Do Regional Trade Pacts Benefit the Poor?

Transcription

1 Public Disclosure Autorized Public Disclosure Autorized Public Disclosure Autorized Public Disclosure Autorized Do Regional Trade Pacts Benefit te Poor? An Illustration from te Dominican Republic-Central American Free Trade Agreement in Nicaragua Maurizio Bussolo* and Yoko Niimi** Abstract Te main objective of tis paper is to provide an ex-ante assessment of te poverty and income distribution impacts of te Central American Free Trade Area agreement on Nicaragua. A general equilibrium macro model is used to simulate trade reform scenarios and estimate teir price effects, wile a micro-module maps tese price canges into real income canges at te individual ouseold level. A useful insigt from tis analysis is tat even if te final total impact on poverty is not too large, its dispersion across ouseolds due to teir eterogeneity of factor endowments, inputs use, commodity production, and consumption preferences is significant and sould be taken into account wen designing compensatory policies. Additionally, growt and redistribution decomposition sows tat, at least in te sort to medium run, redistribution can be as important as growt. Te main policy message tat emerges from te paper is tat Nicaragua sould consider enlarging its own liberalization to countries oter tan te U.S. to boost trade-induced poverty reductions. World Bank Policy Researc Working Paper 3850, February 2006 WPS3850 Te Policy Researc Working Paper Series disseminates te findings of work in progress to encourage te excange of ideas about development issues. An objective of te series is to get te findings out quickly, even if te presentations are less tan fully polised. Te papers carry te names of te autors and sould be cited accordingly. Te findings, interpretations, and conclusions expressed in tis paper are entirely tose of te autors. Tey do not necessarily represent te view of te World Bank, its Executive Directors, or te countries tey represent. Policy Researc Working Papers are available online at ttp://econ.worldbank.org. *World Bank, 1818 H Street, NW, mailstop MC2-200, Wasington, D.C , USA. Tel: , Fax: , mbussolo@worldbank.org. ** World Bank, 1818 H Street, NW, mailstop MC3-303, Wasington, D.C , USA. Tel: , Fax: , yniimi@worldbank.org. 1

2 1 Introduction Te debate on te Dominican Republic - Central American Free Trade Agreement (DR-CAFTA) between te U.S., five Central American countries (Costa Rica, Guatemala, Honduras, Nicaragua, and El Salvador), and te Dominican Republic as been eated by te usual arguments surrounding recent trade deals. A seemingly persuasive argument against tese deals is tat altoug new jobs in Central America may be generated, tis may be done at te expense of American jobs and to te detriment of local workers ired in jobs tat do not comply wit minimum labor standards. 1 Te persuasiveness of tis argument comes from its partiality; te argument considers only te distributional effects of trade reforms and te fact tat tese reforms create winners and losers, wit te poor being most likely to be te latter. Similarly, te pro-trade-deals assumptions tat free trade indisputably favors growt and tat growt trickles down to te poor are partial and deserve scrutiny. A careful assessment of weter trade reform can be beneficial to poor people and wat can be done in te sort-term to correct potential anti-poor effects is needed to settle te debate, but it is also a difficult task. Tere are various cannels troug wic trade liberalization affects te poor as discussed in conceptual terms by McCulloc, Winters and Cirera (2001), altoug empirical evidence is rater tin, disparate and piecemeal. In tis study, a numerical simulation model a computable general equilibrium (CGE) model in conjunction wit a non-beavioral micro-simulation module based on ouseold survey data for Nicaragua 2 is used to estimate ex-ante te effects of a DR-CAFTA-like trade sock on poverty. Te CGE model as te advantage of being a counterfactual analysis tool tat can generate price effects wic are directly and unequivocally linked to a trade reform. Te canges in relative factor prices (particularly between labor and capital remunerations, and between skilled and unskilled labor wages) and relative goods prices (suc as between food and non-food items) are ten linked to te ouseold survey to generate income distribution effects. Tis metodology does not maintain full 1 See Elizabet Becker s CAFTA article on te New York Times article, April 6 t, For similar modeling frameworks see Ravallion and Cen (2004), Nicita and Olarreaga (2004), Bussolo, Lay, and van der Mensbrugge (2005), Bussolo and Medvedev (2005), Hertel et al. (2004), Iancovicina et al. (2001). 2

