s inefficiency stems from the lack o f 36 A t the firm level, see Cohen and Levinthal(1990), Forbes and Wield (2000), Griffith, Redding and Van Reenen (2003), Pavitt (2001) at the national level see, for example, Baumol, Nelson and W o l f (1994). 37 Bosch e t al. (2005) discuss i n detail how these elasticities are estimated and how they vary across regions o f the world. 94 CHAPTER IV. Economic Effect of CAFTA: More Art Than Scietice collaboration between the private sector and research organizations such as u n i ~ e r s i t i e s . ~ ~ Additional statistical exercises showed that Costa Rica’s privileged position compared to the rest o f the L A C countries i s due to higher quality o f research institutions and greater collaboration w i t h private f i r m s . El Salvador’s negative value can be interpreted as an indication o f the extent to which the country underperforms in patenting efficiency relative to the OECD average. 4.88 El Salvador seems to be more inefficient than the average o f LAC countries. Additional statistical exercises showed that El Salvador’s inefficiency i s only partially explained b y variables characterizing the NIS such as quality o f research organizations and their collaboration with the private sector. Understanding the shortcomings o f El Salvador’s NIS remains a topic for future analysis. 4.89 A related topic concerns Central America’s performance with respect to economic discoveries, namely the introduction o f new export products. Hausmann and Rodrik (2003a) provide a theoretical framework that suggests that without public sector intervention the market w i l l not provide incentives for entrepreneurs to invest in discovering new and potentially profitable businesses. In fact, these authors have argued that countries such as El Salvador can revitalize their economic growth through public sector subsidies for the introduction o f new products (Hausmann and Rodrik 2003b). Furthermore, Klinger and Lederman (2004) do find evidence suggesting the market failures might in fact impede economic discovery, although these authors also found that general export growth i s associated with subsequent increases in the probability o f experiencing export discoveries (defined as an episode in which a country begins to export products that were not exported at all at the beginning o f a ten-year period). Furthermore, Khan (2004) finds that the introduction o f new products does affect economic growth b y stimulating productive investment. For Central America, however, the question i s whether policies to stimulate economic discoveries have to be a priority over other policy needs. These issues, including some related to the potential gaps in R&D effort observed in Central America, are addressed in Chapter VI1 o f this report. Institutions 4.90 Although the role o f institutional quality in promoting economic development remains a fertile area for academic research, there i s substantial evidence that suggests that law and order and corruption are key factors in the development process (see, among others, Acemoglu et al. 2001, Easterly and Levine 2003; Rodrik and Subramanian 2003). The economics profession highlighted some time ago the fact that when economic resources are used for rent seeking or directly unproductive activities, the overall level of economic output falls due to the distraction o f these potential productive factors. Krueger (1974) was one o f the first to focus on the effects o f public policies, including trade 38 This result was derived by estimating a patenting function that includes the interaction between R&D investment and a dummy variable for Latin American and Caribbean countries (LAC). I n turn, the same function was estimated but including additional explanatory variables. Among these, the variables from the Global Competitiveness Report on the private sector’s perception of the quality of research institutions and the extent of collaboration between private firms and universities were the ones that eliminated the statistical significance of the L A C variable interacted with R&D. See Bosch et al. (2005) for details. 95 CHAPTER IV. Econornic Effect r$ CAFTA: More Art Than Science policies, through this resource-distraction effect. Others have drawn broader implications for competition policy more generally (Bliss and Di Tella 1997). And there i s some evidence that trade-policy distortions are positively correlated with empirical (but subjective) measures o f corruption (Dutt 2002). This line o f reasoning thus suggests that DR-CAFTA itself might have a salutary effect on overall production and potentially national welfare, b y reducing rent-seeking which would in turn increase potential output. In turn, rent-seeking activities b y private agents can themselves breed public corruption and vice-versa. 4.91 But does trade really help improve indicators o f corruption? Or are there other factors that explain both the incidence of international trade on the domestic economy as well as incidence o f corruption? Table 13 presents results from Lederman, Loayza, and Soares (2005) concerning the determinants (of perceptions) o f national corruption around the globe during 1984-2000. Contrary to previous literature, this evidence suggests that political institutions such as the prevalence and years o f experience under democratic governments are stronger and more robust predictors o f international measures o f corruption than exposure to international trade. Details concerning the two econometric techniques used to derive the two sets o f consistent estimates in Table 13 are present at the bottom o f the table. In any case, these results suggest important policy implications, namely that we should not expect international trade to make significant inroads b y themselves in the fight against corruption in Central America, at least not in the near future. Rather, governments should encourage pro-active policies to improve formal mechanisms o f accountability, such as transparency initiatives (publishing budgets, providing time for public comment on regulatory changes and, of course, protecting the freedom o f the press). In the long run, it i s likely that democratic governance itself, through the formal mechanisms o f checks and balances, w i l l become the underpinning o f clean governments and more vigorous economies. Nevertheless, certain elements o f the DR-CAFTA call for public transparency in government procurement and regulatory changes, thus reducing the scope for discretionary normative changes that can breed corruption among the public sectors o f Central America. Moreover, DR-CAFTA also mandates that governments implement their own labor and environmental regulations, which also reduces the scope for selective enforcement o f laws. Consequently, modern trade agreements such as DR- CAFTA, whose scope goes beyond traditional trade matters, do hold some promise for tackling institutional deficiencies. 96 CHAPTER IV. Econoinic EjJect ojCAFTA: More Art Thun Science I I I I I I I I I I reelect -0.2244 0.0429 -0.3354 I -0.3062 -0.2329 I 0.0385 -0.1668 -0.2676 I 0.1375 I 0.1810 I 0.2929 I 0.2609 I 0.1254 1 0.1477 1 0.2153 1 0.2149 0. I030 0.8130 0.2520 0.2410 0.0630 0.7940 0.4390 0.2140 dstab -0.0340 -0.0423 -0.0410 -0.0453 -0.0272 -0.0307 -0.0234 -0.0284 0.0024 0.0032 0.0055 0.0049 0.0019 0.0022 0.0033 0.0035 O.oo00 O.oo00 0.oooO O.oo00 O.oo00 O.oo00 0.oooO O.oo00 I I I I I I I I state I -0.0968 I 0.1525 I 0.4359 I 0.1625 I -0.1039 I 0.0828 I 0.1693 1 0.0759 I 0.0425 I 0.0543 1 0.1015 I 0.0768 I 0.0370 I 0.0407 I 0.0618 I 0.0557 0.0230 0.0050 O.oo00 0.0340 0.0050 0.0420 0.0060 0.1730 list -0.1654 0.0426 -0.0817 0.3171 -0.1553 -0.0018 -0.0501 0.1937 0.0860 0.1035 0.1733 0.1472 0.0683 0.0689 0.0904 0.0909 0.0040 0.0950 open 0.0000 -0.0015 0.0030 0.0019 00210 0 1900 Ooo00 0 0730 0 2430 0 0040- elf 0.0123 0.0210 0.0109 0.0100 0.0132 0.0103 0 0021 0 0040 0 0029 0 0016 0 0024 0 0020 0 0000 Ooo00 OoooO OoooO Ooo00 OoooO reg/nature v a n no Yes Yes Yes no Yes Yes Yes N Obs 1158 1010 490 605 1158 1010 490 605 Pseudo R2/R2 0.24 0.33 0.45 0.38 0.57 0.70 0.79 0.74 (d for dummy): democracy d, presidential d, possibility o f reelection d, time o f democratic stability, indicator of local elections for state govs, gov control of legislative d, freedom o f press index, gov revenues (8 GDP), transfers from central gov to other levels (8 GDP), openness to trade (imports as 9% GDP), In of per capita GDP, avg schooling in the pop above 15, British legal tradition d, index o f ethno- linguistic fractionalization, period d ‘ s , region d ’ s (E Asia and Pacif, E Eur and C Asia, M East and N Afr, S Asia, Sub-Saharan Afr, and L A m and Carib), and nature variables (landlock d, area, tropical d, long, and lat). govrev, trun.f, open, [ngdp, and 1yrl5 lagged. Regressions include all obs available between 1984-97. Robust std errors used. Intercept terms for each level of corruption (1-6) are not reported. Source: Lederman, Loayza, and Soares (2005, table 7). 97 CHAPTER IV. Economic Effect o j CAFTA: More Art Than Science B. The growth effects of Free Trade Agreements ( F T A s ) ~ ~ 4.92 The previous paragraphs examined literature that provides insights into the potential dynamic effects of trade through intermediate outcomes, such as FDI, innovation, and the quality o f public institutions. This section turns our attention to evidence concerning the overall effects o f FTAs on the rate o f growth o f GDP per capita across countries. 4.93 In this section we examine whether DR-CAFTA i s likely to have an impact on economic growth. While our empirical results w i l l be indicative, they are not expected to produce precise point estimates of the impact o f the FTA on economic growth. Rather the results should provide the average growth impact o f FTAs after controlling for a wide variety o f country specific factors. Because countries and institutions differ in a myriad o f ways, both measurable and immeasurable, one would ideally like to have country-specific empirical results that capture the idiosyncratic circumstances o f each country. Due to obvious data limitations, and the fact the most countries in the region typically have only one (or no) prior regional free trade agreement, statistical analysis on a country-by-country basis o f past experience i s not feasible. Consequently, the empirical analysis undertaken i s a cross-sectional time-series panel data analysis that utilizes the experience o f 132 countries over a 30-year period. The 30-years o f data are divided up into six five-year growth periods and the countries included encompass both developed and developing countries with some 151 country episodes o f regional trade agreements. A full description o f the data can be found in Tables A6 in the Appendix. 4.94 As a starting point for the empirical analysis, we begin b y estimating a fixed effects panel growth model that includes the number o f regional free trade agreements to determine whether they have any power in explaining economic growth. W e also add a variety o f important economic and political variables to control for external and internal factors that may also influence economic growth to confirm the robustness o f the results. Following this, we account for possible selectivity bias (i.e., the choice o f signing a free trade agreement may be endogenously determined b y the state o f the economy) by explicitly taking into consideration a country’s choice to enter into an FTA. 2. Fixed-effects OLS Regressions Benchmark Model 4.95 We begin the analysis with standard panel data analysis utilizing a fixed-effects regression model and 5-year growth periods. Our benchmark model i s the Solow growth model with measures for both physical and human capital investment. The benchmark estimation model takes the following form: 39 This section was written by David Gould (World Bank) and William Gruben (Federal Reserve of Dallas). 98 CHAPTER 1V. Economic Ejfecr o j CAFTA: More Arr Than Science Where, f t i s real GDP per capital growth during period t, CountryDUMt, i s a country specific dummy variable, Y[-I, i s initial level of real GDP per capita, K i s physical capital investment, H i s human capital investment, and p i s the error term. 4.96 As Table 14, column 1 indicates, the standard benchmark Solow model generally behaves as expected-conditional convergence in growth rates i s found as indicated b y the negative and statistically significant coefficient on the initial value o f log real GDP per capita, and physical capital investment i s found to have a positive and statistically significant impact on growth. Our proxy for human capital investment (log o f secondary school enrollment as a percentage of total population o f that age group that corresponds to secondary school age), however, i s negative and not statistically significant. Despite utilizing alternative measures o f human capital investment, such as primary and tertiary school enrollment rates as proxies for human capital investment, measures o f human capital investment did not become significant. The results would indicate that investment in education, as least for the five-year growth periods does not appear to have a significant impact on growth. However, these results may be due to the relatively short period o f growth (5-year periods) or the lack o f a good proxy for human capital investment. 99 CHAPTER IV. Economic Efj’ect of’CAFTA: More Art Than Science T a b l e 14: F i x e d Effects Panel Regressions, 1970-2000 (5 year averages)* GDP (%) (3.57) I (3.59) R-sq within 0.058 0.076 0.144 0.202 0.206 0.208 0.209 R-sa between 0.002 0.002 0.049 0.008 0.015 0.016 0.019 F- statistic 1 13.13 1 13.25 1 17.99 1 16.01 1 12.22 1 11.12 1 10.14 * T statistics in parenthesis. Dependent variable: Current per capita real GDP growth Regional trade agreements 4.97 Regression 2 in Table 14 (column 2) includes a measure for the number o f regional free trade agreements in force. To account for the possibility that regional FTAs may be signed in the middle o f a five-year growth period, the value o f the variable i s the portion o f the period it i s in force. For example, if a country signs i t s first regional FTA in 1971, then the value o f the variable i s zero prior to 1970, i s equal to 0.8 during the 5 year growth period between 1970-75, and i s equal to 1 thereafter (or until another regional F T A i s signed). As regression 2 indicates, regional FTAs appear to have a positive and significant impact on growth. The coefficient on the variable i s 0.008, which suggests that a regional 100 CHAPTER IV. Econornic Efect of CAFTA: More Art Than Science free trade agreement would add about 0.8 percentage points to annual growth all else held constant.40 4.98 Regressions 3 to 7 add various control variables to the benchmark growth model with regional F T A effects. After including these control variables stepwise into the benchmark model with the regional trade agreements variable, we find that the regional trade agreement variable maintains i t s statistical significance while the size o f i t s impact on growth falls marginally (from 0.8 percentage point impact on annual growth to 0.7 percentage point). As far as the other variables are concerned: world real GDP growth has significant and positive spillover effects on country growth (in the range o f 0.7 percent to 1.1 percent); trade as a share o f country GDP also has a positive and significant impact in country growth, but i s much smaller than the spillover impact of world income growth (in the range o f 0.04 to 0.02 percent); as expected, the black market premium has a negative and significant impact on growth, although the impact i s rather small-only a -0.0004 to - 0.0006 percent impact-and the significance level i s lower (95 to 85 percent range); government consumption as a share o f total consumption i s negative as expected, but i s not statistically significant; the fiscal balance as a share o f GDP i s positive, as expected, and i s highly significant suggesting that higher fiscal balances (either due to greater revenues that occur during an economic expansion, or fiscal restraint due to greater tax collections or expenditure cuts) i s associated with greater economic growth. A one percent increase in the fiscal balance as a share o f GDP i s associated with about a 0.1 percent increase in annual growth. Finally, the political and civic freedom index i s positively related to economic growth, but i s not statistically significant. 4.99 The choice to liberalize or, in other words, the period in which a regional FTA i s implemented, i s associated with additional higher real GDP growth -about the same effect as that o f the number liberalizations- 0.8 percent o f annual growth, but i s not statistically significant due partly to multicollinearity (by definition, an increase in the number o f liberalizations i s always associated with the choice to liberalize). Taken together, the longer-term effect o f the number regional trade agreements variable and the shorter term initial impact, indicate that the near-term effects may be about twice as high as the longer- term impacts on growth. 4.100 Additional exercises not reported here utilized ten-year growth periods in the time- series dimension, rather than the five-year growth periods. This reduces the number of 40 Berthelon (2003) estimates the effects of regional free trade agreements on growth using a dummy variable for the period a country enters a regional free trade agreement weighted by the size of the share of world GDP represented by the FTA trading partners. H e also creates another variable that takes the value of this variable but measures i t relative to the size o f the country’s own share of world GDP. While he finds a significant positive value for this variable, we do not find significant results utilizing a similarly weighted variable, nor do we find that the effects o f regional FTAs are significantly stronger between countries in the North (developed) and countries in the South (developing) or for any other types o f regional ETA partners (South-South or North-North). While we do find that growth effects are larger for North-South FTAs, they are not significantly different than South-South or North-North. Our inability to replicate Berthelon’s results may be due to the fact that our data sets are not identical in time periods or countries and that we have different control variables in the regression (including world growth and other variables). 101 CHAPTER IV. Economic Effect of CAFTA: More Art Thun Science observations in the time-series dimension by nearly one half, but the effects o f the regional trade agreement variable i s only slightly smaller (about 0.6 percent compared to 0.7 percent) and i s s t i l l statistically significant at the 95 percent level or higher when including all the control variables. The signs o f the control variables are broadly similar to the five- year regressions, but, in general, the significance o f the control variables drops below the 90 percent level when including the fiscal balance as a share o f GDP into the regression equation. The fiscal balance as a share o f GDP i s significant at the 99 percent level and appears to dominate the impact o f the other control variables that affect growth in the shorter time horizon shown in Table 14. Over a longer period o f time, a more prudent fiscal policy may be a much stronger proxy for policies that effect economic growth (outside o f investment and trade policies) than any o f the other control variables b y themselves. Finally i t i s worth noting that further econometric exercises that rely on the Arellano and Bond (1991) estimator indicate that the results concerning the average growth effect o f FTAs were unaffected by the change in methodology, thus suggesting that results discussed thus far are quite robust. 3. Selectivity bias in the choice to liberalize 4.101 In this section we take into consideration the possibility that regional trade agreements might be chosen during periods o f above normal growth, and, as a consequence, may be the result of, and not the cause o f higher growth. A problem w i t h the empirical analyses above -as well as that used in numerous other studies on trade and economic growth- i s that they rest on the implicit assumption that the choice to enter into a free trade agreement i s exogenous and does not depend on the state o f the economy or other factors that, in turn, may be related to growth. But, this assumption may be too restrictive. Indeed, during periods o f economic expansion, import competing interests may be less apt to lobby against freer trade if they see the overall economic pie growing. Labor in the import sectors may find employment and wages rising and may also be less likely to actively oppose freer trade-even though their gains may not be as large other sectors. In the literature on the political economy o f protectionism i t has been observed that protectionist pressures are the highest during periods to economic contractions; the corollary to this i s that protectionist pressures are the lowest during periods o f expansion (see, for example, Lederman 2005 and literature cited therein). 4.102 In other words, the choice to enter into a free trade agreement may be endogenously determined by the economy and prospects for future growth. I t may simply be the case that free trade agreements are signed during periods of higher than average economic growth and are not the cause of that growth. Those countries with prior economic reforms, international financial support, and better prospects for economic growth may be the most likely to pursue free trade negotiations due to the support o f exporters and the lack of strong protectionist pressures from import competing interests. In those countries experiencing weaker economic growth, contraction, and/or diminished prospects, internal political dynamics and protectionism may be much more difficult to overcome. 4.103 If the decision to enter into a free trade agreement is endogenous, how w i l l the correction for this potential endogeneity affect the estimated impact o f regional FTAs on 102 CHAPTER IV. Economic Eflecr ojCAFTA: More Art Thun Science economic growth? To address this question a simple framework for analyzing growth and policy choice i s presented and then the econometric techniques used to estimate such a model are discussed. Specification of the Selectivity model 4.104 Equations (3) through (5) describe the benchmark growth model with the endogenous choice o f entering into an FTA. The model assesses whether output growth differs significantly between those periods during which a free trade agreement i s signed. I t departs from the previous analysis in that the choice to liberalize i s modeled as endogenous and selectivity bias i s explicitly addressed. The model i s specified as: Y = a&-,+ DI, If + $qt+ +E,, (2) d,, = aZ,, + cn, + 77,s (3) D, = 1 if d,, > 0 ; D, = 0 if d,, < 0 . (4) In equation (2), real GDP growth in each period i s a function o f initial GDP, a dummy variable indicating whether country i signed a free trade agreement during the period, Dit, a vector o f internal and external country environmental characteristics, Xlt, such as world growth, fiscal balance, and black market premium, a vector o f country specific dummy variables n, (fixed effects) to account for country-unique trend growth differences, and an error term which includes unobservable country-specific growth factors (more discussion on this below) and random disturbances. Equations (3) and (4) specify the policy choice decision: a country signs a particular regional free trade agreement in period s if the latent variable d,, rises above zero. This policy choice equation i s based on the notion that the choice to enter into a regional free trade agreement depends on the net benefit a country expects to receive from freer trade and the lobbying efforts o f domestic interest groups. The latent variable i s a function o f a vector o f characteristics, Z,, which include lagged variables such as real GDP per capita growth, initial level o f GDP per capita, world GDP growth per capita, trade share o f GDP, political freedom index, dummy variables to account for unspecified “free trade trends” in the 1980s and 1990s, and a vector o f country-specific dummy variables (fixed effects). 4.105 Table 15 shows the results o f the model that explicitly takes into consideration the potential selectivity bias in the choice o f trade liberalization. Maximum likelihood and two- step estimation techniques are shown, but the results are broadly similar. In short, selectivity bias does not appear to be a significant problem the estimated hazard variable (selectivity bias) in both equations ( fi ) i s not estimated to be statistically significant. Despite prior years o f slower than normal growth and higher than normal world growth being a good predictor of the signing o f a regional free trade agreement, in neither estimation procedure (the maximum likelihood or the two-step procedure) are the estimated coefficients, nor the significance o f the regional trade agreements variables, diminished substantially. Consequently, the evidence suggests that endogeneity in the choice o f liberalization does not appear to be a significant problem and does not change the finding that regional free trade agreements tend to boost economic growth. 103 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science Table 15: Treatment Effects Model. 1970-2000 (5 vear averages)" Current per capita real GDP growth t Maximum ikelihood Estimates I Estimates I Log Initial real GDP p.c. ($) -0.039 -0.039 (-2.90) (-3.88) Log secondary school enrollment (%) -0.0003 -0.0004 Log o f investment share of GDP (%) 0.007 1 0.007 World GDP growth (%) 0.0063 I 0.006 I I (2.57) I (2.60) I Trade share o f GDP (%) 0.00003 0.00003 (0.19) (0.19) Black market premium (%) -0.00001 -0.00001 (-0.57) (-0.94) Government share of consumption (%) 0.0003 0.0003 (0.91) (0.84) Fiscal balance as share of GDP (%) 0.001263 0.001 (2.62) (2.28) Choice to liberalize 0.0103 0.01 1 (1.39) (1.45) Lagged freedom index 0.455 I 0.454 (1.46) (1.59) Dummy for 1980 -0.821 -0.818 (-2.25) (-2.48) Dummy for 1990 -0.047 -0.042 (-0.1 1) (-0.13) Hazard (M -0.001 -0.002 (-0.20) (-0.32) Observations 297 297 Wald Chi Square ... 325.59 Log pseudo-likelihood 552.11 ... * Z statistics in parenthesis. 104 CHAPTER IV. Economic Ejject of’CAFTA: More Art Than Science Potential Impact on the Poor 4.106 Having established that the effect o f an FTA on annual per capita growth i s an increase in the per capita growth rates of 0.6 percentage points a year, the repercussions on poverty rates can be roughly estimated using elasticities o f poverty to changes in economic growth. Such elasticities allow for the calculation o f changes in poverty rates that result from economic growth, holding other factors constant (including income distribution) and are available for most Central American countries from recent World Bank studies. Table 16 presents the estimated changes in poverty and extreme poverty rates five years after implementation o f the DR-CAFTA, assuming that the estimated growth effect materializes for all five countries. Results suggest that overall poverty reductions would vary b y country, ranging from 0.6 percentage points in Costa Rica to 1.6 in Guatemala. The corresponding range for extreme poverty rates goes from 0.3 percentage points in Costa Rica to 1.3 in Honduras. This translates into an absolute reduction in the total number o f poor in five years o f about 530,000 adding the five countries involved, and nearly 380,000 for the extreme poor. Table 16: Five Year Poverty Reduction Effects of F T A for Central American Countries I Headcount Poverty I I Extreme Poverty I I 2005 1 2010 I Difference I 2005 I 2010 I Difference I Costa Rica I 20.4 1 19.8 I -0.6 I 6.0 I 5.7 I -0.3 El Salvador I 36.4 1 35.0 I -1.4 I 14.7 I 14.1 I -0.6 Guatemala 55.9 54.3 -1.6 15.5 14.4 -1.1 Honduras 63.1 61.9 -1.2 45.7 44.4 -1.3 Nicaragua 45.6 44.7 -0.9 14.9 14.2 -0.7 4. Conclusions and Policy Priorities for the DR-CAFTA Beneficiaries 4.107 This chapter reviews various analyses undertaken to assess the potential impacts o f DR-CAFTA on the developing countries o f Central America. I t begins b y highlighting that standard theoretical treatments of the gains from trade indicate that such gains depend on an economy’s capacity to change i t s productive structure. Otherwise, the gains are limited to the gains on the consumption side, which allow domestic agents to consume a bundle o f goods that i s larger in economic value than the one without trade reforms. The gains from productive transformation can be substantially higher than the gains from enhanced consumption alone. These conclusions refer to static analyses o f the gains from trade. 4.108 Regarding empirical analyses o f the potential static gains from trade, the evidence reviewed in the chapter highlights two key complementary factors, namely, the infrastructure that affects international transport costs and the regulatory environment. There i s strong evidence suggesting that exports to the U.S. market w i l l benefit from the shift from unilateral preferences (CBI) to a free trade agreement, but perhaps more 105 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science importantly, international transport costs (freight, insurance) have a robust and large effect on the value of exports, regardless o f the type o f preferential treatment. Also, the evidence reviewed suggest that the gains from trade in terms o f increases in GDP per capita i s intermediated by the regulatory environment that determines how quickly firms and workers can change their sectors o f operation and employment. Thus a complementary agenda to enhance the impact o f the DR-CAFTA should consider these factors, even when concerned about the static gains from trade. 4.109 Partial equilibrium analyses o f the potential sectoral effects o f DR-CAFTA suggested that the main short-term winners of the agreement would be concentrated in the apparel industries, abstracting from any impact of the elimination of world quotas in this sector. Nevertheless, these analyses suffer from an inability to capture the potential effects on sectors that are relatively small, since the effects predicted b y these models are proportional to the initial level o f exports. In addition, they have difficulty dealing with technical issues such as the restrictiveness o f rules o f origin. Furthermore, such partial- equilibrium models do not consider the effects of the trade reforms in the economy as a whole since they do not consider inter-sector interactions through factor and goods markets. 4.1 10 This chapter also presents the simulation results from a so-called “Computable General Equilibrium” (CGE) model for Nicaragua linked to household data. The simulation relates the macroeconomic results o f the model to changes in the returns to unskilled labor to poverty outcomes. Indeed, under a restrictive set o f conditions (e.g., segmented labor markets, no dynamic effects, effective transmission o f tariff reductions to relative producer prices, and no further unilateral trade reforms) DR-CAFTA could have an overall modest positive effect on Nicaragua’s welfare (income per capita) but with a very small (positive) effect on poverty, and the potential for poor rural households to be negatively affected. Thus, as with the other static analyses, these results further support the contention that D R - C A F T A might not be enough to reduce poverty, although these results need to be interpreted with caution, as they are obviously limited b y key theoretical and empirical assumptions. 4.1 11 The rest of the chapter i s dedicated to understanding the potential dynamic gains from DR-CAFTA. The first part covers evidence concerning the potential effect o f free trade agreements (FTAs) - and trade more generally - on foreign investment, corruption, and innovation. Existing evidence suggests that FDI responds to FTAs indirectly, b y enhancing the effect o f exports and GDP on FDI. The evidence also indicates that trade might not have a direct effect on corruption, and thus we should not expect large dynamic gains from DR-CAFTA to come from the impact o f international trade on the quality o f public institutions. The process o f democratic consolidation seems much more important, although certain aspects o f DR-CAFTA that put pressure on governments to improve the enforcement o f their own laws could also be helpful. The existing literature on innovation and economic discovery suggests a mixed picture. O n the one hand, innovation efforts might not be related to the incidence o f international trade. On the other hand, the probability of observing episodes o f “economic discovery” seems to be positively correlated with overall export growth. 106 CHAPTER IV. Economic Effect ojCAFTA: More Art Than Science 4.1 12 This chapter also reviews the econometric challenges and results b y investigating the empirical link between FTAs and subsequent economic growth in a large sample o f countries. The main result i s that the growth rate of GDP per capita i s positively associated with a country’s participation in FTAs. This finding i s robust to the inclusion o f various control variables and econometric methods. Unlike the evidence presented in previous work, the new evidence reviewed does not find that the increase in GDP growth of about 0.6 percent per year was sensitive to the type o f partner in the FTA. In contrast, a previous empirical study using a different set o f control variables and specifications of the empirical models, did find that access to larger markets has a larger effect on growth than FTAs with smaller partners. In any case, there seems to be substantial evidence that FTAs might help accelerate the pace o f economic development, at least for the first five years subsequent to implementation. In the long-run, the steady-state level of income w i l l be determined by a plethora o f other factors and as economies get richer, their pace o f growth w i l l tend to decline. Consequently, there does not seem to be a silver bullet, and DR-CAFTA i s unlikely to be the solution to all development challenges faced by Central America. 4.1 13 The evidence reviewed should make clear that ex-ante analyses o f the potential effects of DR-CAFTA (and trade reforms in general) remain an art rather than a science, since the results are highly sensitive to theoretical assumption and empirical methods. Chapters V, V I and VI1 of this report provide more guidance regarding the “complementary agenda”, which includes policies that can help DR-CAFTA beneficiaries overcome the challenges posed b y the adjustment process as well as the long-term challenge o f economic development in the context o f DR-CAFTA. 