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NAFTA Is Not Enough

December 17, 2003—According to a new World Bank study released today, the North American Free Trade Agreement (NAFTA) has spurred economic development in Mexico, but is not enough to achieve economic convergence with Canada and the United States even in the long run without investment in innovation, infrastructure and adequate institutions. Lessons from NAFTA for Latin America and the Caribbean Countries: A Summary of Research Findings , written in advance of the ten year anniversary of the agreement’s implementation, was prepared to help acquaint countries of the region with possible effects of the Free Trade Area of the Americas (FTAA), currently being negotiated by Western Hemisphere nations.

DevNews spoke with Daniel Lederman, co-author of the report and World Bank senior economist at the Office of the Chief Economist for Latin America and the Caribbean to learn more.

What does this report say?
This report provides some lessons from the Mexican experience that can be useful to other Latin American and Caribbean countries, most of whom are in some stage of trade negotiation with the United States.

The Mexican experience is unique because it is one of the few actual, real-life examples of a comprehensive free-trade agreement between one of the most advanced economies in the world and a developing country.

What are the lessons?
The main lesson is that a free-trade agreement is not a substitute for a development strategy. It is but one of the ingredients in a much broader development framework.

According to one of our estimates, without NAFTA, Mexico’s GPD per capita would have been 4 to 5 percent less than it was at the end of 2002. This indicates that NAFTA had a net positive effect on the economy, but a rather small one after almost a decade of implementation.

NAFTA alone hasn’t been enough to propel Mexico onto a path of fast-paced and sustainable long-term economic growth. There are some structural factors, related to domestic policies that are impeding its development.

Three key factors are constraining the country’s ability to catch up to the levels of development in the United States and Canada. They center around the quality of institutions, a lack of innovation, and deficiencies in infrastructure.

The institutional gaps in North America—levels of corruption, the lack of law and order—observed in Mexico relative to its Northern neighbors are limiting the country’s ability to grow faster.

When comparing levels of innovation and technological progress we found that Mexico not only lags behind its NAFTA trading partners, but it is lagging behind the typical (median) country with Mexico's economic characteristics. Moreover, Mexico lags behind several developing countries that seem to be superstars in terms of their level of investment in research and development (R&D), such as South Korea, Taiwan, and even China and India.

Finally, another key problem includes a lack of access to infrastructure, especially to telecommunications in the poorest Southern states of Chiapas, Oaxaca, and Guerrero, which impedes growth in those areas. This, together with the education of the labor force, were the main reasons why these states performed less favorably than other Mexican regions during the 1990s.

What do these NAFTA lessons mean for pending Free Trade Area of the Americas (FTAA)? The report’s lessons that a trade agreement alone is not enough is probably accurate for other countries in the region. Most of them have a glaring deficit in their investment levels in research and development (R&D) and inefficiencies in their innovation systems. Institutional gaps are present as well; Mexico isn’t the worst case. The lessons regarding the infrastructure gaps are also relevant.

Will the FTAA benefit the countries in Latin America?
The FTAA has not been negotiated yet. We really don’t know what it will contain in the end. However, the agreement the United States signed with Chile is very similar to NAFTA in many respects, and in others, is an improvement on NAFTA. We expect it to have a positive effect on the Chilean economy. However, Chile has invested in several areas of domestic policy to ensure that its free trade policy is but one ingredient in a much broader strategy, and they are currently thinking about how to improve its national innovation system. Our findings suggest that that’s the right approach.

Overall, we think it is worthwhile to pursue these negotiations and tailor them as much as possible to local national characteristics, but they are not enough. Just like NAFTA, the FTAA is not a development strategy per se. These countries need to pursue a broader behind-the-border agenda. That’s where the big payoffs will come from in long-term.

How do these bilateral trade agreements fit with the Bank’s position on free and open trade?
For many years we, in the Latin America and the Caribbean region of the Bank, have been saying that regional trade agreements could accompany unilateral reforms and the pursuit of a multilateral agenda. There is no inconsistency. Since the early 1990s, regional agreements haven’t hampered unilateral or multilateral trade reforms.

