7 Trade and Industrial Policy Reform in Latin America
Author: International Monetary Fund
Language:
English
Keywords:
BOOK; government; country; exchange rate; central bank; trade reform; liberalization policy; trade diversion; trade liberalization reform; trade distortion; Trade liberalization; Tariffs; Exports; Real exchange rates; Trade policy; Central America; North America; Caribbean; South America
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Abstract

Most Latin American countries began to open up to the rest of the world in the late 1980s. This process is perhaps the most impressive achievement of the structural adjustment programs that followed the debt crisis and has effectively put an end to more than four decades of active industrial policies based on import substitution.

Most Latin American countries began to open up to the rest of the world in the late 1980s. This process is perhaps the most impressive achievement of the structural adjustment programs that followed the debt crisis and has effectively put an end to more than four decades of active industrial policies based on import substitution.

However, the process leading to these trade reforms has not been easy. As recently as the mid-1980s, the protectionist view was still influential in many parts of Latin America. In fact, the debt crisis of 1982 provided a new impetus to the protectionist paradigm. In a way that resembled the arguments of the 1930s and 1940s, a number of authors interpreted the crisis as a failure of “the world economic order” and argued that the only way for Latin America to avoid a recurrence of this type of shock was to further isolate itself from the rest of the world through selective protectionism and government intervention (Griffith-Jones and Sunkel, 1986). This perspective was vividly defended by Lance Taylor (1991, p. 119), who argued that the “trade liberalization strategy is intellectually moribund” and that “development strategies oriented internally may be a wise choice towards the century’s end” (p. 141).

In the mid-1980s, Latin America’s external sector was the most distorted in the world. For example, as can be seen in Table 7.1, Central America had the highest degree of import protection in terms of both tariff and nontariff barriers (NTBs)—among developing countries, with South America following closely behind. However, by 1987–88 it became apparent that a permanent solution to the region’s economic problems would imply a fundamental change in its development strategy. In particular, policymakers began to realize that the long-standing protectionist trade policy was at the heart of the region’s problems. During the late 1980s and early 1990s, and with the assistance of the multilateral institutions, a larger and larger number of countries began to reduce their levels of protection and to reform their development views. Reforms on the trade front have accelerated: tariffs have been drastically slashed, in many countries import licenses and prohibitions have been completely eliminated, and a number of nations are actively trying to sign free trade agreements with other Latin American countries as well as with the United States.

Table 7.1.

Import Protection in the Developing World, 1985

(In percent)

article image
Source: Erzan and others (1989).

Includes tariffs and para-tariffs.

Measures as a percentage of import lines covered by nontariff barriers. Dat a on both tariffs and NTBs reported here are weighted averages.

This paper documents and evaluates the process of trade reform in Latin America.1 The next section provides an analytical and historical discussion of the consequence of the traditional industrial policies in Latin America. A distinction is made between policies based on strict import substitution and policies that combined high and uneven import tariffs with export promotion. The paper deals also with the analytics of trade liberalization reforms, including a discussion of the role of supporting policies in assuring the success of trade liberalization reforms. Important questions related to the sequencing of economic reform are discussed in some detail. In particular, emphasis is given to the issue of the appropriate sequencing of stabilization and trade reform policies. The extent of trade reform in Latin America is discussed, and some of the results of the reforms are analyzed. The analysis concentrates on productivity and exports and deals with the experiences of several countries. The role of real exchange rates in a trade liberalization process is carefully taken into account, and the recent trend toward real appreciation in most countries in the region is assessed. Finally, the paper studies the recent attempts at reviving regional integration agreements, the future prospects for free trade agreements with the United States, and the significance of the recent agreement of the General Agreement on Tariffs and Trade (GATT) for the Latin American countries.

Protectionism, Industrial Policy, and Export Promotion

The recent trade liberalization programs in Latin America have sought to reverse protectionist policies that for decades have been at the heart of the region’s development strategy. To place these reforms in perspective, it is useful to first analyze the way in which the protectionist policies affected the economic structure of Latin America and to discuss what the expected effects of the liberalization policies were.

Economic Consequences of Protectionist Industrial Policies

The Great Depression had a fundamental impact on the Latin American economies. Terms of trade plummeted—in Brazil, Chile, and Colombia by almost 50 percent—capital inflows stopped, and real income was severely reduced. The effects of the decline in the worldwide demand for raw materials in 1929–30 were compounded by the adoption of protectionist policies in the United States and Europe through, for example, the Smoot-Hawley Tariff Act in 1930 and the British Abnormal Importations Act of 1931.

Most Latin American countries reacted to these events by abandoning convertibility, devaluing their currencies, and imposing tariff barriers. Diaz-Alejandro (1981) has described these policies as follows:2“Exchange rate devaluations were not the only measures undertaken. . . . [T]here were also increased tariffs, import and exchange controls, bilateral clearing agreements and … multiple exchange rates” (p. 340).

It has generally been thought that sustained protectionism became dominant throughout Latin America in the early 1930s, if not earlier.3 However, Thorp (1992) has recently argued that in the mid- to late 1930s a number of countries in the region—especially Argentina, Brazil, and Chile—implemented substantial trade liberalization policies aimed at encouraging openness and outward orientation. She has argued that export expansion played a key role in the Latin American recovery toward the end of the 1930s. The eruption of World War II put an end to this episode of export-led growth, and once again the Latin American countries responded to the adverse world shocks by resorting to protectionism and inward-looking policies. However, the end of the foreign disturbances was not followed by a new period of openness and the region’s reinsertion into the world economic system. By the late 1940s and early 1950s, protectionist policies based on import substitution were well entrenched and constituted, by far, the dominant perspective (Diaz-Alejandro, 1981).

The creation of the UN Economic Commission for Latin America and the Caribbean (ECLAC) provided an intellectual underpinning for the protectionist position. In particular, the writings of Raúl Prebisch (1950) 4 and Hans Singer (1950) imparted an aura of respectability to import-substitution policies. These authors’ thinking was based on two fundamental premises: (1) a secular deterioration in the international price of raw materials and commodities would result, in the absence of industrialization in the developing countries, in a widening of the gap between rich and poor countries, and (2) to industrialize, the smaller countries required temporary assistance in the form of protection for the newly emerging manufacturing sector. This reasoning was closely related to the infant industry argument for industrialization.5 Between the 1950s and 1970s, a large number of development economists embraced the inward-oriented view and devoted enormous energy to designing planning models that relied heavily on the import-substitution ideas. This view became dominant and was taught with great zeal in most Latin American universities.6

Prebisch’s position developed as a criticism of outward orientation, which he considered to be incapable of permitting the full development of the Latin American countries. He argued that development required industrialization through import substitution and that this approach could be “stimulated by moderate and selective protection policy” (Prebisch, 1984, p. 179). Eventually, however, the degree of protection to the incipient industries became anything but moderate, as more and more sectors required additional tariffs and other types of government support to continue facing foreign competition (Balassa, 1982, and Little, Scitovsky, and Scott, 1970).

During the early years of import substitution, important heavy industries were created in the larger countries, and the basis for the development of a domestic manufacturing sector was set. During the 1950s, the industrial sector grew at rapid real rates, topping in some countries—Brazil and Mexico, for example—8 percent a year (Elias, 1992). With industrialization, however, an array of restrictions, controls, and often contradictory regulations evolved. In most countries, lobbying developed swiftly as a way to secure the rents created by the maze of controls. It was, in fact, because of import restrictions that many of the domestic industries were able to survive. As a consequence, many of the industries created under the import-substitution strategy were quite inefficient. Krueger (1981) and Balassa (1982) found that this inward-looking strategy generated rentseeking activities and resulted in the use of highly capital-intensive techniques, which hampered the creation of employment throughout the region.

