Beyond Borders: The New Regionalism in Latin America by IDB

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Economic and Social Progress in Latin America

Beyond Borders The New Regionalism in Latin America

Distributed by the Johns Hopkins University Press for the Inter-American Development Bank Washington, D.C.

2002 Report

ACKNOWLEDGMENTS

Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter

1: 2: 3: 4: 5: 6: 7: 8: 9: 10: 11: 1 2:

Robert Devlin, Antoni Estevadeordal and Ernesto Stein Robert Devlin and Antoni Estevadeordal Robert Devlin, Antoni Estevadeordal and Marcos Jank Roberto Echandi and Carolyn Robert Arturo Galindo, Alejandro Micco and Cesar Serra Alberto Barreix, John Strong and Juan Jose Taccone Jose Luis Machinea and Josefina Monteagudo Eduardo Fernandez-Arias, Ugo Panizza and Ernesto Stein Ernesto Stein and Ugo Panizza Ernesto Stein, Christian Daude, Stephen Meardon and Eduardo Levy Yeyati Ernesto Lopez-Cordova and Mauricio Mesquita Moreira Suzanne Duryea, Raymond Robertson with Werner Hernani

Other contributors to the chapters were Manuel Agosin, Alberto Barreix, Mario Berrios, Cesar Calderon, Andrew Crawley, Alberto Chong, Daniel Chudnovsky, Edgardo Demaestri, Kenroy Dowers, Ramon Espinasa, Paolo Giordano, Jaime Granados, Jeremy Harris, Peter Kalil, Andres Lopez, Stephen Meardon, Alejandro Micco, Eric Miller, Josefina Monteagudo, Guillermo Ordonez, Magdalena Pardo, Andrew Powell, Fernando Puga, Fernando Quevedo, Ennio Rodriguez, Ricardo Rozemberg, Gilles St. Paul, Matthew Shearer, Kim Staking, Kati Suominen, Gustavo Svarzman, Luiz Villela, and Masakazu Watanuki. Eduardo Lora provided helpful comments, suggestions and advice. Chapter 11 benefited from data provided by the Institute Brasileiro de Geografia e Estatistica (IBGE) and by Mexico's Institute Nacional de Estadistica, Geografia e Informatica (INEGI). We also thank Bank personnel who participated in internal discussion workshops on the background papers for this Report, and who provided comments during revisions. Research assistants were Lucio Castro, David Colin, Megan Dooley, Rosa Finch, Ian Fuchsloch, Virgilio Galdo, Reuben Kline, Josefina Posadas, Alejandro Riano, and Ricardo Vera. The IDB Publications Section handled the editing and design. Madison Boeker and John Dunn Smith provided additional editorial support. Maria de la Paz Covarrubias and Martha Skinner provided general administrative assistance. The opinions expressed in this Report are those of the authors and do not necessarily reflect the views of the Inter-American Development Bank or its Board of Executive Directors.

Beyond Borders: The New Regionalism in Latin America Economic and Social Progress in Latin America ÂŠ Copyright 2002 by the Inter-American Development Bank 1300 New York Avenue, N.W. Washington, D.C. 20577 Distributed by The Johns Hopkins University Press 2715 North Charles Street Baltimore, Maryland 21218-4319 ISBN: 1-931003-23-8 ISSN: 0095-2850

The Research Department, under the direction of Guillermo Calvo, and the Integration and Regional Programs Department, under the direction of Nohra Rey de Marulanda, were responsible for the preparation of this Report. Robert Devlin, Antoni Estevadeordal and Ernesto Stein, with the collaboration of Mauricio Olivera, coordinated the interdepartmental team in charge. The principal authors are as follows:

PREFACE Since independence, the nations of Latin America and the Caribbean have repeatedly pursued an agenda of regional integration in one form or another. Initiatives have varied in terms of their objectives, ranging from monumental political unions to simple agreements for the free trade of goods. However, while efforts to "get together" with neighbors seem to be one of the defining features of the region's history, the goal has always been elusive. Regional initiatives have repeatedly fallen victim to factors such as political and military conflict, skewed distribution of benefits among partners, inappropriate design and implementation, macroeconomic instability and economic crisis, or the physical obstacles of nature. After the disappointing performance of the early post-war economic integration initiatives, the near collapse of regional trade during the crisis of the 1980s, and the shift to a more open market-based development strategy, regional economic integration appeared to have become a relic of the past. To the surprise of many, however, regional integration initiatives reappeared in the 1990s, and in new and robust forms. The regionalism of the 1990s emerged as an integral component of the structural reform process in Latin America, complementing and reinforcing the modernization policies pursued unilaterally and adopted as part of the region's participation in the multilateral liberalization emerging from the Uruguay Round. The structural reforms have changed the face of development policy and the regional initiatives designed to support it. Indeed, the regional integration of the 1990s so dramatically parted ways with the early post-war experience that it has been coined the "new regionalism." This new regionalism has emerged as a result of more favorable conditions on different fronts. The move to more external openness and market-based activity has unleashed new global trade and investment opportunities and provided incentives for new regional approaches to commercial relations. Improved macroeconomic management has made the Latin American economies more resilient. Democracy has fostered social participation, pacified borders, and increased the disposition to cooperate and integrate with other countries, including the industrialized democracies of the North that also are increasingly looking South for regional partners. Meanwhile, the launch in Doha of new World Trade Organization negotiations promises that regional initiatives will be accompanied by stronger multilateral rules. In this new setting, regional integration can create an enabling environment for further liberalizing reforms, encourage productive transformation, and foster the cooperation that will more readily generate net benefits for all. During the 1990s, regional integration has made progress on several fronts. Market access for the trade of goods within the subregions has been substantially liberalized. Functional cooperation in areas such as regional infrastructure, security and protection of democracy is also without historical precedent. Moreover, regional economic integration and cooperation with northern industrialized countriesâ&#x20AC;&#x201D;politically inconceivable only 15 years agoâ&#x20AC;&#x201D;are now advancing on multiple fronts that encompass the major regional markets of the world.

2002 REPORT

Despite these gains, of course, many challenges remain. Important strategic issues for the Latin American countries and their potential industrial country partners are posed by such matters as parallel initiatives for deepening integration in the subregions, widening the scope of the integration process to include integration with industrialized countries, and tying this process into the potential synergies from the multilateral negotiations in Geneva. Existing subregional agreements that "have the necessary political leadership and economic relevancy should redouble efforts to move forward in their common market objectives. Or, absent these conditions, they should consider other more limited but still valuable alternatives, such as preserving and perfecting free trade areas. At the same time, the region must fully exploit the new opportunities to support structural reform and development by integrating with major industrialized regions, as well as with the entire world under the umbrella of the Doha Development Agenda. In pursuing these goals, countries need to take into account the increased demand for participation by civil society, and develop mechanisms to ensure that the fruits of regionalism, and the globalization of which it is part, are more equally distributed. Meanwhile, industrialized countries have a responsibility to provide market access to overly protected sectors in which Latin America has a comparative advantage, facilitate sustainable agreements by supporting trade-related capacity building, and be vigilant of the special problems that smaller economies encounter in regional and multilateral liberalization. Since its founding, the Inter-American Development Bank has been, in the words of its first President Felipe Herrera, the "Integration Bank." That vocation remains strong today and is expressed in the Bank's Corporate Strategy for attaining economic growth and reducing poverty in Latin America. Regional integration stands as one of the four central pillars of that strategy, along with competitiveness, modernization of the state, and social development. The new regionalism clearly can support the overarching objective of development. The 2002 Report on Economic and Social Progress in Latin America attempts to contribute to this endeavor by examining some of the advances and shortcomings of the process and proposing a future agenda to build on the promising developments of the 1990s. The Report is not meant to be the last word on a topic that generates much discussion. But it will give readers a better understanding of the state of regional integration in Latin America and the Caribbean, as well as provide food for thought regarding the future direction of policy.

Enrique V. Iglesias President Inter-American Development Bank

2002 REPORT

CONTENTS Road Map to this Edition

Chapter 1.

Regional Integration: Summary and Agenda

PART I Dimensions of Regional Integration Chapter 2. The New Regionalism in Latin America Chapter 3. Market Access Chapter 4. Regional Institutions and Dispute Settlement Mechanisms Chapter 5. Financial Integration

23 61 87 101

Chapter 6.

125

Regional Infrastructure

PART II Macroeconomic Coordination Chapter 7. Macroeconomic Coordination in the Region Chapter 8. Trade Agreements, Exchange Rate Disagreements Chapter 9. Currency Unions

147 171 191

PART III Effects of Regional Integration Chapter 10. Regional Integration and Foreign Direct Investment Chapter 11. Regional Integration and Productivity Chapter 12. Regional Integration and Wage Inequality

223 245 269

2002! REPORT

ROAD MAP TO THIS EDITION The 2002 Economic and Social Progress Report begins with a summary and agenda in terms of regional integration in Latin America and the Caribbean (Chapter 1). Where does the region stand and where is it going? The focus is on the interaction between current subregional integration schemes, the new agenda launched in Doha for multilateral trade talks, North-South initiatives such as the Free Trade Area of the Americas (FTAA), and inter-regional agreements with the European Union and Asia. Following this overview, the remainder of the book is divided into three parts. Part I focuses on different dimensions of regional integration. Chapter 2 analyzes the merits, objectives and instruments of what has been deemed the "new regionalism" in Latin America in the 1990s. While trade integration and related market access issues have been the focus of much attention (Chapter 3), other dimensions are examined that may be equally important: the institutional requirements necessary to make regional integration agreements run smoothly (Chapter 4), financial integration (Chapter 5) and the integration of infrastructure (Chapter 6). The chapters focus on the main effects of integration in each of these areas, how much has been achieved, and what remains to be done. Part II discusses important issues of macroeconomic coordination. Chapter 7 reviews the costs and benefits of different types of macro coordination, the obstacles that make coordination difficult, and experiences with coordination in Latin America. The focus then turns more closely to a particular type of coordination that warrants special attention: exchange rate and monetary policies. Chapter 8 discusses the potential for problems when countries bound by trade agreements have exchange rate disagreements, and Chapter 9 examines the deepest possible form of exchange rate coordination: the formation of currency unions. Part III focuses on the effects of regional integration on foreign direct investment (Chapter 10), productivity (Chapter 11), and inequality (Chapter 12). A common theme is whether different types of regional integration agreements (North-South, South-South) produce different impacts. Throughout, the authors try to derive lessons from the experiences of Latin America and other regions that can shed light on the potential consequences of regional integration agreements with industrialized countries. Such agreements—among them the FTAA—have become increasingly important to Latin America and will play a critical role in the future of the region.

2002 REPORT

REGIONAL INTEGRATION: SUMMARY AND AGENDA

The 1990s witnessed a resurgence of interest in regional integration throughout the world. Europe, which had steadily advanced in regional integration during the post-war era, began the decade by implementing an ambitious Single European Market and closed it by launching the euro. North America established a comprehensive free trade area through the North American Free Trade Agreement (NAFTA), which was built on the U.S.-Canada free trade area of the late 1980s. The Southeast Asian countries went beyond their long tradition of regional cooperation by expanding the Association of Southeast Asian Nations (ASEAN) into a free trade area. In Africa, there were some 15 mostly new regional integration agreements (RIAs), and in Latin America and the Caribbean, some 30 have emerged since 1990. As the 1990s progressed, there was growing evidence of regional integration initiatives aimed at linking developed and developing economies. Latin America is a case in point. Mexico's joining of NAFTA marked the beginning of efforts in the region to negotiate reciprocal free trade with industrialized markets. The launching of the Free Trade Area of the Americas (FTAA) at the end of 1994 aimed to link the region with the United States and Canada to create the world's largest free trade area by 2005. At the same time, two countries signed bilateral free trade agreements with Canada and a number of other negotiations are under way with Canada and the United States as well. Meanwhile, Chile and Mexico signed free trade agreements with the European Union (EU). Along with Peru, the same two countries participated in the Asian-Pacif-

ic Economic Cooperation (APEC), involving most of Southeast Asia, Japan, Australia, New Zealand and North America. Other agreements are in various stages of negotiation. Why the resurgence of regional integration? There are many reasons, but the overarching motive appears to be the search for additional policy tools to manage insertion into an increasingly globalized and competitive world economy. There is substantial evidence that successful countries deploy policies that can proactively harness the forces of globalization for economic growth and development, while those countries that distance themselves from these same forces lag behind. In effect, regional integration initiatives represent a third tier of trade policy reform, which aims to complement and reinforce the unilateral and multilateral liberalization undertaken as part of the structural reform process that has been underway since the mid1980s. Seen in this light, regional integration is an integral part of the structural reform process itself. The process has brought challenges as well. As we move into the 21 st century, the regional dimension has become a more important component of the overall national policy package, and the stakes have become higher. During the 1990s, trade grew significantly among regional partners, creating in many cases economic interdependencies among neighbors for the first time in modern history. Yet a number of the agreementsâ&#x20AC;&#x201D;particularly in South Americaâ&#x20AC;&#x201D;have encountered difficulties as they have been rocked by unstable international capital flows, macroeconomic instability, political uncertainty and broken momentum

Chapter

CHAPTER

or backsliding on regional commitments. Economic problems in one country now can spill over faster to other countries in the region not only through financial contagion but also via trade shocks in neighboring economies. Clearly, the easy stage of integration is now over; the subregions will need renewed political leadership and a redoubling of efforts if they are to achieve their deep objectives of a common market. Moreover, looming over all the current regional integration agreements is the reality of a successful FTAA process, the negotiations of which cover a broad and complex trade agenda that is now in the intense final lap towards 2005. A major question is how countries will manage the articulation of their FTAA negotiations with their strategically important subregional objectives, negotiations with Europe, and the Doha Development Agenda negotiation in Geneva, also scheduled to finish in 2005. Among the myriad of existing agreements, which ones will have sufficient economic and political relevancy to coexist with the FTAA? Another complex issue is how countries will mobilize the capacity and technical skills to effectively participate simultaneously in so many strategically important negotiations and implement their results. These are questions of monumental proportion because the results of negotiation on all these fronts will effectively regulate the bulk of external trade and investment of the countries involved over the coming decades. The importance of these agreements and future negotiations has not been overlooked by the private sector and civil society, which want to be heard regarding the process of negotiations that will affect them. This democratic demand will require developing channels of communication that permit the public's voice to be heard but protect public authorities from being "captured" by interest groups. Persisting with economic liberalization through regional integrationâ&#x20AC;&#x201D; not to mention the unilateral or multilateral openingâ&#x20AC;&#x201D; will require more than ever domestic consensus building, particularly in the current context in which liberalizing reforms are being called into question by different sectors of the population. One of the potential benefits of North-South agreements like the FTAA is that they can serve as an anchor for the developing country members. Teaming with industrialized partners awards credibility to regional commitments and energizes structural change

through trade and investment commitments. NAFTA has provided to some extent this type of umbrella to Mexico during difficult times in the hemisphere; the FTAA and comprehensive agreements with the ED raise the prospects of other umbrellas being extended to the rest of the region. The opportunity for an ambitious FTAA agreement must not be lost. Recent passage of trade promotion authority in the United States, even though a far from perfect mandate from the standpoint of many regional trade partners, now sets the stage for finishing the negotiation. The negotiations of such a complex agreement among 34 countries with a heterogeneous economic profile and varying geopolitical interests will be extremely difficult. However, the negotiations provide a significant vehicle for the region to pursue reforms and liberalization that have slowed or stalled in subregional agreements, effectively creating a new floor for trade and investment with neighbors and the rest of the hemisphere. For the United States and Canada, it is an opportunity to acquire a bigger productive platform for their firms to compete internationally. At the same time, it presents an opportunity to counteract protectionist tendencies in those sectors that have lost their comparative advantage, but in which Latin American countries are competitive and desperately in need of market access to promote sustained economic recovery and poverty reduction. And for the two parties there is the challenge of developing an FTAA institutional architecture that protects every country's rights and obligations and promotes balanced outcomes among partners with very different capacities. An advancing FTAA, however, should not cause countries to lose sight of simultaneous opportunities to tighten commercial relations with the EU, as well as to look to new markets in Asia. In addition to the benefits that can be derived from cooperation and trade agreements with these regions, it is a way to advance further in the process of open regionalism, and an important component of progress toward global free trade. Finally, the regional integration agenda cannot prosper without a vibrant multilateral system that regulates world trade and the regional agreements that are increasingly part of it. Completion of a comprehensive Doha Development Agenda in Geneva is essential to provide a better foundation for subregion-

al agreements and advance some critical areas of their

post-war period. Early initiatives focused on develop-

extraregional agendas, including those in the FTAA and agreements with the EU. But the synergy is not one

ment of regional free trade areas or common markets. These initiatives were inserted into the then-prevailing

way, since regional agreements are pushing liberal-

import-substitution industrialization (ISI) strategy and

ization forward in areas that are still a distant frontier

were aimed at staving off exhaustion of the model due

in the multilateral system. Working together, the two

to the small scale of domestic markets. Regional inte-

levels of integration can serve to strengthen the global

gration held the promise of creating scale economies

economy and make it more prosperous for everyone.

through formation of a larger regional market. This

t '

market was to emerge through preferential tariff elimination among partners, which at the same time main-

TAKING STOCK OF THE NEW REGIONALISM

tained or increased high barriers to extraregional

OF THE 1 990$

imports and engaged in strong state intervention in

Regional integration is a means to an end and not an

the ISI strategy. The approach was controversial, in

economic activity, all of which were central features of end in itself. Hence it would be surprising if regional

part because high levels of protection were considered

policy consistently moved in a direction contrary to an

to be a source of trade and investment diversion that

overall development strategy of a particular country.

was detrimental to the welfare of the countries

Regional economic integration usually begins with

involved, third parties, and the multilateral trading sys-

some type of trade agreement and can progressively

tem. In any event, after a few years of apparent suc-

expand into a wider scope of collective economic pol-

cess, momentum faltered and the regional agreements

icy as well as cooperation in noneconomic areas, and

fell into disarray.

even evolve into some forms of political union.

The regional initiatives that emerged in the

The classic levels of regional economic inte-

1990s have been characterized as the "new regional-

gration, ranked by scope and deepness of commit-

ism." This is because the role of regional integration

ments, are: (i) a simple free trade area in goods in

has changed dramatically with respect to the early

which tariffs and other border measures are eliminat-

post-war episode. The new regionalism is an integral

ed among partners; (ii) a more ambitious "second gen-

part of an overall structural policy shift in Latin Ameri-

eration" free trade area liberalizing services and other

ca towards more open, market-based economies oper-

areas of economic activity that impinge more directly

ating in a democratic setting.

on domestic policy as opposed to border measures per

What are the motives behind the new region-

se; (iii) a customs union in which a free trade area is encircled by a common external tariff (GET) and a

alism? One is to reinforce market opening undertaken at the unilateral and multilateral levels. The formation

regional mechanism for tariff revenue collection and

of a regional market is also meant to create a more

distribution; (iv) a common market that frees not only

controlled and stable environment for firms to gain

trade but factors of production, including labor move-

export experienceâ&#x20AC;&#x201D;particularly in higher value-

ments; (v) a monetary union that adds a common cur-

added goods that generally demand and spill over

rency, central bank and perhaps other forms of

more knowledge-based skillsâ&#x20AC;&#x201D;and to have an outlet

macroeconomic coordination; and (vi) an economic

for goods that face strong international protectionism.

community or union that embraces collective agree-

In addition to diversifying exports, the scale economies,

ments in most major areas of economic activity. The

attraction of foreign direct investment (FDI) and compe-

sequence that RIAs follow in their path toward deeper

tition generated by a credible regional market are

integration has in practice varied according to the

meant over time to dynamically raise productivity and

case.

develop international competitiveness. Regional inteSince independence, the countries of Latin

gration also is being used as a geopolitical tool to for-

America have made any number of attempts to inte-

tify international bargaining positions and promote

grate both politically and economically. Efforts at eco-

cooperation in achieving "neighborhood" objectives

nomic integration have been especially strong in the

such as peace, democracy, the resolution of border-

Regional Integration: Summary and Agenda

CHAPTER

related problems, and the development of regional infrastructure. In what follows, we will take stock of the progress made with regards to regional integration in a wide variety of dimensions.

Support for Trade Liberalization Trade liberalization has been a centerpiece of the structural reform process. Unilateral liberalization was particularly significant from 1985-95, after which Latin America also assumed the comprehensive disciplines of the Uruguay Round. As for regional integration, it has proven to be an important complement for lowering average levels of protection. The many free trade area and common market agreements have generally involved the comprehensive elimination of tariffs on the trade of goods among partners, with relatively few exceptions. In effect, regional arrangements have established a managed policy environment based on reciprocity, within which countries have signaled their commitment to trade liberalization by going beyond that which was feasible or desirable at the unilateral and multilateral levels. Meanwhile, contemporary regional liberalization has avoided some of the pitfalls of the "old" regionalism, thanks to its working in tandem with the substantial process of unilateral and multilateral opening. Consequently, the authorities' commitment to regional liberalization has been more credible to the private sector than in the past and the risks of trade diversion have been substantially reduced. Moreover, regional liberalization has generally been sustained, even in the face of economic and balance of payment problems. Regional integration to date has not been nearly as effective as a tool for liberalization in areas beyond goods. Most agreements affect goods only, and those that have assumed second-generation disciplines (services, intellectual property, investment, etc.) often have done so with only modest depth or content. The most advanced in this regard is NAFTA, where Mexico's liberalization has been comprehensive. As tariffs have been eliminated, non-tariff measures have become the principal barrier to the trade of goods. Unilateral liberalization and the Uruguay Round eliminated most of Latin America's recourse to quantitative restrictions on imports (licenses

and quotas). However, regional trade is still hindered by non-tariff barriers such as onerous customs procedures, technical standards, and other trade-related surcharges. There also is some evidence that stringent rules of origin have limited regional trade or caused exporters to bypass preferences altogether. Insufficient harmonization or lack of mutual recognition of regulatory frameworks also have limited full exploitation of the opportunities for regional trade. The economic payoff from effectively addressing these issues is high and would substantially reinforce the returns to tariff liberalization. However, the political economy of dismantling these obstacles is complex, and progress has generally been limited to date.

Forming Customs Unions The four main subregional agreements of Latin America (Mercosur, the Andean Community, the Central American Common Market and the Caribbean Community) have all formally aimed at creating common markets or communities. Formation of a customs union is a necessary step in this direction. Since a customs union harmonizes the external tariff structure among partners and allows for a common collection of revenue, third party imports can enter the regional market via any country and then circulate without duty controls thereafter. In contrast, a free trade area (or an imperfect customs union) must administer (often complex) rules of origin to regulate access to preferences and avoid "trade deflection," i.e., the incentive for third party imports to enter the regional market through the lowest tariff partner country. Customs unions also promote leveraged bargaining through joint negotiations (as the countries' tariffs must move in tandem), which is not the case in a free trade area, where each country maintains sovereignty over tariff policy. On the cost side, customs unions are more demanding institutionally, even when imperfect, and countries lose independence in tariff policy and the ability to use it in response to shocks. None of Latin America's subregions is close to being a true customs union. All have agreed to common external tariffs, but they are either in development (Central America and CARICOM), reformulation (the Andean Community), or have suffered serious unilateral perforations (Mercosur). Customs unions in the

Regional Integration: Summary ana Agenda

region have also been permissive regarding the ability

vate sector have also sparked significant trade growth

of individual members to strike bilateral deals with third parties. Historically, Latin America has had great

Mexico free trade area being an example. In terms of economic transformation, regional

union, and this has not changed under the new region-

trade is substantially more laden with higher value-

alism. One of the problems is the tension that has

added manufactures than extraregional trade, and

emerged between the larger market countryâ&#x20AC;&#x201D;the tariff

also displays significantly more specialization through

structure of which is typically a defining feature of a

intra-industry exchange. Hence, regional trade is con-

new GETâ&#x20AC;&#x201D;and smaller partner economies that favor

tributing to export diversification in a region tradition-

lower tariffs to minimize the risk and cost of trade

ally dependent on commodity exports. Mexico's

diversion. Fiscal dependency on tariffs and balance of

participation in NAFTA is a good example: its export

payments problems have also eroded willingness to

structure has evolved from petroleum to machines,

forgo autonomy in tariff policy. Meanwhile, none of the

thanks to integration into the production network of

subregional customs unions have a formula and insti-

North American firms. The opportunities afforded by the creation of

The imperfect status of the region's customs

a regional market are expected to increase productivi-

unions has created precisely the type of costs that the system is supposed to eliminate. Time-consuming and

ty. For this to be important at the aggregate level, the regional agreement must affect a significant amount of

costly border administration is still required to avoid

overall economic activity and induce competition, trade

trade deflection (close to half the time of international

and investment. Empirical estimates suggest that

cargo transport by road in the Southern Cone is due to

NAFTA has had significant productivity effects in Mex-

border delays). Important efficiencies in tariff revenue

ico. Similar work on Brazil suggests productivity gains

collection are forgone. And the potential for leveraged

have been more associated with unilateral external

bargaining is undermined, as the ability to make cred-

opening than with Mercosur as such. This is not sur-

ible group commitments is eroded by the possibility of

prising, since Brazil is by far the largest economy in

unilateral actions.

Mercosur, and hence regional trade and investment are a relatively small share of that economy's total output.

Fostering Trade and Promoting Economic Transformation

But another factor is that Mexico's integration has been with two major industrialized partners with different comparative advantages, allowing Mexico greater

Empirical evaluations to date suggest that, on balance, the regional liberalization of the 1990s has created

gains from trade, relatively more access to FDI and best practices, and access to a large and affluent market

trade. Some trade diversion is inherent in any region-

(all further magnified by geographical proximity).

al integration initiative. However, trade diversion has

The new regionalism is relatively young, and

been contained in most cases due to regional integration working in tandem with very substantial third party

hence it remains to be seen to what extent regional trade becomes a platform for competitive international

trade liberalization. It also should be remembered that

exports. If regional agreements just generate trade in

not all trade diversion reduces welfare, as in the case

goods that are competitive only in the regional market

when it improves the terms of trade or dynamically

("regional goods") due to preferences or other factors,

evolves into increased international competitiveness.

countries may become excessively vulnerable to down-

Measured from the standpoint of the growth of

turns in a partner country's economy.

trade, many of the regional agreements have been

Regional markets have served as an outlet for

economically relevant. In effect, regional preferences

trade in goods that confront sizable levels of interna-

have reinforced the effect of unilateral liberalization in

tional protection (agriculture, food processing, textiles,

allowing neighboring markets to discover each other,

steel, etc.) and in which the region has a comparative

particularly

advantage.

in the major subregions. But regional

agreements and the awareness they create in the pri-

Notwithstanding

numerous multilateral

rounds of trade liberalization, industrialized countries

between distant and unfamiliar markets, with the Chile-

trouble forming a GET, much less a full-fledged customs

tutional structure to share tariff revenue.

CHAPTER

have been resistant to liberalizing sectors that are sensitive to competition from developing countries. The Uruguay Round's elimination of the Multifiber Agreement in 2005 promises to bring relief in textiles. Advances in agriculture-related sectors remain modest, as important tariff peaks, sanitary measures, export subsidies and agricultural domestic support in the industrialized countries are major distortionary obstacles for Latin America to exploit its international comparative advantage. Eyes are now focused on the Doha Development Agenda in Geneva as a hopeful vehicle to open world markets to developing country agriculture-related exports, and to contain the antidumping activity that has often penalized successful export performance. With the exception of NAFTA, cross-border trade in services has been more affected by unilateral and multilateral liberalization than formal regional integration as such. One reflection of this is that financial services integration in Latin Americaâ&#x20AC;&#x201D; for example in banking and equity marketsâ&#x20AC;&#x201D;has largely involved de facto integration with the rest of the world and industrialized countries in particular. Foreign banks of industrialized countries now have a strong presence in most domestic financial markets and have been a major source of competition, modernization and credibility in the domestic banking systems in the region. Moreover, the same foreign banks have established subsidiaries and branches in almost all the countries of the region, creating potential for regional cross-border services. However, the potential opportunities for financial providers to operate at the subregional level will not be fully tapped until member countries adopt and implement financial integration protocols that exceed their commitments in the WTO.

Choice of Partners The pursuit of regional agreements has been freewheeling. The initial wave at the beginning of the 1990s began with the launching, or renewal, of formal common market integration projects in the four subregions. These all involved countries that shared a common geographical area and a post-war history of attempts at economic integration. Parallel to this were initiatives by Chile, not a member of any group, which set out on its own to establish free trade areas with

immediate neighbors and distant countries alike. After joining NAFTA, Mexico set out to sign NAFTA-like agreements with most of Latin America. And since NAFTA, there has been an increasing propensity to link up with industrialized countries, something that would have been politically inconceivable before the new regionalism. As discussed above, being part of a customs union has not been a barrier for individual countries negotiating bilaterally with other countries. Almost all the Andean Community members have at least one bilateral free trade area with another country, and some members of the Central American Common Market, CARICOM and Mercosur have also pursued their own bilateral agreements. These developments sometimes have been divisive to the group's cohesion and eroded the credibility of bloc negotiation. The process may appear somewhat helterskelter, but it does have its logic. The up side is that by pursuing multiple agreements, the countries have been confirming to the private sector their commitments to gradual liberalization (in the controlled and politically attractive setting of a reciprocal regional accord), creating new markets for their exporters, and reducing actual or potential trade diversion from existing preferential agreements. In fact, as the agreements expand their geographical coverage, they begin to approach multilateral proportions, and nearly eliminate trade diversion. For example, Mexico has free trade agreements with North America, Europe and almost all of Latin America, and is now pursuing free trade in Asia through APEC, and through a free trade area with Japan. There also has been a progressive tendency to upgrade to second-generation disciplines, albeit in many cases with cautious depth or content. The biggest upgrade has been the growing interest in integrating with an industrialized market. Since the industrialized country in these instances already has a relatively liberal economic framework, the burden of adjustment falls mostly on the developing country partner. Nevertheless, theory and practice suggest that this can be a powerful tool in locking in liberalizing disciplines, providing incentives for modernization, reducing trade diversion, exploiting international comparative advantage, winning access guarantees to a major export market, generating a source of importation of technology and best practices,

Regional Integration: Summary and Agenda

country's foreign

well. Stating the balance of benefits and costs in a sec-

direct investors. Experience also has shown that nego-

ond best world is a difficult empirical exercise for indi-

tiating an agreement with an industrialized country is

vidual countries and for the world community at large.

an exercise in capacity building. Some countries that

In the meantime, opinions vary both at the theoretical

have negotiated free trade agreements of this type

and policy levels.

have seen their negotiating teams "graduate" to worldclass levels and their domestic firms become less fear-

Attracting Foreign Direct Investment

ful of tackling international competition. Learning by doing seems to work here.

Latin America's attitude toward foreign direct invest-

One of the downsides of these developments

ment has evolved from early post-war skepticism into

has been reduced transparency and increased trans-

being much more receptive. Foreign firms are now

action costs in world trade. A myriad of preferential

generally viewed as potential sources of technology,

agreements, all with different norms and coverage,

export markets and best practices that reinforce the

have created a "spaghetti bowl" of administrative hur-

structural reform process. But there also is a similar

dles for trade in the hemisphere. Another issue that

view in other developing regions, which has increased

warrants attention is the increasing creation of "hub

competition to attract FDI, particularly from OECD

and spoke" trade where certain agenda-setting coun-

countries.

tries establish an extensive web of free trade areas in

Through much of the 1990s, Latin America

which they have free market access with many coun-

experienced strong growth of FDI, which has become

tries, but the same countries do not enjoy similarly

by far the main source of private foreign financing for

favorable access conditions with each other. Chile and

the region. There are several reasons for this surge,

Mexico are hubs in the hemisphere, and Canada and

including macroeconomic stability, the wave of privati-

the United States may also become hubs if the number

zations and institutional reform, as well as regional

of their agreements expands. In terms of the hemi-

integration.

sphere, hubs and spokes are less efficient than a glob-

Empirical work on a worldwide sample of

al FTAA. However, as will be discussed below, under

countries presented in this volume confirms that region-

certain conditions a growing envelope of hubs and

al integration does attract FDI when the host country

spokes could be a building block for forming a welfare

becomes a member of an agreement or when there is

enhancing hemispheric agreement. But if overly lever-

significant extension of the market. These gains, how-

aged with narrow commercial interests, the same strat-

ever, can be unevenly distributed, especially when

egy could perversely lead the way to a welfare reducing and unsustainable FTAA. In particular, in the

location is biased to larger market partners due to uncertain or uneven application of regional rules. The

FTAA, as well as in other extraregional initiatives, it is

empirical work also finds that as source countries

important to pay special attention to the specific needs

expand their participation in regional agreements, the

of small economies, which, among other things, are

existing FDI can be diverted or diluted.

vulnerable to insecure market access, and often lack

At the same time that it contributes to attract-

the necessary institutional capacity to make the most

ing FDI, regional integration, by increasing the geo-

of regional integration processes (see Box 2.5 in

graphical area from which a multinational firm can

Chapter 2).

supply the extended market, increases the scope of

A related issue is the potential negative effects

competition in incentives for the location of FDI. Incen-

of the growing number of bilateral agreements on

tives are warranted when investment projects generate

countries left out of a particular process (an issue of

positive externalities, and can lead to optimal out-

debate for Central America and the Caribbean before

comes in terms of the investment projects that are

they gained non-reciprocal NAFTA parity with the

implemented, and in terms of their location. However,

United States).

aggressive competition in incentives can also tilt the

All these issues are magnified by the fact that

distribution of benefits unnecessarily in favor of the for-

they are arising in most other parts of the world as

eign firm. This has been an important source of con-

and attracting the industrialized

CHAPTER

tention in some subregions. Yet, subregional integration agreements have been slow to find mechanisms to coordinate the incentive schemes in order to help tilt the balance more in favor of the host countries.

proven to be useful, most recently with the disbursement of financing to Bolivia.

Macroeconomic and Monetary Coordination

The very top-heavy regional institutional structures inherited from the old regionalism have been reformed, and the new breed of agreements has tended towards scaled down intergovernmental arrangements. On the whole, neither approach has been fully satisfactory: the institutional architecture of the new regionalism appears to be too weak in the face of growing integration and interdependences as well as the complexity of the agendas emerging in different forums. This is either because some needed institutions are missing, or because those that do exist are underfunded, have insufficient expert staffing, or lack relevance. Weak institutional environments also tend to discourage the full participation of smaller member states with less market power and capacities. An especially important area is dispute settlement mechanisms. One of the main objectives of these judicial procedures, which represent an alternative to backroom diplomacy, is to make decisions more transparent and less dependent on the balance of power between the parties involved. Smaller markets obviously have a special interest in effective dispute settlement, but Latin America, often preferring diplomacy, has been sparse in its use of this approach and lacks effective methods of enforcement and compensation. Moreover, since there is little tradition of using such an approach, many countries lack domestic legal expertise in this area, which inhibits recourse to the mechanisms even when they do exist. This could be a real problem for the region in terms of the FTAA, in which dispute settlement mechanisms can be expected to play an important role.

Crises in member countries and large swings in bilateral exchange rates can cause serious stress in the relationship between RIA partners. The current crisis in the Mercosur countries is a perfect example of this problem. Large exchange rate swings among the partners can generate protectionism in the countries that are hurt, defeating the purpose of the RIA; induce foreign investors to reconsider the location of their subsidiaries; prompt existing firms to relocate their investments toward the country that has gained in competitiveness; disrupt export flows, particularly in goods that are not easy to redirect to alternative markets; and weaken the partners' credibility regarding their own exchange rate commitments, and thus lead to contagion. For all these reasons, macroeconomic instability, and in particular significant exchange rate swings, have at times seriously eroded political commitment for regional integration agreements in their member countries. The danger of contagion has led to an additional effect that has harmed the cohesion of regional integration agreements: the tendency of countries to differentiate themselves from their partners when these are affected by crises. These problems also have created periodic bouts of pressure to scale back an agreement from, for example, a customs union to a free trade agreement. In addition, they have provided incentives for ad hoc bilateral initiatives by adversely affected members. It is hard to envision advancing toward deeper subregional agreements without dealing with these problems in some way. Unfortunately, advances have been modest. There have been some attempts to establish consultation mechanisms, macroeconomic targets or convergence criteria, and common databases to facilitate cross-country monitoring. But those efforts have fallen short of systematic coordination, to the detriment of stability and the deepening of the pacts. Moreover, financial cooperation is still quite limited, although the Andean countries have established a reserve fund (Fondo Latino de Reserves) that has

Regional Institutions

Another key institution needing strengthening is technical secretariats, which provide member countries with access to homogeneous services and often serve as de facto "institutional memory" for integration processes.

Extraregional Initiatives One generally bright spot to date has been the process of integration with industrialized countries. A very

complex FTAA process has advanced steadily since its

with Central America and the Andean countries, while

launch in 1994. Through disciplined organization, clear objectives, energetic participation, and technical,

CARICOM is scheduled to begin negotiations this year for closure in 2008. As for APEC, after a promising

financial and logistical support from regional organi-

beginning, this process seems to have lost momentum

zations, the FTAA has managed to stay on a track tech-

as a free trade exercise.

nically compatible with finishing the negotiation by the target date of 2005. While it remains to be seen

Regional Cooperation

whether the ultimate goal is achieved, the nearly eightyear old FTAA process has already generated a posi-

Infrastructure

tive legacy through numerous beneficial externalities, ranging from creation of an unprecedented esprit de

Increased border trade following the formation of

corps among hemispheric trade negotiators (and con-

regional agreements increases the demand for better

sequently a new forum to discuss bilateral issues), to

integration in infrastructure. In Latin America, serious

the release and publication of much previously unavail-

bottlenecks from increased trade need to be ad-

able data and comparative studies of national and

dressed. Road networks—a primary mode for cargo—

regional trade regulations. It has served as a learning

need to be greatly improved, as does their servicing.

laboratory for cutting edge negotiations and under-

Most other means of transportation need to be

standing complex trade issues and disciplines, includ-

improved as well. Yet, to date, infrastructure connect-

ing those of the WTO, and for creating important

ing integrating countries has generally not been suffi-

demonstration effects for the WTO itself in areas rang-

ciently developed. At the core of the issue is a problem

ing from management of data reporting to transparen-

of externalities. Regional infrastructure projects have

cy, participation, and articulation with civil society.

costs and benefits that extend beyond countries' bor-

The recent EU agreements with Mexico and

ders. The portion of the road that is built on one side of

Chile are a notable sign of a maturing relationship:

the border has benefits for the neighboring country. In

they were the European Union's first free trade agree-

the context of decentralized decision-making, these

ments in the region as part of a general move from

positive externalities will naturally result in underprovi-

non-reciprocal to reciprocal agreements with Latin

sion of regional infrastructure. The key issue is how to

America. Moreover, they were based on a larger inno-

make much needed regional projects happen, establish

vative concept that generates a

"trade-cooperation

forms of coordinated decision-making that internalize

nexus" through negotiation of a formal association

the externalities, and at the same time overcome other

agreement that integrates trade, cooperation and political dialogue. This integration of three areas of action

political and regulatory risks that may arise due to the multi-country nature of the projects. Governments have responded to this challenge. The 12 nations of South

that can make important contributions to development is backed by generous funding for cooperation and by formal medium-term programming exercises to sup-

America, through the Initiative for the Integration of

port the allocation of resources. Also, when linking

Regional Infrastructure in South America (URSA), and Mexico with Central America through the Puebla-

with subregional blocs, the EU focuses its cooperation

Panama Plan (PPP), have each launched unprecedent-

on consolidating subregional integration. In the case of

ed intergovernmental initiatives, with the support of

Mercosur, negotiations aim to achieve the EU's first

regional organizations, to tackle coordinated regional

inter-regional agreement between two customs unions.

infrastructure.

The negotiations have advanced, but the pace has been slowed by a number of factors, including Euro-

Geopolitics

pean sensitivity to the liberalization of agriculture— where Mercosur is a world-class exporter—and serious

Regional arrangements have also contributed to coop-

economic problems in the Mercosur countries. The most

eration in terms of geopolitics. Mercosur and the

recent EU-Latin America Summit established ground-

Andean Community have democratic clauses and have

work for eventual negotiation of reciprocal agreements

used them to stave off threats to democracy in their

Regional Integration: Summary and Agenda

CHAPTER

subregions. Most border conflicts where there were military tensions have been resolved. The subregions also have grouped together to enhance their bargaining power, most notably in trade, where Mercosur, the Andean Community, CARICOM and, more recently, Central America, have negotiated in blocs. Strengthening Institutional Capacity Finally, the new regionalism has increasingly heightened the demand for technical assistance and financing in order to strengthen institutional capacity. North-South regional integration agreement negotiations as well as those in the WTO have been a special catalyst because of the asymmetric capacities between developed and developing countries, in particular the small economies, and the magnitude of the potential market opening. In regional and multilateral forums, Latin American countries have identified at least two strategic priority areas. The first is increased capacity to effectively negotiate complex trade-related commitments and their implementation. The array of needs identified for negotiation is daunting, including training of negotiators, technical support for empirical evaluation of the impact of alternative liberalization scenarios and ex-post evaluation of the effects of regional agreements, and technical assistance for inter-country and inter-agency coordination, as well as for consultation mechanisms with the private sector and civil society. As for implementation, there is substantial need for institutional change and skilled personnel, especially when agreements have deep agendas. The second priority area involves confronting the economic adjustments that are needed to manage costs and maximize benefits of agreements. To manage costs, two areas of immediate concern are fiscal reform to cope with lost tariff revenue, and developing efficient mechanisms to protect social sectors that lose ground as a result of integration. To maximize benefits, the areas of action are many, including education and training, customs modernization, industrial restructuring, identifying export markets, managing infrastructure, attracting FDI, and regulating financial markets. The primary responsibility for carrying out institutional strengthening to confront the challenges of trade and integration agreements corresponds to the

individual developing countries. But organized NorthSouth cooperation can help. Encouragingly, negotiations between developing countries and industrialized markets have served as a catalyst for this cooperation. For instance, more support for capacity building in the multilateral system contributed to the successful conclusion of negotiations in Doha. This has also become a major issue for the progress in the FTAA negotiations, is a central component in ED bilateral trade initiatives, and has been perhaps one of the more distinguishing features of APEC. Cooperation for institutional strengthening in the FTAA process is gaining steam and has focused on trade negotiation and implementation issues (often referred to as trade-related capacity building or technical assistance), and to a more limited extent on economic adjustment issues.

Equity Considerations There is a widespread perception among economists, not to mention anti-globalization groups, that liberalization in developing countries has exacerbated inequality. In theory, this need not be the case. In fact, according to theory, integration with countries in the North should reduce wage inequality in the South, as goods produced in the North have a larger content of skilled labor, which should reduce the demand for skill in the South. On the other hand, integration (and in particular, integration with the North) brings about new technologies and foreign investments, which may increase the demand for skill, and thus increase wage inequality. The overall effect is ambiguous. In spite of widespread perceptions, the evidence from Latin America presented in this volume regarding changes in inequality suggests ambiguous results as well. But even if integration led to increased inequality, should this discourage policymakers from pursuing regional and multilateral liberalization? The answer to this question is an emphatic no. First, integration brings about new technologies and foreign investment, both of which can be important ingredients for improvements in productivity and sustained growth. In the process, technology and FDI may increase the returns to skills, as new technologies and production processes of foreign firms may be more intensive in skilled labor, but overall effects are clearly positive. Second, to the extent that integration contributes to

Regional Integration: Summary and Agenda

liberalization, it also introduced stress, as certain items

increases in the returns to skills provide added incen-

on regional agendas are difficult if not impossible to

tives for students to stay in school, a key ingredient for

complete without further liberalization at the multilater-

future improvements in productivity, and an important

al level. Hence, a successful completion of the Doha

vehicle for social mobility. It is important to keep in

Development Agenda clearly is an important goal for

mind, however, that the effects on inequality may have

Latin America's trade agenda. To live up to its name,

different dimensions. In particular, while some regions

the round will have to succeed in achieving much-post-

may flourish with integration, others may be left behind.

poned access to markets in sectors in which Latin

Trade, then, clearly promises net benefits. But

America has a comparative advantage, but for which

there is a catch, albeit with a remedy: the net benefits

high levels of protection have persisted over decades.

are distributed unequally, and inequality can be avoid-

This will require strong political will of all parties to ful-

ed only with the effective deployment of compensatory

fill the "development" promise of the agenda. It also

mechanisms. This has been a highly sensitive issue in

will require active and effective negotiations by the

Europe, where important compensatory mechanisms

countries of the region, which should benefit from

have been introduced through regional and cohesion

increased trade-related technical assistance, in accor-

funds. This problem has not yet been adequately addressed in the context of the regional integration ini-

dance with the commitments included in the Doha Declaration.

tiatives in the Americas. Serious and persistent short-

The second front for action in building a suc-

comings in designing and financing compensatory

cessful integration process is subregional integration

policies have clearly been the Achilles' heel of global-

itself. This process brings together like-minded coun-

ization and the new regionalism.

tries in agreements that have trade at their initial core, but that aim at much more than a commercial relationship. It is an effort to work together to achieve strategic

AN AGENDA FOR THE FUTURE: SIMULTANEOUS ADVANCES ON MULTIPLE FRONTS

development goals in an ever more competitive and globalized economy, and to address neighborhood problems

and opportunities

that can be better

The launch of the new multilateral Doha Development

addressed, or only addressed, through subregional

Agenda in November 2001 put in place a critical miss-

cooperation. This level of action is critical right now,

ing piece in terms of building a successful regional

since some agreements have the ambitious goal of

integration process. The GATT/WTO is one of the most important international public goods created in the

completing common markets by the middle of this decade, while at the same time an uncertain economic

post-war era and a principal factor behind the re-

environment and macroeconomic instability have

markable growth of world trade. The non-discrimina-

made advancing integration more difficult. In some

tory multilateral system constitutes a base, or floor, for

cases, these problems have even eroded the collective political vision that is at the core of successful subre-

preferential regional agreements. Moreover, as the multilateral system advances and policy barriers to trade fall, the pull of geography becomes stronger and

gional initiatives. Intersecting both of the above fronts for action

so may the incentives to pursue deeper regional inte-

are the emerging North-South integration initiatives,

gration arrangements.

which offer important opportunities for development

However, the failure of the 1999 ministerial

and have important synergies with the subregional and

meeting in Seattle to launch a new round of multilater-

multilateral agendas. At the same time, these initiatives

al talks stalled the momentum that multilateralism

raise strategic issues that must be managed carefully

achieved in the Uruguay Round, revealing some seri-

by the subregions if their potential benefits are to be

ous shortcomings in terms of transparency, interaction

fully realized. Given that progress in North-South

with civil society, and the capacity of developing coun-

agreements (and particularly the FTAA) could have important consequences for subregional agreements in

try members to fully participate. While the failure high-

lighted some of the virtues of a regional approach to

increased productivity and growth, increases in wage inequality need not lead to higher poverty rates. Third,

CHAPTER

the Americas, the agenda that follows will begin by focusing on North-South initiatives.

North-South Integration Initiatives Completing a Balanced FTAA One of the most important immediate objectives of the regional integration strategy of the countries of Latin America is to complete the Free Trade Area of the Americas in a way that balances the interests of all parties. This is important for several reasons. First, guaranteed reciprocal access to the markets in the Americas matters greatly to all the countries in the region, which at present face barriers or insecure access to these markets. Particularly important is access to the U.S. market, although there are also substantial opportunities for increased trade among existing subregional groups that still trade little with each other. Second, the FTAA may contribute to locking in the structural reforms carried out by the countries in the region, some of which are being called into question in the current uncertain international and regional economic environment. Indeed, experience has shown that subregional initiatives among developing countries cannot always provide the same incentives for avoiding a reversal of the reforms as are found in agreements in which an industrialized country participates. Third, the FTAA may help consolidate political links at the hemispheric level, reducing the likelihood of potential conflicts and, perhaps, serving to strengthen and lock in U.S. cooperation with the countries of the region. In effect, increased trade and investment in the hemisphere, and their contribution to the competitiveness of U.S. firms in the global economy, increase that country's stakes in the prospects of Latin America. Taken together, these three elementsâ&#x20AC;&#x201D; improved market access, enhanced credibility of economic reforms, and an increased U.S. focus on the regionâ&#x20AC;&#x201D;may add up to a big difference in the prospects for development in Latin America. While falling far short of the impact of the EU on Southern Europe and countries that are in line for accession, a comprehensive and balanced FTAA could nevertheless serve as an anchor for the Latin American economies, boosting their credibility at home as well as abroad in financial and investment markets.

Within the FTAA initiative, secure market access plays a central strategic role and is the main objective of Latin America. In fact, without a significant change in this dimension, the benefits of signing on to the FTAA would be less obvious and the cost of abandoning the agreement would not be as substantial, which means the lock-in effects of the reforms become weaker. Absent market integration and lockin, the prospects for a sustained favorable evolution of U.S. hemispheric relationships could be reduced. For Latin American countries, effective market access will depend on the dismantling of existing barriers in the industrialized markets of the North; the existence of, and respect for, rules that ensure a secure and predictable environment in the application of contingent protectionist measures; the establishment of an efficient procedure for settling disputes; and the existence of mechanisms to ensure balanced outcomes in the operation of an agreement with 34 heterogeneous countries, some of which have limited institutional capacities. One of the most important and sensitive sectors in market access negotiations will be agriculture. Significant progress must be made in the FTAA negotiations, but a full response will probably be linked to success in the parallel Doha Development Agenda negotiations on agriculture, where developing countries are demanding multilateral action on agricultural tariffs, export subsidies and distortionary domestic support. Meanwhile, the gains for Latin America from more open markets in the North will have to be weighed against the concessions that must be made in any trade negotiation. In the context of the FTAA, it is critical that the Latin American countries effectively evaluate the impact of requests from the North in areas such as intellectual property, investment, government procurement, and trade in services, all of which are of particular interest to North America. Clearly, the different players have different objectives when it comes to the FTAA. Indeed, this is what trade negotiations are all about and what creates the potential for a mutually beneficial agreement. But there are different ways to advance toward the completion of the FTAA. And the outcome of the negotiations may be different depending on the manner in which they are carried out. On the one hand, there is the formal process

of negotiation, launched during the Miami Summit, in

The strategic use of bilateral and subregional

which all 34 nations are represented. On the other,

agreements in the context of the FTAA negotiations is

there is the increasing tendency to pursue bilateral

not unprecedented. An earlier proposal by Brazil for

agreements parallel to the FTAA negotiations. Recent

creating a South American Free Trade Area (SAFTA)

increased interest by the United States in initiating and

fits perfectly within this strategy. Similarly, a number of

concluding bilateral trade negotiations (with Chile,

recent bilateral agreements have included provisions

Central America and Uruguay, for example) has raised

that were relevant to the agreements in question, but

the possibility that the FTAA will emerge as an enve-

could set precedents that will influence the FTAA nego-

lope of these different bilateral agreements.

tiations as a whole. Examples are the export of NAFTA

It is possible that the bilateral approach can

disciplines by Mexico into an array of bilateral agree-

prod the process forward. While 34 countries are an

ments; Chile and Canada's abandoning of anti-dump-

easier vehicle for negotiation than the 140-plus WTO

ing rules in their bilateral agreement, with the aim of

membership, it is still a cumbersome number. But an

setting an example for the FTAA; and the labor and

FTAA emerging implicitly from evolving hub-and-spoke

environment provisions agreed to by Costa Rica and

bilateral agreements poses potential risks as well as

Canada, which emphasize technical cooperation

benefits. A strong agenda-setting country in the FTAA

rather than sanctions.

is even stronger in a bilateral setting. So as the agenda setter pursues a bilateral approach parallel to its

As should be obvious, the process of negotiating a comprehensive FTAA among 34 heterogeneous

FTAA negotiations, there are challenges and responsi-

countries is an extremely difficult task. While the recent

bilities if the FTAA is its ultimate goal. Under the most favorable scenario, the agen-

passage of trade promotion authority in the United States has removed a major obstacle to completing

da-setting nation would approach bilateral negotia-

negotiations, the final outcome of the FTAA process is

tions with a balanced view of the longer-term political

still a question mark, and the scope and depth of a

and economic interests of the hemisphere, as well as

resulting agreement is still an unknown.

the real capacities and specific development needs of all its trading partners. In this case, its bilateral agree-

EU-Latin America Initiatives

ments could become an effective building block for an FTAA that enhances the welfare of all. Alternatively, the hub-and-spoke approach

Just as the FTAA would bring benefits in terms of making subregional blocs more open and less trade divert-

could be geared primarily to achieving the country's

ing, free trade agreements with Europe could do the

narrow commercial interests through sheer leverage in the bilateral negotiations—or through inclusion in

same. One of the reasons Mexico pursued an agree-

some of them of issues that may not entail important concessions for the bilateral counterpart—and then

trade was with the United States, was to minimize residual trade diversion, diversify to new export mar-

using them as precedents to forge similar FTAA agree-

kets, and attract European FDI and know-how. The

ments. In this way, the agenda setter would obtain an

Chilean agreement with the EU, as well as the partici-

ment with the EU, even though the great bulk of its

agreement that is closer to meeting its own goals, with-

pation by Mexico, Chile and Peru in APEC, are based

out having to make many concessions in return. Such

on similar grounds.

an approach could stifle the formation of an FTAA—

Hemispheric integration could be enhanced

leaving a less efficient hub-and-spoke system in

were the EU to finalize ongoing negotiations for an

place—or even create a welfare decreasing one, which

Association Agreement with Mercosur and initiate sim-

would be politically conflictive and probably not sus-

ilar negotiations with the other subregions as soon as

tainable. Finally, while the formal 34-country negotia-

possible. The EU currently treats CARICOM countries

tions and the hub-and-spoke roads are presented here

as part of the African, Caribbean and Pacific Group of

as polar strategies, in reality they are parts of the same

States (ACP). Several factors suggest that there would

process of negotiation, in which actions on one dimen-

be substantial benefits from moving the agenda for-

sion influence actions and the progress in the other.

ward between the EU and Latin America:

Regional Integration: Summary and Agenda

CHAPTER

• Many countries in the region trade as much with Europe as they do with the United States and Canada. Findings in this volume (see Appendix 2.1 in Chapter 2) suggest that the benefits of trade liberalization for several subregions vis-a-vis the EU would be of the same order of magnitude as would be gains from the FTAA. • The EU offers a different model of NorthSouth integration in which well-funded cooperation plays an integral role. Linking up with the EU also offers opportunities for the subregions to be exposed to and learn from the vast integration experience of the EU, which could be particularly valuable if subregional agreements become deeper integration projects. Moreover, these agreements can bring technologies and best practices to the region that may be different than those that can be acquired through the FTAA. Progress in the EU negotiations, by providing an alternative route to access markets in industrial countries, may enhance the bargaining capacity of Latin American countries and subregions as they engage in the FTAA negotiations. The FTAA, in turn, could enhance the region's bargaining power in its dealings with Europe. • With the recent launching of the euro, the current priorities for the EU clearly are to deepen its own integration process and to expand. This may help explain why progress in negotiations with the Americas has advanced at a slower pace. With regards to expansion, it is important to note that the countries in line for EU accession generally do not compete directly with most Latin American countries, and their accession may actually afford more opportunities for trade with Europe. Asia Apart from advancing negotiations with the EU, it is also important for Latin America to continue to make progress in strengthening trade and investment links with Asia. These markets are relatively unexploited and may offer several of the same benefits as those associated with links with the EU. The recent more favorable attitude in Asia with respect to regional integration may make it possible for Latin American countries to engage more actively in bilateral agreements with this region.

Bilateral and Subregional Agreements The FTAA will create a basis or benchmark for determining the relevance of existing as well as potential subregional and bilateral agreements. Those that exceed the FTAA in some significant dimension would have a reason to survive, subject to the additional benefits exceeding the costs of administration. If the FTAA ends up being a shallow agreement, bilateral and subregional agreements will play a larger role. In any event, the formal ambitions, at least, of subregional agreements in Latin America aim for customs unions and common markets, which by definition exceed the obligations of a free trade area. In this context, the logic of continued subregional commitments takes on various dimensions: • Countries that have subregional agreements may benefit from negotiating as a bloc, both at the WTO level, in negotiations with other regions such as the EU, in FTAA negotiations, or even later during the development and implementation of future agreements. Moreover, this negotiating leverage could be used in other international forums that go beyond trade. Naturally, in order to offer concessions collectively, there has to be a strong commitment to act as a bloc in some dimension, such as tariffs. For this reason, countries in customs unions are probably better suited to negotiate as a bloc than are countries in free trade agreements. Similarly, blocs that will likely disappear following the formation of the FTAA may not offer a strong negotiating advantage to their member countries. Hence, agreements that aim to go beyond a free trade area may need to maintain momentum toward achieving their stated objectives if they are to be an effective vehicle for negotiating as a bloc. • Even with a full-fledged FTAA, a subregion that has achieved a common market or beyond, with free movement of factors and other forms of economic cooperation, could combine national resources more effectively to compete within the FTAA, and in the global economy. • If North-South agreements such as the FTAA or those with Europe and the WTO do not achieve as much progress as desired regarding market access, at least in the short term, and if it is still difficult to place some important goods in foreign markets, then subregional agreements would provide alternative access!-

ble markets for the products in which countries have

kets may make it more difficult to advance liberalization

comparative advantage.

of these sectors within the FTAA negotiations.

• The justification for forming subregional

The bottom line is that, apart from pockets of

blocs has in part involved political objectives such as

persistently high protection, the potential benefits of

peace and democracy. While some have argued that

subregional commitments appear to outweigh the pos-

regional trade agreements are not needed to work

sible drawbacks. The effects of the spaghetti bowl

toward such objectives, interdependence through trade

could be ameliorated by making rules across subre-

and investment flows that stem from collective commit-

gional integration agreements, and between these and

ments have been shown to be an endogenous force for

the FTAA, more compatible. (Here the new WTO rules

cooperation, and hence can provide an effective plat-

could help.) The problem does not seem to be too seri-

form for non-economic initiatives. Although the FTAA

ous, as long as it is offset by other effects that are

should contribute to strengthening the political relations

broadly conducive to competitiveness, growth and

in the region, given its hemispheric scope and the het-

development.

erogeneity among the countries in terms of history, lev-

The liveliest debate that has emerged regard-

els of development and geopolitics, the subregional

ing the merits of current subregional trade agreements

agreements will probably maintain a comparative

is the concern about the extent of trade diversion. As

advantage in dealing with many political issues in

mentioned earlier, empirical work suggests that, on

"local neighborhoods."

balance, the new regionalism has created trade. More-

• For similar "neighborhood" reasons, deeper subregional agreements may facilitate other beneficial

over, the FTAA will likely contribute to reduce the scope for trade diversion.

forms of cooperation such as macro coordination,

Indeed, the very creation of a WTO-consistent

functional cooperation, integration of infrastructure, or

FTAA would automatically convert subregional agree-

the provision of regional public goods such as envi-

ments into more open blocs. By incorporating two

ronmental or health projects. Moreover, this coopera-

world-class industrialized economies and a more open

tion in turn may become a foundation for adopting

exchange between subregions, the FTAA would expose

similar cooperation initiatives at the hemispheric level.

individual countries in the subregional agreements

• Coordination in different policy dimensions

more to competition that mimics the whole range of

in turn may increase the credibility of such policies,

comparative advantage in the world economy. In this

making it easier for national authorities to withstand

environment, trade diversion problems should be

pressures from local interest groups. Deep subregional

reduced in most countries. Agreements with the EU

initiatives are a more likely vehicle than the FTAA to

would reinforce this effect.

provide this type of policy coordination.

In this context, pockets of high protection merit special attention and should be dealt with appropri-

Those are the potential gains from subregion-

ately. Just as North America must be sensitive to the

al commitments. There are, however, some potential

benefits of eliminating excessive protection in certain

drawbacks as well. First, the coexistence of an FTAA

sectors, regional partners should use the FTAA negoti-

with subregional and bilateral agreements will likely

ations and those with the EU to accelerate the disman-

increase the complexity and reduce the transparency of

tling of these protected pockets, even if liberalization of

hemispheric and world trading systems, i.e., the so-

these sectors occurs only gradually.

called "spaghetti bowl" effect. Second, although subregional agreements have been negotiated under the

Rethinking Subregional Integration

purview of the new regionalism in the sense that they

Agreements: What Type? How Deep?

have accompanied liberalization vis-a-vis third parties, there remain some pockets of excessively high protection

The FTAA represents a significant change in the inte-

or distortionary regulations that have proven difficult to

gration landscape that will force countries to rethink the

reform (e.g., special automobile regimes in several sub-

role of subregional integration agreements. Govern-

regional agreements). The umbrella of subregional mar-

ments in the hemisphere have broadly accepted in their

Regional Integration: Summary and Agenda

CHAPTER

FTAA negotiations that agreements that are less comprehensive than the FTAA will be absorbed by it. But would current subregional agreements, most of which consist of imperfect and incomplete customs unions, be worth keeping in their current form? The answer is, probably not. The very fact that these customs unions are incomplete negates one of their principal advantages over free trade agreements—the elimination of rules of origin and other administrative burdens at the border. Moreover, the common practice by customs union members in the region of negotiating unilaterally with third parties erodes the potential advantages of negotiating as a bloc. In this context, the marginal advantages provided by current customs unions in the region may not be enough to offset the loss of sacrificing an independent trade policy. Subregional integration agreements looking to preserve a vehicle for group cooperation should complete the customs union, thus fully capturing its potential benefits, or consider falling back to a free trade agreement, provided that is a more comprehensive arrangement than the FTAA. The benefits of completing the customs union would be considerably magnified if it were clearly an intermediate step towards an eventual common market. Moreover, regardless of the success and scope of the FTAA, subregions with common external tariffs should continue to reduce external tariffs, which can benefit all members, but especially smaller ones that are more prone to being affected by unwanted trade diversion. Subregions should also continue to pursue bilateral agreements with industrialized partners, and to gradually liberalize unilaterally on a most favored nation basis. Indeed, there is an immediate incentive for some smaller economies with higher levels of protection to take such steps. They could even consider leaving an agreement if larger members are reluctant to act on excessive levels of protection. Consolidating Subregional Integration Agreements For those agreements worth deepening, what is next on the agenda? What are the priorities? How can countries effectively consolidate agreements that they already have? • Completion of the customs unions projects,

which starts with full implementation of the common external tariff, should be a first priority. Exceptions to free trade within the agreement should be phased out, with removal of other non-tariff barriers to internal circulation of goods. Furthermore, within the context of a complete customs union project, once agreement has been reached on the implementation of the GET, bilateral deals with third parties by individual members of the union should be discouraged. Since the formation of customs unions will not be achieved overnight, modernizing and simplifying customs procedures would save valuable time in what was seen earlier to be a notoriously long delay at border crossings. • Since movement of goods and people across borders drives de facto and de jure integration, success in deepening subregional integration (and FTAA and multilateral trade as well) will depend in no small part on the success in further developing regional infrastructure. Regional infrastructure projects have important externalities, so their undertaking requires coordinated action. In this regard, the URSA and PPP are historic cooperative ventures to coordinate the development of regional infrastructure on an inter-regional as well as intra-regional basis. The two processes are promising in terms of coordinating official positions, but to make projects happen, there will have to be more progress in encouraging active private sector participation. • Viable deepening of subregional integration will require a stronger institutional framework than the subregions have today. One fundamental need is the development and use of transparent and modern dispute settlement mechanisms. The region sorely lacks effective dispute settlement mechanisms, but some assistance may come from the FTAA. Assuming a comprehensive and functional FTAA, it is likely that the center of gravity for dispute settlement for many regional trade-related issues would move to this arena, which would have, at least in the medium term, more credibility, more coverage in terms of precedent setting, and more enforcement capacity than subregional arrangements (as does the dispute settlement mechanism under the WTO). However, if there is progressive deepening in the subregions beyond FTAA commitments, there will be a corresponding urgency to make subregional dispute settlement mechanisms more robust and to use them more frequently. Deepening integration creates many other

institutional demands as well, ranging from mecha-

how much member countries are prepared to deepen

nisms for common customs collection and distribution (for customs unions)/ to agencies that can certify mutu-

their agreements to the extent that it would make sense to put the complex and politically challenging issue of

ally recognized technical standards and other regula-

monetary union on the table. However, given the

tions, anti-trust policy and different forums for policy

potentially endogenous nature of the optimal currency

coordination.

One institutional area of particular

area criteria, and provided there is political will and

importance is member government support and over-

leadership to advance toward deeper integration, the

sight of a well trained and funded, career-oriented

idea merits continued exploration.

professional Technical Secretariat. The goal should be

A less ambitious intermediate option could be

to strengthen a lean expert group so that it can sys-

to try to limit exchange rate volatility, perhaps as a first

tematically cultivate the respect of the national official

step on the road toward a monetary union. The ques-

and private sectors and thereby credibly monitor and

tion is, what is the best way to accomplish this? There

help implement disciplines; technically support intra-

seems to be broad agreement that a system of

and extra-regional negotiations; and even propose a

exchange rate bands such as the European Monetary

future road map for new collective commitments and cooperation. The other part of the equation is to have

System would be unfeasible in a world of high capital mobility. A less demanding form of coordination would

competent national counterparts and high-level politi-

simply involve members of the agreement avoiding the

cal leadership—particularly in the largest market part-

coexistence of inconsistent regimes such as pegs and

ners—with a forward-looking vision of where regional

floating regimes. For example, were all members to

integration should go and a strong commitment to fully

adopt flexible regimes with similar inflation targets, this

and voluntarily comply with the regional commitments

could contribute to reducing exchange rate volatility.

approved by the governments. • One major obstacle to the smooth function-

Sharing information,

increasing transparency and

adopting common standards to allow easier compari-

ing of subregional integration agreements has been

son of data across countries also seem to be warrant-

macroeconomic instability. Crises in the member coun-

ed. Beyond this, some suggest the need for coordinated

tries and large exchange rate swings may stress the

targets a la Maastricht on inflation, fiscal deficits, cur-

relationship among partners and erode political sup-

rent account deficits and credit to the public sector, an

port for integration. Some form of macroeconomic

approach that some subregions have already very ten-

coordination may be required to keep the impetus for

tatively explored. Others are skeptical about such tar-

integration at the subregional level alive. Macro coor-

gets, and suggest a more institutional approach, such

dination has its costs, however, as it entails the sacrifice of some of the government's discretion, for example, on fiscal or monetary policy. So what should countries do?

as strengthening budget institutions and making central

One alternative is to do nothing. But while this

banks independent. But why not consider doing both? Beyond macro coordination, other measures that could help support a less volatile environment

may not be an obstacle for further integration in agree-

include transitory commercial compensation mecha-

ments that are not particularly affected by these prob-

nisms in the face of abrupt swings in exchange rates,

lems, in agreements where members are subject to

as well as regional financial monitoring units and

substantial instability, this option may be tantamount to

regional funds to provide financial support in the event

abandoning the subregional agreement and blending

of substantial negative shocks or to set up incentive sys-

into the FTAA. At the other end of the policy spectrum

tems for compliance with regional targets. This is clear-

is the creation of a monetary union, although most inte-

ly an area where international financial institutions

gration agreements in the region do not appear to be

might be able to help.

good candidates in terms of the criteria developed by

International financial institutions also could

the literature on optimal currency areas. A possible

assist by systematically adopting a regional perspec-

exception is the Central American Common Market,

tive when supporting national programs that anticipate

particularly if the currency is linked in some way to the

the effects of those programs on partner countries and

U.S. dollar. More importantly, it is not clear at this point

on the regional commitments that the country has

Reqional Inteqration: Summary and Aqenda

CHAPTER

assumed. And, of course, moving towards a more socially efficient international financial architecture, while not directly related to integration, would certainly support the new regionalism.

Maximizing Benefits from Regional Integration Agreements Foreign Direct Investment While integration may bring more foreign direct investment, the benefits to the members of regional agreements may not be evenly distributed. In order to get the most out of the FDI that can potentially be attracted by such agreements, countries and subregions should strive to improve their institutions (particularly those involved with compliance with the rule of law), and reduce excessive regulation. Both of these dimensions have been shown to play a major role in attracting foreign investment. Countries should also upgrade the quality of education. While an educated labor force may not necessarily lead to more overall FDI (others may attract it on the basis of low wages, for example), it will affect the quality of FDI (in more advanced sectors, with more potential for technological spillovers) as well as the country's capacity to absorb these spillovers, and thus get the most out of the FDI that is attracted. Policies such as performance requirements for foreign investment (for example, domestic content of inputs), which have been used in the past to try to increase the benefits from FDI, have proven to be ineffective, leading to loss of FDI inflows. They are even less likely to work in the context of regional integration, which expands the location opportunities for multinationals, and shifts the center of gravity from strategies to serve protected domestic markets to global production networks. In this context, national treatment of multinationals seems more than ever to be the way to go. Meanwhile, integration agreements must avoid costly incentive wars that can shift the distribution of benefits in favor of the firm to the detriment of the host countries. Although this is by no means an easy task, it is important to explore mechanisms to coordinate the incentive schemes to attract FDI.

Enhancing Productivity and Competitiveness The evidence included in this volume based on the experiences of Mexico under NAFTA and Brazil under Mercosur suggests that trade and investment can be important catalysts for productivity gains. While the channels through which trade and FDI matter seem to be different in these two cases, one story that emerges is that their impact on productivity is greater when countries integrate with partners in the North. This does not mean that countries such as Brazil should abandon their subregional agreements; rather, it means that if the full range of potential benefits from integration in terms of productivity and growth is to be reaped, this strategy should be complemented by linking up with industrialized countries, be it through the FTAA, the Mercosur-EU Inter-regional Association Agreement, or further opening up at the multilateral level. These strategies need to be complemented with domestic policies to enhance productivity, including strengthening and modernizing credit and labor markets, upgrading institutions to generate an enabling environment for firms to operate in, upgrading the qualify of education and the quality of infrastructure, and setting policies that allow firms to take advantage of information technologies.1 These competitiveness issues should also be addressed at the regional level. The European Union has addressed them both internally and externally by including cooperation in areas of competitiveness in its bilateral Inter-regional Association Agreements. This approach may be something to be emulated in the case of integration initiatives in the Americas, where there has been far less cooperation on issues of competitiveness. Opportunities for cooperation at the subregional level are many. For example, countries could cooperate on issues of technology and research and development, particularly when the appropriate technologies cannot easily be adapted from those used in industrial countries. An example would be the development of technologies for tropical agriculture, which are very different from those that are appropriate in temperate climates. Another dimension with potential

See the 2001 edition of the Economic and Social Progress Report on competitiveness.

gains from cooperation is the marketing of products

vulnerable groups, delaying the dismantling of protec-

from the subregion in international markets, such as through the joint use of distribution channels. It may be

tion creates new generations of potential workers with misaligned skills.

difficult for individual countries to adequately carry out

• Measures to address regional inequality. In

these and other activities, either because of their

addition to its effect on wage inequality, integration

regional public good character, or the lack of adequate

may also intensify regional inequality within a country.

human resources at the individual country level.

In Mexico, for example, border cities and towns along

And the Losers?

were the main beneficiaries of NAFTA. Thus, develop-

the main highways connected to the northern border ing the national transportation infrastructure may be Given that theory and experience show that properly

key to ensuring that the benefits of integration are

designed trade and integration initiatives can generate

more evenly distributed geographically. Indeed, Mexi-

net benefits, but these benefits are not distributed

co's participation in the PPP is designed in part to bring

equally, social policy prescriptions in this area must

the benefits of integration more fully to the southern

focus on how to protect the losers, and how to facilitate

half of the country.

the adjustment process in the labor market. Policies that

• Public awareness that opening up by coun-

can be implemented to protect those who lose out in the integration process include the following:

tries in the South must be matched by the dismantling of trade barriers in the North. Liberalization in the

• Training and job search programs that can

agricultural sector, in particular, is critical to making

smooth the transition and help displaced workers

free trade work for the poor. Poverty tends to be con-

become more productive sooner. The availability of

centrated in rural areas throughout the region. Bound

effective programs of this type in advance of further

tariffs of the OECD countries for agricultural products

liberalization or integration initiatives may also help

are four times higher than those for industrialized

lower worker fears regarding integration, and may

goods. Meanwhile, trade-distorting

thus help consolidate political support for such policies.

equivalent to $700 million a day, almost four times all

A recent example is the United States, where approval

official development assistance. Ongoing trade barri-

of trade promotion authority was accompanied by a

ers, domestic support policies and subsidies for agri-

number of initiatives to protect displaced workers.

culture in the developed world keep the world price of

subsidies are

• Unemployment insurance and workfare pro-

commodities artificially low, which effectively blocks a

grams. Unemployment insurance programs should be

path out of poverty for the approximately 20 percent of

carefully designed to avoid providing disincentives for beneficiaries to go back to work. In turn, workfare pro-

families in the region whose main livelihood comes from agriculture.

grams, in which participants receive a minimum wage in exchange for work, should be implemented in a transparent way in order to avoid politically motivated allocation.

Regional Cooperation ana1 Institutional Strengthening for Trade and Integration

• Social safety nets. While desirable tools,

Regional cooperation for institutional capacity-building

safety nets should not be targeted specifically to those

in integration and trade is critical, but its delivery is still

directly hurt by the process of liberalization. They

very much a work in progress.

should be available to all those in poverty, regardless of its direct cause.

Removing this bottleneck requires more effective coordination and less compartmentalization

• Improvements in education. A labor force

action between donors and financial agencies that pro-

with a broad set of skills will be in a better position to

vide technical assistance, and between them and the

take advantage of the opportunities afforded by glob-

ministries responsible for trade-related issues and

alization, and to weather the adjustments from

related economic adjustments. Moreover, since trade

changes in international prices and advances in tech-

agendas and adjustment problems greatly overlap

nology. While it is tempting to protect highly vocal or

between the major existing agreements and ongoing

Regional Integration: Summary ana Agenda

CHAPTER

trade negotiationsâ&#x20AC;&#x201D;on the FTAA and with the EU, Asia and the WTOâ&#x20AC;&#x201D;the benefits of any specific regional or subregional exercise in capacity-building spill over to other arenas in terms of promoting better agreements. Given these externalities, more centralized coordination in the delivery of financing and assistance might be advisable, perhaps organized around subregions where needs are generally relatively more homogeneous. One way to foster coordination would be for countries to develop (and be assisted where necessary) national action plans for their most pressing capacitybuilding needs in trade, integration and related economic adjustment. This exercise would lay out specifics of institutional capacity-building in terms of priorities, costs, optimal sequencing and timetables for action. It would also serve to better discipline the requests of countries for assistance and the offers of donors and financing agencies that supply it. Development of national strategies would serve another purpose as well: it would mainstream trade and integration in national development agendas and in external financial institutions. All too often, the needs of ministries responsible for trying to harness the forces of trade and integration are at or near the end of the list in countries' pipelines for loans and grants in support of institutional capacity-building. Given that negotiations and implementation of these major trade agreements will regulate much of the interaction between the private sector and the world economy over the coming decades, much higher priority is

merited for strengthening these institutions. This requires effective coordination between those ministries that manage the process and those that regulate their access to external financing.

Multilateral Liberalization and the Doha Development Agenda While not part of the focus of this study, the link between successful regionalism and a healthy multilateral system is fundamental. First, progress in Geneva on certain key negotiation topics such as agriculture and anti-dumping could condition advances in similar topics in the FTAA negotiations, as well as those taking place with the ED and Asia. Second, the Doha Agenda includes negotiations regarding regional rules, which regulate the link between regionalism and the multilateral system, and which have ample room for improvement. These negotiations should clarify issues such as restrictions on the formation and implementation of common external tariffs, preferential rules of origin in regional integration agreements, and mechanisms to encourage compliance with agreed-upon timetables in terms of commitments to such agreements. The bottom line is that success in the Doha Development Agenda is not only strategically critical for Latin America, but also a key to ensuring continued progress on a system of open regionalism, one that constitutes a building "bloc," not a stumbling "bloc," towards global free trade.

Dimensions of Regional Inteation

i^mi

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THE NEW REGIONALISM IN LATIN AMERICA

The dual forces of globalization and regionalization were very much at work during the 1990s. Globalization was in fact quite evident in the sharply increasing participation of international trade, finance and foreign direct investment flows in the world product, the strong presence of multinational corporations, and the increasing importance of immigration flows and worker remittances to their home countries (Table 2.1). Alongside this globalization process was increasing evidence of regionalization. While limitations on data make it more difficult to fully document regionalization, the picture emerges very clearly in trade. Regional patterns of international trade have been steadily growing. By the end of the 1990s, two-thirds of European merchandise trade was with European countries, while the comparable figures for the Asian-Pacific and Western Hemisphere were 40 percent and 50 percent, respectively (Table 2.2). The centrifugal forces of globalization and the centripetal dynamics of regionalization may at first blush appear contradictory. However, they are increasingly interpreted as complementary forces of private market development (Oman, 1998). Indeed, the two processes are being driven by many of the same factors. Advances in the technology of transport, communications, information and other areas have rapidly extended the global reach of market activity, just as they did in the 19th century. The process of globalization is in fact far from a new phenomenon. Economists have identified the early 19th century as the start of globalization, interrupted by the Great Depression but renewing itself in

the post-war period. Then, as well as now, there was a sustained and marked increase in the international flows of goods, capital and people. Indeed, some flows such as labor migration were far superior than today, while it took much of the post-war period for capital and trade flows to exceed those recorded a century earlier (Williamson, 1997; Rodrik, 1997; and Crafts, 2000). At the same time, the post-war evolution of production technology has increased the relative demands for flexibility, timely supply, and decentralized responses to demand and tastes. This also creates economies of agglomeration that have encouraged regionalization of production, even for firms with a global strategy (Oman, 1998; Humphrey and Schmitz, 2000). Policy also has been driving the dual forces of globalization and regionalization. Post-war unilateral liberalization and deregulation, as well as successive multilateral rounds in the General Agreement on Tariffs and Trade (GATT), have freed global trade and finance from the administrative restrictions of the inter-war period, while legal (and varying degrees of tolerance for illegal) cross-border movement of people has noticeably increased immigrant participation in many workforces. Deliberate policy also has driven regionalization. An increasing number of countries are relying on formal regional integration to mediate the forces of globalization. During the 19th century, nation states mediated the global economy directly. However, the collective economic turmoil of the inter-war period induced countries to cooperate and lay the groundwork for the creation of the multilateral system that we

Chapter

CHAPTER

Table 2.1

Globalization Indicators, 197O-99

Indicator Trade (% of GDP) OECD Africa Asia Latin America 1

1970

25.6 49.9 10.2 22.3

Capital flows Gross private capital flows (% of GDP, PPP) World High-income OECD Latin America Gross foreign direct investment (% of GDP, PPP) World High-income OECD Latin America Memorandum item Gross value of foreign capital stock (% of GDP) Developing countries2 Migrations and remittances Migration flows European Union immigration rate3 U.S. immigration rate4 U.S. population percentage Hispanic or Latino Receipts of workers' remittances (balance of payments, % of GDP) Latin America

1980

1990

1999

39.5 60.1 26.2 30.2

37.1 52.6 38.3 28.4

41.1 61.3 53.5 35.6

6.3 7.1 4.7

11.8

8.3

18.3 28.2

3.9

7.3

1.0 1.3 0.6

2.2 3.3 0.4

4.6 7.0 3.0

21.7

10.9

2.4

1.5 2.1 6.4

2.8 3.1 9.0

12.5

0.2

0.4

0.7

2.4 3.6

Latin America corresponds to the Western Hemisphere definition of the IMF. The figure for 1970 refers to 1973; the figure for 1999 refers to 1998. See Maddison (2001). 3 Net migration is estimated on the basis of the difference between population change and natural increase (corrected net migration). Annual rate is per 1,000 EU population. The figures for 1960 to 1980 refer to EU-10. 4 The annual rate is per 1,000 U.S. population; 1980 refers to 1971-80; 1990 refers to 1981-90; 1999 refers to 1991-98. Sources: IDB calculations based on World Bank (2001); U.S. Bureau of the Census; Eurostat; and IMF data. 2

know today, which is designed to promote an international environment conducive to more stability and to expand participation in the world economy (James, 2001). This was further complemented by a web of bilateral agreements between countries covering any number of issues. But as the forces of globalization have gathered force, there have been additional policy responses. These have included decentralization in administration by nation states (IDB, 1997), which has allowed local adaptation to the challenges of globalization, and formal regional integration initiatives. Although regional integration initiatives have a long history in the world economy, there has been a remarkable expansion of this activity in recent years, especially since 1990. Between 1948 and 1979 some 54 regional integration initiatives were notified to the GATT, then another 15 during the 1980s. However,

during the 1990s there was a virtual explosion of new agreements that dwarfed past notifications (Figure 2.1). While there are various reasons for pursuing regional integration, many can be summarized as steppingstones to more effective participation in the multilateral trading system and a globalizing world economy.

REGIONAL INTEGRATION IN LATIN AMERICA At the level of policy, the Latin American and Caribbean region has simultaneously pursued the global and regional paths. Sparked by the economic crisis of the 1980s, the region began to undertake ambitious structural reforms. These included unilateral policies to open up economies to the rest of the world

The New Regionalism in Latin America

Table 2.2

Infra-regional Trade Shares, 198O-2OOO

Region Asia Pacific Cooperation Forum (APEC) 1 European Union and Eastern Europe2 European Union Western Hemisphere Asia Pacific3

1980

1990

1999

2000

55.1 57.5 57.2 44.6 33.4

63.8 65.6 64.5 44.1 32.9

68.4 66.1 62.0 53.0 38.9

68.6 64.2 60.0 53.3 40.6

Note: Infra-regional trade shares are simple averages. 1 Includes Australia, Brunei, Canada, Chile, People's Republic of China, Hong Kong, Indonesia, Japan, Republic of Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Chinese Taipei, Thailand, United States and Vietnam. 2 Includes the European Union plus Bulgaria, Czech Republic, Hungary, Poland, Romania and the Slovak Republic (Czechoslovakia replaces the Czech and Slovak republics prior to 1993). 3 Includes Brunei, Singapore, Thailand, Malaysia, Indonesia, Philippines, Cambodia, Laos, Myanmar, Vietnam, China, Japan, Korea, Australia and New Zealand. Source: IDB calculations based on IMF (2001).

Figure 2.1

Number of Regional Agreements Notified to GATT/WTO, 1 948-2OO2

Note: The data consist of agreements that have notified to GATT/WTO under Article XXIV and under the Enabling Clause. Some agreements included are no longer in force. Accessions to existing agreements are counted in their own right. The data are organized by year of entry into force of the agreement. Source: WTO Secretariat.

and deregulate them in order to provide more space for private sector activity. As an illustration, average

Figure 2.2

Openness Coefficient (Trade as a percent of GDP)

Note: The openess coefficient is a simple average. Source: World Bank (2001).

ments are in different stages of negotiation (Table 2.3). These trade policies are reflected in trade per-

tariffs in the region declined from over 40 percent in

formance. The global opening of the region's

the mid-1980s to about 12 percent in the mid-1990s.

economies contributed to average annual growth of

This was combined with participation in the multilater-

extra-regional trade exceeding the expansion of world

al Uruguay Round and assumption of its very compre-

trade (10.8 percent vs. 6.6 percent) in the 1990s,1 with

hensive disciplines. The region complemented this

growth of imports notably faster than that of exports

global opening with a web of new regional integration initiatives窶馬early 30 since 1990, ranging from free trade areas to customs unions with ambitions of becoming a common market. Any number of other agree-

1 Without Mexico, Latin America's extra-regional trade was 7.8 percent.

(Percentage of infra-regional trade/total trade)

CHAPTER

Table 2.3

Latin American Integration

Figure 2.3

Agreements

Intra-subregional Trade Share (Percent of total trade)

Infra-regional Free Trade/ Customs Union Agreements Central American Common Market (CACM) Andean Community (AC) Caribbean Community (CARICOM) Southern Cone Common Market (Mercosur) Chile-Venezuela Colombia-Chile Costa Rica-Mexico Group of Three (G-3) Bolivia-Mexico Chile-Mercosur Bolivia-Mercosur Mexico-Nicaragua CACM-Dominican Republic Chile-Peru Chile-CACM Chile-Mexico Mexico-Northern Triangle of Central America CARICOM-Dominican Republic Costa Rica-Trinidad and Tobago El Salvador-Panama

North-South Agreements Mexico: NAFTA Chile-Canada Mexico-European Union Mexico-EFTA Mexico-Israel Costa Rica-Canada Chile-European Union

Negotiations in Progress Infra-regional Free Trade Agreements Mercosur-AC Costa Rica-Panama Mexico-Panama Mexico-Peru Mexico-Ecuador Mexico-Trinidad and Tobago

North-South Agreements Free Trade Area of the Americas (FTAA) Mercosur-European Union Chile-EFTA Chile-United States CARICOM-European Union (post-Cotonou reciprocal arrangements) Central America-4-Canada CACM-United States Uruguay-United States Mexico-Japan Chile-South Korea

Others

I9601 19691 19731 1991 1993 1994 1994 1994 1994 1996 1996 1997

19982 1998 1999 1999

2000 2000 20022 20022

Notes: Percentage represents a simple average. Source: IDB calculations based on IMF (2001).

(12 percent vs. 9.7 percent) (IDB, 2000). Figure 2.2 shows that the region's openness coefficient also rose over the same period, but is still very low relative to

1992 1996 1999

2000 2000 20012 2002

other trading areas. Pointing up the regionalization of trade, Latin American subregional trade grew considerably faster than extra-regional trade (Figure 2.3). Comparing 1990 to 2000, Figures 2.4 and 2.5 show a marked increase in the relative importance of intraregional trade, with subregional trade agreements being the primary vehicle for the countries that are members of them. Box 2.1 summarizes the main characteristics of the subregional integration agreements and Box 2.2 provides a more detailed review of the Caribbean Community (CARICOM) as an illustration of the deep integration objectives that characterize all the Latin American initiatives. Incorporating the North American market into the picture shows that its importance for Latin America also was on the rise in the 1990s. On the whole, then, the relative importance of the Western Hemisphere in the region's trade increased, largely at the expense of the European Union (EU).2 Hence, the 1990s exhibit a clear pattern of intensifying regionalization of Latin American trade. Meanwhile, Brazil, Chile and a few

Brazil-China Brazil-Russia 1 2

Relaunched in the 1990s. Awaiting ratification.

For a more detailed analysis, see IDB (2002).

Date of signature

The New Reqionalism in Latin America

Geographical Composition off Trade Flows, 199Q (Percent of total trade with selected countries or regions)

Source: IDB calculations based on IMF (2001).

Figure 2.5

Geographical Composition of Trade Flows, 2OOO (Percent of total trade with selected countries or regions)

Source: IDB calculations based on IMF (2001).

CARICOM countries display a pattern of a more glob-

erential elimination of tariffs among partners and more

al character.

secure market access than that which is offered by the

of Latin America. They include the unilateral opening

rest of the world. Regionalization

of economies, which exposed borders and allowed for

While data are extremely limited and values relatively

the natural pull of geography and common culture and

low compared to extraregional flows, there are indica-

tastes to take hold. But policy-induced regionalization,

tions of increased intra-Latin America investment flows

or regionalism, has also played a role through the aforementioned creation of regional integration agree-

during the 1990s (Garay and Vera, 1998). Meanwhile, NAFTA has been a magnet for U.S. foreign

ments that have provided for, among other things, pref-

direct investment (FDI). Mexico experienced a marked

Many factors have driven the regionalization

has gone beyond trade.

Figure 2.4

CHAPTER

Box 2.1

2 Main Subregional Integration Agreements in the Americas

Andean Community

Central American Common Market (CACM)

Members: Bolivia, Colombia, Ecuador, Peru and Venezuela. Established: The Cartagena Agreement was signed by Bolivia, Chile, Colombia, Ecuador and Peru in May 1969. Venezuela acceded in February 1973 and Chile withdrew in October 1976. Goals: The founding agreement envisaged an Andean customs union as a step towards the creation of a Latin American common market. During the latter half of the 1970s, the integration process lost momentum and was revived in the 1990s when member countries re-launched a common market project. They completed the free trade area by 1992 and agreed on the implementation of a common external tariff. In 1996, the newly institutionalized Summits of the Andean Presidential Council gave fresh impetus to the process and set the stage for the adoption of the Trujillio Protocol that created the Andean Community (it was the Andean Group until then) based on a new functional and more modern institutional structure. Along with institutional renewal, the parties progressively agreed on a timetable for the reincorporation of Peru into the free trade area (suspended since 1992), committed to creation of a common market by 2005, and started the negotiation of a new four-tier common external tariff expected to be in place by the end of 2003. Status: The Andean Community is one of the most institutionalized regional agreements among developing countries. The intra-regional Trade Liberalization Program ended in the completion of the free trade area between Bolivia, Colombia, Ecuador and Venezuela in 1993. Internal free trade applies across the board on the entire universe of tariffs. Peru has been implementing a liberalization program since 1997 that aims at unrestricted internal free trade by 2005. The common external tariff (CET) that entered into force in 1995 between Colombia, Ecuador and Venezuela is structured in four tariff levels (5, 10, 15 and 20 percent) with a nominal average rate of 13.6 percent. Individual countries are allowed to diverge from the CET in certain products, while sectoral exceptions are determined by the implementation of special regimes in the agriculture and the automotive sectors. Some progress on macroeconomic coordination is reflected in the setting of convergence targets for inflation and the public deficit.

Members; Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua. Established: The General Treaty on Central American Economic Integration was signed by Guatemala, Honduras, El Salvador and Nicaragua in December 1960. Costa Rica acceded in July 1962. Goals: The general treaty envisaged the creation of a common market, originally scheduled to come into effect within five years of the agreement's entry into force. After an extremely promising first decade of integration, the process became strained by political conflicts in the member countries and by the debt crisis. It was revived in 1993 with the subscription of the Guatemala Protocol, which provided new foundations for economic integration in the framework of the Central American Integration System. The protocol introduced the principles of gradualism, progressivity and flexibility in the achievement of the full integration of the CACM. Building on these criteria, the members subscribed an agreement for the implementation of a customs union by the end of 2003. Belize and Panama have joined the political body of the integration system. Status: Most intra-regional trade is tariff-free, with the common exception of coffee and sugar and a few other exceptions in the bilateral trade of agricultural goods. El Salvador, Guatemala and Honduras have set up joint customs facilities, and the Puebla-Panama Plan contemplates further simplification of border procedures, the removal of non-tariff barriers in phytosanitary controls and technical standards, and greater integration of infrastructure. Member countries have agreed to a four-tier tariff schedule (0, 5, 10, and 15 percent), with some sectoral and national exceptions and an average level of about 7.5 percent. About 80 percent of the common external tariff has been implemented. Latin American Integration Association (ALADI) Members: Argentina, Bolivia, Brazil, Chile, Colombia, Cuba, Ecuador, Mexico, Paraguay, Peru, Uruguay and Venezuela. Established: The 1980 Treaty of Montevideo established ALADI as a successor to the Latin American Free Trade Association (LAFTA). Goals: To increase bilateral trade among member countries and between members and third countries through bilateral and multilateral agreements. The treaty envisaged an economic preference area for goods from member states and partial agreements

The New Reqionalism in Latin America

North American Free Trade Agreement (NAFTA) Members: Canada, Mexico and the United States. Established: The agreement was signed in December 1992, ratified by the three national legislatures in 1993, and entered into force in January 1994. Goals: NAFTA aims to eliminate trade barriers, facilitate the cross-border movement of goods and services between the countries, promote fair competition in the free trade area, substantially increase investment opportunities, and provide effective protection and enforcement of intellectual property rights. Import duties on virtually all goods will be eliminated by 2008 at the latest. NAFTA is supplemented by two additional side agreements on environmental and labor standards. Status: The trade liberalization program has been implemented according to schedule, or earlier. An April 1998 meeting of the Free Trade Commission agreed to remove tariffs on some 600 goods as of August of that year, thereby eliminating many tariffs 10 years earlier than originally envisaged. Over 90 percent of goods are currently tariff-exempt.

Southern Cone Common Market (Mercosur) Members: Argentina, Brazil, Paraguay and Uruguay. Established: The four member states signed the Treaty of Asuncion in March 1991. Goals: The integration of the members states into a common market through the free circulation of goods, services and factors of production; adoption of a common external tariff and a common trade policy; coordination of macroeconomic and sectoral policies; and legislative harmonization in areas conducive to stronger integration. Status: The Trade Liberalization Program progressively, linearly and automatically lifted intra-regional tariffs establishing a free trade area, with significant exceptions, in 1994. Moreover, a common market project was established with completion of internal free trade by 2000, a goal that has been delayed due to serious economic difficulties in the member countries. A common external tariff (CET) organized in 11 tiers with tariff rates ranging from 0 to 20 percent and an average level of 13.5 percent entered into force in 1995. The CET is imperfect, as there was a phase-in for selected national exceptions. Moreover, special customs regimes apply to the sugar and automotive sectors, although the latter has entered Mercosur under conditions still being negotiated. Common regional provisions covering trade in services, safeguards, anti-dumping and dispute settlement have been approved but only partially implemented. In 2000, the Common Market Council (CMC), the executive body of the Mercosur, agreed on a working program focused on the lifting of residual market access barriers. National exceptions to the CET were extended until December 2002. In 2001, the CMC allowed Argentina to exceptionally and temporarily derogate the application of the CET until December 2002.

increase in flows from North America, which averaged

ber of Latin American countries, worker remittances

more than $6 billion annually between 1994 and

are a more important source of foreign exchange than

1999, compared to about $2 billion in the years pre-

FDI or aid flows (MIF, 2001). There has also been

ECLAC, 1998).

increasing regionalization of functional cooperation

Labor migration to the United States from Latin Ameri-

arrangements, a topic that will be examined later in

ca has been growing significantly. So have workers'

this and other chapters.

ceding that (Lopez-Cordoba, 2001;

remittances to south of the border; indeed, for a num-

aimed at fostering economic complementarity, trade promotion, agricultural commerce, and scientific and technological cooperation. Status: Currently, 40 partial scope agreements involving two or more countries are in force in the ALADI framework, most of which were signed in the 1990s.

CHAPTER

Box 2.2

The CARICOM Single Market and Economy: Current Status and Pending Issues

Members: Antigua and Barbuda, the Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, and Trinidad and Tobago. In 1989, the members of the Caribbean Community (CARICOM) agreed to create a CARICOM Single Market and Economy (CSME) that entailed the removal of obstacles to trade in goods and services; the free movement of skilled persons; the end of restrictions on capital movements; a common external tariff (CET) and common trade policy; and greater coordination in other areas of economic policy. Nine modifying protocols to the CARICOM's founding treaty aim to facilitate completion of the CSME. These cover its Institutional Framework (Protocol I); Establishment, Provision of Services and Movement of Capital (II); Industrial Policy (III); Trade Policy (IV); Agricultural Policy (V); Transport Policy (VI), Disadvantaged Countries, Regions and Sectors (VII); Competition Policy (VIII); and Dispute Settlement (IX). Four of the protocols have entered into force (I, II, IV and VII) and three (III, V and VI) are being applied provisionally by most members. Most countries have signed Protocols VIII and IX, but only one has applied them provisionally. The process of institutional change mandated under Protocol I has been completed and CARICOM's new political and policy-making bodies have been operational since 1997. Intra-regional trade in goods is virtually free: all tariffs and most unauthorized quantitative restrictions have been removed. Trade is affected by some revenue replacement taxes and by authorized exemptions from the free trade regime. Protocol VIII permits anti-dumping actions and the CARICOM Secretariat is drafting model legislation for those countries that lack a modern anti-dumping law. Export subsidies, now prohibited, must be removed before 2003. Efforts have been made to harmonize national customs laws, but member states have yet to implement the corresponding legislation. CARICOM has instituted a regime governing common standards for trade in goods, and is establishing a Caribbean Regional Organization for Standards and Quality (CROSQ). The CET is fully implemented in 10 of 15 countries, with several national exceptions. Additionally, maintenance of a common tariff on third country imports is affected by the right of member states to negotiate bilateral trade agreements with third countries. Protocol

IV lessens the flexibility for bilateral initiatives by obliging members that negotiate such accords to seek the approval of the Council for Trade and Economic Development when tariffs are being negotiated. CARICOM nationals engaged in industrial, commercial and professional non-wage activities are accorded the right of establishment anywhere in the CSME. Member states are to remove all obstacles in this area by 2005. The same deadline applies to the full liberalization of intraregional services trade. In linking intra- and extraregional policies, Protocols II and IV have extended CARICOM's capacity to devise and apply joint policies on trade in goods and services. Members have created a joint mechanism for external trade negotiations, the Regional Negotiating Machinery (RNM). As regards the free movement of capital, Protocol II foresees the removal of restrictions on banking, insurance and other financial services, and on capital and current transactions, as well as greater coordination of foreign exchange policies. Some progress has been made on the cross-listing and cross-border trading of securities on stock exchanges in the region; on reducing or abolishing exchange controls; and on upgrading stock exchanges to facilitate trading and settlement. The free movement of people is limited to certain professional categories. The need for university graduates, media professionals, artists, musicians and athletes to obtain work permits is to be eliminated by 2003. Member states have agreed to establish a CSME accreditation system with harmonized standards for certification, mutual recognition of qualifications, and a regional accreditation body. An agreement on the transfer of social security benefits entered into force in 1997, but not all countries have enacted the corresponding legislation. A CARICOM identity card is to be issued by 2003 for all intra-regional travel. Member countries have sought to harmonize regulatory frameworks. Efforts are also being made to enhance coordination on fiscal, industrial, agricultural and transport policies. Success will depend partly on CARICOM's ability to mobilize the necessary technical and financial resources. Financing is also needed to establish a fund to assist the less developed countries and to effect other institutional changes such as the creation of the Caribbean Court of Justice (CCJ), a competition commission (to ensure adherence to business rules), and the various legal bodies envisaged under the new dispute settlement mechanism.

