metadata: authors: 0: author: Marcelo Gordillo,Darwin
1: author: Schwartz,Jordan Z.
2: author: Stokenberga,Aiga
count: Central America
docna: 0: docna: Understanding the benefits of regional
            integration to trade : the application of a gravity model to
            the case of Central America
docty: Policy Research Working Paper
subtopic: Private Sector Economics,Private Sector Development Law,International Trade and Trade Rules,Marketing,Energy and Mining,Transport Services,Trade and Multilateral Issues
teratopic: Macroeconomics and Economic Growth,Industry,Transport,International Economics and Trade
abstracts: cdata!: The paper identifies the impact of
            physical barriers to trade within Central America through
            the use of an augmented and partially constrained Gravity
            Model of Trade. Adjusting the Euclidian distance factor for
            Central America by real average transport times, the model
            quantifies the impact of poor connectivity and border
            frictions on the region's internal trade as well as its
            trade with external partners, such as the United States and
            Europe. In addition, the authors benchmark Central
            America's trade coefficients against those of a
            physically integrated region by running a parallel Gravity
            Model for the 15 core countries of the European Union. This
            allows for the estimation of potential intra-regional and
            external trade levels if Central America were to reduce
            border frictions and time of travel between countries and
            thus benefit from both the adjacency of each country's
            neighbors and the gravitational pull of the region's
            economies. The analysis is conducted for all of Central
            America's trade and is also disaggregated for three
            groups of products -- processed fruits and vegetables; steel
            and steel products; and grains -- by both volume and value.
            This differentiation tests the consistency of the results
            while providing insight into the differentiation in trading
            patterns and potential for these containerized, break-bulk,
            and bulk products. The results of the model include a
            potential doubling in intraregional exports if Central
            America could achieve the adjacency and time-distance
            factors of a truly integrated region. In addition, the
            region's combined exports to the European Union and the
            United States are projected to increase by more than a third
            compared with the current level, assuming European
            Union-level adjacency performance. Even more external trade
            benefits would accrue by reducing the economic penalty
            imposed by overland transport and border crossing inefficiencies.
repnme: repnme: Understanding the benefits of regional
            integration to trade : the application of a gravity model to
            the case of Central America
display_title: Understanding the benefits of
            regional integration to trade : the application of a gravity
            model to the case of Central America
listing_relative_url: /research/2010/12/13237099/understanding-benefits-regional-integration-trade-application-gravity-model-case-central-america
topicv3: Private Sector Development m1326060 1921,Intraregional Trade m1326248 1175,Transport m1326661 135,Trade m1326924 698,Iron m1503514 2931
publishtoextweb_dt: 2016-05-17T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Industry,Transport,International Economics and Trade
no_of_pages: 31
author_keys: 0: author_key: 937656
1: author_key: 167071
2: author_key: 963564
model_extractions: WPS5506 Policy Research Working Paper 5506 Understanding the Benefits of Regional Integration to Trade The Application of a Gravity Model to the Case of Central America _Darwin Marcelo Gordillo Aiga Stokenberga Jordan Schwartz_ The World Bank Latin America and the Caribbean Region Sustainable Development Department December 2010
Policy Research Working Paper 5506

# **Abstract**

The paper identifies the impact of physical barriers to trade within Central America through the use of an augmented and partially constrained Gravity Model of Trade. Adjusting the Euclidian distance factor for Central America by real average transport times, the model quantifies the impact of poor connectivity and border frictions on the region’s internal trade as well as its trade with external partners, such as the United States and Europe. In addition, the authors benchmark Central America's trade coefficients against those of a physically integrated region by running a parallel Gravity Model for the 15 core countries of the European Union. This allows for the estimation of potential intra-regional and external trade levels if Central America were to reduce border frictions and time of travel between countries and thus benefit from both the adjacency of each country’s neighbors and the gravitational pull of the region’s economies. The analysis is conducted for all of Central America’s trade and is also disaggregated for three groups of products—processed fruits and vegetables; steel and steel products; and grains—by both volume and value. This differentiation tests the consistency of the results while providing insight into the differentiation in trading patterns and potential for these containerized, break-bulk, and bulk products. The results of the model include a potential _doubling_ in intraregional exports if Central America could achieve the adjacency and timedistance factors of a truly integrated region. In addition, the region’s combined exports to the European Union and the United States are projected to increase by more than a _third_ compared with the current level, assuming European Union-level adjacency performance. Even more external trade benefits would accrue by reducing the economic penalty imposed by overland transport and border crossing inefficiencies.

