RETURN T RESTRICTED RpoRTS DESKlRESTR wREPO 'THIN Report No. WH- 1 70a ONE WEE This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION ECONOMIC DEVELOPMENT AND PROSPECTS OF CENTRAL AMERICA (in ,ight volumes) VOLUME I MAIN REPORT JULne 5, 1967 Western Hemisphere Department EQUIVALENTS Currencies = 1 Central American peso (a unit of account) ) = 1 Guatemalan quetzal U. S. dollar 1 ) = 2. 5 Salvadorean colones ) = 2. 0 Honduran lempiras = 7. 0 Nicaraguan cordobas = 6. 62 Costa Rican colones Weights and Measures 1 manzana = 1. 727 acres = 0. 69 ha. 1 (60 kilo) coffee bag = 132 pounds 16. 6 coffee bags = 1 metric ton 1 short ton = 2000 pounds 1 quintal = approximately 101 pounds Approximately 20 quintals = 1 short ton (sugar) 1 banana box = 42 pounds 1 banana stem = approximately 1. 35 banana-boxes 1 banana stem = approximately 57 pounds 1 (cotton) bale = 480 lbs. net THE MISSION Hubert F. Havlik Chief of the Mission Jose Antonio Guerra Deputy Chief Pedro-Pablo Kuczynski Chief Economist Hans 0. Schmitt Economist M. P. Benjamin (FAO) Agricultural Economist Hans Platenius Agricultural Economist C. G. Akhurst (FAO) Agricultural Production Advisor Alain 1Varnod (FAO) Commodities Advisor H. S. Caldlwell (FAO) Livestock Advisor Isaac Kissin (FAO) Forestry and Wood-Using Industries Irwin Baskind (OAS) Industrial Advisor Jose Almeida (consultant) Industrial Advisor Edward S. Prentice (consultant), Transportation Economist Eric Schaefer Highway Engineer Francis C. Soges Highway Engineer S. M. L. van der Meer Port Advisor DietrichL. Regling Railway Advisor Joaquin Campillo (UNESCO) Education Advisor George 0. Pierce (consultant) Water Supply and Public Health Advisor Members of Public Utilities Division, under the coordination of Christian Finne, prepared materials on electric power and telecommunications. VOLIUJE I - MAIN REPORT TA.BLE OF CONTENTS Page No. BASIC DATA SUM1MARY AND CONCLUSIONS i - xvi PREFACE PART ONE GENERAL REPORT CHAPTER I RECENT GROWTH EXPERIENCE IN CENTRAL AERICA 1 A. The Region 1 B. Trends in Growth 2 C. The Common Market 4 D. Conclusions 8 II AGRICULTURE 10 A. General Characteristics 10 B. Mqain export products; developments and prospects 11 C. M.inor export products - developments and prospects 15 D. Grains and other foods for domestic consumption 18 E. Colonization and Settlement 20 F. Conclusions 21 III INDUSTRY 23 A. Recent trends and factors in growth 23 B. Prospects for growth 30 C. Investment and financing 37 D. Conclusions 40 IV PUBLIC INVESTMENT 42 A. Public investment in the recent past 42 B. Public investment programs through 1969 and 1970 44 C. Projects of regional significance h7 D. Conclusions 5 TABLE OF CONTENTS 7continued) -2- CHAPTER Page No. V DEVELOPMENT FINANCING AND GROWTH 56 A. Introduction 56 B. Needs for external financing 56 C. Needs for additional domestic financing effort 58 D. The balance of payments and growth prospects 61 PART TIWO - COUNTRY SUvMARIES Guatemala 69 El Salvador 80 Honduras 90 Nicaragua 99 Costa Rica 108 APPENDIX A - The Comnon Mvarket Maps I - IX VOLUME II STATISTICAL APPENDIX TO MAIN REPORT VOLUME III AGRICULTURE VOLUME IV INDUSTRY VOLUME V FORESTRY AND WOOD-USING INDUSTRIES VOLUME VI TRANSPORTATION VOLM4E VII EDUCATION VOLUME VIII WATER SUPPLY, SEWERAGE AND PUBLIC HEALTH CENTRAL Aivi3'RICA: BASIC DATA Guate- 21 Sal- Hon- Nica- Costa Total mala vador duras ragua Rica Region Area, square miles 42,040 3,061 44,480 57,000 19,700 171,280 Population, millions, 1965 4.28 2.95 2.30 1.63 1.46 12.62 annual percent growth rate 17 3.3 .3.6 3.3 3.0 4.1 3.4 Gross Domestic Product, 1965 CA peso millions 1,415 315 514 531 604 3,871 percent ra e of growth . 7.0 7.3 6.3 8.5 7.3 7.1 percapita 320 278 215 325 422 305 Exports, (f.o.b., million CA pesos) 1961 115 L19 74 70 84 462 percent to Central America 9.3 L2.1 11.5 2.6 2.4 8.1 1965 193 L89 127 149 112 770 percent to Central America 20.5 :24.2 17.5 6.8 16.8 17.9 Public Finance, million CA pesos current revenue, 1965 122 90 55 64 72 403 percent of GDP 8.4 Lle0 10.7 12.0 11.8 10.4 public investment, 1965 34 30 13 25 31 133 percent of GDP 2.4 .3.7 2.5 4.7 5.1 3.4 Debt Service Burden total, 1966, million dollars 8.1 3.5 3.1 8.2 21.4 49.3 percent of 1965 exports 4.2 }4.5 2.4 5.5 19.1 6.4 1/ 1960-1965 2/ Estimated SUNNARY AND CONCLUSIONS The Common Yarlcet 1. Since the early 1950's the economies of the five Central American countries have grovn at a rapid rate. Despite a recession due to export difficulties in 1958-1961, overall the GDP growth rate in the last decade has averaged 5-6 percent per annum, well above the 3.3 percent annual increase in population. The major impulse to growth was in exports of traditional commodities - first bananas and coffee, and beginning in the latter 1950's, cotton. The Central American countries are open economies, and variations in exports (which have constituted 18-22 percent of GDP in the last decade) have markedly influenced investment, imports and national output. 2. Hindered by the small domestic markets and low per capita incomes, the countries sought to provide a wider basis for internal economic expansion by elimination of trade restrictions; their efforts over many years resulted in a treaty in 1960 (which came into effect from 1961 to 1963 as the several countries ratified it) whiclh freed trade from tariffs or other restrictions on all but a small portion of the items and volume of trade. A common tariff on these freed items wzas also established, and a machinery for administration of the Common Market arrangements was established, including an Economic Council of MinisterS and a secretariat. A clearing house for payments between the countries wras established, and with a system for settlement of balances with only very small margin of credit. and directions were given to a monetary counci:L to prepare studies aiming at eventual establishment of a monetary union. The Central American Bank for Economic Integration (CABEI) was established and, financed by subscription by the five governments and mainly by 'Loans from several outside agencies (USAID, IDB, and the Mexican Central Bank), began a series of loans for projects of importance of regional integration and development. 3. WIhile an aim of the Common Market policy makers is to raise income as much as possible nationally since all flve countries are still low-income countries, a stated objective of integration is "balanced" economic growth; in practice, thus far, efforts Ln this direction are largely those of favoring the poorest and slowest growing of the countries - Honduras - by permitting special concessions in fiscal incentives for industrial development, giving preference in allocation of regional (CABEI) funds and technical assistance (from regional and international institutions). Thus far, these efforts are reasonable and desirable in terms of the potential significance of Honduras as a market and as a resource base. 4. Following these steps toward trade liberalization, commerce among the five countries soared, more than tripling in value from 1961 to 1965. This expansion contributed over half the increment in the countriest total exports during the period, and, by 1965, 18 percent of the total exports of the five countries took place among them. As a result, the countries have generally increased their interdependence in trade and development. With integration, there have arisen needs for harmonization of ecoromic policies with respect to industry, trade, fiscal, balance of paymients, investment and other fields. 5. Against this background of economic growth, in recent years, the prospects are that recent grovwth rates are unlikely to be maintained in the next few years or so. This is largely because overall prospects for gro,wth in exports of cotton and coffee are far less favorable than in the recent past, so that to 1970 exports of the region as a whole to the outside TwJorld are likely to increase about 2.5 percent annually (remaining stagnant in El Salvador and Guatemala) as compared with the average growth rate of 12.3 percent in 1961-1965. Farther off, from 1970 to 1i75, the prospects are more favorable and regional exports may rise at some 4.5 percent annually UIhile these estimates are subject to a wide margin of error, they imply that the growtlh rate of the Central American region to 1970 would be in the neighborhood of 2.5 percent annually, with Honduras and Nicaragua somewhat above Costa Rica and El Salvador substantially below it. This slackening of growth, together with the repercussions in a variety of fields, sharpens the policy issues for development in each of the countries and for the integratilon movement as a whole. Industry 6. A pressing issue in Central American economic development, from the viewpoint of the integration of the economies and their longer-run development, is the need to revise and improve industrial policies. Industry has been growing rapidly. Value added in manufacture greTwj at an an- nual rate of 11 percent in the region; and, by 1965, it accounted for 13-17 percent of GDP in the several countries. Industry has been the chief beneficiary of the Common M4arket. About 85 percent of the increase in intra-reginnal trade from 1962 to 1965 wias in manufactured goods. M4ost of the growth in industrial output and a large share of the growtlh in regional trade has been in traditional consumer goods (such as textiles, clothing, and processed foods). Whlbile the common tariff sub- stantially increased the protection given to consumer goods, increased competitiion and widened market, opportunities in a number of lines result- ing from the abolition of intra-regional tariff barriers has been bene- ficial. Thus, generally, prices of goods manufactured in Central America with better utilization of existing capacity and specialization in related products have not increased. Despite the rapid growth of industrial out- put in recent years, there are still important opportunities for reasonably economic import substitution in a market of almost 13 million people, increasing at a rate of 3.5 petrcent annually, with a present regional average per capita income of $305, particularly as existing plants are improved and managerial and technical sklJl gained in recent years come into full play. The newer indLustries now being planned or developed - most of which relate to newer intermediate products or establishment of older lines on a larger scale - raise complex problems of suitable size, - iii - markets, tariffs, fiscal incentives, and financing. There is danger that, if the policy of import substitution is pushed without due regard to efficiency or price, costs to consumers may rise and, more important, costs of inputs for manufactur:ing and for agriculture may be such a.s to hurt growth prospects of the region in the longer run. While prospects for industrial growth on the basis of regional demand are substantial and worth exploita.tion, they will be limited by the relatively small dimensions of the market; hence, further progress toward a. rate of industrial growth which the countries desire and need will depend also on development of export-oriented industries which are capable of competing in world markets. 7. Whether industry will develop in these directions will depend in part on the course of tariff policies pursued in Central America and of policies followed in granting fiscal incentives for industrial devel- opment. Under the present treaties, tariff increa.ses may be accorded to individuals by renegotiations Lof the common tariff, or by individual pro- tocols approving increases for specific items, either for "integration industries" having special market privileges (of which three have been approved so far) or for "new" industries capable of meeting half of regional demand and of particular interest for development of the region. Many requests now being filed under these several provisions involve large increases in tariffs, which could result in substantial price increases; often these industries rely heavily on imported materials or components and have a low added value. While local tariff preferences accorded to "integration industries" are wiped out over ten years, there is no provision for systematic reductions of special external tariffs; and provisions a.s to control of price or quality in these industries' manufactures are vague. The special protection afforded to the new "infantt' is likely to be contin- uous. Moreover, the addition of these tariff privileges on a case-by-case ba.sis lends itself to a give and take by national interests and the criteria of tariff adjustments, particularly as regards their economic effects, have not yet been well developed. Thus, a. major issue is how to develop and strengthen the process of adjusting tariffs, since, as conditions change, the tariff structure may need to be adapted to the new opportuni- ties and new conditions in the Common Market. The mission considers that this would best be accomplished by establishing an autonomous Regional Tariff and Industrial Commission to consider all cases of tariff adjust- ment, with power to increase or decrease existing tariffs within a certain margin (e.g. 50 percent) without reference to further political authority. It should also be authorized to grant quotas for imports at common tariff ra.tes in the ca.ses of specially protected industries if needed to protect the public interest. Should the architects of the Common Market not find it feasible to give autonomy to such a commission, it should be empowered to make findings and recommendations to the Economic Council for recommenda- tions in turn to the Governments for ra.tification. Such a. commission, to be effective, would need strong support from the existing technical agencies, which would need to be strengthened for these purposes. 8. Closely allied to tariff policy is that of fiscal incentives, since, by granting these, the Governments virtually grant subsidies to induce industrial development. The several governments ha.ve been - iv - competing hard in the last several years to attra.ct new industrial investment, often through fisca:L incentives applied under loose criteria. The cost of these exemptions to the economy and to the fisc, while not readily calculable in all aspects, is very considerable. This competition has increased since the beginning of the Common Market. Together with generally higher tariffs, it has increased the dangers of proliferation of industries, with resulting excess capacity and high costs, which would, in most cases, not be capable of competing outside the region. Moreover, the system of progressive. taxation on business income gives motive to entre- preneurs who wish to avoid such penalties on growth in size by securing income tax exemptions under the industrial incentive law; a. change in the tax laws is needed to remedy thi.s. After some years of negotiations, agree- ment ha.s been reached on a. Central American convention establishing a uniform classification of privileges which may be granted; Honduras is permitted special latitude to enable her to catch up with the other coun- tries in industrial development in accord with the doctrine of "balanced" economic growth of the region. Even the new convention, which remains to be ratified, permits generous treatment for new investment with loose economic criteria.. Moreover, it. would also be administered (no doubt competitively) by national administrations for up to seven years. Hence, there is need to central.ize the administration of incentives; and to im- -prove the system. This function would best be lodged in the above-suggested Regional.Tariff and Industrial Commissioh.f 9. Thus far, industry has been able to obtain adequate supplies of capital for the typically medium-and smaller-scale industries established, through profits or local capital, foreign private investment and credits, some direct official credits, and substantial official capital channeled through the Central American Integration Bank, four private financieras and the banking system. Some flow of capital takes place among countries, but the capital market is underdeveloped, and discussions at the private level are under way looking toward establishment of a Central American financiera., to a.ssist in mobiliza.tion of capital within and outside the region, to meet continuing industrial development needs. It is too soon to say whether such a financiera. should obtain support from official cap- ital. In any case, the need for external capital, public and private, while difficult to forecast, is likely to be considerable, including the possibility of some, but relatively few, large projects now being studied (e.g. pulp and paper industries). The application of such capital would be far more effective within the context of industrial policies assuring sound growth of the reg:ion. In this respect, the most urgent and concrete measure is to establish central administration of the Common Agreement on fiscal incentives. The revision of tariff-making machinery, while urgent, is likely to involve difficult negotiations, but a beginning should be made. External funds should give priority to industries likely to endure without high tariff protection, contributing large value added, and especially to those which now or in the visible future are capable of being export oriented. -v - Agriculture 10. In agriculture, a major need in Central America is to develop and expand new lines of agricultural and forest products production for export. These will be needed to replace and supplement coffee and cotton, whose exports are likely to be largely stagnant; production of bananas, the other maior export commodity, is being substantially expanded - mainly in Costa Rica and Honduras - but the possible extent of additional expansion is limited by world market conditions. While coffee exports have risen rapidly in the last few years, the outlook is that, with rising production, all the countries - particularly Guatemala, El Salvador and Nicaragua - will face surpluses above their probable quotas under the International Coffee Agreement from 1967 onward. Guatemala and Nicaragua are making plans to diversify out of coffee (and El Salvador is about to initiate studies of these possibilities), but it is far from clear what crops could be developed on a competitive basis as an alternative in view of the high returns to farmers under present price levels for coffee. While there appear to be real opportunities, mainly in fruits and vegetables, tobacco and livestock, it will take some time to develop these as well as assure markets, mainly abroad. Resources spent on diversification from coffee to other crops are likely to have minimal effect while coffee remains very profitable, partly as a result of the relatively low tax burden on coffee at prevailing prices. Even with scmewhat lower prices for Central American coffees, there would probably be incentive to expand output. Hence, the mission considers that, if expansion of coffee pro- duction is to be discouraged to prevent unmanageable surpluses and to stimulate diversification into other products, coffee production should be taxed more heavily. The alternative of carrying forward excess stocks is expensive and wasteful of resources; direct controls are difficult of enforcement, costly and arbitrary. Moreover, the fiscal revenues of Guatemala, El Salvador and Costa Rica are or will need important reinforce- ments in the next few years to enable them to maintain an effective investment program, including projects and programs of importance to the agricultural sector. The prospects for achieving increased taxation are admittedly uncertain, but a concerted action by the five Governments would doubtless dampen the strong opposition of the coffee growers. If measures to prevent the rise of stocks in excess of export quotas are not taken, the coffee growers face the prospect of being unable to dispose of these stocks even at lower prices and without the advantages of the International Coffee Agreement, including access to member countries. In such case, the export earnings of the countries over the next 10 years or so might well be less than the possible amounts projected by the mission, thereby weakening the economies. While studies looking toward diversifica- tion need to be pressed and efforts made to develop new lines in part with foreign credits for agricultural development, action to increase the burden of coffee taxation appears to be a requisite for an effective pro- gram of broadening the agricultural and export bases, as well as to prevent a possible disorganization in the coffee export price structure. - vi - 11. In view of the urgency of increasing the tax burden on the coffee sector, the simplest approach would be to increase export taxes now to levels which at least would provide a sufficient margin to cover the cost of financing the excess stockls while maintaining present coffee tax revenues and possibly increasing them. While surpluses in Costa Rica in the next few years are not likely to be as large as in the other countries, increases in taxation are needed to discourage further coffee planting and to avoid surpluses likely to arise toward the turn of the decade; the same would apply to Honduras. On the basis of present situation in Guatemala, El Salvador and Nicaragua (likely to have the largest absolute and relative surpluses in the next few years) the mission considers that a minimum export tax of 20 percent ad valorem (at projected prices) should be introduced in 1967 and become applicable to exports no later than those in 1968 to achieve the purpose of covering costs of financing excess stocks plus maintaining coffee tax revenues and acting as a disincentive to production. Such a tax should be applied by all five countries; preferably it should be applied uniformly to minimize possible inducements to avoidance of taxation by shipping through countries with the lowest export tax and to help provide a basis for a common quota in the future. Further improvements in the system of coffee taxation, including revision of income tau: structures or application of production taxes could come at a subsequent stage. 12. In the third major export crop, cotton, which has developed rapidly in recent years, prospects are that with production difficulties, rising costs and falling prices, export volume will remain largely stagnant. But it is likely that, in time, production difficulties and costs could be reduced by better techniques. Studies are being put to motion in El Salvador by the cotton growers association; and they need to be started also in Guatemala. While the private sector should be able to manage and finance these studies, Governments should initiate and support them if they lag. Even at lower world prices, with efficient production, returns from cotton are likely to be better than on food crops; and cotton could eventually make an increasing and substantial contribution to export earnings. 13. With these prospects in the major lines, the national and regional authorities should devote increasing effort to fostering the development of new lines. The greatest potentials lie in beef production and forest products. Meat production, for which foreign (particularly U.S.) markets are promising and for wlhich there are abundant suitable areas in most of Central America, will require a substantial effort. Over-killing, mainly to meet foreign demand, has diminished herds; substantial credits and technical assistance to prevent disease, improve metnods and the race and build up the livestock population, are required. While some of the countries have developed suitable programs of credit aimed at the larger and more efficient farms, others are lagging in the preparation of their programs, even though receiving technical assistance. High priority should - vii - be given to credit projects for livestock development and to technical assistance for such purposes, and to the completion of those road projects which are already started and which will assist in livestock development. External finance for such credit programs will be especially needed since the rate of credit expansion by the banking system in several of the countries is likely to be far more limited than in recent years owing to constraints imposed by balance-of-payment problems. 14. Resources are abundant for development of forest products, mainly lumber or wood products for export and internal consumption, and pulp and paper for which there is a large market in banana boxing. Projects for these products have importance for regional development in view of their contribution to regional trade and import substitution. Development of major pulp and paper projects, also yielding sawn wood, depends largely on completion of feasibility studies (mainly in Honduras) and development of financial plans. In view of increasing consumption, there may be room for two projects within the noxt decade. But once studies are completed and assessed, external agencies could play a large part in their financing as well as the financing of roads or port facilities which will be needed in some cases. The opening o1' lands toward the Atlantic for forest- products' development would also contribute to livestock and other agricul- tural development, including land settlement. 15 The region is largely self-sufficient in production of basic foods, though imports of wheat (not suitable for large production in Central America) have increased. as urbanization and higher incomes brought about consumer preference for wheat bread (instead of traditional corn products). It should be feasible to maintain food production abreast of rising populations, since there are suitable lands for exploitation and substantial margins for increases in yields and improvement of marketing arrangements. Access to new lands and improved access of present farm areas to markets is being provided by many of the principal roads being constructed or to be constructed, as well as feeder-road projects. High- way programs for the future, once the program over the next five years (which is largely determined by studies made and financing commitments completed or being arranged) is nearing completion, should give greater emphasis to the need for opening new regions and improving access of farmers to markets. 16. At present, trade amongst countries in agricultural commodities is relatively small; there are relatively few complementary situations in crude foodstuffs. A step aimed to assist in development of food production and in greater regional specialization has been taken recently by removal of trade barriers among the five countries in basic grains, under a regional treaty. Essenitially, this restricts imports from the outside world (usually made through State Grain Boards) so long as surpluses are available in any of the countries; and, even if supplies are imported, grain boards will need to pay duties which they did not - viii - formerly. A key question will be what levels of grain-support prices will be set for the region by the action of the national grain boards to be coordinated by a regional conmission having limited powers to enforce the agreement. While the price policy has not clearly emerged, evidently prices will have to be sufficiently high to induce increased output, although peasant farmers may find themselves competing with newer commercial farmers if the returns become more attractive. Returns to farmers would be improved by better storage facilities; a regionally coordinated program for such storage facilities has been developed which would be modest in cost, but so far only one country has arranged funds for construction. In financing agricultural programs, external agencies should place high priority on carrying forward these storage facilities; this would also require assurance of provision of adequate funds (probably by local govern- ments) for purchasing and holding stocks to smooth seasonal or annual supply variations. Some experience will be needed to determine whether it would be advisable to organize the administration of the main storage facilities and the trading operations under a single regional authority. Infrastructure 17. To establish an adequate infrastructure for the further growth of their economies, the several governments established investment plans for the period 1966-69. While these plans are primarily national in scope and focus, they reflect also considerations of a regional character to a considerable degree, primarily for highways. The plans, which are ambitious, are unlikely to be achieved within the time limits set. The mission's estimates of possible investment levels, taking account of a variety of obstacles that usually arise in the execution of such plans, suggest that a total direct investment of some CA Pesos 835 million could be reached for the region for the period 1967-'O. This would be about 75 percent above 1963-1966, equivalent to an annual average increase of some 15 percent. In some countries, such as El Salvador and Honduras, the rates of increase are likely to be even higher. For the area as a whole the public investment would be about 4.5 percent of probable GDP in 1970, as compared with about 3.5 percent in 1966, not an unduly high level. 18. The programs concentrate heavily on transportation facilities (mostly highways and to a lesser degree, ports); these together with electric power and telecommunications, would take up about 60 percent of the regional direct investment. Emphasis in the direct agricultural investment would be relatively Emall (less than 9 percent), but would be supplemented by public credit programs to the private sector. In addition to direct public investment, estimated public credit programs to the private sector for both industry and agriculture would amount to some CA Pesos 163 million, of which somewhat more than half would be for agriculture. The general balance of the program together with its composition within the various sectors appears reasonably well designed for the purposes of Central American development. The investment programs have a reasonably - ix - large project content, though especially for the latter years, studies of a number of projects have yet to be undertaken or completed. 19. The main sectors invo:Lving issues of regional investment policy are: transport (roads and highways), telecommunications, electric power, education and agriculture. Since 1963, the five Governments have been agreed on a program to construclt or improve certain "integration" roads; these consist mainly of the Inter-American Highway, important roads pro- viding more and better connections between the several countries, and roads intended to integrate into the Central American and national economies, productive areas (mainly towards the Atlantic), not now adequately connected with the rest of the country or region. Generally well conceived, a large portion of these roads have been built or improved, or are in the process of construction or improvement. Nevertheless, probably CA$90 million remain to be built over the next four years, representing about 35 percent (in Honduras, 70 percent) of the region's highway investment outlays in the period. 20. CABEI has begun to finance a substantial part of the integration roads; its loans, thus far, amount to CA$30 million. The other lending agencies are also participating in financing these and additional roads, of which probably 60 percent or more would come from external sources. Thus far, however, the countries themselves have decided which roads to construct and when to construct them (provided foreign financing was available), including the integration roads. Moreover, in some countries, the road programs are causing real strains on administrative capacity or financing ability or both, and, in others - notably Guatemala - the programs likely to be achieved fall far short of what is needed, in part because of the lack of adequate project studies. There appears to be a real need, therefore, in the highway sector, to develop a more systematic programming of road construction and its financing, which would appear to require as much as US$125 million in new road loans for the period 1967-70 (in addition to those recently contracted). Such systematic programming is important not only for the next few years, but also in the determination of the strategy of the road program in years thereafter. This strategy should give greater stress to the opening of the Atlantic regions and to access roads, and it should be anticipated by the systematic making of feasibility studies required by the several countries. Such coordination is also in the interests of the Common Market's objective of "balanced development" of the region, since some countries are less well endowed with highway transport facilities than others in relation to their developmental needs. 21. Closely linked to the highway investment policy is the policy in regard to charges collected i'rom inter-city highway users by the Governments. Rough estimates indicate that in Central America revenues collected by the several countries from such charges cover from about one-quarter to one-half of costs to the Governments for providing road services, With a view to assuring better allocation of resources over the - x - longer run, as well as contributing fiscal revenues needed by some of the countries, such charges should be increased. By how much would depend on more detailed studie-_ of costs cnd their apportionment among users, taking into account also tne effect of such charges on regional traffic patterns. 22. Issues of regional pol!icy also arise in the case of port expansion. The elimination of trade restrictions within the area, together with the adoption of a common tariff, should lead to the development of ports accord- ing to regional, rather than national, traffic-flow criteria. Even now, there are a few cases in which the development or expainsion of national ports raise questions as to the role which they should play in the region. Beyond doubt, Central America will need to draw up a regionwide program of port development in the next few years, if the best locations are to be chosen from the viewpoint of one Common Market economy; decisions by external financing agencies which have been active in port development in Central America on the financing of specific projects should take account of the regional implications of such projects. 23. An adequate regional telecommunications system has long been recognized as a priority need for economic integration of the region. Studies of national areas and a regional system were completed in 1964. However, the recommendation that an autonomous regional corporation be established to finance, construct and operate such a system (which would involve relatively modest sums, a total of about CA$10.0 million) has not gained the necessary acceptance among the countries. Instead, the countrie agreed in 1966 to go ahead with the regional system with each country constructing and financing its segment of the network, with bids and construction to be coordinated by a technical committee. Before the countries can proceed effectively with the project on a coordinated basis, they will need to ensure that the coordinating committee has sufficient powers to carry out construction smoothly; it would also have to plan for the next stages of expansion. 24. Electric power interconnections among the countries have not yet been developed. The most important project - between Honduras and El Salvador - has been under discussion for some time; but decisions to proceed with local projects which had to be made before agreement could be reached on the interconnection has deferred this interconnection project for some time. Power interconnections among the countries do not appear to be a pressing need for the next several years, since the possible benefits to be gained by interconnections of the present relatively small- sized systems would not be sufficient to justify the necessary investment in transmission lines. In the longer run, however, as power demand and power systems increase in size, mutual benefits could be achieved by interconnections. Experience in other countries shows that substantial problems are encountered in working out coordinated international power connections so that studies need to be made with long lead time. Hence, preliminary studies of possible interconnections in Central America - xi - should be made well in advance. Work on such studies has been started by existing regional committees, with the assistance of U.N. and ECLA, and this should be continued and reinforced to lay a foundation for future joint planning of integration of power systems. 25. Improvement and expansion of educational systems is a priority need in all the countries, although Costa Rica has made large advances in comparison wiith the others. Most countries are programming increased but relatively modest investment in educational facilities to meet deficiencies. However, the education programs emphasize expansion of physical plants and do not adequately provide for improvement of the performance of the educational system, particularly in the supply and quality of teachers. Secondary educational and vocational training are in particular need of expansion. While most of these problems can be dealt with at the national level, joint action in several fields would advance the common interest. Thus, greater support by the countries and external agencies should be given in sending students to selected centralized institutions for post- graduate training under a program developed by a regional council. Support is also needed to strengthen a central institution for educational research and improvement. Consideration should be given to establishment of a regional institute for training of secondary school teachers in fields of specialization which could nct economically be provided in one country, particularly science and vocaticnal or technical training. 