## 4.1    Declining Tariffs

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### Overview and context
- LAC has grown slowly over the past decade and faces the question: Could it grow faster by trading more?
- The paper documents the evolution of trade in LAC, quantifies potential gains from greater integration, and assesses risks from geoeconomic fragmentation.
- Data sources used include: IMF BOP database; IMF DOTS; CEPII BACI; WTO-OECD BaTIS; ITPD-E; CEPII Gravity database; UNCTAD TRAINS; World Bank’s World Development Indicators; Estefania-Flores et al. (2022) for non-tariff barriers; UNCTAD-Eora GVC database; World Input-Output Tables; WB’s LPI; WB’s Enterprise Survey; Penn World Tables revision 10.1.

### Stylized facts on LAC’s trade (summary)
- Trade integration and composition
  - LAC’s trade in goods and services with the rest of the world increased from about 30 percent of GDP in 1995 to 47 percent in 2019.
  - Intra-regional trade stands at a modest 14 percent of total goods trade.
  - Except for Mexico, the top export products of the largest economies of the region are primary commodities, consistently accounting for over 40 percent of merchandise exports.
  - China’s share of LAC’s goods exports (excluding Mexico) increased tenfold, from near zero in 1996 to over a fifth in 2021.
  - By 2018, China became the main consumer of LAC’s products (excluding Mexico); exports to China were heavily concentrated in mineral (about half of exports), vegetable (20 percent), and animal (10 percent) primary products.
  - The share of intra-regional exports has remained steady at about 1/4 of total goods exports during 1996-2021.
- Global value chains and imports
  - LAC’s average backward participation and forward participation stand below other Asian and European EMDEs.
  - Within LAC: South America has forward participation in line with other EMDEs but lower backward participation; Mexico has high backward participation in manufacturing but low forward participation; Central America and the Caribbean show little GVC integration on both dimensions.
  - Capital goods (machinery, electrical, and transportation products) account for over 1/3 of the region’s imports of goods.
  - The share of imports from the US decreased from around 50 percent in 1996 to nearly 30 percent in 2021.
  - As of 2021, LAC’s machinery imports from China represent 8 times Germany’s total machinery exports and 14 times Japan’s total machinery exports.
  - Imports from China to LAC have a product composition very dissimilar to imports from other origins (except the US), implying limited substitutability.
- Services trade
  - Services account for about 15 percent of total trade in LAC, a share that has stayed constant since the 1990s.
  - In the Caribbean, services account for about 40 percent of total trade.
  - Most services exports from LAC are destined to North America.
  - Only about 11 percent of services exports are directed to other LAC countries, compared to about half in European or in East Asian peer regions.
  - Brazil and Mexico stand at the 35th and 36th global ranks for the global value of services exported.

### Regional trend in tariff reduction
- LAC has significantly lowered its import tariffs and ratified over 300 trade agreements since 1996.
- The global trend of declining tariffs on goods and services was particularly noticeable between the 90s and the Great Financial Crisis.
- A Spearman correlation index is used to capture product-structure similarity of LAC’s imports from different origins relative to China (index scaled such that 100 indicates identical product structure to China).

### Divergence across subregions
- Since the late 2000s a divergence has emerged across subregions:
  - In South America and the Caribbean, the reduction in Most Favored Nation (MFN) import tariffs has stalled since the late 2000s.
  - MFN tariffs in Central America fell by up to 8 percentage points on average, reaching levels similar to those observed in other EMDEs.

### Effective tariffs by partner
- Tariff evolution differs by partner:
  - Import tariffs that LAC effectively imposed on China stagnated between 6 and 8 percent since 2010.

