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June 2011 Determinants of Nicaragua’s long-term economic growth Mario A. De Franco Series of special studies Number 7 3 decisions of the rest of society. In poor countries, the different types of poverty traps that typically exist tend to mutually support each other. Graphic 1: Nicaragua, growth by periods. GDP per person 4.500 What are poverty traps? 3.000 4% 2,8% 3% 2,1% 1,4% 0,8% 2.500 3.504 1.500 1.000 500 -0,3% 4.232 2.000 -3,1% 1.640 2% 1% 0% -1% 2.916 2.605 1,0% 1.918 2.081 2.421 Percentage -2% -3% 1920-2007 2001-2007 -4% 1991-2000 0 1920-1950 It is important to identify the type of trap in which a country or family is found so as to identify how to get out of that vicious circle. There are various types. Some of the cases studied are Externalities derived from learning by doing, Externalities of business partners and Externalities due to financing restrictions. There are also theories that explain poverty traps due to the institutional agreement that predominates in society, an agreement that only favors a small group that exercises power, generating uncertainty and instability that affect the saving and investment US$ PPC 2005 3.500 A poverty trap refers to a condition in which an economy, a family or an individual is trapped in a persistent vicious circle of poverty and low growth that is self-perpetuated and self-reinforcing. 3,0% 4.000 Growth % 1979-1990 The central hypothesis of this document is that Nicaragua’s growth is caught in a poverty trap. The country cannot grow because it has a per person capital stock below what is needed to grow so that, even with an important investment injection, it could again fall into a poverty trap unless the factors that lead to capital insufficiency are eliminated. Between 1920 and 1950, the per-capita GDP (US$ PPP) grew 1.4 percent annually; between 1951 and 1960, when this indicator grew the most, it did so at a rate of 3 percent annually. At 2.8 percent, annual growth was also high from 1961 to 1972, and between 1973 and 1978 it grew at 2.1 percent annually. Between 1979 and 1990, the per-capita GDP rate was -3.1 percent annually and it continued dropping between 1991 and 2000, although at the much lower rate of -0.3 percent annually. In recent years, between 2001 and 2007, the per-capita GDP began to grow again, but only at an annual rate of 0.8 percent. Nicaragua’s per-capita GDP has been below Central American countries between 1950 and 2007, with the exception of Honduras between 1953 and 1978. Starting in 1979 the differences between Nicaragua and the region’s other countries began growing exponentially. 1973-1978 The growth of Nicaragua’s average per-capita Gross Domestic Product (GDP), measured in terms of purchasing power parity (PPP), has only been 1 percent annually between 1920 and 2007. In addition to growing minimally in absolute terms and decreasing in comparative terms, the results have been unequally distributed and have caused a large part of the population to live permanently in conditions of poverty and extreme poverty. In constant 2005 US$ PPP, Nicaragua’s per-capita GDP was US$1,526 in 1920 and US$2,183 in 2007, which means it grew an average of US$7.30 each year. 1961-1972 Centering the problem Economic growth facts 1951-1960 Executive summary Source: Based on Penn World Table 6.3 Economic trends and cycles. Over these nearly ninety years of its history, Nicaragua has gone through a dozen economic boom and bust cycles. This large number of economic cycles demonstrates the vulnerability characterizing the economy, a vulnerability that has been influenced over time by changes in international prices, 4 DETERMINANTS OF NICARAGUA’S LONG-TERM ECONOMIC GROWTH both internal and external social problems and problems of war as well as natural disasters, among others. Graphic 3: Nicaragua, Distribution of Income by percentiles. Percent of total income 1920-2007 Number of years 1998 2001 2005 90 Graphic 2: Nicaragua, duration of the economic cycle. 13 12 11 10 9 8 7 6 5 4 3 2 1 0 1993 100 80 70 60 50 40 30 20 10 0 0 19201922 19231926 19271932 19331936 19371949 19501960 19611972 19731979 19801993 19942003 20042009 Duration of cycle 2 3 5 3 12 10 11 6 12 9 5 Duration of growth 1 1 2 1 4 4 4 4 7 5 4 Source: Based on Penn World Table 6.3 Growth and decline. Economic theory indicates that countries with the lowest per-capita income show a greater number of times of negative growth rate. These decelerations have not necessarily been associated as much with external factors as with internal ones, as countries with a similar foreign trade structure are likely to have had similar behavior. Results of the growth: exclusion and poverty. Nicaragua’s economic growth, in addition to a decelerating trend, have also been characterized by an excluding and povertygenerating one. There is no unified theory that shows the correlation between growth and poverty, but there are empirical theories that confirm that inequality diminishes as a country grows. Inequality is one of Nicaragua’s major problems. The country’s income distribution for 1993, 1998, 2001 and 2005 show that in general there are no important changes during that period; on average the poorest 40 percent of the population has around 10 percent of the income and the wealthiest 20 percent has over 40 percent of it. 10 20 30 40 50 60 70 80 90 100 Population percentiles Source: Based on CEDLAC and World Bank data Sources of growth In conducting the traditional Growth Accounting exercise (which measures the contribution of the factors to growth) in different periods of approximately decades, the following is observed: Human capital has not made a significant contribution in any of the periods studied. The total productivity of factors only