IMF Survey: Central America Aims for Stronger Growth

IMF News, August 2, 2007

Source details

Author: Alfred Schipke, IMF Western Hemisphere Department; August 2, 2007.
Central America has made important economic advances after years of political and economic turmoil, aided by improved political stability and favorable global conditions.
Recent improvements:
- Real GDP has recovered.
- Inflation has remained under control despite the upsurge in oil prices.
- Exports have been strong.
Persistent challenges:
- Poverty remains persistent and widespread.
- The region remains vulnerable to economic events outside its control.
Conference context:
- Sixth annual regional conference held in San José, Costa Rica on June 29-30.
- Coincided with publication of IMF Occasional Paper No. 257, Economic Growth and Integration in Central America.

Central objective: reduce poverty, described as Central America's biggest challenge.
Growth performance:
- Average growth rates of the past decade have fallen short of records from the 1960s and 1970s.
- The region's growth has lagged more dynamic emerging market economies, especially in Asia.
Country outcomes:
- Only three countries—Costa Rica, Panama, and the Dominican Republic—have raised GDP per capita above levels observed in the late 1970s.
- Only Costa Rica has a substantially lower poverty level now than three decades earlier.
Sources of growth (1960-2005):
- Increases in output per worker reflected almost exclusively increased investment in capital equipment rather than productivity growth.
- Variations in growth across subperiods and countries were closely associated with differences in productivity growth.
Implication: improving productivity through reforms is paramount to raising living standards and reducing poverty.

Institutional improvements identified as key to raising productivity.
Simulation findings:
- Bringing institutional quality up to Chile's level could raise growth by:
- half a percentage point a year in Central American countries with relatively strong institutions (Costa Rica).
- 3 percentage points or more a year in countries with relatively weak institutions (Guatemala, Honduras, and Nicaragua).
Institutional dimensions cited: government effectiveness, control of corruption, political instability and violence, regulatory burden, voice and accountability, and the rule of law.
Trade agreements:
- A concerted effort to improve institutions and the business environment is paramount to ensure benefits from the Central American Free Trade Agreement with the United States and a potential Association Agreement with the European Union.

Public finances:
- Macroeconomic policies have strengthened, but high debt levels and future contingent claims, especially pension benefits, leave public finances vulnerable.
- Debt levels (with the exception of Guatemala's) remain high, averaging 47 percent of GDP at the end of 2006.
- Authorities need to reduce debt levels and raise tax revenue further to meet social and investment needs in a fiscally responsible manner.
Pension systems:
- Demographics: the ratio of the working-age population to the elderly will fall from about eight today to less than three in 2050.
- Sustainability requires combinations of increased contribution rates, higher retirement ages, and lower benefits in most countries.
- Political support and reform design are both critical for success.
Debt structure:
- Sustainability depends on debt level and structure—currency denomination, maturity composition, capital structure, and solvency.
- Regional characteristics:
- On average, Central America has a lower share of short-term debt than the rest of Latin America but a higher share of foreign currency debt.
- More recently, Central America has reduced foreign currency exposure and lengthened maturity structure modestly.
- Recommendation: continue efforts to move toward "safer" debt structures.

Achievements:
- Countries have succeeded in reducing inflation.
- Progress in strengthening institutional underpinnings for monetary policy: new central bank legislation has enhanced autonomy and focused mandates on price stability.
- Direct political intervention in central bank decisions and monetary financing of fiscal deficits has been curtailed.
Remaining shortcomings:
- Tension between maintaining price stability and preserving external value of domestic currency can cause policy conflicts (e.g., during strong capital inflows) and undermine credibility.
- The executive branch retains substantial leeway to remove central bank governors and directors, maintaining a potential link between the political business cycle and monetary policy decisions.
- Central banks generally lack financial autonomy because legal provisions to protect the integrity of central bank capital are often absent, undermining effectiveness and credibility.
Priority: make progress on legal and institutional features that enhance central bank independence and financial autonomy.

Financial sector structure:
- Region's financial sector is dominated by banks.
- Substantial room for development, except Panama which has a bank-asset-to-GDP ratio of 250 percent.
- Capital markets are underdeveloped; equity and corporate bond listings are generally in the single digits.
- Institutional investors intermediate only a small share of national savings.
Public debt market development:
- Substantial room to develop public debt markets through institutional and operational improvements.
- Recommendation: transfer quasi-fiscal debts of central banks to the government to aid establishment of liquid public debt markets and a unified sovereign yield curve, addressing dual sovereign debt issuers.
Nonstandard and nontradable debt:
- Region has a large stock that should be restructured.
Debt management improvements:
- Important to develop and implement a medium-term debt management strategy and improve technical capacity of debt management units.
- Costa Rica, El Salvador, and Panama have made some improvements in recent years.
Policy linkage:
- Deeper and more liquid public debt markets would allow authorities in countries with their own currency to conduct monetary policy more effectively.

Central message from IMF Deputy Managing Director Murilo Portugal: now is the time for Central America to reform and take advantage of the benign global environment.
Quotation highlighted: "it is in the sunny days that we should fix the roof of the house."