How to Build a Better Trade Pact with Central America

Trade, Equity, and Development Project July 2003 How to Build a Better Trade Pact with Central America By Sandra Polaski INTRODUCTION T he United States is negotiating with five Central American countries to create a new free trade zone the U.S. Central American Free Trade Agreement (CAFTA). 1 This marks the first time the United States has attempted such an economic feat with countries ranked among the poorest in the world. By comparison, when the United States negotiated to create the North American Free Trade Agreement (NAFTA), Mexico s gross national income per capita was $4,230. 2 However, today in Nicaragua, annual income per capita stands at about $400, one tenth that level. In Honduras, it is about $900 per year, 3 and El Salvador and Guatemala have only slightly higher per capita incomes. In all four countries, most people live in poverty, with the proportion ranging from 50 percent in El Salvador to 80 percent in Honduras. 4 Annual income is not the only measure that differentiates the pact being negotiated from anything attempted before. Mexico, before NAFTA, had a developed industrial structure, producing steel and automobiles as well as laborintensive products such as televisions and clothing, while less than a quarter of the population was engaged in agriculture. That level of economic diversification and worker skills is a distant dream for Central America today. Almost half the population there now works in subsistence agriculture. The only significant export industries in four of the five countries Costa Rica being the exception are agriculture and apparel. Of course, economic integration is intended to speed development in the region. However, the starting point is a sobering reminder that the Central American countries have extremely limited capacity to adjust to the dislocations that always follow economic opening. This will be particularly true for countries opening to an economic powerhouse like the United States. Sandra Polaski is a senior associate with the Trade, Equity, and Development Project at the Carnegie Endowment for International Peace. She served from 1999-2002 as the Special Representative for International Labor Affairs at the U.S. Department of State, the senior official handling labor matters in U.S. foreign policy. This publication is also available in Spanish at www.ceip.org/trade

As a result, the proposed free trade zone with Central America will require an economic bargain that takes into account the poverty and fragility of those economies. A poorly constructed CAFTA for example, one that allows U.S. corn and beans to flood those countries and wipe out subsistence farmers will be a development disaster for Central America. On the other hand, a well-constructed CAFTA must take a gradual, developmental approach that allows the countries of the region to adjust at a pace that is bearable for their populations. It must help them build the economic, governmental, and human resources necessary to succeed in a modern open economy. HEADING THE WRONG WAY Unfortunately, the current proposals that the United States has tabled in those negotiations, instead, appear to reflect a latter-day mercantilism aimed at maximizing the profits of U.S. investors, firms, and agricultural interests or, at least, politically well-connected U.S. interest groups. For example, the United States is currently proposing that its corn, beans, and beef be allowed into Central America duty-free immediately, while delaying the import of Central American sugar into the United States until the distant future. On other fronts, such as the laws and regulations that will prevail in the integrated economic space of the free trade area, the United States, so far, has taken a cookie-cutter approach, insisting that terms negotiated with the much more developed countries of Singapore and Chile also be applied to Central America, even though the circumstances are vastly different. At present, the United States is on a course that will produce a deeply flawed trade agreement that may spell economic catastrophe for much of Central America. Why should the United States care about what happens to poor Central Americans? Because the United States has enormous interests in the world that go beyond the profits of particular firms. Economic and political instability around the world have a deep, and sometimes dramatic, impact on U.S. security and on immigration flows to the United States. This is especially true with a near neighbor like Central America. Further, poor farmers who lose their legitimate incomes may turn to the drug trade that already menaces the region. The United States also claims to a be a world leader in fighting poverty and helping poor countries climb out of underdevelopment through economic engagement with its own giant economy. The CAFTA talks present an opportunity for the United States to show that it knows how to do that and is willing to do so. On the other hand, a CAFTA that lopsidedly extends most advantages to U.S. firms at the expense of struggling campesinos and young women working at poverty wages in export assembly plants will produce a development setback for the world to see. It could also produce increased immigration to the United States and provide fertile ground for the encroachment of the drug trade. A TRADE PACT THAT FOSTERS DEVELOPMENT To make this trade agreement a success, the United States will have to do things it has not done before in free trade negotiations. The United States must break new ground in four key areas if it wants to contribute to genuine development gains for Central Americans and avoid harsh economic and political shocks to the region: the terms of agricultural trade liberalization; the need for adjustment assistance to help those who will lose from the 2

