The Dominican Republic-Central America-United States Free Trade Agreement (CAFTA DR): Developments in Trade and Investment
Released: 2012-04-23T00:00:00

Summary:
On August 5, 2004, the United States entered into the Dominican Republic-Central America-United States Free Trade Agreement (CAFTA-DR). Congress passed the implementing bill on July 28, 2005 (P.L. 109-53) and CAFTA-DR entered into force with El Salvador, Honduras, Nicaragua, and Guatemala by July 1, 2006, the Dominican Republic on March 1, 2007, and Costa Rica on January 1, 2009. This permanent, comprehensive, and reciprocal trade agreement eliminates tariff and non-tariff barriers to two-way trade, building on unilateral trade preferences begun under the 1983 Caribbean Basin Initiative (CBI). It enhances rules and other standards for services, intellectual property rights, government procurement, and investment, and other disciplines. It also reinforces Congress's historical support for trade as a foundation of broader foreign economic, political, and security policies in the region. This report supports congressional interest with an analysis of the trade and investment trends since CAFTA-DR entered into force.
CAFTA-DR reinforces trade and investment trends that have been emerging at least over the past decade. The United States remains the region's dominant trade partner, but its share of total trade has begun to decline. Intra-Central America trade and trade with China have seen the largest growth. Still, the United States (1) has vibrant trade in intermediate goods reflecting increasingly integrated production with the region; (2) provides the largest portion of foreign direct investment to the region; and, (3) remains the largest market for high-technology content exports. Because U.S. tariffs were already relatively low, the United States International Trade Commission model predicted that U.S. exports would rise slightly faster than imports, which so far has been the case.
One important indicator is the change in composition of trade. The United States has seen strong growth in exports of mineral fuels, machinery, cereals, yarns, and fabrics. Historically, the CAFTA-DR region has exported agricultural products and later apparel and other assembled goods to the United States. For over the past decade, more sophisticated and higher-value exports have grown, including specialized machinery goods (e.g., small aviation motors), electrical goods (e.g., integrated circuits), and medical equipment, while exports of light manufactures such as apparel have stagnated, or in some cases, declined. Agricultural trade has increased moderately and remains a combination of traditional exports (e.g., coffee and bananas) with little growth in higher value nontraditional goods (e.g., pineapple and sweet peppers).
These aggregate trends, however, mask important country differences. As examples of moving up the value chain, Costa Rica has increased nontraditional production in both its manufacturing and agricultural sectors, and so has experienced the largest growth in exports. Similarly, Nicaragua has begun to enter the assembly manufacturing sector and so experienced the second highest rate of trade growth. The other four countries have seen their exports stagnate or decline for multiple reasons, including dependence on the highly competitive apparel trade, lower levels of investment, public security problems, and broader governance and policy concerns.
CAFTA-DR reinforces the idea that growth in trade correlates closely with policies that promote economic stability, private investment in production, public investment in education, infrastructure, logistics, and good governance in general. Countries with worsening security and governance problems face additional problems in benefitting from CAFTA-DR. It is also important to promote productivity in part by avoiding delays in making necessary adjustments to trade liberalization, focusing public and private resources on trade facilitation, developing strategies for trade diversification, and examining CAFTA-DR trade rules (especially for textiles and apparel) that have perhaps inadvertently hindered trade growth expected from the accord.

subsections: section_title: Introduction
paragraphs: On August 5, 2004, the United States entered into the Dominican Republic-Central America-United States Free Trade Agreement (CAFTA-DR) with Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic (hereafter the CAFTA-DR countries). Congress engaged in a full year of debate before narrowly passing the implementing bill. On July 28, 2005, after assurances from Bush Administration officials on many issues, the House approved it by a two-vote margin (217 to 215), followed by passage in the Senate (55-45), clearing the measure for presidential signature on August 2, 2005 ( P.L. 109-53 ). Implementing the agreement proved equally challenging and occurred on a rolling basis after each country made legal, regulatory, and rule changes to comply with the accord's obligations. CAFTA-DR entered into force with El Salvador, Honduras, Nicaragua, and Guatemala by July 1, 2006, the Dominican Republic on March 1, 2007, and Costa Rica on January 1, 2009.
This report follows up on congressional interest by providing an analysis of the trends in trade and investment since CAFTA-DR entered into force six years ago. Changes in rules governing issues such as intellectual property rights, government procurement, services, labor and others are not easily measured and will require a longer-time frame to evaluate. The report concentrates on trends in all countries, with close attention paid to the CAFTA-DR partner economies. The marginal effects on the U.S. economy are expected to be small by comparison because the CAFTA-DR countries are economically about the size of the Denver metropolitan area, and they already had duty-free access to the U.S. market under various unilateral preference programs.
section_title: Background and Rationale for CAFTA-DR
paragraphs: Historically, the United States has entered into free trade agreements (FTAs) and unilateral trade preference programs with developing countries in the pursuit of both economic and foreign policy goals. In 1983, the U.S. Congress passed the Caribbean Basin Initiative (CBI—formally the Caribbean Basin Economic Recovery Act— P.L. 98-67 ) to support political and economic stability in the Caribbean at a particularly vulnerable time (see Figure 1 , Map of Central America and the Caribbean). The CBI included limited unilateral trade preferences, which required periodic congressional reauthorization. CAFTA-DR builds on this precedent, but makes preferential access comprehensive, reciprocal, and permanent while also enhancing rules and other disciplines on trade. It is intended to strengthen economic relations as a way to stimulate growth, to foster stability, and, in the words of Congress, "to lay the foundation for further cooperation."
