Towards a Sustainable FTAA: Does Latin America Meet the Necessary Financial Preconditions?

Working Paper
02-4
July 2002

This paper focuses on identifying preconditions that will ensure the sustainability of a Free Trade Area of the Americas (FTAA). It argues that the macro, micro, and political conditions advanced in the literature to measure a country’s ability to compete internationally, while necessary, are not sufficient to ensure the success and permanence of a free trade agreement. Instead, two additional financial conditions are needed. The first is that each partner in the free trade area needs to have sustainable public debts as determined by the achievement of credible and sustainable structural fiscal balances. The second is that exchange rate regimes across trading partners should be compatible in the sense that adverse shocks in one country do not generate a policy dilemma in other partners between abandoning their exchange rate system or the free trade area.

A preliminary analysis of the evidence in the Latin American and Caribbean region shows the importance of these two preconditions. An analysis of debt sustainability reveals that there are a number of countries in the region that need to deal with potential solvency problems before reaching the status of credible partners in a regional trade arrangement. Argentina is already deemed insolvent, and countries such as Ecuador and Venezuela rank high on the list of countries where the issue of debt sustainability can become a serious problem. Not resolving this before reaching a regional trade agreement can threaten its long-term stability.

The examination of the compatibility of exchange rate systems across trading partners is also very revealing. Part of the success of NAFTA since the late 1990s and the “impasse” of Mercosur during 1999- 2001 had to do with the choices of exchange rate regimes. In both trade areas the share of trade among the partners is very high, and in NAFTA, this includes significant financial transactions. While Mexico was able to use the flexibility of the exchange rate to improve competitiveness following the sharp decline of portfolio flows from US investors into Mexico following the Asian and Russian crises, Argentina had no mechanisms to deal with an adverse shock from Brazil (such as a depreciation of the real in 1999). From this perspective, the recent move of Argentina towards a more flexible exchange rate system is good news for a sustainable free trade area.