Argentina and Brazil both belong to the Market of the South (Mercosur), a trade bloc that includes Paraguay and Uruguay and was founded in 1991 with the signing of the Asuncion Treaty. Mercosur was conceived as an analog to the European Economic Community, the precursor to the European Union. The goal was to create a bloc that could evolve into a supranational South American political body similar to the European Union. Mercosur was designed to craft a common external trade policy for these four countries, to eliminate non-tariff barriers to trade among them and to provide a tool for eliminating internal tariffs to allow for full economic integration. The ultimate goal was to emplace a functioning customs union, with a common external tariff and no internal barriers to trade, by 1994. The goal has not been achieved and likely never will be. Instead, Mercosur has mostly become a tool for negotiating selective trade protections for specific industries in member countries.
Mercosur's Political Importance
As a political mechanism, Mercosur is meant to enhance ties among the countries of the Rio de la Plata drainage basin — countries already bound inextricably by their shared geography. The Rio de la Plata region is by far the most economically viable, naturally wealthy geographic zone in Latin America, second in the Western Hemisphere only to the Mississippi River Valley. Unlike the Mississippi basin, which is under the control of one country, the rivers of the Rio de la Plata are split among four countries, which accordingly share a host of interests. Though it has been a century and a half since the last regional war, common interests are accompanied by opportunities for competition, and this is where Mercosur comes in. The bloc provides an institutional mechanism to reduce the potential for conflict between Argentina and Brazil.
Mercosur is the most successful example of regional trade integration in Latin America, a region primarily tied to North American and European markets. As mentioned, however, the bloc has not lived up to its original goals. It has largely been used to address the needs of domestic, rather than regional, interests.
Argentina and Brazil's economic interdependence and trade volatility have disproportionately impacted Mercosur's smaller members. The vulnerability of Uruguay and especially of Paraguay is an inevitable function of the two countries' size and geographic positioning.
Though both serve as buffers between Argentina and Brazil, Mercosur's smaller members are strikingly different. Less than half Paraguay's size, Uruguay is far more prosperous because it serves as a banking center with an Atlantic port. Land-locked, agriculture-dependent Paraguay has twice the population but less than half of Uruguay's gross domestic product. Paraguay's most important trade partners are, not surprisingly, Argentina, Brazil and Uruguay. Being inland, Paraguay depends on the Parana River and road transport through Brazil to transport goods to the sea. This makes it particularly vulnerable to trade barriers.
Brazil and Argentina are important export partners for Uruguay, while Paraguay is not even in its top 20. Uruguay's direct access to maritime transport reduces its exposure to Mercosur, giving the small country direct access to major consumer markets including the United States, China and Russia. Uruguay functions as a financial haven and is poised to benefit from currency volatility in Brazil and Argentina. Uruguay is, however, vulnerable to economic crises in Argentina and Brazil.
Paraguay and Uruguay can boost their regional influence by participating in Mercosur, but the trade bloc's center of gravity is and will remain with Mercosur's two larger members.
This reality has been apparent in recent months, as Brazil and Argentina have turned to protectionist measures in response to economic conditions. Mercosur members agreed in December 2011 to permit an external tariff raise of up to 35 percent on 100 items for each country. If approved, the tariffs could go into effect as early as mid-April.
The tariffs are the latest in several rounds of increased protectionism in the wake of the 2008-2009 financial crisis. Along with declining consumption in Europe and the United States, the region has experienced an influx of imports from China over the past three years. Mercosur's return to protectionism thus stems from the desire to protect the ability of local industry to compete in domestic markets with cheaper Chinese products. What could ignite a full-on trade war, however, is the brewing economic instability in Argentina.