The New Regionalism in Latin America

THE NEW VERSUS THE OLD REGIONALISM

rents; and marginal interest in the GATT and the multi-

The contemporary wave of regionalism has been

tries were members during the 1950s, and that number

coined the "new regionalism" (Ethier, 1998; ECLAC,

increased only to 11 by the end of the 1960s).

1994).3 However, regionalism itself is not new for Latin

On the basis of these assumptions, develop-

America. In fact, some of the first initiatives after many

ment strategies promoted infant industries behind high

countries gained independence involved proposals for

levels of external protection, deployed state economic

political union. There also are a number of historical

planning with a leading role for public enterprises in

attempts at economic integration. Indeed, this latter

strategic sectors, and demanded regulation of FDI.

type of regionalism was quite widespread in the early

While the world economy began to rebuild

post-war period, with the formation of ambitious initia-

itself in the early post-war period with gradual process-

tives such as the Latin American Free Trade Association

es of liberalization and recovering flows of interna-

(South America plus Mexico), which evolved into

tional trade and finance, Latin America's growth

ALADI, the Central American Common Market, the

performance began to flag, initially for the smaller

Andean Group (a common market project that evolved

economies and later for the others. But the develop-

into the Andean Community) and the Caribbean Free

ment model, perhaps victim of its own success, was not

Trade Association (later CARICOM, also a deep inte-

fundamentally questioned.4 Rather, the prevailing

gration project).

diagnosis of the time was that the small domestic mar-

What is new about the current wave of region-

kets had exhausted possibilities for efficient ISI and

alism is the objectives, modalities and outcomes. This can

there was a need for a larger market environment in

be seen by contrasting the stylized facts of the pattern.

order to achieve the efficiencies of economies of scale, especially in heavy industries that were at the core of

The Old Regionalism

this strategic approach.

Latin America led the way with import-substitution

tion emerged as one of the potential strategic tools for

industrialization (ISI) development strategies that dom-

strengthening ISI. Oversimplifying,

In the development debate, regional integrathe approach

inated early post-war development policy and theory.

aimed to eliminate trade and investment barriers

This approach had its seeds at the start of the 20th cen-

among partner countries, maintain or even raise pro-

tury in some variations of the then dominant liberal

tection against third parties, extend planning and state

economic policy, but gained full expression in the

intervention to a regional level, regulate foreign direct

Great Depression when private markets and interna-

investment, and support all of this with a collective insti-

tional trade and finance collapsed and governments

tutional architecture in which the emerging European

throughout the world dramatically raised protectionist

integration project was a clear point of reference. The results of these early regional economic

barriers. In the face of these developments, Latin American countries also raised their barriers and govern-

integration initiatives were generally limited in terms of

ments undertook a much more direct role in the

sustained regional tariff liberalization and trade and

economy in order to stimulate investment and growth

investment flows, with Central America being some-

during these difficult years.

thing of an exception for a while. By the mid-1970s,

The post-war arguments for an ISI strategy developed out of some prevailing assumptions, many of

the processes showed very clear signs of fatigue. Some of the key obstacles included:

which had profound roots in the experience of the Great Depression. These included pessimism about the secular trends in the external terms of trade for commodity exporters; skepticism about the entrepreneurial vocation of the private sector; faith in the effectiveness of public enterprise and state planning; fear of dependence on foreign firms and their extraction of exploitative

It was ECLAC that first documented the new approach to regionalism under the logo of "open regionalism."

As Diaz-Alejandro (1985) has pointed out, while New York was enduring the Great Depression, the mills were humming in Sao Paulo.

lateral trading system (only eight Latin American coun-

CHAPTER

• The tendency for national protectionism. The opening up of a regional market was handicapped by the national protectionism inherent in the model. Hence, regional liberalization was generally carried out by a laborious "positive lists" approach, often with results of limited scope. In effect, the strategic tool of regional integration was undermined by the very model that it was designed to rescue. • Tension between the state ana1 the private sector. On the one hand, this reflected extensive state intervention in market decisions, and on the other, the protectionist habits of the private sector. The tension was further aggravated by the top-heavy regional institutions that some of the agreements engendered. • Macroeconomic instability. The ISI model was inherently unbalanced and prone to aggravate macroeconomic instabilities, as it placed heavy demands on capital and intermediate goods imports without a corresponding generation of exports. This was aggravated by unstable commodity prices and financial flows. • Distribution of benefits. Uneven trade balances among partners created serious political tensions in the agreements. • Infrastructure. Sparse regional infrastructure was a limiting factor for growth of regional trade. • Authoritarian governments. The period was dominated by authoritarian governments that stimulated national rivalries, border conflicts and restrictions on the flow of goods, people and development of regional infrastructure. • U.S. skepticism. The U.S. government was not comfortable during this period with regional approaches, as its focus was exclusively on the multilateral system.

The New Regionalism The onset of the debt crisis in the early 1980s was a deathblow for the flagging ISI approach to development and the already faltering integration schemes that were introduced to support it. Once again, crisis was the handmaiden of a major shift in Latin America's development paradigm. The region's economic collapse of the 1980s was localized as the world economy continued to expand and world markets remained open. Moreover, by then, there were clear demonstra-

tion effects in the OECD countries and in Asia of the growth potential from opening markets and exports to the world economy. Under the pressure of a prolonged economic collapse and a shifting policy consensus, the region embarked on another historic venture involving the major structural economic reforms mentioned earlier. The defining difference between the new regionalism of the 1990s and earlier post-war experiences was the policy environment. In effect, the new regionalism was inserted into a framework of policy reform that promotes open and competitive private market-based economies in a modern democratic institutional setting. Indeed, the new regionalism was an extension of that very structural reform process that got underway in the mid-1980s (Ethier, 1998; Devlin and Estevadeordal, 2001). Perhaps the most dramatic change in character was the gradual shift during the 1990s from the traditional intra-regional focus for integration ("South-South") to growing interest in inter-regional ("North-South") agreements that commercially link industrialized countries in reciprocal free trade, often in conjunction with ambitious functional cooperation programs (Table 2.3). This would have been politically inconceivable before the new policy framework that emerged in Latin America. The new regionalism is generally viewed as having the following objectives: • Strengthening structural economic reforms. The overarching motive of the new regionalism is to create a strategic policy tool to reinforce the structural economic reform process in a period of highly competitive globalization. Countries now value greater participation in the world economy as a way to stimulate investment and growth. Regional integration is viewed as an additional policy tool to complement and strengthen national reform processes. The clearest link to the structural reform process is enhancement of commitments to trade liberalization, which has been a central feature of many developing countries' development strategies. As will be analyzed in detail in Chapter 3, regional economic integration has become the final tier of a mutually reinforcing three-tier process that also includes unilateral and multilateral openness. Regional trade liberalization has overcome many of the credibility problems of the old regionalism by working in tandem with unilateral and multilateral openness, and

The New Regionalism in Latin America

Table 2.4

Manufacturing Exports, 198O-2OOO

Market

1980

1986

1992

1998

2000

AC Intra-regional Extra-regional

29 5 36

47.5 6.9

45 5 11 3

56.0 12.8

46.5 10.1

CACM Intra-regional Extra-regional

74 3 57

72.5 10.7

63 7 17 1

59.2 36.5

54.7 38.9

Intra-regional Extra-regional

40.7 28.1

33.7 35.4

49 3 38 2

55.8 35.1

55.7 39.7

Mexico (NAFTA) Intra-regional Extra-regional

92 16 7

52.8 24.2

74 7 43 9

85.1 67.2

84 5 61 4

46.3 10.5

50.7 26.2

57 9 38 9

60.8 54.0

55.9 56.1

Mercosur

Latin America

Intra-regional Extra-regional

Note: Figures are simple averages. 1 Includes Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay and Venezuela.

it has also helped to further lower average levels of

ences and other aspects of a regional scheme can pro-

protection and improve competitiveness. Moreover,

vide new opportunities for export experience and

regional openness as a policy tool benefits from some

diversification and thereby over time serve as a strate-

nontraditional political economy considerations: the

gic stepping stone to compete more effectively in a

compensatory dimension of reciprocity, the ability to

global economy. As can be seen in Table 2.4, inter-

lock-in the reform through legally binding rule-based

regional trade has a considerably greater presence of

commitments, and the possibility of signaling liberal-

higher value-added manufactures than does extra-

ization commitments to the private sector, especially when it is not feasible to pursue further unilateral or

regional trade, which is more heavily laden with com-

multilateral openness (Fernandez, 1997). Meanwhile,

increase in the context of principal trade agreements.

regional trade agreements, especially those with deep objectives—including second-generation free trade

Regional markets also serve as an outlet for an impor-

modities. Moreover, this participation has tended to

tant array of products in which Latin America has a

goods—encourage the structural modernization of

comparative advantage—such as textiles, dairy goods, meat, and food processing—but faces persistently high

institutions directly through the disciplines they intro-

levels of international protection.

areas that go beyond traditional market access in

duce, and indirectly through the increased demands brought about through regional competition.

Thus, while the new regionalism should aim to create trade, its underlying primary objective is to build

• Economic transformation. While liberaliza-

on longer term strategic considerations arising from the

tion and increased participation in the world economy

need to overcome imperfect and incomplete markets at

are viewed as instrumental to modernizing the region,

home and abroad that put developing countries at a

countries have serious vulnerabilities because of a nar-

serious disadvantage in the world marketplace. In

row export base and insufficient competitiveness of

effect, dynamic transformation effects are sought

much of the private sector's export supply. The reciprocal openness, guarantees of market access, prefer-

through the support of preferential access to a secure, enlarged market and the more specific information

(As a percent of intra- and extra-regional total trade)

CHAPTER

Box 2.3

Why Infra-Regional Infra-Industry Trade Matters

Infra-industry trade is two-way trade in similar products. It is a widely observed phenomenon apparently at odds with the standard traditional theoretical models that explain international trade with differences in factor endowments. Building on the pioneering work of Lancaster (1979) and Krugman (1981) a "new" strand of theoretical trade literature provides a rationale for this phenomenon based on the role of economies of scale and product differentiation. The seminal index proposed by Grubel and Lloyd (1975), when computed at a sufficiently disaggregated level, can be used to illustrate the transformation of trade patterns. Table 1 presents the evolution of the Grubel and Lloyd index of intra-industry

Table 1

trade observed in intra- and extra-regional trade flows of Latin American countries or subregions.1 The index shows the dramatic impact of regional integration in the promotion of intra-industry trade. In fact, with the exception of the Dominican Republic, whose intra-industry trade relations with the United States are particularly intense even in the absence of a regional trading agreement, the index was higher in intra- than in extra-regional trade in 1997 in all countries and subregions. Through NAFTA, Mexico achieved the highest measure of regional intra-industry trade. Its levels today are comparable to those of developed economies. Mercosur and the Andean Communi-

Grubel and Lloyd Index, 1 98O-97

Market

1980

1985

AC Infra-regional Extra-regional

7.2 2.8

CAR1COM Intra-regional Extra-regional

1990

1995

1997

7.0 3.9

11.3 7.6

28.7 8.4

30.2 6.7

17.5 9.4

11.5 16.7

23.0 15.4

18.4 8.3

14.2 6.0

CACM Intra-regional Extra-regional

31.0 2.9

36.7 3.8

25.7 7.2

33.9 6.8

33.3 17.0

Mercosur Intra-regional Extra-regional

17.0 10.7

21.1 15.7

36.7 18.8

47.9 15.5

51.2 15.1

Mexico Intra-regional Extra-regional

14.4 6.4

50.2 8.8

34.4 14.6

56.8 16.5

60.0 15.3

Chile Intra-regional Extra-regional

4.4 2.1

6.3 2.1

6.3 3.5

12.2 3.2

15.7 3.3

Dominican Republic Intra-regional Extra-regional

0.3 2.0

1.1 17.3

0.8 37.3

1.9 37.5

2.3 38.5

Panama Intra-regional Extra-regional

4.2 0.2

8.6 0.4

4.7 0.7

5.0 0.2

5.5 0.3

Source: IDB calculations based on Feenstra (2000).

ty also feature an important and increasing degree of two-way intra-regional trade. In these groups, the expansion of regional intra-industry trade clearly accelerated in the last decade parallel to the implementation of new regional integration commitments. At the microeconomic level, the surge of regional intra-industry trade provides preliminary evidence of the qualitative structural transformation fostered by regional integration. In fact, as intra-industry trade typically arises in trade of differentiated industrial products, it is not only a sign of a progressive maturing of the product composition of trade, but also of an expanding matrix of quality and of an emerging functional fragmentation of productive processes among regional partners. At the macroeconomic level, the development of regional intra-industry trade alters the structure of interdependence through trade and promotes an increasing correlation of macroeconomic cycles. In fact, when national economies of an integrated regional market specialize in intra-industry trade, demand and productivity shocks affect partners in the same way. This, in turn, augments the correlation of macroeconomic cycles and points to macroeconomic policy coordination as an optimal policy choice. Another interesting feature is that intra-regional specialization along the lines of intra-industry trade assuages the political economy resistance to trade liberalization, since such trade entails smaller labor market adjustment costs than inter-industry trade. Moreover, the mobility of labor across firms and occupations might be greater within industries than between industries, rel-

ative wages might be more flexible within industries, and other factors of production might also be more mobile within industries. In this light, intra-industry trade could be one of the factors helping to explain why the new regionalism of the 1990s has been relatively better received than globalization by Latin American societies as a tool of economic and institutional transformation It is too early to precisely track the determinants of the intra-industry trade pattern of Latin American economies. Nevertheless, in the coming years, regional policymakers will probably want to nurture the development of intra-industry trade through the implementation of WTO-consistent sectoral policies.

1 For each country, the trade-weighted intra-industry trade index is calculated for each single partner i and sector j according the following formula:

where Xr and M-., respectively, represent exports to and imports from country / in product/'. Calculations were performed using data aggregated at the four-digit level of the SITC (Rev. 2). Regional figures are weighted averages of the national indexes, using the relative share of each country in the total intra- and extra-regional trade of the selected region as weight. Intraregional trade refers to trade occurring with regional partners; extra-regional trade refers to trade with the rest of the world.

flows, defined market competition and identifiable

worldwide competition between developing countries

export opportunities that come from an institutionally

to attract FDI because of its potential to improve export

organized regional platform. Over time, these advan-

networks, technological and know-how spillovers, and

tages vis-a-vis the rest of the world are expected to

institutional modernization. By creating a larger liber-

serve as a catalyst for export diversification, invest-

alized rules-based market with locational advantages,

ment, greater specialization via economies of scale

a regional agreement can distinguish member coun-

and product differentiation, and inter-industry trade

tries and help them compete for and attract FDI (Blom-

(see Box 2.3), all of which increase productivity, competitiveness, employment and growth. In the process, regional integration can also contribute to improving home markets in such areas as labor, finance and technology (Devlin and Ffrench-Davis, 1999).5 â&#x20AC;˘ Attracting foreign direct investment. There is

There is some evidence that regional agreements such as NAFTA are associated with productivity gains. Meanwhile, some sectoral case studies supported by IDB/INTAL (1999) show mixed results regarding the productive transformation effects of regional integration, ana are suggestive of both how those effects take place and how flawed policies can undermine them.

The New Regionalism in Latin America

CHAPTER

Box 2.4

2 An Emerging Opportunity for the FTAA: Hemispheric Petroleum Cooperation and Trade

The hemispheric energy imbalance presents a significant opportunity to deepen trade relations and continental integration all along the energy vector. This means not only the trade of primary energy, but also the trade of capital, technology, goods and services to produce energy-intensive goods from Latin America's large endowment of energy sources. On the one hand, the United States has a growing energy deficit, currently importing 60 percent of the petroleum it consumes: 11 million barrels daily (MBD) with a consumption level of 19 MBD. The energy gap has tripled over the past 15 years, from 3.5 MBD in 1985 to nearly 11 MBD in 2001, as consumption levels have gone up with increased economic activity, and production levels have fallen as North American reserves have been depleted. If the trends of the past 15 years continue, U.S. imports could grow by approximately 9 MBD, or nearly double, over the next twenty years. Both the magnitude and composition of imports have considerably changed in the past 15 years. At present, 50 percent of U.S. petroleum imports come from sources outside the hemisphere, while 30 percent are from NAFTA trading partners (Mexico and

Figure 1

Canada), and 20 percent from the Andean Community, particularly Venezuela. In the late 1980s, extra-hemispheric sources provided less than 30 percent of U.S. oil imports. Imports from outside the continent have quintupled in 15 years. This growing dependency presents concerns for the United States in terms of the security of supply. If net exports from the rest of the hemisphere to the United States do not increase in the future and the growth tendencies of U.S. imports continue, the country could reach an oil import dependence of up to 75 percent on extra-hemispheric sources, entailing greater security risks in terms of supply (see Figure 1). The Latin American countries, on the other hand, are net exporters of energy and have the reserves needed to cover the United States' current and future hydrocarbon import needs. Over the past 15 years, Latin American net petroleum exports have doubled from 2 MBD to 4 MBD. If production and consumption trends remain the same, Latin America's net exports could grow by 2 MBD or 50 percent over the next twenty years. However, even if we assume that all net exports from Latin American countries will go to the Unit-

Production, Consumption and Imports of Petroleui (In millions of barrels per day)

ed States, their share of total U.S. oil imports would still drop from the current level of 32 percent to 27 percent by 2020. If, on the other hand, Latin American countries want their exports to rise to 50 percent of U.S. imports by 2020, exports to the United States would need to grow by 6 MBD instead of 2 MBD. This would mean practically doubling current production over the next 20 years. There appear to be two possible scenarios for Latin American petroleum production. In the first, which we call "tendential," production and consumption levels follow the same trajectory as during the past 15 years. Consumption grows by 4 MBD, production by 6 MBD, and thus exports by 2 MBD. In the second scenario of accelerated growth, production increases by 10 MBD, and as a result, exports grow by 6 MBD.

Both scenarios would require respective investments of either $120 billion or $200 billion just to increase production. And if the costs of maintaining the increase in production were added to these investments, total expenditures in the petroleum sector for both scenarios would hit between $143 billion and $233 billion, respectively. Finally, both directly and indirectly, the impact on the regional GDP is estimated at between $200 billion and $320 billion. These numbers represent 10 percent and 17 percent of the current aggregate value of the Latin American economies in one year. This impact would be significant—greater than the impact of any other individual industrial activity in the region.

strom and Kokko, 1997). Moreover, FDI tends to clus-

nent in the launch of formal regional integration initia-

ter, so initial success can lead to more success (Ethier,

tives (Devlin, Estevadeordal and Krivonos, 2002). First,

1998). However, the strategic response of FDI to

trade usually attracts support from the relatively well-

regional agreements is very complex. The 1990s coin-

organized and financed private business communities.

cided with a boom in flows of FDI to Latin America.

Second, unlike many other economic arrangements,

There is evidence that some of this was the result of

the mutual benefits of trade agreements and their dis-

development of regional agreements such as NAFTA,

tribution can be reasonably assessed ex ante by par-

but in general other domestic market-based factors

ticipants and monitored and enforced ex post, as they

appear to have been more important (Amann and

usually contain very precise legal clauses. In addition,

Vodusek, 2001; IDB/INTAL, 1999).

the institutions for negotiating cross-border agreements

• Geopolitics. A group of like-minded coun-

and administering them are already in place through

tries can use a regional agreement to establish a safe-

trade-related ministries and established negotiating

ty net for fragile democracies, promote disarmament

fora and practice. Third, trade agreements accommo-

and peace among neighbors, and enhance bargaining

date nationalist sentiments, as they can be designed in

power in international fora. These motives were in part

ways that initially involve little concession of national

behind the decisions of Mercosur, the Andean Com-

sovereignty, as do free trade areas. Fourth, these trade

munity and CARICOM to negotiate trade agreements

agreements are subject to certain multilateral rules and

in blocs. The partners of Mercosur and the Andean

procedures in the WTO. Finally, a critical mass of

Community have collaborated to overcome threats to

regional trade among partners acts as a "hanger" on

democracy in member countries and to help resolve

which other areas of regional cooperation can be

border conflicts (Devlin and Estevadeordal, 2001).

draped. (Box 2.4).

• Functional regional cooperation. For several

Indeed, growing and mutually beneficial eco-

reasons, reciprocal preferential trade agreements are

nomic interdependence among

partners typically

a common point of departure or core strategic compo-

induces demands for additional regional economic

The New Regionalism in Latin America

CHAPTER

Table 2.5

Regional Cooperation Programs in APEC

Trade-related cooperation

Non-trade cooperation Economic Macroeconomic policy, financial stability, structural reforms, economic infrastructure, business facilitation, financial systems, free movement of investments, mobility of businesspeople, capital markets, energy, tourism, fisheries, transportation, telecommunications, small- and medium-sized enterprises, agriculture, rural infrastructure, food production and biotechnology Political Political dialogue through ministerial meetings Social and cultural Public safety, social development and gender integration Environment Environmental protection and marine resource conservation Human resources, science and technology Industrial science and technology, human resources development, knowledge and skills development, information and communications technology, and electronic commerce Other Emergency preparedness Source: Devlin, Estevadeordal and Krivonos (2002).

cooperation to exploit more fully the advantages of a

does emerge independently of formal integration, it

maturing regional market. Moreover, demands for

also can constitute a parallel track to such a formal

noneconomic and even political cooperation arise from the social externalities generated by closer economic

process, or over time contribute to the emergence of that process.

ties. Thus, the centripetal forces of trade among partners can be an effective handmaiden of deeper formal

As the regionalization of trade has progressed in the 1990s, there has been growing interest in func-

integration, whether planned or not. There is the con-

tional regional cooperation among members of differ-

temporary example of Western Europe, where grow-

ent integration agreements in economic, social and political areas that address externalities arising from

ing interdependence through trade has served to drive forward a political agenda of certain partners for deep integration and broad-based cooperation. In effect, the

regional, hemispheric and interregional markets.

opening of the regional market in Europe became

Development of regional infrastructure has become a

functional to widening the scope of cooperation, or in

focal point of functional cooperation in Latin America,

the words of Garcia Herrero and Glockler (2000), to "integration by stealth."

as reflected in the South American Initiatives for

increasing interdependencies or dependencies in

Regional Infrastructure Integration

(URSA), which

Regional cooperation between two or more

involve 12 countries, and the Puebla-Panama Plan

countries also can take place without pretensions of

(PPP), which involves eight countries. Support for busi-

regional integration as such (Balassa, 1961). This

ness, control of natural disasters, environmental pro-

more "functional" regional cooperation involves an

tection and regional security are some of the other

adjustment of policies and activities between countries

principal emerging areas of regional cooperation in Latin America.

to achieve outcomes that the parties prefer to the status quo, and is possible in practically any field of public

There are also several ambitious cooperation

policy. While functional regional cooperation can and

initiatives that accompany North-South free trade ini-

Deregulation, dispute mediation, implementation of WTO obligations, customs procedures, standards and conformance, intellectual property rights, competition policy, government procurement and rules of origin

The New Regionalism in Latin America

Table 2.6

Santiago Summit Areas of Action

Table 2.7

Typical Areas of Cooperation in EU-Latin America Inter-regional Integration Agreements

• Preserving and strengthening democracy, justice and human rights Democracy and human rights Education for democracy Civil society Migrant workers Strengthening municipal and regional administration Corruption Financing electoral campaigns Prevention and control of illicit consumption of and trade in drugs and psychotropic substances and other related crimes Terrorism Building confidence and security among states Strengthening of justice systems and judiciaries Modernizing the state in labor matters • Free Trade in the Americas Free Trade Area of the Americas (FTAA) Strengthening, modernizing and integrating financial markets Science and technology Regional energy cooperation Hemispheric infrastructure - General infrastructure - Transportation - Telecommunications

• Political dialogue Peace and stability Confidence and security building measures Protection of human rights, democracy and rule of law Sustainable development Action on drug traffic, arms traffic, organized crime and terrorism • Economic cooperation Industrial cooperation Technical regulations and conformity assessment Services Investment promotion Macroeconomic policy Scientific and technological cooperation Energy cooperation Transport Telecommunications Agriculture Fisheries Customs procedures Statistics Environment Consumer protection Data protection • Financial and technical cooperation Public administration modernization Inter-institutional cooperation Cooperation on regional integration

• Eradication of Poverty and Discrimination Fostering the development of micro and SMEs Properly registration Health technologies Women Basic rights of workers Indigenous populations Hunger and malnutrition Sustainable development Cooperation

• Social and cultural cooperation Social cooperation Education and training Social dialogue Drugs and organized crime Culture

Source: Summit Declarations and Plans of Action.

Source: Devlin (2001).

tiatives. (See Tables 2.5 through 2.7) The 34 democracies of the Western Hemisphere in 1994 launched a number of cooperative initiatives along with the eventual creation of a Free Trade Area of the Americas (FTAA). Meanwhile, the free trade initiatives of the EU are also accompanied by a battery of economic cooperation and political dialogue programs. Extensive cooperative programs are integral to the APEC free trade process as well. Functional cooperation is inherently challenging. The difficulty of negotiating non-trade issues is related to their very nature: whereas preferential trade arrangements, the typical starting point for formal eco-

nomic integration, are concerned with removing distorting policies, cooperation in other economic areas as well as in social and political fields often requires introducing additional policies, which can be more difficult. Moreover, non-trade areas often have less installed institutional cross-border capacities than does trade, and hence need more intensive mobilization of collective financial, logistical and technical support. Finally, many areas of functional cooperation are not easily subject to quantifiable targets, effective monitoring and evaluation of results. These complexities become especially daunting when functional cooperation is inter-regional and involves a large number of

• Education

CHAPTER

heterogeneous countries, as in the case of the hemispheric summit process (Devlin, Estevadeordal and Krivonos, 2002).

Potential Costs of the New Regionalism Regional integration agreements are an integral part of the structural reform process, but like any other structural change, they require adjustments and bear potential costs for the participating countries. Countries should design agreements that minimize unnecessary costs where possible. Some of the typical costs for countries associated with regional integration agreements are: • Trade diversion. Preferences in regional trade agreements (coupled with rules of origin in free trade areas) can potentially divert trade away from more efficient locations in non-member countries. Some trade diversion is inevitable in preferential arrangements, which has costs for domestic consumers and non-members. This must be weighed against trade creation and the potential for the trade diversion to evolve into cost-reducing and welfareenhancing transformation effects that promote future growth and import capacity (Corden, 1972; FfrenchDavis, 1980). The trade creation vs. trade diversion debate goes back to the days of Jacob Viner (1950) (Box 2.5). He pointed out the risks of trade diversion during the era of the old regionalism, when protection against third parties was very high and even rising (Devlin and Estevadeordal, 2001). That risk again has emerged as a source of concern in the contemporary debate over the new regionalism (Bhagwati and Panagariya, 1996). However, recent empirical evidence points largely to the trade creating effects of the three-tier liberalization process, of which regional integration is a part. • Vulnerability of regional goods. A regional agreement can create trade but at the same time support the circulation of goods in the regional market for which there is little demand in the rest of the world. The lack of an external market may be due to the idiosyncratic nature of certain goods based on local culture and tastes, to rigid intra-firm export and marketing networks, or to a lack of international competitiveness of the goods (due, for example, to low productivity or an

overvalued exchange rate), which is accommodated by preferences and rules of origin. If regional trade is created or diverted much faster than the dynamic forces leading to international competitiveness, growing trade and interdependence with a partner country may lead to a member or members becoming excessively vulnerable to recession or exchange rate depreciation in the regional market. This is because in the face of a recessive regional market or depreciation by a major partner, exports cannot be easily redirected to alternative third markets. As noted by Bevilaqua and Talvi (1999), this problem has occurred in Mercosur, where Argentina, Paraguay and Uruguay are very dependent on the regional market for their exports. It may also be a factor in some sectors in Mexico, where through NAFTA there is a high level of integration with the production and marketing networks of the U.S. economy (Dussel Peters, Paliza and Loria Diaz, 2002). This type of vulnerability can occur in any integration arrangement where regional trade expands rapidly under an umbrella of external protection for industrial sectors that is significantly higher than the rest of the world, where rules of origin are restrictive, or where simultaneous exchange rate appreciation among partners could drive sales to the regional market (Devlin and Ffrench-Davis, 1999). Such vulnerability points to the need to progressively reduce external protection and the restrictiveness of rules of origin as commercial interdependence deepens among partners of a regional agreement, and to guard against premature or abrupt currency appreciation with the rest of the world. • Redistributive effects from lost tariff revenue. When there are serious asymmetries in the average external tariff levels between partners of an economic integration agreement, the loss of tariff revenue in the high tariff country can have a serious redistributive impact on the partners (Panagariya, 1996). In effect, part of what would have been realized as tariff revenue on imports by the high tariff country from the lower tariff partner prior to the agreement is transferred to the lower tariff country's producers as tariffs are eliminated in the regional agreement. This is because the low tariff country's exporters refer to the partner's significantly higher third party tariff when establishing their pricing. The problem is aggravated by trade diversion.

The New Regionalism in Latin America

Trade Creation versus Trade Diversion

Although regional integration agreements are seldom

al share among the members of the agreement and the

implemented exclusively on the basis of economic rationales (Fernandez and Fortes, 1998), their welfare effects have been the main focus of an extensive and growing body of literature surveyed both for academic and policy-oriented purposes.1 The analysis is very complex, as preferential trade liberalization engenders second-best equilibria for which analysts need comprehensive analytical frameworks and sophisticated empirical techniques. The early seminal contribution of Viner (1950) to the theory of customs unions set the stage for the debate highlighting the static trade creation and trade diversion effects of regional integration agreements on single industries. As a result of preferential trade liberalization, trade creation is the substitution of a lower-cost source of supply from a member country for a higher-cost domestic source of supply, while trade diversion is the substitution of a higher-cost source of supply from a member country for a lower-cost source of supply from a third country. Under certain conditions, regional integration agreements can result in welfare-enhancing outcomes for member and nonmember countries (Kemp and Wan, 1976), while trade creation and diversion effects may materialize even prior to entry into force of the agreement, as traders and investors anticipate signing of an accord (Freund and McLaren, 1999). The assessment of the net effect therefore needs a careful analysis of the market structure and costs in which integration policy intervenes, a full account of its dynamic effects in the longer run, and an explicit account of the institutional forms of regional integration agreements (Pomfret, 1997). Applied research also provides a progressively better understanding of the magnitude of the effects of regional integration. In particular, in the case of Latin America, the new regionalism of the 1990s stimulated an emerging empirical literature that has progressively mitigated early concerns about the harmful effects of regional integration on the welfare of members and nonmembers. A complete survey of the empirical literature on the region would extend beyond the scope of this study, but a few of the significant contributions focusing on the trade creation/diversion impact of the region's major agreements are reviewed below. Early comprehensive assessments of NAFTA such as Hufbauer and Schott (1993) converge around the conclusion that the extraordinary expansion of intraregional trade flows did not take place at the expense of the rest of the world. Analyzing the geographical evolution and the composition of trade flows at the sectoral level, Krueger (1999) notes that the implementation of preferential trade policy has been more trade-creating than trade-diverting, given the already high intra-region-

parallel increase of trade flows with the rest of the world. Krueger also stresses the role of the evolution of the real exchange rate in explaining the expansion of intra-regional trade flows. The analysis found that the entry into force of the regional integration agreement did not significantly alter the trade pattern, a conclusion also suggested by Soloaga and Winters (1999). Mercosur has received less empirical attention, but it nevertheless has generated a very lively debate. In an early study, Yeats (1997) concluded that the regional orientation of exports grew faster in products where member countries do not have comparative advantages, and accordingly concluded that there was significant trade diversion. This conclusion has been challenged by Nogues (1996), who stressed the actual existence of intra-regional comparative advantages among Mercosur members in certain sectors. Meanwhile, Devlin (1997) noted that an analysis of the trade pattern distortions should be focused on imports, which suggests that the regional bias has been mitigated by the unilateral liberalization that paralleled implementation of the agreement. Nagarajan (1998) comes up with a similar empirical conclusion, hence pointing to the fact that trade creation probably outweighed trade diversion. In addition, Giordano (2001) shows that the reorientation of regional trade flows crucially hinged on the divergent path of the intra- and extra-regional real effective exchange rates. These conclusions are supported by Soloaga and Winters (1999), who, using a gravity model, assert that the significant trend in members' trade presumably reflects unilateral trade liberalization and suggests that trade performance was dominated by currency overvaluation rather than trade policy as such. Meanwhile, Echavarria (1998), examining intra-regional trade flows in the Andean Community, points to the trade-creating effects of the agreement. Finally, computable general equilibrium studies of regional integration that incorporate the findings of the new growth theory have invariably found that trade creation greatly dominates trade diversion (Robinson and Thierfelder, 1999). In the case of NAFTA, this is confirmed by Francois and Shiells (1994) who conclude that all members stand to gain, particularly Mexico, which could increase welfare between 1 and 5 percent. In the same vein, analyzing Mercosur, Flores (1997) showed that Argentina, Brazil and Uruguay might increase GDP by 1.8 percent, 1.1 percent and 2.3 percent, respectively. 1 For academic purposes, see Baldwin and Venables (1995), Winters (1996) and Panagariya (2000). For policy-oriented purposes, see OECD (1995), WTO (1995) and World Bank (2000).

Bex 2.5

CHAPTER

Panagariya (1996) indicates that this effect was significant for Mexico when it joined NAFTA, since the United States and Canada had much lower third party tariffs. It was clearly a price Mexico was willing to pay as part of the trade-off in pursuing the benefits of economically integrating with North America. To offset this cost, Mexico has been lowering average levels of protection by signing free trade agreements with most Latin American countries and the European Union, while pursing such an agreement with Japan. • Asymmetric development impact. In the absence of corrective mechanisms, the development benefits of regional integration are often asymmetrically distributed among partner countries or regions within them (Puga and Venables, 1997). European integration has been very sensitive to this problem, reflected in the creation of a comprehensive battery of collective institutional mechanisms to address potential imbalances (Pastor, 2001). Severe imbalances in trade and adjustments historically have been a major source of tension for Latin American regional initiatives and in some cases have even led to their demise (Salgado, 1979). In the old regionalism, there were extensive provisions for special and differential treatment for less developed countries to address some of these problems. However, the new regionalism has tended to give much less attention to special treatment, typically restricting it to somewhat longer liberalization schedules for the lesser developed partner (Devlin and Estevadeordal, 2001). Asymmetric liberalization may facilitate the phase-in of regional liberalization, but there are many other sources of imbalances and tension among partners when regional trade reaches significant proportions. As economies become more interdependent in the course of developing regional agreements, lack of coordination of macroeconomic policy and exchange rate regimes can be an especially corrosive factor in regional commitments. Indeed, parallel to Latin America's successful phase-in of regional free trade has been a growing and largely unaddressed need to better coordinate macro and exchange rate policies among partners. Regional integration also can have clear asymmetric effects within a partner country. This has occurred in Mexico, where the pull of NAFTA has been

heavily concentrated in the northern states, aggravating a North-South development divide in that country (Perry, 2001). The Puebla-Panama Plan launched in 2001 was inspired in part by the Mexican government's desire to provide compensatory forces of development for its southern states. • Spaghetti bowl. A growing number of economic integration agreements with different liberalization schedules, preferences, rules of origin and other norms and disciplines creates a virtual "spaghetti bowl" of regulatory systems for trade. This reduces transparency and raises administrative costs (Wonnacott and Wonnacott, 1995). As will be seen in Chapter 3, the "spaghetti bowl" in the Americas is large and growing. An additional inefficiency is when hub-andspoke arrangements emerge in which a hub country has free trade agreements with a number of partners that do not have similar agreements with each other. This encourages trade and investment diversion (Wonnacott, 1996). With their multiple agreements, Mexico and Chile have become trade hubs in the Americas. The United States could become a major trade hub as well if it continues to pursue bilateral reciprocal agreements. • Investment diversion. While enlarged regional markets and preferences can attract foreign direct investment, they potentially could divert FDI from more efficient locations (Winters, 1998). In the Vinerian perspective, the location of FDI can be motivated by trade diversion arising from high tariffs and nontariff barriers (including rules of origin) in order to capture the discriminatory static effects of regional integration (Kindleberger, 1966). Even efficient location of FDI can have perceived costs for certain countries. For example, tariff-jumping FDI may relocate to a more efficient location in a partner country when regional trade and investment is liberalized. • Other costs. It has been argued that integration agreements can create a "gang effect" that leaves outside countries with little option but to join for fear of trade and investment diversion (Winters, 2000). This clearly is a dynamic that countries face in the wave of the new regionalism. Uruguay and Paraguay probably could not have easily stood by as passive observers to integration between Brazil and Argentina. Mexico's joining of NAFTA contributed to the demand in Central America for free trade agreements with the

The New Reqionalism in Latin America

United States and Canada. Of course, the coercive

Figure 2.6

effects of regional integration should be evaluated in

Infra-regional Trade, 199O-2OOO (In millions of constant 1990 dollars)

terms of the contribution the agreements give to structural reform versus alternative paths to achieving this, could be a benefit and not a cost. Meanwhile, the formation of large regional blocs can create market power and shift the terms of trade with the rest of the world, a benefit for the region but a cost for others (Stein, 1994; Winters, 1998). In a world of perfect competition, this would represent a welfare loss; however, in the real world in which countries operate, one could not conclude that a priori. In any event, Schiff and Chang (2000) have estimated these effects in the case of the formation of Mercosur.

Evaluating the Balance of Benefits ana1 Costs Finally, it must be remembered that regional integration is not an end in itself but an instrument to achieve an objective. Hence, not all regional integration initiatives make economic sense, and even those that do can go awry if the policy framework is inadequate. Hence, evaluating the benefits of initiatives, and weighing those benefits against the costs, is the only way to determine whether an agreement makes sense for the

Source: IDB calculations based on IMF (2001).

participating countries and the rest of the world. One key question regarding an agreement is its economic

Winters, 2000) to focus more on the difficult-to-evalu-

relevancy. There has been a proliferation of nearly 30

ate world of dynamic sectoral and economic produc-

integration initiatives already in the region and several

tivity and growth effects (or lack of them), and on the

more are being negotiated. But have they generated

contribution of regionalism to the political economy of

trade? Figure 2.6 shows that most of the agreements

structural reform. Moreover, political objectives also

are associated with a significant amount of increased

must be assessed, since these weigh heavily in many

trade.6 The possibility of new markets for trade is only

initiatives, particularly in agreements aimed at a com-

one consideration of the economic value of new agree-

mon market or community. This type of comprehensive

ments. A much more through empirical analysis of

evaluation has largely escaped the debate to date.

effects is required. Unfortunately, empirical evaluation is inherently difficult due to extremely serious gaps in

North-South Agreements and the FTAA

data availability, the complex causality of dynamic productive transformation effects (where one expects the

The growing interest in Latin America for regional

big effects to lie), and the methodological difficulties in

agreements with industrialized countries is in some

generating plausible conclusions from broad counter-

ways the best expression of the new regionalism. Such

factual analysis (Devlin and Ffrench-Davis, 1999).

agreements link countries in the process of structural

Since the new regionalism is about much more than trade as such, the attention of analysts must go beyond the "static" trade creation-diversion examination (which has had its empirical problems as well; see

Of course, more analysis is needed to determine the causality between the agreement and trade.

and in this context the pressure for joining an initiative

CHAPTER

reform with countries that have already achieved a high degree of liberalization. Hence the burden of liberalization in the regional agreement weighs asymmetrically on the reforming country. Moreover, the agreements tend to have a comprehensive second-generation scope of disciplines, so the implications for structural change are large for the developing country partner. Why do countries subject themselves to an asymmetrical liberalization process? Basically because many expect that when a regional agreement is anchored by a credible industrialized country, the benefits for structural reform outlined earlier will be magnified at an acceptable cost. One of the primary goals of the developing country partner is market access. Even though the industrialized partners typically have low average most favored nation (MFN) tariffs and extensive non-reciprocal preferences for the region, there are tariff peaks, quotas and other non-tariff barriers and distortions that inhibit trade in many goods for which Latin America has a clear international comparative advantage. Agricultural products are a notorious example of this problem. Moreover, some analysts have pointed out that North-South agreements are less prone to trade diversion than South-South agreements because of the more general standard of international competitiveness in the industrialized area and the already relatively high participation of trade with these markets (Venables, 2001 )7 In any event, simulations of a Computable General Equilibrium model suggest that North-South market access agreements such as the FTAA, or those with the ED, would have significant impacts on export and GDP growth, assuming that trade barriers in the partner countries are eliminated comprehensively and include agriculture (see Appendix 2.1). Perhaps even more important for the developing country partner is the desire to stabilize market access through a comprehensive set of rules and dispute settlement mechanisms with the industrialized partner. This is because market access can be interrupted by unilateral measures such as anti-dumping action, safeguards, withdrawal of non-reciprocal preferences, and tariff increases within WTO bound rates. Regional agreements are an opportunity to reciprocally confine the use of these types of threats to market access. Another major motivation is to anchor

economies by a regional agreement with a credible industrialized country; this would be expected to significantly lower the country's risk premium and attract investment flows (Ethier, 1998; Fernandez-Arias and Spiegel, 1998). Finally, lock-in effects for reforms of subregional agreements have a checkered history. While they have been better in the era of new regionalism, they still are far from perfect (Devlin and Estevadeordal, 2001). In contrast, lock-in is expected to be stronger in North-South agreements, since industrialized countries tend to have considerable economic power and a battery of national institutional arrangements that vigorously enforce and monitor compliance of agreed rights and obligations (Devlin, Estevadeordal and Garay, 2000). Meanwhile, the motivation of industrialized areas for integration agreements includes eliminating tariff barriers, since average tariffs in the region are three to five times higher than those in the Northern markets. But the major focus is on promoting commitments beyond WTO levels (and setting precedents to expand this frontier even further) on new trade-related areas such as services, investment, intellectual property, and government procurement. Another objective is to promote national policy agendas that are not widely agreed upon in multilateral fora, such as trade and labor standards, transparency, and issues related to consultation with civil society.8 Another important goal is geopolitical market positioning in an age of globalization. The North-South agreements are challenging indeed for the region. The implications for opening markets are substantial in view of the relatively higher levels of protection in the region. Also, Latin America has not yet advanced substantially in many of the new trade issues. For example, liberalization of financial services often has not moved much beyond protocols

7 However, this is not true for all of the important sectors (e.g., textiles), and hence serious trade diversion can be a risk (Panagariya, 1996). 8 This dynamic can be seen in the behavior of the United States and the European Union. U.S. interest in a free trade area with Canada and its extension to NAFTA (breaching that country's singular traditional focus on multilateralism) was spurred by creation of a single market in Europe and an effort to use the NAFTA agenda to drive home U.S. negotiating objectives in a lagging Uruguay Round. Meanwhile, the EU's recent interest in pursuing reciprocal free trade with Latin America is probably partially related to advances in the FTAA (IDB, 2002).

The New Reqionalism in Latin America

Figure 2.7

Structure of the FTAA Negotiations

BaBBBBSJamftB

ica but also between the subregions that do relatively little trade with each other.9 The process was launched at the December 1994 Miami Summit, but only with great difficulty, as trade did not appear on the pro-

Temporary Adminlstrativi Secretariat

Budget and Administrative Subcommittee

some initial ambivalence in North America (Hayes, Trade Negotiations Committee (TNC) (Vice Ministers)

Technical Committee on Institutional Issues

1996). Pressure from Latin America was decisive in putting trade at the center of the summit agenda.10 The FTAA initiative bears all the characteristics of a modern second-generation trade agenda. A comprehensive preparatory process began in June 1995

^^^^^1

^^^^H

Negotiation Groups

^^^^^ffl

H^^^^^^^H

Consultative Group on Smaller

^^^^^M

Economics

and ended with the beginning of formal negotiations in September 1998 involving nine areas (Figure 2.7). The goal is a balanced and comprehensive WTO-consistent agreement by January 2005 that will be determined by consensus and be a single undertaking. The agreement must take into account the needs, economic

•HHBBBI •cjjWjjiiiijijiiii l^^^^^^^^w

^•^^^^9 ^^^H^^^^n

^^^^Q^^9

Electronic Commerce Committee

conditions and opportunities of the smaller economies of the region, which confront special vulnerabilities (Box 2.6). The FTAA can coexist with bilateral and sub-

Intellectual Property

Subsidies AD-CVD

Competition Policy

Civil Society Committee

regional agreements to the extent that the rights and obligations under these agreements are not covered or go beyond the rights and obligations of the FTAA (FTAA Declaration of San Jose, 1998). Hence a comprehensive FTAA could potentially absorb some of the hemisphere's free trade areas or even subregional agreements if because of problems they do not

or statements of intentions. Moreover, there is an asym-

advance beyond (or slip back into) de facto simple free

metric capacity between the industrialized country and

trade zones. The process has proceeded steadily since

the region to negotiate sustainable agreements and implement them. And, of course, many adjustments will be needed to make up for lost fiscal revenue from tar-

1995 (Table 2.8), with disciplined organization and strong commitments on the part of governments in

iff elimination, ensuring stable financial systems and

terms of participation, time and expense. For example,

macroeconomic environments in the face of capital

negotiations in 2000 involved 184 meeting days with

inflows set off by the agreements, and establishing a policy framework that addresses the impact of trade on poverty and equity. A challenging agenda, but one

more than 3,000 participants, generating more than 2,000 negotiating documents. A bracketed draft text of the negotiated FTAA agreement was publicly released

that many Latin American countries are willing to take

in 2001. Meanwhile, in May 2002 the delegations

on in order to capture the potential trade and political

agreed on the methods and modalities for product and

economy benefits from fortifying links with their major

sectoral specific liberalization, which sets the stage for

markets.

the final round of negotiations involving offers and The FTAA is clearly the region's biggest North-

South initiative, involving all democratic Latin American countries and North America. It would be the world's largest free trade area: 34 countries with 800 million people and a $10 trillion regional economy. It promises not only to liberalize trade with North Amer-

For instance, less than 5 percent of Andean and Mercosur trade is between the two blocs (IDB, 2000). 10

The decision was by consensus of 34 countries.

gram until just a few months before the event due to

Ministers Responsible for Trade

CHAPTER

Box 2.6

2 Challenges Facing Small Countries

The onset of globalization and the ongoing process of multilateral trade liberalization have sparked an international debate on the unique circumstances of small countries in the world economy, particularly their vulnerability to adverse external shocks and natural hazards. The debate has spurred proposals that small economies should enjoy longer transition periods to comply with commitments; fewer and less onerous international obligations; assistance with trade adjustment and risk management; and greater security and predictability in market access. Such proposals stem from characteristics these countries share based on their smallness and remoteness. Relative to larger regional neighbors, they tend to have more specialized and less diversified economies, often with exports concentrated in few commodities. They have diseconomies of scale and investment; are unusually open to external economic developments in the areas of trade, capital flows and technology; are heavily dependent on foreign capital flows; and have high international transport costs. An extensive and growing economic literature highlights these common features and examines a number of common problems related to them.

Income Volatility Small countries often have higher rates of growth than larger neighbors, but their growth rates fluctuate more widely. They tend to rely heavily on external trade in goods and services, and to be open to foreign investment, as means of overcoming the inherent scale limitations of small domestic markets and resource bases. Since the share of trade in such countries' GDP is often especially large, and since their exports are generally concentrated in both products and markets, they experience much greater variations in their terms of trade and their growth rates. Small states' standard deviation of annual real per capita growth might be some 25 percent higher than in large countries (Commonwealth Secretariat/World Bank Task Force on Small States, 2000). It has been argued that the disadvantages of volatility are offset by the advantages of trade openness (Easterly and Kraay, 1999). Greater market access, however, does not automatically entail greater market entry: the balance of benefits and risks depends on whether more openness in small countries is matched by more secure market penetration in their trading partners.

External Shocks and Access to Capital Product concentration and export specialization in a small number of key commodities, part of an effort to achieve economies of scale in small countries, can boost productivity and competitiveness in global markets. The limited diversification, however, makes these countries vulnerable to shocks and market disruptions such as commodity price fluctuations, market access difficulties, natural disasters, and product blight, as well as to the strong bargaining power of multinational firms. The banana dispute between the United States and the European Union over the preferential treatment of Caribbean bananas in the European market illustrated the fragility of small states that are reliant on preferential arrangements, as well as their susceptibility to disruptions in market access. Limited diversification also heightens economic risk, which in turn affects the capacity of smaller economies to access international financial markets. Moreover, they are perceived as riskier than large countries. In effect, they are discriminated against: when the quality of their policies and human capital is comparable to that of bigger countries, they are still judged to be a greater investment risk, face higher risk premia, and typically pay higher interest rate spreads. Additionally, intense competition to attract investment prompts the need for ever greater (and fiscally pernicious) incentives and the commitment of increasing resources to investment promotion (Commonwealth Secretariat/World Bank Task Force on Small States, 2001).

Trade Liberalization and Revenue Loss Many small states have benefited from preferential market access and relatively high levels of official development assistance from OECD countries. Members of the African, Caribbean and Pacific (ACP) group of states have enjoyed a special relationship with the EU in both of these areas. As preferential access to traditional markets is eroded by trade liberalization, small states face a dual problem. On the one hand, they must adapt to the loss of preferences in the markets of their main trading partners. On the other, they are obliged to lower or eliminate their own trade barriers. Since they have a small domestic tax base, however, many small countries have depended on tariff income as a substantial source of government revenue. Such earnings will necessarily decline as tariffs are reduced and must be replaced by sizeable adjustments of tax structures to bring in new sources of revenue.

Limited Institutional Capacity Smaller economies have low staffing levels in their public administrations. Personnel tend to be overextended and responsible for multiple tasks, while specialists are often not retained. Limited financing contributes to high staff turnover and precludes frequent training, which in turn hinders the accumulation of management skills and constrains innovation (ECLAC, 2000). One outcome is a curbed capacity to engage effectively in the negotiations that underpin trade and integration initiatives.

Business Adjustments and Private Costs Greater competition from import liberalization leads to the local concentration of small firms in sectors where they have a competitive advantage. The specialization and resource reallocation required for that purpose can have significant adjustment costs, the burden of which often falls on workers in firms and industries that face the immediate prospect of redundancies, and on poor households for which unemployment is highly problematic. The social benefits of reform can offset the social costs over the longer term, but the private costs of adjust-

requests for achieving defined liberalization schedules by December 2004. As pointed out by Blanco and Zabludovsky (2002), while the negotiations have advanced steadily to date, this last stage will be critical and extremely difficult. Although the 34 countries of the FTAA represent a more compact negotiating vehicle for obtaining consensus than the 140-plus WTO membership, agreement among countries as heterogeneous in terms of levels of development (from some of the poorest to the richest in the world) and geopolitical perspectives as those in the FTAA will demand creative formulas that provide for both balance and substantial liberalization. Examining trade patterns, Blanco and Zabuldovsky observe that the most aggressive targets of many countries' FTAA trade agendas are often the most politically sensitive defensive sectors of others, and vice-versa. Then there are complex technical issues such as what types of rules of origin are need-

ment are inequitably distributed, and resistance to them can thwart trade liberalization efforts (Gonzales, 2000). Additionally, the higher transport costs prompted by distance and limited trade volumes, as well as fragmented production bases, conspire to frustrate the greater productivity necessary for international competitiveness. This is especially the case in island and archipelago states, where the problem is not simply one of distance: in some cases there is a small number of transport providers holding a monopoly on service provision.

Natural Disasters Many small countries, notably in Central America and the developing island states of the Caribbean, are unusually exposed to natural hazards. Caribbean countries in the hurricane belt annually face the prospect of devastation and share with other countries of the Americas a natural exposure to volcanic activity, earthquakes, mudslides and floods. Since the economies, land area and populations of these countries are small, natural disasters can adversely affect a large proportion of economic activity and export capacity.

ed to ensure full participation in FTAA trade opportunities, minimize trade and investment diversion, and provide for a manageable administrative burden. How to treat the smaller economies will be a delicate political issue. Bridging these and other tradeoffs will not only tax the technical skills of negotiators, but also require renewed political leadership to overcome the region's recent economic difficulties and increasing signs of protectionist pressures in the hemisphere. Meanwhile, sustainable agreements require effective negotiation and implementation as well as policies to foster socially efficient adjustment. On all these accounts, the institutional capacity of many Latin American countries leaves much to be desired. Agreement on a cost efficient and effective FTAA institutional architecture also may prove difficult given fiscal restraints on all member countries and the diverse traditions in the hemisphere, ranging form purely intergovernmental arrangements to more comprehensive

The New Regionalism in Latin America

CHAPTER

Table 2.8

Chronology of the FTAA Process Event

Action

December 1994

First Summit of the Americas (Miami)

Launches the FTAA process.

January 1995

OAS Special Committee on Trade

Establishes initial work plan and timetable.

June 1995

Denver Ministerial Meeting

Seven working groups established; IDB-OASECLAC Tripartite Committee charged with providing technical support.

March 1996

Cartagena Ministerial Meeting

Four additional working groups established.

May 1997

Belo Horizonte Ministerial Meeting

Working groups mandated to complete all work by next Ministerial Meeting; one additional working group established.

March 1998

San Jose Ministerial Meeting

Launch of negotiations recommended; agreements reached on structure, calendar, leadership and location of negotiations. Nine negotiating groups, two committees and one consultative group established.

April 1998

Second Summit of the Americas (Santiago)

Heads of state launch negotiations.

Buenos Aires Trade Negotiations Committee meeting

Vice Ministers set forth comprehensive work program for each group and committee.

Date

Negotiation period June 1998 September 1998

FTAA Administrative Secretary established in Miami.

September 1998

Commencement of negotiating group and committee meetings.

November 1999

Toronto Ministerial Meeting

Annotated outlines of eventual FTAA chapters reviewed; package of business facilitation measures approved; negotiating groups mandated to produce bracketed text of eventual chapters.

January 2000

Implementation of business facilitation measures begins, thereby fulfilling mandate to make "concrete progress" by 2000.

March 2001

Transfer of Administrative Secretariat to Panama City.

April 2001

Buenos Aires Ministerial Meeting

Review of bracketed text, issuance of new instructions.

April 2001

Third Summit of the Americas (Quebec City)

Public release of the FTAA bracketed text in four languages.

May 2002 October 2002

Launch of product-sector specific negotiations. Ecuador Ministerial Meeting

November 2002

Commencement of Brazil/United States Co-Presidency.

March 2003

Transfer of Administrative Secretariat to Mexico City.

December 2004

Conclusion of negotiations.

December 2005

Entry into force of the FTAA agreement.

Pre-negotiation period

EU-like institutions. Finally, progress in certain impor-

reaching network of trade links and of intergovern-

tant areas of the FTAA negotiationsâ&#x20AC;&#x201D;e.g., agricultural

mental contacts and is viewed as having an existence

domestic supportâ&#x20AC;&#x201D;may be intrinsically linked to

separate from all individual trade links between partic-

advances in the WTO's complex Doha Development

ipants, and in that its separate existence is seen as

Agenda, also scheduled to finish in 2005.

valuable. The trading system's most obvious general-

While completing the FTAA will be a technical

ized norm is non-discrimination (MFN), which immedi-

and political challenge of major proportion, it is impor-

ately and automatically extends bilateral agreements to

tant to note that the process is already leaving a posi-

all members. Reciprocity is diffuse in that governments

tive legacy for the development of Latin America

do accept individual actions that appear not to be in

(Iglesias, 1999). Some of the positive externalities

their immediate interests, but it is generally accepted

emerging from the launch of the process in 1995 are

that, overall, every country has to gain."

quite impressive. For instance, after nearly eight years

Regional integration includes trade liberaliza-

of regular FTAA meetings, there is a certain familiarity

tion among a group of like-minded countries usually

and esprit de corps among the delegations that has

defined by some geographical boundaries. The pref-

allowed them to use FTAA fora to resolve bilateral

erential nature of regionalism makes it exceptional

trade problems and launch new initiatives. The process

with respect to the MFN principle underlying the

also has enhanced transparency by generating a

GATT/WTO, and it is in fact treated as an exception

wealth of hemispheric comparative data on national

with legal rules that attempt to circumscribe the prac-

trade and regulatory

norms that heretofore were

tice (Article XXIV of the GATT reinforced by its Under-

unavailable or very difficult to obtain. Countries have

standing of the Uruguay Round agreements and Article

also used the FTAA negotiations as a learning labora-

V of the GATS).11 Along with the formalization of the Uruguay

tory for WTO disciplines and new pioneering secondgeneration trade issues (e.g., competition policy and e-

Round's more stringent rules governing world trade in

commerce) as well as for exploiting opportunities to

the 1990s, attention increasingly shifted toward the

hone negotiating skills through the extensive participa-

systemic effects of regional integration on the multilat-

tion and leadership that the process has encouraged

eral trading system. Concerns were raised about the

even for the smallest countries of the hemisphere. The

discriminatory behavior of the new regionalism, which

FTAA process also has approved and implemented

runs counter to the non-discriminatory principles of the

customs procedure measures to facilitate business and

multilateral trading system and is perceived by some as

has fostered an emerging hemispheric business com-

having the potential to discourage participation in the

munity that meets regularly around the FTAA trade

system, whose goal is the advance of worldwide trade

ministerial.

liberalization. Thus, studies have emerged that address whether the proliferation of the multilateral trading sys-

THE NEW REGIONALISM AND THE MULTILATERAL SYSTEM

tem is in fact beneficial or detrimental to the strengthening of worldwide trade liberalization (Krugman, 1981; Summers, 1991). The concepts of either building or stumbling blocs (Bhagwati, 1991) have gained

One of the major points of contention about the new

as much prominence as those of trade creation and

regionalism has been its relationship with the multilat-

diversion in the discussion of regional integration.

eral system. The GATT and the WTO that succeeded it

Although it is theoretically plausible that the

are based on multilateral principles. Ruggie (1992) has

dynamic interaction between regionalism and multilat-

conceptualized multilateralism with the defining char-

eralism could lead to the weakening of the latter (Bhag-

acteristics of indivisibility (allegiance to a system as a whole), generalized rules of conduct, and diffuse reciprocity. As Winters (2000) has pointed out, the multilateral trading system shares these characteristics: "It is indivisible in that it permits an extremely dense and far

The other formal exception for integration in developing countries is the Enabling Clause.

The New Regionalism in Latin America

CHAPTER

wati and Panagariya, 1996), the emerging features of the new regionalism may guarantee greater complementarity. In fact, when presenting the characteristics of the new regionalism (Yi, 1996) or when allowing for net benefits in adjusting progressively to competition in world markets (Frankel and Wei, 1996), regional integration may provide economic and political conditions for increased integration in the multilateral system, even though there is a risk that political economy incentives could jeopardize this outcome (Levy, 1997; Krishna, 1998). Moreover, the new regionalism appears to be an endogenous functional response to the growing challenges of integration with the world trading system and thus may contain a grain of systemic compatibility at its very heart. Ethier (1998) shows how successful multilateral trade rounds can actually provide incentives to pursue regionalism.12 Clearly there is a conflict between preferential trade agreements and the multilateral system when the former promote increased protection vis-a-vis the status quo. But is there a serious conflict when regional liberalization works in tandem with unilateral opening and implementation of multilateral commitments to take like-minded countries beyond liberalization attainable in the multilateral trading system? As the new regionalism has progressed, certain measures have been adopted in some agreements that could legitimately raise concerns, and many agreements have significant flaws. However, on balance, as pointed out by the WTO Secretariat (1995), the two processes seem to complement more than conflict with one another. To put the relationship of the new regionalism and the multilateral system in proper perspective, it first should be remembered that the two processes generate different products each in its own way useful for promoting liberalization. The multilateral system is a world "hypermarket" involving more than 140 members that must make decisions by consensus. It establishes a floor for orderly world trade rules. Regionalism encompasses a "neighborhood" market of like-minded countries exploiting trade liberalization possibilities that go beyond the multilateral system because they are not contemplated or feasible at the world level, and which often sustain regional objectives that go beyond a commercial-only agreement such as the WTO.13 Second, a regional integration agreement is a second-best policy option and hence far from a perfect

arrangement. The multilateral system has been an extraordinarily important public good that has liberalized world trade after the protection of the inter-war period. But in practice, the multilateral system also has suboptimal characteristics. After more than 50 years of rounds of trade liberalization, the system has progressed relatively little in liberalizing agricultural-related trade in which many developing countries have a comparative advantage. Also, until the Doha Development Agenda, insufficient attention was paid to asymmetric capacities among countries to participate, negotiate and implement disciplines. Modern regional agreements can and often do overcome these problems, which may have elements of discrimination. Third, Latin America and other developing regions clearly do not see regionalism as a substitute for the multilateral system. In the region, only one country is not a member of the WTO, and the system's membership continues to expand, most recently with the accession of China. Moreover, Latin America was active in the preparation and negotiation of the Doha Development Agenda, as was the European Union and the United States, whose leadership was essential. Fourth, there are important synergies between the new regionalism and the multilateral system that push both in the direction of liberalization. Secondgeneration regional agreementsâ&#x20AC;&#x201D;whose agendas mirror WTO disciplinesâ&#x20AC;&#x201D;serve to help countries prepare for multilateral rounds. Moreover, these agreements can be a laboratory for introducing new disciplines into the multilateral system, as NAFTA was for the Uruguay Round and as the EU and other regional agreements are in terms of substituting competition policy for anti-dumping actions. Regional agreements also can raise pressure for multilateral rounds, as third parties aim to erode preferences, or regional partners attempt to multilateralize their WTO liberalization agenda.

12 Economic distance is equal to geographic distance and trade barriers. As successive multilateral rounds reduce the latter, the pull of geography gains greater weight, fostering regionalization of trade and incentives to pursue regionalism. 13 Even a simple free trade area in goods goes beyond the WTO because it must be in accord with Article XXIV, which aims to eliminate trade barriers on substantially all trade.

Fifth, regionalism needs the WTO to complete agendasâ&#x20AC;&#x201D;such as reducing domestic support in agricultureâ&#x20AC;&#x201D;that are difficult or impossible to negotiate at the regional level. The central problem would seem to be that the multilateral system treats regionalism as an exception rather than a vital component of a liberalized world trading system. This ambivalence was understandable during the era of the old regionalism, with its vocation for protection. But it seems inappropriate in the context of the new regionalism and in a world where more than 50 percent of global trade passes through regional agreements. The only WTO members not having a regional agreement are South Korea and China (including Hong Kong). A better alternative might be to thoroughly embrace regionalism with a comprehensive and better-defined set of rules that promote its potential benefits and minimize its costs to partners and the world economy.

As reported by Serra et al. (1997), the Understanding on Article XXIV of the Uruguay Round reduced but did not eliminate the considerable ambiguity in multilateral regional rules. For instance, the exact amount of total regional trade that must be reciprocally liberalized to be consistent with the WTO remains open to interpretation, as does the determination of the level of protection afforded to a new customs union that would be no more restrictive than the former MFN rates. Incorporation into Article XXIV of treatment of rules of origin would be a major advance, given their powerful potential for serving protectionist interests (Estevadeordal, 1999). Treatment of non-tariff barriers and non-compliance with agreed disciplines are other gaps in the article. Finally, a better WTO monitoring capability is also needed. Hopefully, some of these issues will be addressed in the regional rules negotiation that is part of the Doha Development Agenda.

The New Regionalism in Latin America

CHAPTER

APPENDIX 2.1 EVALUATING HEMISPHERIC FREE TRADE AGREEMENTS: A COMPUTABLE GENERAL EQUILIBRIUM APPROACH1

A crucial element for policymaking is to accurately assess and compare the impact of a country's different trade liberalization options. Among the various methodologies available to policymakers, computable general equilibrium (CGE) models have been widely used in trade policy evaluation and for other policies. Being necessarily a simplified representation of the whole economy, they capture both the aggregate and sectoral impact of policy changes on the economy under study as well as the partners. This is its distinguishing feature vis-a-vis other types of economic models. The model enables us to evaluate the impact by comparing the economies' initial situation (benchmark equilibrium computed from the country's or countries' real data) with the new numeric equilibrium resulting from the adoption of the policy change under study. Although the adjustment time is not specifically mentioned, it is assumed to be long enough for the markets to readjust and thus achieve the new equilibrium. The addendum to this note contains a more detailed description of the model as well as its main advantages and disadvantages. CGE simulations were used to evaluate and compare the differentiated effect of alternative trade agreements involving Latin America, including the FTAA and free trade agreements between the Mercosur and Andean Community countries with their two major partners (the European Union and the United States). All the agreements considered are either being negotiated or have been announced. Since part of the recent discussion on the new regionalism has been concentrated on the relative advantages of NorthSouth versus South-South agreements (Venables, 2001), the results will also provide some insight on this issue. The CGE model used is a multi-country and multi-sector comparative static model that incorporates trade-linked externalities and economies of scale in the manufacturing industries. The policy variables in this exercise are the elimination of tariff protection (including ad valorem as well as specific, mixed tariffs and

tariff-rate quotas),2 export subsidies, and producer support estimates (for the NAFTA countries and the EU). One should note that market access is only one part of the potential net benefits of a free trade agreement, and hence simulations are a very conservative estimate of effects. Appendix Figures 2.la and b compare the impact of the three agreements for Mercosur and the Andean countries. They show the percentage increase in exports that a free trade agreement with the EU, the United States and the FTAA would have on the economies. For simplicity, we aggregate the 15 sectors into three broader groups: primary goods, light manufactures and heavy manufactures. Although the high degree of aggregation makes for an imprecise definition of these groups, they are relatively correlated with the relative use of factors: primary industries are landoriented, light manufactures are labor-oriented and heavy manufactures are, in general, capital-oriented. In terms of scenarios, the highest impact on export growth for Mercosur would be the free trade agreement with the EU (12 percent increase), followed by the FTAA (8 percent increase). For the Andean Community, the FTAA would bring an increase in exports of 6 percent, while an agreement with the EU would increase exports by 3 percent. Although there are many reasons behind these results, they are very much affected by the initial trade links between countries engaged in an agreement (for example, as a destination market, the EU weighs heavier for Mercosur than for the Andean Community), and by the initial trade protection faced by countries. In any event, both the EU and the FTAA are important enough markets that pursuing free trade agreements should not be interpreted as an either/or proposition. The analysis by sectors shows that in all scenarios light manufactures are the faster growing sector, although the relative impact is bigger under a free trade agreement with the EU than in the other two scenarios considered. As expected, light manufactures is

1 Results presented in this appendix come from Monteagudo and Watanuki (2002). 2

Although most tariffs are ad valorem, non-ad valorem tariffs are frequent for agriculture products, especially in the most developed countries.

Appendix Figure 2.1 a

Impact of Potential Regional Integration Agreements on Andean Exports (Percent of exports)

Appendix Figure 2.1 b

Impact of Potential Regional Integration Agreements on Mercosur Exports (Percent of exports)

Appendix Figure 2.2

Change in Exports under FTAA (Percent growth of exports)

led by agriculture-related products (meat and processed food) that are among the sectors facing the highest protection in both the U.S. and EU markets. This result confirms the subregion's comparative advantage in terms of an agreement with more developed countries. As expected, the FTAA reflects the same pattern of growth across macro-sectors as does the agreement with the United States: specialization in light manufactures, followed by heavy manufactures and then primary goods, reflecting in part that the primary sectors are relatively less protected in the Western Hemisphere compared with the EU market. In most cases, the increased heavy manufacturing exports in Mercosur and the Andean countries are resourcebased manufactures. Appendix Figure 2.2 presents the impact of the FTAA by macro-sector. Total export growth ranges from 4 percent to 9 percent across Latin America, except for Mexico (2 percent) because of NAFTA. By sectors, all of the region's countries considered (except Venezuela) specialize relatively more in light manufactures exports (mainly textiles in the Central American and Caribbean group, processed food and other light manufactures in the Mercosur countries, and a more mixed combination for the Andean countries). The heavy manufacturing sector follows as the second fastest growing sector, made up mostly of new exports of automobile and machinery equipment from Brazil and more natural resource-based heavy manufactures such as petroleum in Venezuela and Argentina (also

The New Regionalism in Latin America

CHAPTER

chemicals in this case), and iron and steel in the group formed by Bolivia, Ecuador and Peru (RAC). Finally, an interesting result is to see what difference the presence of Latin American countries makes in the FTAA. Appendix Figure 2.3 shows first that more than 40 percent of the new exports will go to the regional market for all countries, except for Central America (as a result of its high dependence on the U.S. market). The colored cells show the cases where the share of Latin American countries in increased exports is more than 50 percent. Another result worth mentioning is that for primary goods exports, the regional market absorbs more than 50 percent of new exports; these percentages rise to 69 percent for light manufactures and to 72 percent for heavy manufactures. To the extent that specializing in manufactures is an attractive strategic consideration, this is an important result to bear in mind when addressing the importance of the intra-Latin American market in the FTAA negotiations.

Appendix Figure 2.3

Importance of Latin American Exports in the FTAA (Percent of total exports to FTAA)

METHODOLOGICAL ADDENDUM TO APPENDIX 2.1: THE USE OF COMPUTABLE GENERAL EQUILIBRIUM MODELS IN THE EVALUATION OF TRADE LIBERALIZATION POLICIES

specifically examine the efficient use of resource allocation and the equity with which such resources are redistributed. CGE models are computable models in that they provide a unique equilibrium solution and are quantified in a numerical way rather than by analytical means. This provides a precise measurement of the economic impact of a given policy.

Basic Features of CGE Models

What the CGE Captures

CGE models are based on the general equilibrium theory in which equilibrium prices and quantities are determined simultaneously. CGE models are nevertheless a simplified representation of the economy and only identify key economic actors or agents (such as households or consumers, firms or producers, and government). CGE models are equilibrium models because they describe the behavior of the economy as the outcome of supply and demand for each product in each market, allowing prices to adjust so that supply and demand exactly match. There is no excess demand or supply, and all markets simultaneously clear, i.e., supply equals demand. CGE models are general equilibrium models because they capture all the sectors in an economy and all the economic agents involved. This is the most striking advantage of CGE models compared with partial equilibrium models. Consequently, CGE models can

The CGE model captures the main effects of a trade liberalization predicted by standard theory of international trade: • Trade effects: Tariff elimination causes an increase in imports and improved efficiency in the medium term due to the fact that the elimination of the tariff distortions will lead to an increase in exports. • Production effects: Producers (firms) adjust production structures according to a new set of prices and factor returns along with their respective production possibility frontiers. • Government revenue effects: In the short term, the government loses total revenues due to the reduction in tariff revenue; if not offset by alternative revenues, this decrease may lead to a decline in public spending. • Welfare effects: Real household income is affected by a change in real wages and the price of

The New Regionalism in Latin America

other factors (capital and land), as well as that of

struct because of the large amount of data they use

goods and services. All these factors presumably

(national accounts, input-output tables, trade flows,

will increase welfare.

balance of payments, etc.). Much fine-tuning and a compatible and consistent benchmark database.

Noteworthy

mentation of the model. CGE models are highly

Other disadvantages are related to the impleamong the advantages of using CGE

models for economic policy analysis are that they:

dependent on the benchmark data (i.e., on the economic conditions in the base year), and they are very

• Allow policymakers to assess the specific impact of the various policy options under consideration by controlling the effects of other policy instruments.

sensitive to certain parameter estimations or assumptions (such as elasticities). Lastly, the results of CGE models must be carefully interpreted because they do not consider any

• Take into account the complex interdependent

other economic policy action or shocks during the peri-

connections that exist in real economies, or inter-

od of adjustment of the economy to the new equilibri-

actions among the sectors, households and with

um, and because they do not reflect non-economic

trade partners, which is different from partial

effects (such as institutional impacts). Finally, most CGE

equilibrium analysis.

models deal with the real side of the economy, exclud-

• Explicitly model the entire economy.

ing monetary or financial variables and dynamic

• Examine the impact on resource allocation, equi-

effects of capital accumulation.

ty and income distribution. • Measure changes in welfare.

Characteristics of the CGE Model Used

• Simulate policy alternatives. • Provide numerical results so that alternatives can

The model comprises 12 countries or regions. Each of

be compared and the available policy options

these 12 economies includes 15 sectors grouped into

easily ranked.

three main macrosectors: the primary sector, light and heavy manufactures, and services. Among the main

Main Disadvantages

features of the model is that it includes positive externalities linked to trade flows, reflecting the idea that

CGE models do of course have disadvantages,

trade liberalization leads to increased productivity. To

although they share some of them with other methods

some extent, this feature offsets the static nature of the

of economic policy evaluation such as input-output, lin-

model (since it does not reflect capital accumulation

ear programming, optimal control and macroecono-

from one period to the next). The benchmark year for

metric models. Some of the disadvantages concern

this model is 1997.

model construction. CGE models are complex to con-

adjustment of the data is needed in order to construct

Main Advantages

CHAPTER

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Lopez-Cordova, Ernesto J. 2001. NAFTA and the Mercosur Economy: Analytical Issues and Lessons for the FTAA. INTAL-ITD-STA Occasional Paper no. 9, Integration and Regional Programs Department, Inter-American Development Bank. Maddison, A. 2001. The World Economy: A Millennial Perspective. Paris: Development Centre of the Organization for Economic Cooperation and Development. Monteagudo, Josefina, and Masakazu Watanuki. 2002. FTAA in Perspective: North-South and South-South Agreements in the Western Hemisphere. Inter-American Development Bank, Washington, DC. Mimeo. Multilateral Investment Fund (MIF). 2001. Remittances to Latin America and the Caribbean: Cooperative Statistics. MIF, Washington, DC. May. Nagarajan, N. 1998. La evidencia sobre el desvio de comercio en el MERCOSUR. Integracion y Comercio no. 2. Nogues, Julio. 1996. Does Mercosur's Trade Performance Raise Concerns about the Effects of Regional Trade Arrangements? No. Mimeo. Oman, C. 1998. The Policy Challenges of Globalization and Regularization. In Ian Joost Teunissen (ed.), Regional Integration and Multilateral Cooperation in the Global Economy. The Hague: FONDAD. Organization for Economic Cooperation and Development (OECD). 1995. Regional Integration and the Multilateral Trading Systems. Synergies and Divergences. Paris: OECD.

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MARKET ACCESS

Trade liberalization through regional integration initiatives occupies a prominent chapter in any economic history of Latin America and the Caribbean in the 20th century, when external events played a key role in determining the development path for most countries in the region. When future economic historians look back at the region's turning point during the century, they will likely pay special attention to the role of the external trade policies of most countries in the region (and their most important partners) during the 1990s. Among all the structural reforms implemented in the region in recent times, trade liberalization, particularly regarding market access, stands out as the most consistent policy. Although the extent of liberalization has varied from country to country and sector to sector, the period has clearly been the most open in the region since the period before the Great Depression of the 1930s. Despite these historic changes, however, the agenda on hemispheric trade integration is far from completed. This chapter examines the region's complex web of unilateral, multilateral and preferential (bilateral or regional) trade liberalization efforts. These simultaneous policy endeavors have defined a new paradigm in the way that trade and integration policies have been designed and implemented throughout the region. This new paradigm was first labeled "open regionalism" by the Economic Commission on Latin America and the Caribbean, and most recently, in similar but more theoretical fashion, analyzed by Ethier (1998) and Devlin and Estevadeordal (2001) under the name of "new regionalism."

This chapter first provides an overview of Latin America's recent trade policy paradigm, quantifying the importance and the degree of trade liberalization and trade integration achieved on several fronts and with respect to various measures affecting trade. Next, the chapter focuses on agricultural trade integration, emphasizing the importance of looking beyond the region to understand the major market access constraints for agriculture. The final section evaluates the complexity of the regional trading system in the face of the challenge to negotiate further trade liberalization under the most ambitious trade negotiation effort ever in the hemisphere, the Free Trade Area of the Americas (FTAA).

UNDERSTANDING THE COMPLEX WEB OF TRADE LIBERALIZATION Starting in the mid- to late-1980s, most of the developing world began moving toward substantial marketoriented economic reforms, which included, almost without exception, unilateral trade liberalization policies (IDB, 1996). This happened in the context of multilateral efforts in Geneva to liberalize trade in goods and services around the world, which culminated in the Uruguay Round Agreements of 1994 and the creation of the World Trade Organization in 1995. Moreover, a growing interest in regionalism was taking hold around the world, especially in Latin America, by way of traditional regional initiatives or newly crafted preferential trade agreements.

Chapter

CHAPTER

Figure 3.1

2 Most Favored Nation Average Tariff for All Products, 2OOO

Source: IDB calculations based on 2001 Hemispheric Database in the Americas, using only ad valorem tariffs.

The depth of the unilateral trade reforms by most countries in the region is obvious when looking at the average regional tariff rates, which fell from 40 percent in the mid-1980s to 10 percent in 2000. Average maximum tariffs in the region fell from more than 80 to 40 percent, with only very few countries currently applying maximum tariffs of up to 100 percent on a small number of products. Tariff dispersion, on average, has declined from 30 percent in the mid-1980s to an average of 9 percent today. The highest average rate and the highest dispersion rate, as measured by the standard deviation, are currently under 18 and 25 percent, respectively. There are still, however, some important tariff peaks, and approximately 20 percent of tariff lines are subject to rates above 20 percent. Figure 3.1 shows average applied tariffs for every country in the region. This process of opening up unilaterally was accompanied by liberalization efforts under the multilateral trade negotiations of the Uruguay Round. The agreement that entered into force in January 1995, ending almost a decade of negotiations, included the establishment of the WTO, which is responsible for

administering the most sophisticated and comprehensive world trade agreement ever signed. A new round of negotiations was launched in Doha (Qatar) in November 2001, with further commitments to liberalize world trade, particularly regarding areas of importance for developing countries (see Chapter 2). The Uruguay Round negotiations (1986-94) were primarily concerned with two basic issues regarding trade liberalization: first, ensuring greater access to markets by reducing or eliminating obstacles to trade in goods and services; and second, making the new levels of market access legally binding under more stringent WTO regulations and procedures. In the area of tariff liberalization, this latest round of GATT negotiations achieved an average tariff reduction of 38 percent in industrialized countries and, from the standpoint of the Latin American countries, implied substantial commitments to dismantle import barriers. The central obligation with respect to tariffs requires countries to limit their levels to a specified maximum or what is called a "binding" GATT tariff commitment. The latest round resulted in a significant increase in the number of bound tariff lines. In the case of developed countries, the increase went from 22 to 72 percent, and for countries in transition from 78 to 98 percent. Latin America as a whole agreed to bind practically all tariff lines. This is especially significant when compared to the existing levels of tariff bindings before the Uruguay Round began. In Latin America, only 38 percent of tariff lines for industrial products were bound, equivalent to 57 percent of imports. For agricultural products, the percentages were 36 and 74 percent, respectively. The simple average bound tariff for Latin American countries is currently around 35 percent. These unilateral and multilateral efforts were happening just as a flurry of free trade agreements (FTAs) were being signed throughout the Americas. As was noted in Chapter 2, FTAs have a long history in the region, but the 1990s witnessed a revival of trade integration initiatives under the "new regionalism" approach. Several subregional agreements were enacted around the time of the final act of the Uruguay Round. Of particular note were the North American Free Trade Agreement (NAFTA) and the Southern Cone Common Market (Mercosur). In addition, important institutional and policy reforms were carried out in existing agreements such as the Andean Pact (renamed

Andean Community in 1 997), the Caribbean Community (CARICOM) and the Central American Common Market (CACM). In December 1994 came the Miami summit that launched the FTAA, the hemispheric economic integration initiative. Since the mid-1990s, Mexico and Chile have been in the process of consolidating their positions as strategic trade hubs in the region for some time to come. In 1994, Mexico secured three important agreements based on the NAFTA modelâ&#x20AC;&#x201D;with Costa Rica, with Colombia and Venezuela (known as the Group of Three or G-3 Agreement), and with Bolivia. All three agreements were implemented at the beginning of 1995. Mexico then built on this momentum by concluding agreements with Nicaragua in 1997 and with the Northern Triangle (Guatemala, El Salvador and Honduras) in 2000. Finally, Mexico successfully broadened and deepened its agreement with Chile in 1998. For its part, Chile built its status as a trade hub in gradual and consistent fashion. It signed its first and most basic agreements, in terms of the scope and nature of coverage, with Mexico in 1991, Venezuela in 1992, Colombia in 1993 and Ecuador in 1994. The level of sophistication was expanded somewhat in Chile's 1996 agreement with Mercosur and 1998 agreement with Peru. The broadest effort came in 1996 with the signing of a free trade agreement with Canada, which almost mimicked NAFTA. Chile's upgraded agreement in 1998 with Mexico was also based on the NAFTA model, as were its 1999 accords with the countries of the Central American Common Market. Most recently, Chile has been negotiating a free trade agreement with the United States based on the NAFTA model. When concluded, it will add to the ever-growing list of such North-South Agreements in the hemisphere. This dynamism has also been present at the extra-regional level, particularly in the context of the Asia-Pacific Economic Cooperation (APEC) initiative. Mexico joined APEC as a full member in November 1993, Chile entered a year later, and Peru in 1998. During the 2nd Presidential Meeting of APEC in November 1994 in Indonesia (the same year of the launching of the FTAA), leaders agreed to achieve free trade and investment in the region by no later than 2010 for the industrialized economies and 2020 for developing countries.

This brief review of the integration efforts in the 1990s would be incomplete without reference to the European Union's involvement with Latin America. The EU signed a trade and economic cooperation agreement with Mercosur in 1995, followed by a framework cooperation agreement with Chile in June 1996. However, the most far-reaching process to date has been the Economic Partnership, Political Coordination and Cooperation Agreement between Mexico and the European Union. The broad framework agreement was finalized in 1997 and led to the signing of a comprehensive free trade agreement between the two parties in 1999. Formal launching of negotiations for association agreements between the EU and Mercosur and Chile was agreed upon in 2000, with Chile signing the agreement in May 2002. Although all of the 30 reciprocal agreements plus some partial agreements are linked to the objectives of the "new regionalism" approach, each country has pursued its own strategic trade objectives with its own tariff reduction scheme, rules of origin, and technical, procedural and even documental systems. This has given rise to what some observers have dubbed the "spaghetti bowl" effect of trade agreements (Table 3.1 and Figure 3.2). The potential problems represented by this phenomenon will be analyzed in the final section of this chapter in the context of the challenges for the ongoing FTAA negotiations. The "spaghetti bowl" effect notwithstanding, this overview provides some insights on how Latin America's new regionalism has interacted (and will interact in the future) with other approaches to trade liberalization. Some of the commitments undertaken by the countries in the region under multilateral negotiations can be explained by successful unilateral trade liberalization reforms carried out at the national level. In turn, those same commitments at the multilateral level acted as lock-in mechanisms for the domestic reforms. Similarly, the Uruguay Round agreements set the stage for the pursuit of regional agreements under a common umbrella of global trade rules and a clearer set of disciplines under which preferential agreements can be negotiated. Those global rules may be further strengthened under the new Doha round of negotiations. Moreover, while the reciprocal nature of the multilateral round provides a national political underpinning to further liberalization, and the eco-

Market Access

CHAPTER

Figure 3.2

2 The Spaghetti Bowl: Trade Agreements Signed and Under Negotiation in the Americas

nomic advantages of free trade achieved at the multilateral level are well understood, it is sometimes difficult to evaluate net gains in a negotiating forum of more than a hundred countries with very different strategic interests acting as a constraint to new commitments. Regional and bilateral agreements offer certain advantages in this respect. These agreements are based on reciprocity principles involving a smaller group of countries. This can provide a better environment to reach consensus on the complex range of issues in modern trade agendas, better evaluate the potential gains from this bargaining exercise, and gain private sector understanding and support for the liberalization process. Ethier (1998) has pointed out that regional integration can spur multilateral liberalization by facilitating coordination. In sum, the wave of new

regionalism in the Americasâ&#x20AC;&#x201D;including the deepening of existing agreements and the ongoing FTAA negotiationsâ&#x20AC;&#x201D;should be seen as complementing unilateral reforms and multilateral efforts.1

Preferential Tariff Liberalization Market access negotiations under the "old" regionalism (Chapter 2) used to be carried out by means of a fixed preferential tariff under the most favored nation (MFN) tariffs and, in many cases, were only for a selected group of products or sectors. Unilateral and

] See Devlin and Ffrench-Davis (1999) and Devlin and Estevadeordal (2001).

Market Access

Provisions in Selected Trade Agreements in the Americas

NAFTA Tariff elimination HS-based rules of origin

V V

ALADI-based rules of origin Special rules-auto sector Agricultureseparate chap. SPS measures Technical barriers to trade Investment Investor-state dispute settlement Services Temporary entry of business persons Government procurement Intellectual property Anti-dumping/countervail

V V

MexicoChileMexico- CanadaNorth Mercosur Nicaragua Chile Triangle

V V

V V V V

Dispute settlement

Labor/Environment

V V V

ChileCentral America

V V

V V V V

CARICOMBolivia- Dominican Rep. Mercosur

Competition policy

Special and differential treatment

EcuadorG-3 Chile

V V V

V1 V

V V

V V V

V V

Notes: SA = side agreement; BE = best endeavor to define in the future: the parties shall explicitly seek to develop disciplines in these areas in the future; HS = harmonization system. 1 The parties agreed to a reciprocal exemption from the application of anti-dumping.

multilateral tariff reductions had the effect of progressively eroding the margins of preference initially agreed upon. In order to maintain those margins constant over time, countries had to renegotiate the agreements on a continuous basis. Alternatively, some agreements were negotiated by means of preferential tariff reductions as a percentage of current MFN applied rates, in this way keeping the margins of preference constant over time. Today, most new regionalism FTAs have followed the NAFTA model,2 moving towards tariff elimination programs that are relatively quick, automatic and nearly universal. The tariff elimination mechanism follows pre-specified timetables ranging from immediate elimination up to generally a 10-year phase-out, with longer transitional periods for those products regarded as "sensitive." The negotiations usually start with an agreement on a base rate or

base level from which phase-out schedules will be applied. These rates can also be subject to negotiations with the aim of beginning the phase-out schedules from lower rates. Figure 3.3 shows the evolution of MFN tariffs vis-a-vis the preferential rates from 1985 to 1997. The figure compares the average MFN rate for 11 Latin American countries with the average preferential rate that each country applies to all partners in this group under different bilateral or regional trade agreements. It shows in a particularly striking way the simultaneous lowering of external and internal barriers as one of the key features of new regionalism minimizing the proba-

The internal tariff elimination mechanism in Mercosur also followed an automatic linear program.

Table 3.1

CHAPTER

Figure 3.3

2 MFN and Preferential Tariff Liberalization, Latin America, 1985-97 (In percent}

Note: The countries included are Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay and Venezuela. Calculations include only ad valorem tariffs. Source: Estevadeordal and Shearer (2002).

Figure 3.4

MFN and Preferential Average Tariffs for All Products, 1999 (In percent}

much later. For instance, in the case of NAFTA, most trade liberalization between the United States and Canada vis-a-vis Mexico took place during the first year of the agreement, while the bulk of Mexico's liberalization to the NAFTA partners was realized five years after the agreement entered into force. The current average margins of preference of selected countries in the region are shown in Figure 3.4. The figure compares the average MFN rate with the average preferential rate of each country to other selected partners in the region with whom there is a trade agreement. Figure 3.5a estimates the percentage of tariff lines that will be fully liberalized by 2005 as a result of implementing existing tariff liberalization programs, while Figures 3.5b and 3.5c provide estimates in terms of the amount of intra-regional trade covered by those agreements and the percentage that would be fully liberalized by 2005 assuming a stable trade pattern. Based on the estimate that 80 percent of total intra-hemispheric trade will be liberalized by 2005, the year that the FTAA is expected to enter into force, and the fact that compliance with multilateral rules will require that liberalization cover "substantially all trade,"3 it can be concluded that the bulk of the difficulties in negotiating tariff liberalization in the FTAA will affect around 10 percent of current intra-regional trade flows.

Do Preferential Trade Agreements Matter for Trade?

Source: IDB calculations using only ad valorem tariffs.

bility for trade diversion. Although tariffs will be fully dismantled under most trade agreements currently in force (the average percentage of exceptions is around 5 percent, which contrasts favorably with most of the old agreements), the internal dynamics of the tariff phase-out programs vary widely across agreements. For some agreements, more than 50 percent of the products become free of tariffs during the first year of implementation of the agreement. For others, those percentages will not be reached until the fifth year or

Over the past decade, a significant amount of meaningful literature has attempted to assess the implications of preferential trading arrangements for trade patterns, global welfare, and the multilateral trading system.4 This literature has for the most part focused on

GATT Article XXIV (8) mandates that for customs unions and free trade areas to be considered as such under multilateral trade rules, they must provide for the elimination of duties and other restrictive measures on "substantially all trade." No universally accepted definition exists as to what constitutes "substantially all trade." Disputes among parties have arisen over whether the criteria should be the number of tariff lines liberalized, the value of trade liberalized, a combination thereof, or whether or not it must include all major categories of products, (i.e., agriculture). In this calculation we are using 90 percent of trade as the cut-off level for the definition of "substantially all trade." 4 See Bhagwati and Panagariya (1996); Frankel (1997); and Bhagwati, De Melo and Panagariya (1993); Krishna and Panagariya (1999).

Figure 3.5a

Trade Liberalization by 2OO5: Percent of Items to be Tariff-Free

Figure 3.5b

Trade Liberalization by 2OO5: Percent of Free Trade Imports from the Americas (including U.S. and Canada)

Figure 3.5c

Trade Liberalization by 2OO5: Percent of Free Trade Imports from Latin America

SSEESEH32M 67

CHAPTER

Box 3.1

2 A Primer on the Gravity Model

The gravity model provides a useful framework for assessing the impact of policy variables on the behavior of bilateral flows between countries, such as trade, foreign direct investment (FDI) or migration flows. The gravity model was first applied to the analysis of international trade flows by Tinbergen (1962), Poyhonen (1963) and Linnemann (1966). Its name is derived from its passing similarity to Newtonian physics, in that large economic entities such as countries or cities are said to exert pulling power on people (migration models) or their goods (trade models) or capital (FDI models). The simplest form of the gravity model for international trade assumes that the volume of trade between any two trading partners is an increasing function of their national incomes and populations, and a decreasing function of the distance between them. It is also common to use the so-called dummy variables to capture geographical

whether those agreements are good or bad for world welfare from a theoretical perspective. However, the empirical evidence is still relatively limited, and we know very little about the magnitude and significance of changes in trade barriers on a preferential basis and the resulting changes in bilateral trade volumes. Most of the recent literature has explored the effects of preferential trade agreements on trade volumes using a gravity model with the inclusion of dummy variables for trade agreements (see Box 3.1 ).5 In general, the effects of a free trade agreement on intra-area trade are quite large. Frankel (1997) has found that the formation of the EC raised trade among European countries by about 65 percent, and Mercosur and the Andean Pact promoted trade by a factor of about two-and-a-half among their partners. Estevadeordal and Robertson (2002) have examined the effects of preferential agreements on the volume of bilateral trade employing a gravity equation by precisely measuring preferential tariffs.6 They analyze the role of preferential and MFN tariffs on the volume of trade, based on a specification advocated by Anderson and van Wincoop (2000) with data from several Latin American countries and its major industrialized partners, the United States, Canada, Europe and Japan.

effects (such as signaling whether the two countries share a border, or if a country has access to the sea), cultural and historical similarities (such as if two countries share a language or were linked by past colonial ties), regional integration (such as belonging to a free trade agreement or sharing a common currency), as well as other macroeconomic policy variables (such as bilateral exchange rate volatility). Although widely used because of its empirical success, the gravity model had lacked rigorous theoretical underpinnings, and was long criticized for being an ad hoc model. However, Anderson (1979), Bergstrand (1985), and Helpman and Krugman (1985) have derived gravity equations from trade models based on product differentiation and increasing returns to scale. Evenett and Keller (2002) provide a good overview of this debate.

One of the key advantages of this gravity approach is that it directly compares the contributions of "policy" frictions, such as tariffs, with "geographical" frictions due mainly to transportation costs.7 A consistent result of the gravity equation literature is that transportation costs, as proxied by distance to markets, have a large and significant effect on trade volumes. If distance dwarfs the effects of trade barriers, then countries that are relatively far from larger markets may not experience large benefits from integration agreements. Estevadeordal and Robertson (2002), however, find that tariff elasticities (the percent change in trade vol-

See Frankel (1997). There is also considerable literature based on general equilibrium models that estimates the impact on trade of liberalization, including scenarios of regional trade agreements not reviewed here. 6

Linnemann and Verbruggen (1991) have explicitly studied the impact of tariffs on bilateral trade patterns using a gravity model framework. However, Estevadeordal and Robertson (2002) is the first study that explicitly incorporates preferential tariff rates in a gravity model. 7

It is important to understand the magnitude of the impact of removing, those frictions on trade, since some studies also rind a positive refationship between trade and growth (Frankel and Romer, 1999). However, the argument that trade liberalization leads to growth has been disputed by others (Rodriguez and Rodrik, 1999).

umes induced by a 1 percent change in tariffs) are almost equivalent in magnitude to the effects of distance. This suggests that while countries cannot change their location, they can change trade policy in a way to increase the benefits of trade. For example, Chile, which suffers a geographical disadvantage in terms of distance from most industrialized markets, experienced a large increase in bilateral trade after signing a bilateral FTA with Mexico. A similar result is expected from Chile's recent agreement with Canada and one currently being negotiated with the United States. Therefore, FTAs are a speedy way to look for new trade opportunities with distance partners, as in the case of the agreements with the European Union or other Northern partners.

Rules of Origin Rules of origin are an important but often forgotten aspect in analysis of market access in FTAs. Under an FTA, each country maintains its own external tariffs visa-vis the outside world.8 To the extent that these barriers differ, there is always the incentive to import a good through the country with the lowest barriers. Rules of origin are required to prevent such trade deflection. They specify the conditions that goods must meet in order to be deemed as "originating" and hence be eligible for preferential tariff treatment. The growth of international trade in goods that are not manufactured in a single country has made the issue of the rules for determining the "origin" of traded goods one of the most important and complex areas of preferential market access negotiations. While the simpler rules rely on a single uniform criterion across all products, such as in ALADItype agreements, the more complex agreements such as NAFTA9 use a general rule plus additional specific rules negotiated at the product level, combining in different ways three methods to establish "substantial transformation." Those methods can be defined in terms of a "tariff shift" approach, a "value-added" criterion, or a "technical test."10 Immediate precedents of the NAFTA model, with a lower degree of specificity, are the rules of origin contained in the FTA between the United States and Canada. The rules negotiated under the G-3 agreement, the Mexican bilateral agreements with Costa Rica and Bolivia, and the recent Chilean

bilateral agreement with Mexico and Canada are also close to the NAFTA model. Meanwhile, rules introduced under Mercosur and its bilateral agreements with Chile and Bolivia, as well as the Central America Common Market, can be considered intermediate models between the two extreme cases.11 Although rules of origin are well known to trade lawyers and customs specialists (Vermulst and Bourgeois, 1994), they have only recently caught the attention of economists. While the impact of political and economic interests in shaping rules of origin is well known, there have been few attempts to estimate those effects. Economic analysis has been relatively limited both in terms of formal modeling as well as empirical testing. It has been argued that the way in which rules of origin are defined and applied within modern preferential agreements plays an important role in determining the degree of protection they confer and the level of trade distortion effects that they produce (Hoekman, 1993). One of the most convincing treatments of the potential "hidden" protectionism of rules of origin has been by Krishna and Krueger (1995), who argued that, provided that margins of preference are large and rules are restrictive, they can induce a switch in the sourcing of low-cost nonregional to high-cost regional

This is a key difference with a customs union, where the members maintain common external tariffs vis-a-vis the rest of the world.

