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Volume 5 Number 2
2005
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Volume 5 Number 2
economa
2005
Spring
EDITOR
Andrs Velasco
Articles in this publication were developed by the authors for the biannual Economa meetings.
In all cases the papers are the product of the authors thinking alone and do not imply endorsement by the staff members, officers, or trustees of the Brookings Institution or of LACEA, or of
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Copyright 2005
LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION
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economa
Volume 5 Number 2
2005
Spring
Editors Summary
vii
46
63
93
105
141
151
189
235
197
Editor
Andrs Velasco, Harvard University and Universidad de Chile
Editorial Associate
Jennifer Hoover
Managing Editor
Magdalena Balcells
Editorial Board
Rafael Di Tella, Harvard University
Eduardo Engel, Yale University
Francisco H. G. Ferreira, Pontifcia Universidade Catlica, Rio de Janeiro, and
World Bank
ANDRS VELASCO
Editors Summary
early two decades after a wave of policy changes swept through Latin
America, economic reforms continue to be the focus of much discussion. Critics claim that the promarket reforms have failed to
deliver economic growth, and that the time has come to try something else.
Advocates claim that the reforms were never given a fair chancetoo little was done, often too late. Complete the reform process, they claim, and
growth will come.
Both sides do agree on one point: Latin America seems to be suffering
from reform fatigue, and another wave of reforms is unlikely to happen any
time soon. Certainly not in countries led by left-leaning populists, such as
Argentinas Nstor Kirchner or Venezuelas Hugo Chvez. The reform
momentum has even stalled in countries led by promarket conservatives
Mexico under Vicente Fox and Colombia under Alvaro Uribe are two
examples. If such reforms are now unpopular in many quarters, did the
politicians who initially adopted them bear a political cost? Was the Washington Consensus electorally bad for friends of Washington? That is the
question studied by Eduardo Lora and Mauricio Olivera in the lead article
of this, the tenth issue of Economa.
Lora and Olivera analyze the outcome of sixty-six presidential elections and eighty-one parliamentary elections in seventeen Latin American
countries from 1985 to 2002. Their general conclusion is striking: reforming parties and politicians were rewarded electorally only when reforms
involved macroeconomic stabilization and a sharp reduction in inflation;
otherwise, their reforming zeal cost them dearly at the polls. Economic outcomes do matter for electoral outcomes. Lora and Olivera find that the
incumbents party is rewarded in presidential elections for reductions in the
inflation rate and in legislative elections for increases in the growth rate.
Changes in unemployment and income distribution, however, do not appear
to influence voters behavior.
vii
viii
E C O N O M I A , Spring 2005
What is even more surprising is that, at the polls, policies matter irrespective of their resultsthat is, their effects on growth or inflation. Electorates seem not to like reform policies of the kind applied in Latin
America in the 1990s. In a regression with electoral outcomes on the right
hand side, reform indexes have a negative and significant effect, even when
the authors control for changes in inflation and growth. The point estimate of the effect of policies on electoral results implies that the incumbents party typically lost 15 percent of its vote in presidential elections on
account of the average amount of promarket reforms introduced during
its term. More aggressive reformers (say, those reforming one standard
deviation above the mean) sacrificed 27 percent of their vote on account of
promarket reforms. Statistically, this seems to be a very robust result for
presidential elections.1
Moreover, lying about ones true intentions does not seem to be a good
electoral strategy. Several Latin American politiciansincluding Fujimori
in Peru, Menem in Argentina, and more recently Gutirrez in Ecuador
first ran as opponents of the Washington Consensus, then followed orthodox policies. The paper shows that a candidate that said one thing on tax
policy and then did another was, on average, punished more severely at
the polls. Campaign promises do not seem to matter for the effect of other
policies on voting behavior.
These results raise two kinds of questions. For academics, the issue is
why inputs (policies) matter and not just outputs. Is it ideology, pure and
simple? Or is it that because outcomes represent an extremely noisy signal
of politicians competence, the choice of policies conveys some information that voters find useful? For policymakers, the question is political:
what has to change in Latin America before ambitious reforms become feasible again? Are all large-scale reforms out of the question, or only those
that carry the Washington Consensus label? Both sets of questions remain
very much open.
The unpopularity of the reforms does not mean, however, that policy is
frozen everywhere. Trade is one area in which reform has not stopped dead
1. The total effect of reforms on electoral outcomes is the sum of two effects: a direct
effect that runs from policies to votes and an indirect effect that runs from policies to economic outcomes to votes. The first is typically large and negative, while the second is positive insofar as the reforms lowered inflation and stimulated growth. The figures given
correspond to the total effectthat is, after the positive indirect effects have been taken into
account. The direct negative effects are much larger. See the paper for details.
Andrs Velasco
ix
E C O N O M I A , Spring 2005
origin have what trade experts call lenient facilitation devices. In English,
this means that the rules themselves include ways to reduce their restrictiveness. A key aspect is diagonal cumulation, which allows countries tied
by the same set of origin rules to use products that originate in any part of
the common rules-of-origin zone as if they originated in the exporting
country. Therefore, argue the authors, the rules of origin in a future Free
Trade Area of the Americasif one ever materializesshould not be all
that restrictive. One can only hope they are right.
Financial regulation is another area in which policy is changing, as a
result of both internal needs and international changes in standards. The
1988 Basel Accord on bank capitalthe so-called Basel I agreementis
now in place throughout the region, and discussion has shifted to whether
and how Latin American countries should apply Basel II. It is widely
accepted that bank capital ought to be regulated, but how to do so remains
open to debate. The simple approach of Basel I divides assets into very
broad risk categories and establishes an 8 percent minimum capital requirement for risky assets. The potential for arbitraging ones way around this
simple rule has grown, however, as risk management becomes more
sophisticated. In response, Basel II goes well beyond simple quantitative
requirements, proposing two basic approaches: the standardized approach,
which uses external credit rating agencies together with a table that maps
those ratings directly into capital requirements; and the internal ratingsbased (IRB) approach, in which the banks themselves estimate their customers default probability (without relying on external rating agencies) and
then use a particular formula to determine capital requirements as a function of the estimated default probability.
The third paper in this issue, by Giovanni Majnoni and Andrew Powell,
focuses on a key aspect of Basel II application. Many emerging markets
do not have many (or any) external rating agencies, so the standardized
approach may not be applicable. The internal ratings-based approach, in
turn, is complex, and its application and supervision may stretch limited
supervisory resources. Majnoni and Powell suggest a simplification of the
IRB approach that could be used as a transition arrangement. In their
centralized ratings-based (CRB) approach, banks would rate their clients,
but the regulator would determine the rating scale and the way in which
the banks ratings map into default probabilities. Using a centralized scale
would facilitate comparison across banks and greatly ease the monitoring of banks ratings. Those requirements would also be easier to monitor,
Andrs Velasco
xi
since the regulator would determine how banks ratings feed into capital
requirements.
The hard part of the approach is deciding what kinds of standards the
regulator should apply, since what works in rich countries may not work
in emerging economies. Basel IIs IRB approach suggests a formula for calculating a banks capital requirement as a function of three basic variables:
default probability, exposure at default, and loss given default. A regulator
might then ask a bank to hold provisions and capital to cover a specified
percentage of the distribution of losses to ensure the continued solvency
of the bank except in highly extraordinary circumstances. The calibration of
the Basel II IRB formula uses a value at risk of 99.9 percent with a horizon of one yearthat is, a bank is only expected to use up its capital in
one year with a probability of 0.1 percent, or once every 1,000 years.
Majnoni and Powell employ a bootstrapping technique to calculate loss
distribution functions for Argentina, Brazil, and Mexico, using data on loan
performance from public credit registries. They then use these functions to
estimate the size of expected and unexpected losses of an average-sized
bank with a loan portfolio randomly drawn from the universe of loans
within the financial system. Their results show that these three countries
have significantly higher default probabilities than Group of Ten (G10)
countries. As a result, both current practice under Basel I and the suggested standards under Basel II may be inadequate. To achieve a 99 percent
level of protection, capital requirements would need to be close to 15 percent, which is significantly higher than the 8 percent level recommended
in Basel I. Even higher levels would be required to achieve 99.9 percent
protection, as intended in Basel II. They also find that Basel IIs IRB
approach would result in levels of 9095 percent protection rather than the
99.9 percent goal. This is not surprising, since the IRB was calibrated for
the safer economies of G10 countries.
If bank regulation needs modernizing in Latin America, public transport does too. The spectacle of streets packed with old buses spewing black
smoke is all too common in many cities of the region, from Mexico City
to Quito and from So Paulo to Santiago. Poor public transport induces
more private cars to enter the streets, worsening congestion and pollution.
If you think that this is a textbook case of the state not doing the job of
providing public services, think again. Bus systems are private in many
cities in Latin America, and that does not seem to solve the problem. As
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos
xii
E C O N O M I A , Spring 2005
Hilln document in their paper in this volume, the market for urban buses
is ripe with market failures: unclear definition of property rights on the
curbside and on the road; cartelization that results in fares set above the
competitive equilibrium levels; misalignment between the incentives of bus
drivers and owners, in a typical principal-agent conflict; and congestion and
pollution externalities. In many developing countries, these market failures are exacerbated by weak regulation and enforcement. The result often
is too many buses each carrying too few passengers in unsafe conditions,
clogging the streets and soiling the air as they move (or fail to move) along.
One city in Latin America to have tackled the problem head-on is
Bogot, Colombia. Its so-called TransMilenio system is now being imitated
in Quito and Santiago, among others, as well as several cities in Colombia. Echeverry, Ibez, Moya, and Hilln explain the logic behind the new
system and analyze is effects. The key elements of the new system are as
follows: (i) a hybrid public-private system, with concession contracts for
private service providers; (ii) competition for the road (rather than on
the road) in a tendering process, with fare-setting based on long-term
investment recovery; (iii) remuneration based on kilometers traveled rather
than passengers transported, so as to prevent drivers from fighting over passengers on the street; (iv) separation between the transportation service and
the fare collection process; and (v) exclusive road and curb-side service in
metro-like stations.
Congestion, pollution, traffic accidents, travel times, and waiting times
all fell dramatically along the corridors where TransMilenio was first put to
work. The system was initially hailed as the solution of Bogots serious
transport problems. Not all results were unambiguously positive, however,
as the paper makes clear. Increased ridership resulted in jammed buses
and rising waiting times. Moreover, the full system covering the entire
city is not expected to be operating until 2015. This gradual transition did
not help: older buses were displaced to secondary streets, where traffic
and pollution increased.
A cost-benefit analysis of the system as is, with approximately 25 percent of the routes in operation, reveals welfare gains for users of the new
routes, but an overall negative effect stemming primarily from increases
in travel time for passengers using the traditional transport system. Since
congestion costs are highly nonlinear, the welfare losses from heightened
congestion in unserved corridors more than offset the benefits from TransMilenio, even though those benefits are sizeable. The authors conclude by
Andrs Velasco
xiii
arguing that the adoption of a new public transport system must be coupled with improved regulation of all other public transport providers, so as
to avoid the problem that arose in Bogot.
What happens to workers wages and employment prospects once they
are displaced from their current jobsfor instance, by trade reform? If they
are likely to be re-hired quickly at comparable wages, then no policy
response is called for; but if some wage losses are large and lasting, then
targeted help for displaced workers may be called for. David Kaplan,
Gabriel Martnez, and Raymond Robertson study the issue for the case of
Mexico, using an administrative data set that allows them to follow individual workers over a period of thirty-two quarters in four regions that vary
significantly in labor market conditions. They focus on the differences in
institutions, inequality, and labor market conditions that may explain differences in wage behavior after displacement.
One striking result is the heterogeneity of worker experiences, which
range from large wage losses to many instances of gains after displacement.
This is consistent with earlier results for other countries, but it cannot be
attributed to differences in institutions (rates of unionization) or inequality, which are quite similar across Mexico. Rather, Kaplan, Martnez, and
Robertson argue that labor market conditions, which vary quite a bit across
time and regions within Mexico, explain the heterogeneity of experiences.
In good times and in the most economically active regions, postdisplacement wages are generally higher than they were in the previous jobs. However, workers who are fired during times of high unemployment and in
less economically active regions experience lasting effects on wages. If any
public assistance is to be disbursed, Kaplan, Martnez, and Robertson
argue, it should go to these workers.
All papers but one included in this issue were presented at the panel
meeting held in San Jos, Costa Rica, in October 2004. The local hosts, and
particularly Juan Rafael Vargas, provided much help. As usual, associate
editors of Economa, members of the 2004 panel, and outside discussants
and referees have done an outstanding job. Thanks is due to them all.
EDUARDO LORA
MAURICIO OLIVERA
2 E C O N O M I A , Spring 2005
for decades, like Colombia, Costa Rica, and Venezuela, and those where
the third wave of democratization was just arriving, such as Argentina,
Brazil, and Uruguay.
The years of high expectations, both about democratization and about
Washington Consensustype policies, are over. Latin Americans are still
convinced democrats, but enthusiasm has waned. Three out of every four
Latin Americans see democracy as the best form of governmentor rather,
as the least bad, since 68 percent think that democracy is not functioning well in their countries. Latin Americans are even more sceptical about
the benefits of promarket economic policies. Only one out of four Latin
Americans considers privatization to have been beneficial for his or her country and barely 16 percent think that the market economy is doing a good job.1
Malaise is getting the upper hand in a number of places. Electricity and
water privatizations were blocked in Arequipa (Peru) and Cochabamba
(Bolivia), following violent clashes between vociferous opponents and the
police. An ambitious project to attract foreign direct investment to
Bolivias gas sector was derailed by the Indian communities. While these
events may be dismissed as isolated expressions of popular feeling, a new
crop of presidents from Nstor Kirchner in Argentina to Lucio Gutirrez
in Ecuador and Tabar Vsquez in Uruguay has won clear majorities in
popular elections after campaigning against the excesses of marketoriented policies.
In an attempt to establish whether this malaise is justified or not, economists have devoted substantial effort to assessing the economic and social
consequences of the Washington Consensus policies. The dominant view
seems to be that they have had positive effects on economic growth and
income levels, though there is intense debate over the size of those effects,
over whether they are transient or permanent, and over the importance of
each of the components of the Washington Consensus. The dominant view
also holds that the effects have been muted by lack of regulatory and institutional support for the liberalization efforts, though the specific forms of
regulation and institutions necessary for that purpose are far from clear.
Even more intense is the debate over the social and distributional effects of
fiscal stabilization and promarket reforms, which are the two main pillars of
the Washington Consensus.2
1. Opinion data come from the 2003 issue of Latinobarmetro, a public opinion survey
conducted by the Corporacin Latinobarmetro, Santiago, Chile.
2. These debates are surveyed in Lora and Panizza (2002); Kuczynski and Williamson
(2003); and Lora, Panizza and Quispe-Agnoli (2004).
However, the future of these policies will depend not so much on their
efficacy but on whether they receive the support of the electorate. On this,
the state of knowledge is much more scant and fragmentary, as will be seen
below. This paper attempts to help fill that vacuum by evaluating through
econometric methods the electoral consequences of the Washington Consensus. Although our approach is backward looking, it sheds considerable
light on the future. Our study shows that the electorate cares not only about
the outcomes of the policies (maybe about only some outcomes and not
others), but also about the policies themselves, irrespective of whether they
produce good or bad (observable) outcomes. In addition, the electorate
seems to care about whether the policies adopted by a government are
in line with the ideology of the incumbents party and with preelectoral
promises. Furthermore, in presidential regimes voters cast separate votes
for the executive and the legislature, and outcomes and policies affect each
vote differently. The presidential vote is more volatile and more susceptible to economic outcomes and policies, but votes for the legislature are not
completely immune: policies in which the legislature clearly plays a role,
such as privatizations, tend to have electoral consequences. These results
provide a nuanced landscape for the future of Washington Consensus policies, where neither bold backslashes nor aggressive promarket reforms
should be expected in the future. Not only is the time of high expectations
over; perhaps the time for deep reforms is also past.
In the next section of the paper we present a short survey of the literature
assessing the electoral consequences of the Washington Consensus policies
and derive our empirical hypotheses. On that basis, we then discuss the theoretical and econometric approaches that support the empirical analysis.
In subsequent sections we describe the data, present the econometric findings, and discuss our conclusions.
A note on terminology is in order before proceeding. Neo-liberal,
market-oriented, orthodox, and a variety of other labels have been
attached to the set of economic policies in vogue since the early nineties in
Latin America and elsewhere. We use these terms interchangeably, but not
loosely: for the sake of clarity and brevity, this paper deals with the ten policies summarized in the classic article by Williamson that made the term
Washington Consensus famous.3 We assume that all those labels refer to
that same set of policies (as detailed below in the section titled Data).
3. Williamson (1990a).
4 E C O N O M I A , Spring 2005
8. For a review of this debate, see Duch and Stevenson (2004); and Keech (1995).
9. On prospective behavior, see, for instance, Lewis-Beck (1988).
10. Remmer (1991, 2003); Coppedge (2001); Roberts and Wibbels (1999); Stokes (2001b).
11. Remmer (1991).
12. Stokes (2001b, p. 27).
13. Remmer (2003).
6 E C O N O M I A , Spring 2005
T A B L E 1 . Summary of Empirical Findings on Economic Voting in Latin America
Study
Dependent variable
Remmer (1991)
Electoral volatility
Remmer (2003)
Vote shares
Electoral volatility
Roberts and
Wibbels (1999)
Coppedge (2001) Vote shares
Probability of a
Stokes (2001b)
security-oriented
candidate being
elected
Election type
(number of
countries)
Period
Estimation
method
Presidential (12)
198290
Pooled OLS
Presidential (8)
198399
Pooled OLS
Legislative and
presidential (16)
Legislative (11)
Presidential (15)
198097
Pooled OLS
197895
198295
Pooled OLS
Probit
Main results
Inflation ; GDP
growth +a
Inflation ; GDP
growth +
Inflation a; GDP
growth +
Inflation
Inflation ; GDP
growth +
changes in the rate of inflation from one administration to the next, whether
positive or negative, produce the opposite effect. Short-term inflation influences support for incumbent presidents, but growth changes have only a
weak effect on the vote for incumbents, which suggests that voters are
more inclined to hold them directly accountable for monetary stability
than economic growth. Although electoral volatility is influenced by economic performance, it is also related to the institutional characteristics of
political regimes and party systems, and to the structure and organization
of class cleavages.14
In her study of neoliberalism by surprise, Stokes uses data from
twenty-three elections in the 1980s and 1990s in order to assess how the
electorate judges incumbents who, having campaigned for stability-oriented
or protectionist policies, once in office switch to market-oriented ones. She
finds that for both, switchers and non-switchers, economic growth
and inflation affect their vote share in the expected ways. Furthermore,
voters are more sensitive to economic outcomes in the case of switchers,
although this result is not statistically significant (more on these results
below).15
These empirical studies taken together lend support to the retrospective
economic voting argument in both presidential and legislative elections.
They make clear that voting decisions are also influenced by political, institutional, and structural factors and that some of these factors may influence
the severity with which voters judge economic outcomes. Therefore, based
on these studies, two testable propositions are derived:
1. Electoral support for the incumbents party is higher, the better the
aggregate economic outcomes during his or her administration.
2. The sensitivity of electoral support to economic outcomes depends on
the institutional characteristics of the political regime and the party system.
As mentioned, in normal economic voting only past outcomes influence
peoples views. However, as in all six of the Stokes case studies on market reforms in new democracies, people sometimes react to economic
deterioration by supporting the government more strongly; and conversely,
they sometimes respond to economic improvements with pessimism and
opposition.16 Normal economic voting is not the only pattern, especially in
the process of deep economic reform. If there are good reasons to believe
14. Roberts and Wibbels (1999), quote from p. 584.
15. Stokes (2001a).
16. Stokes (2001a).
8 E C O N O M I A , Spring 2005
that past circumstances are not good indicators of the future, information
other than past economic outcomes may influence peoples electoral decisions. For instance, voters may recognize that past circumstances were
affected by factors beyond the governments control and exonerate the
incumbent from the responsibility for past declines in their welfare. Voters may then forecast their future welfare as a function of government policy, rather than as an extrapolation of the past. This sounds simpler than
it is, of course, because future government policies are unknown and
because the relationship between policies and outcomes is diffuse. Peoples expectations of future policies may be formed on the basis of the
policies adopted or announced by the incumbent or on the basis of his
partys ideology. These policy expectations may then be translated into
expected outcomes through a set of beliefs and hypotheses about their possible consequences.
It is often implicitly assumed that peoples (average) beliefs conform
to the actual functioning of the real world. If that is so, assessing the
effects of economic policies would help explain voters electoral decisions.
Economists have devoted considerable effort to evaluating the impact of
Washington Consensus policies on economic growth, income distribution, employment levels, and a host of other variables.17 However, there
has been no comparable effort to examine whether these results are consistent with how the electorate responds to those policies. The only study
on the subject, by Carlos Gervasoni, has found positive correlations
between several indicators of heterodox (that is, anti-neoliberal) policies
and losses in the vote shares of the parties of the incumbents who adopted
those policies.18 The variable with the largest and most significant effect is
money supply growth. Import protection indicators are also significant,
whereas fiscal deficit and the share of the state in GDP are not significant.
These results suggest that Washington Consensus policies do not entail
electoral costs and may even produce electoral benefits, probably because
they bring positive economic effects. It is suggestive that the most significant policy variable is the money supply, because it is well known that
inflation is, ultimately, a monetary phenomenon, and as mentioned, empirical evidence suggests that inflation is a key economic outcome influencing
electoral decisions.
17. For surveys of the literature, see Inter-American Development Bank (2003, chap. 5);
Kuczynski and Williamson (2003); and Lora and Panizza (2002).
18. See Gervasoni (1997), citing a 1995 study.
However, it is a great leap of faith to assume that peoples beliefs conform to the actual consequences of policies. In mapping policies on outcomes, ideology and leaders opinions may be more important for most
people than their limited understanding of how policies work their influence
through the social and economic structures to affect production, employment, or income distribution. Evidence on how those factors influence
electoral responses to economic policies is very scant. However, in-depth
case studies on Argentina and Venezuela by Javier Corrales clearly show
that the reaction of the electorate to the adoption of neoliberal economic
policies in the 1990s was mediated by the party structure and other institutional factors.19 The cohesion and tactics of the Partido Peronista help
explain the electorates support of the neoliberal reforms in Argentina in
the early 1990s, as well as their demise a decade later. Venezuelas Accin
Democrtica lacked that cohesion, and its reforms were soon rejected by
the electorate.
If voters care about policies and not only about past outcomes, the policy announcements of presidential candidates will be a key source of information. However, campaign promises are often poor predictors of actual
policy: according to Stokes, of the thirty-three Latin American governments that adopted promarket reforms between 1982 and 1995, only about
half (seventeen) hinted during their campaigns that such reforms were
going to be implemented.20 This raises several empirical issues. First, do
policy announcements in fact influence electoral decisions? Empirical evidence from the United States and other advanced industrialized economies
shows that they do: people seem to base their opinions in part on campaign
announcements, and voters punish ambiguous campaigns.21 Of course,
some promises may resonate more than others, depending on, among other
things, economic circumstances. For thirty-eight Latin American elections
in the 1980s and 1990s, Stokes finds that stability-oriented candidates (as
opposed to market-oriented ones) stand a better chance of being elected,
the lower the rates of GDP growth and inflation.22
A second empirical issue is whether deviating from campaign promises
carries electoral costs for the incumbent. Although deviations may in
principle be costly, they may produce a positive payoff if they signal the
19.
20.
21.
22.
Corrales (2002).
Stokes (2001a).
For a brief review of this topic, see Stokes (2001a, pp. 45).
Stokes (2001a, pp. 9397).
10 E C O N O M I A , Spring 2005
incumbents commitment to achieving highly desirable economic outcomes at the expense of more immediate partisan support.23 According to
Stokes, deviating from campaign promises does carry electoral costs,
although only weakly.24 However, since her estimates control for economic outcomes, this result implies that policy switches may still have a
positive electoral payoff if the new policies bring substantial economic
improvement. Neoliberalism by surprise may still be a good political
strategy.25
A common theme in the literature on economic voting is the conditional
nature of voters responses to economic outcomes and policies. As mentioned, the severity of their judgment depends on their attachment to the
party in power, the structure of the party system, and other institutional
considerations. It also depends, although weakly, on whether the policies
adopted by the incumbent are in line with his campaign pronouncements.
An additional variation on this theme holds that the electorate is better prepared to support untested policies, even if they may cause short-term duress
or if they run counter to established beliefs, when economic conditions have
deteriorated.26 However, once conditions improve or simply stabilize, tolerance subsides and support for further reforms wanes. Therefore, while
uncertainty is welcome at the outset of the reform process, certainty is the
key factor for its consolidation. Based on case studies of Peru and Argentina,
Kurt Weyland offers persuasive evidence that the public was supportive to
the reform process while there was a perception of acute economic crisis.27
Even though the reformers were reelected, support for their economic programs was already diminishing. Corrales endorses this view in his analysis
of the reform process in Argentina and Venezuela, although he acknowledges that in the latter case support for reform was never very strong.28
Therefore, the literature on economic voting suggests that policies, not
only outcomes, may influence electoral decisions. As with outcomes, voters
position with respect to policies may be mediated by a host of factors,
including ideological considerations, policy pronouncements during the
23. For a theoretical approach, see Cukierman and Tommasi (1998).
24. Stokes (2001a, p. 95).
25. Cukierman and Tommasi (1998); Navia and Velasco (2003).
26. This behavioral hypothesis is based on seminal work by Thaler and others (1997),
Kahneman and Tversky (1979), and Tversky and Kahneman (1991), who find that people are
more prone, even eager, to assume risks after experiencing losses.
27. Weyland (2002).
28. Corrales (2002).
11
electoral campaign, and the state of the economy at the time of elections.
This gives rise to the following additional testable propositions:
3. Electoral support for the incumbents party depends on the economic
policies adopted. Policies may carry electoral costs even when they deliver
good economic outcomes.
4. The electorates tolerance of unpopular policies depends on the ideology of the incumbents party, his or her campaign statements, and the
initial state of the economy.
Empirical Approach
None of the empirical literature just reviewed offers a full-fledged theoretical model of electoral behavior, and we have no intention of providing
one. However, the series of hypotheses arising from that literature can be
organized in a simple framework such that the persistence of the vote for
the incumbents party is a function of a vector of economic outcomes and
a vector of policies (both relative to their past values):
X
P
Vt
= A t t ut ,
Xt 1 Pt 1
Vt 1
where Vt and Vt 1 are the share of the vote for the incumbents party at the
end and the beginning, respectively, of its term in office; Xt and Xt 1
are the economic outcomes at the time of each election; and Pt and Pt 1
are the policies at those two moments. A is the set of other parameters that
may influence the stability of the vote for the party in office, and ut is an
error term. and are our parameters of interest. In this simple framework, hypothesis 1 states that is positive for economic outcomes that are
desirable, such as growth, or negative for undesirable ones, such as inflation or unemployment (and assumes that is zero, since it ignores the
influence of policies). Hypothesis 2 postulates that is a function of some
features of the political system, such as party fragmentation or the ideological polarization of the party system. The stronger these features, the
higher the electorates response to the economic outcomes. Hypothesis 3,
which postulates that the electorate cares about the choice of policies,
implies that is not zero but probably negative if the policies are market
oriented. Finally, hypothesis 4 states that some aspects of the political
and economic context when the incumbents party was initially elected
may affect the way the electorate judges the adoption of policies. This
12 E C O N O M I A , Spring 2005
13
uated, and t 1, when it was elected for office; d log(Xt) and d log(Pt) are
the changes in (log measures of the) outcomes and policies, respectively;
t is equivalent to log(ut); and + log(F ) is equal to log(A), with as a
constant parameter and F as a set of political control variables.
We estimate separate models for presidential and legislative elections
with panel data for seventeen countries starting from the mid-1980s
described below. Potential problems of heteroscedasticity and endogeneity need to be addressed in this type of specification. The former may arise
from country or party heterogeneity and is dealt with by the use of White
robust standard errors. The endogeneity problem stems from potential omitted
variables, since differentiating countries solely by the economic and policyrelated variables included in sets X and P may not capture all the sources of
heterogeneity.32 This is partly dealt with by the inclusion as controls of a set
of political variables (represented by F). However, other country-related
factors might bias the estimations if they are correlated with the explanatory
variables. To take care of this problem, we run all the regressions with country fixed effects (although, admittedly, our sample size is too small to get
precise estimation of these effects).33 The fixed effects estimator is
d log(Vt ) = + log( Ft ) + d log( Xt ) + d log( pt ) + C + t ,
where C is the set of country dummies.
3 (198999)
4 (198597)
3 (198998)
3 (198999)
5 (198602)
5 (198602)
5 (19862000)
4 (198898)
4 (198499)
4 (198599)
5 (19852001)
3 (19882000)
3 (19902001)
4 (19852000)
4 (19892003)
3 (198499)
4 (19882000)
66
Presidential
8 (198599)
4 (198597)
4 (198698)
4 (19892001)
5 (198698)
5 (19862002)
4 (19862000)
7 (198698)
6 (19852000)
5 (198597)
5 (19852001)
6 (19852000)
3 (19902001)
4 (19852000)
4 (19892003)
3 (198499)
4 (19882000)
81
Legislative
2
3
2
2
2
2
3
4
2
4
2
2
1
3
1
2
4
2.4
Presidency
3
3
2
2
1
2
3
2
2
4
2
1
2
4
1
2
1
2.2
2.77
4.06
6.60
4.90
2.66
2.31
2.48
6.05
2.68
3.31
2.18
2.38
2.05
3.80
2.21
3.19
3.92
3.39
Mean
2.30
3.42
2.76
4.84
2.21
2.21
2.18
4.29
2.41
2.35
2.00
1.85
2.05
2.50
1.88
2.92
2.34
2.62
Minimum
Fragmentationa
3.06
5.08
8.27
4.99
3.09
2.56
2.88
7.56
3.06
4.44
2.58
2.82
2.05
5.83
2.54
3.32
5.79
4.11
Maximum
0.23
0.52
0.25
0.16
0.16
0.42
0.55
0.36
0.39
0.24
0.42
0.32
0.58
0.51
0.40
0.42
0.30
0.37
Polarization index
Source: Payne and others (2002), complemented with the Political Database of the Americas (Organization of American States and Georgetown University).
a. Effective number of parties in the legislature.
b. In Chile, the effective number of parties differs from the number of coalitions (Concertacin and Alianza por Chile), which are close to 2 in effective terms and of which only Concertacin has held the presidency.
Argentina
Bolivia
Brazil
Chileb
Colombia
Costa Rica
Dominican Republic
Ecuador
El Salvador
Guatemala
Honduras
Mexico
Nicaragua
Peru
Paraguay
Uruguay
Venezuela
Total or average
Country
Presidential elections
Votes (share)
Fragmentation
Polarization
Promises
Ideology
Growth (log, change)
Inflation (loss of
purchasing
power, change)
Unemployment (change)
Gini index (change)
Macro index
(log, change)
Structural index
(log, change)
Institutional Index
(log, change)
0.24
0.55
0.13
0.16
0.25
0.05
0.18
0.24
0.02
0.22
0.14
0.24
0.07
0.09
0.27
0.33
0.46
0.19
1.00
0.09
0.05
0.03
0.02
1.00
0.32
0.20
0.16
0.16
0.21
1.00
0.32
0.45
0.06
0.15
0.08
0.27
0.02
0.16
0.21
1.00
0.37
0.25
0.00
0.05
0.11
0.16
0.28
0.09
1.00
0.14
0.01
0.24
0.25
0.41
0.27
0.23
1.00
0.10
0.26
0.12
1.00
0.48
0.13
0.24
0.33
0.27
1.00
0.09
0.15
0.37
0.00
1.00
0.03
0.02
1.00
0.44
1.00
1.00
(continued )
Inflation (loss
Institutional
Votes
Growth
of purchasing Unemployment Gini index Macro index Structural index
index
(share) Fragmentation Polarization Promises Ideology (log, change) power, change)
(change)
(change) (log, change) (log, change) (log, change)
T A B L E 3 . Correlations
0.07
0.12
0.61
0.26
0.29
0.10
0.20
0.15
0.26
0.31
0.08
0.13
0.17
0.29
0.04
0.14
0.47
0.18
0.09
0.32
1.00
0.36
0.23
0.24
0.34
0.38
0.19
1.00
0.40
0.38
0.03
1.00
0.16
0.32
0.20
0.33
1.00
0.11
0.43
0.19
0.09
0.19
Legislative elections
Votes (share)
Fragmentation
Polarization
Promises
Ideology
Growth (log, change)
Inflation (loss of
purchasing
power, change)
Unemployment
(change)
Gini index
(change)
Macro index
(log, change)
Structural index
(log, change)
Institutional Index
(log, change)
0.21
0.34
0.08
0.07
0.43
0.24
1.00
0.05
0.15
0.08
0.83
0.01
0.38
0.30
1.00
0.23
0.20
0.63
0.17
0.34
1.00
0.47
0.01
0.10
0.18
1.00
0.20
0.51
0.08
1.00
0.29
0.15
1.00
0.32
1.00
1.00
Inflation (loss
Institutional
Votes
Growth
of purchasing Unemployment Gini index Macro index Structural index
index
(share) Fragmentation Polarization Promises Ideology (log, change) power, change)
(change)
(change) (log, change) (log, change) (log, change)
T A B L E 3 . Correlations (continued )
17
Dependent Variable
Our dependent variable is the change in the share (in logs) of votes36 for
the incumbents party in presidential elections, and for the majority party
34. The effective number of parties is calculated using the Laako-Taagepera index, defined as the inverse of the sum of the squares of the shares (measured by the number of seats)
of all the parties in the legislature; Payne and others (2002).
35. More precisely, the index is calculated in two steps. First, the average position of
the electorate on a left-right scale (APLR) is calculated as a weighted average of the party
positions on a scale from 1 to +1, where the weights are the shares of the votes:
APLR = 1*(% votes obtained by parties on the extreme left) 0.5*(% votes for parties
on the center left) + 0.5*(% votes for parties on the center right) + 1*(% votes for parties on
the extreme right).
