Information about Western Hemisphere Hemisferio Occidental
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chapter 1 Introduction and Overview

Dominique Desruelle, and Alfred Schipke
Published Date:
November 2008
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Information about Western Hemisphere Hemisferio Occidental
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Dominique Desruelle and Alfred Schipke 

Central America1 has made substantial progress over the past years in moving economic reforms forward and deepening regional and global integration. As a result, Central America has benefited from continued macroeconomic stability and an improved growth performance. Despite this progress, the region is still vulnerable to adverse shocks and faces widespread poverty. The challenge now is to strengthen further the region’s resilience to shocks and improve the living standards of all.

These are some of the issues addressed in this publication, which complements two previous IMF volumes on Central America.2 After rapidly reviewing recent developments and the economic outlook, this chapter provides a brief overview of the publication. Because Central America is moving forward with economic integration, and because national policymaking is increasingly confronted with integration-related vulnerabilities, Chapter II analyzes Central America’s process of integration and policy coordination. It highlights that Central America is a prime candidate for increased integration, but that the process needs to be accompanied by increased coordination of public policies at the regional level.

Given strong economic linkages with the United States, Chapter III then assesses the extent to which business cycles in Central America are subjects to spillovers from the United States. It finds that a cyclical fall in output in the United States typically has a significant and adverse impact on most countries in the region. Central America’s high levels of poverty and income inequality place fiscal issues at the center of the policy debate. A key component of this debate is whether fiscal policies benefit the poor. Chapter IV analyzes the distributional effects of taxation and social spending in Central America, demonstrating that increased taxation combined with higher social spending can have a strong effect on reducing poverty.

The region’s decision to move forward with the establishment of a customs union will further facilitate intraregional trade, but its implementation also presents the challenge of ensuring that the region’s tax revenue are protected. Chapter V highlights important tax administrative requirements for establishing a Central American customs union based on international experience. Building on the recent progress, the chapter points out that important decisions still have to be made, and suggests that the implementation of the customs union should be gradual and go hand-in-hand with institution building. Following a discussion of financial sector issues related to banking and public debt markets in previous volumes, Chapter VI takes stock of Central America’s private debt and equity markets and identifies key impediments for the development of these markets. Given the inherent size limitations of domestic markets, one of the recommendations of the chapter is to consider taking advantage of existing exchanges in Latin America or developing of a regional securities market.

Recent Developments and Economic Outlook

Until mid-2007, Central America benefited from a favorable global environment but more recently has been confronted with two significant external shocks—weakening external growth and commodity price hikes. The United States, the region’s main trading partner, is experiencing an economic downturn, which was sparked by the bursting of the housing market bubble and ensuing financial turmoil. At the same time, the fuel and food commodity price boom has had a largely negative impact on the region. While the region is a net food exporter, it is a net importer of cereals, whose price rose dramatically in 2007; furthermore, as a net oil importer, the region has seen its oil import bill rise dramatically, from 5.7 percent of GDP in 2004 to 8.3 percent of GDP in 2007.

Against this backdrop, Central America’s economic performance in 2007 was still robust, but the region also experienced higher inflation. On average the region posted a growth rate of 6.8 percent in 2006 and 6.7 percent in 2007 (Table 1.1, Figure 1.1), with particularly strong growth in Costa Rica, Honduras, the Dominican Republic, and Panama. As in other parts of the world, controlling inflation has been a major policy challenge. In part driven by higher international food and oil prices, inflation rose across the region, with average annual inflation of about 9 percent at end-2007, compared with an average of 6 percent at end-2006.

