Information about Western Hemisphere Hemisferio Occidental
Journal Issue
Share
Chapter

chapter 2 Moving Forward with Economic Integration

Author(s):
Dominique Desruelle, and Alfred Schipke
Published Date:
November 2008
Share
  • ShareShare
Information about Western Hemisphere Hemisferio Occidental
Show Summary Details
Author(s)
Dominique Desruelle and Alfred Schipke 

Introduction

Central America appears to be an ideal candidate for economic integration. Despite differences in economic development, the countries share a common language, history, culture, and geography. At the same time, the economies are similar in terms of the size of their domestic markets and proximity to their largest trading partner, the United States. They face similar challenges from increased global competition in some of their key export markets (e.g., textiles) and are prone to similar shocks in the form of natural disasters (hurricanes, earthquakes, and volcanic eruptions) and terms of trade. With about 40 million people, Central America accounts for about 7 percent of Latin America’s population and about 5 percent of its total output.1 With a population about equal to that of Argentina or Colombia, if the region were economically integrated, it would be in a better position to take advantage of scale economies, coordinate large infrastructure projects to avoid duplication, and represent its economic interests effectively at the global level.

Indeed, faced with increased global competition, Central America has been responding by accelerating both regional integration and access to global markets. After a long period of trade liberalization and the more recent entry into force of the free trade agreement with the United States, policymakers are moving forward with the creation of a Central American customs union, and have started negotiations on an Association Agreement with the European Union. In addition, Central America has experienced an acceleration of cross-border activities, and more and more companies and financial institutions are operating regionally. These welcome developments will allow Central America to improve the growth potential of the region and significantly raise living standards. At the same time, increased integration calls for more policy coordination and, in certain areas, the establishment of common standards, regulations, and norms to maximize the benefits from integration and reduce vulnerabilities.

This chapter takes stock of Central America’s integration process, discuss recent developments, and identify areas where more policy cooperation is warranted. In particular, it briefly reviews Central America’s history of integration; analyzes how far the region has advanced in the area of trade, financial sector, labor market, and monetary integration; and highlights areas where more coordination and harmonization might be necessary.

History of Economic Integration

Central America’s integration dates back to the nineteenth century. In fact, for a short period, Central American countries operated as a unified region after they gained independence from Spain (1821) and severed ties with Mexico (1823). The Central American Republic was made up of what are now Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. Precipitated by efforts of the congress of the then Central American Republic to take control of customs revenue, the respective countries split to become separate republics in 1838.2

While the region has had strong advocates for economic integration since the breakup, integration efforts experienced a real boost in the 1950s. This was reflected in the signing of bilateral trade agreements among the countries of the region and the foundation of the Organization of Central American States (1951), and culminated with the Central American General Treaty of Economic Integration in 1960 (see Table 2.1). The latter was quite ambitious in that it envisaged not only the creation of a free trade zone, but also the establishment of a Central American common market. In many respects, the initial vision of integration was very similar to the early integration efforts of the European Union. In 1963, the Central American presidents even declared their intention to establish a monetary union, which was followed by an agreement of the central banks in 1964 setting out the procedures to establish such a union. To promote and finance economic integration, the governments of the region established the Central American Bank for Economic Integration (CABEI).

Table 2.1.Key Regional Agreements on Economic Integration
NameYear
Organization of Central American States (San Salvador letter)1951
Multilateral Treaty for Free Trade and Economic Integration in Central America1958
Economic Association Treaty1960
General Treaty for Central American Economic Integration11960
Central America Declaration1963
Central American Monetary Agreement1964
Central American Organization of States1962
Agreement on Central American Tariff and Customs Union Regime1984
Tegucigalpa Protocol1991
Guatemala Protocol1993
Central American Monetary Agreement1999
Amendment to Tegucigalpa Protocol2002
Treaty on Investment and Trade Services2002
Framework Agreement for the Establishment of a Central American Customs Union2007
Source: IMF staff.

Costa Rica joined the treaty in 1962.

Source: IMF staff.

Costa Rica joined the treaty in 1962.

Despite these initial efforts, however, integration faced substantial obstacles and came almost to a complete standstill during the 1970s and 1980s. While this can be explained—at least in part—by the armed uprisings in some countries of the region,3 this period also revealed that successful integration efforts require broad-based political support and that a road map for integration has to take into consideration each country’s capacity to implement such agreements. It also highlighted that integration needs to be accompanied by the development of an appropriate institutional capacity.

Learning from this experience, the more recent phase of integration has been more pragmatic. Based on two regional agreements (Tegucigalpa, 1991, and Guatemala, 1993), Central America still aims to establish a Central American common market by fostering the free movement of trade, capital, and labor. But the region moved away from the objective of import substitution and now embraces global opening. Also, in contrast to efforts in the 1960s, the process is meant to be gradual and participation voluntary, taking into consideration the unique circumstances of each country. The explicit goal of adopting a common currency was dropped.

In contrast to the European Union, where integration has gone hand in hand with the creation of supranational institutions (such as the European Commission, the European Anti-Trust Court, and the European Central Bank), Central America’s recent integration process has largely relied on intergovernmental bodies (e.g. councils). For example, the recently signed framework for the establishment of a Central America Customs Union (see below) does not envisage the establishment of a supranational institution, but instead relies on national tax authorities and the destination principle to distribute tariffs collected at the external borders of the customs union.

