The Effects of Increasing Openness and Integration to the MERCOSUR on the Uruguayan Labour Market: A CGE Modeling Analysis 1.

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1 The Effects of Increasng Openness and Integraton to the MERCOSUR on the Uruguayan Labour Market: A CGE Modelng Analyss 1. María Inés Terra 2, Marsa Buchel 2, Slva Laens 3, Carmen Estrades 2 November 2005 The authors acknowledge the collaboraton of Gabrel Katz n dfferent phases of the study. Abstract Uruguay s a small economy. Its ntegraton to MERCOSUR has ncreased the exposure to regonal macroeconomc nstablty. The am of ths paper s to assess the mpact of regonal ntegraton on the country s labour market and poverty. We estmated wage dfferentals between labour categores, fndng a 60 percent wage gap between formal and nformal workers. A CGE model wth an effcency wage specfcaton for unsklled labour was bult, wth results showng that regonal shocks deeply affect the Uruguayan economy. The consderaton of an effcency wage model s partcularly mportant when shocks lead to a reallocaton of resources towards sectors ntensve n unsklled labour. A subsdy on formal, unsklled labour could contrbute to decrease nformalty and therefore ncrease GDP, but ths type of polcy needs to be carefully mplemented because t may have negatve effects on nvestment. Fnally, the effects on poverty and ncome dstrbuton obtaned through mcrosmulatons are consstent wth the results of the CGE experments. Keywords: Uruguay, labour market, general equlbrum model, regonal ntegraton, effcency wage, mcrosmulaton, poverty JEL Classfcaton: D58, I32, F15, F16, J41 1 Ths work was carred out wth the ad of a grant from Poverty and Economc Polcy (PEP) Research Network, fnanced by the Internatonal Development Research Centre (IDRC). We are very grateful to Maurzo Bussolo, Ntesh Sahay, Bernard Decaluwe, Nabl Annab, John Cockburn, Randy Spence and Alvaro Forteza for ther useful comments and suggestons. All remanng errors and omssons are our own responsblty. 2 Department of Economcs, School of Socal Scences, Unversdad de la Repúblca. Rodó 1854, Montevdeo, Uruguay. E-mal addresses: 3 CINVE. Uruguay 1242, Montevdeo, Uruguay. E-mal address: 1

2 Introducton In the nnetes, wth the sgnng of the MERCOSUR agreement, Uruguay deepened ts economc ntegraton wthn the regon and hastened the country s trade lberalzaton process. As a result, trade wthn MERCOSUR ncreased sgnfcantly but also ncreased wth the rest of the world. Trade openness led to resource reallocaton from the manufacturng sector towards servces, profoundly affectng labour market structure. The regonal economc crss that started wth the Brazlan currency devaluaton n 1999 led to a four-year economc recesson, worsenng labour market and poverty ndcators. The purpose of ths study s to fnd out how the labour market s affected by external shocks, partcularly those assocated wth the ntegraton process or by changes n trade polces of the bloc. It ntends to estmate the effects on specalzaton, trade, employment and wages stemmng from those shocks or from changes n trade polces, takng nto account the mperfectons and specfc features of the labour market n dfferent sectors of the Uruguayan economy. It also dentfes the mpacts of these polcy changes on poverty and ncome dstrbuton. Fnally, the study evaluates polcy optons to lower the costs assocated wth ths process, drected to mprove employment. The study began wth a revew of the man characterstcs of the Uruguayan labour market and an estmaton of wage dfferentals between sectors and labour categores n order to obtan the stylsed facts to be consdered n the model. A CGE model was then bult wth the purpose of runnng dfferent scenaros of regonal shocks, and trade and labour market polces. Fnally, mcrosmulatons were run n order to evaluate the mpact of these shocks on poverty and ncome dstrbuton. In Secton 2 a bref overvew of the Uruguayan economy s presented and the man features of the labour market are analysed, ndcatng the exstence of mperfectons that should be taken nto account for the specfcaton of the CGE model used n the analyss. Secton 3 descrbes the man characterstcs of the CGE model, the manner of calbraton and the desgn of smulatons carred out. It also presents the man aspects of the mcrosmulatons methodology that was adopted to analyse the mpact on poverty and ncome dstrbuton. 2