107 CHAPTER IV. Economic Efject ojCAFTA: More Art Than Science Technical Appendix: The Gains from Trade for Small Economies and the Underlying Assumptions 4.114 The purpose o f this appendix i s to summarize a textbook model o f the gains from trade b y highlighting the role o f the gains due to consumption and the gains due to the productive transformation o f a small open economy. The starting point i s the standard simplifying assumption, whereby we assume that the economy produces two broad categories o f products, 1 and 2. Furthermore, each good i s produced with labor and sector- specific technology, which determines the amount of labor required to produce a unit o f each good. Thus equations (1) and (2) below represent the production functions of each good, where a1 and a2 represent the out per unit o f labor for each sector, and L1 and L 2 represent the number of workers dedicated to producing each good. 4.115 Consequently the economy’s total labor force (L) i s simply the sum of workers in sectors 1 and 2, as expressed in equation (3). This assumption also implies that the labor participation rate does not change, or that the economy maintains a constant level o f employment equal to L. As argued in this chapter and subsequently in Chapter V, government policies designed to help the process o f adjustment can be instrumental in maintaining a given level o f total employment as relative prices change due to trade policies (DR-CAFTA). (3) L=L,+L, 4.1 16 Hence the economy’s production frontier, which represents the quantities o f both goods that i t can produce when all labor (L) i s employed in production, can be expressed as the quantity o f good 1 ( Q l ) that can be obtained if all labor i s employed in that industry and the quantity o f good 2 (Q2) that can be produced if all labor were in this sector. In other words, the production frontier for the economy in this simple model i s the line joining both o f these maximum production possibilities. This production frontier i s formally expressed in equation (4): 4.1 17 In this framework, the composition o f production depends on available technologies in this economy compared to the technologies o f production in the rest o f world (or in the economy’s trading partners). Here we assume that the economy under consideration can produce good 1 relatively more efficiently than good 2 when compared to i t s trading partners: (5) > -a, , a1 . a2 a2 108 CHAPTER IV. Economic Eflect of CAFTA: More Art Thun Science Thus we assume that this economy has a comparative advantage in the production o f good 1. Note that it can have lower labor productivities in both sectors, but i t would s t i l l have a comparative advantage. 4.1 18 Figure A1 illustrates the economy’s production frontier as the downward-sloping line that goes from point a l * L on the vertical axis to point A in the horizontal axis. As mentioned, point a1*L i s the maximum quantity o f good 1 that can be produced if all labor were employed in that sector, whereas point A i s equal to a2*L. The slope o f this line i s equal to the negative ratio of a1 over a2, as shown in equation (4) above. 4.119 N o w assume that the initial structure o f production i s represented by some point along the production frontier. In this case, the value o f this production mix based on the economy’s trading partners’ relative efficiencies i s given by the consumption frontier portrayed b y the dotted line that goes through the production point and extending down to point B in the horizontal axis. In terms of the quantity o f good 2 that the economy can consume, the gains from trade without changes in the structure o f production are given b y the distance between points A and B in Figure A l . That is, with trade, consumers in this economy can consume larger quantities o f good 2 than would be possible without free trade, because in autarky consumption must l i e on the production frontier. 4.120 The gains from trade become larger if the economy i s able to change i t s production structure. In the graph, this entails a movement o f the production point from the previous point to the point on the vertical axis where all o f the economy’s labor i s dedicated to production in sector I. In turn, the consumption frontier shifts outward from point B to C on the horizontal axis. Consequently, the gains from trade depend on the ability o f the economy to change i t s production structure even if the so-called dynamic gains from trade are not considered. This report argues that the capacity o f the economy to be transformed w i l l depend on key public policies and thus the gains from trade are not automatic. 0 A B C Q* 109 CHAPTER IV. Economic Ejjecr of CAFTA: More Art Thun Science Appendix Tables - Table Al: Costa Rica Estimated effects of US. tariff elimination in partial equilibrium - HS Code Actual Exports DR-CAFTA" Change Product Description 2001 Potential Gain (%o) ($000) ($000) Total 731,448 197,550 27 % 61 Art o f apparel & clothing access, knitted or croc 396,414 139,893 35% 62 I Art o f apparel & clothing access, not knittedkro I 293,864 52,198 18% 02 I Meat and edible meat offal 26,176 2,446 9% 42 Articles o f leather; saddlery/harness; travel goo 3,529 1,276 36% 64 Footwear, gaiters and the like; parts o f such art 1,730 708 41% 56 Wadding, felt & nonwoven; yams; twine, cordage, 4,045 37 1 9% 58 I Special woven fab; tufted tex fab; lace; tapestries I 1,840 177 10% 55 1 Man-made staple fibers 1,175 159 14% 54 Man-made filaments. 568 138 24% 16 Prep o f meat, fish or crustaceans, molluscs etc 379 70 19% 59 Imoremated. coated. cover/laminated textile fabr 517 50 10% 19 I Prep. o f cereal, flour, starcwmilk; pastry cooks' I 4 0 2% of CBS ' I preferential tariffs. * DR-CAFTA estimated as unilateral tariff elimination by the US to Central American countries 110 CHAPTER IV. Economic Efecf of CAFTA: More Arr Thun Science - Table A2: El Salvador Estimated effects of U.S. tariff elimination in partial equilibrium Product Description 1 Actual Exports DR-CAFTA I 2001 ($000) I potential Igain I I Change (%) Total I 1,664,350 I 355,512 I 21% 60 IKnitted or crocheted fabrics. Total 1,309 683 I 52% 54 ban-made filaments. Total 626 180 I 29% 59 bmpregnated, coated, cover/laminate Total 1 0 I 8% 53 lother vegetable textile fibers; pap Total 1 0 I 12% 111 CHAPTER N. Econornic Effect ojCAFTA: More Art Than Science - Table A3: Guatemala Estimated effects of U.S. tariff elimination in partial equilibrium Hs Code I Product DescriDtion I 2001 ($000) Gain Total 1,652,343 777,969 47% 61 Art o f apparel & clothing access, knitted 880,543 514,248 58% 62 t o f apparel & clothing access, not knitted 743,844 255,137 34% 24 Tobacco, manufactured tobacco substitutes 8,185 4,673 57% 63 Other textile articles; sets; worn clothing 5,223 1,322 25% 64 Footwear, gaiters and the like 2,954 1,24 1 42% 42 Art icles o f leather; saddlery/harness 863 282 33% 52 Cotton 1,063 232 22% 65 yeadgear and parts thereof. 1,599 188 12% 55 an-made staple fibers 540 170 1 31% 54 an-made filaments. 470 162 I 34% Source: Estimations using SMART with trade data from UNCOMTRADE and Tariffs from TRAINS 112 CHAPTER IV. Economic Ejject of CAFTA: iMore Art Thun Science - Table A4: Honduras Estimated effects o f U.S. tariff elimination in partial equilibrium HS Code Product Description (S 000) ($000) 19 prep. o f cereal, flour, starcwmilk; pastry cooks' 56 1 2% 113 CHAPTER IV. Economic Effect of'CAFTA: More Art Than Science Table A5: Nicaragua - Estimated effects of U.S. tariff elimination in partial equilibrium Actual DR-CAFTA' HS Code Product Description Exports 2001 Potential Gain Change ($000) ($000) (%) 62 61 12 02 24 63 56 04 0 21 42 17 46 Manufactures o f straw. esuarto/other ulaitinn mat 1 3 1 0 I 5% 58 Source: Esti DR-CAFTA estimated as a unilateral tariff elimination by the U S to Central American countries 114 CHAPTER IV. Economic Efecf of CAFTA: More Art Thon Science Table A6: El Salvador: Estimated effects of tariff elimination on U.S. imports in partial equilibrium Imports Change Change HS Code Product Description 2004 In Imports %i ($000) ($000) 87 27 94 85 39 40 10 21 48 52 33 62 61 84 95 64 63 4 E- l 96 I 54 Meat and edible meat offal 2,712 1,229 45 % Preparations of vegetable, fruit, nuts or other 4,674 1,119 24 % Miscellaneous articles o f base metal 7,052 1,009 14% Pearls, precious stones and metals 2,202 985 45 % I I Other exports 209,708 13,959 7% Source: E s mations using SMART, exports f r o m UNCOMTRADE, tariffs from TRAINS. * D R - C A F T A effect estimated as a unilateral tariff elimination (immediate drop to zero o f all tariffs) by El Salvador to U.S. imports. 115 CHAPTER IV. Economic Effect of CAFTA: M o r e Art Than Science Table A7: Costa Rica: Estimated effects of tariff elimination on US. imports in partial equilibrium rl HS Code Product Description Imports 2004 Change I n Imports Change (%) Source: Estimations using SMART, exports from UNCOMTRADE, tariffs from TRAINS. DR-CAFTA effect estimated as a unilateral tariff elimination (immediate drop to zero o f all tariffs) by Costa Rica to U.S. imports. 116 CHAPTER IV. Economic Effect of CAFTA: More An Than Science Table AS: Guatemala: Estimated effects of tariff elimination on U.S. imports in partial equilibrium Product Description Source: Estimations using SMART, exports from UNCOMTRADE, tariffs from TRAINS. * DR-CAFTA effect estimated as an unilateral tariff elimination (immediate drop to zero o f all tariffs) by Guatemala to U.S. imports. 117 CHAPTER IV. Economic Efect of CAFTA: More Art Than Science Table A9: Honduras: Estimated effects of tariff elimination on U.S. imports in partial equilibrium Imports Change Change HS Code Product Description 2004 I n Imports (%) ($000) ($000) 26 % 50% 52% 52% 15% 10% 30% 17% 11% 9% 14% 61% 8% 55% 21% 13% 60% 1% 19% 3% 43% 32% 18% 19% 5% 22% 15% 7% jource: Estimations using SMART, exports from UNCOMTRADE, tariffs from TRAINS. * DR-CAFTA effect estimated as an unilateral tariff elimination (immediate drop to zero o f all tariffs) by Honduras to U.S. imports. 118 CHAPTER IV. Econoinic Effect of CAFTA: M o r e Art Than Science Table A10: Nicaragua: Estimated effects of tariff elimination on US. imports in partial equilibrium Imports Change Change Source: Estimations using SMART, exports from UNCOMTRADE, tariffs from TRAINS. * DR-CAFTA effect estimated as a unilateral tariff elimination (immediate drop to zero o f all tariffs) by Nicaragua to U.S. imports. 119 CHAPTER IV. Economic Efect of CAFTA: More Art Than Science Table A l l : Summary Statistics (1960-2002) of Variables Used by Gould and Gruben in estimation of growth effects of Free Trade Agreements 120 CHAPTER V. Policy Approuches to iliiunaging the Economic Transition: Chapter V. Policy Approaches to Managing the Economic Transition: Ensuring that the Poor Can Benefit from DR-CAFTA Abstract 5.1 While the vast majority o f people in Central America are expected to benefit from DR-CAFTA in the medium to long-term, there are at least some people who are at risk o f bearing the costs o f trade-related economic adjustment in the short-term. In particular, the introduction o f more trade competition for sensitive agricultural commodities under D R - C A F T A can be expected to lead to lower domestic prices for sensitive commodities in each country. The analysis presented in this chapter indicates that 90 percent o f Nicaraguan households, 84 percent o f Guatemalan households, and 68 percent o f Salvadoran households, respectively, were found to be net consumers o f the basket o f sensitive agricultural commodities and thus can be expected to benefit from DR-CAFTA-related price changes. Only about 9 percent o f Nicaraguan households, 16 percent o f Guatemalan households, and 5 percent o f Salvadoran households were found to be net producers o f the basket o f sensitive commodities and, thus, would be expected to experience welfare losses. For El Salvador, a further 27 percent were estimated to remain unaffected. The average estimated size o f losses to net producers are relatively l o w - about 2.2-2.3 percent o f per capita consumptiordincome in Guatemala and El Salvador - although such impacts may not be trivial for the poorest Central Americans. 5.2 DR-CAFTA has built into to i t considerable grace periods, safeguards and extended phase-out periods for eliminating tariffs and quotas that provide reasonable protection to producers o f sensitive crops over a prolonged adjustment period. In addition, potential income losses can be mitigated through a variety o f additional policy options: (i) “decoupled” income support payments to farmers o f sensitive crops (e.g., Mexico’s PROCAMPO program), (ii) technical assistance programs to farmers o f sensitive crops, (iii) conditional cash transfers (CCTs) to rural families, effective only as poor families make investments in their children’s education, health, and nutrition, and (iv) provision o f public goods (e.g., economic infrastructure, basic education, rural financial services, technical assistance) targeted to households andor regions that are expected to be particularly affected by DR-CAFTA. The choice of which type o f support program would be more appropriate should be made on the basis o f country-specific factors, taking into account institutional capacity, characteristics and regional concentration of vulnerable populations, the need to provide incentives for productive diversification and overall fiscal constraints. 121 CHAPTER V. Policy Approaches to Managing the Econoniic Transition: 1. Introduction 5.3 While the vast majority o f people in Central America are expected to benefit from DR-CAFTA in the medium- to long-term, there are at least some people who are at risk of bearing the costs o f trade-related economic adjustment in the short-term. For example, although the Central American economies are already relatively open, due to the unilateral trade liberalization efforts undertaken in the 1990s described in Chapter 1 1, a handful o f “sensitive” agricultural commodities (e.g., maize, beans, dairy, and poultry) s t i l l have significant levels o f protection. This protection w i l l be reduced or eliminated as a result of DR-CAFTA, as described in Chapter 1 11, potentially resulting in short-term employment and income losses to those who currently produce those goods. Especially if those adversely affected are among the poor or near poor, then some kind of trade adjustment assistance or social safety net may be warranted to ensure that those negatively impacted are able to maintain a minimum level o f welfare while making the transition to new and more remunerative economic opportunities arising from the Agreement. 5.4 The main objectives o f this chapter are to: (i) analyze ex-ante the potential impacts on household welfare arising from DR-CAFTA; and (ii) examine policy approaches that may be useful in enabling trade adjustment and mitigating any negative impacts of the Agreement. The chapter focuses on the five original parties to the DR-CAFTA - Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua - and explores approaches to ensure that those who might bear the cost o f trade adjustment in the short-term are able and equipped to take advantage o f opportunities arising from DR-CAFTA in the medium-to-long term. Because the largest changes in trade protection are expected to affect a handful o f so-called “sensitive agricultural commodities,” this chapter focuses predominantly on the effects o f liberalizing trade in these commodities. To fulfill i t s objectives: Section 2 outlines briefly the state o f trade protection on sensitive agricultural goods in Central America, as well as the types o f trade reforms negotiated under the DR-CAFTA Section 3 lays out a framework for assessing the welfare impacts o f DR-CAFTA ex-ante, focusing on how price changes are transmitted to households and how households manage risk in the face o f changing economic circumstances Section 4 presents new case evidence o f the expected welfare impacts of DR-CAFTA in El Salvador, Guatemala, and Nicaragua, based on analysis of these national household survey data in these countries Section 5 examines two broad policy approaches to addressing possible negative impacts o f DR-CAFTA, comparing the relative benefits o f phasing out trade protection as negotiated under the Agreement versus and approach that couples quick trade reform with compensatory measures targeted toward adversely affected groups Section 6 reviews specific possible policy instruments for mitigating short-term costs of DR-CAFTA under a “quick liberalization” scenario, as well as approaches to facilitating trade adjustment among those who might be adversely affected by terms of trade changes. This section includes review of selected transfer programs, as well as interventions to 122 CHAPTER V. Policy Approaches to Managing the Economic Transition: enhance people’s economic mobility and public information efforts that can help facilitate adjustment. 0 The chapter concludes with an assessment of the relative strengths and weaknesses o f different policy alternatives with respect to enabling a successful economic transition and ensuring that the poor are equipped and prepared to benefit from the DR-CAFTA. 2. Liberalization of Sensitive Agricultural Commodities under the DR-CAFTA 5.5 Unilateral trade liberalization on the part of the Central American countries during the 1990s, left trade protection levels low, with the exception o f a handful of so-called bienes sensibles agri’colas, or sensitive agricultural commodities, including corn (maize), beans (frijol), milk and other dairy items, rice, sugar, beef, pork, and poultry meat. 5.6 As can be seen in Table 1, pre-DR-CAFTA levels of tariff protection on these sensitive commodities were often quite high in the five Central American countries.’ As o f 2001, tariffs o n the import o f poultry meat was as high as 170 percent in Nicaragua, 150 percent in Costa Rica, 50 percent in Honduras, and 45 percent in Guatemala. Tariff rates were as high as 65 percent on milk (Costa Rica), 62 percent on rice (Nicaragua), and 55 percent on sugar (Nicaragua). Table 1 also shows that the dispersion of tariff rates on sensitive agricultural goods were high within individual countries and highly variable across the 5 countries. Table 1: Tariffs on Key “Sensitive” Commodities in DR-CAFTA Countries’ r I Honduras 15% 1-45% 0-45% 15% 40% 15% 15% 35-50%3 Nicaragua 40% 0-30% 62% 10% 55% 15% 15% 170% Sources: Monge-Gonzilez, Lorfa-Sagot, and Gonzilez-Vega (2003), Portner (2003), Marques (2005); Marques (for Honduras, personal correspondence). ’ Notes: Data from latest available year, 2001-2005.2 Where tariff ranges are indicated this signifies tariff levels for imports of products within and outside established quota levels.3 In the case o f poultry imports to El Salvador, tariffs are 20 percent for non-Central American Common Market (Mercado Comdn Centroamericano, M C C A ) countries, except for the U.S., f r o m which poultry imports carry a tariff level o f 164 percent. For both El Salvador and Honduras, the tariff levels also differ depending on the type of poultry meat. ’ This i s true at least for trade outside the Central American Common Market (Mercado Comdn Centroamericano, M C C A ) . Within the MCCA, imports generally carry lower and often zero percent tariff levels. 123 CHAPTER V. Policy Approaches to Managing the Economic Trunsition: 5.7 In addition to tariffs, several o f the countries also had non-tariff barriers o f various kinds. For example, there i s a system o f tariff-rate quotas (TRQs) - sometimes called “within- quota” and “out-of-quota” tariffs - that results in different levels of protection depending on the quantity o f imports. This i s illustrated in Table 1 b y the tariff ranges shown for several specific commodities. This system enables a limited quantity of sensitive commodity imports to come into a country at relatively l o w tariff rates. Any imports above quota levels, however, come in at elevated tariff levels. In the case of yellow maize, for instance, tariff levels rise from 0 percent to 15 percent in El Salvador, 5 percent to 35 percent in Guatemala, and from 0 percent to 30 percent in Nicaragua once imports exceed nationally established quota levels (Table 1). Likewise, tariffs on rice rise from 0 percent to 40 percent in El Salvador and from 6 percent to 35 percent in Guatemala once imports exceed quota levels (Table 1). In addition, several commodities face sanitary and phyto-sanitary restrictions. For example, both milk and poultry meat face trade-related health and safety restrictions within the Central American Common Market (Mercado Comu’n Centroamericano, MCCA); whereas trade in beef faces heath and safety-related restrictions with countries outside the M C C A (e.g., related to hoof-and-mouth disease, mad cow disease, etc.).2 5.8 Reduction or elimination o f tariff and non-tariff protections under the D R - C A F T A would thus be expected to lead to lower domestic prices for sensitive commodities in each ~ountry.~ Given the high levels o f protection on some of these goods, the expected price declines on these goods could be considerable in some countries. For this reason, DR- C A F T A includes a wide range o f provisions (described in Chapter 1 11) for dealing with the liberalization o f sensitive goods, including grace periods for initiating liberalization, extended phase-out periods for tariffs, interim quotas and/or phase-downs o f TQRs, as well as special safeguard measures to protect local farmers from undue harm. The exact provisions were negotiated country-by-country and, therefore, differ somewhat across the regions. Overall, however, the Central American countries were successful in negotiating generous timetables for reducing protection on their bienes sensibles agricolas as demonstrated in Chapter I II. Phase-out periods are, for some commodities, as long as 20 years and, at least for a few countries, white maize, an important staple crop produced b y the poor, was exempted from liberalizing (Box 1). 5.9 In sum, while the specific differ from country-to-country, the D R - C A F T A has built into i t a prolonged and predictable period over which these bienes sensibles agricolas can be liberalized, providing for an extended period over which producers can, at least in principle, adapt to expected price declines in these commodities. These provisions in themselves represent important protections for producers of sensitive crops, giving them an extended timeframe over which to undertake the necessary economic adjustments. Monge-GonzBlez, Loria-Sagot, and GonzBlez-Vega (2003); see Table (Cuadro) 33, p. 46. In turn, these price reductions would reflect themselves in a fall in national consumer prices indexes, which would depend on the level o f tariffs and non-tariff barriers and on the share of these sensitive commodities in the bundle o f consumption goods used to calculate such prices indexes. Such an exercise i s difficult to undertake due to the problems in predicting the exact magnitude of the domestic price reductions, especially when quotas are in place and when the price-transmission between border price changes and producer prices within countries i s imperfect. 124 CHAPTER V. Policy Approaches to Manuging the Economic Transition: 3. Framework for Analyzing Welfare Impacts of the DR-CAFTA 5.10 The literature on trade reform identifies a number of channels through which trade reforms can impact people’s welfare, including through: (i) changes in the prices and availability o f goods; (ii)changes in factor prices, employment, and incomes; (iii) changes in government tax revenues and transfers (which may be affected b y changes in revenues from trade-related taxes); (iv) improved incentives for investment and innovation, which strengthen prospects for long-run economic growth; (v) and increased exposure to external shocks, in particular, through changes in the terms o f trade; (vi) the costs o f adjusting to changes economic e n ~ i r o n m e n t . ~ Box 1: D R - C A F T A Schedules for Liberalizing Sensitive Agricultural Commodities: The Cases of Honduras and El Salvador The Central American countries have, overall, negotiated generous timetables for liberalizing sensitive agricultural commodities under the DR-CAFTA, including grace periods, extended timetables for tariff reduction or elimination, phasing down of TQRs, and various safeguard provisions. While the exact reform schedules were negotiated country-by-country, the broad parameters are similar in many ways, as can be seen i n the context of liberalization in Honduras and El Salvador. . I n Honduras: Tariff reductions on Rice are allowed to be phased over an 18-year period, following a 10-year grace period. Tariff reductions on Pork are allowed to be phased over a 15-year period, following a 6-year grace period. 1 While the US will receive immediate market access for high-quality cuts of Bovine Meat (e.g., choice, prime), lower quality cuts of beef w i l l be liberalized over a 15-year period. . Tariff reductions on Poulrry Meat are allowed to take place over an 8-year period, starting in 2015. 1 Tariff reductions on Dairy Products are allowed to be phased over a 20-year period. 1 Tariff reductions on Yellow Maize are allowed to be phased over a 15-year period, following a 6-year grace period. In El Salvador: Tariffs on imports of Beans will to be phased out i n equal installments over a 15-year period with no grace period. Tariffs on Rice for imports exceeding (the currently high) quota levels will be phased out over 7 years, following a 10-year grace period. Tariffs on Poultry i s be phased out over 7 years, following a IO-year grace period. The current TRQ on Pork will increase by 10 percent a year, while tariffs are to be phased out over an 8-year period starting in year 7. While prime beef parts already enter duty free, TRQs on a l l other Bovine Meat will increase by 5 percent a year; tariffs will be phased out over a 12-year period, following 2-year grace period. Tariffs on M i l k and Cheese are to be phased out over 10 years, following a 10-year grace period. In an important exception, i n both Honduras and El Salvador, White Maize - a key staple produced and consumed by the country’s rural poor - will he exempted indefinitely from liberalization. Moreover, for a l l the sensitive products, special Safeguard Measures have been agreed upon to ensure against unforeseen harm to local producers caused by rapid increases in imports from the U.S. Sources: Government of Honduras (2003), Marques (2005). Winters (2001) and Hertel and Reirner (2004) as cited in Marques (2005). 125 CHAPTER V. Policy Approuches to Manuging the Economic Trunsition: 5.11 Early concerns about the impacts of DR-CAFTA focused on the short-term price effects o f liberalization and, in particular, what they would mean for producers o f sensitive agricultural crops in Central America. For this reason, this section focuses largely on the effects of border price changes expected to occur from liberalizing sensitive agricultural commodities in Central America - although other channels of impact, for example, related to growth prospects and the role o f transfers, are discussed later in the chapter in the context o f public policy responses. Specifically, the section lays out a framework for understanding the pathways through which border price changes are transmitted to households and how households manage relative price changes (or “shocks”). 5.12 A key message o f applying this framework i s that the effect on households o f a price change on household welfare (such as the kind resulting from liberalizing the bienes sensibles agricolas w i l l be smaller - sometimes significantly so - than the change in the market price. 5.13 This i s due to the fact that households: 0 have diverse consumption bundles and often have multiple income sources, 0 at least in rural areas, are often both consumers and producers o f key goods (and that the consumption and production effects o f price changes work in opposite directions), 0 adjust their consumption and production patterns in response to relative price changes, and 0 Employ a number o f ex-ante and ex-post strategies to manage price and income risks. 5.14 This section examines each o f these factors in turn. Multiple Consumption Goods, Sources of Income Households, whether rich or poor, consume a diverse bundle o f goods. They also often have multiple sources of income. This multiplicity o f consumption goods and income sources serves, among other things, to moderate the short-term effects on household well-being - both positive and negative - of good-specific price changes. Analysis o f household consumption patterns using Nicaragua’s 200 1 national household survey, the Encuesta de Medicidn del Nivel de Vida (EMNV) indicates, for example, that commodities such as maize and rice make up between 3 and 6 percent o f households’ consumption bundles, on average, and between 7 and 8 percent of the consumption bundle o f Nicaragua’s poorest 20 percent o f households (Table 2). Together, the group o f sensitive agricultural commodities makes up about 54 percent of all food consumption, on average, and about 31 percent of total household consumption. Price declines for these goods w i l l thus have a positive impact in households’ ability to purchase these goods for consumption, with the largest effects being felt in the bottom half o f the welfare distribution. At the same time, increase in purchasing power w i l l be less than if the bundle o f sensitive agricultural commodities (whose prices are expected to decline) made up a larger proportion of total household consumption - say 50, 80 or even 100 percent. 126 CHAPTER V. Policy Approaches to iWunuging the Economic Trunsition: Table 2: Consumption Shares of K e y Commodity Groups, Nicaragua, 2001 Source: Adapted from Monge, Saavedra, and del Socorro Vallecillo (2003), based on analysis of Nicaragua’s national household survey, Encuesta de Medicio’n del Nivel de Vida (EMNV), 2001. 5.15 The same data set shows that households also tend to have a diversified set o f income sources (or income “portfolios”). As can be seen in Figure 1, income from self-employed agricultural enterprises such as production o f maize, beans, and rice - or chickens and cows in the case o f smallholder farm households - makes up about 19 percent o f the income, on average, among o f the poorest rural households in Nicaragua and about 28 percent o f incomes among rural households in the fourth q ~ i n t i l e . ~ contrast to the case o f consumption, In declines in the prices o f the sensitive agricultural commodities w i l l act to reduce the incomes o f households producing these goods. Nonetheless, the fact that households generally have multiple income sources means, however, that the negative income effect operates only on a portion o f households’ total income portfolio, again serving to moderate the impact of the price change. These quintile averages conceal potentially important variation in the share o f sensitive agricultural commodities i n total income o f specific households within a quintile. Nonetheless, even the least diversified households tend to have multiple sources o f income, both in terms o f crops, and in terms o f a m i x o f wage and self-employed income within and outside o f agriculture. Although not shown in Figure 1, the income share o f income derived from self-employed agriculture (and thus from sensitive agricultural commodities) i s much lower among urban than rural households in Nicaragua. 127 CHAPTER V. Policy Approuches fo Managing the Economic Transition: Figure 1: Distribution of Income Sources for Rural Households in Nicaragua, by Quintile, 2001 Poorest 2nd 3rd 4th Richest Quintiles 0 Wage Non-Agriculture 0 Self-Employed Non-Agriculture I Non-Labor Income I Source: World Bank Staff Estimates, using the EMNV 2001 Households as Both Consumers and Producers of Key Goods 5.16 The fact that households, particularly in rural areas, are often both consumers and producers o f key goods also served to soften the impact o f a price change on family welfare. This i s because the effect o f a price change has the opposite effect on consumption and production. If, for example, a household were to consume exactly the same amount o f a particular good - say maize - as i t produces, then a decline in the border price would have no net impact on household welfare, as the purchasing power benefits o f consuming less expensive maize would be exactly offset b y the loss in income associated with lower producer prices for maize. If a household were to consume more maize than i t produced, then a reduction in the maize price would, on net, benefit the welfare o f that household. However, the benefits would only equal the amount o f the price decline multiplied b y the excess o f maize consumption over maize production (Le., the net amount o f maize purchased from the market). In contrast, if a household were to produce more maize than i t consumed, then i t would experience a welfare loss as a result o f a decline in the maize price. In this case, the loss would be the amount o f the price changes multiplied b y the excess o f maize production over consumption (i.e., the net amount of maize sold into the market). Similarly, offsetting price effects would occur with any other sensitive commodities that households both consumed and produced. 5.17 The economics literature terms households that consume more than they produce o f a good “net consumers” o f that good, whereas those households that producer more than they 128 CHAPTER V. Policy Approaches to Munaging the Econoniic Transition: consume o f a good “net producers” of that good.6 Stated simply, net consumers o f a good would be expected to benefit from a decrease in the price o f that good (at least at the margin), while net producers would be expected to lose from a price decline. Conversely, a price increase for a particular good would be expected to benefit net producers o f that good and negatively impact the welfare o f net consumers. 5.18 Analysis o f household survey data from Guatemala (ENCOVI 2000) shows that the. vast majority of Guatemalans are net consumers o f maize - about 80 percent of households overall. This compares with only about 12 percent o f Guatemalan households, in all, that are net producers o f maize. The remaining roughly 8 percent of households are neither net consumers nor net producers o f maize; they consume and produce equal amounts. I t should noted that the percentage o f households that are net consumers (net producers) o f maize varies somewhat across the welfare distribution, however (Figure 2). For example, about 71 (17) percent o f the poorest households are net consumers (net producers) o f maize, while about 92 (4) percent o f the wealthiest households are net consumers (net producer^).