trade pact adapt to new economic circumstances; the reform of the region s inadequate labor laws; and the need for credible, external monitoring during the start-up phase of the agreement. Each of these four areas affects the incomes of average (meaning poor) Central Americans, as the issues are interrelated through the functioning of labor markets. What happens to small farmers as a result of the agricultural terms of the trade agreement will determine how much labor is released from the agricultural sector, and at what pace. If U.S. grain exports are allowed to displace too many campesinos too rapidly, the large redundant labor force will then migrate to the cities, producing an unwanted supply shock to labor markets already saturated with underemployed workers scraping out a living in the informal sector as well as a young population coming of age. Wages in maquila assembly plants will decline because of the imbalance in the labor market and, in most cases, those wages are currently below the poverty line. The resulting imbalance in the already asymmetrical power relationship between employers and employees in factories there will be further skewed, reinforcing inequities in income and rights. And in Central America, the distribution of incomes and rights between the small wealthy class and the rest of the population stand among the most unequal in the world. Each of these areas can be managed, however, through effective negotiating approaches. The following sections define the four critical issues and what the United States must do differently, if it wants a successful CAFTA. AGRICULTURE The terms on which agricultural trade is liberalized under CAFTA will likely determine whether four of the five Central American countries are net winners or losers from the agreement for the foreseeable future. It will certainly determine whether poverty increases or decreases in those countries for many years to come, because agriculture employs the largest share of the population in Honduras, Nicaragua, Guatemala, and El Salvador: 42 percent on average for the four countries. 5 The impact on rural households that depend on agricultural income will critically affect whether the countries adjust to free trade with only tolerable disruptions and adjustment costs or, instead, face a wrenching dislocation that worsens poverty, swamps urban labor markets, and increases migration to the United States. Central American governments are hoping CAFTA will result in more manufacturing firms that will employ the labor released from the agricultural sector. But in all those countries except Costa Rica, the only currently viable manufacturing export industry is textile and apparel. Even if it grows at double-digit rates, this industry alone will not have the capacity to absorb large numbers of displaced rural workers. For example, in El Salvador, about a million people are employed in agriculture, while the textile and apparel sector employs only about 200,000. 6 Agricultural production in the region includes staple crops, such as corn and beans, for household consumption, similar production for local markets, and cash crops, such as coffee and sugar, for export. Changes in tariffs and other trade rules will affect each of these crops differently. The optimal combination of trade terms for Central American rural development would be to phase out the tariffs on staple crops very slowly and gradually, so that 3

subsistence farmers have time to adapt, while increasing access to the U.S. market for the region s traditional cash crops such as sugar and other agricultural products that exploit the comparative advantages of the region. As already noted, however, the current market access proposal of the United States does exactly the opposite, demanding immediate access for U.S. corn, beans, rice, beef, and chicken, while delaying improved access for sugar to an unspecified date in the distant future. If adopted, this proposal would lead to an almost immediate displacement in Central American markets of staples produced by local subsistence farmers. These crops would be replaced with U.S. corn, beans, and other products that are produced more efficiently and also benefit from U.S. government subsidies that allow them to be sold below their cost of production. Meanwhile, production of sugar and other export products that could absorb some of the labor displaced from staple crops would be denied greater access to U.S. markets for many years and thus constrain any labor-absorbing growth. This is hardly a picture of free trade, and more importantly, it would not be a happy outcome for Central America. While households there would face cheaper prices for some food products, the great bulk of rural households would lose all possibility of selling their crops, and thus lose the cash income needed to buy U.S. agricultural products. Moreover, such an outcome would take place at the same time that one of the major agricultural exports of the region coffee is facing historically low prices, which is leading to abandonment of many coffee plantations and destruction of existing wage labor jobs for rural workers. 