Strengths and Weaknesses of US Trade and Development Policy: A Study of the Situation in Central America

Strengths and Weaknesses of US Trade and Development Policy: A Study of the Situation in Central America

Theme: This paper evaluates US trade and cooperation policy in Central America, focusing on the impact of the Free Trade Agreement between Central America, the Dominican Republic and the United States (DR-CAFTA) and of the Millennium Challenge Account on economic development in the region.

Summary: The Central American experience is useful to evaluate the basic features of US trade and development cooperation policy, which is based on encouraging free trade agreements and increasing aid to countries that meet specific criteria. In Central America, the DR-CAFTA creates significant opportunities in terms of market access and promotion of foreign direct investment (FDI); yet, it also reduces the number of policy instruments available and will lead to serious problems of adjustment in many sectors (1). While the Millennium Challenge Account –the new US cooperation program that has already been implemented in Honduras and Nicaragua– could facilitate sectoral adjustment, it has serious shortcomings. This study does not discuss the geopolitical goals of DR-CAFTA, which the US has used to strengthen its influence in Latin America and to advance its project of hemispheric regional integration.


Introduction: The Role of the US in the New Economic Model in Central America
In the past two decades, Central America has undergone profound changes in its economic model. Traditional specialisation in raw materials has been replaced by new comparative advantages in assembly of light manufacturing and by the expansion of remittances from emigrants. Among Central American Common Market countries, primary exports dropped from 56.6% in 1990 to 27.9% in 2003, while textile exports rose exponentially. At the same time, the agricultural sector lost relative weight and services rose to at least 50% of the gross domestic product (GDP) in all countries of the region.

The changes in the Central American economic model have been driven by trade liberalization, deregulation of domestic markets, privatization of a significant number of state-owned enterprises and the promotion of exports.  All these measures favoured the expansion of multinational corporations, which have become a central actor in the region.  Foreign direct investment has risen significantly, from US$676 million per year in 1991-95 to US$2.428 billion in 2000-03. MNCs contributed to the initial development of export processing zones (EPZs) and have established alliances with the big domestic business groups in the local markets.

The United States has played a decisive role in consolidating the new model. Since the Reagan Administration, the US government has promoted trade liberalization and EPZs as the best instruments to accelerate economic growth in the Isthmus. USAID development funds were used to support economic reforms and finance research centres such as FUSADES in El Salvador and investment promotion agencies, such as CINDE in Costa Rica –one of the most successful in Latin America–. The Reagan Administration also approved the Caribbean Basin Initiative (CBI), which included a large number of incentives to expand Central American exports to the United States. The Caribbean Basin Economic Recovery Act, passed in 1983, established duty-free access to products assembled in the region. The law complemented previous incentives which, since the 1960s, had facilitated the importation of textile products produced with US raw materials. In 1986, quotas on textile products imported from Central America and the Caribbean were also eliminated.

In the 1990s Central America became increasingly linked to the US economy. The share of exports from the Central American Common Market going to the United States rose from 39% of total exports in 1990 to 55% in 2003.  Additionally, remittances sent back by emigrants living in the US have become one of the main sources of foreign currency for the region. The recent signing of the Free Trade Agreement between Central America, the Dominican Republic and the United States (DR-CAFTA) –which has now entered into force in three of the six member countries– is yet another step in strengthening this link. For three of the countries (Honduras, Nicaragua and El Salvador), this initiative is further complemented by the signing of agreements as part of the Millennium Challenge Account (MCA), which will help to consolidate the region’s new focus on exports.

The DR-CAFTA: Main Features
The DR-CAFTA is part of the US’s trade strategy. The difficulties in reaching a satisfactory agreement in the Doha round of the World Trade Organisation (WTO) and the failure of the Free Trade Area of the Americas (FTAA) has strengthened the US interest in formalising bilateral treaties. In recent years, the United States has signed free trade agreements (FTAs) with many countries including Singapore, South Korea, Malaysia, Israel and Morocco, and, in Latin America, with Chile, Colombia and Peru.

