## _wp11248

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### Introduction and summary
- Purpose: construct a model capturing key factors that influence growth and identify reforms Central American countries could undertake to raise medium- to long-run economic growth.
- Data sources: IMF structural efficiency database and Penn World Table (PWT) Version 7.0 (extends through 2009).
- Econometric method: System GMM (dynamic panel data technique).
- Key quantitative findings:
  - Increasing the investment-to-GDP ratio by 5 percentage points raises growth by 0.6 percent.
  - Increasing advanced educational attainment by one year raises growth by 0.3 percent.
  - Raising the broad structural efficiency index by one standard deviation (7 points on a 100 point scale) raises annual growth by ½ percent.
- Structural reforms with strongest estimated growth effects: domestic financial system and external transactions; within finance, banking supervision frameworks and well-developed securities markets have the largest impact.

### Historical growth performance (1960–2009) — Central America
- Regional averages and comparisons:
  - Central America annual average growth in PPP GDP per capita: 1.7 percent.
  - Region’s per capita income declined to 16 percent of the U.S. level in 2005–2009, from 19 percent in the early 1960s.
  - The region as a whole averaged 2.6 percent growth in per capita PPP GDP per year from 2000 to 2008.
  - Average U.S. growth reference: 2.2 percent.
  - Advanced economies averaged 2.1 percent (2000–2008); all other emerging economies almost 4 percent.
- Country heterogeneity:
  - Dominican Republic and Panama: per capita income grew by about 3 percent per year.
  - Nicaragua: per capita income has fallen.
  - Costa Rica, El Salvador, Guatemala, Honduras: growth between 1 and 2 percent per year.
- Outlook (IMF staff forecasts for 2011–16): majority of economies expected to decelerate compared to pre-crisis period; continued slow convergence except for the Dominican Republic and Panama.

### Analytical framework and data
- Theoretical basis: Solow framework with Cobb-Douglas production function (A, K, H), where H = hL and h is human capital per worker.
- Key explanatory variables used:
  - Investment-to-GDP ratio (proxy for change in capital stock).
  - Share of population that is of working age.
  - Average years of advanced schooling (secondary + tertiary) of working-age population.
  - Macroeconomic indicators (inflation), political stability, institutional features, and time dummies.
- Structural reform measures:
  - Three sectoral indexes (0–100 scale; higher = greater efficiency), averaged equally into a broad structural efficiency index:
    - Financial system index (controls on credit allocation, interest rate controls, entry barriers, bank supervision, securities market development).
    - External transactions index (average tariffs, restrictions on current and capital account transactions).
    - Product markets index (flexibility in agriculture, electricity, telecommunications).
  - Regression sample: 79 countries (all Central American countries except Panama) with full structural efficiency data.

### Cross-country regression results (System GMM) — main estimates (1960–2009, five-year non-overlapping periods)
- Coefficients and statistics (Table 1, final specification):
  - Broad structural index coefficient: 6.199*** (T-statistic [2.928]).
  - Financial system index coefficient: 3.542*** ([2.751]).
  - External transactions index coefficient: 4.195** ([2.336]).
  - Product markets index coefficient: 2.254* ([1.955]).
  - Lagged income (log of PPP GDP per capita): -1.537*** ([-3.258]).
  - Capital formation (log of investment to GDP): 3.270*** ([4.137]).
  - Human capital (log of advanced schooling): 1.166** ([2.227]).
  - Inflation (log of 1 plus inflation rate): -2.255* ([-1.726]).
  - Labor force (as share of population, log): 0.724*** ([5.746]).
  - Observations: 757.
  - Number of countries: 79.
  - Number of instruments: 26.
  - Hansen test p-value: 0.197.
  - AR(2) test p-value: 0.293.
- Interpretation of magnitudes:
  - A one standard deviation increase in the broad structural index (7 points on 0–100) is estimated to raise growth by ½ percent per year.
  - A 5 percentage point increase in investment-to-GDP is estimated to raise growth by 0.6 percent.
  - One additional year of advanced schooling is estimated to raise growth by 0.3 percent.
- Sectoral subcomponents (Table 2, column 1 highlights):
  - Banking supervision: 4.013*** ([4.068]).
  - Securities markets: 2.671*** ([2.845]).
  - Competition in services: 1.613** ([2.104]).
  - Average tariffs on trade (increase implies lower tariffs): 2.182** ([2.464]).
  - Current account transactions: 3.654** ([2.425]).
  - Capital account transactions: 1.430* ([1.814]).
- Robustness:
  - Excluding Sub-Saharan Africa, excluding advanced OECD members, and excluding Central American countries produce consistent coefficient patterns for the broad index, financial index, and external index.
  - Regional dummies and interactions with a Central America dummy were not significant; interactions of Central America dummy with structural indexes, investment, and human capital were not significant.
  - Joint significance: F-test p-value for joint significance of reform indexes: 0.006***.