26. In general, the public investment programs of the Central American countries are well adapted to new needs in the coming 10-15 years. In the main, the programs, while not uniform, are consistent with each other. The transportation, telecommunication and power programs, if carried out, would contribute importantly to the essential infrastructure of all the countries; moreover, they are in effect not inconsistent and are inter-related. There are no important examples of an investment or development program in one country being adversely affected by deficiencies in the structure of investment in others, although, as indicated above, there are various projects of regional significance which are being or will need to be tackled with regional considerations in mind. Aside from these, however, failure of any of the countries to substantially carry out their programs would eventually have an adverse effect upon the possibilities that others may achieve their potentials within the common goal of integration. Financing Investment 27. The major issue immediately facing the region generally is how to sustain a higher level of investment required for further growth of the economies and the integration of the region when, in the next few years, the rates of GDP growth will be declining and the balance-of-payments' positions of the countries deteriorating. The policies adopted in order to deal with it may be largely thie responsibility of individual countries, but their decisions will, in many aspects, affect the welfare or interests - xii - of the others, as well as the success of common programs or policies for in.tegration. 28. To sustain the levels of public investment needed for national progress and regional integration, as outlined above, the countries will need to obtain very large amounts of foreign financing for projects. For 1967-1970, drawings on external sources (including those from CABEI) by the five countries would need to run at about US$115 million annually for direct investment (plus some US$28 million annually for development credits for industry and agriculture); these would cover about 54 percent of the total investment outlays (varying somewhat among the countries). While such a proportion of gross external financing is somewhat higher than the 50 percent prevailing in 1962-15965, it is not unreasonable, given the effort to increase public investment for developient, at a time when GDP will be growing at a slower pace and balances of payments often will be in difficulty. 29, To secure such flows on external funds, the countries would need to obtain new loan commitments am.-ounting to about US$575 million during 1967-1970. Nore than half woulct be for transportation and electric power projects. On the average, such project loans, based on prevailing practices of lending institutions, would cover about 62 percent of the total costs of the projects financed (varying f'rom Eo percent in Nicaragua to 70 percent in Guatemala and Honduras). Even with this new borrowing, debt service zi relation to projected foreign-exchange earnings would rise to moderate peaks by 1975, ranging froni about 5.0 percent to about 7.5 percent among the five countries, though in the meantime Costa Rica's ratio would be higher (18 percent in 1966 and 9 percent in 1970). 30. To complement the external funds, all five countries will need to increase the level of public savings both absolutely and in relation to GDP. Restraints in nondevelopment current expenditures will be needed particularly to permit current dlevelopmental expenditures to increase as needed. Costa Rica, Guatemala, and El Salvador will need to increase their internal public savings effort by considerable margins - the first two countries urgently - by enacting new revenue measures. In Costa Rica, the need is particularly acute, since the past financing pattern of recourse to private banlk loans abroad and a failure to restrain current outlays arnd to provide more revenues has led to a financial and exchange crisis. The position of lionduras, with its present taxes and revenue projects, is likely to be close to balance. Nicaragua, which has sharply stepped up its tax effort, has increased its savings; on the basis of present expenditure patterns, it would generate some surpluses; but these ought to be used to augment the lagging investment effort in certain sectors, particularly education and public health, which may occasion some increase in current outlays. 31. W-1hile there are possibilities for increasing public savings by higher charges for public services or, in some cases, by reductions in Central Governmnent transfers to independent agencies, the major effort in Costa Rica, Guatemala, and El Salvador will have to come from a greater tax effort; by 1970 this would need to produce somie 10-25 percent more than presently forecasted revenues in those countries. While the objective - xiii - is revenues, it would be important, from an economic viewpoint, to: (a) increase the burden of taxes on the coffee sector throughout the area. (whether by export or other taxes) to stimulate diversification out of coffee; (b) increase consumption or sales taxes to discourage demand for imports, preferably on nonessential items; (c) increase property taxes since these are now very low and moderate increases, even on present valuations, would close a. large part of the gap in the three deficit countries. Aside from these measures, others set forth in a.recent detailed study prepared under the joint auspices of the OAS and IDB could be under- taken. Losses from fiscal exermptions granted for industrial development could be reduced and the compet;itive role in granting them abated if these were replaced by uniform provisions for a.ccelerated depreciation and if income taxes on companies were levied on a proportional basis rather than on the basis of the progressive personal income tax now applied to them by four of the countries. In addition, there is a. case in all countries for increasing road users' charges:, bearing in mind, however, their implications for regional aspects of transportation. 32. Tax reforms are needed not only to solve the short-run fiscal problems in three countries but also, throughout the area, to lift the levels of government revenues which are low. Revenues are now 9-12 percent of GDP in the five countries; these percentages are no higher than they were before the boom got under way five years ago, in part because of substitution of duty-free imports from the Common Market for dutiable imports from abroad and libera:L granting of fiscal exemptions as industrial incentives. Levels of fiscal :revenues and public savings throughout the region need to be raised to enable the countries to contribute beyond 1970 a higher proportion from domestic resources to the higher investment levels they will be trying to attain. 33. Recourse to the banking system cannot substitute for increased fiscal effort to finance the investment programs, given the need to reserve any increase in bank credit facilities to permit private-sector growth in the next few years. As noted below, the prudent margin for internal credit expansion in the next few years is very slim indeed. 34. If the necessary internal savings are not created to fill the financing gaps, particularly i:n Costa. Rica., El Salvador, and Guatemala, their investment programs would inevitably be reduced. Since it would probably be necessary to reduce or postpone some projects financed in part abroad, the amount of the reduction in investment would probably have to be considerably greater than the shortfall in local currency requirements. Heavy reductions in public investment would adversely affect the prospects for longer-term economic growth, and the mission did not try to postulate alternative reduced investment programs since it considered that it would be feasible, with tax measures such as those suggested above, to close the gaps and avoid the heavy sa.crifice in investment program. Growth Prospects and External Finances 35. At best, over the period to 1970, the growth rate in all the countries will slow down because of less favorable prospects for the major - xiv - exports to world markets. Expansion in the Common Market will be affected by this weakening in export earnings, and trade within is likely to grow much less rapidly than in recent years. Annual GDP growth rates in 1967-70 are likely to range between one percent in El Salvador and Costa Rica to 2 percent in Guatemala., and 4 and 5 percent in Honduras and Nicaragua. With continuing rapid growth of population, per capita GDP is likely to fall, except in Honduras and Nicaragua where it may rise slightly. 36. Implicit in these growth rates is a slower rate of import growth, particularly in El Salvador, Costa-Rica, and Guatemala.; import growth rates in Hondura.s and Nicaragua, while less than in recent years could still be substantial. There seems little room for relieving this import restraint by drawing down reserves. In these circumstances, excessive internal credit expansion would immediately add to balance-of-paymentst pressures, given the high tendency to import. Thus, net internal credit growth, which doubtless will be affected in any case by a falling off of deposits as export receipts weaken, could probably not exceed some two percent annually in Guatemala, about one percent in El Salvador, and two percent in Costa. Rica; in Honduras and Nicaragua, it could probably run at some 5-6 percent. 37. Imports of capital goods, which accounted for a major share of the rise in imports from abroad in recent years, will doubtless be affected by the slower rate of internal expansion. However, the advance of indus- trialization, bringing with it needs to continue imports of replacement parts, raw materials, or semi-finished inputs has created an element of rigidity in the import structure. The authorities may well need to take measures to restrain internal demand and consequently, demand for imports for industry for the less essential types of consumer goods (e.g. by restraints on consumer credit, selected sa.les taxes). These difficulties of adjusting to lower growth of import capacity serve to underline the need for re-examination of the policy of granting industrial incentives for industries relying heavily on imported inputs and adding relatively little in value in the process of production. 38. While cost increases internally have affected the profitability and hence export possibilities of some commodities (particularly cotton, due to cost of combatting plagues and trying to increase output by apply- ing more fertilizer), and avreakening of export prices may well affect the major commodities in varying degree, there seems to be no general case at present for promoting exports by devaluation of the exchange rate. Such a move on the import side would doubtless discourage imports, but with restraints on credit and appropriate tax measures, imports could be kept under control. As for indivi-dual countries in the region, membership in the Common Market implies sevrere restraints in correcting balance-of- payments' pressures by alteriLng their exchange rate. W4hen one of the countries makes a change in its exchange rate, the others are immedia.tely affected, a.s has been shown recently when Costa.Rica.instituted a. dual- rate system, part of which was a. free rate applying to certain commodities, whatever their origin. While the Costa Rican system was soon changed so a.s to leave imports from the Common Market at the earlier rate, the coun- tries now fa.ce the complex q-aestion of whether a. member of the Common Market may maintain certain :rates for transactions within the Common Market - xv - and others for transactions with the outside world. The Costa Rican experience may yet demonstrate that imports from outside through other Common Market countries cannot be prevented indefinitely and that its multiple rate system is therefc,re not a solution to its problems. Such a development would precipitate for the first time critical and difficult issues as to which balance-of-payments' policies are consistent with the Common Market relationships ancd which are not. The other countries could, of course, provide credit to the country in difficulty, based on under- standings as to corrective policies, and thereby avoid the difficult issue of exchange-rate adjustment in the Common Market. However, the possibilities of such intra-regional transfers now are limited by the relative shortage of resources of all the countries. 39. The unfavorable outlook for growth of exports and domestic output in the next few years reinforcEs the need for public authorities, national and regional, to promote possibilities of increasing exports, including new lines (as suggested in Chapters II and III). It also reinforces the need to give priority to the use of available local and foreign funds in special credit programs giving early results in output and exports. The mission's estimates of public investment include provision for such special credit programs. These are estimated at about CA$40 million average annually during 1967-1970 for the region (including the use of some US$28 million of foreign funds annually) to levels rising somewhat through the period. External loans for these purposes could be disbursed fairly quickly if administrative organization is adequate and would have an early impact on production. The public authorities, both national and regional, should therefore push forward with the preparation and execution of projects for channeling foreign funds in development credits to the private sector to achieve at least the levels projected by the mission and if possible to surpass them. These programs for utilization of foreign funds warrant high priority also because prospects are that internal credit expansion over the next few years will need to be kept within much narrower limits than in the past in order to restrain import growth; particularly in Costa Rica, Guatemala and El Salvador. To the extent that such programs can be increased efficiently, they would both help to relieve balance of payments restraints on domestic credit in the next few years and also benefit the longer-range growth potential of the countries. While an increase in foreign lending for such programs above the lerels assumed by the mission would raise the debt service burden above the ratios mentioned earlier (paragraph 28), there is still room for moderate additional debt service provided the countries keep on growing. 10. To sum up, it appears feasible for the countries of Central America to sustain a rise in public investment in the face of lower rates of growth of exports in the next few years, provided foreign financial assistance for project loans is forthcoming and is matched by additional internal fiscal measures in at least three of the countries. The measures adopted by any one of them - to control credit, remedy their fiscal or balance-of-payments' imbalances, promote industrial growth - will affect the prospects of the other countries. Hence, harmonization - that is, mutual adjustment of policies to achieve consistent common objectives - - xvi - will be increasingly important in a variety of fields, mainly taxation, fiscal policy, tariffs and industrial incentives, educational programs, coordinated programs in infrastructure (particularly transport, power, teleconmunications, grain storage, and education) and monetary policies. Such harmonization would be advanced if the countries strenghtened their capacity to make decisions on vital matters of common interest much more rapidly and effectively than in. the past. It was suggested above that a tariff and industrial commissicn be established. The Governments should also strengthen the central body of the integration organization - the Economic Council - by taking the necessary internal measures to enable its mermbers to speak for their governments on all issues which should come before it rather than solely on. those which fall within the jurisdictior of the economic ministries. 41. Similarly, the external agencies will need to look at their lending operations increasingly in the context of regional considerations and emerging issues of regional policy. By and large, external lending agencies have, in the past, regarded the countries of Central America as individual unrelated economic entities, though support has been given to the regional bank and some investment programs of regional significance. Future assessments of the economic situation and projects of individual countries will need to take account of what is happening in the rest of the region, particularly to assure that their projects and policies do not run at cross purposes with those of other countries and the development of the region as a whole. in several sectors, external lenders will need to consider projects in terms of their part in a regional program (e.g. highways, grain storage) or in terms of the fact that they cannot be carried out suitably except on a regional basis (e.g. telecommunications, education) or because their role transcenc national boundaries (e.g. ports) or because they constitute the best solution to supplying emerging needs (e.g. potentially electric power interconnections) or a combination of these several factors. External lenders will also need to be concerned with the improvement of industrial and tariff policies in the Common Market, particularly to centraLize the granting of industrial incentive orivileges, to improve tariff making and revision of processes so as to secure an efficient and economical industrial establishment and to develop export-oriented industries. Too, they will need to concern themselves with the agricultural policies to be followed to diversify out of coffee (including concerted adoption of heavier taxation on that sector) and to provide financing and technicaL assistance for development of new production and export possibilities - sucia as, livestock and forest products. 42. The bold action of the Central American countries to create a Common Market undoubtedly has broadened the basis for economic growth of all of them. The rapid growth of regional trade should not, however, obscure the fact that the Common Mlarket cannot be an end in itself. But with support from abroad, within the framework of effective national and regional policies, it could become not onlyr a basis for more rapid internal growth but also a more effective means of developing the new exports needed for longer-term growth. PREFACE This report was prepared by a Bank mission which visited Central America in April-June 1966 to evaluate the development programs and the economic prospects of the Cenbral American countries within the context of the economic integration of that area which has been taking place since the early 1960's. The framework of that movement is commonly known as the Central American Common Market. The countries included in the Common Market, and covered by this study, are Guatemala, El Salvador, Honduras, Nicaragua and Costa Rica. Panama, which is linked to these countries geo- graphically and tied to them culturally, has long been considering partici- pation in the Common Market but thus far remains in the role of interested observer. As a result of the efforts of planning authorities of the five countries, winch received important assistance from the Central American Joint Planning Mission, each of the countries in the region has a national investment plan. There are aLso a numiber of regional arrangements and agreements, as well as institutions, whiclh reflect regional development policies and bear upon the implementation of the3e pclicies and national plans. The Bank mission discussed these investment programs, agreements and policies with officials at the national level, in Government ministries and agencies, financial institutions and in the private sector, and also with officials of several regional agencies and of the Economic Commission for Latin America which continues to be active in this field. This report presents the results of the m:Lssion's work. It attempts to identify the economic prospects and the principal economic problems in the region and, in this context, to appraise the development and investment programs and policies of the several countr'ies and their plans for financing them. Part I of the Main Report deaLs with the region as a whole while Part II deals in summary form with problems of the individual countries. PART ONE I. RECENT GROWTH EXPERIENCE IN CENTRAL AMERICA A. The Region 1. Stretching for almost 1200 miles overland from the Mexican border in the northwest to the Panamanaian border in the southeast, the five Central American countries have until recently developed in their ol'm separate ways. Spanish rule, which had provided a unified administration until 1821, was succeeded by a federation which functioned sporadically until 1838. While efforts over the following century to achieve some political or economic integration were unsuccessful, historical connections and the community of language and culture supported attempts to revive regional unity. Particularly since 1950 efforts were increased, and beginning in the latter part of the decade a rapid succession of measures for economic cooperation were taken. Beginning in 1961, a Central American Common Market made great strides toward a uniform external tariff and the elimination of internal tariffs and trade restrictions; important agreements for govern- ment action or policy were established in related fields, particularly industry, transportation, agriculture, education and regional payments. Henceforth, development prospects in the Central American states will need to be considered not only in terms of their national economies but also in terms of Central America as an economic region. The analysis of development plans in Central America in this report is based upon this premise. 2. The common characteristics of the five countries are more striking than their many differences. With some variations and with the notable exception of Costa Rica, public affairs have been characterized by political instability, dictatorships anc. the preponderance of the military in the conduct of political life in the several countries. In some cases, political uncertainty has not only interfered in the planning and execution of develop- ment programs but also affected the expectations of private enterprise and the growth of this sector of the economies. Other important common charac- teristics are the importance cof exports of two or three main commodities in the movement of the economies and the general similarity of their production activities. The Gcvernments of Central America, with some exceptions such as Costa Rica, have played a relatively limited role in orienting the direction of their economic development. With the coming of the Common Market and facecl by the rapid growth of population together with the desire to raise per capita incomes, the Governments have in recent years become more active in planning development. 3. The area as a whole covers about 170,000 square miles (or 4h2,000 square kilometers); with a population of 13 million people, the density of population is low, averaging 29 inhabitants per square Im. over the region. El Salvador, the smallest of tihe countries, accommodates an average of 148 persons per square kilometers. Generally about a third of the population lives in urban centers, these are widely distributed, and relatively small; - 2 - the seven largest cities in the region range from 75,000 to 575,000 in- habitants. Most of the population is still concentrated in the central highlands and mountainous regions which enjoy temperate climates and generally have rich volcanic soils; more recently the population has increased along the Pacific coastal slopes. Mountainous and upland areas dominate the region contributing to difficulties of transport. The coastal plain along the Pacific, with alternate wet and dry seasons is generally very productive but averages only about 50 kilcmeters in width; extensive plains with abundant rain fall are found in. eastern Guatemala, down along the Atlantic coast in Honduras, narrowing in Costa Rica, althougl inland in Costa Rica (San Carlos), near the Nicaraguan border there are abundant good soils. 4. There are still available substantial areas of land for development, especially toward the eastern portions, although information on the types and locations of their soils arLd their adaptability to different crops is far from complete. Large foreEt areas including extensive stretches of pine in Guatemala, Honduras and Nicaragua, offering possibilities of develop- ment of forest products, inclucling wood pulp, are still available for exploitation. There are few rnineral deposits, particularly of nickel and bauxite, which may lead to the establishment of moderately large modern operations in the next decade. Iron ore and ferrous sands exist in some quantity in Honduras and Costa Rica and studies are being made as to the possible exploitation of these, There are no important supplies of fuels (coal or petroleum) but the abundant water supplies of the region have provided the basis for recent lhydroelectric power development which is far from completely exploited. Central America also has an advantage in its relative geographical nearness to the large U. S. market. 5. Growth of population :ln all five countries has been very rapid. Even a decade ago it increased 3 percent annually in the region, and in the last four years, the increase lhas averaged about 3.5 percent annually, ranging from about 3.0 percent in Nicaragua to about 4.1 percent in Costa Rica. This rapid population growth has increased the pressure for economic expansion. In view of the limitations imposed by the smallness of national markets, which even in 1965 ranged from 4.3 million persons in Guatemala to about 1.5 million in Costa Rlica and with GDP's per capita ranging from about $215 in Honduras to about $420 in Costa Rica, averaging about $300 for the region, efforts were made to break down the trade barriers between the countries in order to widen the markets, mainly to provide a basis for further industrial expansion in the region. B. rrends in Growth 6. Thus far these efforts have taken place during a period of substatt-.a economic growth in the region. While the economic progress of the five Central Akrerican countries in the last ten or fifteen years has not been continuous, the overall results have been encouraging, particularly if com-pared with most other less developed countries. GDP in the region as a Tshole grew at an annual rate of 5-6 percent in the last decade. At the same time, population growth averaged 3.3 percent annually in the region, so that per capita income rose in real terms from about US$240 equivalent i1 1955 to about US$300 in 1965, or at an average annual rate of 2.3 percent. - 3 - Between 1960 and 1965, however, regional GDP grew at an even higher rate, averaging 8.1 percent annuall;y, while per capita GDP rose 4.4 percent annually. This rapid growth of income was achieved with low levels of gross domestic investment in relation to GDP, at a regional level of 12-13 percent of GDP during most of the decade, though reaching 15 percent in the mid-fifties and the boom years of 1964 and 1965. Most of the investment was in the private sector; direct public investment varied from 20 to 30 percent of total gross domestic investment over the decade. While the private sector was the most dynamic element in this economic expansion, public sector investment provided essential infrastructure - mainly roads and electric power. In addition, public agencies channeled foreign funds in development credit to private industry and agriculture; these were an important factor in the development of some countries, notably Costa Rica. 7. The Central American countries are open economies: the single most important influence upon movements in investment, imports and output have been the variations and prospects for the major agricultural exports. Export earnings for the aggregate of the five countries have typically accounted for 18-22 percent of GDP in the last decade, although this average conceals fairly wide variations between the countries, from 33 percent of GDP in Nicaragua to 15 percent in Guatemala in 1964. With the stagnation and decline of export earnings in 1958-61, per capita income fell or stagnated in all countries. More recently, in the last five years, the Central American boom was fed by a sharp growth in total merchandise export earnings; for the five countries, these rose from US$433 million in 1960 (at the trough of recession) to US$770 million in 1965 (or from US$4OO million to US$634 million after excluding intraregional trade among the countries). Thus the combined merchandise exports of the five countries grew at a rate of 12.2 percent annually from 1960 to 1965 and even for the decade 1955-65 as a whole, the average annual rate of growth was a substantial 6.1 percent. 8. While the variation of export prices was a major factor in the stagnation and decline of exports in 1958-ol, the recovery of export earnings since then has resulted only partially from increases in export prices, the most important of which was in coffee. Previously the average price of coffee fell from 65 Us cents per pound in 1956 I/ to about 35 Us cents in 1962 and 1963. From the end of 1963, prices rose to 44 US cents in 1965; this recovery contributed 30 percent of $170 million expansion of exports in 1964 and 1965. Yet., by 1943, when coffee prices had reached their lowest point, the majority of the Central American countries were already well launched on an export boom. One main new element in the boom was the spectacular increase in cotton production after 1961. This was not the result of changes in cotton price, which stayed constant from 1960-65. Rather it reflected the reaction of the private sector to the preceding fall in coffee earnings and to the increased opportunities for cotton growing offered by the opening up of the rich Pacific coastal lands through road construction. The other main new source of export growth was 2 This is the average for the coffee earnings of the five Central American countries. the rapid expansion of manufactures, one-fifth of which went into the acce- lerated increase in trade among the five countries as tariff barriers were removed under the Common Market arrangements. These intraregional exports of manufactures constituted the major portion of the rise in intraregional trade, from $37 million in 1961 to $136 million in 1965. This groawth accounted for almost 44 percent of the total increment in exports of the five countries from 1961 to 1565. 9. Against this background of overall growth, the general prospects are that recent growth rates are unlikely to be maintained in the next few years or so. As will be indicated in detail later in the report, prospects for growth of major export crops are far less favorable than in the past: in cotton, prices will be less favorable and difficult production problems have to be mastered; in coffee, probable exports within the inter- national quotas designed to prevent a complete breakdown of the price structure in the face of increasing world supplies writh slow growth of consumption, will require checking the fast rate of coffee production in Central America; and the prospect of growth in bananas while fairly favorable, will not impell overall growth to past rates. The merchandise exports of the region as a whole to the outside world are likely to increase about 2.5 percent annually through 1970. In the succeeding five years as a result of rising world consumption and to some extend development of new lines, export prospects would improve so that possibly exports might rise at a rate closer to five percent annually. While these estimates are subject to a wide margin of error, they imply that regional GDP will rise at about 2.5 percent annually from 1965 to 1970 (with variations above or below this rate among the countries). This slackening of growth in the next few years, together with the repercussions in a variety of fields, sharpens the issues for development in each of the countries and for the integration movement as a whoLe. C. The Common Market 10. In the early 1950's several of the countries began to arrange bi-lateral agreements freeing trade between them so as to widen the basis of economic growth. Since then continuous studies and negotiations took place which by a series of steps led to the General Treaty of Central American Economic Integration of December 13, 1960, now in effect between all the five countries. l/ This came into force for Guatemala, El Salvador and Nicaragua in 1961, for Honduras in 1962 and Costa Rica in 1963. While the Treaty aims at the creation of a common market, its provisions are directed mainly at the establishment of free trade within the area and a common external tariff but not to the free movement of capital and persons. The structure of integration includes a Uniform Code for Customs Procedures adopted in 1963, an agreement to regulate trade in basic grains (1965), and a convention for common rules on fiscal incentives for industrial development (negotiated in 1962 but not yet in force). The main administrative structure includes the Central American Economic Council, consisting of the Ministries of Economy of the several countries, a superior body to direct the integration of the Central American economies and to coordinate their economic policy. For a more detailed description of the instruments of the Common Market and related developments, see Appendix A. The Permanent Secretariat of the Integration Treaty (SIECA) serves as a technical body for the Economic Council and carries on studies and preparatory work for negotiations concerning the common market. It is closely assisted by the M4exico Office of the Ecoriomic Commission for Latin America. Recently it incorporated the personnel of the Central American Joint Planning Mission w-hich has been assisting the coumtries in their planning work and which helped formulate the national development plans for 1965-1969. 11. Progress thus far in trade matters has been striking. A common tariff on imports from outside the area has come into effect and tariffs on trade within the region have been eliminated on all but 32 tariff sub- items. In 1964, trade on these latter items represented about 18 percent of the region's total imports and 6.5 percent of intra-regional imports. Wheat and wheat flour and oil products accounted for approximately half of the total still pending agreement and assembly goods (such as radios, automobiles, refrigerators) for the other half. Most of the countries engage in processing wheat flour and refining petroleum and some have assembly industries. Discussions for further liberalization on these items are still in progress. 12. Generally the common tariff represents a shift toward distinctly higher rates on imports from outside the area; these shifts are discussed more fully in Appendix A and Chapter III on Industry. The common tariff particularly increased the duties on consumer goods, which are now very substantial and often high by any criteria of evaluation. The common duties on raw materials, machinery and equipment are relatively low; even these are often waived administrative'Ly under the industrial incentive laws. Nevertheless, in each of the economic categories, the common tariff is higher than the average of the five previous national tariffs in such categories. Provected by higher tariffs and stimulated by the general rise of purchasing power generated by exports to the outside area while taking advantage of unused industrial capacity, intraregional trade grew rapidly. Exports among the Central American countries rose from CA$37 million in 1961 to CA$136 million in 1965. In 1965 this intraregional trade constituted 15 percent of total imports of the countries compared to some 7.5 percent in 1961. The greatest rise was in manufactured goods which now account for some 60 pearcent of all the regional trade; trade in crude materials and foodstuffs increased at a slower rate. Evidently there has been substitution of regional production for imports from abroad in many categories of goods but because of sharp increases in imports of raw or semi-finished materials from outside required by regional industries, there was no overall net substitution (as indicated in Chapter V). 13. W"khile intra-regional trade is still heavily concentrated in the northern three countries (Guatemala, El Salvador and Honduras) the common market is providing a stimulus for Costa Rica's exports to neighboring Nicaragua as well as the other countries. The common market thus is becoming important for each of the countries as an outlet of exports or a sourc- of imports or both. Trade balances of each country with the rest have not developed marked surpluses or deficits except for Nicaragua which has had a persistent and increasing deficit. While the Nicaraguan authorities have expressed concern at this development, it is the overall trade and balance - 6 - of payments position of each country which is of primary importance and its balance or imbalance regionally should be viewed in that context. Moreover, Nicaragua has several important, industrial projects underway which, when they come into production, should increase Nicaragua's regional exports. The increasing trade inter-dependence of these five countries is already creating pressures for harmonization of policies affecting their mutual trade positions, including exchange policies. 14. While it is too early to judge wihether the slackening in the growth of intraregional trade in 1965 signifies the passing of the initial stage of import substitution, the general outlook is that increases will not continue at the same high rates over the coming years. Part of this will be due to general limitations of the market, which is still relatively small, and the slackening of growth of incomes in all the countries due to the levelling off in the rate of growth of major exports to the outside world which appears likely in the next five years, as elaborated in subsequent portions of this report. 