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Chapter 1: External Linkages and Economic Integration as of 2009

Author(s):
Marco Pinon, Alejandro Lopez Mejia, M. (Mario) Garza, and Fernando Delgado
Published Date:
July 2012
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Author(s)
Andrew Swiston

The global recession of 2008–09 and the prospect of another downturn in advanced economies bring to the forefront the depth and nature of the linkages between Central America, Panama, and the Dominican Republic (CAPDR)1 and other economies, both within the region (see Desruelle and Schipke, 2008; and Brenner, 2006) and outside of the region (see Baroni, 2008; Roache, 2008a; Kim and Papi, 2005; and Kose, Rebucci, and Schipke, 2005). What has been the impact of global shocks on the region, through which transmission channels do they occur, and how should economic policy in the region respond?

To shed light on these issues, this chapter investigates CAPDR’s external linkages in light of its increased integration into the global economy covering the period from 1995 to the second quarter of 2009. The chapter is organized into six sections. The second section outlines recent trends in economic integration. The third section examines business cycle synchronization, both among the countries of CAPDR and with the United States. The fourth section estimates the effects of external shocks on CAPDR economic activity and assesses the impact of the global recession. The fifth section investigates the channels through which shocks to other economies are transmitted to the region. The final section concludes.

Trends In Economic Integration

This section examines CAPDR’s effective integration with the global economy in three areas: trade, financial linkages, and remittances. It focuses on the situation as it stood in the years preceding the global recession of 2008–09.

Trade Integration

CAPDR’s main trade ties are with the United States, reflecting the region’s geographical proximity, recent free-trade agreements, and previous preferential trading arrangements (Figure 1.1).2 From 2003 to 2007, about 60 percent of all goods exports were to the United States, ranging from less than half for Costa Rica, Guatemala, and Panama to more than two-thirds for Honduras and the Dominican Republic. Trade links within CAPDR are also sizable, representing 20 percent of exports on average, with the exception of Panama and the Dominican Republic. Intraregional linkages are strongest for El Salvador and Guatemala. Other major trading partners include other advanced economies and emerging Western Hemisphere economies.

Figure 1.1Trade Integration: Major Trading Partners

(Goods exports as percent of total, average, 2003–07)

Sources: Haver Analytics; IMF, Direction of Trade Statistics and World Economic Outlook; and author’s calculations.

Note: CAPDR = Central America, Panama, and the Dominican Republic.

Integration in global product markets has been increasing over time, with the share of goods exports in GDP rising from 21 percent during 1990–94 to 27 percent during 2000–07 (Figure 1.2). The rise of Nicaragua’s export share was particularly pronounced, with exports there increasing by nearly 20 percent of GDP. Export shares also rose significantly in Costa Rica, El Salvador, and Honduras. Most of the increase in export shares occurred by the mid-1990s, except in the case of Nicaragua. The breakdown between U.S. and rest-of-world trade has remained relatively stable over time.

Figure 1.2Trade Integration: Ratio of Exports to GDP

(Goods exports as percent of GDP, period averages)

Sources: Haver Analytics; IMF, Direction of Trade Statistics; World Economic Outlook; and International Financial Statistics; and author’s calculations.

Note: CAPDR = Central America, Panama, and the Dominican Republic.

a Data begin in 1993.

b Simple average.

Trade in services is another important source of economic integration, accounting for more than 10 percent of GDP for Costa Rica, Panama, and the Dominican Republic. However, trade in services has not increased as rapidly as a share of the economy as has merchandise trade, as the simple average rose from 8.7 percent of GDP during 1990–94 to 10.1 percent of GDP during 2000–07. Although comprehensive bilateral data on services trade are not available, the data that are available appear to suggest that linkages are concentrated with the United States and within the region.3 The lack of quarterly data on services trade for several countries precludes those data from being presented separately in the quantitative analysis in later sections.

Several empirical studies have concluded that deepening trade ties intensify business cycle synchronization. Calderón, Chong, and Stein (2007) conducted a comprehensive study focused on developing countries and found a positive, statistically significant relationship between trade intensity and output comovement among 147 countries over four decades. Fiess (2007) analyzed CAPDR and industrial countries and found a mild positive relationship between trade intensity and output comovement. Several studies focusing on Mexico-U.S. synchronization since the inception of the North American Free Trade Agreement (NAFTA) have concluded that tighter trade linkages increased the degree of correlation between the Mexican and U.S. economies.4 Thus, the rising degree of integration of CAPDR with global product markets would be expected to result in a greater correlation between domestic and foreign economic activity, especially that in the United States. Focusing narrowly on trade volumes, comovement between U.S. import volumes and CAPDR export volumes has indeed risen for every country since the 1990s, although the average correlation of 0.5 is below Mexico’s correlation of 0.8 (Figure 1.3).

Figure 1.3Trade Volume Comovement

(Correlation of country’s export volume growth with U.S. import volume growth)

Sources: IMF, World Economic Outlook; and author’s calculations.

a Excludes 1999 because of the effects of Hurricane Mitch.

Financial Integration

Three features of the financial systems in CAPDR are likely to represent especially important transmission channels: their being bank based (in particular the involvement of foreign banks), their relatively high asset and liability dollarization, and the rising exposure of the CAPDR economies to cross-border capital flows.

