Abstract
This Selected Issues paper for Nicaragua reports that the Central America–Dominican Republic-United States Free Trade Agreement (CAFTA-DR) provides a general framework for country-specific bilateral agreements. In addition to the phased liberalization of trade in goods, CAFTA-DR provides broad market access for services and includes provisions in areas such as intellectual property rights, investment, government procurement, and competition policies. Labor provisions are slightly tighter than under other similar agreements by offering a platform to examine the quality of existing legislation, rather than only ensuring its implementation.
I. The Impact of CAFTA-DR on the Nicaraguan Economy1
1. Expected to promote new development opportunities to its members, the Central America-Dominican Republic-United States Free Trade Agreement (CAFTA-DR) represents a significant change in the macro-economic environment of Central America. This chapter provides an overview of what recent studies say about the expected macroeconomic impact of the Agreement. Section A presents its main features. Section B describes Nicaragua’s trade and economic relations with the other members of CAFTA-DR. Section C reviews the expected impact on trade, growth, and business cycles. Finally, section D analyzes the fiscal impact.
A. What is CAFTA-DR?
2. CAFTA-DR was signed on May 28, 2004 between the United States and Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua; the Dominican Republic joined on August 5, 2004.2 Its stated objectives are to (i) encourage expansion and diversification of trade between signatories; (ii) eliminate barriers to trade; (iii) promote conditions for fair competition; (iv) increase investment opportunities; (v) protect and enforce intellectual property rights; (vi) create procedures for the resolution of disputes; and (vii) establish a framework for further integration. As of December 2005, all countries except Costa Rica had ratified the Treaty, whose implementation is scheduled to start in early 2006.3
3. The scope of the agreement is wide and goes beyond only trade in goods. In addition to the phased liberalization of trade in goods, CAFTA-DR provides broad market access for services and includes provisions in areas such as intellectual property rights, investment, government procurement, and competition policies. Labor provisions are slightly tighter than under other similar agreements by offering a platform to examine the quality of existing legislation, rather than only ensuring its implementation. However, the investment provisions do not appear to contain mechanisms to offset the potential impact on the balance of payments of transfers related to a wide range of financial and direct investments. The Treaty also provides dispute resolution procedures. CAFTA-DR comes with a commitment from the United States to provide technical assistance in the areas of sanitary and technical standards, regulation, and financial sector supervision.
4. CAFTA-DR provides a general framework for country specific bilateral agreements. While CAFTA-DR is a regional agreement under which all parties will be subject to the same set of obligations and commitments, specific provisions and, in particular, tariff elimination schedules, were negotiated on a bilateral basis between the U.S. and each country. CAFTA-DR does not incorporate provisions for intra-Central American integration.
5. The tariff elimination schedule depends on the countries and products. CAFTA-DR classifies each traded good into one of eight categories (labeled A though H), which define the period over which duties will be eliminated and the schedule of tariff reductions. Many goods will be zero rated immediately (schedule A), while the tariffs on others will be phased out over 5 to 20 years. On the U.S. side, all nonagricultural and nontextile goods will enter the U.S. duty free from day one of the implementation of the Treaty. On the Central American side, each country has a different allocation of goods to the eight categories, and hence a different time profile of tariff reduction. In the case of Nicaragua, only 4.4 percent of total imports and 16.7 percent of imports from the U.S. fall into the schedule A category. This is the lowest share in the region. In the case of Costa Rica, for instance, 99.5 percent of imports from the U.S. are schedule A imports.
6. Enhanced market access to the U.S. for Central American agriculture and textile products is somewhat more limited than for other products. The agreement comprises long transition periods (up to 20 years) for several agricultural goods, and maintains import tariffs on sensitive items (such as sugar and corn), while increasing related import quotas. For textiles, the main changes will be the permanent nature of the existing preferences under the Caribbean Basin Initiative (CBI) and an easing of the rules of origin.
B. Main Features of Nicaragua Trade
7. For Nicaragua, CAFTA-DR represents one more step along the path of trade liberalization, regional integration, and increasing linkages to the U.S. that started more than a decade ago. By any standard, Nicaragua’s economy is now largely open. Exports and imports of goods and services represented 36 percent and 63 percent of GDP respectively in 2004.
8. Nicaragua’s trade openness reflects the country’s participation in several regional and bilateral trade agreements. Nicaragua is a member of the Central American Common Market (CACM, since 1960), the System of Central American Integration (SICA, 1993), the Free Trade Area of the Americas (FTAA, 1995), and the Caribbean Basin Trade Partnership Act (CBTPA, 2000). It also signed a bilateral agreement with Mexico (1998) and the CACM has a trade agreement with Chile. As a result of these agreements, Nicaragua is strongly integrated with other countries in Central America. The region as a whole has an open trade regime and, to a large extent, a common external tariff. In addition, Central America has been benefiting from preferential access to the U.S. market in the context of the CBI since 1984.
