(a) the decline in inflation rates, and the subsequent consolidation of macroeconomic stability in those countries;

(b) the public debate on the credibility and transparency of government policies, especially with respect to the permanence of the instruments governing international trade.

Latin America remained largely unaffected by these changes for a number of years. Although foreign trade was flourishing everywhere after 1983, trade between Argentina and Brazil, for example, fell by 50% between 1980 and 1985, while that between Colombia and Venezuela shrank by 65% between 1981 and 1986. In fact, restrictions imposed in the wake of the foreign debt crisis, combined with a bureaucratic apparatus inherited from the old import substitution days, prevented these economies from gaining access to new business strategies that were being promoted by technical progress in the computer industry. This situation began to change gradually after 1985, through a series of initiatives such as the protocols signed between Argentina and Brazil in the period 1986-1988, the revision of the Andean Pact in 1990, the Mercosur initiative, and most importantly, the unilateral trade reforms that were adopted in the region in recent years.

For Brazilian firms, one of the major challenges implicit in the FTAA idea resides in the need to make rapid adjustments to their production vectors and their long-term strategies, both domestically and abroad, to bring them into line with the current profile of production and transaction costs. In other countries, such as the United States and United Kingdom, for example, this meant a process of industrial restructuring that went on for more than a decade, within a macroeconomic context that ensured that the rules of the game would remain stable. This challenge also applies, of course, to other Latin American economies, but it is most intense in the Brazilian case, due to the scale and complexity of its installed industrial makeup. As we shall see in the following sections, overcoming this obstacle is a basic requirement for dealing with most of the issues that currently figure on the Brazilian economic agenda.

3. The international integration of the Brazilian economy

Table 2, showing the geographic distribution of Brazil’s foreign trade over the past 20 years, provides some indicators as to what the FTAA will mean for the country’s economy. The first noteworthy aspect is the decline of the American market as a destination for absorbing Brazil’s exports. After a period of growth between 1975 and 1985, the placement of Brazilian products in that market began to lose steam, just as the United States was consolidating its position as the primary world power.

Source: International Monetary Fund, Direction of Trade Statistics, various editions.

The imbalance in the Brazil-USA bilateral relationship has been the subject of several recent studies (see for example Abreu, 1995; Markwald et al, 1995; Motta Veiga and Machado, 1997). As Markwald pointed out (1995), "Brazil-USA economic relations have been characterized by the existence of asymmetries that embrace both trade in goods and trade in services. In recent years, the USA has succeeded in increasing its sales into the domestic market at a pace greater than the rate of growth of Brazilian exports; on the other hand, Brazilian exports to the USA grew more slowly, in comparison with the behavior of Brazil’s exports to other markets, and this helped to reduce the Brazilian share in total US imports. Overall, this performance has implied a gradual reduction in the volume of bilateral trade over the period 1990-1994, and a reversal of the trade balance, […] which produced a deficit for Brazil in 1995." (page 1)

The decline in the competitiveness of Brazilian exports, the origins of which relate to the issues discussed in the previous section, has been exacerbated in recent years with the over-valuation of the exchange rate under the Plano Real, and the short-term focus that has dominated the country’s external trade policy since mid-1994. As noted by Baumann et al (1997), between July 1994 and September 1996, of the 13,428 tariff items that make up Brazil’s Harmonized System, 11,183 items have been changed, and 939 of these have undergone more than three amendments. ⁵ Capital goods and intermediate inputs were among the items most heavily affected: import rules governing them have been changed more than five times! Given the upstream and downstream linkages of these sectors, those changes implied relative price instability for the entire economy.

The second noteworthy aspect in table 2 is the importance of Brazil’s trade flows with the European Union and the rest of the world, which together have accounted for more than 60% of the country’s foreign transactions over the last twenty years. This points to a feature that distinguishes the FTAA from other regional initiatives: both Brazil and the United States, the two principal economies in the proposed pact, are countries with widely diversified trading partners. On the other hand, as we shall see in section 4, the competitiveness of the major exporting industries in both countries is particularly sensitive to the economies of scale that will be generated by hemispheric integration, illustrating nicely the logic of regionalized production and globalized markets. Thus, access to the European market, the maintenance of dialogue with strategic partners such as Japan, and the strengthening of the WTO as a multilateral negotiating forum are priorities for both the leading FTAA countries. These characteristics are by themselves no guarantee that governments will adopt the most appropriate strategies in terms of their respective national interests, due to factors that we shall examine later on in section 6. But they do at least suggest that the potential contradictions between regionalism and multilateralism are not particularly germane to the FTAA case.