3 consistency between te micro data and te CGE results; owever, by combining te two, it maps aggregate results from te CGE to te detailed information available in te ouseold survey and provides a muc more nuanced and useful analysis of poverty impact. Tis approac also allows decomposing te total effect on poverty into an aggregate income growt component and a redistribution component. A useful insigt from tis analysis is tat even if te total impact on poverty is not too large, its dispersion across ouseolds due to teir eterogeneity of factor endowments, inputs use, commodity production, and consumption preferences is significant and tis sould elp in designing compensatory policies. Additionally, our growt and redistribution decomposition sows tat, at least in te sort to medium run, redistribution can be as important as growt. Te paper is structured as follows: section 2 presents te CGE model, te micro module and te relevant data. Te first part of section 3 describes te general equilibrium results of te trade policy socks, and te second part te poverty implications. Te final section presents some conclusions. 2 Measuring te effects of trade reforms on poverty: linking a CGE model to ouseold surveys Tis section describes te main features of te CGE model and ouseold survey micro-simulation module. Te Nicaragua general equilibrium model and its data A 2000 Social Accounting Matrix (SAM) represents te initial bencmark equilibrium for te CGE model. Tis SAM, wic includes 39 sectors, 39 commodities, 3 factors (skilled and unskilled labor and one composite capital), an aggregate ouseold account, and oter accounts (government, savings and investment, and te Rest of te World), as been assembled from various sources incorporating data from te 2000 Input-Output Table and te 2001 Living Standards Measurement Survey (LSMS). As 3

4 explained in more detail in te results section, te quality of te initial dataset represented by tis SAM directly influences te quality of te model results. For tis reason, particular attention as been devoted in estimating te value added, trade, and tariff components of te SAM. 3 Te CGE model is based on a standard neoclassical general equilibrium model, i.e. a model tat combines te standard consumer and producer teories and te Heckscer-Olin-Samuelson trade teory wit a compatible data-set for a specific country, and te following subsections describe its main features. Production. Output results from nested CES (Constant Elasticity of Substitution) functions tat, at te top level, combine intermediate and value added aggregates. At te second level, te intermediate aggregates are obtained combining all products in fixed proportions (Leontief structure), and te value added is an aggregation of te primary factors. Te full structure of production nests is sown in te annex. Income Distribution and Absorption. Labor income and capital revenues are allocated to ouseolds according to a fixed coefficient distribution matrix derived from te original SAM. One of te main advantages of using te micro-module is to enric tis rater crude macro distribution mecanism. Private consumption demand is obtained troug maximization of ouseold specific utility function following te Linear Expenditure System (LES). Houseold utility is a function of consumption of different goods. Once teir total value is determined, government and investment demands 4 are disaggregated into sectoral demands according to fixed coefficient functions. International Trade. Te model assumes imperfect substitution among goods originating in different geograpical areas. 5 Import demand results from a CES aggregation function of domestic and imported goods. Export supply is symmetrically modeled as a Constant Elasticity of Transformation (CET) function. Producers allocate teir output to domestic or foreign markets according to relative prices. Under te small country assumption, Nicaragua is unable to influence world prices and its imports and exports prices are treated as exogenous. Assumptions 3 For more details on te SAM, see Bussolo (2004) and te Annex to tis paper. 4 Aggregate investment is set equal to aggregate savings, wile aggregate government expenditures are exogenously fixed. 5 See Armington (1969) for details. 4

5 of imperfect substitution and imperfect transformability grant a certain degree of autonomy of domestic prices wit respect to foreign prices and prevent te model from generating corner solutions. Furtermore, tey permit te model from cross-auling a feature normally observed in real economies. Te balance of payments equilibrium is determined by te equality of foreign savings (wic are exogenous) to te value of te current account. Wit fixed world prices and capital inflows, all adjustments are accommodated by canges in te real excange rates: increased import demand, due to trade liberalization, must be financed by increased exports, and tese can expand due to improved resource allocation. Price decreases in importables drive resources toward export sectors and contribute to falling domestic resource costs (or real excange rate depreciation). Factor Markets. Labor is divided into two categories: skilled and unskilled. Tese categories are considered imperfectly substitutable inputs in te production process. Moreover, some degree of market segmentation is assumed: composite capital is sector specific, and labor markets are segmented between agriculture and non-agriculture, wit labor fully mobile witin eac of te two broad sectors, but fully immobile across tem. Tese restrictive conditions are imposed on te modeling framework so tat it mimics in te best possible and least contentious way te sort-term impact of trade reforms on te Nicaraguan economy. Dynamic features, market imperfections, and oter complications could be introduced. However, questions about te links between trade policy and growt would emerge and, altoug important, is a muc more difficult issue. 6 Finally, te segmented version of te model also facilitates linking te macro results of te CGE model to te ouseold survey micro-model, were ouseolds are not allowed to respond to price canges by migrating, increasing teir uman capital endowments, or even canging teir consumption coices. Te labor market specification is a key element of te model and an important driver of poverty and distributional results. Terefore, its specification calls for some clarification and justification. Te labor market skill segmentation 7 as become a 6 No systematic analysis of te ex-ante predictions of CGE studies exists; owever, a few papers ave evaluated tese models performance in predicting te NAFTA outcomes and ave found tat tey did not score too well, especially in terms of sectoral reallocations (i.e., relative growt rates of exports and production). Generally, tese studies igligt tat introducing dynamic effects in tese models is very difficult. For an example of tese studies on NAFTA see Keoe (2003). 7 See Taubman and Wacter (1986) for a general discussion of labor market segmentation. 5