In the second step, the polarization index (IP) is calculated as a weighed deviation from
the APLR:
IP = 1 APLR * (% votes left) + 0.5 APLR * (% votes center left) + 0.5
APLR * (% votes center right) + 1 APLR * (% votes right).
A minimum of 0 is reached when all the votes are in one ideological bloc; and a maximum of 1, when half of the votes are at each extreme. Ideological orientations are taken
from Coppedge (1997) and the World Banks Database of Political Institutions, 2002
(www.worldbank.org/research/bios/pkeefer.htm).
36. The share of votes comes from Payne and others (2002).
18 E C O N O M I A , Spring 2005
in the legislature in legislative elections. Since we use logs for both the
dependent and (when possible) the independent variables, the estimated
coefficients can be interpreted as elasticities.
Some calculations were necessary in order to compute the share of votes,
especially for presidential elections, when party coalitions or party dissolutions had taken place before and after the elections, as well as to be able to
account for new independent parties. These calculations treat coalitions as
regular parties. The vote for the coalition party in the election previous to its
creation is simply computed as the sum of the votes of the joining parties.
When parties break up, the same procedure is used for the following elections. Table 4, which presents summary statistics for the most important
variables, shows that the share of votes varies from 0 to 64 percent for
presidential elections and 62 percent for legislative elections, with means
of 35 percent and 36 percent, respectively.
Political Variables
The political variables used as independent variables attempt to measure
key dimensions of the party system and the political environment. Following the literature review, they are to be included in the regressions both as
independent controls and/or interacted with the variables measuring economic outcomes. Fragmentation (or the effective number of parties) and
polarization, already described, are the two basic dimensions of the party
system. In addition, we use a dummy for divided governments (when the
presidents party is not the largest party in the legislature).37
We also use several variables intended to measure the electorates expectations about the future orientation of economic policies. The first, named
promarket promises, measures to what extent the positions adopted by
incumbents during their election campaigns were promarket; it is a rescaled version of a variable computed by Stokes.38 The second, named
right-oriented ideology, a measure taken from the World Banks Database
37. Taken from Payne and others (2002). Divided government is not frequent in Latin
America, in contrast to the United States; Alesina, Londregan, and Rosenthal (1993);
Alesina and Rosenthal (1995, 1996); Fiorina (1992). The only cases in our data set are
mainly concentrated in Brazil and Ecuador (six), with one in the Dominican Republic. More
recently, the PRI lost its monopoly power in Mexico.
38. Based on an ordinal variable computed by Stokes (2001a, p. 3) that classifies forty presidential pre-electoral campaigns according to the importance assigned by the candidates to
issues of economic security vis--vis economic efficiency, the promises variable takes values
on a scale from 0 to 1, where higher values indicate more efficiency-oriented messages.
Dependent
Votes (shares)
Political
Fragmentation
Polarization (01)
Divided government (dummy)
Rule of law
Promises (01)
Ideology (01)
Switch index with ideology (1, +1)
Switch index with promises (1, +1)
Outcome
Inflation (log, change)
Growth (log, change)
Crisis
Unemployment (log, change)
Gini index (log, change)
Washington Consensus
Macro index (log, change)
Structural fiscal balance (ratio to GDP, change)
Real exchange rate (detrended in logs, change)
Social expenditures (share of GDP, change)
Structural reforms index
Structural reform index (log, change)
Trade index (log, change)
Financial index (log, change)
Tax index (log, change)
Privatizations index (change)
Institutional index
Variable
T A B L E 4 . Summary Statistics
0.03
0.01
0.01
0.00
0.01
0.09
0.01
0.02
0.00
0.01
0.12
0.00
0.00
0.01
0.23
0.18
0.30
0.10
0.09
0.27
49
52
52
44
49
51
44
51
50
49
49
51
52
52
51
0.19
0.06
0.03
0.06
0.00
0.19
0.06
0.00
0.04
0.00
2.70
0.33
0.00
0.44
0.50
0.50
0.00
0.01
3.33
0.38
0.13
0.23
0.55
0.60
0.00
0.05
52
51
47
16
33
42
39
32
0.36
Median
0.35
Mean
48
Number of
observations
0.21
0.30
0.44
0.23
0.17
0.35
0.40
0.04
0.26
0.02
0.24
0.08
0.04
0.03
0.03
1.62
0.22
0.34
0.50
0.26
0.33
0.08
0.12
0.17
Standard
deviation
Presidential elections
0.32
0.14
0.15
0.09
0.10
1.70
0.12
0.67
0.05
0.78
1.15
1.38
0.81
0.97
1.26
1.00
0.07
0.61
0.02
0.09
0.32
0.15
0.29
0.03
0.22
8.27
0.92
1.00
1.19
1.00
1.00
0.48
0.24
0.64
Maximum
0.74
0.25
0.00
0.08
0.10
1.85
0.03
0.00
0.81
0.25
0.00
0.11
0.06
0.00
Minimum
68
68
70
72
72
71
70
63
70
69
71
72
72
63
69
72
67
72
16
25
68
39
72
Number of
observations
0.17
0.15
0.23
0.10
0.06
0.19
0.08
0.00
0.01
0.01
0.07
0.02
0.02
0.00
0.00
3.37
0.34
0.01
0.23
0.56
0.55
0.00
0.36
Mean
0.12
0.04
0.03
0.03
0.00
0.10
0.04
0.00
0.01
0.00
0.04
0.02
0.00
0.00
0.01
2.80
0.30
0.00
0.44
0.50
0.33
0.00
0.38
Median
0.19
0.29
0.35
0.23
0.15
0.28
0.34
0.03
0.22
0.02
0.20
0.06
0.03
0.03
0.03
1.54
0.19
0.12
0.50
0.27
0.32
0.08
0.14
Standard
deviation
Legislative elections
0.09
0.24
0.15
0.29
0.01
0.51
0.99
0.07
0.61
0.03
0.71
0.19
0.14
0.06
0.10
1.85
0.03
0.00
0.81
0.25
0.00
0.11
0.00
Minimum
0.78
1.15
1.38
0.71
0.97
0.93
1.70
0.11
0.67
0.06
0.40
0.15
0.00
0.07
0.10
8.27
0.91
1.00
1.19
1.00
1.00
0.48
0.62
Maximum
20 E C O N O M I A , Spring 2005
Economic Outcomes
Following the empirical literature on economic voting, we focus on inflation
and growth as the two main economic outcomes of interest, but we also test
other variables, such as unemployment and income concentration. We measure inflation as the average annual loss of purchasing power of a currency
unit, rather than as the increase in the price index, since this reduces the
extreme observation problem that arises with the cases of high or hyperinflation. We apply the formula 1 (1/(1 + )), where is the price increase
during the last year of the administration. Economic growth is measured
as the rate of annual change (in logs) in GDP. In addition to inflation and
growth, we test for the influence of two other outcomes: the unemployment
rate and the Gini coefficient of distribution of per capita household income.41
Policy Variables
As mentioned in the introduction, we define the Washington Consensus in
accordance with the list of policies included in Williamson.42 Since those
policies cover a variety of areas, from fiscal to institutional, we use the
39. World Bank, Database of Political Institutions, 2002 (www.worldbank.org/research/
bios/pkeefer.htm); Coppedge (1997).
40. The switch indexes range from 1 to +1. In the first type, 1 indicates that having
adopted the most pro-efficiency stance during the campaign, the candidate does not implement any promarket reform once in office; +1 indicates that having adopted the most prosecurity position in the campaign, the candidate once in office becomes the most aggressive
promarket reformer. The formula is then SI = [change in reforms (PROMISES median
PROMISES)]. In the other type of switch index, the variable PROMISES is replaced by our
measure of party ideology.
41. Prices and GDP are taken from International Monetary Fund, World Economic Outlook (online). Unemployment is from ECLAC (various years). Gini coefficients for incomes
are from Deininger and Squire (1998).
42. Williamson (1990a).
21
22 E C O N O M I A , Spring 2005
used in this calculation are from the World Bank and terms of trade data
are from the Economic Commission for Latin America and the Caribbean
(ECLAC).45
Public expenditure in social services includes only education and
health expenditures, based on data from ECLAC and complemented with
data from World Bank.46
The measure of competitive exchange rates is the log distance between
the observed real exchange rate and its trend, computed with a standard
Hodrick-Prescott filter.47
Tax reform is taken from previous work by Lora, who constructs a
composite index of the levels and effectiveness of corporate, personal, and
value added taxes.48
Interest rate liberalization is measured by Loras index of financial
liberalization, which includes information on interest rate freedom, reserve
requirements, and quality of regulation and supervision of the financial
sector.
Trade liberalization is also taken from Lora, who uses an index that
combines import tariff averages and dispersion.
Privatization is measured by Loras index of the cumulated value of
the sales of state-owned firms to the private sector, as a share of the GDP.
Protection of property rights is a combined measure of the risk of
expropriation and the risk of repudiation of government contracts, on a
scale from 0 to 1 (the higher the index, the lower the risk).49
The composite index of macroeconomic policies is a simple average
of the indicators of its three components scaled from 0 to 1, where 0 corresponds to the lowest observation and 1 to the highest observation for the
whole period and set of countries in the sample.
The composite index for structural reforms is calculated as the simple average of the indexes for tax reform, financial liberalization, trade liberalization, and privatization (each of which is also calculated on a scale
from 0 to 1).50
45. World Bank, World Development Indicators (online); ECLAC (various years).
46. World Bank, World Development Indicators (online); ECLAC (various years).
47. Real exchange rate data are from IMF, World Economic Outlook (online).
48. Tax reform, interest rate liberalization, and privatization are all from Lora (2001).
49. Taken from the International Country Risk Guide, 2004 (www.icrgonline.com).
50. Note that this composite index is not identical to the total reform index computed
by Lora (2001), since the latter includes labor reform, which is not among the Washington
Consensus policies.
23
Econometric Results
Before discussing the hypotheses in detail, it is helpful to convey the thrust
of our findings. The regression summarized in table 5 indicates that the
electorate is highly sensitive to one economic outcomeinflationand
strongly rejects the adoption of promarket policies. Our estimates imply
that the typical reduction in the rate of inflation, from say 20 percent to
8 percent during a presidents tenure, boosts the vote for his party by
21 percent.52 However, if that same incumbent also introduces the average
amount of promarket reform, the resultant party losses account for 23 percent of the vote. Put a different way, the adoption of the standard Washington Consensus package brings positive electoral payoffs only when
implemented in a period of high inflation. Thus, if the same dose of promarket reform is adopted as part of a package that reduces inflation from
100 percent to 8 percent, the net electoral effect is a handsome 82 percent
increase in vote share.
Admittedly, our basic regression overstates the negative effect of the
promarket policies because those policies may help to reduce the rate of
inflation and increase the rate of growth.53 Taken to the extreme, this argument would imply that the total effect of the adoption of promarket policies would be the sum of the direct effect captured in the coefficient of the
regression in table 5 and the indirect effects of the changes in the rates of
inflation and growth. Based on this calculation (see tables 6A and 6B), the
total effect does appear to be substantially milder: 0.97 instead of 1.57.
Nevertheless, it would still be substantial, as it would imply that the typi-
51. These results, which are not included in this version of the paper, are available upon
request from the authors.
52. This reduction corresponds to the average value of our measure of the change of
inflation.
53. The regression includes several other control variables that may also affect the vote
(see notes to table 5).
24 E C O N O M I A , Spring 2005
T A B L E 5 . Impact of Economic Outcomes and Washington Consensus Policies
in Presidential Elections, 19852002: Country Fixed Effects Results
Independent variablesa
Economic outcomes
Inflation (change in loss of purchasing power)
Growth (change in growth rate, log)
Washington Consensus reforms
Structural reforms index (log, change)
Constant
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
cal reformist government must still sacrifice 15 percent of the vote for the
sake of the reforms.54 However, this calculation most likely overestimates
the effects of the reforms on growth and inflation, as we have not isolated
the influence of other factors on these two variables. Therefore, the central
conclusion is that even if we grant that promarket reforms have strong beneficial effects on growth and inflation, their electoral cost is far from negligible.
Apart from promarket reforms, the other Washington Consensus policies do not affect the electorates behavior. Likewise, we find no robust
evidence that any economic outcomes other than inflation affect the vote
in presidential elections. We do find that these results are affected by some
features of the political system. In legislative elections the results are less
straightforward, as they are strongly mediated by several contextual and
political variables.
Do Outcomes Matter?
We start our empirical analysis by testing the simplest version of the economic voting model, in which voters update their opinion on the incumbents party based entirely on the changes observed since the last election
54. Note that the total effect would be reduced only slightly (to 0.84) if the indirect
effect through growth, which has the wrong sign, is not included.
25
Inflation
Growth
0.361
2.030
0.733
0.133
1.016
0.135
Total
0.598
1.569
0.971
Inflationa (1)
Growthb (2)
0.361 (1.88)*
0.103 (0.48)
0.133 (2.10)**
0.063 (0.78)
49
17
0.37
Yes
49
17
0.26
Yes
43
17
0.47
Yes
0.804
(1.73)*
0.345
(1.05)
0.588
(1.31)
(1)
43
17
0.48
Yes
0.453
(1.41)
0.938
(0.80)
0.442
(0.82)
(2)
43
17
0.48
Yes
1.028
(2.13)**
0.588
(1.19)
0.939
(0.79)
0.539
(1.11)
(3)
43
17
0.6
Yes
0.743
(1.30)
1.127
(1.80)*
0.121
(0.18)
0.700
(0.73)
0.451
(0.86)
(4)
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
Constant
Economic outcomes
Inflation (change in loss of purchasing power)
Polarization (lagged)
Political
Fragmentation (lagged)
Independent variable
43
17
0.48
Yes
1.030
(1.99)*
0.034
(0.03)
0.589
(1.14)
0.938
(0.78)
0.537
(1.09)
(5)
41
17
0.48
Yes
1.157
(1.82)*
0.624
(0.23)
0.669
(1.19)
1.192
(0.70)
0.584
(1.05)
(6)
37
15
0.56
Yes
2.510
(1.06)
0.824
(1.01)
0.364
(0.45)
3.636
(1.11)
0.629
(1.98)*
(7)
T A B L E 7 . Impact of Economic Outcomes in Presidential Elections, 19852002: Country Fixed Effects Resultsa
37
15
0.74
Yes
1.924
(2.08)*
2.683
(1.45)
2.256
(0.70)
4.307
(1.24)
0.806
(0.99)
0.546
(0.59)
3.150
(1.44)
0.171
(0.48)
(8)
43
17
0.66
Yes
0.786
(1.56)
1.674
(1.91)*
2.828
(1.70)
0.023
(0.04)
0.509
(0.64)
0.269
(0.76)
(9)
27
Table 7 lends some support to this simple version of the economic voting
hypothesis: in all the regressions, changes in inflation have the expected sign
and have a significant impact on the presidential vote. However, changes in
growth rates are seldom significant and when included in a regression with
inflation show the wrong sign. Results for unemployment and inequality
are similarly weak. When all four economic variables are included in the
same regression, inflation remains the only significant variable. In legislative elections (see table 8) growth is the only one that is sometimes
significantbut it is not when all economic variables are included in the
same regression. Therefore, inflation and growth seem to matter for the leading party or parties, but through different channels. The size of the coefficients suggests that the incumbent loses 12 percent of his vote for
each (additional) 1 percent of (annual) loss in the purchasing power of the
currency in the last year of his administration (with respect to the loss in
the year prior to his administration). Likewise, the largest party in the legislature increases its share of seats by about 1 percent for each (additional)
1 percent of economic growth in the year before the election (with respect
to the year immediately before the previous election). Neither changes in
the unemployment rate nor income distribution changes appear to have a
clear effect on electoral behavior.
These conclusions must now be qualified in accordance with our second hypothesis, namely, that the electorates response to the economic
outcomes, , depends on several features of the political system, F (some
of which, as tables 7 and 8 show, also have a direct influence on voters
behavior):
= + log( F0 ).
Replacing in the previous equations gives (with fixed effects)
+ log ( F0 d log ( X t + C + t .
Note that in the interaction terms we use the values of F at the earliest period of our sample, F0, in order to reduce endogeneity. However,
we use the values of F at the beginning of each electoral cycle, Ft 1, to
directly control for these variables, since the inclusion of country fixed effects
74
17
0.53
Yes
0.911
(3.33)***
0.007
(0.05)
0.868
(3.86)***
(1)
74
17
0.30
Yes
0.204
(1.19)
0.068
(0.21)
0.279
(1.52)
(2)
74
17
0.53
Yes
0.998
(3.31)***
0.894
(4.01)***
0.240
(0.70)
0.014
(0.09)
(3)
71
17
0.40
Yes
0.649
(2.77)***
0.086
(0.38)
0.572
(2.99)***
0.157
(0.53)
0.011
(0.08)
(4)
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
Constant
Unemployment (change)
Economic outcomes
Inflation (change in loss of purchasing power)
Polarization (lagged)
Political
Fragmentation (lagged)
Independent variable
71
17
0.43
Yes
0.526
(2.26)**
0.861
(1.77)*
0.507
(3.26)***
0.125
(0.49)
0.052
(0.41)
(5)
72
17
0.55
Yes
1.027
(3.39)***
1.322
(0.79)
0.915
(4.23)***
0.304
(0.78)
0.017
(0.12)
(6)
65
15
0.60
Yes
1.529
(0.86)
1.356
(3.69)***
1.056
(4.42)***
1.116
(2.26)**
0.029
(0.19)
(7)
(8)
62
15
0.47
Yes
0.07
(0.26)
0.064
(0.10)
0.043
(0.03)
1.070
(0.59)
0.937
(2.75)***
0.705
(2.87)***
0.853
(2.08)**
0.001
(0.00)
Dependent variable: Change in log of vote share of party with most seats in legislature
T A B L E 8 . Impact of Economic Outcomes in Legislative Elections, 19852002: Country Fixed Effects Resultsa
71
17
0.43
Yes
0.542
(2.33)**
0.053
(0.23)
0.913
(1.64)
0.529
(2.85)***
0.120
(0.46)
0.051
(0.40)
(9)
29
precludes the use of time-invariant F0. None of the results reported below is
sensitive to whether we include the set of F variables as direct controls.
Tables 9 and 10 suggest that the electorates response to the economic
outcomes is indeed affected by the structure of the political system, and in
the expected manner. In presidential elections (table 9), the more fragmented the party system, the more harshly the electorate punishes the
incumbents party for an increase in the inflation rate.56 The intuition
behind this result is that in more fragmented party systems there is more
competition for votes, and probably also more information available to
the voters and a wider choice of policy proposals, all of which enhance
the response of the electorate to changes in the economic situation. One
should expect this response to be stronger in presidential than in legislative elections, given the winner-take-all nature of the former. A divided
government affects the response of the electorate to inflation in a similar
way. However, due to the small number of cases of divided government,
we do not attach much relevance to this result.57 In contrast to party fragmentation, the degree of polarization does not seem to have any significant
influence on the electorates response to the economic outcomes in presidential elections.
In legislative elections (table 10), the opposite is the case: while the interaction terms between economic outcomes and fragmentation are not significant, the interaction with ideological polarization is significant for inflation
and for growth. This implies that the more distanced the economic policy
platforms of the parties, the stronger the swings of the electorate in response
to changes in the macroeconomic outcomes. From regression 5, when the
degree of polarization is high (0.53), each percentage point of extra growth
brings an increase of about 1 percent in the vote for the largest party in the
legislature, while this elasticity becomes negative (0.4) when the degree of
polarization is low (0.15). Our results indicate that the legislative vote is also
sensitive to inflation outcomes, depending on the degree of ideological
polarization of the party system, with implied elasticities of 0.3 when
polarization is high and 0.38 when polarization is low (regression 2).
To summarize, our results suggest that economic outcomes do matter in
presidential as well as in legislative elections, though in different ways.
The executive is held more accountable for increases in inflation, and
56. However, this result does not hold in a similar regression without fixed effects (results
available from the authors upon request).
57. Furthermore, similar regressions for growth show implausibly high coefficients for
the interaction term (GROWTH*DIVIDED GOVERNMENT).
Growth*initial polarization
Growth*initial fragmentation
Inflation*divided government
Inflation*initial polarization
Inflation*initial fragmentation
Polarization (lagged)
Political
Fragmentation (lagged)
Independent variable
3.153
(2.66)**
3.351
(3.50)***
1.316
(2.27)**
0.426
(0.77)
0.5
(1.46)
(1)
5.039
(1.62)
3.288
(1.86)*
0.187
(0.24)
0.054
(0.08)
0.19
(0.40)
(2)
4.868
(19.97)***
0.402
(1.89)*
0.692
(1.53)
0.205
(0.40)
0.373
(0.92)
(3)
1.717
(0.48)
1.751
(0.40)
0.732
(1.15)
1.002
(0.83)
0.492
(0.91)
(4)
2.849
(0.40)
1.198
(0.49)
0.667
(1.35)
1.04
(0.78)
0.664
(1.00)
(5)
1.032
(0.95)
0.141
(0.19)
1.518
(1.11)
1.028
(1.59)
T A B L E 9 . Impact of Economic Outcomes Interacted with Political Features in Presidential Elections, 19852002: Country Fixed Effects Resultsa
43
17
0.80
Yes
1.545
(2.45)**
43
17
0.70
Yes
0.474
(0.52)
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
Constant
Growth*divided government
43
17
0.87
Yes
0.938
(2.10)**
43
17
0.49
Yes
1.191
(1.95)*
43
17
0.49
Yes
1.142
(2.03)*
43
17
0.59
Yes
36.076
(1.80)*
0.427
(0.67)
Inflation*divided government
Inflation*initial polarization
Inflation*initial fragmentation
Polarization (lagged)
Political
Fragmentation (lagged)
Independent variable
0.560
(0.61)
0.680
(0.66)
0.606
(3.25)***
0.135
(0.45)
0.007
(0.05)
(1)
1.781
(3.03)***
0.646
(2.16)**
0.566
(2.77)***
0.205
(0.76)
0.069
(0.50)
(2)
0.495
(1.37)
0.322
(1.14)
0.565
(2.96)***
0.132
(0.52)
0.039
(0.31)
(3)
0.035
(0.03)
0.523
(3.32)***
0.124
(0.48)
0.038
(0.29)
(4)
1.024
(1.54)
0.566
(3.75)***
0.078
(0.35)
0.002
(0.02)
(5)
2.678
(1.54)
0.468
(2.56)**
0.066
(0.25)
0.158
(1.05)
(6)
Dependent variable: Change in log of vote share of party with most seats in legislature
0.429
(0.57)
1.263
(1.77)*
0.543
(1.68)*
0.557
(2.82)***
0.127
(0.57)
0.044
(0.31)
(7)
T A B L E 1 0 . Impact of Economic Outcomes Interacted with Political Features in Legislative Elections, 19852002: Country Fixed Effects Resultsa
71
17
0.41
Yes
0.687
(3.00)***
71
17
0.46
Yes
0.699
(2.89)***
71
17
0.45
Yes
0.630
(2.53)**
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
Constant
Growth*divided government
Growth*initial polarization
Growth*initial fragmentation
71
17
0.44
Yes
0.553
(2.32)**
0.981
(0.69)
71
17
0.48
Yes
0.631
(2.84)***
3.781
(3.40)***
71
17
0.45
Yes
2.072
(1.15)
0.340
(1.26)
71
17
0.51
Yes
0.647
(2.66)**
2.548
(1.80)*
34 E C O N O M I A , Spring 2005
Do Policies Matter?
The next step is to establish whether the electorate cares about policies,
and not only about outcomes. For parsimony, and given our limited sample sizes, we ignore the influence that the features of the political system
may have on voters sensitivity to the economic outcomes. We also ignore
other factors that may affect how the electorate feels about the adoption of
certain policies and focus on the direct electoral effects of the policies
themselves, as captured in :
d log(Vt ) = + log( Ft 1 ) + d log( Xt ) + d log( Pt ) + C + t .
The first four regressions in table 11 assess the influence on presidential elections of the set of macroeconomic policy indicators defined earlier.
The only indicator that shows some significance is the structural fiscal balance, which appears with a negative sign in regression 2, implying that the
electorate reacts against fiscal restraint (however, the coefficient implies
that this effect is very small). Note that inflation always keeps the right
sign and remains significant in this particular regression, although it loses
its significance in some others. Therefore, although the electorate seems to
want price stability, it does not rewardand may even punishan incumbent for some of the macroeconomic policies that may be needed to achieve
those outcomes, such as stronger fiscal balance.
The electorate is more emphatically opposed to some of the promarket
reforms, according to regressions 5 to 9. The coefficients for the total index
of reforms and for trade liberalization policies are highly significant, with
elasticities of 1.57 and 0.84, respectively. Regression 5 is the basis for
the analysis in tables 3 and 4, where we show that the total electoral pay58. None of our main conclusions, in either this or the following sections, is altered
when the regressions are run for the share of votes of the incumbents party (results available from the authors upon request).
59. All these results persist when the set of political control variables is excluded from
the regressions.
35
off of the reforms remains strongly negative, even if we take into account
the full indirect effects implied in the correlations between the changes in
the reform index and the changes in inflation and growth. As mentioned, the
point estimate of the direct effect implies that the incumbents party typically lost 23 percent of its vote in presidential elections on account of
the average amount of promarket reforms introduced during its term (or
15 percent if we take into account our rough estimate of indirect effects).
More aggressive reformerssay, those reforming 1 standard deviation
above the meanwould sacrifice 40 percent of their vote on account of all
the promarket reforms (or 27 percent with the indirect effects). As the
remainder of the paper shows, the negative electoral payoff of the adoption of promarket reforms is a remarkably robust result.
Regression 10 evaluates the effect of the protection of property rights
and finds that it does not influence the behavior of the electorate. Regression 11 is an attempt to summarize the influence of all the Washington
Consensus policies, using the composite indexes for the macroeconomic
and structural policies, along with the index of property rights. This regression indicates that while the electorate does not hold strong views on
macroeconomic or property rights policies, it does on promarket policies.
Finally, the last two regressions in table 11 test the robustness of the policy variables that were found to be significant in previous regressions,
namely, the fiscal balance, the total reform index, and the trade liberalization index. Only the total reform index is robust to the inclusion of the
other variables.
In summary, this evidence lends support to the hypothesis that the electorate rewards the incumbents party for good macroeconomic results
inflation, in particularbut punishes it for the adoption of the promarket
policies endorsed by the Washington Consensus.
Table 12 presents a similar set of regressions for legislative elections.
Those that test the significance of the macroeconomic policy indicators are
consistent with the conclusion that the electorate does not care about these
policies. However, in regression 3 the real exchange rate is significant at
10 percent with a positive sign, suggesting that the electorate favors more
depreciated exchange rates.60 The set of regressions dealing with the various indicators of promarket reforms suggests that they do not carry electoral
costs in legislative elections. Since some of these policies fall under the
control of the executive, this result is not surprising. However, as we show
below, privatizations, which are strongly influenced by the legislature, do
60. However, this result does not hold in a similar regression without fixed effects.
Washington Consensus
Macroeconomic reforms index (log, change)
Economic outcomes
Inflation (change in loss of purchasing power)
Polarization (lagged)
Political
Fragmentation (lagged)
Independent variable
1.087
(1.21)
0.934
(0.95)
0.695
(1.99)*
(2)
0.463
(1.72)
0.066
(2.20)**
1.544 1.82
(1.61)
(2.15)*
2.861 2.788
(1.75)* (1.59)
0.122
(0.16)
0.341
(0.42)
0.19
(0.51)
(1)
(4)
(5)
0.403
(0.88)
6.79
(1.31)
1.569
(2.98)***
(3)
0.844
(2.24)**
1.736
(1.81)*
1.256
(0.99)
0.945
(0.97)
1.834
(1.21)
0.199
(0.57)
(6)
(9)
0.099 0.118
(0.12) (0.15)
0.35
0.608
(0.42) (0.61)
0.258 0.401
(0.69) (0.87)
(8)
(11)
0.052 1.722
(0.06) (2.11)*
0.159 2.114
(0.21) (2.17)**
0.209 0.107
(0.61) (0.46)
(10)
1.347
(1.93)*
3.357
(2.48)**
0.194
(0.69)
(12)
0.007
(0.41)
1.938
1.825
(3.95)*** (4.23)***
0.353
(1.43)
0.043
(0.05)
0.165
(0.23)
0.177
(0.53)
(7)
T A B L E 1 1 . Impact of Economic Outcomes and Washington Consensus Policies in Presidential Elections, 19852002: Country Fixed Effects Resultsa
0.845
(1.82)
0.012
(0.38)
2.159
(3.11)**
2.003
(1.17)
1.026
(0.84)
4.456
(2.60)**
0.404
(0.65)
(13)
40
15
0.67
Yes
0.792
(1.18)
33
15
0.79
Yes
1.837
(1.83)*
40
17
0.64
Yes
39
16
0.64
Yes
0.933 0.85
(1.56) (1.47)
37
17
0.80
Yes
0.627
(0.85)
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
Constant
37
17
0.76
Yes
0.061
(0.08)
39
17
0.70
Yes
0.759
(0.92)
0.073
(0.37)
0.776
(1.50)
40
17
0.63
Yes
40
17
0.69
Yes
0.826 0.647
(1.31) (1.03)
0.064
(0.09)
39
16
0.71
Yes
36
15
0.89
Yes
0.232 0.049
(0.73) (0.20)
0.654 0.805
(0.79) (1.07)
31
15
0.91
Yes
0.197
(0.29)
31
15
0.91
Yes
0.62
(0.62)
0.877
(1.43)
Washington Consensus
Macroeconomic reforms index (log, change)
Economic outcomes
Inflation (change in loss of purchasing power)
Polarization (lagged)
Political
Fragmentation (lagged)
Independent variable
0.08
(0.74)
0.077
(0.33)
0.948
(1.60)
0.588
(3.24)***
0.138
(0.54)
0.038
(0.29)
(1)
0.002
(0.20)
0.086
(0.33)
1.037
(1.50)
0.618
(3.01)***
0.174
(0.58)
0.02
(0.12)
(2)
0.281
(1.78)*
0.048
(0.21)
0.916
(1.69)*
0.59
(3.65)***
0.11
(0.48)
0.034
(0.27)
(3)
0.089
(0.36)
1.034
(1.78)*
0.593
(3.19)***
0.142
(0.54)
0.024
(0.17)
(4)
0.007
(0.03)
0.786
(1.26)
0.524
(2.60)**
0.26
(1.10)
0.043
(0.32)
(5)
0.025
(0.10)
0.712
(1.16)
0.533
(2.43)**
0.292
(1.30)
0.038
(0.29)
(6)
(8)
0.023
(0.09)
0.599
(1.05)
0.051
(0.22)
1.086
(1.84)*
0.595
0.615
(3.03)*** (3.15)***
0.314
0.173
(1.27)
(0.66)
0.021 0.024
(0.16)
(0.18)
(7)
0.609
(3.19)***
0.279
(1.03)
0.035
(0.26)
(10)
0.018
0.025
(0.07) (0.10)
1.084
0.703
(1.89)* 1.16
0.507
(2.51)**
0.07
(0.26)
0.061
(0.48)
(9)
Dependent variable: Change in log of vote share of party with most seats in legislature
0.167
(1.12)
0.071
(0.28)
0.133
(0.23)
0.524
(2.64)**
0.438
(2.17)**
0.033
(0.23)
(11)
0.327
(1.84)*
0.006
(0.03)
0.693
(1.21)
0.551
(3.00)***
0.224
(1.04)
0.034
(0.25)
(12)
T A B L E 1 2 . Impact of Economic Outcomes and Washington Consensus Policies in Legislative Elections, 19852002: Country Fixed Effects Resultsa
0.305
(1.78)*
0.004
(0.02)
0.653
(1.13)
0.572
(2.65)**
0.276
(1.35)
0.018
(0.13)
(13)
0.134
(0.71)
0.083
(0.73)
0.057
(0.66)
0.318
(1.03)
0.131
(0.83)
0.296
(1.44)
0.103
(0.58)
0.23
(0.78)
0.087
(0.71)
68
15
0.45
Yes
61
15
0.41
Yes
68
17
0.49
Yes
67
16
0.41
Yes
65
17
0.48
Yes
65
17
0.48
Yes
67
17
0.46
Yes
69
17
0.47
Yes
69
17
0.46
Yes
68
16
0.47
Yes
63
15
0.53
Yes
64
15
0.52
Yes
64
15
0.53
Yes
0.191
0.298
(1.12)
1.6
0.634 0.683 0.615 0.65
0.583 0.615 0.718 0.663
0.518 0.741 0.7
0.592 0.638
(2.69)*** (2.24)** (2.86)*** (2.60)** (2.27)** (2.23)** (3.06)*** (2.69)*** (2.01)** (2.90)*** (2.45)** (2.23)** (2.26)**
0.283
(0.13)
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
Constant
40 E C O N O M I A , Spring 2005
61. Crisis is measured as the (log) distance between GDP and its trend when GDP is
below its trend, and 0 otherwise.
41
Conclusion
This paper has assessed the electoral consequences of Washington Consensus policies in Latin America on the basis of testable hypotheses derived
from econometric and case studies on the subject. The results lend qualified support for our main four hypotheses, as follows.
62. A more complete set of results is available from the authors upon request.
63. The switch indexes are defined above. We also tested a switch index measured with
respect to the ideology of the party, and those same indexes in absolute values (which measure whether the incumbent has lied or not, regardless of the direction of the switch). None
of these alternative measures was found to be significant.