This paper is a product of the Sustainable Development Department, Latin America and the Caribbean Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at dmarcelo@worldbank.org, astokenberga@worldbank.org, and jschwartz3@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Understanding the Benefits of Regional Integration to Trade: The Application of a Gravity Model to the Case of Central America**<sup>**1**</sup>

Darwin Marcelo Gordillo The World Bank Aiga Stokenberga The World Bank and Jordan Schwartz The World Bank

> 1 Authors are Economist, Junior Professional Associate, and Lead Economist, respectively, in the Economics Unit of the Sustainable Development Department at the Latin America and the Caribbean Region. The authors would like to acknowledge and thank the following colleagues for their inputs and suggestions: Augusto de la Torre, Maurice Schiff, Robin Carruthers, J. Humberto Lopez, Francisco Ferreira, Tom Haven, Tomas Serebrisky and Gregor Wolf. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors, and do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent.  The authors are also solely responsible for any incomplete or inaccurate data. They may be contacted via email at dmarcelo@worldbank.org, <u>astokenberga@worldbank.org, and jschwartz3@worldbank.org.</u>
# **Contents**

|_1._<br>_Introduction: Understanding the Impact of Physical Barriers to Trade_................................ 3|
|---|
|_2._<br>_Preliminary results: Part 1_..................................................................................................... 8|
|_2.1._<br>_Establishing a Benchmark for Central America’s Spatial Integration_................................ 8|
|_2.2._<br>_Results for the CA intraregional trade only_......................................................................... 9|
|_3._<br>_Preliminary results: Part 2_.................................................................................................... 14|
|_3.1._<br>_Establishing a benchmark for Central America’s extra-regional trade behavior_............. 15|
|_3.2._<br>_Results for the CA regional trade including the U.S. and the EU27_................................. 16|
|_4._<br>_Potential intraregional exports in Central America_.............................................................. 17|
|_5._<br>_Conclusions and Policy Implications_.................................................................................... 20|
|_References_..................................................................................................................................... 21|
|_Annexes_......................................................................................................................................... 23|
|Annex 1: Detailed Representation of Results.............................................................23|
|Annex 2: Regression Results ........................................................................................................ 25|
|Annex 3: Central America’s Intra-regional and Overall Exports in value terms, 2007 ............... 26|
|Annex 4: Central America’s Extraregional Containerized Exports Destinations, 2007 ............... 27|
|Annex 5: Export Structures of Selected Central American Economies...............................28|

2
# **_1. Introduction:  Understanding the Impact of Physical Barriers to Trade_**

As tariffs and other formal barriers to trade have fallen across developing and industrialized regions, transport and logistics costs have become, in many cases, the biggest cost factor in the final price of delivered goods.<sup>2</sup> Likewise, efficient and cost-effective transport infrastructure, freight and logistics services, intermodal and cross-border connectivity what—might be referred to as the physical components of trade—are becoming ever more important catalysts for development and regional integration. As evidenced by the experience of the European Union, integration of markets and regional infrastructure networks stimulates growth. These reduced barriers to trade facilitate the gains from structural change, speeding up technology transfer, underwriting marketsize effects on research and development (R&D), and stimulating investment and innovation through reduced transaction costs.<sup>3</sup> Improving the efficiency of connections between demand centers and production and distribution points connects rural and small producers to markets, creates employment opportunities for the manufacture of traded goods, and reduces the delivered prices of staples, inputs to production and household goods.

The recent signing of a free trade agreement among Central American countries, CAFTA-DR (hereinafter “CAFTA”), represents an important step towards regional trade integration, particularly for the six contiguous countries of the region.<sup>4</sup> However, a number of infrastructure and logistics-specific challenges need to be resolved for the region’s countries to be able to reap the full benefits of CAFTA and to integrate not only with each other, but also with the rest of the global economy. A series of logistics supply chains of goods moving through and into Central America analyzed by the World Bank reveals that poor road conditions, lack of scale economies in freight haulage and bottlenecks at the region’s border crossings, mostly attributed to customs delays, present the key burdens for trade of agricultural products across the region.<sup>5</sup> This is consistent with logistics supply chain analyses conducted throughout Latin America and the Caribbean (LAC) in recent years. In other parts of the LAC Region, the effect of delays in customs clearance are significant, for instance, resulting in an increase in transport costs by between 4 and 12 percent. This is equivalent in cost to an approximately 50 percent increase in the physical distance that a good must travel to reach its destination.