6 standard assumption in CGE modeling and it is easily justifiable for te case of Nicaragua, were inequalities in educational endowments and access to education support tis assumption. Te assumption tat te market for labor is furter segmented into agricultural and non-agricultural activities is more controversial. To test its validity, we ceck weter incomes in agriculture are still below incomes in oter sectors once te following wage determinants are controlled for: education, experience, gender, and employment-status variables suc as self-employment. Additionally, to account for price differentials across space, geograpical variables capturing differences among Nicaraguan regions are included in te wage estimation. Taking te largest nonagricultural sector of employment, commerce, as a reference group, te regression analysis sows tat agricultural individual labor incomes are significantly below tis reference group and te gap widens between unskilled and skilled workers. Table 1: Estimation results for te labor market segmentation Wage equation for testing segmentation ypotesis - Unskilled Skilled No. of obs No. of obs. 3E+05 F(15, ) F(15, ) 9144 Prob > F Prob > F 0 R-squared R-squared Root MSE Root MSE Robust Robust Coef. Std. Err. t P> t [95% Confi. Interval] Coef. Std. Err. t P> t [95% Confi. Interval] Individual caracteristics Years of scooling E E Experience E E Experience squared E E Female Geograpical dummies urban (Managua) Pacific Central Atalantic Self-employed Sectoral dummies Agriculture Mining and gas Manufacturing Construction (Commerce) Services Government services Constant

7 Tere can be a number of reasons for observing tis income gap between agricultural and non-agricultural employment. One explanation may be tat agricultural income, in particular from self-employment, is systematically underreported. However, we control for tis by including a self-employed dummy, wic in fact sows a negative sign in support of tis ypotesis. Anoter explanation for te sectoral income differential may lie in positive externalities associated wit agricultural employment. Examples of suc externalities include food self-sufficiency and employment opportunities for oter family members. Yet, one can also easily tink of negative externalities of agricultural employment, suc as te exposure to weater socks or ard pysical work. Tese externalities are difficult if not impossible to quantify. If we accept te existence of an income differential between agriculture and nonagricultural sectors, te question ten becomes wy individuals do not respond to tis differential by moving to te non-agricultural sector until incomes in bot sectors equalize. A likely answer is tat tere must be barriers to mobility between agricultural and non-agricultural employment and tat tese barriers are relevant to te period under our analysis. A potentially important factor tat may act as a barrier to mobility, altoug we do not test for tis ypotesis, is represented by te specificity of uman capital acquired in te agricultural sector. 8 Model Closures. Te equilibrium condition on te balance of payments is combined wit oter closure conditions so tat te model can be solved for eac period. First, consider te government budget. Its surplus is fixed and te ouseold income tax scedule sifts in order to acieve te predetermined net government position. Second, investment must equal savings, wic originate from ouseolds, corporations, government and te Rest of te World. Aggregate investment is set equal to aggregate savings, wile aggregate government expenditures are exogenously fixed. 8 Results in Table 1 sow tat wage differentials also exist across oter sectors. One could tus argue tat sectoral segmentation affects labor markets beyond our assumption of te two agricultural and nonagricultural segments. However, witout additional analysis, mobility barriers among say, services and manufacturing, seem less plausible and, judging from te sectoral dummies coefficients in te estimations, seem lower tan tose between agriculture and te rest of te economy. 7

8 Te micro module: linking ouseold surveys to te CGE model Poverty effects of trade reforms are estimated using a top-down approac. Initially te CGE model calculates te new equilibrium (i.e., new relative prices and quantities for factors and commodities) following a trade sock. Ten prices are transferred to te micro module to estimate a new income distribution and poverty effects are calculated. No feedback from te micro module to te macro model is explicitly accounted for in tis version. Te following equation 9 represents te core of te micro module: W Y c = θ & 123 &, pg + θ + (1) g g labor income remit tan ces g profits consumption l (& & ) { & R { & kap T w + θ / w + θ π + θ, t g g mg tariff revenue were te relative gains or losses (W represents welfare) for eac ouseold () depend on: 1) canges in prices for purcased goods (p g, were a dot represents percentage c cange) and te initial sare of expenditure on eac good ( θ,g ); 2) canges in factor returns (w stands for returns to skilled and unskilled labor, and π is returns to capital) and l te sares of total initial income by source ( θ and θ kap ); 3) remittances and oter transfers wic depend on te wage rate and te government revenues. Income by source is calculated for eac member of te ouseold, and te above equation, to keep notation simple, sows results after aggregating incomes for eac individual in te same ouseold. Once te canges in welfare are calculated, a new distribution of income is generated and tis counterfactual distribution is ten compared to te initial distribution. Te main advantage of tis approac is tat it takes into account important sources of eterogeneity across ouseolds given tat te structure of income by type and te composition of consumption by commodity, te various θ s in te above equation, are ouseold specific. A large literature on trade and poverty 10 as sown tat canges in te distribution of income (or consumption) migt differ considerably across different 9 Te formal derivation of tis equation is presented in te Annex to tis paper. 10 See Winters et al (2004) for an excellent survey. 8

