In this paper we develop a dynamic CGE model to examine the impact of CAFTA on production, employment and poverty in Honduras. We model four aspects of the agreement: tariff reductions, quotas, changes in the rules of origin for maquila and more generous treatment of foreign investment. We first show that trade liberalization under CAFTA has a positive effect on growth, employment and poverty but the effect is small. What really matters for Honduras is the assembly (maquila) industry. CAFTA liberalized the rules of origin for imports into this industry. That raises the growth rate of output by 1.4% and reduces poverty by 11% in 2020 relative to what it would otherwise have been. Increasing capital formation through an increase in foreign investment in response to CAFTA has an even larger impact on growth, employment and poverty.
These simulations say something important about the growth process in a country like Honduras in which it seems reasonable to assume that there is underemployed, unskilled labor willing and able to work more at a fixed real wage. In such an economy changing the structure of demand in favor of sectors that use a lot of unskilled labor will have a big impact on growth. That is what the maquila simulation does, because maquila uses a lot of unskilled labor relative to skilled labor and capital. Alternatively the supply of capital can be increased by increasing the rate of capital formation. Either of these two has a far larger impact on growth and poverty than tariff reductions alone.