Tearing Down the Walls: Growth and Inclusion in Guatemala

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1 Inter-American Development Bank Banco Interamericano de Desarrollo Banco Interamericano de desenvolvimento Banque interámericaine de développment GU-P1031 Country Department Central America, Mexico, Panama and Dominican Republic (CID) Non-Edited Draft Tearing Down the Walls: Growth and Inclusion in Guatemala An Inter-American Development Bank Research Project October 2007

2 Inter-American Development Bank (IDB) Tearing Down the Walls: Growth and Inclusion in Guatemala An IDB Research Project October 2007

3 Table of Contents I. Background and Objectives... 8 II. A Brief Description of the Guatemalan Economy... 9 III. Methodology and Preliminary Diagnostics IV. Constraints on Growth A. Low Economic Growth and Investment A.1. Is Economic Growth Low and is It Low Across the Board? A.2. Growth Decomposition Analysis A.3. Is Capital Accumulation Low? B. Barriers to Investment. Credit Market Imperfections B.1. Is investment financing readily available at a reasonable cost in Guatemala? B.2. International Comparison of Financing Conditions B.3. Are shallow, under-developed and poorly regulated financial markets a drag on investment? B.4. Is private return to investment higher than the interest rate? C. Social Returns to Economic Activity C.1. Global Competitiveness C.2. Human Capital Accumulation, Education and Returns C.3. Poor Infrastructure C.4. Incomplete linkages to the external sector in Guatemala C.5. Adoption of New Technologies D. Is Appropriability Low? D.1. Quality of governance D.2. Crime D.3. Does the tax structure hinder investment? D.4. Is expropriation risk high in Guatemala? D.5. Are there large externalities, spillovers or coordination failures? D.4. Are there information externalities that account for low levels of self-discovery? E. Informality and Growth E.1. Is informality of the economy and labor force a drag on investment? E.2. Is inflexibility in the labor market lowering the returns to otherwise appropriate investments? V. Conclusions 90 VI. Policy issues and reform sequencing References Tearing Down the Wall: Growth and Inclusion in Guatemala 2

4 Index of Tables Table 1. Per Capita GDP in constant international USD PPP Table 2. Economic Volatility in Selected Countries Table 3. Annualized Growth Rate by Economic Sector (In percentage) Table 4. Sector Contribution to Economic Growth (In percentage) Table 5. Labor Informality by Economic Sector Table 6. Update of Loening s TFP estimation approach. Guatemala Table 7. Harberger s TFP estimation. Guatemala, Table 8. Average Savings Ratio in Selected Countries Table 9. Guatemala: Market Capitalization and Investment (2000) Table 10. Guatemala: Stylized Facts of Investment in the Formal Sector Table 11. International Clustering by Financing Conditions Table 12. International Clustering by Availability of Credit Table 13. Cross-Country Clustering of Firms by Terms of Financing Table 14. Relative Performance Table 15. Literacy rate according to gender and ethnicity, Table 16. Recent Evolution of Education in Guatemala Table 17. Health Indicators. Guatemala vs. Latin American and High Income countries Table 18. Health Indicators. Guatemala vs. Central America Countries Table 19. Access to water and sanitation facilities Table 20. Returns to Schooling Table 21. Evolution of Returns to Schooling in Guatemala Table 22. Years of Schooling Table 23. Mincer Equation and Indigenous Groups Table 24. Returns to education for Migrants in the US Table 25. International Trade in Selected Countries (Average ) Table 26. Average distance for groups of products Table 27. Discoveries by Country Table 28. Kaufmann s Indicators Table 29. Investment Climate from an International Perspective Table 30. Statutory Tax Burden on Capital. International Benchmarking Table 31. Average Income in the Formal and Informal Sectors Table 32. Real Value Added in the Formal and Informal Sectors (as a percentage) Table 33. Capital Accumulation in the Formal and Informal Sectors Table 34. Labor Market conditions in Guatemala Table 35. Labor Taxes in Guatemala Tearing Down the Wall: Growth and Inclusion in Guatemala 3