3 In Secton 4 we present the results obtaned and fnally n Secton 5 the man conclusons are drawn. Economc overvew Recent economc performance Durng the last 25 years Uruguay gradually adopted several reforms focused on the lberalzaton and openng of real and fnancal flows, n order to ncrease Uruguay s tes wth the world economy, acheve macroeconomc stablty and set the market as the man mechansm for resource allocaton. The process started n the md-seventes, wth great transformatons n the fnancal sector but only mnor progress n terms of openness to trade. By the end of the 70s, fnancal flows were completely lberalzed, whle trade flow reforms were carred out more gradually. Startng from a maxmum of 150 percent n 1980, by January 1993 the hghest tarff was set at 20 percent. The 1990s were domnated by the creaton of the MERCOSUR, an mperfect customs unon among Argentna, Brazl, Paraguay and Uruguay. The creaton of the MERCOSUR mpled the exstence of free trade wthn the bloc and the adopton of a common external tarff (CET), whch was agreed n 1994 and enforced n The adopted CET vared from 0 to 20 percent, wth an average tarff of 11 percent. However, many exceptons to ts applcaton were accepted, and presently the four countres stll apply dfferent external tarffs to some goods, manly captal goods and computng and telecommuncaton goods. The full enforcement of the CET by 2010 wll mean that Argentna, Paraguay and Uruguay would have to ncrease ther tarffs on these goods, an unwelcome development snce these countres beleve that such wll hnder compettveness n most sectors. Snce the creaton of the MERCOSUR Uruguayan exports mproved ther access to a very large market (the sum of Argentna and Brazl). Trade wthn MERCOSUR ncreased sgnfcantly, and by 1998, 55 percent of Uruguay s goods were destned for the bloc. Ths was, n part, because of MERCOSUR, but ths was also due to the loss of compettvness of Uruguayan exports to thrd countres. The latter was a result of an overvalued local currency, the consequence of a polcy of prce stablzaton based on exhange rate. Snce 3

4 smlar stablzaton polces were adopted n Brazl and Argentna, exports to those countres remaned compettve. The stuaton changed dramatcally when the Brazlan currency started to float n January 1999, affectng Uruguayan exports drectly, and ndrectly (through the Brazlan mpact on Argentna). The share of Uruguayan goods exported to Brazl declned from more than a thrd n 1998 to a lttle more than 20 percent n In 2002, the fnancal crss n Argentna also affected the Uruguayan economy. The reducton of Argentne ncome levels, the restrctons on credt access, and the change n relatve prces n that country had a negatve mpact on Uruguay s trade outflows. The total servce exports (toursm bascally) fell more than 35 percent n the frst quarter of 2002 compared to the same perod n 2001 (that year, 80 percent of the toursts were Argentnes). Exports of goods to Argentna dropped about 70 percent n the frst semester of 2002 relatve to the frst semester of the prevous year. The Argentne crss had relevant effects on fnancal actvty as well. By 2001, the share of depost stock of non-resdents from Argentna was hgh, but n February 2002 Uruguay experenced an mportant captal flght due to the wthdrawal of non-resdent deposts. The crtcal stuaton worsened by fraud n three of the man prvate Uruguayan banks. By August, the depost stock n the Uruguayan bankng system had been reduced by 50 percent relatve to the begnnng of the year, whch forced the abandonment of the exchange rate system n June A floatng exchange rate was adopted, leadng to a sgnfcant deprecaton of the local currency. The exchange rate accumulated a total 106 percent ncrease from December 2001 to December Towards the end of July 2002, gven the nternatonal reserves loss due to captal flght, the Uruguayan government decded to call a bankng holday n order to make sgnfcant changes n the bankng system. The restructurng entaled the compulsory reprogrammng of term deposts n state-owned banks and the closure of four nsolvent prvate banks (wth a very large market-share). After the restructurng, the branches of nternatonal banks ncreased ther mportance n the bankng system. Ths new fnancal stuaton mpled severe restrctons on bank credt access, whch dd not affect unformly across sectors. 4