42 E C O N O M I A , Spring 2005
T A B L E 1 3 . Impact of Washington Consensus Policies Interacted with Contextual
Features in Presidential Elections, 19852002: Country Fixed Effects Resultsa
Dependent variable: Change in log of vote
share of incumbent presidents party
Independent variable
Political
Fragmentation (lagged)
Polarization (lagged)
Divided government (dummy, lagged)
Economic outcomes
Inflation (change in loss of purchasing power)
Growth (change in growth rate, log)
Washington Consensus
Tax index (log, change)
Promises*tax reforms index
(1)
(2)
(3)
0.377
(0.65)
1.124
(1.33)
0.000
(0.00)
0.762
(1.70)
0.156
(0.30)
0.317
(0.91)
0.192
(0.38)
1.143
(1.34)
0.000
(0.00)
0.808
(1.75)*
0.063
(0.13)
0.382
(1.19)
0.696
(1.57)
0.524
(0.49)
0.517
(1.34)
0.897
(1.17)
0.701
(1.85)*
0.319
(0.37)
0.622
(1.50)
0.909
(1.18)
1.564
(1.92)*
1.424
(1.62)
0.283
(0.36)
0.394
(1.65)
0.061
(0.11)
0.154
(0.65)
1.658
(2.72)**
0.190
(0.32)
1.057
(2.27)**
0.371
(0.67)
6.489
(0.48)
1.115
(2.31)**
27
14
0.67
Yes
38
17
0.64
Yes
26
14
0.72
Yes
38
17
0.64
Yes
(4)
1. Electoral support for the incumbents party is higher, the better the
aggregate economic outcomes during his or her administration. The incumbents party is rewarded in presidential elections for reductions in the rate
of inflation; and in legislative elections, for increases in the rate of growth
(although the latter result is not robust in this first hypothesis). Neither
changes in unemployment nor changes in income distribution appear to
influence voters behavior.
43
(1)
(2)
(3)
(4)
0.568
(2.80)***
0.045
(0.16)
0.104
(0.79)
0.657
(3.36)***
0.185
0.7
0.085
0.62
0.658
(3.25)***
0.098
(0.35)
0.042
(0.28)
0.59
(2.90)***
0.003
0.01
0.018
0.12
0.278
(1.19)
1.168
(1.99)*
0.089
0.4
1.198
(2.05)**
0.251
(0.94)
0.638
(0.94)
0.291
1.32
0.539
0.64
2.076
(2.97)***
0.680
(2.45)**
0.333
0.79
0.583
(1.61)
2.068
(3.01)***
0.67
(2.48)**
0.046
0.19
15.173
(1.61)
Growth*polarization
Constant
Summary statistic
Number of observations
Number of countries
R2
Country fixed effects
0.525
(2.04)**
0.684
(2.34)**
0.760
(2.90)***
3.546
(3.12)***
0.626
(2.43)**
67
14
0.54
Yes
67
17
0.5
Yes
69
14
0.5
Yes
67
17
0.58
Yes
44 E C O N O M I A , Spring 2005
45
this question, some results (not reported) suggest that many of the simpler
hypotheses proposed to answer it are at best incomplete. It has been widely
argued that such rejection is due to the social and distributional effects of
the reforms, but we have not found any evidence either that voting decisions are directly affected by social or distributional outcomes or that the
electorates response to the reforms is influenced by them.64 It has also
been argued that frustration with the reforms is due to their weak economic
impact in countries that lack the institutional support needed to harvest the
benefits of market liberalization.65 Again, we find no evidence in support
of this view. Relatedly, several authors have suggested that opposition to
promarket policies is stronger when those who make the liberalization
decisions or benefit from them are perceived to be corrupt.66 However, we
do not find that any measure of perceived corruption helps explain the
electorates response to the adoption of promarket reforms.67
Many other hypotheses beyond those that we have been able to test
are possible. Based on psychological theory and experimentation, Sergio
Pernice and Federico Sturzenegger have argued that public opposition to
a successful reform process can be explained by universal cognitive
biasesconfirmatory bias and self-serving biasif the principles of the
reform are at odds with their beliefs and self-serving view of the world.68
And Sanjay Jain and Sharun Mukand have developed a theoretical model
to explain why successful reforms may run aground: if the reform process
tilts the political balance in a way that makes the redistribution of the benefits less likely, public opinion may turn against the continuation of the
reform process.69 Why Latin Americans reject promarket reforms at the
polls remains an open question.
64. For a summary of such arguments, see Lora and Panizza (2002); and Lora, Panizza
and Quispe-Agnoli (2004).
65. See Lora and Panizza (2002), on the basis of public opinion data.
66. Di Tella and MacCulloch (2004) have uncovered empirical evidence consistent
with this hypothesis.
67. For instance, when we include the interaction between our measure of reform and
a measure of control of corruption (taken from International Country Risk Guide, 2004;
www.icrgonline.com) in the basic regression from table 5, the coefficient is positive but not
significant.
68. Pernice and Sturzenegger (2003).
69. Jain and Mukand (2003).
Comments
Sebastin Galiani: This paper by Lora and Olivera is very interesting.
It investigates whether the Latin American governments that adopted
market-oriented reforms during the late 1980s and early 1990s were rewarded with votes by the electorate. Certainly, this is an interesting and
much-debated question. It is also a very hard one. There are many
sources of complexity.
A virtue of the paper is that the authors keep the analysis at an explorative level. Identifying the impact of the reforms implemented during the
1990s on the voting behavior of the electorate is an intrinsically delicate
matter, since there is no good way to assess how the same electorate would
have voted had the reforms not been implemented (in precisely the way
they were). Another serious difficulty is the lack of a more detailed theory
to help disentangle the effects under consideration from the data.
The authors rely on cross-country panel data to attempt to control for factors that could potentially impact the effects they are interested in. Clearly,
this is the best strategy for the data sets they use. They analyze both presidential and legislative elections, with separate empirical models.
A first question, which is very important for their analysis, is whether
the electorate cares about policies per se, or only in relation to the effects
they have on outcomes. This would determine whether the effect of economic reforms on voting behavior is a structural parameter or not. The
authors assume that voters do care about policies per se, and that they vote
on the basis of policies in the recent past.
Of course, the reforms of the 1990s were not implemented in a vacuum.
They could be expected to affect variables such as growth and inflation
and were also likely to hit unemployment, although transitorily. All of
these variables are likely to influence voters, and thus should be included
as controls in the regression models. The authors do so.1 What is more,
1. They also include other time-varying political control variables. The authors report
that the results are robust to the inclusion of year effects, but it is not clear why they do not
just report those results instead, since they encompass the ones presented here.
46
47
they also rightly compute the total effect (in addition to the direct effect)
of the reforms on voting, using ancillary models that estimate the effects
of the promarket reforms on these macroeconomic outcomes.
In presidential elections, the authors find that the incumbents party is
rewarded for reducing inflation, but once this is controlled for, the electorate seems to oppose market-oriented reforms.2 Even when the total
effect of these reforms is computed, it appears that reforming parties paid
a price for adopting them. Given the relative importance of inflation among
the explanatory variables, it would have been useful to check extensively
the robustness of this result. Unfortunately, there are episodes of very high
inflation that might be driving the results.
In any event, one question naturally arises: why did so many governments adopt promarket reforms? A common argument today is that structural reforms were supposed to deliver more growth than they did. However,
even if this were the case, growth is found to have little effect on presidential elections. Thus, if one sticks to the estimated model, one needs to look
elsewhere for the answer. Perhaps these reforms were also an essential component of the stabilization programs adopted by the countries that reduced
inflation during this period, in a way not captured by the ancillary models
reported in the paper? This seems to be the case for Argentina.3
Another important issue is how the reforms affect voting, once the main
economic outcomes are controlled for. It is true that voting may well reflect
the taste of the electorate for these policies. But it could also capture other
things. It is likely to depend on the way these policies were implemented.
It might perhaps capture distributive effects. For example, voters might not
have fixed ideas about trade liberalization in general. Maybe, in deciding
how to vote, an individual only considers his own economic situation,
which could have been affected by this particular policy reform and is also
affected by the macroeconomic performance of his country.
Consider privatization. Firms improved substantially after privatization.
And consumers, in general, also benefited.4 But not everyone gained: displaced workers lost earnings and employment security, even in the long run.5
2. They find that the results for legislative elections are different. This is troublesome,
because there is no theory to help interpret it. Why should one expect inflation to be more
influential in presidential elections, for example, and growth to be more influential in legislative elections?
3. Galiani, Heymann, and Tommasi (2003).
4. See, for example, Galiani and others (2005); Galiani, Gertler, and Schargrodsky (2005).
5. See, for example, Galiani and Sturzenegger (2005).
48 E C O N O M I A , Spring 2005
Although the average benefits outweigh the costs, privatization might have
a small positive effect on the welfare of each consumer but a large cost
among the small group of displaced workers. The former might not decide
how to vote on the basis of the outcome of privatization, but the latter would
certainly do so. This is just a speculative counterexample. These issues need
to be explored further. A promising research strategy would be to exploit
panel data on voting at the smallest electoral district level, where the proportions of potential winners and losers from each reform can be identified
using census data.
Ernesto Dal B: The 1990s saw several governments in Latin America
implement various combinations of the reforms commonly associated with
the Washington Consensus. One important question concerns the effects of
these reforms. A vast body of work in several different applied literatures
has dealt with, for example, the impact of trade liberalization, deregulation, and privatization. As the reform process seems to be losing momentum across the continent, a second important question has emerged: what
are the constraints on the reforms sustainability?
This paper by Lora and Olivera relates to the second, which is a crucial
question if one believes that market-friendly reforms are, under some guise,
beneficial. In a democratic government, reforms must appeal to the electorate, or a large enough portion of it. This, in turn, is a precondition for
politicians to have a stake in implementing such reforms. Lora and Oliveras
central claim is that apart from macroeconomic stabilization programs, the
effect of the Washington Consensus policies tends to be to drive votes away:
privatization, tax reform, trade and financial liberalization generally cost
votes.1 If this is true and more reforms are desirable, the challenge appears
substantial: why expect political entrepreneurs to provide policies that lose
votes? This question is crucial because we would like both to see policies
that can bring Latin America prosperity and to preserve democracy.
The authors study variations in the vote shares of the party associated
with the incumbent president or the dominant party in the legislature.
1. Williamson (1990b) includes ten priorities in his synthesis on what Washington
means by policy reform: fiscal discipline; tax reform; the liberalization of interest rates,
foreign investment, and trade; a competitive exchange rate; privatization; deregulation; the
redirection of public expenditure toward social areas such as health, education, and infrastructure; and the protection of property rights. In practice, some reforms were emphasized
over others. As I argue below, there are reasons to believe this bias may have had important
consequences.
49
Two Observations
The problems of estimating the impact of a policy (and hence how it will
affect voters opinions) are well known. Here, I argue that the potential
benefits of policy reform might be underestimated, in terms of both their
economic and their electoral impacts. For instance, consider a few countries set on various growth trajectories. Assume now that, foreseeing collision, policy reform is implemented more aggressively when countries
get to very bad stages of their growth trajectoriesthat is, reforms are
endogenous. It may be possible for the reforms to improve growth outcomes relative to what the countries would have experienced without the
reforms, while estimates indicate that reforms are associated with less,
rather than more, growth. The key problem is that we lack the counterfactual trajectory for each country, corresponding to less or no reform. When
estimates of the reforms impact on economic outcomes are used in com-
50 E C O N O M I A , Spring 2005
The Specification
The basic specification driving the analysis in this paper is reported in column 1 of table 5 and in table 11. This specification includes both economic
outcomes and policy indexes as explanatory variables of variation in vote
shares. One problem with this specification is that it could be unfair to the
policies. After all, if the policies are improving economic outcomes and
these outcomes are included as regressors, the coefficient on the policy variable will never capture some of the policys electoral rewards. These will be
attributed to the improved economic outcomes. Also, to the extent that the
policies affect the economic outcomes, the regressors are not independent.
A better approach might be to estimate the impact of policies on all relevant outcomes, and then estimate the impact of those outcomes on votes.
A crucial question, of course, is how to identify all the relevant outcomes
that the policies might affect. Moreover, this strategy does not attempt to
determine whether voters disapprove of reforms for reasons other than
their economic consequences. The authors are highly concerned about this
second issue, and the inclusion of policy variables next to economic outcome variables is meant to capture any intrinsic value that the public may
place on policies.
51
On Interpretation
The authors emphasize that the negative coefficient on the structural reforms
index represents an intrinsic distaste on the part of voters for market-oriented
policies. One could argue against this interpretation. The reason relates
to the question of defining the complete set of relevant outcomes. To be
concrete, suppose that reforms reduce inflation and improve growth but
also severely damage the environment, causing air quality to drop to
unhealthy levels. Now, suppose one runs the authors regression with
the change in the share of votes as the dependent variable and inflation,
growth, and a reform policy index as independent ones, without including an air quality variable. If people punish the government for the
decline in air quality, using the authors interpretation for this regression
one would conclude that the public dislikes market-friendly reforms. In
this case, that conclusion is wrong. People may not care in the least about
policy labels but care strongly about air quality, which has been affected
by the policies.
Therefore, I believe that the conclusion that Latin American people dislike
market-friendly reforms per se is premature. A much larger set of controls for
various relevant outcomes should be explored in the future. I discuss below
some possible reasons why voters may be unhappy with reforms irrespective
of their ideological profile. One potential candidate is the deterioration in the
social atmosphere that some countries have experienced. As reforms went
deeper in Argentina, for example, there were alarming increases in crimes
52 E C O N O M I A , Spring 2005
against property.2 A relatively safe society just a few decades ago, its social
air has now become a lot less easy to breathe; even middle-class people now
discuss defensive tactics against express kidnapping.
53
thus to reductions in child mortality.6 The privatization of power generation in Argentina led to a large increase in generating capacity, which in
turn contributed to lower energy prices. The privatization of energy distribution, in particular, when coupled with regulation through price caps, had
beneficial effects on productivity.7
Given the need for electoral support in order for the reform agenda to
progress, it seems important to ask why, if reforms have a number of benefits, one does not see stronger support for them. There are several possible reasons.
One answer is given by Lora and Olivera: voters are strongly ideological. There is little reformers can do about this. If ideology is a fixed taste
that goes against economic convenience, then maximizing social happiness may require abstaining from further reforms.
It is possible that reforms constitute an investment, and as such entail costs
during the first few years, whereas benefits will tend to accrue later on. If
voters are not aware of this temporal pattern, they may be quick to punish
reformers when experiencing the costs. Voters may not realize that judged in
terms of net present value contribution, the reformers deserve to be rewarded.
Moreover, reforms may create very diffuse benefits and highly concentrated costs, and voters may react more strongly in the face of large variations in payoffs. For example, privatizations tend to increase consumer
surplus but generate layoffs. Suppose that one such reform creates a small
benefit for 80 percent of the population, so that this fraction of the population is now likely to reelect the reformer with a 60 percent chance when
he faces a challenger (assume no abstentions nor a third candidate). This
gives the reformer a 48 percent vote share from the winners. But the
remaining 20 percent of the population is badly hurt by the reform, so only
5 percent of this group will reelect the reformer. Thus the overall vote
share for the reformer is only 49 percent of the vote, which is insufficient
to obtain reelection even though a large majority gained from the reform.
Economists can get biased estimates when they lack the appropriate
counterfactual, and so can voters. Therefore, voters may not associate
reforms with improved economic outcomes, even when they have been
beneficial. This outcome is even more likely if voters compare their governments performance to that of neighboring nations, and it is the countries on the worst trajectories that implement more reforms.
6. Galiani, Gertler, and Schargrodsky (2005).
7. Estache and Rossi (2005).
54 E C O N O M I A , Spring 2005
It may be the case that reforms are made possible by one of two things
(or both): a large fiscal crisis or a substantial amount of corruption.8 Either
of these two factors could facilitate reform by softening the resistance of
vested interests. Traditional economics emphasizes the role of compensating transfers to facilitate Pareto-improving moves. These transfers can
be hard to implement openly. Corruption could then facilitate reform,
because it allows reformers to pass compensating transfers to losers or
players with veto power over the reform process. But if crisis and corruption facilitate reform, voters may associate reforms with these two traits,
which in themselves have a number of negative consequences that may
cost votes. In this case, it is not reform that costs votes. The electoral consequences of the facilitating factors are confused with those of reforms.9
Voters may also be motivated by spite and considerations of fairness.
Even when reforms create a substantial consumer surplus, individuals may
be negative about them as a result of the fortunes that some key players
have made in the process.
Another interpretation is that voters are cruel pragmatists. They elect
leaders who they think will be pragmatic enough to effect the transfers that would make reform happen. Examples of successful reformers
who were later accused of corruption are Fujimori in Peru and Menem in
Argentina. Once these leaders have delivered the reforms, why would
rational voters keep them around? The social benefits from their (alleged)
corruption have been realized, and there would be only costs to be reaped
further down the line.
Voters assessments of reform may be affected by the economic cycle.
The debate on the negative opinions of reform is relatively new. As such, it
may be marked by the fact that since about 1998 a few Latin American
countries have encountered new macroeconomic problems and less abundant foreign capital. It would be interesting to see if opinions remain negative during a future wave of capital inflows and macroeconomic recovery.
It is possible that voters may associate reforms (rightly or spuriously)
with a number of outcomes that economists have not paid enough attention
to when discussing policy reform. Here, I discuss only one such possibility:
reforms may be correlated with a deterioration in the social atmosphere.
8. On fiscal crisis as a catalyst, see, for instance, Drazen and Grilli (1993).
9. In their conclusion, Lora and Olivera note in passing that they did not find any connection between perceptions of corruption and electoral results. It would be worthwhile to
explore this connection further, under alternative specifications.
55
56 E C O N O M I A , Spring 2005
57
sive, such forces may unleash an appropriation backlash that leaves all
agents in the economy worse off.
We tend to consider a number of reforms convenient because we expect
their efficiency gains will make societies more prosperous. However,
when the protection of property rights is imperfect, we are in a secondbest world. The welfare implications of reforms may then depend on new
considerations, and the set of reforms that are desirable and sustainable
will change. It may pay to reassess the Washington Consensus from this
perspective.
Conclusion
Lora and Olivera have produced an interesting, thought-provoking piece.
The problem they tackle belongs to a set of complicated issues on which
it is hard to derive definitive conclusions. More work is needed. Their evidence suggests that market-friendly reforms may not have produced handsome electoral payoffs beyond those secured in the macroeconomic
stabilization phase. This is consistent with survey evidence on public attitudes toward reforms and with the sentiment one perceives in casual interactions on the continent.
One challenge that lies ahead is to reconcile the evidence of important
benefits from some reformsnotably privatizationswith the fact that
many Latin Americans seem to reject the idea that they have benefited
from the reforms. I have here proposed a few potential approaches,
including (1) examining how opinions on reforms are affected by factors
ranging from the economic cycle to the perceived fairness of their implementation, (2) analyzing how corruptiona much vilified traitmay
have been instrumental in pushing reforms forward, and (3) investigating
the role of a social constraint on the implementation of reforms. In particular, a reassessment of the reform process in terms of its impact on social
peace and criminal activities would be profitable. This should entail more
reflection on what constitutes desirable and sustainable policy in a world
where the protection of life and property can only be imperfect.
58 E C O N O M I A , Spring 2005
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61
ANTONI ESTEVADEORDAL
KATI SUOMINEN
Estevadeordal and Suominen are with the Inter-American Development Banks Integration
and Regional Programs Department, Integration, Trade, and Hemispheric Issues Division.
We are grateful to Andrs Rodrguez, Pablo Sanguinetti, Alberto Trejos, and Andrs
Velasco for outstanding comments.
1. PTAs include free trade agreements, customs unions, common markets, and single
markets.
2. The Doha Declaration states, We also agree to negotiations aimed at clarifying and
improving disciplines and procedures under the existing WTO provisions applying to
regional trade agreements. The negotiations shall take into account the developmental
aspects of regional trade agreements.
3. The figures refer to formal free trade agreements and exclude the economic complementation agreements.
63
64 E C O N O M I A , Spring 2005
Hong Kong
EU, EFTA
FTAA
APEC
PR China
Brunei
Taiwan
Cambodia
Canada
Costa CACM
Rica El Salvador
Guatemala
Honduras
Nicaragua
Korea
Thailand
Malaysia
Philippines
Japan
USA
Panama
Mercosur
Paraguay
Argentina Brazil
Uruguay
Mexico
Myanmar
Bolivia
ASEAN
Singapore
New Zealand
Laos
Indonesia
Vietnam
Chile
Ecuador
Andean
Peru Community
Australia
Colombia
Venezuela
Russia
Bahamas
Dominican
Republic
CARICOM
Dominica Trinidad & Tobago
Suriname Grenada Barbados
Jamaica St. Vincent & Grenadines
Guyana Antigua & Barbuda
St. Kitts & Nevis Belize
Haiti St. Lucia
65
PTA fronts simultaneously. This is a particular consideration in the Americas, where each country belongs to an average of four PTAs.4
Rules of origin are a key market access rule (or discipline, in the jargon
of trade negotiators) in PTAs. Rules of origin are the crucial gatekeepers
of commerce: a product shipped from an exporting PTA member must
meet the corresponding rule of origin to receive preferential treatment
from the importing member. Rules of origin epitomize the hemispheres
policy problem: a growing number of the regions PTAs carry complex
and restrictive rules of origin, and the many rules-of-origin regimes differ from each other. Consequently, the rules-of-origin spaghetti could
hold back the trade-creating potential of the hard-earned PTAs.
This paper presents an in-depth diagnosis of rules-of-origin regimes in
the Americas and offers policy recommendations for the region to
counter the potential negative effects of rules of origin. We hope to make
two contributions: to deepen understanding of the types and effects
of rules of origin used in Western Hemisphere PTAs, and to add rigor to
the policy debate on the implications of PTAs to the multilateral trading
system.5
The paper is organized in four parts. The first part surveys the state and
latest trends in the rules-of-origin regimes in the Americas. The next section summarizes the recent research on the political economy reasons
behind the choice of rules-of-origin instrument in PTAs. The third section
does the same for the economic effects of rules of origin, and discusses the
implications of the research findings to the hemispheres PTA spaghetti
bowl. The fourth part contains our policy recommendations, and a final
section concludes.
66 E C O N O M I A , Spring 2005
such as antidumping and countervailing duties, safeguard measures, origin marking requirements, discriminatory quantitative restrictions or tariff quotas, and rules on government procurement. The WTO is in the final
stages of the decade-long process of harmonizing nonpreferential rules of
origin at the multilateral level.6 Preferential rules of origin, the focus of
this paper, are employed in PTAs and in the context of a generalized system
of preferences. They define the processes to be performed and inputs to be
incorporated in a product in the territory of an exporting PTA member
in order for the product to qualify for preferential access to an importing PTA member. The justification for preferential rules of origin is to
curb trade deflectionto prevent products originating from non-PTA
members from being transshipped through a low-tariff PTA partner to a
high-tariff one under the PTA-provided preferential treatment. Rules of
origin, in short, are tools for keeping non-PTA parties from free riding on
the PTA preferences. They are an inherent feature of free trade agreements in which the members external tariffs diverge or in which the
members wish to retain their individual tariff policies vis--vis the rest of
the world. Rules of origin are also used in aspiring customs unions to govern sectors for which the members have yet to establish a common external tariff.7
Rules of origin have become increasingly important over the past decade.
This is due both to the globalization of productionthe growth of international trade in goods manufactured in multiple countriesand to the
fact that todays PTAs quickly reduce the preferential tariff, the more traditional tool regulating preferential market access, to zero across most
product categories. Indeed, rules of origin are currently a key arbitrator of
the effectiveness of multilateral trade rules requiring PTAs to cover substantially all trade between the partner countries and not to raise barriers
vis--vis third parties.
Preferential rules of origin have thus far eluded multilateral regulation.
As a result, a wide repertoire of rules-of-origin types and combinations
has developed around the world. This section surveys the rules of origin
employed in the Western Hemispheres PTAs.
6. See Estevadeordal and Suominen (2005a) and Suominen (2004) for details on the
harmonization process.
7. Rules of origin are thus employed in the vast majority of PTAs. The Asia-Pacific
Economic Cooperation (APEC) forum is a prominent exception in that it operates on the
concept of open regionalism, with the preferential tariffs essentially being extended also to
nonmembers.
67
68 E C O N O M I A , Spring 2005
10. The Revised Kyoto Convention is an international instrument adopted by the World
Customs Organization (WCO) to standardize and harmonize customs policies and procedures around the world. The WCO adopted the original Convention in 1974. The revised
version was adopted in June 1999.
69
NAFTA
U.S.Chile
G3
0.54
0.51
4.05
MercosurChile
Andean
Community
ChileKorea
U.S.Jordan
E.U.Mexico
E.U.Chile
0.39
2.04
1.39
0.39
2.39
1.39
83.94
10.91
1.57
0.20
11.90
1.57
0.20
16.06
7.62
7.62
0.70
0.70
0.51
0.02
100.00
0.54
0.78
0.53
4.05
0.00
100.00
1.29
100.00
24.82
26.16
0.04
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
1.29
2.52
0.04
0.40
16.56
5.57
0.14
0.04
0.42
0.04
1.54
0.73
0.10
0.04
4.60
0.20
0.20
1.90
1.78
0.27
0.27
2.37
2.25
32.99
5.13
32.86
4.56
6.66
12.68
0.86
6.66
12.78
0.37
0.02
0.02
58.34
57.25
0.02
0.02
0.10
1.68
0.47
2.11
0.16
0.04
0.83
4.35
22.77
7.88
0.00
17.09
19.18
0.02
0.14
3.54
0.58
0.10
23.70
11.19
0.34
0.44
3.25
0.48
16.45
13.45
0.97
0.26
2.01
46.00
40.65
39.40
0.00
9.99
23.97
46.02
100.00
0.00
46.87
9.12
0.14
20.04
8.06
4.82
4.42
2.95
0.49
0.00
59.57
0.00
(continued)
70 E C O N O M I A , Spring 2005
T A B L E 1 . Distribution of Rules-of-Origin Combinations, Selected PTAs
in the Americas (continued )
Requirementa
NAFTA
CC
CC + ECTC
CC + TECH
CC + ECTC + TECH
CC + VC
CC + ECTC + VC
CC + VC + TECH
CC + ECTC + VC + TECH
30.95
17.71
0.02
5.76
U.S.Chile
G3
23.18
5.83
0.06
8.08
0.06
21.09
5.90
5.43
6.65
0.14
MercosurChile
Andean
Community
ChileKorea
U.S.Jordan
22.49
4.71
0.08
5.67
1.80
E.U.Mexico
E.U.Chile
2.16
1.02
0.04
11.25
2.16
1.02
0.04
11.02
2.67
0.20
Subtotal
54.44
37.21
42.08
0.00
0.00
34.75
0.00
14.47
14.24
Total
100
100
100
100
100
100
100
100
100
degree of diversity in rules-of-origin regimes in the Americas. Nevertheless, four main hemispheric rules-of-origin families can be identified.11 One
extreme is populated by the older trade agreements such as the Latin American Integration Agreement (LAIA), which uses one general rule applicable
to all products (either a change of heading level or a 50 percent regional
value content). The LAIA model has been the point of reference for the
Andean Community and Caribbean Community rules-of-origin regimes.
At the other extreme lie the so-called new generation PTAs such as
NAFTA. The NAFTA model served as the reference point for numerous
recent bilateral agreements, including the U.S.Central America free trade
agreement (CAFTA) and the U.S.-Chile, Chile-Canada, Mexico-Bolivia,
Mexico-Chile, MexicoCosta Rica, Mexico-Nicaragua, MexicoNorthern
Triangle (El Salvador, Guatemala, and Honduras), and the Group of Three
(or G3, encompassing Mexico, Colombia, and Venezuela) free trade agreements. The model, particularly the versions employed in the U.S.-Chile
free trade agreement and CAFTA, is also widely viewed as the likeliest
blueprint for the FTAA rules of origin. The NAFTA-based rules-of-origin
regimes are complex: depending on the product, the rules of origin may
require a change of chapter, heading, subheading, or item, and the change
11. Garay and Cornejo (2002).
71
72 E C O N O M I A , Spring 2005
the length of the jump over the Harmonized Systems tariff lines required
by rules of origin: a change of chapter is more restrictive than a change of
heading, a change of heading more restrictive than a change of subheading, and so on. Value content and technical requirements add to the rules
restrictiveness.
Figure 2 reports the restrictiveness values of rules of origin in some of the
main PTAs. Since it is based on coding at the six-digit level, it also reveals
the degree of interproduct dispersion of restrictiveness values, which serves
as a measure of the selectivity of regimes. The final bar represents the likeF I G U R E 2 . Restrictiveness of Rules of Origin in Selected PTAsa
8
7
6
5
4
3
2
1
0
al
nti
ere
ref
np
No
TA
AF ile
h
.-C
E.U exico
.-M
E.U rope
u
n-E
Pa el
ra
-Is
US dan
r m.
-Jo
US n Com ia
v
a
de oli
An sur-B
rco hile
Me ur-C
s
rco
Me rea
-Ko
ile ivia
Ch -Bol ica
o
xic ta R
Me -Cos
o
xic
Me
G3
FTA
CA ile
h
.-C
U.S
FTA
NA
73
74 E C O N O M I A , Spring 2005
Prohibition of duty drawback, which precludes the refunding of tariffs on nonoriginating inputs that are subsequently included in a final product that is exported to a PTA partner. Drawback in the context of a PTA is
viewed as providing a cost advantage to producers who gear their final
goods to export over producers who sell their final goods in the domestic
market. However, ending drawback increases the cost of nonoriginating
components to producers who have thus far benefited from it.16
Certification method, which defines the instance authorized to certify
an origin claim. The main methods are self-certification by exporters; certification by the exporting countrys government or a certifying agency; and a
two-step combination of the private self-certification and the public governmental certification. High bureaucratic hurdles for obtaining a certificate of
origin lower the incentives for exporters to seek preferential treatment.
Whereas de minimis and cumulation clauses insert leniency in the application of product-specific rules of origin, drawback prohibition and complex certification methods may have the opposite effect, namely, increasing
the difficulty of complying with the rules-of-origin regime.17
Table 2 compares the regimewide rules of origin in the various rulesof-origin regimes. Bilateral cumulation is applied in virtually all regimes,
but use of other regimewide components varies considerably. Again, the different rules-of-origin families stand out. The NAFTA-model regimes set de
minimis levels at 710 percent, preclude diagonal and full cumulation, do
not permit drawback (often after a certain transition period), and are based
on self-certification.18 There are exceptions; for example, CAFTA, the latest
of the NAFTA-model regimes, allows cumulation within Central America,
16. Many PTAs in the Americas include duty drawback provisions in the market access
chapter rather than in the rules-of-origin protocol. However, the implications of ending
drawback are very similar to the implications of stringent rules of origin, namely, increasing production costs for exporters. Cadot, de Melo, and Olarreaga (2001) show that duty
drawback may have a protectionist bias due to reducing producers interest in lobbying against
protection of intermediate products.
17. Nonmembers of a cumulation area may view the cumulation system as introducing
another layer of discrimination in that it provides incentives for member countries to outsource from within the cumulation zone at the expense of extrazone suppliers.
18. Two qualifications are in order. First, the de minimis principle has numerous exceptions in most regimes. For example, in NAFTA, it does not extend to dairy products, edible
products of animal origin, citrus fruit and juice, instant coffee, cocoa products, and some
machinery and mechanical appliances. Many regimes also calculate de minimis levels in
textile products as the percentage of weight rather than the value of the final product. Second,
although NAFTA prohibits drawback, it has launched a refund system, whereby the producer will be refunded the lesser of the amount of duties paid on imported goods and on the
exports of the good to another NAFTA member.
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Not mentioned
Not mentioned
Yes
Yes
Yes
Yes
Yes
Not mentioned
Yes
Yes
Yes
10
Not mentioned
2
10
2c
7
7
7
8
9
Not mentioned
Not mentioned
10
Not mentioned
Not mentioned
10
10
10
7
10
10
Roll-up
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Bilateral
Yes
Not mentioned
Not after 10 years
No
Yes
Not mentioned
No after 7 years
No after 8 years
Not mentioned
Not mentioned
No after 5 years
No after 5 years
Yes
Not mentioned
Yes
Not mentioned
No after 2 years
No after 4 years
No after 7 years
No after 12 years
Not mentioned
Drawback
allowed?
No
No
Yes in chap. 62 with Mexico
and Canada
No
No
No
No
No
No
No
No
No
No
No (OP and ISI allowed)a
No
No
Diagonal
Cumulation
G3
MexicoCosta Rica
Mexico-Bolivia
Chile-Korea
Canada-Chile
Mercosur-Chile
Mercosur-Bolivia
Central American Common Market (CACM)
U.S.-Jordan
U.S.-Israel
U.S.-Singapore
E.U.-Mexico
E.U.-Chile
Other regions
Pan-European
ASEAN Free Trade Agreement (AFTA),
AustraliaNew Zealand Closer Economic Relations Trade
Agreement (ANZCERTA)
Southern African Development Community (SADC)
Common Market for Eastern and Southern Africa (COMESA)
Americas
NAFTA
U.S.-Chile
CAFTA
De minimis
(percent)
76 E C O N O M I A , Spring 2005
Mexico, and Canada of materials that Central America may use for producing U.S.-bound goods.19 The clause covers only a limited quota, however, and it enters into force only after Canada and Mexico agree on it. The
Central American Common Markets regimewide rules of origin resemble
those of the NAFTA model, but they do not prohibit drawback. Mercosurs free trade agreements do not have de minimis levels or cumulation
provisions, they phase drawback out in five years, and they are based on
public certification.20 The European Unions rules-of-origin regimes stand
out for employing diagonal cumulation extensively across Europe.21
As in the case of the restrictiveness of product-specific rules of origin,
the facilitation provided by regimewide rules of origin to the application
of the rules-of-origin regime can be systematically assessed through an
index. The facilitation index developed by Estevadeordal and Suominen
incorporates de minimis levels, diagonal cumulation, full cumulation, and
drawback (all of which can be expected to cut producers production costs
by amplifying their pool of low-cost inputs), as well as self-certification
(which can keep producers administrative costs lower than the other
methods).22 Figure 3 shows the behavior of the index. Regimes styled
after NAFTA and the European Union feature the highest levels of facilitation, while the Mercosur- and LAIA-based rules of origin score relatively low. The result suggests some correlation between the restrictiveness and facilitation indexes: regimes with the highest restrictiveness
of product-specific rules of origin tend to also have the highest facilitation values.