^ The share o f households that are net consumers o f maize also varies significantly across regions o f Guatemala. Roughly 69 (18) percent o f rural households are net consumers (net producers) o f maize, whereas 91 (5) percent o f urban households are net consumers (net producers).8 Figure 2: Net Consumers and Net Producers of Maize in Guatemala, by Quintile, 2000 100% 80% 60 c7c 40%- 20°C 0ffr Poorest 2nd 3rd 4th Richest Quintiles 4 Net Consumers H Net Producers 1 1E Source: W o r l d Bank Staff Estimates, using the ENCOVI 2000 See Deaton (1997). ’ This net consumer-net producer framework is extended to all the sensitive agricultural commodities and used (below) to estimate the potential welfare impacts o f liberalizing these goods in El Salvador, Guatemala, and Nicaragua. In none o f these cases does the percentage o f net consumers and net producers of maize sum to 100, due to the fact that in each category at least a small proportion o f households consume and produce exactly the same quantities o f maize, according to the ENCOVI (2000) data set. 129 CHAPTER V. Policy Approuches to Munuging the Economic Trunsirion: Adjustment to Relative Price Changes 5.19 I t i s important to highlight that households are not simply passive recipients o f price changes. Rather, households often adjust their consumption and production practices in response to changes in relative prices to help make the most o f their limited resources and mitigate adverse price and income shocks (Deaton 1997). On one hand, households adjust to take the best advantage of favorable changes in prices. For example, if the price o f chicken goes down, households tend to increase their consumption o f this protein-rich food, all prices being constant. On the other hand, households adjust their consumption and production patterns in ways to help to mitigate the effects o f negative price shocks. For example, when world coffee prices fell dramatically between 1997 and 2001, coffee farmers in El Salvador and Nicaragua reduced their production or abandoned coffee production, shifting their work effort toward more remunerative economic activities within and outside o f agriculture (Kruger, Mason, and Vakis 2003, Beneke de Sanfeliu and Shi 2004, Trigueros and Avalos 2004). 5.20 I t i s worth noting that while there i s extensive empirical evidence from developed and developing countries showing that households adjust to changing prices, such adaptations may neither be smooth nor instantaneous, especially with respect to production. In general, households’ abilities to adjust their consumption w i l l be greater in the short-term than their ability to adjust their production patterns. The fact that households’ consumption bundles tend to be more diverse than their productiodincome portfolios and that, at least some portion o f household consumption can be purchased in markets, makes substituting one consumption good for another (at the margin) relatively easy. O n the production side, however, households may face a variety o f constraints to adjusting their income portfolio, at least in the short-term. For example, for poor rural households that are relatively specialized in agricultural production, the agronomic potential o f their farmland, seasonal or weather-related constraints on crop production, absence o f irrigation or other production technologies, and/or limited availability o f credit (or other forms o f working capital) may serve to limit households’ ability to adjust their income portfolios quickly. Such production-side constraints tend to loosen over the longer-term, and can be reduced through strategic investments in education and training and in infrastructure and technology that reduces agronomic constraints, lowers transactions costs, and increases the profitability alternative rural enterprises.’ I n cases where long geographic distances or lack o f communication or transport infrastructure result in high transactions costs, households may not be well connected to markets and, thus, may not experience very strong price signals to which to adjust. In such cases, infrastructure and other investments to reduce transactions costs and strengthen poor farmers’ ability to benefit from markets represent important long-run challenges for policymakers. I t should be noted, however, that such a lack o f connection to the market would mean that households would not experience very strong price signals - either positive or negative - as a result of the type o f domestic price changes that w i l l likely be induced by DR-CAFTA. This relative absence o f price signals appears to have been the case for some households in southern Mexico following NAFTA. Largely self-sufficient farmers in remote rural areas appear not to have been significantly affected - either for better or for worse - by NAFTA-related price changes in commodity prices (de Ferranti et a1 2004). 130 CHAPTER V. Policy Approaches to Managing the Economic Transition: Household Risk Management Strategies 5.21 Central American households employ a number of strategies to manage risk in uncertain and changing economic environments. Indeed, empirical evidence from Central America and beyond indicates that having a relatively diversified income “portfolio” (ex-ante) and adjusting to price changes (ex-post) are but two strategies that Central American households - and those in neighboring countries - seem to employ. In Guatemala, for example, the recent World Bank ( 2 0 0 3 ~ ) found that households not only adjust their consumption patterns in response to shocks, but also increase their hours worked and/or draw down financial savings and other assets to protect their income and consumption levels. Evidence from Mexico also indicates that households send additional household members into the labor force in response to a real or expected employment shock (Cunningham 2001). In El Salvador, migration and remittances have also been a key element o f household risk management - both ex-ante and ex-post (Arias 2004, Beneke de Sanfeliu and Shi 2004). In Nicaragua, evidence indicates that households also rely in important ways on informal social networks, including through memberships in community, religious, or neighborhood organizations, that can provide an alternative source o f resources - as loans or gifts - in the event o f an adverse shock (Klugman, Kruger, and Withers 2003). 5.22 A new empirical study o f the impacts o f the coffee crisis in four Central American countries also illustrates how households in the region have managed recent changes in relative prices (World Bank 2005e). In El Salvador, in response to declines in the coffee price - and related labor demand in the coffee sector - many wage earning households increased their hours devoted to non-agricultural enterprises. These sectoral shifts in employment - along with remittances - have helped Salvadoran families involved the coffee economy to mitigate significantly the effect on household income o f the significant fall in the world coffee price (Trigueros and Avalos 2004; Beneke de Sanfeliu and Shi 2004). In Honduras, evidence also indicates that coffee sector families increased their labor supply in an attempt to offset effects o f the coffee price decline (Coady, Olinto, and Caldes 2004). Some household risk management strategies, such as developing diversified income earning portfolios (ex-ante), or increasing adult labor supply or drawing down financial savings (ex-post), may be seen as appropriate responses to price and income risk. Others strategies, however, such as engaging in distress sales o f productive assets such as land, withdrawing children from school, or deferring utilization o f preventative or curative health services may create other risks - to long-term family welfare. Indeed, there i s evidence that, in Nicaragua and Guatemala, some coffee farmers sold o f f assets - such as land or livestock - as a means o f coping with the lower coffee prices (Vakis 2004; Vakis, Kruger, and Mason 2004). In addition, smallholder coffee farmers in Nicaragua appear to have withdrawn children from school - or delayed their enrollment - and employed child labor in an effort to deal with declines in their coffee sector incomes (Vakis, Kruger, and Mason 2004). Taking children out o f school i s o f particular concern, however; evidence from Mexico suggests that children who are removed from school in response to a shock are one-third less likely ever to continue school than those who are allowed to continue during a shock (Sadoulet, Finan, de Janvry, and Vakis 2004). Thus, this risk management mechanism can result in long-term losses in their productivity, adversely affecting both their economic productivity and increasing the likelihood o f intergenerational transmission o f poverty. 131 CHAPTER V. Policy Approaches to Managing the Economic Transition: 5.23 A number o f recent empirical studies - within and outside Latin America - have tried to measure how effectively households smooth their consumption - or “self-insure” - in the face o f adverse income shocks. While the specific findings differ from country to country, these studies find that households are partially - but not fully - effective at mitigating the impacts of shocks to household income. Overall, the evidence suggests that households, on average, are able to protect between 60 and 90 percent o f their consumption per capita in the face o f changes in income (Table 3). That is, a 10 percent “shock” to household per capita income translates into a roughly 1 to 4 percent change in per capita consumption. I n general, poor households seem to have fewer instruments available - and are less successful - in insuring themselves against risk than non-poor households. I n China, for example, the wealthiest households only experienced a 1 percent decline in per capita consumption in the face o f a 10 percent decline in per capita income; in contrast, the poorest households experienced a 4 percent decline in consumption response to the same decline in income (Table 3). Table 3: Household Consumption Smoothing in Developing Countries - Recent Evidence Change in Household P e r Capita Consumption Resulting from a 10 Percent Change in Country per capita Income (Percent) Source Mexico (rural) 3.7 Skoufias (2002) Nicaragua (all country) Peru (Urban) 2.5 3.0-3.6 1 Klugman, Kruger, and Withers (2003) Glewwe and Hall (1998) China (Rural) Jalan and Ravallion (1999) Poorest 4.0 Richest 1.o I India (Rural) I 1.2-4.6 I Ravallion and Chaudhuri (1997) I 5.24 Together, the evidence suggests that public social protection programs have an important part o f a country’s not only to ensure a minimum level o f well-being among a country’s population in the event o f shocks, but by helping to protect human capital investments and other productive assets o f the poor in the event o f shocks, safety nets can play an important role in a country’s long-term strategy for economic development and poverty reduction. lo ’” Several approaches to providing social protection as a means to manage the short-term adjustment costs as well as the economic transition associated with DR-CAFTA are outlined below. 132 CHAPTER V. Policy Approuches to Munuging the Economic Transition: 4. The Expected Impacts of Liberalizing the Sensitive Agricultural Commodities: New Evidence from El Salvador, Guatemala and Nicaragua. 5.25 Given the above, what might a policymaker expect to be the impacts o f liberalizing trade in sensitive agricultural commodities under the DR-CAFTA? Three new empirical studies - Portner (2003), Monge, Castro, and Saavedra (2004), and Marques (2005) - commissioned for this report, shed light on this issue. All three studies use nationally representative household survey data and apply a net consumer-net producer framework to assess likely first-order impacts on household welfare o f eliminating quotas and reducing to zero tariffs on several bienes sensibles agricolas, including on maize, beans, milk, poultry meat, bovine meat, pork, wheat, and rice." 5.26 As discussed above, a decrease in the price of any o f these commodities can be expected to benefit net consumers o f that good and have a negative impact on well-being o f net producers o f that good. One difference between the analysis the discussion o f net consumers and producers above and the analysis presented here i s that this section focuses largely o n the net welfare impacts o f liberalizing the entire basket o f sensitive commodities in each country - although the role and importance o f several specific commodities on household welfare are discussed below. (For additional information on the methodology used in the country case studies, see Box 2.'*) 5.27 The analyses presented here present expected impacts as if all tariffs and quotas were going to be removed completely and immediately under the DR-CAFTA. While this i s obviously not what was ultimately negotiated under the DR-CAFTA, the approach provides useful insights into the first-order impacts o f liberalizing the sensitive commodities. As w i l l be discussed further below, this approach i s also a useful baseline from which to discuss policy options, as well as some important policy trade-offs associated with the gradual liberalization that was negotiated versus an approach in which liberalization i s undertaken quickly and combined with targeted transfers to negatively affected households. " For Nicaragua, Monge et a 1 (2004) use the 2001 Encuesta de Medicidn del Nivel de Vida (EMNV); for Guatemala, Portner (2003) uses the 2000 Living Standards Measurement Survey (ENCOVI); for El Salvador, Marques (2005) uses the 2003 Encuesta de Hogares para Propdsitos Mliltiples (EHPM). '* For additional technical detail on the methodology, see Deaton (1997), McColloch (2002), Portner (2003), Monge, Castro, and Saavedra (2004), and Marques (2005). 133 CHAPTER V. Policy Approuches to Managing the Economic Trunsition. Box 2: Analyzing the Expected Impacts of Liberalizing Sensitive Agricultural Commodities in El Salvador, Guatemala and Nicaragua: A Net Consumer-Net Producer Approach The case studies presented i n this chapter apply a partial equilibrium approach, sometimes known as a net consumer-net producer approach. This approach enables analysts to estimate the first-order effects o f a price change on household welfare. The theoretical underpinnings for the approach used here are described i n Deaton (1997), McCulloch (2002), and Chen and Ravallion (2003). The approach assumes that each household has a utility function that fulfills certain requirements such as the separability between consumption and production and between leisure and other consumption. Given a set of (small) price changes the gain or loss to the household can be calculated by the money metric change in the household utility and i s simply equal to the price change multiplied by total sales of the product minus the price change multiplied by the total consumption of the product. Households can be divided into net producers and net consumers of a given product. I f with the implementation o f DR-CAFTA there i s a reduction in the import tariff o f that product and o f i t s domestic price, then all households who are net producers o f that product would experience a loss, while all households who are net consumers o f that product would experience a gain. There may also be households who neither produce nor buy the product or that produce only for self-consumption; in these cases, under this framework, there would be no change i n welfare. Note that the framework abstracts away from transport cost and/or intermediaries margins. The estimation procedure requires calculating the price changes brought about by the DR-CAFTA. Here, expected price changes following the elimination o f tariffs under the DR-CAFTA are calculated as weighted average (by quantity) of the tariffs applied at the within- and out-of-quota levels. Estimates o f expected changes in the prices o f sensitive agricultural commodities in El Salvador, Guatemala, and Nicaragua, due to the DR- CAFTA are presented in Annex 1. Other approaches - such as computable general equilibrium models (CGEs) - exist for estimating the welfare impacts of trade reform. I n principle, these models can account for several different channels through which welfare effects are transmitted, although CGEs are considerably more demanding in terms o f data and computational costs. Moreover, as Hertel and Reimer (2004) note in their review o f the various approaches to analyzing the poverty impacts o f trade, CGEs models can be quite complex, making i t hard to distinguish “the extent to which results are driven by particular modeling assumptions or whether they are robust to model specification and largely data-driven”. That said, the “comparative static” results presented here should be interpreted with several caveats in mind. First, the approach assumes that in the “short run” households neither adjusts their production or consumption patterns in response to price changes nor engages in any other household risk management strategies. Second, the estimates do not attempt to incorporate any longer-term benefits associated with increased labor demand that might be associated with the increased foreign investment, expansion o f exports, or increased economic growth expected to accompany. Third, the analysis assumes implicitly that tariffs are eliminated at once and that the price impact i s immediate. Therefore, consumers would realize an immediate gain and the producers would experience an immediate loss. However, DR-CAFTA has been negotiated to include long phase-out periods, often following an initial grace period. In this context, the impact o f prices changes would only be felt over a much longer period o f time. Fourth, even if elimination o f tariffs were immediate, there are reasons why the price changes experienced by households might be lower than those suggested by nominal tariff changes. For example, remote and isolated rural communities may only have weak links to commercial markets and, thus, households i n those areas may experience only weak price effects relative to those living in urban or “well-connected rural areas. Indeed, recenl empirical analyses o f local price changes resulting from border price changes‘find that the transmission effect i s commonly less than one-to-one (Winters, McCulloch and McKay 2004). Moreover, the fact that Central American trade i s already highly integrated - with zero tariffs on intra-regional trade for many sensitive commodities and, probably, some contraband - may also mean that price effects arising from DR-CAFTA may be somewhat muted. For these and related reasons, the types o f estimates presented here are generally referred to i n the “net consumer-net producer literature as “worst case” scenarios o f impacts (McColloch 2002). 134 CHAPTER V. Policy Approuches to Munaging the Economic Transition: I t i s important to note, however, that there are also factors that could work in the opposite direction in terms o f actual versus estimated impacts. For example, capital allocation away from adversely affected sectors could serve to reduce the marginal product o f labor in those sectors, compounding the static losses faced by net producers o f affected goods. Indeed i t i s possible, at least in principle, to imagine a longer-run “worst-case” scenario in which the dynamic gains from DR-CAFTA are low and where returns to unskilled labor fall economy-wide due both to the direct price effects and the indirect effects o f reallocation of capital from adversely affected sectors. A final caveat i s that, strictly speaking, partial equilibrium analysis i s valid only for small price changes. As can be seen in Annex 1, the expected price changes are substantial some cases. Despite these caveats, the net consumer-net producer approach i s useful in helping policy makers identify the expected “first-order’’ effects o f the DR-CAFTA, including which types o f households are most likely to gain or lose as a result o f liberalizing the sensitive agricultural commodities, as well as the likely size of the impacts. In doing so, i t provides an important analytical base on which to develop policy and programmatic responses to sumort those likelv to be adverselv affected bv reforms. Identifying Prospective “Winners” and “Losers ”from the Reforms 5.28 To assess who i s likely to w i n and who i s likely to lose from the liberalization o f the sensitive agricultural commodities, the analysis first examines whether households are net consumers or net producers o f each sensitive commodity, as in the case o f maize in Guatemala highlighted above (Figure 2). I t then estimates the per capita consumption gains to “winners” and losses to “losers” associated with liberalization o f each good. Finally, i t calculates the net welfare impact for each household o f removing tariffs and non-tariff barriers on the basket o f sensitive commodities in each country. As can be seen in Figure 3, the vast majority o f people in Nicaragua, Guatemala, and El Salvador are net consumers o f the basket o f sensitive commodities. 5.29 Specifically, the evidence indicates that 90 percent o f Nicaraguan households, 84 percent o f Guatemalan households, and 68 percent o f Salvadoran households are net consumers o f the basket o f sensitive agricultural commodities and, thus, on net, can be expected to benefit from the sum o f the price changes expected to occur when sensitive agricultural commodities are liberalized. Conversely, about 9 percent o f Nicaraguan households, 16 percent o f Guatemalan households, and 5 percent o f Salvadoran households are net producers o f the basket o f sensitive commodities and would, thus, be expected to experience (static) welfare losses arising from the price changes induced b y DR-CAFTA. Some proportion o f households, perhaps as high as 19 percent in the case of El Salvador, would neither benefit nor lose as a result o f DR-CAFTA-related price changes, due either to the fact that they neither consume or produce the sensitive commodities, or that they consume and produce them in roughly equal amounts. 135 CHAPTER V. Policy Approaches to Managing the Economic Transition: Figure 3: Net Consumers and Net Producers of Sensitive Agricultural Commodities in Nicaragua, Guatemala and El Salvador* Xicaragua Guatcmala El Sal\ador 1 E l N e t Consumers HNet Producers 1 Sources: Portner (2003), Monge, Castro, and Saavedra (2004), and Marques (2005) * Note that for data reasons, in the case o f El Salvador, the proportion of both net consumers and net producers may both be underestimated. 5.30 I t i s important to note here that in the case o f El Salvador i t i s likely that both the proportion o f net consumers and net producers i s underestimated. Both the Nicaraguan EMNV and the Guatemalan ENCOVI surveys are designed as consumption, expenditure, and income surveys, which also include detailed data on food prices. As such, they are ideally suited for undertaking the type o f net consumer-net producer analysis presented here. In contrast, El Salvador’s E H P M survey i s designed primarily as an income and employment survey. The EHPM does contain information on agricultural production, self-consumption, as well as data on purchase o f food items - although in practice these latter data have rarely been used. Review o f the EHPM modules suggest that both agricultural production for own consumption and household consumption expenditures may be under-reported, with some households (especially many poor households) reporting no such production or consumption spending. This i s reflected in the fact that the proportion o f both net producers and net consumers i s lower in the El Salvador analysis than in the cases of Nicaragua and Guatemala. 5.31 The El Salvador findings must, thus, be interpreted with some caution, especially in the case o f the disaggregated results reported b y region (rural vs. urban) and by welfare quintile which are analyzed using smaller data cell sizes and where measurement problems among a single or small group o f households could significantly influence the results. In this context, i t should be noted that Marques (2005) conducts some tests o f the robustness o f the findings to outliers in the data. H e finds that the results are robust to outliers, although that i s no guarantee that there are missing data reports, especially among poor households, that might have altered the findings somewhat. That said, the overall patterns o f net consuming and net producing households for El Salvador are very consistent with those from Nicaragua and 136 CHAPTER V. Policy Approaches to Managing the Econoniic Transition: Guatemala, giving some level o f confidence that they reflect real income and consumption patterns on the ground.I3 5.32 Rural-Urban DifSerences. While the majority o f Nicaraguans, Guatemalans, and Salvadorans are likely to benefit even in the short-term from price declines in sensitive agricultural commodities, the distribution o f beneficiaries differs somewhat across rural and urban areas (Table 4). In Nicaragua and Guatemala, for example, the evidence indicates that a higher proportion o f households in urban areas w i l l benefit than in rural areas. In Nicaragua, 97.6 percent o f urban households are expected to benefit compared with 78.8 percent in rural areas. The pattern i s similar in Guatemala; 93.6 percent o f urban households are expected to benefit from price changes under DR-CAFTA compared to 75.1 percent in rural areas. Note that while the proportion who are expected to benefit in rural areas i s lower in rural than in urban areas, the percentage i s s t i l l high - three-quarters or more in those two countries are expected to benefit. Poorest Quintile 85.7 12.4 78.5 20.8 22.1 7.5 Znd Quintile 86.5 11.8 75.4 24.1 76.6 4.1 3rd Quintile 91.1 8.5 81.2 18.6 82.1 2.8 4th Quintile 92.9 6.5 85.5 14.2 81.4 3.1 Richest Quintile 94.8 4.7 92.0 7.5 79.0 2.8 Sources: Portner (2003), Monge, Castro, and Saavedra (2004), and Marques (2005) 5.33 Conversely, the proportion o f net producers - households expected to experience negative impacts o f DR-CAFTA-related price changes - i s considerably higher in rural areas than in urban areas. In the case o f Nicaragua, for example, nearly 20 percent o f the rural l3As will be discussed further below, El Salvador i s a less rural country, with less o f i t s economy based on agriculture than either Nicaragua or Guatemala. Since urban areas i n Nicaragua and Guatemala have higher concentrations o f net consumers than do rural areas, once would expect a higher proportion o f net consumers in El Salvador than in the other two countries, all other things being equal. This, too, provides some confidence that the El Salvador analysis does not grossly overstate the likely beneficiaries or understate those who may be adversely affected by price changes under DR-CAFTA. 137 CHAPTER V. Policy Approuches to Munuginfi the Economic Transition: households are expected to be negatively affected b y DR-CAFTA-related price changes, compared w i t h less than 2 percent in urban areas. In Guatemala, nearly a quarter o f rural households are expected to be adversely b y price changes associated with liberalizing sensitive agricultural commodities under DR-CAFTA; this compares with just under 6 percent in urban areas. I t i s important to note, moreover, that there i s likely to be considerable variation in the impacts of DR-CAFTA within rural and urban areas in Central American, due to considerable heterogeneity in production and consumption patterns. For example, data from Nicaragua indicate that about 34 percent of rural households in the Atlantic region are net producers o f the basket of bienes sensibles agricolas, considerably higher than the rural average; for Guatemala, the data suggest that over 60 percent o f households in the Peten region may, in fact, be net producer^.'^ 5.34 The data from El Salvador tell a slightly different story regarding rural versus urban impacts, with a slightly higher proportion o f rural households being net consumers than urban households: 72.1 versus 65.2 percent. I t i s not completely clear why this i s the case - as in general rural households would be expected to produce a greater share o f sensitive agricultural commodities than urban households - and/or whether this pattern might be related to the limitations of the data mentioned above. El Salvador i s a country in which the economic importance o f agriculture has declined dramatically in recent years. One possibility, then, i s that Salvadoran households, whether rural or urban, now tend to be net consumers o f the basket o f sensitive agricultural commodities. 5.35 Another possibility could be related to how rural and urban are defined in the EHPM survey. El Salvador i s a geographically compact and densely populated country, which may limit the usefulness o f the traditional, administrative definitions o f rural and urban used in the survey. Potentially compounding this problem i s that El Salvador has not had a population census since 1992. Combined, the EHPM identification o f rural versus urban, based on administrative definitions and a series o f post-1992 assumptions about populations dynamics, may have led to a blurring o f functional rural-urban differences in the data.15 The main message from the El Salvador data, however, as in the other countries, i s that the proportion o f households that are net consumers - and, thus, that are expected to benefit from price changes induced b y the DR-CAFTA - s t i l l greatly out-number the proportion o f households that are net producers, both in rural and in urban areas. l4It i s possible that in remote areas such as Peten, the transmission o f price effects may be extremely weak, due to high transactions costs and relatively weak integration with markets. In the case, o f Peten, some analysts have also argued that due to i t s proximity to Mexico, households may have already experienced some (or all) of the impact they will feel from liberalization, through the effects o f NAFTA and informal cross-border trade o f staple crops. l5 The Salvadoran statistical agency, DIGESTYC, estimates that approximately 55 percent o f El Salvador’s population i s now urban, based on their population projections and using traditional administrative definitions o f rural versus urban. In contrast, a new World Bank study on rural development i n Latin America and the Caribbean (2005) that the European Union’s definition o f rural and urban, based on population density and geographic distance from major urban centers, estimates that roughly 80 percent o f the Salvadoran population could be classified as urban. 138 CHAPTER V. Policy Approaches to Managing the Economic Transition: Diflerences Across the Welfare Distribution. 5.36 The country case studies also indicate a common pattern o f likely “winners” and “losers” across the welfare distribution; specifically, a higher percentage o f the non-poor are expected to benefit than the poor. In Nicaragua, for example, 94.8 percent o f households in the wealthiest quintile are net consumers, as compared to 85.7 percent o f households in the poorest quintile (Table 4). In Guatemala, the 92.0 percent o f households in the wealthiest quintile are net consumers, as opposed to 78.5 percent in the poorest quintile. The mirror image o f these patterns i s that a higher proportion o f poor households are net producers and, thus, likely to be adversely affected b y DR-CAFTA-related price changes. In Guatemala, for example, 20.8 percent of households in the poorest quintile are net producers, compared with only 7.5 percent o f households in the wealthiest quintile. 5.37 In El Salvador, this pattern i s less strong on the net consumer side, with the highest proportion o f net consumers found in the third and fourth quintiles. Nonetheless, the pattern i s s t i l l seen clearly among net producers; at 7.5 percent, the percentage o f net producing households in the poorest quintile i s roughly 1.5 times higher than the percentage o f net producing households in the wealthiest households. Again, i t i s important to highlight that non-responses in the production for home consumption as well as the consumption expenditures module appears to be affecting the point estimates o f net consumers and net producers in El Salvador - although probably not the overall qualitative findings. This problem appears to be the strongest among households in the poorest quintile where the data seem to suggest that over 70 percent o f all households are neither net consumers nor net producers (Le., neither positively nor negatively affected b y price changes in sensitive agricultural commodities). Prospective Gains to Net Consumers and Losses to Net Producers 5.38 Due to differences in household patterns o f consumption and production, net consumers (net producers) stand to gain (lose) different amounts across countries - and within different sub-groups in a particular country. This can be seen clearly in Table 5, which presents the estimated gains to net consumers and estimated losses to net producers in Nicaragua, Guatemala, and El Salvador. Expected gains and losses are resented at the national level, for rural and urban areas and across the welfare distribution. 18 In Nicaragua, i t i s estimated that if all bienes sensibles agricolas were liberalized instantaneously, the 90.2 percent o f households that are net consumers would experience a benefit o f 3.8 percent o f per capita consumption on average. This compares with a an expected benefit o f only 0.5 percent o f per capita consumption for net consumers in Guatemala (83.8 percent o f households), and an intermediate benefit o f 2.0 percent of per capita income predicted among net consumers in El Salvador (no less than 68.2 percent o f Salvadoran households). Monge, l6 Castro-Leal, and Saavedra (2004) present estimated gains to net consumers and losses to net producers at the national level, as well as for rural and urban areas. They do not, however, report expected gains and losses by quintile. 139 CHAPTER V. Policy Approuches to Munuging the Econoniic Trunsition: Table 5: Estimated gains by net consumers and losses by net producers of the basket of sensitive 1 1 1; agricultural commodities in Nicaragua, Guatemala, and El Salvador, b y Rural-Urban and b y Quintile I I I I Nicaragua Guatemala El Salvador Gains by Losses by Gains by Losses b y Net Net Net Consumers Producers Consumers Producers (%of p/c ( % o f p/c ( % o f p/c ( % o f p/c Group consumption) consumption) consumption) consumption) income) income) All Country -0.8 0.5 -2.3 Rural 3.3 -1.7 0.6 -2.3 2.0 -2.3 Urban 4.2 -0.2 0.4 -2.3 2.0 -2.1 Poorest Quintile da da 0.8 -2.2 1.4 -3.4 da da 0.6 -2.0 2.0 -2.2 2”d Quintile 3rd Quintile da da 0.5 -1.8 2.2 -1.9 da da 0.4 -2.8 2.0 -1.0 4th Quintile Richest Quintile da da 0.2 -3.2 1.8 -0.7 5.39 Expected losses among net producers also differ across countries. In the case of Nicaragua, expected losses are relatively low, on average: only 0.8 percent o f per capita consumption, on average (for the 8.8 percent o f households who are net consumers). This compares with estimated losses o f between 2.2 and 2.3 percent o f per capita consumption (or income) among net producers in Guatemala (15.7 percent o f households) and El Salvador (4.1 percent of households), respectively. 