Obstacles to increased intraregional trade are also posed by the quality of roads and trucking services that effectively increase the “real distance” to both domestic and export markets. In Costa Rica, domestic businesses have identified road quality as one of the three main impediments to their growth and productivity, with poor road quality causing direct losses from

> 2 For example, Schwartz, et al (2009) find average ad valorem tariffs for food imports in LAC have decreased to a range of 3 to 12 percent of product value while international maritime and road haulage costs alone constitute about 20 percent of the FOB value of goods.  The total of all logistics costs can be greater than 50 percent of a good’s value, depending on product and trade route.

> 3 Academic research has also shown that openness to trade results in dynamic benefits through productivity growth, with a small contribution coming through increased investment (see Dowrick and Golley, 2004).  The strategy of trade liberalization, in turn, is often accompanied by policies that promote export diversification that, similarly, is believed to be a positive driver of growth (Hesse 2009).

> 4 For the purposes of this study, Central America is defined as the six Spanish-speaking countries that lie between Mexico and Colombia:  Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama.

> 5 Fernández, R. and S. Flórez (2010 - Forthcoming)

3
delays in shipments as well as breakage and theft totaling 8 to 12 percent of the sales value of exported goods (World Bank, 2006b). For South American countries, the World Bank calculates that a 10-percent reduction in transport costs would increase trade by 3.6 percent in Uruguay, 5.5 percent in Brazil, and 3.3 percent in Argentina (World Bank, 2009).

Product and trade-route specific diagnoses, such as logistics supply chain analyses, can be a useful source of disaggregated information on the detailed costs and time requirements involved in cross-border trade. They reveal the relative share of each logistics cost component in the price of the delivered goods and shed light on particular barriers to trade along specific routes. That said, a micro-level supply-chain approach to trade flow does not seek to capture overall regional trading trends or the impact on trade flows of key socioeconomic and spatial variables, including the importance of the size of the trading economies, their proximity to one other and the adjacency or “neighboring” benefits of nearby economies. This geographical information and the related spatial patterns can play a crucial role in the dynamics of regional integration. When coupled with practical tools such as logistics supply chain analyses, sectoral diagnoses and freight flow modeling, spatially-based analyses and geographical representations can serve as complementary tools for informing decisions on public investments, trade and transport regulations and the optimization or prioritization of government resources.

To complement recent supply chain and studies and productivity competitiveness and sectoral diagnoses now underway for Central America, the current paper takes a spatial approach to evaluating the potential impact of physical integration in Central America. It benchmarks the current intra-regional trade performance of the region against the patterns observed in the European Union—selected as a case study of an integrated region with low border frictions and low time-to-distance ratios for transport. This provides some insight into the potential trade volumes that would take place in a "spatially integrated" Central America. Specifically, the paper attempts to measure the extent to which various physical variables act as obstacles to—or drivers of—intra-regional trade. Conversely, it also estimates the maximum potential gains—in terms of increased trade volumes—that could be achieved from raising the level of Central America’s physical trading.

# **_The Use of Gravity Models to Identify Barriers to Trade_**

For estimating the relative impact of such trade-related variables as the distance between production and consumption centers,<sup>6</sup> the adjacency among countries, and the relative incomes of the trading economies, the paper applies a Gravity Model of Trade (GMT). This explains the behavior of the various variables at the regional level and highlights their linkages, correlations and dynamics over time, simultaneously making it feasible to generate and extract spatial information to explain socioeconomic phenomena. The GMT is a “spatially-conscious” econometric model that incorporates a geographical perspective to explain trade flows as the function of two criteria: mass (e.g., GDP, capital stocks, or population) and distance between gravity centers. The GMT, as other models of this type, attempts to explain trade between two countries by their bilateral connectivity, adjacency, and respective market size, assuming that

> 6 Distance measured either in Euclidian terms or adjusted based on such factors as time between points, road quality, trucking costs, or customs efficiency.

