TRADE CREATION IN THE CENTRAL AMERICAN COMMON MARKET

TRADE CREATION IN THE CENTRAL AMERICAN COMMON MARKET

W. T. WILFORD. Louisiana State University in N m Orlwna

In addition to the potential advantages of economic integration accru- ing to customs union participants in the form of higher growth rates stemming from larger markets, external economies, and lessened uncer- tainty, the formation of a union can increase the efficiency of resource utilization in accordance with static comparative advantage. Although there have been several studies on the impact of regional integration of the European Economic Community [21 [71 [ 141, such analysis has not yet been applied to the Central American Common Market. Determining whether the growth in intra-regional trade during the first seven years of CACM economic integration has, on balance, been of the trade creating or trade diverting variety is the focus of this paper.

1

Since Jacob Viner’s pioneering analysis of customs unions [ 161, it has been recognized that regional economic integration creates both beneficial and detrimental effects on resource allocation, with shifts that increase efficiency being labeled as “trade creating,” and shifts that reduce it identified as “trade diverting.” Trade creation occurs when the positive effects on production and consumption from the elimination of customs unions duties between countries leads to a shift in production from inefficient protected firms to those whose operations are the most efficient within the union. Trade diversion occurs when goods formerly imported from countries outside the area are replaced by goods produced within the union by firms less efficient than those that they are replacing. The net of these effects indicates, in static terms, the contribution of the customs union to improved global resource allocation.’ If trade creation exceeds trade diversion, the consequence of customs union formation is “net” trade creation.

Although the customs union is a step in the direction of freer trade, it may not result in a movement towards Paretian optimum if trade diverting effects of the common tariff wall exceed trade creating effects.

*The author is grateful to C. Fishbaugh, R. A. Labrge, T. Hocevar, and the Editorial staff Of the Western Economic Journal for their comments and to Eddie Betanco of the Agency for Inter- national Development Regional Office in Guatemala City for his valuable statistical sedces . A preliminary version of this paper was presented to the Southwestern Economic Association Meetinp in April, 1969. Responsibility for remaining errors rests solely with the author.

1. In dynamicterms short-run net trade diversion can occur and the region still be better off if other structural changes are taking place, so the analysis of net trade creation need not neces- sarily determine the long-run impact of common market formation. Nevertheless, net trade creation would be clear evidence of improvement in resource allocation. Several studies of the EEC are inconclusive in their findings regarding its trade creating effects 17 1 I IS 1 I I7 I .

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62 WESTERN ECONOMIC JOURNAL

It is generally agreed, further, that a priori judgments of the net effects of customs unions on trade flows cannot be made [ 1 I [21 [81, and R. G. Lipsey has demonstrated that under certain conditions a net trade diverting customs union can still improve welfare if the favorable consumption effect more than compensates for the trade diversion resulting from won- ened external terms of trade (81 [ l l ] . In the analysis that follows, distribution effects within the customs union are ignored, and the welfare of CACM members is assumed to increase if integration creates net static improvement in resource allocation, i.e., if net trade creation has occurred. As B. Balassa points out in his evaluation of the actual effects of inte-

gration in EEC trade flows, the rise of intra-area trade as a proportion of total intra- and extra-area exports and imports has often been cited as evidence for the trade creating effects of common markets [ 2, p. 21. The data suggest, on the basis of this measure, that the CACM has experienced significant trade creation? Balassa rejects this and other tests for trade creation, however, and indicates the need for a methodology that (a) abstracts from growth effects on trade flows, (b) ensures comparability of estimates for trade creation and diversion, and (c) provides for disaggre- @ion of results into main commodity categories [ 2, p. 21. The approach suggested by Balassa in his analysis of the EEC is used in this study.

Balassa's model assumes that the most important factor underlying the trade flows within a customs union is the formation of the union i t ~ e l f . ~ A comparison of ex post income elasticity of import demand for extra- and intra-area trade before and after the formation of the customs union, under the assumption that the income elasticities would have remained unchanged in the absence of the common market, can provide a measure of the magnitude of trade creation or diversion." The procedure allows ab- straction from the effects of economic growth on trade flows [ 2, p. 3 1 and provides for comparability of estimates on trade creation and divers i~n.~

2. Aggregate intra-regional trade of the five countries totalled $10.8 million in 1952, reached only $32.7 million in 1960, and climbed to $253 million in 1968. Between 1961 and 1967 intra- area trade rose an average annual 70 percent. Intra-area trade as a percentage of total CACM imports w a s only 3.5 percent in 1952, 7.1 percent in 1961. and increased to 20.9 percent by 1967. The sectoral composition of intra-regional trade in 1960 included: foodstuffs, 45.7 percent; manufactured products, 28.2 percent; and raw materials, 4.9 percent. By 1967 the percentage composition was manufactured products, 48.4 percent; foodstuffs. 22.3 percent; chemical products, 15.4 percent; and machinery and transportation equipment, 4.5 percent.