(Exports+Imports)/GDP,1994-2004 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
(Exports+Imports)/GDP,1994-2004 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
(Exports+Imports)/GDP,1994-2004 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
9. The U.S. and other CAFTA-DR members are by far Nicaragua’s main trading partners. In 2003, 36 percent of Nicaragua’s exports of goods were to the U.S., and 38 percent to the other CAFTA-DR members. Similarly, 25 percent of Nicaragua’s imports came from the U.S. and 23 percent from the other CAFTA-DR members. The importance of CAFTA-DR members as Nicaragua’s trading partners has been rising since the late 1980s. At its lowest point in 1988, trade with the U.S. and other CAFTA-DR members as a block accounted for only 7 percent of Nicaragua’s total trade. While the share of this block in Nicaragua’s total exports has been rising continuously since then (Figures 2 and 3), its share in total imports rose until 1999, but dropped markedly in 2000 and has not since recovered (Figure 4). This reflects in part the increase in oil prices, but also a steady rise in imports from Asia, and a surge in imports from Mexico following the inception of Nicaragua’s bilateral agreement with that country (Figure 5). It is possible that part of the latter actually be imports that originated in the U.S. and transited through Mexico to take advantage of NAFTA and the Mexico-Nicaragua bilateral agreement.
Nicaragua: Share of DR-CAFTA members in total exports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of DR-CAFTA members in total exports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of DR-CAFTA members in total exports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of main trading partners in total exports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of main trading partners in total exports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of main trading partners in total exports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of DR-CAFTA members in total imports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of DR-CAFTA members in total imports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of DR-CAFTA members in total imports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of main trading partners in non-oil imports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of main trading partners in non-oil imports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Nicaragua: Share of main trading partners in non-oil imports, excluding maquila sector, 1984-2003 (percent)
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
10. Outside of the maquila sector, Nicaragua exports mainly food products (Figure 6). Raw agriculture products, livestock, meat, seafood, and processed food account for three-fourth of total exports of goods (excluding maquilas). 4 Coffee and meat are the main export products (17 percent and 15 percent of exports respectively in 2004), followed by shrimp and lobsters (11 percent). Manufactured products, including processed food other than meat, account for a third of total exports. In addition, net inflows from the maquila sector amount to 22 percent of receipts of exports of goods.
Nicaragua: Share Exports by sectors, 2004 1/
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Source: BCN1/ Excluding maquilasNicaragua: Share Exports by sectors, 2004 1/
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Source: BCN1/ Excluding maquilasNicaragua: Share Exports by sectors, 2004 1/
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Source: BCN1/ Excluding maquilas11. By contrast, Nicaragua imports mainly manufactured goods and oil products. In 2004, the latter accounted for 19 percent of all imports of goods, while consumer goods accounted for 33 percent, intermediate non-oil goods 29 percent, and capital goods 18 percent.
12. Foreign direct investment (FDI) to Nicaragua has increased significantly in recent years. While it was almost nil in the 1980s, FDI rose to an estimated 4 percent of GDP in 2004. FDI inflows from the U.S. doubled from 1999 to 2002 to US$242 million.5 The scarcity of reliable data prevents a comprehensive analysis of financial capital flows between Nicaragua and other members of CAFTA-DR.
C. Trade, Growth, and Business Cycles 6
13. CAFTA-DR is likely to have substantial macroeconomic implications for Nicaragua, but the extent of these implications is difficult to assess ex ante. While the overall macroeconomic impact is expected to be positive, the literature and empirical studies are often inconclusive regarding the size, and sometimes even the sign, of detailed impacts through the various transmission channels. This section discusses the potential impacts on trade flows, foreign direct investment, economic growth, and the business cycle. The section following examines the fiscal impact.
14. Trade flows between Nicaragua and the United States could increase rapidly as a result of CAFTA-DR. Simulations using a multi-country general equilibrium model estimate that the exports of Central American countries to the U.S. could increase by 28 percent after the inception of CAFTA-DR, mainly spearheaded by textile, clothing, and processed agricultural exports. This is consistent with Mexico’s experience under the North America Free Trade Agreement (NAFTA). Mexico’s exports to the U.S. rose by more than 50 percent in U.S. dollar terms in the two years following the inception of NAFTA. Other studies argue that growth in trade flows could be even larger because of the impact of CAFTA-DR on productivity and specialization patterns, resulting from the various provisions of the agreement with regards flows of investment, financial services, and intellectual property.