Level of Integration and Recent Developments

Over the past few years, economic integration has advanced rapidly. At the policy level, governments have continued to move forward with trade and financial sector liberalization. Compared with the past, though, integration is accelerating even more rapidly on the ground, with more and more nonfinancial corporation and financial institutions operating across borders. In addition, integration is advancing not only among the Central American economies but also with respect to the region’s integration into the world economy. To assess Central America’s level of integration, the following sections review both policies and outcomes with respect to the different areas of integration, covering trade, the factor markets (capital and labor), monetary integration, and institutional development.4

Trade Integration

Multilateral Trade Liberalization

As a result of a long process of liberalization, trade integration is relatively advanced in Central America. In 1993, the region committed itself to adopting a common trade nomenclature and in 1997 to implementing a common external tariff. Although the pace of implementation has been uneven across countries, a remarkable overhaul of tariff structures has taken place, bringing about a major reduction in average collected tariffs. Today, all countries in the region have tariff rates of less than 5 percent, which is low by international standards (see Table 2.2). More recently, reflecting the difficulties in completing the Doha Round on multilateral trade, with its large number of players and therefore slow progress of negotiations, Central America has sought alternatives. After the entry into force of the Central American–Dominican Republic–United States Free Trade Agreement (CAFTA-DR) in 2006/07, Central America started to negotiate an Association Agreement with the European Union in the fall of 2007, and has sought additional bilateral trade agreements.5

Table 2.2.Average Collected Import Duty Rates, 1985–2006(In percent of total imports)
Average
1995200020061990–951996–20002001–06
Costa Rica7.22.21.98.03.22.1
Dominican Republic12.814.34.315.312.97.6
El Salvador6.53.02.86.04.03.0
Guatemala8.44.53.47.86.04.4
Honduras9.63.61.711.96.32.4
Nicaragua4.53.11.610.43.72.2
Panama9.47.57.211.18.57.7
Unweighted average8.35.53.310.16.44.2
Sources: IMF, Government Finance Statistics (GFS); IMF, World Economic Outlook (WEO), April 2008.
Sources: IMF, Government Finance Statistics (GFS); IMF, World Economic Outlook (WEO), April 2008.

Bilateral Trade Agreements

CAFTA-DR

CAFTA-DR has been an important milestone in Central America’s recent economic integration process, boosting trade, investment, and the region’s growth potential. The implementation of the agreement also has contributed to much-needed institutional strengthening across a range of trade- and investment-related areas. With its implementation in all countries except Costa Rica (El Salvador, Guatemala, Honduras, and Nicaragua in 2006; the Dominican Republic in 2007), the member countries benefited immediately from tariff reductions on all non-agricultural and non-textile exports to the United States.6 In the case of products that already had preferential access under the Caribbean Basin Initiative, the agreement provided increased certainty by making the preferences permanent and in certain areas, such as textiles, the agreement led to an easing of the rules of origin. With passage of an important referendum on October 7, 2007, Costa Rica is expected to implement the agreement in 2008 once complementary laws, including those opening the telecommunications and insurance markets, have been approved by congress.

Association Agreement with the European Union

Formally, the two regions decided to launch negotiations on an Association Agreement at the European Union–Latin America and the Caribbean Vienna Summit in May 2006. Although the Association Agreement goes substantially beyond economic issues, the establishment of a bi-regional trade and investment agreement is a central component. Both Central America and the European Union will negotiate as a region; the European Commission will negotiate on behalf of the European Union (EU), and Central America will be represented by a single spokesperson on a rotating basis from each country. It is expected that the negotiations will be completed in 2009.7

Central American Customs Union

As mentioned above, Central America started to establish a common external tariff in 1997. As a result, and prior to the implementation of the CAFTA-DR, about 95 percent of the tariff lines were harmonized (SIECA, 2008). However, the remaining 5 percent that need to be harmonized reflect politically sensitive items, such as agricultural products (e.g., sugar, chicken), textiles, petroleum derivatives, metal products, and pharmaceuticals.8

With the signing of the framework agreement in December 2007, Central America is a step closer to a customs union. In the agreement, the signatory countries (Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua) have laid out, in broad terms, the path toward the creation of such a union. According to the agreement, the customs union will be established in three stages: (1) the free circulation of goods, (2) the establishment of a common external tariff, and (3) the harmonization of trade-related regulation and norms such as sanitation. The third stage would also aim to harmonize trade-related institutions. Because a number of countries in Central America collect not only tariffs at the border (which are relatively small) but also a large share of domestic taxes, especially value-added taxes, the framework does not envisage the elimination of border controls in the near future. Given limitations in the short to medium term to establishing other forms of domestic controls, a premature elimination of borders would result in significant revenue losses. Instead, the agreement envisages converting the borders into “trade facilitation centers.”

The agreement leaves open the possibility for other countries that form part of the system of economic integration in Central America (Belize and Panama) to join the customs union at a later stage. In May 2008, Panama announced interest in joining the negotiations. The Council of Ministers of Economy (COMIECO) is charged with implementing the agreement in consultation with other sectoral councils such as the Council of Finance Ministers. The next step will be to establish a specific timetable for the implementation of the different stages.9

Central America’s Trade Structure

Central America’s trade policy has been reflected in strong trade flows with the rest of the world, especially the United States. Today, Central America’s exports and imports amount to about 90 percent of GDP, of which more than 40 percent is traded with the United States. However, only 1 percent of all U.S. imports come from Central America and the region’s market share in the United States has declined since 2003, driven mainly by competition from China in textiles, the region’s top export to the U.S. market.

