## _op257ch1

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---

### Regional macroeconomic snapshot and vulnerabilities
- Regional current account deficit remained stable at about 5 percent of GDP in both 2005 and 2006, aided by strong export growth and rising remittances.
- Strong capital flows have led to further accumulation of foreign exchange reserves.
- Public debt levels (excluding Guatemala) averaged about 53 percent of GDP at end-2005, despite debt relief delivered to Nicaragua and Honduras under the Heavily Indebted Poor Countries (HIPC) Initiative.
- Public finances remain vulnerable; urgent increases in priority spending will require raising revenue, reducing exemptions, and reorienting spending.
- Financial sector intermediation is increasing, but vulnerabilities include:
  - Financial dollarization.
  - Weaknesses in supervision (notably offshore banking sector and nonsupervised deposit-taking institutions).
  - Rapid credit growth: increases in credit of 3½ percentage points of GDP or higher in Costa Rica, Nicaragua, and Panama during 2006.
- Recent banking failures in Guatemala (including Banco del Café and Banco del Comercio) highlight the need to improve supervision and bank resolution frameworks at national and regional levels.

### Economic growth: diagnosis and potential gains from reform
- Growth performance:
  - Average growth rates over the past decade have fallen short of records achieved in the 1960s and 1970s.
  - Only three countries (Costa Rica, Panama, and the Dominican Republic) have succeeded in raising GDP-per-capita levels above their levels in the late 1970s.
- Growth accounting (1960–2005):
  - Increases in output per worker almost exclusively reflected capital deepening rather than productivity growth.
  - Variations in growth across subperiods and countries were closely associated with differences in productivity growth.
- Institutional improvements can yield substantial growth gains:
  - Bringing institutional quality up to Chile’s level could raise growth by 0.5 percentage points per year in countries with relatively strong institutions (Costa Rica).
  - The same improvement could raise growth by 3 percentage points or more per year in countries with relatively weak institutions (Honduras and Nicaragua).
- Trade integration:
  - Ensuring that CAFTA-DR implementation and potential EU trade agreements produce expected productivity improvements requires stronger institutions and improved business environment.

### Fiscal issues, pension reform, and sovereign debt structures
- Pension systems:
  - The ratio of the working age population to the elderly will fall from about eight today to less than three in 2050.
  - By international standards, benefits are very generous relative to contributions and retirement ages are low, even allowing for life-expectancy differences.
  - The real internal rate of return of the defined-benefit systems is about 10 percent on average (more than twice the growth rate of the real wage bill or the average growth performance over past decades).
  - Pension reform is warranted for both pay-as-you-go defined-benefit systems and privatized defined-contribution systems; sustainability requires some combination of increased contribution rates, higher retirement ages, and lower benefits in most countries, and strengthening the link between contributions and benefits.
  - Countries that privatized still need parametric reforms to old defined-benefit systems to reduce transition costs.
  - Success depends on design and ability to mobilize necessary political support and broad-based consensus.
- Sovereign debt structure:
  - Central America has relatively high public debt levels (except Guatemala) and a higher share of foreign currency debt in total debt (except Costa Rica) than the rest of Latin America.
  - Central America compares favorably with other Latin American countries on share of short-term debt, except for Costa Rica and the Dominican Republic.
  - Recent trends show modest reductions in foreign currency exposure and modest lengthening of maturity structure.
  - Public sector balance sheets often exhibit significant mismatches in currency denomination, maturity composition, capital structure, and solvency.
  - Policy actions to improve debt structures:
    - Strengthen institutions to enhance domestic debt issuance capacity.
    - Promote financial development to lower shares of foreign currency and short-term debt.
    - Implement medium-term debt management strategies and improve technical capacity of debt management units.
    - Transfer quasi-fiscal debts of central banks to governments to support establishment of liquid public debt markets and a unified sovereign yield curve.
  - Costa Rica, El Salvador, and Panama have made some improvements in debt management over the past few years.
  - A regional public debt market could help overcome size and scale limitations in the medium to long term, conditional on improvements in local markets and harmonized technical standards of public debt issuance.

