Country DePL ILatin America and the Caribbean Region

Economic Notes

Industrial -Policyin MERCOSUR

Issues and Lessons

Claudio FrischtakDanny M. Leipziger

John F. Normand

August 1996

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INDUSTRIAL POLICY

IN MERCOSURISSUES AND LESSONS

August 1996

Claudio FrischtakDanny M. Leipziger

John F. Normand

The paper has been prepared for The World Bank's Latin American and the Caribbean Region Country Depariment IMERCOSUR project. All views expressed are those of the authors and do not represent the opinions or positions of the WorldBank or its affiliates. The authors are Economic Consultant (Brazil), Lead Economist (World Bank) and Researcher (WorldBank), respectively. Comments should be addressed to Danny Leipziger at the World Bank, Washington, D.C.

Acronyms

ABNT Asociacion Brasilera do Normas Tecnicas

ADTEN Apoyo ao Desenvolvimento Tecnologico da Empresa Nacional

(Brazil)

BANADE Banco Nacional de Desarrollo (Argentina)

BHN Banco Hipotecario Nacional (Argentina)

BICE Banco de Inversion y Comercio Exterior

BNA Banco de la Nacion (Argentina)

BNDES Banco Nacional de Desenvolvimento Economico e Social (Brazil)

BPBA Banco de la Provincia de Buenos Aires

CET Commnon External Tariff

CNI Confederacao Nacional do Industria (Brazil)

CTA Centro Technologico da Aeronautica (Brazil)

CVDs Counter-Vailing Duties

EPZs Export-processing zones

FGV Fundacao Getulio Vargas (Brazil)

FIEL Fundacion Industrial y Economica Latinoamericana (Argentina)

FTA Free Trade Agreement

FTZ Free Trade Zone

FUNCEX Fundacion de Comercio Exterior (Argentina)

GDP Gross Domestic Product

ICMS State Value-Added Taxes

INPE Instituto Nacional de Pesquisas Espaciais

INTAL Interamerican Development Data Base

IOF Income and Financial Operations

IPI Federal Value-Added Taxes (Brazil)

ISO International Standards Organization

MERCOSUR Mercado del Cono Sur

MICT Ministrv of Industry, Commerce and Tourism (Brazil)

MP Provisional Measure

NICs Newly Industrialized Countries

PBQP Brazilian Quality and Productivity Program

PIS Programa de Integrazao Social

PROEX Programa de Apoyo a Exportaciones

PyMEs Pequenas y Medianas Industrias (SMEs)

QRs Quantitative Restrictions

R&D Research and Development

S&T Science and Technology

SEBRAE Servicio Brasileiro do Apoio as Micro e Pequena Empresas

SME Small and Medium Enterprises

TQM Total Quality Management

Contents

Introduction 1

I. The Industrial Policy Menu 2

II. Mercosur's Objectives and Implementation Plan 3

III. European Experience with Industrial Policy Harmonization 7

Industrial Policy in Theory: Goals and Objectives 7

Industrial Policy in Practice: Implementation Record and Unresolved Issues 7

Lessons Learnedfrom EUPolicy and Relevancefor MERCOSUR 10

IV. Industrial Policies in Brazil 11

Core Policies 12

Horizontal Instruments 17

Sectoral Policies and Programs 19

V. Industrial Policies in Argentina 22

Trade Policy 22

The Impact of the CETon Argentina 23

Automobile Sector Promofion 24

T he Industrial Specialization Regime 25

Capital Goods Regime 28

Tax Policy 29

Regional Development 29

Free Trade Zones 30

Directed Credit Policies 30

Vi Harmonization Approaches and Transition Issues 31

Final Lessons 35

Annexes 37

Endnotes

Bibliography

Executive Summary

Both Brazil and Argentina currently The major conclusions are that while bothemploy various industrial policy instruments countries employ some "industrial policies," bysuch as sectorally-targeted trade, tax and credit and large these are isolated and moderate inpolicies in order to promote national economic degree. Whereas Argentina favors some exportgoals such as regional development, export development policies, Brazil is more prone topromotion, small and medium enterprise (SME) selective industrial promotion. Both countriesdevelopment and high value added have distinct policies towards the automotivemanufacturing. If major, such policies could sector, and both countries favor regionaldistort resource allocation among Mercosur development schemes. Nevertheless, first-ordermember countries and prevent them from fully estimates of the fiscal costs of industrial policiescapturing the predicted efficiency gains from appear to be perhaps one percent of GNP inintegration. The European Union's experience each, a moderate level. Whereas federal levelwith industrial policy harmonization portends policies will require some rationalization, greaterpotential obstacles for Mercosur in reconciling difficulty will be encountered in future industrialstate assistance programs to industry and incentives offered by sub-national governments insuggests several implementation measures for both countries, but particularly in Brazil.successfully industrial policies in member Drawing on the experience of the EIJ, thecountries. Recent experience from rapidly recommendation is to deal with this potentialgrowing economies in East Asia highlights the problem sooner rather than later. Observationsfact that most sectorally-based industrial policies are also offered in how to deal with declininghave tended to be costly and ineffective, raising industries, inasmuch as this may occuI moreadditional red flags for targeted policies. The frequently in a context of rapid economicpurpose of this paper is to review the status of integration.industrial policies in Argentina and Brazil, drawlessons from the experience of the EuropeanUnion, and indicate future policy issues whichMercosur partners will have to confront.

Introduction

Combining the majority of Latin and a loss of economic efficiency. Second,America's population, land and economic output, industrial policies assume an additionallythe Southern Cone Common Market (Mercosur) complex political element since such programsrepresents the deepest attempt at economic provide a popular remedy for import-competingintegration. Initiated by the Treaty of Asunci6n firms reluctant to accept the readjustmentin 1991, Mercosur aims to eliminate all internal required by trade liberalization. As was the casetariff and non-tariff barriers on goods and factors in the Europe Union, membership in Mercosurof production, implement a common external will imply an inevitable economic adjustment intariff, and harmonize numerous macroeconomic which some sectors will no doubt benefit fromand sectoral policies among Argentina, Brazil, access to larger markets, while other industriesParaguay and Uruguay. If successful, Mercosur previously protected by trade barriers ormember countries will gain from greater cushioned through state aid will decline underproduction rationalization, more efficient increased competition. While aggregate welfareresource allocation and expanded consumption may increase, the costs and benefits will not beopportunities.' shared equally. Thus integration itself may

inspire calls for more subtle state support toIf history serves as any guide, however, protect threatened industries.

successful implementation of Mercosur is neitherguaranteed nor easy. Despite more than two pinally, integration may inspiredozen attempts at regional integration in the competition among governments to outspend oneworld over the past four decades2, only the another in order to confer a competitiveEuropean Union has successfully -albeit advantage on domestic industries. Any positivecircuitously--forged the path from free trade area benefit conferred by state aid in one country mayto customs union to common market and now be canceled out by countervailing measures intowards eventual monetary union.3 The EU's another, leading to squandering of resources.experience has shown that the predicted welfare Thus, a common approach to industrial policy isgains from integration do not result automatically necessary in order to (i) maximize potential gainsfrom tariff reduction alone, but rather depend on fom integration, (ii) provide clear rules of theremoval of other barriers to competition.4 game for governments in dealing with inevitable

pressures for state aid in one form or another,

Industrial policies constitute one thorny and (iii) prevent actions, and reactions, which inpolicy area with the potential to frustrate full the end may jeopardize Mercosur's success.integration in Mercosur. Broadly defined,industrial policies encompass the combined effect We must be careful at the outset toof government policies designed to affect the define what is meant by "harmonization." Theallocation of resources among economic activities term is used in this paper in a neutral rather thanand produce an outcome different from what activist sense, namely, that IP harmonizationotherwise would have occurred in the market. implies an agreed approach to industrial policiesSuch policies could include tax exemptions or - particularly emerging, protected or decliningreduchtpoicis oruspecific includuiesx sexemtios oret industries -- with a common framework or rules,reductions for specific industries, selective credit remedies, and sanctions. It does not imnply, atschemes, concessional loans or administeredtrade protection measures such as anti-dumping least m our calculus, a coordinated,measures and countervailing duties. interventionist IP by the customs union partners.

This is an important distinction.5

For several reasons industrial policy The paper has three objectives: to assessconstitutes an obvious area for Mercosur's t he papprohes to objectnves policiessattention both during these early phases of trade the current approaches to industrial policies inliberalization and throughout the entire Argentina and Brazil, to set out a possibleintegration process. First, any type of selective harmonized approach within MERCOSURindustrial assistance programs which distorts drawing on the experiences of the Europeanrelative prices will lead to resource misallocation Union; and to discuss transition issues during the

harmonization process. Part I provides a brief . non-tariff barriers ranging formconceptual framework for analyzing the outright QRs to more subtleeconomic validity of various augments for and protection such as product labelingagainst industrial policy. Part 11 summarizes the and packaging requirements, safetyobjectives of MERCOSUR vis-a-vis the EU, standards;reviews their respective implementation status * administered protection such ;1s anti-and highlights those policy areas most critical for dumping measures andindustrial policy harmonization. Part III countervailing duties;analyzes the European Union's experience with * differential rules of origin orindustrial policy harmonization with particular domestic content requirements;attention to trade policy, tax policy, credit policy,policy towards declining industries and policies Tax policiestowards new high technology sectors. Parts IVand V, assess the state of industrial policy in * tax credits, allowances, exemptionsBrazil and Argentina, respectively, in order to or deferrals for particular firms,identify emerging policy issues. Finally, Part VI sectors, or regions;offers some observations on common issues andtransition mechanisms. Credit polices

L. The Industrial Policy Menu * below-market interest rate loans;

government-backed loan guarantees;Broadly defined, industrial policies * equity participation by the

encompass any state acts or policies designed to government;affect the allocation of resources among * direct grants from the state budget .economic activities and alter what wouldotherwise have been the market outcome. This Why a government should utilize suchdefinition is quite broad and can include sector industrial policies is subject to much confusion.6

specific interventions, industry specific Some authors treat the question of industrialinterventions or those applicable to all industries, poiyamsasadctmushiebtwn

i.e. funtionl inervetion. On canfind policy almost as a dichotomous choice betweeni.e., fiinctional interventions. One can find the traditional neo-classical notions ofevidence worldwide of such policies in use to competitive markets and the "new" politicalsupport a variety of economic and political economy of government-led capitalism.7 Such aobjectives. The United States, for example, dichotomy isfalse. Economics provides rigorousextends concessional credit to small businesses rationales for and against industrial policyand to farmers, while European nations have contingent upon underlying marketused equity participation to support automobile characteristics.and aircraft production. Korea used directedcredit programs to support heavy industry such One frequently cited goal of industrialas shipbuilding and chemicals, while Indonesia policy is to assist resource reallocation fromhas employed import protection and government declining to rising sectors, especially in theloans to develop a commercial aircraft sector. context of integration where trade liberalization

will inevitably hasten such a process. lTheoryRegardless of their national argues, however, that barring critical distortions

particulapties, industrial policy instruments can or rigidities, such as informnation asymmetries,be grouped under the rubric of trade, tax and market forces should provide the appropriatecredit policies. Specific examnples of each incentives to move resources from sunset toinclude: sunrise sectors without incurring the fiscal cost

of government intervention or engagingTrade policies governments in the difficult task of picking

winners. Other justifications for industrial policy* selective duty rebates and non- center on the externalities associated with

uniform tariffs

3specific industries. In sectors which create government and generally fail. The decision totechnology spillovers or yield benefits which pursue a particular industrial policy thus reducesfirms cannot fully appropnate, firms may be to weighing the costs and benefits. The questionreluctant to enter the market. In these cases, is not whether a particular industrial objective isintervention is often advocated. desirable, but whether industrial policies make

the achievement of that goal more likely, whetherRelated to this argument is so-called the aggregate benefits of attaining such a goal

"strategic trade policy" which contends that in exceed the program's cost, and whether such acertain global oligopolistic markets characterized policy engenders collateral distortions in otherby high fixed costs, economies of scale and sectors. Industrial policies in MERCOSUR mustproduction externalities, government intervention be scrutinized with these criteria in mind.may be both necessary and justified in order tohelp domestic firms capture a larger share of an H. Mercosur's Objectives andinternational pool of excessive profits. These Implementation Planarguments are most often applied to hightechnology industries such as commercial aircraft Mercosur's aim to create a commonproduction and advanced electronics. However, market comes as the latest in a long series ofin those markets which exhibit the ideal regional economic integration plans mn thecharacteristics of a global oligopolistic market, developing world since the 1950s, over half ofempirical studies suggest that firms have not which were initiated in Latin America. Amonggenerally been able to capture large benefits from the nearly dozen integration attempts in Latinstrategic intervention. The case is even weaker America since the 1950s, few were fullyfor relatively competitive markets, such as those implemented and others were simply abandonedfor automobiles, where all but a few companies during the nacroeconomic crises of the 1980s.fail to make significant profits.

Although policymakers are justifiablyThus, while the use of industrial policy more sanguine about Mercosur's prospects in the

does enjoy some theoretical justifications 1990s8 , member countries have few benchmarkscontingent upon underlying market structure, the for assessing the relative progress of integration.existence of externalities or the presence of The European Union provides one possiblemarket rigidities, it is also clear that many gauge. To be sure, MERCOSUR countries todayconventional arguments do not pass analytic differ considerably from the original EUmuster. The case for intervention is strongest for members in 1960 in terms of level ofnew, export-oriented industries (which facilitate development, industrial structure and regionalthe diffusion of foreign technology) in developing disparities, all of which affect the nature ofeconomies, and new technology-intensive integration, the speed of implementation and theindustries (which result in innapropriable gains to difficulty of policy harmonization. From itsother firms and sectors) in advanced economies. inception the EU was comprised of sixIntervention may also be temporarily justified in industrialized nations (hereafter referred to as thedeclining sectors if rigidities retard the EU-69) with relatively homogenous economiceconomy's internal ability to adjust. structures and strongly interrelated trade

relations. As indicated in Table 1, the origiral sixThe key argument against industrial EC members where characterized by a strong

policy intervention is that faulty intervention industrial presence both in terms of industrialoften costs more than neutrality since poor contribution to GDP (46 percent) and to exportstargeting diverts resources from economically (65 percent). Intra-regional exports were alsobeneficial activities. Governments which follow high. The EC-6 exported over one-third of theira "hunch" to support a particularly prestigious products among member countries, a figureindustry without clear empirical evidence of a which suggests a high degree of initial trademarket failure, or those which identify favored integration even before all provisions of the tradesectors based on political rather than economic pact were implemented.criteria, will impose a high fiscal cost on the