In most countries, starting in the late 1940s, import substitution was accompanied by an overvalued domestic currency that precluded the development of a vigorous nontraditional export sector.7 In an early study using data from the 1960s, Balassa (1971) found that the Latin American countries in his sample—Brazil, Chile, and Mexico—had some of the most distorted foreign trade sectors in the world. These findings coincide with those obtained by Little, Scitovsky, and Scott (1970) in their pioneer study on trade policy and industrialization in the developing world. These authors persuasively argued that the high degree of protection granted to manufacturing in Latin America resulted in serious discrimination against exports, resource misallocation, inefficient investment, and deteriorating income distribution. They further argued that the reversal of the protectionist policies should be at the center of any reformulation of Latin America’s development strategy. The agricultural sector was particularly harmed by real exchange rate overvaluation. The lagging of agriculture became one of the most noticeable symptoms of many countries’ economic problems of the 1950s and 1960s. The overvaluation of the real exchange rate played an important political role during this period because it kept down the prices of imported goods consumed by urban dwellers.8

In many countries—especially in Argentina, Brazil, Chile, Colombia, Peru, Uruguay, and Venezuela—fiscal imbalances became a staple of government policies. However, the dominant view did not consider this to be an overly serious matter; it was, in fact, believed that fiscal disequilibrium was only indirectly related to inflation.9 The inflationary problem became particularly serious in Chile, where the rate of increase of consumer prices averaged 36 percent a year during the 1950s, reaching a peak of 84 percent in 1955.

The discouragement of export activities took place through two main channels: first, import tariffs, quotas, and prohibitions increased the cost of imported intermediate materials and capital goods used in the production of exportables, reducing their effective rate of protection. In fact, for years a vast number of exportable goods, especially those in the agricultural sector, had negative protection of their value added. Second, the maze of protectionist policies resulted in real exchange rate overvaluation that reduced the degree of competitiveness of exports. This antiex-port bias explains the poor performance of the export sector, including the inability to aggressively develop nontraditional exports, during the twenty years preceding the debt crisis. Paradoxically, policies that were supposed to reduce Latin America’s dependency on the worldwide business cycle ended up creating a highly vulnerable economic structure where the sources of foreign exchange were concentrated in a few products intensive in natural resources, and where imports were concentrated in a relatively small group of essential goods (United Nations, 1992).

A second general and important consequence of traditional protective trade policies was the creation of a manufacturing sector that, in most countries, was largely inefficient. Instead of granting short-term protection to help launch new activities, high tariffs, quotas, and prohibitions became a fixture of the region’s economic landscape. An important consequence of the pressures exercised by lobbyists and interest groups was that the protective structure in Latin America became extremely uneven, with some sectors enjoying effective tariff rates of more than 1,000 percent, and others suffering from negative value-added protection (Edwards, 1992). Moreover, as is argued below, in the 1970s interest group pressures resulted in the superimposition of an array of special export subsidies for a handful of firms that were deemed to be strategically important (Nogués, 1990).

The protectionist policies also had serious effects on labor markets. In particular, the protection of capital-intensive industries affected the region’s ability to create employment. A number of studies have shown that in developing countries more open trade regimes have resulted in higher employment and in a more even income distribution than protectionist regimes. For example, after analyzing in detail the experiences of ten countries, Krueger (1983) concluded that exportable industries tended to be significantly more labor intensive than import-competing sectors. In the conclusions to this massive study, Krueger argues that employment has tended to grow faster in outward-oriented economies and that the removal of external sector distortions will tend to help the employment creation process in most developing countries. These results were broadly supported by other cross-country studies, including those by Balassa (1982) and Michaely, Papageorgiou, and Choksi (1991).

In terms of income distribution, the protection system largely benefited local industrialists—in particular, those able to obtain import licenses and concessions—and urban workers, but at the cost of depressing the incomes of rural workers. As discussed in Edwards (1993b), for example, during the 1970s income distribution was significantly more unequal in Latin America than in Asia.

In summary, although several decades of protectionist policies succeeded in creating an industrial sector in Latin America, this goal was achieved at high cost. Exports were discouraged, the exchange rate became overvalued, employment creation lagged behind, and massive amounts of resources—including skilled human resources—were withdrawn from the productive sphere and devoted to lobbying for an ever-favorable treatment of different sectors of the economy.10 An increasing number of comparative studies in the 1980s made the shortcomings of the Latin American development strategies particularly apparent. In the aftermath of the debt crisis, the long stagnation, and even retrogression, of the region’s export sector—with an average rate of decline of 1 percent a year between 1965 and 1980—became particularly painful to the local public, analysts, and policymakers.

Industrial Policy and Export Promotion

As discussed above, after an auspicious beginning, the import-substitution strategy began to run into difficulties during the late 1950s and early 1960s. At that time most of the obvious substitutions of imported goods had already taken place, and the process was rapidly becoming less dynamic (Hirschman, 1968). For example, during the 1960s total real industrial production grew in most countries at one-half the annual rate of the previous decade (Elias, 1992). Also, an increasing number of politicians and economists began to agree that Latin America was facing long-run economic problems. It was generally recognized that the easy phase of the import-substitution process had ended and that inflation and the recurrent crises of the external and agricultural sectors had become serious obstacles to growth. Furthermore, the increasingly unequal distribution of income and the unemployment problem represented serious challenges to any new economic program. Although most experts pointed out that low rates of domestic savings and investment represented an important obstacle to growth, they differed markedly on some other aspects of their diagnosis and on the proposed policy packages to take the country out of its relative stagnation.11 At this time, the simple import-substitution policies came under attack from two flanks: on the one hand, a small number of economists, sometimes associated with the monetarist position, argued for orthodox stabilization programs based on fiscal restraint and a greater reliance on market forces.12 On the other hand, a growing number of intellectuals in the Marxist tradition—including the group known as dependencistas—argued that there was too little government presence in economic decisions and postulated a massive move toward full-fledged planning, in the Eastern European style.13

Facing this two-pronged attack, the structuralist thinkers eventually concluded that their policies had to be reformed. Fishlow (1985) notes that the dominant economic view in Latin America experienced two important developments during the 1960s. First, import substitution was expanded from the country sphere to the regional level, and a number of attempts to create regional trading agreements were undertaken. Perhaps the most comprehensive of these was the Andean Pact created in 1969 and grouping Bolivia, Chile, Colombia, Ecuador, Peru, and, later, Venezuela. However, the proposed regional arrangements did not tackle the high levels of protection and distortions imposed in the previous twenty years. In fact, in the Andean Pact, the proposed common external tariff was extremely high and uneven, representing the expansion of the traditional structuralist thinking to a supranational level (see Edwards and Savastano, 1988). The evolution of integrationist attempts in the region is addressed in greater detail below.

The second development discussed by Fishlow (1985) was the recognition of the importance of capital inflows as a way to supplement domestic savings and finance higher rates of capital accumulation. However, this option was centered around official capital flows through multilateral institutions and did not give private flows a significant role. Also, no specific recommendations were made to alter the basic incentive structure of the economy or to provide a greater role to market forces in long-run development strategies.

In the late 1960s and the 1970s, the structuralist view continued to evolve, as it became increasingly evident that the dynamism of most Latin American economies was in rapid decline. In particular, in a number of countries the expansion of exports became an important component of otherwise traditional economic programs. Brazil provides, perhaps, the clearest example of a strategy for expanding manufacturing exports with the aid of an aggressive industrial policy based on export subsidies, tax allowances, and subsidized credit to selected industries. At the macroeconomic level, this industrial policy was supplemented by an active crawling peg exchange rate system aimed at avoiding real exchange rate overvaluation.14

Although this policy resulted in a very rapid rate of growth of GDP and manufacturing exports, Brazil’s economic base remained somewhat rigid and fragile.15 As Fishlow (1991) has argued, after decades of an industrialization strategy based on protective policies, Latin America, and especially Brazil, had relatively high wages and its exports could not become the “engine of growth” as in East Asia. In spite of expanding at a rapid pace, exports still failed to relax the required foreign exchange constraint that for years had affected most countries. As a consequence, during the 1970s virtually every country in the region resorted to heavy foreign borrowing to obtain foreign exchange. The rapid accumulation of debt made these economies particularly vulnerable, as the region painfully learned in 1982.