15. The rapid economic growth of recent years in the region has not been taking place at equal rates among the countries. Growth of income in Honduras, at present the poorest of the five countries, has in fact, been somewhat slower than in the othler four economies. This is generally recognized by the Common Marke-t policy malcers. While their general aim is to raise incomes as much as possible nationally, since all five countries are still low income countries, various preferences have been accorded to Honduras (in fiscal incentives, allocation of regional resources and technical assistance) with a view to speeding its economic growth. As yet, however, differences in income and employment opportunities among the countries have not been sufficient to lead to pressures for permanent migration from one country to another. Although some temporary migration across borders takes place because of seasonality of harvests, at present there exist no pro- visions permitting large scale employment of labor outside their native country in the other Central American countries, nor is there vocal pressure for such a liberty of movement or employment. Development of Central American Financial Institutions 16. In 1961, the Central American Bank for Economic Integration (CABEI) began operations; its general objective is to promote the economic integration of the region and the balanced growth of the member countries. Total lending resources to the end of mid-1966 were approximately $102.7 million, of which $17 million constituted capital paid in by the five countries. Major sources of CABEI's external funds have been the U.S. AID ($62.5 million), the Inter-American DLevelopment Bank ($14 million) and Mexico ($o million). I/ 2/ Early in 1967, the Inter-American Development Bank approved two loans equivalent to US$15 million to CABEI to be used for financing of infrastructure projects of regional scope. - .7 - 17. To mid-1966, CABEI had committed loans of almost $77 million. A little over 40 percent ($33 million) of these commitments were for industry (including technical studies). Another $33 million was committed for infra- structure projects, the great bulk of this recently and almost exclusively for highways; the major portion of the remaining loans (some $10 million) were for housing. 18. CABEI's loan disbursements to mid-1966 totalled almost $26 million, about four-fifths for industry. Total disbursements on loans from all external sources to the public sector of the five countries (including development credits for industry or agriculture) were approximately $316 million for 1962 through 1965. Of this amount, CABEI disbursed about $22 million. However, CABEI's rate of disbursements will probably rise in the near future as the new series of road loans are drawn upon. CABEI's loans by country range between $13 to almost $19 million, the largest amounts being for Honduras and Nicaragua with El Salvador following closely, owing to substantial earlier industrial loans in that country. 19. Loans by CABEI for roads recently have been covering 100 percent of project costs at an interest rate of 3.5 percent with a term of 25 years including 7 years grace; these roads are the "integration" roads, selected because of their importance to the development of a regional road infrastructure. Industrial loans are substantially less liberal, covering up to about 60 percent of project cost with interest rates currently at 7 or 8 percent, (somewhat higher than before mid-1965). CABEI's available funds have been quicklycommitted; as of mid-1966, CABEI's available loan funds were about $25 million of which $13 million were reserved for industry under terms of the loans received by CABEI. Hence CABEI's future activities depend in large part on its ability to arrange for new external funds. j Further increases in local government subscriptions would at best be relatively small. 20. In addition to its loans for direct investment, CABEI has financed a series of studies, including the large study of future requirements in Central American transport and some new studies of export opportunities abroad, which should contribute to the development of exports. Regional Clearing House 21. The framework of the Common Market also includes a Regional Clearing House under which over 80 percent of intraregional trade was compensated in 1965. These compensations took place with very limited credit since each Central Bank is obliged to grant a maximum of CA$500,000 in regular credits to the other four, with settlement in cash every six months; however, some obligations might be carried forward without cash I/ Early in 1967, the Inter-American Bank announced approval of two new loans to CABEI totalling the equivalent of US$15 million to be used for financing of infrastructure projects of regional scope. - 8 - settlement by voluntary bi-lateral credit arrangements. A stated objective of integration set forth in the General Treaty is a monetary union among the countries. The achievement of this objective is under study by a Central American Monetary Council consisting of the presidents of the five Central Banks. The Council provides for closer and continous consultation and is guiding the studies of problems of the monetary union. The goal of monetary union will require considerable progress in several fields of policy which will take quite some time, but in any event the common market has a machinery for consultation on monetary matters wjhich should assist in progress toward that eventual goal. D. Conclusions 22. Each of the five Central American countries has emerged from the rapid growth of recent years with a more diversified and stronger economic structure than a decade ago. Exports came to depend principally upon three major products instead of two and minor imports have been increasing in importance. Infrastructure necessary for growth has been expanded. Advances have been made toward a modern transport system between the main economic centers. Large new power capacity has been installed and the institutions responsible for power development have been strengthened and new ones created and put into operation; these are capable of proiding for the substantial further expansion of power faciliti" wjhich will be nrcessary. Institutions designed to provide medium and longer term credit for the dev.3loprnt of private agriculture and industry are being developed. The capacity of the public sector to plan and execute new investment programs has increased markedly. In the private sector, a new entrepreneurial and managerial group is emerging and showing considerable vigor and industrial development has made great strides. Nevertheless progress in some areas has been slow; thus, while public expenditures on education have increased substantially, the abilities of the educational systems of most of the countries to produce the skills and manpower needed for future growth are still severely limited. In agriculture, the low income peasants, wjho comprise over half the population and are responsible for the production of food staples, remain with poor skills and low incornesscarcely better than a decade ago. While peasants have demonstrated that they can respond to price and market incentives and food output has managed to keep up with population, their income appears to have grown at a much slower rate than the rest of the economy. The uncertain outlook for the improvement of their lot remains a most pressing and difficult problem. 23. The strengthening of the Central American economies and of the export sector and the progress of the integration movement has provided a stronger basis from which they can attack their basic development problems. The means for largely overcoming these problems - discussed in the following chapters - wiill be contingent largely upon the success of the efforts of the Central American Governments, independently and jointly, in maintaining momentum in economic growth during the next few years when prospects are that some of the main factors of strength, primarily export performance, appear unlikely to be maintained. Within the common market there remain urgent questions bearing upon the more effective use of regional instruments in effecting the allocation of resources which will provide the basis for - 9 - economic growth, including that, of the export sector. In the past the Governments of Central America, with the exception of Costa Rica, have played a fairly limited role in orienting the direction of economic development. For the future, with aims to provide more adequate incomes to their ever increasing populations and with the increasing complexity of economic arrangements, the several governments will have to be more active in promoting development, projects and pursuing more clear cut development policies to realize the potentialities of their resources. Increasingly, they will need tc do so in consultation with each other, since, within the Common Market. the impact of one country's actions is often likely to react and have effect upon plans or developments in other countries and, in addition, common action in promoting development of material and human resources is likely to be more effective and pro- ductive than unconcerted single actions. 14hile an encouraging beginning has been made in this direction. in recent years, there is a wide variety of serious problems that have yet to be overcome. - 10 - II. AGRICULTURE A. GenerEL Characteristics 24. Agriculture provides the major share of income, employment and foreign exchange earnings of the five countries. However, in the last decade the agricultural sector did not grow as fast as the overall econo- mies. Its share of GDP in the region fell from about 40 percent in 1955 to 33 percent in 1965, varying in the latter year from 44 percent of GDP in Honduras to 30 percent in El Salvador. Even so, agricultural exports still account for about 95 percent of merchandise exports of the region to the outside world and agriculture absorbs about 60 percent of total identifiable employment. Expansion of agricultural exports in the last several years has been the main absorber of wage labor. 25. Agricultural structure and performance are broadly similar among the five countries. Widespread and backward peasant agriculture, producing m.ostly food for domest;ic consumption, co-exists with a well- organized and efficient export sector. The commercial farmers producing for export have expanded their operations, while achieving some of the highest yields in the world in coffee and cotton production. They have been the main beneficiaries fron the opening of new and fertile lands on the Pacific coast of Guatema:la, El Salvador and Nicaragua, following the control of malaria in the early fifties and the construction of the Pacific highway and the improverment of several ports. With the lower proifitability of coffee production resulting from the drop in prices starting in 1957, farmers turned increasingly to the exploitation of these lands, principally in prodluction of cotton. This expansion was aided by substantial internal and external credit. Cattle and sugar production as well as some othe-^ minor products also increased. These developments stimulated the growth of export earnings while reducing the dependence on coffee and banana exports. Whereas, in 1955 coffee and bananas accounted for 79 percent of the $413 millions of exports to the outside world, in 1965 they represented 59 percent of exports of $634 million. However, the prospects for further development of the principal export crops is not as favorable in coming years as in the past; these prospects are discussed in following sections of this chapter. 26. No such major changes have occurred in agriculture producing for the domestic market. Agricultural production for the domestic market, largely foodstuffs, such as corn, beans, rice, sorghum, fruits, and meat and dairy products, is carried almost entirely in small farms; about 80 percent of all farms in Central America in the mid-fifties were "minifundia", or very small farms. Of approximately 12 million hectares reportedly under cultivation in Central America (out of a total land area of 42 million hectares) about 2 million are in grains, mostly in farms under 5 hectares. Except in Costa Rica, the peasant far-mers operate with little credit and assistance for improving pro- duction practices or in marketing their crops. Credit for basic grains is very small in nroportion of total agricultural credit and this has not risen in recent years. Aside from the economic weakness of the small farms, the widespread uncertainty as to title to land has inhibited the extension of credit to small farmers. While the number of farmers lacking clear title appears to be increasing, as in El Salvador and Honduras, in the latter country this reflects in part the spontaneous settlement of unoccupied lands toward the Central and Eastern part of the country. 27. Despite the absence of technical improvements in production for the domestic market, food procduction has kept pace with the rapid growth of population. Imports of food in relation to GDP have remained prac-- tically the same despite risirng incomes from 1961 to 1965 with no evidence of rising prices. Increases in domestic output of food - mainly corn, rice and beans, and also to some extent, fruits, vegetables and dairy products - have resulted mairJy from expanding acreage. There are indi- cations, as in the case of rapid expansion of corn exports from Honduras to El Salvador in some years, that existing peasant agriculture is res- ponsive to market opportunities. 28. There is still much agricultural land in Central America avail- able for development. Sizeab]e investments in transport, would be neces- sary to open up new areas. Thlere are also some signs of increasing population pressure in certairn areas, particularly in El Salvador and also in the long-settled areas in the Central Plateau of Costa Rica, Western Honduras and some parts of the Guatemalan highlands. Thus, while there is scope for improvements of production and income of peasant farmers through introduction of better technology, more adequate credit and marketing, there will be a rising need to bring new areas into pro- duction, particularly toward the Atlantic seaboard. While climate and soils of the Atlantic regions are less favorable generally than on the highlands and pacific slopes, these areas could develop production for export of beef, bananas, and 3'orest products and could relieve the rising population pressures in congested areas. But to accomplish this dual objective will require inputs and build up of institutions and personnel for agricultural development, as well as careful orientation of future infrastructure projects. 29. In addition there is need to improve transport and communication in existing rural areas; their inadequacies have inhibited agricultural development in many ways - ranging from difficulties of marketing to introduction of improved methods and better education. B. M4ain Export Products; Developments and Prospects 30. Coffee production is the largest economic activity in Central America and the single largest; employer. It accounts for between 8 and 12 percent of GDP in the three major producing countries, Guatemala, El Salvador and Costa Rica, wlhich are especially endowed with soils and climatic conditions for coffee production. Returns on coffee production have been high, probably better than on any other crop in most of the post-war period. UJnder these conditions output in the last ten years increased by 75 percent. The increase in production was largely the - 12 - result of higher yields in El Dalvador and of the area cultivated in the other cotmtries. The Central American countries have not produced quantities of coffee for export in excess (in any important degree) of the quotas established under the International Coffee Agreement. This was mainly because crops were smaller than expected in Guatemala and El Salvador in 1964/65 and because Costa Rica's production fell due to a. volcanic eruption and disease. Over the next five years, however, Central America is likely to develop a substantial export surplus (about 20 percent over probable export quotas) under the International Coffee Agreement as a result of double planting, better pruning and increase in acreage in certain countries in the last two or three years and increasing use of fertilizers. Prospects are that coffee exports from Central America are likely to increase foreign exchange earnings very little (less than 10 percent) from 1965 to 1970, although for Costa Rica, which is still recovering from the reduction caused by the volcanic eruption, the in- crease would be about 40 percent. 31. The authorities in Guatemala and Nicaragua are carrying on studies or instituting prograns aimed at stimulating diversification from coffee into other crops, in order to prevent the emergence of un- manageable surpluses. El Salvador has asked UNDP for assistance in similar studies. But coffee is likely to remain a more profitable crop than most of the alternatives. If the expansion of coffee production is to be discouraged to prevent unmanageable surpluses and to stimulate diversification into other products, the mission considers that authorities should make coffee production less attractive through increasing the burden of taxation. With the exception of El Salvador, the Governments of the five countries have captured little of the increase in the value and average price of coffee exports in the last three or four years. The tax burden on the coffee sector is generally low: the export tax rate at present prices does not exceed 15 percent of f.o.b. prices and the burden of income taxes on the coffee sector is probably rather low. In El Salvador, income from coffee production is free of income taxes; in Guatemala a large initial deduction for agricultural producers in effect also exempts coffee income from income taxes; but in Nicaragua coffee growers are subject to income tax which is collected directly by deduc- tions from export proceeds. 'he export taxes actually paid in recent years appear to have been somewhat lower than what should have been collected (the rate applicable at a given f.o.b. price): the highest effective coffee export tax rate in 1965 was 10.8 percent in El Salvador, and the lowest 2.5 percent in Nicaragua (see Volume III, Appendix A). WJhile the export taxes are progressive in relation to price in Guatemala, El Salvador and Costa Rica (the taxes in Honduras and Nicaragua are specific), the progressivity is very mild and they have probably not been significant in diminishing the incentive to expand production in the period of higher prices since 1964. While in 1962 and 1963, coffee export taxes collected were 9.2 percent of coffee export earnings for the three countries, they had risen to only 11.6 percent in 1965. 32. M1ission projections of possible export earnings from coffee indicate a somewhat more rapid growth from 1970 to 1975, about 12 percent. But these assume that the Governments will have taken action which would - 13 - adjust production to possible exports under the International Coffee Agreement. More specifically, t'his means that they would have substan- tially increased taxation on the coffee sector in the late 1960's, despite the vocal political opposition of coffee growers to increased taxation of the coffee sector, through export, production or income taxes, or taken other steps to restrain a further increase in output. Otherwise the non- saleable surplus is likely to be such that it would be unmanageable and the financing of excess coffee stocks would divert substantial funds which could be used for higher priority tasks. The prospects for achieving increases in coffee taxation are admittedly very uncertain, but a concerted approach by the five Governments together might help dampen the strong opposition of the coffee growers. Alternatively, coffee growers face the prospect of direct controls on planting, difficult and arbitrary in enforce- ment, or the prospect of being unable to dispose of stocks unless they are willing to forego the advantageE accruing from the International Coffee Agreement including access to marxkets of member importing countries. In addition, the Central American countries would probably benefit if they were to join together and arrange a common quota under the Coffee Agreement3 this would allow unfilled quotas (occurring because of an unexpected shortfall in production) to be used to supplement the quotas of other countries having surpluses. 33. In view of the urgency of increasing the tax burden on the coffee sector, the simplest approach would be to increase export taxes now to levels which at least would provide a sufficient margin to cover the cost of financing the excess stocks while maintaining present coffee tax revenues and possibly increasing them. Wlhile surpluses in Costa Rica in the next few years are not likely to be as large as in the other countries, increases in taxation are needed to discourage further coffee planting and to avoid surpluses likely to arise toward the turn of the decade; the same would apply to Honduras. On the basis of present situation in Guatemala, El Salvador and Nicaragua (likely to have the largest absolute and relative surpluses in the next few years) the mission considers that a minimum export tax of 20 percent ad valorem (at projected prices) should be introduced in 1967 and become applicable to exports no later than those in 1968 to achieve the purpose of covering costs of financing excess stocks plus main- taining coffee tax revenues and. acting as a disincentive to production. Such a tax should be applied by all five countries; preferably it should be applied uniformly to minimize possible inducements to avoidance of taxation by shipping through countries with the lowest export tax and to help provide a basis for a common quota in the future. Further improvements in the system of coffee taxation, including revision of income tax structures or application of production taxes could come at a subsequent stage. 34. Cotton expansion has provided the major element of diversifi- cation of agricultural production and exports since 1961 in Guatemala and El Salvador. Nicaragua's production was already substantial in the fifties, and output doubled between 1961 and 1965. The role of highway and port construction, and availability of credit in this expansion has been mentioned previously. While in Honduras production has also expanded in the last sew years, it is still small, limi-ted by availability of suitable soils on the Pacific plains. Costa Rica began a significant expansion in 196)4/65, but - 14 - production is still small, cotton has competed for land with rice production enjoying a high support price, wghich has been lowered for 1966/67. Cotton expansion in Central America has been made possible not only by opening new lands, but also by increased yields, which are among the highest in the world for non-irrigated land. In 1965 there was some slow-down in the cotton boom; production fell by 10 percent, mainly as a result of droughts and pests, especially in El Salvador. The cotton policy of the U.S. has already led to some weakening of prices in the world market. Cotton production and exports of Central America depend in substantial degree on the extent to which pests may be brought under control, and on more efficient use of fertilizers and insecticides, so that production costs may be reduced to offset drops in prices. Efforts are being made on these lines in some of the countries. Central American cotton production in the next five years is likely to be only slightly higher than in 1964/65; export volume will barely rise and, with a probable fall in prices, export earnings may be about $130 million, some 13 percent less than in 1965. By 1975, however, the prospects are that more efficient producers would increase their output, even if prices remain stable, and that, despite a rising off-take for domestic industry, export earnings should increase by about 40 percent over 1970, totalling about $170 million. The principal increases would come from the major producers - Guatemala, Nicaragua and El Salvador. 35. Wlhile production and export prospects for bananas are encouraging, they are likely to provide a major stimulus only for Costa Rica and to a lesser extent Honduras. Nicaragua does not have suitable soils for banana production on her Atlantic coast; however, trial plantations on her Pacific slopes are being made to ascertain whether climatic conditions are suitable for bananas. In Guatemala, the transfer of banana cultivation from the Pacific side to the Atlantic side has not been so far very successful due to wTater-logging and possibly also because of political unrest in the area; prospects are therefore still uncertain. Due mainly to the considerable expansion of Ecuadoreani banana exports, Central American expoi-ts remained stagnant in the last fifteen years at around 800,000 tons annually. The banana companies preferred to expand in Ecuador mainly due to the higher costs of handling large plantations in Central America, "blow-downs" caused by hurricanes and the onset of disease and floods. It also proved possible in Ecuador to obtain production from many smaller producers and without making large scale investments. But with the spread of the Panama disease in Ecuador and their large investments in Central America, the com- panies are turning again to the area for new supplies. Thus banana exports from Honduras rose sharply to reach 590,000 tons in 1965, from a level of about 350,000 tons in the previous four years, while Costa Rica's exports reached 320,000 tons, compared to 273,000 tons five years earlier. The fruit companies are now actively engaged in expanding production on the Atlantic side; in Costa Rica, this expansion rests mainly on long-term con- tracts with independent producers. On the basis of present plans, already well advanced, Central America's banana exports may be able to reach 1.4 million tons by 1970, or about 75 percent increase above 1964, with prices at a slightly lower level than at present. In Costa Rica, the increase would require expansion of port facilities on the Atlantic (already being considered) and increased credit facilities for the independent farmers. - 15 - Credit would be also required in Honduras for increasing the production of independent farmers. Further expai.ision of banana exports in volume and earnings after 1970 is likely to be somewhat slower, say about 5 percent annually. 36. Overall, for the major export crops, the prospects are that export earnings are likely to increase from 1965 to 1970 at a rate of about 1.4 percent arnually. Thereafter, they should be somewhat better, increas- ing at a rate of slightly over 4 percent annually from 1970 to 1975, when they would total about $665 million. Nevertheless, such growth is far from satisfactory. Hence there is and will continue to be a very pressing need for diversifying and developing newq export products, as suggested below, and to actually implement the projects of banana expansion. C. iqinor Export Products - Developments and Prospects 37. Among the lesser export products to the outside world, the largest gains over the last five years have been in beef, sugar and the "other" category embracing a large variety of products. Taken all together, these minor exports have increased by 26 percent from 1961 to 1965 when they reached a total of $116 million. Progress in diver- sifying exports has thus been made, but they will have to be strongly pushed in the face of the prospects of coffee and cotton, which in 1965 still accounted for 68 percent of total exports of the region to the outside world. The greatest potential for further expansion based on agriculture lies in beef production and forest products. 38. For beef production, so far concentrated on the Pacific side, Central America has large land areas on the Atlantic side well suited for pasture, is free of foot and mouth disease and is close to the large market in the Eastern United States. Honduras and Costa Rica, where some sizeable operations toward the Atlantic are already taking place, appear to have large possibilitiesj potentialities Drobably exis-t in Nicaragua. Future development will require expansions of the road network, some of which is already taking place or being programmed. Construction or ex- pansion of Atlantic ports in Costa Rica and Honduras are planned and a possible Atlantic port in Nicaragua, now the subject of preliminary study, would also assist in expansion of livestock output. However, a basic pre-condition is to build up the herds. In recent years these have been badly depleted by slauighter for the attractive export market, despite efforts of governments to regulate slaughtering and the volume of exports. 39. Aware of the need to build up the herds, the banking systems have provided increasing amounts of credit for livestock development. Thus in Guatemala, El Salvador and Honduras, total outstanding credit for livestock rose from $14.5 to $2h.4 between 1960/61 and 1965. About two-thirds of this credit was taken up by the larger producers. Substan- tial add-tional programs for livestock credit are in an advanced stage of preparation by the public authorities in several countries - mainly Costa Rica and El Salvador. Te,hnical assistance in project preparation by interrational financial agencies is being provided in all five coun- tries. Costa Rica probably wil:L not need to import breeding stock, as - 16 - will the other countries, which may find that the scarcity and expense of such supplies from abroad may limit their rate of expansion. The possibility of exports to the U.S. market will depend on keeping Central America free of the foot and mouth disease. Measures being applied by the Central American authorities for this are in need of reinforcement. If the foreign credits envisagedl become actually available and are adequately supervised and used to increase the herds, their growth may increase from the present 1.5 percent annually to 3 percent annually. On this basis, the value of livestock exports, to the outside world, could, despite slightly lower prices, more than double from 1965 to 1975, reaching a value of about $40 million (and a volume of 185 million pounds). About 60 percent, or some 115 million pounds, of 1975 meat exports would probably go to the United States. Since January 1, 1965, U.S. legislation permits the President to impose import quotas; total imports in any year may be limited to 110 percent of an adjusted basic quantity. U.S. imports have been well below this permissive level. In the future, if it were strictly applied, legislation might operate to limit meat imports by the U.S., including those from Central America. 1/ Such a development is unlikely considering consumer pressures in the U.S. for restraint on beef prices and the permissive character of the legislation. Forest Products 40. Approximately one-half of the land of Central American countries is forested and is thinly populated, although El Salvador has little forest area. The majority, or a large proportion of forest land is publicly- owned (except in El Salvador). Most of the forest resources consist of a wide variety of hard-wood species in evergreen rain forests on the Atlantic plains, containing well-known valuable tree species. Not more than one- third of these valuable hard-wood species are utilized by local industry and the number of species exported is even more limited. Much of the broadleaved forest has lost itz best timber or has become degraded. But there still remain vast untapped tracts of forest which constitute one of the largest remaining reserves of tropical hard-woods relatively near North America, where demand for these woods has been expanding vigorously (as it has in other major importing areas). Some of these broad.leaved forests, including several in Costa Rica, Honduras and Nicaragua, would seem to permit industrial utilization with comparatively little infra- structural investment. In other areas, such as the Peten in Guatemala and the Olancho district of Honduras, utilization would require substantial improvements in transport. 41. Forests of coniferous species are most extensive in Honduras; there are also large areas in CGuatemala and Nicaragua and a small area in El Salvador, while Costa Rica has practically none. These areas cover an estimated 4.4 million ha. containing 166 million m3 of timber, much of it in mountain country, making transport difficult. The conifers are 1/ In 1965, actual U.S. impor1;s were 737 million pounds as compared with the quota which might have been imposed of 931 million pounds. Central American exports to the U.S. in 1964 were 62 million pounds. - 17 - a potential source of supply of 'Long-fiber pulpwood for manufacture of papers of high strength, as well as sawn wood, and are exploited much more intensively than the hard-wood forests. In the more accessible localities, coniferous forests have been depleted and in other areas they contain a large proportion of overmature trees capable of yielding sawlogs but also susceptible to ,1amage from insects and disease and thus liable to become a focus of infection. Rational management in pine forests containing overmature timber wilL be an increasing necessity for conservation of coniferous resources in the entire region. 42. The wood-using industry in Central America includes sawmilling, board products and manufacture of paper and paperboard (see Volime V, Forestry and lUood-Using Industries and the following chapter). There is widespread local production of sawnwood by small sawraills scattered through the area, mostly for domestic use. Total exports of forest products from Central America to outside markets have been rather stagnant in the last few years, due basically to the loss of the Cuban market and the inability to replace it by new markets in other countries without reducing prices. However, Honduras, the largest producer has begun to export high-quality pine wood to new European markets. On the basis of new projects being prepared, the mission estimates exports of wood products and timber to the outside world at about $21 nillion by 1970 and $28 million by 1975. Production of pulp and paper products is also likely to become important: trade in these products would be mainly within the common market within the visible future. Thus Honduras could export some $8 million of these products within the Common Market by 1975 if the Olancho project moves forward fairly soon. 43. The growth of sugar exports will be limited by the high cost of production and the internal prices higher than world prices, as well as rapidly increasing local consumption. Production almost doubled from 1960 to 1965 when it reached 50(,000 tons, as a result of high world market prices in 1963 and the obtaining of a share in the former Cuban quota in thie U. S. market. But even if world prices rose to 4 cents per pound, Central American sugar could not compete in the world market except in the protected U. S. market under legislation in force until 1971. The combined quota for the five countries varies from 143,000 to 187,000 short tons, depending on the U. S. requirements from abroad. Thus sugar exports, are unlikely to contribute significantly to the expansion of Central American exports in the visible future. L4. The production and export of cigar tobacco has made a good start in Honduras and the National Bank of Nicaragua is beginning a credit program for that crop. While U. S. demand for cigar tobacco is rather stagnant, Central America is well placed to gain a larger share of that market. Since cigar tobacco production is a delicate activity requiring careful cultivation, and its high unit value yields a high gross return per hectare, it is particularly suited for small farms, where the production of cheap crops is not sufficient to support a family. The same is true or several fruits and vegetables, such as tomatoes and others, except citrus. These crops also are very labor-intensive and offer possibilities of increasing both employment and incomes in agriculture, in contrast to - 18 - livestock, in which the labor intensity is low compared to the fixed investment required for efficient production. The largest potential for a significant contribution to agricultural exports and income among these crops exist in citrus and pineapple, for which the U. S. market is very large and growing and whose present suppliers are experiencing substantial increases in production costs; important market possibilities exist in several European countries and Canada. However, large scale and efficient production of citrus and pineapple require larger farms than is the case for tobacco and other fruits and vegetables. 45. The development of these newer types of crops on a scale suffi- cient to make a significant contribution to agricultural income and foreign exchange earnings calls for special and sometimes difficult efforts. Such efforts, however, are already starting. El Salvador, with its scarcity of arable land, is already well advanced in the preparation of two irri- gation projects intended to increase intensively cultivated land by 15,000 hectares in the next eight years, a significant amount for that country. A credit program for agricultural diversification is also being prepared by El Salvador for external financing. The Costa Rican banking system has plans ready for a $10 million three-year program to expand beef, bananas and cotton production. In addition, a $2.5 million loan was obtained recently from a private U. S. bank to expand banana production. Guatemala has obtained a loan of $3.3 milLion from IDB to continue long-term lending to farmers, mostly for livestoclc. Similar programs are being financed also by the Inter-American Bank in Honduras and Nicaragua. 