5.40 Patterns of gains and losses differ somewhat across rural and urban areas within a country as well (Table 5). The clearest example o f this appears to be in Nicaragua where gains to net consumers are estimated to be as high as 4.2 percent o f per capita consumption in urban areas, compared with 3.3 percent in rural areas. At the same time, prospective losses to net producers are expected to be higher among rural than among urban households. Indeed, net producers in rural areas are expected to lose the equivalent o f 1.7 percent o f per capita consumption on average, due to DR-CAFTA-related price changes, compared to only 0.2 percent of per capita consumption among net producers in urban areas. Differences in gains and losses across rural and urban in habitants are estimated to be much smaller, and at times non-existent, in Guatemala and El Salvador. Moreover, in contrast to Nicaragua, the small differences in estimated benefits to net consumers in Guatemala slightly favor rural households. In all three countries, gains to “winners” and losses to “losers” vary noticeably across different locations within rural and urban areas - again due to location-specific differences in production and consumption pattern^.'^ ” See Portner (2003), Monge, Castro, and Saavedra (2004), and Marques (2005) for details. 140 CHAPTER V. Policy Approuches to Munuging rhe Economic Trunsition: 5.41 While n o data i s reported for Nicaragua on the expected size of gains b y net consumers and losses b y net producers across quintiles, the Guatemala and El Salvador case studies do not show somewhat different patterns o f gains and losses as a function o f wealth. In Guatemala, the largest expected benefits - albeit s t i l l relatively small - are expected to accrue to the poorest net consumers, while in El Salvador the data suggest that middle-income net consumers stand to benefit most. In contrast, while the data from El Salvador suggest that the poorest net producers stand to lose the most, the Guatemalan data indicate that net producing households in the top two quintiles stand to lose the most as a percentage o f their per capita consumption. Whether across regions or across quintiles, the precise nature o f expected gains and losses by households in Nicaragua, Guatemala, and El Salvador are determined - sometimes in quite complex ways - by country- and location specific patterns o f household production and consumption. In this context, the contrasting distributional impacts o f liberalizing trade o f maize and poultry are shown in B o x 3. Box 3: The distribution of Losses and Gains to Different Sensitive Commodities in Guatemala: the differential impacts of corn versus poultry liberalization. Portner (2003) examines the predicted effects o f individual commodities by consumption percentile for Guatemala to better understand: (i) the distributional effects o f liberalizing sensitive agricultural commodities and (ii) the role for public intervention to mitigate the poverty and social impacts o f the DR-CAFTA. His analysis points to a tremendous heterogeneity o f impacts across different commodities. I t also points to the political economy o f reform o f different commodities. Box Figures 1 and 2 present contrasting patterns of estimated impacts on per capita consumption associated with liberalizing two different commodities - maize and poultry meat - in Guatemala." These figures show, b y percentile o f per capita consumption, (i) the median effect on per capita income (shown by the x-s); (ii) the interval between the 5'h and 95'h percentile o f effects (indicated by the solid vertical lines); and (iii) the maximum and minimum predicted effects of removing trade protection (indicated with the upper and lower solid lines, respectively). As can be seen from the x-s in Box Figure 1, the average estimated effect o f eliminating trade protection on maize i s positive across the consumption distribution - although the size o f the net impact i s very small, on the order o f 0.10 percent o f per capita consumption. A t the same time, the graph shows that there i s considerable heterogeneity o f expected outcomes across net consumer and net producer households, even among the poor. For example, among the poorest 30 percent of households in the consumption distribution, there are a substantial number of households that are net consumers o f maize, that are predicted to experience significant gains relative to their current per capita consumption. Indeed, the expected gains to per capita consumption due to maize liberalization, at least in percentage terms, are actually largest among the poorest households. A t the same time, however, a considerable number o f the poorest households are net producers o f maize who seem likely to experience relatively large losses. Indeed, the largest losses (as a percentage o f per capita consumption) appear likely to be experienced by the poorest 20 percent o f households. These findings frame a central challenge for policy makers - how to assist net producers households deal with declining producer prices, without forfeiting the benefits to be accrued by the majority o f net consuming households. '* I t should be noted that because Guatemala data do not allow one to differentiate between the production and consumption of yellow and white maize, Portner (2003) examines the effects o f liberalizing trade i n all maize. As such, Portner's calculations will overestimate (to an undetermined degree) the impacts o f maize price changes due to DR-CAFTA among those households that produce and/or consume white maize. 141 CHAPTER V. P o k y Approuches to Munuging the Economic Trunsirion: Box Figure 1: Estimated Gains and Losses of Liberalizing Maize, 5 I n contrast to the situation for maize, analysis of eliminating trade protection for poultry meat provides a striking picture of production specialization (Box Figure 2). On average, positive welfare gains to liberalizing trade in poultry are predicted - although, again, the magnitude i s very small (on the order o f 0.01 percent o f per capita consumption). Indeed, the vast majority o f households will neither gain nor lose significantly from liberalization of poultry. A t the same time, the large downward spikes pictured at the 70thpercentile and above, suggest there are a few, relatively wealthy producers o f poultry who stand to lose significantly from liberalization o f poultry. (Similar patterns are also seen in the case o f beef.) While these patterns o f large losses among a handful of relatively wealthy households may not call for trade adjustment assistance on poverty or basic welfare grounds, i t does suggest that for some commodities there may be small numbers of (potentially politically influential) producers who will be opposed to liberalization, who might try to lobby for extending grace or liberalization periods as grace periods end, or for other types of special support. Box Figure 2: Estimated Gains and Losses o f Liberalizing Poultry Meat, 1 Source: Portner (2( Average Impacts 5.42 Adding up and averaging the expected gains among net consumers and expected losses among net producers in each country, i t can be that these societies w i l l benefit overall 142 CHAPTER V. Policy Approuclzes to Munaging the Economic Trunsirion: as a result o f the price changes associated with DR-CAFTA. The size of the average gains differ considerably across countries and, sometimes, socio-economic groups within countries. This reflects both the composition of net consumers and net producers in each society as well as sizes of gains and losses among these groups. 5.43 Benefits related to price changes are expected to be greatest in Nicaragua - equivalent to 3.0 percent o f per capita consumption, on average (Figure 4). Average benefits are estimated to be higher in urban than in rural areas, equivalent to 4.0 and 1.6 percent of per capita consumption, respectively. Static, price-related benefits are estimated to be much smaller in Guatemala, equivalent to only 0.03 percent o f per capita consumption on average. Indeed, households in rural areas are expected to experience small welfare losses - about 0.12 percent o f per capita consumption, on average. Estimated average gains in El Salvador are also small, although considerably larger than those estimated for Guatemala. Average gains are expected to be about 1.3 percent o f per capita income, with average gains to rural and urban households being nearly identical.'' Figure 4: Average Estimated Gains (Losses) from CAFTA-related Price Changes in Nicaragua, Guatemala, and El Salvador Sources: Portner (2003), Monge, Castro, and Saavedra (2004), and Marques (2005) 5.44 The ways in which DR-CAFTA affects different socio-economic groups across the income/consumption distribution, on average, also differs across countries - although not necessarily in ways that would be predicted, ex-ante. In Nicaragua, for example, there i s no clear pattern of average benefits across the welfare distribution. Average benefits in the l9 As noted above, it i s not clear the extent to which similarities i n benefit patterns in rural and urban El Salvador are due to actual similarities on the ground as opposed to limitations of the data set and the current administrative definitions o f urban and rural. 143 CHAPTER V. Policy Approaches to Munuging the Economic Trunsition: poorest quintile are slightly above the national level, and essentially equal to those in the 3'd and 4th quintiles (Table 6). In contrast, in Guatemala, expected benefits are largest, on average, among households in the lowest quintile, and they are slightly negative among households in the highest two quintiles. (The latter, while quite small as a percentage o f per capita consumption, reflects mostly expected losses among relatively wealthy producers o f poultry and beef.) In El Salvador, with the exception o f the poorest quintile, for whom average gains appear to be close to zero, there are no obvious patterns in the size o f benefits across the welfare distribution. And, as discussed earlier, i t is not clear the extent to which the benefit figure for the poorest quintile reflects real benefits as opposed to under-reporting (or non-reporting) problems in the data. Nicaragua Guatemala El Salvador Average G a i d o s s Average GaidLoss Average G a i d o s s Group (% o f p/c consumption) (% of p/c consumption) (% of p/c income) All Country 3.0 0.03 1.3 Rural 1.6 -0.12 1.3 Urban 4.0 0.19 1.2 Poorest Quintile 3.3 0.21 0.1 Znd Quintile 2.5 0.01 1.4 3rd Quintile 3.3 0.08 1.7 4th Quintile 3.3 -0.06 1.6 Richest Quintile 2.8 -0.01 1.4 Summary 5.45 New analysis o f the first-order welfare impacts o f DR-CAFTA in Nicaragua, Guatemala, and El Salvador indicates that the vast majority o f households in these countries stand to gain from the price changes associated with liberalizing trade in the so-called sensitive agricultural commodities. More specifically, 90 percent o f Nicaraguan households, 84 percent o f Guatemalan households, and 68 percent o f Salvadoran households, respectively, were found to be net consumers o f the basket o f sensitive agricultural commodities who can be expected to benefit from DR-CAFTA-related price changes. Only about 9 percent o f Nicaraguan households, 16 percent o f Guatemalan households, and 5 percent o f Salvadoran households were found to be net producers o f the basket o f sensitive commodities and, thus, would be expected to experience welfare losses. 144 CHAPTER V. Policy Approaches to Munaging the Economic Transition: 5.46 While the vast majority o f people in these three countries stand to gain from liberalization o f the sensitive agricultural commodities, the evidence suggests that the number o f people who could be adversely affected b y DR-CAFTA-related price changes i s not trivial - at least in the absence o f measures to mitigate those impacts. The proportion o f net producers estimated for each country implies, for example, that roughly 260,000 (out o f 6.5 million) Salvadorans, 484,000 (out o f 5.5 million) Nicaraguans, and 1.9 million (out o f 12.3 million) Guatemalans would be negatively affected b y price effects of DR-CAFTA. 5.47 The analysis also suggests that specific sub-groups face higher-than-average risks o f experiencing negative impacts o f price changes in the absence o f complementary policy measures. In Nicaragua, for example, nearly 20 percent o f the rural households are expected to be negatively affected b y DR-CAFTA-related price changes, while nearly a quarter o f rural households are expected to experience adverse impacts in Guatemala. Even these averages conceal considerable variation in the impacts o f DR-CAFTA within rural areas. In the Atlantic Region o f Nicaragua, for instance, roughly 34 percent o f rural households are net producers o f the basket o f bienes sensibles agricolas and will, thus, experience negative impacts arising form their liberalization; in rural Peten, in Guatemala, over 60 percent o f households may be exposed to negative price effects, on net. 5.48 While the average estimated size of losses to net producers are relatively small - about 2.2-2.3 percent o f per capita consumptiodincome in Guatemala and El Salvador - such impacts may not be trivial for the poorest Central Americans. Moreover, at least in El Salvador, the evidence suggests that those losses among net producing households in the poorest quintile could be as much as 3.4 percent o f per capita income. As with patterns o f net consumers and net producers, the actual size o f gains and losses that households experience w i l l be determined in important ways b y local patterns o f production and consumption. Hence, despite similarities in patterns o f impacts across the Central American countries, i t w i l l be important to take local circumstances into account in designing policies and programs to ensure that all Central Americans w i l l be able to benefit from DR-CAFTA in the medium- to long run. This point w i l l be discussed at further length in the following section. 5.49 Finally, the country case evidence suggests that while the average gains associated with liberalizing the sensitive agricultural commodities i s positive in all three countries, the static gains associated with the price changes may not be large. The largest static gains appear likely in Nicaragua, where average gains are estimated at 3.0 percent o f per capita consumption. At an estimated 1.3 percent o f per capita income, the estimated gains in El Salvador are smaller. They are even smaller in Guatemala, where average gains are estimated to be less than one-tenth o f one percent of average per capita consumption. The general- equilibrium static analysis o f Nicaragua discussed in the previous chapter and conducted b y Bussolo and Niimi (2005) also predicted rather small effects on both average incomes and poverty rates. These analyses thus suggest that the largest benefits from DR-CAFTA are likely to come from dynamic gains associated with increased foreign direct investment and related improvements in technology and productivity, increased employment, and higher levels of economic growth (see Chapter 4). This in turn highlights the prospective importance not only o f working to mitigate any negative impacts o f DR-CAFTA-related price changes, 145 CHAPTER V. Policy Approaches to Managing ?heEconomic Transition: but also o f investing in people and places in Central America so as to maximize all people’s ability to participate in emerging opportunities arising from the DR-CAFTA. 5. Alternative Approaches to Mitigating the Adverse Impacts of DR-CAFTA 5.50 As discussed in Section 2, DR-CAFTA includes a wide range o f provisions for dealing with the liberalization o f sensitive agricultural commodities, including grace periods for initiating liberalization, extended phase-out periods for tariffs, interim quotas and/or phase- downs o f TQRs, and special safeguard measures to protect local farmers from undue harm due to increased agricultural imports under the Agreement. While the exact provisions were negotiated country-by-country and, therefore, differ somewhat across the region, collectively the Central American countries were successful in negotiating generous timetables for reducing production on their bienes sensibles agricolas. As shown earlier (Box l), phase-out periods are as long as 20 years in some cases. DR-CAFTA has, thus, built into the Agreement itself a type o f safety net for those who might be adversely affected b y liberalization o f sensitive agriculture commodities: a prolonged and predictable timeframe over which producers can undertake the necessary economic adjustments. Quick Liberalization Combined with Compensatory Transfers vs. Phased Reduction of Trade Protection: Can Countries Do Better? 5.51 While the grace periods and extended phase-out periods for tariffs and quotas do provide reasonable protection to producers o f sensitive crops, the approach negotiated under DR-CAFTA also has some economic costs. Specifically, although phasing o f reforms has the benefit o f giving producers an extended period to make the necessary economic adjustments, i t also deprives consumers for that same extended time period, the benefits associated with lower prices for key agricultural staples. 5.52 One alternative to the negotiated approach would simply be to liberalize trade in the sensitive agricultural quickly as assumed in the case studies above. This would provide immediate benefits to consumers, but as discussed above would impose costs on net producers o f sensitive goods, many o f whom are poor staple crop farmers in rural areas o f Central America. Given the painstaking negotiations undertaken to provide for phasing o f trade reform, specifically to protect these groups, i t i s unlikely that this approach would be taken in practice. So, i s there an alternative which would allow consumers to benefit quickly while producers were given a reasonable period for making the economic adjustment? Indeed. Such an approach would involve quick liberalization o f trade in the sensitive agricultural commodities, coupled with the provision o f compensatory transfers, for some finite time period, to those who are expected to be negatively affected b y DR-CAFTA in the short-term. 5.53 In principle, quick liberalization coupled with transfers targeted to households affected negatively b y DR-CAFTA, would be more efficient economically than the approach actually negotiated under the Agreement, as consumers would not have to wait up to 20 years to reap the full benefits o f lower prices. Indeed, real food prices have already been declining in Central America in recent years, and these declines in prices have themselves contributed in important ways to poverty reduction in Nicaragua and El Salvador (see, for example, World 146 CHAPTER V. folic? Approaches to iManaging the Economic Trunsition: Bank 2003e; World Bank 2004~).Coupling well-designed transfer programs with quick liberalization would thus be a way to enhance households’ purchasing power - with important welfare impacts on the poor - while simultaneously providing producers with financial support to help them manage the economic transition. 5.54 T o be effective in practice, several conditions have to hold, however. First, implementing a program o f compensatory transfers requires budgetary resources (that are not required to implement the approach negotiated under the DR-CAFTA). To ensure that producers o f sensitive commodities are protected and that consumers reap the benefits o f lower staple prices would require a commitment o f fiscal resources. Second, to be effective and efficient, i t would require that the county-level institutions have adequate administrative capacity to implement a transfer programs, as well as the ability to target effectively interventions t o adversely affected households. And, third, since the objective point o f any trade-related compensatory transfer program would be to provide temporary assistance, there would have to be transparently and clearly communicated “rules-of-the-game”, including a finite time-horizon for assistance, to ensure that the transfers function as support for trade adjustment rather than becoming a “permanent” rural entitlement program. Options for Compensatory Transfers 5.55 If the DR-CAFTA countries in Central America were to pursue quick liberalization coupled with a system o f compensatory transfers, there i s a wide range o f possible compensation and safety net-type programs which countries could choose from including, for example, “decoupled” income support payments to farmers, conditional cash transfers (CCTs), cash-for-work or food-for work (Le., workfare) program, or single compensation payments, among others (Castaiieda 2004). Indeed, several o f these programs have been or are currently being implemented with some success in Latin America and beyond: Decoupled income payments to farmers, which de-link payments from current production and prices, have been used recently in several countries including in the European Union (EU), the United States (US), Turkey, and Mexico. Mexico’s decoupled income support program, PROCAMPO, was initiated in 1994 to provide support to farmers who were expected to adversely affected b y price changes occurring under NAFTA. Conditional cash transfer programs, which condition cash payments on family investments in children’s human capital development, have been recently introduced in a number o f Latin American and Caribbean countries including Brazil, Colombia, Honduras, Mexico, Nicaragua, Jamaica, as well as outside the region, for example, in Turkey. Workfare programs have been implemented worldwide to address problems of unemployment, including over an extended period o f time in Argentina and in response to periodic employment shocks (e.g., during the recent coffee crisis in Nicaragua).20 5.56 Not all possible categories o f support provide equal protection or show equal promise in the context o f DR-CAFTA, however. While workfare has been a staple o f social assistance ~ ~~ *I’ Spectrum, Fall 2003; World Bank 2005. 147 CHAPTER V. Policy Approaches to Managing the Economic Transition: in many developing countries, such programs are better suited for employment than income shocks. Yet, given that most o f the sensitive agricultural commodities are staple crops produced on family farms, the income effects should significantly dominate employment effects, weakening the likely impacts o f workfare type interventions (World Bank 2005~). Similarly, to be effective, support should enhance a household’s ability to make the necessary economic transition, which in many cases w i l l take a multiple production seasons to complete. In this context, and in the absence of strong rural capital markets in Central America, one- time payments are unlikely to provide sufficient support to successfully implement the necessary transition. While decoupled income payments to farmers and conditional cash transfers to households respond to somewhat different needs o f poor, rural households, each intervention shows some promise to assist households in weathering the economic transition associated with DR-CAFTA. Decoupled income support payments. 5.57 “Decoupling” can be defined broadly as the replacement o f agricultural support programs that are based on current or future production and prices with direct payments that are based on clearly defined and fixed historical measures (Baffes and de Gorter 2003). In principle, decoupling income transfers avoids creating the economic distortions caused by many traditional agricultural support programs through their influence on domestic prices, input use, technology choice, or current or future production decisions. By not distorting production and, in turn, trade, properly designed decoupled transfer programs also fall into the “Green B o x category o f income support programs as agreed under W T O rules (Box 4). Box 4: Ensuring the Compensation Measures are Consistent with WTO Agreements I f appropriately designed and implemented, decoupled direct income payments to farmers as well as income safety net programs like conditional cash transfers conform to allowable (“Green Box”) interventions under existing multilateral trade agreements. To be allowable under WTO rules, such programs are required to adhere to the following criteria: Decoupled Direct Income Payments. Under the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) in 1994 there was an agreement about reduction in and expenditure limits on domestic agricultural subsidies, with some exemptions. The exemptions included domestic support measures that have no, or at most minimal, distorting effects on trade and production. If support i s provided via public funding and not via transfers from consumers, and if i t does not have the effect of providing price support to producers, then direct payments to producers can then be used if they meet the following conditions: Eligibility for such payments shall be determined by clearly-defined criteria such as income, status as a producer or landowner, factor use or production level i n a defined and fixed base period; The amount of such payments in any given year shall not be related to, or based on, the type or volume of production (including livestock units) undertaken i n any year after the base period; The amount o f such payment in any given year shall not be related to, or based on, the prices, domestic or international, applying to any production undertaken i n any year after the base period; The amount of such payment in any given year shall not be related to, or based on, the factors of production employed in any year after the base period; N o production shall be required in order to receive such payments (WTO 1994). 148 CHAPTER V. Policy Approaches to Munaging the Economic Transition: Safe9 Net Programs. According to Annex 2 o f GATT rules, another type o f direct payments that i s permitted includes government financial participation i n income insurance and income safety-net programs. These programs must meet the following criteria: Eligibility for such payments shall be determined by an income loss, taking into account only income derived from agriculture, which exceeds 30 percent of average gross income or the equivalent in net income terms (excluding any payments from the same or similar schemes) in the preceding three-year period or a three-year average based on the preceding five-year period, excluding the highest and the lowest entry. Any producer meeting this condition shall be eligible to receive the payments. The amount of such payments shall compensate for less than 70 percent o f the producer’s income loss in the year the producer becomes eligible to receive this assistance. The amount o f any such payments shall relate solely to income; i t shall not relate to the type or volume o f production (including livestock units) undertaken by the producer; or to the prices, domestic or international, applying to such production; or to the factors of production employed. Where a producer receives i n the same year payments under income insurancetsafety-net provisions and under provisions for relief from natural disasters, the total o f such payments shall be less than 100 per cent of the producer’s total loss. Source: WTO (1994), IATRC (2001), as cited in CasteAeda (2004). 5.58 Using decoupled income supports to farmers is, in essence, the approach Mexico adopted under NAFTA. Although Mexico, like the D R - C A F T A countries, had negotiated extended grace and phase-out periods for protection o f sensitive agricultural commodities, the Government has never invoked those provisions, opting rather for a de facto quick liberalization and transfers. Specifically, in 1994, Mexico introduced a “decoupled” income support program, PROCAMPO, to assist farmers who were expected to be adversely affected as a result o f agricultural sector liberalization undertaken under NAFTA. The program was designed as a 15-year transition and i s expected to be terminated in 2008. 5.59 PROCAMPO provides eligible agricultural producers with a fixed payment per hectare. Eligible producers are those that cultivated one or more o f nine crops - corn, sorghum, beans, wheat, barley, cotton, cardamom, soybeans, or rice - in one o f the three agricultural cycles (autumn-winter or spring-summer) prior to August 1993. Payment goes to whoever i s cultivating the property, regardless of whether i t i s the owner, a renter, or sharecropper. Producers with less than one hectare are paid for one hectare, and there i s a maximum eligibility o f 100 hectares for irrigated land and 200 hectares for rain-fed land. Since producers on irrigated land can cultivate for up to two seasons per year, they are eligible for payments up to twice a year; producers on rain-fed land are eligible for only one payment per year.21 Payments are decoupled from current cultivation - although PROCAMPO does impose a restriction that land must either be used in crops, livestock or forestry, or be part o f an approved environmental program (beneficiaries are free to choose among these options). 5.60 In addition to conforming to WTO rules, decoupled transfer payments have the benefit of addressing specifically the income “shock” resulting from liberalization of sensitive I n 1997, payments averaged U S $67 per hectare and U S $317 per recipient (Cord and Wodon 2001). 149 CHAPTER V. Policy Approuches to Munuging the Economic Trunsition: agricultural commodities. I fimplemented for a limited time period, decoupled transfers also provides a clear and predictable timeframe under which producers can, in principle, make the necessary economic adjustments (as under the phased liberalization negotiated under D R - CAFTA). Recent impact evaluation o f PROCAMPO in Mexico also indicates that the program has conferred a number of positive impacts - protecting recipients against negative income effects, generating positive income multipliers for many farm families, and raising household consumption and nutritional status. These in turn have contributed to lower poverty rates among ejido sector households (Box 5). Box 5: PROCAMPO: Positive Impacts on Income, Consumption, and Poverty Recent impact analysis of PROCAMPO indicates that the program has had a number of positive benefits - from increasing household incomes and protecting recipients from negative income shocks, to increasing household consumption, to contributing to poverty reduction among rural agricultural households. For example: Income effects. PROCAMPO payments appear to have generated income multiplier effects among many o f its recipients, apparently due to i t s effect on increasing liquidity among agricultural producers. The analysis indicates that, on average, for every peso received, households generate incomes that are 1.5 to 2.6 times higher (Sadoulet, de Janvry, and Davis 2001; Cord and Wodon 2001). Multipliers are highest among households with medium and large farms, non-indigenous households, households with fewer adults, and those farming on irrigated land. PROCAMPO also appears to provide a good counter-cyclical tool in the face of economic downturns. I n 1994, for instance, incomes of PROCAMPO recipients increased by about 18 percent, while incomes of otherwise similar households that did not receive PROCAMPO declined by about 4 percent (Sadoulet de Janvry, and Davis 2001). Poverty and Income Distribution. Given its special acreage provisions, PROCAMPO appears to provide relatively larger benefits to poor farmers - as a percentage of household income (Cord and Wodon 2001). While in 1997 transfers represented 8 percent of household income in the ejido sector as a whole, it represented 40 percent of household income among those in the poorest decile. Moreover, analysis of panel data indicate that PROCAMPO payments reduced the probably o f being poor among the ejido population by 10 percent (Cord and Wodon, 2001). A recent World Bank Poverty Assessment for Mexico found, as well, that in spite of high land concentration in Mexico, the benefit-incidence of PROCAMPO i s slightly progressive overall (World Bank, 2003d). Food Consumption and Nutrition: Evidence also indicates that PROCAMPO has contributed to increased food consumption among recipients, raising households’ calorie intake and nutritional diversity (Ruiz-Arranz et a1 2002; Davis et a1 2002). 5.61 At the same time, the evidence suggests that PROCAMPO has not contributed to significant improvements in farm sector efficiency (World Bank 2003d), nor has i t been particularly effective in inducing farmers - at least smallholders and producers o f rain-fed crops - to make the necessary economic transition to more remunerative means o f production (Sadoulet, de Janvry, and Davis 2001). This appears to be due, in part, to the fact that the poorest recipients have tended to use transfers disproportionately for consumption purposes rather than for investment. The relative lack o f impact on pattern o f rural production also appears to be due to insufficient reforms and investments in complementary factors o f production (e.g., energy, transportation infrastructure, etc.) that affect the cost structure and competitiveness o f the rural sector more broadly (World Bank 2003d). 150 CHAPTER V. Policy Approaches to Managing the Econotnic Trunsition: Conditional cash transfers. 5.62 Among the fastest growing - and most successful - category o f rural poverty alleviation programs in Latin America (and elsewhere) are conditional cash transfers (CCTs). CCTs provide cash transfers to poor families residing in selected rural areas, conditional on these families making specific investments in their children’s human development - e.g., sending school-age children to school, obtaining regular health check-ups, ensuring that children under five years o f age are vaccinated, etc. The rationale for this i s that poor rural families, even if they recognize the long-term benefits o f education and (preventative) health measures, do not have the resources to cover the costs of school (e.g., books, uniforms, etc) or healthcare andor can not afford to afford the opportunity cost o f schooling for school-age children. Cash transfers thus have the dual objective o f providing immediate short-term assistance to families to improve their basic consumption, health, and nutrition and of supporting long-term human development children to reduce the chances o f the inter- generational transmission o f poverty. 