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 StandardsMeasurement Survey MCCA Central American Common Market MFN Most FavoredNation 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 a1Campo (Mexico) PROGRESA Programa de Educacidn, Salud y AlimentaciBn (Mexico) R&D Researchand Development RIA Regional IntegrationAggrement RPS "Red de Proteccidn Social" SAM Social Accounting Matrix SAT "Superintendencia de Administracidn Tributaria" SPS Sanitary and Phytosanitary TFP Total Factor Productivity TPL Trade PreferenceLevel TRIPS Trade-Related Aspects of IntellectualProperty Rights TRQs Tariff-Rate Quotas International Unionfor the Protection of New Varieties of Plants us UPOV United States USTR United States Trade Representative UNCTAD U.N.Conference onTrade andDevelopment UNECLAC United NationsEconomic 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 May Sector Manager Mauricio Canizosa Task Managers Carlos Felipe Jaramillo Daniel Lederman "DR . CAFTA:CHALLENGESAND OPPORTUNITIES FORCENTRALAMERICA" Table of Contents Chapter I:Summaryof FindingsandIntroduction ........................................... 1 1. Introduction ..................................................................................... 1 2. ISince s DR-CAFTA the Endof the Road? Trade and Development in Central America 1990...................................................................................... 2 3. The Contents of DR-CAFTA:Implicationsfor Market Access and Domestic Reforms ......................................................................................... 3 4. Economic Effects of DR-CAFTA: More Art than Science............................. 5 5. Policy Approaches to Managingthe Economic Transition: Ensuringthat the Poor CanBenefitfrom DR-CAFTA: ........................................................ 7 6. Macroeconomic Implications of DR-CAFTA............................................ 9 7. Obtaining the Payoff from DR-CAFTA: Priorities for the Complementary Agenda 11 Chapter11:I s DR-CAFTATheEndof the Road?:Trade andDevelopmentin ................................................................. 13 1. Introduction...................................................................................... CentralAmerica since 1990 14 2. Trade Policies inCentral America 1990-2003.............................................. 14 - Tariff and non-tariff barriers................................................................ 14 - Export Promotion............................................................................ 16 - IntegrationInitiatives........................................................................ 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 Chapter111:TheContentofDR-CAFTA:Implicationsfor MarketAccessand DomesticReforms ............................................................................. 31 1. Introduction...................................................................................... 32 2. Market Access for Goods....................................................................... 33 - Agriculture...................................................................................... 33 - Manufactures.................................................................................. 38 - Apparel and Textiles ......................................................... 40 3. Services........................................................................................... ("Maqui2a") 42 4. Other Provisions............................................................................... 44 - Investment Protection...................................................................... 44 -- IntellectualProperty Rights............................................................... 45 Labor and environment..................................................................... 47 - Government Procurement and Corruption.............................................. 49 - Customs........................................................................................ 51 -- Trade Capacity Building................................................................... Dispute Settlement............................................................................ 51 52 5. Provisions to Deepen RegionalIntegration................................................ 52 6. Conclusions.................................................................................... 53 Chapter IV: EconomicEffects of DR-CAFTA: More Art than Science .................... 1. Introduction...................................................................................... 57 58 2. Trade Liberalization and the Static Gains from Trade..................................... 60 88 4. Conclusions andPolicy Priorities for the DR-CAFTA Beneficiaries.................... 3. Complementary Policies and the Dynamic Gains from Trade........................... 105 Chapter V: Policy Approachesto Managingthe EconomicTransition: Ensuringthat the Poor Can Benefit from DRXAFTA ................................................... 121 2. Liberalization of Sensitive Agricultural Commodities under the DR.CAFTA ........ 123 1. Introduction...................................................................................... 122 125 4. The ExpectedImpacts of Liberalizing the Sensitive Agricultural Commodities: 3. Framework for Analyzing Welfare Impacts of the DR.CAFTA ......................... 133 5. Alternative Approaches to Mitigating the Adverse Impacts o f DR.CAFTA ......... New Evidencefrom ElSalvador. Guatemala and Nicaragua ........................... 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 ........................... 1. Introduction...................................................................................... 163 164 2. Potential Fiscal-Revenue Losses from DR.CAFTA ....................................... 164 4. Summary and Policy Recommendations................................................... 3. DR.CAlTA, Trade Structure and Business-Cycle Synchronization................... 169 179 ChapterComplementary the Payoff from DR-CAFTA: Priorities for the VII: ObtainingAgenda 183 1. Introduction.................................................................................... ........................................................................ 184 2. Trade Facilitation................................................................................ 185 .Roads ............................................................................................. 185 .Ports .............................................................................................. 186 .Customs ......................................................................................... 190 3. Institutions and Regulations.................................................................... 193 .LaborRegulations ........................................................................... 194 .FirmEntry ................................................................................... 195 -.Regulations andAccess to Credit......................................................... Administrative Corruption ................................................................. 196 199 4. Innovation andEducation.................................................................. 202 - Innovation: outputs, inputsand efficiency.............................................. 202 - Discovering new export products......................................................... 205 .EducationforInnovationandgrowth................................................... 206 .Areasforaction .............................................................................. 208 5. Summarizingpriorities 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 11; C. Felipe Jaramillo and Daniel Lederman, Chapter III;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. FelipeJaramillo and Daniel Lederman. Excellent research assistance was provided by Ricardo Tejada (chapters II,111, IV), Jorge Camacho (chapter 11, 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 colleaguesincluding HelenaRibe, 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 coordinatedtranslation services. Rodrigo Jarque and Beatriz Prieto-Oramasprovided proofreading and editinghelp. 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 tradeintegration and ruraleconomies), Caroline Freund and BineswareeBolaky (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 CBI 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) (onlegal andinstitutional changes), Amy Angel (FUSADES) (on agricultural quotas). Most importantly, this report reflects a long process of interactive researchand 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 Conferencein San Salvador, ElSalvador, inFebruary of 2004, co-sponsoredby 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 representativefrom other donor agencies. The authors would like 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), ReginaVargo (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 like to thank all of those who gave generously of their time to meet with the team and sharetheir thoughts. Chapter I.SummaryofFindingsandIntroduction 1.Introduction 1.1 A central factor in determining the future of Central America will be the ratification and implementation of 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 is an important issue, not only because the U.S. is these nations' major trading partner, but also becausethe treaty holds the potential of increasing trade and investment inthe region, which in turn i s key to lifting economic growth and improving the welfare of the people of Central America and the DR, including those living inpoverty. 1.2 This report provides a preliminary assessment of DR-CAFTA, with particular attention to three key themes: (i) expected trade and non-trade benefits, (ii) that actions Central American countries need to pursue to capitalize optimally on the new opportunities, and (iii)identification of the population groups that may require assistance to adapt to a more competitive environment. The report focuses on the developing countries of Central America, namely Costa Rica, ElSalvador, 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 of 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 will arise due to the removal of 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- CAFTA 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 of foreign and domestic investment, by improving the certainty of 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 will be made more credible under DR- CAFTA commitments. 1.4 At the same time, the report's analysis of the gains from trade suggest that, as has been found with other trade agreements, these gains will depend on the ability o f the Central American economies to successfully adjust to the changes that the agreement will bring (including changes inrelative prices) and to handle effectively the ensuingrestructuring o f the economy. Hence, the magnitude o f the benefits from DR-CAFTA will depend critically on the Analysisof the effectsof DR-CAFTA on the economy ofthe DominicanRepublic canbefoundinWorldBank (2005a and2005b). CHAPTERI : 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 it 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 of the population in Central America i s likely to experience welfare gains from implementation of DR-CAFTA, even in the short run. At the same time, the removal of trade barriers in sensitive agricultural crops could adversely affect a small share of the population living in rural areas in Central America. Although provisions in DR-CAFTA will 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 will be required to ensure that the rural poor have the means to take full advantage of the new opportunities arisingout of DR-CAFTA. 1.6 The rest of this summaryreviews the main findings o f the chapters of the report inthe order in which they appear. Chapter I1places DR-CAFTA in the historical context of the economic reforms that Central American countries have been undertaking since the late 1980s.Chapter I11provides a summary overview of 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 IV reviews various analyses that assess the potential impacts of DR-CAFTA on the developing countries of Central America. Chapter V focuses on the identification and quantification of potentially affected populations from the easing of trade restrictions in sensitive agricultural products and analyzes policy options to assist vulnerable groups. Chapter VI reviews evidence related to key macroeconomic implications of DR-CAFTA, namely the potential revenue losses that might be produced by the removal of import taxes and the treaty's potential effect on the patterns of 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, inorder 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 I1provides 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 of trade markets through the negotiation of bilateral trade agreements. The C B I preferences granted by the U.S. have also opened important opportunities, especially inthe development of new maquila exports. 1.8 However, these impressive achievements inthe 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 of new exports -- including the impressive growth of maquila inmost Central American countries and hightechnology goods inCosta 2 CHAPTERI: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 inCentral America since 1990, its 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 of the constraints to progress in the region, such as the still inadequate progress inimproving infrastructure, education andgovernance, or continuing vulnerabilities in areas of macroeconomic and financial management that continue to add to investors' uncertainties in some of 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 still fragile due to the growing competition from Asian competitors. Although the diversification of Central American countries' exports has increased, this tendency partly reflects negative trends during the period, such as the decline or stagnation in exports of traditional commodities such as cotton, coffee and bananas. Ironically, while Honduras has achieved the highest degree of trade openness relative to its level o f income, it i s also the country with the weakest record of growth in Central America since the early 1990s. 1.10 Why these mixed results? As noted earlier, trade policy is unfortunately not the only determinant o f trade (or growth) outcomes. There are still 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 of reforms in Central America, particularly inthe trade area. It offers a great opportunity to make further progress infostering 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 of unilateral removal o f trade barriers and trade preferences, as it 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 of 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 of this initiative, as will bejustified inmore detail in Chapter IV of this report and illustrated by the identification of certain country-specific elements of the complementary agenda in Chapter VII. 3. The Contentof DR-CAFTA:Implicationsfor MarketAccess andDomesticReforms 1.12 Chapter I11 provides an overview of 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 CHAPTERI: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 DR-CAlTA should be expected to have a positive impact on trade flows and investment. 1.13 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 CBI 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 Ipreferences. Other significant results would include the flexibilization of 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- CAFTA also includes reciprocal commitments on access to service markets, which consolidate domestic reforms that opened most of 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 inimports or declines inprices. 1.15 Commitments embedded in DR-CAFTA would gradually erode current protection levels for various products that have retained highprotection inCentral American economies, during earlier efforts at easing trade restrictions in the past. The gradual decline expected in prices of basic food staples as a result should prove positive for the vast majority of Central Americans who are net consumers of 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 still excessively restrictive rules of origin for the entry o f textile products to the U.S. - represent barriers to trade that will continue to foster some inefficiencies in the deployment o f domestic resources both inthe 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 of 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 incurrent levels of accessof 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 its 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 of these areas of the Costa Rican economy. 4 CHAPTERI:Summary of Findings and Introduction 1.18 Aside from consolidating and spurring further reforms, the treaty should strengthen commitments to upgrade enforcement levels of domestic legislation. This represents a significant challenge in areas like labor, environment and intellectual property rights, which will require decisive efforts and resources to modernize and boost the capacity of public agencies. The net impact of these efforts should be positive, as investment i s likely to be attracted to environments with effective institutions. However, while DR-CAFI'A will put pressure on the modernization of these institutions, it will not by itself create such modernization. Countries will need strong independent plans of action and sufficient dedication of 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. It 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 of the negotiation of 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 will deepen regional integration efforts in the region and facilitate the creation of a Central American Customs Union. 4. Economic Effectsof DR-CAFTA: More Art than Science 1.21 Chapter IV reviews various analyses undertaken to assess the potential impacts of DR- CAFTA on the developing countries of Central America. It 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 its productive structure. Otherwise, the gains are limited to the gains on the consumption side, which allow domestic agents to consume a bundle of goods that i s larger ineconomic 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 of 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 of exports, regardless of the type of preferential treatment. Also, the evidence reviewed suggest that the gains from trade in terms of increases in GDP per capita i s intermediated by the regulatory environment that determines how quickly firms and workers can change their sectors of operation and employment. Thus a complementary agenda to enhance the impact of the DR- CAFTA 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 of the potential sectoral effects of 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 by these models are proportional to the initial level o f exports. In addition, they have difficulty dealing with technical issues such as the restrictiveness of rules of origin. Furthermore, such partial-equilibrium models do not consider the effects of the trade reforms inthe 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 of the model to changes in the returns to unskilled labor to poverty outcomes. Indeed, under a restrictive set of conditions (e.g., segmented labor markets, no dynamic effects, effective transmission of 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 of 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 of exports and GDP on FDI.The evidence also indicates that trade mightnot have a direct effect on corruption, and thus we should not expect large dynamic gains from DR- CAFTA to come from the impact of international trade on the quality of public institutions. The process of democratic consolidation seems much more important, although certain aspects of DR-CAFTA that put pressure on governments to improve the enforcement of 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 linkbetween FTAs and subsequent economic growth in a large sample of 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 of various control variables and econometric methods. Unlike the evidence presented in previous work, the new evidence reviewed does not find that the increase inGDP growth o f about 0.6 percent per year was sensitive to the type of partner inthe FTA.Incontrast, a previous empirical study using a different set of 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. Inany case, there seems to be substantial evidence that FTAs might help accelerate the pace of 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 of income will be determined by a plethora of other factors and as economies get richer, their pace of growth will 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 of 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, VI and VI1of 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 of economic development in the context of 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 of 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 of 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 II), a handful of sensitive agricultural commodities (e.g., maize, beans, dairy, and poultry) still have significant levels o f protection. Chapter V focuses on quantifying the size of the potentially affected population and the magnitude o f the potential effects. It additionally examines alternative policy approaches on how to best assist vulnerable groups to ensure that they can benefit from emerging opportunities arising out of the DR-CAFTA. 1.29 Given current levels of 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 of provisions (described inChapter 111)for dealing with the easing oftrade restrictionson sensitive goods, including grace periods for initiating the removal o f tariffs, extended phase-out periods for tariffs, interim quotas and/or phase-downs of 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 of 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 of 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, 7 CHAPTERI: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, andrice. Despite the phasing out of 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 of introducing more competition in the markets for sensitive commodities. It 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 negotiatedunder 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 of Salvadoran households, respectively, were found to be net consumers of the basket of 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 of Guatemalan households, and 5 percent of Salvadoran households were found to be net producers of the basket of 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 bejustified. 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 of sensitive crops over a prolonged adjustment period, this approach i s not without its own economic and social trade-offs. While phasing of reforms provides producers an extended period to make the necessary economic adjustments, it 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 of removal of 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 of lower prices. Coupling well-targeted transfer programs with quick easing of trade restrictions could thus enhance households' welfare in the short-term on the consumption side while providing producers with a reasonable period of support to make the economic transition. 1.33 Regardless of whether the DR-CAFTA countries in Central America choose to pursue this alternative approach, it is important to understand the broad options that policy makers can use to mitigate potential income losses arising from declines in commodity prices if a CHAPTERI : Summary of Findings and Introduction extended phase-outs and safeguards are deemed insufficient: (i) "decoupled" income support payments to farmers of sensitive crops (e.g., as in Mexico's PROCAMPO program), (ii) technical assistance programs to farmers of 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 of 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 first i s the institutional sophistication required to implement support programs, recognizing that different approaches will tax the implementation capacity o f Central American countries to different degrees. This criteria recognizes that effective programs will require, inter alia, a viable method o f targeting vulnerable populations, a minimumdegree o f know-how among the civil servants o f the implementing public sector agency, the creation of new government organizations (or transformation of old ones) and a minimum degree of independence to ensure the application of 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 of 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 of which type of support program would be more appropriate should be made on the basis of 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 this 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 VI reviews evidence related to two macroeconomic policy issues. The first 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 internationaltrade. 9 CHAPTERI: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 of public finances. At present, all Central American countries with the exception of 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 of 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 of the key measures needed to optimize its effect require increases in public investments (e.g., infrastructure, education, institutional strengthening, and transitional adjustment programs). While some of these expenditures may be temporary and could arguably be financed by greater indebtedness, this may be difficult in practice due to highcurrent debt levels. 1.39 The fiscal response to DR-CAFTA should be adapted to the fiscal situation of each country. For the cases of El Salvador and Guatemala, where tax revenue ratios are low (below 13 percent of 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 still 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), will likely require additional fiscal revenues, improvements in expenditure efficiency and attraction of private financing to respond to the opportunities of DR-CAFTA. In all countries, an essential element of efforts to improve fiscal performance should include the institutional strengthening of tax agencies and their collection capacity, as well as the elimination of exonerations from VAT andincome 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 of 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. Infact, synchronization inCentral America is highest between Costa Rica andElSalvador, 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 US i s still below the levels among NAlTA andeven MERCOSURmembers. 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 of Costa Rica, there i s virtually no evidence of 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 of NAFTA (Canada and the US) and the EU (Germany and France). Finally, the degree of 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 internationalevidence. As such, the gain in synchronization through trade expansion could be modest. 1.43 Insum, at present neither Central America's trade structure nor its 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 of trade flows change so will business cycle patterns. To fully assess the consequences of closer trade integration for the conduct of macroeconomic 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 of macro policy will be less of a concern. However, if trade integration takes the form of higher inter-industry trade then businesscycles are likely to diverge from current levels and the ability to conduct independent macro policies will grow more important. In the meantime, other factors that are not directly related to the structure of 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 of dollarization of financial assets and liabilities. Hence the macro agenda in the light of DR-CAFTA should remain focused, at least in the short-run, on fiscal consolidation. 7. Obtainingthe PayofffromDR-CAFTA:Prioritiesfor the ComplementaryAgenda 1.44 Chapter VI1reviews 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 CHAPTERI:Summary of Findings and Introduction 1.45 The challenges for Honduras and Nicaragua are likely to encompass a broader set of 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 of ports and increasing the quality of roads and their density. They also need to improve their capacity to absorb knowledge from abroad, strengthen institutions in charge of 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 businessventures. 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. Inaddition, efforts should be deepenedto 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 of future bilateral, regional and global commitments with the new framework providedby DR-CAFTA. Inaddition, 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 inthe future. 1.47 All of the elements of the complementary agenda mentionedhere 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 of Central America has highlighted the highreturn 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. Is DR-DR-CAFTA TheEnd Of The Road?: Chapter 11.I s DR-CAFTA The EndOf The Road?: Trade And Development InCentral 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 of new exports including the large growth of maquila goods and high technology goods from Costa Rica. Greater trade volumes have also made a significant contribution to growth in Central American inthe 1990s, although their impact has not been sufficient to compensate for less dynamic factors, including low levels of education, weak governance, lagging infrastructure, and weaknesses in macro policies and financial sectors. From this perspective DR-CAFTA can be seen as offering an important opportunity for further progress in consolidating trade-led growth, but it needs to be complemented by addressing key bottlenecks that can maximize its trade, investment and growth impact. 13 CHAPTER II. Is DR-DR-CAFTA TheEnd Of TheRoad?: 1.Introduction 2.2 Negotiations for a free trade agreement between the U.S. and the nations of Central America follow a long process of 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 of 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 of 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 its promise. 2.3 This chapter sets the background for DR-CAFTA's appearanceinthe scene inCentral America. To better understand the context for this 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 of trade flows, trade diversification and overall growth. The analysis of the potential effects of DR- CAFTA 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 of its 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 policiesinCentralAmerica 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 of 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 of exchange controls, opening up to FDIand efforts to boost the efficiency of government programs. 2.6 A key aim of the reforms has been to increase trade openness and the outward orientation of the economy. Reforms in this area included unilateral liberalization of trade barriers, removal of 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 andnontariff 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 inCentral America were among the lowest in the L A C region. For the five DR-CAFTA members, average import duties fell 14 CHAPTER11, Is DR-DR-CAFTA TheEnd Of TheRoad?. 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- 11999- I * Data for 1989. Source: Lora (2001) and IDB (2004). 2.8 The reduction of 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 low 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 still exhibit a few tariff peaks (e.g., ad valorem rates over 20 percent), protecting sensitive areas of the economy. While the list 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 of 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 of non tariff barriers - often using phitozoosanitary arguments - continue to be reported with some reg~larity.~addition, some In 1 This common tariff structure consist of rates of 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 * Costa C A and 15 percent for final goods. Rica's tariff levels beyond 20 percent currently include: 30, 35,40,45,50,65 and 150percent. 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 accusedinrecent years of the arbitrary use of sanitary and phytosanitary measures in agriculture, particularly in reference to imports of poultry, dairy products, pork, feed grains and rice (U.S Embassy Honduras, 2003). 15 CHAPTER II, Is DR-DR-CAFTA TheEnd Of TheRoad?: countries continue to require importers to purchase part o f the local crop of some sensitive commodities before issuingimport permit^.