The economic rationale rests on preferential access for agricultural and manufactured goods produced in the region. By removing regional barriers to trade, CAFTA-DR encouraged the development of specialized co-production in assembly manufacturing between the United States and CAFTA-DR countries based on comparative advantage and economies of scale. This strategy has increased the productivity (a major benefit of trade) of firms in all countries. Firm competitiveness rests on value-added supply chain relationships, particularly in the area of apparel manufacturing, later extended to automobile parts, medical equipment, integrated circuits, and other products. Tariff preferences under CAFTA-DR (and CBI previously) have helped firms remain marginally competitive with Asian and other low-cost global producers.
By moving from limited unilateral trade preferences to comprehensive bilateral free trade under CAFTA-DR, U.S. exporters also stood to benefit from reduced trade barriers, both for final goods and the increasingly large intermediate goods trade characteristic of the supply chain model. Market access, therefore, was central to the FTA negotiations. Equally important for the United States were enhanced rules covering multiple disciplines including trade in services, intellectual property rights, sanitary and phytosanitary regulations, investment, government procurement, labor, and environment, among others. From the Central American and Dominican perspectives, permanently reducing barriers to the U.S. market was the core objective, assuring investors that exports would have permanent duty-free access to the large U.S. market, while ensuring lower-cost imports (including capital and intermediate goods) for consumers and producers alike.
Increased trade can raise a country's long-term growth rate through multiple channels including increased market size, production specialization, scale economies, transfer of technology and managerial/worker expertise, more efficient resource use, and increased investment. With these factors in mind, the agreement takes on an added importance given the dominant role of the U.S. economy for the CAFTA-DR countries.
Market access in a reciprocal trade agreement works both ways, however, so countries also face certain challenges. In the United States, CAFTA-DR raised concerns over negative effects on import-competing firms. This is often part of the cost inherent in a free trade agreement, though it is expected to be small relative to the U.S. economy as a whole. For CAFTA-DR countries, U.S. agricultural exports, including staples such as corn and rice, increasingly compete with local production of basic grains. A transition period was built in with an extended tariff phase-out schedule and safeguards as a partial response to this concern. As a matter of development policy, however, CAFTA-DR countries also envision diversifying agricultural sectors into higher value nontraditional exports, and integrating rural economies more deeply with other sectors. CAFTA-DR's success will in part be judged by how well this transition is made, and so far, results have not been uniform among the six countries.
section_title: CAFTA-DR Trade Rules
paragraphs: Market access is at the center of free trade agreements and refers to provisions that govern barriers to trade such as tariffs and quotas. Rules of origin determine which goods are eligible for tariff preferences based on their regional content, and are particularly relevant for textile and apparel trade. CAFTA-DR requires that each country accord national and most favored nation treatment (non-discrimination) to all parties. The FTA also replaces and consolidates in a permanent bilateral agreement trade preferences formerly extended unilaterally under the Generalized System of Preferences (GSP), the Caribbean Basin Economic Recovery Act (CBERA), and the Caribbean Basin Trade Partnership Act (CBTPA).
CAFTA-DR calls for the progressive elimination of nearly all customs duties. Each country negotiated a list of its most sensitive products for which duty-free treatment is delayed, including separate provisions for certain apparel and agricultural products. For non-textile manufactured goods, duties on 80% of U.S. exports were eliminated immediately, with the rest phased out over a period of up to 10 years. For agricultural goods, duties on over 50% of U.S. exports were eliminated immediately, with the rest phased out over a period of up to 20 years. In some cases, duty-free treatment is "back loaded," meaning it will not begin for seven years or more after the agreement takes effect. For the CAFTA-DR countries, 100% of non-textile and non-agricultural goods began to enter the United States duty free upon implementation. Safeguards are retained for certain agriculture and textile goods over the period of duty phaseout, but antidumping and countervailing duties were not addressed in the CAFTA-DR, leaving all U.S. and other country trade remedy laws fully enforceable under the World Trade Organization (WTO). 
subsections: section_title: Apparel Rules
paragraphs: CAFTA-DR apparel enters the United States under a "yarn forward rule," with some exceptions, building on the standard developed for the region under the CBTPA in 2001. Yarn production and all operations that follow, from fabric production through cutting and apparel assembly, must be done in either the United States or a CAFTA-DR country, if the good is to qualify for duty-free treatment. From 2008 to 2011, 82% of qualifying textile and apparel imports from CAFTA-DR countries entered the United States under this rule.
