APPENDIX 2
ECONOMIC AND TRADE POLICIES IN LATIN AMERICA AND THE CARIBBEAN

Bloated corporate statist economies are now privatized, reformed, more competitive, and more open ... [G]overnments began to support ... good banking reforms. Generally, the financial system is in a more resilient shape today than it was, for example, six years ago. So in a word, Latin America is more resilient, more able to respond and withstand the shocks and turbulence of world capital market uncertainties and trade and investment ups and downs than they have been in the past. [Bob Clark, 25:1555-1600]

Latin America and the Caribbean

Latin America and the Caribbean include 46 countries and territories (see Exhibit A2.1) with a population of 518.4 million people. Economic activity in the region is estimated at US $2 trillion as measured by its constituent countries' combined gross domestic product (GDP). By simply dividing the latter statistic by the former, Latin American and Caribbean economic welfare can be considered modest at US $3,917 per individual in 1997.

Trade Developments in Latin America

Latin America has experienced several waves of trade regime reform over the past half century. From the mid-1950s through to the end of the 1980s, Latin America had, for the most part, a restrictive trade regime in place, first relying heavily on import quotas and high tariff rates, followed by a shift away from quotas towards very high tariffs and other non-tariff barriers. However, with the collapse of their economies in the 1980s, virtually all Latin American countries reversed direction, opting instead for the formation of subregional free trade areas and customs unions, along with substantial, unilateral tariff reductions with their entry into the World Trade Organization (WTO).1 While riding the crest of this newest wave has been a trying financial balancing act - there being the occasional external balance of payments crisis in the transition period2 - the reversal in trade policy has, in general, been successful.

Perhaps an abbreviated historical summary would shed more light on Latin America's economic experience and the need for reform of its restrictive trade regime. Since the mid-1950s, Latin American countries pursued structuralist economic policies, spear-headed by the import-substitution strategy, which hold that developing countries are better off industrializing behind high protective tariffs and restrictive import quotas. Trade strategies premised on specializing production in commodities and manufactures where there was a comparative or competitive advantage were discarded in favour of nurturing home-grown companies and industries that are shielded from international competition. Export subsidies, even though they by and large achieve the same trade objective as a tariff, were seldom employed as governments clearly recognized these privileges as a significant cash drain on their balance sheet; in contrast to a tariff which would show up on the government's books as a tax revenue. They were, nevertheless, made available to specific sectors in regions with strong political lobby groups, such as in Mexico's maquiladora and Argentina's Tierra del Fuego regions.3

It took a while before Latin American officials realized the full impact of their restrictive trade policies, possibly because their effects were intertwined with those of other policies, such as the highly stimulative macroeconomic stabilization strategies of the 1970-80s, making disentangling and distinguishing their respective economic impacts difficult. These policies would include generous government services and programs to the public, financed by equally easy monetary conditions and heavy foreign borrowings, thinking that they could buy greater economic prosperity and a lower unemployment rate at the price of more inflation. This proved correct in the short term, but this favourable mix of economic outcomes could not be sustained once everyone adjusted their expectations to the new underlying financial realities created by these expansionary public expenditure and credit policies. That is, once labourers, managers and capitalists together demanded and got inflation protection for their personal efforts and investments, thereby dissipating the financial stimulus provided by their monetary policies, economic growth would grind to a halt and the unemployment rate would creep back up to traditional levels. It would not, therefore, be until the late-1980s when Latin American trade officials could discern the impact of their restrictive trade policies and they were unequivocally negative (see Box A2.1).

From a statistical perspective, the 1970s witnessed these stimulative macroeconomic policies generate tremendous growth for Latin America, in the order of 5.4% per annum (p.a.), but the economic benefits were short-lived. Over the longer term, these strategies only served to generate high inflation rates, high nominal rates of interest and a lower national savings rate. In fact, hyperinflation in the order of 8,000% p.a. in Bolivia in 1985, 3,080% p.a. in Argentina in 1989, 7,650% p.a. in Peru in 1990, and 2,489% p.a. in Brazil in 1993 were observed. Even higher nominal interest rates followed, but to the extent that interest rate ceilings were imposed by fiat, the savings rates of these economies collapsed (Bolivia, Chile, El Salvador, Guatemala). The end result of these poor financial conditions was declining domestic investment, languishing labour productivity, non-competitive wage rates and unsustainable high domestic currency values. To add insult to injury, the region's terms of trade declined 47% between 1980 and 1989.