9 NAFTA arguably contains the most sophisticated origin regime yet devised. These highly disaggregated and heterogeneous rules run for many pages and make liberal use of the different types of origin methodologies. Understandably, the negotiating history of NAFTA is replete with battles over the content of specific rules of origin, for the difference between a favorable and unfavorable rule can easily run in the millions of dollars annually for some firms. 10

The "tariff shift" criterion requires that after transformation of one or several imported inputs in the exporting (originating) country, the processed product exported falls under a different heading of the tariff nomenclature than that under which the imported inputs were classified. The "value-added" criterion prescribes the minimum percentage of value that must be added in the exporting country or the maximum percentage of value accounted by imports in order to be qualified as originating. Finally, the "technical test" is based on manufacturing or processing operations that are required to confer originating status. 1]

While the method for conferring origin to a product constitutes the central element of an origin regime in a free trade agreement, there are other important provisions that are not analyzed in this chapter. These include the cumulative provisions that establish the conditions under which imports from certain sources may be counted as domestically supplied in the preference-receiving exporting country. Other provisions related to origin consideration include whether or not there are duty drawback rules.

Market Access

CHAPTER

inputs in order for producers to take advantage of the preferential rates. Thus, restrictive rules may provide additional protection to regional producers of intermediate goods, to the detriment of downstream or final goods producers. Moreover, outside producers of intermediate goods hurt by restrictive rules may have an incentive to move production facilities into the lowercost country within the region, even though it is not the lowest cost producer worldwide.

Figure 3.6

From U.S.-Canada FTA to NAFTA: Rules of Origin and Utilization Rates

Do Rules of Origin Matter for Trade? As noted in a recent document of the United Nations Conference on Trade and Development, "the mere granting of tariff preferences or duty-free market access to exports originating in LDCs does not automatically ensure that the trade preferences are effectively utilized by beneficiary countries" (UNCTAD 2001, p. 8). Brenton and Manchin (2002) have estimated that in 1999, whereas the EU's Generalized System of Preference (GSP) theoretically covered 99 percent of EU imports from eligible countries, only 31 percent of exports were shipped under preferential rates by those countries. According to the authors the main reason was restrictive rules imposed by the EU, coupled with the costs of compliance with those rules. Estevadeordal and Miller (2002) have also shown that in the case of NAFTA, those "missed preferences" (UNCTAD, 2001) can be directly related to the restrictive effects and compliance costs of the rules of origin.12 The study shows that for those sectors where the NAFTA rules of origin became more restrictive vis-a-vis the rules governing the previous FTA agreement between the United States and Canada, the "utilization rates," or the percentage of trade that uses preferential tariffs as opposed to MFN tariffs, experienced a substantial decline (Figure 3.6). Depending on individual sectors, this effect can be attributed to the sudden administrative burden of dealing with a new set of complicated rules to which firms may eventually adjust, or to absolutely restrictive effects of more stringent rules. Rules of origin should be viewed as primary policy instruments in any market access negotiations, not just as having a supportive role in the application of a primary instrument such as preferential tariffs. Estevadeordal (2000) has documented the interaction

Source: Estevadeordal and Miller (2002).

between the degree of stringency of the NAFTA rules of origin and the speed of tariff liberalization, stressing the importance of considering rules of origin as key policy instruments in the design and implementation of FTAs. In the case of NAFTA, the study finds that the origin regime clearly performed its main role as an instrument against trade deflection. It finds a strong correlation between the differential of Mexican and U.S. MFN tariffs, which provides an incentive for trade deflection, and the degree of restrictiveness imposed by the rules of origin. However, as discussed earlier, those rules can have an additional intended or unintended protectionist effect. In the case of NAFTA, there is evidence that sectors with more restrictive rules of origin were also the ones with longer tariff phase-out periods; that is, rules of origin and phase-out periods

12 From a methodological point of view, the study takes advantage of the fact that the preferential tariff regime negotiated in the U.S.Canada FTA was not modified under NAFTA, while the major changes in market access conditions were due to the drastic overhaul of the origin regime.

could be viewed as complementary instruments of a discriminatory tariff policy. However, a more sophisticated interpretation of this result would be the existence of a substitution effect; that is, although preferential tariffs would be fully dismantled at the end of the phaseout period, the origin requirement would remain in place, providing some protective effects. Borrowing the language of the endogenous protection literature, one could conclude that the same forces that push for tariff protection also push for more stringent origin rules.13

Obstacles to Market Access Liberalization: Non-tariff Measures Because governments have to a significant degree abandoned across-the-board protectionism, they are increasingly seeking other restrictive trade instruments that can be used effectively at the sectoral level. Hence the burgeoning interest in rules of origin and other non-tariff measures (NTMs). A major accomplishment of several rounds of multilateral trade negotiations in the context of the GATT agreement has been the steady reduction of tariffs across sectors and countries. Tariff reductions negotiated during the Kennedy Round (1967) and the Tokyo Round (1979) were followed by an increased use of non-tariff barriers in the form of quantitative restrictions. The Uruguay Round made important progress in reducing those types of trade barriers. Although consistent under WTO rules, countries are progressively relying on more subtle forms of protection such as anti-dumping investigations or the use of technical standards. The level of protection provided by such barriers is far more difficult to quantify than for tariffs or other quantitative restrictions, making negotiations for their removal difficult. But while determining the tariff equivalent of quantitative restrictions is difficult, figuring out the costs to an importer of the paperwork for a health permit, a change in packaging requirements, or inconsistent enforcement of customs standards often proves practically impossible. The benefits of traditional trade liberalization can be greatly reduced if countries merely compensate by imposing hidden protective technical measures. Although most regional agreements contain provisions on the application of non-tariff measures, in most cases those are applied on a most-favored nation basis (minimum price setting, automatic license

arrangements, non-automatic licenses, tariff rate-quotas,14 import prohibitions, monopolistic measures in the administration of imports, and other technical measures). During the period prior to trade liberalization reform, most countries required import licenses in order to assure that imports did not surpass pre-set quotas. These levels could be modified by authorities in response to foreign exchange crises, becoming in practice an instrument to deal with balance of payment problems. The countries of the region gradually eliminated quantitative limits on imports both unilaterally and within the framework of multilateral commitments assumed during the Uruguay Round. There remains, however, trade regulation that could potentially restrict trade, such as government purchasing arrangements, inappropriate use of anti-dumping measures, and the increasing use of certain competitive policies and technical measures for protective purposes. Figure 3.7 gives an overall estimate of NTM coverage as well as a measure of the incidence of quantitative and technical measures.15 Although their importance differs greatly among countries, these measures clearly are significant, particularly in light of their potential use as protectionist measures.16

THE SPECIAL CASE OF AGRICULTURAL TRADE LIBERALIZATION Agriculture is a sensitive, complex and heterogeneous sector for most Western Hemispheric countries, having different importance and meaning for each country. Overall, it absorbs a considerable portion of the eco-

An extension of this analysis can be found in Cadot et al. (2002).

A tariff-rate quota (IRQ) is a two-tiered tariff. In a given period, a lower in-quota tariff is applied to a given amount of first imports and a higher over-quota tariff is applied to all subsequent imports. 15 Those measures are based on data compiled by UNCTAD and the Inter-American Development Bank under the project TRAINS for the Americas. 16 The empirical evidence on the administrative costs of non-tariff measures and other regulations is scant. Using firm-level data, Koskinen (1983) estimated administrative compliance costs under the FTA between the European Free Trade Association (EFTA) and the EC were between 1.4 percent and 5.7 percent of the value of export transactions, while according to Holmes and Shephard (1983), the average export transaction from EFTA to the EC required 35 documents and 360 copies.

Market Access

CHAPTER

Figure 3.7

2 Non-tariff Measure Incidence Indicator as a Percent of Tariff Lines Covered

nomically active population, and represents a high percentage of GDP and exports. For small economies such as most of the Caribbean countries, it means strong dependence on preferential or duty-free access agreements such as the Generalized System of Preferences (GSP) or the Lome-Cotonou Agreements between the European Union and the ACP countries. The elimination of subsidies is a sensitive issue for the net food importer countries, since they depend strongly on lowcost food imports and consequently resist the elimination of export incentives in the developed world such as agricultural export subsidies and credits and food aid mechanisms. For medium-sized economies such as Brazil and Argentina, agriculture is a competitive sector with strong potential to generate trade balance surpluses. These countries can be expected to demand further liberalization. For large economies like the European Union, the United States and Japan, agriculture is a politically sensitive sector due to the pressure that lobby groups exert on the lawmaking process. As a result, agriculture is a strategic issue for all Latin American countries in all of the regional and multilateral trade negotiations. Despite the achievements of the Uruguay Round Agreement on Agriculture, the sector continues to be the most protected in the world economy. Protection through ad valorem tariffs continues to be the main

vehicle for trade protection; however, agricultural products are unique in that they also are protected through specific and compound tariffs, tariff rate quotas, sanitary restrictions, domestic and export subsidies, and many different types of non-tariff barriers (licensing, standards, voluntary export restrictions, prohibitions, state trading, etc.). This section examines some of those policy instruments used today throughout the Western Hemisphere to protect the agricultural sector. It analyzes current agricultural trade in the region as well as tariff profiles and comparative protection levels.17'18 Agricultural trade in the Western Hemisphere totals $200 billion and represents approximately 30 percent of the world's agricultural trade and 7 percent of total hemispheric trade. Approximately half of the countries included in this study run agricultural trade surpluses. Figure 3.8 shows trade performance as a share of GDP of the five regional blocs within the Western Hemisphere. Even though NAFTA is by far the major hemispheric trader of agricultural products, it has the smallest trade as a percentage of GDP. Mercosur and Central America have the largest trade surplus in relative terms, while the 15 Caribbean countries show an overall deficit, mainly concentrated in food products. Specifically, in 2000, the United States, Argentina, Brazil and Canada had the largest agricultural trade surpluses, while Mexico, Venezuela, the Bahamas and the Dominican Republic had the largest deficits (see Appendix 3.1, Table 1). The most commonly used methods to measure tariff protection are the mean to depict the overall level of tariffs, and the standard deviation to measure tariff dispersion. The average tariff on agricultural products in the region is 16 percent, with Barbados, the Bahamas, Mexico, Dominica, the Dominican Republic and Canada having the highest ad valorem equivalent

17 See Appendix 3.1 for data definitions and methodologies used in this section. 18 This chapter uses data collected from the 2001 Hemispheric Database of the Americas for 30 of the 34 FTAA member countries (excluding Belize, Suriname, Guyana and Haiti, due to lack of traderelated data). The objective is to build a complete profile of the levels of protection by country and by main groups of products. The study uses MFN applied rates, since these will be the tariffs used in the FTAA negotiations. Therefore, preferential and intra-bloc tariffs were not considered.

Figure 3.8

Total Agricultural Trade in the Western Hemisphere, 2OOO (Percent of GDP)

Chile, the Dominican Republic and Panama. Source: Hemispheric Database in the Americas, 2001.

Figure 3.9

Tariff Structure in Agriculture, 2OOO (In percent]

tariffs (AVE), averaging over 20 percent. Nicaragua, Chile, Guatemala and Bolivia have the lowest average tariffs, below 10 percent (Figure 3.9 and Appendix 3.1, Table 1). However, aggregates such as the mean and dispersion do not tell the whole story. For example, comparing the mean and the median of a country's tariff schedule may provide valuable insights into the agricultural trade policy of different countries.19 Most countries of the Western Hemisphere have close mean and median tariffs, indicating that their tariff schedule is normally distributed. However, in Canada, the European Union and the United States, the median is far lower than the mean. This indicates the simultaneous presence of a large number of tariff lines far below the mean, and a smaller number of tariff lines with very high rates, commonly called "tariff peaks" or "megatariffs." In other words, these countries apply very high tariffs on a very small group of sensitive products, while the remainder of their tariffs are kept at low levels.20 Canada ranks first with 98 tariff lines above 50 percent, with some products from the milling industry reaching equivalent rates of up to 530 percent. In the case of the United States, 4 percent of its tariff lines (61 lines) have rates above 50 percent, and up to 350 percent in some tobacco products. Nevertheless, the United States' high proportion of low rates (83 percent of its tariff lines have rates below 15 percent) offsets the impact of its megatariffs and ultimately results in a low overall average. In the case of Mexico, 5 percent of its tariff lines (54 tariff lines) are above 50 percent and run as high as 260 percent. But Mexico also represents the third highest mean among all FTAA countries (23 percent). All the South American countries except Peru have means and medians that are very close. This

19 The arithmetic mean is what is commonly called the average and is the sum of all the scores divided by the number of scores. Dispersion is measured through the standard deviation, which measures the degree to which a value varies from the distribution mean. The median is the midpoint of a tariff schedule's distribution in ascending order of value: half the scores are above the median and half are below the median.

Source: IDB calculations based on Hemispheric Database in the Americas, 2001 including the conversion of all specific and mixed tariffs into ad valorem equivalents.

20 Olarreaga and Soloaga (1997) study several industry conditions that are correlated to high tariff protection, including high levels of industry concentration, low import penetration ratios, low share of sector production that is purchased by other sectors as intermediaries, high labor/capital ratio, and small share of intra-industry trades.

Market Access

CHAPTER

shows that the process of liberalization in the 1990s was accomplished without exclusions in the agricultural sector. Mercosur countries in particular have experienced a strong convergence in their agricultural tariffs. These countries all have means of approximately 12 percent; medians of exactly 1 3 percent; and standard deviations of about 6 percent. Andean countries have means and medians ranging between 10 percent and 17 percent and dispersions below 6.5 percent. Chile is a particular case. Even though its ad valorem tariffs appear to be one of the lowest, set at 9 percent for all products, agricultural imports are subject to price bands21 and other restrictions that significantly protect against imports. This is a clear example of how nontariff barriers make measurement of tariff protection a difficult task. Another important measure of tariff protection is the type of tariff applied. Tariff barriers in agriculture are not only based on ad valorem tariffs, but also on the extensive use of specific and mixed tariffs and tariff-rate quotas.22 NAFTA countries in particular stand out for their use of such tariffs. More than one-third of U.S. tariffs are specific, followed by Canada with 19 percent and Mexico with 1 percent. Some Caribbean countries also apply specific tariffs, which results in higher protection the more competitive the exporting country is. All the South American countries only use ad valorem tariffs. The concentration of exports in some specific agricultural product groups is a clear phenomenon in Latin American and Caribbean countries. The Hirschmann-Herfindahl Index (HHI)23 can be used to measure the level of trade concentration in specific products (see Figures 3.10a and b and Appendix 3.1). According to the HHI, exports are approximately seven times more concentrated than imports. Caribbean and Central American countries have the highest levels of export concentration in specific products. Examples are St. Kitts and Nevis, where raw sugar represents 75 percent of agricultural exports; St. Lucia, where bananas and beer represent 92 percent of exports; and Honduras, with coffee and bananas representing 74 percent of exports. The most diversified countries in terms of exports are the United States, Canada and Mexico. A country whose main exports are raw sugar and bananas is not interested in the overall level of tar-

iffs imposed by another partner, but only on the tariffs imposed on its main exports. In fact, this country will be interested in the additional access that would be provided to its primary traded products through multilateral and regional negotiations. Statistical aggregates such as those shown above (e.g., means, medians and dispersions) do not measure the real importance and levels of tariff protection on very specific and sensitive products. A better measure in those cases is the Relative Tariff Ratio (RTR) index, originally developed by Sandrey (2000). The index considers a two-country world, where each tariff line of country A is weighted by country B's total exports for the same tariff line, and vice versa (Appendix 3.1). The index is constructed as the ratio between a country's faced tariffs in the numerator and its imposed tariffs in the denominator. Following the RTR concept, Jank, Giordano and Devlin (2002) propose an extension of a new RTR index at the regional level called the Regional Export Sensitive Tariff index (REST, see Appendix 3.1). The REST index aggregates all tariffs faced and imposed by each country at the regional level into a single indicator, representing a ratio of the weighted value of those tariffs. The index measures each country's faced tariffs from its partners, weighted by its total exports in

Price bands regulate markets so prices remain within a specified range. In the case of Chile, for example, the price band for wheat is a pair of variable tariffs: one increases to defend a floor price and one decreases to defend the ceiling price. The band has two tariffs, an ad valorem tariff that is always imposed, and a specific tariff that is determined by a tariff algorithm. When international prices are between the floor and the ceiling, the specific tariff is zero and only the ad valorem tariff is imposed! When the international prices are below the floor or above the ceilinq, the specific tariff is increased or lowered to keep the price within the set limits. The price band loses its capacity to offset international prices when the tariff increase reaches its bound level or when it is decreased to zero. See Skully (2001 b). 22 Ad valorem tariffs are calculated as a percentage of the value of the goods, which is normally the GIF (cost, insurance and freight). Specific tariffs are calculated as a percentage or a fixed amount per volume units (i.e., kilograms), and consequently result in higher protection levels the more competitive the exporting country is (lower import prices result in higher ad valorem equivalents). Mixed or compound tariffs are a combination of ad valorem plus specific rates. 23

The Hirschmann-Herfindahl Index (HHI) is equal to the sum of the squared shares of all products (tariff lines) exported. When a single export product or tariff line produces all the revenues, the HHI equals 100; when export revenues are evenly distributed over a large number of products, HHI approaches zero (see Appendix 3.1).

Market Access

Figure 3.1 Oa Agriculture Trade Concentration: The Hirschmann-Herfindahl Index for Exports

Figure 3.11

Weighted Agricultural Tariffs Faced and Imposed (In percent}

Source: IDB calculations based on Hemispheric Database in the Americas, 2001, including the conversion of all specific and mixed tariffs into ad valorem equivalents.

Source: IDB calculations based on Hemispheric Database in the Americas, 2001.

Figure 3.1 Ob The Hirschmann-Herfindahl Index for Imports (0-100)

Source: IDB calculations based on Hemispheric Database in the Americas, 2001.

the numerator, and each country's imposed tariffs, weighted by the total exports of all its partners in the denominator, calculated on a bilateral basis. Both the RTR and the REST indices can be used to gauge the concessions that each country would be making relative to those it would receive, in the event of the elimination of barriers for agricultural trade. The advantage of the REST index is that it can go far beyond the bilateral level, and address the important issue of liberalization at a regional or multilateral level. Figure 3.11 displays the value of the agricultural tariffs effectively faced and imposed by 20 individual countries in the Americas as well as by the CARICOM nations. Figure 3.12 presents the calculation of the REST index for agricultural products considering the same sample and using MFN tariffs. These figures show very clearly that NAFTA, Caribbean and most Andean countries impose higher weighted tariffs than they face in the Western Hemisphere. The biggest face-off is in Mexico and the United States, whose high tariffs imposed on a very small group of products are significant to potential FTAA partners. In other words, those countries are net liberalizers within the integration process in terms of tariff protection. But this could be substantially modified when one considers other

(0-100)

CHAPTER

Figure 3.12

2 Regional Export Sensitive Tariffs Index (REST)

Source: IDB calculations based on Hemispheric Database in the Americas, 2001, including the conversion of all specific and mixed tariffs into ad valorem equivalents.

aspects of protectionism, such as non-tariff barriers, domestic support and export subsidies (see Box 3.2). One of the best ways to measure the trade effects of removing tariff protection and subsidies is through the use of a computable general equilibrium model (CGE). Appendix 3.2 displays an exercise of the potential trade effects of agricultural reform in the Americas. On the other hand, all the Mercosur nations, Chile and most Central American countries would be net winners of agricultural liberalization. Brazil would rank second in this process above Uruguay, Chile and Argentina as a result of the high tariffs faced by Brazil's sensitive products such as sugar, orange juice and tobacco. All Mercosur countries should take into consideration the important potential gains to be realized in the agricultural sector as a result of balanced FTAA negotiations, as well as the setback that they could face in the absence of this agreement. In brief, agricultural trade liberalization in the Western Hemisphere will prove to be one of the main challenges throughout the FTAA negotiations, but also one of the main areas for market access opportunities.

THE "SPAGHETTI-BOWL" OF TRADE AGREEMENTS IN THE AMERICAS AND THE FTAA NEGOTIATIONS The FTAA faces a difficult job in defining the terms of coexisting with other trade agreements in the hemisphere. The ministers have coined a language that does not necessarily contribute to solving the technical problems involved.24 For practical purposes, more than 30 trade agreements now coexist in the hemisphere, in addition to those that are under negotiation or that will be negotiated by 2005. This implies the challenge of deciding how to deal with current and potential market access conditions for the goods that will benefit from this complex set of trade agreements, each with its own tariff reduction schemes, rules of origin, and technical, procedural and even documental systems. Many of these agreements have led or are leading to different complex programs to phase out trade barriers. The pace and speed of each depends on the results of negotiations among member states. Some of these also exclude certain goods or give special treatment to specific sectors. Consideration clearly must be given to what kind of treatment the FTAA can give these goods or sectors; or, if the treatment given under other agreements differs from that negotiated in the FTAA framework, it is worth considering whether such agreements can in fact coexist. In addition to the multitude of programs for phasing out trade barriers in the hemisphere, each agreement also has its own rules of origin regime.25 Rules of origin in themselves can add considerable complexity, both to negotiations and to their execution and verification. Likewise, the criteria for determining origin, the precise content of the "accumulation" clauses, and the specific rules for goods can vary greatly

24 The Ministerial Declarations made at the San Jose and Buenos Aires conferences establish that "the FTAA can co-exist with bilateral and subregional agreements, in so far as the rights and obligations under such agreements are not covered by or do not exceed the rights and obligations of the FTAA." Despite these observations, it is important to remember that the agreements in force are the building blocks of the FTAA. In many countries in the hemisphere, these agreements have helped build political consensus in favor of freer trade and the FTAA. 25 For a detailed analysis of the different regimes, see Cornejo and Garayf 1999, 2001).

Market Access

Agricultural Domestic and Expert Subsidies

One of the major breakthroughs of the Uruguay Round Agreement on Agriculture was the recognition of the direct link between agricultural subsidies and international trade. In terms of domestic support, agricultural policies that have trade-distorting effects were identified by an indicator called the "aggregate measurement of support" (AMS). The "amber box" was created based on this AMS. In addition, the agreement required countries to notify (identify) their export subsidies. While under GATT export subsidies for industrial products have been prohibited during the multilateral rounds, in the case of agriculture, such subsidies were only subject to limited disciplines and reductions. The table below shows the evolution of domestic and export subsidy notifications in the Western Hemisphere, compared to all

Table 1

other major players in the world. The potential FTAA members have low levels of both subsidies, but the United States has been increasing its domestic support in recent years, a trend expected to continue after the approval of the 2002 farm bill (the Farm Security and Rural Investment Act). The Western Hemisphere countries traditionally have very low levels of export subsidies and would easily be able to eliminate such subsidies in the near future. However, other similar measures—such as officially supported export credits on agriculture, the abuse of international food aid programs, the presence of state trading enterprises, and export restrictions—have been used in the region and could be relevant in the multilateral and regional negotiations.

WTO Notifications in Domestic Support and Export Subsidies (Millions of US$)

Domestic support1

United States Mexico Canada Venezuela Argentina Colombia Brazil Costa Rica FTAA European Union "Like-minded"3 Others World

Export subsidies

1995

19984

%\2 (%)

6,214 452 568 542 123 58 7,957 64,436 44,716 2,427 119,536

1 0,400 1,258 522 211 83 10 83

7.1 0.8 0.5 0.4 0.1 0.0 0.0 0.0 8.8 58.1 31.1 2.0 100.0

12,567 52,453 1 1 ,479 934 77,433

1995

1998

(%)3

26 38 3

147 4 na na

18 85 6,292 619 116 7,112

1.5 0.1 0.2 0.1 0.0 0.3 0.0 0.8 3.1 88.0 7.6 1.3 100.0

123 297 5,843 440 62 6,642

Notifications of total AMS (aggregate measurement of support) reduction commitments in the "amber box." Average for 1995-98. "Like-minded" countries are the Czech Republic, Hungary, Iceland, Norway, Poland, Switzerland, Liechtenstein, Japan and Korea. 4 Most countries did not notify their subsidies after 1999. Source: WTO. 2

from agreement to agreement. This begs the same

the FTAA is precisely this—to simplify trade in the

question as before: How can different rules of origin

hemisphere. At the technical and political levels, how-

schemes coexist during the FTAA transition period? If a

ever, the question of coexistence is complex and will

businessperson wants to export and has an FTAA rule

require a great deal of analysis.

of origin and another different rule for the same prod-

The agreements currently in force in the hemi-

uct under a bilateral agreement, how can his or her

sphere often contain disciplines relating to exporting

decision be facilitated? In fact, one of the basic aims of

and importing procedures, document and labeling

Bex 3.2

CHAPTER

requirements, technical regulations and standards, and requirements for verification and certification.26 Once again, it will be up to the negotiators to define the best way of simplifying these requirements—something not always easy. The panorama is indeed complex for current FTAA negotiations. However, three possible scenarios are most likely: (i) the FTAA negotiates its own tariff elimination program, set of rules of origin, and requirements, while exporters decide on a case-bycase basis whether to opt for FTAA treatment or for treatment in accordance with another agreement, depending on what best suits their interests; (ii) the FTAA invalidates pre-existing agreements on tariffs, origin and technical and procedural requirements,

making FTAA criteria the only valid ones; and (iii) the FTAA does not step in to regulate tariffs, origin or procedural requirements among countries that already have a trade agreement in force. Each of these options has its advantages and disadvantages. What is certain is that if the FTAA manages to rationalize the spaghetti bowl, it will have achieved a significant positive externality. It is still early to predict to what degree the FTAA will be able to do this, but there is no reason to be too pessimistic. Perhaps the most important conclusion is that the FTAA could become a regional agreement that will contribute to the construction of a vigorous multilateral system— an example of regionalism as a building block rather than a stumbling block.

For an idea of the vast number of agreements in this area, see FTAA (1998).

APPENDIX 3.1 TECHNICAL NOTES: TRADE CONCENTRATION AND TARIFF PROTECTION INDICES

General methodology: The objective of the study was to compile all trade-related data available for agricultural products country by country, using the 2001 Hemispheric Database of the Americas. A database was created containing both 6-digit and 8-digit (or more) harmonized system tariff lines. It includes product descriptions, most favored nation (MFN) ad valorem tariffs, MFN specific and mixed tariffs, preferential rates, and ad valorem equivalents for such tariffs, import value and volume, import price, export value, export volume, and an indication of whether the tariff is a tariff rate quota (IRQ). Once all tariffs were expressed in terms of ad valorem equivalents, we were able to calculate the number of tariff lines and IRQ, mean, median, tariff dispersion, maximum and minimum tariffs, and frequency distributions. Tariff conversions: The first step in developing tariff profiles was the conversion of all specific and mixed tariffs into ad valorem equivalents (AVE). Specific tariffs are tariffs that are set as a monetary amount per unit of import, i.e., a product can have a specific tariff, which charges $1.50 per kilogram. Countries may also combine ad valorem and specific tariffs so that a product's tariff may be the sum of the ad valorem tariff plus the specific tariff, called mixed or compound tariffs. According to the WTO, AVE are usually calculated "either by comparing collected custom revenues to the value of imports or by comparing unit values of traded products with the applied non-ad valorem tariff." The methodology followed in this study to obtain ad valorem equivalents was to divide the product's specific rate by its import price. In this case, the price was calculated by dividing the value of imports by the quantity of imports. Where no trade data were available, the price of the closest related product was used. Tariff rate quotas: As a result of the "tariffication" effort of the URAA, many products that used to be protected with import quotas are now protected through TRQs. In this case, lower "within access commitment" rates are set for specified quantities, and higher "over access commitment" rates are set for

quantities that exceed the quota. The in-quota tariff would be the tariff rate up to the quota limit, and the over-quota tariff is the higher duty rate. Hirschmann-Herfindahl Index (HHI): The HHI is equal to the sum of the squared shares of all individual products exported, where / stands for a particular product and n is the total number of products. When a single export product (tariff line) produces all the revenues, HHI equals 100; when export revenues are evenly distributed over a large number of products, HHI approaches zero.

Relative tariff ratio index (RTR): The RTR index was developed by Sandrey (2000) and assumes, in the first instance, that only the bilateral partners exist in the world, placing great emphasis on tariffs from an importing country that are of the greatest importance to the exporting partner. So, the index is always calculated on a bilateral basis, using country A's total exports as weights in the calculation of a weighted average tariff of country B, and vice-versa. For example, if the tariff line "boneless frozen meat of bovine animal" represents 23 percent of Uruguay's exports, it will weight 23 percent on Uruguay's "faced" tariffs from each FTAA country. The RTR is the ratio between country A's faced tariffs in the numerator and imposed tariffs in the denominator, relative to country B, or:

where A, B = countries A and B X- = ad valorem equivalent (AVE) tariff rate for product /; YJ = share of exports of product / in total exports; Regional export sensitive tariff index (REST): The REST index of Janks, Giordano and Devlin (2002) measures each country's faced tariffs from its partners weighted by its total exports in the numerator and each

Market Access

CHAPTER

country's imposed tariffs weighted by the total exports of all its partners in the denominator, calculated one by one, considering a potential regional integration agreement (RIA). Each combination of tariffs and share of export ratios for one country is weighted by the relative importance of total exports to the region in the case of faced tariffs and total imports in the case of imposed tariffs. Preexisting RIAs need to be considered using preferential tariffs or assuming a zero tariff in the case of a future free trade area.

where A, B, C,..., N = member countries of an RIA. X^ = maximum ad valorem equivalent tariff rate at HS96 level for tariff line / /â&#x20AC;˘ = share of exports of product / in total exports for each country; or: X^ = country's total exports of tariff line ;' to the world

Mg = country A's total imports from country B Mj = country A's total imports from all RIA countries, excluding preferential trade Xg = country A's total imports to country B Xj= country A's total imports to all RIA countries, excluding preferential trade.

1,241,539 919,306 98,404 141,281 -90,269 1,567,390 -327,892 -67,856

Bolivia Colombia Ecuador Peru Venezuela Costa Rica Guatemala Honduras Nicaragua El Salvador

£ Chile u Dominican Rep. IPanama

38,277,394 -4,625,098

926 1,227

999 1,000 1,024 998 1,021 1,015 579 886 676 1,007

747 778 1,334

1,138 811 869 869 937

873 881 865 900 865

1,016 979 989

940 940 945 908

60 852

22 0 1 439 27

19 24

53 362 747

Ad Non-ad valorem valorem1

144 845

218 389 285 257 410 120 159 0 152 117

442 505

246 80 238 257 61 351 55 349 788 392

747 229 455

858 280 268 530 278

15 0 20 0 0

0 0 67

496 656 1,083

30 538 372

796 215 425 638 217

564 565 576 552

79 79 79 77

238 208 0 197 217

0-15

0 0 0 0 0 40 0 5 9 0 0 0 41

0 0 0 56 0 64 0 13 7 49 0 272 48

0 601 577 314 591 0 388 426 18 429 0 277 723

113 136

14 80

16.0 18.3

17.3 16.6 16.5 17.5 17.2 18.2 22.7 36.6 25.4 17.0

9.0 21.2 15.0

13.8 9.2 11.5 7.3 11.2

9.8 14.5 14.3 17.1 14.6

23.3 20.8 11.4

12.7 12.6 12.3 12.4

Mean

14.1 11.5

20.0 15.0 10.0 10.0 15.0 15.0 25.0 20.0 30.0 10.0

9.0 25.0 15.0

14.0 10.0 15.0 10.0 15.0

10.0 15.0 15.0 12.0 15.0

15.0 3.0 3.7

13.0 13.0 13.0 13.0

Median

15.3 24.5

14.7 16.7 16.0 16.3 17.0 15.1 17.9 51.6 17.6 15.0

10.6 20.8

20.0 6.5 8.4 7.4 8.9

1.3 5.5 5.7 6.5 5.4

37.8 61.6 32.0

5.9 5.8 5.6 5.6

St. dev.

Main statistics

99 252

969 256

0 0 0 0 0 0 0 37 0 0

0 0 57

9 35 300 45 75 45 40 75 40 45 243 260 40

73 31 0 17 37

0 66 21 0 59

68 123 376

TRQs

162 20 55 77 40

10 20 20 30 20

260 530 350

32 27 30 23

Max.

261 513

208 245 173 120 224 219 78 194 0 228

0 2 0 0 5 0 0 97 3 0

54 98 61

62 3 59

427 46 161

327 284 328 364 321 324 287 246 0 270

0 0 0 0

1 0 4 0

296 296 286 279

>50

30-50

15-30

Frequency distribution of tariff rates (%)

Non-ad valorem = sum of all specific and mixed rates. HS = harmonized system. Source: 2001 Hemispheric Database of the Americas and the Agricultural Market Access Database (AMAD).

TOTAL (sum or average) EU-15

-73,457 -49,375 -43,929 -27,211 -133,611 -19,639 -8,666 -94,877 -615,499 -4,874

169,664 1,441,657 1,117,100 -258,173 -1,309,192

Mexico Canada United States

Antigua & Barbuda Trinidad & Tobago St. Lucia St. Kitts & Nevis Jamaica Grenada Dominica Barbados Bahamas St. Vincent

-2,101,401 4,142,472 14,237,485

Argentina Brazil Paraguay Uruguay

«j <

9,494,815 8,050,652 302,221 579,329

Country

No. of tariff lines

Agricultural Trade and Tariff Structure at HS 8-digit Level, 2OOO

Trade balance ('000)

Appendix 3.1 Table 1

Mercosur NAFTA CACM CARICOM

CHAPTER

APPENDIX 3.2 AGRICULTURE TRADE POLICY REFORM IN THE AMERICAS1 Agricultural trade barriers and producer subsidies distort global agriculture, a sector where Latin America and the Caribbean have a salient comparative advantage and strong export competitiveness. Trade barriers lower demand for products from trade partners; domestic support creates an excess supply of agricultural products, and export subsidies lead to lower prices. The current negotiations on market access and agriculture in the FTAA process will offer promising opportunities and potential gains for countries in the region. To evaluate the potential trade effects of agricultural reform, a multi-region, multi-sector, comparative static CGE model was used. The analysis focuses on three pillars of agricultural policies distorting world prices and restricting trade flows: market access (trade barriers), domestic support, and export subsidies. The model simulates to examine the individual and complementary effects of these policy variables in the Western Hemisphere. It also assesses the impact of the liberalization of agriculture between Mercosur and the European Union under negotiation. In the Western Hemisphere, the elimination of all tariffs (including tariff equivalents) increases Latin America's exports by 14 percent. However, the impact significantly differs by sector. Due mainly to high protection across the hemisphere, dairy and beverage/ tobacco exports grow fastest at 25 percent and 22 percent, respectively, followed by sugar and oilseeds (23 percent and 19 percent, respectively). The removal of domestic support has few positive effects on Latin America's exports except for oilseeds (2.7 percent), and eliminating export subsidies alone does not appear to enhance exports. For Mercosur, the patterns of trade gains from the Mercosur-EU liberalization are sharply distinguished from those of the hemispheric agricultural reform process. The elimination of tariffs between the two blocs increases Mercosur's exports by 37 percent. Among the agricultural exports from Mercosur, bovine

Based on Monteagudo and Watanuki (2002).

Appendix 3.2 Figure 1 a.

Impact of Hemispheric Agricultural Reform on Latin America's Exports to Hemispheric Market (Percent change from the base)

Appendix 3.2 Figure 1 b.

Impact of Hemispheric Agricultural Reform between Mercosur and the EU on Mercosur's Exports to the EU Market (Percent change from the base]

Appendix 3.2 Figure 1 c.

Impact of Agricultural Reform on Exports in the Western Hemisphere (In percent]

meat dramatically jumps by almost 230 percent, due

In sum, Latin America will greatly benefit from

largely to the EU's highest initial protection (55 percent

agricultural reform in the Western Hemisphere and

ad valorem equivalent). Mercosur also increases exports

beyond. The elimination of high protection for agricul-

of other foods and poultry meat by more than 10 per-

tural commodities in the form of tariffs is the primary

cent. The EU's removal of domestic support increases the

factor contributing to the potential trade gains. Com-

bloc's exports by 2.7 percent. Exports of bovine meat

pared with the hemispheric agricultural reform, the lib-

jump by 36 percent and oilseeds by 27 percent. The

eralization process with the European Union also

abolishment of the EU's export subsidies in a variety of

generates sizable positive effects (on Mercosur). The

agricultural commodities again does not boost exports.

simulation therefore suggests that the simultaneous

However, due to strong complementary effects among

integration process would likely create strong cross-fer-

policy variables, the implementation of all agricultural

tilization effects for countries in Latin America.

reforms chiefly in the European Union raises Mercosur's exports by 55 percent from the baseline.

Market Access

CHAPTER

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REGIONAL INSTITUTIONS AND DISPUTE SETTLEMENT MECHANISMS

Over the last couple of decades, there has been a growing awareness in academic and policymaking circles regarding the importance of institutions for economic development. Institutions constitute the rules of the game in a society or, more precisely, the restrictions designed by members of a society to influence human interaction. Any transformation affecting these rules may clearly have a direct impact on behavioral patterns (North, 1990). As new cross-country institutional databases have become available, a growing body of empirical work has been confirming the important role played by the quality of institutions in a wide variety of dimensions of economic performance, such as the depth of financial markets, success in attracting foreign direct investment (FDI) or keeping inflation under control, and, most importantly, the growth performance of nations. While institutions have an impact on economic development, important economic reforms, such as the creation of a regional integration agreement, may in turn affect the development of national institutions. They do so by establishing new rules and expectations as to how various policy options should be selected and implemented; by opening up new opportunities as well as establishing restrictions in the design and application of economic and trade policy; by generating new stakeholders while disenfranchising previous ones; and by laying the groundwork for a new philosophy in development policy. Accordingly, Rodrik (1999, 2000) has pointed out that assessing the ultimate effectiveness of economic and trade policy reforms should be based not only on their immediate

impact on economic variables, but also in terms of their contribution to the development of a high-quality institutional environment in a given country. The move toward trade liberalization in the countries of Latin America under the framework of the World Trade Organization (WTO), as well as the formation of regional trade agreements, has tested the adequacy of the prevailing institutions, both at the national and regional level, and in various instances led to their strengthening and reform. Just as national institutions are key determinants of national economic performance, regional integration agreements also require their own wellfunctioning institutions in order to be effective. The effectiveness of regional integration agreements, in terms of their impact on trade and investment flows, is closely related to the capacity of the countries involved to enforce the obligations stipulated in such agreements. This chapter describes the key institutional factors involved in integration experiences in the region. In particular, it looks at the development of dispute settlement procedures, discusses the extent to which they have been used, and demonstrates the vital policy role that these mechanisms play in the process of economic integration.

INSTITUTIONAL ASPECTS OF THE REGIONAL INTEGRATION PROCESS Observance of the rule of law plays a vital role in sustaining and increasing trade and investment flows

Chapter

CHAPTER

between countries participating in an integration scheme. To that end, private players consider an effective, transparent regulatory and legal framework, as well as the establishment of institutional mechanisms and structures to regulate the interaction between the different players involved, to be a necessary precondition for the integration process. The structures of institutional organization that accompany the coordination and implementation of trade integration must be considered as part of this process. In other words, how will the necessary communication and decision-making links, as well as the mechanisms to settle disputes arising between countries, be established? Examination of regional integration finds two model institutional structures regarding the vertical dimension: minimalist and maximalist (Mattli, 2001 j.1 These models explain the extent to which decisionmaking and authority shift from the national levels to the regional or global ones (Box 4.1).

Intergovernmentol Institutional Model Under the intergovernmental or minimalist institutional model, the countries, protective of their national sovereignty, retain power and initiative for decision and action. The process is therefore based fundamentally on interaction between governments. Under this scheme, the institutions are agents to which the governments grant few powers. As a result, the institutions lack sufficient authority and cannot effectively move the integration process forward any more quickly than dictated by the wishes of the countries, according to their interests and priorities. Under this minimalist institutional model, the larger countries exercise de facto veto power over the rules of the process, which tend as a result to converge toward the lowest common denominator reflecting the interests of those countries. Some experts believe that this model also entails the problem of supervision and how to avoid noncompliance with agreements.

tions to a new, broader central authority in which the institutions have some jurisdiction over the member countries. In contrast with the minimum institutional model, the governments give broad powers to the supranational institutions so that they are not merely specialized technical agents serving the countries, but play a strategic role in the integration process, with a clear mandate for its promotion. The capacity and autonomy of supranational institutions to play this strategic role depend, however, on the rules established and the discretion of the mandate that they are given.

Regional Experience Based upon the objectives of the agreements involved, regional economic integration processes in the Western Hemisphere have been developed on the basis of both the intergovernmental institution model as well as on supranational institutional structures. The North American Free Trade Agreement (NAFTA) is clearly the best example of a minimalist institutional integration model. From the beginning of the negotiations, the participating countries made two fundamental decisions on the architecture of the treaty: that it would be strictly a free trade agreement and that the governing mechanisms and institutions would be limited to a minimum. The deliberate decision to establish a minimalist institutional arrangement is explained by the hesitance of the U.S. executive branch and Congress to establish new institutions.2 This preference was welcomed by the governments of Canada and Mexico, as the negotiators from all three countries shared two concerns about the institutional structure of the treatyâ&#x20AC;&#x201D;its repercussions on national sovereignty and its costsâ&#x20AC;&#x201D;and these concerns prevailed in the design and architecture of NAFTA. The special concern of the United States, the largest partner, about sovereignty was also reflected in the dispute settlement mechanisms provided in the treaty. Washington's position, for example, was that

Supranational Institutional Model At the other extreme is the supranational, or maximalist institutional model, under which the policy players are persuaded to transfer their activities and expecta-

1 According to Mattli, horizontal integration refers to the mechanisms of communication and integration between the public sector, the private sector, and civil society in general. 2

Weintraub(1994, p. 28).

Regional Institutions and Dispute Settlement Mechanisms

Institutional Organization in Regional Integration Arrangements: Decision-making and Executive Bodies

Supranational or Maximalist Model The supranational or maximalist model generally involves subregional organizations with international legal status and powers transcending those of the member countries. These organizations typically include certain permanent decision-making and executive bodies. A policy steering body comprised of presidents or ministers of the member country governments and vested with legislative powers is generally the highest authority in the process. It exercises maximum political representation for the group, formulates policy on integration, and is responsible for making decisions to ensure that the objectives of the process are met. The policy steering body is generally complemented by an executive body that ensures compliance with and execution of arrangements and programs adopted by the member countries, generally in direct coordination with the jurisdictional authority. These bodies typically have the capacity to make proposals to the competent legislative authorities. In addition, there is generally a jurisdictional body that is responsible for enforcement and uniform interpretation of the agreement. It hears disputes in which member countries may be involved, and its decisions are binding. In most cases, the jurisdictional body also presides over disputes that involve subregional institutions, firms and individuals. Many arrangements based on the maximalist model also include a parliamentary body as well as bodies representing other sectors of society. The parliamentary body, comprised of representatives from member country legislatures, generally plays a consultative and deliberative role and has few if any legislative pow-

each country's national legislation should apply in the

ers. Other bodies generally include representatives from economic and social sectors, including the private sector. Inter-Governmental or Minimalist Model The minimalist model rests exclusively on inter-governmental decision-making and coordination authority and as such has no supranational institutions with independent legal status. The decision-making and executive bodies under this type of arrangement generally include an administrative commission for the agreement that is responsible for enforcement and proper application of obligations. Comprised of ministers of trade and integration, it serves as a consultative body, with responsibility for settling disputes between countries related to the application and interpretation of the agreement. The commission has limited powers to propose and agree on new regulatory texts. Another component of this model is the technical committees, working parties and expert groups. These entities are responsible for technical monitoring of the implementation of specific obligations stipulated in the agreement, for proposing ad hoc recommendations to the administrative commission on various topics, and for conducting technical studies. Finally, the dispute settlement bodies serve as mechanisms for resolving differences between the parties through settlement proceedings conducted by an impartial outside authority (panel), based on standards and principles previously approved and established in the agreement.

The NAFTA negotiation for all three countries

treatment of laws against unfair trade practices. In other

involved a key foreign policy initiative. As a result, no

words, the agreement substantially constitutes an instru-

complex institutional structures were required to hold

ment to ensure transparent application of national reg-

the governments' interest in the process. Because of the

ulations. This is also the spirit of the parallel agreements

importance that it represented to all three countries,

on labor and environment. The situation is different,

NAFTA also helped improve the technical and deci-

however, in the case of the mechanism for settling dis-

sion-making capacity of the three signatory countries

putes between countries, which is analyzed below.

by introducing important institutional changes in all

Box 4.1

CHAPTER

three governments.3 Some authorities maintain, however, that, eight years on, it is becoming clear that NAFTA lacks the intrinsic institutional capacity to maintain the active interest of the governments to continue its implementation and to enhance and expand some areas of the integration process.4 Mercosur is another example of the minimalist institutional approach. It differs from NAFTA, however, in that the signatory countries initially decided to establish a customs union as the first step toward building a common market, and not simply a free trade agreement. The problems that have occurred in the process of implementing the customs union (partial application of the common external tariff, delays in formulating and implementing common trade policies, insufficient progress in eliminating nontariff barriers, unilateral noncompliance, etc.) have brought to light the weakness of the institutional mechanism under the agreement.5 One should bear in mind, however, that the economic differences between countries have widened rather than narrowed since 1995. It would also seem that the larger partners are not interested in yielding sovereignty in their trade and economic policy management to supranational institutions, which may limit their flexibility in making decisions. Clear examples of this reluctance were the establishment of a secretariat with purely administrative functions, and the recent introduction of a strictly intergovernmental dispute settlement mechanism. In the cases of the Andean Community (AC) and the Central American Common Market (CACM), as is true for Mercosur, the countries set the establishment of a common market as the ultimate objective of the integration process. Unlike Mercosur, however, the partners decided to establish institutional schemes with some supranational discretion, inspired in both cases by the European model. The clearest example is perhaps the Andean Community, which is comprised of a set of supranational bodies and institutions with legal status. The Andean Integration System (AIS) includes the Andean Presidential Council, the maximum authority in the system; and the Council of Foreign Ministers and the Commission, which are the management and decision-making bodies. In addition, the SecretariatGeneral, the executive body, has the capacity to propose and enforce agreements, and the Andean Court of Justice, the jurisdictional body, is responsible for

overseeing the legality of the regulations and settling disputes. A similar institutional structure was agreed upon by the Central American countries, which established the Meeting of Presidents and Councils of Ministers, the Central American Court of Justice, and a Secretariat of Economic Integration.6 Despite the existence, at least in theory, of a supranational institutional scheme, many problems related to effective implementation of a common external tariff and harmonization of policies and standards have until now delayed the initial objective of consolidating a customs union and common market among all signatory countries. In addition, some of the institutions established do not have sufficient legitimacy to override the interests of the countries and private players. The courts of justice responsible for settling disputes are often not perceived as flexible and specialized mechanisms to settle disputes.7'8 These experiences demonstrate both the importance and the weakness of the institutional mechanisms established in the processes of trade integration in the region. The following section analyzes the specific case of dispute settlement systems. While they constitute key instruments for promoting the process of liberalization to the extent that they shield the opening process from attack by protectionist pressure groups, these systems may be weakened in practice by countries' overriding political interests.

Fernandez de Castro (2001).

SeeDymond (2001).

Bouzas(2001).

It is important to bear in mind that the Andean and Central American integration processes began during the 1970s and 1960s, respectively, in the context of an import-suDstitution economic model. Both, however, like the Caribbean Community (CARICOM), underwent institutional reform during the 1990s. 7 Only three of the five Central American countries ratified the statute of the Central American Court of Justice. Even the countries that signed the statute, thereby acknowledging the jurisdiction of the Court, have not resorted to that mechanism to solve their trade differences. At least 16 trade disputes have occurred between the member countries, and only one involved recourse to the Court for settlement. 8

Even the general public has this perception. See Cerdas (2002, p. 19).

Reaional Institutions and Disoute Settlement Mechanisms

DISPUTE SETTLEMENT SYSTEMS: OBJECTIVES, CHARACTERISTICS AND FUNCTIONS

procedures,

compliance with obligations

would

depend on the willingness of the national govern-

For a number of decades, the specialized literature has

In addition, the willingness of national gov-

addressed the issue of what should be the function of a

ernments to observe standards and disciplines covered

dispute settlement mechanism within the context of a

in trade agreements depends on the capacity available

trade agreement. Effective legal mechanisms for set-

to these governments at a given time to address pres-

tling disputes perform two essential functions.9

sure groups defending the status quo and whose inter-

First, these mechanisms help provide the eco-

ests will be affected. This capacity is normally limited,

nomic players with a sufficiently consistent and sound

particularly when confronting pressure groups has a

environment to engage in economic activities at the

high political cost for the prevailing administration.

international

Penetration of new markets

An effective trade dispute settlement system

through trade or investment is an intrinsically risky

level.

goes a long way to avoiding such situations. The pos-

activity. Moreover, it requires the commitment of sub-

sibility of an adverse reaction at the international level

stantial resources to produce yields in the medium or

for failing to meet an obligation under a trade agree-

long term. Hence there is a need for legal institutions to

ment represents a shield for governments that are par-

help reduce some of these risks by clearly establishing

ticularly vulnerable to domestic protectionist pressure.

the rules of the game applicable to the economic play-

This applies especially to countries with insufficient

ers involved, and the mechanisms to maximize compli-

institutional strength, and with legal systems that are

ance with these rules.

insufficiently strong to withstand pressure from more

Second, legal systems for trade dispute settle-

powerful interest groups that as a result can easily

ment also play a key political role. The use of an

influence government decisions. Even in countries with

impartial outside entity to settle disputes helps prevent

more developed institutions, however, the need to

a trade problem from becoming politicized and from

reach a solution through a dispute settlement mecha-

being affected by other non-trade considerations that

nism represents a way for governments to avoid bear-

may eventually exacerbate it. De-politicizing disputes

ing the full political brunt of complying with an

increases the probability that the violating country will

obligation opposed by powerful interest groups. This

comply with the final decision. Further, an effective dis-

political cost will be shifted to the treaty itself, or to the

pute settlement mechanism in the last instance provides

international institution responsible for its application. What features do trade dispute settlement

an outlet to channel the tensions that the application of

mechanisms require to operate effectively? At least in

trade barriers can generate between countries. Experience in subregional integration process-

the context of the Western Hemisphere, where devel-

es during the past decade in the Western Hemisphere,

oping countries are numerically predominant, these

and particularly in most Latin American countries

mechanisms should meet three fundamental require-

where these negotiations have supplemented profound processes of economic reform, demonstrates another important function of trade dispute settlement mechanisms: consolidating

the economic liberalization

process. Within this context, dispute settlement mechanisms provide government sectors promoting the reform with institutional protection against pressures from corporate interests attempting to impede or delay economic liberalization. Dispute settlement mechanisms represent the instrument of last resort that can be used to guarantee compliance with the substantive obligations

under

trade agreements. Without effective dispute settlement

The use of the term "legal" to qualify these trade dispute settlement mechanisms is a deliberate reference to a mechanism through which a dispute between two or more parties to a trade agreement is settled in a proceeding conducted by an impartial outside entity on the basis of substantive standards and principles previously agreed to by those parties and stated in the treaty. This type of legal mechanism is differentiated from other types of dispute settlement mechanisms that are based on negotiations between the parties involved rather than being subject to an adjudication proceeding. 10 See Jackson (1997), Petersmann (1997), and Cameron and Campbell (1998). 1] This assertion is proven by experiences in applying numerous trade agreements of partial scope negotiated between Latin American countries during the 1960s and 1970s.

ments.11

CHAPTER

ments: they must be expeditious, effective and inex-

Another fundamental feature of dispute settlement mechanisms, particularly in the context of devel-

pensive. They must be expeditious in that they must

oping countries, is to be usable at a low cost. The cost

have the capacity to determine quickly whether or not

of resorting to dispute settlement proceedings should

a given measure is compatible with the obligations

be substantially lower than the cost of tolerating the

under the trade treaty. If a given measure has been

disputed measure. Further, if another function of the

contested, it is likely that in practice the measure rep-

legal dispute settlement system is to try to smooth the

resents a substantial source of economic damage to a

immense asymmetries derived from economic or polit-

given economic sector. Hence the need for issuing a

ical differences between the countries, then the weak-

resolution on the legality of this measure as quickly as

est countries are those that most need such settlement

possible in order to avoid lengthy interruptions and

mechanisms to defend their interests.

distortions to free and normal trade flows. An expedi-

Countries having greater economic weight, in

tious settlement process becomes a particularly press-

fact, are in a better position to defend their interests with

ing objective when the controversy involves relatively

alternative methods to legal settlement. The facts, how-

small, highly vulnerable enterprises in the export mar-

ever, indicate an ironic reality. In many regional inte-

kets, as is normally the case when one of the parties to

gration arrangements in the Western Hemisphere, and

the dispute is a small economy.

at the multilateral level in the World Trade Organiza-

Despite the vital importance for a dispute set-

tion, the relatively more developed countries are the

tlement mechanism to operate expeditiously, this goal

ones that most frequently use dispute settlement mecha-

is in fact often difficult to achieve in practice. First, the

nisms. This suggests not only the need to assess the inci-

country affected by the contested practices will be

dence of the costs of such proceedings on their use by

required to dedicate some time to amicable consulta-

relatively less-developed countries, but also the need to

tions with the government that imposed the measures,

strengthen the institutions by establishing technical

in order to explore the possibility of reaching a settle-

teams in the competent agencies to enable countries to

ment. Second, depending on the obligation in question

make effective use of the dispute settlement mechanisms

and the contested measure, settlement of the conflict

theoretically available to defend their trade interests.

may require establishing numerous facts and complex scientific or technical records, inherently requiring the participation of experts in the process. This process tends to be time-consuming.13

EVOLUTION AND USE OF DISPUTE SETTLEMENT MECHANISMS

It is also vitally important that dispute settlement mechanisms be effective. Such mechanisms

Experience in the settlement of trade disputes at the

should serve as the last resort to induce the party that

regional and multilateral levels can be analyzed from

violated an obligation to comply with the settlement. The effectiveness of the systems should also be such that the penalty or threat thereof must be sufficiently credible to serve as a clear deterrent against violating the obligations involved. The effectiveness of these mechanisms is vital to executing the intrinsic function of the systemâ&#x20AC;&#x201D;what good is a settlement if it is not observed? Further, effectiveness is basic to the credibility of the system and the economic integration process as a whole. Despite the importance of effective mechanisms, however, there are many cases in the Western Hemisphere when resolutions are ignored by the party involved, seriously undermining the credibility of the integration process.

12 For an enterprise whose total income is generated by foreign sales, being prevented from placing products on its traditional export market as a result of a problem under a trade agreement is tantamount to undergoing financial suffocation. This vulnerability increases in the case of small economies for which the exporting enterprises tend to have export markets highly concentrated in one or several countries. This underscores the need for dispute settlement mechanisms to include precautionary measures and remedies to avoid irreparable damage. In this connection, however, there is much scope for improvement in international legal doctrine and negotiating practices at the regional and multilateral levels. 13 In light of the WTO, there are also delays attributable to the requirement to conduct the proceeding in more than one language. One of the challenges of the WTO's dispute settlement mechanism has been the need to translate the lengthy reports from panels into the organization's three official languages.

Reaional Institutions and Dispute Settlement Mechanisms

two standpoints. First, it is important to observe the

Body responsible exclusively for examining potential

actual features of dispute settlement mechanisms under

legal errors in resolutions by panels.

different integration arrangements in order to identify

The fact that the resurgence of the regional

predominant patterns in the legal evolution of this type

economic integration process in the Western Hemi-

of regulation. The second standpoint focuses not on the

sphere began during the early

evolution of dispute settlement procedures, but on their

Uruguay Round was still pending completion, largely

use in different subregional integration schemes as well

explains the influence of the latter on the architecture of

as in the WTO.

the integration schemes that began to be negotiated during that period.

Evolution: "Legalization" and Regulatory Migration

This "regulatory migration" resulted in part from the interest of the United States in reflecting at the regional level the same trade agenda that was pro-

Although experience with regional integration in Latin

posed in the multilateral arena. It is therefore no acci-

America dates to the 1960s, the topic of negotiation

dent that NAFTA negotiations comprised practically the

and the use of dispute settlement processes conceived

same content as the Uruguay Round, including what

as adjudication instruments did not begin to take effect

were known at the time as new issues, which until then

until almost 30 years later with the rise of what has

had been excluded from regional trade agreements.

been called the "new regionalism" of the 1990s.

Once NAFTA was negotiated, it became a model free

Until the early 1990s, interpretation of or

trade agreement that was reproduced throughout Latin

compliance with the obligations established under eco-

Americaâ&#x20AC;&#x201D;first by Mexico and later by Chile and the

nomic integration agreements tended to be viewed as

countries of Central America.

problems that could or should be resolved by the par-

The influence of the WTO in determining the

ties themselves. As a result, settling trade disputes in

characteristics of the dispute settlement procedures

these treaties was originally designed primarily as

included in the hemisphere's subregional economic

processes of political consultation between the interest-

integration agreements has been an ongoing process.

ed parties rather than settlement processes. This can be

Lessons learned from the application of the WTO's Dis-

seen in the many bilateral agreements of partial scope

pute Settlement Understanding were reflected in the

negotiated

dispute settlement instruments negotiated

between the 1960s and

1980s in the

recently

framework of the Latin American Integration Associa-

among countries in the hemisphere. Moreover, prefer-

tion (LAIA).14 By contrast, in customs unions estab-

ential agreements negotiated in the region provided

lished during the 1960s and 1970s, the formal exis-

solutions to problems that arose in application of that

tence of supranational courts either proved ineffective

understanding.16

or did not become effective until the 1990s.15 The negotiation of legally oriented dispute settlement mechanisms beginning in the 1990s reflects the events in the multilateral arena during that period. The "legalization" of the dispute settlement system was one of the main results of the Uruguay Round that culminated in the establishment of the new institutional structure of the multilateral trade system. With the entry into force of the Dispute Settlement Understanding (DSU) in 1995, the legal orientation of dispute settlement mechanisms of the multilateral trade system was consolidated with

the development

two

fundamental

characteristics: the possibility that a resolution by a panel could be binding, even without the unsuccessful party's consent; and the establishment of the Appellate

14 Resolution 114 of the LAIA provides for consultation by the parties or intervention by the Committee of Representatives as mechanisms to settle disputes regarding obligations under the 1980 Montevideo Treaty. 15 See footnote 7 regarding the Central American Court of Justice. In the case of the Andean Community, the court was not established as a legal body until 1979. The Cochabamba Protocol, which has been in effect since 1999 and now governs the functioning and competence of that court, was not signed by the AC members until 1 996. 16 For example, recently negotiated dispute settlement instruments such as the Mercosur Olivos Protocol, the CACM Dispute Settlement Treaty, and the chapter on dispute settlement in the free trade agreement between Canada and Costa Rica explicitly prohibited one of the parties in a dispute from determining unilaterally whether the other party had effectively complied with the recommendations of the panels, thereby eliminating any doubt in connection with the application of Article 21.5 of the Dispute Settlement Understanding disputed in the context of the WTO.

1990s, when the

CHAPTER

Trends in the Use of Dispute Settlement Mechanisms

fear may involve the latent risk that the accused country might retaliate by politicizing the trade conflict, thus

Trade dispute settlement mechanisms during the past

agenda that usually exists within the normal scope of

decade have been concentrated within a few regional

international relations between countries. Whether or

integration agreements. Although there are approxi-

not a country resorts to an international settlement

mately 30 reciprocal trade agreements on the Ameri-

jurisdiction is, after all, a political decision, and as such

cas (in addition to partial scope agreements signed

it is the product of a balance of power within the gov-

within the framework of ALADI), only three have regu-

ernment that makes such a decision. It is sometimes no

larly used dispute procedures: NAFTA, the Andean

easy matter to reach a consensus within the govern-

Community and Mercosur.17

ment to summon a trading partner before a regional or

There are three possible explanations for not

multilateral forum. The passive approach to using dispute settle-

using settlement mechanisms. First, this type of mechanism might not be available to the parties of the con-

ment mechanisms may also be attributable to institu-

flict, either because it does not exist or because it is not

tional deficiencies such as a lack of technical and

efficient or functional, and therefore not helpful to the

financial resources required for adequate preparation

parties in settling disputes. This forces the parties to use

and defense of the country's trade interests. Not all

alternative mechanisms such as negotiation, media-

governments in Latin America have technical and pro-

tion, or sheer economic or political force.

fessional staff capable of preparing and defending a

Second, the affected party takes a passive

petition before an international trade court.18 Those

approach. Although the mechanisms exist, a party

that do not must also have the financial capacity to

might be unable to use them for other reasons such as

contract specialized external attorneys to that end. As a rule, the countries that tend to use dispute

intimidation or insufficient resources. A third and final explanation could be the

settlement mechanisms most at the regional level also

absence of a sufficiently important conflict to justify the

resort to such proceedings more frequently at the mul-

use of a settlement mechanism.

tilateral level. This suggests that such countries have the

In the Western Hemisphere, limited activity in

institutional capacity to more proactively defend their

trade settlement proceedings can be explained by all

trade interests. The Western Hemisphere countries that

three variables discussed. Many trade agreements, in

have most frequently invoked WTO dispute settlement

fact, do not include settlement mechanisms to resolve

procedures represent the strongest economies in the

trade conflicts. Other agreements include settlement

region: the United States, Canada, Brazil, and Mexico.

mechanisms in theory, but have not accomplished their

They are also members of subregional integration

function in practice and have failed to meet the needs

agreements that have registered trade settlement activ-

of the parties. This has been the case of the Central

ities.

American Court of Justice, although that situation can

Another variable that plays a role in the use or

be expected to change in the short term due to the sign-

failure to use dispute settlement mechanisms is insuffi-

ing by the five Central American countries of the Dispute Settlement Treaty. Further, the passive approach by signatory countries of these agreements in using international settlement proceedings, despite the existence of mechanisms potentially capable of serving this purpose, may be attributed, at least in the Western Hemisphere, to two additional but fundamental reasons. The first reason is political in nature and involves a government's fear of initiating an international settlement proceeding to solve a quarrel. This

17 There are three regional integration agreements in which only one trade dispute has been registered since their inception: the Central American Common Market, the agreement of partial scope between Chile and Bolivia in the framework of ALADI, and the free trade agreement between Mercosur and Chile. 18 For this reason, many governments have been forced to contract specialized attorneys abroad (particularly in the United States). The participation of private attorneys in dispute settlement processes has even been subject to debate in the WTO and, more specifically, in the wake of the banana conflict involving several Caribbean countries. To defend their positions, some of these countries were forced to contract foreign experts. See World Trade Organization (2002).

posing problems to other components of a broader

Reaional Institutions and Disoute Settlement Mechanisms

Trade Share and Number of Disputes Average annual intra-regional trade share

NAFTA Mercosur

AC (Tribunal) CACM CARICOM G-3 Mercosur-Bolivia Mercosur-Chile Mexico-Bolivia

Mexico-Costa Rica Mexico-Chile Mexico-Nicaragua Chile-Bolivia

Canada-Chile

Average annual intra-regional trade share growth rate (%)

1 989-2000 (%)

1989-2000

42.11 17.93 9.10 13.78 8.63 2.30

2.07 5.65 6.75 -0.96 4.01 0.49 -2.58 2.45 -2.85 -2.73 3.75 0.70 2.90 3.79

1.10 4.59 0.04

0.26 0.65 0.07 1.13

0.22

Total number of disputes

1995-2000

1989-2000

1995-2000

1 87 1 34

105 18

17 9

54 1

63 36 59 94 90 76 07

na 0 0 1 0 0 0

1 92

-3 55 -6 38 2 -9 2 1 -4 3 -4

5 66 0 74

0 1

Source: IDB Integration and Regional Programs Department.

cient trade flows between many countries that signed

among countries that are geographically close—gen-

free trade agreements during the 1990s. Table 4.1

erally neighbors—and whose trade flows have some

shows that rather than regulating dense trade flows,

relative importance (namely, NAFTA, the Andean

most free trade agreements have been negotiated with

Community and Mercosur).

a view to generating new trade and investment flows

Table 4.2 shows that the Andean Community

that were practically insignificant when the treaty was

is the subregional integration scheme that registers the

being negotiated. As they account for a small relative

most frequent use of dispute settlement mechanisms.

share of total imports in the destination market, poten-

Over 1995-2001, 61 complaints involving controver-

tially competing sectors for the new exports generated by free trade agreements do not perceive them to be a threat. As a result, there is no pressure on the govern-

sies were filed with the Andean Court of Justice—more than three times the total number of requests for consultation in the context of NAFTA and Mercosur.

ment of the importing country to impose trade barriers.

Decisive in explaining the active use of the

It follows that, while trade flows increase significantly in absolute terms, since they are limited in comparison

Andean dispute settlement system is the preponderant role of the Secretariat of the Andean Community as the

with flows from nonmember countries, they transpire

presiding body in the process. Countries and even rep-

without any major problems. Trade barriers that might

resentatives from productive sectors must go before the

arise for whatever reason can be easily eliminated or

Secretariat of the Community in the first instance.

resolved by informal consultation between the parties,

When a complaint has been prepared, the Secretariat

in light of the significant discretion available to the

takes responsibility for conducting the investigation. If

administrative authorities to dismantle these barriers.

there are inconsistencies with the Andean regulations,

The importance of trade flows as an impetus

the Secretariat must file a petition with the Andean

for the use of dispute settlement mechanisms is con-

Court of Justice against the country in question.

firmed by the fact that virtually all disputes in connection with the application of economic integration

cracy has a significant mediating effect on the political

agreements in the Western Hemisphere have occurred

dynamics that normally characterize the use of trade

The active role of the supranational bureau-

Table 4.1

CHAPTER

Table 4.2

Number of Trade Disputes between Western Hemisphere Countries

Referrals to the WTO Subregional disputes:1 NAFTA AC Mercosur CACM

1995

1996

1997

1998

1999

2000

2001

3 8 7 1 0 0

5 7 3 3 1 0

9 4 1 3 0 0

2 17 5 10 1 1

7 19 0 14 5 0

14 26 1 23 2 0

13 15 0 7 8 0

Conflicts formally submitted to dispute settlement mechanisms.

dispute settlement mechanisms. In such cases, the governments of the parties do not hold the monopoly on activating the dispute settlement mechanism, which multiplies the risk that petitions not sponsored by any government are filed, which could lead to problems in system compliance and effectiveness. From a time standpoint, Table 4.2 shows a trend that merits discussion owing to its important implications. While in both the Andean Community and Mercosur, the number of disputes grew substantially beginning in 1998, in the case of NAFTA, the number of requests for consultation were concentrated during 1995-98, and began to decline substantially in 1999. In the Andean Community, the number of disputes submitted for consideration by the Andean Court of Justice tripled in 1998 compared with the preceding year—a trend that continued in 1999, intensified in 2000, and declined abruptly in 2001. In the case of Mercosur, the number of disputes brought before the dispute settlement mechanism began to increase in 1998, and increased further in 1999 and 2001. In the cases of Mercosur and the Andean Community, the increased use of the dispute settlement mechanism would seem to be associated with pressures derived from financial and political crises that affected virtually all member countries during that period.19 This trend would also seem evident in the case of NAFTA. The highest number of requests for consultation were registered from 1995—which marked the beginning of the Mexican financial crisis and the devaluation of the peso—until 1998. Of the 16 dispute settlement cases filed during that period, more than

half were initiated by Mexico, and all were against the United States, suggesting Mexico's reaction to the restrictive trade measures implemented by its main trading partner. The increased used of trade dispute settlement systems in times of crisis—at least in some trading blocs—suggests two concepts vital to understanding the context and function of these mechanisms. An initial conclusion seems to be that governments are more likely to apply protectionist measures in times of crisis (see Chapter 7). A second conclusion, perhaps less evident and more important than the first, is that increased use of dispute settlement mechanisms in times of crisis would appear to highlight the important function of these mechanisms as a protective shield for the gradual process of economic liberalization and as a counterweight against protectionist pressures that tend to gain negotiating power against governments whose political capital is eroded by the crisis.20

Lessons from the WTO The credibility of the WTO Dispute Settlement Understanding is reflected in the increasing use that countries in the hemisphere have made of this mechanism, in

19 Brazil was forced to devalue the real and most members of the Andean Community recorded serious economic imbalances. 20 See Echandi and Robert (forthcoming), for a more specific analysis of particular trends in the use of mechanisms to solve trade disputes under certain specific integration agreements and the WTO.

proportions that even exceed the relative share of their

multilateral system enables alliances to be developed

reciprocal trade flows in world trade. Approximately

with other countries having similar interests, thus help-

25 percent of the total dispute settlement cases filed

ing intensify the pressure to eliminate or amend the

under the WTO were between countries in the Western

questioned measure. For example, in many conflicts

Hemisphere.21

that have arisen in the WTO between countries of the

Many of these cases involved countries of the region that were not members of any

region, other countries of the Western Hemisphere,

integration

besides the defendant or complaintant, have appeared

scheme or free trade agreement amongst themselves,

as interested third parties. Last, use of the multilateral

and therefore had no alternative dispute settlement

mechanism provides incentives to promote the creation

mechanism under such preferential agreements. As a

of jurisprudence, which is found to be quite important,

result, recourse to the WTO was the only option. It is

particularly when addressing very sensitive issues that

interesting to note, however, the substantial number of

also have more global implications and scope.

conflicts that have arisen in the framework of the WTO

The satisfactory record of compliance in the

Dispute Settlement Understanding between countries in

WTO shows the effectiveness of the multilateral mech-

the region that are both members of a preferential

anism and lends it great credibility, which is quite

agreement for trade or integration. This is true of

important for countries in the region, particularly when

Canada, the United States and Mexico, as well as

dealing with economies of different sizes and having

some of the conflicts that have occurred between Mer-

substantial asymmetries in terms of political and eco-

cosur countries and between the latter countries and

nomic power. Trends in the use of the Dispute Settlement

others with which they have some preferential associa22

Understanding by Western Hemisphere countries also

The substantial number of cases between

indicate the importance of existing interrelations

countries in the region that are not members of prefer-

between the multilateral trade system and regional and

ential trade or integration schemes or agreements evi-

bilateral agreements. This is particularly important in

dences the importance that an ultimate dispute

the context of the negotiations in progress in connec-

settlement scheme would have within the context of the

tion with the WTO as well as the FTAA.

tion agreement, such as Chile.

These dynamics will create vital synergies

Free Trade Area of the Americas (FTAA). There is another hypothesis as to why coun-

between both processes of negotiation, with important

tries that have alternative mechanisms at their disposal

implications in the area of dispute settlement. The syn-

under preferential arrangements are increasingly turn-

ergies will probably promote a greater

"regulatory

ing to the WTO Dispute Settlement Understanding.

migration" between both agreements, as was true for

Clearly, even if a preferential arrangement exists, the

the NAFTA and the WTO agreements negotiated dur-

challenged measure may involve a violation of obliga-

ing the Uruguay Round.23

tions under multilateral agreements rather than those

The foregoing presents major challenges for

stipulated in the framework of preferential arrange-

countries of the region, which, with their aim to create

ments. In this case, recourse to the multilateral mechanism is the only option. It would seem, however, that other variables also explain the frequent use of the multilateral mechanism to resolve conflicts between members of a bilateral or subregional agreement. In some cases, there may be the perception that the multilateral mechanism might be more effective considering the sensitivity of the issue or conflict in question, and that the subsequent politicization of the controversy in the framework of preferential regional or bilateral relations might make the conflict difficult to resolve. In addition, recourse to the

More than half the cases are related to the application of unfair trade practices and safeguard measures. In addition, in a number of cases, disputes were related to patent protection and compliance with obligations under the agreements on agriculture, agricultural goods, and textiles and clothing. 22 23

See Echandi and Robert (forthcoming).

In many free trade agreements in effect in the Western Hemisphere, the trend has been to refer to WTO regulations to govern certain aspects of bilateral trade (such as technical barriers to trade and sanitary and phytosanitary measures), and the provisions of the WTO regulation have been incorporated into the free trade agreements.

Reaional Institutions and Disoute Settlement Mechanisms

CHAPTER

a free trade area in the Western Hemisphere while

clude with certainty whether the countries are in fact

strengthening the multilateral system, need to find the

respecting and meeting their obligations under prefer-

best way to ensure that effective, expeditious and inex-

ential agreements, even in cases when doing so

pensive regional mechanisms exist to settle disputes,

involves a substantial political cost to the current gov-

while not detracting from the multilateral system or pro-

ernment. Only three regional integration arrangements

moting development of contradictory jurisprudence

have consistently and substantially used these mecha-

with similar obligations negotiated in different forums.

nisms. Accordingly, in most cases where regional trade agreements have been signed during the past decade, it will take some time to determine whether countries

CONCLUSIONS

comply on a generalized basis with the dispute settlement resolutions.

The evolution and use of trade dispute settlement mech-

The concentration of litigious activity in the

anisms by countries in the Western Hemisphere during

area of trade in only three of the approximately 30

the past decade demonstrate the vital roles that institu-

reciprocal regional trade agreements is evidence that

tions play in the development and growth of market

the effectiveness of most dispute settlement mechanisms

economies. The success of these integration processes

provided under trade agreements negotiated during

in the region depends on the existence of effective insti-

the past decade has yet to be tested. However, there is

tutional mechanisms that can encourage national gov-

at least cause to be optimistic in light of the trends with

ernments to uphold their commitments to economic

these three agreements in terms of respect for the

liberalization, even when some powerful domestic sec-

emerging system of law in the trade area.

tors oppose it. Hence the importance of legally oriented

In addition, the increasing use of and compli-

dispute settlement mechanisms, which provide the eco-

ance with resolutions issued by the WTO dispute set-

nomic players with enhanced certainty for long-term

tlement system also suggests credibility

business planning. They also represent an institutional

oriented mechanisms among countries in the region.

shield for national governments that are vulnerable to

Many countries have resorted to the WTO at least once

domestic interest groups that attack the integration

to defend their trade interests against other trading

process when their interests are affected by it.

partners. While it is true that countries that use the

in legally

Encouraging trends over the past decade sug-

mechanism more regularly have a higher relative

gest progress among the countries of the region toward greater institutional maturity, with enhanced accept-

development index, it is clear that this trend is largely attributable to institutional problems rather than to

ance, confidence and respect for an emerging legal

problems of confidence in or credibility of the system.

system in the area of economic integration. After three

This shows the need for existing cooperation mecha-

decades during which negotiations were considered

nisms in the region to include in their priorities the

the only way to solve disputes related to integration

exploration of effective mechanisms to strengthen the

schemes, the 1990s brought a shift in the approach of

institutional capacity of governments to optimize use of

countries in the region toward legally oriented trade dis-

dispute settlement mechanisms, at both the regional

pute settlement mechanisms. The fact that two subregion-

and multilateral levels, to defend their interests.

al economic integration agreements in the hemisphere in 2002 adopted new instruments for this purpose seems to be no coincidence. In both cases, the instruments are based on the principles, concepts and rules of the WTO Dispute Settlement Understanding, and extend further to incorporate solutions to problems that have arisen in the application of multilateral agreements. Judging from the actual use of these mechanisms by countries in the region, it is difficult to con-

Reaional Institutions ana Dispute Settlement Mechanisms

REFERENCES

Mattli, Walter. 2001. Institutional Models for Regional

Bouzas, Roberto. 2001. Mercosur Ten Years After:

North, Douglass C. 1990. Institutions, Institutional

na. Unpublished. Cameron, James, and Karen Campbell (eds.). 1998. Dispute Resolution in the World Trade Organization. London: Cameron May. Cerdas, Rodolfo. 2002. For Amor a Morazan? La Nacion, San Jose, Costa Rica, March 24. Dymond, William A. 2001. The Regional Dynamics of the FTAA Negotiations. Regional Dialogue on Trade and Integration, Inter-American Development Bank. May. Echandi, Roberto A., and Carolyn Robert. Forthcoming. Solucion de diferencias comerciales en el hemisferio. European Communitiesâ&#x20AC;&#x201D;Regime for the Importation, Sale and Distribution of Bananas. 1997. Report of the Dispute Settlement Body, WTO, WT/DS27. Fernandez de Castro, Rafael. 2001. Las consecuencias institucionales del TLCAN. May. Mimeo. Jackson, John H. 1997. The World Trading System, Law and Policy of International Economic Relations. Second Edition. Cambridge, MA and London: MIT Press.

Change and Economic Performance. Cambridge University Press. Petersmann, Ernst-Ulrich. 1997. The GATT/WTO Dispute Settlement System: International Law, International Organizations and Dispute Settlement. London, The Hague and Boston: Kluwer Law. Rodrik, Dani. 1999. Institutions for High-quality Growth: What They Are and How to Acquire Them. Harvard University. October. 2000. Trade Policy Reform as Institutional Reform, Paper prepared for a Handbook on Developing Countries and the Next Round of WTO Negotiations. August. Weintraub, Sydney.

1994. NAFTA: What Comes

Next? Washington, DC: Center for Strategic and International Studies. World Trade Organization. 2002. Update on WTO Dispute Settlement Cases. WT/DS/OV/4, Geneva. February.

Learning Process or Deja-Vu? FIASCO, Argenti-

Integration: Theory and Practice. October.

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FINANCIAL INTEGRATION

Financial integration is the process through which a country's financial markets become more closely integrated with those in other countries or with those in the rest of the world. It implies the elimination of barriers for foreign financial institutions from some (or all) countries to operate or offer cross-border financial services in others. This may imply linking banking, equity and other types of financial markets. Financial integration can be achieved in a number of ways. It may emerge as a result of formal efforts to integrate financial markets with particular partners, typically those that share membership in a regional integration agreement (RIA). Integration in this sense may involve eliminating restrictions to crossborder financial operations by firms from countries in the same RIA, as well as harmonizing rules, taxes and regulations between the member countries. Financial integration can also emerge in the absence of explicit agreements. Such forms of integration as foreign bank entry into domestic markets, foreign participation in insurance markets and pension funds, securities trading abroad, and direct borrowing of domestic firms in international markets—all of which have occurred in Latin America and the Caribbean— have for the most part occurred de facto, without the need for formal agreements. As in much of the developing world, this de facto integration in the region has primarily been with the developed world. The two different forms of integration are in some ways related. A formal financial integration agreement, for example, may require harmonizing certain regulations that govern financial markets. Sim-

ilarly, in order to integrate de facto with the financial markets of the world, a country may redefine its own regulatory setup and converge toward international standards, thus becoming more attractive to foreign financial institutions, even without the need for an explicit agreement. These two forms of financial integration complement rather than substitute for one another. Formal financial integration at the regional level may increase financial links with the rest of the world. For instance, a group of small countries—such as those in the Central American Common Market (CACM) and the Caribbean Community (CARICOM)—may decide to harmonize standards and regulations to attract foreign participation from both financial institutions within the region and from the rest of the world. That same effort done by each country individually would likely be less effective because of the small scale of each individual market and the need to establish multiple operations under different regulatory regimes. Justifying such a strategy naturally implies that one believes that foreign participation is beneficial for the host countries, a subject that will be discussed at length throughout this chapter. Deeper integration with world financial markets may also lead to more financial links within a group of developing countries bound by an RIA. An example is foreign banks that have established subsidiaries or branches in almost all the Latin American countries. The presence of these banks may lead to strengthened financial ties between the host countries involved, as financial services linked to trade and

Chapter

CHAPTER

Figure 5.1

5 Financial Structure of Latin American Nonfinancial Firms (In billions of constant 7 995 US$)

can firms come from domestic financial markets and funds raised through ADRs, as other forms of integration become more important, regional financial integration may follow.

FINANCIAL INTEGRATION IN LATIN AMERICA

Source: Fitch IBCA's Bankscope for domestic and foreign bank loans; BIS for cross-border bank loans and external and domestic debt; Economatica for local equity capital; and Moel (2001) for ADR equity capital.

investment flows will likely be facilitated by the use of the same financial institution at both ends of the deal. Initiatives for formal financial intaegration in the region have been quite limited and constrained primarily to the North American Free Trade Agreement (NAFTA) and CARICOM. Yet, Latin American firms are strongly integrated into international financial markets (Figure 5.1). In 2000, more than $479 billion in financing in the region came from foreign sources or was intermediated through foreign agents. With respect to direct funding, the most relevant were ADRs (American Depositary Receipts), accounting for $117 billion, and cross-border bank loans of nearly $116 billion. In addition, foreign banks located in the firm's country lent nearly $180 billion. Taken together, these forms of funding represented nearly half of the firms' external (to the firm) sources of funding. Given the limited number of formal regional financial integration agreements in Latin America and the importance of de facto financial links, this chapter focuses more on the latter type of integration, including the evolution, benefits and disadvantages of allowing deeper foreign participation in domestic banking markets and integrating stock markets with the world. From the point of view of Latin American firms, these are the most relevant forms of financial integration. Although the principal sources of external funds for Latin Ameri-

The case of foreign banks is a notable example of how financial integration in Latin America has occurred mostly in de facto fashion with developed countries, rather than with other countries of the region. More than 98 percent of the foreign bank share of assets comes from developed country banks, and only 2 percent comes from banks within the region. The same is true for cross-listings and other forms of financial integration. The main reason is that capital is scarce and financial development is limited in the Latin American countries.1 Moreover, the main incentive to open up to external markets in search of cheaper sources of capital is missing in pairings between Latin American economies. The process of integrating into international financial markets started for most developing countries in the early 1980s, when restrictions were lifted on capital account movements and foreign participation of international actors in domestic financial markets. Figure 5.2 shows that by the early 1970s, financial sectors in most developed countries were already significantly liberalized, while in most developing countries they were still repressed. The liberalization process was gradual but steady in most regions except in Latin America, where there was a significant reversal in the 1980s. Driven by Southern Cone countries with laissez faire financial policies that supported unrestricted private participation in financial markets without direct government regulation, liberalization spread rapidly in Latin America starting in the early 1970s. Combined with serious macroeconomic disorders, however, this process led to massive bankruptcies and a financial crisis throughout the region (Diaz-Alejandro, 1985). Coun-

1 The lack of regional financial integration schemes may also have limited this process.

1O2

Financial Intearation

Figure 5.2

Financial Liberalization in Developed and Developing Countries

1O3

the region due to capital account and stock market liberalization that allows businesses to access foreign markets directly. Through these mechanisms, firms have been allowed to issue cheaper debt abroad and markets, including the administration of pension funds and insurance companies.

FINANCIAL INTEGRATION THROUGH FORMAL AGREEMENTS Finance and trade were once distinct realms. However, over the past 15 years, provisions governing "trade in financial services" have increasingly been incorporated into trade agreements. This process has been drivNote: The liberalization index is calculated as the simple average of three indexes (liberalization in the capital account, domestic financial system and stock market) that range between 1 and 3, where 1 means no liberalization and 3 means full liberalization. These data are then aggregated as the simple average between countries of each region in each decade. Source: Kaminsky and Schmukler (1 999).

en by both the accelerating pace of cross-border mergers and acquisitions in the financial sector, and by the development of comprehensive disciplines governing other types of services. Rules on trade in financial services define the degree of market access and the national treatment granted by signatory countries in the banking, securities and insurance subsectors,

tries abandoned laissez faire practices and introduced

broadly defined. From the beginning of their integra-

tighter regulations and restrictions to their financial sys-

tion into the trading system, financial services have

tems. There was also a de facto nationalization of the

been treated as distinct from other types of services. The

banking sector. Later, at the beginning of the 1990s,

centrality of the financial system to the whole economy

Latin America engaged once again in the liberalization

calls for a degree of caution in the liberalization process

strategy.2 The main difference with respect to the earli-

that is not so much required in tourism or air transport

er liberalization effort was that, this time, regulatory

services liberalization, to cite just two examples.

and supervision mechanisms were implemented to avoid the previous type of crisis.

There are several advantages of integrating financial systems through these types of agreements.

Financial integration in Latin America has

The most important oneâ&#x20AC;&#x201D;which is also gained though

been strongly linked to integration on other fronts. Inte-

informal mechanisms of financial integrationâ&#x20AC;&#x201D;is the

gration through trade and FDI has been an important

exploitation of economies of scale, traditionally impor-

determinant of the integration in banking and crosslisting of equity. Two salient features have been notable since the liberalization process of the 1990s. Large international banks have increased their presence in the region, and firms have gained the ability to increase their sources of funding by tapping international capital markets directly, mostly through the listing of Depositary Receipts (DRs) on foreign stock markets. Despite the fact that local credit markets have not increased significantly in size, the efficiency of credit allocation has improved.3 However, the size of other markets has increased significantly for the firms within

A crucial question regarding liberalization is its impact on country growth rates. Galindo, Micco and Ordonez (2002) rind that liberalization in general has had an important positive impact on growth rates of economic sectors that rely deeply on external financing. The degree of impact of liberalization depends on the quality of the institutions that support the proper functioning of credit markets. 3

Galindo, Micco and Ordonez (2002) show that when creditors are unprotected, as in Latin America, financial liberalization has little effect on credit market development. Galindo, Schiantarelli and Weiss (2002) provide direct evidence on financial liberalization improving the efficiency of investment. They show that financial liberalization is associated with increasing financial flows towards relatively more profitable projects.

foreign banks have been allowed to penetrate financial

CHAPTER

tant in financial markets. This is particularly vital for small and medium-sized firms that will be able to access deeper financial markets. In a sense, this can be equivalent to removing certain forms of credit constraints faced by businesses.4 Moreover, from the perspective of financial institutions, businesses become better clients because they have less exposure to individual risks. The law of large numbers guarantees less exposure to credit risk as the number of clients increases. Hence, both from the perspectives of firms and financial intermediaries, integrating into larger markets, or even the formation of larger markets, is beneficial. Additional advantages linked more specifically to formal integration agreements are associated with gaining regulatory independence and avoiding regulatory arbitrage. Problems in these areas are notable in less developed countries. When the financial system is small and there are direct links between regulators and banks, supervision is usually not guided by independent policies.5 Integrating formally can reduce this risk, as it increases the number of participants and interests governing the financial system. In an integrated system, regulatory principles are driven by supranational principles that are likely to be less influenced by domestic interests. The most basic principles needed to achieve such forms of integration are harmonizing regulatory, accounting and auditing standards. This is crucial to guarantee transparency and comparability across financial sectors. Equally important is to harmonize the valuation criteria of the risk of bank assets. Different risk valuations, for example, can lead to totally different accounting of required capital to buffer shocks as well as to regulatory arbitrage.6 Ideally, financial institutions in all countries participating in an integration arrangement should adhere to similar financial regulations. Such harmonization leads not only to cross-border integration between countries within a treaty, but also can attract foreign players, which, as will be discussed below, can improve the stability of the financial system. In addition, financial markets can become better integrated if information is shared across countries. Harmonizing rules that govern credit information and collateral registries, as well as allowing for data sharing between countries, can also support regional financial integration. Any policy that facilitates information

sharing across countries or increases its efficiency at any level relevant to financial markets can help promote cross-border trading of financial services.

Financial Integration in NAFTA NAFTA includes three bilateral agreements regarding financial integration between each of the three countries involved (Canada, Mexico and the United States). However, prior to passage of NAFTA in 1993, and even before the Canadian-U.S. Trade Agreement (CUFTA) in 1989, U.S. and Canadian financial markets were already highly integrated.7 Although the CUFTA was less ambitious in other respects than NAFTA, it explicitly treated the issue of financial services trading and accepted the principle of national treatment of foreign banks.8 On the other hand, Mexico's financial sector was highly repressed prior to NAFTA, with numerous restrictions on the participation of foreign players, including interest rate controls and directed credit policies. Despite this, many firms, especially large ones, had direct access to international markets, and citizens also exploited savings and investment benefits of foreign domestic financial markets, particularly those of the United States (see White, 1994). Like CUFTA, NAFTA deals directly with financial integration. Chapter 14 of NAFTA addresses these issues and is based on forward-looking principles designed to enhance market access. The main guiding principle recognizes that financial institutions should have equal access to member countries, either through cross-border trading or by directly establishing facilities, and should not be subject to discriminatory treat-

Recent research by Love (2000) shows that firms in countries with deeper financial markets have lower credit constraints. 5

Examples are some Central American countries, where bankers have a seat on the boards of the supervisory agency.

Regulatory arbitrage refers to the possibility of intermediaries acting strategically to avoid certain regulations in particular countries.

Canada, for example, has had essentially no capital or foreign exchange controls since the 1950s. Restrictions to foreign bank entry were lifted in the 1980s. 8

This principle states that foreigners should have the same rights as nationals. Note that this differs from the reciprocity principle that claims that a foreigner in a host country should be given the rights of a host country resident in the foreign country.

1O4

105

ment. NAFTA contains provisions to ensure trans-

Between 1994 and 1999, $4 billion entered the bank-

parency of government decisions in this area, includ-

ing system, with the United States and Canada

ing a financial services committee and dispute

accounting for nearly 70 percent of these flows.10 As a

settlement procedures.

result, foreign majority ownership (defined as owning

The guiding principle of NAFTA with regard to

more than 50 percent of bank assets) in Mexico's bank-

financial supervision is that it is a host country affair.

ing system already accounted for 20 percent of total

However, regulators are permitted to negotiate bilater-

assets by 1998, five times more than in 1994.

al agreements leading to regulatory and supervisory harmonization. The evolution of certain U.S. regulators

Other Regional Agreements

regarding harmonization is notable. A clear example is the U.S. regulatory position regarding the linkages

Advances in formal regional financial cooperation

between banking and securities industries. The since-

have been very limited among the Latin American

repealed Glass-Steagall act passed in 1933 stated that

countries. As an example, aside from NAFTA, there

these industries should remain separate. This led to a

has not been much progress in regional financial serv-

financial system structure in the United States very dif-

ice liberalization beyond approval of protocols.

ferent from the universal banking approach of Canada

However, some initiatives are worth noting,

and Mexico. However, the United States allowed some

such as certain efforts to integrate stock markets, as

exceptions for Canadian banks, and while the practi-

well as the creation of subregional development banks

cal effect of this exemption was minimal, it marked the

in Central America (BCIE), the Andean area (CAF), the

first time that the United States had shown a willingness

Southern Cone (FONPLATA)11 and CARICOM (CDB).

to modify some part of its domestic regime to further

Some CARICOM countries (Barbados, Jamaica and

integration.

Trinidad and Tobago) have moved toward a regional

Regarding rules of origin, the United States

stock market with cross-listing and trading in securities

and Mexico agreed to treat financial institutions resid-

on existing stock exchanges in order to facilitate the

ing within their jurisdictions as nationals. This helped

cross-border purchase and sale of securities. The small

facilitate the entrance of European foreign banks into

islands of the Association of Eastern Caribbean States,

Mexico. Canada, however, treats U.S. and Mexican

part of CARICOM, have a long-functioning common

banks ultimately owned by non-member country insti-

currency and a common central bank.

tutions as non-NAFTA banks.

In addition, the Latin American Reserve Fund

Initially, NAFTA restricted foreign investment

(LARF) provides forms of balance of payments support

in the Mexican financial system. Under the original

to the Andean Community (AC) countries and Costa

treaty, Mexican banks were protected from foreign

Rica. The goals are to help correct payments imbal-

competition through provisions that limited foreign

ances through loans with terms of up to four years and

ownership.9 However, these restrictions were liberal-

guarantees extended to members; to coordinate their

ized after the 1995 peso crash and the collapse of the

monetary, exchange and financial policies; and to pro-

financial system. Even when Mexico had the discretion to establish market share limits to U.S. and Canadian banks, barriers to foreign investment in banking were eliminated in 1998 to attract fresh capital and modern technologies to the financial sector. Since 1995, the Mexican financial system has gone through a profound transformation. The banking sector has witnessed foreign institutions merging with and buying domestic banks. Most notable are the entrance of Citibank, Banco Bilbao Vizcaya and Banco Santander. These and other international banks have injected significant capital into the financial system.

The treaty allowed for a transition period until 2000, when limits on the aggregate share of all foreign bank assets in Mexico would be in place, me proportion of total financial system capital that foreign banks could hold was limited to 8 percent and was allowed to increase gradually to 15 percent by 2000. After 2000, any NAFTA country bank could establish a wholly owned subsidiary in Mexico, though no single bank could own more than 4 percent of the financial system's total capital unless that capital had been raised in the form of retained earnings. 1

Â° See de la Mora (2001).

The Fondo Financiero para el Desarrollo de la Cuenca del Plata (FONPLATA) includes Argentina, Bolivia, Brazil, Paraguay and Uruguay.

Financial Intearation

CHAPTER

mote the liberalization of trade and payments in the Andean subregion. Since its inception, LARF has lent around $9.2 billion to its member countries. Meanwhile, at a regional level, ALADI has developed a reciprocal payments system to finance trade among members. The system, designed to overcome foreign exchange obstacles to trade, has facilitated around $212.1 billion in commercial operations since its beginnings in 1966. However, only 3.3 percent of the total imports from ALADI were financed throughout this system in 2001, in sharp contrast to around 90.9 percent in 1989. Finally, it is important to note that throughout the 1990s, Latin American financial integration has been driven by market forces. Indeed, increasing participation of foreign banks and investment funds has driven de facto integration of financial markets across the region. One of the RIAs in which the issue of financial integration is attracting attention is the Central American Common Market (see Box 5.1).

efficient capital utilization, the development of the financial industry itself, and better fiscal discipline. Liberalization of financial services was achieved through the creation of the "Single Passport," which allowed the provision of financial services, either by trading or by investing, in host countries without further authorization beyond that of the home country. However, the program led to heterogeneous integration across both sectors and countries. While the wholesale banking sector deepened its integration process, retail banking remained fragmented and strongly localized. Securities markets experienced deeper integration, whereas the insurance subsectors were limited because of legal barriers.12 What can Latin America learn from Europe? Latin America presents a different departure point in many aspects. The initial level of economic development is significantly lower, there is much less convergence between economic policies, and the financial systems are much more shallow. The European experience nevertheless shows that financial integration requires that there be:

Lessons from the European Union Financial integration in the European Community followed a gradualist approach that was implemented through a coordinated process of legislation among the member countries. The goal was to create a legislative framework that would allow greater integration of financial markets without giving up public policy interests of each member state in terms of prudential rules, market stability and consumer protection. In this regard, the Single Market Program to create a European economic system was based on the principle of home country control, regulatory competition and minimum standards harmonization. Under the home country control principle, primary supervision was left under direct control of national authorities. Mutual recognition and regulatory competition between the state members were acknowledged. However, participants' national laws did not have to be fully harmonized, and home country rules were accepted as the ones governing cross-border provision of services and the activities of branches in host countries. Integration brought several benefits to the regional market in the form of greater exposure to international competition, improved efficiency in financial intermediation, more

• Clearly defined long-term aims beyond sectoral efficiency, including economic development and global competitiveness; • Recognition that minimum harmonization of regulatory frameworks and cross-border financial activities require reform of public administration, particularly regarding tax treatment, banking and insurance legislation, and joint supervision of securities markets, in order to make the "Single Passport" system feasible and reliable; and • Commitment to a considerable degree of fiscal harmonization and economic coordination, in order to avoid financial crisis that would hinder effective financial integration. A glance at Latin American countries reveals clear obstacles to implementing an orderly process of financial integration in the European style, including

12 Major barriers appear to have been differentials in the tax treatment of savings and financial income, which distort the optimal allocation of capital, and the enactment of a let-out clause by the European Commission, which weakened the home country principle by establishing that the host country also has the right to regulate activity in order "to protect the public interest."

1O6

Financial Inteqration

Should Central America Advance toward Financial Integration?

The 40 years during which the integration process in Central America has been under way has seen major strides in consolidating the Central American Common Market (CACM). Progress has been uneven, however, in that it has targeted goods more than services. Particularly in terms of financial services, the five CACM economiesâ&#x20AC;&#x201D;Costa Rica, El Salvador, Guatemala, Honduras and Nicaraguaâ&#x20AC;&#x201D;continue to operate as separate compartments. There are convincing reasons to bring financial services under the umbrella of the CACM, and to move towards a true common market with free-flowing mobility of goods, services, capital and, eventually, labor. Central America's domestic financial markets suffer from severe limitations that restrict their ability to channel resources efficiently among economic agents. Table 1 shows the standard measures of financial development in these countries and compares them with countries that have deeper financial sectors. CACM country financial systems are underdeveloped relative to their economies, charge high spreads, and do not seem to have effective screening processes for loans. Furthermore, in such small economies, it is not possible to develop the array of sophisticated financial products necessary for development, among them stock markets, venture capital facilities and insurance services. Underdeveloped financial markets also make it difficult to undertake pension system reform. In Nicaragua, for example, there are only 200,000 contributors to the private system.