4Mercosur's departure point were quite redistributional policies. Differences in the

different. The economies of the member states extent of econornic liberalization suggests thatwere more heterogeneous and not as interrelated responsibility for policy harmonization may fallas the European states. Despite the fact that all disproportionately on some countries. A countryMercosur members could be classified as middle- like Argentina with relatively few industrialincome developing countries according to the support programs may find that harmonizationWorld Bank's typology, the level of development implies either forcing a faster pace ofwithin this category varies considerably. liberalization on Brazil or "ratcheting up" to aArgentina is nearly twice as wealthy as Brazil in level higher than the present . To what extentper capita terms, and more than four times policy convergence will entail reversing the trendwealthier than Paraguay.10 Brazil, however, of liberalization over the past five years is acomprises more than three quarters of critical issue for Argentine policymakers, whoMercosur's output, and together with Argentina, have to date been the fastest liberalizers.represents 96 percent of the bloc's GNP.Another important difference concerns Differences notwithstanding, Mercosurdifferences in productive structures as seen in and the EU share several common integrationTable 1. In terms of intra-regional integration, goals which are sununarized in Table 2. Three ofonly 18 percent of exports from MERCOSUR these differences highlight potential policycountries were sold within the bloc in 1994, obstacles to industrial policy harmonization incompared to an intraregional export level of 33 MERCOSUR. First, MERCOSUR does notpercent in the EC-6 at its inception in 1960, but define any financing mechanism for regionalup dramatically from 1990. Mercosur trade rose development, industrial restructuring orfrom $3.6b. to $10b. in 1994, driven by a trade reconversion initiatives or joint research andexplosion between Brazil and Argentina. development projects. Secondly, Mercosur's

institutional arrangements are far weaker thanEconomic differences, while not those in the EU which coordinate and enforce

mitigating the potential economic benefits of policy through supranational entities such as theintegration, will determine the distribution of European Parliament and the Court of Justicecosts and benefits and may engender political which enjoy authority over member states.rivalries which work to frustrate integration Mercosur's inter-governmental working groupsattempts. Regional disparities among Mercosur do not enjoy such legal autonomy or budgetarycountries (and for that matter, within countries) powers.raise the likelihood that integration will aggravateregional income disparities in the same way thatthe accession of Portugal, Spain and Greece tothe ECU heightened the need for coordinating

5

TABLE 1. Comparative Economic Indicators: MERCOSUR (1994) and EC-6 (1960)

% of sector in GDP

GDP Per Agric. Industry Services Manufact. % of intra-(US$b.) Capita (Manufact.) as % of regional

GDP* Exports exportsArgentina 207 6,050 6 31 (20) 63 32 28Brazil 532 3,340 11 37 (20) 52 60 14Uruguay 9 2,770 11 29 (19) 61 43 40Paraguay 6 1,380 24 23 (15) 52 17 41

Mercosur 4343 3,864a 101 353 (20)a 54a 52b 18baverageEC-6 average, 382a 8,493a 9a 46- (35)3 46a 6 5 b 33b1960

EC-6: France, West Germany, Italy, Belgium, Luxembourg and the Netherlands'Weighted by relative output.b Weighted by relative exports.* Constant SUS (1990 base year)Source: World Bank

Finally, the Treaty of Asuncion's provisions for on the issue of industrial policy harmonizationharmonization of monetary, tax and industrial leaves several critical questions unanswered. Inpolicies do not specify either timetables or particular the treaty does not specify whether allimplementation mechanisms for achieving these industrial policy instruments will be prohibited orgoals. This ambiguity is neither unintentional nor simply limited. If they are to be limited, thenecessarily undesirable at this stage; the range of treaty does not specify whether restrictions willpolicies to be harmonized and the number of be levied on the absolute amount of stateconstituencies involved is sufficiently broad and assistance, on the acceptable tools for subsidizingcomplex that member interests may be better industry, or on both. Further, a commonserved by specifying only the broadest objectives standard is not specified. Also left vague are theand allowing Mercosur's ten intergovernmental issues of Mercosur policy towards decliningworking groups negotiate the terms of eventual sectors, the enforcement mechanism in cases ofpolicy harmonization. Such a process is similar trade disputes, and cooperation on supranationalto that followed through the EU's harmonization programs like research and development. Theseprocess in which broad goals were outlined in the particulars of industrial policy harmonizationinitial treaty, but the eventual policy also were omitted from the Treaty of Romeharmonization details were left to working groups establishing the European Community in 1957and task forces, the Council of Ministers or the and were only developed over a 30 yearEuropean Comnuission. integration process. Part III examines the

European experience with the process and notesThis approach holds the potential for some of the potential obstacles for Mercosur to

both opportunity and difficulty in the context of avoid as well as opportunities for improving onindustrial policy harmonization. As was the the European experience.case in the EU, the treaty's deliberate vagueness

6

TABLE 2. Principal Provisions of Mercosur and the European Union

Policy Area Mercosur Objective Status European Union Objective Status

Trade of goods 100 percent elimination of tariff 100 percent elimination of tariff andand non-tariff barriers; non-tariff barriers; harnonization ofimplementation of common customs administration;exteral tariff (CET); implementation of CET. iharmonization of customsadministration; establishment ofrules of origin criteria. "

Capital mobility Free movement of capital goods. Free movement of capital;@ establishment of "national treatment"

laws for investment.

Labor mobility Coordination of policies on labor Free movement of labor amongrelations, migration, training and 0 member countriessafety.

Monetary/ Coordination of monetary Establishment of fixed exchange rateexchange rate policies in order to reduce real system (within predetermined bands)policy exchange rate fluctuations and o among member countries and cormmon

resulting disruptions in trade currency.flows.

Tax policy Harmonization of tax policies. Harmonization of sales, corporate and0 excise taxes.

Unfair trade Establishment of common norms Establishment ofjudicial body topractices for administering anti-dumping ( administer CVDs and anti-dumping 0

measures and countervailing measures.duties.

Dispute resolution Establishment of dispute Establishment of Court of Justice toresolution mechanism and ( resolve disputes among EU members; O

procedures to resolve trade adoption of enforcement mechanism tocontroversies among Member ensure compliance.countries.

Decision-making Establishment of Common Establishment of supra-nationalbody Market Group, Common Market European Commission and European 0

Council and inter-govemmental Parliament to consider legislation.working groups in ten policyareas.12

Research and Coordination of science and Promotion of EU-wide R&D initiativesdevelopment technology policies. ( in areas such as aerospace and

electronics through specific budgetoutlays.

Regional Harmonization of regional Creation of funds (Europeandevelopment development programs. 0 Investment Banks and European Social

'~ Fund) to reduce regional developmentdisparities.

Industrial policy Harmonization of industrial 0 Harmonization/elimination ofdevelopment policies. industrial promotion policies.

Source: Treaty of Asunci6n (1991); General Report on the Activities of the European Communities, EU Commission, variousyears.

* Fully implemented )Partially implemented, Partially implemented, 0 Still under discussion;but on schedule but delayed few implementations taken

7M. European Experience with adaptation to changing technological condition orIndustrial Policy Harmonization market demand, not to bailout uncompetitive

finms. Eliminating excess capacitv andIndustrial Policy in Theory: Goals and redirecting investment should be the goals, andObjectives aid should diminish over time. State aid without

a restructuring plan is considered unacceptableThe Treaty of Rome which founded the (Swann 1993).

European Community in 1957 (now theEuropean Union) did not provide for a common The EU also uses its central budget toindustrial policy with the samne specificity that it fund several pan-European industrial projects inoutlined the Comrnon Agricultural Policy, high technology sectors where research andCommon Transport Policy or Commnon Social development costs might be prohibitivelyPolicy. The most substantive provisions are expensive for single countries. These includeArticles 92-94 prohibiting all state assistance to electronics, nuclear energy, bio-engineering andindustry which distort or threaten to distort aerospace.competition by favoring certain enterprises or theproduction of certain goods.'3 Export assistance Industrial Policy in Practice:is not allowed and cannot be exempted for any Implementation Record and Unresolvedreason, including regional development purposes. IssuesThe instruments of industrial policy, while notexplicitly enumerated in the Treaty, are generally In practice the EU record with industrialtaken to include direct transfers from the policy harmonization has been lackluster.government, subsidized credit, government loan Although the Treaty of Rome envisionedguarantees, tax reductions and exemptions and eliminating state aid to industry which couldgovernment equity participation in a firm. distort competition (Article 92-94), it was some

tine before these objectives were codified intoDespite Article 92, this prohibition explicit policy. For either lack of political will or

against state aid is far from absolute. The Treaty differences in economic philosophy, coordinatedmaintains several specific exemptions allowing industrial policy as such received scant attentionstate aid for regional development purposes, during the first decade of the EC's existence (El-projects to promote the common European Agraa 1991). In fact, throughout the evolutioninterest, and measures to offset "serious of the European Union, coordination of industrialdisturbances" (like recessions) in the economy of policies with the goal of reducing state assistancea member state. The ECU Commission, the chief to industry and minimizing distortions in theadministrative body of the Union, is charged with common market has been subordinated to other,monitoring, reviewing and authorizing all forms often political, objectives. During the 1970s, theof state aid.'4 In recent years, the Commission economic downturns induced by successive oilhas elaborated more detailed guidelines for shocks encouraged member countries to grantspecific industrial policy guidelines for regional increasing subsidies to industry in an attempt todevelopment, declining industries and high preserve employment, a move which wastechnology sectors. Regional assistance permitted by the European Commission. (Theprograms should be transparent and region- Commission later tried with marginal success tospecific. They should not cover entire national limit such subsidies in several sectors, includingterritories but instead should be concentrated on steel, textiles and shipbuilding.) By the 1980sproblem areas. Maximum limits have been industrial policy assumed a new form in Europe.established on the level of assistance allowed for Rather than focus on eliminating or coordinatingvarious regions, classified under four categories state assistance programs, the EU tumed moreaccording to the degree and depth of development decidedly to developing joint initiatives toin Vach. support community-wide initiatives, especially in

high technology sectors such as aerospace andSectoral assistance to declining or sunset electronics.

industries should be given to firms to promote

8Ironically for a trade bloc which 43 billion) still represents sizable sum. While

expressed in its founding article an intention to distortions of competition could not be simplyreduce, eliminate or coordinate industrial equated with the volume of aid, the sheer volumepolicies, it was not until 1989--a full three suggests that the EU faces a daunting task indecades after the founding of the EC--that the reducing, much less eliminating, state assistanceCommission undertook its first quantitative to industry."6

analysis of the volume, trends, form andobjectives of aids to manufacturing and other Disaggregated by country (Figure 2),sectors (CEC 1990).1 Thus the move to industrial assistance programs among EUcoordinate industrial policies is a relatively new countries exhibit considerable variance. Greece,aspect of European integration and has largely Italy, Portugal and Ireland, which each provideconcentrated on efforts to assess the extent of aid equivalent to more than six percent ofindustrial assistance, identify its varied forms, manufacturing value added, are the heaviestrender programs more transparent and attempt to subsidizers while Germany, Denmark and thereduce the level of assistance through supra- United Kingdom provide the least state aid (lessnational enforcement mechanisms. than three percent of value added). This

disparity suggests that industrial assistanceFigure 1 shows the level of state aid to programs are far from harmonized among EU

manufacturing in the EU expressed in absolute members. Tables 3 and 4 provide furtherterms (billion ECU, current) and as a percentage disaggregations of industrial assistance programsof value added in the sector. By either measure, by type of aid (tax exemptions, concessionarythe level of industrial assistance decreased in the loans) and by objective (i.e., horizontal objectivesEU between 1986 and 1990 (the latest year for applying uniformly to all industries, sector-which figures are available.) However, the specific aid or regional objectives).overall aid level of 34 billion ECU in 1990 ($US

FIGURE 1. State Aid to Manufacturing in the EU, 1986-90(as % of value added and billion current ECU)

54.5 4.2

-~ 4 3.7

3.5 . 3.2

.~ 3

2.5

~12 40.6 35.8 32.6 4.1euu ecu1.5 ecu ecu ecu1.51

0.5

1986 1987 1988 1989 1990

Source: Commission of the European Communities (1992)

9

FIGURE 2. State Aid to Manufacturing By Country(percentage of value added)

6-

U

4 2- 1 t0 1986-8F

0

UK Den Ger Lux Neth Fra EU Spa Bel Ire Por Itaavg

Source: Commission ofthe European Communities (1992)

TABLE 3: State Assistance to Manufacturing by Type of Aid, 1988-90

(yearly average as % of total aid)Grants Tax Equity Soft Tax Loan

reductions participation Loans Deferrals Guarantees

Belgium 55 27 5 5 0 8Denmark 59 3 0 37 0 0

Germany 26 61 0 7 3 1Greece 44 17 18 11 0 11

Spain 78 0 10 11 0 1France 26 16 11 14 3 26Ireland 50 44 2 0 0 3

Italy 53 40 5 2 0 0

Luxembourg 75 5 2 16 0 1

Netherlands 66 27 0 4 0 3

Portugal 34 3 59 4 0 1

United Kingdom 76 4 8 3 6 1

EU average 47 32 7 7 2 6Source: Commission of the European Communities (1992)

10

TABLE 4: State Assistance to Manufacturing by Objective, 1988-90

Horizontal Particular Regional

objectivesa sectors objectives

Belgium 76 4 21Denmark 59 38 3Germany 29 11 61

Greece 81 5 15Spain 28 67 5France 66 25 9

Ireland 50 9 42Italy 30 15 55

Luxembourg 39 0 61Netherlands 77 11 12Portugal 17 76 5United Kingdom 45 20 34

EU average 42 20 36B Research and development, environmental protection, small and medium enterprises promotion.Source: Commission of the European Communities (1992)

Several trends emerge from Table 3. First, interventions are less troubling than aid togrants and tax reduction are by far the most specific sectors since they affect relative pricesfrequently used forms of aid in the EU, possibly equally among all industries. One fifth of EU aidbecause they are more easily administered in is sector specific, particularly for steel andterms of parliamentary procedures than other shipbuilding. Several EU members also spendinstruments of industrial policy such as changes for regional objectives.in tax laws. State equity participation is not amajor component of industrial policy except in Lessons Learned from EU Policy andPortugal where it accounts for over half of state Relevance for MERCOSURassistance. By far this form of state aid is theleast transparent and the most difficult to As illustrated in the previous section,monitor. Concessionary loans and tax deferrals industrial policy harmonization in the EU has notare an important form of aid only in Denmark, yet been realized, whether measured in terms ofFrance and Luxembourg. EU states generally harmonizing appropriate tools for industrialavoid this form of aid because it places a heavy policy, imposing strict limits on the level ofburden on the state budget. Tax deferrals acceptable assistance, or reducing the extent of(mainly accelerated depreciation) is seldom used subsidization among member countries. Despitein the EU. Loan guarantees constitute a small these shortcomings, the overall level of aid toshare of total industry aid. These are also not a industries did decline in the late 1980s, yet itvery transparent form of assistance. remains to be seen how this trend moved in the

early 1990s.Table 4 outlines industrial assistance

programs by objectives. 17 As seen, most If one takes the starting point forindustrial policy is directed towards horizontal concerted industrial policy harmonization to beobjectives such as research and development, 1989 (the first year the EU collected statistics onenvironmental programs, SME development and the extent of industrial assistance programs), itenergy conservation. In general these functional appears that the EU experience provides only