There are numerous exceptions including the "cut and assemble" rule, which allows for use of third country inputs (typically lower-cost Asian yarns and fabrics) for certain specified goods provided they are cut and assembled in a CAFTA-DR country. A de minimis rule permits duty-free entry of goods in which up to 10% of the weight of the fibers and yarns may come from third country sources. Separate rules (tariff preference levels—TPLs) for Nicaragua and Costa Rica allow for specified quantities of duty-free apparel imports that may be assembled from limited amounts of third country materials. A "short supply" list allows for use of fibers, yarns, and fabrics from third countries when not available in commercial quantities in the region, and CAFTA-DR allows for "cumulation" or the use of inputs from the various countries within the region, with limitations on the use of Mexican yarns and fabrics for wool, denim, cotton, and man-made fiber. Other exceptions exist for hand-loomed fabric of a cottage industry, folklore handicrafts, and other products. A "fabric-forward" rule allows for wool yarn from third countries to be used in certain textile and apparel goods and more detailed rules exist for specific cases of apparel manufacturing. Another 15% of qualifying imports entered duty free under these rules.
section_title: Agriculture Rules
paragraphs: Under agriculture, domestic support programs are not addressed in the CAFTA-DR, which focuses instead on reducing tariffs and defining quota levels, the most costly trade-distorting policies. Average applied tariffs on agricultural goods by most CAFTA-DR countries range from 7% to 23%. Most agricultural imports face no tariff in the United States. But for select products in all countries, the pressing challenge was negotiating tariff rate quotas (TRQs—see below), or limits on the quantity of imports that can enter the United States before higher tariffs are applied. Tariffs for sensitive agricultural products have the most generous phase-out schedules, with up to 20 years for some products (e.g., rice and dairy). This approach acknowledges that the agricultural sectors bear most of the trade adjustment costs and so are given more time to make the transition to freer trade.
All agricultural trade eventually becomes duty-free except for sugar imported by the United States, fresh potatoes and onions imported by Costa Rica, and white corn imported by the other Central American countries. These goods will continue to be subject to quotas that will increase by approximately 2% each year in perpetuity, with no decrease in the size of the above-quota tariff. Over half of current U.S. farm exports to Central America became duty free upon implementation, including cotton, wheat, soybeans, certain fruits and vegetables, processed food products, wine, and high quality cuts of beef.
section_title: Trends in CAFTA-DR Merchandise Trade
paragraphs: Following is a discussion of the major trends in merchandise trade from 2000 to 2011. For comparative purposes, this encompasses a period of time before and after the agreement entered into force. It is a starting point for raising questions over the possible effects of CAFTA-DR.
subsections: section_title: CAFTA-DR Direction of Trade
paragraphs: There have been three major changes in the direction of CAFTA-DR trade over the last decade, including the period of time the agreement has been in force:
first, although the United States remains the CAFTA-DR countries' dominant trade partner, U.S. trade has fallen relative to other countries; second, trade with China and Mexico has increased; and third, intra-Central America trade and integration has increased and deepened.
As seen in Table 1 , in 2000, the United States accounted for 73% of CAFTA-DR exports and 55% of its imports. By 2010 (latest available data), these figures had fallen to 43% and 46%, respectively, the decline occurring in all CAFTA-DR countries. From 2000 to 2010, exports to China rose from near zero to 6% of CAFTA-DR exports, and the import share increased from 2% to 7%. Intra-Central America trade rose from 2% to 11% of the region's exports, with imports climbing similarly, making Central America, in the words of one analysis, the hemisphere's "region that trades the most with itself."
CAFTA-DR plays a supporting, rather than leading, role in these evolving trade patterns. The rise in exports to China, for example, is accounted for entirely by Costa Rican semiconductor exports. Increased intra-Central American resulted from a long-sought effort to deepen subregional integration. In addition to CAFTA-DR, the effort came to fruition with the signing of the Mexico-Central America Free Trade Agreement on November 22, 2011. The deepening integration resulted in a nearly four-fold increase in Mexico-Central America trade over the past decade that is in part supported by the supply chain relationships that U.S. and other firms have developed in the Caribbean, Central America, and Mexican economies (particularly in automobile, apparel, and computer electronics industries).
CAFTA-DR reinforces regional integration with rules of origin that allow greater cumulation of production between Central American and Mexican producers using U.S. inputs. With increased harmonized rules of origin, the region becomes globally more competitive by increasing co-production relationships, reducing delays at the border, and allowing for greater economies of scale in production. New cumulation rules also allow for U.S. duty-free treatment of imports assembled from inputs produced in Central America or Mexico.