### Financial sector development and public debt market deepening
- Central America’s financial system is largely bank-based.
  - Panama has a bank-asset-to-GDP ratio of 250 percent.
  - Guatemala and the Dominican Republic have bank-asset-to-GDP ratios of around 35 and 40 percent, respectively.
- Capital markets are underdeveloped and dominated by public debt markets; equity and corporate bond listings are generally in the single digits (except in Panama).
- Institutional investors (pension funds, mutual funds, insurance companies) intermediate only a small share of national savings.
- Policy priorities to develop capital markets:
  - Restructure large stocks of nonstandard and nontradable debt.
  - Develop and implement medium-term debt management strategies.
  - Improve technical capacity of debt management units.
  - Harmonize standards across countries to support a regional public debt market over time.

### Monetary policy challenges and institutions
- All countries in the region have made substantial progress in strengthening the institutional underpinnings for formulating and executing monetary policy.
- New central bank legislation has given monetary authorities enhanced autonomy and a clearer mandate focused on preserving price stability, while some attention remains on competitiveness of the tradable sector.
- Central banks have benefited from increased de jure political autonomy.
- Remaining shortcomings:
  - Dual objectives of price stability and preserving the external value of the domestic currency raise concerns about objectives, cause policy conflicts (for example, in the case of strong capital inflows), and undermine central bank credibility.
  - Potentially strong link remains between the political business cycle and monetary policy decisions because the executive branch continues to have substantial leeway to remove central bank governors and board members.
  - Central banks generally lack financial autonomy; often there are no legal provisions to protect the integrity of central bank capital.
- Quasi-fiscal debt stocks cited as substantial: 11 percent of GDP in Costa Rica and 18 percent in the Dominican Republic.
- Bringing inflation down to the level of trading partners remains a challenge.
- Monetary policy in non-dollarized economies is tested by:
  - Regional integration with the United States.
  - Record levels of remittance flows.
  - Increasing integration into global capital markets in some cases.
- Some countries (for example, Costa Rica and Guatemala) are reviewing policy regimes to make them more effective.

### Regional integration, trade agreements, and policy coordination
- Trade liberalization and bilateral trade agreements:
  - CAFTA-DR became effective in El Salvador, Guatemala, Honduras, and Nicaragua in 2006.
  - The Dominican Republic followed in 2007.
  - Ratification in Costa Rica is pending; the new government of Oscar Arias in Costa Rica has made ratification a priority.
  - Panama, not part of CAFTA-DR, concluded technical-level negotiations on a separate agreement with the United States.
  - Central America is set to begin negotiations for an Association Agreement with the European Union in early 2007, which would create a free trade area between the two regions.
  - Negotiation format with the European Union will employ a single regional spokesperson (rotating among Central American countries).
- Integration and policy coordination — overview:
  - Increased regional coordination is required to maximize integration benefits and reduce integration-related vulnerabilities.
  - Key needs: standardize norms and regulations (e.g., customs); improve the flow of information among government agencies (e.g., financial sector supervisors); improve policy coordination in areas such as tax policies.
  - Central role of the Central American System of Integration in bringing together heads of state and regional councils and committees of ministers, central bank presidents, and superintendents.

### Tax coordination and institutional steps
- Increased economic integration will likely cause short-term customs revenue losses and could intensify tax competition.
- Recent and planned responses include improving tax administration and raising taxes in some countries (notably Guatemala, Costa Rica, Nicaragua, and the Dominican Republic).
- Ministers of finance have identified areas to coordinate tax policies. Key measures are:
  1. Increasing transparency by compiling a matrix of current tax incentives in the respective countries and making the information available to the seven countries.
  2. Reducing the risk of a “race to the bottom” and further proliferation of tax incentives by seeking an agreement on a code of conduct on good practices for fiscal incentives for investments.
  3. Protecting the corporate tax base by defining clear rules on transfer pricing and thin capitalization.
  4. Increasing cooperation between tax and customs administrations through a systematic exchange of information, which will be even more necessary given the stated goal of creating a customs union.
  5. Improving international taxation by establishing treaties to avoid the double taxation of income and capital.
- Institutional strengthening: establishment of a regional Committee of Finance Ministers and a supporting technical secretariat, closing an institutional gap alongside the Central American Monetary Council and the Council of Ministers of Economy and Trade.

