# **6 Trade Reform**

## **6.1 Description of simulations**

In order to assess the potential effects of DR-CAFTA accession for Honduras, this section contrasts a Business-as-Usual scenario with five alternative simulations that highlight different aspects of trade liberalization under DR-CAFTA, while the next section will focus on the potential effects of increased FDI inflows into Honduras. The following paragraphs review the main features of each of the scenarios, starting with the _BaU_ . To keep the discussion focused, the text will concentrate on major differences across scenarios; features that are not specifically mentioned remain the same in all scenarios as in the _BaU_ .

_Business-as-Usual (_ BaU _)_ . The _BaU_ simulation defines a backdrop against which other scenarios will be compared by establishing a baseline growth path from 2004 through 2016. Under _BaU_ conditions, real GDP per capita grows at an average rate of 2.2 percent per year. This is consistent with the IMF, World Bank, and government of Honduras growth projections (see, for example, International Monetary Fund, 2006), but much faster than the 0.5 percent average annual growth recorded over the 1990–2004 period.<sup>24</sup> Most macroeconomic variables, including foreign remittances, public spending, private investment, FDI, public investment, and external debt, remain a fixed share of real GDP through the model horizon (i.e., they grow at the same rate as real GDP).

_Bilateral CAFTA with the US (CBL)_ . The _CBL_ simulation envisages a gradual removal of tariff barriers between the USA and Honduras over the 2004–2016 period. Although in principle DR-CAFTA is a regional agreement rather than a hub-and-spoke arrangement, this simulation models the agreement’s implementation as a bilateral deal for two reasons. First, this choice facilitates comparison with other studies of DR-CAFTA, all of which have modeled it as a bilateral arrangement. Second, since DR-CAFTA preferences gradually replace those available under the CBI as Central American countries join the treaty, the agreement is identical to a hub-and-spoke arrangement until all member countries ratify it. Therefore, this scenario models DR-CAFTA as a bilateral agreement, while the implications of the accession of all other parties to the agreement will be explored in a subsequent simulation.

Given the limited level of sectoral detail in the model, it is impossible to reproduce the implementation of DR-CAFTA tariff provisions exactly. Instead, this simulation imposes a pattern of liberalization that is roughly similar to the main provisions of the agreement. In order to change the tariff structure of Honduras’ trading partners, this paper uses the protection data of Table 4 to shock the partner-specific vector of world export prices—in this case, that of the US. Since most of the US trade barriers are to be eliminated immediately, this simulation increases the US export prices by the full amount starting in 2007. This is clearly an optimistic scenario, especially because several US import quotas (which are not explicitly modeled in this analysis) will be relaxed but not fully eliminated.<sup>25</sup> Nonetheless, it is useful to consider it as a “best-case” possibility. Honduras’

> 24Between 1990 and 2004, real GDP growth averaged 3.3 percent—just slightly faster than the growth rate of population—and consumption per capita has been virtually stagnant.

> 25To take account of the sugar quota, the model imposes a finite export elasticity on the exports of sugar to the US. In the case of a finite elasticity, the producers’ decision to export more drives down the world price and leads to lower export demand. The result is that the value of Honduran sugar exports to the US in _BaU_ increases by only three percent between 2004 and 2016. Currently, Honduran sugar quota is 9.6 tons, which expands immediately to 17.6 tons following the implementation of DR-CAFTA and eventually (in year 15 of the agreement) to 10.2 tons. However, the US reserves the right to keep the sugar quota at its original pre-CAFTA level and instead compensate Honduras unilaterally. The complicated and restrictive language of sugar quota provisions has led Francois et al. (2005) to conclude that “the trade agreement will produce no substantial changes in current bilateral trade conditions

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