Financial conditions in other regions could feed through to CAPDR by affecting the lending capacity of multinational financial institutions (Árvai, Driessen, and Ötker-Robe, 2009). Commercial banks are the dominant providers of credit in the region, accounting for a significant majority of financial intermediation in all countries (Brenner, 2006; and Shah and others, 2008). Although involvement of global financial institutions (with the exception of Panama) was low through the early 2000s, regional financial groups constituted a significant share of the financial systems in El Salvador and Nicaragua (Morales and Schipke, 2005). Foreign acquisitions of regional and domestic banks picked up beginning in 2004, and foreign-owned banks now account for roughly 30 percent of commercial bank assets in Costa Rica, Honduras, and Nicaragua, and more than 90 percent of assets in El Salvador. The recent increase in foreign ownership of the region’s financial institutions means that the influence of this channel will probably be more evident in transmission of future shocks than in the past.

Dollarization of financial system assets or liabilities constitutes a direct channel of transmission of financial conditions from other regions, predominantly the United States, in the case of fluctuations in the value of currencies in the region against the dollar. In addition, movements in U.S. interest rates should change the rates prevailing on dollar-denominated instruments in the region. Panama has been officially dollarized for more than 100 years, and El Salvador became officially dollarized in 2001. By 2007, dollarized instruments constituted the majority of financial assets and liabilities in Nicaragua, and more than 40 percent in Costa Rica, with lower levels of dollarization in Guatemala, Honduras, and the Dominican Republic (Table 1.1). Historical data on financial system assets are lacking, but liability dollarization has increased since 1990 throughout the region.

Table 1.1Financial Dollarization

(Percent of total domestic assets or liabilities)

AssetsLiabilitiesa
20012007199020012007
Costa Rica4443313843
Dominican Republicb261932026
El Salvador1001004100100
Guatemala25340516
Honduras192423028
Nicaragua3958407167
Panama100100100100100
Simple average5054265254
Sources: Central American Monetary Council; Central Bank of the Dominican Republic; Rennhack and Nozaki, 2006.

Data for 1990 refer to deposits only.

Loans and deposits only. Column for 1990 refers to 1996 data.

Sources: Central American Monetary Council; Central Bank of the Dominican Republic; Rennhack and Nozaki, 2006.

Data for 1990 refer to deposits only.

Loans and deposits only. Column for 1990 refers to 1996 data.

Financial integration as measured by cross-border asset holdings has increased since the mid-1990s, with average external liabilities in the region rising to 55 percent from 40 percent of GDP by 2007 (Figure 1.4).5 Most of this investment is concentrated in foreign direct investment and bank lending, with securities holdings relatively small given the lack of deep, liquid markets (Shah and others, 2008). Financial integration appears to be less centered on the United States than is trade, as U.S. claims on CAPDR constitute only about 20 percent of total external liabilities.6 This amounts to about 12 percent of GDP, on average, up from 5 percent in 1994. Transmission of economic activity via cross-holdings of financial assets or cross-border capital flows could work in multiple ways. For example, movements in foreign interest rates affect interest payments and the external financing options of agents in CAPDR, fluctuations in foreign equity prices and interest rates alter foreign firms’ capacity to engage in foreign direct investment, and capital flows have been shown to depend significantly on advanced economy financial and economic conditions (Reinhart and Reinhart, 2008). Imbs (2006) and Schiavo (2008) find larger output correlations in countries with higher degrees of bilateral financial integration, as measured by cross-holdings of financial assets.

Figure 1.4Financial Integration: Cross-Border Asset Holdings

(External financial liabilities as percent of GDP, period averages)

Sources: Bank for International Settlements; Haver Analytics; IMF, World Economic Outlook and International Financial Statistics; U.S. Bureau of Economic Analysis; U.S. Treasury; and author’s calculations.

Note: CAPDR = Central America, Panama, and the Dominican Republic.

a Rest-of-world holdings not shown for Honduras and Nicaragua because of breaks in series on account of debt relief. Honduras, Nicaragua, and Panama are excluded from the regional average (the last on account of its sizable offshore financial center).

Remittance Flows

Remittance receipts in CAPDR grew rapidly in the period preceding the global crisis. Indeed, remittances increased from 3 percent of GDP in the 1990s to more than 8 percent of GDP on average during 2000–07 (Figure 1.5). A time series breakdown of the source countries is not available, but Ratha and Shaw (2007) use a geographic decomposition of the residence of migrants, along with host and recipient country income levels, to construct a matrix of bilateral remittance flows. They estimate that 80 percent of remittance flows into CAPDR originate in the United States (Table 1.2). Intraregion flows are significant only from Costa Rica to Nicaragua.7

Figure 1.5Remittance Receipts

(Workers’ remittance receipts as percent of GDP, period averages)

Sources: Haver Analytics; IMF, World Economic Outlook and International Financial Statistics; national sources; and author’s calculations.

Table 1.2Remittance Flows

(Source of remittance inflows in 2005, percent of total)

United StatesOther Central America
Costa Rica747
Dominican Republic800
El Salvador882
Guatemala871
Honduras893
Nicaragua6130
Panama815
Simple average807

If remittances are tied to employment and wage levels in the source country and boost expenditure in the recipient country, then they provide a direct positive link between economic activity abroad and in CAPDR. However, this positive relationship could in theory be offset by appreciation of the recipient country’s real exchange rate or a reduction in the domestic labor supply, and there is no consensus in the literature on the effect of remittance receipts on economic activity in the recipient country (World Bank, 2005; Sayan, 2006; and Chami and others, 2008).