9 groups of ouseolds and tat predetermined groupings may not capture te wole spectrum of possible outcomes. Poor ouseolds temselves are poor for different reasons and designing compensatory policies tat are targeted to te rigt recipients can be greatly facilitated by aving a wole new counterfactual distribution. In te new distribution, ouseolds, as well as individuals, can be identified according to te full set of socio-economic caracteristics recorded in te survey. It is tus easier to identify a specific caracteristic suc as region of residence, employment status, gender, education, age, etc. tat may strongly correlate wit larger tan average losses from te trade policy reform and ten use tis information in targeting compensatory measures. Clearly ow tis new counterfactual distribution is generated is rater important. Te above equation only considers first order effects and excludes important second order mecanisms tat may account for large income canges. Specifically, movements in and out of employment or across sectors of production are excluded as well as substitution in consumption, altoug not accounting for te latter does not normally result in large errors. Tis approac is better suited to estimating sort run impacts and it may overestimate te effects of a trade sock, given tat quantity adjustments and substitutions are ruled out. Acknowledging tese limitations, te main advantages are transparency and low data requirements, and ease of implementation. Equation (1) implies tat, for eac ouseold, individual incomes can be readily imputed to te relevant factors of production, namely te two labor types and te composite capital. Tis is fairly straigtforward for urban wage-workers. However, for a large group of te Nicaraguan population tis imputation is not obvious. As explained in te next subsection, disaggregating income for te self-employed workers in te farm sector can be a laborious and error prone procedure; te labor and capital components are not often easily separable. For ouseolds wose eads belong to tis group of workers, an approac tat bypasses tis imputation as been used. Tis is represented by te following equation: W Y = j O O I I w C C θ j p& j θ k p& k + θ f w& f θ g p& g (2) k f g 9

10 were, as before, te relative cange in welfare is represented by a cange in consumption (te last term in te left and side of te equation), by a cange in explicit wage earnings and by profit generated via te activity run by te ouseold (te term in squared brackets). Tis is estimated as te difference between sales (olding constant te quantity sares of te different goods sold θ O j ) and input costs (again witout canging te structure of input quantities θ I j ). Finally, it sould be noted tat te consumption of ome production (autoconsumption ereafter) as been explicitly excluded from te computations in bot equations (1) and (2) given tat price canges in te sort run, and tose of te order of magnitude considered ere do not affect it. In terms of equation (2), tis means tat not only does final consumption need to exclude auto-consumption, but also tat input costs ave to be netted of te costs related to production for auto-consumption. Houseold survey data preparation and brief description of te pre-liberalization income distribution Te ouseold survey used for te computations is te LSMS 2001 for Nicaragua. At te individual level, te active employed population aged more tan 12 years are classified into skilled and unskilled according to teir education level. Te employed population is also classified into wage-workers and self-employed. For wageworkers, te entire factor-related income is eiter unskilled or skilled labor income. In te first stage, we assume tat income reported by te self-employed is assumed to ave bot a labor and a capital component. To separate tese two components, a wage for te self-employed is imputed based on a wage equation tat is estimated for te wage-workers separately for rural and urban areas. Te wage equation is a simple Mincerian wage equation wit log wage earnings as te dependent variable and education, education squared, age, age squared, and additional regional and sectoral dummies as explanatory variables. Te coefficients of tese wage equations are ten used to impute a wage for te self-employed. Te difference between te reported income from self-employment and te imputed wage is assumed to represent te capital 10

11 component of self-employment income. In rural areas, te difference sould be interpreted as a mixed factor income from land and capital, as te micro-data do not allow differentiating between tese two factors. Tis procedure yields some negative differences tat were set to zero, toug te proportion of self-employed wit an imputed wage iger tan teir reported self-employment earnings was quite low. In te second stage, equation (2) is used to estimate incomes for ouseolds wose eads were classified as self-employed farmers. 11 Total ouseold income is ten calculated by aggregating te incomes of individual ouseold members. Tis ouseold income includes, in addition to te capital income from self-employment, oter capital incomes suc as dividends, interest and property rental income. It also includes transfers tat consist of imputed rent, remittances, gifts, carities and pensions. In addition, for agricultural self-employed ouseolds, ouseold income is augmented by auto-consumption. 11 Tese two metods, namely using just equation (1) for te wole sample or a combination of te two equations applied to te relevant ouseolds, do not result in very different poverty assessments. A complete set of results across all te metods is available upon request. 11