### Illustrative counterfactuals: How Central America could boost growth (vs. LA-3: Chile, Mexico, Peru)
- Method: compute gap between a Central American country and the LA-3 for each determinant, multiply by estimated coefficient to obtain implied long-run growth increase (logs used).
- Investment-to-GDP (average 2005–09 vs. LA-3):
  - El Salvador investment ratio: 15 percent of GDP (lowest in region).
  - Estimated potential growth gains:
    - El Salvador: between 1½ and 2 percent from raising investment to LA-3 level.
    - Dominican Republic and Guatemala: over 1 percent.
    - Costa Rica and Panama: lower estimated effects.
  - Honduras and Nicaragua: investment ratios higher than LA-3 (may reflect quality/valuation issues).
- Human capital (average years of advanced schooling, 2005–09):
  - Guatemala: less than one year of advanced schooling; 0.7 years behind El Salvador (the next closest country).
  - Panama: 3.9 years of advanced schooling (ahead of LA-3).
  - Estimated potential growth gains:
    - Guatemala: over 1½ percent from raising education to LA-3 level.
    - El Salvador: nearly 1 percent.
- Structural reforms (average 2005–09):
  - All Central American countries score below the LA-3 on the domestic financial system index.
  - Regional weaknesses: bank supervision and development of domestic securities markets.
  - External transactions: El Salvador and the Dominican Republic have the largest gaps versus LA-3.
  - Product markets: Honduras and Costa Rica have the largest room for improvement.
- Estimated potential aggregate growth gains from reaching LA-3 levels of flexibility:
  - Honduras: potential gains about 2½ percent (primarily financial sector reforms, secondarily product markets).
  - Costa Rica and Dominican Republic: potential gains about 2 percent.
  - Guatemala and Nicaragua: gains would mainly come from financial sector reforms.
  - El Salvador: gains would come mainly from external reforms.
  - Panama: already benefitting from high investment rate, relatively well-educated labor force, and external openness.

### Conclusions and policy implications
- Structural efficiency is an important determinant of long-run growth in addition to investment, human capital, and macroeconomic stability.
- Cross-country estimates suggest Central American countries could, in the long run, raise annual growth by ½ to 2½ percent by matching LA-3 levels of structural flexibility and regulation.
- Policy priorities implied by the model and counterfactuals:
  - Bolster financial supervision and develop domestic securities markets.
  - Liberalize and reduce distortions in external transactions (tariffs and current account restrictions).
  - Advance reforms in product markets where gaps are largest (agriculture, electricity, telecommunications), recognizing heterogeneity across countries.
  - Raise investment in physical capital and sustained investment in advanced education where gaps are largest.
- Caveats:
  - These are illustrative long-run magnitudes; reforms are deep-seated, may take years to implement, and quality of investment and education matters but is not fully captured by available indicators.

*Source: _wp11248 - Appendix Tables (extracted content).*

### References .............................................................................................................