Many rules-of-origin regimes have devised further, more idiosyncratic
ad hoc mechanisms to help the members adjust to the rigors of rules of
origin.23 Some such mechanisms include phase-in periods for stringent
value content rules of origin; a number of different options for calculating value content rules of origin; and tariff preference levels, which allow
19. See chapter 62 of CAFTA. (The full text of CAFTA is available at www.sice.
oas.org/Trade/CAFTA/CAFTADR_e/CAFTADRin_e.asp.)
20. The Mercosur rules-of-origin regime is similar, but allows for drawback. Drawback
is, however, prohibited for Argentine and Brazilian imports of intermediate automotive
products when the final product is exported within Mercosur.
21. The absorption by the European Union customs union of the ten new member countries implied that thirty-four of the pan-European free trade agreements vanished overnight.
Prior to the accession, the diagonal cumulation incorporated sixteen partners and covered
no fewer than fifty free trade agreements.
22. Estevadeordal and Suominen (2005a); Suominen (2004).
23. For a more thorough treatment, see Estevadeordal and Suominen (2005a).
77
NAFTA
U.S.Chile
CAFTA
G3
Mexico- Mexico- Chile- Merco- Merco- Andean U.S.- U.S.- Pan- E.U.- E.U.Costa Bolivia Korea sursur- Comm. Jordan Israel Europe Mexico Chile
Rica
Chile Bolivia
AFTA
78 E C O N O M I A , Spring 2005
leather, plastic, apparel, and footwear sectors. In very general terms, this
means, for instance, that some producers based in Costa Rica have greater
leeway to procure inputs or perform operations outside the PTA zone
under the recently signed CAFTA than they do under the 1995 Costa
RicaMexico free trade agreement. What is more, NAFTA itself is liberalizing some of its rules of origin.24 The Working Group in charge of the
rules-of-origin review process is designing new rules of origin on the basis
of consultations with consumers and producers and a review of the rulesof-origin protocols that each NAFTA member country has negotiated in
their post-NAFTA free trade agreements, such as the United States with
Singapore or Mexico with the European Union. If this latter process results
in interregime rules-of-origin borrowing, it could enhance convergence
between the NAFTA rules of origin and the rules of origin of other regimes
around the world.
24. The initial set of revised NAFTA rules of origin took effect on 1 January 2003; they
involve alcoholic beverages, petroleum/topped crude, esters of glycerol, pearl jewelry,
headphones with microphones, chassis fitted with engines, and photocopiers. See Regulations Amending the NAFTA Rule of Origin Regulations, Canada Gazette, 1 January 2003
(available at canadagazette.gc.ca/partII/2003/20030115/html/sor24-e.html). In July 2004,
the trade ministers of the NAFTA countries instructed the trilateral Working Group on
Rules of Origin to extend the liberalization drive to chemicals, pharmaceuticals, plastics
and rubber, motor vehicles and their parts, footwear, copper, and all items with a zero mostfavored-nation tariff for all of the NAFTA members. See A Decade of Achievement,
NAFTA Free Trade Commission, 16 July 2004 (available at www.freetradealliance.org/
pdf/2004%20Advocacy/JointStatement.pdf).
79
dized by PTA formation.25 Rules of origin can be employed to favor intraPTA industry linkages over linkages between the PTA and the rest of the
world and thus to indirectly protect PTA-based input producers vis--vis
their rivals outside the PTA.26 If rules of origin provide captive markets
downstream, they may even be superior for the import-competing intermediate producer lobbies than exclusions of their products from the PTA.27
Furthermore, stringent rules of origin can also extend protection to uncompetitive intra-PTA final-good producers. This happens when their extraPTA competitors are too hard-pressed to switch to the components
prescribed by the rules of origin. Even if an extra-PTA firm were to move
operations to the PTA market, the edge of producers with existing intraPTA supply links would continue until the new entrants regional sourcing met the rules of origin.28
Rules of origin, in short, enable governments to balance the competing
claims of export lobbies, which seek a liberalizing PTA in which all products are subjected to tariff phase-outs, and import-competing lobbies,
which are intent on halting all liberalization. Rules of origin compensate
and can even benefit import-competing lobbies, while export interests
accept stringent product-specific rules of origin as a preferable and politically attainable alternative to a PTA rife with exclusions.29 Indeed, regimes
with the most stringent rules of origin also tend to feature the highest facilitation values, which may be a sign of counter-lobbying by exporters threatened by the restrictive rules of origin.
Empirical work supports the hypotheses about the protectionist impulses
behind rules of origin. Both Estevadeordal and Suominen find that restrictive rules of origin tend to be put in place in sectors that are also marked by
high most-favored-nation tariffs and long preferential tariff liberalization
25. Rules of origin are a particularly useful trade policy instrument for two reasons.
First, like tariffs, rules of origin are a highly targetable instrument because they are often
negotiated at the product level. Second, unlike the tariff, rules of origin can be defined in
technical and diverse terms, so they can be tailored differently for each individual good, while
their presumed protection can be hidden since rules of origin are not as immediately quantifiable as a tariff.
26. Krueger (1993); Krishna and Krueger (1995).
27. Suominen (2003).
28. Graham and Wilkie (1998). Given that rules of origin hold the potential for increasing local sourcing, governments can also use them to encourage investment in sectors that
provide high value-added or jobs (Jensen-Moran, 1996; Hirsch, 2002).
29. Suominen (2003).
80 E C O N O M I A , Spring 2005
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82 E C O N O M I A , Spring 2005
36. Many regimes call for self-certification, including NAFTA, CAFTA, and the
U.S.-Chile, MexicoCosta Rica, Canada-Chile, Central American Common Market
(CACM), CACM-Chile, Chile-Korea, U.S.-Singapore, and U.S.-Jordan agreements. The
Mexico-Bolivia agreement implements self-certification after an initial four-year period of
two-step private and public certification. The pan-European, European UnionMexico,
and European UnionChile agreements are mostly based on two-step private and public
certification, with limited self-certification. The G3 agreement, LAIA, the Common Market for Eastern and Southern Africa (COMESA), and the Southern African Development
Community (SADC) specify two-step private and public certification, whereas Mercosur, Mercosur-Chile, Mercosur-Bolivia, Andean Community, Caribbean Community
(CARICOM), and most rules-of-origin regimes in Asia and the Pacific rely on public
certification or delegate certification to a private entity. See Estevadeordal and Suominen
(2005a); Suominen (2004).
37. Cadot, Estevadeordal, and Suwa-Eisenmann (2005).
83
84 E C O N O M I A , Spring 2005
link the mere 64 percent utilization rate of NAFTA preferences to stringent rules of origin.41
In addition to their short-run trade effects, stringent rules of origin may
cause investment diversion in the long run. This occurs when extra-PTA
final-good producers move production to the PTA area with the sole purpose of meeting the rules of origin, even if the PTA is not the most efficient location for production. Rules of origin can also divert investment
within the PTA. Final-good producers may want to get around rules of origin by moving production to the territory of the PTA partner that has the
largest domestic demand or the lowest external tariff on third-country
inputs (or both)such as the United States in NAFTA.42 From a theoretical perspective, requirements for a high regional value content can paradoxically encourage investment to the PTA country that has the highest
production costs (that is, is the most inefficient producer), because goods
made in member countries with low production costs may be hard-pressed
to meet the rules of origin. Rodriguez theorizes that stringent rules of origin
can lead to distortions in production structures within the PTA, while Estevadeordal, Lpez-Crdova, and Suominen encounter preliminary empirical
evidence that flexible rules of origin are conducive to foreign direct investment (FDI) inflows.43
Transaction Costs
Analysts have yet to understand whether differences among rules-oforigin regimes generate transaction costs and impart economic effects.44
41. Cadot, Estevadeordal, and Suwa-Eisenmann (2005). Krueger (1993) reports that
under NAFTAs predecessor (the U.S.-Canada free trade agreement), Canadian producers
opted to pay the tariff rather than go through the administrative hurdles to meet the rules of
origin. Brenton (2003) and Inama (2004) show that rules of origin shape developing countries odds of qualifying for treatment under the generalized system of preference.
42. For example, a Mexican and a U.S. firm selling on the U.S. market and purchasing
their inputs from outside the NAFTA region would be treated unequally under NAFTA: the
Mexican firm would be disadvantaged vis--vis the U.S. firm because it fails to meet the
rules of origin required to export to the U.S. market (Graham and Wilkie, 1998, p. 110).
43. Rodriguez (2001); Estevadeordal, Lpez-Crdova, and Suominen (2004).
44. Garay and Cornejo (2002) provide the only rigorous examination of the diversity in
rules of origin across regimes. They evaluate the correlations between types of rules of origin in NAFTA, CACM, Mercosurs free trade agreements, and Mexicos free trade agreements. The study finds that only 10 percent of the product-specific rules of origin are exactly
identical or highly similar between the regimes, although up to 75 percent of the rules of origin in most chapters within both the Mercosur and Mexican regimes are highly similar.
85
Any adverse effects would clearly be heaviest for countries that are party
to several relatively different rules-of-origin models, such as Chile and
Costa Rica. These so-called spoke countries require customs that are wellequipped to verify and implement the different rules-of-origin regimes, and
they may eventually have to tailor their production structures differently
for each PTA market.45 This generates transaction costs that would be nil
in a world with one rules-of-origin model. The costs will be highest for
small producers in spokes with a narrow domestic sourcing base. In contrast, producers and customs alike in rules-of-origin hubssuch as the
European Union, Mercosur, Mexico, and the United Statesescape most
of these costs. If the transaction costs of operating on many PTA fronts
become excessive, then producers in spoke countries may be compelled to
specialize for one preferential channel over the others.46 At the global
level, the market specialization induced by rules of origin could give rise
to policy-driven, trade-diverting PTA hubs.
Other factors, however, could mitigate the costs associated with crossregime differences. First, a small producer generally produces only a few
items and would thus need to apply only a couple of different rules of
origin when exporting to the various preferential markets. Multinational
companies selling a variety of goods in different markets may face greater
complexity, but they are also better equipped to economize any transaction costs given their superior human, technical, and financial capacities.
Second, even when rules of origin differ across PTA markets, a single
production process may qualify for preferential treatment in each market.
45. Consider a Chilean producer of typewriters (heading 8469): the firm will have to
comply with rules of origin that stipulate a ceiling of 50 percent import content to enter the
European Union; a change of subheading (except from subheading 8469.12) to enter the
United States; a change of heading to enter Korea (except from heading 84.13 or, alternatively, a change from heading 84.13, provided the regional value content is not less than
45 percent using the build-down method or not less than 30 percent using the build-up
method); and a 60 percent regional value content (that is, a ceiling of 40 percent import content) to enter Mercosur. Meanwhile, a European Union producer in the same heading can
use the same rules of origin50 percent import contentto enter Mexico, Chile, South
Africa, and the whole pan-European system. This example also illustrates the comparative
complexities faced by customs: if each rules-of-origin regime stipulates rules of origin for
5,000 products, the Chilean customs would basically have to verify 20,000 different rules
of origin, whereas customs in the European Union countries would only need to verify
5,000 rules of origin.
46. Inter-PTA divergences also allow countries wishing to join these preferential
arrangements to engage in PTA shopping, choosing to join the agreements that best accommodate their existing domestic standards and interests, rather than joining PTAs that are liberalizing, neutral vis--vis third parties, and welfare-enhancing.
86 E C O N O M I A , Spring 2005
87
88 E C O N O M I A , Spring 2005
89
90 E C O N O M I A , Spring 2005
91
regimes.55 It could also facilitate the prospects of multilateral harmonization of preferential rules of origin.
Whether accomplished through interlinking PTAs or through the FTAA,
a hemispherewide cumulation zone appears to be the most promising
optionparticularly when its rules of origin are flexible enough to prevent
trade diversion. A sustained fluid operation of a hemispherewide cumulation zone will require solid verification tools. Poor verification is a major
problem in most of Latin America, and it has been accentuated by the
growing inflows of goods, particularly from Asia. This situation could
provoke a backlash against regional trade liberalization. The strong verification regime that CAFTA introduces in the textile and apparel sector
could serve as a starting point, along with technical assistance to countries
with the most feeble verification systems. Information technology should
be fully harnessed to facilitate verification.56
The countries of the Americas cannot afford to pursue new policies
only within the hemisphere, but should push their WTO partners on two
fronts. First, they should call for launching the harmonization of the worlds
preferential rules-of-origin regimes. This option is increasingly timely
given the proliferation of free trade agreements with different rules of origin around the world and, in particular, the establishment of free trade
agreements between the hemispheres countries and extraregional partners. Harmonizing multilateral rules of origin is hardly a novel idea, but
rather is a long-standing international commitment: the Uruguay Round
Agreement on Rules of Origin stipulates that once the signatories conclude the harmonization of nonpreferential rules of origin, they will move
to harmonize preferential rules of origin, using the relatively flexible and
simple harmonized nonpreferential rules of origin as a blueprint.
The second multilateral policy that the countries of the Americas should
pursue is the lowering of tariffs and nontariff barriers. The higher the PTA
partners most-favored-nation barriers, the wider the preferential margins
and the greater the willingness of firms in the partner countries to comply
55. Even if the different hemispheric rules-of-origin regimes were left to coexist with
the FTAA rules of origin (as occurred with the Central American Common Market and
CAFTA rules of origin), exporters would be better off for two reasons: first, firms could
choose between two alternative rules of origin when trading with their pre-FTAA PTA partners, and second, the FTAA rules of origin could be less restrictive, in practice, than the
prior PTA rules of origineven if they are more restrictive on paperbecause the FTAA
cumulation zone is vastly expanding the pool of inputs available to any member country.
We thank Jeremy Harris for pointing this out.
56. See Cornejo (2004).
92 E C O N O M I A , Spring 2005
even with costly and distortionary rules of origin. The expansion of the
PTA spaghetti bowl must be accompanied by open regionalism, in which
most-favored-nation liberalization proceeds hand-in-hand with preferential
opening.57
Conclusion
This paper has analyzed the various rules-of-origin regimes in the Americas, reviewed the latest research findings on the effects of rules of origin,
and provided policy recommendations for the regions countries to reduce
the adverse economic impact of rules of origin. We have found that the
NAFTA rules-of-origin model, which is expanding in the hemisphere, carries restrictive and complex rules of origin, and such rules of origin can
counteract PTA-inspired trade liberalization. These findings raise concerns about the hemispheres increasingly complex rules-of-origin bowl.
The worrisome features can be tamed, however, through regional cooperation, in particular the adoption of simple and transparent product-specific
rules of origin, the incorporation of mechanisms to promote regimewide
flexibility, and the implementation of cross-PTA diagonal cumulation.
Given the globalization of regional integrationthat is, the movement of
regional partners to negotiate interregional agreementsthe countries of the
Americas should also live up to the Uruguay Round commitment of harmonizing preferential rules of origin at the global level.
Preferential rules of origin matter only as long as there are multilateral
barriers to trade. If there is a silver bullet for reducing the negative effects
of rules of origin, it is the multilateral liberalization of tariffs and nontariff
barriers. If the Doha Round negotiators succeed in producing deep cuts in
most-favored-nation tariffs and nontariff barriers, and if the proliferation of
PTAs engenders a dynamic of competitive liberalization worldwide, the
importance of preferential rules of origin as gatekeepers of commerce will
progressively dissolve.
57. See Bergsten (1997) and Wonnacott (1996). Wonnacott suggests that free trade
agreements should be replaced by customs unions or a hybrid arrangements of customs
unions and free trade agreements, lest the benefits of preferential opening be lost.
Comments
Pablo Sanguinetti: This is a very interesting paper that deals with an
important and often neglected aspect of preferential trading agreements
(PTAs), namely, the determination of rules of origin. Rules of origin are
the regulations that determine under what circumstances a good is considered to be produced in the region and thus able to enjoy the preferential
tariff treatment. The definition of these regimes, which is mainly the concern of lawyers and policy practitioners, could have important economic
impacts on trade and investment flows. Rules of origin have therefore
become an alternative trade policy instrument targeted by governments
and especially by the private sector in the integrating countries.
The paper does four things. First, it offers a very complete and detailed
survey of the various rules-of-origin regimes that have been put in place in
the context of the huge increase in PTA initiatives for the world economy
and the Americas in particular over the last fifteen years. Second, the paper
draws on the political economy literature to examine why the use of rules
of origin has become such an important policy for government and private
sector lobbies and why the level of restriction implied by rules of origin
has increased over time. Third, given what the (positive) theory predicts
regarding why rules of origin are established, the paper summarizes the
evidence about the effects of these regulations on trade and investment
flows. Finally, the paper ends with policy recommendations. I concentrate
my comments on the first two of these issues: the features of the various
rules-of-origin regimes in the Americas and the political economy aspects
of these rules.
94 E C O N O M I A , Spring 2005
agreements like the old LAIA system and also those applied in Mercosur
and in the free trade agreements between Mercosur and Chile and Bolivia.
Is this bad news for free trade in the region? To a certain extent, it is not
surprising that the NAFTA model has been extended to various free trade
agreements in the Americas. Many of these new free trade agreements
were signed by NAFTA member countries (including all the bilateral free
trade agreement signed by the United States), which presumably would
establish similar rules in their new agreements in the interest of internal
consistency and for the same political reasons that originated the NAFTA
rules-of-origin system. It is also not surprising that the NAFTA-type rulesof-origin regime is more restrictive than those established in previous preferential trade initiatives. As the authors mention, initiatives such as LAIA
were much less ambitious than NAFTA, and many sectors and goods were
exempted from free trade. Import-competing producers did not have to ask
for an alternative mechanism to receive some sort of import relief because
they were already excluded from the agreements. The free trade agreements signed since the beginning of the 1990s, however, are more in
accordance with Article 24 of GATT in that they cover a significant part
of trade and go much deeper in terms of eliminating trade barriers (even
compared to unilateral or multilateral liberalization schemes). Governments and import-competing sectors naturally try to target additional
measures like rules of origin to ease the cost of adjustment for sensitive
sectors. This reasoning implies that this development is not necessarily
bad news for free trade in the Americas, since the extension of rules of origin is precisely a reaction to further trade integration. On the other hand,
the impact of these added restrictions may partially undo the gains from
liberalization resulting from decreasing tariffs.
Mercosur differs from NAFTA in that it is an incomplete customs
union, which has certain advantages. Since the main normative argument
for adopting rules of origin is to avoid trade deflection (that is, imports
entering the member country with the lowest tariff and being reshipped to
the other partners with no additional tariffs), rules of origin are not relevant for items that have already converged to the common external tariff
of the trade union. One would therefore expect a more lenient regime in
Mercosur than in NAFTA. By the same argument, Mercosur rules of origin should also be less restrictive than those included in the free trade
agreements signed by Mercosur with other countries, like Chile and Bolivia.
Table 3 presents an index that measures the degree of restrictiveness of the
Mercosur, Mercosur-Bolivia, and Mercosur-Chile regimes. The index
95
Mercosur
Mercosur-Bolivia
Mercosur-Chile
1.3
1.8
1.0
1.2
2.5
1.1
1.7
1.6
1.0
1.7
2.9
1.7
1.4
2.7
1.2
2.6
2.0
1.3
1.4
2.9
1.4
1.3
2.6
1.1
2.6
1.9
1.2
Total
1.7
2.3
2.2
ranges from one to four, with one being the most lenient regime and four
the most restrictive.1 The overall level of restriction implied by rules-oforigin rules is 1.7 for intra-Mercosur trade, 2.2 for Mercosur-Chile trade,
and 2.3 for Mercosur-Bolivia. The table also shows that sectors like textiles, chemicals and basic metal products (steel) are among those most
affected by these regulations. Estevadeordal and Suominen find similar
results for NAFTA.
Despite the fact that Mercosur is an incomplete customs union (so that
rules of origin should only matter for items that are exempted from the common external tariff, as mentioned above), in practice, the rules-of-origin
regime is applied to all items independently of whether they are included in
the common external tariff. This evidence confirms that these rules are used
not only for the normative prescription of avoiding trade deflection, but also
as a policy tool that could potentially offer some type of import protection.
96 E C O N O M I A , Spring 2005
how do they relate to other key trade policy variables like tariff preferences?
The paper addresses some of these concerns, but I wish to offer some comments to complement the authors discussion.2
Grossman and Helpman provide a political economy model of the emergence of free trade agreements.3 According to their approach, the decision
of whether to form a free trade agreement is subject to political pressures
from the potential losers and winners of trade creation and trade diversion.
Grossman and Helpman use the term enhanced protection to describe trade
diversion and reduced protection for trade creation (relative to the tariffridden situation prevalent before the free trade agreement). This approach
suggests that exporters that stand to gain the most from trade diversion in
the partner country will be most in favor of establishing the trade agreement, while import-competing sectors that will suffer from trade creation
originating in imports from the other members will most vividly oppose
the free trade agreement. Thus producers will support a free trade agreement when the probability of generating trade diversion is maximized
and trade creation is minimized. This is the case when, from a normative
point of view, a free trade agreement is not fully justifiable. In practice,
the final result will depend on how efficient these different groups are in
influencing government policy through lobby activity and how the government objective function weights consumer welfare vis--vis that of producer groups.
The original Grossman and Helpman model does not address the issue
of intermediate inputs, so it cannot be easily applied to study the endogenous determination of rules of origin. This extension is provided by Cadot,
Estevadeordal, and Suwa-Eisenmann, who present a simple partial equilibrium model in which two countries (North and South) engage in a free
trade agreement and both tariff preferences and rules of origin are jointly
determined.4 They focus on a case in which intermediate-good interests in
the North wish to use the free trade agreement to create a captive market
for their product. These interests lobby their government (though political
contribution, as in Grossman and Helpman) to establish strong rules of origin to obligate Southern final-good producers to source in the North in
order to qualify for preferential access. This clearly reduces the effective
protection that the Southern producers receive for entering into the finalgood market in the North. The authors assume that the South is always on
2.
3.
4.
97
Summary Remarks
As I indicated at the beginning, this paper by Estevadeordal and Suominen
is a very interesting piece of work that carefully analyzes the political, economic, and policy implications of rules-of-origin regimes in the Americas.
I hope this survey-type of work encourages further research on the topic.
Alberto Trejos: I quite like this paper, which thoroughly addresses the
topic of rules of origin in current and future free trade agreements in the
Americas. Motivations for this kind of work include concerns that the growing complexity of the administration of rules-of-origin regimes will be
compounded as very disparate rules are implemented across different
agreements; the problem that many free trade agreements may use stringent rules of origin as an alternative (and less visible) mechanism for
maintaining high rates of protection; and the possibility that such disparate
rules of origin will turn free trade agreements into a stumbling block,
rather than a building block, in the process of world trade liberalization.
Understanding this topic is necessary if governments are to design the
correct policies, including better free trade agreements, in the future. The
5. In this case, exports of the final good will not increase significantly as a consequence
of the free trade agreement initiative. Thus the lobby for stronger tariff preferences by the
intermediate-good industry in the North will not face strong opposition from the final-good
industry in the same country. There will be very low trade creation in final goods and a
strong trade diversion in intermediates.
6. Estevardeordal (2000); Sanguinetti and Bianchi (2005).
98 E C O N O M I A , Spring 2005
99
I would add to these causes for optimism the fact that recent agreements
include a variety of new flexibilities to make rules of origin less stringent.
De minimis clauses, phase-ins, tariff preference levels, and, most important, accumulation of origin are the most important of such flexibilities.
The authors similarly mention the possibility of building on the progress
at the WTO on multilateral harmonization of rules of origin in a mostfavored-nation basis; I am not optimistic about achieving relevant progress
there at this time.
While criticisms of the restrictiveness of rules-of-origin regimes are
largely valid, the political economy of trade negotiations is such that restrictive rules of origin are often the only way to maintain a particular product
in the tariff phase-out commitments of a free trade agreement. Not only do
rules of origin give the local producer of the good more protection (in
which case the rules of origin undo some of the progress attained in the
phase-out), but restrictive rules of origin create other winners (the regional
producers of the key inputs to that good), often tilting the balance. Trade
diversion toward the parties involved in a free trade agreement is always
politically more feasible than trade diversion away from them, and this is
used in negotiations to generate political backup for further liberalization.
A flexible rule of origin (which is always preferable, of course) may
reduce the feasibility of achieving a quick tariff reduction in the first place
by shifting the sourcing of materials to third countries. Under that light,
one may see restrictive rules of origin as a necessary, and transitory, evil
in some cases.
The authors neglect to look carefully at the growing web of subregional
agreements in the hemisphere. Mercosur, the Andean Pact, CARICOM, and
the Central American Common Market involve plans of economic integration that go much further than current free trade agreements. These efforts
will probably converge to a situation in which nations that belong to the
same subregional group, in their efforts to construct customs unions, will
homogenize their existing bilateral agreements with third parties, committing to the same rules of origin and allowing for origin accumulation among
the subregional partners. This will probably take a long time to come to
fruition, but when it does it will significantly simplify the spaghetti bowl
problem and reduce the distortionary impact of rules of origins.
The authors should also address the question of how rules-of-origin
regimes differ across free trade agreements in another way: while rulesof-origin procedures may be very heterogeneous across different goods
within a given free trade agreement, specific goods might be treated similarly
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GIOVANNI MAJNONI
ANDREW POWELL
Majnoni is with the World Bank; Powell is with the Universidad Torcuato Di Tella. This
paper is part of a project on Credit Information, Credit Risk Measurement, and Solvency
Ratios in Emerging Countries supported by a grant from the World Bank Research Committee. We thank Margaret Miller and Nataliya Mylenko for their collaboration on this project. Andrew Powell gratefully acknowledges the World Bank, which he visited between
August and December 2003, for financial support.
We are grateful to Matas Gutierrez from the Central Bank of Argentina, Jos Luis
Negrn, Javier Mrquez, and Alberto Romero from the Bank of Mexico, and Ricardo
Schectman from the Central Bank of Brazil for invaluable help in the quantitative analysis.
We thank Jerry Caprio, Mark Carey, Patricia Correa, Charles Goodhart, Michael Gordy,
Patrick Honohan, Patricia Jackson, Rafael Repullo, Roberto Steiner, Kostas Tsatsaronis,
and Andrs Velasco for very helpful comments.
1. See the Financial Stability Forum website on financial standards (www.fsforum.org).
2. Below we discuss the possibility that too many countries will adopt Basel II, in
which case its role as a standard in creating peer group pressure would have been too great!
105
107
tries. These differences have strong implications for the application of the
IRB approach.
We also discuss Basel II implementation for Latin America and more
generally across all emerging countries. Typically there are few external
rating agencies in these countries, so the standardized approach would have
little effect in linking regulatory capital to risk.8 But the IRB approach may
not be calibrated appropriately for emerging markets, and its implementation and supervision may stretch limited supervisory resources. Given the
data on compliance with the Basel Core Principles for Effective Banking
Supervision across Latin America, it may not be advisable for many countries to implement the IRB approach for a long time.
Given this situation, we suggest an innovative simplification of the IRB
approach that builds on current policies regarding provisioning in some
emerging countries and that may be used as a transition arrangement
toward the IRB approach. We call this the centralized ratings-based (CRB)
approach. Under this approach, banks would rate their clients, but the regulator would determine the rating scale and the way in which the banks
ratings map into default probabilities. The use of a centralized scale would
facilitate comparison across banks and greatly ease the monitoring of
banks ratings.9 Those requirements would also be easier to monitor, since
the regulator would determine how banks ratings would feed into capital
requirements.
Countries must choose whether to stay on Basel I or, if not, which Basel
II alternative to apply (here we include our proposed CRB approach). To
date there is little guidance on this important decision. We therefore develop
a Basel II decision tree to assist countries deciding whether to adopt Basel
II and, if so, how. Our broad advice is that many countries should stay on
Basel I or only adopt Basel II for a subset of banks at least for several years
beyond 2007. Regulators should not move to complex rules too quickly sim-
8. This may also be the case for smaller and regional banks in G10 countries. These
banks are unlikely to be systemic, however, whereas systemic banks in emerging countries
will typically have mostly nonrated assets. See Ferri, Liu, and Majnoni (2001) for a discussion on the global pattern of ratings.
9. Bank ratings could be compared directly in the case of banks lending to the same
corporate client. Bank ratings for similar types of loans (to companies in the same economic
sector, business line, or region) could also be compared and outliers investigated. Some G10
regulators informally acknowledge that even where the IRB approach is likely to be employed,
supervisors will compare banks internal ratings of important corporate clients (as they do
today) and for that purpose will no doubt map ratings into a centralized scale.
ply because of peer group pressure or pressure from the large international
banks. We also argue that countries in the region should seriously consider
the CRB approach, and we suggest ways in which this may be made compatible with Basel II for the purpose of assessing standards.10
The paper proceeds as follows. In the next section we provide a highly
synthetic account of the new Accord. The paper then introduces our methodology for testing the calibration of the proposed requirements for the IRB
approach and also presents and discusses these results. We go on to consider broader questions regarding Basel II implementation. The closing
section concludes with a discussion of policy.
10. Countries may be concerned about how banking regulations and supervision will be
assessed by the International Monetary Fund and the World Bank, in the context of the
Financial Sector Assessment Programs (FSAPs).
11. The definition of capital has not changed from Basel I, but the new Accord includes
important changes in the level of consolidation that banking supervisors should apply
(scope of application) and for the first time introduces rules on lending to affiliated companies (related lending).
12. The Core Principles refer to supervision. They cover what banks should report to the
supervisor, but not what banks should disclose to the market (Basel II, pillar 3). Strictly
speaking, following Basel I is neither necessary nor sufficient for a country to be compliant
with the sixth Core Principle (on capital adequacy). In practice, however, Basel I is normally considered a necessary condition, and the Financial Stability Forum deems it one of
the critical financial standards that countries should implement (see www.fsforum.org).
109
Securitization risks
Operational risk
Basic indicator:
Capital = 15% gross
income
Simplified
standardized
Standardized
Internal
ratings-based
Foundation
Advanced
Basic indicator, or
standardized
approach where
bank capital =
weighted sum of
gross income
across activities.
More sophisticated
banks will be
expected to
graduate to the
advanced
measurement
approach where
capital requirement is given by
own risk measurement system.
As for Foundation IRB
approach.
banks, and the distribution of rated claims will probably also be different.15
This implies that the operational risk requirement may approximate a simple add-on, increasing overall capital requirements. While this may not be
undesirable, it may be an impediment to the implementation of Basel II in
some countries.
15. Local supervisors may also employ local ratings (that is, ratings conducted
according to a national or local scale rather than an international scale). However, the three
major rating agencies (Fitch, Moodys, and Standard and Poors) all warn customers that
local ratings are not necessarily comparable across countries. This raises an important issue
for the use of the standardized approach as a financial standard.
111
default.17 The expected loss for a single claim is the multiplication of the
three variables if expressed in appropriate units. However, the provisions
a bank holds are typically identified with expected losses, and capital is
identified with a value-at-risk (VaR) concept. A regulator might then ask
a bank to hold provisions and capital to cover a specified percentage of the
distribution of losses to ensure the continued solvency of the bank except
in highly extraordinary circumstances.
This is illustrated in figure 1, where the segment OB represents the total
value at risk associated with a specific probability of occurrence, that is,
the level of losses that corresponds to a certain percentile of the distribution function of expected losses (99 percent in the figure). A regulator
might then ask a bank to hold general provisions to cover the expected loss
represented by the segment OA, where A is the mean of the loss distribution, and to hold capital to cover the unexpected loss represented by the
segment AB (that is, the difference between the total value at risk defined
with respect to a particular percentile of the distribution and the mean or
expected loss). The calibration of the Basel II IRB formula employs a value
at risk of 99.9 percent with a horizon of one year. Hence a bank is only
expected to use up its capital in one year with a probability of 0.1 percent,
or once every 1,000 years.18
The inputs for the Basel II IRB formula are the parameters for a single
loan or claim, and the output is the capital requirement for that instrument. Subject to an underlying assumption regarding the correlation of
asset risks, this single-instrument approach should approximate the result
of a portfolio credit risk model. An econometric methodology is typically
employed to estimate individual instrument default probabilities, and these
estimates are then fed into a model with other parameter estimates to obtain
the loss distribution curve for the portfolio.19 Simplifying assumptions are
employed in both estimating the parameters and developing the model.
Commonly used models include Moodys KMV option-based model,
the McKinsey macroeconomic simulation model, the CreditMetrics model
17. See Altman and Saunders (1997) for a useful discussion.
18. This assumes that draws from the distribution are independent over time.
19. This may be for a particular bank or a specific business line of a bank. As we directly
mimic the portfolio of a bank, we do not discuss further the important issue of aggregation.
Suffice to say that the Basel II IRB formula is by business line (sovereign, commercial, and
retail) and is calibrated with particular assumptions regarding asset correlations in each sector. The results are simply added, implying an assumed perfect positive correlation between
business lines.
113
Probability
General
provisions
Capital
99th percentile
Expected
losses
O
Unexpected
losses
A
Loss
20. See Balzarotti, Falkenheim, and Powell (2002) and Balzarotti, Castro, and Powell
(2004) on the implementation of CreditRisk+ in Argentina. See Mrquez and others (2003)
for the case of Mexico and Foglia (2003) for a discussion and model-based estimates of
credit risk using Italian credit registry data.
In this paper we take a quite different approach: we adopt a bootstrapping technique that essentially enables us to mimic the shape of the loss
distribution function of any specified loan portfolio.21 This approach minimizes the impact of estimation errors and maximizes the degree of comparability across countries. Even without an underlying model, bootstrapping
techniques can be used to simulate the frequency distribution of credit
losses. The resampling approach is very flexible and lends itself to many
alternative simulation exercises aimed, for example, at measuring the exposure to credit losses of portfolios characterized by different loan sizes,
maturities, ratings, geographic locations, or economic sectors.
