© 2005 International Monetary Fund

Production: IMF Multimedia Services Division

Typesetting: Alicia Etchebarne-Bourdin

Cataloging-in-Publication Data

Central America: global integration and regional cooperation/edited by Markus Rodlauer and Alfred Schipke—Washington, D.C.: International Monetary Fund, 2005.

• p. cm.—(Occasional paper); 243

Includes bibliographical references.

ISBN 1-58906-446-1

• 1. Central America—Economic integration. 2. Central America—Economic conditions—Statistics. 3. Free trade—Central America. 4. Foreign exchange rates—Central America. 5. Poverty—Central America. I. Rodlauer, Markus. II. Schipke, Alfred, 1959–III. Occasional paper (International Monetary Fund); no. 243.

HC141.C36 2005

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Contents

• Foreword

• Preface

• Abbreviations and Acronyms

• I. Introduction and Overview

  • Markus Rodlauer and Alfred Schipke

  • Background

  • Recent Developments

  • Overview

• II. Macroeconomic Implications of CAFTA-DR

  • M. Ayhan Kose, Alessandro Rebucci, and Alfred Schipke

  • Implications for Trade and Investment Flows

  • Implications for Economic Growth and Welfare

  • Could CAFTA-DR Help Reduce Poverty in the Region?

  • CAFTA-DR’s Potential Impact on Macroeconomic Volatility and the Co-Movement of Business Cycles

  • Conclusions

  • Appendix I. The Model

  • Appendix II. Volatility and Co-Movement of Macroeconomic Variables

  • References

• III. Trade Liberalization and Tax Coordination

  • Chiara Bronchi and Dale Chua

  • Structure and Trend of Tax Revenues in Central America

  • Estimating the Loss of Tax Revenue from CAFTA-DR

  • Dealing with the Revenue Impact of CAFTA-DR

  • CAFTA-DR and Issues of Tax Coordination

  • Conclusions

  • Appendix. Data and Methodology for the Calculation of Revenue Losses

  • References

• IV. Fiscal Sustainability: A Value-at-Risk Approach

  • Ricardo Adrogué

  • Analytical Issues and the Traditional Sustainability Approach

  • Modeling the Debt-to-GDP Ratio Using VaR

  • Assessment of Policy Options

  • Conclusions

  • Appendix. Value-at-Risk Methodology

  • References

• V. Regional Integration and Exchange Rate Arrangements

  • Jun Il Kim and Laura Papi

  • Issues Concerning Exchange Rate Regimes in Developing Countries

  • Current Exchange Rate Arrangements

  • Long-Run Options for Exchange Rate Regimes in Central America

  • Choosing Among the Long-Run Options: Key Factors

  • Choosing Among the Long-Run Options: An Index Approach

  • Conclusions

  • Appendix. Technical Appendix

  • References

• VI. Regional Integration and Financial System Issues

  • R. Armando Morales and Alfred Schipke

  • Financial Sector Development and Structure

  • Challenges for Financial Regulation and Monitoring

  • Recent Progress and Looking Forward

  • Conclusions

• VII. Regional Issues in Macroeconomic Statistics

  • Lorraine Ocampos

  • Data Suitability for Analytical Purposes

  • Moving Toward a Harmonized Statistical Framework

  • Technical Assistance to the Region

  • Conclusions

  • Appendix. Statistical Issues, Suitability of Data for Analytical Purposes, and Technical Assistance Missions

• VIII. The Political Economy of Implementing Pro-Growth and Anti-Poverty Policy Strategies in Central America

  • Luis Breuer and Arturo Cruz

  • Setting

  • Political Support for Pro-Growth and Anti-Poverty Strategies

  • Generating Consensus on a Long-Term Reform Strategy

  • Implications for the IMF

  • References

• Boxes

  • 1.1. Regional Economic Institutions

  • 3.1. Revenue Effects of Growth Enhancement from CAFTA-DR

  • 3.2. Current Status of Customs Administration in Central America

  • 5.1. History of Exchange Rate Regimes in Central America

  • 5.2. Regression Results

  • 5.3. Projections for Indices of Central American Countries

  • 6.1. Institutions Conducting Cross-Border Financial Transactions in Central America