### _wp11248 - References ................................................................................................................................. 19

### Figures
- 1.     Economic Growth Around the World ................................................................................. 4
- 2.     Relative Incomes Around the World .................................................................................. 4
- 3.     Economic Growth in Central America ............................................................................... 5
- 4.     Economic Growth in Central America ............................................................................... 5
- 5.     Central America: Growth Forecasts .................................................................................... 5
- 6.     Structural Efficiency: Broad Index ..................................................................................... 9
- 7.     Central America and Comparators: Investment-to-GDP Ratios ....................................... 14
- 8.     Central America: Effect on Growth from Raising Investment ......................................... 14
- 9.     Central America and Comparators: Years of Advanced Education ................................. 15
- 10.   Central America: Effect on Growth from Raising Advanced Education ......................... 15
- 11.   Central America and Comparators: Broad Structural Index ............................................. 16
- 12.   Central America and Comparators: Domestic Financial System Index ........................... 16
- 13.   Central America and Comparators: External Index .......................................................... 16
- 14.   Central America and Comparators: Product Markets Index ............................................. 16
- 15.   Central America: Effect on Growth from Structural Reforms .......................................... 16

### Tables
- 1.     The Impact of Structural Reforms on Growth: Broad Indexes ......................................... 10
- 2.     The Impact of Structural Reforms on Growth: Components ............................................ 12

*Source: _wp11248 - References*

### Appendix Tables

### _wp11248 - Appendix Tables

### Introduction and summary
- Purpose: construct a model capturing key factors that influence growth and identify reforms Central American countries could undertake to raise medium- to long-run economic growth.
- Data sources highlighted: IMF structural efficiency database and Penn World Table (PWT) Version 7.0 (extends through 2009).
- Econometric method: System GMM (dynamic panel data technique).
- Key quantitative findings:
  - Increasing the investment-to-GDP ratio by 5 percentage points raises growth by 0.6 percent.
  - Increasing advanced educational attainment by one year raises growth by 0.3 percent.
  - Raising the broad structural efficiency index by one standard deviation (7 points on a 100 point scale) raises annual growth by ½ percent.
- Structural reforms with strongest estimated growth effects: domestic financial system and external transactions; within finance, banking supervision frameworks and well-developed securities markets have the largest impact.

### Central America’s historical growth performance (1960–2009)
- Regional and cross-region comparisons:
  - Central America annual average growth in PPP GDP per capita: 1.7 percent.
  - Region’s per capita income declined to 16 percent of the U.S. level in 2005–2009, from 19 percent in the early 1960s.
  - The region as a whole averaged 2.6 percent growth in per capita PPP GDP per year from 2000 to 2008.
  - Average U.S. growth reference: 2.2 percent.
  - Comparison: advanced economies averaged 2.1 percent (2000–2008), and all other emerging economies almost 4 percent.
- Country heterogeneity:
  - Dominican Republic and Panama: per capita income grew by about 3 percent per year.
  - Nicaragua: per capita income has fallen.
  - Other four countries (Costa Rica, El Salvador, Guatemala, Honduras): growth between 1 and 2 percent per year.
- Outlook (IMF staff forecasts for 2011–16): majority of economies in the region expected to decelerate compared to pre-crisis period; continued slow convergence except for the Dominican Republic and Panama.

### Framework to analyze determinants of growth and data
- Theoretical specification: Solow framework with Cobb-Douglas production function (A, K, H), where H = hL and h is human capital per worker.
- Key explanatory variables used:
  - Investment-to-GDP ratio (proxy for change in capital stock).
  - Share of population that is of working age.
  - Average years of advanced schooling (secondary + tertiary) of working-age population.
  - Macroeconomic indicators (inflation), political stability, institutional features, and time dummies.
- Structural reforms data:
  - Three sectoral indexes (0–100 scale; higher = greater efficiency), averaged equally into a broad structural efficiency index:
    - Financial system index (controls on credit allocation, interest rate controls, entry barriers, bank supervision, securities market development).
    - External transactions index (average tariffs, restrictions on current and capital account transactions).
    - Product markets index (flexibility in agriculture, electricity, telecommunications).
  - Sample for regressions: 79 countries (all Central American countries except Panama) with full structural efficiency data.