Table 1.1.Main Economic Indicators
Output Growth

(annual rate in percent)

(e.o.p. rate in percent)2
Private Credit Growth

(change in percent of GDP)
1995–2000 Avg.2001–2005 Avg.200620071995–2000 Avg.2001–2005 Avg.200620071995–2000 Avg.2001–2005 Avg.20062007
Central America14.
CA simple average4.
Costa Rica4.
Dominican Republic7.13.510.
El Salvador3.
Latin America and Caribbean2.
United States3.
Ext. Current Account

(in percent of GDP)
Export Growth

(US$, in percent)

(in percent of M2)
1995–2000 Avg.2001–2005 Avg.200620071995–2000 Avg.2001–2005 Avg.200620071995–2000 Avg.2001–2005 Avg.20062007
Central America1-5.0-4.1-4.9-6.712.44.811.411.921.525.630.532.0
CA simple average-6.5-5.3-5.5-7.813.86.111.912.324.730.635.336.3
Costa Rica-3.4-4.6-4.7-5.813.44.612.715.620.921.628.331.2
Dominican Republic-2.30.7-3.5-
El Salvador3-1.8-3.5-3.8-4.811.73.921.813.8
Latin America and Caribbean-2.9-
Public Sector Balance (in percent of GDP)Public Sector Debt (PSD) (in percent of GDP)Foreign Currency PSD (in percent of total PSD)
1995–2000 Avg.2001–2005 Avg.200620071995–2000 Avg.2001–2005 Avg.200620071995–2000 Avg.2001–2005 Avg.20062007
Central America1-2.1-3.6-1.7-0.963.655.146.137.476.
CA simple average-2.2-3.6-1.3-0.889.368.151.238.676.177.169.665.0
Costa Rica-3.4-4.2-0.50.651.
Dominican Republic-1.6-4.4-3.5-1.730.841.344.
El Salvador3-2.2-3.7-2.9-2.429.740.241.941.1
Latin America and Caribbean-4.1-2.9-1.0-1.349.261.851.450.432.451.530.927.0
Sources: IMF World Economic Outlook; and IMF staff estimates.

Weighted average. Weighted by PPP GDP.

End-of-period rates, i.e., December on December.

Fully dollarized. The concept of reserve coverage and foreign-currency-denominated public sector debt (i.e., currency risk) is not relevant.

Sources: IMF World Economic Outlook; and IMF staff estimates.

Weighted average. Weighted by PPP GDP.

End-of-period rates, i.e., December on December.

Fully dollarized. The concept of reserve coverage and foreign-currency-denominated public sector debt (i.e., currency risk) is not relevant.

Figure 1.1.Selected Macroeconomic Indicators

Sources: IMF, World Economic Outlook; IMF, International Financial Statistics; IMF, Information Notification System; and Economic Commission for Latin America and the Caribbean.

Note: rhs = right hand scale; lhs = left hand scale; CA = Central America; LA = Latin America.

1Cumulative first-round impact on current accounts resulting from changes in primary commodity prices, for 2007, in percent of 2002 GDP.

2Excludes Panama and El Salvador.

Continued fiscal prudence, improvements in tax and customs administration, and high growth resulted in a strong fiscal performance. Average public sector deficits fell to 0.7 percent of GDP in 2007 from 1.8 percent of GDP in 2006. With a slight increase in non-interest expenditure as a share of GDP in 2007, this further improvement in fiscal balances was driven by a modest decline in interest expenditure and, predominantly, by an increase in revenue. There are indications that a significant portion of the observed increase in revenue has been structural in a number of countries (Vladkova Hollar and Zettelmeyer, 2008; Cubero and Sow-erbutts, 2008). Public debt levels continued their downward path from 46 percent of GDP in 2006 to 37 percent in 2007. Efforts to reduce vulnerabilities continued in all countries, and the share of foreign-currency-denominated debt fell from 63 percent in 2006 to just under 60 percent of total public debt in 2007.

While external positions generally remained strong, the regional current account deficit widened. On average, current account deficits increased from 5 percent of GDP in 2006 to 6.7 percent of GDP in 2007. The rising oil import bill in particular had an important effect in all countries of the region, although in some countries strong export growth and remittance flows partly offset the negative terms of trade shock. Despite strong competition from China, which adversely affected textile exports to the United States, overall exports grew by over 11 percent in both 2006 and 2007. As capital inflows to the region continued, international reserves remained at high levels, rising slightly in proportion to broad money.