7 Faced with hunger, poor rural families would drift to the cities to join the ranks of the underemployed or migrate to the United States as illegal immigrants. What will it take to change the U.S. bargaining posture and avoid these perverse outcomes? The U.S. government will have to take on agricultural lobbies that seek to influence the terms of the agreement and be firm in its design of policies that benefit broader U.S. interests. While the power of those lobbies is formidable, the actual impact on the United States of a more pro-central American, pro-poor proposal would be negligible. The entire agricultural sector in the United States employs less than 1 percent of the U.S. workforce. 8 Profits of farm owners and agribusiness firms would be barely affected, since the Central American market is relatively small and very poor. One can only assume that the reason for the inappropriate U.S. proposal is a concern about precedent for other trade negotiations. However, no trade agreement need form a precedent for others, and the risk of a major negative shock to Central American farmers and economies cannot justify basing policy on any such distant, tactical concern. The U.S. proposal should provide long transitions, of twelve years or more, for staple food crops produced by subsistence farmers in Central America. It would be worth exploring the possibility of a gradual phase out of tariffs and other market restrictions on these crops to incrementally change the incentives and prices for producers and households. On the import side, U.S. liberalization of access for Central American export crops, including sugar, should occur early in the agreement to allow for absorption of labor from subsistence agriculture. TRADE ADJUSTMENT ASSISTANCE A second area that will require attention, even if the United States offers a more appropriate agricultural proposal that allows for a gradual transition of Central American economies away from subsistence agriculture, is the need to help 4

those countries, and specifically, their poor rural households, make the transition. It is important to remember four key points: (1) underemployment is already high; (2) the labor force will continue to grow rapidly over the medium term due to earlier high population growth rates; (3) education levels are low; and (4) illiteracy is high. Those who lose their incomes due to CAFTA-induced changes will be poorly equipped to find other employment. None of the Central American countries currently provide social safety nets such as unemployment insurance for workers who lose their jobs. Assistance to help farmers and workers displaced by CAFTA will be essential if the net impact of the agreement is to be positive and poverty is to be reduced, not increased. The countries involved will need help, both to construct and finance the programs needed. Technical assistance to design the programs is available from international agencies such as the International Labor Organization (ILO) or the UN s Economic Commission on Latin America and the Caribbean (ECLAC). Financial resources will have to be pieced together from a variety of sources, and the U.S. government should be among them. The United States will benefit from a stable, developing Central America in myriad ways that include reduced migration flows, less drug production and transit, and a reduction in the instability and criminality that flow from the drug trade. The benefits of freer trade with the region, though modest, will redound to U.S. firms. Therefore, the U.S. government for the first time should accept the responsibility to contribute to needed transitional adjustment programs, just as the wealthy countries of Europe assisted Portugal and Greece with their transition from agricultural to modern economies and as they will do again with the Eastern European countries that accede to the European Union in 2004. Free trade imposes adjustment costs, and those costs should be distributed throughout the free trade area with some acknowledgement of ability to pay. The multilateral financial institutions, including the World Bank and the Inter-American Development Bank (IDB), should also assist through grants and loans. However, loans cannot constitute the major source of finance debt burdens that are already difficult would become unsustainable. New funds are needed, and some of the resources must come from the United States. LEGAL FRAMEWORK FOR LABOR MARKETS A third area that requires attention and new thinking by the United States is the need for better labor laws in Central America. The region suffers from the most egregious income inequalities in the world, and this is both reflected in and partly explained by the highly unequal distribution of rights and protections in the laws of those societies. In most of the countries of Central America, small ruling classes (referred to locally as the oligarchs or families) have dominated both the economies and the polities for centuries. In every Central American country except Costa Rica, this domination led to numerous civil wars, including those of the 1980s and 1990s. The societies are still deeply polarized. Laws are inadequate to balance the rights of the weak (workers and the poor) with the de facto power of the oligarchs and employers. Enforcement is irregular, and impunity for the powerful is the norm. 9 Collusion of government labor inspectors with employers is not uncommon. When workers attempt to organize to improve their bargaining power with private sector employers, they are routinely fired. The employers often circulate their names to other firms and the workers may be blacklisted and denied employment elsewhere. Thus, the existing unequal economic and power relationships in society are preserved and perpetuated in 5

