The Central America Project

Central America at the Crossroads

By Felipe Larran B.

After decades of armed conflict and political instability, Central America is entering a period of peace and democracy that opens promising perspectives of economic and social progress. The signing of the Guatemalan Peace Treaty in December 1996 marked the end of four decades of violent confrontation in that country. For Central America as a whole this was a particularly meaningful date: for the first time in one hundred years, the region started 1997 without any internal or external armed struggle

After this long period of internal conflict, the countries of the region are now facing the immense challenge of improving living conditions for their people and taking advantage of the rich base of resources they possess. More than 50% of Central Americans live under the poverty line, although the situation varies from country to country. Countries have a moral imperative to implement policies that would lead their people out of poverty. There is another dimension to this, too. Successful integration of the poor into the society will provide a growth bonus for the countries as well.

In a lucid and far-sighted decision, the region's Presidents formed the Alliance for Sustainable Development in Central America in August 1994. Responding to the opportunity provided by the advent of peace, the region?s governments joined their efforts to seek higher and sustainable levels of human development. The goal of this initiative was to pursue economic development in tandem with social welfare, political democracy and environmental balance.

In this context, Harvard University was commissioned to help design the policies that would lead countries toward these objectives. This has been a joint effort with INCAE, a regional business school, counting on the active participation of government and private sector representatives from the region. The initial assessment determined the need to direct research and advisory efforts into five main areas: business competitiveness, environment, governance, legal reform and macroeconomics. Because economic and social development is a multi-faceted process, isolated progress in a particular area cannot produce successful development. Only a coherent effort in several fronts may succeed in this task.

As part of this effort, faculty from Harvard Business School, Harvard Law School, the Harvard Institute for International Development (HIID), the John F. Kennedy School of Government, the Center for International Development and the David Rockefeller Center for Latin American Studies have been engaged in a three-and-half year multidisciplinary effort. The results of this project, which have already been presented to the Presidents of Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua, will give shape to a series of volumes to be published under the Harvard Studies in International Development, a collaboration of Harvard University Press and HIID. It is impossible to do justice in a short space to the work of so many people. Therefore, this article concentrates mainly on how macroeconomic policies can contribute to development.

In the early 1960s, Central America had an average per capita income similar to that of the other Latin American countries and higher than East Asia's. Three decades later, East Asia's per capita income was five times larger than Central America's, while Latin America's income was twice as large. The decade of the 1980s was particularly hard for the region, which saw its income per capita decline at an average of 1.5% per year.

What happened to Central America over these thirty years? Why, in spite of its privileged geographical location, so close to the largest world market, did the region stagnate? The answer must be found in the mix of political instability, violence and failed economic policies.

The resolution of major political conflicts and armed struggles in the 1990s has brought new hopes to Central America. Growth has resumed, real wages have increased, and the countries are attracting significant foreign investments. Exports have shown interesting dynamism, especially in non-traditional sectors. Despite all these good news, however, the region still has a lot of unexploited potential. With adequate policies and some foreign cooperation (especially in terms of market access), Central America can aspire to economic growth of 5 to 6% over the next two decades. This can be achieved through increased investment coupled with faster productivity gains.

The characteristics of the region in terms of location, size, cost of the labor force, and climate render export-led growth as the only viable economic development strategy. Central America is privileged in its proximity to the U.S. market, but so far this advantage has not been exploited adequately. For example, despite the fact that the distance between Central America and the U.S. is a third of that between Asia and the U.S., the cost of shipping goods to North America is lower from Asia.

So far, Central America?s exports have been concentrated in a few natural resources. The share of natural resource exports in total exports ranged between 50 and 70% for the different countries in 1996. Even though these are large numbers, they show an improvement with respect to 1985, when the same ratio ranged between 70 and 90% of total exports. Efforts are currently focused on diversification, moving towards a composition of exports with a larger base on manufactures and higher value added products. Honduras and Nicaragua, and more recently Costa Rica, have experienced a remarkable change in this respect over the last decade.

Diversification of exports will reduce the region?s vulnerability to external shocks. The current expansion of Export Processing Zones (EPZs) is broadening the export base. Remarkably, the arrival of Intel to Costa Rica is giving a big boost to the diversification of manufactured goods and exports. By itself, Intel is already generating over $1 billion of exports, which amounts to around 10% of Costa Rica?s national output.