^ Figure 1:Average Tariffs- SelectedLatinAmerican Countries 101987 W 1998 02001I Source: Ledermanet a1(2002) with data from WITS, USITC and IADB. ExportPromotion 2.1 1 As part of the trade reforms of 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 firms 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 regimeshave greatly facilitated the expansiono f exports throughout the region since the late 1980s. Integrationinitiatives 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 inwhat has been termed a three-tiered strategy (Salazar, 2002). At the global level, all countries participated actively in the Uruguay Round (1986-1994) and those that were not already membersjoined 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. Is DR-DR-CAFTA The End Of The Road?: WTO. At the regional levels Central American countries revitalized the CACM under new principles (see below) and participated actively in the negotiations for the Free Trade Area of the Americas. At the bilateral level, all countries actively engaged in negotiations of 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). CACM 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 of 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 of some controversy (see IADB, 2002, Chapter 2). On the one hand, it has created a multiplicity of 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". On the other hand, these agreements have opened new trading opportunities, improved the capacity of 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 of intra-regional trade inrecent years. Created in 1961 as the first regional trade agreement in L A C under the inward looking strategy of industrialization as a Customs Union with low barriers to intra-regional trade and high barriers to imports from third countries, it faced growing obstacles to its consolidation since the late 1960s and suffered from the macroeconomic and political upheavals that were present inthe region inthe 1980s. Itwas significantly restructured andre-launched inthe 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 1991 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 of 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 of the CACM have yielded an impressive resurgence of intra-regional trade, which has grown at rates that are more than double those of extra-regional trade between 1990 and 2004. While intra-regional trade averaged only 21 percent of all trade in Central America in 1990, by 2004 these flows hadincreased 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 of the CACM. Intraregional trade still faces tariff and non Inaddition,ElSalvadorGuatemala,HondurasandNicaraguaarejointly negotiatinganFTAwithCanada.The five countries are in the early stages of ETA talks with the EuropeanUnion. Inaddition to FTAs, several CentralAmerican countrieshave signedpartial scopetrade agreements with Colombia and Venezuela. 17 CHAPTERII. Is DR-DR-CAFTATheEnd Of TheRoad?: tariff barriers, in products such as non-roasted coffee, cane sugar, wheat flour, and ethyl alcohol. For the CACM to become a fully operating customs unions, further progress will need to be made in the harmonization of external tariffs. As of early 2004, still 8 percent of tariff lines required harmonization, including some inconsistencies arising from the differences in some of the bilateral agreements that were not negotiated by the five countries jointly. A well functioning customs union will also require upgrading of the rules of origin framework, to bring them to the same level o f formality as the rules of origin that will 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 of the non- trade commitments have had few practical consequences and regional institutions in other areas are still weak. Clearly, trade stands out as the area where most substantive achievements have been made. A noteworthy development of the past decade i s the significant growth o f cross border investment within the region, which has gone hand inhand with greater regional trade flows. The expansion of 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 beginningof a deeper phase o f integration. CaribbeanBasinInitiative 2.17 Since 1983, Central American countries have enjoyed trade preferences to the U.S. market under the Caribbean Basin Initiative (CBI). This initiative allows duty-free access to the US.market for a substantial number of 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 of the maquila production of apparel in the region. In 2000, the U.S. Trade and Development Act extended the benefits of the CBI by granting trade concessions similar to those enjoyed by 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 of 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, it 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 of items made from knit fabric made in the region from U.S. yarn, although subject to an annual quota. In 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 of some inputs (i.e., findings and trimmings) o f non U.S. origin. 18 CHAPTERII,Is DR-DR-CAFTA TheEnd Of TheRoad?: 2.19 The CBI has brought considerable benefits for trade expansion to Central American nationse6All have become significant exporters of apparel to the U.S., with the largest export volumes coming from Honduras, El Salvador and Guatemala - with the former achieving substantially greater exports over the others as a result, inter alia, of 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 limitedthe 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 CBI 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 on the hurdles that have remained to further expansion o f exports despite CBI preferences reveal the continued existence of non tariff barriers for agricultural products in the U.S. (e.g., sanitary and phytosanitary restrictions, standards, labeling), complex rules of origin for some sectors such as textiles as well as the highcosts of transport and the lack of economies of scale (Monge, Loria and Gonzalez Vega, 2003). Figure2: TextileandApparelImportsintothe 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 intrade and FDIassociatedwith CBIpreferences is also the result o fcomplementary actions by Central American governments, including export promotion and investment attraction policies. The latter included the active role of specialized agencies (CINDE in Costa Rica, FUSADES in El Salvador and FIDE inHonduras) which played an important role indesigning incentives, policies andactualpromotionalwork. Rules of origin restrictions explain why a significant o f apparel exports to the U.S. do not qualify for CBI 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 CHAPTERII. Is DR-DR-CAFTA TheEnd Of TheRoad?: 3. The results of trade policies: Trade and growth outcomes 2.20 The ultimate test of success of trade policies i s significant growth and diversification of trade flows. However, simple assessments using these criteria are problematic as improvements in trade are usually determined also by a number of different policy and exogenous issues. Nevertheless, in this section we attempt a preliminary assessment of 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 of recent years may have contributed to overall economic performance since the early 1990s. Trade openness 2.21 Table 1 displays a common measures of trade flows (also known as trade openness, defined as exports plus imports as a share of GDP) for Central American countries and other LAC countries for 1990-91and 2000-01.8The 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 of 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 of trade volumes was most impressive for Honduras (62 ppts) and Nicaragua (40 ppts) and less so - but still 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 of trade policy, strictly speaking it i s an outcome variable that reflects a broad array of policies and other structural features of an economy (Le., area, landlocked situation, oil exporter). The indicators of trade volume presented in this section include the best available information for all trade, including all imports and exports related to free trade zones and maquila activity. One of the reasons for the apparent large trade openness (and gains) magnitudes as a share of GDP obtained for Honduras and Nicaragua i s the potential underestimationof their gross domestic product figures. 20 CHAPTER II. Is DR-DR-CAFTATheEnd Of TheRoad?: Table 2: Trade Openness* (Percent of GDP) I 1990-9112000-01khanrrel * Exportsand 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 of 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 of capital flows (including 31, aid and public and private indebtedness) which allowed for the financing of 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 ingreat part due to the surge inmaquila 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 of export, including high technology exports (e.g., Intel microchips) and a wide array of other manufacturingproducts. 21 CHAPTERII. Is DR-DR-CAFTATheEnd Of Re Road?: Table3: Trade Openness,Exports andImports" (Percentof GDP) ] 1991 I 2001 Change I I Guatemala 0.39 0.50 0.11 Exports 0.18 0.19 0.01 Imports 0.21 0.31 0.10 ElSalvador 0.42 0.57 0.15 Exports 0.14 0.21 0.07 ImDorts 0.29 0.36 0.08 * Exportsandimportsof goods, includingnaquila (gross). Source: World Bank with data fromCentral 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, it i s useful to compare their trade outcomes with those of 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, oil exports)." In this light, the positive performance of 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 of progress achieved in this lo Accounting for the factors mentioned i s done so that we do not unfairly attribute to trade policy what i s merely the result of structural country characteristics.We follow here the corrections included in Loayza et al(2002). 22 CHAPTERII.Is DR-DR-CAFTA TheEnd Of TheRoad?: front.l1 However, the fact that most of the countries continued to exhibit shortfalls by the early 2000s in relation to international comparators i s a likely result of continued constraints intransportationcosts, portbottlenecksandother behindthe border weaknesses. Figure3: Trade Opennessas a percent of GDP: Deviations from PredictedValues by Level of Income 6o3 I Tlggo 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. It is well known that countries that rely heavily on a few goods for its 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 ina study by Ledermanand Maloney (2002) which found that countries that exhibit a highconcentration o f exports ina 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 of traditional commodity exports declining in favor o f light manufactures. The case o f El Salvador i s representative. Traditional exports fell from 50 percent o f total exports in 1990 to 15 percent in 2002. In the same period, the shares of non traditional exports and net maquila exports went from 48 percent to 58 percent and from 3 percent to 28 percent, respectively. *'The reductions inthe deficit for El Salvador, Guatemala and Costa Rica seem small by comparison to achievements inHonduras and Nicaragua, but the latter may be overestimated due to the undervaluation of GDP. 23 CHAPTER II. Is DR-DR-CAFTA The End Of The Road?: Despite the structural change in the composition of 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 of exports in maquila manufactures (Figure4). Results for Guatemala show unchangingdiversification levels untilthe late 1990s, followed by increasing concentration levels in recent years. Costa Rica displays a diversification trendthat ends abruptly in 1999, when the sudden surge inexports 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 of maquila products and microprocessors - industries that are still 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 ,- Um 0.3 58 0.2 0.1 - 0 : J 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 -E-i0.250 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. Is DR-DR-CAFTA TheEnd 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, it i s possible to detect three distinct phases. The first i s of relatively high growth rates between 1990 and 1995. The second i s one of 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 low growth until 1994 and a boom situation in2000 inducedby aid flows after HurricaneMitch. 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, 7 1 7 6 A.a ? A ? ? A 2 7 d., ? 9 I I. I I I." I I I I.d I & . I I d .I I Source: Central Banksof Central America and World Bank projections. 2.28 An important question i s whether the expansion of 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 this point with data from a large sample of countries. Can we conclude then that the positive trade results of recent years had no discernible impact on growth? 25 CHAPTERII. Is DR-DR-CAFTA TheEnd Of TheRoad?: O.lo0 1 0 I .. 0.040 0 0 0 0 :*. 0 . 0 0 t 0 0 0 0 0 . 0 0 0.020 0 3. t 0 eo.. - 0 * O .,.*58,550 =>I 17,100 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 of customs in order to facilitate trade among signatory parties. Provisions seek to facilitate customs procedures and reduce room for discretion. It includes rules of origin that are designed to be easier to administer. It also requires transparency, procedural certainty and efficiency in administering customs procedures, including DR-CAFTA rules of origin. Central American countries committed to a list of actions within three years to accomplish goals such as the publication of all norms and regulations in the Internet, the automatization of the clearance procedures, the electronic presentation of certificates of origin and the implementation of management and risk evaluation systems. All signatories also agreed to share information to combat illegal trans-shipment of goods. A program of technical assistance was agreed to support Central American countries in carrying out their commitments inthis 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 firms, complaints against customs procedures and officials usually top the list. The clarifications and simplifications of some procedures with respect to verifying rules of origin are of value but unlikely to be enough to end deep seated problems. Central American nations will need to push ahead with strong reforms (independent of DR-CAFTA) if they are to reap the full benefits of trade for development. Disputesettlement 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. It includes monetary penalties to enforce commercial, labor and environmental obligations. Evaluation 3.62 The dispute settlement section of 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 by 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 CBI 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 of the Central American nations. Also the creation of the Institute for Trade Capacity Building, in New Orleans, which will focus on developing capacity for support programs for small and medium enterprises. In addition, a coalition of U.S. companies came together to support the creation and strengthening of trade capacity in Central America. Evaluation 3.64 While it i s too early to evaluate results of these provisions that have not been included in other U.S. free trade agreements, the Committee could be of use for the coordination of actions by donors, NGOs and the private sector for the improvement of institutional capacity, adjustment to new liberalization commitments and sensitive enforcement challenges. 5. Provisions to deepen regionalintegration 3.65 Central American countries took a momentous decision in making DR-CAFTA a treaty that would be applied multilaterally. Initially, it 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 it 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 it 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 of areas, most significantly in facilitating further trade and deepening regional integration efforts. 3.66 The multilateral application of DR-CAFTA will make more goods qualify for free trade between Central American countries than current norms.26Under DR-CAFTA all goods made with inputs from any o f the parties of the agreement will qualify as meeting the rules of 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 will allow free trade in goods produced in Export Processing Zones, as long as they meet origin requirements. As pointed out by Gonzhlez (2005), firms will enjoy an expanded set of input sourcing options when producing for exports to DR-CAFTA members, reducing the distortions that are created by the existence of multiple parallel FTAs. However, to avoid confusion, it may be important to modernize some of the existing Central American instruments which are not superseded by DR-CAFTA, in order to ensure that they are consistent with the treaty and more up to date with recent international trends. 26Some o f the arguments presented here draw from the excellent analysis of the application of DR-CAFTA 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 will not contribute to the "spaghetti bowl" syndrome associated with the administration of multiple treaties, particularly costly in terms of the administration of multiple sets of complex rules of origin regulations. Instead, it i s likely to foster an atmosphere conducive to finalizing steps for a Customs Union between CACM 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 of entry into the region, and then proceed to move freely across the region's borders.27 3.68 Multilateral application of 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 will now provide modern rules and disciplines for relations among Central American countries and the Dominica1Republic in the areas of trade in services, investment protection, and government procurement - including financial services, telecoms and e-~ommerce.~~Moreover, it will allow the use of 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 inthe future. 6. Conclusions 3.69 This chapter provides an overview of 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 CBIpreferences. Other significant results would include the flexibilization of 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. of promising non traditional agricultural exports. DR- 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 '*Negotiationsin periods and for the specific country commitments that were made for tariff rate quotas in sensitive goods. 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 DR-CAFTA discussions started. 29In government procurement, Central American countries applied much stronger commitments to each other than they allowed with the US., by eliminating minimum thresholds or exemptions to any government agency in purchases o f goods or services (Gonzhlez, 2005). 53 CHAPTERIll.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 of basic food staples as a result should prove positive for the vast majority of Central Americans who are net consumers `of 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 still excessively restrictive rules of origin for the entry of textile products to the U.S. - represent barriers to trade that will continue to foster some inefficiencies in the deployment of 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 of the policy and regulatory changes implemented in recent years for the opening of competition in previously protected sectors (e.g., telecoms, financial services, energy) and the modernization of key norms and procedures in areas such as government procurement, intellectual property rights and the treatment of foreign investment, by locking incurrent levels of access of investors (and bidders)from the U.S. 3.74 Costa Rica i s the only country that will be required to make significant legislative changes to adapt policies and regulations to its 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 of these areas of the Costa Rican economy. 3.75 Aside from consolidating and spurring further reforms, the treaty should strengthen commitments to upgrade enforcement levels of domestic legislation. This represents a significant challenge in areas like labor, environment and intellectual property rights, which will require decisive efforts and resources to modernize and boost the capacity of public agencies. The net impact of these efforts should be positive, as investment i s likely to be attracted to environments with effective institutions. However, while DR-CAFTA will put pressure on the modernization of these institutions, it will not by itself create such modernization. Countries will need strong independent plans of action and sufficient dedication of 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. It 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 of the negotiation of DR-CAFTA has been the advancement of regional integration efforts. The decision to make the provisions of the agreement apply multilaterally among Central American countries and the Dominican Republic will deepen regional integration efforts in the region and facilitate the creation of 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 of DR-CAFTA:More 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 of 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 will depend on the ability of 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 andeducation. 57 CHAPTER IV. Econonlic Effect of'CAFTA: More Art Than Science 1. 1.Introduction 4.2 Like many Latin American countries, the economies of Central America that recently signed the Central America Free Trade Agreement (DR-CAFTA) underwent a period of dramatic trade reforms in the early 1990s. These reforms were implementedin an era when academics, political leaders, and various civil society organizations from throughout the globe were questioning the merits of 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 of measuring trade policy, as opposed to other factors that might affect the incidence of international commerce on national economies. In the public domain, traditional defenders of free trade are now questioning its benefits in the context of international capital flows (Roberts and Schumer 2004). Infact, a recent World Bank report on the impact of the North American Free Trade Agreement (NAFTA) concluded that this controversial agreement had been moderately positive for the Mexican economy, but that it was certainly not enough to spur fast long-term economic development in Mexico (Ledennan, Maloney, and ServCn2005). 4.3 This chapter highlights various analytical arguments and their limitations infavor of trade reforms and contrast them with the findings of various analyses undertakento assess the potential impacts of the DR-CAFTA on the developing countries of Central America, namely Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. 4.4 Assessing the impact of any public policy before it i s actually implemented i s admittedly difficult. Indeed, Kehoe (2003) points out that popular ex-ante general equilibrium analyses of NAFTA written in the early 1990s turned out to be quite off the mark relative to their predictions about the structural (in terms of industry-level growth) effects of NAFTA on the Mexican economy, mainly because such models are generally incapable of predicting dynamic effects of trade reforms and Free Trade Agreements (FTAs). The problem, however, is 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 of focusing on the effects of the FTA on the beneficiary countries. But, since the agreement has not been implemented, these analyses are thus limited by a broad set of assumptions required to make such predictions before the policies are implemented. In contrast, statistical analyses of the impact of international trade and FTAs already in operation have the advantage of using real-world experiences, but are not strictly related to the DR-CAFTA countries themselves. Hence these econometric exercises need to be controlled for an array of variables in an attempt to identify the average effects of FTAs, independent of other country characteristics. In the end, understanding the effects of DR-CAFTA prior to its implementation remains more art than science, but the technical aspects of the various approaches to some extent determine the results obtained from each. For this reason, this chapter provides a wealth of technical discussions of methodologies. Non-technical readers are encouraged to browse the various results and proceed to the other chapters. 58 CHAPTER IV. EconotnicEflecr 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 of DR-CAFTA on each country's structure of 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 of DR-CAFTA. Two such characteristics are transport infrastructure and the regulatory environment that affects the ease with which workers and firms can take advantage of new opportunities. 4.6 The dynamic approach includes statistical analyses of the impact of 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 of this chapter reviews new estimates of the impact of FTAs from throughout the world on the rate of growth of 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 of technology from abroad. Preliminary evidence, from econometric estimates that control for the possibility that economic conditions themselves determine the probability of signing an FTA (Gould and Gruben 2005), suggests that economies that sign Free Trade Agreements tend to increase their annual growth rates by about 0.6 in the five years following its 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 of its recent modifications. The evidence based on data from 2001 and presented by 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 of 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 FDIthan non-members, by increasing the responsiveness of FDIto a country's economic performance. 4.8 Second, the magnitude of these positive effects and how they are distributed within the national economies of Central America will depend crucially on each country's ability to take advantage of the opportunities offered by the agreement, particularly because the gains from trade depend on each economy's ability to change its production and employment patterns and to adopt foreign technologies. More specifically, the evidence suggests that institutional reforms and public investments in innovation and infrastructure will affect the magnitude of the impacts on foreign direct investment, technology transfer, and international commerce. 59 CHAPTER IV. Economic Ejjecr of CAFTA: More Art ThanScience 4.9 Third, the agreement will undoubtedly have differential effects within countries. Perhaps more importantly, the overall benefits of DR-CAFTA for these countries will depend on their ability to help the sectors, especially workers that will be negatively affected by the expected changes in relative prices. In other words, the implementation of efficient adjustment programs will help not only the workers that will face important adjustment challenges, but will also affect the magnitude of the overall gains from DR- CAFTA. 4.10 The rest of this chapter provides an analytical overview of both the intuition and empirical evidence that suggest why DR-CAFTA and other trade reforms might not be enough to help Central America enhance its 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 by summarizing the main findings and highlightingbroad policy implications, most of which are discussed in more detail inother chapters. 2. Trade Liberalization and the Static Gains from Trade A. Background 4.11 The standard textbook theories that predict gains from international commerce do so usually by comparing the welfare of consumers in a country without trade to that same country after full trade liberalization. At the center of these arguments lies the idea of "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 of consumption for a given level and structure of production, plus the gains derived from the reallocation of labor and other factors of production towards the sectors with the lowest relative costs of production (or higher relative prices of the relevant goods). The technical appendix at the end of this paper reviews some of the basics and shows why the gains from trade have never been thought to be automatic. 4.12 A finding of particular relevance for Central America is that the gains from trade are unambiguously positive only if the structure of production changes as a consequence of 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 of relative prices after trade liberalization by maintaining a constant level of employment. The static gains from trade will make all citizens better off only if workers that will bear the costs of adjustment by having to change their economic activities are compensated for their efforts. The term "small" is used here to refer to any economy that cannot affect international prices o f goods and services. 60 CHAPTER IV. Economic Effect (fCAFTA: More Art Than Science 4.13 More generally, the potential gains from trade exist in most contexts: when comparative advantage i s caused by differences in factor endowments (the Hecksher-Ohlin framework), technologies (the Ricardian model), tastes, the size of domestic markets (in the presence of increasing returns to scale), and even in the presence of trade costs, such as transport and transaction costs. Interestingly, there are gains from trade for small countries even when the sectors of comparative advantage are unknown in the sense that it 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 of production does not change. 4.14 Some observers have argued that even this conclusion i s tenuous in the presence of international capital flows. The argument seems to be that capital will 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 of the empirical literature suggest that there i s no systematic evidence of increased trade leading to the deterioration of wages. Moreover, Figure 1 shows that there i s actually no statistical relationship between the incidence of international trade and unemployment rates across countries, thus suggesting that there i s no long-term relationship between international commerce and unemployment. As will be discussed in detail below, there might be short- termeffects as economies adjust to changesintrade policies andthus the public sectorhas 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 is associatedwith the worsening of environmental outcomes (Stern 2003; Brown et al. 2003; Dean 2001 on environmental standards; Copeland and Taylor 2003 on the environment). Figure1:Unemploymentandthe Incidenceof InternationalTradeinthe Long-Run I I I 2 4 6 8 i o 12 14 16 18 20 Unemployment rate ("4) 1OLACcountries .Rest of the Worldi Source: De Ferranti, Perry, Lederman, and Maloney (2002, Figure 5.2) 61 CHAPTER IV. Economic Efject of CAFTA: MoreArt ThunScience 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 by the ratio of 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 of civil 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 of collective bargaining rights and allegedly labor-intensive exports as a share of total exports. Greater female labor participation actually increases the share of labor-intensive exports, as does the participation of children (ages 10-14), whereas the OECD's index of 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 from endogeneity biases, and that the data did not permit the inclusion of all relevant labor-market variables. More importantly, Busee (2002) is 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 of issues related to international commerce in the presence of international capital flows. The main theoretical conclusion with respect to the potential gains from trade i s that the presence of international capital flows, or even international migration of 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 of such international capital or labor. The main intuition behind this result i s that international flows of factors of production will reinforce the incentives to specialize in the production of goods and services where a given country has a relative productivity advantage. However, international capital or labor flows do make it more difficult to predict in which sectors an economy will 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 of specialization. 4.17 The Mexican experience with NAFTA highlights how an economy adjusts and changes its pattern of trade and employment, which in turn allowed it to benefit from the agreement. Figure 2 shows the evolution of Mexico's pattern of net exports, covering ten broad commodity groups. The implementation of NAFTA in 1994 was associated with the rise of this country's share of net exports of machinery (e.g., vehicles and parts, telecommunications equipment, and computers). De Ferranti, Perry, Lederman, and Maloney (2002) showed that this change in Mexico's pattern of trade with respect to the U.S. became apparent by 1993, just prior to the implementation of the trade agreement. Thus NAFTA had structural effects even prior to the formal implementation of 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 is representative of the structural change experienced by the Mexican economy, which, given that overall unemployment was not higher after NAFTA (except for 1995during the so-called Tequilacrisis), represents a healthy structural shift. Figure 2: Mexico: Structure of Net Exports, 1981-1999 100% 80% 60% 40% Machinery 0Capital-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 CHAPTERIV. Economic E#ect ojCAFTA: More Art ThanScience Figure 3: Mexico: RegisteredAgricultural and Maquila Workers, 1983-2003 1.1w7 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 of 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 of jobs in agriculture declines with development, the absolute number tends to decline inthe most developed economies. 