What could derail the Cuban economy? This could arise from a sharp external shock to the economy. A clear event that many analysts and commentators have in mind is the falling apart of the tight relationship between Cuba and Venezuela which is broadly compared to the alliance between Cuba and the Soviet Union during 1961-1990.
The precise elements, timing and scope of a breakdown in the Cuba-Venezuela relationship are of course unknowable. Here I simulate the case of an extreme event where there is a sharp sudden breakdown of the relationship leading to the departure of Cuban health, administrative, security and other personnel and the end of concessional oil terms for Havana. Some analysts in Venezuela and elsewhere think such a drastic outcome is unrealistic no matter the political evolution in Caracas, with or without the ruling PSUV party in power. It is very useful nonetheless to study a sharp shock to gauge the resilience of the economy and gain insights into the implications for growth and development. The Venezuelan shock has two elements, the most important one comprising the cut of Venezuelan imports of Cuban health, administrative and other services. The second element involves a higher relative price of oil imports in terms of Cuban resources plus a technological impact because of the temporary inability to use a segment of Cuba’s capital stock, for example oil refineries geared to process Venezuelan crude.
The simulation is carried out with the help of a two sector growth model of the Cuban economy described in a previous post in ASCEBLOG (Luis, 2014). The model simulates the growth path of the Cuban economy over a 10-year period as a function of labor, capital and human capital given key parameters of the economy and assumptions on exports and foreign investment.
The shock simulated here involves a cut of 80% in Cuba’s non-tourist services exports or roughly an amount equivalent to the level of such services provided to Venezuela[i]. This shows as a sudden displacement of human capital in the model. In addition a smaller shock which would be transmitted by the higher price (in terms of real exports) Cuba would have to pay for petroleum imports as well as a technological impact from temporary dislocation of refinery and other Venezuela related output. This in turn is expressed in the model as a 5% slackening of utilization of the capital stock. The simulation also takes into account some adjustment by means of a 10% per year continuing increase in non-tourism services exports elsewhere though these would take place at a discount to Venezuelan terms. This takes for granted that Cuban doctors sent to Venezuela are of the same qualification and experience required in other countries while it is doubtful that Cuban security services will readily find a market elsewhere. Since the simulation uses a pure growth model I do not incorporate financial assets that could be used to cushion external shocks as discussed in Luis (2012). These external assets have dwindled since 2012 reflecting diminished financial flows from Venezuela arising from economic problems there.
Even on the assumption that the economy is on the preferred growth path of the government (Base Case), the sharp shock leads to a depression in economic activity. Output falls by 7.6 percent on the year after the shock. As the direct links with Venezuela involve almost exclusively the state sector its production falls by 14.5%. Average worker productivity in the state sector falls a whopping 13.7%. There are effects on private sector output through the higher cost of energy. It helps that foreign investment continues to shield private activity, and output continues to expand. The shock reduces overall output of the economy to an average of 4% for the 10 year simulation period, a nearly 2% annual drop from the base case in the absence of a shock, with only 1.3% growth for the state sector. This is expected as the state sector is closely tied to Venezuela through the exports of services and oil imports. While the model considers an oil price impact on the private sector it does not show income effects arising out of the sharp shrinkage of the state sector. This means the estimates obtained here underestimate the impact of the shock.
Source: Simulation based on model by the author.
I also run a shock simulation under the more likely assumptions of lower savings, foreign investment and growth of services exports (More Likely Case). These assumptions involve a savings rate of 8.6%, foreign direct investment of 2% of GDP and real growth of non-tourism services exports of 5% per year. The table above compares the results of the two shock simulations. In the second case output falls 9.5% or nearly 2% more than under the base case shock, and 16% in the state sector. Long-term output growth is 2.3% as against 4% while the state sector stagnates and worker productivity advances just 1.7%
The calculations from the model are of a similar order of magnitude as those reached by Hernández-Catá (2013) but sharper than an estimate by Pavel Vidal (2014) using different models that reflect the historical structure of the economy. Hernández-Catá finds the impact at 7% to 10% of GDP from macroeconomic effects, mostly the decline in utilization of the capital stock, a range similar to the 7.6% to 9.5% estimated here. Vidal (2014) finds out that GDP would fall 7.7% over a four year period upon the dissolution of the Cuban-Venezuelan alliance if it follows the same time pattern as the breakdown in relations between Cuba and the Soviet Union. To be sure the time-pattern of the decline in output will vary depending on diverging assumptions in these models. The model used here for example assumes only a one-year disruption of the capital stock.
An important consequence of the sharp Venezuelan shocks is the impact on the sectorial structure of output. At the end of a 10-year period the share of output of the private sector after the shock is about 42% while without shock it is 36%. This is a reflection of the wide impact a sharp Venezuelan shock would have on the Cuban economy and society. The stagnation of the state sector will lead to a deeper shift of labor out of the state sector or within the sector from state enterprises to cooperatives. One may speculate as to whether or not such a shock may lead to deeper market-oriented reforms. These prospects would naturally depend on changes in outlook of and constrains on the political leadership However, almost surely the economy would need to open up further to international trade and investment as a means to make-up losses from the breakup of the Caracas alliance.
REFERENCES
Hernández-Catá, Ernesto, 2013, “Cuba, the Soviet Union, and Venezuela: A Tale of Dependence and Shock.” Cuba in Transition: Volume 23, pp.195-204.
Luis, Luis R. 2012, “Cuba: External Cash Flow, Barter Trade and Potential Shocks”, Cuba in Transition: Volume 22.
Luis, Luis R, 2014, “Cuba’s Growth Strategy Features Human Capital and Foreign Investment – May it Work?”.
Vidal, Pavel, 2014, “Proyecciones macroeconómicas de una Cuba sin Venezuela.” Desde la Isla, Cuba Study Group, 20 de febrero de 2014.
[i] This number is a rough estimate obtained by working down from the figure for exports of goods and services in the national accounts and subtracting merchandise and tourism exports and an estimate for health services exports from official statements. There remains a sizable residual of non-tourism, non-health services which apparently relate to other services Cuba provides Venezuela.