Integration and open markets

The Central American Common Market (CACM) has five member countries:  Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua. These five countries have joined efforts to improve regional integration and have achieved significant results in the area of regional trade.

The completion of the Central American Free Trade Agreement is in its final stages and the formation of a Custom Union, which will eliminate tariff barriers among participating countries and impose uniform tariffs for nonmembers, is underway. The regional integration efforts are carried out under the auspices of the Central American System of Integration (better known as SICA), coordinated by the Ministers of Foreign Affairs with the participation of the Ministers of Finance, Trade Ministers and Central Bank Presidents.

 The approval of the Central America-Dominican Republic-Free Trade Agreement (CAFTA-DR) and the negotiation of an Association Agreement with the European Union are significant new opportunities for the Central American region and should have positive impacts on the integration process.

The Mexican-sponsored Plan Puebla-Panama (PPP), which includes the CACM countries as well as Mexico, Belize, Panama and Colombia, will also impact regional development. The PPP already has $4 billion in financing, approximately 50 percent of the total planned investment, and encompasses 99 projects related to transportation infrastructure as well as projects in the area of energy, telecommunications, commerce and tourism. 

Currently, the international trade openness coefficient is higher than levels in the 1990s, with intraregional exports representing 35 percent of the total, excluding exports generated from the “maquila” industry—factories that import materials and equipment on a tax-free basis for assembly and re-export.

The establishment of a Custom Union and tariff harmonization will foster additional expansion of intraregional trade and encourage productive links between countries. The region also has multiple commercial agreements within Central America as well as agreements between CACM countries and the United States, European Union, Dominican Republic, Chile, Colombia, Taiwan and others.

Macroeconomic stability

The international macroeconomic environment has been positive for the region. Recent growth (4.8 percent average annual growth between 2003 and 2006) and increase in world commerce (17 percent increase between 2003 and 2005) have generated greater external demand and increased the flow of remittances. In addition, the dynamic world economy helped reduce interest rates and increased the liquidity of financial markets, which resulted in higher levels of foreign investment in the region, especially in the financial sector.

These external conditions resulted in strong economic expansion in Central America in recent years. The increased capital inflows, a dynamic tourism sector and the strong inflow of foreign currency from remittances contributed to the financing of current account deficits and increased household income and consumption.

From 2003 to 2006, the CACM economies grew, on average, 4 percent per year.  The largest economies within the CACM are those of Costa Rica, El Salvador and Guatemala, accounting for 84 percent of the regional gross domestic product (GDP). GDP per capita for the CACM grew 2.3 percent from 2003 to 2006. Urban unemployment decreased from 7 percent to 5.6 percent between 2003 and 2006.

Outside the CACM, Panama experienced strong economic growth and according to the United Nations Economic Commission for Latin American and the Caribbean (ECLAC), this country will experience the most dynamic growth in the region during 2007. See Table 1 for a more detailed breakdown of the region’s GDP.

During 2007, the international environment should remain favorable, despite a weakening U.S. economy, as an expansion of the Asian economy and recovery of Japanese and European markets is predicted. The future economic performance of the Central American economies will also be determined by the success of CAFTA-DR, the strengthening of the commercial ties to the European Union, and the progress obtained in the integration efforts, especially those related to customs unification and the infrastructure initiatives laid out in the PPP.  Regional growth is expected to decelerate slightly but still maintain a positive edge over the population growth rate.

The CACM countries have been experiencing a decreasing rate of inflation with the exception of 2004, due to price increases in petroleum derivatives in world markets (see Table 2). In the last two years, inflation dropped from 9.3 percent to 6.7 percent, despite continued high fuel prices. Inflation has been controlled by increased discipline in managing fiscal and monetary policies along with exchange rate stability. Other factors that may affect internal prices in the future are the price of corn and the excess of liquidity, which is reflected in sharp increases in credit.

In addition to achieving greater growth and relative inflation control, the countries in the region have also undertaken efforts to maintain fiscal discipline and, in the case of Honduras and Nicaragua, to obtain foreign debt relief through the Heavily Indebted Poor Country Initiative (HIPC), Paris Club and the Multilateral Debt Relief Initiative (MDRI). This has contributed significantly to improve their public finances.

Despite increases in oil price, the current account balance has remained relatively stable. This can be attributed to foreign remittances and other capital inflows, which have financed the trade deficit and built up foreign reserves. With the exception of Costa Rica, foreign remittances have acquired special importance in the Central American economies by greatly increasing the ratio of current transfers to exports and foreign direct investment.
Growth in exports (Table 3) was due mainly to increased sales volume while imports grew at a faster rate, mainly due to foreign purchases and pricing effects, thereby increasing the trade deficits considerably.

According to Inter-American Development Bank (IDB) studies, between 2003 and 2006, net income from financial capital to the CACM member countries was, on average, $3 billion per year—almost twice the capital inflows registered in the previous four years (see Tables 4 and 5).