The empirical exercises performed in this paper are for Argentina, Brazil,
and Mexico. In each of the three countries, the central bank maintains a
public credit registry that contains information on a very large number of
loans in the financial system.22 Each financial system requires a clear
amount of capital plus provisions every year to confront total credit losses.
However, that observation tells us little about the required capital and provisions for an average bank in that year. Conditional on the overall macroeconomic conditions, the losses suffered by an average bank depend on
the sensitivity of the banks loan portfolio performance to the prevailing
economic conditions and the idiosyncratic risk of the portfolio. The Basel
II IRB approach assumes that the correlation structure of a bank portfolio
is known and summarizes credit loss correlations as sensitivities to a single factor, but credit risk correlations are not known with certainty and a
single factor model can at best be thought of as an approximation to a more
complex reality.
The technique we employ generates conditional loss distribution functions based on overall economic performance, the correlation of credit losses,
and any residual idiosyncratic risks in a large number of sample portfolios.
We then use these distributions to measure the expected and unexpected
losses. In other words, conditional on the overall performance of the financial system over the period of analysis, our results provide a measure of
the level of expected and unexpected losses of a bank of average size with
21. Here we are following Carey (2002). Also see Carey (1998) for further analysis of
credit risk in G10 portfolios.
22. See Miller (2003) for details on public credit registries around the world; see Powell
and others (2004) for an empirical analysis of the value of public credit registries in
Argentina, Brazil, and Mexico and a discussion of their use for predicting credit losses.
115
a loan portfolio randomly drawn from the universe of loans within the
financial system.23
We limit our empirical analysis to only one specific year owing to changes
in definitions, the scope of coverage, and data quality across the credit registers from the three countries. Our findings should therefore be regarded
as illustrative of a methodology that needs to be repeated over several
years to achieve its full empirical relevance. This point is shown in greater
detail in figure 2, which shows a sequence of conditional distributions estimated at different points in time (namely, t1, t2, and t3, which represent a
sequence of good-bad-good years over a hypothetical economic cycle) and
the unconditional distribution resulting from pooling the data from all the
conditional distributions. Our estimates reflect the events of the chosen
year and thus cannot be taken as representative of the unconditional distribution. However, we chose a year close to the cyclical trough for each
country (the period t2 in the characterization of figure 2), so our estimates
may properly reflect those observations that carry a greater weight in shaping the right tail of the unconditional distribution of credit losses. For
instance, the Argentine data are for 2001. In that year, a recession led to a
fall of GDP equal to 4.4 percent in real terms and a deepening crisis. Bank
deposits were frozen in December 2001, and there was considerable economic and political uncertainty that resulted in the removal of the president amid riots. Over the same period, Mexico experienced a stagnation of
economic activity with zero GDP growth and a reduction of the ratio of
bank credit to GDP to 11.9 percent, the lowest value of the last decade. In
Brazil, a slowdown in economic activity brought GDP growth down to
only 1.3 percent and led to a contraction of bank credit in real terms. To
summarize, while the results naturally reflect a period in time, the snapshot
captures economic stress in all three countries.
23. Our one-point-in-time distributions might be thought of as distributions across idiosyncratic risk or, alternatively, of distributions of correlations of asset risk within our sample portfolios. For a one-factor model, the systemic risk of a portfolio might be approximated
by average correlations as portfolio size increases. In practice, however, asset correlations
may differ substantially across bank portfolios if asset correlations depend on many factors,
including sector, loan, and borrower characteristics, and if portfolios are lumpy in terms of
their exposures across these factors. Indeed, one common explanation of why one bank may
fail during a recession whereas another does not is based on differences in exposure to systemic factors rather than pure idiosyncratic risk. The Basel II IRB formula assumes that
there is a single systemic factor, that bank portfolios have zero idiosyncratic risk, and that
asset correlations are identical for companies of the same size (and decrease with company
size), but correlations are always assumed to be known and stable.
Unconditional
Losses
(%)
UL2
UL
UL3
UL1
EL2
EL
EL3
EL1
t1
t2
t3
Time
Frequency
The first step of the procedure consists of extracting from the public
credit registry a large pool of performing loans to the nonfinancial corporate sector at a particular date. This pool reflects the overall risks of lending to the corporate sector in each particular country. Second, we define
default as the event of payments that are over ninety days past due.24 Third,
we classify loans into two categories according to whether they maintain
their initial status or default over the following twelve months. Fourth,
from this pool of loans, we randomly sample a predefined number of loans
(in our case 500), intended to mimic the loan portfolio of a medium-sized
bank.25 Given a predefined recovery ratio, we compute the value of the
losses of the sampled portfolio, expressing this as a fraction of the face
value.26 Fifth, we replicate the last step a large number of times (20,000 in
24. This follows the typical definition of a nonperforming loan according to international best practices and to one of the criteria set out by the Basel Committee on Banking
Supervision.
25. Modifying the sampling procedures would enable the selection of predefined risk
profiles and the analysis of different risks embedded in bank portfolios (see Carey, 2002).
26. We assume a predefined recovery ratio of 50 percent of the face value of a defaulted
loan. The Basel Committee on Banking Supervision employs a loss given default of 45 percent for the foundation IRB approach. Our conversations with the central banks indicated
that this might be somewhat low for emerging markets, so we selected the figure of 50 percent
for the purposes of our calibration exercises. The bootstrapping methodology would be considerably more precise if data on loss given default were available at the individual loan level.
117
this case) to generate a frequency distribution of credit losses. This frequency distribution simulates the actual distribution of credit losses faced
by banks in that financial system at that time. Finally, we use the frequency
distribution of credit losses to calculate a number of statistics in a reasonably homogeneous way across countries. In particular, we calculate the
expected and unexpected losses up to different statistical tolerance values
across the different portfolios. We compare these estimates in each country against current regulations (inspired by Basel I), the actual provisions
and capital of banks, and a simulated capital requirement using estimated
default probabilities and following the Basel II IRB formula.
Having described the methodology, we reiterate the caveat that the
results reflect a snapshot of a particular country in a particular year. The
results cannot and should not be interpreted as average values representing credit risk exposure over different time horizons or over the full business cycle. Moreover, the results are dependent on the universe of loans
collected by the public credit registry. For Argentina and Mexico, we are
confident that this universe of commercial loans is representative of the
financial system as a whole, but in the case of Brazil, we could only access
the universe of larger corporate loans, for reasons explained below.27 Our
results should thus be interpreted as tentative and conditional on the time
and loan universes obtained. Nevertheless, they are highly suggestive, tend to
back up other evidence, and could provide the catalyst for similar studies
in other countries or in the same countries over longer time periods.
Frequency (percent)
60
50
40
30
20
10
21
71
2,4
21
2,2
71
2,1
21
1,9
71
1,8
21
1,6
71
1,5
21
1,3
71
1,2
1,0
92
77
62
47
32
17
21
73
11
6
15
9
20
2
24
5
28
9
33
2
37
5
41
8
46
2
50
5
54
8
59
1
63
4
67
8
72
1
76
4
80
7
85
1
89
4
93
7
Frequency (percent)
9
0.1
0
0.1
2
0.1
3
0.1
5
0.1
6
0.1
8
0.1
9
0.2
0
0.2
2
0.2
3
0.2
5
0.2
6
0.2
8
0.2
9
0.0
0.0
6
0.0
5
0.0
0.0
0
0.0
0.0
Frequency (percent)
Frequency (percent)
30
25
20
15
10
5
1
59
2
70
3
81
4
92
5
1,0
36
1,1
47
1,2
58
1,3
69
1,4
80
1,5
91
1,7
02
1,8
13
48
37
25
14
37
Frequency (percent)
3. 0
2. 5
2. 0
1. 5
1. 0
0. 5
27
5
33
4
39
2
45
1
50
9
56
8
62
6
68
5
74
3
80
2
86
0
91
9
97
7
1,0
36
1,0
94
1,1
53
1,2
11
1,2
70
0. 0
.39
.48
16
.56
15
.64
14
.72
13
.80
12
11
6
.88
10
9.9
9.0
8.1
7.2
6.2
5.3
4.4
3.5
2.6
0.7
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1.7
Frequency (percent)
119
0
89
8
99
6
1,0
94
1,1
92
1,2
90
1,3
88
1,4
86
1,5
84
80
70
60
50
40
4
21
2
31
0
16
11
Frequency (percent)
29
1,1
41
60
1,0
.5
38
99
.9
92
85
78
71
64
57
50
9
43
1
37
30
23
16
95
26
Frequency (percent)
.0
35
.4
33
.9
30
.3
.8
28
25
.3
23
.7
20
.6
.2
18
15
.1
13
.6
10
8.0
5.5
3.0
0.4
Frequency (percent)
121
lic credit registries and which represent the universe from which our samples of 20,000 loans are drawn; panel B shows the frequency distribution
of the dollar value of the 20,000 randomly selected portfolios; and panel
C shows the distribution of credit losses of the 20,000 randomly selected
portfolios as a fraction of the face value of the respective portfolios.
A visual inspection of the charts shows clear differences among the
three samples. Mexico has the lowest concentration in terms of loan size,
and about 80 per cent of all the loans extracted from the credit register are
smaller than U.S.$100,000. The same figure for Argentina is about 60 percent. We adopted a different sampling procedure for Brazil because of the
huge size of the credit market and following advice from the Central Bank.
Specifically, we included only those companies whose gross exposures
with the financial system were above U.S.$300,000, and hence the only
smaller loans included are those to companies that had other larger loans
outstanding (about 40 percent of loans were less than U.S.$100,000). We
were advised that this sampling methodology would capture the major
credit risks in the Brazilian financial system. The charts for Argentina and
Mexico thus show considerably more skewed distributions for both the
value and credit losses of the portfolios than the comparable distribution
computed for Brazil. As a supplement to the visual information provided
by the charts, table 2 summarizes a set of descriptive statistics of the distribution of the 20,000 randomly sampled portfolios.
No.
observations
Mean
Median
Mode
Standard
deviation
Minimum
Maximum
70,017
41,784
188,165
242
551
85
215
538
62
182
510
33
104
110
89
72
275
16
943
1,306
1,477
Unexpected loss
Default
probability
Expected
loss
95%
99%
99.9%
9.60
8.32
2.70
3.00
6.24
4.80
4.16
1.35
1.50
3.12
7.30
3.51
4.44
1.62
2.54
14.80
6.07
16.58
2.55
3.80
21.80
10.46
31.64
3.91
5.36
14.93
14.15
9.68
10.07
12.70
123
Table 4. Capital and Provisions in Argentina: Unexpected and Expected Losses Estimations
Based on Loan Universes with Different Minimum Exposure Thresholds
Percent
Minimum size of individual
borrowers loan exposure
U.S.$20,000
U.S.$300,000
Unexpected loss
Default
probability
Expected
loss
95%
99%
99.9%
9.6
8.2
4.8
4.1
7.3
3.6
14.8
5.6
21.8
8.0
The results for Brazil reflect the fact that the category of commercial
loans is restricted to borrowers with consolidated borrowing of more than
U.S.$300,000. To test the effect of this different definition of the loan category, we report a summary of the results for the Argentine bootstrapping
with the same restriction as Brazil (see table 4). In this case, the capital that
would be required for Argentine banks is reduced to 5.6 percent (for 99 percent unexpected losses) or 8 percent (for 99.9 percent unexpected losses),
which is actually somewhat lower than the estimated requirements for
Brazil. These results suggest that Brazils risks are roughly in line with
those of Argentina when we take into account the different definition of
the loan universe. They also call into question the adjustment made for
lending to small and medium-sized enterprises in Basel II, which reduces
capital requirements for this sector. In other words, the reduction in required
capital, which reflects the additional diversification of risks, appears to be
more than outweighed by increased default probabilities in our sample of
emerging economies.
We compared our results with the level of capital that would be generated using the estimated probability of default and the formula proposed
by the Basel Committee for the foundation IRB approach.29 The Basel for29. We used the formula for assessing the capital requirement for the corporate portfolio as described in the Basel Committees third consultative paper (Basel Committee on
Banking Supervision, 2003) and revised in January 2004 (Basel Committee on Banking
Supervision, 2004b).
Rating
Default probability
Expected loss
Basel unexpected
loss (Jan 2004)
CCC
BB+
BBB+
27.87
1.38
0.37
13.94
0.69
0.19
19.57
8.07
4.75
mula applied to simulated default probabilities generates capital requirements of 14.9 percent, 14.1 percent, and 9.7 percent for Argentina, Brazil,
and Mexico, respectively (see the last column of table 3). These are considerably lower than our simulations at the 99.9 percent level of confidence
for Argentina and Mexico and higher than the 11.5 percent requirement
that we computed for Brazil.
We also compared our results to those of a similar exercise conducted
by Carey, which was intended to mimic the risk exposure of a representative U.S. bank in the period 198991 and also in a period of high stress for
the financial system (namely, 1929).30 These results are included in table 3.
The expected loss for a U.S. bank in 1929 was about 3.1 percent, which
falls between our estimates of 1.4 percent for Mexico and 4.2 percent for
Argentina and Brazil. However, the estimates of unexpected loss for the
United States in 1929 are significantly below our estimates for the three
emerging countries at each statistical confidence level. Finally, our results
can also be compared to the capital requirements generated by the Basel
formula, using a one-year default probability appropriate to the Standard
and Poors sovereign rating in domestic currency (see table 5).31 The results
for expected and unexpected losses are also given. Table 6 provides details
on the domestic currency sovereign ratings across the whole region, as
well as the simulated Basel II IRB capital requirements.
30. See Carey (2002).
31. The default probabilities are estimated by Standard & Poors based on their historical data of defaults by rating category, including corporate claims.
125
Table 6. Capital and Provisions in Latin American Countries Based on Standard and
Poors Ratings
Percent
Standard and
Poors classification
AAA
AA
A
BBB
BB
B
CCC
Country
Chile
Barbados, Mexico, and Trinidad
and Tobago
Colombia
Belize, Brazil, Costa Rica, El Salvador,
Guatemala, Panama, and Peru
Bolivia, Jamaica, Suriname, Uruguay,
and Venezuela
Ecuador, Paraguay, and Dominican
Republic
Expected
loss
Basel unexpected
loss (Jan 2004)
0.00
0.00
0.34
0.61
0.34
0.62
0.02
0.17
1.56
4.75
1.59
4.91
0.62
8.07
8.69
2.71
12.54
15.25
12.54
19.57
32.11
Three conclusions can be drawn from the results. The first is that the
Basel formula, applied to Argentina and Mexico, generates levels of protection inferior to the advertised 99.9 percent.32 In the case of Brazil, our
results indicate the opposite, but they are affected by the different universe
of loans used. As the IRB approach is currently calibrated, the degree of
protection would be in the range of 9599 percent of the credit loss distribution for Argentina and Mexico. Another way to state this result is that
achieving the advocated 99.9 percent level of protection would require
substantially higher capital requirements than those advocated in Basel II.33
Moreover, the fact that different levels of capital are required to achieve
the level of protection theoretically granted by the Basel IRB curve calls
into question the curve calibration. In other words, given the types of default
32. This conclusion is conditional on events in the year chosen for the analysis.
33. The Basel II IRB formula in fact calculates assets at risk, and capital requirements
are defined as 8 percent of those assets at risk. Assets at risk are then 12.5 times required
capital. Our results may be interpreted as saying that assets at risk must be larger (maintaining the 8 percent capital requirement) or that the 8 percent should be increased to
achieve 99.9 percent protection. This discussion also assumes that provisions cover expected
losses.
127
ity, expected loss, and unexpected loss can be considered as a floor for the
corporate sectors default probability, expected loss, and unexpected loss.37
Table 4 shows that, notwithstanding the lower level of capital requirements derived from Standard and Poors ratings and default probabilities,
increased capital charges are likely to emerge for most Latin American
and Caribbean countrieswhere the sum of expected and unexpected
losses already exceeds the value of the all-encompassing 8 percent capital
requirement of the current Accord.
In short, our results suggest that while the foundation IRB approach
implies a rather generalized increase in capital requirements, it may not
afford the 99.9 percent protection advocated by the Basel Committee on
Banking Supervision given the default probabilities encountered in
emerging countries. This result also calls into question the calibration of
the published curve for use in these environments. If we assume that provisions cover expected losses, then achieving 99 percent protection
would require capital levels significantly higher than the Basel I recommendation of 8 percent and around a 15 percent overall requirement.
Achieving 99.9 percent protection would require even higher levels of
capital. While these levels were close to Argentinas overall capital
requirement in 2001, they represent a steep increase in capital requirements for many countries.
37. Having said that, each of the three major rating agencies now allows private institutions to break through the sovereign floor, although each is subject to slightly different rules.
38. Kupiec (2001) also discusses Basel II calibration for developing countries. However, he considers the original Basel II curve and examines specific assumptions on particular types of loans in a model-based approach.
39. In fact, the concern of many larger G10 banks is that Basel II does not give them
sufficient freedom to use their own portfolio models of credit risk and that they must use the
IRB formula to approximate the risk of a loan portfolio. See the comments by several large
banks on the proposals at www.bis.org.
40. The Basel Committee on Banking Supervision has decided to maintain the formula
rather than allow banks to use internal models for multiple reasons, including the issues of
parameter and model risk and perhaps the fundamental moral hazard reasons discussed in
the introduction.
41. The more sophisticated emerging markets will present exceptions to this, and local
banks that are branches or subsidiaries of large G10 banks are likely to have benefited from
the risk management methodologies implemented across the globe.
42. See Pagano (2001) for a set of papers on issues related to the legal system and credit
risk in Latin America.
43. There are actually twenty Core Principles; here we count the subprinciples of principle 1 as principles in their own right to obtain thirty.
Compliant
Largely compliant
10
20
30
50
Percent
Materially noncompliant
40
60
Noncompliant
70
Figure 6. Emerging Countries Compliance with Specific Basel Core Principles for Effective Banking Supervision
80
Not applicable
90
100
As discussed earlier, however, the standardized approach may yield little in relating regulatory capital to risk because of the low penetration of
rating agencies in emerging countries. Therefore an intermediate approach
is warranted to serve as a transition measure to the IRB model. We refer
to this as the centralized ratings-based approach.
44. For a supervisory-based application using cluster analysis, see Foglia, Iannotti, and
Marullo Reedtz (2001). Rating agency scales are typically through the cycle, whereas internal bank rating scales tend to specify a twelve-month or other horizon. Supervisors may
wish to adopt a through-the-cycle scale to reduce concerns of procyclicality.
131
into finer ones with a smaller range of default probabilities, thereby achieving a more precise measure of required bank capital. The supervisor would
most likely define the buckets to be appropriate for the largest, systemic
institutions in the banking sector.45 Consequently, these problems would
be limited to relatively small institutions. One solution would be to adopt
the U.S. model, which calls for such institutions to remain on Basel I or
adopt the standardized approach of Basel II.
Countries may be concerned that the CRB approach would not be seen
as compatible with Basel II. Some emerging countries, especially in Latin
America, already use a type of CRB approach for calculating provisions,
and the level of provisions tends to be high in the region.46 In our simulations we defined default as more than ninety days past due and a loss given
default of 50 percent, whereas many countries in Latin America ask for
100 percent provisions for noncollateralized loans in this category.
This discussion underlines the need for a highly coordinated system for
loan loss reserves and capital requirements. It is the sum of provisions and
capital that should be compared against the value at risk (the sum of expected
and unexpected losses)and not necessarily provisions against expected
loss and capital against the unexpected component.47 If for some reason
(legal or otherwise) there are impediments to increasing capital to cover
unexpected losses relative to the desired level of protection, then provisions might be increased over and above the level of expected loss.
The methodology should gauge the overall value at risk of loans rather
than their expected or unexpected loss components. This calls into question the common system combining a general loan loss reserve, a specific
loan loss classification and provision depending on past performance (say,
according to the traditional five-category classification), and a specified level
of capital.
45. In a more complex proposal, the regulator could allow the use of more than one centralized scale to reflect different banking specializations. The Hong Kong Monetary Authority planned the introduction of a loan classification regulation similar to that described in
this paper (with loan grades characterized by an upper and lower default probability for each
grade; see Hong Kong Monetary Authority (2002)).
46. Colombia, for example, is developing a system labeled SARC (Sistema de Administracin de Riesgos de Crdito) to quantify loan loss reserves based on individual banks
assessments of expected losses (internal models). Argentina and Brazil also have databases
that include a rating scale determined by the regulator, which is used to monitor provisioning.
47. We abstract here from a discussion of the potential dynamic aspects of banks provisioning policies or counter cyclical regulations regarding loan loss reserves; see Cavallo
and Majnoni (2002) and Laeven and Majnoni (2003) for discussions.
133
vant buckets; to do so, they could very easily establish a homogeneous scale
for comparing different banks ratings of particular corporate clients, corporate clients of similar characteristics, corporate clients in particular economic sectors or regions, and so forth. The homogeneous scale would also
allow the supervisor to easily verify loan classifications based on the default
probabilities. Second, the CRB approach provides a consistent treatment of
capital and loan loss reserves, which is a vital component of Pillar 2 and
Basel Core Principle 8. Third, a risk-based capacity is developed within the
banking system, independently of each countrys decision to officially remain
in Basel I or to adopt the different options of Basel II. Fourth, the homogeneity of bank classification schemes implies that bank data could easily be
aggregated at a country level, thereby generating an important (and thus far
largely missing) source of data for prudential monitoring at the macroeconomic level. These data would be useful for analyzing changes in the asset
structure of the financial system, developing tools to consider aggregate
financial sector risk, and predicting where problems might occur and their
potential depth. Finally, if countries (in a region or more widely) could coordinate the number and definitions of their rating buckets, then this would
enhance aggregation and comparability across countries. Under the standardized approach, local regulators will likely use incomparable local ratings,
and comparability will undoubtedly be lost under the IRB approach, in which
individual banks will use their own rating methodologies. From this perspective, the CRB appears particularly suited for ensuring the dissemination
of a new risk-based regulatory standard.
desire to develop, domestic capital markets; and the availability of information and the degree of sophistication of both banks and the supervisor
in assessing and monitoring loan loss provisioning.
As discussed above, evidence from Financial Sector Assessment Programs completed by the International Monetary Fund and the World Bank
illustrates that many countries are far from being fully compliant with the
Basel Core Principles for Effective Banking Supervision and, on average,
emerging countries lag behind their G10 counterparts.52 Of particular concern is the lack of (i) effective consolidated supervision, (ii) supervisory
independence, resources, and authority, and (iii) effective prompt corrective action. If supervisors lack resources and the basics of effective bank
supervision, then correcting this deficiency should be the first priority, and
the implementation of complex rules on capital requirements may well be
counter productive. Basel II also introduces a significant change in the
level of consolidation required for banking supervisionfrom the bank
itself to its holding company. Since many countries do not comply with more
modest versions of consolidated supervision, these countries remain far
from the spirit of the Basel II proposals.
However, full compliance with the Basel Core Principles for Effective
Banking Supervision is too strict a precondition for moving to Basel II.
After all, many G10 countries are not compliant with all the Core Principles. A country should be compliant with the Core Principles to the degree
required to implement the appropriate alternative chosen within the Basel
II framework. For example, if a supervisor does not have the resources
(including data, information, technical competence, staffing, and management) to consider whether the calibration of the Basel II IRB approach is
appropriate to that country, or to monitor effectively how banks would
apply the IRB methodology, then a simpler alternative should be adopted.
Many emerging countries will probably opt for the simpler Basel II
approaches, including the simplified standardized approach and the standardized approach. An important difference between the two is that the
latter allows for the use of credit ratings from private agencies, whereas
the former only uses the ratings of official export credit guarantee agencies
for sovereign risk assessment. The problem for many emerging countries,
however, is that markets for credit ratings are shallow, so the standardized
approach would not improve much on either the simplified standardized
approach or Basel I in terms of aligning capital requirements with risk.
52. See the joint IMFWorld Bank project (IMF and World Bank, 2002)
135
Adopting the standardized approach may create incentives for such ratings markets to develop, but this brings its own dangers in terms of companies buying a good rating and provoking a race to the bottom in ratings
quality. The second key characteristic, then, is the state of the ratings market. The standardized approach makes little sense for a country with no
ratings market to speak of. Such a country should stick with Basel I or
adopt the simplified standardized approach. Alternatively, if the countrys
compliance with the Core Principles is reasonably high, the authorities
could consider the CRB approach as a potential precursor to the Basel II
IRB approach. For a country with an active ratings market, the standardized approach makes more sense.
If a country adopts either the simplified standardized approach or the
standardized approach, Basel II will likely increase bank capital requirements.53 The source of the extra capital charge is operational risk. An
increase in capital requirements may not be a bad thing, but an emerging
country deciding whether to adopt Basel II should carefully consider the
current level of bank capital and the feasibility of increasing required bank
capital. This is the third characteristic listed above.
Basel II also includes enhancements for the credit risk implications of
securitization risk and for credit risk mitigation techniques. A country
with a fairly inactive ratings market may still benefit from the use of ratings in these areas. For example, if a country has an active market for securitized claims (a market that is currently growing in importance in some
countries), then those claims will most likely be rated and the Basel II
standardized approach regarding securitization risk might be gainfully
adopted. This may not seem to be a critical feature, but if a country wishes
to develop capital markets, then it needs to ensure that banks have the right
incentives to securitize claims. Basel II does a better job here than Basel I.
A similar argument can be made for credit risk mitigation techniques.
Basel II makes useful improvements in this area, so it may be appropriate
if markets using securities as collateral are important or if a country wishes
to develop them. The fourth characteristic listed is thus the importance of
local capital markets and the desire to develop them.
The final characteristic suggested above is the sophistication of the supervisor and banks in terms of provisioning rules, monitoring, and control. Basel
53. This may also depend on the long list of items under national discretion. Two such
issues are the risk weights for mortgages and for retail exposures. Capital requirements are
more likely to rise if the more generous treatments are not applied. We do not go further into
the specific items left to national discretion.
Basel I
Basel I
Not feasible/desirable to
increase capital
requirements
Basel II A
Pillar I: Simplified
standardized approach
Feasible/desirable to
increase capital
requirements
Basel II B
Pillar I: Standardized
approach
More sophisticated
provisioning rules
Rating penetration
may be low
with many of the basic Basel Core Principles are probably advised to stay
with Basel I. However, a country that wishes to increase bank capital requirements should consider the Basel II simplified standardized approach if the
extra burden of supervising operational risk is feasible. Countries that
have only a shallow market for ratings will get limited benefits from the
standardized approach and should be advised that this will also lead to an
increase in capital requirements. They should stick with the simplified standardized approach if supervisory resources are limited. Countries that have
deeper capital markets or a strong desire to develop them should reconsider
the standardized approach for its enhancements to securitization risk and
credit risk mitigation techniques. Finally, countries that have made advances
in terms of forward-looking provisioning rules and that have the information and systems to control banks provisioning practices are better placed
to consider the CRB or even the IRB approach.55
Conclusions
In this paper we have discussed the implementation of the Basel II Accord
in emerging countries, with an emphasis on Latin America. The discussion
suggests three broad concerns with the new accord. First, given the low
penetration of rating agencies, the Basel II standardized approach (which
uses external ratings to gauge credit risk) will do little to link regulatory
capital to risk in Latin America. For countries adopting the standardized
approach, moving to Basel II will imply only a marginal correction of other
problems in Basel I, and it will not address the fundamental problems of
Basel I that motivated the new accord.56 Second, the more advanced Basel
II internal ratings-based approach may require recalibration given our estimates of credit risk. It also appears complex and will stretch scarce supervisory resources in many countries. Finally, the essence of a standard may
be lost if many countries adopt the standardized approach (using incomparable local ratings) or the IRB approach (using many different private
banks ratings and default-probability estimation methodologies).
We propose an intermediate approach between the standardized and
IRB approaches, which we call the centralized ratings-based approach.
55. We perceive a loss of comparability across countries as a cost of the IRB approach.
56. Implementing the standardized approach has advantages stemming from improvements in the treatment of securitization risk and credit risk mitigation techniques.
139
Our approach might be used as a transition measure to the IRB methodology; it might be employed to more fully integrate capital and provisioning
regulations; and it might allow increased coordination on a standardized
risk-based reserving policy across countries in the region or beyond. A
main difference with the IRB approach is that although banks would rate
their clients (and estimate default probabilities), the regulator would define
the rating scale and the way in which the rating buckets would map to
default probabilities. This approach could be used to set forward-looking
provisioning requirements only. A country could then adopt the Basel II
standardized approach, set provisions using the CRB methodology to cover
the value at risk minus the standardized approachs capital, and thereby
ensure that banks total reserves (provisions plus capital) covered the entire
value at risk up to the desired level of protection.
We employed a homogeneous bootstrapping methodology to analyze
credit risk in three emerging markets in Latin America. The bootstrapping
methodology implies that our estimates are free from the usual problems
of parameter estimation error and model error that plague standard attempts
to measure portfolio credit risk. At the same time, our results should be
taken as indicative only, and we hope that future research will attain further precision by extending the empirical methodology over time. The results
indicate that to achieve a 99 percent level of protection (in other words,
such that capital covers the unexpected loss to 99 percent of the distribution), capital requirements would need to be significantly higher than the
8 percent level recommended in Basel I and closer to 15 percent. Even higher
levels would be required to achieve 99.9 percent protection, as intended in
Basel II. We also find that the Basel II foundation IRB approach, while
resulting in increases in capital requirements above Basel I, would result
in levels closer to the 9095 percent protection rather than the 99.9 percent
level stated as used in its calibration. We believe that further research is
required in this area to consider if and how the Basel II IRB methodology
might be recalibrated for countries that have default probabilities significantly higher than G10 countries.
We also discuss Basel II implementation in Latin America more generally and develop a simple Basel II decision tree. Countries should consider
five characteristics when deciding whether to stay on Basel I or implement
Basel IIand if the latter, how. An important characteristic is how countries comply with the Basel Core Principles for Effective Banking Supervision and, hence, with the second pillar of Basel II. If compliance with the
Core Principles is weak, then countries should consider staying on Basel I.
57. We have not discussed a number of issues pertinent to Latin America that receive
less attention in the new Accord: namely, bank lending to its own government, lending in
foreign currency (domestic dollarization), and related lending. The Basel Accord addresses
all three cases, but the treatment should be tightened in each case.
Comments
Patricia Correa: Endless pages have been written on the potential flaws
that could prevent Basel II from achieving the ultimate goal of increasing
financial stability worldwide by improving bank risk management and
making capital requirements more sensitive to risk. Criticisms, which are
sometimes contradictory, can be grouped into five categories. First, the new
accord offers alternative approaches for measuring capital requirements
(two versions of the standardized approach and two of the internal ratingsbased, or IRB, approach), but it does not create proper incentives to use the
most risk-sensitive approach, thereby opening the door for arbitrage. Second, in countries with little capital market and financial development, reliable external ratings are not available for most of the assets in the banks
credit portfolio; in such cases, the standardized approach will do little to
link better capital to risk and would be, at best, a poor substitute to Basel I.
Third, Basel II relies heavily on methodologies that lead to capital requirements that tend to accentuate the cycle, which can eventually increase,
rather than diminish, financial instability. Whether this flaw can be attributed to the methodologies themselves or to the length of the databases
employed to make the respective estimates is a controversial issue, but this
topic is certainly an important one in the discussion. Fourth, the new framework will most probably increase the amount of minimum regulatory capital regardless of the measurement methodology chosen, and many banks,
particularly in emerging economies, are simply not ready to meet the additional capital requirement. Finally, regulatory and supervisory bodies in
most emerging economies are not prepared to meet the challenges posed
under the second pillar of the accord, owing to lack of infrastructure, inadequate human capital, and so forth.
Majnoni and Powells paper represents an important contribution to the
understanding of the potential impact of Basel II on emerging economies
and sheds light on the validity or relevance of the aforementioned criticisms. The authors contribution is particularly valuable in two aspects: it
141
143
bration of the Basel II IRB curve, stating that it is not clear that it would
be appropriate for emerging economies to apply the IRB curve to individual instruments to ensure a good approximation of risk. They suggest that
as with Basel I, countries should or may choose to recalibrate the curve or
make the requirement more stringent (for example, establishing a 10 percent capital adequacy requirement instead of 8 percent). They also conclude that the foundation IRB approach is, notwithstanding its benevolent
risk calibration, likely to set higher capital requirements than the existing 8
percent under Basel I.2
While the methodology employed by the authors has its advantages, the
data limitations and the short period chosen for the estimations (issues that
are acknowledged in the paper) make it premature to categorically conclude that the Basel II models need to be recalibrated. Only after many
years of experience and collection of quality data would it be possible to
quantify those default rates and value-at-risk levels appropriately and,
incidentally, reduce the procyclicality inherent to all approaches based on
empirical estimations (even those using bootstrapping). Several related
questions come to mind. Has the bootstrapping methodology been contrasted with that of Basel II using G10 data? If so, for what periods? How
sensitive are the comparisons of bootstrapping and Basel II to the period
chosen? Are Brazils small credit loans necessarily more risky than large
ones, as assumed by the authors?
In any event, these limitations should not serve as an excuse for regulators and banks to not move forward in refining internal risk measurements.
Neither should the fact that Basel II implies more capital requirements. To
advance Basel IIs general goal, the problem of raising additional capital
could be solved by phasing in the meeting of the new requirements, rather
than halting progress in the implementation of IRB systems.
I turn now to the papers qualitative analysis. In assessing the difficulties that emerging economies may have in applying the new capital accord,
Majnoni and Powell outline the minimum conditions that countries have
to meet before they begin implementation, and they summarize documentation that proves that many emerging economies do not yet meet these
requirements. I disagree with the authors approach to tackling these problems, which is basically to strengthen institutions before starting to implement Basel II. It is true that the ideal conditions are not present in many
countries (I would dare say any country), and many institutional weaknesses
2. Specifically, 15 percent for Argentina and 1014 percent in Mexico and Brazil.
prevail in the supervisory agencies and the banking industry. My experience as a banking supervisor in Colombia, however, made me a firm
believer that the only way to create such conditions, particularly regarding
the second pillar, is precisely by moving forward and setting clear goals
and deadlines. In this ever-evolving field, which is more art than science,
learning by doing is the only way to succeed, as has long been the process
in the developed world. A sure way to delay preparedness is to postpone
the definition of policy goals such as the development of good risk assessment within banks and matching regulatory capital. Again, gradually phasing in the objective is preferable to not starting the run.
