Impact of the Western Hemisphere’s free trade agreements on the foreign sector and the sustainability of the debt José Luis Machinea 15 August 2003 Departament of Integration and Regional Programs Inter-American Development Bank

Macroeconomics and regional integration 1.Macroeconomic conditions for successful agreements 2.Macroeconomic impacts of the agreements Institutional Framework Foreign Sector Public Accounts and Debt 3. Coordination of macroeconomic policies

1.Macroeconomic conditions for successful agreements The importance of macroeconomics –Economic impacts –Political economy Stability and foreseeability of the principal macroeconomic variables The performance of the region –Inflation –Fiscal deficit –Growth –Debt –Institutions and investment climate

2. The macroeconomic conditions for successful agreements: Exchange systems Low volatility of the real rate of exchange Flexible or rigid rates of exchange Regional trade The level of dollarization Credibility and the institutions

Intra-regional trade

Dollarization

Macroeconomics and regional integration 1.Macroeconomic foreseeability 2.Macroeconomic impacts a) Institutions and integration b) Foreign sector c) Public accounts and debt 3. Macroeconomic coordination

a) Institutions and Integration Characteristics of the partner Number of partners Depth of the agreement Commitments included in the agreement The empirical evidence

b) The foreign sector (and the rate of exchange in particular) Trade component Foreign investment Other capital movements Productivity Influence of other factors in the rate of exchange

b) The foreign sector Trade component -Level of initial protection -Size

b) The foreign sector Trade component Foreign investment Number of countries and the structure of relative prices The experience of Europe and NAFTA Econometric estimates

Number of countries and the structure of relative prices

The econometric evidence Free trade agreements generate a major increase in foreign investment Its size is larger when they allow access to a large market, i.e. if they include developed countries. Levy Yeyati et.al. (2002) estimate that the increase in the stock of FDI in Latin America as a consequence of FTAA ranges from 20% for the “large” countries to over 100% for the “small ones.” Buch and Piazolo (2000) calculate that FDI flows to the countries of Eastern Europe as a result of their entry into the EU could even double. According to a report by the Mexican CB, NAFTA accounts for between 40% and 70% of the increase in FDI in Mexico. Nevertheless, as is also shown by the pertinent studies, the agreements are not sufficient to increase investment→institutions and macro stability

Source: Alfredo Cuevas, Miguel Messmacher and Alejandro Werner Foreign Direct Investment

b) The foreign sector (and the exchange rate in particular) Trade component Foreign investment Other movements of capital Productivity Influence of other factors in the rate of exchange

b) The foreign sector (and the exchange rate in particular) Trade component Foreign investment Other movements of capital Productivity Influence of other factors in the rate of exchange

Effective real rate of exchange

Macroeconomics and regional integration 1.Macroeconomic foreseeability 2.Macroeconomic impacts a) Institutions and integration b) Foreign sector c) Public accounts and debt 3. Macroeconomic coordination

c. Impact on public accounts and the debt Tariffs and fiscal deficit The public debt Sustainability Sensitivity to certain variables The impact of the agreement on the debt

Loss of Revenue from Tariffs

c. Impact on public accounts and the debt Tariffs and fiscal deficit The public debt Sustainability Sensitivity to certain variables The impact of the agreement on the debt

Rate of growth International rate Country risk and real domestic interest rate The risk of an excessive fiscal deficit covered with foreign indebtedness (Eastern Europe)

Macroeconomics and regional integration 1.Macroeconomic foreseeability 2.Macroeconomic impacts a) Institutions and integration b) Foreign sector c) Public accounts and debt 3. Macroeconomic coordination

Macroeconomic coordination Macroeconomic stability: public good The exchange rate To adopt or to seek consensus FTAA: is it possible to generate incentives? Subregional agreements –Political will –Incentives

Conclusions Without macro stability: few benefits. The incentives to stabilize: “greater competition” Need to improve competitiveness: exchange flexibility Need to restructure the tax system Scarce incentives for coordination. Subregional agreements