  • 6.2. Panama’s Financial System and Regional Offshore Center

  • 6.3. Dominican Republic: Banking Crisis and Financial Reform

  • 7.1. Main Data Issues in Central America

  • 7.2. Dominican Republic: Data Issues

  • 8.1. Institutional Aspects of Strategies to Boost Growth and Reduce Poverty

  • 8.2. Consolidated Supervision of the Financial Sector

• Tables

  • 2.1. Tariffs in Central America, 1980–99

  • 2.2. Selected Economic Indicators: Central America and Mexico, 2004

  • 2.3. Growth of Exports and Imports

  • 2.4. Top Eight U.S. Merchandise Imports from Central America, 2003

  • 2.5. Top Eight U.S. Merchandise Exports to Central America, 2003

  • 2.6. Diversification of Exports

  • 2.7. Gross Foreign Direct Investment Flows

  • 2.8. Foreign Direct Investment Inflows from the United States

  • 2.9. Dynamics of Economic Growth

  • 2.10. Contributions to GDP Growth

  • 2.11. Potential Welfare Gains from International Risk Sharing

  • 2.12. Forecast Variance Decomposition of GDP Growth

  • 2.13. Forecast Variance Decomposition of GDP Growth (Regional Shocks)

  • 2.A1. Volatility of Macroeconomic Aggregates

  • 2.A2. Co-Movement of Macroeconomic Aggregates with U.S. Aggregates

  • 3.1. Consolidated Central Government: Tax Structure for Selected Central American Countries, 2000–03

  • 3.2. Central America: Average Collected Import Duty Rates

  • 3.3. Customs Revenue on Imports from the United States, 2003

  • 3.4. Schedule A Imports, 2003

  • 3.5. Revenue Impact of CAFTA-DR, First Year

  • 3.6. Honduras and Nicaragua: Revenue Impact of CAFTA-DR, First Year

  • 3.7. Summary Table: Revenue Loss of CAFTA-DR

  • 3.8. VAT Productivities

  • 3.9. Excise Tax Summary

  • 4.1. Results from Traditional Debt Sustainability Analysis

  • 4.2. Main Vulnerability Measures

  • 4.3. Projected Change in Primary Balance

  • 4.4. Relative Contribution by Risk Factor

  • 4.5. Effect of Increased Reliance on Domestic Currency Debt

  • 5.1. Exchange Rate Regimes

  • 5.2. Exchange Rate Regimes, Natural Classification

  • 5.3. Trade Structure and Openness

  • 5.4. Consolidated Claims of BIS Reporting Banks on Central American Countries

  • 5.A1. Co-Movements in Output

  • 5.A2. Source of Output Co-Movements

  • 5.A3. Terms of Trade

  • 5.A4. Co-Movements in the Terms of Trade

  • 5.A5. Correlations of Terms of Trade

  • 5.A6. Inflation Performance

  • 5.A7. Co-Movements in Prices

  • 5.A8. Optimum Currency Area Index: Regression Results

  • 5.A9. Optimum Currency Area Indices for Central America and Europe vis-à-vis Anchor Country

  • 5.A10. Central America: Projections for the Optimum Currency Area Indices vis-à-vis the United States

  • 6.1. Central America: Structure and Performance of the Financial Sector, 1996–2003

  • 6.2. Regional Banks, 2003

  • 6.3. Prudential Requirements

  • 6.4. Financial Sector Assessment Programs

  • 7.A1. Statistical Issues

  • 7.A2. Suitability of Data for Analytical Purposes

  • 7.A3. Statistics Technical Assistance Missions, 1995–end-January 2005

  • 8.1. Comparative Social Indicators

  • 8.2. Comparative Governance Indicators

• Figures

  • 1.1. Central America: Real GDP Per Capita Growth

  • 1.2. Poverty in Central America

  • 2.1. Trade Openness

  • 2.2. Trade with the United States

  • 2.3. Exports to the United States

  • 2.4. Imports from the United States

  • 2.5. Growth Rate and Volatility of Macroeconomic Aggregates in Mexico and Central America

  • 2.6. Impulse Responses of GDP

  • 2.7. Co-Movement of Economic Variables in Mexico and the United States

  • 2.8. Co-Movement of Economic Variables in CAFTA-DR Countries and the United States (Average Correlation)