Trade integration among the Central American countries has been accelerating, especially over the past few years (see Table 2.3). Guatemala and Costa Rica are net exporters to the region, with Costa Rica importing the least from the region. Intraregional trade is diverse: food and beverages made up a little over 30 percent of intraregional trade in 2007, and a wide range of manufactured goods were traded across the region, such as pharmaceuticals (12 percent), plastics, cables and wires, and paper products.10

Table 2.3.Intraregional Trade(In millions of U.S. dollars)
Annual Growth

(in percent)
200320042005200620052006
Exports3,7644,2444,7955,85713.022.2
Costa Rica1,0121,1531,3151,59514.021.3
El Salvador8158931,0021,23312.223.1
Guatemala1,2671,4581,5951,9519.422.3
Honduras29932840650523.824.2
Nicaragua23425930037116.123.5
Panama10310212313920.113.5
Dominican Republic365153634.519.1
Imports4,3454,2125,5246,19331.112.1
Costa Rica48347353656313.35.0
El Salvador9981,0951,1791,2697.77.6
Guatemala1,2518351,5201,55782.02.4
Honduras7117741,0681,31837.923.5
Nicaragua45052861976317.323.3
Panama2863303614309.219.3
Dominican Republic16517624129336.521.6
Source: IMF, Direction of Trade Statistics.
Source: IMF, Direction of Trade Statistics.

Financial Sector Integration

In parallel with trade liberalization, Central America has also moved forward with financial sector liberalization. As a result, the Central American countries have open capital accounts, and there are no formal restrictions on the establishment or acquisition of financial institutions by regional or foreign banks or on the right of nonresidents to obtain new banking licenses.11 In addition, under CAFTA-DR, the countries committed themselves to opening up the insurance market.

Despite the fact that Central America’s financial system is largely bank based and capital markets are underdeveloped, financial sector integration has been advancing rapidly over the past few years. Initially, local financial institutions expanded regionally, establishing representative offices, branches, or subsidiaries in neighboring Central American countries. By 2005, regional financial institutions with local capital managed about 50 percent of total bank assets. This first stage of integration was rather unique when compared to other parts of the world, because the presence of large financial institutions from outside the region was more limited.

In tandem with CAFTA-DR, Central America is now experiencing a second phase of financial sector integration with large international financial institutions—such as HSBC, Citibank, Scotiabank, and others—acquiring regional and local banks and increasing their regional presence.12 In addition, Bancolombia (from its subsidiary in Panama) has ventured into the region, acquiring the largest bank in El Salvador. Some local banks have expanded their operations to position themselves against the competition from abroad.13 Over the past three years, the share of international banks has increased from less than 20 percent to almost 40 percent in terms of total bank assets (see Figure 2.1). This development has been particularly pronounced in El Salvador, whose banking sector today is now almost fully owned by large international financial institutions.

Figure 2.1.Financial Institutions, 2003–07

(In percent of total assets)

Source: Financial sector superintendents.

Labor Market Integration

Despite treaty provisions to foster the free movement of labor, formal labor market integration in Central America is in its infancy.14 As stated in the Guatemala Protocol of 1993, the governments of Central America committed themselves to fostering the free movement of labor by putting the necessary policies into place. So far, little progress has been made and most labor movements are informal. More recently, however, countries with labor shortages have encouraged temporary cross-border movements in certain sectors. For example, labor shortages in agriculture and housing construction in Costa Rica in 2007 prompted the Costa Rican government to provide temporary work visas to workers from Guatemala and other Central American countries. There have been similar arrangements between El Salvador and Honduras.

Monetary Integration

Despite initial efforts, the goal of adopting a common currency was abandoned in the early 1990s. As mentioned above, Central America’s experience of a common currency dates back to the period of the Central American Republic. After the breakup of the Central American Republic, the integration efforts of the 1960s initially envisaged the establishment of fixed exchange rate systems among the Central American economies and ultimate adoption of a common currency.15 In 1963, the Central American peso was established as a unit of account with the objective of fostering trade within the region.16 Even though the goal of adopting a common currency was abandoned and the role of the Central American peso became insignificant, the Central American peso is still used as a formal unit of account within regional institutions and regional import tariffs are expressed in Central American pesos.

Instead of a common currency, the Central American countries initially opted to peg their exchange rate to the U.S. dollar, though more recently some countries have been moving toward more flexible change rate systems.17 As a result, today, the Central American countries cover the whole spectrum of exchange rate systems, ranging from countries with more flexible exchange rates (Guatemala and Costa Rica are moving toward inflation targeting, while the Dominican Republic targets monetary aggregates) to countries with a crawling band or peg (Nicaragua and Honduras) and to those that officially adopted the U.S. dollar (El Salvador and Panama).

In this context, the emphasis has been to improve the effectiveness of monetary policy in countries that have not officially adopted the U.S. dollar by strengthening central bank independence, moving toward open market operations to manage liquidity, and in some countries moving toward inflation-targeting frameworks. At the same time, the countries have committed themselves to foster gradual monetary and financial sector integration through a convergence of mac-roeconomic policies, especially in the areas of monetary, credit, exchange rate, and financial sector policies (see CAMC, 1999).