The third fact that stands out from table 2 is the growth in trade with member countries of ALADI over the last ten years. Since the mid-1980s, the Brazilian government has been gradually revising its external policies with respect to neighboring countries. After decades of isolation, which saw the combination of bureaucratic restrictions based on the import substitution model and the political limitations imposed by successive military governments, the conditions of trade within the region reached their low point in the first half of the 1980s, thanks to the measures that Brazil took to deal with its eternal debt crisis. Between 1981 and 1985, Brazilian imports from member countries of ALADI were cut by half, and as a result exports also fell by the same proportion. Not only were such measures useless in attacking the country’s balance of payments problems at that time, they also helped to accentuate the domestic recession and to spread it throughout the continent. In 1985, ALADI absorbed only 9% of Brazil’s exports, while generating 12% of its imports.

Just as with the bilateral agenda with the United States, the FTAA is but one of the possible configurations for Brazil’s future links with its neighbors. An assessment of those possibilities involves an examination of four topics:

(a) the behavior of the Brazilian economy as a source for generating direct investments and technology transfers;

(b) the scope of the arrangements that will be put in place to support monetary stability within the hemisphere;

(c) the progress of the Mercosur initiative; and

(d) the institutional framework that will regulate the functioning of domestic markets. The following sections address these issues in turn.

 

4. Export performance and hemispheric integration

Tables 3 and 4 point up some contrasts between the European Union and the FTAA, on the basis of indicators relating to the size and degree of industrial development of the countries participating in those integration schemes. In Europe, it makes little difference whether we rank member countries according to population, gross domestic product (GDP) or industrial size: the results are virtually identical. There are a few minimal distortions. For example, Italy’s population is slightly less than that of the United Kingdom, while its GDP and its industrial output are both 3% greater than those for Britain. Other differences are more significant: the levels of industrial development in Spain, Portugal and Greece are lower than those of the other partners. The asymmetry of size is also considerable, since the four largest economies represent roughly 80% of the GDP and industrial output for the community as a whole. Yet, when compared with the disparities to be found in the rest of the world, and in the FTAA zone in particular, the European common market appears remarkably homogenous.

European Union: Member States by relative size (1993)

Source: Eurostat, Basic Statistics of the Community, 1993.

FTAA: Major economies by relative size (1995)

Source: World Bank, World Development Report, 1997.

The FTAA is a kind of antithesis of the European model. Its overriding feature is the presence of the United States, which has not only confirmed its position as the leading world power, but has been going through a golden age of growth during the 1990s, with full employment, stable prices and intense technological dynamism in all areas of its economy: from agriculture to software, from baking services to quality control for the goods sold in supermarkets. In addition to the United States, there are seven intermediate-sized economies in the FTAA, listed in table 4, of which only two – Canada and Chile – meet the three basic requirements for a successful trade negotiation: that is to say, economic agents in those countries have already built into their decision-making parameters the existence of a sound exchange rate, stable domestic prices, and consistent external trade rules. In the other five countries, as in most of the remaining 26 members of the FTAA zone, economic decisions are still colored by memories of recent crises, or by hesitancy over the outcome of economic reforms now in progress, or by the impact of over-valued exchange rates. Such uncertainties accentuate the resistance that is normally evoked by trade liberalization moves, and make it more difficult to formulate coherent national negotiating strategies.

Quite apart from their differing economic circumstances, it is impossible to overstate the structural asymmetries within the FTAA, as table 4 demonstrates. The US population accounts for 34.9% of the hemisphere’s inhabitants, but produces 76.2% of its GDP and 72.7% of its industrial goods. Brazil’s population is five times that of Canada, but the domestic markets of the two countries are similar in size. Mexico has three times as many people as Argentina, but its domestic output is apparently lower, thanks to the monetary disparities between the two economies. Among the 34 countries in the zone, the four largest countries account for 93.2% of total industrial production.