Finally, the papers policy recommendations aim to facilitate the transition toward the Basel II IRB regime in emerging economies. The authors
propose a centralized ratings-based (CRB) approach to cover credit risks,
which is compatible with the IRB model and which has the following characteristics: banks estimate default probabilities according to their own
internal models, as in Basel II; the regulator defines the rating scale to be
used and the mapping of each rating bucket to a range of default probabilities (in Basel II this is done independently by each bank, not uniformly by
the regulator); and loan loss provisions are defined as the expected loss
given default for each category of loans, and regulatory capital is defined
as the total value at risk minus the expected loss (or, in the case of legal or
other problems with changing the capital regime during the transition
period, provisions could be defined as the difference between the desired
total level of protection and the current capital requirement, and provisions
could thus be over the expected loss).
This transition regime has a number of advantages. It coordinates the
system for loan loss provisioning and capital requirements, and it would
facilitate comparisons across banks and the handling and interpretation of
data on credit risk. This proposal is in many ways similar to the system
being implemented in Colombia. It is extremely appealing and should
receive more attention and backing by international regulators. While it
certainly simplifies matters for both regulators and banks, it is perfectly
compatible with the spirit and ultimate goal of Basel II.
Philip Brock: In 1988 the Basel Committee on Banking Supervision formulated the first Basel accord for bank capital requirements (Basel I). Its
purpose was to raise overall levels of capital adequacy in the thirteen
member countries while simultaneously homogenizing standards. Basel I
was a great success, with over a hundred countries adopting the framework.
145
Concerns arose, however, over the side effects of the accord. Among other
issues, the capital standards of Basel I are relatively insensitive to the riskiness of bank portfolios, and the accord creates incentives to engage in regulatory arbitrage, whereby banks increase their risk within the parameters
of Basel I without raising levels of capital.1
These concerns with the somewhat blunt nature of the Basel I capital
standards led to the forging of a second accord (Basel II) in June 2004,
which seeks to make bank capital more responsive to credit risk. Basel II
offers four approaches to calculating bank capital. The first two, the standardized and simplified standardized approaches, map the ratings of credit
rating agencies into capital requirements. The second two rely on banks
own internal ratings-based (IRB) models to generate levels of capital adequacy. Although this menu of approaches to capital requirements addresses
the concern that Basel I is not sensitive enough to bank risk, Basel II has
its own flaws. The two standardized approaches have highlighted concerns about the ability of risk-rating agencies to provide meaningful assessments of bank risk.2 The two IRB approaches rely heavily on value-at-risk
(VaR) models that only provide point estimates of the loss distribution,
leaving substantial room for so-called spike-the-firm events involving
high losses with low probability.3 Regulatory arbitrage could also occur
across banks adopting different approaches (for example, the standardized
versus IRB approaches).4
Majnoni and Powells paper centers on the adaptation of Basel II to
Latin American financial systems. Their first concern is the lack of penetration of credit-rating agencies in Latin America, which makes the implementation of Basel IIs standardized approach difficult. The second is the
accuracy of the VaR approach for calculating capital adequacy levels. A
centerpiece of the paper is the use of a bootstrapping methodology to calculate levels of capital adequacy that cover losses in 99 and 99.9 percent
of potential outcomes in any given year. The authors apply this bootstrapping methodology to loans from Argentina, Brazil, and Mexico. When they
compare the bootstrapping methodology with a VaR model calibrated using
Basel II values, they find that that the VaR model underestimates the amount
of capital that banks should be holding in each of the three countries. The
1.
2.
3.
4.
authors find, among other factors, that the Basel II risk weights for small
and medium-sized business loans are too low for Latin America, in
comparison with the empirically derived results from the bootstrapping
exercises.
The authors concerns with the application of the standardized and IRB
approaches of Basel II leads them to propose a hybrid approach, which
they call the centralized ratings-based (CRB) approach. This approach
relies on bank supervisors to develop risk ratings for banks based on the
information that banks provide to the supervising authorities. In contrast
with Basel II, the CRB imposes uniform (rather than bank-specific) risk
weights across categories of loans for all banks, but the risk weights are
determined with the active interaction of the banks and the bank supervisor. The CRB approach is similar to approaches currently in use in several Latin American countries.
A primary purpose of the Basel capital accords is to promote the stability
of financial systems. As with Basel I and II, there are some worries associated with the CRB approach. Like Basel II, the CRB approach may lead to
procyclical capital requirements, since lower measured credit risk will lead
to lower capital-asset ratios during extended periods of good banking performance. This is less apt to be the case with Basel I, in which capital
requirements respond less to changes in risk. Regulatory capture is another
concern with the CRB approach. In particular, the regulator may come under
pressure at times to be lenient in the classification of bank loans.
Any capital adequacy framework that a country adopts may destabilize,
as well as stabilize, the financial system. Basel I, Basel II, and the CRB
approach all strengthen bank supervision, but they may result in unwanted
risk taking. Much risk faced by banks is macroeconomic, and this type of
risk is underemphasized in Basel II.5 Other financial sector policies can
partially address this macroeconomic risk. For example, evidence indicates that policies geared toward reducing dollarization in Latin America
would stabilize financial systems.6 Policy measures to cushion the impact
of sudden stops of foreign capital would also increase the stability of the
banking systems.7 Ultimately, the success of Basel II or the CRB approach
in Latin America will depend on the accompanying policy measures taken
to stabilize the economies against macroeconomic shocks.
5.
6.
7.
Blaschke and others (2001); Carling and others (2002); Sorge (2004).
Herrera and Valdes (2004); Levy-Yeyati (2004).
Calvo, Izquierdo, and Meja (2004).
147
References
Altman, Edward I., and Anthony Saunders. 1997. Credit Risk Measurement:
Developments over the Last Twenty Years. Journal of Banking and Finance
21(1112): 172142.
Balzarotti, Veronica, Christian Castro, and Andrew Powell. 2004. Reforming
Capital Requirements in Emerging Countries: Calibrating Basel II Using Historical Argentine Credit Bureau Data and CreditRisk+. Business School
working paper. Universidad Torcuato Di Tella.
Balzarotti, Veronica, Michael Falkenheim, and Andrew Powell. 2002. On the
Use of Portfolio Risk Models and Capital Requirements in Emerging Markets:
The Case of Argentina. World Bank Economic Review 16(2): 197212.
Basel Committee on Banking Supervision. 2003. Overview of the New Basel
Capital Accord. Consultative document 3 (April). Basel: Bank for International Settlements.
. 2004a. An Explanatory Note on the Basel II IRB Risk Weight Functions. Technical paper (October). Basel: Bank for International Settlements.
. 2004b. Modifications to the Capital Treatment for Expected and Unexpected Credit Losses in the New Basel Accord. Technical paper (January).
Basel: Bank for International Settlements.
Berger, Allen N., Richard R. Herring, and Giorgio P. Szego. 1995. The Role of
Capital in Financial Institutions. Journal of Banking and Finance 19(34):
393430.
Blaschke, Winfrid J., and others. 2001. Stress Testing of Financial Systems: An
Overview of Issues, Methodologies, and FSAP Experiences. Working paper
01/88. Washington: International Monetary Fund.
Calvo, Guillermo, Alejandro Izquierdo, and Luis-Fernando Meja. 2004. On the
Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects. Working
paper 10520. Cambridge, Mass.: National Bureau of Economic Research.
Carey, Mark S. 1998. Credit Risk in Private Debt Portfolios. Journal of Finance
53(4): 136387.
. 2002. A Guide to Choosing Absolute Bank Capital Requirements.
Journal of Banking and Finance 26(5): 92951.
Carling, Kenneth, and others. 2002. Capital Charges Under Basel II: Corporate
Credit Risk Modelling and the Macroeconomy. Working paper series 142.
Stockholm: Sveriges Riksbank.
Cavallo, Michelle, and Giovanni Majnoni. 2002. Do Banks Provision for Bad
Loans in Good Times? Empirical Evidence and Policy Implications. In Ratings, Rating Agencies and the Global Financial System, edited by Richard
Levich, Giovanni Majnoni, and Carmen Reinhart. New York: Kluwer Academic Publishers.
Danielsson, Jon, and others. 2001. An Academic Response to Basel II. Special
paper 130. London School of Economics, Financial Markets Group.
149
Echeverry, Ibez, and Moya are with the Universidad de los Andes, Department of Economics, in Bogot, Colombia. Hilln is with the Colombian Ministry of the Environment.
We express our thanks to Marcela Melndez and Edgar Sandoval, who worked on a first
draft of this paper. We are particularly grateful to Andrs Gmez-Lobo for on-going cooperation with successive drafts, as well as to Mauricio Crdenas, Kenneth McConnell, Norman
Offstein, and Andrs Velasco. Excellent research assistance was provided by ngela Fonseca
and Mnica Hernndez.
151
which results in fares set above competitive equilibrium levels; misalignment of the incentives of bus drivers and owners (a typical principal-agent
problem); and congestion and pollution.1 In many developing countries,
these market failures are exacerbated by weak regulation and enforcement. In Bogot over the last three decades, city transportation was in the
hands of private entrepreneurs, and local authorities were in charge of regulating the system and maintaining the road infrastructure. This arrangement suffered to some degree from all of these market failures. At the end
of the 1990s, the system had an excess supply of usually empty and slow
buses, low-quality service, and widespread inefficiency. Average travel
time to work was one hour and ten minutes; obsolete vehicles were used;
average speed was only ten kilometers per hour during peak hours; 70 percent of air pollution in the central corridors was generated by traffic; and
accidents were frequent.
TransMilenio, a hybrid public-private scheme, was designed to overcome these market failures and improve urban transport quality. The first
market failure, the unclear definition of property rights on the curbside
and on the road, was solved via exclusive lanes and the construction of
restricted-access elevated stations. Passengers pay for access to a system
of buses and stations, as in an underground metro system, and not for access
to the vehicles, as was previously the case. TransMilenio uses the left lane
of the streets, and there is no staircase for accessing the buses, which facilitates transfers in different directions and improves the speed of passengers movements.
The second failure TransMilenio addressed involved fares. These were
traditionally set above competitive equilibrium levels, largely as a result
of capture of the regulator. The theoretical literature identifies reasons for
market power by the bus owners that can also support overpricing. Overinvestment in busses was profitable, leading to excess supply, low use, overcrowding of streets, low speeds, and pollution. In contrast, TransMilenio
fares are set at the level at which they finance the long-term cost of provision, defined through a route-tendering process in which potential providers compete for the exclusive use of the roads based on the lowest cost
bidding. Fares evolve based on the change in input prices and the number
of passengers transported.
TransMilenio also faced a third market failure, which resulted from the
private solution to the agency problem between affiliating firms and bus
1. Estache and Gmez-Lobo (2005).
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
153
led to negative spillovers and reduced the benefits of TransMilenio. Recognizing these risks up front is useful for avoiding similar mistakes in
cities that are planning to reform their mass transit system. The paper is
organized as follows. The next section reviews the market failures prevailing in the provision of public transport, describes Bogots mass transit system before TransMilenio, illustrates the main characteristics of the
new system, and discusses some political economy issues of its implementation. Both positive and negative changes in the quality of life resulting from the new mass transit system, as well as its particular adoption and
a cost-benefit analysis, are included in the subsequent section. A final section presents our concluding remarks.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
155
implies that the fare received from a pedestrian at the curb does not belong
exclusively to the firm authorized to operate on that route. In the absence
of regulation and control, other means of transportation can interlope and
offer pedestrians a ride, which they may accept because waiting time is
costly.4 The implication of this lack of property rights differs in developed
and developing countries. Demand for mass transit in developed countries
can be low (that is, markets are thin), in which case it needs to be induced
by a regular, high-quality service. Once this demand is created, incentives
arise for illegal interlopers to start operating. Hence investments by legal
operators may not be recuperated. This induces underinvestment. In contrast, demand in developing countries tends to be high (that is, markets are
thick).5 Excessive bus entry is the norm, resulting in strong competition for
passengers on the curb. This strong competition spurs distortions in
investment, such as deficient service quality and the use of small vehicles,
which are more maneuverable but produce more pollution, congestion,
larger investment per seat, and safety problems.6
In developing countries, fares are often set above competitive equilibrium levels. This promotes excessive entry of buses. Because buses are not
perfect substitutes, price competition is not an effective mechanism for
regulating the optimal quantity of buses in the market. To minimize waiting time, riders prefer to use the first bus that arrives even though a cheaper
bus may come along in a few minutes. Time, not fares, might be the most
important decision variable for the rider, so the bus can exercise its market power by raising fares. As a result, prices are set above efficient levels
and returns on investment are high, creating incentives for entry and an
excessive number of buses on the road.7 This feature can also result from,
or be exacerbated by, the capture of the regulator. The excess supply of
buses, paired with deficient service, leads to congestion, pollution, and traffic accidents.
Another source of market failures results from the private solution to the
principal-agent problem. This solution, which tries to cope with the misalignment between the interests of the bus driver and the bus owner, introduces further inefficiencies in the provision of mass transit. The profits of
bus owners depend on the number of passengers carried per bus. To align
the interests of bus owners and drivers, the owners typically pay the drivers
4.
5.
6.
7.
Evidence shows that passengers consider waiting time more costly than travel time.
Most of the population in these countries lacks transportation alternatives.
Estache and Gmez-Lobo (2005).
Evans (1987).
based on the number of passengers carried. This contract between the owner
and the driver, however, introduces further complications for the provision
of mass transit. On the one hand, bus drivers compete for passengers to
maximize their payments, causing negative externalities in terms of safety
problems and congestion. On the other, this compensation scheme promotes the use of smaller buses, despite the congestion and pollution problems, because they are better equipped to compete for passengers.
The problems described above are deepened and new inefficiencies
arise when drivers are responsible for fare collection. High monitoring
costs promote the sale of vehicles to the drivers and cause the atomization
of the bus industry in terms of bus ownership. Although this atomization
is effective for aligning the interests of the owner and drivers, it leads to
additional costs. The large number of owners makes it difficult to exploit
economies of scale on coordination and economies of density. Deficient
regulation, weak enforcement, and capture of institutions also worsen market failures.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
157
600
40
550
35
500
30
450
25
400
20
350
15
Passengers per vehicle
Fare
300
1970
1975
1980
1995
10
2000
2005
Source: Authors calculations, based on data from the National Administrative Department of Statistics (DANE).
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
159
Vehicles
25,000
BUSETA
EJECUTIVA
SUPEREJECUTIVA
TOTAL BUSETAS
VEHICLES
20,000
6,000
15,000
5,000
4,000
10,000
3,000
2,000
5,000
1,000
1970
1975
1980
1985
Year
1990
1995
2000
2005
ture intensified the struggle for economic rents, increased the number of
buses on the streets, and contributed to the aging of the vehicle fleet. Market and policy failures thus accentuated the problem of oversupply.
We estimated the economic rents for Bogots traditional mass transit
system by simulating the contracts between affiliating firms and ownerdrivers (see appendix A for a description of the methodology). This industry operated at efficiency levels (nearly zero profits) in only two periods:
the end of the 1970s and the beginning of the 1990s (see figure 3). Outside
of these two periods, economic rents were positive, substantial, and highly
of waiting, which is highly valued by eventual passengers; this permits the charging of a
higher fare. Consequently, rising tariffs create excessive returns to investment and promote
the entry of new buses beyond the socially efficient level (see pp. 1215). The capture of (or
political influence on) the regulator is yet another reason for high fares. As a result of excessive entry, buses in Bogot and Santiago, Chile, have witnessed a sharp decline in occupancy, as illustrated below.
18.00
Driver-owners
36.00
16.00
Fleet administrator
32.00
28.00
12.00
24.00
10.00
20.00
8.00
16.00
6.00
12.00
4.00
8.00
2.00
4.00
19
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
2099
2000
2001
2002
03
14.00
Year
Source: Authors calculations, based on DANE (2003).
variable. These rents rose in the 1980s, when fares grew from U.S.$.10 to
U.S.$.30, which was associated with the introduction of smaller capacity
vehicles. Rents accrued to both the fleet administrating firms and the bus
owner-drivers.
As figure 3 illustrates, however, the composition of rents changed in the
1990s, favoring the affiliating firms vis--vis bus owner-drivers, and total
daily rents never returned to the peak observed at the end of the 1980s. A
new development was observed at the beginning of the 1990s, when the
affiliating firms lobbied for further fare increases based on different levels
of service quality. The so-called executive buses carried only seated passengers, used relatively new vehicles, and offered faster service at higher
fares than traditional buses. This behavior reveals either the capture of the
regulator or the authorities ignorance regarding the true costs of bus transportation, or both.
In sum, the market failure stemming from the absence of price competition in urban bus transport was exacerbated by a policy failure that granted
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
161
free affiliating privileges and periodic fare negotiation with a cartel, leading to systematic economic rents. In addition, this incentive scheme forced
bus drivers to compete for passengers along the central corridors. Drivers
therefore did not respect assigned bus stops or delineated areas for bus
transit in the pursuit of passengers.13
At the end of the 1990s, the excess bus supply, coupled with a substantial increase of private vehicles, exceeded the traffic capacity of Bogot.
From 1991 to 1995, the total number of cars registered in Bogot increased
by 75 percent, and 40 percent of the countrys vehicles were circulating in
the city.14 By 1998, private cars occupied 64 percent of the road space and
mobilized only 19 percent of the population.15 As a result, gridlock was
commonplace, accidents abounded, and travel times were unbelievably
high. Estimates show that in 1995 the average number of daily trips per
household was 11.9, the average number of daily trips per person was 1.7,
and the total number of daily trips was about 10 million.16 The average
speed for public transportation during peak hours was ten kilometers per
hour, which could drop to five kilometers per hour in the center of the
city.17 Inequality of travel times between public transport users and car
owners was sizeable. Mean travel time was 66.8 minutes for public transport users, whereas car owners faced a mean travel time of 42.6 minutes.18
These problems finally led to a rethinking of the entire bus transport system in Bogot, which culminated in the design and implementation of the
first phase of the TransMilenio system in 2001.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
163
mass transit markets, was solved via exclusive bus transit lanes and exclusive stations.
Finally, the recurrent problem of setting fares above market equilibrium
levels was solved with concession contracts awarded through public competition. The concessionaires income is no longer associated with the number
of passenger-trips serviced. Transport providers, both local and foreign, are
called to associate and participate under a new set of rules. The new transport
firms own a number of buses that meet certain specifications and whose operation is subject to the leadership of a central authority, TransMilenio S.A.
These buses have a specified service life stipulated at the outset of the contracts. The concessions expire when the vehicle fleet reaches an average
mileage of 850,000 kilometers, with no individual bus reaching more than
1,000,000 kilometers. If the average mileage threshold is reached in less than
ten years, then the concession extends to the tenth year. If the average
mileage threshold is not reached by the tenth year, the concession lasts until
this happens or until the fifteenth year, whichever comes first.21 The new contracts also establish a payment per kilometer traveled. The number of kilometers traveled depends on the manner in which the central authority
dispatches service and, ultimately, on demand. The reward per kilometer
traveled is the central variable by which the firms compete for these contracts.
TransMilenio S.A. carries out thorough calculations of the costs involved in the provision of the transportation service, as well as demand
forecasts, which enables the authority to set the range of acceptable fees
per kilometer traveled. This range guarantees a fair return to the participating investors and is used as a parameter in the selection process of the
concessionaires.22 TransMilenio thus represents a hybrid private-public
model that replaces competition on the road by competition for the road.23
These measures turned the entire incentive scheme of the previous system upside down. They eliminated the affiliating firm and the license business. They also removed any gains from cutting maintenance costs, since
the service is to be provided over a specified period under safety and efficiency standards: cutting down on costs today implies incurring greater
costs tomorrow to comply with the norms. These measures gave rise to a
21. There is a restriction by which the concessionaire is forbidden to add new vehicles
to the fleet to deliberately bring its average mileage down when a certain portion of the concession period has expired. This contract resembles those analyzed by Engel, Fischer, and
Galetovic (2001).
22. The range is given by a real return on investment between 14 percent and 16 percent.
23. Estache and Gmez-Lobo (2005).
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
165
ing the administration costs of the regulating authority and costs of the
fiduciary contract through which fare revenues are managed.
Authorities decided during the design stage that fares would not be set
to recover the infrastructure investments, since that would render the system unfeasible. TransMilenio fares set to recover the systems operating
costs were already significantly higher than the current bus fares. Imposing
on TransMilenio the obligation of recovering the infrastructure investments
or its maintenance costs would have resulted in negative profitability,
thereby eliminating the participation of the private sector. In addition, the
intervention on TransMilenio corridors includes a full renovation of two
lanes for private cars and the curbside; benefits from this investment accrue
not only to TransMilenio providers and users, but also to other population
groups. Thus investment in the infrastructure required to operate the system
was said to be social investment.
After the opening of the first TransMilenio lines, traditional buses continue to mobilize nearly 80 percent of the population. The TransMilenio
concession contracts obligated the operators to purchase and scrap buses
that previously operated in TransMilenio corridors. Only 1,410 of these
buses were effectively scrapped, however, and the remaining 4,670 buses
were relocated into unserved TransMilenio corridors. Although the
demand for the old system dropped, causing revenues per vehicle to fall, a
loose regulation of the system permitted the excessive entry and overprovision of services in these corridors. Moreover, the fares for the traditional
system were still allowed to rise after TransMilenio came into operation,
as illustrated in figure 4. The introduction of TransMilenio thus did not
spur a substantial reduction in the transport fleet of buses from the traditional system.
the numbers contained in the contracts, and costs are adjusted assuming a monthly average
of 6,400 km per vehicle. Third, to conform to available coin values, the passengers fare is
rounded to the nearest multiple of fifty. Finally, the difference per ticket goes into a fund
that compensates for cost increases not reflected in the fare. Costs are revised monthly, and
the fare is revised (up or down) to the next closest multiple of fifty when the technical fare
changes by more than twenty-five pesos.
Buses
TransMilenio
600
400
200
De
c-9
Ap 5
rAu 96
g-9
De 6
c-9
Ap 6
rAu 97
g-9
De 7
c-9
Ap 7
rAu 98
g-9
De 8
c-9
Ap 8
rAu 99
g-9
De 9
c-9
Ap 9
rAu 00
g-0
De 0
c-0
Ap 0
rAu 01
g-0
De 1
c-0
Ap 1
rAu 02
g-0
De 2
c-0
Ap 2
rAu 03
g-0
De 3
c-0
3
0
Month
Source: TransMilenio S. A.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
167
constant since its adoption. Thus the demand for public transport as whole
did not expand, but rather the appearance of a new transportation mode led
to a distribution of this demand between TransMilenio and the traditional
system.
Demand for public transportation stems mainly from the lower-income
households, yet TransMilenio users are concentrated in the fourth and
fifth income quintiles, as seen in figure 5. In contrast, demand for traditional buses is primarily from the first, second, and third quintiles. The
highest income quintiles thus use TransMilenio more than the lower in-
Bus
50
25
Private vehicle
0
Percent of
population
10
3
Income quintile
8
5
3
0
3
Income quintile
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
169
2001
2002
2003
74
23
4
68
29
2
74
17
5
come quintiles.30 The top two quintiles are also the main users of private
vehicles.
TransMilenios impact on travel times and average speed varies widely
across users of TransMilenio, private vehicles, and the traditional public
transport system. Two years after TransMilenio began operating, the average trip time in Bogot decreased to 35 minutes, from 44 minutes in 2001.
The average speed of cars increased to 20 miles per hour, from 16.8 miles
per hour in 2000.31 Table 1 shows that the percentage of individuals who
spent more than an hour traveling from home to work fell from 23 percent
to 17 percent, while the frequency of trips under one hour rose during 2003.
The benefits of travel time reductions accrued mainly to TransMilenio
users. The average speed of other forms of public transportation actually
dropped, which caused travel times to increase by 10 percent.32 Slow scrapping of buses from the traditional system may be causing the uneven distribution of benefits. An important share of these buses were relocated to
corridors not served by TransMilenio, worsening congestion. Attributing
worsening congestion solely to the relocation of buses is not accurate,
however; slow adoption of other measures to control traffic congestion
and the increase in the number of taxis, as a result of simultaneous interventions, are partially responsible, as well.
Lleras studies TransMilenios impact on public transportation users,
mainly through travel times.33 In 2002 a revealed preference survey was
30. Of all TransMilenio users, 62 percent (325,925 users) correspond to the fourth and
fifth income quintile, while 38 percent (203,830 users) correspond to the first three income
quintiles (DANE, 2003).
31. See www.transitobogota.gov.co.
32. To date, the impact on travel times for riders using unserved corridors has not been
officially measured. The union of small providers of public transportation argues that travel
times in unserved corridors increased by 10 percent as a consequence of bus relocation
(Pico y Placa seguir en discussion, El Tiempo, 11 March 2001).
33. Lleras (2003).
applied to 2,095 public transport riders who could choose between TransMilenio and the traditional system for their transportation. Respondents
were interviewed in the street near areas where routes from the two systems run. The survey elicited information about the transportation mode
selected, the expected attributes of the trip, and various socioeconomic
characteristics. The data were used to estimate random utility models,
which provide the coefficients to calculate the value of time for users of
both systems in the different stages of the process (for example, walk-in
and walk-out times). The study shows that declines in travel times were
not uniform across TransMilenio users. TransMilenio passengers starting
the trip in the vicinity of the main corridors travel 12 minutes less per trip
than passengers of the traditional system. In contrast, passengers requiring
one or more transfers did not experience drops in travel times. In fact, total
travel time is two minutes shorter in the traditional system because of the
waiting time required for the TransMilenio feeder routes.34
Waiting-in and waiting-out time increased for all TransMilenio users,
however, because these times are extremely low for the traditional bus
system.35 TransMilenio users have to buy tickets, wait in line, exit the station, and walk to the final destination, whereas users of the traditional system enter the bus at any location, pay the bus driver directly, and stop the
bus at the point nearest to their destination, since there are no official bus
stops in Bogot. Improvements in TransMilenio travel times arise, therefore, from in-vehicle travel time.
Estimations of the value of time for TransMilenio passengers, vis--vis
users of the traditional system, show unambiguous improvements in traveling conditions for the former. Overall, people are willing to pay less for
savings in travel time than people using the traditional system, indicating
that TransMilenio is a less painful experience. For example, the value
of waiting time for the traditional system is U.S.$3.08 per hour, while in
TransMilenio it is U.S.$1.14 per hour.36
These figures indicate that the first phase of TransMilenio enhanced
travel conditions for a certain population group, although improvements
34. Lleras (2003).
35. Waiting-in time refers to the time spent waiting for the bus; waiting-out time is calculated from the time the passengers step off the bus until they arrive at their destination.
Lleras (2003) estimates that waiting-in and waiting-out times increased 2.95 and 5.16 minutes, respectively, for TransMilenio users vis--vis users of the traditional public transport
system.
36. Lleras (2003).
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
171
1,400
1,200
1,000
800
600
400
200
0
Traffic collisions
Pedestrian accidents
Injuries
Fatalities
Source: TransMilenio S. A.
should not be entirely attributed to the new mass transit system.37 Nevertheless, benefits from the new system are not distributed widely across the
entire population; gains were perceived largely by TransMilenio users, in
particular downtown dwellers.
The quality of services also improved, and TransMilenio corridors
experienced a decline in the external costs caused by public transport
namely, accidents and pollution. Traffic accidents decreased dramatically
in TransMilenio corridors. Figure 6 depicts the incidence of traffic collisions, pedestrian accidents, injuries, and fatalities in TransMilenio corridors
before and after the system came into operation. After two years, traffic
collisions and pedestrian accidents decreased by 94 percent, injuries to
passengers by 76 percent, and fatalities by 94 percent. This is, by all accounts,
an impressive performance.
Finally, air pollution, which is a major concern in Bogot, exhibited a
declining trend in TransMilenio corridors. Half of the districts in the city
currently exceed the particulate matter (PM-10) and ozone pollution limits. Studies indicate that automobiles are the most significant emission
37. Bogots authorities implemented several programs to transform traffic conditions,
including mobilization restrictions during traffic peaks, investment in road infrastructure,
and increased traffic fines.
40
20
0
Daily average -Monitoring
station 1
Source: Authors calculations based on data from the Bogot Air Quality Monitoring Network (Red de Monitoreo de la Calidad del Aire
de Bogot, or RMCAB).
a. The RMCAB maintains thirteen monitoring stations, located throughout Bogot, that measure hourly emissions for a group of
pollutants.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
173
Mndez analyzes the impact of several pollution programs implemented in Bogot.41 Her study evaluates the evolution of particulate matter and ozone in monitoring stations located near TransMilenio corridors
and far from industrial areas from 1997 to 2002. Mndez defines categorical variables to denote the implementation of three policy interventions
(namely, the introduction of TransMilenio, mobilization restrictions,
and mandatory inspection and maintenance) and then estimates time
series regressions to predict the trend of particulate matter and ozone
levels, controlling for these policy interventions. Her results reveal that
TransMilenio is the most effective program for curbing pollution, with a
much stronger impact than programs specifically designed to control
emissions. Mandatory inspection and maintenance reduced ozone levels
by 13.6 percent, while restrictions on car mobilization lowered ozone
levels by 21 percent. The first phase of TransMilenio, however, produced a 28.8 percent decline in ozone levels. Similar estimations for particulate matter indicate that TransMilenio abated PM-10 pollution levels
by 9.2 percent.
Air pollution levels rose in other areas of the city, because the slow
scrapping rate of buses from the traditional system triggered the relocation of buses to non-TransMilenio corridors. To evaluate the negative
pollution spillovers of TransMilenio, we used a difference-in-differences
approach to compare readings from a monitoring station located near a
TransMilenio corridor to readings at a baseline monitoring station. The
baseline monitoring station should have two characteristics: it should
have similar particulate matter readings to the TransMilenio monitoring
station before entry into operation of the system; and it should be located
near a non-TransMilenio corridor without negative spillovers from bus
relocation. Other interventions in the city can also affect the results,
namely, the entrance of new taxis and the construction of new TransMilenio corridors. The evolution of particulate matter in both monitoring
stations is illustrated in figure 8.
Readings of PM-10 soared in the monitoring stations with negative spillovers after TransMilenio fully entered into operation in June 2001.42 It
remained constant in the monitoring station without the negative spillovers. The difference-in-differences calculations indicate that bus reloca41. Mndez (2004).
42. TransMilenio started partial operations in January 2001, and the full system with the
three trunk corridors was in place in June 2001.
With
Without negative spillovers
With negative spillovers
50
40
30
20
Mar-98
May-98
Jul-98
Sep-98
Nov-98
Jan-99
Mar-99
May-99
Jul-99
Sep-99
Nov-99
Jan-00
Mar-00
May-00
Jul-00
Sep-00
Nov-00
Jan-01
Mar-01
May-01
Jul-01
Sep-01
Nov-01
Jan-02
Mar-02
May-02
Jul-02
10
Month
Source: Authors calculations, based on data from RMCAB.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
175
Cost-Benefit Analysis
Understanding the welfare gains and losses from the introduction of TransMilenio is crucial for evaluating whether investments in this new scheme
produced net benefits for the population and identifying future adjustments to the system. Welfare changes can be approximated by measuring
variations in the consumer and producer surplus caused by the adoption of
TransMilenio. We used the above information and data on investments,
costs, and revenues of the systems operation to conduct a cost-benefit
analysis. Only the first phase of TransMilenio (25 percent of the system)
was evaluated. Ideally, we should estimate the consumer and producer
surplus before and after TransMilenio and then calculate the changes in
both surpluses; however, data restrictions limited our analysis to calculating changes in both surpluses as a result of the adoption of the system. A
detailed description of the assumptions and methodology used to perform
the analysis is included in appendix B. Table 2 presents a summary of
results.44
Who wins and who loses with TransMilenio? The previous section
suggests how benefits and costs are distributed among different groups of
the population. We now undertake a detailed cost-benefit analysis to clarify those findings. On the production side, benefits arise for the private
TransMilenio operators but are lost for the owners of the scrapped buses.
The producer surplus of private TransMilenio operators represents welfare gains. In contrast, the former producer surplus that the owners of the
scrapped buses no longer collect represents welfare losses. The shaded
areas depicted in figure 9 denote those welfare gains and losses.
On the demand side, the evaluation of TransMilenio must account for
changes in travel times faced by TransMilenio users and users of the traditional system. An appropriate welfare indicator for these changes is the
willingness to pay for improvements in travel time. The value of time is
defined as the marginal rate of substitution between travel time and a mon44. Detailed calculations of the costs and benefits are available on request.
STS(F)
STM(F)
FATM
FBTM
TATM
Number of
trips
TBTM
Number of
trips
a. The shaded area denotes welfare gains (panel A) and losses (panel B). The subscript BTM indicates the fare and number of
passengers in TransMilenio corridors before TransMilenio, and the subscript ATM indicates the fare and number of passengers after
TransMilenio. Supply curves for private TransMilenio operators and for owners of scrapped buses (STM and STS, respectively) are
assumed to depend on fares (F).
etary cost. Figure 10 presents welfare changes resulting from the adoption
of TransMilenio. When TransMilenio started operations, TransMilenio
users experienced two welfare enhancing effects: travel time decreased,
and the ride was more pleasant than on the traditional system.45 The movement from point A to point B in the indifference curve map for TransMilenio users shows the combined effect on utility; X 20 X 12 measures
willingness to pay for these improvements in traveling conditions. Riders
of the traditional system faced costs from increases in travel time, while their
traveling conditions were practically unchanged. As a result, travel times
rose, but the marginal rate of substitution between savings in travel time
and the numeraire good remained constant. By moving from the status quo
(point C) to the new condition (point D), riders of the traditional system
experienced welfare losses, represented by X 22 X 23.
