## CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS (_dp0801) ## Source details **Canonical URL:** [CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS (_dp0801)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2008/_dp0801.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2008/_dp0801.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2008/_dp0801.pdf.json) --- ### High-level assessment and IMF engagement - Political/economic progress: - Political dialogue replacing civil conflicts; smooth transitions of power. - Broad consensus on macroeconomic stability and poverty reduction. - Risks: - A protracted U.S. slowdown could jeopardize recent gains. - Surges in petroleum and food prices have adverse effects. - IMF action: - Planned establishment of a regional technical assistance center (CAPTAC-DR) in Guatemala in early 2009. ### Recent developments and macroeconomic outlook - Growth and inflation: - Regional output growth: average growth rate of 6.8 percent in 2006 and 6.7 percent in 2007. - Short-term projection: regional growth projected to be still robust in 2008; most countries would still have a positive output gap by end-2008 under this scenario. - Inflation: average annual inflation of about 9 percent at end-2007, compared with an average of 6 percent at end-2006. - External environment and shocks: - Two significant external shocks: weakening external growth driven by a U.S. downturn; commodity price hikes (fuel and food). - Trade/remittances: - Exports grew by over 11 percent in both 2006 and 2007. - Remittances accounted for 14 percent of regional GDP (excluding Panama) during 2006. - Exports accounted for 20 percent of regional GDP in 2006. - Since the early 1980s, share of total merchandise exports to the United States averaged about 40 percent (country range: 27 percent in Nicaragua to 53 percent in Honduras). - External balances and reserves: - Current account deficits (regional average) increased from 5 percent of GDP in 2006 to 6.7 percent of GDP in 2007. - International reserves: remained at high levels, rising slightly in proportion to broad money. - Fiscal and public debt developments: - Average public sector deficits fell to 0.7 percent of GDP in 2007 from 1.8 percent of GDP in 2006. - Public debt fell from 46 percent of GDP in 2006 to 37 percent of GDP in 2007. - Share of foreign-currency-denominated debt: fell from 63 percent in 2006 to just under 60 percent of total public debt in 2007. - Representative fiscal numeric phrase repeated: "5.7 percent of GDP in 2004 to 8.3 percent of GDP in 2007." - Private sector and financial indicators: - Private sector credit: reached 24 percent on average in 2007 compared with 19 percent in 2006. - No evidence of exposure to the U.S. sub-prime market in regional financial systems. - Capital inflows continued; international reserves high. - Financial integration: increased activity of international banks and foreign ownership of domestic banks. ### Transmission from the United States and cyclical linkages - Empirical estimates and methodology: - Uses annual real GDP, 1950–2006, for Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama, and the United States. - A five-lag VAR selected by AIC; cointegration tests suggested 3 cointegrating vectors → 4 common trends; common cycles test could not reject 4 common cycles at the 5 percent level. - Applies common cycles method (Vahid and Engle (1993)) and Beveridge-Nelson-style decomposition. - Key quantitative findings: - A growth slowdown of 1 percentage point in the United States would typically be associated with a cyclical fall in output growth of 0.5 to 1 percentage point in most countries of the region (largest effects in Costa Rica and El Salvador). - Debt owed to foreign banks reporting to BIS by Central American borrowers (excluding Panama) ≈ 15 percent of GDP at end-2006. - Direct debt owed to U.S. banks ≈ 3 percent of GDP. - Loans with maturity < one year account for almost half of outstanding claims by BIS banks on Central America. - Foreign ownership of domestic banks: < 15 percent in Guatemala; > 90 percent in El Salvador. - Policy implication: - Distinguish cyclical vs. permanent components when deciding to spend or save windfalls; if growth is cyclical, optimal to "save" most of it. ### Regional integration: trade, customs union, and policy coordination - Trade integration status: - CAFTA-DR: implementation for El Salvador, Guatemala, Honduras, and Nicaragua in 2006; Dominican Republic in 2007; Costa Rica passed a referendum on October 7, 2007, expected to implement in 2008 after complementary laws. - Negotiations on an Association Agreement with the European Union began in fall 2007; negotiations expected to be completed in 2009. - Central American Customs Union (CACU): - Framework Agreement signed in December 2007 by Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. - Three-stage path: (1) free circulation of goods, (2) establishment of a common external tariff (CET), (3) harmonization of trade-related regulation and norms. - Common external tariff basic rates: zero for capital goods/raw materials not competing with those in Central America; 5 percent on raw material competing with those produced in Central America; 10 percent on intermediate goods not competing with those produced in Central America; 15 percent on final consumer and other goods (SIECA, 2008). - Internal customs posts to be converted gradually into trade facilitation centers; taxes collected at the border to be transferred to countries of destination (Central America opted against a common fund). - Fiscal coordination needs: - Revenue-to-GDP ratios range from 12 percent in Guatemala to 18 percent in Honduras. - COSEFIN (Council of Finance Ministers) established in 2006; by March 2008 approved a policy framework on good practices on tax incentives and initiated stocktaking and model legislation on transfer pricing, thin capitalization, and double-taxation treaties. - Recommendation: gradual approach to customs union; harmonize tax administration, adopt minimum legal/administrative standards, and build institutional capacity. ### Customs union operational and design considerations (CTA perspective) - Main CTA concerns and requirements: - Normative convergence, institutional development, administrative/operational strengthening. - Electronic filing and payment; risk analysis; strategic management; information sharing; joint audits. - CU operational trade-offs: - CE T distribution options: central fund or destination-based transfers. - Maintain internal customs posts initially to protect tax revenue and control sensitive goods; gradual removal recommended only after institutional capacity improvements. - International lessons: - EU experience: move to a complete CU took decades; internal controls often persist long after launch; VAT carousel fraud remains a serious issue. - Other CUs (SACU, GCC, Mercosur) illustrate varied models and common problems: revenue-sharing challenges, internal controls retained, and asymmetric capacities. ### Distributional effects: taxation and social spending - Poverty and inequality: - Except for Costa Rica, almost 50 percent of Central America’s population lives in poverty. - Tax systems and incidence: - Central government average tax burden in Central America in 2003 ≈ 13 percent of GDP. - Panama: 8.7 percent of GDP in 2003. - Income taxes contribute about one-quarter of overall collection on average in Central America; Panama > 40 percent. - Share of trade taxes fell from 20 percent to just over 10 percent (1995–2006); VAT share rose from 32 percent to 38 percent. - General result: tax systems are generally regressive across Central America, with exceptions (Panama; Guatemala shows mixed indicators). - Key numeric indicators (selected): - Pretax income Gini coefficients: - Costa Rica (2000) 45.1 - El Salvador (2000) 47.4 - Guatemala (2004) 46.3 - Honduras (2004) 47.2 - Nicaragua (2000) 51.0 - Panama (2003) 53.8 - Quasi-Gini coefficients for total taxes: - Costa Rica (2000) 44.9 - El Salvador (2000) 31.7 - Guatemala (2004) 46.4 - Panama (2003) 57.1 - Kakwani indices for total taxes: - Costa Rica (2000) -0.2 - El Salvador (2000) -15.7 - Guatemala (2004) 0.1 - Panama (2003) 3.3 - Social spending: - Share of social spending in GDP averaged 11½ percent in 2004 for Central America, an increase of 2¼ percent of GDP since 1995. - Cross-country levels (share of GDP): - Costa Rica: 18½ percent - Panama: 17 percent - Honduras: 13 percent - Guatemala: 6½ percent - Social assistance spending averages about 1¾ percent of GDP. - Social spending composition: - Health and primary education: strongly progressive. - Social security and public pensions: pronouncedly regressive. - Tertiary education: regressive. - Combined redistributive effects: - Combined taxation plus social spending: progressive in all countries for which data are available. - Magnitude examples: - Costa Rica: reduction in Gini coefficient of 6 points due to social spending. - Panama: reduction in Gini coefficient of 7.4 points due to social spending. - Simulation (conservative): - An increase in tax revenue collection of 1 percent of GDP distributed evenly in absolute terms would increase the income of the poorest 20 percent by up to 6 percent (text summary). - Table 4.9 simulations: a 1 percent of GDP increase in social spending financed by increased taxes reduces income Gini coefficient by country- and scenario-specific amounts (examples): - Simulation 1: Costa Rica change in Gini 3.3; Panama change in Gini 5.4. - Simulation 2: Nicaragua change in Gini 6.1. - Summary textual outcome: the reform would reduce the income Gini coefficient between 0.5 and 0.8 percentage points in Costa Rica, Guatemala, Nicaragua, and Panama, and between 0.2 and 0.4 percentage points in El Salvador and Honduras. - Policy guidance: - Improving income distribution is best achieved on the expenditure side; taxes should be collected efficiently. - Well-targeted social spending financed even by VAT can produce progressive net outcomes in most countries. ### Financial sector development: markets, infrastructure, and policy recommendations - Market size and structure: - Banking system assets ≈ 80 percent of regional GDP. - Pension funds, insurers, mutual funds ≈ 9 percent of regional GDP. - Equity and bond financing provided by capital markets: 12 and 6 percent of GDP, respectively. - End-2006: fewer than 100 companies listed in the entire region; market concentration high (top five companies represent large shares of market capitalization). - Equity and corporate debt market status: - No equity markets in Guatemala, Honduras, Nicaragua, and the Dominican Republic; small/shrinking markets in Costa Rica, El Salvador, Panama. - Corporate bond markets concentrated: Costa Rica accounts for 60 percent of all corporate debt securities outstanding in the region. - Most corporate debt securities have short maturities; banks account for bulk of demand. - Market infrastructure weaknesses: - Clearing and settlement: legal frameworks deficient; settlement cycles vary (t + 3, t + 1, or undefined); only Costa Rica and Panama achieve DVP. - Custodial infrastructure underdeveloped; dematerialization not universally mandatory. - Regulators: staffing and budgets vary widely; some regulators staff < 10; others ~100; enforcement capacity uneven. - Accounting/auditing: heterogeneity in IFRS adoption; gaps in auditor qualifications and oversight. - Constraints to market development: - Small firm size, family ownership, poor corporate governance, unwillingness to disclose information publicly. - Ample banking liquidity and regulatory/tax treatment favor bank finance over securities issuance. - Legal/regulatory shortcomings (e.g., in Guatemala only financial institutions authorized to raise funds in public markets). - Policy and regional integration recommendations: - Strengthen securities laws and regulators' powers; improve budget/staffing of regulators. - Simplify and speed up issuance approval processes; adopt time-bound, materiality-focused procedures. - Improve accounting, auditing, and corporate governance standards. - Promote dematerialization, DVP settlement, and strengthened CSDs. - Develop pension/mutual fund sectors and consider relaxing investment restrictions. - Consider regional options: leverage existing exchanges in Colombia or Mexico; develop a regional securities market with harmonized laws, mutual recognition, and phased integration. - Suggested phased strategy for market integration: incremental harmonization; mutual recognition mechanisms; raise/converge regulatory capacity. OMX/Nordic-Baltic experience cited as precedent. ### Financial supervision and regional prudential coordination - Prudential requirements and reserves (selected exact figures from table): - Costa Rica: Capital Requirements 10.00; Domestic currency reserve 15.00; Foreign currency reserve 15.00. - El Salvador: Capital Requirements 12.00; Domestic currency reserve §22.00; Domestic currency liquid asset requirement 6.00. - Guatemala: Capital Requirements 10.00; Domestic currency reserve 14.60; Foreign currency reserve 14.60. - Honduras: Capital Requirements 12.00; Domestic currency reserve 10.00; Foreign currency reserve §9.00; Domestic currency liquid asset requirement 9.00; Foreign currency liquid asset requirement §19.00. - Nicaragua: Capital Requirements 10.00; Domestic currency reserve 16.25; Foreign currency reserve 16.25. - Panama: Capital Requirements 8.00; Domestic currency liquid asset requirement 30.00. - Dominican Republic: Capital Requirements 10.00; Domestic currency reserve 20.00; Foreign currency reserve 20.00. - Prudential convergence needs: - Capital adequacy ratios range from 8 to 12 percent across the region. - CFSS (Council of Financial Sector Superintendents) signed a regional memorandum of understanding in September 2007 for consolidated supervision. - Recommendation: strengthen supervision and regulation for cross-border banking, develop regional crisis-management arrangements, harmonize prudential standards to minimize regulatory arbitrage. ### Road ahead: vulnerabilities and reform priorities - Main vulnerabilities: - Exposure to U.S. cyclical downturn via trade, financial flows, and remittances. - Commodity price shocks (oil, food) and global financial fragility. - Underdeveloped tax systems and reliance on regressive indirect taxes in several countries. - Underdeveloped capital markets and limited institutional investor base. - Priority reforms and sequencing: - Consolidate macroeconomic stability and reduce poverty to anchor gains. - Strengthen national tax administrations and fiscal coordination (COSEFIN). - Modernize CTAs: electronic services, risk analysis, integrated IT, staff training. - Gradual but targeted implementation of CACU: begin with effective free trade area and institutional capacity building for customs union stages. - Deepen financial supervision and regional cooperation; harmonize statistics (monetary, fiscal, external) to support policy coordination. - Pursue capital market reforms and consider regional market integration options to achieve economies of scale. *Italic: Source: IMF publication — CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS (content, foreword, preface, and Introduction and Overview as provided in _dp0801).* ### 1. Economic integration—Central America. 2. Economic development—Central America. ### CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS ### Foreword — High-level assessment - Central America has made substantial progress toward dynamic and open societies, with political dialogue replacing civil conflicts and smooth transitions of power becoming the norm. - The region has achieved broad consensus on maintaining macroeconomic stability while prioritizing poverty reduction. - Recent years saw a strong pickup in economic growth, sustained capital inflows, and some reductions in poverty. - Risks identified: - A protracted U.S. slowdown could jeopardize recent gains. - Surges in petroleum and food prices have adverse effects. - IMF engagement: - Planned establishment of a regional technical assistance center for Central America, Panama, and the Dominican Republic (CAPTAC-DR) in Guatemala in early 2009 to deepen technical assistance across the region. ### Preface — Scope, contributors, and acknowledgments - Purpose: Review Central America’s integration efforts, cyclical links with the United States, and progress on selected economic reforms; complements IMF Occasional Papers Nos. 243 and 257. - Publication team led by Dominique Desruelle and Alfred Schipke; includes authors from Fiscal Affairs, Monetary and Capital Markets, and Western Hemisphere Departments. - Acknowledgments list IMF staff and regional authorities; notes that opinions are those of the authors and do not necessarily reflect IMF management or regional authorities. ### Introduction and Overview — Key themes and structure - Geographic scope (unless otherwise stated): Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic. Notes on Panama: - Panama is not formally part of Central America for historical reasons but has strong regional financial links and membership in the Central American Integration System. - Central objectives of the publication: - Analyze Central America’s integration process and need for increased regional policy coordination (Chapter II). - Assess spillovers from the United States to Central American business cycles (Chapter III). - Examine distributional effects of taxation and social spending and implications for poverty reduction (Chapter IV). - Discuss tax-administrative requirements and challenges for implementing a Central American customs union (Chapter V). - Review private debt and equity market development and impediments, including recommendations to consider regional exchange options (Chapter VI). ### Recent Developments and Economic Outlook — External environment and vulnerabilities - Until mid-2007, Central America benefited from a favorable global environment. - Two significant external shocks affected the region more recently: - Weakening external growth driven by a downturn in the United States, the region’s main trading partner; the U.S. downturn was sparked by the bursting of the housing market bubble and ensuing financial turmoil. - Commodity price hikes: a fuel and food commodity price boom with largely negative impacts on the region. - Trade and commodity specifics: - Although the region is a net food exporter, it is a net importer of cereals, whose price rose dramatically in 2007. - The region is a net oil importer; oil import bills rose dramatically (text stops at this point in supplied content). ### Chapter-level highlights (as presented in contents) - Chapter I: Introduction and Overview — assesses progress, vulnerabilities, and provides a roadmap for the volume. - Chapter II: Moving Forward with Economic Integration and Cooperation - Topics: history of integration, level of integration and recent developments, areas for increased policy coordination, harmonization of macroeconomic statistics (Appendix 2.1). - Chapter III: Central America’s Regional Trends and U.S. Cycles - Topics: stylized facts, literature review, data and common cycle methodology, results, and policy implications; includes an appendix on the Common Cycles Method. - Chapter IV: Equity and Fiscal Policy: Income Distribution Effects of Taxation and Social Spending - Topics: tax systems and distributional impact, social spending trends and distributional impact, net distributional effects summary, conclusions. - Chapter V: Central American Customs Union and Challenges for Tax and Customs Administration - Topics: regional integration process requirements for CTAs, free trade areas, customs union design, international experiences, key tax and customs principles, modernization requirements for tax and customs administrations. - Chapter VI: Financial Sector Development: Equity and Private Debt Markets - Topics: regulation and supervision of securities markets, market infrastructure, rating agencies, business environment for issuance, accounting and disclosure standards, institutional investors, equity and corporate debt markets, incentives, asset-backed securities, scope for regional capital market development; includes appendices with tables and a "Summary of Recommendations" table (6.A12). ### Analytical and policy conclusions emphasized in the front matter - Integration and policy coordination: - Central America is a prime candidate for increased integration but needs stronger regional policy coordination mechanisms accompanying integration. - External linkages: - Business cycles in the United States have significant and adverse spillovers on most Central American countries (detailed analysis in Chapter III). - Fiscal policy and poverty: - High poverty and income inequality make fiscal policy central to the policy debate; Chapter IV demonstrates that increased taxation combined with higher social spending can have a strong effect on reducing poverty. - Customs union implementation: - The planned customs union can facilitate intraregional trade but poses challenges to protecting tax revenue; implementation should be gradual and accompanied by institution building (Chapter V). - Financial market development: - Domestic market size constraints imply a role for regional market integration or leveraging existing Latin American exchanges to develop equity and private debt markets (Chapter VI). ### Document structure and supporting materials - Extensive tables, figures, boxes, and appendices are included across chapters covering: - Macroeconomic indicators, financial institutions, regional institutions of economic policy coordination, measures of integration, GDP growth and cyclical analyses, tax incidence and progression, social spending composition and incidence, customs union frameworks, securities market regulations, and a range of country and regional statistics. - Notable numeric references and organizational items appearing in the contents: - Chapters numbered I through VI. - Appendices and tables with numbered designations (for example, Appendix 2.1; Tables 1.1, 2.1–2.4, 3.1–3.3, 4.1–4.9, 5.1–5.4, 6.1–6.8; Appendices 6.A1–6.A12). - Specific years referenced include 1950–2006, 1960–2006, 1970–2006, 1985–2006, 1995–2006, 2003–07, 2006, 2007, and planned CAPTAC-DR opening in early 2009. *Source: IMF publication — CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS (contents, foreword, preface, and Introduction and Overview as provided).* ### 5.7 percent of GDP in 2004 to 8.3 percent of GDP in 2007. ### _dp0801 - 5.7 percent of GDP in 2004 to 8.3 percent of GDP in 2007. ### Macroeconomic performance, 2006–2007 - Regional output growth: average growth rate of 6.8 percent in 2006 and 6.7 percent in 2007. - Strongest country growth noted in Costa Rica, Honduras, the Dominican Republic, and Panama. - Inflation: average annual inflation of about 9 percent at end-2007, compared with an average of 6 percent at end-2006. - Exports: overall exports grew by over 11 percent in both 2006 and 2007. - Private sector credit: reached 24 percent on average in 2007 compared with 19 percent in 2006. - Representative time-series/table entry: "5.7 percent of GDP in 2004 to 8.3 percent of GDP in 2007." ### Fiscal outcomes and public debt - Average public sector deficits fell to 0.7 percent of GDP in 2007 from 1.8 percent of GDP in 2006. - Public debt: continued downward from 46 percent of GDP in 2006 to 37 percent of GDP in 2007. - Share of foreign-currency-denominated debt: fell from 63 percent in 2006 to just under 60 percent of total public debt in 2007. - Drivers of fiscal improvement: modest decline in interest expenditure and, predominantly, an increase in revenue, with indications that a significant portion of the revenue increase has been structural in a number of countries. ### External sector and reserves - Current account deficits (regional average): increased from 5 percent of GDP in 2006 to 6.7 percent of GDP in 2007. - External shock drivers: rising oil import bill was an important effect; in some countries strong export growth and remittance flows partly offset negative terms of trade. - International reserves: remained at high levels, rising slightly in proportion to broad money. ### Financial system and vulnerabilities - No evidence of exposure to the U.S. sub-prime market in regional financial systems. - Rapid private credit growth over the past two years, especially in Costa Rica, Honduras, Guatemala, and the Dominican Republic. - Capital inflows continued; international reserves high. - Financial integration: surge in activities of international banks, increased foreign ownership of domestic banks. - Policy/supervisory challenge: need for strengthened supervision and regulation to address cross-border banking operations; regional initiatives include adoption of a regional memorandum of understanding for consolidated supervision. ### Growth outlook, shocks, and scenarios - External risks: prospect of global growth slowdown, a U.S. downturn, high commodity prices, and continued fragility in global financial markets. - Short-term projection: regional growth projected to be still robust in 2008; under this scenario most countries would still have a positive output gap by the end of 2008. - Transmission from the United States: empirical estimates indicate that a growth slowdown of 1 percentage point in the United States would typically be associated with a cyclical fall in output growth of 0.5 to 1 percentage point in most countries of the region, with the largest effects in Costa Rica and El Salvador. - Policy implication: in the short term macroeconomic policies should be oriented primarily toward bringing inflation under control and easing the impact of the food price shock on the poor in a fiscally responsible manner. - Monitoring: policymakers should continue to closely monitor highly volatile external developments and be prepared to adapt domestic policies accordingly. ### Regional integration and cooperation - Trade integration: implementation of CAFTA-DR and negotiations toward a Central American customs union and an association agreement with the European Union. - Fiscal coordination: increased trade integration calls for more fiscal coordination to avoid harmful tax competition and minimize fiscal implications of further trade liberalization; possible scope to seek convergence of specific taxes and, later, a common framework for other indirect taxes. - Institutional arrangements: regional forums (finance ministers, central bank presidents, ministers of economy and trade, financial sector superintendents) and executive secretariats (including SIECA) exist and will need to play an increasingly important role in policy coordination and standardization. ### Remittances and U.S. linkages - Remittance importance: remittances have grown rapidly and account for a large share of GDP and financial flows (excluding Costa Rica and Panama). - Country examples (2007): remittances ranged from 8 percent of GDP in the Dominican Republic to 20 percent of GDP in Honduras (excluding Panama and Costa Rica). - Transmission channels from the United States: trade, financial flows (including interest-rate transmission where dollarization exists), and remittances. ### Equity, taxation, and social spending - Poverty and inequality: except for Costa Rica, almost 50 percent of Central America’s population lives in poverty; high levels of income inequality persist. - Tax systems: generally regressive across Central America, with the exception of Panama; prevalence of value-added (VAT) and sales taxes leads to higher effective tax rates relative to income for poorer households in most countries. - Redistributive impact of taxes: limited overall redistributive impact from current tax systems. - Social spending: public social spending is progressive relative to income; however, components differ: - Health and primary education spending: strongly progressive. - Social security and public pension systems: pronouncedly regressive. - Tertiary education spending: regressive. - Policy guidance: improving income distribution is best achieved on the expenditure side, while taxes should be collected in the most efficient way. *Sources: IMF World Economic Outlook; IMF staff estimates; text excerpts from _dp0801.