Empirical evidence on the existence of a link between economic activity in the source country and remittance outflows is mixed. Roache and Gradzka (2007) find little support for a strong link between aggregate U.S. business cycles and remittances to CAPDR or South America. At a macro level, the correlation between real growth in remittance receipts and real GDP growth in CAPDR is found to be only 0.1. Magnusson Bernard (2009) focuses on remittances to Mexico and El Salvador and activity indicators in U.S. states with high concentrations of immigrants from those countries and does find a positive relationship between state-level economic conditions and those countries’ remittance receipts. Similarly, the effects of remittances on recipient-country growth are also unclear. Chami and others (2008) fail to find a strong impact in a growth regression framework, and Sayan (2006) finds that receipts are typically acyclical with respect to economic activity in the recipient country.

Business Cycle Comovement

This section establishes the stylized facts of business cycle comovement between CAPDR countries and the United States, and among the countries of the region. Work before the crisis, reviewed in Swiston (2010), finds that synchronization among the countries of the region was moderate (Kose, Rebucci, and Schipke, 2005; Fiess, 2007; Iraheta, 2008; and Roache, 2008a, 2008b) and did not rise to the levels seen in more highly integrated areas, such as within the euro area or between Mexico and the United States (see Kim and Papi, 2005). Linkages to U.S. activity appear to have become stronger since the mid-1990s, even before negotiation of U.S. free-trade agreements, although part of the increased correlations can be attributed to the end of the domestic armed conflicts experienced in the 1980s (Baroni, 2008).

Previous work has generally employed annual real GDP data, with some use of monthly activity indicators. This chapter extends the analysis to quarterly real GDP data for most countries in the region, because the series, which has become long enough to perform econometric analysis, is consistent with the annual real GDP numbers but is free of the noise often found in monthly data.8

Influence of the U.S. Cycle

Despite the region’s sizable links to the United States, before the crisis the correlation of economic activity with U.S. growth was relatively low, averaging less than 0.2 for annual data since 1950, and had not increased since 1995 (Table 1.3). The correlations on quarterly data since 1995 are below those of other countries with strong U.S. ties: 0.7 for the United Kingdom and Canada, 0.6 for Mexico, and 0.4 for the euro area.9

Table 1.3Real GDP Growth Correlations with the United States
Costa RicaDominican

Republic
El

Salvador
GuatemalaHondurasNicaraguaPanamaSimple

average
Purchasing-power-

parity-weighted

aggregate
Annualdata, 1951–2008
U.S. real GDP0.33−0.130.360.160.430.06−0.020.170.26
U.S. industrial production0.34−0.080.390.310.480.110.080.230.36
Annualdata, 1995–2008
U.S. real GDP0.350.250.11−0.08−0.210.580.090.150.20
U.S. industrial production0.360.420.440.15−0.010.540.200.300.41
Quarterly data, 1995–2008, year-on-year
U.S. real GDP0.290.110.050.14−0.200.250.330.110.16
U.S. industrial production0.320.270.390.140.060.250.390.240.36
Real exports, 1995–2008, annual
U.S. real GDP0.630.670.460.36−0.180.230.120.330.49
U.S. industrial production0.670.780.640.580.100.410.010.460.73
Source: Author’s calculations.Note: Coefficients in bold are statistically significant at the 5 percent level.
Source: Author’s calculations.Note: Coefficients in bold are statistically significant at the 5 percent level.

The economies of the region appear to move more closely with U.S. industrial production than U.S. GDP. This can be explained by the importance of service industries in the U.S. economy. The output of service industries relies less on tradable goods, whereas industrial production relies more heavily on traded inputs and thus affects imports from CAPDR more directly. As expected, fluctuations in U.S. activity have a larger impact on the exports of the region than on other areas of the economy, with significant correlations between U.S. industrial production and real exports since 1995 for Costa Rica, El Salvador, Guatemala, and the Dominican Republic.10

Synchronization of CAPDR Cycles

The period through the early 1970s was marked by strong growth on average and by the highest year-to-year volatility for most countries in the region (Table 1.4, Figure 1.6). There was a generalized downturn in the early 1980s, coinciding with a double-dip recession in the United States, the Latin American debt crisis, and the onset of armed conflict in some countries. Growth remained subdued until the 1990s, when activity began to expand at a rate exceeding the long-term average in the midst of stable external and domestic environments. The slowdown in the early 2000s was less pronounced but still affected all countries. Since the mid-1990s, volatility has fallen in all countries, and negative outcomes have been less frequent. The annual figures through 2008 show only the initial wave of the impact from the global recession, because the economies of the region were not as heavily affected until late in the year.

Table 1.4Volatility of Economic Growth

(Standard deviation of change in annual real GDP growth)

1951–20081951–731974–941995–2008
Costa Rica5.47.24.43.3
Dominican Republic7.310.55.23.6
El Salvador3.13.43.41.7
Guatemala2.42.92.41.3
Honduras4.34.84.73.2
Nicaragua7.25.110.72.0
Panama4.53.95.93.3
Simple average4.95.45.22.6
Source: Author’s calculations.
Source: Author’s calculations.

