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Cuba’s Growth Strategy Features Human Capital and Foreign Investment: May it Work?


Cuba’s economic policy is firmly based on ideological grounds.  Consequently it is not wholly appropriate to evaluate current reforms and its growth strategy in the usual terms for transition economies that emphasize efficiency, the role of markets and ownership rights, European Bank for Reconstruction and Development (2013).

Nonetheless, taking into account the ideological context and the seeming inability to instill deep market-oriented reforms, it is still useful to gauge prospects against the government’s own goals.

This approach to evaluating the government’s growth strategy starts by ruling out two possible favorable events which an analyst can not safely take as given.  These favorable events would be: 1) a swift normalization of relations with the US and 2) the discovery and rapid exploitation of sizable oil fields.  At the same time I also leave out possible events or shocks that could derail the growth strategy, for instance the swift cessation of concessional oil supplies and other business arrangements with Venezuela or a catastrophic weather event.  Such events are not unlikely, and they can be evaluated as an extension of this note.

It is clear from actions and statements by the government that the new approach to growth and development features two factors, the improved use of human capital and a new opening to foreign investment. A better use of labor and associated human capital is at the heart of the shift of employment from the state sector to the private sector.  As of 2013 the share of output of the non-cooperative private sector was about 24% of GDP.[ii] The other key mechanism to improve utilization of Cuba’s considerable endowment of human capital is by way of the export of services of health and other professionals.  Such non-tourism services exports have boomed from 3.2% of GDP in 2000 to 14.3% in 2012 according to official Cuban data ONE (2013 and previous issues).

The second factor in the new strategy is an opening to foreign investment. Data on fixed capital formation and capital goods imports suggest an upper limit of around 1% of GDP for foreign direct investment in 2012, Luis (2014).  This is well below the 4.3% average of 19 Latin American countries and partly explains the low investment level in the island.  As a result the government is taking new measures including the approval of a new foreign investment law on March 29, 2014.  The vice-president of the council of ministers Marino Murillo indicated that Cuba needs between US$2 and US$2.5 billion annually to meet development plans.[iii]  Murillo stated that in the last decade the overall investment ratio has been 13% of GDP.  In fact, gross capital formation was 8.6% of GDP according to the 2012 national income accounts. Murillo also indicated that the economy needs output expansion of between 5% and 7% per year.

In order to explore if such goals are plausible I engage in a simulation exercise with a model of the Cuban economy which incorporates physical and human capital, labor and foreign investment in the state and private sectors.  The model is an extension of well known approaches to the theory and empirics of growth by Lucas (1988) and Mankiw, Romer and Weil (1992).  The derived simulations are not a forecast, just a rather mechanical check to find out if the goals of policy are consistent with the broad parameters of the economy and prospects and assumptions regarding services exports and foreign investment.

simulation-results

Note: Savings is gross domestic savings as a % of GDP, Xnts is annual real growth of non-tourist services exports, FDI is annual foreign direct investment as a % of GDP. Savings is assumed to equal gross domestic investment. Source: Simulation based on model by the author. Please see Appendix.


The base case scenario in the simulation contains minister Murillo’s desired upper level for foreign investment. It also assumes ambitious growth of non-tourism services exports which expand at a 10% annual real rate.  Foreign direct investment is assumed to be US$2.5 billion or 3.4% of 2012 GDP a relative level maintained in the 10-year simulation.  The savings rate is 12% and is considered entirely converted into physical capital in both sectors.  Under these assumptions yearly output growth averages nearly 6% with the private sector expanding at a bit over 10%.  This is because foreign direct investment flows wholly into the private sector as well as the continuing shift of employment from the state to the private sector.  At the end of the simulation period of 10 years the share of the private sector would be 36% of output as against 24% in 2013.

What if savings and investment are equal to the 2012 investment level of 8.6% of GDP?  A failure to lift the savings and investment rates would mean that output growth would be below the 5% minimum level outlined by Mr. Murillo while state sector growth would nearly halve.

Is Cuba able to raise exports of services at a high rate?  There are signs that the export of health professionals is beginning to strain medical services in Cuba.  In Simulation 3 the model is run with such services expanding at 5% per year rather than 10%.  The impact on growth is not severe – about half a percentage point cut.  Likewise a decline in foreign direct investment from 3.4% of GDP to 2% does not have a very large impact on output growth.

Simulation 5 combines the assumptions in the previous three simulations, which may be more realistic than the base case, and it does have a sizable impact, slashing yearly output and productivity (output/worker) growth by two percentage points from the base scenario.  In this scenario growth is well below the desired path.

These calculations point out to the difficulty of meeting the objectives of the government growth strategy and the crucial role of domestic savings.  In addition, the mechanical approach of the calculations overlooks obstacles at the firm level because of the lack of working market mechanisms to improve resource allocation which suggest the need for a more vigorous approach to price liberalization.

The government could be more ambitious regarding foreign investment than it is now signaling.  Success in attracting foreign investment has to do much less with the new law than with the creation of a positive business environment and a secure level playing field for foreign corporations.  Success in attracting even the moderate investment flows Mr. Murillo outlined would nonetheless change the complexion of the economy and bring about a more important role for the private sector while providing access to new technologies and management know how.  At the end will economics trump ideology?