* ### Introduction and Overview ### Introduction and Overview ### Redistribution, Taxation, and Social Spending - The combined redistributive effect of taxation and social spending is progressive in all countries of the region. - The redistributive potential of social spending is much larger than that of taxation. - The distributional impact of total social spending in Central America is diluted by its relatively low level and, in some cases, by poor targeting, limiting its impact on high pre-fiscal-policy levels of poverty. - A reform that increases tax revenues through the VAT and devotes the proceeds to social spending would unambiguously improve the income of the poorest households. - A conservative simulation shows that an increase in tax revenue collection of 1 percent of GDP that is distributed evenly in absolute terms to all income groups (i.e., not specifically targeted to the poor) would still increase the income of the poorest 20 percent of the population by up to 6 percent. - Assistance transfers’ effects are mixed and generally small, given the limited resources devoted to them. ### Central American Customs Union and Issues for Tax and Customs Administration - In December 2007, the governments in the region signed a framework agreement for the establishment of a Central American customs union. - Footnote: The agreement was signed by Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. - The agreement defines characteristics of the future customs union, including elimination of quantitative restrictions and charges equivalent to customs duties, adoption of common legal and normative standards, and strengthening of the existing institutional framework. - Internal customs posts are to be converted gradually into trade facilitation centers, allowed to continue collecting internal taxes and controlling fraud. - Taxes collected at the border will be transferred to countries of destination; Central America opted against a common fund. - International experience (EU, South African Customs Union, Gulf Cooperation Council, Mercosur) suggests: - Institution building is critical. - Internal customs controls typically remain in place for long periods after launch. - A coherent and integrated strategy is needed to adopt minimum legal and administrative standards. - Recommended gradual approach to establishing the customs union includes: - (1) a free trade agreement with free circulation of goods, requiring harmonizing technical restrictions; - (2) temporary provisions for sensitive goods or sectors, with a clear definition of internal customs posts’ role; - (3) gradual convergence of free trade agreements with nonmember countries (tariff levels, convergence deadlines, rules of origin, volumes); - (4) establishment of a Central American External Tariff (CET) that is eroded as little as possible by discrepancies, asymmetries, and bilateral FTAs; - (5) definition of a regional trade policy; and - (6) institutional capacity building (staff training, integrated IT systems, risk analysis, harmonized procedures, minimum standards in key areas). ### Financial Sector Development: Private Debt and Equity Markets - Financial intermediation occurs primarily through the banking sector; banking system assets amount to 80 percent of regional GDP, substantially higher than assets of pension funds, insurers, and mutual funds. - Regional banks dominated historically; increasing presence of large international banks is changing the landscape. - Capital markets allocation of savings and investment remains very limited. - At end-2006: - Fewer than 100 companies were listed in the entire region. - Market concentration was very high; the top five companies made up, for example, two-thirds of market capitalization in Costa Rica and Panama. - Trading in secondary markets is almost nonexistent. - Corporate bond markets vary substantially across countries: - Costa Rica accounts for 60 percent of all corporate debt securities outstanding in the entire region, followed by Panama and El Salvador. - Most debt securities have short maturities, and banks account for the bulk of demand. - No equity markets exist in four countries: Guatemala, Honduras, Nicaragua, and the Dominican Republic; in the others markets are small and shrinking. - Specific constraints on corporate debt and equity development include: - Unwillingness to disclose information publicly. - Ample liquidity in local and foreign banking systems. - Legal and regulatory shortcomings (e.g., in Guatemala only financial institutions are authorized to raise funds in public markets). - Predominance of family ownership, poor corporate governance, memories of political and financial crises, and a weak institutional investor base for equities. - Recommended measures to develop capital markets and improve business environment: - Improve accounting and auditing standards. - Upgrade frameworks for company establishment, execution of collateral, and initiation of bankruptcy proceedings. - Improve security laws and regulation (mutual funds, asset-backed securities, derivatives are absent in some countries). - Improve infrastructure such as clearing and settlement systems. - Regional options: - Take advantage of existing exchanges in Colombia or Mexico. - Develop a regional securities market, weighing economies of scale against implementation and coordination costs. - Regional integration would require harmonization of securities laws and regulations, approval and listing processes, supervision standards, disclosure norms, corporate governance, strong supervisory cooperation, and political backing. - Costa Rica, El Salvador, and Panama have already made significant efforts; it may be advantageous for other countries to join these efforts. ### The Road Ahead - Central America’s reforms have produced significant positive results: strong growth performance, lower public debt levels, more solid financial systems, and improved external positions. - Improved economic fundamentals and policy frameworks led to improved credit ratings and increased investments by foreign companies, international financial institutions, and fund managers. - The region is in a better position to confront adverse shocks, but ongoing oil and food price shocks and a global and U.S. downturn will test policy frameworks and expose remaining weaknesses. - Further reforms are needed to reduce vulnerabilities and increase policy space to respond to external shocks. - Anchoring macroeconomic stability gains will require securing a significant reduction in poverty. - The following chapters address the issues discussed above in more depth. *Introduction and Overview, _dp0801* ### Introduction ### Introduction ### Regional Rationale for Integration - Central America shares common language, history, culture, and geography. - Population: about 40 million people. - Central America accounts for about 7 percent of Latin America’s population and about 5 percent of its total output. - Including the Dominican Republic, the total population of Central America makes up about 10 percent of the population in Latin America and the Caribbean and accounts for about 6 percent of its total output. - If economically integrated, the region could take advantage of scale economies, coordinate large infrastructure projects to avoid duplication, and represent its economic interests more effectively at the global level. - The region faces common shocks: hurricanes, earthquakes, volcanic eruptions, and terms of trade shocks. - Increased integration requires more policy coordination and, in certain areas, establishment of common standards, regulations, and norms to maximize benefits and reduce vulnerabilities. ### Scope and Purpose of the Chapter - The chapter takes stock of Central America’s integration process, discusses recent developments, and identifies areas where more policy cooperation is warranted. - It reviews Central America’s history of integration; analyzes progress in trade, financial sector, labor market, and monetary integration; and highlights areas where more coordination and harmonization may be necessary. ### History of Economic Integration - Early unity: After independence from Spain (1821) and severing ties with Mexico (1823), the Central American Republic included Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua; the republic split into separate states in 1838. - Integration boost in the 1950s: bilateral trade agreements, founding of the Organization of Central American States (1951), culminating in the Central American General Treaty of Economic Integration in 1960. - 1963: presidents declared intention to establish a monetary union; 1964: agreement of central banks setting out procedures to establish such a union. - Central American Bank for Economic Integration (CABEI) established to promote and finance integration. - Integration stalled in the 1970s–1980s, revealing the need for broad political support and institutional capacity. - Post-1990s approach: more pragmatic, gradual, voluntary participation, moved away from import substitution, embraced global opening; explicit goal of adopting a common currency was dropped. - Regional integration mainly relies on intergovernmental bodies rather than supranational institutions. ### Level of Integration and Recent Developments (Overview) - Integration has advanced rapidly in recent years across policies and on-the-ground cross-border economic activity. - Progress across areas reviewed: trade, factor markets (capital and labor), monetary integration, and institutional development. ### Trade Integration — Multilateral and Regional Developments - 1993 commitment to a common trade nomenclature; 1997 commitment to a common external tariff. - Major overhaul of tariff structures has occurred, with a major reduction in average collected tariffs. - Today, all countries in the region have tariff rates of less than 5 percent. - After difficulties in Doha Round, Central America pursued alternatives: - Entry into force of the Central American–Dominican Republic–United States Free Trade Agreement (CAFTA-DR) in 2006/07. - Negotiations on an Association Agreement with the European Union began in fall 2007; negotiations expected to be completed in 2009. - Additional bilateral trade agreements have been sought. ### Trade Integration — CAFTA-DR and Bilateral Agreements - CAFTA-DR has boosted trade, investment, and growth potential and contributed to institutional strengthening in trade- and investment-related areas. - Implementation timeline: El Salvador, Guatemala, Honduras, and Nicaragua in 2006; the Dominican Republic in 2007; Costa Rica not yet implemented as of the chapter. - CAFTA-DR provided immediate tariff reductions on all non-agricultural and non-textile exports to the United States; tariffs on other goods phased out over a 5- to 20-year period. - Costa Rica passed a referendum on October 7, 2007, and is expected to implement the agreement in 2008 once complementary laws, including those opening the telecommunications and insurance markets, have been approved by congress. ### Trade Integration — Association Agreement with the European Union - Formal launch decision at the European Union–Latin America and the Caribbean Vienna Summit in May 2006. - Association Agreement goes substantially beyond economic issues; a bi-regional trade and investment agreement is central. - Negotiation modalities: the European Commission negotiates on behalf of the EU; Central America negotiates as a region with a single spokesperson rotating among countries. - Negotiations expected to be completed in 2009. ### Central American Customs Union - Common external tariff initiation in 1997; prior to CAFTA-DR implementation about 95 percent of tariff lines were harmonized (SIECA, 2008). - Remaining 5 percent to be harmonized reflect politically sensitive items (sugar, chicken), textiles, petroleum derivatives, metal products, pharmaceuticals. - Framework agreement signed in December 2007 lays out a three-stage path toward a customs union: 1. Free circulation of goods. 2. Establishment of a common external tariff. 3. Harmonization of trade-related regulation and norms (e.g., sanitation) and trade-related institutions. - The agreement does not envisage immediate elimination of border controls; borders to be converted into “trade facilitation centers” to avoid significant revenue losses given domestic tax collection practices. - Other countries in the regional system (Belize and Panama) may join later; Panama announced interest in joining negotiations in May 2008. - The Council of Ministers of Economy (COMIECO) is charged with implementing the agreement in consultation with other sectoral councils such as the Council of Finance Ministers; next step is establishing a specific timetable for implementation of stages. - The common external tariff consists of four basic rates: zero for capital goods and raw materials not competing with those in Central America, 5 percent on raw material competing with those produced in Central America, 10 percent on intermediate goods not competing with those produced in Central America, and 15 percent of final consumer and other goods (SIECA, 2008). ### Central America’s Trade Structure and Outcomes - Exports and imports combined amount to about 90 percent of GDP. - More than 40 percent of that trade is with the United States. - Only 1 percent of all U.S. imports come from Central America. - The region’s market share in the United States has declined since 2003, driven mainly by competition from China in textiles, the region’s top export to the U.S. market. - Intraregional trade has accelerated in recent years. - Guatemala and Costa Rica are net exporters within the region; Costa Rica imports the least from the region. - Intraregional trade composition (2007): food and beverages a little over 30 percent; pharmaceuticals 12 percent; other manufactured goods include plastics, cables and wires, paper products. ### Financial Sector Integration - Central American countries have open capital accounts; no formal restrictions on establishment/acquisition of financial institutions by regional or foreign banks or on the right of nonresidents to obtain new banking licenses. - Under CAFTA-DR, countries committed to opening up the insurance market. - Financial systems are largely bank based; capital markets are underdeveloped. - First phase of regional financial integration: local financial institutions expanded regionally; by 2005 regional institutions with local capital managed about 50 percent of total bank assets. - Second phase: large international financial institutions (HSBC, Citibank, Scotiabank, others) have been acquiring regional and local banks and increasing regional presence; Bancolombia (via its Panama subsidiary) acquired the largest bank in El Salvador. - Local banks have expanded operations to position against foreign competition (examples: Banco General, Banco Industrial, LAFISE, Promerica). - Over the past three years described in the chapter, share of international banks increased from less than 20 percent to almost 40 percent in terms of total bank assets. - El Salvador’s banking sector is now almost fully owned by large international financial institutions. ### Labor Market Integration - Formal labor market integration is in its infancy despite treaty provisions to foster free movement of labor. - Guatemala Protocol of 1993 committed governments to fostering free movement of labor, but little progress has been made; most labor movements remain informal. - More recent temporary cross-border movements have been encouraged where labor shortages exist (e.g., Costa Rica in 2007 provided temporary work visas to workers from Guatemala and other Central American countries due to shortages in agriculture and housing construction); similar arrangements occurred between El Salvador and Honduras. - There has been substantial migration from Central America to the United States; as a consequence of past civil unrest in Nicaragua, a large number of Nicaraguans are working in Costa Rica. ### Monetary Integration - Goal of adopting a common currency was abandoned in the early 1990s. - Historical note: 1963 Central American peso established as a unit of account to foster trade; 1964 central banks agreement set procedures toward monetary union. The Central American peso is still used as a formal unit of account within regional institutions and regional import tariffs are expressed in Central American pesos. - Rather than a common currency, Central American countries initially pegged exchange rates to the U.S. dollar; the chapter notes more recent changes in exchange rate regimes but does not provide further detail in the supplied excerpt. *Source: _dp0801 - Introduction* ### References to the objective of creating a common currency appear in documents dating back to the 1920s. ### _dp0801 - References to the objective of creating a common currency appear in documents dating back to the 1920s. ### Exchange rate systems and monetary integration - Historical objective: references to creating a common currency date back to the 1920s. One Central American peso is equivalent to one U.S. dollar. Formally, the Central American Monetary Council can change its value and determine its use. - Current spectrum of exchange rate systems: - More flexible exchange rates: Guatemala and Costa Rica are moving toward inflation targeting. - Dominican Republic targets monetary aggregates. - Crawling band or peg: Nicaragua and Honduras. - Official U.S. dollar adopters: El Salvador and Panama. - Empirical assessment: - Kim and Papi (2005) using an optimal currency index shows the region has become more suitable for a dollar peg or dollarization, reflecting increased synchronization of business cycles and a reduction in inflation differentials between Central America and the United States. - The study highlights Central America would still be less suitable for a common currency than Western Europe was in the 1970s. - Political dimension: adoption of a common currency would require full commitment at the political level (European experience cited). ### Institutional integration and policy coordination - Key regional institutions and coordination architecture: - System of Central American Integration (SICA) — meeting of Presidents. - Council of Finance Ministers (COSEFIN) — fiscal policy coordination. - Central American Monetary Council (CAMC) — some monetary policy coordination. - Council of Financial Sector Superintendents (CFSS) — some financial sector coordination. - Council of Ministers of Economy or Trade (COMIECO) — high trade policy coordination. - Areas identified for increased coordination: fiscal policy, financial sector regulation and supervision, harmonization of prudential standards, and statistical harmonization. - Progress highlights: - CAMC and other councils have supported convergence of macroeconomic policies in monetary, credit, exchange rate, and financial sector areas. - Regional payment and security exchange settlement system agreement signed in 2007 to foster financial market integration (as of August 2008, El Salvador, Guatemala, and the Dominican Republic have signed; at least three ratifications needed for effectiveness). - Council of Financial Sector Superintendents signed a regional memorandum of understanding in September 2007 to foster consolidated supervision of regional institutions. ### Trade integration and fiscal policy - Trade integration status: - Central America is highly integrated in trade; further integration via CAFTA-DR, customs union, and an Association Agreement with the European Union is expected. - Fiscal vulnerability and coordination needs: - Revenue-to-GDP ratios range from 12 percent in Guatemala to 18 percent in Honduras. - Increased trade integration may cause short-term revenue losses and harmful tax competition. - COSEFIN established in 2006; by March 2008 it approved a policy framework for a regional convention on good practices on tax incentives emphasizing transparency, avoidance of tax competition, and coherence with WTO obligations. - COSEFIN actions: stocktaking of existing tax incentives; development/approval of model legislation for (1) transfer prices, (2) thin capitalization, and (3) double-taxation treaties. - Framework agreement for a customs union includes provisions to protect the collection of internal revenue at the border. - Policy suggestions: - Consider convergence of specific taxes to avoid contraband and define common principles (e.g., minimum rates) for other indirect taxes. - Strengthen national tax systems and consider medium-term expenditure frameworks (MTEFs) to impose fiscal discipline and communicate strategic spending priorities. ### Financial sector coordination, harmonization, and risks - Benefits of financial integration: - Regional conglomerates and cross-border lending allow scale economies, reduce funding costs, foster investment and growth, and provide greater risk diversification for companies and households. - Increased presence of international financial institutions could disseminate international standards in capitalization, risk management, and corporate governance, and increase competition. - Risks and vulnerabilities: - Exposure to large fluctuations associated with developments abroad and volatile capital flows if global banks engage in cross-border treasury operations. - Potential for lengthened credit booms, increased credit dollarization, creation of risky financial positions difficult to evaluate, reduced transparency of consolidated operations, and segmentation of the credit market leaving local banks with riskier positions. - Small and medium-sized companies may face more difficulties obtaining credit as international banks apply standardized credit evaluations. - Prudential convergence needs: - Capital adequacy ratios range from 8 to 12 percent across the region. - Need convergence of prudential standards, regulation, and supervision to minimize regulatory arbitrage. - CFSS initiated projects including an MOU for consolidated supervision (September 2007) and a project to assess implications of increased assets managed by international banks. - Banking system stresses and regional crisis management: - Stress in one country’s banking system could quickly transmit to others; need for improved national bank resolution frameworks and regional arrangements for crisis management and early coordinated intervention. ### Reserve, liquidity, and prudential requirements (selected figures) - Capital requirements and reserve/liquid asset requirements (excerpted figures shown exactly as in source): - Costa Rica: Capital Requirements 10.00; Domestic currency reserve 15.00; Foreign currency reserve 15.00. - El Salvador: Capital Requirements 12.00; Domestic currency reserve §22.00; Domestic currency liquid asset requirement 6.00. - Guatemala: Capital Requirements 10.00; Domestic currency reserve 14.60; Foreign currency reserve 14.60; Domestic currency liquid asset requirement none; Foreign currency liquid asset requirement none. - Honduras: Domestic currency reserve 10.00; Foreign currency reserve §9.00; Capital Requirements 12.00; Domestic currency liquid asset requirement 9.00; Foreign currency liquid asset requirement §19.00. - Nicaragua: Capital Requirements 10.00; Domestic currency reserve 16.25; Foreign currency reserve 16.25. - Panama: Capital Requirements 8.00; Domestic currency reserve none; Foreign currency reserve n.a.; Domestic currency liquid asset requirement 30.00; Foreign currency liquid asset requirement n.a. - Dominican Republic: Capital Requirements 10.00; Domestic currency reserve 20.00; Foreign currency reserve 20.00; Domestic currency liquid asset requirement none; Foreign currency liquid asset requirement none. - Footnote details (preserved verbatim): - Liquidity requirements are 25 percent for current account deposits and 20 percent for savings and term deposits. At present, the weighted average requirement is about 22 percent. In mid-2008, and as a precautionary measure in the run-up to the 2009 presidential and congressional elections, banks were required to hold an additional 3 percent as liquid reserves abroad. After official dollarization, reserve requirements were substituted by remunerated liquidity requirements. - El Salvador and Panama are officially dollarized economies. - While domestic currency reserve requirements are 12 percent, for banks that direct 80 percent of their lending to the "productive" sector (i.e., neither consumer nor commercial loans), reserve requirements are 7 percent. Currently, the effective rate is about 9 percent. - Foreign currency liquid asset requirements are 24 percent, however, banks that have 70 percent of their foreign currency loan portfolio in the "productive" sector are required to hold 14 percent in liquid assets (as of November 2008). The effective rate is about 19 percent. - Includes cash in vault (up to a maximum of 5 percent of liabilities subject to reserve requirements). - A compulsory investment requirement is being phased out gradually, which accounted for less than US$8 million at end-September 2008. ### Capital markets, regional exchange initiatives, and statistics - Capital markets: - Domestic capital markets are underdeveloped and segmented by currency, creditworthiness, regulation, restrictions on domestic institutional investors, and absence of a regional exchange. - Public debt markets are better developed than equity and corporate debt markets (corporate markets are almost nonexistent). - 2006 agreement: Panama, Costa Rica, and El Salvador signed an agreement to establish a regional exchange to create a regional capital market. - 2007 MOU among exchanges and securities superintendents to harmonize norms, share comparable information, and establish a regional executive secretariat. - Data and statistics: - Central America has launched three large multiyear projects to improve monetary and finance, fiscal, and external statistics (see Appendix 2.1 in source). - Improving macroeconomic statistics requires high-level commitment, appropriate resources, continuous investment in human capital, and a medium-term perspective. - Once sufficient progress is made in monetary, fiscal, and external statistics, there would be additional scope to harmonize national accounts data. *Source: CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS (excerpt)._dp0801 - References to the objective of creating a common currency appear in documents dating back to the 1920s.* ### Conclusions ### _dp0801 - Conclusions ### Regional integration: progress and benefits - Central America’s regional integration is advancing rapidly in policies and on the ground in response to increased global competition. - The countries share many characteristics (size, proximity to the United States, history, and language) and therefore appear well positioned to benefit from increased integration. - A unified region with almost 40 million people would be able to represent its economic interests more effectively at the global level than the individual countries would. - Key benefits identified: - Ability to take advantage of scale economies and specialization. - Stronger collective representation in the global economy. ### Trade integration and fiscal coordination - Central America has advanced most in trade integration, both intraregionally and globally, reflecting a long process of trade liberalization culminating in the implementation of CAFTA-DR. - Further trade integration and objectives such as a customs union and an Association Agreement with the European Union require more fiscal coordination to: - Avoid harmful tax competition. - Minimize the fiscal impact of further trade liberalization. - Possible policy responses as trade integration increases: - Convergence of specific taxes to avoid contraband. - Adoption of a common framework for other indirect taxes. - Institutional development: - The Central American Council of Finance Ministers, although only recently established, has become a crucial forum to foster fiscal coordination. ### Financial sector integration: opportunities and challenges - Financial sector integration has advanced rapidly despite largely bank-based systems and underdeveloped capital markets. - Initial stage dominated by expansion of regional institutions with local capital; currently experiencing a dramatic surge in the arrival of international banks. - Expected outcomes from international bank entry: - Dissemination of international standards in capitalization, risk management, and corporate governance. - Increased competition for local institutions. - Challenges and regional responses: - Potential supervisory and regulatory challenges from greater cross-border banking activity. - Regional initiatives underway, e.g., the regional memorandum of understanding for consolidated supervision of regionally operating banks. - Ongoing assessment of challenges for local supervisors, regulatory frameworks, and prudential requirements. ### Institutional frameworks for deeper integration - Successful integration requires appropriate institutions to foster information exchange, policy coordination, and adoption of common standards, regulations, and norms. - Central America has established regional forums and corresponding executive secretariats for: - Finance ministers. - Central bank presidents. - Ministers of economy and trade. - Financial sector superintendents. - Secretariat for Economic Integration in Central America (SIECA). - As integration advances, these institutions will play an increasingly important role in spearheading policy coordination and standardization. ### Policy guidance: maximize benefits, minimize risks - Moving forward with increased regional and global integration will bring substantial benefits to Central America. - The process should be accompanied by appropriate improvements in policy coordination and the adoption of common regulations, standards, and norms to maximize benefits and minimize integration-related risks. ### Appendix 2.1 — Harmonization of macroeconomic statistics: scope and timelines - Central America has made significant efforts to improve data quality and provision at the national level, but statistical deficiencies remain, with uneven data quality across sectors and countries. - Drivers for harmonization: - Deepening economic integration. - Increased access to global financial markets. - Stronger economic linkages across countries. - Three large regional projects were embarked upon to harmonize: - Monetary and finance statistics. - Fiscal statistics. - External statistics. Monetary and Finance Statistics - Project launched in 2006 with goals to: 1. Improve existing monetary and financial statistics compilation systems. 