46. All these efforts in :Lending for the development of export products, especially livestock, mostly directed to medium and large farmers capable of making effectlive use of the funds and requiring less technical assistance than the sraall producer, are needed to improve the production and export prospects of all the countries in the next few years. For certain high value crops, such as tomatoes, pineapples, citrus and others, good quality and uniformity of the produce and steady supply is essential for entering the export markets. Efforts are being made, and will need to be pursued vigorou:31y to interest distributors in the external markets in the development of these exports, including joint investment ventures, since their knowledge of techniques and of marketing arrangements would provide greater and quicker assurance of success. D. Grains and Other Foods for Domestic Consumption 47. It should be feasible to increase production of food for domestic production. Suitable land is available and there are substantial possibi- lities of increasing yields and improving marketing arrangements. Only in El Salvador are land areas for expansion limited. To gain access to new lands it will be necessary to give feeder roads a larger place than in the past in the transpor-tation investment programs of the coun- tries. These roads would facilitate the marketing of products in the urban centers and reaching the farmers with credit and technical assist- ance. However, planning for such roads will need to be based on more adequate soil studies than has often been the case hitherto. - 19 - 48. Supervised credit programs to develop production and yields of small farmers have been initiated in almost all the countries; these vary greatly in scope and effectiveness. The well-established credit program of Costa Rica, embracing over ha:lf the number of farms, is an important factor in improving their agricu:Ltural performance. In El Salvador, the Government Rural Welfare Agency (,ABC) started in 1963, has reached only about 2 percent of the farm units, while in Honduras the supervised credit to small farmers is scarcely evident. WThile the investment programs of the Government for the next three years envisage the expansion of these programs, they will have to be accompanied by substantial increases in field staff to be effective, particularly in Guatemala, El Salvador and Honduras. Storage and Marketing 49. With the exception of Costa Rica, present grain marketing arrangements are marked by lack of financing and of storage capacity. Thus, generally the peasant sells at low prices at harvest time, usually through an intermediary. Seasonal variations in the prices received by the farmer are wide and often prices outside the harvest season are about 50 percent higher than during the harvest season. Existing storage capacity is usually concentrated at one or two cities in each country; in soine cases these operate well below capacity due to the lack of working capital to acquire grair.. Local or regional storage capacity is generally lacking. To remedy these shortcomings, the national grain boards in the several countries have developed under the aegis of SIECA, a regional program which would double storage capacity in the next five years or so, provided construction is carried forward without delay. These should permit a level of purchases by the grain boards consistent with the main- tenance of reasonably stable prices to the producer. The cost of the additional capacity is estimated. at about CA pesos 7 million; most of it would be in Guatemala, Honduras and Nicaragua. As yet, however, none of the countries, except Nicaragua, has so far arranged the necessary funds to begin construction. Moreover, the programs ought to include more storage facilities at the local level as well as provision of adequate working capital for the grain bcards. The Grains Agreement 50. Thus far, there has been relatively little trade among the countries in agricultural products since they are substantially similar in agricultural structure. However, some livestock has moved from Honduras to El Salvador and Guatemala, and, in recent years, during the cotton boom in El Salvador, corn and beans were imported in substantial quantity from Honduras. Shortfalls in supply in other countries were met by imports from the outside through the state grain boards. / In the future, the pattern of production of basic grains in the region may well be influenced 1/ At preseint world prices, the common external tariff amounts to about 140 percent for corn and about 200 percent for milled rice. In fact, imports from the outside are almost exclusively by the state grain boards, which are exempt from the payment of duties. -. 20 - by the Special Treaty on Grains, which came into effect as of mid-1966. This agreement wiped out the remaining tariff and quantitative barriers on trade in grains between the countries, except on corn traded between El Salvador and Nicaragua and oin wheat and flour among all the five countries. Local flour mills, imaporting wheat grain from abroad, have been successful thus far in maintaining protected national markets. The key provision of the Grains Agreement is that each grain board must give first priority, in meeting short:f'alls in supply, to imports from other Central American countries. Inports from outside the region may only be made after consultation with the other countries, and, if made, must pay a duty equal to the difference between the import price and the official internal support price which is :Vixed by coordinated action among the national grain boards. Thus, the Grains Agreement aims to provide an incentive for the Central American area as a whole to continue being self- sufficient in grains. A coordinating commission with limited powers has been established to enforce the .'Protocol. If in fact first priority is given to grain imports from within the area, the grains agreement could lead to increased competition among Honduras, Guatemala and Nicaragua in providing exports of corn to iSl Salvador; it could also result in competition among Nicaragua, El 3alvador and Guatemala in exports of rice to the other two countries. At this stage it is difficult to judge, especially for corn, what changes in increases in specialization of pro- duction or changes in pattern of trade might take place under the new agreement. E. Colonization and Settlement 51. As indicated at the beginning of this chapter, the wide existence of minifundia and population pressulres in certain areas, have been building up pressures for resettlement of small farmers. The colonization and settlement programs now underway in Central America vary in extent and orientation but generally are small in scope and not very effective. The Agrarian Settlement Institute (ICR) in El Salvador, to be more effective, requires a better coordination v'ith the credit agencies and additional feeder roads. Despite the limited availability of land, the Institute has been able to acquire 100,000 hectares for resettlement in the last two decades (about 7 percent of the total area in farms in the country). It has stepped up its activities in recent years, and since 1963 has distributed about 3,000 parcels of land on long-term sale contracts. Guatemala's land reform agency (INTA), operating since the early fifties, has in recent years settled only several hundred families on the Pacific Coast. Its plans for a large settlement near the south of the undeveloped Peten forest region on the Atlantic side, a difficult venture at best, have Inot materialized. Costa Rica's Land and Colonization Institute, established in 1962, has settled only about 1600 families thus far. It has decided to concentrate its efforts outside of the densely-populated Central Plateau, and about 600 families have been settled as part of a project for the production of bananas for export under long-term contracts. In Honduras and Nicaragua, the colonization institutions have had similar experience. While all these efforts are costly and difficult to adminis- ter, they are bound to continue and must be regarded as part of the general sw;eep of social and economic change. - 21 - 52. For the future, given the need to develop agricultural exports, the quickest and most economical results of new investment resources will be obtained by concentrating them on medium and large producers. But major efforts in this direction - bananas, cattle, forest products - will require exploitation of newer regions toward the Atlantic, though some Pacific areas still remain to be developed. Under these circumstances, public agricultural policy should be oriented toward linking such develop- ment with colonization and land settlement schemes designed to induce rural migration to new areas from the present congested zones of the Costa Rican Central Plateau, Western hEonduras and the Guatemalan Highlands. Projects for agricultural expansion and diversification through medium- size and large producers, might well be supplemented by programs for nearby smaller farmers who, while not necessarily an integral part of larger projects themselves, could benefit from their proximity by absorbing improved agricultural practices as well as supervised credit. 53. The prospects of imprcving the level of skills and technology of the small farmer depend in part on improvement of the educational system. The present educational. system and programs are grossly inadequate for this purpose in all the countries. The percentage of rural children in school will have to be substantially raised in all the countries (the proportion of rural children aged 7 and 12 actually in school is at best about 40 percent in Guatemala, ';0 percent in El Salvador and about 85 percent in Costa Rica); and a large proportion of rural schools - except in Costa Rica - provide only the first and second grades of primary education (see Volume VII, EducELtion). The national programs for in- vestment in education are in gerneral likely to result in a substantial proportional increase in rural enrollment. However, there also is urgent need to begin to adapt the content of education in rural primary schools to the needs of pupils most of wihom are likely to remain in farming and receive only primary school training. F. Conclusions 54. In suxmnary, the prospects for agricultural growth in the next five years are less favorable than in recent years in two of the commer- cial export crops - cotton and coffee - which have been the main factors of growth in the recent past; although over the years thereafter they should improve appreciably. In substantial measure these changes in prospects reflect circumstances of the external markets. Policies and measures to minimize the effects of adverse outward changes will need to be adopted and implemented. Further expansion of coffee production should be arrested to avoid the creation of unmanageable surpluses. Con- certed action by governments in the region to tax the coffee sector more heavily is needed as a discentive to production beyond the foreseeable export markets; it would also be a means of obtaining additional govern- ment revenues needed especially in Guatemala, El Salvador and Costa Rica for their public investment progTrams. At the same time the studies in Guatemala, Nicaragua and El Salvador to diversify agricultural production in coffee areas into other alternative crops, need to be pushed forward. In the case of cotton, the basic need is to overcome the production diffi- culties which have affected the sector in the last fewr years through a - 22 - more careful and economic use of fertilizers and insecticides and better storage and transportation facilities to further reduce costs. The pool- ing and inter-change of experiences in improving production techniques to lower costs and improve quality could be undertaken jointly by the producers' associations, which have enough resources for undertaking t.;e necessary studies of production problems. 515. The development or expansion of new lines of agricultural production for export - livestock, bananas, fruits and vegetables, forest products - for which the region enjoys certain advantages and markets are favorable, need to be pushed vigorously and urgently. Some of these lines, like livestock will take several years to develop for their poten- tial to be realized, but this should be only an additional reason for accelerating the implementation of the several projects already prepared by public authorities and to prepare new ones. Central America, on the basis of estimates of public prc,jects being prepared or to be prepared for foreign financing, appears to need external loan commitments for agriculture of close to $100 million over the period 1967-70, to help finance projects costing almost $180 million (not including feeder roads). More than half of these commitments would represent agricultural credit programs mainly for commercial and export crops and storage, the effect of which could be felt well witlin the next five years provided that their preparation and negotiations for foreign financing proceed without delay. These are needed particularly to attenuate the slackening effects of the pace of growth of some of' the major export crops. III. 1IDUSTRY A. Recent Trends and Factors in Growth 56. Manufacturing has been the fastest growing sector of the Central American economies from 1962 through 1965, during which value added in manufacturing for the region as a whole expanded by an average annual rate of 11 percent in real terms. While the rapid growth of manufacturing in Central America is not a nev phenomenon - during the fifties it averaged 6 percent annually - the considerable acceleration of this expansion in recent years is a new feature. Among the main factors which have made possible this acceleration has been the growth of the market; this took place through rapid increase in internal purchasing power as a result of the export boom which began in 1962, and through the liberalization of trade between the five countries beginning in 1961. Moreover, there was a substantial increase in the availability of finance for industry, par- ticularly from foreign official loans and foreign direct investment. Even with this rapid expansion, however, the manufacturing sector is still a relatively small contributor to the output of the five countries, and in 1965 accounted for 15 percent of the GDP of the region. 57. As in many less deve]oped countries, the so-called "traditional" consumer goods industries - primarily food processing, beverages and tobacco, textiles, shoes and clothing - predominate, accounting for about 75 percent of industrial output. Domestic demand for these products rose with the sharp rise in disposable incomes after 1962; as a result, output of these lines expanded substantially, though slightly less than the level of total manufacturing. New branches of industry were established in most of the countries in the late fifties cnd early sixties, and were responsible for a slight change in the composition of total industrial output; these included petroleum refining in particular but also chemicals and metal products. 53. During this first stage of expansion, a considerable portion of production evidently came from increased utilization of previously underutilized capacity. However, there was a considerable increase in investment for the modernization of the traditional industries and for the establishment of the new branches of industry which are generally more capital intensive than the tralitional lines. Overall, the growth in employment in manufacturing ha, been considerably less than in output. VIhile employment data are not altogether satisfactory, available data indicate that during 1950-1964L, in four countries (excluding Guatemala), employment grew at an annual rate of growth of 2.6 percent while output grew by as much as 7 percent. 59. The highest rates of growth in manufacturing have been reached in Guatemala and El Salvador, which have the largest and longest-established industrial sectors, and account for two-thirds of the industrial output of the region. The expansion of manufacturing in the other countries has started from a lower base and with smaller internal markets; but even in - 24 - Honduras and Nicaragua, the rate of growth of manufacturing also speeded up in 1963 and 1964, reaching atbout 12 percent annually in both countries in these years. Annual PercentagE increase in value Percentage share Total value added added to manufac- manufacturing in by manufacture (in tures GDP million CA pesos) 1963-1965 1 9 6 5 Guatemala 14 15 219 El Salvador 12 17 136 Honduras 7 14 68 Nicaragua 9 13 69 Costa Rica 10 15 80 Total Region 11 15 572 60. Of the increment to manufacturing activity in the years 1963 through 1965, three-quarters was due to the rise in local or national demand and 20 percent to the expansion of intraregional trade in industrial products. For somie countries, however, the growth of trade in these items with their Coimnon Market partners was of greater significance: for El Salvador and Costa Rica, the increase in these exports accounted for 30 and 35 percent respectively of the increment to industrial output. Exports of manufactures to the outside world have been relatively small, accounting for the balance (5 percent) of manufacturing expansion in 1962-1965, by far the largest portion being processed foods (meat and sugar). Growth in intraregional trade: characteristics and structure 61.. Industry was the main beneficiary of the growth of trade following the rapid elimination of custom barriers between the countries which began in 1961. Some 85 percent of the increase in intraregional trade from CA$50 million in 1962 to CA$136 million in 1965 was in manufactured goods. In 1965, trade in manufactures (including processed foods) amounted to CA$105 million. 62. As indicated in the tabulation below, covering about 90 percent of the increment in intraregional trade in manufactured products frcm 1962 to 1965, less than halfcame from the traditional products (largely pi-ocessed foods, textiles, shoes and clothing). These industries have been primari]y dependent upon national markets and the recent increases in their exports to the Common Market trade have represented only a small portion of the increment to industrial production. Of the increase in trade in non-traditional products, somewhat over one-fifth was accounted for by fertilizers and petroleum products due to certain factors (mentioned below) which may not be of a permanent nature. The other non-traditional products consisted principally of a variety of chemicals and metal oroducts, produced by industries largely aew to the region and intraregional trade - 25 - has taken an important share of the recent growth in their output. All these newer non-traditional industries depend to a great extent on imported raw materials and intermediate goods. As indicated in Chapter V, imports of these categories of goods from outside areas have been increasing rapidly and their share of total imports from outside the area has risen subs- tantially. Absolute value of in- Share of total crease in intra-trade increase in 1962-1965 intra-trade (million CA pesos) (percentages) Manufactured foods / 8.8 11.6 Textiles 11.4 15.1 Clothing and shoes 10.8 14.3 Wood products and furniture 4.3 5.6 Fertilizers 4.0 5.3 Petroleum products 3.2 4.2 Toiletries, cosmetics and related products 5.5 7.3 Other chemicals 6.4 8.5 Basic metals and fabricated products 4.3 5.6 Mlachinery and transport equipment 3.9 5.2 Total 62.6 j Including inedible fats and oils. The role of the common tariff 63. Aside from the removal of trade barriers within the Common Market, a main instrument of integration has been the cormmon tariff; this has important implications for industrial development. At present, the common external tariff and elimination of restrictions on intraregional trade (or the phased achievement of both) cover products accounting for more than 80 percent of total imports and almost 95 percent on intra- regional trade. In general, the common tariff, while differing in many individual instances from the national tariffs previously in effect, is essentially similar to them in overall structure. Broadly, it gives heavy protection to consumer goods and their components, has low rates on raw materials not found in the region, and gives little or no protection on capital goods. However, on most items, in particular consumer goods and their inputs which are important in regional trade, the common tariff is higher than preceding national tariffs (see Volume IV, Industry). Appendix A contains an analysis of the differences between the previous national tariffs and the current common tariffs for a sample of 83 products - 26 - which accounted for a substantial share of total external imports in 196)4 as well as of the growth in intra-trade, particularly in regards to consumer goods. For the sample, the median of the list of rates applicable under previous national systems was U" percent while under the common system it is 6L percent. The shift to higher duties is shomn in other measures; for example, under the national tariffs, ad valorem rates of 70 percent or more were in effect for only 18 percent of the items in the sample but under the Common System, such rates afpplLed to 41 percent of the products. 64. No reliable data are available to show whether the higher tariffs which have been gradually put into effect since 1962 have led to higher priDes to the purchasers. The available consumer price indices (Table 17) are probably correct in suggesting that the cost of living for the bulk of the low-income population in the capital cities has risen only slowly in recent years (by 1-2 percent annually). Certain major producer goods, such as cement, construction materials, certain metal structures, have fallen in price in sone coimtries with the establishment of local plants and the consequent elimirnation of costly ocean freight. On the wihole, it is probably true to say that while some local price increases have resulted froin the boon in manufacturing generally the price levels have not been increased. The factors responsible for this situation are to be found in the basic conditions underlyring both production and trade for the products which until now have accounted for the expansion in intraregional trade. 65. The expansion in regional trade at the expense of imports from third areas is most readily seeni in the case of a number of important inputs for traditional or consumner goods industries. For example, within the textile group - which has accou.ated for 15 percent of the increase in intra- regional trade in manufactured aroducts - most of the trade expansion has taken place among cotton products in which there has been a substantial growth in both regional output .nd demand. For cotton cloth, the common tariff represented a substantial increase in comparison with most of the previous national tariffs - more than doubling on the medium and lighter fabrics, and about 70 percent higher on heavier cloths. Cotton cloth imports fron outside the region fell in both relative and absol-ute terms (from CA$19.5 mnillion in 1962 to m418.6 million in 1965) while intra- regional trade expanded considerably (from Gh$1.1 million to CA$5.8 millionl) But the increase in competition which has developed in this industry as existing plants throughout the region have been seeking to take advantage of the new regional market and to expand output to meet the increasing local demand - by increased utilization of capacity, modernization of production methods and often specialization by product lines - has operated to limit price increases thus far. 66. The development of specialization as a result of the widening of the market (the trade expansion effect) is clearly seen in the case of shoes,i clothing and processed foods. Previously production of such items was scattered throughout the region but plant output was limited by the smsallness of the national markets. Wnihere there was no production of such products in a colntry, thie iterms had to be imported. lrJith high tariffs under tthe national systems, the relatively high cost of such goods kept imports, as well as consumption, at low levels. The removal of tariffs - 27 - on these items within the region, coming at a time of rising personal incomes, gave consumers easier access to a wider range of consumption goods produced within the region. Consequently intraregional trade in these products rose very sharply (proportionately more than their total production or consumption). As indicated in the tabulation below, the increase in intraregional trade in these items accounted for practically all of the increase in their total imports and, in some cases, there was a decline in the region's imports from external sources. Percent increase Imports from CACM / Share of increase in value of total as share of total in intraregional imports 1962 to imports 1962 trade in total in- 1965 crease 1962-1965 Clothing 74.7 24.4 95.2 Shoes 234.3 62.0 106.6 Processed fruits and vegetables 117.4 31.6 67.4 Candy and sugar preparations 125.t 70.7 112.0 IlTood products 183.5 65.4 110.7 Furniture and accessories 126.5 21.7 95.9 j Central American Common Market Expansion in New Industries 67. The growth of intraregional trade in non-traditicnal prcducts is also due in some cases to factors other than trade liberalization, even though in most cases it has been linked to the liberalization process (as reflected in the high proportion of output of these items that enter regional trade). A specific instance is refined petroleum products, which is one of the few items n.ot yet duty free in regional trade. The recent interchange in these products, practically all concentrated in exports from El Salvador to Guatemala, is due mainly to the delay in 1964 and 1965 in the coming on-stream of the second refinery in Guatemala (at Escuintla) so that it was convenient to import petroleum products from the refinery in El Salvador (at Acajutla) hihich had begun operations in late 1963. It is unlikely that this trade will expand and in fact the 1965 level was well below that of 1964. 68. Similarly, practically all the intraregional trade in fertilizers originates from a plant in Costa Rica producing various fertilizer mixes, based on imported ammonia and phosphate rock. This plant has been having difficulties in selling to the region, both in meeting prices of fertilizers imported from other areas (the common tariff is very low - effectively 5 percent ad valorem on the basis of 1964 import values) and in adjusting the composition of its product mix to satisfy local requirements; the level of trade has fallen markedly since 1964 and, as matters stand, does not appear likely to expand in the immediate future. 69. The bulk of the expanEion in intra-trade in the non-traditional category has occurred in chemicals, pharmaceuticals and cosmetics, basic metals and metal fabricated products and items such as paper and rubber manufactures. Their production is based on imported inputs; local inputs and/or value added are generally quite low. In some instances, the economies of transport and handling justify the establishment of local production facilities (which often is nothing more than assembly). However, for the pharmaceuticals and cosmetics in particular as well as for some of the other products, the growth of both production and trade is linked to the existence of industrial development incentive laws in each country; as currently administered they have been excessively liberal in permitting tariff-free imports of inputs required for manufacturing the final product. The latter are generally subject to relatively high tariffs; even in those cases 'where duties may be superficially moderate in level, in relation to value added they are often extremely high. Fiscal Incentives for Industrial Development 70. Comprehensive lawis to promote investment in industry were adopted in all five countries, toward the end of the l950's (Honduras and Nicaragua in 1958, Costa Rica and Guatemala in l959, and El Salvador in l952 but vwidened substantially in 1961).. In most instances the broad sweep of the legislation represented a new approach by the governments to industrial promotion, establishing for the first time elaborate systems of incentives and the criteria for their application, which have a number of common characteristics among the countries. 71. Fiscal incentives in tihe form of exemption from income taxes and from tariffs on imported capital equipment and inputs are granted to individual enterprises in accordance with certain classifications which are established under specified but fairly broad criteria. In two countries, Guatemala and Costa Rica, the only criteria are whether the product to be produced is new or whether it is already established in the sense that it is already being produced domestically in excess of a certain proportion of existing national demand. 7n addition to this general distinction between "new" and "established",, in the three remaining countries economic characteristics of the product are considered in determining the benefits to be granted. Thus different benefits are accorded to "necessary" industries in El Salvador as d:Lstinguished from "convenient"; and in Nicaragua and Honduras benefits depend on whether industries are classed as "fundamental" (or basic), "necessary" or "convenient". The criteria for classification in these ca,es are extremely vague or cover many elements and, in practice, the classification accorded depends almost completely on administrative discretion. While the range and type of exemptions vary among the countries, it is fair-ly usual for "new" or "fundamental" industries to receive complete exemptions on customs duties on imported machinery, equipment, construction and raw materials and fuels for 10 years; complete exemption on sales taxes for 5 years (and sometimes an additional five years for one-half of sales taxes); complete exemption on income tax for 5 years and exemption on one-half for another 5 years; plus complete exemption for five years on ta:xes on capital plus partial exemptions for another 5 years. Exemptions o:n other economic categories are usually considerably less, but still generous. - 29 - 72. In recent years, an increasing number of enterprises have been classified under these laws in all of the countries and received corresponding benefits j . Recourse to fiscal exemptions has been stimulated in part by the fact that in 4 countries (i.e. excluding El Salvador) business income taxes are levied on the same basis as personal income taxes, with a progressive rate; this is a dlisincentive to the establishment of larger scale enterprises which has encouraged wide use of the provisions of the incentive laws. 73. The number of business enterprises which are accorded benefits considerably exceeds those wJhich have actually gone into production and used their benefits. Aside from delays in putting a business into operation, evidently some promoters of projects succeed in obtaining classification before their proposals are full;y formulated as a means of pre-empting the product field. In addition, for certain products for which plant location is not critical, entrepreneurs have apparently applied for benefits in more than one country in order to determine which will grant the most favorable conditions. The possibility of competition among the countries for industrial plants is, in fact, explicitly recognized in two of the national incentive laws (Guatemala and Honduras as recently revised). In both instances, national enterprises may receive benefits additional to those for vihich they qualify under the relevant legislation, if they can show that similar enterprises in other countries receive better treatment. 74. As a result of this ccmpetition, there has been a proliferation of small or medium size mixing or assembly plants producing mainly consumer goods, based on tariff-free imports of the intermediate inputs with high tariff protection afforded to the final product. Among the pharmaceuticals and cosmetics, the competition in the market has developed intensively particularly as regards foreign brands, and prices to consumers have been relatively favorable thus far. But growth of production has required higher imports of materials or other inputs to produce finished items on which high tariffs had been imposed to curtail imports from abroad and/or to produce goverrnent revenues. 75. On the other hand, the competition among countries to secure for themselves the location of important plants of this type, with resulting uncertainty as to the possibility that future competitors might obtain more favorable conditions from another country in a different site may have hindered investment in larger scale enterprises producing either intermediate or final goods in the chemical and metal fabricating industries. Although a main motive for economic integration was to create larger markets and encourage the establishments of the larger enterprises, only a few such plants have come into operation or even under construction since integration began. Even these have generally had direct links with buyers of the products to ensure disposition of output. g/ In one country, 369 enterprises were granted fiscal benefits from 1960 to 1965; the annual number rose steadily from 8 in 1960 to 108 in 1964 and 97 in 1965. - 30 - 76. Perhaps the single most important instance in which competition for plant location by giving fiscal privileges has given rise to uneconomic investment is petroleum refining. Five relatively small plants designed to satisfy local or national needs have been constructed in four countries (two in Guatemala, one each in El Salvador, Nicaragua and Costa Rica) and a sixth is in the planning stage in Honduras; all of these must import the crude oil required. In terms of total demand within the region, one large scale installation would probably be more efficient both in achieving lower costs of production as wiell as providing adequate supplies of by- products, as a basis for other production processes, although consideration of transport costs to the main consuming centers might justify the esta- blishment of two smaller installations. While the desire of each of the five governments to have national refineries has played a fundamental role, the foreign oil companies undertook the investment with a view to ensure their continued presence and operations in the area. 77. The fiscal impact of duty exemptions under the existing national industrial promotion laws has been considerable. The percentage of exempted to assessed duties has risen sharply in all countries from 1962 to l965; in the latter year it ranged from 11 percent in Honduras to 16 percent in Guatemala, and from 23 to 24 percent in Nicaragua, Costa Rica and El Salvador; the total of such exemptions was some CA$33 million in 1965 (Table 13). To offset such losses of current revenues, Costa Rica began in mid-1964 to impose sales taxes on many of the final products encouraged by the incentive laws (i.e. automobiles, television sets, radios, detergents, cosmetics); these taxes are also intended to have a dampening effect on imports although in general they have only partly made up for the tax revenue lost, through the exemptions. The impact of exemptions granted on income and other direct taxes is not known, and hence the cost of exemptions is not readily calculable, although with the existing income taxes applicable to businesses, which pay the same rates as persons in most countries, the revenue impact is likely to have been substantial. B. Prospects for growth 78. As indicated previously, the growth of major exports to the outside world is likely to slacken considerably in the next five years - though quickening in the quincluennium thereafter - with the overall prospects that growth of GDP in the region is likely to be considerably lower than in recent years, probably about 2.5 percent annually. Given these prospects, it is most like!ly that the rate of growth in demand for manufactured goods will rise at much lower rates than in the recent past. The mission's projections for intraregional trade reflect this outlook, even though account is taken of the probable effect of new industries where this can be estimated. Irttraregional trade increased by an annual average of 60 percent from 1960 to 1965 but the rate of increase slackened to 29 percent in 1965. For 1965-1970, the projected increase in intraregional trade is of the order of 6 percent per annum and the growth in the following five years to 1975 about 9 percent per annum. The proportion of intraregional exports to the total value of overall exports of the region would probably rise from some 18 percent in 1905 to about 22 percent in 1975. Probably a - 31 - major portion of the increase in intraregional trade - some 80 to 90 percent - will be in manufactures. These projections of intraregiornal trade are subject to especially wide margins of error, given the relatively short period of experience with industrial production and trade movernents in the Common Market. Particularly it is difficult to judge how far the process of import substitution, opened up biy the larger market created by integration, may go further. There are evident]y important possibilities of furthering the process. All the countries halre possibilities for further indlustrial growth and this margin has been increased by the creation of the Common Market. Nevertheless, the five countries combined still represent a relatively small population with a relatively low purchasing powver, given the low per capita incomes for the region. Hence, while the possibilities of industrial growth on the basis of regional demand are still significant and need to be exploited, they are not sufficient:Ly large at this stage to achieve a rate of industrial growth which most countries would desire. Thus further progress in industrialization will be intimately linked, first, to general developmental policies aimed at ra:ising incomes in all sectors, and, second, to the development of export-oriented industries. The strategy should therefore be two-pronged: (a) to pursue policies and measures to encourage the growth of industries serving the regional market, to meet growing consumption and a changing structure of demand within the regional economy, and (b) to promote export-oriented industries, involving maximum elaboration of those natural resources which the region contains in some abundance. These elements are not mutually exclusive; in fact, they are complementary in large measure since the expansion of excports will require a healthy development of regional industries which can compete in world markets. Possibilities for industrial growth 79. Imports from outside the area still remain heavily concentrated in finished manufactures - both producers and consumers goods. Even wiith a slower rate of growth than previously, import substitution possibilities will emerge. Given the wide range and substantial number of industries covered by existing feasibility and pre-feasibility studies often made by foreign consultants, i/the mission was not able to examine in detail specific products or projects. Nevertheless a review of some of them and discussions with both public and private sector officials concerned with industrial growth provide a basis for identification of broad categories of goods having growth possibilities. 