Given such a picture, it is appropriate to ask: What are the factors that would make sustainable a unified economic space based on such a heterogeneous set of partners? This section will address this question by examining the region’s export profile. Table 5 lists 1994 exports for a group of industries selected in accordance with the following criteria: for Latin American countries, all industry sectors were included that had external sales greater than one billion dollars per year over the period 1990-1994; for Canada and the United States, the twenty major exporters over that period were included. The notion of industry used here is quite flexible, since our objective is to provide a comprehensive description of the hemisphere’s export profile. The level of aggregation thus ranges from large industrial complexes, such as chemicals, to highly specific activities such as making orange juice, but in most cases it relates to the three-digit level of the Standard International Trade Classification (SITC). In this way, we have identified nine exporting countries and 40 industries, 11 of which are engaged in the agri-industrial sector, 10 in the basic inputs industry, 11 in capital goods and components, and eight in consumer durables. Table 5 also shows exports exceeding 500 million dollars in 1994, but only for that selection of industries and countries.

One aspect that stands out clearly from table 5 but receives little attention in debates over hemispheric integration, is that there are only four countries in the region that have truly diversified export economies: the United States, Canada, Brazil and Mexico. Moreover, 21 of the exporting industries are manufacturers of capital goods, components and basic inputs, where international transactions are directly associated with investment decisions and the process of creating and disseminating technology. This means that, regardless of any bilateral disputes they may have, or their degree of commitment to subregional integration schemes, these four countries have convergent interests in creating a hemispheric market that will allow them to enhance the efficiency of their strategic industries.

Regional Integration and Economic Growth

The role of the basic inputs industry in the integration process arises from an interesting peculiarity: technological innovations incorporated in this type of industry make themselves felt immediately throughout the rest of the economy, through forward linkages to the productive system. Trade liberalization in such goods promotes two virtuous circles. In exporting countries, dynamism is sustained by taking advantage of new economies of scale arising from the existence of a broader market, while in importing countries, the elimination of systemic inefficiencies stimulates a similar process of technological dissemination. Thus, the role played by basic inputs producers is that of ensuring that the benefits of regional integration are not limited to a single shift in productivity indices, and that they include a permanent increase in the region’s rates of economic growth, as suggested in the studies conducted by Romer (1990) and other authors who have written recently on the theory of integration and growth.

The capital goods industry has a similar role to play, but through different mechanisms, by virtue of the special links that exports from this industry have to three other basic components of the integration process: investment flows, the provision of services, and the transfer of technology. Machinery may be purchased for a variety of objectives, such as maintaining the profitability of existing lines of production, expanding installed capacity, or introducing a new technology, but in any case it is always associated with an investment project. In addition to maintenance and consumer services, the production of equipment creates employment opportunities for a wide range of businesses in the areas of project engineering, product design, financial operations, systems analysis, etc. Finally, any machine incorporates a technology that will place limits on the pattern of productivity growth for the industries that make use of it. Thanks to this series of linkages, international trade in capital goods promotes economic growth through the working of two complementary effects: in the exporting country, it stimulates the dissemination of new technologies through the demand for components and services, i.e. by generating backward linkages; while in the importing country, user industries benefit from the transfer of technology, i.e. from the effects of forward linkages.

On the notion of technological progress, which was the subject of countless disputes among economists for some two hundred years, there is now a fair degree of consensus, at least with respect to three basic points. The first is that technological innovation should be regarded as a central variable in the process of growth, since it is the principal source for creating investment opportunities which, once they are realized, will foster the search for further innovations. The second point highlights the special interaction that exists between private investments in R and D and public expenditure on education and basic science. The generation of technical progress depends on the play of both variables. The long-term rate of economic growth will not be sustainable if either of them falls short of the minimum levels necessary to maintain the dynamism of the relationship between the advance of scientific knowledge and the Schumpeterian profits of innovating firms. The third point is that all technology-intensive industries benefit from economies of scale, because every innovation reflects a given volume of R and D spending that was made in the past, and that has been transformed into know-how that can be freely used indefinitely, unless or until it is superceded by some new innovation. Since these are random events, the process of industrial growth necessarily calls for the formation of diversified sectoral structures, typified by the presence of oligopolistic competition, the particular design of which — temporary, of course — will depend on the particular mix between the nature of existing technological know-how, the size of the market, and the existence of barriers to the entry of new competitors.