12 Figure 1: Factor Allocation (stacked area) and food sare in consumption (line) by centile Income Population percentile SKILL UNSKILL CAPITAL TRANSFER AUTOCONSUMPTION FOOD Notes: Te unskilled, skilled, and capital stacked areas measure te percent contribution of eac factor to tat part of income wic is affected by factor price canges (auto-consumption and transfers are a large fraction of te total income of te poor but tey are not affected by price canges in te market). Te food line represents te percentage of (marketed) food consumption on total (marketed) consumption. Bot factor contributions and food percentages are measured for eac centile in te population ordered by income levels. Given tat te impact of liberalization-induced price canges on ouseolds depends on te relative importance of various income sources and on consumption patterns, it is wort examining ow Nicaraguan ouseolds earn and spend teir income. Figure 1 sows te factor income sares for Nicaragua wen its wole population is ordered in income centiles. Some salient features of te Nicaraguan income distribution are igligted by tis grap. Auto-consumption and transfers, income components not directly linked to market prices, represent a large sare of income for te poorest ouseold, up to 60%, wereas tey appear muc less relevant for te upper income centiles. Similarly, toward te top part of te distribution, unskilled labor, te most important source of income for te poorer, is substituted for skilled labor and capital revenues. Finally, food related expenses drop from about 60% of total consumption to about 40% as we move from poor to ric ouseold. Tis grap visually summarizes some key caracteristics of income 12

13 distribution for te wole population in Nicaragua. Table 2 expands te analysis of income distribution by grouping ouseolds according to income sources, sector of employment and geograpic location. Table 2: Income distribution in Nicaragua (2001), Income % by source, sector and location self-employed wages farm non-farm farm non-farm skilled unskill capital skilled unskill capital skilled unskill skilled unskill transfer autocons food % All Poor-Urban Poor-Rural NPoor-Urban NPoor_Rural Income decile (all) Income decile (urban) Income decile (rural) For te population as a wole, non-farm unskilled wages are found to be te largest source of income, accounting for almost one-quarter of total income (see te first row of Table 2). However, tere are substantial differences in tese sares depending on ow well-off te ouseold is and weter te ouseold resides in te urban or rural sector (wic is a ouseold caracteristic different from tat of earning a large sare of income from farm activities). For te poorest decile income group, bot in urban and 13

14 rural areas, transfers make up te igest sare of total income, wile capital is an important source of income only for iger income ouseolds. Skilled labor is a minor source of income for most ouseolds except for tose in te upper decile income groups in te urban sector. Regarding te consumption side, average food sare is about 51%. It remains above 50% for all rural ouseolds except for tose in te igest income decile group, wereas it is less tan 50% for te upper four income groups and drops to one-tird of total expenditure for te igest income decile in te urban sector. It sould also be pointed out tat auto-consumption as a relatively ig sare for less well-off ouseolds in te rural sector. Te implication is tat tese ouseolds are less engaged in market transaction and would benefit or suffer less from te price socks depending on weter te socks are positive or negative. Summing up, even at te ig level of aggregation of Table 2, different groups of ouseolds display a ig degree of eterogeneity more so across teir income sources tan in teir consumption patterns. Incomes appear to originate from few sources for te poor. Te rural poor earn on average 40% of teir income from te farm sector, wic is a very ig sare considering tat 36% of income is attributed to transfers and autoconsumption wile te remaining sare tat is not directly related to agriculture account for only 24%. Furtermore, tis is an average across all poor rural ouseolds; te poorest ave even iger degree of concentration in teir income sources. Figure 2 reports te Herfindal-Hirscman index of concentration calculated as te sum of te squared sares of different income sources for te ten deciles of rural ouseolds and it sows an unambiguous downward trend as income rises, meaning tat poorer ouseolds ave income originating from a more concentrated set of sources. 14