### Cross-country regression results (System GMM)
- Main estimates (Table 1, sample: 1960–2009, five-year non-overlapping periods):
  - Broad structural index coefficient: 6.199*** (T-statistic [2.928]).
  - Financial system index coefficient: 3.542*** ([2.751]).
  - External transactions index coefficient: 4.195** ([2.336]).
  - Product markets index coefficient: 2.254* ([1.955]).
  - Lagged income (log of PPP GDP per capita): -1.537*** ([-3.258]).
  - Capital formation (log of investment to GDP): 3.270*** ([4.137]).
  - Human capital (log of advanced schooling): 1.166** ([2.227]).
  - Inflation (log of 1 plus inflation rate): -2.255* ([-1.726]).
  - Labor force (as share of population, log): 0.724*** ([5.746]).
  - Observations: 757.
  - Number of countries: 79.
  - Number of instruments: 26 (reported for final specification).
  - Hansen test p-value: 0.197.
  - AR(2) test p-value: 0.293.
- Interpretation of magnitudes:
  - A one standard deviation increase in the broad structural index (7 points on 0–100) is estimated to raise growth by ½ percent per year.
  - A 5 percentage point increase in investment-to-GDP is estimated to raise growth by 0.6 percent.
  - One additional year of advanced schooling is estimated to raise growth by 0.3 percent.
- Sectoral subcomponents (Table 2, column 1 highlights):
  - Banking supervision: 4.013*** ([4.068]).
  - Securities markets: 2.671*** ([2.845]).
  - Competition in services: 1.613** ([2.104]).
  - Average tariffs on trade (increase implies lower tariffs): 2.182** ([2.464]).
  - Current account transactions: 3.654** ([2.425]).
  - Capital account transactions: 1.430* ([1.814]).
- Robustness checks:
  - Excluding Sub-Saharan Africa, excluding advanced OECD members, and excluding Central American countries produce consistent coefficient patterns for the broad index, financial index, and external index.
  - Regional dummies and interactions with a Central America dummy were not significant; interactions of Central America dummy with structural indexes, investment, and human capital were not significant.
  - Joint significance: F-test p-value for joint significance of reform indexes: 0.006***.

### How Central America could boost growth (illustrative counterfactuals vs. LA-3: Chile, Mexico, Peru)
- Method: for each growth determinant, compute gap between a Central American country and the LA-3, multiply by estimated coefficient to obtain implied long-run growth increase (logs used per specification).
- Investment in physical capital (average 2005–09 vs. LA-3):
  - El Salvador investment ratio: 15 percent of GDP (lowest in region).
  - Estimated potential growth gains:
    - El Salvador: between 1½ and 2 percent from raising investment to LA-3 level.
    - Dominican Republic and Guatemala: over 1 percent.
    - Costa Rica and Panama: lower estimated effects.
  - Honduras and Nicaragua: investment ratios higher than LA-3 (may reflect quality/valuation issues).
- Human capital (average years of advanced schooling, 2005–09):
  - Guatemala: less than one year of advanced schooling; 0.7 years behind El Salvador (the next closest country).
  - Panama: 3.9 years of advanced schooling (ahead of LA-3).
  - Estimated potential growth gains:
    - Guatemala: over 1½ percent from raising education to LA-3 level.
    - El Salvador: nearly 1 percent.
- Structural reforms (broad index and sectoral indexes, average 2005–09):
  - All Central American countries score below the LA-3 on the domestic financial system index.
  - Regional weaknesses highlighted: bank supervision and development of domestic securities markets.
  - External transactions: El Salvador and the Dominican Republic have the largest gaps versus LA-3.
  - Product markets: Honduras and Costa Rica have the largest room for improvement.
- Estimated potential growth gains from reaching LA-3 levels of flexibility (by country and sector; Figures summarized):
  - Honduras: potential gains about 2½ percent (primarily financial sector reforms, secondarily product markets).
  - Costa Rica and Dominican Republic: potential gains about 2 percent (room to improve in multiple sectors).
  - Guatemala and Nicaragua: gains would mainly come from financial sector reforms.
  - El Salvador: gains would come mainly from external reforms.
  - Panama: already benefitting from high investment rate, relatively well-educated labor force, and external openness.

### Conclusions and policy implications
- Structural efficiency is an important determinant of long-run growth in addition to investment, human capital, and macroeconomic stability.
- Cross-country estimates suggest that Central American countries could, in the long run, raise annual growth by ½ to 2½ percent by matching LA-3 levels of structural flexibility and regulation.
- Policy priorities implied by the model and counterfactuals:
  - Bolster financial supervision and develop domestic securities markets.
  - Liberalize and reduce distortions in external transactions (tariffs and current account restrictions).
  - Advance reforms in product markets where gaps are largest (agriculture, electricity, telecommunications), recognizing heterogeneity across countries.
  - Raise investment in physical capital and sustained investment in advanced education where gaps are largest.
- Caveats:
  - These are illustrative long-run magnitudes; reforms are deep-seated, may take years to implement, and quality of investment and education matters but is not fully captured by available indicators.