2. Expand coverage by gathering data from all major financial institutions in the region, including offshore banks and other financial intermediaries such as pension funds, insurance companies, and investment funds. 3. Define common classification and valuation criteria for financial instruments and economic sectors. - Milestones and next steps: - The first stage was completed in 2007; all Central American countries, including Panama and the Dominican Republic, now have harmonized systems for compiling monetary and financial statistics based on standardized report forms for monetary data. - The second stage is expected to conclude in mid-2008 with dissemination of harmonized monetary statistics by national authorities and on the website of the Central American Monetary Council. - Consideration of a third stage to cover compilation of data for other financial corporations (insurance companies, pension funds, etc.) and derivation of matrices to support the balance sheet approach to debt vulnerability analyses. Fiscal Statistics - In 2008, the Council of Finance Ministers initiated a project to harmonize government finance statistics due to differences in institutional and transaction coverage, compilation methodologies, and data sources. - Project components: 1. Compilation and dissemination of sub-annual and annual government finance statistics using the IMF’s Government Finance Statistics Manual 2001 (GFSM 2001) format. 2. Preparation of a detailed migration plan to gradually adopt the full GFSM 2001 methodology and develop new or improved data sources. - Implementation approach: - The first component will rely on available data sources to compile GFS data according to the GFS Yearbook Questionnaire, the High Frequency Questionnaire, and a simplified public debt template. - The second component requires diagnosis of current practices, identification of institutional data gaps, and elaboration of steps and a timetable to implement GFSM 2001 gradually. - The initial phase will take longer and may require subsequent projects and detailed action plans. External Statistics - Increased cross-border financial flows (portfolio and foreign direct investment and remittances) necessitate improved external statistics to enhance policy analysis and monitoring of external vulnerabilities. - A regional project aims to harmonize and improve external sector statistics with the objective of compiling comprehensive and consistent external sector statistics region-wide in line with the fifth edition of the Balance of Payments Manual (BPM5). - Project steps: 1. Development of harmonized compilation systems for balance of payments statistics and international investment positions. 2. Improvement in coverage through collection of data for relevant items, including trade, remittances, income account, portfolio investment, and direct investment, where applicable. 3. Improvement of data consistency across macroeconomic statistics using agreed common definitions of financial instruments, economic sectors, and valuation criteria. - Challenges and prerequisites: - External sector statistics rely more heavily on private sector information than monetary and fiscal statistics. - Authorities should evaluate current national legal frameworks that support data collection from financial and nonfinancial private sector for statistical purposes. - Expected timeline: - Quarterly statistics on the international investment position and external debt statistics could become available for all countries in the region in 2010. *Conclusions section from _dp0801 - Conclusions* ### Introduction ### _dp0801 - Introduction ### Overview - Central America exhibits considerable comovement of GDP growth with the United States over a long period. - Major transmission channels from the United States to Central America: trade, financial sector, and remittances. - Remittances accounted for 14 percent of regional GDP (excluding Panama) during 2006. - Exports accounted for 20 percent of regional GDP in 2006. - The chapter applies the common cycles method of Vahid and Engle (1993) to analyze linkages and address questions about dependency and decoupling between Central America and the United States. ### Stylized Facts: Trade, Financial Linkages, and Remittances - Trade linkages: - Since the early 1980s, the share of total merchandise exports from the region as a whole to the United States has averaged about 40 percent. - Country range: 27 percent in Nicaragua to 53 percent in Honduras (Figure 3.2). - Second largest destination: other Central American countries, averaging about 20 percent over the same period. - Financial linkages: - Debt owed to foreign banks reporting to BIS by Central American borrowers (excluding Panama) ≈ 15 percent of GDP at end-2006. - Direct debt owed to U.S. banks ≈ 3 percent of GDP. - Loans with maturity < one year account for almost half of outstanding claims by BIS banks on Central America. - Foreign ownership of domestic banks varies from less than 15 percent in Guatemala to more than 90 percent in El Salvador. - Remittances: - Remittance flows have grown rapidly and for some countries rival or dwarf FDI as a source of external financing (Table 3.1). - Empirical evidence on remittances as a channel of U.S. spillovers is ambiguous; Roache and Gradzka (2007) suggest remittances may not have been an important source of U.S. spillovers until now. - Possible explanations: data weaknesses, migrant smoothing of remittance amounts, or employment-weighted behavior of migrants. ### Literature Review (selected findings reported) - Fiess (2007): - Close relationship among Costa Rica, El Salvador, Guatemala, and Honduras and between this group and the United States. - Nicaragua and Panama exhibit low or negative correlations in most cases. - Controlling for U.S. common effect reduces correlations but they remain fairly high between certain pairs (e.g., Costa Rica–Guatemala 0.48). - Intraregional coherence: highest pairs include Costa Rica–El Salvador (0.53), El Salvador–Guatemala (0.53), El Salvador–Nicaragua (0.51), Honduras–Nicaragua (0.55). - Kose and Rebucci (2005): - External shocks accounted for one-third of output variance across sample; country range from Costa Rica (67 percent) and Guatemala (55 percent) to Dominican Republic (10 percent) and Nicaragua (18 percent). - NAFTA shocks explained an average of 22 percent of output variance for regional economies; regional shocks explained on average one-half of output variance; domestic shocks explained remainder (24 percent). - Common cycles literature: - Cerro and Pineda (2002): tests indicated seven common trends and four common cycles across 11 Latin American economies (1960–2000); regional cyclical correlations peaked 1970–80, declined 1980–90, risen since. - Hecq, Palm, Urbain (2006) and Hecq (2005): evidence for multiple cointegrating and codependent vectors across Latin American samples; methods improve model accuracy. ### Data and Methodology - Data: - Annual real GDP, 1950–2006, for Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama, and the United States. - Sources: IMF’s International Financial Statistics and Penn World Tables for earlier periods. - Methods used: - Simple correlations with various cyclical decompositions. - Common cycles approach (Engle and Kozicki (1993); Vahid and Engle (1993)), an extension of Johansen (1988) cointegration framework applied to cyclical (stationary) features via codependence. - Beveridge-Nelson-style decomposition to recover permanent (trend) and transitory (cyclical) components when r + s = n. - Model specification decisions: - A five-lag VAR selected by AIC; cointegration tests suggested three cointegrating vectors → four common trends. - Common cycles test indicated it was not possible to reject the hypothesis of four common cycles among the GDP series at the 5 percent level. - Estimation used iterative three-stage least squares to recover cointegrating and cofeature vectors. ### Results - Growth correlations: - Correlations of GDP growth rates are often neither particularly high nor statistically significant (Table 3.3). - Cluster of economies—Costa Rica, El Salvador, Guatemala—correlate fairly closely but links are not very strong. - Common trends and cycles: - Tests suggest three cointegrating vectors (implying four common trends) and three common cycles (in principal specification). - When r + s = n, each GDP series decomposed into separate trend and cycle components. - The trend component from the common cycle model tends to be relatively volatile (a noted caution). - Cyclical correlations: - Correlations of the cyclical part of GDP from the common cycles model are much higher than for annual growth rates or HP-filter cycles. - Costa Rica, El Salvador, and Honduras appear most sensitive to the U.S. business cycle. - Cyclical and trend elasticities to the United States: - Assuming one truly exogenous cycle (the United States), elasticities estimated by OLS show Central America is very cyclically sensitive to the United States. - Elasticities highly significant for four countries (Guatemala’s elasticity somewhat lower due to low historical GDP volatility). - Long-run trend shocks in the United States have a lesser impact on Central America, implying trends are more regionally determined. - Variance decomposition by factor: - For most Central American countries, the cycle contributes most to changes in GDP (Figure 3.7). - Exception: Honduras, where the trend is more important and more closely linked to the U.S. trend. - Exception: Guatemala, where the cycle tends to damp changes in the trend (possibly due to low GDP volatility in historical series). - Results are sensitive to ordering in VAR variance decomposition and identification of shocks. ### Key Statistics and Exact Figures (preserved as presented) - Remittances accounted for 14 percent of regional GDP (excluding Panama) during 2006. - Exports accounted for 20 percent of regional GDP in 2006. - Since the early 1980s, share of total merchandise exports to the United States averaged about 40 percent; country range: 27 percent (Nicaragua) to 53 percent (Honduras). - Debt owed to BIS-reporting foreign banks by Central American borrowers (excluding Panama) ≈ 15 percent of GDP at end-2006. - Direct debt owed to U.S. banks ≈ 3 percent of GDP. - Loans with maturity < one year account for almost half of outstanding claims by BIS banks on Central America. - Foreign ownership of domestic banks: < 15 percent in Guatemala; > 90 percent in El Salvador. - Data sample: annual real GDP, 1950–2006, for six Central American countries and the United States. - A five-lag VAR selected by AIC; cointegration tests suggest 3 cointegrating vectors → 4 common trends; common cycles test could not reject 4 common cycles at 5 percent level. - Table 3.2 examples (1951–2006 summary statistics, mean and standard deviation shown as in source): - Costa Rica mean 5.4 standard deviation 4.1 Max. 18.4 Min. –7.3; 1995–2006 mean 4.8 standard deviation 2.7 Max. 8.4 Min. 0.9. - El Salvador mean 3.3 standard deviation 4.0 Max. 12.0 Min. –11.8; 1995–2006 mean 3.1 standard deviation 1.4 Max. 6.4 Min. 1.7. - Guatemala mean 3.9 standard deviation 2.5 Max. 9.5 Min. –3.5; 1995–2006 mean 3.5 standard deviation 0.9 Max. 4.9 Min. 2.4. - Honduras mean 3.8 standard deviation 4.0 Max. 17.9 Min. –8.6; 1995–2006 mean 3.6 standard deviation 2.1 Max. 6.0 Min. –1.9. - Nicaragua mean 3.2 standard deviation 6.4 Max. 15.0 Min. –26.5; 1995–2006 mean 4.2 standard deviation 1.7 Max. 7.0 Min. 0.8. - Panama mean 4.7 Max. 18.7 Min. –13.4; 1995–2006 mean 4.5 standard deviation 2.6 Max. 8.1 Min. 0.6. - Appendix diagnostics and robustness checks reported (e.g., alternative specifications with four shared cycles and three shared trends produced qualitatively similar results). ### Policy Implications and Recommendations - Main conclusion: Almost all sample countries—including the United States—share a common business cycle; the United States is the dominant economy and exerts a powerful cyclical linkage to Central America. - Implication for fiscal policy: - Governments should distinguish cyclical vs. permanent (structural) components of growth when deciding to spend or save windfalls. - Evidence suggests government tax revenues in the region rise by more than one-for-one with growth (example: Costa Rica tax revenue elasticity with respect to GDP ≈ 1.1 for total taxes as reported in related work). - If growth is due to permanent structural factors → appropriate to “spend” (higher expenditure or lower taxes). - If growth is cyclical (temporary) → optimal to “save” most of it and smooth benefits over time; adjust spending to structural level of revenues (potential or long-run growth). - How cyclical linkages may evolve: - Cyclical linkages are unlikely to weaken absent significant diversification of exports and investment beyond the United States and perhaps the region. - CAFTA-DR could strengthen cyclical linkages via increased trade, FDI, and financial integration with the United States. - Alternatively, CAFTA-DR could promote productivity, investment from new sources (e.g., Asia), and market penetration beyond the United States, potentially diversifying cyclical exposures. - Other bilateral agreements (e.g., with the European Union) could further encourage cyclical diversification. - Longer-run trend growth: - Periods of decoupling from the United States have been driven by long-run structural factors (e.g., armed conflict, terms of trade shocks, poor policy responses). - The diversification of export destinations toward other regional markets may signal an emerging regional growth dynamic that could provide partial insulation from U.S. cycles if it leads to broader market linkages or a sufficiently large regional economic mass. *Source: _dp0801 - Introduction* ### Conclusions ### Conclusions ### Overview - The economies of Central America and the United States are closely intertwined. - The open nature of the region’s economies, combined with geographic proximity to the United States, produces multiple transmission channels through which U.S. cyclical fluctuations could impact the region. - As the implementation of CAFTA-DR moves forward, links between the two regions are likely to become even stronger. ### Main transmission channels - Trade. - Financial flows. - Remittances. ### Empirical findings on cycle synchronization - Historical data show that business cycles in Central America move in the same direction as those in the United States. - Based on empirical estimates, a growth slowdown of 1 percentage point in the United States would typically be associated with a cyclical fall in output growth of 0.5 to 1 percentage points in most countries of the region. - In light of this dependence, a prolonged downturn in the United States would be expected to have significant implications for the region. ### Methodology (Common Cycles and Econometric Approach) - Let yt denote the (7 x 1) vector of log GDP series for the economies in the sample. - Standard tests (Table 3.A1) confirm these data are I(1) while their first differences Δyt are I(0). - Δyt has a Wold representation with matrix polynomial C(L) and stationary innovations. - The Beveridge-Nelson decomposition is used to express I(1) series as the sum of a trend (T) and a cyclical (C) component. - If common trends r exist, C(1) can be decomposed into factor-loading matrices; analogously, common cycles imply the existence of cofeature vectors that eliminate common cycles. - Existence of common cycles is tested using the canonical correlation procedure of Vahid and Engle (1993). - A vector error correction model is estimated to recover the long-run relationship. - Two random vectors Υt and Ζt (linear combinations of Δyt and the vector of lags and error-correction terms xt) are formed and transformed by matrices A and B. - Canonical correlations ri are calculated; the test statistic analogous to the Johansen trace statistic uses the s smallest squared canonical correlations τi2 and follows a chi-squared distribution under the null. - If s cofeature vectors exist, the s pseudo-structural equations for the first s terms of Δyt are specified; the system is completed by unconstrained reduced-form equations for the remaining (n – s) elements and may be estimated by maximum likelihood or iterative three-stage least squares. ### Key statistics and diagnostic findings - Sample size for GDP series: 56 observations per country (Table 3.A1). - Table 3.A1 (first-difference of log values unless otherwise specified) selected entries: - Costa Rica: Sample Size 56; Mean 5.1; Standard Deviation 3.9; Skewness –0.2; Unit Root Test p-Values — Levels 0.20; Changes 0.00. - El Salvador: Sample Size 56; Mean 3.1; Standard Deviation 4.0; Skewness –1.9; Unit Root Test p-Values — Levels 0.51; Changes 0.03. - Guatemala: Sample Size 56; Mean 3.8; Standard Deviation 2.4; Skewness –0.7; Unit Root Test p-Values — Levels 0.66; Changes 0.01. - Honduras: Sample Size 56; Mean 3.7; Standard Deviation 3.8; Skewness 0.0; Unit Root Test p-Values — Levels 0.20; Changes 0.00. - Nicaragua: Sample Size 56; Mean 2.9; Standard Deviation 6.7; Skewness –2.4; Unit Root Test p-Values — Levels 0.20; Changes 0.00. - Panama: Sample Size 56; Mean 4.5; Standard Deviation 4.7; Skewness –1.1; Unit Root Test p-Values — Levels 0.45; Changes 0.00. - United States: Sample Size 56; Mean 3.3; Standard Deviation 2.2; Skewness –0.5; Unit Root Test p-Values — Levels 0.81; Changes 0.00. - Table 3.A2 reports VAR lag-order selection criteria; the criteria include small-sample adjusted log likelihood ratio test; Aikake information criteria (AIC); Schwarz-Bayes information criteria (SBC); Hanan-Quinn information criteria (HQ). - Tests for the number of cointegrating vectors (Table 3.A3) and for the number of cofeature vectors (Table 3.A4) are reported; results are based on the author’s calculations. - Growth elasticity model diagnostics (Table 3.A5) report: - Observations: 56 for cycle and trend equations reported. - Examples of diagnostic statistics (selected): R-Squared and DW-Statistic values are shown for cycle and trend equations across countries; LM Autocorrelation Test and LM Heteroscedasticity Test probability values are reported. ### Graphical and factor findings - Figure 3.A1 compares average correlation of cyclical GDP component to the United States using multiple methods: first-differenced log values; first difference of HP-filtered cycle; first difference of the common cycle factor from the Vahid and Engle (1993) decomposition; and variations using 3-cycle and 4-cycle models for 1950-2006 and 1995-2006. - Figure 3.A2 compares average correlation of cyclical GDP components across Central American countries using methods including first-differenced log values, first differences adjusted for the U.S. effect, HP-filtered cycle, and common cycle factor methods. - Figure 3.A3 displays Common Cyclical and Trend Factors (Cyclical Factor 1–3 and Trend Factor 1–4) over the sample period. ### Policy implication - Given the strong synchronization, Central American policymakers should account for potential spillovers from U.S. cyclical fluctuations transmitted via trade, financial flows, and remittances. - A prolonged U.S. downturn would likely have significant implications for Central American output, fiscal positions, and macroeconomic stability. *Source: Conclusions (Central America's Regional Trends and U.S. Cycles), author’s calculations and appendices as presented in the provided content.* ### Introduction ### Introduction ### Overview - Central America faces high levels of poverty and income inequality; poverty has edged down in the past decade but remains well above that in Latin America as a whole. - Inequality in income distribution in Central America is as high as in other parts of Latin America and stands out globally. - Distributional outcomes reflect the distribution of productive resources (physical and human capital, land) and their rates of return, but public policies can influence market-determined income distribution either by changing the distribution of resources/returns or by redistributing market income. - This chapter examines the distributional effects of taxation and social spending in Central America, surveying existing tax and expenditure studies, assembling underlying data into a comparative framework, and providing reference evidence for other countries in Latin America and Europe. ### Scope and Limitations - Focus is limited to taxation and social spending; other components of fiscal policy and indirect effects of the overall fiscal stance are not included. - Incidence and distributional impacts are treated statically (for example, public education spending effects on future earnings are not modeled). - Interactions between taxation and public provision of social services/transfers and behavioral responses (for example, incentives to work or invest) are not analyzed. - Efficiency, effectiveness, and administrative simplicity of taxes and spending are not directly addressed. - Reliance on existing incidence studies constrains cross-country comparability because methodologies and assumptions differ and constrains the time frame of the data: most underlying studies for the region use data that range between 2000 and 2004 (2003 for Panama and 2004 for Guatemala). ### Main Findings and Conclusions - The overall distributional effect of taxation in the region is small. - The redistributive impact of social spending is much larger, producing a progressive combined redistributive effect of taxation plus social spending in all countries of the region for which data are available. - Raising tax revenues, even if solely through the value-added tax (VAT), and devoting the proceeds to social spending would unambiguously result in an improvement in the income of the poorest households. - These qualitative conclusions hold across all Central American countries with available data and are consistent with evidence elsewhere; they are unlikely to have been significantly affected by recent changes in taxation or social spending because tax structures change slowly and social spending has trended up across the region. ### Tax Systems in Central America: Structure and Evolution - Central government average tax burden in Central America in 2003 was around 13 percent of GDP, marginally higher than its 1995 level. - Regional and country-specific figures: - Panama: 8.7 percent of GDP in 2003. - Honduras: 16.3 percent of GDP in 2003. - With the exception of Guatemala and Costa Rica, the ratio of tax collections to GDP rose by as much as 2 percentage points of GDP between 2003 and 2006. - Tax revenue accounts for most central government revenues across the region; exception: - Panama: taxes represented just 56 percent of central government revenue in 2006 (income from the Panama Canal accounts for a large share of government revenues). - Compared with advanced economies, Central America relies more on indirect taxes and less on income taxes: - Income taxes contribute on average about one-quarter of overall collection in Central America (and Latin America as a whole), compared with one-half in the OECD. - Panama: income taxes account for more than 40 percent of tax collections. - Average share of trade taxes in total tax revenues is about 14 percent in Central America (about one-fourth in Panama and the Dominican Republic), compared with 1¼ percent in the OECD. - Taxes on goods and services (VAT, sales, and excise taxes) account for similar shares of total revenue in Central America and the OECD. - Other taxes, including property taxes, play a relatively small role in Central America (exception: Honduras). - Structural shifts between 1995 and 2006: - Share of trade taxes in total tax revenue fell from a regional average of 20 percent to just over 10 percent. - VAT share in total collections rose from 32 percent to 38 percent. - Contribution of income taxes has slightly increased; share of excise taxes has fallen. ### Distributional Effects of Taxation: Methodological Considerations - Analysis of distributional effects requires assumptions about economic incidence (who ultimately bears the burden) versus statutory incidence (who is legally liable). - Incidence depends on factors such as price elasticities of supply and demand, openness, market structure, and business regulation. - Methods for establishing incidence: - Computable general equilibrium (CGE) models (data-intensive). - Imposing tax-shifting assumptions (commonly used). - Conventional tax-shifting assumptions used in the literature: - Consumption taxes (VAT, sales, excise, and import taxes) are fully shifted forward to consumers. - Export taxes are paid by producers. - Personal income taxes are paid by the income recipients. - Payroll taxes: employee contributions are borne by employees; employer contributions can be borne by the employer or shifted to the employee. - Corporate income taxes require more demanding assumptions because they can be shifted backward to capital owners or workers (through lower returns) or forward through higher consumer prices. *Italic source-attribution line.