Domestic Linkages as a Condition for Gains from Free Trade Agreements: Welfare and Poverty implications of DR-CAFTA for Costa Rica and Nicaragua

The free trade agreement between the United States and the Central American countries plus the Dominican Republic (DR-CAFTA) signed in 2004 has spurred great controversy in all signatory countries about the expected economic and social gains and losses of the further trade opening. The debate has been particularly fierce in Costa Rica and Nicaragua. This paper contributes to this debate by providing an ex-ante impact assessment of the agreement through a dynamic computable general equilibrium (CGE) analysis for Costa Rica and Nicaragua. The CGE analysis is complemented by a microsimulation methodology using household survey data to capture the full distributive (and poverty) implications of the tariff and quota changes implied by the DR-CAFTA. A key finding of the study is that the agreement would potentially yield welfare gains for both countries but the source of the gains differ as a consequence of a difference in the degree of economic diversification of the two economies. Nicaragua’s main gains would come from newly acquired preferential access to textile markets in the United States, but in order to achieve such gains the production structure of the economy would have to become heavily specialized in the import-dependent maquila industry and producers in that sector would have to be able to withstand Asian competition. Costa Rica, in contrast, would benefit most from tariff reductions and gains would be spread throughout the economy as exports are more diversified and their production has relatively strong linkages with the domestic economy. Costa Rica thus stands to obtain more sustainable welfare gains from trade liberalisation than Nicaragua.