Trade Cooperation between the PRC and Latin America: Alternative CGE Scenarios

Looking forward, the rapid rise of the PRC and other East Asian economies will significantly reshape the global growth pattern, leading to a shift of global economic gravity toward Asia. This presents tremendous opportunities for expanding economic cooperation between East Asia and Latin America. To realize this potential, policy reform that supports the economic integration of the two regions will be vital.

Latin America has a long tradition in pursuing regional integration. However, after substantial progress in the 1990s, its regional integration has become lackluster in recent years. Most south-south free trade agreements in Latin America are shallow and narrow, impaired by the persistence of non-tariff barriers, behind-the-border restrictions, inadequate regional infrastructure, and weakness in national and regional institutions. The most prominent northsouth free trade agreement in the region, the North American Free Trade Agreement (NAFTA), is doing better, bringing many significant benefits to participants such as Mexico. But the effects of preferential access to the US market are falling, as the US is expanding its network of free trade agreements to economies outside the Americas and importing from these new emerging and developing partners. In recent years, reflecting the increased economic ties between Latin America and East Asia, some LAC countries have pursued free trade agreements with Asian countries, resulting in agreements such as Republic of Korea- Chile, Japan-Mexico, PRC-Chile, Japan-Chile, and, most recently, PRC-Peru. These crossregional agreements will help LAC countries to boost their underperforming exports to East Asian countries and facilitate the entry of Latin American firms to global manufacturing production networks.

Despite the progress toward greater openness and integration with regional and global economies, there has also been a risk of a resurgence of protectionism in Latin America, especially in response to rapidly growing imports from the PRC. For example, Facchini et al. (2007) found that LAC countries have a higher level of import protection toward products originating from the PRC. This is costly for them because it creates efficiency losses.

To shed some light on the possible outcome of different policy choices to promote trade cooperation between Latin America and East Asia, we conducted simulation analysis of four scenarios using a global computable general equilibrium (CGE) model with imperfect competition, increasing returns to scale technology, and firm heterogeneity in productivity. The CGE model used here has its intellectual roots in the group of multi-country applied general equilibrium models used over the past two decades to analyze the impact of trade policy reform (Shoven and Whalley 1992; Hertel 1997). In contrast to previous models, we incorporated firm heterogeneity and a fixed cost of exporting—in addition to variable trade costs—in our model. This enabled us to investigate the intra-industry reallocation of resources and the exporting decision by firms, thereby capturing the intensive and extensive margins of trade in the model.⁸

Table 4 [ PDF 12.6KB | 1 page ] summarizes the four scenarios we considered. The first scenario, labeled as LAC_CLOS, represents a pessimistic scenario under which LAC countries raise their tariffs for imports from the PRC by 50%. This scenario may not be realistic, but it reflects the potential risks of protectionism in Latin America. The second scenario, FRAG, features a world trading system that is fragmented into two trade blocs—East Asia and the Americas.⁹ It assumes that LAC countries continue to view the US as their major trade partner and form a pan-American free trade area (FTA). It also assumes that East Asian economies form an East Asia-wide FTA. The third scenario, EALAC, assumes that economic cooperation between East Asia and Latin America leads to the creation of a large cross-regional FTA between the two regions. The final scenario, EALAC_DI, augments EALAC with “deep integration” measures. In this scenario, a high-quality FTA between East Asia and Latin America is assumed to cover not only trade in goods and services, but also investment and trade facilitation. Specifically, bilateral, variable trade costs are reduced by 5% of the value of trade in both the merchandise and services sectors, and bilateral fixed exporting costs are also cut by 50% in the manufacturing and services sectors.¹⁰