*Source: _wp11248 - Appendix Tables (extracted content).*

### REFERENCES

### _wp11248 - REFERENCES

### References
- Abiad, A., E. Detragiache, and T. Tressel, 2010, “A New Database of Financial Reforms,” IMF Staff Papers, Vol. 57, pp. 281–302 (Washington: International Monetary Fund).
- Aisen, A., and F. Veiga, 2011, “How Does Political Instability Affect Economic Growth?” IMF Working Paper 11/12 (Washington: International Monetary Fund).
- Arellano, M., and S. Bond, 1991, “Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations,” Review of Economic Studies, Vol. 58, pp. 277–297.
- Arellano, M., and O. Bover, 1995, “Another Look at the Instrumental Variable Estimation of Error-Components Models,” Journal of Econometrics, Vol. 68, pp. 29–51.
- Barro, R., and J. Lee, 2010, “A New Dataset of Educational Attainment in the World, 1950–2010” NBER Working Paper 15902 (Cambridge, MA: National Bureau of Economic Research).
- Blundell, R., and S. Bond, 1998, “Initial Conditions and Moment Restrictions in Dynamic Panel Data Models,” Journal of Econometrics, Vol. 87, pp. 115–143.
- Chang, R., L. Kaltani, and N. Loayza, 2009, “Openness Can Be Good for Growth: The Role of Policy Complementarities,” Journal of Development Economics, Vol. 90, pp. 33–49.
- Cohen, D., and M. Soto, 2007, “Growth and Human Capital: Good Data, Good Results,” Journal of Economic Growth, Vol. 12, pp. 51–76.
- Delgado, F., and M. Meza, 2011, “Developments in Financial Supervision in Central America and the Use of Macroprudential Measures,” unpublished manuscript (Washington: International Monetary Fund).
- Durlauf, S., P. Johnson, and J. Temple, 2005, “Growth Econometrics,” in Handbook of Economic Growth, ed. by P. Aghion and S. Durlauf (Amsterdam: North-Holland).
- Easterly, W., 2005, “National Policies and Economic Growth: A Reappraisal,” in Handbook of Economic Growth, ed. by P. Aghion and S. Durlauf (Amsterdam: North-Holland).
- Escaith, H. and I. Paunovic, 2004, “Reformas Estructurales en América Latina y el Caribe en el Período 1970–2000: Índices y Notas Metodológicas,” ECLAC Working Paper (Santiago, Chile: Economic Commission for Latin America and the Caribbean).
- Hall, R., and C. Jones, 1999, “Why Do Some Countries Produce So Much More Output Per Worker Than Others?” Quarterly Journal of Economics, Vol. 114, pp. 83–116.
- Heston, A., R. Summers, and B. Aten, 2011, “Penn World Table Version 7.0,” Center for International Comparisons of Production, Income, and Prices at the University of Pennsylvania.
- Kumar, M., and J. Woo, 2010, “Public Debt and Growth,” IMF Working Paper 10/174 (Washington: International Monetary Fund).
- Laeven, L., and F. Valencia, 2008, “Systemic Banking Crises: A New Database,” IMF Working Paper 08/224 (Washington: International Monetary Fund).
- Lora, E., 2001, “Structural Reforms in Latin America: What Has Been Reformed and How to Measure It,” IADB Research Department Working Paper 466 (Washington: Inter-American Development Bank).
- Mehrhoff, J., 2009, “A Solution to the Problem of Too Many Instruments in Dynamic Panel Data GMM,” Discussion Paper No. 31/2009 (Frankfurt: Deutsche Bundesbank).
- Prati, A., M. Onorato, and C. Papageorgiou, 2010, “Which Reforms Work and Under What Institutional Environment: Evidence from a New Dataset on Structural Reforms,” unpublished manuscript.
- Reinhart, C., and K. Rogoff, 2009, “The Aftermath of Financial Crises,” American Economic Review, Vol. 99, pp. 466–472.
- Roodman, D., 2009a, “How to Do xtabond2: An Introduction to Difference and System GMM in Stata,” The Stata Journal, Vol. 9, pp. 86–136.
- Roodman, D., 2009b, “A Note on the Theme of Too Many Instruments,” Oxford Bulletin of Economics and Statistics, Vol. 71, pp. 135–158.
- Sala-i-Martin, X., G. Doppelhofer, and R. Miller, 2004, “Determinants of Long-Run Growth: A Bayesian Averaging of Classical Estimates (BACE) Approach,” American Economic Review, Vol. 94, pp. 813–835.
- Shah, H., and others, 2008, “Financial Sector Development: Equity and Private Debt Markets.” In Central America: Economic Progress and Reforms, ed. by D. Desruelle and A. Schipke (Washington: International Monetary Fund).
- Spilimbergo, A., J. Ostry, and A. Prati, 2009, “Structural Reforms and Economic Performance in Advanced and Developing Countries,” IMF Occasional Paper No. 268 (Washington: International Monetary Fund).
- Windmeijer, F., 2005, “A Finite Sample Correction for the Variance of Liner Efficient Two-Step GMM Estimators,” Journal of Econometrics, Vol. 126, pp. 25–50.