4
T i<sup>Ax</sup><sup>~~eer~~</sup> Tyjp<sup>=</sup> ~~GDP jit*GDP~~ <u>jt</u> Dij <!-- Start of picture text -->
*, )is<br>NY ?<br>hag«  ><br><!-- End of picture text -->

<!-- Start of picture text --> a ‘<br><!-- End of picture text -->
Usually, gravitational models are estimated through a linear transformation so as to express the relationship between the flows (measured in exports terms) and the regressors (importers’ GDP, exporters’ GDP and distance) in terms of elasticities. However, augmented versions of the standard GMT have also been used--for instance, to better understand the benefits of free trade agreements and free trade zones, including MERCOSUR and the Andean Community (Carrillo and Li, 2002), NAFTA (Montenegro and Soloaga, 2004), the Western Balkan trade zone (World Bank, 2007), the West African Monetary Zone (Balogun, 2008), the Eastern European region (World Bank, 2005), and the Arab Maghreb region (PIIE, 2008). Furthermore, GMT has helped to assess the benefits of trade facilitation measures (Asia-Pacific Economic Cooperation Secretariat, 2010; World Economic Forum, 2008; World Bank, 2008) and to estimate trade potentials (Benedictis and Vicarelli, 2005).

Often, these augmented versions of the GTM include dummy variables to capture fixed effects at the country-pair level. For example, common language and _adjacency_ (common border) are factors associated with lower costs for doing business (PIIE, 2008), and a vast number of studies have found positive effects on bilateral trade as a result of adjacency (Helpman, 2005; Benedictis and Vicarelli, 2005; Balogun, 2008; World Economic Forum, 2008; World Bank, 2008; PIIE, 2008).

An implication of using highly disaggregated versions of augmented Gravity Models is that bilateral trade between two countries may be as low as zero. In fact, the more disaggregated the model and the larger the sample of countries included in the estimations, the greater the chance of having no bilateral trade between two countries. Missing information (i.e. “observations”) caused by absence of bilateral trade may, in turn, introduce a bias in the overall estimations, overestimating the explanatory power of the independent variables (WER, 2008). Methodology for correcting for this selection bias was originally proposed by Heckman (1979), and has been subsequently modified by Helpman (2005), whereby a two-stage model is applied to the specific case of the determinants of bilateral trade.

# **_Construct of This Gravity Model_**

Estimations proposed in this study correspond to an augmented version of the GMT that includes both the fixed effect of adjacency and the two-stage sample selection bias correction suggested by Helpman (2005). Coefficients have been expressed as elasticities and semi-elasticities through the linear transformation: Where ����� denotes the natural logarithm of the variable ���, ��� is a dummy variable that takes value 1 if the country-pair �� shares a common frontier, and � is the non-selection hazard computed in a first-stage as where � corresponds to the normal density function and Φ to the standard cumulative normal function.

6
tJ ijt <!-- Start of picture text --> /<br>.<br><!-- End of picture text -->
_economic_ distance between two countries (geographic distance adjusted by time penalties caused by additional burdens posed by poor road conditions and congestion) and improving efficiency at border crossings.

# **_2. Preliminary Results:  Part 1_**

The first set of GMT estimations is organized as follows. The model is estimated using intraregional bilateral export flow data for the more integrated part of the European Union (EU15) and, second, for the Central America region. Estimations for both regions were first carried out in terms of total exports (measured in US$) and then for the disaggregated groups of goods: (i) Grains, including rice, maize, wheat, and barley, in both value (US$) and volume (kg) terms; (ii) Steel and Steel products, including ingots and other primary forms, iron and steel castings, tubes, rods, pipes and fittings, universals, iron and steel bars, rails and railway track construction materials, in both value and volume terms; and (iii) Processed Fruits & Vegetables in both value and volume terms. Estimations were carried out over a nine-year period from 2000 to 2008 controlling by country-pair fixed effects in a pooled regression. In the figures, results are presented at the 10-percent level of significance.

# **_2.1. Establishing a Benchmark for Central America’s Spatial Integration_**

The results obtained for the EU15 countries for total intraregional exports (Figure 3) correspond to what is expected according to the intuition underlying the GMT theory: the GDP of both the importing and the exporting countries is significant and positively related to export flows, while the distance between each pair of economies has a significant and negative impact on trade, whereby an increase in distance by 1 percent reduces the expected exports by 0.93 percent.