4.19 The structural change experienced by Mexico under NAFTA i s thus consistent with gains from trade, but it i s likely that public policies can help Central American economies ensure that DR-CAFTA will deliver on its promises of 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 of the potential static gains offered by DR-CAFTA. B. Static gainsfrom 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 of an economy to prevent unnecessary declines in overall employment as the economy adjusts to a new set of 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 tradefacilitation 4.21 As mentionedabove, the restructuring of an economy is crucial for taking advantage of the economic opportunities offered by trade agreements. A successful adjustment entails the avoidance of substantial job losses, and thus might require that labor literally move to regions that have attracted new investment and that exports of 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. If national infrastructure, covering both the movement of people and goods, i s not adequate then exports will not rise as much and labor might thus be stuck inthe low 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 of exports to the U.S. Table 1 reports various econometric estimates by Lederman and Ozden (2004) concerning the impact of each additional dollar in transport and transaction costs on the value of exports to this market. Regardless of econometric technique, the impact of these costs seems to be quite high. Although the empirical analyses by Lederman and Ozden do not cover all types of infrastructure, logic dictates that telecommunications or the provision of basic services to emerging sectors can also help the economic transformation promised by DR-CAFTA. Chapter VI1 of this report provides some guidance regarding the types of infrastructure needs, if any, that should be prioritized in the complementary agenda of the DR-CAFTA beneficiaries. Explanatory TOBIT Model TOBIT Model TreatmentModel Heckman Variables (Preferences (Preferences (Preferences as Selection Model representedby representedby 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: A11 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 of each country; dummy variable for membership in the WTO; dummy variable for English-speaking countries; dummy variable for islands; and variables for the AGOA 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 of one for each program. In specifications 2 and 4, the use of preferences by each exporting country i s captured by the percent of 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 CHAPTERIV. Economic Effect of CAFTA: More Art Than Science 4.22 Other relevant results from the estimations by Lederman and Ozden concern the effect of FTAs on exports to the U.S. market, especially when contrasted with the effects of unilaterally provided preferences such as the Generalized System of 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 unilateralpreferences. Only in model 2 i s the CBI effect larger, but since the average product-country utilization rates of FTAs (58 percent) i s significantly higher than those of CBI (36 percent) in the year of 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 of control variables constant in the regressions (see Table 1Notes at the bottom of the table). The data and the coefficients in regression 2, therefore, suggest that DR-CAFTA could raise the value of U.S. by almost 11 percent relative to the benefits offered by the CBI.3 If we take the more generous results under column 4, these benefits in terms of exports increase to over two times C B I benefits. In any case, the exact magnitude of the contribution of 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 of access to the U.S. market. These gains are probably due to a combination of factors, including the fact that the utilization of the FTA preferences might be easier due to less restrictiverules of origin (see Chapter I11on the contents of DR-CAFTA) as well as the fact that FTAs provide more secured market access rules that entrepreneurs can rely on to makelong-termbusiness investments, which would then be reflected inrising exports to the U.S. Labor and the adjustment process 4.23 Another regulatory area concerns labor markets and the ability of firms to enter new markets and the ease with which uncompetitive firms exit other markets. The restructuring of an economy, whereby factors of production migrate from one economic activity to another, requires the disappearance of some firms and the emergence o f others. Likewise, it requires workers to find new employment opportunities. Edwards and Edwards (1994) had previously reviewed various theoretical settings where lack of 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 of Central America to take advantage of the opportunities offered by DR-CAFTA. 4.24 One way of examining the role of regulations in determining the gains from trade i s to look at how regulations affect the magnitude and sign of the correlation between the incidence of international trade on the domestic economy and the level of development, measured by the value of 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 is estimated in log-log form. Thus the effect of FTAs relative to CBI is equalto the ratio of exponentialof the product of the FTA coefficients reportedinTable 1 multiplied times the average utilization rate divided by the CBI coefficients times the average CBI utilization rate. 66 CHAPTERIV. Economic Ejfect of CAFTA: More Art Than Science burdens, and those with the highest regulatory burden. The index of 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 of 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 it 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. Figures4a-c: Trade and Levelsof Development: The Regulatory Environment A: All countries. I In(Realper capita GDP at PPP) = 9.80 t 0.88 In(Trade/GDP) T statistic 8.26 1 L.ii k4 11 T i il .n + -B - t E 05 1 I I ~ -4 -3 5 -3 -2 5 -2 -1 5 -1 -0 5 0 In(TradelGDPat PPP) 67 CHAPTER1V.Econoniic E ~ e coft CAFTA: More Art Than Science Matters I B: One-thirdleast regulatedcountries. In(Rea1per capita GDP) =9 90 + 0 I E 92 In(Trade/GDP) ; T statistic 5 22 l2T 11 r Bil.- * * _-*---*- * * . - a ___--- *,--ma-- i 0 I g I -&Z -8 t I -3 -2 5 -2 -1 5 -1 -0 5 0 0 5 1 1 5 In(Trade/GDPat PPP) I C: One -thirdmostregulated countries. In(Real per capita GDP) = 9 31 + 0 49 ln(Trade/GDP) c ![ T statistic 2 11 k* 9 U B .-9a .- - - - *-a- - - 3 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 will automatically change jobs or that capital will instantaneously reallocate to the most productive activities. Moreover, some workers could experience income losses greater than the gains in terms of lower prices of consumption goods. As highlightedby 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 will also depend on the El Salvador is covered in the World Bank regulatory database and thus we leave to the interested reader to undertake the necessary evaluation of this country's regulatory burden. On the other hand, the data reviewed in Chapter VI1 of 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 of the labor market. 4.27 Thus there is a role to be played by the public sector in terms of aiding the adjustment process. Inthe case of 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 by excessively large adjustment assistance programs. Rather, it i s likely that any pro-adjustment program can be contained by 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 of the sensitive commodities i s also an important ingredient for designing efficient adjustment programs, as argued inChapter 5. C. Simulationsfrom partial-equilibrium models 4.28 To quantify the potential short-term effect of the elimination of U.S. tariffs on Central American exports, results of 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 intobacco products. ~~ Simulation results calculated with SMART software, using tariffs that are corrected by the 2001 utilization rates of the CBTPA preferences (Le., the share o f U.S. imports from 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: CentralAmerica - Changesinexports as result of UStariff 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 of utilization rates of trade preferences i s an improvement over traditional analysis of potential apparel gains, simulations cannot easily deal with the complicated structure of export restrictions associated with rules or origin requirements that are likely to be inplace inDR-CAFTA. 4.30 For most countries in the region, the greatest potential for expanded Central American apparel exports resides in the loosening up of the rules of origin that govern current tariff preference rules. As explained in Chapter 111, DR-CAFTA will facilitate apparel goods to qualify for duty free treatment by allowing for unlimited use of regional inputs, accumulation of origin with regional partners, exceptions for specific types of apparel, and temporary quotas for goods that do not need to meet strict rules of origin for Costa Rica and Nicaragua. Some of 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 from third countries that are not widely available inthe U.S. 70 CHAPTER IV. Economic Ejject of CAFTA: MoreArr 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 of the global textile quotas inJanuary 2005. While there has been a noticeable spike in imports into the U.S. market from China in the first few months of 2005, strong import growth from Central American countries in the same period suggest that other traditional exporters are bearing the brunt of Chinese shipments. Inpart, 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 of rules of 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 andjust-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 by Central American apparel exporting firms should create significant opportunities for development of local linkages for this cluster, beyondthe 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 of the FTA. Simulations made for Mexico before NAFTA also underestimated the expansion of 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 mentionedabove. 4.33 Regarding the possible impact of tariff elimination on U.S. imported products to Central American economies, Tables A 6 to A10 show there will be trade increments in a wide range of manufactures, following the same partial equilibrium model methodology. The higher absolute increases will be concentrated for most of the countries in vehicles, mineral oils, furniture, electrical machinery and textiles. The import aggregated increase will vary from 10per cent to 12 per cent in Nicaragua, El Salvador and Guatemala, and up to 26 per cent inHonduras. D.A Simulationfrom a General Equilibrium Modelfor Nicaragua6 4.34 This section describes the main features of the CGE model and household survey micro-simulation module that were applied by Bussolo and Niimi (2005) to study the sectorial and national effects of further unilateral trade liberalization and DR-CAFTA on Nicaragua. Unlike the previous partial models, these CGE simulations consider the interactions across industries and factors of 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, it i s worthwhile to look at this case in detail from a poverty This section draws heavily from Bussolo and Niimi (2005). 71 CHAPTERIV. Economic Effect of CAFTA: More Art Than Science perspective. Nevertheless, at this point it 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 1percent of 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 of DR-CAFTA and compare them with what could be obtained (under the same restrictive assumptions) with further unilateral trade reforms. TheNicaragua 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 of the world), has been assembled from various sources incorporating data from the 2000 Input Output table and the 2001 LSMS households survey. Since the quality of the initial dataset represented by this SAM directly influences the quality of the model results, particular attention has been devoted in estimating the value added, the trade, and tariff components of the SAM.7 The CGE 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 of the underlying economics concerning constant elasticities of substitution on the production side. The Nicaragua analysis i s unique, however, in its treatment of 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 of the main advantages of using the micro-module i s to enrich this rather crude macro distribution mechanism. Private consumption demand i s obtained through maximization of household specific utility function following the Linear Expenditure System (LES). Household utility i s a function of consumption of 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 Inthe model we assume imperfect substitution among goods originating indifferent geographical areas.' Imports demand results from a CES aggregation function of domestic and imported goods. Export supply i s symmetrically modelled as a Constant Elasticity of 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 its imports and exports prices are treated as exogenous. The assumptions of imperfect substitution and imperfect transformability grant a certain degree of autonomy of domestic prices with respect to foreign prices and prevent 'For more details on the S A M see Bussolo (2004). Aggregate investment is 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 permitto model cross-hauling a feature normally observed in real economies. The balance of payments equilibrium i s determined by 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 by changes in the real exchange rate: increased import demand, due to trade liberalization must be financed by 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, it assumes that tariff reductions at the border are directly transmitted to domestic relative prices as viewed by 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 of zero-duty imports allowed to stem rising prices or for specific uses (e.g., feed grains for poultry in Nicaragua). Moreover, changes inborder policies do not necessarily mean that producer prices in the interior of Nicaragua will change due to the natural protection offered by distance to markets. Thus all results from this simulation exercises needto 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 of 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 it mimics in the best possible and least contentious way what would be the short term impact of 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 of the model also facilitates linking the macro results of the CGE model to the household survey micro- model, where households are not allowed to respond to price changes by migrating, increasing their human capital endowments, or even changing their consumption choices. 4.39 The labor market specification is a key element of our model and an important driver of poverty and distributional results. Therefore, its specification calls for some clarification andjustification. The labor market skill segmentation" has become a standard assumption in CGE modeling and it i s easily justifiable for the case of 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. To test its 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 of workers. They concluded that the possibility that agricultural loSee Taubman and Wachter (1986) for a general discussion of labor market segmentation. 73 CHAPTER IV. Econotnic Effect of CAFTA: MoreArt Than Science workers have different wage from similar workers in other industries cannot be rejected. Although this finding i s not conclusive, becausethe estimated wage gap might have various interpretations and be caused by other factors that were not included in the analysis, it might be sufficient to justify the assumption of segmented labor markets in the CGE simulation exercise. The micro module: linking household surveys to the CGE model 4.40 Poverty effects of 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 of the micro module: , labor income remittances profits ~ I, , 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 of expenditure on each good (6&); (b) changes in factor returns (w stands for returns to skilled and unskilled labor, and 7ci s returns to capital) and the shares of total initial income by 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 of 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 of this approach i s that it takes into account important sources of heterogeneity across households given that the structure o f income by type and the composition of consumption by commodity, the various 8's in the above equation, are household specific. A large literature on trade and povertyI2has 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 of 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 by 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 of socio-economic characteristics recorded in the survey. It i s thus easier to identify a specific characteristic - such as region of residence, employment status, gender, education, age, etc. "'* TheWinters et formal derivation of this equation is presented in the annex of Bussolo and Niimi (2005). See a1 (2004) for an excellent survey. 74 CHAPTER IV. Economic Ejject ofCAFTA: More Art Than Science -that may stronglycorrelate with largerthan averagelossesfromthe tradepolicy reform and then use this information intargeting 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 of 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 it may overestimate the effects of a trade shock, given that quantity adjustments and substitutions are ruled out. Knowing these limitations, its main advantage though i s its transparency and low, in terms of data and time, implementationcosts. 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 of 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 of workers, an approach that bypassesthis imputation has beingused. This i s represented by the following equation: r as before, the relative change in welfare i s represented by a change in consumption (the last term in the left hand side of the equation), by a change in explicit wage earnings, and by the profit generated by the activity run by the household (the term in squared brackets). This i s estimated as the difference between sales (holding constant the quantity shares of the different goods sold t9jo)and input costs (again without changing the structure of input quantities 0;). 4.43 Finally, it 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 of the order of magnitude considered here - do not affect it. In terms of 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 of the general equilibrium model and then the poverty estimations obtained by 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 of trade ministers in the Central American region: this agreement should provide almost full free access to one of their major markets, it should assist the implementation of additional 75 CHAPTER IV. Economic Effect of' CAFTA: More Art ThanScience domestic market reforms, and, by requiring reciprocal opening, it should produce significant efficiency gains due to resource reallocations towards more competitive sectors. However, as brilliantly illustrated by the Chilean multi-pronged strategy of trade liberalization, DR-CAFTA i s just one of 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 it with a benchmark case of full liberalization. Two main scenarios are considered: (a) DR-CAFTA, and (b) a unilateral non-discriminatory liberalization. The potential advantages and disadvantages of the reciprocal liberalization entailed by the regional scenario are illustrated by further decomposing the DR-CAFTA 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 of the simulations i s based on a comparative static framework with no capital accumulation, no changes in labor supply or skill levels and factor market segmentation. Consequently, as happened with the early-1990s CGE modeling attempts of the Mexican experience under NAFTA, the results from the simulations might be quite off the mark since dynamic effects might overwhelm the static effects predicted by the simulations even if the assumptions regarding the key parameters (Le., elasticities of substitution on the demand and supply sides for each of the 28 industries) were realistic (see Kehoe 2004 for an ex-post review of the accuracy of 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 on the economy it i s helpful to describe the adjustment process as if it 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 of the endogenous variables - of the new equilibrium: a) the starting level of some key variables in the initial equilibrium, i.e. the prices and quantities implicit in the initial SAM; b) the functional forms of 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 of substitution in demand between domestic and imported commodities and the elasticity of 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 line 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 of this type o f models. Systematic sensitivity 76 CHAPTER IV. Economic Effect of CAFTA: More 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 its problems and we do not attempt it here. 4.47 The bottom line is thenthat results presentedhere 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 of this type of model are that it representsthe 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 of 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 of 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 of the policy simulations, we will be referring to data in this table repeatedly. 4.49 The initial import protection, both in its level and sectorial variability, i s among the key elements determining the simulation outcomes. Three key features are highlighted by the tariff data: a) the overall trade-weighted protection rate i s rather low, b) its dispersion i s high with a clear bias against agricultural imports and c) tariffs against the US. are generally above the trade-weighted average of tariffs against the Rest of 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 of protection, enjoy a large share of total imports of agricultural commodities (41 percent). Anticipating the results shown below, it i s likely that a liberalization of 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 by the level of sector aggregation used inthe model. It 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 of negative impacts should not be completely ruled out. 77 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science Table 3: Nicaragua's economicstructure (2000) Notes: in the left panel, Xp represents the sectoral output as a percentage of total output, M the sectoral total imports, Ex the exports shares, X c the private consumption shares; in the middle panel, MUS the initial share of imports coming from the US over total imports, Ex US the initial share of exports going to the US; in the right panel there are tariffs: Nic against US and other partners imports, respectively, and US - Nic are US -US and Nic ROW are Nicaraguan tariffs - 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 by this reform is initially described in terms of sectoral demand and supply changes, as shown in Table 4. Consider first the demand/imports side. Initial tariff rates tm13are 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 of import volumes once protection i s removed, assuming of course that the border-price changes are fully transmitted to domestic consumers throughout the Nicaraguan economy and that the model parameters concerning the responsiveness of 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 is the trade weighted average of the Nicaraguan tariffs against U.S. and the Rest of the World (which are separately shown in Table 3). 78 CHAPTER IV. Economic Effect ojCAFTA: 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 of local demand (MD)in agriculture or food processing. Thus, even with a high (presumed) elasticity of substitution between local production and imports (= 3), the impact of increased imports on sales of domestic goods (AS) i s low in these sectors. In fact, the model predicts that other manufacturing sectors suffer slightly bigger domestic sales contractions due to their larger initial share of import dependency despite their lower initial level of protection. Reflecting Nicaragua's dependency on foreign production of capital goods, intermediates and energy, imports are well above 50 percent of 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 of domestic production. Table 4: Sectorial effectsoffullunilateraltrade 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 of domestic sales of domestic output, AF'd the percent variation in domestic prices for local sales, AEx the percent variation in the voiumes of exports, ExlXp the ratio of exports to domestic output (the sectoral export orientation), AXp the percent change of domestic output, APx the percent change of output prices. 4.52 For the economy as a whole, these low or moderate domestic market share losses are reflected in small declines of producers' prices for local sales (APd). Some of 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~rnmodities.'~ 4.53 These demandhmports side effects are linked to the supply response to which we now turn. For producers of exportable goods, the reduction of prices in local markets (APd) combined with unchanged export prices creates incentives to increase the share of sales destined to foreign markets. This export response ( E x ) varies across sectors and it i s linkedto the pattern of 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 of 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) of fixed export prices and domestic prices. 4.54 In summary, trade liberalization, even if consists of the elimination of 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 its high tariffs and low export orientation; whereas, among others, Coffee and Other Agricultural Products enjoy significant export-led growths. Similarly in the non-farm portion of 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 inTable 5, are another important aspect of the structural adjustment caused by trade reform. Changes in wages and capital return are linked to changes of 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 of disaggregation, namely the tariff line. Although trade data at this level may be available, production, consumption and other important variables are unavailable. l5Dueto the sectorial classification, some sectors in 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 of exports (probably re-exports) by even lower levels of domestic production. Exports of TobaccoandMachinery and Equipmentjointly account for just 2 percent of total exports. l6 Due to the closure rule of the external account, namely the fixing of foreign savings, and the full employment assumption, the larger expansion of the volumes of 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 of 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. Table5: Factorpricechangesduetofulltrade 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 FoodPrice Index -1.5 CPI -2.4 I I Sources: author calculations from model results. Notes: the first column, AP, represents the percent variation of the price of each factor with respect to the initial levels; A(S/CPI) i s the percent variation of 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 of the contraction of the unskilledlabor-intensive sector, Basic grains, unskilledlabor records a greater reduction than skilled labor. 4.57 Turning to the non-farm segment and considering the bottom panel of Table 6, it i s easy to see that Food Processing, the sector with the largest output expansion, i s relatively intensive in the use of capital, and, in terms of number of 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 of labor combined with initial levels of protection and output changes explains the observed wage movements. 81 CHAPTER IV. Economic Effect of CAFTA: More Art Thun Science Table 6: Value addedand employmentby sector andfactor, and sectoralintermediateuses 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 100percent in each sector, Sk represents skilled labor, Usk and K&Lunskilled labor and capital and land respectively, Xint is the share of intermediate inputs in total output, AXp is the percent change of domestic output due to full trade liberalization 4.58 The combination of the trade shock with this production structure explains why unskilledlabor i s the largest gainer in the non-farm segment, followed by skilled labor and capital as shown in Table 5. These results are consistent with the comparative advantage of Nicaragua, a country with abundant unskilled labor, which specializes in the production of agriculture derived products, and i s import dependent for capital goods and intermediates, which are normally produced by sectors using skilled workers intensively. 4.59 Even with segmented labor markets, the farm and non-farm sections of the economy have strong interconnections that determine the final results. These inter segment links are illustratedinTable 7 for the Agricultural and the Food Processing aggregate sectors.l7Both l7 These two sectors account for a third of total production and for almost 40 percent of total employment. 82 CHAPTER IV. Economic Effect of CAFTA: More Art 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 by significant structural shifts that are qualitatively differentfor these two sectors. 4.60, For Agriculture, the main adjustment consists of a reductionof one single sub-sector and a specialization towards export oriented sectors. Prices for imported intermediate goods are reduced by the removal of tariffs, however due to the moderate use of intermediates (35 percent of 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 by 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 still compete in domestic markets by enjoying reduced production costs due to their use of cheaper intermediates, which represent on average almost 3 quarter of total input value. In fact, most of these intermediate inputs come from agriculture whose prices following the trade shock are reduced. Table7: Inter-sectoral links betweenAgriculture andFoodprocessing 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 of imports following tariff abatement. For instance, the absence of imports surge for Livestock, after the market opening, i s explained by 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 of inter-sectoral linkages. DR-CAFTAbilateral 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 of this regional free trade area. This policy by 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 inan evaluation of this policy option. 83 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science 4.64 Nicaragua's liberalization of 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 of 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 by 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 by the initial U.S. tariffs.'* Given the initial low level of 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 of 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 of 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 Table8: Effectsof the DR-CAFTAagreementonNicaragua'seconomic sectors Notes: tm representsinitial tariff rates, M 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 of domestic sales of domestic output, Al'd the percent variation in domestic prices for local sales, AEx 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 of 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 from partial trade reform i s roughly equal to one quarter of 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 from the U.S. inTable 3: the economy-wide average share i s 24 percent, however imports o f U S agricultural goods represent more than 40 percent of total imports in that macro-sector, with peaks o f 72 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 to the year 2000). Thus, the DR-CAFTA agreement-induced imports surge of agricultural goods i s equal to 94 percent of that induced by a full unilateral liberalization, whereas the economy-wide average stands at 76 percent. These sectoral distortions explain why factor returns in the farm 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 of the full liberalization shock. AP A(PICP1) % ofFull Liberalization Non-Farm Segment: SkilledLabor 1.2 60 FoodPriceIndex -1.4 I 39 Non FoodPriceIndex 0.0 I -1 4.66 In summary, the impact on factor remuneration of 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 it may, at least temporarily, be negative for rural wage earners (but not necessarily negative for subsistence farmers). For agricultural households receiving part of their income from capital and land, or even from 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 kindof trade reform." Decomposing the DR-CAFTA scenario 4.67 In order to distinguish the effects of market access from those of own-tariff liberalization, the simulated reciprocal DR-CAFTA 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. it preferentially liberalizes imports from Nicaragua.20 This outcome may not hold under a different production specification where skilled workers, for example, are modeledas a complement to capital, rather than as substitutes. 20This decomposition is 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 of 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 is 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 by 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 inexports of food processing products. Table 10: Decomposingsectoraleffects ofDR-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 of exports, AXp the percent change of domestic output, AF'x the percent changeof output prices. 4.69 The two unilateral liberalizations are consistent intheir sectoral output effects. Both induce additional growth of agricultural and food processing sectors and, in this sense, helps Nicaragua exploit its 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. marketsmay then bring some advantages. Table 11:Decomposingfactor price changesdue to DR-CAFTA - - - - Nicaragua Unilateral Liberalization U.S.Unilateral Liberalization AP I A(P/CPI) I % of CAFTA 0I AP A(P/CPI) % of CAFTA I I Sources: author calculations from model results. Notes: the first column, AF'. represents the percent variation of the price of each factor with respect to the initial levels; A(S/CPI) is the percent variation of the price deflated by the Consumer Price Index; the column, percent of DR-CAFTA,shows the percent ratio of the real price changes in the unilateral liberalizations with respect to the bilateral DR- CAFTA case. 87 CHAPTER IV. Economic Effect of CAFTA: More Art ThunScience 4.70 As long as factor markets effects are concerned, Table 11 suggests that the non- reciprocal removal of Nicaragua's tariffs causes factor prices of 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. Inthe case of U.S. liberalizing its tariffs, factor prices go up due to the increased export demand and this inflationary effect i s not counterbalanced by inflows of cheaper imports. However, these inflows explain why factor prices tend to contract with the unilateral liberalization of Nicaragua, thus showing that access to the U.S. market mitigates the potentially negative shocks to farm incomes associated with the liberalization of 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 by rather small amounts, as reported by Bussolo and Niimi (2005). But these authors' reported poverty-reduction effect of DR- CAFTA alone i s slightly lower than the predicted poverty effect of a full unilateral reform by Nicaragua. That is, Bussolo and Niimi predict that Nicaragua's percent of poor families would fall by 0.3 percent under DR-CAFTA but by 1.6 percent under the full-liberalization scenario.21 3. ComplementaryPoliciesand the Dynamic GainsfromTrade 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 term i s used to refer to the impact of trade policies on factors that can affect the long-term growth rate of developing economies, namely aggregate investment, technological progress, and the quality of public institutions. The following sections review relevant literature and empirical evidence concerning these channels of influence. A. Dynamic gainsfrom trade through FDI, innovation, and the quality of institutions Foreign direct investmed2 4.72 A specific aspect of DR-CAFTA relevant for investment location decisions was the adoption of rules of origin for the determination of the goods that could benefit from the preferences established by the treaty. These rules, which vary across goods (see Chapter 111), provided new incentives for the location of 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 by the rules. 