Figure 1.6Real GDP Growth

(Annual percent change)

Sources: IMF, International Financial Statistics and World Economic Outlook; World Bank, World Development Indicators; and author’s calculations.

Real GDP growth correlations across countries in the region average only about 0.2 over the full sample (Table 1.5), which is consistent with results from Roache (2008a) and Fiess (2007). Synchronization has been higher since 1995, but the average correlation is still only 0.3. Quarterly data show statistically significant correlations among many countries of the region, with the most idiosyncratic cycles observed in Honduras and Nicaragua.

Table 1.5Real GDP Growth Correlations within CAPDR
Costa RicaDominican

Republic
El SalvadorGuatemalaHondurasNicaraguaPanama
Annual data, 1951–2008
Costa Rica
Dominican Republic0.08
El Salvador0.430.16
Guatemala0.300.300.45
Honduras0.35−0.020.240.47
Nicaragua0.140.120.340.11−0.14
Panama0.120.050.170.260.120.20
Simple average0.240.120.300.320.170.130.15
Annual data, 1995–2008
Costa Rica
Dominican Republic0.40
El Salvador0.520.48
Guatemala0.630.630.73
Honduras−0.030.140.070.21
Nicaragua0.070.170.21−0.09−0.33
Panama0.660.460.320.700.34−0.02
Simple average0.370.380.390.470.070.000.41
Quarterly data, 1995–2008, year-on-year
Costa Rica
Dominican Republic0.33
El Salvador0.530.42
Guatemala0.320.450.25
Honduras0.000.050.040.00
Nicaragua0.260.060.31−0.01−0.11
Panama0.560.250.260.360.320.08
Simple average0.290.260.310.200.000.100.30
Source: Author’s calculations.Note: Coefficients in bold are statistically significant at the 5 percent level. CAPDR = Central America, Panama, and the Dominican Republic.
Source: Author’s calculations.Note: Coefficients in bold are statistically significant at the 5 percent level. CAPDR = Central America, Panama, and the Dominican Republic.

Given this pattern of linkages, a substantial portion of the common movements in Central American business cycles could be the result of similar responses to external shocks. Both Fiess (2007) and Roache (2008a) regress CAPDR growth on U.S. growth and show that correlations across the region are lower when the U.S. effect is excluded, but that activity elsewhere in the region is still a relevant determinant of growth for many countries.

Effects Of External Shocks

This section identifies the response of CAPDR economic activity to external shocks. Previous work has focused largely on the effects of U.S. shocks on CAPDR, using models in which the United States is treated as the “rest of the world.” This chapter extends the analysis to other regions, for two purposes. First, although U.S. links predominate, fluctuations elsewhere can also be expected to affect CAPDR, especially because trade and financial links with other regions have increased in recent decades. Second, the large country–small country framework used in previous studies fails to control for the effects that other regions (or global exogenous shocks) could have on the United States, opening up the possibility for omitted-variables bias.

Structural Vector Autoregression Methodology and Data

Common movements in economic growth could result from the contributions of global shocks, similar responses to shocks to other regions, or idiosyncratic country shocks that happen to be correlated. In a setting in which multiple regions affect activity in Central America, this chapter employs a structural vector autoregression (SVAR) framework, which allows it to incorporate interdependencies among regions, thus tracing the effects of each shock back to the appropriate source. With lags to allow for the transmission of shocks in prior periods included, the system of equations under analysis becomes

in which X is a vector including GDP growth for each region, A is a vector of coefficients, v is a vector of error terms, and m is the number of lags in the system. Coefficients in A can be set to zero, so that there is no direct impact of economic activity between particular regions.

The SVAR in equation (1.1) establishes relationships between the current and past values of the variables in the system; the Cholesky decomposition is used to identify relationships across variables in the current period. This technique assumes that the correlation between two variables is driven by the variable ordered first in the SVAR (see Sims, 1980). Once the shocks are orthogonalized using this technique, the coefficients of the SVAR are applied to compute the impulse response function (IRF), that is, the time path of the response of any variable to a shock to any other variable.

Given the patterns of integration described earlier, system (1.1) includes four major regions: (1) the United States, (2) advanced economies other than Japan, (3) emerging Asia plus Japan, and (4) large emerging Western Hemisphere economies. The aggregates are constructed by weighting the individual countries by their GDP at purchasing power parity, except for the advanced economies, each of which is weighted equally to avoid giving the euro area a weight of two-thirds and swamping the variation in other countries. Although a spike in the growth rate in one individual country could be seen as the result of an idiosyncratic country shock, a generalized synchronous movement is more likely to capture global or regional factors. Central America is assumed not to drive the economic activity of the other regions, so it is ordered last in the SVAR, and its impact on other regions is set to zero by restricting the appropriate coefficients in the model.

The SVARs are conducted on quarterly real GDP growth since 1994, with the sample length constrained by the availability of quarterly real GDP series or high-frequency activity indicators for CAPDR. The results of standard tests selected anywhere from one to four lags, but four lags have been included in all runs for uniformity, as well as a priori assumptions about the amount of time necessary for the transmission of shocks across regions. Thus, the estimation period of the models spans from the second quarter of 1995 to the second quarter of 2009.