11limited evidence from which to draw conclusions equally expensive regional initiatives, then theabout the process. Assessing the extent and gains from more efficient resource allocation willnature of industrial polices on a regional level is be seriously compromised.the first step in harmonizing industrial policies.This necessity may seem self-evident, but for IV. Industrial Policies in Brazilmnany non-economic reasons such an initial stepis often difficult to undertake. Nevertheless, The objective of this section is to describereducing the distortionary effects of such policies the ain industrial policy instuments operationcannot proceed without first defining and in the Brazilian economy, and briefly assess theirquantifying the paramneters of industrial policies impact.18 It is useful to regard some instruments asin Mercosur. part of the government's de facto core policies

towards industry - fundamrentaly trade policy, andSecondly, treaty texts which may initially the wide dissemination of total quality management

call for a harmonization often accord substantial and productivity enhancing measures. Another setlatitude for manipulation and abuse and could be of mechanisms are "horizontal" in nature: they areconstrued to permnit almost any sort of state focused on prornoting exports, investment andassistance, especially for declining industries and R&D, as well as stimulating small and mediumregional development programs. Such a enterprise (SME) development. Finally, thepossibility underscores the need for strict government has defined a few sectoral policies andguidelines for state assistance specifying the type programs, some focused on more traditionalof aid, absolute spending ceilings, and phase-out segments, as in the case of the automotive industry,periods. Related to this rules-oriented approach for example; others targeted at technology-intensiveto policy harmonization, the EU experience areas, with expected long-term economic results, asemphasizes the necessity of a credible in the case of the space program.institutional framework to monitor industrialsubsidy programs and enforce mutually agreed Brazil has had a long history of industrialupon rules for industrial policy. The European policy interventions. Since WWII, successiveCommission can enforce to some degree its governments have been concerned with buildmg updecisions through the Union's budgetary powers, and developing an industrial base. After an initialwith sometimes varying degrees of success. It period where the perceived foundations of industrialremains to be seen how Mercosur's Common development were targeted - the production of steelMarket Group or Council will guarantee similar and few other interneiates, and the build-up of ancompliance. infiastructure network - there were two important

moments in industrial policy formulation m theFinally, the EU experience illustrates country. First, in the rnid-1950s, with President

that industrial policy harmonization involves two Kubitchek's comprehensive Piano de Metas;tasks. The first concerns the reconciliation of second, a few years later, when the II Nationalnational policies to support domestic industry. Development Plan (1974-79) provided a coherentThis was the goal of the EU survey of state framework for "deepening" import substitution,assistance programs to industry initiated in 1989, with a major push for the capital goods andthe challenges of which have been noted. The intermediates industries.second task involves the debate over theappropriate role for supra-national industrial It is arguable that since the late 1970s,policies to support bloc-wide industrial initiatives Brazil has not pursued an industrial policy, in thesuch as regional development programs or strict sense of a set of instruments intent ondownsizing of declining industries. Similarly, changing the sectoral allocation of resources in aregional integration provides opportunities for systematic and purposeful way. Although duringcollaboration on joint initiatives such as research the 1980s, successive governments have madeand development in areas which were formal industrial policy announcements, the absenceprohibitively expensive for a single country of effective mechanisms, and most importantly, thebefore integration. If national industrial policies exhaustion of the import substitution paradigrn as ain Mercosur are reduced only to be replaced by model of industrial development, translated into a de

12facto policy vacuum. It has only been since 1990, considerable influence from Planning and Foreignafter an eleven year hiatus, that a new government Affairs. Export policies, and associated fiscal andhas redefined a new trade and industrial strategy. financial incentives, come under the purview ofTrade liberalization has been most effective in Finance and Planning, with inputs from MICT andchanging the incentive regime for industry, where Foreign Affairs. The investment promotion regime,the competitive ability of firms became the basic particularly that elated to financial incentives, aredeterminant of success. The trade regime has been, under the Ministry of Planming, "parent" of thetherefore, at the core of the Government's industrial National Development Bank. Technology andstrategy. R&D policy is mostly concentrated in the Ministry

of Science and Technology, although related fiscalThe transition towards a more open and incentives are filtered by the economic Ministries.

competitive economy has been greatly helped by a The direction of industnal policy thus oscillates,quality and productivity-enhancing program depending which Ministry has the upper hand, andlaunched in 1990, as part of the new policy regime, is generally characterized by excessive influenceexplicitly to strengthen finns in view of the new from political and short-term considerations.environment brought about by trade liberalization.While the latter (combined with a recessionary Core Policieseconomy) imposed strict discipline upon firms, theBrazilian Quality and Productivity Program Trade Policy. Brazil has become in the last(PBQP) helped educate and reshape the internal few years an increasingly open and competitiveorganization of firms, with the introduction of new economy. The 1988 tariff rationalization efforts -management concepts and tools. In this sense, the which reduced both average tariffs and theirProgram was instrumental in ensuring that Brazilian standard deviation - were followed by afinns effectively reacted to post-1 990 open economy comprehensive trade reform. Starting in March ofenvironment. 1990, the process of trade liberalization involved the

immediate removal of explicit non-tariff barriersThe institutional responsibility for (the so-called Annex C) and the announcement of a

industrial policy formulation and implementation in time-bound decrease in the level and dispersion ofBrazil rests with the Ministry of Industry, tariffs (Table 1). As of January 1, 1995, MercosurCommerce and Tourism (MICT). De facto, countries share a common external tariff (CET)however, there is significant power fragmentation with 11 tariff levels, ranging from 0% to 20%, in(and lack of coordmation), and only PBQP is increments of 2%.effectively in the Ministry's hands. Thus, tradepolicy is dictated by the Ministry of Finance, with

Table 1: Brazil - Evolution of Tariff Structure 1987-93(in %)

Feb Jan Oct Jul Mid1987 1988 1990 1991 1992 1992 1993 1995

Average 55.6 35.0 31.5 23.6 19.7 17.1 16.1 12.2Mode 30 40 40 20 20 20 20 20.0St.Dev. 26 17 19.6 17.4 14.2 10.7 7.9 n/aAmplit. 0-105 0-105 0-105 0-85 0-65 0-55 0-35 0-70

Source: Mana Helena Horta, Guida Piani and Honono Kwne, in "Perspecivas da Economia Brasileira, 1992" IPEA, Rio de Janeiro,DTT/SECFXAfICT, Government ofBrazil; and FU?..CE

A more detailed look by major product group shows tradables, intermediates, durables and non-durablesthe significant decreases in tariff levels in the 1990- (Table 2).94 period, affecting a fairly broad spectrum of

13Particularly striking are the tariff annual average rate of 27.8%in the 1992-94 period.

reductions in products which were vulnerable to Imports expanded from US$ 20.4 billion in the baseimport competition, namely, synthetic fibers, tools, year to US$ 33.3 bilhon im 1994. Still, theelectric mnachinery, vehicles and toys. Although the stagnation in the value of imports in 1991-92numbers displayed refer to nominal rates of concealed the threat they actually posed First,protection, the overall reduction in the levels of immediately after 1990, the ratio of import tovariance (as indicated by data on standard domestic consumpntion increased substantally in adeviations from Table 1) suggest that effective rates number of industrial sectors, intensifying importof protection must have also moved down competition (Table 3). Second, firms were pressuredsubstantially, not only by acual unport penetraon, but by the

fact that custoners could credibly invoke the threatAlthough import response was initially slow of looldng for altemative foreign suppliers in order

(after a spurt in the first year of liberalization), to obtain better purchasing terms.partly due to the 1990-92 recession, import levelsincreased significantly thereafter, growing at an

Table 2: Brazil - Tariff Levels by Major Product Groups(percents)

NBN Chapters 1990 Sept. 1994 DifferenceCotton 30.6 13.9 16.7Wool 14.7 11.4 3.3Synthetic Fibers 30.0 15.1 14.9Garments and Accessories 50.0 20.0 30.0Shoes 50.0 19.6 31.4Iron and Steel 21.9 11.2 10.7Aluminum 22.5 12.3 10.2Tools 43.4 17.8 25.6Electric Machinery 38.8 16.5 22.3Vehicles 63.3 18.0 45.3Boats 35.8 16.8 19.0Furniture 41.8 17.8 24.0Meat 18.5 10.0 8.5Cereals 20.7 6.7 14.0Beverages 75.1 19.7 55.4Organic Chemicals 24.3 6.3 18.0Drugs 22.8 10.1 12.7

Source: CNI (National Confederatic of Industhy)

Table 3: Brazil - Imports/Domestic Consumption - 1990-92

Segment 1990 1991 1992Electric power equipment 11.9 17.6 26.6Electric Components for Vehicles 6.1 9.9 15.1Electric machinery 27.4 36.4 45.9Engines and autoparts 7.5 11.2 18.8Fertilizers 17.3 22.6 24.3

Source:BNDES

14Industrial firms responded to the import the pressure from import competition (comnbined

threat (and the immediately preceding recession) by with the 1990-92 recession) were sufficiently strongundertaking the most drastic defensive restructuring for prices in real terms to fall for major productactions witnessed in Brazil since the onset of categories, with the exception of foodstuff ancd drugsindustrialization. They greatly improved (Table 4). In both instances, finns benefited fromproductivity, and reduced costs. In the period 1990- removal of price controls, and used the opportunity94, industrial labor productivity grew at an average to recover their target profit margins through theannual rate of 8.3%, compared to -0.5% in 1985- exercise of monopoly power.90.'9 This allowed industrial prices to fall intandem. Indeed, as a result of the 1990 trade reform,

Table 4: Price Changes for Selected Product(in %) - Dec. 1989 - July 1994

Product Groups Percentage ChangeGarments 45.5Electronics 46.3Vehicles -28.5Machinery and Equipment - 31.0Cleansing Material -22.4Household Appliances -45.0Foodstuff 42.9Drugs 110.9

Source: FGVandBiasilpar

Since the Real stabilization plan and the monetary index increased by 28.7% in the period July 1994-reform of July 1, 1994, relative prices have shifted June 1995, retail prices by 38.5% and industrialconsiderably. While industrial prices, particularly wages by 44.1%/, the prices of inputs of industialfor tradables, have remained under competitive nature (from 39 subsectors) rose by just 12.7%,pressure, priees of services and other non-trdables while prices of imported inputs conracted by 0.5%(including labor), excepting public utilities, have (Table5).risen significantly. Thus, while the aggregate price

Table 5: Post-Stabilization Industrial Cost DynamicsJuly 1994-June 1995

(percents)Industrial Inputs Share Price Changes Cost ChangesDomestic Inputs 68.8 12.7 8.7Imported Inputs 7.9 - 0.5 - 0.4Hourly Wages 15.4 44.1 6.8Public Utilities 1.4 -6.5 - 0.9Other 6.5 18.9 1.2Total 100.0 15.4

Source: FNCEAX

15

The gains in productivity and the shift in policy instability, with an adverse effect onrelative prices attest to the impact of trade investment and other long-term decisions.liberalization on productivity, costs and prices. Yetthe growing pressure from imports (and balance of The Brazilian Quality and Productivitypayment difficulties) has also led to a number of ad- Program. The ability of Brazilian firns to face inhoc protectionist measures. The Mercosur tariff the early 1990s the challenge of recession andagreement includes a "list of exceptons" for 300 liberalization of imports is a reflection of producers'products whose tariff levels wil converge to the commitment to cost-reducing and quality-enhancingcommon external tariff, some by the year 2001 measures. They led to the vertical disiritegration of(including vehicles and capital goods), others by activities, as firms subcontracted or hived off the2006 (in case of computer hardware and least economical; to the reduction of hierarchicalprofessional electronics). To this list one should add levels, in an attempt to improve inrafirma "rotating" list of approximately 150 products, for communication among emnployees, and betweenwhich tariffs are set above or below pre-agreed them and management; and the introduction oflevels at the Government's policy convenience.20 The kaizen ("contnuous improvement"), quality circles,underlying reasons why products are included or just-in-me and other techniques of total qualitydeleted from this latter list are related to temporary management and worker involvement, so as toindustrial "relief' (as in the case of shoes and gready reduce the high levels of waste andtextiles, among other products, for which tariffs inefficiencies that have historically characterizedhave been set at 70%/o); balance of payment Brazilian industiy.difficulties (as exemplified by the tariff increase inMarch 1995 affecting some 109 consumer durables It is arguable that firms' adoption of newand vehicles, again to 70%/o); or to an apparent standards of quality and productivity was drivenundersupply of foodstuff or industrial inputs, which fundamentally by the fact that, with liberalization ofled to tariff reductions to zero (as in the case of imports, they had either to beccxne internationallycorn, tomatoes, certain chemical and textile inputs) competitive or exit the market. Nonetheless, it isor to some intermediate level. highly unlikely that the pace of dissemination of ISO

standards, and most important, the degree ofIn fact, since the Govemment decided awareness in society regarding the importance of

favorably on the convergence to the conmmon total quality management, would be the same were itexternal tariff on a more rapidly than anticipated, not for the Govemmenufs Brazilian Program forthe trade regime has been characterized by Quality and Productivity (PBQP). The program wassignificant turbulence. Changes in the tariff regime laundced in November 1990, to exert a "decisiveand the erection of new barriers since early 1995, role in the competitive restructuring of nationalhas been supplemented by new non-tariff obstacles. industry."2'Although few doubt the importance of, and theGovernment's commitnent to an open economy, the Although the program has been based onprocess of liberalization has actualy unleashed voluntary public and private actions, the PBQP ispressure of competition. In some cases, these considered, together with trade liberalization, theactions are legitimate and economically justifiable; driving fbrce behind the "productive revolution"predatory dumping and the heavy use of subsidies experienced by Brazilian industry since the earlyare still pervasive in some foreign industries, 1990s. The PBQP is based on both "general" andincluding textiles, where the employment impact of "sectoral" programs. The former is focused onimports has been the greatest. At the same time, motivating agents and raising their level ofsmuggling, particularly from Paraguay (in this case awareness; disseminating infornation conceringestimated at $US 12 bilion), clearly represents the importance of improving the qualty andunfair competition. In other cases, however, there is productivity levels for all economic activities; andno economic justification for renewed protection. In promoting the development and diffusion of newany case, the noise introduced by frequent changes managerial methods.22 There are also 29 ongoingin the trade regime castitute an unwanted source of sectoral (and statewide) programs, involving 240

public and private institutions. The effectiveness of

16the program is based on large-scale training. By end countries and industrial cultures, critical at a time1994, 17,000 managers and specialists - "quality when firms are part of a globalized market. Themultipliers" - were trained and an additional 95,000 gains are most pronounced from a global sourcingwere as a result introduced to total quality perspective, as communality of standards, normsmanagement techniques and practices, lower inspection and supervision

costs.The commitment to total quality

management is expressed in firms' adherence to Producers' perceptions confirm the notioninternational total quality standards, as codified in that standardization gains are significant. In a recentthe Iernational Standards Organization (ISO) survey of 93 ISO-9000 certified producers,9000 series. Certification has become a major goal undertaken by the National Confederation offor industrial finns in Brazil, both for internal Industry (CNI), in only four cases there was noproductivity and quality-related reasons, and as an positive inpact from certification efforts (Table 6).effective marketing device, a signal to clients, This is a formidable statistic and one which helpssuppliers, creditors, shareholders and the public-at- explain the pace of adoption of ISO standards in thelarge, that their quality standards (and performance) country. Moreover, as shown by anecdotal e%idence,are close to the itemational frontier. Moreover, the already in the process of certification firms benefitstandards provide a common "language" and from reduced waste and overall higher levels ofproduction methodology for producers of different labor productivity.23

Table 6: Brazil - Reported Impact of Adoption of ISO-9000

Main Results (in %)Nature of Impact (in %)Productivity Increases 54.9Standardization of Processes 35.2Staff Involvement with Quality 31.9Product Quality Improvement 25.3Improvement in firms' External Image 20.9Increase in Client's Satisfaction 20.9Cost Reduction 17.6Improvement in Qualit System 9.9Fulfill Export Requirements 6.6Results Still to Come 4.4

Source: CNI based on a sample of 93fiimas.