  • 2.9. Impulse Responses

  • 2.A1. Production Structure of the CAFTA-DR Model

  • 3.1. Tax Revenue, 1990–2003

  • 3.2. Central America: Composition of Tax Revenue, 1990–2003

  • 3.3. Composition of Tax Revenue, 1990–2003

  • 3.4. Estimated Minimum VAT Rate to Compensate for Tariff Loss, 2003

  • 4.1. Distribution of the Public Ratio of Debt to GDP in 2008

  • 5.1. Nominal Exchange Rate Variability, 1984–2003

  • 5.2. Optimum Currency Area Indices, 1984–2003

  • 5.3. Comparison of OCA Indices vis-à-vis the United States, 1994–2003

  • 5.4. Central America and Europe: Optimum Currency Area Indices

  • 6.1. Central America: Public Debt, 1990–2003

  • 6.2. Central America: Financial Sector Development

  • 6.3. Banking Sector Dollarization, 2003

  • 6.4. Organizational Structure of Cuscatlán

Foreword

Central America has come a long way since it emerged from the so-called lost decade of the 1980s. Peace and democracy have been firmly reestablished; governments have implemented important economic and social reforms; and, as a result, the region enjoyed relatively strong growth and improved macroeconomic stability in the 1990s.

Nevertheless, Central America still faces important economic, social, and political challenges. Poverty remains high in most countries, as institutional weaknesses have tended to undermine growth and governments’ ability to deliver on the high expectations associated with the peace process; and weak fiscal positions and financial sectors have left economies vulnerable to shocks and natural disasters to which the region is particularly exposed.

In the face of these challenges, recent years have seen a renewed effort at adjustment and reform across the region, geared toward boosting growth and reducing poverty in a lasting way. Central America is also becoming increasingly integrated, as a region and globally, and there is growing recognition, at home and abroad, that increased regional cooperation is key to each country’s success as it tries to compete successfully in the global economy.

This study looks at these challenges and how Central America is attempting to meet them, with particular emphasis on issues and challenges arising from the growing integration under way in the region. By focusing on the policy implications of increased trade and financial integration, the study should help policymakers make the best of Central America’s considerable potential and set the region on a path of sustainable rapid growth. The IMF stands ready to continue to assist the region in its efforts to meet these challenges.

Rodrigo de Rato

Managing Director

International Monetary Fund

Issues raised by Central America’s growing economic integration are at the center of this study coordinated by our team in the Western Hemisphere Department. A core theme is the need to intensify regional collaboration in a number of areas to maximize the benefits offered by globalization in terms of sustained growth, poverty reduction, and broader social progress. In particular, the study provides a framework for deepening cooperation in banking supervision and regulation, tax policy and administration, and economic statistics. It also notes that integration must be anchored in strong domestic economic policies, especially fiscal reforms to ensure sustainable public debt levels and structural reforms to raise productivity and competitiveness. The study is especially timely as the Free Trade Agreement with the United States (CAFTA-DR) will provide a new impetus for economic integration in the region and its ability to compete successfully in the global economy.

Anoop Singh

Director, Western Hemisphere Department

International Monetary Fund

Preface

This Occasional Paper is the product of a team effort led by Markus Rodlauer and Alfred Schipke, both staff members of the IMF’s Western Hemisphere Department. The team includes authors from a number of other departments in the IMF, as well as an outside co-author from the region.

The authors would like to express their deep appreciation for the valuable guidance provided by Olav Gronlie, who—as the head of the Central American Division—was instrumental in moving the project forward as part of the IMF’s increased emphasis on regional issues and those related to regional integration. They would like to thank and acknowledge the comments received from Agustín Carstens. Also, the authors are grateful to Tamim Bayoumi, Michael Keen, Anoop Singh, Teresa Ter-Minassian, and Philip Young for their comments and advice.

Particular thanks go to Susan McCuskey and Hildi Wicker Deady, who worked extremely hard to ensure the timely publication of this paper, and to Mauricio Bourdin for valuable research assistance. The authors would like to thank the authorities of the respective countries in Central America and the Dominican Republic, the Central American Monetary Council, and the participants of an internal IMF Workshop on Central America for helpful comments and suggestions. Marina Primorac of the External Relations Department coordinated the production of the publication.

The opinions expressed in this paper are solely those of its authors and do not necessarily reflect the views of the International Monetary Fund, its Executive Directors, or the authorities in the respective Central American countries and the Dominican Republic.

Abbreviations and Acronyms