80. Among consumer goods, there is room for expansion of textiles, particularly the newer synthetics and mixed fabrics; demand for these has proven to be highly income elastic in the range of incomes prevailing in the urban centers. Similarly, there is potential for expansion of processed foodstuffs to supply the growing urban population, especially canned fruits and vegetables, i/meat and dairy oroducts. g/ The quality and depth of thesa studies varies widely. However, even a brief review reveals a general need to greatly strengthen the cost analyses made of possible new lines or products, as well as technical problems to be dealt with. Many studies, in fact, have all but ignored the cost aspect, providing no more than demand or market projections. j Export possibilities for these items also appear promising and are discussed below. - 32 - 81. Among producers goods, personal income growth as well as expansion of public construction over coming years provides a basis for increased output of a wide range of construction materials, such as cement and concrete blocks, ceramics and structural steel. With greater research and promotion, there may be substantial scope for low-cost housing based on properly treated wood products. i/ 82. Some possibilities also exist for expansion of production of fertilizers, insecticides and fungicides; these agricultural inputs bulk large in imports of the region. The basic compounds for their production are subject to very substantial economies of scale in output; hence under current demand conditions, local plants would tend to be high cost producers. There remain, however, possibilities for establishing local mixing plants and some simple transformation processes. A similar situation prevails for plastics and synthetics. The former have had growing use both for industrial and household uses, based on imports of intermediates such as pow^dered poly-vinyl-chloride, polyethelene and polysterene. Project proposals for establishing plants to produce the basic compounds for these items are now being prepared but pose the same scale problem as the other chemicals. 83. A number of project proposals have been prepared for the establishment of various assembly industries covering both consumer (e.g. passenger cars radio and television sets) goods and some producers goods (e.g. trucks). A protocol is now under consideration which would specify the procedure and criteria to be used to permit the extension of the common tariff to these products and to free intra-regional commerce in them. In view of past experience in Central America as well as in other areas, such plants should be carefully screened before fiscal incentive privileges are granted so as to insure that the advantages to be obtained (in terms of employment for example) at least offset the possible losses in government revenues, effects on the volume of imports and the impact on other economic activities if the items are produced at a high cost. Moreover, the effects of these projects in creating rigidities in the import structure will need to be carefully assessed. 84. The existence of forest of suitable conifers and the rapidly growing demand in the region for packaging papers, including cardboard liner and corrugating medium now in almost universal use for manufacture of boxes for the export of bananas, provides a basis for establishment of one or two large pulp and paper projects in the region in the next several years. Several relatively large projects are in various stages of study (see Volume V) and appear promising. Perhaps the best known is the Olancho (Honduras) pulp and paper mill project which has been under study in one form or another for almost 20 years. As presently conceived - though some important aspects are still to be worked out - a plant would be constructed to produce pulp and packaging paper including cardboard liner and corrugated medium. High grade sawnwood would also be produced, primarily for export to Europe. The investment required would be substantial, in the order of j See discussion in Volume V, Forestry and Wood-Using Industries. - 33 - CA$50 million. The Governrment of Honduras in 1966 commissioned the preparation of detailed feasibility studies and a financial plan. When these are ready, the project would warrant urgent consideration in view of the contribution which such a project could make, not only directly to economic growth in Honduras but indirectly to the entire region (stimulating the establishment of supplier industries, for example). Consideration should be given to other projects in this same field as studies are completed in view of the evidence that demand for packaging materials may be exceeding earlier expectations. Export-oriented industries 85. At present, there appear to exist excellent opportunities for expanding exports to world market of processed foods and wood products. Expansion of processed foods for export, particularly meat and canned fruits and vegetables, will depend in the first instance on expansion and improvements in raw product supply and quality which will often require programs of official assistance. Production facilities for meat have already been established and are being planned. Eventually there will be need to expand processing plants for fruits and vegetables, these now have underutilized capacity and efforts should be made to utilize this as a basis for initiating export programs in order to ascertain the most advantageous pattern of future expansion. Particular emphasis must be given to developing means of marketing given the inexperience in the region and the economies of scale in dLstribution. Current exports of wood products to other areas are weli below the region's capacityr in view of its resources and increasing world market demand. Emphasis should be given in official programs of assistance, both technical or financial, to the creation of production facilities for such items as sawnvood, veneer, plywood, and chip board as well as to the establishment of marketing facilities. 86. The possibilities for exporting more elaborated products with a higher labor component, such as cotton textiles and clothing, appear to be promising, as recent intra-regional competition has been encouraging the establishment of modern and reasonably efficient plants in these branches. In general, the region would in the immediate future have its best opportunities for developiag exports products characterized by both high labor inputs (taking advantage of the prevailing reasonably low wage rates) and locally produced low cost raw materials. Some proposals are being considered to create eaxport industries on the basis of imported raw materials or intermediate goods (with tariff exemptions). Tllese should take into account the external competition from areas such as the Far East where wages are considerably below those prevailing in Central America. WVage rates for factory workers are low in absolute terms in Central America, averages for the five countries ranging between CA$0.20 to CA$0.27 per hour, excluding social charges. However productivity also tends to be low. Wlhile employers are often content to train their own labor, there is need to raise labor productivity by improving skills and capacities, especially among the foremen and supervisors. Hence the prospects for increasing the efficiency of labor, depending in large part on management, would be improved by betterment of the educational system, including - 34 - vocational training, and by raising the level of education, which at present is very low. Thus a key elemert in the industrial prospects of Central America will be the extent to which the countries succeed in effecting badly needed improvements in the educational system. Efforts in this field warrant a high economic priority (see Volume VII, Education). While the entrepreneurial and managerial class in Central America is in its beginning stages of development, it has ehown strong evidences of vitality and growth. Improvements in training and education are also needed to help overcome growing shortages of administrative and managerial personnel. Industrial Tariff and Incentive Policy Issues 87. Wfith the generally narrow raw material base of the area, the new industries serving the regional market will be increasingly dependent upon imports of the necessary inputs. Moreover, they will tend to be found among products for which economLies of scale in production will limit the possibilities of competition within the region. In these circumstances, the development of appropriate tariff and incentive policies to ensure the establishment of economically sound enterprises becomes increasingly important. These will be particularly important for the future in order to avoid the possibilities that, policies on these matters might operate to limit competition, with adverse effects on prices and qualities of goods produced. 88. The present common tariffs represents the result of long and complicated negotiations among the five countries. Yet economic conditions change and it can be expected that pressures for various adjustments on tariffs will grow. SIECA has in fact already received a number of requests for tariff adjustments and the Executive Council is to act on these at its forthcoming sessions. If approved, they would require ratification by the several governments. While there may be resistance to reopen negotiations so laboriously completed, it is hardly avoidable that new adjustments should take place; moreover it is desirable if the region is to continue to grow. It is vitally necessary that some agreement be reached on criteria for adjusting the tariffs. Where upward revisions are requested, their approval should be based on the expectation of achieving a cost of production reasonably competitive with world prices, in a reasonable time. In other instances, procluctive sectors, such as agriculture, which require access to low-cost intermediate products, so that they may operate efficiently, particularly if tthey face competition in world markets, may need reductions in tariffs if these affect them adversely. 89. Most likely, the major revisions in the tariffs in the immediate future are likely to be sought by recourse to the Special System for the Promotion of Productive Activities, part of the San Salvador Protocol to the Integration Industry Agreenent (1963). The special system was designed to stimulate establishment of "new" industries "of particular interest" for the development of the region. Under it, special tariff increases may be granted by protocol to come into effect upon a determination that the proposed beneficiary industry has sufficient installed capacity to satisfy 50 percent of regional demand. The first two expressions are loose and the capacity criterion has no apparent economic justification. Prices are not set in the individual tariff protocols, although the Executive Council is charged with maintaining vigilance to avoid prices excessivelyr higher than those prevailing in world markets and imports from abroad may be authorized at the former lower common tariff level (or former national tariff if applicable) in such instances. But there is no mechanism specified to ensure systematic determination of prices and costs. M4oreover, there are no provisions for any systematic or periodic tariff reviews or adjustments, and the criteria for the applicability of this special system are loose, and open the door for what could turn out to be dangerously large increases in tariffs. Tariff increases under this system have gone into effect recently for plants producing electric light bulbs, glass bottles and machetes and a large number of additional requests have been filed for tariff increases under this provision, including some types of insecticides. 90. The Special System was, in essence, designed to supplement the Regime for Integration Industries formulated in 1958 before the decision was taken to move rapidly to complete freedom in intra-trade; once the countries moved toward this liberalization, the incentive features of the Regime were of little effect. Under the Regime, industries (in practice, individual plants or establishments) designated as "integration industries" would be given free access to the whole Central American market, with special tariffs and tax incentives. Imports frorn outside would only be allowed if the plant could not meet the needs of the market, and other competitors would be subject to existing Central American tariffs in diminishling degree over 10 years. Moreover, since unanimous agreement would be needed to give similar privileges to a new competitor, a monopolistic position was in effect assured. In exchange for these privileges, the designated integration industry would adhere to specified quality standards and price limits and follow norn-discriminatory pricing practices. Under the integration industry scheme, the advantages of size would be obtained without, in theory, the evils of monopoly; equitable or "balanced" dis- tribution of its benefits would be assured by the proviso that no country could have more than one such plant before the others had one. So far, "integration industry" status has been concluded for a tire and tube factory now in operation in Guatemala, and for caustic soda and chlorated insecticide industry to be completed in Nicaragua in 1967. A protocol granting integration status to a sheet glass plant for Honduras was agreed in 1965 but has not yet been ratified. A draft protocol for another tire plant in Costa Rica has been prepared but has not yet been acted upon by the Executive Council even though the plant is under construction. The margins of protection accorded to these industries have been considerable (in the case of tires, the effective tariff in 1964 was 126 percent ad valorem as compared to an average of 10 percent under the previous national tariffs), in some instances the prices fixed by the protocol vwere at levels loTwer than the c.i.f. prices plus approved duties mainly as protection of "unfair" or "dumping" competition from abroad. Once the countries moved toward trade liberalization, the incentive of internal tariff advantages for an "integration industry" over potential competitors lost its effect. Hence the integration industry scheme appears to have doubtful practical significance for the future. - 36 - 91. There is need to subject the applications for tariff increases under the Special System to the economic tests and administrative procedures suggested in connection with possible renegotiations of items in the common tariff. There is danger that the Special Regime, by providing the outward appearance of technical criteria and regional considerations, may become an instrument for the trading of reciprocal concessions among the five countries in the name of regional industrial development without due regard to costs and efficiency. Procedures and standards now in effect for tariff adjustments are deficient: all changes are by protocols, to be ratified by five national assemblies and the criteria for adjustment are lost in inadequate analyses plus the process of bargaining for mutual advantage. The mission believes that an effective approach to these problems would be through the creation of a Tariff and Industrial Commission discussed below. 92. As noted above, there has been excessive competition among the countries in granting fiscal privileges for industries. The need to har- monize the national legislation on fiscal incentives was recognized in 1962 when an Agreement on Fiscal Incentives was negotiated. This has not entered in force since Honduras made its ratification dependent upon preferential treatment; this was later agreed in a protocol in September 1966 which must be ratified by the other countries before being ratified by Honduras. Yieantime, the national incentive systems remain in force. 93. Even when the Agreement on Fiscal Incentives comes into force, it will be administered by national agencies. Qualification and classifi- cation of industries for exemption shall, according to the Agreement, take place on a "Central American basis" not later than the seventh year. It is not clear whether this means that administration shall be vested in a Central American authority within seven years. Even if such an interpreta- tion, often adduced by Central American officials, is valid, there will still be national administration for up to seven years. While the Agree- ment is somewhat more explicit than national laws as regards the criteria of classification, it still leaves substantial room for administrative discretion. Only on complaints from other countries may the Executive Council review the classification given by a national authority. Under these circumstances a central administration should be established as soon as possible. Moreover, the application of the criteria should be based on more careful review than hitherto of the benefits to be achieved and the contribution of the incustry to economic growth, as well as to prevent the proliferation of plants which may be uneconomic and create substantial excess capacity. While central administration would be a long step forward in reducing competition in granting of fiscal privileges, it would not fully end it. Income taxes (unlike tariffs) are not uniform and exemptions from them may be more significant in one country than another. Thus there is need to revise and improve the industrial incentive system. In fact SIECA has recently been instructed by the Economic Council to prepare a general revision. The mission considers that in so doing, it should give great weight to: (a) the elimination of exemptions on income taxes and to the institution of proportional taxes on business incomes in four countries; (b) a shift to accelerated depreciation of investments, and (c) the granting of tariff exemptions for products rather than for specific enterprises so as to avoid difficulties in distinguishing between new and established industries. - 37 - An Industrial and Tariff Comaission 94. From the foregoing review of tariff issues and the fiscal incentive system, the mission concludes that one of the most urgent needs of the integration movement is to establish a regional authority to administer centrally the granting of all concessions or privileges under the terms of the Central American Agreement on Fiscal Incentives for Industrial Development. Decisions on incentives should take account of protection provided by existing tariffs or which would result if requests for tariff adjustments were granted. Public action in the tariff and incentives fields could best be coordina-ued by establishing an autonomous Regional Tariff and Industrial Commission to administer centrally the industrial incentives system and to consider all cases of tariff adjustment with powers to increase or decrease existing tariffs within a certain margin (e.g. 50 percent), without further reference to political authority. The Commission should also be auth-lorized to exercise powers to grant quotas for imports at the common tariff in the case of the specially protected industries if needed to pro lect the public interest; such powers are now vested in the Economic Council. 95. The proposal to centralize authority over these matters in an autonomous regional body may well encounter serious political difficulties. Should the architects of the Common Market not find it feasible to give autonomy to such a Commission, it could then be empowered to make findings and recommendations to be acted upon by the Economic Council, for recommen- dations in turn to Government's for ratification. Both SIECA ani ICAITI j should be strengthened to enatble them to make adequate econozmic, financial and technical studies and recommendations on tariff and incentive problems coming before the Tariff and 3:ndustrial Commission. The economic justi- fications and consequences of tariff adjustments and fiscal privileges will require better analysis and evaluation than has been the case hitherto if the improvements in the decision-making process suggested above are to become effective. C. Investment and Financing 96. Rough estimates of navestment in industry, based on imports of industrial equipment, suggest that it was in the order of CA$65 million in 1962 rising to CA$100 million in 1965. The traditional lines - textiles, clothing, shoes and food processing - accounted for two-thirds of industrial equipment imports in 1962, but fell to one-half as a result of the growth of the newer industries. Growth of industrial investment was especially marked in El Salvador, embracing newer industries such as metalworking and chemicals, as well as textiles. The traditional reliance on private savings and reinvestment of earnings (including those from agriculture or commerce) for investment in industry was buttressed by expansion of commercial bank lending to industry. Year-end balances of commercial bank credits to industry rose from CA$48 million in 1961 to CA$110 million in 1965, mostly on relatively short term, and reflected the sharp increase in needs for wzorking capital as industrial output and regional trade grew. j/ Central American Institute for Technical and Industrial Investigation. - 38 - 97. Long-term capital came from a variety of sources. INSAFI (El Salvador) and INFOiAC (Nicaragua) - both public development institutions - disbursed CA$1-2 million eacn annua]ly, IHFOD\AC also made some equity investments. Direct U. S. private investment, including reinvestment, rose rapidly reaching about US$15 million in 1965 for manufacturing alone; in addition, private investment in petroleum refining reached US$20 million in 1964 though this has since cleclined as the major construction of refineries was completed. Direct private investment from countries other than the United States evidently has been on a far smaller scale. Suppliers credits also have financed privrate industry, although, with the availability of foreign official funds at easier terms, such credits have probably not been substantial. Foreign commercial bank funds channeled through the Central Banks in El Salvador and Guatemala to private industry ranged from US$2-3 million annually from 1962 to 1965. 93. Official external funds from IBRD, IDB, AID, IFC and, lately, the Bank of Mexico, were channeled to industry through CABEI, national public and private intermediaries, Central Banks as vwell as directly to individual enterprises. CABEI confined itself to direct loans. About one-fourth of CABEI's industrial loan commitments totalling CA$32 million came from its own resources and to that extent its loans were not external to the region. As of mid-1966, CABEI had borrowed abroad some CA$36 million for industrial lending - from AID (CA$17 million), IDB (CA$13.8 mil- lion) and Mexico (CA$5.O million). Actual flows of official funds to industr- are sunmmarized below. Total 1962 1963 1964 1965 1962-1965 (in millions CA pesos) Total official external financ:Lpl to industry 2.3 8.9 10.5 15.5 37.2 Indirect 1.3 2.6 3.0 8.9 15.8 via private financieras j - - o.8 3.9 47 via other agencies j 1.3 2.6 2.2 5.0 11.1 Direct 1.0 6.3 7.5 6.6 21.4 from CABEI 3 0h T7; 7 v 17.7 from other sources J 0.4 1.7 0.8 0.8 3.7 j From AID j From IBRD, IDB, AID 31 Excludes financing of indusitrial studies, amounting to approximately CA$0.4 million. 4/ From IFC and IDB directly t,o individual firms. - 39 - 99. Total foreign loan disbursements (including CABEI), together with direct U.S. private investment, some loans from foreign commercial banks, increased sharply from aCbout CA$5 million in 1962 to CA$16 million in 1963, CA$23 million in 1964h and CA$34 million in 1965. External lending thus played a large part in financing the rise in annual manufacturing investment in the last few years. 2 -0. A new channel for iniiastrial finance -was opened up in 1962 when pri;te development banks or "'financieras" were established in El Salvador, Honduras, Nicaragua and Costa Rica. The inpetus to their fcrnasion was provided by AID loans of U3$5 million (US$3 million in lNicaragua) on 20-year repayment terms with low rates of interest (2-2.5 percent); matching local equity was CA$1.0 million in each instance. The financieras initially tended to place their capital in a variety of ventures, some non-industrial in character, on short term, in order to earn a return pending the development of longer range projects. However, their portfolios, from a development point of view, have been improving as industrial projects were worked up and financed. The financieras in Niicaragua and Honduras have committed their funds rapidly and have requested new loans from AID for US$5 million and US$3 million respectively. 101. At the end of 1965, the undisbursed balance from existing loans to industry made by CABEI and external agencies, was approximately CA$23 million. In addition, as of rmid-1966 CABEI had available for commitments for industrial loans about CASI3 million (including CA$S million from an AID loan andr C$. n milli-or froan the Mtjexican loan). The present availa- bili-ties from these balances are not excessive, ar.:urnting to a little over 2 years disbiursements at recent arnrual rates. 102. Despite the uncerta:inty as to the rate of growth in coming years, it seems likely that a continuing and substantial supply of foreign loans and equity capital will be needed. Further rises in output are likely to require new investments among a diversity of industries, even thiough the overall supply of local capital is not likely to expand rapidly in the next few years. Wdhile there wil7 be a need for direct lending for the larger projects now under consideration, such as the Olancho pulp and paper mill, there would be advantage in channeling a substantial portion of new external funds through a regional financial intermediary, which could gauge the changing needs of the area close to the scene. Such an intermediary could assist the existing financieras, work with the public intermediaries, and engage in direct operations, either singly or in participation with other regional or local institutions, in direct financing of new enterprises requiring relatively large capital sums. Proposals have been under dis- cuss_on in Central America 2ooking towar-d the creation of a joint investment company sponsored by the existing prAvSate financieras Kand possit-1> a Panamanian f-.nanciera) with additicnal participation of external Eources, including ADELA. These proposals are evidently at an early stage of dis- cussion and their details are yet to be Twiorked out. - ho - 103. So far, no regional capital market exists in Central America. There have, it is true, been direct investments by nationals of one country into another country (mostly from El Salvador into Honduras), and there have also been a few major industrial projects with equity participations from various countries (for example, the glass bottle factory recently opened in Guatemala, in which the breweries of several of the countries have an interest). With the present pattern of ownership in Central American industry, which is either in foreign subsidiaries or in companies with a small closed number of stockholders, who are either relatives or close friends, a capital market which could mobilize domestic savings, including those of the growing middle-class, for financing industry will talke time to develop. Nevertheless, as capital requirements become larger, such a de-velopment will become a necezsity: the Central American "financiera" discussed above could help lay the basis for such a development. D. Conclusions 104. The substantial expansion of industrial output in Central America in recent years has contributed to overall economic growth, although the share of industry in total GDP is still low. The industrial structure continues to be dominated by the "traditional" industries, such as food processing, beverages and tobacco, textiles and shoes and clothing, Twhich account for three fourths of total industrial output. In the last few years, however, the output of newer branches of industry - including petroleum refining, chemicals and metal products - grew more rapidlyr than the traditional industries. Many cf these industries require a large component of imports for their operation. add little to the final value and do not contribute much to emploYment. l05. Recent industrial expansion was stimulated by increased incomes arising from the export boom arid by removal of trade barriers within the Common Market. Exports within the Common IMarket accounted for about one-fifth of total increase in industria] output. The Common Tariff, although generally higher than the average of the previous national tariffs - very often substantially so - was a stimulus in some cases. But there have not been appreciable rises in general indices of prices, largely owing to increasing competition, particularly stemming from specialization by product lines. While national systems of fiscal incentives existed before the Common Market was created, the larger regional market permitted such fiscal incentives to play a much greater role in stimulating industrial investment, hence competition among the countries in granting privileges developed rapidly. New or expanded national and regional financial ins- titutions, with increased resources, also contributed substantially to industrial growth as did foreign private investment. 106. Industrial production hlas been the main beneficiary of free trade in the area; manufactures accounted for about two-thirds of the expansion of intra-regional trade in 1962-65. Substantial, and in some lines total, import substitution took place. The expansion of regional trade represented trade creation rather than trade diversion. However, the growth of imports of capital goods, raw materials and semi-manufactures needed by Central American industries caused the ratio of imports from. she outside to GDP to increase (see paraoraph 162S). Or the ;hole t'.e in:uustrial expansion o2 1962-1965 i:as a positive factor of econonic -ro2ta in real ternis. - 41 - 107. Substantial and worthwhile opportunities for import substitution still remain. Industrial growth on this basis in coming years will probably be much more restricted than in the recent past; with a much slower rate of growth of major exports to the outside world than in the recent past, growth of incomes and hence internal regional demand is likely to be less rapid than previously. Wlith the limitations of the size of the Comnon Market, public policies and activities should be increasingly aimed at the development of exports to the outside world; several elements of public influence could play a part, such as the granting of fiscal incentives, assisting in financing, providing technical assistance in studies or promotion of new lines. The most promising possibilities are forest products, meat, canned fruit and vegetables, and possibly textiles; these would involve processing resources which the region has or could develop in abundance. 108. For these industries as well as lines which still offer possi- bilities in the internal market, the public authorities, in exercising their influence and power, will need to give greater consideration to production costs and efficiency than they have in the past. This is particularly true for products which constitute inputs for other productive activities, principally agriculture, which must compete in the outside markets. In this respect, the most essential step is to put an end to competition among the countries in granting privileges which seems bound to occur even under the Agreement on Fiscal Incentives for Industrial Development, still to be completely ratified. Administration of privileges should be centralized in a regional authority so as to reduce the com- petition which will take place under national administrations, and the system itself should be improved. Moreover, the process of adjusting tariffs, which may need to be adapted to new opportunities and new con- ditions within the Common Market, should be improved. The functions of administering fiscal privileges and of tariff revision should be coordinated; thus they should both be lodged in a single Regional Tariff and Industrial Comminsion with powers to consider all tariff adjustment cases, and to raise or lower tariffs within stated margins. If these improvements in adjustment of tariffs and administration of fiscal privileges are to be- come effective, it will be necessary to strengthen SIECA and ICAITI to enable then to make adequate studies on problems coming before the Regional Commission. 109. Industrial growth should continue to receive assistance of external public and private captial, possibly for some large projects now being studied, both directly and through financial intermediaries. It is too soon to say whether a regional financiera, supplying capital to industries or intermediaries of the region and helping to mobilize local capital, which has been under discussion, should obtain support from official capital. Application of external capital would be far more effective within the context of policies fostering sound industrial growth of the region. An urgent and concrete measure is to establish central administration of the Agreement on Fiscal Incentives and to improve the system. Revision of tariff making machinery, while urgent, is likely to involve difficult negotiations, but a beginning should be made. In any event, external funds should give priority to industries likely to endure without high tariffs, contributing large value added and especially to those capable of being export-oriented now or in the visible future. - 42 - IV. PUBLIC INVESTIENT A. Public Investrient in the Recent Past 110. Public investment has not been a major component of aggregate demand in Central America. For the region, it has fluctuated between 4.4 and 2.8 percent of GDP over the last decade staying usually slightly above 3 percent. These levels have not differed significantly among countries, although they have been usually lower in Honduras and some- what higher in Nicaragua and Costa Rica. Despite an increase of 48 per- cent of regional GDP over the same period, the ratio has remained prac- tically stationary in three countries over the last eight years, and even dropped in Guatemala and Honduras. Due to its small relative mag- nitude, public investment has not been important as a stabilizing influ- ence on the level of economic aictivity, which continues almost wholly dependent on exports, the dominant factor in determining output, incomes and public revenues in all countries of the region. 111. Direct public investment has played, nevertheless, an important role in the economic progress of the past decade by substantially expanding the basic infrastructure required for economic growth. Broadly, direct public investment has corresponided to the most essential and urgent needs of the individual countries and their economic integration. The construc- tion of the Pan American Highway in the early fifties and of the Pacific Littoral Highway through Guatemala and El Salvador, provided overland transportation and facilitated development along the Pacific slopes, where the main population centers and production areas are located. The Atlantic Highway in Guatemala, the Western Highway in Honduras and the road from Tegucigalpa to the Pan American Highway - which will link to the North Road from Tegucigalpa to Northern Honduras now under construction - have linked large areas of these two countries to the main transportation arteries along the Pacific side, thus linking the most impo-rtant develop- ing areas of the five countries. The construction of other roads in El Salvador, Nicaragua and Costa Rica to their shipping ports in the Pacific and in Guatemala and Honduras to their main ports in the Atlantic, have complemented the railroads which were the only transportation facilities to the shipping ports up to relatively recent times. The roads built over the last two decades and those progran-med for completion or improve- ment over the next few years thus serve the multiple purposes of promoting growth of exports to external markets, linking the countries more closely together and facilitating intraregional traffic and travel and stimulating development of new agricultural and industrial areas. Closely related to the development of overland transport were important port development works, particularly in Nicaragua, Guatemala and El Salvador. 112. The expansion of the road network was accompanied by a very substantial growth in traffic. Vehicle registration slightly more than doubled in the past ten years, both as a result of the greater use of passenger vehicles resulting from the process of urbanization but, more important, the increase in commercial traffic, which rose especially in the last few years; truck regi3trations practically doubled in the decade 43 - and their carrying capacity uncLoubtedly increased even more. Truck hauling has taken up most of the substantial increase in the volume of trade with countries outside the region. Intraregional traffic, moved almost ex- clusively by truck, increased from 45,000 tons in 1961 to 222,000 tons in 1965. A substantial increase in land utilization and growth of population has occurred betweern 1952 and 1963 in the areas traversed by the roads constructed or improved (see MELp I); a striking example is the development of cotton production in the Pacific coastal plains of Guatemala and El Salvador following the construction of the Littoral Highway. 