5 Although n the long run the Uruguayan economy shows a poor performance, e.g. the average ncrease of GDP was 1.9 percent between 1970 and 1990, the 1990s were a perod of economc growth. Between 1990 and 1998 GDP ncreased by an annual rate hgher than 4 percent (see Table 1). However, by the end of 1998 ths process began to reverse tself and after the Brazlan currency devaluaton of January 1999 the country was n complete recesson. In 2003 economc recovery started n Uruguay, manly drven by exports, whch grew 18 percent. Uruguayan exports had an 80 percent compettveness gan n relaton to Brazl and other trade partners as a result of the deprecaton of the Uruguayan currency. Total GDP ncreased 2,2% n 2003 and 12,3% n 2004 Table 1 Man ndcators Year GDP a/ Annual Fscal Current Imp. Exp. Gross Unempl. nflaton balance account goods & goods & captal rate c/ a/ b/ balance serv. b/ serv. b/ formato b/ n b/ ,3 112,5-3,0 2,0 18,10 23,53 12,20 8, ,5 102,0-1,8 0,7 17,86 20,69 15,13 8, ,9 68,5 0,3-0,8 19,63 20,45 15,38 9, ,7 54,1-1,7-1,8 19,56 19,13 15,64 8, ,3 44,7-2,8-2,3 20,38 19,77 15,87 9, ,4 42,2-1,5-1,3 19,10 19,00 15,41 10, ,6 28,3-1,4-1,2 19,86 19,67 15,24 11, ,0 19,8-1,4-1,1 20,54 20,55 15,22 11, ,5 10,8-0,9-1,8 20,58 19,85 15,87 10, ,8 5,7-4,0-2,3 19,30 18,03 15,14 11, ,4 4,8-4,0-2,8 20,98 19,30 13,96 13, ,4 3,6-4,3-2,6 20,04 18,35 13,77 15, ,0 25,9-4,2 3,1 20,01 21,97 11,52 16, ,2 10,2-3,2-0,5 24,56 26,07 12,59 16, ,3 7,6-1,8-0,8 27,94 29,65 13,29 13,1 Source: Elaborated wth data from BCU and INE. a/ Annual cumulatve varaton b/ Percentage of GDP (current prces) c/ Urban areas 5

6 Recent trends n the Uruguayan labour market In the nnetes, the economc reforms carred out n Uruguay, along wth ncreased trade openness and the creaton of the MERCOSUR led to a restructurng process that determned changes n the composton of GDP as well as n the use of technology (Casson and Fachola, 1997; Croce, Macedo and Trunfo, 2000; Tansn and Trunfo, 1998a; 1998b). Between 1991 and 2002, the share of manufacturng employment was gradually reduced, from 21 percent to 13 percent of total urban employment 4. On the other hand, the share of servces, especally n retal, restaurants, hotels and fnancal servces, ncreased: these sectors, together wth the constructon sector, rose from 27.5 percent of total employment n 1986 to 39 percent n Ths, n turn, drastcally affected the Uruguayan labor market, dsplacng workers from some economc actvtes and changng the requrements of the work force. The followng facts thus characterzed the evoluton of the Uruguayan labor market n the nnetes: a) a generalzed ncrease n labor productvty (output per worker); b) an ncrease n the unemployment rate assocated wth the destructon of unsklled jobs; c) an ncrease n wage dsperson, wth a relatve mprovement of sklled wages; and d) an ncrease n nformalty. These trends have deepened n the current decade. Regardng the skll level of workers 5, data analyss shows that the unemployment rate s consderably lower for sklled workers, whereas unsklled workers show the hghest unemployment rates. The unemployment rate n Uruguay clmbed from 8.8 percent n 1991 to 16.9 percent n Even pror to the severe economc crss that affected Uruguay between 1998 and 2002, the unemployment rate showed an ncreasng trend n a context of economc growth. Ths evoluton dffered clearly accordng to the educaton level of the labour force. Another relevant change that occurred durng the nnetes was the reducton n publc employment as a result of the ongong state reform process. Publc employment share n total employment fell from 24 percent n 1986 to 18 percent n However, publc employment for sklled workers rose slghtly durng the same perod. As a consequence, 4 In 2001 the share of manufacturng employment was 17%. Between 2001 and 2002 methodology to measure ndustry product was modfed by the INE, so the fall n 2002 mght be overvalued. 6

7 ths structural change renforced the effects of the changes observed n tradable sectors: greater destructon of unsklled jobs (UNDP, 2001) 6. It should be noted that the changes n productve structure affected not only the quantty but also the qualty of employment. Several studes suggest that precarous jobs, nformalty and underemployment ncreased throughout the decade, especally for workers wth low educaton levels. 7 The destructon of low sklled jobs that took place both n the publc sector and n the tradable sector drove unsklled workers towards employment n small productve unts or self employment, thus leadng to an ncrease n precarousness and nformalty (UNDP, 2001; Buchel, 2005). In ths context, nformalty became one of the most mportant mperfectons n the Uruguayan labour market, affectng more than one thrd of employed workers durng ths perod. Methodology Labour market specfcaton As cted n the prevous secton, the Uruguayan labour market presents serous problems of unemployment and nformalty. Therefore, we consdered that these mperfectons had to be captured n the model. However, we needed to focus on one type of mperfecton. Snce one of the dstngushng features of the Uruguayan labour market s the exstence of a persstent wage dfferental between formal and nformal jobs, a dual market labour approach was adopted for the study. The theory of dual labour markets s based on a two-ter regme where a prmary and a secondary sector coexst wth unemployment. Workers n the upper ter (prmary sector) enjoy hgher wages and frnge benefts; also, stablty, unon protecton and labour regulaton enforcement are more lkely n ths sector. Meanwhle, n the low wage (secondary) sector, the labour market clears and workers n ths sector are not able to 5 Ths study consders that a worker s sklled f he has at least 12 years of formal educaton. 6 In , 22,400 unsklled and 5,600 sklled publc jobs were destroyed. Durng the same perod new sklled jobs were created. The outcome was the destructon of publc jobs. 7 Precarous workers are those prvate dependent workers who are not covered by socal securty, have an unstable job, or receve no remuneraton for ther work. Informal workers are those not covered by socal 7