5.63 Although CCT-related transfers focus on consumption and human capital investment rather than production support for rural families, they may be appropriate for compensating rural households for loss o f employment or income resulting from tariff reductions and the loss o f trade protection associated with DR-CAFTA. Decoupled payments, such as those provided under PROCAMPO, compensate farm managers, but not necessarily hired labor, who may also be affected b y the loss o f trade protection. Moreover, decoupled producer supports function best where there are good records o f land ownership or use (Baffes and de Gorter 2003; Castaneda 2004). Where hired labors as well as self-employed farmers are affected b y trade liberalization, or where records regarding ownership or use o f land are weak or non-existent, appropriately targeted CCTs may provide a viable alternative approach to supporting affected households. In addition, in the case o f DR-CAFTA countries, C C T programs already exist; two countries - Nicaragua and Honduras - already have targeted programs operating and a third - El Salvador - i s in the process o f developing one. In this context, using CCTs to compensate DR-CAFTA-affected households might have the additional benefit o f being able to build on existing programs, rather than requiring development from scratch o f a new transfer program (and related institution). 5.64 As with PROCAMPO, recent impact evaluations undertaken for CCT programs in Mexico and Nicaragua show that they have important benefits to recipient families - increasing families’ consumption and nutrition, increasing children’s school enrolments, and improving preventative health outcomes (Box 6). 151 CHAPTER V. Policy Approaches to Managing the Economic Trunsition: Box 6: Conditional Cash Transfer Programs - Strengthening Education, Health, and Nutrition Outcomes among the Poor Recent evaluation results from two conditional cash transfer programs in Latin America - PROGRESA (Oportunidades) i n Mexico and the Red de Proteccidn Social (RPS) i n Nicaragua, show that conditional cash transfers are an effective instrument for improving and protecting consumption while increasing the human capital o f poor in poor households. Specifically: Increasing and Protecting Consumption. Evidence indicates that consumption have grown faster for households participating i n conditional cash transfer programs than for similar households who did not participate. In Mexico, for example, the average consumption level i n PROGRESA households increased rapidly (14 percent), after more than a year o f program operation median food expenditure was 11 percent higher i n program participant than in control group households. In Nicaragua, control households experienced a sharp decline i n consumption due i n part to low coffee prices and a drought, whereas the RPS provided some measure o f protection in the face o f a shock; average per capita household expenditures in RPS areas did not change over the same period. Improving Education. Conditional cash transfer programs have raised enrollment rates for both boys and girls. In Mexico, primary school enrollment rates increased around 1 percentage point from a high pre-program level o f about 90 percent. At the secondary school level, enrollment rates rose 7.2-9.3 percentage points for girls from baseline enrollment rates o f 67 percent and from 3.5-5.8 percentage points for boys from a baseline o f 73 percent. In Nicaragua, program impacts are even more impressive. Average enrollment rates o f children ages 7- 13 in grades 1 to 4 i n treatment areas increased nearly 22 percentage points as a result o f the program, from a low starting point of around 70 percent. Program impact on attendance rates are more mixed. In Nicaragua, the RPS produced an increase o f 30 percentage points in the share o f children who had fewer than six unexcused absences during a two-month period. Strengthening Child Health and Nutrition. Evaluations show improvement in health and nutrition too. Growth- monitoring visits o f PROGRESA beneficiaries up to three-years-old have increased between 30-60 percent, and beneficiaries up to six years old have a 12 percent lower incidence o f illness compared with control group children. In Nicaragua, around 60 percent o f children under three-years-old participated in nutrition monitoring before the RPS was implemented. After a few months of program operation, more than 90 percent of children in RPS areas benefited from nutrition monitoring compared with 67 percent in control areas. The RPS increased timely immunization among children 12-23 months old by 18 percentage points. Source: Rawlines and Rubio (2003). World Bank 2005b 5.65 As in the case o f PROCAMPO in Mexico, i t i s not clear the extent to which CCTs are well suited to support the economic transition that w i l l be necessary under the DR-CAFTA. A recent evaluation o f the impacts o f the Red de Proteccidn Social (RPS) during the recent coffee crisis in Central America suggests that the effects o f such programs on promoting structural change in rural production may be limited. While the evaluation o f the RPS did show that the program has performed like a crisis safety net, the evidence on whether the RPS enabled coffee households to reallocate their resources in ways that are consistent with the historical downward trends in coffee prices i s more mixed (Maluccio 2004). Program beneficiaries who worked in the coffee sector as laborers were more likely to exit the industry, but self-employed coffee producers were less likely to exit. At the same time, although program beneficiaries living in coffee growing regions reduced total hours worked in agriculture, they increased the role of agriculture in their portfolio-to the detriment of non-agricultural activities. 152 CHAPTER V. Policy Approaches to Munuging the Economic Trunsition: 5.66 As in the case o f decoupled income support payments, i t would be important that in the context o f DR-CAFTA, program benefits to affected households be made only for a limited and clearly specified time horizon, to ensure the greatest possible incentives for households to make the necessary economic adjustments. Moreover, as in the case o f decoupled income supports, to be maximally effective, i t would be important for CCTs to be accompanied by a complementary set o f policies and investments that w i l l enable affected families and their children to take the best advantage o f new opportunities arising out o f the DR-CAFTA.~~ The Potential Fiscal Costs of Compensating those Adversely Affected by CAFTA 5.67 If i t were possible to identify net producer households and the extent o f their losses and to target compensation perfectly, then the fiscal costs o f compensating those negative affected would not be high. Indeed, estimates o f the aggregate annual value o f losses to net producers in El Salvador, Guatemala, and Nicaragua range from 0.01 percent o f GDP in the case o f El Salvador to 0.13 percent o f GDP in the case o f Guatemala. These relatively l o w figures reflect two main factors: first, the share o f net producers in each country i s relative small (from 4.1 percent in El Salvador to 15.7 percent in Guatemala; Table 4); and, second, the average value o f losses b y net producers in each country i s relatively l o w (from 0.8 percent in Nicaragua to 2.3 percent in Guatemala; Table 5). 5.68 The actual fiscal costs o f implementing a compensatory transfer program i s likely to be considerably higher than 0.13 percent o f GDP however - at least if i t entails creating a new program. This i s due to multiple factors, including: (i) that i t i s impossible, in practice, to identify and target program beneficiaries perfectly (i.e., without “leakage” o f resources to recipients who are not intended beneficiaries), and ( ii ) experience from recent decoupled income support and conditional cash transfer programs suggest that the size o f the program benefits may be larger than the average losses o f net producers, at least if regional norms are followed. In addition, any new program entails at least some administrative costs. 5.69 For a variety o f data-related and administrative reasons, i t i s impossible to identify and target net producers perfectly. Indeed, targeted programs commonly make important errors o f exclusion and inclusion in targeted programs; some people are excluded from the program who rightfully deserve to receive benefits, while others are included who are not part o f the intended beneficiary population. In practice, when efforts are made to minimize errors o f exclusion, errors o f inclusion tend to increase, raising the costs o f a program (Coady, Grosh, and Hoddinott 2004). Targeted programs often risk transferring considerable resources to people outside the group o f intended beneficiaries, especially when the targeted group i s geographically disbursed or the targeting criteria are hard to observe, as i s the case with net producers o f sensitive agricultural commodities in Central America. T o illustrate leakage in a targeted program, consider the Mexican experience: The benefits o f the PROGRESA/Oportunidades program in Mexico, which uses a combination o f geographic and household criteria for targeting poor households, are highly progressive, and the program i s considered a well-targeted. Nonetheless, in 2002, 28 percent o f households receiving benefits 22 See Section VI, “Policies and Investments to Ensure the Poor Can Benefit from DR-CAFTA,” below. 153 CHAPTER V. Policy Approaches to Munuging the Economic Transition: were outside the bottom three income deciles, the program’s target population (World Bank 2005a).23 5.70 While average losses among net producers are estimated at no more than 2.3 percent o f per capita consumptiordincome in the three countries analyzed, regional norms regarding benefits from decoupled income support and CCT programs are generally larger. In 1997, for example, transfers from PROCAMPO in Mexico averaged 8 percent o f household per capita income in the target population as a whole (Table 7; Box 5). As can be seen in Table 7, the size o f conditional cash transfers relative to household consumption (income) varies considerably across programs and countries. While transfers average less than 5 percent o f per capita income in the case o f the PRAF program in Honduras, they are as high as 21 percent o f per capita expenditure in PROGRESNOportunidades in Mexico. Table 7: Size of Transfers in Selected Transfer Programs - Decoupled Income Support and Conditional Cash Transfers - in Latin America Progradcountry Number of Subsidy per Transfer Program Budget Beneficiaries (in family per year (as a percent of (in US $ and as a thousands) (US $) household per percent of GDP) capita spending) Decoupled Income Supports PROCAMPO 3,000 3 67 8 $1.1 billion (0.17% of GDP, 2001) Conditional Cash Transfer ProgresdOportunidades 4,200 380 21 $2.3 billion (Mexico) (0.32% of GDP, 200 1) Familias en Acci6n 315 260 15 (of M W ) $83 million (Colombia) (0.12% of GDP) Red de Protecci6n Social 10 236 18 $5 million (Nicaragua) 1 (0.02% of GDP) PRAF 51 110 <5 $8 million (Honduras) 1 (0.2% of GDP) 5.71 What might this imply for the fiscal costs o f a program to compensate net producers adversely affected b y DR-CAFTA in El Salvador, Guatemala, and Nicaragua? O n one level, this question i s impossible to answer, as the costs o f a program are dictated b y any number of political and institutional factors, including decisions about the size o f the transfer, the country’s capacity to target, i t s tolerance for program leakage (errors o f both exclusion and inclusion), and whether the government wants to launch a new program or to build on an existing initiative. Nonetheless, recent experience in the region can provide some guide on the costs o f these types o f programs, given i t s size, the size o f benefits, and so on (Table 7). Moreover, building on this and some assumptions about benefit sizes and leakages, i t i s 23 Consistent with this finding, a recent study on targeting transfers in developing countries found that 62.6 percent of program transfers went to the poorest 40 percent of the population, while 37.4 percent went to the wealthiest 60 percent (Coady, Grosh, and Hoddinott 2004). 154 CHAPTER V. Policy Approaches to Managing the Economic Trunsition: possible to undertake illustrative calculations regarding the possible fiscal costs of a transfer program to compensate those adversely affected b y DR-CAFTA. For example, if program benefits were set at 10 percent o f household per capita consumptiodincome (roughly the middle o f the range o f benefits of programs listed in Table 7), all households that were adversely affected b y DR-CAFTA received benefits, and there was no program leakage, then the estimated annual fiscal costs o f the transfer program would be roughly 0.03 percent of GDP in El Salvador, 0.55 percent o f GDP in Guatemala, and 0.66 percent of GDP in Nicaragua. I f program benefits were set at 10 percent o f household per capita consumptiodincome, all adversely affected households received benefits, and for reasons o f targeting error, 28 percent o f all program beneficiaries had not been adversely affected b y DR-CAFTA (Le., levels o f program leakage were s i m i l a r to those found in PROGRESA/Oportunidades), then the estimated fiscal costs would reach about 0.05 percent o f GDP in El Salvador, 0.76 percent o f GDP in Guatemala, and 0.92 percent o f GDP in Nicaragua.24 Decoupled Income Support vs. Conditional Cash Transfers - Does One Program Approach Dominate the Other? 5.72 The choice o f one or the other type o f transfer program would depend on a number o f factors that are both economic and institutional in nature, and which may differ across countries. Decoupled programs have the benefit o f being designed specifically as producer- side interventions, providing income support directly in response to expected income losses associated with trade liberalization. Given the nature o f the sensitive agricultural commodities to be liberalized under DR-CAFTA, and the fact that these commodities are commonly produced b y self-employed farmers (as opposed to wage laborers), decoupled transfers are also likely to be appropriate and potentially effective in reaching their target constituency. Nonetheless, implementation (targeting) o f decoupled programs requires good cadastral records, and if such records do not exist then efforts would need to be undertaken to establish them, while the transfer program itself would provide incentives in favor o f land titling.25 Also, in spite o f the evidence on the positive impacts o f PROCAMPO on beneficiary- household incomes, the track record on implementation in Mexico and elsewhere i s mixed (Baffes and de Gorter, 2003, Castafieda, 2004). One issue i s that decoupled programs, b y themselves, do not appear to have contributed significantly to economic adjustment among agricultural producers in line with trade-related or other economic changes. This suggests that decoupled programs, if implemented, ought to be undertaken along with other measures - whether technical assistance or complementary investments - that would help to diversify income sources among DR-CAFTA-affected producers. 5.73 In contrast, CCTs have not traditionally been used to support trade adjustment or in response to terms o f trade shocks. Rather, they have been implemented to foster household 24 These calculations do not include the administrative costs of such a program. Moreover, they assume the implementation o f new programs rather than the expansion of existing programs, such as the Red de Proteccih Social in Nicaragua. 25 Strengthening a country’s land rights and landholding records may be an important development objective in i t s own right, and production-decoupled transfers can provide incentives for farmers and other agents to formalize their property titles since such transfers would require proof of sensitive-crop cultivation in the past. 155 CHAPTER V. Policy Approuches to Manuging the Economic Trunsition: investments in human capital among the poor and, through that, long-term poverty reduction. Nonetheless, while CCTs have not been designed to provide assistance to poor farmers during transitory adjustments, recent evidence suggests that these programs can be effective in protecting households from the worst effects of terms-of-trade or related income shocks, including negative effects on household consumption and investments in children’s education, health, and nutrition (World Bank, 2005d). As i s well-documented in the literature, short-term shocks to children’s human capital development can have detrimental long-run impacts on children’s well-being, productivity as adults, and on poverty. Moreover, as CCTs are implemented - or are soon to be so - in several Central American countries, they may have the advantage of providing an existing programmatic and institutional infrastructure upon which policymakers can build. Indeed, to the extent that net producers o f basic grains are already targeted b y existing CCTs, i t would likely be efficient to build on those programs, both in terms of the targeting mechanisms and the fiscal costs o f the program.26 5.74 In short, each type o f program brings with i t i t s own particular strengths (and weaknesses) in the context o f DR-CAFTA. Should the DR-CAFTA countries choose to pursue an approach o f quick trade liberalization, the choice between a decoupled transfer program vs. a conditional cash transfer would likely hinge in part on very practical considerations - that is, on the specific institutional environments in each country and the pre- existing administrative capacity to implement one type o f program or another. Does the country have good cadastral records o f land ownership and/or usage, or can they be developed with a reasonable period o f time? Does i t have (or can i t develop quickly) the capacity and systems to target the programs to DR-CAFTA-affected households in such as way to minimize targeting errors - Le., the exclusion o f adversely affected households and inclusion of non-affected households? In Nicaragua, Honduras, and El Salvador, where CCTs are being operated or under development, can building on the existing programs provide the basis for effective intervention while containing the marginal fiscal costs o f efforts to assist D R - C A F T A affected households? 6. Policies and Investments to Ensure the Poor Can Benefit from DR-CAFTA 5.75 Whether or not DR-CAFTA countries choose to pursue quick liberalization coupled with compensatory transfers, i t w i l l be important for the Central American governments to implement a core set o f complementary policies and investments i f they are to ensure that those adversely affected by liberalization o f sensitive agricultural commodities - and especially those among the poor - are able to benefit from emerging opportunities arising out of the DR-CAFTA. These policies and investments mirror closely the complementary agenda outlined elsewhere in this report - although here the focus i s on more deliberate policies and investments that are targeted to households and regions that are either expected to be particularly affected b y DR-CAFTA or that i s particularly poor at the outset o f the agreement. These policies and investments would focus on facilitating greater economic progress in poor 26 To the extent that countries in the region do not currently operate CCTs, but would benefit from them in terms o f their long-term impacts, DR-CAFTA may provide a window of opportunity for putting i n place a conditional cash transfer program that focus f i r s t on DR-CAFTA-affected households, and then scales up over time to meet i t s longer-term objectives o f reducing structural poverty. 156 CHAPTER V. Policy Approaches to Managing the Economic Transition: regions and greater economic mobility among poor or adversely affected households, including: Strengthening access and quality to basic education Targeting investments in economic infrastructure to poor areas that lowers households’ transactions costs and increases poor people’s economic competitiveness and access to markets Deepening o f rural financial services (both savings and credit) to enable investments in rural enterprises Technical assistance to promote innovation and higher productivity in agriculture as well as diversification o f rural enterprises Public information campaigns, to promote widespread understanding o f DR-CAFTA- related reforms and to create greater certainty in the investment climate 5.76 These areas o f emphasis are highlighted b y several recent W o r l d Bank studies on poverty reduction and on trade. For example, a recent World Bank study o f the impacts o f NAFTA in Mexico found that the poorer, less developed southern states o f Mexico have not benefited from to the same degree that the more developed northern and central states (Lederman, Maloney, and Serven 2005). Empirical analysis of the reasons behind these regional differences in benefits suggests that the southern states o f Mexico have been less prepared to benefit due to the relatively l o w levels o f education, economic infrastructure, and l o w quality o f local institutions. These findings for Mexico mirror in important ways the findings o f recent World Bank Poverty Assessments that examine why the poorest Central Americans are often not able to benefit from economic progress in the region. Poor families commonly lack the education necessary to take advantage o f new or emerging economic opportunities (World Bank 2004d, World Bank 2005~).Moreover, poor rural families often lack sufficient access to markets as well as to rural financial services, either due to large physical distances or to a relative paucity o f economic infrastructure in poor areas. 5.77 Yet, investments in quality education for the poor and in basic economic infrastructure, along with efforts to deepen rural financial services in poor, rural areas would go far to strengthen the capacity o f the poor to take advantage o f new and emerging opportunities arising out o f DR-CAFTA - through increasing their capabilities, b y reducing transactions costs and b y increasing economic competitiveness o f poor people’s enterprises in rural areas. In addition, i t w i l l be important for the region’s governments to carry out information and communication campaigns to promote widespread understanding o f D R - CAFTA-related reforms - especially among the poor and those who are likely to be adversely affected b y DR-CAFTA in the short-term. Making clear the nature o f the forthcoming economic changes and the timeline for implementation would help enormously in creating greater certainty in the investment climate as well as in establishing a known timeframe and appropriate expectations for undertaking the inevitable economic adjustments. 157 CHAPTER V. Policy Appronches to ikfunuging the Econornic Trunsition: 7. Summary and Conclusion 5.78 While the vast majority o f people in Central America are expected to benefit from DR-CAFTA in the medium to long-term, there are at least some people who are at risk o f bearing the costs o f trade-related economic adjustment in the short-to-medium term. Specifically, although the Central American economies are already relatively open, due to unilateral efforts at lowering barriers to trade undertaken in the 1990s (Chapter I I)a,handful o f sensitive agricultural commodities (e.g., maize, beans, dairy, and poultry) s t i l l have significant levels o f protection. Chapter V focuses on quantifying the size o f the potentially affected population and the magnitude o f the potential effects. I t additionally examines alternative policy approaches on how to best assist vulnerable groups to ensure that they can benefit from emerging opportunities arising out o f the DR-CAFTA. 5.79 Given current levels o f protection, the introduction of more trade competition for sensitive agricultural commodities under DR-CAFTA can be expected to lead to lower domestic prices for sensitive commodities in each country - in some cases significantly lower prices. For this reason, DR-CAFTA includes a wide range o f provisions (described in Chapter 111) for dealing with the easing o f trade restrictions on sensitive goods, including grace periods for initiating the removal o f tariffs, extended phase-out periods for tariffs, interim quotas and/or phase-downs o f tariff-rate-quotas, as well as special safeguard measures to protect local farmers from undue harm. Indeed, the Agreement includes extended timetables for reducing protection on sensitive agricultural crops. Phase-out periods are, for some commodities, as long as 20 years and, at least for a few countries, white maize, an important staple crop produced b y the poor, was exempted from the commitments to eliminate tariffs. These provisions in themselves represent important protections for producers o f sensitive crops, giving them an extended timeframe over which to undertake the necessary economic adjustments. 5.80 Given this, what might policymakers expect to be the impacts o f removing barriers to trade in sensitive agricultural commodities under the DR-CAFTA? Three new empirical studies using nationally representative household survey data from Nicaragua, Guatemala, and El Salvador help shed light on this and related policy issues. All three studies apply a comparable net consumer-net producer framework to assess likely first-order impacts on household welfare o f eliminating quotas and reducing to zero tariffs on several sensitive agricultural products, including maize, beans, milk, poultry meat, bovine meat, apples, pork, wheat, and rice. Despite the phasing out o f trade protection negotiated under the DR-CAFTA, these analyses examine expected impacts as ifall tariffs and quotas were going to be removed completely and immediately under the DR-CAFTA. The approach provides useful insights into the first-order impacts o f introducing more competition in the markets for sensitive commodities. I t also provides a useful baseline from which to examine policy options - including some important policy trade-offs implicit in the gradual approach to easing trade barriers negotiated under the Agreement. 5.81 This analysis on Nicaragua, Guatemala, and El Salvador indicates that the vast majority o f households in these countries stand to gain f r o m the price changes associated with removing trade barriers for the "sensitive" agricultural commodities. More specifically, 90 158 CHAPTER V. Policy Approuches to Managing the Economic Trunsition: percent o f Nicaraguan households, 84 percent o f Guatemalan households, and 68 percent o f Salvadoran households, respectively, were found to be net consumers o f the basket o f sensitive agricultural commodities, and as such, can be expected to benefit from DR-CAFTA- related price changes. Only about 9 percent of Nicaraguan households, 16 percent o f Guatemalan households, and 5 percent o f Salvadoran households were found to be net producers o f the basket o f sensitive commodities and, thus, would be expected to experience welfare losses. For El Salvador, a further 27 percent were estimated to remain unaffected due to their essentially negligible gains or losses. Even though potential losers are thus relatively small minorities, nonetheless appropriate attention needs to be paid to ensure that anticipated losses do, not harm the poorest and most vulnerable groups, for which targeted programs aimed at those that may suffer significant welfare losses may be justified. 5.82 While DR-CAFTA has built into i t considerable grace periods and extended phase-out periods for eliminating tariffs and quotas that provide reasonable protection to producers o f sensitive crops over a prolonged adjustment period, this approach i s not without i t s own economic and social trade-offs. While phasing o f reforms provides producers an extended period to make the necessary economic adjustments, i t also deprives consumers for that same extended time period of the benefits associated with lower prices for important agricultural staples. In this context, an alternative (and some might argue more efficient) approach might involve a shorter period o f removal o f trade barriers for the sensitive commodities, coupled with transfers targeted to those adversely affected b y DR-CAFTA in the short-term. In principle, a shorter liberalization period combined with targeted transfers i s more efficient economically than phased removal o f barriers, as consumers do not have to wait up to 20 years to reap the full benefits o f lower prices. Coupling well-targeted transfer programs with quick easing o f trade restrictions could thus enhance households’ welfare in the short-term o n the consumption side while providing producers with a reasonable period o f support to make the economic transition. 5.83 Regardless o f whether the DR-CAFTA countries in Central America choose to pursue this alternative approach, i t i s important to understand the broad options that policy makers can use to mitigate potential income losses arising from declines in commodity prices if extended phase-outs and safeguards are deemed insufficient: (i) “decoupled” income support payments to farmers o f sensitive crops (e.g., as in Mexico’s PROCAMPO program), ( ii) technical assistance programs to farmers o f sensitive crops, (iii) conditional cash transfers (CCTs) to rural families, effective only as poor families make investments in their children’s education, health, and nutrition, and (iv) provision o f public goods (e.g., economic infrastructure, basic education, rural financial services, technical assistance) targeted to households and/or regions that are either expected to be particularly affected b y DR-CAFTA. 5.84 These options can be viewed f r o m two different perspectives. The first i s the institutional sophistication required to implement support programs, recognizing that different approaches w i l l tax the implementation capacity o f Central American countries to different degrees. This criteria recognizes that effective programs w i l l require, inter alia, a viable method o f targeting vulnerable populations, a minimum degree o f know-how among the c i v i l servants o f the implementing public sector agency, the creation o f new government organizations (or transformation o f old ones) and a minimum degree o f independence to 159 CHAPTER V. Policy Approaches to Munuging the Economic Transition: ensure the application o f technical criteria and avoid political interference. The second dimension i s related to whether the program provides incentives (or other support) for broad production diversification, including strengthening the capacity o f families to exploit new income opportunities for off-farm and/or non agricultural activities - which may be critical to ensure greater economic mobility among poor households. Table 8: Options for support programs to potentially affected populations by DR-CAFTA Incentivedsupport for production diversification Low Hinh Low Decoupled Public goods transfers 3 cd 8 .G .3 u o 3 g .3 u c d Uz o High Technical assistance CCTs 5.85 The classification i s useful to assess the requirements and objectives that may be relevant in each country, as the choice o f which type o f support program would be more appropriate should be made on the basis o f country-specific factors (See Table 8). Decoupled transfers require relatively l o w institutional sophistication but offer few incentives for farmers to seek new income opportunities, as demonstrated by the PROCAMPO experience in Mexico. Technical assistance programs place a greater burden on the capacities o f government agencies, while giving incentives for productive diversification (or upgrading), but only within agriculture. Public goods programs require less institutional sophistication by relying on existing institutions for program delivery, while creating conditions for rural inhabitants to diversify economic activities - although programs o f this type may require a strong regional concentration o f potentially affected poor households in order to make economic sense. CCTs require relatively sophisticated new institutional capacity (especially in countries where programs o f this type are not currently being implemented, such as in Costa Rica, Guatemala and El Salvador), although b y strengthening families' human capital, they offer broad support for production diversification. 160 CHAPTER V. Policy Approaches to Muncrging the Economic Transition: Annex 1: Effective Tariff Rates Used in Ex-Ante Impact Analyses for El Salvador, Guatemala, and Nicaragua Table A1.1: Nominal and Effective Tariffs for Sensitive Commodities in Nicaragua (in percent) Products Nominal Tariffs Effective Tariffs Milk 20% 20% Rice 62% 38% Beans 10% 10% White Maize 10% 10% Bovine Meat 15% 15% Poultry Meat 170% 170% Nicaraguan Ministry o f Industrial Development and Trade (Ministerio de Foment0 Industrial y Comercio) Table A1.2: T a r i f f Rates and Levels of Imports o f Sensitive Crops in Guatemala, 2001 Tariff Rates (in percent) Global Weighted Sensitive Crop Quota (MT) Imports Average Within-Quota I Out-of-Quota (MT) Tariff Apples Beans I 15.0 I 15.0 I N o quota I 15.0 BovineMeat I 0.0 I 30.0 I 1,595 I 10,595 1 25.5 Maize (Yellow) 5.0 35.0 501,820 515,912 5.8 Milk I 15.0 I 15.0 I N o quota I 15.0 Pork 15.0 15.0 N o quota 15.0 Poultry Meat 15.0 45 .O 7,000 14,915 30.9 Rice 6.0 36.0 33,435 42,165 12.2 Wheat 1.2 6.0 39 1,322 407,470 1.4 Source: Portner 2003. 161 CHAPTER V. Policy Approuches to il-lunuging the Economic Trunsition: Table A1.3: Effective Tariff Reduction in El Salvador, 2003 Source: Marques 2005. 1/ Central America Tariff Classification 21 In 2003, wheat flour was imported from Guatemala (19,558 MT), Nicaragua (4,763), Honduras (44 MT), and Costa Rica (20 MT) at zero tariff. The 10 percent tariff on U.S. imports will be eliminated during a five-year period under DR-CAFTA. 162 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA Chapter VI. Macroeconomic Policy Implications of DR-CAFTA Abstract 6.1 This paper examines two macroeconomic issues related to DR-CAFTA. The first i s a short- to medium-term issue related to the potential revenue losses associated with the reduction o f import taxes (tariffs) that signatories w i l l have to implement. The existing calculations o f the potential revenue losses are small as a fraction of GDP, but there might be losses nonetheless that would need to be compensated in order to maintain revenues at existing levels, even without considering the fiscal costs o f the so-called complementary agenda. Estimates o f the losses are even smaller when the potential dynamic effects o f D R - CAFTA are considered, although such gains remain a prediction rather than a fact. Moreover, even in the dynamic growth case, the tariff reductions w i l l represent a decline in the level of fiscal revenues as a share o f GDP. The second issue concerns macroeconomic management in the long-term. That is, DR-CAFTA might have an impact on the nature of the synchronization o f business cycles across Central American countries as well as with respect to the U.S. I f DR-CAFTA were to lead to increases in intra-industry trade (as opposed to further specialization across countries and rising inter-industry trade) then this could justify efforts to coordinate monetary policies among DR-CAFTA countries and perhaps with the U.S. The existing empirical evidence suggests that this i s unlikely to occur due to the l o w current levels o f business-cycle synchronization and low levels o f intra-industry trade between the U.S. and Central America. These structural factors, however, might change with time as a consequence o f CAFTA. Nevertheless, the choice of Central American monetary policies in the coming years might be dictated by financial considerations, including the extent o f dollarization of financial assets and liabilities. 