Journal Issue

Regional Outlook: Central America Aims for Stronger Growth

International Monetary Fund. External Relations Dept.
Published Date:
September 2007
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Times are better in Central America. After years of political turmoil, the region has made important economic advances against a backdrop of both improved political stability and favorable global economic conditions. Real GDP has recovered (see table), inflation has remained under control despite the upsurge in oil prices, and exports have been strong. Still, poverty is persistent and widespread, and the small nations that make up Central America remain vulnerable to economic events outside their control. They need to improve productivity and strengthen government finances and the financial sector. Top government officials in the region met in June and agreed that further economic reforms were needed.

The aim of all the reforms is the reduction of poverty, Central America’s biggest challenge. Average growth rates of the past decade have fallen short of records achieved in the 1960s and 1970s, and the region’s growth performance is less favorable than that of the more dynamic emerging market economies in the world, especially those in Asia. Only three countries in the region (Costa Rica, the Dominican Republic, and Panama) have succeeded in raising GDP per capita above their levels in the late 1970s, and in only one, Costa Rica, are poverty levels substantially lower. Addressing issues of economic growth will be paramount if Central America is to lift people out of poverty and significantly raise living standards.

But as it seeks to maintain high growth, Central America must also act in areas where it remains economically vulnerable, an assessment that Central American ministers of finance, central bank governors, and financial superintendents concurred with at the recent Sixth Annual Regional Conference on Central America, Panama, and the Dominican Republic, held in Costa Rica. In a communiqué issued on June 29, following the conference, the officials said participants agreed that the region must take “advantage of good times to tackle the daunting tasks of entrenching stronger growth, reducing still-high levels of poverty, and decreasing vulnerabilities against adverse shocks.”

Institutional quality

Improving the growth performance in Central America will depend to a large degree on the countries’ abilities to implement productivity-enhancing reforms. During 1960-2005, gains in output per worker almost exclusively reflected increased investment in capital equipment rather than productivity growth; and variations in growth within subperiods and across countries were closely associated with differences in productivity growth.

How then to raise productivity in Central America? The extensive literature on sources of growth in developing countries points, for example, to the benefits of strengthening institutions. Indeed, an illustrative simulation suggests that raising overall institutional quality—such as government effectiveness; control of corruption, political instability, and violence; regulatory burden; voice and accountability; and the rule of law—to Chile’s level could raise growth by half a percentage point a year in Central American countries with relatively strong institutions (Costa Rica) and by 3 percentage points or more a year in countries with relatively weak institutions (Guatemala, Honduras, and Nicaragua).

A concerted effort to improve institutions and the business environment in Central America is also paramount to ensuring that the Central American Free Trade Agreement with the United States and a potential association agreement with the European Union will lead to the expected productivity improvements and tangible benefits for all.

Macroeconomic policies have strengthened, but high debt levels and future contingent claims, especially pension benefits, still leave public finances vulnerable. Authorities must take further steps to reduce debt, which, except in Guatemala, remains high, averaging 47 percent of GDP at the end of 2006. In parallel, they need to raise tax revenue further in order to meet pressing social and investment needs in a fiscally responsible manner.

Putting Central America’s pension systems on a sound long-term footing is a key component of this strategy. Although Central America has more favorable demographics than countries with low or even declining birth rates, its population will age substantially and the ratio of the working-age population to the elderly will, for example, fall from about 8 today to less than 3 in 2050, rendering the systems unsustainable. Although there is no one-size-fits-all solution, sustainability requires some combination of increased contribution rates, higher retirement ages, and lower benefits in most countries.

“Safer” debt

Another key element in reducing vulnerability is moving toward “safer” debt structures, since sustainability is a function not only of the level of debt but also of its structure. Currency denomination, maturity composition, capital structure, and solvency play an important role in the likelihood of a crisis, and often public sector balance sheets exhibit significant mismatches along those dimensions. An analysis of Central America’s sovereign debt structures reveals that, on average, the region has a lower share of short-term debt than the rest of Latin America but a higher share of foreign currency debt. In line with broader developments in emerging markets more recently, Central America has been able to reduce its foreign currency exposure and lengthen its maturity structure modestly. Such efforts are a step in the right direction and should be continued.

Inflation reduction, monetary policy

Central American countries have succeeded in reducing inflation, but bringing it all the way down to the level of trading partners generally remains a challenge. In pursuit of this objective, 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 the monetary authorities enhanced autonomy and, as a result, the mandate of central banks is more clearly focused on preserving price stability. Direct political intervention in central bank decisions and monetary financing of fiscal deficits have been curtailed.

Nevertheless, monetary policy frameworks have some remaining shortcomings. Efforts to maintain price stability while 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 the credibility of central banks. There is still a potentially strong link between the political business cycle and monetary policy decisions because the executive branch continues to have substantial leeway to remove central bank governors and other members of the board of central bank directors. Furthermore, central banks generally continue to lack financial autonomy because there are often no legal provisions to protect the integrity of central bank capital, which in turn substantially undermines the effectiveness and credibility of monetary policy. It will be important to make progress on these issues in the coming years.

Steady GrowthOver the last three years real GDP in Central America has steadily improved, and slower but solid growth is forecast through 2008.
Central America4.
Costa Rica4.
Dominican Republic2.09.310.78.04.5
El Salvador1.
Source: IMF, World Economic Outlook database.
Source: IMF, World Economic Outlook database.

Development of financial systems

The financial sector in the region is dominated by banks and, with the exception of Panama—which has a bank asset-to-GDP ratio of 250 percent—there is substantial room for further development. Capital markets are underdeveloped across countries, and equity and corporate bond listings are generally in the single digits. Institutional investors such as pension funds, mutual funds, and insurance companies intermediate only a small share of national savings.

While there is no simple solution to developing private equity and corporate bond markets, there is substantial scope to develop public debt markets, especially through institutional and operational improvements. In most countries, it will also be important to develop and implement a medium-term debt management strategy and improve the technical capacity of debt management units. In that respect, Costa Rica, El Salvador, and Panama have made some improvements over the past couple of years. Deeper and more liquid public debt markets, in turn, would also allow the authorities in countries with their own currency to conduct monetary policy more effectively.

A propitious time for reform

As IMF Deputy Managing Director Murilo Portugal emphasized in his recent speech in San Jose, Costa Rica, now is the time for Central America to reform, taking advantage of the benign global environment. After all, “it is in the sunny days that we should fix the roof of the house.”

Alfred Schipke

IMF Western Hemisphere Department

This article is based on IMF Occasional Paper No. 257, Economic Growth and Integration in Central America, edited by Dominique Desruelle and Alfred Schipke.

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