8 underbd those n the prmary sector. A ratonng of jobs n the prmary sector explans the exstence of queues and the persstence of unemployment. On the other hand, the secondary sector provdes flexblty to the economy, adjustng ts sze to fluctuatons n the busness cycle. The effcency wage model provdes a mcroeconomc foundaton for these features. Dfferent versons propose a persstent wage gap and a negatve relatonshp between the rate of unemployment and the upper ter wage (Sant Paul, 1996). In the Shapro-Stgltz verson frms are nterested n payng wages above the expected rates because of cost montorng reasons (Shapro and Stgltz, 1984). The model assumes some nablty of employers to observe workers effort. Ths allows the worker to choose how much effort he wants to make but f he shrks, he faces the probablty of beng fred. There s a crtcal wage above whch the worker wll not shrk. As far as frms are concerned, they compete by offerng wage packages that take nto account the mnmum wage requred to nduce workers effort. In equlbrum, f wages are very hgh, workers wll value ther jobs not only by the hgh wage tself but also by the low level of employment (due to low labour demand at hgh wages). Among others reasons, the crtcal wage for non shrkng wll be greater; ) the lower the probablty of beng caught shrkng. ) the hgher the expected utlty of beng unemployed (e.g. the most generous the unemployment subsdy program) and ) the hgher the flows out of unemployment. The same results arse n versons based on recrut, retan and motvate reasons. On one hand, a hgh wage eases vacances fllng, reduces the qut rate and motvates effort. On the other hand, hgh unemployment affects the lkelhood of fndng a new job f dsmssed (thus affectng effort) and the ease of voluntary turnover (qut). In the CGE model we assumed that an effcency wage model mght explan the wage gap between formal and nformal workers. In order to estmate the wage gap, the study used the Contnuous Household Survey (CHS) collected by the Natonal Statstcs Insttute (INE) n We restrcted the sample to wage earners and self-employed workers between 18 securty. Underemployment comprses workers who work less than 40 hours a week but would be wllng to work addtonal hours. 8

9 and 59 years of age. Informal workers are defned n ths paper as those who do not contrbute to the socal securty system. Dfferent estmatons of the wage gap were used n the smulaton. Frst, we used a very smple econometrc model: we regressed by ordnary least squares (OLQ) the log hourly wage on ndvdual and labour characterstcs, ncludng a dummy varable that dentfed f the worker was formally employed. 8 The estmated dummy parameter (G1) s a measure of the wage gap. Then we used the usual way of decomposng wage dfferences, proposed by Oaxaca (1973) and Blnder (1973). The study estmated an earnng equaton for the formal workers and another one for nformal workers. The dfference of the characterstc s rewards --weghted by the mean of the formal workers -- s nterpreted as the mean wage gap (G2). Analogously, the study estmated the dfference between coeffcents but weghted by the average characterstcs of nformal workers (G3) Ths estmaton gnores the endogenety of the selecton decson beng formal or nformal. We expect unobservable, ndvdual characterstcs to be correlated wth beng formal or nformal (.e. people wth easy access to nformal networks or to nformal benefts could have more potental gans than beng nformal). To deal wth ths problem we estmated a swtchng regresson model and used t to calculate the gap between the predcted wage of an average nformal worker and the wage he would have had n the formal sector (G4). The results of the estmatons are shown n Appendx 1. We report the dfferent estmatons of the wage gap n Table 1. The four alternatve estmatons suggest that formal workers are hghly remunerated. 8 We controlled personal characterstcs (age, educaton, gender, martal status, geographcal regon), the type of occupaton (publc servants, sze of the establshment of the prvate wage earners, self-employed who own some property and self-employed who do not) and other labour characterstcs (part-tme and ndustry). 9

