The U.S.-Central America Free Trade Agreement (CAFTA): challenges for sub-regional integration.

Summary

On January 27, 2003, negotiations began on the U.S.-Central America Free Trade Agreement (CAFTA). Nine meetings are scheduled for 2003 between the United States and the five Central American Common Market countries: Guatemala; Honduras; El Salvador; Nicaragua; and Costa Rica, with all parties having expressed confidence that the agreement can be completed by year-end. This report provides background and analysis on the proposed CAFTA and will be updated periodically.

U.S. interests in CAFTA are broad, but the dollar value of U.S. trade with Central America represents less than 1% of U.S. foreign commerce. Thus, CAFTA may expand trade at the margin, but the effects will be small on a macroeconomic level, although no doubt important to those firms affected by the regional trade. For the United States, market access (especially for agricultural products) is a key issue. U.S. business interests generally want equal or better treatment than that afforded to exports from Canada and Mexico under their own free trade agreements with Central America. As highlighted in recent negotiations with Chile, a bilateral agreement also affords the United States a chance to delve into other issues of commercial importance such as intellectual property rights, government procurement, foreign investment, e-commerce, and services, particularly financial services.

From the Central American perspective, reducing barriers (especially for textile and agricultural products) to their largest export market and attracting foreign direct investment are cause enough to proceed. This point is directed specifically at improving and making permanent the trade benefits Central America currently enjoys under the Caribbean Basin Initiative (CBI) programs, but which require periodic reauthorization by Congress. CAFTA also would potentially increase U.S. foreign direct investment, which has been instrumental in the creation of the production sharing (maquiladora) manufacturing industries in the region. In short, CAFTA fits into Central America's strategy of developing economically through increased trade and investment.

CAFTA supporters highlight the long-term U.S.-Central American trade relationship. From the early days of independence, agricultural export promotion has been key to Central American economic growth and since 1984, the Central American nations have enjoyed a preferential trading position with the United States as beneficiaries of the CBI. More recently, U.S. trade and investment interests have turned to apparel manufacturing in maquiladoras. Geopolitical and strategic concerns are also important; CAFTA may reinforce stability by providing institutional structures that will undergird gains made in democracy, the rule of law, and efforts to fight terrorism, organized crime, and drug trafficking. CAFTA may also be a way for the United States to garner support for the Free Trade Area of the Americas. CAFTA doubters point to equally broad themes, such as the pervasive social and economic inequality perpetuated by existing economic systems, and question whether CAFTA will perpetuate or perhaps worsen the status quo. For this reason, the labor and environment provisions will be important negotiating areas to follow. U.S. firms competing with Central American imports have also registered concern.

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On January 27, 2003, negotiations began on the U.S.-Central America Free Trade Agreement (CAFTA). Nine meetings are scheduled for 2003 between the United States and the five Central American Common Market countries: Guatemala, Honduras, El Salvador, Nicaragua, and Costa Rica, with all parties optimistic that the agreement can be completed by year-end. President George W. Bush summarized the goals of CAFTA as being no less ambitious than to "strengthen the economic ties we already have with these nations ... to reinforce their progress toward economic, political, and social reform ... and to take another step toward completing the Free Trade Area of the Americas." (1)

This report provides background and analysis on CAFTA in support of Congress and its role in the trade negotiation process. Congress has defined trade negotiating objectives and the executive branch trade consultation process in Trade Promotion Authority legislation (Title XXI of P.L. 107-210). It ultimately also has responsibility for final acceptance of any trade agreement via passage of trade implementing legislation. This report will be updated periodically.

Why Trade More Freely?

Countries trade because it is in their national economic interest to do so, a proposition supported by theory and practice. Comparative advantage remains the core principle explaining the efficiency gains that can come from trade, which have now been recognized for over 200 years. It states that countries can improve their overall economic welfare by producing those goods at which they are relatively more efficient, while trading for the rest. Empirical evidence since the close of the Second World War supports this claim; countries that have adopted relatively more open trading regimes generally experienced higher levels of economic growth and development, other things equal.

Measuring and understanding the benefits of freer trade are often not straight forward processes. There is a tendency to count exports, imports, and the oftmisrepresented importance of the trade balance as indicators of the fruits of trade. This approach tends to give undue weight to exports at the expense of understanding the benefits from imports. More importantly, the true gains from trade are better understood through the increases in consumer selection, prices, and productivity that trade can bring. Comparative advantage, scale economies, and competition lead to specialized production that drives these gains and forms the basis for why most countries want to trade more freely. As developing and industrialized countries began to trade more, various issues related to these concepts may come into play. Because of lower wage levels, low-skilled, labor-intensive jobs have migrated to developing countries, where they frequently reside in production sharing (maquiladora) facilities. (2) Economists have come to refer to such specialized production as "breaking up the value added chain" and it accounts for why products as diverse as automobiles, computers, and apparel are often made or assembled in Latin America and Asia in partnership with U.S. firms. (3)

Three factors regarding the discussion of the rationalization of international trade are important. First, the discussion generally assumes that trade and free trade agreements (FTAs) are executed and implemented in a multilateral setting. In fact, given the slow process by which the World Trade Organization (WTO) negotiation rounds proceed, countries have often opted for preferential arrangements, that is regional and bilateral agreements like CAFTA. Latin America is full of them and economists are still debating the extent to which they can be trade distorting through trade diversion. This occurs when trade is redirected to countries within a limited agreement that does not take into account countries outside the agreement, which may in fact be even more efficient producers. Preferential trade agreements are also cumbersome to manage, requiring extensive rules of origin, among other administrative complexities. Finally, there is a debate whether FTAs will help move the world toward multilateral trade liberalization, as some claim. (4)

The second factor is that the benefits of trade flow broadly to all participating countries, but not all sectors of an economy are affected equally. While consumers benefit, for example, some industries and workers may actually be hurt from the adjustments to freer trade and some communities may be disproportionally affected by changes in trade rules if their economies are heavily dependent on an import competing industry. Economists generally argue that it is far less costly for society to rely on various types of trade adjustment assistance than opt for selective protectionism, the frequent and forcefully argued choice of trade-affected industries. The public policy difficulty is that both options have costs and benefits, but result in different distributional outcomes. (5)

Third, there are clearly implications in the trade negotiation process for smaller countries' bargaining leverage when they choose to negotiate with a large country in a bilateral rather than multilateral setting. Both Chile and the Central American countries realized early in the process that there were negotiating issues with which they would have little or no leverage. Neither agreement will have a trade remedies (e.g. antidumping) chapter and resolving agriculture issues will also be limited, particularly in light of ongoing WTO agricultural talks.

The Impetus for a CAFTA

It is clear that the United States has decided to move ahead with preferential trading agreements. In part, this decision has been influenced by external events, as well as broader strategic interests. With the proliferation of regional agreements around the world, trade negotiations for some countries have become a tactical issue of picking off gains where they are perceived relative to what other countries are doing. In response to this, it was repeatedly argued by the U.S. business community that the U.S.-Chile agreement, for example, was necessary to equalize treatment of U.S. businesses competing with Canadian firms that already enjoyed preferential treatment with Chile. The case is made for Central America as well, which has trade agreements with Mexico, …