4.73 But the effect of FTAs on the perceived riskiness of investment - the so-called `credibility effect' -- can be even greater than the profitability effect. While the term 21These numbers were calculated with respect to a national poverty rate of 49.8 percent, which was used as the initial level of poverty in Bussolo and Niimi (2005). 22This section appears in Chapter 4 of Lederman, Maloney, and ServCn (2005) and the econometric analysis was undertakenby Cuevas et al. (2002). 88 CHAPTER IV. Economic Eflect oj CAFTA: More Art Than Science `credibility' is somewhat vague, in the present context it encompasses three different things:23 (i) the FTA's locking-in effect of 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). example, EU accession i s viewed by a majority of observers as having For 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 of a RIA such as NAFTA, the main effects should in principle accrue through the `secured access' channel and the locking-in of Mexico's commitment to trade opening initiated in the late 1 9 8 0 ~as ~ , ~the treaty entails 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 it i s virtually impossible to know with certainty given that Mexico suffered a major financial crisis during the first years of NAFTA and relatively little time has transpired since then.26 4.75 To gauge the effect of NAFTA on FDIflows, and disentangle it from that of other factors affecting FDI, we turn to an econometric analysis of the influence of FTA membershipon direct investment flows. We then use the empirical estimates to quantify the relative contribution of 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- CAFTA countries. 4.76 The approach i s described indetail in Cuevas et a1(2002), so here we provide only a summary. The analysis focuses on aggregate FDIflows to 45 countries over 1980-2000.27 This sample includes the same FTAs studiedby Frenkel and Wei (1998).28The framework assumes implicitly that North-North, North-South and South-South FTAs are all the same interms of FDIeffects. This i s worth noting becauseNAFTA is the only North-South FTA in the period studied by 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 in 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 of antidumping duties, they neverthelessdo offer formal mechanisms for dispute resolution. In this sense, they do provide a guarantee of uninterrupted market access. See Fernandez and Portes (1998). 25This locking-in is 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 it is not clear that the absence of a crisis is due to NAFTA. 27 This is 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 is the EU, NAFTA, the Group of Three, the Andean Group in its recent revival, Mercosur, and COMESA (which in the analysis is 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 of the host country (FTAMEM) and another capturing the anticipation of future membership (EXFTAMEM).29 In addition, we include a measure of the extended market size of the FTAs to which the host country belongs, given by 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 of the degree of trade integration of other countries (INTEGRATION) i s used; this i s basically a weighted sum of the GDP of all the sample countries participating in FTAs, with the weight of each country's GDP given by the fraction of worldwide GDP covered by its FTA arrangement^.^' 4.77 Table 12 reports empirical estimates of the determinants of FDI obtained from this spe~ification.~~Four variants are reported, with different combinations of the FTA-related variables and the institutional variables. On the whole, the explanatory power of 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 of a more direct measure of integration, extended market size (FTAGDP), which i s always significant. The elasticity of 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, it should expect FDI inflows to rise b y fifty percent or more. In contrast, we find no significant effects of the variable capturing investment diversion (INTEGRATION), perhaps due to the rudimentary nature of this measure. 29The results below correspond to the case when FTA membership is anticipated two years ahead of its occurrence. Alternative time horizons were used too, without any substantialchanges in results. 3"Thus, an increase in INTEGRATIONholding FTAGDP constant would imply a reducedFDIappeal for the host country inquestion. Note that this variable has only time-series variation. 31 The dependent variable is 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 is potentially an issue, especially in the case of GDP growth. However, specification tests could not reject its exogeneity.Additional experiments are reported in Cuevaset al (2002). 90 CHAPTER IV. Economic Effect o j CAFTA: iMore Art Than Science Table 12: Fixed-EffectsRegressionsof the Logof FDIagainst Membershipina Free TradeArea and Other Variables Note: Standard errors appear in italics under the correspondingcoefficients. 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 by Albuquerque et a1 (2002) on the role of global factors in FDI flows: other things equal, faster growth in the rest of the world reduces a country's appeal for international investors. 91 CHAPTERIV. Economic Eaect of CAFTA: More Art Than Science Inturn, the international interest rate is generally insignificant. Finally, world FDIflows are strongly significant and positive, as should be expected.32 4.79 Among the local factors, the elasticity of 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.33Host country growth is also consistently positive and significant, likely reflectingthe positive impact of 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 measuredby GDP, carries a consistently positive but insignificant coefficient. Inturn, the negative coefficient on the current account balance in all regressions seems to reflect financing need (likely driven by domestic investment) rather than an unstable macroeconomic environment. Finally, the measure of 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 FDIinflows.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 of the quality of the bureaucracy indicator, which fails to be significant. On 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 of FTAs on FDI inflows to member countries. This agrees with earlier empirical studies of the impact of FTAs based on a variety of 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, it i s notable that the estimated impact of FTAs i s much less than what proponents of NAFTA, for example, have argued (e.g., see the USTR's web site) since FDIto Mexico increased by much more than 40 percent (the effect of NAFTA implied by the aforementioned results). Moreover, the results suggest that it i s the interaction of FTA membership with other economic outcomes that really has an impact, rather than an FTA by itself. Finally, the variables representing the quality of public sector institutions have strong and independent effects on FDI, thus again suggestingthat quality institutions are key for attracting FDI, not just for improving the allocation of factors of 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 FDIrecipients are excluded from the sample due to lack of complete data. Our measure of total FDIinflows is not the sum of 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 is consistent with expectations and previous results concerning the role of openness, simultaneity is a potential concern, as FDI may target traded sectors and lead to stronger export performance. However, there is likely a long gestation period between new investment and exports, which reduces the risk of simultaneity. 34 Albuquerque et a1 (2002) report this result using direct measures of 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 of FDI on the same industry's TFP. This i s consistent with numerous other studies.35The early cross-sectional work by Blomstrom and Wolff (1994) found that both the rate of local firms' labor productivity growth and their rate of catch up to the multinationals were positively related to the industry's degree of foreign ownership. They point out, however, that it 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 of growth. 4.83 The macroeconomic evidence regarding the role of FDIin spurring TFP growth i s also pessimistic. First,most studies of 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 of 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 will automatically result from FDIinflows. Innovation and education 4.84 The most talked about channel through which internationaltrade can raise long-term productivity growth i s through the importation of foreign technologies in the form of 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 of Mexican industrial total-factor productivity, whereas capital imports from the Europe or other industrialized countries had negligible 35Lipsey (2002), in a comprehensive review of 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 is 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 in 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 in 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 in their sample affecting TFP is own country R & D. Xu (2000) using panel data on technological transfer from US finds a technology transfer effect by US 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 of FDIin the Czech Republic from 1995-1998. Smarzynska (2002) finds no direct impact of FDIin Lithuania on firms in 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 by Keller (2002). This author finds that the productivity gains due to the importation of foreign capital goods declines with geographic distance of the trading partners. This result alone should shed some doubt on the channel of influence, since geographic distance should affect the quantity of trade but not necessarily the marginal effects of capital imports. Thus it is likely that the dramatic effects captured by Schiff and Wang for Mexico under NAFTA are due to greater business interactions and learning via contacts rather than through the magic of 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 of spending on research and development (R~LD).~~ 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. Infact, Pavitt (2001) argues that investment in pure research i s also important for developing countries. First, those most familiar with the frontiers of basic science will best train the applied problem solvers inthe 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 of development observed around the world. 4.86 Low rates of investment in R&D can be due to low 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 of Costa Rica's level of income are high at around 65 percent. Further statistical analysis by Lederman and Maloney suggests that financial depth, protection of intellectual property rights, ability to mobilize government resources, and the quality of research institutions are key determinants of R&D effort across countries. Notably absent as a robust predictor of national R&D effort in the preliminary analyses presented by these authors was the incidence of international trade. That is, after controlling for the aforementioned variables, international trade does not seem to be a crucial factor indetermining how much each country invests inR&D. 4.87 Low 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 of a NIS i s by examining how R&D investments translate into commercial patents and how the "elasticity" of patents with respect to R&D investment compares to the world average.37Chapter VI1 includes a review of the efficiency of R&D expenditures in Costa Rica, El Salvador and numerous other countries. For the case of 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 of 36At 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 Wolf (1994). 37Bosch et al. (2005) discuss in detail how these elasticities are estimated and how they vary across regions of the world. 94 CHAPTERIV. Economic Effect of CAFTA: More Art Than Scietice collaboration between the private sector and research organizations such as uni~ersities.~~ Additional statistical exercises showed that Costa Rica's privileged position compared to the rest of the LAC countries is due to higher quality of research institutions and greater collaboration with private firms. El Salvador's negative value can be interpreted as an indication of 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 of LAC countries. Additional statistical exercises showed that El Salvador's inefficiency i s only partially explained by variables characterizing the NIS such as quality of research organizations and their collaboration with the private sector. Understanding the shortcomings of 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 of new export products. Hausmann and Rodrik (2003a) provide a theoretical framework that suggests that without public sector intervention the market will 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 of 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 of experiencing export discoveries (definedas an episode in which a country begins to export products that were not exported at all at the beginning of a ten-year period). Furthermore, Khan (2004) finds that the introduction of new products does affect economic growth by 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 VI1of this report. Institutions 4.90 Although the role of 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 of these potential productive factors. Krueger (1974) was one of the first to focus on the effects of public policies, including trade 38This 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 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 LAC 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 of corruption (Dutt 2002). This line of reasoning thus suggests that DR-CAFTA itself might have a salutary effect on overall production and potentially national welfare, by reducing rent-seeking which would in turn increase potential output. In turn, rent-seeking activities by private agents can themselves breed public corruption and vice-versa. 4.91 But does trade really help improve indicators of corruption? Or are there other factors that explain both the incidence of international trade on the domestic economy as well as incidence of corruption? Table 13 presents results from Lederman, Loayza, and Soares (2005) concerning the determinants (of perceptions) of national corruption around the globe during 1984-2000. Contrary to previous literature, this evidence suggests that political institutions such as the prevalence and years of experience under democratic governments are stronger and more robust predictors of international measures of corruption than exposure to international trade. Details concerning the two econometric techniques used to derive the two sets of consistent estimates in Table 13 are present at the bottom of the table. Inany case, these results suggest important policy implications, namely that we should not expect international trade to make significant inroads by 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 of accountability, such as transparency initiatives (publishing budgets, providing time for public comment on regulatory changes and, of course, protecting the freedom of the press). In the long run, it is likely that democratic governance itself, through the formal mechanisms of checks and balances, will become the underpinning o f clean governments and more vigorous economies. Nevertheless, certain elements of 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 of Central America. Moreover, DR-CAFTA also mandates that governments implement their own labor and environmental regulations, which also reduces the scope for selective enforcement of 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 reelect II-0.2244 -0.2329 I 0.0385 -0.1668 -0.2676 0.1375 II 0.0429 0.1810 II -0.3354 I -0.3062 II I1 I1 I 0.2929 I 0.2609 0.1254 1 0.1477 0.2153 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 I O.oo00 I O.oo00 I 0.oooO I O.oo00 O.oo00 O.oo00 0.oooO O.oo00 state I I -0.0968 II 0.1525 I1 0.4359 0.0425 0.0543 0.1015 II 0.1625 II I I I -0.1039 0.0768 0.0370 II0.0828 0.0407 II 0.1693 1I I 0.0759 0.0618 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 O o o 0 0 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 O o o 0 0 OoooO OoooO O o o 0 0 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 of reelection d, time of democratic stability, indicator of local elections for state govs, gov control of legislative d, freedom of press index, gov revenues (8 GDP), transfers from central gov to other levels (8GDP), opennessto trade (imports as 9%GDP), In of per capita GDP, avg schooling in the pop above 15, British legal tradition d, index of 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-SaharanAfr, and L Am 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 oj CAFTA: More Art Than Science B. The growth effects of Free TradeAgreements ( 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 of public institutions. This section turns our attention to evidence concerning the overall effects of FTAs on the rate of growth of GDPper capita across countries. 4.93 In this section we examine whether DR-CAFTA is likely to have an impact on economic growth. While our empirical results will be indicative, they are not expected to produce precise point estimates of the impact of the FTA on economic growth. Rather the results should provide the average growth impact of FTAs after controlling for a wide variety of country specific factors. Because countries and institutions differ in a myriad of ways, both measurable and immeasurable, one would ideally like to have country-specific empirical results that capture the idiosyncratic circumstances of 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 of 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 of 132 countries over a 30-year period. The 30-years of 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 of regional trade agreements. A full description of the data can be found inTables A6 inthe Appendix. 4.94 As a starting point for the empirical analysis, we begin by estimating a fixed effects panel growth model that includes the number of regional free trade agreements to determine whether they have any power in explaining economic growth. We also add a variety of important economic and political variables to control for external and internal factors that may also influence economic growth to confirm the robustness of the results. Following this, we account for possible selectivity bias (i.e., the choice of signing a free trade agreement may be endogenously determined by the state of the economy) by explicitly takinginto consideration a country's choiceto 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: 39This section was writtenby DavidGould(World Bank) and William Gruben (Federal Reserveof 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, is a country specific dummy variable, Y[-I,i s initial level of real GDP per capita, K is physical capital investment, H i s human capital investment, andp 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 by the negative and statistically significant coefficient on the initial value of 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 of secondary school enrollment as a percentage of total population of that age group that corresponds to secondary school age), however, i s negative and not statistically significant. Despite utilizing alternative measures of human capital investment, such as primary and tertiary school enrollment rates as proxies for human capital investment, measures of 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 of growth (5-year periods) or the lack of a good proxy for human capital investment. 99 CHAPTER IV. Economic Efj'ect of'CAFTA: More Art Than Science Table 14: FixedEffects Panel Regressions, 1970-2000 (5 year averages)* GDP (%) (3.57) I (3.59) R-sqwithin 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 * Tstatistics in parenthesis. Dependent variable: Currentper capita real GDP growth Regional trade agreements 4.97 Regression 2 in Table 14 (column 2) includes a measure for the number of regional free trade agreements in force. To account for the possibility that regional FTAs may be signed in the middle of a five-year growth period, the value of the variable is the portion of the period it is in force. For example, if a country signs its first regional FTA in 1971, then the value of the variable is 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 FTA 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 FTA 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 its statistical significance while the size of its 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 of 0.7 percent to 1.1 percent); trade as a share of 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 of 0.04 to 0.02 percent); as expected, the black market premium has a negative and significant impact on growth, although the impact is 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 of total consumption i s negative as expected, but i s not statistically significant; the fiscal balance as a share of 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 of 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 is implemented, i s associated with additional higher real GDP growth -about the same effect as that of the number liberalizations- 0.8 percent of annual growth, but i s not statistically significant due partly to multicollinearity (by definition, an increase in the number of liberalizations i s always associated with the choice to liberalize). Taken together, the longer-term effect of 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- termimpacts 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 40Berthelon (2003) estimates the effects of regional free trade agreementson 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 representedby the FTA trading partners. H e also creates another variable that takes the value of this variable but measures it relative to the size of 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 of regional FTAs are significantly stronger between countries in the North (developed) and countries in the South (developing) or for any other types of 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 of the regional trade agreement variable i s only slightly smaller (about 0.6 percent compared to 0.7 percent) and is still statistically significant at the 95 percent level or higher when including all the control variables. The signs of the control variables are broadly similar to the five- year regressions, but, in general, the significance of the control variables drops below the 90 percent level when including the fiscal balance as a share of GDP into the regression equation. The fiscal balance as a share of GDP i s significant at the 99 percent level and appears to dominate the impact of the other control variables that affect growth in the shorter time horizon shown in Table 14. Over a longer period of time, a more prudent fiscal policy may be a much stronger proxy for policies that effect economic growth (outside of investment and trade policies) than any of the other control variables by themselves. Finally it is worth noting that further econometric exercises that rely on the Arellano and Bond (1991) estimator indicate that the results concerning the average growth effect of 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 duringperiods of above normal growth, and, as a consequence, may be the result of, and not the cause of higher growth. A problem with 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 of the economy or other factors that, in turn, may be related to growth. But, this assumption may be too restrictive. Indeed, during periods of 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 of protectionism it 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 of 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. It 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 of 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 will the correction for this potential endogeneity affect the estimated impact of regional FTAs on 102 CHAPTERIV. 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 of entering into an FTA. The model assesses whether output growth differs significantly between those periods during which a free trade agreement i s signed. It 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&-,+ If DI,+$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 is a function of initial GDP, a dummy variable indicating whether country i signed a free trade agreement duringthe period, Dit, a vector of internal and external country environmental characteristics, Xlt, such as world growth, fiscal balance, and black market premium, a vector of 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 of domestic interest groups. The latent variable i s a function of a vector of characteristics, Z,,, which include lagged variables such as real GDP per capita growth, initial level of GDP per capita, world GDP growth per capita, trade share of GDP, political freedom index, dummy variables to account for unspecified "free trade trends" in the 1980s and 1990s, and a vector of country-specific dummy variables (fixed effects). 4.105 Table 15 shows the results of the model that explicitly takes into consideration the potential selectivity bias in the choice of 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 of slower than normal growth and higher than normal world growth being a good predictor of the signing of a regional free trade agreement, in neither estimation procedure (the maximum likelihood or the two-step procedure) are the estimated coefficients, nor the significance of the regional trade agreements variables, diminished substantially. Consequently, the evidence suggests that endogeneity in the choice of 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 ThanScience Table 15: Treatment Effects Model. 1970-2000(5 vear averages)" t Maximum ikelihood Estimates I Estimates I Current per capita real GDP growth LogInitialreal GDP p.c. ($) -0.039 -0.039 (-2.90) (-3.88) Log secondary schoolenrollment (%) -0.0003 -0.0004 Log of investment share of GDP (%) 0.007 1 0.007 World GDP growth(%) 0.0063 0.006 I I (2.57) II (2.60) I Trade share of GDP (%) 0.00003 0.00003 (0.19) (0.19) Black marketpremium (%) -0.00001 -0.00001 (-0.57) (-0.94) Government share of consumption(%) 0.0003 0.0003 (0.91) (0.84) Fiscalbalance as share of GDP (%) 0.001263 0.001 (2.62) (2.28) Choiceto liberalize 0.0103 0.011 (1.39) (1.45) Laggedfreedom 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 (-0.11) (-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 of 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 of poverty to changes in economic growth. Such elasticities allow for the calculation of 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 of the DR-CAFTA, assuming that the estimated growth effect materializes for all five countries. Results suggest that overall poverty reductions would vary by 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 of poor in five years of 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 2005 2010 Difference 2005 2010 Difference I Costa Rica II 20.4 19.8 -0.6 II 6.0 II 5.7 -0.3 ElSalvador I 36.4 111 35.0 III -1.4 I 14.7 I 14.1 III -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 of DR-CAFTA on the developing countries of Central America. It begins by highlightingthat standard theoretical treatments of the gains from trade indicate that such gains depend on an economy's capacity to change its productive structure. Otherwise, the gains are limited to the gains on the consumption side, which allow domestic agents to consume a bundle of 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 of the gains from trade. 4.108 Regarding empirical analyses of 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 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 of the type of preferential treatment. Also, the evidence reviewed suggest that the gains from trade in terms of increases in GDP per capita i s intermediated by the regulatory environment that determines how quickly firms and workers can change their sectors of operation and employment. Thus a complementary agenda to enhance the impact of the DR-CAFTA should consider these factors, even when concerned about the static gains from trade. 4.109 Partial equilibrium analyses of the potential sectoral effects of 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 by these models are proportional to the initial level of exports. In addition, they have difficulty dealing with technical issues such as the restrictiveness of rules of 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. 4.110 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 of the model to changes in the returns to unskilled labor to poverty outcomes. Indeed, under a restrictive set of conditions (e.g., segmented labor markets, no dynamic effects, effective transmission of 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. 4.111 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 of 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 of 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 of international trade on the quality of public institutions. The process of democratic consolidation seems much more important, although certain aspects of DR-CAFTA that put pressure on governments to improve the enforcement of 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 of international trade. On the other hand, the probability of observing episodes of "economic discovery" seems to be positively correlated with overall export growth. 106 CHAPTERIV. Economic Effect ojCAFTA: More Art ThanScience 4.112 This chapter also reviews the econometric challenges and results by investigating the empirical link between FTAs and subsequent economic growth in a large sample of countries. The main result is that the growth rate of GDP per capita i s positively associated with a country's participation in FTAs. This finding is robust to the inclusion of 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 of partner in the FTA. In contrast, a previous empirical study using a different set of 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 of economic development, at least for the first five years subsequent to implementation. In the long-run, the steady-state level of income will be determined by a plethora of other factors and as economies get richer, their pace of growth will 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. 4.113 The evidence reviewed should make clear that ex-ante analyses of 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 VI1of 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 of economic development in the context of DR-CAFTA. 107 CHAPTER IV. Economic Efject ojCAFTA: More Art Than Science TechnicalAppendix: The Gainsfrom Trade for SmallEconomiesand the UnderlyingAssumptions 4.114 The purpose of this appendix is to summarize a textbook model of the gains from trade by highlighting the role of the gains due to consumption and the gains due to the productive transformation of a small open economy. The starting point i s the standard simplifying assumption, whereby we assume that the economy produces two broad categories of 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 of each good. Thus equations (1) and (2) below represent the production functions of each good, where a1 and a2 represent the out per unit of labor for each sector, and L1 and L2 represent the number of workers dedicated to producing each good. 4.115 Consequently the economy's total labor force (L)is 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 of employment equal to L. As argued in this chapter and subsequently in Chapter V, government policies designed to help the process of adjustment can be instrumental in maintaining a given level of total employment as relative prices change due to trade policies (DR-CAFTA). (3) L=L,+L, 4.116 Hence the economy's production frontier, which represents the quantities of both goods that it can produce when all labor (L)is employed in production, can be expressed as the quantity of good 1 (Ql) that can be obtained if all labor i s employed in that industry and the quantity of 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 of these maximum production possibilities. This production frontier i s formally expressed inequation (4): 4.117 In this framework, the composition of production depends on available technologies in this economy compared to the technologies of production in the rest of 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 its 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 advantageinthe productionof good 1. Note that it can have lower labor productivities in both sectors, but it would still have a comparative advantage. 4.118 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*Li s the maximum quantity of 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 of this line is equal to the negative ratio of a1 over a2, as shown in equation (4) above. 