As a result, the diffusion of ISO-9000 among There are a number of non-core horizontalindustrial firms, and to a lesser extent, within policies which purport to have a real impact on theservice organizations, has been surprisingly rapid in competitive standing of Brazilian industry. AmongBrazil (Table 7). Between 1990 and 1994, the them, export support policies, which attemnpt tonumber of certified units increased from 18 to 577, expand the relatively low levels of exportan average annual growth rate of 138%. After penetration; investment and R&D incentives, used1991, in every single year, the number of producers as a means of offsetting the slow rate of embodiedadopting TQM standards more than doubled. It is technical change, and the still incipient productprojected that by end 1995, a total of some 1,300 differentiation and innovation efforts by firms, andunits will have been certified in the country, which institutional support for small and mediumcompares favorably with all other industrializing enterprise development.economies (with the possible exception ofSingapore).

17Table 7: Brazil - Evolution of ISO-9000 Certification

1990-1995

Year Number Certified in Year Cumulative Number Certified1990 18 181991 17 351992 61 961993 129 2251994 370 5791995 a/ 421 1000

Source:Comite Brasileiro de Qualidade -ABNTNote: a/mid November, 1995. Estimateshave 5500firms cetified bymid 1997, accounfingforperhaps two-thirds of industialoutput.

Interest rate equalization is also available forHorizontal Instruments exporters to offer compettve post-shipment

supplier's credit.25 Finally, pre- and post-shipmentExport Development. There are two key finance of capital goods exports is available from

mechanisms to support the development of exports: BNDES (through the FINAMEX program), withfiscal incentives in the form of tax exemptions, and PROEX funds, for up to 100% of the value of thefinance. Manufactired exports are exempted from exported good (depending on degree of domesticFederal and State value-added sales taxes (IPI and valuedded).26 In 1995, the Government aLtcatedICMS), in addition to the 2% sales-related US$ 840 million for interest rate "equalization" (soCONFINS tax, while a tax credit is available for the that finance provided by Brazilian exporters isIPI (as well as for the PIS and CONFINS taxes) competitive) and US$ 200 million for direct financepaid on purchases of dornestic inputs for export- of capital goods and services exports. In view oforiented production. In addition a drawback regime current excess supply of funds, the 1996 budget hasis available for both direct and indirect exporters, in been reduced to US$ 500 million and US$ 120the form of import duty exemption, restitution or million respectively, a figure equal to about 1 2% ofsuspension (the latter im the case of "temporary total exports.2

admission"). Income derived from manufactaredand services exports is taxed at a maximum of 30%, Brazil's export promotion policies do notis exempted from the "social contribution over seem to have been very effective. Between 1988profits" (a 10% flat rate), while payments of interest and 1993, the counmtry's export-GDP ratio decreasedand service charges for export financing, and for from 10.4% to 8.7%, a little over a third of Southexport logistics and marketing, are tax exempt from Korea's, and less than traditionally inward lookingincome and financial operations (IOF) taxes. India (9.6%). Brazilian exports as a percentage ofFinally, 18 tax-sheltered export-processing zones world exports contracted in the same period from(EPZs) have been approved, but so far only four are 1.2 to 1.0 percent. Although the effictive exchangeslated to begin operations in 1996. Different, adjusted incentive rate vanes considerably acrosshowever, from other Mercosur partners, Brazilian product groups, the domestic market is generallyEPZs must direct 100% of their production to the more profitable than export markets. Exportsexternal market, which might require harmization remain, for the most part, a countercycical activity.of current legislation.24 Momover, the relatively high costs of doing

business in the country has become an effectiveDirect finance for exports is available from impediment to the sustainable growth of exports.

the PROEX program for a restricted positive list of These additional costs include high indirect taxes (itgoods and services (basically focused on capital has been estimnated that steel exports are taxed at agoods and engineering services). The program rate of 26.90, compares to 10% in South Koreafinances up to 85% of the FOB value of exports, at and 15% in Japan and labor costs (the basicLibor plus rates, and for a period of 10 years. nonwage costs - social security taxes, leave,

18holidays, 13th salary etc. and add up to 102%); highport charges and poor transportation infrastructure; R&D and design activities, the basis ofhigh real interest rates; and the still high levels of product innovation and differentiation, are stillilliterary (19% in 1990) and the poor absorption of incipient in Brazil. Govermment's R&D policy isknowledge and long-terrn growth in labor directed to increase R&D effort (in 1990, totalproductivity.28 These impediments far exceed science and technology expenditures in Brazil werecompetitive export financing in terms of price 0.72% of GDP, which compared unfavorably withcomparisons. other rapidly industrializing countries, which spent

1-2% of GDP in these activities); expand theInvestment and R&D Incentives. In the involvement of the private sector (80-90% of

industrial sector, in particular, most progress has expenditures are financed and undertaken by thebeen attained by enhancing efficiency of current government); and improve the interface between thecapital assets.29 Although a combination of strong productive sector, and university and researcheconomic expansion (GDP growth climbed from institutions.nearly to zero in 1991-92, to 4.2% in 1993 and5.67% in 1994, and is expected to reach 5% in Current legislation (laws 8248/91 and1995) and high levels of capacity utilization are 8661/93, and decree 949/93) allows firms to chargeproviding a major stimulus for the expansion of their R&D expenditures (including expenses paid toinvestment, government investment incentives play a third parties) against a maxinum of 8% of owedsubsidiary, though non-marginal role. The National income tax. In addition, capital goods andDevelopment Bank (BNDES) provides the only instruments dedicated to R&D may be importeddomestic source of long-term finance, at rates without federal value-added tax (IPI), are subject tohowever which generally do not compare favorably accelerated depreciation (at twice the normal rate),with those quoted intemationally for projects with while expenditures associated with intangibles aresimilar risk-retum profiles. The current govenmment- amortized at an accelerated rate. Finally, firms aredetennined "long-term interest rate" is in the order allowed a 50% credit of income and financialof Libor plus approximately 6% (in addition to operation taxes associated with the payment ofother BNDES service charges). Still demand for royalties, technical assistance and specializedBNDES resources have grown considerably; services payments to foreign parties. Thesedisbursements went from an average of US$ 3.1 incentives are non-automatic, and are awarded afterbillion in 1991-93 to US$ 5.5 billion in 1994, of being assessed by Ministry of Science andwhich US$ 3.2 billion to finance machinery and Technology accredited organizations. The impliedeuipment." BNDES is thus responsible for fiscal cost of these incentives since they becanefinancing approximately 8% of gross capital operational (early 1994) and until mid 1995 was R$formation in the Brazilian economy (where most 492.5 million, generating R$ 1.2 billion in R&Dfirms are lowly leveraged and generally finance and technology modernization outlays.32 By endinvestment out of retained earnings). decade, the Government expects finms to becorne

responsible for 30-40% of S&T outlays, whichFederal tax incentives are only available for would then correspond to 1.5% of GDP.

investments located in the Northeast and Amazonregions.31 Most states and many municipalities R&D term finance is available fromcompete, however, quite fiercely for new FINEP, a govemrnent agency. FINEP's ADTENinvestments, through a mixture of explicit (sales and program is the agency's key instrunt for financingproperty) tax reductions and rebates, state banks' innovation and design-related activities of industrialloans (although these are increasingly scarce), as firms. In the period 1992-94, the agency financed anwell as through the supply of infiastructure services yearly average of US$ 130 million at significantlyon a preferential basis. The fiscal cost of state and positive interest rates. Prior to Decenber 1994,municipalities subsidies has not been so far modal real interest rates charged for ADTEN loansestimated with any degree of precision, although the were 12%; thereafter firms pay the above-definedarnount of revenue foregone is a source of concern "long-term interest rate", a variable risk factor andto the federal government in view of the dire fiscal an ADTEN-specific interest charge varying fiom 4-health of most states. 10 percent per anmum. On a smaller scale, R&D

19resources are also available from BNDESpar, a operational since March 1994, on the basis of aBNDES subsidiary, on a venture capital basis. US$ 5 million fund.Since 1988, a total of US$ 30 million has beenapproved (an average of just 4 projects per year in Sectoral Policies and Programsthe period 1992-94), for product development intelecommunications, software, industrial equipment, For many years, industrial policy in Braziland other areas. was characterized by a profusion of sectoral policies

and incentives, with the objective of substitutingSmall and Micro Enterprise imports and guaranteeing domestic production in the

Development. SMIEs in Brazil make up 95% of basic sectors of the econcomy capital goods,industrial establishments, and are responsible for consurmer durables and i iat. Although23% of sales, 42% of employment, while most trade and investment-related import-contributing with approximately 9% of GDP. substittion policies have been phased out, andBackdng for SMEs is codified in a special statute emphasis today is the attainment of intemnational(Law 8864/94), which differentiates small and competitiveness across sector, there remain a fewmicro enterprises (the former defined as firms with sectoral policies and programs with considerablesales below R$ 556,000, while the latter is limited to impact. There is, in addition, ad-hoc GovermnentR$ 199,000) from larger firms for tax, regulatoxy relief against compet$ive (and predatory) imports,and other purposes. It specifies income and payrol1 as in the case of the shoes and textile industries."tax exemptions, in addition to a more flexible Below the programs related to the automoouve andtreatment with regard to labor laws (which in itself space industries are described, as major exanples ofrequires a change in article 179 of the 1988 sectorally focused govermnent efforts. The formerConshtution). The detailed regulations which make illustrates one of the few remaining moderatelythe statute operational have yet to be approved by effective sectoral regimes - together withCongress.33 informatics and capital goods. Its intinsic

importance is related to the economic weight of theMost SME support in Brazil has SEBRAE industry (nearly 10% of GDP), and the fact that it is

(Servico Brasileiro de Apoio is Micro e Pequena the object of dispute with Brazil's trading partners.Empresas) as the focal point. SEBRAE is a The latter, though de facto the major sectoralprivately-managed agency, present in 27 states with program undertaken in Brazil in a frontier arearegional offices, financed through a payroll tax (together with high-performance computing,(initially - when it was created by law 8212/91 - vaccines for tropical diseases and deep-sea oilthe tax amounted to 0.3% of the wage bill, while exploration), has been overlooked, because itscurrently it is 0.6%), corresponding to industrial dirmension, long-tern economnic inpactapproximnately US$ 500 million in 1995, and which and commercial applications are only nowconcentrates on the provision of informnational and surfacing.other support services to SMEs on a dcetalized The Automotive Regime. In fact, thebasis. SEBRAE's network of over 400 "windows" Mercosur automotive industry has attainied a(balcoes) generate approximately 30,000 daily considerable degree of integration. In the periodqueries regarding tax, regulatory, market demand 1980-92 the industry stagnated, production hoveredand other issues, in addition to flagging new around one nillion units (one-fourth of whichbusiness opportumities for SMEs.34 Considerable directed to export narkets), the rate of new modelresources are employed in dissemination of introduction slowed considerably, and entry came toinfornation through nass media, publications, a halt - the last time a mnajor new ranufacturerseminars etc. Finally, SEBRAE is engaged in (FIAT) entered the market was im the mid-].970s.promoting and funding a credit insurance scheme The liberalization of inports in March 1990 had("Fundo de Aval"), on the possibly correct multiple impacts: it led to a fall in prices and thepresumption that lack of guarantees constitute the rapid expansion of domestic production (form l.lb.mnajor barrier for SMEs to access finance at in 1992 to 1.6b. in 1994), with the enlargement ofcompetitive rates. A pilot schemne has been the market; it brought about higher quality modelsestablished with FINEP, and has become allowed by more flexible domestic content rules; it

stimulated competitive behavior in an industry

20accustomed to quasi-cartelized conduct; and it Subsectoral trade is growing considerably, andattracted new entrants (including Renault, reached US$ 1.14 billion in 1994 (includingMercedes-Benz, as well as Kia Motors and Asian autoparts) - with Brazilian exports to the MercosurMotors, among other South Korean automakers). reaching US$ 765.4b. and Brazilian imports US$Both assemblers and autopart producers are 375.4b. In particular, the industry has been thedirecting their investrnents with a view of the mnajor factor in the rising proportion of intrainidustrycommon market, setting up complementary trade between Argentina and Brazil. Theproduction lines, in order to reap the considerable intraindustry trade coefficient for the two countrieseconomies of scale (and product differentiation) reached 39% of total trade for 1993, 51.3% forwhich characterize the industry (Table 8). Brazil is manufacturing trade and 77.3% in case of thebecoming a locus of production of compact and automotive industry.36subcompact cars, as well as trucks and buses.

Table 8: Intrabloc Integration and Specialization

Car Models Produced in the MercosurArgentina Brazil Uruguay

Gol, Parati,Gol, Voyage, Santana, Fusca,

VW Pointer KornbiFord Escort, Verona Fiestae

Project 178,Project 178 - Tipo, Tempra,

Fiat Uno Duna, Spazio Fiorino, Uno ElbaGM Pick-up D-20 Corsa and others

Renault 19,Renault Clio, Traffic Meganec

Peugeout 40S,Peugeout 40S Break, 504 Peugeout 205, 306Citroen Citroen ZX

Source: Gazeta Mercantil, October 9, 1995.Notes: alproductium start-up in 1996; b/production stant-up in 1996, with 178 sedan model produced mn Argentina, while hat-hbackmodel in Brazil; c/production start-up in 1998. 38

automotive regimes of both Brazil and Argentina.The March 1990 trade reforn, with the It offers sharp tariff reductions for imports of parts,

removal of non-tariff barriers and the progressive components, capital equipment and vehiles,, forreduction in tariff levels to a low of 18% in those producers willing to commit themselves toSeptember 1994, led to an upsurge in imports, at a specific export and investmnent targets. In therate the Government felt would be unsustainable Brazilian case, for every dollar of exports orfrom a balance of payments perspective, and highly purchase of domestically manufactured capitaldamaging to domestic industry. In March 1995, the goods, producers will be able to import imp-utes -government raised tariffs back to 32% and in June intermediates, parts and comnponents - and fully1995 to 700/o, in addition to imposing (what in assembled vehicles with tariffs reduced by 90% andretrospect tumed out to be non-binding) quotas 50% respectively (although the conmnon externalthrough "provisional measure" (MP) 1204 3. In tariff remains binding at 20% as a floor forDecember 1995, the Mercosur govemance signed a vehicles). The value of imports favored withnew Automotive Agreement that will take effect on reduced tariffs would be limited to 100% of exportsJanuary 1, 1996 and will last until end-1999. The and 140% of capital goods purchases, the latterDecember Agreement provides the frame for the progressively reduced to 70% by 1999, converging

21with Argentina's incentive rates (which vwill increase The US$ 1.1 billion program was steeredgradually from the current 40% of investment to exploit the countrys scientific ands technologicaloutlays). Finally, in order to provide flexibility to potential, as well as its privileged geographicnew assemblers, domestic contents requirements for position for satellite launching purposesentrance will need to average just 50% over the first (particularly Alcantara's proximity with the equator3 years of operations (still, for assemblers to benefit and favorable climatic conditions). The idea was tofrom zero tariffs in intra-Mercosur trade, the position the country to take advantage of thedomestic contents of vehicles would need to reach emerging market for small satellites, particularly in70%). the communications area. Although at start-up, in