This relationship is evident in the production of integrated circuits, automobile parts, and apparel, in which the United States ships parts from all these industries to the region for further processing. For example, Mexico imports integrated circuits from Costa Rica, apparel from Guatemala, and wire harness sets for automobiles from Nicaragua, all transformed from U.S. inputs. These goods are used for assembly of computers, apparel, and automobiles for export to the United States and elsewhere in Latin America. Similarly, fabric produced in the United States, the Dominican Republic, Honduras, and Guatemala is used in apparel production in many of the CAFTA-DR countries, with final goods receiving duty-free treatment when they enter the United States. So unlike previous commodity-driven export growth, much of region's trade reflects global supply chain manufacturing related to U.S. production and global consumption.
In addition, analysis of the technology content of CAFTA-DR country exports suggests that the agreement supports the trend of the United States being the largest market for technology-enhanced exports, ranging from low-technology apparel to high-technology medical equipment and integrated circuits. Exports from Costa Rica and the Dominican Republic have the highest concentration of technology intensiveness, Guatemala and Nicaragua the lowest. The potential for future benefit from technology-enhanced exports is uncertain, however, given the need for CAFTA-DR countries to increase productivity and adopt complementary policies to become more globally competitive and take fuller advantage of the trade agreement.
section_title: U.S.-CAFTA-DR Bilateral Trade
paragraphs: Aggregate U.S.-CAFTA-DR bilateral trade is presented in Figure 2 . Two trends dominate:
Trade and U.S. economic growth trend together, reflecting only modest growth for much of the decade until the 2010 recovery from the global recession; and, Growth in U.S. exports has outpaced U.S. imports, resulting in a U.S. trade surplus each year since CAFTA-DR entered into force.
U.S. demand is a key factor defining trade growth, influencing both imports and exports because of significant intra-industry trade. Also, because a large portion of CAFTA-DR exports entered the United States duty free prior to implementation of the agreement, the United States International Trade Commission (USITC) model predicted that the marginal trade effects of the accord would be a relatively larger increase in U.S. exports, as appears to be the case, so far.
subsections: section_title: U.S. Exports by Country
paragraphs:  Figure 3 shows the value of U.S. exports by country, reflecting a modest, but upward trend for all countries except during the 2008-2009 global recession. In recent years, the trend in U.S. export growth has been skewed by the rise in price and volume of refined petroleum products, which on a value basis increased from 3.2% of total exports to the region in 2000 to 23.7% in 2011. 
section_title: U.S. Imports by Country
paragraphs: U.S. imports from CAFTA-DR countries reflect demonstrably different trends since 2000. As seen in Figure 4 , there has been little real growth in U.S. imports from the region in most cases. Interestingly, in percentage terms, U.S. imports have also grown the most from Costa Rica and Nicaragua, the richest and poorest CAFTA-DR countries, respectively, whereas U.S. imports from the other four countries have shown much slower growth, with the Dominican Republic actually registering a decline.
These trends are also seen in Figure 5 , which compares the relative position of each CAFTA-DR country with respect to U.S. imports and exports in 2000 and 2011. As may be seen, most countries that experienced a relative increase or decline in U.S. exports between these two years also experienced a similar increase or decline in U.S. imports (another indication of importance of intra-industry trade common in the manufacturing sector). Costa Rica accounted for 36% of U.S. imports from the region in 2011, up from 22% in 2000 and Nicaragua's portion rose from 4% to over 9%. The remaining four countries experienced a counterbalancing decline in their share of U.S. imports, particularly the Dominican Republic.
section_title: Composition of U.S.-CAFTA-DR Trade
paragraphs: Examining the trade data at the product level provides shows changes in the composition of U.S. trade among these countries. This focus also points to the possible development aspects of trade liberalization to the extent that the value added of a country's exports increases by transitioning away from traditional to nontraditional, and from low-tech to high-tech intensive products.
 Figure 6 compares the composition of U.S.-CAFTA-DR trade for the years 2000 and 2011. Product groups have been combined by Harmonized Tariff System (HTS) codes to provide an indication of broad trends in trade composition. The first category is defined as apparel, yarns, and fabrics. It includes knit, woven, and footwear goods plus yarns and fabrics (HTS 52, 55, 60, 61, 62, 63, and 64). The second category comprises electrical and non-electrical machinery products (HTS 85 and 84). The third category constitutes agriculture products such as fish, vegetables, fruit, coffee, sugar, and tobacco (HTS 03, 07, 08, 09, 17, and 24). Finally, optical and medical equipment capture imports of HTS 90.
Key trends from Figure 6 and Table 2 include
the structure of U.S. exports has not shifted dramatically, with the notable rise in the value of petroleum products; U.S. imports have shifted from apparel to higher value-added manufactures;
Costa Rica stands alone as a non-apparel, high tech exporter; Honduras, El Salvador, and Nicaragua export large amounts of low tech apparel; Guatemala splits major exports between agriculture and apparel; and, the Dominican Republic has the most diversified export structure with medical manufactures, mining, apparel, and processed agricultural goods.
subsections: section_title: Textiles and Apparel
paragraphs: From 2000 to 2011, aggregate U.S. exports of apparel, yarns, and fabrics declined from 33.4% to 12.4% of total U.S. exports to the CAFTA-DR countries. Although all categories declined, it was particularly steep for knit and woven apparel parts shipped for further assembly. Basic fibers, yarns, and fabrics declined as well, but less in relative terms. This relative shift away from apparel exports towards more yarn and fabric suggests that more of the production process (e.g., computerized design and cutting) is being done in the CAFTA-DR countries.