the workplace. Some of the worst abuses of the right to organize occur in export sectors, including apparel and export agriculture. 10 These problems are widely documented and well-known to the U.S. government. The U.S. Department of State, Department of Labor, and the Office of the United States Trade Representative have engaged the Central American governments in recent years to seek reforms of weak laws and enforcement capacities. 11 Technical assistance has also been provided, but little has changed. U.S. negotiators risk perpetuating this unsatisfactory status quo under CAFTA unless they make it a condition of the agreement that the Central American governments finally make the changes to law and practice needed to protect the most basic human rights of workers. Necessary legal changes in each country have been identified by the ILO, which has been designated by all CAFTA countries as the international standardsetter and interpreter of fundamental labor rights. Most of the Central American countries have made previous commitments to improve their labor laws, whether as part of peace agreements to end civil wars or to qualify for preferential trade benefits under programs that the United States extends unilaterally to the region. However, these commitments have not been fulfilled. The Central American governments clearly have not had sufficient interest or political will to do so. Their desire to conclude a free trade agreement with the United States should be used as leverage to secure the reforms they have long promised to their own citizens and to the United States. Given the history of failure to abide by previous commitments, the labor law changes must be agreed to in writing, with specific time frames for completion. At the end of the day, the benefits of CAFTA must be at risk should the signatory countries fail to comply with their pledges. This requirement of labor law reform would be new for the United States in a regional free trade agreement, but there are precedents. The United States routinely requires trading partners to amend their intellectual property laws as a condition of free trade and will undoubtedly do so in the CAFTA. Workers, whose labor is often their only economic asset, should enjoy labor rights protections at least as strong as those for property rights. It is only when the legal regimes of Central America are brought into line with modern norms that the political and economic imbalances in the region will begin to be rebalanced. MONITORING OF IMPLEMENTATION A final area that requires attention and innovation in the CAFTA is oversight of the implementation of labor rights commitments. Because of the deep polarization of these societies and the weak enforcement capacity of the region s governments, compliance with the terms of the agreement and with domestic labor laws will require neutral, credible outside oversight for a significant transition period. This is a necessary part of the effort to rebalance the highly unequal distribution of rights and power between employers and employees. It is also necessary to address concerns of firms that might invest in Central America or use the region as an important sourcing location, thus creating new jobs. Firms that have invested in their brands and reputations will locate only where their reputations are not put at unacceptable levels of risk. It is widely recognized that most manufacturing growth in Central America in the medium term will be in the apparel sector, because some infrastructure and skills already exist. Apparel trade currently takes place under a 6

global quota system due to be phased out at the end of 2004. Then production will no longer be distributed globally under the quota system, and the prospect of tarifffree access to the U.S. market will be an incentive for firms to produce and source in Central America. The proximity to the United States will be an additional factor in favor of investment in the region. However, the region s labor costs, while low, are not nearly as low as in China and other Asian countries. Therefore, in the complex equation that drives investment and sourcing decisions, the question of whether a country poses acceptable risk to a firm s brand reputations will loom large. Most apparel firms have invested heavily in their brand identity and reputation a primary determinant of pricing power. Apparel is also a sector of considerable activism by consumer and nongovernmental organizations. Thus, a monitoring system that can provide firms with reasonable certainly about conditions in factories and compliance with laws could provide the tipping factor in favor of investment and sourcing in the region. The logical organization to provide such monitoring is the ILO. The agency is recognized by all of the parties to CAFTA as having the right to assess compliance with internationally recognized labor standards. Moreover, the ILO has recently gained experience and expertise in factory monitoring in Cambodia under an innovative agreement between the U.S. and Cambodian governments. The ILO proved there that it could conduct costeffective, neutral and credible monitoring that won the trust indeed, praise of all parties. The primary