15. CAFTA-DR could also contribute to an increased diversification of Nicaragua’s trade base. Evidence for this is again provided by the experience of Mexico under NAFTA. After the inception of NAFTA, Mexico’s pace of export diversification accelerated. Vertical integration increased, with member countries of NAFTA increasingly specializing in particular stages of the production process, in particular in the context of the maquilas. Intra-industry and intra-firm trade also rose significantly and contributed to trade diversification. CAFTA-DR is likely to have a similar effect on Nicaragua, which has already started to diversify its trade base.
16. FDI flows to Nicaragua are also likely to be boosted by CAFTA-DR. Recent studies show that NAFTA significantly increased the volume of FDI to Mexico, partly because of the increased vertical specialization, as well as the agreement’s effect on Mexico’s commitment to liberalization and reform programs. CAFTA-DR is expected to have a similar effect. In addition, it could help attract foreign multinational corporations to Central American countries, as NAFTA did to Mexico.
17. CAFTA-DR is expected to enhance the growth performance of Central American. Some estimates suggest that GDP in the region could be higher by 1.5 percent as a result of the impact on exports. Other studies argue that the impact could be larger, owing to the dynamic effects of higher capital accumulation resulting from increased FDI, changes in specialization patterns, and stronger productivity. However, for the full growth potential to materialize, the agreement needs to go along with sustained structural reforms, including a strengthening of the institutional framework.
18. CAFTA-DR is also likely to reduce macroeconomic volatility in the Central American region. While the comovement of business cycles between the U.S. and Central America has substantially increased on average over the past 10 years, CAFTA-DR is likely to lead to further cyclical interdependence through increased trade and financial flows. This implies that shocks originating in the U.S. would play a more prominent role in driving macroeconomic fluctuations in Central America. Since these shocks are generally less volatile than shocks specific to the region, CAFTA-DR is expected to contribute to a more stable macroeconomic environment. Also, an increase in the importance of shocks from the U.S. implies that Central American countries would be faced with more common shocks, which would facilitate the regional coordination of macroeconomic policies.
D. Fiscal Impact7
19. Over the years, Nicaragua’s reliance on trade taxes has been decreasing, thereby reducing the country’s vulnerability to the fiscal impact of CAFTA-DR. Nicaragua’s overall tax performance has been improving gradually since the mid-1900s. The ratio of tax revenue to GDP reached 16 percent in 2004. At the same time, Nicaragua diversified its sources of revenue. While customs duties accounted for some 20 percent of total tax revenues in the early 1990s, their share had fallen to 6 percent by 2004 (1 percent of GDP). Given the share and specialization of imports from the U.S., customs duties on U.S. imports accounted for 1.8 percent of total tax revenue (27 percent of import duties) in 2003, equivalent to 0.4 percent of GDP.
Nicaragua: Tax Revenues and Custom Duties
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Source: Nicaraguan authorities and staff estimates.Nicaragua: Tax Revenues and Custom Duties
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Source: Nicaraguan authorities and staff estimates.Nicaragua: Tax Revenues and Custom Duties
Citation: IMF Staff Country Reports 2006, 173; 10.5089/9781451829273.002.A001
Source: Nicaraguan authorities and staff estimates.20. The magnitude of the fiscal impact will depend on various factors, including trade diversion, import price elasticities, and the overall response of economic activity. The direct effect results from the simple application of the new tariffs to the unchanged import volumes and prices (before custom duties). It arises not only from the impact on tariff revenues, but also on the domestic taxes imposed on tariff-inclusive import values (e.g., VAT and ad valorem excises). Indirect effects result from changes in volume or prices (before tariffs) induced by the implementation of the new tariffs. In particular, CAFTA-DR may lead to trade diversion, with imports from the U.S. replacing those from third countries whose tariffs are not reduced. This, in turn, may have various effects depending on the intensity of the competition between import suppliers. For example, third country exporters may react by cutting their pre-tariff prices by enough to leave their prices after tariffs at the same level as the now tariff-free price of imports from the U.S. In both cases, revenues from customs duties would be lower than that resulting only from the direct effect. On the other hand, the tariff cuts by themselves are expected to increase the demand for imports, which should result in higher volume that would mitigate somewhat the other effects.