5 Index of Figures Figure 1. Guatemala s GDP Compared to the United States Figure 2.Relative performance of Guatemala, Figure 3. Guatemala: GDP trend-cycle decompositions by economic sector Figure 4.Average Productivity and Output Growth, Figure 5.Gross Fixed Capital Formation in the Formal and Informal Sectors Figure 6. Foreign Direct Investment in Selected Latin American Countries ( ) Figure 7. Guatemala: External Resource Inflows Figure 8. Average Interest Rate Spreads in Selected Countries Basis Points ( ) Figure 9.Guatemala vs. High-Cost Countries Figure 10. M2 and Credit to the Private Sector Figure 11. Global Competitiveness Index, Figure 12. Ranking in the GCI and Income Level Figure 13. Ranking in worst relative pillar situation and Income Level Figure 14. International Benchmarking, year Figure 15. International Benchmarking. Public Expenditure in Education as a percentage of GDP, year Figure 16. International Benchmarking. Private sector share in secondary school, year Figure 17. Growth Rate and Increase in Returns to Schooling in Latin America Figure 18. Distribution of the Human Capital Stock in Guatemala (2004) Figure 19. Distribution of the Human Capital Stock in Guatemala (2004) Figure 20. Ranking in Telephony Coverage Figure 21. Cost of a 3-minute call to the US Figure 22. Internet users in the Americas. Each 100 inhabitants Figure 23. Electricity Coverage in Selected Countries Figure 24. Electricity Consumption in Selected Countries Figure 25. Guatemala: Exports and the Real Exchange Rate Figure 26. Recent Export Trends by Main Export Components Figure 27. Open Forest Analysis Figure 28. Export productivity (EXPY) and GDP per capita in Latin America Figure 29. Export Composition. Guatemala, Figure 30. Crossing Distances Figure 31. Exports. Guatemala Figure 32. Patent Applications in Selected Countries Figure 33. Cross-Country Comparison of ISO Certifications Figure 34. Spending in Research and Development in Selected Countries Figure 35. Intellectual Property Rights Index Figure 36. Kaufmann Indexes of Institutional Quality. Guatemala Figure 37. Tax Revenues as a percentage GDP. Guatemala, Figure 38. Real Value Added in the Informal Sector Figure 39. Capital Accumulation in the Formal and Informal Sectors Tearing Down the Wall: Growth and Inclusion in Guatemala 4

6 Acronyms and Abbreviations AGEXPORT ASAZGUA CACM CAFTA CBERA CBI CBTPA CEPAL CIEN CIID CNEE CONCYT DIACO ENCOVI ENSMI FDI FENACOAC FOPA FTA FTAA FTZ GDP GNP GUATEL ICA ICAITI ICS ICT IDA IDB IGSS IMAE IMF INCAE INDE INTECAP IPR ITU MAGA MCIV MDG MEM MFA MFIs MFN MSE MSPAS NAFTA NGO NIS NSST NTB OECD PRONACOM Guatemalan Exporters Association Guatemalan Sugar Association Central American Common Market Central America Free Trade Agreement Caribbean Basin Economic Recovery Act Caribbean Basin Initiative Caribbean Basin Trade Partnership Act Economic Commission for Latin America and the Caribbean Centro de Investigaciones Económicas Nacionales Consejo de Investigaciones e Información en Desarrollo Comisión Nacional de Energía Eléctrica Consejo Nacional de Ciencia y Tecnología Office for the Attention and Assistance to Consumers Encuesta de Condiciones de Vida National Survey on Maternal and Child Health Foreign Direct Investment Federación Nacional de Cooperativas de Ahorro y Crédito Deposit insurance fund Free Trade Agreement Free Trade Area of the Americas Free-Trade Zone Gross Domestic Product Gross National Product Empresa Guatemalteca de Telecomunicaciones Investment Climate Assessment Instituto Centroamericano de Investigacion y Tecnologia Industrial Investment Climate Survey Information and Communication Technologies International Development Association Inter-American Development Bank Guatemalan Social Security Institute Indice Mensual de la Actividad Económica International Monetary Fund Instituto Centroamericano de Administración de Empresas Instituto Nacional de Electrificación Technical Institute for Training and Productivity Intellectual Property Rights International Telecommunications Union Ministry of Agriculture, Livestock, and Food Ministry of Communication, Infrastructure and Housing Millennium Development Goals Ministry of Energy and Mining Multilateral Fiber Agreement Microfinance Institutions Most Favored Nation Medium and Small Enterprises Ministry of Public Health and Social Action North America Free Trade Agreement Non-Governmental Organization National Innovation System National System of Science and Technology Non-Tariff Barriers Organisation for Economic Co-operation and Development National Competitiveness Program Tearing Down the Wall: Growth and Inclusion in Guatemala 5