3. As indicated by Johnson 161, a necessary condition for trade creation in the customs union b a positive production or resource effect. The present analysisof the CACM focuses on trade flows and consequently measures only indirectly the impact of this allocation effect.

4. Income elasticity of import demand is defined an the annual percent change in imports divided by the annual percent change in gros regional product.

5. This procedure does not allow evaluation of inter-country gains and losses within the region. Such interrelationships merit additional research and d l be of particular importance as CACM countries evaluate their p i n s vlr d viS other participants. Salvador and Honduraa, in view of their July, 1969 conflict, are undoubtedly reviewing their intersountry p i n s from participation in the CACM.

WILFDRD: TRADE CREATION 43

A rise in the income elasticity of demand for intra-regional imports after the formation of the customs union indicates that “gross trade creation” has occurred, while an increase in the income elasticity of import demand for all products (extra- and intra-regional) would reflect “net trade creation.” At the same time, a fall in the income elasticity of import demand for extra-area imports would suggest “gross trade diversion,” while a fall in the coefficient for total imports would support the hypothesis that net trade diversion had occurred. In addition to measuring the aggregate trade effects, the same procedure can be applied in analyzing specific classifica- tions of imports to determine allocation effects at the disaggregated level.

Comparable data are now available to undertake preliminary analysis of the static effect of regional integration of Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. Although similar in many respects to other emerging regions in the world, these five governments are unique in that they have formed the most advanced regional economic community in the developing world. The two periods for this study are 1956 through 1961 (the “pre-integration” period), and 1961 through 1967 (the “post-integration” period). Since three of the five member governments jointly eliminated most intra-regional tariffs effective June 4, 1961, that year was chosen for the benchmark period.

Two notes of caution are indicated regarding the interpretation of the data. First, the number of observations for the disuggreguted commodity detail for the two periods are only six and seven respectively, too few to set statistically reliable confidence limits. Consequently, the conclusions for disaggregated commodity detail must be considered preliminary, repre- senting tendencies rather than exact amounts.

Second, while the periods are generally representative of normal years of Central American economic activity, any structural irregularities that caused temporary aberrations in normal trade patterns could affect the quality of the income elasticity coefficients. For example, the comparison of the periods immediately before and after integration could be affected by the combined facts that the growth rates of gross regional product were different for the two periods and that in developing regions the elasticity of demand for imports may vary with the growth rate. The rate of growth of gross regional product during the post-integration period was more rapid than the pre-integration period because of relatively high prices for Central American exports and the dynamic effects of regionalization.

Since capacity to import is partially a function of foreign exchange earnings, unusual variation in extra-area export growth during the test periods could affect the quality of the coefficients. Analysis of the data indicates: ( 1) between 1953 and 1958 extra-regional exports rose steadily

I1


and, after temporarily falling in 1958 and 1959, resumed growth;6 (2) from 1959 through 1966 such exports continued their steady increase at a rate higher than the expansion during the mid-1950’s; (3) in 1967 extra-area exports dipped sharply. As a result, the pre-integration period includes two years of absolute decline in extra-area exports which might bias the income elasticity of import demand downward, while the post-integration period includes one such year.

Steps were taken to minimize the possibility of unreliable results due to differing growth rates in the two periods. While data are not available prior to 1956 in disaggregated commodity detail, the allcommodity coefficients (Table 1) are computed and averaged for 1953 through 1961, a period that included both rapid (1953-57) as well as sluggish (1 958-59) export growth. Further, the tests for trade creation or diversion were calculated not only for aggregate trade flows, but also for categories disaggregated into commodity detail. On net balance, the sample periods were sufficiently similar to merit identification as “representative” time spans.