4.119 Now assume that the initial structure of production i s represented by some point along the production frontier. In this case, the value of this production mix based on the economy's trading partners' relative efficiencies i s given by the consumption frontier portrayed by the dotted line that goes through the production point and extending down to point B in the horizontal axis. In terms of the quantity of good 2 that the economy can consume, the gains from trade without changes in the structure of production are given by the distance between points A and B in Figure Al. That is, with trade, consumers in this economy can consume larger quantities of good 2 than would be possible without free trade, because in autarky consumption must lie on the production frontier. 4.120 The gains from trade become larger if the economy i s able to change its production structure. In the graph, this entails a movement of the production point from the previous point to the point on the vertical axis where all of the economy's labor is 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 of the economy to change its production structure even if the so-called dynamic gains from trade are not considered. This report argues that the capacity of the economy to be transformed will 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: CostaRica Estimatedeffectsof US.tariff eliminationinpartial - equilibrium - HS Code Actual Exports DR-CAFTA" Change Product Description 2001 Potential Gain (%o) ($000) ($000) Total 731,448 197,550 27% 61 Art of apparel & clothing access, knitted or croc 396,414 139,893 35% 62 Art of apparel & clothing access, not knittedkro I 293,864 52,198 18% 02 IIMeat 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, 4,045 371 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 CBI'S 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 TableA2: ElSalvador Estimatedeffects of U.S. tariff eliminationinpartial - equilibrium Change Product Description 1 Actual Exports DR-CAFTA I I I I 2001 potential (%) ($000) I gain 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 TableA3: Guatemala Estimatedeffectsof U.S. tariffeliminationinpartial - equilibrium Hs Code I Product DescriDtion I 2001 ($000) Gain Total 1,652,343 777,969 47% 61 Art of apparel & clothing access, knitted 880,543 514,248 58% 62 t of 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 1,241 42% 42 Articles of 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 UNCOMTRADEandTariffs from TRAINS 112 CHAPTER IV. Economic Ejject of CAFTA: iMore Art Thun Science TableA4: Honduras Estimatedeffects of U.S. tariff elimination inpartialequilibrium - HS Code Product Description (S 000) ($000) 19 prep. of cereal, flour, starcwmilk; pastry cooks' 56 1 2% 113 CHAPTERIV. Economic Effect of'CAFTA: More Art Than Science Table A5: Nicaragua Estimatedeffects of U.S. tariff elimination inpartial - 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 Manufacturesof straw. esuarto/other ulaitinn mat 1 3 1 0 I 5% 58 Source:Esti DR-CAFTAestimatedas a unilateraltariff eliminationby the US to Central American countries 114 CHAPTERIV. Economic Efecf of CAFTA: More Art Thon Science Table A6: ElSalvador:Estimatedeffects of tariff eliminationon U.S.importsinpartialequilibrium 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 E- 4 l 96 I 54 Meat and edible meat offal 2,712 1,229 45% Preparationsof vegetable, fruit, nuts or other 4,674 1,119 24% Miscellaneous articles o f base metal 7,052 1,009 14% I Pearls, precious stones and metals 2,202 985 45% Other exports 209,708 13,959 7% ISource: Es mations 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 El Salvador to U.S.imports. 115 CHAPTER IV. Economic Effect of CAFTA: More Art Than Science TableA7: CostaRica: Estimatedeffectsof tariff eliminationon US.importsinpartialequilibrium rl Imports Change Change HS Code Product Description 2004 In Imports (%) Source: Estimations using SMART, exports from UNCOMTRADE, tariffs from TRAINS. DR-CAFTA effect estimated as a unilateral tariff elimination (immediatedrop to zero of all tariffs) by Costa Rica to U.S. imports. 116 CHAPTER IV. Economic Effect of CAFTA: More An Than Science Table AS: Guatemala: Estimatedeffectsof tariffeliminationon U.S.importsinpartialequilibrium Product Description Source: EstimationsusingSMART, exports from UNCOMTRADE, tariffs from TRAINS. * DR-CAFTA effect estimated as an unilateraltariff elimination(immediate drop to zero of all tariffs) by Guatemalato U.S. imports. 117 CHAPTER IV. Economic Efect of CAFTA: More Art ThanScience Table A9: Honduras:Estimatedeffects of tariff eliminationon U.S.importsinpartialequilibrium Imports Change Change HS Code Product Description 2004 In 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 unilateraltariff elimination (immediatedrop to zero of all tariffs) by Hondurasto U.S.imports. 118 CHAPTERIV. Econoinic Effect of CAFTA: More Art ThanScience TableA10: Nicaragua:Estimatedeffectsof tariffeliminationon US.importsinpartialequilibrium Imports Change Change *Source:Estimationsusing SMART, exports from UNCOMTRADE, tariffs from TRAINS. DR-CAFTA effect estimated as a unilateraltariff elimination (immediate drop to zero of all tariffs)by Nicaraguato U.S.imports. 119 CHAPTER IV. Economic Efect of CAFTA: More Art Than Science Table All: Summary Statistics (1960-2002)ofVariablesUsedby Gouldand Gruben inestimationof growtheffectsof 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 of 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 of trade-related economic adjustment in the short-term. In particular, 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. The analysis presented in this chapter indicates that 90 percent of Nicaraguan households, 84 percent of Guatemalan households, and 68 percent of Salvadoran households, respectively, were found to be net consumers of the basket of sensitive agricultural commodities and thus can be expected to benefit from DR-CAFTA-related price changes. Only about 9 percent of Nicaraguan households, 16 percent of Guatemalan households, and 5 percent of Salvadoran households were found to be net producers of the basket of 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 of losses to net producers are relatively low - about 2.2-2.3 percent of 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 it considerable grace periods, safeguards and extended phase-out periods for eliminating tariffs and quotas that provide reasonable protection to producers of sensitive crops over a prolonged adjustment period. In addition, potential income losses can be mitigated through a variety of additional policy options: (i) "decoupled" income support payments to farmers of sensitive crops (e.g., Mexico's PROCAMPO program), (ii) technical assistance programs to farmers of 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 of 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 of support program would be more appropriate should be made on the basis of 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 of 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 of 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 11, a handful of "sensitive" agricultural commodities (e.g., maize, beans, dairy, and poultry) still have significant levels of protection. This protection will be reduced or eliminated as a result of DR-CAFTA, as described in Chapter 111, potentially resultingin 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 of welfare while making the transition to new and more remunerative economic opportunities arising from the Agreement. 5.4 The main objectives of this chapter are to: (i) ex-ante the potential impacts on analyze 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 of trade adjustment in the short-term are able and equipped to take advantage of opportunities arisingfrom DR-CAFTA in the medium-to-long term. Because the largest changes in trade protection are expected to affect a handful of so-called "sensitive agricultural commodities," this chapter focuses predominantly on the effects of liberalizing trade in these commodities. To fulfill its objectives: Section 2 outlines briefly the state of trade protection on sensitive agricultural goods in Central America, as well as the types of trade reforms negotiated under the DR-CAFTA Section 3 lays out a framework for assessing the welfare impacts of DR-CAFTA ex-ante, focusing on how price changes are transmitted to households and how households manage risk inthe face of changing economic circumstances Section 4 presents new case evidence of 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 of DR-CAFTA, comparing the relative benefits of phasing out trade protection as negotiated under the Agreement versus and approach that couples quick trade reform with compensatory measurestargeted 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 of different policy alternatives with respect to enabling a successful economic transition and ensuring that the poor are equippedand preparedto benefit from the DR-CAFTA. 2. Liberalizationof SensitiveAgriculturalCommoditiesunderthe 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 of 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 of 2001, tariffs on the import of poultry meat was as high as 170 percent in Nicaragua, 150 percent in Costa Rica, 50 percent inHonduras, 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:TariffsonKey "Sensitive" CommoditiesinDR-CAFTACountries' 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: ' Datafrom 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, MCCA) countries, except for the U.S., from which poultry imports carry a tariff level o f 164 percent. For both El Salvador and Honduras, the tariff levels also differ dependingon the type of poultry meat. ' This is true at least for trade outside the Central American Common Market (Mercado Comdn Centroamericano, MCCA). 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 of the countries also had non-tariff barriers of various kinds.For example, there i s a system of tariff-rate quotas (TRQs) - sometimes called "within- quota" and "out-of-quota" tariffs - that results in different levels of protection depending on the quantity of imports. This is illustrated in Table 1 by 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 low 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 inEl 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 MCCA (e.g., related to hoof-and-mouthdisease, mad cow disease, etc.).2 5.8 Reduction or elimination of tariff and non-tariff protections under the DR-CAFTA would thus be expected to lead to lower domestic prices for sensitive commodities in each ~ o u n t r y . ~ Given the high levels of protection on some of these goods, the expected price declines on these goods could be considerable in some countries. For this reason, DR- CAFTA includes a wide range of provisions (described in Chapter 111) for dealing with the liberalization of sensitive goods, including grace periods for initiating liberalization, extended phase-out periods for tariffs, interim quotas and/or phase-downs of 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 III. 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 liberalizing (Box 1). 5.9 In sum, while the specific differ from country-to-country, the DR-CAFTA has built into it 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 of tariffs and non-tariff barriers and on the share of these sensitive commodities in the bundle of consumption goods used to calculate such prices indexes. Such an exercise is difficult to undertakedue to the problems in predictingthe 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 is 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) in changes government tax revenues and transfers (which may be affected by 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 of trade; (vi) the costs of adjusting to changes economic en~ironment.~ Box 1: DR-CAFTA Schedulesfor 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, phasingdown of TQRs, and various safeguard provisions. While the exact reform schedules were negotiated country-by-country, the broad parameters are similar inmany ways, as can be seen in the context of liberalizationinHonduras andEl Salvador. In Honduras: . Tariff reductions on Rice are allowed to be phasedover an 18-year period, following a 10-year graceperiod. Tariff reductions on Pork are allowedto be phasedover 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 will be liberalizedover a 15-yearperiod. Tariff reductions on Poulrry Meat are allowed to take placeover an 8-year period, starting in 2015. 1 Tariff reductions on Dairy Products are allowedto be phasedover a 20-year period. 1 Tariff reductions on Yellow Maize are allowedto be phasedover a 15-yearperiod, following a 6-year grace period. InEl Salvador: Tariffs on imports of Beans will to be phasedout in 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 graceperiod. Tariffs on Poultry is be phasedout over 7 years, following a IO-yeargrace period. The current TRQ on Pork will increase by 10percent 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 all other Bovine Meat will increaseby 5 percent a year; tariffs will be phasedout over a 12-yearperiod, following 2-year grace period. Tariffs on Milk and Cheese are to be phasedout over 10 years, following a 10-yeargrace period. In an important exception, in both Honduras and El Salvador, White Maize - a key staple produced and consumedby the country's rural poor - will he exempted indefinitely from liberalization. Moreover, for all the sensitive products, special Safeguard Measures have been agreed upon to ensure against unforeseen harm to local producers causedby rapid increases in imports from the U.S. Sources: Governmentof 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 of liberalization and, in particular, what they would mean for producers of 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 of transfers, are discussed later in the chapter in the context of 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 of applying this framework is that the effect on households of a price change on household welfare (such as the kindresulting from liberalizing the bienes sensibles agricolas will 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 multipleincome sources, 0 at least in rural areas, are often both consumers and producers of key goods (and that the consumption and production effects of price changes work in opposite directions), 0 adjust their consumption and production patterns inresponseto relative price changes, and 0 Employ a number of ex-ante and ex-post strategies to manage price and income risks. 5.14 This section examines each of these factors inturn. Multiple Consumption Goods, Sources of Income Households, whether rich or poor, consume a diverse bundle of goods. They also often have multiple sources of income. This multiplicity of 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 of household consumption patterns using Nicaragua's 2001 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 of households' consumption bundles, on average, and between 7 and 8 percent of the consumption bundle of Nicaragua's poorest 20 percent of households (Table 2). Together, the group of 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 will thus have a positive impact in households' ability to purchase these goods for consumption, with the largest effects being felt in the bottom half of the welfare distribution. At the same time, increase inpurchasing power will be less than if the bundle of 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: ConsumptionShares of Key CommodityGroups,Nicaragua,2001 Source: Adapted from Monge, Saavedra, and del SocorroVallecillo (2003), basedon analysis of Nicaragua's national householdsurvey, 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 of income sources (or income "portfolios"). As can be seen in Figure 1, income from self-employed agricultural enterprises such as production of maize, beans, and rice - or chickens and cows in the case of smallholder farm households - makes up about 19 percent of the income, on average, among of the poorest rural households in Nicaragua and about 28 percent of incomes among rural households in the fourth q~intile.~ In contrast to the case of consumption, declines in the prices of the sensitive agricultural commodities will act to reduce the incomes of 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 of 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 in 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 mix 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 HouseholdsinNicaragua, by Quintile, 2001 Poorest 2nd 3rd 4th Richest Quintiles 0Wage Non-Agriculture 0Self-EmployedNon-Agriculture Non-LaborIncome II Source: World Bank Staff Estimates,usingthe 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 of key goods also served to soften the impact of a price change on family welfare. This is because the effect of a price change has the opposite effect on consumption and production. If, for example, a household were to consume exactly the same amount of a particular good - say maize - as it produces, then a decline in the border price would have no net impact on household welfare, as the purchasing power benefits of consuming less expensive maize would be exactly offset by the loss in income associated with lower producer prices for maize. If a household were to consume more maize than it produced, then a reduction in the maize price would, on net, benefit the welfare of that household. However, the benefits would only equal the amount of the price decline multiplied by the excess of maize consumption over maize production (Le., the net amount of maize purchased from the market). In contrast, if a household were to produce more maize than i t consumed, then it would experience a welfare loss as a result of a decline in the maize price. In this case, the loss would be the amount of the price changes multipliedby 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 of a good "net consumers" of that good, whereas those households that producer more than they 128 CHAPTER V. Policy Approaches to Munaging the Econoniic Transition: consume of a good "net producers" of that good.6 Stated simply, net consumers of a good would be expected to benefit from a decrease in the price of 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 of that good and negatively impact the welfare of net consumers. 5.18 Analysis of household survey data from Guatemala (ENCOVI 2000) shows that the. vast majority of Guatemalans are net consumers of maize - about 80 percent of households overall. This compares with only about 12 percent of Guatemalan households, in all, that are net producers of maize. The remaining roughly 8 percent of households are neither net consumers nor net producers of maize; they consume and produce equal amounts. It should noted that the percentage of households that are net consumers (net producers) of maize varies somewhat across the welfare distribution, however (Figure 2). For example, about 71 (17) percent of the poorest households are net consumers (net producers) of maize, while about 92 (4) percent of the wealthiest households are net consumers (net producer^).^ The share of households that are net consumers of maize also varies significantly across regions of Guatemala. Roughly 69 (18) percent of rural households are net consumers (net producers) of maize, whereas 91 (5) percent of urban households are net consumers (net producers).8 Figure2: NetConsumersandNetProducers of Maize inGuatemala,by Quintile,2000 100% 80% 60c7c 40%- 20°C 0ffr Poorest 2nd 3rd 4th Richest Quintiles 1E4Net Consumers HNet Producers 1 Source: World 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 of these cases does the percentage of 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 of 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 It i s important to highlight that households are not simply passive recipients of price changes. Rather, households often adjust their consumption and production practices in response to changes in relative prices to help make the most of 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 of chicken goes down, households tend to increase their consumption of 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 of 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 of 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 will 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 of household consumption can be purchased in markets, makes substituting one consumption good for another (at the margin) relatively easy. On the production side, however, households may face a variety of 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 of their farmland, seasonal or weather-related constraints on crop production, absence of irrigation or other production technologies, and/or limited availability of credit (or other forms of working capital) may serve to limit households' ability to adjust their income portfolios quickly. Such production-sideconstraints 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 of 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 marketsrepresent important long-run challenges for policymakers. It should be noted, however, that such a lack of 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 of domestic price changes that will likely be induced by DR-CAFTA. This relative absence of 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-relatedprice changesincommodity 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 beyondindicates 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 (2003~)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 additionalhouseholdmembers into the labor force inresponse to a real or expected employment shock (Cunningham 2001). InEl Salvador, migration and remittances have also been a key element of 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 of resources - as loans or gifts - in the event of an adverse shock (Klugman, Kruger, and Withers 2003). 5.22 A new empirical study of the impacts of 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). InEl Salvador, in responseto declines inthe coffee price -andrelatedlabor demand inthe 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 of the significant fall inthe world coffee price (Trigueros and Avalos 2004; Beneke de Sanfeliu and Shi 2004). InHonduras, evidence also indicates that coffee sector families increased their labor supply in an attempt to offset effects of 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 of productive assets such as land, withdrawing children from school, or deferring utilization of 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 off assets - such as land or livestock - as a means of 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 of school i s of 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 of intergenerational transmission of poverty. 131 CHAPTER V. Policy Approaches to Managing the Economic Transition: 5.23 A number of recent empirical studies - within and outside Latin America - have tried to measure how effectively households smooth their consumption - or "self-insure" - in the face of 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 of their consumption per capita in the face of 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. Ingeneral, poor households seem to have fewer instruments available - and are less successful - in insuring themselves against risk than non-poor households. In China, for example, the wealthiest households only experienced a 1percent decline in per capita consumption in the face of 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: HouseholdConsumptionSmoothinginDeveloping Countries -RecentEvidence Change inHousehold Per Capita Consumption Resulting froma 10Percent Change in Country per capita Income (Percent) Source Mexico (rural) 3.7 Skoufias (2002) Nicaragua (all country) 2.5 1Klugman, Kruger, and Withers (2003) Peru (Urban) 3.0-3.6 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 of a country's not only to ensure a minimum level of well-being among a country's population in the event of shocks, but by helping to protect human capital investments and other productive assets of the poor in the event of shocks, safety nets can play an important role in a country's long-term strategy for economic development and poverty reduction. lo '" Severalapproaches 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 Liberalizingthe Sensitive Agricultural Commodities: New Evidencefrom ElSalvador, Guatemala and Nicaragua. 5.25 Given the above, what might a policymaker expect to be the impacts of 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 of 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 of these commodities can be expected to benefit net consumers of that good and have a negative impact on well-being of net producers of that good. One difference between the analysis the discussion of net consumers and producers above and the analysis presented here i s that this section focuses largely on the net welfare impacts of liberalizing the entire basket of sensitive commodities in each country - although the role and importance of several specific commodities on household welfare are discussed below. (For additional information on the methodology used inthe 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 of liberalizing the sensitive commodities. As will 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 a1 (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 Encuestade 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 ExpectedImpacts of Liberalizing Sensitive Agricultural Commodities inEl Salvador, Guatemala and Nicaragua: A Net Consumer-NetProducer Approach The case studies presented in 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 of a price change on household welfare. The theoretical underpinnings for the approach used here are described in 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. If with the implementation of DR-CAFTA there is a reduction in the import tariff of that product and of its domestic price, then all households who are net producers of that product would experience a loss, while all households who are net consumers of 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 in welfare. Note that the framework abstractsaway 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 of 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 of expected changes in the prices of sensitive agricultural commodities in El Salvador, Guatemala, and Nicaragua, due to the DR- CAFTA are presentedin 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 of data and computational costs. Moreover, as Hertel and Reimer (2004) note in their review of the various approaches to analyzing the poverty impacts of trade, CGEs models can be quite complex, making it 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 associatedwith increased labor demand that might be associated with the increased foreign investment, expansion of exports, or increased economic growth expected to accompany. Third, the analysis assumes implicitly that tariffs are eliminated at once and that the price impact is 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. Inthis context, the impact of prices changes would only be felt over a much longer period of time. Fourth, even if elimination of 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 in those areas may experience only weak price effects relative to those living in urban or "well-connected rural areas. Indeed, recenl empirical analyses of 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 is 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 of estimates presented here are generally referred to in the "net consumer-net producer literature as "worst case" scenarios of impacts (McColloch 2002). 134 CHAPTER V. Policy Approuches to Munaging the Economic Transition: It is important to note, however, that there are also factors that could work in the opposite direction in terms of actual versus estimated impacts. For example, capital allocation away from adversely affected sectors could serve to reduce the marginal product of labor in those sectors, compounding the static losses faced by net producers of affected goods. Indeed it is 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 of reallocation of capital from adversely affected sectors. A final caveat is that, strictly speaking, partial equilibrium analysis is 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 is useful in helping policy makers identify the expected "first-order'' effects of the DR-CAFTA, including which types of households are most likely to gain or lose as a result of liberalizing the sensitive agricultural commodities, as well as the likely size of the impacts. In doing so, it 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 is likely to win and who is likely to lose from the liberalization of the sensitive agricultural commodities, the analysis first examines whether households are net consumers or net producers of each sensitive commodity, as in the case of maize in Guatemala highlighted above (Figure 2). It then estimates the per capita consumption gains to "winners" and losses to "losers" associated with liberalization of each good. Finally, it calculates the net welfare impact for each household of removing tariffs and non-tariff barriers on the basket of sensitive commodities in each country. As can be seen in Figure 3, the vast majority of people in Nicaragua, Guatemala, and El Salvador are net consumers of the basket of sensitive commodities. 5.29 Specifically, the evidence indicates that 90 percent of Nicaraguan households, 84 percent of Guatemalan households, and 68 percent of Salvadoran households are net consumers of the basket of sensitive agricultural commodities and, thus, on net, can be expected to benefit from the sum of the price changes expected to occur when sensitive agricultural commodities are liberalized. Conversely, about 9 percent of Nicaraguan households, 16 percent of Guatemalan households, and 5 percent of Salvadoran households are net producers of the basket of sensitive commodities and would, thus, be expected to experience (static) welfare losses arising from the price changes induced by DR-CAFTA. Some proportion of households, perhaps as high as 19 percent in the case of El Salvador, would neither benefit nor lose as a result of 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 inroughly equal amounts. 135 CHAPTER V. Policy Approaches to Managing the Economic Transition: Figure 3: Net Consumersand Net Producersof SensitiveAgricultural Commodities inNicaragua, Guatemala and ElSalvador* Xicaragua Guatcmala El Sal\ador 1 E l NetConsumers HNet Producers 1 Sources: Portner (2003), Monge, Castro, and Saavedra(2004), and Marques (2005) * Notethat for data reasons, in the case of El Salvador,the proportion of both net consumersand net producersmay both be underestimated. 5.30 It i s important to note here that in the case of El Salvador it is likely that both the proportion of net consumers and net producers i s underestimated. Both the Nicaraguan EMNV and the Guatemalan ENCOVIsurveys 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 of net consumer-net producer analysis presented here. In contrast, El Salvador's EHPM survey i s designed primarily as an income and employment survey. The EHPMdoes contain information on agricultural production, self-consumption, as well as data on purchase of food items - although in practice these latter data have rarely been used. Review of 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 of both net producers and net consumers i s lower inthe El Salvador analysis than inthe cases of Nicaragua and Guatemala. 