The Economic Future of Central America After the Coming into Force of the DR-CAFTA: A Not Entirely Risk-Free Opportunity

The Economic Future of Central America After the Coming into Force of the DR-CAFTA: A Not Entirely Risk-Free Opportunity

Theme: This paper analyses the coming into force of the United States-Dominican Republic-Central America Free Trade Agreement (DR-CAFTA) and its consequences for the new Central American growth model.

Summary: Economic growth in Central American countries (Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua) has been stable, though moderate and insufficient, in recent years. This is the context in which the DR-CAFTA will be enforced, a free trade agreement (FTA) with the main economic partner in the region and with which certain imbalances prevail. This paper assesses whether or not the FTA can contribute to overcoming the constraints that make it difficult to achieve higher growth rates in the region. After identifying these constraints, the potential impact of the DR-CAFTA on Central American economies is analysed, as well as its implications for Spanish investment, co-operation and trade relations with the region.


Constraints on Economic Growth in Central America
After the lost decade that was the 1980s, the new economic model being advocated by the Washington Agreement has managed to make economic growth recover in Central America. Nevertheless, this growth has not sufficed to tackle the social challenges facing Central American countries. In recent years, the average regional growth rate has ranged from 3.2% to 3.5%.

There are many factors making it difficult for the countries in question to achieve higher growth rates. Some of the problems of the past have disappeared with the overcoming of political and military instability and by way of achieving reasonable macroeconomic stability. Nonetheless, there are still some old problems that have failed to go away such as the lack of competitiveness and the prevailing inequality with respect to the distribution of income. With the relative exception of Costa Rica and El Salvador, the rest of the countries are considerably behind in competitiveness. According to the World Economic Forum competitiveness index ranking for 2005, Central American countries occupy the following positions out of a total sample of 117 countries: 56th (El Salvador), 64th (Costa Rica), 93rd (Honduras), 97th (Guatemala) and 99th (Nicaragua).

Central America is a region that is characterised by its high level of inequality with respect to the distribution of income. With the exception of Costa Rica, the rest of the countries reach Gini coefficient indices of over 50%. Such a high degree of inequality exercises an adverse effect on economic growth by limiting the size of the market and of aggregate demand. Moreover, it makes it difficult to reduce poverty, given that in countries with high inequality indices greater growth is required in order to achieve a reduction of poverty equal to that of a country with a low inequality level in terms of income.

In addition to these persistent constraints, new obstacles to growth have arisen with the current economic model: among others, the limited capacity of the productive chain and the expansion in productivity of the new export sectors. The new growth model has managed to increase and diversify Central American non-traditional exports, particularly those destined for its main market, the US, which accounts for half of its export market. A considerable increase in the participation of manufacturing companies in extra-regional export actions has been achieved, as well as a change in its structure, with the incorporation of new products, such as the clothing maquila and, in the case of Costa Rica, electronic products. The success of the application of the new model was greatly facilitated by the unilateral concession since 1984 of trade preferences by the United States to products from Central America within the framework of the Caribbean Basin Initiative Agreement (CBI).

Nevertheless, the new export sectors have shown little local integration, a fact reflected in the high import content of the maquiladora exports. This acts as a brake on economic growth on account of its low capacity to generate externalities towards other sectors in the national economy. In addition, the new specialisation pattern is limited by the low and stagnant labour productivity of the maquila industries. With little or no growth in productivity, the maquiladoras represent a sector that can only expand on the basis of low wages. In fine, economic growth is limited both by old constraints as well as by new obstacles. In relation to the foregoing, neither should we lose sight of the fact that the Central American economies are small and that they are exposed to natural disasters, which further complicate the attainment of higher growth rates. It is within this context that the DR-CAFTA will have an effect.

Potential Economic Impact of the DR-CAFTA
After the signing of the treaty that established the Central American Common Market (CACM) in 1960, the DR-CAFTA constitutes the main trade agreement signed by the Central American countries in recent times. This FTA was signed in 2004 and should have come into full force on 1 January, 2006. However, it still has to be ratified by Costa Rica. Moreover, its coming into force has not been completed in the rest of the signatory countries that have already ratified the agreement. In only three of them –El Salvador, since March, and Honduras and Nicaragua, since April– has the agreement come into force. It is possible that in the forthcoming weeks Guatemala can also be added to this list.