As foreign lenders and other short-term capital providers began to reverse course, it would not be long before Latin America's economic bubble would burst. For without unlimited foreign currency reserves or the credit to obtain them, their pegged currency exchange rate policies were destined for devaluation, the only question being when and by how much. Even when these currency regimes were accompanied by a regulatory control framework on foreign capital, which attempted to manipulate increasingly global financial markets in ways to dampen the outflow of portfolio and other flight capital from the region while simultaneously stemming currency speculation, they too proved wholly unsuccessful.4

By the end of the 1980s, after considerable economic contraction throughout the region, Latin America's GDP managed an average annual growth rate of only 1%. Indeed, five of 17 Latin American countries experienced negative growth throughout the 1980s, one had no growth, and only four countries recorded more than a 2% annual growth rate in the decade. Latin America thus suffered its largest and most protracted economic decline since the Great Depression of the 1930s.5 As it turned out, the region's restrictive trade and expansionary macroeconomic policies only served to raise the cost of living, as their economic planners woefully misallocated resources to inefficient economic activities. The 1980s would eventually be coined by regional commentators as Latin America's "lost decade."

In the end, no less than 18 Latin American countries restructured their debts with their creditors in the 1980s. Under advice from the International Monetary Fund and World Bank, these countries also began to exercise more responsible and sustainable fiscal and monetary policies. Indeed, Latin America has progressively tidied up its financial problems to more manageable levels and a new wave of liberal trade policy has taken hold. Three sets of reforms were put in place: (1) the removal of many protectionist policies, including unilateral tariff reductions and a general shift from import quotas to tariffs when protection from foreign competition is granted; (2) less government intervention into the economy and greater reliance on liberalized markets with the deregulation and privatization of firms in many key sectors; and (3) the conduct of more conventional macroeconomic stabilization policies that are geared to produce stable long-term growth. By and large, these economic reforms took place or were phased-in in this chronological order as well.

-- not available;  1995;  GDP Deflator

Sources: IMF, Structural Policies in Developing Countries, 1994; World Bank, World Development Indicators, 1998; U.S. Trade Representative, Foreign Trade Barriers, 1998, ECLAC, Preliminary Overview of the Economies of Latin America and the Caribbean, 1998.

Latin America's conversion to freer trade is, in part, demonstrated by the extent of tariff reductions reported in Table A2.1; average country tariff rates of 20% to 92% in 1985 are now in the order of 9.6% to 13.3%. Furthermore, all Latin American countries are members of the WTO/GATT; almost all are, or are in various stages of becoming, compliant with their WTO trade obligations. State-owned enterprises also play a much smaller role in the economies of Latin America. Indeed, the privatization of numerous state-owned enterprises has generated in excess of US $86.3 billion for Latin American governments between 1990-96.

Finally, the shift in emphasis of their macroeconomic policies towards stable economic growth and lower inflation has also been successful. For example, the standard deviation in annual GDP growth for Latin American countries declined from 10.3 to 7.1 percentage points between 1984-90 and 1991-97, respectively, signalling a more stable economic climate in the 1990s. This economic performance compares to an increase in the standard deviation of GDP growth from 4.7 to 5.3 percentage points for Canada and a slight decline from 4.3 to 3.9 percentage points for the United States over the same periods.6 On the inflationary front, price increases, as measured by their consumer price indexes, declined significantly for 12 of 18 countries in the latter decade. There are also no more triple- or quadruple-digit annual rates of inflation in Latin America anymore; single-digit inflation is not now uncommon, but double-digit rates are more the norm. Indeed, by 1997, annual inflation averaged 10.1% throughout Latin America. Not that there is a lesson to be learned by countries with a poor track record in monetary policy, but it is interesting to note that the two countries adopting the U.S. dollar as its domestic currency (or as a part of it), Panama and Argentina, experienced the lowest price inflation of the region throughout the past decade.