Why wasn’t export promotion more successful in Latin America? After all, industrial policies explicitly aimed at encouraging exports were implemented aggressively and very successfully in many East Asian countries. For example, in the 1960s an aggressive export-promotion scheme became an important complement of the Korean trade liberalization strategy. Throughout the years, exports have been subsidized through a number of channels, including (1) direct cash subsidies (until 1964); (2) direct tax reductions (until 1973); (3) interest rate preferences; (4) indirect tax reductions on intermediate inputs; and (5) tariff exemptions to imported intermediate materials.16 Kim (1991) has recently calculated that these subsidies were reduced from 23 percent to zero between 1963 and 1983. He has argued, as others have, that in Korea, export subsidies played an important role during the earlier years of the country’s export boom.17 A recent massive study undertaken by the World Bank (1993a) has explored with great detail the reasons for the East Asian export success. It is argued that in most cases the government organized “contests” among private firms, with export performance as the main criterion to determine “winners.” Those firms with a strong export record were rewarded with access to preferential credit and other types of special treatment. This study suggests that by picking exports as the general activity to be rewarded, rather than production in a particular sector (for example, steel), the East Asian countries avoided major distortions and, in particular, were able to minimize the extent of rent-seeking activities. It may be argued that while the Latin American export-promotion policies—especially those developed in Brazil—subsidized selected industries that were deemed to have export potential, East Asian government policies were based on whether the final destination of production was, in effect, the world market.

Lin (1988) has compared trade policies in Korea, Taiwan Province of China, and Argentina. His computations indicate that in the 1970s the overall rate of effective protection was 10 percent in Korea, 5 percent in Taiwan Province of China, and 47 percent in Argentina. The contrast was even greater in the manufacturing sector, where the effective rates of protection were −1 percent in Korea, 19 percent in Taiwan Province of China, and almost 100 percent in Argentina. These differences in protective rates affected relative incentives, generating a substantial antiexport bias in Argentina. Modern theories of economic growth have linked openness with productivity growth: more open economies tend to engage in technological innovation faster, exhibiting more rapid productivity improvements. According to Lin (1988), labor productivity increased at an annual rate of 8.7 percent in Korea during 1973–85 and at only 0.5 percent a year in Argentina. The vigorous growth experienced by other East Asian countries—including the second generation “miracle” countries of Indonesia, Malaysia, and Thailand—since the late 1980s has added impetus to the idea that a development path based on openness and market orientation can be extremely rewarding. Increasingly, Latin American leaders are turning toward East Asia for inspiration and economic partnership.

A number of authors have argued that the conduct of macroeconomic policy constitutes a second crucial difference between East Asia and Latin America (see Sachs, 1987). As has been extensively documented by a number of authors, inflation has been significantly higher in the Latin American countries than in the East Asian countries. Moreover, Latin America has also been affected by higher inflation variability and real exchange rate volatility. The greatest advantage of a stable macroeconomic environment is that it reduces uncertainty, thereby encouraging investment. Moreover, to the extent that the real exchange rate is stable, investment in the tradables sector will increase, as will exports. Sachs (1988) and Fischer (1988), among others, have pointed out that in the adjustment-cum-reform process, the achievement of macroeconomic stability should precede trade liberalization in the developing countries. Based on the experiences of Korea, Taiwan Province of China, and Japan, Sachs (1988) has argued that massive and deep tariff reduction should take place only after macroeconomic stabilization is firmly in place.18 This issue is addressed with greater detail in the next section.

Trade Liberalization: Expected Results and Transitional Problems

The main objective of trade liberalization programs is to reverse the negative consequences of protectionism and, especially, its antiexport bias. According to basic theory, trade liberalization will result in a reallocation of resources, according to comparative advantage, in a reduction of waste, and in a decline in the prices of imported goods.19 Moreover, to the extent that the new trade regime is more transparent—for example, through a relatively uniform import tariff—it is expected that lobbying activities will be greatly reduced, releasing highly skilled workers from unproductive jobs. According to traditional international trade theory, it is expected that once negative effective rates of protection and overvalued exchange rates are eliminated, exports will not only grow rapidly, but will also become more diversified.

From a growth perspective, the fundamental objective of trade reform is to transform international trade into the engine of growth. In fact, newly developed models of endogenous growth have stressed the role of openness.20 For example, Romer (1989) has developed a model in which, by taking advantage of larger markets—the world market—an open economy can specialize in the production of a larger number of intermediate goods and, thus, grow faster. Other authors have recently concentrated on the relationship between openness, technological progress, and productivity growth. Grossman and Helpman (1991) and Edwards (1992), for example, have argued that openness affects the speed and efficiency with which small countries can absorb technological innovations developed in the industrial world. This idea, based on an insight first proposed by John Stuart Mill, implies that countries with a lower level of trade distortions will experience faster growth in total factor productivity and, with other things being equal, will grow faster than countries that inhibit international competition.21

In recent papers, a number of authors have tested the general implications of these theories using cross-country data sets.22 Although different empirical models have yielded different results, the general thrust of this line of research is that countries with less distorted external sectors appear to grow faster. As Dornbusch (1990) pointed out, openness possibly affects growth through not just one channel, but through a combination of channels, including the introduction of new goods, the adoption of new methods of production, the reorganization of industries, the expansion of the number of intermediate goods available, and the conquest of new markets that permit the expansion of exports.

The importance placed by liberalization strategists on the reduction of the antiexport bias has resulted in significant emphasis on the role of exchange rate policy during a trade reform effort. A number of authors have argued that a large devaluation should constitute the first step of trade reform. Bhagwati (1978) and Krueger (1978) have pointed out that in the presence of quotas and import licenses, a real exchange rate depreciation will reduce the rents received by importers, shifting relative prices in favor of export-oriented activities and, thus, reducing the extent of the anti-export bias (see Krueger, 1978, 1981, and Michaely, Papageorgiou, and Choksi, 1991).

Speed and Sequencing of Trade Liberalization Reform

Two fundamental problems must be addressed in the transition toward freer trade: first, it is important to determine the adequate speed of reform. For a long time, analysts argued for gradual liberalization programs (Little, Scitovsky, and Scott, 1970; Michaely, 1985), because they maintained that gradual reforms would give firms time to restructure their productive processes and, thus, would result in low dislocation costs in the form of unemployment and bankruptcies. These reduced adjustment costs would, in turn, provide the needed political support for the liberalization program. Recently, however, the gradualist position has been under attack. There is increasing agreement that slower reforms tend to lack credibility, inhibiting firms from engaging in serious restructuring. Moreover, the experience of Argentina in the 1970s has shown that a gradual (and preannounced) reform allows those firms negatively affected by it to lobby successfully against reductions in tariffs. According to this line of reasoning, faster reforms are more credible and thus tend to be sustained over time (Stockman, 1982).

The thinking on the speed of reform has also been influenced by recent empirical work on the short-run unemployment consequences of trade liberalization. Contrary to conventional wisdom, a World Bank study directed by Michaely, Papageorgiou, and Choksi (1991) on liberalization episodes in 19 countries strongly suggests that, even in the short run, the costs of reform can be small. Although contracting industries will release workers, those sectors that expand as a result of the reform process will tend to create a large number of employment positions. The study shows that, in sustainable and successful reforms, the net effect—that is, the effect that nets out contracting and expanding sectors—on short-run employment has been negligible.

The second problem that must be addressed when designing a liberalization strategy is the sequencing of reform (Edwards, 1984). This issue was first addressed in the 1980s in discussions dealing with the Southern Cone (Argentina, Chile, and Uruguay) experience and emphasized the macroeconomic consequences of alternative sequences. It is now generally agreed that resolving the fiscal imbalance and attaining some degree of macroeconomic reform should be a priority of structural reform. Most analysts also agree that trade liberalization should precede liberalization of the capital account and that financial reform should be implemented only after a modern and efficient supervisory framework is put in place.23

The behavior of the real exchange rate is at the heart of this policy prescription. The central issue is that liberalizing the capital account, under some conditions, results in large capital inflows and an appreciation of the real exchange rate (McKinnon, 1982; Edwards, 1984; Harberger, 1985).24 The problem with this scenario is that an appreciation of the real exchange rate will send the “wrong” signal to the real sector, frustrating the reallocation of resources called for by the trade reform. The effects of this real exchange rate appreciation will be particularly serious if, as argued by McKinnon (1982) and Edwards (1984), the transitional period is characterized by “abnormally” high capital inflows that result in temporary real appreciations. If, however, the opening of the capital account is postponed, the real sector will be able to adjust and the new allocation of resources will be consolidated. According to this view, only at this time should the capital account be liberalized.