In short, if the FTAA idea is to succeed in harmonizing the asymmetric interests involved in establishing a hemispheric market, it is essential that the regions’ larger countries fulfil their role as generators of growth. As we have seen above, it is not enough to abolish trade barriers — we must also ensure the continuity of direct investment flows and the transfer of technology which, in fact, are the sole mechanisms capable of overcoming asymmetries among trading partners.

From Brazil’s viewpoint, such requirements imply two additional challenges, beyond those already discussed in the preceding sections. On one hand, as we shall see in section 6, if Brazilian firms are to be encouraged to fulfil their Schumpeterian functions, there will have to be a framework for regulating the competition process, and one is in fact now in the initial stages of adoption. On the other hand, raising public and private investments in technology, within the setting of an open economy and fiscal austerity, will require a policy debate of a kind that has not yet taken place in Brazil. That debate must encompass, as we shall see in section 7, not only a collective surveillance of the priorities that will guide public investment, but also a broad understanding of the sources of competitiveness within the economy. Meanwhile, before addressing these issues, we shall examine in the next section the mechanisms that might serve to sustain monetary stability within the FTAA.

5. The management of monetary stability

he exchange rate is the most important price in any economy, because it is called upon to fulfil at least three basic functions simultaneously: (a) it defines the purchasing power of the domestic currency on the international market, and hence the average level of wealth of a country’s people in comparison to the rest of the world; (b) it affects the international competitiveness of local industry; and (c) it has an influence on the behavior of prices and on the attractiveness of domestic financial assets. One aspect that is frequently overlooked in debates about monetary policy is the fact that no government can opt permanently for one of these functions to the exclusion of the others. An appreciating exchange rate may artificially raise a country’s standard of living, while discouraging exports and, eventually, helping to fight domestic inflation by keeping the price of imports down. Such a strategy will generally lead the country, however, into a balance of payments crisis. On the other hand, a depreciating exchange rate may generate trade surpluses over long periods of time, but it does so through in effect transferring a country’s resources to the rest of the world, and impoverishing its own people.

Thus the only feasible long-term objective is to seek a stable equilibrium. And yet here again, no government has the power by itself to ensure this goal, in a world where there is broad freedom of capital movements. In other words, domestic price stability is a necessary but not a sufficient condition for ensuring stability in the exchange rate. Therefore, monetary questions are bound to assume increasing importance within the recently launched multilateral trading system, under the aegis of the World Trade Organization and the new regional integration agreements.

Exchange rates and the harmonization of macroeconomic policies

When the real exchange rates of a group of countries are kept stable, and there are reliable indicators that this situation is likely to be permanent, then we have at a stroke eliminated the major source of uncertainty in international transactions, namely the exchange risk. In the face of more transparent foreign markets, trade flows tend to become more regular, thanks to the trend to longer-term contracts for the routine supply of goods and services. As we saw in section 2, the fact that the major OECD countries were able to maintain monetary stability over the last ten years was the key factor that allowed the spread in those countries of new models of business management based on outsourcing, intra-industry trade and technological partnerships. In an environment of macroeconomic instability, the process of productive restructuring described in figure 1 (page 6) would simply not be viable, since technological innovations in the computer industry would not have translated into declining transaction costs.

Thus, exchange-rate stability is a basic prerequisite for marshalling all the other steps necessary to constitute a unified economic space. European experience over the last thirty years offers an eloquent illustration of this statement. Each stage in the formation of the common market corresponded to a particular exchange rate arrangement. In the 1970s, the coordination mechanism that came to be known as the "snake" allowed the integration process to proceed despite the unfavorable international economic circumstances of the time, which saw the collapse of the fixed parities system that had been created at Bretton Woods. In the 1980s, the mechanism became known as the European Monetary System (EMS), a regime of exchange-rate bands that succeeded in establishing the degree of stability required for implementing the Europe 92 plan, by which the members finally abolished their remaining barriers to trade in goods and services, to capital flows, and to the movement of citizens within the community. ⁶ In the 1990s, under the aegis of the Treaty of Maastricht and the European Monetary Institute, governments are now preparing to launch the common currency, the euro, at a time when the rest of the world has already grown accustomed to treating the community as a single economic entity.