Brazilian Concerns
At the outset of the financial crisis in 2008, Brazil's trade with the United States fell while Chinese interest in Brazilian raw commodities rose sharply. The combination made China the largest importer from Brazil for the first time in March 2009 and changed the complexion of Brazil's external market. While Brazil's exports to the United States primarily comprised manufactured and semi-manufactured goods, China is primarily an importer of raw commodities like oil, iron ore and soybeans. This rising interest in imports from Brazil and investment in the production of Brazilian primary commodities, combined with a generalized interest in Brazil as an emerging market, spurred growth in Brazil during a time of global malaise, greatly strengthening the country's currency. The strengthening real combined with stronger growth spurred a rise in import consumption. Meanwhile, concerns grew about the impact on Brazil's manufacturing sector.
Brazil began accusing China of selling goods below cost — a practice known as trade dumping. Brazil has since implemented a number of tariff increases on Chinese goods and has filed suit at the World Trade Organization (WTO) against countries with artificially low currencies. Brazil also has sought compromises with China, signing specific investment and trade deals and asking China to increase its imports of manufactured goods.
Brazil is concerned, however, that Mercosur states are being used to circumvent Brazilian trade restrictions. Brazil has accused both Uruguay and Paraguay of allowing Chinese inputs in textile products to exceed agreed-upon standards (goods must be made of inputs of at least 50 percent regional origin), prompting Brazil to limit textile imports from both countries. After Chinese company Lifan openly asked Uruguayan car company Effa to help Lifan's products reach Brazil, Brasilia threatened to collect retroactive tariffs on cars it believed to contain too many Chinese inputs. Brazil also has accused Argentina of allowing goods with too much Chinese content to enter Brazil through the Argentine Tierra del Fuego free trade zone.
Brazil's concerns are not limited to China and Mercosur. The country has pursued trade negotiations with Mexico in the automotive sector and has sought tariff hikes on goods affecting trade with a wide range of partners. Brazil has also openly advocated that the WTO raise the 35 percent cap on member tariffs, an effort that, although unlikely to be pursued, would radically change global trade dynamics.
A recovery in the U.S. consumer market is relieving some of the pressure on Brazil's industrial sector. After plummeting from $27.7 billion in 2008 to $15.7 billion in 2009, Brazilian exports to the United States recovered to $25.9 billion in 2011. Exports of manufactured machine parts have recovered alongside total imports, but crude oil and iron ore are growing as a percentage of total exports. This increased dependence on commodity exports, alongside reports that Brazil's industrial production declined for the sixth consecutive month, indicate that Brazil's serious concerns about de-industrialization will continue. Beyond obvious growth challenges, a struggling industrial sector means fewer jobs and a weakened impulse toward modernization and technological development — a daunting prospect for any government.
Argentina's Balance of Payments Challenge
Argentina's volatile trade policies are tied much more directly to the country's political climate. In the wake of the Argentine economic crisis of 2001-2002, the administrations of presidents Nestor Kirchner and Cristina Fernandez de Kirchner drew heavily on the populist tradition of former Argentine President Juan Peron. The Kirchners' cultivation of political popularity involved economic growth and tightly controlled consumer prices driven by a combination of subsidies and controls on industry. During this period, debt outstanding from Argentina's 2002 default has kept the country isolated from international lending markets. This means that financing for deficit spending has had to come from Argentina's internal markets and through monetary expansion, which has accelerated inflation to around 25 percent (though some estimates put it as high as 40 percent).
A spike in spending ahead of October 2011 elections and a strong-currency policy led to a sharp rise in imports, further increasing inflation and capital flight. In reaction to this dynamic, the months since the election have been characterized by a rapid-fire series of policy shifts designed to lock down capital flight and slow imports.
Most notably, Argentina in February eliminated automatic licensing on imported goods, causing an immediate and measurable slowdown in imports. Though the precise international impact is difficult to gauge, industry representatives in Paraguay have claimed declines in trade of up to 70 percent as a result of Argentina's policy shift. Reports have also emerged that Argentine officials have blocked Paraguayan shippers from exporting goods along the Parana on the grounds of new import restrictions. Uruguay claims that February trade with Argentina fell 48 percent year over year, and Uruguayan President Jose Mujica has promised affected industries that Uruguay, too, will raise protective tariffs.