More recent discussions on the sequencing of reform have expanded the analysis to include other markets. An increasing number of authors have argued that the reform of the labor market—in particular the removal of distortions that discourage labor mobility—should precede the trade reform as well as the relaxation of capital controls. As argued by Edwards (1992), it is even possible that the liberalization of trade in the presence of highly distorted labor markets will be counterproductive, generating overall welfare losses in the country in question. Discussions on the sequencing of reform have addressed in detail only the order in which the liberalization of various “real” sectors in society should proceed. For instance, only a few studies, such as those by Krueger (1981) and Edwards (1984), have dealt with the order of reform of agriculture, industry, government (i.e., privatization), financial services, and education. The key question is the extent to which independent reforms will bear all their potential fruits or whether the existence of synergism implies that in a broad liberalization process the reforms in different sectors reinforce each other.25

As the preceding discussion has suggested, real exchange rate behavior is a key element during the transition to trade liberalization. According to traditional manuals on how to liberalize, a large devaluation should constitute the first step of trade reform. Maintaining a depreciated and competitive real exchange rate during trade liberalization is also important in order to avoid an explosion in import growth and a balance of payments crisis. Under most circumstances, a reduction in protection will tend to generate a rapid and immediate surge in imports. On the other hand, the expansion of exports usually takes some time. Consequently, there is a danger that trade liberalization will generate a large trade balance disequilibrium in the short run. This, however, will not happen if there is a depreciated real exchange rate that encourages exports and curbs imports.

Many countries have historically failed to sustain a depreciated real exchange rate during the transition, mainly because of expansionary macroeconomic policies that generate speculation and international reserve losses and, in many cases, lead to a reversal of the reform effort. In the conclusions to the massive World Bank project on trade reform Michaely, Papageorgiou, and Choksi (1991) succinctly summarize the key role of the real exchange rate in determining the success of liberalization programs: “The long term performance of the real exchange rate clearly differentiates liberalizers’ from ‘non-liberalizers’” (p. 119). Edwards (1989) used data on 39 exchange rate crises and found that, in almost every case, real exchange rate overvaluation led to drastic increases in the degree of protectionism.

Order of Stabilization and Trade Liberalization Policies

The question of sequencing macroeconomic stabilization and structural reform—especially trade reform—has recently become an important policy issue in a number of places, including Latin America, Eastern Europe, and the countries of the former Soviet Union. Analysts have asked whether fiscal reform should precede structural reform or whether both types of policies should be implemented simultaneously. By the late 1980s, most analysts began to agree that in countries with serious macroeconomic imbalances the most appropriate sequencing required early and decisive action on the macroeconomic front, including the elimination of the debt-overhang problem.26 It was argued that the uncertainty associated with high inflation, including high relative price variability, would reduce the effectiveness of market-oriented structural reforms, especially trade liberalization policies. This high degree of uncertainty would result in low investment and, in some cases, could even direct investment toward the “wrong” sectors (Fischer, 1986).

A second argument for the “stabilization-first” sequence is based on the contribution of foreign trade taxes to public revenues: if public finances have not been brought under control, the reduction of import tariffs would make things worse by increasing the fiscal deficit. This argument is considered to be particularly valid for low-income countries that rely heavily on taxes on international trade.

As in the case of trade versus capital account liberalization, the real exchange rate is at the center of the debate. Under a set of plausible conditions, macroeconomic stabilization programs will tend to result in an appreciation of the real exchange rate, while, as pointed out above, a successful trade reform will require a real depreciation.

A limitation of the approach that advocates stabilization before liberalization is that it does not distinguish between different degrees of macroeconomic disequilibria at the time the reforms are initiated. While the relative price variability and real exchange appreciation arguments are eminently plausible for high-inflation countries, they are unlikely to be as important in countries that start from moderate inflation. For example, Krueger (1981) has argued that the Asian and Middle Eastern experiences suggest that there is little connection between the determinants of inflation and the orientation of the trade regime. Along similar lines, Edwards (1992) has argued that, in countries with moderate rates of inflation, trade liberalization and macroeconomic stabilization will tend to reinforce each other. In particular, the reduction of import tariffs and the exposure of the domestic industry to foreign competition will tend to introduce “price discipline.” Moreover, the increase in productivity growth usually associated with trade reforms will tend to offset mild real exchange rate appreciations that take place during the stabilization effort. A second limitation of this approach is that it tends to ignore the political economy of reform. Two points are in order regarding this issue. First, once embarked on a major transformation process, reform-minded policymakers tend to take advantage of whatever opportunity they have. Second, in many cases it is easier to attack the protectionist lobby—which is fairly well defined and concentrated in specific industries—than to deal with the interest groups that lead to fiscal imbalances and inflation.

In spite of these limitations, the stabilization-first approach has become the dominant view among policy analysts, including the staffs of multilateral financial institutions such as the International Monetary Fund and the World Bank. However, as documented in World Bank (1993b), almost every country in Latin America ignored this piece of advice and either embarked on trade reform first or implemented trade liberalization and stabilization policies simultaneously.

Determinants of Successful Trade Liberalization Policies

Two economic aspects of trade liberalization are particularly important for analyzing the political economy of transition and the likelihood that reforms can be sustained over time. First, it takes time for the structural reforms to bear fruit. This means that even though in the long run the reforms will have a positive effect on the aggregate economy, there will be some short-run costs. These transitional costs, however, will not be even and will affect some groups more heavily than others. Second, even in the long run some groups will lose and will see their real incomes diminish. These groups will be those that have benefited from the prereform maze of regulations, and, in most cases, they will tend to oppose the reforms from the beginning. Politically, then, trade reforms will survive only if they show some benefits early on and if these benefits expand gradually, affecting larger and larger segments of society.

The extensive comparative studies by Little, Scitovsky, and Scott (1970), Balassa (1971, 1982), Krueger (1978, 1980), Bhagwati (1978), and Michaely, Papageorgiou, and Choksi (1991) have provided abundant evidence on the key determinants of a successful trade reform that will change the trade structure of a country. These elements can serve as a guide for policymakers who want to implement trade liberalization policies that will be sustained over time. Existing historical evidence suggests that successful (i.e., sustained) reforms have been characterized, in the short and medium run, by at least some of the following elements: 27

  • Exports, particularly nontraditional exports, expand at a pace that exceeds the historical rate.

  • Productivity growth increases rapidly, helping generate rapid growth for the economy as a whole.

  • The trade balance does not exhibit “unreasonable” deficits. If such deficits exist, the public will be skeptical about the viability of the reform and will speculate against the domestic currency.

  • The overall level of unemployment stays at a relatively low level. • Real wages increase, at least in the medium run. For this increase in wages to affect a broad sector of society, trade liberalization should be supplemented by other structural reforms aimed at deregulating and liberalizing other sectors of the economy.

Recent Trade Liberalization Reforms in Latin America and the Caribbean

The pioneer in the Latin American trade liberalization process was Chile, which, between 1975 and 1979, unilaterally eliminated quantitative restrictions and reduced import tariffs to a uniform level of 10 percent. After a brief interlude with higher tariffs (at the uniform level of 35 percent), by 1992 Chile had reduced its degree of protection to a uniform tariff of 11 percent, totally abolishing licenses and other forms of quantitative controls. Uruguay implemented its reform in 1978 and, after a brief reversal, pushed forward once again in 1986. Bolivia and Mexico embarked on their reforms in 1985–86, followed by a number of countries in the late 1980s. By early 1992, a number of Latin American countries, including Brazil, were proceeding steadily with scheduled rounds of tariff reduction and the dismantling of quantitative restrictions. However, at the time of this writing, it is still unclear whether all these reforms will become a permanent feature of the Latin America economies or whether some of them will be reversed. Recent developments in Argentina and Colombia indeed suggest that in some countries higher tariffs may be implemented, once again, in the near future.

The Latin American trade reforms have been characterized by four basic components: (1) the reduction of the coverage of nontariff barriers, including quotas and prohibitions; (2) the reduction of the average level of import tariffs; (3) the reduction of the degree of dispersion of the tariff structure; and (4) the reduction of export taxes. These measures have generally been supported by exchange rate policies aimed at maintaining a competitive real exchange rate.