Financial integration in Central America would dramatically increase market size, thereby increasing competition, reducing spreads and interest rates, and improving efficiency through economies of scale and scope. Moreover, the expanded market size would create incentives to provide new and more sophisticated financial services. There are many problems that must be tackled before financial integration becomes a reality, foremost among them the issue of currency risk. Currently, the CACM countries have different exchange rate regimes. El Salvador has undergone dollarization, Guatemala follows a "dirty float" policy, and the other countries have crawling pegs (Honduras within a band and Costa Rica and Nicaragua without). In order to reap the benefits of financial integration, countries would have to move toward adopting a common regime. Here a range of options is open to them, from a common regime such as that of the pre-Euro European Union, to joint dollarization. Financial regulation is another important hurdle along the path to financial integration for CACM countries. Banking regulation, for example, has been unable to forestall banking crises in almost all of the countries. It is necessary to move towards consolidated regulation with common standards across countries, and to ensure that offshore banks are not left out of the process. All of these policies will eventually pave the way for common regulation at the regional level.

Table 1 Core Financial Indicators, 2OOO Credit to the private sector {% of GDP) Costa Rica El Salvador Guatemala Honduras Nicaragua Chile United States Switzerland Singapore 1

22.8 40.8 17.8 36.6 51.1 67.2 73.8 165.4 100

Real interest rates1 (%)

Spread (%)

16.7

11.5

9.6

4.7

14.2 16.4

10.7 10.9 11.9

8.8

10.3 3 7 3.9

5.6 2.8 1.3 4.1

Non-performing loans2 (% of total loans)

Assets per bank (In millions of US$)

4.5 4.2

342 583 220 193 224

7.1 3 3.6 3.8 1.9

0.3 4 4.1 5

3,600 750

3,476 1,643

Average nominal interest rate on loans minus prior year inflation rate (consumer prices). Non-performing loans defined as past due loans plus restructured loans. 3 From the year 2001. 4 90-day past due loans. Source: IDE estimates based on information from the IMF, World Bank, Central American Monetary Council, and national banking and monetary authorities. 2

Box 5.1

1O7

108 CHAPTER5

Table 5.1 Current Foreign Bank Ownership in Selected Developed and Emerging Markets, 2OO1

Total assets (US$ billions)

Number of banks

Developed countries New Zealand Luxembourg Finland United States Japan Sweden

83.9

493.0 254.0 10,800.0 8,720.0 557.0

118 11

744

211 28

Foreign control1 (%) 99.20 92.71 63.48 10.3 0.02 0.42

Emerging markets Europe Czech Republic Hungary Poland Turkey Uzbekistan Yugoslavia Latin America Mexico Argentina Peru Chile Venezuela Brazil Colombia

Asia Malaysia Korea Thailand Indonesia India China

50.3 28.2 85.4

156.0 4.7 26.8

156.0 166.0 20.1 77.1 31.6 397.0 31.4 180.0 496.0 155.0 87.4 273.0 1,090.0

21 29 39 45 8 13 38

97 17 28 70 138 39

51 27 23 67 75 37

92.99 68.84 63.58 6.68 0.93 0.00 76.53 54.50 53.75 43.71 42.28 30.61 21.35 16.76 8.73 6.37 4.92 0.80 0.21

1 Ratio of assets of banks where foreigners own more than 50 percent of total equity to total assets. Source: IDB estimates based on data from Fitch IBCA's Bankscope database.

i) the lack of the political cohesion necessary to carry through on protocols and develop the parallel legisla-

tion sharing across countries, as discussed above. Examples of these groups are foreign banks or corpo-

tive programs that need to accompany financial inte-

rations that have business in or with several countries

gration; ii) the heterogeneity of domestic regulatory

of the region, and that would benefit directly from

institutions and the persistence of fiscal imbalances; iii)

financial integration.

the lack of recognition of foreign regulations, con-

The lack of capital in the region has led to a

straining the "home country control" principle; iv) the

strong North-South de facto integration as opposed to

frequent acquiescence to interest group pressures; and

a South-South integration pattern. Even formal efforts

v) the threat implied by currency misalignments. Clear-

to integrate into external markets have focused on

ly, achieving European levels of financial integration in

gaining access to financial markets in the North. For

Latin America does not seem viable at least in the short

this reason, the remainder of this chapter will focus on

run. However there are particular groups that have

de facto integration, particularly the internationaliza-

vested interests in achieving at least some more basic

tion of the banking and stock market sectors, dis-

forms of financial integration, such as by harmonizing

cussing in each case its evolution, as well as the

regulations and institutional arrangements for informa-

benefits and costs associated with it.

Region

Financial Intearation

FOREIGN BANK PENETRATION IN DOMESTIC FINANCIAL SYSTEMS

Figure 5.3

1O9

Foreign Control in Latin American Banking Systems (Percent of banking system total assets)

Foreign direct investment (FDI) worldwide was notably grew from $19.3 billion to $142.6 billion during the decade. FDI in financial services was also of note, particularly that originating in OECD countries, which accounted for nearly 23 percent of total FDI from OECD countries in 1990 and 31 percent in 1998. Latin America and Central Europe were the major recipients of international capital flows to the banking sector. Table 5.1 shows current foreign participation in selected developed and emerging market banking systems. The table reveals that foreign banking is of great importance in Latin America and Eastern Europe. During the second half of the 1990s, the share of for-

Source: Galindo, Micco and Serra (2002).

eign ownership of banks in both regions increased significantly.13 Figure 5.3 shows that foreign ownership of banking institutions grew notably between 1994 and 2001 in Latin America. Most foreign investment in banking in Latin America comes from OECD country banks, particular-

What Determines Bonk Location Abroad?

ly Spanish and U.S. institutions.14 Table 5.2 shows the source of foreign banking grouped by world regions.

The location of foreign banks across the world is influ-

Europe has the highest degree of intra-regional finan-

enced by many factors. Investment decisions by banks

cial integration (15.9 percent), followed by Africa and

take into account the profitability of investment, the

the Middle East (7.7 percent), while Latin America has

development of the financial system, and the need to

the lowest (0.6 percent).15 Between regions, the major

follow similar strategies as their competitors and main-

recipient of foreign participation has been Latin Amer-

tain their market share. However, there are other crucial

ica, where OECD countries, Europe, the United States and Canada own 46.5 percent, 28.2 percent and 1 8

factors that influence decisions regarding expansion abroad. In particular, the decision appears to be

percent, respectively, of total assets of the regional banking system.

strongly determined by other forms of integration.

These numbers, however, underestimate the influence of foreign banks in Latin American economies. In most cases, foreign bank participation is accompanied by a very relevant role in managing private pension funds. Table 5.3 shows the share of foreign firms in pension funds in Latin American countries. The share is highest in Bolivia, Peru and Argentina, where foreign intermediaries account for nearly 85.3 percent, 78.5 percent and 73.6 percent of pension funds, respectively. In mature systems such as that of Chile, where the size of the system is nearly 54 percent of GDP, foreign firms manage 54.1 percent.

13 Several reasons led to this outcome. Restrictions on entry of foreign banks were removed as a part of the liberalization process; formerly, public banks were privatized and foreign investors participated in the process; and the banking sector used international funds to recapitalize after the sequence of external shocks that hit the region during the decade. 14 Banco Bilbao Vizcaya Argentaria (BBVA) and Banco Santander Central Hispano (BSCH) have become the largest international players in Latin American retail banking markets. Banks from different regions have had different patterns in their expansion into Latin America. While U.S. banks have tended to focus exclusively on U.S. firms operating in the region, European banks have had a more retail oriented approach. See Guillen and Tschoegl (1999). 15 Taking the region as a whole, the financial integration measure is a little higher (1.5 percent).

dynamic during the 1990s. FDI in emerging markets

110

CHAPTER

Table 5.2

Cross-Border Shareholdings around the World1 (In percent)

Africa & Middle East Asia & Pacific Latin America2 Latin America3 U.S. & Canada Europe in transition4 Europe5 TOTAL OECD6

7.68 0.05 0.11 0.13 0.08 0.01 0.34 0.34 0.20

Asia & Pacific

0.14 1.32 0.23 0.27 0.68 0.26 2.49 1.64 1.59

Latin America2

Latin America3

0.00 0.00 1.47 -

0.03 0.02 0.03 0.05 0.02

U.S. & Canada 1.89 1.22 18.81 18.03 0.95 4.45 3.34 2.47 2.27

0.00 0.00 _

0.64 0.01 0.00 0.02 0.03 0.01

Europe in transition4

Europe5

0.03 0.00 0.06 0.07 0.00 1.39 0.02 0.02 0.01

3.66 3.30 26.64 28.17 8.61 34.69 15.89 11.25 -

TOTAL

OECD6

13.39 5.89 47.32 47.31 10.34 40.82 22.11 15.77 15.29

5.65 5.03 45.74 46.53 10.21 39.82 14.25 14.00

Ownership data reflect changes up to July 2001, while balance sheet data are the most recent available. Excludes the Bahamas, Cayman Islands and Panama. 3 Only includes Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay and Venezuela. 4 Includes economies in transition from Central and Eastern Europe. 5 Excludes Europe in transition. 6 Excludes Czech Republic, Hungary, Korea, Mexico, Poland and Slovakia. Source: IDB estimates based on data from Fitch IBCA's Bankscope database. 2

Table 5.3

Foreign Participation in Latin America's Private Pension Funds Size of private managed pension fund

Foreign participation

Foreign participation1

Country

(% of GDP)

(%)

Argentina Bolivia Chile Colombia Mexico Peru Uruguay Total

8.40 12.91 53.59 5.83 5.60 7.45 5.58 9.80

73.64 85.26

68.58 37.89 49.07 44.62 59.36 59.27 29.52 56.46

54.13 47.36 66.55 78.46 29.52 62.94

1 Only includes the ownership of private pension funds of foreign holding companies that also have bank subsidiaries or branches in the country. Source: Superintendencies of Private Managed Pension Funds.

Galindo, Micco and Serra (2002) show foreign bank participation is enhanced by integration via trade, foreign direct investment in different sectors, and by sharing legal features. The theoretical underpinning for the idea that economic integration is related to foreign banking is that international banks follow their customers (multinational firms) around the world in order to provide them with financial services and exploit informational advantages derived from long-term bank-client rela-

tionships.16 In the case of trade, firms can also rely on international banks to minimize the costs of international transactions by using the same bank for any type of bilateral payments. Econometric results from Galindo, Micco and Serra (2002), using the gravity model and bilateral data from 176 countries, suggest that

See Petersen and Rajan (1994) and Rajan (1998).

Source region Africa & Middle East

Host region

Financial Integration

Figure 5.4

Foreign Bank Penetration and Legal and Regulatory Variables (In billions of US$)

Ill

bank participation by 1.3 percent (see column 2 of Appendix Table 5.1). Sharing features imbedded in legal codes also increases foreign bank participation. Sharing legal process, and can also reduce operational costs, given that certain economies of scale can be exploited at the international level. Banks are more willing to locate in foreign countries with which they share legal features. As shown by La Porta, Lopez-de-Silanes and Shleifer (1997, 1998), the sharing of certain basic legal features such as the origin of the legal code implies that further regulations that protect creditors and shareholders in different ways tend to evolve in similar fashions. Similarities in these regulations reduce costly adaptation to new environments. The left panel of Figure 5.4 reports the strong

Note: Foreign control measures total assets of banks where foreign ownership exceeds 50 percent. Source: Galindo, Micco and Serra (2002).

relationship between sharing legal origin and crossborder banking. It shows that countries receive an average of $16.642 billion from countries with whom they share legal codes, while in contrast they receive only $11.635 billion from countries with different legal origin. Using econometric techniques that control for additional factors, Galindo, Micco and Serra (2002)

trade integration is a significant determinant for the 17

expansion of banks abroad.

A 1 percent increase in

trade raises foreign bank participation by 0.7 percent (see column 1 of Appendix Table 5.1 ).

find that foreign participation in country pairs that share legal codes is 26 percent greater than when codes differ. Similarly, the right panel of Figure 5.4 reports

With respect to firms that have located

that if the host countries have prudential regulation and

abroad via FDI, having a known bank can also be

supervision practices similar to source countries, there

advantageous, given the informational benefits that it implies. However, this line of reasoning does not

is greater investment in banking. On average, host countries worldwide receive nearly $20.525 billion

explain why banks decide to open a branch or a sub-

from source countries with similar prudential regula-

sidiary rather than just operating through a representative office that could provide similar financial

tions, while they receive less than $9.475 billion from countries with different standards. This finding is sub-

services. Rather, the reason can be linked to the fact

ject to double causality, however. It is also feasible that,

that foreign firms need to have access to capital

as foreign participation increases, local authorities are

denominated in local currency to avoid a currency

forced to converge toward external practices. Galindo,

mismatch between revenues and costs. In such a case, the foreign bank may decide to locate in the foreign country and intermediate funds from the local market towards the international firms. For portfolio diversification reasons, the foreign local bank also has incentives to operate in other retail banking activities, as has been the case of most international banks in Latin America. According to Galindo, Micco and Serra (2002), a 1 percent increase in FDI increases foreign

17 In previous studies, Brealey and Kaplanis (1996), Focarelli and Pozzolo (2001) and Moshirian (2001) found a correlation between trade and investment in banking sectors abroad. However, unlike Galindo, Micco and Serra (2002), none of these studies focused on the bilateral nature of the data. 18 This does not necessarily mean that direct investment in banking increases in the same magnitude, since banks, by the nature of their business, tend to have high leverage.

regimes can minimize learning costs in the investment

CHAPTER

Micco and Serra (2002) estimate that when supervisory practices are similar, foreign participation is increased by nearly 19 percent. This finding also suggests that harmonizing regulations across countries can increase financial market integration even at the regional level by increasing the participation of external and national players in several markets simultaneously.

The Effect of Foreign Bank Penetration in Domestic Markets Financial liberalization makes a financial system function better, in turn fostering growth, by improving system efficiency and under certain conditions increasing the availability of funds. In particular, the financial liberalization process in recent decades has allowed foreign banks to freely participate in local markets (Figure 5.3). Overall empirical evidence on the impact of foreign banks on domestic markets is scarce. However, the fragmented evidence available suggests that the effects of internationalizing the banking system are positive, since banking systems increase their competitiveness and efficiency, in particular when foreign banks come from a more developed country.19 However there is some controversy as to whether credit volatility is reduced by foreign banks.20 On the one hand, some authors claim that foreign banks are able to stabilize credit because they have access to external funds, and, due to their reputation (brand name), they are able to stabilize local deposits. In addition, foreign bank entry may generate competitive pressure that leads to measures that guarantee future stability through more aggressive provisioning standards and higher capital ratios (Crystal, Dages and Goldberg, 2001). On the other hand, some economists claim that foreign banks are more sensitive to shocks in the host economy because they can substitute local assets with alternative investments abroad that are not easily available for local banks.

Foreign Banks, Efficiency and Regulatory Standards

tion and the diffusion of new technologies. Foreign institutions improve the quality and availability of financial services by bringing new and better skills, management techniques, training procedures and technology. Moreover, Levine (1996) argues that the presence of foreign banks seems to lead to the development of better rating agencies, accounting standards and credit bureaus that acquire and process information, as well as better bank supervision and a more adequate legal framework. Foreign banks tend to follow prudential practices adopted in their home country. In the case of foreign banks from developed countries, these practices are usually more stringent than those of developing ones. In such cases, the increased security inspired by international banks leads domestic banks as well as supervisors to adopt international standards in order to ease competitive pressures coming from depositors searching for the safest institutions. The presence of foreign institutions can boost competition and improve the operation of the domestic market (local banks), which in turn stimulates improvement in resource allocation and faster economic growth. In addition, international competition reduces interest rate margins and local banks' profitability.21

Credit and Deposit Stability and Foreign Banks The huge increase in the number of foreign banks in Latin America, coupled with the region's credit crunch at the end of the last decade, have raised the question of whether the presence of foreign banks played a role in stabilizing domestic credit and deposits. This is a controversial issue in the literature. Some authors claim that foreign banks, due to their access to foreign liquidity, are less dependent on erratic local deposits, and therefore can stabilize credit in the host country. In addition, foreign banks, with their brand name (repu-

19 See Levine (1996), Claessens, Demirguc-Kunt and Huizinga (2001), Martinez Peria and Schmukler (2001). 20

Foreign banks traditionally have been associated with better resource allocation and higher efficiency. In particular, they have been linked with increased competi-

See Goldberg (2001) and Crystal, Dages, and Goldberg (2001).

Foreign banks from non-Latin American countries located in Latin America tend to have higher profits, lower overhead costs, lower nonperforming loans, and fewer employees per loan than domestic banks.

112

113

tation), allow depositor-fly-to-quality to occur within

medium-sized firms.25 Small businesses tend to have

the domestic market during financial turmoil, stabiliz-

exclusive dealings with a single bank with which they

ing both deposits and credit.22

have developed an "informal relationship" that

On the other hand, others argue that foreign

reduces asymmetric information. Large foreign banks

banks decrease their exposure to the country when

are likely to have difficulties developing these types of

domestic conditions deteriorate,

increasing credit

relationships. While large foreign banks are unlikely to

volatility.23 Moreover, these banks can transmit shocks

replicate the lending method of small domestic banks,

from their home countries. Changes in a foreign bank's

they can bring new technological innovations that fos-

claims at home or in other countries can spill over to the

ter credit to small and medium-sized firms. An exam-

host country. In Latin America, most foreign banks

ple would be new credit scoring methodologies.26

come from developed countries that are also the main

Empirical evidence about the impact of for-

consumers of Latin American exports. Therefore, a con-

eign banks on the amount of credit to small businesses

traction in these countries would affect Latin America

in developing countries is scarce and inconclusive.

not only through a contraction of external demand, but

Some studies from Argentina associated foreign bank

also through a reduction in local credit, amplifying the

participation with a reduction of bank lending to small

Latin American business cycle even more.

firms from around 20 percent of total lending in 1996

To test the validity of these two views, we study

to 16 percent in 1998. However, during the same peri-

individual bank credit behavior after a change in

od, foreign banks increased both their propensity and

deposits or in business opportunities. The measure of

their market share to this sector.

business opportunity is the change in external

In an analysis of the behavior of foreign banks

demand.24 Appendix Table 5.2 shows that all bank

in four Latin American countries (Argentina, Chile,

credit reacts to changes in deposits, but this reaction is

Colombia and Peru), Clarke et al. (2002) found that

smaller for foreign banks. Foreign bank credit is 20

foreign banks generally lend less to small business than

percent less sensitive to changes in domestic deposits

do private domestic banks. However, these results are

than is domestic bank credit. With respect to bank

mainly driven by small foreign banks, which were

reaction to business opportunities, after a contraction

found in all four countries to lend less to small busi-

in external demand, all banks reduce their loans, but

nesses than did similar domestic banks. The opposite is

this reduction in credit is 50 percent smaller for domes-

true for medium-sized and large foreign banks in Chile

tic banks.

and Colombia, but not for Argentina and Peru. Final-

The results suggest that foreign banks would

ly, in Argentina and Chile, the two countries where the

increase credit volatility if shocks were mainly changes

financial sector developed most during the study peri-

in business opportunities in the host country, but would

od, lending to small businesses by medium-sized and

reduce it if the main source of credit volatility were the domestic supply of deposits. Which dominates remains an empirical question. 22

Foreign Banks and Market Segmentation Despite the potential benefits of foreign bank penetration described above, some analysts have suggested that increased foreign bank penetration in developing countries might reduce access to credit to some segments of the market, particularly small and mediumsized firms that heavily depend on bank financing. In general, foreign banks are large and organizationally complex financial institutions that find it difficult to lend to informationally opaque small and

See IMF (2000).

Caballero (2002) shows that local and foreign banks in Chile increased their positions in foreign assets during the 1 998 recession, but this increase was substantially more pronounced for foreign banks.

External demand is defined as the weighted average of the growth rate of trading partners. 25 Goldberg (1992) shows that foreign banks in the United States tend to lend to large firms. See Berger and Udell (1995) for a discussion about the relationship between large banks and credit for small and medium-sized companies. 26

Mester (1997) argues that there could be a U-shaped relationship between bank size and lending to smaller firms. One extreme would be small domestic banks using relationship-lending types of services, and the other would be large banks using more standard products for smaller businesses based on credit scoring.

Financial Intearation

CHAPTER

large foreign banks was growing faster than lending to this sector by domestic banks. The authors speculate that the better institutional environments in Argentina and Chile allowed large foreign banks to use scoring methodologies, enabling them to increase their lending to smaller firms. Foreign banking has increased significantly in Latin America since the 1990s. Empirical evidence tends to favor the advantages of foreign bank penetration over possible negative implications. Greater efficiency and less instability after deposit shocks from foreign banks have been noted in the region (except in major crisis episodes where all banks suffer equally). However, when idiosyncratic business opportunity shocks hit, foreign banks tend to move out in search of better opportunities in other countries. Evidence is inconclusive regarding foreign bank presence and lending to small and medium-sized enterprises. On balance, however, evidence is supportive of foreign bank participation in Latin American markets.

STOCK MARKET INTEGRATION International listings almost entirely in the form of a North-South integration have been an important source to raise capital and expand the shareholder base for Latin American corporations. In 1994, Mexico was ranked third among countries with the most companies traded (in value terms) on the New York Stock Exchange (NYSE), with Argentina ranked fifth and Chile seventh. During the same year, Latin American companies trading in the United States in the form of ADRs (American Depositary Receipts) represented more than 50 percent of their local market indices. For Mexico and Brazil, this percentage reached respective levels of 87 percent and 71 percent. In the last decade, the amount of aggregate capital raised by Latin American firms in the ADR market has been a substantial portion of the capital raised in local stock markets. For example, Figure 5.5 shows that in 1996, Latin American corporations raised $22 billion in the form of ADRs and only $13 billion in local markets. Moreover, in contrast to ADRs from developed markets, those from emerging markets, and particularly Latin America, are usually traded more actively in the United States than in the domestic market.

Figure 5.5

Latin American ADR Market, 1991-2OOO

Note: Capital raised through ADRs includes Level III and SEC Rule 144A programs. Source: Moel (2001).

Firms that are able to issue ADRs on the NYSE reduce their credit constraints and are able to take advantage of foreign debt markets, reducing both their financial costs and their vulnerability to local market volatility. However, as shown by Moel (2001), the migration of these firms, generally the biggest ones, reduces the liquidity of local equity markets, increasing financial costs for local firms and reducing the incentive for new firms to enter in the local equity market.

Stock Market Integration in Latin America There is little stock market integration in Latin American countries. Figure 5.6 shows the ratio of foreign firms hosted in domestic stock markets to stocks from domestic firms. The numbers for the region are extremely low compared to other parts of the world, meaning that very few foreign firms list on Latin American markets. Up until now, Latin American countries have been completely isolated from the world in this sense, as well as from other countries within the region itself. As seen in Figure 5.7 most Latin American firms list abroad, particularly the United States, and the degree of regional integration in Latin America is almost null. Aside from a few Argentine firms listing in Brazil, there is virtually no stock market integration within the region.

114

Financial Integration

Figure 5.6

Figure 5.7

Foreign Firms Listed in Domestic Markets/Domestic Firms Listed in Domestic Markets, 2OO2

115

Location of Foreign Listings of Latin American Firms

Source: World Federation of Exchanges and regional stock exchanges. Source: Sarkissian and Schill (2001).

What Determines the Decision to List Abroad?

higher shareholder base leads to increased investor recognition, reduced information costs, and lower costs of capital for firms.31 Listing abroad also provides liq-

Stock exchange investors are well known for investing 27

uidity gains, which is important because it allows firms

There are many factors that reduce

to avoid reduction in funding when the home economy

informational barriers and increase the degree of

is hit by domestic shocks. In such cases, and if shocks

familiarity of an external asset. Empirical literature has

are not completely symmetrical, an

shown that sharing several legal, cultural and geo-

diversified firm can continue to receive funding from its

graphical features reduces barriers for asset trading.

outside listings when domestic markets are contracting.

Sharing a language, trading with the country where

The quality of institutions is of great impor-

the asset is originated, and being geographically near

tance for firms when choosing where to list. La Porta,

that country are among others the factors that increase

Lopez-de-Silanes and Shleifer (1997, 1998) have

the likelihood of trading in another country's assets.

shown that countries differ substantially in their rules

Taking advantage of these features allows foreign firms

and regulations that protect the property of sharehold-

in familiar assets.

internationally

to list their stock in foreign stock exchanges.29 There are several advantages for firms from listing their stock abroad. Since capital markets are not fully integrated, businesses can benefit from lower cap30

ital costs by tapping external capital markets.

On the

one hand, a premium for accessing restricted foreign securities can contribute to the lowering of capital costs; on the other, at the local level, the signaling effect of operating in international markets can increase the valuation of a firm's equity. From this perspective, diversifying to external listings can improve a firm's capacity to access cheaper forms of capital. Tapping international stock markets also enables firms to access a higher shareholder base. A

For example, French and Poterba (1991) and Tesar and Werner (1995) discuss in detail the home bias feature. 28

Grinblatt and Keloharju (2001) provide a detailed discussion on the impact of these variables on stockholdings and trading in Finland. Rauch (1999) has greater cross-country coverage and finds that colonial ties are also of great relevance. 29

Empirical analysis by Sarkissian and Schill (2001) finds that the features noted in the text here are important determinants of crossborder listing. It also finds that better institutions, in the form of a stronger rule of law, attract foreign firms to local stock exchanges. 30 31

See Errunza and Losq (1985).

See Merton (1987) and Foerster and Karolyi (1999) for theoretical and empirical discussions.

(In percent)

CHAPTER

ers. Investors who want to reduce the risk of expropriation can choose to invest in countries where the legal codes favor them. This increases the size of stock markets and can lead foreign firms to list in those markets and exploit the higher liquidity and shareholder base available.32 Firms also migrate in order to avoid high clearance and settlement risks, and high taxation and exchange controls in domestic markets, as well as to exploit the ease of trading and the lower transaction costs of developed markets. In addition, regulations that inhibit domestic trading, such as high taxation of trading, also lead to firm migration. These issues also limit the expansion of domestic trading. Despite the advantages of listing abroad, such a decision can also be costly. Disclosure costs and the need to adopt international accounting standards are two of the main costs frequently discussed. However, to a certain extent, paying those high costs in the short run can translate into long-run benefits. Once more stringent accounting standards are adopted, external funds can become cheaper in the domestic market as a result of a signaling effect. Differences in the tax regimes can also motivate or inhibit decisions to list abroad. Hong Kong and Singapore, for example, have tax concessions for external participants. Empirical exercises by Sarkissian and Schill (2001) show that tax havens are a fundamental factor when analyzing the pattern of cross-border listings around the world. As in the discussion of foreign banking, there are other forms of integration that reduce transaction costs for investors and increase cross-border activity. An example is the similarity in regulations, which can attract foreign firms just as does the quality of regulations. Having similar legal codes or sharing relevant features in the laws and regulations that protect shareholder rights increases the chance of cross-border listing. Results supporting this finding are reported in Appendix Table 5.3. Several measures of legal proximity have significant impacts on the decision to list abroad. The similarity of regulations, however, is not an unconditional requirement for integration of stock markets. It is important only if these are high quality regulations in the sense that they protect shareholders. Column 3 of Appendix Table 5.3 shows that similarity in legal codes is only relevant if the codes are based on

common law, that is, in countries where creditor and shareholder rights tend to be better protected. La Porta, Lopez-de-Silanes and Shleifer (1998) show that these codes tend to favor shareholders the most. Similarities in non-common law based regulations do not provide incentives for stock market integration. Firms are willing to cross-list in similar countries that have good protection for shareholders.

The Effect of Cross-listing for Domestic Markets Cross-listing reduces the cost of capital to firms that are able to issue shares in other markets. This is true for large Latin American corporations that have been able to issue ADRs. When firms decide to issue abroad instead of in the local market, it places pressure on local exchanges, brokers, and regulatory authorities to modernize operations, improve disclosure standards, and strengthen small shareholder rights to improve the local market in terms of liquidity, transparency and efficiency. Following this argument, the external competition generated by the cross-listing of large Latin American corporations should have a positive externality on domestic financial markets and, therefore, on small and medium-sized local firms that are not able to issue abroad. However, policymakers in emerging markets are concerned that the globalization of trading will lead to fragmented markets, diverting other flows to foreign markets, reducing liquidity in the domestic market and inhibiting its development. This fear seems to be supported by the inverse evolution of the amount of aggregate capital raised by Latin American corporations in the ADR market and the number of Initial Public Offerings (IPOs) in Latin America. Figure 5.5 shows that the number of IPOs in Latin America falls once the large corporations start to raise capital issuing ADRs. From both theoretical and empirical points of view, it is unclear whether cross-listing benefits or harms domestic liquidity and volume traded. Theoretical models show that the impact on domestic market liquidity and volume can be positive or negative, depending on

Sarkissian and Schill (2001) provide empirical evidence supporting this claim.

116

Financial Integration

117

whether it expands the shareholder base, the extent of

that reduces information costs, and access by firms to

domestic restrictions (foreign ownership restrictions),

cheaper sources of funding. The question from the per-

domestic market liquidity prior to listing, and inter-mar-

spective of developing countries is whether these gains

ket information transparency.

Initial empirical works

summarized in Karolyi (1998) show that, in general,

come only from integration with developed countries (North-South

integration), or are also present in

domestic liquidity and volume traded increase overall

regional integration agreements with other less devel-

(for all firms in the domestic market with and without

oped countries (South-South integration). In general,

cross-listing).

access to cheaper sources of funding does not seem to

Moel (2001) has analyzed the effects of ADRs

be a motive for this South-South integration for Latin

on 28 emerging markets, with a particular focus on

American countries, since capital is not abundant and

local market transparency, growth, and the liquidity of

is a costly resource in most countries in the region. In

companies that are left behind and only traded in the

addition, given the similar low levels of shareholder

local market. In developing countries, ADRs seem to

protection and the general lack of development of

improve financial disclosure (accounting standards

accounting standards and their enforcement, the sig-

and openness), but they reduce both liquidity and the

naling advantages pointed out previously may not be

ability of local markets to grow in terms of the number

present. The possibility of protecting themselves against

of listed firms and capitalization ratios. A 1 percent

shocks by diversifying the shareholder base might not

increase in the proportion of firms listed with ADRs

be present either, given that the region as a whole

leads to a reduction in the sample mean market

tends to be exposed to similar capital market shocks.

turnover from 54 percent to 45 percent. The effect of

However, it is possible that the increase in the

ADR listing is highly detrimental to the listing of new

shareholder base might reduce the cost of capital for a

firms in domestic markets. For every firm that lists its

regional firm, not only because it would gain some

ADRs, the local stock market loses approximately one

additional liquidity, but also because it can increase

additional firm. The study shows that the impact of

regional recognition. This could be more important if

ADRs varies substantially by region. Africa and Latin

one considers that financial integration might come

America are generally the most negatively affected by

with an increase in regional trade and FDI. An impor-

cross-listing.

tant caveat regarding this and other forms of financial

The previous results corroborate the concern among Latin American policymakers with regards to

integration is that it increases the vulnerability of the host country to foreign shocks.

the effect of ADRs on domestic markets. They also raise

There are several barriers that limit the possi-

a number of policy issues. How should governments

bility of exploiting these gains. As discussed previous-

react to this new scenario? Is there a place for local or

ly, the size of markets matters for firms. The under-

regional equity markets in the future? Should all small

developed nature of stock markets in Latin America,

and medium-sized firms move from equity financing to

and hence their low liquidity, limits incentives for partic-

debt markets?

ipation in these markets. It is likely, though, that as financial integration proceeds, the regional market can

Major Constraints to Stock Market Integration within Latin America

become more attractive to international players. There are additional barriers to stock market integration in Latin America pertaining to the legal,

From the point of view of Latin American countries, the

regulatory and judicial structure, underlying macro-

benefits to be derived from stock market integration are

economic policy, the historical and cultural context of

more associated with integrating with developed coun-

the different jurisdictions, and the nature of the finan-

tries than with countries within the region.

cial infrastructure pertaining to trading mechanisms,

Integration of Latin American stock markets to world markets can be beneficial because it allows for greater liquidity of firms' stocks, a higher and more diversified shareholder base, a gain in firm recognition

33 See Hargis and Ramanlal (1997), Domowitz, Glen and Madhavan (1998) and Foerster and Karolyi (1996).

CHAPTER

Figure 5.8

Effective Shareholder Protection (Index 0-1)

Note: Effective shareholder protection is the product of the rule of law and an index measuring the degree to which regulation protects shareholders. Higher values indicate higher effective protection. Source: La Porta, Lopez-de-Silanes and Shleifer (1998).

accounting conventions and taxation systems. The barriers also reflect the underlying prerequisites needed for effective implementation of a strategy for securities market integration. These include clear laws and regulations about property rights, macroeconomic stability, and free movement of capital.34 The quality of regulations that protect shareholders is an important determinant of cross-border listings. Figure 5.8 shows a measure of effective shareholder protection constructed as the product of the rule of law and a measure of regulation quality. The findings suggest that in this area, the Latin American countries rank well below international averages. This limits incentives for cross-border listings. Cross-border activity depends on the existence of currency convertibility and limited exchange controls, particularly for the currency of the countries under consideration. Currency convertibility or limited controls are needed to limit asynchronous prices and trading, and to ensure that the appropriate hedging mechanisms are in place. Unstable exchange rates and the lack of mechanisms to hedge exchange rate risks are also factors that have inhibited the development of regional capital markets. Effective securities market integration presumes the existence of some integration of the regulatory and supervisory framework. If market participants are subject to multiple frameworksâ&#x20AC;&#x201D;and particularly if

Figure 5.9

Opacity Index (O-1OO)

Note: The opacity index is a composite index based on opacity data for five different areas that affect securities markets: corruption, legal system, government macroeconomic and fiscal policies, accounting standards and practices, and regulatory regime. High numbers indicate a high degree of opacity. Source: PriceWaterhouseCoopers (2001).

they are not harmonized, as is the case across Latin Americaâ&#x20AC;&#x201D;then they are likely to face uncertainties, complexities, and increased costs, both directly in terms of having to comply with multiple regulatory regimes, and indirectly in having to incur the cost for multiple monitoring and enforcement regimes. Inappropriate arrangements for cooperation and mutual assistance between national supervisors can also hinder regional securities market integration. Many types of legislative and regulatory impediments can also limit integration, including differences in bankruptcy regimes, sanctions regimes, restrictions on ownership by non-nationals, the imposition of rules to protect national industries, requirements to establish local companies, and restrictions of many types on issuers, intermediaries and investors in providing cross-border services. Local or regional laws may also be too detailed and thus too inflexible in changing circumstances. Accounting and auditing differences as well as differences between disclosure requirements would restrict the ability of market participants to establish a core basis for financial statement analysis and to ensure consistency in valuation intra-regionally. To some extent,

Lee (2001) summarizes some of the main barriers to integration.

118

119

the introduction of international accounting and auditing

ipation in the region of foreign banks from developed

standards will reduce the significance of this factor as a

countries, and in the rise of cross-border equity trading

deterrent to securities market integration. However, for

in developed countries. Regarding regional or South-

many countries that are yet to truly adopt International

South integration, there have been far fewer advances.

Accounting Standards (IAS), accounting differences

In general, the macroeconomic and institutional setup

remain a real threat and barrier to securities market inte-

of countries within Latin America has not favored the

gration. Although Latin American countries have made

development of integrated markets. However, regional

progress in ensuring compliance with

international

integration has been achieved to some extent by means

accounting standards, they have a long way to go

of international financial institutions that do business in

toward wholesale compliance, particularly in terms of

several countries simultaneously.

both the stringency and the standardization of disclosure requirements.

A number of different types of policies can foster integration. Direct policies such as eliminating con-

Lack of information about all aspects of secu-

trols for foreign agent participation or creating specific

rities markets across a region can constrain regional

agreements between countries or within regions can

integration. This includes information about regulatory

serve as a basis for financial integration. Besides

requirements, exchange prices and quotes, company

NAFTA and formal agreements within

finances and strategies, investor allocation policies, or

countries, however, such agreements have been few

CARICOM

intermediary products and historical records. The qual-

and far between.

ity of information is critical to ensure market efficiency

Types of indirect policies that play an impor-

and equal access to financial opportunities. Analysis

tant role for future financial integration include adopt-

by PriceWaterhouseCoopers on the level of opacity

ing international best practices regarding accounting

(Figure 5.9) reveals that many Latin American coun-

standards, disclosure of information, and tax regimes.

tries rank very low in terms of access to good informa-

Other useful instruments include harmonizing regula-

tion.

tions that govern information sharing, and allowing cross-border information sharing.

CONCLUSIONS

Even if full harmonization of regulations is reached, however, problems with key national institu-

Latin American financial markets have had a consider-

tions and macroeconomic instability can hinder the

able amount of integration with the developed world.

process of financial integration both with the devel-

North-South integration apparently has been fruitful,

oped world and within the region. Protection of prop-

and has been the strategy chosen by international and

erty rights and legal stability are clearly needed to

regional participants. Financial integration in Latin

attract foreign players into Latin American markets.

America comes mainly in the form of increased partic-

Financial Integration

1120 CIQjQUMl

Appendix Table 5.1

Foreign Bank Penetration and Economic Integration: Regression Results

1.225 (0.141)*** 0.475 (0.072)*** -0.056 (0.038) 0.689 (0.029)***

Border Common language Distance (log) Bilateral trade (1+, log)2 Bilateral FDI (1+, log)

3.342 (0.641)*** 2.661 (0.357)*** -0.904 (0.165)***

1.324 (0.092)***

Constant

0.674 (0.441)

R2 Estimation method2 No. of observations

0.25 IV 20,000

10.357 (1.854)***

0.40 IV 3, 227

Note: Standard errors in parentheses. 1 Refers to banks with a foreign ownership higher than 50 percent of equity capital. 2 1998 values of bilateral trade and FDI are instrumentalized using 1990 values. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.

Appendix Table 5.2

Credit Stability and Foreign Banks: Regression Results Dependent variable: Percentage change of real credit Reg. 1 Reg. 2

Percent change of real deposits Percent change of real deposits * Foreign abroad LAC Percent change of real deposits * Foreign inside LAC1 Real external demand shock Real external demand shock * Domestic Percent change of real GDP2

0.560 (0.022)*** -0.135 (0.050)*** -0 .132 (0.098) 19.536 (4 241)*** -13 .391 (4 .282)***

0.555 (0.022)*** -0. 1 65 (0.051)*** -0.127 (0.098)

Constant

-0.005 (0.014)

4.456 (0.913)*** -2.475 (0.993)** -0.023 (0.020)

R2 Estimation method2 No. of observations

0.49 OLS 2, 795

0.49 IV 2,795

Percent change of real GDP * Domestic

Note: Standard errors in parentheses. 1 Refers to foreign banks whose owners are from a Latin American country. Values of percent change of real GDP are instrumentalized using the real external demand shock variable. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.

Dependent variable: Foreign bank control1 (1+, log) Reg. 1 Reg. 2

Financial Inteqration

Appendix Table 5.3

What Determines the Decision to List Abroad? Regression Results

Dependent variable:

Common border (dummy)

0.457 (6.45)***

Common language (dummy) Distance (log)

Reg. 2 0.462 (6.21)***

Reg. 3 0.467 (6.25)***

Reg. 4 0.478 (6.09)***

Reg. 5 0.424 (4.87)***

0.341

0.339

0.341

0.219

(6.26)***

(5.05)***

(5.02)***

(5.21)***

-0.05

(2.21)**

-0.056

-0.065

-0.042

(2.56)**

(2.76)***

(2.73)***

(2.95)***

(1.59)

0.397

0.074

Share legal code origin (dummy)

(2.26)**

0.119

Share common law legal code origin (dummy)

(1.87)* 0.046

Share non-common law legal code origin (dummy)

(0.98) Similarities between shareholder regulations1

R2 Estimation method1 No. of observations

0.5 OLS

1,740

0.071

0.349

(2.58)**

(2.11)**

0.49

0.51

0.53

OLS

1,660

1,476

Notes: All estimates include host and source country fixed effects. Similarities between shareholder regulations measure if countries have similar regulations as defined in the La Porta, Lopez-de-Silanes and Shleifer (1998) index of shareholder protection. Absolute value of t-statistics in parentheses. 1 Values of similarities between shareholder regulations are instrumentalized with "share legal code region" variable. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level. Source: IDB estimates based on the Sarkissian and Schill (2001) cross-listing database.

Reg. 1

Cross-listings (1+, log)

CHAPTER

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Diaz-Alejandro, Carlos. 1985. Good-bye Financial Repression, Hello Financial Crash. Journal of Development Economics 19. Doidge, Craig, Andrew Karolyi, and Rene Stulz. 2001. Why Are Foreign Firms Listed in the U.S. Worth More? Ohio State University. Mimeo. Domowitz, I., J. Glen, and A. Madhavan. 1998. International Cross-listing and Order Flow Migration: Evidence from an Emerging Market. Journal of Finance 53(6). Errunza, V, and E. Losq. 1985. International Asset Pricing under Mild Segmentation: Theory and Test. Journal of Finance 40. Focarelli, Dario, and Alberto Pozzolo. 2001. The Patterns of Cross-border Bank Mergers and Shareholdings in OECD Countries. Journal of Banking and Finance 25. Foerster, S., and G. A. Karolyi. 1996. The Effects of Market Segmentation and Illiquidity on Assets Prices: Evidence from Foreign Stocks Listing in the U.S. Ohio State University. Mimeo. 1999. The Effects of Market Segmentation and Investor Recognition on Assets Prices: Evidence from Foreign Stocks Listing in the U.S. Journal of Finance 54(3).

Clarke, George, Robert Cull, Maria Soledad Martinez Peria, and Susana Sanchez. 2002. Bank Lending to Small Businesses in Latin America: Does Bank Origin Matter? World Bank Domestic Finance Working Paper no. 2760, Washington, DC.

French, K., and J. Poterba. 1991. Investor Diversification and International Equity Markets. American Economy Review, Papers and Proceedings.

Cochrane, J., J. Shapiro, and J. Tobin. 1996. Foreign Equities and U.S. Investors: Breaking Down Barriers Separating Supply and Demand. Stanford Journal of Law, Business and Finance.

Galindo, Arturo, Alejandro Micco, and Guillermo Ordonez. 2002. Financial Liberalization and Growth: Empirical Evidence. Inter-American Development Bank, Washington, DC. Mimeo.

Crystal, Jennifer, Gerard Dages, and Linda Goldberg. 2001. Does Foreign Ownership Contribute to Sounder Banks in Emerging Markets? The Latin American Experience. Staff Reports 137, Federal Reserve Bank of New York.

Galindo, Arturo, Alejandro Micco, and Cesar Serra. 2002. Determinants of Cross-Border Banking Activity: The Role of Economic and Legal Relationships. Inter-American Development Bank, Washington, DC. Mimeo.

de la Mora, Luz Maria. 2001. Mexico's Appraisal of NAFTA. Unpacking NAFTA: Progress, Problems and Potential. In Jorge Vargas (ed.), Mexican Law: A Treatise for Legal Practitioners and International Investors. St. Paul, MN: Westgroup.

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124

REGIONAL INFRASTRUCTURE

As the Latin American and Caribbean economies have opened up to their neighbors in recent years, demand has increased for regional infrastructure. This in turn has led to significant progress in the supply response of the public and private sectors. Infrastructure concessions have played a major role in that improvement, and there has been greater willingness on the part of public, local and foreign capital to support infrastructure development. However, much remains to be done. Trade, investment, and the movement of people are still obstructed and sometimes deterred by physical, institutional and social barriers at borders, and in the main intra- and inter-regional trade corridors. In addition, countries have not yet developed a shared and integrated strategic vision of how to cooperate and plan for infrastructure networks that would not only spur regional integration but also support international (extra-regional) and domestic activity as well.

THE IMPORTANCE TO DEVELOPMENT OF REGIONAL INFRASTRUCTURE Latin American infrastructure deteriorated significantly in the 1980s and early 1990s, when the region lost considerable ground relative to industrial countries and faster growing emerging economies (Serven, 2001). High levels of debt, structural adjustments, and serious fiscal imbalances led to an overall decline in infrastructure investment beginning in the mid-1980s. With private sector involvement lacking in most countries,

the result was a decline in overall investment, leading to a widening infrastructure gap. This gap contributed to lower productivity, higher transport and logistics costs, reduced competitiveness and slower growth. Given public sector constraints, Latin America made major efforts to increase the extent of private participation in infrastructure. Indeed, Latin America has been the leading region in opening infrastructure to private capital, with a total investment of over $250 billion. This represents more than 43 percent of the total for all developing regions (IDB, 2001 a). This has led to a partial recovery in infrastructure investment, but the results have been uneven across sectors and countries. In Chile and Colombia, infrastructure investment rose markedly, while other countries still show flat to declining trends in infrastructure spending, with investment at 2 percent of GDP or less (Serven, 2001). Investment has been concentrated in energy and telecommunications, which have been the most attractive to private investors while providing services that are in the public interest and in demand. High private rates of return are in some cases a function of the transfer of previous state monopolies to private control, and in part due to exclusivity provisions provided in some concessions. Infrastructure investment in Latin America is entering a new stage. Much progress has been made in reducing public sector funding shortfalls and in improving productivity in infrastructure operations (Foster, 2001). These initiatives shared common features, such as private participation, entry of new operators and sources of capital, a reduction in the State's

Chapter

CHAPTER

management role, and the creation of new instruments for regulating and overseeing public services. The participation of the private sector through privatization and concession has helped meet crucial infrastructure needs. However, infrastructure demands remain large and ongoing, and the financial capacity to undertake new projects has clearly been affected by the financial crises in major economies of the region since the late 1990s. Fay (2001) has forecast infrastructure needs in Latin America for 2000-2005 based on income levels. She projects a doubling of telephone mainlines per capita, a steady increase in electricity generating capacity, and steady expansion of road infrastructure, with rail transport becoming less important. Investments of $57 billion annually (roughly 2.6 percent of Latin America's GDP) will be needed over the period for electricity ($22 billion), roads ($18 billion), and telecommunications ($6 billion). Private investment exceeds predicted need for telecommunications (although the model did not include costs associated with the emergence of cellular phones), covers about half the demand for roads, and meets just a fraction of needs in power and water and sanitation. Moreover, these projections are likely to be on the low side because they cover new investments rather than rehabilitation or maintenance. The fact that infrastructure networks remain incomplete limits the ability of some areas to participate in economic growth. In addition, insufficient capacity across all infrastructure sectors in major corridors linking the region's metropolitan areas has resulted in bottlenecks that create delays, raise costs, and limit potential gains from trade and development. Thus, the current situation might be viewed as a stage to complete, consolidate and extend the recent reforms.

CONCEPTUAL ISSUES IN REGIONAL INFRASTRUCTURE DEVELOPMENT Trade, Infrastructure and Development There is a well-established relationship across countries between income levels and the quality of infrastructure (IDB, 2001 a). Infrastructure is an important determinant of productivity and development. Higher income

levels and growth feed back into larger demands for transport, telecommunications and energy services. These linkages are particularly pronounced in facilitating trade that is critical for regional integration. The opening up of Latin American economies has led to marked increases in international trade, financial capital and foreign direct investment. There has also been an upswing in regional trade: both the share and the growth rates of intra-regional trade in the 1990s grew much faster than extra-regional activity (see Chapter 2). This growing commercial interdependence has been associated with various kinds of regional cooperation, especially in terms of regional trade agreements. Even the regional orientation to international markets has spurred greater specialization and intra-industry regional trade. This trade also has been in higher value-added goods and services. The higher value in turn requires higher quality infrastructure, especially in telecommunications, data transfer, roads and multimodal transport (Guasch and Kogan, 2001). This expanded activity also has focused attention on the need for greater integration of trade infrastructure, both in terms of physical investments and institutional coordination. For example, border crossings remain a major impediment to transport connections within Latin America. Working to resolve these issues will not only make regional infrastructure linkages more effective, but also spur new opportunities for integration. The level of regional trade depends critically on the quality of supporting infrastructure. Poor infrastructure represents 40 percent or more of transport costs in developing countries, with substantial effects on trade. But regional provision of infrastructure has lagged behind. Even with the investments in the 1990s, transport, telecommunications and electricity networks remain incomplete, with underdeveloped linkages across some borders, or with insufficient capacity in key corridors. Transport costs in the region remain high relative to the rest of the world (Guasch and Kogan, 2001). Moreover, improvements in infrastructure (ports, roads, telecommunications) in developing countries can help to significantly reduce inventory levels and thus the cost of doing business.

126

Reqional Infrastructure

Notional Legacies, Regional Projects ana1 Externalities

127

under different legal, contractual and organizational structures, thereby making coordination and integration

flows are rarely channeled

Regional infrastructure projects present other

through specific infrastructure, but rather use networks

Regional integration

issues as well. In addition to traditional domestic exter-

that are shared with domestic and global traffic. In

nalities, transnational projects are likely to have costs

practice, services of differing geographical scope

and benefits that are distributed asymmetrically across

share segments of the same infrastructure network. For

countries. This creates an incentive for a country to

example, vehicles connected with interurban and inter-

make individual decisions taking into account only

national traffic use the same roads; domestic and inter-

costs and benefits within its borders. As a result, some

national

potentially valuable regional projects are likely to be

air

passengers use the same airport;

electricity, oil and gas share interconnection lines and

ignored or abandoned (Bond, 2001). A combination

pipelines; and local and international data can move

of factors makes the development of such projects dif-

over the same fiber optic network. As a result, infra-

ficult (Beato, Benavides and Vives, 2002). First, it is dif-

structure investment has tended to be viewed in nation-

ficult for one country to identify the benefits it may

al terms, both in the form of public provision and for

obtain from a regional project. Second, even if bene-

private concessions.

fits are known, for political reasons countries may be

Many of the infrastructure problems that con-

unwilling to pay for regional investments outside their

strain regional integration also hinder domestic devel-

borders even if the domestic benefits exceed these

opment and international trade. These include the need

costs. Third, there currently are few socially acceptable

to upgrade and complete service networks, such as

institutional mechanisms to distribute regional benefits

electricity; add capacity to eliminate bottlenecks in key

and costs across affected countries.

transport corridors, especially at border crossings; link

Another issue regarding regional infrastruc-

transport modes at ports, airports and trucking termi-

ture projects involves potential problems in establishing

nals; expand oil and natural gas access; and increase

and managing a portfolio of regional projects (Beato,

access to Internet and telecommunications services.

Benavides and Vives, 2002). Country authorities may

Infrastructure projects generally are character-

view regional initiatives as a mechanism for low-cost

ized by network and scale economies. For example, in

financing of national projects. This also creates incen-

Central America the small size of countries and nation-

tives to overestimate the regional benefits of predomi-

al markets has prevented infrastructure investments

nantly national projects.

from achieving scale and network economies, thereby

To date, there have been very few successful

raising the costs and associated required rates of

transnational infrastructure projects that were devel-

return. These scale effects could also bring environ-

oped as such. The most successful projects have been

mental benefits, because fewer physical sites are nec-

those where key inputs are in one country while user

essary for a given output level. Similarly, the extension

markets are in another, such as the Brazil-Bolivia gas

and completion of regional infrastructure networks can

pipeline. Other successful efforts have involved linking

help relieve congestion and improve environmental

existing network components by upgrading or expand-

aspects associated with current patterns of concentrat-

ing access to existing corridors. One such project is the

ed development and urbanization.

road connecting

Manaus, Brazil

and

Caracas,

Even when regional activity has been sizable,

Venezuela. This is a "success story" with many lessons:

though, there has not been a shared vision of regional

each country knew exactly what it had to do and to

planning to develop a network of regional infrastructure.

gain; the money was provided by development funds

Indeed, this situation has become more complex, given

and spent inside the countries; the construction compa-

the now-established role of private participation in most

nies liked it; the beneficiary states (as well as the

infrastructure sectors in the region. These new private

national governments) were in favor of it; and the per-

stakeholders are likely to have different views about the

formance has met investment expectations (Guasch

needs and priorities for investment. They often operate

and Strong, 2001).

of national infrastructure networks more difficult.

CHAPTER

Figure 6.1

6 Principal Current Hubs of the Volume of Flows in South America

between federal and state governments in Mexico have slowed connections between road corridors and bridge and border crossings into the United States. In short, regional projects present a number of challenges. They have more potential for compounding problems and conflict. There is the ongoing temptation to press for projects based on politics rather than in terms of trade benefits, and to justify bundling purely domestic projects under the umbrella of complementarity with the international network. This is particularly problematic in cases where national bottlenecks or constraints limit regional activity.

STARTING POINTS: THE ECONOMIC CONTEXT OF REGIONAL INFRASTRUCTURE Development of regional infrastructure initiatives should take into account existing networks, organization and governance, and financing patterns, each of which will be discussed in turn.

Infrastructure Networks: Hubs and Corridors of Development Source: IDB (2000).

Where projects are financed on national accounts, or where national contributions are required for private sector projects, there is a "free rider" problemâ&#x20AC;&#x201D;each party is trying to maximize its benefits and limit its commitments. This is particularly the case when many project benefits go primarily to one country while costs are incurred by another nation. This issue has surfaced in the recurring discussions about the Buenos Aires-Colonia Bridge between Argentina and Uruguay with respect to Brazil's benefits and (lack of) contribution to and participation in the Binational Bridge Study Commission. This situation also occurs when an intermediate country serves as a "crossing corridor" between origin and destinations. This creates "hold up" incentives in the absence of benefit-sharing or costsharing mechanisms. In addition, the role of states and local governments in affecting the success of transnational projects should not be underestimated. For example, differences in political party affiliations

Evaluating the prospects for regional projects should take into account the prevailing geographic structure of demand, the network of already existing infrastructure, and the roles of the public and private sectors in infrastructure investment, operation and regulation. Trade flows in South America are dominated by a few major corridors and associated hubs of activity (IDB, 2000), as shown in Figure 6.1 and discussed in Box 6.1. Exchange hubs with smaller current volumes but still with significant growth potential complement these hubs (Figure 6.2). The economic patterns reflected in Figures 6.1 and 6.2 have been shaped by physical geography, historical ties, urban development and, especially recently, by policy initiatives aimed at opening markets and borders. To the extent that current trade flows could be further enhanced, these hubs and corridors indicate where additional investment might have the highest returns by reducing bottlenecks and expanding capacity. Using an approach that takes these hubs into account would help in defining policy and investment priorities more carefully (IDB, 2001 a). In addition, approaching regionalism via a framework of hubs and

128

Reqional Infrastructure

Major Hubs and Corridors in South America

Figure 6.2

Exchange Hubs with Significant Growth Potential in South America

Mercosur-Chile hub: The largest in the region, linking Rio de Janeiro-Sao Paulo-MontevideoBuenos Aires-Santiago. Rather than a main route, the density of this corridor has produced a grid with numerous nodes and routes. In 1998, the corridor carried 18 million tons of freight, including 8 million tons of petroleum moved through pipelines. The remainder, mostly general cargo, was transported by truck. Rail transport remains marginal. Colombia-Venezuela hub: Links Bogota and Caracas and carries more than 3 million tons of cargo annually, about half by truck and half by river and sea transport. There also is an electricity transmission line with 380 MW of capacity. Paraguay-Parana waterway hub: This 3,000 km navigable network carries about 10 million tons annually, comprised of cereals, oil, agricultural products, minerals and fuel. One-third of the corridor traffic is transnational, with the other twothirds serving import or export markets. There are three binational power stations with 17,500 MW capacity, as well as transmission lines between countries. Southern transverse hub: The Bolivia-Brazil corridor is dominated by the gas pipeline, which can potentially transport 30 million cubic meters daily. About a million tons of land cargo move through the corridor along road and rail networks. Atlantic and Pacific maritime hubs: The Atlantic corridor, spanning the coast from Venezuela through Argentina, saw cargo traffic of over 25 million tons in 1998, mostly solid and liquid bulk commodities. Submarine cables along the corridor also enable extensive voice and data transmission. The Pacific maritime hub is similar in nature, although with lower cargo volumes and less telecommunications traffic. Source: IDB (2000).

corridors would help identify potential flows that could

nant one. As concessions have developed, issues of

be spurred by more integration, taking into account

traffic flows and transport network planning have

complementarities between economies and developing

become more important, both nationally and across

plans to tie other regions into the existing network.

borders. This does not imply that concessions are the preferred structure for organizing or financing region-

Regional Infrastructure ana Concessions

al infrastructure; in fact, many "next generation" concessions will require some form of public support to be

Private participation in transport infrastructure in Latin

sustainable. However, since much of the existing infra-

America today has a significant role, if not a domi-

structure is in private hands, regional linkages must

Bex 6.1

129

CHAPTER

take into account how to tie these concessions together. Multilateral institutions should support initiatives by these concessions to analyze, craft and work towards linkages with each other. This will require a supportive environment with respect to transborder linkages between national concessions. In addition, the private incentives that served to improve performance are also likely to serve a valuable role in planning major corridor initiatives.

Financing Issues Infrastructure is expensive. Fiscal difficulties, overindebtedness, multilateral conditionality on new obligations, and country risk premia will continue to limit the capacity of the public sector to provide infrastructure. In addition, financial crises and the volatility of real exchange rates have substantially increased country risk premia since the late 1990s. Also, most infrastructure services are only tradable within the region and thus generate revenues in local currencies, while a substantial portion of their costs and financing are contracted in hard currencies. Therefore, multilateral credit institutions should provide new forms of financing and financial instruments, not only to channel funds but also to mitigate risks and costs. Social security reforms based on individual savings and professional management might constitute a new source for financing infrastructure. By matching the long time span of such savings and allowing for sector and country diversification, regional infrastructure investment could be an attractive alternative for pension funds. Even when regional projects have superior operating economics, however, private capital markets are likely to be wary of the risks of operating across countries. In many parts of the world, infrastructure projects that involve different countries have required special treaties that established rules and governance frameworks that supersede national structures. This has been true of highway and energy projects in Eastern Europe and the countries emerging from the former Soviet Union. Multilateral institutions will also play a major role in providing technical and financial support for regional infrastructure initiatives, especially in terms of managing political and regulatory risks. Some of the major innovations in risk management in the past

decade have been partial risk and policy guarantees by multilateral institutions. There is a growing need to develop multi-country guarantee instruments with respect to policy and sectoral reforms and operations. This is especially true for regional projects in which country guarantees are not seen as credible in financial markets.

Institutional Development and Harmonization The strategic vision behind infrastructure policy must be consistent with a regional approach. This will require countries to identify regional integration projects and forge complementary agreements with other economies. This common approach includes defining shared priorities; identifying both physical and regulatory institutional bottlenecks; achieving balanced subregional coverage; and defining the nature and scope for private sector participation. It also will require governance structures that restrict the "veto power" of an individual country over regionally attractive projects. The difficulties in federal/state relations in infrastructure projects also provide lessons for transnational projects. Disagreements between states and the federal government about priorities, contributions and levels of support can doom projects before regional aspects are brought into account. Any transnational undertaking requires strong common shared objectives between the countries involved. Established multilateral agreements might become more durable than bilateral agreements because of the greater collective loss that might be sustained and the less idiosyncratic dispute resolution mechanisms that are put in place. But in general, a good rule of thumb seems to be that the difficulty of agreement increases by the square of the number of parties involved. These objectives must be strong enough to survive changes in political parties and governments. A resilient public/private coalition must exist in countries to keep the project going despite political shakeouts and unsettled macroeconomic times. The participation and commitment of multilateral institutions in coordinating technical and financial support could play a role in guaranteeing the sustainability of the process. Another key aspect involves harmonizing the regulatory functions of governments. This is a significant challenge in light of the fact that reform efforts in

13O

Regional Infrastructure

Sectoral Priorities for Regional Infrastructure Development

Regulatory changes to deal with industry dynamics Regulatory harmonization Concession integration Border crossings Completion or upgrading of national networks Regional project development and financing Multimodal initiatives Network planning and strategy

Roads

Railways

Ports

Airports

Gas

Electricity

Medium Medium High

Lower Medium Medium

Lower

Medium

Lower High High

Medium High High

High High Medium

Medium

High

Medium

High

Lower

Medium High High

Lower High Medium

Medium Lower Lower

High

Lower

High Lower

High

Medium

Latin American countries vary widely in terms of their

Medium Lower Medium

Telecoms

Transport

scope, institutional requirements, programming horizons and the degree of local market openness.

By the late 1980s, much of Latin America's transport

Europe's experience with regional integration, particu-

sector was in crisis. Railways were falling into irrele-

larly in the energy and telecommunications sectors,

vance and disrepair, while requiring huge subsidies

does not point towards the emergence of competitive

from the state (Thompson, 2001). State-owned airlines

markets. Vertical and horizontal reintegration process-

lost huge amounts of money, while airports and sea-

es may be at work, and ownership may be concentrat-

ports required substantial ongoing subsidies for oper-

ed. This will make it necessary to proactively create a

ating expenses, especially labor. Perhaps even more

single market by establishing a community legal frame-

importantly, these operational financial drains severely

work based on regulatory consistency, not only in those

limited governments' ability to fund urgently needed

areas specific to the subsector, but also in terms of

investments for capita I-starved public enterprises,

accounting practices, taxation and the environment.

inevitably resulting in poor service and inefficiency that

For this reason, the European Community has estab-

had consequences for competitiveness, economic

lished guidelines to assist national regulatory authori-

development and equity (since the poorest groups often

ties in developing a competitive internal market (Lutz,

suffered the worst services).

2001). Harmonization of regulatory and institutional

Since then, Latin America has been in the

processes is the deciding factor in moving from bilater-

vanguard of restructuring transport and mobilizing pri-

al activity to a common market.

vate sector participation (Kerf, 1998; Basanes, Uribe and Willig, 1999; Estache and de Rus, 2000; Asian Development Bank, 2000). At the beginning of the

REGIONAL INFRASTRUCTURE INTEGRATION ISSUES BY SECTOR

1990s, virtually all of the region's railways were under public ownership and control. Ten years later, there were only a few, small publicly operated railways. Sea-

In addition to facing the general issues described

ports generally have been concessioned under alterna-

above, each infrastructure sector must address specific

tive models. Most airlines have been privatized and

issues with respect to regional investment initiatives.

airport concessions of varying types have been put in

These sector-specific challenges are outlined below,

place throughout the region. Toll roads have been

while cross-cutting policy needs and priorities are

developed or extended with varying degrees of success.

shown in Table 6.1.

While the reforms in the transport sector in Latin Amer-

Table 6.1

131

CHAPTER

ica have been considerable, there are a number of issues that remain unaddressed. The most notable is the lack of a strategic vision for the transport sector, including network planning, multimodal needs, and regulation. There also is a need to develop strategies for the financing of regional transport projects that are not fully financially viable by the private sector, such as smaller airports, ports, secondary and rural roads, and parts of transnational corridors that have not been government priorities. If improvements are to be made in the operation of those services, governments will have to bridge the gap to make the concession viable (Guasch and Strong, 2001). A much better understanding, modeling and forecasting of the effects of national macroeconomic shocks on transport infrastructure projects is also needed. The interaction of price, income, GDP, trade and financial market elasticities has undermined major corridor projects. It also has proven difficult to forecast traffic demand in such projects without a full trade model that incorporates the hidden costs of border crossings. Road transport. Regional road programs suffer from most of the problems that plague roads at the national level. The national orientation of planning has made it difficult to exploit major corridor opportunities, such as linking Central America and the poorer states of southern Mexico with the markets of northern Mexico and the United States (IDB, 2000). The hubs that account for most of the traffic suffer from a lack of capacity. The most serious road capacity problems are in the Mercosur hub, where increasing levels of local traffic are compounded, in some cases, by international flows (Amjadi and Winters, 1997). Smaller hubs principally are affected by poor road surfaces, maintenance, standards and design. Many highways are old, with sections in mountainous terrain. In some potential hubs, roads are not paved or cannot be used all year round. Less than 30 percent of the road network in Latin America is paved, the lowest of any developing region in the world. Other problems continue to raise regional transport and logistics costs. Cargo reservation schemes have increased in recent years, requiring unloading and reloading of trucks at the border. In many cases, these schemes are forced on companies under pressure from national truckers trying to avoid

regional competition. In addition, there are problems stemming from national design standards that are inadequate for the movement of vehicles from another country. For example, the capacity of bridges on Uruguay's road network is being improved to allow the transit of Argentine, Brazilian and Chilean trucks. Border crossings are especially problematic for integration, as there typically are independent, dual controls in each country. For example, the Buenos Aires-Sao Paulo corridor (2,400 kilometers) by way of the Paso de los Libres-Uruguayana border accounts for more than 20 percent of the total tonnage of international freight transported on highways in the Southern Cone plus Bolivia and Peru.1 Currently, only 30 percent of the trucks delivering merchandise into Brazil are able to take in the load in the same day and, as result, 13.1 percent of the total trip time is spent at the border. Greater transparency and efficiency in border service operations (customs clearance process, immigration procedures, etc.), including private agent activities (dispatchers, importers, freight collection), could reduce delays from 12 to 5 hours (Olivieri et al., 2001). A recent study of 11 transportation routes in the Andean Community arrived at a similar finding and concluded that, on average, trucks spend more than half of total trip time at border crossings (Pardo, 2001). Greater efficiency at the border might cut crossing time by half or more, significantly reducing freight costs and improving efficiency. Rail transport. Railway restructuring and reform has taken place in most Latin American countries, with perhaps the most extensive changes in Mexico, Brazil, Argentina and Peru. After years of decline, traffic has stabilized or grown slightly, labor productivity has increased markedly, and financial performance generally has improved. Access issues and regional integration are surfacing as next-generation issues. Balancing concession network interconnections without creating cartels is a significant issue for some commodities and for compe-

1 Total bilateral highway-based trade between these six countries in 2000 was 39 percent and 22 percent of total trade, respectively, by value and volume, while the estimated margin was close to 6 percent of the value of goods traded.

132

tition policy, although road freight transport continues to provide important competitive alternatives for many types of goods that move by rail. Poor network infrastructure constrains the use of trains large enough to develop economies of traffic density. The condition of the network limits cargo capacity and speed limits. Although most of the network has been shifted to private control, railway concessions have found it difficult to make the significant investment to overcome infrastructure deficiencies. At a regional level, gauge differences between countries and the lack of multimodal regulations and linkages to road and port infrastructure also severely limit the potential contribution of railways to regional integration. Air transport. Privatizations and industry consolidation among airlines have led to more air service between countries. Although growing, both regional and domestic air cargo and passenger flows between South American countries remain small compared with air transport in the rest of the world. The capacity problems evident in several airports generally stem from growing domestic demand rather than regional or international traffic. Capacity difficulties are matched by problems of service quality (IDB, 2000). The reliability, safety and security of air transport also serves as an impediment to regional integration. There is a need to harmonize regulatory and operating standards for both airports and airline operations, especially to ensure that regional civil aviation meets or exceeds international standards. If these standards are not met, aviation will continue to be limited in its participation in international traffic and trade. Air traffic control systems need to be upgraded to make air networks more dependable, while additional investments are needed to ensure passenger and cargo safety. As with other modes of transport, the streamlining of customs clearances would facilitate air cargo flows. The major regulatory impediments to regional air transport are in market reservation policies enacted through bilateral air agreements. Although some progress has been made in the Andean region toward open skies, the rest of the region still retains effective limitations on who can provide air services. These agreements tend to keep passenger and cargo tariffs high and thus constrain traffic and trade growth. River and maritime transport. Maritime trade has become increasingly global and concentrated. The

133

world's largest shipping companies achieve economies of scale and density through hub-and-spoke operations via a system of global mega-ports, supported by different levels of feeder ports. In contrast, the port systems in Latin America have developed on a national basis, with only limited specialization and regional linkages. The need is to move from a linear system of shipping routes to networks in which smaller ports might serve as feeders to the region's largest facilities, particularly in the Caribbean. This hub-and-spoke port system typically requires more cooperation and coordination to facilitate growth of transshipment and operate at higher activity levels.2 Therefore, there is a need to develop better intermodal linkages and to ensure that key shipping corridors have adequate capacity and maintain safe and reliable navigability (IDB, 1998). South America's river networks have enormous transport potential. There is a significant amount of river transport in the three main basins (Amazon, Orinoco and Paraguay-Parana). These rivers serve as large estuaries that facilitate the access of overseas shipping. Given this international role, only a limited amount of traffic can be thought of as regional in nature. Some of the river traffic between ports of different countries is subsequently transferred to other overseas ports. Another important but specialized aspect is trans-border river crossing traffic. While important locally, the facilities serving river crossings generally are poor. The region's seaports serve as terminals in which numerous flows converge. Intra-regional traffic is a relatively small share of total waterborne traffic. The port system of South America is in transition, with growing private sector involvement. Port infrastructure suffers from a number of problems, such as land access and the lack of multimodal terminals. However, international trade is likely to continue to drive port investments and development. Fortunately, much of what is needed to facilitate global imports and exports will help support regional trade as well.

Economies of scale are relevant in maritime transportation. On average, a vessel 50 percent larger, if fully utilized, can generate savings in unit cost per ton-mile up to 20 percent. In addition, fixed costs related to port operations can be significantly reduced by specialization by type of cargo and vessel type.

Regional Infrastructure

CHAPTER

Figure 6.3

6 Average Number of Days for Port Clearance by Region

has been the continuation of cargo reservation policies. In addition, river navigation regulations limit the size of convoys or impose service contracts for nonessential services.

Energy

Source: Camara Maritima y Portuaria de Chile (1999).

Figure 6.4

Average Number of Days for Port Clearance in Latin America

Source: IDB (2001).

Delays related to customs and port handling continue to be a major constraint to trade and integration. Figures 6.3 and 6.4 show that the regional average is over seven days for customs processing, with many countries even higher, ranking the region's processing time as among the highest in the world. Although significant progress has been made in recent years, regulatory restrictions persist in river and maritime transport. The most important of these

Gas. Natural gas promises to grow in importance in world energy markets, given its relatively favorable reserve levels, lower transport costs, environmental advantages, wide range of uses, and technical advantages over other energy sources in certain applications. During the last decade, more than $12 billion was invested in 37 natural gas transportation projects (Izaguirre, 1999). The sharp increase in gas reserves and regional production has encouraged both public and private firms to develop regional gas transport links to neighboring countries. In the Southern Cone countries, 12 gas pipelines currently are operating or under construction, covering almost 8,000 kilometers and with a potential transportation capacity of 85 million cubic meters per day.3 The two major pipeline networks run between Argentina, Brazil, Chile and Uruguay; and from Bolivia to Brazil. Additional projects have been proposed that would almost double both current longitude and capacity (7,000 kilometers and 75 million cubic meters per day). In spite of this physical integration, serious institutional and regulatory problems impede the formation of a regional gas market. The lack of harmonized technical standards and the dominant power of some producers and transporters make integration difficult. For example, in Brazil, Petrobras has a dominant position in the importation and local production of gas, as well as being the main transporter of it. Similarly, Bolivian concession agreements give priority transport to the gas fields operated by Petrobras and Repsol-YPF (IDB, 2001 b). These market structures and preferences need to be addressed through greater harmonization of regulatory frameworks at the regional level. These national frameworks vary widely in their scope and effectiveness (Guasch and Spiller, 1999).

3 Private sponsors have also participated in domestic transportation of natural gas in Colombia and Mexico.

134

Reaional Infrastructure

nections. The Regional Commission for Power Integra-

Regional wholesale electricity markets make it easier to

tion (CIER4) estimates that the economic benefits of electricity integration could reach $1 billion annually.

achieve scale economies and thus lower-cost genera-

The SIEPAC system in Central America is finally becom-

tion projects, as in the case of the Central American

ing a reality, spurred by the increased incentive of links

Electricity Interconnection Project (SIEPAC). Intercon-

to Southern Mexico.

necting networks also allow for diversifying the energy

Latin America's hydroelectric resources offer

sources used in generation. This reduces the risk of

significant potential for power generation and oppor-

shortages by linking different hydrographic regimes or

tunities for regional integration. Binational hydroelec-

providing alternatives, such as balancing predominant

tric projects include the Itaipu project linking Brazil and

hydroelectric systems with natural gas. However, phys-

Paraguay; the Yacyreta hydroelectric project linking

ical integration is not sufficient to create a regional

Argentina and Paraguay; and the Salto Grande hydro-

market and needs to be coupled with adequate institu-

electric project linking Argentina and Uruguay. Trans-

tional and regulatory frameworks.

mission line connections exist between Colombia and

The economic organization and ownership

Venezuela (the Cuatricentenario-Cuestecitas lines, El

structure of the region's electricity sector underwent a

Corozo-San Mateo lines and Tibu-La Fria lines). Links

radical transformation in the past decade, so that new

also exist between Colombia and Ecuador via the Ipi-

electricity projects are almost exclusively operated by

ales-Tulcan lines. Connections between Pasto and

the private sector. The electricity sector undoubtedly

Quito and between Ecuador and Peru are in the plan-

has become an engine of economic integration in the

ning stages.

Southern Cone, with clear potential to do so in the Andean and Central American subregions as well.

Much larger

benefits might be possible

through the development of regional energy markets.

Structural reform and the privatization of pub-

The evolution of exchanges from binational deals to

lic companies in the energy sector have enabled many

regional markets requires mechanisms regarding the

countries in the region to begin to develop national

use of the system of interconnection, operating security

energy markets. However, the nature, intensity and

and the energy purchase-sale operations. A regional

performance of sectoral reforms have varied by coun-

market would likely require common regulations for the

try. Given these differences, it is not surprising that

international exchanges (Rufin, 2001). These requisite

the international projects currently underway to con-

minimums involve an energy purchase-sale method

nect electricity networks stem mainly from bilateral

based on economic principles with transparent rules,

agreements on interconnection and energy provision, rather than from open markets. Thus, the generation,

the elimination of subsidies (especially if there is prominent state participation), the application of nondiscrim-

transmission and distribution facilities are for specific use, limiting the sector to exchange and supply con-

ination principles relating to export and access, and implementation of a regulatory structure for transmis-

tracts.

sion covering use and payment of the internal network (European Commission, 1999).

Regional initiatives have traditionally been

Regulatory reforms instituted by Chile and

accomplished through bilateral agreements, such as the 1997 Brazil-Argentina agreement to integrate elec-

Argentina

tricity markets. But these agreements tend to be through

national regulations. Chilean reforms include the elim-

ad hoc contracts and not part of a plan to integrate

ination of monopolies and the corresponding deregu-

markets. More recently, larger initiatives have been

lation

illustrate the complexity of

generation.

Argentina

harmonizing

mandates the

undertaken, such as the 1998 Mercosur Memorandum of Understanding on Electricity, which fosters the creation of an integrated electricity market in the Southern Cone. The Cartagena Agreement in the Andean region in 2001 also represents a positive step toward regional regulatory harmonization of transmission intercon-

CIER (Comision de Integration Energetica Regional) is a non-profit international organization that includes electric utilities and nonprofit entities linked with the national energy sectors of 10 South American countries.

Electricity. Regional integration can help to improve electricity services in a number of ways.

135

CHAPTER

unbundling of generation, transmission and distribution, with no one firm permitted to participate in more than one segment of the market. Maximum generation produced by one company may not exceed 10 percent of the total market. However, ownership of the dispatch of electricity differs significantly in both systems. In Chile, dispatch is generator owned, while in Argentina it is jointly owned by all segments of the industry (generation, transmission, distribution, government and large users). Until these are harmonized, interconnection will be more difficult (Woolf and Halpern, 2001).

Telecommunications Telecommunications has quickly and aggressively responded to changes arising from restructuring and deregulation. Latin American countries generally have been able to restructure the telecommunications sector, separating telephony from the government and establishing new regulatory systems. Because access and service levels lagged far behind developed countries, private investment was able to quickly step in, improving access and introducing new services and technological innovation. The reforms have improved efficiency, expanded network coverage and access, and improved the quality of services. They also have generally led to increased prices, although it is difficult to assess when and how much, considering the improvements in the quality of service and taking into account the effects of periods of exclusive market power and other regulatory aspects (IDB, 2000). There continues to be significant technological innovation and integration in global telecommunications. Telecommunications networks have sprung up as a result of market liberalization, and are being expanded by service carriers and companies that build and operate trunk networks for both specific and general use. At the same time, separate firms are being formed to provide infrastructure support for those operating the service networks. Another emerging issue is the trend toward mergers and consolidation of telecommunications, television, Internet and IT services. Voice and data transmission services, which are increasingly operated by private companies, have often converged, making traditional regulatory definitions and boundaries obsolete. In addition, the fact that many of these companies are regional, multinational

or even global in scope creates pressures for regulatory harmonization that can address monopoly and access issues while recognizing the dynamic nature of the sector (Guasch and Spiller, 1999). Latin America is no exception to such international trends. In the early 1990s, foreign firms that were usually fixed-telephone monopolies in their home countries were attracted to the region by the high levels of pent-up demand coupled with low productivity levels and outdated technology, as well as investorfriendly privatization programs (Moguillansky and Bielschowsky, 2001). During the first years of the concession, coverage and quality standards improved dramatically, and indicators of technological progress and productivity such as telephone density, digitalization percentage and lines in service per employee doubled or tripled. However, exerting market power on fixed-lines and long distance calls under weak regulatory environments allowed significant monopoly rents. On the other hand, the Chilean experience after 1994 and the subsequent Brazilian telecom market liberalization tended to foster competition in the different segments through regulation and bidding processes (Calderon and Mortimore, 2001). In the late 1990s, fierce competition among the main transnational operators for global market share was a major factor behind the second wave of telecom investments in the region. New investments in cellular services and the Internet attracted hemispheric giants, which started to compete on a regional scale with the European operators (see Table 6.2). The entry of these global firms with hemispheric interests in the most dynamic segments of the regional telecommunications market will eventually trigger major changes. It will also pose a complex challenge to harmonize technology, even within organizations that have developed through mergers and acquisitions. The outlook for the sector in terms of integration depends on the coordination and effectiveness of both governments and national regulators in attracting investments to keep up the fast pace of technological change, increase efficiency, and maintain competitive markets (European Commission, 2001). In addition, equity considerations require governments to encourage service expansion and market access to the new information technologies, especially for low-income households and rural areas.

136

Reqional Infrastructure

Telecom Operations in Latin America, 2OOO Countries

Markets1

Millions of clients

9 8 5 4 7 4 11

22 13 5 4 10 8 14

40 18 10 14 13 1.5 9

Telefonica de Espana2 Telecom Italia Verizon SBC Communications America Movil3 Bell Canada International Bell South 1

Participation by firms in different market segments. Includes partnerships with Portugal Telecom. Spinoff from Telmex in 2000. Source: Calderon and Mortimore (2001) and IDB (2000). 2 3

INFRASTRUCTURE INITIATIVES: INTEGRATION OF REGIONAL INFRASTRUCTURE IN SOUTH AMERICA AND THE PUEBLA-PANAMA PLAN

development in the world economy. It is extremely rich in natural resources, with a diversified climate and long stretches of Pacific, Atlantic and Caribbean coast. More than 300 million people of rich cultural diversity

The conceptual issues and frameworks for regional

live and work in an area of 18 million square kilome-

infrastructure development are being put into practice

ters, with a GDP of $1.1 trillion. The countries of South

in two major initiatives: the Integration of Regional

America also have important historical, commercial

Infrastructure in South America (URSA); and the

and political ties with the main industrial centers of

Puebla-Panama Plan (PPP), which links Mexico with

Europe, North America and, increasingly, Asia.

Central America. URSA and PPP represent a new planning approach, coordinating national sectoral policies

Integration and development hubs ana1 sectoral processes. URSA is a political and strategic

as well as implementing projects consistent with the

regional vision based on the development of a hub

policies of the regional partners. These initiatives also

strategy encompassing—for the first time in history—

attach high priority to protecting the environment and

the 12 countries of South America. To meet this objec-

respecting local communities.

tive, and using the multilateral institutions as catalysts and coordinators, an action plan was developed spec-

Integration of Regional Infrastructure in South America (URSA)

ifying policies based on three premises: i) strengthening national investment planning and coordinating among countries to increase its synergies; ii) standard-

URSA was launched at a summit in Brazil in September

izing and harmonizing regulatory and institutional

2000 by the nations of South America, with the sup-

aspects; and iii) developing a portfolio of projects that

port of the IDB, the Andean Development Corporation

encourage private sector participation and innovative

(CAP), and the Financial Fund for the Development of

financing schemes.

the River Plate Basin (FONPLATA). The goal is to

In practice, URSA organizes 12 integration

improve integration infrastructure to foster productivity

hubs serving all of South America, complemented by

and competitiveness in three areas: energy, transporta-

six sectoral integration processes that deal with issues

tion and telecommunications. URSA is a multinational,

common to the development hubs, particularly techni-

multisectoral and multidisciplinary initiative for setting

cal harmonization and institutional and regulatory

up coordination mechanisms between governments,

coordination among countries (Table 6.3).

multilateral financial institutions and the private sector.

Implementation mechanisms. The action plan

South America is an important pole of growth and

calls for the commitment of senior government author-

Table 6.2

137

CHAPTER

Table 6.3

URSA Development Hubs and Sectoral Integration Processes

Development hubs Mercosur-Chile hub Andean hub (Caracas-Bogota-Quito-Lima-La Paz) Brazil-Bolivia-Peru-Chile inter-oceanic hub Venezuela-Brazil-Guyana-Suriname hub Orinoco-Amazon-River Plate Multimodal hub Amazon multimodal hub (Brazil-Colombia-Ecuador-Peru) Atlantic maritime hub Pacific maritime hub Neuquen-Concepcion hub Porto Alegre-Asuncion-Jujuy-Antofagasta hub Bolivia-Paraguay-Brazil hub Peru-Brazil hub (Acre-Rondonia)

Sectoral processes Multimodal transport operating systems Air transport operating systems Facilitating border crossings Harmonization of Internet technical and regulatory policies Instruments for financing regional physical integration projects Normative frameworks for regional energy markets

Source: URSA (2000).

ities, technical and financial support from regional

ate economies of scale in basic infrastructure, thereby

multilateral organizations, and technical working

improving regional competitiveness.

groups of national experts, including those in the pri-

The Puebla-Panama Plan is managed by an

vate sector. The goal is to identify and prioritize proj-

Executive Commission, which is composed of one del-

ects by establishing timetables, sequential objectives

egate from each of the eight countries involved, and an

and specific tasks for the working groups regarding the

Inter-institutional Technical Group that provides support in areas relevant to regional development. The

integration hubs and sectoral processes.

group includes representatives from the IDB, the Eco-

Puebla-Ponama Plan (PPP)

nomic Commission for

Latin America

and the

Caribbean (ECLAC), and the Central American Bank The Mesoamerican region between Puebla and Pana-

for Economic Integration (CABEI).

ma, with a population of 64 million and a GDP of $143 billion, shares valuable characteristics such as a

Infrastructure objectives and proposals. The proposed integration infrastructure and targets out-

cultural and historical affinity, integrated ecosystems, a strategic location, common social and economic chal-

and telecommunications interconnections. The initiative

lenges, and a shared potential for development.

also sets out proposals in other important regional

The region covers 503,200 square kilometers

lined in the plan are highway integration and energy

in southern and southeastern Mexico, with an average

development areas such as sustainable development, human capital development, disaster prevention and

GDP per capita of $2,300 and exports totaling $13.5

mitigation, promotion of ecological, cultural and his-

billion. The Central American portion, which includes

torical tourism, and the facilitating of trade.

Costa Rica, Nicaragua, Honduras, El Salvador,

Highway integration. The initiative calls for

Guatemala, Belize and Panama, has a total area of

integration projects involving main highway construc-

522,900 square kilometers, with an average GDP per

tion, rehabilitation and improvements in the region;

capita of $1,900 and exports totaling $12.8 billion.

modernization of customs and border points; and the

Despite the common ground between these countries, intra-regional trade levels between Southern

harmonization of transportation codes and technical regulations.

Mexico and Central America are relatively low. And

To establish the location of priority corridor

while cooperation in social and environmental areas is

and secondary roads to meet the integration objective,

increasing, it continues to be below its potential. This

minimum infrastructure requirements were taken into

initiative will produce the demand necessary to gener-

account as well as realistic fiscal assumptions. The five-

138

Regional Infrastructure

Pueblo-Panama Plan: Road Integration

Source: Puebla-Panama Plan (2001).

year work plan covers over 8,000 kilometers, including some 5,000 kilometers slated for improvements, at a total estimated cost of $3.5 billion, 50 percent of which is in Mexico. The transportation plan covers the Pacific and Atlantic highway integration corridors, as well as the secondary roads of the Puebla-Panama corridor. These projects are intended to facilitate port access to better integrate southern Mexico with Central America, and to improve the transport corridor linking the region with markets of northern Mexico and the United States (Figure 6.5). Energy interconnection. This is aimed at unifying and interconnecting electricity energy markets with a view to promoting increased investment in the sector and lower electricity rates. The size of the region's electricity market is relatively small. In 2000, the region

had a maximum capacity of 4,600 MW5 and electric energy requirements totaling 25,000 gigawatts per hour (GWh). It is estimated that by 2005, maximum installed capacity will be 6,400 megawatts, with requirements increasing to an estimated 34,800 GWh. These levels of demand are best met by constructing larger plants than those currently in operation, and by attracting private plants that can generate electricity on more favorable terms and prices than is currently pos-

In comparison, neighboring countries such as Mexico and Colombia have installed capacity of 36,400 MW and 13,200 MW, respectively.

Figure 6.5

139

14O

CHAPTER

Figure 6.6

6 Pueblo-Panama Plan: Energy Interconnection

230 Kw. line Length (km)

Guatemala

282

El Salvador

282

15.4

Honduras

369

20.2

Nicaragua

294

16.1

Costa Rica

463

25.3

Panama

140

7.6

1,830

100.0

TOTAL

15.4

Source: Puebla-Panama Plan (2001).

sible. To this end, the countries decided to create a regional electricity market and to build a new regional electricity interconnection grid (Figure 6.6). The Central American Electric Interconnection Project (SIEPAC) involves developing a wholesale electricity market in Central America, including regional transmission systems. The regional market involves an interconnected network supported by a single 230 kW line from Guatemala to Panama with a total length of 1,830 kilometers. In this regional market, qualified agents would be free to buy and sell electricity, with nondiscriminatory access to the transmission network, in exchange for payment of a flat fee. The market would develop gradually, providing a permanent way of effecting commercial transactions for electricity,

through short-term transactions, based on the provision of electricity using regional economic criteria and through medium- and long-term contracts between agents. The development of a regional electricity market will face two major challenges: design and implementation of the regional regulatory framework, and establishment of regional institutions. Political independence and technical capacity of the regulating agencies is essential to ensure effective competition, particularly in the generation and distribution of electric power, and to promote investment by reducing project risk. In addition, the project will promote the convergence of national liberalization plans as well as greater coverage of services.

Country

Reaional Infrastructure

141

Telecommunications. The strategy in this area

opportunities for regional infrastructure projects. These

is to develop the region's computer interconnection infrastructure and provide citizens, particularly rural

existing economic and trade networks, and thereby

and vulnerable groups, with greater access to global

supporting improved competitiveness and develop-

information. This requires developing telecommunica-

ment.

tory framework to promote

private

There is a need for a shared strategic vision

and public

that addresses infrastructure priorities; identifies physi-

investment in connectivity. From a technical standpoint,

cal and institutional bottlenecks; promotes policies that

the project calls for a fiber optic network with a total

support regional economic, financial and political sta-

length of approximately 5,500 kilometers linking the

bility; and envisages the form and extent of private sec-

Central American nations to the southern and south-

tor participation.

eastern states of Mexico and the rest of the world.

Regional initiatives based on this shared

There may be opportunities to jointly develop these

strategic vision can spur infrastructure projects by pro-

telecommunications networks simultaneously with the

viding better information about benefits, creating

initiatives for the regional electricity transmission grid.

regional mechanisms to allocate the costs and benefits

A second fiber optic network to strengthen the Central

of the investments, and harmonizing regulatory and

American system is currently in the planning stages

institutional frameworks for sectoral and concession

and will be based on the SIEPAC line wiring. Both net-

activities. These efforts will increase the confidence of

works will support information transmission speeds of

countries in the likelihood of gaining long-term benefits

up to 2.5 gigabytes/second.

from projects that are (at least partially, if not wholly) physically located outside their borders.

LOOKING AHEAD

Long-term support for regional development will best be spurred by concrete examples of successful regional infrastructure initiatives. URSA and the Puebla-

Historically, transnational projects in Latin America

Panama Plan, just to cite two examples, are of critical

largely have been bilateral in nature, due to key input

importance not only because of the specific benefits

or market locations or to political, historical or eco-

they will bring, but also to show the value of regional

nomic ties. As these ties become increasingly regional

coordination in infrastructure planning and investment.

in scope, there will be greater needs and significant

tions infrastructure and establishing a regional regula-

projects will be critical to strengthening and extending

REFERENCES Amjadi, Azita, and L. Alan Winters. 1997. Transportation Costs and "Natural" Integration in Mercosur. World Bank Policy Research Working Paper no. 1742, Washington, DC. Asian Development Bank. 2000. Developing Best Practices for Promoting Private Sector Investment in Infrastructure. Manila: Asian Development Bank. Basanes, R, E. Uribe, and R. Willig (eds.). 1999. Can Privatization Deliver? Infrastructure for Latin America. Washington, DC: Inter-American Development Bank. Beato, Paulina, Juan Benavides, and Antonio Vives. 2002. Challenges to Regional Initiatives Promoting Transnational Infrastructure Projects. Infrastructure and Financial Markets Review 8(1). Inter-American Development Bank, Washington, DC. Bond, Eric. 2001. Multilateral vs. Regionalism: Tariff Cooperation and Interregional Transport Cost. Inter-American Development Bank, Washington, DC. Mimeo. Calderon, Alvaro, and Michael Mortimore. 2001. Inversion extranjera en America Latino y el Caribe. Santiago: United Nations. Camera Maritima y Portuaria de Chile. 1999. Memoria Anual Numero 56. Santiago: Camera Maritima y Portuaria de Chile. Estache, A., and G. de Rus. 2000. Privatization and Regulation of Transport Infrastructure. Washington, DC: World Bank. European Commission (EC). 1999. La electricidad a partir de fuentes de energia renovables y el mercado interior de electricidad. European Commission, Brussels. 2001. Propuesta para un marco regulador de las redes y los servicios de comunicaciones electronicas. European Commission, Brussels. Fay, Marianne. 2001. Financing the Future: Infrastructure Needs in Latin America, 2000-2005. World Bank Policy Research Paper 2545, Washington, DC.

Foster, Vivien. 2001. Los pobres en las reformas de infraestructura. World Bank, Washington, DC. Mimeo. Guasch, Jose, and Jorge Kogan. 2001. Inventories in Developing Countries: Levels and Determinants A Red Flag for Competitiveness and Growth. World Bank Policy Research Working Paper 2552, Washington, DC. Guasch, Jose, and Pablo T. Spiller. 1999. Managing the Regulatory Process: Design, Concepts, Issues, and the Latin American and Caribbean Story. World Bank, Washington, DC. Mimeo. Guasch, Jose L., and John S. Strong. 2001. Lessons Learned in Latin American Transport Sector Reforms. World Bank, Washington, DC. Mimeo. Institute for the Integration of Latin America and the Caribbean (INTAL). 2001. DATAINTAL 3.0. Trade Statistics System for the Western Hemisphere. INTAL, Buenos Aires. Integration of Regional Infrastructure in South America (URSA). 2000. Action Plan for Regional Infrastructure Integration in South America. Montevideo: Inter-American Development Bank (IDB), Andean Development Corporation (CAF), and Financial Fund for the Development of the River Plate Basin (FONPLATA). Inter-American Development Bank (IDB). 1998. CARICOM Regional Programming Paper. Inter-American Development Bank, Washington, DC. Mimeo. 2000. A New Push for Regional Infrastructure Development in South America, Inter-American Development Bank, Washington, DC. Mimeo. 2001 a. Competitiveness: The Business of Growth. Economic and Social Progress in Latin America. Washington, DC: Inter-American Development Bank. .. 2001 b. Integracion energetica en el Mercosur ampliado. Inter-American Development Bank, Washington, DC. Mimeo. Izaguirre, Ada Karina. 1999. Private Participation in the Transmission and Distribution of Natural Gasâ&#x20AC;&#x201D;Recent Trends. Viewpoint, Note no. 176. World Bank, Washington, DC.

142 I CHAPTER

Reqional Infrastructure

Lutz, Wolfgang F. 2001. Reformas del sector energetico, desafios regulatorios y desarrollo sustentable en Europa y America Latino. Serie Recursos Naturales e Infraestructura no. 26. ECLAC, Santiago. Moguillansky, Graciela, and Ricardo Bielschowsky. 2001. Investment and Economic Reform in Latin America. Santiago: ECLAC. Olivieri, Roberto, Jorge Sanchez, Ricardo Sicra, and Enrique Filgueira. 2001. El comercio por modo carretero entre los poises del Cono Sur. InterAmerican Development Bank, Washington, DC. Mimeo. Pardo, Magdalena. 2001. Pasos fronterizos en la Comunidad Andina. Inter-American Development Bank, Washington, DC. Mimeo. Puebla-Panama Plan. 2001. Plan Puebla-Panama. Iniciativas Mesoamericanas y Proyectos. Available at: www.iadb.org/ppp/document.

Rufin, Carlos. 2001. Institutional Change in the Electricity Industry: A Comparison of Four Latin American Cases. Babson College, Babson Park, MA. Mimeo Serven, Luis. 2001. Infrastructure in Latin America: A Macroeconomic Perspective. World Bank, Washington, DC. Mimeo. Sistema de Interconexion Electrica para los Poises de America Central (SIEPAC). 2001. Hacia una integracion regional de electricidad. Inter-American Development Bank, Washington, DC. Mimeo. Thompson, L. 2001. Private Investment in Railways: Experience from South and North America, Africa, and New Zealand. World Bank, Washington, DC. Mimeo. Woolf, Fiona, and Jonathan Halpern. 2001. Integrating Independent Power Producers into Emerging Wholesale Power Markets. World Bank Policy Research Paper 2703, Washington, DC.

Kerf, Michael (ed.). 1998. Concessions for Infrastructure. Washington, DC: World Bank and the InterAmerican Development Bank.

143

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MACROECONOMIC COORDINATION IN THE REGION

Macroeconomic coordination entails, by definition, a collective decision-making mechanism that reflects the interests of the parties involved. Imprecise terminology is often used to describe the different degrees of cooperation between countries. The terms policy convergence, coordination and harmonization are often used interchangeably, even though the concepts imply different levels of economic cooperation. According to Steinherr (1984), convergence policy is defined as a reduction of divergences between national objectives. Coordination requires national policies to be applied based on the acknowledgement of the policies and objectives of other countries and the effects of decisions by each country on the others. Harmonization is a process of steering towards a more uniform economic structure among countries that may lead to a unification of policies; that would occur, for example, when a single authority is responsible for bank supervision and regulation, or when monetary policy is unified under an independent central bank. As the distinctions between these concepts are quite subtle, it is difficult to reach a consensus on their use that reflects different levels of cooperation. Consistent with the common practice, in this chapter, we shall use the concepts of cooperation and coordination interchangeably to refer to different levels of agreement in the macroeconomic arena, except when a precise distinction is required.

REASONS FOR COORDINATION Macroeconomic coordination among the member countries of a trade bloc takes on a special meaning when policy decisions have a substantial effect on the trading partners. In this case, if the countries fail to consider the spillovers on other economies of making such decisions, the result can be less favorable to the parties as a whole than if a scheme of cooperative decisions were applied. In other words, cooperation may increase the well being of the overall group to the extent that externalities are present. Demand for coordination, then, is a direct function of the importance of these externalities to each country involved. This, in turn, depends on a set of factors that we shall analyze below.

Degree of Interdependence A high level of interdependence implies that each county in the bloc is affected by the events in the other countries. By contrast, if Country A is dependent on the situation in Country B, but not vice versa, interdependence does not exist, reducing the possibilities for macroeconomic cooperation (Box 7.1). In modifying import demand and export supply, domestic macroeconomic changes will affect the key trading partners through the impact of positive and negative cycles. There are two indicators used to measure trade interdependence between the members of a bloc: the share of regional trade in domestic product for each country, and the share of intra-regional trade

Chapter

CHAPTER

Box 7.1

7 Dependence anil Interdependence

The figures below illustrate the level of dependence or interdependence in different regional agreements based on two indicators: intensity of reciprocal trade between the largest partner in each agreement and the rest of the bloc; and distribution of regional GDP. Both indicators show a lower level of dependence of the largest member, in the case of NAFTA and Mercosur, while interdependence is substantially greater under the other agreements.

Figure 1

Degree of Interdependence (In percent)

Note: The indicator is estimated with the following formula:

There clearly may be other economic or political reasons beyond trade interdependence for coordination among members of an agreement. If trade dependence in the bloc varies substantially from country to country, however, it is reasonable to consider that there might be fewer incentives for the largest country to coordinate.