Similarly, although apparel is still the largest U.S. import sector in 2011, capturing 30.4% of total merchandise imports from the region, this is notably smaller than the 56.1% of 2000. Apparel rules under CAFTA-DR are intended to support trade from the region. To qualify for duty-free treatment, most apparel enters under a yarn forward rule. Nonetheless, the decline in apparel as a percentage of total U.S. imports from the region coincides with the growing U.S. import penetration from Asian and other low-cost producers, and may be seen in the slowed growth of U.S. imports from the major apparel producers: Honduras, El Salvador, and Guatemala. These countries are vulnerable to competition from lower-wage countries and without a shift in investment to higher value-added production, they may continue to see limited growth in their exports to the United States, despite preferential access accorded apparel under CAFTA-DR.
By contrast, U.S. imports in general from Costa Rica and Nicaragua have shifted for two very different reasons. With the exception of some specialty high-end products, Costa Rica, the most developed of the CAFTA-DR countries, has ceded the apparel trade to other countries. It has shifted to other higher value-added goods. Nicaragua, the poorest and least developed of the group, is expanding into apparel exports to the United States for two reasons in particular. First, it is the beneficiary of CAFTA-DR tariff preferences levels (TPLs), which allow Nicaragua to export apparel goods assembled from limited amounts of third country materials (e.g., less expensive Asian yarns). Second, relatively low wages in Nicaragua mean its firms are still competitive with those in Asian countries for the lower-skilled sector of the industry (see Table A-10 , International Hourly Wage Rates, in the Appendix ). The Dominican Republic appears to be in transition, moving away from apparel except for footwear, as seen in its diversified export structure.
section_title: Machinery and Other Manufacturing
paragraphs: Machinery and electrical machinery goods, by contrast, display a different pattern. U.S. exports in this group have declined from 20.5% to 16.2% as a percentage of total exports, from 2000 to 2011, but have continued to grow in dollar terms at a modest rate. U.S. imports, however, have grown dramatically, from 10.9% of total imports in 2000 to 28.8% in 2011. In addition, U.S. imports in the medical instruments category have also grown, the more technology-intensive products coming from Costa Rica and the Dominican Republic.
One key factor is Costa Rica's so-called "Intel Effect," as seen in the country's strong growth in exports despite the global recession. It points to the transformation of the Costa Rican economy away from not only traditional agricultural exports, but traditional apparel manufacturing as well. Costa Rica has moved toward more sophisticated manufacturing processes involving integrated circuits, medical equipment, and machine parts (e.g., specialized aviation motors) destined for the U.S. market and based on U.S. inputs. In addition, as a matter of policy, Costa Rica has identified and encouraged the development of related industries, such as specialized packaging for electronics goods that previously had been contracted to foreign suppliers.
Although still dependent on agriculture, Nicaragua also deserves a special note for transitioning to assembly-type manufacturing, including wire harnesses for automobiles. Nicaragua is the poorest country in Central America, but appears to be undergoing economic transformation, moving into low-skilled assembly manufacturing even as Costa Rica exits the industry. In both cases, these are signs of economic development. U.S. import data for the Dominican Republic reflect a sharp decline in apparel, except for footwear, falling from 55% of total U.S. imports in 2000 to 17% in 2011 (data not shown). At the same time, there has been an increase in imports of medical equipment and other manufactures, perhaps indicating the country may also be undergoing transition in economic production.
section_title: Agriculture
paragraphs: The United States has experienced strong growth in agricultural exports since CAFTA-DR entered into force. Cereals account for only 6% of U.S. exports, but have increased from $508 million in 2000 to $768 million in 2005 and $1,800 million in 2011. Corn represents over half of the cereals exports in 2011, followed by wheat and rice. Meat exports increased from $60 million in 2000 to $91 million in 2005 and $290 million in 2011, a three-fold increase since the FTA was implemented. Agricultural exports may be expected to rise further as the phased-in tariff reductions continue to be implemented over time.
In the aggregate, U.S. imports of agriculture from the CAFTA-DR region have grown modestly from 2000 to 2011, rising from 10.9% to 15.5% of total U.S. imports. Costa Rica has experienced a decline in total agricultural exports to the United States, but has distinguished itself again in making the transition to more value-added, nontraditional agriculture exports, particularly pineapple. The Dominican Republic has seen little agricultural export growth except for sugar and tobacco, and Guatemala, Nicaragua, and Honduras have seen slight increases in fruit, fish, and specialized coffee exports, demonstrating some shift in production to nontraditional exports. A key problem has been the limited ability to make the transition to nontraditional exporting more fully, reflecting a need for further structural reforms and support for the sector in order for agriculture to take greater advantage of CAFTA-DR. 