Nontariff Barriers

A key component of the trade reform programs has been the elimination, or at least the severe reduction, of the coverage of NTBs. During the early and mid-1980s in some countries, such as Colombia and Peru, more than 50 percent of import positions were subject to licenses or outright prohibitions. In Mexico, as in most of Central America, NTBs covered almost all import categories in 1985 (Table 7.1).

Table 7.2 contains data on protectionism in 1985–87 and 1991–92 and shows that in almost every country the coverage of NTBs has been substantially reduced.28 In fact, in a number of countries they have been fully eliminated. The process through which NTBs have been eased has varied from country to country. In some cases, such as Honduras, they were initially replaced by quasi-equivalent import tariffs and then slowly phased out. In other countries, like Chile, they were eliminated rapidly without a compensating hike in tariffs.

Table 7.2.

Selected Latin American Countries: Decline in Level of Protection

(In percent)

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Sources: World Bank; UNCTAD, Handbook of Trade Control Measures of Developing Countries; and Erzan and others (1989).

These figures are unweighted averages.

As Table 7.2 shows, in spite of the progress experienced in the past few years, significant NTB coverage remains in a number of countries. In most cases, these NTBs correspond to agricultural products. For example, in approximately 60 percent of Mexico’s agriculture sector, tariff positions were still subject to import licenses in mid-1992. Those for U.S. imports were scheduled to be eliminated as a result of the North American Free Trade Agreement. An important feature of the region’s liberalization programs is that they have proceeded much slower in agriculture than in industry. This has largely been the result of the authorities’ desire to isolate agriculture from fluctuations in world prices and unfair trade practices by foreign countries.29 Although, according to a recent study by Valdés (1992), this approach based on quantitative restrictions entails serious efficiency costs, more and more countries are addressing these concerns by replacing quantitative restrictions with variable levies and by introducing a system for smoothing price fluctuations based on price bands.

Tariff Dispersion

The development strategy based on import substitution that Latin America pursued for decades created highly dispersed protective structures. According to the World Bank (1987), Brazil, Chile, and Colombia had some of the highest degrees of dispersion in effective protection in the world during the 1960s. Also, Heitger (1987) shows that during the 1960s Chile had the highest rate of tariff dispersion in the world—with a standard deviation of 634 percent—closely followed by Colombia and Uruguay. Cardoso and Helwege (1992) have pointed out that highly dispersed protective structures generate high welfare costs by increasing uncertainty and negatively affecting the investment process. These highly dispersed tariffs and NTBs were the result of decades of lobbying by different sectors to obtain preferential treatment. As the relative power of the different lobbies changed, so did their tariff concessions and the protective landscape.

An important goal of the Latin American trade reforms has been the reduction of the degree of dispersion of import tariffs. Table 7.3 contains data on the tariff range for a group of countries for 1985–87 and 1991–92 and clearly documents that the reforms have indeed reduced the range between minimum and maximum tariffs. In many cases this has meant increasing tariffs on goods that were originally exempted from import duties. In fact, this table shows that in many countries the minimum tariff was zero in the mid-1980s. Generally, zero tariffs have been applied to intermediate inputs used in the manufacturing process.30 From a political-economy perspective, the process of raising some tariffs while maintaining a pro-liberalization rhetoric has not always been easy. Those sectors that had traditionally benefited from the exemptions tried to oppose them strongly as they suddenly saw their privileged situation coming to an end.

Table 7.3.

Range of Import Tariffs

(In percent)

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Sources: World Bank; UNCTAD, Handbook of Trade Control Measures of Developing Countries; Erzan and others (1989).

An important question addressed by policymakers throughout the region is: By how much should tariff dispersion be reduced? Should a uniform tariff be implemented or is some dispersion desirable? Although from a strict welfare perspective, uniform tariffs are advisable only under special circumstances, they have a strong administrative and politicaleconomy appeal. In particular, a uniform tariff system is transparent, making it difficult for the authorities to grant special treatment to particular firms or sectors (Harberger, 1990).

Average Tariffs

Reducing the average degree of protection is, perhaps, the fundamental policy goal of trade liberalization reforms. Traditional policy manuals on the subject suggest that once the exchange rate has been devalued and quantitative restrictions have been reduced or eliminated, tariffs should be slashed in such a way that both their range and average are reduced.31 Table 7.2 contains data on average total tariffs (tariffs plus para-tariffs) in 1985 and 1991–92. As can be seen, the extent of tariff reduction has been significant in almost every country. Even countries that have acted somewhat cautiously on the reform front have experienced important cuts in import tariffs, making the environment more competitive and reducing the degree of antiexport bias of the trade regime.

Countries that have embarked on trade liberalization in recent years have moved much faster than those that decided to open up earlier. There has, in fact, been a clear change in what is perceived to be abrupt and rapid removal of impediments to imports. What only 15 years ago were seen as brutally fast reforms are now viewed as mild and gradual liberalizations. When Chile initiated its trade reform in 1975, most analysts thought that the announced tariff reduction from an average of 52 percent to 10 percent in four and a half years was an extremely aggressive move that would cause major dislocations, including large increases in unemployment. The view on the speed of reform has changed in the early 1990s, as an increasing number of countries have opened up their external sectors very rapidly. For instance, Colombia slashed total import tariffs by 65 percent in one year, reducing them from 34 percent in 1990 to 12 percent in 1991. This fast approach to liberalization has also been followed by Argentina, Nicaragua, and Peru. Nicaragua eliminated quantitative restrictions in one bold move and slashed import tariffs from an average of 110 percent in 1990 to 15 percent in March 1992.

Exchange Rate Policy

In the vast majority of countries, the first step in the recent trade reform process was the implementation of large nominal devaluations. In many cases, this measure represented a unification of the exchange rate market. Most countries implemented large exchange rate adjustments as early as 1982 in order to address the urgent needs of the adjustment process. The purpose of these policies was to generate real exchange rate devaluations as a way to reduce the degree of antiexport bias of incentive systems.

Many countries adopted crawling peg regimes, characterized by a periodic, small devaluation of the nominal exchange rate to protect the real exchange rate from the effects of inflation.32 Table 7.4 contains data on real exchange rates for a group of Latin American countries for 1980, 1987, and 1992. Once again, an increase in the index represents a real exchange rate depreciation and thus an improvement in the degree of competitiveness. Between 1980 and 1987, almost every country in the sample experienced large real depreciations (see World Bank, 1993b), although in many countries they have been partially reversed in the past few years. The reversals have been the consequence of a combination of events, including the inflow of large volumes of foreign capital into these countries since 1990 and the use of the exchange rate as the cornerstone of the disinflation policies. This subject is addressed below. Overall, however, in most countries the real exchange rate was depreciated significantly more by late 1991 than it was in 1981. This greatly encouraged exports, helping revert decades of discriminatory policies.

Table 7.4.

Real Exchange Rates in Selected Latin American Countries

(1985 = 100)

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Source: Calculated using data from IMF, International Financial Statistics database.

Preliminary.

Note: Increases indicate currency depreciation against the dollar.

Effects of Trade Liberalization

The trade liberalization reforms implemented in Latin America had three fundamental objectives: (1) to reduce the antiexport bias of the old regime and, thus, to encourage exports; (2) to help create an increase in total factor productivity growth through greater competition and enhanced efficiency; and (3) to increase consumer welfare by reducing the real prices of importable goods. In this section, the evolution of productivity and exports in the postreform period are analyzed in some detail.

Trade Liberalization and Productivity Growth

The relaxation of trade impediments has had a fundamental impact on the region’s economies. Suddenly, Latin America’s industry, which to a large extent had developed and grown behind protective walls, was forced to compete. Many firms have not been able to survive this shock and have become bankrupt. Others, however, have met the challenge of lower protection by embarking on major restructuring and have increased their level of productivity.

The ability, and willingness, of firms to implement significant adjustment depends on the degree of credibility of the reform and the level of distortions in the labor market. If entrepreneurs believe that the reform will not endure over time, they will have no incentives to incur the costs of adjusting the product mix and increasing the degree of productive efficiency. In fact, if the reform is perceived as temporary, the optimal behavior is not to adjust but to speculate through the accumulation of imported durable goods. This approach, as Rodríguez (1982) has documented, was adopted in Argentina during the failed Martinez de Hoz reforms.33

In their studies on the interaction between labor markets and structural reforms, Krueger (1980) and Michaely, Papageorgiou, and Choksi (1991) found that most successful trade reforms have indeed resulted in major increases in labor productivity. In most countries in which this has happened, labor markets have been characterized by some degree of flexibility. Countries with rigid and highly distorted labor markets—including countries with high costs of dismissal, limitations on temporary contracts, and rigid minimum wage legislation—have generally exhibited modest improvements in labor productivity since the reform.