Figure 2

Regional GDP Distribution (In percent)

Note: The distribution measures each country's GDP share of the 1990 average regional GDP. Source: IDB calculations based on World Bank (2001).

which shows the ratio between the exports of the larger country j to the regional integration agreement B, and the sum of the exports of the rest of the country members i to the larger country j. In both cases, exports are normalized by the respective total exports. In parentheses, the left axis shows the larger country in terms of its share to regional GDP. Source: IDB calculations based on IMF (2001 a) and World Bank (2001).

in total trade. The impact of intra-regional trade on

What are the characteristics of Latin America

product reflects both the weight of intra-regional trade

and the Caribbean from this standpoint? The indicators

and the openness of the economy. Levels of intraregional trade may be high as compared with total trade while, at the same time, insignificant in terms of product due to the fact that economies are relatively closed.1

1 A high level of intra-regional trade, however, makes a country more vulnerable to the situation in the region, particularly when sucn trade entails a substantial component of "regional goods," i.e., those not easily exported to the rest of the world (see Chapter 8).

148

Figure 7.la

Degree of Interdependence by Regional Bloc for Infra-regional Exports (Percent of total exports)

Figure 7.1 b

Degree of Interdependence by Regional Bloc for Infra-regional Exports (Percent of regional GDP)

Note: For CARICOM, the latest available data are for 1997. Source: IDB calculations based on IMF (2001 a) and World Bank (2001).

show that interdependence in regional integration agreements (RIA) has increased substantially during the past decade. Nonetheless, the interrelationships within the different blocs are still less important than in other regions. These findings are evident when we analyze intra-regional trade with respect to total trade, and particularly intra-regional trade in terms of gross domestic product (Figures 7.la and 7.1b). The results are primarily attributable to the openness of the countries, although the fact that regional agreements in Latin America represent a smaller relative share of world product also plays an important role.2 Accord-

149

ingly, the low level of interdependence in Mercosur and the Andean Community (AC) is attributable primarily to the relative closure of the economies involved, while levels in the Central American Common Market (CACM) and the Caribbean Community (CARICOM) are higher, reflecting the intensity of intra-regional trade, and the fact that they are the most open blocs in the region. In any case, these values contrast with the greater importance of intra-regional trade in terms of product in Europe during the late 1980s, i.e., before the decision was made to create a monetary union, or the Association of Southeast Asian Nations (ASEAN) of today. The greater importance of intra-regional trade in the case of NAFTA is basically explained by the fact that it represents approximately 30 percent of GDP for Canada and Mexico. While the topic of interdependence has been discussed generally from the standpoint of trade relations, the intense globalization of financial markets during recent years has led to greater financial interdependence and, through different channels, has generated contagion effects in critical situations.3 Empirical studies have shown the existence of strong interconnections between financial markets in emerging countries that are clearly influenced by geographic proximity, trade links and economic policy similarities.4 Does membership in a given trade bloc increase financial contagion beyond the indirect impact through trade? There is evidence that a country's currency crises are more closely associated with

The share of Mercosur, AC, CACM and CARICOM in world output is 3.3 percent, 0.8 percent, 0.15 percent and 0.07 percent, respectively, while the European Union accounts for 29 percent. The contrast with ASEAN, which accounts for a lower share of world product than Mercosur, demonstrates that an economy's openness, in addition to its size, is a fundamental factor in increasing regional interdependence. 3 One exception is the absence of contagion in the final phases of the Argentine crisis. This could be attributed to the "absence of surprise" as events unfolded, which permitted investors to prepare themselves by reallocating their assets gradually. During the preceding months, however, there was an impact on other countries in the region, and during 2002 the crisis severely affected Uruguay. Although there are different definitions of contagion, references here are to a situation in which a crisis in another country increases the probability of crisis in the home country, after controlling for the economic fundamentals (Eichengreen, Rose and Wyplosz, 1996). 4

See De Gregorio and Valdes (2001); Eichengreen, Hale and Mody (2000); Dornbusch, Park and Claessens (2000); Forbes and Rigobon (2000); Froot, O'Connell and Seasholes (2001); and Click and Rose (1999).

Macroeconomic Coordination in the Region

CHAPTER

Box 7.2

7 How Can Volatility Be Measured?

The standard deviation of a series was used to estimate its level of dispersion (or volatility). For individual countries, the indicator is immediate and intuitive. Where regions are concerned, however, an aggregate indicator must be constructed. In this chapter, we chose two complementary methods for each regional integration agreement, calculated in most cases on the basis of rates of variation in each series: a) the simple average

exchange rate misalignments vis-a-vis the partners in a

of the volatility of each countryâ&#x20AC;&#x201D;a measurement that focuses on the volatility of member countries independent of their size; and b) the volatility (standard deviation) of the "regional" variations, calculated on the basis of the weighted average rates of variation in absolute terms for the series of each country. The average GDP for the decade of the 1990s in constant 1995 dollars was used for the weightings.

Reducing Volatility in the Bloc

trade agreement than with the rest of the world.5 When we measure contagion through the impact of a change

Extent of volatility. By increasing uncertainty, macro-

in a country's capital flows on the other partners in an

economic volatility affects the rate of economic growth

agreement, however, the evidence is more ambigu-

(see Box 7.2).9 In recent decades, Latin American

ous. These results are consistent with further empirical

countries have evidenced a high degree of volatility,

evidence that shows that interdependence in financial

measured by the inflation rate and its variability, vari-

markets is manifested to a greater extent in price vari-

ations in the real exchange rate, and in part as a result

ations than in levels of capital flows.7

of these factors, sharp variations in the growth rate. This volatility declined during the past decade, sub-

Political Support for the Degree of Integration

stantially as a result of more responsible fiscal and monetary policies that reduced the level and variabili-

Greater demand for coordination is a function of the

ty of the inflation rate, inducing a reduction in real

present level of interdependence, as well as the deci-

exchange rate volatility.10 In addition, while the rate of growth of GDP increased, its variability declined sig-

sion of governments to deepen the process of integrationâ&#x20AC;&#x201D;that is, of future interdependence. For example, when the objective of the integration process is to achieve a monetary union, incentives to cooperate at the macroeconomic level increase substantially, as it is difficult to move forward in creating a single currency if inflation rates differ substantially between the countries, or if the fiscal deficit generates substantial growth in public debt. Integration processes in the region, particularly in recent years, have been characterized by the goal of going beyond free trade areas. This political willingness, however, is not always reflected in specific decisions in support of this objective. As macroeconomic cooperation has its costs, which we shall discuss below, in order to move forward governments must prove tangibly that the national agenda is giving way to the regional one.8

nificantly. Still, volatility continues to be high, particu-

5 Fernandez-Arias, Panizza and Stein (2002). See Chapter 8 for a detailed discussion. 6

Hernandez and Mellado (2002) find no significant contagion, other than that generated by trade, from changes in capital flows from one country to the others in the bloc, with the exception of portfolio investment in some trade blocs. 7

See Eichengreen, Hale and Mody (2000) and Froot, O'Connell and Seasholes (2001). Changes in the value of shares, fluctuations in the cost of indebtedness in domestic and international markets, or changes in the exchange rate could affect growth to an extent equal to or greater than changes in capital flows. 8

This is demonstrated by adoption of a common external tariff, elimination of non-tariff barriers to intra-regional trade, and gradual progress toward establishment of supranational institutions. 9 10

IDB (1995) analyzes the negative impact of volatility on growth.

Except in CARICOM countries, where both inflation and volatility remained at similar low levels throughout the period.

150

Macroeconomic Coordination in the Region

Table 7.1

151

Macroeconomic Volatility

Annual rate of Inflation1 1991-2001 1971-2001

Quarterly inflation rate 1991-2001 1971-2001

Annual GDP growth 1991-99 1971-99

Multilateral real exchange rate 1991-2001 1980-2001

32.22 31.51

142 51

3.06 4.93

30.04

1.84 2.65

1.67 3.06

1. 65 5. 40

7.85 14.90

CARICOM

11.66 13.89

8 84 9 01

1.53 3.06

1 29 2 93

0.71 3.06

1.78 5.15

2. 28 3. 78

2.33 4.77

CACM

37. 42 3 78.36

98 60

215.17

4.26 15.44

5 50 23 13

1.29 2.21

1.72 4.40

2. 08 6. 75

3.72 15.29

393. 664 155.57

367 60 196 92

40.94 17.92

46 58 31 64

1.55 3.36

2.56 4.84

4. 26 3. 85

5.32 7.81

7.50 11.20

8 44 11 29

2.22 2.97

1 86 3 37

2.23 3.65

2.11 4.16

4 41 5. 50

3.43 7.51

2.69 3.19

5 47 6 33

0.33 0.65

0 90 1 38

0.90 1.75

1.34 2.25

1 05 2. 37

0.86 2.25

Mercosur ASEAN EU

90.05

16 84

Cells in red show the average across countries' annual inflation rate weighted by the countries' GDP, and in blue the simple average. Cells in red show volatility across countries' average change in absolute value weighted by the GDP, and cells in blue show the simple average of the countries' volatility. 3 Excluding 1991 (high inflation in Nicaragua), the average inflation rate decreases to 12.03 percent. 2

Since 1995, the average inflation rate for Mercosur has decreased to 1 1.49 percent.

Source: IDB calculations based on IMF (2001 b) and World Bank (2001).

larly in comparison with the European Union, although certain indicators register levels similar to ASEAN (Table 7.1). This higher level of volatility not only affects the rate of investment and growth in the country directly exposed to it, but also those rates in the interconnected countries. High and variable inflation rates and substantial variability in GDP make the partner unpredictable, although the most relevant issue among regional partners, for reasons discussed below, is exchange rate variability. Figure 8.2 in Chapter 8 shows that the variability in the intra-regional exchange rate has been considerably higher for all agreements in Latin America than for the European Union or ASEAN. In the region, Mercosur, followed distantly by the AC and CACM, register the highest levels of volatility. Effects. As economic agents are typically risk adverse, the increase in uncertainty usually associated with volatility can be expected to have a negative impact on economic activity. While a country's volatility affects its partners in different ways, exchange rate

volatility typically attracts the most attention due to its effects on trade and on the political economy of the integration process. Most empirical studies that have analyzed the impact of exchange volatility on trade flows have found ambiguous or slightly negative effects that can be explained by the existence of exchange risk hedging mechanisms.11 The absence of a stronger negative effect is strengthened by the fact that these studies primarily used data from developed countries in which exchange coverage mechanisms are more advanced.12 As developing countries began to be incorporated into the studies, volatility had a greater negative impact on exports.13 It is not surprising, then, that a monetary

11 From a theoretical standpoint, models with agents neutral to risk or risk lovers can also be constructed. See Mckenzie (1999). 12 The estimates show a lower impact of volatility with improvement in coverage instruments for transactions in foreign exchange (Frankel and Wei, 1998). 13 See Estevadeordal, Frantz and Saez (2001) and Giordano and Monteagudo (2002).

Standard deviation2

CHAPTER

Figure 7.2

7 Terms of Trade Volatility and its Impact on GDP, I971-2OOO a. Terms of Trade Volatility

b. Impact on GDP

Notes: Regional volatility is calculated as the standard deviation of the average change in the countries' terms of trade, weighted by GDP. For CARICOM, available data in Figures 7.2a-b are for Guyana, Haiti, Jamaica and Trinidad and Tobago, which represent 63 percent of subregional GDP.

Notes: The impact on GDP is calculated as the product between the weighted average of the openness coefficient (1990-99) and the volatility coefficient in Figure 7.2a. Source: IDB calculations based on World Bank (2001).

union has a positive impact on trade by eliminating exchange rate uncertainty and reducing transaction costs. Chapter 9 analyzes these results. In addition to its economic impact, volatility also affects the political economy of the integration process. First, economic instability affects external and domestic financing possibilities. Since it is inconvenient for countries that have substantial current account deficitsâ&#x20AC;&#x201D;and therefore considerable financing requirementsâ&#x20AC;&#x201D;to be associated with a country in difficulty, attempts by a country to differentiate from a partner believed to be "unreliable" lead to political problems that seriously undermine the integration process. Second, if the instability is associated with exchange rate volatility, resistance is created as a result of the loss of competitiveness by producers in the country whose currency has appreciated. In this context,

of Brazil's devaluation in 1999 (see Chapter 8). By contrast, exchange rate modifications within NAFTA do not appear to have produced similar effects. This can be explained by the growth rate in the region at the time of the exchange modifications, and more specifically, by the size of the devaluating country.14 In summary, no one wants to have a partner with a highly volatile macroeconomy. If that is the case, there are two alternatives: reduce interdependence or find cooperation mechanisms to reduce volatility. If, for reasons of geographic proximity, political considerations or other factors, the country with which there is a strong trade or financial relationship will continue to be an important partner in the future, then the higher the levels of volatility, the greater the incentive to cooperate in the macroeconomic area. Causes. The causes of volatility are essential to assessing how to approach cooperation. When the reasons are internal, cooperation will focus on fiscal, monetary and exchange rate issues. If the volatility is the result of exogenous shocks, macroeconomic coordination among countries could be less effective and a

devaluations are considered opportunistic behavior by the partners, weakening solidarity within the region and increasing political pressure to adopt protectionist measures, while reducing support for integration. For example, the devaluations in some European countries in 1992 and 1993 led to protectionist reactions in other countries of the European Common Market and ultimately convinced the parties that the way to avoid such problems in the future was to adopt a single currency. Another example is the substantial increase in protectionist measures in Mercosur countries as a result

The United States recorded a high rate of growth at the time of the Mexican devaluation, while Brazil's devaluation occurred during a recession in the region. Further, Mexico's share in NAFTA's GDP amounts to only 4 percent, while Brazil accounts for more than 65 percent of Mercosur's product.

152

lStSS5^SSSSSSSSS^SBS3S3SSSSS^^S3t^ ' S3\

Private Capital Flows, 1971-2OOO (In percent of GDP)

Figure 7.3b

FDI and Otker Capital Flows in Latin America, 1971-2OOO (In percent of GDP)

Source: IMF (2001 c) and World Bank (2001).

different kind of coordination, as discussed below, might be required. In Latin American agreements, both factors have interacted over time as the region has been exposed to substantial external shocks—primarily terms of trade and private capital flows—the impact Table 7.2

of which has been amplified by macroeconomic policy deficiencies and the absence of institutions to address them. Figure 7.2a shows that terms of trade volatility has been high in Latin America, although the figures

Volatility of Private Capital Flows (In percent of GDP) 1971-80

Mercosur Weighted average Simple average AC Weighted average Simple average CACM Weighted average Simple average CARICOM1 Weighted average Simple average NAFTA Weighted average Simple average ASEAN Weighted average Simple average

EU Weighted average Simple average

1981-90

1991-99

1971-99

0.69 1.87

0.80 1.51

1.14 2.28

1.20 2.09

0.60 1.80

1.06 3.63

1.67 4.00

1.23 4.13

0.83 2.84

1.29 5.21

3.11 10.04

2.43 7.18

0.90 3.89

1.41 4.94

2.43 5.82

1.97 6.16

0.20 0.87

0.87 2.17

0.90 1.84

0.75 2.05

0.83 1.18

1.92 3.00

5.12 6.44

3.14 5.20

0.39 1.30

0.50 1.13

0.97 2.66

0.68 2.44

Notes: The weighted average shows the volatility of the average across countries, weighted by GDP. 1 Available data for CARICOM include Guyana, Haiti, Jamaica and Trinidad and Tobago, which represent 63 percent of subregional GDP. Source: IDB calculations based on IMF (2001 c) and World Bank (2001).

Figure 7.3a

CHAPTER

Figure 7.4a

Private Capital Flows: Magnitude of Volatility Dimensions and "Sudden Stops" by Region, 1972-99

Figure 7.4b

Regional Integration Agreements and "Sudden Stops"

Notes: The two figures present the percentage of annual observations when net private capital flow changes are greater than 3 percent of current GDP, based on country data. The bars with vertical lines present sudden stops, which are cases when the negatives changes were greater than 3 percent of current GDP. Source: IDB calculations based on World Bank (2001) and IMF (2001 c).

are not much different from the volatility within ASEAN, despite that region's greater diversification of exports.15 Figure 7.2b shows the impact of this volatility in terms of product, which depends crucially on the economy's openness and explains its relatively low impact in Mercosur. During the past few years, however, volatility in the region and in emerging countries in general has mainly come from changes in private capital flows. Figures 7.3a and 7.3b show that oscillations in capital

flows in emerging regions have been substantial, particularly when foreign direct investment is excluded. Similarly, Table 7.2 shows that this volatility has been greater in all the Latin American blocs than in Europe.16 To illustrate the magnitude of this volatility, a sample of 121 countries (23 developed and 98 developing countries, according to the IMF classification) is used to calculate cases in which annual variations in net private capital flows exceeded 3 percent of GDP in the receiving country over 1972-99. Figure 7.4a shows that for all developing countries, this level is exceeded in 44 percent of the observations, although it drops to 38 percent when developing countries having income levels below $20 billion (in 1995) are excluded.17 The same coefficient is 27 percent for developed countries, and 6 percent when only the G-7 countries are considered. Given the impact that sharp reductions in capital flows have on GDP and on the exchange rate (Calvo, 2001), the same figure also shows how many of these variations correspond to reductions exceeding 3 percent of the countries' GDP. In developed and developing countries, there are approximately the same number of cases of sudden stops as sudden starts of capital flows, which would seem to imply that the sudden whims of the markets occur in both directions.18 Figure 7.4b presents the same information by regional integration agreement. With the exception of Mercosur, in all of the remaining agreements in Latin America, the cases where changes in annual capital flows exceed 3 percent of GDP are around 45 percent. While for closed economies fluctuations in capital flows as a percentage of GDP could be low, the impact in terms of variation in GDP and the real exchange rate required to adjust the current account

15 Volatility is calculated for the past three decades, a period during which the export structure is not uniform. In fact, volatility in terms of trade decreases substantially for ASEAN when only the past decade is considered. 16 For Mercosur, however, this is true only when the indicator is weighted by country size. NAFTA is found to have volatility similar to Europe. 17 The maximum values for developing countries are found in Latin America (44 percent) and Africa (42 percent). 18

Sharp increases in capital inflows tend to produce a substantial increase in product and appreciation in the exchange rate, which, in many cases, is indicative of future crisis.

154

may exceed that required in more open economies. This is the case of Mercosur compared to other agreements in Latin America. In fact, when the number of observations in which the annual fluctuations in capital flows exceed 20 percent of exports, Mercosur is found to have a higher level of volatility than other blocs, as observations with these characteristics amount to 39 percent of the total, as compared to 29 percent for the AC and 23 percent for CACM. All of this represents further proof of the magnitude of the region's financial volatility—volatility that is not only the result of changes in the external context, but also of internal factors that traditionally have shown great instability in emerging countries. In summary, while volatility declined during the past decade, subregional blocs still exhibited macroeconomic instability, explained by both domestic and external factors. There is, accordingly, broad scope to establish policies that reduce the impact of external shocks (for example, through diversification of exports and adoption of measures to reduce the impact of the variability of capital flows). There are also opportunities for cooperation to address these external shocks, such as by creating regional financing mechanisms. Volatility of internal origin might be reduced through coordination of macroeconomic policies, mainly in the monetary and fiscal areas.

Discipline under Domestic Pressure Regional agreements can serve to implement measures that generate domestic resistance. An international agreement may strengthen certain actions by associating them with a consensus with other countries, therefore making them less subject to a decision of the national authorities. To date, in countries of the region, the external discipline mechanism has been introduced under agreements with international financial institutions rather than under coordination agreements with the regional partners. The advantage of a regional agreement, however, is that it typically is viewed as a choice by the country, over which it normally has some degree of control, while agreements with international organizations are often considered to be imposed by outside interests. In any case, the importance of regional agreements in imposing some degree of internal discipline

155

depends on whether the agreement is perceived as advantageous to the country. While this has been true for Europe, it has not necessarily been so for Latin America. As a result, there is a risk that implementation of unpopular economic policies will be viewed as the result of an agreement whose benefits are not clear, therefore generating incentives for its termination.

Increasing Credibility Coordination of macroeconomic policies with partners that enjoy a good reputation can generate positive externalities. In an extreme case, even if there are not conditions to create a monetary union, coordination could lead to the adoption of a single currency with a view to gaining further credibility. Similarly, the countries may decide to adopt the currency of a country outside the region if it is believed that the benefits of that country's reputation may offset the costs associated with the absence of monetary policy. Unlike Europe, where coordination is viewed as a responsible policy given the reputation of some of the partners, the absence in Latin America of countries with a tradition of monetary stability implies that the qualification of a country as "responsible" in macroeconomic policy management has little to do with honoring commitments with the country's partners. Coordination between countries without reputation can generate credibility gains if it enables more responsible economic policies to be implemented—among other reasons, because it can help reduce domestic pressures. For coordination to be credible, however, there must be some costs associated with noncompliance.

Eliminating Distortions and Reducing Fiscal Costs As countries eliminate tariff barriers, reduce exchange rate volatility, and advance in their level of interrelations, distortions in competition resulting from different tax systems generate increasing costs, and therefore also incentives to coordinate policies in the area. Elimination of barriers to the flow of goods and services—a minimum level of integration to which all modern second-generation agreements aspire— increasingly requires establishment of trade-neutral

Macroeconomic Coordination in the Region

CHAPTER

taxes among the countries involved. For this reason, indirect taxes are typically the first to be harmonized with value-added tax (VAT) based systems that avoid the cumulative effect of taxes in cascade, and guarantee tax neutrality.19 Since it is not so obvious that differences in direct taxation are distortionary, the need for harmonization in this area is not evident. Coordination, however, is also advisable to avoid discrimination and obstacles to the circulation of factors required to achieve a common market. For example, differences in corporate income taxes may affect decisions on investment and the location of enterprises; and personal income tax may affect labor movements, as do the benefits, costs, and the option to transfer accumulated social security entitlements. Tax coordination as a cooperative action between countries for the mutual adaptation of their taxation systems is therefore advisable to guarantee the free mobility of goods, services and factors, and to eliminate distortions to competition between jurisdictions. Tax coordination, however, is also an instrument to fight loss of fiscal revenue resulting from fraud and tax evasion, as well as from a possible race to zero taxation or greater subsidies. Regarding tax evasion and fraud, an example is provided by the lack of coordination in connection with jurisdictions that do not withhold interest collected by nonresidents, and that exchange little or no information with the agent's country of residence.20 Although it might be argued that tax competition has positive aspects, since it prevents governments from imposing confiscatory charges, the downside can also be substantial if it leads to a "race to the bottom" between countries. The location of investment becomes a basic theme between countries that are net recipients of foreign capital and investments, and there is a risk of promoting sectoral and regional policies through tax incentives in a disorderly fashion.21 The effect is particularly important between countries in a free trade area, and particularly when tariffs are high. An example of this "race to the bottom" is the competition between states in Brazil to attract companies in the automotive sector (see Box 7.3). This provides a good illustration of the type of competition that can occur between countries when the level of integration is quite high. Given the degree of trade integration in Mercosur, competition among Brazilian states might have

affected other Mercosur member countries by shifting investment from them to Brazil. In summary, while tax competition promotes control of states that tend to maintain excessive tax pressure, the process can be traumatic and lead to a tax war, in which all countries lose revenue. Since the effects tend to be greater between countries that have reduced the barriers to trade in goods and services, the most reasonable alternative, supported by successful integration experiences, is some degree of coordination reflecting the features of each agreement.

COORDINATION: COSTS AND DIFFICULTIES The costs associated with macroeconomic coordination depend on the type of coordination that is adopted, which can range from the time required for standardization and exchange of information to delays in making economic policy decisions owing to the need to report or reach a consensus, or the inability to do so because of the compromises of coordination on monetary, exchange rate or fiscal policy.

Autonomy The use of advanced macroeconomic policy cooperation mechanisms often involves the loss of autonomy in making national policy decisions, and particularly, reduced discretion in national policies to address specific shocks. Examples are the adoption of a single currency, with the resulting loss of monetary autonomy, and reduced fiscal discretion under the Maastricht agreement and the European Stability and Growth

19 The European Economic Community in 1970 introduced the VAT as a replacement for various taxes on production and consumption levied by member countries. Most Latin American countries have adopted the VAT, although in some cases, such as Argentina and Brazil, it subsists with other taxes on production and sales, generating a cumulative effect that leads to competitiveness problems. 20

In addition, the existence of tax-immune zones normally entails complicated control of goods in transit, with the resulting tax evasion problems. 21

Fernandez-Arias, Hausmann and Stein (2001) demonstrate that, under certain conditions, the location of investment is not optimal in the absence of benefits from the countries, and in such cases, specially-designed incentives are advisable. Coordination, in any event, may improve the distribution of benefits in favor of the country or region receiving the investment.

156

Macroeconomic Coordination in the Region

157

Beginning in the early 1990s, the automotive industry in Brazil expanded significantly. Investments in new plants from 1994 to 2000 totaled more than $6.1 billion. Tax incentives provided by state governments—the tax war—led to a process of deconcentration in production. Without these incentives, investment would quite probably have continued to be located in the more industrialized region of Sao Paulo-Rio de janeiro-Minas Gerais, or in some cases, in another Mercosur country. The typical benefits from the incentives can be divided into three categories: i) a short-term budget impact (grants of land and port facilities or execution of infrastructure works); ii) short- and medium-term credit benefits (subsidized loans to finance fixed asset purchases, and state tax exemptions for purchases of machinery and equipment); and iii) long-term tax benefits. An analysis of the tax cost associated with the incentives provided for installation of three automotive plants (General Motors in Rio Grande do Sud, Renault in Parana, and Mercedes Benz in Minas Gerais) showed the following results: • The value of the approved benefits is 24 percent greater than the capital invested by General Motors; equal to the investment for Mercedes Benz; and comes to 35 percent of invested capital for Renault; • The main benefit is deferred or postponed payment of the tax on circulation of merchandise and services;

• The estimated tax cost per job directly generated is $443,800 for Mercedes Benz, $359,400 for General Motors, and $139,600 for Renault; • Considering that the investments would still have been made in the country or region in the absence of the incentives, the estimated fiscal cost can be interpreted as the price that the country or region pays for the relocation of resources from the optimal location in the absence of the benefits.2 The tax war between states to attract automotive sector investment is not unique to Brazil. In 1980, Tennessee attracted a Nissan plant that employed 1,900 persons at a tax cost of $33 million ($17,400 per job generated). Five years later, the cost to Tennessee of attracting a General Motors plant that created 6,000 jobs amounted to $150 million ($25,000 per job). In 1993, Alabama agreed to provide $300 million in incentives to attract a Mercedes Benz plant that employed 1,500 workers ($200,000 per job).

See Barreix and Villela (2002).

While the assumption that the investment would occur in the region independent of the subsidies may seem strong, it is not necessarily so in this case, given the size of the market and the high protection from external competition.

Pact. This analysis assumes that countries can use

partially reflect the relative size of each country.23 This

instruments of economic policy, which is not the case in

does not imply that agreements involving countries of

some Latin American countries. An example is the

similar size promote integration, since the absence of a

inability of most countries in the region to use anti-

country or countries to lead the process may make the

cyclical fiscal policies and the difficulty of using mone-

bloc less dynamic. The optimal combination seems to

tary or exchange rate policy in highly dollarized

be the existence of lead countries with an integrationist

economies.

When fewer economic policy instruments

are available, the costs of giving up some discretion are clearly lower. In general, this loss of autonomy tends to be perceived as more costly the greater the relative size of the country, and therefore the less dependent it is on the bloc. To reduce this resistance, supranational decision-making mechanisms may be adopted that at least

The region's difficulties in applying anticyclical fiscal policies should be considered a problem that needs to be corrected rather than a permanent characteristic. To that end, fiscal surpluses must be generated during cyclical upswings. See Ocampo (forthcoming). 23

For example, the Executive Board of the European Central Bank is comprised of permanent representatives from Germany, France and Italy, while representatives from other countries serve on a rotating basis (see Box 9.1 in Chapter 9).

The Tax War in Brazil's Automotive Sector1

Box 7.3

158

CHAPTER

vocation that steer the process, along with an acknowl-

Figure 7.5

Business Cycle Correlation, 196O-99

edgement of the relative size of the partners in the supranational bodies.24

The costs of economic coordination will be lower to the extent that the countries face similar situations. If the cycles of the countries involved are synchronous, economic policy decisions will be similar, and therefore the cost of forgoing national policy will be lower.25 Countries in subregional blocs in Latin America have historically registered less synchronous cycles than countries of the European Union. Figure 7.5 provides two cycle synchronism indicators: the percentage of correlation coefficients between the cycle component of GDP of member countries of an agreement that is positive and

Note: Percentage of statistically significant correlation coefficients and average of correlation coefficients weighted by GDP. Source: IDB calculations based on World Bank (2001).

significantly nonzero, and the average of all correlation coefficients weighted to reflect the share of the countries in the product of the bloc.26 The highest degree of synchronism is found among countries of the European Union, although CACM countries are also found to have a relatively high level of correlation.27 Mercosur countries register the lowest levels of synchronism in the region, particularly when the correlation is weighted by the countries' size. While the highest degree of synchronism in economic cycles facilitates coordination of macroeconomic policies, a lack of synchronism does not necessarily mean that coordination is not convenient. Non-synchronic cycles may provide a reason to coordinate fiscal policies, as the country in the best fiscal situation as a result of being on the upside of the cycle may have resources to lend to countries needing to finance a larger deficit.28 On the other hand, asynchronous economic cycles can be the result of divergent macroeconomic policies, different exchange regimes, or asynchronous external shocks. When different macroeconomic policies are applied, it is clear that cooperation, by definition, will increase synchro29

nism.

Different exchange rate regimes may be com-

patible with macroeconomic policy coordination, although in economies subject to significant external shocks this situation may introduce much variability in the exchange rate between countries.30 Last, external shocks with differentiated impacts across countries are more difficult to manage, as they may require different

It can be argued that a system of representation that reflects the relative size of the countries might benefit large countries, since they might better resist internal pressures without excessive costs in terms of autonomy. 25 If cycles are asynchronous, advanced forms of macroeconomic coordination might not generate costs in the presence of full price and wage flexibility. On an alternative or complementary basis, the lack of synchronicity may be replaced at least partially with high levels of labor mobility and fiscal transfers. Labor mobility reduces unemployment, as workers move between countries in the agreement depending on the economic cycle, and fiscal transfers can be expected to play an anticyclical role in the countries or regions. 26

Synchronism in cycles is assessed as the correlation between the series of deviations of the countries' GDP with respect to its trend calculated using the Hodrick-Prescott filter. 27 These results remain relatively invariable when only the past 20 years are included. Synchronism in CACM is explained in part by the trade interrelations between the members, although "external coordination" associated with the cycle of the United States seems to be more relevant (see Panizza, Stein and Talvi, 2000). 28

Coordination would function in this case as insurance for the ability to apply anticyclical policies. To that end, a system of transfers that requires sophisticated fiscal institutions that do not exist in the region is needed. This transfer mechanism does not even exist in the European Union, where transfers are linked to the countries' relative development, rather than to their economic cycles. 29

This does not mean that countries with a lengthy history of similar macroeconomic policies should be overlooked. Their economic policies will undoubtedly be easier to coordinate in the future. 30 While experience in Mercosur has shown that variability in exchange rates between countries was greater during the 1980s when exchange regimes were similar (Fanelli, 2001), the change in the real bilateral rate between Brazil and Argentina in 1999 was the result of an external shock that affected the real equilibrium exchange rate in both countries, although, in light of Argentina's convertibility system, it only affected the nominal and real exchange rate in Brazil.

Cyclical Synchronism

Macroeconomic Coordination in the Region

macroeconomic policies, and in particular, they may

Figure 7.6

change the equilibrium exchange rate between the

159

Terms of Trade Correlation, 196O-2OOO

members of a bloc. It is therefore important to assess whether or not the different blocs in the region are Before proceeding with this analysis, let us consider a related topic: the relationship between trade levels and synchronous economic cycles. When countries specialize in goods in which they have comparative advantages and that intensify inter-industrial trade, there is no reason for greater trade interrelations to promote cyclical synchronism, since specialization can accentuate its idiosyncratic nature, particularly if the price of goods marketed is determined on the international market.31 Alternatively, higher levels of intraindustrial

trade

lead

to greater

similarities in

productive structures, and therefore trade will not only have an impact through import demand or export supply, but will reduce the level of asynchronous external perturbations.32 As shown in Chapter 2, Mercosur and the AC have registered steady increases in intra-industrial trade that can be expected to increase cyclical syn-

Note: The correlation is calculated as a simple average of the correlation coefficients of terms of trade changes between member countries of the same regional integration agreement. Available data for CARICOM include Guyana, Haiti, Jamaica and Trinidad and Tobago, which represent 63 percent of subregional GDP. Source: IDB calculations based on World Bank (2001).

chronism, although in the case of Mercosur, the fact that the large economies are fairly closed reduces the impact of trade on the economic cycle. The other inte-

shocks are independent, and that supply shocks per-

gration agreements in the region do not show any sig-

manently affect product while demand shocks only

nificant increase, although for CACM, intra-industrial

affect it temporarily.35

trade has been relatively important for some time.

Another way to assess whether countries that

(Chapter 8 provides a detailed analysis of the empiri-

belong to different blocs are facing similar perturba-

cal evidence on the relationship between trade and

tions is to analyze the correlation of external shocks to

cycle synchronization.)

the region. One of the most relevant shocks in Latin

Returning to the nature of the shocks, a num-

America is the behavior of external prices. Figure 7.6

ber of studies have made the distinction between

shows the correlation between the terms of trade vari-

demand and supply shocks. Under the assumption that the former are more contaminated by controllable domestic factors and policies than supply shocks, the

correlation between the latter would be effective proof

of the probabilities that macroeconomic coordination between the members of an integration agreement will be successful. The results of these studies show no correlation between supply shocks in countries of NAFTA,

See Krugman( 1993).

Frankel and Rose (1998) discuss the economic interdependence argument as a synchronizing factor between cycles, and provide empirical evidence for industrial countries. 33 See Bayoumi and Eichengreen (1994); Arora (1999); and Bayoumi and Mauro (2002). 34

Mercosur or the AC.33 By contrast, some degree of cor-

In Eastern Asia and Europe, 15 percent and 19 percent of the respective estimated correlations were significant.

relation is found in a group of East Asian countries and

in Europe during the period prior to the establishment of the European Union.34 While the results of this methodology are easy to interpret, it has some limitations, such as assumptions that supply and demand

An example may clarify the problems of using an aggregate supply and demand model such as the one underlying this methodology. A stabilization plan that attracts foreign investment mayâ&#x20AC;&#x201D;given the impact on investment and incorporation of technologyâ&#x20AC;&#x201D;have a permanent effect on income levels. But the model will not be able to properly capture the relationship between the demand shock and the permanent change in the income level.

exposed to synchronous shocks.

CHAPTER

ation rates for countries belonging to the same bloc. As we might expect, given the similarity in their productive structures, countries of the European Union have highly correlated terms of trade. In all other regional agreements, with the exception of CACM, the correlation is significantly lower.36 As discussed above, numerous studies have shown the interrelation between private capital flows to emerging countries, as well as between financial asset prices.37 This interrelation results in part from the existence of exogenous factors, which are common to all the emerging countries or to a region in particular, and that therefore should help generate greater synchronism in economic cycles.38 Similarly, the synchronism of cycles also increases when a variable (prices of public or private bonds, exchange rates, or capital inflows) is affected by the behavior of the same variable in other emerging countries—an influence that increases with geographic proximity and trade volume. In summary, the empirical evidence shows that there is no cyclical synchronism in Mercosur or AC countries. Nor is there much correlation between the changes in terms of trade. This is not the case for CACM countries, which have a relatively high level of correlation between their cycles and between their terms of trade. The entire region, however, is affected by similar financial shocks, which clearly helps enhance the synchronism between economic cycles. It could be concluded that, from the standpoint of these indicators, the cost of macroeconomic coordination, and, in the extreme, of monetary union, is substantial in the various blocs, with the possible exception of CACM.

Difficulties with Coordination Experience has shown that macroeconomic cooperation entails difficulties associated with differences in perception about the economy's underlying model and in the policy objectives of the national authorities. That makes it difficult to determine how to distribute the benefits obtained from coordination efforts.39 For example, it was impossible to coordinate exchange policies in Mercosur during the 1990s owing to the existence of different exchange regimes in Argentina and Brazil. Another problem derives from the difficulty in internalizing the benefits of cooperative arrangements,

particularly when the future benefits exceed the present ones, and when the discount rate is high. In addition, the risk of individual losses when adopting a cooperative strategy not supported by the other participants discourages national authorities from being cooperative, resulting in a negative outcome for all participants (the prisoner's dilemma). A less pessimistic conclusion can be reached by considering the dynamic aspect of international coordination: to the extent that, over time, all players will be making decisions that promote mutual trust and understanding and that reduce their economic policy options, progress in increasing forms of cooperation could be made, as the costs from uncooperative behavior by the other agents would be bounded. 40 To this point we have analyzed the benefits and costs associated with macroeconomic coordination. Obviously, the relevant concept is the net benefit. For instance, a high level of synchronism of the countries' cycle—perhaps the most significant cost— reduces the costs of forgoing economic policy instruments and, therefore, increases the net benefit of macroeconomic coordination. One factor to be borne in mind is that some of the elements analyzed so far are interrelated, as proved by the fact that the greater the trade and financial interdependence, the more synchronous the cycles will be. Therefore, in this case the benefits and costs will be simultaneously affected, increasing the net benefits from macroeconomic coordination.

In the case of NAFTA, the negative correlation of the terms of trade would seem somewhat strange, particularly if we consider that there is a positive correlation between export and import prices in countries belonging to the bloc. This can be partly explained by a positive correlation between export and import prices for each country and by the fact that what is being correlated is the rate of change in terms of trade. 37

Forbes and Rigobon (2000), for example, find that all correlations between the return on Brady bonds exceed 0.8 for a sample of 13 emerging countries. For the same sample of countries, they also find a significant correlation in returns on stocks. Further estimates show a high level of correlation between returns on sovereign paper for a sample of emerging countries, although, for Argentina, the correlation begins to decline in mid-2001 until it disappears. 38 See Calvo (2001) and Calvo, Leiderman and Reinhart (1993). For an assessment of the importance of these factors during the 1970s, that is, during the first upswing in private capital income in the region, see Devlin (1989). 39 40

SeeGhymers(2001). Ibid.

16O

Macroeconomic Coordination in the Region

COORDINATION IN PRACTICE

Figure 7.7

161

Convergence in the EU

a. Inflation Rate (In logarithms)

Setting aside conceptual considerations for a moment, practical experience has shown that difficulties with the positive incentives. Little progress has been made in this area, with the obvious exception of the European Union.

However, in some subregional

integration

agreements, there have been attempts at macroeconomic cooperation driven by the success of the European experience, and by greater

interdependence

within each bloc. When reviewing past experiences, it should be borne in mind that macroeconomic coordination efforts are not limited strictly to integration arrangements, since they also derive from the acknowledgement of

mutual

interdependence

in the global

framework. One example is the attempt by the G-5

b. Fiscal Deficit

(later expanded to the G-7) to coordinate macroeco-

(In percent of GDP)

nomic policies during the latter half of the 1980s. Recognizing the need for coordinated action to resolve macroeconomic disequilibria among major industrial countries, the countries adopted a form of multilateral oversight through objective indicators. The aim was not only to coordinate exchange rates or interest rates, but also other national policies that supported those objectives. Some of the obstacles faced by these agreements were increasing capital flows that made independent monetary policy difficult, the absence of consensus on inflation risks (consensus on the underlying

model),

problems in agreeing on fiscal policies, and the absence of independent

central banks that limited

agreements between policy authorities. Cooperation

Source: IDB calculations based on IMF (2001 b).

was nonetheless an important factor in heading off Second, exchange rate policy agreements led

major international tensions. The achievements and setbacks that character-

to de facto convergence of fiscal and monetary policies

ized the long European experience provide useful les-

and inflation rates, as it became more evident that

sons for other integration agreements.41 First, in

enhanced stability was a requirement for macroeco-

Europe, exchange rate policy was a decisive element in

nomic cooperation. Figure 7.7a shows that the conver-

macroeconomic cooperation. Following the end of the

gence of the European Union economies, as measured

Bretton Woods agreement on fixed exchange rates,

by the reduction in the inflation rate and its variance

and faced with tensions between member countries

among countries, was achieved during the years pre-

caused by floating exchange rates, European countries

ceding the Maastricht agreement, although the agree-

instituted different exchange rate arrangements to

ment seems to have been essential in aligning fiscal

maintain some degree of stability within the region.

deficits (Figure 7.7b).

Accordingly, exchange rate policy became the vehicle for indirect monetary and fiscal policy coordination.

See Eichengreen (1993), Goodhart (1995) and Ghymers (2001).

macroeconomic coordination seem to have exceeded

CHAPTER

Third, progress was gradual and resulted from mutual trust created between national representatives, fostered by periodic meetings between the key policy and economic players and the functioning of technical groups that included members from the different countries involved. This approach and compliance with certain agreements reduced the risk that the parties would engage in opportunistic behaviors. Fourth, the experience of the 1980s clarified the need for the assessment of compliance with the agreements not to be limited to the policy authorities of the countries. Rather, the assessments should be broadly disseminated, as should the recommendations provided by the members of the agreement or the supranational organizations regarding how to correct imbalances. This approach allows for oversight of the policy authorities by their own citizens and the international community (countervailing powers). At the same time, it improves the market credibility of the agreements so that countries can be rewarded or punished accordingly. Finally, supranational organizations play an important role in enabling criteria shared by the parties to be established, ensuring some degree of independence in assessing national policies, and providing recommendations on how to correct economic policy deviations. In this area, as in many others, it is advisable to make progress incrementally, beginning with institutional rules that do not significantly reduce the autonomy of the countries. Perhaps the most important lesson from the European Union is that the attempts at macroeconomic cooperation consistently complemented progress toward integration. In other words, interdependence provided incentives for coordination, and macroeconomic cooperation, particularly in the area of exchange rate arrangements, allowed enhanced interdependence.42 What can be said about macroeconomic coordination efforts in Latin America? Box 7.4 shows that some integration agreements have attempted to follow European convergence criteria (Maastricht). Mainly because there were no incentives for compliance, these attempts were not very significant. However, beyond the absence of agreements to achieve a certain degree of macroeconomic convergence, the different blocs and the region as a whole have con-

verged toward more responsible macroeconomic policies. Figures 7.8a-d show a decline in inflation levels and its dispersion among the member countries of different agreements during the 1990s. In the area of exchange rate policy, there have been few coordination efforts. This is of course explained by the existence of different exchange regimes within some blocs, and by problems in defending the value of the local currency against speculative attacks. Clearly, it is difficult to coordinate exchange rate policies when economies have "polarized" exchange rate schemes, such as convertibility or dollarization, and floating exchange regimes. Figure 7.9 shows the differences in exchange rate regimes within the different blocs.43

WHAT OPTIONS ARE AVAILABLE? Progress in macroeconomic coordination under integration agreements is complex from the economic and political standpoints. The scarce progress in Latin American subregional agreements is a clear manifestation of these difficulties. From the economic standpoint, although trade interdependence increased during the 1990s, it is still considerably lower than the levels in other regional agreements. While levels of financial interdependence are much higher than they were a decade ago, attempts by countries to differentiate themselves from a partner have been decisive in moments of crisis, aggravating political problems and undermining progress in the integration process. The perception that coordination with regional partners generates more negative than positive externalities is crucial to explain this attitude. In turn, it leads to the increasing conviction that the partner will behave in an uncooperative manner, which further weakens the prospects for progress in macroeconomic policy coordination.

Europe is also a case in which macroeconomic cooperation was accompanied by coordination in other areas (policy on labor, income, mobility of goods and services, capital markets, etc.), which helped increase interdependence.

The IMF classification used has the problem that some schemes appear to be floating regimes, but perform otherwise. See Calvo and Reinhart (2002).

162

Macroeconomic Coordination in the Region

Macroeconomic Cooperation in Practice

• Andean Community (AC)

2002: Adoption of common objectives that would include a maximum of 5 percent inflation and targets for fiscal variables.

1997: An advisory council was created for central bank governors and treasury ministers. 1999: Inflation convergence criteria were adopted. 2001: The target of single-digit inflation was agreed upon for December 2002. Fiscal convergence criteria were adopted (ratio between deficit and GDP and public debt and GDP not to exceed 3 percent and 50 percent, respectively). A community monitoring system was established in compliance with targets.

The growing interconnections between the economies involved as a result of NAFTA has led to an enhanced exchange of information and more effective informal contacts among the authorities.

• The Caribbean Community (CARICOM)

• European Union (EU)

1997: The Council for Finance and Planning was established, indicating a willingness to coordinate fiscal and monetary policies, and particularly interest rates, exchange rates, tax structures and budget deficits. Late 1990s: Convergence criteria were established to determine eligibility for monetary union, consisting of a rule on exchange rates, reserve coverage, and a debt service to export ratio.

1970s: Coordination mechanisms were consolidated in light of the instability following the breakdown of the Bretton Woods agreement. The Werner Report (1970) proposed a monetary union. The currencies of the European Economic Community were tied through the European mechanism for managing currency fluctuations beginning in 1972, although the macroeconomic instability that characterized the first half of the 1970s made convergence impracticable. The European Monetary System (EMS) was established in 1978 and the currencies of eight countries were linked through the Exchange Rate Mechanism (ERM), which permitted fluctuations within pre-established limits. Between 1979 and 1987, there were 11 realignments, although the parities were maintained under the agreement from that time until 1992, when Great Britain left the system. Other currencies followed suit. 1993: Convergence criteria proposed in the Maastricht Treaty were adopted. 1999: Creation of the Monetary Union. 2002: The euro entered circulation.

• Central American Common Market (CACM) 1960s-80s: A region-wide policy of exchange rates pegged to the U.S. dollar was pursued, creating an implicit monetary area and achieving some degree of convergence. 1998: Objectives to control inflation were announced through budget deficit regulation and gradual elimination of the quasi-fiscal deficit. Late 1990s: Reciprocal consultations were increased between monetary authorities and financial system regulators.

• Southern Cone Common Market (Mercosur) 2000: The Macroeconomic Monitoring Group was established to harmonize statistical processes for calculation of certain key indicators (consumer price indices, budget deficit, and net debt of the consolidated public sector). A quarterly publication providing these indicators was introduced. A two-phase convergence mechanism was established as a transition through which countries would announce their objectives in terms of the indicators.

• North American Free Trade Agreement (NAFTA)

• Association of Southeast Asian Nations (ASEAN) During the late 1990s, a process was established to monitor the region's macroeconomic development and to stimulate adoption of transparent policies through a policy of revision. An initiative was also approved to provide support in the event of balance of payments crises.

The difference in the European experience is

ond, the gains associated with elimination of exchange

significant. In Europe, there are at least three types of

rate volatility with key trading partners; and third, the

incentives to comply with the objectives established under the Maastricht agreement and the Stability Pact. First, being considered a responsible country;44 sec-

For countries with better reputations, there are incentives to eliminate opportunistic behavior by the other members.

Box 7.4

163

CHAPTER

Figure 7.8

7 Convergence in Latin America a. Mercosur Inflation Rate

c. AC Inflation Rate

b. CACM Inflation Rate

d. CARICOM Inflation Rate

Note: All the series are in logarithms. Source: IDB calculations based on IMF (2001 b).

existence of a system of penalties for countries that fail to meet fiscal targets.45 These factors have not been present in South-South regional agreements, and particularly in Latin America. Under these agreements, qualifying countries as "responsible" in macroeconomic policy management for now and in the near future has nothing to do with meeting commitments within the area. Rather, it involves agreements with multilateral credit institutions, and particularly, with the International Monetary Fund. Although intra-bloc exports are substantial in a number of regional agreements, the levels registered in the European Union have not been

attained by any of them. Finally, the countries of the region have not established mechanisms to levy penalties for noncompliance with the proposed objectives. The relevant question then is whether it makes sense to attempt to coordinate macroeconomic policies under regional integration agreements in Latin America. One answer is that this depends on the intended level of integration. If the agreement's objective is a

Penalties should be commensurate with the purpose. In some cases, penalties entailing publication of slippages might be more effective than pecuniary Fines.

164

Macroeconomic Coordination in the Region

Exchange Rate Regimes in Latin America

1 Members of a monetary union whose currency is fixed with the dollar. Source: IMF, Exchange Rate Agreements, Annual Reports, various years.

free trade area, it would not seem necessary to move forward with significant forms of coordination, except perhaps efforts designed to avoid tax wars between the member countries. Even for agreements that attempt to move toward higher forms of integration, it might be argued that macroeconomic coordination should be the result of greater independence. For instance, if volatility of members creates problems

under the agreement, a need for coordination would arise in due course. However, as mentioned, the absence of macroeconomic coordination mechanisms weakens the process of integration. While the example of Europe is commonly used to affirm that demand for coordination increases with the level of interdependence, the European case shows that there is an interactive process between coordination and interdependence that

Figure 7.9

165

CHAPTER

makes them complementary. Therefore, the need arises to move forward jointly on both fronts. Due to the magnitude of the external shocks and the absence of an exogenous coordination mechanism similar to the one provided for the exchange rate under the Bretton Woods agreement during the early years of European integration, Latin America faces greater difficulties than Europe in coordinating its macroeconomic policy.46 What type of coordination is possible, then, in the subregional agreements in Latin America? Clearly, this will depend on the specific characteristics of each agreement, although certain general criteria can be established considering the international experience and the reality of the region. The European experience shows that there has been convergence as a result of establishing limits to the level of disequilibrium in the public accounts and inflation rates, as well as through the different attempts to coordinate exchange rate policy that culminated in the adoption of a single currency. The fact that Europe has not been willing or able to move forward toward higher levels of fiscal coordination might help to establish certain criteria for Latin America. It has been argued, however, that progress in areas that involve institutional changeâ&#x20AC;&#x201D;such as independence for central banks and price and wage flexibilityâ&#x20AC;&#x201D;would be more important than establishing goals for certain variables (Eichengreen, 1998). This is true to the extent that inflation and budget deficit reductions can be transient, and therefore it is better to emphasize the structural changes, such as independence of the central bank, which would make possible low long-term inflation rates. Regarding prices and wages, flexibility would make it easier to cope with asynchronous perturbations in a context of macroeconomic coordination.47 However, there is no way to ensure that the institutional changes will be permanent, as many of them are based on a law.48 Further, to the extent that the cooperative scheme requires generating confidence between the different countries involved, it would seem that this should be achieved by reducing volatility for a prolonged period of time so that stability becomes a public asset that instills confidence in the partners and will transcend the current government. Creating institutions that help maintain this stability in the medium term is of greater importance, and, accordingly, the institutions must be complementary with, rather than

substitute for, macroeconomic convergence. Similarly, creation of the institutions that facilitate flexibility in nominal variables would certainly support any coordination effort. In addition to macroeconomic convergence and the institutional reforms necessary to help sustain it in the long term, moving toward mechanisms of exchange rate coordination would also be advisable. Exchange rate volatility not only weakens the possibility of enhanced trade integration, but also generates policy tensions within the agreement. yVlacroeconom/c convergence. No one wants to associate with an unstable country. Besides, it is difficult to imagine that macroeconomic policies could be coordinated with a highly volatile partner. Macroeconomic stability is therefore vital in order to make progress in the integration process. This is where macroeconomic convergence matters: there are certain economic criteria essential to achieve stability, which is crucial for any integration agreement to function. Stability is therefore an objective shared by each country and by the regional bloc as a whole. A realistic mechanism for regional coordination, therefore, is convergence of fiscal policies (deficit and debt) and inflation rates. The European experience has shown that the acceptable fiscal disequilibrium should entail the structural deficit rather than the current one, i.e., the deficit adjusted by the level of economic activity.49 The history of Latin America suggests that the level of this deficit should be considerably lower than it is in Europe. Given the region's exposure to external shocks, a maximum level of current account disequilibrium, or at least

This does not imply that the region has no other mechanisms for exogenous coordination, such as the impact on financial regulations and supervision mechanisms for substantial foreign investment flows in the financial area.

47 From the standpoint of the change in relative prices, full price and wage flexibility would mean that changes in nominal exchange rates would not be necessary. Of course, in the case of contracts with nominal interest rates denominated in domestic currency, price deflation generates problems in the financial system beyond those produced oy a flexible exchange rate. 48

Argentina is one case where it can be argued that the low inflation rate for a decade ultimately proved to oe transient. However, Argentina also showed that institutional reforms (such as the loss of the central bank's independence in 2001) also ultimately proved transient. 49

Establishing the structural budget deficit as a target would eliminate objections involving the difficulty of implementing anticyclical fiscal policies, as has been the case in Europe.

166

Macroeconomic Coordination in the Region

Exchange rate coordination. The literature on

considered.

Furthermore, as the weakness of finan-

currency crises offers a number of explanations for

cial systems in emerging countries has been one of the

exchange rate variability, and therefore its volatility

main reasons for instability, it is important to achieve

within a bloc. In addition to these explanations, the

minimum harmonization criteria in the areas of finan-

existence of large external shocks and

cial regulation and supervision.

exchange rate regimes within integration agreements

different

In addition to moving forward with these crite-

must be considered. So far, we have discussed external

ria, it is important to know how to convert a regional

shocks and synchronism in economic cycles. When dif-

macroeconomic convergence agreement and the

ferent exchange regimes are involved, an external

appropriate institutional reforms for long-term stability

shock that has the same effect on the equilibrium

into a relevant instrument within the region and within

exchange rate of two countries can change the current

the international framework. To that end, beyond the

bilateral exchange rate between them, as is evident in

incentives generated by agreements with the interna-

the extreme case when one country has a fixed

tional credit institutions—which in any case function as

exchange rate and another a floating rate. Therefore,

"exogenous coordination" mechanisms—the region

the existence of similar exchange regimes should elim-

should set its own incentives. One possibility is to

inate at least one of the reasons for exchange rate vari-

assign more importance to convergence agreements,

ability within the bloc. When countries adopt managed

for example, through public dissemination of the results

floating regimes, coordinating exchange rates will

and recommendations to be made by a group of tech-

require, in addition to macroeconomic convergence,

nical experts to countries that have not observed the

substantial international reserves or the capacity to

agreed-upon

borrow in critical situations. This introduces limitations

guidelines. Another

possibility, which

may be complementary, would be to create a regional

to those schemes aimed to reducing exchange rate

fund for which access would be authorized, among

volatility through the establishment of floating bands

other requirements, when the countries meet the condi-

(the "European way"). However, this is particularly dif-

tions established under the macroeconomic conver-

ficult, since there is greater capital mobility than during

gence agreements. As noncompliance with the agreed

the 1970s and 1980s, and since, unlike Europe, there

terms would generate additional regional costs, the

are no loan agreements between countries in the event

rules of macroeconomic convergence—and the related

of critical situations, and none of the currencies in the

institutional reforms—would receive more serious con-

region can function as a reserve currency. On the other

sideration from the members, and from the interna-

hand, the alternative of adopting a fixed exchange sys-

tional community.

tem, or even dollarization, entails significant costs in

Since coordination in complementary areas

terms of flexibility to adjust to external shocks, as the

favors the integration process, which will increase the

recent Argentine experience shows. Thus, the decision

demand for macroeconomic coordination, it would be

to adopt a mechanism with these features cannot be

advisable for international organizations to support

based only on the attempt to reduce exchange rate

regional proposals aimed at that objective. The incen-

volatility to promote trade integration.

tives that these organizations might provide, in addition

In light of these observations, and the fact that

to technical cooperation, include rapid-disbursement

the domestic dollarization component plays a central

loans to support the implementation of common policies

role in selecting an exchange regime or in the

(rules of competition, trade standards, an institutional

exchange rate variability that countries are prepared

dispute settlement framework, establishment of regional

to accept in floating schemes, it does not appear real-

technical agencies, regulation and supervision of the

istic at this stage to propose exchange rate coordina-

financial system, etc.) and institutional reforms that

tion mechanisms, unless sufficiently broad bands are

would help macroeconomic policy coordination (inde-

involved. To the extent that different blocs must coexist

pendence of central banks, labor regimes, relations between the national and subnational governments, the social security system, etc).

See Zahler (2000).

of short-term external indebtedness, should also be 50

167

CHAPTER

with certain degrees of exchange volatility, and in light of the costs this imposes on the integration processes, transparent mechanisms to offset excessive changes in exchange parities should be considered. The compensation should be transient, not exceed the trade preference under the agreement, and take into account the exchange rate with the partner relative to the one with the rest of the world.51 Finally, since Latin America is exposed to large external shocks, particularly in terms of capital flows, reducing volatility and moving forward with macroeconomic coordination requires mechanisms that make it possible to manage abrupt changes in the

international environment. Beyond domestic policies directed toward that goal, progress must be made in redesigning the international financial architecture. While recommendations in this area are beyond the scope of this chapter, they clearly should include establishing effective financial facilities for automatic disbursementâ&#x20AC;&#x201D;in the event of liquidity restrictions and declines in terms of tradeâ&#x20AC;&#x201D;as well as loans from development banks to partly offset movements of private capital flows. The possibility of creating regional funds to offset these shocks, while laying the groundwork for progress with coordination within the regional framework, should also be explored.52

The more important factor is the exchange rate with the partner relative to the one with the rest of the world. In other words, similar exchange rate appreciation for members of the agreement with relation to the rest or the world should not be the object of compensation (Machinea, 2002). 52

Regarding regional funds, see Agosin (2001), Griffith-Jones (2001), Ocampo (1999) and Mistry (1999).

168

Macroeconomic Coordination in the Region

Agosin, Manuel. 2001. Fortalecimiento de la cooperacion financiera regional. Revista de la CEPAL. April. Arora, Vivek. 1999. Exchange Arrangements for Selected Western Hemisphere Countries. International Monetary Fund. Mimeo. Barreix, Alberto, and Luiz Villela. 2002. Coordinacion tributaria e integracion: Lecciones para el Mercosur. Inter-American Development Bank. Mimeo. Bayoumi, Tannin, and Barry Eichengreen. 1994. One Money or Many: Analyzing the Prospects for Monetary Unification in Various Parts of the World. Princeton University Studies in International Finance no. 76. Bayoumi, Tamin, and Paolo Mauro. 2002. The Suitability of ASEAN for a Regional Currency Arrangement. World Economy 24(7) July. Calvo, Guillermo. 2001. Globalization Hazard and Weak Government in Emerging Markets. InterAmerican Development Bank. Mimeo. December. Calvo, Guillermo, and Carmen Reinhart. 2002. Fear of Floating. Quarterly Journal of Economics. Calvo, Guillermo, Leonardo Leiderman, and Carmen Reinhart. 1993. Capital Inflows and Real Exchange Appreciation in Latin America: The Role of External Factors. IMF Staff Papers 40(1). De Gregorio, Jose, and Rodrigo O. Valdes. 2001. Crisis Transmission: Evidence from the Debt, Tequila, and Asian Flu Crises. World Bank Economic Review 15(2). Devlin, Robert. 1989. Debt and Crisis in Latin America. The Supply Side of the Story. Princeton, NJ: Princeton University Press. Dornbusch, Rudiger, Yung Chul Park, and Stijn Claessens. 2000. Contagion: Understanding How It Spreads. World Bank Research Observer 15(2) August. Eichengreen, Barry. 1993. European Monetary Unification. Journal of Economic Literature 31 (3) September.

1998. Does Mercosur Need a Single Currency? Center for International and Development Economics Research Paper C98-103, University of California, Berkeley. Eichengreen, Barry, Galina Hale, and Asoka Mody. 2000. Flight to Quality. Paper presented at the conference on "International Financial Contagion: How it Spreads and How it Can Be Stopped." World Bank, Asian Development Bank and International Monetary Fund. Eichengreen, Barry, Andrew Rose, and Charles Wyplosz. 1996. Contagious Crises. National Bureau of Economic Research Working Paper 6370, Cambridge, MA. Estevadeordal, Antoni, Brian Frantz, and Raul Saez. 2001. Exchange Rate Volatility and International Trade in Developing Countries. Inter-American Development Bank. Mimeo. Fanelli, Jose M. 2001. Coordinacion de politicas macroeconomicas en el Mercosur. Siglo Veintiuno de Argentina Editores and Red Mercosur. Fernandez-Arias, Eduardo, Ricardo Hausmann, and Ernesto Stein. 2001. Courting FDI: Is Competition Bad? Inter-American Development Bank. Mimeo. Fernandez-Arias, Eduardo, Ugo Panizza, and Ernesto Stein. 2002. Trade Agreements, Exchange Rate Disagreements. Inter-American Development Bank. Mimeo. Forbes, Kristin, and Roberto Rigobon. 2000. Contagion in Latin America: Definitions, Measurement, and Policy Implications. NBER Working Paper no. 7885, September. Frankel, Jeffrey, and Andrew K. Rose. 1998. The Endogeneity of the Optimum Currency Area Criteria. Economic Journal 108(449) July. Frankel, Jeffrey, and Shang-Jin Wei. 1998. Regionalization of World Trade Currencies: Economies and Politics. In Jeffrey Frankel (ed.), The Regionalization of the World Economy. Chicago: University of Chicago Press. Froot, Kenneth A., Paul G. J. O'Connell, and Mark S. Seasholes. 2001. The Portfolio Flows of International Investors. Journal of Financial Economics 59(2) February.

REFERENCES

169

CHAPTER

Ghymers, Christian. 2001. La problematica de la coordinacion de politicas economicas. ECLAC Series on the Macroeconomics of Development. Giordano, Paolo, and Josefina Monteagudo. 2002. Exchange Rate Instability, Trade and Regional Integration. Inter-American Development Bank. Mimeo. Click, Reuven, and Andrew K. Rose. 1999. Contagion and Trade: Why Are Currency Crises Regional? Journal of International Money and Finance 18(4) August. Goodhart, Charles. 1995. The Political Economy of Monetary Union. In Peter Kenen, Understanding Interdependence. Princeton, NJ: Princeton University Press. Griffith-Jones, Stephany. 2001. Reforms of the International Financial Architecture: Views, Priorities and Concerns of Governments and the Private Sector in the Western Hemisphere and Eastern Europe. Institute of Development Studies, University of Sussex. Hausmann, Ricardo, Ugo Panizza, and Ernesto Stein. 2001. Why Do Countries Float the Way they Float? Journal of Development Economics 66(2). Hernandez, Leonardo, and Pamela Mellado. 2002. slncrementan los acuerdos de integracion regional la interdependencia financiera? Inter-American Development Bank. Mimeo. Heymann, Daniel. 2001. Regional Interdependences and Macroeconomic Crises. Notes on Mercosur. ECLAC Studies and Perspectives Series no. 5. ECLAC, Buenos Aires. Inter-American Development Bank (IDB). 1995. Overcoming Volatility. Economic and Social Progress Report in Latin America. Washington, DC: IDB. International Monetary Fund (IMF). 2001 a. Direction of Trade Statistics. Washington, DC: IMF. 200 Ib. International Financial Statistics. Washington, DC: IMF.

200Ic. World Economic Outlook. Washington, DC: IMF. Krugman, Paul. 1993. Lessons of Massachusetts for EMU. In F. Giavazzi and F. Torres (eds.), The Transition to Economic and Monetary Union in Europe. New York: Cambridge University Press. Machinea, Jose Luis. 2002., La volatilidad cambiaria y la coordinacion macroeconomica en el Mercosur. Inter-American Development Bank. Mimeo. Mckenzie, Michael D. 1999. The Impact of Exchange Rate Volatility on International Trade Flows. Journal of Economic Surveys 13(1) February. Mistry, Percy S. 1999. Coping with Financial Crisis: Are Regional Arrangements the Missing Link? In UNCTAD, International Monetary and Financial Issues for the 1990s, vol. 10. Geneva. Ocampo, Jose Antonio. 1999. Reforming the International Financial Architecture: Consensus and Divergences. CEPAL Serie-Temas de Coyuntura no. 1. Forthcoming. Developing Countries' Anticyclical Policies in a Globalized World. In Amitara Duff and Jaime Ros (eds.), Development Economics and Structuralist Macroeconomics Essays in Honour of Lance Taylor. United Kingdom: Edward Elgar. Panizza, Ugo, Ernesto Stein, and Ernesto Talvi. 2000. Measuring Costs and Benefits of Dollarization: An Application to Central American and Caribbean Countries. Inter-American Development Bank. Mimeo. Steinherr, A. 1984. Convergence and Coordination of Macroeconomic Policies: Some Basic Issues. European Economy no. 20, July. World Bank. 2001. World Development Indicators. Washington, DC: World Bank. Zahler, Roberto. 2000. Estrategias para una cooperacion/union monetaria. Integracion y Comercio no. 13, January-April. Inter-American Development Bank.

17O

TRADE AGREEMENTS, EXCHANGE RATE DISAGREEMENTS

Problems often arise when partners in regional inte-

ful, or whether similar problems can be expected fol-

gration agreements (RIA) have divergent exchange

lowing devaluation in non-member trading partners.

rate policies, as has happened in recent years with the

Types of problems that emerge include the following: •

Southern Cone Common Market (Mercosur). The Janu-

Increased protectionism and the scaling

ary 1999 devaluation of the Brazilian real strained the

back or elimination of trade arrangements: The coun-

relationship between Argentina and Brazil, setting off

try that loses competitiveness as a result of a real

a series of events that included protectionist measures

exchange rate appreciation vis-a-vis its trade partners

in Argentina, Argentine businesses threatening to relo-

may resort to increased protectionism. The existence of

cate or actually relocating in Brazil, and additional

an RIA may preclude the country from increasing tar-

pressures on the Argentine peso. These events con-

iffs within the bloc. As a result, the country may

tributed along with many other factors to the end of the

increase protection vis-a-vis the rest of the world,

convertibility plan in December 2001.

resulting in trade diversion, or it may increase protec-

Problems such as these are not unique to Mercosur. They typically emerge when countries have trade

tion vis-a-vis the bloc partners, resorting to less transparent

methods such as antidumping,

sanitary

agreements but exchange rate disagreements. Similar

restrictions, or other administrative measures. This last

problems have occurred between Venezuela and

course of action defies the objective of increased trade

Colombia, or even in the European Union after the

integration within the bloc, an objective that may be

exchange rate mechanism (ERM) crisis of 1992. But

hurt further if increased protection brings about retali-

there is a difference. In Europe, the crisis occurred in

ation. Countries may also choose to scale back or

spite of—or as a result of the failure of—attempts to

abandon their trade arrangements altogether. • Reduction in trade flows: Exchange rate dis-

coordinate exchange rate policy among member coun1

tries. In contrast, there have been no such efforts to

agreements can lead to reduced exports from the coun-

coordinate exchange rates in most RIAs in the Americ-

try that loses competitiveness to its partner. If the

as or around the world.

disagreement occurs in the context of an RIA with high

This chapter looks at the circumstances and the types of RIAs under which exchange rate disagreements may arise, as well as the policy responses that can help alleviate such problems.2 Throughout the discussion of the potential problems, it is important to ask whether there is something special about being members of the same regional integration agreement that makes exchange rate disagreements particularly harm-

In the case of the European Economic Community (later the European Union), there was concern regarding exchange rate coordination as early as the 1957 Treaty or Rome, which already identified the exchange rate among its member states as a matter of common interest (Eicnengreen, 1997). 2 By exchange rate disagreements, we mean large swings in bilateral real exchange rates.

Chapter

CHAPTER

external protection, trade among partners may not reflect true comparative advantage, and it may be difficult for the country that loses competitiveness to redirect some of its exports to alternative markets. The protectionist pressures discussed above may also contribute to reduced trade flows. • Relocation of investments: Regional trade arrangements may spark intense competition for the location of investment. Elimination of trade barriers may induce firms to produce in a single location within a bloc, and serve the extended market from this location. This intensifies competition for foreign direct investment (FDI). Under these conditions, important swings in the bilateral real exchange rates may have significant consequences for the location of new investment, and in many cases may shift the location of existing investment as well. • Exchange rate crises: Depreciation in one of the member countries may reduce the credibility of the partner's commitment to a fixed parity, and can generate speculative attacks on its currency. A country may thus be forced to abandon its preferred exchange rate policy due to the exchange rate disagreement. This problem may be particularly relevant during periods of financial turmoil, when access to financial markets is hindered. To study these problems, this chapter draws on the experiences of 37 countries that belong to six different RIAs: Mercosur, the North American Free Trade Agreement (NAFTA), the Central American Common Market (CACM), the Andean Community (AC), the Association of Southeast Asian Nations (ASEAN), and the European Union (EU). The sample covers the period from 1989 through 2000 and includes SouthSouth, North-South, and North-North agreements. This facilitates study of whether the problems identified above are equally relevant for all types of RIAs, or whether they are more relevant to some than others. This, in turn, may provide useful insights regarding potential problems and policy issues for the Free Trade Area of the Americas (FTAA). In general, exchange rate disagreements are in fact more costly when they occur between RIA partners, having a greater effect on the balance of payments (both trade and FDI flows) and increasing the risk of currency crises.

EXCHANGE RATE DISAGREEMENTS AND PROTECTIONISM One of the reasons why exchange rate disagreements may harm members of regional integration agreements is that they often lead to protectionist pressures, thus preventing the gains from trade from being realized. In the context of the European Union, Eichengreen (1993) has argued that this political economy argument represents the only compelling reason for monetary unification to follow the Single European Act. "[W]ider exchange rate swings would compound the adjustment difficulties associated with completing Europe's internal market. If national industries under pressure from the removal of barriers to intra-European trade find their competitive position eroded further by a sudden exchange rate appreciation, resistance to the implementation of the Single European Act would intensify. The SEA might be repudiated. In this sense, and this sense alone, monetary unification is a logical economic corollary of factorand product-market integration." There are plenty of examples of protectionist pressures following large exchange rate swings in the context of the European Union. The September 1992 ERM crisis, for instance, gave rise to considerable tensions among the EU member countries. These tensions emerged in part as a response to the relocation of several production plants to the United Kingdom following the depreciation of the sterling, the most prominent being the move of the Hoover vacuum cleaner plant from Dijon to Scotland.3 France accused the United Kingdom and Italy of harming the overall stability of the European Union. French public officials went as far as to threaten the British with exclusion from the single market, and even EC Commission President Jacques Delors got into the act, warning the British about the incompatibility of their exchange rate policies with the single market.4 French entrepreneurs started calling for protectionist measures, while Belgium's finance minister

Another notable case was that of Phillips, which relocated the production of cathode tubes from the Netherlands to the United Kingdom. See Eichengreen (1993) and Eichengreen and Wyplosz (1993). 4

See Eichengreen (1993).

172

Figure 8.la

Bilateral Real Exchange Rate

Note: t is defined as the month of the episode. One month before the episode the index is 100. The episodes analyzed are the Brazilian devaluation of January 1999 for Argentina, the pound devaluation of September 1 992 for France and the United Kingdom, and December 1994 for the United States and Mexico. Source: Fernandez-Arias, Panizza and Stein (2002).

Figure 8.1b

Multilateral Real Exchange Rate

173

a full-blown single market that allows no restrictions on factor flows, no subsidies for domestic industries, and no national preferences for public procurement. Thus, the impact of a given currency swing on the profitability of national industries should be larger than in other RIAs, and so should the extent of lobbying for protection and subsidies.5 As an example, Eichengreen points to the case of NAFTA, where Mexico's 1994 depreciation led to complaints in the United States, but not to the adoption of any protectionist measures.6 There are a number of arguments, however, that point in the opposite direction. First, countries in other RIAs, and in particular developing countries, have more limited access to financial markets, particularly in periods of financial turmoil when capital inflows come to a sudden stop, and therefore have more limited tools to defend their currencies.7 Thus, while similar swings in exchange rates may give rise to less protectionist pressures under conditions of shallow integration, the recent experience shows that exchange rate swings have not really been similar (Figures 8.la and b). Another way to look at the differences is to focus on the average volatility of real bilateral exchange rates for the 1990s. The EU is by far the RIA with the lowest volatility, while Mercosur is at the highest end of the spectrum (Figure 8.2).8 The EU also has much more power to enforce trade rules among its member countries than do countries in other RIAs, particularly those formed by developing countries. Thus, even if exchange rate swings were comparable, more

The Common Agricultural Policy (CAP) provides another reason for exchange rate coordination in the case of the EU. Note: t is defined as the month of the episode. One month before the episode the index is 100. The episodes analyzed are the Brazilian devaluation of January 1999 for Argentina and Uruguay, and the pound devaluation of September 1992 for France. Source: Fernandez-Arias, Panizza and Stein (2002).

warned of retaliatory trade actions against countries resorting to competitive devaluations. While Eichengreen (1993) cited the danger of a protectionist backlash as the main justification for the European Monetary Union, in a subsequent paper (Eichengreen, 1997) he pointed out that this reasoning does not necessarily carry over to other RIAs. The EU is

In fact, the devaluation in Mexico did generate some protectionist pressures, particularly surrounding the imports of Mexican tomatoes. Florida growers complained that Mexico was dumping the tomatoes at below cost prices. While the International Trade Commission ruled against the Florida growers' case, the Department of Commerce threatened Mexico with tariffs, and in the end Mexico agreed to a price floor for its tomato exports to the United States. In return, Mexican growers were able to export up to the quota that had been agreed to under NAFTA. See "The Tomato Debate Between Mexico and the United States" (www.american.edu/TED/TOMATO.HTM) 7

Calvo (1998) has used the term "sudden stop" referring to large reversals in capital inflows.

In a 1998 study on Mercosur, Eichengreen also finds that its member countries have too much exchange rate volatility, even after controlling for a number of factors such as country size, trade linkages, correlation of business cycles, and similarities in the composition of trade.

â&#x20AC;˘Trade Agreements, Exchange Rate Disagreements

174

CHAPTER

lobbying in the case of the ED need not result in more

Figure 8.2

protectionism.9

Intra-regional Volatility of the Real Multilateral Exchange Rate, 1989-2OOO (In percent)

The comparison to NAFTA may not be the ed States, whose real effective exchange rate suffered only a minor blip in December 1994. In contrast, a country such as Brazil is the most important trading partner for each of its Mercosur partners.10 The 1999 devaluation in Brazil gave rise to significant protectionist pressures in its RIA partners. While none of the countries threatened to leave Mercosur, there was talk in Argentina of scaling the customs union back to a free trade area. More recently, Uruguay, which was hit by the double whammy of Brazil and Argentina, has started negotiating a free trade area with the United States independent of its Mercosur partners. Box 8.1 discusses some of the protectionist pressures that

Source: IDB calculations based on IMF, International Financial Statistics.

occurred in Argentina as a result of the devaluation in Brazil, as well as trade disputes linked to exchange rate swings in the Andean Community. The box suggests that these problems will be particularly damaging in countries with strong exchange rate commitments that also have large and volatile RIA partners.

centage, compared to exports in the opposite direction.12 The figures also suggest, however, that the

REAL EXCHANGE RATE MISALIGNMENTS AND EXPORTS

tradable producers' concerns about the effect on exports seem to be justified. Exports to Brazil from Argentina and Uruguay fell by 28 percent and 40 percent in 1999, respectively. Likewise, exports from

Concerns regarding exchange rate disagreements on the part of tradable producers in the country that "suffers" the disagreement are generally twofold: they worry about an avalanche of imports from the depreciating country; and they worry about the effect of the

France to Italy and the UK fell by 8 percent and 23 percent in 1993. But how costly is this reduction in exports? The answer is that it depends. If a country that suffers an exchange rate realignment by a trading

exchange rate swing on their capacity to export. Are these concerns justified? A look at the behavior of bilateral trade during episodes of exchange rate realignments suggests that the concern regarding an avalanche of imports seems unwarranted. Figures 8.3a-e show the evolution of exports between Argentina and Brazil, Uruguay and Brazil, France and the United Kingdom, France and Italy, and the United States and Mexico around episodes of large exchange rate swings. As expected, exports from the country that loses competitiveness fell quite substantially. In nearly all cases, however, exports from the depreciating country to its partners did not increase. In most cases these exports fell considerably, although by a smaller per-

Obstfeld (1997) makes a similar point, comparing the enforcement power of the ED to that of the World Trade Organization.

10 In the case of Uruguay, Brazil and Argentina in fact have similar shares. 11 Interestingly, volatility played a lesser role in Colombia and Venezuela, since the episodes of large deprecation in Venezuela in 1994 and 1995 were not perceived in Colombia to have permanent effects on the real exchange rate. 12 An exception is the case of Mexico and the United States, in which Mexican exports increased. In this instance, the devaluation coincided with the creation of NAFTA, which may be contributing to this result. In the rest of the cases, exports from the depreciating country may have declined due to valuation effects (if prices are set in domestic currency, prices in dollars will fall), protectionist measures by the partner, or the recessionary effects of the depreciation on the county's partners.

most useful one. Mexico is small compared to the Unit-

Figure 8.3a

Exports between Argentina and Brazil (In millions of US$)

Figure 8.3d

Exports between Italy and France (In millions of US$)

Figure 8.3b

Exports between Brazil and Uruguay (In millions of US$)

Figure 8.3e

Exports between Mexico and the United States (In millions of US$)

Figure 8.3e

Exports between France and the United Kingdom (In millions of US$)

Source: Fernandez-Arias, Panizza and Stein (2002).

175

â&#x20AC;˘Trade Agreements, Exchange Rate Disagreements

CHAPTER

Bex 8.1

8 Exchange Rate Disagreements and Protectionism

Protectionism in Argentina following the Real Crisis1 Since the Brazilian devaluation of January 1999, Mercosur has been the scene of a large number of disputes that have at times stressed the relations between its two largest members. The devaluation of the real, which produced a large swing in the bilateral real exchange rate, was compounded by a recessionary environment, as well as by the end of the transitory adaptation period that had allowed for a more gradual reduction of tariffs in sensitive sectors. In this context, the Brazilian devaluation generated great concern among Argentine entrepreneurs. One week after the devaluation, the Union Industrial Argentina was already publicly lobbying for a compensatory tariff mechanism on Brazilian imports, accompanied by drawbacks on exports to Brazil. While the Argentine government did not accede to this request, it did resort to a variety of protectionist measures in response to the industrial lobbies. The conflicts that followed were quite broad and involved many sectors. A few examples are discussed below. In the pork sector, Argentine producers had been complaining for years about Brazilian subsidies for pork production and export. Following the devaluation of the real, the Argentine government submitted the case to arbitration, in accordance with the dispute settlement mechanism agreed upon in Mercosur (see Chapter 4). After an unfavorable ruling, Argentine pork producers asked the government to set sanitary restrictions to impede imports of pork from Brazil. The Argentine government instead encouraged producers to reach a private agreement of voluntary export restraints with their Brazilian counterparts. An agreement was not reached, and in March 2000, the Argentine Association of Pork Producers accused its Brazilian counterparts of dumping. It asked for quotas on pork products originating in Brazil, countervailing duties on those imports, and an increase from 15 to 35 percent in the common external tariff for imports of pork products from outside the region. Ultimately, only this last measure was implemented. As a result, the "solution" ended up diverting trade away from other suppliers, in particular Italy and Spain. The iron and steel sector had been the center of repeated disputes even before the Brazilian depreciation. However, disputes intensified following the devaluation, which coincided with the end of residual tariffs that protected Argentine firms from more efficient Brazilian producers, and with a drop in aggregate demand.

In April 1999, the Argentine Ministry of the Economy ruled in favor of an anti-dumping demand by Argentina's Siderar S.A. against the Brazilian Companhia Siderurgica Nacional for imports of hot rolled steel. The measure imposed minimum prices of $410 per ton, below which other duties would apply. The Brazilian foreign affairs minister objected to the measure, and threatened to initiate a complaint in the World Trade Organization. The Brazilian firm, in turn, presented a formal note to the Argentine president, arguing that at that price, Argentine importers would be able to import cheaper steel laminates from outside producers, even paying for the 15.5 percent common external tariff. Ultimately, in December 1999, the Argentine government approved an agreement by which the Brazilian producers voluntarily agreed to limit exports to Argentina and impose minimum prices (between $325 and $365 per ton), in exchange for the elimination of anti-dumping duties. As a result of its inclusion in the adaptation period, the shoe sector had been protected from intraMercosur trade since the formation of the customs union. The devaluation of the real and the end of the adaptation period resulted in a substantial surge in Argentine shoe imports from Brazil, which increased nearly 30 percent. This, in turn, generated significant protectionist pressures from Argentine shoe manufacturers, who requested measures to compensate them for what they considered generous subsidies enjoyed by their Brazilian counterparts. While both private sectors were unsuccessfully trying to negotiate voluntary export restraints, the Argentine government introduced import license requirements, allowing up to three months for the approval of the licenses. This measure would have temporarily paralyzed imports of shoes. Brazil reacted immediately, announcing its decision to re-impose license requirements on 400 products of Argentine origin including chemicals, food products and autos. At the same time, it included Argentina on a list of countries whose exporters would be subject to inspections by the Brazilian Secretary of Sanitary Defense. In the end, cooler heads prevailed, as both governments encouraged their respective private sectors to negotiate a temporary voluntary export restraint.

Exchange Rate Swings and Protectionism in the Andean Community2 Colombia and Venezuela are mutually important trading partners, particularly for non-traditional exports. The year 1994 marked the beginning of a period of macro-

176

economic instability in Venezuela, which gave rise to large real bilateral exchange rate swings. In May 1994, the bolivar was allowed to float, after a period in which the exchange rate was fixed but inflation was high. This led to a large depreciation. While the depreciation of the bolivar caused concern among some sectors in Colombia (particularly Fedemetal, the association of metallurgic producers, and some agricultural sectors), these concerns were probably not as strong as those in Mercosur. The reason for this is twofold. On the one hand, the perception in Colombia was that, due to the magnitude of macroeconomic instability in Venezuela, the misalignment of the exchange rate would be shortlived. At the same time, some producers in Colombia actually benefited, not directly from the Venezuelan depreciation, but from its imposition of exchange rate controls, from which Colombian exports were exempt due to the payments agreement under ALADI. There were, however, a few episodes worth discussing. In the rice sector, Colombian producers were greatly affected by the depreciation of the bolivar. Colombian authorities were under heavy pressure from the rice producers to implement some protectionist measures against Venezuelan rice. The position of the Colombian authorities, in general, was to try to avoid measures against Venezuela that might strain the relations between the two countries. In response to pressures from the rice producers, however, they ended up imposing safeguards against Vietnamese rice instead. This happened in July 1994, right after the Venezuelan depreciation. Vietnam, apart from being an important supplier of rice to Colombia, was not a member of the GATT at the time, which made it easier for Colombia to

177;

impose this measure without risking a trade dispute with that country. The safeguard was eliminated a few months later, as soon as the Venezuelan real exchange rate came back to normal levels. As in the case of the pork sector in Mercosur, however, the measures ended up diverting trade from suppliers from outside the region. Following the 1996 real depreciation of the bolivar, Colombia finally did impose a safeguard against Venezuelan rice, which is still in effect. Venezuela's suspension of the ALADI payments system began with events in November 1995, when the country's real exchange rate (which was again fixed) was highly overvalued. This had serious effects on Venezuela's tradable producers and exerted great pressure on the balance of payments. To avoid a large devaluation, the Venezuelan authorities imposed a variety of protectionist measures. In November 1995, they suspended the ALADI payments system, a measure that would have serious effects on exports from Colombia. A few days later, they tried to impose a special exchange rate for ALADI imports, from the official exchange rate, at 170 Bs/US$ to the Brady Plan exchange rate of 330 Bs/US$. These events generated a heated reaction in Colombia. After threats of retaliation, Venezuela reversed its decision regarding the exchange rate, and reestablished the payments mechanism on November 24. After another attempt to impose restrictions on payments, Venezuela was forced once again into a large devaluation on December 12. 1

Based on Rozemberg and Svarzman (2002).

Based on Pardo (2002).

partner is able to shift its exports to other markets at a

vis its RIA partners has a larger impact, all else being

reasonable cost, then the consequences for exporters

equal, than a similar misalignment vis-a-vis nonmem-

should not be as harsh. If, on the contrary, exports to

bers. In other words, are exchange rate disagreements

the partner cannot easily be relocated to other markets,

potentially more harmful between countries

exporters will suffer. This suggests that what is crucial is

regional integration agreements?

the evolution of total exports, not just bilateral exports,

with

Why would the impact be any different? Our

around these episodes of exchange rate disagree-

main hypothesis is that RIAs, depending on their

ments.

nature, can affect the degree to which exports can be This section looks at the impact of real

relocated in the event of an exchange rate disagree-

exchange rate misalignments on total exports. In par-

ment. By virtue of the preferential access with its RIA

ticular, it tests whether a country's misalignment vis-a-

partners, a country can export goods in which it is not

â&#x20AC;˘Trade Agreements, Exchange Rate Disagreements

CHAPTER

internationally competitive. If these exports are suddenly curtailed due to a depreciation in the RIA partner, it may be very hard to find alternative markets for these goods. Following Bergara, Dominion! and Licandro (1995) and Bevilaqua, Catena and Talvi (2001), exports that cannot easily be relocated can be labeled "regional goods." Consider the case of trade in agricultural products in the European Union, or automobile trade in Mercosur. Argentine car exports to and from Brazil are made possible by preferential access, and by a special regime that translates into high protection on car imports from the rest of the world. If for whatever reason (say, a depreciation) Brazil were to stop demanding Argentine cars, it would be difficult for Argentine producers to find alternative markets. Consider instead a commodity such as oil, another of Argentina's main exports to Brazil, and a product in which Argentina is internationally competitive. If for whatever reason Brazil's demand for oil were to decline, oil producers in Argentina would be able to relocate these exports somewhere else, even if this relocation were not costless.13 It should be pointed out that regional goods might also exist in the absence of regional integration agreements. Some goods, such as fresh milk or services provided to tourists in regional vacation destinations, may only be tradable regionally. In these cases, the regional character of the goods is due not to preferential access, but to geographical proximity.14 However, RIAs are likely to increase the importance of regional goods, because preferential access may create a demand for goods that are not internationally competitive.15 If regional integration agreements increase the importance of regional goods, total exports would be expected to decline more when the exchange rate is overvalued with respect to RIA partners, and less when the overvaluation occurs vis-a-vis other countries. To study whether this hypothesis has empirical support, we need to follow a number of steps.16 First, we need to define when a country's currency is overvalued, and what is the extent of the overvaluation. This is done by means of econometric techniques, which decompose the real exchange rate into a trend (or "equilibrium" level) and the deviations from this trend.17 When the exchange rate is below its equilibrium level (measured as the price of the foreign currency in terms of the

domestic one), the exchange rate is overvalued, and the extent of overvaluation is given by the percentage deviation from the trend. We can now ask whether overvaluation leads to a decline in total exports. The results presented in Figure 8.4a suggest that, all else being equal, an overvaluation of 10 percentage points would be associated with a decrease in total exports of 6 percent.18 Next, we decompose the misalignment into regional and nonregional components. Each of these components represents the contribution of RIA partners and that of countries outside the RIA to the overall misalignment. Consider, for example, a country in the EU. If 60 percent of this country's trade occurs within the bloc, and the exchange rate of this country is overvalued by 5 percent with respect to its RIA partners, the contribution of the RIA to the country's overall misalignment will be an overvaluation of 3 percent. Consider instead a country in the Central American Common Market (CACM), where only 10 percent of trade occurs within the bloc. If the exchange rate of this country is overvalued by 5 percent vis-a-vis its RIA partners, the RIA contribution will be only 0.5 percent. It is obvious that a 5 percent within-bloc misalignment should have larger effects in the first case. That is why the variables of interest are not the within-RIA and outside-RIA misalignments, but rather the contributions of RIA countries and other countries to the overall misalignment. In other words, the question we ask is if the effect on exports of a given overall overvaluation is the same, regardless of the source (within or outside RIA) of the overvaluation.

Taken from Bevilaqua, Catena and Talvi (2001).

In the case of some agricultural products, tradable goods may also become "regional" as a result of protectionist policies in the rest of the world. 15 In addition, RIAs may lead to the adoption of common standards and regulations, or through their effect on trade, to more uniformity in demand among member countries. Either of these factors would make relocation of exports more difficult, and thus increase the degree of "regionality" of trade. 16 For a more complete treatment, see Fernandez-Arias, Panizza and Stein (2002). 17 Details of the de-trending methodology used are provided in Appendix 8.1. 18

Appendix Table 8.1 presents the results of the regressions.

178

â&#x20AC;˘Trade Agreements, Exchange Rate Disagreements

Figure 8.4a

Effect of Real Exchange Rate Misalignments on Exports Depending on Source of Misalignment (In percent)

179

The results in Figure 8.4a suggest that the regional goods channel discussed above may be at play. However, if the presence of regional goods is a function of the degree of preferential access a country has vis-aalignments on total exports should be a function of this preferential access. Figure 8.4b repeats the previous experiment, but this time we separate countries into two groups: those for which the degree of preferential access to their RIA partners is large, and those for which it is small. The effect of overvaluation on exports is only large and significant when the overvaluation comes from within an RIA with high preferential access.20 These results lend some support to the hypothesis that regional goods play an important role in magnifying the impact of exchange rate misalignments within highly protected regional integration agreements.21 It is important to keep in mind that the prob-

Figure 8.4b

Effect of Real Exchange Rate Misalignments on Exports Depending on Degree of External Protection of RIA

lems a country will face in this regard will be in direct

(In percent)

It is unlikely, for example, that such problems may arise

proportion to the size and volatility of its RIA partners. in the context of the CACM. Since trade within that RIA only represents a small portion of overall trade, the contribution of the RIA countries to overall misalignment is likely to be small.

EXCHANGE RATE DISAGREEMENTS AND THE LOCATION OF FOREIGN DIRECT INVESTMENT The relocation of the Hoover production plant from France to Scotland mentioned earlier is just one such episode to result from exchange rate disagreements between partners in regional integration agreements. A more recent example was the move to Brazil of sev-

Source: Fernandez-Arias, Panizza and Stein (2002).

eral Argentine auto parts companies following the devaluation of the real. The Venezuelan devaluation of 1994 also led to a number of investments there by The answer shown in Figure 8.4a is that it is

Colombian nationals (see Pardo, 2002).

not (see also column 2 in Appendix Table 8.1). Overvaluation has larger effects when its source is the RIA. An RIA contribution of 10 percentage points to the overall overvaluation reduces total exports by 14 per-

cent, while a similar contribution from outside countries

reduces exports by only 3.5 percent.

Moreover, the

difference between within-RIA and outside RIA contributions is statistically significant.

In this last case, the effect is not statistically different from zero.

See Appendix 8.1 for details on the methodology, and column 5 in Appendix Table 8.1 for the results.

If the differential effects of regional versus nonregional misalignments were solely due to geographical proximity, we would not have expected different effects for the high and low protection cases.

vis its RIA partners, then the impact of regional mis-

CHAPTER

There has been some debate in the literature regarding the potential effects of exchange rates on FDI. Most of the work in this area was inspired by the spectacular increase in FDI into the United States following the depreciation of the dollar in 1985 (Feenstra, 1999). This literature identifies several channels through which depreciation can be associated with larger FDI inflows. The first, proposed by Froot and Stein (1991), is related to capital market imperfections. In particular, informational asymmetries regarding the value of an investment will limit the leverage of firms, making it costly or impossible to fully finance the investment through borrowing. Changes in the real exchange rate affect wealth, and thus borrowing constraints. If foreigners tend to hold relatively more nondollar assets, a depreciation of the dollar increases their relative wealth, and relaxes their borrowing constraints. This in turn will allow them to acquire more investments abroad. Blonigen (1997) proposes an alternative channel. He notes that the acquisition of a firm allows knowledge transfers from the parent company to the subsidiary, but also from the subsidiary to the parent company. This knowledge may take the form of a product or process development. If this technology can be applied by the parent company in its own market, this would lead to a stream of profits in the home market, in domestic currency. If this is so, a depreciation in the target host country lowers the cost of this stream of revenues. This may explain why a Japanese firm may invest more in U.S. assets following a depreciation of the dollar, particularly in sectors that are intensive in research and development. While this last channel seems like a plausible story for FDI between developed countries, it does not fit well with North-South FDI. Firms in developed countries rarely would acquire a firm in a developing country in the hope of obtaining a technology to apply in the home country. Their multinational activity in the South is usually done for one of two reasons: either to take advantage of the difference in relative factor endowments in order to reduce overall costs of production (as in the vertical models of FDI), or to serve a protected market that would be too expensive to serve through trade (as in the horizontal models of FDI).22 In the case of vertical FDI, firms that produce for the world market locate different stages of production in different

countries in order to reduce costs. As the level of the real exchange rate generally affects the cost of land and labor, a depreciated exchange rate will attract FDI in activities that are intensive in these factors. In the case of horizontal ("tariff-jumping") FDI, whether a firm engages in FDI in a particular country will depend on the relative cost of serving this market via either trade or domestic production. All else being equal, an exchange rate depreciation in the host country will reduce the cost of producing the good through multinational activity, and thus may result in higher FDI. These channels suggest that movements in the bilateral exchange rate between two countries will affect the relative amounts of FDI these two countries receive. But are exchange rate swings more likely to have large effects among countries with trade agreements? In the case of vertical FDI, in which a firm produces for the world market, a depreciation may favor location in the depreciating country at the expense of all other potential hosts with similar factor endowments, if production is for a regional market, however, countries that are both similar and proximate should suffer more from another country's depreciation. To the extent that RIAs include countries that are both similar and proximate (as in South-South and North-North RIAs), RIA partners may be more sensitive to exchange rate swings. But, through this vertical FDI channel, sensitivity will be due mostly to proximity, not to the RIA itself. In the case of horizontal FDI, however, RIAs create an enlarged internal market protected from the outside world. Provided there are economies of scale, the elimination of trade barriers within the bloc will induce firms to produce in a single location, and serve the extended market from this location. Regional trade arrangements may thus create a space of intense competition for the location of investment, not unlike that which often exists among states of a single country (see Box 7.3 in Chapter 7). Under these conditions, swings in the bilateral real exchange rates that affect relative costs of production in countries in the bloc, to the extent that those swings are perceived to be permanent, may have important consequences for the location of new investment. In many cases they may shift the location of

22 For a discussion of the vertical and horizontal models of FDI, see Chapter 10 and Markusen and Maskus (2001).

ISO

Trade Agreements, Exchange Rate Disagreements

Figure 8.5

Effect of Exchange Rate Misalignments

181

TRADE AGREEMENTS AND CURRENCY CRISES

on FDI Inflows (In percent)

There have been several episodes during the 1990s when a devaluation by one country generated pressure ian lira from the European Monetary System in 1992, for instance, was almost immediately followed by the abandonment of the peg by the United Kingdom, causing enormous pressure on the French franc (Buiter, Corsetti and Pesenti, 1998). The depreciation of the Thai bhat in July 1997 was followed closely by depreciations in Singapore, Malaysia, Indonesia and the Philippines.25 The devaluation of the real in Brazil exerted pressure on the Argentine peso, and was one of the factors that contributed to the demise of the con-

Source: Fernandez-Arias, Panizza and Stein (2002).

vertibility plan.26 This in turn caused pressure on the Uruguayan peso, which was allowed to float in June 2002. Of course, there are also countless examples

existing investment as well. This argument suggests that

of contagion beyond RIAs. The Mexican peso crisis of

swings in the real bilateral exchange rate will have

1994 exerted strong pressures on the Argentine peso,

larger effects among members of an RIA. For this to

the 1997 Asian crisis on the ruble, and the 1998 Russ-

matter, however, external protection for the RIA has to

ian crisis on the real. It is not obvious, then, whether

be high enough to support horizontal FDI.

countries (and in particular, countries with strong

In order to evaluate this hypothesis, we study

exchange rate commitments) tend to be more severely

the effects of real bilateral exchange rates on relative

affected by depreciation within their respective RIAs. In

inflows of FDI, and check whether the response of rel-

this section, we attempt to see whether this is the case.

ative FDI to bilateral swings in exchange rates is larg-

The connection between currency crises and

er among RIA partners. Moreover, we study whether

prior misalignment of the real exchange rate is well

the results depend on the character of the country pair

established in the literature on leading indicators of

involved (North-North, North-South, or South-South).

crises.27 Goldfajn and Valdes (1997) show that an

After accounting for other determinants of rel-

overvalued real exchange rate increases the likelihood

ative FDI inflows (such as relative income or openness),

of a currency crisis under a number of alternative

Figure 8.5 finds that a 1 percent depreciation of the real bilateral exchange rate increases relative inflows by 1.3 percent when both countries are members of the same RIA.23 In contrast, the impact is not statistically

significant in the case of outside countries. If the exer-

cise is limited to South-South country pairs, we obtain similar results, but the impact is smaller (0.8 percent) among countries with RIAs. The largest impact is obtained for North-North country pairs with common membership in RIAs, in which case a 1 percent depreciation increases relative FDI by 1.9 percent. This may be due to the fact that the EU, which accounts for most North-North pairs in regional integration agreements, is much more deeply integrated than other RIAs.24

The complete results are presented in Appendix Table 8.2.