7 PRONADE R&D RCA REDIMIF RER RGP RIC ROA ROE SAC SAT SEGEPLAN SENACYT SIAF SIECA SINCYT SME TFP TRIPS UNCOMTRADE UNDP UNESCO VAT WB WBES WDI WEF WHO WIPO WTO National Program of Education Research and Development Revealed Comparative Advantage National Microfinance Industry Association Real Exchange Rate Registro General de la Propiedad Registro de Información Catastral Returns on Assets Returns on Equity Central American Tariffs System Superintendencia de Administración Tributaria General Secretariat of Planning National Secretariat of Science and Technology Sistema Integrado de Administración Financiera Secretariat for the Economic Integration of Central America Sistema Nacional de Ciencia y Tecnología Small and Medium Enterprise Total Factor Productivity Trade-Related Aspects of Intellectual Property Rights United Nations Commodity Trade Statistics Database United Nations Development Programme United Nations Educational, Scientific and Cultural Organization Value-Added Tax World Bank World Business Environment Survey World Development Indicators World Economic Forum World Health Organization World Intellectual Property Organization World Trade Organization Tearing Down the Wall: Growth and Inclusion in Guatemala 6

8 Acknowledgements This paper was prepared by Daniel Artana, Sebastián Auguste and Mario Cuevas. The authors wish to thank Hugo Maul for his guidance in the preparation of the section on informality, and Jaime Díaz for able and dedicated research assistance. We take this opportunity to thank our peer reviewers, Manuel Agosín, Ronan Le Berre, Osmel Manzano, Ernesto Stein, and Alfie Ulloa, for the very useful comments that we received. Also, the authors would like to recognize the value of the lively and focused discussions held in May 3-4, 2007 and September 20-22, 2007 at the IDB Headquarters in Washington DC, in the context of the seminar Competitiveness and Growth in Latin America and The Caribbean. The feedback and comments provided by seminar participants were extremely useful in the preparation of this paper. Also, we would like to express our gratitude to the administrative staff at the IDB, especially Raquel Gómez, for the assistance and guidance that we have received throughout the life of this project. Finally, we commend the efforts, financial and otherwise, of the Office of the Chief Economist of the IDB, in promoting and sponsoring economic research in the region. Tearing Down the Wall: Growth and Inclusion in Guatemala 7

9 I. Background and Objectives Since the 1980s countries in Latin America and the Caribbean have been searching for a strategy to improve economic performance and reduce poverty. No unequivocally successful strategy has been found so far and the region s economic performance has fallen behind most of the rest of the developing world, especially the emerging economies of Asia and Eastern Europe. Guatemala has not escaped the trend set by the region and greater understanding is required concerning the constraints that are holding back the country s performance. New approaches are needed that would help to identify binding constraints to growth, i.e., constraints whose removal would have a particularly large payoff in terms of growth. It is likely that common patterns of constraints exist across countries in Latin America, but a successful approach to the identification of growth constraints has to be flexible enough to accommodate the country s specific conditions. From a public policy perspective, bare identification of binding constraints is insufficient. Policy design requires prioritization on the basis of knowledge of constraints that are most binding in the sense that its removal would have a larger effect on growth, so that the most pressing issues are addressed first. A Growth Diagnostics Methodology (GDM) has been developed recently that seeks to simultaneously resolve the identification, prioritization and sequencing issues that arise in the removal of binding constraints. Objectives of the study This study aims at identifying and prioritizing constraints in such way that useful and specific policy recommendations would follow. The study will apply the GDM approach adjusting it as needed to fit country conditions. The paper identifies and prioritizes constraints following a "clinical economics" approach (Sachs (2005)), formulating a set of questions about constraints to competitiveness and growth and then looking for evidence to support the proposed answers. Tearing Down the Wall: Growth and Inclusion in Guatemala 8