Beginning April 1, Argentina will put similar barriers in place for services purchased abroad. The new rules will require Argentines to seek government permission before spending more than $100,000 on foreign services, or to make installment payments of more than $10,000 for such services. This change can be expected to affect a wide array of sectors, including legal services, technology transfers and IT services. Though Argentina's trade data reporting became inconsistent in 2011, the services industry was more than $14 billion in 2010 and likely grew in 2011.
Argentina hopes these measures will achieve several goals. First, by restricting imports and implementing strict capital controls, Argentina can ensure it is a net recipient of foreign capital. In February, the Argentine government reported a 121 percent year-on-year increase in the country's trade surplus, bringing the total surplus for the first two months of 2012 to $1.9 billion. International transactions involving Argentine goods are largely effected in dollars, and a trade surplus translates directly to extra foreign capital in Argentina's financial system. This can be borrowed against for government funds, trade financing and investment in national industry — all things Argentina is running dangerously short on.
The impact of these import restrictions on domestic industry has to a certain extent offset macroeconomic gains. According to the Argentine press, supply shortages have most strongly impacted automobile, machinery and electronics manufacturing, along with chemicals and fuel production. Consumer goods have also suffered — there are reports of shortages in goods ranging from furniture to medicines. Ultimately, these shortages will be the limiting factor on import restrictions. If Argentine consumers cannot access basic goods — either because domestic producers cannot access sufficient supplies, or because internationally produced goods are unavailable — there will be negative political consequences for the Fernandez government. However, fully lifting import restrictions will risk the very problem of capital scarcity the government is attempting to mitigate.
The Fernandez government may have something to be optimistic about: impending gains from the soybean harvest and its export. The soybean crop, ready for harvest in April and May, provides an export critical to both Argentina's balance of trade and its tax revenues. The influx of foreign capital that will follow the harvest will feed government coffers and help Argentina balance its payments. However, this year the soybean harvest is expected to decline nearly 6 percent as a result of drought conditions, so its profits will not provide as substantial a boost as in years past.
Even if domestic pressure and the influx of soybean payments push the government to relax trade barriers, the damage may already be done, both to trading relationships within Mercosur and between Mercosur states and outside partners. For Argentina and Brazil this concern takes a backseat to pressing domestic needs in the short term — but there are long-term implications. Once implemented, trade protections are difficult to lift.
While a functional short-term solution to protect specific interest groups, in the long run trade protections limit the competitiveness of companies and entire industries. They essentially cap the market share companies can access, limiting opportunities for long-term growth. Protectionist moves also trigger reciprocal rounds of retaliatory measures. The WTO tries to mitigate just this problem by setting a tariff cap at 35 percent, but this still allows for significant flexibility in trade policy and is not as effective at protecting states from the impact of non-tariff barriers.
Though the negative impacts of these policies will continue to be felt largely by Mercosur member states, the process underlines the utility of a trade regime tailor-made to support the domestic demands of both Argentina and Brazil. Each of the steps taken to escalate trade tensions was aimed at addressing critical domestic concerns. It will likely take a crisis on the order of the South American government transitions of the late 1980s, or a repeat of the financial turmoil that hit developing economies in the late 1990s, before either Brazil or Argentina reconsiders its stance on protectionism and on Mercosur as an economic tool.
That crisis may not be so far away if economic turmoil continues. The Argentine government is engaging in brinksmanship on a number of policies. Recent politically motivated decisions to back down from subsidy reductions mean inflationary pressures will likely continue. This should be further compounded by the recent push for additional lending by the central bank, which indicates that there are no plans to slow down government spending. Furthermore, the government may be undermining the central bank's ability to mitigate the impact of currency fluctuations, putting Argentina at risk of another currency crisis. Though Argentina holds less foreign debt than it did ahead of the 2001 financial crisis, a currency failure would effectively end the current political regime and would cause domestic turmoil.
