Pacific Alliance: Integration Paves The Way For Enhanced Competitiveness

BMI View: The Pacific Alliance is fast becoming Latin America's pre-eminent trade bloc, particularly following an ambitious plan to eliminate most tariffs on goods announced in February. We believe that there is still significant room for integration between member states in the coming years, highlighting the services and capital sectors as areas that will require further attention in order to increase investment and realise supply chain efficiencies.

Over the last 12 months, the Pacific Alliance (PA) - a trade bloc consisting of Colombia, Chile, Mexico and Peru - has continued to differentiate itself from other regional integration organisations in Latin America by promoting a pragmatic, business friendly agenda and following through on proposed reforms in a timely manner, something which has eluded regional heavyweight Mercosur in recent years ( see 'Regional Divide To Widen Between Pacific Alliance And Mercosur', May 30 2013). In addition, the bloc's focus on external trade with strategic partners, such as Asia, will provide a strong, long-term growth market for exports, while its lack of geographic restrictions for membership open the door for a broader agenda in the long term. Moreover, the already large size of the PA makes it an attractive market for investors, as we forecast the member states' share of regional GDP to rise to a notable 40.9% by 2015, from an estimated 38.4% in 2013, before declining modestly towards the end of this decade.

We believe that recent steps have put the PA on track to become the pre-eminent trade bloc in the region in the coming years, as it looks to further break down tariff and non-tariff barriers to regional trade, promote visa-free travel, and the free flow of services and capital with a strong commitment by member states. That said, we caution that wavering dedication on the part of heads of state could see the Alliance's rapid progress slow, particularly in the implementation phase of a significant reduction in goods tariffs, which is expected to run until 2015. Below we assess how far the PA has come in several key areas, how much further integration has to go, as well as of the potential benefits and challenges.

Pacific Alliance To Become A Major Player
Latin America - Nominal GDP, US$bn

Pacific Alliance: Integration Paves The Way For Enhanced Competitiveness

BMI View: The Pacific Alliance is fast becoming Latin America's pre-eminent trade bloc, particularly following an ambitious plan to eliminate most tariffs on goods announced in February. We believe that there is still significant room for integration between member states in the coming years, highlighting the services and capital sectors as areas that will require further attention in order to increase investment and realise supply chain efficiencies.

Over the last 12 months, the Pacific Alliance (PA) - a trade bloc consisting of Colombia, Chile, Mexico and Peru - has continued to differentiate itself from other regional integration organisations in Latin America by promoting a pragmatic, business friendly agenda and following through on proposed reforms in a timely manner, something which has eluded regional heavyweight Mercosur in recent years ( see 'Regional Divide To Widen Between Pacific Alliance And Mercosur', May 30 2013). In addition, the bloc's focus on external trade with strategic partners, such as Asia, will provide a strong, long-term growth market for exports, while its lack of geographic restrictions for membership open the door for a broader agenda in the long term. Moreover, the already large size of the PA makes it an attractive market for investors, as we forecast the member states' share of regional GDP to rise to a notable 40.9% by 2015, from an estimated 38.4% in 2013, before declining modestly towards the end of this decade.

Pacific Alliance To Become A Major Player
Latin America - Nominal GDP, US$bn

We believe that recent steps have put the PA on track to become the pre-eminent trade bloc in the region in the coming years, as it looks to further break down tariff and non-tariff barriers to regional trade, promote visa-free travel, and the free flow of services and capital with a strong commitment by member states. That said, we caution that wavering dedication on the part of heads of state could see the Alliance's rapid progress slow, particularly in the implementation phase of a significant reduction in goods tariffs, which is expected to run until 2015. Below we assess how far the PA has come in several key areas, how much further integration has to go, as well as of the potential benefits and challenges.

Goods Trade Integration: Moving Right Along

The PA's announcement in February that it will eliminate tariffs on 92% of goods is a significant achievement, demonstrating the bloc's continued progress on its stated goals. The accord signed on February 10 leveraged off of existing free trade agreements (FTAs) - the main membership criteria for the bloc is the conclusion of agreements with all existing members - and provisions included the rationalisation of common rules of origin, whereby inputs and raw materials from one country can be used by another, and the end product will be considered a national product. In addition, member countries can now better exploit the bloc's supply chain, enabling each member state to take advantage of trade agreements negotiated by others, allowing products to reach new markets. For Colombia, this will open up the possibility of preferential access to Japanese and Chinese markets, countries with which it does not currently have trade agreements, helping to fulfil President Juan Manuel Santos's goal of a continued pivot towards Asia for Colombian exports. Mexico also will have potential for more favourable access to the Chinese market, a potential area of growth in the coming years ( see table below).