Interestingly, these prudent macroeconomic policies in combination with liberalized trade policies have had other - some would claim unexpected - economic payoffs. When comparing the performances of Latin American GDPs over the 1980-90s, every country, except Paraguay, experienced a higher average annual growth rate in the 1990s. Moreover, no national economy of Latin America contracted throughout the 1990s in contrast to the many that did in the 1980s. The average annual growth rate of Latin America's GDP has been 3.7% so far this decade, featuring a range starting from 2.7% in Nicaragua to 8.0% in Chile. In contrast, Latin America posted an average annual growth rate in GDP of 1% throughout the 1980s, with a range beginning with -1.5% in Nicaragua and ending with 3.7% in Colombia. So a period of stable growth in the 1990s coincided with, or may have been the cause for, a protracted period of relatively high growth as well.

As a consequence of the policy actions taken, many countries of Latin America are considered by some as relatively promising markets for trade and investment. Table A2.2 provides selective financial data for the region, most notably, Latin America maintained a foreign debt balance of US $540 billion in 1997. The region also demonstrated that, except for a handful of countries, every country has taken important strides in reducing its foreign debt exposure relative to GDP. Taken together, the region's foreign debt-to-GDP level was almost halved, from 56.9% to 32.3%, between 1986 and 1997. The curtailed fiscal policies that has restrained the region's dependence on foreign debt is also showing up in their ability to service this debt. Foreign debt service-to-exports levels have substantially declined from 50.7% to 37.2% between 1986 and 1997. The best performers appear to be those whose terms of trade improved in the period (i.e., Costa Rica, El Salvador, Uruguay). Conversely, the poorest performers appear to be those countries whose terms of trade declined in the period (i.e., Nicaragua, Honduras, Colombia). In any event, private capital which trickled into Latin America at the beginning of this decade is now gushing in. Annual net private capital flows increased more than eightfold since 1990; in fact, while US $11.2 billion in net private capital flowed into the region in 1990, the year 1996 saw a US $93.7 billion inflow.7

-- not available

Source: World Bank.

For Latin America, the political focus now turns to the next generation of reforms that would solidify as well as build upon the economic gains achieved so far. On the immediate agenda would be the adoption of common minimum standards of financial regulation and supervision, credible codes of conduct in implementing fiscal and monetary policies, and sound corporate governance principles to improve the institutional framework in which financial markets operate. Over the longer term, the development of autonomous public institutions, such as independent central banks and judiciaries, and the encouragement of higher domestic savings rates to be able to invest more in human and physical capital, such as education and transportation and communications infrastructure, which tend to yield higher long-term economic returns, would be advisable. It is further expected that the MERCOSUR might first shore up its institutional arrangements and broaden its scope to include the Andean Community in accomplishing some of these tasks and thereby improve Latin America's readiness for any free trade agreement with North America.

The Caribbean Challenge

The Caribbean Basin comprises 25 countries and territories as depicted in Exhibit A2.1, not including Belize, Guyana and Suriname which are members of the CARICOM, a subregional association of 14 countries devoted to free trade within, and for some members a common or single market of, the Caribbean. These island and coastal nations are small economies; their populations not being sufficient in size to allow firms to exploit extant economies of scale in the production of manufactures. Like Canada, a small economy which exports almost 40% of its GDP, the Caribbean countries have had to become open trading economies in order to obtain and sustain an adequate standard of living for their residents. Indeed, more than 40% and sometimes as much as 50% of a Caribbean country's GDP is exported.