The most problematic situation is that which is to be found in Costa Rica, where the new government of Oscar Arias will have to achieve Congress ratification of the DR-CAFTA and will then have to have national legislation brought into line with it in order to enable its coming into force. Among other consequences, this will involve the obligatory privatisation of the state monopoly on insurance and telecommunications, two sectors that are subject to a high degree of social and economic sensitivity in the country. The extremely tight electoral victory of Oscar Arias –by barely 18,000 votes– over Ottón Solís, who rejected the agreement in its final form, does not bode well for a smooth ratification process.

The contents of the DR-CAFTA are very similar to the previous FTA’s signed between the US and Mexico, Chile and Singapore. In addition to the practically complete liberalisation of reciprocal goods trading, the agreement provides for a significant liberalisation of foreign investment and services trade. Moreover, it includes measures with respect to intellectual property, labour rights and environmental issues, and obliges Central American governments to take part in the setting up of new institutions to administer the FTA. A significant creation of trade is not foreseen in the short term as a result of the coming into force of the DR-CAFTA, since the majority of the products exported by Central American nations already enjoy temporary preferential tariffs in the American market. These tariffs had been granted by the CBI. It is much more likely that there will be an increase in trade flow in the medium and long term as a result of the access to be had by new Central American products to the American market, and as a result of the increase of export product share.

The foreseeable benefits will be prompted by means of the attraction of direct investments and the strengthening of the institutions in Central American countries. The DR-CAFTA will provide a more stable legal framework than that of unilateral customs duty relief granted by the CBI, which in turn will encourage investment in Central America. On the other hand, the adoption, within the framework of DR-CAFTA, of trade and of foreign investment handling disciplines with higher standards than those currently being applied, will contribute to the positive reform of Central American institutions and will strengthen their capacity to attract new investments that will boost economic growth.

The quantitative assessment of the potential impact of the DR-CAFTA is essential, since we are dealing with an FTA signed with the main trade partner in the region and with which significant economic imbalances exist. The empirical studies available have been carried out from different methodological perspectives, which makes it difficult to assess the reliability of the results obtained. Nonetheless, the majority of these studies coincide in three basic results. In the first place, they attribute a net positive effect to the DR-CAFTA with respect to future growth in Central America in comparison to other alternatives that do not include the coming into force of the FTA. Secondly, the net positive effect is seen to be increased whenever the DR-CAFTA is accompanied by a deepening of Central American integration. Lastly, the distribution estimates for such benefits in terms of individual countries suggest that economic growth would be greater in Guatemala and El Salvador.

Although there are no econometric studies that give a detailed breakdown of the benefits to be gleaned from the DR-CAFTA in terms of the production sectors in all Central American countries, it is possible to identify some of the sectors that may benefit from the FTA on the basis of the available studies. With respect to the primary sector, it seems reasonable to expect that the non-traditional farming produce sectors (such as fruits, vegetables and plants) will benefit from the consolidation of the advantages that had been granted by the CBI. Among the traditional farming sectors, the one which will potentially benefit most will be the sugar sector, which will increase its export share to the US.

As far as the secondary sector is concerned, textile manufacturers and the clothing industry will have an opportunity to boost the development of a regional textile industry, and not only of the clothing maquila. The DR-CAFTA enables regional accumulation, that is to say, the use of threads and yarns from the seven signatory countries to the DR-CAFTA and from the North American FTA partners in the fabrication of cloths to be exported, duty-free, to the US. In order to make the most of the advantages of the regional accumulation, the Central American producers will have to act in a co-ordinated manner. In this way, potential productive chains can be promoted, such as those based on the cotton-textile-clothing chain.

Central American governments expect that the generation of employment in the livestock sectors of the DR-CAFTA will contribute to reducing poverty in the region. Nevertheless, there is a risk that the FTA will end up having an important negative impact on employment. It is not expected that a significant number of new jobs will be generated in CBI-related sectors, but rather that, overall, the jobs will be maintained. Moreover, in the short term it is quite likely that jobs will be lost in the textile and clothing sector as a result of the dismantling of the Multi-fibre Agreement and the appearance of new exporting countries with lower labour costs (China, Pakistan, India, Vietnam and Bangladesh). If additional measures are not taken, the DR-CAFTA will be unable both in the medium and long terms to counter this trend. One can also add to the foregoing the loss of jobs in production sectors related to the internal market in the light of the expected massive importation of cheaper goods produced in the US. Workers in the small and medium-sized enterprises (SME’s) will be less able to adjust to the new situation.