Response of CAPDR Activity to External Shocks

Figure 1.7 shows IRFs tracing out the cumulative impact on CAPDR real GDP of one standard deviation shocks to real GDP in the major regions. Standard-error bands encompassing the 95 percent confidence interval are also shown.

Figure 1.7Real GDP Spillovers from Major Regions

(Cumulative response, in percentage points, to a one standard deviation shock)

Source: Author’s calculations.

A one standard deviation positive shock to U.S. real GDP is associated with a gradual and statistically significant rise in activity in CAPDR, adding about ½ percent to real GDP in the year after the shock. Given that the typical U.S. shock is slightly less than ½ percent on impact and averages 0.6 over the first year, the elasticity of the CAPDR cycle to the U.S. cycle is 0.8, slightly higher than the estimates in Roache (2008a). The gradual nature of the pass-through from U.S. to CAPDR activity underscores the importance of both current and past U.S. developments in the outlook for the region.

Shocks to other advanced economies have a similar effect on CAPDR activity, reaching about a cumulative 0.5 percent four quarters after the initial shock.

Their impact is also statistically significant. CAPDR’s response to Asian and Western Hemisphere shocks is smaller and not significant.

Spillovers to Individual CAPDR Countries

Spillovers to the individual countries in the region are estimated using the same methodology, expanding the number of countries or regions under analysis to six. Each individual Central American country is placed last in an SVAR, with the four major regions remaining the same, and the fifth region comprising a purchasing-power-parity-weighted aggregate of the other Central American countries. Figure 1.8 shows the responses without standard error bands, but statistical significance is noted in the following discussion where applicable.

Figure 1.8Real GDP Spillovers to Individual Countries

(Cumulative response, in percentage points, to a one standard deviation shock)

Source: Author’s calculations.

The results suggest that a positive shock to the United States has different impacts in CAPDR countries. In particular, a one standard deviation positive shock to the U.S. economy raises activity by about 1 percentage point in Nicaragua and Panama; by between ½ and 1 percentage point in Costa Rica, El Salvador, and Honduras; and by smaller amounts in Guatemala and the Dominican Republic. These spillovers are statistically significant at various horizons for Costa Rica, El Salvador, Honduras, Nicaragua, and Panama. The total impact tends to build within the first few quarters of the shock and stabilize thereafter.

Similar results are obtained when the shock is experienced by other advanced economies. A one standard deviation shock to other advanced economies shifts activity by between ½ and 1 percentage point in Central American countries except Guatemala and Honduras, where the impact is slightly lower, and Panama, where the impact is nil. Spillovers are statistically significant with the exception of Honduras and Panama. Spillovers from elsewhere in the Western Hemisphere and from Asia are generally not found to be statistically significant.11

Spillovers within CAPDR

The 6 × 6 SVAR also allows an examination of the impact of developments within the rest of the region on each individual country, which is relevant given the importance of intraregional trade and financial linkages. The correlation between economic activity in an individual country and the rest of the Central American region is ascribed first to the common effects of U.S. shocks and then to the effects of disturbances among other major regions. The correlation that remains once these effects are accounted for is attributed to regional shocks.

Although spillovers from major regions drive a significant proportion of the comovement among economies of the region, there is also evidence of a common business cycle at the regional level, above and beyond the common response to external shocks. Figure 1.9 shows the responses of activity in each country to the regional aggregate (excluding that particular country). Spillovers from activity elsewhere in the region are noticeable for all countries except Honduras. For Costa Rica, El Salvador, Guatemala, Nicaragua, and the Dominican Republic, a one-standard-deviation shock to the rest of the region yields a response ranging from 0.2 to 0.4 percent after two years. The responses of El Salvador and Guatemala to the rest of the region are statistically significant.

Figure 1.9Real GDP Spillovers within CAPDR

(Cumulative response, in percentage points, to a one standard deviation shock)

Source: Author’s calculations.

Note: CAPDR = Central America, Panama, and the Dominican Republic.

Geographic Drivers of CAPDR Business Cycles

Variance decompositions of real GDP growth are performed using the 6 × 6 SVARs estimated above. These decompositions attribute the variation in domestic activity to the region from which the fluctuations originate. External shocks contribute, on average, about one-half of the variation in Central American activity at a two-year horizon, ranging from 25 percent for the Dominican Republic to more than half for Costa Rica, El Salvador, and Panama (Table 1.6). Shocks to the Central American region are responsible for 9 percent of business cycle variation, on average, with El Salvador and Guatemala affected the most by regional events. Domestic shocks are responsible for roughly 40 to 50 percent of the typical country’s cycle, with a lower contribution in the officially dollarized economies of El Salvador and Panama. However, there is no clear evidence of an effect of dollarization on macroeconomic volatility, since El Salvador ranks second-lowest in volatility while Panama ranks second-highest.

Table 1.6Variance Decompositions of Real GDP
Share of variance at eight quarters

explained by
External

shocks
Regional

shocks
Domestic

shocks
Standard deviation

of real GDP growth
Costa Rica546401.08
Dominican Republic255700.57
El Salvador5112370.45
Guatemala3717460.43
Honduras435520.72
Nicaragua406541.38
Panama6611241.15
Simple average459460.83
Purchasing-power-parity-weighted aggregate56440.46
Source: Author’s calculations.Note: Ellipsis points indicate data are not available.
Source: Author’s calculations.Note: Ellipsis points indicate data are not available.

