In Cuba, a Potential for Prosperity

Analysis

A vintage car with U.S. flags passes the U.S. Embassy in Havana on July 20, 2015. (ADALBERTO ROQUE/AFP/Getty Images)

Forecast

• Cuba and the United States will continue to strengthen political ties in the coming months and years.
• In the short term, Cuban tourism revenue could increase and certain financial restrictions ease, but the country may still feel the impact of Venezuela's economic downturn.
• In the longer term, the impact of the Cuba's opening will depend on Havana's ability to address structural issues in its economy and on when and how the United States decides to lift the trade embargo.
• The Cuban government will likely introduce reforms gradually and selectively to take advantage of economic opportunities while maintaining a firm grip on political power.

Analysis

Cuba has been shunned for so long that it is easy to forget just how important it is to the United States. The island nation has a prominent position at the mouth of the Gulf of Mexico, separating access to the gulf into two chokepoints: the Yucatan Channel and the Straits of Florida. Cuba is also situated on the sea-lanes between the U.S. East Coast and the Panama Canal, the shortest route for naval traffic between the two coasts of the United States. Cuba, which lies just 145 kilometers (90 miles) off the coast of the United States, has thus been pivotal to safeguarding economic activity in the Gulf of Mexico and naval transport routes beyond that. When the United States and Cuba are on opposing sides, the U.S. imperative is to try and neutralize and counter foreign support to Cuba from more powerful sponsors interested in meddling in the United States' backyard. If Cuba is on friendly terms with the United States, this task becomes all the more manageable.

In terms of Cuba's own economy, it has historically been driven, like many Latin American countries, by the production and export of raw materials. Cuba's most important resources have traditionally been sugar and tobacco, although the country is also a significant producer of nickel and hard alcohol. However, in large part because of its strategic location and interest from external powers, Cuba has experienced a unique political and economic trajectory over the past six decades.

The Cuban Revolution of 1959, led by Fidel Castro, dramatically shifted Cuba's economic structure from a capitalist economy integrated with that of the United States to a socialist, centrally planned economy oriented toward the Soviet Union. With Castro's revolution came the nationalization of the Cuban economy, sweeping land reforms and radical wealth redistribution. The Cuban government took control of virtually all major economic activity in the country, even to the point of confiscating foreign — and particularly Western — businesses operating on its soil, including the extremely powerful U.S.-based United Fruit Company. At the same time, the new Cuba became closely dependent on the Soviet Union for key goods such as oil and food.

With the collapse of the Soviet Union in 1991, Cuba lost one of its major economic patrons. The highly subsidized oil shipments it had been receiving from Russia fell 86 percent from 1989 to 1992, and food imports from Russia dropped more than 40 percent in the same period. These factors, along with a major drop in sugar prices, provoked a major economic recession in Cuba in the early 1990s, which in turn sparked some important reforms to the Cuban economy: Fidel Castro's government opened the country to tourism and limited foreign investment, while semi-legalizing the use of the U.S. dollar.

Nevertheless, Cuba still remained largely closed off to the United States, which retained a trade and travel embargo on the island. Cuba eventually found a new economic patron in Venezuela, whose left-wing government under President Hugo Chavez began sending subsidized fuel shipments to Venezuela as the Soviet Union had done. Even with the political transition from Fidel to his brother Raul Castro in 2008, when Cuba began engaging in some limited economic reforms such as the legalization of informal business activity, the state continued to play a dominant role in an economy that remained largely closed off to the United States.

A Diplomatic Opening: Short-Term Effects

The death of Hugo Chavez in 2013 and rising political and economic instability in Venezuela over the past two years have once again endangered Cuba's primary economic patron, which in part explains the latest major development trend in Cuba's political and economic evolution: renewed diplomatic ties with the United States. Beginning in late 2013, there were signs of a warming between Cuba and the United States, including a handshake between U.S. President Barack Obama and his Cuban counterpart, Raul Castro, at a memorial service for Nelson Mandela, and the start of bilateral talks in 2014 over various issues, such as the U.S. embargo on imports from Cuba and the use of Guantanamo Bay. 