15 Figure 2: Herfindal-Hirscman index of concentration of income sources (rural ouseolds by income deciles) decile 1 decile 2 decile 3 decile 4 decile 5 decile 6 decile 7 decile 8 decile 9 decile 10 Tis strong dependence on a few income sources, especially for te poor ouseolds, may be a result of a rational coice aiming at avoiding risks, or it may reflect more limited employment opportunities due to limited skills and remote location. A consequence of tis limited number of income sources is tat it may trap tese ouseolds in teir poverty condition. Recent studies estimating ouseolds response to price incentives suc as tose induced by trade reforms sow tat poor ouseolds respond less to tese incentives. Deininger and Olinto (2000) sowed tat, for ouseolds in Zambia, te absence of key productive assets (draft animals, implements) was a major limitation in exploiting opportunities created by trade liberalization. López, Nas and Stanton (1995) found tat te level of capital inputs was, on average, directly related to te responsiveness to price incentives across a sample of farm ouseolds in Mexico. Tese suggest tat te micro analysis approac in tis paper, were no quantity response nor occupational/sectoral cange is allowed, is appropriate and tat its intrinsic bias in considering just first order effects may be less significant for te poor ouseolds tat are our primary interest. Finally, tis literature, togeter wit te segmentation regression sown above, supports te assumption of segmented markets in te CGE model, making te wole macro-micro analysis more consistent. 15

16 3 Poverty effects of trade policy reforms Tis section first presents te results of te general equilibrium model and ten te poverty estimations obtained by linking canges in te macro variables to te ouseold survey data. 3.1 Policy scenarios Te Dominican Republic-Central America Free Trade Agreement (DR-CAFTA) is a recently negotiated free trade agreement (FTA) between Central American countries (Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua), te Dominican Republic and te U.S. 12 Central American countries ave already been enjoying te preferential market access to US markets troug te Caribbean Basin Initiative (CBI) program. DR- CAFTA will not only consolidate and formalize tese existing benefits, but also provide greater market access by eliminating remaining tariffs on goods tat ave been exempted from te CBI preferences. Te agreement also incorporates a gradual opening of Central American markets for US agricultural commodities. 13 Oter main acievements of DR- CAFTA include te greater flexibility of rules of origin for textiles and apparel, commitments to elp producers meet sanitary and pytosanitary standards required for te entry into te U.S., reciprocal commitments on access to service markets, and te institutional and legal framework to ease foreign direct investment (FDI) flows to te region. 14 Besides providing almost full free access to one of teir major markets, te DR- CAFTA agreement sould assist te implementation of additional domestic market reforms, and produce significant efficiency gains due to resource reallocations toward more competitive sectors by requiring reciprocal opening. However, as brilliantly 12 DR-CAFTA was approved by te US Senate and House of Representatives in June-July 2005 and it as also been approved by te legislatures in El Salvador, Guatemala and Honduras, wile its approval is pending in Costa Rica, te Dominican Republic and Nicaragua as of writing tis paper. 13 DR-CAFTA, owever, exempts from furter liberalization some sensitive agricultural products including sugar imports to te U.S., wite maize imports to four Central American countries (El Salvador, Guatemala, Honduras and Nicaragua), and potatoes and onions to Costa Rica. 14 For more details see: (Francois et al., 2005; World Bank, 2005). 16

17 illustrated by te Cilean multi-pronged strategy of trade liberalization, 15 CAFTA is just one of te many trade options tat te Central American countries can pursue, and probably te best way to evaluate te opportunities offered by suc a regional agreement is to compare it wit a bencmark case of full liberalization. Two main scenarios are tereby considered: 1) a CAFTA type reciprocal liberalization, and 2) a full unilateral non-discriminatory trade liberalization. Te potential advantages and disadvantages of te reciprocal liberalization entailed by te regional scenario are illustrated by furter decomposing te CAFTA scenario into two separate unilateral liberalizations: first, Nicaragua liberalizes vis-à-vis te U.S., wic does not reciprocate, and ten te U.S. unilaterally liberalizes vis-à-vis Nicaragua. Altoug not being a realistic policy coice, te full unilateral liberalization provides a useful measure against wic CAFTA can be evaluated. In all te simulations, only tariffs are modified and tey are completely eliminated in one step wit no attempt to capture any sequencing across sectors or paseout periods. As mentioned earlier, eac of te simulations is based on a comparative static framework wit no capital accumulation, no canges in labor supply or skill levels, and factor market segmentation. Te sort-term time orizon implicit in tis CGE set up was assumed to focus on te immediate impact of trade socks on poverty and to facilitate communication between te macro and micro modules, were no substitution (i.e., no long term beavior) is allowed. Additional simulations were factor mobility restrictions are eliminated are carried out to complete te analysis and assess te implication of te assumption of factor markets segmentation. However, in tese cases, given te beavioral limitations imposed on te micro module, poverty and income distribution results will only be inferred from te macro results. 15 Cile started liberalizing trade unilaterally toward te end of te 1970s and ten moved toward signing trade agreements in te early 1990s, te idea being tat it could get useful concessions from trade partners tat were not available wit unilateral tariff reductions. Cile as signed Agreements wit most economies in Sout America: Bolivia, Colombia, Cuba, Ecuador, Peru, Venezuela and Mercosur. Cile as also signed standard FTAs wit te: European Union, Canada, Mexico, te United States, EFTA, Central America, and a recently ratified agreement wit Sout Korea. Besides, Cile enjoys full membersip of te WTO and benefits from te multilateral rounds of trade liberalization under te WTO s auspices. Troug tis strategy, Cile as acieved almost fully free access to most OECD markets and te oter developing countries relevant to its trade. 17