Part of this effect could be due to the proximity between countries that share common membership in RIAs. Future research might extend the sample of countries to the entire world in order to be able to discriminate between the effect of proximity and that of RIAs. 25 It also affected Hong Kong and Korea, which are not part of ASEAN. 26

The host of other factors that contributed to the end of convertibility included the sudden stop of capital inflows into the region, the depreciation of the euro, an unstable political environment, and the failure of the Argentine authorities to generate the required fiscal adjustments. 27

See Kaminsky, Lizondo and Reinhart (1998) for a survey of this literature.

on the currency of its RIA partners. The exit of the Ital-

CHAPTER

Figure 8.6

8 Effect of Real Exchange Rate Misalignments on the Probability of a Crisis (In percent)

Source: Fernandez-Arias, Panizza and Stein (2002)

measures of overvaluation and a number of definitions of currency crisis.28 The question here is whether the impact of overvaluation on the risk of currency crisis is any different when the currency is overvalued with respect to the partners in the regional integration agreement. In a sense, the answer to this question should be yes. One of the main channels of contagion identified in the literature is related to trade links between countries. Since integration increases trade links, countries that are tightly integrated should, all else being equal, be more vulnerable to each other's problems. The question is whether countries are more vulnerable to overvaluations within their regional agreements even after accounting for the effects of RIAs on trade links. The analysis and evidence shown in previous sections suggests a positive answer. The overall balance of payments impact of a given exchange rate misalignment with respect to a trading partner (both via exports and FDI inflows) appears to be larger if it happens within an RIA. In addition, RIAs constrain the ability of member countries to adjust to an adverse shock to competitiveness through the use of import tariffs and other offsetting trade policies.29 In other words, RIAs enlarge the balance of payments consequences of

exchange rate overvaluation and reduce the ability to offset them in ways that diffuse the downward pressure on the currency. This suggests that countries in regional integration agreements with exchange rate disagreements may be more prone to currency crises. Naturally, the problem will be more serious when the RIA partners are large and volatile. As we did for exports, we first look at the impact of an overall overvaluation in the previous month on the probability of a balance of payments crisis, regardless of the source of the overvaluation, and after accounting for other factors that may affect crises.30 Although we worked with different definitions of crisis, the preferred definition used for the calculations in Figure 8.6 was a monthly depreciation of the real effective (or multilateral) exchange rate of at least 5 percent.31 All else being equal, an overvaluation of 10 percent increases the probability that a crisis will occur during the next month by 2.3 percentage points. Since the average probability of a crisis in any given month was also around 2.3 percent, in effect a 10 percent overvaluation doubles this probability to 4.6 percent.32 Next, we decompose the overvaluation into the contribution of RIA partners, and the contribution of other countries, as explained above. A 10 percent overvaluation explained by exchange rate movements within the RIA increases the probability of a crisis by 4 percentage points. In contrast, a similar overall over-

The latter include large nominal depreciation in the spirit of Frankel and Rose (1996), their own definition based on large real depreciation, as well as an index of pressure on the currency that combines nominal depreciation with the loss of international reserves, as in Kaminsky and Reinhart (1999). 29 In the case of customs unions (unlike free trade areas), the country in question cannot even increase outside tariffs unilaterally. 30

We control for access to financial markets (lack of access tends to increase the probability of crises), and for recent changes of government (governments are usually reluctant to devalue before elections, and new governments can devalue early and blame it on their predecessors). 31

Other definitions used in the literature are more complicated (combining depreciations and reserve losses), use nominal depreciations (which requires some decisions in terms of how to deal with inflation), or have different thresholds per country, with the unappealing consequence that in very stable countries episodes of very small depreciations are counted as crises. 32

Note that a 4.6 percent probability of a crisis within the next month corresponds approximately to a 43 percent probability of a crisis within the next year.

182

183

valuation contributed by non-RIA countries increases

liabilities in both countries. Differences in the structure

the probability of crisis by only 1.7 percent. Moreover,

of liabilities may lead countries to respond to common

the two effects are statistically different. Results are fair-

shocks with different policies, which may result in sig-

ly similar when a crisis is defined as a real deprecia-

nificant exchange rate disagreements. Countries often

tion of 10 percent. Altogether, we worked with 10

decide to join RIAs due to geopolitical considerations,

different definitions of crises.

In nine out of 10, the

impact of a given overall overvaluation is larger when

however, so the scope for this policy may be somewhat limited.

the source of the overvaluation is within the RIA. In

Given its RIA partners, a country can adapt its

eight of 10, the impact is at least twice as large within

policies to reduce vulnerability to exchange rate dis-

the RIA. In most cases, however, the difference between

agreements. For example, it could relax or abandon

these effects was not statistically significant.

an exchange rate commitment potentially inconsistent with its partners' exchange rate policies, and thus avoid large overvaluation vis-a-vis its partners. Indus-

POLICY ISSUES

trial policy could also be adapted to protect the country against excessive specialization

in "regional

Traditional analysis of RIAs has focused mainly on

goods," that is, goods that are difficult to redirect to

trade issues, such as changes of trade patterns and

alternative markets outside the RIA bloc. Macroeconomic

their welfare implications. But potential problems

policy

coordination:

The

caused by divergent exchange rates within RIAs can

deeper and more comprehensive the RIA, the more

also have major welfare implications. Exchange rate

important the question of macroeconomic policy coor-

disagreements have more serious consequences when

dination. The European Union has always attached

they occur among countries bound by trade agree-

great importance to this issue. For Latin America, the

ments. They have a larger impact on exports, FDI, and

policy question is, at what point should the countries in

crises and contagion. Furthermore, exchange rate dis-

the region move in the direction of Europe by coordi-

agreements have the potential to break up or weaken

nating more forcefully with their RIA partners? And

support for RIAs themselves.

how serious should this coordination be? Should it

There are three types of policy issues linked to

involve specific outcomes or just policy rules, such as

the risks that emerge from exchange rate disagree-

inflation targets? Fiscal deficit and debt limits? Com-

ments: i) unilateral policies that countries may choose

pensatory income transfers between countries? A key

to make themselves less vulnerable to exchange rate

area is exchange rate coordination to avoid harmful

disagreements within RIAs; ii) macroeconomic policy

misalignments within RIAs. However, such coordination

coordination among RIA members; and iii) adequate

entails the loss of monetary independence. On one extreme is the possibility of a mone-

international financial architecture to support RIAs. Unilateral policies: The most direct way to

tary union, which would completely eliminate nominal

reduce the risks associated with exchange rate dis-

exchange rate misalignments.34 Such a union might

agreements within RIAs is for countries to take into

involve a new currency for the RIA, or the adoption of

account the potential divergence in exchange rate

the currency of the lead country, or even of an outside

regimes when choosing partners. The likelihood and

country with a strong currency. Short of a monetary

the size of the potential exchange rate shocks depends

union, coordination between national currencies may

on the underlying macroeconomic volatility of the part-

take the form of currency bands. Recent experience

ner, as well as its divergence in terms of fundamentals

with intermediate exchange rate regimes suggests that

and policy. From the point of view of an individual

such a solution may not be feasible in a world of high

country, countries with lower volatility and countries with similar (convergent) exchange rate regimes and cyclical macroeconomic patterns would make better

partners. Another important consideration may be the

term structure and currency composition of financial

See Fernandez-Arias, Panizza and Stein (2002) for details.

Monetary union, however, does not completely rule out exchange rate misalignments.

Trade Agreements. Exchange Rate Disagreements

CHAPTER

capital mobility. A lesser degree of coordination would entail RIA members avoiding the coexistence of inconsistent regimes (such as pegs and floating regimes) within the RIA. For example, the adoption of flexible regimes with similar inflation targets in all RIA partners may contribute to reducing exchange rate volatility. Alternatively, the pressure of large exchange rate misalignments on currencies and on the RIA itself may be diffused by designing more flexible RIAs, allowing temporary exceptions to some of the rules of the RIA for the country facing sudden depreciation by a partner. Supporting international financial architecture: This could facilitate international trade and reduce the risks associated with exchange rate disagreements in RIAs. There is a common interest in reducing exchange rate instability, of which competitive devaluations are an extreme example. However, global institutions in charge of monitoring and advising on exchange rate matters, such as the International Monetary Fund, have a national scope in dealing with each country's program. Within the bounds of this scope, country programs may support divergent exchange rate regimes within RIAs. Would it be advisable to empower global institutions to expand the national scope for the purpose of advising and for program conditionality? Lack of access to the international capital market increases the probability of a currency crisis. Archi-

tecture that ensures international financing to smooth out temporary shocks and efficiently limit financial and balance of payments crises would dramatically reduce the frequency and size of exchange rate misalignments within RIAs. In fact, misalignments often result from changes to financial rather than trade conditions. International financial turmoil and sudden stops to capital inflows associated with crises, a frequent occurrence in the developing world in the last five years, are major causes of significant exchange rate misalignments and subsequent currency crises. There is full agreement on the objectives of international financial architecture reform. The policy question in this case concerns whether to create regional institutions to perform some of these tasks until global institutions do so, or even to create them afterwards as a supplement. An example is the currency swap arrangements among some ASEAN countries, and the recent Chiang Mai initiative to expand the scope of those plans. A regional example is the Latin American Reserve Fund (LARF), which provides balance of payments support to the Andean Community and Costa Rica (see Chapter 5). The question remains as to whether regional financial institutions should be designed to provide liquidity in support of individual central banksâ&#x20AC;&#x201D;either in RIA member countries or beyondâ&#x20AC;&#x201D;in order to avoid unnecessary misalignments.

184

â&#x20AC;˘Trade Agreements, Exchange Rate Disagreements

APPENDIX 8.1 REGRESSION ESTIMATION

185

measured as a percentage of the multilateral equilibri-

CALCULATION OF MULTILATERAL, REGIONAL AND NONREGIONAL REAL EXCHANGE MISALIGNMENT To estimate the multilateral real exchange misalignment, we use the monthly real exchange rate variable from the IPS. The first step is to compute the equilibrium exchange Finally, we define REG-1 = w;R_/?EG(- f and

rate using a Hodrick-Prescott decomposition. The second step is to compute the exchange rate misalignment as the

NOREGjt = (]-w.)NR_REGj t. By weighting the regional

percentage difference between the actual and the equi-

and nonregional

librium real exchange rate. In symbols,

shares in total trade, we can interpret REG-1 as the con-

misalignments by their respective

tribution of the regional misalignment to the multilateral misalignment, and NOREGlt as the contribution of the nonregional misalignment of country / at time t.

COUNTRIES IN THE SAMPLE where RERit is the multilateral real effective exchange rate misalignment in country ; and time t; RERjf is the

For the estimation, we use all country pair combina-

level of the real exchange rate; and RER;t is the equi-

tions of the following countries and free trade agree-

librium level of the real exchange rate as predicted by

ments:

the trend in a Hodrick-Prescott decomposition for country / and time t.

European Union (EU): Austria, Belgium, Denmark, Fin-

The third step is to decompose the multilateral

land, France, Germany, Greece, Ireland, Italy, Luxem-

real exchange rate misalignment into a within-RIA

bourg, Netherlands, Portugal, Spain, Sweden, United

component (or regional misalignment) and an outside-

Kingdom

RIA component (or nonregional misalignment) as fol-

North American

lows:

Canada, Mexico, United States

Free Trade Agreement

(NAFTA):

Southern Cone Common Market (Mercosur): Argentina, Brazil, Paraguay, Uruguay Andean

Community

(AC):

Bolivia,

Colombia,

Ecuador, Peru, Venezuela where w( is the share of the RIA partners in total trade of country / and

R_RERift and

NR_RERit are the

Central American Common Market (CACM): Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua

exchange rate misalignments of country / with respect

Association of Southeast Asian Nations

to regional and nonregional trading partners, respec-

Indonesia, Malaysia, the Philippines, Singapore, Thai-

(ASEAN):

tively. The R_RERjt and NR_RERjt are weighted aver-

land (Brunei and Vietnam are also ASEAN members,

ages of bilateral exchange rate misalignment, with

but were excluded from the analysis because of the unavailability of data).

CALCULATION OF THE INDEX OF PROTECTION The index of protection measures for each country and where cofo(. and conofo; are weighted within and outside

the average level of protection of its RIA partners is

the RIA, respectively. In this way, the misalignments are

constructed as follows:

um level

186

CHAPTER

8 variable that assigns the value of 1 to countries that have RIA partners with average protection above the sample mean, and 0 to countries that have average protection below the sample mean. As a result of this

where trade- is the average trade between country /

belonging to highly protected RIAs: Argentina, Bolivia,

and country / between 1989 and 2000, t1995 is the

Brazil, Colombia, Costa Rica, Ecuador, El Salvador,

average external tariff of country / in 1995, and n is

Guatemala, Honduras, Nicaragua, Paraguay, Peru,

the number of countries that form the RIA of which

Singapore, Uruguay and Venezuela. Note that with the

country / is a member. The trade data are from the IMF

exception of Singapore, all are developing countries.

and the tariff data from the World Bank.

Likewise, we generate the low protection dummy vari-

Next we compute the sample mean of the pro-

able.

tection index and generate the high protection dummy

REGRESSION RESULTS Appendix Table 8.1 Exports and Real Exchange Rate Misalignments: Regression Results Dependent variable: Exports (log) Reg. 1 All countries Log(GDP) Total misalignment

0.433 (6.89)*** 0.613 (3.09)***

(a) Regional misalignment (b) Nonregional misalignment (c) High protection * Regional misalignment

Reg. 2 All countries

Reg. 3 Developing countries

Reg. 4 Developed countries

Reg. 5 All countries

0.433 (6.85)***

0.23 (1.93)*

0.42 (7.30)***

0.429 (6.81)***

1 (2 0 (1

2.649 (2.31)** -0.115 (0.30)

0.602 (1.20) -0.304 (0.86)

0.321 (1.25)

(2.93)*** 0.572 (0.72) -1.159 (0.74)

449

19)** 347 35)

2.9

(d) Low protection * Regional misalignment Constant

-1.263 (0.81)

-1 255 (0 80)

2.772 (0.98)

-0.01 (0.01)

No. of observations No. of pairs R2

394 36 0.79

394 36 08

208 19

185 17

0.79

0.91

394 36 0.8

Tests on difference between coefficients (a)-(b) (c)-(d) (c)-(b) (d)-(b)

1 102 [0.09]*

2.764 [0.02]**

0.906 [0.09]*

2.328 [0.025]** 2.579 [0.009]*** 0.251 [0.39]

Notes: Absolute value of t-statistics in parentheses, one tail p-values in brackets. Year dummies and country fixed effects included in all regressions not reported. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1 % level. Source: Fernandez-Arias, Panizza and Stein (2002).

calculation, the following countries were classified as

^SS^S3S^SSSS^SSSSB^SESS^S^^li^SS^^Sf^ Appendix Table 8.2

187

FDI and! Real Exchange Rate: Regression Results Dependent variable: FDI/FDIj (log) Reg. 2 South-South

All countries

GDP difference

1.5169 (16.386)***

1.1501 (5.843)*** -0.0127 (6.829)*** 0.7891 (2.604)*** 0.097 (0.552) -1.0844 (1.329)

0.001

Openness difference

(1.005) 1 .2991 (5.973)*** 0.1 19 (1.174) -1.8293 (3.690)***

(a) Same RIA * Real exchange rate (b) Not same RIA * Real exchange rate Constant

6,120

No. of observations No. of pairs

1.7225 (13.513)*** 0.0036 (2.650)*** 0.7142 (0.639) 0.304 (2.097)** -1.7156 (2.385)**

1,654 171 0.096

630

0.094

Reg. 4 North-North

Reg. 3 North-South

2.0372 (10.031)*** 0.0143 (6.488)*** 1.8943 (5.234)*** 0.4806 (1.227) -6.6943 (4.482)***

3,139 323 0.127

13,27 136 0.107

Tests on difference between coefficients

(a) - (b)

1.18

0.69

[0.000]***

0.41

[0.010]***

1.41

[0.355]

[0.000]***

Notes: Absolute value of t-statistics in parentheses, one tail p-values in brackets. Year dummies and country fixed effects included in all regressions not reported. * Significant at 10% level ** Significant at 5% level *** Significant at 1% level. Source: Fernandez-Arias, Panizza and Stein (2002). Appendix Table 8.3

Real Misalignments and Currency Crisis: Probit Regression Results Dependent variable: A crisis is a real devaluation A crisis is a real devaluation greater than 5%

Independent variables

Reg. 1

(a) Multilateral misalignment

-0.2288 (8.180)***

(b) Regional misalignment

Reg. 2

(e) Dummy nonregional misalignment

No. of observations No. of groups R2

Reg. 4

-0.0194 (3.040)*** 0.0157 (1.486) 3,848 28 0.1368

Reg 5

Reg 6

-0.127 (6.591)***

(d) Dummy regional misalignment

(g) Government change

Reg. 3

-0.4046 (4.183)*** -0.1652 (4.285)***

(f) Access to foreign credit

greater than 1 0%

-0.0188 (2.977)*** 0.0166 (1.563) 3,848 28 0.137

-0.3388 (3.800)*** -0.0598 (2.298)** 0.1459 (6.435)*** 0.0719 (7.835)*** -0.0172 (2.888)*** 0.0162 (1.623) 3,848 28 0.173

-0.0049 (1.075) 0.0162 (1.817)*

-0.0035 (0.868) 0.0147 (1.814)*

2,716 19 0.1436

2,716 19 0.1577

0.1242 (5.146)*** 0.0457 (6.375)*** -0.0027 (0.845) 0.0136 (1.997)*

2,716 19 0.2248

Tests on difference between coefficients

(b)- (c) (d)- (e)

-0.24 [0.023]**

-0.28 [0.005]*** 0.07

[0.069]*

0.08

[0.090]*

Notes: The coefficients reported in the table are marginal effects. Absolute value of t-statistics in parentheses, one tail p-values in brackets. Year dummies and country fixed effects included in all regressions not reported. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level. Source: Fernandez-Arias, Panizza and Stein (2002).

Reg. 1 Independent variables

CHAPTER

REFERENCES Bergara, M., D. Dominion!, and J. Licandro. 1995. Un modelo para comprender la "enfermedad uruguaya." Revista de Economic, Segunda Epoca 2(2) November: 39-76. Banco Central del Uruguay, Montevideo. Bevilaqua, A., M. Catena, and E. Talvi. 2001. Integration, Interdependence, and Regional Goods: An Application to Mercosur. Economic 2: 153-207.

Fernandez-Arias, E., U. Panizza, and E. Stein. 2002. Trade Agreements and Exchange Rate Disagreements. Paper presented at the Annual Meetings of the Board of Governors of the Inter-American Development Bank and Inter-American Investment Corporation, Fortaleza, Brazil. March. Frankel, J., and A. Rose. 1996. Currency Crashes in Emerging Markets: An Empirical Treatment. Journal of International Economics 41: 351 -66.

Blonigen, B. 1997. Firm-Specific Assets and the Link between Exchange Rates and Foreign Direct Investment. American Economic Review 87(3): 447-65.

Frankel, J., and S. Wei. 1998. Regionalization of World Trade and Currencies: Economics and Politics. In J. Frankel (ed.), The Regionalization of the World Economy. Chicago: University of Chicago Press.

Buiter, W., G. Corsetti, and P. Pesenti. 1998. Financial Markets and European Monetary Cooperation. The Lessons of the 1992-93 ERM Crisis. Cambridge, UK: Cambridge University Press.

Froot, K., and J. Stein. 1991. Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach. Quarterly Journal of Economics 106: 1191-217.

Calvo, G. 1998. Capital Flows and Capital-Markets Crises: The Simple Economics of Sudden Stops. Journal of Applied Economics 1(1): 35-54.

Glick, R., and A. Rose. 2001. Does a Currency Union Affect Trade? The Time Series Evidence. European Economic Review.

Calvo, G., A. Izquierdo, and E. Talvi. 2002. Sudden Stops, the Real Exchange Rate and Fiscal Sustainability: Argentina's Lesson. Inter-American Development Bank, Washington, DC.

Goldfajn, I., and R. Valdes. 1997. Are Currency Crises Predictable? IMF Working Paper no. 97/159. International Monetary Fund, Washington, DC.

Edwards, S. 1999. How Effective Are Capital Controls? Journal of Economic Perspectives 13(4): 6584. Eichengreen, B. 1993. European Monetary Unification. Journal of Economic Literature 31: 1321 -57.

Kaminsky, G., and C. Reinhart. 1999. The Twin Crises: The Causes of Banking and Balance-of-Payments Problems. American Economic Review 89(3): 473-500. Kaminsky, G., S. Lizondo, and C. Reinhart. 1998. Leading Indicators of Currency Crisis. IMF Staff Papers 45: 1 -48.

1997. Free Trade and Macroeconomic Policy. In S. Burki, G. Perry and S. Calvo (eds.), Trade: Towards Open Regionalism. LAC ABCDE Conference, World Bank, Montevideo, Uruguay.

Klein, M., and N. P. Marion. 1997. Explaining the Duration of Exchange-Rate Pegs. Journal of Development Economics 54: 387-404.

Eichengreen, B., and C. Wyplosz. 1993. The Unstable EMS. Brookings Papers on Economic Activity 1: 51-143.

Klein, M., and E. Rosengreen. 1994. The Real Exchange Rate and Foreign Direct Investment in the United States. Journal of International Economics 36: 373-89.

Feenstra, R. C. 1999. Facts and Fallacies about Foreign Direct Investment. In Martin Feldstein (ed.), International Capital Flows. Chicago: University of Chicago Press and NBER.

Markusen, J., and K. Maskus. 2001. General-Equilibrium Approaches to the Multinational Firm: A Review of Theory and Evidence. NBER Working Paper 8334, National Bureau of Economic Research.

188

Obstfeld, M. 1997. Europe's Gamble. Brookings Papers on Economic Activity 2: 241 -317. Pardo, M. 2002. Tipo de cambio real cruzado de Colombia con los principales poises con los que existen acuerdos de integracion. Grupo Consultivo de la Comunidad Andina. Mimeo. Rose, A. 2000. One Money, One Market: Estimating the Effect of Common Currencies on Trade. Economic Policy 30: 7-45.

189

Rozemberg, R., and G. Svarzman. 2002. El proceso de integracion Argentina-Brasil en perspectiva: conflictos, tensiones y acciones de los gobiernos. Document prepared by the Division for Integration, Trade and Hemispheric Affairs of the InterAmerican Development Bank.

â&#x20AC;˘Trade Agreements, Exchange Rate Disagreements

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CURRENCY UNIONS

The economics of currency unions has attracted considerable attention since the creation of the European Monetary Union (EMU). Countless papers have been written in recent years regarding the prerequisites for currency unions, prospects for the EMU and lessons for other groups of countries that might consider following its example, and the effects of currency union on such areas as trade. Currency (or monetary) unions represent the deepest possible form of exchange rate policy coordination among a group of countries. While the only currency union in Latin America and the Caribbean is the Organization of Eastern Caribbean States (OECS), there have been plenty of discussions in academic and policy circles regarding the viability of such unions for Mercosur, the Caribbean Community (CARICOM) and the Central American Common Market (CACM). An overview of currency unions must begin by examining their principal advantages—reduction in transaction costs and gains from credibility—as well as their disadvantages, such as the loss of monetary independence. The discussion must also examine the criteria that countries should take into account when considering creating or joining a currency union, since these criteria may affect the balance between advantages and disadvantages. Currency unions are very demanding in terms of institutional frameworks. Examples of this, which are discussed in this chapter, are the institutional setup for the Euro countries as well as the workings of the European Central Bank (Box 9.1). A closely related topic to currency union-is unilateral adoption by one country of the currency of

another, which is usually referred to as dollarization. Within Latin America, two countries—Ecuador and El Salvador—have recently adopted the dollar, although for very different reasons and under very different circumstances.1 Given the many common elements between currency unions and dollarization, and the fact that other countries such as Argentina have considered such a move, we will provide a brief account of the early experience of the recently dollarized economies (Box 9.2). However, while there are similarities between currency unions and dollarization, there are also important differences. Dollarization is a unilateral decision by a country, and therefore not really a form of macroeconomic policy coordination. The link between regional integration—the subject of this volume—and unilateral dollarization is therefore somewhat tenuous. For this reason, the main focus in this chapter is not on unilateral dollarization, but rather on currency unions. Naturally, countries that join a monetary union may choose to create a new currency (such as the Euro), adopt the currency of one of the member countries, or adopt the currency of a third country (for example, the dollar). Two important issues related to the merits of currency unions are also discussed in this chapter: the impact of currency unions on trade, and the effects of trade on the symmetry of the business cycle. If currency unions increase trade, and trade integration increas-

In addition, Panama has been dollarized since 1904.

Chapter

CHAPTER

es the symmetry of the business cycle among member countries, then the concerns about losing monetary independence as a result of joining a currency union would be lessened. Thus, two countries may become good candidates to join a currency union ex post, even though they do not appear to be good candidates ex ante. While several authors have focused on these issues in recent years, the conclusions that can be drawn from existing literature for the countries of Latin America are questionable. This chapter presents some new research and evidence that provides a better idea of the potential costs and benefits associated with the formation of currency unions among the countries of the region.

PROS AND CONS OF CURRENCY UNIONS The pros and cons of forming a currency union have been the subject of important studies known as the optimal currency area (OCA) literature. This literature, which began in the early 1960s with the works of Mundell (1961) and McKinnon (1963), specifically aims to establish the conditions under which a country should form a monetary area with another. Considered from another standpoint, under what conditions would it be too costly for a given country to sacrifice its monetary policy independence in order to reduce the transaction costs associated with trade and investment flows? While the traditional literature focused on the reduction in transactions costs as the main benefit of monetary union, more recent work has emphasized potential advantages in terms of credibility.

Benefits of Reduced Transaction Costs One of the traditional OCA criteria relates to the level of trade integration between the potential currency union members. A common currency reduces the exchange rate risk involved in trade and investment transactions between countries. If individuals are risk averse, this should reduce transaction costs. While there are ways to hedge against this risk, doing so may be costly or impossible, especially when a developing country currency is involved. A common currency also reduces other transaction costs, such as those associated with the need to deal with multiple currencies. The larger the trade and investment flows between the

countries, the greater the gain from a reduction in transaction costs. While the argument that lower exchange rate volatility will reduce transaction costs and increase trade and investment flows sounds very appealing, in theory, firms could actually profit from exchange rate volatility.2 Perhaps due to these considerations, the empirical literature on the effects of volatility on trade has not yielded conclusive results. While there is some empirical evidence suggesting that there are negative effects of exchange rate volatility on trade, these effects are generally quite small, have decreased over time, and vary widely in significance depending on the study in question.3 Frankel and Wei (1997), for example, find significant negative effects of exchange volatility on bilateral trade flows from 1965 through 1 980, but the effect disappears in more recent periods, perhaps due to the appearance of different hedging instruments. In the case of developing countries, however, such hedging markets may not exist, or may be very illiquid. Thus, we expect these effects to be more important for the developing countries.4 Three recent studies confirm this expectation. Panizza, Stein and Talvi (2002) use a large dataset put together by Rose (2000) to study the impact of nominal exchange rate volatility on bilateral trade, dividing the sample into industrial country pairs and other country pairs.5 For industrial country pairs, they find that the

2 Consider an individual who sells a service and faces an uncertain demand, which is sometimes high (in which case the price of the service being sold is high), and sometimes low (in which case the price is low). If the seller works more hours when demand is high, and fewer hours when demand is low, he or she will earn more than if demand were stable. Similarly, a firm that faces an uncertain price for its exports due to exchange rate volatility may sell more when the exchange rate is high, and Tess when it is low, thus earning higher returns. This positive effect of volatility may be undone, however, if the firm is risk averse. 3 For an early survey of this literature, see Edison and Melvin (1990). Of 12 studies they examined, six find negative and significant effects, five have inconclusive results, and one finds effects that are positive and significant. 4

In some cases, reducing exchange rate volatility vis-a-vis one trading partner may entail increasing the volatility with respect to others. This is particularly relevant for countries such as Brazil and Chile, which trade heavily with the United States and other Latin American countries, but also with the European Union. 5

The methodology is based on the gravity model of bilateral trade (see Box 3.1 in Chapter 3) that accounts for other factors that affect bilateral trade, such as GDP, distance, and common border and language.

192

Currency Unions

ly found smaller effects using different methodologies,

positive, although generally not significant. In pairs

in almost all cases the impact of currency unions has

involving developing countries, the effect of exchange

been positive and large.14 A shortcoming of these stud-

rate volatility is negative and significant, and has no

ies is that the common currency effect is drawn from

declining trend.

the experience of very small or poor countries joining

Using a similar methodology, Estevadeordal,

currency unions or adopting the currency of a larger

Frantz and Saez (2001) find that trade between two

country. It is not clear whether the experiences of these

developing countries falls from 1 to 2 percent for every

countries are relevant to most Latin American countries.

1 percent increase in exchange rate volatility. While

This literature will be reviewed in more detail later in

most studies on the impact of exchange rate volatility

the chapter, when we present the results of our own

rely on measures based on the standard deviation,

research based on the early experiences of the coun-

these authors also look at the effects of extreme

tries in the European Monetary Union. Thus, we pro-

changes in the exchange rate.6 They find that, all else

vide evidence drawn from the other end of the

being equal, extreme swings in the exchange rate

spectrum regarding country size and income. The

reduce bilateral trade significantly.

impact on most Latin American countries should prob-

Giordano and Monteagudo (2002) study the

ably lie somewhere in between these two extremes.

impact of exchange rate volatility on bilateral trade

Although Rose's work suggests that integration

among members of three RIAs in Latin America: Mer-

may itself depend on whether countries adopt currency

cosur, the Andean Community, and the Central Ameri-

unions, it is worthwhile to ask the extent to which Latin

can Common Market. Their results suggest that cutting

American countries are integrated with their RIA part-

exchange rate volatility in half would produce an

ners (see Figure 7.1 in Chapter 7). Whether the degree

increase in intra-regional exports of between 3 and 7

of integration is normalized by total trade or by GDP,

percent, depending on the RIA in question.8 Taken

none of the Latin American RIAs match the degree of

together, this evidence confirms that exchange rate volatility still may be an important discouraging factor when it comes to trade flows involving developing countries.9 The effects of joining a currency union, however, go beyond the reduction of exchange rate volatility. Currency unions eliminate the transaction costs arising from the need to operate with multiple currencies.10 Sharing a common currency has an additional effect: it results in irrevocably fixed exchange rates, eliminating exchange rate volatility between the partners for the foreseeable future.11 Neither of these factors is captured by the traditional literature on exchange rate volatility and trade, which focuses on volatility for each period.12 The first direct test of the impact of currency unions on trade was provided by Rose (2000).13 He found that two countries that share a common currency trade over three times as much as do otherwise similar countries with different currencies. This result is important because it suggests that two countries may comply with OCA trade integration criteria after forming the currency union, even if they did not comply with it to begin with. While some authors have subsequent-

In their study, extreme changes in the bilateral exchange rate are captured by the kurtosis, which measures the weight of the tails of the distribution. 7

They do this by estimating export equations using real intra-regional exchange rates, demand from partner countries, a measure of the cycle of the exporting country, and the measure of volatility as explanatory variables. 8 They also find that intra-regional exports are more sensitive to exchange rate volatility than exports outside the region. 9

Calvo and Reinhart (2001) reach similar conclusions based on a review of the literature of exchange rate volatility and trade with a special focus on developing countries.

10 These costs are, to a certain extent, independent from exchange rate volatility. De Grauwe (1994) reports that the cost of exchanging Belgian francs for guilders or deutsche marks is similar to the cost of exchanging them for pounds sterling or U.S. dollars (approximately 0.5 percent), despite the low volatility of the Belgian franc vis-a-vis the guilder or deutsche mark. 11 This in turn may increase market transparency and foster competition among firms in different countries. 12 An additional benefit for developing countries that share a currency with a developed oneâ&#x20AC;&#x201D;either through union or dollarizationâ&#x20AC;&#x201D;is that it allows firms to hedge risk in transactions with other countries. 13 Rose (2000) in fact looked at the effects of sharing a common currency, since he does not distinguish between currency unions and dollarization. 14

See Persson (2001), Tenreyro (2001), and Click and Rose (2001).

effects of exchange rate volatility on bilateral trade are

193

CHAPTER

integration found in the EU. While the ratio of intraregional trade to total trade for the EU is close to 55 percent, the corresponding figure for the North American Free Trade Agreement (NAFTA) is 47 percent; for Mercosur, 22 percent; and for the CACM, the Andean Community and CARICOM, below 15 percent.15 While these figures show the extent of intraregional trade for the RIA taken as a whole, the story may be very different for the individual countries. This is particularly true for NAFTA and Mercosur, where the values represent to a great extent the experience of the largest countries—the United States and Brazil, respectively—and are not representative of the experience of the average country. NAFTA represents more than 80 percent of Mexico's trade, and Mercosur represents 31, 44 and 57 percent of total trade for Argentina, Uruguay and Paraguay, respectively. Accordingly, different countries may have different preferences for monetary integration, at least in relation to this criterion.16

Benefits of Credibility There is now widespread agreement that the primary goal of monetary policy should be a low and stable rate of inflation, and that there is no long-run trade-off between inflation and unemployment. However, politicians and politically motivated central bankers may still be tempted to use monetary policy to exploit the shortrun trade-off between inflation and unemployment, generating in the process self-fulfilling inflationary expectations (Barro and Gordon, 1983). Thus, the presence of a credible constraint on the ability to issue money can help limit short-run monetary policy actions that are inconsistent with the long-run objective of low and stable inflation. One way in which a country may subject itself to a credible constraint is by joining a currency union. Currency unions, however, are not the only way to constrain monetary policy. Countries can also impose such constraints by means of a nominal anchor, that is, an intermediate monetary policy target that helps the public form expectations regarding the future path of inflation. Nominal anchors may take the form of exchange rate pegs, monetary targets or inflation targets.17 While monetary and inflation targeting allow some degree of monetary independence, they are also more demanding in terms of institutional capacity and

initial credibility requirements. In fact, with these regimes, countries can gain credibility over time by meeting the targets, but there is no immediate boost in credibility—what is called a "credibility bonus"—when the regime is announced.18 This suggests that countries that have a history of monetary irresponsibility cannot easily adopt this monetary policy framework.19 Fixed exchange rates are not an automatic source of credibility either. To achieve credibility, the currency must be credibly fixed to a strong anchor currency in a country with a sound reputation in monetary policy management. Monetary unions, by creating irrevocably fixed exchange rates, are a potential source for a credibility bonus. By adopting a currency with a history of low inflation, a country can immediately import the credibility of this currency. Creating a new credible currency may be a more difficult task. This was achieved in the European Union by modeling the European Central Bank along the lines of the German Bundesbank and symbolically locating it in Frankfurt. The credibility gain of the European Monetary Union was particularly evident for Southern European countries (Greece, Italy, Portugal and Spain) that saw their inflation and real interest rates rapidly converging towards the low levels of Germany. Creating a new credible currency would be more difficult for a group of emerging market countries without a reputable anchor.20 In addition, such a move would not solve the problem known as "original sin," that is, the inability of agents to borrow abroad in their own currency, and thus would not eliminate cur-

15 Normalizing by GDP, however, CACM and CARICOM become more integrated than Mercosur. 16 Figures 2.4. and 2.5 in Chapter 2 shows the degree of infraregional trade for the individual Latin American countries. 17 Monetary targets went out of fashion because their main requirement (a stable money demand) is rarely satisfied. See Panizza (2000) for a survey of monetary policy options for emerging market countries with flexible exchange rate regimes. 18 Bernanke et al. (1999) and Cecchetti and Ehrmann (1999) have shown that there is no credibility bonus associated with inflation targeting. 19 The recent experience of Brazil, however, suggests that even countries with a history of hyperinflation may be able, under some circumstances, to adopt inflation targeting and make it work. 20

A currency union among developing countries may be more fragile than one among developed countries, since the former tend to be exposed to larger external shocks that may require divergent monetary policies and put the union under considerable stress.

194

Currency Unions

195

rency mismatches in the balance sheets of banks, gov-

sions tend to be synchronized. If cycles are asymmet-

ernments and the private sector that may result in finan-

ric, the monetary policy will reflect the needs of the

cial fragility.21

union taken as a whole, and perhaps the relative power of the countries that compose the union (see Box 9.1 for a discussion of monetary policy in the case of

fits of monetizing public deficits accrue to the deficit

the EMU). It is possible for the union to adopt a restric-

country, while the costs in terms of higher inflation

tive monetary policy precisely when one of its members

would spread to all the members. Since all members

is going through a deep recession.22 Under unilateral

are usually represented in the decision process, poli-

dollarization, the loss of monetary policy is even

cies that reward the country that misbehaves are less

greater, since the monetary policy is simply that of the

likely to be followed. Furthermore, currency unions

anchor country (see Box 9.2). The higher the level of

may create the necessary conditions for the establish-

asymmetry in output shocks, the more important the

ment of institutional mechanisms (such as the EMU Sta-

exchange rate becomes as a relative price adjustment

bility and Growth Pact) that limit public deficits and

mechanism, and the more costly the sacrifice of mone-

hence increase the credibility of the common currency.

tary independence.

In addition, the fact that monetary policy decisions are

Chapter 7 discussed the degree of symmetry

taken by a collective body in which all member

of shocks and cycles within the different RIAs. Here we

countries are represented may protect individual deci-

present a different measure, developed by Bayoumi

sion-makers from domestic pressures, and hence coun-

and Eichengreen (1996), that measures not correla-

terbalance possible inflationary

biases that may

tion, but rather the degree of asymmetry. We compare

characterize individual central banks, particularly when

RIAs in the Americas with the European Union.23 Fig-

they lack the necessary independence. In fact, Worrell,

ure 9.1 shows that the level of cycle asymmetry in

Marshall and Smith (1998) report that the balanced

NAFTA and the CACM is similar to that among coun-

membership of the Organization of Eastern Caribbean

tries in the EU. In Mercosur and the Andean Commu-

States (OECS) prevented the Eastern Caribbean Cen-

nity, as in the case of the Free Trade Area of the

tral Bank from monetizing large deficits in Antigua in

Americas (FTAA), the degree of asymmetry is much

1986 and in Grenada in 1991, forcing these countries

larger. The same pattern appears by looking at the cor-

into much needed fiscal adjustment.

Costs Associated with the Loss of Monetary Independence The most important cost of a monetary union is the loss of monetary independence. When effective, an independent monetary policy can be used as a stabilization tool, in order to dampen cyclical fluctuations. The factors that affect the value a country derives from monetary independenceâ&#x20AC;&#x201D;particularly the degree to which countries are subject to asymmetric shocks, the existence of alternative adjustment mechanisms, and, to a lesser extent, the effectiveness of monetary policyâ&#x20AC;&#x201D; have received considerable attention in the OCA literature. Degree of asymmetry of economic shocks and cycles. By joining a currency union, countries adopt a common monetary policy that will be more appropriate for all countries involved if their booms and reces-

For a discussion on "original sin," see Hausmann and Eichiengreen (1999). 22

Within the EMU there have been institutional reforms proposed to address this problem. Wyplosz (1999) suggests three mechanisms to increase the regional stabilization capacity of the EMU. The first is to build a system of tradable permits that would allow countries to deviate temporarily (but not on average) from the targets of the Growth and Stability Pact. The second involves an EU level unemployment compensation system, similar to that of the United States. Each country would contribute to an unemployment benefit fund according to its size, and the EU would disburse funds to unemployed workers. The third proposal calls for increased weight in ECB monetary policy decisions for countries that are facing a crisis (defined, for instance, as an output gap that is three standard deviations higher than the average output gap). In the current system, decisions are based on aggregate economic conditions or the countries that belong to the EMU, and hence each country has a weight that is proportional to its size. 23

To measure asymmetry, these authors use the standard deviation of changes in the log of relative GDP between the economies. If the cyclical component of output is exactly equal in the two countries, this indicator will be equal to 0, even if growth trends are different across countries. The indicator increases in direct proportion with the asymmetry between the cycles.

Even in these cases, however, there may be some credibility gains. In a currency union, the bene-

CHAPTER

Bex 9.1

9 The European Monetary Union and the European Central Bank

The European Monetary Union was created after almost 50 years of economic integration among European countries and 10 years of preliminary work. The key message that emerges from the European experience is that the institutional setup is rather complex. Countries interested in forming a currency union need to first strengthen their process of economic integration and create a common market for goods, services, labor and capital. At the same time, management of these forms of economic integration requires a political integration mechanism, as well as a preliminary process of economic convergence in terms of inflation, interest rates and budget deficits. It also demands well-functioning and operationally independent national central banks. What follows briefly highlights the main stages of the process that led to the creation of the European Monetary Union. Exchange rate consistency was already identified as a matter of common interest by the Treaty of Rome that gave origin to the European Economic Community (now the European Union). In 1970, a plan was introduced to move toward the establishment of irrevocably fixed exchange rates by 1980. The necessity of limiting exchange volatility became particularly urgent after the collapse of the Bretton Woods system. The first step was the creation in March 1972 of the "snake in the tunnel," which consisted of fluctuation bands among European currencies (the "snake"), which in turn would exhibit limited floating with respect to the dollar (the "tunnel"). Divergent economic conditions and the 1973 oil shock caused a collapse of the snake. The next effort involved the creation of the European Monetary System (EMS) in 1979 based on the idea of fixed but adjustable rates. Although the adjustment mechanism was used several times over 1979-87, stability between 1987 and 1992 gave new stimulus to monetary integration, which was also seen as a necessary condition for full removal of restrictions on the mobility of goods, labor and capital. The full removal of capital controls eventually led to the EMS crisis of September 1992. The creation of a single currency was decided in the Maastricht Treaty of December 1991, which laid out three stages for the transition to a monetary union. The first stage, which began before the signing of the Maastricht treaty, gave more responsibilities to the Committee of Governors of the Central Banks of Member States, such as promoting the coordination of monetary policies with the aim of achieving price stability. The beginning of the second stage was marked by the establishment of the European Monetary Institute (EMI)â&#x20AC;&#x201D;the precursor of the European Central Bank. The EMI played an important role in coordinating the national central banks' monetary policies, and establishing the necessary conditions for access to the

monetary union. Member states were also asked to strengthen the independence of their central banks and to achieve certain convergence criteria in terms of inflation, interest rates, budget deficits and debt. The EMI was transformed into the European Central Bank (ECB) in June 1998, and the third and final phase of the EMU started in January 1999, when the currencies of the member states were fixed with respect to the Euro. The ECB started conducting a single European monetary policy. The third stage concluded in January 2002 with the introduction of Euro bills and the elimination of domestic currencies in the 12 EMU countries.

The European Central Bank It is no easy task to create a central bank that guarantees impartiality for a group of politically and fiscally independent countries, with independent banking supervision agencies, limited cross-country transfers, and segregated labor markets. Ideally, the institutional framework would guarantee three conditions. Coordinated and unbiased monetary policy: European monetary policy is conducted by the European System of Central Banks (ESCB or Eurosystem), composed of the ECB and the national central banks of the member states of the European Union. The institutional framework adopted is similar to that of the U.S. Federal Reserve System. The structure is based on centralized decision-making and decentralized execution of monetary policy operations that are carried out by the national central banks. This decentralization takes into account the different financial market make-ups and legal systems that characterize the various member countries. Three decision-making bodies govern the Eurosystem: (i) the Executive Board; (ii) the Governing Council; and (iii) the General Council.1 Unbiased monetary policy is guaranteed by the requirement that the governing bodies may only base their decisions on information regarding aggregate European data, and not use country level data,2 and by majority voting of each country, independent of its size. Coordination between monetary and fiscal policy: The main mechanism is the Stability and Growth Pact, which imposes limits on deficits and debt, limiting the possible fiscal policies available to national governments. Besides being aimed at avoiding public default and debt monetization, the pact increases the weight of the ECB in the choice of the fiscal-monetary policy mix. There is, however, no formal coordination mechanism between the ECB and the various national fiscal authorities.3 Banking supervision and lender of last resort functions: Banking supervision is delegated to national authorities based on national competence and cooper-

196

ation. National competence means that banks follow national regulatory standards according to the principle of "home country control." A bank can conduct business in the entire European Union using a single banking license and acting under the supervision and rules of the country that has granted the license. The ECB lacks a formal mechanism for dealing with banking crises that would require a lender of last resort. Several EU directives highlight the necessity of generating a mechanism for cooperation among national bank supervisors. However, these directives do not specify how this cooperation should be implemented. Some cooperation involving exchange of information exists within the Banking Supervision Committee of the ECB. There has been some criticism of the Eurosystem regarding the lack of a well-specified lender of last resort mechanism, and its lack of crisis management capacity. The ECB has replied that in developed countries, bank runs are extremely rare, and fiscal revenues provide national governments with a first mechanism of defense, without requiring the ability to print new money. Furthermore, it has been claimed that if a sys-

Figure 9.1

Business Cycle Asymmetries across Free Trade Agreements, 199O-99 (Bayoumi and Eichengreen measure)

197

temic crisis were to occur, the ECB does have the necessary instruments to intervene, and that by not providing details of the policies that would be adopted in the event of an emergency, the institution maintains a level of "constructive ambiguity" that is helpful in reducing moral hazard.4

1 For a summary of the different responsibilities for each decision body, see www.ecb.imt 2

Members of governing bodies are also forbidden from following orders from their national authorities. This mechanism prevents the ECB from giving special consideration to countries that are going through a perioa of deep crisis. To address this issue, there have been proposals to create mechanisms of monetary federalism that would automatically increase the weight of crisis countries in the decisions of the ECB's governing bodies. See Wyplosz(1999). 3

The extreme concern of the ECB for price stability has been criticized for being exceedingly conservative and blamed for delivering sub-optimal macroeconomic stabilization to the Euro area. 4

See the 1998 IMF Capital Market Report for a critical view, and Padoa Schioppa (1999) for an answer to these criticisms.

relation between purely exogenous shocks, such as the terms of trade (see Figure 7.6 in Chapter 7). Recent studies by Frankel and Rose (1997, 1998) suggest that the symmetry of cycles can be endogenous. In studying the link between trade integration and cycle synchronization for industrial countries, these authors find that economic cycles tend to be more symmetrical in countries with close trade relations. Accordingly, a country might meet this OCA criterion ex post, even if it does not meet it ex ante. The increase in trade associated with the creation of a currency union could in turn result in more synchronized cycles, thus lessening the value of an independent monetary policy. While the Frankel and Rose results are relevant for the industrial countries upon which they base

Source: Calderon, Chong and Stein (2002).

their study, it is not clear whether those findings would apply to developing countries.

Currency Unions

CHAPTER

Bex 9.2

9 Recent Experiences with Dollarizatient Ecuador and El Salvador1

In recent years, a small but varied group of Latin American countries has seriously considered the option of fully dollarizing its economies. In Ecuador and El Salvador, dollarization was actually adopted, although under very different circumstances. There are, of course, costs and benefits associated with full dollarization. As in the case of currency unions, a country that adopts the currency of another country sacrifices an independent exchange rate and monetary policy. However, this loss is more important in the case of dollarization, since the United States or any other "anchor" country would not take economic conditions in dollarizing countries into account when conducting its monetary policy. In addition, dollarization implies the loss of seigniorage revenues, which can be substantial, and restricts the ability of the central bank to act as a lender of last resort in case of widespread bank runs/ On the positive side, dollarization maximizes the gains from credibility, representing the strongest commitment to a stable currency from a country with a sound reputation for monetary policy management, and eliminates the scope for currency crises. These credibility gains cannot be matched by the formation of a currency union among emerging economies. Moreover, in the case of countries with a high degree of de facto dollarization, the elimination of currency risk associated with full dollarization may result in the reduction of country risk, as it eliminates important currency mismatches in the balance sheets of the financial, private and public sectors.3

Ecuador: Dollarization as Crisis Resolution In the early 1990s, Ecuador benefited from a successful stabilization program, higher oil prices and large capital inflows. But the boom turned to bust in 1995-96. A "sudden stop" in capital inflows, coupled with a banking sector that was undergoing rapid liberalization but had weak regulatory oversight, created problems in several financial institutions. Things got worse in 199798, given the lack of decisive action on problem banks and compounded by El Nino, contagion from the Russian default, and sharp declines in oil prices. The failure to maintain the exchange rate within a band, coupled with high levels of dollar debts, generated a spiral of corporate default, capital flight and devaluation. The exchange rate depreciated to over 5,000 sucres per U.S. dollar by the end of 1998 and more than 10,000 by June 1999. The banking and currency crisis was accompanied by a major fiscal crisis as the real economy imploded. In September 1999, Ecuador deferred payments on its Brady bonds. A deposit freeze stabilized the sucre through July 1999,

but further runs, sparked by the fear of default, sent the sucre into a tailspin that reached 26,000 per U.S. dollar in January 2000. The full dollarization announced in January 2000 to stabilize the exchange rate and bring back confidence was implemented through the Economic Transformation Law passed several months later. The law prohibited new issues of sucres, required the central bank to exchange sucres for dollars at the exchange rate of 25,000, and forced companies to convert their accounts into dollars. By Latin American standards, Ecuador had neither a high degree of trade integration with the United States nor a business cycle highly correlated with that country. It did have important de facto dollarization, and was in desperate need of stability and credibility. Dollarization, by definition, stabilized the currency market. The surprise, for many observers, was how the Economic Transformation Law calmed the nerves of depositors in the banking system, even though the bank resolution process was by no means complete.4 The law included other important policy changes such as fiscal and labor market reforms, and led to an IMF agreement in April 2000.5 In addition, Ecuador finally had some good luck, since oil prices through the first quarter of 2001 rose dramatically. Finally, Ecuador's default was resolved relatively quickly and perhaps more smoothly than many anticipated. The rate of 25,000 sucres per dollar implied that the real exchange rate was very significantly undervalued, and ensured that the central bank had "excess reserves" to provide liquidity to the banking system in dollars if needed. Interest rates declined to around 20 percent, which, coupled with the slow decline in inflation, implied continuing negative real interest rates through the transition. These factors helped the real economy, in particular corporate borrowers who saw their profitability rates rise and their debt diluted.6 Ecuador still faces many challenges. The banking system has improved but could be strengthened further and the fiscal situation remains a concern. Dollarization did not and cannot provide a solution to these issues. While there were many other factors at play, the preliminary conclusion is that dollarization, coupled with other appropriate policy reforms and some good luck, did appear to help to put Ecuador back on the road to economic stability.

El Salvador: Dollarization to Consolidate Economic Success El Salvador had relative economic success through the 1990s. Since 1993, the exchange rate has been fixed

198

and constant. Growth averaged 3.9 percent annually over 1995-98, and although it declined for 2000 and 2001, this was largely a result of significant external shocks and the country's devastating earthquakes. Moreover, with a fiscal deficit that hovered around 1.5 percent of GDP from 1993 to 1999 and with both monetary and financial stability, the country obtained a much prized investment grade credit rating. The motivation for dollarization was at least threefold. First, perceived devaluation risk persisted, as evidenced by a spread between colon and dollar interest rates. By dollarizing, the authorities hoped to bring down domestic interest rates, increasing investment and growth. Second, dollarization was seen as a way to reduce transaction costs and enhance integration. El Salvador's exports to the United States and to the dollarized trading regime of Central America represent 70 percent of total trade, local companies have been borrowing directly from international banks, and El Salvador benefits hugely from substantial remittances from the United States. A third motivation may have been more political: the government had been pushing through a radical reform program, and dollarization may have been seen as a way of locking in those reforms. Dollarization commenced at the start of 2001 when the Monetary Integration Law made the U.S. dollar legal tender and all new financial contracts became denominated in them. The central bank started to exchange colons for dollars, voluntarily, at the rate of 8.75 colons per U.S. dollar. After one year, more than 50 percent of colons in circulation had been retired. Colon interest rates have ceased to exist and dollar rates, which are comparatively lower, have implied a significant fall in the cost of financing.7 There is also evidence of an increase in the availability of different forms of credit. In particular, mortgages are now available at maturities of 15 years and longer, and at interest rates of 10.5 percent, benefiting both the house-

Existence of alternative adjustment

199

hold and the corporate sector. Credit from foreign banks extended directly to local companies has grown substantially, more than compensating for a decline in domestic credit. This suggests that dollarization has had a large impact on financial integration. It is difficult to assess the effect of full dollarization on the real economy, in part because the process is not yet complete. Through 2001, El Salvador was hit by a series of negative shocks: earthquakes, a significant fall in coffee prices, a severe drought, and finally the effects of the terrorist attacks on the United States in September. These developments have raised concerns regarding both competitiveness and the country's fiscal position, as lower growth and reconstruction efforts have placed pressure on the budget. The government must continue to enhance perceptions of fiscal sustainability and the economy needs to be highly flexible to respond to these and other shocks in order to reap the full benefits of dollarization.

This box was written by Andrew Powell.

Calvo (1999) argues that countries that provide effective services as lenders of last resort are those that are able to borrow in such times, rather than just print money. 3

For a discussion of the link between currency risk and country risk, see Powell and Sturzenegger (forthcoming).

Bank deposits rose gradually from $2.7 billion in January 2001 to $4.4 billion by mid-2001. 5

The IMF was not consulted on the decision to dollarize. See Fischer (2000) for an account of the relations between Ecuador and the IMF. 6

See de la Torre, Garcia Saltos and Mascaro (2001) for an account of the "inflation hump and dilution of debts." 7 Interestingly, dollar rates did not fall. This follows academic predictions, given that the country was not particularly dollarized previously and had high credibility, as evidenced by its investment grade rating. See Berg and Borensztein (2000) and Powell and Sturzenegger (forthcoming).

mecha-

slower and more costly, as it leads to extended periods

nisms. Exchange rate adjustment is not the only mech-

of high unemployment. Wage inflexibility thus makes

anism to restore equilibrium in case of asymmetric

exchange rate flexibility and monetary independence

shocks. Other possible mechanisms are wage flexibili-

more desirable.24

ty and labor mobility. If wages are perfectly flexible, restoring equilibrium through depreciation is almost equivalent to achieving this effect through a reduction in wages. In contrast, when wages are downwardly inflexible, adjustment through wage reductions is much

Eichengreen (1996) has argued that the emergence of universal suffrage and increasing unionization led to the collapse of the Gold Standard, as it became politically difficult for countries to sustain the extended periods of unemployment associated with the lack of monetary independence.

Currency Unions

CHAPTER

When labor is mobile across borders, asymmetric shocks can be absorbed through migration, without requiring relative price changes. Labor mobility is particularly important in the presence of wage rigidities. Fiscal transfers from the boom to the recession country may provide yet another adjustment mechanism. These transfers enhance the capacity of union members to engage in countercyclical fiscal policy, reducing the need for an independent monetary policy. These transfers are frequent within countries, particularly when the government budget is centralized, but are more difficult to implement across countries.25 Of these alternative adjustment mechanisms, probably the most important is the degree of wage flexibility. Eichengreen (1998) makes this point convincingly, arguing that immigration and fiscal transfers are less direct and more politically demanding substitutes for wage flexibility. In Europe, for example, labor mobility has remained remarkably low, in spite of the efforts to encourage it by the EU countries (see Box 9.3). How plausible is this adjustment mechanism in the RIAs in Latin America? While no data are available on wage flexibility, there are data on other characteristics of labor markets, such as the cost of worker dismissal, which may affect the degree of wage flexibility. Figure 9.2 presents data compiled by Heckman and Pages (2000) on dismissal costs (measured in number of monthly wages) for selected countries in the region and compares them to the corresponding cost in developed countries. While dismissal costs in the Caribbean are comparable to those in the industrial countries, in Latin America they are almost twice as high, in spite of recent labor reform in some countries.26 The very high rates of unemployment in many countries in the region provide further evidence of the lack of flexibility. Thus, it does not seem very likely that wage flexibility will provide the necessary adjustment, at least in most of the region's RIAs. Effectiveness of monetary policy: Monetary policy obviously has less value if it is ineffective. One factor that can reduce the effectiveness of monetary policy is the degree of openness. In highly open economies, changes in the exchange rate are rapidly reflected in the price level, i.e., the pass-through from exchange rate to prices tends to be high. In such cases, the exchange rate tends to become a central factor in contracts, including those involving labor. Openness,

Figure 9.2

Dismissal Costs (In number of monthly wages)

Source: Ministries of Labor.

through high pass-through, decreases the value of monetary independence, since any required adjustment in relative prices will come at a higher cost in terms of inflation. Another factor that can affect the effectiveness of monetary policy is the extent of foreign currency liabilities. Monetary policy can be used to influence the price level, and thus to avoid costly deflationary adjustment in the event of severe adverse shocks. The increase in the real value of debt as a result of price deflation may lead to widespread bankruptcies, and may be one of the most important causes of major economic depression.27 However, if debts are denominat-

In certain countries with a large proportion of the population living abroad, such as El Salvador or the Dominican Republic, remittances can play the role of these fiscal transfers. For this adjustment mechanism to work, these remittances would have to increase when the receiving country is in recession. 26 Dismissal costs average 1.7 months of wages in industrial countries and 3.1 months in Latin America. These differences may be smaller than suggested by these numbers, given the importance of Latin America's informal labor markets. By comparison, there are no dismissal costs in the United States. 27

See Fischer (1933) and Calvo (1999) for a discussion of the problems associated with debt deflation.

2OO

Currency Unions

unions do increase trade and that trade reduces asym-

bankruptcies and depression. Thus, in highly dollar-

metries. The key question is how relevant is this evi-

ized economies, adjustment through devaluation loses

dence for the countries in the region? In the next two

one important advantage over deflationary adjustment,

sections we will attempt to answer this important ques-

namely the capacity to dilute the real value of debt.28

tion based on the results of our own research.

This suggests that the higher the initial degree of liability dollarization, the less the cost of forgoing monetary independence. This is a crucial issue for many countries in Latin America that are highly dollarized.

THE IMPACT OF CURRENCY UNION ON TRADE: EVIDENCE FROM THE EUROPEAN UNION

There has been a debate in the literature regarding the extent to which flexible exchange rates,

In the last couple of years, there has been a growing

and the monetary independence that comes with them,

amount of literature on the impact of common curren-

have been effective in emerging countries. In particu-

cies on trade. The first to tackle this issue was Rose

lar, Calvo and Reinhart (2002) have suggested that

(2000). Using a large sample of countries, he found to

emerging countries exhibit "fear of floating"â&#x20AC;&#x201D;that is,

his own surprise and that of the rest of the profession

they float with a large cushion of reserves, and do not

that countries that share a common currency trade over

let the exchange rate move much. These authors, as

three times as much as do otherwise similar countries

well as Hausmann, Panizza and Stein (2001), find

with different currencies.30 Most country pairs with

some evidence that pass-through from exchange rates

common currencies in the sample are either formed by

to prices, and particularly dollar liabilities, is an impor-

very small or poor countries (such as those in the East-

tant determinant of the way emerging countries with

ern Caribbean Currency Area or the African Financial

flexible regimes manage their exchange rate policy. Yet

Community) or by very small or poor countries adopt-

it appears that countries with flexible exchange rates,

ing the currency of larger ones (such as Tonga and

such as Brazil, Chile, Mexico and Colombia, are

Australia, or Reunion and France).31 It is not clear,

increasingly using the flexibility afforded to them by

then, how applicable these results would be for other

their exchange rate regimes.

countries such as those in Latin America.

Our discussion of the pros and cons of cur-

Rose's first study was based on cross-section

rency unions, together with the data presented for Latin

analysis. Therefore, the question it answers is whether

America, suggests that, with few exceptions, RIAs in

countries that share a common currency trade more

the region do not appear to comply with the criteria set forth by OCA literature, at least when one considers the European Union as a benchmark for comparison. The degree of trade integration, with the exception of 29

NAFTA and perhaps Mercosur, is not very large.

Business cycles are not very correlated, with the exception of the CACM. Wages are probably not flexible enough to provide an adequate adjustment mechanism in the absence of exchange rate flexibility. Does this mean that the Latin American countries should disregard the idea of currency unions? The answer from the recent literature on endogenous optimal currency areas would be not necessarily. Forming a monetary union will in itself increase trade integration substantially. In turn, integration will bring about increased cycle correlation, making the lack of wage flexibility less harmful. As discussed above, there is evidence to support this view, suggesting that currency

28 See Panizza, Stein and Talvi (2002) and Fernandez-Arias and Talvi (1999). 29

Trade integration increases considerably when looking at different groupings, such as CACM plus the United States. 30

To study the common currency effect on trade, Rose added a common currency dummy variable to a gravity model of bilateral trade (see Box 2.1 in Chapter 2), in which he controls for variables such as GDP, distance, common border and language, colonial links and membership in the same RIA. In order to have enough country pairs with common currencies, he included not only countries, but also dependencies, territories and colonies for which trade data was available. 31 Levy Yeyati (2001) separates the effects of common currency on trade for multilateral currency unions from those that arise in the case of dollarization, including in this last group both what he calls parent links (such as the United States and Panama) and sibling links (such as Ecuador and Panama, both having adopted the U.S. dollar). He finds the impact of dollarization to oe similar to that found by Rose (2000). However, for multilateral currency unions, he finds the impact to be smaller (around 65 percent), although still statistically significant.

ed in foreign currency, depreciation may also lead to

2O1

CHAPTER

Bex 9.3

Labor Mobility in the European Union1

The goal of full mobility of labor within the European Union was already stated in the Treaty of Rome and formally embodied in European law in 1968. However, just as for the mobility of goods, many barriers remained. It was not until the European Act of 1986, which was implemented in 1992, that precise steps were taken to practically implement labor mobility within the EU. Such steps include detailed directives about harmonization of labor standards and mutual recognition of qualifications, as well as the establishment of a cross-border European Employment Service (EURES). Prior to 1992, however, there were some multilateral agreements that guaranteed labor mobility among a subset of European countries. For example, the Common Nordic Labor Market established between Denmark, Finland, Norway and Sweden in 1954 allowed nationals from any of these countries to work in any other Nordic country without a work permit. Similarly, in 1958, the Benelux countries (Belgium, Netherlands, and Luxembourg) signed an economic integration treaty that went much further than the European Community. Nationals of any Benelux country could freely enter any other Benelux country to engage in any economic activity. The Benelux treaty guaranteed that they would be treated on par with nationals of the host country. Finally, in 1990, free movement was extended beyond the EU's border, since it was granted to countries of the European Economic Area.2 That the 1968 agreement was not sufficient to remove barriers to mobility, and that such a right had to be repeatedly reasserted in European treaties since then,3 shows that progress in establishing full labor mobility has not been as rapid as expected. Euro-law does not prevent national governments from establishing some subtle barriers. For example, it does not prevent border controls. For that reason, a subset of European countries has signed the Schengen Agreement, which goes further than the Maastricht Treaty by abolishing border controls among members. This treaty came into effect in 1995 and currently includes all EU countries except the United Kingdom and Ireland. Euro-law does not guarantee the free movement of people. Thus, one may move to seek work, but not just to settle or to be on welfareâ&#x20AC;&#x201D;typically, unemployed persons are allowed to move only if they can prove financial autonomy. In practice, this means that job seekers are allowed a three-month stay. While the European Court recently stated that longer periods were appropriate, this is a potential source of conflict. Furthermore, given the traditionally long duration of unemployment in most European labor markets, three or even six months is not a long period relative to the time it

takes to find a job. Thus, such limitations, which are motivated by the need to discourage "welfare shopping," may also act as a barrier to labor mobility. More serious barriers come from a lack of recognition of professional qualifications. Given the convergence in income levels, and the linguistic barriers to mobility, intra-EU migrants would be expected to be mostly skilled. Consequently, inadequate recognition of qualifications can be a very effective barrier to labor mobility. The European Commission states: "The rights of EU citizens to establish themselves or to provide services anywhere in the EU are fundamental principles of European Union law. Regulations which only recognise professional qualifications of a particular jurisdiction present obstacles to these fundamental freedoms." As a result, the European Commission has issued 17 directives in order to ensure mutual recognition of professional qualifications. Since the establishment of the single market, many court cases have come up regarding failures of member states to implement such directives. Examples include art restorers, school doctors, architects, hairdressers, nurses, lawyers and ski instructors. In each of these cases, someone from one of the professions was barred from working in another EU country because his or her degree or professional experience was not recognized by the host country. As recently as April 2002, that is, 10 years after the Maastricht Treaty, the commission launched an infringement procedure against 11 member states for failing to implement an EC directive relating to mutual recognition in some areas. These cases suggest that progress in implementing the labor mobility part of the Single European Act has been slow. A person considering working in another member country faces substantial uncertainty regarding whether he or she will actually be allowed to do so by the host country's government. Such uncertainty remains a significant barrier to labor mobility. One reason why the process is slow is that the EC has opted for a piecemeal approach, issuing specific directives for specific sectors and professions. Given the large numbers of countries and professions, this involves complex regulations and opportunities for cheating. Alternatively, the EC could have tried a more liberal and ambitious approach by challenging the very principle of recognition as a prerequisite for being allowed to work. Under such an approach, national governments would issue certifications rather than authorizations. Such certifications would be a signal of quality, and workers with different certifications by different governments (or by any private certification agency) would be allowed to freely compete in the same territory. This is, after all, what prevails for the bulk of wage earners.

2O2

While the administrative tradition prevailing in the EC makes it unlikely that it will evolve toward such a view (which might also be blocked by some member states), the community has nevertheless recognized that "over the years the legal environment for the recognition of professional qualifications has become more and more complex," and, in the aftermath of the Stockholm European Council, has launched a consultation to put forward a more uniform, transparent and flexible system. Another important impediment to mobility is lack of pension portability. This involves two main issues. The first is whether previous contributions in another member country can be validated when computing the pensions. This will not be the case if eligibility is conditional on a minimum contribution period and if mobility takes place before that period has elapsed. The second issue is whether differences in tax practicesâ&#x20AC;&#x201D;such as taxation at the date of contribution in one country versus the date when pension income is paid in anotherâ&#x20AC;&#x201D;can be offset to prevent double taxation of mobile workers' pensions. While main pension schemes were made transferable in the European Union Treaty, this is not the case for supplementary schemes, which represent a substantial portion of skilled workers' pensions. In the aftermath of the Stockholm Council, the commission has pledged to make proposals to increase supplementary pension portability. The European Union also has a piecemeal and discretionary approach when considering enlargement. Newcomers need not be fully integrated within the EU's legal framework overnight. For example, in the case of the accession of Greece (1981), Portugal and Spain (1986), a transition period of seven years was imposed before full labor mobility was granted. The European Commission proposed a similar transition period in 2001 for the next wave of enlargement, which will include 10 Central and Eastern European countries. The philosophy behind such restrictions is probably to ensure, in order to avoid being flooded by migrants from newly admitted countries, that enough convergence in income levels has taken place before boundaries are fully open. Indeed, such provisions were not imposed in 1995 when three wealthy countries joined (Austria, Finland and Sweden), nor in 1971, when Denmark, Ireland and the UK joined. Finally, according to EC plans, two accession candidates with small populations, Cyprus and Malta, will be able to bypass the seven-year transition period for labor mobility. Labor mobility in the European Union is traditionally low and is not very elastic to economic conditions. This is true for interregional as well as cross-border mobility. In France and Germany, among foreign residents only 37 percent and 25 percent,

2O3

respectively, are EU nationals. In terms of flows, in 1997, Germany still had a large inflow of about 150,000 EU residents, while the UK had 61,000 and France only had 6,400 and Italy 9,200.4 Presumably, the large influx of foreign EU residents in Germany is due to longstanding migration channels of unskilled workers from the south of Italy, while the UK benefits from having a virtually universally spoken language. By contrast, the French and Italian figures suggest that, absent these factors, cross-border EU migration is minute. It is also estimated that if unemployment goes up by 100 people in a particular area, only 30 of them would leave if that area were in Germany, only 8.4 in France, and only 3.7 in Italy.5 From an economic perspective, there is a large degree of complementarity between the European Monetary Union and closer integration of labor markets. Because of the EMU, individual countries can no longer offset an adverse shock by depreciating their currency. Alternative options are increasing price and wage flexibility, which requires painful structural reforms, or increasing cross-border labor mobility. If labor mobility is high, then when a region or country faces an adverse shock, people will move to other places with more favorable labor market conditions. This allows adjustment in the absence of movements in relative prices. However, the evidence of low cross-border migration, and low responsiveness of migration to shocks, suggests that this mechanism will be weak and that asymmetric shocks will generate tensions within the EMU. For these reasons it is important to remove remaining barriers to labor mobility within the Euroarea, such as the legal barriers that are described above. However, this is likely to be insufficient in light of the importance of linguistic barriers and the fact that even intra-country and interregional migration are low in Europe.

This box was written by Gilles St. Paul.

That area now only includes Iceland, Liechtenstein and Norway. EEA membership in effect is equivalent to EU membership, but excludes participation in the Common Agricultural Policy. 3 For example, in the Single European Act of 1986, the Social Charter of 1990, and the 1998 Treaty of Amsterdam. 4 5

See Bruecker et al. (2001).

SeePuhani(2001).

Currency Unions

CHAPTER

than others that do not. While obviously interesting, it is not exactly the right question from a policy perspective. What one would want to know, as a policymaker, is the impact of a currency union on those countries that adopt it. Click and Rose (2001) address this question using panel data from 1948 through 1997. This extended period of time is crucial, since it allows the authors to have enough country pairs with periods during which they shared currencies, as well as periods during which they did not. These are actually the country pairs that provide the information from which the currency union effect is estimated. Click and Rose find that adopting currency unions nearly doubles bilateral trade among member countries. However, the sample ends in 1997, before the creation of the EMU. And most changes in common currency status are exits, rather than countries joining currency unions. Thus, while Click and Rose attempt to answer the right policy question, their answer is relevant mostly for very small and poor countries leaving currency unions. These controversial findings by Rose and his co-authors have launched a large number of studies seeking to "shrink" the currency union effect.32 Persson (2001) and Tenreyro (2001) point out that the likelihood that two countries will adopt a common currency is not random, and may depend on the characteristics of the countries. Failure to account for this non-random selection may bias the results. Using different techniques to address this problem, these authors find common currency effects on the order of 60 to 65 percent, much smaller than those found by Rose, and not always statistically significant. Yet, nothing in these studies addresses the issue that concerns us: all the results are derived from the experience of very small or poor countries. Two studies that provide some hints about the common currency effect on trade in large countries using historical data are Estevadeordal, Frantz and Taylor (2002) and Lopez-Cordova and Meissner (forthcoming). Both look at the experience of countries during the gold standard, using smaller samples that consist primarily of industrial countries and a small group of large developing countries. Using data from 1870 through 1939, Estevadeordal, Frantz and Taylor find that common participation in the gold standard increased trade between 34 and 72 percent, depending on the specification used. Lopez-Cordova and

Meissner, using data from 1870 through 1910, find the gold standard effect to be 60 percent. In addition, they find that currency unions double trade, a result similar to that found by Click and Rose (2001). Another recent study that has addressed this problem is Rose and van Wincoop (2001). It estimates the potential EMU effect on trade, using data on preEMU common currencies. According to the theory developed by Anderson and van Wincoop (2001), bilateral trade between a pair of countries depends on their bilateral trade barrier relative to average trade barriers with all trade partners (i.e., their multilateral trade barrier or "multilateral resistance.") This implies that the larger the levels of pre-union trade among the members of a currency union, the smaller the percentage increase in trade.33 Accordingly, a currency union between two small and distant countries will have a larger effect than one among large and proximate countries. Welfare effects, however, are larger among countries that do trade a lot. The methodology allows the authors to estimate the trade effect of different potential currency unions, even those that have not yet been created. For the case of the EMU, Rose and van Wincoop find that trade would increase on the order of 60 percent, while the gain in welfare would be 11 percent. While this methodology is appealing, the estimated effects depend crucially on a number of assumptions (such as assumptions regarding the elasticity of substitution between different goods). Moreover, it is now possible to estimate the effects of EMU on trade between its members directly, since data on trade are already available for 1999 through 2001. In what follows, we present our own results on the trade effect of currency unions drawn from the early experience of the countries in the European Monetary Union. By focusing on the experience of these countries, we

The prize for best title among Rose's critics goes to Volcker Nitsch, for his 2001 study entitled "Honey, I Just Shrank the Currency Union Effect." 33

When a country reduces trade barriers vis-a-vis an important trading partner, the bilateral trade barrier falls, but the multilateral trade barrier falls as well. Thus, the relative trade barrier does not fall as much. In contrast, a reduction of trade barriers with a country with which one trades very little will have almost insignificant effects on multilateral trade barriers. Therefore, the relative trade barrier falls almost as much as does the bilateral trade barrier.

2O4

Currency Unions

provide evidence derived from countries that are at the

Figure 9.3

other end of the spectrum regarding country size and

2O5

EMU Effect on Trade (In percent)

income, and that have actually joined (rather than exited) a currency union. The impact on most Latin Amer-

Empirical Evaluation We work with bilateral trade data between 1980 and 2001 for the 14 countries in the European Union (counting Belgium and Luxembourg as one) from the International Monetary

Fund's Direction of

Trade

(2000).34 Ten of the countries have been members of the European Monetary Union since 1999.35 This sample results in 45 country pairs that share a common currency, and 46 country pairs that do not.36 We Source: Micco, Stein and Ordonez (2002).

exploit this variation to evaluate the effect of EMU on trade. As with most of the literature on the effect of currency unions on trade, our study is based on the gravity model of bilateral trade, modified to include a dummy variable that takes a value of 1 when the two

bilateral trade was on the order of 14 percent (1.43 /

countries in the pair belong to the EMU. In our case,

1.25 = 1.144).38 The figure shows two other key

this dummy takes a value of 1 for these pairs even

points. First, the increase in the EMU effect can be seen

before the formation of the European Monetary Union.

already in 1998, in anticipation of official establishment

As an example, we assign a value of 1 to the Spain-

of the union.39 Second, the impact of the EMU on trade

Germany country pair for the year 1993, even though

was still increasing in 2001, the last year for which we

the Euro did not exist at the time. The goal of our

have trade data, suggesting that the EMU effect may be

experiment is to follow the value of the coefficient for

somewhat larger, when all is said and done.

this dummy over time. If the EMU has an effect on trade, we should observe an increase in the coefficient corresponding to our EMU dummy following its creation. Figure 9.3 presents the evolution of the EMU effect since 1992, the year when the Maastricht treaty was signed.37 The EMU effect is always positive, even before the union was officially established. The key is not the size of the EMU effect as measured in the figure, but rather its jump after 1999, following the formal creation of the EMU. Take, for example, the year 1996, which is more or less representative of the preformal EMU effect. Bilateral trade among EMU-bound countries that year was already 25 percent larger than trade between other country pairs, all else being equal. For the year 2000, however, the EMU effect is 43 percent. Thus, the impact of the formal creation of EMU on

Micco, Stein and Ordonez (2002) also work with a larger sample of 22 industrial countries. Since the results are fairly similar, this chapter concentrates on the results obtained with the EU sample. 35

Since Greece only joined the EMU in 2001, it was considered a non-EMU country for the purposes of our empirical evaluation, although results are similar if we consider it within the EMU countries (see Micco, Stein and Ordonez, 2002). 36 The number of EMU country pairs is calculated as 10 x 9 / 2 = 45. The total number of country pairs is (14 x 13) / 2 = 91. That leaves us with 46 country pairs that do not share a currency union. 37

The regression is presented in Appendix Table 9.1. In order to follow the evolution of the EMU effect over time in the context of our panel dataset, we interacted the EMU dummy with year dummies. 38 The EMU effect for 1999, 2000 and 2001 was significantly different from that in each one of the pre-EMU years. 39

The impact in 1998, however, is not significantly different from that in previous years.

ican countries should probably lie somewhere in between these two extremes.

CHAPTER

The methodology used above has the advantage that we can follow the evolution of the EMU effect over time. The drawback is that we cannot come up with a single figure for the impact of the EMU on bilateral trade. Had we chosen 1995 and 2001 as our preand post-EMU years, we would have arrived at a different figure. An alternative methodology, which produces a single figure, is what is called the "difference-in-difference" approach. Consider an experiment in which a number of patients with a certain affliction are given a drug to test its effectiveness. Other patients are used as a "control" group, and are therefore not provided with the treatment. In order to measure the effectiveness of the treatment, it is not enough to compare the health of the treated patients before and after treatment. The reason is that the patients in the control group may also have improved their health, perhaps due to other factors (such as a change in the weather conditions, for example). The key to measurement of the effectiveness of the treatment is to check whether the treated patients improved more than the control group. Thus, the focus is on the difference (between treated and non-treated patients) in difference (before and after the treatment). The idea is that the use of the control group will help account for other factors that are changing over time. Here, we take a similar approach, in which the treatment is the creation of the EMU, the treated observations are the EMU country pairs, and the control group is the rest of the country pairs. The effect of the EMU treatment is 24 percent (24 = e°-213-1, see Appendix Table 9.2) when using the 1980-2001 period. However, this result is due in part to the fact that EMU countries increased their trade more rapidly than other country pairs during the 1980s.40 For this reason, we restrict the sample to the 1992-2001 period. In this case, the EMU effect is reduced to 12 percent (12 = e 0111 -!, see Appendix Table 9.2). In conclusion, we find the impact of the EMU on bilateral trade to be positive and significant, but much smaller than that suggested by the literature. While this may be due in part to the fact that not enough time has passed since the formation of the European Monetary Union, it is more likely associated with the type of countries involved: large and industrialized, as opposed to the very small and poor countries that drove the results in most of the previous

literature. Therefore, we expect that the impact of monetary union, at least among the larger middle-income countries in Latin America, will be smaller than that suggested by the literature to date.

TRADE INTENSITY AND BUSINESS CYCLE SYNCHRONIZATION: ARE DEVELOPING COUNTRIES DIFFERENT? While in the previous section we analyzed the first part of the endogenous optimal currency area (OCA) argument—that currency unions will result in increased trade integration—this section tackles the second part of the argument: the presumption that trade integration will result in increased cycle correlation. Empirical studies for industrial countries (Frankel and Rose, 1997, 1998; Fatas, 1997; Clark and van Wincoop, 2001) provide evidence that countries with closer trade linkages exhibit highly correlated business cycles. This finding prompted Frankel and Rose to state that countries that are ex ante poor candidates to enter a monetary union could satisfy the criteria ex post. As is obvious, the link between trade intensity and business cycle correlation plays a crucial role when considering the merits of a currency union among countries that a priori do not seem to comply with the OCA criteria, as is the case of most Latin American countries. But are the lessons from the experiences of industrial countries useful to help guide policy decisions in developing countries? To answer this question, it is useful to think about the channels through which trade integration may affect cycle correlation. One of these is a demand channel. Positive output shocks in a country might increase its demand for foreign goods. The impact of this shock on the cycle of the country's trading partners should be positive, and its magnitude should depend on the depth of the trade links. Through this demand channel, then, trade integration will increase cycle correlation. For example, the cycle in the United States may have a larger effect on the cycle in Mexico, which trades mostly with the United States, than it would in Chile.

Within the context of our difference-in-difference approach, this means that the pre-EMU level of bilateral trade will be much lower on average than the post-EMU level, and thus the effect of the treatment may be overestimated.

2O6

Another important channel is related to industry-specific shocks. Through this channel, trade integration may result in lower cycle correlation. If trade leads to specialization in different industries, as is often the case among developing countries, industry-specific shocks will treat trading partners asymmetrically. However, this effect will be smaller when the pattern of specialization occurs within industries, as is often the case among industrial countries, for which trade tends to be intra-industry.41 The overall effect of trade intensity on cycle correlation will depend on the relative importance of the demand and industry-specific channels, and on the pattern of trade and specialization among the countries involved. The differences in the pattern of trade and specialization among different types of countries suggest that the impact of trade integration on cycle correlation in developing countries may differ substantially from that among industrial countries. Here we extend Frankel and Rose (1998) in order to analyze the impact of trade integration on business cycle correlation, not only among industrial countries, but also among developing countries, as well as among "mixed" (industrial-developing) country pairs. Our expectation is that trade intensity should have a positive effect on cyclical output correlation among industrial countries, in which trade is mostly intra-industry, and a smaller (and ambiguous) effect among other country pairs.42 To the extent that developing countries tend to have more intra-industry trade when they are partners in an RIA, it is possible that the impact of trade intensity on cycle correlation among RIA partners may resemble that among more developed countries.

2O7

We collected annual data for 147 (industrial and developing) countries over 1960-99 on both GDP and bilateral trade,44 then split the sample into four decades: 1960-69, 1970-79, 1980-89, and 199099. We then compute the measure of business cycle synchronization between each pair of countries, as well as averages of our annual bilateral trade intensities, over each decade. Figure 9.4 presents the average cycle correlation by decade, and by type of country pair. Two results are worth mentioning. First, there has been an increase in cycle synchronization around the world. While the correlation between business cycles was 0.023 in the 1960s, it was close to 0.06 in the 1980s and 1990s. More importantly, cycle correlation varies substantially depending on the nature of the country pair: for the 1990s, correlation among industrial countries was on average 0.25, while that among developing countries was only 0.042. Meanwhile, the cycle correlation among mixed (industrial-developing) country pairs lies somewhere in between (0.075). For the case of country pairs in Latin America, the correlation of the business cycle is on average 0.07. From these observations, we can conclude that North-North cycles are more synchronized than South-South cycles, and are a priori better candidates to form currency areas, according to this criterion. Figure 9.5 provides a first look at the link between trade intensity and cycle correlation for different types of country pairs. For the whole sample, we find a positive and significant relationship between these two variables (the correlation is 0.079), suggest-

Empirical Evaluation The key ingredients for our empirical evaluation are measures of bilateral trade intensity and measures of cycle correlation between country pairs. As a measure of trade intensity, we use the ratio of bilateral trade flows between each country pair to output in both countries. To measure the degree of business cycle correlation between pairs of countries, we follow Frankel and Rose (1997, 1998) and compute the correlation between the cyclical components of output for each country pair.43 Higher correlation implies a higher degree of business cycle synchronization.

For a discussion on intra-industry trade, see Box 2.3 in Chapter 2.

Trade flows among mixed country pairs, which have large differences in factor proportions, may oe even more inter-industry in nature than trade among developing country pairs.

In order to do this, it is necessary first to decompose each country's output into a trend component and a cyclical component. This decomposition can be done using a variety of de-trending techniques. The results we discuss below were obtained using our preferred de-trending method (the Band-Pass filter, developed by Baxter and King, 1999), but they are robust to the use of other methods, as well as alternative measures of trade intensity (see Calderon, Chong and Stein, 2002). 44

The bilateral trade data are taken from the International Monetary Fund's Direction of Trade (2002). Output data are from the World Bank's World Development Indicators.

Currency Unions

CHAPTER

Figure 9.4

Business Cycle Synchronization a. By decades

b. By country pairs (1990s)

Source: Calderon, Chong and Stein (2002).

ing that increased trade integration is associated with higher cycle synchronization. We also find important differences in the correlations, depending on the nature of the country pair involved: while for the case of industrial countries this correlation is 0.27, for developing and mixed country pairs, the correlation is 0.049 and 0.038, respectively. For Latin American countries, the correlation is 0.057. Although the link between cycle correlation and trade intensity seems to be positive in all cases, these simple correlations suggest that the link is much weaker for developing countries, which is exactly what we expected to find. In order to look more carefully at the relationship between trade intensity and cycle correlation, we perform some regression analysis, in which we control for asymmetries in the production structure of the countries in the pair, since we expect countries with similar production structures to have higher cycle correlation.45 In the regressions, we account for potential problems of endogeneity. For example, cycle correlation could lead to currency union, which in turn could lead to increased trade intensity. Or, both of our variables could be explained by a third one, namely whether the countries in question share a currency union, which may lead to higher trade integration (due to reduced transactions costs) as well as to increased cycle correlation (due to policy coordination).46

The main results are presented in Figure 9.6, which illustrates the impact on cycle correlation of a one standard deviation increase in trade intensity for the different country pair groups.47 The corresponding increase in cycle correlation is 0.08 for industrial country pairs, 0.010 for mixed pairs, and 0.017 for developing country pairs. Taking into account the average cycle correlation for each group of country pairs for the 1990s presented in Figure 9.1, these results suggest that a one standard deviation increase in trade intensity would increase cycle correlation between industrial countries from a mean of 0.254 to 0.334. Meanwhile, the impact on developing country pairs would be to increase cycle correlation from a mean of 0.042 to 0.059.48 Are the results any different for countries that are partners in an RIA? The answer is provided in Figure 9.7. Cycle correlation is greater among countries

We use a measure of production asymmetries suggested by Krugman (1991). See Appendix 9.1 for details on the construction of the index.

We deal with this problem in the standard way, by using instrumental variables estimation.

The regressions are presented in the tables in Appendix 9.1. More complete results can be found in Calderon, Chong and Stein (2002). 48

The impact on mixed pairs is an increase from 0.075 to 0.085.

2O8

Currency Unions

Simple Correlation between Business Cycle Synchronization and Bilateral Trade Intensity, 196O-99

Note: Bilateral trade measure normalized by GDP. Source: Calderon, Chong and Stein (2002).

Figure 9.7

Effects of Trade Intensity on Business Cycle Synchronization by Country Pair Type and RIAs

Figure 9.6

Effects of Trade Intensity on Business Cycle Synchronization by Country Pair Type

Source: Calderon, Chong and Stein (2002).

that are partners in RIAs, as evidenced by the bottom portion of the stacked bars. The difference is quite large both for industrial as well as developing country pairs. For the latter, cycle correlation jumps from 0.041 among countries without RIA links to 0.145

among

countries that share an RIA. As expected, the impact of trade intensity on cycle synchronization is also larger for countries in RIAs.49 For the whole sample, the effect of a one standard deviation increase in bilateral trade intensity increases the cycle correlation from 0.052 to 0.079 for country pairs without RIAs, and from 0.259 to 0.367 for country pairs with RIAs. When we decompose these responses by country pair type, we see that for industrial country pairs, the impact of a one standard deviation increase in bilateral trade intensity does not depend on the RIA status.50 In contrast, for developing country pairs an increase of one standard deviation in trade intensity raises the cycle correlation from 0.145 to 0.209 for country pairs with RIAs and from 0.041 to Source: Calderon, Chong and Stein (2002).

0.067 for country pairs without RIAs.

We allow the RIA dummy to change both the intercept and the slope in these regressions. 50

The difference is quite small and not statistically significant.

Figure 9.5

209

CHAPTER

The impact of trade integration on business cycle synchronization is positive and significant for all groups of country pairs, but our results suggest that the impact is much weaker in the case of developing country pairs, even those that share membership in the same RIA. While the impact of trade integration on business cycle synchronization may be enough to warrant the formation of a currency union among industrial countries that did not seem good candidates to do so ex ante, as a general rule it would be hard to argue in favor of such a move in the case of developing countries, based on the evidence we have provided. On the other hand, it is important to recognize that a monetary union may have an impact on cycle correlation that does not go through trade integration, since it eliminates exchange rate swings, which may be a determinant of cycle asymmetries.

CONCLUSIONS AND POLICY DISCUSSION Most RIAs in Latin America and the Caribbean do not meet the criteria for optimal currency areas. Although forming currency unions would increase trade integration and perhaps cycle correlation, it is not clear that these effects would be large enough to justify the formation of monetary unions. However, the answer to whether some of these RIAs should consider forming currency unions in the future will depend on the extent to which member countries want to commit politically to deeper integration within their respective blocs. Unless countries are willing to expand the scope of the RIAs much beyond customs unions or free trade areas, monetary integration makes little sense. The Latin American RIA in which the question of monetary union has received the most attention is Mercosur.51 Perhaps this is fitting, given that Mercosur has been subject by far to the greatest exchange rate volatility of any of the RIAs in the region (see Figure 8.2 in Chapter 8). Before concluding that some exchange rate coordination is needed, it is important to ask whether this volatility is excessive. Bilateral exchange rate volatility may simply be an indication that the countries in question are subject to asymmetric shocks, and that the needed adjustment is taking place. In an excellent article about the merits of a single currency for Mercosur, however, Eichengreen (1998) finds that

the exchange rate volatility in Mercosur is two and a half times greater than what would be warranted given the characteristics of its member countries.52 This leaves an RIA such as Mercosur with three options. The first is to do nothing, and learn to live with the volatility. As discussed in Chapter 7, however, exchange rate swings can be costly and, unless actions are taken to reduce these costs, may end up eroding support for the RIA in the member countries. The second option is to try to establish some mechanisms to limit volatility. The third option is a monetary union. It is not clear, at this point, that the member countries have the political will to pursue a more ambitious integration project, within which a monetary union would make more sense. If such political will develops over time, a monetary union may be worthy of serious consideration. In the meantime, we are left with the second option, i.e., limiting exchange rate volatility, which in any case may be seen as a first step on the long road to a monetary union.53 There are different approaches to limiting volatility. There seems to be broad agreement that a system of exchange rate bands such as the European Monetary System would be unfeasible in a world of high capital mobility (Eichengreen, 1998). Sharing information, increasing transparency and adopting common standards to allow easier comparison of data across countries seems to be warranted. Beyond this, authors such as Lavagna and Giambiagi (1998) suggest the need for coordinated targets a la Maastricht on inflation, fiscal deficits, current account deficits and credit to the public sector. Other authors such as Eichengreen (1998) are skeptical about targets

Although there are some earlier studies on the subject, discussions on a single currency for Mercosur in academic and policy circles intensified considerably after Argentine President Carlos Menem proposed the idea in April 1997. For a discussion about monetary union in Mercosur, see Giambiagi (1999), Lavagna and Giambiagi (1998), Eichengreen (1997, 1998), Licandro Ferrando (2000), Fratianni and Hauskrecht (2002), and Carrera and Sturzenegger (2000). 52

Eichengreen (1998) controls for asymmetry of output shocks, asymmetries in the composition of output and trade, the degree of trade integration, and country size. 53 Even those who support a monetary union for Mercosur recognize that the process will take time (see, for example, Giambiagi, 1999). An exception is Fratianni and Hauskrecht (2002), who argue that a long transition process in which countries give independence to their national central banks and adopt credible inflation targets would be more desirable, yet recommend the immediate adoption of the Brazilian real by Argentina as a way to resolve the current crisis.

21O

211

and suggest a more institutional approach that

different approach would be to follow the example of

strengthens budget institutions and provides independ-

the countries of the Organization of Eastern Caribbean

ence to the central banks.54

States (OECS), which are pegged to the U.S. dollar, or

An RIA in Latin America that may be closer to

the CFA countries in Africa, which are pegged to the

meeting the necessary conditions for monetary union is

French franc.57 One advantage of this option is that the

the Central American Common Market, particularly if

union does not give up the seigniorage revenues. It

the countries adopt a hard peg vis-a-vis the U.S. dol-

also provides the flexibility to depreciate, as the CFA

lar. While the extent of trade integration among the

countries did in 1994. However, it is unlikely to solve

CACM countries alone is not that large, once the Unit-

the problem of "original sin," since it may not reduce

ed States is included, intra-regional trade for the five

the extent of dollar liabilities in the balance sheets of

CACM countries becomes even larger than that among

firms, households, banks and governments.

the EU countries. It is worth noting that, in addition to

Finally, it is important to stress that there are a

being future partners in the FTAA, the countries in the

number of conditions needed for a monetary union to

CACM are currently negotiating a free trade area with

work reasonably well. While different authors stress

the United States. Cycle asymmetries among the CACM

different conditions, here we will follow Eichengreen

countries, as well as between them and the United

(1998), who emphasizes the importance of four condi-

States, are also comparable to those found in Europe.55

tions in particular. First, countries that form a currency

Some of these countries (El Salvador, Guatemala) have

union should make sure that their common central

important migration flows to the United States, and

bank is independent, and thus insulated from political

receive substantial remittances from the migrants. Migra-

pressures. The same has to be true of the national cen-

tion flows are also substantial between Nicaragua and

tral banks, if they continue to have a role, as they do

Costa Rica. The CACM countries are also part of an

in the EU, after the creation of the joint common cen-

important initiative to integrate their physical infrastruc-

tral bank. In the case of Europe, central bank inde-

ture (the Puebla-Panama Plan, see Chapter 6), and are

pendence at the national level was a pre-condition for

starting to consider the convenience of financial integra-

entry into the EMU. Second, countries should work to

tion (see Chapter 5). El Salvador has already adopted

increase wage and price flexibility. Otherwise, asym-

the dollar (see Box 9.2), and the remaining CACM coun-

metric shocks may give rise to high unemployment,

tries are de facto highly dollarized, reducing the effec-

which in turn could lead to pressures to abandon the

tiveness of monetary policy.56 The fact that the CACM countries seem to comply with some of the OCA criteria, however, does not mean that they should necessarily go on to form a monetary union. Relinquishing a country's currency is a politically sensitive issue, and member countries may not have the political will to advance in that direction. As before, the key is the extent to which these countries wish to transform their current RIA by pursuing a much more ambitious integration project. Should countries in the CACM wish to form a monetary union, they would have a number of options. The adoption of the dollar in each country would probably maximize the credibility benefits (lower inflation, lower interest rates) and would be institutionally less demanding. In addition, it would automatically eliminate the problems associated with currency mismatches, and provide a vehicle for firms in these countries to hedge risk in commercial and financial transactions with the rest of the world. A

See Zahler (1999) for a more general discussion of the steps countries should take toward the formation of a currency union. 55

See Panizza, Stein and Talvi (2002).

As of 1999, the share of dollar deposits in the banking sector was 41 percent for Costa Rica, 35 percent for Honduras and 71 percent for Nicaragua, and nationals of these countries held a significant portion of their deposits in dollars in offshore markets. Offshore markets were also important for Guatemala, a country that until recently did not allow dollar deposits in its domestic system (see Panizza, Stein and Talvi, 2002). Interestingly, El Salvador, the one country in this group that has adopted the dollar, did not have a high degree of de facto dollarization. Balino, Bennett and Borensztein (1999) classify as highly dollarized those countries where the share of dollar deposits is greater than 30 percent. 57

The Eastern Caribbean Central Bank (ECCB), which is the common central bank of the OECS, functioned as a currency board until October 1983, when it was converted into a central bank with the responsibility to manage monetary policy. However, the ECCB is required to maintain foreign reserves equivalent to no less than 60 percent of its liabilities. The exchange rate vis-a-vis the dollar has never changed since 1 975, when the OECS switched from the peg to the pound sterling to the dollar (see Worrel and Smith, 1998).

Currency Unions

CHAPTER

union. This flexibility could be complemented by measures to increase labor mobility, although this may be more difficult politically, and Eichengreen does not think it is essential, provided there is enough wage flexibility. Third, countries should strengthen their financial sectors in order to reduce the likelihood of bank runs

and the pressures for the common central bank to provide bailouts. Fourth, there should be serious barriers to exiting the currency union. If countries can opt out easily, the currency union will not be credible, and the potential benefits will not be realized.

212

Currency Unions

APPENDIX 9.1 BILATERAL TRADE INTENSITY AND CYCLE CORRELATION: REGRESSION ESTIMATION

213

In our panel regressions, we control for asymmetries in the production structure of the country pair using an index suggested by Krugman (1991) which is,

trade intensity and cycle correlation, we use data from 147 countries arranged in pairs for the period 19601999, which we divide into four decades. To measure

where sn â&#x20AC;˘ and sn are the GDP shares of industry n in

the degree of business cycle correlation between pairs

countries / and /'. The higher the value of this index, the

of countries for each decade, we compute the correla-

greater the difference in industry shares across the

tion between the cyclical components of output for each

country pair and, therefore, the greater the differences

country pair, after decomposing each country's output

in the production structure. We compute two versions

series into a trend component and a cyclical compo-

of this index. In the first one, we use a simple 3-sector

nent. In the results shown in the text, we used the Band-

classification (agriculture, industry and services) and in

Pass filter in order to do the decomposition.