* ### Conclusions on the distributional effects of taxation are sensitive to incidence as- ### _dp0801 - Conclusions on the distributional effects of taxation are sensitive to incidence as- ### Sensitivity to incidence assumptions - Conclusions on the distributional effects of taxation are sensitive to incidence assumptions and must be taken with caution. - CGE models suggest that changes in incidence assumptions can substantially alter conclusions about who bears the cost of taxes (Gemmell and Morrissey, 2002). - Some standard incidence assumptions may be less appropriate for developing countries, particularly for indirect taxes; import quotas, price controls, informal markets, and widespread evasion limit the scope for forward shifting of import and sales taxes (Shah and Whalley, 1991). - Analytical convenience and lack of reliable data on price elasticities of demand and supply constrain researchers’ options. - Implicit assumption noted: infinitely elastic supply curves imply full forward shifting of taxes to prices paid by consumers; in practice the extent of shifting depends on price elasticities of demand and supply. ### Indicators of distributional impact and definitions - Tax progression - Measures the effective tax ratio (tax effectively paid relative to income) per quantile (decile, quintile, quartile). - A tax is proportional, progressive, or regressive if the effective tax ratio remains constant, grows, or falls, respectively, as one moves up the income distribution scale. - The analysis uses a normalized measure called the relative tax burden: the effective tax rate (as a proportion of income) that each income group pays divided by the average tax rate for the population as a whole. - Note: a less stringent indicator, average rate progression, measures how the effective tax ratio changes as income increases; progression in this broader sense indicates progressivity only under certain assumptions (e.g., no re-ranking of individuals between pretax and post-tax). (Reference: Gemmell and Morrissey, 2002.) - Lorenz and concentration curves - A concentration curve measures cumulative tax paid per quantile of pre-tax income. - Compare the pre-tax Lorenz curve for income with the concentration curve for that tax; a tax is progressive over the entire income distribution if the concentration curve lies consistently under the pre-tax Lorenz curve (Lorenz dominance). - Quasi-Gini coefficients - Global summary measure: the Gini coefficient for a tax’s concentration curve is called the quasi-Gini. - The higher the quasi-Gini coefficient for a given tax, the more progressive it is. - Quasi-Gini is useful when pretax Lorenz and concentration curves cross and Lorenz dominance fails. - Kakwani index (K) - Defined as the difference between the quasi-Gini coefficient for a given tax and the Gini coefficient for pre-tax income. - If K > 0, the tax burden is distributed more unequally than pre-tax income (tax is progressive). - If K < 0, the tax is regressive. - Reynolds-Smolensky (RS) index - Defined as the pre-tax Gini coefficient minus the quasi-Gini index for post-tax income. - Measures how income inequality changes (in terms of Gini points) as a result of the tax. - RS sign is consistent with K: positive (negative) means progressive (regressive). - RS incorporates the revenue importance of the tax relative to the economy and thus its redistributive potential; a highly progressive tax with a very small revenue share may have a negligible RS index despite a high K. ### Measurement base: income versus consumption (Box 4.1) - Rationale for current income - Traditional measure in tax incidence studies is current income per household as a proxy for opportunities and capacity to pay. - Problems with current income: - It is volatile and subject to temporary shocks; surveys over a period may misrepresent longer-run household position. - Underrepresentation in surveys of self-employment, professional services, capital income (interest, dividends), and implicit income from nonmarket transactions. - Inheritances, transfers, and family remittances often not well captured; remittances are an important source of income and welfare in Central America, especially for the poor. - Data availability constraints often force use of current income for cross-country comparisons. - Rationale for consumption - Consumption is less volatile than current income and may proxy permanent income; it is less likely to be under-reported and tends to reflect donations and remittances even if not fully captured in income. - Consumption tends to be more evenly distributed than income; studies using consumption as welfare measure tend to find overall taxation, and consumption-based taxes in particular, more progressive (Fullerton and Rogers, 1993). - Empirical findings: El Salvador, Nicaragua, Panama, Guatemala, and Honduras show more progressive results when consumption is used (Appendix Table 4.A4; Auguste and Artana, 2005; Gillingham, Newhouse, and Yakovlev, forthcoming). - Limitations of consumption measure - Consumption may be a deficient proxy for permanent income in the presence of bequest motives or precautionary savings. - Richer households empirically consume a lower permanent share of income than poorer households. - Many household surveys do not measure consumption, limiting practical use. ### Data scope, methodology notes, and limitations - The analysis summarized is based on current total income as the welfare measure to allow some consistency across countries. - Underlying data are limited to central government taxes, except: - Honduras includes municipal taxes. - Nicaragua reflects taxes for the city of Managua. - Implicit taxes (such as price controls) and the inflation tax are excluded from the tax incidence data. - The inflation tax is broadly acknowledged to be regressive because the poor normally have a higher ratio of money to income and reduced ability to hedge against inflation; Bolaños (2002) finds the inflation tax very regressive in Costa Rica. - Data harmonization note: incidence data for Honduras and Nicaragua are based on quintiles; Costa Rica and El Salvador data based on deciles were converted to quintiles for netting out tax and social spending effects. The conversion implies that figures for tax progression and global measures in this paper are not the same as those presented by authors of source papers; measures are sensitive to the number of income groups used. - For Panama, incidence data were ordered by quintiles of income per capita; Panama’s income taxes have a much greater weight in total tax revenues than in the rest of the region, driving paradoxes between progression measures and Gini indices when concentration and Lorenz curves cross. ### Findings on the distributional impact of taxes in Central America - General result - The tax systems in Central America are generally regressive: although richer segments pay the bulk of total taxes in absolute terms, the poor pay more taxes relative to income (as shown by the relative tax burden). - Summary indicators - Negative Kakwani indices in most countries imply the tax burden is distributed more evenly than income (i.e., regressive). - Exceptions and conflicting evidence - Guatemala and Panama present conflicting evidence between tax progression measures and Gini-based indices: - In these countries the poorest quintile pays more taxes relative to income than the richest quintile and the population as a whole. - Yet the quasi-Gini index for taxes is slightly larger than the Gini for income (Kakwani index positive), suggesting the overall tax systems are mildly progressive (in Guatemala, basically proportional) according to the Kakwani summary measure. - This paradox arises because the concentration curve for taxes and the Lorenz curve for income cross (Lorenz dominance fails), illustrating weaknesses of the Gini coefficient as a summary measure. - Regional and international context - Regional data on incidence and distributional effects are complemented by data for other Latin American countries, the United States (federal taxes only), and the European Union for broader perspective; comparator selection was based on relevance and data availability. - Dominican Republic - No recent studies of overall tax incidence; Santana and Rathe (1993) find the Dominican tax system was progressive in 1989. *Italic: Content synthesized from _dp0801 - Conclusions on the distributional effects of taxation are sensitive to incidence as-* ### 17.2 percent. ### _dp0801 - 17.2 percent. ### Distribution of Pretax Income and Taxes (Table 4.2 highlights) - Pretax income Gini coefficients (selected): - Costa Rica (2000) 45.1 - El Salvador (2000) 47.4 - Guatemala (2004) 46.3 - Honduras (2004) 47.2 - Nicaragua (2000) 51.0 - Panama (2003) 53.8 - Bolivia (2000) 55.6 - United States (federal, 2004) 43.8 - EU-15 (2001) 39.9 - Quasi-Gini coefficients for total taxes (selected): - Costa Rica (2000) 44.9 - El Salvador (2000) 31.7 - Guatemala (2004) 46.4 - Honduras (2004) 40.8 - Nicaragua (2000) 37.4 - Panama (2003) 57.1 - Bolivia (2000) 49.8 - United States (federal, 2004) 58.4 - EU-15 (2001) 50.0 - Kakwani indices for total taxes (selected): - Costa Rica (2000) -0.2 - El Salvador (2000) -15.7 - Guatemala (2004) 0.1 - Honduras (2004) -6.4 - Nicaragua (2000) -13.6 - Panama (2003) 3.3 - Bolivia (2000) -5.8 - United States (federal, 2004) 14.6 - EU-15 (2001) 29.6 ### Degree and Patterns of Tax Regressivity in Central America - Overall tax regressivity varies substantially across Central America. - El Salvador, Honduras, and Nicaragua: taxation burden falls disproportionately on the poor (Panel C). - Example: In El Salvador the poorest quintile pays more than two and a half times as much taxes relative to their income as the average citizen, and three and a half times what the richest quintile pays. - Costa Rica and Guatemala: relative tax burden is distributed fairly evenly; tax progression is U-shaped (mildly regressive in lower quintiles, then progressive), favoring middle classes. - Panama: U-shaped distribution with a deeper trough; bottom quintile pays 28 percent more taxes than the average household, top fifth pays 11 percent more. - Compared with the Andean countries, United States, and EU-15, Central American taxation (based on income) is generally more regressive, except for Guatemala and Panama. ### Consumption versus Income as Welfare Measure - Using consumption/expenditure instead of income reduces measured regressivity: - Quasi-Gini indices for consumption are smaller than income Gini coefficients by: - El Salvador 15.7 percentage points - Nicaragua 11.6 percentage points - Panama 15.3 percentage points - Consequences: - Overall taxation in El Salvador and Nicaragua becomes almost proportional when measured relative to consumption. - Panama’s system becomes strongly progressive when consumption is used. - Note: Appendix Table 4.A4 displays these comparisons and limitations of using consumption for tax incidence analyses are noted. ### Redistributive Impact of Taxes (Table 4.3 highlights) - Redistributive potential measured by the Reynolds-Smolensky (RS) index is generally small across Central America. - Selected RS (Reynolds-Smolensky) indices and related figures: - Costa Rica (2000): Gini pre-tax income 45.1; Quasi-Gini for taxes 44.9; C = B - A = –0.2; Tax pressure 20.8; Quasi-Gini for post-tax income 45.1; RS 0.0 - El Salvador (2000): Gini pre-tax income 47.4; Quasi-Gini for taxes 31.7; C = –15.7; Tax pressure 8.1; Quasi-Gini for post-tax income 48.8; RS –1.4 - Guatemala (2004): Gini pre-tax income 46.3; Quasi-Gini for taxes 46.4; C = 0.1; Tax pressure 17.3; Quasi-Gini for post-tax income 46.3; RS 0.0 - Honduras (2004): Gini pre-tax income 47.2; Quasi-Gini for taxes 40.8; C = –6.4; Tax pressure 14.4; Quasi-Gini for post-tax income 48.3; RS –1.1 - Nicaragua (2000): Gini pre-tax income 51.0; Quasi-Gini for taxes 37.4; C = –13.6; Tax pressure 27.5; Quasi-Gini for post-tax income 56.2; RS –5.2 - Panama (2003): Gini pre-tax income 53.8; Quasi-Gini for taxes 57.1; C = 3.3; Tax pressure 6.4; Quasi-Gini for post-tax income 53.6; RS 0.2 - Explanations for small redistributive impact: - Low tax pressure in some countries. - Relatively similar distributions of taxes and income (small Kakwani indices). - Nicaragua is an exception where higher measured redistribution effect results from marked regressivity combined with a relatively high ratio of taxes to household income. - International comparators (Andean countries, United States, Europe) also show only modest effects of taxation on income distribution. ### Progressivity of Individual Taxes - Income taxes: - Generally progressive in Central America (global measures indicate progression), particularly in Panama. - In Guatemala and Panama, incidence of income taxes is U-shaped across quintiles. - Income taxes contribute little to overall redistribution because they account for about one-fourth of total tax take on average and their redistributive effect is at or under 0.4 percentage point of the pre-tax Gini coefficient for all countries. - Note: In Costa Rica social security contributions are treated as taxes on wages and included under income tax, which may underestimate income tax progressivity relative to other countries. - VAT / Sales taxes: - Except for Costa Rica, VAT and sales taxes are notably regressive when assessed relative to income and account for much of the regressive impact of overall taxation. - Empirical patterns: - El Salvador: poorest 20 percent pay over three times more VAT relative to their income than the average household and five times as much relative to the richest 20 percent. - Nicaragua: Kakwani index for VAT is even higher than in El Salvador because underlying income distribution is more unequal. - Costa Rica: VAT regressivity is much lower; all quintiles except the richest pay a slightly higher effective rate than the average—linked to targeted exemptions and exclusion of a basic basket of goods and services consumed mostly by the poor. - Because VAT/sales taxes are the single most important source of tax revenue for most Central American countries, their regressivity materially affects overall distribution in El Salvador, Honduras, and especially Nicaragua. ### Comparative and Concluding Findings - Tax systems in the region, whether progressive or regressive, have limited effect on overall income distribution—consistent with international experience. - The overall redistributive impact of taxation depends on: - Pre-tax income distribution. - Distribution of tax payments across income groups. - Tax pressure (ratio of total taxes considered to total income before taxes). - The chapter indicates a contrast between the modest redistributive effect of taxes and the large redistributive potential of social spending (addressed in later sections). *Source: _dp0801 - 17.2 percent.* ### Appendix Table 4.A3 suggests. ### _dp0801 - Appendix Table 4.A3 suggests ### VAT incidence and consumption vs. income measures - The regressivity of the VAT in Central American countries is partly explained by the high ratio of consumption to income in the poorer households; measured relative to consumption the regressivity is substantially reduced or reversed. - Standard explanation: consumption is more evenly spread than income, so the ratio of consumption to income tends to be very high (and the savings rate correspondingly low or negative) for the poorest income groups and much lower for the richer ones. - Example: in El Salvador the ratio of consumption to income is 177 percent for the lowest quintile, compared with 52 percent for the highest. - Evidence that measuring by consumption changes the incidence: - If consumption is used instead of current income as an indicator of welfare or of permanent income, the VAT becomes much less regressive in El Salvador and Nicaragua, and turns progressive in Panama. - For Guatemala and Honduras, studies find the VAT turns from regressive relative to income to mildly progressive when measured relative to consumption. - Jenkins, Jenkins, and Kuo (2006) find for the Dominican Republic (measuring by household expenditure) that the VAT is highly progressive: the effective tax rate paid by the richest quintile is twice as large as that paid by the poorest. - Nonmarket factors that introduce progressivity: goods and services consumed by the poor are often traded in informal markets and are administratively impractical to tax; barter and self-consumed production are naturally excluded from the VAT. - Tax design factors can induce regressivity even when measuring relative to consumption: - Appendix Table 4.A4 shows the VAT is still regressive in El Salvador and Nicaragua when measured relative to consumption, suggesting exemptions disproportionately benefit the rich. - Many VAT exemptions fall on services, which normally account for a larger share of expenditures for higher income groups. - Policy implication: regressivity of the VAT can be reduced if exemptions and zero-ratings are reduced to a narrow and well-targeted basket of goods and services consumed disproportionately by the poor. - Cross-country note: Appendix Table 4.A3 shows the VAT is progressive in Ecuador and Venezuela, even when considered relative to income. ### Excise taxes and international trade taxes - Excise taxes: - Are regressive in most Central American countries, except Costa Rica and Guatemala. - Are strongly regressive in El Salvador, Honduras, and Nicaragua; in Honduras and Nicaragua they are the most regressive tax and, because their share in total taxation is sizable, they have a palpable effect on overall income distribution (Reynolds-Smolensky index, Appendix Tables 4.A2 and 4.A3). - Regressive incidence driven mainly by taxes on alcohol, tobacco, and fuel, because consumption of these goods accounts for a larger share of the income of poorer households. - Panama: excise taxes are regressive as a whole, but much less so; excises on tobacco and alcoholic drinks are very regressive, while those on cars and other luxury items are progressive. - Guatemala: excise taxes are essentially neutral (somewhat U-shaped progression pattern and a small positive Kakwani index). - Costa Rica: excise taxes are fairly progressive and in Costa Rica are even more progressive than income taxes (as measured by their quasi-Gini and Kakwani indices) because of broader coverage including luxury goods. - Cross-country evidence is mixed: excise taxes are highly progressive in Bolivia but regressive in the United States (Appendix Tables 4.A2 and 4.A3). - International trade taxes: - Are highly regressive in all countries except Guatemala. - Reason: tariffs tend to be higher on imported consumption goods that are also produced domestically, especially food and lightly processed manufactured goods, which represent a larger share of the consumption basket of poorer households. - Guatemala appears an exception, suggesting imported goods subject to tariffs may be more prominent in the consumption patterns of the rich in that country. - Caveat: analysis based on Auguste and Artana (2005) may overestimate progressivity of import tariffs because intermediate good imports were excluded; some “final” imports may be used as intermediate goods, making incidence roughly proportional in other studies. ### Social spending trends in Central America - Aggregate and cross-country summary: - The share of social spending in GDP was on average 11½ percent of GDP in 2004 for Central America, an increase of 2¼ percent of GDP since 1995 (Table 4.4). - Substantial cross-country differences in levels of social spending (share of GDP): - Costa Rica: 18½ percent of GDP - Panama: 17 percent of GDP - Honduras: 13 percent of GDP - Guatemala: 6½ percent of GDP - Public spending on education and health in the region is roughly similar, as a share of GDP, to the Latin American average (and median). - The average and median levels of public spending on social protection are significantly below those of Latin America as a whole. - Social assistance spending (including conditional cash transfer programs) amounts to about 1¾ percent of GDP on average for Central America. - Changes over time and fiscal priority: - The increase in public social spending levels reflects both an increase in total expenditures and an increase in the share of social spending in overall public expenditures. - Overall central government expenditures have grown over the past decade (by upwards of 3 percentage points of GDP in El Salvador, Guatemala, and the Dominican Republic). - Share of social spending in total expenditure: - Costa Rica: 68½ percent of total expenditure allocated to social spending, increasing by 6 percentage points from its 1994–95 level. - Honduras, the Dominican Republic, and Nicaragua each direct less than 40 percent of expenditure to social spending. - Honduras increased the share of social spending in total expenditure by 13 percentage points over the past decade. - Nicaragua increased the share by about 5 percent, aided by a significant decline in interest payments under debt relief from the HIPC Initiative. - Evidence indicates higher fiscal priority is being placed on social spending and that public funding of social programs, although procyclical, has become less volatile over time. - Cyclicality and volatility: - A commitment to protecting social spending would be reflected in acyclical total public social expenditures and countercyclical expenditure on social assistance programs; however, evidence indicates public social spending in Central America has been procyclical. - Simple analysis (Hodrick-Prescott filter to extract cyclical components) shows that, with the exceptions of Costa Rica and Honduras, social spending varied positively with the economic cycle in both the early 1990s and in more recent years (Appendix Table 4.A5). - Despite increased volatility of growth in 1998–2004, the volatility of overall social spending and of some key categories decreased over that sub-period (Appendix Table 4.A6). ### Incidence and distributional impact of social spending — methodological points - Definitional distinction: - Absolute incidence: the share of total social spending that each income group receives (e.g., bottom quintile receives 45 percent while top receives 5 percent = progressive in absolute terms). - Relative incidence: the distribution of social spending relative to the distribution of pre–fiscal policy income (e.g., bottom quintile receives 10 percent of spending and top quintile receives 30 percent — not progressive in absolute terms but can improve income distribution if more equally distributed than income). - Measurement and indicators: - Absolute and relative incidences of social spending are measured with the same set of indicators used to assess distributional impact of taxation but interpreted differently. - The quasi-Gini coefficient of spending is conceptually analogous to the quasi-Gini coefficient for taxes (represents the Gini coefficient for the concentration curve of spending). - Possible values of the quasi-Gini coefficient of spending lie between –1 and 1, with a negative value denoting progressivity in absolute terms (concentration curve of spending lies above the 45-degree line). - Methodological heterogeneity across studies: - Identifying actual beneficiaries of social spending programs is sometimes direct (e.g., primary spending by primary school enrollment ratios based on household surveys) and sometimes indirect (e.g., social assistance to the disabled proxied by general share of disabled in population or enrollment in programs). - Studies surveyed show relative homogeneity in some beneficiary identification methods and heterogeneity in others. *Source: _dp0801 - Appendix Table 4.A3 suggests.* ### Box 8.1 of IDB (1998) provides a very clear mathematical and graphical illustration. ### _dp0801 - Box 8.1 of IDB (1998) provides a very clear mathematical and graphical illustration. ### Distributional impact of total social spending - Definition: K (Kakwani index) = quasi-Gini coefficient of spending minus Gini coefficient of original income distribution. If K < 0, spending is progressive relative to original income distribution. - Overall finding: Total public social spending in Central America is progressive in relative but not in absolute terms for Costa Rica, Guatemala, and Panama: positive quasi-Gini coefficients of spending (Table 4.5, Panel A, column 2) but negative Kakwani indices (Table 4.5, Panel A, column 3). - Excluding social security: social spending becomes much more progressive (Table 4.5, Panel B, column 2, and Figure 4.5). Social spending excluding social security is progressive in absolute terms in Costa Rica, El Salvador, and Panama. - Magnitude varies across countries: - Costa Rica: reduction in Gini coefficient of 6 points. - Panama: reduction in Gini coefficient of 7.4 points. - El Salvador: reduction in Gini coefficient of 3.6 points. - Guatemala and Honduras: reductions of about 3 Gini points. - International comparison: - Reduction of pre–fiscal policy Gini of 6–7.5 Gini points in Costa Rica and Panama is similar to Italy, Spain, and Portugal (Table 4.5, column 5) and greater than the Andean countries (3.5 to 5 Gini points). ### Post–social spending inequality - Post–social spending Gini in Central America remains high; with exception of Costa Rica, post–social spending Gini is above pre–social spending Gini in European countries (Table 4.5, column 6). - Incidence shares to lowest three quintiles: - EU-15 average: 81 percent to lowest three quintiles (quasi-Gini = –24.5). - El Salvador: about 70 percent to lowest three quintiles. - Costa Rica, Guatemala, Panama, Honduras: about 60–65 percent. - Nicaragua: about 50 percent. ### Incidence by social spending component - Social protection (mainly pensions) is pronouncedly regressive in Central America; comparison of quasi-Gini coefficients with and without social protection shows regressivity for social insurance/pensions. - World Bank finding (Lindert, Skoufias, and Shapiro): all 16 social insurance programs studied are regressive in absolute terms (note: study focuses on net transfers). - Social assistance (eligibility not tied to formal labor market participation): targeting is mixed; a “typical” social assistance program transfers 38 percent more to bottom quintile than universal allocation, but targeting varies tremendously. - Education spending: - Overall education spending: generally neutral redistributive effects; progressive in absolute terms in El Salvador and to a lesser degree in Panama. - Primary education: strongly progressive, unambiguously pro-poor in all surveyed countries. - Secondary education: inverted U-shape; benefits highest for middle three quintiles except Guatemala (strong regressivity). - Tertiary education: regressive across the board; average only 25 percent of public spending on tertiary accrues to bottom 3 quintiles. Guatemala and Honduras: tertiary spending regressive even in relative terms (positive Kakwani). - Health spending: - Progressive in absolute terms in four of seven surveyed countries: - Costa Rica and El Salvador: 26–27 percent of total public health spending to poorest quintile; 70–74 percent to bottom three quintiles (Figure 4.7). - Nicaragua and Dominican Republic: modest but pro-poor incidence. - Guatemala, Honduras, Panama: neutral absolute incidence (about 60 percent to bottom three quintiles). ### Net distributional effects of fiscal policy (taxation + social spending) - Method: compare concentration patterns before and after fiscal policy via Reynolds-Smolensky index (RS Index); positive RS Index denotes progressivity. - Central America: net redistributive effect of fiscal policy is progressive but modest. - Main channels: initial income distribution, shares of taxation and social spending in income, distribution of taxes and spending across income groups. - Taxation vs social spending: - Taxation: small regressive effect in many Central American cases. - Social spending: larger progressive impact that more than offsets tax regressivity in most countries. - Country-specific net impacts (Table 4.7 and Table 4.8): - Costa Rica: reduction in income inequality of 6–8 Gini points; increase in income of poorest quintile by 60 percent (text). - Panama: reduction in income inequality of 7–8 Gini points; increase in income of poorest quintile by 162 percent (text). - Guatemala: modest net reduction of 3.7 Gini points. - Nicaragua: taxation highly regressive but offset by social spending; fiscal policy reduces Gini by 3.1 points; net increase in income of poorest quintile only 8 percent due to relative sizes. - El Salvador and Honduras: modest net effects (RS Index small). - Comparison with other regions: - Andean countries: similar pattern to Central America (regressive taxes, progressive social spending; modest net). - EU-15: much larger net redistributive impact; post–fiscal quasi-Gini index 12.5 points lower than pre–fiscal Gini; income of poorest quintile almost doubles in some EU comparators. ### Simulations: 1 percent of GDP increase in social spending financed by additional tax revenue (Table 4.9) - Four simulation permutations: 1. Increase in all taxes proportional to current shares in total collection; proceeds distributed according to current incidence of social spending. 2. Increase in all taxes proportional to current shares; proceeds channeled evenly to income groups (equal per-capita). 3. Increase in VAT collection; proceeds distributed according to current incidence of social spending. 