10 II. A Brief Description of the Guatemalan Economy Guatemala at a glance Guatemala is the largest country in Central America in terms of population (almost 13 million). About 40% of the population is indigenous and live in rural areas. In addition, population is growing rapidly (around 2.5% per annum) and is relatively young (about half the population is under eighteen years of age). Also, Guatemala is the largest economy in Central America (over US$32 billion) with economic activity relying mainly on commerce, agriculture and manufacturing. GDP per capita currently stands at around US$2,500. Despite being considered a Middle-Income Country (MIC), Guatemala s social indicators reflect slow growth and a skewed income distribution. 1 Education attainment is extremely low (between four and five years on average) for a MIC and, despite advances in enrollment in primary education, the illiteracy rate remains close to one third. Health indicators are similarly poor: only two thirds of the population enjoys access to basic health care, the child malnutrition rate is high, and maternal and infant mortality rates are among the worst in Latin America. Not surprisingly, the poverty rate is unusually high for a MIC, since over half of the population lives below the poverty line. The Peace Agreement as a milestone The civil strife ended in 1996 with the signing of a Peace Agreement. The long conflict deepened historical divisions, thwarted institutional development and weakened governance. The Peace Agreement sought to establish an agenda of public policies to develop the country and reduce inequality, emphasizing social policies targeted to those who were historically marginalized (indigenous and rural populations). The Peace Agreement did not provide a detailed roadmap on how to achieve the objectives After the agreement, the coordination among different groups of interests and the design of those policies proved to be very hard, and therefore little progress has been done so far in terms of reaching the agreement s goals. Economic performance: steady but slow Despite the fact that real GDP growth averaged slightly more than 4% per year since 1950, per capita GDP growth averaged only 1.3%. As a result of slow growth, the country has been falling behind internationally, its share on the world GDP is today 21% below the share in The comparison is even less favorable when we look at high-growth emerging economies. For instance, Singapore s GDP per capita is almost seven times Guatemala s GDP per capita today, while at the end of the fifties they were similar. Costa Rica, the fastest growing country in the Central America region, grew by 54% between 1975 and 2000 (real GDP per capita), whereas in the same period Guatemala only did it by 20%. 1 The income-based Gini Coefficient is 0.57 (the second highest in Latin America and one of the highest in the world.) Tearing Down the Wall: Growth and Inclusion in Guatemala 9

11 Table 1. Per Capita GDP in constant international USD PPP Country Costa Rica 5,791 6,609 6,005 6,396 7,200 8,621 8,931 El Salvador 4,658 4,187 3,523 3,607 4,339 4,595 4,742 Guatemala 3,342 3,856 3,261 3,366 3,667 3,978 3,997 Honduras 2,149 2,644 2,434 2,495 2,570 2,506 2,494 Nicaragua 6,460 4,386 3,957 2,852 3,049 3,278 3,291 South Korea 3,721 4,847 6,649 9,793 13,597 16,179 19,560 Singapore 6,579 9,752 10,896 14,755 19,512 23,744 26,764 Thailand 1,904 2,510 3,022 4,552 6,471 6,279 7,649 Malaysia 2,955 3,987 4,660 5,538 7,663 8,927 9,699 Indonesia 1,100 1,462 1,769 2,267 3,011 3,028 3,437 Asian Countries Average a 3,252 4,512 5,399 7,381 10,051 11,631 13,422 Source: CIEN calculation based on the World Development Indicators. The calculations were made using PPP US$ of a This average contains the follow countries: South Korea, Singapore, Thailand, Malaysia, Indonesia. Although with a slower long term, growth in Guatemala have followed broadly the same regional pattern: during the sixties and seventies economic growth was fairly rapid, it slowed down in the eighties and rose again in the nineties, but it did not reach pre 80s level. Inflation has been relatively low by Latin American standards, averaging less than 10% annually since the sixties and it is worth highlighting that, unlike most other countries in the region, Guatemala has not endured many macroeconomic crises. Coefficient of Variation of: Table 2. Economic Volatility in Selected Countries Country Costa Rica Nicaragua Guatemala Malaysia Singapore Thailand Argentina Brazil Exchange Rate (% change) Chile Costa Rica Nicaragua Guatemala Malaysia GDP per capita (PPP in constant US$ Singapore Thailand Argentina Brazil dollars) Chile Costa Rica Nicaragua Guatemala Malaysia Singapore Thailand Argentina N.A Inflation Rate Brazil N.A (% Change) Chile Source: CIEN calculation based on the International Financial Statistics. This index is constructed dividing the standard deviation of each variable by its mean and multiplied by 100. Slow policy and structural change Economic policies in Guatemala have followed closely the trend observed in other Latin American countries. For example, in the fifties and sixties Guatemala introduced import substitution policies, controls on interest rates, a fixed exchange rate, credit targets and large-scale infrastructure investments. As in other countries, import substitution turned out Tearing Down the Wall: Growth and Inclusion in Guatemala 10