The Caribbean countries do, however, differ significantly from the rest of the Americas in that their small geographic size means that each country, on its own, is not endowed with a commensurate diversity of natural and human resources to provide an adequate comfort level of economic security in the case of an economic or natural disaster (i.e., sharp declines in the terms of trade in the case of the former; hurricanes, tornados, etc. in the case of the latter, see Box A2.2). As history would have it, the region's staple industries evolved to include tourism, financial centres and agriculture (sugar, bananas, citrus fruits, etc.). For example, in The Bahamas tourism accounts for as much as two-thirds of its GDP and 80% of its export earnings; it accounts for 60% of Antigua & Barbuda's GDP; and 55% of Bermuda's GDP. On the other hand, selective Caribbean countries have been able to develop other sectors of their economies, most notably, those endowed with industrial natural resources such as minerals and metals (bauxite, alumina, aluminum, gold, etc.), forest products, oil, natural gas and petrochemicals. In addition, some Caribbean countries have reaped a competitive advantage in the production of simple industrial products, such as textiles and electronic products and components, based primarily on cheap labour, carried out in what has become known as the tax-free export processing zones, and favourable North American trade legislation.

The United States and Canada already extend preferential treatment to Caribbean export goods in their markets under the Caribbean Basin Initiative (CBI) and CARIBCAN, respectively.8 These programs provide the Caribbean countries with tariff-free access on a very broad range of goods, including agricultural products. While it may at first glance appear that these preferential trade arrangements are one-sided deals in the Caribbean's favour, North America, in particular the United States corporations, benefits tremendously from them as well. This special access to the United States market, along with tax-free operations in export processing zones, allows North American firms to take advantage of relatively low wages in the Caribbean Basin while sharing the production and assembly of labour-intensive products (primarily apparel, footwear and simple electronics) to improve their ability to compete with imports, particularly from Asia, in their domestic market.

FDI in the Caribbean Basin has many sectoral destinations, most notably tourist resorts, petroleum, mining and services, but much of it finds its way into the establishment of assembly plants, usually in export processing zones. Indeed, the spike in FDI flows into the Caribbean Basin since the mid-1980s, following the sharp devaluations of national currencies associated with the region's debt problems, is closely linked to the expansion of assembly plants.

More specifically, FDI flows into the Caribbean island and coastal nations amounted to US $4 billion in 1997, which is more than double the average annual inflows of US $1.8 billion in the late-1980s. Consulting Table A2.3, as of 1997, FDI stocks of the Caribbean are in excess of US $47.3 billion; Bermuda garnering the lion's share with more than 60%. Carrying a foreign debt charge estimated at US $13.9 billion in 1997, the Caribbean, like Latin America, is in much better financial shape than a decade ago. Foreign debt-to-GDP levels of all but four Caribbean countries are down significantly, with the CARICOM showing an overall decline from 65.9% to 52.6% between 1986 and 1997. The foreign debt service-to-exports level of the CARICOM has declined slightly from 18.6% to 14.8% in the same period. The Caribbean remains, therefore, a modestly promising market for trade and investment.

Nevertheless, the challenges presented by a hemispheric free trade agreement will be formidable because the region has a far more vulnerable economic profile, quite different from most of their continental counterparts pursuing an FTAA. These challenges will deserve careful attention in the transition period. Given these atypical natural and economic circumstances, one might question why these Caribbean politicians and officials are contemplating a free trade agreement with the Americas.

-- not available

Source: World Bank.

The answer to this question lies in the recent deterioration in the relative competitiveness of Caribbean exports entering the American market subsequent to Mexico's passage of a free trade agreement with the rest of North America in 1994. The implementation of the NAFTA represented a major challenge to the assembly operations of the Caribbean Basin, particularly those in the apparel industry, because Mexican firms benefited from the equivalent of a six-point tariff advantage, no quotas on many items, and local inputs counted as having North American content. Should such a deterioration extend to Central and South America within an FTAA that did not include the Caribbean, an FTAA would immediately become in their economic interest. Moreover, it would be economically and, indeed, politically risky for the Caribbean to increasingly polarize from the rest of the Americas and become more dependent on foreign aid to maintain their current standard of living, particularly as this aid has been declining with North American budget restraints being put into effect and increasing pressures for financial assistance from the newly formed East European market economies. "Trade not aid" has become a fashionable slogan in selective political circles of the CARICOM.