The GDP

the second one we use a 9-sector classification from

data come from the World Bank's World Development

the 1 -digit level ISIC code. The data for these indexes

Indicators.

come from the World Bank and UNIDO. The results

As a measure of bilateral trade intensity, we

reported in the text correspond to the 9-sector index,

use the ratio of bilateral trade flows between each

which is our preferred one. The 3-sector index, howev-

country pair to output in both countries. In the regres-

er, has wider coverage. In Appendix Tables 9.3, 9.4

sions presented in the appendix tables, we also use an

and 9.5, we report the regressions without this control

alternative measure in which bilateral trade is normal-

(model 1), using the 3-sector index (model 2) and the

ized by total trade in both countries, instead of total

9-sector index (model 3). The results using this last

output. The results reported in the text, however, corre-

index, and the bilateral trade intensity measure nor-

spond only to our preferred measure, in which bilater-

malized by output are highlighted in the table, because

al flows are normalized by output. We use annual

these are the ones that were used for the figures and

trade data from the IMF's Direction of Trade, and cal-

the discussion in the text.

culate the simple average of the bilateral trade intensity for each pair of countries over each decade. In our estimation of the relationship between these two variables, we use an instrumental variable model in order to deal with the problem of endogeneity. We take advantage of the gravity equation of international trade in order to choose our set of instruments for the bilateral trade intensity, which is instrumented using the following variables: distance between coun-

1 For a discussion of the Band-Pass filter, see Baxter and King (1999). Calderon, Chong and Stein (2002) discuss the convenience of using this technique, and show that the results are robust to the use of other methods. 2

The variable remoteness of country / is defined as the weighted average of that country's distances to all of its trading partners (except for the country / involved in a determined country pair). The weights for this average are the share of its partner's outputs in world GDP. In symbols,

tries / and /', remoteness of countries / and /,2 output, population, and geographic area of both countries, dummy variables for common border, dummy common membership in RIAs, number of islands in the (/',/) country pair, and the number of landlocked countries in the (/',/') country pair. Except for the dummy variables, the determinants are expressed in logs. The results obtained for this regression are consistent with those commonly obtained in the literature.

where m is defined over all trading partners of country /', except for country /'. For more details, see Calderon, Chong and Stein (2002), Wei (1996), Deardorff (1998) and Stein and Weinhold (1998).

To estimate the empirical association between bilateral

CHAPTER

Appendix Table 9.1

Independent variables GDP (log)

Per capita GDP (log) RIA

European Union 1992*EMU 1993*EMU 1994*EMU 1995* EMU 1996*EMU 1997*EMU 1998*EMU 1999*EMU 2000*EMU 2001* EMU

No. of observations

EMU Coefficients: Panel Data Regression Results (198O-20O1)

Appendix Table 9.2

Dependent variable Bilateral trade (log) 0.568 (9.19)*** 0.086 (1.72)* 0.095 (4.42)*** 0.085 (3.64)*** 0.224 (4.38)*** 0.202 (3.91)*** 0.222 (4.14)*** 0.206 (3.52)*** 0.222 (3.69)*** 0.228 (3.26)*** 0.274 (3.87)*** 0.339 (5.62)*** 0.357 (5.62)*** 0.397 (6.22)***

0.89 2,002

Note: The EMU dummy does not include Greece, which only became a member in the year 2001. Although in the regression we control for all possible year EMU interactions, we only report them from 1995 onwards. For a complete set of results, see Micco, Stein and Ordonez (2002). Country pair and year dummies are also included in the regressions but not reported. The European Monetary Union was created in 1999. Numbers in parentheses represent robust t-statistics. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level. Source: Micco, Stein and Ordonez (2002).

Difference-in-Difference Model: Fixed Effects Regression Results Dependent variable Bilateral trade (log) 1980-2001

Formal EMU dummy GDP (log)

GDP per capita (log) RIA

European Union R2 No. of observations

0.213 (8.51)*** 0.743 (11.72)*** -0.032 (0.61) 0.104 (4.48)*** 0.093 (3.72)***

0.886 2,002

1992-2001 0.111 (6.33)*** 4.729 (7.72)*** -4.486 (6.96)*** 0.044 (1.69)* 0.000 (0.02)

0.599 910

Note: Numbers in parentheses represent absolute values of robust t-statistics. Country pair and year dummies are included in the regressions but not reported. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level. Source: Micco, Stein and Ordonez (2002).

214

Currency Unions

Business-Cycle Synchronization and Trade Integration: Panel Data Regression Results Industrial Countries vs. Developing Countries Sample of All Country Pairs, 196O-99 Dependent variable: Business cycle synchronization

Independent variables

Model 1

Model 2

Model 3

1. Bilateral trade intensity (as a ratio of total trade in the country pair) Industrial-industrial Developing-developing Industrial-developing

R2 No. of observations

55.202 (14.18)** 36.171 (6.40)** 17.641 (5.56)**

60.306 (11.35)** 31.803 (4.51)** 20.644 (5.98)**

66.885 (9.08)** 36.585 (4.11)** 22.992 (6.29)**

0.02 16,647

0.02 12,652

0.01 9,760

29.154 (14.53)** 14.281 (4.71)** 9.59 (5.53)**

32.077 (11.55)** 11.153 (2.99)** 10.376 (5.71)**

35.152 (8.41)** 13.744 (2.86)** 11.72 (6.08)**

0.02 15,460

0.02 12,378

0.01 9,533

II. Bilateral trade intensity (as a ratio of output in the country pair) Industrial-industrial Developing-developing Industrial-developing

No. of observations

Note: Instrumental variables panel estimation. Time dummies for each decade included in all regressions are not reported. Cyclical output is computed using Band-Pass filter. In Model 1 we do not include the index of similarity; in Model 2 we include the 3-sector index of similarity, and in Model 3 we use the 9-sector index of similarity. For Figure 9.6 we use the bilateral trade intensity as a ratio of output in the country pair and model 3 (9-sector index of similarity). The standard deviation of the bilateral trade intensity of the country pairs is: 0.002263 for Industrial-industrial, 0.001225 for Developing-developing, and 0.000817 for Industrial-developing. Numbers in parentheses represent t statistics. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level. Source: Calderon, Chong and Stein (2002).

Appendix Table 9.3

215

216

CHAPTER

Appendix Table 9.4

Business-Cycle Synchronization and Trade Integration: Panel Data Regression Analysis The Effect of Regional Integration Agreements Sample of all Country Pairs, 196O-99

Independent variables

Model 1

Model 2

Model 3

1. Bilateral trade intensity (as a ratio of total trade in the country pair) Non-RIA member RIA member

R2 No. of observations

29.715 (5.25)** 14.066 (8.74)**

30.011 (4.46)** 1 1 .406 (6.36)**

0.02 15460

0.01 12378

28.055 (3.60)** 12.805 (6.48)** 0.01 9533

II. Bilateral trade intensity (as a ratio of output in the country pair) Non-RIA member RIA member

R2 No. of Observations

28.527 (9.04)** 66.153 (5.16)** 0.02 16,647

25.472 (7.11)** 62.914 (4.12)** 0.02 12,652

27.995 (7.08)** 68.814 (4.19)** 0.01 9,760

Note: Instrumental variables panel estimation. Numbers in parentheses represent t statistics. Time dummies for each decade included in all regressions are not reported. Cyclical output is computed using Band-Pass filter. In Model 1, we do not include the index of similarity; in Model 2 we include the 3-sector index of similarity, and in Model 3 we use the 9-sector index of similarity. For Figure 9.7 we use the bilateral trade intensity as a ratio of output in the country pair and Model 3 (9-sector index of similarity). The standard deviation of the bilateral trade intensity of the country pairs is: 0.001566 for RIA members, and 0.000959 for non-RIA members. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level. Source: Calderon, Chong and Stein (2002).

Dependent variable: Business cycle synchronization All countries

Currency Unions

Business-Cycle Synchronization and Trade Integration: Panel Data Regression Analysis The Effect of Regional Integration Agreements by Country Pair Sample of all Country Pairs, 196O-99 Dependent variable: Business cycle synchronization All countries

Independent variables

Model 1

Model 2

Model 3

1. Bilateral trade intensity (as a ratio of total trade in the country pair) (Industrial-industrial ) with non-RIA member (Developing-developing) with non-RIA member (Industrial-developing) with non-RIA member (Industrial-industrial) with RIA member (Developing-developing) with RIA member RIA

No. of observations

35.525 (8.58)** 9.744 (5.19)** 14.573 (4.70)** 28.328 (5.15)** 10.333 (1.35) -0.009 (0.17)

28.715 (4.19)** 10.478 (5.37)** 1 1 .472 (3.04)** 31.59 (4.86)** 8.823 (1.03) 0.011 (0.18)

0.02 15,460

0.02 12,378

0.01 9,533

68.663 (3.78)** 22.4 (5.76)** 32.911 (4.60)** 65.586 (4.56)** 23.305 (1.40) -0.034 (0.46)

103.588 (3.07)** 25.497 (6.14)** 38.352 (4.22)** 84.14 (5.44)** 40.575 (2.35)* -0.116 (1.52)

36.774 (3.20)** 12.021 (5.79)** 14.327 (2.93)** 37.655 (4.88)** 14.187 (1.58) -0.03 (0.47)

II. Bilateral trade intensity (as a ratio of output in the country pair) (Industrial-industrial ) with non-RIA member (Developing-developing) with non-RIA member (Industrial-developing) with non-RIA member (Industrial-industrial ) with RIA member (Developing-developing) with RIA member RIA

No. of observations

84.194 (8.39)** 18.816 (5.20)** 37.14 (6.44)** 62.158 (5.15)** 0.89 (1.97)* -0.064 (1.05)

0.02 16,647

0.02 12,652

0.01 9,760

Note: Instrumental variables panel estimation. Numbers in parentheses represent absolute values of t statistics. Time dummies for each decade included in all regressions are not reported. Cyclical output is computed using Band-Pass filter. In Model 1 we do not include the index of similarity; in Model 2 we include the 3-sector index of similarity, and in Model 3 we use the 9-sector index of similarity. For Figure 9.7 we use the bilateral trade intensity as a ratio of output in the country pair and Model 3 (9-sector index of similarity). The standard deviation of the bilateral trade intensity of the country pairs is: 0.001349 for Industrial-industrial with RIA member, 0.001571 for Developing-developing with RIA member, 0.001062 for Industrial-industrial with non-RIA member, and 0.001003 for Developing-developing with non-RIA member. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level. Source: Calderon, Chong and Stein (2002).

Appendix Table 9.5

217

CHAPTER

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Fischer, I. 1933. The Debt-Deflation Theory of Great Depressions. Econometrico 1 (4) October: 337-57.

Hausmann, R., and A. Powell. 1999. Alternative Exchange Rate Regimes for the Region. InterAmerican Development Bank. July.

Fischer, S. 2000. Ecuador and the IMF. Hoover Institution Conference on Currency Unions, Palo Alto, CA. May.

Hausmann, R., U. Panizza, and E. Stein. 2001. Why Do Countries Float the Way they Float? Journal of Development Economics. December.

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Wei, SJ. 1996. Intro-National versus International Trade: How Stubborn Are Nations in Global Integration? NBER Working Paper no. 5531. April.

Panizza, U., E. Stein, and E. Talvi. 2002. Assessing Dollarization: An Application to Central American and Caribbean Countries. In E. Levy Yeyati and F. Sturzenegger (eds.), Dollarization. Cambridge, AAA: MIT Press.

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Persson, T. 2001. Currency Union and Trade: How Large is the Treatment Effect? Economic Policy: A European Forum 33: 433-48.

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Effets of regional integrion

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REGIONAL INTEGRATION AND FOREIGN DIRECT INVESTMENT

Just as there has been a proliferation in the number and depth of regional integration agreements worldwide over the past two decades, there has also been a dramatic surge in flows of foreign direct investment (FDI). While world trade has increased over the period by a factor of two, flows of FDI have increased by a factor of ten. The increased FDI has flowed toward both developed and developing countries, and in fact has become the main source of foreign financing by a large margin for emerging markets, and particularly for Latin America and the Caribbean. In light of these developments, the role of regional integration agreements (RIAs) as a determinant of the location of FDI has become a key issue for emerging economies. For Latin America, the concern regarding the impact of RIAs on FDI is related to a wide range of initiatives, including subregional agreements, South-South arrangements, and agreements with the European Union (EU). The most wide-ranging agreement, of course, will be the Free Trade Area of the Americas (FTAA), which raises a number of important questions. What effect will the FTAA have on FDI from the United States and Canada to Latin American countries? How will it affect FDI from the rest of the world? What are the implications for a country such as Mexico, whose preferential access to the United States may be diluted? Should we expect to see winners and losers? What determines whether a particular country will win or lose?

RECENT FDI TRENDS IN LATIN AMERICA AND THE WORLD1 While FDI has been increasing rapidly for the last 20 years, the surge in multinational activity around the world was most dramatic during the second half of the 1990s, when FDI flows increased by more than 30 percent per year. FDI flows to Latin America followed a similar trend through 1999, but fell by nearly 20 percent during 2000 following seven years of steady growth (Figure 10.1).2 The spectacular rise in FDI in Latin America has resulted in a substantial increase in its importance, as measured by the stock of FDI as a share of GDP (Figure 10.2). While FDI stock represented less than 10 percent of GDP as recently as 1990, today it stands at around 23 percent. This is a far cry from the 60 percent share it represents for East Asia, but it is quite a bit larger than the corresponding figure for the industrial countries, which is on the order of 14 percent. Latin America has not been alone in terms of the significant increase in multinational activity: Figure 10.2 shows all regions in the world have experienced the same phenomenon.

1 For a more detailed analysis of recent FDI trends, see ECLAC (2000) and UNCTAD (2001). 2 It is not clear yet whether this fall marks a change in the trend, or whether it is just associated with the lumpy character of FDI. Some $15 billion of the $80 billion of FDI flows into Latin America in 1999 corresponded to a single operation: the purchase of Argentina's oil company by Spain's Repsol. Yet the downturn could also be explained by the fact that there is little left to privatize.

Chapter

224 CHAPTER

Foreign Direct Investment Flows, 198O-2OOO (In millions of US$, 7 996 constant prices)

Source: IMF, International Financial Statistics.

Figure 10.2

Source: IDB calculations based on IMF, International Financial Statistics and World Bank, World Development Indicators.

Figure 10.4

Figure 10.3

Index of FDI Flows by Region

Source: IDB calculations based on IMF, International Financial Statistics and World Bank, World Development Indicators.

A different way to compare the evolution of FDI in Latin America with that of other regions is by using an index of inward FDI developed by UNCTAD, in which a region's share in world FDI flows is divided by its share in world GDP (Figure 10.3). A value of 1 in this index indicates that the country attracts FDI in exact proportion to its GDP. The value of the index for Latin America increased substantially, from 1.08 dur-

Stock of FDI, 199O, 1999 (Percent of GDP)

Index of FDI Flows for Selected Countries and RIAs

Source: IDB calculations based on IMF, International Financial Statistics and World Bank, World Development Indicators.

ing the second half of the 1980s to 1.62 in the late 1990s. In other words, Latin America now receives 60 percent more FDI than what would be warranted by its share in world GDP. In fact, the region is now near the top of the rankings according to this index, closely following East Asia and the rest of Asia, which is dominated by China.

Figure 10.1

Regional Integration and Foreign Direct Invest

Table 1O.1

FDI Inflows to Latin America (Percent of GDP)

Latin America. Chile was included by itself in the figure because its integration strategy has not followed a subregional pattern. Mexico, apart from NAFTA, has a similar integration strategy and, had it been included within NAFTA, its index would have reflected mainly the evolution of FDI in the United States, by far the largest member of the group. Table 10.1 presents the evolution of the index for each of the individual countries as well. The results shows that the index increased for each of the RIAs considered, except for the Central American Common Market (CACM), which shows a small decline. Particularly noteworthy is the Caribbean Community (CARICOM), where the index increased dramatically. This group's share in FDI inflows is now three times larger than its share of GDP. The Andean Community (AC) and Mercosur are the other two groups with large increases in the index. Mexico, and especially Chile, while showing small declines in the index, are still among the countries that receive the most FDI in relation to GDP. Figure 10.5 shows the evolution of the composition of FDI by sector. For the world as a whole, there has been a shift in FDI from natural resources to services, which now account for half of total FDI stocks, while the share of manufacturing has remained fairly constant at about 40 percent. Not surprisingly, FDI in developed countries follows a similar pattern, since those nations represent a very large share of the total stocks.

Mercosur Argentina Brazil Paraguay Uruguay CACM Costa Rica El Salvador Guatemala Honduras Nicaragua AC

Bolivia Colombia Ecuador Peru Venezuela CARICOM Antigua & Barbuda Bahamas Barbados Belize Dominica Grenada Guyana Jamaica St. Lucia St. Kitts & Nevis St. Vincent Suriname Trinidad & Tobago Chile Mexico

1985-90

1995-2000

0.73 1.18 0.59 0.4 0.45 1.55 2.27 0.58 2.03 1.47 0.0 1.08 0.71 2.70 1.31 0.17 0.28 0.71 15.1 -0.35 0.7 4.36 9.7 7.50 0.22 0.99 11.3 22.80 5.85 -13.55 0.97

1.37 1.77 1.25 1.06 0.45 1.22 1.77 1.00 0.5 1.38 4.01 1.96 4.57 1.61 1.79 2.21 2.00 3.16 2.65 na 0.37 1.69 6.05 5.09 1.66 2.38 4.21 7.28 10.43

3.76 1.68

3.69 1.59

4.28

Source: IDB calculations based on IMF, International Financial Statistics and World Bank, World Development Indicators.

In Latin America, however, the pattern has been very different. First, the share of FDI in natural resources has increased from 9.6 to 12 percent. This

Figure 10.5

Sectoral Composition of FDI Stock, by Region (Percent of GDP)

can be explained by deregulation and privatization in mining, oil and gas, coupled with the discovery of new reserves. Second, the share of manufacturing has been cut in half. A likely explanation for this is the end of import-substitution industrialization. As we will see later in this chapter, one of the reasons for multinational activity is that it allows firms to "jump" trade barriers, and serve through domestic production a market that is too costly to serve through trade. As tariff barriers decline, this motivation for firms to engage in multinational activity becomes weaker. Third, the increase in the share of services in Latin America has been particularly large compared with other regions. While around the world the increase in services has been

Source: UNCTAD (2001).

Figure 10.4 shows the same index for inward FDI for a number of RIAs, and for some countries in

CHAPTER

linked mostly to the financial sector (see Chapter 6), in Latin America the privatization of telecommunications and other public utilities has also played a very substantial role.3 Having discussed the evolution and composition of FDI in Latin America, we can now return to the main focus of the chapter: the link between regional integration and FDI. For the most part, from here on we will be concentrating on FDI in the tradable sector. The impact of integration on FDI in non-tradables, such as the privatization of public utilities, is less clear, although there may be some potential links worthy of mention. First, some forms of integration may bring about an increase in institutional quality (less corruption, strengthened rule of law, etc.), which in turn may affect foreign participation in the privatization process. Second, the increasingly competitive environment that is brought about by integration may increase pressure from the private sector for competitive and reliable services, such as in electricity. This in turn may increase demand for privatization, which may bring about FDI. Finally, to the extent that integration in physical infrastructure becomes deeper (see Chapter 6), some activities that are usually thought of as non-tradables (such as electricity) may become tradables.

VARIETIES OF FDI One difficulty in assessing the impact of regional integration agreements on FDI is that there are many channels through which RIAs can potentially affect the location of investment. Moreover, the impact may run in opposite directions through the different channels. For instance, a firm may invest abroad in order to serve, through sales of a foreign affiliate, a protected market that it could otherwise serve only at a high cost through trade. Integration makes the market less protected and thus weakens the firm's motive for FDI. Alternatively, the firm may invest abroad in order to exploit different countries' comparative advantages for the various stages of production of a good. Following certain stages, the good will cross national boundaries and incur tariff costs; integration reduces such costs and so strengthens the firm's motive to invest. Depending on the motive for foreign investment, therefore, the relaxation of trade barriers implic-

it in an RIA may have completely different implications for the location of FDI. But there is more to consider than the motive alone. The impact of RIAs on bilateral FDI will also depend on whether or not the source country is a member of the RIA. NAFTA, for example, has affected flows of FDI to Mexico from U.S. sources differently than it has affected flows to Mexico from German sources. The same is true of whether or not the host country is a member of the RIA. NAFTA has affected FDI flows from the U.S. to Mexican hosts differently than it has affected flows from the U.S. to Caribbean hosts. Finally, the impact of RIAs will also depend on other characteristics of the host countries that make them relatively more or less attractive than their RIA partners as a potential location of foreign investment. From the outset it must be noted that the determinants of FDI may be viewed through different lenses, many of which overlap. One views FDI as either asset-seeking, that is, directed towards acquisition of new assets to make the firm more competitive in its present market; market-seeking, towards the firm's entry into growing markets; resource-seeking, towards finding less costly inputs; or efficiency-seeking, towards using presently employed inputs in a less costly manner.4 Different categories may be affected differently by integration. An RIA could generate more resourceseeking FDI, for example, by facilitating cross-border trade in inputs; but it could diminish market-seeking FDI if, after integration, the market in question no longer justifies domestic production of certain goods. But the effect of RIAs on other categories may be less clear-cut. For example, FDI seeking strategic assets may be affected differently depending on whether the asset in question is used to exploit the domestic market (for example, a distribution network) or the world market. Another view of FDI brings into focus that the above categories tend to apply to multinational economic activity in general, not just foreign investment. FDI is commonly defined as the acquisition of a 10 per-

FDI in water, gas and electricity amounts to more than 11 percent of total FDI in Latin America but only represents 2.5 percent of the total worldwide. 4

See Dunning (1993).

226

Reaional Integration and Foreian Direct Investment

respective corporate and production facilities require a

gle investor located in a different country. However,

different mix of factors of production, firms localize

behavior characterized as asset-seeking, market-seek-

each "stage" of production to take advantage of inter-

ing, resource-seeking, or efficiency-seeking need not

national differences in factor prices. The production

entail one firm's acquiring ownership of another. A firm

facility produces for the markets in both the host coun-

could seek resources by contracting with a foreign firm

try and the source country. An implication of the model

to supply the resources; or it could seek markets by

is that no FDI would be observed between countries

licensing the use of its patented production technique

with similar factor endowments: such countries would

to foreigners. In neither case would the activities be

have similar factor prices, eliminating the advantage of

registered as FDI, because they do not entail acquisi-

separating firms' corporate and production facilities.10

tion of an ownership stake. To understand the deter-

Horizontal FDI corresponds to the market-

minants of FDI, then, it is necessary to consider why

seeking and, in some instances, the asset-seeking cate-

some transactions are better undertaken within the

gories of FDI. Models of horizontal FDI typically feature

firm rather than at arm's length, between firms and

firms with multiple production facilities producing a

through markets.

homogeneous good, with one of those facilities located

The explanation is commonly framed in terms

at the company's headquarters.11 Each

production

of the importance, where FDI is commonplace, of "pro-

facility supplies its domestic market. A key assumption

prietary assets" like brand names or innovative pro-

in the horizontal model is the presence of firm-level

duction techniques.

Often firms that own these

fixed costs, arising from the necessity of only one cor-

proprietary assets will prefer to keep transactions with-

porate facility per firm. Firm-level fixed costs imply

in the firm, particularly when licensing contracts are

economies of scale that give multinational firms an

not easily enforceable, or when imitation and diffusion

advantage over domestic firms.

of the innovative technique is a concern. The impact of

The volume of horizontal FDI depends on the

RIAs on FDI therefore may depend on whether integra-

interplay between firm-level fixed costs, plant-level

tion facilitates the utilization of proprietary assets with-

fixed costs, and trade costs.12 In the absence of trade

in the firm, or instead does more to facilitate trans-

costs, there would be no reason for multinational pro-

actions involving such assets between firms.

duction: firms would concentrate their production in a

While acknowledging the usefulness of these

single facility at a single location, incurring plant-level

overlapping and complementary views of FDI, this

fixed costs only there and serving other markets

chapter will employ yet another one. Much of the liter-

through trade. As trade costs increase, so does multi-

ature on the topic refers to two broad categories of foreign direct investment: vertical and horizontal.8 For the purposes of this chapter, the vertical and horizontal categories represent a preferable way of "slicing" the myriad motives for FDI. While integration affects the strategic-asset seeking motive ambiguously, it affects the vertical and horizontal motives much less so.

Vertical and Horizontal FDI

Graham and Krugman (1995, p. 9) discuss the 10 percent criterion. The OECD (1996, 2000) uses the same criterion. 6

Caves (1996, pp. 3-5).

These concerns may also help determine whether the foreign firm enters through a joint venture, or as majority owner. 8 The discussion of these two categories is based on Markusen and Maskus(2001). 9

Vertical FDI corresponds roughly to the resource-seeking, efficiency-seeking and, in some instances, the asset-seeking categories of FDI. Models of vertical FDI typically feature a firm with a corporate facility (which may produce management services and research and development) and a production facility. The two are presumed to be geographically separable.9 As the

Helpman (1984) and Helpman and Krugman (1985) are early and seminal models of vertical FDI. 10 For this reason, Brainard (1993) characterizes vertical FDI as the factor-proportions approach to FDI. 11 For models of the horizontal variety, see Markusen (1984), and Markusen and Venables (1998). 12 Trade costs include both trade barriers and other transaction costs, such as transportation costs. Due to this interplay between scale economies and trade costs, Brainard (1993) has labeled this type of model the "proximity-concentration" approach.

cent or greater share of ownership of an asset by a sin-

227

CHAPTER

national production. An extreme case is illustrative: with trade blocked, each market must be served entirely by local production. The presence of firm-level fixed costs implies that the least costly way to serve local markets is to operate local facilities as branches of a multinational firm. In this sense one can think of horizontal multinational activity as a "tariff-jumping" strategy. As expected, the empirical implications of the horizontal model of multinational activity differ from those of the vertical model. Unlike vertical FDI, horizontal FDI is less likely to be found among countries with very different factor proportions. Dissimilar factor proportions imply dissimilar factor prices that induce firms to produce only in the location where the factor used intensively has the lowest price. In addition, horizontal FDI is discouraged by differences in country sizes. With a big country and a small country as potential plant locations, a firm is likely to produce only in the country with the large home market and serve the other country through trade, incurring trade costs on a small trade volume, but foregoing the cost of establishing a second plant. The implications of the horizontal and vertical FDI models seem to suggest that direct investment flows from North to Southâ&#x20AC;&#x201D;between countries whose sizes and factor proportions differ substantiallyâ&#x20AC;&#x201D;are more likely to be vertical, while North-North and SouthSouth flows are more likely to be horizontal. But the matter is not so clear-cut. First, countries in the North tend to have much lower trade barriers, at least in the manufacturing sector. As discussed above, both natural and policy-related trade barriers are a key ingredient of horizontal FDI. The general absence of high trade barriers among developed countries weakens the likelihood that North-North FDI will be horizontal. If the tariffs to be jumped are small, there is little point in tariff jumping.13 Second, horizontal FDI can arise between Northern and Southern countries, even when their factor endowments are very different, as long as trade barriers are high enough. The automobile industry in Latin American countries during the period of import substitution (or even today, within the protected environment of Mercosur) is an example of horizontal FDI. Finally, it may be that much of FDI does not fall neatly into either of the above categories. FDI may represent the acquisition or installation by firms of over-

seas plants, as in the horizontal model, but the plants may produce different varieties of a final good that are consumed in the local market and exported as well.14 FDI of this kind (we will call it "differentiated goods" FDI) may be likely where there are substantial firm-level fixed costs (otherwise there would be no advantage for multinational enterprises relative to separate firms in separate locations); when there are also substantial plant-level fixed costs (otherwise the multinational might set up a separate plant for each variety in each location and not export); and when the proprietary assets of brand or knowledge are particularly important. Such conditions may be accompanied by a difference of preferences among countries.15 A key difference between horizontal FDI and differentiated goods FDI is that, in the latter, production in each plant is not just for the domestic market, but for exports as well. In contrast to horizontal FDI, direct investment for differentiated products does not substitute for trade.

WHY Do REGIONAL INTEGRATION AGREEMENTS MATTER FOR FDI? Most data collected for FDI do not classify it as vertical or horizontal.16 It is not so easy to identify the motives for investment with any precision. To a certain extent, however, the nature of FDI flows between a pair of countries may be inferred from some characteristics of the source and host countries involved: whether the host country's economy is open or closed; whether the source and host countries are geographically proximate or apart; or whether they are big or small, rich or

The importance of tariff jumping as a motive for FDI is contested. Caves (1996, p. 55) writes that "historical evidence strongly confirms the effect of a tariff to lure the MNE's production behind the barrier." Yet, Markusen (1997, p. 2) argues mat "stylized facts suggest that...direct investment is not caused primarily by trade-barrieravoidance." 14

Helpman (1985) has modeled multinationals that produce different varieties of a final good in different locations. He called this FDI horizontal, a label criticized by Markusen and Maskus (2001). 15 Honda, for instance, produces its minivans in North America, a market that seems to love this brand of automobile, and not in Japan. Daimler-Chrysler produces minivans in the United States and the Mercedes Benz in Germany and exports in both directions. 16 Or, for that matter, as seeking markets, assets, efficiency or resources.

228

poor, or similar or dissimilar in resources. Most studies of the impact of RIAs on FDI focus on the last two variablesâ&#x20AC;&#x201D;the countries' levels of development and the similarity of their resource endowments. There is theoretical reason to believe that these variables are important, the data are easy to gather, and they are correlated, so they boil down essentially to a single variable. The relation of regional integration to FDI is thus examined most often by segregating the data into cases of North-North integration (between highly developed countries with resource endowments abundant in capital and skills), South-South integration (between less developed countries with endowments abundant in labor), and North-South integration (between countries of dissimilar levels of development and dissimilar endowments). In each of these cases, studies typically stress the difference between the impact on FDI between RIA partners, and that on FDI inflows from outside sources. One way to learn about the different cases is to study each of them separately. Among recent studies of North-North agreements, Dunning (2000) finds that since Europe's 1985 launch of its Internal Market Program, both intra-EC and outside-EC FDI have been stimulated, particularly the latter; FDI has grown the most in knowledge-intensive activities; and the growth of FDI has been complementary to the growth of trade. Of South-South agreements, Chudnovsky and Lopez (2001) find that FDI in Mercosur has been largely from nonregional sources; has taken the form primarily of mergers and acquisitions; has displaced domestic investment; and has been directed towards supplying the internal market (see Box 10.1). Of North-South agreements, Waldkirch (2001) finds that NAFTA has substantially increased FDI in Mexico, mostly from intra-regional partners Canada and the United States (see Box 10.2). He infers that the agreement's impetus to vertical integration is the likely explanation. Blomstrom and Kokko (1997) take a similar approach, although they group three case studies together to work towards a more comprehensive analysis. The Canada-U.S. Free Trade Agreement, their example of a North-North RIA, reduced the relative importance of intra-regional FDI to both countries but increased extra-regional FDI to Canada. In neither case was the effect dramatic, though, a fact attributed to the lack of major changes in economic policy result-

229

ing from the agreement.17 The South-South RIA, Mercosur, witnessed a substantial expansion of extraregional FDI, though macroeconomic stability is found to be a more important determinant of the inflows than the RIA. The North-South RIA, NAFTA, is found to have evidenced a dramatic increase in FDI inflows, particularly extra-regional FDI to Mexico, due to a combination of broader policy reforms undertaken contemporaneously in Mexico as well as Mexico's proximity to the U.S. market and its abundance of labor.18 In the end, there are few sweeping conclusions regarding FDI and RIAs that the authors are willing to draw from their case studies. Perhaps the most comprehensive is that the overall "environmental change" that is brought about, either because of or independent of the RIA, is what matters most. The case study methodology has the advantage that one can take into account the institutional detail of the countries under study when reaching conclusions about the impact of integration on FDI. At the same time, however, they demonstrate the difficulty of drawing conclusions about the importance of RIAs for FDI when so many other variables complicate the particular cases. In Mercosur, for example, it is difficult to disentangle the effect of the RIA from that of macroeconomic stabilization, which occurred approximately at the same time. In Mexico, the effect of NAFTA is hard to distinguish from that of other changes in policies toward FDI that took place contemporaneously. Moreover, the particular circumstances of each of the cases studied make it difficult to extrapolate the findings to other potential RIAs, particularly when these do not share the same circumstances. The boom of FDI in Mexico following NAFTA might have been unimaginable had this country not shared a border with the United States. To what degree was it the unique circumstances of each set of countries that mattered for FDI, and to what degree was it their RIA? Case stud-

17 Tariffs between the United States and Canada were already low prior to the agreement. 18 Blomstrom and Kokko's study emphasizes the increase of extraregional FDI flows to Mexico, while Waldkirch emphasizes intraregional flows to Mexico, because of changes in the data found in the time between their studies (1997 and 2001). According to the OECD bilateral FDI data we use later in this chapter, Mexico's FDI increased both from NAFTA and extra-regional sources.

Regional Integration and Foreign Direct Investment

CHAPTER

Box 1O.1

10 FDI In Mercosur in the 1990s1

Mercosur as a whole received more than $200 billion of foreign direct investment inflows between 1990 and 2000, of which 98 percent went to Argentina and Brazil. FDI came mostly from extra-regional sources, especially in the larger countries, where intra-regional FDI amounted to just around \ percent of the total. In contrast, intra-regional FDI accounted for 20 to 25 percent of FDI inflows to Uruguay and 40 percent to Paraguay. What has been the role of Mercosur in attracting extra-regional FDI inflows? At first glance, it would seem that Mercosur did contribute in this regard. While Mercosur partners received 1.4 percent of world FDI inflows between 1984-89, this figure increased to 2.1, 3.7 and 6 percent in 1990-93, 1994-96 and 1997-99, respectively. However, it is difficult to disentangle the role of Mercosur from the other changes that took place simultaneously, such as the adoption of structural reform programs and a more favorable macroeconomic climate than in the 1980s. An examination of the sectoral pattern of FDI inflows and of the objectives and strategies of multinational corporations (MNCs) that invested in the region in the 1990s may shed light on this issue. Services were the main destination sector for FDI, accounting for 80 percent of FDI inflows to Brazil, and around half of total inflows in the other three countries. Mercosur probably had little to do with attracting this purely market-seeking FDI, which was concentrated in public utilities (linked to privatization in Argentina and Brazil), banking, and retail and wholesale trade. For the most part, these investments led to stand-alone affiliates that replicate, at smaller scales, most of the functions of the respective headquarters, without closely integrating with the rest of the corporation units. FDI aimed at exporting labor-intensive goods has been marginal in all Mercosur countries, especially Brazil and Argentina. Instead, export-oriented, resourceseeking investments, although marginal in Brazil, have been the main form of vertical FDI in the region, accounting for 35 percent of flows to Argentina (in the mining and oil sectors), and 20 to 25 percent of sales of MNCs in Paraguay and Uruguay.2 With the possible exception of FDI in agriculture in Paraguay, Mercosur has probably had little impact on the location of these resource-seeking MNCs, since their exports are mainly directed to countries outside the regional integration agreement. The manufacturing sector has attracted mostly horizontal market-seeking investments. In Argentina and Brazil, as a general rule, these investments have been directed toward the domestic rather than the extended market. Although a substantial share of exports from manufacturing MNCs has gone to Mercosurâ&#x20AC;&#x201D;60 percent for Argentina, 30 percent for Brazilâ&#x20AC;&#x201D;these exports represent

a very small portion of these firms' sales.3 In contrast, in Uruguay and Paraguay, exports to Mercosur comprise a much larger share of manufacturing MNC sales. Thus, intra-regional exports are more relevant in MNC strategies in the case of the smaller member countries. This would suggest that membership in Mercosur has been more important as a locational advantage for FDI in Paraguay and Uruguay than in Argentina and Brazil. However, especially in Uruguay, there is also evidence of MNCs divesting in the country in order to supply the market from Argentina or Brazil, a possibility favored by the dismantling of trade barriers among Mercosur member countries, there is also some evidence of investment diversion from Argentina to Brazil, especially after the 1999 devaluation of the real, in a context where significant incentives were offered by national and subnational governments in Brazil, mainly in the automotive sector. Mercosur has perhaps been most relevant in sectors where efficiency-seeking strategies have been used. This is notably the case of the automotive sector, where U.S. and European MNCs, on the basis of their own global and regional strategies, and fostered by specific policies in Mercosur, have tended to specialize their affiliates, creating a horizontal regional division of labor in which Argentine affiliates produce low-volume vehicles while Brazil specializes in high-volume models. What has been the impact of Mercosur on intra-regional FDI? While both Argentina and Brazil have become more significant as source countries (approximately tripling their annual outflows of FDI between the first and the second half of the 1990s), the bulk of these outflows went to extra-regional host countries.4 Available estimates covering 1990-96 indicate that Mercosur accounted for only 17 percent and 10 percent of outward FDI in Argentina and Brazil, respectively (see Chudnovsky, Kosacoff and Lopez, 1999). However, these figures correspond to a period when Mercosur was not yet in full force, and there is some evidence that the intra-regional share may have increased considerably in the late 1990s. 1

This box was written by Daniel Chudnovsky and Andres Lopez.

For Argentina, the figure excludes FDI in agriculture, which has been significant, but for which data are not available. 3 Even in sectors where MNC exports are relatively high (higher than the host country's average), exports to Mercosur by MNCs in manufacturing in Argentina and Brazil are only 10 percent and 4 percent of total sales, respectively (Chudnovsky and Lopez, 2001). 4

FDI outflows from Argentina jumped from an annual average of $500 million to $1.9 billion between 1989-94 and 19952000, while in Brazil the respective figures were $600 million and $1.7 billion.

23O

Regional Integration and Foreign Direct Investment

Has NAFTA Increased FDI in Mexico?1

Since the formation of the North American Free Trade Agreement (NAFTA) in 1994, Mexico has had an impressive increase in FDI inflows. From an annual average of $4.6 billion over 1989-93, FDI increased to $9.9 billion in 1996, $14.2 billion in 2000, and $24.7 billion in 2001 (Dussel Peters, 2002). Only China and Brazil outshine Mexico as targets of FDI among the emerging markets (UNCTAD, 2000). Whether the bulk of FDI inflows following NAFTA have come from Mexico's NAFTA partners, the United States and Canada, or from the rest of the world, is a subject of contention. Different databases suggest different stories. According to Dussel Peters, for example, the United States and Canada appear to be the main engines behind the increase in these inflows, with their share rising from 50 percent in 1994 to 79 percent in 2000 (the maquiladora sector excluded). However, a comparison of data on total inflows from the Banco de Mexico, and data on U.S. outflows to Mexico from the U.S. Bureau of Economic Analysis, suggests that the share of FDI inflows corresponding to the United States remained fairly stable throughout the period. The bulk of FDI in Mexico has flowed to the manufacturing sector—particularly the automotive, electronics and electrical equipment industries—which captured more than 60 percent of the total over 1994-2000. However, the importance of FDI in financial services has become more pronounced with foreign acquisitions of Mexican banks and insurance companies. In 2000-2001, FDI in financial services reached $18 billion, or 48.2 percent of total FDI flows to Mexico.2 Does NAFTA explain foreign investors' growing interest in Mexico? There are at least four reasons to believe so: (1) Mexico's preferential access to the North American market may have attracted both extra- and intra-regional FDI to exploit the country's comparative advantage in labor-intensive processes; (2) NAFTA's rules of origin may have induced input suppliers to move to Mexico from outside the NAFTA region; (3) NAFTA's investment provisions and dispute settlement mechanism likely enhanced Mexico's credibility as a favorable investment location; and (4) NAFTA in general has fostered Mexico's economic prospects by locking in and extending the country's unilateral economic reforms launched in the 1980s. However, NAFTA's impact on the upswing of FDI in Mexico is difficult to separate out from other competing explanations, such as the country's liberal foreign investment law of 1993 that opened nearly all economic sectors to foreign capital. Furthermore, the growth of FDI in Mexico is part of a global trend of increased FDI

to emerging markets. Indeed, while FDI to Mexico increased significantly in the 1990s, the country's share of total FDI flows to developing countries, or even to all of Latin America and the Caribbean, actually declined, as did its share in FDI outflows from the United States, from 3.8 percent in 1990-93 to 2.9 percent in 19942000. In the case of manufacturing, on the other hand, Mexico did increase its share in U.S. outflows (Dussel Peters 2002). These factors notwithstanding, NAFTA can be considered key to solidifying Mexico's economic reforms, as well as to ensuring continuous FDI inflows, even in the wake of the 1995 peso crisis. Indeed, had NAFTA not been formed, it is estimated that FDI flows from Canada and the United States to Mexico would have been 42 percent lower between 1994 and the end of 1999 (Waldkirch, 2001). NAFTA's impact can also be discerned from qualitative changes in firm behavior: it has made North America a single spatial unit, resulting in locational reshuffling and integration of the three countries' industries into regional production networks, particularly in the automotive sector (Eden, 2002). What of extra-regional FDI? The impact of NAFTA on extra-regional investment remains contested. While some argue that NAFTA served mainly to boost intra-regional FDI (Waldkirch, 2001), others maintain that the agreement was instrumental in inducing extraregional investors to move to Mexico in order to enjoy preferential access to the North American market (Blomstrom and Kokko, 1997). Still others speculate that extra-regional investors may have redirected part of their FDI from the United States and Canada to Mexico following the start-up of NAFTA (World Bank, 2000). In sum, notwithstanding the fact that NAFTA coincided with other factors accounting for the growth of FDI in Mexico, it can be regarded as important in shaping firms' regional strategies as well as in fostering Mexico's investment climate and thus helping sustain FDI inflows. Furthermore, plausible causal variables inherently related to NAFTA—such as sector-specific rules of origin—may be too subtle to be captured by an analysis of aggregate FDI inflows, and await a more careful examination of firm- and industry-level data.

1 2

This box was written by Kati Suominen.

Unless otherwise noted, these figures are taken from Dussel Peters, Paliza and Loria Diaz (2002).

Bex 1O.2

231

CHAPTER

ies, however well informed, cannot provide definitive answers.19 Another way to proceed, which provides a nice complement to the case studies, is to try to control for some of those circumstances within a large set of countries, all of which are sources or hosts of FDI, and most of which are parties to RIAs. There are enough RIAs in existence, and enough bilateral FDI data, to try to sort out quantitatively the effects of an RIA from the effects of other circumstances. What follows are the results of our own study (Levy Yeyati, Stein and Daude, 2002). As far as we know, this is the first systematic empirical evaluation of the effects of regional integration on FDI for a large sample of countries.

EMPIRICAL EVALUATION Before turning to the evidence, it may be useful to discuss briefly the different channels through which RIAs may affect FDI. To organize the discussion consistent with the case study evidence focusing on the different effects of FDI from insiders and outsiders, we consider what could be expected to happen when both the source and host are party to a particular RIA, and then compare that to what would happen were only one or the other party to the agreement.

Channels of Influence Effects on FDI from insiders. If the source and host countries become members of the same RIA, the data may evidence a tariff-jumping effect or an international vertical integration effect, depending on the kind of FDI that predominates. If FDI is horizontal, with tariff jumping as its motive, the reduction in trade barriers implicit in the RIA will probably lead to a reduction in FDI, as trade and foreign investment are alternative ways to serve the domestic market. If FDI is vertical, with integration of stages of production as its motive, the effect of the RIA will probably be to increase FDI, as transaction costs to engage in vertical integration across international borders are reduced. The net effect should depend, among other things, on how high the trade barriers were in the first place. Regardless of its impact on total FDI, an RIA can have the effect of changing the composition of FDI from horizontal to vertical. As sug-

gested previously, FDI among developed countries is in part associated with the production of differentiated varieties, and so fits neither the horizontal nor the vertical models. To the extent that this third type of FDI depends on the possibility of trading differentiated goods, an RIA should facilitate multinational activity of this type. Whatever the motive for FDI, if an RIA includes investment provisions to liberalize capital flows, harmonize legal norms, and set up institutions to handle cross-border disputes, it should be expected through this channel to increase FDI flows between its members.20 Effects on FDI from outsiders. The entrance of a country into an RIA may make it a more enticing host of FDI from an extra-regional source through an extended market effect, particularly if the FDI is horizontal. When Brazil entered Mercosur, for example, it may have been perceived as a more attractive host for FDI from outside sources. Foreign investors may find it more worthwhile to "jump" the common external tariff and set up plants in Brazil to supply the entire Mercosur region, whereas before they supplied each of the countries individually through exports. On the other hand, the extended market may encourage vertical FDI just as well as horizontal: an RIA reduces the costs incurred by extra-regional sources of FDI in locating different stages of production in several of the countries within the region. In fact, this effect can also be present for the case of FDI from source countries within the same RIA. Thus, whatever the motive for FDI, the extended market effect of a host country's entry into an RIA should result in more FDI for the RIA as a whole.21'22

19 The problem is one of too many variables that may matter, and too few observations from which to make inferences. 20

See Slemrod (1990) for an empirical study of the effects of investment provisions to FDI for the United States.

21 This effect may be particularly large in the case of Southern countries forming North-South RIAs. These countries may become particularly attractive to outside sources, since they combine some "southern" locational advantages (for example, low wages) with access to a developed market. Production of some Volkswagen automobiles in Mexico is a case in point. 22 In the case of free trade areas, rules of origin provide an additional reason for RIAs to foster extra-regional FDI, as firms in the region may shift from extra-regional suppliers to intra-regional suppliers of intermediate inputs in order to comply with the origin rules, providing incentives for the foreign suppliers to establish production within the region (see Chapter 3).

232

Regional Integration and Foreign Direct Investment

Yet within the RIA there may be winners and

233

Empirical Evidence In order to look at the impact of RIAs on FDI, we use

effect of FDI within the region. Before the RIA is

data on bilateral FDI stocks from the OECD's Interna-

launched, for instance, a multinational corporation

tional Direct Investment Statistics. The dataset covers

might have horizontal FDI in each of the countries in

FDI from 20 source countries, all of them from the

the region. When barriers to trade within the region

OECD, to 60 host countries, from 1982 through 1998.

are eliminated, the firm may choose to concentrate

One shortcoming of these data is that they do not cover

production in a single plant in a single country and

FDI between developing countries. Yet, it is the most

supply the rest of the countries through trade.

complete source available for bilateral FDI, which is a

The size of the individual economies may be an important variable in determining whether they are

key ingredient to study the effects of integration on foreign investment.

winners or losers from the redistributive effect. In the

As in several chapters of this volume, the

preceding example, Brazil was chosen deliberately.

empirical approach is based on the gravity model (see

Plant-level fixed costs may induce the firm to locate its

Box 3.1, Chapter 3), which has been used widely in

plant in the larger market, or perhaps the most cen-

the literature to examine the determinants of bilateral

trally located market, in order to minimize the cost of

trade, and has more recently been used to study the

supplying the whole region. The biggest losers, mean-

determinants of FDI.27 In its simplest formulation, the

while, could be medium-sized countries: large coun-

model presumes that bilateral trade flows (in our case,

tries are more likely to be FDI winners, and small

bilateral FDI stocks) are related positively to the prod-

countries are more likely to be supplied by trade rather

uct of the GDPs of both economies and negatively to

than FDI with or without the RIA.23 Beyond market size

the distance between them.

and location, countries that offer a more attractive

In studying the impact of RIAs on FDI, one

overall package for foreign investors due to the quali-

approach would be to work with cross-section regres-

ty of their institutions, the quality of their labor force,

sions, thus exploiting the variation across countries to

the development of their infrastructure, or their tax

see whether RIAs matter for FDI. The question, in this

treatment of multinationals will be more likely to be

case, would be whether countries that share RIAs with

winners in this redistributive game.

the source country receive more FDI than countries that

Effects of RIA by source country. When a source country enters into an RIA, the data may evidence a diversion or dilution effect. If membership in a regional integration agreement makes each member a more attractive host for FDI—as it does in the vertical model—then the RIA will make non-members appear relatively less attractive. We call this effect FDI diversion, an analogy to Viner's (1950) classic trade diversion concept: FDI from a source to non-partners may decline as the source enters an RIA.24' 25 Members of an RIA may experience a similar effect when the agreement is enlarged. Take, for instance, the potential effects of the FTAA on FDI flows from the U.S. to Mexico. To the extent that U.S. investment in Mexico is intended to exploit some locational advantages of Mexico, then as the preferential access of Mexico to the U.S. becomes diluted by the FTAA, part of the FDI may be relocated to members of the 26

larger agreement that have similar advantages.

23 As an example, the auto industry in Uruguay was virtually undeveloped even during the years of import-substitution industrialization. 24

As in Viner's trade diversion, the formation of an RIA may divert FDI from the most efficient location to a partner. For example, following NAFTA, a U.S. firm may locate in Mexico the production of an intermediate input it might have otherwise located in Costa Rica, in the absence of the preferential access enjoyed by Mexico. In Mexico, this "trade diversion" effect will be combined with all other effects of common membership with the source country. What we call trade diversion is the loss suffered by Costa Rica, as well as other countries, as a result of the creation of NAFTA. 25

Another example of investment diversion is found in the European Union. See Baldwin, Forslid and Haaland (1999).

Dilution is in a way different from diversion. Going back to the example of NAFTA and U.S. FDI in Mexico and Costa Rica, dilution is more the result of leveling the playing field, at least for a certain group of countries. In this case, with the FTAA, Costa Rica and Mexico will now be playing under the same rules, and FDI will go to the most efficient location within the region. 27

See Eaton and Tamura (1994), Frankel and Wei (1997), Wei (1997, 2000), Blonigen and Davis (2000), Stein and Daude (2001), and Levy Yeyati, Panizza and Stein (2001).

losers. Notwithstanding the increased FDI brought to the region as a whole, there may be a redistributive

CHAPTER

do not. There are a number of problems with this approach. First, it is possible that FDI is affected by other characteristics of the countries, which are difficult to account for. Second, countries may form RIAs because they already have large stocks of FDI, in which case there will be problems of endogeneity. In other words, trade agreements would not be causing FDI; rather, FDI would be causing RIAs. Finally, while the cross-section evidence may provide useful information, it does not answer directly the policy question that one would want to address: what is the impact of changes in RIAs on the countries that form them? Our empirical evaluation deals with these issues by using data that combine the cross-section and time series dimensions (i.e., panel data), and by concentrating on the effects of changes in RIAs on the bilateral FDI of each country pair.28 The fact that we are following each country pair over time helps us control for all the characteristics of the country pairs that are invariant over time, such as distance, whether the two countries share a common border or a common language, the similarity of their factor proportions, etc. It also helps account for other variables that may be relevant for FDI location but which may be difficult to observe. In addition, the data allow us to focus on the right policy question, that is, on the effects of changes in the RIA status of country pairs, leaving out the crosssectional dimension.29 We also include source and host nominal GDP to control for size, and year dummies to control for the spectacular increase in FDI over time. Finally, we include a number of variables associated with the effects of regional integration. The first of our regional integration variables is Some FTA, a dummy variable that indicates whether the source and the host countries belong to the same free trade area.30 This variable captures a combination of channels: tariff-jumping, international vertical integration, and the potential effect of investment provisions on FDI. A second integration variable we use is Extended market host, which captures the size of the extended market of the host country.31 For example, for the case of Brazil in the years before Mercosur, Extended market host takes the value of Brazil's GDP at the time; for the years after Mercosur, it takes the value of the four Mercosur countries combined. Following the previous discussion, as well as the existing empirical evidence, we expect an increase in the size of the

extended market to have positive effects on FDI for the RIA as a whole. Finally, a third integration variable is Extended market source, which captures the FDI diversion/dilution effects. We expect its coefficient to have a negative sign, suggesting that FDI to a host country diminishes when firms in the source country have other free trade agreement partners in which to locate their investments. Appendix Table 10.1 presents the results of our regressions.32 The main results are shown in Figure 10.6, which corresponds to column 1 in Appendix Table 10.1. The first bar in the figure shows the impact of the same free trade agreement variable. The impact is very large: forming an agreement with a source country increases the stock of FDI from that country by 116 percent.33 The positive effect reveals that the possible FDI loss due to the tariff-jumping argument is more than offset by other effects that operate in the opposite direction. The second bar captures the impact of the host extended market effect. Doubling the size of the extended market increases FDI from all sources by nearly 6 percent. Thus, by enlarging its home market through a free trade agreement, the host increases its attractiveness as a location for FDI. While this effect appears to be small, it is important to keep in mind that sometimes the increase in the size of the extended mar-

We do this by including in the regressions country-pair fixedeffects, that is, dummy variables corresponding to each of the country pairs. 29

To a certain extent, the inclusion of the country pair dummies addresses potential endogeneity problems, which would arise if countries select their RIA partners on the basis of the multinational activity between them. 30 The dummy is also 1 if countries are in the same customs unions or single market. However, we did not include as free trade agreements country pairs that have preferential trade agreements in which trade barriers among members are reduced but not eliminated. The source for this variable is Frankel, Stein and Wei (1997). 31 It is defined as the log of the joint GDP of all the countries to which the host has tariff-free access due to common membership in a free trade agreement (we include the host's own GDP as well). 32

The dependent variable is the log (1 + FDI). The log specification is the one typically used in the gravity model literature. The reason we add 1 to FDI is to avoid throwing away all the observations with no FDI, which provide useful information. For a discussion of the methodological issues associated with the treatment of the observations with 0 FDI, see Levy Yeyati, Stein and Daude (2002). 33 The coefficient for the same free trade agreement in Appendix Table 10.1 is 0.7682. Since FDI is in logs, it is necessary to transform this coefficient, by computing exp(0.7682)-1=1.155.

234

Regional Integration and Foreign Direct Investment

Figure 10.6

Impact of Regional Integration on FDI (In percent)

235

increases. The FTAA would represent an increase of around 16 percent in the extended market of the United States, with an associated decline of U.S.-originated FDI of 4.3 percent due to the dilution effect.37 In would be a significant increase of nearly 165 percent in the United States' direct investment position in Argentina. The result for Mexico would be quite different. Since Mexico and the United States are already members of NAFTA, the FTAA would have no direct effect on U.S.-originated FDI. There would be an indirect effect, however, due to the extension of Mexico's market. The extension of Mexico's market from its existing free trade agreements to the FTAA would be a scant 1 3

Note: All the coefficients are significant at the 1% level. Source: Levy Yeyati, Stein and Daude (2002).

percent, corresponding to an increase of U.S.-originated FDI of only 0.75 percent.38 Netting the source extended market effect (-4.3 percent), we arrive at an overall decline of U.S. FDI stocks in Mexico of 3.5 percent. While this small loss may be partially compensat-

ket is very large: for instance, when Mexico entered

ed by additional FDI from other sources (which also

NAFTA its extended market increased by a factor of

would increase by three-quarters of a percent), the fact

1 8. Finally, the doubling of the extended market of the

that the United States is by far the biggest FDI player in

source leads to an expected decline in the FDI stock

Mexico may still mean that this country could lose FDI

originating from that country of nearly 27 percent.

as a result of the FTAA.

Columns 2 and 3 in Appendix Table 10.1 show that

The numbers in this simple exercise can illus-

these results do not change much when we account for

trate potential asymmetries in the impact of the FTAA

other variables that may explain FDI location, such as

for different countries, but they must be taken with a

the stock of privatization to date (in order to control for

great deal of caution. The estimates that we use repre-

the fact that most FDI linked to privatization is in non-

sent the average impact of our regional integration

tradables) or the rate of inflation (in order to control for macroeconomic conditions). An interesting exercise that gives us a notion

variables over the whole sample. However, the impact may differ according to the characteristics of the countries in question. For example, FDI in countries that are

of the magnitude of these effects is to compare the

highly protected may be mostly horizontal, a type of

impact that the creation of the FTAA would have for FDI

FDI that substitutes for trade, in which case the impact

from the United States to Mexico and Argentina, according to the results presented above.34 Since it does not have a free trade agreement with the United sharing an agreement with the source, increasing U.S.-

34 The exercise is meant as an illustration of potential effects, and does not pretend to measure the specific effects of the FTAA on Argentina and Mexico with a high degree of precision.

originated FDI stock by 116 percent. In addition, the

States, Argentina would benefit from the direct effect of

Argentine economy would become more attractive to FDI because of the extension of its market from Mercosur to the FTAA.35 The 900 percent increase of its market would lead to an increase of U.S.-originated FDI stock of 53 percent.36 On the other hand, the source extended market effect would partially offset these

Note that given our methodology, the results would also be similar for any of the Mercosur countries, since the extended market variables change in the same way for all of them. 36

0.058*921 =53.418.

-0.267* 16.06 = -4.3.

The extension of the market for Mexico is smaller than that for the United States, since Mexico has a host of other free trade agreement partners in the region.

sum, the overall effect of the creation of the FTAA

CHAPTER

of Some FTA may be higher in more open economies. Similarly, the impact of extending the size of the host market may depend on the initial size of the market, or on the relative attractiveness of the economies that make up the extended host market. In what follows, we will perform some additional exercises in order to look, in a preliminary way, at potential asymmetries of the effect of regional integration on FDI. Two factors that may affect the impact of common membership in a regional integration agreement on FDI are the openness of the host country, and the similarity of factor proportions between the host and the source. These variables may matter because they help determine whether the bilateral stock of FDI is mostly vertical or horizontal. All else being equal, closed economies are expected to have a larger share of horizontal FDI, which according to the theory should decrease with regional integration. Economies that are similar in their factor endowments are not expected to have vertical FDI. This would suggest that FDI between similar countries should not benefit as much from integration. However, if a large part of FDI among developed countries is, as suggested above, of the differentiated good type, then the effects of similarity of factor endowments may be ambiguous. So the question is not just whether belonging to the same free trade agreement has an impact on bilateral FDI between the source and the host country. We want to know whether the impact of the same agreement changes with the degree of openness of the host country, and with the similarity in factor endowments between the source and the host. The results are reported in columns 4 and 5 of Appendix Table 10.1,39 The simplest way to present these results here is by means of Figure 10.7a, which shows that the impact of Some FTA increases with openness.40 In Figure 10.7b, we can see that its impact decreases as factor endowments (we used the absolute difference in capital per worker) become more dissimilar.41 In this last case, our results suggest that a host country that is very different from the source country with which it integrates may actually experience a fall in FDI from this source. These results have to be taken with caution, however, since they are drawn from the countries that have RIA links with source countries. In our sample, then, these results are drawn only from the experience of developed countries and Mexico.

Figure 10.7a Openness and the Impact of Common Membership in an RIA on FDI Stock (In percent)

Note: The extension of the line corresponds to the range of the sample regarding the degree of openness of the countries included.

Figure 10.7b Difference in Factor Proportions and Impact of Common Membership in an RIA on FDI Stock (In percent)

Note: The extension of the line corresponds to the range of the sample regarding the difference in capital per worker of the countries included. Source: Lev! Yeyati, Stein and Daude (2002).

Our regressions looked at these issues by adding to our baseline regression an interaction term multiplying Some FTA by openness, or by similarity of factor endowments. This allows us to look at the impact of common membership in the agreement at different values of these variables. 40

We used average openness for the host country during the sample period (see Appendix 10.1 for details). The impact of openness is weaker if, instead of interacting openness with Some FTA, we use a dummy variable for openness, which classifies as open those countries for which trade over GDP is above the sample mean.

Differences in land per capita, or the level of skill of the labor force, yield qualitatively similar results, although results are weaker when land per capita is used.

236

Regional Integration and Foreign Direct Investment

cians, engineers and managers with domestic firms

RIAs through the extension of the size of the market

may result in knowledge spillovers. Positive spillovers

may depend on country characteristics as well. Extend-

may also arise if the foreign firm trains workers who

ing the size of the market will bring more FDI for the

may eventually be hired by domestic firms. A related

RIA as a whole, but the effects may be unevenly dis-

source of positive spillovers, studied by Rodriguez-

tributed. A firm that had production facilities in each of

Clare (1996), is the potential for the development of

the countries in an RIA may want to concentrate pro-

new inputs, encouraged by the demand created by the

duction in a single facility once internal trade barriers

foreign firm, which may then become available to

are eliminated, and serve the whole extended market

domestic producers. Aitken, Hanson and Harrison

from that location. The choice for that location may

(1997) point out that multinationals that export their

depend on country size (particularly if trade costs are

goods to foreign markets may induce domestic firms to

not completely eliminated) and, more generally, on the

follow suit, thus acting as catalysts for domestic firms to

overall attractiveness of the host country. Preliminary

become exporters. Borensztein, De Gregorio and Lee

results (not shown in the appendix) suggest that most of

(1998) find evidence that FDI has a positive effect on

the benefits from the extension of the market are con-

growth, provided the level of human capital in the host

centrated either on the largest country in the RIA, or on

country is sufficiently high. Thus, in order to benefit from

the one that seems to offer the most attractive overall

the advanced technology introduced by foreign firms,

package. This last finding suggests that market

the host country has to have the capacity to absorb it.43

enlargement has a stronger positive effect on FDI in an

However, FDI may also generate negative

FDI-friendly environment.

spillovers. Domestic firms may be displaced by the foreign firm, or may find that the cost of factors of production increases as a result of the foreign investment.

FDI POLICY IN INTEGRATING COUNTRIES

While most of the earlier empirical literature on the subject supported the presence of positive externalities,

The evidence discussed in this chapter suggests that

recent work based on firm-level data has found some

RIAs can have important effects on foreign direct invest-

evidence of negative externalities. Aitken and Harrison

ment to members and non-members alike, although

(1999) find that growth of total factor productivity in

those FDI gains are unlikely to be distributed evenly. The

Venezuela was lower for domestic firms in sectors where

results indicate that the gains may be smaller for coun-

FDI was greater. The authors focus on within-industry

tries that are less developed, closed to international

spillovers, however. Kugler (2000) and Chapter 11 in

trade, and altogether unattractive to foreign investors.

this volume find evidence of important positive inter-

The discussion throughout this chapter has

industry spillovers for Colombia and Mexico.44

equated gains in FDI with gains in general welfare. The national "winners" from RIAs are presented as those whose FDI inflows increase, and the national "losers" are those whose FDI inflows might decline. However,

investment is at best a mixed blessing, bringing with it

To examine this last issue, we constructed an index of attractiveness for host countries by looking at the extent to which they receive FDI, after controlling for size, for the formation of RIAs, and for geographical characteristics. Once we control for these characteristics, whether a country receives little or much FDI may depend on factors such as the quality of institutions, the education of the labor force, the quality or their infrastructure, their tax treatment of multinationals, and their factor proportionsâ&#x20AC;&#x201D;in other words, on their overall attractiveness as a destination for foreign investment.

a measure of harm that may outweigh the good.

the question of whether FDI generates positive welfare effects for the host countries has been a subject of great debate. While most authors believe that FDI tends to be beneficial, there are some who believe that foreign

Our presumption that FDI is good is based on the idea that it may generate positive spillovers for the rest of the economy through a variety of channels. If the foreign firm is technologically more advanced than most domestic companies, the interaction of its techni-

For a more complete discussion of FDI spillovers, see Blomstrom and Kokko (1998) and Hanson (2000). 44

Kugler (2000) argues that the lack of intra-industry spillovers may be due to the fact that foreign affiliates will appropriate as many of the benefits as possible of their imported technology, thus preventing spillovers from leaking to their competitors. On the other hand, they may want to upgrade the technological capabilities of a supplier, which explains the existence of inter-industry spillovers.

As with our Same FTA variable, the effect of

237

CHAPTER

Beyond the possibility of negative spillovers,

transfer and performance requirements. Domestic affil-

other authors have identified other potential sources of

iates of foreign-owned firms may be required to train

welfare losses for host countries as a result of FDI.

domestic workers to certain standards, locate R&D

Some have focused on national security concerns/

activities in the country, use a minimum content of local

when FDI occurs in sectors related to the defense indus-

inputs, export a certain proportion of their output, or

try, particularly if it involves a technology that the gov-

employ certain technologies. Such policies clearly aim

ernment would prefer to keep secret.45 Others have

to relieve balance of payments pressures and promote

noted that, if ownership of capital in a country is most-

spillovers, and there are reasons why they may be

ly in foreign hands, policies that increase domestic pro-

effective. If FDI is horizontal, the purpose of the invest-

duction but at the same time redistribute income from

ment is to serve the domestic market. If the multina-

labor to capital will mostly benefit foreigners, while

tional firm has not served the market according to the

most domestic citizens will lose.46 But both sets of cir-

stipulated requirements, it would not be able to serve it

cumstances are relatively uncommon. The few instances

at allâ&#x20AC;&#x201D;a powerful inducement to accept the require-

in which national security is an issue can be addressed

ments, provided they are not too onerous. For that rea-

by simply limiting FDI in those particular cases; and a

son, although

RIAs commonly include investment

policy tilted towards capital at the workers' expense,

chapters that bind members to the principle of nation-

combined with an overwhelming concentration of for-

al treatment (as did the Canada-U.S. free trade agree-

eign ownership, is unlikely in a democracy where most

ment), the members may negotiate exceptions to the

voters are workers and none are foreigners.

principle to allow some performance requirements (as

A different problem may be related to the fact

they did subsequently in NAFTA).49 Yet the evidence

that compared to domestic firms, affiliates of multina-

suggests that performance requirements have been

tional companies tend to import more of their inputs,

ineffective. Blomstrom, Kokko and Zejan (2000, Chap-

and thus contribute to generating balance of payments

ter 13) offer strong evidence that the requirements

deficits.47 Yet even this problem may be uncommon.

actually reduce multinational employment of technolo-

Just as foreign affiliates tend to import more of their

gy, and weaker evidence that they increase capital

inputs, they also export more of their outputs, and as

imports as well. In addition, some of these require-

discussed above, this may even induce domestic firms

ments, such as local content or trade balancing

to mimic their behavior and export more as well.48 This discussion of the potential benefits and

requirements, are either prohibited or being phased out under current WTO rules.

costs of FDI suggests that not all FDI carries similar ben-

Whether or not performance requirements are

efits. In particular, FDI may be more beneficial if it tar-

beneficial under some circumstances, they are least

gets more advanced industries (so that potential

likely to be so in circumstances of regional integration.

technological spillovers are larger); if it establishes

RIAs tend to promote vertical over horizontal FDI; they

strong forward and backward linkages with domestic firms (which may thereby absorb the spillovers); if it exports part of the production (relaxing balance of payments concerns, and inducing domestic firms to follow suit); and if domestic firms have the capacity to absorb those spillovers. The key question is, what kind of policies can countries adopt to ensure that the resulting FDI inflows are beneficial? In addition, how does

45 Graham and Krugman (1995, Chapter 6) offer several examples. An illustrative one is the prevention or the attempted takeover in the early 1990s of a U.S. aerospace industry supplier, Mamco Manufacturing Company, by the China National Aerotechnology Import and Export Corporation. 46

The commonly cited reference for this possibility is Bhagwati and Brecher(1980).

regional integration affect the desirability and effec-

tiveness of those policies? And what does all this sug-

gest regarding the type of provisions that should be included in an RIA investment chapter? Some of the policies that countries have used to try to get the most out of FDI involve technology

See Graham and Krugman (1995, p. 70).

Horizontal FDI, which may rely on imported capital and intermediate inputs but produces for the domestic market, may contribute to balance of payments deficits, depending on whether it substitutes imports or crowds out domestic production. Export-oriented vertical FDI, on the other hand, probably does not. 49

See Graham and Krugman (1995, p. 136).

238

239

also tend to extend the market for horizontal FDI from

these benefits through two different channels. First, an

individual countries to that of the RIA, thus making FDI

educated labor force may influence the type of FDI a

more footloose within the region. While a horizontal

country receives, shifting it toward more advanced

multinational firm may accept performance require-

industries, which may generate larger spillovers. Sec-

ments if it is necessary to serve a particular country's

ond, for a given type of investment, better education

output market, enlargement of the market with an RIA

increases the capacity of the labor force and of domes-

allows the firm to choose as its host whichever member

tic firms to absorb spillovers. In addition, foreign firms

country has the fewest requirements. A vertical multi-

that are attracted by an educated labor force become

national, even more, may simply choose a country out-

a strong constituency in favor of further improvements

side the region for a particular stage of production.

in education. This is clearly the case of Intel in Costa

Performance requirements, in other words, may be

Rica, where enrollment in engineering schools has

best suited for a state of the world that RIAs are

doubled in a matter of only a couple of years. In con-

designed deliberately to dismantle. The implication for

trast, foreign firms that are attracted by cheap labor

regional integration policy is that, where it comes to an

will probably lobby for the government to ensure its

RIA's investment chapter, unadulterated national treat-

continuous availabilityâ&#x20AC;&#x201D;a scenario far less appealing

ment may work better than any alternative to help a

as a development strategy.

country avoid becoming an FDI loser.51 If performance requirements are not helpful in

Competition in Incentives

attracting FDI to integrating countries, two other polar strategies may attract it. The first, which has been com-

To the extent that FDI produces positive spillovers, it

pared to a "beauty contest" (by Oman, 2000), involves

makes sense for governments to offer incentives to

improving the quality of institutions, educating the

potential investors to lure them into their territory.54

labor force and developing the country's infrastructure.

Provided there are economies of scale, eliminating

The second entails aggressive use of fiscal and finan-

trade barriers will induce firms to produce in just one

cial incentives to attract foreign investors. This is obvi-

location within a bloc and serve the extended market

ously a false dichotomy, as countries tend to do a little

from this location. Competition between countries for

of both. Yet it provides a useful way of organizing the

FDI may become intense. Yet the competition in incen-

discussion.

tives leads to allocative efficiency: the efficient number of investments end up being made, and they are

Beauty Contest One important advantage of what has been called the "beauty contest" strategy is that, beyond its effects on FDI, it can generate more obvious benefits for the whole society. Improvements in infrastructure, education or the quality of the institutional environment will certainly benefit domestic citizens and firms, regardless of their impact on FDI. Beyond these general benefits, there is evidence suggesting that improving the quality of institutions can have a large impact on FDI.52 The evidence regarding the impact of education and infrastructure on the location of FDI is weaker.53 This, however, does not mean that countries should not pursue these policies. While they may not contribute to the total amount of FDI a country receives, such policies can affect the benefits host countries derive from FDI. Education, for example, can affect

Coordinated adoption of performance requirements may solve the problem of location within trie extended market, but it does not stop vertical FDI from seeking more convenient locations. 51

The FTAA draft as of the Spring of 2002 includes in its investment chapter an article on performance requirements that would proscribe them. But the text is thoroughly bracketed and includes several bracketed exceptions. The question is under negotiation. See http://www.ftaa-afca.org/ftaadraft/eng/draft_e.asp 52

Stein and Daude (2001) show that a 1 standard deviation improvement in an index of institutional quality developed by Kaufmann, Kraay and Zoido-Lobaton. (1999) results in an increase in bilateral FDI of 130 percent. According to their study, reducing excessive regulation, enforcing property rights, improving the quality of the bureaucracy and reducing corruption seem to be some of the most promising policies in terms of attracting foreign investors. 53 54

See Stein and Daude (2001).

That is, it makes sense as long as the government is considered a social planner seeking to maximize the country's welfare. A potential problem with incentive-based competition, however, is that negotiations with potential entrants are rarely transparent and open to public scrutiny, so they could lead to arbitrariness and corruption.

Regional Integration ana Foreign Direct Investment

CHAPTER

directed toward the location where the social rates of

Improving the distribution of the benefits of FDI

return are highest. If there is a problem in the competi-

in favor of host countries may require some form of

tion, it is instead distributional in nature: if social rates of

coordination of incentive schemes among the region's

return for an investment in different locations do not dif-

host countries.55 As difficult as this coordination may

fer too much, foreign firms will be able to extract most of

be for South-South RIAs, it may be an even greater

the benefits associated with the investment. As a result,

challenge for a North-South RIA such as the FTAA,

we may see among countries of the region the same type

where the interests of source and host countries are

of subsidy wars previously seen between states in such

more likely to come into conflict.

countries as Brazil (see Box 7.3 in Chapter 7)

55 See Fernandez-Arias, Hausmann and Stein (2001), who show that elimination of incentive-based competition is not the optimal solution for host countries and, under some circumstances, may leave them worse off than they were when incentive-based competition was occurring.

240

HB^BSSZHinS'EEBSlEDHGSn^HiESBSMinSaSCuEnBi 241 m^^^^u^^^^^^^l^^^^^^m^^mi^ Dependent Variable: FDI stock (log)

GDP host (log) GDP source (log) Same RIA Extended market source Extended market host

Reg 1 0.8432 (14.60)*** -0.1282 (1.25) 0.7682 (9.54)*** -0.2670 (11.84)*** 0.0576 (2.58)***

Privatization

Reg 2 0.8587 (0.06)*** -0.1266 (0.10) 0.8131 (0.08)*** -0.2693 (0.02)*** 0.0482 (0.02)** 0.0196 (0.01)***

Reg 3 0.9111 (0.07)*** -0.2085 (0.11)* 0.7896 (0.08)*** -0.2650 (0.02)*** 0.0461 (0.02)**

Reg 4 0.8357 (14.44)*** -0.1277 (1.24) 0.1243 (0.57) -0.2688 (11.90)*** 0.0632 (2 82)***

0.4666 (8.74)*** -0.3632 (2.73)*** 1.1521 (9.02)*** -0.2739 (9.21)*** -0.0205 (0.68)

0.0641 (0.05)

Inflation

0.0095 (3.16)***

Same RIA * average openness

-0.7800 (4.19)***

Same RIA * difference in capital per worker

No. of observations R2

Reg 5

18,608 0.1234

18,608 0.1231

17,234 0.0945

18,528 0 1245

Notes: Country pair and time fixed effects included in all regressions not reported. Absolute value of z-statistics in parentheses. * Significant at 10% level. ** Significant at 5% level. *** Significant at 1% level. Source: Levy Yeyati, Stein and Daude (2002).

12,343 0.0389

Independent variables

CHAPTER

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244

REGIONAL INTEGRATION AND PRODUCTIVITY

One of the key rationales for what has been called the "new regionalism" is to increase productivity. While economists since Adam Smith and his pin factory have known that productivity enhancement is not an end in itself, it is arguably the principal source of economic growth and rising standards of living. As such, it takes on particular importance to regions such as Latin America and the Caribbean, where long-term sustainable growth has long been an elusive goal. Growth in the region has trailed that of East Asia since the 1960s, and in the past two decades has fallen below the overall developing country average (IDB, 2001). Growth accounting exercises that isolate the contributions of inputs (e.g., capital, education and labor) and total factor productivity to the growth process suggest that Latin America has been not only slow in accumulating inputs, but also particularly weak in raising productivity. The World Bank (1991) estimates that the region's average productivity growth over 1967-87 was zero, whereas the averages for East Asia and the developing countries as a whole were, respectively, 1.9 and 0.6 percent. The IDB (2001) estimates that productivity in Latin America declined in the 1980s and 1990s despite gains achieved elsewhere, particularly in the developed world. Against this backdrop, it seems clear that by promising productivity gains, the move to regional integration has touched a raw nerve in the region. Why and how these gains are supposed to be delivered in Latin America, and what empirical evidence is available to date to support those positions, is the focus of this chapter. It gives particular attention to the two

largest economies in the region, Brazil and Mexico, and to the performance of their manufacturing sectors. Given the size, geography and relative sophistication of their economies, these two nations might not be wholly representative points of comparison for all Latin American countries, but their experiences are nonetheless important because they involve two alternative modes of integration in the region: North-South and South-South agreements. Mexico pursued North-South integration through NAFTA, whereas Brazil signed South-South agreements, joining Mercosur. These divergent strategies provide a valuable policy experiment in terms of assessing implications for productivity growth.

WHY REGIONAL INTEGRATION MATTERS FOR PRODUCTIVITY Regional integration is, perhaps above all, about promoting trade and investment among countries (see Chapter 2). One can argue, then, that the nature of the costs and benefits involved is, to a great extent, the same as that of a process of unilateral, non-preferential integration into the world economy. This is particularly true for the "channels" that might impact productivity. Yet, there are some important specificities related to the preferential nature of integration that cannot be overlooked. For analytical purposes, it is worth looking first at the more general (non-preferential) case of integration and then move on to the specifics of the regional schemes. Hereafter, the term "integration" is used in the sense of the general process

Chapter

CHAPTER

of economic (trade and investment) integration, be it preferential or otherwise. For the specific cases of integration, the terms regional (or preferential) or global (or non-preferential) integration are used. The literature usually refers to two main channels through which integration might affect productivity: trade and foreign direct investment.

The Trade Channel The linkages between trade and productivity can operate in at least three dimensions: the economy as whole, the sector, and the firm. The first dimension is the best known and has been around since the work of the classical economists Adam Smith and David Ricardo. The other two dimensions have only recently gained importance in the debate. The economy-wide dimension. The classical argument for free trade, immortalized by Ricardo's wine-and-cloth example, contains the very first attempt to deal with the trade-productivity issue. The basic idea is that trade increases economy-wide productivity by reallocating resources towards those sectors in which a country has a comparative advantage. More recent theoretical developments have exploited other possibilities while adding some ambiguity to the results. The first breakthrough came from the new theories of trade, which have shown that there are also gains to be reaped from the advantages of large-scale production (Helpman and Krugman, 1985). What these theorists have done, first, is to highlight the importance of "increasing return" industries, where average costs fall as production increases due to large fixed costs associated with machinery or research and development. Second, it has been shown that trade, by enlarging the potential market of these industries, provides untapped opportunities to reduce costs and, therefore, increase productivity. Yet, theorists have also made clear that these potential gains might turn into losses if countries have those industries dislocated by imports. Even though one can hardly overestimate the importance of gains from comparative advantage and scale, they cannot be relied upon to induce sustained increases in productivity. They tend to produce a onetime jump in the level of productivity without providing fuel for constant improvements. In economists' parlance, they are level and not growth effects (Lucas, 1988).

It was to take another theoretical breakthrough to show the links between trade and sustainable productivity growth, and it came at the hand of the "new growth theories" of the late 1980s. The key was to assume, unlike the "old" growth theories (Solow, 1956), that the production of knowledge takes place within the course of economic activity and is driven just as any other activity by the profit motive. This new view of technology allowed for exploring new trade-productivity links based on two main stories: learning-by-doing, and innovation. The former assumes that technological progress is mainly the byproduct of the learning that occurs when firms are producing goods or installing equipment (Young, 1991). The latter, in turn, views technological change as driven mainly by deliberate efforts to produce knowledge, such as research and development (Grossman and Helpman, 1991). In learning-by-doing, the impact of trade on productivity is indirect and depends to a great extent on what happens to the composition of the post-trade GDP. If trade leads to a specialization in sectors where the potential for learning is high, the end result tends to be clearly positive. Yet, if the opposite happens, productivity growth might fall. In the innovation case, the links are broader in scope and the potential benefits are higher. Trade is seen to boost productivity in two ways. First, it expands the range of intermediate inputs available, and, therefore, allows producers more flexibility in matching their input mix to the technology available (Ethier, 1982). Second, it increases producers' access to foreign knowledge in a number of ways, such as imported intermediate inputs, imitation of import varieties (Keller, 2001), and access to knowledgeable buyers (learningby-exporting) (Westphal, 2001). The nature of the input effect is similar to the traditional gains from trade and therefore can be seen as a "level effect." Access to knowledge, however, has a permanent impact on the ability of countries to learn and produce knowledge, and, as such, can be seen as the basis for sustainable productivity growth. The effectiveness of this second factor, however, hinges crucially on how easily knowledge spills across the borders and on what happens to knowledge-producing sectors after trade. Firm and sectoral dimensions. It was not until the early 1990s that economists began to focus on the

246

Regional Integration ana Productivil 247

microeconomic foundations of trade and growth theo1

and exports forces the least efficient firm to contract or

ries. This effort to understand what was happening to

exit and the most efficient to expand. As with the com-

sectors and firms produced a series of hypotheses

parative advantage case, this "share effect" is basical-

about the micro-linkages between trade and productiv-

ly a one-time gain.

class inputs, technology acquisition via imports or

The Foreign Direct Investment Channel

exports, import discipline, and higher turnover. The first two micro-channels are basically the

The more important insights about the FDI-productivity

same effects discussed in the new growth theories, but

linkages would only come to light in the second half of

now seen in a microeconomic setting. The last two are

the 1980s, when the pieces of a more formal general

the main contributions of this literature and therefore

theory of the multinational firm began to be put togeth-

deserve more attention. The import discipline effect,

er (Blomstrom and Kokko, 1998, and Markusen and

"the oldest insight in this [trade policy] area" accord-

Maskus, forthcoming). This literature points to four

ing to Helpman and Krugman (1989), affects produc-

main effects: an entry effect, competition, knowledge

tivity in at least three ways: by reducing the slack in

spillovers and linkage effects.

firm management (so-called X-efficiency); by forcing

All these conduits are close cousins of the

firms to increase their output and therefore improve

trade-related channels. The first is the FDI counterpart

their scale efficiency; and by increasing the firms'

of the turnover argument. The idea is that the entry of

incentive to innovate.

world-class competitors raises the average productivity

The gains accruing from better firm manage-

of industry. One can also draw a parallel between the

ment are quite intuitive, but economists have problems

pro-competitive effect and the import discipline

in putting a solid theory behind them because they run

hypotheses. As in the case of trade, FDI is expected to

against one of the pillars of modern microeconomic

improve firm management, raise scale efficiency and

theory: the assumption that firms maximize profits. The

provide more incentives to innovation. Once again,

scale efficiency gain is basically the result of competi-

though, solid theoretical foundations do not match the

tion preventing firms from restricting output and raising

intuition behind this hypothesis. The entry of large

prices. Higher competition results in lower prices and

multinational firms in limited domestic markets raises

higher output, which, in turn, lowers average costs.

the possibility of collusion, which makes the results

This result, though, depends heavily on the assumption

even more difficult to pin down.

made about how easily firms enter and exit markets (Tybout, forthcoming). Finally, the argument about incentives to inno-

Knowledge spillovers and linkage effects are the channels more likely to have long-term implications

vate, which is key to linking trade to long-term produc-

for productivity growth, since they might improve the firms' ability to innovate. FDI knowledge spillovers are

tivity growth, is also quite intuitive, but its theoretical

said to take place when local firms increase their pro-

foundations are somewhat shaky. Rodrik (1992) and

ductivity by copying the technology of affiliates of for-

Goh (2000), for instance, reach totally different results

eign firms. Although widely believed to be an

when trying to model the impact of protection on inno-

important source of technology diffusion, particularly

vation. The former argues that trade might reduce the

to developing countries, it also has its limitations. First,

firms' incentive to innovate if their market shares are

there is the issue of absorptive capacity. Without a

reduced by imports, whereas the latter says that pro-

qualified workforce or investments in R&D, spillovers

tection reduces innovation because it raises the oppor-

from FDI are unlikely (Saggi, 2000). And second,

tunity cost of technological effort.

given the foreign firms' strong interest in protecting

As for the high-turnover hypothesis, it is related

their competitive edge and, therefore, in minimizing

to trade effects at the sectoral level. The argument is that "trade can promote industry productivity growth without necessarily affecting intra-firm efficiency"(Melitz, 2002). This is because the simultaneous expansion of imports

1For a review of this literature, see Tybout (2000 and forthcoming).

ity, covering issues such as the availability of world-

CHAPTER 11

Box 11.1

Externalities and Linkages

Economists define externalities as actions by firms (or individuals) that affect other firms (or individuals), but are not reflected in their costs and benefits. Externalities can be transmitted by market transactions or bypass the market altogether. The former is called pecuniary externalities and can be found, for example, when the investment made by an automobile company generates enough demand for the development of an auto parts industry. Among those that bypass the market, the socalled technology externalities (Scitovsky, 1963) stand

technology transfer, spillovers are more likely to be "vertical" (among their clients and suppliers) than "horizontal" (among their competitors) (Kugler, 2000). Finally, the rationale behind the linkage effects is similar to the input availability channel discussed in the "new growth" theories, but the transmission mechanism is more complex. The argument relies on the concept of pecuniary externalities (see Box 11.1). FDI is believed to generate positive pecuniary externalities to local firms by improving the local supply (quality and variety) of intermediate goods (Markusen and Venables, 1999). This happens both directly through investment in these industries (forward linkages), or indirectly through investment in final (consumer) goods, which could create enough demand and technology spillovers for the establishment of intermediate industries (backward linkages).

What Does Regional Integration Specifically Bring to Productivity? The preferential character of regional integration adds some specificity to the way trade and FDI channels operate. This is particularly important for trade-related linkages, where there are two major issues worth considering: comparative advantage and the scale effects. On the FDI side, the changes are mainly related to the level and type of flows, and since the impact on productivity is at best indirect, these changes are discussed elsewhere in this report (Chapter 10).

out. A good example is the hiring of highly trained workers of a foreign firm by its local competitor. Thanks to the work of Hirschman (1958), externalities (pecuniary or not) transmitted across the production chain also became known as linkages. They are said to be "backward" when producers generate positive externalities to suppliers, and "forward" when suppliers generate positive externalities to producers. In the automobile company example given above, the firm's demand for auto parts is seen as part of its backward linkages.

Comparative advantage. When integration is regional, the traditional comparative advantage gains from trade are no longer assured. To understand why, one has to come to terms with the concepts of trade creation and diversion discussed in Chapter 3. Trade creation generates exactly the same gains experienced by a country that opens up unilaterally. So there is nothing specific about it. Trade diversion, though, reduces productivity and is very specific to regional agreements, since it can only arise because of preferences given to partner countries. This productivity loss arises because the importer country is not buying from the most efficient suppliers and the exporter country is moving away from its comparative advantage. True, this loss might be compensated, as discussed below, by scale gains generated by these very same preferences. As far as comparative advantage is concerned, though, the impact of trade diversion is negative, and, accordingly, the overall productivity impact of regional integration is ambiguous, depending on the balance between trade creation and diversion. Venables (1999) gives more nuances to the trade diversion story by arguing that this type of loss is more likely in SouthSouth (e.g., Andean Community) agreements than in North-South (e.g., NAFTA) ones because, inter alia, the North concentrates the most efficient producers of the goods most likely to be imported by the South (see Chapter 3). Scale. In contrast to comparative advantage effects, the specificities of regional integration regard-

248

Regional Integration ana Productivil 249

The Evidence on Regional Integration

is that the potential gains from scale are much higher in the context of non-preferential worldwide integra-

Looking first at the macro, economy-wide level, the

tion than in a regional setting. The former offers the

results for the 1990s—the decade when virtually all of

world, the latter only a region of this world. This,

Latin America embraced integration—are not very

though, is just one part of the story. The other part lies

encouraging. True, there has been no effort to establish

in the uncertainty of these scale gains. There is

any causality between integration and productivity. Yet,

always the threat of increasing returns industries

the examples that exist suggest that for most countries,

being dislocated by imports, the more so for a devel-

what few integration-related gains that occurred were

oping country whose domestic market is limited and

not strong enough to offset other negative influences

whose firms, as a consequence, face size disadvan-

such as the region's extreme macroeconomic volatility.

tages. These scale losses might also have long-term

The IDB (2001) found that Latin America's

negative implications for productivity growth. The

total factor productivity (TFP) (see Box 11.2) fell by 0.6

smaller the markets, the lower the financial viability of

percent a year in the 1990s, with only six of 22 coun-

R&D activities. What a firm can learn depends not

tries showing TFP growth.3 The report attributes these

only on the volume of output produced at each point

results mainly to the region's poor educational levels

in time (so-called static economies), but also on the

(low absorptive capacity) and fragile public institutions

cumulative output across time (so-called dynamic

(poor incentives to develop and assimilate new tech-

economies, along the lines of the learning-by-doing

nologies). Baier, Dwyer Jr. and Tamura's (2002) results

story examined earlier).

are even more disappointing, with TFP in the region

One can argue, then, that regional integration

dropping by approximately 2.9 percent a year. Fajn-

involving a smaller number of partners lowers the risk

zylber and Lederman (1999) somehow buck the trend,

of damaging dislocations, while at the same time

reporting 1.1 percent TFP growth for Latin America dur-

boosting the (static and dynamic) scale advantages of

ing 1990-95. However, their analysis does not cover

the member countries vis-a-vis the rest of the world

the whole decade and they do not take into account

either through trade creation or diversion (Devlin and

changes in human capital (basically education), which

Ffrench-Davis, 1999).2 This might be particularly rele-

can drastically reduce the TFP "residual."

vant for South-South integration, where the difference

Looking at the sectoral level and more specifi-

in market size among member countries tends to be

cally at manufacturing—the most protected sector dur-

smaller and the size disadvantages with respect to the

ing the import substitution years—the picture is not so

rest of the world more pressing. The flip side of SouthSouth agreements, though, is that small differences in size might be especially damaging for the smaller and

gloomy. Figure 11.1 shows that labor productivity in the region's largest countries grew substantially during the 1990s, particularly in Argentina, Brazil and Mexi-

poorer members. In the absence of institutional safe-

co. These three countries outperformed the United

guards, the combination of scale disadvantages and

States (though not Korea) by a large margin, suggest-

agglomeration economies (i.e., the advantages that arise when firms locate close to each other) might con-

ing a reduction in the productivity gap vis-a-vis the country considered to have the best practices in tech-

centrate the more productive industries in the larger

nology. Although impressive, this evidence has some

partners (Venables, 1999). In North-South agree-

important pitfalls. First, since labor productivity does

ments, this risk would be mitigated by the differences in

not take into account all the inputs used in production,

input costs such as that of labor, which tends to favor the smaller and poorer countries. Moreover, one can also argue that Southern countries have more to "learn" in North-South agreements (i.e., the potential knowledge spillovers through trade and FDI would be higher), given that the stock of knowledge is concentrated in the North.

One could also argue that regionalism, by formally guaranteeing market access among member countries, reduces the uncertainty that might restrict the scale (or enlarged market) gains (see Chapter 3). 3

They were Chile, Argentina, Uruguay, the Dominican Republic, Peru and Barbados.

ing scale are not so clear-cut. What is readily evident

CHAPTER

Box 11.2

How to Measure Productivity?

Productivity looks at first sight to be a very simple concept: the ratio of output to input. Yet it is not that simple, since this concept admits different measurements. The most intuitive and widely used is what is called labor productivity, i.e., output divided by the number of workers. It does not take a high level of sophistication to see that this is only a partial measureâ&#x20AC;&#x201D;all the other inputs used in production, such as machinery and raw material, are not accounted for. This can lead to misinterpretations, such as labor productivity growth being read as improvements in technology, when it is not more than the result of an increase in the number of machines (capital stock) per worker. Given this drawback, economists came up with the notion of total factor productivity (TFP), which is defined as the ratio of output to all inputs combined. Most TFP analysis focuses on how it changes over time and uses the "production function" approach pioneered by Solow (1956). In this approach, TFP growth is meas ured by the residual growth rate not explained by inputs. For example, assume that a firm's output has grown 3 percent a year in the last five years. Its capital stock also

Figure 11.1

Labor Productivity in Manufacturing in Selected Latin American Countries, Korea and the United States (Index)

grew at about the same rate, whereas the number of employees grew at only 1 percent per year. Assuming that this firm uses only these two inputs and that their share of total output is, respectively, one-third and twothirds, input contribution to output growth would be 1.7 percent a year (one-third x 1 percent plus two-thirds x 3 percent). So, the TFP contribution would be 1.3 percent per year, which is the difference between output (3 percent) and input growth (1.7 percent). This so-called Solow residual is supposed to measure the impact of technical and organizational innovations that happen within firms (industries or countries). In practice, though, due to difficulties in measuring the flow of inputs, particularly capital stock, and in estimating the firms' technology (production function), this residual ends up capturing other unwanted contributions. This problem prompted one economist to argue that this residual is a "measure of our ignorance" (Abramovitz, 1956). Despite the difficulties, TFP is the profession's best available tool to measure productivity changes.

macro-evidence, the evidence tells little about the causal relationship between integration, regional or otherwise, and productivity. Studies based on firm-level data have made progress in addressing the first and the last of these problems (Tybout, forthcoming). The number of countries studied, though, is still limited. For instance, studies on Mexico, Brazil and Chile report positive rates of TFP growth in manufacturing. For Mexico, Tybout and Westbrook (1995), covering the first period of trade liberalization (1986-90), put TFP annual growth at 1.8 percent. Calculations in this chapter (see next section) put the same figure for the NAFTA period (1993-99) at 1.1 percent. Muendler (2002) estimates 0.8 percent of TFP annual growth for Brazil over 1992-98, which covers most of the country's

Source: Country Statistical Offices.

trade liberalization period, while this chapter finds annual increases of 5.2 percent for the second half of

it gives only a partial view of what actually happened

the 1990s. Finally, Pavcnik (2000) estimates 2.8 percent in TFP annual growth for Chile following the

in terms of technology. Second, this data only cover a handful of countries in the region. Finally, as with the

country's radical trade reforms (1979-86). To give some perspective to this story, similar plant-level stud-

25O

â&#x20AC;˘Regional Integration and Productivity

251

ies on East Asia point to 3 percent or higher TFP

level data for Colombia (1981 -91) and Mexico (1984-

growth after liberalization. Aw, Chen and Roberts (2001) speak of 3.2 percent annual TFP growth in

90). Results from Alvarez and Robertson (2000), however, point to a strong link between exporting and

On the issue of how much of this TFP growth

and Chile (1993-95). The World Bank (2000), based

can be ascribed to trade liberalization, most of these

on plant-level data for Mexico over 1990-1998, found

studies concentrate on the trade channel and more

suggestive signs of learning-by-exporting.

specifically on the import discipline, scale and turnover

Finally, the (scarce) evidence on the FDI chan-

hypotheses. Pavcnik (2000), Fernandes (2001), Tybout

nel tends to support the prevalence of vertical (inter-

and Westbrook (1995) and Muendler (2002) find evi-

industry) over horizontal (intra-industry) spillovers and

dence of a strong import discipline effect in, respec-

to highlight the importance of countries' absorptive

tively, Chile (1979-86), Colombia

(1977-1991),

capacity.5 Aitken and Harrison (1999) find that for-

Mexico (1986-90) and Brazil (1986-98). There is little

eign equity participation raises plant productivity in

evidence of important turnover or scale-related gains.

Venezuela (1976-89),

Nonetheless, Pavcnik's (2000) estimates suggest that

spillovers are negative. Likewise, Kugler (2000)

but also that

horizontal

import discipline would have been dwarfed by the

reports limited horizontal spillovers for Colombian

turnover effect, and Muendler (2002) finds that the

manufacturing plants over 1974-98, but finds evi-

elimination of trade barriers increases the likelihood

dence of "widespread inter-industry spillovers from

that low-efficiency firms will shut down, which in the

FDI." Results from Kugler (2000) as well as Kokko,

long run would have a positive impact on aggregate

Tansini and Zejan (1996) support the relevance of

productivity.

absorptive

capacity. The former shows that the

Evidence is more limited on the other trade

absorptive capacity of local firms lagged behind that

effects, particularly those that are believed to impact

of foreign firms, which, in turn, would explain the

not only the level but also the rate of productivity

prevalence of vertical (generic knowledge) over hori-

growth. On the availability of world-class inputs and

zontal (specific knowledge) spillovers in Colombia.

related technology acquisition effects, Muendler

The latter find evidence that horizontal spillovers

(2002) finds a positive but relatively unimportant

among Uruguayan plants (1988) were virtually non-

impact on productivity in Brazil. Yet, Alvarez and

existent, except for a small group of firms whose tech-

Robertson (2000), working with plant-level data from

nological gap vis-a-vis foreign plants was relatively

Chile and Mexico, detect a significant and positive

small.

relationship between importing intermediate inputs and innovation in the latter country.4 Evidence based on country and sectoral level data also point to a positive input effect. Blyde (2002)

INTEGRATION AND PRODUCTIVITY IN BRAZIL AND MEXICO

finds that technological spillovers diffused through imported machinery have a positive impact on pro-

Whether through the trade or FDI channels, the evi-

ductivity. Estimates by Schiff, Wan and Olarreaga

dence on how integration might affect productivity

(2002) point to North-South and South-South techno-

seems to make up only part of a story that, while gen-

logical spillovers, diffused through imports. North-

erally consistent with what the theorists say, still lacks

South spillovers would be higher and would affect

some main chapters. When it comes to the more reli-

mainly R&D intensive industries, whereas South-South

able microeconomic, plant-level analysis, coverage of

spillovers would be relevant mostly to other types of industries. The acquisition of knowledge through exports is also the subject of a few studies, although the evidence is mixed. Clerides, Lach and Tybout (1998) found no evidence of learning-by-exporting on plant

They were unable to test the link between imported inputs and innovation in Chile due to data limitations.

For a general review that includes studies from other regions, see Blomstrom, Kokko and Zejan (2000).

investment in innovation in both Mexico (1993-95)

Taiwan in the 1981-91 period.

252 CHAPTER 11

the countries in the region is still very limited, just as is discussion about the long-term growth effects of integration on productivity. One of the key missing chapters of this story seems to be the specific effects of regional integration. The dearth of evidence on regional integration is understandable, since most of the efforts to study it are relatively new. To deal properly with this issue, one must confront two challenges: first, to distinguish between the competing forces that affect a country's productivity; and, second, to differentiate between preferential and non-preferential integration. The discussion that follows provides some initial evidence of how integration in the Americas has affected productivity, with a focus on Brazil and Mexico during the 1990s.

Figure 11.2

Average Manufacturing Tariff, Mexico, 1993-2OOO

Source: Lopez Cordova (2002).