12 to be unsustainable and created rigidities in the economy. When policy reforms were introduced in the eighties and nineties, the growth balance changed. The GDP shares of manufacturing and agriculture have been falling steadily while the service sector has been rapidly growing. Agriculture, although, remains an important sector in the economy, particularly in terms of employment generation. The services sector currently includes the most dynamic activities in the Guatemalan economy, including commerce, transport, power, telecommunications and banking. The benefits and challenges of economic diversification The Guatemalan economy is now less volatile than it used to be. A more stable growth pattern reflects in part the dampening effects of increased economic diversification, since services tends to be less volatile than agriculture. The reduced volatility was also brought about by responsible macroeconomic management and the adoption of policies that dampen the impact of external shocks, such as interest rate liberalization and a floating exchange rate. As a result, growth and inflation volatility of the Guatemalan economy are lower than regional averages. On the up side, economic diversification is already pointing to factors that may be important for sustaining future growth. For example, there is now increased demand for a better quality labor force and modern infrastructure, as well as pressure to strengthen the policy and institutional framework. Unfortunately, deep structural imbalances remain to be addressed, since current trends do not as yet seem to be promoting the fuller integration of domestic markets, by reducing the growing gap between the formal and informal sectors or fostering rural development. Uneven responses and linkages to the external sector Despite progress in reducing tariffs and liberalizing trade, developments in maquila and exports of other nontraditional products, total exports are not growing fast, and in the last 5 years its share on GDP have stagnated at around 17%.. Guatemala remains a relatively closed country, the ratio of Trade flows (exports plus imports) as percentage of GDP has increased from 39 % in 1991 to 46 % in 2006, almost exclusively due to the increase in imports, and this ratio is still the lowest in Central America. The stagnant export ratio of recent years is the result of major divergences in the trends of the three leading export sectors. The first is the maquila sector, which benefited greatly from the U.S. trade preferences and the relative success of the Free Trade Zone (FTZ) regimes in attracting FDI. The second is the group of traditional exports (like coffee, bananas and sugar) which saw trade volumes fall steadily during the nineties as a consequence of slow demand growth and low commodity prices. The third is nontraditional exports (including flowers, vegetables, fruits and organic crops) which developed rapidly in the nineties. 2 As a result of these diverging trends, the Guatemalan export basket diversified despite stagnation in export values relative to total GDP. 2 Growth of services exports has accelerated recently. A recent study completed by CIEN (2006) highlights the growth in services exports such as business process outsourcing, medical services, medical tourism and long-term care. Two out of the six industrial clusters supported by the National Competitiveness Program are in the services sector (tourism and software). Tearing Down the Wall: Growth and Inclusion in Guatemala 11

13 The rapid growth of non-traditional agricultural exports is generally attributed to: (a) previous agricultural policies to promote diversification; (b) access to long-term financing from public credit programs; and (c) investments in infrastructure facilities like irrigation, roads and electricity. In addition, private organizations and trade associations like the Exporters Association (AGEXPORT), played a catalytic role in promoting nontraditional exports. Policy reforms in overlapping waves The transition to democracy in the mid eighties triggered successive waves of overlapping policy reforms. In the last twenty years, the country has undergone three major phases of policy reforms. First, the trade regime was liberalized in the mid to the late eighties, especially, although not exclusively, in the context of the Central American Common Market (CACM); tariffs were reduced and exchange controls and many non-tariff barriers eliminated; fiscal incentives through tax and duty exemptions were granted to maquilas and non-traditional agricultural exporters. During the first wave of reforms the country joined the GATT, entered into several trade agreements and was included in the Caribbean Basin Initiative (CBI). The first wave of reforms deepened in the nineties with the removal of export taxes, tariff reductions (the unweighted average tariff was reduced to less than 10%) and further exchange rate liberalization. The first wave of policy reforms opened up the economy and signaled a drastic departure from the import substitution model. The second wave of policy reforms was meant to liberalize the financial sector. Beginning in the early nineties interest rates were liberalized, independence of the Central Bank was strengthened, standardized reserve requirements were introduced, compulsory lending was eliminated, supervision of the banking sector was improved and a deposit guarantee scheme was introduced. These policies were also meant to enhance competition and facilitate restructuring of the banking sector through mergers and acquisitions. These reforms deepened financial markets and facilitated the expansion of available services; for example, financial depth measured by the ratio of broad money to GDP rose from 22% in 1990, to 29% in Further legal and policy reforms in the financial sector were introduced in The third wave of reforms, starting in the late nineties increased the participation of the private sector in infrastructure and modernized the regulatory framework. The reforms included privatization of power and telecommunications, concessions for the operation of the rail network and road construction, a management contract for mail services, as well as further liberalization of foreign investment, among others structural policy reforms. The third wave of reforms facilitated the acceleration of growth in the non-financial services sector and set the stage for the subsequent recovery of the construction sector. Together, the three waves of policy reforms overhauled public policy in Guatemala. However, as it will be discussed later, there are still important reforms left to be implemented, which are critical to realize the full benefits of previous reforms. Adjustment to economic shocks In recent years, Guatemala has been subjected to several economic shocks, both internal and external. In the late nineties, the terms of trade were negatively affected as a result of a Tearing Down the Wall: Growth and Inclusion in Guatemala 12