APPENDIX

The model utilized here is based on production functions augmented with a variable for human capital and an efficiency mechanism lowering underemployment in the state sector.  The human capital variable is linked to non-tourism services exports, where human capital may be paid closer to its marginal product than domestically, at least to the state if not to individual professionals.  The main parameters of the model are derived wherever possible from national accounts and labor force data.  The capital elasticity of output for the state sector of 0.6 is close to the average of seven estimated equations by Hernández-Catá (2014B) and matches the capital share of income in the national income accounts.  The labor share of income is adjusted for income from non-tourism service exports.  Foreign direct investment assumptions are incorporated into the capital dynamics of the private sector.  A policy variable has to do with the shift of labor from the state to the private sector.

The model consists of the following equations:

Xt=AKtα(Lt-Wt)λMt1-α-λ    (1)

X*t=AK*tβ(L*t-W*t)μM*t1-β-μ   (2)

ΔK=s[A(1-δ)Kt-1α(Lt-1-Wt-1)λMt-1 1-α-λ ]    (3)

ΔK*=s[A(1-δ)K*t-1β(L*t-1-W*t-1)μM*t-1 1-β-μ ]  + F­t-1  (4)

ΔH = (1+g)(Lt-1– ρWt-1)  – Wt      (5)

ΔH* = (1+g)L*t-1 + ρWt-1 – W*t   (6)

ΔM = (1+π)Mt-1                               (7)

ΔM* = (1+π)M*t-1                           (8)

ΔL = (1+g)Lt-1 – ρWt-1                    (9)

ΔL* = (1+g)L*t-1 + ρWt-1                 (10)

Ft  = γ(Xt-1 + X*t-1)                         (11)

Ht ≡ Lt – Wt                                      (12)

In the model the * variables correspond to the private sector.  So Xt is state sector output in year t and X*t private sector.  Augmented production functions determine sectorial output where Kt is capital, Lt labor available, Wt unutilized labor and Mt human capital of the Mankiw, Romer and Weil (1992) variety.  Ht and H*t are effective labor used by each sector, entering directly into the production functions.  The production functions are linear and homogeneous on parameters α, λ and β, μ.  Other parameters are s, the savings rate, deemed to be equal for both sectors, g the overall rate of increase of the labor force, π the growth rate of non-tourism services exports, ρ the proportion of unutilized labor in the state sector shifted to the private sector  and δ the capital depreciation rate.  Ft  is foreign direct investment, a constant fraction of output γ, set by a policy target. Δ denotes a first difference.

The system is simulated recursively with initial conditions matching 2013 sector shares of output consistent with production functions.  The initial endowment of human capital is derived residually by making output consistent with the production functions.

 

 REFERENCES

European Bank for Reconstruction and Development, 2013, “Transition Indicators Methodology”. www.ebrd.com/pages/research.

Hernández-Catá, Ernesto, 2014A, “The Institutional Structure of Production in the Cuban Economy”.  Paper to be presented at the Annual Meeting of ASCE, Miami, August 2014.

Hernández-Catá, Ernesto, 2014B, “Accounting for the Growth of Real GDP in Cuba.  An Exploratory Empirical Study”.  In Economic Behavior, Game Theory and Technology in Emerging Markets.  Brian Christiansen and Basilgam Muslum, editors.  IGI editions (2014).

Lucas, Robert E., 1988, “On the Mechanics of Economic Development.”  Journal of Monetary Economics, 22(1):3-42.

Luis, Luis R. , 2014, “Foreign Investment in Cuba: Mariel and Liberalization.”  www.ascecuba.org/blog/post/2014/02/08

Mankiw, N. Gregory, Romer, David and Weil, David, 1992, “A Contribution to the Empirics of Economic Growth.” Quarterly Journal of Economics, 107(2): 407-37.

Nova, Armando (2011), “Las cooperativas agropecuarias en Cuba 1959-presente” in Camila Piñeiro Harnecker (ed), Cooperativas y Socialismo: Una Mirada desde Cuba.  Habana. Editorial Caminos, pp. 221-236.

Oficina Nacional de Estadísticas, 2013, Cuentas Nacionales 2012.

 

[i] This note benefitted from incisive comments from Ernesto Hernández-Catá.

[ii] This estimate for private sector output draws on private sector GDP estimates by Hernández-Catá (2014A) adjusted by subtracting estimated output from CCS cooperatives and adding output from investments by foreign private corporations. CCS cooperatives or Cooperativas de Credito y Servicio largely encompass farmers who own farmland and associate themselves in a cooperative to obtain services such as distribution, farming services and credit.  While these cooperatives have elements of free enterprise they are tightly linked to state marketing and agricultural agencies.  Going forward the expansion of CCS will also entail leasing land from the state which may well reduce operational independence.  As a general reference please see Nova (2011).

[iii] “Cuba promueve inversion extranjera para desarrollar su modelo.” www.cubasi.cu/26790, March 2014

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