Changes in Trade and Investment Policies Both Brazil and Mexico moved towards integration after at least half a century of import-substitution policies. These policies—an arsenal of tariffs, quotas, import licenses, multiple exchange rates, FDI regulations and soft loans—were effective in promoting growth and in pushing their economies through a substantial structural change. Yet, by the late 1970s there were clear signs that the model was no longer sustainable. Productivity after an initial period of high growth set into a downward trend and by the early 1980s was clearly stagnated (see Bacha and Bonelli, 2001, on Brazil, and World Bank, 1998, on Mexico). This slowdown, compounded by macroeconomic mismanagement, eventually lead to the collapse of the old regime amid the debt crisis of the 1980s. The countries' response to that technological and economic stagnation was integration into the world markets. Mexico moved first and faster, and by the early 1990s had already made substantial progress. Tariffs on a most favored nation (MFN) basis fell from 28.5 percent in 1985 (the first year of trade liberalization) to 11.4 percent in 1993, while only 192 tariff lines were subject to import licenses—in contrast to 1982, when all imports were subject to them.6 In manufacturing, tariffs fell from around 30 percent in 1985 to 15.5 percent in 1993, although in general they were less subject to import licensing requirements. From 1994 on, as a result of NAFTA, these tariffs declined

even further and more rapidly. While in 1993 only around 15 percent of imports from the United States were subject to tariffs under 10 percent, in 1994 that figure reached 60 percent. By the year 2000, less than 1 percent of manufacturing imports faced duties of 10 percent or higher. As a result, Mexico's average tariff on manufacturing imports from the world was only 5 percent in 2000 (Figure 11.2). Some industries such as textiles and apparel saw MFN tariffs increase during the 1990s. The share of Mexico's trade subject to MFN tariffs has declined, however, since the country has established a network of free trade agreements in the Americas and with European nations. Trade liberalization was accompanied by FDI deregulation, also deepened by NAFTA, which led to the removal of most sectoral restrictions and approval and performance requirements.7 Brazil, by contrast, took longer to open up. The removal of nontariff barriers and a drastic drop in tariffs had to wait until 1990. The average for MFN tariffs fell from 52 percent in 1987 to 9.9 percent in 1994 and edged up to 12.9 percent by 2000, reflect-

See Ten Kate (1992) and Lopez Cordova (2001).

See Dussel Peters, Paliza and Diaz (2002).

(In percent)

Regional Integration and Productivity

Figure 1 1.3

Average MFN and Mercosur Tariff, Brazil, 1987-2OOO (In percent)

253

increasing from $2.6 billion over 1980-88 to $5.7 billion over 1989-93. During the initial NAFTA period (1994-2000), FDI flows received another boost, reaching an average of $14.5 billion (see Chapter 10).10 ed to imports, which increased on average by 13.8 percent a year in the post-liberalization period from 1990-2000. Exports also grew, but at the much more modest rate of 5.8 percent. The changes in the export composition were also modest, with manufacturing exports increasing their share of total exports from 54 to 58 percent over the same period. Exports to Mercosur, though, proved to be more dynamic, increasing at 16.8 percent a year, which raised the regional agreement's share of total exports from 5.6 percent in 1990 to 14 percent in 2000 (and from 6 to 20 per-

Source: For MFN, Kume, Pianl and Braz de Souza. (2000) and Receita Federal. For Mercosur Estevadeordal, Goto and Saez (2000) and Receita Federal.

cent in the case of manufacturing exports). The share of Mercosur in Brazil's total trade followed a similar trend, jumping from 7 to 14 percent over the same period.1 ] FDI flows also responded to the new regime,

ing Brazil's response to the 1995 Mexican crisis. Tar-

but only after inflation was controlled in the second

iffs on manufacturing followed a similar trend, with the

half of the 1990s.12 Average flows, which were close

average dropping from 57 percent in 1987 to 11 per-

to $1.3 billion over 1980-94, climbed to $19.3 billion

cent in 1994 and rising marginally to 13.9 percent by

over 1995-2000.

2000. As in Mexico, trade liberalization was deep-

Figure 11.4 presents a good picture of what

ened by a regional trade agreement, Mercosur, and

all these changes in trade flows meant for manufactur-

was associated with deregulation on FDI. The former brought the intra-regional average tariff from 59.5

ing in the two economies. There are three issues worth noting. First, the two countries were in distinctly differ-

percent in 1987 (one year after the first Brazil-Argenti-

ent positions when they moved into trade liberaliza-

na agreement) to close to zero in 2000 (Figure 11.3),

tion. In the first year of Mexico's trade reforms, 1985,

and the latter extended national treatment to foreign firms except for a few sectors (such as investments in

the import penetration ratio in manufacturing was 9.3 percent (Weiss, 1999, not shown in the figure), where-

communications services). These policy changes had a profound impact

as in Brazil, in an equivalent year (1989), the same fig-

on trade and investment flows in both countries. In

ure was 4.9 percent. In other words, Brazil went much further down the import-substitution road. Second,

Mexico, both imports and exports boomed. Total

import penetration increased substantially in both

imports grew on average by 16.3 percent a year dur-

countries, but the "openness gap" remained consider-

ing 1985-2000, followed closely by exports, which reached an average growth of 14.2 percent a year. Manufacturing exports and intra-regional (NAFTA) trade were the key factors behind the export take-off.

The share of manufactured goods in total exports rose

from 27 percent in 1985 to 83 percent in 2000, whereas NAFTA's share of total Mexican trade went from 78 to 83 percent (and the share of total exports

See Kume, Piani and Braz de Souza (2000).

Mexican trade data is from Banco de Mexico (www.banxico. org.mx). Unless otherwise stated, figure includes maquiladora (inbond assembly) trade. 10 Due to methodological changes, pre- and post-NAFTA figures are not strictly comparable. See Dussel Peters, Paliza and Diaz (2002).

from 80 to 91 percent) during the same period.9 There

Brazilian trade data is from Secex (www.mdic.gov.br).

was also rapid growth in FDI, with average flows

See Pinheiro, Giambiagi and Moreira (2001).

In Brazil, the trade boom was mainly restrict-

CHAPTER

Figure 1 1.4

Brazilian and Mexican Import Penetration and Export Ratios in Manufacturing, 1988-2OOO (In percent)

Note: Import penetration is imports divided by domestic consumption. Export ratio is exports divided by output. Data for Mexico do not include maquiladoras. Source: IDB calculations based on IBGE and INEGI manufacturing surveys.

able and in favor of Mexico. And third, export ratios (excluding Mexico's maquiladora exports) also showed an upward, if more volatile, trend in both countries, but the gap between them was and remained much smaller than that of import penetration, despite the differences in export performance.13

Productivity Performance In light of this substantial opening of the Brazilian and Mexican economies, one should expect to find a measurable impact on economic efficiency in the two countries. The importance of this impact, though, would likely vary in each country given the differences, inter alia, in the macroeconomic environment, initial openness, depth and scope of the reforms, and the regional integration strategy. Some of these issues are particularly relevant. For instance, as mentioned before, Mexico was considerably more open than Brazil when the new trade policy was put in place. One could argue, therefore, that Brazil stood to gain relatively more from opening up than Mexico. Accordingly, productivity might have grown faster in Brazil than in Mexico in the first years of the reforms.

On the other hand, on the issue of the depth and scope of reforms, there is little doubt, judging by the level of tariffs and trade indicators, that Mexico was much more aggressive in pursuing trade-related gains than Brazil. The option for a North-South regional integration agreement can be seen as part of this aggressiveness. By linking up with the United States and Canada, given the differences in size and resources involved, Mexico got much closer to achieving free trade at a multilateral level than Brazil with Mercosur. Involving countries of limited size and similar resources, Mercosur was bound to offer more limited trade-related productivity gains (or costs), at least when seen as an end in itself. So, if one believes that integration gains tend to outweigh costs, a reasonable premise would be that Mexico would have better performance in terms of productivity, or at least would reap more trade-related gains, than Brazil. In order to ascertain such possibilities, one first needs to gauge the behavior of productivity in the two economies. To this end, the following discussion relies on micro-data for the Brazilian and Mexican manufacturing sectors. (Appendix 11.1 provides a description of the methodology used herein).14 Figure 11.5 presents aggregate indices of total factor productivity (TFP) for Brazilian and Mexican manufacturing during their respective periods of trade liberalization. Two estimates with similar firmlevel methodologies covering different periods are included for each of the two countries: for Brazil, Muendler (2002), which covers most of the liberalization period (1989-98), and this chapter's estimates, which refer to the second half of the 1990s (1996-99); and for Mexico, Tybout and Westbrook (1995), which cover Mexico's non-preferential liberalization (198690), and this chapter's estimates, which focus on the NAFTA period. Keeping in mind that this comparison should be taken with some caution, given that the

13 Manufacturing exports (defined as SITC 5 to 8, except for 68) grew at an average rate of 22 percent a year in Mexico and 5.4 percent a year in Brazil over 1990-2000. 14 For Brazil, we use firm-level data, whereas for Mexico we rely on plant-level data. The text employs the term "firm" indistinctly. The sample of Mexican plants used in this estimation does not include maquiladora (in-bond assembly) plants. Productivity figures for Brazil come from Lopez Cordova and Moreira (2002), anafor Mexico from Lopez Cordova (2002).

254

Figure 11.5

Total Factor Productivity Average Annual Growth in Manufacturing, Post-Trade Liberalization: Brazil and Mexico (In percent)

Source: Country Statistical Offices

methodologies are similar but not exactly the same, the results suggest that productivity growth in Mexico was higher during the first, non-preferential period than in the regional period. One possible explanation would be that the policy changes were more radical in the first period and, therefore, most of the level effects occurred during this time. A second possibility would be that there were factors other than trade policy, such as the 1994-95 peso crisis, that might have affected the periods differently. For Brazil, the 1989-98 estimate suggests that productivity growth was positive but significantly lower than that of Mexico in both periods, which might be seen as supporting the aggressiveness argument raised above. Yet, the estimates for the second half of th decade support the initial conditions argument, showing impressive productivity growth that outstrips that of Mexico's NAFTA period and would be considered high even by the East Asian standard of 3 percent or more of TFP growth. Given that the most radical changes in trade policy, including Mercosur, took place in the first half of the decade, this might imply that stagflation, which prevailed for most of the first half of the decade, would have been a major drag on Brazil's productivity, particularly on trade-related productivity gains. This

255

also underlines the difficulty in looking at the impact of integration without controlling for other relevant factors at play. Before moving into a more careful attempt to uncover the trade-productivity links in these two countries, it is worth looking behind these aggregate figures to get a sense of, first, how trade orientation correlates with productivity growth among manufacturing industries and, second, what was the relative importance of intra-firm vis-a-vis intra- and inter-industry gains. TFP by trade orientation. Figures 11.6a and b, relying just on this chapter's estimates, show that there were wide differences in productivity performance among manufacturing industries. Trade policy, to the extent that it treats industries differently, might be one of the key factors behind this variation. As a first approximation to evaluating such a possibility, Figures 11.7a and b distinguish TFP performance according to industry or plant characteristics. Leaving plant characteristics aside, one would expect to find that, in the context of a more liberal trade regime, those industries that are more exposed to competition from imported goods or that participate more actively in foreign markets would perform better than industries where little trade takes place. Figures 11.7a and b offer some support to the view that import discipline is an important force behind productivity improvements.15 Productivity growth among Brazilian import-competing industries was higher than in the manufacturing sector as a whole, reaching 7.2 percent a year over 1996-99. The per formance of industries that compete with Mercosur imports was also above average, but was not as impressive as that of the import-competing industries in general. In Mexico, import-competing industries were also the top performers, with annual productivity growth of 4.2 percent over 1993-99. They were followed closely by industries that compete with North American imports. Exporting industries in both countries experienced more modest productivity growth of 4.3 percent a year (Brazil) and 1.6 percent (Mexico).

15 Import-competing and exporting industries are defined as those in which import penetration or the ratio of exports to output, respectively, are above the median for the manufacturing sector as a whole. Non-traded industries are those that are neither import-competing nor exporting.

â&#x20AC;˘Reaional Intearation and Productivity

CHAPTER

Figure 11.60

111 a

Brazil: Annual Total Factor Productivity Growth, 1996-99 (In percent)

Figure 11.6b

Mexico: Annual Total Factor Productivity Growth, 1996-99 (In percent)

Source: Lopez Cordova and Moreira (2002).

However, whereas in Brazil exporting industries grew below the manufacturing average, particularly those exporting to Mercosur, this was not the case in Mexico, where regional and international exporting industries performed at or above average. The lower relative growth rate of exporting industries in both countries could be explained by the possibility that, in order to participate in foreign markets successfully, producers must show a degree of efficiency, leaving less room for additional productivity improvements. The relatively better performance of exporting industries in Mexico, though, might reflect the post-NAFTA export boom, something that Brazil could not replicate with Mercosur. But, perhaps, the more telling contrast in Figures 11.7a and b is the poor performance in both countries of industries with few trade links. Infra-firm versus reallocation gains. Another way of looking behind the aggregate figures is to decompose annual changes in TFP into three effects: intra-firm gains (i.e., variations in productivity that occurred inside the firms resulting from technological and managerial innovations); intra-industry reallocation or turnover, reflecting changes in market share between low and high productivity firms within the same industry; and inter-industry reallocation, measuring changes in TFP brought about by shifts in the composition of manufacturing output (e.g., the share of the car industry rises whereas that of textiles falls). The details of this decomposition are in Appendix 11.1. The results in Figures 11.8a and b show that reallocation effects in both countries, particularly across industries, were a major force behind productivity growth. In Brazil, reallocation accounted for 51 percent of total productivity growth, with reallocation across industries explaining 63 percent of total reallocation gains. In Mexico, the importance of these effects was even more pronounced and was the overwhelming factor behind TFP growth. As in Brazil, shifts in the composition of manufacturing output accounted for the lion's share of the reallocation gains. Although one cannot attribute these changes directly to trade on the basis of this evidence alone, it does clearly suggest, first, that trade might have played a role in the replacement of low productivity firms by higher productivity ones. Second, as indicated by the inter-industry reallocations gainsâ&#x20AC;&#x201D;particularly important in industries

256

Regional Integration and Productivity

Figure 11.7a

Brazil: Annual Total Factor Productivity Growth, by Industry or Plant Characteristics, 1996-99

Figure 11.8a

257

Brazil: Productivity Decomposition (In percentage share)

Figure 11.7b

Mexico: Annual Total Factor Productivity Growth, by Industry or Plant Characteristics, 1996-99

Figure 11.8b

Mexico: Productivity Decomposition (In percentage share)

Source: Lopez Cordova and Moreira (2002). Source: Lopez Cordova and Moreira (2002).

more exposed to trade (traded industries)â&#x20AC;&#x201D;the dislocation of increasing return or knowledge producing industries by imports might not have been significant, or, at least, not significant enough to offset comparative advantage and scale gains. When industries are grouped by trade orientation, what stands out is that in both countries, traded

industries accounted for almost all TFP growth and intra-firm gains. This exercise also hints at the relative importance of the regional agreements for both countries. Although it is extremely difficult to disentangle regional from extra-regional effects, NAFTA seems to have played a major role for Mexico, explaining virtually all TFP and intra-firm improvements, whereas Mer

(In percent)

258

CHAPTER

Table 11.1 Firm Productivity and Integration in Brazil and Mexico: Summary of Econometric Evidence Brazil Channel

Mexico

TFP level

TFP growth

TFP level

TFP growth

na na

Positive Positive

Tariff elimination Import penetration

Foreign direct investment Foreign ownership of firm Spillovers Infra-industry Through backward linkages Through forward linkages Net effect Exporting activity Exporter status Exports/sales Mercosur exports/sales Preferential access to U.S. market Imported inputs

Positive 0

Positive 0 0

Positive Negative

Negative

na na na na

Negative

Positive

Negative Positive Positive Positive

na na na

Positive Positive Positive Negative

0 na

Positive

0 na 0

0 or positive

Positive

Negative

Note: See Appendix 11.1 for details of these estimations. Sources: Muendler (2002), Lopez Cordova and Moreira (2002), and Lopez Cordova (2002).

cosur seems to have played a more subsidiary role for Brazil (33 percent of total TFP growth).16

Integration and Productivity Links While Figures 11.7 and 11.8 are highly suggestive of positive links between trade liberalization and productivity growth, one cannot yet conclude that trade policy, or trade itself, was behind the contrasting industry performance or the intra-firm or intra- and inter-industry gains. Indeed, establishing such a link proves rather challenging, since a number of events affected the economies of the two countries during the same period, from the devaluation of the Mexican peso in December 1994 and the Brazilian real in 1999, to rapid U.S. productivity growth and the Asian financial crisis in the second half of the decade. In order to provide more conclusive indications of whether trade liberalization, either regionally or otherwise, has had a positive impact on productivity, the following discussion relies on econometric evidence. This evidence seeks to isolate trade and FDI from the other forces that influence manufacturing efficiency. Some of these forces are specific to a firm, such as its age and size, while

others reflect industry-wide characteristics and macroeconomic conditions that are external to the firm. The latter include, inter alia, industrial output concentration (either across firms or regions), exchange rate fluctuations that affect external supply and demand, and changes in domestic consumption over the business cycle. Appendix 11.1 describes the econometric approach. Import discipline. Table 11.1 summarizes the main results of the econometric exercise used for analyzing trade liberalization in Brazil and Mexico. A first finding is that heightened competition from foreign goods resulting from the elimination of import duties has had a substantial and positive impact on productive efficiency. For Brazil, Muendler (2002) analyzes trade policy during 1986-98 and finds that tariffs are inversely correlated with TFP change in a large sample

16 Industries traded in Mercosur and NAFTA were defined as those whose import-penetration and export ratio were in the fourth quartile of their distribution. Although this definition ensures that the regional markets are important for those industries, it does not eliminate overlapping with industries traded in extra-regional markets.

Competition from imports

â&#x20AC;˘Reqional Integration and Productivil 259

of manufacturing firms. Although the author focuses on

do not contain information on where exports went,

Brazil's unilateral trade liberalization, his period of

there is some indication that the preferential margin on Mexican products entering the U.S. market that result-

concludes that a 10-point reduction in tariffs would have increased TFP (in logarithms) by 2.8 percent. Moreover, he finds that import penetration explains a

ed from NAFTA's tariff phase-out has increased the probability that a manufacturing plant becomes an exporter.]9 Has export activity induced higher productivi-

good deal of the increase in TFP growth. Similarly, the experience of Mexico from 1993

ty among Brazilian and Mexican manufacturers? As

to 1999 confirms that tariffs negatively impact both the

Figures 11.7a and b illustrate, exporters in both coun-

level and the growth rate of productivity. Since tariffs

tries seem to have experienced more rapid productivi-

on the rest of the world also affect productivity, one

ty growth than non-exporters.

should consider total Mexican duties and not simply

exporters experienced even faster TFP growth. The fol-

those applied on North American goods.17 Neverthe-

lowing discussion considers whether such results hold

In Brazil, Mercosur

less, the previous discussion suggests that NAFTA has

under

been, by far, the main factor behind tariff changes in

described in Appendix 11.1.

the more rigorous econometric analysis

Mexico during the 1990s. Quantitatively, as the estimates in Appendix 11.1 suggest, the 10-point reduc-

in the preferential margin enjoyed by Mexican

tion in import duties over 1993-99 would account for

exporters in the U.S. market over their competitors

an increase of between 5 to 9 percent in total factor

from the rest of the world suggests that NAFTA would

Consider first the case of NAFTA. An increase

productivity. Since productivity grew by around 7 per-

have created export opportunities for Mexican produc-

cent during the period, the estimates suggest that tariff cuts during NAFTA's first six years contributed signifi-

ers that, in turn, would have translated into more rapid productivity growth. Another possibility, though, is that

cantly to the sector's average growth, offsetting other

the preferential access to the U.S. market would have

forces that affected productivity negatively during the

lessened the incentives for Mexican manufacturers to

1990s. In addition, the elimination of Mexican tariffs

improve their efficiency. The econometric results show,

also had a positive impact on productivity growth, with

however, that an increase in the tariff margin in favor

a 10-point reduction in import duties increasing the

of Mexican goods in the U.S. market is positively asso-

growth rate by 10.5 to 13 percent. Greater presence

ciated with an increase in productivity. A 1 point

of foreign goods in the Mexican market, as measured

increase in the tariff preference granted to Mexican

by the ratio of imports to output, also had a substantial impact on productivity.

producers yields a 0.5 percent increase in productivity

Scale and learning by exports. As argued ear-

(see Appendix Tablel 1.2). That conclusion differs from findings by other

lier, global and regional integration may also be con-

authors that fail to find a causal link between exporting

ducive to enhanced efficiency through economies of scale and learning associated with improved export

and productivity growth, and which argue that,

opportunities in the expanded market. Both Brazil and

inroads into foreign markets. To further explore this

Mexico saw the proportion of manufacturing firms that

issue, one may ask whether productivity growth among

instead, high productivity plants are what make

participate in world markets increase during the 1990s: from 39 percent in 1996 to 44 percent in 1999 in Brazil, and from 28 to 43 percent in Mexico over 1993-99.18 At the same time, the proportion of exports as a proportion of firm output in the two countries rose from 11.6 to 16.9 percent in Brazil over 1996-99 and from 14.6 percent in 1993 to 27.6 percent in 1999 in Mexico. In Brazil, the proportion of firms exporting to other Mercosur countries increased in tandem, from 28 to 32 percent. Although the data available for Mexico

17 Total Mexican duties are calculated as the trade-weighted average of preferential and non-preferential rates. 18 These percentages refer to the proportion of exporters in a sample of manufacturing firms in Brazil and Mexico, which are biased toward medium-sized to large firms. The corresponding figures for all manufacturing firms would be smaller. 19 The latter stems from an econometric exercise that estimates the probability that a plant is an exporter. The preferential margin in the U.S. market on Mexican goods is positively correlated with the probability of exporting.

analysis coincides with the creation of Mercosur. He

CHAPTER

exporters is higher than in non-exporting firms in Brazil and Mexico.20 The evidence in this regard is ambiguous.21 TFP growth among Brazilian manufacturers seems to be positively correlated to the ratio of exports to sales, with a 1 percent increase in the ratio of exports to sales increasing annual productivity growth by around 0.1 percent. In contrast to the results presented in Figures 11.7a and b, exports to Mercosur do not seem to provide a further bounce to productivity. There is little to suggest, though, that exporting induces productivity growth among Mexican producers. In fact, being an exporter actually seems to reduce productivity growth among Mexican producers, as in the U.S. data analyzed by Bernard and Jensen (2001). As in that study, however, our previous discussion regarding Figure 11.8 argued that reallocation of resources toward exporting firms is an important channel for industry-wide productivity gains. Imported inputs. Another way that integration by Brazil and Mexico might have enhanced manufacturing efficiency is through better availability of worldclass intermediate inputs. From 1996 to 1999, the proportion of Brazilian firms using imported inputs increased slightly, from 31.4 to 33.7 percent, and imported inputs went from 22.7 percent of material costs to 23.2 percent. The use of imported inputs in Mexico seems to have risen more rapidly, as they went from 27 to 32.5 percent of all non-wage costs of production from 1993 to 1999. The proportion of all plants using imported inputs rose from 51.5 to 55 percent during that seven-year span. Is there evidence suggesting that the expanded use of imported inputs favored productivity improvements? Figures 11.7a and b show that while in Brazil users of foreign inputs saw productivity rise faster, the opposite was true for Mexico. A more careful look at the data for Brazil and Mexico using econometric techniques shows that the impact on productivity is modest, at best. For instance, Muendler (2002) argues that foreign inputs contributed minimally to Brazilian manufacturing TFP growth during 1986-98 The use of imported inputs may actually have a negative impact on productivity growth (see Appendix Tables 11.1 and 11.2). That could happen if, as Muendler (2002) argues, firms fail to adjust their operations at the same time that their use of imported intermediate goods increases, rendering them unable to

make appropriate use of the more expensive imported inputs. For Mexico, imported inputs do have a positive effect on the level of productivity, but their quantitative impact is rather small. The estimates suggest that the 5.5 percent hike in foreign input use in Mexico from 1993 to 1999 resulted in TFP growth of 0.2 to 0.3 percent over the entire period. The FDI channel. Beyond the trade effects analyzed so far, there is the issue of whether higher FDI inflows have had an impact on productivity in Brazil and Mexico. Figures 11.7a and b compare TFP growth differentials between domestic and foreign producers. Whereas in Mexico productivity growth of foreign firms (particularly those from Canada and the United States) outpaced that of domestic producers, TFP of domestic manufacturers in Brazil grew faster. However, once one takes into account productivity differences in industry and firm size, Brazil's results are reversed: for eign firms outpaced domestic ones by 5 percentage points, whereas in Mexico, foreign firms maintained the lead. The better performance of foreign producers in Mexico and Brazil suggests that their increasing presence might have had a positive impact on productivity growth. The FDI impact might have reflected the combination of entry, competitive, knowledge and linkage effects discussed earlier. To disentangle the contribution of each one of these effects is a daunting, if not impossible, task. Yet, by using information on owner ship and on the firms' cost and demand structure (see Appendix 11.1), it was possible to estimate at least part of the overall impact of FDI on productivity, and to assess whether its effects were more important to the foreign firms' competitors (intra-industry effects) or to their buyers and suppliers (inter-industry effects). The result shows that the intra-industry effects in Brazil were negligible, whereas in Mexico they reduced the level of productivity. In both countries, however, the growth rate of productivity was unaffected. In contrast, in the two countries, foreign firms had positive and statistically significant effects on the level of productivity of the buyers of their products. In Mex

Bernard and Jensen (2001) perform such an exercise on U.S. data. 21

See Appendix Tables 11.1 and 11.2.

260

ico, the same held true with regard to suppliers of for-

rather sketchy. Economy-wide measures of productivity

eign firms, but in Brazil the impact was actually nega-

suggest, with a few exceptions, a rather gloomy sce-

tive. In terms of productivity growth rates, the impact

nario of low or even negative productivity growth. Yet,

on both buyers and suppliers of foreign firms was pos-

analysis of manufacturing, by far the sector most

itive in Mexico, whereas only the effects on suppliers

affected by integration in the region, suggests a differ-

were statistically significant for Brazil, and they

ent and more upbeat story, indicating perhaps that the

reduced productivity growth.

gains did not reach the economies' non-tradable side.

In order to get a feeling for the quantitative

In any case, this type of sectoral analysis, based on

impact of these findings, consider an increase of 1 per-

more reliable plant-level data, covers only a handful of

centage point in the output produced by foreign plants

countries in the region, offering little basis for general-

as a proportion of total industry output, both in the

ization.

industry to which a firm belongs, as well as among its

Against this backdrop of scarce evidence, the

buyers and suppliers. As a result of negative intra-

case study of Brazil and Mexico throws some light on

industry effects, productivity would fall by 0.15 percent

the more general links between productivity and inte-

among Mexican manufacturers.22 FDI impact on the

gration and on the nuances of different strategies of

buyers of its products raises productivity by 0.7 percent

regional integration. The results show that productivity

in Brazil and by 1.1 percent in Mexico. Last, the effect

growth in manufacturing was positive in both coun-

on suppliers leads to a 0.4 percent fall in Brazilian

tries, reversing a downward trend that prevailed until

productivity and to a 0.4 percent increase in Mexico.

the 1980s. The two countries also coincided in three

When one considers these opposing forces in the

other points. First, they did not show signs of a change

aggregate, the net FDI effect on the productivity of

in the composition of output that would indicate

Brazilian firms is statistically negligible, while in Mexi-

economies of scale losses or damage to knowledge

co, FDI has a net positive effect that indicates that FDI

producing sectors. Second, and as a consequence,

results in a point-by-point increase in total factor pro-

they experienced reallocation effects that accounted for

ductivity.

most of the productivity growth. And third, when it comes to direct evidence on trade-productivity links, import discipline emerged as the dominant effect. The

CONCLUSIONS

results on learning-by-exporting and FDI effects varied between countries, but they seem to have played a

Economic theory suggests that integration can be the

minor role in both Brazil and Mexico. Brazil shows

handmaiden of productivity growth, either through

some signs of learning-by-exporting,

while Mexico

trade or foreign investment. This potential is particular-

shows almost none, despite its higher export orienta-

ly important for a region that, with but a few excep-

tion and the export boom of the 1990s. Regarding FDI, foreign firms appear to have had a positive impact on

tions, has a dismal record on productivity and has been struggling in recent decades to get back on a sustainable growth path. The theory also indicates that

their buyers and suppliers in Mexico, despite the lower local content and greater export orientation of Mexi-

both global and regional integration can offer sub-

co's industry, whereas in Brazil, their overall impact

stantial productivity gains. Because it involves larger

was statistically insignificant and only buyers of goods

markets and a broader spectrum of comparative

produced by foreign firms appear to have been

advantages, global integration offers larger potential

favored.

gains. Regional integration, though, can be a strategic

Regarding the strategy of regional integration,

stepping-stone to global integration by speeding up

Mexico's more aggressive stance with NAFTA seems to

negotiations, mitigating adjustment costs, and offering

have paid off, at least as far as productivity is con-

safeguards against the downside risks of integration. After more than a decade of pro-trade policies throughout the region, the empirical evidence on the relevance of these productivity-related gains is still

Recall that intra-industry spillovers in Brazil are negligible.

Regional Integration ana Productivil 261

CHAPTER

cerned. Tariff reductions as part of the agreement appear to have had a sizable positive impact on productivity growth, which added to the already substantial gains reaped during the period of non-preferential liberalization. As the theory suggests, the differences in labor costs between NAFTA partners appear to have kept the threat of damaging dislocations in increasing returns and knowledge-intensive sectors at bay. On the other hand, there is not enough evidence to argue that Brazil's more cautious approach to trade, which involved Mercosur, was misguided. The fact that the preferential and non-preferential liberalizations were carried out simultaneously makes it very difficult to disentangle regional and nonregional effects. What one can argue without erring too much on the side of speculation is that the lion's share of Brazil's productivity gains during this period came from the non-preferential liberalization, given that Mercosur at its peak did not account for more than 17 percent of Brazil's total trade. And this comes as no surprise in view of the relative size and resources of Brazil's partners in the regional agreement. The little evidence uncovered in this regard points to learning-by-exporting gains on Mercosur trade, but these gains do not appear to have been any different from those from exports to the rest of the world. Considering the limits

of Mercosur gains, the importance of the import-discipline effect and the fact that productivity growth only took off in the second half of the 1990s, it is tempting to believe that Brazil would have had a better performance if it had pursued a more aggressive approach towards integration, that is, one that would not have excluded Mercosur, but that would have gone beyond it, in search of more sizable trade gains. Leaving strategic and counterfactual considerations aside, the bottom line seems to be that both Brazil and Mexico reaped important productivity gains from integration. It is perhaps too soon to tell how much of these gains were "level or growth effects" or whether or not the "integration shock" will produce the same sort of rapid, sustainable and long-term productivity growth seen in East Asia. That will depend very much on the long-term effects of import discipline on the countries' rate of innovation. In any case, one could not realistically expect that integration would do the entire job. When it comes to a stable macroeconomic environment and investment in education, technological capabilities and institutionsâ&#x20AC;&#x201D;all key ingredients of productivity growthâ&#x20AC;&#x201D;both countries (not to mention the entire region) still lag behind their counterparts in East Asia.

262

•Regional Integration and Productivity

APPENDIX T 1 . 1 EMPIRICAL METHODOLOGY

263

and controlling for unobserved plant characteristics via fixed-effect panel techniques. Since trade policy is potentially endogenous— more protection from policymakers—one needs to find

integration in Brazil and Mexico on total factor pro-

appropriate instrumental variables to obtain consistent

ductivity in manufacturing.1 The underlying analysis

estimates of the coefficient j81 in the previous regression

relies on firm- or plant-level data, which pose chal-

equation. In the Mexican case, the analysis uses the

lenges but allow for better estimates of productivity.

NAFTA tariffs as instruments for the actual Mexican

Methodology: The analysis applies an algo-

tariffs on world trade, as well as for U.S. tariffs on

rithm by Olley and Pokes (1996) to account for simultaneity and sample selection issues in estimating

Mexican goods. NAFTA tariff phase-out negotiations finished in August 1992. Moreover, according to

parameters of a Cobb-Douglas production function

NAFTA Annex 302.2, paragraph 2, the base rates for

with labor (skilled and unskilled), material and capital

determining import duties after applying the staging

inputs, and output as the dependent variable. Different

category agreed upon "generally reflect the rate of

production functions were estimated for 8 manufactur-

duty in effect on July 1, 1991." Thus, we can safely

ing industries (industries 31-38

consider that they are exogenous (not influenced by

in the International

Standard Industrial Classification, revision 2). Produc-

plant-level TFP levels during the 1993-99

tivity was defined as output unexplained by the inputs.

Moreover, they are highly correlated with actual tariffs.

period).

Aggregate productivity growth in Figures 11.6

To address the potential endogeneity between

and 11.7 was calculated as the output-weighted aver-

import penetration and productivity, we used a gravity

age of firm-level productivity growth, excluding the

equation approach to estimate trade flows based on

lower and upper 1 percent tails of the distribution of

geographical variables. This estimate was used as an

TFP to remove outlying observations. Figure 11.8

instrumental variable in the regression analysis.

extends the productivity decomposition of Griliches

Data: The data come from annual industrial

and Regev (1995) by distinguishing between intra-

surveys in Brazil (Pesquisa Industrial Anual) and Mex-

and inter-industry reallocation of resources. That

ico (Encuesta Industrial Anual) on

approximately

decomposition requires aggregating across firms in

11,000 manufacturing firms (in Brazil) and 6,500

industries with different production functions, so TFP

plants (in Mexico). These data were complemented

estimates were normalized as in Pavcnik (2000) by

with trade, tariff and other information from official

subtracting the productivity level of a "reference firm" in the initial year (1996 for Brazil, 1993 for Mexico). Thus, implicit TFP growth rates in Figure 11.8 are not

sources in Brazil, Mexico and the United States. To measure intra- and inter-industry spillovers from FDI, the analysis uses information on the percent

readily comparable to those in Figures 11.6 and 11.7.

of equity owned by foreigners (1996 for Brazil, 1993

With the productivity estimates in hand, one

for Mexico). We assume that the structure of ownership

may explain a firm's efficiency as a function of trade

remained unchanged through 1999. A firm is consid-

policy variables (e.g., tariffs), foreign capital partici-

ered to be "foreign" if foreigners owned more than 50

pation and FDI, exports, imported input use, as well as

percent of equity. The proportion of industry output

other controls needed to prevent omitted variable bias-

produced by foreign plants in each industry was taken

es. Thus, one may estimate equations of the form:

as the measure for foreign capital participation. To account for the possibility of spillovers from industries

Productivityjjt

- /^Trac/e,--, + /32FD//;f + controls + £,/f

upstream or downstream in the production process, we consider average foreign capital participation in indus-

where the dependent variable, Productivity in plant i,

tries with backward or forward linkages based on

belonging to industry j, during year t, is measured

input-output information for each country.

either in log-levels or in log-differences. The availability of panel data allows tracking each plant over time

See Lopez Cordova & Moreira (2002) and Lopez Cordova (2002).

for example, less productive industries may receive This appendix summarizes findings on the impact of

0.0006 (0.0001)***

Reg 3

Reg 4

29,103 10,859 0.0110

1.88

29,103 10,859 0.0103

1.89

-0.0004 (0.0002)

Reg 9

0.0003 (0.0001)***

Reg 10

29,103 10,859 0.5892 0.30

29,103 10,859 0.5893

0.37

29,103 10,859 0.5892

0.29

29,103 10,859 0.5892

0.31 0.31 1.91

0.31

29,103 10,859 0.5892

0.32

29,100 10,858 0.5893

0.1133 0.1116 0.1129 (0. 1 009) (0.1008) (0 . 1 009) -0.4039 -0.3966 -0.4076 (0 .1870)** (0.1870)** (0.1870)** 0.4393 0.4300 0.4266 (0.2732) (0.2732) (0 .2732)

(0.0010)

0.0008

Reg 8

29,103 10,859 0.5892

0.1134 (0.1008) -0.4032 (0.1870)** 0.4443 (0.2732)

0.0009 (0.0004)**

Reg 7

0.1122 (0.1009) -0.4021 (0.1870)** 0.4285 (0.2732)

0.0082 (0.0088)

Reg 6

0.1131 (0.1009) -0.4021 (0.1870)** 0.4312 (0.2732)

0.0024 (0.0087)

Reg 5

29,100 10,858 0.0115

0.1131 -0.1349 -0.1391 -0.1358 (0.1009) (0.0999) (0.0999) (0.1000) -0.4022 -0.5067 -0.4809 -0.4939 (0.1854)*** (0.1853)*** (0.1852)*** (0.1870)** 0.4310 0.9915 0.9671 0.9778 (0.2707)*** (0.2707)*** (0.2705)*** (0.2732)

-0.0009 (0.0002)***

Reg 2

Dependent variable: Change in TFP (log)

Notes: All regressions were estimated using fixed effects on a panel of firms. All regressions include the following controls: size, industry output (excluding the plant's own output), capacity utilization, industrial and geographic concentration indices, U.S. consumption, log of exchange rate times, U.S. PPI in the industry, and year dummies. Regressions 4 to 10 also include log TFP in year t. Standard errors in parentheses. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.

Number of observations Number of firms Within R2 F statistic for null hypothesis (Sum FDI spillovers = 0)

From backward linkages

From forward linkages

Intra-industry (%)

FDI spillovers

Imports/material costs

Imported-input/material costs

Reg 1

Dependent variable: TFP (log)

Total Factor Productivity and Integration in Brazil: Regression Results

Imported intermediate goods

Mercosur exports/sales

Exports/sales

Mercosur exporter (dummy)

World exporter (dummy)

Exporting activity

Independent variables

Appendix Table 11.1

26,703 5,302 0.0142

-0.0046 (0.0021)**

-0.0050 (0.0023)**

Reg 1 Reg 3

Reg 4

Reg 5

Reg 6

Reg 7 Reg 8

Reg 9

Reg 10

0.0463 (0.0155)***

49.56

26,683 5,302 0.0144

46.31

26,683 5,302 0.0164

49.39

26,683 5,302 0.0145

26,703 5,302 0.3638

-0.0029 -0.0053 -0.0053 (0.0020)*** (0.0020)*** (0.0020)

-0.1519 -0.1509 -0.1458 (0.0570)*** (0.0570)*** (0.0570)** 1.1387 1 .0755 1.1427 (0.1740)*** (0.1746)*** (0.1740)*** 0.3989 0.3964 0.4120 (0.0788)*** (0.0789)*** (0.0788)***

-0.0052 (0.0020)**

-0.0028 (0.0020)

25.89

26,683 5,302 0.3653

23.87

26,683 5,302 0.3662

-0.0269 -0.0310 (0.0548) (0.0548) 0.6602 0.7169 (0.1677)*** (0.1683)*** 0.2954 0.2815 (0.0759)*** (0.0759)***

-0.0028 (0.0020)

25.82

24.33

25.982

26,683 5,302 0.3656

25,903 5,191 0.3595 26,683 5,302 0.3650

-0.0422 (0.0149)***

-0.0026 (0.0020)

-0.0304 -0.0256 (0.0548) (0.0515) 0.7194 0.6845 (0.1593)*** (0.1676)*** 0.2319 0.2798 (0.0722)*** (0.0758)***

-0.0182 (0.0145) -0.0010 (0.0019)

-0.0324 (0.0548) 0.7140 (0.1677)*** 0.2845 (0.0759)***

-0.0029 (0.0020)

-0.0083 (0.0049)*

-0.0087 -0.0119 -0.0087 -0.0084 -0.0122 -0.0119 -0.0118 -0.0120 -0.0110 (0.0022)*** (0.0022)*** (0.0022)*** (0.0021)*** (0.0021)*** (0.0021)*** (0.0021)*** (0.0020)*** (0.0021)*** 0.0216 0.0186 (0.0058)*** (0.0060)***

Reg 2

Dependent variable: Change in TFP (log)

Notes: All regressions were estimated using two-stage least squares on a panel with fixed effects. Instruments are NAFTA-negotiated tariffs to control for potential endogeneity of tariffs in Mexico and the United States. All regressions include the following controls: age, age squared, size, industry output (excluding the plant's own output), capacity utilization, industrial and geographic concentration indices, U.S. consumption, log of exchange rate times, U.S. PPI in the industry, and year dummies. Regressions 5 to 10 also include log TFP in year t. "Mexican tariff" is the ISIC (rev 3) 4-digit industry tariff on world imports, weighted by trade. "U.S. tariff" is the difference between effective tariffs on Mexican imports and on imports from the rest of the world in the industry. FDI variables refer to the fraction of output produced by for eign plants; linkages were calculated using Mexican input-output data as weights. Standard errors in parentheses. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.

Observations Number of plants Within R2 Chi2 statistic for null hypothesis (Sum FDI spillovers = 0)

From backward linkages

From forward linkages

FDI spillovers Intra-industry (%)

Imported intermediate goods Imported inputs/total non-labor costs

U.S. tariff (Mexico-rest of the world)

Exports/sales

Exporting activity Exporter (dummy)

Imports/industry output

Competition from imports Mexican tariff on total imports (%)

Independent variables

Dependent variable: TFP (log)

Appendix Table 1 1 .2 Total Factor Productivity and Integration in Mexico: Regression Results

CHAPTER

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268

REGIONAL INTEGRATION AND WAGE INEQUALITY

There is little disagreement among most economists that countries benefit from trade liberalization. Yet, whether unilateral, multilateral (through the World Trade Organization) or through regional integration agreements (RIAs), trade liberalization has been one of the most controversial economic issues of our time. It is the focus of everyone from politicians to union leaders and anti-globalization forces because, while there are overall welfare gains from liberalization, these gains are not evenly distributed. What's more, in addition to some groups actually hurt by trade liberalization, there are others who have the perception at the very least that it has led to increased inequality, that is—that the burden of trade liberalization falls mainly on the poor. Latin America has come a long way in terms of liberalization, reducing barriers to trade and eliminating restrictions to capital flows. While much of the liberalization occurred at the unilateral level, during the 1990s most countries deepened trade links at the subregional level as well (see Chapter 2), entering into a variety of South-South and North-South RIAs within the Americas. Several countries are currently negotiating trade arrangements with the European Union, and the hemisphere as a whole is moving toward the Free Trade Area of the Americas (FTAA). South-South and North-North integration may have very different effects on wage inequality. In the context of the wave of trade liberalization sweeping Latin America—and all the perceptions and controversies surrounding it—this chapter will examine its impact on wage inequality in the region, with a focus on how wage inequality is affected by different forms

of regional integration. The effects on poverty are examined as well (see Box 12.1), although the link between trade and poverty is less direct than that between trade and wage inequality, since in the former, factors such as labor force participation decisions among household members and the price of the consumption basket intervene. The chapter first explores trends in relative wages across skill groups, then moves on to examine the theory behind how trade and labor markets are related. We begin with the neoclassical HeckscherOhlin model in which countries differ in the relative endowment of factors. In its strictest form, this model offers relatively straightforward predictions of how trade and wages—especially wage inequality—should be related. This model is perhaps most relevant for countries with large differences in relative endowments (North-South trade). Relaxing some assumptions allows for considering the effects of North-North and South-South trade, in which trading partners are generally more similar in terms of relative factor endowments. After describing the model and its implications, we focus on the assumptions of the model and try to gauge how they contrast with reality, including Latin America's relative endowments and tariff structures prior to liberalization, labor market imperfections (which give rise to unemployment), and the flows of capital. The chapter then reviews empirical studies of how trade liberalization in Latin America has affected labor markets. While our interest is on the effects of different types of integration, the bulk of the literature

Chapter

CHAPTER

Box 12.1

Poverty and Trade Liberalization

The relationship between trade liberalization and poverty is far from straightforward, encompassing various channels of influence. One might think that higher wage inequality automatically implies higher poverty levels, but this is not necessarily the case. Consider four interceding transmission mechanisms. • Level of wages. Productivity may have risen for less-skilled workers, but at a lower rate than for the higher skilled. A rise in the wage level for low-skilled workers should lower the poverty rate, regardless of how much higher the wages of high-skilled counterparts have risen. (See Chapter 11 for more details on the debate over the effect of trade on productivity.) • Distribution of the newly unemployed among households. The distribution of wages is calculated at the unit of individual earners, whereas poverty rates are based on the average income per capita of household members. The level and distribution of wages observed among earners may stay the same, but if unemployment associated with the adjustment to new labor demand is concentrated among families that were previously close to the poverty line, poverty will increase. • Distribution of new jobs among households. Trade may alter the demand for labor and bring new workers with new wages into the labor market. Suppose the wages stayed the same for all workers who had been in the labor market prior to liberalization, but that new opportunities attracted low-skilled women into the

labor market. Under this scenario, the incomes among the poorest households would likely rise. Although the per capita incomes of the poor may be higher, wage inequality as measured by the wages of all earners would increase with the addition of very low wages to the distribution. • Price of consumption basket. Since poverty is defined in relation to the ability to purchase a constant basket of consumption goods, any change in the real price of the goods basket will change the poverty rate. If trade causes the purchasing power adjusted price level for the basket to fall, the poverty line falls, which reduces the number of families living below the threshold. The many different channels of influence make tracing the effects of trade on poverty extremely difficult. Further complicating the task are other determinants of poverty that are unrelated to trade but are changing over time and have important implications for the poverty rate. The most important factor is changing demographics. As the dependency ratio falls over time, income is divided among fewer family members, leaving more households above the poverty line. The decline in fertility rates and household size are unlikely to be linked to trade liberalization, but have powerful implications for the poverty rate. One major debate is centered on how to interpret declines in poverty rates occurring simultaneously with trade liberalization.Within Latin America, Szekely

focuses more generally on trade liberalization. We will

ity are disputed, trade liberalization was generally

try to extract implications from this existing literature

associated with rising productivity and changes in firm

for the issue at hand: the link between different types of

behavior that contributed to increased demand for

integration and wage inequality. Several results

skill, and therefore rising wage inequality. Firms initial-

emerge from the empirical studies. First, there is no

ly reduced employment and made investments that

clear consensus about the long-run effects of trade lib-

helped the remaining workers become more produc-

eralization on wage inequality. Isolating the effects of

tive. This reallocation of labor and investment gener-

a change in one set of factors may be straightforward

ates some optimism for long-run growth. Third, some

in a laboratory setting but far more complicated in a

studies suggest that the direct effect of trade via

world with simultaneously changing policies and eco-

changes in goods prices and factor supplies may be

nomic conditions. Some

Latin American

countries

small relative to the role played by changes in technol-

experienced an increase in wage inequality following

ogy or increases in foreign direct investment associat-

trade liberalization, but emerging evidence suggests

ed with integration.

that this pattern may reverse in the long run. Second/ while the direct links between trade and wage inequal-

270

(2001) documents the meager reduction in poverty over the 1990s: the poverty rate fell on average by only 4 percentage points, from a level of 43 percent to 39 percent, based on calculations for 11 countries.1 Using international data, Dollar and Kraay (2000) examine the trend in the incomes of the poorest quintile and suggest that in periods of economic growth, these incomes generally rise at the same rate as the incomes of the rich. In addition, they find that countries with a higher share of trade per GDP experience more economic growth. Rodrik (2001) and Rodrik and Rodriguez (1999) question the supposition that recent declines in poverty are linked to trade liberalization. From their perspective, stating that declines in poverty caused trade liberalization makes as little sense as saying that trade liberalization caused declines in poverty, since the correlations in the two trends are unlikely to be causally related and instead are likely to be reflecting other factors. It is extremely difficult to properly control for the various determinants of poverty when attempting to identify the effects of trade liberalization. Most studies do not present a convincing link to liberalization, often relying on the problematic "before and after" approach. An ambitious set of studies by Gonzaga, Filho and Terra (2001) attempts to link the effect of trade liberalization to changes in poverty by specifically examining the pathways of change at the microeconomic level.2 The studies examine changes in the wages of earners and

DIFFERENCES IN WAGES ACROSS SKILL LEVELS

271

changes in employment, unemployment and job informality for the Dominican Republic, Paraguay, Jamaica, Brazil and Chile. The studies find inconsistent effects of whether poverty increases or decreases with liberalization, but in all cases the magnitude of the effects of trade liberalization on poverty are small. While rising inequality does not necessarily imply higher poverty rates, it can be shown theoretically that in the presence of asymmetries of information and capital market imperfection, high income inequality can lower the accumulation of human capital and the prospects for long-term growth. Furthermore, the higher the level of income inequality, the lower the reduction in poverty for a given level of growth (see Ravallion, 1997. Given that wage inequality is the primary determinant of income inequality, the distributional effects of liberalization on wages are important to consider.

Szekely's measure of poverty is the share of individuals with per capita household incomes under $2 a day. 2

The studies consider the effects of trade liberalization and financial liberalization on the full distribution of per capita income. For the countries mentioned, a computable general equilibrium model is used to explicitly model the effects of liberalization, and then is combined with microsimulations to trace the pathways at the household level.The effects of capital account liberalization are also found to be small.

using specific measures of completed schooling for this group, which has persistently high employment rates

In terms of the ratio of "skilled" to "unskilled" wages in

over the period, we are more likely to pick up changes

Latin America, it is best to begin with words of caution:

in prices, and not compositional changes.

skill is in the eye of the beholder. That is to say, there is

Figure 12.la shows that on average, the

no agreed upon definition of "skill" in the literature.

hourly wage for workers with completed tertiary

Some studies compare the wages of production work-

schooling is approximately 100 percent higher than for

ers to non-production workers; others compare wages

workers who have completed secondary schooling.1

across education levels. To examine relative wages

According to this measure of the skills gap, the skill

across skill groups, we compare wages of workers who

premium rose slightly over the 1990s. The figure is

have completed different levels of schooling. We exam-

based on the differences in the 12 countries shown in

ine the difference in wages for a group whose wages are most likely to reflect changes in the demand for skill: urban males between the ages of 30 and 50 who worked at least five hours in the reference week. By

1 The definition of the exact years of completing the different schooling levels per country are shown in the notes for Table 1 2.1.

â&#x20AC;˘Regional Integration and Wage Inequali

CHAPTER

Figure 12.1

Percent Difference in Hourly Wages for Urban Males Ages 3O to 5O a. Complete Tertiary vs. Complete Secondary

Figure 12.1

c. Complete Tertiary vs. Complete Primary

Note: The data are for the 12 countries in Table 12.1. To balance the panel for these figures, missing intermediate points are interpolated on a per country basis. Missing endpoints use the latest 1990s point from Table 12.1. Source: IDB calculations based on household surveys.

Figure 12.1

b. Complete Secondary vs. Complete Primary

Table 12.1.2 During the early 1990s, workers with completed tertiary schooling earned approximately 105 percent more than their counterparts with completed secondary schooling. By the end of the 1990s, they earned on average 115 percent more than their counterparts; in other words the skills premium rose by approximately 9 percent. This measure of skill, typical in the literature for developed countries, is likely a reasonable proxy for Argentina and Chile, where average years of schooling (10.4 and 10.2 years, respectively) are only a few years lower than the average for the United States (13.4 years).3 However, the difference in wages across the tertiary to secondary level is not necessarily the most appropriate for countries with low levels of schooling,

such as Honduras and Brazil, where the mean years of schooling for the population aged 30-50 is 5.3 and 6.5, respectively. Completed secondary school would appear to correspond to a high level of skill. Figure 12.1b thus presents the difference in hourly wages across completed secondary education and completed primary education. In general, the skill premium fell over the 1990s, with the absolute difference in wages declining from approximately 53 percent to 42 percent by the late 1990s. As can be seen in Table 12.1, over the 1990s the skill premium according to this measure fell in Argentina, Brazil, Peru, Costa Rica, Honduras and Bolivia.4 The difference remained at similar levels over the 1990s in Panama, Venezuela, Colombia and Mexico, with a small increase for Chile and Uruguay.

The average across countries shown in Figures 12.1 and 12.2 is not weighted by population. Countries for which survey data were available for at least three years in the 1990s were included in Table 12.1. Data were unavailable for the Caribbean region as a whole as well as for Guatemala, Nicaragua and Paraguay. 3 The average years of schooling are reported for the full population of persons ages 30-50. The survey data represent only urban areas in Argentina. 4

This pattern is consistent with the findings of Duryea, Jaramillo and Pages (2002), who reported that the relative wage of male workers with secondary schooling has fallen in comparison with workers with primary schooling, even after controlling for labor market experience. The decline in returns to secondary schooling is more pronounced for the Andean region and for Mexico/Central America.

272

â&#x20AC;˘Regional Integration and Wage Inequality

Table 12.1

273

Percent Difference in Hourly Wages by Completed Level of Schooling for Urban Males Ages 3O-5O

47 51 102

Argentina Bolivia Brazil

111

142 30

Chile Colombia

Costa Rica 34

Honduras

Mexico Panama Peru

48 23

Uruguay

Venezuela

39 38 93

105 44

91 71

49 117 47 54 42 76

76 75 47

50 34 78

112

138

Chile Colombia

Costa Rica 5 1

Honduras

103

Mexico

160 133

Uruguay

Venezuela

90 119

72 131 192 107 88

123 61

Panama Peru

146 1 02 147

121 176

144 141 142

86 94 145 177 115 88

362

Brazil

412 208

Chile Colombia Costa Rica 1 03

142

132

Honduras

168

Mexico Panama Peru Uruguay Venezuela

1 08

124

139

292 363

243 178 377 231 97

352 298 262 274

72 98 131 155 151 120 139

157 402 349 194 232

260 324 323 124

166 116

172 194 395 315 188 233 229 176 97

73 87 134 166 81 110 120 98 89 104

79 55

Argentina

52 32 26

36 96 44 45 12 57 57 75 60 32

1996 1997 1998

53 67

35 40 111

37 18 62 15

117

Tertiary versus primary 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Bolivia

59 71

54 27

Argentina

119

27 33 100 50 50

Tertiary versus secondary 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Bolivia Brazil

1996 1997 1998

70 149 181 163 111 116 210 79

80 103

1996 1997 1998 119 164 363 283 275 251 309

133 161 393 303 139 165 202 133 207 135

130 389 304 280 136 239 385 213 189 168

1999 2000 32 46 98 39 40 45

34 58 20

1999 2000 64 93 146 167 107 105

185

96 131

1999 2000 117 181 389 272 190 196

277

163 264 132

148

Notes: Complete primary is defined as up to grade 6, except for Bolivia and Colombia (5), Argentina (7), Brazil and Chile (8). Complete secondary is defined as up to grade 1 2 except for Brazil, Colombia, Costa Rica, Peru and Venezuela, where it is 11 years. Complete tertiary is defined as having completed four or five years of tertiary schooling. The difference in wages is first calculated as the difference in average log wages, then exponentiated. The sample is restricted to the population that worked at least five hours in the reference week of the survey. Hourly wages from the primary job are used except for Argentina and Colombia, for which wages from all jobs are used. All cells represent at least 5 percent of the sample of urban males ages 30-50. Source: Household survey data.

Secondary ve rsus primary 1985> 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

CHAPTER

One concern with the first two measures of skill is that they are both potentially affected by the increased supply of workers with secondary schooling. In other words, these measures may be capturing more about the supply of secondary schooling than a change in the demand for skill. For the last measure, we consider the gap between workers with tertiary and primary schooling, since it is not affected by the supply of secondary schooling. Figure 12.1c shows no generalized trend in this third and preferred measure of the skill gap. It is important to consider the disaggregated trends, which are presented in Figure 12.2 for the 12 countries. While the tertiary to primary wage gap has been falling in Panama, Honduras, Argentina and, more recently, in Colombia, it has been rising in Mexico, Uruguay, Chile, Peru, Costa Rica, Bolivia and Venezuela. The gap for Brazil changed little over the decade. Both Mexico and Costa Rica had rapid increases in the gap in the early 1990s with reversals occurring in the latter part of the decade. It is difficult to read any widespread trends in the skill premium from the full set of figures, but perhaps that in itself is noteworthy. Increases in skill gaps are observed in many cases, but as a whole, these figures contrast somewhat with the widespread view that less skilled workers in the region are consistently falling farther and farther behind their more skilled counterparts. Although there is evidence of a rise in the return to very highly skilled labor in numerous countries, the pattern of tertiary to primary wages found for Panama, Honduras and Argentina conflict with perceptions.5 How can we reconcile the results with the widespread notion among trade economists as well as anti-globalizers that liberalization is associated with rising gaps in wages across skill groups? First, early studies for Mexico and Costa Rica correctly noted the rapid increase in the skills gap in the early 1990s, but few countries have since mirrored such large increases. Second, by applying the typical measure of tertiary to secondary schooling, the skills gap may in some countries be contaminated by large changes in the supply of secondary schooling, instead of reflecting changes in the demand for skill. Brazil, Costa Rica and Peru show much more moderated change in the tertiary to primary gap than in the tertiary to secondary gap. Third, even estimates of the skill-premium from regressions indicate that the typical approach of comparing two points over time

may be inaccurate for capturing the trend. Finally, it is important to note that the information in Figures 12.1 and 12.2 is not explicitly linked to trade. It may be that while liberalization does increase the demand for skill and bring pressure for wage inequality to increase, in some countries these pressures may have been offset by other changes in the labor market.

THEORETICAL PREDICTIONS: How DOES TRADE LIBERALIZATION AFFECT LABOR MARKETS? Stolper-Samuelson Theorem The study of the relationship between trade liberalization and labor markets has a long history in economics. One of the first formal treatments of the relationship between trade liberalization and wage inequality was by Wolfgang Stolper and Paul Samuelson (1941). They based their analysis on the neoclassical HeckscherOhlin trade model, which predicts that comparative advantage emerges from differences in relative factor endowments. These differences are most stark between Northern and Southern countries, suggesting that this model may be most relevant for North-South integration. Countries that are relatively abundant in lowskilled labor (generally assumed to be the countries in the South) will be able to produce goods that intensively use low-skilled labor more cheaply than countries with relatively more high-skilled labor. This difference in costs will determine the pattern of trade as countries export the goods they produce at least cost. Trade theory predicts that such voluntary trade will create net gains for all trading partners, but these gains may not be equally distributed throughout the population. Stolper and Samuelson show that, following trade liberalization, some groups gain, others lose, but the gains to the winners would be enough to compensate the losers. To understand the empirical relevance of these predictions, it is helpful to explain the mechanics behind the theory.

Regression results are similar, but sensitive to the specification used to characterize experience and education.

274

Regional Integration and Wage Inequality

Percent Difference in Hourly Wages (Complete Tertiary vs. Complete Primary) Urban Males Ages 3O-5O, 1985 to 2OOO

Figure 12.2

275

276

CHAPTER

Mexico

Costa Rica

Brazil

Honduras

Notes: Countries are sorted from highest to lowest average education. Source: IDB calculations based on household surveys.

Figure 12.2 (conl.)

A reduction in tariffs will reduce the relative

The key to this story is that changes in trade

price of imported goods. These price changes will be greatest between countries that are the most different.

policy affect wages through changes in the relative

Since less skill-abundant countries would be importing

prices of goods. However, the precise theoretical relationship between output prices and relative wages,

more skill-intensive goods, they would experience

known as the Stolper-Samuelson (SS) theorem, only

falling prices for skill-intensive goods after trade liber-

holds under very restrictive assumptions.

alization. The fall in the price of the skill-intensive

In particular, the model assumes that there are

goods (and the corresponding increase in the relative

two goods made with two factors of production (labor

price of the less skill-intensive good) would change the

and capital, or low-skilled and high-skilled labor). In

demand for skill. The increase in the relative price of

addition, the model assumes that markets are perfect,

the less skill-intensive good would increase the demand

that factors can costlessly move between industries, that

for less-skilled workers, relative to skilled workers, and

factors cannot move across countries, and that returns

therefore the wages of the less skilled workers would

to scale and technology are constant and the same for

increase and the wages of the skilled workers would

all countries. The numerous restrictions embodied in

fall. Since less skilled workers have lower wages to

the theory create a large number of ways in which the

begin with, this kind of trade liberalization should

model may deviate from reality. These deviations affect

reduce wage inequality.

our expectations of how trade liberalization will affect

While the theory applies to trade liberaliza-

inequality.

tion in general, it can be loosely extended to examine the effects of preferential agreements to lower tariffs across countries or regions. For example, if Brazil signs

Pattern of Protection

a preferential agreement with Canada, a parallel

One example lies in the pattern of protection. The

reduction in tariffs between the two countries implies

Stolper-Samuelson theorem predicts that the change in

that the relative price of skilled goods would fall in

tariffs will affect relative wages through a change in

Brazil and rise in Canada. It is then likely that Canada

prices. Yet, how tariff reductions affect prices depends

would import more low skill-intensive products from

on the pattern of tariffs prior to liberalization, particu-

Brazil, while Brazil would import more of Canada's

larly on differences in tariff levels between skill-inten-

high skill-intensive exports. This implies that in Brazil,

sive and less skill-intensive goods. Since a country's

the relative demand for the relatively abundant factor,

scarce factor stands to lose from trade liberalization, a

low-skilled labor, would increase, leading to a reduc-

reasonable expectation based on the theory is that

tion of wage inequality. As the relative demand for the

countries use tariffs to protect their scarce factor. If this

high-skilled workers rises in Canada, wage inequality would increase there. A different partner or set of part-

were the case, the Stolper-Samuelson predictions would apply. But country realities may differ from these

ners is likely to have different implications for the

expectations. For instance, prior to joining the GATT in

changes in wages. For example, a preferential agreement signed with China could have very different

ing higher tariffs on those goods that intensively used

1986, Mexico protected its less skilled workers by plac-

Brazil is abundant in skilled labor. As tariffs fell, the

less skilled workers.6 Similarly, for Argentina, the Mercosur tariff is higher and provides more protection in

demand for unskilled labor would likely fall in Brazil,

the industries that are intensive in low-skilled workers

while the demand for skilled labor would

(Porto, 2001). Under these conditions, trade liberal-

implications for Brazil, since in comparison to China,

likely

increase. As the wages of the less skilled rose in com-

ization that reduces protection in the low-skilled manu-

parison with the wages of the more skilled, wage

facturing sector to a greater extent than in other sectors

inequality would rise in Brazil. Regardless of the

may increase the gap in wages between skill groups, a

changes in relative wages, the gains from trade in the form of lower prices and higher income per capita should be larger, given wider differences in the factor endowments of the trading countries.

Hanson and Harrison (1999), Revenga (1997) and Robertson (2002) describe these patterns for Mexico.

â&#x20AC;˘Regional Integration and Wage Inequalil 277

CHAPTER

result that would appear to contradict the predictions of Stolper-Samuelson. There are at least two possible explanations for this apparent contradiction. First, less skilled workers may have more of an influence in trade policy in that they are relatively more successful in securing tariffs to protect their wages.7 If the pattern of tariff protection is more strongly linked to the political process than to the concept of comparative advantage, it is not necessarily expected that trade liberalization will increase the relative wages of the abundant factor. Another possibility is that Latin American countries are not relatively abundant in less skilled workers, in which case the pattern of protection would be consistent with expectations.

Abundance of Which Factor? The question of whether Latin American countries are abundant in less skilled workers depends critically on what countries fall into the relevant comparison group. Should a country's relative supply of labor be compared with the countries it trades with, or with the rest of the world? While Latin American countries are relatively endowed with less skilled labor when compared to the developed countries, they are probably not abundant in less skilled labor relative to the rest of the world, especially with respect to Asia and Africa.8 Thus, while over 70 percent of Mexico's imports and exports are with the United States, China's growing international market presence may have important effects on wages in Mexico. In the context of bilateral and regional agreements, wage changes should be linked to differences in factor endowments across partners, but the presence of other trading associates external to the agreement may moderate the gains from trade. In our example of a preferential agreement between Canada and Brazil, the relative wage of the less skilled in Brazil may rise to a lesser extent after the agreement if Canada has been trading with China. Similarly, there may be large differences in the definition of "skill" across countries. Workers considered skilled in one country may be unskilled in another, complicating direct comparisons. While a worker with 10 years of education would be considered skilled in Mexico, he or she may not be considered skilled in the United States. Furthermore, the rankings of factor abundance also depend on what factors are consid-

ered. If a third factor of production is introduced, such as natural resources or land, the standard StolperSamuelson result does not necessarily hold.9

Factor Content The Stolper-Samuelson theorem predicts that the change in relative prices drives the change in relative wages. Several analysts have suggested that changes in imports and exports, rather than changes in relative prices, can be compared with changes in wages to determine how liberalization affects inequality. The justification for using imports and exports, aside from being intuitive measures of trade, is that imports increase the effective supply of the factors used to produce them. For example, importing labor-intensive goods would increase the effective supply of labor in the country importing those goods. The effects on labor markets can therefore be determined by the factor content of traded goods. Trade economists tend to be skeptical of this approach because imports may increase for reasons other than trade liberalization (such as an economic boom), but some studies have shown that this approach is appropriate under certain conditions.10 The results of this debate notwithstanding, imports and exports remain popular measures of integration, as the empirical results illustrate.

Adjustment Costs/Unemployment The neoclassical model generally assumes that markets adjust easily, so that, in the purest form, there is no unemployment. Understanding market imperfections and adjustment costs that give rise to unemployment

Marktanner (2000) finds that it may be more politically efficient to use trade policy to address distributional concerns, which may explain the use of tariffs in ways contrary to the Stolper-Samuelson predictions. 8

Wood (1997) and Spilimberao, Londono and Szekely (1999) make this point by comparing the relative endowments of several factors. 9 Fischer (2001) shows that when a country is land abundant (relative to labor), trade liberalization may increase income inequality in the long run. He finds this effect for land-abundant Chile, while the opposite happened in labor-abundant Taiwan. See also Learner et al. (1999). 10 For more on this debate, see Freeman (1995), Panagariya (2000) and Deardorff (2000).

278

279

can also help us understand how trade liberalization

Relatively little theoretical work has been done

will affect employment and unemployment. When bar-

relating intra-industry trade with wage inequality. That is

riers to trade fall, resources move in response to the

not surprising, given that the models are based on a rep-

change in relative prices. If adjustment costs are signif-

resentative agent methodology that does not lend itself to

icant, and therefore adjustment is slow, unemployment

an analysis of relative wages. One might expect smaller

may result.11 Several studies examine adjustment costs

changes in wages if South-South trade is based on

in Latin American countries. The persistence of inter-

smaller differences in comparative advantage. Current

industry wage differentials and labor market adjust-

research, however, suggests that intra-industry trade

ment costs suggests that labor markets may not adjust

may also contribute to rising inequality.

instantly, leading to worker dislocation.

Syropoulos and Xu (1999) find that increasing intra-

The degree of market inflexibility in Latin America has also been the subject of debate. Heck-

Dinopoulos,

industry trade can increase the demand for skill and therefore increase wage inequality.

man and Pages (2000) show that mandatory hiring and firing provisions are more stringent in Latin Amer-

Other Implications of Integration

ica than in industrial countries. However, while the results of their 2000 study suggested a negative effect

Integration generally involves much more than reduc-

on employment, their recent work with better regulato-

ing trade barriers. Recent measures to promote inte-

ry measures and a larger data set suggests otherwise.

gration include provisions to facilitate capital flows and

It is likely that the presence of large informal labor mar-

increase the flow of technology. Each of these can have

kets reduces the effect of mandatory regulations in

significant implications for the effects of integration on

Latin America. In terms of costs, Robertson and

labor markets.

Dutkowsky (2002) use industry-level data and find that

One constraint on growth and employment is

measured labor market adjustment costs in Mexico are

the lack of capital. Integration agreements that pro-

about one-tenth the size of comparably-measured

mote FDI can therefore increase labor demand. The

adjustment costs in the United States and the United

implications for wage inequality depend on the kind of

Kingdom. The size of the adjustment costs affects the

workers that are generally employed by foreign capi-

relative adjustment of wages and employment. When

tal. Conventional wisdom suggests that plants with for-

labor market adjustment costs are high, negative

eign capital tend to use more advanced technology

shocks may affect wages more than employment.

and hire relatively more skilled workers. In fact, it is also possible that capital movements from developed to

Trade among Similar Countries

developing countries can raise the demand for skill in both countries, thus increasing inequality in both coun-

Differences in relative factor endowments give rise to

tries (Feenstra and Hanson, 1996). For example, if

trade in the Heckscher-Ohlin model, but most world

capital that generally employs workers with a high

trade is between the developed countries of the North

school education moves from the United States to Mex-

that have relatively similar factor endowments. In the

ico, this will reduce the demand for high school work-

early 1980s, this phenomenon inspired a "new" trade

ers in the United States (where they are low skilled

theory based on intra-industry trade (two-way trade in

workers) and increase the demand for these workers in

similar products) and monopolistic competition. In these

Mexico (where they are high skilled).

models, countries with similar endowments specialize in

Acemoglu (1999) shows that if trade is asso-

varieties of products and exchange different varieties to

ciated with changes in technology that are more likely

satisfy consumers' love of variety. Trade liberalization between similar countries tends to favor intra-industry trade, as has been well established for developed countries. Guell and Richards (1998) find that regional agreements between Latin American countries have increased intra-industry trade there as well.

1] Hungerford (1995) finds that trade shocks have only a small effect on the probability of layoffs in the United States. Kletzer (1998), on the other hand, finds evidence of significant job displacement in some U.S. industries.

â&#x20AC;˘Regional Integration and Wage Inequality

CHAPTER

to be used by high skilled workers, wage inequality will increase in both the high-skill abundant and low-skill abundant trading partners. This process is often referred to as skill-biased technological change. Greater integration may reduce the costs of technology and therefore motivate innovation. Technology has received much attention as a factor raising the demand for skills in the developed countries.12 Most technology in Latin America is imported. Thus, trade liberalization may reduce the costs of importing technology. If this technology complements skills, the lower cost of technology will increase the demand for skill. Notice that if trade leads to the adoption of new technology, and technology is complementary with skill, trade will at the same time increase productivity and increase inequality. Thus, increases in wage inequality are not necessarily welfare reducing; the level of wages for the high skilled may have merely increased at a greater rate than the wages for the low skilled (for example, poverty rates can fall while the skill gap increases).

REVIEW OF EMPIRICAL FINDINGS Does Trade Liberalization Increase Inequality? In between the passionate anti-globalization view that trade liberalization increases inequality and poverty, and the equally strong convictions of trade theorists that liberalization increases living standards, lies the simple fact that, despite a great deal of careful empirical work, the debate over the effect of trade liberalization on wages in developing countries remains unresolved. A definitive answer may be elusive in a changing world: societies are not laboratories where tariffs can be lowered while everything else is kept constant in order to see what happens. Other reforms press ahead simultaneously, and societies change constantly in terms of related variables ranging from the female labor supply to family structure and macroeconomic conditions. However, while the empirical evidence on the short-run effects of trade liberalization on wage inequality in Latin America is not entirely clear, the results seem to suggest that the reduction of tariffs in Latin America was followed at least initially by an increase in wage inequality. In the longer run, wage

inequality may fall depending on further liberalization of the initial trade reforms. Wage inequality in Chile rose from 1970 to 1990, when inequality began to fall.13 The cause for the reversal is not clear. Mexico experienced a similar reversal that may be easier to explain. Various studies find that wage inequality rose in Mexico following its accession to the GATT, but fell following Mexico's entrance into NAFTA (Figure 12.3).14 This is consistent with the idea that the type of integration matters (North-South vs. South-South). The GATT liberalization for Mexico occurred with respect to the world, while the NAFTA liberalization was with the North, which may help explain the different patterns in subsequent wage inequality. Mexico is not necessarily abundant in less-skilled workers in comparison to world trading partners such as China, but it is less skilled in comparison with the United States and Canada. It is also possible that the changes in wages in the initial years after GATT were dominated by the dismantling of the extra protection for less-skilled workers, given Mexico's pattern of protection before GATT. Interestingly, GATT and NAFTA liberalization also had different effects on another dimension of inequalityâ&#x20AC;&#x201D;the geographical distribution of employment in manufacturing (see Box 12.2). Coinciding trends of rising wage inequality and trade liberalization, even when they do occur, do not necessarily imply that one causes the other. Likewise, liberalization can contribute to a change in the demand for skill that is offset by other changes in the economy. Formal studies of the link between inequality and liberalization in Latin America vary somewhat based on the theoretical method motivating the approach. In particular, studies can be grouped into those that examine the link between tariffs, prices of goods, and wages (price studies); studies that examine the effects of changes in trade volumes on inequality; and studies that look at other channels.15

12 Two of many studies in developed countries that compare trade and technology are by Haskel and Slaughter (1999, 2001). 13

See Bravo and Marinovic (2001).

See Airola and Juhn (2001), Acosta and Montes Rojas (2001), and Robertson (2001). The trends in the secondary to primary wage gap for Mexico shown in Table 12.1 are similar to the trends in Figure 12.3. 15

For a thorough review of the literature, see Robertson (2002).

28O

â&#x20AC;˘Regional Integration and Wage Inequali

Figure 12.3

Relative Wages in Mexico, 1987-2OO1

281

ing trade reforms in 1988, and that trade liberalization may help explain the fall in wage inequality. However, while wage inequality fell in Brazil, one of the countries with the lowest levels of schooling in the region, cation. Meanwhile in Mexico, wage inequality rose during the GATT years and fell after NAFTA (Figure 12.3). This evidence, taken together, may be consistent with observations that while Mexico is not abundant in low-skilled labor with respect to the world, it is abundant in low-skilled labor with respect to Canada and the United States.

Note: This figure shows the wage ratio of nonproduction workers to production workers, weighted by industry employment. The data are from Mexico's Monthly Industrial Survey conducted by INEGI. The ratio is normalized so that the value of January, 1 987 is equal to one. Source: Robertson (2001).

Supply and Demand Studies A supply and demand approach has been commonly used to compare the factors that may affect the relative demand for skill, although the links to theory are much

Price Studies

weaker. Many of the studies ignore the factor content

Price studies link changes in relative prices to changes

ies generally find that increased trade flows are asso-

in relative wages. Although the link from prices to

ciated with increased wage inequality.

of trade and focus on the quantity of trade. These stud-

wages is the closest to the Stolper-Samuelson theory,

In Argentina, Galiani and Sanguinetti (2000)

relatively few Latin American studies take this

find that trade flows increased wage inequality follow-

approach. Beyer, Rojas and Vergara (1999) compare

ing liberalization. Rising inequality in Argentina and

changes in relative prices and wages in Chile and find

falling inequality in its largest Mercosur partner, Brazil,

that the rise in the relative price of skill-intensive goods

is consistent with standard trade theory in the sense

helps explain the increase in inequality. This is consis-

that Brazil can be considered abundant in low skill and

tent with the standard theory if Chile is relatively abun-

Argentina abundant in high skill. In Brazil, 50 percent

dant in skilled labor.16 For Mexico, Hanson and

of persons ages 20 to 60 have completed less than six

Harrison (1999) examine firm-level data and industry-

years of schooling, while in Argentina the respective figure is 8 percent.

level prices during 1984-90 and find little evidence of a relationship between changes in output prices and

In terms of magnitude, Galiani and San-

changes in wage inequality. Alternatively, they identify

guinetti (2000) find that trade explains a small portion

changes within industries, such as foreign investment

of the increase in inequality. In another study on

and export orientation, as significant contributors to

Argentina, Acosta and Montes Rojas (2001) find that while trade did contribute to the rising demand for skill,

rising wage inequality. Robertson (2001) finds that movements in relative prices were both consistent with

technology probably played a more important role.

Mexico's tariff liberalization and the rise in inequality

Thus, both studies reach similar conclusions as found in

between 1986 and 1994. He finds that the relative

U.S. studies: the direct effect of trade was small and

price of skill-intensive goods fell after 1994, which may

technology was probably more important.

help explain the fall in wage inequality after NAFTA.

In Costa Rica and Colombia, Robbins and

Another possible explanation is that the effects of lib-

Gindling (1999) and Robbins (1996) find that trade

eralization have different short- and long-run effects.

increased wage inequality. They use household surveys

For Brazil, Gonzaga, Filho and Terra (2001) compare tariff changes, price changes and wage inequality, concluding that wage inequality fell follow-

16 The average years of schooling in Chile for the population age 25 and older is 9.6. In the United States, the average is 13.

inequality rose in Chile, which has high levels of edu-

282 CHAPTER 12

Economic Geography of Mexico

The gains from trade may be distributed unevenly not only across wage classes, but across regions. In Mexico, the regional effects of trade policies can be viewed from the vantage point of two milestones: Mexico's entry into the GATT in 1986 and formation of the North American Free Trade Agreement (NAFTA) in 1994. In 1985, Mexico's trade-weighted tariff on manufactured goods stood at 28.5 percent, and 92.2 percent of such goods required import licenses. By 1998, the trade-weighted tariff had fallen to 6.6 percent and the licenses were nearly eliminated. Over the same years, the ratio of Mexico's exports to GDP rose from 15.4 percent to 30.8 percent, and the share of its exports sold to the United States rose from 60.4 percent to 87.9 percent. In short, through these trade policy changes, Mexico has become more integrated with the rest of the world and, in particular, with the U.S. As a result, it has also experienced extensive changes in the distribution of employment among municipalities. In 1998, of Mexico's 2,443 municipalities, the 16 that constitute the Federal District contained 12 percent of the nation's manufacturing employment. If the municipalities of the surrounding state of Mexico are added, the statistic doubles to 24 percent. Yet, if Mexico City's preeminence is striking, so too was its erosion during the preceding 10 years of integration. Table 1 ranks leading cities by changes in their percent shares of national manufacturing employment from 1988 to 1998. Of the negative changes, one was in Monterrey, one in Guadalajara, and the rest in delegaciones of the Federal District. Over the decade, Mexico saw a deconcentration, if not an exodus, of manufacturing from its mega-city and its burgeoning cousins. Among the greatest positive changes were those in border cities such as Tijuana, Ciudad Juarez and Mexicali. Collectively, they grew from being home to 5.6 percent of Mexico's manufacturing workforce in 1988 to 10 percent in 1998. This marked an increase of 275,000 workers in three municipalities that together now rival the industrial preeminence of the Federal District. But much of the story is told below the top ten. Figure la shows the changes in municipal shares from 1988 to 1993, and Figure Ib shows the changes from 1993 to 1998. Positive changes are represented by red peaks, negative changes by blue depressions. Although other factors have also influenced the outcomes, comparing the figures shows whether the two different trade policies—non-preferential opening under the GATT and preferential opening under NAFTA—have had different consequences. The figures show many similarities: Tijuana, Ciudad Juarez and Reynosa on the U.S. border stood out as growth centers in both periods. Their growth was led by radio, television, communications and medical equipment assembly and apparel manufacture, almost

Figure 1

Change in Municipal Percentage of National Manufacturing Employment a. 1988-93

b. 1993-98

all destined for export to the U.S. Tehuacan, in the state of Puebla, and Leon, in Guanajuato, although less than 250 miles from Mexico City, also flourished as apparel export manufacturing centers in the 1990s. But the figures also show notable differences. Merida and several other municipalities in Quintana Roo, Campeche and Chiapas, near ports or the southern border, grew in the non-preferential opening period but not in the preferential opening period. Conversely, Mexicali, on the U.S. border, and Torreon, near it, grew substantially in the preferential period but not in the nonpreferential period. On balance, there is some evidence of regional repercussions of Mexico's change from nonpreferential to preferential trade liberalization. The dominant features of the figures—the peaks centered on Tijuana, Ciudad Juarez, Leon and Tehuacan, and the crevasse underlying Mexico City— represent a dramatic reversal of fortune. There was some perceived advantage to the mega-city's agglomeration, after all, that continued to fuel its growth in both absolute and relative terms until the mid-1980s. Part of the advantage was undoubtedly the centralization in Mexico City of power, political influence and public spending; part stemmed from externalities, manifested

Bex 12.2 Integration and the

â&#x20AC;˘Regional Integration ana Wage Inequali 283

Table 1

Cities Ranked by Share Change in National Manufacturing Employment, 1988-98 Positive changes

1 Tijuana (BCN) 2 Ciudad Juarez (CHI) 3 Apodaca (NLN) 4 Zapopan (JAL) 5 Mexicali (BCN) 6 Guadalupe (NLN) 7 Reynosa(TAM) 8 Leon (GTO) 9 Tehuacan (PUE) lOHermosillo(SON)

41,872 108,172 8,303 24,989 24,562 13,289 24,141 55,508 8,981 11,294

1 Azcapotzalco (D-F) 2 Tlalnepantla (MEX) 3 Naucalpan (MEX) 4 Monterrey (NLN) 5 Guadalajara PAL) 6 Cuauhtemoc (D-F) 7 Gustavo Madero (D-F) 8 Miguel Hidalgo (D-F) 9 Iztapalapa (D-F) 10 Benito Juarez (D-F)

87,493 80,502 80,202 92,001 102,453 60,838 47,944 55,061 68,293 36,386

153,530 240,782 37,214 63,337 61,375 41,414 55,080 103,397 28,471 31,795

Change in share

3.76 5.90 0.91 1.55 1.50 1.02 1.35 2.53 0.70 0.78

2.15 1.74 0.59 0.59 0.56 0.50 0.42 0.40 0.35 0.34

1.83 1.80 1.93 2.53 3.10 1.54 1.07 1.42 1.95 0.76

-1.71 -1.45 -1.32 -1.19 -1.04 -0.93 -0.87 -0.80 -0.82 -0.71

Negative changes 74,588 73,606 78,697 103,457 126,737 62,710 43,718 58,143 79,502 31,122

in technological spillovers and labor training; and part lay in the simple fact that people had already chosen to locate there. Manufacturing industries were unlikely to stray far from their principal output market, particularly given the large transport costs they would incur in supplying that market from outside the Valle de Mexico. The GATT liberalization and NAFTA combined with other causes to unravel these advantages. Political decentralization supporting state and municipal self-government militated against the first advantage; negative externalities in the form of congestion costs, including pollution and the consequent limitations to auto circulation and factory emissions, began to balance against the second; and Mexico's opening, combined with its physical geography and transport infrastructure, undermined the third. As Mexico exports a larger part of its output, more of manufacturing firms' output markets lie in the United States rather than Mexico City. The capital's distance from the border, coupled with the lack of multi-lane and restricted access divided highways over parts of the distance, gives more advantages to establishing manufacturing plants in the north and fewer advantages to Mexico City. What is more, the north's advantages are compounded cumulatively as its share of manufacturing industry grows: other northern plants and migrant employees are among the new plants' suppliers and consumers, so by locating in the North they are all locating alongside a growing portion of their markets. Integration has thus diminished regional

inequalities in Mexicoâ&#x20AC;&#x201D;with an important caveat. It has "chosen" regions that might not have figured as largely as others in policymakers' development plans, particularly post-NAFTA. To illustrate, in Figure 1 b, a path of red is discernible running south from Ciudad Juarez past Torreon, surrounded by a sea of blue. The red is situated exactly on one of the principal highways from Mexico's interior to the northern border; the blue contains the small towns and ejidos far from it. In the immediate post-GATT period, in addition to well-situated areas like those on the highway, many of the more numerous and poorly situated areas also experienced relative growth. This cannot be said as accurately of the post-NAFTA period. From 1988-93, 68 percent of municipalities recorded positive changes in their shares of national manufacturing employment, but over 199398, that fell to 51 percent. Will the trend of manufacturing deconcentration in Mexico City, and its growing concentration at the border and a handful of particular areas inland, continue? Perhaps not. The limitations to agglomeration already confronted by Mexico City now begin to emerge in the border cities, as labor and congestion costs there rise. Meanwhile, improvements in national transport infrastructure should reduce the cost difference between serving the U.S. market from the border and from more distant locations. Trade liberalization and integration will continue to influence shifts in Mexico's economic geography, but their epicenters may change.

Employment, 1988 Employment, 1998 Share in national (number of persons) (number of persons) manufacturing, 1998 (%)

CHAPTER

to control for changes in the supply of education (and several other institutional factors) and find that much of the increase in wage inequality that followed trade liberalization in both countries was due to a rising demand for skill. A few studies examine changes in trade policy instead of changes in trade quantity. Although they do not analyze the effect of changes in the prices of goods, these studies are closely related to the policy decision to lower tariffs. A recent study takes the novel approach of linking indices of policy reforms to a series of household surveys from 18 countries covering the 1990s. Behrman, Birdsall and Szekely (2001) compare the contributions of trade liberalization, privatization, financial market reforms and technology using data from 18 Latin American countries. They find that trade liberalization had no significant effect on wage inequality, but technology and financial market reforms (including capital account liberalization and tax changes) had a significant impact on changes in wage inequality.17 Robbins (1996) relates changes in wages to changes in tariffs in Costa Rica and does not find evidence that trade liberalization increased the demand for skills in ways consistent with the Stolper-Samuelson theorem. Instead, he argues that technological changes were behind the increase in wage inequality. Concern continues to be raised about the impact of trade liberalization on women's wages and employment opportunities. The "before and after" studies that claim to measure the effects of trade liberalization are even more problematic for women than for men, since the secular changes in female labor force participation may have larger effects on the distribution of female wages than changes in trade liberalization. The effects of trade liberalization on women's labor market outcomes remain an important area for future research.

FDI and Technology Chapter 10 suggests that regional integration agreements are associated with an increase in foreign direct investment both from member countries and outside sources. Foreign investment flows have played a very important role in the economies of Latin America.18 Foreign investment may affect employment either directly (through new hires and expansions over time) or indirectly (through linkages with local firms) (Lall,

1995). Regarding the direct channel, Feenstra and Hanson (1996, 1997) develop and test a model in which foreign capital represents a transfer of jobs that are considered less skilled in the developed countries but are skilled in the developing countries. Examining Mexico's maquiladoras, they find support for their hypothesis that foreign capital increased wage inequality in Mexico. Foreign capital can also bring in new technologies whose complementarity with skills may increase the demand for skill.19 Thus, integration that increases capital and technology flows may increase inequality. This effect may be especially important in Latin American countries that develop much less of their own technology. Alvarez and Robertson (2001) find that domestic firms that partner with foreign capital are more likely to innovate than firms without foreign capital. Foreign capital tends to use the most advanced production techniques (Buitelaar, Padilla and Urrutia, 1999). These effects are complementary with trade liberalization that makes importing machine tools, especially computer-controlled machine tools, much less expensive for Latin America (Alcorta, 2000). These imports may have contributed to rising productivity. If workers need more skills to work with these technologies, the demand for these skills, and thus inequality, increases. Another channel through which integration may affect relative wages and poverty is through technology. In the United States and developed countries, trade and technology are often posited as alternative explanations for changes in the wage structure.20 The fact that the South in general, and Latin America in particular, generally do not develop technology to the same extent as the North suggests that increased integration between the North and the South may facilitate

17 Trade liberalization is measured as the mean of the average level and average dispersion of tariffs, per Lora (1997). 18 Some of the many studies that discuss capital flows into Latin American countries are Agosin, Fuentes and Letelier (1994); Agosin and Ffrench-Davis (1997); and Gil Diaz (1999). 19 Blonigen and Slaughter (1999) find that, for the United States, FDI increases the demand for less skilled workers. 20

Acemoglu (1998, 1999) shows some of the patterns of skill and suggests that in the United States, the increase in the supply of skilled workers has induced the development of skill-complementary technology. These technologies affect the relative demand for skill (Autor, Katz and Krueger, 1998).

284

â&#x20AC;˘Regional Integration and Wage Inequality

South or South-South, economic integration causes a

depend on productivity, these flows may hold the

reallocation of resources between industries. Trade

promise of reducing poverty as well.

opening is expected to bring long-run gains in the form

There are several ways that technology may

of increases in productivity and growth, but the process

change as a result of trade liberalization. First, export-

of integrating markets means that economies are more

ing may create the incentives to implement more

susceptible to swings in world prices. Given the fact

advanced technologies to meet the demands of world

that some adjustment is certain, programs to facilitate

consumers or reduce inefficiency afforded to them by

the process for workers and families are important.

protection.

Several studies have found that exporting

firms are more productive, and that exporting is linked

Training and Job Search Programs

to incentives to invest in new technology (see Chapter II).22 These new technologies may have increased the

Worker training and job search programs that smooth

demand for skill (Macario, 2000). Importing interme-

transitions to new types of employment will particular-

diate inputs as well as machinery may also create

ly help workers become more productive sooner. The

effects analogous to technological change. Finally,

availability of effective programs prior to further

reducing barriers to trade may make it easier to

rounds of liberalization will also make workers less

acquire foreign technologies. If countries have more

anxious about prospects for integration. New skills

flows of goods, services and communication between

taught to displaced workers should reflect the new pro-

them, the cost of diffusing technology falls. Firms are

file of demands in the economy, regardless of whether

more able to learn from other countries and apply that

those news demands derive from generalized techno-

accumulated knowledge at home. Acosta and Montes

logical change or tariff reductions. Currently, most

Rojas (2001), using household-level data for Mexico

training institutes are designed based on the pre-

and Argentina, compare the roles of trade and tech-

1980s framework of import-substitution, in which the

nology and find that technology may have had larger

state could highlight a few industries and provide train-

effects on inequality than trade flows.

ing for a determined set of skills. Although flush with funds from earmarked taxes, many institutes have not been linked to the changing demands for skill.

POLICY IMPLICATIONS

One promising innovation is the regulatory approach to training being used in Chile. The Nation-

The most ambitious integration initiative pending for the

al Training and Employment Service (SENCE) does not

region is the Free Trade Area of the Americas (FTAA).

provide the training directly, but rather uses an income

Under the assumption that the South is relatively abun-

tax rebate for businesses that contract or directly pro-

dant in less skilled workers, North-South integration

vide a program to their employees. The program must

should reduce wage inequality there. On the other

meet SENCE's criteria for relevance and quality for the

hand, if integration facilitates the flow of capital and

firm to be eligible for the rebate. Since the firms are

technology, this integration may increase the demand

self-financing a portion of the training costs, they have

for skill and increase wage inequality (at least in the

the incentive to select programs that suit their demands.

short run). The existing empirical literature offers only

The same type of rebate is available to firms offering

little clarity. There seems to be some consensus that wage inequality increased in Latin America following trade liberalization, and most studies agree that this increase in inequality was correlated with an increase in the demand for skill, especially in the short run. While there are several factors that may explain the response of inequality to integration, all of the factors seem to generate similar policy implications. Regardless of whether further integration is North-

Currie and Harrison (1997) find evidence that firms increased productivity following trade liberalization in Morocco. 22 See Aw and Hwang (1995), Bernard and Jensen (1997), and Alvarez and Robertson (2001). Dijkstra (2000) argues that the link between trade liberalization and technological change seems weak. Technological change may have been correlated with other factors, such as industrial policy and exchange rate movements that encouraged restructuring in the manufacturing sector.

technology flows southward. Since living standards

285

CHAPTER

apprenticeships to potential employees drawn from workers displaced from their old jobs. The challenge for institutes that provide their own courses, such as the National Training Institute (INA) in Costa Rica, is to identify and provide training that provides skills that are well aligned with the demands of businesses. Displaced workers with high levels of education may have strong prospects for being re-hired without job training, and may benefit quickly from job search programs. But it is important for job search assistance to be well integrated with the training programs. A new program in El Salvador run by the nongovernmental organization FEDISAL lists training course openings in the national job registry. Programs combine counseling along with listings of job openings. The model is innovative in that private, nongovernmental and governmental institutions are collaborating to better link services with changing demands. Walk-in facilities that offer computerized searches of national job registeries are becoming more common, but these services are not necessarily accessible in all geographic areas (Mazza, 2001).

Unemployment Insurance and Workfare Programs Traditionally, unemployment insurance in the region came in the form of a generous severance payment available when formal sector workers were involuntarily separated from their jobs. Heckman and Pages (2002) suggest that unemployment insurance slows the reallocation of workers to new positions, since employers have the incentive to maintain inefficient staff to avoid paying the stiff penalty. Unemployment insurance as is implemented by developed countries, with smaller monthly payments, is often criticized for discouraging labor supply. A new hybrid unemployment insurance in Chile directs a share of wages and the employer's contribution to individual accounts. Workers first draw down their personal accounts before they are eligible to receive government payments. Since the worker's contributions roll over to retirement accounts if they are not used, the worker has the incentive to conserve the account. These schemes are also portable from job to job, an attractive feature in dynamic economies.

Employment programs in which participants receive a minimum wage in exchange for work have advantages over standard unemployment insurance, since the unemployment transfers are typically only available for formal sector workers and provide a disincentive to work. Workfare programs are more expensive to administer than cash transfers, but do not discourage labor supply. If the wage is not set artificially high, the program is effectively "self-targeted" in that jobs tend not to be captured by high-skilled workers who have better prospects elsewhere. Another feature of a low-level wage is that participants have the incentive to self-graduate to "regular" jobs with better wages. Unfortunately, too often the allocation of positions is subject to discretionality based on political objectives, diminishing the effectiveness of the program. The ensuing benefits to society of trade liberalizationâ&#x20AC;&#x201D;higher productivity and growth and lower pricesâ&#x20AC;&#x201D;are diffuse, whereas the costs of economic transformation are concentrated and visible. Perceived losses by workers in specific industries create strong interest groups opposed to the dismantling of protection. Targeting re-training programs to specific industries or geographic areas with expected losses can reduce political opposition to integration. Generous severance packages may reduce opposition in the short run, but do not necessarily leave the dislocated workers with good prospective earning streams. Some workers may have interests in running their own businesses but lack the capital and expertise. Providing credit and training to small and medium-sized enterprises is important for directing displaced labor towards more efficient production. Promoting exports, ties to foreign markets, and new technologies may help increase worker productivity in ways that are necessary for long-run improvements in living standards.

Safety Nets Targeting employment and training programs to workers in sectors affected by liberalization may be desirable, but most social welfare policies should not be linked to the process or policies of liberalization. Social safety nets should be available to those in poverty, regardless of the direct cause of that poverty. In the context of reducing poverty and raising living standards, social safety nets must consider the welfare and

286

Regional Integration and Wage Inequality

287

capacities of all family members, not only those who

duras are succeeding in raising the schooling attain-

have lost jobs. Still, the added vulnerability of families

ment of school age children by providing cash transfers

to external shocks, such as precipitous drops in coffee

to families conditional on their children remaining in

prices, indicates that the social safety nets need to be

school. Other programs such as Nuevas Oportunidades in Costa Rica change the supply of schooling. The program offers flexible schedules that enable

Promotion of Competitiveness in Rural Economic Activities

dropouts, both children and adults, to complete pri-

Worldwide trade liberalization in agriculture is critical

with teachers operating in non-standard facilities such

for making trade work for the poor. Poverty tends to be

as churches or municipal buildings, and complete the

concentrated in rural, agricultural areas throughout the

lion's share of coursework according to their own

mary and secondary schooling at their own pace. Students attend a minimum number of formal course hours

region. Continued subsidies in the agriculture sectors in

schedules. PRAF also includes components to improve

the developed world keep the international price of

the quality of education.

commodities artificially low, which effectively blocks off

Often a basic set of skills is necessary before

a path out of poverty for the approximately 20 percent

job specific training is effective. If the relative demand

of families in the region whose main livelihood comes

for skill increases, the increasing returns to skill provide

from agriculture.23 In the highly indebted poor coun-

an additional incentive to stay in school longer. But this

tries (HIPC) of the region, approximately 30 percent of

is not possible if the quality and quantity of education-

households depend primarily on the agricultural sector

al opportunities are lacking. To meet the rising demand

as their main source of household income.24 Low prices

for skill that seems to follow liberalization, public

are not the only problem. There is a lack of technology

investment in broad-based education becomes increas-

and production alternatives, particularly in tropical

ingly important. While the temptation exists to retain

countries where agriculture has been protected.

protection for highly mobilized or vulnerable groups,

Regional integration in infrastructure, such as trans-

delaying the dismantling of protection creates new

portation, is critical for generating opportunities in

generations of potential workers with misaligned skills.

agriculture. There have also been difficulties in getting agricultural products from Latin America to foreign markets because firms have not met export standards, which are not uniform among importing countries. Some unification of the standards would facilitate exports. Countries can also provide assistance to small and medium-sized firms to help them meet the standards required for their agricultural products. Both technical assistance and credit for investing in new technologies can facilitate commodity exports by small and medium-sized producers.

Education The education of the next generation of workers should be a priority. A labor force with a high level of general skills will be best placed to take advantage of or weather the adjustments from changes in international prices and advancements in technology. Targeted human development programs such as Bolsa-Escola in Brazil, Oportunidades in Mexico, and PRAF in Hon-

23 Some workers in the labor-intensive sector of non-traditional agriculture benefit from trade barriers. 24

Based on sector of activity of the household head. The estimates are 31 percent in Honduras, 34 percent in Bolivia and 35 percent in Nicaragua.

flexible enough to expand during crises.

CHAPTER

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