5.31 The El Salvador findings must, thus, be interpreted with some caution, especially in the case of 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 of households could significantly influence the results. In this context, it should be noted that Marques (2005) conducts some tests of the robustness of the findings to outliers in the data. He finds that the results are robust to outliers, although that i s no guarantee that there are missingdata reports, especially among poor households, that might have altered the findings somewhat. That said, the overall patterns of 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 of confidence that they reflect real income and consumption patterns on the ground.I3 5.32 Rural-Urban DifSerences. While the majority of Nicaraguans, Guatemalans, and Salvadorans are likely to benefit even in the short-term from price declines in sensitive agricultural commodities, the distribution of beneficiaries differs somewhat across rural and urban areas (Table 4). InNicaragua and Guatemala, for example, the evidence indicates that a higher proportion of households in urban areas will benefit than in rural areas. In Nicaragua, 97.6 percent of urban households are expected to benefit compared with 78.8 percent in rural areas. The pattern i s similar in Guatemala; 93.6 percent of 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 still 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 ZndQuintile 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 of net producers - households expected to experience negative impacts of DR-CAFTA-related price changes - i s considerably higher in rural areas than in urban areas. In the case of Nicaragua, for example, nearly 20 percent of the rural l3As will be discussed further below, El Salvador i s a less rural country, with less of its economy based on agriculture than either Nicaragua or Guatemala. Since urban areas in Nicaragua and Guatemala have higher concentrations of net consumers than do rural areas, once would expect a higher proportion of 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 understatethose 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 by DR-CAFTA-related price changes, compared with less than 2 percent in urban areas. In Guatemala, nearly a quarter of rural households are expected to be adversely by price changes associated with liberalizing sensitive agricultural commodities underDR-CAFTA; this compares withjust under 6 percent in urban areas. It is 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 inproduction and consumption patterns. For example, data from Nicaragua indicate that about 34 percent of rural households in the Atlantic region are net producers of the basket of bienes sensibles agricolas, considerably higher than the rural average; for Guatemala, the data suggest that over 60 percent of 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 of rural households beingnet consumers than urban households: 72.1 versus 65.2 percent. It i s not completely clear why this i s the case - as in general rural households would be expected to produce a greater share of 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 of 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 of the basket of 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 of the traditional, administrative definitions of rural and urban used inthe survey. Potentially compounding this problem i s that El Salvador has not had a population census since 1992. Combined, the EHPM identification of rural versus urban, based on administrative definitions and a series of post-1992 assumptions about populations dynamics, may have led to a blurring of 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 of households that are net consumers - and, thus, that are expected to benefit from price changes induced by the DR-CAFTA - still greatly out-number the proportion of households that are net producers, both inrural and inurban areas. l4It is possible that in remote areas such as Peten, the transmission of price effects may be extremely weak, due to high transactions costs and relatively weak integration with markets. In the case, of Peten, some analysts have also argued that due to its proximity to Mexico, households may have already experienced some (or all) of the impact they will feel from liberalization, through the effects of NAFTA and informal cross-border trade of staple crops. l5The Salvadoran statistical agency, DIGESTYC, estimates that approximately 55 percent of El Salvador's population is now urban, based on their population projections and using traditional administrative definitions of rural versus urban. In contrast, a new World Bank study on rural development in Latin America and the Caribbean (2005) that the European Union's definition of rural and urban, based on population density and geographic distance from major urban centers, estimates that roughly 80 percent of 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 of likely "winners" and "losers" across the welfare distribution; specifically, a higher percentage of the non-poor are expected to benefit than the poor. In Nicaragua, for example, 94.8 percent of households in the wealthiest quintile are net consumers, as compared to 85.7 percent of households in the poorest quintile (Table 4). In Guatemala, the 92.0 percent of households in the wealthiest quintile are net consumers, as opposed to 78.5 percent in the poorest quintile. The mirror image of these patterns i s that a higher proportion of poor households are net producers and, thus, likely to be adversely affected by 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 of households inthe wealthiest quintile. 5.37 In El Salvador, this pattern i s less strong on the net consumer side, with the highest proportion of net consumers found inthe third and fourth quintiles. Nonetheless, the pattern i s still seen clearly among net producers; at 7.5 percent, the percentage of net producing households in the poorest quintile i s roughly 1.5 times higher than the percentage of net producing households in the wealthiest households. Again, it 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 of 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 of all households are neither net consumers nor net producers (Le., neither positively nor negatively affected by price changes in sensitive agricultural commodities). Prospective Gains to Net Consumersand Losses to Net Producers 5.38 Due to differences in household patterns of 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.18In Nicaragua, it i s estimated that if all bienes sensibles agricolas were liberalized instantaneously, the 90.2 percent of households that are net consumers would experience a benefit of 3.8 percent of per capita consumption on average. This compares with a an expected benefit of only 0.5 percent of per capita consumption for net consumers in Guatemala (83.8 percent of households), and an intermediate benefit of 2.0 percent of per capita income predicted among net consumers in ElSalvador (no less than 68.2 percent of Salvadoran households). l6 Monge, 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: 1 Table 5: Estimatedgains by net consumers and losses by net producers of the basket of sensitive 1 agricultural commodities in Nicaragua, Guatemala, and El Salvador, by Rural-Urban and by Quintile I I I I 1; Nicaragua Guatemala ElSalvador Gains by Losses by Gainsby Losses by Net Net Net Consumers Producers Consumers Producers (%of p/c (%of p/c (%of p/c (%of 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 d a d a 0.8 -2.2 1.4 -3.4 2"dQuintile d a d a 0.6 -2.0 2.0 -2.2 3rd Quintile d a d a 0.5 -1.8 2.2 -1.9 4th Quintile d a d a 0.4 -2.8 2.0 -1.0 Richest Quintile d a d a 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 of households who are net consumers). This compares with estimated losses of between 2.2 and 2.3 percent of per capita consumption (or income) among net producers in Guatemala (15.7 percent of 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 of this appears to be in Nicaragua where gains to net consumers are estimated to be as high as 4.2 percent of 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 of 1.7 percent of 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^.'^ "SeePortner(2003),Monge,Castro,andSaavedra(2004),andMarques(2005)fordetails. 140 CHAPTER V. Policy Approuches to Munuging rhe Economic Trunsition: 5.41 While no data is reported for Nicaragua on the expected size of gains by net consumers and losses by net producers across quintiles, the Guatemala and El Salvador case studies do not show somewhat different patterns of gains and losses as a function of wealth. In Guatemala, the largest expected benefits - albeit still 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. Incontrast, 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 of their per capita consumption. Whether across regions or across quintiles, the precise nature of 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 of household production and consumption. In this context, the contrasting distributional impacts of liberalizing trade of maize and poultry are shown in Box 3. Box 3: The distribution of Lossesand Gains to Different Sensitive Commodities in Guatemala: the differential impacts of corn versus poultry liberalization. Portner (2003) examines the predicted effects of individual commodities by consumption percentile for Guatemala to better understand: (i) the distributional effects of liberalizing sensitive agricultural commodities and (ii)the role for public intervention to mitigate the poverty and social impacts of the DR-CAFTA. His analysis points to a tremendous heterogeneity of impacts across different commodities. It also points to the political economy of reform of different commodities. Box Figures 1 and 2 present contrasting patterns of estimated impacts on per capita consumption associatedwith liberalizing two different commodities - maize and poultry meat - in Guatemala." These figures show, by percentile of 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 of 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 of eliminating trade protection on maize i s positive across the consumption distribution - although the size of the net impact is very small, on the order of 0.10 percent of per capita consumption. At the same time, the graph shows that there is considerable heterogeneity of 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 of maize, that are predictedto 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. At the same time, however, a considerable number of the poorest households are net producers of maize who seem likely to experience relatively large losses. Indeed, the largest losses (as a percentage of per capita consumption) appear likely to be experienced by the poorest 20 percent of 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 of net consuming households. '* Itshould 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 of liberalizing trade in all maize. As such, Portner's calculations will overestimate (to an undetermined degree) the impacts of maize price changes due to DR-CAFTA among those households that produce and/or consume white maize. 141 CHAPTER V. Poky Approuches to Munuging the Economic Trunsirion: Box Figure 1: Estimated Gains and Losses of Liberalizing Maize, 5 Incontrast to the situation for maize, analysis of eliminating trade protectionfor 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 is very small (on the order of 0.01 percent of per capita consumption). Indeed, the vast majority of households will neither gain nor lose significantly from liberalization of poultry. At the same time, the large downward spikes pictured at the 70thpercentile and above, suggest there are a few, relatively wealthy producers of poultry who stand to lose significantly from liberalization of poultry. (Similar patterns are also seen in the case of beef.) While these patterns of large losses among a handful of relatively wealthy households may not call for trade adjustment assistance on poverty or basic welfare grounds, it 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 of 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, it can be that these societies will benefit overall 142 CHAPTER V. Policy Approuclzes to Munaging the Economic Trunsirion: as a result of 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 of 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 of per capita consumption on average. Indeed,households in rural areas are expected to experience small welfare losses- about 0.12 percent of 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 of per capita income, with average gains to rural and urbanhouseholds being nearly identical.'' Figure 4: Average EstimatedGains (Losses) from CAFTA-related Price Changes inNicaragua, Guatemala,andElSalvador 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 l 9As noted above, it is not clear the extent to which similarities in 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 of 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 of per capita consumption, reflects mostly expected losses among relatively wealthy producers of poultry and beef.) In El Salvador, with the exception of the poorest quintile, for whom average gains appear to be close to zero, there are no obvious patterns in the size of benefits across the welfare distribution. And, as discussed earlier, it 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 ElSalvador Average Gaidoss Average GaidLoss Average Gaidoss Group (% of 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 PoorestQuintile 3.3 0.21 0.1 ZndQuintile 2.5 0.01 1.4 3rd Quintile 3.3 0.08 1.7 4th Quintile 3.3 -0.06 1.6 RichestQuintile 2.8 -0.01 1.4 Summary 5.45 New analysis of the first-order welfare impacts of DR-CAFTA in Nicaragua, Guatemala, and El Salvador indicates that the vast majority of 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 of Nicaraguan households, 84 percent of Guatemalan households, and 68 percent of Salvadoran households, respectively, were found to be net consumers of the basket of sensitive agricultural commodities who can be expected to benefit from DR-CAFTA-related price changes. Only about 9 percent of Nicaraguan households, 16 percent of Guatemalan households, and 5 percent of Salvadoran households were found to be net producers of the basket of 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 of people in these three countries stand to gain from liberalization o f the sensitive agricultural commodities, the evidence suggests that the number of people who could be adversely affected by DR-CAFTA-related price changes i s not trivial - at least in the absence of measures to mitigate those impacts. The proportion of net producers estimated for each country implies, for example, that roughly 260,000 (out of 6.5 million) Salvadorans, 484,000 (out of 5.5 million) Nicaraguans, and 1.9 million (out of 12.3 million) Guatemalans would be negatively affected by price effects of DR-CAFTA. 5.47 The analysis also suggests that specific sub-groups face higher-than-average risks of experiencing negative impacts of price changes in the absence of complementary policy measures. In Nicaragua, for example, nearly 20 percent of the rural households are expected to be negatively affected by DR-CAFTA-related price changes, while nearly a quarter of rural households are expected to experience adverse impacts in Guatemala. Even these averages conceal considerable variation in the impacts of DR-CAFTA within rural areas. In the Atlantic Region of Nicaragua, for instance, roughly 34 percent of rural households are net producers of the basket of bienes sensibles agricolas and will, thus, experience negative impacts arising form their liberalization; in rural Peten, in Guatemala, over 60 percent of 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 of 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 of per capita income. As with patterns of net consumers and net producers, the actual size of gains and losses that households experience will be determined in important ways by local patterns of production and consumption. Hence, despite similarities in patterns of impacts across the Central American countries, it will be important to take local circumstances into account in designing policies and programs to ensure that all Central Americans will be able to benefit from DR-CAFTA in the medium- to long run. This point will 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 of per capita consumption. At an estimated 1.3 percent of 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 of one percent of average per capita consumption. The general- equilibrium static analysis of Nicaragua discussed in the previous chapter and conducted by 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 of working to mitigate any negative impacts of DR-CAFTA-related price changes, 145 CHAPTER V. Policy Approaches to Managing ?heEconomic Transition: but also of investing in people and places in Central America so as to maximize all people's ability to participate inemerging opportunities arising from the DR-CAFTA. 5. Alternative Approaches to Mitigatingthe Adverse Impacts of DR-CAFTA 5.50 As discussed inSection 2, DR-CAFTA includes a wide range of provisions for dealing with the liberalization of sensitive agricultural commodities, including grace periods for initiating liberalization, extended phase-out periods for tariffs, interim quotas and/or phase- downs of 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 by liberalization of 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 of sensitive crops, the approach negotiated under DR-CAFTA also has some economic costs. Specifically, although phasing of reforms has the benefit of giving producers an extended period to make the necessary economic adjustments, it 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 of sensitive goods, many of whom are poor staple crop farmers in rural areas of Central America. Given the painstaking negotiations undertaken to provide for phasing of trade reform, specifically to protect these groups, it 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 of trade in the sensitive agricultural commodities, coupled with the provision of compensatory transfers, for some finite time period, to those who are expected to be negatively affected by DR-CAFTA in the short-term. 5.53 Inprinciple, quick liberalizationcoupledwith transfers targeted to households affected negatively by 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 of 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 To be effective in practice, several conditions have to hold, however. First, implementing a program of compensatory transfers requires budgetary resources (that are not required to implement the approach negotiated under the DR-CAFTA). To ensure that producers of sensitive commodities are protected and that consumers reap the benefits of lower staple prices would require a commitment of fiscal resources. Second, to be effective and efficient, it 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 to adversely affected households. And, third, since the objective point of 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. Optionsfor Compensatory Transfers 5.55 If the DR-CAFTA countries in Central America were to pursue quick liberalization coupled with a system of compensatory transfers, there i s a wide range of 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 of these programs have been or are currently being implemented with some success inLatin 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 UnitedStates (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 by 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 of Latin American and Caribbean countries including Brazil, Colombia, Honduras, Mexico, Nicaragua, Jamaica, as well as outside the region, for example, inTurkey. Workfare programs have been implemented worldwide to address problems of unemployment, including over an extended period of time in Argentina and inresponse to periodic employment shocks (e.g., during the recent coffee crisis inNicaragua).20 5.56 Not all possible categories of support provide equal protection or show equal promise in the context of DR-CAFTA, however. While workfare has been a staple of 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 of the sensitive agricultural commodities are staple crops produced on family farms, the income effects should significantly dominate employment effects, weakening the likely impacts of 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 will 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 of 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 of 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, inturn, trade, properly designed decoupled transfer programs also fall into the "Green Box category of income support programs as agreed under WTO rules (Box 4). Box 4: Ensuringthe CompensationMeasuresare Consistentwith WTO Agreements If 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: DecoupledDirect Income Payments. Under the Uruguay Round of the GeneralAgreement 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 it does not have the effect of providing price support to producers, then direct paymentsto producerscan then be usedif 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 in 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) undertakenin any year after the base period; The amount of such payment in any given year shall not be related to, or based on, the prices, domestic or international,applying to any production undertakenin any year after the base period; The amount of such paymentin any given year shall not be related to, or based on, the factors of production employed in any year after the base period; No productionshall 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 of GATT rules, another type of direct payments that is permitted includes government financial participation in 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 compensatefor less than 70 percent of the producer's income loss in the year the producer becomeseligible to receive this assistance. The amount of any such payments shall relate solely to income; it shall not relate to the type or volume of 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 in the same year payments under income insurancetsafety-net provisions and under provisions for relief from natural disasters, the total of such payments shall be less than 100 per cent of the producer's total loss. Source: WTO (1994), IATRC (2001),as citedin CasteAeda (2004). 5.58 Using decoupled income supports to farmers is, in essence, the approach Mexico adopted under NAFTA. Although Mexico, like the DR-CAFTA countries, had negotiated extended grace and phase-out periods for protection of 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 of 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 of nine crops - corn, sorghum, beans, wheat, barley, cotton, cardamom, soybeans, or rice - in one of 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 of 100 hectares for irrigated land and 200 hectares for rain-fed land. Since producers on irrigated landcan 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.21Payments 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 of an approved environmentalprogram (beneficiaries are free to choose among these options). 5.60 Inaddition 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 US $67 per hectare and US $317 per recipient (Cord and Wodon 2001). 149 CHAPTER V. Policy Approuches to Munuging the Economic Trunsition: agricultural commodities. If implemented for a limitedtime 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 DR- CAFTA). Recent impact evaluation of 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 contributedto lower poverty rates among ejido sector households (Box 5). Box 5: PROCAMPO: PositiveImpactson Income,Consumption,andPoverty Recent impact analysis of PROCAMPO indicatesthat 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 reductionamongrural agricultural households. For example: Income effects. PROCAMPO payments appear to have generated income multiplier effects among many of its recipients, apparently due to its effect on increasing liquidity among agricultural producers. The analysis indicatesthat, 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. In 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 percentageof householdincome (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 reducedthe probably o f beingpoor among the ejido population by 10percent(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 is 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 a12002). 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 of rain-fed crops - to make the necessary economic transition to more remunerative means of 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 of impact on pattern of rural production also appears to be due to insufficient reforms and investments in complementary factors of production (e.g., energy, transportation infrastructure, etc.) that affect the cost structure and competitiveness of 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 of 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 of age are vaccinated, etc. The rationale for this i s that poor rural families, even if they recognize the long-term benefits of 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 of schooling for school-age children. Cash transfers thus have the dual objective of 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 of the inter- generational transmission of 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 of employment or income resulting from tariff reductions and the loss of 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 by the loss of trade protection. Moreover, decoupled producer supports function best where there are good records of land ownership or use (Baffes and de Gorter 2003; Castaneda 2004). Where hired labors as well as self-employed farmers are affected by trade liberalization, or where records regardingownership or use of land are weak or non-existent, appropriately targeted CCTs may provide a viable alternative approach to supporting affected households. In addition, in the case of DR-CAFTA countries, CCT programs already exist; two countries - Nicaragua and Honduras - already have targeted programs operating and a third - El Salvador - i s in the process of developing one. In this context, using CCTs to compensate DR-CAFTA-affected households might have the additional benefit of being able to build on existing programs, rather than requiring development from scratch of 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: ConditionalCash Transfer Programs- StrengtheningEducation,Health,andNutritionOutcomes amongthe Poor Recent evaluation results from two conditional cash transfer programs in Latin America - PROGRESA (Oportunidades) in Mexico and the Red de Proteccidn Social (RPS) in Nicaragua, show that conditional cash transfers are an effective instrument for improving and protecting consumption while increasing the human capital of poor in poor households. Specifically: Increasing and Protecting Consumption. Evidence indicates that consumption have grown faster for households participating in conditional cash transfer programs than for similar households who did not participate. In Mexico, for example, the average consumption level in PROGRESA households increased rapidly (14 percent), after more than a year of program operation median food expenditure was 11 percent higher in program participant than in control group households. In Nicaragua, control households experienced a sharp decline in consumption due in part to low coffee prices and a drought, whereas the RPS provided some measure of protection in the face of 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 1percentage point from a high pre-program level of about 90 percent. At the secondary school level, enrollment rates rose 7.2-9.3 percentage points for girls from baseline enrollment rates of 67 percent and from 3.5-5.8 percentage points for boys from a baseline of 73 percent. In Nicaragua, program impacts are even more impressive. Average enrollment rates of children ages 7- 13 in grades 1 to 4 in treatment areas increased nearly 22 percentage points as a result of 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 of 30 percentage points in the share of 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 of 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 of illness compared with control group children. In Nicaragua, around 60 percent of 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 percentagepoints. Source: Rawlinesand Rubio (2003).World Bank 2005b 5.65 As in the case of PROCAMPO inMexico, it is not clear the extent to which CCTs are well suited to support the economic transition that will be necessary under the DR-CAFTA. A recent evaluation of the impacts of the Red de Proteccidn Social (RPS) during the recent coffee crisis in Central America suggests that the effects of such programs on promoting structural change in rural production may be limited. While the evaluation of 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 of decoupled income support payments, it would be important that in the context of 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 of decoupled income supports, to be maximally effective, it would be important for CCTs to be accompanied by a complementary set of policies and investments that will enable affected families and their children to take the best advantage of new opportunities arising out of the DR-CAFTA.~~ ThePotential Fiscal Costs of CompensatingthoseAdversely Affected by CAFTA 5.67 If it were possible to identify net producer households and the extent of their losses and to target compensation perfectly, then the fiscal costs of compensating those negative affected would not be high. Indeed, estimates of the aggregate annual value of losses to net producers in El Salvador, Guatemala, and Nicaragua range from 0.01 percent of GDP in the case o f El Salvador to 0.13 percent of GDP in the case of Guatemala. These relatively low figures reflect two main factors: first, the share of 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 of losses by net producers in each country i s relatively low (from 0.8 percent inNicaragua to 2.3 percent inGuatemala; Table 5). 5.68 The actual fiscal costs of implementing a compensatory transfer program i s likely to be considerably higher than 0.13 percent of GDP however - at least if it entails creating a new program. This i s due to multiple factors, including: (i)that it i s impossible, in practice, to identify and target program beneficiaries perfectly (i.e., without "leakage" of 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 of the program benefits may be larger than the average losses of net producers, at least if regional norms are followed. Inaddition, any new program entails at least some administrative costs. 5.69 For a variety of data-related and administrativereasons, it i s impossibleto identify and target net producers perfectly. Indeed, targeted programs commonly make important errors of 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 of the intended beneficiary population. In practice, when efforts are made to minimize errors of exclusion, errors of inclusion tend to increase, raising the costs of a program (Coady, Grosh, and Hoddinott 2004). Targeted programs often risk transferring considerable resources to people outside the group of 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 of sensitive agricultural commodities in Central America. To illustrate leakage in a targeted program, consider the Mexican experience: The benefits of the PROGRESA/Oportunidades program inMexico, which uses a combination of 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 of households receiving benefits 22See Section VI, "Policies and Investmentsto Ensurethe Poor Can Benefitfrom 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 of 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 of household per capita income in the target population as a whole (Table 7; Box 5). As can be seen in Table 7, the size of conditional cash transfers relative to household consumption (income) varies considerably across programs and countries. While transfers average less than 5 percent of per capita income inthe case of the PRAFprogram in Honduras, they are as high as 21 percent of per capita expenditure in PROGRESNOportunidades inMexico. Table 7: Size of TransfersinSelectedTransferPrograms-DecoupledIncome Support and ConditionalCash Transfers -inLatinAmerica Progradcountry Number of Subsidy per Transfer ProgramBudget Beneficiaries(in family per year (as a percent of (in US $ and as a thousands) (US $) householdper percent of GDP) capita spending) DecoupledIncome Supports PROCAMPO 3,000 367 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, 2001) Familias en Acci6n 315 260 15 (of MW) $83 million (Colombia) (0.12% of GDP) Redde Protecci6nSocial 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 of a program to compensate net producers adversely affected by DR-CAFTA in El Salvador, Guatemala, and Nicaragua? On one level, this question is impossible to answer, as the costs of a program are dictated by any number of political and institutional factors, including decisions about the size of the transfer, the country's capacity to target, its tolerance for program leakage (errors of 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 of these types of programs, given its size, the size of benefits, and so on (Table 7). Moreover, building on this and some assumptions about benefit sizes and leakages, it i s 23Consistent with this finding, a recent study on targeting transfers in developing countries found that 62.6 percentof programtransfers went to the poorest 40 percentof 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 by DR-CAFTA. For example, if program benefits were set at 10 percent of household per capita consumptiodincome (roughly the middle of the range of benefits of programs listed in Table 7), all households that were adversely affected by DR-CAFTA received benefits, and there was no program leakage, then the estimated annual fiscal costs of the transfer program would be roughly 0.03 percent of GDP in El Salvador, 0.55 percent of GDP in Guatemala, and 0.66 percent of GDP in Nicaragua. If program benefits were set at 10 percent of household per capita consumptiodincome, all adversely affected households received benefits, and for reasons of targeting error, 28 percent of all program beneficiaries had not been adversely affected by DR-CAFTA (Le., levels of program leakage were similar to those found in PROGRESA/Oportunidades),then the estimated fiscal costs would reach about 0.05 percent of GDP in El Salvador, 0.76 percent of GDP in Guatemala, and 0.92 percent of GDP in Nicaragua.24 Decoupled Income Support vs. Conditional Cash Transfers - Does One Program Approach Dominate the Other? 5.72 The choice of one or the other type of transfer program would depend on a number of factors that are both economic and institutional in nature, and which may differ across countries. Decoupled programs have the benefit of being designed specifically as producer- side interventions, providing income support directly in response to expected income losses associated with trade liberalization. Given the nature of the sensitive agricultural commodities to be liberalized under DR-CAFTA, and the fact that these commodities are commonly produced by 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) of 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 of land titling.25 Also, in spite of the evidence on the positive impacts of 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, by 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 of trade shocks. Rather, they have been implemented to foster household 24These calculations do not include the administrative costs of such a program. Moreover, they assume the implementation of new programs rather than the expansion of existing programs, such as the Red de Proteccih Social in Nicaragua. 