4. Increase in VAT collection; proceeds channeled evenly to income groups. - Qualitative result: net distributional effect is progressive in all permutations; reduces income Gini coefficient by country- and scenario-specific amounts. - Reported simulated reductions in quasi-Gini (postfiscal policy income after reform minus before reform, times 100) and percentage changes in postfiscal income by quintile (selected reported outcomes, Table 4.9): - Simulation 1 (1 percent of GDP increase in overall tax collection devoted to social spending): - Costa Rica: change in Gini 3.3; quintile percentage changes: 1., 40., .6, -0.1, -0.9, -0.6 (table formatting shows population income quintiles from lowest to highest). - El Salvador: change in Gini 4.4; quintile percentage changes: 1., 30., .4, -0.2, -0.5, -0.4. - Guatemala: change in Gini 3.7; quintile percentage changes: 2., 11., .1, 0.2, -1.1, -0.7. - Honduras: change in Gini 4.0; quintile percentage changes: 1., 40., .5, 0.0, -0.7, -0.5. - Nicaragua: change in Gini 3.3; quintile percentage changes: 2., 11., .3, 0.1, -0.8, -0.6. - Panama: change in Gini 5.4; quintile percentage changes: 2., 71., .2, 0.4, -1.2, -0.8. - Simulation 2 (1 percent of GDP increase in overall tax collection channeled evenly): - Costa Rica: change in Gini 2.5; quintile percentage changes: 1., 10., .7, 0.0, -0.8, -0.5. - El Salvador: change in Gini 3.2; quintile percentage changes: 0.9, .3, -0.1, -0.4, -0.3. - Guatemala: change in Gini 4.6; quintile percentage changes: 2., 10., .9, 0.1, -1.1, -0.7. - Honduras: change in Gini 3.9; quintile percentage changes: 1., 60., .6, 0.0, -0.7, -0.5. - Nicaragua: change in Gini 6.1; quintile percentage changes: 2., 71., 1.2, 0.1, -1.1, -0.8. - Panama: change in Gini 5.5; quintile percentage changes: 2., 31., .2, 0.4, -1.1, -0.7. - Simulation 3 (1 percent of GDP increase in VAT collection devoted to social spending): - Costa Rica: change in Gini 3.3; quintile percentage changes: 1., 40., .5, -0.2, -0.8, -0.6. - El Salvador: change in Gini 3.9; quintile percentage changes: 1., 10., .3, -0.2, -0.4, -0.4. - Guatemala: change in Gini 3.3; quintile percentage changes: 1., 70., .9, 0.1, -0.9, -0.6. - Honduras: change in Gini 3.3; quintile percentage changes: 1., 10., .3, -0.1, -0.5, -0.4. - Nicaragua: change in Gini 2.2; quintile percentage changes: 1., 40., .9, -0.2, -0.4, -0.4. - Panama: change in Gini 5.4; quintile percentage changes: 2., 50., .9, 0.1, -1.0, -0.7. - Simulation 4 (1 percent of GDP increase in VAT collection channeled evenly): - Costa Rica: change in Gini 2.5; quintile percentage changes: 1., 10., .6, 0.0, -0.7, -0.5. - El Salvador: change in Gini 2.7; quintile percentage changes: 0.7, .2, -0.1, -0.3, -0.2. - Guatemala: change in Gini 4.2; quintile percentage changes: 1., 70., .6, -0.1, -0.8, -0.6. - Honduras: change in Gini 3.2; quintile percentage changes: 1., 30., .3, -0.1, -0.5, -0.4. - Nicaragua: change in Gini 5.1; quintile percentage changes: 2., 00., .7, -0.2, -0.7, -0.6. - Panama: change in Gini 5.4; quintile percentage changes: 2., 00., .8, 0.1, -0.9, -0.7. - Note on table format: Table 4.9 reports "Percentage Change in Postfiscal Policy Income Before the Reform" by quintile and change in quasi-Gini; population income quintiles listed from lowest to highest. - Summary numeric outcomes (text): - The reform would reduce the income Gini coefficient between 0.5 and 0.8 percentage points in Costa Rica, Guatemala, Nicaragua, and Panama, and between 0.2 and 0.4 percentage points in El Salvador and Honduras. - Two key messages from simulations: 1. Improving targeting of social spending beyond absolute neutrality yields considerable gains in inequality reduction (example: Nicaragua—improving from regressive to at least flat distribution would double impact on poorest quintile). 2. Redistributive impact of increased social spending is not much affected by financing via VAT compared with other taxes; differences in Gini impact are small except in Nicaragua where VAT is more regressive. ### Sectoral and policy implications (synthesized from findings) - Social spending targeted to the poor (excluding regressive social security/pension components) has greater redistributive power than relying on tax progressivity alone. - Reforms that (a) improve targeting of social spending and (b) reduce regressivity in taxation (for example, eliminate regressive exemptions) would enhance the net redistributive effect of fiscal policy. - Even when financed by relatively regressive tax instruments such as the VAT, well-targeted increases in social spending can produce progressive net outcomes, with country-specific exceptions where VAT is particularly regressive relative to income distribution. *Italic: Source: IMF staff calculations and analysis as presented in the provided PDF content.* ### Conclusions ### Conclusions ### Redistributive potential of taxation - The limited redistributive potential of taxation, especially compared with that of social spending, implies a key focus of tax policy should be raising revenue efficiently. - The distributional impact of taxes is generally small, whether a tax is progressive or regressive. - There is often a trade-off between the progressivity of a tax and its potential to raise revenue: if progressivity derives from granting exemptions or applying differential tax rates, the tax base may be eroded. - Increasing the progressivity of the tax system may reduce the pool of resources available for redistribution through social spending and may ultimately be detrimental for reducing poverty and inequality. - By contrast, broadening the tax base—even if that implies eliminating progressive exemptions—may enhance the overall progressivity of fiscal policy. - Numerical illustration from related simulation evidence: a hypothetical 1 percent of GDP rise in VAT revenues that is distributed equally (in absolute terms) among all income groups would reduce the income Gini coefficient by between 0.4 and 0.6 percentage points in Guatemala, Colombia, and the Dominican Republic, and between 0.3 and 0.4 in Argentina and Chile. ### Tax design, equity, and administrative implications - Equity should remain a consideration in tax policy debates. - Income taxes can be much less progressive and VATs and sales taxes much less regressive in some countries than in others; differences may reflect economic structures and weaknesses in tax design. - Weak tax design features (for example, exemptions that disproportionately favor richer segments) may: - Make the tax more regressive. - Elicit evasion. - Reduce revenue. - Harm equity, efficiency, effectiveness, and administrative simplicity simultaneously. ### Social spending: levels, targeting, and effectiveness - Social spending can potentially have a powerful redistributive effect, but its impact in Central America is undermined by its relatively low level. - Countries in the region have increased social expenditures in recent years, but public social spending remains generally low both relative to GDP and as a share of total public spending. - Targeting of social spending can be improved: - Spending on health and primary education is strongly progressive. - Spending on pensions and tertiary education is very regressive; access and coverage of these two components should be improved to enhance their impact on the poor. - Well-targeted social assistance programs, such as cash transfers conditional on school attendance, can have a significant effect on poverty reduction, especially in the long run. ### Combined fiscal effect and country example - The combined effect of taxation and well-targeted social spending can substantially improve the income of the poor, even if the tax system individually considered is regressive. - Example: In Panama, the net effect of fiscal policy is estimated to more than double the income of the poorest 20 percent of the population. *Conclusions (chapter text).* ### Introduction ### _dp0801 - Introduction ### Background and purpose - In December 2007, the governments of Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua signed the Framework Agreement for the Establishment of the Central American Customs Union (CACU). - The agreement reflects broad sharing of experiences, negotiation, and joint work by officials from the five countries, together with representatives of Panama and the Dominican Republic. - The chapter examines the process of establishing the CACU from the perspective of the customs and tax administrations (CTAs) and outlines requirements, effects, and modernization needs. ### Key unresolved issues for CTAs under the CACU - Free circulation of goods and how to proceed regarding the control of sensitive goods. - Operation of internal customs posts (or the “centers of trade facilitation”). - Administration and control of the free trade zones (where maquiladora companies are located). - Continued ability of signatories to conclude bilateral free trade agreements with non-CACU members and potential negative effects on customs administration. - Model for distributing the revenue collected through customs to the destination country. ### Role and strategic needs of CTAs - The term CTA refers to both customs and domestic tax administrations; these activities may be carried out by two separate institutions or by one integrated administration. - Central American CTAs require a well-defined strategic plan addressing three main areas: - (1) normative convergence, - (2) institutional development, and - (3) administrative and operational strengthening. - CTAs support trade facilitation, help protect member countries against tax fraud and contraband, and generate revenue to finance expenditures. - Modernization priorities include electronic filing, services and payment; risk analysis; strategic management; information sharing; implementing tax treaties; and performing joint audits. ### Regional integration as a continuum and implications for CTAs - Regional integration deepens both economic and institutional relations; institutional integration helps deepen economic integration (Dorrucci and others, 2004). - Integration stages and direct implications for customs and tax administration: - Free Trade Area (FTA): tariffs and quotas abolished for imports from area members; national tariffs and quotas against nonmembers retained. - Customs Union (CU): an FTA with common tariffs and quotas for trade with nonmembers (known as the common external tariff—CET). - Common Market (CM): a CU with no nontariff barriers to trade or restrictions on the movement of capital and labor. - Economic and Monetary Union (EMU): a full economic union (potentially a monetary union) requiring significant coordination and harmonization of domestic laws. ### Quantitative and qualitative effects on CTAs - Quantitative: increases in number of taxpayers, returns, and tax transactions. - Qualitative: new business processes, management capacity needs, and organizational arrangements. - Larger economic flows imply more service and enforcement activities (e.g., phone calls, Internet hits, customs clearances, transfer pricing operations). - Integration creates new possibilities for fraud and evasion (example: VAT carousel fraud in the European Union after elimination of intra-EU borders). ### Minimum requirements and the trade-off between integration and control - CTAs must meet legal, institutional, and operational requirements at various stages of integration (see Table 5.1). - Minimum standards should be established for all core functions of a CTA, including human resources policies and infrastructure. - The greater the effort to establish common institutional and administrative arrangements, the greater the advantages—and the greater the requirements. - Different institutional arrangements are needed at different stages of regional integration; many requirements demand intense political negotiation and institutional change. - Integration experiences often yield “incomplete CUs” where legal definitions exist but implementation is partial due to weak information systems, lack of unified procedures, or limited administrative capacity. ### Requirements and implications by integration stage (high-level summary of Table 5.1) - FTA institutional and legal requirements and administrative requirements: - Elimination of internal tariffs. - Establishment of treaties on information sharing among countries of the group. - Certification of origin. - Elimination or reduction of trade restrictions (quantitative quotas). - Adoption or negotiation of treaties on double taxation. - Electronic information sharing. - Elimination or reduction of charges and measures having an equivalent effect to a customs duty. - Gradual convergence of various bilateral free trade treaties signed with nonmember countries. - Basic coordination of customs procedures. - Maintenance of national tariff and trade policies in respect of nonmember countries. - CU institutional and legal requirements and administrative requirements: - Elimination of internal tariffs. - Adoption of a common customs code, regulations, and various manuals. - High level of coordination of customs procedures. - Elimination of trade restrictions (quantitative quotas). - Standardization or harmonization of materials related to customs transit, customs valuation, documentation, technical barriers (sani­tary, etc.). - Creation of compatible or unified information technology systems. - Elimination of charges and measures having an equivalent effect to a customs duty. - Harmonization of trade regulations (certificates, labels, trade defense, public procurement system, etc.). - Mutual assistance programs (joint audits, coactive collection, presence of officials from other countries in customs, etc.). - Adoption of a common external tariff. - Code of conduct for customs officials. - Strengthening of external customs posts. - Adoption of common policy on trade with nonmember countries. - Training school. - Use of internal customs posts for specific controls and domestic taxes. - Integrated customs border posts. - CM institutional and legal requirements and administrative requirements: - Free circulation of persons (labor) and capital, in addition to the elimination of restrictions that prevent the circulation of goods and services. - Elimination of internal customs and internal para-customs controls. - High degree of cooperation and data sharing. - Unification of customs and trade policies and other legislation. - Unification of customs procedures and documentation. - Integrated planning and tasks (risk controls, integrated plan for combating fraud). - Harmonization of indirect taxation. - Greater attention to integrated work on income tax: investment flow, royalties, transfer prices. - Harmonized tax concessions policy (duty-free areas, special arrangements, etc.). - Integrated electronic systems (management, statistics, records, etc.). - EMU institutional and legal requirements and administrative requirements: - Unification of monetary policy and adoption of a single currency. - Greater integration at the administrative, documentary, information-sharing, and procedural levels. - Integrated strategic planning. ### Specific operational considerations for FTAs and CUs - Free Trade Areas: - Customs must differentiate between intra- and extrazone goods because they face different tariff levels and controls. - Certifying the origin of goods becomes critical; Protocols of origin define criteria such as change in tariff classification, type of transformation, and value added (materials not originating in the FTA generally should not exceed 40 percent of the final value). - Many FTAs administer lists of intrazone sensitive goods where tariffs continue to be collected. - Customs must administer exceptions while facilitating intra-zone trade. - Domestic tax administrations must increase information sharing and joint audits with customs and control foreign trade and investment transactions (e.g., transfer pricing, thin capitalization). - Customs Unions: - A common external tariff (CET) makes extrazone goods subject to an identical tariff regardless of entry point; after external clearance, goods circulate freely within the CU. - No need to control origin to differentiate intra- and extrazone goods for internal movement, though rules of origin remain applicable with nonmembers (e.g., antidumping). - Application of similar controls and procedures at all external customs posts is essential to avoid fraud schemes exploiting weaker posts. - Coordination among customs, minimum standards of procedures, risk control, and human resource policies (including a code of ethics) are critical. - Many CUs are incomplete in practice: internal controls may be retained for sensitive goods and to collect domestic taxes; exceptions to the CET, quantitative quotas, charges, measures equivalent to duties, weak administrative capacity, ineffective information sharing, or lack of integrated rules can persist. *Source: _dp0801 - Introduction* ### 5.1 depicts the concepts of complete and incomplete customs unions. A com- ### _dp0801 - 5.1 depicts the concepts of complete and incomplete customs unions. A com- ### Concepts of complete and incomplete customs unions - A complete CU is rated “level 1” for all relevant categories and is represented by the outer line of the polygon; an incomplete CU is represented by the inner line. - A CET less than 1 denotes that a CET is in force but there are exceptions in effect. - The notion of an “incomplete CU” is a didactic and pragmatic representation of a process in transition; many CU arrangements live with transitory phases and may be more advanced than FTAs while not complying with all legal requirements for a CU. - Countries should move as fast as possible to minimize the length of the transitory phase and avoid deferring economic benefits while enduring administrative complications. ### Revenue distribution and domestic consumption taxes - Two relevant issues for a CU: - The model for distributing customs revenue (e.g., revenue from applying the CET) among member countries. - The collection of domestic taxes on consumption (VAT and excise taxes). - CET revenues collected at external customs may: - Be deposited into a central fund to finance common expenditures (example: European Union), or - Be distributed according to the final destination of goods. - Distribution may use economic and statistical criteria; each model implies different political commitment and management methods. - Proper methods for levying domestic consumption taxes are needed because rates vary among members: - If internal customs posts exist, adjustments and controls can be made at these borders; absence of internal posts can create arbitrage and fraud opportunities when combining different tax rates with the destination principle. - Efficient risk control systems and information sharing are necessary; these challenges exist even for advanced European CTAs. ### Costs and institutional requirements for establishing a customs union - Establishing a CU implies costs from: - Coordination efforts (meetings, joint audits, integrated information systems). - Training. - Infrastructure investment (customs ports, warehouses, scanners, computers). - Other related costs. - Lessons from international experience: - Institutional building is critical to support the process. - Internal customs controls are often maintained for long periods. - A coherent, integrated strategy to adopt legal and administrative standards is needed. - Political reluctance to transfer competency to supranational/regional institutions is another reason for fewer CUs compared with other regional trade agreements. ### European Union experience (summary of evolution and operational lessons) - Treaty of Rome (1957) established a CU and calendar for dismantling customs duties; the process toward a “complete” CU took almost 40 years. - Until 1992 (Maastricht Treaty), internal customs controls were in place throughout Europe; since 1993 the EU has operated without internal customs controls and goods from outside are cleared at external customs at first port of entry. - Tariffs collected on these goods flow into a common fund that is part of the EU general budget. - Elimination of internal customs controls led to a VAT regime with no border charge for intra-Community transactions; VAT payment is deferred until declared in the next VAT return; goods subject to special taxes circulate under special relief arrangements. - EU operational minimum requirements developed over years include: - Strong administrative cooperation among CTAs, automatic information sharing, integrated IT systems (example: VIES system), risk systems and fraud prevention, standardized sanitary and para-customs controls, full harmonization of the CET and trade policy toward nonmembers, unified customs procedures (European Customs Code), and improved external customs facilities. - Despite progress, fraudulent schemes remain serious problems: - VAT carousel fraud has involved losses of about 10 percent of net VAT revenue in some countries and prompted proposals for radical VAT collection changes (e.g., reverse charge mechanism). ### Other customs union experiences and characteristics - Many existing customs unions are “incomplete” (examples cited): SACU, GCC, Mercosur; each follows a different integration model suited to member circumstances and political commitments. - SACU: - Oldest CU, dating to 1910; marked by economic and political asymmetries and weak administrative capacity. - 2002 agreement created a new model for distribution of customs and excise taxes: customs duties distributed based on share of each country in intrazone imports; excise tax revenue distributed on share of each country in regional GDP. - Common problem: access to reliable statistical information to support revenue-sharing mechanisms. - GCC: - Established in 1981; CU process started in 2003 as part of plan for a common currency and common market in 2010. - Internal border controls are mainly administrative to monitor alcohol and arms; scheduled to be eliminated by 2012. - During transition, tariffs are collected at the first point of entry into the GCC and distribution is based on final destination of goods; plans to introduce a common fund for tariffs exist but no fund yet. - Gulf states have not introduced a VAT, although introduction is planned; work is under way to design a VAT that mitigates intra-Community VAT fraud risks. - Example: Dubai is principal importer and most efficient first point of entry; customs clearance in Saudi Arabia takes 16 days versus 3 days in Dubai. - Mercosur: - Created by Treaty of Asunción (1991); after a four-year transition phase, established in 1995 as an incomplete CU with free circulation of goods for about 80 percent of intraregional trade. - Lists of exceptions still apply to sensitive goods; CET is applied but with exceptions for a fixed number of goods by country; lists reviewed every 6 months. - Mercosur retains internal customs controls and verification of origin; no common distribution fund; in some cases double collection of CET occurs (external and internal borders). - Common customs code exists but had not been ratified by all members as of the source text; ratification was a goal to be achieved in 2008. - Large asymmetries among member countries’ customs capacity pose risks for eliminating internal customs posts. - Other CU examples mentioned: EAC, EU-Turkey CU, EU-San Marino CU, Economic and Monetary Community of Central Africa, WAEMU, SADC, COMESA. ### Key tax and customs principles for the Central American Customs Union (CACU) - Framework Agreement signed in December 2007 defined key characteristics of the CACU: - Elimination of quantitative restrictions and charges having an equivalent effect as a customs duty. - Adoption of common legal and normative standards. - Maintenance of internal customs posts. - Transfer of taxes collected at the border to countries of destination (i.e., no establishment of a common fund). - Strengthening of existing institutional framework without creating a supranational body. - Remaining decisions and challenges for designing the CU model include administration of exceptions (sensitive goods, CET, numerous tax exemption regimes—zonas francas), implementation, coordination and control issues, and institutional capacity building. ### Specific implementation issues for CACU - Free circulation of goods: - High portion of goods originating in Central America already circulate without tariff and nontariff restrictions. - Decisions pending for “Annex A Goods” (products facing restrictions): sugar (all five members); ground coffee—unroasted coffee (all five members); roasted coffee (between Costa Rica and all others); oil products (between Honduras and El Salvador); ethyl alcohol (between Honduras and El Salvador and between Costa Rica and El Salvador); and alcoholic beverages (between Honduras and El Salvador). - Incomplete CUs often operate with lists of sensitive goods temporarily; additional customs controls needed to certify origin and classification and discourage fraud. - Maintenance of internal customs posts: - Given current economic and institutional context, maintaining internal customs posts is justified for the foreseeable future to monitor exception lists, collect domestic consumption taxes, and control prohibited goods (drugs and arms). - Central American countries are still developing reliable VAT collection and enforcement systems; customs controls at internal borders will be needed until such systems are adequate. ### Box 5.2 — Main features of the Framework Agreement for Establishing the CACU (selected points) - General: Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua reaffirm intent to establish a customs union based on existing integration tools and Article XXIV of GATT. - Phases: three main phases — (1) promotion of free circulation of goods and trade facilitation, (2) modernization and convergence of the legal framework, (3) institutional development. - Customs control: internal customs posts will continue to operate and promote coordinated efforts to facilitate trade and collect revenue. - Quantitative restrictions and equivalent charges: permits, licenses, quotas, or other equivalent measures that hinder trade among members will not be allowed. - Sanitary/veterinary standards and nontariff barriers: member countries will develop common systems and definitions. - Modernization/convergence of legal framework objectives: - Reach full harmonization regarding the common external tariff (CET). - Establish external customs points as entry points for goods from outside the CU. - Harmonize regional legal framework related to all areas covered by the agreement, considering prior international trade commitments. - Promote gradual convergence of different FTAs signed by each member country. - Tariff regime: unique tariff system regarding the Harmonized System (HS) code, descriptions, and tariffs; establish mechanisms to administer the tariff regime when fully harmonized. - Procedures and requirements: coordinate customs services to apply same procedures, forms, requirements, deadlines; apply common IT systems and similar staff conduct guidelines; harmonize non-customs requirements and services (sanitary, veterinary, quality control). - Origin of goods: COMIECO will act to ensure convergence of rules of origin. - Tax regime: member countries will apply the principle of destination to international trade operations and agree on mechanisms for collecting taxes on international and intraregional trade. - Institutional development: establish principles for institutional strengthening required for adequate operation and consolidation of the CU. - Structural and investment fund: member countries will establish an international structural and investment fund targeted to contribute to sustainable development. *Source: Excerpt from CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS (chapter on Challenges for Tax and Customs Administration), IMF document _dp0801* ### Box 5.3. Joint Customs Posts Currently in Operation in Central America ### Box 5.3. Joint Customs Posts Currently in Operation in Central America ### Purpose and rationale - The Central American countries started a pilot project of joint operations in some internal and external customs. - The project is important as a way of sharing experiences, adopting harmonized procedures, and facilitating trade. - Despite the existence of a Unified Manual of Customs Procedures (signed by Guatemala, Honduras, El Salvador, and Nicaragua), customs operations and procedures in the region are far from harmonized, and there are inconsistencies even within countries. - The absence of a stable, professional customs career system in some countries has hindered human resource development and the creation of a corps of customs officers who can interpret and apply customs norms consistently. - The pilot project is a good opportunity to identify differences in the application of standards and practices, and to narrow these gaps. ### Joint internal customs border posts in operation - El Amatillo, El Salvador (El Salvador–Honduras) - El Poy, El Salvador (El Salvador–Honduras) - Las Chinamas, El Salvador (Guatemala–El Salvador) - El Guasaule, Honduras (Nicaragua–Honduras) ### Joint external customs (mainly ports) in operation - Puerto de Acajutla (El Salvador–Guatemala) - Puerto Cutuco (El Salvador–Guatemala) - Tecún Uman (El Salvador–Guatemala) - Puerto Quetzal (El Salvador–Guatemala) - Puerto Santo Tomás de Castilla (El Salvador–Guatemala) - Puerto Barrios (El Salvador–Guatemala) - Puerto Cortés (El Salvador–Honduras) - Peñas Blancas (Nicaragua–El Salvador–Guatemala) *Source: Box 5.3, "Joint Customs Posts Currently in Operation in Central America" (excerpt).