1979, the space program contenplated dual use ofThe automotive industry illustrates a more the technologies developed or mastered, over time

general phenomenon of import substitution policies the long-term objective came to be defined in termswhich became outdated, but remained in place for of its commercial civilian applications. Iniially,lack of a politically acceptable alternative. It is Alcantara was to become an alternative vehicleunquestionable that, ex-post, trade reform and the assembly/testing ground and launch site to France'sadvent of Mercosur, have been major forces for the Kourou base in French Guyana, open to non-modernization of the automotive industry. It is traditional players in the market (particularly thearguable that policymakers had few choices other Chinese and the Russians, in addition to Americanthan introducing a more open and competitive finns looking for less expensive altematives). Overregime, at the risk of condemning the industry to an the medium to long term, Brazil was to offerirreversible state of backwardness. As in the case of satellite imaging and geosensonng services, as wellthe "informatics" industry - which for over 15 years as launching vehicles. The creation of the Brazilianwas protected from the challenge of imports and the Space Agency in 1994, modeled after NASA, is aentry of foreign producers - technological progress significant step towards consolidating the notion thatand the forces of globalization forced a the program's success will be linked to itsreassessment of sectoral policies. Although the latter commercial applications and orientation.are far from neutral - they still privilege domesticproduction, at a moderate cost to consumers - they The space program represents a systematicare more in line with the requirements of an effort of a multiplicity of agencies - civilian andinternationally integrated industry, where both military - targeted at achieving an ambitioussourcing and production is undertaken on a global objective by developing country standards. Itscale. involved numerous industries with significant

(though yet to be measured) technological spilloverThe Brazilian Space Progran. Brazil has effects to producers involved in the development of

had a relatively long tradition of space-related new, more resistant materials - high quality steels,activities. Embraer, privatized in December 1994, is bronze and aluminum special alloys, and high-one of the two major aircraft producers in precision engineering plastics - for the launchindustrializing countries (and other being vehicle; the production of solid fuel (whichIndonesia's governmert-owned IPTN), catering eventually led to new plastic resins, currentlyboth to the civilian and military markets.39 The exported by Petrobras) and related combustionBrazilian Space Program is the other major system; and the development of the guidance systemgovernment initiative in the field, comprsing the for the launch vehicle, as well as the earti controldevelopment by INPE (Instituto Nacional de station systems. In addition, INPE, CTA and thePesquisas Espaciais) of data collection and remote new agency have developed the capacity tosensing satellites, as well as earth stations, while assemble and test both satellites and their launchCTA (Centro Tecnologico da Aeronatica) became vehicles, activities essential for the country to enterresponsible for the development and launching of the commercial launch business. Clearly thesethe satellite launch vehicle, as well as the venures must be commercially viable, without anyconstitution and operation of the Launch Base of continuance of public subsidy to validateAlcantara.i Government's initial involvement in these mfant,

high-echnology industries.

22V. Industrial Policies in Argentina

The export regime has also undergoneTrade Policy major reform as part of the post 1991 reform

agenda, and despite an initially overvaluedUntil the late 1980s Argentina's trade exchange rate, exports have boomed in

regime provided considerable protection for Argentina, even during the 1995 recession.domestic industries through high and escalating Generally, all export subsidies have beentariffs, quantitative restrictions and import eliminated, the major policy exception being thesurcharges. Since 1987, however, Argentina has "mirror scheme," which grants to each exportundertaken a radical reorganization of its trade category a rebate equal to the tariff on competingregime and in the process substantially reduced imports of the same product. The way itthe scope of trade-related measures as tools of operates, compensating by import category ratherindustrial promotion. In particular, the Argentine than by actual duties paid, can be viewed (seegovernment has undertaken several significant Rodriguez, 1994) as an incentive to inefficientliberalization measures including: (i) the industries rather than as a form of duty drawbackelimination of nearly all quantitative import scheme. Export reimbursement varies from 2.5restrictions (except on automobiles, sugar and to about 20 percent, with the mode about 7some paper and textile products); (ii) the percent of export value. Rajapatirana (1985),reduction of average nominal tariffs from 42 estimates that export promotion schemes cost thepercent in 1987 to 15 percent in 1994; (iii) Argentine tax payer $1.6 billion annually.narrowing tariff dispersion to seven levelsranging from 0 to 20 percent; and (iv) rendering The trade regime is also affected byautomatic several features of the import regime other taxes, most notably the statistical servicesuch as duty drawback and access to financing tax levied originally at 3 percent in 1991 and(Rajapatirana 1995). later raised to 10 percent due to severe fiscal

constraints and the need to quickly raiseThis reflects very significant and largely government revenue. Although the statistical tax

irreversible liberalization (see Berlinski, 1993, is intended as an interim measure-it was enacted1994). Although some selective increases in as a temporary regulation (resoluci6n) ratherduties for imports of textiles, clothing, and shoes tman as a change in the import law for fiscalfrom non-Mercosur countries have occurred, and reasons-its effect on average tariffs is importanthave an increase in a number of tariff tiers, a when considering the impact of Mercosur'ssomewhat artificial linkage between export and Common External Tariff (CET). As shown inimport duties via the so-called mirror principle, Table 5 Argentina's unweighted average tariffsand greater complexity in the system. excluding the statistical tax are the second lowestNevertheless, both compared to past regimes and in Mercosur, but the highest if the statistical taxconsidering the ad-hoc nature of changes rather is factored in.4' Fortunately, the statistical taxthan fundamental shifts in direction, one can still was removed in January 1995, but re-instated atsee Argentine trade policy in a very favorable a lower 3 percent rate in March of 1995.light.

TABLE 5. Tariff Structure Mercosur, 1994

Country Avg. Tariff Range MERCOSUR CET rangeunweighted (%) CET avg rate

tariff rates (%) (unweighted)

Argentina 9.3* /15.8 0-20 12 0-20Brazil 10.7 0-35 12 0-20Paraguay 8.0 0-32 12 0-20Uruguay 14.7 0-20 12 0-20

* average unweighted tariff excluding the temporary statistical tax** average unweighted tariff including the 10 percent statistical taxSource: Garay and Estevadeordal (1995)

23For the most part Argentina's trade and base line tariff rates are compared to the

policy reformns during the 1990s have sought to CET, the impact is quite different. As shown inmitigate against the use of trade policy for the table below, the CET will raise averagesectoral promotion.42 Yet despite clearly liberal tariffs across 79 tariff chapters covering over 71trade regime which has prevailed in the 1990s, percent of all imports, while lowering them inthe current policy framework maintains (i) the only 19 chapters (29 percent of total imports)."industrial specialization regime" which grants To be sure, raising tariffs on certain items is anpreferential trade provisions to certain industries; inevitable part of convergence to a CET and is(ii) the automobile industry which benefits from not in itself an immerising policy if the tradeseveral promotional programs in addition to those creation effects from lowering tariffs on otheraccorded under the industrial specialization items exceeds the trade diversion losses fromregime; and (iii) the capital goods regime which raising average tariffs on these six chapters notedprovides both preferential trade and domestic tax above. Indeed, recent empirical work doesconcessions on capital goods.43 Each of these suggest that trade creation will exceed tradeprograms will be assessed along with an diversion in all Mercosur countries exceptevaluation of the impact of the Common External Paraguay (Losada, 1994).45Tariff (CET) of Mercosur.

Concerning the impact of higher externalThe Impact of the CET on Argentina tariffs, Morisset and Revoredo (1995) provide

some estimates of these price pass throughAs of 1 January 1995 Argentina adopted effects. Analyzing price behavior in the

Mercosur's CET which has eleven tariff levels Argentine industrial sector46 as a function ofranging from 0 to 20 percent. Most rates fall four variables (unit costs, the domestic price ofbetween 12 and 16 percent. The lowest rates (0 foreign goods, current excess demand and futureto 9 percent) apply to raw materials and some excess demand), they estimate that a one unitfood products, intermediate rates (10 to 15 increase in the domestic price of foreign goodspercent) apply to some agricultural products and will lead to a less than proportional (.57) unitsemi-processed goods, and the highest rates (15 increase in domestic prices, holding all otherto 20 percent) apply to textiles, manufactured factors constant.47 Although the Morisset-goods and consumption goods. The CET Revoredo specification is used to explain pricecurrently covers 85 percent of harmonized tariff behavior during inflationary periods inlines. The remaining 15 percent of tariff lines Argentina, their findings can also be used to(which cover almost half of all intra-Mercosur extrapolate the impact of changes in the domestictrade) are exempted temporarily to facilitate prices of foreign goods due to tariff increases.adjustment but are all scheduled to converge to As indicated in Table 5, the CET will increasethe CET within specified time limits (2001 for tariff rates in at least 42 tariff chapters coveringcapital goods and 2006 for telecommunications almost 53 percent of current imports. Since theseand informatics, for example). This implies that chapters fall in the industrial sector, Morisset andthe major adjustment is yet to come. Revoredo's estimate implies that over half the

tariff increase would be passed on as higherAs shown in Table 5 above, the CET can prices. This development is particularly

either increase or reduce average unweighted problematic in two areas: capital goods andtariffs from the current level, depending on the automobiles. In the case of automobiles,Argentine statistical tax.44 Compared to average mfaintaining tariff barriers sustain a subsidytariff levels including the statistical tax, the CET program that is already heavily protectionist andwill raise average tariffs in 42 chapters (covering costly for the Argentine government and53 percent of all imports) and lower them in 56 consumers. The costs of such a program arechapters (47 percent of imports). If the covered in more detail in the next section.temporary statistical tax is excluded, however,

24TABLE 6. Impact of CET on Argentina's Average Tariffs4 8

No. of chapters affected Total import volume Percentage of totalaffected (US$ millions) imports affected (%)

CET impact on average tariffsincluding statistical taxRaises average tariffs> 100% 1 339 2%Raises average tariffs 50-99% 9 5,097 23%Raises average tariffs 0 - 49% 32 6, 142 28%

subtotal 42 11,578 53%Lowers average tariffs 56 10,242 47%

CET impact on average tariffsexcluding statistical taxRaises average tariffs > 100% 18 5,444 25%Raises average tariffs 50-99% 14 946 4%Raises average tariffs 0 - 19% 47 9,056 42%

subtotal 79 15,446 71%Lowers average tariffs 19 6,328 29%

Source: World Bank estirates

Currently, capital goods are imnported Automobile Sector Promotionduty free (plus a 10 percent statistical surcharge)into Argentina but will be subject to a 14 percent Since production was first initiated inCET as of 2001. The increased price of capital 1951, Argentina's auto industry has been thegoods will thus be passed on to users of capital target of industrial promotion and tradegoods imports, primarily Argentine enterprises protection through such tools as high tariffs,which irmport capital equipment for retooling and import quotas, domestic content requirernents andplant modernization. The World Bank (1995b) export targets. Over the past four decades theestimates that trade liberalization has lowered the regime has been modified periodically, and isrelative price of capital to labor some 40 percent currently govemed by the following provisionssince 1990, a trend which would be partially set out in a December 1991 decree (No. 2677):reversed by a rise in the average tariff level oncapital goods imports. Higher tariffs as a result * Vehicles are divided into two classesof the CET will likely result in higher capital (A and B) depending on their loadgoods prices, decreased investment and slower capacity. The maximum allowableplant modernization. import content is 40 percent for

Category A and 42 percent forSeveral sectors are temporarily excluded category B,

from the CET including automobiles, sugar, * Manufacturers are required tocapital good, telecommunications and informatic submit a conversion plan coveringproducts. Although each of these sectors is investments; manufacture inscheduled to come under the CET within the Argentina of models of the samedecade, their temporary exemption means that vintage as those produced by theirindustrial policies are in place during the interim. head office; reduction of modelIn the case of Argentina, the major implications ranges; the means by which theyare for the automobile regime, the more general plan to achieve the export targetsindustrial specialization regime, and the capital required by decree,goods regime, all of which are govemed by some * Manufacturers are required to exportcombination of special tariff exemptions, quotas, at least the same volume as. theyand export targets. Each of these sectors will be import. Import totals may includeexamined in turn.

25auto parts as well as finished vehicle prices have fallen an estimated 33 percentvehicles, in dollar terms from the December 1990 level

* Imports of auto parts, if partly through a reduction in taxes and partly in acompensated by exports, pay a duty reduction in margins by dealers and producersof 2 percent, (Morisset and Revoredo, 1995).

* Manufacturers may import vehicleswithout limitation (provided they However, production volumes alonehave a favorable trade balance) with gloss over sizable welfare costs imposed by thea duty of 2 percent, special trade privileges accorded the automobile

* Manufacturers not established in sector. Three particular inefficiencies can beArgentina may import vehicles at a identified in the regime: domestic contenttariff rate of 18 percent as long as requirements which compel producers to usetheir imports are offset by exports of higher-priced local produced inputs; importdomestically manufactured quotas which lead to industry concentration andautomotive products for use in sustain market power for a few firms; and tariffvehicles manufactured by them, and exemptions on imported finished cars or inputs

* Imports under the general regime are which lower government revenue. The subsidy tosubject to a quota equal to ten the automobile industry arising from tariffpercent of domestic production. exemptions alone is estimated at $300 million(FIEL, 1993). annually (FIEL, 1993).

These provisions are scheduled to be in effect Attempts to manage the automotiveuntil 31 December 1999, after which time the sector's incentive regime proves costly in otherregime will be govemed by GATT norms on the ways as well. The regime is inordinatelyautomotive sector. The current details of the complex and carried out in the absence of anyautomotive agreement among Mercosur members evidence of a market failure or rigidity justifyingwere previously noted. govemment intervention. Moreover, the

balancing of automobile exports with imports hasT he Argentine government hs little a priori economic justification. The ultimate

articulated that this regime, which requires test of the Argentine auto sector's intemationalindustrial conversion and meeting export targets competitiveness will come in 1999 when thein exchange for trade privileges, is intended to present regime is set to expire. If the Argentinefurther integrate the Argentine auto industry into producers are not able to compete internationallyintemational markets and to boost domestic by the end of the decade, there is no aprioriproduction to the point where domestic producers reason to believe that continued protection afterattain the economies of scale characteristic of the the year 2000 would enhance competitiveness.intemational automobile industry (Ministerio de After four decades of protection, it would beEconomia 1994). In this sense, the justification difficult to argue that govermment policies arefor govemment involvement in this sector follows fostering an infant industry rather than protectingclosely the classic infant industry argument a favored sector.purporting to provide temporary protection fornascent industries until such time as they attain The Industrial Specialization Regimescale economies and become intemationallycompetitive. From one perspective, it would In 1992 the benefits accorded theseem that such a policy has produced some automobile industry were extended to anypositive results in terms of increased plant industry group which agreed to set export targetscapacity, lower costs for consumers and in exchange for tariff preferences from theincreased exports. Domestic auto production has Secretary of Industry and Commerce. This planreached historic levels in Argentina, up from was aimed at facilitating the productive99,600 units in 1990 to 342,400 units in 1993. restructuring of companies producingExports have risen as well from 1,126 units in manufactured goods. Under the program1990 to 29,976 in 1993. At the same time, participating companies are required to increase

26their export over those made the previous year in cover four sub-periods: 1993-96, 1997, 1998 andexchange for import licenses with preferential 1999 (See Table 7). Until 1996 two percenttreatment up to the value of the increase in duties apply to all imports regardless of the

Box 1. Brazil-Argentine Automotive SectorIntegration and Dispute][Resolution:

The Brazilian and Argentine:automotive sectors enjoy a long history of commercialintegrationdt0ing from the firt bilatel accords in 1979 which first establishedbilateral tariffpreferncesandexendingthrough :Merosuwprovisions:whichcalforcompleteintgtioand i

acommonexternaltariff:of20 percentby theyear 20000.: However, a recent Braziliandecision to impose unilateral quotas on auto imports raised: sevel thorny questions aboutmacroeconomic&policy hamonization and the dispute resolution mechanism innMercosur.: 1

Following. anftimport surgein Brazil, President Fernando Henrique Cardoso issued: a..June: 1995 executive::decree limiting Brazilian car imports for the remainder of theyearto only:50 percent of those registered in the previous six months, a: move :which threatened to limitA::gentine T?car exports to Brazil t :12,000 uits: instead of the 40,000 uxnts previouslynegotiated. After' several high-level exchanges, including a theat by. Argentine:PresidentCarlos Menen. to boycott the Mercosur summit in June ff the dispute weref not settled, BraMzil:0decided to lift theimport quotas. . . . . . . . ..

i :The dispute highlights two issues for the future.of economic integiaion in Mercosr.At one level it ilhmates how using the trade instrument -to-accomplish a braderwmacroeconomic objecive M(lke controlling Brazil's oonsumer boom)lcanwcompromia major; :trading:parter.in an economic.union.. ::.Coordinating regional-:macroeconomic :policies: in theface of domestic policy, interests iis therefore one of the principal challenges in. any reionalintegration scheme.