### Appendix — Data sources (Table A.2)
- PPP GDP per capita: Heston and others (2011)
- Investment (in PPP terms): Heston and others (2011)
- Educational attainment: Barro and Lee (2010); Cohen and Soto (2007) for countries not contained in Barro and Lee
- Inflation (consumer price index): IMF, International Financial Statistics and World Economic Outlook databases
- Total population and working-age population: United Nations, World Population Prospects
- Financial system index and subcomponents: Authors’ calculations based on detailed data in Abiad and others (2010)
- External transactions index and subcomponents: Authors’ calculations based on detailed data in Spilimbergo and others (2009)
- Product markets index and subcomponents: Authors’ calculations based on detailed data in Spilimbergo and others (2009)

### Appendix — Countries Included in the Analysis (Table A.1)
- Note: A * indicates structural reforms data are available. Countries in bold are included in the analysis of 1960–2009 growth rates.

- ADVANCED
  - Malaysia *BarbadosMadagascar *
  - Australia *Nepal *BeninMalawi
  - Austria *Philippines *Botswana Mali
  - Belgium *Singapore *
  - Bulgaria  *
  - Canada *Sri Lanka *Burkina Faso *Mauritius
  - Denmark *Taiwan, P.o.C. *Burundi Morocco *
  - Finland *Thailand *Cameroon *Mozambique *
  - France  *
  - Vietnam  *
  - Cape Verde Namibia
  - Germany *
  - SAMEX
  - Central African RepublicNiger
  - Greece *Argentina *Chad Nigeria *
  - Iceland                                       Bolivia                                       *Comoros                                       Pakistan                                       *
  - Ireland *Brazil *Congo Papua New Guinea
  - Italy *Chile *Cote D'Ivoire *
  - Poland *
  - Japan *Colombia *Cyprus Romania *
  - Luxembourg *Ecuador *Egypt *Rwanda
  - Netherlands *Mexico *Equat Guinea Senegal
  - New Zealand *Paraguay *Ethiopia *Seychelles
  - Norway *Peru *Fiji Sierra Leone
  - Portugal *Uruguay *Gabon South Africa *
  - Spain *Venezuela *Gambia, The Syria
  - Sweden *
  - CAPDR
  - Switzerland *Costa Rica *Guinea Togo
  - United Kingdom *Dominican Rep *Guinea-BissauTrinidad and Tobago *
  - United States *El Salvador *Haiti Tunisia *
  - EASIA
  - Guatemala *
  - Hungary *
  - Turkey *
  - Bangladesh *Honduras *Iran, I.R. ofUganda *
  - China *Nicaragua *Israel Zaire
  - Hong Kong SAR *Panama Jamaica *Zambia
  - India *
  - OTHER
  - Jordan *Zimbabwe *
  - Indonesia *
  - Albania *
  - Kenya *
  - Korea *Algeria *Lesotho

*Source: _wp11248 - REFERENCES (PDF chapter/section).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11248.pdf_