113. Besides roads and ports, air transport has progressed substan- tially. Airports in capital cities have been enlarged and improved to accommodate jet aircraft, thus providing cheaper and faster transport services which may be of importance for promotion of exports of certain categories of products, some of which are beginning to take place. Many local airports were built enab]ing the Central American countries, with their difficult topography, to advance from primitive transport modes, sormetimes changing from mule back and cart hauling directly to the air-- plane. Wqhile trunk and feeder roads are needed for the large bulk of cargo traffic, alr transport has an important role to play in movement of certain categories of goods and passenger travel. Given the physio- graphy of the Central American area and the dispersion of many potentially productive areas, air transport often offers cheaper and more feasible transport in linking these areas to regional markets and international air routes than second class or difficult local roads. 114. Electric power has been second only to transportation in public investment in Central America. Installed capacity and power generated have increased by about one and one-half times in the last ten years, and consumption more than treb'led. Economic growth was thereby stimulated: while residential and governrnent consumption has doubled, industrial con- sumption has grown about five times and commercial consumption about four. Pubilic ernterprises play the major role in power expansion. Although they have been strengthened and are generally capable of administering and maintainirig their systems efficiently, some of them are still weak in long-term planning. 115. Public investment in education has been a minor part - about 4 percent - of total public investment in Central America in the last decade; in proportion to GDP it was much lower than in many countries with lower per capita incomes. Educational systems were significantly expanded in the last fifteen years by increasing the number of classrooms and teachers at the primary ana intermediate levels. Despite large in- creases in school-age populatiDn, four of the countries have succeeded in raising appreciably the ratio of enrollment to school--age population. This expansion has been reflected, however, in substantial increases in recurrent expenditures while fixed investment in school buildings, labora- tories and libraries has remained small. The needs and problems of the five countries are very similar. Hence the countries have entered into an agreement (in force among all countries except Costa Rica where ratifi- cation is pending) by adopting a similar structure of courses and minimum curricula at the primary and intermediate levels. The agreement recognizes the validity of national training certificates throughout the region and - 44 - validates services rendered by teachers in the different countries for purposes of promotion and retirement; these provisions aim to facilitate the use of the teaching force throughout the region. The possibilities of education projects which could offer definite advantages if undertaken on a regional basis will be extmined later in this chapter. 116. Direct public investment in agriculture and industry has been very limited in Central America; the bulk of investment outlays in these fields originate in and are made by the private sector although special credit programs by which public finanLcial intermediaries channel public domestic and foreign funds to the private sector have been growing in importance and have played an -Important role in some countries, notably in Costa Rica. These have been discussed in the Chapters II and III. B. Public Investment P:rograms Through 1969 and 1970 117. The Central American countries, through the National Planning Offices in each country, with assistance provided by the Joint Planning Mission sponsored by ECLA, the OAS, BID, CABEI, and SIECA, formulated national development plans for 1965-1969 (in Costa Rica from 1964-1968). The development plans, while national in character, were to be harmonized at the regional level, so as to avoid inconsistencies and ensure that in- dividual programs might not have adverse effects upon the possibilities of other countries achieving their potential within the common goal of economic integration. 118. The tabulation below summarizes the planned investment expendi- tures for 1966-1969 in comparison with those achieved in 1962-1965. CENTRAL XAERICA: ANNUAL AVERAGES OF DIRECT PUBLIC INVESTMENT 1962-1965, Actual Expenditures; 1966-1969, Official Country Programs (in million CA pesos) Guatemala El Salvador Honduras Nicaragua Costa Rica 1962- 1966- 19e2-_ 1966- 1962- 1966- 1962- 1966- 1962- 1966- 1965 1969 196)5 1969 1965 1969 1965 1969 1965 1969 3/ Transport 11 27 5 12 6 20 9 13 5 20 Telecommuni- cations 1 3 .1 1 1 1 1 1 1) 11 Power 3 15 4 6 4 6 5 6 10) Education 1 6 1 6 1 2 1 3 1 4 Health and water 3 15 3 6 1 6 2 5 4 10 Housing 2 8 3 13 - 2/ 3 1 6 2 6 Agriculture 1/ 2 21 1 6 - 2/ 10 - 2/ 6 - 2/ - 2/ Other 6 6 2 8 3 6 2 2 1 2 Total 29 101 19 60 15 54 21 42 25 52 1/ Excluding credit programs. 2/ Less than CA$1 million. 3/ The Costa Rican program extended to 1968 only. - 45 - Comparing the levels of investment planned for 1966-1969 with thcse achieved in 1962-1965 for the region as a whole, the average annual increase would amount to some 28 percent. These planned levels are on the ambitious side and will probably not be achieved in full due to the variety of factors examined in the following chapter (and in individual country chapters in Part II). However, the mission believes that it should be feasible to raise investment levels in 1967-1970 about 75 percent above their 1963-1966 levels, bringing investment u) to some 4.5 percent of GDP in 1970 as com- pared with 3.5 percent in 1966. l/ The mission's estimates of 1967-1970 direct investment, by countries, in comparison with levels achieved in 1963-1966, are shown below. Average annual % increase Annual Averages 1963-1966 1/ 1967-19,70 (in mill'ion CA pesos) over over Country 1963-l9667L/ 1967-1970 1959-1962 1963-1966 Guatemala 27 45 3.5 14.0 El Salvador 24 51 15.6 21.1 Honduras 16 37 9.9 22.6 Nicaragua 25 41 14.8 12.8 Costa Rica 28 36 11.4 7.4 Total Region 120 209 7.5 15.0 1/ 1966 investment data based on estimates of national authorities. Source: Tables 18a-e and 20a-e. In addition to direct public investment, the mission has also estimated possible indirect investment, in the form of credit programs to the private sector for both agriculture and industry. They might amount to an average of CA Pesos 40 million annually in the region, of which more than half would be for agriculture. The country programs have a fairly high propor- tion of prepared projects with a reasonably high degree of priority; this represents a major achievemert compared to the situation ten or even five years ago and should permit the needed increases in inflows of foreign funds to supplement local public savings. 119. The Government's investment plans are primarily national in scope, though they also reflect considerations of a regional character to some extent, primarily for highways. With five well-defined centers of economic activity and little permanent migration between the countries, it is not surprising that the programs for housing, water supply, health and education are almost entirely designed to cope with national problems. The main sectors where regional considerations ought to enter and which have in varying degrees been discussed among the countries are communica- tions (road transport, ports, and telecommunications) and to a lesser 1/ The mission estimated possible investment levels in 1970, based on known programs and projects of the several countries (see Table 20 a-e), - 46 - extent electricity (interconnections among the country systems), agri- culture (especially the regionaL grain storage program) and scme areas of education; these are discussed in the next section. 120. By and large, the government programs are generally well con- ceived in terms of objectives and balance among sectors and largely correspond to their priority needs. The programs still are heavily concentrated in transport. This is understandable as, despite important progress in the last several years, the road construction and improvement programs for the next few years represent in large part the completion or improvement of the basic road network in the Pacific side and the linking to these main arteries of large areas in Western Guatemala and Northern Honduras and some highly productive agricultural areas in Eastern Nicaragua and Northern Costa Rica. While providing for national needs, the programs include important roads wthich would help comolete the regional road network. 121. The larger than average proportion that transportation represents in the total investment program of Honduras reflects its larger needs in comparison with the other countries, particularly the need to link the rich and rapidly developing northern area of the country with its central part and the main arteries of regional traffic. The lower than average propor- tion of transport in El Salvador's total investment program reflects the greater advances made by the country in this sect.or; in good part, the transport investment programmed is for improvements in the main trunk routes of the Pan American and Littoral Highways. The programs in Nicaragua and Costa Rica contain projects which in the opinion of the mission are not of as high priority as others and which could therefore Jeopardize or delay the completion of priority roac`s since the full programs may be too large to be carried out fully as planned. 122. The investment in ports represents expansion or modernization of the main Corinto port of Nicaragua - on the Pacific - and of Honduras and Costa Rica on the Atlantic. Except Costa Rica, where insufficient priority appears to have been given to the road from Siquirres to the Atlantic sea- board to provide access to the much needed port contemplated in the de- velopmenit plan, the port and road programs fit well together. 123. The investments projected in electric power are generally well designed to satisfy needs for expansion. However, past delays in executing major projects in Guatemala, El Salvador and Ricaragua, and to a lesser extent in Honduras, may require supplementary installations to avoid short- ages in the next few years should demand continue to increase at past rates. The investments planned in education, while a substantial improvement com- pared to the past, still fall short of the needs of the next few years if the educational systems, which suffer from serious deficiencies, are to be improved in quality and output. However, even the relatively modest levels programmed in education may no,"; be achieved because project preparation has been lagging in the last two years. The outlays planned in public health and water supply and sewerage are much needed, but seem to the mission con- siderably beyond the present capabilities for implementation in most of the countries. - 47 - 124. The mission's estimates of the distribution of possible public investment for 1967--1970 among sectors is shown below: CENTRAL AVERICA: DISTRIBUTION OF PROJECTED DIRECT PUBLIC INVESTMENT BY SECTORS AND BY COUNTRIES, 1967-1970 (in percentages) Central El Costa Sectors America Guatemala Salvador Honduras Nicaragua Rica Transportation 40.0 43.3 25.1 50.2 38.3 47.5 Telecommunication 5.1 5.3 5.8 5.5 3.2 5.4 Pouer 14.9 18.2 11.9 12.1 19.4 12.8 Education 9.8 7.2 13.6 8.4 6.9 11.6 Health and Sanitation 11.4 9.4 14.9 9.3 10.3 12.1 Public housing 10.3 8.5 15.4 6.4 12.3 7.2 Agriculture 8.6 8.0 13.2 8.1 9.3 3.4 Total 100.0 100.0 100.0 100.0 100.0 100.0 Source: Tables 20 a-e. In all cases transportation is the largest individual sector ranging from 25 percent of total investmenlt in El Salvador, which is tending to level off its road construction effort, to about 50 percent in Honduras and Guatemala mainly due to large major highway investments. Telecommunications and elec- tric power together are next riost important in size, constituting from 17 to 23 percent of the total in the several countries. Investment in the social sector - education, health and sanitation, public housing - varies considerably from country to country but overall it comprises about 25 to 30 percent of the total investment in four countries; in El Salvador, how- ever, it would be almost 45 percent because of its efforts to provide its dense population with education, water supply and housing, after having invested heavily in physical infrastructure. Direct investment in agricul- ture constitutes a relatively small share of total investment - a little over 8 percent for the region - rather lower in Costa Rica and highest in El Salvador where important irrigation projects are being scheduled. This relatively small share, as indLicated above, is likely to be very substan- tially increased by government efforts to channel local and external public funds to agriculture through special credit programs. C. Projects of Regional Significance Roads 125. The five Governments have for several years discussed the needs for a regional road construction program. 1/ In 1963 they designated 13 roads as Central American `integration" roads (designated by a "CA" number) 1/ See Volume VI - Transportation and Map I. - 48 - basic to the region and agreed to complete new construction or improvement. These C.A. roads have a combined length of some 5,000 kmss; about three-fifths have been constructed, some 1,500 kns are under construction and 750 kms still to be constructed or improved. Likely expenditures on these roads, in 1966-1969, are estimated by the mission at about CA$97 million, or about 35 percent of the probable combined outlays of the five countries on all types of roads. 126. After the United States Government, following the visit of President Kennedy to Central America early in 1963, offered to assist in financing a Fund for Central American Economic Integration, the five Governments and the United States agreed that this fund, at least in its first stages, should be used to finance the improvement or construction of roads in the Central American system. The fund, administered by CABEI, was initially established at US$$42 million, of which US$7 million equivalent is contributed by the countries and the remainder comes from a USAID loan. A first tranche of loans totaling US$30 million has already been committed in 1966 and early 1967; the distribution of the remaining US$12 million is still under consideration. (In early 1967 the Inter-American Development Bank approved loans of US$15 million equivalent to CABEI for the Integra- tion Fund.) The conditions of the first tranche lcans were designed to stimulate the interest of the several countries in constructing regionally important roads; thus they cover 100 percent of the estimated project cost and bear an interest rate of 3. 5 percent per annum with a maturity of 25 years (including 7 years of grace). 127. An important aspect of the Integration Fund from the regional point of view is that while the national contributions are in equal shares, the use of the funds are not to be related to national contributions, but should be apportioned among the countries in accordance with the invest- ment needs of the region considered as a whole. It is to be a common, regional fund to be utilized on1 the basis of regional rather than national considerations. Each of the five countries in fact received part of the first trarche loans from the fund, some for roads deemed to be of regional importance even though they had not been designated as "integration roads." However, Honduras, centrally located in the region and lagging in road construction relative to the other countries received the largest share, almost one-third of the first tranche. 128. The road construction covered by the first tranche of loans from the fund would cover roughly a third of the countries' combined proposed investment in integration roads in the period 1966--1969. Substantial portions of the integration road system, particularly in Honduras and Costa Rica, are to be constructed or improved with financial assistance from IBRD/IDA, IDB, and Eximbank. 129. The strategy of the large integration road program is to improve the Inter-American Highway, the main artery of the Common Market, up to a uniform standard in all the countries, to construct or improve other im- portant roads providing better connections between the countries, and to begin integrating into the Central American and national economies produc- tive areas, mostly towards the Atlantic, which do not at present ha've an - 49 - adequate road connection with thle rest of the region. One such area is the Coban area in northern Guatemala, which will ultimately provide access to the soutthern Petena and the farming and forestry resources of the Polochic Valley. 1/ Another is the northlern coast of Honduras which, although it is the main tanana producing area in Central America and has a recognized potential for livestock production, does not have an adequate land connec- ticn wi4th the rest of the count:ry. HSowever, the Eastern IHighw-ay to the Atlantic in Ficaragua, and the road linking the Central Plateau to the Costa I;ican Atlantic port of Limnon are rLot listed among the 'integration"' roads. in terms of development potential and of providing a road connection to a major a:rea of the Costa Rican ana also of the Central American economy, the latter project probably deserves a high priority in the immediate years ahead in a Central American high:way program. 130. Among the connections between countries which have in principle been agreed upon as integration roads are two new roads between Honduras andl Nicaragua; however, no plans have yet been made to finance the con-- struction of the Honduras side of one of these connections. Another regional connection would be a road between the Atlantic ports of Guatemala and Puerto Cortes in Honduras: such a connection vould provide the indus- trial center of San Pedro in Honduras with a market in Guatemala, develop a relatively accessible and fertile agricultural areas and at the same time permit a more efficient use of the three ocean ports serving the area. Two of these ports are now fed in Guatemala by the Atlantic Highway, and on the Honduran side, by the Western Highway connecting witlh El Salvador and by the 3Nlorth Road from Tegucigalpa. A good road already connects Tegucigalpa to the Pan American Highway. The improvement of all these roads was or is being carried out writh the help of IBBID or IDA financing. While the Honduran road to the Guatemalan border is under way, no concrete plans existed (as of mid-1966) for Guatemalan construction of the remainder of the link betw-een the Atlantic ports. 131. The agreement reached by the countries in 1963 in selecting the "'integration" roads to be built or improved during 1965-1969 and the in- clusion in the national development plans for that period of most of such roads represented a major step in approaching public investment in roads from a regional point of view. However, experience to date suWgests that identification of "integrationrr roads can present difficulties. National and regional priorities, have, in some cases, not been adequately related. Agreewert regarding identification of interconnecting roads and schedules for feasibility studies and constructicn will be required if the further development of the Central American road network is to proceed without unnecessary delay and waste. MWoreover, the preservation of an adequate regional transport network will. require agreement among the five countries on m.ininum standards of maintenance and observance of such standards. Ex- ternal lending agencies could play a useful role in assisting the countries in these matters. 1/ The financing contemplated for this road from the Integration Fund at present includes construction only as far as Purulha which is a little over half the distance from El Hancho, on the Atlantic Highway to Coban. - 50 - 132. As a result of programs of regional and national road con- struction, Central America is likely to have by the early part of the 1970's the kind of highway network which is envisaged for the late 1960's. After the substantial investments in the Inter-American Highway and the Pacific coastal highway in the 1960's and following upon investments which will have been made or are in process in providing major road connections to the Atlantic seaboard, the investment programs in the 1970's should probably place heavier emphasis on opening up new areas with penetration roads and on developing the feeder road system. Ports 133. While investment in roads of regional significance in the next few years will reflect decisions taken at the regional level, agreement on port development programs does not yet exist. There are only a few cases where one port might serve an area transcending national boundaries instead of several national ports; but these cases could in the next few years become important for the coordinated port development of the region. In view of the removal in recent years of tariff barriers within the region and the creation of a regional common tariff, port planning should begin to reflect regional, rather than primarily national, traffic flows. 134. The Gulf of Fonseca, which includes the shorelines of El Salvador, Honduras, and IJicaragua, is the principal case in point. Nicaragua and El Salvador already have ports serving the general area. At present the Salva- dorean port (Cutuco) is operated by the private International Railways of Central America and the wharf is accessible only to rail traffic. Complex problems of railway - government relationships will have to be solved before its expansion could be undertaken. The Nicaraguan port (Corinto), whose expansion is being planned, will become economically accessible to Hon- duran traffic when the road shortcut from Honduras is completed (probably in the early 1970's). But the Honduran authorities have felt for some time that a major Honduran port on the Pacific coast might be necessary for the more rapid development of its Pacific coastal region even though it might be more economical to ship through Nicaragua, once the new road is built, or even through El Salvador. L/ SIECA has been endeavoring for some time to develop the bases for a joint study of the agricultural and indus- trial potentialities in the Gulf of Fonseca area and of the transportation facilities needed to provide a sound basis for regional development. Funds for port feasibility studies have been included in the US$4.6 million loan made by the Bank in 1966 to Honduras for the develcpment of Puerto Cortes. Clearly, there should be close consultation among the countries, the re- sponsible Central American organizations, and the external financing agen- cies before decisions to initiate important new port facilities in this area are made. 135. Two other areas might be suitable for coordinated regional port development. The Guatemalan authorities have been planning to construct a modern deep-water port on the Pacific coast (at San Jose or Champerico) 1/ Preliminary evidence is given in Central American Transportation Study, T.S.C. Consortium, 1964-1965. - 51 - to replace the two lighterage ports now in operation. At the same time, the capacity of the Salvadorean port of Acajutla (120 miles from Guatemala City) is being increased, as part of a long-range expansion. While expan- sion of cotton production in Guatemala in the seventies might supply sub- stantial traffic for a Guatemalan port, given the large expenditure investment (probably CA$16 million) required for a new port, the alter- native of relying on expanded facilities in El Salvador should also be explored. One other case is that of the Atlantic ports of Guatemala, one of which is at present being expanded, and Puerto Cortes in Honduras, which is about to be improved with the help of an IBRD loan. At present, the ports serve two distinct hinter:Lands; however, with the possible improve- ment of a shortcut road from El Salvador to Guatemala's Atlantic Highway and the construction of a road connecting the ports on both sides, there would be increasing choice for Salvadorean shippers among the Atlantic ports of Honduras and of Guatemala. jUthough the next stage of expansion of the Atlantic ports - beyond the present one - is still some years away, the decision on this further stage should take into account the coordinated development of the Atlantic ports in both countries. 136. Aside from these three cases the other major port development projects in Central America do not pose significant issues of regional coordination. But the cases described make it clear that Central America will need to draw up a region--wide program of port development in the next few years, if the best locations for expansion are to be chosen from the point of vilew of one common marlket economy. 137. Taken together, the road and port development investments will have substantially integrated the five countries and their main economic areas in a physical sense by the early seventies. During the same time, a common external tariff will have been established on all items and the limited barriers to trade within the area will have been removed. Under these conditions, the choice of routes and of ports in receiving imports and shipping exports will 'be determnined exclusively by transport costs. If such total transport cests differ significantly among routes, changes in the existing traffic patterns may take place which raay have far reaching effects. For examnule, they cou]d affect custom duties revenues of the individual countries and thus the prospect of achieving the customs union which is one of the main objecti-ves of the General Treaty. If the coun- tries cannot agree soon on a system of apportioning the regional import duties revenues among the countries, later shifts in the pattern of trade may make negotiation of the customs union more difficult. Again, the harmonization (by adopting common standards) of port handling and road user charges, which now vary widely among countries, will need to be accomplished in a not too distant future if the transport network and ports are to function at optimui efficiency. Telecommunications 138. There has long been general agreement in all the Central American countries that a system of modern telecommunications between the countries is necessary. The rapid increase in regional trade has increased the urgency of providing a regional system, which would require a relatively - 52 - small investment. At present, service between the countries is expensive, slow and unclear, and some of the telephone calls have to be channeled through the United States. In addition, the lack of a Central American system impedes the establishment of a wider Latin American system from Mexico to South America. Since 1965, the Aerial Navigation Corporation of Central America (COCESNA) has been leasing a few channels for private telephone service, but these facilities are very limited and will eventually be needed to service the rapid increase in air navigation. 139. In 1961, the five coumtries and Panama jointly approached the United Nations Special Fund and were granted financial assistance for a study of a regional Central American network and national telecommunications needs of the several countries. The IBRD was named executing agency and the study was completed by French consultants early in 1964. It recommended, in view of the differing stages of skills and development of the national telecommunications authorities, that an autonomous regional corporation be established to finance, construct and operate the regional system. The idea of a separate regional corporation failed to obtain the support of the majority of the countries, and, as an alternative, the countries in April 1966, in the Treaty of Managua which is still to be ratified, agreed to go ahead with the construction of a regional system on the specifications pro-- posed in the UI,SF study, but w:Lth each country constructing and financing its segment of the network. A coordinating technical committee would be responsible for arranging the ,oordinated calling for bids, construction and operation; but without establishing an autonomous corporation. The countries are at present discUssing the ways in which to put the Treaty into practice and are seeking -he necessary financing for the equipment. With revisions in the design of the system to provide for higher initial capacity and also to provide for possible transmission of television pro- grams, the total cost of the reLgional facilities would be about $10 million. Before the countries can proceed effectively with the project on a coordina- ted basis, they will need to en.isure that the coordinating committee has sufficient powers to carry out construction smoothly and to plan for the next stages of expansion. Arrangements remain to be worked out with the Panamanian authorities and the private telephone company there (which were not parties to the Managua Treaty) and Mexico under which the Central Anmerican system would be connected to the existing systems of these coun- tries and other parts of the world. In relation to the relatively small investments needed, the proposed regional telecommunications network is the highest priority regional investment in Central America at this time. Electric Poter 140. Until recent years, no need was felt in Central America for electrical interconnections between countries. With demand for electricity principally limited to the capital cities and taking into account the dis- tance involved between these cities and the relatively limited size of their power systems, there has been little scope for possible interconnections between the systems. 141. One exception is the proposed interconnection between the main systems of Honduras and El Salvador. This has been under discussion for some years between the two countries and in the United Mation's Central - 53 - American Mission for Electrification and Hydraulic Resources and the sub- committee on electrification. The main feature of the project, as described in the feasibility study, 1/ was to construct a transmission line to San Salvador from Lake Yojoa in Hondiuras where a 40 mw hydro plant would be con- structed near the existing plant. About half the output of the new plant would be reserved for El Salvador. As envisaged in 1964-1965, when the project was under most active discussion between the two national power authorities, its immediate purpose would have been to bridge a gap in El Salvador's power requirements a-t the end of the sixties. The Honduran Goverlment, however, has been slow to decide whether to go ahead with the project, partly because it felt that its development plans for the Pacific Coast would absorb all the energy produced by the new plant in Honduras. As a result of the delay, El Sa:Lvador had to reach a decision on expansion of generating capacity to meet its growing needs and it proceeded with the construction of a thermal plant at Acajutla. While the need for the pro- posed interconnection is no longer immediate, the two countries have con- tinued discussions to establish whether there is a basis for working out an agreement for a long-term exchange of power which would justify the con- struction of an interconnecting transmission line, but progress has been slow . 142. Two other interconnection projects which have reached the stage of preliminary discussion among governments are local in character and do not involve linking the major national networks. One proposes linking the Golfito area in Costa Rica with the Chiriqui system in Panama and re- lying on one larger source of supply rather than on the two small plants now serving the area; however, the proposed site in Panama can only be economically developed once a much larger demand exists than that of the two systems combined in the foreseeable future. A similar arrangement has been discussed for the border area of Nicaragua and Costa Rica, but discussions have so far been preliminary. 143. In the next several years, the interconnection of the systems of the various countries will probably not be a pressing need, since the pos- sible benefits to be gained by -the interconnection of the relatively small-sized systems would not be sufficient to justify the necessary in- vestment in transmission lines. In the longer run, however, as power demand and the power systems increase in size, mutual benefits would be achieved by interconnections. Experience in other countries shows that substantial problems are encountered in working out coordinated power development programs across international borders; hence a sufficiently long period of time will have to be allowed for preliminary studies of interconnection possibilities and problems. In Central America, work in this field is already being carried forward by the United Nations Central American Mission on Electrification working with ECLA and with a subcom- mittee including representatives of the power utilities in the five coun- tries which meet regularly to discuss common problems. This cooperation should be reinforced and expanded to lay the foundation for the future joint planning of integration of power systems. 1/ Honduras-El Salvador Electrical Interconnection and the San Buenaventura Hyd_oelectric Project, February 1964, prepared by Harza Engineering Co. - 54 - Agriculture 144. In the field of agriculture there are possibilities of developing on a regional basis, the program of grain storage that is required for the operation of the Special Treaty on Basic Grains that the countries adopted in mid-1966. If adequate working capital for the purchasing operations of the National Grain Boards is provided by the respective Governments, the external lending agencies cou]d have a useful role to play in helping to finance the construction of the storage facilities needed. Education 145. While most of the educational problems can be handled at the national levels, there are several fields in which joint projects or action would serve the common interest of the five countries. The program begun by the Council of the Central American Universities (CSUCA) aims at con- centrating all the region's postgraduate training in certain fields; 1/ the selected institutions should be more adequately supported and the specialized institutions should be strengthened. Generally, thus far, this program has not made satisfactory progress, in large part because goverr- ments have failed to pro-vde funds to finance travel and living expenses for their respective nationalE eligible to attend these specialized centers. Another fruitful field for centralized regional effort is research on im- provement of education and harmonization of educational standards. Formerly IDE (Institute for Educationel Research and Improvement), supported by the five Central American countries and financed by a grant of USAID, car- ried on useful work in this field. In recent years, due to lack of support, IIME's activities have faltered. IIIIE should be strengtihened and given greater support by the five countries, possibly under the aegis of ODECA (the Organization of the Central American States). Consideration should be given also to establishing a regional institute to provide training for secondary school teachers in fields of specialization which could not be economically provided in one country, particularly science and vocational or technical training. In the field of training for business administra- tion, a matter of importance fbr the future, an interesting beginning is being made by a nonpublic institution located in Nicaragua, supported by Central American businessmen, with advice and assistance from a leading United States university. D. Conclusions 146. The public investment programs of the five Central American Republics as outlined by them for the next few years are all ambitious and unlikely to be completely achieved. Even so, it should be feasible to substantially increase the levels of investment over those of recent years to meet national needs and carry forward projects for regional de- velopment. Much remains to be done in project studies particularly for 1/ The fields selected thus far are: sanitary engineering, public health, chemistry and microbiology; and at the undergraduate level, veterinary science and animal husbandry and microbiology. - 55 - those which will begin in 1969--1970 and the need is acute in agriculture (including credit programs) and in fields in which planning and execution of projects with foreign financing have lagged in the past such as education and public health. On the whole, the general balance of the investment programs and the comiposition of the various sectors appears to be well designed for purposes of development. 