The year 1967 was chosen rather than 1968 or 1969 as the terminal date for the post-integration period in order to avoid distortive influences of exogenous factors on the import data during the latter years. In June, 1968 the five member countries agreed in the San Jose Protocol to raise the common tariff barrier by a blanket twenty-five percent above its prior level. The protocol, to become effective upon ratification of three member countries, represented the first agreement to undertake major alteration of the regional external tariff structure since CACM formation in 1961 .’ In addition to increasing the possibility of trade diversion by increasing tariff protection, the agreement had the effect of immediately stimulating import demand prior to ratification by three of the countries. The military hostilities between Honduras and El Salvador in July, 1969 and the subsequent closing of borders to intra-regional trade destroyed the usefulness of the 1969 trade data.

Annual income elasticity of import demand for all commodities for 1953 through 1967 is indicated in Table 1, and the ex post coefficients suggest overall net trade creation after regional integration. The coefficient for total import elasticity of demand more than doubled from an average W.6 during the 1955-61 period to +1.4 for the fmt seven years of the CACM. Based on the 1953-61 average, the increase was from M.9 to

6. The neptlve coefficients for 1958 and 1959 (Tabk 1 ) reflect both low grasr regional product growth rata and limitations on import capacity caused by abaolutely declining extra-area exports. The negative coefficients for 1961 are explained by the immediate shift from extra- to intrr-area trade after regional barriers were reduced in that year.

7. The San Jose Protocol is analyzed in a paper by Pincus 1121.

YtW 1953 1954 1955 1956 1957 1958 1959 1%0 1% 1 1962 1%3 1964 1%5 1966 1%7 Averages: 1953 -6 1 1955-61 196 1 -67

WILFORD: TRADE CREATION 65

Table 1 -Central American Common Market: Income Elasticities of Import Demand for Total, Intra-Regional, and

Extra-Regional Imports, 1953 - 1%7 Income Elasticity of Income Ehticity of Iiicome Elasticity of

Total Imports Intra-Regional Imports Extra-Regional Imports +0.6 t3.5 4.0.9 t2.1 +1.8 -0.5 -1.6 +2.7 -1.0 +1.7 t1.8 +2.0 t2.0 +1.0 t2.1

t0.9 t0.6 +1.4

t1.5 t4.2 -1.2 +o. 1 +3.7 +5.8 +9.4 +4.5 +3.8 +5.6 +3.5 +6.5 +3.7 +5.3 +4.8

+3.6 +3.7 t4.8

+0.6 +3.4 +2.4 +2.1 +1.4 -0.9 - 2.8 +4.4 - 2.0 t1.4 +1.9 + I S +1.7 +0.3 +1.2

+0.9 +0.7 t0.9

Sources: Grosa regional product data are based upon [ 5 I [9] and [ 181. Intra- and extra-regional data w based on statistics from 131 [lo] and 1131.

+I .4.* The coefficient for intra-area imports, averaging +3.6 for 1953-6 1, rose to 4.8 for the period of the CACM. The relatively high +3.6 coefficient for the pre-integration period reflects both the small base from which htra-regional trade was growing and the early attempts (led by the Eco- nomic Commission for Latin America) of individual governments to provide incentives for import substitution in manufacturing. These pro- grams intensified after 1961 with the new industrial incentives offered by individual governments, with financing for manufacturing provided by the Central American Bank for Economic Integration and, of course, with the elimination of intra-area trade barriers. The overall intra-area income elasticity of import demand rose to +4.8 during the post- integration period largely as a result of these factors.

Data, using 1953-61 as the pre-integration base, suggest that the coefficient for extra-area imports was unchanged at +0.9. When the

8. In spite of the limited number of observations, the 1953-61 mean elasticity coefficient is significantly different from the 1961-67 mean at the .9 level.


1955-61 period is compared to the post-integration period, the coefficient rose from +0.7 to M.9. With foreign aid flowing into the area throughout both periods (much of it “tied”), one would have expected higher coefficients for extra-regional imp~rts .~

XU While the aggregate data support the hypothesis that, on the whole,

net trade creation occurred during the first seven years of the CACM, there remains the possibility that specific commodities experienced net trade diversion. To test this hypothesis a similar set of coefficients was computed for disaggregated trade categories for both periods (Table 2).

