Toward a Renewal of Economic Integration in Latin America and the Caribbean

Globalization - Trade

This article is based on Better Neighbors: Toward a Renewal of Economic Integration in Latin America, the World Bank’s 2017 LAC Flagship Report.

Few doubt that a deeper and more robust integration into international markets is crucial for Latin America and the Caribbean (LAC) to succeed in lifting its long-term growth rate. Paradoxically, just as the region’s citizens and policy makers appear ready to embrace outwardly-oriented growth strategies, the world is not helping. The current sluggishness of global trade may be prolonged, and anti-globalization attitudes have been hardening in advanced economies. Given these global circumstances, regional integration has moved to the forefront of the policy debate in LAC, as it seems to offer a viable intermediate solution.

Whether such a response will deliver the expected growth dividends is not obvious, however. It will depend on the underlying vision of regional integration and the extent and quality of complementary domestic policies and reforms. Sustained efforts will be needed to push toward an intelligent renewal of “open regionalism” (OR), whereby an improved and more integrated LAC decidedly promotes deeper integration with the world, and vice versa.

The Case for Open Regionalism

Economic theory has long highlighted that the gains from trade depend on the characteristics of trading partners. The gains predicted by neo-classical models are greatest when trade occurs between structurally different economies. Learning models suggest that dynamic gains from trade (i.e., gains that raise the country’s production possibilities over time) are largest when a less developed country trades with knowledge hubs or countries with numerous and deep global connections. This line of reasoning clearly militates in favor of global, rather than regional integration, as LAC economies appear to have similar trade structures, do not have as many trade connections with the world as other regions, and invest little in R&D.

Why, then, pursue an OR agenda? The short answer is that the economic benefits of regional and global integration are intertwined. In particular, since the flows of goods, services, labor and capital, as well as economic performance more generally, are geographically clustered, neighboring economies have to strive to make the best of their neighborhood in order to enhance their global competitiveness. The starkest example of this concerns “regionally traded goods and services.” These face such high trade costs that they are typically only exchanged between neighboring economies. By enhancing the scope for trading in these goods and services, regional integration can generate benefits equivalent to the gains from global integration. Notable examples include electricity and land transportation, which are key inputs in other economic activities. Thus, efforts to assure the efficient provision of these types of goods and services across adjacent borders can be crucial for the region’s ability to improve international competitiveness.

Similar arguments can be made about labor markets. Migration decisions are shaped by the costs workers face in order to move and successfully adapt to another country. These costs arguably increase with distance, both spatial and cultural. Geographic proximity, coupled with cultural affinities among neighboring countries, facilitate growth-promoting flows of labor, particularly where skill complementarities exist. Additionally, new evidence that documents significant persistence in wage differentials between countries in LAC suggests that there is scope for achieving region-wide efficiency improvements by enhancing intra-regional labor mobility.

The geographic clustering of trade also implies that economies can seize learning opportunities from nearby countries. The strength with which these channels affect a country’s growth, however, is greater the higher the degree of global economic integration of its neighbors. In addition, a country’s likelihood to enter into and survive in third markets is enhanced when its trading partners already export to those markets. Both of these suggest that LAC countries are better off integrating amongst themselves as well as with the rest of the world.

Toward a Renewal of Open Regionalism

Since the 1990s, with varying timing and intensities, LAC has been pursuing a global integration agenda. Consistent with the notion of OR, this was typically done through a combination of unilateral trade liberalization and free trade agreements, especially with neighboring countries. The early momentum from the 1990s, however, has slowed in some countries and stalled in others. Moreover, insufficient attention has been given to reform efforts that seek to lower non-tariff barriers to trade and to integrate Latin American factor markets. The rest of this note illustrates what could be done going forward in the five areas that constitute the proposed renewal.

1.Tariff Liberalization: An Unfinished Agenda

Most favored nation (MFN) tariffs fell significantly in most LAC countries in the 1990s, and continued to fall well into the 2000s in many Central American countries, Mexico, and in some South American countries such as Colombia, Chile, and Peru. In other South American countries, reductions in MFN tariffs stalled. Further reductions in MFN tariffs would result in a more collectively open LAC, which, as mentioned, can facilitate entry into global export markets for countries in the region, especially to the extent that they can learn from the experiences of their regional partners.

Even countries with relatively low MFN tariffs display noticeable tariff binding “overhang,” whereby the tariff levels to which a country is committed under the WTO are higher than applied MFN rates. Tariff binding “overhang” introduces uncertainty in trade relationships as governments have the option to raise import tariffs without risking WTO-sanctioned retaliation. Reducing this overhang can stimulate local economic activity and attract foreign investment.

2.Enhancing Global Integration of the Americas through Regional Preferences

There are clear divisions within the region in terms of tariff preferences granted to regional partners. For example, the group of countries comprised by Bolivia, Ecuador, and the members of Mercosur, provide each other with fairly universal coverage of bilateral tariff preferences, but similar preferences are typically not granted to other countries in the region. By contrast, the group comprising Chile, Colombia, Peru, Mexico, and Central American and Caribbean countries, typically grants tariff preferences to most countries in LAC. Hence there is scope for additional preferential trade agreements (PTAs), especially between countries in South America and those in Central and North America, because these are precisely the countries in LAC that present the largest differences in terms of their patterns of net exports which indicates there may be substantial benefits from trade between these countries.

