A new trade world: Routes for Latin America and the Caribbean to grow

Andrew Powell, José Juan Ruiz Gómez

Latin America and the Caribbean needs higher growth without increasing debt. This column, based on the new 2017 IDB macroeconomic report, argues that completing intra-regional trade integration is a low-hanging fruit. Trade deals abound, the region has advanced, but regional trade is low – current agreements are too complex and inconsistent. A bottom-up, concrete, politically viable action plan is outlined. Deeper integration would boost growth in any scenario, but the pay-off is even larger if the world becomes more protectionist.

“It never rains but it pours” sometimes seems to be just too appropriate a motto for Latin America and the Caribbean. Just as Argentina and Brazil appear set to post positive growth this year, uncertainty regarding global protectionism and the prospects of higher US interest rates could dampen growth prospects across the region. Analysts project only moderate positive growth for 2017, but a G-VAR modelling exercise suggests that the combination of greater US stimulus, monetary normalisation provoking a correction to asset prices, and growing trade frictions would be negative for the region (IMF 2017).1 The impacts would be both direct (especially on Mexico) and indirect, in part through China and commodity prices, on other countries (see Figure 1).2

Figure 1 US stimulus, financial shock, and trade frictions

Note: estimated with a statistical model of the world economy (a Global Vector Auto-Regression or G-VAR) developed at the IDB, including 14 countries in Latin America and the Caribbean.

Despite the current uncertainties, there have been several positive domestic developments. Many countries have pursued fiscal reform seeking higher efficiency in public spending. Tax reform efforts in some countries have been very successful in boosting revenues and moving towards greater equity and efficiency.3 The nature of fiscal consolidation plans has also changed. Considering the explicit fiscal adjustment plans of 15 countries in Latin America and the Caribbean, those with higher tax burdens are focusing on cutting expenditure and greater emphasis is being placed on cutting current expenditures while maintaining public investment that tends to have higher tax multipliers.4

As discussed in previous Inter-American Development Bank (IDB) Latin American and Caribbean Macroeconomic Reports, it is often the detail of fiscal policy that is critical for its success. The region responded to the Global Crisis with a fiscal impulse, but an analysis of actual policies at that time showed that it was more a permanent increase in spending than a counter-cyclical response. Indeed, as output gaps became positive again, several countries pursued procyclical fiscal expansions leading to higher debt levels and high deficits, particularly when growth receded. As commodity revenues also fell, many countries in the region were forced to adopt fiscal adjustment programmes.5 The fact that the composition of fiscal policies is now more appropriate to the situation is welcome news and implies a much-improved probability of success.

Most of the larger economies have adopted inflation targeting regimes. A credible inflation target allows for exchange rate movements with relatively low pass- through to prices and nominal exchange rates have indeed been very flexible. This has provided a shock-absorber, which in many cases is boosting domestic production and import penetration is falling (see Figure 2).6

Figure 2 Import penetration (IP) has been falling

Source: IDB estimates based on INTrade system data.

In more recent data, dollar export values are also rising, although the fall in commodity prices and the generally slower growth in global trade clearly had an impact. Still, IDB estimates suggest that the required external adjustment process is close to completion in the majority of countries, implying that growth should now come more easily.

Monetary policy remains finely balanced. Some have commented that as policy interest rates have been raised with GDP at less than potential, monetary policy has been procyclical. But this ignores the role of the exchange rate. While interest rates may have been procyclical, they have served as a response to large nominal depreciations. Thus, it’s likely that the monetary stance, including exchange rate impacts, has been counter-cyclical.

Employing a New-Keynesian monetary model calibrated to five inflation targeters, IDB estimates suggest that if central banks respond to negative output shocks in a less restrictive fashion, then inflation may be significantly higher with little benefit in terms of output. As the private sector is assumed to know the new reaction function of the central bank, demand is higher, as is inflation. Therefore, the central bank, even with a less restrictive policy function, may eventually have to raise interest rates anyway. The end result: inflation is higher but with little benefit in terms of output.7

Latin America and the Caribbean needs to find ways to boost growth and it must do so with tight fiscal constraints, and without large budget outlays. Routes to Growth argues that deeper trade integration within the region would help (Powell 2017). There are no fewer than 33 preferential trade agreements (PTAs) involving the 26 regional members of the Inter-American Development Bank. In fact, about 80% of intra-regional trade is currently under preferences so in that sense, the region is not far from a free trade area (FTA) (see Figure 3).

Figure 3 Percentage of trade under preferences

Source: IDB estimates.

But the amount of trade is relatively low. This patchwork of relatively small PTAs, each with its own set of rules of origin, and other regulations does not allow the region to reap the rewards of the significant amount of work already done. Actual trade is stifled by the complexity and inconsistencies between the different PTAs as well as some important missing links. Moreover, the spaghetti bowl of agreements does little to create one market, which would allow Latin American and Caribbean firms to grow and exploit economies of scale, thereby increasing their competitiveness in the global marketplace. IDB estimates suggest only agreements such as NAFTA and CAFTA-DR were capable of boosting exports from Latin American and Caribbean countries to outside of the relevant PTA.8

If the world does turn more protectionist, this could have serious impacts on the small open economies of the region. Deeper integration helps Latin America and the Caribbean in any scenario, but IDB estimates show it would be particularly beneficial in a more negative scenario.9

But it is not enough to simply call for more Latin American and Caribbean integration. Indeed, history is littered with failed over-ambitious projects along those lines.10 We therefore propose a set of concrete policy actions that can be taken separately, at different speeds across countries, and with little cost; if completed, they would culminate in a LAC-FTA. Those actions can be summarised as follows:

Harmonise (and cumulate) rules of origin across existing PTAs11 Fill in missing links with new agreements (especially Mexico–Mercosur) ensuring rules of origin are harmonised and with cumulation Improve trade facilitation and logistics requiring little fiscal outlays Actions 1-3 would approximate a LAC-FTA in all but name; a final action would then be to formally convert the existing PTAs to an FTA with a harmonised agreement to lower any remaining tariffs to zero

This bottom-up approach could be voluntary in nature. Assuming certain missing links were filled, countries would tend to join rather than be left out. The plan is focused on trade; other important topics such as movement of labour, investment, environment, and finance might be left for further down the road. And it would not require any ambitious plan regarding multilateral institutions. It could be handled through current government structures following the example of the Pacific Alliance.