Some of the early Latin American reformers have experienced important labor productivity improvements. For example, according to Edwards and Edwards (1991), labor productivity in the Chilean manufacturing sector increased at an average annual rate of 13.4 percent between 1978 and 1981. The available evidence also suggests that the increases in labor productivity in the Mexican manufacturing sector in the postreform period have been significant. According to Sánchez (1992), labor productivity in Mexico’s manufacturing sector increased at an annual rate of almost 4 percent between 1986 and 1991. This figure is more than double the historical annual rate of growth of labor productivity of 1.6 percent in the manufacturing sector between 1960 and 1982 (Elias, 1992).

As discussed above, recent models of growth have suggested that countries that are more open to the rest of the world will exhibit a faster rate of technological improvement and productivity growth than countries that isolate themselves from the rest of the world. From an empirical point of view, countries that open up their external sectors and engage in trade liberalization reforms will experience an increase in total factor productivity (TFP) growth relative to the prereform period. The empirical regression analysis presented in the appendix to this chapter supports the idea that, when other variables (such as human capital formation, government size, political volatility, and the development gap) are held constant, the degree of openness of the economy is positively associated with the rate of growth of productivity. What is particularly important is that this result appears to be robust to the proxy used to measure trade policy orientation.

Table 7.4 contains data on the change in aggregate TFP growth in the period following the implementation of trade liberalization reform in six Latin American countries.34 Although these data cannot be interpreted as capturing causality, they are still suggestive. As can be seen, Chile and Costa Rica, two of the earliest reformers, experienced very large increases in the growth of TFP in the postreform period. The results for Chile coincide with those obtained by Edwards (1985), who found that in the late 1970s after the trade reforms had been completed, TFP growth was approximately three times higher than the historical average.35 Although the outcome has been less spectacular in Argentina and Uruguay, these countries still exhibit important improvements in productivity growth following the opening up. Bolivia, on the other hand, presents a flat profile of productivity growth. Sturzenegger (1992) argues that the very slow improvement in Bolivian productivity growth has been, to a large extent, the result of negative terms of trade shocks and, in particular, the collapse of the tin market.36

Perhaps the most puzzling result in Table 7.5 is the slight decline in aggregate productivity growth in Mexico after the reforms. Martin (1992) shows that this finding is robust to alternative methods of measuring TFP growth, including different procedures for correcting for capacity utilization. Also, Harberger (1990) has found a slowing down of productivity growth in Mexico in 1986–90 relative to 1975–82.37 However, the aggregate nature of the data in Table 7.5 tends to obscure the actual sectoral response to trade reform in Mexico. According to new theories on endogenous growth, faster productivity will be observed in those sectors where protectionism has been reduced and not in those that are still subject to trade barriers or other forms of regulation.

Table 7.5.

Changes in Total Factor Productivity Growth

(In percent)

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Source: Martin (1992).

Prereform period is 1972–78.

A distinctive characteristic of the Mexican reform is that, contrary to the Chilean reform, it proceeded at an uneven pace. In particular, while most of the manufacturing sector—with the exception of automobiles—experienced a significant reduction in protection in the early stages, agriculture continues to be subject to relatively high tariffs and substantial nontariff barriers. Moreover, until very recently, the Mexican land tenure system was subject to a legal system—the ejido—that, among other things, severely restricted the market for land and distorted economic incentives in many other directions. Although most agricultural sector regulations were legally eliminated in early 1992, these reforms have not yet had a practical impact because the titling process, where property rights are actually assigned, is still in its infancy. By mid-1993 practically no ejidos had yet been converted into private landholdings.38 Also, during much of the period following the debt crisis, large fragments of the services sector in Mexico—including telecommunications and financial services—were under direct government control and subject to distortions.

Table 7.6 contains data on productivity growth in Mexico’s manufacturing sector for 1940–89.39 These figures indicate that since the trade reform period was implemented, the rate of productivity growth in the Mexican manufacturing sector has exceeded every subperiod since 1940 for which there are data. This evidence favors the view that, once the sectors actually subjected to increased competition are considered, Mexican productivity growth has indeed improved since the trade reform. This proposition is supported by results recently obtained by Weiss (1992), who used regression analysis to investigate the impact of the trade reforms on productivity and cost margins.

Table 7.6.

Mexico: Total Factor Productivity Growth in Manufacturing, 1940–90

(In percent)

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Sources: Dat a for 1940–80 are from Elias (1992); for 1985–89, from Ibarra (1992).

An important question that arises when the effects of trade reform are evaluated has to do with the speed with which productivity growth will react to the new incentives. Will the response be rapid, or will it be necessary to wait for a long time before the reforms yield results? Existing data for Chile provide some support for the idea that total factor productivity growth will react quite fast. For example, Edwards (1985) found that already by 1979—the year the trade reform reached its goal of a uniform 10 percent import tariff—aggregate total factor productivity growth in Chile had reached 5.4 percent, significantly higher than the historical level. More recently, Agacino, Rivas, and Román (1992) found that total factor productivity growth averaged 3.9 percent a year during 1976–81, greatly exceeding the historical average of approximately 1 percent. These author salso found significant variations across industries during 1976–81. In some industries, for example, wood products and glass industries, average productivity growth exceeded 10 percent a year, while in others, for example, nonelectric machinery, it was negative.

Trade Reforms and Exports

An important goal of trade reform has been to reduce the traditional degree of antiexport bias of Latin American trade regimes and to generate a surge in exports. In fact, based on the East Asian model, Latin American leaders have increasingly called for the transformation of the external sector into the region’s engine of growth. As pointed out previously, it is expected that the reduction of this traditional antiexport bias will take place through three channels: a more competitive—that is, more devalued—real exchange rate; a reduction in the cost of imported capital goods and intermediate inputs used in the production of exportables; and a direct shift in relative prices in favor of exports.

The volume of international trade in Latin America, and, in particular, that of exports, increased significantly after the reforms were initiated (see, for example, Nogués and Gulati, 1992). Although the volume of exports for the region as a whole grew at an annual rate of only 2 percent between 1970 and 1980, it grew at a rate of 5.5 percent between 1980 and 1985 and at an annual average of 6.7 percent between 1986 and 1990. The real value of exports, however, has evolved at a somewhat slower pace because the terms of trade in every subgroup of countries underwent a significant deterioration during 1980–93 (see United Nations, 1992). Although, strictly speaking, it is not possible to attribute this export surge fully to the reforms, there is significant country-specific evidence suggesting that a more open economy and, in particular, a more depreciated real exchange rate, has positively affected export growth.40 Some countries, notably Costa Rica, also implemented a battery of export-promotion schemes, including tax credits—through the Certificado de Abono Tributario— duty-free imports, and income tax exemptions. However, some authors, including Nogues and Gulati (1992), have argued that these systems have been fiscally expensive and have not been an effective way of encouraging exports.41

Table 7.7 presents detailed country-level data on the rate of growth of the total value of exports (in constant dollars) for three different periods.Table 7.8 contains information on the evolution of export volume for 1970–93. A number of facts emerge from these tables. First, while exports have grown rapidly for the region as a whole, there are nontrivial variations across countries; some countries have experienced a decline in the real value of exports—for example, Peru. Second, export performance during the subperiods 1982–87 and 1987–92 has not been homogeneous. In the majority of the countries, exports performed significantly better during 1987–92 than in the previous five years, reflecting, among other things, the fact that it takes some time for exports to respond to greater incentives.

Table 7.7.

Selected Latin American Countries: Value of Exports of Goods and Nonfactor Services

(Annual percentage growth rates in constant prices)

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Source: World Bank, International Economics Department database.

Preliminary.

1974–80.

An interesting fact that emerges from these tables is that in the country that has lagged behind in terms of trade reform—Ecuador—the performance of export volume has been, in recent years, below the 1970–80 historical average. In contrast, in two of the early reformers—Bolivia and Chile—exports were very strong during 1987–90.