### Coordination of financial sector regulation, supervision, and market initiatives
- Regionalization of financial services is accelerating, with more banks establishing offices and subsidiaries across countries.
- Integration reduces funding costs and diversifies risk but requires regulation and supervision to minimize regulatory gaps, arbitrage, and cross-border contagion.
- Central American Council of Financial Sector Superintendents is strengthening coordination and has initiated a regional project to:
  1. Strengthen understanding of current operations of regional financial groups and governing regulatory systems.
  2. Devise an adequate regulatory framework for cross-border consolidated supervision by improving the flow of information and enhancing collaboration between supervisory authorities.
  3. Adopt minimum regulatory standards and harmonize them regionally.
  4. Create mechanisms to monitor progress.
- In 2006, Panama, Costa Rica, and El Salvador signed an agreement to establish a regional exchange for equity and corporate bonds to create a regional capital market.
- Security superintendents initiated creation of a Central American Council of Security Regulators, starting at their first regional meeting in the Dominican Republic in 2006.

### Harmonization of macroeconomic statistics
- Deepening integration and policy coordination require reliable and comparable data across countries.
- The region has made progress in data quality and provision but remains heterogeneous and lacks a coordinated, consolidated, and harmonized statistical system.
- A regional project to improve and harmonize monetary and finance statistics has been launched, with possible later extension to fiscal statistics. The project will:
  1. Improve existing monetary and financial statistics compilation systems.
  2. Expand coverage by gathering data from all the 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.
- The project is expected to be completed in 2008.

### Selected statistics and indicators
- Regional current account deficit: about 5 percent of GDP in both 2005 and 2006.
- Average public debt (rest of region, at end-2005): about 53 percent of GDP.
- Credit increases in 2006: 3½ percentage points of GDP or higher in Costa Rica, Nicaragua, and Panama.
- Pension systems' real internal rate of return (defined-benefit systems, regional average): about 10 percent.
- Demographic ratio: working age population to elderly will fall from about eight today to less than three in 2050.
- Table 1.1. Central America: Real GDP Growth (selected values; 2004, 2005, 2006 preliminary):
  - Central America: 4.0, 5.1, 6.0
  - Costa Rica: 4.1, 5.9, 7.5
  - Dominican Republic: 2.0, 9.3, 10.1
  - El Salvador: 1.8, 2.8, 4.2
  - Guatemala: 2.7, 3.2, 4.6
  - Honduras: 4.6, 4.2, 5.5
  - Nicaragua: 5.1, 4.0, 3.7
  - Panama: 7.5, 6.4, 6.5
- Note: 2006 numbers are preliminary.

### Moving forward — challenges and prospects
- Central America has experienced improved economic performance in recent years, reflecting sound economic policies and a benign global environment.
- The region is well positioned to build on progress: political and economic institutions are maturing, and there is broad consensus on maintaining macroeconomic stability, leveraging globalization benefits, and strengthening regional cooperation.
- Key challenge: reduce poverty, improve living standards, and increase resilience to adverse shocks. Subsequent chapters address these issues in more depth.