18 3.2 Trade reforms: macro results first In a general equilibrium model all relative prices and quantities are determined simultaneously. However, to disentangle te trade policy reform effects on te economy, it is elpful to describe te adjustment process as if it were sequential. First, tariffs are reduced and impact import flows, wic in turn displaces domestic production and generates resource reallocations. Tese sifts, by interacting wit factor supply and demand, determine factor prices, and combined wit new goods prices, ultimately affect te ouseold s real income level. Ten, canged ouseold incomes feed back into te system troug canges in consumption coices and te process continues until a new equilibrium is reaced. Tree main elements determine te position i.e., te values of te endogenous variables of te new equilibrium: 1) te starting level of some key variables in te initial equilibrium, i.e., te prices and quantities implicit in te initial SAM; 2) te functional forms of te model s beavioral equations; and 3) some key parameters, namely substitution elasticities among factors in te production process and, for a trade reform analysis, te elasticities of substitution in demand between domestic and imported commodities and te elasticity of transformation in supply between domestic and foreign markets. A broad consensus as emerged about te appropriate functional forms, and te model used ere is in line wit tis consensus. Te values for te elasticities ave been borrowed from te available econometric literature, owever, depending on te estimation metods as well as on te period or country considered, tese values sow considerable variation, and as created eated controversies among supporters and skeptics of tese types of models. Systematic sensitivity analysis, were all elasticities are randomly canged and results are presented wit accompanying confidence intervals, as been proposed as a solution to tese controversies. Neverteless, even tis rater computationally intensive proposal as its problems and we do not attempt it ere. Te bottom line is tat results presented ere are indicative of a likely response to te analyzed socks. In most cases, te sign and relative, if not absolute, magnitude of 18

19 te model s results for example, a finding tat gains for unskilled labor are larger tan tose for skilled labor sould be reliable. Major advantages of tis type of model are tat it represents te wole economy in a consistent and teoretically sound framework and tat te structural features of te country investigated strongly influence te final results. Table 3 sows tese features for Nicaragua in terms of sectoral sares of gross production, imports, exports and private demand; te middle panel details, for eac sector, te U.S. weigt in total trade; te rigt panel sows Nicaraguan tariffs against te U.S. and oter partners and te U.S. tariffs against Nicaraguan products. For convenience, te bottom panel of te table reports measurements for aggregate macro sectors, altoug te model s actual 28 sectors are sown in te top panel. In commenting on te results of te policy simulations, we will refer to data in tis table. Te initial import protection, bot in its level and sectoral variability, is among te key elements determining te outcome of te simulated trade reforms. Tree key features are igligted by te tariff data: 1) te overall trade-weigted protection rate is rater low, 2) its dispersion is ig wit a clear bias against agricultural imports, and 3) tariffs against te U.S. are generally above te trade-weigted average of tariffs against te Rest of te World. Table 3 also sows tat domestic Nicaraguan agricultural producers may be facing strong competition from U.S. imports, wic are 41% of total imports of agricultural commodities. It is likely tat a liberalization of U.S. imports, wic reduces an anti-agricultural import bias, would lead to an increase of competition in te agricultural sectors wit a potential initial negative sock for ouseolds strongly dependent on farming incomes. Clearly, te level of sector aggregation used in te model may exacerbate tis potentially negative outcome. It may be tat at finer sectoral levels, one finds tat imports and domestic products are complements rater tan substitutes. For example, lower feed costs could stimulate livestock and poultry productions. However, agricultural products are normally fairly omogeneous, and tus substitutable, and te risk of negative impacts sould not be completely ruled out. 19