### Role of regional trade agreements and FTAs
- Regional trade agreements (Mercosur, NAFTA-USMCA, Andean Community) have simplified regional trade policies and lowered tariffs applied to neighboring countries.
- FTAs have accelerated convergence of tariff schedules among signatories.
- Tariff schedules are complex (example noted: Mexico’s complete tariff schedule covers thousands of tariff lines over more than 300 pages).
- Customs unions and free trade areas simplify and harmonize schedules (example: Mercosur members adopt Mercosur’s Common Nomenclature and Mercosur’s Common External Tariffs (CET)).
- Hierarchical cluster analysis (using UNCTAD-TRAINS data and Minkowski distance of percentage-point differences) shows:
  - Between 1993 and 2005 most tariff structures converged as tariffs generally declined.
  - The tariff schedules of Argentina and Brazil in 2005 have become as close as Canada’s and USA’s were in 1993.

### FTAs as insulation against unilateral tariff increases
- FTAs can insulate members against unilateral tariff increases because such increases are usually precluded by existing agreements.
- Example: Mexico raised import tariffs on steel and 392 other products in August 2023 and only countries with no pre-existing trade agreements with Mexico were affected.
  - (Reference in source: Decreto por el que se modifica la Tarifa de la Ley de los Impuestos Generales de Importaci ́on y de Exportaci ́on, Diario Oficial de la Federaci ́on 15/08/2023.)

### Trade policy developments and challenges (summary)
- LAC has made substantial progress in reducing import tariffs over time, with heterogeneities across subregions and trade partners.
- Looking ahead, the broad decline in LAC’s barriers to trade faces challenges related to non-tariff trade barriers and climate concerns.

### Analytical contributions linked to tariffs and fragmentation (connections noted)
- Dynamic trade elasticities
  - A dynamic gravity framework finds that trade flows in LAC react less to changes in tariffs in the long run than in other regions (LAC exhibits a similar elasticity of trade to import tariffs in the short, medium, and long runs, while other EMDEs show sharper long-run declines).
  - Agricultural trade is less elastic over time than merchandise trade.
- General equilibrium and counterfactual analyses
  - General equilibrium trade models are used to calculate gains from lowering trade barriers via better infrastructure and to evaluate consequences of geoeconomic fragmentation.
  - In the context of rising trade tensions, counterfactual analyses emphasize dynamic implications through the capital (investment) channel: geoeconomic fragmentation can depress growth by inducing countries to reduce investment.

### Key statistics and exact figures (selected)
- LAC trade share: about 30 percent of GDP in 1995 → 47 percent in 2019.
- Intra-regional goods trade: 14 percent of total goods trade.
- Primary commodities: over 40 percent of merchandise exports (largest economies except Mexico).
- China’s share of LAC goods exports (excluding Mexico): increased tenfold from near zero in 1996 to over a fifth in 2021.
- Product concentration to China by 2018 (excluding Mexico): mineral about half; vegetable 20 percent; animal 10 percent.
- Intra-regional exports share: about 1/4 of total goods exports during 1996-2021.
- Capital goods account for over 1/3 of LAC goods imports.
- US import share to LAC: around 50 percent in 1996 → nearly 30 percent in 2021.
- LAC machinery imports from China (2021) relative to competitors: 8 times Germany’s total machinery exports; 14 times Japan’s total machinery exports.
- Services share of total trade in LAC: about 15 percent (constant since 1990s); Caribbean: about 40 percent.
- MFN tariff decline in Central America: up to 8 percentage points on average.
- Tariffs applied to China by LAC: stagnated between 6 and 8 percent since 2010.
- LAC has ratified over 300 trade agreements since 1996.

*Source: IMF Working Paper — Section 4.1 “Declining Tariffs” (content unit: wpiea2024253-print-pdf).*

### 4.1    Declining Tariffs   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  

### 4.1    Declining Tariffs

### Overview and context
- Latin America and the Caribbean (LAC) has been growing at a slow pace for the past decade and faces the question: Could it grow faster by trading more?
- The paper documents the evolution of trade in LAC, quantifies potential gains from greater integration, and assesses risks from geoeconomic fragmentation.
- Data sources used include: IMF BOP database; IMF DOTS; CEPII BACI; WTO-OECD BaTIS; ITPD-E; CEPII Gravity database; UNCTAD TRAINS; World Bank’s World Development Indicators; Estefania-Flores et al. (2022) for non-tariff barriers; UNCTAD-Eora GVC database; World Input-Output Tables; WB’s LPI; WB’s Enterprise Survey; Penn World Tables revision 10.1.