And Mexico was not an exception. There are gains from trade reforms that demand both trade liberalization by developing countries and market access by developed countries. We estimate that Mexico's global exports would have been between 25-30 percent lower if it hadn’t entered into NATFA, and we found no evidence that NAFTA has caused trade diversion in aggregate trade flows.

The lessons of NAFTA are consistent with the Bank’s overall global message that national trade reforms must be accompanied by reforms on the part of rich countries to open up their markets to developing country exports, because these agreements in fact demand reciprocal trade liberalization.

Another message is the importance of the behind-the-border development agenda, which has been an important part of the Bank’s global dialogue with our clients.

Nevertheless, the evidence from Mexico’s experience could be construed as showing that the benefits are not as large as those promised by their supporters. The report argues that to some extent this was due to certain remaining trade distortions that were not fully removed under NAFTA. For example, NAFTA didn’t succeed in eliminating rich countries’ agricultural subsidies, which is important for some developing countries, and some of its rules of origin are limiting the market access for Mexican firms.

This is another reason why it is important to keep pursuing the Doha Round, and another example why the FTAA, or other regional trade agreements, are not incompatible with the Doha Round. What may not succeed in an individual context could succeed in a multilateral one. The key seems to be not to drop the ball once it has been signed with the U.S.

You mentioned that one of Mexico’s main hindrances is underinvestment in research and development? Why is that?
Our statistics indicate that investment in research and development at the national level rises with the protection of intellectual property rights and the development of domestic financial systems that can help firms finance risky R&D investments. NAFTA helped with the former, but not necessarily with the latter. The level of R&D investment also seems to rise with the ability of the government to effectively mobilize public resources to support and stimulate private efforts in research and development, and these are lacking in most Latin American and Caribbean countries, including Mexico.

Latin American countries are also inefficient in using their already scarce R&D resources. There are only very weak links between the productive sector and the research community. Much work remains to be done to learn how to stimulate private research and development and establish linkages between universities, research centers, and the private sector.

These deficiencies have just recently been recognized. Since the debt crises of the recent past, the region has been focused on more glaring issues such as macroeconomic stabilization, reforms of the trade regime, a lack of safety nets for poor people, and reforms of the education system, for example.

But there was no awareness that national development and the effectiveness of education depend on synchronizing the education and innovation systems. These innovation systems include the trade regime, foreign direct investment (FDI), and the education system--improving the general quality of education, expanding the coverage of secondary education, providing financing for students interested in pursuing tertiary education -- but also the incentives facing scientific researchers and the private sector. Since trade and FDI reforms help countries tap into the global stock of knowledge, the educational system and innovation incentives need to be tailored to an open economy so that they produce the necessary skills for the labor force and higher levels of R&D investment that are necessary for successful technological adoption and entrepreneurial creativity.

It is important to link the entire education system to the productive sector so that future students, professors and researchers develop a mentality to apply their technical knowledge to potentially viable commercial ideas.

What’s next for Mexico and NAFTA?
We are currently preparing another report on the topic of deepening NAFTA for economic convergence in North America, which focuses on identifying a post-NAFTA agenda for Mexico in terms of unilateral and behind-the-border reforms. Some of the issues I’ve already mentioned are part of both agendas.

Mexico has started reforming the government’s support for private sector R&D. We are working with the authorities on that.
Mexico also needs to pursue a North American innovation agenda, together with its NAFTA partners. Mexico’s innovation system needs to be more integrated into the U.S. and Canadian national innovation systems by expanding existing student and researcher exchange programs. The United States government remains the single largest investor in research and development in the world, and even the Canadians are concerned about their relative backwardness. Thus, we believe that Mexico's NAFTA partners will provide receptive ears to forthcoming proposals from Mexico to scale up the financing of such innovation efforts. But this is just one example, and the North American economic cooperation agenda will be a very complex one in the coming years, hopefully covering issues related to the movement of people, improving infrastructure, and eliminating delays and other inefficiencies that are still afflicting regional trade flows.


Daniel Lederman, World Bank senior economist at the Office of the Chief Economist for Latin America and the Caribbean and co-author of the report.

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