Part II: Policy Challenges: A View from 2011
- Marco Pinon, Alejandro Lopez Mejia, M. (Mario) Garza, and Fernando Delgado
- Published Date:
- July 2012
This part of the book aims to provide a policy road map for Central America, Panama, and the Dominican Republic (CAPDR) to improve upon historical economic performance and navigate a challenging period ahead. Taking as background the region’s record of macroeconomic performance and policies discussed in Part I, these seven chapters analyze the region’s economic challenges, including through assessments of economic policy and institutional frameworks in place in each of the countries. The approach relies on a broad array of tools, including cross-country econometric studies, tailor-made surveys conducted within the region, and newly constructed indices comparing institutional strength in the region with international best practices. Particular attention is paid to the evaluation of vulnerabilities revealed across the globe during the recent global crisis and the policy tools that have been proposed to address them.
The general thrust of the analysis suggests that the reform agenda should be broad, targeting several complementary fronts. Policy measures and reforms should aim to increase productivity, protect macroeconomic stability, and improve the effectiveness of macroeconomic tools. It will be essential for the region to foster higher levels of private investment, strengthen human capital, and further increase the flexibility of CAPDR economies by, among other actions, encouraging competition and consolidating financial and monetary reforms. These structural reforms must be underpinned by supportive fiscal policies to increase the governments’ capacity to provide essential public goods and ensure public debt sustainability.
The chapters are grouped in three sections. The first section delves into possible reforms and policy measures for raising economic growth. The analysis covers both macroeconomic and structural policies, but emphasizes the prospect of reforms to raise private investment and productivity in the region. It relies to a significant extent on a recently prepared cross-country IMF database to build a large array of indicators for the quality and strength of structural frameworks and policies. The analysis is presented in one chapter:
- In Chapter 3, Swiston and Barrot estimate an econometric panel growth regression using the latest data available for a large sample of countries, initially incorporating the standard variables of economic convergence, factor accumulation, and a selection of macroeconomic variables. Using an IMF database on structural reforms (2009), the study adds in the growth regression indices on the quality of structural conditions and policies for each country, with three subindices (domestic financial systems, external transactions, and product markets). The authors’ results suggest that by undertaking structural reforms in one or more sectors, all countries in the region could raise their long-run growth by ½–2 percent per year. In some countries, however, low levels of physical and human capital are also identified as major constraints to growth.
The second section examines the fiscal challenges confronting CAPDR and the policy options to regain the fiscal space used during the 2008–09 global crisis. The two chapters deal with the issue of the appropriate level of debt for the countries in the region; discuss possible medium-term fiscal balances and debt targets; and assess potential fiscal adjustment measures.
- Bannister and Barrot, in Chapter 4, develop a method for assessing the CAPDR countries’ degree of intolerance to public debt and for setting debt targets that would support credit rating upgrades. They improve on previous econometric estimates by using a dynamic panel method and correcting for the endogeneity of the regressors, and by basing the calculation of debt targets on outside credit ratings, a more objective criterion. The application of this method suggests that the level of tolerance for indebtedness varies by country in the region, with vulnerabilities arising at relatively low levels of debt. Thus, despite debt levels in the region (25–66 percent of GDP) that could be considered moderate by some criteria, the countries could improve their credit ratings by targeting and achieving lower debt levels over the medium term.
- In Chapter 5, Garza, Morra, and Simard analyze the adjustment that may be necessary to regain fiscal space and discuss policy options to achieve alternative debt targets. They highlight that in the absence of adjustment measures, revenue will likely remain below, and expenditure above, precrisis levels. They conclude that the required fiscal effort ranges between 1 and 5 percent of GDP, depending on the country and the medium-term target (stabilize, precrisis, or improve creditworthiness). Based on international comparators, the authors find that the fiscal effort should largely focus on increasing revenues through a combination of reductions in tax expenditures and improvements in administration, but also in some cases, higher tax rates. This effort would need to be supplemented by substantial improvements in the composition of public spending, because, in several cases, current spending, particularly the wage bill, has reached relatively high levels by international standards, whereas capital spending has remained low.
The third section identifies possible reforms and policy measures that countries in the region could undertake to strengthen their monetary and financial frameworks. The four chapters in this section conduct thorough diagnostics of the frameworks and policies in place under alternative methodologies, assessing compliance with best practices and international standards, and identifying vulnerabilities.
- In Chapter 6, Medina Cas, Carrión-Menéndez, and Frantischek assess the quality of the monetary policy frameworks in CAPDR by constructing a detailed index encompassing key factors such as (1) the clarity of the objectives of monetary policy, (2) the degree of fiscal dominance, (3) effectiveness of monetary instruments, and (4) central bank independence. The indices range broadly (between 0.29 and 0.67, where 1 denotes the highest quality), indicating that the strength of monetary frameworks in the region varies significantly, with countries with no or little exchange rate flexibility rating lower, and countries that have made strides toward inflation targeting scoring higher. Nevertheless, all countries would benefit from increased exchange rate flexibility and more effective and developed monetary instruments.
- In Chapter 7, Swiston assesses the costs and benefits to El Salvador of adopting the U.S. dollar as its currency in 2001. He addresses the issue from two perspectives. First, he uses an uncovered interest parity framework to measure econometrically the net benefits realized from lower interest rates. Second, he addresses whether giving up monetary policy has had a negative impact, given the possibility that business cycles in the United States differ from those in El Salvador. He finds that, although interest rates remained above U.S. rates, El Salvador realized considerable benefits from its interest rates dropping by 4–5 percent, mostly owing to reduced currency risk. Furthermore, he concludes that U.S. monetary policy has contributed significantly to cyclical stability of inflation and output in El Salvador, probably attributable to the country’s tight economic integration with the United States.
- In Chapter 8, Medina Cas, Carrión-Menóndez, and Frantischek estimate the degree of pass-through from policy rates to short-term market interest rates and the key factors behind the pass-through level for a large panel of countries. They conclude that the pass-through in Central America is moderate, on the order of 0.5–0.6, compared with close to 1 in the larger Latin American economies that have more advanced monetary frameworks. They also conclude that the pass-through, and with it the effectiveness of monetary policy, could be improved in the region through increased exchange rate flexibility and, over time, through policies to foster financial de-dollarization, enhance competition in the banking sector, and reduce fiscal dominance.
- Delgado and Meza, in Chapter 9, comprehensively assess financial regulation and supervisory practices and the use of macroprudential norms in the region to identify latent vulnerabilities and offer a road map for the future. They first construct indices of compliance with the Basel Core Principles (BCP) (with subindices for risk-based supervision, consolidated supervision, institutional factors, and governance). These results are supplemented by a survey of the superintendents of the region conducted in December 2010, which captured more recent information and elements not included in the BCP assessments. The authors conclude that, despite notable progress during the past decade, significant potential exists for improvement in financial supervision in some areas, particularly in moving toward risk-based supervision and increasing the supervisory perimeter. The set of macroprudential instruments could also be strengthened so the superintendencies would be better prepared to deal with surges in capital flows or credit and the possibility of asset bubbles.
- Chapter 3: The Challenge of Boosting Growth
- Chapter 4: A Framework for Assessing the Level of Public Debt
- Chapter 5: The Fiscal Position: Prospects and Options for Adjustment
- Chapter 6: Monetary Policy Frameworks
- Chapter 7: Official Dollarization in El Salvador as an Alternative Monetary Framework
- Chapter 8: The Effectiveness of Monetary Policy
- Chapter 9: Financial Supervision and Macroprudential Policies