Elasticities of CAPDR Activity to External Shocks

The IRFs presented earlier show the time path of the impact of one-standard-deviation shocks. These results can be used to compute the elasticity of domestic growth to external growth (Table 1.7). The figures reported are chosen for the sake of comparability with annual forecasts. Thus, a 1 percentage point shock to annual real GDP growth in year 1 is taken as the point of departure, from which three elasticities are calculated: the average response in year 1, the additional lagged response in year 2, and the total effect on the level of economic activity over two years.

Table 1.7Elasticities of CAPDR Activity to External Shocks
Costa

Rica
Dominican

Republic
El

Salvador
GuatemalaHondurasNicaraguaPanamaPurchasing-

power-parity

-weighted

aggregate
Year 1
United States0.80.60.30.10.90.91.00.5
Advanced economies1.61.40.70.10.51.3−0.10.9
CAPDR0.10.60.60.3−0.50.40.5
Year 2 (marginal)
United States0.3−0.30.50.00.40.80.60.2
Advanced economies−0.2−0.10.60.60.40.2−0.20.1
CAPDR0.80.00.40.80.10.21.0
Total
United States1.10.30.90.11.21.71.60.7
Advanced economies1.31.41.30.70.91.5−0.31.0
CAPDR0.90.60.91.1−0.40.61.4
Source: Author’s calculations.Note: Ellipsis points indicate data are not available. CAPDR = Central America, Panama, and the Dominican Republic.
Source: Author’s calculations.Note: Ellipsis points indicate data are not available. CAPDR = Central America, Panama, and the Dominican Republic.

A 1 percentage point positive shock to annual growth in the United States (equivalent to a shock of two standard deviations) causes, on average, an increase in growth in year 1 of 0.7 percent. The impact ranges from 0.1 in Guatemala to 1.0 in Panama. The lagged effects are also relevant with the exception of Guatemala and the Dominican Republic, raising the impact on the region to 1.0 over a two-year period.

The effects of a 1 percentage point shock to advanced economies (equivalent to three standard deviations) are typically front loaded and end up having an important impact on all countries except Panama. A Central American shock affects all countries except Honduras, with the effects more drawn out than those of a U.S. or advanced economy shock.

Impact of the 2008–09 Crisis

The models estimated above can be used to generate predictions for the path of real GDP in the region, given the performance of external demand. For example, Figure 1.10 compares the actual path of activity through the second quarter of 2009 to the performance of in-sample real GDP forecasts starting in the first quarter of 2008, indexing both series to the fourth quarter of 2007. The purchasing-power-parity-weighted regional aggregate grew 3 percent over this period, compared with a model-based forecast of 5 percent. Growth in Costa Rica, Nicaragua, and the Dominican Republic was overpredicted by the model, whereas forecasts for El Salvador, Guatemala, Honduras, and Panama tracked actual developments quite closely.12

Figure 1.10Model Performance during Crisis

(Real GDP, 2007:Q4 = 100)

Source: Author’s calculations.

The IRFs estimated previously can also be used to quantify the impact of the global financial crisis on CAPDR activity. The coefficients from these IRFs are applied to the residuals from the associated SVARs to trace out the time path of the impact of the shock in each period, starting with the first quarter of 2008, and ending with the second quarter of 2009. Given the lags typical in the transmission of external shocks, estimates of their effects are carried through to the end of 2009, assuming no shocks—positive or negative—occurred in the second half of the year. This produces an estimate of the impact of the initial wave of the crisis on real GDP in the region and in each country.13

According to this exercise, the impact of the global financial crisis on CAPDR was very large (the lines representing “total” in Figure 1.11 show the estimated cumulative impact of shocks to the United States and other advanced economies). Although total spillovers remained low through the first half of 2008, coinciding with a mild contraction in the United States and some growth in other advanced economies, the cumulative effect of the crisis on most CAPDR countries increased as the downturn intensified and generally peaked in mid-2009 (with some of the effects expected to revert in the second half of the year, especially in Costa Rica and the Dominican Republic). Nicaragua was the country hit hardest, with U.S. and advanced economy factors reducing real GDP by a total of 8 percent by mid-2009, whereas the peak impact on Guatemala was only 2 percent. Spillovers to the other countries and the regional aggregate ranged from 4 to 6 percent relative to a scenario with no shocks. These magnitudes are in line with forecast revisions observed in the IMF’s World Economic Outlook (WEO), as the region’s real GDP growth for 2009 was 5 percent lower, on average, than envisaged in the April 2008 WEO.14

Figure 1.11Impact of Advanced Economy Shocks during the Crisis

(Contribution, in percent, to real GDP; cumulative, starting in 2008:Q1)

Source: Author’s calculations.

Note: CAPDR = Central America, Panama, and the Dominican Republic.

aSimple average.