147. The investment programs clearly reveal the need for coordinated or regional planning or action in several fields - principally highways, ports, teleconmmunications, grain storage, education, and electric poter. In these fields and eventually possibly others, the countries and the regional authorities as well as the external lending agencies will need to take account of the regional aspects of projects in the various national public investment programs; increasingly there may be difficult questions of relative priorities between projects of national and regional importance at the regional level. Coordination of investment planning of the five countries has been taking form. The heads of the five National Planning Offices meet fairly regularly to review investment problems and act as an advisory body to the Economic Council (formed by the Ministers of Econ- omy). Ministers responsible for particular fields in their respective countries increasingly meet together as do various subcommittees such as those on electric power and teLecommiunications to coordinate their respec- tive programs and to plan for studies of immediate or future problems. Assistance from JOPLAN, now a part of SIECA, and ICAITI in helping countries formulate investment projects or programs which should be suitable for in- ternational financing - making use of available assistance from interna- tional agencies - would be a rewarding field for regional action on invest- ment problems. Moreover, as the economic integration and development of the region advances, the need for coordination of investment plans and the development policies of the five countries will become increasingly apparent. V. DEVELOPMENT FINANCING AND GROWTH A. Introduction 148. The major issue immediately facing the region generally is how to sustain a higher level of investment required for further growth of the economies and the integration of the region when, in the next few years, the rates of growth of GDP will be declining and the balance of payments positions of the countries deteriorating. The policies adopted in order to deal with it will be largely the responsibility of individual countries. This issue presents itself in somewhat different manners and dimensions in each of the countries. Hence the particular situation and prospects of each country are summarized separately in Part II. However, the decisions of each of the countries, will, in many respects, affect the welfare or interests of the others, as well as the success of common programs or policies for integration. The present chapter therefore attempts to present a general view of the dimensions of the region's problems and the major elements in its solution. Necessarily, the discussion at many points is couched in statistical terms. These, particularly as they refer to the future are intended to illustrate and define the direction of trends amd magnitudes of problems, based on assessments and estimates made by the mission. They are, however, subject to wide margins of error and in the event they may well be influenced by the actions within the powers of the governments of Central America, individually or combined. B. Needs for External Financing 149. The levels of public investment needed for national progress and regional integration during 1967-1970 by the five countries, as es- timated by the mission, would total some CA$840 million for direct public investment plus some CA$160 million for indirect investment through special credit programs for agriculture and industry. As part of the pattern of financing such levels of investment, governments would need to increase their levels of public savings substantially, as described in the next section of this chapter. To complement their internal savings, the countries will need to obtain large amounts of foreign financing for projects of both national and regional significance. The possible amount of such external financing has been estimated by the mission on the basis of probable drawings on existing loan balances, plus possible drawings on new loans which may be made during the period by external lending agencies (including CABEI) for projects suitable for external financing (as discussed below). For the five countries, the total of such estimated drawings on external loans in 1967-1970 would be in the order of CA$560 million, including CA$450 million for direct public investment projects and about $110 million for special credit programs for the development of private industry and agri- culture. The drawings for direct investment in 1967-1970 would be twice the amount realized in 1962-19655. While the levels of external financing would vary from year to year during 1967-1970, they would generally tend to rise over the period, as the investment program advanced. - 57 - 150. For the region as a who]e, such external funds would contribute some 54 percent of direct public investment during 1967-1970, ranging from 51 percent to 55 percent among the five countries. (Net of external debt amortization, the external funds would amount to 45 to 51 percent of invest- ment, except in Costa Rica, where extremely heavy repayments scheduled on external bank credits would bring the percentage down to 16 percent for the period.) Such a proportion of gross external financing would be slightly higher than the five country average of 50 percent which prevailed in 1.92-1965 (mainly because of increases in the proportion of external financing for Guatemala, El Salvador and Nicaragua, despite decreases for Honduras and Costa Rica). However, the mission considers this proportion not unreasonable in iiew of the effort to raise the levels of public investment for development, at a time when G'3P will be growing at a slower pace and the balance of payments of countries often will be in difficulty. 151. To assure such flows of external funds, the five countries wJould need to obtain new loan commitments in the order of US$575 million. Of this amount $325 million might be committed during 1967-1968 (including $20 million already signed in late 1966), and the remaining $250 million in 1969-1970. More than half the external borrowing of the region would be for transportation and electric power projects, which have a high foreign exchange component. Based on the practices followed by the several external lending agencies for projects, the total of project loans would be equivalent to about 62 percent of the total of the project costs (varying from 56 percent in Costa Rica to some 70 percent in Honduras and Guatemala). Specific projects already studiec. or in preparation can be identified which would lay a basis for most of the borrowing in 1967-1968. However, identifi- cation of projects is less complete and their state of readiness less advanced for loans to be committed in 1969-1970, and the countries will need to exert greater efforts in the preparation of projects to avoid slippage in their borrowing programs. 152. The terms of lending to the Central American countries by the several external lenders vary- considerably. Generally, there has been - except in Costa Rica in recent years - little accumulation of relatively early maturing debt. Some loans will probably be obtained on virtually concessional terms, and a small portion of borrowing may be repayable in local currencies. The mission has therefore considered that on the average the new borrowing would be at an interest rate of 6 percent, with a maturity of 20 years (including a grace period of 4 years). In the case of Costa Rica, however, this would require a change in the policy of contracting substantial amounts of privately-placed debt with early maturities. On this basis, debt service payments on the new debt which might be contracted through 1970 for public investments projects, plus that already incurred, would rise in the future somewhat in all countries, except in Costa Rica, whose present high debt burden should fall as the existing medium-term debt is amortized. The total debt service burden in relation to foreign exchange earnings in 1970 would be between 5 and 6 percent in four countries and 9 percent in Costa Rica in 1970. Even in 1975 the burden on such debt would range between about 5.0 percent, to 7.5 percent among the five countries. Generally these overall burdens are not excessive in and of themselves and would be within the power of the countries to service without excess strain provided that investment prograns outlined were followed and related econoirie policies necessary to maintain financial stability were implemented. - 5B - C. Needs for Additional Domestic Financing Effort 153. To complement the external funds, all five countries will need to increase the level of public savings both absolutely and in relation to GDP. Fiscal revenues of the five countries increased rapidly in the last several years in response to the boom in exports and incomes. But, while GDP had increased rapidly (46 percent from 1961-1965) fiscal revenues in 1965 remained 9 to 12 percent of GDP, not appreciably higher than they were five and ten years earlier (except in Nicaragua and Honduras). Thus the tax systems evidently failed to increase the fiscal share of the rising income brought about by the exlpansion of exports and the growth of industrial output. Taxes on property remained very low, and generally the highly profitable export sector was not taxed mnore heavily than before. Meanwhile the development of the Common Market and the related industrial policies affected the revenue base adversely; there was a substantial substitution of duty-free imports from within the Common Market for imports from the outside >world, especially in finished manufactures for consumption, and a growth of exemptions from import duties to promote industrial development. The share of foreign trade taxes in total revenues dropped in all countries between 1961 and 1965. Hence in order to maintain revenue growth, all countries introduced new tax measures. Consumption taxes were a principal source, but receipts from direct taxes also rose substantially in four countries, partly as a result of changes in tax structures and also because of improved collection practices. They rose rapidly in Nicaragua where the tax on income of the main export sector was levied by retention of export proceeds. i54. Current expenditures evidently rose less rapidly on the average than the current revenues of the Central Governments in all the countries except Costa Rica5 current savings of the Central Governments tended to increase, except in Costa Rica. Total public sector savings appear to have moved roughly in line with those of the Central Goveriments. The public savings effort of the various countries in relation to GDP improved signi- ficantly in most countries over 1962-1965, as shown below, except in Costa Rica where they decreased; however, the level in Guatemala is still very low, and only moderate in the other countries except in Nicaragua. Public Savings in Relation to GDP Country (Percentages) 1962 1965 Guatemala 1.2 1.6 El Salvador 1.1 2.7 Honduras 1.0 2.6 Nicaragua 3.0 5.6 Costa Rica 3.1 2.8 Internal credit, including non-bank credit, was used in varyring degrees in the several countries, but the tendency was to use bank credit for the public sector in relatively modest amounts. - 59 - 155. Revenue prospects in the several countries to 1970 have been estimated by the mission taking account of some improvement in collection of present coffee taxes, lower rates of growth of foreign trade than in the past, and possible implementation of certain consumption and property taxes which were either being taken or considered at the end of 1966, i.e., with no change in present policies. In projecting current expenditures the mission has considered that it, will be necessary for the several governments to exercise great restraint in non-development current expen- ditures so that current outlays for developmental purposes might increase as needed with the growth of popu'Lation and the projected investment programs. It has also allowed for growth in savings of the autonomous agencies, which however will be absorbed in their investment programs. On this basis, the internal public savings effortof three of the countries will fall short of the amount needed to finance the projected public investment in 1967-1970, even with the assistance of the inBflows of external funds, referred to above, which the public savings must complement. Thus, Costa Rica, Guatemala and El Salvador will need to increase their internal public savings effort by considerable margins, in order to finance the projected public investment programs. The first two need to do so urgently by enacting new revenue measures. In Costa Rica, the neel is particularly acute; failure to restrain rising expenditures, and to provile more revenue leading to borrowing abroad from commercial banks at relativeLy short term, thus raising debt service sharply, and recent recourse to the Central Bank, has resulted in a financial and exchange crisis. The position of Honduras, with its present tax system and revenue prospects (and the foreign financing prospects indicated above), is not likely to be out of balance. Nicaragua has sharply stepped up its tax effort in recent years. It therefore may be able to generate public savings large enough to result in some surpluses; should they arise, they ought to be used to augment the lagging investment effort in certain sectors, especially education and public health, which may occasion some increase in current outlays. Central America: Public Sector Investment and Its Financing by Countries,1967-77 (In million CA pesos) El Sal- Costa Guatemala vador Honduras Nicaraeua Rica Public Investment 21h 242. 162 207 175 Direct l§0 202 7 161 i:; Credit Programs 34 40 16 46 26 Financing 185 191 162 234 107 Publid, aviing 3 77 -T- 137 75 External Credit (net) 98 1-14 82 97 28 (Gross) (125) (132) (90) (118) (97) (Amortization) (-27) (-18) (.8) (-21) (-69) Net Internal Bonds 4 4 - 4 Gap or Surplus (-) 29 1 0 -27 68 Source: Tables 20 a-e - 60 - 156. While there are worthwhile possibilities in some of the countries for increasing public savings by higher charges for public services, or, in some cases, by reductions in Central Government transfers to independent agencies, the major effort to close the gaps shown above will need to come from a greater tax effort. By 1970 this effort would need to produce some 10 to 25 percent more than the revenues forecasted by the mission, with present policies. This might best be accomplished by concentrating on (a) increasing the burden of coffee taxes; (b) increasing consumption or general sales taxes (preferably at the wholesale level) to discourage demand for imports, preferably non-essential items; (c) increasing property taxes since these are now very low and a small increase, even on present valuations, would close a large part of the domestic financing gap in the three deficit countries. Aside from these rieasures, others set forth in a recent detailed study of taxation prepared undler the joint auspices of the OAS and IDB could be undertaken. The losses from competitively granted fiscal exemptions could be reduced if these were replaced by uniform pro½rsions for accelerated depreciation and if income taxes on companies were levied on a proportional basis rather than on the basis of the progressive tax applied to personal incomes by four of the countries (see para. 72). Also, there is a case in all countries for increasinig road user charges, bearing in mind, how.ever, their implications for regional aspects of transportation. 157. Tax reforms are needed not only to solve the medium-term fiscal problems in three of the countries but also, throughout the area, to enable the countries to raise the proportion of domestic financing after 1970 in the higher levels of :nvestment which they will be trying to attain. 158. In the coming years, the prospects are that recourse to the banking system could not be relied upon as a substitute for an increased fiscal effort to finance the investment programs. Any increase in bank credit facilities will need to be reserved to permit private sector growth in the next few years. As noted below, the prudent margin for internal credit expansion in the next few years is very slim indeed. 159. If the necessary int;ernal savings are not created to fill the domestic financing gaps which appear likely to arise in Costa Rica, El Salvador and Guatemala, their investment programs would suffer reductions. Since it would probably be necessary to reduce or postpone undertalcing some projects which would be expected to be financed in part abroad, the amount of the total reduction in investment would probably have to be considerably greater than the shortfall in local currency requirements. Heavy reductions in public investment would adversely affect the prospects for longer-term economic growth. The mission did not try to postulate alternative reduced investment programs for Costa Rica, Guatemala and El Salvador, since it considered that it would be feasible, with tax measures such as those suggested above, to close the gaps and avoid heavy sacrifices in the investment program. - 61 - D. The Balance of Payments and Growth Prospects 160. Despite the rapid growth of exports in recent years, by the end of 1965 both the trade and the current account deficits rose substantially in all countries, except El Salvador and Honduras. However, inflows of private and official capital in 1961-1965 more than offset the current account deficits in El Salvador, Nicaragua and Honduras (vwhich increased their net internationial reserves) and all but a small margin in Guatemala which had a slight fall in reserves. But Costa Rica's balance of payments position deteriorated so rapidly that, despite substantial private bank borrowing abroad toward the end of the period, its net reserves disappeared and became negative by the end of 1965. Even in the other four countries, the ratio of net international reserves to imports remained modest in 1965, ranging from about 15 to 20 percent, affording comparatively little margin for coxnpensating for adverse fluctuations in exchange receipts. Industrialization and the Balance of Payments 161. The overall balance of payments position of each of the countries was not materially affected by expansion of intra-regional trade, except in Nicaragua. As barriers to trade with the region were removed and the process of import substitution accelerated, exports to the Common Market added substantially to the expension of total exports of the countries and became an increasingly importarnt share of their total exports. Intra-Regional Exports and their Relatlon to Total Exports Exports Percentage Increase in exports Percentage of exports Country to region increase irn to region as percen- to region to total and (millions exports to tage of increase in exports year of region total exports 1961 ald 1965 CA$) 1961 to 1965 1961 to 1965 Guatemala 1961 10 9 1965 38 269 37 21 El Salvador 1961 14 B 1965 45 213 4 2h Honduras 1961 8 12 1965 22 166 25 18 Nicaragua 1961 2 3 1965 10 444 11 18 Costa Rica 1961 2 2 1965 18 84o 60 17 Source: SIECA - 62 - 162. Differences between annual intra-regional exports and imports of the individual countries within the region have been fairly small between 1961 and 1965; most countries haLve experienced alternating surpluses and deficits; only Guatemala has hacd consistent though not large surpluses and only Nicaragua has had increasing trade deficits with the rest of the region. As there have been no significant intra-regional investment income or intra-regional capital movements, the substantial growth of intra-regional trade in itself in the last five years had little effect on the overall balance of payments position of the countries, and even Nicaragua's overall trade balance was in surplus from 1962 to 1965 despite her adverse balances in Common Mlarket trade. But the structure of trade has been undergoing important changes. Imports from outside the area rose more rapidly than exports to the outside in the last few years. Moreover, the process of industrialization has affected -he structure of imports from the outside; thus imports of raw materials, semi-manufactures and capital goods from outside increased faster than i3nports of finished manufactures from the outside were replaced by domestic production. As a result, the individual Central America: Imports by Economic Category (Percentages) GTuate- El Sal- Nica- Costa Category _nala vador Honduras ragua Rica Total Imports: 1965 Consumer goods 31 30 44 33 36 Intermediate goods 10 13 7 10 5 Raw materials 6 6 2 4 1 Capital goods S/ 53 51 47 53 57 Total j 100 100 100 100 100 Increments: 1962-1965 Consumer goods 26 15 48 27 38 Intermediate goods 8 10 7 15 3 Raw materials 8 12 1 9 2 Capital goods 1/ 59 63 j4i 50 56 Total i, 100 100 100 100 100 2;/ Including unfinished M Nay not add due to rounding, Source: SIECA data classified biy the mission - 63 - countries and the region as a whole increased their dependence on outside imports, as measured by the ratio of imports from outside to GDP, which increased from 17.1 percent to 19.4 percent between 1962 and 1965. But if imports from outside of finished capital goods are excluded, the ratio of imports from outside to GDP of the remaining categories of goods increased by 1.2 percentage points. Thus through 1965 the region was able to iLncrease substantially its stock of capital equipment - either by modernization or net addition or both - without appreciably increasing the ratio of all other imports to GDP. Imports of crude materials and semi-manufactures from outside the region grew at rapid rates. Composition of Imports from Abroad into Central America, by Economic Categories, and Annual Average Rates of Increase, 1962-1965 (Percentages) Shares of Total Annual Average Shares of Tote Category in 1962 Rates of Increase in 1965 Consumer goods / 39.5 8.8 35.5 Crude materials 2.3 39.3 4.4 Semi-manufactures j 14.8 17.2 16.3 Finished capital goods 43.4 12.3 43.8 Totals 100.0 13.0 100.0 2/ Includes crude foodstuffs, manufactured foodstuffs and other finished manufactures for consumption. j/ Includes semi-manufactures for consumer goods and for industry. Source: SIECA official trade figures as classified by the mission. 163. The growth of crude materials imports, shown in the table above - 39 percent annually - reflects to a large extent the substitution of crude and semi-refined oil for gasoline imports as local refineries were built in four countries. But, even after taking account of this factor, crude materials imports grew at a yearly average rate of 25 percent, and semi-manufactures at 17 percent. Raw materials and semi-manufactures will no doubt have increasing weight in future imports from abroad if the process of industrialization along recent lines advances further and will thereby introduce new rigidities in the balance of payments of the region. 164. In its first four years the Central American Common MIarket has been a positive factor of economic growth. Value added in manufacture and employment in industry has increased wjithout appreciable rise in internal price levels. However, while the creation of the Common Marlcet has lwidened the margins for industrial growth, for which there appear to be substantial possibilities, further industrialization through import substitution alone faces serious constraints in the prospective balance of payments positions of the individual countries. With the present pattern of industrialization these are likely to be felt increasingly. - 64 - Hence, as already indicated in Chapter III, an essential condition for further industrialization and for the fuller utilization of the remaining opportunities of internal growth will be to develop exports, including industrial products, to international markets. Prospects for Economic Growth 165. Should the exports of major commodities to world markets develop much more slowly in the future, as estimated by the mission on the basis of available market and production indications, this would adversely affect the prospects for growth of the economy of Central America. The main export factors have been discussed in Chapter II: in summary, international cotton prices are likely to weaken and affect output which has encountered production difficulties resulting in cost increases; export quotas under the International Coffee Agreement, likelv to rise slowly due to slowl increases in world demand, are expected to be applied strictly, in the face of declining coffee prices; banana production in principal producing areas is likely to rise only slowly with a secular increase in world demand. Such slowJdowins in growth of export proceeds to the outside world are likely to affect demand for Common iIarket manufactures and intra-regional trade wzould therefore be likely to grow less rapidly than in recent years (as indicated in Chapter III). 166. Estimates of possible exports of goods and services for 1970 and 1975 by the mission are surnmarized below. Given the substantial uncertainties of future market and production developments, there may well prove to be substantial variations from these estimaates. MIoreover, some new hitherto overlooked or underestimated export possibilities may yield additional earnings. Etut these estimates serve to illustrate Total Exports of Goods and Services, Actual 1965 and Estimated 1970 and 1975 (million CA pesos) (Percentages) Actual Estimated Average annual growth rate Country 1965 1970 1975 1960-1965 1/ 1965-1970 2/ 1970-1975 2/ Guatemala 228 260 350 11.6 2.6 6.1 El Salvador 213 220 275 13.0 0.6 4.6 Honduras 130 160 210 13.8 4.2 5.6 Njicaragua 174 210 260 15.9 3.8 4. Costa Rica 138 195 260 9.4 7.2 5.9 j From national accounts data. j These figures exceed estirnated future commodity exports (Table 28a-e) by a fixed margin, based in each case on a fairly stable relationship in recent years between invisible and visible exports: about 20 percent in Guatemalaj 10 percent in El Salvador; 5 percent in Honduras; 20 percent in Nicaragua, and 20 percent in Costa Rica. Source: Official data and mission estimates - 65 - probable trends as they now can best be foreseen. They point to average rates of growth in export earnings during 1965-1970 wJhich would be sub- stantially less than in recent years for all countries except Costa Rica, where the fall off would be relatively minor mainly owing to improvement of banana exports and recovery of coffee exports. Such low rates of export growth would in all likelihoodl result in rates of economic growth much lower than in the last five years and than the satisfactory average rate of 5-6 percent achieved in the decade 1956-1965. So far as can be estimated annual GDP growth rates in 1967-1970 would be likely to range between one percent in El Salvador and Costa Rica to 2 percent in Guatemala and 4 to 5 percent in Nicaragua and Honduras. With growth of population at recent rapid rates, per capita GDP i<; therefore likely to fall during the period, except in Nicaragua and Honduras where it may rise slightly. 167. Implicit in such rates of economic growth are slower rates of import growth, particularly in El Salvador, Costa Rica and Guatemala; these would range from an annual average of about one percent to 3 percent during the period. In Nicaragua and Honduras, import growth rates, while less than in recent years cou:Ld still be substantial, in the order of 6 and 9 percent annually. As indicated above, there seems to be little room for relieving restraint on imports to this degree by drawing down net international reserves. Given the high propensity to import, excessive internal credit expansion wou'Ld immediately add to balance of payments pressures. Within the limits of the foreign exchange earnings as estimated by the mission, net annual intlernal credit growth, which doubtless will be affected in any case by a 2alling off in growth of bank deposits as growth of export receipts slackens, would need to be restrained to modest limits. Thus, it probably could not exceed something in the order of one percent in El Salvador and two percent in Guatemala and Costa Rica; in Nicaragua and Honduras it could probably run at about 5 to 6 percent annually. With such prospect-:ve limitations on credit growth, the financi.al authorities can hardly look to bank credit to assist in financing deficits in the public budget, since the available increases in bank credit will be needed for the private sector. 168. A slower rate of internal growth will doubtless affect imports of capital goods which accounted for a large share of the incremental increase in imports from abroad in recent years, although, to sane extent, capital goods imports will be covered by financing from abroad. Generally, however, the advance of industrialization, bringing with it needs to im- port of replacement parts, rawq materials or semi-finished inputs, has increased the elements of rig:Ldity in the import structure. It may well become necessary for the authorities to pursue policies intended to re- strain internal demand, and consequently demand for imported inputs for manufactures, especially for the less essential types of consumer goods (e.g. by restraints on consumer credit, selective sales taxes). In the view of the mission, the lower growth of import capacity and the consequent difficulties of adjusting to it, serve to emphasize the need for re- examination of the policy of granting industrial incentives for industries relying heavily on imported ilputs and adding relatively little in value in the process of production. - 66 - 169. While the outlook for export growth in coming years appears unfavorable there seems to be no general case, at present for promoting exports by a devaluation of the currencies. Some increases in internal production costs have affected the profitability and hence the export possibilities of some commodities (particularly, cotton, due to costs of combating plagues and attemp)ts to increase output by applying more fer- tilizer), and a weakening of export prices may well affect the major commodities in varying but relatively small degree. But export markets for cotton, coffee and bananas are not likely to be increased by devalu- ation (given the peculiarities of their markets, such as the importance of U.S. price policy for cotton, the quota system for coffee, and the slow rate of increase in consumption of bananas). Moreover, there are good prospects that studies of techniques of cotton production (now going on in El Salvador), may bring down present costs of production, which, in some cases, rose because of speculative development of production under previous market conditions. Thle prospects for new export lines depend mainly on establishing markets and developing latent production capaci- ties; thus far prices abroad do not seem a principal determent. On the import side, a devaluation wouLd doubtless discourage imports, but with restraints on credit and appropriate tax measures, imports could probably be kept under control. 170. As for individual countries in the region, membership in the Common Market implies severe restraint in recourse to alterations of their exchange rates as a means of dealing with balance of payments pressures. When one of the countries make,s a change in its exchange rate, the others are immediately affected, as has been shown recently when Costa Rica in- stituted a dual-rate system, part of which was a free rate applying to certain commodities, whatever their origin. Costa Rica soon changed this system so as to trade with the other Common Market members at the earlier official rate. However, should this arrangement continue, the countries will continue to face the comp:Lex question of whether a member of the Common Market may maintain certain rates for transactions within the Common Market and others for transactions with the outside world. The Costa Rican case may yet demonstrate that imports from the outside through other Common Market countries cannot be prevented indefinitely and that a mul- tiple rate system is not a soluition to its problem. Such a development would precipitate for the first time critical and difficult issues as to which financial and balance of payment policies are consistent with the Common Market relationship and which are not. The Common Market partners therefore have a vital interest in the choices made and in the means of correction of the causes leading to the balance of payment difficulties. They could, of course, provide credit assistance to the country in diffi- culty based on understanding a; to corrective policies and thereby avoid the difficult issue of exchange rate adjustment in the Common Market context; however, the possibilities of such intra-regional assistance now are limi- ted by the relative shortages of resources of all countries. This experi- ence also serves to emphasize that they have a vital common interest in the pursuit of economic and finiancial policies which would avoid or minimize crises of this kind; or this, they will need to begin to coordi- nate their policies. - 67 - 171. The unfavorable outloc,k for growth of exports and domestic output in the next few years reinforces the need for public authorities, national and regional, to promote possibilities of increasing exports, including new lines (as suggested in Chapters II and III). It also re- inforces the need to give priority to the use of available local and foreign funds in special credit programs giving early results in output and exports. The mission's estimates of public investment include pro- vision for such special credit programs. These are estimated at about CA$40 million average annually during 1967-1970 for the region (including the use of some $28 million of foreign funds annually), the level rising somewhat through the period. External loans for these purposes could be disbursed fairly quickly if administrative organization is adequate and would have an early impact on production. The public authorities, both national and regional, should therefore push forward with the preparation and execution of projects for channeling foreign funds in development credits to the private sector to achieve at least the levels projected by the mission and if possible to surpass them. These programs for utiliza- tion of foreign funds warrant high priority also because prospects are that internal credit expansion over the next few years will need to be kept within much narrower limits than in the past in order to restrain import growth, particularly in Costa Rica, Guatemala and El Salvador. To the extent that such programs can be increased efficiently, they would both help to relieve balance of payments restraints on domestic credit in the next few years and also benefit the longer-range growth potential of the countries. While an increase in foreign lending for such programs above the levels assumed by the mission would raise the debt service burden above the ratios mentioned in paragraph 152, there is still room for moderate additional debt service provided the countries keep on growing. 172. To sum up, it appears feasible for the countries of Central America to sustain a rise in public investment in the face of lower rates of export growth in the next few years, provided foreign financial assis- tance for project loans is forthcoming, and is matched by adequate internal savings effort, which will require additional internal fiscal measures in at least three of the countries - El Salvador, Guatemala and Costa Rica. Moreover, looking beyond 1970, additional effort by all the countries will be needed in order to confront their needs for rising investment levels in the future. The measures adopted by any one of them - particu- larly to control credit, remedy their fiscal or balance of payments im- balances, promote industrial growth - will affect the prospects of the other countries. Hence, harmonization - that is, mutual adjustment of policies to achieve consistent common objectives - will be increasingly important in a variety of fields: taxation, monetary and fiscal policy, tariffs and industrial incentives, educational programs and coordinated programs in infrastructure (particularly transport, power, telecommuni- cations, grain storage and education). Such harmonization could be greatly advanced if the countries strengthened their capacity to take decisions as a group on vital matters of common interest much more rapidly and effectively than in the past. It was suggested above (Chap- ter III) that a regional tariff and industrial commission be established. - 68 - Equally important, the several governments need to make the central body of the integration organization - the Economic Council - more effective by taking the necessary measures internally to enable its members to speak for their governments on all issues which need to come before it rather than being restricted to problems falling within the jurisdiction of the Ministries of Economies. 173. On their side, the external lending agencies will need to look at their lending operations in the area increasingly within the context of regional considerations and emerging issues of regional policy. By and large, external lending agencies have, in the past, regarded the coun- tries of Central America as individual unrelated economic entities, though support has been given to the regional bank and some investment programs of regional significance. Future appraisals of the economic situation and of projects of individual countries will need to take account of what is happening in the rest of the region, particularly to assure that their policies and projects do not run at cross purposes with those of other countries and the development of the region as a whole. In several sectors, external lenders will need to consider projects in terms of their part in a regional program (e.g. highways, grain storage), or in terms of the fact that they cannot be carried out suitably except on a regional basis (e.g. telecommunications, education) or because their role transcends national boundaries (e.g. ports), or because they constitute the best solution to supplying emerging needs (e.g. potentially electric power interconnections), or a combination of these several factors. External lenders will need to be concerned with the improvement of industrial and tariff policies in the Common Market, particularly to centralize the granting of privileges as incentives for industrial development and to better that system, to improve the processes of tariff making and revision so as to secure an efficient and economical industrial estabLishment and to develop export oriented industries. They will also need to be concerned with the agricultural policies to be followed to diversify out of coffee (including concerted adoption of heavier taxation on that sector) and to provide financing and technical assistance for development of new production and export possi- bilities - such as livestock and forest products. 