One interesting lesson that can be drawn from European experience is that exchange-rate stability is not the direct result of any policy decision to adopt a fixed rate regime or a system of currency bands, but rather flows from the harmonization of monetary and fiscal policies. Harmonization of this kind must include, as a minimum, the following:

(a) solid understandings as to the instruments that are to be used to fight inflation at the regional level,

(b) transparency in member countries’ taxation and fiscal systems;

(c) convergence in national policies on subsidies, tax exemptions, and regional or sectoral incentives,

(d) central banks that are exclusively dedicated to the functions of a monetary authority;

(e) symmetry in the mechanisms for adjusting the balance of payments.

The relationship between exchange-rate regimes and national policy harmonization may be examined using the typology proposed by Peter Kenen (1989), which establishes three levels of commitment between governments: consultation, collaboration, and coordination. At the first level, transactions between governments are limited to the exchange of information, without any commitment as to its use, (examples can be found now in the working groups on the FTAA and on certain issues within Mercosur). At the second level, governments take consensus objectives into account in the measures they adopt, but this does not imply any restrictions on their national policies (example: the current stage of evolution of the protocol for the preservation of competition in Mercosur). At the third level, governments commit themselves to amend their policies and to subordinate them to certain supranational goals. As Kenen noted, "international monetary history has been full of consultation and a good deal of collaboration but there has been very little full-fledged coordination (p. 13)".

In fact, the typology proposed by Kenen can be considerably expanded, since there are at least four distinct forms of exchange policy coordination, which relate to a hierarchy of increasingly strict commitments among governments. The first form, the "softest" one, consists in setting up comparable institutional mechanisms for regulating exchange markets in the economies taking part in the integration initiative. This will serve, for example, to avoid situations where one country follows a multiple exchange rate system, another has a floating rate regime within limits set by the Central Bank, a third has pegged its economy to the dollar, etc., as has been the pattern in Latin America. The second form of coordination, somewhat more binding, implies a commitment to ensure that exchange parities fluctuate within agreed limits, as was the case with the "snake" that preceded the EMS. The third form is based on joint action by central banks to support the value of a currency that is under speculative pressure, or to overcome balance of payments distortions among economies in the region. Finally, the fourth form of coordination calls for monetary unification, under which national currencies disappear, and a single regional Central Bank is created.

The Monetary System of the Americas

In the FTAA case, there are three major obstacles to the creation of a regional monetary system that would at the same time ensure long-term macroeconomic stability and international competitiveness for the Latin American economies involved in the process. The first obstacle is of a circumstantial nature, but one that might generate serious resistance to the adoption of any commitment to regional policy coordination in the near future. It refers to the fact that most of the macroeconomic stabilization programs now underway in Latin America re based on the use of "anchor" currencies to contain domestic price increases. Regardless of the possible merits and limitations of this kind of strategy, it will be recalled that a fixed nominal exchange rate implies necessarily some degree of volatility and over-valuation in the real exchange rate during the entire stabilization period. Even where such an approach is successful, the government will be prevented from applying consistent policies to promote the international competitiveness of its domestic industry, as long as the anchor currency is in effect. Moreover, the emergency measures that the government will be forced to take in an effort to offset the loss of competitiveness, and to keep the trade deficit in check, such as export subsidies, import restrictions, regional or sectoral incentive programs, and other types of fiscal exemptions, represent in themselves additional obstacles to regional integration.

On the other hand, one way to overcome these contradictions is precisely through adherence to a regional monetary scheme that will have sufficient credibility to allow the gradual removal of the exchange anchor. As Miller et al noted, "an agreement to cooperate will not be credible in the absence of an enforcement mechanism. Negotiating exchange-rate rules or a formal exchange-rate arrangement can be understood as an investment in credibility. Nations invest political and economic capital when they join an exchange-rate arrangement like the European Monetary System. If they fail to coordinate their policies so as to maintain their membership, that investment is lost, generally at the expense of the politicians responsible. Hence establishing an exchange-rate arrangement can be understood as a pre-commitment to policy coordination." (1989, page 2).

