Now Is the Right Time for Reforms in Central America

Washington, August 11, 2015.- The economies of Central America, Panama and the Dominican Republic are benefitting from their close ties to the recovering U.S. economy and from the persistence of relatively low oil prices. This is therefore an opportune moment for the region to try to achieve sustainable and inclusive growth, further reduce poverty and inequality on a durable basis, and strengthen the region’s buffers to shocks through improved policy frameworks.

Against this background, the IMF and the government of El Salvador held a two-day conference to review the economic outlook and challenges for the region and discuss policy options in light of experiences from Mexico, Peru, and the Netherlands. Here, we would like to share with you the main takeaways.

Laying the foundations for growth

According to our most recent projections, growth in the region is expected to be moderate at about 4.1 percent for 2015-16, with most countries operating near capacity.

But the relatively subdued growth is not cyclical and cannot be addressed with countercyclical policies, such as fiscal loosening or monetary expansion to boost credit. Thus, progress in resolving structural challenges will be key, since several countries have deep-rooted competitiveness problems—partly due to low human capital—and difficult business environments.

Participants agreed that the policy agenda should emphasize reforms to raise investment, educational attainment, and boost productivity. Higher government revenue and more efficient public expenditure are vital to support reforms to improve security and modernize infrastructure, and increase both the level and the quality of social and educational spending. Strengthening the business environment and governance will be critical to support greater private investment. Furthering regional integration, diversifying exports, and moving the region upwards on the global value chain could also provide additional channels of growth.

Rebuilding fiscal buffers

As mentioned, the external environment is generally favorable, but policy buffers are depleted and downside risks remain. As a legacy of the global crisis and country specific developments, several countries in the region face high and rising public debt burdens whose service costs crowd out social and investment spending, while raising vulnerabilities. This is an ideal time to close fiscal sustainability gaps and build room for countercyclical fiscal policies, including by saving direct budgetary windfall gains from faster U.S. growth and, where energy subsidies are sizable, from lower oil prices.

Based on the experiences from Peru and Netherlands, conference participants recommended “locking in” budgetary consolidation, by putting in place stronger fiscal institutions, including fiscal councils and rules, as well as medium-term fiscal frameworks.

Countries should draw upon international experiences while recognizing that policies should be tailored for each country’s circumstances. It was also widely agreed that the pace of fiscal adjustment should be calibrated to safeguard jobs and growth, while building strong public support for fiscal responsibility.

Strengthening policies

Normalization of monetary conditions in the United States—at a time when many emerging markets are slowing down—could also create financial headwinds for the region. Central America, and its banks in particular, are well positioned to manage these risks, and in our baseline scenario these headwinds would be more than offset by the benefits of a stronger U.S. economy. Drawing on the example of Mexico, participants noted that the region should nonetheless maintain strong reserve cushions and solid debt structures. It was also stressed that moving toward greater exchange rate flexibility will not only help safeguard against external shocks but also strengthen inflation targeting frameworks by establishing inflation as the undisputed monetary anchor and reduce incentives for dollarization.

Financial integration within and outside the region poses opportunities and risks. Although banks in the region are generally well capitalized and comfortably meet regulatory requirements, the conference highlighted the need for improving cross-border consolidated supervision and upgrading crisis prevention plans at the regional level. Broader adoption of macro-prudential tools would also help insure against risks arising from interconnectivity.

Altogether, prospects for Central America, Panama, and the Dominican Republic have become more favorable. This is the right time to tackle difficult policy challenges and break supply side constraints which hinder growth and much desired social progress. We hope that the policy dialogue and the sharing of lessons from within and outside the region continue after this year’s conference, which remains a vital forum for the dialogue within the region and with the IMF.

Lastly, participants also praised the IMF’s engagement with the region, in particular the high quality of technical assistance provided by our technical assistance center (CAPTAC).