Similarly, as expected, adjacency represents opportunities for increasing exports within a highlyintegrated region. Expressed as the percentage change in total exports,<sup>8</sup> EU15 countries that share frontiers have 83 percent higher expected bilateral export flows than countries that do not.<sup>9</sup> Positive and significant effects associated with adjacency, although of different magnitude, have also been found in studies focusing on other European economic blocks - 56 percent (World Bank, 2005), the Latin America and the Caribbean Region overall - 174 percent (Carrillo and Li, 2002), and in large country-samples covering the rest of the world - 289 percent (World Economic Forum, 2008).

> 8 The discrete change in expected exports correspond to ∆�� <u>��</u><sup>�</sup> |������ �1 � ���<sup>�.�</sup> ���<sup>��</sup> �1 � ���<sup>��</sup> �1 ��<sup>�</sup> |������ ���<sup>�.�</sup>

> 9 Expressed as (���������1).

8
aprox. exp(1.4)-—1
**Figure 4** :  Costa Rica’s Exports by Destination, 2000 versus 2008 (US$)

<!-- Start of picture text --> A 77% increase<br>in total exports<br>A 130%<br>increase in<br>exports to CA<br><!-- End of picture text --> According to calculations by SIECA, for the region overall,<sup>11</sup> since the signing of the Central America Free Trade Agreement, the share of intraregional exports in total export has fluctuated between about 26 and 30 percent in US$ FOB terms, reaching the highest share in 2008 and then decreasing slightly in 2009 (Figure 5). In fact, over the past five years, the region was the second largest trading partner for the individual Central American economies.

Source: LCSSD Economics Unit calculations based on WITS data, 2010

**Figure 5** :  Central America’s Intraregional and Total Export Flows, 2005-2009 (US$’000)

<!-- Start of picture text --> Total Exports<br>Intraregional Exports 29.5%<br>27.2% 26.5%<br>26.6%<br>27.2%<br><!-- End of picture text --> Source: SIECA According to the model results produced for the current paper, the size of the domestic exporting markets and the distance between trading partners are the main factors affecting bilateral trade in Central America. Given a 1-percent increase in GDP of the exporting country, it is expected that exports from that country to the rest of the region increase by nearly 1.7 percent. Conversely, a 1-percent average increase in distance between each country and its export partners is associated with reductions in expected exports by 1.6 percent.

In contrast to the EU15, in Central America, the “gravitational pull” (proxied by the Importing Countries’ GDP) is relatively low or even insignificant when the model is disaggregated. A 1- percent increase in the GDP of the importing country (i.e. the export partner) increases expected

> 11 Calculations exclude Panama

10
exp(—0.5) — 1
e(Tijt) = eBotBiln (GDPit)+Bz In(GDPjr)+B3 In(Dij*1.675)+BaAGjij+ BsAijet eije <!-- Start of picture text --> a<br>—<br>—<br>a<br>a<br>a<br><!-- End of picture text -->
<!-- Start of picture text --> 7<br><!-- End of picture text -->
# **_4. Potential Intraregional Exports in Central America_**

One of the main benefits of the GTM is that it allows projecting the "potential level" of exports based on a specific set of coefficients. In turn, the ratio between the observed and the potential export flows provides a measure of the closeness ─ or _proximity index_ ─ of a specific country or country-pair to its expected exports level ─ _expectations frontier_ . Following Benedictis and Vicarelli (2005), this closeness measure �<sup>�</sup> can be expressed as: Where ���� captures the observed export flows from the exporter country � to the importer country � and ����� are the expected exports flows generated by the gravity equation. To calculate the potential export flows, four different sets of coefficients were used for calculating �����, resulting in four different scenarios or “proximity indices.” The first scenario is based on the coefficients for the CA intra-regional trade model (Figure 6). The second one projects the exports flows in CA from the estimated coefficients obtained for the EU15 intra-regional model (Figure 3). A third scenario is obtained by applying the highest country-pair adjacency coefficient, obtained from the disaggregated GTM for Central America (with results illustrated in Figures 7 and 10),<sup>16</sup> while the fourth scenario applies the adjacency coefficient resulting from the EU15 intra-regional model (Figure 3).

Figure 13 below illustrates the results obtained from the four different scenarios, in this case, comparing Costa Rica with Honduras. In Costa Rica’s case, the observed-to-projected exports are close to the unconstrained _Expectations Frontier_ (i.e. a ratio equivalent to 1), except for when the country’s currently observed exports are compared to what its exports would be expected to be under the assumption of an “EU15-like” behavior of all the independent trade variables (distance, adjacency, and the GDP of both the exporting and the importing country). In the case of Honduras, on the other hand, the ratio is far from 1 in all of the scenarios, including when the country’s observed exports are compared to what they would be expected to be assuming an adjacency effect equivalent to the adjacency effect of the best performer in Central America.