The second obstacle flows from the asymmetries discussed in section 4. Paradoxically, the dollar does not meet the conditions necessary to play the role of a nominal anchor in any Monetary System of the Americas (MSA). Since the US government would have no interest in coordinating its macroeconomic policy with other FTAA partners, an MSA anchored on the dollar would impose two constraints on those countries. First, they would have to surrender their monetary sovereignty unconditionally, without receiving any instruments of macroeconomic cooperation in return. In the very best case, to use Peter Kenen’s typology, they might be able to establish some consultation mechanism, one that would not involve any commitment among governments. Secondly, in situations of disequilibrium in regional transactions, the costs of adjustment would fall exclusively on those countries that are in deficit.

This situation creates a unique opportunity for four countries: Argentina, Brazil, Canada and Mexico. If those countries were to enter into a commitment to harmonize their exchange rate policies, their currencies could serve as an initial anchor for creating an MSA. Latin American countries could then align their currencies against this four-currency basket , which in turn would fluctuate in relation to the US dollar. One of the immediate consequences of such an agreement would be to raise monetary negotiations to the second level in Kenen’s typology. At this stage, FTAA members would have at their disposal an effective mechanism for cooperation between the region and the US government, which would make it feasible to set long-term goals for the gradual convergence of macroeconomic policies throughout the hemisphere.

The third obstacle is of a fiscal nature. A common feature of twentieth-century economies has been the conflict between the demand for public funds and the State’s limited revenue-generating powers. Indeed, the ability to resolve this problem in a transparent manner has become, in recent decades, the major point of distinction between advanced and under-developed nations. As Sven Steinmo has noted, "In the late 20th century, every OECD democracy relies on a small number of taxes with which to generate the vast bulk of government revenues. Just five taxes (personal income, corporate profits, general consumption, property, and social security charges) today contribute an average of 79.5 percent of total government revenues in OECD nations. Most of these taxes did not exist a hundred years ago. Modern democracies not only rely on broadly similar types of taxes, but have also tended to change, adapt, and reform their tax systems at almost exactly the same times and in roughly similar ways throughout the 20^th century." (1993, page 14).

In Brazil, as in most Latin American economies, a growth strategy based on import substitution allowed this fiscal dilemma to be swept under the rug for several decades. One of the main subterfuges was to protect local industry through quantitative imports controls and other market-reserving mechanisms that allowed a portion of demand for public resources to be met through direct income transfers from one segment of society to another, without passing through the state budget. Other, more evident mechanisms included the subsidies implicit in the operations of the Banco do Brazil, the Central Bank, the BNDES, the state-owned banks and various public agencies. Finally, such expedients were supplemented by a long list of government measures that could only be viable in times of inflation, such as over-estimating tax receipts, accumulating arrears in the settlement of accounts, granting fiscal incentives that would be offset through additional taxes, which in turn would create opportunities for new forms of tax relief, etc.

The implementation history of the Plano Real, in the period since the 1994 monetary reform, provides an eloquent example of the fact that even today, several years after the end of the import substitution era, Brazil’s tools for controlling public spending are still rather shaky: in the first nine months of 1997, foregone import revenues amounted to some 5 billion reais (cf. Gazeta Mercantil, 11/21/97), while the Banco do Brazil’s management report recorded R$11.3 billion in "tax losses and inter-temporal differences" for the period ending 30/06/97. For its part, the government announced its intention on 11/10/97 to make a fiscal adjustment of R$20 billion to deal with the emergency arising from the collapse of the Hong Kong stock market.

In short, the issues addressed in this section show that the FTAA plan will only be sustainable if its 34 member countries are prepared to adopt and work with mechanisms for maintaining monetary stability in the region. Otherwise, the project will be shelved as soon as the first balance of payments crisis appears. As things stand now, most Latin American countries have yet to conclude the economic reforms that were initiated in recent years, and the matter of exchange rate policies does not even figure on the negotiating agenda.