25Strengtheninga country's land rights and landholding records may be an important development objective in its 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 assistanceto 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 inchildren's education, health, and nutrition (World Bank, 2005d). As i s well-documented inthe 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 of basic grains are already targeted by existing CCTs, it would likely be efficient to build on those programs, both interms of the targeting mechanisms and the fiscal costs of the program.26 5.74 In short, each type of program brings with it its own particular strengths (and weaknesses) in the context of DR-CAFTA. Should the DR-CAFTA countries choose to pursue an approach of 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 ineach country and the pre- existing administrative capacity to implement one type of program or another. Does the country have good cadastral records of land ownership and/or usage, or can they be developed with a reasonable period of time? Does it have (or can it 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 of adversely affected households and inclusion of non-affected households? InNicaragua, 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 of efforts to assist DR- CAFTA affected households? 6. PoliciesandInvestmentsto Ensurethe Poor CanBenefitfrom DR-CAFTA 5.75 Whether or not DR-CAFTA countries choose to pursue quick liberalization coupled with compensatory transfers, it will be important for the Central American governments to implement a core set of complementary policies and investments if they are to ensure that those adversely affected by liberalization of 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 by DR-CAFTA or that i s particularly poor at the outset of 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 of their long-term impacts, DR-CAFTA may provide a window of opportunity for putting in place a conditional cash transfer program that focus first on DR-CAFTA-affected households, and then scales up over time to meet its longer-termobjectives of 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 increasespoor people's economic competitiveness and access to markets Deepening of 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 of rural enterprises Public information campaigns, to promote widespread understanding of DR-CAFTA- related reforms and to create greater certainty inthe investment climate 5.76 These areas of emphasis are highlighted by several recent World Bank studies on poverty reduction and on trade. For example, a recent World Bank study of the impacts of NAFTA in Mexico found that the poorer, less developed southern states of 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 of Mexico have been less prepared to benefit due to the relatively low levels of education, economic infrastructure, and low quality of local institutions. These findings for Mexico mirror in important ways the findings of 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 of 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 of economic infrastructureinpoor 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 of the poor to take advantage of new and emerging opportunities arising out of DR-CAFTA - through increasing their capabilities, by reducing transactions costs and by increasing economic competitiveness of poor people's enterprises in rural areas. In addition, it will be important for the region's governments to carry out information and communication campaigns to promote widespread understanding of DR- CAFTA-related reforms - especially among the poor and those who are likely to be adversely affected by DR-CAFTA in the short-term. Making clear the nature of 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 of 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 of 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 II), a handful of sensitive agricultural commodities (e.g., maize, beans, dairy, and poultry) still have significant levels of protection. Chapter V focuses on quantifying the size of the potentially affected population and the magnitude of the potential effects. It additionally examines alternative policy approaches on how to best assist vulnerable groups to ensure that they can benefit from emerging opportunities arising out of the DR-CAFTA. 5.79 Given current levels of 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 of provisions (described in Chapter 111)for dealing with the easing of trade restrictions on sensitive goods, including graceperiods for initiating the removal of tariffs, extended phase-out periods for tariffs, interim quotas and/or phase-downs of 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 of 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 of 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 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 of 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 of introducing more competition in the markets for sensitive commodities. It 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 from 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 of Nicaraguan households, 84 percent of Guatemalan households, and 68 percent of Salvadoran households, respectively, were found to be net consumers of the basket of 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 of Guatemalan households, and 5 percent of Salvadoran households were found to be net producers of the basket of 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 bejustified. 5.82 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 of sensitive crops over a prolonged adjustment period, this approach i s not without its own economic and social trade-offs. While phasing of reforms provides producers an extended period to make the necessary economic adjustments, it 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 of removal of 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 of lower prices. Coupling well-targeted transfer programs with quick easing of trade restrictions could thus enhance households' welfare in the short-term on the consumption side while providing producers with a reasonable period of support to make the economic transition. 5.83 Regardless of whether the DR-CAFTA countries in Central America choose to pursue this alternative approach, it 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 of sensitive crops (e.g., as in Mexico's PROCAMPO program), (ii) technical assistance programs to farmers of 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 of 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. 5.84 These options can be viewed from two different perspectives. The first i s the institutional sophistication required to implement support programs, recognizing that different approaches will tax the implementation capacity of Central American countries to different degrees. This criteria recognizes that effective programs will require, inter alia, a viable method of targeting vulnerable populations, a minimumdegree of know-how among the civil servants of the implementing public sector agency, the creation o f new government organizations (or transformation of old ones) and a minimum degree of independence to 159 CHAPTER V. Policy Approaches to Munuging the Economic Transition: ensure the application of 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 of 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: Optionsfor supportprogramsto potentially affectedpopulations by DR-CAFTA Incentivedsupportfor production diversification Low Hinh Decoupled 3 Low Public goods cd .3 8 .G transfers .3 3 g u o u c d Technical U z o High 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 of which type of support program would be more appropriate should be made on the basis of country-specific factors (See Table 8). 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 of 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 of this type may require a strong regional concentration of potentially affected poor households in order to make economic sense. CCTs require relatively sophisticated new institutional capacity (especially in countries where programs of this 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. 160 CHAPTER V. Policy Approaches to Muncrging the Economic Transition: Annex 1:EffectiveTariff Rates Used inEx-AnteImpact Analyses for ElSalvador, Guatemala, and Nicaragua Table A1.1: Nominal andEffectiveTariffs for SensitiveCommoditiesinNicaragua (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 of Industrial Development and Trade (Ministerio de Foment0 Industrial y Comercio) Table A1.2: Tariff Rates and Levels of Imports of Sensitive Crops inGuatemala, 2001 Tariff Rates(in percent) Global Weighted Sensitive Crop Imports Average Within-Quota I Quota (MT) Out-of-Quota (MT) Tariff Apples Beans 15.0 15.0 No quota 15.0 BovineMeat II 0.0 II 30.0 II 1,595 I 10,595 I1 25.5 Maize (Yellow) 5.0 35.0 501,820 515,912 5.8 Milk I 15.0 I 15.0 I No quota I 15.0 Pork 15.0 15.0 No 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 6.0 391,322 407,470 1.4 Source: Portner 2003. 161 CHAPTER V. Policy Approuches to il-lunuging the Economic Trunsition: Table A1.3: Effective Tariff Reduction inEl Salvador, 2003 Source: Marques2005. 1/Central America Tariff Classification 21In 2003, wheat flour was importedfrom Guatemala(19,558 MT), Nicaragua(4,763), Honduras(44 MT), and Costa Rica(20 MT) at zero tariff. The 10percenttariff on U.S.importswill be eliminatedduring afive-year periodunder 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 of import taxes (tariffs) that signatories will have to implement. The existing calculations of 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 of the so-called complementary agenda. Estimates of the losses are even smaller when the potential dynamic effects of DR- CAFTA are considered, although such gains remain a prediction rather than a fact. Moreover, even in the dynamic growth case, the tariff reductions will represent a decline in the level of fiscal revenues as a share of 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 of business cycles across Central American countries as well as with respect to the U.S. If 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 couldjustify 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 low current levels of business-cycle synchronization and low levels of intra-industry trade between the U.S. and Central America. These structural factors, however, might change with time as a consequence of CAFTA. Nevertheless, the choice of Central American monetary policies in the coming years might be dictated by financial considerations, including the extent of dollarization of financial assets and liabilities. 163 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA 1. Introduction 6.2 It is 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 of 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 by the welfare theory of commercial policies as one of the exceptions to the idea that freer trade i s always superior to the imposition of trade taxes (Corden 1974). 6.3 A second policy issue i s related to the long-term consequences of trade liberalization ingeneral andDR-CAFTA inparticular. Since these policies will 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 will affect the costs and benefits of pursuing the coordination of macroeconomic policies. That is, if the economies of Central America become more similar to each other, then the probability that they will face common macroeconomic shocks will increase and thus the benefits of having independent monetary policies will decline. The same logic applies with respect to coordinating monetary policies with the U.S., which in this case can be narrowed to possibility of adopting the U.S. dollar, as El Salvador has already done. In a previous publication, Lederman, Perry, and Suescdn (2004) concluded that DR-CAFTA 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 II, therefore, focuses on the potential implications of DR-CAFTA in terms of its impact on fiscal revenues. Section I11turns to the issue of how the structure of 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 of business- cycle synchronization across countries. Section IV summarizes the main findings and policy implications. 2. PotentialFiscal-Revenue Losses from DR-CAFTA 6.5 The implementation of DR-CAFTA will lower fiscal revenues in Central American countries. Due to the sharp reduction of tariffs that has taken place since the late 1980s in the region (see Chapter 11) 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 of Central America, revenues from trade taxes fell from a range of 3-6 percent of GDP in the 1980s to only 0.5-2 percent of 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 of 0.9 percent, with the 164 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA share of total tax revenues ranged from a low of 8 percent in Costa Rica to a high of 14 percent inHonduras (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 of 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, it should not surpass 1percent of GDP. Four recent estimates (including one commissioned for this study) suggest a range from 0.5 to 0.8 percent of 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 of imports (direct effect) and the effect on revenues from value added or excise taxes (indirect effect) which incorporate tariff modified prices as part of the tax base. These are the only potential effects that do not require strong assumptions about potential responses in the economy to the lowering of tariffs, such as the effect of potential changes in volumes due to tariff changes, the effect of 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 of GDP. Table 2: Alternative estimates of fiscal lossesfrom 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 will be lower than those incurred once the treaty i s fully implemented, as a result of the gradual phase out of tariffs that Central American countries negotiated. On average, only 55 percent of all imports from the U.S. will become duty-free in the first year of the treaty (Bronchi and Keen, 2004). Results for the first year from studies reported inTable 3 indicate that the average loss will range from 0.2 to 0.5 percent of 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 it will liberalize most of its trade with the U.S. in the first year. Table 3: Alternative estimatesof fiscal losses from DR-CAFTA inthe first year (% of GDP) Costa Rica 0.39 0.32 0.28 ElSalvador 0.15 0.09 0.38 Guatemala 0.15 0.16 IHonduras 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 of the changes in production and consumption structure that could be induced by the treaty, including the impact of greater investment levels and growth. While such estimates are beyond any of the studies that have been made for the case of DR-CAFTA, Table 4 reports results from two studies (including our own estimates) which have attempted to quantify the potential effects of greater growth on fiscal losses. As expected, the growth effect generates compensatory revenues that diminish the fiscal impact. 6.9 The study by Paunovic (2004) uses estimates of the growth trajectories of the DR- CAFTA countries provided by Hinojosa-Ojeda (2003), which predict GDP growth due to CAFTA of 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 CAFTA) to his organization's (UNECLAC) growth projections, multipliedthe resultinggrowth rates times estimates of the elasticity of imports with respect to GDP growth, which was then multiplied by the author's estimate of 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 of CAFTA through growth on indirect taxes paid by risingimports. 6.10 Our calculations assume that the growth effect of DR-CAFTA will be around 0.6-0.8 percent per year, which i s the range of the estimations provided by 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 of revenues, so that when GDP grows by one percentage point, revenues rise proportionately by 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 of taxation i s not progressive and focused on income taxes or property taxes. This i s not necessarily a critique of the Central American tax systems, but these are undoubtedly important elements in assessing the validity of our assumptions regarding the potential revenue-recovery effect of CAFTA. In any case, it should be acknowledged that the assumption of a unitary elasticity of revenues with respect to long- term GDP changes implies that the ratio of tax revenues over GDP will remain constant after the DR-CAFTA tariff reductions. Thus even these calculations imply a permanent reduction of the revenue-GDP ratio, in spite of the rise of revenues driven by DR-CAFTA's dynamic effects. This growth-related revenue compensation varies per country but can reach as much as 0.5 percent of GDP for the case of Honduras. (1) (2) CostaRica 0.21-0.26 0.00-0.15 ElSalvador 0.22-0.32 0.43-0.59 IIGuatemala 0.27-0.37 0.25-0.40 I Nicaragua Honduras II 0.78-0.83 11 0.92-1.17 II 0.31-0.40 0.09-0.3 I 167 CHAPTER VI: iMacroeconomic Policy Implications of DR-CAFTA Table 5: Correlationsbetweenmacroeconomic andfiscal variables and GDP inLatinAmerican countries capital formation; trade balance = exports of goods and services - imports of 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., it is expected that there will be closer links in business cycles among Central America and the U.S.From a theoretical point of view, the impact of 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 of a specialization process, then businesscycles are likely to become less similar as shocks specific to particular industrieswill become responsible for shaping business cycles. On the other hand, if trade integration leads to a higher share of intra-industry trade, business cycles will 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 of the influence of important trading partners on the business cycle fluctuations in the domestic economies. Information about the degree of 169 CHAPTER VI:IMacroeconomicPolicy Implications of DR-CAFTA business cycle synchronization i s important as it provides information on the necessity of independent fiscal and monetary policy. If 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 low degree of business cycle synchronization - then, the ability to conduct independent monetary and fiscal policy i s generally seen as important in helpingan 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. Rubinand 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 it 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 by investigating simultaneously common trends and common cycles, where evidence of a common European cycle i s taken as evidence of perfect synchronization of 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 of business cycle synchronization between countries i andj. To measure this variable, we follow Frankel and Rose (1998) and compute the correlation between the cyclical component of the output in countries i and j, where a higher correlation implies a higher degree of business cycle synchronization. The cyclical component of output i s obtained using different de-trending methods. Given the lack of consensus on the optimal procedure and the sensitivity of the cycle to the de-trending method, this approach should provide a robustness check of 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. To provide some inference about the level of 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 inTable 7 below. 6.17 Interestingly, the correlation with the U.S.business cycle i s also high. In the case of 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 of Central America, with the exception of Nicaragua.* It appears that based on business cycle synchronization, the rest of 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 EUaverage (0.43). 6.18 Business cycle synchronization in the two Mercosur countries, Argentina and Brazil, i s below the levels of Costa Rica, El Salvador and Guatemala. While business cycle synchronization i s also substantial between the U.S. and Canada, it i s however surprisingly low between the U.S. and Mexico. The finding of low 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 inbusiness cycle synchronization in the more recent past. 6.19 Table 9 shows business cycle synchronization between Central American countries after controlling for common impact of the U.S. business cycle.3 Once the common impact of the U.S. business cycle i s removed, it appears that only Costa Rica and Guatemala, Costa Rica and El Salvador and Guatemala and Honduras are affected by common factors other than the U.S. business cycle. As these countries also account for the largest share of intra-regional trade, this finding can be taken in support of 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 GDP series orthogonal to the US business cycle. 171 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA Table 7: BusinessCycle Synchronization-Band pass filter -Central America bandpass Central America Costa Rica El Salvador 1 IGuatemala Honduras Nicaragua Panama I I 1 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 is usually defined in the range of 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 of monthly data, where output i s proxied by seasonally adjusted monthly indices of 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 ineconomic activity as a summary measure of business cycle synchronization (Garnier 2003). The advantage of using cross-spectral densities over simple correlations in the analysis of business cycle synchronization i s twofold. First, spectral analysis avoids possible business cycle distortions due to filtering, because it 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 it provides a richer analysis of 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 of business cycle synchronization implies a highcoherence and a low phase lag. Table 10 shows the average coherence at business cycle frequency between year-over-year growth rates of economic activity during 1995 and 2003. The results broadly confirm the findings of 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 of NAFTA and MERCOSUR.4 D. Trade Structure, ExchangeRate 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 of 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, will make business cycles more dissimilar and hence decrease the degree of 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 of the same good, then industry-specific shocks will 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. Inthat 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 of trade i s also decisive in shaping the competitive impact of bilateral exchange rate fluctuations. If trade and production are predominately vertical, Le. producers specializes in different stages of 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 if intra-industry trade i s predominately horizontal. In this case, the impact of 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)). To 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 of 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 estimatedif the coherence is small, which is the case for most country pairings in Table 10. 174 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA comparison. Unlike for NAFTA, EU and MERCOSUR 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 of total exports barely exceed 10 percent. The U.S. i s by 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 to 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 of Costa Rica, El Salvador and Guatemala. Table 11:CentralAmerica's Trade Structure:BilateralExportdTotalExports I FreeTrade Zone 39.1% 54.5% U.S. reportedimports CIF 62.4% 68.1% 66.3% 175 CHAPTER VI: Macroeconomic Policy Implications of DR-CAFTA Table 12: CentralAmerica's Trade Structure:BilateralExporWGDP 1US.reportedimportsCIF I 19.4% [ 11.8% I 11.7% I I I I I Note:Interpretation of this table i s as follows. The table should be read column-wise, where eachrow 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 of Trade Statistics, IMF. 6.27 Table 13 provides information on the importance of 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 of 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 highwith Mexico and Brazil. AUT= n i C ( X ;+Mi )- I Where X and M are exports and imports of 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 of 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 low 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 of bilateral export/GDP ratios and average coherence at business cycle frequency with respect to the U.S.6,7 We are able to identify a positive relationship between trade intensity and business cycle synchronization. We further find that slope of the regression line i s quite flat as most countries appear to fall into a relatively narrow range of business cycle synchronization (0.4 to OS), independent of their level of trade intensity. As an example, despite a big difference intrade intensity, France and Mexico have a similar degree of 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 by trade intensity. In other words, for El Salvador to reach Mexico's level of BCS with the U.S. - which i s only slightly higher - in GDP terms El Salvador would have to more than double its 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 of trade intensity. Figure A1 in the appendix expands the analysis to all countries covered in Tables 7 and 8. Argentina's relatively high level of BCS despite low trade intensity appears to be linked to dollarization and capital flow integration. 177 CHAPTER VI: MacroeconomicPolicy Implications of DR-CAFTA 6.30 Thus the evidence suggeststhat the effects of DR-CAFTA on the structure of trade are unlikely to change the costs and benefits of macro policy coordination in the foreseeable future. Consequently, the choice of monetary and fiscal policies along the business cycle of these economies will continue to be driven by none trade issues, such as the extent of financial asset and liability dollarization inthe region. , Figure 1:Business Cycle Synchronization and Trade with the US I Business Cycle Syncronization and Trade with the US ...........II.... "...____..I _......_..__.I,..i.,_ --,.l.l.l........-l_...". ~ I- ~ ~._.,......_I,._ I~..._.._..,I..__ I 0.500 Argentina Can + + Costa Rica ranee El Salmdor * + 0.400 A + Mex + Honduras 0.300 + Guatemala 0.200 Nicaragua I 0.100 - y = 0.10 5 5 ~ 0.3873 + i R2= 0.1389 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 .p 0.400 c ** li Costa Rica France 'E 0.300 * * 5E y = 0.216 4 ~0.376 + 0 R2= 0.5433 0.200 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 of trade and business-cycle synchronization i s less than conclusive. Other research by Calder6n et al. (2002) and Calder6n (2003) looked at the relationship between bilateral-trade intensity across countries and over time for a large sample of over 100 countries during 1960-1999. The econometric evidence 178 CHAPTER VI:iMacroeconomicPolicy Implications of DR-CAFTA discussed by 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 of developing countries or developing-industrialized countries. Since the incidence of 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 it 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 of bilateral-trade intensity on BSC across pairs of 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 of 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 of 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. SummaryandPolicy 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 of import taxes. The other topic i s related to the treaty's potential effect on the patterns of business-cycle synchronization (BCS) that could be affected b y changes in the structure of 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 of public finances. At present, all Central American countries with the exception of 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 of 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 of the key measures needed to optimize its effect require increases in public investments (e.g., infrastructure, education, institutional strengthening, and transitional adjustment programs). While some of these expenditures may be temporary and could arguably be financed by greater indebtedness, this may be difficult in practice due to highcurrent debt levels. 6.35 The fiscal response to DR-CAFTA should be adapted to the fiscal situation of each country. For the cases of 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 in 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 of 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 still short of 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), will likely require additional fiscal revenues, improvements in expenditure efficiency and attraction of private financing to respond to the opportunities of DR-CAFTA. In all countries, an essential element of efforts to improve fiscal performance should include the institutional strengthening of tax agencies and their collection capacity, as well as the elimination of exonerations from VAT and income taxes. 6.36 DR-CAFTA implementation should also be used to deepen regional coordination efforts in the realm of tax policy. Going forward, a regional coordination agenda should include gradual harmonization of 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 low compared to NAFTA and EU, but not when compared to MERCOSUR. Infact, synchronization inCentral America is highestbetween 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 of co-movement with the U.S. than with any other Central American country. Yet synchronization with the U S i s still 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 by far Central America's most important trading partner. With the exception of Costa Rica, there i s virtually no evidence of intra-industry trade between Central America and the U.S. The level of intra-industry trade within Central America i s comparable to that of MERCOSUR, but below the levels of NAFTA (Canada and the US) and EU (Germany and France). Finally, the degree of business cycle synchronization seems only weakly related to trade intensity and trade structure (intra-industry trade), although the relationship between intra-industry trade and synchronizationi 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 its 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 of trade flows change so will business cycle patterns. To fully assess the consequences of closer trade integration for the conduct of 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 of macro policy will be less of a concern. However, if trade integrationtakes 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 will grow more important. In the meantime, other factors that are not directly related to the structure of international trade will remain more important considerations for the design of 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 of 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: Obtainingthe Payofffrom DR-CAFTA: Chapter VII. Obtainingthe Payofffrom DR-CAFTA: Prioritiesfor the ComplementaryAgenda Abstract 7.1 This paper highlights key issues for the complementary agenda for DR-CAFTA, with emphasis on those weaknesses of 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 of 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 of new export products. 7.2 The challenges for Honduras, and Nicaragua are likely to encompass a broader set of 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 of primary education, improving the operational efficiency of ports and increasing the quality of roads and their density. They also need to improve their capacity to absorb knowledge from abroad, strengthen institutions in charge of innovation policy and increase linkages public R&D programs with the needs of 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 VII: Obtaining the Payoff from DR-CAFTA: 1.Introduction 7.3 The benefits from DR-CAFTA will depend on the ability of the Central American economies to pursue a complementary policy agenda, as was explained in Chapter IV.DR- CAFTA by itself is unlikely to lead to substantial developmental gains without parallel efforts in certain key areas. This chapter presents a review of the remaining areas of the complementary agenda for DR-CAFTA, in addition to those related to the management of the transition presented in Chapter V and the macroeconomic implications covered in Chapter VI. The goal i s to provide a brief assessment of 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 of 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 of firms and workers to seek out new opportunities created by DR-CAFTA and the consequent expected increase in trade and investment flows. The third area concerns innovation and education policies, which will 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 of where the Central American economies are located relative to each other and relative to countries of similar levels of development. While this type of benchmarkingadmittedly does not say much about the potential social returns that can be obtained from specific policy interventions, it reveals where the different countries seem to be lagging behind expectations in terms of intermediate development outcomes, such are the coverage and quality of 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 inthe long-run. 7.6 We acknowledge that while the chapter tries to identify deficiencies and areas of "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 of the growth agenda.* However, here we focus on what remains to be done. At the end, we conclude the chapter by 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 will only available in the second half of 2005. Useful attempts to outline some of the challenges of the complementary agenda include Salazar- 'SeeXirinachs and Granados (2004), Lizano and GonzBlez (2003) and Rodlauer and Schipke (2005). for example the referencesincludedin 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 still show significant deficiencies in Guatemala, Nicaragua and Honduras. In comparisons with countries of similar income per capita, road density i s furthest from expected values for Guatemala (near 70 percent), while Nicaragua and Honduras fall short by about 30 percent. B y contrast, El Salvador's performs 20 percent beyond expectations due to the large investments of recent years, while Costa Rica comes out at the predicted level for its level of income (Figure Figure 1:Road Access and Quality in Central America Deviationsfrom 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 by their levels of 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 low and costly, and affects the potential trade competitiveness of goods produced in rural areas. 