Policy Updates

The scope for reducing transport costs today, and the likelihood of productivity gains, is much higher than the benefits seen from further reductions to tariffs. Overall, a 10 percent reduction in transport costs would boost both intra-regional exports and the number of products exported by a far greater margin than a 10 percent tariff reduction. The median expansion in intra-regional exports would be almost five times larger than that from cutting tariffs. The median increase in the number of products exported to the region would be nine times larger.

For instance, if Chile were to reduce its average manufacturing tariff and freight rates to U.S. levels, the required fall in the average tariff would be only around 10 percent while the required reduction in freight costs would be more than 50 percent. The improvement in productivity arising from a better allocation of resources would be nearly three times higher than that triggered by the cut in tariffs.

This speaks volumes about the urgency to focus on transport costs if the region wants to get serious about fostering productivity through trade.

An international comparison of Latin America’s freight rates with those of other regions show that Chile is not an isolated case. For instance, while the average ad valorem freight rate of Latin America’s exports to the United States is around 6 percent, it is only about 3.7 percent in the European Union. This result is not explained by distance to the Southern Cone alone but also reflects the realities of countries in the Caribbean and Central America that are closer to the United States.

These figures illustrate that there is plenty of room to cut transport costs. The question is: what can governments do? After all, freight rates, unlike tariffs, are not just the product of bad policies alone. Factors such as geography or the composition of trade also matter.

Two important clues arise when looking at the differences in transport costs between Latin America and other regions. First, trade composition is important.The goods that the region imports and exports—particularly products such as mineral or agricultural goods—are considerably “heavier” than those of the United States or Europe.

Therefore, poor and costly transport infrastructure can severely undercut the rents that countries can extract from exporting their natural-resource-intensive goods, leaving less money on the table relative to other regions that specialize in less transport-intensive goods.

This alone serves as a powerful reminder of the strategic importance of transport infrastructure for Latin America and the Caribbean.

The second clue: factors like port efficiency or competition in transport services are key contributors to the higher freight rates observed in the region. For instance, inefficiencies in ports and airports generally explain about 40 percent of the difference in shipping costs between the region and the U.S. or Europe. For the typical Latin American country, improving port efficiency to the U.S. level would lower transport costs by about 20 percent.

These results suggest that there is no shortage of policy areas where the region can delve more deeply. For example, many countries have yet to adopt the successful regional and global experiences for port terminal concession contracts that have brought modern operation practices and higher berth productivity. Promoting investment to expand the limited current capacity of the port network in the region is imperative.

Regarding air transportation, many countries in Latin America still operate under dysfunctional bilateral agreements. Liberalized market access in other parts of the world, achieved through “open skies” agreements, have not been matched in the region. Modernizing custom procedures, facilitating border crossings and promoting investment and competition in logistic networks are also elements of this new trade agenda.

Trade liberalization has opened up many opportunities, but the almost exclusive focus on traditional trade barriers has meant that the region has missed out on substantial productivity gains in other sectors.

An all-out effort to revamp the transport infrastructure could unlock these gains and help the region close its still-sizeable productivity gap with the developed world.

In contrast to the inflation and devaluation of the 1990s, dollarization has introduced a sense of stability that has directly benefited Ecuadorans. From 2000 to 2006, real family income increased 14 percent. In the last four years (through June 2010), real salaries rose an additional 25 percent.

The urban poor in particular have reaped clear gains from the policy. At the time when the government introduced dollarization in December 2000, 54 of every 100 Ecuadorans were living below the poverty level. Six years later, the Instituto Nacional de Estadísticas y Censos de Ecuador reports this figure dropped to 26 percent. As of December 2009, the urban poverty rate fell to 25 percent.

At the same time, the minimum annual wage—now in a reliable currency—rose from $67 in 2000 to $280 in 2010. And as a result, Ecuador is experiencing an influx of workers from countries such as Colombia and Peru.

But fiscal policies have shifted since President Rafael Correa came into office in January 2007.

The President has stepped up government intervention in the economy, boosting public spending to deliver on his campaign promises of increasing social outlays and expanding government efforts to reduce poverty and inequality. During the first six years of dollarization, expenditure in the non-financial public sector (NFPS) amounted to 25 percent of GDP. This figure has escalated to 39 percent of GDP, on average, during the last four years—a trend that threatens the strict fiscal discipline necessary to survive a fixed exchange rate model.

Correa’s subsidy policies are also threatening the long-term survival of dollarization.

In 2010, a general fuel subsidy, electricity subsidies, a monthly stipend for more than a million poor Ecuadorans, and a subsidy for the poor to afford housing and agricultural products totaled approximately 7 percent of GDP. These expansionary fiscal policies are simply unsustainable with a monetary policy constrained by the rigors of a dollarized economy.

On top of that, government intervention since 2007 has led to a decrease in private investment—a prime driver of employment. It is not surprising that the creation of 91,000 new government jobs has been accompanied by the loss of 100,000 formal jobs over the same period. The lack of private investors has become a drag on Ecuador’s economy and job growth: today 2.6 million people are either unemployed or underemployed.

Today, even government proponents like Alberto Acosta, the former president of the constituent assembly, have recognized that employment is the government’s Achilles’ heel.

Sustaining dollarization is Correa’s top priority in the fourth year of his administration. Economic stability will depend to a large extent on the price of oil—though both production and exports have fallen. But the government will also need to put the brakes on public spending, find new and much-needed sources of income, and develop a sound, viable budget.

The alarm has already sounded. This year’s annual budget calls for a 6 percent deficit in NFPS spending as a percentage of GDP. On top of that, since 2008, the Correa administration has sold $3 billion in domestic bonds to the Instituto Ecuatoriano de Seguridad Social (IESS) to finance current expenditures.

The Central Bank has also used $500 million of its liquidity to finance the public budget. Last year, the government had to borrow $1 billion from China—under less than favorable conditions—to keep it afloat and another $1 billion was being negotiated when this magazine went to press. Additionally, its credit line is maxed out with the Corporación Andina de Fomento and the Inter-American Development Bank.

Against this background, it is questionable whether the Correa administration can continue to sustain its ambitious, multiple campaign pledges.

Ecuador would do well to learn from the recent chaos in Greece—another country with a strong currency but out-of-control public spending. While the circumstances of the two countries are quite different—Ecuador, for example, does not have an excessive national debt—the risk of a currency collapse is a possibility without better policy management.
In order not to endanger the stability and growth brought on by dollarization, Ecuador must get its fiscal house in order.