benefit provided by the ILO was transparency: all interested parties, including the two governments, factory owners, workers, buyers, and consumers, had access to information about what actually went on in the factories. Thus, efficient decisions could be made by brands regarding whether potential sourcing factories complied with labor laws. International consumers, media, and NGO activists learned that they could rely on ILO information as accurate. The result was that compliant factories gained increased orders, while noncompliant factories did not. This is precisely the kind of mechanism that sends appropriate market signals to all actors. In Central America, unlike Cambodia at the beginning of the ILO monitoring project, a number of independent monitoring groups already exist, although they are very small in scale. It is easy to envision a rapid start-up of monitoring led by the ILO, which could then engage these existing groups, provided they met ILO-determined standards and procedures. Who would pay for such a project? There are a number of possibilities. In the case of Cambodia, the cost was split between the U.S. government (70 percent of the total), Cambodian government (15 percent), and Cambodian apparel manufacturers (15 percent). It would be fair to require the multinational firms that buy from the factories and export farms to contribute as well, since they gain such apparent value from the arrangement. An alternative to government contributions might come from multilateral development finance organizations such as the IDB and the World Bank. Both entities have facilities to make grants to projects that enhance development, and this approach would certainly qualify. It would be optimal to begin designing such a monitoring effort now, while negotiations for CAFTA are still underway. That would minimize any delay in launching the operation once CAFTA is completed and thus provide an early incentive for firms to decide to produce and source in the region. 7

CONCLUSION The CAFTA negotiations represent a potential turning point for Central America. The region is economically fragile and politically precarious. A wellconstructed CAFTA could reinforce weak institutions and government capacities and thus allow positive market forces to take hold, creating jobs and gradually allowing the region to grow out of poverty. But the large size of the agricultural sector, the severe constraints on workers and households, the lack of public funds for adjustment, as well as the deficient laws and weak enforcement systems all demand that CAFTA be constructed with extraordinary care. Otherwise, the positive opportunity could instead produce a major development setback. To achieve progress and avoid peril, the United States will have to make proposals and take steps it has never undertaken. U.S. negotiators have long recognized that a cookie-cutter approach to trade pacts does not produce good results. CAFTA will be the most demanding test of their ability to break new ground. 1 The Central American countries involved are Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. 2 World Bank, World Development Indicators Database. Data for 1993. 3 Ibid. Data for 2001. 4 United Nations Economic Commission for Latin America and the Caribbean (ECLAC), Social Panorama of Latin America, 2001 2002. Data for 1999. 5 Based on a compilation of data from the International Labor Organization, World Bank, and ECLAC by Jose M. Salazar-Xirinachs and Jaime Granados in The United States Central America Free Trade Agreement: Opportunities and Challenges, paper prepared for the Institute of International Economics conference on Free Trade Agreements and U.S. Trade Policy, May 7 8, 2003, Washington D.C. Paper on file with the author. 6 U.S. Department of State, Country Reports on Human Rights Practices for 2002 El Salvador. Available at <www.state.gov>. 7 Some analysts promote the idea that horticultural products, fish, and other nontraditional primary sector exports can take up the slack. However these are the very products that are also being promoted in Mexico, the Andes, and other parts of the developing world. The risk of overproduction in these products and a resulting collapse of prices, as with coffee is very real and reinforces the case for a gradual transition away from subsistence crops. 8 U.S. Bureau of Labor Statistics, Occupational Employment and Wages, 2001. Available at <www.bls.gov>; U.S. Department of Agriculture, National Agricultural Statistics Service, Farm Labor, November 2002. Available at <http://jan.mannlib.cornell.edu/reports/nass>. 9 Authoritative information on the deficiencies in labor law and enforcement can be found in the U.S. Department of State s Country Reports on Human Rights Practices. Available at <www.state.gov>. 10 Ibid, reports for 2000, 2001, and 2002. 11 In addition to the extensive documentation of ongoing problems found in the U.S. Department of State s Country Reports on Human Rights Practices, the Office of the United States Trade Representative issued the Fourth Report to Congress on the Operation of the Caribbean Basin Economic Recovery Act December 31, 2001. The report notes similar problems and includes the observation that prior commitments have not been kept, for example, in Honduras (pp. 43 44). CARNEGIE ENDOWMENT FOR INTERNATIONAL PEACE 1779 Massachusetts Avenue, NW Washington, DC 20036 Phone 202-483-7600 Fax 202-483-1840 www.ceip.org Copyright 2003 Carnegie Endowment for International Peace 8