Perhaps paradoxically, Central America has become an unintended casualty of the North American Free Trade Agreement (NAFTA). NAFTA was, of course, never intended to hurt this region. Nonetheless, as a consequence of the agreement, Mexico now enjoys preferential access to the U.S. market with better terms than Central America. Mexican goods now face lower tariffs in the U.S. through NAFTA than Central American goods through the Caribbean Basin Initiative (CBI). Moreover, NAFTA is a treaty, whereas the CBI is a unilateral concession. The garment industry in Central America, a vitally important sector, has been affected by this differential treatment. Foreign investors with an eye on the U.S. market find Mexico to be a safer bet. In the dynamic and competitive global economy, this hurts both exports from Central America and foreign investment in the region. It is imperative for Central American development to get on an equal footing with Mexico on access to the U.S. market. A recent U.S. Senate bill led by Senator Graham has attempted to correct ?though only partially?this disadvantage.

Changes in fiscal policy can also make a large contribution to development. Public sector expenditures are too low in El Salvador and Guatemala to fulfill the necessary role of the government as provider of goods and services. A problem also exists with the composition of those expenditures: public spending in education and health is notoriously low almost in every country, insufficient to meet the most basic needs and to promote an equitable development process. The Guatemala Peace Treaty of 1996 included an important commitment to improve social expenditure, which is a good indication in that respect.

Tax reform is also needed to provide an increase in total tax collection in the countries where the public sector is too small and a reduction of distortions caused by overly complex tax systems. A simplified system will rebuild public trust and will help combat tax evasion. Tax policy must also contemplate specific corrective levies geared to align private incentives with environmental considerations.

Another important factor constraining development is the burden of the external debt. This problem severely affects Honduras and Nicaragua. Their low level of income makes an even more urgent case for them to obtain relief on their debt obligations from the international community. The Highly Indebted Poor Countries Initiative (HIPC) ?including its recent more flexible interpretation-- appears as a possible alternative, although current conditions may still delay relief quite substantially and/or provide insufficient relief. The international community should provide a fast and deep response to this problem.

There are, to be sure, many steps that the Central American countries can take on their own to foster development. One pending issue that may bring important positive effects in several areas is the reform to the social security systems. So far, this reform has only been implemented in El Salvador. Currently, pensions systems cover a very low fraction of the population, with the exception of Costa Rica. Their financing basis?a pay-as-you-go formula?delivers low return in the demographic context that Central America is facing, with low fertility ratios and increasing life expectancies. The moment seems appropriate for countries to move to schemes based on the funding of contributions and private management. The cost of such a move is low now, precisely because the coverage of current social security is very low.

The benefits of such a reform will have multiple dimensions. Funded systems can obtain larger rates of return than the systems they replace. This implies that rates of contributions can be reduced, which benefits workers directly. At the same time, distortions in the labor market are reduced and coverage of a larger fraction of the population becomes more feasible. Pension funds can also have a crucial role in the development of financial markets, as the experience of countries that have gone through this reform, such as Chile, attests. For Central America, where financial markets have low levels of development, private pension funds can constitute a cornerstone for their expansion.

Financial markets may contribute significantly to the development process, as recent empirical studies show. For a long time, however, financial markets were repressed in the region. Limits to interest rates and government intervention in the allocation of credit were common throughout the region in the 1980s. In Costa Rica, El Salvador and Nicaragua the whole banking sector was public. During the 1990s, financial liberalization proceeded. Interest rates were freed and credit allocation reduced remarkably, while increased private sector participation has been allowed.

The liberalization of the financial sector has required substantial improvements in the regulatory skills of the government. In some cases, the expansion of financial activities has gone faster than the capacity of governments to respond to the changes and provide appropriate supervision of financial institutions. A few financial companies have been liquidated in El Salvador and the situation of banks is believed to be rather fragile in some countries.

The greater the extent of privatization, the more important the role of the government becomes as an efficient regulator. This imposes a new role on the government in terms of providing skilled and up-to-date regulation techniques. Even though this may seem costly, countries in the region can avoid the duplication of costs by integrating regulatory efforts across the region. This would save resources and would constitute a significant step towards economic integration. Moving towards regional institutions that regulate and supervise different activities will be a strong force towards homogenization of rules and standards across the region. This, in turn, will facilitate the operation of firms across borders.

The recent tragedy of Hurricane Mitch highlighted another crucial element for successful development in Central America: the need to reduce its vulnerability to natural disasters. There is a clear need for a stronger safety net in the region, which should include environmental, economic and social elements. Much has been accomplished in Central America during the current decade, but much still remain to be done.