All these agreements are based on similar principles: permanent and permanent access to the world’s biggest market in exchange for a gradually opening up of the domestic market and the introduction of major institutional and regulatory changes. This kind of FTA goes beyond WTO agreements, since it establishes equal treatment for domestic and US companies in practically the entire regulatory framework and requires greater and more effective protection of intellectual property.  The FTAs also eliminate the possibility of discriminating in favour of local businesses in government procurements, and establish international arbitrage systems in cases of dispute between foreign investors and national governments. Most FTAs also include labour and environmental agreements.

In the case of the DR-CAFTA, opening trade to the US market essentially means institutionalising unilateral privileges already established in the CBI. The United States has also agreed to liberalise the few sectors not covered by the previous initiative (with the exception of sugar) and to adopt regional rules of origin. In the case of the textile sector, the new rules of origin allow zero tariff access to the US market for textiles that use materials from Mexico, Canada or Central America. Until now, only US products could be used.

In exchange, Central American countries have agreed to gradually liberalise their trade in goods. Tariffs on many agricultural goods will be gradually eliminated over periods of five to twenty years. A number of ‘sensitive’ goods –including potatoes and onions in Costa Rica and maize in El Salvador, Honduras, Guatemala and Nicaragua– will remain protected. Industrial goods will be liberalised more quickly, with immediate effects on 80% of goods in this category. Only 4% of goods will remain protected for the maximum 12-15 year period.

The DR-CAFTA also institutionalises and deepens other reforms aimed primarily at guaranteeing a favourable and stable regulatory framework for foreign companies. Among the many measures included, the following are particularly significant:

  • The DR-CAFTA prohibits all regulations that discriminate against companies in any of its signatory countries and imposes standards of conduct in areas such as the use of local intermediate goods and the transfer of technology. The agreement goes beyond the WTO regime in terms of trade-related investment, since it affects all foreign companies and not only those whose activity involves trade in goods.
  • Liberalisation of almost all services, including the financial, telecommunications and insurance sectors in the Costa Rican case.
  • Increased protection of intellectual property. The DR-CAFTA obliges member countries to sign all international agreements in this area (including those relating to biodiversity) and lengthens the duration of patents and copyright, as well as the confidentiality period for data from tests used to develop drugs and chemical products. The agreement also requires penalties for copying products under copyright and improved procedures for enforcing the laws covering this area.
  • Establishment of more transparent public contracting systems that eliminate the right to discriminate in favour of domestic companies, and modernisation of the trade system, including changes to customs procedures and more flexible sanitary restrictions.
  • Creation of an international arbitrage system for cases of dispute between a US company and a national government. Following the example of chapter 11 of the FTA between Mexico, the US and Canada (NAFTA), foreign companies will have the right to go directly to impartial international arbitrage if they believe their interests have been harmed.
  • Commitment to maintain and respect existing labour and environmental regulations.

The DR-CAFTA: Opportunities, Threats and Questions
The DR-CAFTA contributes to the consolidation of the economic model in place since the mid-nineties. It improves preferential access to the United States by the countries in the region, makes it difficult to reverse economic reforms and increases protection of foreign investors. The agreement could also help accelerate the regional expansion of big domestic companies.

Its effects on economic development are difficult to quantify, since this depends on the assumptions with regard to trade creation and, in particular, on the characteristics and speed of the dynamic processes of structural change. Defenders of the model hope that the DR-CAFTA will help accelerate economic growth through a positive impact on exports, on the price of many goods and on foreign direct investment.

The most expected positive effect is the growth of investment, mainly foreign, but also domestic. Consolidation of privileged access to the US market, along with the adoption of regional rules of origin should help attract companies interested in reducing costs and increasing their exports to the United States. In the textile sector, for example, several countries hope to attract cloth producing companies and also link the free export zones more directly with local suppliers. Furthermore, improving the institutional framework and legal security for foreign companies provides an incentive to invest in the production of goods and services for the domestic market and also in exporting activity. Central American countries also hope that improving the quality of institutions and reducing corruption will help create more transparent societies and clearer and more stable rules.

There will almost certainly be an increase in foreign investment and exports in the coming years, as was the case in Mexico after NAFTA took effect. However, making access to the US market the driving force behind economic growth also involves major risks and raises important questions. One of the most important is the growth of textile exports produced in the EPZs, given China’s growing threat, particularly, since the Multifiber Agreement was dismantled in January 2005. According to 2002 data, the hourly wage in the textile sector is US$0.70-US$0.90 in China, compared with US$$2.70 in Costa Rica, US$1.70 in the Dominican Republic, US$1.60 in El Salvador, US$1.50 in Guatemala and Honduras and US$1.00 in Nicaragua. In addition to the wage differences, China has higher levels of productivity and cheaper supplies of raw materials, making it clear that better access to the United States may not be enough to continue increasing Central American textile exports.