### Stylized facts on LAC’s trade (summary)
- Fact 1: LAC’s trade integration lags many other regions.
  - LAC’s trade in goods and services with the rest of the world increased from about 30 percent of GDP in 1995 to 47 percent in 2019.
  - Intra-regional trade stands at a modest 14 percent of total goods trade.
- Fact 2: Commodities dominate LAC’s exports and China is an increasingly important destination.
  - Except for Mexico, the top export products of the largest economies of the region are primary commodities, consistently accounting for over 40 percent of merchandise exports.
  - China’s share of LAC’s goods exports (excluding Mexico) increased tenfold, from near zero in 1996 to over a fifth in 2021.
  - By 2018, China became the main consumer of LAC’s products (excluding Mexico), with exports to China heavily concentrated in mineral (about half of exports), vegetable (20 percent), and animal (10 percent) primary products.
  - The share of intra-regional exports has remained steady at about 1/4 of total goods exports during 1996-2021.
- Fact 3: LAC’s integration into global value chains (GVCs) remains limited.
  - The region’s average backward participation and forward participation stand below other Asian and European EMDEs.
  - Within LAC: South America has forward participation in line with other EMDEs but lower backward participation; Mexico has high backward participation in manufacturing but low forward participation; Central America and the Caribbean show little GVC integration on both dimensions.
- Fact 4: Merchandise imports are concentrated in capital goods, with China a key supplier.
  - Capital goods (machinery, electrical, and transportation products) account for over 1/3 of the region’s imports of goods.
  - The share of imports from the US decreased from around 50 percent in 1996 to nearly 30 percent in 2021.
  - As of 2021, LAC’s machinery imports from China represent 8 times Germany’s total machinery exports and 14 times Japan’s total machinery exports.
  - Imports from China to LAC have a product composition that is very dissimilar to imports from other origins (except the US), implying limited substitutability.
- Fact 5: LAC’s trade in services is low, particularly within the region.
  - Services account for about 15 percent of total trade in LAC, a share that has stayed constant since the 1990s.
  - In the Caribbean, services account for about 40 percent of total trade.
  - Most services exports from LAC are destined to North America.
  - Only about 11 percent of services exports are directed to other LAC countries, compared to about half in European or in East Asian peer regions.
  - Brazil and Mexico stand at the 35th and 36th global ranks for the global value of services exported.

### Trade policy developments and challenges
- LAC has made substantial progress in reducing import tariffs over time, with heterogeneities across subregions and trade partners.
- Looking ahead, the broad decline in LAC’s barriers to trade faces challenges related to non-tariff trade barriers and climate concerns.

### Analytical contributions relevant to tariffs and fragmentation
- The paper estimates new dynamic trade elasticities for LAC using a dynamic gravity framework and finds that trade flows in LAC react less to changes in tariffs in the long run than in other regions.
- General equilibrium trade models are used to:
  - Calculate gains from lowering trade barriers via better infrastructure in LAC.
  - Evaluate consequences of geoeconomic fragmentation for the region.
- In the context of rising trade tensions, the paper conducts counterfactual analyses of fragmentation, emphasizing dynamic implications through the capital (investment) channel: geoeconomic fragmentation can depress growth by inducing countries to reduce investment.