Secondly, the auto sector conflicthighlights the need fur anetive dispute resluton:mechanism in Mertosur. Arg and Brazil may find themselves at odds ini other trade.areas such as wheat,.:household appliances,: sugar and :textiles. Mely the threat of unilateralaction such as Brazil's decision to impose quotas is enough: to disrupt trade:flows iandi confer a atemporary advantage on the:restition imposing country (see Leipziger-and Shin,1991). Apermanent,rimpartial and politically.insulated.body:perating undrclearlydeinedTprocedures:and timetables for: reviewing dispute claims Yill1 be a necessareature of Meicosur in order tolavert the potential trade disruptions such as those seen in ihe recent:auto sector dispute.

exports agreed. Preferential duties only apply to current duty. In subsequent years the duty rateimports in the same sector (according to NCE varies according to a sliding scale.49 Table 7classification) as the product exported by the details the reduced duty rates over the course ofbeneficiary. These programs may cover one or the industrial specialization regime.several years. The differential tariff treatments

those companies not meeting their export agreedtargets. According to the Secretariat of Industry,

Table 7 illustrates several characteristics between Decernber 1992 and November 1994, aof the industrial specialization regime. Until total of 2,027 programs had been approved for1996 all imports are assessed the same two the industrial specialization program. Thepercent duty, implying no production bias amount of increased exports committed for thedepending on the degree of fabrication or the type period 1993-1997 (during which time the twoof imported good. The benefits from the percent duty will apply) is $988 mnillion. Annexdifferential duty decline over time and increases Table 1 shows the distribution of programs bythe greater the existing duty. Penalties apply to sector.

28

TABLE 7. Tariff Concessions under the Industrial Specialization RegimeCurrent duty 5% 7.5% 10% 12.5% 15% 20% Coefficient B

Year

1992-96 2% 2% 2% 2% 2% 2% --1997 2.8% 3.4% 4% 4.6% 5.3% 6.5% .251998 3.5% 4.8% 6% 7.25% 8.5% 11% .501999 4.3% 6.1% 8% 9.8% 11.8% 15.5% .75Source: Ministerio de Economia (1994)

government subsidy for an activity which mayThe program, although intended to meet have occurred even in the absence of a

a laudable goal of expanding exports, engenders government program. Assuming that the tradeseveral economic costs. First, the program regime does not embody an anti-export bias,imposes a fiscal cost in terms of foregone firms should be willing to undertake therevenue which is estimated at $46 million necessary restructuring and retooling in order tothrough 1996 (Table 8). Secondly, the enter those export markets. This is therefore aspecialization regime provides an implicit program whose life should not be extended.

TABLE 8. Estimates of Fiscal Costs of Industrial Specialization Regime, 1993-96(US$ millions)

Total incrementalBase Additional export exports eligible for Avg. unwtd tariff Reduced tariff Tariff

exports commitments under ISR preferential on participating under ISR subsidy1992

1993 1994 1995 1996 tariff sectors regime 8% on_______ $574.5

507.7 160.2 138.1 138.1 138.1 574.5 10% 2% S46million

Source: World Bank estimates

Like the auto regime, the industrial specialization arbitrarily imposes a production bias againstregime imposes a complex balancing requirement inputs from other tariff lines which is not basedon imports and exports within a given sector in on any a priori consideration of input-outputorder for firms to qualify for special tariff requirement other than the government'sexemptions. Such a requirement is inordinately assigning a higher social value to export-orientedrigid especially in a sophisticated production activities. Further, the regime embodies anstructure which may require inputs from a wide implied discretionality in approving industries forarray of import categories. By requiring that participation in the regime and penalizing firmsfirms balance their imports with exports of the which do not comply with their previouslysame product category, the specialization regime committed export quotas.

Capital Goods Regime 15% on the sale price of new domesticallymanufactured capital goods used for investment

Argentina's trade policies maintain two activities, eligibility determined by the Secretariatprograms to encourage the use of capital goods. of Industry and Commerce. The second progranThe first program was established by Decree No. is the duty free import of new capital goods; used937/93 which authorized a reimbursement of capital goods were still subject to tariff and were

29assessed a 10 percent statistical tax like all other the CET would be a logical, in fact essential,imports. The declared objective of the capital measure in the near term for the Argentinegoods regime has been to stimulate the government.restructuring, re-equipping and competitivenessof the industrial sector. Tax Policy

The regime has several economic Tax incentives as a tool for industrialimpacts. The first is that by lowering the local promotion gamed prominence im Argentina in theprice of capital through the VAT rebate, the late 1970s as a means of promoting economicgovernment encourages an increase in domestic activity beyond major urban areas and ofinvestment which can be broken down into three developing certain favored industries. Beginningcomponents. First is the subsidy to local industry in the late 1980s, successive attempts to reduceresulting from the tax rebate on new capital the fiscal deficit and reorder the public accountsequipment produced domestically. This subsidy have all but eliminated most of these taxwas estimated at $260 million for the period May incentive programs. Except in the cases of mining1993 until November 1994 (Ministenro de activities and certain minor local sectors,Economia, 1994). As noted previously, the Argentina maintains no significant tax incentivesrelative price of capital to labor has fallen almost for industry. Law 23.658 in 1988 suspended40 percent since 1990. This has resulted from new promotional benefits, a policy which hastwo developments: the decline in the price of been elaborated by subsequent decrees. Thoseimported capital goods (due to trade which endure were authorized before this dateliberalization and the peso appreciation) and a and thus an estimated 3,000 firms have beenfall in the price of domestically produced capital "grandfathered" into receiving tax concessions,goods because of VAT reimbursement's on new although all are not still in existence. Thesecapital products. To the extent that an increase benefits are scheduled to expire by the yearin the CET on capital goods raises the price of 2000.50inputs, Argentine producers should expect to payhigher prices for their imported capital inputs. Among these fiscal allowances, the

exemption from the value added tax is the mostThe CET represents a higher average costly, accounting for an estimated 75 percent of

tariff for capital good imports into Argentina the fiscal costs, or about $2 billion annually (CEIwhich currently enter the country at low (0-5 1994).5 Most of these tax exemptions orpercent) rates. Since these rates were deferrals have since been replaced by tax creditimplemented in the early 1990s, capital good bonds which can be used to settle tax obligations.imports have surged, thus facilitating the Although the government has imposed amodemization and retooling of firms. Capital moratorium on extending tax preferences to newgood imports rose by 32 percent between 1992 companies since 1988 and existing preferencesand 1993, compared to a 11 percent increase for are due to expire by the end of the decade,overall imports. The share of capital good several additional preferential tax treatmentsimports in gross domestic investment nearly remain for the mining sector, regionaldoubled between 1991 and 1994, reaching 34 development, and free trade zones.percent. By comparison to other rapidlyindustrializing economies, this figure was 36.4 Regional Developmentpercent for Korea and 38.2 percent in Taiwan(China) in 1985 when these countries were Argentine legislation authorizesundergoing a similar stage of industrial provincial governments to provide incentives fortransformation (World Bank 1995a). regional economic development in the country'sMaintaining access to capital goods at world poorest provinces. Most such programs operateprices is critical for continuing this process of in San Luis, La Rioja, San Juan and Cataniarcacapital stock upgrading. The high CET for and offer one or a combination of he followingcapital goods represents a clear challenge to this incentives: exemption, reduction, suspension ofpolicy goal. As noted earlier, negotiating down deferment of national level taxes; accelerated

30depreciation; duty free capital goods imports and These provisions will be eliminated by 2013.other inputs. The fiscal benefits granted for new The most significant such zone is the specialprojects are authorized for 15 years. In 1993 the customs are of Tierra del Fuego created in 1972.fiscal cost of such programs was estimated at Special legislation (Law no. 19640) exemptsapproximately $1.54 billion. The bulk of firms located on the island from taxes on income,expenses ($1002 million) are concentrated in San taxes on capital, the sales tax, taxes on trade andLuis, followed by La Rioja ($137 million), the tax on patrimony. In order to estimate theChubut ($115 million), San Juan ($125 million) economic value of the benefits given to theand Catamarca ($97 million). The remainder is island, a comparison was made to evaluate thespread among other provinces (Ministerio del profit obtained by a producer in continentalInterior, 1995). Argentina relative to a producer of an electronic

item in Tierra del Fuego that only sells hisThese programs have been criticized on product in continental Argentina. FIEL (1994)

the grounds that they have failed to achieve their found that given the differential cost structure,stated goals of employment generation and total cost for producers in continental Argentinaindustrial development, in addition to imposing a were 15 percent higher than for producers inhigh annual fiscal cost. FIEL (1993), for Tierra del Fuego. The government also providesexample, notes that many projects approved for a rebate of 7 to 12 percent on exports maderegional development would have proven through the ports of Patagonia. The Ministry ofunprofitable had they not received tax Interior estimates the value of these fiscalexemptions. Further, the exemption of taxes on concessions at $226 million in 1994 (Ministeriocapital goods has lowered the relative price of del Interior, 1995).capital to labor and encouraged more capitalintensive production, clearly against the goal of Directed Credit Policiesemployment generation.

The Argentine government hasAlthough these programs are not undertaken several measures over the past five

ostensibly designed to promote particular sectors- years to reduce the scope of directed credit to-indeed the expressed goal of such programs is to industry. Interest rate controls and directedremedy income inequality among the provinces- credit have mostly been eliminated. Severalthese programs also represent a slight sectoral federal and commercial banks and BANADEbias. Most regional development activities under (Banco Nacional de Desarrollo) have beenthese provincial programs are in the following closed, while others have been privatized orsectors: spinning and weaving (17.5%), metal converted into second tier lenders. Other publicproducts except machinery (12.6 percent), banks, including the federally-owned Banco de laelectrical machinery (10.9 percent), chemicals Naci6n, the largest commercial bank, have been(8.9 percent) and garments (5 percent). The fact downsized and restructured. These measuresthat so many firms in the program operate in have reduced the scope of state financialimport-competing sectors suggests that the assistance to industry.special tax preferences (including VATexemption) may be aiding firms which might Nevertheless, the Argentine bankingotherwise have been subject to greater system still maintains several directed creditinternational competition. programs, mostly for small and medium

enterprises(PyMEs), home mortgages and exportFree Trade Zones industries. Directed credit programs are

administered by four principal institutions: theFree zones in Argentina were designed Banco de Inversi6n y Comercio Exterior (BICE);

to fulfill similar regional development aims. Banco de la Naci6n Argentina (BNA), BancoThese zones combine tax incentives with tariff Hipotecario Nacional (BHN) and Banco de laelimination, including exemption on all national Provincia de Buenos Aires (BPBA). Theirtaxation for activities undertaken in the FTZ; and activities, available credit instruments andexemption on import duties for capital goods. lending provisions are summarized in Annex

31Table 2. Often the interest rate charged on these SMEs ($1 billion) and BHN, BNA, BPBA'sis well below the prevailing market rate. subsidized mortgage programs ($500 million).

(See Table 9) One approach is to calculate theThe simplest calculation of the fiscal subsidy on the basis of the government rate for

costs of these programs would include the three that maturity borrowing (Murphy, Girault andmain programs whose disbursernents receive a Valdes 1994). The resulting four percent subsidyfour percent interest subsidy from the on $2.5 billion in disbursements yields a cost ofgovernment. These include BNA's Cedulas $100 million annually, equivalent to .4 percent ofHipotecarias Rurales for mortgages ($1 billion), total lending by state banks, .25 percent of theBICE's Programa Trienal de Fomento y federal budget or .03 percent of GDP.Desarrollo de la Pequenia y Mediana Empresa for

TABLE 9. Estimation of Magnitude of Directed Credit in Argentina

Program Programs ($m)Banco de la Naci6n Argentina (Cedulas Hipotecarias Rurales) 1000BICE (Programa Tnenal de Fomento y Desarrollo de la Pequeffa y 1000Mediana Empresa)BHN, BNA and BPBA subsidized mortgages 500

Total subsidized portfolio 2,5004 % interest subsidy

Estimated total subsidy cost 100

Source: Murphy, Girault and Valdes (1994)

Alternatively, one may measure the benefit of VI. Harmonization Approaches anddirected credit programs . One approach could Transition Issuesbe to compare the cost of private versus publiccredit for SMEs. A gross approximation can be The review of industrial policies inderived by using a weighted average of lending Brazil and Argentina yields the overallrates on peso and dollar loans for private53 and conclusion that industrial policy interventions arepublic sector banks in 1994. On average, private on the whole relatively modest in both countries.banks lend at 26.4 percent on peso-denominated Concerted industrial promotion efforts, asloan compared to 15.9 percent for state-owned practical in countries pursuing activist IPs (seebanks. The spread of 10.5 percent on peso loans Leipziger and Thomas, 1993, for a review) areis used a proxy for the rate of government largely absent, and industry-specificsubsidization. On dollar-denominated loans, the interventions, although they do exist, are limitedspread is much smaller. Private held banks in number. This is good news in terms ofcharge an average of 14.17 percent on dollar Mercosur harmonization.loans, compared to 11.7 percent in the publicsector. The resulting spread is 2.47 percent. As The estimate of the annual cost ofshown in Annex Table 4, these spreads are industrial policies in Argentina, provided inmultiplied by the fraction of credit denominated Table 10, is about equal to 1 percent of GNP, ain each currency which is lent through the four modest amount. Initial estimates, which need tomain state banks. The resulting estimate of the be refined, place Brazilian support for industry atcost of directed credit programs in 1994 was around the same magnitude. At the national or$122 million, very close to the Murphy et. al., federal level, therefore, the use of tax and creditestimates. policies to support industry in general, or certain

32portions thereof, such as the SME sector or basic tendency has been to maintain openness.exports, is small and generally visible. Harmonization of tariffs will tend to raisc tariffTemporary, and sometimes selective, tariff levels in Argentina, if we take as the base the preprotection either in the guise of anti-dumping 1994 rates prior to the statistical surtax (Seeresponses or reactions to balance of payments Annex Table 4).problems, has at times been used; however, the

TABLE 10. Summary of Principal Industrial IncentivePrograms and Estimated Annual Costs, 1994

Arlentina I BrazilIncentives USS(m.) Incentives USS(m)

Sector-specific Sector-specificQuotas and special tariff 300 Automobiles n/aconcessions for auto sector

Other sectors under Industrial 46 Informatics 297Specialization Regime

Regional RegionalTax concessions for regional 1500 3663economic development

Tax concessions for 226investment in Tierra delFuego

Functional FunctionalConcesssionary tariff rates on n/a Tax concessions for 350capital goods imports the technology

developmentTax concessions for purchase 260 Tax concessions for 646of new capital goods purchase of new

capital goodsSubsidized credit for SMEs 122 Subsidized credit for 534and home mortgages SMEs and home

. .................................................... . .. . S................................................Total 2454 5490

The review of ECU experience shows a In the US, experience has shown, asvery pronounced level of state assistance to reflected in Table 11, that local municipalitiesmanufacturing, ranging from 20/o-7% of value and states provide $40,000-50,000 in incentivesadded at the end of 1980s. While federal support per job created. The analog in the Mercosurof this magnitude in the Mercosur context is not context is likely to be states having an "industrialto be expected, there may be a concern that states promotion" policy limited only by their fiscal andin Brazil and provinces in Argentina will begin to financial constraints. Experience from the EUvie for and subsidize industries in order to gain shows that the problem of state-aid to industry islocal employment. Some of this has already a pervasive one, and some early attention bybegun in Brazil with respect to large automobile Mercosur planners is warranted.plant investments.

