As the global economy shows new signs of life this year, Central America appears poised to reap the benefits of a disciplined approach adopted by a number of governments in recent years. It needs it, too: Extreme poverty remains a daily reality for millions of people in the region, which has some the highest levels of violence in the world.

The optimism comes off a relatively robust 2016, when Central American economies achieved the much-sought cocktail of solid GDP growth rates and low inflation. The region has benefited from low oil prices and, for the second year running, resilient domestic demand has compensated for a less favorable external environment. With sovereign ratings trending upwards in most economies of the region, countries such as Guatemala and Nicaragua have drawn the attention of investors and appear set to join Panama and Costa Rica as regional presences in emerging markets portfolios.

However, the road to prosperity looks somewhat bumpier in 2017. Political deadlock has strained the finances of Costa Rica and El Salvador, and recovering oil prices, along with rising interest rates in the US, could affect domestic demand across the region, according to the United Nations’ Economic Commission for Latin America and the Caribbean (ECLAC).

The US Federal Reserve’s monetary policy is not the only cloud from the US. Trade and immigration policies supported by President Donald Trump could significantly damage economies that rely heavily on what happens up north.

But the general outlook for Central American economies continues to be positive, especially in comparison with their Latin American peers. “Central American economies tend to behave much differently from the rest of Latin America,” says Carmen Aída Lazo, dean of economics and business at ESEN, a Salvadoran business school.

The main difference, she notes, is that economies in the region do not have much to offer in terms of commodities. Although that means they failed to benefit from the China-fueled boom of the 2000s, they were not brought to their knees when the commodity bubble dramatically deflated in recent years.

“After the 2012 crisis, when oil prices came down, Central America recovered relatively quickly,” Lazo says, noting that the region imports almost all its oil.

ECLAC has forecast that the Central American economies, plus the Dominican Republic, will expand by an average of 4.5% in 2017, repeating last year’s performance, which is a significantly faster pace than the sluggish 1.3% expected for Latin America as a whole.

Within the region, growth rates are set to vary considerably, with Panama reaching 5.9% and Nicaragua achieving 4.7%, compared with El Salvador, which is forecast to grind out a mere 2.2% increase. External factors account for some of the disparity, but economists put much of the blame on local political and economic conditions.

Wrangling debt

Exhibit number one is El Salvador, which in April defaulted on part of its internal debt, triggering sovereign downgrades that took the country’s ratings to Greek and Venezuelan levels. “El Salvador is an outlier in Central America,” Lazo says. “We have a chronic economic growth problem.”

In her view, the main impediment to economic expansion is the inability of the Salvadoran government to reduce the country’s growing public debt, which reached 65% of GDP in 2016. The country’s politics are dominated by two parties whose origins date back to the civil war, which ended in 1992, and who seem unable to reach any agreements on tax reform or issuing new debt to pay old obligations.

As a result, a string of Salvadoran governments regularly passed stop-gap budgets that only delayed the day of reckoning. “El Salvador needs a structural solution for its fiscal problems,” Lazo says. “And it needs to happen soon. In October, a new electoral cycle will begin, and any chance of an agreement will then be closed.”

To make matters worse, El Salvador’s dollarized economy gives the government no leverage to counter its fiscal imbalances with monetary action. The situation discourages investment that could create much needed jobs. “The Salvadoran government does not promote foreign investments and has generated some doubts about institutional security,” says Esteban Brenes, strategy and entrepreneurship professor at INCAE, a business school, and a partner at BAC y Asociados, a consulting firm in San José, Costa Rica. “El Salvador has first-quality entrepreneurs, but they are investing abroad due to their doubts about the country’s politics.” He forecasts that El Salvador will grow by a miserly 1.5% to 2% in the next few years.

Political wrangling has similarly hobbled Costa Rica, formerly a model student in the region. Abelardo Medina, an economist at the Instituto Centro Americano de Estudios Fiscales (ICEFI), a Guatemala-based think-tank, noted that the Costa Rican government has run large deficits for the past several years and, as result, government debt has spiraled ever higher. “It is true that most debt is held by banks, which are owned by the government, but it could generate solvency issues in the banking system down the road,” he says. According to ECLAC, total public Costa Rican debt increased to $34.4 billion last year, or more than 60% of GDP, from $16.1 billion, or 43.3% of GDP, in 2010.