20 Table 3: Nicaragua s economic structure (2000) Agriculture Minin gene Food Processing Oter Manufacturing Services Sectoral sares US weigt Tariffs Xp Μ Ex Xc M Us Ex Nic - Nic - US - US US ROW Nic Coffee Sugar Cane Basic Grain Oter Agri. Products Livestock Forestry Fisery Mining Electricity Gas Water Water Distribution Meat and Fis Products Sugar Producs Dairy Oter Food Beverages Tobacco Textiles Cloting & Leater Wood Products Paper Print Products Refined Oil Cemicals Glass No-Metal Products Metal Products Macinery and Equipment Construction Commerce Oter Services Transport Services Total Aggregate sectors averages --- Agriculture Food Processing Mining and Energy Oter Manufacturing Services Source: Nicaragua SAM estimated by te autor. Notes: In te left panel, Xp represents te sectoral output as a percentage of total output, M te sectoral total imports, Ex te exports sares, Xc te private consumption sares. In te middle panel, M US te initial sare of imports coming from te U.S. over total imports, Ex US te initial sare of exports going to te U.S. In te rigt panel, tere are tariffs: Nic - US and Nic - ROW are Nicaraguan tariffs against te U.S. and oter partners imports, respectively, and US - Nic are te U.S. tariffs against Nicaraguan exports. Te main macro results for te trade policy reforms are described in te following subsections. First, we examine te effects of te unilateral non-discriminatory full liberalization in te bencmark scenario. Ten, te CAFTA case is analyzed and compared wit te bencmark and te effects of tis regional agreement are decomposed into tose originating from liberalization of Nicaragua wit no response from te U.S. and tose derived from te U.S. reciprocating. Finally, to assess te sensitivity of te results to te assumption of factor markets segmentation, bot te non-discriminatory and te regional trade reforms are simulated allowing perfect factor mobility in te model. Tis set up sould more closely represent te likely impact of te reforms in te longer run, altoug no factor accumulation or explicit dynamic effects are accounted for. 20

21 Unilateral liberalization against all trading partners As outlined above, te adjustment process caused by tis reform is initially described in terms of sectoral demand and supply canges as sown in Table 4. Consider first te demand/imports side. Initial tariff rates tm 16 are igest in Agriculture and Food Processing sectors in particular in Basic Grains, Meat and Fis Products, Sugar Products and Dairy accordingly tese sectors experience te largest imports once protection is removed. Observing te aggregate results (in te bottom panel of te table), import volumes increase (ΔM) by 23% for Agriculture and 6% for Food Processing from teir pre-liberalization levels; tese increases compare wit te average 2% increase for total imports. However, imports do not represent a large sare of local demand (M/D) in Agriculture and account for just a moderate one in Food Processing. Tus, even wit a ig elasticity of substitution between local production and imports (3), te impact of increased imports on sales of domestic goods (ΔS) for Agriculture and Food Processing is very low. Compared to tese sectors, te oter manufacturing sectors suffer sligtly larger domestic sales contractions due to teir larger initial sare of import dependency despite teir lower initial level of protection. Reflecting Nicaragua s dependency on foreign production of capital goods, intermediates, and energy, imports are well above 50% of total local demand for Oter Manufacturing and just below tat tresold for energy and mining. For te oter manufacturing sectors, ceaper imports displace almost 3% of domestic production. 16 Note tat column tm in Table 4 is te trade weigted average of te Nicaraguan tariffs against US and te Rest of te World (wic are separately sown in Table 3). 21

22 Table 4: Sectoral effects of full unilateral trade liberalization Agriculture Mining Ene Food Processing Oter Manufacturing Services Imports and Local Sales Exports and production tm ΔM M/D ΔS ΔPd ΔΕx Ex/Xp ΔXp ΔPx Coffee Sugar Cane Basic Grain Oter Agri. Products Livestock Forestry Fisery Mining Electricity Gas Water Water Distribution Meat and Fis Products Sugar Producs Dairy Oter Food Beverages Tobacco Textiles Cloting & Leater Wood Products Paper Print Products Refined Oil Cemicals Glass No-Metal Products Metal Products Macinery and Equipment Construction Commerce Oter Services Transport Services Total Aggregate sectors averages --- Agriculture Food Processing Mining and Energy Oter Manufacturing Services Notes: tm represents initial tariff rates, ΔM te percent variation in total import volumes wit respect to te initial levels, M/D te ratio of imports to domestic demand (te sectoral import dependency, calculated using pre-liberalization levels), ΔS te percent variation in te volumes of domestic sales of domestic output, ΔPd te percent variation in domestic prices for local sales, ΔEx te percent variation in te volumes of exports, Ex/Xp te ratio of exports to domestic output (te sectoral export orientation), ΔXp te percent cange of domestic output, and ΔPx te percent cange of output prices. For te economy as a wole, tese low or moderate domestic market sare losses are reflected in small declines of producer prices for local sales (ΔPd). Some of tese effects are larger wen disaggregated sectors are examined, and complementary analyses considering very disaggregated sectors of production may be needed to identify specific sensitive commodities Tese usually analyses consider data at te tariff line level, i.e., at a very fine degree of disaggregation. Trade data at tis level may be available, but production, consumption and oter important data needed to calibrate CGE models are normally available at a muc more aggregate level. Terefore tariff lines analyses are normally partial equilibrium analyses and tey sould be considered in conjunction wit te general equilibrium analysis presented ere. 22