*IMF Occasional Paper chapter text*

### 2006.  At  the  same  time,  the  regional  current  account

### _op257ch1 - 2006.  At  the  same  time,  the  regional  current  account

### Regional macroeconomic snapshot and vulnerabilities
- Regional current account deficit remained stable at about 5 percent of GDP in both 2005 and 2006, aided by strong export growth and rising remittances.
- Strong capital flows have led to further accumulation of foreign exchange reserves.
- Public debt levels (excluding Guatemala) averaged about 53 percent of GDP at end-2005, despite debt relief delivered to Nicaragua and Honduras under the Heavily Indebted Poor Countries (HIPC) Initiative.
- Public finances remain vulnerable; urgent increases in priority spending will require raising revenue, reducing exemptions, and reorienting spending.
- Financial sector intermediation is increasing, but vulnerabilities include:
  - Financial dollarization.
  - Weaknesses in supervision (notably offshore banking sector and nonsupervised deposit-taking institutions).
  - Rapid credit growth: increases in credit of 3½ percentage points of GDP or higher in Costa Rica, Nicaragua, and Panama during 2006.
- Recent banking failures in Guatemala (including Banco del Café and Banco del Comercio) highlight the need to improve supervision and bank resolution frameworks at national and regional levels.

### Economic growth: diagnosis and potential gains from reform
- Growth performance:
  - Average growth rates over the past decade have fallen short of records achieved in the 1960s and 1970s.
  - Only three countries (Costa Rica, Panama, and the Dominican Republic) have succeeded in raising GDP-per-capita levels above their levels in the late 1970s.
- Growth accounting (1960–2005):
  - Increases in output per worker almost exclusively reflected capital deepening rather than productivity growth.
  - Variations in growth across subperiods and countries were closely associated with differences in productivity growth.
- Institutional improvements can yield substantial growth gains:
  - Bringing institutional quality up to Chile’s level could raise growth by 0.5 percentage points per year in countries with relatively strong institutions (Costa Rica).
  - The same improvement could raise growth by 3 percentage points or more per year in countries with relatively weak institutions (Honduras and Nicaragua).
- Trade integration:
  - Ensuring that CAFTA-DR implementation and potential EU trade agreements produce expected productivity improvements requires stronger institutions and improved business environment.

### Fiscal issues, pension reform, and sovereign debt structures
- Pension systems:
  - The ratio of the working age population to the elderly will fall from about eight today to less than three in 2050.
  - By international standards, benefits are very generous relative to contributions and retirement ages are low, even allowing for life-expectancy differences.
  - The real internal rate of return of the defined-benefit systems is about 10 percent on average (more than twice the growth rate of the real wage bill or the average growth performance over past decades).
  - Pension reform is warranted for both pay-as-you-go defined-benefit systems and privatized defined-contribution systems; sustainability requires some combination of increased contribution rates, higher retirement ages, and lower benefits in most countries, and strengthening the link between contributions and benefits.
  - Countries that privatized still need parametric reforms to old defined-benefit systems to reduce transition costs.
  - Success depends on design and ability to mobilize necessary political support and broad-based consensus.
- Sovereign debt structure:
  - Central America has relatively high public debt levels (except Guatemala) and a higher share of foreign currency debt in total debt (except Costa Rica) than the rest of Latin America.
  - Central America compares favorably with other Latin American countries on share of short-term debt, except for Costa Rica and the Dominican Republic.
  - Recent trends show modest reductions in foreign currency exposure and modest lengthening of maturity structure.
  - Public sector balance sheets often exhibit significant mismatches in currency denomination, maturity composition, capital structure, and solvency.
  - Policy actions to improve debt structures:
    - Strengthen institutions to enhance domestic debt issuance capacity.
    - Promote financial development to lower shares of foreign currency and short-term debt.
    - Implement medium-term debt management strategies and improve technical capacity of debt management units.
    - Transfer quasi-fiscal debts of central banks to governments to support establishment of liquid public debt markets and a unified sovereign yield curve.
  - Costa Rica, El Salvador, and Panama have made some improvements in debt management over the past few years.
  - A regional public debt market could help overcome size and scale limitations in the medium to long term, conditional on improvements in local markets and harmonized technical standards of public debt issuance.