14 severe and protracted collapse in the international price of coffee; export revenues halved between 1999 and 2002, hurting an estimated 600,000 people directly or indirectly involved in the coffee business. Subsequently, an economic slowdown in the United States and other trading partners in again hit exports revenues, especially maquila products. More recently, the sharp increase in the price of oil has led to a rising fuel import bill and deteriorating terms of trade. Guatemala has adjusted to both internal and external shocks and, despite the stagnation in the level of real per capita GDP, consumption has continued to increase. This is in part the result of foreign exchange inflows that have softened the impact of external shocks. Such inflows include remittances (rising from around US$400 million in 1997 to US$3,575 million in 2006) and external financing for the private sector. Other types of flows have likely cushioned the impact of external shocks, including possibly revenues from the trafficking of illicit goods and money laundering. Internal shocks have also taken place. The Central Bank fell into a policy trap by seeking to sterilize financial inflows, while simultaneously emphasizing controls on money aggregates and fostering nominal exchange rate stability, thus leaving little room for responding to real shocks. Political conditions during also slowed growth, since tensions between the government and the private sector led to deterioration in the investment climate and delays in the reform agenda. The end of the negative terms of trade shock, improved economic performance in the United States and other trading partners, as well as rapid growth of international liquidity, set the stage for recovery starting in More recently, positive expectations fueled by CAFTA-DR have increased investor confidence and domestic monetary easing (responding to external conditions) has validated the economic recovery in terms of low real interest rates. The debate about the policy reform agenda There is a consensus internationally that the most immediate challenge for Guatemala is improving the provision of public goods, which almost unavoidably requires overcoming strong domestic opposition to increasing tax collection. The Peace Agreement set a tax revenue target of 12% of GDP to be reached by 2002, a significant increase from the level that existed at the time of the Agreement (7.9%). Unfortunately, progress in terms of tax revenues has been slow, limiting the implementation of public policies and leaving little room for increasing investment in key public goods, such as education, security and infrastructure. The exchange rate is also generating concern in Guatemala. Remittances and private financial inflows, as well as flows associated with illegal activities, are driving a sustained real exchange rate appreciation. 3 Such concerns are misplaced to the extent that the level of the real exchange rate is set not only by the behavior of the nominal exchange rate and inflation differentials, but also by factors that would not be resolved by engineering a shortlived nominal depreciation. 3 Illegal capital inflows are related to criminal activities (e.g. drug trafficking) that are difficult to control by the State. Tearing Down the Wall: Growth and Inclusion in Guatemala 13

15 Aside from fiscal and monetary policy, the current debate on policy reform in Guatemala spans other policy areas too. Education, health, infrastructure and domestic security today appear prominently in the debate. It has been mentioned already that Guatemala scores poorly in terms of education and health, infrastructure bottlenecks may set a ceiling on growth, and security concerns sour the investment climate. The population and some segments of the business community appear rather unexcited about the signing of the CAFTA-DR (2006), in the face of a dysfunctional public education system, a derelict public health and social security system, crumbling public infrastructure and a constant stream of violent crime. Attempts at building consensus around reform One initiative, named Plan Visión de País, aims at building and strengthening a broad consensus among political actors on the key principles that should guide policy reform in the next several years (in education, security, health and nutrition, rural development, macro-fiscal policy and intercultural relations). The Plan was promoted by a particular segment of the business community and a committee of senior public figures. Following complex negotiations, all political parties with representation in Congress signed a declaration of principles. Unfortunately, the Plan was temporarily shelved after falling victim to the complex political environment prevailing in Guatemala. The Pacto Fiscal has also been revived, to review and strengthen the country s faltering tax policy. The current Pacto Fiscal follows several previous attempts at building a consensus on tax reform and is supported by various political actors, interest groups and the government. Its aim is to find a more sustainable solution to long-standing shortcomings in fiscal policy. It is worth noting that some of the patches introduced by previous incarnations of the Pacto Fiscal expire in 2008, leaving a potential gap in public revenues unless new solutions are forthcoming. It is worth highlighting that the Pacto Fiscal is now emphasizing transparency in fiscal policy, especially with regard to expenditures, to complement tax reforms. In light of this discussion, it would appear that the next government will have a full plate of challenges from the day of its inauguration. It also appears that a study dealing with the fundamentals of growth and competitiveness in Guatemala is especially timely and has the potential to contribute fruitfully to the coming round of discussions on policy reforms. Tearing Down the Wall: Growth and Inclusion in Guatemala 14