The financial systems in the region were not directly affected by global market turmoil. In particular, there has been no evidence of exposure to the U.S. sub-prime market. Private sector credit, however, grew rapidly over the past two years, especially in Costa Rica, Honduras, Guatemala, and the Dominican Republic, reaching 24 percent on average in 2007 compared with 19 percent in 2006.

Faced with the prospect of a global growth slowdown, a U.S. downturn, high commodity prices, and continued fragility in global financial markets, Central America’s growth outlook has moderated. Nevertheless, regional growth is projected to be still robust in 2008; and, under this scenario, most countries in the region would still have a positive output gap by the end of this year.3 At the same time, actual inflation and inflation expectations have risen sharply, and the rise in food prices is threatening to undermine recent progress in reducing poverty. Thus, in the short term, macroeconomic policies will need to be oriented primarily toward bringing inflation under control and easing the impact of the food price shock on the poor in a fiscally responsible manner. In addition, policymakers will need to continue to closely monitor external developments, which remain highly volatile, and be prepared to adapt domestic policies accordingly.


Moving Forward with Economic Integration and Cooperation

In parallel with increased global competition, Central America’s regional integration is advancing rapidly, both with respect to policies and on the ground. In addition to moving forward with the implementation of the free trade agreement with the United States (Central America—Dominican Republic—United States Free Trade Agreement, CAFTA-DR), policymakers signed a framework agreement to establish a Central American customs union and have started negotiations on an association agreement with the European Union. At the same time, private sector companies and financial institutions are increasingly operating throughout the region. The Central American countries appear to be ideal candidates to benefit from increased integration because they share many characteristics in terms of size, proximity to the United States, history, and language. There are, however, differences in terms of economic development, with Costa Rica being the most advanced economy in the region. In addition to being able to take advantage of scale economies and specialization, a unified region with almost 40 million people would be able to represent its economic interests more effectively at the global level.

Not surprisingly, Central America has advanced the most in the area of trade, with respect to both intraregional trade and the global economy (Chapter II). This reflects a long process of trade liberalization that culminated in the entry into force of CAFTA-DR. Increased trade integration and Central America’s objectives of moving forward with the establishment of a customs union and an Association Agreement with the European Union, however, calls for more fiscal coordination, among other things, to avoid harmful tax competition and minimize the impact of the fiscal implication of further trade liberalization. As trade integration increases, there might also be scope to seek convergence of specific taxes to minimize contraband and, still at a later stage, to develop a common framework for other indirect taxes. Although the Central American Council of Finance Ministers was established only a few years ago, it has become a crucial forum to foster fiscal coordination.

Financial sector integration also has been advancing rapidly over the past couple of years. After a first stage of integration that was dominated by the expansion of regional institutions with local capital, Central America is now experiencing a striking surge in the activities of international banks. This is a welcome development because it will foster the dissemination of international standards in terms of capitalization, risk management, and corporate governance, and may result in more competition for the provision of financial services. At the same time, it presents challenges in terms of both supervision and regulation. The authorities at the regional level have already initiated a number of projects to address some of these issues (such as the adoption of a regional memorandum of understanding for consolidated supervision of regionally operating banks) and are currently assessing further the implications of this development for local regulatory frameworks and prudential requirements.

Successful integration also calls for appropriate institutions to foster exchanges of information, promote policy coordination, and facilitate the adoption of common standards, regulation, and norms. In key economic policy areas, Central America is substantially advanced in that it already has regional forums, such as the ones for finance ministers, central bank presidents, ministers of economy and trade, and financial sector superintendents, and their corresponding executive secretariats, including the Secretariat for Economic Integration (SIECA). As integration continues to move forward, these institutions will have to play an increasingly important role, spearheading policy coordination and standardization.