33Table 11: U.S. States' Incentive Packages

Funding Cost per JobProject State Year ($m) Jobs Created ($000)Sears IL 1986 240 5,500 43.6Toyota KY 1988 150 3,000 50.0Diamond Star IL 1988 118 2,900 40.7GM/Satum TN 1990 70 3,000 23.3United Airlines IN 1992 300 6,000 50.0BMW SC 1992 135 1,900 71.1Mercedes AL 1993 253 1,500 168.7Motorola VA 1993-5 86* 5,000 17.2Defasco Steel KY 1994 140 400 35.0

* excludes municipal funding

The overall experience in the EU and elsewhere costs and benefits of such policies.leads us to suggest the following five principles It is therefore strongly recommendedconcerning industrial policy that need to be that the Mercosur Secretariat initiateincorporated into a harmonized industrial policy: a periodic review of industrial

assistance programs in memberTransparency of industrial policy countries in order to assess theactivities. Although this paper has nature and extent of subsidization.presented several estimates of Such a review process, nowindustrial policy use and costs in undertaken biennially in theBrazil and Argentina, the estimates European Union, would serve toare somewhat imprecise given data accurately asses the economiclimitations. Assessing trade impacts of state assistance programsprotection, especially when as well as to facilitate enforcementadministered through tariffs, is of commonly agreed to Mercosursomewhat straightforward and standards.transparent. Government equityparticipation in state-owned * Rapid phase-out of subsidyenterprises (more prevalent in Brazil programs. Once industrialthan Argentina given the extent of assistance programs have beentheir respective privatization assessed and quantified, Mercosurprograms) is the least transparent countries should set bindinginstrument. Estimating the extent of timelines for eliminating suchdirected credit depends on much programs which lack a soundmore detailed accounts of lending economic justification. Here theactivities by state-owned banks and failures of the EU are moregovernment incentives to private instructive than any success. Steelbanks to do the same. Tax and shipbuilding, two sectors inincentives are equally difficult to which European nations haveestimate especially when they are gradually lost market share to lower-granted on the local and municipal as cost producers like Korea and Japan,well as on the national level (Brazil). continue to drain the Union'sThe result is often overlapping or treasury due to the inabilitv ofcompeting incentives within the member counties to agree on either acountry, and a less transparent comprehensive restructuringsystem which frustrates the program or to eliminate subsides bycomprehensive quantification of the a fixed date. Regional integration

34has ironically facilitated community- suggests that the regionalwide subsidization rather than development issue may be bestliberalization, and in turn extracted a discussed at the Mercosur levelheavy resource cost. Mercosurcountries would be better advised to * Anticipate requests for assistanceset phase-out time limits for from declining (sunset) industries.assistance programs and avoid the If Mercosur is to work, resourcessubsidization wars which have will have to be reallocated and someplagued European countries trying to industries will have to fold. Existingprotect sunset industries. employment programs will be

insufficient and demand for subsidiesLimit admissible types of first and adjustment assistanceintervention. If some form of second will be high. Evidence isassistance to industry can be clear that phase-out should be rapidjustified on sound economic grounds, and that adjustment assistance isgovernments should work towards nnot cost-effective. However,adopting uniform policy instruments assistance programs to facilitatem order to promote greater adjustment, should be temporary andtransparency and reduce collateral conditional upon restructuringdistortions in other markets. Moving efforts such as reducing excesstowards uniform instruments in this capactity. Reviewing evidence inway can serve as a precursor to this area is useful. (See Box 2)subsidy phase-out in the same waythat replacing import quotas with * Consider only functionaltariffs is often undertaken before a interventions. Both theory andgeneral tariff reduction during trade practice confirm the positiveliberalization. In choosing the most economic benefits of governmentappropriate uniform program, assistance to industry in the case ofMercosur countries should choose market failures such as in researchthe one which would introduce the and development. Functionalfewest additional distortions. For interventions, i.e., state aid directed aexample, both Argentina and Brazil general objective such as R&Dhave created free trade or export without favoring a particular sector,processing zones to attract industry can be welfare improving. Seedto less developed regions through money for training facilities orspecial tax exemptions, higher re- business incubators, harmonizedimbursements for exports and product standards such as ISO, orreduced tariffs on capital imports. general tax consessions for R&D areSuch policies use a blunt tool of a few examples of such programs.trade policy in order to accomplish a However, government support ofmore narrow objective of regional specific enterprises such as thedevelopment. Given that resource European support of Airbus or there-allocation from integration may Japanese experiment with highexacerbate regional income definition television are generallydisparities, Mercosur countries recogiuzed as costly for governnentswould be wise to adopt common and seldom produce returns to justifyregional development policies such their expense.as lump-sum transfers, which do notcompromise the trade instrument.The EU's policy on developing acomprehensive union-wide strategy

35

Box 2:Policies Towards Declining Industries in the United States, Japan and the European Union

The governments of the United States, Japan and the European Union have adopted three alternativeapproaches to assisting declining industries. Though often guided by political exigencies rather than economictheory, these contrasting approaches nonetheless provide some insights into options facing policymakers whenconfronting the inevitable adjustment issues brought on my Merocsur integration. (Lawrence, 1989)

The U.S. government, despite its traditional support of free trade, has used formal trade protection as thepreferred means of assisting declining industries. Smaller industries typically appeal to the U.S. InternationalTrade Commission, a quasi-judicial body which in addition to imposing anti-dumping measures andcountervailing duties, also grants temporary protection to domestic industries which can prove that importcompetition constitutes a significant source of injury. Larger industries, such as the automotive and steelindustries, at times have lobbied the President or Congress directly for assistance when faced with decliningprofitability due to strong import competition. Examples of such trade protection during the 1980s include theU.S. government's decision to impose quotas on steel imports and sugar, to obtain "voluntary" export restraintson Japanese car imports, and to grant loan guarantees to the Chrysler Corporation. To a lesser extent the U.S.government provides supplemental unemployment benefits for workers who lose their jobs as a result of importcompetition. Such assistance programs have been the common means of addressing sectoral unemploymentresulting from NAFTA.

In contrast, the Japanese government has avoided formal trade protection but has instead employed a two-pronged policy which drafts a detailed industry program for reducing excess capacity and which canrelizesremaining firms in the industry. The Japanese government identifies 'depressed industries" as those which meetthe following criteria: (i) the industry must have severe over capacity; (ii) more than half the firms must be in direfinancial condition; (iii) firms representing two-thirds of the industry must sign a petition seeking protection; and(iv) there must be broad agreement among the firms that scrapping facilities would be a necessary component ofadjustment. In exchange for an industry-wide agreement to eliminate excess capacity, the Japanese governmentoften grants antitrust immunity to the remaining cartel of producers sometimes offers loan guarantees to financeretooling, and offers implicit protection. (See also Goto, Levin & Peck, 1988 and Leipziger, 1988).

The European Union has combined elements of formal trade protection (import quotas, price floors onimports, voluntary export restraints) with government subsidies and capacity reduction plans. In the steelindustry, for example, the (then known as) EC instituted a plan in the late 1970s which imposed import controls,mandatory minimum prices on steel products and production quotas for member countries. The EC also adopted acommunity-wide scheme for coordinating national subsidies to the steel sector in the hopes of eventuallyeliminating state assistance programs to the industry. By most accounts these attempts to reduce both excesscapacity and state subsidies were largely unsuccessful through the 1980s (Tarr 1988).

The results of these programs has been mixed. Tarr (1988) shows that U.S. and European adjustmentpolicies relying on blunt trade protection tools such as import quotas or VERs generate more negative side-effects(higher prices and producer rents) than they yield in positive adjustment (plant modernization or workerrelocation). While the Japanese government's policy of cartelization avoids trade distortions, it too engenderssignificant welfare costs through the monopoly power created by relaxing antitrust measures. The Europeanprograms have been additionally costly due to the EC-wide direct grants to steel and other declining industries,again with little evidence that the objectives of capacity reduction or worker relocation have been achieved.

36Final Lessons facilitate resource transfer to rising

sectors. Worker relocationIn dealing with adjustment assistance to programs of extended

declining industries: unemployment benefits such asthose in the U.S. serve this end.

The U.S., Japanese and European Indefinite protection through aexperience suggest several blunt trade policy tool such as aguidelines for drafting adjustment quota does not.programs for Mercosur. First, theleast distortionary adjustment * Finally, temporary protectionprograms minimize government without quid pro quo is ineffective.involvement in determining which In cases where an industry offers afirms survive in a declining sector. credible case for assistance,Except for the Chrysler case, U.S. perhaps on the grounds that suddenadjustment programs are not firm- import competition might have aspecific and usually permit the severe regional impact, such relieflarge losses suffered by domestic should be temporary andfirms to be the market guide for conditional on a plan to reinvestplant closures. This approach cash flows in modernization andcontrasts with that of the Japanese reduce excess capacity. Japan isgovernment which requires a the only country which imposesdetailed industry plan for capacity such a requirement on industriesreduction in exchange for antitrust seeking protection, though itsexemptions. (See Goto et al., 1988) cartelization approach raisesThe European plan as well required additional antitrust concerns whichextensive government intervention may engender additionalto administer elaborate domestic distortions. Credibly temporarycartel involving production quotas protection leave firms no choiceand minimum prices. but to yield to market pressures.

* Secondly, adjustment policies It would be useful for Mercosur partnersshould be used to facilitate to address these issues conceptually and establishadjustment rather than hinder it. If mechanisms to both monitor behavior anda country loses comparative consider remedies. Doing so prior to the statusadvantage in a product, it is of economic deslocation or political pressure willunlikely to regain it, which renders ensure more effective harmonization andsuspect any industry claim for adherence to open, market principles."temporary" protection in order tomodernize operations. Morejustified are those programs which

37

ANNEX TABLE 1. Sectoral Breakdown of Argentine Industrial Specialization Program (as of 15November 1994)

Sector No. of Programs Base Export values Committed increase Increase committed(millions) for 1993 for 1993-99

(millions) (millions)Food, drinks and 7 19.1 2.4 45.7tobaccoAutoparts 31 15.3 11 188.2Cables 1 2.2 2.8 8.2Footwear 4 10.6 .94 12.1Rubber 3 .19 .15 .77Leather and hides 2 1.5 .15 1.1Household 19 3.4 2.7 102.8appliancesRailroad equipment 1 .57 .43 .43Professional and 4 13.3 .99 14.2scientific equipmentToys 3 .12 .07 .98Wood and furniture 1 .009 0 .062Electrical machinery 20 4.6 3.6 .33Non-electrical 6 3.7 2 5.5-nachineryTransport material 2 3.2 12.1 46.2Non-ferrous metals 3 36.7 28.7 33.4Basic metals 8 313.6 50.6 213.4Non metallic 6 11.5 10.4 72.5mineralsMotorcycles and 3 .037 .018 7.2bicyclesTires 8 5.6 6.1 32.9Other manufactured 3 .11 .26 3.6industriesPaper 5 4.8 1.4 16.3Plastics 5 .86 .43 2.2Metal products 10 10.5 2 18.5Chemicals 25 34.8 10.1 70.7Textiles 27 10.5 10.7 59.2

Total 207 506.7 160.2 988.9

Source: Minsterio de Economia (1995)

38ANNEX TABLE 2. Directed Credit Programs in Argentina

Institution Targeted Credit Programs Lending Limits Loan Period Interest Rates(anmual)

Banco de Inversion Export financing for SMEs (85 % $20,000 - $2.5 6 mo. - 5 yrs. 6 mo to 2 yrs: 8%y Comercio Exterior of FOB for capital goods; 10 % of mil 2 - 3 yrs: 9%(BICE) FOB for capital goods) 3-5 yrs: 10 percent

financing for fairs and $50,000 up to 2 years LIBOR + 1%expositions

financing for locally produced $20,000 - 6 mo. - 5 yrs. LIBOR + 2.5%,capital goods $500,000 3.5% or 4.5%

depending on termlength

financing for investment or to $200,000 - $5 up to 8.5 yrs. decided oni case byincrease export capacity mil. case basis

acquisition of capital goods, new 111%/-15%'4technologies and working capital(Programa Trienal de Fomento yDesarrollo de la Pequena yMediana Empresa)

Banco de la Nacion export financing na 4yrsforcapital 10 12%Argentina (BNA) goods; 1.5 yrs

for consumerdurables

prefinancing na 180 days 10%

working capital, capital goods na 1.5 yrs - 4 yrs 120/.5-and acquisition of newtechnologies

credits for purchasing tractors na na 16%and capital goods for mnining andagriculture

microenterprise credit na 4.5 yrs 14%

credit for agricultural production na na 10%in Patagonia

rural mortgages (Cedulas 7.9% for first twoHipotecarias Rurales) years, and LIBOR

+ 2.9% thereafterBanco Hipotecano mortgages 20 yrs. 9%Nacional (BHN)

"immediate access" (acceso up to $25,000 5 - 7 yrs. 13.5%inmediato) funds

mortgages for veterans and 13% (scientists)repatriated scientists and 10% (veterans)

construction financing up to 24 mo. LIBOR + 8%

39Institution Targeted Credit Programs Lending Limnits Loan Period Interest Rates

(annual)Banco de la SME loans for capital investment 10.5 (investment)Provincia de Buenos and working capital and 12% iworkingAires (BPBA) capital)

mortgages 12%

Source: Murphy, Ricardo Lopez, Alfredo Gutierrrez Girault and Ruben Vales. "El Credito Dirigido en LaArgentina", FIEL, 1994.