As integration deepens, the question of which exchange rate system might best serve the region in the long run is likely to resurface. In addition to floating currencies, other possibilities are the introduction of a common currency or official dollarization, that is, the adoption of the U.S. dollar as the official regional currency. A study by Kim and Papi (2005) using an optimal currency index shows that the region has become more suitable for a dollar peg or dollarization, reflecting an increase in the synchronization of business cycles and a reduction in inflation differentials between Central America and the United States. Nonetheless, the study also highlights that Central America would still be less suitable for a common currency than Western Europe was in the 1970s. In any case, as the European experience shows, the adoption of a common currency would require full commitment at the political level.

Integration and Development of Regional Institutions

Institutionally, Central America has advanced substantially over the years, and has established a number of key regional institutions (Figure 2.2.). At the highest level is the System of Central American Integration (SICA), which brings together the countries’ presidents. In addition, there are a number of regional councils that involve the respective sectoral ministers or financial sector superintendents and are supported by their respective executive secretariats. These councils have become the cornerstone of regional coordination efforts.18

Figure 2.2.Regional Institutions of Economic Policy Coordination

Source: IMF staff.

Note: The figure is illustrative and does not necessarily reflect the formal legal structure. The degree of policy coordination is classified as: “none,” “some,” and “high.”

Areas for Increased Policy Coordination

As Figure 2.3 summarizes, Central America is already highly integrated in trade and to quite some degree in the financial sector as well. As economic integration deepens, there is a need for more coordination of policies and, in certain areas, the harmonization of regulation, supervision, and norms. These efforts will maximize the benefits of integration while reducing integration-related vulnerabilities. At this juncture, both fiscal policy and financial sector regulations and supervision are of particular importance.

Figure 2.3.Level of Economic Integration

Source: IMF staff.

Note: The level of integration is classified as “none,” “some,” and “high.”

Trade Integration and Fiscal Policy Coordination

Despite the growth of regional arrangements, the largest benefits of trade liberalization materialize in a multilateral context. The completion of the Doha trade round is, therefore, still the most important vehicle for promoting strong global growth and sustained poverty reduction, and although Central America’s regional and bilateral trade arrangements are expected to be beneficial, they need to be viewed as a step toward multilateral opening.

Trade liberalization, however, requires complementary reforms to maximize the benefits from increased trade. For Central America to fully benefit from trade liberalization, complementary and productivity-enhancing reforms are needed to ensure that resources are reallocated and lead to productivity increases in the face of new trading opportunities. In particular, there is substantial scope for improving institutions, the business environment, property rights, the rule of law, and corporate governance. At the same time, the reforms need to be accompanied by increased labor market flexibility and significant investment in human capital. This will ensure that resources can move to the most productive sectors.

The implementation of CAFTA-DR, the establishment of a customs union, and an Association Agreement with the European Union will provide additional economic benefits to the region. However, increased trade integration might be associated with revenue losses, at least in the short term, and may lead to further harmful tax competition to attract foreign investment. This would be detrimental to most countries in the region, given their low revenue-to-GDP ratios (ranging from 12 percent in Guatemala to 18 percent in Honduras) and the need to raise tax revenue to address social needs and fight poverty.

Faced with these challenges, there is need for more fiscal coordination, in addition to strengthening tax systems at the national level. Although the Central American Council of Finance Ministers (COSEFIN) was established only in 2006, it has already taken a number of important steps to forge common positions and foster policy coordination. In the area of fiscal incentives, it undertook a stocktaking exercise by developing a matrix of existing tax incentives.19 At its meeting in March 2008, it approved an important policy framework for a regional convention on good practices on tax incentives, emphasizing transparency, avoidance of tax competition within the region, and coherence with World Trade Organization (WTO) obligations.20 Other areas of recent successful cooperation have been in the development and approval of model legislation for (1) transfer prices, (2) thin capitalization to reduce the risk that companies will use debt to avoid taxation, and (3) double-taxation treaties. In addition, as a result of the coordination among Central American ministers, the framework agreement for a customs union now includes provisions that will protect the collection of internal revenue at the border.21

These are important steps. In the future, there may also be merit in considering convergence of specific taxes to avoid contraband and the definition of common principles (e.g., minimum rates) for other indirect taxes.

Financial Sector Coordination and Harmonization

Increased financial sector integration is a welcome development. The formation of regional conglomerates and cross-border lending in Central America allow financial institutions to take advantage of scale economies and therefore reduce funding costs, which in turn fosters investment and growth. At the same time, companies and households have more opportunities to diversify risk, making them less vulnerable to adverse shocks. The recent expansion of activities by international financial institutions in Central America is an additional positive development, because it could foster the dissemination of international standards in terms of capitalization, risk management, and corporate governance, and could generate greater competition in the provision of financial services. In some countries, the increased presence of international institutions has also led to an acceleration of the consolidation process of locally based financial firms. The increasing presence of international institutions therefore has the potential to further improve the efficiency and stability of the Central American financial systems.