Although trade liberalization will take place gradually, it will still require a huge modernisation effort in various sectors and will have a particularly hard impact on traditional agriculture. Small and medium-size manufacturers, who have already felt the impact of more open trade in the nineties in countries such as the Dominican Republic, will face even greater competition. The arrival of cheap agricultural goods from the United States, which still maintains its farm subsidy programmes, could have positive effects on the prices of some basic foods, but will further deteriorate production capacity in the rural areas where most of the poor live.

Institutional reforms also present major challenges. The emphasis on transparency and the need to reduce corruption is positive. Reorganising government procurement systems in countries such as the Dominican Republic, where until recently there was no public tendering, should reduce arbitrariness in the search for suppliers and the misuse of public funds. However, by making it impossible to discriminate in favour of domestic companies, an essential instrument will be lost to promote internal capacities and companies in strategic sectors.

Other reforms introduced in the DR-CAFTA are not priorities for the economic development of Central America.  Yet, they will require a huge investment of political and institutional capital. As Dani Rodrik has argued in his assessment of other trade negotiations, all governments have limited political capital and institutional capacity to promote reforms; the trade-offs offered by alternative policies must always be taken into consideration. In the case of Central American countries, for example, it is not clear that defending copyrights and fighting piracy should be a political priority right now. Rather, these are measures with clear political costs that will not provide any direct benefits to most of the population. There are also questions as to the effect that extended patents could have on the price of drugs and on seeds and other intermediary goods for agriculture.

In any case, the final impact of the DR-CAFTA will depend mainly on thecomplementary reforms that may be adopted to deal with the enormous shortcomings of the Central America’s economies. It will be essential to carry out a medium and long term plan that raises the quality of social services and increase the resources allocated to social spending, particularly in health and primary and secondary education. All the countries in the region will also have to improve their infrastructure and design plans to facilitate the modernisation of small and medium-size companies, particularly in the informal sector, and improve their access to credit. Significant headway in all these areas will require large quantities of public resources. A priority, therefore, is to design new progressive or neutral tax reforms that not only compensate for the loss of tariff revenue, but also increase the total tax load as a percentage of GDP.

The MCA: A Complement to the DR-CAFTA
The high costs of adapting to the DR-CAFTA and the urgent need for complementary policies will also require accelerated development aid. Unlike the European integration project, the FTAs promoted by the United States do not include compensatory funds or any other significant aid. Given this lack of specific resources, the creation of the Millennium Challenge Account (MCA) by the Bush Administration is particularly important. The MCA is a new instrument for development cooperation created in 2004 for the sole purpose of promoting economic development in low and middle income countries that meet certain requirements.

Driven by the idea (defended by various World Bank studies) that development aid is especially effective in countries with solid institutions and appropriate policies, MCA funds can only be provided to countries that are above average in sixteen international indicators. Based on a relatively biased definition of what the ideal policies and institutions are, these indicators measure variables such as economic openness, the inflation rate and public deficit, the time needed to open a business, the quality of the Rule of Law and the effectiveness of government action. Health and education spending are also included.

To date, the MCA includess three Central American countries: Honduras, Nicaragua and El Salvador. Honduras and Nicaragua joined the programme in its first year and have been among the first countries to prepare a five-year programme. El Salvador is a case apart: as a low-middle income country it was only allowed to join the list of candidates in 2006and it is currently preparing its own programme (at the draft stage).

Honduras and Nicaragua have similar programs focused on the modernization and promotion of rural areas. The Honduras program, totalling US$215 million, has two main goals: to increase the competitiveness of its small and medium-size agricultural producers (to whom 34% of the budget is allocated) and to reduce transport costs by improving road infrastructure (58% of the budget). To accomplish these two goals, the programme introduces measures such as the promotion of high-added-value fruit and vegetable production, the expansion of the credit available to small farmers and the contruction of roads and a highway.