*Source: IMF Working Paper — The Dynamics of Trade Integration and Fragmentation in LAC (content unit: 4.1 Declining Tariffs).*

### 4.1    Declining Tariffs

### 4.1    Declining Tariffs

### Regional trend in tariff reduction
- LAC has significantly lowered its import tariffs and ratified over 300 trade agreements since 1996.
- The global trend of declining tariffs on goods and services was particularly noticeable between the 90s and the Great Financial Crisis.
- A Spearman correlation index formulation is presented to capture product-structure similarity of LAC’s imports from different origins relative to China:
  - Spearman i = 100 P p s i,p s CHN,p q P p s 2 i,p q P p s 2 CHN,p where s i,p denotes the share of LAC’s imports of product p from country i such that P p s i,p = 1. An index of 100 indicates that LAC’s imports from country i have the same product structure than LAC’s imports from China.

### Divergence across subregions
- A divergence has appeared across LAC’s subregions since the late 2000s:
  - In South America and the Caribbean, the reduction in Most Favored Nation (MFN) import tariffs has stalled since the late 2000s.
  - MFN tariffs in Central America fell by up to 8 percentage points on average, reaching levels similar to those observed in other EMDEs (Figure 7, left panel).

### Effective tariffs by partner
- Not all trading partners experienced the same tariff evolution.
- The tariffs that LAC effectively imposed on China and other trade partners have not fallen as much:
  - Import tariffs with China stagnated between 6 and 8 percent since 2010 (Figure 7, right panel).

### Role of regional trade agreements and FTAs
- Regional trade agreements like Mercosur, NAFTA-USMCA and the Andean Community have played important roles in simplifying regional trade policies and lowering tariffs applied to neighboring countries.
- FTAs have accelerated convergence of tariff schedules among their signatories.
- Tariff schedules are complex (example: Mexico’s complete tariff schedule covers thousands of tariff lines over more than 300 pages).
- Customs unions and free trade areas simplify and harmonize schedules (example: Mercosur members adopt Mercosur’s Common Nomenclature and Mercosur’s Common External Tariffs (CET)).
- Figure 8 (authors’ calculations using UNCTAD-TRAINS data) shows:
  - The proximity of tariff schedules is computed using hierarchical cluster analysis, where the distance between tariffs structure is calculated as the sum of absolute differences (Minkowski distance) in percentage points.
  - Between 1993 and 2005 most tariff structures converged as tariffs generally declined.
  - The tariff schedules of Argentina and Brazil in 2005 have become as close as Canada’s and USA’s were in 1993.

### FTAs as insulation against unilateral tariff increases
- FTAs can insulate members against unilateral tariff increases because such increases are usually precluded by existing agreements.
- Example: Mexico raised import tariffs on steel and 392 other products in August 2023 and only countries with no pre-existing trade agreements with Mexico were affected.
  - Reference to the decree: Decreto por el que se modifica la Tarifa de la Ley de los Impuestos Generales de Importaci ́on y de Exportaci ́on, Diario Oficial de la Federaci ́on 15/08/2023.

*Source: IMF Working Paper — “The Dynamics of Trade Integration and Fragmentation in LAC” (section 4.1).*

### 4.3    Beyond Tariffs:  the Role of Non-tariffs Trade Barriers

### 4.3    Beyond Tariffs:  the Role of Non-tariffs Trade Barriers

### Role and prevalence of non-tariff measures
- Trade policy extends beyond tariffs to tools such as quotas and regulations; WTO Agreement on Technical barriers to trade specifies exceptions for “national security requirements; the prevention of deceptive practices; protection of human health or safety, animal or plant life or health, or the environment”.
- LAC has signed 74 deep FTAs in the past 20 years (Rocha and Ruta, 2022).
- Despite broad declines in tariffs, non-tariff Trade Barriers (NTBs) have remained “stubbornly high” in most LAC subregions, as measured by the Measures of Aggregate Trade Restrictions (MATR). Central America is an exception, with NTBs on par with advanced economies.
- NTBs particularly affect:
  - agriculture (often as sanitary and phytosanitary measures),
  - services (regulatory hurdles preventing foreign firms from accessing domestic markets).
- A group of Andean countries — Ecuador, Chile, Colombia, and Peru — reduced trade barriers in services between 2008 and 2016 (Borchert et al., 2020b).