However, the increased presence of global banks could exacerbate latent vulnerabilities. They could expose the region to large fluctuations associated with developments abroad, or lead to volatile capital flows if global banks engage in cross-border treasury operations. Access to deep funding pools could contribute to lengthening credit booms and increasing credit dollarization. Finally, these banks may create risky financial positions that are difficult to evaluate, reduce transparency of consolidated operations, and possibly segment the credit market leaving local banks with riskier positions (Medeiros and others, 2008). As international banks apply standardized credit evaluations, small and medium-sized companies might face more difficulties in obtaining credit, given the lack of adequate information on the operations of such institutions. This calls for an improvement of accounting standards and increased transparency. Yet the arrival of international institutions also could lead to a significant increase in consumer lending, which would need careful monitoring.

Therefore, to minimize integration-related vulnerabilities, more coordination and, in certain areas, harmonization is needed. In the case of regionally operating institutions, there is a risk of regulatory arbitrage—that is, efforts by institutions to exploit differences and loopholes in regulation across countries and the transfer of risks to less supervised areas. To overcome this risk, Central America needs to move toward the convergence of prudential standards (capital adequacy ratios, for example, range from 8 to 12 percent), regulation, and supervision (see Table 2.4). The regional Council of Financial Sector Superintendents has initiated a number of projects to address some of the more immediate supervisory issues. For example, in September 2007, the members of the council signed a regional memorandum of understanding (MOU) to foster consolidated supervision of regional institutions, which now needs to be implemented. In addition, the council has initiated a project to assess the implications of the surge in assets managed by international banks. The project analyzes the potential challenges for local supervisors and identifies appropriate prudential responses. Also, the project assesses whether the changed access to foreign liquidity will have implications for the stability and volatility of cross-border capital flows.22

Table 2.4.Reserve and Prudential Requirements(In percent)
Reserve RequirementsLiquid Asset Requirements
Capital

Requirements
Domestic

currency
Foreign

currency
Domestic

currency
Foreign

currency
Costa Rica10.0015.0015.00
El Salvador1,212.00≈22.00n.a.6.00n.a.
Guatemala10.0014.6014.60nonenone
Honduras10.00≈9.00312.009.00≈19.004
Nicaragua10.0016.2516.25
Panama28.00nonen.a.30.00n.a.
Dominican Republic10.0020.00520.00none6none
Sources: Country authorities; and IMF staff.

Liquidity requirements are 25 percent for current account deposits and 20 percent for savings and term deposits. At present, the weighted average requirement is about 22 percent. In mid-2008, and as a precautionary measure in the run-up to the 2009 presidential and congressional elections, banks were required to hold an additional 3 percent as liquid reserves abroad. After official dollarization, reserve requirements were substituted by remunerated liquidity requirements.

El Salvador and Panama are officially dollarized economies.

While domestic currency reserve requirements are 12 percent, for banks that direct 80 percent of their lending to the “productive” sector (i.e., neither consumer nor commercial loans), reserve requirements are 7 percent. Currently, the effective rate is about 9 percent.

Foreign currency liquid asset requirements are 24 percent, however, banks that have 70 percent of their foreign currency loan portfolio in the “productive” sector are required to hold 14 percent in liquid assets (as of November 2008). The effective rate is about 19 percent.

Includes cash in vault (up to a maximum of 5 percent of liabilities subject to reserve requirements).

A compulsory investment requirement is being phased out gradually, which accounted for less than US$8 million at end-September 2008.

Sources: Country authorities; and IMF staff.

Liquidity requirements are 25 percent for current account deposits and 20 percent for savings and term deposits. At present, the weighted average requirement is about 22 percent. In mid-2008, and as a precautionary measure in the run-up to the 2009 presidential and congressional elections, banks were required to hold an additional 3 percent as liquid reserves abroad. After official dollarization, reserve requirements were substituted by remunerated liquidity requirements.

El Salvador and Panama are officially dollarized economies.

While domestic currency reserve requirements are 12 percent, for banks that direct 80 percent of their lending to the “productive” sector (i.e., neither consumer nor commercial loans), reserve requirements are 7 percent. Currently, the effective rate is about 9 percent.

Foreign currency liquid asset requirements are 24 percent, however, banks that have 70 percent of their foreign currency loan portfolio in the “productive” sector are required to hold 14 percent in liquid assets (as of November 2008). The effective rate is about 19 percent.

Includes cash in vault (up to a maximum of 5 percent of liabilities subject to reserve requirements).

A compulsory investment requirement is being phased out gradually, which accounted for less than US$8 million at end-September 2008.

Given the potential risks of spillovers from local institutions that operate regionally, stress in the banking system of one country could quickly be transmitted to others in the region. Although there is scope in Central America to improve bank resolution frameworks at the national level, increased emphasis also should be placed at the regional level on arrangements for crisis management and mechanisms for early coordinated intervention of regionally operating institutions.

The Central American Monetary Council has made substantial progress in a number of areas to facilitate financial sector integration. For example, to foster financial market integration, in 2007, countries in the region signed an agreement creating a regional payment and security exchange settlement system. In addition to creating a regional platform, the agreement will further strengthen the respective national payment systems.23

Although the banking system is well developed and integration is advancing rapidly, domestic capital markets are underdeveloped and remain segmented in terms of currency, creditworthiness, regulation, restrictions on domestic institutional investors, and the absence of a regional exchange. The development of capital markets in Central America presents a challenge given the lack of potential scale economies, a limited local investor base, and high transaction costs. The development of a regional market could potentially overcome some of these limitations and entail benefits for both investors and issuers in terms of better risk diversification and more efficient allocation of capital allocation, as well as greater access to regional savings.