The Chilean case is particularly interesting. Since most of its liberalization effort was undertaken prior to 1980, there are enough data points to provide a more detailed evaluation of the export response to the new regime. Between 1975 and 1980—when tariffs were reduced to a uniform 10 percent and nontariff barriers were completely eliminated—the performance of Chilean exports was spectacular, growing (in volume terms) at an average of 12 percent a year—many times higher than the historical average of 1960–70 of only 2.6 percent a year. What is particularly impressive is that most of the export surge took place in the nontraditional sector (United Nations, 1991).

The story of Chile’s success in the past few years is closely related to a boom in agriculture, forestry, and fishing exports. During 1960–70, Chile was basically a net importer of agricultural goods, whereas today, agricultural, forestry, and fishing exports play an increasingly important role in the Chilean economy. In 1970, Chile exported US$33 million in agricultural, forestry, and fishing products; by 1991 this figure had jumped to US$1.2 billion. This figure excludes the manufactured goods that are based on the elaboration of the agriculture sector. There is little doubt that economic policy lies behind the stellar performance of the Chilean agriculture and export sectors in the past years. First, the liberalization of international trade substantially lowered the costs of agricultural imported inputs and capital goods, making the sector more competitive. In fact, the liberalization of international trade put an end to a long trend of discrimination against agriculture. In contrast, Mexican agriculture has not yet benefited from the very recent liberalization measures. For example, the reform of the old ejido system has not yet occurred. Second, the exchange rate policy pursued aggressively in Chile since 1985 has provided clear incentives for the expansion of exports. However, as is discussed in some detail in the section on real exchange rate behavior and capital flows, the current trend toward real exchange rate appreciation represents a cloud in the future of the sector. A third, fundamental policy-based explanation of the success of the Chilean agriculture has to do with the pursuit of a stable macroeconomic policy. This has allowed entrepreneurs to have confidence in the system and to plan their activities over the longer run. Many of the export-oriented agricultural activities have required sizable investments that are undertaken only in an environment of stability and policy continuity. Fourth, the strict respect for property rights, and the emergence of a stable and legal framework, also had significant, positive effects on the evolution of Chilean agricultural exports.

As Tables 7.7 and 7.8 show, Mexico has exhibited a slower rate of growth of total exports in the postreform period than during 1970–80. This, however, is largely an illusion stemming from the fact that during the 1970s Mexico’s oil production increased rapidly—at a rate exceeding 18 percent a year. When nontraditional exports are considered, the post-reform performance is remarkable, with an annual average rate of growth for 1985–91 of more than 25 percent (see Table 7.9).42

Table 7.8.

Selected Latin American Countries: Volume of Exports of Goods

(Annual percentage growth rates)

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Source: United Nations, Economic Commission for Latin America and the Caribbean, Statistical Yearbook for Latin America, various issues.

Preliminary.

Table 7.9.

Share of Nontraditional Exports

(In percent of total exports)

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Source: United Nations, Economic Commission for Latin America and the Caribbean, Economic Survey of Latin America, various issues.

Industrial products.

1989 data; subsequent data are classified differently.

1990 data.

Manufactured products.

After two successive years of decline, the volume of exports in Brazil increased rapidly during 1992, to 4.9 percent. In 1993, Brazilian exports expanded by almost 12 percent in volume terms. Although it is too early to determine what forces are behind this rapid growth, and whether it will be sustained, there is some indication that the highly depreciated real exchange rate and the reduction in the degree of protection in the country have helped increase the degree of international competitiveness of Brazil’s exports.43 This interpretation is supported by recent empirical results by Bonelli (1992), who found that productivity growth in Brazil’s manufacturing sector has been positively affected by export orientation.

A stated objective of trade reforms has been to increase the degree of diversification of exports. Table 7.10 contains data for 12 Latin American countries on the share of manufacturing exports and shows that following the trade reforms their importance has increased steadily in the early reformers—Bolivia, Chile, and Mexico. Also, in the majority of the countries, the share of the ten most important export goods in total exports has declined significantly in the last few years (United Nations, 1991).

Table 7.10.

Exports of Manufactured Goods

(In percent of total)

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Source: United Nations, Economic Commission for Latin America and the Caribbean, Statistical Yearbook for Latin America, various issues.

1990 data.

A somewhat troublesome recent development is that during 1993 the rate of export growth (measured in constant value) has slowed down significantly in many Latin American countries. The slowdown is the result of a number of factors, including the sluggishness of the world economy, the slowing down of productivity gains, and, especially, the recent trends toward real exchange rate appreciation observed in most countries in the region.

Real Exchange Rate Behavior, Capital Inflows, and the Future of Trade Reforms

In the past few years, competitive real exchange rates have been at the center of the vigorous performance of most of Latin America’s external sectors. In fact, trade reforms have been driven by highly competitive real exchange rates, making Latin American products very attractive in world markets. However, as pointed out previously, in most Latin American countries real exchange rates have recently experienced significant real appreciations and losses in competitiveness. Chart 7.1 presents the evolution of real exchange rates for selected countries.

Chart 7.1.
Chart 7.1.

Real Effective Exchange Rates in Selected Latin American Countries

(1985= 100)

Note: An increase in the index denotes a real depreciation.Source: IMF, International Financial Statistics, various editions.

These real appreciations and losses in international competitiveness, which have generated considerable concern among policymakers and political leaders (see Calvo, Leiderman, and Reinhart, 1992), result from two developments: first, a large number of countries are using exchange rate policy as an anti-inflationary tool, and, second, recent massive capital inflows into Latin America have made foreign exchange “overabundant.”

Tables 7.11 and 7.12 contain data on capital inflows into Latin America and show that, after eight years of negative resource transfers, there was a significant turnaround in 1991–92. The increased availability of foreign funds has affected the real exchange rate through increased aggregate expenditure. A proportion of the newly available resources has been spent on nontradables—including the real estate sector—putting pressure on their relative prices and on domestic inflation. An interesting feature of the recent capital movements is that a large proportion corresponds to portfolio investment and relatively little is foreign direct investment. As can be seen, Mexico has been the most important recipient of foreign funds in the region in the past few years. Indeed, this large availability of foreign financing has allowed that country to have a current account deficit of 5–6 percent of GDP. An important question is whether these inflows are sustainable, or whether a decline in the level of funds available is foreseen in the near future.

Table 7.11.

Latin America: Capital Inflows and Net Resource Transfers

(In billions of U.S. dollars)

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Source: Jaspersen (1992).
Table 7.12.

Selected Latin American Countries: Net Capital Inflows

(In percent of GDP)

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Sources: World Bank, International Economics Department database (GDP); and IMF, Balance of Payments Statistics database (capital Inflows).

Preliminary.

Real exchange rate appreciations generated by increased capital inflows are not a completely new phenomenon in Latin America. In the late 1970s, most countries in the region, but especially those in the Southern Cone, were flooded with foreign resources that led to large real appreciations. The fact that this previous episode ended in the debt crisis has added drama to the current concern about the possible negative effects of these capital flows.

Whether these capital movements are temporary—and thus subject to sudden reversals, as in 1982—is particularly important in evaluating their possible consequences. In a recent study, Calvo, Leiderman, and Reinhart (1992) argued that the most important causes of the generalized inflow of resources are external. In particular, their empirical analysis suggests that these capital movements were triggered primarily by the recession in the industrial world and the reduction in U.S. interest rates. These authors suggest that once these world economic conditions change, the volume of capital flowing to Latin America will decline. At that point, the pressure on the real exchange rate will subside, and a real exchange rate depreciation will be required.

The countries in the region have tried to cope with the real appreciation pressures in several ways. Colombia, for instance, tried to sterilize the accumulation of reserves by placing domestic bonds on the local market in 1991.44 However, to place these bonds, the authorities had to increase the local interest rate to make them more attractive. This move generated a widening interest rate differential in favor of Colombia, which attracted new capital flows that, in order to be sterilized, required new bond placements. This process created a vicious cycle that contributed to a large accumulation of domestic debt without significantly affecting the real exchange rate. This experience shows vividly the difficulties faced by authorities wishing to handle real exchange rate movements. In particular, this case indicates that real shocks—such as an increase in foreign capital inflows—cannot be tackled successfully using monetary policy instruments.