### Gravity and general equilibrium modeling approach
- A partial equilibrium gravity model (Bhattacharya and Pienknagura, 2024) is embedded into an Anderson and van Wincoop (2003) general equilibrium trade model; infrastructure, governance, and human capital affect international trade costs (Donaubauer et al., 2018).
- Key model structure and assumptions (as in source):
  - CES preferences with elasticity of substitution σ (assumed σ = 5 for backouts).
  - Iceberg trade costs t_ij.
  - Equilibrium equations (as stated): X_ij = Y_i E_j / Y [t_ij Π_i P_j]^{1−σ}, Π_i, P_j multilateral resistance terms, etc.
- Estimation strategy:
  - Step 1: estimate trade costs in partial equilibrium gravity; allow Z_i = [Infra_i, H_i, Gov_i] to affect bilateral trade costs via interaction with international border dummy INTL_ij.
  - Step 2: back out trade costs assuming σ = 5 and solve equilibrium.
  - Step 3: compare baseline with counterfactual equilibria where infrastructure conditions are improved.

### Main gravity regression findings (Table 1 coefficients and notes)
- Regression specification: Equation (8) estimated with PPML, exporter and importer fixed effects, main coefficient of interest β_6 on INTL_ij·Z_i.
- Selected coefficient estimates (preserve values exactly as in source Table 1):
  - Distance: -0.454***; -0.417***; -0.453***; -0.501***; -0.389***; -0.363***
  - Contiguity: 0.579***; 0.605***; 0.602***; 0.582***; 0.617***; 0.652***
  - Border: -2.937***; -8.218***; -6.501***; -3.227***; -10.62***; -11.22***
  - ln(Tariff): -6.114***; -3.464***; -3.194**; -3.091**; -3.270***; -2.856***
  - Trade agreement: 0.316**; 0.342***; 0.349**; 0.249**; 0.388***; 0.460***
  - Physical infra x Border: 0.876**; 0.776*; 0.787*
  - Customs infra x Border: 0.584; 0.953+; 1.019*
  - Human capital x Border: 1.107***; 0.522**; 0.594**
  - Governance x Border: 0.790***; -0.451*; -0.588**
- Notes: standard errors in parentheses; +p<.20, *p<.10, **p<.05, ***p<.01. Column (6) additionally controls for interaction between GDP per capita in 2017 and border dummy. Observations reported per column (e.g., Obs. 445093; 308530; 738406; 282866; 224260).

### Counterfactuals: infrastructure gap closures and gains
- Counterfactuals increase each LAC country’s infrastructure conditions so the gap relative to the average advanced economy is reduced by 10, 20, and 50 percent.
- Aggregate regional results:
  - Exports would increase by 5, 11, and 30 percent, respectively, for the 10, 20, and 50 percent infrastructure-gap reductions.
  - LAC’s output would increase by 1.5, 2.5, and 7 percent, respectively, under the same scenarios.
- Decomposition for a 20 percent closure of the infrastructure gap:
  - Total output gain for LAC: 2.8 percent.
  - Contribution of transport infrastructure improvements: 1.5 percentage points (pp).
  - Contribution of customs efficiency improvements: 1.1 pp.
  - Interaction between transport and customs improvements: 0.2 pp (transport gains larger when customs efficiency is better).
- Heterogeneity:
  - Country-level output gains from a 20 percent infrastructure gap closure range from 1.5 to 6 percent, depending on initial infrastructure gaps and proximity to large trading partners.

### Policy recommendations to close infrastructure gaps (from World Bank LPI guidance used in analysis)
- Streamline, automate, and digitize customs procedures; reduce bureaucratic red tape; enhance transparency in trade processes.
- Invest in the quantity, quality, and integration of different transport modes; improve transport-related technologies such as digital tracking systems.
- Develop a logistics sector with efficient freight forwarding, warehousing, and providers by encouraging competition and fostering Public-Private Partnerships.
- Train customs and transportation personnel to enhance their skills.