21. of all the signatory countries, Nicaragua is expected to face the smallest fiscal impact.8 Bronchi and Keen (2005) have carried out simulations of the immediate (i.e., first year) fiscal impact of CAFTA-DR, under various scenarios: direct effect only, or combined direct and indirect effects, the latter being assessed under different assumptions regarding the degree of substitutions and intensity of competition. In all cases, because of its low share of schedule A imports, and relatively lower share of U.S. imports, Nicaragua would be the least affected in terms of fiscal impact. The immediate direct impact would range between 0.05 percent and 0.20 percent of GDP, equivalent to 0.23 percent and 0.99 percent of total revenue respectively (Table 1). By contrast, the immediate direct impact could be almost 0.4 percent of GDP in Guatemala, equivalent to 3.6 percent of total revenue.
Nicaragua: Revenue Impact of CAFTA-DR First Year
Nicaragua: Revenue Impact of CAFTA-DR First Year
| Percent of tax revenue | Percent of GDP | Percent of total revenue loss | ||
|---|---|---|---|---|
| Direct impact only | 0.23 | 0.05 | 12.71 | |
| Indirect impact | ||||
| With no trade diversion | 0.28 | 0.06 | ||
| With 20 percent trade diversion | 0.42 | 0.08 | ||
| With 100 percent trade diversion | 0.99 | 0.20 | ||
Nicaragua: Revenue Impact of CAFTA-DR First Year
| Percent of tax revenue | Percent of GDP | Percent of total revenue loss | ||
|---|---|---|---|---|
| Direct impact only | 0.23 | 0.05 | 12.71 | |
| Indirect impact | ||||
| With no trade diversion | 0.28 | 0.06 | ||
| With 20 percent trade diversion | 0.42 | 0.08 | ||
| With 100 percent trade diversion | 0.99 | 0.20 | ||
22. Indirect taxes (excises and VAT) have a key role to play in responding to any revenue loss due to the implementation of CAFTA-DR. In Nicaragua, the VAT rate adjustment required to offset the custom duties loss would be quite small in the first year, but would reach almost two percentage points once full liberalization is achieved. This estimate could be reduced to the extent that the VAT efficiency is improved through measures to broaden its base and enhance its administration.
23. CAFTA-DR also strengthens the case for increased tax coordination among participant countries. In particular, the pressure to attract or retain foreign companies that seek to take advantage of the opportunities offered by the Treaty will increase further, and so will the risk to see further corporate tax reduction (direct or indirect through tax holidays and ad hoc exemptions). At a minimum, the adoption of a non-binding code of conduct, the loosest form of corporate tax coordination, would be a useful starting point for discussions.
E. Conclusions
24. CAFTA-DR will have substantial macroeconomic implications for Nicaragua. Though the extent of these implications is difficult to assess ex ante, the overall macroeconomic impact is expected to be positive; CAFTA-DR will enhance the growth performance of the Central American region. The main effects for Nicaragua are likely to be a rapid increase in trade flows with the United States, an increased diversification of the trade base, a boost of FDI inflows, and reduced macroeconomic volatility. Of all the signatory countries, Nicaragua is expected to face the smallest fiscal impact, mainly owing to a favorable schedule of tariff reductions. Sustained structural reforms, including a strengthening of the institutional framework, would ensure that Nicaragua reaps the full benefits of the agreement.
References
Bronchi, C. and Keen, M., 2005, “Trade liberalization and tax coordination,” in Central America: Global Integration and Regional Cooperation (Chapter III), IMF occasional paper 243, edited by Markus Rodlauer and Alfred Schipke.
CAFTA-DR: the full text, including tariff schedules, is accessible on line at: http://www.ustr.gov/Trade Agreements/Bilateral/CAFTA/CAFTA-DR_Final_Texts/Section_Index.html
Kose, A., Rebucci, A. and Schipke, A., 2005, “Macroeconomic implications of CAFTA,” in Central America: Global Integration and Regional Cooperation (Chapter II), IMF occasional paper 243, edited by Markus Rodlauer and Alfred Schipke.
Monge-Gonzalez, R., Castro-Leal, F. and Saavedra Gutiérrez, D., 2005, “Nicaraguan Agriculture and CAFTA,” document to be Published by the Nicaraguan Ministry of the Economy, with technical support by the World Bank and Cosude.
Prepared by Jean-Francois Dauphin.
In addition, on February 18, 2005, members signed an Environmental Cooperation Agreement and an Understanding Regarding the Establishment of a Secretariat for Environmental Matters under the CAFTA-DR, with a view to establishing a framework for cooperation in environmental protection.
Nicaragua’s National Assembly approved the Treaty on October 10, 2005.
Maquilas are factories where imported inputs are assembled into final or semi-final goods that are themselves exported.
Source: U.S. Department of Commerce, Bureau of Economic Analysis, in Kose, Rebucci, and Schipke (2005). Data is not reconciled with the balance of payment data from the Central Bank of Nicaragua.