* ### Box 5.5. The EU Fiscal Blueprints: Setting a Benchmark for ### Box 5.5. The EU Fiscal Blueprints: Setting a Benchmark for Customs and Tax Administrations ### Overview of the Fiscal Blueprints (FB) - The fiscal blueprints (FB) exercise provides benchmarking that Central American CTAs could follow as a preparatory step toward strengthening the region’s institutions and preparing them for implementing the CACU. - Quoted definition: “The fiscal blueprints are practical guidelines laying down clear criteria based on EU best practice, against which a tax or fiscal administration is able to measure its own operational capacity. They can be used to analyze gaps between the existing situation in individual countries and the blueprint standards and thus provide a basis for plans to undertake fiscal reforms.” - The EU defines two main purposes of the fiscal blueprints: - (1) to provide a set of best practices and recommendations for tax administrations - (2) to serve as a tool for the tax administration to provide a speedy and clear identification of its strengths and weaknesses. - Development history: - The FBs were developed in 1999, during a period of EU expansion, “to serve as a tool for the candidate countries for accession to the EU to enhance their administrative capacity in adopting, applying and enforcing the Community legislation in preparation for membership.” - This exercise was carried out in cooperation with the Intra-European Organization of Tax Administration (IOTA). - Current version referenced: EU Fiscal Blueprints (2007). ### Structure and key content of the FBs - The current version of the Fiscal Blueprints (2007) has fourteen chapters, each specifying an overall aim, strategic objectives and key indicators: - 1) Framework, structure and basis: Overall framework of a tax administration; structure and organization; tax legislation. - 2) Human and behavioral issues: Ethics; human resources management. - 3) Systems and functioning: Revenue collection and enforcement; tax audit; administrative cooperation and mutual assistance; fraud and tax avoidance. - 4) Taxpayer services: Taxpayer rights and obligations; systems for taxpayers’ management; voluntary compliance. - 5) Support: Information technology; communications. ### Recommendations and benchmarks for Central American integration (CACU preparatory steps) - Policy and trade-framework recommendations: - Review and harmonize the CET, taking into account the need to review bilateral trade agreements and formulate a clear policy in this area. - Work toward the gradual convergence of the various free trade treaties, in particular the bilateral agreements signed by each of the countries with non-member countries. - Review and approve the new version of the common customs code (CAUCA IV) and the relevant regulations (RECAUCA), in accordance with the standards in each country and with the framework agreement. - Review and harmonize the regional regulations in the areas covered by the framework agreement, especially specific rules of origin, customs transit, sanitary and phytosanitary measures, security measures, technical barriers to trade, trade defense, trade in services and investments, rules of public procurement, intellectual property, competition policy, and public procurement. - Analyze and review documents and agreements related to the coordination of domestic taxes (a key aspect is convergence with respect to exemptions and incentives). - Adopt the Agreement on Good Investment Practices, with a view to adopting a common policy on tax concessions for free trade zones in the region and to establishing a “level playing field” for the countries competing for foreign investment. - Implement the agreements on information sharing and agreements on mutual assistance and technical cooperation; start building knowledge on advanced issues, such as transfer pricing rules, thin capitalization, and treaties to avoid double taxation (these issues have started to be addressed in some meetings of the regional ministers of finance). - Strengthen the Central American Customs and Tax Training School. ### Administrative and operational requirements (benchmarks and minimum standards) - Establish good practices and identify minimum standards for the CTAs in the region. - Define and implement IT systems with minimum functionalities, flexible responses, and high communicability (in particular, attention should be given at the outset to the operating status of the customs systems: unified customs information system, electronic sharing of customs data forms, the electronic transmission of international transit declarations, etc.). - Strengthen external customs posts. - Harmonize procedures and risk analysis criteria for customs control, with clear channel selectivity and also separation of the prior, immediate, and ex post audits. ### Challenges for Tax and Customs Administration (operational priorities) - Streamline and clean up the taxpayer registers, managing reliable data information that will be the crucial backbone of all exchanged information in the region. - Expand e-filling and e-payment for all types of taxpayers throughout the region. - Strengthen taxpayer services, including online help (websites and e-mails), giving attention to providing clear and targeted information for economic operators doing business in the CACU area. - Start a coordinated program of tax education to reach taxpayers in the region, focusing on the CACU requirements and encouraging better compliance in the whole region. - Apply massive controls and cross-checking methods to all taxpayers, but focus audit efforts (external audits) on targeted, high-value cases (selected through risk analysis). - Strengthen key areas in the fight against smuggling and fraud: customs and domestic tax intelligence, audit, and control; and increase cooperation among such areas. ### Conclusions and implementation approach for the CACU - Signing the framework agreement to establish the CACU poses great challenges for the Central American countries and their CTAs. - At their current level, the Central American CTAs have clear needs for improvement when compared with international models of good practices. - A further challenge is implementing a customs union in a region characterized by a large informal economy, high levels of evasion and fraud, and relatively low levels of revenue collection. - Effective implementation of the CACU will require considerable efforts among the Central American countries at the strategic, institutional, and operational levels. This should be based on an agreed-upon and well-defined strategic plan for the future development of the CACU. Such a plan should specify: - clear strategic guidelines, - related operational activities, - funding and resource allocation for each activity, - the responsible institutions for each activity, - sequencing of the activities and the linkages among them, - realistic targets, - performance indicators, and - deadlines. - A gradual approach to establishing the CACU is appropriate. However, efforts should be made to minimize the transitory phase and to reach the full benefits of a complete customs union. This effort should begin with the establishment of an effective free trade area in the region, while standards are prepared and institutions are strengthened to pave the way for the customs union. ### Basic goals in the CACU process - Creation of a single customs territory, in the form of an FTA with free circulation of goods, which will require harmonizing technical restrictions. - Temporary provision for sensitive goods or sectors, along with a clear definition of the role of internal customs posts. - Gradual convergence of the free trade agreements signed by each country with nonmember countries, especially with respect to the level of tariffs, convergence deadlines, rules of origin, and the volume of goods involved. - Establishment of a CET that is eroded as little as possible by discrepancies, asymmetries, and bilateral free trade treaties. - Definition of a regional trade policy. - Institutional capacity building to support the entire process, based on staff training, integrated IT systems, risk analysis, harmonized procedures, and the achievement of minimum standards in all key areas. *Source: EU Fiscal Blueprints (2007); text as presented in Box 5.5 of the chapter.* ### Introduction ### _dp0801 - Introduction ### Financial structure and market size - Banks and their affiliates dominate financial intermediation in Central America. - Assets in the banking system: 80 percent of regional GDP. - Assets of pension funds, insurers, and mutual funds: 9 percent of regional GDP. - Bank lending to the private sector ranges from 19 to 82 percent of GDP across countries, and 42 percent of the region. - Equity and bond financing provided by capital markets: 12 and 6 percent of GDP, respectively. - The chapter documents that until recently regional financial conglomerates dominated the banking system; recent acquisitions by global financial institutions (examples cited in source) have increased global banks’ regional presence. ### Causes of capital market underdevelopment - Structural and business factors: - Small size of most regional businesses. - Dominance of family-owned businesses and conglomerates. - Gaps in corporate governance and disclosure that generate informational asymmetries and favor bank financing. - Market composition and liquidity: - Little use of asset-backed securitization (ABS) except in Panama and Costa Rica. - Institutional investors aggregate resources: barely 9 percent of regional GDP, limiting long-term demand for securities. - Confidence and contract enforcement: - Episodes of financial distress (bank failures, mutual fund crisis, sovereign debt problems) and political strife have weakened confidence. - Problems with execution of collateral, lengthy and unpredictable judicial proceedings, and outdated bankruptcy laws impede retail demand. ### Regulation and supervision of securities markets - Legal and regulatory framework gaps: - Shortcomings include corporate governance for listed companies, regulator powers, division of oversight between regulators and exchanges, and cross-jurisdiction cooperation. - Important gaps: ABS framework (El Salvador, Guatemala, Dominican Republic, Honduras) and mutual funds (El Salvador, Guatemala). - Guatemala and Nicaragua have the farthest to go to complete basic securities laws; Nicaragua approved a new securities law in 2006 but lacked implementing regulations. - Authorization process for issuance: - Approval focuses on formal requirements rather than material issues affecting transparency/value. - Authorization often protracted (often six months or more), costly, and uncertain, incentivizing bank loans over securities issuance. - Some regulatory remedies: deadlines for comments and authorization (Costa Rica; Costa Rica, El Salvador, Panama), and fast track/shelf registration (Costa Rica; Panama for commercial paper). - Structure, independence, and resourcing of regulators: - Costa Rica, the Dominican Republic, El Salvador, and Panama have specialized securities regulators; Honduras and Nicaragua house securities regulation within broader financial-sector units; Guatemala has only a securities registry. - Governing boards often include finance ministers or central bank governors (except Honduras and Panama), potentially reducing independence. - Funding: public sources account for 75–100 percent of regulator budgets in Guatemala, El Salvador, Costa Rica, and Nicaragua; Panama and Honduras have different mixes. - Staff and budget tiers: - Guatemala, Honduras, Nicaragua: staff < 10. - El Salvador and Panama: staff ~40 and budget ≈ US$1.5 million. - Costa Rica and the Dominican Republic: personnel in the hundreds and budgets ≈ US$4 million. - Enforcement: generally weak across the region due to legal framework limitations and a culture of weak enforcement. ### Market infrastructure: exchanges, clearing, settlement, custodial services - Securities exchanges: - Exchanges exist in all seven countries; Guatemala has two exchanges. - Majority are mutualized corporations, except El Salvador, Nicaragua, and Panama (demutualized). - All exchanges have electronic automated systems except Honduras. - Continuous trading systems only in Costa Rica and Panama. - Trading systems are order driven; no market makers except a pilot project in Costa Rica (two companies volunteered; one market maker appointed). - Some exchanges enjoy privileges (e.g., primary public debt issuance restricted to exchanges in several countries; mandatory routing of certain transactions through exchanges in Costa Rica, Guatemala, Nicaragua). - Clearing and settlement: - Legal frameworks deficient in netting, novation, irrevocability, and finality; addressed in a regional treaty under legislative ratification. - Settlement cycles vary: El Salvador, Costa Rica, and Panama settle at t + 3 (t + 1 in Costa Rica for debt); Dominican Republic and Guatemala at t + 1; Nicaragua and Honduras have no standardized cycle. - Clearance/settlement arrangements differ: Costa Rica does multilateral netting; El Salvador and Panama do cash-side netting and gross securities-side settlement. - Risk management: Guatemala and Honduras have no formal mechanisms; Costa Rica and Panama are more advanced. - Only Costa Rica and Panama achieve delivery versus payment (DVP). - Depository and custodial infrastructure: - Custodial infrastructure underdeveloped and insufficiently centralized; public debt often not dematerialized and CSD functions sometimes performed by central banks or public banks. - Honduras has no centralized securities depository (CSD). - CEVALDOM (Dominican Republic) and Latin Clear (Panama) pursuing alliances to improve technology and capital base; Costa Rica, El Salvador, and Panama have signed sub-custody arrangements. - Dematerialization required only in El Salvador; Nicaragua requires dematerialization for listing; Costa Rica and Panama require immobilization for trading. In practice most new private securities issuances are dematerialized, but some jurisdictions (Panama) permit requesting paper securities afterward. ### Markets for ratings and price vendors - Rating agencies present throughout the region except Nicaragua; local agencies often affiliated with Fitch; U.S. national rating agencies have no direct presence. - Licensing/supervision of rating agencies varies; some jurisdictions require local ratings. - Illiquid securities and insufficient price vendors create valuation problems for mutual and pension funds: - Only Costa Rica and Panama have made progress addressing price valuation practices. - PIPCA announced in June 2007 it will start providing prices to investors in Costa Rica, Panama, and El Salvador (as reported in source). ### Business environment, accounting, auditing, and legal frameworks - Business environment indicators are generally low (World Bank Doing Business rankings cited: in 2006 El Salvador ranked 71 of 175 countries; Guatemala ranked 118). - Accounting: - Unlisted companies generally not required to use IFRS in Guatemala, Honduras, and Nicaragua (Honduras to require IFRS from January 2008); El Salvador applies IFRS as of 2003; Costa Rica, the Dominican Republic, and Panama require IFRS for unlisted companies. - Implementation challenges due to lack of familiarity. - Auditing: - Qualifications for auditors generally low; professional examinations not required; continuous education not mandatory. - Oversight of audit profession is limited; higher standards often required only for auditors of regulated entities or listed firms. - Corporate and commercial laws: - Registration procedures not the major constraint (some scope to streamline); Panama has the most efficient registration process in Latin America per source. - Problems with constitution and execution of collateral: delays in registration, lack of movable-assets pledge registration, lengthy judicial enforcement. - Bankruptcy laws outdated across the region; reforms in some countries (Costa Rica, Dominican Republic) to permit reorganization proceedings, but limitations exist. - Taxation: - Tax treatment generally favors public debt over private securities and bank deposits over debt and equity securities. - Interest and capital gains from private debt and equity generally taxed at higher rates than corresponding public debt; dividends subject to double taxation in many cases. - Costa Rica: complex framework with different tax treatments by issuer, currency, and investor. - El Salvador: appears most neutral; Dominican Republic close second. ### Regulatory framework for public issuance - Listed companies (except in Guatemala) required to use IFRS or U.S. GAAP and to audit and publish financial statements. - Regulators have tightened accounting, auditing, and disclosure requirements for public issuers, and have imposed additional auditor independence/professional requirements in many cases. - Equity issuance: - Minimum issuance amount for equity specified only in Costa Rica: C 100 million (about US$2 million). - No country requires a minimum float. - Disclosure requirements for equity issuers are weak across most countries (timely disclosure of insider/substantial holdings, material events, and prospectus standards often deficient). - Corporate governance and minority protection frameworks are weak; mandatory tender offers on acquisition of control exist in four countries (Costa Rica, the Dominican Republic, Honduras, Panama under certain circumstances); codes of corporate governance exist only in Honduras and Panama (require strengthening). - Corporate debt issuance: - Disclosure requirements more complete than equity; main weakness is timeliness of material-event disclosure (Guatemala notably weak). - Most countries (except Panama) require a rating for each issue; in some countries two ratings are required in certain circumstances (Honduras, Dominican Republic). - Authorization and post-issuance supervision: - Authorization needs streamlining; processes often sequential, bureaucratic, and inconsistent across time/issues, prolonging approvals to six months or more. - Review of periodic disclosure limited: supervision often limited to verifying timely submission rather than content; enforcement weak in several countries. ### Institutional investors: pension funds, mutual funds, insurers - Pension funds: - Aggregate assets ~ US$7.4 billion at end-2006, or about 5.4 percent of regional GDP. - Aggregate assets significant only in El Salvador and Honduras (about 19 percent of GDP) and in Costa Rica (7 percent). - Pension funds face tight investment limitations: equity investment capped at 10 percent of total portfolio in any country; corporate debt and ABS tightly restricted. - Private pension fund frameworks have gaps in Guatemala, Honduras, Nicaragua, and Panama. - Mutual funds: - Exist in only two countries: Costa Rica and Panama (El Salvador and Guatemala have quasi-mutual fund products). - Mutual funds industry: 163 mutual funds with aggregate assets ≈ US$2.1 billion (Table 6.4); average mutual fund manages about US$12 million. - Mutual funds industry faces scale and product-diversity constraints and image problems from past informal pooled products. - Insurance industry: - Penetration rates very low, especially in life and annuities; assets under management 0–5 percent of GDP. - Fragmented: 105 insurance companies operating at end-2006. ### Equity markets: status, incentives, and obstacles - Current status: - No equity markets in four of seven countries: Guatemala, Honduras, Nicaragua, and the Dominican Republic. - Small and shrinking markets in Costa Rica, El Salvador, and Panama. - Market capitalization: El Salvador and Panama about 40 percent of GDP; Costa Rica about 8 percent of GDP. - High concentration: top five companies make up >50 percent of capitalization in El Salvador and >66 percent in Costa Rica and Panama. - Low turnover: only 1 and 3 percent of market capitalization changes hands per year in some markets. - At end-2006, 88 equity issues listed regionally: Costa Rica 18 (25 in 2001), Panama 24 (28 in 2001), El Salvador 43 (40 in 2002). - New equity issuance volume fell from US$270 million in 2002 to US$95 million in 2006. - Supply-side constraints to equity issuance: - Small firm size and family ownership leading to aversion to minority shareholders and limited free float. - International acquisitions prompt founders to prefer whole-business sales rather than public flotation. - Information secrecy for competitive and tax reasons deters public offering. - Protracted issuance processes (sometimes up to six months) encourage listings abroad or bank finance. - Bank financing is relatively cheap and fast due to high banking liquidity and “house” bank relationships. - Tax treatment discourages equity (equity income subject to corporate income tax, dividends, and capital gains tax). - Lack of secondary-market liquidity reduces issuer interest (limited price discovery, poor exit options). - Demand-side constraints: - Underdeveloped institutional investors: few mutual funds and constrained pension funds. - Poor diversification opportunities in domestic securities; regional portfolio construction difficult without a seamless market. - Corporate governance and investor protection concerns dampen domestic and foreign investor demand. ### Corporate debt markets: status and incentives - Current status: - Regional corporate bond markets grew from US$6.3 billion in 2001 (6.6 percent of GDP) to US$8.3 billion in 2006 (6 percent of GDP). - Costa Rica accounts for 60 percent of regional corporate debt outstanding; Panama ≈ 25 percent; El Salvador is the only other country with a measurable debt market. - Costa Rica corporate debt grew from US$3.0 billion in 2001 to US$5 billion in 2006; in Costa Rica total corporate debt ≈ 23 percent of GDP in 2006. - Features: more liquidity in secondary bond markets than equities; most issuers are financial institutions (mainly banks); maturities typically 3–12 months (some up to 3–5 years). - ABS issuance minimal regionally except Panama (12 securitizations, 11 mortgage-backed). - Institutional demand: - Banks provide most demand for corporate debt (sometimes tax-driven). - Pension funds important institutional investors in Costa Rica and El Salvador. - Regulations in most countries bias allocation toward government securities. - Foreign investors and high net worth individuals important in select markets (noted interest in El Salvador and Panama). - Incentives and impediments: - Macroeconomic factors: dollarization (Panama, El Salvador fully dollarized) fragments markets between currencies; public debt management problems hamper benchmark yield curve development. - Information and rating constraints: poor financial disclosure limits investment-grade ratings; mandatory ratings (except Panama) are common; in some cases two ratings or multiple approvals are required (Honduras, Dominican Republic). - Mark-to-market accounting seldom used; tax rules may not recognize mark-to-market, discouraging trading. - Supply-side: family-controlled firms prefer bank financing; excess banking liquidity competes with bond markets; fixed costs of issuance and small issuer size limit viable issues. - Demand-side: crowding out by government securities (tax advantages, reserve treatment, liquidity) reduces investor appetite for corporate debt. ### Asset-backed securities (ABS) - Current status: - ABS markets incipient: limited transactions—Panama 12, Guatemala 1, a few in Costa Rica; several securitizations structured abroad in foreign law/currency. - Problems impeding ABS issuance: - Legal framework gaps: El Salvador and Guatemala lack specific ABS laws; Dominican Republic and Honduras have few provisions; trust laws absent in Dominican Republic and Nicaragua. - Little economic incentive due to bank appetite to hold assets given large liquidity and emphasis on balance-sheet size. - Banks’ inexperience and regulatory uncertainty about ABS issuance and rating. - Taxation: creation/transfer of mortgages can attract multiple taxes (stamp taxes, municipal taxes, financial transaction taxes), discouraging transfers to special-purpose vehicles. - Nonstandardized mortgage origination and linkages to bank deposit rates hinder securitization. - Infrastructure deficiencies: real estate registries obsolete in some countries (e.g., Nicaragua). - Opportunity: - ABS offer potential to expand domestic fixed-income markets and create highly rated securities attractive to pension/mutual funds and retail investors. - Panama example: enabling legal/tax frameworks, standardized mortgages, and dollarization supported ABS growth and placements with domestic and foreign investors. - Foreign acquirers of regional banks and global financial institutions’ presence may boost ABS issuance and expertise. ### Scope for policy action and regional integration - Costs of underdeveloped capital markets: - For businesses: potentially lower valuations, higher financing costs, constrained growth prospects, and more difficult exit options for major shareholders—especially medium-sized businesses. - For investors (pension, mutual funds, insurers, retail): inability to attain well-diversified regional portfolios; disproportionate costs borne by local investors compelled to invest regionally. - For banks: long-run strategic weakness from lack of access to capital markets and limited securitization options, increasing concentration risk in banking systems. - For public policy: small/illiquid markets reduce foreign portfolio investment, complicate policy-based investment restrictions, and constrain financing for housing/infrastructure and privatizations. - Limited scope for developing individual country markets: - Four countries (Dominican Republic, Guatemala, Honduras, Nicaragua) unlikely to develop sustainable domestic stock markets soon; issuers may prefer listing in Costa Rica, El Salvador, or Panama. - Even the three better-developed markets (Costa Rica, El Salvador, Panama) collectively had only 90 stocks at end-2006, with limited free float and liquidity; total market capitalization ≈ US$16.4 billion (end-2006), with top 15 stocks ≈ US$11.4 billion. - Individual exchanges can absorb issuances up to US$50–$100 million but lack appeal to large/global issuers and investors. - Case for regional integration: - Given small issuance volumes and limited liquidity, regional integration could provide economies of scale and a larger investable universe. - International precedents (U.S., India, Euronext, OMX) show consolidation and integration trends, though no single model directly maps to Central America. - The chapter suggests examining regional integration as a potentially effective way to bolster issuance, liquidity, and investor interest, while recognizing significant implementation and coordination challenges. *Source: _dp0801 - Introduction (PDF chapter content provided).