Pacific Alliance Countries' Selected Trade Agreements
US EU Japan China
Chile Yes Yes Yes Yes
Colombia Yes Yes No No
Mexico Yes Yes Yes No
Peru Yes Yes Yes Yes
Source: BBVA

We expect that the reduction of tariffs and greater integration of supply chains within the PA will provide a boost to export competitiveness, enabling firms to produce goods more cheaply within the bloc, as well as providing them access to strategic export markets and a significant internal market. As such, we expect that the most recent agreement will be a strong positive for foreign direct investment, incentivising firms to allocate capital in markets that they know allow for the nearly-free movement of goods within the bloc, and which have extensive free trade agreements with fast-growing economies, particularly in Asia ( see table above). We expect that the bloc's focus on rule of law and its investment-friendly policy orientation will also be a constructive in this regard, ensuring that operating climates remain relatively stable, and that investors are able to divest when necessary.

Investment To Continue On The Upswing
Latin America - Selected Economies Inward Foreign Direct Investment Stock, US$mn

Moreover, the size of the alliance's combined consumer market will be another draw for companies looking to invest in Latin America, as we expect several of the member states to maintain relatively robust real GDP growth rates in the coming years, further supporting increases in per capita incomes. Nevertheless, given that the February agreement remains in the implementation phase, we will be watching closely for signs that any member states are lagging behind, potentially indicating a less robust commitment to the bloc than recently signed agreements would suggest.

Pacific Alliance An Increasingly Attractive Consumer Market
Latin America - GDP Per Capita, US$

But Still Further To Go

While we believe that the February agreement is a major step forward in terms of regional trade, and should facilitate greater preferential access to new markets for the bloc and bolster investment, we believe that improvement in transport and logistics will be necessary in order to boost intra-regional trade and ensure long-term gains in cost competitiveness. Potential reductions in firms' costs, on the back of lower tariffs and improvements in the speed of moving goods within the bloc due to shorter customs processes, are likely to be limited by the still-high cost of transporting goods from one country to another. Indeed, our Infrastructure team highlights that existing infrastructure is currently unable to support the smooth transportation of goods between the PA countries. As such, continued improvements in the quality of air, rail, and road transport networks will be key to capitalising on the benefits of tariff reduction and unlocking further advancements in export competitiveness. Moreover, additional steps forward with regard to visa-free travel, particularly for business visas, will help facilitate the growth of more robust trade and business ties within the trade bloc. In addition, given that several of the bloc's members are major exporters of raw materials - Colombia, Chile, and Peru - the economic complementarities may be relatively limited at this stage, further underscoring the need for better transport infrastructure and the free movement of people in order to facilitate intra-regional trade.

Services & Capital Integration: A Long Road Ahead

The next big phase of integration will concern the services sector, as well as capital markets. The so-called 'additional protocol' to the alliance's framework agreement, which was signed in February, has provisions in the areas of professional services, telecommunications, financial services, as well as transport that go beyond existing bilateral agreements. In addition, the member states have established common rules for investment to build upon those in previously-negotiated bilateral agreements. However, the integration of financial services and capital is likely to be a continued challenge given inconsistent tax treatment across countries, as well as differing rules for pension fund investments, among other issues. Nevertheless, integration continues to proceed with regard to the member's equity bourses. Indeed, the Mercado Integrado Latinoamericano (MILA), which already includes Chile's IPSA equity exchange, Peru's IGBVL, and Colombia's IGBC, is expected to add Mexico's IPC this year, likely making it Latin America's largest index by market capitalisation, surpassing Brazil's Bovespa. While we believe that goods trade integration remains the bloc's first priority, further attempts to normalise trade in services and standardise rules for investment in member states will reinforce the progress made with regards to the goods trade, incentivising investment as firms see greater benefits to their supply chains.

New Membership: How Far Will It Extend?

While governments have been clamouring to join the alliance as observers in recent quarters, we believe that the bloc's significant attempts to break down both tariff and non-tariff barriers are likely to dissuade some countries from pursuing full membership. Indeed, Costa Rican President Laura Chinchilla, who officially started the integration process in February, has received pushback from constituents in recent months over the timeline for implementing tariff liberalisation. Moreover, opposition presidential frontrunner, Juan Guillermo Solís has modestly backtracked on his support for the PA in recent weeks, stating that he needs more information before deciding whether he will support it, and raising questions about Costa Rica's membership under a Solís government. Given that the PA's other candidate country, Panama, has a presidential election coming up in May, we will be watching for signs that the country could also dial down its support for the alliance in the event of an opposition victory. That said, given the alliance's open policy towards observer states, we expect that major global economies and smaller states more likely to see themselves as potential candidate countries will sign up to ensure that they are able to reap the benefits of the PA's continued progress.

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