In the case of Panama, exports differ substantially from the CACM countries in which basic products, tourism and maquila dominate and remittances are of lesser importance. In Panama’s economy, the service sector is the most important, comprising 78 percent of the GDP. In 2006, 31 percent of exports were accounted for by income from the Panama Canal, 22 percent by financial services, 21 percent tourism, 15 percent re-exports from the Colon Free Zone, 6 percent goods and 5 percent ports.

Recent years show greater exchange rate stability throughout the region due to an improved position of international reserves (see Figure 1 and Table 6). El Salvador and Panama have dollar-based economies.

Financial Sector

The region has experienced a strong expansion in financial intermediation and foreign investment in this sector has increased considerably. With the exception of Panama, where financial penetration is high and well developed capital markets have existed for some time, financial intermediation in the CACM countries is mainly dominated by commercial banks. However, the recent ratification of CAFTA-DR attracted the attention of global financial groups and increased potential for investments and commerce on a regional basis.
Several recent investments emphasize the growth in this sector:

• In May 2005, GE Money acquired a 49 percent minority interest in Grupo BAC-Credomatic, one of the largest issuers of credit cards in the region.
• Later in June 2006, Scotiabank expanded its operations into Costa Rica with the acquisition of Interfin Group, a major player in Costa Rica’s private financial sector, for $293.5 million. With this acquisition, Scotiabank continued an expansion effort that had begun in El Salvador with the purchase of Banco de Comercio, the third largest bank in El Salvador.
• In July 2006, HSBC bought Panama-based Grupo Banistmo. At $1.77 billion, this was the largest acquisition in the financial sector in this region.
• Finally in October 2006, Citigroup closed a cycle of acquisitions with two important transactions in the Central American banking system. First, they bought Grupo Financiero Uno, the largest issuer of credit cards in the region, for an estimated $1.4 billion. Then they announced the purchase of Grupo Financiero Cuscatlán through UBCI Holdings in Panama, for a total of $1.51 billion. The purchase included banks and insurance companies located throughout the region.

Foreign direct investment

During the last five years, foreign direct investment in CACM exceeded $9 billion. Costa Rica was the largest recipient of these investments, accounting for approximately $4 billion or 44 percent of the total. If Panama is added to the foreign direct investment (FDI) figures, the total for this period is almost $15 billion (see Table 7).

Approximately 95 percent of FDI comes from outside the region, with the United States being the largest investor. El Salvador leads the countries in inter-regional investment with 60 percent of the total. Foreign direct investment was oriented mainly toward the service sector (telecommunications, commerce and real estate) and maquila industry.

In the process of market expansion, more regional corporations are being created with new capital formation as well as through mergers and acquisitions of regional companies on behalf of multinational companies and other foreign enterprises. Additionally, Central American companies have begun to invest outside the region.

Sectors with the greatest potential

Due to the characteristics of the region and advances in integration, tourism is one of the sectors with the greatest potential. The region possesses sites of archaeological, ecological, historical, cultural and recreational interest. According to the World Tourism Organization, Central America was the sub region with the greatest growth worldwide at a rate of 13.4 percent in 2005. Other sectors in the region that have experienced change in recent years include construction, financial services, transportation and communications.

The agribusiness sector has not yet reached its potential, despite the favorable climate conditions. However, the sector has traditionally been of great importance to the Central American economies and promises to maintain its significance.

With its combination of easy access to the United States and existing commercial agreements, the region possesses comparative advantages in the maquila industry, where growth has been sustained for several years and where vertical integration of textile products is advancing rapidly and diversification into other product lines is also increasing.

Costa Rica and Honduras are the leading countries in maquila exports, followed by Guatemala and El Salvador (see Table 8). While Nicaragua has the smallest contribution to this sector, it showed the highest growth rate for the 2003 to 2005 period, averaging 25.6 percent.

The maquila sector has acquired great importance in employment generation throughout the region. It is estimated that this sector employed more than 400,000 people between 2005 and 2006, with Honduras and Guatemala accounting for 53 percent of these jobs.

The maquila industry faces critical challenges in the future, especially due to competition from China in the textile market. China represented 11.5 percent of total textile imports in the United States in 2000 and 28.6 percent in 2006 (see Figure 2). Nevertheless, the CACM has been able to maintain its share of the U.S. market and there are strong indications it will continue to do so, given the positive trends towards industry vertical integration and product diversification. In addition, due to Central America’s convenient location and easy access to markets in the United States and Europe, Asia could also represent opportunities.

Some of the greatest challenges facing the region are the reduction of high levels of poverty and achieving equitable economic growth. However, the region is on its way to better standards of living. To quote Rodrigo de Rato, Managing Director of the International Monetary Fund, “There is substantial optimism about Central America’s investment and growth potential, reflecting continuing political and economic stability, and deepening global and regional integration to achieve sustainable employment growth and poverty reduction. This optimism has already led to increased investment in the region….”