### Financial sector development and public debt market deepening
- Central America’s financial system is largely bank-based.
  - Panama has a bank-asset-to-GDP ratio of 250 percent.
  - Guatemala and the Dominican Republic have bank-asset-to-GDP ratios of around 35 and 40 percent, respectively.
- Capital markets are underdeveloped and dominated by public debt markets; equity and corporate bond listings are generally in the single digits (except in Panama).
- Institutional investors (pension funds, mutual funds, insurance companies) intermediate only a small share of national savings.
- Policy priorities to develop capital markets:
  - Restructure large stocks of nonstandard and nontradable debt.
  - Develop and implement medium-term debt management strategies.
  - Improve technical capacity of debt management units.
  - Harmonize standards across countries to support a regional public debt market over time.

### Monetary policy challenges
- Bringing inflation down to the level of trading partners remains a challenge.
- Monetary policy in non-dollarized economies is tested by:
  - Regional integration with the United States.
  - Record levels of remittance flows.
  - Increasing integration into global capital markets in some cases.
- Some countries (for example, Costa Rica and Guatemala) are reviewing policy regimes to make them more effective.

### Selected statistics and indicators (as presented)
- Regional current account deficit: about 5 percent of GDP in both 2005 and 2006.
- Average public debt (rest of region, at end-2005): about 53 percent of GDP.
- Credit increases in 2006: 3½ percentage points of GDP or higher in Costa Rica, Nicaragua, and Panama.
- Pension systems' real internal rate of return (defined-benefit systems, regional average): about 10 percent.
- Demographic ratio: working age population to elderly will fall from about eight today to less than three in 2050.
- Table 1.1. Central America: Real GDP Growth (selected values; 2004, 2005, 2006 preliminary):
  - Central America: 4.0, 5.1, 6.0
  - Costa Rica: 4.1, 5.9, 7.5
  - Dominican Republic: 2.0, 9.3, 10.1
  - El Salvador: 1.8, 2.8, 4.2
  - Guatemala: 2.7, 3.2, 4.6
  - Honduras: 4.6, 4.2, 5.5
  - Nicaragua: 5.1, 4.0, 3.7
  - Panama: 7.5, 6.4, 6.5
- Note: 2006 numbers are preliminary.

*Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/op/257/_op257ch1.pdf*

### Chapter  VI  shows  that  all  the  countries  in  the

### _op257ch1 - Chapter  VI  shows  that  all  the  countries  in  the

### Monetary policy institutions and autonomy
- All countries in the region have made substantial progress in strengthening the institutional underpinnings for formulating and executing monetary policy.
- New central bank legislation has given monetary authorities enhanced autonomy and a clearer mandate focused on preserving price stability, while some attention remains on competitiveness of the tradable sector.
- Central banks have benefited from increased de jure political autonomy.
- Remaining shortcomings:
  - Dual objectives of price stability and preserving the external value of the domestic currency raise concerns about objectives, cause policy conflicts (for example, in the case of strong capital inflows), and undermine central bank credibility.
  - Potentially strong link remains between the political business cycle and monetary policy decisions because the executive branch continues to have substantial leeway to remove central bank governors and board members.
  - Central banks generally lack financial autonomy; often there are no legal provisions to protect the integrity of central bank capital.
- Quasi-fiscal debt stocks cited as substantial: 11 percent of GDP in Costa Rica and 18 percent in the Dominican Republic.

### Integration and policy coordination — overview
- The region is moving toward greater trade liberalization and negotiating additional regional and bilateral trade agreements as intermediate steps toward greater multilateral opening and completion of the Doha trade round.
- Increased regional coordination is required to maximize integration benefits and reduce integration-related vulnerabilities. Key needs:
  - Standardize norms and regulations (e.g., customs).
  - Improve the flow of information among government agencies (e.g., financial sector supervisors).
  - Improve policy coordination in areas such as tax policies.
- Central role of the Central American System of Integration, which brings together heads of state and regional councils and committees of ministers, central bank presidents, and superintendents.