We may appear to be swimming against the tide by proposing integration while some industrialised economies seem to be moving in the opposite direction. But the effects of trade liberalisation can be quite different in emerging economies than in their richer counterparts. As trade boomed in Latin America in the 2000s, inequality fell. Still, countries should be careful to address potential losers from a deeper integration process.12

There is a strong case to deepen integration in the region, allowing countries to reap the full rewards of the work already done, and there is a concrete way to do it. Given constrained macroeconomic policies plus the uncertainties regarding global trading relations and higher world interest rates, Latin America and the Caribbean needs to find new ways to boost growth. Deeper integration in the region is a low hanging fruit and the time is ripe for the picking.

Editors' note: Launch meetings for the 2017 IDB Latin American and Caribbean Macroeconomic Report will be held on 6 April at George Washington University, Washington, DC (see https://elliott.gwu.edu/routes-growth-new-trade-world) and on 11 April at Canning House in London (see https://www.canninghouse.org/events/latin-america-caribbean-routes-growth-new-trade-world/).

References

Arenas de Mesa, A (2016), “Sostenibilidad fiscal y reformas tributarias en América Latina”, Economic Commission for Latin America and the Caribbean and Inter-American Development Bank.

Cesa-Bianchi, A, M H Pesaran, A Rebucci, and T Xu. (2012), “China’s Emergence in the World Economy and Business Cycles in Latin America”, Economía 12(2): 1–75.

Christiano, L J, M Eichenbaum and C L Evans (2005), “Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy”, Journal of Political Economy 113(1): 1–45.

Corbacho, A, V Fretes and E Lora (2013), More than Revenues, Palgrave-Macmillan, Inter-American Development Bank Flagship.

Giordano, P, M Watanuki and O Gavagnin (2013), “Modelo de equilibrio general computable BID-INT: marco teórico y aplicaciones”, IDB Technical Note no. 505, Washington, DC.

IMF (2017), World Economic Outlook (January update), Washington, DC.

Mesquita Moreira, M (ed). (forthcoming), Making Sense of Regional Integration in Latin America and the Caribbean, Washington, DC: Inter-American Development Bank.

Powell, A (coord. 2012), The World of Forking Paths: Latin America and the Caribbean Facing Global Economic Risks, 2012 Latin American and Caribbean Macroeconomic Report. Washington, DC: Inter-American Development Bank.

Powell, A (2017), Routes to Growth in a New Trade World, 2017 Latin American and Caribbean Macroeconomic Report, Inter-American Development Bank. Available at www.iadb.org/macroreport

Endnotes

[1] The IMF World Economic Outlook (January update) indicates 1.2% growth for LAC for 2017.

[2] On the G-VAR methodology, see Powell (2012) and Cesa-Bianchi et al (2012). This simulation is calibrated such that the net shocks are neutral on US growth; see Powell (2017) for more explanation.

[3] For example, Chile, Colombia, Jamaica and Mexico all implemented successful tax reforms in recent years; see Box 4.1 in Powell (2017) and Arenas de Mesa (2016). On the need for such reforms, see Corbacho et al (2013).

[4] Such plans are attempting to improve fiscal balances on average for about 2% of GDP with 0.6% of GDP current spending cuts, 0.2% of GDP capital spending cuts and a 1.2% of GDP increase in revenues (Powell 2017).

[5] Previous reports are available at www.iadb.org/macroreport

[6] See Appendix D in Powell (2017) detailing an econometric analysis at the economy level, manufacturing sector level and at a disaggregated level with many manufacturing sub-sectors. A decrease in import penetration as a result of exchange rate devaluation is found in most specifications using traditional real exchange rates and import weighted real exchange rates.

[7] The model adapts Christiano et al. (2005) but adds a fiscal policy rule, partial pass-through of exchange rate changes to prices, a role for imported inputs in domestic production and a commodity sector; see Appendix A in Powell (2017). The model was calibrated for Brazil, Chile, Colombia, Mexico, and Peru.

[8] An estimated gravity model considers the impact of (a) preferred trade areas within the region such as the Andean Community, Central American Common Market, CARICOM and MERCOSUR, and (b) North-South PTAs such as NAFTA and CAFTA; see Powell (2017) and Mesquita et al (forthcoming).

[9] This statement comes from simulations of a computable general equilibrium model with various scenarios of global trade and the potential LAC response; see Appendix E in Powell (2017) and Giordano et al. (2013).

[10] See Box 6.1 in Powell (2017), which summarises the history of integration in LAC.

[11] Cumulation is a term used to describe a system that allows originating products of country A to be further processed or added to products originating in country B, just as if they had originated in country B.

[12] See Box 6.2 in Powell (2017), which considers the impact of trade on inequality in richer industrialised countries and in poorer emerging economies, and Silva and Messina (forthcoming) on inequality in LAC.