Trading to avoid falling behind in the COVID-19 crisis: Lessons from Central America to boost prosperity

 By Rodrigo Méndez Maddaleno, Economist at Chief Economist Office, Central American Bank for Economic Integration (CABEI)

This blog is part of a series on tackling COVID-19 in developing countries. Visit the OECD dedicated page to access the OECD’s data, analysis and recommendations on the health, economic, financial and societal impacts of COVID-19 worldwide.

Panama City, Panama – container vessel leaving the Panama Canal. Photo: Shutterstock

If what and where you export matters, Central American countries need to upgrade the quality of their exports, produce new ones and dive into new markets.

Central American countries are open to international trade. Trade in the region represents 67% of GDP, more than the world’s average of 51%. Average tariff rates for the region have also shown a consistent decline since 2005 going from 7% to 5%. However, the region’s economic performance has not reflected this, with an average GDP per capita growth of around 2.5% in the 2000s, which means that income doubles approximately every 30 years. So why has there not been an economic take-off? What is missing in the region when it comes to trade and economic policy in general? These questions are even more relevant today, as COVID-19 and the global crisis are affecting the region and its major trading partners.

To address this, it is important to analyse several aspects of Central American trade, such as export composition, main destination markets, and discuss what the region can do to improve its situation and boost economic growth and prosperity.

Central American countries mainly export commodities. Historically, as Bulmer-Thomas puts it, these countries adopted an export-led growth model with an emphasis on agricultural goods. The region’s top 10 exports – according to the HS96 classification at 4 digits – mainly consist of agricultural products such as coffee, bananas, sugar, palm oil, gold, cigars -accounting for 20% of total exports- while manufactured goods, such as medical supplies and textiles, account only for about 10% of total exports.

Nonetheless, Central America has increased its products’ economic complexity over the years. Hausmann et al define the economic complexity index as a combination of product diversification and sophistication, according to which they rank around 133 countries from most to least complex. In Central America, the most notable cases are Costa Rica and El Salvador, which since 2000 have moved up more than 10 positions, while other countries have made little progress. However, the progress made by these two economies has been through diversification, rather than technological innovation. There is significant room to improve export sophistication, quality and most importantly productivity in the region.

In terms of sophistication of exports, a set of non-traditional products have been growing at consistently high rates and gaining a larger share of total exports. Out of approximately 1200 product categories, 24 “star” products are growing much faster than the rest, amounting to a total of almost US$ 8 billion in exports. They include technological products such as medical instruments, radio or TV transistors, television cameras, as well as other non-traditional agricultural products such as cocoa, avocado, dates, and figs. These “star” products need consistent support to boost their productivity, firm size and exported value.

The United States is the main trading partner for Central America, accounting for 39% of its total exports since 2000, while intraregional trade accounts for 23%. These numbers show the high geographical concentration of the region’s export destinations. Why is this important? In part because it makes countries more vulnerable to the US business cycle, so in case of economic downturn, countries can be hard hit by a reduced demand for their goods – a situation in clear display now with the consequences of the COVID-19 crisis. Another incentive for market diversification is that new destinations require quality improvements, which can push firms to enhance their production methods and productivity to reach new customers.

Governments have made significant efforts to help Central American exporters reach new markets. The region has negotiated several free trade agreements as a block, such as the Dominican Republic-Central America FTA (CAFTA-DR) trade agreement with the US and association agreements with the European Union and with South Korea. At the country level, Central American countries have each negotiated an average of over seven agreements. However, there have been neither major changes in export concentration, nor a significant surge in export volumes to new markets. This might indicate that regional firms face other challenges like non-tariff barriers such as safety, sanitary and phytosanitary requirements. Also, firms may be facing additional problems, like lack of business intelligence, language barriers and production constraints due to a lack of capacity to supply several markets at once.

So, what can countries do to take advantage of trade and generate prosperity? The following four policy recommendations can help countries tackle their trade constraints (see the Central America in the Global Economy: Development Opportunities through Trade report):

First, it is urgent to improve investment in research and development to upgrade the technological content of exports, foster new products and improve quality and production methods. The role of public investment should be acknowledged throughout the stages of the product cycle, with an emphasis on basic research. The policy must focus on multiple dimensions, from improvements in packaging and new productive processes, to technology adoption and creation of new products. By improving quality and productivity, firms may be able to cater to different markets and take better advantage of governments’ efforts to opening trade.

Second, there needs to be more analysis to understand the bottlenecks that firms face, especially in relation to rising “star” products. In general, clear policy should focus on helping businesses reach a minimum efficiency scale to be competitive in international markets. This also means taking action to foster better management techniques and improving technical education, as well as overall workforce skills.

Third, in order to reach new markets, additional measures are needed to improve quality and product standardisation. To achieve this and promote regional products in new markets, other areas for public policy intervention include contact generation with distributors, banks and business intelligence on commercial laws, as well as capacity to comply with sanitary and phytosanitary requirements.

Fourth, amidst the COVID-19 global economic crisis, trade will continue to be crucial for small open economies in Central America. Multilateral institutions certainly have a role to play, providing new opportunities like co-financing research and development, strengthening financial markets, financing technology adoption and helping firms access new markets. These actions must be complementary however, to governments’ policy responses, incorporating private sector participation to understand what is needed to take better advantage of trade.

To sum up, reaching new markets and producing more sophisticated products will be critical for the future of Central American economies to help them become stronger and more resilient to global economic downturns, and to boost their economic growth and shared prosperity. The global crisis makes this shift in trade and production transformation policies even more urgent. Thus, more sophisticated economy and stronger regional value chains will increase the region’s ability to respond to its population’s development needs. Finally, innovation is necessary to address future health and environmental crises.