The immediate challenge of an FTAA for the Caribbean will be both a political one and an economic one, involving: (1) a shift away from tariffs towards a value-added tax (VAT); and (2) industrial restructuring that would include rationalizing production on a CARICOM subregional basis. As was stated above, although put in a different way, what these island nations produce is not, in general, what they consume. For example, it is estimated that 70% of market goods in both St. Kitts & Nevis and the Dominican Republic are imported.9 Under these economic conditions, an ad valorum tariff, apart from its discriminatory effects, is very much like a consumption tax, such as a sales tax or VAT which have a similar broad tax base. When one further factors in the relative ease of administering such a tax at the port of entry, as well as the little public opposition that a hidden tax such as a tariff will encounter, it is not surprising that tariffs are a significant portion of government revenue. In fact, tariffs are the main source of revenue for most of these countries, accounting for as much as 60% of government revenues in The Bahamas. Caribbean countries will, therefore, need time to reform their taxation systems in the advent of any free trade deal. On that note, several CARICOM countries have been (i.e., Barbados, Belize and Trinidad & Tobago), or are currently contemplating (i.e., The Bahamas), replacing the lost revenues associated with lower tariff rates with those of a VAT. Gasoline, due to its relative price insensitive demand characteristic, would also be a natural candidate for the imposition of an excise tax as it has proven in North America.

Finally, the island-nation model of the Caribbean has proved to be too small an economic unit for the competitive production of many industrial goods. Rationalizing the number of production facilities throughout the CARICOM under a more comprehensive subregional trade agreement and further economic integration, possibly including the adoption of a regionally administered competition law and a broader and much deeper free trade arrangement between CARICOM nations, would improve the competitiveness profile and prospects of local firms. The elimination or centralization of industrial policy in the CARICOM could also produce social benefits by reducing wasteful lobbying for protection and privileges, thereby refocusing the region's limited entrepreneurial acumen on creating value rather than merely redistributing it. Given the historically and culturally fragmented nature of the Caribbean, which has led to insular and quite different rigid power structures and institutions, with the only seemingly common feature or shared experience being that they are located in the Caribbean Basin, this agenda will clearly pose a significant challenge to the CARICOM and the Association of Caribbean States.

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1 The earliest attempts at economic integration took place in the 1960s with the formation of the Latin American Free Trade Association (LAFTA or ALALC using its spanish acronym) and signed by Argentina, Bolivia, Brazil, Colombia, Chile, Ecuador, Mexico, Paraguay, Peru, Uruguay and Venezuela; CACM in 1960; the Caribbean Free Trade Association (CARIFTA) in 1965; and the Pacto Andino in 1969, which originally included Chile, Colombia, Ecuador, Peru and later Venezuela with Chile withdrawing. Somewhat paradoxically, these formative free trade areas, customs unions and common market arrangements were seen as vehicles to speed up the industrialization process of their small economies by allowing them to achieve greater economies of scale in production when complemented by import-substitution policies.

2 Brazil was a latecomer in this trade and macroeconomic stabilization policies reversal movement and is still in the throes of this transition.

3 The Tierra del Fuego free trade zone benefited from an industrial investment subsidy estimated at US $226 million in 1994 (see Liepziger et al., "MERCOSUR: Integration and Industrial Policy," World Economy, 1997, p. 69-87).

4 These regulations, sometimes referred to as capital controls, would include time reserve requirements on capital inflows and repatriation restrictions on capital outflows. They can be characterized respectively as entry and exit barriers to capital mobility that can either forestall or impede foreign capital entry from the outset or prolong the stay of pre-committed foreign capital beyond a period which investors might deem compatible with their risk tolerance. An unintended side-effect of these capital controls is, therefore, to restrict the country to narrower, more costly investor types, thereby raising the domestic cost of capital in the longer term.

5 Wrobel, Paulo S., A Free Trade Area of the Americas in 2005?, International Affairs, 74(3), 1998, p. 551.

6 International Monetary Fund, International Financial Statistics Yearbook, various years.

7 World Bank, World Investment Report 1998.

8 Under the CBI and the General System of Preferences, many products produced in the Caribbean enter the United States duty free provided they meet one of two requirements: (1) at least 35% of the product's value originated in the Caribbean; or (2) at least 20% of the product's value originated in the Caribbean if not less than 15% of its value originated in the U.S. or Puerto Rico.

9 The Americas Review 1998.