10 Table 2 Estmated mean dfference n earnngs between formal and nformal workers (log Wf log W) Raw gap 0,85 Estmated gap G1 0,59 G2 0,65 G3 0,60 G4 0,52 A CGE model that captures these conclusons s presented n the next secton. The CGE model A Computable General Equlbrum (CGE) model was used to analyse the effects of several external shocks and some specfc polces on the Uruguayan labour market,. It s based on the model by Laens and Terra (2000), wth several changes regardng labour market behavour, export demand and nsttutonal desgn. The structure of the core CGE model s qute conventonal n terms of the analyss of traderelated ssues, but an alternatve specfcaton s made regardng the labour market. We used two dfferent versons of the model for the smulatons: an effcency wage 9 model and a compettve labour market model. The man features of ths model are as follows: S It s a mult-sector model wth 23 sectors, ncludng two specal sectors. One of the two specal sectors gathers all the actvtes (manly, publc servces and the fnancal sector) where employment and wages are fxed, because nsttutonal arrangements and/or trade unons are a deterrent to workers dsmssal or to wage reductons. By law, publc employment s fxed: no new publc employers are hred, and the exstng ones cannot be fred. Although trade unons could have been 10

11 ntroduced n the model, our ntenton was to focus on labour market dualty between formal and nformal workers. Trade unon modellng mght be ncluded n a future specfcaton of the model. S The other specal sector s an nformal sector that produces one type of good destned to domestc fnal consumpton. S We assume that Uruguay has three tradng partners (Argentna, Brazl and the rest of the world). The Uruguayan economy s explctly modeled whle n the case of the other tradng partners only the supply of mports and the demand for exports are endogenous. S Perfect competton s assumed n all sectors. However, goods are not homogenous, as they are dfferentated by geographc orgn. S We assume that there are ten representatve households whch represent dfferent ncome levels (by decles of the ncome dstrbuton). S Government collects tarffs and taxes. Government revenue s used to buy goods and servces and to make transfers to households. We assume that government has fxed consumpton of goods and servces (n physcal unts) and the transfers to households are updated by the change n the average wage 10. Government savngs s obtaned as a resdual. S On the producton sde, the study uses a nested producton functon. At the top level, frms combne ntermedate nputs wth value added followng a Cobb- Douglas functon. Value added s obtaned wth a constant elastcty of substtuton (CES) functon that combnes captal and composte labour. Then, composte labour s obtaned by combnng sklled and unsklled labour wth a CES. In the nformal sector, value added s only composed by unsklled labour. 9 Followng Therfelder, K.E., C.R. Shells (1997) and Annab, N. (2003) 10 In 2001 socal securty transfers represented nearly 83 percent of total government transfers to households. In 1989 a consttutonal reform measure establshed that socal securty benefts are adjusted to the evoluton of Average Wage Index. 11

12 S Goods are mperfect substtutes n consumpton (Armngton). The small country assumpton s made for mports, so the country faces a perfectly elastc supply curve n the external markets. However, t s assumed that the country faces a downward slopng demand curve for exports (quas small open economy) 11. Export demand s a functon of relatve prces and real ncome n the trade partners, whch are consdered exogenous. S Total demand for each sector s composed by domestc demand (ntermedate and fnal) plus exports to each of the tradng partners. S Trade balance s fxed, so that mports and exports of goods and servces mantan the dfference exstng n the benchmark data. The equlbrum n the model s defned by the smultaneous equlbrum n goods and factor markets and n the external sector. S There are three factors of producton: captal, sklled, and unsklled labour (the labour market s segmented by qualfcatons). The supply of each factor s fxed and there s no nternatonal moblty. Sklled labour can only be employed n the formal sectors, whle unsklled labour can also be employed n the nformal sector. S In the model wth effcency wages, ths behavour s appled to all formal actvtes, except for those n the fxed employment sector, whch we named APUBLIC, because t s manly composed of publc actvtes. Unemployment s fxed, so when unsklled workers are fred from the effcency wage sectors, they go to the nformal sector where they receve a lower wage. The specfcaton of effcency wage behavour follows Therfelder and Shells (1997). The model was run usng GAMS (General Algebrac Modelng System). Calbraton of the CGE model The model was calbrated usng a Socal Accountng Matrx (SAM) wth data for the year It was taken from Barrenechea, Katz and Pastor (2004). Orgnally, the SAM 11 Followng Cox s specfcaton (1994). 12