163 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA 1. Introduction 6.2 I t i s common knowledge that trade reforms can have important implications for macroeconomic policies in developing countries, and DR-CAFTA i s not an exception. Such reforms entail the reduction of trade taxes; especially import tariffs, which are often an important source o f financing for the public sector, especially in countries with limited revenue-raising capacity through direct domestic taxes, such as income and property taxes. In fact, this concern has been long recognized b y the welfare theory o f commercial policies as one o f the exceptions to the idea that freer trade i s always superior to the imposition o f trade taxes (Corden 1974). 6.3 A second policy issue i s related to the long-term consequences o f trade liberalization in general and D R - C A F T A in particular. Since these policies w i l l probably affect the structure of production within the beneficiary countries, especially those from Central America that are small economies relative to the U.S., then how the economies change over time w i l l affect the costs and benefits o f pursuing the coordination o f macroeconomic policies. That is, if the economies o f Central America become more similar to each other, then the probability that they w i l l face common macroeconomic shocks w i l l increase and thus the benefits of having independent monetary policies w i l l decline. The same logic applies with respect to coordinating monetary policies with the U.S., which in this case can be narrowed to possibility o f adopting the U.S. dollar, as El Salvador has already done. In a previous publication, Lederman, Perry, and Suescdn (2004) concluded that D R - C A F T A might in fact lead to further business cycle synchronization and thus to the need to coordinate monetary policies, thus leaving fiscal policy as the main shock-adjustment policy tool available in the long-run for Central American countries. 6.4 This chapter revisits relevant empirical evidence that address both macroeconomic policy issues. Section I I,therefore, focuses on the potential implications o f DR-CAFTA in terms o f i t s impact on fiscal revenues. Section I11 turns to the issue o f how the structure o f trade affects business cycle synchronization across countries, reviews the evidence on cycle synchronization across Central American and with respect to the US., and provides new evidence on the role of intra- versus inter-industry trade in affecting the extent o f business- cycle synchronization across countries. Section I V summarizes the main findings and policy implications. 2. Potential Fiscal-Revenue Losses from DR-CAFTA 6.5 The implementation o f DR-CAFTA w i l l lower fiscal revenues in Central American countries. Due to the sharp reduction o f tariffs that has taken place since the late 1980s in the region (see Chapter 1 1) and the associated reduced importance o f trade taxes, fiscal losses associated with further tariff reductions should not pose as large a cost as in other liberalization experiences. For the case o f Central America, revenues from trade taxes fell from a range of 3-6 percent o f GDP in the 1980s to only 0.5-2 percent o f GDP in the early 2000s (Barreix et al. 2004). In 2000-01, trade taxes accounted for an average 1.6 percent of GDP in Central America, somewhat above the regional LAC average o f 0.9 percent, with the 164 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA share of total tax revenues ranged from a low o f 8 percent in Costa Rica to a high of 14 percent in Honduras (Table 1). Table 1: Import Tax Revenues, 2000-2001 Share of total Country Share of GDP Tax revenues % % Costa Rica 1.03 8 El Salvador 1.07 10 Guatemala 1.23 12 Honduras 2.37 14 Nicaragua 1.38 10 C A average 1.55 11 L A C average 0.90 5 6.6 Estimates o f the permanent direct fiscal loss that would be incurred once all tariffs on imports from the U.S. are eliminated suggest that under most scenarios, i t should not surpass 1 percent o f GDP. Four recent estimates (including one commissioned for this study) suggest a range from 0.5 to 0.8 percent o f GDP for the Central American average (Table 2). The estimates reported in Table 2 take into account the effect of lower tariffs on a constant volume o f imports (direct effect) and the effect on revenues from value added or excise taxes (indirect effect) which incorporate tariff modified prices as part o f the tax base. These are the only potential effects that do not require strong assumptions about potential responses in the economy to the lowering o f tariffs, such as the effect o f potential changes in volumes due to tariff changes, the effect o f changes in tariff and other revenues from imports from third countries, and the change in overall revenues from general equilibrium changes in production and consumption structures. While there i s significant heterogeneity among countries, results from different sources are also different. Most studies suggest that Honduras would suffer the largest losses (0.9 to 1.6 percent of GDP) with other countries suffering losses ranging from 0.3 to 0.8 o f GDP. Table 2: Alternative estimates of fiscal losses from DR-CAFTA ( % of GDP) (1) (2) (3) (4) Costa Rica 0.65 0.33 0.30 0.38 El Salvador I 0.39 1 0.32 1 0.41 I 0.78 I Guatemala Honduras Nicaragua 0.39 0.39 Average 0.68 0.48 0.50 0.76 (1) Barreix, A.; L. Villela y J. Roca (2005). (2) Bronchi and Keen (2004). (3) Paunovic (2004). (4) Authors’ calculations. 165 CHAPTER VI: Macroeconomic Policy Itnplications of DR-CAFTA 6.7 Fiscal losses for the first years w i l l be lower than those incurred once the treaty i s fully implemented, as a result o f the gradual phase out o f tariffs that Central American countries negotiated. On average, only 55 percent o f all imports from the U.S. w i l l become duty-free in the first year o f the treaty (Bronchi and Keen, 2004). Results for the first year from studies reported in Table 3 indicate that the average loss w i l l range from 0.2 to 0.5 percent o f GDP. In two studies, the first year losses for Nicaragua, El Salvador and Guatemala are very small (under 0.16 percent of GDP). B y contrast, Costa Rica’s first years losses tend to be closer to the full implementation losses, as i t w i l l liberalize most of i t s trade with the U.S. in the first year. Table 3: Alternative estimates of fiscal losses from D R - C A F T A in the first year ( % of GDP) Costa Rica 0.39 0.32 0.28 El Salvador 0.15 0.09 0.38 Guatemala 0.15 0.16 I Honduras I 0.29 I 0.22 I 0.82 I Nicaragua 0.11 0.05 0.42 - Average 0.22 0.17 0.47 6.8 A more comprehensive calculation of fiscal revenue changes from DR-CAFTA would require an assessment o f the changes in production and consumption structure that could be induced b y the treaty, including the impact o f greater investment levels and growth. While such estimates are beyond any o f the studies that have been made for the case o f DR-CAFTA, Table 4 reports results from two studies (including our own estimates) which have attempted to quantify the potential effects o f greater growth on fiscal losses. As expected, the growth effect generates compensatory revenues that diminish the fiscal impact. 6.9 The study b y Paunovic (2004) uses estimates o f the growth trajectories o f the DR- CAFTA countries provided b y Hinojosa-Ojeda (2003), which predict GDP growth due to C A F T A o f 0.76 percent for Costa Rica, 1.59 percent for El Salvador, 2.32 percent for Guatemala, 0.89 percent for Honduras, and 1.49 percent for Nicaragua. In turn, Paunovic added these predicted growth rates (allegedly to be caused by C A F T A ) to his organization’s (UNECLAC) growth projections, multiplied the resulting growth rates times estimates o f the elasticity o f imports with respect to GDP growth, which was then multiplied by the author’s estimate o f the gain in indirect taxes charged on imports (Le., VAT taxes). Consequently Paunovic (2005) contemplates a revenue-recovery effect that i s limited only to the potential effect o f C A F T A through growth on indirect taxes paid b y rising imports. 6.10 Our calculations assume that the growth effect o f D R - C A F T A w i l l be around 0.6-0.8 percent per year, which i s the range o f the estimations provided b y Gould and Gruben (2005) 166 CHAPTER VI: Macroeconomic Policy Implications of DR-ChFTh and discussed in Chapter N of this report. Moreover, we assume that the long-term relationship between GDP and fiscal revenues i s exactly one. That is, we assume a unitary elasticity o f revenues, so that when GDP grows b y one percentage point, revenues rise proportionately b y one percent as well. This assumption seems generous, since the empirical evidence for various Latin American and Central American countries suggests that the correlation between short-term indicators of GDP and tax revenues per capita are below one - see Table 5. Moreover, tax revenues in Central American countries are heavily dependent on consumption-related taxes rather than on progressive income or property taxation, as shown in Table 6. Economic logic dictates that more progressive tax systems can generate higher revenues for each improvement in GDP as the average marginal tax rate would tend to rise as people become richer. This revenue augmenting effect would undoubtedly be small or nonexistent in economies where the structure o f taxation i s not progressive and focused on income taxes or property taxes. This i s not necessarily a critique o f the Central American tax systems, but these are undoubtedly important elements in assessing the validity o f our assumptions regarding the potential revenue-recovery effect o f CAFTA. In any case, it should be acknowledged that the assumption of a unitary elasticity o f revenues with respect to long- term GDP changes implies that the ratio o f tax revenues over GDP w i l l remain constant after the D R - C A F T A tariff reductions. Thus even these calculations imply a permanent reduction o f the revenue-GDP ratio, in spite o f the rise o f revenues driven b y DR-CAFTA’s dynamic effects. This growth-related revenue compensation varies per country but can reach as much as 0.5 percent o f GDP for the case o f Honduras. (1) (2) Costa Rica 0.21-0.26 0.00-0.15 El Salvador 0.22-0.32 0.43-0.59 I Guatemala I 0.27-0.37 1 0.25-0.40 I I Honduras I 0.78-0.83 1 0.92-1.17 I I Nicaragua 0.3 1-0.40 0.09-0.3 I 167 CHAPTER VI: iMacroeconomic Policy Implications of DR-CAFTA Table 5: Correlations between macroeconomic and fiscal variables and GDP in Latin American countries capital formation; trade balance = exports o f goods and services - imports o f goods and services. All variables except net exports and government debt are in per capita terms and in logarithms; all variables filtered with the Hodrick-Prescott filter. Output correlation i s the contemporaneous correlation with GDP. Tax data are from the IMF Government Finance Statistics database. Government debt figures are constructed as indicated in the text. The remaining data are taken from the World Development Indicators Source: Suescdn 2005, Table 9 168 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA Social Country Consumption Security Taxes on Other Taxes* Contributions Income Taxes Argentina 46.7 36.9 11.5 4.9 Bolivia 65.6 13.1 8.2 13.1 Brazil 33.5 28.4 19.5 18.6 Chile 66.0 8.0 21.3 4.8 Colombia 56.4 0.0 41.8 1.8 Costa Rica 54.2 32.4 12.3 1.1 Dominican Republic 76.1 4.2 18.3 1.4 Ecuador 41.4 0.0 56.7 1.9 El Salvador 70.5 0.0 26.7 2.9 Guatemala 73.5 0.0 22.9 3.6 Mexico 56.0 11.9 30.2 1.9 mean 56.5 13.5 24.2 5.8 median 56.4 10.1 19.5 3.6 I *Consumption taxes = Taxes on goods and services + Taxes on international trade Source: Own calculations based on Government Finance Statistics database (IMF),World Development Indicators cited in Suesclin (2005). 3. DR-CAFTA, Trade Structure and Business-Cycle Synchronization 6.11 With deeper trade integration between Central America and the U.S., i t i s expected that there w i l l be closer links in business cycles among Central America and the U.S. From a theoretical point o f view, the impact o f trade integration on business cycle synchronization i s not clear, as increased trade can lead business cycles to convergence or divergence: if trade integration leads to increased inter-industry trade as a part o f a specialization process, then business cycles are likely to become less similar as shocks specific to particular industries w i l l become responsible for shaping business cycles. O n the other hand, i f trade integration leads to a higher share o f intra-industry trade, business cycles w i l l become more similar, as industry-specific shocks affect trading partners in a similar way. 6.12 Assessing business cycle synchronization between Central America and the U.S. i s not only important for a better understanding o f the influence o f important trading partners on the business cycle fluctuations in the domestic economies. Information about the degree o f 169 CHAPTER VI: IMacroeconomic Policy Implications of DR-CAFTA business cycle synchronization i s important as i t provides information on the necessity o f independent fiscal and monetary policy. I f the business cycles are similar and shocks are common, then a coordination of macro policies can become desirable, with a common currency as the ultimate form of policy coordination. On the other hand, if shocks are predominately country-specific - resulting in a l o w degree o f business cycle synchronization - then, the ability to conduct independent monetary and fiscal policy i s generally seen as important in helping an economy adjust to a new equilibrium. A. Business-cycle synchronization - Data and methodology 6.13 As shocks are not observed directly, empirical studies rely on econometric methods for their identification. Helg et al. (1995) and Bayoumi and Eichengreen (1993) adopt a structural VAR approach, whereas Artis and Zhang (1995) develop an identification scheme based on cyclical components. Rubin and Tygesen (1996), Beine and Hecq (1997) and Beine, Candelon and Hecq (2000) use a codependence framework. Filardo and Gordon (1994), Beine, Candelon and Sekkat (1999) and Krolzig (2001) use a Markov Switching VAR model. This empirical work demonstrates that i t i s important to distinguish between short and long- run effects. Bayoumi and Eichengreen (1993), Helg et al. (1995) and Rubin and Thygesen (1996) use differenced variables in the VAR representation. However, such a specification does not allow for long-run relationship between the variables. Beine et al. (2000) overcome this b y investigating simultaneously common trends and common cycles, where evidence o f a common European cycle i s taken as evidence o f perfect synchronization o f shocks. Breitung and Candelon (2001) use a frequency domain common cycle test to analyze synchronization at different business cycle frequencies. 6.14 The key variable in our study i s the degree o f business cycle synchronization between countries i and j . To measure this variable, we follow Frankel and Rose (1998) and compute the correlation between the cyclical component o f the output in countries i and j , where a higher correlation implies a higher degree o f business cycle synchronization. The cyclical component of output i s obtained using different de-trending methods. Given the lack o f consensus on the optimal procedure and the sensitivity o f the cycle to the de-trending method, this approach should provide a robustness check o f our results. For annual data we use first- differencing and band-pass filtering (Baxter and King, 1999). Spectral analysis i s used to assess business cycle synchronization with monthly data. 6.15 Data availability for Central America seriously limits the scope for any econometrical analysis. T o provide some inference about the level o f business cycle synchronization and the link between trade structure and business cycle synchronization in Central America we make use of annual data on GDP from 1965 to 2002 and monthly data on economic activity from 1995 to 2003. B. Synchronization results with annual data 6.16 Band pass filtered data, our preferred method for business cycle extraction in this section, shows that in Central America business cycle synchronization i s highest between Costa Rica, Guatemala, El Salvador and Honduras. Nicaragua and Panama appear to follow a 170 CHAPTER VI: MacroeconomicPolicy Implications of DR-CAFTA different cycle, as correlation across business cycles i s in most cases even negative, though not statistically significant.' These results are reported in Table 7 below. 6.17 Interestingly, the correlation with the U.S. business cycle i s also high. In the case o f Costa Rica, El Salvador and Honduras business cycle synchronization with the U.S. appears even higher than among regional neighbors, indicating that bilateral relationships with the U.S. through trade and remittances are more important than regional effects. Somewhat surprisingly, business cycle synchronization between US. and Panama, which adopted full dollarization in 1904, appears to be much lower than in the rest o f Central America, with the exception o f Nicaragua.* I t appears that based on business cycle synchronization, the rest o f Central America would be better candidates for a currency union with the U.S. than Panama. In fact, business cycle synchronization between the U.S. and Costa Rica, Guatemala, Honduras and El Salvador i s even higher than the EU average (0.43). 6.18 Business cycle synchronization in the two Mercosur countries, Argentina and Brazil, i s below the levels o f Costa Rica, El Salvador and Guatemala. While business cycle synchronization i s also substantial between the U.S. and Canada, i t i s however surprisingly l o w between the U.S. and Mexico. The finding of l o w business cycle synchronization between the U.S. and Mexico, as well as Brazil and Argentina i s partly explained by long time period (1965-2002) under consideration, but the next section shows that there has been a substantial increase in business cycle synchronization in the more recent past. 6.19 Table 9 shows business cycle synchronization between Central American countries after controlling for common impact o f the U.S. business cycle.3 Once the common impact o f the U.S. business cycle i s removed, i t appears that only Costa Rica and Guatemala, Costa Rica and El Salvador and Guatemala and Honduras are affected b y common factors other than the U.S. business cycle. As these countries also account for the largest share o f intra-regional trade, this finding can be taken in support o f the often postulated positive relationship between trade intensity and business cycle symmetry. Results based on first-differences are not reported here but are available in Fiess (2004). Panizza et al. (2000) report a similar result. Table 8 reports the correlation between the cyclical components o f band pass filtered G D P series orthogonal to the U S business cycle. 171 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA Table 7: Business Cycle Synchronization - Band pass filter - Central America bandpass Central America Costa Rica 1 El Salvador I Guatemala I Honduras I Nicaragua 1 Panama Table 8: Business Cycle Synchronization - Other FTAs 172 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA Table 9: Business Cycle Synchronization - orthogonal to US. business cycle C. Synchronization results with monthly data 6.20 The business cycle i s usually defined in the range o f 6 to 32 quarters, and thus low- frequency annual data might be insufficient to fully assess the degree of business cycle synchronization. In this section we therefore complement our analysis from the previous section with an analysis o f monthly data, where output i s proxied b y seasonally adjusted monthly indices o f industrial production and economic activity. 6.21 We use spectral analysis to estimate the correlation at different frequencies and use the average “coherence” at business cycle frequency (6 to 32 quarters) of year-over-year changes in economic activity as a summary measure o f business cycle synchronization (Garnier 2003). The advantage o f using cross-spectral densities over simple correlations in the analysis o f business cycle synchronization i s twofold. First, spectral analysis avoids possible business cycle distortions due to filtering, because i t i s well known that the cycles change with the de- trending method (Canova 1998). Second, contemporaneous correlation i s unable to take lagged co-movement into account. As coherence measures the correlation between two series in the frequency domain (Le., within each time window) and provides information on leads and lags i t provides a richer analysis o f business cycle dynamics. While coherence measures the extent to which two business cycles are dominated by the same frequency, the phase lag shows how elements with the same frequency are related over time (lags). In sum, a high degree o f business cycle synchronization implies a high coherence and a l o w phase lag. Table 10 shows the average coherence at business cycle frequency between year-over-year growth rates o f economic activity during 1995 and 2003. The results broadly confirm the findings o f the previous section. Table 10: Average coherence at business cycle frequency Mexico 0.332 0.453 0.242 0.366 0.288 0.537 1.000 0.361 U.S. 0.454 0.427 0.336 0.421 0.322 0.486 0.468 0.554 Brazil 0.318 0.322 0.382 0.319 0.272 0.500 0.608 0.467 173 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA 6.22 Within Central America, business cycle synchronization i s found to be again highest between Costa Rica and El Salvador, El Salvador and Guatemala, El Salvador and Nicaragua, and Honduras and Nicaragua. With respect to the U.S., business cycle synchronization i s highest for Costa Rica, El Salvador and Honduras, however, at levels lower than those prevailing among members o f NAFTA and MERCOSUR.4 D. Trade Structure, Exchange Rate Stability and Business Cycle Synchronization 6.23 The impact of trade liberalization on business cycle synchronization i s theoretically ambiguous. Standard trade theory (Heckscher-Ohlin) predicts that the removal o f trade barriers leads to an increasing specialization in production, leading to inter-industry trade patterns. As industry-specific specialization increases, industry-specific shocks, e.g. a shock to commodity prices, w i l l make business cycles more dissimilar and hence decrease the degree o f business cycle synchronization. 6.24 Experience from industrial countries show a trend towards intra- rather than inter- industry trade. If intra-industry trade i s vertical, i.e. particular countries are specializing on different production stages o f the same good, then industry-specific shocks w i l l make business cycles more similar. The same results if intra-industry trade i s horizontal, i.e. countries trade and compete with the same products. In that case industry-specific shocks are also expected to increase business cycle synchronization. 6.25 Exchange rate stability i s often considered important for trade integration. While volatile exchange rates increase transaction costs, misaligned exchange rates create unfair competitive advantages for the trading partner with the undervalued currency and generate political backlash against free trade in the countries confronted with an import surge. Exchange rate stabilization and monetary coordination are therefore often seen as an effective tool to contain the political pressure against further trade integration. However, as Eichengreen and Taylor (2003) point out, the vertical-versus-horizontal structure o f trade i s also decisive in shaping the competitive impact o f bilateral exchange rate fluctuations. If trade and production are predominately vertical, Le. producers specializes in different stages o f the production process - as in the case of NAFTA, where Mexican producers provide inputs and assembly operations for manufacturers designed and marketed in the U.S. - the exchange rate fluctuations are less likely to increase competition. The case i s reversed i f intra-industry trade i s predominately horizontal. In this case, the impact o f undervalued exchange rates i s likely to be much larger. This effect i s amplified further, if the goods in question cannot be relocated to a third market (regional goods, Le. they are uncompetitive outside the regional trade area. (Fernandez-Arias, Panizza and Stein, 2002)). T o summarize, intra-industry trade, vertical or horizontal, i s expected to increase business cycles synchronization; exchange rate instability can become a concern for further trade integration if intra-industry trade i s horizontal rather than vertical. 6.26 Tables 11 and 12 provide information about Central America’s trade structure. Trade patterns o f NAFTA and some countries in EU and MERCOSUR are again provided for We abstain from reporting the phase lag as the phase lag i s very poorly estimated if the coherence i s small, which i s the case for most country pairings in Table 10. 174 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA comparison. U n l i k e for NAFTA, EU and M E R C O S U R members, trade, measured as bilateral exports over total exports, in Central America i s not predominantly intra-regional. Even within the so-called Northern Triangle (Guatemala, El Salvador and Honduras), and between El Salvador and Nicaragua, bilateral exports as a ratio o f total exports barely exceed 10 percent. The U.S. i s b y far Central America’s most important trading partner; although trade with the EU i s also o f some significance. As there appears to be some underreporting o f exports t o the U.S., imports from Central America to the U.S. as reported by the US. are provided as an alternative measure. These data indicate that exports to the U.S. account for more than 60 percent in the cases o f Costa Rica, El Salvador and Guatemala. Table 11: Central America’s Trade Structure: Bilateral ExportdTotal Exports I Free Trade Zone 39.1 % 54.5% U.S. reported imports CIF 62.4% 68.1% 66.3% 175 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA Table 12: Central America’s Trade Structure: Bilateral ExporWGDP 1 US. reported imports CIF I 19.4% [ 11.8% I 11.7% I I I I I Note: Interpretation o f this table i s as follows. The table should be read column-wise, where each row represents the share of bilateral exports in the column-countries GDP. As an example, the top-left figure indicates that exports from Costa Rica to El Salvador represent 0.8 percent of Costa Rica’s GDP. Source: Direction o f Trade Statistics, IMF. 6.27 Table 13 provides information on the importance o f intra-industry trade in Central America based on the adjusted Grubel-Loyed intra-industry trade index.5 This index can take values between 0 (no intra-industry trade) to 1 (all trade i s intra-industry). There appears to be some importance of intra-industry trade within Central America, however, with the exception o f Costa Rica (0.3) there i s virtually no evidence of intra-industry trade with the U.S. For El Salvador and Guatemala intra-industry trade appears to be quite high with Mexico and Brazil. i AUT= n C ( X ;+ M i ) - I Where X and M are exports and imports o f industry respectively. The adjusted Grubel Llyod index makes an adjustment for trade imbalances. 176 CHAPTER VI: iMacroeconomic Policy Implications of DR-CAFTA Brazil 0.08 0.43 0.51 0.03 0.28 0.39 0.51 0.11 U.S. 0.30 0.05 0.05 0.06 0.02 0.10 0.46 0.66 0.56 Germany 0.06 0.02 0.01 0.02 0.02 0.13 0.79 0.33 0.70 E. Business Cycle Synchronization and Trade 6.28 Empirical evidence on trade integration and business cycle synchronization i s somewhat mixed. While Frankel and Rose (1998), Choe (2001), Calderon, Chong and Stein (2002) and Calderon (2003) find that a higher trade intensity tends to increase business cycle synchronization, Shin and Wang (2003) find that increasing trade itself does not necessarily lead to more synchronized business cycles, evidence for East Asia suggests that only the expansion o f intra-industry trade had such an effect. However, Garnier (2003) finds only weak or no relations between intra-industry trade and business cycle synchronization for 16 industrialized countries and concludes that intra-industry trade at most only partially explains business cycle transmission; the l o w correlations reported by Calderon, Chong and Stein (2002) would suggest a similar interpretation for trade intensity and business cycle synchronization. 6.29 Using the statistics calculated in the previous section, we attempt to contribute to this debate. Figure 1 shows a cross-plot o f bilateral export/GDP ratios and average coherence at business cycle frequency with respect to the U.S.6,7 W e are able to identify a positive relationship between trade intensity and business cycle synchronization. We further find that slope o f the regression line i s quite flat as most countries appear to fall into a relatively narrow range o f business cycle synchronization (0.4 to O S ) , independent o f their level of trade intensity. As an example, despite a big difference in trade intensity, France and Mexico have a similar degree o f business cycle synchronization with the U.S.8 This seems to support Shin and Wang’s (2003) and Garnier’s (2003) claims that business cycle symmetry i s only partly explained b y trade intensity. In other words, for El Salvador to reach Mexico’s level o f BCS with the U.S. - which i s only slightly higher - in GDP terms El Salvador would have to more than double i t s exports to the U.S. As in Shin and Wang (2003) and Garnier (2003), the link between intra-industry trade and business synchronization i s found to be stronger. We find similar results if bilateral exports/ total exports are used as a measure o f trade intensity. ’Figure A1 in the appendix expands the analysis to all countries covered in Tables 7 and 8. Argentina’s relatively high level o f BCS despite low trade intensity appears to be linked to dollarization and capital flow integration. 177 C H A P T E R VI: Macroeconomic Policy Implications of DR-CAFTA 6.30 Thus the evidence suggests that the effects of DR-CAFTA on the structure o f trade are unlikely to change the costs and benefits o f macro policy coordination in the foreseeable future. Consequently, the choice o f monetary and fiscal policies along the business cycle of these economies w i l l continue to be driven by none trade issues, such as the extent o f financial asset and liability dollarization in the region. Figure 1: Business Cycle Synchronization and Trade with the US , I Business Cycle Syncronization and Trade with the US .. .....I.. ~ "...____..I _......_..__.I,..i.,_ I- ~ --,.l.l.l....-l_..". ~ ._.,......_I,._ I~..._.._..,I..__ + I Can Argentina 0.500 + Costa Rica ranee + El Salmdor A * + 0.400 Mex + + Honduras 0.300 Guatemala Nicaragua 0.200 I 0.100 - y = 0.10 5 5 + ~ 0.3873 R2 = 0.1389 i 0.000 I , , I 1 Figure 2: Business Cycle Synchronization and Intra-industry trade intra-Industry Trade and Business Cycle Synronization 0.600 Argentina Can* 0.500 c .p 0.400 ** Costa Rica France i l * * 'E 0.300 y = 0.21 6 4 +~0.376 E 5 0 0.200 R2 = 0.5433 0.100 0.000 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 IIT 6.31 The evidence discussed thus far on the structure o f trade and business-cycle synchronization i s less than conclusive. Other research b y Calder6n et al. (2002) and Calder6n (2003) looked at the relationship between bilateral-trade intensity across countries and over time for a large sample o f over 100 countries during 1960-1999. The econometric evidence 178 CHAPTER VI: iMacroeconomic Policy Implications of DR-CAFTA discussed b y these authors seems consistent with the ongoing discussion: They find that the positive relationship between BCS and bilateral-trade intensity i s highest among pairs of industrialized (high-income) countries than among pairs o f developing countries or developing-industrialized countries. Since the incidence o f intra-industry trade among high- income countries i s higher than among developing countries, then this evidence i s consistent with our findings that BSC among Central America and with the U.S. are relatively low, but that i t would tend to rise if intra-industry trade were to increase. Calder6n (2003) also finds that FTAs tend to increase the magnitude of the effect o f bilateral-trade intensity on BSC across pairs o f countries, but this effect i s still lower for developing countries than for industrialized economies.’ Hence the international evidence suggests that DR-CAFTA could lead to more intra-industry trade with the U.S. and thus to higher BSC, but these structural changes could be quite modest. Consequently, the potential effects of DR-CAFTA on the costs and benefits of dollarization or other forms o f monetary policy coordination among the Central American and U.S. economies could be small relative to the relevance of other factors, such as the extent o f financial (asset and liability) dollarization, which could lead countries to maintain stable dollar exchange rates to shield the financial system from sudden changes in the exchange rate (see Lederman, Perry, and Suescdn 2004). 4. Summary and Policy Recommendations 6.32 This chapter reviews evidence related to two macroeconomic policy issues. The first concerns the potential revenue losses that might be produced b y DR-CAFTA’s removal o f import taxes. The other topic i s related to the treaty’s potential effect on the patterns o f business-cycle synchronization (BCS) that could be affected b y changes in the structure o f international trade. 6.33 The fiscal losses that DR-CAFTA i s likely to create need to be compensated in all Central American countries to avoid further deterioration o f public finances. At present, all Central American countries with the exception o f Guatemala exhibit relatively high debt indicators and require tight fiscal stances to maintain or decrease indebtedness. However, relatively small losses in the first years allow for some flexibility in the timing o f the fiscal response in some of the countries -- particularly as some time may be needed for adequate political conditions to emerge. 