Real GDP spillovers from the United States and other advanced economies are also decomposed in Figure 1.11 into an “expected” component and a “surprise” component. Expected spillovers could have been foreseen ex ante by running the model through the first half of 2008 and applying the associated coefficients to the shocks obtained from the model over the full sample. This provides an estimate of the impact of the downturn in external demand if it had been known beforehand, given the elasticities available at the beginning of the crisis. The surprise component is the difference between spillovers estimated using the coefficients for the full sample and the expected component. The precrisis fit varies widely across countries. Spillovers to Guatemala, Honduras, and Panama are in line with what would have been predicted ex ante, whereas spillovers to Costa Rica, El Salvador, and Nicaragua turn out to be much stronger than precrisis elasticities would have predicted. The precrisis model predicts 50–60 percent of the impact of the advanced economy recession, on average; 40–50 percent would have come as a surprise. Evidence from WEO data again supports the broad contours of these findings, as 30 percent of the revisions between the April 2008 forecast for CAPDR and the actual outcome occurred after publication of the April 2009 WEO, when the depth of the advanced economy downturn was relatively well established.15

Transmission Channels For External Growth Spillovers

This section attributes the growth spillovers identified in the previous section to the channels responsible for the transmission of the shock. The SVARs are augmented with data on various transmission channels as exogenous variables, one at a time, as in Bayoumi and Swiston (2009). The contribution of each channel k to the total spillover between two countries i and j is calculated as the following:

This is simply the difference between the overall responses of growth in country i to country j, minus the response of growth in country i to country j estimated with the spillover channel included as an exogenous variable. The exogenous variables directly account for the impact of that transmission channel on growth, leaving in rij,k only that part of the response of growth that is not accounted for by the transmission channel. The sum of the contributions across channels is not constrained to add to the IRF that was estimated separately and thus provides an independent verification of the magnitude of growth spillovers.16

Identifying the Channels

The transmission channels considered in this exercise are trade, commodity prices, financial conditions, and remittances.17 Trade spillovers are identified using the contribution of net exports to real GDP growth for CAPDR and the contribution of exports to real GDP growth for advanced economies. For all channels, only the contemporaneous value and first lag are included to avoid picking up reverse causality from GDP shocks to the variables in future periods.

The commodity prices used are the average petroleum spot price and the Standard & Poor’s/Goldman Sachs nonenergy commodity price index. Movements in commodity prices brought about by a supply shock will probably have the same impact on foreign commodity importers as they do on activity in the region, generating positive commodity price spillovers. If external growth raises commodity prices through a demand shock, then activity in the region will move in the opposite direction, bringing about negative commodity price spillovers.

Financial spillovers can occur through different channels (Swiston, 2010). However, given the preponderance of CAPDR-U.S. links, this chapter focuses on U.S. variables—the 3-month London interbank offered rate (LIBOR), the 10-year Treasury yield, real equity prices, and the Federal Reserve’s Senior Loan Officer Survey (Swiston, 2008, examines the role of this variable in U.S. financial conditions). Domestic financial conditions are excluded because they are assumed to reflect either idiosyncratic domestic factors or the domestic response to external shocks.

Spillovers related to remittances are identified using the quarterly change in the ratio of remittances to the GDP of the recipient country. It is important to note that the variables used would need to be correlated with both foreign and domestic activity to serve as spillover channels. For remittances, however, the theoretical and empirical support for that assumption is weak.

Decomposition of Spillovers to CAPDR

Spillovers from external shocks are found to be transmitted mostly through financial and trade channels. In particular, for CAPDR as a whole, U.S. financial conditions transmit more than half of growth spillovers, whereas trade channels contribute one-third (Figure 1.12).18 Spillovers through financial and trade channels are important across most of the CAPDR countries, whereas commodity prices and remittances are not typically substantial. The crisis-generated surprises mentioned earlier are transmitted through both financial and trade channels, as spillovers through these channels are smaller in estimations based on precrisis data. This is also consistent with the region’s increased level of financial and trade integration. The failure to find a consistent impact from remittances is in line with the existing literature, as noted earlier. This result could stem at least partly from breaks in the data due to improvements in coverage over time, which would tend to obscure the underlying series’ correlations with economic activity in source and recipient countries. A more complete examination of this transmission channel is an important area for future research.

Figure 1.12Decomposition of Real GDP Spillovers from the United States

(Percentage point response to a one standard deviation shock)

Source: Author’s calculations.

Note: CAPDR = Central America, Panama, and the Dominican Republic.

Conclusion

CAPDR has become increasingly integrated with the rest of the world through stronger trade links, rising cross-border financial asset holdings and capital flows, and sharply higher remittance flows. Many of these trends began in the mid-1990s, well before the implementation of free-trade agreements with the United States, although these agreements will likely further spur both trade and financial integration in the future.

One policy challenge posed by economic integration is greater exposure to external shocks. The empirical findings of this chapter indicate that economic growth in the region depends significantly on external fluctuations, although the short time span over which data are available adds a measure of uncertainty to these inferences. A 1 percentage point shock to U.S. growth is found to be associated with a response of CAPDR activity of 0.7 to 1 percent, on average. Global shocks cause fluctuations of a similar magnitude. Spillovers have typically been transmitted through both financial and trade links, while remittances are not found to play an important role in transmitting business cycles across borders. Some evidence is also found of a regional cycle above and beyond the common response to external shocks, as activity elsewhere in the region is found to be important for some countries.