> 16 For Grains (in volume and value terms) and Overall Trade (in value terms) the best country-pair adjacency effect corresponds to the Costa Rica- Nicaragua; for Steel and Processed Fruit & Vegetable exports, even the best “Adjacency Performance” across the country couples is 0.

17
**Figure 13** : Closeness of CA’s total intra-regional exports value to the Unconstrained Expectations Frontier

<!-- Start of picture text --> Expectations Frontier<br>Costa Rica<br>Honduras<br><!-- End of picture text --> Source: World Bank calculations based on trade flows data from WITS, LCSSD Economics Unit (2010) In terms of the closeness to the frontier of expected exports by separate export types, Grains and Steel products are particularly strong examples of the two countries being at very different levels of “adjacency performance” (Figure 14). In line with the results shown in Figure 10, Costa Rica’s is close to the level of the region’s best performer, while Honduras is much more distant from the benchmark.

**Figure 14** : Intra-regional Observed Exports vs. Projected Exports, assuming that Costa Rica and Honduras’ Trade Behavior follows Central America’s own “Best Adjacency Performance"

<!-- Start of picture text --> Expectations Frontier<br>1.0<br>0.9<br>Costa Rica<br>0.8<br>0.7<br>0.6<br>0.5<br>Honduras<br>0.4<br>0.3<br>0.2<br>0.1<br>0.0<br>Total Exports Grains (Volume) Steel (Volume) Proc. Food (Volume)<br>(Value)<br><!-- End of picture text --> Source: World Bank LCSSD Economics Unit calculations based on WITS data, 2010 In turn, when projecting the potential increase in total absolute intra-regional exports under three different scenarios—each of which represents a type of improvement in the region’s “trade performance”—estimations show that intra-regional trade could be 33-percent higher if the effect of adjacency between each pair of the six Central American countries were to improve to the level of the region’s “best performer.” If, however, the improvement in adjacency performance 18
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economic penalty imposed by the need to use sub-optimal roads and trucking services in covering overland road distances and from reducing the obstacles to greater “gravitational pull” from import markets.

# **_5. Conclusions and Policy Implications_**

As highlighted by the Gravity Model–based results analyzed above, intra-regional trade in Central America does not behave like it does in a highly spatially-integrated region _._ Instead, it is still inhibited by a number of inefficiencies that overshadow the formal trade tariff and non–tariff barriers that have historically figured high on the regional integration agenda.

The economic **_distance_** between the markets of Central America is being distorted and magnified by a number of inefficiencies, including the poor road quality, the congestion at the border crossings and metropolitan areas, the inadequate supply of trucking services, and other overland transport inefficiencies. These factors may explain why in Central America the negative effect of distance on trade flows tends to be higher than in a spatially-integrated region.

Similarly, the results show that Central American economies fail to take advantage of **_adjacency_** - not only to the extent that it affects intra-regional trade patterns but also the region’s trade with the U.S. and other external partners. As highlighted by recent supply chain analyses that are able to capture these specific micro-level challenges, the reasons why country adjacency in Central America does not seem to exhibit the positive impact on trade flows that it would be expected to include burdensome customs procedures, delays, and lack of regulatory harmonization (e.g. in terms of phytosanitary standards for agricultural exports).

Finally, the Gravity Model results indicate that Central American countries are experiencing a lower **_“gravitational pull”_** from the nearby economies. Intuitively, this is due to poorly established trade linkages, an atomized shipping industry, little information sharing on cargo and backhaul, and relatively few options and competition for shipping (i.e. absence of coastal shipping, rail services, and low road density).

The overall policy implications of the above estimations are similar to those identified in the recent supply chain analyses carried out in Central America that, instead, highlight the microlevel challenges related to overland transport inefficiencies, burdensome border crossing procedures, and lack of regulatory harmonization posed. As highlighted previously, in order to reduce the inefficiencies that currently offset the positive benefits that Central American countries could obtain from being adjacent to one another, policy and regulatory actions need to be focused on improving the region’s border crossings, while additional investments and institutional coordination initiatives are warranted to reduce the ‘economic’— i.e. the cost- and time-equivalent—overland distance between production and consumption centers within the region.

20