The adoption of TransMilenio also produced both positive and negative
impacts on pollution readings, leading to gains and losses for the popula45. The improved quality of the ride reduces willingness to pay for improvements in
travel time.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
177
X2
X 20
X2
Losses
A
X 22
X 23
Gain
U0
U1
X 21
U0
X1
U1
X1
a. The horizontal axis represents savings in travel time (X1), and the vertical axis represents a numeraire good measured in monetary
units (X2).
EATM
EBTM
PM-10
EBTM
EATM
PM-10
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
179
7 percent
9 percent
12 percent
3.628
2.702
6.858
6.005
0.608
1.686
2.766
3.026
6.217
5.852
0.283
0.832
5.03
2.720
2.025
5.046
4.410
0.447
1.240
2.034
2.225
4.572
4.303
0.212
0.625
3.71
2.114
1.574
3.870
3.378
0.343
0.950
1.559
1.705
3.504
3.298
0.165
0.486
2.85
5.014
10.239
0.357
15.61
10.59
3.762
7.682
0.268
11.71
8.00
2.925
5.973
0.208
9.11
6.26
U.S.$8 million. The increased travel times for users of the traditional system, resulting from bus relocation, drive these results. Pollution in nonTransMilenio corridors also reduces benefits, but the contributions are not
significant and are partially offset by drops in pollution in TransMilenio
corridors. Benefits stemming from less in-vehicle travel time for TransMilenio users, operational revenues, and reductions in mortality, although
significant, are not sufficient to cover these costs.
Because congestion costs are highly nonlinear, the congestion relief
brought about by TransMilenio has been more than offset by increases in
congestion in others areas. Currently, TransMilenio covers 13 percent of
the public transportation demand, whereas the public transportation system covers the remaining 87 percent. TransMilenio has indeed improved
the traveling conditions of its users, but it has worsened the conditions of
a high proportion of the populationnamely, users of the traditional public system.
Negative spillovers have resulted from three features of the current
mass transit system of Bogot. First, only 25 percent of the TransMilenio
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
181
mass transit systems of Curitiba, Brazil, and Quito, Ecuador, but it introduced some novelties that have become its trademark. The new transit
system is a hybrid model that combines public planning of the network
structure, route tendering conditions, regulation, and supervision, with private operation of the separate functions of revenue collection and transport
service. Among the most salient features are the financial fiduciary management; the division of services among separate private providers that
simultaneously administer the firm TransMilenio S.A.; the flexible contracts for bus operation; the separation of concessions for feeder buses and
regular buses; the payment per kilometer instead of per passenger; the definition of property rights for the road and the curbside; and the use of the
faster left lanes.
This paper is the first to provide a full economic account of the origins,
design, political economy, and costs and benefits of TransMilenio. The
system had a sizeable impact on users by improving travel conditions significantly. Congestion, pollution, and traffic accidents fell sharply in TransMilenio corridors. But the type of transition adopted for corridors not
covered by TransMilenio caused unforeseen negative spillovers, as a consequence of slow scrapping rates and bus and route relocation. Although
the cost-benefit analysis for the first phase of the corridors covered by
TransMilenio is positive, the citywide net effect is negative mainly as a
result of increases in travel time for passengers using the traditional transport system. To minimize the negative spillovers during the full implementation of TransMilenio, integration of the traditional and new systems
should continue, and strict regulation of the traditional public transportation system should be crafted.
There remain potential vulnerabilities. As Estache and Gmez-Lobo
indicate, the institutional capacity of the national and municipal planning
authorities for defining the network configuration, quality requirements,
and service levels are crucial.54 One of the advantages of the private system
is its flexibility to modify routes, cover new developing areas of the city,
and bring bus routes closer to consumers. These challenges now need to
be answered satisfactorily by good planning and regulation. The tendering
system requires special care to ensure competition and avoid collusion
among potential bidding concessionaires, as has been argued in the case of
Pereira, the second Colombian city to implement a TransMilenio-type system. The application of contracts also needs to be monitored. This is par54. Estache and Gmez-Lobo (2005).
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
183
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
185
OLS model
ARMAX model
605.2
0.15 106
123.34
0.8064
0.167 10
40648.9
0.24*
0.3363**
6003.83
=0
OLS model
AR(1) model
ARMAX model
52.8123
0.1212 101
0.1062 105
0.2484 1010
21.4539
0.5918 103
0.1053 106
0.2776 1011
33.5797
0.7134 102
0.6694 106
0.1538 10
284.49
0.7466*
0.9674
139.77
0
0.8316
137.78
=0
10
*Durbin Watson.
Source: Authors calculations.
a. E(t) = 0 implies that autocorrelation does not persist.
bus owners. We thus obtained the optimal number of vehicles per affiliating
firm, the affiliation fee, and rents for the affiliating firm and bus owners.
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
187
by the value of travel time for traditional system users and the number of
traditional system users that transit throughout corridors to which traditional buses were relocated. (e) Negative congestion spillovers in traditional system corridors: five city corridors received the bulk of relocated
buses when TransMilenio began its operation (namely, Avenida Calle 68,
Carrera 7a, Carrera 13, Carrera 15, and Avenida 19). Information regarding the number of daily passengers that transit these selected corridors was
provided by the Districts Transit Secretariat. (f ) TransMilenio times: we
calculated all TransMilenio times for two segments of the population. Segment one includes users who do not use feeder lines, as their trips originate in the vicinity of the Trunk Corridors (55 percent of the population,
according to Lleras).6 Segment two encompasses the remaining 45 percent,
who start their trips in areas served by feeder lines and thus have to engage
in one or more transfers. (g) Traditional system times: we calculated all
traditional system times for two segments of the population. Segment one
includes those who only take one bus to their destination (55 percent of
the population), while segment two (the remaining 45 percent) includes
those who take two or more buses to their destinations.
We estimated the effects on air pollution as follows. Reductions in PM10 emissions associated with TransMilenio operations in trunk corridors
were based on Mndez.7 Emission reductions or increases in TransMilenio
corridors are assumed to affect 20 percent of the population. Finally, we
conducted a difference-in-differences analysis to determine the increases in
PM-10 emissions associated with traffic spillovers to non-TransMilenio
corridors.
To determine reductions in mortality, VSL estimates for Chile were
adjusted for Colombia using the per capita GNP of both countries.8 We
then calculated the risk of death for public transportation users before and
after TransMilenio as the number of deaths divided by the number of public transit users.
To calculate TransMilenios net present value, we used social discount
rates of 7.00 percent, 9.33 percent, and 12.00 percent.
6. Lleras (2003).
7. Mndez (2004).
8. VSL estimates for Chile are from Bowland and Beghin (1998).
Comments
Mauricio Crdenas: This is a very interesting paper on a subject that is
highly relevant and relatively ignored by the profession. The success story
of TransMilenio has received ample press coverage in Colombia and elsewhere, but little academic attention. This public policy initiative was able
to change an entrenched status quo and deliver positive results in a short
period. Since other large cities are following the example of Bogot, it is
valuable to understand the main features of the new scheme, including its
limitations and main challenges.
The authors discuss many dimensions of the problem of organizing
transportation in large cities. The paper provides useful analysis and data
on the optimal amount of intervention in urban transportation and the type
of intervention that works best in developing countries. The paper discusses the cost effectiveness of different kinds of intervention and their
impact on living standards, particularly the health impact of air quality.
The experience of Bogot is characteristic of many large cities in the
developing world. Bogot tried for decades to deal with market failures
associated with transportation systems, experimenting with solutions such
as trolley buses and publicly owned and operated buses. Based on the
information shown in the paper, these policies tended to exacerbate, rather
than resolve, market failures. This is what the authors call the pervasiveness of huge service inefficiencies, and it is reflected in variables such as
the excessive number of buses, the low average speed of circulation, the
high frequency of accidents, and the low air quality. TransMilenio has not
solved all the problems, however, and many inefficiencies are still present
today. For example, the authorities of Bogot have been unable to regulate
the flow of buses originating in conjoining municipalities that circulate in the
city. Also, TransMilenio has increased multileg trips and, hence, the total
fare costs for the average user.
The paper emphasizes the excessive number of private cars in the city.
However, contrary to the conventional wisdom that guides policies in the
sector, Bogot has only 130 cars per 1,000 inhabitants, far fewer than
189
other cities of similar size and per capita income. For example, Curitiba,
Brazil, which was one of the early and influential adopters of a bus rapid
transit system, has 300 cars per 1,000 inhabitants. Other international
comparisons suggest that rather than having too many cars, Bogot has
too few kilometers of paved roads. Since per capita income is rising, vehicle demand will undoubtedly continue to increase rapidly, more so after
trade liberalization has lowered the cost of many durable goods, including automobiles. Consequently, while TransMilenio can solve some traffic problems and reduce commuters travel time, the contribution will be
short-lived unless important investments are made in additional infrastructure or policies are adopted to discourage the use of cars through
market mechanisms.
The institutional aspects of TransMilenio are also of interest. The creation of an entity relatively insulated from political competition was critical for attracting individuals with better technical qualifications, who are
paid competitive salaries. The paper sometimes favors the role of individuals, but the fact that the system has been maintained and improved with
the passage of time speaks well of institutional features. The adoption and
expansion of the system has been the responsibility of three successive
municipal administrations that have shown important ideological differences on other issues. This suggests that the institutions were designed in
a way that prevented policy volatility.
The public policies behind the TransMilenio system have not only been
stable, in the sense of remaining in place beyond the tenure of political
officeholders, but they have also been flexible. The system is not based on
rigid rules, so the authorities have been able to fine-tune important aspects,
most notably in relation to the bidding criteria and the contractual design.
Recent contracts have thus transferred more risks and fewer revenues to
the private sector concessionaires. The various agents involved in the process have exhibited a good amount of coherence and coordination, including the different agencies in charge of building the infrastructure and the
company that operates the system. The policymaking process has generated incentives for increasing efficiency in delivery. Most important,
policies have generated broad (as opposed to concentrated) benefits, resembling true public goods.
This brings me to the political economy of the implementation, which
is one the most interesting and relevant aspects of the paper. I agree with
much of what is said and with the overall spirit of the argument, but four
aspects merit greater emphasis. First, the institutional reform in the city of
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
191
Bogot (implemented in 1993) was a consequence of the 1991 Constitution. This enhanced the powers of the mayor and reduced the influence of
the city council. Prior to 1993, the city council coadministered the city,
especially in relation to public utilities and transportation policies. Corruption was rampant. Privatizing public utilities and changing transportation policies would have been very difficult without that reform. Second,
privatization and fiscal reform allowed the city to improve its finances,
providing the necessary resources for a large investment project such as
TransMilenio. Third, given the electoral importance of the capital city, the
presidential candidates in the 1998 election supported the idea of committing national funds to the public transportation system for Bogot. The
question was whether to build a metro or a bus-based system like TransMilenio. The economic technocracy of the national government ruled out
the metro and opted for TransMilenio because it was the only fiscally feasible alternative. In fact, the national government actually chose the TransMilenio solution while the city administration was still considering the
metro as an option. This decision carried political costs because it was
seen by the public as an inferior solution to the transportation problems of
the city, but in truth it is a much better solution. TransMilenios area of
influence (500 meters on each side of the busway) covers 85 percent of the
urban area, whereas the metro would have covered only 8 percent of the
city. In addition, the metros infrastructure would have cost twice as much
as TransMilenios and its operation twenty times more. Fourth, multilateral
banks did not have an important role in this process. Conversations on a
credit facility for the construction of infrastructure for a bus rapid transit
system started in 1986. These loans never materialized and had endless
obstacles. Cities in need of overhauling their transportation systems cannot
count exclusively on the advice of multilateral banks.
As the authors rightly point out, congestion, pollution, and traffic accidents fell significantly in TransMilenio corridors, explaining why the
partial cost-benefit analysis is positive. When they look at the general equilibrium effects, they find that the opposite is actually true, mainly because
congestion increased in the unserved corridors, where more buses continue
to compete for passengers. The authors use difference-in-differences calculations to show that emissions have increased in unserved corridors,
more than offsetting the reductions in TransMilenio corridors. These calculations are sensitive to the number of data points (before and after TransMilenio) and the number of monitoring stations, among other factors. The
value of time, the value of life, and the conversion of emissions into monetary
amounts also make the results sensitive to specific assumptions. Therefore, the results should not be taken as unambiguous proof that TransMilenio has had a short-run negative impact. However, I fully share the
authors view in favor of speeding up the process of implementation of
TransMilenio and improving the regulatory framework that applies to traditional public transportation in order to minimize the potential downsides of the scheme. These are important lessons for other cities building
on the experience of Bogot.
Andrs Gmez-Lobo: The paper analyzes the origins, justification, and
results of TransMilenio, an urban transport plan introduced in Bogot,
Colombia, in 2000. Urban transport policy is not a prominent issue in the
discussions of economists who study Latin America, but it nonetheless
merits more attention from specialists. The macroeconomic costs of having
a large portion of the population wasting several productive hours a day
traveling to work or the extra costs for companies that need to distribute
products throughout a city are rarely measured. Urban transport efficiency
may be just as important for economic development as the sophistication
and efficiency of other network industries such as telecommunications.
This paper, insofar as it presents a novel experience in urban transport policy, is relevant for countries throughout the region.
Gwilliam points out that in developing countries urban bus services are
usually characterized by competition in the market.1 Competition among
urban transport providers has been suspect as a welfare maximizing policy, however, since Chadwicks famous article advocating competition for
the market rather than in the market for certain industries, including urban
transport.2 Interestingly, the market failures of competitive urban bus transport markets are still not well understood from a theoretical perspective.
Congestion in the absence of road pricing is an obvious and well-understood
problem, but what is more puzzling is why fares seem to increase rather
than decrease when competition is introduced.3 The ensuing high tariffs
generate excessive entry into the industry, capacity utilization of each bus
diminishes, and the final result is economically inefficient and socially
harmful (for example, reduced safety and increased pollution).
This paper briefly reviews the arguments behind the observed market
failures in urban bus markets. This is not the best part of the paper since
1. Gwilliam (2001).
2. Chadwick (1859).
3. Estache and Gmez-Lobo (2005).
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
193
some of the arguments are presented very succinctly and are thus out of
focus. For example, the authors mention the principal-agent relationship
between bus owners and drivers as a market failure. When owners are interested in the number of passengers carried, they will naturally try to align
drivers incentives with their own by offering drivers a share of each passengers fare. There is no market failure here. The problem is that the
owner does not take into account the externalities that these incentives
generate in the form of more aggressive driving and frequency distortions.
The main aim of the paper, however, is not to review the theoretical literature, but rather to describe the transport reform in Bogot and undertake a cost-benefit analysis of the first stages of this reform. There is a
growing consensus among policymakers that state-of-the-art regulatory
policy in the transport sector, at least for middle-income countries, involves what Estache and Gmez-Lobo call the hybrid system.4 In this
scheme, the authorities design the network and impose quality standards,
frequencies, and tariff integration, while the private sector operates the services under a concession system. Revenues are centralized, and operators
are not paid according to the number of passengers carried but receive
either a fixed fee or rate per kilometer traveled. This hybrid scheme avoids
the most important failures associated with state-provided monopoly transport services, as well as the market failures of competition in the streets.
This policy has been adopted in London and Curitiba, Brazil, and it will
also be implemented in Santiago, Chile, in 2005. Bogotas TransMilenio
experience provides another interesting example of the application of this
hybrid model, and its documentation and evaluation provides interesting
lessons for policymakers worldwide.
What can one learn, then, from the experience of Bogot? The current
paper raises two sets of issues that are particularly interesting: first, the
design of the concessions and the way risks are allocated among agents;
and second, the evaluation of the benefits and costs of the reform, which
produces two unexpected results. With regard to the design issue, a key
point is the way contracts were designed for the bus operators in the main
corridors. Since the authorities determine dispatch frequencies, the number
of kilometers served is not under the operators control. Operators are paid
according to the kilometers actually served, however, to avoid competition
on the road. It seems rational that operators should not face a demand risk
that is not under their control, whereas the state is better suited to adminis4. Estache and Gmez-Lobo (2005).
ter this risk. This was achieved in Bogot through a novel variable-length
concession that is reminiscent of Engel, Fisher, and Galetovics leastpresent-value-of-revenue concessions.5 If at the end of the tenth year the
concessionaire has not served the number of kilometers stipulated in the
contract, the concession is automatically extended. This design has several
attractive properties, and a similar system has been adopted for the future
reform in Santiago, Chile.
At the same time, this scheme has the disadvantage that since operators
are shielded from demand risk, they will make no extra effort to take-on
extra passengers or change route designs when demand patterns change.
This will probably be a greater problem in routes outside the main corridors and in the periphery of the city where new neighborhoods may generate new transport demands. The TransMilenio planners wisely relaxed
the payment method for feeder services by combining a payment per kilometer traveled with a payment per passenger carried, thereby providing
incentives to cater to passengers needs and demands in the feeder zones.
On the evaluation of the first stage of TransMilenio, the paper presents
two surprising results that should be given serious attention by policymakers in other countries embarking on similar reforms. First, the reform
was regressive. Those that benefited (that is, TransMilenio users) include
a higher proportion of wealthy individuals than those that lost (namely,
users of the traditional system). Given that infrastructure investments,
which represent a large fraction of the costs of the reform, will be paid for
not by users but by taxpayers in general, the distributional impact of the
first stage of the reform is worrying. Second, the overall cost-benefit analysis shows that the extra pollution and congestion generated on unserved
corridors more than offset the benefits on TransMilenio corridors.
The above two results suggest that it may be socially preferable to undertake a more comprehensive reform rather than implementing the system in
a piecemeal fashion as in Bogot. In Santiago, Chile, the reform of the bus
transport system scheduled to start in August 2005 is all-encompassing,
simultaneously changing the whole transport system of the metropolitan
area. A few years will have to pass before it is evident whether the added
costs and complexities of a citywide reform, as in Santiago, more than offset the benefits of avoiding some of the negative effects of the piecemeal
approach used in Bogot.
5. Engel, Fisher, and Galetovic (2001).
Juan Carlos Echeverry, Ana Mara Ibez, Andrs Moya, and Luis Carlos Hilln
195
References
Bowland, Brad, and John Beghin. 1998. Robust Estimates of Value of a Statistical Life for Developing Economies: An Application to Pollution and Mortality
in Santiago. Staff general research paper 4046. Iowa State University, Department of Economics.
Cavallazi, Marcelo. 1996. Contaminacin atmosfrica en Bogot. Revista Cmara
de Comercio 97. Bogot.
Castro, Ral, and others. 2001. Clculo de la tarifa ptima para el sistema de
transporte masivoTransMilenio. Final report presented to TransMilenio
S.A. Universidad de los Andes, Department of Economics.
Chadwick, Edwin. 1859. Results of Different Principles of Legislation and Administration in Europe; of Competition for the Field, as Compared with Competition within the Field, of Service. Journal of the Statistical Society of
London 22(3).
Chaparro, Irma. 2002. Evaluacin de impacto socioeconmico del transporte
urbano en la ciudad de Bogot: el caso del sistema de transporte masivo, TransMilenio. Serie recursos naturales e infraestructura 48. Santiago: United Nations
Economic Commission for Latin America and the Caribbean.
DANE (Departamento Administrativo Nacional de Estadstica). 2003. Encuesta
de Calidad de Vida. Bogot.
Engel, Eduardo M. R., Ronald D. Fischer, and Alexander Galetovic. 2001. LeastPresent-Value-of-Revenue Auctions and Highway Franchising. Journal of
Political Economy 109(5): 9931020.
Estache, Antonio, and Andrs Gmez-Lobo. 2005. Limits to Competition in Urban
Bus Services in Developing Countries. Transport Reviews 25(2):13958.
Evans, Andrew. 1987. A Theoretical Comparison of Competition with Other
Economic Regimes for Bus Services. Journal of Transport Economics and
Policy 21(1): 736.
Gwilliam, Kenneth M. 2001. Competition in Urban Passenger Transport in the
Developing World. Journal of Transport Economics and Policy 35(1): 99118.
Ibez, Ana Mara, and Eduardo Uribe. 2003. Medio ambiente y desarrollo econmico: priorizacin de la inversin ambiental con criterios econmicos. CEDE
Document 2003-33. Universidad de los Andes. Bogot.
Klein, Daniel B., Adrian Moore, and Binyam Reja. 1997. Curb Rights: A Foundation for Free Enterprise in Urban Transit. Brookings.
Lleras, Germn. 2003. Bus Rapid Transit: Impacts on Travel Behavior in Bogot.
Masters thesis, Massachusetts Institute of Technology, Department of Urban
Studies and Planning.
Lozano, Nancy. 2003. Air Pollution in Bogot, Colombia: A ConcentrationResponse Approach. Masters thesis, University of Maryland at College Park,
Department of Agriculture and Resource Economics.
DAVID S. KAPLAN
GABRIEL MARTNEZ GONZLEZ
RAYMOND ROBERTSON
197
The literature also offers conflicting explanations of why these estimates vary. Kuhn suggests that differences in inequality and institutions
in France, Germany, and the United States can explain the different estimates for these countries.4 Alternatively, Howland and Peterson, Carrington, Jacobson, LaLonde, and Sullivan, and Farber suggest that labor
market conditions can affect postdisplacement wages.5 Since a wide variation in displacement costs makes targeting aid difficult, the efficiency gains
from identifying determinants of postdisplacement wages are potentially
significant.
This paper studies the Mexican labor market to contrast various explanations for differences in postdisplacement wage changes. We hope to
identify patterns that may help policymakers target aid to displaced workers. An environment with varying temporal and regional economic conditions and with economic conditions and institutions substantially different
from those in the countries previously studied is ideally suited to identify
such patterns. If institutions vary little across regions, then the institutional
hypothesis would be an unlikely explanation of differences across regions
in postdisplacement wages.
Mexico meets these conditions. Differences between Mexico and other
countries, as well as differences within Mexico over time and space, can
help us identify these patterns in postdisplacement wage changes. First,
wage dispersion is higher in Mexico than in France, Germany, or the United
States.6 If inequality drives differences in postdisplacement wages, then
Mexican workers should have much more negative postdisplacement experiences than observed in these countries.
Second, institutions such as workers separation costs, the legislated
costs of displacement (to the firm), and unions are very different in Mexico
than in other countries. Mexican workers are much less likely to leave firms
voluntarily than workers in other countries, which suggests that they have
4. Kuhn (2002).
5. Howland and Peterson (1988); Carrington (1993); Jacobson, LaLonde, and Sullivan
(1993b, chap. 6); Farber (2003). When examining local labor market conditions, Jacobson,
LaLonde, and Sullivan (1993b) compare two Pennsylvania regions over the same time
period. Carrington (1993) and Howland and Peterson (1988) provide much wider geographic coverage, but these studies are not directly comparable to Jacobson, LaLonde, and
Sullivan because they use cross-section data that are subject to recall error rather than tracking the actual wages of workers over time.
6. The Deininger and Squire data set (available at www.worldbank.org/research/
growth/dddeisqu.htm) shows that Mexicos historically averaged Gini coefficient (52.92) is
higher than that of the United States (35.79), France (37.71), and Germany (32.91).
199
201
We present our analysis in five sections. We start by presenting our simple theoretical framework. The subsequent section describes the source,
collection, and limitations of our data, discusses the Mexican economic
environment, defines the term displaced worker, and finally describes the
various comparison groups. We then explain our empirical approach and
present our results. A final section concludes.
Theory
This section illustrates how differences in economic conditions can result
in either an increase or a decrease in wages following displacement. The
model modifies McLaughlins theory of quits and layoffs by incorporating
a separation cost that the worker bears in the case of a quit but that the firm
pays to the worker in the case of a layoff.13 We present the model in its
simplest form to illustrate the concepts that guide our empirical work.
Workers receive a wage, w, and produce value to the firm, W. We
assume that the value to the firm is a function denoted W(X, G) in which X
represents worker-specific characteristics and G represents firm-specific
characteristics, including the firms output price and productivity shocks.
Workers have the ability to search on the job. Denote as E(r) the expected
value of an outside wage offer from a firm that values the worker at R. We
assume the outside offer is costlessly verifiable once it is made, and that
the expected value of the offer is a function of external characteristics,
including the number of firms that value the workers skills (following
Stevens), the unemployment rate (which reduces the expected value), and
the economic activity in the region (which increases the expected value).14
We employ McLaughlins important distinction between layoffs and
quits. McLaughlin defines a quit as the result of a firm-refused, workerinitiated attempt to increase wages and a layoff as the result of a firminitiated, worker-refused attempt to lower wages. Firms (workers) have
the option to accept proposals for changes in the wage, and they will do so
as long as the value of the wage is not larger (smaller) than the value of the
output to the firm, or the reservation wage. We modify McLaughlins model
by adding a separation cost. The separation cost may stem from the loss of
shared surplus from firm-specific training, an institutional arrangement that
13. McLaughlin (1991).
14. Stevens (1994).
encourages long-term employment, or other reasons.15 The relevant characteristic is that this cost is paid to the worker in the event of a layoff. This
is particularly relevant for the Mexican case, because Mexico, like some
European and many Latin American countries, follows a more preventative stance.16 Article 50 of the Mexican Federal Labor Law mandates that
workers hired for an indefinite period who are laid off (without cause) are
entitled to twenty days pay for each year of service.17 This mandate may
significantly increase the cost of separation in Mexico.18
The effect of this type of legislation on employment flows is still under
debate.19 One particularly relevant study argues that this kind of legislation
in Brazil creates the incentive for workers to negotiate with firms to make
quits look like layoffs, in order to receive this payment.20 This behavior
creates a procyclical turnover pattern, because workers may be particularly interested in getting their separation payment in good times to start
new businesses or invest in areas with higher returns. Kaplan, Martnez
Gonzlez, and Robertson examine job creation and job destruction in
Mexico.21 They find that the pattern of job destructionespecially the
component that is due to contraction (layoffs)is weakly counter cyclical. Over the 19862001 period, the component of job destruction stemming from firm contraction moved negatively with the net growth rate of
employment. We are therefore confident that the kind of adverse incentives and false layoffs documented in Brazil do not affect our results.22
203
E(r)
E(r)
II
III
IV
E(r) C
E(r)
separation. The effect of this payment means that workers with expected
wages above the new wage, w, will be laid off. Some of those workers will
receive lower wages than in their prior employment (workers with
expected wages in region II), but other workers will now take jobs with
higher wages (workers with expected wages in region III). Workers with
wages in regions II and III will both have higher postdisplacement wages
than workers in the same firm (region I).
The effect of displacement on wages is therefore ambiguous: wages
may either rise or fall after displacement. Wages may go up because the
separation cost keeps workers from voluntarily moving to take advantage
of higher potential wages in other firms. This result illustrates why a
worker who involuntarily separates from a firm may have higher wages
after separating, while lacking the incentive to take a higher-paying job
(before incurring the separation cost) prior to being displaced.
For a given level of separation costs, the value of wages in other jobs
(that is, the expected value of the outside offers) depends on several factors.
If labor markets are not perfect and worker experience is valued outside a
single firm, then increasing the number of firms that value the workers
experience or that would compete for workers will drive up the outside
wage offers into region III.23 Alternatively, a higher unemployment rate
reduces the expected value of wage offers into region II, which implies
that displaced workers would tend to enter firms with lower wages. The
model thus illustrates that the heterogeneity of results found in the literature (negative, zero, and positive) is consistent with a simple theory and
that this heterogeneity can be linked to institutions and labor market conditions in ways that can be empirically compared.
When assessing a theoretical framework such as this one, it is useful to
consider alternative explanations that may generate similar results. Most
theory in this literature focuses on explanations for lower postdisplacement
wages. Suggestions include loss of firm-specific capital and seniority.
These concepts can be easily incorporated into the model above, but they
offer little guidance for the case of higher postdisplacement wages. Higher
postdisplacement wages are somewhat more difficult to reconcile if workers can move to higher paying jobs. This argument, however, assumes that
moving is basically costless. As explained above, a positive moving cost
directly addresses this concern. Furthermore, the model described above
differs from previous approaches that focus on either positive or negative
23. See Stevens (1994).
205
The Data
Mexican labor laws require all private sector firms to report wage and
employment information on all employees to the Mexican Social Security
Institute (Instituto Mexicano del Seguro Social, or IMSS). In practice, however, firms report information on roughly half the private sector employees.
Firms may choose not to formally register in order to evade taxes and social
security contributions. Academic studies of Mexicos informal sector use
the act of reporting to the IMSS as a criterion for formal sector participation.
The IMSS records thus represent a census of private firms in the formal sector of the Mexican economy.24 Our data come directly from these records.
The IMSS data are collected at the firm level rather than at the establishment level. Each formal sector firm in Mexico has a firm identifier
called its registro patronal. The registro patronal is similar to the employer
identification number (EIN) that is commonly used as a firm identifier in
U.S. data sets. Just as several subsidiary EINs in the United States might be
owned by one parent firm, several registros patronales might be owned by
the same parent company in Mexican data. The registro patronal may
incorporate more than one establishment in a single firm (again like EIN in
U.S. data), but in almost all cases, we identify individual establishments (or
plants in the case of manufacturing industries). We use the registro patronal to link observations over time, to follow workers as they move among
firms, and to track workers wages within their given firm over time.25
As an initial check of data quality, we compare our sample with official
IMSS employment statistics. The motivation behind this comparison is
that the IMSS reports formal employment statistics based on their data,
which are used as an indicator of Mexican employment, but their method
for calculating these statistics is not known to us. A favorable comparison
24. Public sector workers and members of the military have social security accounts
with other agencies.
25. Firms could potentially change their registros patronales from time to time for
administrative reasons, and this would generate false births and deaths stemming from
changes in the registro patronal for continuing firms. In practice, however, very few firms
(fewer than four) closed entirely and opened again in the next quarter with the same employees. These firms were dropped from the sample.
with official statistics would indicate that we have a reliable data set, and
in fact the figures match up quite well in a comparison with data from official IMSS statistics.26
Our data represent all sectors of the Mexican economy.27 To verify coverage, we compared the 1993 average employment in manufacturing in our
data (2,958,715.5) with the 1993 average total employment in the 1993 Mexican Industrial Census (3,246,039.0). Our data thus cover about 91.1 percent of
total manufacturing employment. This leads us to conclude that the distinction between formal and informal labor markets, which is so important in
developing economies, is mainly an issue outside the manufacturing sector.
Since our data are effectively a census of formal sector employment, we
are particularly concerned about the rate of attrition in our sample. Workers may leave our sample for three reasons: they may leave the labor force,
become unemployed, or enter the informal sector. To get a sense of the
rate of attrition in our sample, we focus on workers who worked at least
one quarter in 1993. Of these workers, 78 percent worked at least once in
1994, and 57 percent worked at least once in 2000. About 87 percent of the
workers who appear in our sample for at least one quarter in 1993 appear
in our sample for at least one quarter between 1994 and 2000.
Analytically, treating workers who leave the labor force or become unemployed is straightforward. The complication in our data arises because a
potentially significant number of workers who leave our sample may enter
the informal sector. The informal sector has traditionally been thought of as
an employer of last resort, in which workers earn lower wages and experience
inferior working conditions. Maloney challenges this view for Latin America generally and for Mexico in particular.28 He shows that workers who
become self-employed in the informal sector often earn 25 percent higher
wages, on average, than they did as salaried workers in the formal sector.
Salaried workers in the informal sector, however, always earn less than their
formal sector counterparts. This result suggests that there is no clear presumption of bias, or, more specifically, the direction of a bias from not being
able to account for informal sector employment is unclear. In the empirical
section below, we address this potential bias by comparing results across
samples that include and exclude workers who drop out of our sample.
26. The official data are from www.imss.gob.mx/ventunica/memoria_2001/2/024000.htm.
A table showing this comparison is available on request.
27. Our data cover all economic sectors and are classified using a four-digit industry
code that is similar, but not identical, to the U.S. 1987 SIC code.
28. Maloney (2004).
207
We analyze employee-level records for the period 1993 to 2000, measuring wages on 31 March, 30 June, 30 September, and 31 December of
each year. This yields thirty-two quarters of data. While the period is determined by data availability, it is a particularly interesting time in which to
study displacement because it encompasses several reforms and macroeconomic events, including the implementation of the North American
Free Trade Agreement (NAFTA) in 1994 and the December 1994 collapse
of the peso, which induced a serious recession that lasted until 1996.
34
North
South
29
24
19
14
1993
1995
1997
Year
1999
2001
B. Unemployment rates
Percent
7.5
Border
Central
North
South
4.5
1.5
1992q3 1993q3 1994q3 1995q3 1996q3 1997q3 1998q3 1999q3 2000q3 2001q3 2002q3
Time Period
a. The four lines represent GDP per capita for the different regions. The GDP of each region is calculated as the sum of the real state GDP of
all states in each region. The population of each region in each year was calculated using a linear growth trend from data between the 1990
and 2000 population censuses. The real state GDP is in thousands of 1993 pesos. The distribution of states into regions is identified in the text.
b. Regional unemployment rates are the simple averages of city-level unemployment rates in each region, as identified in the text.
Tic marks are at third quarter of given year.
209
and border regions are much more economically dynamic than the north.
The central region has the largest amount of measured economic activity,
although it has the fewest states. The border and the north regions have similar levels of total GDP, but GDP per capita is much higher in the border
region, suggesting that economic activity is more concentrated in the border
region than in the north. The border region also had a higher GDP growth
rate than the north for most of the sample period. All regions experienced a
sharp recession in 1995; the years following 1995 are recovery years. We
expect that, to be consistent with the model, postdisplacement wages would
generally be lower in the north than in the central and border regions.
The model also suggests that unemployment rates can affect postdisplacement wages. Panel B of the figure presents regional unemployment
rates calculated as a simple average of the official urban unemployment for
the main cities in each state. The recession is especially evident here.
Unemployment rates are highest in the third quarter of 1995, and they fall
steadily in the third quarters of subsequent years in our sample. Unemployment rates track each other quite closely across regions, but the south tends
to have lower unemployment rates than the rest of the country. The north
has the highest peak unemployment rate. Prior to the collapse, the border
region had higher unemployment rates than other regions, but rates in the
border region fell faster than the rest of the country during the recovery
period. We expect that, to be consistent with the model, postdisplacement
wages would generally be lower for workers who separated during the
height of the recession.