As in El Salvador, the crux of the problem is that fiercely opposed political groups are unable to address the country’s deteriorating fiscal position. “Costa Rica faces a serious governability problem,” Brenes says. “We have too many laws and institutions.”

Rating agencies have taken note of the problems and started to downgrade Costa Rica. In mid-2015, Moody’s slapped the country with a Baa3 rating. By February, the rating had already fallen two notches to Ba2, with a negative perspective to boot. The flip side is that the economy is still expected to grow, with ECLAC expecting GDP to expand 3.9% this year.

How much austerity is too much?

Other governments in the region have done a better job of putting their books in order. A particularly successful example has been Honduras, where tax reforms implemented in 2014 have cleared the path for future investments. “Honduras should do pretty well in the next few years,” Brenes says. “The government has done an extraordinary job with the economy.”

ECLAC expects Honduras to grow by 3.4% this year, which is down slightly from last year’s 3.5% and hardly an Asian pace, but beats the 2.8% rate posted before the reform. Brenes believes the economy has the potential to expand at more than 4% annual clips in years to come.

In Medina’s opinion, Honduras’ newly found ability to promote public investments is good news in a region where governments have been relucant to spend, too intent on keeping the public safes tightly locked. He says that in places like Costa Rica, austerity has failed to reduce public debt because more decisive action on tax reforms has not materialized. Even in countries where debt is not a worry, governments have felt compelled to keep spending as low as possible.

“In Guatemala, the government has been shrinking, even though there is much need for improvements in the public sector and debt levels rank among the lowest in the world,” Medina says. “It is not necessary to keep implementing austerity measures, but it is an idiosyncrasy of the country. Guatemala has implemented strong inflation target policies for three decades.” ECLAC numbers show that Guatemalan government debt closed 2016 at just over 23% of GDP.

With stingy governments keeping a tight rein on spending, Central American economies will do well to attract private investments to achieve faster growth. Lazo sees potential for private investment in sectors that can benefit from El Salvador’s proximity to the US, such as logistics, call center services and medical tourism. Medina stresses that Costa Rica has carved a niche in high technology industries, particularly biomedicine, and offers the skilled labor force required to attract foreign firms.

To tempt private investors, however, Central American economies need to improve both the business environment and the rule of law. The region fares poorly in the World Bank’s Doing Business rankings, with Costa Rica leading the lot in the dubious 62nd position. Panama ranks 70th and Guatemala comes in at 88th.

Governments are not the only culprits for the miserable rankings. “Especially in Guatemala, Honduras, El Salvador and Nicaragua, the private sector is very opaque, as companies fear that, if they release too much information, they will have to pay more taxes,” Medina says.

Curiously, the Central American economy with the worst business environment, Nicaragua at 127th, may look more promising for investors, according to Brenes. He remarks that the government has kept its books in order, paving the way for a robust 4.7% growth spurt this year.

A stumbling block for many investors is the Sandinista government of President Daniel Ortega, who has a knack of aligning himself with Venezuela and other hard left Latin American regimes. “Democracy does not work very well in Nicaragua, but the economy does,” Brener says. “The problem is that investors do not feel confident about the rule of law.”

Other challenges remain across Central America, such as increasing formal employment, improving education in order to boost labor productivity and augmenting tax revenues, which stand at less than 13% of GDP in the region, bottoming out at a tad over 10% in Guatemala and Panama. High levels of violence, especially in the Northern Triangle of Guatemala, El Salvador and Honduras, also constrain economic growth, Lazo points out.

The job of reforming the area could be made even harder by policies implemented by the Trump administration. Medina does not believe that a spike in US protectionism could affect local economies much because Central America has a trade deficit with the US, and Trump has much tougher battles to fight with the likes of Mexico and China, before turning his attentions to the Central American Free Trade Agreement (CAFTA).

A radical clampdown on immigration could be another story, though. In Medina’s view, mass deportations of illegal immigrants to El Salvador, Guatemala and Honduras would create extensive social challenges that their governments are poorly equipped to deal with.

It would also reduce foreign remittances, which are a vital part of Central American economies. Money sent to their families from immigrants, especially from the US, amounted to 20% of Honduras’ GDP in 2016, as estimated by ECLAC. In El Salvador, the ratio was 17.1%, and in Guatemala, 10.4%. In countries struggling to grow, such a blow could be painful indeed. LF