### Trade liberalization and bilateral trade agreements
- CAFTA-DR became effective in El Salvador, Guatemala, Honduras, and Nicaragua in 2006.
- The Dominican Republic followed in 2007.
- Ratification in Costa Rica is pending; the new government of Oscar Arias in Costa Rica has made ratification a priority.
- Panama, not part of CAFTA-DR, concluded technical-level negotiations on a separate agreement with the United States.
- Central America is set to begin negotiations for an Association Agreement with the European Union in early 2007, which would create a free trade area between the two regions.
- Negotiation format with the European Union will employ a single regional spokesperson (footnote explains the position will be held on a rotating basis by a representative of each Central American country).

### Tax coordination — measures and institutional steps
- Increased economic integration will likely cause short-term customs revenue losses and could intensify tax competition when countries need to raise tax revenue to address social needs and reduce high debt-to-GDP ratios.
- Recent and planned responses include improving tax administration and raising taxes in some countries (notably Guatemala, Costa Rica, Nicaragua, and the Dominican Republic).
- Ministers of finance have identified areas to coordinate tax policies. Key measures are:
  1. Increasing transparency by compiling a matrix of current tax incentives in the respective countries and making the information available to the seven countries.
  2. Reducing the risk of a “race to the bottom” and further proliferation of tax incentives by seeking an agreement on a code of conduct on good practices for fiscal incentives for investments.
  3. Protecting the corporate tax base by defining clear rules on transfer pricing and thin capitalization.
  4. Increasing cooperation between tax and customs administrations through a systematic exchange of information, which will be even more necessary given the stated goal of creating a customs union.
  5. Improving international taxation by establishing treaties to avoid the double taxation of income and capital.
- Institutional strengthening: establishment of a regional Committee of Finance Ministers and a supporting technical secretariat, closing an institutional gap alongside the Central American Monetary Council and the Council of Ministers of Economy and Trade.

### Coordination of financial sector regulation and supervision
- Regionalization of financial services is accelerating, with more banks establishing offices and subsidiaries across countries.
- Integration reduces funding costs and diversifies risk but requires regulation and supervision to minimize regulatory gaps, arbitrage, and cross-border contagion.
- Central American Council of Financial Sector Superintendents is strengthening coordination and has initiated a regional project to:
  1. Strengthen understanding of current operations of regional financial groups and governing regulatory systems.
  2. Devise an adequate regulatory framework for cross-border consolidated supervision by improving the flow of information and enhancing collaboration between supervisory authorities.
  3. Adopt minimum regulatory standards and harmonize them regionally.
  4. Create mechanisms to monitor progress.
- In 2006, Panama, Costa Rica, and El Salvador signed an agreement to establish a regional exchange for equity and corporate bonds to create a regional capital market.
- Security superintendents initiated creation of a Central American Council of Security Regulators, starting at their first regional meeting in the Dominican Republic in 2006.

### Harmonization of macroeconomic statistics
- Deepening integration and policy coordination require reliable and comparable data across countries.
- The region has made progress in data quality and provision but remains heterogeneous and lacks a coordinated, consolidated, and harmonized statistical system.
- A regional project to improve and harmonize monetary and finance statistics has been launched, with possible later extension to fiscal statistics. The project will:
  1. Improve existing monetary and financial statistics compilation systems.
  2. Expand coverage by gathering data from all the 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.
- The project is expected to be completed in 2008.

### Moving forward — challenges and prospects
- Central America has experienced improved economic performance in recent years, reflecting sound economic policies and a benign global environment.
- The region is well positioned to build on progress: political and economic institutions are maturing, and there is broad consensus on maintaining macroeconomic stability, leveraging globalization benefits, and strengthening regional cooperation.
- Key challenge: reduce poverty, improve living standards, and increase resilience to adverse shocks. Subsequent chapters address these issues in more depth.

*IMF Occasional Paper chapter text*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/op/257/_op257ch1.pdf_