CENTRAL AMERICA/CARIBBEAN: Trade zone pros and cons

Analysis

The expansion of manufacturing exports was behind high rates of economic growth in Korea, Taiwan, Hong Kong and Singapore between the 1950s and 1990s:

• While low wages were initially the main competitive asset in all these countries, sustained increases in labour productivity helped them gain comparative advantages in more complex products with higher value added.
• Furthermore, East Asian countries were able to use their initial success in textiles to develop new knowledge assets and export sectors.

For example, Korea moved from comparative advantages in textiles, wood products and clothing in the 1960s, to metal products and cement in the 1970s, and shipbuilding, iron and non-metal products, and road vehicles in the 1980s. Taiwan and Singapore followed a similar path, slowly upgrading the technological content of their exports.

During the 1980s and 1990s, countries in Central America and the Caribbean also moved away from traditional exports and developed new comparative advantages in manufacturing goods. In the Dominican Republic -- the most extreme case -- traditional exports have dropped to less than 4% of total exports.

The expansion of new exports has been made possible through a combination of processes, namely:

• trade incentives and technical aid from the United States through the Caribbean Basin Initiative and other special access norms in the US tariff code;
• the creation of free trade zones, which offered income tax exemptions and duty-free imports of intermediate and capital goods, and benefited from relatively efficient regulatory regimes;
• currency devaluation during the 1980s; and
• multinational corporations' search for efficient cost structures, particularly in the apparel sector.

Positive effects. The expansion of industrial production for export in free trade zones has had several positive effects in Central America and the Caribbean:

• Employment creation. According to a UN Development Programme (UNDP) report, free trade zones in 2001 provided employment for over 109,000 workers in Honduras, 86,000 in El Salvador, 37,000 in Nicaragua and 35,000 in Costa Rica. In the Dominican Republic, employment in free trade zones has increased more than tenfold over the past two decades, from 16,400 in 1980 to 170,883 in 2002.
• Export diversification. The contribution of exports from free trade zones to total exports in the region increased from 20.6% in 1995 to over 44.0% in 2003. In 2003, free trade zones provided 81% of total exports in the Dominican Republic, 60% in El Salvador, 59% in Costa Rica and 35% in Honduras. As a result, dependency on a few primary products -- such as coffee, bananas and sugar -- has sharply decreased.
• Entrepreneurial capabilities. The expansion of free trade zones has led to the emergence of a new group of dynamic domestic entrepreneurs in most countries. For example, in the Dominican Republic, firms such as Grupo M, Interamericana Products International and D'Clase Corporation are some of the largest and most productive employers and have become the leading apparel producers in the region.

Shortcomings. However, at the same time, the strategy has some shortcomings that make the 'East Asian miracle' difficult to replicate in Central America and the Caribbean:

• Low value added. Free trade zones have weak linkages with the rest of the economy because most intermediate inputs are imported or produced in house. The contribution of manufacturing exports to domestic production is limited to wages paid to workers, and does not constitute an engine of growth for the economy as a whole.
• Long-run price reduction. The apparel sector dominates production in Central American and Caribbean free trade zones. Apparel is a traditional, mature sector where competition takes place through price. Apparel prices have risen slowly during the second half of the 1950s, thus losing value with respect to other sectors in the global economy. In the United States -- the main importer of apparel from the region -- the price index for personal consumption of clothing and textiles increased by an annual average rate of 1.6% between 1950 and 1995, while the price index for aggregate personal expenditure increased by 3.6% per year.
• Difficulties sustaining export upgrading. Central America and the Caribbean -- with the partial exception of Costa Rica -- have not succeeded in moving to manufacturing sectors with higher value added and higher long-term demand growth. They continue to specialise in apparel production, and compete through low wages alone. Even when a 'full package' has been developed -- whereby apparel suppliers source, cut and sew their own fabrics, add all the complements and deliver the final product to the client -- as is the case in the Dominican Republic, this has been more a defensive strategy to meet client demands than an offensive strategy to become more profitable and productive.

Costa Rica: partial exception. High levels of social stability and human capital allowed Costa Rica to lure Intel to invest in the country in 1997. The arrival of Intel and other high tech international producers has resulted in higher real wages in the sector. It may also contribute to higher growth of Costa Rican exports and technological upgrading in the future. Nevertheless, Intel's presence does not guarantee that some of the shortcomings will be overcome of a strategy based on free trade zones:

• Value-added generated within the country is still low. Local inputs as a percentage of total inputs used in free trade zones actually decreased from 6.2% to 2.7% with the arrival of Intel.
• Export dependence on Intel and other large corporations may contribute to macroeconomic instability. Exports from free trade zones increased by more than 300% between 1997 and 1999, decreasing by 34% between 1999 and 2001. At the same time, investment income outflows in the form of profit repatriation increased from 60 million dollars in 1995 to 1.7 billion dollars in 1999 and later decreased to 347 million dollars in 2002.
• Costa Rica faces increasing competition from low-wage countries such as China in the production of semiconductors.

Outlook. The contribution of free trade zones to economic development in Central America and the Caribbean may be more uncertain than ever before. This may be an ideal time to redefine the export-led industrialisation strategies in the region:

• The elimination of the Multifibre Agreement (MFA) in January 2005 has increased competition from low-wage economies such as China and Bangladesh (see PROSPECTS 2005: Textiles, MFN erosion on trade agenda - December 1, 2004).
• Tax exemptions are to be eliminated in 2008 following a WTO agreement, thus reducing incentives to invest in the region.

Approval of the Central American Free Trade Agreement (CAFTA) between Central America, the Dominican Republic and the United States may improve access to the US market in the short run (see CENTRAL AMERICA: Pressure mounts for CAFTA approval - January 21, 2005), but will not solve other problems with free trade zones, such as low value added and specialisation in apparel.