In contrast, institutions (such as unions) and inequality differ very little
across regions in Mexico. Fairris and Levine find unionization rates for
1998 of 0.21 both in states that share a border with the United States and
in states that do not.32 In general, they find little heterogeneity in unionization rates across regions in Mexico. Inequality varies little across regions, as well. As a measure of income inequality, we calculated the Gini
coefficient of the natural logarithm of the real daily wage (the wage measure used in the empirical work below) for each region in our data. In the
first quarter of 1993, the Gini coefficients for the border, north, central,
and south regions were 0.424, 0.422, 0.422, and 0.439, respectively.33
32. Fairris and Levine (2004).
33. For the first quarter of 1991, the Gini coefficients were, in the same order, 0.406,
0.409, 0.419, and 0.405. The regional Gini coefficients generally track each other closely
over time, rising after Mexicos entrance into GATT and then leveling off when NAFTA
went into effect. See Robertson (2004) for further discussion of Mexican wage inequality.
These rates are much more similar to each other than they are to the Gini
coefficients of France, Germany, and the United States.
211
80
72
64
56
48
40
32
24
16
8
87.1
89.1
91.1
93.1
95.1
Time Period
97.1
99.1
01.1
a. Separation rates are calculated based on the Mexican quarterly Encuesta Nacional de Empleo Urbano. The two rates do not add up
to 100 because we excluded separation resulting from injury and other exogeneous factors.
age, and sector changes. To focus on the effects of tenure, we restricted our
sample to workers who were in the displacing firm for the entire period up
until the displacement event, left the firm at the time of displacement,
found work in another firm either immediately or after spending some time
out of our sample, and then worked in one firm until the end of the sample period. We refer to this group as C1. Workers who are out of the sample may be either unemployed or working in the informal sector.36 Since
we cannot distinguish between these two conditions, we created another
subsample of displaced workers who found jobs immediately after the displacement event and then remained employed for the rest of the sample.
We label this group C2. Our third group comprises workers who worked
at the same (displacing) firm for less than two years prior to displacement
and then worked at one firm following displacement (C3); these workers
may not be in the sample for the entire period. This short-tenure criterion
contrasts directly with the long-tenure criterion for workers in the first
group. The final group consists of workers who worked at one firm prior
to displacement, are in the sample in all periods, but may have worked at
several firms following displacement (C4).
We contrast the wage patterns of these workers against two comparison groups. Employees in the first group (A) worked in every quarter at
firms that did not experience large contractions in any quarter during our
period of study. Given the large size of the data set, we selected these
workers from a 1 percent sample of all workers in nondisplacing firms.
For 1995, our sample of this group begins with 3.87 million observations,
or about 121,000 per quarter. The second group (B) consists of workers
who worked at a displacing firm in every period of the sample (that is,
workers in displacing firms who remain with the firm after the displacement event).37
About 18 percent of the observations represent multiple firms per worker
in each quarter. This could be due to the fact that workers could hold several formal sector jobs, change jobs frequently within the quarter, or are
not coded correctly. The problem of multiple jobs becomes slightly more
serious when considering displacement because being displaced from your
second job may not have the same implications as being displaced from
36. See appendix A for a discussion of the age differences of those who are displaced
and those who leave the sample.
37. Since we want to compare the wages of workers who remain in displacing plants,
we omit plants that shut down completely.
213
Summary Statistics
Tables 1 and 2 contain summary statistics for the 1995 ABC1 and ABC2
samples (that is, samples covering groups A, B, and either C1 or C2) by
sector and region. The 1995 sample refers to the sample for the 1995 displacement event and contains observations for every quarter between 1993
and 2000. The summary statistics in tables 1 and 2 summarize data for
1996 from these samples. Our measure of wages is the natural log of the
real daily wage.38 Several interesting results emerge. Workers are generally youngest in the central and border regions, and wages are lowest in the
border. The border and the north have higher employment shares in manufacturing than in services.
Table 3 disaggregates the A, B, and C components of the sample and
compares the sample summary statistics before and after the 1995 displacement event by summarizing the data for 1994 and 1996. The table
shows that the wages of all workers fell between 1994 and 1996. Interestingly, the average wages of workers who remained in displacing firms fell
by more than workers who were displaced.
One potential concern is that the ages of displaced workers and workers who left the sample affect our results. Appendix A formally compares
the ages of workers in each subsample and those who leave our data. This
comparison reveals two main results. First, for workers who remained in
the sample, there is no statistical difference between workers who were
displaced and workers who remained in displacing firms in the 1995 and
1996 sample (workers who remained in displacing firms were, on average,
38. We converted nominal wages to real wages using the national-level consumer price
index available at www.banxico.org, based on the index values corresponding to the month
of observation.
Geographic region
Border
North
Central
South
Total
2.94
37.51
8.79
2,674
2.87
37.52
13.11
3,096
2.80
39.51
10.59
236
2.46
44.2
18.78
905
2.84
38.46
12.1
6,911
3.34
33.62
1.94
1,029
3.36
35.06
1.8
778
3.04
36.92
11.11
72
3.63
35.79
2.96
540
3.40
34.66
2.4
2,419
3.25
30.4
33.04
22,455
3.52
33.18
29.89
45,223
3.39
33.63
29.61
36,741
3.47
32.69
17.67
9,909
3.42
32.74
29.36
114,328
3.50
29.4
28.03
2,472
3.61
32.72
14.91
1,254
3.86
33.64
10.2
2,107
...
...
...
0
3.65
31.65
18.77
5,834
3.21
35.81
3.05
15,042
3.23
33.89
2.78
12,888
3.20
33.82
11.62
5,997
3.46
35.05
9.01
8,033
3.26
34.79
5.33
41,960
4.03
38
14.44
561
4.32
39.51
16
2,025
4.15
39.01
12.6
1,619
3.96
38.36
12.59
588
4.18
39.02
14.25
4,793
3.20
35.38
35.75
19,492
3.35
36.09
42.42
35,706
3.49
34.81
39.76
42,777
3.32
36.04
42.19
17,636
3.37
35.49
40.28
115,611
3.23
33.58
24.91
63,725
3.42
34.57
29.66
100,970
3.45
34.33
32.43
89,549
3.38
35.17
27.06
37,612
3.38
34.36
29.14
291,856
215
Geographic region
Border
North
Central
South
Total
2.89
40.21
14.49
552
2.71
41.33
13.31
1,052
2.79
44
7.32
164
2.39
45.72
18.33
720
2.66
42.53
14.63
2,488
3.70
37.59
3.41
352
3.49
36.75
1.01
396
3.28
38.71
14.29
28
3.92
34.81
1.47
272
3.67
36.58
2.29
1,048
3.63
33.94
32.79
8,344
3.79
35.76
25.82
12,020
3.70
37.73
24.8
13,500
3.70
36.28
17.31
2,888
3.71
36.11
26.36
36,752
3.77
30.93
35.73
1,500
3.84
33.5
14.68
436
4.18
35.94
7.21
1,276
...
...
...
0
3.94
33.27
21.54
3,212
3.45
39.22
14.56
632
3.38
35.32
7.78
1,028
3.74
34.19
7.69
780
4.02
36.54
47.77
628
3.62
36.09
17.34
3,068
4.16
39.79
17.27
440
4.04
39.83
20.97
744
4.27
40.37
6.95
1,208
4.01
40.4
14.12
340
4.16
40.13
13.32
2,732
3.55
38.33
44.8
7,884
3.38
38
45.72
13,936
3.81
38.15
39.7
15,112
3.48
37.84
48.66
5,540
3.58
38.09
43.79
42,472
3.59
36.01
35.85
19,704
3.55
37.08
33.5
29,612
3.79
37.91
29.94
32,068
3.53
37.88
35.43
10,388
3.64
37.23
32.98
91,772
C1
C2
C1
C2
3.820
(0.829)
35.962
(9.902)
0.349
(0.477)
0.035
(0.184)
0.012
(0.107)
0.330
(0.470)
0.049
(0.216)
0.012
(0.109)
0.038
(0.192)
0.524
(0.499)
0.263
(0.441)
0.271
(0.445)
0.369
(0.482)
0.097
(0.295)
62,260
4.189
(0.806)
33.519
(9.311)
0.299
(0.458)
0.002
(0.047)
0.014
(0.117)
0.640
(0.480)
0.007
(0.081)
0.049
(0.216)
0.014
(0.119)
0.274
(0.446)
0.103
(0.304)
0.468
(0.499)
0.255
(0.436)
0.174
(0.379)
23,480
3.541
(0.785)
33.042
(10.641)
0.342
(0.474)
0.018
(0.133)
0.008
(0.088)
0.319
(0.466)
0.010
(0.101)
0.179
(0.383)
0.008
(0.087)
0.459
(0.498)
0.181
(0.385)
0.374
(0.484)
0.305
(0.460)
0.140
(0.347)
251,313
3.907
(0.774)
34.301
(9.455)
0.248
(0.432)
0.019
(0.135)
0.000
(0.000)
0.207
(0.405)
0.000
(0.000)
0.074
(0.261)
0.001
(0.036)
0.699
(0.459)
0.145
(0.352)
0.284
(0.451)
0.523
(0.500)
0.048
(0.213)
6,032
3.569
(0.854)
37.962
(9.902)
0.349
(0.477)
0.035
(0.184)
0.012
(0.107)
0.330
(0.470)
0.049
(0.216)
0.012
(0.109)
0.038
(0.192)
0.524
(0.499)
0.263
(0.441)
0.271
(0.445)
0.369
(0.482)
0.097
(0.295)
62,260
3.854
(0.848)
35.519
(9.311)
0.299
(0.458)
0.002
(0.047)
0.014
(0.117)
0.640
(0.480)
0.007
(0.081)
0.049
(0.216)
0.014
(0.119)
0.274
(0.446)
0.103
(0.304)
0.468
(0.499)
0.255
(0.436)
0.174
(0.379)
23,480
3.278
(0.737)
33.134
(10.474)
0.273
(0.446)
0.023
(0.149)
0.007
(0.081)
0.382
(0.486)
0.013
(0.112)
0.194
(0.396)
0.010
(0.100)
0.372
(0.483)
0.218
(0.413)
0.355
(0.478)
0.294
(0.456)
0.133
(0.340)
206,116
3.607
(0.804)
36.301
(9.455)
0.248
(0.432)
0.042
(0.202)
0.000
(0.000)
0.192
(0.394)
0.000
(0.000)
0.193
(0.395)
0.002
(0.045)
0.570
(0.495)
0.145
(0.352)
0.288
(0.453)
0.519
(0.500)
0.048
(0.213)
6,032
a. Displacement occurred between 1995:3 and 1995:4. The groups are defined as follows: group A: workers who are not in displacing
firms and remain in the same firm; group B: workers who are in displacing firms but do not separate from displacing firms; group C1:
workers who are in displacing firms, separate from those firms, and are not necessarily employed in every period in the sample; and
group C2: workers who are in displacing firms, separate from those firms, and are employed in every period in the sample. Standard
errors are in parentheses.
1.32 years older than displaced workers in 1997). The point estimates
suggest that workers displaced in 1995 and 1996 were slightly older than
workers who remained in displacing firms. Second, workers who left the
sample were younger than those who remained in the sample. Other studies suggest that workers in Mexico often leave the formal sector to become
entrepreneurs in the informal sector.39 Since risk is often associated with
39. Maloney (1998, 2004); Maloney and Krebs (1999).
217
youth, our results seem to be consistent with the idea that when displaced,
young workers may find the informal sector attractive and therefore remain out of our sample.
Table 3 also shows that sample ABC2 is balanced, but ABC1 is not,
since workers in C1 are allowed to exit and return to the sample after the
displacement event. When we consider only a balanced panel of workers,
the average age of all workers is two years higher in the later period. The
table also shows that displaced workers who found a job right away were
most likely to be male, while the difference in the percent of females in C1
and C2 suggests that workers who were displaced and exited the sample
were more likely to be female.
The table also includes information about the sectoral distribution of
each group in each period (the sum over the sectors in each column
equals one hundred percent). Since workers who did not change firms
did not change sectors, the sectoral distribution of the first two groups
remains constant. One might expect that the sectoral distribution of the
two groups of workers who were in displacing firms would be identical,
but we restrict the sample to workers who were employed in every period.
Therefore, differences in the sectoral distribution between the second two
groups reflect the differences in future employment patterns. In our sample, no workers who were displaced from transportation equipment or
mining remained in those sectors when they were displaced. They could
be excluded from the sample as a result of extended search times or they
could have moved to other sectors, such as construction or agriculture.
The percent of displaced workers in construction and agriculture more
than doubles following displacement (for workers who immediately
found employment).
Regional differences in displacement patterns are also evident in table 3.
The majority of employment is in the central region, but so are most of the
displaced workers who immediately found jobs. The north has the highest
share of workers who either were in displacing firms and did not leave or
were displaced and exited the sample at some point. This may be consistent with the shift in production from the central region to the north, as
described by Hanson.40 On the other hand, the overall regional pattern of
employment in table 3 displays a large degree of stability, suggesting that
few workers who were displaced in a particular region moved to other
regions in the very short run to begin other jobs.
40. Hanson (1998).
Empirical Approach
To maximize comparability with studies in developed countries, we employ
the methodological gold standard established by Jacobson, LaLonde, and
Sullivan.41 We first define displacement indicators as Djit, which equals
one if the worker separated from a displacing firm (and zero otherwise) to
compare the wages of displaced workers with all other workers. After presenting these initial results below, we redefine the displacement indicator
to identify workers in each of three groups ( j = 1, 2, 3). The first variable
takes on the value of one for workers who were not in displacing firms, and
zero otherwise (group A). The second takes on a value of one for workers
in displacing firms who remained with the same firm, and zero otherwise
(group B). The third variable takes on a value of one if the workers left
firms that contracted more than 60 percent in the quarter in which they separated (that is, they are in one of the C samples). We estimate each aggregated sample separately (ABC1, ABC2, and so forth). We begin with the
following specification.
(1) wit = ai + t + x it + j j Dji + j t Dji it jt + it .
The dependent variable is the natural log of the real wage, which is calculated by adjusting the nominal wages variable by the Mexican national
consumer price index using 1994 as the base year. The ai term captures
individual-specific fixed effects that take on a value of one for each individual in the sample. The parameter t represents time-specific effects.
Each estimated equation includes a dummy variable for each quarter-year
(for thirty-one of thirty-two periods, omitting the first quarter in the sample). The vector xit represents other time-varying characteristics of workers, including age. We also include the indicator for the individuals
displacement group status, excluding the workers not in displacing firms
as a control group. We then interact the time effects with the displacement
group indicators to compare wages in each group before and after the displacement event. We estimate this equation separately for each of the four
geographic regions in our sample.42
By fully interacting displacement status with the time effects (dummy
variables for each quarter), we allow the time trend for displaced workers
41. Jacobson, LaLonde, and Sullivan (1993a, 1993b).
42. We estimate separate equations for each region because the sample sizes are so
large.
219
to differ from the time trend for nondisplaced workers. These differential
time trends are identified off differences over time in wage changes between
displaced workers and nondisplaced workers. We would expect, for example, that wage changes over time would be fairly similar for displaced
workers and nondisplaced workers before the displacement event, but that
wage changes would begin to differ sharply after the displacement event.
This is, in fact, what we normally observe.43
Results
We begin by estimating equation 1 by ordinary least squares (OLS) for
each region. All but thirteen of the 124 estimated marginal effects of the
displacement x time variables (thirty-one coefficients for each of four
regions) for sample ABC1 are statistically significant at the 5 percent
level. The R2 are all 0.90 or higher. A nearly identical pattern of significance emerges for sample ABC2.44 The standard errors are generally very
small. Since we are particularly concerned about the pattern of the relative
wages of displaced workers wages over time, however, a graphical presentation may more effectively facilitate comparisons across years and
sectors.45 Figures 4 and 5 graph the estimated coefficients for the 1995,
1996, and 1997 displacement samples. The patterns of standard errors and
diagnostic statistics are similar for the other years.46
As in Jacobson, LaLonde, and Sullivan, wages in all periods and all regions fell prior to displacement; in contrast with Jacobson, LaLonde, and
Sullivan, no region exhibits a sharp drop in wages at the time of displacement.47 Figures 4 and 5 do show significant effects of displacement,
but these effects vary by region and time of displacement. Figure 4, for
example, reveals that workers who were displaced in 1995, the trough of
the recession, did worse than other workers. Workers displaced in later
years, however, recovered. The heterogeneity across time is especially
evident in the central and border regions. Workers in the relatively poor
43. We are required to use some normalization for both time trends. For both displaced
workers and nondisplaced workers, we set the coefficient equal to zero for the dummy variable corresponding to nine quarters before the (potential) displacement event.
44. The tables are available on request.
45. Appendix B provides a more extensive evaluation of statistical significance and
standard errors.
46. These results are also available on request.
47. Jacobson, LaLonde, and Sullivan (1993a, 1993b).
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
-16 -12 -8 -4 0
8 12 16 20
Quarters from Displacement
8 12 16 20
a. The sample is defined as workers who were in the displacing firm for the entire period up until the displacement event, left the
firm at the time of displacement, found work in another firm either immediately or after spending some time out of our sample, and
then worked in one firm until the end of the sample period (sample ABC1 in the text). Estimated coefficients of the time x displacement
status effects for displaced workers are from equation 1. Groups A and B were both omitted, so these coefficient estimates represent the
difference between the wages of displaced workers and all other workers in the sample. The reference time period is nine quarters prior
to the displacement event for each sample.
north show few effects of displacement and fewer of recovery. While the
wage trends in the border and central regions become positive at the time
of displacement, wage trends remain flat in the north and (to a lesser
degree) the south.
The second important message emerging from figures 4 and 5 is that
the effects of being displaced in 1995 seem to be permanent, or at least
long-lasting. That is, there is little evidence of recovery over the sample
period. This is especially true in the border and central regions. The results of being displaced at times of peak unemployment are therefore similar to the findings of Jacobson, LaLonde, and Sullivan.48 Being displaced
at different times generates different results that include positive postdisplacement wages.
48. Jacobson, LaLonde, and Sullivan (1993a, 1993b).
221
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
-16 -12 -8 -4 0
8 12 16 20
Quarters from Displacement
8 12 16 20
a. The sample is defined as workers who were in the displacing firm for the entire period up until the displacement event, left the
firm at the time of displacement, found work in another firm immediately (that is, they spent no time out of our sample), and then
worked in one firm until the end of the sample period (sample ABC2 in the text). Estimated coefficients of the time x displacement
status effects for displaced workers are from equation 1. Groups A and B were both omitted, so these coefficient estimates represent the
difference between the wages of displaced workers and all other workers in the sample. The reference time period is nine quarters prior
to the displacement event for each sample. The omitted category is workers who were not in displacing firms and remained in the same
firm for the entire sample.
The differences between figures 4 and 5 suggest that workers who may
not be in the sample in all periods may suffer more serious repercussions
from displacement than other workers. In general, workers who were employed immediately did better than workers who were out of the sample
for any length of time. The difference between 1995 and 1996 becomes
more pronounced in the north and somewhat less pronounced in other regions when we focus on those in the sample in all periods. Even workers
who were employed immediately in the north continued to experience
falling wages, whereas workers in the dynamic central and border regions
did much better when employed immediately.
Figures 4 and 5 compare the wages of displaced workers with all other
workers, which allows us to compare our results with other studies in the
A. Sample BC1
1995
1997
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
8 12 16 20
-16 -12 -8 -4 0
8 12 16 20
(continued )
223
B. Sample BC2
1995
1997
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
8 12 16 20
-16 -12 -8 -4 0
8 12 16 20
workers who stayed behind. This result is consistent with the model presented earlier (specifically, regions II and III of figure 1).
The second result that emerges from figure 6 is that many of the patterns described in the analysis of figures 4 and 5 remain: wages fall prior
to displacement and the long-run effects of being displaced in 1995 are
less positive than the effects of being displaced in recovery years. Displacement in the border and central regions is followed by higher wages
than in the north and south. Workers displaced in 1995 in the north and
south took much longer to recover than their counterparts in the border
and central regions. As the economy recovered, so did the prospects of
displaced workers.
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
8 12 16 20
-16 -12 -8 -4 0
8 12 16 20
(continued )
One of the findings in the current literature is that tenure increases the
adverse effects of displacement. To investigate the effects of tenure, we
created a sample similar to the first except that we dropped all workers
with more than two years tenure in the displacing firm. We performed the
same empirical exercise using this sample and present the results in figure 7. The results in panels A and B can be directly compared with the
results in figures 4 and 6 (panel A). Panel A of figure 7 suggests that
short-tenure workers did better than workers with longer tenure. This is
consistent with worker training and other hypotheses in the literature.
Short-tenure workers displaced in 1995, however, did worse than workers displaced in 1996 and 1997 in the border and central regions, since the
225
B. Sample BC3
1995
1997
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
8 12 16 20
-16 -12 -8 -4 0
8 12 16 20
latter immediately earned higher wages and the former experienced a downward trend in wages. Time of displacement also induces more heterogeneity in the northern region: short-tenure workers in the north who separated
in 1995 did much worse than long-tenure workers who displaced at the
same time.
Tenure does not seem to matter when comparing displaced and nondisplaced workers from displacing firms, in the sense that the overall results in figures 6 (panel A) and 7 (panel B) are very similar. Workers in all
periods and regions eventually did better than workers who stayed behind.
Workers displaced during recovery periods did the best in all regions, and
workers displaced in the border and central regions did better than workers in the north and south regardless of tenure. Therefore, differences in
A. Sample ABC4
1995
1997
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
8 12 16 20
-16 -12 -8 -4 0
8 12 16 20
(continued )
227
B. Sample BC4
1995
1997
1996
Border
North
Central
South
.6
.45
.3
.15
0
-.15
-.3
.6
.45
.3
.15
0
-.15
-.3
-16 -12 -8 -4 0
8 12 16 20
-16 -12 -8 -4 0
8 12 16 20
not driven by the restriction that workers stay in the same firm for the
remainder of the sample. Overall, the regional and temporal heterogeneity
seem to matter more than the workers switching cost.
One of our concerns about displacement is that workers may lose specific human capital. This problem may increase with the degree of change
a worker experiences from the original position. To consider some of the
potential effects of the loss of such capital, we differentiated the effects
of displacement for workers who remained in the same two-digit sector
and those who changed sectors. To isolate the comparison, we focused on
sample ABC4, which is the sample in which workers are observed for all
periods but may change firms more than once following displacement. We
then created an indicator variable based on whether the worker changed
sectors at the time of displacement. The results are presented in figure 9.
1996
.6
.45
.3
.15
0
-.15
-.3
-16
-12
-8
-4
0
4
8
Quarters from Displacement
12
16
20
12
16
20
1996
.6
.45
.3
.15
0
-.15
-.3
-16
-12
-8
-4
0
4
8
Quarters from Displacement
229
Panel A compares workers who change sectors and all other workers, while
panel B compares workers who remain in the same sector and all other
workers. For these regressions, we pooled all of the regions and controlled
for region-specific effects using regional dummy variables.
As in previous studies, our results suggest that Mexican workers experience some loss to capital from changing sectors or, perhaps more precisely,
a gain from remaining in the same sector. Workers who changed sectors at
the time of displacement do not seem that much different from other workers for the majority of the sample. Displaced workers who remained in the
same sector, however, follow a pattern similar to those workers in previous
samples. Wages fell prior to displacement, and rose following displacement if the workers were displaced after 1995.
As an additional robustness check, we considered all of the samples and
results described above using a contraction of 30 percent, rather than 60 percent, as our criterion for identifying displacing firms. If selection bias
severely affects our sample, then the bias would be larger with firms under
the 30 percent contraction criterion, because workers leaving firms that
contract by 30 percent would probably include a higher proportion of voluntary separations. These results are nearly identical numerically and qualitatively to the results presented above.50 We find no evidence of a rising
problem of selection bias when we expand the sample. This may be due to
the fact that we include individual-specific fixed effects in all of the regressions, and these effects may effectively be capturing unobserved characteristics that are correlated with ability and other features that could drive
selection bias. This result, along with the fact that we follow established
approaches designed to minimize selection bias, leads us to believe that
selection bias does not significantly drive our results.
Conclusions
Given limited resources and a desire to support displaced workers, policymakers could increase the efficiency of support programs if they targeted
aid when and where it is needed most. Studies on the effects of displacement on wages have generated a wide range of results, but they do little
theoretically or empirically to formally explain the underlying sources of
this heterogeneity. Previous studies suggest that differences in institutions,
50. The results are available on request.
inequality, or labor market conditions might explain the results, but no study
that we are aware of compares these possibilities using matched workerfirm data over time.
In this paper we examine the costs of displacement to workers using an
administrative data set that allows us to follow workers over thirty-two
quarters and four regions that vary significantly in labor market conditions.
By following an established empirical methodology to estimate postdisplacement wages, we focus on the differences in institutions, inequality, and
labor market conditions in a single study in an attempt to understand the
difference in results.
Several findings emerge. First, our results exhibit the same heterogeneity
found in the current literature. We find a range of postdisplacement experiences from negative (such as those documented by Jacobson, LaLonde, and
Sullivan) to positive (such as those documented in Kuhn).51 Since inequality and institutions (unions) are similar throughout Mexico but the empirical results vary through time and space, we therefore conclude that our
analysis provides little support, if any, for the institutional explanation.
This conclusion is further backed by international comparisons. If national
institutions alone explained the differences in results between Germany
and the United States, we would expect to see little heterogeneity within
Mexico rather than the very wide range of results we find.52 Furthermore,
if France and Germany have positive postdisplacement because wages are
more compressed than in the United States, then we would expect the displacement effects in Mexico to be mainly negative because Mexicos
inequality is greater than that of the United States. Instead, we find much
heterogeneity in the results, with many instances of positive postdisplacement wages.
We conclude that differences in local labor market conditions (over
both space and time) are most consistent with our results. We do find large,
negative, and lasting effects of displacement on wages for workers who
are displaced during times of high unemployment and in less economically active regions.53 Postdisplacement wage changes are typically zero
or positive in good times and in the most economically active regions. This
231
could affect our results through a sort of selectivity bias. If workers who
left the sample are systematically younger than the workers who stayed,
for example, then the remaining workers wages may appear higher simply because these were older workers with more experience.
The results illustrate several points. First, workers in displacing firms
are generally younger than workers in nondisplacing firms. The age of displaced workers is not statistically different from that of workers who remained in displacing firms for 1995 and 1996, although the point estimates
suggest that displaced workers were slightly older. In 1997, displaced
workers were younger than workers who remained in displacing firms, and
the difference (about 1.32 years) is statistically significant.
Second, we find that workers who left the sample were significantly
younger than workers who remained in the sample. As discussed in the
text, this seems to be consistent with other papers that find relatively high
rates of entrepreneurship in the informal sector. Our results may be biased
downwards (upwards) if these workers earn higher (lower) wages, on
average, than workers in the formal sector. These results are shown in
table A1.
1995
1996
1997
2.308
(0.215)**
32.503
(0.032)**
112,032
0.00
5.814
(0.129)**
30.937
(0.031)**
116,437
0.02
6.174
(0.146)**
30.313
(0.029)**
136,321
0.01
2.222
(0.207)**
0.108
(0.230)
34.811
(0.191)**
23,711
0.01
1.034
(0.140)**
0.171
(0.183)
36.751
(0.116)**
26,537
0.00
2.186
(0.152)**
1.324
(0.193)**
36.487
(0.130)**
24,579
0.01
*Statistically significant at the 5 percent level; ** statistically significant at the 1 percent level.
a. Standard errors are in parentheses.
233
.15
1997
1996
0
1995
-.15
-.3
-18
-12
-8
-4
4
time
12
16
20
North
0
Central
-.15
Border
-.3
-12
-8
-4
4
time
12
16
20
Comments
Narcio Menezes-Filho: This interesting paper on the costs of job displacement in Mexico is commendable for several reasons. First, it deals
with an important issue, namely, the earnings trajectory of individuals who
change their jobs. While there is an established literature on this subject
for developed countries, studies on developing countries are scant, despite
the fact that most of the recent reforms that provoked labor reallocation
occurred in the latter, where the problems of poverty and inequality are
severe. Second, the paper addresses this issue using very good data
essentially a census of private firms in the formal sector of the Mexican
economyover a long period. Finally, the analysis is thorough, as the
authors submit their results to various robustness tests using different subsamples. The main drawback of the paper lies in the interpretation of the
results, as I detail below.
The paper does not fully distinguish among the different explanations
for the costs of displacement. It presents interesting graphical analyses of
the wage changes for different periods and regions of displacement, but it
offers very little formal statistical analysis as to whether these differences
are statistically significant (apart from two figures in appendix B). The
authors could have pooled the data and explicitly tested for differences in
the displacement effect across regions and periods or included indicators
of labor conditions at the time of displacement, such as regional unemployment, directly in the regression. Moreover, institutions and inequality
may differ across regions in Mexico. Their explanatory power should be
tested as well, if the aim is to provide a formal test of the different explanations for the displacement effect. It does not suffice to state that
inequality and institutions vary less within Mexico than across countries,
so they are not likely to be the main explanations for the different costs of
displacement.
The authors could also have spent more time interpreting the results,
since reconciling them with the theory is not straightforward. The model
235
237
The paper provides an extensive and concise review of the literature in this
area and presents novel results that highlight the heterogeneous potential
earnings impacts of displacement depending on labor market conditions.
The paper will be useful for both researchers and policymakers to better
understand the role of factors mediating the impact of displacement on
earnings and factor these into policy design.
The paper uses a unique panel data set for a large sample of Mexican
workers registered in social security over a reasonably long period. The
authors discuss the methodological difficulties of isolating the impact of
displacement on future earnings. Three sets of issues merit special attention: the problems caused by omitted variables and self-selection (sample
composition biases); attrition or incomplete employment spells (censoring
biases); and the existence of heterogeneous impacts. The first two refer to
the inability to appropriately control for worker and firm characteristics
that may be correlated with both displacement probabilities and postdisplacement earnings, to the restriction to workers with social security
registration (that is, formal sector), and to the possibility that workers who
drop out of the sample may have different characteristics and earnings performance than those who stay. The paper proposes several ways to address
these issues and discusses the implications for the robustness of the results. The third point relates to the fact that average postdisplacement earnings may vary widely across workers depending on context-specific factors
and workers skills. The paper argues that the empirical results favor an
important role for varying labor market conditions over that of local institutions and inequality. I focus my comments on some questions for future
research with regard to the methodological approach and the robustness of
the empirical evidence to discern competing explanations of impacts.
Although not framed in this way, the paper deals with an impact evaluation problem, in which the treatment effect corresponds to the change in
displaced workers earnings. The counterfactual is given by the change in
earnings that would have occurred had these workers not been displaced, and
it is approximated by the change in earnings of comparable nondisplaced
workers. This raises issues familiar from the impact evaluation literature:
identifying the parameter(s) of interest, whether the control (comparison)
groups are good proxies of the counterfactual, and validity of the identifying assumptions. The recent evaluation literature highlights that alternative treatment (impact) parameters could be of interest, although they are
not always identifiable. For example, one may want to measure the average impact of displacement (the effect on any randomly selected worker),
the average effect on the treated (the impact on formal workers actually
displaced), or a local average effect on the treated (the impact for workers
close to displacement thresholds, such as those fired first in a recession).1
These parameters have different interpretations and, more important, lead
to different implications regarding the impact of displacements. For example, the latter parameter tends to capture impacts on marginal workers
(that is, those displaced at the margin during layoffs). These impacts may
depend on both observed skills (for example, human capital measures like
years of education or tenure) and unobserved skills (such as individual
ability or labor market connections). The parameter thus fails to fully capture the impact of large-scale layoffs such as those that would occur in
major recessions or economic restructuring. The paper analyzes multiple
treatment groups that seem to resemble local average impacts, and it is not
entirely clear that the estimated effects readily generalize to the impacts of
displacements of any size or to well-defined groups of workers. Consequently, the results may have limited application for interventions targeted
to massive numbers of workers.
The question of the validity of comparison groups is fundamental to the
results. Lacking other identifying restrictions, this boils down to whether
earnings trends prior to displacement were the same in the displaced
(treated) and nondisplaced (control) samples. The paper does not explicitly discuss this identifying condition. It does not seem to hold for all of
the displaced samples considered since wages decline prior to displacement in some regions or periods. If these trends were not matched in the
corresponding comparison groups of nondisplaced workers, it would raise
questions of possible biases arising from dissimilar composition of the samples (that is, differences in worker characteristics across groups) or mean
reversion (in which earnings eventually move back towards their mean). It
would be useful for future work to discuss these issues in detail.
The paper maintains that the results support a greater role for labor market conditions in mediating the impacts of displacements vis--vis other
factors such as labor institutions and inequality. While well argued and
suggestive, this claim deserves further exploration in future studies. First,
the reported similarity of inequality levels within Mexico does not conform to results from other studies that find significant differences in inequality levels across Mexican regions.2 The reported Gini coefficients are
1.
2.
239
obtained from the sample of formal sector workers under study (who are
likely to have equally dispersed earnings across regions), while the relevant statistics should cover the entire local labor markets. Second, varying
regional capacities to enforce labor legislation may lead to de facto regional differences in relevant regulations. Finally, it is ultimately difficult
to separate labor market conditions (outcomes), such as unemployment,
from the characteristics of labor institutions. For example, differences in
the enforcement of regulations that prescribe high severance payments or
nonwage benefits correlate with differences in the rates of unemployment
or informal employment.
Thus the reported variation in displacement effects across regions and
time does not support definitively disregarding the potential role of
inequality and institutions in mediating the impacts of displacement.
Future empirical research should delve further into the questions raised by
the new results of the paper and their implications for informing the design
of policies to better balance protection against job loss and more flexible
labor regulations in the region.
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