These talks culminated in a major breakthrough in December 2014, when Cuba released former U.S. contractor Alan Gross in exchange for three Cuban spies who had been held in the United States. Shortly thereafter officials from both countries announced high-level political discussions focused on renewing their diplomatic relationship. Then, in March 2015, the U.S. Office of Foreign Assets Control removed dozens of Cuban companies connected to tourism and shipping from the sanctions list. On July 1, Obama finally made the official announcement that the United States and Cuba were to re-establish diplomatic ties and eventually reopen embassies in Havana and Washington.

Washington has also loosened economic restrictions to allow more money to flow into Cuba. Americans currently send $2 billion to Cuba in the form of remittances each year, but new changes allow individuals to send up to $2,000 per quarter to family members in Cuba, up from $500 per quarter previously. In addition, U.S. banks can now process credit card transactions from Cuba, a move that enables Americans who travel to the island to use their credit and debit cards.

Thanks to the diplomatic thaw, the Cuban tourism sector is on the rise. Tourist traffic to the island is up 15 percent compared with the same period last year, with around 1.7 million people visiting in the first five months of 2015. Moreover, each of the first five months has seen a double-digit increase in visitors — many of whom are coming from the United States. For May that number jumped 21 percent. Perhaps not coincidentally, Cuba's economic performance in the first half of 2015 registered a growth of 4.7 percent, which shows a reversal of the downward trend between 2013 and 2014. Now Cuba's economy is projected to grow 4 percent this year, largely driven by the construction and agriculture sectors. That is almost four times its growth rate in 2014, the fastest climb Cuba has seen since 2008. Even if economic statistics out of Cuba are not always completely reliable, they can still help paint a general picture of the country's prospects for growth.

The Long-Term Outlook

The next few years may be promising for Cuba's economy. The island has a highly literate population, relatively cheap labor, abundant population and natural harbors. Cuba also has a small but promising biotechnology sector with the significant potential for medical and drug manufacturing. Indeed, many international pharmaceutical companies already having identified Cuba as a potential site for drug making. There is also potential for Cuba to serve as a transshipment hub, contingent on upgrades and expansions to the country's ports.

But despite these factors and the initially positive economic signs amid the thaw between Cuba and the United States, the imbalances created by five decades of economic isolation will constrain Cuba's long-term economic growth. The Cuban government remains by far the largest employer on the island, and state-owned exporting businesses (as well as limited joint ventures with foreign firms) are highly inefficient compared with foreign competitors. Cuba's two-tiered currency exchange rate — in which a convertible peso is pegged to the dollar and used for foreign trade and the tourism industry, while the local peso is used for local goods and for paying local wages — is also problematic and dissuades foreign investment. Moreover, the country's restrictive foreign investment law, which taxes foreign-owned firms heavily and limits international arbitration to settle disputes, is a major drag on foreign investment.

The Cuban government does have plans to have a legal draft in place for the unification of the dual currency rates by sometime in 2016, but the pace of Cuba's opening to foreign capital will in large part depend on whether the United States actually ends the Cuban trade embargo within the next few years. According to U.S. law, Congress has to see a transitional government in place in Havana before it has the authority to amend or annul the ban on trade with the island. With Cuban President Raul Castro set to step down in 2018, the United States could wait until then to see if Cuba meets the legislative criteria to lift the embargo. A second option, promoted by some members of the U.S. Congress from both sides of the aisle, is for Congress to amend the law underpinning the embargo, thereby removing the legal rationale for maintaining the ban.

Even if Congress does lift the embargo, Cuba must manage its internal structural problems, including a monetary policy divorced from trade, poor energy and transport infrastructure and lack of capital stock — all of which limit its economic growth. In the coming years, Havana will try to address these issues but take care to keep those economic reforms from undermining its strong grip on power as the presidency transfers from Raul Castro to First Vice President Miguel Mario Diaz-Canel Bermudez.

Given the tenuous political situation, Havana's reforms are likely to be measured and gradual, and certain structural issues may impede the process. Cuba nevertheless has the potential to become an attractive and competitive low-end and middle-end manufacturing environment and see strong economic growth in the wake of its opening with the United States.