The establishment of such markets would be more long term and require first a conversion of standards and regulation and potentially the creation of a regional trading platform or a regional exchange. Because public debt markets are better developed than equity and corporate debt markets, which are almost nonexistent, the first priority would be to advance in this area. Jointly, the Central American Monetary Council and Council of Finance Ministers have taken initial steps to harmonize public debt market standards and debt management practices. This project has already led to some advancement in establishing common market conventions and calculation standards, adopting standardized securities in new issuance, and building consensus toward analytical approaches.24 Progress, however, has been varied across the region, and much remains to be done. With respect to equity and corporate bond markets, in 2006, Panama, Costa Rica, and El Salvador signed an agreement to establish a regional exchange with the objective of creating a regional capital market. In addition, the exchange and securities superintendents signed an MOU in 2007 to promote the harmonization of norms and legislations and to encourage the sharing of comparable information as well as to announce the establishment of a regional executive secretariat.

Increased integration, both among the Central American economies and with the rest of the world, will further aid macroeconomic policy coordination. As the recent oil and commodity price hikes demonstrate, Central America faces common shocks. In addition, spillovers from strong linkages with the United States (via trade, the financial sector, and remittance flows) call for similar policy responses across countries.25 Faced with these common shocks, the respective regional councils are well placed to deepen their analysis of common challenges and increasingly discuss the merits of different policy responses.

Improved Macroeconomic Data and Harmonization of Statistics

Deepening economic integration, increased access to global financial markets, and corresponding stronger linkages across countries call for the provision of timely, comparable, and adequate macroeconomic statistics to ensure sound economic policymaking and continued investor confidence. Despite statistical deficiencies in a number of areas, Central America has a good track record in improving macroeconomic statistics at the country level and has embarked on three large multiyear projects to improve monetary and finance, fiscal, and external statistics (see Appendix 2.1). Improving macroeconomic statistics in these areas requires commitment at the highest level, appropriate resources, continuous investment in human capital, and a medium-term perspective. Once sufficient progress has been made in these areas, there would be additional scope to harmonize national accounts data as well.

Conclusions

Responding to increased global competition, Central America’s regional integration is advancing rapidly both with respect to policies and on the ground. Because the countries share many characteristics in terms of size, proximity to the United States, history, and language, they appear to be well positioned to benefit from increased integration. 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 than the individual countries would.

Reviewing the different areas of economic integration ranging from trade, factor markets, and the monetary sector, not surprisingly, Central America has advanced the most in the area of trade, with respect to both intraregional trade and the global economy. This advance reflects a long process of trade liberalization that culminated in the implementation of CAFTA-DR. Increased trade integration and Central America’s objective of moving forward with the establishment of a customs union and an Association Agreement with the European Union require 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 for the convergence of specific taxes to avoid contraband and the adoption of a common framework for other indirect taxes. Although only recently established, the Central American Council of Finance Ministers has become a crucial forum to foster fiscal coordination.

Despite the fact that Central America’s financial systems are largely bank based and capital markets are underdeveloped, financial sector integration has also advanced rapidly over the past few years. The first stage of financial sector integration was dominated by the expansion of regional institutions with local capital, but Central America is now experiencing a dramatic surge in the arrival of international banks. This will foster the dissemination of international standards in terms of capitalization, risk management, and corporate governance, and will expose Central America’s local institutions to more competition. At the same time, it presents challenges potential challenges in terms of both supervision and regulation. Authorities at the regional level have already initiated a number of projects to address some of these issues (such as the regional memorandum of understanding for consolidated supervision of regionally operating banks) and are currently assessing the challenges for local supervisors, regulatory frameworks, and prudential requirements.

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

Moving forward with increased regional and global integration will bring substantial benefits to Central America. However, the process should be accompanied by appropriate improvements in policy coordination and the adoption of common regulations, standards, and norms to maximize benefits and minimize integration-related risks.

Appendix 2.1. Harmonization of Macroeconomic Statistics

Central America has made significant efforts in recent years to improve data quality and provision at the national level, with a view to ensuring sound economic policymaking and fostering investor confidence. Despite the progress so far, statistical deficiencies remain, with uneven data quality across sectors and countries. Outdated methodologies, poor source data, and inconsistency across sectors affect countries to different degrees, hampering policy formulation and monitoring. Deepening economic integration, increased access to global financial markets, and corresponding stronger economic linkages across countries imply that the provision of both timely and adequate statistical information becomes ever more important and call for the harmonization of statistics to ensure comparability across countries. To address some of these shortcomings, the Central American countries have embarked on three large regional projects to harmonize monetary and finance, fiscal, and external statistics.

Monetary and Finance Statistics

Mirroring Central America’s integration efforts, in 2006, the region initiated the first project to harmonize monetary and finance statistics. The focus of the project has been to (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; and (3) define common classification and valuation criteria for financial instruments and economic sectors.

The first stage of the project was completed in 2007, and all Central American countries, including Panama and the Dominican Republic, now have harmonized systems in place for compiling monetary and financial statistics based on the standardized report forms for monetary data. The second stage of the project is expected to conclude in mid-2008 with the dissemination of harmonized monetary statistics by the national authorities and on the website of the Central American Monetary Council.

