Central America and the North American Free Trade Agreement /How Does the North American Free Trade Agreement Affect Central America? / Edward E.Leamer ... [et al.]

NAFTA seems like a very troubling agreement for Central America, especially in apparel and textiles. Losses from NAFTA depend on the economic size of Mexico. Central America can gain from NAFTA provided Mexico is "big enough" to satisfy completely U.S. import demands and Central America can redirect its products from U.S. to Mexican markets.Most Central American economies experienced slower growth in the 1980s than in the 1960s and 1970s, trailing far behind the Asian Tigers. Contributing to slow growth were severe external shocks, sizable macroeconomic disturbances, and widespread political instability.The challenges Central America faces now may be even greater, conclude Leamer, Guerra, Kaufman, and Segura, because of Mexican liberalization, continuing instability of the real exchange rate, low savings rates, and, finally, the North American Free Trade Agreement.Improvements in per capita income are closely linked with exports to North America of labour-intensive manufactures. Earnings from the export of tropical agricultural products are important, but the Central American labor force is unlikely to earn higher wages unless countries diversify more into manufacturing.The Asian Tigers began their economic miracle by shifting into such labour-intensive manufactures as apparel and footwear, which they could export to a vast high wage market. But the U.S. market for such exports is now more crowded and threatens to become more so, with exports from China and other very low wage countries. With Asian competition hurting Central America's chances, it could be said that wages in Central America are set in Beijing, not in San Jose.Leamer, Guerra, Kaufman, and Segura examine the critical drivers of Central America's future competitiveness: economic liberalization, uncertainty about the real exchange rate, distance from key markets, savings rates, and NAFTA. Central American economies have low wage rates, and a considerable locational advantage over Asia in selling in North American markets, especially Mexico. But real exchange rates in Central America are more unpredictable than those in Asian countries.Central America faces a chicken and egg problem. To stabilize its terms of trade, it must expand exports of manufactures. But instability in the terms of trade deters the investments that would lead to expanded exports of manufactures. By greatly increasing Mexico's attractiveness to foreign investors, NAFTA could be the straw that breaks the camel's back, as far as Central America is concerned.For this reason, the governments of Central America need to do all in their power to increase domestic savings and reduce investment risks. Exchange rate stabilization should be carried out obviously with appropriate macroeconomic policies --- but also by encouraging exports of labour-intensive manufactures with appropriate incentives, supporting infrastructure and educational investments. The key conclusion is that the future of Central America rests importantly on exports to Mexico, a market which today is pretty much untapped. Investments in transportation infrastructure that can facilitate this emerging trade are likely to have very large payoffs for the Central American economies.This paper --- a product of the Country Operations Division, Latin America and Caribbean, Country Department II --- is a self standing summary of a longer report (Central America and the North American Free Trade Agreement) commissioned by the department and completed in August 1994. The study was funded by the Bank's Research Support Budget under the research project "Central America and a Liberalized Mexico with and without NAFTA" (RPO 67873). Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Sandra Vallimont, room I4554, extension 37791 (58 pages)The full report is available on the World Bank FTP server