16 III. Methodology and Preliminary Diagnostics The Growth Diagnostics Methodology (GDM) According to the growth diagnostic methodology (GDM) proposed by Hausmann, Rodrik, and Velasco (2004), factor accumulation depends on the (risk-adjusted) private returns to factor accumulation and the cost of financing. Therefore the concept of growth constraint involves: (a) factors that affect the (risk-adjusted) private return to accumulation and (b) factors that affect the cost of financing accumulation. If (a) is more important (or most binding) we are in presence of a case of lack of opportunities (as in El Salvador according to Hausmann et al.) If factor (b) is more important, we are in presence of a case of high cost of financing. The lack of opportunities could arise because social returns are low (for instance, because of the lack of complementary inputs, low competitiveness or too little self discovery) and/or the rate of appropriability is very low (corruption, risk of fiscal or financial crisis, taxes, etc.). On the other hand, costly financing could be due to poor international financing or weak domestic policies. Guatemala in light of the GDM In the context of the GDM, Guatemala can be characterized as a case of slow growth, with a mix of low productivity growth as well as slow physical and human capital accumulation (see the decision tree adapted to Guatemala, where we indicate in bold the critical factors.) In terms of (risk-adjusted) social returns, in Guatemala there are several factors influencing risks and appropriability such as the poor quality of institutions and weaknesses in the investment climate (especially, although not exclusively, concerning domestic security). There are also several factors reducing social returns, such as: poor human capital when compared to other economies (even economies with the same income level); underdeveloped infrastructure; and, in general, poor provision of public goods due to the Government s inability to tax revenues. From the financing side, international factors do not seem to be a significant constraint in the case of Guatemala. Macroeconomic indicators broadly show that Guatemala is characterized by relative macroeconomic stability, low inflation and generally conservative fiscal policies. Foreign exchange inflows due to remittances and other private inflows are abundant, although the remittances are mostly consumed rather than invested (OIM, 2006). 4 From the micro point of view, there are some factors distorting domestic financial markets such as weak banking regulation and supervision, poor creditor protection and inadequate bankruptcy procedures. 4 According to the Encovi survey, of the 7276 households sampled, 1620 reported to receive remittances. Of these 1620 households, only 96 are net savers (i.e. only for 96 households the total expenditure is lower than the household income, including all the sources of income, even remittances.) Of course part of the expenditure can be considered investment and not consumption, since household can spend on education (investing in human capital), on durable goods and housing (investing in housing physical capital), but the low savings rate for the households receiving remittances shows that this flow is not going to business investment. Tearing Down the Wall: Growth and Inclusion in Guatemala 15

17 k& k Low Growth: = σ [ r(1 τ ) p ρ] and Low I/GDP High Private Return but Barriers to Investment Low Returns to Economic Activities (Lack of Opportunities) Costly International Finance - High Country Risk Costly Local Finance Low Appropriability Low Social Returns Poor public debt management, FDI conditions unattractive Capital controls Low Domestic Savings: 1. Financial system weakness 2. Inappropriate savings-boosting framework Poor Intermediation (high spreads) 1. Little competition 2. Weak Regulation 3. Thin domestic markets High Micro Risk: 1. Risk of expropriation 2. Legal Instability 3. Corruption High Macro Risk: 1. Poor banking regulations (high risk of banking crisis) 2. Risk of financial or fiscal crisis 3. Foreign exchange risk High tax rates or inefficient tax structure. Externalities, spillovers and coordination failure Low supply of complementary inputs: 1. Human capital 2. Poor infrastructure High transport, telecommunications or shipping costs. Low Competitiveness due to: 1. appreciated foreign exchange rate (Dutch Disease problem originated by remittances) 2. Lack of access to international markets Lack of R&D Property Right badly defined or enforced Too little self-discovery Informality Tearing Down the Wall: Growth and Inclusion in Guatemala 16