In the traditional Central American farming and livestock sector it is expected that there will be an important fall-off in production and, consequently, an increase in unemployment. The DR-CAFTA does not provide for an American commitment to abolishing its farming aid policy by means of subsidies. In this context, the traditional farming sector (especially that of the basic grains) and the livestock sector (particularly, milk, chicken, pork and beef) are going to suffer unfair competition from highly-subsidised American produce. This could bring with it serious losses for sensitive farm goods producers, who will see themselves ousted from the market. In sum, sectors such as that of the traditional farming of basic grains and livestock farming, as well as some manufacturing activities that are bound up with the SME, run the risk of being harmed by the effects of the DR-CAFTA. These sectors include vulnerable low and medium income groups, which will demand some compensation.

Is This an Opportunity to Overcome the Constraints?
The DR-CAFTA has the potential to exercise a net positive effect on Central American economic growth. Nevertheless, the empirical evidence available to us as regards trade liberalisation experiences coincides in alerting us to the fact that an FTA of itself will not suffice to generate economic growth, unless it be accompanied by economic policies that make it possible to take advantage of any opportunities that may arise and to reduce the potential risks. Policies have to be identified that will serve to accompany the DR-CAFTA, ones which, at the same time, bear in mind economic growth constraints. Policies concerned with attracting investment and strengthening competitiveness, as well as socially oriented policies, will have to form part of such an agenda.

The accompanying agenda will only be feasible if sufficient financial resources are put in place to ensure its application. To this end, Central American governments will have to commit themselves to an overall tax reform which will serve to increase their income. In recent years, the shortage of tax resources has become worse as a result of customs duty relief measures adopted as part of the process to bring together Central American customs, and due to the signing of bilateral and multi-lateral FTAs. The coming into force of the DR-CAFTA will worsen even more the reduction of tax income from customs duties. While the tax reform is being introduced, recourse might be had to external loans and international co-operation in order to finance the accompanying agenda. In this case, it would be a good idea for the Central American governments to have access to official financing in terms of concessions and to international aid flows with the aim of avoiding added problems of external debt.

Finally, the majority of accompanying agenda national policies should have a regional dimension. The empirical studies available suggest that the process of consolidating the Central American integration process is an essential element to enable Central America to make the most of the opportunities presented by the FTA, especially because we are dealing with a group of small, open economies with very little room for manoeuvre. Though it is quite certain that progress has been made in the new CACM, there is still a lot left to be done. If the necessary measures are not taken in order to strengthen the creation of a joint Central American customs system, the coming into force of the DR-CAFTA may even endanger many of the advances that have been made in recent years. The harmonisation of the common external tariff (CET) is a perfect example of this situation.

The simultaneous setting up of a CET within the framework of the CACM with an FTA with the US may question the harmonisation achieved in the CET, given that the coming into force of the DR-CAFTA will not come about in a uniform manner in all Central American countries. The customs duty concessions were negotiated bilaterally, which means that the time schedule for DR-CAFTA customs duty relief will be different for each country, thus, the CET will not be applied in its entirety in all countries during the customs duty relief period (20 years). The fact that the US is the main trade partner of the CACM, representing practically 40% of its total imports, turns the exceptions to the CET caused by the application of the DR-CAFTA into a potential disturbance factor of Central American customs union.

The Implications for Spain with Respect to its Economic and Co-operation Relations with Central America
The trade and investment relations that exist between Spain and Central America are quite modest. According to the Secretary of State for Tourism and Trade, in 2000-05 the average annual value of Spanish exports to Central America was around €342 million, a mere 5.1% of Spanish exports to Latin America as a whole, and which amounts to no more than 0.3% of total export figures. The situation as regards Spanish imports from Central America is along similar lines, the annual value of which is around €184 million, 2.5% of Spanish imports from Central America and a mere 0.1% of total imports. As far as net Spanish investment in Central America is concerned, its annual average value for the same period barely exceeds the €81 million mark, which represents only 1% of overall Spanish investment in Latin America and a mere 0.2% of Spanish investment in world terms.

The DR-CAFTA is a factor that of itself can boost these rather limited economic relations, on awakening greater interest in Spanish companies using the region as a production access platform to the American market. This interest may grow in the medium term due to the DR-CAFTA coinciding with three other relevant factors: the signing of an FTA with the European Union (EU), the drive towards Central American integration and the development of the Panama Puebla Plan (PPP).

The most visible result of the IV EU–Latin American Summit held recently in Vienna (11–13 May) has been the European decision to begin negotiation on a strategic association agreement with Central America, which includes political dialogue, co-operation and free trade. The growing fragility of the Andean Community of Nations and of Mercosur, allied to a greater degree of relative progress in the CACM has made this result possible. If the negotiations are successfully concluded, Central America will become –along with Mexico and Chile– one of the few Latin American regions with an FTA with both the United States and the European Union. This will place Central America in a privileged position in the sense that it will enable European countries to intensify their economic relations with the region, thus reducing the risk of trade deviation provoked by the DR-CAFTA.