In Nicaragua, the US$175-million project is focused on the regions of León and Chinandega and also includes goals such as the reduction of transport costs by building a new highway (53% of the total budget) and the expansion of the income of small and medium-size agricultural producers through technical and financial aid (19%). Another 15% of the budget will be allocated to improving the management of agricultural property rights in the province of León.

There is no doubt that the projects financed in both countries (and those planned in El Salvador) focus on important areas that could help to deal with the challenges of trade liberalization. It is especially important to support small and medium-size agricultural businesses to compensate for the difficult adjustments caused by the DR-CAFTA and to increase non-traditional primary exports. However, these are relatively modest projects without the capacity to have the kind of impact on economic growth that the MCA had originally intended. For Honduras, this new disbursement by the US government accounts for only 8% of all aid received by the country in 1999-2003 and 48% of the aid allocated by the World Bank during the same period. For Nicaragua, the figures are even lower: 5% and 44%, respectively. Furthermore, the programmes do not help to deal with the underlying limitations on growth, which have to do with problems in the area of education and technical training.

The overall MCA programme also reveals the incoherency of this new instrument, particularly when we compare the cases of the three middle-low income countries in the region: El Salvador, Guatemala and the Dominican Republic. Since the DR-CAFTA requires similar institutional reforms and similar anti-corruption measures, it does not seem reasonable that El Salvador, the country with the best indicators according to the classification of the MCA, should be the only one of three to receive funds. Both Guatemala and the Dominican Republic have high levels of corruption, relatively ineffective governance and inadequate spending on human development. These are areas in which both countries must improve both to meet the DR-CAFTA requirements and to face the challenges of free trade. It would seem important for US aid to help solve these problems in order to enhance the potential benefits of integration.

A deeper criticism of the MCA and the DR-CAFTA has to do with their one-dimensional concept of the policies needed to accelerate economic growth and promote development. Despite the shortcomings of the Washington Consensus in the region, the US continues to promote a single model based on free trade, economic and financial deregulation, and the consolidation of governments focused exclusively on establishing clear rules, guarantying basic political rights and protecting foreign investment. Although all these instruments are important, they are not necessarily the only ones to achieve sustainable development. As the successful management of foreign investment by Singapore and China shows, and as recent works by Joseph Stiglitz, Dani Rodrik and others support, the development process demands constant experimentation, adopting home-grown institutional frameworks, focusing political capital on the most important goals and consolidating a State capable of promoting specific sectors on a selective basis. It is not clear that the new US policy instruments will make a positive contribution in any of these three areas.

Conclusions: The promotion of FTAs by the United States must be understood as part of its geopolitical strategy as well as part of its trade and development policy. From a political perspective, by signing the DR-CAFTA, the George W. Bush Administration is pursuing various goals, including a bid for greater support for its project to integrate the hemisphere, strengthen formal democracy, control illegal immigration and consolidate US influence in Central America. This study, however, has focused on the impact of the DR-CAFTA on trade and development. In this area, signing the DR-CAFTA is an opportunity to promote foreign direct investment and regional exports. The agreement, however, may be flawed as an instrument for development, since it imposes low-priority reforms, eliminates useful economic policy instruments and involves high adjustment costs.

The new plans for cooperation in Honduras, Nicaragua and El Salvador within the MCA framework include interesting projects to compensate for some of the adjustment problems and increase competitiveness. However, their limited volume and the absence of Guatemala and the Dominican Republic from the list of beneficiaries will reduce the effectiveness of this new instrument to promote economic development in the region. There is also a need for a more balanced view of the relationship between the State and the market in these countries, considering the shortcomings of the Washington Consensus.

Probably the biggest question regarding the combination of US policies that contribute to the consolidation of the liberal model in the region is whether they will be able to accelerate economic growth and improve the distribution of income. Given the slow economic growth in the region since the early nineties (with the partial exceptions of Costa Rica and the Dominican Republic) and the lack of linkages between the export sector and the rest of the economy, there is little evidence to suggest that this will be the case.

Diego Sánchez Ancochea
Lecturer in the Economics of Latin America, University of London

(1) In the context of this analysis, Central America includes Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and the Dominican Republic. Statistics given on the Central American Common Market include all the above mentioned countries except the Dominican Republic.