During 1993, Argentina tried to deal with the real appreciation by engineering a pseudo devaluation through a simultaneous increase in import tariffs and export subsidies. Although it is too early to know how this measure will affect the country’s competitiveness, preliminary computations suggest that the magnitude of the adjustment obtained through a tariffs-cum-subsidies package may be rather small. Mexico followed a different route, deciding to postpone the adoption of a completely fixed exchange rate. In October 1992, the pace of the daily nominal exchange rate adjustment was doubled to 40 cents. As the unfolding of the Mexican peso crisis of December 1994 showed, this measure was clearly not enough. At this point, however, it is difficult to know how the implementation of the North American Free Trade Agreement (NAFTA) will affect Mexico’s equilibrium real exchange rate and its competitiveness.

Chile has tackled the real appreciation by implementing a broad set of measures, including conducting exchange rate policy relative to a three-currency basket, imposing reserve requirements on capital inflows, allowing the nominal exchange rate to appreciate somewhat, and undertaking significant sterilization operations. In spite of this multifront approach, Chile has not avoided real exchange rate pressures. Between December 1991 and December 1992, the Chilean bilateral real exchange rate appreciated by approximately 10 percent. As a result, exporters and agriculture producers have been mounting increasing pressure on the government for special treatment, arguing that it had broken an implicit contract by allowing the real exchange rate to appreciate. This type of political reaction is becoming more and more generalized throughout the region and has been particularly important in Colombia, adding a difficult social dimension to the real exchange rate issue.

Although there is no easy way to handle the real appreciation pressures, experience shows that the authorities have at least two options. First, in those countries where the dominant force behind real exchange rate movements is price inertia in the presence of nominal exchange rate anchor policies, the adoption of a pragmatic crawling peg system will usually help. This means that, to some extent, the inflationary targets will have to be less ambitious because a periodic exchange rate adjustment will result in some inflation.45 However, to the extent that this policy is supplemented by tight overall fiscal policy there should be no concern regarding inflationary explosions.

Second, the discrimination between short-term, speculative capital and longer-term capital should go a long way toward alleviating the preoccupations about the effects of capital movements on real exchange rates. To the extent that short-term capital flows are more volatile and capital inflows are genuinely long term—especially if they help finance investment projects in the tradables sector—the change in the real exchange rate will be a “true equilibrium” phenomenon. Policymakers should recognize them as such by implementing the required adjustment resource allocation. In practice, however, discriminating between “permanent” and “transitory” capital inflows is difficult; ultimately, policymakers are forced to make a judgment call.

Regional Trading Blocks, Multilateralism, and Industrial Country Protectionism

As the twenty-first century approaches, the world economy is moving toward the formation of a small number of trading blocs. Although the European Economic Community and NAFTA are considered the most formidable ones, a number of other trading blocs, with different degrees of cohesion, are rapidly emerging. Among these, the Association of South East Asian Nations (ASEAN), with its dynamic and aggressive members, is especially promising. This is particularly so if the formation of a yen zone in the Pacific—comprising Japan and the ASEAN countries—takes shape in the next few years.46

In the last few years, however, some new important trading blocs in the Western Hemisphere have emerged and are now attracting increasing attention from policy analysts. Among these, the Southern Cone Common Market (Mercosur) and the Andean Pact, which jointly comprise nine Latin American countries, are two of the most important ones and have a volume of international trade that is expected to approach US$250 billion a year by the year 2000.47 What makes this new integrationist effort in Latin America particularly interesting is that it is taking place within a context that strongly favors export promotion and the expansion of international trade throughout most of the developing world.

In addition to the somewhat large, multimember trade agreements, there has recently been a proliferation of bilateral integration agreements. Table 7.13 presents a brief summary of trade agreements negotiated since 1990. The majority of the Latin American countries have expressed keen interest in joining NAFTA and see the bilateral—or, for that matter, small multilateral—agreements as an intermediate step. Table 7.14 contains data on the evolution of intraregional trade, and Table 7.15 on bilateral trade for selected countries. Several important facts emerge from these tables. First, after having reached a low in 1985, intraregional trade has expanded greatly in the past few years. Contrary to popular belief, intaregional trade as a proportion of total trade is still significantly below its 1975–80 level. This means that there is significant room for further expanding intraregional trade. In this context, it is notable that intraregional trade in East Asia accounts for almost 30 percent of total trade. In a recent study, Losada (1993) found that, with reduced trade impediments, distance is the main determinant of bilateral trade.

Table 7.13.

Regional Integration Agreements in the Americas After 1990

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Sources: Lustig (1994); and World Bank.
Table 7.14.

Intraregional Trade in Latin America and the Caribbean

(Intraregional exports as percent of total exports)

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Source: IMF, Direction of Trade Statistics.
Table 7.15.

Intraregional Exports

(f.o.b. values; percent of total)

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Source: IMF, Direction of Trade Statistics.

Data through October 1993 except for exports from Argentina to Brazil, which correspond to May 1993.

Mercosur

Mercosur is a trade agreement signed by Argentina, Brazil, Paraguay, and Uruguay in 1991.48 Its main goal is to eliminate all tariffs for intraregional trade by December 1994 and to establish a common external tariff that would guide international trade between the member countries and the rest of the world. What is particularly interesting about MERCOSUR is that it groups the two largest countries in South America—Argentina and Brazil—with two of the smallest.49 Table 7.16 contains data on some basic indicators for these countries, as well as for Andean Pact members (see below). These data highlight some of the differences across the countries, including size, recent performance, and extent of international indebtedness. There is little doubt that the future of MERCOSUR will depend on the policies of Argentina and Brazil; Uruguay and Paraguay, as smaller members, will play a limited role in the political-diplomatic process that will determine the actual characteristics of the agreement.

Table 7.16.

Economic Indicators for Mercosur and Andean Pact Countries

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Sources: World Bank, World Development Indicators (1993); International Economics Department databases; and country department staff estimates.

Calculated according to the World bank Atlas method.

1991 data.

Exports of goods and nonfactor services, in constant prices.

Growth in GDP deflator, compound rate.

Note: All 1992 data are preliminary estimates.

Table 7.16, however, does not capture some important recent economic developments that are likely to affect the future of this agreement. Although Argentina has recently been able to make substantial progress in attaining macroeconomic stability and in launching an ambitious privatization program, Brazil has faced economic and political problems. The resignation in 1992 of President Fernando Collor de Mello added further uncertainty to the future of Brazil’s reform programs. Brazil’s inability to control inflation is particularly serious. In fact, there is widespread agreement that many of the troubles encountered by early integrationist attempts in Latin America during the 1960s and 1970s had their roots in the marked differences in countries’ macroeconomic performance, including inflation and exchange rate policies.50

The differences in strategy regarding the speed and depth of privatization and trade reform suggest that disagreements could easily erupt between Argentina and Brazil on points closely related to MERCOSUR. In particular, an increasingly large number of observers in Argentina are concerned that Brazil will insist on a higher common external tariff (CET) than what would be acceptable to Argentina. The current structure of protection in the individual members of MERCOSUR, discussed above, shows that there may indeed be some room for disagreement. Whereas Argentina has recently embraced a significant free trade stance—slashing tariffs, reducing nontariff barriers considerably, and completely eliminating export taxes-Brazil is aiming at a higher and more variable tariff structure.

Table 7.17 contains data on the recent level of intraregional trade for MERCOSUR members. It shows that intraregional trade is more important for Argentina (with 17 percent) than for Brazil (11 percent).51 This suggests that it is, in fact, Argentina that is bound to lose more if MERCOSUR is aborted. From a political-economy perspective, it is likely that in negotiations regarding policies toward third parties, Brazil may have an important edge. If it does, and if MERCOSUR is implemented around high import tariffs—with a range of 0–40 percent, which corresponds to the Brazilian liberalization target—it is unlikely that its members would experience a net gain over the long run. More specifically, if Argentina joins a trade agreement with a common external tariff set at the Brazilian level, the likely result will be trade diversion, which would more than offset any benefits derived from trade creation.52

Table 7.17.

Trade Among Mercosur Countries, 1992

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Source: IMF, Direction of Trade Statistics.