There also seems to be unexploited efficiency gains available via PTAs with high income countries (especially the U.S. or the EU). Pursuing these agreements can give countries in LAC access to economies with different economic structures, which can result in efficiency gains from trade specialization as well as dynamic gains from increased transfers of knowledge by deepening ties with knowledge hubs. PTAs with high-income countries can also facilitate further reductions in extra-regional tariffs. Indeed, the trends since the 2000s suggest that continued reductions in external tariffs in LAC seem to be associated with having reached preferential trading agreements with high-income countries.

3.Harmonizing Regulatory Frameworks in LAC to Achieve Global Competitiveness

Non-tariff impediments to trade are increasingly recognized as barriers to integration around the world. One example of these impediments are rules of origin requirements (RoOs) established by existing PTAs. RoOs can impose hefty administrative and compliance costs to exporting firms, costs that are aggravated by the fact that there are a growing number of PTAs and each of them establishes its own RoOs. Hence, efforts to harmonize and allow for RoOs with full accumulation can help LAC attain higher dividends from its existing PTAs. RoOs with full accumulation are those that allow products of one country of a PTA to be further processed or added to products of other countries in the PTA as if they had been produced in the latter. Thus, they allow firms to use materials from other countries without losing preferential access.

Another example of non-tariff impediments to trade are differences in regulatory frameworks, some of which are particularly problematic for the exchange of regionally traded goods and services. In the specific case of electricity, while important steps towards an integrated energy grid have been taken, especially in Central America and Mexico, countries in the region have been unable to fully capitalize on these efforts partly because of conflicting regulatory standards.

4.Reducing Distance Costs

In addition to policy obstacles, LAC faces barriers to integration related to the region’s relatively high costs associated with geographic distance. In effect, measures based on gravity models suggest that trade in LAC is more sensitive to distance than in other regions.

One reason behind this may be the poor quality of the region’s infrastructure, a key factor known to drive up trade costs. For example, while the share of unpaved roads in LAC is around 70%, it is less than 50% in the South Asia region and less than 30% in East Asia and the Pacific. Arguably, LAC needs even better road transport infrastructure than other regions, given its challenging geography.

A second reason for LAC’s higher trade costs is the region’s comparatively weaker position in the global network of maritime and air transport. LAC is largely connected to these networks via branch lines (as opposed to main lines between hubs), putting it at a disadvantage when it comes to international integration. This is partly the result of LAC ranking poorly in port efficiency. There is thus much scope for LAC to improve its position in the global system through investments that seek to improve the efficiency and infrastructure of the region’s ports.

5.Factor Market Integration

Aside from trade integration, evidence shows that there could be substantial efficiency gains through better integration of labor and capital markets. Some regional agreements in LAC have taken notice of the poten­tial benefits of pursuing policies to integrate factor markets, namely labor and capital markets. Nonetheless, even in these cases the emphasis on trade preferences overshadows the emphasis on factor market integration.

Labor market integration allows workers to flow from low productivity sectors to high productivity sectors, thus allowing for the realization of aggregate efficiency gains. In the case of LAC, there are large and persistent wage differentials between workers of similar characteristics across countries. This could be interpreted as persistent differences in productivity across LAC and therefore implies that there is scope for improving region-wide efficiency through migration.

There is also scope for greater mobility of capital across the region. This is particularly important considering the evidence that knowledge diffusion appears to decay with distance, which puts limits on the positive spillovers from FDI from faraway economies. As with trade, the direct growth dividends from intra-LAC capital flows can be boosted to the extent that LAC firms invest more in innovation and improve managerial practices.

Investment agreements can also yield collective efficiency gains through other channels, and, if enacted jointly, can magnify the benefits from global capital integration. For example, the Pacific Alliance’s Latin American Integrated Market (MILA, according to its Spanish acronym) provides a unified set of norms and reduces transaction costs for regional and global investors. Similarly, regional agreements can facilitate coordination in the provision of incentives to foreign capital among countries in the region and avoid a race to the bottom whereby countries sacrifice revenue as they compete for FDI. As a result, such coordination has the potential to maximize the positive impact of foreign capital across the region. The bottom line is that initiatives such as MILA should be seen as efforts to improve the collective investment climate.

The time is ripe to bring LAC’s open regionalism back onto center stage. The challenge lies in designing an agenda that is conducive to region-wide efficiency gains by exploiting the complementarities between regional and global integration. Importantly, the ambitious agenda presented in this note should not be seen as a substitute to domestic reforms. On the contrary, the extent to which the region as a whole can reap the benefits of OR is likely intertwined with the strength of each country’s individual reform agenda. After all, evidence suggests that successful global integration is hard to achieve without building a strong neighborhood.

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