6.34 A more comprehensive fiscal response to DR-CAFTA requires efforts to raise revenues above and beyond fiscal losses, as some o f the key measures needed to optimize i t s effect require increases in public investments (e.g., infrastructure, education, institutional strengthening, and transitional adjustment programs). While some o f these expenditures may be temporary and could arguably be financed b y greater indebtedness, this may be difficult in practice due to high current debt levels. 6.35 The fiscal response to DR-CAFTA should be adapted to the fiscal situation of each country. For the cases o f El Salvador and Guatemala, where tax revenue ratios are low (below Calder6n (2003, 2 ) reports that a “one standard deviation increase in bilateral trade intensity will increase output correlation from 0.53 to 0.64 among industrial country pairs with FTA i n the 1990s, from 0.21 to 0.29 among developing country pairs with FTAs.” 179 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA 13 percent o f GDP), the ideal fiscal response would be actions that go significantly beyond recovering direct losses, in order to finance additional social and infrastructure investments that are needed to boost growth and that are made more urgent and productive b y the opportunities o f DR-CAFTA. In Costa Rica, where the tax ratio i s higher but s t i l l short o f the level needed to guarantee debt sustainability, the ideal response should also involve going beyond compensation for the relatively low projected losses, making improvements in the efficiency and allocation of public expenditures, as well as attracting private financing to fund some of the most significant infrastructural needs. Honduras and Nicaragua, which have benefited recently from the Heavily Indebted Poor Countries Initiative (HIPC), w i l l likely require additional fiscal revenues, improvements in expenditure efficiency and attraction o f private financing to respond to the opportunities o f DR-CAFTA. In all countries, an essential element o f efforts to improve fiscal performance should include the institutional strengthening of tax agencies and their collection capacity, as well as the elimination o f exonerations from VAT and income taxes. 6.36 DR-CAFTA implementation should also be used to deepen regional coordination efforts in the realm o f tax policy. Going forward, a regional coordination agenda should include gradual harmonization o f VAT and excise rates, fiscal incentives for foreign investors, information exchange for tax enforcement efforts, double taxation treaties and transference prices. 6.37 Regarding the prospects for macroeconomic policy coordination among Central American countries and perhaps with the U.S., business cycle synchronization within Central America i s quite l o w compared to NAFTA and EU, but not when compared to MERCOSUR. In fact, synchronization in Central America i s highest between Costa Rica and El Salvador, El Salvador and Guatemala, El Salvador and Nicaragua and Honduras and Nicaragua. Costa Rica and Honduras have a higher degree o f co-movement with the U.S. than with any other Central American country. Yet synchronization with the U S i s s t i l l below the levels among NAFTA and even MERCOSUR members. 6.38 Furthermore, unlike NAFTA, EU and MERCOSUR, trade in Central America i s not predominantly intra-regional. The U S i s b y far Central America’s most important trading partner. With the exception of Costa Rica, there i s virtually no evidence o f intra-industry trade between Central America and the U.S. The level o f intra-industry trade within Central America i s comparable to that o f MERCOSUR, but below the levels of NAFTA (Canada and the U S ) and EU (Germany and France). Finally, the degree o f business cycle synchronization seems only weakly related to trade intensity and trade structure (intra-industry trade), although the relationship between intra-industry trade and synchronization i s slightly stronger, which i s consistent with existing international evidence. As such, the gain in synchronization through trade expansion could be modest. 6.39 In sum, at present neither Central America’s trade structure nor i t s degree of business cycle synchronization make a compelling case for macro coordination within Central America or between Central America and the U.S. Clearly, trade integration i s a dynamic process and as trade intensities and compositions o f trade flows change so w i l l business cycle patterns. T o fully assess the consequences o f closer trade integration for the conduct o f macroeconomic 180 CHAPTER VI: iMacroeconomic Policy Implicutions of DR-CAFTA policies, information about the future evolution of trade structures in DR-CAFTA are needed. If trade becomes more intra-industry (vertical or horizontal), business cycles are expected to become more similar and independence o f macro policy w i l l be less o f a concern. However, if trade integration takes the form o f higher inter-industry trade then business cycles are likely to diverge from current levels and the ability to conduct independent macro policies w i l l grow more important. In the meantime, other factors that are not directly related to the structure o f international trade w i l l remain more important considerations for the design o f macroeconomic policies over the business cycle in Central America. One important consideration, for example, i s the extent of dollarization of financial assets and liabilities. Hence the macro agenda in the light o f DR-CAFTA should remain focused, at least in the short-run, on fiscal consolidation. 181 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA 182 CHAPTER VU: Obtaining the Payofffrom DR-CAFTA: Chapter VII. Obtaining the Payoff from DR-CAFTA: Priorities for the Complementary Agenda Abstract 7.1 This paper highlights key issues for the complementary agenda for DR-CAFTA, with emphasis on those weaknesses o f each country in the areas of trade facilitation, institutional and regulatory reforms, and innovation and education. The main challenges for Costa Rica are improving road quality, port and customs efficiency, boosting financial depth, and improving the quality and coverage of secondary education. For El Salvador, priorities should focus on increasing road quality, reducing shipping costs, battling corruption, as well as improving the quality and coverage of secondary education. Both countries need to devote more public resources to R&D, strengthen public private partnerships for innovation and enhance the institutional capacity to enforce intellectual property rights laws. In addition to tackling weaknesses in most o f the areas identified for Costa Rica and El Salvador, Guatemala needs to continue to build on recent accomplishments in improving customs administration, coverage and quality of primary education, and road density, as well as devoting some attention to fostering the development o f new export products. 7.2 The challenges for Honduras, and Nicaragua are likely to encompass a broader set o f policy issues, as they face more limitations due to their lower development level. Both countries need to battle corruption, work on improving the coverage and quality o f primary education, improving the operational efficiency of ports and increasing the quality o f roads and their density. They also need to improve their capacity to absorb knowledge from abroad, strengthen institutions in charge o f innovation policy and increase linkages public R&D programs with the needs o f the private sector. Honduras also needs to upgrade customs administration and reduce the costs and times to establish new business ventures. All Central American countries share a regional agenda which should focus on achieving a Customs Union and strengthening policy and regulatory coordination in several areas. 183 CHAPTER V I I : Obtaining the Payoff from DR-CAFTA: 1. Introduction 7.3 The benefits from DR-CAFTA w i l l depend on the ability o f the Central American economies to pursue a complementary policy agenda, as was explained in Chapter IV. DR- C A F T A b y itself i s unlikely to lead to substantial developmental gains without parallel efforts in certain key areas. This chapter presents a review o f the remaining areas o f the complementary agenda for DR-CAFTA, in addition to those related to the management o f the transition presented in Chapter V and the macroeconomic implications covered in Chapter VI. The goal i s to provide a brief assessment o f the key policy priorities for Central American countries. * 7.4 While virtually all public policies can in a sense be complementary and affect future economic development, this chapter focuses on three policy areas that have obvious interactions with international trade, some o f which were highlighted in Chapter IV. These include, first, trade facilitation infrastructure and institutions, such as ports, roads and customs procedures. The second policy area concerns other institutional and regulatory reforms that affect the ability o f firms and workers to seek out new opportunities created b y DR-CAFTA and the consequent expected increase in trade and investment flows. The third area concerns innovation and education policies, which w i l l affect Central America’s ability to adopt and adapt technologies embodied in imported goods and to introduce new export products and services. 7.5 The analyses contained in the following sections provide estimates o f where the Central American economies are located relative to each other and relative to countries o f similar levels o f development. While this type o f benchmarking admittedly does not say much about the potential social returns that can be obtained from specific policy interventions, i t reveals where the different countries seem to be lagging behind expectations in terms o f intermediate development outcomes, such are the coverage and quality o f infrastructure, regulations, and innovation. The purpose i s to provoke public discussion about what each country can do to improve their performance in these policy areas that are most likely to determine the extent of the gains from DR-CAFTA in the long-run. 7.6 We acknowledge that while the chapter tries to identify deficiencies and areas o f “weakne~ses’~, virtually all Central American nations have made substantial strides in reforming their policies since at least the early 1990s. Details about the advances made in most areas can be found in the Bank’s recent country-specific studies on the challenges o f the growth agenda.* However, here we focus on what remains to be done. A t the end, we conclude the chapter b y briefly stating what seem to be the most pressing future priorities for each Central American country, derived from the evidence reviewed here. ’ The assessment and recommendations summarized draw from recent CEM/DPR studies performed in El Salvador (2004), Honduras (2004), Nicaragua (2004) and Guatemala (2005), as well as Investment Climate (IC) Assessments in Honduras (2004), El Salvador (2005), Nicaragua (2004) and Guatemala (2004). IC comparisons do not include Costa Rica, as data from this survey w i l l only available in the second half of 2005. Useful attempts to outline some o f the challenges of the complementary agenda include Salazar- Xirinachs and Granados (2004), Lizano and GonzBlez (2003) and Rodlauer and Schipke (2005). ’ See for example the references included in the previous footnote. 184 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: 2. Trade Facilitation Roads 7.7 Despite progress in recent years, indicators of road access s t i l l show significant deficiencies in Guatemala, Nicaragua and Honduras. In comparisons with countries o f similar income per capita, road density i s furthest from expected values for Guatemala (near 70 percent), while Nicaragua and Honduras fall short b y about 30 percent. B y contrast, El Salvador’s performs 20 percent beyond expectations due to the large investments o f recent years, while Costa Rica comes out at the predicted level for i t s level o f income (Figure Figure 1: Road Access and Quality in Central America Deviations from Predicted Levels (%) 40.0 20.0 0.0 -20.0 -40.0 -60.0 -80.0 Source: Own calculations. 7.8 Road quality indicators for Central American countries are lower than predicted b y their levels o f development. Costa Rica, Guatemala and El Salvador exhibit the largest shortfalls in the share of paved roads with respect to GDP levels (Figure 1). The overall poor quality of roads implies mobility i s l o w and costly, and affects the potential trade competitiveness of goods produced in rural areas. 7.9 L o w fiscal availability and inadequacies in the legal framework for private sector participation are key limitations to improvement in coverage and quality. The low fiscal base in most countries o f Central America constrains investment in roads. Tight fiscal situations in recent years have led to contractions of public capital formation, which has contributed to a slow down in construction and upkeep o f regional infrastructure. While there are examples o f private sector participation in all segments o f transport activities (construction, rehabilitation and maintenance o f infrastructures, and operation o f transport services), the significant potential in this area has not been developed yet mainly due to deficient and uncertain legal frameworks and poor institutional capacity o f the entities in charge of regulations. I n comparisons of road availability per inhabitant, El Salvador joins Guatemala and Honduras among lagging countries, while Nicaragua surpasses comparators due to i t s relatively low population. 185 CHAPTER VII: Obtaining the Payofffrom DR-CAFTA: 7.10 Improving access to roads and their quality to boost competitiveness and attract investment requires actions in several fronts: 0 Coverage of the road network should be extended selectively within a strategy aiming at strengthening rural-urban linkages, developing trade corridors and incorporating a regional perspective, b y inter alia strengthening the regional road network (Red Internacional de Carreteras Mesoamericanas). This i s particularly important for reducing trade costs in countries such as El Salvador and Nicaragua, which rely on access to ports in neighboring countries for significant shares o f their trade. 0 Road quality needs to be improved b y designing institutional mechanisms to assign funds for road maintenance. 0 Regulatory frameworks need to be strengthened (esp., concession legislation) as well as the institutional capacity to attract private sector participation in the construction, operation and maintenance o f transport infrastructure. 0 Public investments in those areas where private financing i s unlikely (e.g., rural roads and rural telecoms) must be protected. 0 Planning capacity at both central and local levels must be reinforced and stronger coordination efforts are required for significant cross country road developments with other Central American countries. Ports 7.11 The quality and productivity of ports services in Central American i s l o w b y international standards according to a variety o f sources. Figure 2 displays a benchmarking exercise using a port efficiency indicator designed to measure the quality o f maritime and air ports facilities (Wilson, Otsuki and Mann, 2003).4 All Central American countries perform short o f the benchmark b y at least 5 percent, with the exception o f El Salvador which f a l l s short only b y 1 percent. Most notable are the deviations of over 10 percent for Costa Rica, Guatemala and Nicaragua. A parallel exercise in which the benchmarking takes place using the value o f trade per capita yields similar results, with deviations o f over 15 percent for all countries, with the exception o f El Salvador. The indicator i s an average of three indexes. The first (port efficiency index) i s taken from Maritime Transport Costs and Port Efficiency, World Bank Group, and the second (port facilities and inland waterways) and third (air transport) are taken from the Global Competitiveness Report. See Wilson, Otsuki and Mann (2003). 186 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 2: Port Efficiency with Respect to GDP per Capita 7.12 High costs for Central American ports have been attributed to low volumes, poor management b y public agencies, and lagging infrastructure. In many cases, these problems have been compounded b y slow customs procedures, security problems and poor human resource management (Londofio-Kent and Kent, 2003; World Bank, 2004b). Puerto CortCs in Honduras exemplifies well many o f the typical problems. In this port, container ships lie idle 22 percent o f the time spent in port, compared to an international standard o f 5 percent. General cargo i s moved at the rate o f 24-55 tons per hour, substantially below the international standard o f 90 tons per hour, while dry cargo in bags moves at, 89 tons per hour versus the international standards o f 1,000 tons per hour. As a result o f these problems and relatively l o w volumes, shipping costs to major U.S. destinations are higher from Central American ports than from ports in South American competitors (Figure 3). 187 CHAPTER V I I : Obtaining the Payoff from DR-CAFTA: Figure 3: Shipping Costs per 20 foot container ~ Chile I l l Peru Colombia Brazil I 2 3 0 Nicaragua ~ a New York E v) 1 Bl Miami Honduras Guatemala El Salvador I I 0 500 1,000 1,500 2,000 2,500 3,000 3,500 cost (US $) Source: Pizarro (2005). 7.13 L o w quality and productivity in Central American ports contribute to higher maritime transport costs. According to data from the U.S. Department o f Transportation for garment exports, maritime transport costs from Central American ports compare favorably (except for Acajutla, El Salvador) with global competitors in shipments to the East Coast o f the U.S. However, Acajutla, Puerto Cortes (Honduras) and Santo Tomas (Guatemala) do not compare as well in shipments to the West Coast, even in relation to ports as far away as Turkey, China and Thailand (Figure 4). More evidence on this i s provided in Table 1, in which the shipping costs o f textiles and apparel to the U.S. for Central American countries i s compared to those o f other developing countries. While most countries o f the region have relatively l o w shipping costs due to their geographic proximity to the U.S., i t i s notable that Colombia and even Mexico have highly competitive shipping costs. Port inefficiencies are likely to play a role, as well as other factors that can also raise freight values, such as the size o f the ships and containers used and higher fixed costs from lower trade volumes. More in depth analysis in this area i s required in order to determine the relative weight o f these factors in explaining higher maritime transport costs from ports in Central America. 188 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 4: Maritime transport costs to the U.S. from selected ports as share of export value Mantlmr Tramprl Costs lor Garmnts Fxpnrts l o lhe L 5 b West Coast ( T m p o n Coil B 7~of Expon Value) Source: U.S. Department o f Transportation as quoted in El Salvador ICA. Table 1: Use of Shipping Modes to the U.S. for Textile and Apparel Industry Mexico 2.2 5.6 2.0 Peru 2.6 7.2 41.5 Bangladesh 5.3 22.9 11.3 China 3.6 11.1 24.3 Honn Kong 2.8 12.4 24.0 I Indonesia I 4.2 I 17.0 I 17.0 I I Africa I Kenya 4.5 I 20.3 1 19.3 Lesotho 4.3 I 18.5 I 16.5 Mauritius 4.1 I 14.4 27.6 South Africa 5.1 I 17.1 18.3 7.14 Stagnant port development in recent years i s due to outdated legal and institutional frameworks which have hindered trade expansion prospects in the region. Concessioning or privatization attempts have been limited, partly due to a lack of stable regulatory environment 189 CHAPTER W I : Obtaining the Payoff from DR-CAFTA: (e.g., lack o f adequate concession legislation). Progress i s under way in El Salvador (Acajutla) and Costa Rica (Caldera) where upcoming private participation i s expected to improve infrastructure and port efficiency. In Guatemala, the only port in private hands (Puerto Barrios) i s perceived b y private users as more efficient, while Santo Tomas, where private sector involvement has been minimal, i s still considered b y users as the least efficient (Guatemala ICA, 2004). In the latter, plans now underway for private participation through the construction o f a new private warehousing facility which i s expected to improve the situation. More broadly for the region as a whole, the absence o f strong and efficient regulatory bodies, state-owned port operators (empresas portuarias) have become powerful and heavily politicized institutions, reducing opportunities for reform. 7.15 Key actions to improve the efficiency o f ports in Central America include: 0 Implement regulatory and institutional reforms to facilitate private participation in ports with the aim o f upgrading infrastructure and improving administration. 0 Improve public administration where ports cannot be privatized, including actions to foster greater transparency, improved management (including human resources), reduction o f political interference, greater participation by users in the executive boards and strengthened financial discipline. 0 Include port development in a coordinated regional transportation strategy for Central America, to ensure rational use o f resources to facilitate trade within the region and with external partners. Reduction o f the costs and times at border crossings are imperative, particularly to resolve bottlenecks faced by Nicaragua and El Salvador in reaching ports in the Atlantic. Customs 7.16 Customs performance in the region has been traditionally considered deficient b y international standards and custom procedures have often been considered a major obstacle for business operations in the region. Figure 5 displays a benchmarking exercise using a customs environment indicator designed to measure the administrative transparency o f customs and border crossings (Wilson, Otsuki and Mann, 2003).5 In this exercise, Nicaragua and El Salvador perform well, just above of the benchmark value, while the remaining countries fall short o f the values predicted b y their level o f income by 10-13 percent. The performance i s less satisfactory for all countries (except for El Salvador) in a similar exercise benchmarking by the value o f trade per capita. The indicator i s the average of five indexes. The first three (irregular payments, import fees are low and hidden import barriers) are dram from the Global Competitiveness Report, the fourth (bribery and corruption) are taken from IMD Lausanne’s World Competitiveness Yearbook and the fifth (corruptions perceptions index) i s from Transparency International. See Wilson, Otsuki and Mann (2003). 190 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 5: Benchmarking with Respect to GDP per Capita Gyatrrmala 7.17 An alternative assessment o f actual port operation delay times caused b y customs procedures i s given b y the results o f recent investment climate surveys. Figure 6 displays results on the average and longest delays reported b y importers for a sample o f countries. The Central American countries for which the information i s available perform near the sample average (with the exception o f Guatemala), better than Brazil, Peru and China, but worse than Hungary, Croatia, Turkey, Malaysia, Poland and Morocco. This i s also confirmed for the case o f delays faced b y exporters (Figure 7). This good performance i s a likely reflection o f recent modernization and simplification efforts. However, despite the progress achieved, interviews with private custom agents and freight transporters reveal there i s s t i l l room for improvement. The reduction in clearance times achieved with the internet based system i s sometimes offset b y the delays caused b y stringent physical controls conducted b y security agencies aimed at fighting smuggling and drug trafficking. Other problems arise as a result o f the use o f excessive discretion b y officials, the lack o f an adequate and enforceable code o f conduct, the importance o f the political affiliation o f candidates when filling positions, the lack o f modern risk analysis techniques and appropriate equipment for non-intrusive inspections and faster turnaround o f laboratory sample testing. 191 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 6: Custom delays for Imports (Investment Climate data) Average and longestperiods to clear customs, for imports ( I n te r n a tio n a I c o m p a riso n , days ) D d v e r a g e p e n o d u i o n g e s r period I I 1 Source: Investment Climate Surveys. Figure 7: Custom delays for Exports (Investment Climate data) A v e r a g e a n d l o n g e s t p e r i o d s to c l e a r c u s t o m s , f o r e x p o r t s (International comparison, days) 18 15 12 9 6 3 0 l a v e r a g e period n l o n g e s t period I Source: Investment Climate Survey. 7.18 Custom-related constraints were a greater concern in Guatemala than in other Central American countries, and tend to acquire much greater importance in the context o f DR- CAFTA. While less than 10 percent o f the firms surveyed in Nicaragua, El Salvador and Honduras reported that they face major or very severe constraints in the area of customs (Figure 8), this percentage i s much higher for Guatemala (23.7 percent).6 The concerns are significantly higher when firms are asked whether problems at customs could constrain their ability to benefit from DR-CAFTA: 51 percent o f Guatemalan firms report major or very severe constraints, compared to about 37 percent for El Salvador, 35 percent for Nicaragua and 25 percent for Honduras (Figure 9). In addition, importers are more likely to report customs concerns than exporters. The World Bank 2003 Guatemala ICA's results indicated that, among the infrastructure variables, customs regulations are the major obstacle to business operation and growth for large enterprises. These results may have reflected a deterioration i n the business environment which had intensified towards the end o f the Portillo administration. Prior to this period Guatemala had made strong gains in the efficiency o f customs procedures, when customs were integrated in the modern and autonomous Superintendenciu de Administrucion Tributuria (SAT), and computerization allowed streamlining 90 percent o f custom declarations. These efforts are getting renewed impetus under the Berger administration. 192 CHAPTER W: Obtaining the Payoff from DR-CAFTA: Figure 8: Firms Constrained by customs (%) Figure 9: Firms Constrained by customs if DR-CAFTA 51 0% Guatemala El Salvador Nicaragua Honduras Guatembd Nicara,w El Salvador Honduras Source: Investment Climate Survey. Source: Investment Climate Survey 7.19 The implementation of Central American customs unions i s the key next step to facilitate trade in the region. The elimination o f border crossings between countries would allow substantial reduction in transportation costs and times, while fostering the economies o f scale and greater efficiency that would be derived from a true regional market. While important advances have been made over the past year towards this goal -- including the preparation o f a unified customs’ regulation (CAUCA) and i t s reglamento (RECAUCA), as well as the creation o f unified customs between El Salvador, Guatemala and Honduras - Central American nations need to adopt the remaining steps needed to abolish all border controls between them. Key steps include elimination of tariffs on a few pending goods for intra-regional trade, full agreement on the common external tariff schedule, and procedures to facilitate the distribution o f VAT and tariff revenues among member nations. Temporary arrangements may be needed to deal with differential external tariffs arising from bilateral treaties that were signed by different C A C M members with third countries, as well as with differences in DR-CAFTA tariff phase out periods and excluded goods. In the short run, key actions are the implementation o f the manual unico de procedimientos de aduanas, and the full integration of binational customs procedures in order to have only one control post at each border. 7.20 Central American countries should deepen modernization efforts, with a focus on reducing costs and delays faced by importers. This requires pressing forward with recent modernization processes, intensifying training, and implementing quality-based management - a good initiative i s that of the I S 0 9,000 certifications in El Salvador. Remaining deficiencies in customs procedures and operations could be addressed b y facilitating inspections through the incorporation o f modern equipment and risk analysis techniques, as well as b y increasing the professionalization o f the customs agencies. 3. Institutions and regulations 7.21 Certain institutions and regulations are essential to ensure that trade opportunities arising from DR-CAFTA materialize and are eventually translated into higher growth levels. As argued in Chapter IV, most relevant for this connection are indicators o f the ease with which firms and factors can be redeployed to take advantage o f new productive opportunities. Other important areas that can create unnecessary costs to the reallocation o f productive resources are those related to administrative corruption (which also affects the attractiveness to foreign investors) and those which reduce access to credit. 193 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: 7.22 Excessive levels of regulation across Central American countries in comparison to those elsewhere in Latin America and among other developing countries suggest that regulatory reform should be a key priority in the complementary agenda. Using the labor and firm entry index o f regulations constructed b y Bolaki and Freund’ - available for Costa Rica, Honduras, Nicaragua and Guatemala - all Central American countries fall short o f their expected levels b y income, with Costa Rica and Honduras lagging furthest behind (see Figure 10). Figure 10: Regulations Index 1 HND CRI \ GTM 0.5 - 0.5 I: \,* ,/ ..I^ . 0 - 25 & -0.5 g - B -’ -1.5 ! -2 - * * -2.5 ‘ I Log per cap GDP Source: Own calculations based on Bolaki and Freund (2003). Labor regulations 7.23 An assessment o f the labor regulations component o f the regulations index o f Bolaki and Freund (2003) reveals significant levels o f underperformance for all Central American countries (6 percent to 11 percent o f predicted values) with Guatemala and Nicaragua exhibiting the widest gaps.’ While this may be reflecting some excess regulations in formal norms, in economies in which the informal sector accounts for a large size o f employment it i s unknown how costly these regulations may be. While the partial evidence available does not ’ The index of regulations i s a weighted average o f an index of labor regulations and an index o f firm entry regulations, with weights determined by factor analysis (Bolaki and Freund, 2003). Higher values o f this index reflect a greater degree of regulation both in the labor market and the business sector. Due to delays in data collection, El Salvador i s not included in this analysis. The labor regulations index i s the sum o f an employment laws index and an industrial relations law index. See Bolaki and Freund (2003) for further details. 194 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: suggest that labor turnover rates - firing and hiring rates - are abnormally low in Central American countries, more in depth studies o f labor markets in Central America are required.' Firm entry 7.24 Excessive regulations for firm entry are an issue in some countries in Central America, as measured by the number of days required b y respondent manufacturing firms to register for the first time. According to World Bank's Doing Business surveys, a typical firm in Nicaragua takes 29 days to register compared to 46 days in El Salvador, 56 days in Guatemala and 83 days in Honduras (Figure 11). Summing up the average number of days required to go through six different types of registration procedure leads to 74 days in El Salvador, 82 in Nicaragua, 251 in Guatemala and 215 in Honduras." Figure 11 compares the available data on registration times from the investment climate surveys and the World Bank's Doing Business database." A benchmarking exercise using the firm entry component of the regulations index o f Bolaki and Freund (2003) finds that Honduras exhibits the largest lag with respect to the predicted value for i t s level o f income per capita (entry procedures take almost 3 times longer to be completed compared to the rest of the world). Costa Rica exhibits only a modest gap, while Guatemala and Nicaragua are near levels predicted for their respective levels o f income.12 Preliminary evidence from recent investment climate surveys suggests that Salvadoran firms appear to be the least constrained by labor regulations, while those from Guatemala are the most constrained within the Central American context. In addition, a larger percentage o f (formal) firms i n Honduras pointed to laws and regulations regarding dismissal of workers as a significant factor affecting employment levels. '"The six registration processes are draft o f constitution o f the firm, inscription o f the firm i n the Public Registry, registration with the tax authority, operating license, registration with the Health Ministry, and environmental permits. The Doing Business database finds that the registration o f a limited liability company i n San Salvador takes 115 days on average (or close to four months) which seems to contradict I C s results. This could be attributed to Doing Business relating to only limited liability companies, and reflecting the answers o f only one law firm, which supplies the data on duration o f business registration. I n contrast, the I C s covers more than 400 firms in each country, o f different legal status, and the respondents are the firm managers. l2The index o f entry regulations uses data on the number o f procedures and the time i t takes to start a business i n each country (Bolaki and Freund, 2003). 195 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 11: Number of Days to Register a Firm Nicaragua 82 I I 115 I El Salvador I I I I I Guatemala 25 1 0 50 100 150 200 250 300 days 0 Number of days for registering a firm, Doing Business database Total duration of registration (including obtaining all necessary licenses and permits), ICs 1 E! Total average duration o f registration (sum o f average days needed to obtain six licenses and permits), ICs, Source: World Bank Investment Climate Surveys and World Bank Doing Business Database. Administrative Corruption 7.25 The prevalence o f corruption i s a significant issue o f concern in several Central American countries. Administrative corruption can have a deleterious effect on the costs faced by private firms in doing business and affect the country's attractiveness to foreign investors. Moreover, corruption and weak rule o f law can also make any regulatory environment exert unintended consequences when legal norms and regulations are not applied accordingly. 