There is an ongoing debate over CAFTA-DR's effects on small agricultural producers in the region. Early estimates suggested that overall increased agricultural trade could be an important source of rural development. In addition to increasing CAFTA-DR country agricultural exports, the majority of households are net consumers of agricultural goods and stand to gain from lower prices, the equivalent to an increase in family income. Because subsistence farmers' generally produce little for sale, they are unlikely to be greatly affected by changes in market prices.
Still, some small producers of agricultural goods may be harmed, and many economists argue that adjustment policies are necessary to increase productivity in this segment of agricultural producers. The tariff transition period is intended to provide space to do this. The alternative is to protect certain industry groups, by maintaining artificially high domestic prices, while delaying and making more difficult necessary competitive adjustment, a deficient strategy often associated with Mexico under the North American Free Trade Agreement (NAFTA). It may be a problem for certain CAFTA-DR industries as well. Costa Rica, for example, supports domestic rice production with subsidies and price controls, delaying and perhaps eventually compounding the adjustment that will be needed as the tariff rate quotas for U.S. rice phase out over 20 years. 
section_title: Foreign Direct Investment in CAFTA-DR Countries
paragraphs: FTAs are often considered as much about investment as trade, and foreign direct investment (FDI) is one measure of a country's foreign attractiveness. An FTA can encourage FDI through two channels. First, permanent preferential access to the U.S. market reassures potential investors that access to the largest market is more stable. Second, enhanced investment rules protect investors. Investment is a critical component of a country's economic growth and development, and where domestic savings rates are low, or opportunities are readily apparent, FDI is one way to meet demand for capital. There are potentially many economic benefits to FDI, although their realization depends on where and how FDI is invested, and the policies governing its use. In general, however, there appears to be broad recognition that the benefits of FDI outweigh the costs in most cases for developing countries.
Trends in FDI vary among the six CAFTA-DR countries and total net foreign direct investment is shown in Figure 7 , with the United States the largest investor in the region. Trends suggest that a formal investment agreement alone is not sufficient to guarantee uniform results. Three trends stand out:
first, FDI increased in all CAFTA-DR countries immediately prior to and after the FTA entered into force, but magnitudes differed widely; second, investment is also influenced by macroeconomic conditions, as reflected in the decline following the 2007-08 global financial crisis; and, third, Costa Rica and the Dominican Republic outdistanced the rest of the countries in attracting new FDI. They have the highest labor rates (see Table A-10 in the Appendix ) and level of manufactured exports, indicating that investment is not necessarily drawn to low-cost producers, but rather to countries that have relatively higher levels of stability, education, and productivity.
section_title: An Analysis of Trade and Investment Trends
paragraphs: Both theoretical and empirical literature on trade presents differing viewpoints on the benefits of liberalizing commercial exchange in small developing countries. Trade can promote growth through increased productivity, and firm-level studies corroborate the strong link between firm productivity and exporting, but they often argue that the benefit from trade comes from "facilitating the growth of high-productivity plants, not by increasing productivity growth at those plants." That is, productivity may increase trade more than the other way around, although both directions of influence are likely. Many economists also argue that trade liberalization can increase a country's long-term growth rate through other channels including increased market size, production specialization, scale economies, transfer of technology and managerial/worker expertise, more efficient resource use, and increased investment. Case studies, however, offer contradictory evidence, pointing up examples where growth has or has not followed trade opening. Such seemingly irreconcilable outcomes raise fundamental questions over how and why the benefits of trade seem to be more robust in some cases, but not in others.
CAFTA-DR countries comprise an economically heterogeneous group and seem to mirror the disparate responses to trade liberalization found in the economic literature. Country- and product-specific trade and FDI trends vary significantly. Noticeable differences exist with respect to a number of variables that may affect a country's ability to manage openness under an FTA. For the export model of development to succeed, productivity improvements are necessary, which in addition to private sector initiatives implies an important public sector role in creating a solid business environment. Failure to do so may be equivalent to restricting many of the CAFTA-DR countries to a diminished development model of trade in which they are locked into low-level manufacturing and low-value agricultural production, competing with the poorest countries of the world. In such a scenario, improving economic well-being will be a slow process.
Managing openness implies encouraging macroeconomic stability, investment, and complementary policies to enhance economic growth directly, which can improve chances for reaping the benefits of trade liberalization. Stated otherwise, developing countries may respond less to trade liberalization because they are less invested in policies that, in and of themselves, promote growth more directly than trade. A non-exhaustive list includes support for private sector investment, infrastructure, education, and good governance, including an efficient and predictable regulatory framework. As discussed below, the fiscal commitment to accomplish these goals has been lacking, with the possible exception of Costa Rica. To the extent that these, and perhaps other non-trade policy areas, function to improve economic growth and efficiency, they can directly and indirectly support a country's ability to take fuller advantage of trade liberalization. Differences in growth of exports and FDI seem to correlate closely with similar trends in these variables.