13 ncluded 30 dfferent actvtes and 36 dfferent commodtes. Even though ths dsaggregaton was qute approprate for ths study, some adjustments had to be made. Specfcally, t was necessary to show the dfferences n labour, accordng to the qualfcaton of workers and ther status of formalty or nformalty. Therefore, labour was separated nto sklled and unsklled labor. Among sklled workers, nformalty s not easly avalable, so t was assumed that sklled labour s always formal. Informaton about qualfcatons and formalty of workers was taken from the 2003 Contnuous Household Survey (CHS) collected by the Natonal Statstcs Insttute (INE). Workers wth twelve or more years of formal educaton were consdered sklled workers. In order to study the labour market, t was also necessary to dstngush between prvate and publc actvtes, because there are rgdtes concernng both wages and employment n the publc sector. Some actvtes, whch are carred out by publc and prvate agents (for example, educaton or electrcty supply), needed to be decomposed. Therefore, a new actvty was created that ncluded all actvtes carred out by the publc sector 12. Ths sector combnes sklled and unsklled labour, such as those found n the prvate sector, but publc employment s consdered fxed. To separate publc from prvate actvtes, nformaton was also taken from the 2003 CHS. In addton, government fnal consumpton was dsaggregated n the new matrx. In the orgnal SAM, government fnal consumpton expendture was ncluded n a mscellaneous sector called other servces. Fnal consumpton expendture of government was estmated from Natonal Accounts. Then, fnal consumpton expendture was dsaggregated accordng to the nformaton provded by the 1995 SAM (Lorenzo, Osman and Caputt, 1999; Laens and Terra, 2000). The rest of the world needed to be dsaggregated as well. Argentna and Brazl were separated from the rest of the world, creatng three foregn agents. In ths case, data was taken from Natonal Accounts and trade statstcs from the Central Bank (BCU). 12 That s: Electrcty and Water Supply, Petroleum Refnery, Communcatons, Postal Servce, Fnancal Servces and Educatonal Servces. 13

14 Fnally, an nformal sector was created besdes those orgnally consdered n the SAM. It was assumed that the nformal sector produces a composte good of all the actvtes n whch nformal labour was dentfed. Ths nformal good s produced entrely for fnal consumpton of households. It was assumed that value added of the nformal sector ncludes only wages. The total amount of nformal sector wages was estmated wth data from the CHS. As a result, the nformal sector ncludes actvtes such as agrculture and other prmary actvtes, constructon, retal, and textles and clothng, whch have an mportant component of nformalty. The mcrosmulatons methodology The CGE model provdes some nsghts about the poverty effects of the shocks and polces that were smulated. However, the combnaton of these results wth a mcrosmulaton methodology provdes more precse nformaton about poverty and ncome dstrbuton by trackng the economy-wde changes at the household level. Several approaches have been developed wth ths purpose, as shown by Bourgugnon, Perera de Slva and Stern (2002). The mcrosmulatons are based on household data but there s no need to reconcle ths data wth the SAM because the procedure only needs nformaton about changes n wages, employment and unemployment. The method assumes that changes n the labour market can be replcated by a random selecton procedure, whch mposes counterfactual changes n labour market parameters calculated for the benchmark year. Ths approach follows Paes de Barros and Lete (1998), Paes de Barros (1999), Frenkel and González (2000), Ganuza et al (2002) and Ganuza et al (2004). It was appled for the case of Uruguay by Buchel et al (2002) and by Laens and Perera (2004). The SPSS program used n ths paper s the same one used n the latter work. The ratonale for usng mcrosmulatons s that a CGE model captures only partal dstrbuton of ncome between famles, therefore makng t dffcult to see the real mpact of shocks or publc polces on ncome dstrbuton and poverty. A crucal assumpton adopted n ths methodology s that a person s poston n the labour market s the man determnant of hs ncome and poverty status. 14

15 The procedure takes CGE results as nputs. Labour market structure s consdered as a functon of sx parameters: partcpaton rate, unemployment rate, wage structure, overall average wage, worker s educaton level and structure of employment (sector of actvty and occupaton category). In ths study, the partcpaton rate s fxed, so t s not consdered for the mcrosmulatons. In turn, sector of actvty s defned n terms of formal or nformal actvty. Once the changes n the labour market parameters are obtaned from the CGE results, the mcrosmulaton methodology s appled. The procedure uses random numbers to smulate the changes n the labour market structure that are consstent wth the parameters ntroduced. On average, the effect of the random changes wll reflect the mpact of the new (smulated) parameters n the labour market. The mcrosmulatons are repeated a large number of tmes usng Monte Carlo numbers to allow for the determnaton of confdence ntervals for the poverty and ncome dstrbuton ndcators. In each smulaton, changes n poverty and ncome dstrbuton are measured through the percentage of populaton under the poverty lne, the poverty gap, the Gn coeffcent and the Thel coeffcent. Data from CHS for the year 2000 was used. For each scenaro, several changes n labour market structure were smulated, frst separately, then sequentally. The dea behnd establshng a sequence s that changes n labour parameters follow some order, whch s not neutral. The commonly accepted sequence s the followng: frst the person decdes whether to partcpate or not n the labour force; then the market decdes whether he or she wll be employed or not; then the person decdes whether to work n the formal or formal sector and ths determnes a certan wage level and, n the aggregate, the average wage. Fnally, labour market structure by educaton level s defned. Ths sequence was appled n the three models consdered. As unemployment s fxed n the model, the correspondng rate remans unchanged. The analyss was made takng the whole sequence nto account. 15