7.26 Transparency International's Corruption Perception Index (CPI) places Costa Rica and El Salvador respectively in the 72th and 66th percentiles o f a sample o f 145 countries, compared to the 24'h percentile, on average, for Guatemala, Honduras and Nicaragua. A similar ordering can be derived from the World Bank Institute's 2004 indicator of the control of corruption, although El Salvador falls further behind Costa Rica and i s actually surpassed b y Nicaragua (Figure 12).13 l3 I n the larger sample o f 195 countries used i n WBI's indicator o f control o f corruption El Salvador i s placed only at the world's 34Ih percentile, compared to the 77Ih for Costa Rica, and the average 341d percentile for Guatemala, Honduras and Nicaragua. This may be related to poor perceptions in the areas o f judicial independence and organized crime, according results from the World Economic Forum's Growth Competitiveness Index, as El Salvador performs quite well i n the indexes o f corruption i n public services, corruption i n foreign trade and corruption i n tax collection. 196 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 12: International Transparency rankings of Central American countries Guatemala 21 I I 0 25 50 75 100 percentile IQKaufrnann et al. (2003) HTransoarencv International (2004) 1 7.27 Similar rankings with respect to Central American countries are obtained for other governance indexes covering the prevalence of the rule o f law, government effectiveness and regulatory quality. Indeed, as seen in Figure 13, El Salvador systematically ranks below Costa Rica, but above Guatemala, Honduras and, with the exception of the index for corruption, also above Nicaragua. Figure 13: WBI Governance Indicators for Central America, 2004 Control of Corruption (Latin h e r i c a region. 1 I) Rule o f tar (Latin k r i c CHILE WLE COSTA RItR i aDlA RlCR URWRV WGW P R WR PRYRlR BRRnL mzn COLaiSIn HEXICD WICRRAGUR c u PERU EL 5RLMIOoR RRtDIllNR o omL 1Rw ERBLIC HOWRRS CURTEIRR ECWaOR BOLIVIA 'VEHEZLELR PARAGMI 1 PARRCURV VENEZWLR 1 197 CHAPTER VII: Obtaining the Payoff from DR-CAFTA: Government Effectiveness (Latin America region, cmnE URWRl c Rm CIR BRRZIL PnHRnn MEXICO cnwm EL mtwota RRENTDlR OOMMI C RN REPUBLIC PERU BOUYIR nowm mIcwmn ECURODR cunc r wn E VWY ZUL ER PnRffiuni 8 R 58 Cmnty's P e r m t i l e Rank (B-1881 Source: World Bank. Figure 14: Inconsistency and unpredictability of regulations, Government inefficiency and bribery 75 0 71 0 441 498 E l Salvador Nicaragua Honduras Guatemala rn Interpretations of regulations inconsistent and unpredictable 1 Government considered Inefficient 0 Bribes "to qet Thinqs Done" considered common Source: Investment Climate Surveys. 7.28 Honduras firms lead the region in the perception that bribes are required "to get things done" (Figure 14). In 2003, Guatemalan f i r m s were more likely than their peers to describe the government as inefficient and to state that government regulations are interpreted in an inconsistent and unpredictable way - although this result may be partly attributable to the intense conflict that existed between the private sector and the government under the Portillo administration. At the other end, Salvadoran firms have more confidence in public officials than do their counterparts from other Central American countries: only 35 percent o f the firms state that public officials do not interpret government regulations in a consistent and predictable way, compared to about 45 percent in Honduras and Nicaragua, and 71 percent in Guatemala. However, while lower than in neighboring countries, administrative corruption seems to affect almost half o f the firms surveyed in El Salvador. 198 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Regulations and Access to Credit 7.29 Sufficient access to credit i s important for firms to respond to new investment opportunities arising from DR-CAFTA. While the level o f access to credit varies across Central American countries, firms seem to face significant credit constraints in all. One sign o f credit constraints i s the intensive usage o f retained earnings to fund new investments. This source supplies over half o f the funds for firms in Honduras, Nicaragua and Guatemala (Figure 15).14 Credit constrains may be much higher than in global competitors: according to investment climate survey data, the share o f firms with access to loans in Central America ranged between 43 percent and 63 percent, in comparison with 87 percent for countries like Thailand and Malaysia (Figure 16). Within Central America, the share of firms facing constraints i s lower in El Salvador (17 percent) than in Guatemala (28.1 percent) and Honduras (27.8 percent), with Nicaragua lagging behind (36.2 percent). Figure 15: M a i n Sources of finance for investment capital, by country (%) Banks Retained earnings Supplier Credit 8 Malaysia H Honduras 0 Ecuador 0 Guatemala H Nicaragua El Brazil El Salvador I Source: Investment Climate Survey. Figure 16: Share of Firms with Loans (%), International Comparison 87.3 87.1 51 2 503 Source: Investment Climate Survey. l4A large body o f research has shown that investment decisions o f smaller firms depend on the availability of internal funds (e.g., retained earnings), thus suggesting that they are credit-constrained (Fazzari, Hubbard and Petersen, 1988). For applications to countries i n Latin America see Galindo and Schiantarelli (2003). A recent study by Beck, DemirguqKunt and Maksimovic (2002) showed, using data on firms from 54 countries, that financial constraints in terms o f access and cost o f funds exert an influence on firm growth and that smaller firms are most adversely affected by those constraints. 199 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: 7.30 Smaller firms face more restrictions in accessing credit. Within El Salvador, for example, the fraction of credit constrained enterprises decreases with firm size: only 6 percent o f large and 10 percent o f medium sized f i r m s are in that status, compared to 30 percent and 23 percent respectively for micro and small f i r m s (Figure 17).15 The l o w share o f finance constrained firms among the large i s explained b y their overall easier access including to external finance. In addition, access to formal credit in rural areas tends to be low, despite high repressed demand (Guatemala CEM, 2005). Figure 17: El Salvador. Firms reporting major or severe obstacles related to finance, by size Availability o f Cost o f Financing A c c e s s to F i n a n c i n g Financing 1 mTotal I M icro O S m all O M e d I L a r g e 1 Source: Investment Climate Survey. 7.31 Measured b y broader indexes o f financial depth, Guatemala and Costa Rica underperform their peers relative to their level o f development. B y contrast, El Salvador, Honduras and Nicaragua perform above expected levels, using private sector credit as a share o f GDP.16 In addition, interest rate spreads are very l o w in El Salvador - due to the dollarized regime and a more efficient banking sector - while those in Costa Rica are among the highest in Latin America (see Table 2). l5Credit constraints are prevalent when firms with viable investment projects do not have access to credit. This means that it i s difficult to conclude that firms are constrained when they report obstacles to access finance. This is particularly important when assessing the constraints b y firm size, because if scale matters for profitability o f investment projects, then naturally small firms w i l l be less likely to access credit than large firms, not because there i s something wrong in the credit market, but because their investment projects might not be profitable. Thus the analyses,reported here and in other studies need to be complemented with subsequent analyses that directly assess credit constraints in a more rigorous fashion. l6Results from a benchmarking exercise o f private sector credit as share o f G D P against l o g GDP per capita and a squared term. Results for Honduras may be affected b y a potential undervaluation o f i t s true GDP. 200 CHAPTER VU: Obtaining the Payojjjrorn DR-CAFTA: Assets Assets Credit to private Deposits Real Interest (US$,bln) relative to sector relative to relative to lending rate Costa Rica I 8.2 56.9 36.0 43.4 I 16.1 I 15.2 Source: Nicaragua Development Policy Review, (World Bank, 2004e). 1/ Data for El Salvador, Costa Rica, and Nicaragua relative to GDP are for 2002. 2/ Total o f claims excluding fixed and other assets. 3 / The real lending rate i s calculated as the average lending rate reduced by CPI inflation. 7.32 Credit access limitations in Central America are linked to key institutional and regulatory weaknesses such as weak enforcement of creditor rights, slow and politicized judiciaries, inoperative bankruptcy procedures and poor registry systems for property rights, and weaknesses in banking supervision and regulation. Key actions o f an agenda aimed at improving access to credit should include: Strengthen creditor’s rights b y making enforcement procedures o f secured and unsecured claims shorter and more efficient. Improve the efficiency and independence of the judiciary, including judges’ experience with and knowledge o f commercial law in order to bring more certainty to the resolution o f commercial disputes. Modernize and unify registry systems for both immovable and moveable assets, and continue with efforts to clarify property rights for real estate and their formal registration. Upgrade bankruptcy and reorganization procedures to facilitate speedy reorganization of viable insolvent enterprises as well as the efficient liquidation o f non-viable ones. Develop credit information systems to reduce the high operational costs o f micro- finance institutions. Strengthen banking regulations and supervision. 7.33 To cope with the increasing integration o f Central America’s financial sectors, which i s likely to speed up with DR-CAFTA, actions should be taken to consolidate supervision. The increasing regional nature of most financial groups in Central America allows for the quick cross-border transmission o f shocks originating in any one country. DR-CAFTA i s also likely to make industrial and commercial operations more regionalized in Central America. While many commercial banks have quickly adjusted b y organizing themselves on a regional basis, the region’s supervisory authorities have not. Efforts to develop a coordinated strategy 20 1 CHAPTER VII: Obtaining the Payoff from DR-CAFTA: for effective regional consolidated supervision and regulation are required to avoid the limitations o f the current individual country a p p r ~ a c h . ' ~ 4. Innovation and Education 7.34 As explained in chapter N , DR-CAFTA offers opportunities for Central American countries to boost long term productivity b y increasing imports o f capital goods and adapting foreign technology. However, adopting existing technology i s not without cost and an enabling environment requires a well functioning national innovation system (NIS) as well as complementary actions on the education front (World Bank, 2003a). This section provides a preliminary assessment of how Central American countries perform in these areas b y concentrating in three themes. First, we benchmark some Central American countries on their enabling environment for innovation, by reporting data on innovation outcomes, inputs and the efficiency o f R&D. Second, we assess the recent performance o f Central American countries with respect to discoveries o f new export products, a key outcome that has been linked in the recent literature to growth and productive investments. Third, we provide a quick assessment o f educational performance in Central America, with special emphasis on those areas that are required for the functioning o f a successful NIS. At the end, we offer some recommendations are presented. Innovation: outputs, inputs and efficiency 7.35 Central America's success in intermediate innovation outcomes across time can be tracked b y following two common measures: the number o f patents granted b y the US. patenting authority, and the number of scientific publications. Figure 18 benchmarks performance b y researchers residing in Costa Rica and El Salvador in each dimension, comparing them with the average of those in countries with the same levels o f GDP, the same '~ size labor force, and the same value o f merchandise exports to the U.S. since the 1 9 6 0 ~The graph shows how far these countries are from the average o f similar economies (the zero line). A negative number on the vertical axis i s evidence o f under performance. Because the predicted number of patents are relatively small (1 or 2) the performance o f Costa Rica in terms o f patents appears to be erratic. Nonetheless, one could say that Costa Rica does not seem to under perform systematically. Conversely, the outcome o f scientific publications i s around 50 percent below average. El Salvador has historically underperformed in scientific publications by about 95 percent, although this can only be taken as suggestive since in absolute numbers are quite small. The picture for patents i s ambiguous, again due to the small absolute numbers, although Figure 18 suggests certain deficiencies in patent achievement. This i s the subject of an important recent report by the IMF for Central America (IMF, 2005). To answer this question we use data collected by Lederman and Saenz (2003) on patents granted by the U.S. Patent Office to innovators residing around the globe and the number of scientific publications provided by the U.S. National Research Foundation. The series plotted are the residuals from a regression on GDP and Population and their squares. See Bosch, Lederman, and Maloney (2005) for technical details about the methodologies and data. 202 CHAPTER W: Obtaining the Payoff from DR-CAFTA: Figure 18: D o Costa Rica and El Salvador Underperform in Innovation Outputs? Costa Rica I n n o v a t i o n Outputs .. I - Scientitic Publications ----- Pdten t s E l Salvador I lnno va ti o n Outp uts S c le n tific Pub Iic a t ion s ---- Patents I Decade Patents Scientific 1 ; Publications ;::: ’” 90s 3 62 60’s Source: Lederman and Saenz (2003). 7.36 Similar benchmarking can be done with two indicators o f innovation inputs: expenditures on research and development (R&D) and payments for licensing o f new foreign technologies, again with respect to GDP and labor force. The former extends beyond investment in “cutting edge” technologies to most expenditure in adoption and adaptation o f technologies. Not only does the share o f GDP dedicated to R&D in the average country increase with income per capita, but several high growth comparator countries - Finland, Korea and Israel - had dramatic take-offs relative to this benchmark, a path which China and India appear to be attempting to follow (Lederman and Maloney 2003). Disappointingly, the 203 CHAPTER V l l : Obtaining the Payoff from DR-CAFTA: average effort of 5 Latin American countries for which data exists (Argentina, Brazil, Chile, Costa Rica and Mexico) i s substantially below trend. 7.37 Costa Rica’s under performance in the outcomes of innovation i s partly due to lackluster performance in innovation investments, at least in R&D expenditures. Costa Rica’s R&D effort has been weak compared to countries of similar size. On the other hand, the share o f GDP Costa Rica devoted to licensing does not show significant gaps with respect to the proper benchmark. This i s not because o f low private and social returns to R&D, as Lederman and Maloney (2003) estimate that the economic returns to R&D and to licensing for countries o f Costa Rica’s level o f income are high at around 65 percent. More likely, Costa Rica’s l o w investments in this area are probably linked to deficiencies in the areas o f financial depth, protection of intellectual property rights, ability to mobilize government resources, and the quality o f research institutions, which have been shown to be key determinants o f R&D effort across countries. As a result, not only i s Costa Rica not experiencing a take o f f in innovation effort such as those seen in dynamic economies such as Finland, Korea, or Israel, i t i s below the “average” performer. 7.38 L o w levels of innovation outcomes may also arise from inefficiencies in the way in which existing innovation-related resources are utilized through the NIS. One way of estimating the efficiency o f a N I S i s b y examining how R&D investments translate into commercial patents and how the “elasticity” o f patents with respect to R&D investment compares to the world average.” Figure 19 shows the elasticity or sensitivity o f patents with respect to R&D in Costa Rica, El Salvador, and several comparator countries. Costa Rica’s positive value can be interpreted as an indication o f the extent to which the country performs in patenting efficiency relative the OECD average. In fact, Costa Rica together with Venezuela, are the only two Latin America and the Caribbean (LAC) countries that perform better than the OECD average. Additional statistical exercises showed that Costa Rica’s privileged position compared to the rest o f the L A C countries i s due to higher quality of research institutions and greater collaboration with private firms. l9 Bosch et al. (2005) discuss i n detail how these elasticities are estimated and how they vary across regions o f the world. 204 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 19: Efficiency of R&D Expenditures Compared to the OECD -15 ' I Source: World Bank 7.39 El Salvador i s more inefficient in innovation outcomes than the average o f L A C countries. A good share o f this inefficiency i s likely related to the lack o f collaboration between the private sector and research organizations such as universities, which i s the main explanation found for the case o f Latin American and the Caribbean b y Bosch, Lederman, and Maloney (2005).20 Discovering new export products 7.40 Recent attention has been given to the linkage between the appearance o f new export products and economic growth. Some authors have argued that public sector policies are needed to provide incentives for entrepreneurs to invest in discovering new and potentially profitable businesses, due to problems with externalities and private appropriation o f rents similar to those that hinder innovation and technology adaptation (Hausmann and Rodrik, 2003a). In fact, for the case o f El Salvador, Hausmann and Rodrik (2003b) argue that public sector subsidies for the introduction of new products may be needed to revitalize economic growth. Furthermore, Klinger and Lederman (2004) do find evidence suggesting the market - This result was derived by estimating a patenting function that includes the interaction between R&D investment and a dummy variable for Latin American and Caribbean countries (LAC). In turn, the same function was estimated but including additional explanatory variables. Among these, the variables from the Global Competitiveness Report on the private sector's perception o f the quality of research institutions and the extent o f collaboration between private firms and universities were the ones that eliminated the statistical significance of the L A C variable interacted with R&D. See Bosch et al. (2005) for details. 205 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: failures might in fact impede economic discovery, and Khan (2004) finds that the introduction o f new products does affect economic growth b y stimulating productive investment. 7.41 Among Central American countries, Guatemala has been the main underachiever in terms o f discovery of new export products. Figure 20 shows the predicted and the observed number o f export discoveries in the 1990s, which are a function o f the level o f development (GDP per capita) of each country.2' El Salvador, Honduras and Nicaragua show only slight levels o f underperformance while Costa Rica i s a strong overachiever. Given this evidence, policies to stimulate economic discoveries should not be a strong priority over other policy needs, with the only possible exception o f Guatemala. a Costa Rica and Panama Honduras and Nicaragua / 1 Education for innovation and growth 7.42 Innovation and technological change require a strong education base. This i s the key conclusion o f the innovation and education flagship (World Bank, 2003a) which highlighted how technological innovation and educational levels (particularly s k i l l s and ability to learn) are complementary and reinforce each other's contribution to economic growth. The study showed the need to coordinate and sequence both education and technology absorption policies. I t also argued that there must be a sharp acceleration in educational attainment in order to benefit from the knowledge economy and from the growth enhancing potential o f technology transfers through FDI and trade. 21 A discovery i s defined as a good exported for less than $10,000 in 1995, but for more than $1,000,000 in 2000, 2001, and 2002, based on disaggregated export data classified at the 6-digit level of the Harmonized System. See Klinger and Lederman (2004). 206 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: 7.43 DR-CAFTA and the greater flows of foreign investment that should accompany i t s introduction are likely to increase the demand for secondary and skilled workers. Investors are likely to require higher s k i l l s (including bilingual skills) to function in an increasingly globalized market and to use new imported inputs. Local firms willing to take advantage of new DR-CAFTA-related opportunities w i l l also likely demand new s k i l l s to adapt innovations and improve productivity levels. Most countries o f Central America, with the only exception o f Costa Rica, are likely to face shortages o f appropriately skilled workers to meet these demands. The absence of a considerable mass o f secondary educated workers in most countries o f Central America i s due to the slow expansion o f educational opportunities and i t s unbalanced pattern. Most countries have not followed an orderly and sequential growth between educational levels as reflected in the fact that from 1960 to 2000, the ratio o f workers with university education to those with secondary education almost quadrupled in El Salvador, Costa Rica and Guatemala, and tripled in Honduras. The result i s high labor force inequities: most workers only have minimum literacy and math skills; very few have skills in quantitative analysis, communication and other basic competencies provided b y secondary education; but a larger percentage has university education. This tendency may be reversing in Costa Rica and El Salvador, given recent persistent increments in secondary education investment. 7.44 Coverage and quality o f secondary education i s s t i l l a weakness in all Central American countries, while inefficiencies o f resource use are more acute in Honduras and Nicaragua. This i s a concern, as higher levels of secondary schooling are crucial to facilitate the technological upgrading o f local manufacturers, to attract FDI with high technological content, and to benefit from the potential spillovers o f those investments to the rest o f the economy. Coverage of the secondary cycle i s l o w (around 55-60 percent) or very low (around 30-37 percent) in all countries (Table 3). Quality i s s t i l l l o w at all educational levels, as illustrated b y the s t i l l high repetition rates and the unsatisfactory results reported at the standardized national exams (di Groppello, 2004). Inadequate curricula and textbooks, combined with insufficient learning times and teacher quality are identified as being among the main contributing factors to l o w educational achievement in the region. Inefficiency o f resource use i s a problem in Honduras due to the excessive share o f spending on salaries relative to non-salary expenditures, combined with lack o f effective teacher incentives. Inefficiencies in Nicaragua relate to excessive central administration costs. Table 3: Gross Enrollment Rate at the Secondary Level (2001 or 2002) El Salvador Guatemala . 1 Honduras I 37 I I Nicaragua I 62 I Source: Di Gropello, 2005. 7.45 Central American firms use in-house and external s k i l l s training to upgrade and complement the educational profile o f their workforce. While there may be some reasons to believe that markets may underprovide training relative to the social optimum (due to the 207 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: externalities associated w i t h a higher skilled workforce), public provision o f training has been characteristically inefficient and unresponsive t o private sector needs across Central America. F o r instance, returns t o public training programs in Guatemala have been shown t o b e very low, while they are positive for privately provided and funded training ( W o r l d Bank, 2004f). Recent reforms to I N S A F O R P in El Salvador have removed i t f r o m directly providing training, a k e y factor in the improvement o f training services in that country (see B o x 1). Box 1: The Positive Experience of Reform of VET system in El Salvador The organization primarily finances training solicited by companies and provided by private training centers. Only when no private provider exists, does INSAFORP provide direct training. This structure seems to avoid at least one of the two common pitfalls of many training systems in Latin America: (i) provision of irrelevant training with little impact on productivity and wages; and (ii) inefficient public provision o f training. Whether the creation of INSAFORP led to additional skill formation, or instead it simply substituted for firm payment of training i s uncertain. However, with the high levels of training achieved in 2001, it seems plausible that the introduction of the training levy raised the level o f training beyond the pure market solution and thus successfully addressed some of the market failures involved in the provision of training. INSAFORP i s facing issues of financial sustainability : The rapid increase in funded courses has outpaced revenue growth, and as a consequence INSAFORP used accumulated reserves during 2001 to accommodate high demand. Hence, the current high level of firm training i s unsustainable in the medium to the long run without additional funds or efficiency savings. El Salvador Country Economic Memorandum, (World Bank, 2003b). Areas for action 7.46 F o r lower income countries such as Honduras and Nicaragua, national innovation systems should focus o n facilitating primarily technology absorption. Priority actions should include: 0 Improve the capacity t o absorb n e w technologies f r o m the external stock o f knowledge, by simplifying processes t o i m p o r t capital goods and to license foreign technologies. 0 Strengthen the institution in charge o f innovation p o l i c y and i t s coordination with private sector needs. Improve the quality o f the information o n R&D. 0 Improve the efficiency o f l o w R&D public spending by increasing linkages with private sector, and increasing the accountability o f the use o f these resources. 7.47 F o r middle income countries such as Costa Rica, El Salvador and Guatemala, national innovation systems should support technology adaptation and generation. Priority actions include: 208 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: 0 Strengthen public-private partnerships by increasing linkages between public research centers and private firms, aligning incentives for research in universities and improving the accountability o f R&D performed with public resources. 0 Promote output-basedmarket-oriented R&D in public research institutes and universities, by gradually reducing their access to earmarked funds and - at the same time- expanding their autonomy to look for new sources o f funding, particularly through different partnerships with the private sector; and b y introducing flexibility in the regulation ruling the assignment o f property rights over inventions generated in these institutions, possibly allowing main researchers and their institutions to benefit from their discoveries; 0 Gradually increase public R&D funding, preferably through an innovation fund to finance experimental development (as opposed to basic research) b y matching grantskompetitive subsidies directed to commercial applications. 0 Strengthen the governance o f technology policy, b y defining an explicit technology and innovation policy, enhancing the policy making role o f a public-private board, and b y simplifying the concessions of public funds for research and development. 0 Enhance institutional capacity to enforce IPR laws, possibly b y up-grading the registries, investing in process simplification and staff training. 7.48 Sequencing o f education policies with the stage o f development and innovation policies i s important. For those countries farthest away from the technological frontier -such as Honduras and Nicaragua- the best technology policy i s likely to be simply sound education policy. The agenda for countries that require education levels to adapt relatively simple technologies should be aimed at achieving completion o f universal primary education, with gradual expansion o f secondary education. In the more advanced settings o f Costa Rica and El Salvador, where adaptation and creation o f new technologies i s more important, issues o f education quality and completion of secondary schooling are more important. 7.49 In vocational training policy, Central American countries should change the existing public-private balance towards greater in-service training and introducing competition in the provision of training services. Training policy should be viewed not just subsidizing or providing training, but also increasing the demand for training through appropriate technology policy, and increasing the trainability o f workers through appropriate education policy. For this, i t i s important to build partnerships between the private sector and universities or technical schools, as well as encourage apprenticeships. 7.50 While i t i s important to ensure that appropriate supply for tertiary education i s available, the justification for public funding i s weak, as high private returns already create high demand. Public policies towards expansion o f tertiary should focus on facilitating private investment through regulation that would improve functioning o f the market for higher 209 CHAPTER V I I : Obtaining the Payoff from DR-CAFTA: education. These initiatives could include (i) increase information available to students; ( ii) maintain flexible accreditation system and (iii)greater cost recovery in public universities.22 7.5 1 Universal primary completion remains an important unfinished agenda in Guatemala, Honduras and Nicaragua. In order to compete in a globalized economy, ensuring quality universal primary education for all boys and girls o f all ethnicities, and ensuring that they acquire basic cognitive skills o f literacy and numeracy must be the top priorities in education in Central America. The trends for Honduras and Nicaragua, and Guatemala indicate that they need to redouble efforts to achieve MDG for universal completion in 2015. Except for Guatemala, these countries are already spending a high proportion o f national budget on education. Thus, reforms and external support are essential for these countries to achieve universal primary completion. 5. Summarizing priorities for countries 7.52 The chapter reviews recent evidence in the areas o f trade facilitation, institutional and regulatory reforms, and innovation and education, in order to identify key priorities for the complementary agenda for DR-CAFTA. The main challenges identified for Costa Rica include improving road quality, port and customs efficiency, boosting financial depth, and improving the quality and coverage o f secondary education. For El Salvador, priorities focus around increasing road quality, reducing shipping costs, and tackling governance challenges, as well as improving the quality and coverage o f secondary education. Both countries need to devote more public resources to R&D (with monitoring and evaluation efforts put in place to assess results over time), strengthen public private partnerships for innovation, and enhance the institutional capacity to enforce intellectual property rights laws. I n addition to tackling weaknesses in the areas identified for Costa Rica and El Salvador, Guatemala also needs to continue to build on recent accomplishments in improving customs administration, coverage and quality o f primary education, and road density, as well as devoting some attention to fostering the development of new export products. 7.53 The challenges for Honduras and Nicaragua are likely to encompass a broader set o f policy issues, as they face more limitations due to their lower development level. Both countries need to address governance, and work on improving the coverage and quality o f primary education, improving the operational efficiency o f ports and increasing the quality o f roads and their density. They also need to improve their capacity to absorb knowledge from abroad, strengthen institutions in charge o f innovation policy and increase linkages between public R&D programs and the needs of the private sector. Honduras also needs to upgrade customs administration and reduce the costs and time to establish new business ventures. 7.54 A l l Central American countries share a regional economic agenda which needs to focus urgently on achieving a Customs Union, which i s critical to reduce transaction costs to trade within the region. In addition, efforts should be deepened to coordinate the development of infrastructure that benefits from a regional perspective, including major road networks, and 22 Holm-Nielsen, Lauritz, Andreas Blom and Patricia Zuniga Garcia, “The World Bank in Tertiary Education in LAC”, En Breve, No. 18, World Bank, Washington DC. 210 CHAPTER VU: Obtaining the Payofffrom DR-CAFTA: the development of ports. Mechanisms to formulate a common regional trade policy need to be strengthened, to ensure coherence of future bilateral, regional and global commitments with the new framework provided b y DR-CAFTA. In addition, improved coordination of key regulatory policies (e.g., financial supervision, competition, fiscal incentives) may be needed to establish the basis of a deeper and more integrated regional market in the future. 7.55 All o f the elements o f the complementary agenda mentioned here are also components of the broader agenda to boost economic growth in the region. Recent analytical work produced b y the World Bank to prioritize actions for broad-based growth in the nations o f Central America has highlighted the high return that would be obtained from improvements in the areas o f infrastructure, education and governance. DR-CAFTA enhances the social return to these actions and makes them more urgent. 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