Table 2-Central American Common Market: Income Elasticities of Total Imports

Average Average 1956-61 1961 1962 1963 1964 1965 I966 1967 1961-67 Category (SITC)

0 Foodstuffs +0-3 -1.2 +1.9 +1.5 +1.6 t1.2 +1.4 t2.1 +1.2 1 BeveragesandTobacco -1.0 -3.6 +2.1 +0.2 t0.2 +4.1 t1.3 +4.3 t1.2 2 Raw Materials t1.3 +5.0 +3.1 +2.3 +1.8 +1.9 +3.3 +6.7 t3.4 3 Fuelsandhbricants t1.4 +1.0 +0.2 +1.9 tO.3 -0.3 +1.0 +O.O +0.6 4 Fats and Edible Oi ls t4.9 +2.2 +4.4 -1.2 t0.5 t2.9 t8.6 -0.1 t2.5 5 Chemical Products t1.4 +0.6 t1.9 +2.0 t2.2 +1.3 tO.0 t4.6 +1.8 6 Manufactured Products

Classifiedby Material +0.7 -0.6 t1.3 +1.8 t j . 9 +2.2 tO.9 +1.9 +1.3 7 MachineryandTransport +0.8 -3.0 +2.9 +2.6 +2.5 +2.4 +1.0 +1.3 +1.4 8 Miscellaneous Manufac-

turing -0.9 -2.8 +0.1 t2.8 t1.2 t2.3 +2.5 t2.4 +1.2

6plus8 +0.3 -1.1 +1.0 +2.0 t2.0 t2.2 t1.3 +2.0 +1.3 Sources: G r o i regional product data are based on I S ] [9] (181. Intra- and extra-regional data are based on statistics from [3] [lo] [13].

Net trade diversion is indicated for two categories. The coefficient for fuels and lubricants fell from +1.4 in the pre-integration period to M.6 in the CACM period. However, petroleum products are among the few commodities not free traded within the region, and individual governments have opposed liberalized trade policies in favor of national self- sufficiency. Indeed, in 1965 Guatemalan law allowed no petroleum imports except insofar as domestic production could not meet national requirements [4]. As a result, internal economies usually associated with customs unions were not available to the petroleum industry. While the goal of national self-sufficiency through import substitution in fuels has

9. Between 1961 and 1967 foreign lending t o the CACM countries was more than $680 million, with the Agency for International Development loaning over $221 million, the Inter American Development Bank providing $244 million. and the International Bank for Reconstruction and Development supplying almost S 100 million 1191.


been achieved by several countries, the data indicate that such protective policies have encouraged high-cost inefficient refining and consequent trade diversion.

The second category evidencing net trade diversion was fats and edible oils, whose coefficient declined from +4.9 to +2.5. The high coefficient for 1956-61 was the result of an increase in 1960 imports to $5.1 million from $3 million the prior year. Excluding 1960, the average coefficient for the pre-integration period is only +1.6 for fats and edible oils.

Food represented around 10 percent of total Central American imports in 1967, and significant trade creation is indicated in the growth of the average Coefficient from +0.3 to +1.2. The statistic for raw materials rose from +1.3 to +3.4, while the chemical products (accounting for almost 20 percent of total CACM imports) figure rose from +1.4 to + I .8.

As indicated earlier, the five governments have made special effort to encourage regional manufacturing of semifiished and finished products. Intra-area trade in this category (Standard International Trade Classifica- tions 6 plus 8) rose from $12.4 million in 1961 to over $103 million in 1967. Manufacturing growth was apparently not of the diversionary sort, since the average coefficient rose from +0.3 during the pre-integration period to +1.3 for the post-integration period.

The machinery and transportation coefficient also rose, increasing from +0.8 to +1.4. Nevertheless, regional output remains an insignificant frac- tion of total area needs, amounting to only $7.6 million in 1966 while extra-area imports were $258 million. The rise in the coefficient for machinery and transportation was partially due to a non-integration event-the growth of international loans to Central America for transportation infrastructure projects and the accompanying needs for higher regional imports.

While the data at the disaggregated level support the view that improved resource allocation has been occasioned in almost all major categories that are regionally free traded, data are not available to study the extent to which “gross” trade creation or diversion has taken place, i.e., a comparison of the changes in disaggregated coefficients for intra- and extra- regional trade before and after integration. While comparable data on intra- and extra-area trade prior t o 1961 on a disaggregated basis are not available, Table 3 gives annual average coefficients by major category for the seven-year period 1961-67. Categories experiencing high income elasticity for intra-area imports since 1961 are manufacturing (average coefficient 6.8), chemical products (7.7), machinery and transportation equip ment (4.6), and fats and edible oils (4.5). Lower intra-area elasticities were observed for raw materials (3.9), beverages and tobacco (3.4), foodstuffs (2.1 ), and fuels and lubricants (-0.8). The extra-area coefficients for 196 1-