Central America’s Regional Trends and U.S. Cycles

The economies of Central American and the United State are closely intertwined. The open nature of the region’s economies, combined with the geographic proximity to the United States, has resulted in a number of transmission channels through which U.S. cyclical fluctuations could impact the region. As the implementation of CAFTA-DR moves forward, the links between the two regions are likely to become even stronger. The main channels through which shocks are transmitted are trade, financial flows, and remittances. An analysis of the links between the two regions is particularly timely given the significant U.S. slowdown and the resulting spillovers posing challenges for policymakers in Central America.

Central America has both strong trade and financial sector links to the United States. The United States is by far Central America’s main export market. Since the early 1980s, the share of total merchandise exports to the United States has averaged about 40 percent, ranging from about 30 percent in Nicaragua to 50 percent in Honduras. The use of the U.S. dollar as the official currency in El Salvador and Panama, high levels of financial dollarization in some other countries of the region, and current exchange rate policies imply that changes in financial conditions in the United States are rapidly transmitted to Central America via interest rates. Financial sector links with the United States are further reinforced by rising foreign ownership of domestic banks.

Remittance flows sent by migrant workers to Central America have grown rapidly and now account for a large share of GDP and financial flows. With the exception of Costa Rica and Panama, remittances are sizable. In some cases, they dwarf foreign direct investment, ranging from 8 percent of GDP in the Dominican Republic to 20 percent of GDP in Honduras in 2007.4 Although the empirical evidence is still ambiguous, one would expect that in the short term, cyclical fluctuations in the United States are likely to influence remittance flows while, over the longer term, socioeconomic and institutional factors in both the host and recipient country are likely to be dominant.

Given these links, it should be no surprise that the Central American economies appear to be strongly influenced by cyclical fluctuations in the United States. Historical data show that business cycles in Central America move in the same direction as those in the United States. Based on empirical estimates discussed in Chapter III, a growth slowdown of 1 percentage point in the United States would typically be associated with a cyclical fall in output growth of 0.5 to 1 percentage point in most of the countries of the region, with the largest effects being felt in Costa Rica and El Salvador. In light of this dependence, a prolonged downturn in the United States would be expected to have significant implications for the region.

Equity and Fiscal Policy: Income Distribution Effects of Taxation and Social Spending

With the exception of Costa Rica, almost 50 percent of Central America’s population lives in poverty, and the region faces high levels of income inequality. This situation calls for appropriate public policies to improve the living conditions of the poor. Fiscal policy in particular is at the center of this dialogue because taxation and social spending can have important effects on the market-determined distribution of income. As Chapter IV shows, improving income distribution is best achieved on the expenditure side, while taxes should be collected in the most efficient way.

Central American tax systems are generally regressive, with the exception of that in Panama. This is because of the prevalence of value-added (VAT) and sales taxes, whose effective tax rates relative to income are higher for poorer than richer households in most countries. However, regardless of their incidence, tax systems in Central America have only a small overall redistributive impact, consistent with international experience.

Public social spending in Central America, in contrast, is progressive relative to income. This said, there are important differences in the incidence of various components of social spending. Whereas spending on health and primary education is strongly progressive, social security and public pension systems are pronouncedly regressive, as is spending on tertiary education. The impact of social assistance transfers is mixed and generally small, given the limited resources devoted to them.

The combined redistributive effect of taxation and social spending is progressive in all countries of the region, highlighting the fact that the redistributive potential of social spending is much larger than that of taxation. However, the distributional impact of total social spending in Central America is diluted by its relatively low level and, in some cases, by poor targeting, thus limiting its impact on high pre-fiscal-policy levels of poverty.

Reforms combining efficient taxation and well-targeted spending could significantly reduce poverty in the region. For instance, a reform that increases tax revenues through the VAT and devotes the proceeds to social spending would unambiguously result in an improvement in the income of the poorest households. A conservative simulation exercise shows that an increase in tax revenue collection of 1 percent of GDP that is distributed evenly in absolute terms to all income groups (in other words, that does not specifically target the poor) would still increase the income of the poorest 20 percent of the population by up to 6 percent.