Table 5 [ PDF 15KB | 1 page ] presents the simulation results on real income (measured as equivalent variation). Under the scenario of Latin America raising tariffs on imports from the PRC by 50% (LAC_CLOS), both LAC countries and the PRC would experience welfare losses, albeit at a small magnitude, partly due to the relatively small existing trade flows between them. The US, Europe, a few Asian countries, and the rest of the world would gain slightly, as the increased trade barriers against the PRC would give their products a competitive advantage over Chinese products in LAC markets. In Latin America, Mexico would experience the largest welfare loss, reflecting its high dependence on imports of manufacturing intermediate goods from the PRC. Unlike other LAC countries, Mexico has a relatively large manufacturing export base, and its manufacturing production heavily depends on imported parts and components. The PRC is the major source of electronics and auto parts imports for Mexico, and these two sectors are Mexico's leading export sectors. With the rising tariffs on imports from the PRC, the manufacturing producers in Mexico would face higher prices and fewer varieties of intermediate inputs. As a result, their costs of production would rise and exports would shrink. As shown in Table 6 [ PDF 12.1KB | 1 page ], the exports of Mexico would shrink by 1% in the wake of the tariff increase against the PRC, and its real exchange rate would depreciate. This result reveals the important economic ties between the PRC and Mexico implied by manufacturing production chains. Overall, global welfare would decline by US$2.2 billion (at 2004 prices), or 0.01% of world GDP, suggesting some—albeit small—welfare cost of protectionism in Latin America.

If two separate regional trade blocs in East Asia and the Americas were created, all members of the respective FTAs would benefit in terms of welfare and all outsiders would lose, with the exception of the PRC. Similarly to our previous findings, the PRC would lose from an East Asian FTA, reflecting the special features in the PRC's trade pattern.¹¹ In aggregate, the welfare gains from the two regional trade blocs would be 0.7% of GDP for East Asia and 0.3% of GDP for Latin America. Given the higher trade dependence of many Association of Southeast Asian Nations (ASEAN) countries, their welfare gains relative to their GDP would be much larger than those of other East Asian and LAC countries.

With the formation of an East Asia-Latin America FTA, more benefits would be created for both East Asian and LAC economies. The overall welfare gains of both East Asia and Latin America would rise by 30% compared to the scenario of separate free trade blocs for East Asia and Latin America. The welfare gains of East Asia and Latin America would be respectively 1.0% and 0.5% of GDP. However, Latin America's shift of FTA partners from the US and Canada to East Asia would lead to an uneven distribution of gains among its countries. Mexico, Chile, and Argentina would be better off compared to scenario FRAG, while other countries would be worse off. Of the two LAC subregions, South American countries would tend to gain and Central American and Caribbean countries would tend to lose due to the creation of an East Asia-Latin America FTA. This result highlights the large heterogeneity across LAC economies. The LAC countries with a higher proportion of manufacturing exports and larger trade linkages with East Asia would benefit from a crossregional FTA with East Asia. For countries with smaller manufacturing sectors and limited trade linkages with East Asia, a pan-American FTA would be more in line with their interests.

The above simulations are limited to the elimination of tariff distortions to merchandise trade. Although they provide useful insight into the economic incentives and disincentives of trade liberalization and regional integration, they may be misleading due to the neglect of deep integration. The recent wave of free trade agreements in Latin America, East Asia, and the rest of the world has gone substantially beyond conventional agreements and includes a number of “behind-the-border” issues that are typically not subject to World Trade Organization (WTO) discipline. Issues such as regulatory reforms; facilitation of customs procedures; cooperation in science and technology, media and broadcasting, electronic commerce, and information and communication technology; movement of natural persons; and human resource development, are often included in recent free trade agreements in addition to trade liberalization. Deep integration aims at reducing market segmenting effects of domestic regulatory policies through international cooperation and coordination. An FTA with these wider issues is an important vehicle of deep integration, as some sensitive crossborder and behind-the-border issues cannot be addressed under multilateral settings such as the WTO.

Scenario EALAC_DI mimics the effects of deep integration by reducing variable trade costs and fixed exporting costs in all merchandise and services sectors. Its simulation results suggest that the reward of deep integration would be significantly higher than that of traditional shallow integration. This is most evident in the remarkable real income rises in some of the most trade-dependent East Asian economies, such as Malaysia and Singapore. Although the PRC may lose from an East Asia-wide FTA or a cross-regional East Asia-Latin America FTA, it would gain significantly from deep integration between East Asia and Latin America. In contrast to a shallow East Asia-Latin America FTA, the deep integration between the two regions would benefit all LAC economies. Although Mexico and Chile would still enjoy the largest gains among LAC economies, the benefits to small economies in Central America and the Caribbean would also be substantial.

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