This harmonization project is rather unique in that it is comparable only to the efforts to achieve statistical harmonization in the European Union. This experience has not only become the model for the new Central American harmonization projects in the fiscal and external sectors (see below) but could also become a model for other regions in the world. Also, the Central American authorities are considering expanding the project to a third stage, which would cover the compilation of data for other financial corporations (insurance companies, pension funds, etc.) and the derivation of the matrices to support the balance sheet approach to debt vulnerability analyses.

Fiscal Statistics

Given the current state of fiscal statistics, characterized among other things by differences in institutional and transaction coverage, compilation methodologies, and data sources, in 2008, the Council of Finance Ministers initiated a project to harmonize government finance statistics. A major benefit of the project will be the compilation and dissemination of homogeneous data for all countries in the region, using an analytical framework to facilitate the monitoring of fiscal policy across countries and allow for international comparisons.

The project has two main components: (1) compilation and dissemination of sub-annual and annual government finance statistics using the IMF’s Government Finance Statistics Manual 2001 (GFSM 2001) format; and (2) preparation of a detailed migration plan to gradually adopt the full GFSM 2001 methodology and develop new or improved data sources. The first component of the project will rely on available data sources to compile government finance statistics (GFS) data according to the GFS Yearbook Questionnaire, the High Frequency Questionnaire, and a simplified public debt template. The second component would require a diagnosis of current GFS compilation and dissemination practices, identification of institutional data gaps, and the elaboration of specific steps and a timetable to implement the GFSM 2001 methodology gradually. The initial phase of the will take longer and may require the development of subsequent projects and detailed action plans at a larger stage.

External Statistics

Increased cross-border financial flows, especially as they relate to portfolio and foreign direct investment as well as remittances, require an improvement of external statistics (among other things). This will improve not only the effectiveness of policy analysis but also the monitoring of financial external vulnerabilities. The Central American countries recognize this and have therefore embarked on a regional project to harmonize and improve external sector statistics. Although compilation systems for external sector data are diverse across the region, there is potential to produce of a common set of external sector statistics. Their harmonization will enable data comparison across different countries and preparation of regional external sector statistics. The project should establish the basis for improved quality and consistency of macroeconomic statistics prepared by national statistical agencies through common statistical definitions.

The project is aimed at the compilation of comprehensive and consistent external sector statistics region-wide, bringing together internationally accepted core principles, standards, and practices for compilation and dissemination, in line with the fifth edition of the Balance of Payments Manual (BPM5). The project is composed of the following steps: (1) development of harmonized compilation systems for balance of payments statistics and international investment positions; (2) improvement in the coverage of external sector statistics through collection of data for most relevant items, including trade, remittances, income account, portfolio investment, and direct investment, where applicable; and (3) improvement of data consistency across macroeconomic statistics produced by national statistical agencies, using agreed-upon common definitions of financial instruments, economic sectors, and valuation criteria, among others, in all countries.

Compared with monetary and fiscal statistics, one of the main challenges for improving external sector statistics is that they rely to a greater extent on private sector information.26 As an important prerequisite of data quality, the authorities should evaluate the current underpinning of national legal frameworks that support data collection from the financial and nonfinancial private sector for statistical purposes. It is expected that quarterly statistics on the international investment position and external debt statistics could become available for all countries in the region in 2010.

References

    CasselDieter and Paul J.J.Welfens2003“Wirtschaftsintegration, Regionalismus und multilaterale Wirtschaftsordnung: Entwicklungstendenzen und Gestaltungsprobleme,” inRegionale Integration und Osterweiterung der Europäischen Unioned. by DieterCassel and Paul J.J.Welfens (Stuttgart: Lucius & Lucius DE) pp. 325.

    • Search Google Scholar
    • Export Citation

    Central American Monetary Council (CAMC) 1999“Acuerdo Monetario Centroamericano” (San José). Available via the Internet: http://www.secmca.org/Docs/inf_Juridica/REGIONAL/Acuerdo%20Monetario.pdf.

    • Search Google Scholar
    • Export Citation

    ClineWilliam R. and EnriqueDelgadoeds. 1978Economic Integration in Central America (Washington: Brookings Institution).

    KimJun Il and LauraPapi2005“Regional Integration and Exchange Rate Arrangements” in Central America: Global Integration and Regional Cooperation IMF Occasional Paper No. 243ed. by MarkusRodlauer and AlfredSchipke (Washington: International Monetary Fund) pp. 6998.

    • Search Google Scholar
    • Export Citation

    Larraín B. Felipe and JoséTavares2001“Central American Development in Perspective,” inEconomic Development in Central AmericaVol. 1Growth and Internationalizationed. by FelipeLarraín B. (Cambridge, Massachusetts: Harvard University Press) pp. 152.

    • Search Google Scholar
    • Export Citation

    MedeirosCarlos and others forthcoming“International Banking in Central America,”IMF Working Paper (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

    PérezEsteban and Juan Carlos MorenoBrid2001“La Dollarización y la Integración Centroamericana,”Oportunidades y riesgos del ALCAVol. 62 (May–August). Available via the Internet: http://www.sela.org/public_html/AA2K1/ESP/cap/N62/rcap62-16.htm.