Central American Customs Union and Issues for Tax and Customs Administration

In December 2007, the governments in the region5 signed a framework agreement for the establishment of a Central American customs union, further demonstrating that the region has embarked on a gradual but dynamic process of deepening regional integration. The agreement defines important characteristics of the future customs union, such as the elimination of quantitative restrictions and charges that are equivalent to customs duties, the adoption of common legal and normative standards, and the strengthening of the existing institutional framework. With respect to the internal customs posts, the authorities decided to convert them gradually into trade facilitation centers, allowing them to keep collecting internal taxes and controlling fraud. Because taxes collected at the border will be transferred to the countries of destination, Central America opted against a common fund, which would have distributed revenue based on a particular formula.

The framework agreement is an important first step, but a number of important decisions are still needed regarding the customs union, especially in relation to tax and customs administration. Chapter V reviews the international experience in establishing customs unions, including the European Union, the South African Customs Union, the Gulf Cooperation Council, and the Southern Common Market (Mercosur). International experience suggests that institution building is critical to support the process, that internal customs controls typically stay in place for long periods after the launch of customs unions, and that there is a need for a coherent and integrated strategy to adopt minimum legal and administrative standards.

Given Central America’s circumstances, a gradual approach to establishing the Central American customs union appears appropriate. Such an approach could include the following steps: (1) a free trade agreement with free circulation of goods, which will require harmonizing technical restrictions; (2) temporary provisions for sensitive goods or sectors, along with a clear definition of the role of internal customs posts; (3) a gradual convergence of the free trade agreements signed by each country with nonmember countries, especially with respect to the level of tariffs, convergence deadlines, rules of origin, and the volume of goods involved; (4) the establishment of a Central American External Tariff (CET) that is eroded as little as possible by discrepancies, asymmetries, and bilateral free trade treaties; (5) the definition of a regional trade policy; and (6) institutional capacity building to support the entire process, based on staff training, integrated information technology systems, risk analysis, harmonized procedures, and the achievement of minimum standards in all key areas.

Financial Sector Development: Private Debt and Equity Markets

Financial sector intermediation in Central America takes place primarily through the banking sector. Assets in the banking system, which amount to 80 percent of regional GDP, are substantially higher than those of financial institutions, such as pension funds, insurers, and mutual funds. Regional banks dominated the banking system until recently, but an increasing presence of large international banks has changed this landscape. In line with other small developing countries, the allocation of savings and investment via capital markets is still very limited.

As Chapter VI reveals, while public debt markets are sizable, private equity and corporate debt markets are significantly underdeveloped. There are no equity markets in four countries of the region (Guatemala, Honduras, Nicaragua, and the Dominican Republic), and in the others, the markets are small and shrinking. At end-2006, fewer than 100 companies were listed in the entire region and market concentration was very high, with the top five companies making up, for example, two-thirds of market capitalization in Costa Rica and Panama. Furthermore, trading in secondary markets is almost nonexistent.

The importance of corporate bond markets varies substantially in size and importance across countries. Costa Rica accounts for 60 percent of all corporate debt securities outstanding in the entire region, faring relatively well compared with other emerging markets, followed by Panama and El Salvador. However, most debt securities have short maturities, and banks in the region account for the bulk of the demand. As in the case of equity markets, corporate debt markets in the other Central American countries remain at an incipient stage.

As regards corporate debt, these specific constraints include an unwillingness to disclose information to the public, ample liquidity in local and foreign banking systems, and several legal and regulatory shortcomings. For instance, in Guatemala, only financial institutions are authorized to raise funds in public markets. As concerns equities, some of the key obstacles have been the predominance of family ownership, poor corporate governance, memories of political and financial crises, and a weak institutional investor base.

There is no simple formula for the development of Central America’s private debt and equity markets. However, a number of measures would be worth implementing quickly because they are not only critical for the development of capital markets but also important for the improvement of the business environment in general. For example, there is substantial scope in Central America to continue improving accounting and auditing standards as well as upgrading the frameworks for the establishment of companies, the execution of collateral, and the initiation of bankruptcy proceedings. More specific measures for the development of capital markets would, at a minimum, require improvements in security laws and regulation—which, in the case of mutual funds, asset-backed securities, and derivatives, are completely absent in some of the countries—as well as in infrastructure, such as clearing and settlement systems.