* ### Box 6.1. Steps Toward Integration of Regional Capital Markets ### Box 6.1. Steps Toward Integration of Regional Capital Markets ### Recent initiatives and institutional actions - Regulators: - El Salvador and Panama signed a memorandum of understanding (MoU) in 2003 committing to a fast track registration. - In 2003 Panama granted El Salvador the status of recognized jurisdiction; in practice mutual recognition has not worked well because Panamanian firms wishing to list in El Salvador faced additional regulatory requirements. - In 2003 El Salvador and Costa Rica signed an MoU to engage in best efforts to streamline the registration process; limited progress beyond clarifying main differences between the two regulatory frameworks. - In 2004 Panama and Costa Rica initiated a similar process; Costa Rica chose not to sign an MoU, preferring moves toward more uniform regional standards before such agreements. - In 2005 Panama unilaterally recognized Costa Rican jurisdiction allowing fast track registration of Costa Rican issuers in Panama. - As of now, Panama has given a fast track registration to eight corporations and mutual funds originally registered in El Salvador and Costa Rica. - A 2006 regional seminar by the Toronto Center prompted regulators to explore implications of regional integration; the Dominican Republic proposed creation of a Central American Institute of Securities Markets. - Regulators agreed to create a council of Central American superintendents and requested a second Toronto Center seminar on global experience and next steps. - Security exchanges: - Bolcen (Association of Central American and Caribbean stock exchanges) created in 1994 to promote capital market development and aim for one single market with interconnected exchanges; limited progress to date. - Costa Rica, El Salvador, and Panama stock exchanges signed an MoU in September 2006 to develop a common trading platform for real-time trading across the three markets through correspondent local brokers, targeting development by March of 2007; technical problems (different settlement conventions, disagreement on common trading) have stalled the project. - The exchanges sought technical support from OMX. - The Panama Stock Exchange is exploring an order-routing system with South American countries whereby local intermediaries would place client orders to buy and sell foreign exchange listed securities to those exchanges for a fee. ### Key challenges to regional market development - Structural and institutional heterogeneity: - Region not fully integrated in economies, monetary or fiscal policies. - Important divisions include currencies, restrictions on domestic institutional investors, presence of as many as eight exchanges and custodians, mutual structure of most exchanges, and competing exchanges and custodians. - Regulatory concerns and risks (summarized from Tafaris and Peterson, 2007): - Permitting foreign access to local investors without direct oversight could create unknown risks to investors and capital markets, with regulators lacking powers to investigate or discipline foreign issuers or intermediaries. - Risk of regulatory arbitrage if issuers/intermediaries register in jurisdictions with weaker investor protection while accessing other local markets. - Difficulty for local investors to understand differences among investment options subject to differing frameworks. - Legal, political, and reputational risks for regulators if scandals arise involving foreign participants operating under different conditions than locals. - Operational challenges: - Current variety of trading platforms and settlement systems are incompatible: variations in settlement cycles, degree and requirement of dematerialization, and degree of delivery versus payment. - Lack of a common currency implies integration may require a platform capable of trading and settling multiple currencies. - Practical challenge of multiple exchanges, CSDs, settlement banks, and related institutions agreeing to collaborate, share costs, and appoint common management while avoiding interruption of existing trading arrangements. ### Key elements and phased strategy for successful integration - Preconditions for regulatory confidence and cooperation: - (1) Comfort in requirements established by the home country regulator. - (2) Comfort with capacity of the home country regulator for reviewing issuer information. - (3) A robust framework permitting exchange of information and cooperation. - (4) Regional legal frameworks that meet minimum standards of investor protection and regulatory authority. - Suggested three-pronged strategy: - (1) Incremental harmonization of regulation and supervision. - (2) Mutual recognition of foreign securities and regulatory actions (e.g., registration, licensing, submission of periodic information, off-site and on-site supervision). - (3) Raising/converging regulatory capacity to regionally appropriate standards (e.g., staff strength, quality, training, implementation of common manuals). - Operational and implementation notes: - Harmonization: countries needing new laws/regulation should seek regional counterparts with similar needs or prior experience, aim for regional/international standards, and minimize national deviations. - Mutual recognition could take the form of “blanket” acceptance of securities admitted in another jurisdiction or fast track approval processes focusing on disclosure to foreign jurisdictions while minimizing substantive approval. - Use of third-party consultants to facilitate process and maintain regional commitment and confidence. - Phasing: more developed markets could lead legal and regulatory harmonization; phased application of harmonized standards to brokers, issuers, and markets before full extension to all participants. ### Possible configurations and strategic considerations - Scope of a common market: - A common regional securities market linking the seven Central American countries may be sensible, but alternatives include bilateral integration with more developed neighbors (e.g., Mexico or Colombia) or formation of smaller exchange groups. - Arguments against full seven-country integration: burden on more developed markets to upgrade others, greater private-sector incentives to integrate with larger neighbors, and ease of bilateral adoption of a senior partner’s standards. - Arguments in favor: relatively small size of the seven economies compared with Colombia, Peru, Mexico, or Venezuela; common language; physical proximity; political appeal and acceptance; other regional initiatives (common customs union, supervision of financial conglomerates); existence of regional political bodies and association of exchanges. - Practical outcome: many issuers may find a regional securities market more appropriate than migrating to more developed foreign markets. - Market structure: - Integration need not imply a single physical location; convergence could maintain separate exchanges linked to a common electronic platform, ownership/shareholding arrangements, and gradual replacement of multiple institutions. ### Lessons from Nordic/Baltic experience (Box 6.2) - OMX consolidation timeline and outcomes: - OMX began as a derivative exchange in 1985; merged with Stockholm Stock Exchange in 1998 initiating joint trading platform for Nordic exchanges. - Common member and trading rules instituted in 2001. - Merger of OMX and HEX (including Tallinn and Riga exchanges) in 2003; acquisition of Vilnius Stock Exchange in 2004; mergers with Copenhagen (2005) and Icelandic (2006) Stock Exchanges. - OMX directly or indirectly owns central securities depositories in most of these countries and accounts for more than 80 percent of the exchange trading in the Nordic and Baltic countries. - OMX is the fifth largest equity exchange and third largest equity derivatives exchange. - In 2007, OMX and NASDAQ announced their intention to combine the two companies. - Relevance and lessons for Central America: - Initiative led largely by the private sector; process difficult and took years; often involved acquisition/merger of one exchange at a time with CSD integration usually following. - Some exchanges retained separate legal identity as subsidiaries operating under different local securities laws and regulators while sharing common trading system, listing and index structures, cross-border trading and settlement, cross-membership, and a single market source of information. - Practical solutions included two lists (Nordic and Baltic) with varying listing standards and adopting English as corporate language. - Implication: merging exchanges is complex and may take years and strong leadership; several paths exist (e.g., shared technology platform, formation of exchange groups) that can yield substantial benefits of a regional market. ### Policy and leadership recommendations - Political and strategic leadership: - Regional authorities may need to establish the vision and provide strategic leadership and consensus; national regulators and private sector actors may lack the authority or neutrality to steer the process alone. - May require resolution by political authorities and creation of a regional tripartite working group to spearhead work. - Existing analyses and initiatives can be harnessed with external support (e.g., Toronto Center and/or interested international financial institutions) to jump-start the process. - Role of the private sector and public incentives: - Private sector should lead market-integration arrangements, particularly for marketplace integration and technology. - Public sector can provide powerful incentives (decisive signals to harmonize regulation; government efforts facilitating listing and trading in shared/linked marketplaces). - About 90 percent of market capitalization and trading in securities is in government securities; regional government efforts to facilitate listing/trading could be the most powerful driver of integration. - Overall assessment: - Articulating and pursuing a regional capital market integration vision is major and radical; success unlikely without years of hard work, strong political commitment, regulatory harmonization, and operational coordination. - Without such effort, the region may fail to achieve many benefits of an efficient and liquid capital market; opportunity costs warrant sustained regional effort. *Source: Box 6.1, “Steps Toward Integration of Regional Capital Markets,” in the supplied IMF content unit.* ### Conclusions ### Conclusions ### Overall Approach - Remedial measures should focus on the removal of obstacles and expansion of potential opportunities, rather than direct promotion, tax concessions, or subsidies aimed at capital market transactions. - The following summarizes the main insights and recommendations of this chapter (Table 6.A12). ### Securities Laws and Regulation - The regional legal framework needs strengthening in several areas. - Securities laws need to be updated in most countries, and overhauled in El Salvador. - Securities laws need to be amended to: - provide to regulators better and clearer powers over the market and its participants, - widen the range of sanctions, - facilitate MoUs and the exchange of information between regulators, as well as with the stock exchanges. - Regulatory framework for mutual funds, asset-backed securitization, and derivatives need to be completed or thoroughly modernized in several countries, and particularly in Guatemala, Nicaragua, and El Salvador. ### Securities Regulators - Need to strengthen the budget and staff of securities regulators in El Salvador, Guatemala, Honduras, and Nicaragua. - Regulators may wish to make maximum use of regulation, laws, and good supervision practices already available within the region and elsewhere, and develop required regulation jointly. - No specific recommendation on regulatory structure (e.g., within or outside the central bank, or a combined or single regulatory agency); arrangements should: - ensure a degree of independence to the regulators, - ensure the ability to attract and retain the right staff, which may require independence from civil service pay scales. - Need to substantially simplify and speed up the issuance approval process in most of the region because the process is generally considered bureaucratic, lengthy, uncertain, and involving multiple levels of scrutiny. - Measures to improve issuance approval process include: - making the process more efficient, time-bound, and certain without sacrificing thoroughness or lowering standards, - setting business standards for responses and clearances, - responding to all aspects of an application at one go, - focusing on materiality rather than formality, - eliminating scrutiny by multiple regulators in all cases, - better coordinating with the stock exchange. - Supplementary measure: proactive, regular, and business-like dialogue with representatives of issuers and investors to identify and address problems, and develop applications, criteria, and supervision approaches for new products jointly with market participants. ### Developing Institutional and Retail Investor Bases - Further development of institutional investors, particularly mutual and pension funds, is needed to facilitate sound intermediation in securities markets. - Several countries have important gaps in basic enabling laws (El Salvador, Nicaragua, and Guatemala) for mutual funds; some need to force and facilitate the transition of poorly structured and regulated quasi-mutual funds into properly regulated mutual funds. - Regulatory reforms in some countries (e.g., Guatemala) allowing private pension funds would facilitate establishment of an institutional investor base. - Potential scope to relax investment restrictions on pension funds, particularly for foreign and private sector securities. - Restrictions on pension fund products need comprehensive review to permit the offer of diverse portfolios suitable to different investors. - Need to develop a retail investor base through investor education about equity, bonds, asset-backed securities, and mutual funds, and inform investors of regulatory efforts to improve corporate governance, disclosure, and safety of market conduct. - Regional cooperation and development of standards and educational tools may be particularly efficient. - Corporate bond rating standards: - Could be made more uniform across the region. - Countries with no rating or multiple rating requirements (e.g., El Salvador, where pension funds are required to invest only in bonds with two ratings) should converge to requiring one rating. - A mandatory rating is needed in the region to improve transparency and pricing at this stage of the market, but requirements for two ratings are excessive for most regional issuers and unnecessary for investment by institutional investors. - Regional rating agencies are not of uniform quality; there may be a need to gradually improve capital and experience thresholds required from rating agencies, tempered by low issuance activity and low income of agencies. - Standardization of criteria for rating agency accreditation and facilitating regional operation of agencies (e.g., through mutual recognition) could improve rating standards and homogenize ratings across the region. - Steps needed to develop a regulatory framework and market for ABS: - Securitization represents the most promising step toward developing fixed income private markets given presence of regional and foreign financial conglomerates with skill and interest in ABS, strong demand from institutional investors, and successful completion of several transactions in Panama. - In the Dominican Republic, El Salvador, Honduras, and Nicaragua, authorities still need to address important gaps in current law or regulation. - Most countries need to resolve gray areas or problems in tax treatment (particularly double taxation), inefficiency of registration or execution of collateral, bankruptcy remoteness, and borrower consent requirements. - Banks, institutional investors, and financial regulators need to collaborate in improving standardization of mortgages and other securitizable assets, and related pricing norms. - There may be a role for moral suasion, fine-tuning of prudential parameters, and developing criteria for any government-supported mortgages or insurance to encourage standardization. - Development of adequate pricing standards and methodology for more complex and structured products such as securitization is an important need. - Development of regulation, standards, and pricing methodologies are useful areas for further regional collaboration. ### Development of Equity Markets - Need to promote development of a regional corporate governance code. - Such a code should ideally be developed jointly by investors, issuers, regulators, and government, with government taking a substantial lead. - Need to encourage greater participation of minority shareholders in family-owned companies; discussions around a corporate governance code could be used by authorities and private business leaders to foster this change. ### Market Infrastructure - Regulators, exchanges, and CSDs could take steps to improve efficiency and security of exchanges, including: - requirement of dematerialization for new security issuance, - a phased program to dematerialize existing securities (with authorities taking the prominent lead with respect to government and central bank debt), - favoring a private sector–led (but widely held) CSD, - eliminating requirements on specific investors (such as Asps in the Dominican Republic) for holding securities outside CSDs. - In some countries, CSDs need resources to be adequately capitalized and to implement technological upgrades; low trading volumes and resulting revenue severely hamper this process. - Authorities could facilitate these measures by reining in public sector banks or central banks from attempting to develop CSDs. - Improvements in DVP and settlement are needed in most countries: - Several countries do not have DVP or settlement in central bank funds. - Settlement practices vary across exchanges, and these differences are an important operational hurdle to linking or integrating the regional exchanges. - With emergence of regional financial groups, a region-wide settlement bank is easier to find. ### Broader Policy Measures - Need to eliminate uneven taxation of securities income: - Relative tax concessions aimed at public securities and bank deposits should be reviewed and either extended to income from private securities or all such income should be taxed uniformly. - Improve general tax collection to a point that successful tax avoidance and maintenance of two books of accounts are not serious impediments to public issuance of private securities. - Governments should consider eliminating unnecessary incentives to “promote” capital markets: - Concessions and regulations aimed at conducting repo transactions through the stock exchanges for institutional investors, issuance of public debt through the stock exchange, and requiring pension funds to deal through brokers in primary markets may be phased out. - Such changes should be phased in without reducing price transparency; prices of both on- and off-exchange transactions should be captured, consolidated, and disseminated in a timely way. - Governments could consider supporting private capital markets through measures in public debt management, infrastructure financing, or privatization, including: - increasing the share of the standardized, tradable portion of the public debt, - consolidating public debt both across issues and between the central bank and the government, - developing a domestic yield curve, - dematerializing government securities, - facilitating retail investment in public debt. - Use of securitization techniques for infrastructure financing is an important policy tool. - Governments could support equity market development through full or partial privatization of large state-owned companies (especially utilities) through the exchanges, without necessarily eliminating a strategic buyer, and setting high standards of disclosure and corporate governance. - Governments should continue to work on improving the business environment; for securities market development, the most critical issues are: - improving the accounting and auditing framework applicable to all corporations, - the legal framework for the constitution, and execution of collateral, - insolvency proceedings. - Some of these issues would require changes in the judiciary. *Source: _dp0801 - Conclusions* ### Appendix Tables ### _dp0801 - Appendix Tables ### Securities regulators: structure and resources (Table 6.A1) - Names and nature: - Costa Rica: Superintendencia General de Valores — Separate legal entity; Dependency of the central bank. - Dominican Republic: Superintendencia de Valores de la Republica Dominicana — Separate legal entity; Dependency of the central government. - El Salvador: Superintendencia de Valores — Dependency of the presidency. - Guatemala: Registrador del Mercado de Valores — Separate legal entity. - Honduras: Comisión Nacional de Bancos y Seguros — Separate legal entity. - Nicaragua: Superintendencia de Bancos y de Otras Instituciones Financieras — Dependency of the central government. - Panama: Comisión Nacional de Valores — Separate legal entity. - Governance structure and board composition: - Costa Rica: Board and superintendent; 7 members, including 5 from private sector, the ministry of finance, and the president of the central bank. - Dominican Republic: Board and superintendent; 7 members, including the superintendent, 1 representative of the central bank, 1 from the ministry of finance and 4 from the private sector. - El Salvador: Board and superintendent; 5 members, including the superintendent, 1 from the ministry of finance; 1 from the central bank; 1 from shortlist from the unions, 1 from shortlist from professional associations. - Guatemala: Registrar (there is no board). - Honduras: Board and superintendent; 3 members, one acts as President of the Comisión Nacional de Bancos y Seguros. - Nicaragua: Board and superintendent; 6 members, including 4 from private sector, the bank Superintendent, and the president of the central bank. - Panama: Board only; 3 members from private sector. - Funding, budget, staff, and 2006 funding (US$ million): - Costa Rica: Funding — Central bank: 80%; fees on participants: 20%. Budget — Central Bank Budget. 2006 staff — 109. 2006 funding (US$ million) — n.a. - Dominican Republic: Funding — Central bank. Budget — Separate budget. 2006 staff — 115. 2006 funding (US$ million) — n.a. - El Salvador: Funding — Central government: 90%; fees on participants: 10%. Budget — Central government budget. 2006 staff — 45. 2006 funding (US$ million) — 1.23 - Guatemala: Funding — Central government. Budget — Central government budget. 2006 staff — 5. 2006 funding (US$ million) — 4.01 - Honduras: Funding — Central government: 50%; fees on participants: 50%. Budget — Central government budget. 2006 staff — 3. 2006 funding (US$ million) — 3.86 - Nicaragua: Funding — Central bank: 25%; fees on participants: 75%. Budget — Central government budget. 2006 staff — 7. 2006 funding (US$ million) — 1.57 - Panama: Funding — Central government: 40%; fees on participants: 60%. Budget — Separate budget. 2006 staff — 42. 2006 funding (US$ million) — n.a. - Note: "Sources: Country authorities; and IMF staff." ### Securities exchanges: structure and trading (Table 6.A2) - Exchange identities: - Costa Rica: Bolsa Nacional de Valores — Mutualized. - Dominican Republic: Bolsa de Valores de la Republica Domincana — Mutualized. - El Salvador: Bolsa de Valores de El Salvador, S.A. de C.V. — Mutualized and listed itself. - Guatemala: Bolsa de Valores Nacional and Bolsa de Productos y Mercancias — n.a. on nature. - Honduras: Bolsa de Valores de Centroamérica — Mutualized. - Nicaragua: Bolsa de Valores de Nicaragua — Demutualized. - Panama: Bolsa de Valores de Panamá — Demutualized and listed itself. - Trading system automation and modes: - Is it automated? Costa Rica: Yes. Dominican Republic: Yes. El Salvador: Yes. Guatemala: Yes. Honduras: No. Nicaragua: Yes. Panama: Yes. - Continuous/discontinuous: - Costa Rica: Hybrid: continuous with market calls. - Dominican Republic: Discontinuous. - El Salvador: Discontinuous. - Guatemala: n.a. - Honduras: n.a. - Nicaragua: Discontinuous. - Panama: Continuous. - Order-driven/quote-driven: All listed markets use Order-driven (Limit order book) or Order driven. - Note: "Sources: Country authorities; and IMF staff." ### Clearing and settlement systems (Table 6.A3) - Entities in charge and settlement periods: - Costa Rica: Bolsa Nacional de Valores (BNV) with participation of Central de Valores (CEVAL). Settlement period: t + 3 for equity; t + 1 for debt; t + 0 for repos. - Dominican Republic: CEVALDOM, Central de Valores Dominicana. Settlement period: t + 1. - El Salvador: BVN, using accounts at the central bank; securities liquidated at the CSD. Settlement period: t + 3 for secondary market; t + 0 for repos. - Guatemala: Can be done on or off exchange; if on exchange, the BVN is in charge. Settlement period: t + 1 if done in the BVN. - Honduras: Carried out off exchange by parties in the trade. Settlement period: Agreed bilaterally by parties. - Nicaragua: n.a. Settlement period: Not defined by regulation. - Panama: Latin Clear with participation of Banco Nacional de Panama. Settlement period: t + 3. - Systems and risk management: - Costa Rica: System — Multilateral netting (MN). Risk management — Blocking of securities after trade; settlement fund. Is it DVP? Yes, model 2 (1.5 hours difference between cash settlement and securities settlement). Is it central bank money? No. Is dematerialization mandatory? No, but immobilization is required for trading. CSD — CEVAL. - Dominican Republic: System — Gross for securities; MN for cash. Risk management — n.a. Is it DVP? No. Is it central bank money? No. Is dematerialization mandatory? No. CSD — CEVALDOM. - El Salvador: System — Gross for securities; MN for cash. Risk management — Predeposit of securities; overdraft limits in bank accounts. Is it DVP? No. Is it central bank money? Yes. Is dematerialization mandatory? Only for corporate debt. CSD — CEDEVAL. - Guatemala: System — n.a. Risk management — None. Is it DVP? No. Is it central bank money? No. Is dematerialization mandatory? No. CSD — The exchange itself. - Honduras: System — Agreed bilaterally by parties. Risk management — None. Is it DVP? No. Is it central bank money? No. Is dematerialization mandatory? No. CSD — There is no CSD. - Nicaragua: System — n.a. Risk management — n.a. Is it DVP? No. Is it central bank money? No. Is dematerialization mandatory? Dematerialization required for listing and trading. CSD — CENIVAL. - Panama: System — Gross for securities; MN for cash. Risk management — Predeposit of securities; individual bank guarantees. Is it DVP? Yes, model 2. Is it central bank money? Yes. Is dematerialization mandatory? No, but immobilization required for trading. CSD — Latin Clear. - Rating agencies: - Are there rating agencies? Costa Rica: Yes; Number registered: 2. - Dominican Republic: Yes; 2. - El Salvador: Yes; Number registered: n.a. - Guatemala: Yes; 3. - Honduras: Yes; 1. - Nicaragua: No; n..a. - Panama: Yes; 5. - Note: "Sources: Country authorities and IMF staff." ### Indicators of ease of doing business, 2006 (Table 6.A4) - Ease of doing business rank and starting a business: - Ease of doing business rank: Costa Rica 105; Dominican Republic 117; El Salvador 71; Guatemala 118; Honduras 111; Nicaragua 67; Panama 81; Central America Average 95.7. - Starting a business rank: Costa Rica 99; Dominican Republic 119; El Salvador 123; Guatemala 130; Honduras 138; Nicaragua 62; Panama 26; Central America Average 99.6. - Starting a business procedures (number): Costa Rica 11; Dominican Republic 10; El Salvador 10; Guatemala 13; Honduras 13; Nicaragua 6; Panama 7; Central America Average 10; Latin America Region 10.2; OECD 6.2. - Starting a business time (days): Costa Rica 77; Dominican Republic 73; El Salvador 26; Guatemala 30; Honduras 44; Nicaragua 39; Panama 19; Central America Average 44; Latin America Region 73.3; OECD 16.6. - Starting a business cost (% of income per capita): Costa Rica 23.5; Dominican Republic 30.2; El Salvador 75.6; Guatemala 52.1; Honduras 60.6; Nicaragua 131.6; Panama 23.9; Central America Average 56.8; Latin America Region 48.1; OECD 5.3. - Minimum capital (% of income per capita): Costa Rica 0; Dominican Republic 1.1; El Salvador 119.7; Guatemala 26.4; Honduras 28.6; Nicaragua 0; Panama 0; Central America Average 25.1; Latin America Region 18.1; OECD 36.1. - Getting credit: - Getting credit rank: Costa Rica 33; Dominican Republic 33; El Salvador 33; Guatemala 48; Honduras 21; Nicaragua 48; Panama 13; Central America Average 32.7. - Legal rights index: Costa Rica 4; Dominican Republic 4; El Salvador 