    • Search Google Scholar
    • Export Citation

    ShahHement2007“Financial Sector Development: Public Debt Markets,” inEconomic Growth and Integration in Central America. IMF Occasional Paper No. 257ed. by DominiqueDesruelle and AlfredSchipke (Washington: International Monetary Fund) pp. 6076.

    • Search Google Scholar
    • Export Citation

    Secretariat for Economic Integration in Central America (SIECA) 2008“Estado de Situación de la Integración Económica Centroamericana” (GuatemalaFebruary). Available via the Internet: http://www.sieca.org.gt/site/VisorDocs.aspx?IDDOC=Cache/17990000002500/17990000002500.swf.

    • Search Google Scholar
    • Export Citation
1Including the Dominican Republic, the total population of Central America makes up about 10 percent of the population in Latin America and the Caribbean and accounts for about 6 percent of its total output.
2For a discussion of past integration efforts, see Larraín and Tavares (2001) and Cline and Delgado (1978).
3The Organization of Central American States ceased to exist in 1973.
4Regional economic integration often takes place in stages. The first stage is usually the creation of a free trade area, in which member countries trade freely among themselves, while maintaining differential tariffs vis-à-vis third countries, followed by the establishment a customs union with a common external tariff. To avoid goods and services from third countries entering the free trade zone via the country with the lowest external tariff, specific rules of origin need to be in place. For a discussion of different models of customs unions in the world, see Chapter 5. A common market in turn also calls for the free movement of capital and labor across countries; a full economic and monetary union would also imply the adoption of a common currency, as in the case of the 15 countries that make up the European Monetary Union and as envisaged by the Gulf Cooperation Council, which plans to adopt a common currency by 2010 (see Cassel and Welfens, 2003).
5The first country in the region to do so, Costa Rica, started negotiations on a bilateral trade agreement with China in the fall of 2007.
6Tariffs on other goods will be phased out incrementally over a 5- to 20-year period.
7Central America already has preferential access to the EU on the basis of the generalized system of preferences (GSP) and provides access to EU markets for all industrial products as well as duty-free access for some agriculture products from Central America. The first three rounds of negotiations took place in Costa Rica (October 2007), Brussels (February 2008), and Lima (May 2008).
8The common external tariff consists of four basic rates: zero for capital goods and raw materials not competing with those in Central America, 5 percent on raw material competing with those produced in Central America, 10 percent on intermediate goods not competing with those produced in Central America, and 15 percent of final consumer and other goods (SIECA, 2008). The tariff structure reflects the participation of the Central American countries in the so-called Central American Common Market (CAMC). Most-favored-nation (MFN) tariffs are defined by the Central American Customs Systems.
9On customs administration issues, see Chapter 5.
11Although there are no capital account restrictions, there are some limitations, which make it more costly for foreign market participants to enter the domestic market. For example, in most countries foreign brokers cannot participate in public debt auctions; they can only participate through domestic brokers.
12International banks have been present in Central America for decades, but their role and importance has changed over time. In Panama, international banks have operated since 1904; Citibank was Panama’s fiscal agent for nearly 50 years. So far, international banks have focused on the retail but not on the wholesale or investment banking market.
13Local banks of this kind include Banco General, Banco Industrial, LAFISE, and Promerica.
14Of course, there has been substantial migration from Central America to the United States and, as a result of the former civil unrest in Nicaragua, a large number of Nicaraguans are working in Costa Rica.
15References to the objective of creating a common currency appear in documents dating back to the 1920s. See Pérez and Moreno Brid (2001).
16One Central American peso is equivalent to one U.S. dollar. Formally, the Central American Monetary Council can change its value and determine its use.
17For decades, starting in the 1920s, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua pegged their respective currencies to that of their largest trading partner, the United States. Honduras maintained its parity for the longest time, until 1990. The Dominican Republic used the U.S. dollar as legal tender between 1905 and 1947.
18Formally, the Council of Ministers of Economic Integration (COMIECO), which comprises the respective ministers of economy or commerce, is responsible for all integration-related issues in consultation with the respective sectoral ministers.
19Also, given the region’s commitment to establishing a customs union, COSEFIN created a working group of directors of tax and customs administrations to design an implementation plan that would take into account the experiences of other customs unions in the world to protect the low revenue base.
20Initially, the convention would include El Salvador, Guatemala, Honduras, and Nicaragua, with an option for Costa Rica to join at a later date.
21Ministers are working together to evaluate the benefits and requirements of implementing medium-term expenditure frameworks (MTEFs). MTEFs are an important mechanism to impose fiscal discipline on spending ministries, develop and communicate strategic spending priorities to the public, and allow for budget efficiency.
22For a detailed discussion about the benefits and challenges of the entry of international financial institutions in Central America, see Medeiros and others (forthcoming).
23As of August 2008, El Salvador, Guatemala, and the Dominican Republic have signed the agreement. For the agreement to become effective at least three countries had to ratify it.
24For a discussion of the development of capital markets, see Chapter 6 and Shah (2007).
25See Chapter 3 on linkages between Central America and the United States.
26Unlike government finance and monetary and financial statistics, which regularly rely on administrative data, the Central American countries could consider whether balance of payments statistics should be compiled at the intraregional level. However, it may be advisable to leave this resource-intensive taks for a later stage, once external sector statistics are fully harmonized.

    Other Resources Citing This Publication