### Caveats and implementation considerations
- Large infrastructure improvements may imply potentially large financial and environmental costs.
- Policy implementation requires:
  - Case-by-case analysis of key bottlenecks to prioritize.
  - Observance of fiscal policy constraints and leveraging private investment when available.
  - Correct assessment of risks to environmental services and biodiversity (UNEP, 2022).

### Dynamic trade elasticities and tariffs: LAC versus peers
- Methodology: use Anderson and Yotov (2023) dynamic gravity framework where bilateral capacity λ_ijt evolves and ρ captures frequency of capacity adjustment; estimation via PPML with exporter-time, importer-time, and exporter-importer-time-interval fixed effects.
- Key dynamic findings (Figure 14 summary):
  - LAC exhibits a similar elasticity of trade to import tariffs in the short, medium, and long runs.
  - Other EMDEs show small short-run declines in trade flows but sharper long-run declines as trade links adjust; reducing import tariffs on LAC’s exports will not boost trade in the long run by as much as in other EMDEs.
  - Agricultural trade is less elastic over time than merchandise trade.
  - Export elasticities tend to be smaller in magnitude than import elasticities; the difference is not statistically significant at 1 percent in the long run.
- Explanatory factors for LAC’s different long-run responses:
  - Agriculture accounts for a large share of LAC’s trade and LAC is on average a net exporter (differently than other EMDEs, particularly East Asia).
  - Demand for agricultural goods is less elastic than for manufacturing goods.
  - Agricultural supply faces environmental constraints (e.g., growing cycles).

### Fragmentation risks and potential opportunities
- Trends and risks:
  - Harmful trade interventions (discriminatory production subsidies and anti-dumping measures) surged during the pandemic; LAC has faced over 800 interventions imposed by other countries and has also increased interventions imposed on other countries.
  - Rising trade restrictions risk dividing countries into economic blocs (“geoeconomic fragmentation”), with potential disruptions to trade and financial linkages, migration, remittances, capital and labor allocation, and technological diffusion—potentially lowering GDP growth.
  - Fragmentation could hinder international cooperation on public goods (climate change, pandemic preparedness, international taxation, AML/CFT).
- Opportunities:
  - Manufacturing and commodity sectors in LAC could benefit from supply-chain relocation and trade diversion.
  - Mexico shows signs of benefiting from trade diversion (e.g., supplanting China as the United States’ main trading partner in 2023Q1, and booming investment in industrial real estate).
  - Selective expansion opportunities in manufacturing (e.g., medical or IT devices in Costa Rica or Dominican Republic).
  - LAC’s resources of minerals critical for green technologies and decarbonization (lithium, silver, copper) position the region as a central player for advanced economies seeking secure supplies; with appropriate policy frameworks, these resources could attract substantial investments.

*Source: wpiea2024253-print-pdf — Section 4.3, “Beyond Tariffs: the Role of Non-tariffs Trade Barriers.”*

### 7.1    Fragmentation Scenarios

### 7.1    Fragmentation Scenarios

### Scenario definitions and bloc formation
- Two illustrative types of scenarios are explored: a mild fragmentation scenario and two more extreme fragmentation scenarios.
- Mild fragmentation scenario:
  - Full suspension of trade between Russia and US-EU.
  - Trade between China and US-EU remains open, except for high-tech sectors.
  - Trade among other countries remains unchanged.
  - LAC maintains economic ties with the two blocs.
- Extreme fragmentation scenarios:
  - All trade between the US-EU and China-Russia blocs come to a halt.
  - Other countries are forced to trade exclusively within a bloc and face the alternative to join either US-EU or China-Russia and suspend trade with the other.
  - Two hypothetical assignments to blocs are considered:
    - Assignment based on strength of bilateral trade links (using share of bilateral trade in goods and services in 2019). Under this criterion most LAC countries would join the USA-EU bloc.
    - Assignment based on geopolitical proximity (for example, similarity of voting patterns at the United Nations General Assembly), under which most Latin American countries’ positions at the UNGA align more closely with China.
- High-tech sectors are defined using the ISIC Rev. 3 Technology Intensity Definition (OECD, 2011), highlighting two high-tech sectors: electronics and machinery, and transport equipment.