Countries of the region are too small to support a viable securities market each in the long run. One option could be to take advantage of existing exchanges in Colombia or Mexico. Alternatively, Central America as a whole could consider developing a regional securities markets, balancing the benefits from economies of scale against implementation and coordination costs. Developing a regionally integrated market would require the harmonization of securities laws and regulations, approval and listing processes, supervision standards, disclosure norms and corporate governance. In addition, a high degree of supervisory cooperation and political backing would be essential to underpin efforts by securities’ exchanges and their members to harmonize, link, or integrate their operations. As Costa Rica, El Salvador, and Panama have already made significant efforts to move into this direction, and considering the length of this process, it may be advantageous for other countries to join these efforts.

The Road Ahead

Central America’s commitment to implementing economic reforms over the past years has had significant positive results. The region has benefited from a strong growth performance, lower public debt levels, more solid financial systems, and improved external positions. Improved economic fundamentals and policy frameworks in turn have led to improved credit ratings and general optimism about the region’s economic prospects, as reflected in increased investments by foreign companies, international financial institutions, and fund managers.

Today the region is in a better position to confront adverse shocks. However, the ongoing oil and food price shocks as well as a global and U.S. downturn will put to the test the region’s policy frameworks and expose remaining weaknesses. Hence, as is fully recognized by authorities in the region, further reforms will be needed to reduce vulnerabilities and increase policy space to respond to external shocks. Furthermore, to anchor hard-won macroeconomic stability gains, it will be important to secure a significant reduction in poverty. The following chapters address the issues discussed above in more depth.


    Cubero, Rodrigo, and RhiannonSowerbutts,forthcoming, “Actual versus Structural Fiscal Balances: Evidence from Costa Rica,”IMF Working Paper (Washington: International Monetary Fund).

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    Desruelle, Dominique, and AlfredSchipke,eds., 2007, Economic Growth and Integration in Central America, IMF Occasional Paper No. 257 (Washington: International Monetary Fund).

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    International Monetary Fund, 2008, World Economic Outlook, April, World Economic and Financial Surveys (Washington).

    Rodlauer, Markus, and AlfredSchipke,eds., 2005, Central America: Global Integration and Regional Cooperation, IMF Occasional Paper No. 243 (Washington: International Monetary Fund).

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    Vladkova Hollar, Ivanna, and JerominZettelmeyer,2008, “Fiscal Positions in Latin America: Have They Really Improved?”IMF Working Paper 08/137 (Washington: International Monetary Fund).

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Unless otherwise stated, in this publication Central America refers to Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic. Although for historical reasons, Panama is not formally part of Central America, it has very strong links to the region, especially in the financial sector, and is a member of the Central American Integration System. The same is true for the Dominican Republic, which participates actively in a number of Central American regional institutions, such as the Central American Monetary Council, the Council of Finance Ministers, and the Council of Financial Sector Superintendents.


The first volume, edited by Rodlauer and Schipke (2005), was published as IMF Occasional Paper No. 243 and covers the following topics: (1) the macroeconomic implications of CAFTA-DR, (2) trade liberalization and tax coordination, (3) fiscal sustainability—a value-at-risk approach, (4) regional integration and exchange rate arrangements, (5) regional integration and financial system issues, (6) regional issues in macroeconomic statistics, and (7) the political economy of implementing pro-growth and anti-poverty policy strategies in Central America. The second volume, edited by Desruelle and Schipke (2007), was published as IMF Occasional Paper No. 257 and covers (1) growth performance, (2) pension reform, (3) assessing sovereign debt structures, (4) the development of public debt markets, and (5) characterizing monetary policy.


Based on IMF (2008).


Excluding Panama and Costa Rica. Panama’s remittance inflows are insignificant. Costa Rica in turn is both a recipient and host country of remittances.


The agreement was signed by Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua.

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