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Central America Grapples with Policy Responses to Global Risks

Garment factory worker in Managua, Nicaragua—venue of regional conference to discuss Central America’s current policy challenges (photo: Oswaldo Rivas/Newscom)

Central America-IMF Conference

Central America Grapples with Policy Responses to Global Risks

By Natalie Ramirez-Djumena
IMF Survey online

July 22, 2011

  • Recovery in Central America gaining strength, but global uncertainties pose risk
  • Conference to focus on impact of rising energy prices, tepid U.S. recovery
  • Important challenges remain to improve fiscal positions, strengthen competitiveness

Economic growth in Central America—home to approximately 40 million people—is expected to be about 4 percent in 2011, but rising energy prices and the tepid recovery in the United States are creating a challenging environment for the region’s policymakers.

The IMF and senior policymakers of Central America, Panama, and the Dominican Republic will meet in Managua, Nicaragua, to discuss the current policy challenges for the region, in particular the implications of the global outlook, including high oil and food prices.

The conference, which will take place on July 28–29, will provide finance ministers, central bankers, superintendents of banks, and other high-level officials an opportunity to take stock of economic policies in Central America almost three years after the global financial crisis.

In an interview with IMF Survey, ahead of the two-day conference, Miguel Savastano, Deputy Director of the IMF’s Western Hemisphere Department, said that Central America needs to have a stronger fiscal position to guard against future shocks. To boost growth in the medium term, Savastano stressed that priority should be given to policies that strengthen competitiveness.

IMF Survey online: What is the main purpose of holding this conference? And what types of issues will be discussed?

This is an annual gathering of IMF staff with the policymakers of the seven countries in the Central American region. And this is the tenth year we have been holding this conference. As in previous years, the purpose of the conference is to discuss with the authorities the global outlook, the regional outlook, the implications of these trends for the economic policies that they are planning to implement, and what adjustments may be necessary given the external situation.

IMF Survey online: What has been the impact of the global financial crisis on Central America?

The global financial crisis had an important effect on economic activity in Central America, mainly from the downturn in activity in the United States, particularly in the construction sector, which is a key source of remittances to the region.

Prior to the crisis, the region as a whole was growing at slightly above 4 percent per year, but in 2009 growth dropped to zero and, in some cases, it turned negative. The counterpart to this downturn in activity was a decline in fiscal revenues, larger fiscal deficits, and higher public debt. So this region, which had been lowering its debt burden in the years before the crisis, has seen its debt ratios rise again. That is the main legacy of the crisis.

Importantly, the global financial crisis did not have an effect on domestic banking systems or international reserves. That was a very good outcome.

IMF Survey online: You mentioned Central America’s strong links to the United States. How is the lukewarm recovery in the United States affecting the region?

The tepid recovery in the United States, but, more importantly, the prospects for generally modest growth over the medium term, which is what we are expecting now, is of crucial importance to Central America’s outlook. The United States is the region’s main trading partner and also the region’s main source of remittances and foreign direct investment.

In all Central American countries, remittances are important to finance private consumption. So, for example, if growth in the U.S. construction sector is expected to remain weak, then remittance-led demand growth in Central America will be low, and consumption and investment are not going to grow much. This is what we are seeing in Central America as a result of the lukewarm recovery in the United States—a period of weaker private domestic demand than before the crisis.

IMF Survey online: How is the region coping with rising oil and food prices?

Central America’s main commodity exports are agricultural—mainly coffees. The higher prices for these products have increased export earnings, but imports of foodstuff also have increased. Central America has definitely been hit hard by high oil prices because the region is a net importer of oil and the import bill is large. Fortunately, most countries in the region have reasonably good pass-through mechanisms in place, meaning that most of the oil price increases are passed through to the consumers without impacting the budget.

However, because of the large increase in oil prices this time around—as was the case in 2007–08—some governments are providing targeted subsidies to mitigate the effects of higher prices on the poorest members of society. And that, of course, puts pressure on the fiscal deficits.

Another effect of the high commodity prices is on inflation. For example, the two fully dollarized countries in Central America—Panama and El Salvador—are experiencing high inflation even though their inflation rates are historically very similar to U.S. inflation. But because the consumption baskets used to construct the Consumer Price Index in these two countries are very different than the one in the United States, the inflation rates are very different. Inflation in El Salvador and Panama for end-2011 is projected at about 6–7 percent compared with to 2 percent in the United States. And these two dollarized countries do not have monetary policy tools to try to contain the impact of higher commodity prices on headline inflation.

IMF Survey online: Looking ahead, what reforms are needed to boost growth and competitiveness in the region?

This is one of the key topics of the conference. There are essentially two things that Central American countries can do.

The first is to try to strengthen their fiscal position and regain “fiscal space,” which is a challenge because, as I noted, these countries are not going to grow too fast. But they nonetheless need to lower their debt burden and regain the capacity to adopt countercyclical policies when the next round of adverse shocks materializes. They have used much of that space already.

On the structural side, you mentioned the key word: competitiveness. Central America shares the low productivity syndrome with most of Latin America. There is a lot that Central American countries can do to increase productivity.

For instance, the region has segmented labor markets and a wage structure that generates distortions in favor of organized groups like unionized public sector employees. Although these countries have a relatively high level of literacy, they have trouble adapting to new skill sets. These are the areas where these countries need to put their efforts to increase their medium-term growth potential.

IMF Survey online: What should our member countries in Central America expect from this conference?

I think the governments of these countries appreciate this forum because it gives them an opportunity to discuss with each other and also with IMF the global, regional, and domestic economic challenges and their policy options.

My sense is that this time they want to discuss precisely the question that you ask: how should they address the challenges posed by the medium-term prospects for the U.S. economy and the world economy.

Latin America is currently experiencing tailwinds from strong capital inflows and high commodity prices, but Central America is affected differently by these factors. Central America has a different dynamic and this conference is an opportunity for the IMF to present its analysis and help policymakers come up with policy responses tailored especially for them.