### Static input-output model findings (mild vs. extreme)
- Mild fragmentation scenario outcomes for LAC:
  - Changes to LAC’s output would be near zero and marginally positive on average.
  - LAC would be better placed than advanced or other emerging economies, which are estimated to lose on average ½ to 1 percent of output relative to a world where there is no fragmentation.
  - Two mitigating factors for LAC’s resilience:
    - Export similarity with commodities exported by Russia allows South American fossil fuel and agricultural exporters in particular to benefit from trade diversion and temporary higher prices.
    - Limited integration into GVCs means severing trade between EU-US and China in high-tech has little impact on the region’s trade flows.
- Extreme fragmentation scenario outcomes for LAC:
  - Permanent output losses would average from 2 to 4 percent.
  - These losses are still less than those estimated for AEs and other EMEs.
  - Larger losses reflect the stark assumption of a complete cutoff of trade between opposing blocs.
  - Vulnerabilities and heterogeneity:
    - Both US and China account for large shares of LAC’s trade; aligning with either bloc would imply disrupting trade with a major partner.
    - Countries could be separated from neighboring countries if they join opposing blocs, generating additional losses; costs would be largest for countries isolated from neighbors.

### Dynamic fragmentation channel: capital goods and investment
- Rationale:
  - Static input-output models abstract from dynamic channels such as capital accumulation; fragmentation could depress capital investment.
  - LAC relies on machinery and equipment imported from China, with few readily available and cost-competitive alternative sources.
  - Historical evidence: trade liberalization increased investment rates; tariff increases have been associated with declines in investment rates (Wacziarg and Welch, 2008).
- Model structure and calibration:
  - A dynamic multi-country trade model with capital accumulation is simulated, embedding a neoclassical growth model (growth driven by capital accumulation) into a standard trade model.
  - The trade model is the multi-country Eaton and Kortum (2002) framework; production uses nested Cobb-Douglas functions with three sectors: consumption, investment, and intermediates.
  - Capital accumulation equation includes depreciation at rate δ and adjustment costs controlled by parameter λ.
  - In steady state, capital intensity k_i = K_i / L_i is inversely proportional to the price of investment goods P_xi.
  - Investment goods are more trade intensive than consumption goods (resulting empirically in 1−ν_xi > 1−ν_ci), making investment prices more sensitive to trade fragmentation.
  - Calibration data sources: WIOD for trade data, Penn World Table 10 for capital stocks, and CEPII for gravity variables.
  - Sample includes LAC’s five largest economies (LA5), 38 other economies, and the rest of the world aggregated.
  - Baseline assignment of countries to blocs is based on which of US-EU or China is the larger trading partner.
- Dynamic model findings:
  - Investment rates in LAC’s largest economies could drop by 2 to 5 percent, with Mexico and Brazil hit particularly hard.
  - Capital intensity in these economies would gradually falter compared to a baseline with no fragmentation.
  - Including the investment channel amplifies output losses due to extreme fragmentation by about 40 percent compared to a simulation of the same extreme fragmentation scenario when the investment channel is shut down.
  - Policy uncertainty associated with fragmentation risks can also negatively affect investment and FDI.