16 Smulaton desgn and results Smulaton desgn In Secton 2 we ponted out that ncreasng trade openness and the ntegraton of the Uruguayan economy to the MERCOSUR augmented the country s vulnerablty to external shocks, partcularly those orgnatng n Argentna or Brazl. Wth that dea n mnd, the study carred out some smulatons n order to show how and why some of the forces at work durng the 2002 crss affected the Uruguayan labour market. Agan as explaned n Secton 2 the crss had many components: recesson n Argentna and Brazl, changes n relatve prces that affected Uruguayan exports to those countres, credt constrants, fnancal turmol, external debt growth, captal flght, etc. Unfortunately, t s mpossble to evaluate wth our CGE the specfc weght of each of these factors n the geness and the deepenng of the crss, partcularly because t had a very sgnfcant fnancal component, whch cannot be tracked by ths model. Nevertheless, we chose to smulate two relevant components of the 2002 crss: the change n relatve prces vs-à-vs the man trade partners (due to devaluatons n those countres) and the foregn savngs constrant. In order to assess the effects of the change n relatve prces that occurred when Argentna abandoned the currency board regme, we smulated a 40 percent declne n domestc prces nomnated n dollars n Argentna and a 7 percent decrease n the prce of mports from that orgn (ARGRP scenaro), whch was what really happened n Argentna between 2000 and In order to compare the effects of the shocks orgnatng n one or the other MERCOSUR partner, we smulated an dentcal change n prces n Brazl (BRARP). The thrd smulaton was a restrcton n foregn savngs. In 2000 the Uruguayan current account was runnng a defct, whch was fnanced by captal nflow from the rest of the world. In 2002 the stuaton was reversed and no captal nflow was avalable, so a severe adjustment was needed to obtan a current account surplus. Therefore, n ths smulaton we fxed the current account balance (EXTSAV) at zero. 16

17 As cted n Secton 2, the MERCOSUR s an mperfect customs unon because the common external tarff has not been fully enforced across the four countres. Its full enforcement was smulated n order to assess the effects that t mght have on the Uruguayan labour market, especally because the rse n captal goods tarffs mght have a negatve effect due to a compettveness loss (CET). Fnally, we smulated a specfc labour market polcy. Assumng that a reducton n the relatve cost of labour mght mprove employment, the study smulated a 10 percent drect subsdy on formal employment of unsklled labour (DIRTAX). Table 3 summarzes the fve experments and shows how varables or exogenous parameters are affected. The complete model equatons are presented n Appendx 2. Table 3 Smulaton scenaros Smulaton scenaro Varable or exogenous parameters Varaton (%) ARGRP Domestc prce ndex (DP ARG ) -40% Exports prce from Argentna (PW ARG ) -7% BRARP Domestc prce ndex (DP BR ) -40% Exports prce from Brazl (DP BR ) -7% EXTSAV Current account balance (B) -100% * CET Common external tarff (t) DIRTAX Labour taxes (trab) -10% * In benchmark the current account balance was 4% of GDP The results of these fve smulatons wth the CGE model are presented n Tables 4 (Varaton of man macroeconomc varables) and 5 (Effect on labour market varables). Smulatons of regonal shocks and results These experments show the vulnerablty of the Uruguayan economy to regonal shocks, whch have ncreased due to geography and the deepenng of the ntegraton process wth the MERCOSUR countres. 13 Data was taken from Indec- Natonal Insttute of Statstcs and Censuses of Argentna. 17