4; Guatemala 4; Honduras 6; Nicaragua 4; Panama 6; Central America Average 4.6; Latin America Region 4.5; OECD 6.3. - Credit information index: Costa Rica 6; Dominican Republic 6; El Salvador 6; Guatemala 5; Honduras 5; Nicaragua 5; Panama 6; Central America Average 5.6; Latin America Region 3.4; OECD 5. - Public registry coverage (% adults): Costa Rica 2.5; Dominican Republic 11.9; El Salvador 30.5; Guatemala 16.1; Honduras 8.3; Nicaragua 12.5; Panama 0; Central America Average 11.7; Latin America Region 7; OECD 8.4. - Private bureau coverage (% adults): Costa Rica 39.2; Dominican Republic 57.1; El Salvador 79.6; Guatemala 9.2; Honduras 18.7; Nicaragua 3.4; Panama 59.8; Central America Average 38.1; Latin America Region 27.9; OECD 60.8. - Protecting investors: - Protecting investors rank: Costa Rica 156; Dominican Republic 135; El Salvador 99; Guatemala 135; Honduras 151; Nicaragua 83; Panama 99; Central America Average 122.6. - Disclosure index: Costa Rica 2; Dominican Republic 5; El Salvador 6; Guatemala 3; Honduras 1; Nicaragua 4; Panama 3; Central America Average 3.4; Latin America Region 4.3; OECD 6.3. - Director liability index: Costa Rica 5; Dominican Republic 0; El Salvador 2; Guatemala 3; Honduras 5; Nicaragua 5; Panama 4; Central America Average 3.4; Latin America Region 5.1; OECD 5. - Shareholder suits index: Costa Rica 2; Dominican Republic 7; El Salvador 6; Guatemala 6; Honduras 4; Nicaragua 6; Panama 7; Central America Average 5.4; Latin America Region 5.8; OECD 6.6. - Investor protection index: Costa Rica 3; Dominican Republic 4; El Salvador 4.7; Guatemala 4; Honduras 3.3; Nicaragua 5; Panama 4.7; Central America Average 4.1; Latin America Region 5.1; OECD 6. - Paying taxes: - Paying taxes rank: Costa Rica 160; Dominican Republic 146; El Salvador 85; Guatemala 122; Honduras 152; Nicaragua 153; Panama 164; Central America Average 140.3. - Payments (number): Costa Rica 41; Dominican Republic 87; El Salvador 66; Guatemala 50; Honduras 48; Nicaragua 64; Panama 59; Central America Average 59.3; Latin America Region 41.3; OECD 15.3. - Time (hours): Costa Rica 402; Dominican Republic 178; El Salvador 224; Guatemala 294; Honduras 424; Nicaragua 240; Panama 560; Central America Average 331.7; Latin America Region 430.5; OECD 202.9. - Total tax rate (% profit): Costa Rica 83; Dominican Republic 67.9; El Salvador 27.4; Guatemala 40.9; Honduras 51.4; Nicaragua 66.4; Panama 52.4; Central America Average 55.6; Latin America Region 49.1; OECD 47.8. - Enforcing contracts: - Enforcing contracts rank: Costa Rica 114; Dominican Republic 108; El Salvador 116; Guatemala 149; Honduras 124; Nicaragua 49; Panama 164; Central America Average 117.7. - Procedures (number): Costa Rica 34; Dominican Republic 29; El Salvador 41; Guatemala 36; Honduras 36; Nicaragua 20; Panama 45; Central America Average 34.4; Latin America Region 39.3; OECD 22.2. - Time (months): Costa Rica 51; Dominican Republic 38; El Salvador 52; Guatemala 122; Honduras 40; Nicaragua 41; Panama 57; Central America Average 57.3; Latin America Region 53.5; OECD 29.3. - Cost (% of debt): Costa Rica 18.7; Dominican Republic 35; El Salvador 15; Guatemala 26.5; Honduras 30.4; Nicaragua 21.8; Panama 50; Central America Average 28.2; Latin America Region 23.4; OECD 11.2. - Closing a business: - Closing a business rank: Costa Rica 118; Dominican Republic 142; El Salvador 79; Guatemala 83; Honduras 102; Nicaragua 66; Panama 71; Central America Average 94.4. - Time (years): Costa Rica 3.5; Dominican Republic 3.5; El Salvador 4; Guatemala 3; Honduras 3.8; Nicaragua 2.2; Panama 2.5; Central America Average 3.2; Latin America Region 2.6; OECD 1.4. - Cost (% of estate): Costa Rica 14.5; Dominican Republic 38; El Salvador 9; Guatemala 14.5; Honduras 8; Nicaragua 14.5; Panama 18; Central America Average 16.6; Latin America Region 13.6; OECD 7.1. - Recovery rate (cents on the dollar): Costa Rica 17.6; Dominican Republic 7.4; El Salvador 29.2; Guatemala 28.3; Honduras 23; Nicaragua 34.3; Panama 32.3; Central America Average 24.6; Latin America Region 25.7; OECD 74. - Economy characteristics: - GNI per capita (US$): Costa Rica 4590; Dominican Republic 2370; El Salvador 2450; Guatemala 2400; Honduras 1190; Nicaragua 910; Panama 4630; Central America Average 2648.6. - Population: Costa Rica 4,327,228; Dominican Republic 8,894,907; El Salvador 6,880,951; Guatemala 12,599,059; Honduras 7,204,723; Nicaragua 5,486,685; Panama 3,231,502. - Note: "Source: World Bank, Doingbusiness.org. Note: Indices range from 0 to 10, with higher scores indicating more favorable business conditions. Rankings compare 175 economies during 2006." ### Taxation of income from securities (Table 6.A5) - Legend used in tables: - S = Subject to income tax - E = Exempt - D = Deductible from income tax - WH = Withholding tax - NS = Not subject to tax - N = Nonexistent - ND = Nondeductible from income tax - Corporations income tax and regimes: - Costa Rica: Corporations Income tax 30%. - Dominican Republic: Special regime 29% (also listing of various S/E/NS/WH annotations in the table). - El Salvador: 25% (General regime 25%). - Guatemala: 5% Temporary for SME (gross) (table shows mixed entries). - Honduras: 30%. - Nicaragua: 30%. - Panama: 31% Optional regime (net) — table contains multiple special-case annotations. - Specifics on withholding, interest, capital gains, dividends, and other taxes (selected verbatim items preserved exactly as presented): - Private Debt Securities Interest — Listed: 8% colones; 8% WH/D (Costa Rica column shows 8% colones; others show WH/D, WH/ND, or E). - Capital gains — Listed trading at Stock Exchange — multiple entries including 29% S; 10% General regime; 31% Optional regime in various country columns. - Other taxes examples: - Costa Rica: Listed — N 3.00% Transfer taxes; VAT exempt; 0.15% Check taxes; 1.00% Fixed asset tax. - Dominican Republic: Listed — N 3.00% Transfer taxes; 12% VAT; 0.01% Stamp duty; 0.15% Check taxes; 1.00% Special Fund; 1.00% Fixed asset tax. - Panama: Listed — N 3.00% Transfer taxes; 3% Stamp duty; 0.15% Check taxes; 1.00% Fixed asset tax. - Equity securities dividends (selected entries): - Costa Rica: Listed 5.00% in cash; 29.00% in cash (table contains juxtaposed figures and S/E annotations). - Dominican Republic, El Salvador, and other columns show mixed entries including "25% S for corporations", "29.00% in cash", "Optional regime", and "E in stock if share's issuer declared them and paid tax". - Bank deposits interest and mutual funds: table presents country-specific withholding and tax treatments, e.g., for Costa Rica bank deposits interest annotated as NS, 29%; for mutual funds various entries like 0% interest on securities that already paid or were exempted from tax. - Pension funds tax treatment: entries include "Mandatory of the PF", "public pension funds contributions are not deductible as expenses but pensions are tax free", and mixed annotations (E, N, D) across countries. - The table includes many country-specific special cases, conditional exemptions, withholding regimes (WH/D, WH/ND), and notations such as "All supervised Fis have no WH income tax for banks and Fis", "31% net income tax", and other verbatim fragments presented in the source tables. - Note: "Sources: Country authorities; and IMF staff." ### Equity issuers: registration requirements (Table 6.A6) - Issuer registration and listing: - Do issuers have to carry out separate registration and listing processes? Yes for all seven countries. - Minimum issuance amount (a): Costa Rica C100 million; Dominican Republic: No; El Salvador: No; Guatemala: No; Honduras: No; Nicaragua: No; Panama: No. - Minimum free float requirement (b): No for all seven countries. - Is dematerialization mandatory? Costa Rica: No, but immobilization required for trading; Dominican Republic: No; El Salvador: No; Guatemala: No; Honduras: No; Nicaragua: No; Panama: No, but immobilization required for trading. - Prospectus and disclosure requirements: - Mandatory filing? Yes for Issuance, Issuing company, Risk factors, Financial results (Management report), Directors, managerial staff, employees, Insider/substantial holdings, related-party operations — generally "Yes" across countries. - Mandatory auditing? Yes across all countries. - Local GAAP/IFRS in 2008: IFRS in many jurisdictions; table indicates "IFRS in 2008". - Number of audited periods that have to be presented: Dominican Republic 3 fiscal years; Honduras 3 fiscal years (or less if company is new); Nicaragua 3 fiscal years; Panama Last fiscal year; other entries n.a. - Mandatory filing for prospectus minimum content/legal and administrative information: Costa Rica — "Main info in prospectus; rest available at SUGEVAL". Other countries: mixed "Yes"/"No" entries; for specific items the table lists "Yes" or "No" per country. - Issuance agreement required if company provides certain information: Costa Rica Yes; Dominican Republic Yes; El Salvador Yes; Guatemala No; Honduras Yes; Nicaragua Yes; Panama Yes. - Notes: - "1 If the offering is carried out off the exchange." - "Note: IFRS = International Financial Reporting Standards; GAAP = Generally Accepted Accounting Principles." - "Sources: Country authorities; and IMF staff." *Sources: Country authorities; and IMF staff.* ### 1. System2. Registration Requirements3. Financial Statementsc) Accounting principles? ### _dp0801 - 1. System2. Registration Requirements3. Financial Statementsc) Accounting principles? ### Equity Issuers: Ongoing Disclosure Requirements (Table 6.A7) - Countries covered: Dominican Republic, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama. - Quarterly Financial Statements - Is filing required? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: Yes - Guatemala: Yes - Honduras: Yes - Nicaragua: Yes - Panama: Yes - Deadline - Dominican Republic: 20 days if issuer does not consolidate; 30 business days if issuer consolidates with local companies; 40 business days if issuer consolidates with foreign companies - Costa Rica: Not defined - El Salvador: 30 days after close of quarter - Guatemala: 3 days after end of quarter - Honduras: 20 calendar days after end of quarter - Nicaragua: 1 month - Panama: 2 months - Annual Financial Statements - Is filing required? - All seven countries: Yes - Deadline - Dominican Republic: 40 days if issuer does not consolidate; 45 days if issuer consolidates with foreign companies - Costa Rica: Not defined - El Salvador: 35 days after close of fiscal year or consolidates with local companies; 45 days if issuer consolidates with foreign companies - Guatemala: n.a. - Honduras: 30-Apr - Nicaragua: 3 months - Panama: 3 months - Do they have to be audited? - All seven countries: Yes - Material Events - Mandatory disclosure? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: Yes - Guatemala: No - Honduras: Yes - Nicaragua: Yes - Panama: Yes - Deadline - Dominican Republic: No later than 1 business day - Costa Rica: Not defined - El Salvador: 8 days - Guatemala: n.a. - Honduras: 15:00 hours of following day - Nicaragua: Immediate - Panama: 1 business day - Insider Holdings - Must insider participation be disclosed? - Dominican Republic: Yes - Costa Rica: No - El Salvador: Yes - Guatemala: No - Honduras: No - Nicaragua: No - Panama: Yes - Is there a threshold? - Dominican Republic: No - Costa Rica: n.a. - El Salvador: 10% - Guatemala: n.a. - Honduras: n.a. - Nicaragua: n.a. - Panama: No - Filing deadline - Dominican Republic: 5 business days - Costa Rica: n.a. - El Salvador: 8 days - Guatemala: n.a. - Honduras: n.a. - Nicaragua: n.a. - Panama: In the prospectus - Is this information public? - Dominican Republic: Yes, at the SUGEVAL registry - Costa Rica: n.a. - El Salvador: Yes, in the prospectus - Guatemala: n.a. - Honduras: n.a. - Nicaragua: n.a. - Panama: In the prospectus - Substantial Holdings - Must substantial holdings be disclosed? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: Yes - Guatemala: No - Honduras: Yes - Nicaragua: Yes - Panama: Yes - Percentage share that must be disclosed? - Dominican Republic: 10% - Costa Rica: Not defined - El Salvador: 10% - Guatemala: n.a. - Honduras: 10% - Nicaragua: 5% - Panama: 25% - Filing deadline - Dominican Republic: 5 business days - Costa Rica: Not defined - El Salvador: 8 days - Guatemala: n.a. - Honduras: n.a. - Nicaragua: 1 month - Panama: No, must be included in prospectus - Is this information public? - Dominican Republic: Yes, at the SUGEVAL registry - Costa Rica: n.a. - El Salvador: Yes in the prospectus - Guatemala: n.a. - Honduras: Yes - Nicaragua: Yes - Panama: Yes, in prospectus - Prospectus - Must prospectus be updated frequently? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: No - Guatemala: No - Honduras: Yes - Nicaragua: Yes - Panama: Yes - Frequency - Dominican Republic: Annually - Costa Rica: Annually - El Salvador: n.a. - Guatemala: n.a. - Honduras: Any time the conditions of the offering have changed - Nicaragua: Annually - Panama: Annually; 30 days after the report is submitted ### Debt Issuers: Registration Requirements (Table 6.A8) - Countries covered: Dominican Republic, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama. - System - Do issuers have to carry out separate registration and listing processes? - All seven countries: Yes - Is there an obligation to list debt issuances? - Dominican Republic: No - Costa Rica: No.1 - El Salvador: Yes - Guatemala: Yes - Honduras: Yes - Nicaragua: Yes - Panama: No - Note 1: But all secondary market transactions have to be carried out in the stock exchange. - Is there an obligation to carry out secondary market transactions in the stock exchange? - Dominican Republic: Yes - Costa Rica: No - El Salvador: Yes - Guatemala: Yes - Honduras: Yes - Nicaragua: Yes - Panama: No - If no, is there an obligation to report all OTC transactions? - Dominican Republic: N.A - Costa Rica: No. Mandatory - El Salvador: n.a. - Guatemala: n.a. - Honduras: n.a. - Nicaragua: n.a. - Panama: No - Registration requirements - Is there a minimum issuance amount? - Dominican Republic: C 100 million - Costa Rica: No - El Salvador: No - Guatemala: No - Honduras: No - Nicaragua: No - Panama: No - Is standardization mandatory? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: No - Guatemala: No - Honduras: Yes - Nicaragua: Yes - Panama: Yes - Is dematerialization mandatory? - Dominican Republic: No - Costa Rica: No - El Salvador: Yes - Guatemala: No - Honduras: No - Nicaragua: No - Panama: No - Is a legal representative of debt holders required? - Dominican Republic: No - Costa Rica: Yes - El Salvador: No - Guatemala: Yes - Honduras: Yes - Nicaragua: No - Panama: No - Risk rating - Is rating mandatory? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: Yes - Guatemala: No - Honduras: Yes - Nicaragua: Yes - Panama: No - If yes, number of required ratings - Dominican Republic: 1 - Costa Rica: 2 - El Salvador: 1 (2 for pension funds) - Guatemala: n.a. - Honduras: 1 - Nicaragua: 1 - Panama: (no value given) - Financial statements - Mandatory filing? - All seven countries: Yes - Mandatory auditing? - All seven countries: Yes - What are the accounting principles? - Dominican Republic: IFRS - Costa Rica: IFRS - El Salvador: IFRS - Guatemala: Local GAAP - Honduras: IFRS - Nicaragua: US GAAP - Panama: IFRS or US GAAP - Number of audited periods that have to be presented - Dominican Republic: N.A. - Costa Rica: 3 fiscal years - El Salvador: Last fiscal year - Guatemala: N.A. - Honduras: 3 fiscal years - Nicaragua: 3 fiscal years - Panama: n.a. - Prospectus - Mandatory filing? - All seven countries: Yes - Minimum content items (Issuance; Issuance guarantees; Issuing company) - All seven countries: Yes for each item - Risk factors - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: No - Guatemala: Yes - Honduras: Yes - Nicaragua: Yes - Panama: Yes - Financial results (Management report) - All seven countries: Yes - Legal and administrative information: mandatory filing of the following documents - Company by-laws - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: Yes - Guatemala: Yes - Honduras: Yes - Nicaragua: Yes - Panama: No - Issuance agreements - All seven countries: Yes - Guarantees - All seven countries: Yes - Notes appended in table: - OTC = Over the counter; IFRS = International Financial Reporting Standards; GAAP = Generally Accepted Accounting Principles. - Table context: as of 2008. ### Debt Issuers: Ongoing Disclosure Requirements (Table 6.A9) - Countries covered: Dominican Republic, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama. - Rating - Mandatory update? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: Yes - Guatemala: n.a. - Honduras: Yes - Nicaragua: Yes - Panama: n.a. - Frequency - Dominican Republic: Biannually - Costa Rica: Not defined - El Salvador: Every 3 months - Guatemala: n.a. - Honduras: Every 3 months - Nicaragua: Every 3 months - Panama: n.a. - Quarterly Financial Statements - Is filing required? - All seven countries: Yes - Deadline - Dominican Republic: 20 days if issuer does not consolidate; 30 business days if issuer consolidates with local companies; 40 business days if issuer consolidates with foreign companies - Costa Rica: Not defined - El Salvador: 30 days after end of quarter - Guatemala: Not defined - Honduras: 20 calendar days after end of quarter - Nicaragua: 1 month - Panama: 2 months after end of quarter - Annual Financial Statements - Is filing required? - All seven countries: Yes - Deadline - Dominican Republic: 40 days if issuer does not consolidate or consolidates with local companies; 50 days if issuer consolidates with foreign companies - Costa Rica: Not defined - El Salvador: 45 days after end of fiscal year - Guatemala: Not defined - Honduras: 30-Apr - Nicaragua: 3 months - Panama: 3 months after end of fiscal year - Mandatory auditing? - All seven countries: Yes - Material Events - Mandatory disclosure? - Dominican Republic: Yes - Costa Rica: Yes - El Salvador: Yes - Guatemala: No - Honduras: Yes - Nicaragua: Yes - Panama: Yes - Deadline - Dominican Republic: Immediate but not later than 1 business day - Costa Rica: Not defined - El Salvador: 8 days - Guatemala: n.a. - Honduras: 15:00 hours of following day - Nicaragua: Immediate - Panama: 1 business day *Sources: Country authorities; and IMF staff.* ### 5. Prospectus a) Mandatory update? ### 5. Prospectus a) Mandatory update? ### Mutual and Pension Fund Regulation — key findings - Mutual Funds: Legal framework present in Costa Rica, Dominican Republic, Honduras, Nicaragua, Panama; absent in El Salvador and Guatemala (notes: 1 Brokerage houses administer ‘carteras de inversión,’ which are poorly regulated quasi-mutual funds; 2 The legal framework includes ‘sociedades de inversion,’ which are poorly regulated quasi-mutual funds). - Complementary regulations issued by regulator: Costa Rica (Yes); Dominican Republic (Yes); Honduras (No); Nicaragua (Yes); Panama (Yes); El Salvador and Guatemala (n.a.). - Mutual funds allowed to invest in: - Public debt: Costa Rica (Yes); Dominican Republic (Yes); Honduras (Yes); Nicaragua (n.a.); Panama (Yes); El Salvador and Guatemala (n.a.). - Stocks: Costa Rica (Yes); Dominican Republic (Yes); Honduras (Yes); Nicaragua (n.a.); Panama (Yes); El Salvador and Guatemala (n.a.). - Corporate debt: Costa Rica (Yes); Dominican Republic (Yes); Honduras (Yes); Nicaragua (n.a.); Panama (Yes); El Salvador and Guatemala (n.a.). - Securitization issuances: Costa Rica (Yes); Dominican Republic (Yes); Honduras (Yes); Nicaragua (n.a.); Panama (Yes); El Salvador and Guatemala (n.a.). - Foreign securities: Costa Rica (Yes); Dominican Republic (Yes); Honduras (Yes); Nicaragua (n.a.); Panama (Yes); El Salvador and Guatemala (n.a.). - Pension Funds: Legal framework presence: - Costa Rica (Yes), Dominican Republic (Yes), El Salvador (Yes), Guatemala (No), Honduras (Only for public pension funds), Nicaragua (Yes, but not implemented), Panama (Yes). - Regulator issued complimentary regulations for pension funds: Costa Rica (Yes), Dominican Republic (Yes), El Salvador (Yes), Honduras (n.a.), Nicaragua (Yes), Guatemala and Panama (n.a.). - Pension fund investment limits and permissions (as reported): - Local public debt: Dominican Republic (Max 50%), Costa Rica (No), El Salvador (Max 50%), Guatemala (n.a.), Honduras (Max 50%), Nicaragua (n.a.), Panama (n.a.). - Stocks: Dominican Republic (Max 10%), Costa Rica (Yes), El Salvador (Max 5%), Guatemala (n.a.), Honduras (Max 10%), Nicaragua (n.a.), Panama (n.a.). - Corporate debt: Dominican Republic (Yes), Costa Rica (Yes), El Salvador (15-40%), Guatemala (n.a.), Honduras (Max 10%), Nicaragua (n.a.), Panama (n.a.). - Securitization issuances: Dominican Republic (Yes), Costa Rica (Yes), El Salvador (Max 20%), Guatemala (n.a.), Honduras (Max 30% with rating), Nicaragua (n.a.), Panama (n.a.). - Foreign securities: Dominican Republic (Max 25%), Costa Rica (No), El Salvador (Max 20% but must be done through the local stock exchange), Guatemala (n.a.), Honduras (No), Nicaragua (n.a.), Panama (n.a.). Sources: Country authorities; and IMF staff. ### Size of Emerging Capital Markets (As of end-2006) — selected Central American entries and regional aggregates - Central America - GDP (US$ billion): 138.1 - Equity Market Capitalization (US$ billion): 16.4 - Equity Market Capitalization (% of GDP): 11.9 - Private Bonds Outstanding (US$ billion): 68.5 - Private Bonds Outstanding (% of GDP): 8.2 - Equity + Private Markets (% of GDP): 17.8 - Costa Rica - GDP (US$ billion): 21.4 - Equity Market Capitalization (US$ billion): 1.8 - Equity Market Capitalization (% of GDP): 8.6 - Private Bonds Outstanding (US$ billion): 15.0 - Private Bonds Outstanding (% of GDP): 5.0 - Equity + Private Markets (% of GDP): 31.9 - El Salvador - GDP (US$ billion): 18.3 - Equity Market Capitalization (US$ billion): 7.7 - Equity Market Capitalization (% of GDP): 42.0 - Private Bonds Outstanding (US$ billion): 7.5 - Private Bonds Outstanding (% of GDP): 0.8 - Equity + Private Markets (% of GDP): 46.5 - Guatemala - GDP (US$ billion): 35.3 - Equity Market Capitalization (US$ billion): n.a. - Equity Market Capitalization (% of GDP): n.a. - Private Bonds Outstanding (US$ billion): 8.9 - Private Bonds Outstanding (% of GDP): 0.1 - Equity + Private Markets (% of GDP): 0.4 - Panama - GDP (US$ billion): 17.1 - Equity Market Capitalization (US$ billion): 6.8 - Equity Market Capitalization (% of GDP): 39.8 - Private Bonds Outstanding (US$ billion): 12.5 - Private Bonds Outstanding (% of GDP): 2.1 - Equity + Private Markets (% of GDP): 52.0 - Honduras - GDP (US$ billion): 9.0 - Equity Market Capitalization (US$ billion): n.a. - Equity Market Capitalization (% of GDP): n.a. - Private Bonds Outstanding (US$ billion): 3.5 - Private Bonds Outstanding (% of GDP): 0.0 - Equity + Private Markets (% of GDP): 0.0 - Nicaragua - GDP (US$ billion): 5.4 - Equity Market Capitalization (US$ billion): n.a. - Equity Market Capitalization (% of GDP): n.a. - Private Bonds Outstanding (US$ billion): 8.1 - Private Bonds Outstanding (% of GDP): 0.0 - Equity + Private Markets (% of GDP): 0.4 - Dominican Republic - GDP (US$ billion): 31.6 - Equity Market Capitalization (US$ billion): n.a. - Equity Market Capitalization (% of GDP): n.a. - Private Bonds Outstanding (US$ billion): 13.1 - Private Bonds Outstanding (% of GDP): 0.2 - Equity + Private Markets (% of GDP): 0.6 Sources: Local exchanges; Bloomberg. ### Summary of Recommendations — prioritized reforms and country-specific notes - Regulator capacity, independence, and powers - Create a securities regulator: Dominican Republic (X). - Review role and composition of the board: Costa Rica (X); El Salvador (X); Guatemala (X); Nicaragua (X); Panama (X). - Strengthen administrative independence by removing limitations on number and salaries of staff: Costa Rica (X); Panama (X). - Appoint commissioner / Delink periods of commissioners from presidential periods: Panama (X). - Securities market law: Amend — Costa Rica (Amend); Dominican Republic (Amend); El Salvador (Revamp); Guatemala (Revamp); Honduras (Amend); Nicaragua (Provide explicit powers over brokerages) — explicit powers over auditors and rating agencies noted for specific cases; Exchange of information: Costa Rica (X); Nicaragua (X). - Supervision and enforcement: Implement risk-based supervision of securities intermediaries — Dominican Republic (X); enhance regulator capacity — Costa Rica (Too limited); implement a more active enforcement policy — Costa Rica (X); clarify responsibilities of the exchange via MoU or other document — Costa Rica (X); Dominican Republic (X); El Salvador (X); Guatemala (X); Honduras (X); Nicaragua (X); Panama (X). - Market infrastructure - Trading: Eliminate obligation to conduct repos through brokerage houses; work toward DVP — Costa Rica (X); Dominican Republic (X); El Salvador (X); Guatemala (X); Honduras (X). - Ratify treaty on payments: Costa Rica (X); Dominican Republic (X); El Salvador (X); Guatemala (X); Honduras (X); Nicaragua (X); Panama (X). - Central securities deposit: Impose dematerialization and work on conversion of physical securities — Costa Rica (X); Dominican Republic (?); El Salvador (X); Guatemala (X); Honduras (X); Panama (X). Prohibit reversion of dematerialization and eliminate central bank custody where indicated: Costa Rica (X). - Price formation and valuation - Develop mechanisms for appropriate price disclosure: Nicaragua (X). - Develop a strategy for mark to market valuation of carteras de inversión: Nicaragua (X). - Legal and regulatory framework for issuance and disclosure - Equity issuers: Strengthen disclosure requirements for equity issuers and enhance public disclosure: Costa Rica (X); Dominican Republic (X); El Salvador (X); Guatemala (X); Honduras (X). Include disclosure of insider holdings, substantial holdings, material events, and establish deadlines for disclosure where noted. - Debt issuers: Stop non-standard issues; strengthen disclosure requirements and ensure timely disclosure of material events: indicated for multiple countries, including Dominican Republic (X). - Registration, ABS, and investment products - Streamline registration process and improve coordination with Stock Exchange: Dominican Republic (X); El Salvador (X); Guatemala (X); Honduras (X). - Expand shelf registration of bonds: Panama (X). - ABS regulation: Clarify authority of public institutions to constitute trusts for ABS; Strengthen ABS framework, enact ABS law, develop regulations — recommendations distributed across countries (Dominican Republic, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama) with explicit items: Develop standardized mortgage contracts (Costa Rica X); Develop reference rate (Costa Rica X); Issue regulations for marketing of foreign securities (Costa Rica X). - Mutual funds and pension funds: Issue mutual fund regulations — Costa Rica (X); Dominican Republic (X); El Salvador (X); Honduras (X); Panama (X). Enact mutual fund law where recommended. Reduce rating requirement for pension fund investment (El Salvador X); Phase out carteras de inversión (Nicaragua X). Allow pension fund investment in government debt and foreign securities, and eliminate second individual security approval for AFPs — recommended for specific countries (Dominican Republic X; Costa Rica X). - Preconditions: legal, accounting, and tax - Commercial and corporate law: Streamline process to constitute companies — Dominican Republic (X); streamline registration of mortgages — Dominican Republic (X); Guatemala (X); develop mechanisms for expedited execution of collateral — multiple countries (X); modernize bankruptcy framework — Dominican Republic (X); El Salvador (X); Guatemala (X); Honduras (X); Panama (X). - Accounting, auditing, and transparency: Implement IFRS — El Salvador (X); Guatemala (X); Complete implementation — Nicaragua (X); Consider thresholds for filing and auditing of financial statements and enhance auditors requirements and oversight — recommendations across multiple countries (Dominican Republic X; Costa Rica X; El Salvador X; Guatemala X; Honduras X; Nicaragua X; Panama X). - Taxation: Review taxation framework of different financial products; note a 4.3% tax at origination and transfer to the SPV cited in context; remove tax on financial transactions recommended (Dominican Republic X). Sources: Country authorities; and IMF staff. *Source: CENTRAL AMERICA: ECONOMIC PROGRESS AND REFORMS — Tables and text as provided in the chapter.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2008/_dp0801.pdf_