174. The bold action of the Central American countries to create a Common Market undoubtedly has broadened the bases for economic growth for a3l of them. The rapid recent growth of trade within the region should not, however, obscure the fact that the Common Market cannot be an end in itself. But with support from abroad, within the framework of effective national and regional policies, it could become not only a basis for more rapid internal growth but also a more effective means of developing the new exports needed for longer-term growth. PART II COINTRY SUviARIES GUATEMAIA 175. The economic performance of Guatemala in the last 15 years has been influenced somewhat more by political developments than has been the case in other Central American countries. In the early 50's, at a time when the other economies were growing rapidly as a result of rising coffee prices, Guatemala's economy ecpanded only slowly because of the uncertain- ties surrounding the Arbenz Regime and the instability that followed its overthrow. It is only since :L963 that Guatemala has benefitted from rapid economic growth: since then, real income per head has grown by almost 4 percent annually. This rapid growth has been the consequence of an accelera- ted expansion of cotton production for export, some increase in coffee production accompanied by a recovery in export prices in 1964 and 1965, and a faster expansion of manufacturing, partly as a result of the Central American Common Market. The rLapid growth of the economy was not, however, paralleled by any significant increase in public investment. Such invest- ment in recent years has been running at about 2.4 percent of GDP, well below the peak levelp reached in 1956-58, at the time the Inter-American Highway and the Atlantic Highwqay were being built. Balance of Payments 176. A prospective rise in public investment - discussed below - will be taking place against a bac],Kground of rather slower economic growth in the next five years than in t]e recent past. Peak exports in 1966 of $223 million (preliminary data) were attained by (1) exporting half again as much coffee as Guatemala's quota under the International Coffee Agree- ment envisaged, most of which found its way to traditional markets, (2) by exporting a record cotton crop, and (3) by taking maximum advantage of the Central American market for manufactures. Exports to the Common Market contributed one-third of the Increment in total exports from 1962 to 1965, and reached 15 percent of Guatemala's total exports. iMedium-term prospects are now dampened by the need to cut back coffee exports to international quotas in the face of declinin-g world prices; by stagnation in cotton out- put, here as in other Central American countries, due to a squeeze between falling world prices and risiLag production costs; and by a consequent slow- down in the expansion of the (Common Market generally. Estimated merchandise exports are therefore unlikely to exceed US$215 million in 1970, very little above the US$193 million registered in 1965 and expected once more to obtain in 1967. Some additions to earnings from rising tourism may take place over the period, but are unlikely to materially change the order of magni- tude of total exchange earnings. The slower growth of export earnings for the next four years or so will be reflected in a substantially slower growth of income than in recent years. Guatemala may not be able to keep the annual growth of income f:om falling below the rate of population growth. - 70 - 177. The slower growth of -exports is likely to limit substantially the growth of import capacity, after taking into account the foreign ex- change availabilities from the projected increase in drawing on existing and potential new foreign loans for the public investment estimated by the mission (discussed later) and other receipts from abroad, as shown in the following tabulation. (Million CA pesos) 1970 Export earnings 257 Public capital receipts (net) 28 Private capital receipts (net) 10 Total exchange availabilities 1970 295 1965 Imports 249 Permissible annual growth rate 1965-1970 3-4% This limitation will require a much more restrictive monetary policy than in the last few years, unless Guatemala is rapidly to reduce its modest foreign exchange reserves. On the basis of the mission's projections, the annual growth of imports of gocds and services to 1970 will need to be limited by exchange availabilities to about 3-4 percent; this compares with an annual growth of imports of almost 12 percent annually in the boom period 1961-1965. Even with a fairly normal growth in foreign bank loans to the banking system, the permissible annual rate of growth of domestic credit over the next few years within the context of such import limits is unlikely to be much above approximately 2 percent. In the light of experience in the period of export stagnation from 1958-1961, during which imports and domestic creo.it were stagnant also, these limitations should be manageable for the GLtatemalan authorities. They will, however, require: (1) a balancing of the Government budget, after taking account of disbursements on foreign development loans, if the growth of credit, to the private sector is not to be arrested altogether; and (2) an effective po]icy to control coffee production in order to avoid diverting scarce bank credit for storage of surpluses in excess of coffee quotas. - 71 - 178. Economic boom conditiLons over the period 1961-1965 attracted increasing proportions of bank credit into agriculture, livestock and in- dustry. Though this trend refLected primarily the pull of market forces, it was actively encouraged by lthe monetary authorities. A slowdown in credit expansion in coming years would therefore be likely to be felt most acutely in these directly productive sectors also. Precisely this factor makes credit restraint effectivre as a policy to restrict imports: the rapid increase in imports on the upswing was largely concentrated in capi- tal goods and a decline in bus:Lness activity can therefore be expected to have an immediate impact in the same category as well. Reluctant to go too far in this direction, however, the Guatemalan authorities in early 1967 signed a stand-by agreemenit with the International Monetary Fund for $13.4 million, reserving the right (1) to introduce selective import con- trols on a temporary basis should the need arise in the course of the year, and (2) to borrow abroad up to US$3 million on terms of no more than 3 years (all other borrowing to be on terms of no less than 5 years). In addition, they are seeking a substantial program loan from abroad, to underwrite an acceleration of public investment. Public Investment 179. Public investment in the last eight years has on the whole failed to meet the requirements for growth in the Guatemalan economy. In addi- tion, the composition of actua]. investment expenditures left something to be desired from the viewpoint of their development impact. Investments in education and electric power have been unduly low. Some of the "social" investment has been on low-priority public buildings, such as the lavish buildings for the Social Security headquarters, the municipality and the headquarters of some state banks. In contrast, however, some of the road construction projects have represented high-priority expenditures and the land settlement projects have had a worthwhile aim, although implementa- tion has fallen short of expec1tations. 180. The Government's pub-lic investment program for the period 1966- 1969 calls for a very substantial increase in public investment to an annual average of CA$100 million in 1966-1969, three times the level of recent years. A level of CA$1()0 million in 1968 or 1969 would represent about 6-7 percent of prospective GDP and would not be unreasonable in an economy in which, because of the backlog of social and economic problems, including a large Indian population outside the mainstream of economic life, the public sector is necessarily called on to play an important role. Guatemala faces major problems to attain these objectives, however, since it is unlikely that the public sector will be able to prepare enough suitable projects to be implemented during the plan period, and also since the domestic public savings necessary to carry out a program of this mag- nitude, even with considerable foreign assistance, are not likely to be attainable without important fiscal reforms. - 72 - 181. The new government that took office in July 1966 rapidly embarked on the preparation of major projects in high-priority sectors. Among the larger of these projects are twfo power projects (for one of which loan documents have been signed), a highway program for the eastern part of the country (which will open up promising areas for agriculture, livestock and lumbering), and a program for primary, secondary and technical education. Late in 1966, loans for agricuLtural and industrial credit, totalling $6.0 million were obtained abroad by the Central Bank to be channeled to the private sector, and a loan of $4.2 million from CABEI for highways was signed. Even with such andl additional efforts, however, the level of public investment that is likely to be realizable will be in the order of an annual average of CA$h5 milLion, a level which is still too low for Guatemala's development needs. 182. The main items in a realizable investment program, over the next 3-4 years will be for transportation. The most important of these will be the reconstruction and improvement of roads: the main road to the Coban area, an eastward link to the Lake Izabal area and back again to the main Atlantic Highway, and an expansion of feeder roads. These projects, for which feasibility studies are yet to be completed, merit priority be- cause of the agricultural potential of the Polochic Valley they will serve, and also because they will permit access to forest resources, including the southern Peten. Total investment for road construction may amount to some $48 million over the next, four years. This is about half of what the official plan projected, but about 50 percent more than the levels achieved in recent years. Even this amount of projected road investment, given the variety of roads included, would strain Guatemala's present capacity to plan and administer road building programs. 183. Port investment would include two main projects: the expansion of the Atlantic port of I4atias de Galvez, which is being financed by an Export-Import Bank loan, and the proposed construction of a m.odern port on the Pacific coast. The studies for the latter port have not yet been completed, and it is still uncertain whether the high cost of construction of the port (about US$15 million) in relation to its projected traffic volume (from 250,000 to 500,000 tons) would yield a sufficient rate of return to justify the investment. Despite this uncertainty, for the sake of financial planning, some allowance for expenditures on such a port has been included in the mission'S estimates of projected investment. 184. In the case of electlric power, the authorities are about to embark upon a major expansion program, to be carried out by the Government's electrical Institute (INDE), whose staff has been strengthened in recent months. INDE completed in 1966 a 13 MW hydroelectric project financed by the Inter-American Bank and, wiith the assistance of a US$15 million IBRD loan, will begin construction of a 60 MW hydroelectric project in 1967. The new capacity is unlikely to be available before 1970, and the central region of Guatemala may well face a power shortage in 1968-1969 if the load continues to grow at the recent rate of 12 percent annually. The authorities are therefore considering the installation of additional - 73 - thermal capacity to provide some reserve. The cost of these projects in this second stage of INDE's program is tentatively estimated at about CA$27 million, including foreiga exchange costs of about US$20 million. 185. The Government had planned to increase the number of telephones in the country by about 37,000 over the period 1965-1970 at a cost of about CA$12.5 million; such an increase is justified since at present there are only 24,000 telephones, or 0.55 phones per capita, a low propor- tion. The program began in 1965, but the financing from the supplier only covers equipment for the first year of the program. This plan is being reviewed by the Government and preliminary studies are being made for a project which would cost about CA$10 million, which might prove suitable for external financing of $7.0 million to cover the foreign exchange costs; this might be ready in 1968. An autonomous telephone agency is to be established to plan, finance arnd expand adequate facilities, and to operate them efficiently. 186. In the social sector, heavy investment in education at all levels is needed if Guatemala is not t,o be faced within a decade or less by a growing obstacle to its development in the form of unprepared manpaier. The authorities are acceleratirig preparation of a project including primary school, secondary schools and technical and teaclher training at the middle and university levels: they plan to present a project for external financial assistance early in 19067. Investment in education, not only in facilities but also in training and improving the efficiency and quality of education, undoubtedly dese.rves very high priority in Guatemala's public investment and current expenditures. In housing, the Government housing institute has for severcal years carried on a modest program of construction of lower middle-income housing; the program is now to be ex- panded over the period 1967-69, to build 5,700 houses at a total cost of US$9.7 million, of which US$5.3 million wfill be financed by an existing ID3 loan and the remainder by Jentral Government transfers. But the housing authori-ty expects to enter the low-cost housing field on a larger scale to a total of CA$16 million over the period; this would require more trans- fers from. the Central Government and additional foreign funds of some $3 million. In the last four years, the housing institute has spent about a third of its funds for houses for teachers and military officers: all this construction has been in Guatemala City, and was in part for buyers selected many years ago; these activities should be phased out. 187. There is ample need for expansion of facilities in the field of water su sewerage, especially outside Guatemala City, where the municipality has been using it.s savings to improve the water and sewerage system. vLith the assistance of IDB loans, various municipalities are excpanding their waterworks, although the levels of investment envisaged in the plan will not be achieved in the period. Water facilities could be more effectively developed by having one central agency responsible for coordination, supervision and planning rather than through the various separate Government agencies that now administer and construct water - 74 - systems. In public health, the program envisages building enough hospitals to have three hospital beds per 1,000 inhabitants instead of the present ratio of 2.6. The program rightly places more emphasis on areas outside Guatemala City, where the bulk of facibities and doctors have so far been concentrated. However, plans for building the facilities and for staffing them are still uncertain. Altogether, it seems likely that realizable in- vestment expenditures in the entire social sector in 1966-69 may constitute a little less than a third of direct public investment, not an unduly high proportion. 188. In agriculture, the Governrnent's public investments program pro- poses large expenditures, mostly in colonization and land settlement, but there are delays in the formulation of the specific projects. Expenditures are also proposed for cadastral surveys and for grain storage, markets and some small irrigation projects, for which studies are under way. No direct investments are proposed in industry. For both agriculture and industry the public sector has been an important channel for foreign loans and some local resources to the private sector. These credit programs have been left largely to the initiative of the Bank of Guatemala. Thus, in recent years, the Bank of Guatemala has acted as a channel for loan funds from foreign official agencies and U.S.$5 to $7 million annually in 1962-65. In consequence, the banking system has been able to raise the proportion of its longer-term lending to agriculture (Volume III, Agriculture, Table 14a). 189. The mission considers that the flow of these funds ought to be stepped up considerably in the next few years. The authorities will need to speed up the preparation of sufficient projects for submittal to official external agencies to increase the flow of this lending in the immediate future, particularly if the availability of medium-term funds from U.S. banks on which they have relied, to a substantial degree, should diminish. A US$6 million loan from the IDB was approved in October 1966 for agri- cultural and industrial lending: a major part of the loan will be devoted to small and medium livestock producers (i.e. those with under 200 animals or so). There is need for a similar project for larger ranchers, some of whom have sought loan funds abroad on their own account, and the authori- ties ought to prepare a credit program for this sector of agriculture. Loans to these farmers on sufficiently long repayment terms are needed to permit a much needed build-up cf herds. 190. In sum, the present outlook is that delays in project preparation together with the administrative problems of trying to increase rapidly the levels of investment from those of recent years, make it unlikely that the Guatemalan public sector will be in a position to spend effectively much more than an average of $45 million annually during 1967-701/ for direct ;./ The mission has projected the investment estimates for another year beyond the 1965-69 plan. - 75 - public investment; another $8.5 million average annually would probably be added through indirect public investment by special credit programs to the private sector. These levrels represent a moderate increase over those achieved in 1962-65 when direct investment averaged some $30 million annually and credit programs lto the private sector about some $5-7 million. Nevertheless, to carry out the projected levels of investment, the authori- ties will need to make increased efforts in speeding up and improving preparation of projects particularly those to be financed abroad and their execution once they are financed. Financing the Investment Prog?am 191. Along with such efforts, increased endeavours in internal mobili- zation of savings will be requ.ired to finance the program. Since 1962 the authorities have moved to strengthen the fiscal position of the Government, and have succeededl in almost doubling the savings of the Central Government. Public savings, after amortization of external debt, have been sufficient to finance about 40 percent of admittedly low levels of public investment and the budget deficit has been limited to manageable proportions. (Ihile the Government has borrowed abroad on short-term to help manage its budget, most of this borrowing has been for temporary needs and has been repaid within a year of being incurred, without leading to an accumulation of short and medium-term Central Government external debt. In 1962-63, the Government, faced with the prospect of rapidly rising expenditures, especially for education, put into effect a number of tax reforms, chiefly the introduction of a personal income tax and a doubling of the rates on the ;tamp tax. These reforms, together with a much improved collection of direct taxes, during a period of rapidly rising incomes, increased Central Government current revenues substantially. But the revenue effort is still very low; even in 1965 Central Government current revenues were equivalent to only 8.5 percent of GDP, while public savings were only 1.6 percent of GDP. 192. The new Government, inaugurated in mid-1966, has been aware from the beginning that in order to move forward with the needed higher level of public investment, it will have to increase the saving capacity of the public sector. Gross disbursements on existing and potential new foreign borrowing on the basis of the present lending practices of external agencies, might cover some 55 percent of projected feasible direct in- vestment estimated by the mission for the period 1967-1970. While such a proportion of external financing of direct investment is not low, it is supported by the need to increase the investment effort, including major projects with a high foreign exchange component and by Guatemala's efforts to improve economic and financial performance. But local resources would need to be increased even with this pattern of foreign financing, as indicated in the tabulation below: -76- Guatemala: Public Investment and Financing for Period 1967 - 1970 CN.!llion CA peos Public Investment 214 Direct investment 1- Credit programs 34 Financing 185 Public Savings 73 External credit (net) 98 gross receipts 125 amortization 27 Net internal bonds 4 Gap 29 193. Hence, measures to cover the gap will be necessary. The public savings estimate shown above is based on the assumption that the growth of current expenditures will be held to a minimum consistent with feas- ible development programs and with the continued provision of social ser- vices on a constant per capita basis; if the authorities exceed these levels, there will be a shortfall in the estimated savings. Estimated revenues already take account of emergency legislation passed by the Assembly in November 1966 and expected to yield aboat CA$6 million, before it lapses at the end of 1967. Even should this legislation be renewed, therefore, the authorities will still be faced with a gap of about CA$7 million annually, on the basis of the financing pattern out- lined above. Anticipating such problems, the Government of Guatemala at the end of 1966 set up a commission to propose permanent tax reforms: its report is expected in June 1967, with legislation scheduled to beccme effective in 1968. For the interim, it has been seeking a program loan abroad to help bridge the gal). 194. From the point of view both of budgetary balance, and to dis- courage coffee production in excess of international quotas, increased taxation of the coffee sector commands a high priority. Three specific taxes should be considered iri this context. (1) Exrt taxes: from 1960 to 1965 proceeds failed to increase in spite of the export boom, as the tax base for coffee was shifted from identifiable price quotations in New York to local contract; prices. In 1965, consequently, while the theoretical yield of coffee export taxes should have been 14 percent ad valorem, the CA$8.4 million actually collected came to less than 10 percent of export value. (2) Income taxes: the basic exemption for agricultur- al incomes of less than CA$I',,000 exempts the majority of coffee growers from income tax liability. (3) Property taxes: These are now a virtually untapped source of revenue in Guatemala. Property is now taxed at a rate of only 0.3 percent of assessed value and yielded only CA$2.6 million in 1965, accoumting for a little over 2 percent of -77- Central Government current revenues. If the foregoing sources are not sufficient, increases in sales and excise taxes, particularly on non- essential items, would not only yield revenue but also immediately affect import demand. 195. Even with measures adequate to close the prospective budgetary gap in 1968-1970, Guatemala's public savings effort would be relatively low - less than 2 percent of GDP., probably the smallest relative sav- ing effort among the Central American countries. Guatemala needs to increase public investment in priority fields, if possible above the levels projected in 1968-1970, and certainly in following years. She should also endeavor to reduce her heavy reliance on foreign financing for such investment; consequently she should begin now to take tax mea- sures providing a basis for an even higher relative level of public savings with late 60ts and 1970's. External Debt 196. Effective new tax measures yielding at least CA$13 million per annum are required to finance even the scaled-down investment program considered technically feasible by the mission, provided external loan funds to finance some 55 percent of direct public investment would become available. This ratio would be about the same in the mission's projec- tions if public borrowing for credit programs to the private sector is included and account is taken of private investor's contribution to the projects financed under the credit programs. Based on lending procedures of various external agencies, foreigh loans fbr the major public invest- ment projects which appear to be suitable for foreign financing would, on the average, cover about 70 percent of the total project costs. This percentage would be mainly influenced by the high foreign exchange cost component of the major projects in electric power and transporation and, in some instances, 100 percent financing of roads by CABEI. 197. At the end of 1965, Guatemala had only US$25 million in undis- bursed foreign loans available to finance public investment and programs of credit channeled by public institutions to the private sector. The new potential foreign loan ccmmitments implied in the mission's projec- tion total abcut US$140 million over the next four years or so. About one-third of the borrowing fcor 1967-68 is covered by completed studies, and one-half by studies yet to be completed. Projects for commitments in the 1969-70 period are almiost entirely still to be prepared. It is clear that the timely execution of the levels of public investment pro- jected by the mission will require an intensified project preparation effort. The service on Guatemalats external public debt service is still low, falling from 3.5 percent of export earnings in 1966 to 2.7 percent of projected export earnings in 1970. The additional borrowing over the period 1966-1970 of abcut $140 million would raise debt service to about 5.5 percent of projected export earnings in 1970 and to 5 percent in 1975. -78- 18. Such a debt service b.rden is not heavy and suggests that Guatemala could further increase its external debt to finance additional projects if they can be formulated and also to tide the country over the coming period of financial stringency. The authorities have been exploring the possibility of a foreign program loan. For the relatively brief period until adequate tax measures can be introduced, some program lending may be justified. W4ith adequate tax measures, balance of pay- ments equilibrium wouLld be attainable, on the assumption of tight credit restrictions, though per capita GDP would be declining. Furt'her incre- ments in foreign borrowing for the purpose of ameliorating the slowdown in economic growth might best be channeled through the Central Bank, how- ever, in support of credit programs to agriculture and industry if it is possible to expand them efficiently, on condition that firm ceilings are established on access to bank credit by the coffee sector. Increased foreign assistance can in this way be tied most directly to an attack on the underlying longer range problems of export expansion and diversifi- cation. Creditworthiness 199. Guatemalats medium-term prospects are nuch less bright than they have been in the recent pastt Guatemala is committed to reduce its exports of coffee to within its quota for 1967, its cotton acreage has shrunk by 16 percent in consecquence of rising costs and declining world prices, and its export earnings far 1967 are therefore expected to drop by about 13 percent below those in the record year of 1966. The Govern- ment has responded to these impending difficulties by (1) arranging a stand-by with the Internaticnal Monetary Fund for S1304 million, (2) exploring with a foreign Government the possibility of a program loan pendi ng fundamental tax reformds later in the year, and (3) accelerating the signing and disbursement of foreign development loans. These measures, together with the possibility of imposing temporary import controls and of borrowing up to US$3 million on short-term from foreign commercial banks under the stand-by arrangement, are likely to hold the loss of net external reserves of the Central Bank to small amounts. 200. In the longer term, beyond 1970, Guatemala's economic outlook is more encouraging. Guatemala still has fairly large unoccupied areas on the productive Pacific coa.st suitable for cotton production. Even at prospective lower prices of the 1970's, Guatemala should be able to resume a large scale expansion of cotton output after cotton producers have had time to adjust to lover prices (an adjustment which should be feasible in view of the very high yields already obtained and of possible improvement in production practices). The proposed highway investment on the Atlantic coastal plains should, in the early 1970's, facilitate the development of Guatemala's excellent potential for forest products and cattle. A resumption of economic expansion in neighboring countries of the Common Market is likely to stirnlate a recovery of manufacturing. Guatemala's leading position in producing fruits and vegetables, as com- pared to the other Central American countries, should furthermore enable -79- it to industrialize some of its agi'icultural products for export on a larger scale than at present. There are also favorable prospects for exploitation of substantial nickel ore deposits. The slowdown of economic growth over the next few years is likely to be temporary; however, the realizatioh of duatemalats encouraging long-term potential depends, perhaps more than in the other Central American countries, on substantial investments to take advantage of its resources. While re- sulting external borrowing is large and will require additional comple- mentary measures to generate public savings, the debt burden should be manageable in view of Guatemala's favorable longer term prospects, its low service on the existing external public debt, and its general tradition of prudent monetary management. EL SALVADOR 201. El Salvador's econc,mic activitty in the last 15 years has continued to be principally dependent on agriculture, particularly agriculture for export. This narrow base has nevertheless, in most years, permitted a substantial rate of growth in GDP, averaging over 7 percent annually from 1956 to 1965, while population increased at a rate of 3.5 percent annually. In the early and mid-fifties, economic growth was in large part the result of high and rising world prices for coffee. With the sharp drop in coffee prices in 1958 economic expansion slowed down considerably. But from 1960 to 1965, export earnings grewl at an annual average rate of 13 percent reach- ing $190 million. Cotton production had risen rapidly, in part stimulated by the construction of a highiway on the Pacific coastal lands. This rapid expansion of cotton production was supplemented by the recovery of coffee prices in 1963/64. These twc) items still accounted for some 70 percent of export earnings in 1965. However, the growth of exports to the Common Market has been a major element in the expansion of export earnings. With the rapid expansion of manufacturing, exports to the Common Market, mainly manufactures, almost tripled from 1961 to 1965, and accounted for 50 percent of the increase in Salvador'S total exports in that period. By 1965, Salvadorean exports to the rest of Central America totaled US$46 million, almost one-quarter of her to!,al exports; and her imports from the Common Market were some $42 million., or about one-fifth of her total imports. 202. During the rapid economic growth of the last 15 years, the lower economie levels of society have been modernizing gradually, as a result of industrialization, the spread1 of cotton production, and the introduction of a minimum wage, in a manner which would not have resulted from a simple coffee boom. Moreover, the authorities have taken advantage of the pros- peroty of the last few years to launch several programs in the social sectors and in credit and technical assistance to small farmers. The authorities have also been s-trengthening the institutions of the public sector, particularly the Planning Office, so that El Salvador is now much better equipped than ten or five years ago to face the decisions and prepare the projects necessary for its continuing development. 203. El Salvador will probably face stagnation or decline in its export receipts in the next four or five years. Cotton production fell by almost 40 percent in the crop year :1965/66 due to bad weather and disease: the prospect of lower cotton prices in the next few years, combined with a dis- incentive effect of the last crop and higher costs, will probably lead to a decline of cotton production and exports in the next few years. El Salvador faces a surplus of exportable coffee starting in 1966/67; with prospective quotas under the International Coffee Agreement, however, coffee export earnings cannot be ex?ected to grow by much in the next few years. It is likely that manufacturing plants already under construction or pro- jected will lead to some increase in the exports of manufactures to the Central American Common Market, which would largely account for the modest overall increase in exports projected for 1970, representing an average annual increase in export receipts of about 0.6 percent over the period 1965-1970. In the long run, El Salvador has, apart from its dynamic entre- preneurial class, no special natural resource advantages compared to the other Central American countries. With its limited land area, El Salvador does not have the potential for livestock and forest products of the other Central American countries or any further substantial extension of the margins of cultivation. While, therefore, the setback to export earnings may be of a temporary nature, and exports from 1970 to 1975 may rise at a more rapid rate, at about 4-5 percent per annum, the future growth of Salvadorean production and exports in the seventies is uncertain, depending on recovery in cotton and development of markets for manufactures in Central America. 20h. Such low rates of export growth in the next few years will adversely affect the growth of domestic production. Based on recent relationships of export and population growth to changes in GDP, and taking account of the need to restrain import within the limits of estimated resources, growth rates in 1967-1970 are likely to be about one percent annually, far less than the population growth rate of 3.5 percent. Such rates of growth will pose serious problems regarding the balance of payments and credit restraints. To illustrate, the following data summarize estimates of El Salvador's prospective exchange availabilities in 1970 in comparison with imports in 1965, and the annual growth in imports to 1970 which would need to be ob- served in order to avoid balance of payments difficulties or an excessive drawdown of reserves. Public capital flows, net of amortization and interest payments, are derived from disbursements proposed by the mission from foreign financing of the finance investment program. Private capital flows, (net of amortization and direct investment income) have varied considerably between CA$7.5 million to CA$16.3 million in the period 1961-1965, but averaged about $5 million. There will still be opportunities for private investment in El Salvador and, while any estimate on net capital flow is subject to wide error, it seems reasonable to assume that net inflow in 1970 would be some CA$5 million, about the same as the annual average of 1961-1965. On this basis estimated exchange availabilities in 1970 would be as follows: CA$ million Export Earnings 220 Net Private Capital 5 Net Public Capital 20 Total 245 In comparison, imports of goods and services in 1965 (net of income payments), were CA$232 million. Thus, if such imports were not to exceed the exchange availabilities in 1970, they could grow no more than an average rate of one percent annually. In previous years, imports had been growing at a much more rapid rate, consistent with rapid export and GDP growth while rising deficits in the current account balance were covered by heavy private and public capital inflows. 205. A direct implication of the foregoing is that internal credit restraint in the next few years will need to be geared to the lower rate of internal growth and permissible import growth. A drawing down of exchange -82- resources does not appear to offer much room for deliberately raising the rate of import growth, since even though banking system net international reserves doubled from 1962 to 196', they amounted to about two and one-half months' imports. Assuming that the relationships between growth of output and demand for credit in recent years remains unchanged, the growth of in- ternal credit would need to be left at slightly less than one percent annually. In recent years (e.g. l965), only about one-fifth of total bank credit was extended to the Centra7. Government. However, public demands on the credit system to help finance the investment program in the next few years will need to be severely lirnited to permit a maximum leeway for the private sector. One source of credit expansion for productive purposes -which should be expanded consists of foreign long-term loans for agriculture and industry. 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T /.t.* * To VT MCo ci OCTO,Eo To \ RO-1863 CENTRAL~~~~~~~~~~~~~~~L H-d- MERPOFA AREARCAF oi e KILOMETERS 12 > *§Qi~~~~~~~~~~~~~~~~~~~~~~~~~KIOETR ocToaER~~~~~~~~~ S 196 15RD-186 MA P IX V'p S. F., , ; CENTRAL AMERICA . A'. LOCAL AIRLINE ROUTES-iw AI RLI NE ROUTE5 d..S_. i =OOK~~~~~~~~M,. SEPTEMBER 1966 JSRD-1879