18 Table 4 Macroeconomc varables for each smulaton Percent Varaton Relatve prces change wth Argentna Relatve prces change wth Brazl External Savngs Restrcton Common External Tarff Subsdy to Unsklled labour Perfect competton model Absorton* -0,38-0,24-4,42-0,23-0,03 Household Consumpton* -0,14-0,12-0,66-0,18 1,65 Investment* -2,24-1,19-31,32-0,77-10,00 Exports* -7,26-2,79 9,97-3,18-0,44 Imports* -5,95-2,04-11,82-2,54-0,36 Real GDP -0,48-0,33-0,54-0,29-0,03 Real Exchange Rate 4,19 2,15 1,45-0,36-0,81 Export Prce -0,12-0,09 0,00 0,00 0,00 Import Prce -2,96-2,44 0,00 0,00 0,00 Consumer Prce 0,05 0,00-0,25 0,09-0,21 Effcency wage model Absorton* -1,13-0,30-4,59-0,22 0,20 Household Consumpton* -0,28-0,23-0,58-0,17 1,85 Investment* -7,38-1,03-33,13-0,75-9,39 Exports* -8,99-4,62 10,25-2,78-0,34 Imports* -8,22-4,27-11,91-2,14-0,26 Real GDP -1,11-0,27-0,64-0,29 0,19 Real Exchange Rate 4,37 2,57 1,57-0,45-0,60 Export Prce -0,40-0,29 0,00 0,00 0,00 Import Prce -2,67-2,16 0,00 0,00 0,00 Consumer Prce 0,04 0,03-0,14 0,09-0,17 A change of relatve prces n any of the MERCOSUR partners generates a GDP declne n Uruguay, a reducton of exports and mports, and a decrease n nvestment. The reducton of both exports and mports s due to our choce of model closure, whch fxes current account balance. When export demand falls as a consequence of the relatve prce change wth the tradng partner, mports fall as well, and adjustment s done through the exchange rate, wth a devaluaton of local currency. The macroeconomc mpact of the same change n relatve prces s more pronounced when t happens n Argentna than when t happens n Brazl. Ths could be explaned by the relatve mportance of exports to each country n the benchmark: 24 percent of total exports were destned for Argentna, 17 percent for Brazl and 59 percent for the rest of the 18

19 world. In turn, the share of mports from those orgns was 26 percent, 18 percent and 56 percent, respectvely. Ths result should be taken wth cauton because t s not necessarly true that a shock comng from Brazl wll always have lower effects on the Uruguayan economy than a shock from Argentna. Ths result s hghly dependent on the prevalng macroeconomc condtons, as the regon has been affected by severe nstabltes that have sgnfcantly changed the trade composton by orgn or destnaton. As long as Brazl ncreases ts relatve mportance as trade partner for Uruguay, the mpact of a relatve prce change n that country could ncrease substantally. The mpact of a relatve prce change n Argentna s hgher when effcency wages and the exstence of an nformal sector are assumed. In ths case, real GDP falls by 1.1 percent, whle t decreases 0.38 percent when the neoclasscal assumptons are adopted. The varaton of Argentne relatve prces generates a very sgnfcant reducton of nvestment n Uruguay, whch would reach 7.4 percent n the effcency wage model and 2.2 percent n the perfect competton model. Investment declnes because government savngs declne (as government revenue s lower) along wth household savngs. Relatve prces change wth Argentna Table 5 Labour Market Varables for each smulaton Percent Varaton Relatve prces change wth Brazl External Savngs Restrcton Common External Tarff Subsdy to Unsklled labour Perfect competton model Informal Emp -0,48 0,21 0,48-0,01-4,97 Unsklled Emp 0,10-0,04-0,10 0,00 1,02 Unsklled Wage 0,34-0,33-1,14-0,17 6,98 Sklled Wage -0,95 0,20-0,33-0,23 0,07 Effcency wage model Informal Emp -0,28 0,19 0,37 0,02-4,36 Unsklled Emp 0,12-0,08-0,16-0,01 1,86 Wage Dfferental 0,16-0,11-0,21-0,01 2,75 Unsklled Wage 0,00-0,42-0,94-0,19 6,50 Sklled Wage -1,00 0,09-0,23-0,23-2,76 19

20 On the other hand, a change of relatve prces n Brazl has greater mpact on the Uruguayan GDP when the perfect competton model s used. Ths could be explaned by the factor ntensty of goods traded, whch s qute dfferent from one country to the other. Trade flows wth Argentna are more ntensve n sklled labour than trade flows wth Brazl (see tables 6 and 7). Therefore, a compettveness loss wth Argentna generates a reallocaton of resources towards ndustres that make ntensve use of unsklled labour and captal (see table 8). Table 6 Factor Intensty of export by destnaton Argentna Brazl Rest of the world Sklled labour / Unsklled labour Captal / Unsklled labour Skll Labour/ Non Skll Labour Table 7 Specalzaton and Factor Intensty by sector Captal/ Trade Balance Non Skll (mllons of U$S) % of Exports % of Imports Labour ARG BRA RM ARG BRA RM ARG BRA RM Agrculture & agrondustres Other manuf. goods Servces Total The study assumes that the sklled labour market s perfectly compettve whle the unsklled labour segment s subject to effcency wages, so that an ncrease n demand for unsklled labour and a reallocaton of resources to those sectors make the results dffer more than n the case when the reallocaton of resources operates n the opposte drecton. In fact, when there are reasons for payng an effcency wage, an neffcent resource allocaton takes place. The producton possbltes fronter shfts to the left when specalzaton becomes based towards the producton of goods ntensve n unsklled labour. Therefore, the larger the specalzaton n goods ntensve n unsklled labour, the 20

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