The 2008–09 global crisis weighed heavily on activity in the region in 2008 and 2009, cutting 2009 growth by an average of 4 to 5 percent. The impact was almost twice as large as elasticities estimated on precrisis data would have predicted and accounted for the majority of the observed output slowdown. The extent to which these spillovers were a surprise illustrates the larger-than-expected impact of the recent crisis and raises questions about the region’s sensitivity to external growth once the crisis fully subsides. The absence of any severe recession in advanced economies in the precrisis data, combined with the region’s increased integration, suggests that the region’s sensitivity to external shocks will remain high.19

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This chapter is based on A. Swiston, 2010, “Spillovers to Central America in Light of the Crisis: What a Difference a Year Makes,” IMF Working Paper 10/35, February (Washington: International Monetary Fund).

1

CAPDR comprises Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama, and the Dominican Republic.

2

The Dominican Republic–Central America Free Trade Agreement (CAFTA-DR) was implemented between 2004 and 2008 by the signatory countries: Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, and the United States. Panama has a similar free-trade agreement with the United States. Implementation of these agreements is likely to spur further integration with the United States, but the already sizable trade linkages suggest that the impact could be lower than, for example, that of the North American Free Trade Agreement (NAFTA) on Mexico.

3

Baroni (2008) found that U.S. tourists accounted for between 20 and 45 percent of visitors to the region in 2005 (excluding the Dominican Republic, which was not included in the study). Visitors from within CAPDR constituted the majority of tourists in El Salvador, Guatemala, Honduras, and Nicaragua, but there is no breakdown of the dollar value of receipts by tourist origin.

4

See, for example, Torres and Vela (2003); Kose, Meredith, and Towe (2004); Chiquiar and Ramos-Francia (2005); Lederman, Maloney, and Servén (2005); Bergin, Feenstra, and Hanson (2009); Fiess (2007); Sosa (2008); and Swiston and Bayoumi (2008). The latter study also finds that greater U.S. Canada integration increased the synchronicity of those countries’ business cycles.

5

Honduras and Nicaragua are excluded from the discussion of the regional average because external debt forgiveness led to breaks in their data.

6

This number may represent a lower bound, because of offshore financial center bias in the bilateral holdings data. As of end-2006, offshore financial centers held more than 30 percent of the region’s portfolio liabilities.

7

Improvement in data quality over time might partly explain the measured increase in remittances. As the costs of transferring remittances through formal channels have declined, the accuracy of official statistics has increased, because they capture remittances through formal channels better than those through informal channels (World Bank, 2005). The effect of this would occur only gradually and appears in the data as extended high trend growth in remittances, thus complicating the analysis of their determinants and effects.

8

For countries that were not publishing quarterly real GDP when this study was concluded (Guatemala and Honduras), the index of monthly activity (Índice Mensual de Actividad Económica) is used to construct a quarterly profile for real GDP that is consistent with the annual real growth rate. Details on the transformation of these monthly series are given in Swiston (2010). Guatemala began publishing quarterly real GDP data in 2010. Panama produces quarterly real GDP dating back to 2003; data have been extended back to 1999 using its monthly index of economic activity and to 1992 using an index of manufacturing production.

9

Idiosyncratic country factors such as natural disasters or currency or banking crises account for some of the low correlations, but adjusting for those factors would still leave business cycle comovement below the levels seen for the other countries reported here.

10

Nevertheless, the analysis in this chapter focuses on real GDP, given its importance as a policy variable and the wider availability of real GDP forecasts.

11

The only statistically significant response found is that of Honduras to Asian activity, but this is likely due to the occurrence of Hurricane Mitch several quarters after the Asian crisis began to hit growth (see Baroni, 2008).

12

The predictions of the model do not account for policy responses or idiosyncratic factors at the country level, although policy responses would tend to lead the model to underpredict growth given the countercyclical response that was implemented by most countries in the region.

13

Policy stimulus enacted in the United States and other advanced economies after this window could have mitigated this impact to some extent, whereas further shocks mean that the full impact could have been greater.

14

The model estimates do not account for policy responses made to mitigate the impact of external shocks, whereas the forecasts would account for the effects of these policies.

15

The timing is not exact, as the forecasts were finalized before first-quarter data for advanced economies was released. At the same time, advanced economy growth in the second half of 2009 was revised upward after the April 2009 WEO, lending support to the argument that the 30 percent figure constitutes a lower bound for surprise spillovers to the region.

16

Although this procedure does not account for collinearity among the effects of the various channels, thus tending to overstate the total impact, the results can be seen as a gauge of the relative importance of each transmission channel. Bayoumi and Swiston (2009) enter all channels into the vector autoregression simultaneously to investigate the extent of multicollinearity among the spillover channels. That is not possible in the current exercise because of degrees-of-freedom constraints in the data.

17

See Swiston (2010) for more details on the identification of these channels.

18

Figure 1.12 shows a decomposition of spillovers from the United States to the CAPDR aggregate and to each individual country. The sum of spillovers estimated from the individual channels is not constrained to equal the IRF estimated directly in the previous section. Multicollinearity between channels could therefore lead to the sum of the parts being greater than the whole, whereas the presence of other unexplained transmission channels could cause the reverse.

19

Although differences between Mexico and CAPDR limit somewhat the parallels that can be drawn, the heightened sensitivity of Mexico’s business cycle to that of the United States following the approval of NAFTA suggests that closer integration could contribute to a further increase in synchronization between CAPDR and the United States in the future.

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