One of the conditions established by the EU with respect to the signing of an association agreement is that the Central American integration process be further consolidated and deepened. This exogenous factor can serve to force a renewal of the commitment of Central American governments to achieving an effective thrust of the CACM, beyond the mere rhetoric of presidential declarations. If the regional economic space manages to be consolidated by means of the creation of a customs union, there will be a greater chance of Central America making the most of the opportunity provided by the DR-CAFTA and of it encouraging greater foreign investment, which will be attracted by both the American market and the Central American market itself.

The development of a regional infrastructure that reduces transaction costs will be another essential element in the setting up of a regional economic space. The PPP launched in 2001 to develop the Mesoamerican region is an ambitious, regional infrastructure programme the essential pillars of which are founded on roadway, energy and telecommunications’ interconnections. The Plan has been shaping up not merely as a vital complement in preparing the competitive participation of Central America in the DR-CAFTA, but also as an additional factor in attracting Spanish investment by virtue of encouraging the presence of companies in the tendering for PPP projects (eg, the participation of Endesa in the regional electric network). The relevance of this instrument in infrastructure integration has been increasing over the last year, especially by the interest shown by Colombia to become part of it, as well as because of its link to other more widespread initiatives such as the Middle American Energy Integration Programme which was proposed by the President of Mexico, Vicente Fox, who has invited the participation of the PPP members, the Dominican Republic, Colombia, Canada and the US.

The DR-CAFTA of itself, or in conjunction with the three factors highlighted above, offers Spain an opportunity that must be made the most of in order to intensify its limited economic relations with the region. The areas identified as containing the greatest potential for expansion are to be found both in production activities (especially agroindustry, textiles, clothing, electronic and biotechnology), as well as services and infrastructure (financial services, business services, tourism and the Central American Logistics Corridor of the PPP). Even though this opportunity should not be overlooked, it is not very likely that Central America will end up becoming a strategic partner for Spain with respect to its economic relations, given the limited size of the Central American market and the possibility of using Mexico as an alternative access platform both to the American market and to the Central American market.

Unlike what is happening with commercial and investment flows, Spanish aid counts Central America as one of its privileged destinations. The Reports on the Annual International Co-operation Plans (AICP) for the 2000-04 period reveal that the region received practically half of the net bilateral aid channelled to Latin America and around a quarter of the net bilateral aid in total. The expenditure estimates for the 2005 and 2006 AICP’s continue to suggest that Central American countries are one of the geographical priorities of the new 2005-08 Spanish Co-operation Director Plan, though with a slightly less, relative share. The main implication of the DR-CAFTA centres on the drawing up of Country Strategy Documents as of 2008, which will have to take into account the first effects observed after the coming into force of the DR-CAFTA. It is quite likely that this will demand granting priority to strategic axes such as institutional consolidation, competitiveness, rural development and social cohesion.

As far as multi-lateral co-operation is concerned, Spain has considerably increased its presence in the region after its joining of the Central American Bank for Economic Integration (CABEI) in 2004. With a subscribed capital of some US$200 million, Spain has become the most important extra-regional partners of the CABEI. The fact that this regional development bank is the main source of multi-lateral financing for Central America, affords it a relevance that must be made the most of by Spain, both in terms of supporting regional participation in the DR-CAFTA, as well as with respect to encouraging bilateral economic relations.

Conclusions: The majority of the empirical studies available suggest that the DR-CAFTA can have a potentially positive net effect on economic growth in Central America. The benefits to be gleaned will arise more from the attraction of direct investment than from the creation of trade, given that regional export products enjoy temporary customs duty preferences that have been unilaterally granted by the US as part of the CBI.

In order that these benefits avoid being minimised, or lost, as a result of the risks and uncertainties involved in RD-CARTA, the FTA needs to be accompanied by policies that enable the full exploitation of the opportunities offered and that combat the extant constraints on economic growth. The policies aimed at attracting investment and strengthening competitiveness at a regional level, as well as social policies, are among the most important. The limited ability of Central American governments to increase their tax resources may bring into question the feasibility of these accompanying policies.

The DR-CAFTA of itself, in conjunction with other relevant factors –the signing of a Free Trade Area Agreement with the EU, the effective drive towards the customs union of Central America and the complete carrying out of PPP projects– provides an opportunity for Spain to intensify its modest economic relations with Central America.

Fernando Rueda-Junquera
Lecturer in Applied Economy and Deputy Dean of the Faculty of Economic and Business Science at the University of Burgos