Table 3-Central American Common Market: Average - Income Elasticities of Import Demand for Intra-

and Extra-Regional Trade, 1% 1 - 1967

Category ( S I X ) Intra-Regional 0 Foodstuffs t2.1 1 Beverages and Tobacco t3.4 2 RawMaterials i3.9 3 Fuels and Lubricants -0.8* 4 Fats and Edible Oils t4.5 5 Chemical Products t7.7 6 Manufactured Products Classified by Material t 6 3 7 Machinery and Transportation Equipment t4.6 8 Miscellaneous Manufacturing t7.0

6 plus 8 t6.8

Extra-R egional t0.5 +0.8 t2.7 W.1 t1.8 t1.5 t0.8 t1.3 w.5 N.7

T h e elasticity coefficient for fuels and lubricants in 1962 was unusually high due to m macase in output from practically zero in 1961. The fwre indicated is the average coefficient 196367. Sources: Gross regional product data are based upon IS] 191 1181. Intra- and extra-regional data are baaed on statistics from 131 1101 1131.

67 were lower than their intra-regional counterparts, with the category exhibiting the highest coefficient being raw materials (2.7), followed by fats and edible oils (1.8), chemical products (1 3, machinery and transportation equipment (1.3), beverages and tobacco (0.8), manufactured products (0.8), and foodstuffs (0.5).

In summary, evidence suggests that, on balance, net trade creation has resulted from the elimination of intra-regional tariff bamers and the creation of a common external tariff wall in Central America. Thus, the CACM experiment in economic integration appears to have been suc- cessful in improving the utilization of regional resources.

REFERENCES 1. B. Balassa, The Theory ofEconomic Integratfon Homewood 1961. 2. ~, “Trade Creation and Trade Diversion in the EuropeanCommon Market,” Econ. lour..

3. Consejo Monetario Centroamericano, Bole th EstadOtico Centmamericano, AAo IV. Numcm 4. Guatemala City 1967.

4. Government of Guatemala, Decreto Ley 58. Guatemala City 1965. 5. International Bank for Reconstruction and Development. Stattstical Appendix to Economic

Development and Perspectlvrs In L a t h America Washington, D.C. (undated). 6. H. G. Johnson, “DiscfimiMtOry Tariff Reduction: A Marshallinn Analysis,” Indun lour. Of

Econ., July 1958, 38, 3947. 7. L. B. Krause, “European Economic Integration and the United States.”Am Econ. Rev.. h c . ,

May 1963, 53, 185-96. 8. R. G. Lipsey. “The Theory of Custom Unions: A General Survey,” Ecoa lour., September

9. Misibn Conjunta de Rogramacibn para Centroamerka, Cenhoomerica: Series e s t a d i d m h b

March 1967. 77, 1-21.

1960. 70, 496-513.

torlcas seleccionadas. Guatemala City, undated.


10. Permanent Secretariat of Central American Integration, Corto Informotiwq Guatemala City, various issues 1966, 1967, 1968.

11. R. L. Pfister, K. I. Rothwell. M. 0. Clement, 7’heoreticol Issues in Intemationol Economics. New York 1967.

12. J. Pincus, Origin o d Estimated Effects of the Son JON Protocol, United States Agency for International Development, El Salvador, July 1968.

13. United Nations, Yeorbook of Intentotionol StotLttlcs. New York 1956, 1959, and 1963. 14. P. 1. Verdoorn, “A Customs Union for Western Europe-Advantages and Feasibility,” World

IS. -, and F. J. M. Meyer zu Schlochtern, “Tra,de Creation and Trade Diversion in the Common Market,” Integmrion Europkne e t Rdolitd Economique, Brussels 1964, 95-1 37.

16. J. Viner, The Cus tom Unlon Issue. New York 1950. 17. J. Waelbroeck, “Le Cqmmerce de la Communautk EuropCene avec les Pays Tiers,” Integration

Europdene et RdolitC Economique. Brussels 1964, 139-64. 18. United States Agency for International Development, Data Hondbook for Lotin America.

Washington, D.C. 1968. 19. -, Regional Office for Central America and Panama, “Report of Foreign Aid Loans

Extended to Central America 1961-1967,” Guatemala City 1968.

Politic4 July 1954. 7, 482-500.

Documents

TRADE CREATION IN THE CENTRAL AMERICAN COMMON MARKET