40

Annex Table 3. Estimated Cost of Directed Credit Programs in Argentina, 1994Bank/Program Estimated % of Total wtd. avg. Subsidy % of Total wtd. avg. Subsidy Total

directed portfolio amount in subsidy on on US$ portfolio amount in subsidy on on peso subsidycredit in US$ US$ US$ loans loans in pesos pesos peso loans loans ($m.)(US$ (m.) (%) (m.) ($m.) (%) ($m.)

million)BNA (Cedulas 1000 70 700 2.47 17.29 30 300 10.5 31.5 48.79Hipotecarias Rurales)

BICE (Programa 1000 80 800 2.47 19.76 20 200 10.5 21 40.76Trienal de Fomento yDesarrollo de laPequefla y MedianaEmpresa)

BHN, BNA and BPNA 500 50 250 2.47 6.17 50 250 10.5 26.25 32.43subsidized mortgages

Total subsidy $122 million

Source: World Bank estimates

41Endnotes

A burgeoning literature has highlighted both the trade creation gains as well as the potential trade diversionlosses in Mercosur and has generally posited an overall welfare improvement resulting from regional integration inthe Southern Cone. See Primo Braga, Safadi and Yeats 1994; Losada 1994; Michaely 1994; and Bouzas 1995.

2 de Melo, Montenegro and Panagariya (1992) and de Melo and Panagariya (1992) offer some explanations for thefailure of regional trade alliances to produce the purported gains from integration in the developing world.

3 A free trade agreement (FTA) is one which removes all barriers to trade in goods among member countries whileeach members maintains its individual tariffs vis-a-vis non-member countries. A customs union is an FTA inwhich member countries adopt a common external tariff towards non-member countries. A common marketprovides for the free flow of goods and services, institutes a common external tariff and allows the free flow offactors of production such as capital and labor.

4In some cases these predicted gains can be quite large. Estimated static gains from the creation of the EuropeanUnion range from 2 to 6 percent of GDP. See Boltho (1982) and Molle (1990). Estimates for welfare gains inMercosur are smaller, but still positive. See Note 1.

5 On IP typologies, see Leipziger and Petri (1993).

6 This section builds on previous work by Leipziger and Petri (1993).

7 This debate over the appropriate role of government in promoting economic development has been further fueledby the rapid growth of the East Asian NICs. most of which utilized selected and sometimes substantial governmentintervention while still maintaining high growth rates. See Vogel (1991), World Bank (1993), Leipziger andThomas (1993), and Leipziger (1996, forthcoming) for general overviews as well as Wade (1990) on Taiwan,Yamamura (1993) on Japan, and Kim et. al. ( ) on Korea.

8Primo Braga, Safadi and Yeats (1994) cite a more liberalized trading environment throughout Latin America; theincreased importance of intra-industry trade which mitigates the distributional consequences of integration; and thestrong U.S. support for minilateral initiatives as reasons for greater optimism.

9France, West Gernany, Italy, Belgium, the Netherlands and Luxembourg.

'° By comparison ,the wealthiest EC-6 member (Luxembourg) was less than twice as rich as the poorest (Italy).

" Normally rules of origin are not needed in a common market due to the implementation of a common externaltariff which removes the incentive for transshipment of goods from low-tariff to high-tariff countries. Theexistence of rules of origin for Mercosur is however, necessary in the interim period before the CET isimplemented. It is also needed to address the potential problems created by export process zones in membercountries.

12 The Common Market Council comprises the Ministers of Foreign Affairs and the Ministers of the Economy ofthe member countries. The Common Market Group is the main executive body and consists of senior governmentofficials from the Ministries of Foreign Affairs, the Ministries of the Economy and the Central Banks. Workinggroups have been established to address the following policy issues: trade; customs; technical standards; fiscal andmonetary policies; inland transport; maritime transport; industrial and technology policy; agricultural policy:energy policy; macroeconomic policy and labor relations.

13 The provisions apply only to policies which would affect trade among member countries and do not apply topolicies with only domestic impacts.

'4 In turn, all member states must inform the Commission of plans to grant aid or to alter them and must abide bythe Conunission's recommendations with respect to these actions. If the Commission finds that a given state's

42

industrial policies are incompatible with the promotion of a common market, it may require the state to amend itspolicy or abolish it (Swann 1983).

s To be fair, the EU was ahead of the United States and Japan in compiling and publishing such figures, a processwhich is rarely popular among government officials or favored constituencies.

16 For example, when assessing the degree of distortion inherent in any industrial policy, one must consider thecontext of the given industry, the form of the aid, the volume of the aid, and the financial situation of the firm. Insome circumstances, a small absolute level of aid in a sensitive or overcapacity sector with small profit marginsand large interstate trade can have a greater distorting effect than a larger aid granted in other less sensitivesectors. See CEC (1989).

'7 To be sure, the distinction between final objectives is somewhat arbitrary. In some countries R & D which mightnormally be considered a horizontal objective is in fact channeled through only specific sectors and thus could aslikely be considered a sector-specific industrial policy. Further, final objectives do not give a true picture of thefinal beneficiaries; a large part of regional aid may in fact be paid to mall and medium enterprises. Consequently,conclusions about shifts in the objectives of industrial policy must be made with some caution.

"' For a detailed description of some of the main industrial policy instruments for the four Mercosur countries see JoaoBosco M. Machado, 'Poltica Industrial no Mercosul," mimeo, FUNCEX, Rio de Janeiro, 1995. See also EduardoAugusto Guimaraes, "A Experiencia Recente de Politica Industrial no Brasil: urna avaliacw," Texto Para Discussao no.326, Instituto de Economia Industrial, Universidade Federal do Rio de Janeiro, March 1995.

19See Confederacao Nacional da Industria, Brasil -Comparacoes Intemacionais, Rio de Janeiro, 1995, p.24.

20 This additional list is supposed to be phased out by April 18, 1996. See Gazeta Mercantil, August 7, 1995.

2] See Government of Brazil, "Programa Brasileiro de Qualidade e Produtividade", Brasilia, 1991.

2 It encompassed, among other actions, instituting the National Quality Prizr, patterned after its Japanese and Americancounterparts. Moreover, surveys reveal that a majority of the 1000 largest firm participate in TQM programs.

23Sade Vigesa, for instance, reduced 75% of electricity transmission towers fabrication defects in the process of adapting

the firm to ISO standards; Freios Varga lowered by 50% casting defects during the ISO implementation period (See 0Globo, November 13th 1994). Phillips Lighting, the first producer of light bulbs in Latin America to be certified,reduced its defect ratio from 322 lamps per million to 26 per million during and after conforming to ISO-9002 standards;similarly for Castrol, a producer of motor oils, which saw input rejection rates drop from 8% to 0.5% and rework from13% to I % between 1990 and 1995, with results appearing already during the period the frm was in the process ofattaining the ISO-9001 certification (see Gazeta Mercantil, May 10th 1995), p.12.

24 Twenty-seven EPZs - one for each Province - have been recently approved in Argentina, in addition to the Tierra delFuego Free Zone. In Uruguay there are nine EPZs, five of them operational.

25 In an operation for 10 years and 10% interest rates, the importer would typically pay 8%, with the remainder 2%covered by Proex. Currently the maximum interest rate differentials absorbed under the program is 3.5 %.

26 Among 1445 operations undertaken between January 1993 and July 1995, 1166 were demanded by BNDES'FINAMEX program.

27 The program is regarded by exporters to be quite restrictive - in terms of its positive list and financing terms - andbureaucratized. In December 1995 the Government expended the list of eligible goods to include among others, textiles,ceramics, leather goods and food stuff. The Government also increased the maximum rate of interest rates equalizationand made it available for shorter term operations. It is also expected that the Government will simplified PROEX rulesand operational norms, while providing greater independence for producers and financial institutions to agree oncontractual terms of specific export financing operations.

43

28 See Confederacao Nacional da Induistria, Custo Brasil, Rio de Janeiro, 1995.

29 In 1992, the rate of capital accumulation or investment reached, according to the Government's IPEA institute ilsnadir, with just 13.7 % of GDP (compared to 16.6% in 1989). This rate climbed to 14.4 % in 1993, and reached 17 % atthe last quarter of 1994. Although current estimates are that it will reach 18% in 1995, these are still low levels whencompared to other fast-growing industrializing countries.

30 See Jomal do Brasil, February 15, 1995.

31 It should be mentioned that non-competing capital goods imports have zero tariffs.

32 See Gazeta Mercantil, October 10, 1995.

33 Neither Paraguay nor Uruguay have a differential treatment of firms by size. In Argentina, a specific statute for smalland medium enterprise was approved by Congress in March 1995 (law 24,467), conferring fiscal incentives, making theapplication of labor laws more flexible, and facilitating access to credit. Small and medium firms are enticed to invest inlow-growth and high unemployment areas. These incentives apply for producers with less than 40 employees; amaximum eligibility-related turnover amount will possibly be defined when the operational details of the statute isapproved by Congress.

34 Information, and technical assistance to SMEs, are provided quite effectively by university-based 'dial-technology'services. The University of S. Paulo inaugurated this program in late 1991, and since then it generated 8,000consultations (90% of which from SMEs), while spawning 14 other equivalent programs in other parts of the country.

35 The textile sector has been considerably affected by competing East Asian imports. While in 1990-92, the sectorexports were on average nearly three times the level of imports (on a total trade volume of US$ 1.5 to 2.0 billion), by1995 (January-July) the ratio of imports to exports was two-to-one. As a result, there were a total of 20,000 job lossesand the closing of approximately 400 plants in Sao Paulo's Americana region, the largest textile pole in Latin America.The Government responded by increasing tariffs for 13 items from 18-20% to 70% until April 1996, while importers of40 other items will have to settle their balances within a 30-day period, in order not to take advantage of the large interestrate differences.

36 See Jorge Lucangeli, "El Intercambio Argentino-Brasileno en 1994: Se Consolida un Padron de ComercicoMaduro," mimeo. The intraindustry trade coefficient reflects the proportion of intraindustry trade within aparticular segment relative to total trade volume in that segment. Thus, when the value of exports and importswithin the industry are equal, the coefficient is 100%; when to positive exports (imports) correspond no imports(exports) from within the industry, the coefficient is zero. Or algebraically, the intraindustry trade coefficient II= [1 - ([abs. (X-M) ] / [X+MI ) ] times 100%.

37 In the first semester of 1995, 300,000 vehicles were imported; for the remainder of the year, the Governmentallowed in an additional 150,000. Yet a combination of high interest rates and other credit restrictions, and anincrease in tariff levels to 70%, lead to a sharp fall in demand for imported vehicles. In any case, the vehiclequotas were condemned by World Trade Organization in early October 1995, which rejected the balance-of-payments rationale argued by the Brazilian government. See Gazeta Mercantil, October 9, 1995.

3 The "Regimen Automotriz Argentino" was established on December 20, 1991, through Decree 2677, validuntil the end of the decade. It allowed local assemblers to import at a reduced tariff rate of 2 %, parts,components and vehicles, against actual exports or investment commitments. Those benefits were extended toproducers of autoparts contracted by the car manufacturers. According to Decision 29/94 of the Ouro PretoAgreement -- which established the operational basis of the Free Trade area -- common automotive regime will benegotiated by 1997, and will take effect as of January 1, 2000. This regime will be characterized by intrablockfree trade, a common external tariff (20% for cars), and the absence of distortionary incentives that might steerinvestment to any country within Mercosur.

44

39 See C. Frischtak, "Leaming, Technical Progress and Competitiveness in the Brazilian Aircraft Industry: An Analysisof Embraer", CEPR Publication no. 356, Stanford University, December 1992. An abridged version of this paper waspublished in Research Policy, Spring 1994.

40 See Carlos L. Cavagnari Filho, 'P&D Militar: situacao, avaliacao e perspectivas," Serie Ciencia e Tecnolo2ia noBrasil, Fundacao Getulio Vargas, abril 1993.

41 To be sure, comparing average tariffs rates across countries as proxies for trade restrictiveness presents severalmethodological problems. Unweighted average nominal tariffs tend to bias estimates upward due to the fact thatthe highest rates only apply to a few categories of goods. Import-weighted averages, however, tend to be biaseddownward since highly restrictive rates which dramatically lower imports will have a small weight in the average(and prohibitive tariffs will have zero weight). A useful alternative is weighting by the amount of domesticproduction protected by the tariff. In this paper every effort has been made to remain consistent in tariffcomparisons using unweighted average tariffs which is more readily available than production-weighted dataComparisons using other tariff averages are appropriately noted in the text.

42 Significantly reducing tariff dispersion is one such example. Even the statistical tax, though clearly an importsurcharge, was adopted as a temporary measure and imposed on a non-discriminatory basis. It therefore appliesuniformly across all sectors and does not introduce an additional bias into the trade regime.

43 The free trade zone issues, though an important trade policy with sectoral impacts, will be addressed in thesubsequent section on Tax Policies since the bulk of its provisions are tax and not tariff related.

44 This lower average tariff is also consistent with GATT regulations on CETs in customs unions. ArticleXXIV:5(a) of the GATT states that the duties and other import barriers in customs unions "shall not be on thewhole higher or more restrictive" than those in force before the establishment of the union, based on an overallassessment of weighted average tariff rates. However, the interpretation of this phrase has been the subject ofmuch disagreement among GATT members.

45 Using seven product categories (food, agriculture, mineral ores, fuels, chemicals, machinery and equipment andother manufacturers) Losada finds that trade creation will exceed trade diversion in Mercosur in all sevencommodity groups. He estimates a net trade creation effect of $273 million for Argentina.

46 The authors also estimate price pass through effects in the retail commerce, service and agricultural sectors.

47 Morisset and Revoredo partially attribute this imperfect correlation between domestic and foreign prices to theexistence of trade barriers such as quotas in the automobile sector and preferential tax treatment for durable goodsproduced in Tierra del Fuego.

48 Using unweighted average tariffs at the two digit level from November 1994 and total imports for 1994.Percentages may not sum to 100 because of rounding.

49 Tariff reductions are calculated according to the following formula:DI= 2% + (A-2/) x Bwhere DI is the resulting import dutyA is the current import dutyB is a coefficient equaling 0.25 in 1997, .50 in 1998 and .75 in 1999.

50 Incentives formerly granted include: an exemption on the value added tax, tax on earnings and capital gainstaxes for up to 15 years; exemption from the stamp tax; exemption or reduction of import duties on capital goods;special reimbursements for exports; and preferential prices for inputs used for promotional enterprises, usually forthe petrochemicals industry. As noted, these are no longer granted.

52 See Leipziger (1983) on the calculation of grant elements of a subsidized loan.

53 Private banks include privately owned domestic banks, foreign owned banks and cooperatives.

45

54 Rates reflect auction bids by commercial banks for BICE loans. Commercial banks disbursing these BICE loanscharge 4 points higher than these rates, with the difference subsidized by the Secretariat of Industry.

ss The market rate charged by BNA is 16%, with the four point difference subsidized by the Secretariat of Industryas in the case of BICE loans.

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