### Policy implications and recommendations
- First-best global outcome is to avoid fragmentation.
- Policy directions for LAC given rising fragmentation risks:
  - Strengthen trade integration and policy coordination among LAC countries to limit the impact of fragmentation.
  - Deepen intra-regional trade integration and foster regional coordination to boost trade and increase diversification opportunities.
  - Nonalignment with either bloc can limit the risk of a costly intra-regional division into opposite blocs and improve bargaining position vis-à-vis large economies, but nonalignment may generate policy uncertainty deterring FDI.
  - Ensure a more robust WTO able to handle trade disputes to maintain openness and predictability in the international trade system.

*Source: 7.1 Fragmentation Scenarios, IMF Working Paper excerpt provided.*

### References

### References

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### Notes on figures and data sources cited in references
- Figure B.1: Geopolitical Proximity based on UNSG voting patterns. Notes: Author’s calculations using United Nations voting data from Bailey et al. (2017).
- Figure B.2: Share of US and China trade among LAC countries, in 1995 and 2021. Notes: Author’s calculations using COMTRADE data. The size of the bubbles are proportional to the size of the country’s GDP.
- Figure B.3: Impact of Geo-economic Fragmentation in Static model. Notes: Impact on GDP for group of countries, compared to a baseline scenario where there is no fragmentation. CA = Central America; CAR = Caribbean; SA = South America. Emerging markets refer to EMDEs excluding Low Income Countries. The horizontal lines in the bars represent the median, for the countries in the group, the cross the average, the bars the interquartile range, the whiskers the min and max, except for outliers (dots) lying outside 1.5 times the interquartile range away from the median. See main text for the description of the two scenarios.

### Annex A: Static Geoeconomic Fragmentation Model

### Model structure and channels
- The model used to evaluate the impact of fragmentation on GDP in LAC in Section 7 is the static trade model with sectoral linkages in Bolhuis et al. (2023).
- Model features:
  - Several sectors connected through input-output linkages both within and between countries.
  - Distinguishes between two types of good: non-commodities and commodities.
  - Only non-commodities can be consumed as final goods; commodities are more upstream in the production process.
- Fragmentation scenarios are simulated by exogenously changing trade costs; countries endogenously re-allocate their exports and imports when trade costs change.

### Decomposition of real income impact
- At first order, the impact of fragmentation on a country’s real income is a weighted average of the impact in each sector.
- Each sectoral impact decomposes into three terms:
  - Exposure term: proportional to the share of expenditure a country has on goods in the other bloc (captures exposure to the other bloc through trade).
  - Price effect term: direct effect of breaking trade linkages on goods prices; larger for goods and commodities with lower trade elasticities (i.e., harder to substitute).
  - Indirect/amplification term: captures indirect effects through input-output linkages; shocks in upstream commodities propagate downstream.

### Distributional implications and robustness
- Countries more tightly integrated to global trade and participating in GVCs that span the competing bloc are more severely impacted by fragmentation.
- Countries buying commodities with low trade elasticities produced in the other bloc are particularly hurt.
- Countries that produce hard-to-substitute commodities are hurt the least.
- Trade elasticities play a key role; Bolhuis et al. (2023) conduct robustness exercises using the range of estimates in the literature.
- The extreme fragmentation scenario assumes a full partition of trade into two blocs.
- The model abstracts from other channels such as financial linkages, migration, or technological spillovers; disruption of these channels could further compound the cost of fragmentation.

### Annex B: Additional Figures

### Figure notes and interpretation
- Figure B.1: Geopolitical proximity measure constructed from United Nations voting data (Bailey et al. (2017)).
- Figure B.2: Historical comparison (1995 vs 2021) of the share of US and China trade among LAC countries using COMTRADE data; bubble sizes proportional to country GDP.
- Figure B.3: Shows impacts on GDP by country groups under mild and extreme fragmentation scenarios relative to a no-fragmentation baseline; group definitions include CA = Central America; CAR = Caribbean; SA = South America; emerging markets refer to EMDEs excluding Low Income Countries. Boxplot elements described explicitly in figure notes.

*Source: wpiea2024253-print-pdf - References*

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_Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024253-print-pdf.pdf_