subsections: section_title: Macroeconomic Factors
paragraphs: Maintaining macroeconomic stability, particularly when an international economic crisis occurs, may be one of the most important goals to ensure long-term growth and higher benefits from trade liberalization. Macroeconomic stability, in short, supports competitiveness. Over the last two decades, the CAFTA-DR countries reinforced this theme with their own reform agendas, which have contributed to relatively higher economic growth and stability, despite recent global volatility. They have experienced solid, but not spectacular economic growth since 2002 (see Table A-1 in the Appendix ). Costa Rica, Honduras, and the Dominican Republic show above average expansion for the region, while El Salvador and Nicaragua tend to lag. These economies have become increasingly open, particularly among themselves and with the United States, setting a sound development foundation to begin to utilize the opportunities of CAFTA-DR. The downside of this relationship is that as small, open economies, they are heavily dependent on the U.S. economy and susceptible to global shocks, particularly through price channels. The sharp fluctuations in commodity prices and global recession of 2008-2009, for example, disrupted growth trends in trade and output. 
section_title: Microeconomic Factors
paragraphs: In addition to macroeconomic reforms and stability, so-called "second generations reforms" are essential for trade to become an engine of growth and development. Since CAFTA-DR was first proposed, new microeconomic indicators have been developed to analyze the regulatory environment for business, a critical variable for assessing competitiveness or readiness to undertake the obligations and benefit from a U.S. reciprocal free trade agreement.
subsections: section_title: Doing Business Indicators
paragraphs: The World Bank calculates a series of measures referred to as Doing Business Indicators, which provide a comparative measure of the business regulatory environment. These metrics add an important dimension for assessing economic competitiveness, particularly for countries that have achieved other important goals such as peace and macroeconomic stability. These indicators compare the efficiency, accessibility, and implementation of a country's regulations, a key consideration in evaluating a country's ability to fulfill its CAFTA-DR obligations. In addition, having good rules, the World Bank argues, is a key to supporting small and medium-sized businesses, which are an important avenue for achieving income growth, equality, and social inclusion.
As shown in Table 3 , the CAFTA-DR countries do not rank high on improving the business environment over time, and regulatory reform still tops the list of concerns for the region. Although strides have been made in regulatory reform in recent years, the CAFTA-DR countries have not kept pace with many other developing countries. Should businesses find operating in CAFTA-DR countries more difficult than others, the countries are in a relatively weaker position to take full advantage of the FTA, and evaluations of CAFTA-DR effectiveness will likely understate its potential impact absent improvements in these indicators. In general, trends in foreign direct investment shown in Figure 7 are consistent with the relative Doing Business rankings in Table 3 , with the exception of Costa Rica.
section_title: Logistics Performance Index
paragraphs: The World Bank has recently begun to produce a Logistics Performance Index (LPI), which summarizes performance in six areas: customs efficiency; trade and transport infrastructure; ease of arranging competitively-priced shipping; logistics services; tracking and tracing shipments; and frequency with which shipments reach destination on time. This information points to a critical factor in evaluating a country's ability to trade efficiently and can be used to identify major supply-chain bottlenecks. The composite index might best be thought of as conveying an overall assessment of the "time and cost burdens of import and export transactions."
 Table 4 summarizes the rankings of composite LPI index for the CAFTA-DR countries. For the region, Costa Rica, the Dominican Republic, and Honduras all rank in the top half of the LPI midpoint. By contrast, El Salvador, Guatemala, and Nicaragua rank in the bottom half of the group. Differences among countries can be large, with Costa Rica clearly outperforming the group on logistics capabilities, while Nicaragua lags. This stark difference may reflect various issues including level of economic development and political decisions to support trade, in general, and CAFTA-DR in particular.
section_title: Security, Governance, Corruption, and Economic Freedom
paragraphs: Many CAFTA-DR countries suffer from structural problems in governance. First, tax systems in many countries are regressive and provide inadequate revenue to meet public needs, hindering development. The Costa Rican tax burden is roughly 23% of GDP, twice that of Guatemala, and significantly higher than the other countries except Nicaragua. Inadequate and regressive tax systems, combined with a general bureaucratic ineffectiveness, are incapable of helping make adjustments that might diminish the region's high levels of inequality. These deficiencies have been directly linked to the growing violence and crime, much related to drug trafficking, which threatens the social fabric of society.
The inability to counter the extreme violence and security violations in the northernmost countries of Central America has been costly—one estimate ranges between 7.5% to 8.0% of GDP. The long-term cost lies in the region's inhibited development, persistent poverty, and inequality. In many areas, organized crime operates with virtual impunity, in part a result of weak national government bureaucracies and corruption. These broad problems diminish the business climate, inhibiting countries from taking full advantage of CAFTA-DR. The level of national insecurity, most prevalent in the "Northern Triangle" countries of Honduras, El Salvador, and Guatemala, appears highly correlated with low levels of FDI (see Figure 7 ). Business investment at the firm level provides corroborating evidence, with some business executives pointing to, for example, production shifts from violence-prone Mexico and Colombia to Costa Rica largely because of security concerns.