18 Informality and the GDM decision tree A striking characteristic of Guatemala is the very large share of the informal sector in the economy and, particularly, the labor force (75%). Informality is endogenous, it emerges as a result of the decisions of firms and workers. Thus, high informality might hinder factor accumulation and economic growth across the whole economy. As Gordon and Lee (2005) point out, for firms the main benefits of becoming "formal" are access to foreign markets, access to credit markets, property rights enforcement and access to the judicial system, at the cost of paying higher taxes (and probably higher compliance costs.) 5 This is a risky decision, where the balance of enforcement and penalties influences decision outcomes too. The benefits of becoming formal can be low because of several reasons, including: Credit market imperfections; Restricted access to foreign markets or lack of countrywide international competitiveness; Problems in the judicial system or property rights (inappropriate regulations and laws, or inefficient application of existing rules). Not all productive sectors offer the same possibilities as these depend on sector-specific costs and benefits. For instance, informality is less likely in export-oriented activities since law enforcement is easier in this case. Sectors where economies of scale are substantial might require large, visible firms which generally can be more closely audited. In addition, lack of complementary inputs of capital (such as human capital or public infrastructure) or problems with the enforcement of property rights might favor activities that are less capital intensive and more likely to become informal. This turns into a vicious circle: since the hard-to-tax sector of the economy is large, tax revenues are low and hence the government cannot invest in complementary factors that would make formality more attractive. In turn, since the government needs to collect revenues, it is forced to increase tax pressure on the formal sector, thus encouraging informality. For individuals there is a similar trade off. A worker in the formal sector benefits from social security at the cost of paying higher taxes (payroll and income taxes), but workers in the informal sector benefit from some public goods regardless of contributions to their provision. The perception that taxpayers have about government services also influence decisions. The typical logic followed by taxpayers goes along the lines of why should I pay taxes if corruption is high and tax revenues will be pocketed by politicians or bureaucrats rather than coming back to me as public goods? What is clear in Guatemala is that the government has had problems increasing tax revenues, public investment has remained historically low, economic growth is low, socio-economic indicators are extremely poor, and informality has been growing in response to these conditions. The fact that informality is endogenous does not necessarily mean that informality has not 5 The literature on compliance costs (see Auguste (2006) for a survey) shows that usually there are large economies of scale, what means these costs are regressive, and therefore the incentive to become informal higher for smaller firms. Several countries in the region have introduced simplified tax regimes for very small firms (impuesto único) with the intention to increase revenues and reduce informality reducing compliance costs.

19 had a negative effect on growth. High informality obviously shows that the benefits of becoming formal do not, in practice, compensate the costs. In this sense informality is a symptom of the underlying weaknesses and distortions in the Guatemalan economy. But once a firm decides to go informal, it has to distort its behavior to avoid detection and this doing so hurts growth. At this point, informality becomes not only a symptom but also a factor constraining growth. To see this, note that the informal sector usually is: (a) less capital intensive, because of restrictions in accessing credit markets, lack of protection afforded by law, and the need to remain invisible to evade taxes; (b) less innovative, because of the lack of protection afforded by law; (c) distorting the use of technology (i.e. if two technologies are available for production, a firm that decides to be informal probably will choose the less capital intensive one though it may be relatively inefficient); (d) less human capital intensive (since human capital usually is complementary of physical capital and the degree of sophistication of the technology, informal firms might demand less human capital, not favoring its accumulation). As a consequence of these characteristics and distortions in firm behavior, the informal sector is usually associated with lower labor productivity and slower TFP growth, which translate into low economic growth. In this study we will analyze these hypotheses in greater detail following a clinical economics approach, starting from the beginning of the decision tree and moving down to the branches, seeking to identify how these factors (financing or lack of opportunity) are constraining growth and also which factors might be most binding. Tearing Down the Wall: Growth and Inclusion in Guatemala 18

20 IV. Constraints on Growth A. Low Economic Growth and Investment A.1. Is Economic Growth Low and is It Low Across the Board? Growth, structural change and lingering disappointments Guatemala s GDP per capita is now 5.9% of the U.S. GDP per capita when in 1960 it was almost 9%. Since 1950, real GDP per capita has increased by only 1.3% yearly and the country has lagged behind developed economies. Guatemala s share of the world economy is now 20% less than it was in 1980 and it is growing close to the world average rate, far behind the growth rates of successful economies in the region (such as Costa Rica and Chile) and fast growing developing countries in the world. Figure 1. Guatemala s GDP Compared to the United States (Ratio of nominal GDP per capita in US$ in Guatemala relative to the US) Ratio Guatemala/US of per capita US$ nominal GDP 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Figure 2.Relative performance of Guatemala, GDP based on purchasing-power-parity (PPP) as a share of world total (index 1980=100) Malaysia Index 1980= Source: Own elaboration based on World Economic Indicators Mauritius Chile Costa Rica Guatemala The country s growth process can be divided into three broad phases. Reasonably healthy growth rates in (average real GDP growth rate of 4.8% per year). A second phase, , characterized by external shocks and the internal conflict, with a slowdown that starts shortly after the international oil crisis and a major earthquake in 1976 (average real GDP growth rate of 2.2% per year). Finally, there is a third phase that Tearing Down the Wall: Growth and Inclusion in Guatemala 19

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