7.9 Low 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 of 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 of regional infrastructure. While there are examples of private sector participation in all segments of transport activities (construction, rehabilitation and maintenance of infrastructures, and operation of transport services), the significant potential in this area has not been developed yet mainly due to deficient and uncertain legal frameworks andpoor institutional capacity of the entities incharge of regulations. In comparisons of road availability per inhabitant, El Salvador joins Guatemala and Honduras among lagging countries, while Nicaragua surpasses comparators due to its 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, by 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 of their trade. 0 Road quality needs to be improved by 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 of transport infrastructure. 0 Public investments in those areas where private financing i s unlikely (e.g., rural roads and rural telecoms) mustbe 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 low by international standards according to a variety of sources. Figure 2 displays a benchmarking exercise using a port efficiency indicator designed to measure the quality of maritime and air ports facilities (Wilson, Otsuki and Mann, 2003).4All Central American countries perform short of the benchmark by at least 5 percent, with the exception of El Salvador which falls short only by 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 of trade per capita yields similar results, with deviations of over 15 percent for all countries, with the exception of El Salvador. The indicator i s an average of three indexes. The first (port efficiency index) is 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 Respectto GDP per Capita 7.12 High costs for Central American ports have been attributed to low volumes, poor management by public agencies, and lagging infrastructure. In many cases, these problems have been compounded by 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 of the typical problems. In this port, container ships lie idle 22 percent of the time spent in port, compared to an international standard of 5 percent. General cargo i s moved at the rate of 24-55 tons per hour, substantially below the international standard of 90 tons per hour, while dry cargo in bags moves at,89 tons per hour versus the international standards of 1,000 tons per hour. As a result of these problems and relatively low 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 VII: Obtainingthe Payoff from DR-CAFTA: Figure 3: Shipping Costs per 20 foot container ~ Chile Peru Colombia I I l2l Brazil 3 0 Ea NewYork ~ v) Nicaragua 1Bl 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 Low quality and productivity in Central American ports contribute to higher maritime transport costs. According to data from the U.S. Department of 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 of 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 of textiles and apparel to the U.S. for Central American countries i s compared to those of other developing countries. While most countries of the region have relatively low shipping costs due to their geographic proximity to the U.S., it i s notable that Colombia and even Mexico have highly competitive shippingcosts. Port inefficiencies are likely to play a role, as well as other factors that can also raise freight values, such as the size of 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 of these factors in explaining higher maritime transport costs from ports in Central America. 188 CHAPTER VU: Obtainingthe Payoff from DR-CAFTA: Figure 4: Maritime transport costs to the U.S. from selectedports as share of export value MantlmrTramprl Costs lor Garmnts Fxpnrtslo lhe L5b West Coast (TmponCoil B 7~of ExponValue) Source: U.S. Departmentof Transportationas 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 IIndonesia 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 SouthAfrica 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 WI: Obtainingthe Payoff from DR-CAFTA: (e.g., lack of adequateconcession legislation). Progress i s under way inEl 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 by private users as more efficient, while Santo Tomas, where private sector involvement has been minimal, i s still considered by users as the least efficient (Guatemala ICA, 2004). In the latter, plans now underway for private participation through the construction of a new private warehousing facility which i s expected to improve the situation. More broadly for the region as a whole, the absence of 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 of ports in Central America include: 0 Implement regulatory and institutional reforms to facilitate private participation in ports with the aim of upgradinginfrastructure and improving administration. 0 Improve public administration where ports cannot be privatized, including actions to foster greater transparency, improved management (including human resources), reduction of 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 of resources to facilitate trade within the region and with external partners. Reduction of 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 by 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 of 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 of the values predicted by their level of 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 of trade per capita. The indicator is 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 IMDLausanne's World CompetitivenessYearbook and the fifth (corruptions perceptionsindex) i s from Transparency International. See Wilson, Otsuki and Mann (2003). 190 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure5: BenchmarkingwithRespectto GDPper Capita Gyatrrmala 7.17 An alternative assessment of actual port operation delay times caused by customs procedures i s given by the results of recent investment climate surveys. Figure 6 displays results on the average and longest delays reported by importers for a sample of countries. The Central American countries for which the information i s available perform near the sample average (with the exception of 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 of delays faced by exporters (Figure 7). This good performance i s a likely reflection of recent modernization and simplification efforts. However, despite the progress achieved, interviews with private custom agents and freight transporters reveal there i s still room for improvement. The reduction in clearance times achieved with the internet based system i s sometimes offset by the delays caused by stringent physical controls conducted by security agencies aimed at fighting smuggling and drug trafficking. Other problems arise as a result of the use o f excessive discretion by officials, the lack of an adequate and enforceable code of conduct, the importance of the political affiliation of candidates when filling positions, the lack of modern risk analysis techniques and appropriate equipment for non-intrusive inspections and faster turnaround of laboratory sample testing. 191 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure6: Customdelaysfor Imports(InvestmentClimatedata) A v e r a g e and longestperiods to clear customs, for imports ( I nte r n a tio n a I com p a riso n, days ) II D d v e r a g e penod u i o n g e s r period 1 Source: InvestmentClimate Surveys. Figure7: Customdelays for Exports(InvestmentClimatedata) A v e r a g e a n d l o n g e s t periods to c l e a r customs, f o r exports ( I n t e r n a t i o n a l c o m p a r i s o n , days) 18 15 12 9 6 3 0 I l a v e r a g e period nlongest period Source: InvestmentClimateSurvey. 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 of DR- CAFTA. While less than 10 percent of 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 of 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 in the business environment which had intensified towards the end of the Portillo administration. Prior to this period Guatemala had made strong gains in the efficiency of customs procedures, when customs were integrated in the modern and autonomous Superintendenciu de Administrucion Tributuria (SAT), and computerization allowed streamlining 90 percent of custom declarations. These efforts are getting renewed impetusunder the Berger administration. 192 CHAPTER W: Obtainingthe Payoff from DR-CAFTA: Figure8: FirmsConstrainedby customs (%) Figure 9: FirmsConstrained by customs if DR-CAFTA 51 0% Guatembd Nicara,w El Salvador Honduras Guatemala ElSalvador Nicaragua 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 of border crossings between countries would allow substantial reduction in transportation costs and times, while fostering the economies of 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 of a unified customs' regulation (CAUCA) and its reglamento (RECAUCA), as well as the creation of 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 of 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 CACM 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 of the manual unico de procedimientos de aduanas, and the full integrationof binationalcustoms procedures inorder 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 is that of the IS0 9,000 certifications in El Salvador. Remaining deficiencies in customs procedures and operations could be addressed by facilitating inspections through the incorporation of modern equipment and risk analysis techniques, as well as by increasing the professionalization of 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 of the ease with which firms and factors can be redeployedto take advantage of new productive opportunities. Other important areas that can create unnecessary costs to the reallocation of 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: Obtainingthe 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 of regulations constructed by Bolaki and Freund' - available for Costa Rica, Honduras, Nicaragua and Guatemala - all Central American countries fall short of their expected levels by income, with Costa Rica and Honduras lagging furthest behind (see Figure 10). Figure 10: RegulationsIndex 1 HND \ GTM CRI 0.5 - 0.5 I: ,/ \,* ..I^. 0 - 2 5 & -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 of the labor regulations component of the regulations index of Bolaki and Freund (2003) reveals significant levels of underperformance for all Central American countries (6 percent to 11 percent of predicted values) with Guatemala and Nicaragua exhibiting the widest gaps.' While this may be reflecting some excess regulations in formal norms, ineconomies in which the informal sector accounts for a large size of employment it i s unknown how costly these regulations may be. While the partial evidence available does not 'The index of regulations is a weighted average of an index of labor regulations and an index of firm entry regulations, with weights determined by factor analysis (Bolaki and Freund, 2003). Higher values of 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 is not included in this analysis. The labor regulations index i s the sum of 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 of labor marketsin Central America are required.' Firmentry 7.24 Excessive regulations for firm entry are an issue in some countries in Central America, as measured by the number of days requiredby 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 inEl 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 of Bolaki and Freund (2003) finds that Honduras exhibits the largest lag with respect to the predicted value for its 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 of 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 of (formal) firms in Honduras pointed to laws and '" regulations regarding dismissal of workers as a significant factor affecting employment levels. The six registration processes are draft of constitution of the firm, inscription of the firm in 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 in San Salvador takes 115 days on average (or close to four months) which seems to contradict ICs results. This could be attributed to Doing Business relating to only limited liability companies, and reflecting the answers of only one law firm, which supplies the data on duration of business registration. I n contrast, the ICs covers more than 400 firms in each country, of different legal status, and the respondents are the firm managers. l2The index of entry regulations uses data on the number of procedures and the time it takes to start a business in each country (Bolaki and Freund, 2003). 195 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure 11:Number of Daysto Registera Firm Nicaragua 82 I I I 115 El Salvador I I I I I Guatemala 251 0 50 100 150 200 250 300 days 0Numberof daysfor registeringafirm, DoingBusinessdatabase Totalduration of registration(including obtaining all necessary licensesandpermits), ICs E! Total averageduration of registration (sum of averagedays neededto obtain six licensesandpermits), ICs, 1 Source: World Bank Investment Climate Surveys and World Bank Doing BusinessDatabase. Administrative Corruption 7.25 The prevalence of 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 of law can also make any regulatory environment exert unintended consequenceswhen 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 of a sample of 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 by Nicaragua (Figure 12).13 l3I n the larger sample of 195 countries used in WBI's indicator of control of corruption El Salvador is placed only at the world's 34Ihpercentile, compared to the 77Ihfor Costa Rica, and the average 341dpercentile for Guatemala, Honduras and Nicaragua. This may be related to poor perceptions in the areas of judicial independence and organized crime, according results from the World Economic Forum's Growth Competitiveness Index, as El Salvador performs quite well in the indexes of corruption in public services, corruption in foreign trade and corruption in tax collection. 196 CHAPTER VU: Obtainingthe Payoff from DR-CAFTA: Figure12: InternationalTransparencyrankingsof CentralAmericancountries Guatemala 21 I I 0 25 75 100 percentile 50 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 of law, government effectiveness and regulatory quality. Indeed, as seen inFigure 13, El Salvador systematically ranks below Costa Rica, but above Guatemala, Honduras and, with the exception of the index for corruption, also above Nicaragua. Figure13: WBI GovernanceIndicatorsfor CentralAmerica, 2004 Control of Corruption (Latin herica region. 1I) Rule o f tar (Latin k r i c CHILE WLE COSTA RItR i aDlARlCR URWRV WGW PRWR PRYRlR BRRnL mzn COLaiSIn HEXICD WICRRAGUR uc PERU EL 5RLMIOoR RRtDIllNR oom1LRw ERBLIC HOWRRS CURTEIRR ECWaOR BOLIVIA 'VEHEZLELR PARAGMI PARRCURV VENEZWLR 11 197 CHAPTER VII: ObtainingthePayoff from DR-CAFTA: Government Effectiveness (Latin America region, c m n E URWRl c m RICR BRRZIL PnHRnn MEXICO cnwm EL mtwota RRENTDlR OOMMICRNREPUBLIC PERU BOUYIR nowm mIcwmn ECURODR cunrcwn VEWYZUELR PnRffiuni 8 R 58 Cmnty's P e r m t i l e Rank (B-1881 Source: World Bank. Figure 14: Inconsistency and unpredictabilityof regulations, Government inefficiency and bribery 71 0 75 0 4 4 1 498 E l Salvador Nicaragua Honduras Guatemala rnGovernment of regulations inconsistent and unpredictable Interpretations 1 0Bribes "toqet Thinqs Done"considered common considered Inefficient Source: InvestmentClimate Surveys. 7.28 Honduras firms lead the region in the perception that bribes are required "to get things done" (Figure 14). In 2003, Guatemalan firms 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 of 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 of the firms surveyed inEl Salvador. 198 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Regulationsand 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 of access to credit varies across Central American countries, firms seem to face significant credit constraints in all. One sign of credit constraints i s the intensive usage of retained earnings to fund new investments. This source supplies over half of 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 of 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: Main Sources of finance for investment capital, by country (%) Banks Retained earnings Supplier Credit 8Malaysia HHonduras 0Ecuador 0Guatemala HNicaragua ElBrazil El Salvador I Source: InvestmentClimate Survey. Figure 16: Share of Firmswith Loans (%), International Comparison 87.3 87.1 51 2 503 Source: InvestmentClimateSurvey. l4A large body of research has shown that investment decisions of 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 in 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 of access and cost of funds exert an influence on firm growth and that smaller firms are most adversely affected by those constraints. 199 CHAPTER VU: Obtaining the Payofffrom 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 of large and 10 percent of medium sized firms are in that status, compared to 30 percent and 23 percent respectively for micro and small firms (Figure 17).15 The low share of finance constrained firms among the large is explained by their overall easier access including to external finance. In addition, access to formal credit in rural areas tends to be low, despite highrepresseddemand (Guatemala CEM, 2005). Figure 17: El Salvador. Firms reporting major or severe obstacles relatedto finance, by size A v a i l a b i l i t y o f C o s t o f F i n a n c i n g A c c e s s t o F i n a n c i n g F i n a n c i n g 1 m T o t a l I M i c r o O S m a l l O M e d I L a r g e 1 Source: InvestmentClimate Survey. 7.31 Measured by broader indexes of financial depth, Guatemala and Costa Rica underperform their peers relative to their level of development. B y contrast, El Salvador, Honduras and Nicaragua perform above expected levels, using private sector credit as a share of GDP.16In addition, interest rate spreads are very low in El Salvador - due to the dollarized regime and a more efficient banking sector - while those in Costa Rica are among the highest inLatin America (see Table 2). l5Credit constraints are prevalent when firms with viable investment projects do not have access to credit. This means that it is difficult to conclude that firms are constrained when they report obstacles to access finance. This is particularly important when assessing the constraints by firm size, because if scale matters for profitability of investment projects, then naturally small firms will be less likely to access credit than large firms, not because there is 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 GDP against log GDP per capita and a squared term. Results for Honduras may be affected by a potential undervaluation o f its 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 of claims excluding fixed and other assets. 3/ The real lending rate is 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 of an agenda aimed at improving access to credit should include: Strengthen creditor's rights by making enforcement procedures of secured and unsecured claims shorter and more efficient. Improve the efficiency and independence of the judiciary, including judges' experience with and knowledge of commercial law in order to bring more certainty to the resolution of 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 of non-viable ones. Develop credit information systems to reduce the high operational costs of micro- finance institutions. Strengthenbankingregulations and supervision. 7.33 To cope with the increasing integration of 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 of 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 by organizing themselves on a regional basis, the region's supervisory authorities have not. Efforts to develop a coordinated strategy 201 CHAPTER VII: Obtainingthe Payofffrom DR-CAFTA: for effective regional consolidated supervision and regulation are required to avoid the limitations of the current individual country appr~ach.'~ 4. Innovation and Education 7.34 As explained in chapter N, DR-CAFTA offers opportunities for Central American countries to boost long term productivity by increasing imports of 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 by 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 of R&D. Second, we assess the recent performance of Central American countries with respect to discoveries of new export products, a key outcome that has been linked inthe recent literature to growth and productive investments. Third, we provide a quick assessment of educational performance in Central America, with special emphasis on those areas that are required for the functioning of 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 by following two common measures: the number of patents granted by the US. patenting authority, and the number of scientific publications. Figure 18 benchmarks performance by researchers residing in Costa Rica and El Salvador in each dimension, comparing them with the average of those in countries with the same levels of GDP, the same size labor force, and the same value of merchandise exports to the U.S. since the 1 9 6 0 ~The ' ~ graph shows how far these countries are from the average of similar economies (the zero line). A negative number on the vertical axis i s evidence of under performance. Because the predicted number of patents are relatively small (1 or 2) the performance of Costa Rica in terms of patents appears to be erratic. Nonetheless, one could say that Costa Rica does not seem to under perform systematically. Conversely, the outcome of 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 inpatent achievement. This is the subjectof an important recent report by the IMFfor Central America (IMF,2005). To answer this question we use data collected by Lederman and Saenz (2003) on patents grantedby 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 regressionon GDP and Population and their squares. See Bosch, Lederman, and Maloney (2005) for technical details about the methodologiesand data. 202 CHAPTER W: Obtainingthe Payoff from DR-CAFTA: Figure18: Do CostaRicaand El Salvador Underperformin InnovationOutputs? Costa Rica Innovation Outputs ... I - ----- S c i e n t i t i c P u b l i c a t i o n s Pdten ts E l Salvador lnnova tio n Outputs I S c le n tific PubIication s ---- Patents 1 I Decade Patents Scientific ; Publications ;::: 90s 3 '" 62 60's Source: Ledermanand Saenz (2003). 7.36 Similar benchmarking can be done with two indicators of innovation inputs: expenditures on research and development (R&D) and payments for licensing of 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 of technologies. Not only does the share of 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 Vll: ObtainingthePayoff 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 of GDP Costa Rica devoted to licensing does not show significant gaps with respect to the proper benchmark. This i s not because of 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 of Costa Rica's level of income are high at around 65 percent. More likely, Costa Rica's low investments in this area are probably linked to deficiencies in the areas of financial depth, protection of intellectual property rights, ability to mobilize government resources, and the quality of research institutions, which have been shown to be key determinants of R&D effort across countries. As a result, not only i s Costa Rica not experiencing a take off 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 Low 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 of a NIS i s by examining how R&D investments translate into commercial patents and how the "elasticity" of patents with respect to R&D investment compares to the world average." Figure 19 shows the elasticity or sensitivity of 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 of 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 of the L A C countries i s due to higher quality of research institutions and greater collaboration with private firms. l 9Bosch et al. (2005) discuss in detail how these elasticities are estimated and how they vary across regions of the world. 204 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: Figure19: Efficiencyof R&D ExpendituresComparedto the OECD -15 ' I Source: World Bank 7.39 El Salvador is more inefficient in innovation outcomes than the average of LAC countries. A good share of this inefficiency i s likely related to the lack of collaboration between the private sector and research organizations such as universities, which i s the main explanation found for the case of Latin American and the Caribbean by Bosch, Lederman, and Maloney (2005).20 Discovering new export products 7.40 Recent attention has been given to the linkage between the appearance of 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 of rents similar to those that hinder innovation and technology adaptation (Hausmann and Rodrik, 2003a). In fact, for the case of 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 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. 205 CHAPTER VU: Obtaining the Payoff from DR-CAFTA: failures might infact impede economic discovery, and Khan (2004) finds that the introduction of new products does affect economic growth by stimulatingproductive investment. 7.41 Among Central American countries, Guatemala has been the main underachiever in terms of discovery of new export products. Figure 20 shows the predicted and the observed number of export discoveries in the 1990s, which are a function of the level of development (GDP per capita) of each country.2' El Salvador, Honduras and Nicaragua show only slight levels of 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 of 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 of the innovation and education flagship (World Bank, 2003a) which highlighted how technological innovation and educational levels (particularly skills 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. It 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 of technology transfers through FDIand trade. 21A discovery is 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: Obtainingthe Payoff from DR-CAFTA: 7.43 DR-CAFTA and the greater flows of foreign investment that should accompany its introduction are likely to increase the demand for secondary and skilledworkers. Investors are likely to require higher skills (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 will also likely demand new skills to adapt innovations and improve productivity levels. Most countries of Central America, with the only exception of Costa Rica, are likely to face shortages of appropriately skilled workers to meet these demands. The absence of a considerable mass of secondary educated workers in most countries of Central America i s due to the slow expansion of educational opportunities and its 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 of 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 minimumliteracy and math skills; very few have skills in quantitative analysis, communication and other basic competencies provided by 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 of secondary education i s still a weakness in all Central American countries, while inefficiencies of 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 of local manufacturers, to attract FDI with high technological content, and to benefit from the potential spillovers of those investments to the rest of the economy. Coverage of the secondary cycle i s low (around 55-60 percent) or very low (around 30-37 percent) in all countries (Table 3). Quality i s still low at all educational levels, as illustrated by the still 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 low educational achievement in the region. Inefficiency of resource use i s a problem in Honduras due to the excessive share of spending on salaries relative to non-salary expenditures, combined with lack of effective teacher incentives. InefficienciesinNicaragua relate to excessive central administration costs. Table 3: Gross Enrollment Rate at the Secondary Level (2001or 2002) El Salvador 1I Nicaragua Guatemala . Honduras I I 37 62 II Source: Di Gropello, 2005. 7.45 Central American firms use in-house and external skills training to upgrade and complement the educational profile of 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 with a higher skilled workforce), public provision of training has been characteristically inefficient and unresponsive to private sector needs across Central America. For instance, returns to public training programs in Guatemala have been shown to be very low, while they are positive for privately provided and funded training (World Bank, 2004f). Recent reforms to INSAFORP in El Salvador have removed it from directly providing training, a key factor inthe improvement of training services inthat country (see Box 1). Box 1: The Positive Experience of Reform of VET system inElSalvador 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 of 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 of training beyond the pure market solution and thus successfully addressed some of the market failures involved inthe provision of training. INSAFORP is 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 is unsustainable inthe mediumto the longrun without additional funds or efficiency savings. ElSalvador Country Economic Memorandum, (WorldBank, 2003b). Areas for action 7.46 For lower income countries such as Honduras and Nicaragua, national innovation systems should focus on facilitating primarily technology absorption. Priority actions should include: 0 Improve the capacity to absorb new technologies from the external stock o f knowledge, by simplifying processes to import capital goods and to license foreign technologies. 0 Strengthen the institution in charge o f innovation policy and its coordination with private sector needs. Improve the quality o f the information on R&D. 0 Improve the efficiency of low R&D public spending by increasing linkages with private sector, and increasing the accountability o f the use of these resources. 7.47 For 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 of 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 of funding, particularly through different partnerships with the private sector; and by introducing flexibility inthe regulationrulingthe assignment of 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) by matching grantskompetitive subsidiesdirected to commercial applications. 0 Strengthen the governance of technology policy, by defining an explicit technology and innovation policy, enhancing the policy making role of a public-private board, and by simplifying the concessions of public funds for research and development. 0 Enhance institutional capacity to enforce IPR laws, possibly by up-grading the registries, investing inprocess simplification and staff training. 7.48 Sequencing of education policies with the stage of 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 of universal primary education, with gradual expansion of secondary education. In the more advanced settings of Costa Rica and El Salvador, where adaptation and creation of new technologies i s more important, issues of 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, it i s important to build partnerships between the private sector and universities or technical schools, as well as encourage apprenticeships. 7.50 While it i s important to ensure that appropriate supply for tertiary education is available, the justification for public funding i s weak, as high private returns already create high demand. Public policies towards expansion of tertiary should focus on facilitating private investment through regulation that would improve functioning of the market for higher 209 CHAPTER VII: Obtaining the Payoff from DR-CAFTA: education. These initiatives could include (i) increase information available to students; (ii) maintain flexible accreditation system and (iii) cost recovery inpublic universities.22 greater 7.51 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 of all ethnicities, and ensuring that they acquire basic cognitive skills of literacy and numeracy must be the top priorities in education inCentral 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 of 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 of 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 of 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 of 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 of 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 of 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 of primary education, improving the operational efficiency of ports and increasing the quality of roads and their density. They also need to improve their capacity to absorb knowledge from abroad, strengthen institutions in charge of 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 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 of infrastructure that benefits from a regional perspective, including major road networks, and 22Holm-Nielsen,Lauritz, Andreas Blom and PatriciaZuniga Garcia, "The World Bank in Tertiary Education in LAC", En Breve, No. 18, World Bank, Washington DC. 210 CHAPTER VU: Obtainingthe 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 by 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 inthe future. 7.55 All of the elements of the complementary agenda mentioned here are also components of 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 of Central America has highlighted the highreturnthat would be obtained from improvements in the areas of infrastructure, education and governance. DR-CAFTA enhances the social return to these actions and makes themmore urgent. 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