Two indicators provide additional evidence of the problems. The Index of Economic Freedom, prepared by the Heritage Foundation and the Wall Street Journal, is a composite number reflecting 10 indicators. The criteria provide a business perspective and the overall score gives a broad indication of how countries may rank (see Table 5 ), but should not be given too much weight without understanding how countries perform with the individual indicators. A summary of this performance suggests that the CAFTA-DR countries do reasonably well on macroeconomic and trade reform, but with the exception of Costa Rica, come up short on two important indicators: upholding property rights and dealing with corruption. Both these indicators point to traditionally weak judicial branches of government, among other problems.
Transparency International produces the Corruption Perceptions Index. It measures perceptions based on extensive survey work, and is the basis for the corruption indicator used in the Index of Economic Freedom. As may be seen in Table 5 , some of the CAFTA-DR countries still rank low, suggesting corruption may be hindering the conduct of business and inhibiting progress on attracting investment, promoting development, and reducing poverty. The Office of the United States Trade Representative (USTR) corroborates concerns over corruption throughout the region, particularly for Honduras and Nicaragua. These indicators seem to correlate closely with the CAFTA-DR countries' overall economic performance over the long run, and over time the worst performers may see investment and trade trends lag relative to their CAFTA-DR neighbors.
section_title: Outlook and Issues for Congress
paragraphs: Although it is still early to pass judgment on the success or failure of CAFTA-DR, the accord has provided enhanced incentives to deepen a trade partnership built on a model of trade preferences that stretches back nearly three decades. The crowning features of CAFTA-DR include transitioning to a reciprocal agreement, making tariff preferences permanent, creating more flexible rules of origin, liberalizing trade rules in new areas and commerce, and promoting institutional capacities in many areas to support the new trade and investment arrangement.
The data suggest that CAFTA-DR has supported a long-term trend in the region toward trade and investment liberalization, encouraging diversification into higher value-added, and in some cases, technology-enhanced goods. U.S. exports have grown, with gains in agriculture and more modest growth in manufactured goods. Part of this growth appears to be related to CAFTA-DR and will likely continue as the trade agreement is fully implemented over time.
There are two major challenges to CAFTA-DR operating better. First, the longer-term need for deeper structural transformation in the CAFTA-DR region may be hindering the development potential of the FTA. As suggested by the trends identified in this report, the level of transformative change varies dramatically among the six countries, and to a large extent appears to reflect national business climates and the degree to which national strategies and complementary policies are instituted to support productivity enhancements necessary to be competitive in a global market, a difficult and long-term proposition. Deteriorating security and governance capabilities in some countries further complicate the trade and investment environment. Over time, however, expectations of CAFTA-DR's success rely on policy changes that will improve chances for all countries to benefit more from this deepening and still evolving trade arrangement.
Second, there are a number of issues that are being addressed in the short term, and which Congress may wish to continue monitoring. At the top of the list is enhancing trade facilitation, which refers to improving the rules and capacity of firms and countries to apply them to take full advantage of a trade agreement. Officials in CAFTA-DR countries, and firms operating there, have identified numerous important obstacles to the full and effective implementation of the trade agreement:
rules of origin, which can be highly complex for textile trade, are frequently the object of firm complaints. Many specific rules seek to protect U.S. producers from third country competition. For example, multiple cases have been identified in which U.S. producers are no longer capable or willing to supply the yarn or fabric covered by the rule, resulting in CAFTA-DR products having to use inputs that are subject to high tariffs or to forgo production entirely. In other cases, rules covering U.S. inputs do not match up clearly, causing delays at the U.S. border. customs determinations for these and other matters have caused delays at the U.S. and CAFTA-DR country borders. In order to meet production deadlines, U.S. importers have at times decided to pay tariffs rather than wait for determinations that would have likely been made in their favor. Also, in some cases, U.S. customs procedures and rules have not been well understood by CAFTA-DR exporters. In other cases, CAFTA-DR country customs modernization has been an issue. Assistance has been provided under USAID contracts to ensure U.S. exports are not delayed unnecessarily, but in some cases, further resources and dedication are needed to ensure a continuous smooth flow of U.S. goods. the short supply list is also intended to protect U.S. producers, but the "first come" rule for use of tariff rate quotas has been criticized as inequitable and complicating production planning. To the extent that these rules unnecessarily inhibit competitive trade, the agreement falls short of meeting its goals. Other challenges include interpretation and application of highly technical rules in areas such as intellectual property rights, sanitary and phytosanitary regulations, and telecommunications.
The complexities of the CAFTA-DR make for many operational challenges, with new ones emerging periodically. Over time, the trade data will likely reflect the extent to which the CAFTA-DR countries and the United States make use of the trade agreement, in part enhanced by addressing these and possibly other issues. It is still early to pass judgment on this FTA, but indicators to date suggest that both long- and short-term policy decisions may go a long way to improving the conditions that will allow CAFTA-DR to provide economic benefits for all participants.
subsections: section_title: Appendix. CAFTA-DR Country Economic Data