contributed positively to growth between 1961 and 1972 and between 1973 and 1978, and only minimally in that latter period. In the other periods its contribution has been negative. The labor force has participated more or less constantly, between 1.8 percent and 2.5 percent. Capital’s contribution, which has always been positive, has had a dramatic and permanently decreasing behavior. Graphic 4: Accounting of Growth in Nicaragua. (contribution of factors) 7 5 3 1 -2 -4 1961-1972 1973-1978 1979-1990 1991-2000 2001-2007 PTF 1,1 0,1 -3,0 -0,4 -0,3 H 0,5 0,3 0,4 0,7 0,7 L 2,2 2,5 2,1 1,9 1,8 K 2,4 2,3 0,4 0,5 0,6 GDP 6,1 5,2 -0,2 2,7 2,8 Source: Based on data of Daude and Fernandez-Árias (2010) 5 EXECUTIVE SUMMARY In Central America, only Honduras has had similar behavior to Nicaragua’s with respect to total productivity. Sources of growth: the demand side. The contributions to total growth of each of the components on the demand side can be calculated. In the 1950s and 60s (up to 1972), Nicaragua’s growth was explained first by the growth of domestic demand, particularly the strong increase in private consumption and per-capita investment. The reduction of growth that occurred between 1979 and 1990 was based on an extremely high per-capita compression of consumption of 4.1 percent annually, and on a percapita reduction of exports of 1.2 percent. Public spending was cut drastically between 1991 and 2000, particularly in the second half of the decade. Private per-capita consumption increased and investment grew at an annual rate of 1.8 percent while per-capita exports grew 1.1 percent. The exceedingly modest growth achieved from 2001 to 2007 is explained by the growth of exports. The per-capita private consumption growth was 1 percent. Furthermore, in this last period, the growth rate of investment was negative. From the 1950's to the early 70's, exports evidently grew at high rates, although due to their relative weight they did not have an equal impact on the growth rate per se, but perhaps more importantly they did result in income growth of individuals, which meant that private consumption and domestic demand grew. Per-capita capital and investment-GDP: a Poverty Trap Although Nicaragua has had the highest proportion of investment to GDP in Central America in the past fifty years, per-capita investment as of 1978 has been among the lowest. While a lot is invested as a proportion of today’s GDP, investment may be insufficient to contribute to growth due to the low accumulated levels. Nicaragua had per-capita capital of US$ 7,799 in 2007, but the minimum required to get onto a sustained growth path is US$14,083, according to the methodology and data used, which indicates that the country is in a poverty trap. Taking into account that its per-capita GDP that same year was US$2,180 in 2005 dollars, the investment required to achieve the minimum capital required would be nearly 290 percent of the GDP, much higher than that observed in the current Nicaraguan economy, which does not exceed 30 percent, including public investment. Graphic 6: Capital per person. (US$ 2005) kel_p 150.000 140.000 130.000 120.000 110.000 100.000 90.000 80.000 70.000 60.000 50.000 40.000 30.000 20.000 10.000 0 High threshold Los threshold Nic 2007 Nicaragua (2007), US$ 7,799.01 Graphic 5: Nicaragua, sources of aggregate demand growth. Internal demand Growth rate % 4,0% 3,5% 3,0% 2,5% 2,0% 1,5% 1,0% 0,5% 0,0% -0,5% -1,0% -1,5% -2,0% -2,5% -3,0% -3,5% -4,0% 2,99% 2,79% Export Import 2,22% Source: Based on data of Daude and Fernandez-Árias (2010). GDP 0,75% 0,73% -0,22% -3,16% 19511960 19611972 19731978 Import -0,9% -0,8% Export 0,8% 0,9% Internal demand 3,1% GDP 3,0% Source: Based on Penn World Table 6.3 19791990 19912000 20012007 19512007 -0,6% 0,1% -2,9% -1,4% -1,1% -0,1% -1,2% 1,1% 1,7% 0,5% 2,7% 3,0% -2,1% 1,6% 0,5% 1,3% 2,8% 2,2% -3,2% -0,2% 0,7% 0,7% Determinants of private investment Even if an investment level is provided exogenously such that a minimum threshold required or even more comes into the country, it could again lead to a poverty trap due to capital insufficiency if the factors that led to its reduction are not eliminated. The results of the econometric model used show that the investment in any quarter pulls 29 percent of the private 6 DETERMINANTS OF NICARAGUA’S LONG-TERM ECONOMIC GROWTH investment from the previous quarter, an increase of 1 percentage point of the profitability expected in the second quarter generates a private investment increase of 2.3 percent of the GDP and a 1 percent increase in the product gap generates a private investment increase of 0.5 percent of the GDP. Furthermore, a 1 percent increase in the real wage generates a private investment increase of 0.2 percent of the GDP, which suggests the presence of the efficiency wage effect, and/or the effect on the salary mass and aggregate demand. On the other hand, the reduction of uncertainty in one unit generates a private investment increase of 0.5 percent of the GDP. Similarly, an increase in the credit portfolio of 1 percent of the GDP generates a private investment increase of 0.6 percent of the GDP. Lastly, a public investment reduction of 1 percent of the GDP generates a private investment increase of 0.6 percent of the GDP. Decomposition of business profitability The net profitability of capital explains 54 percent of the changes in the evolution of private investment as a percentage of the GDP. In this regard, the most efficient way to stimulate private investment in Nicaragua is to create the conditions for average business profitability to increase considerably. Profitability components in Nicaragua Financial restrictions: Credit has been very costly, scarce, concentrated in a small group of activities and businesses, and reduced to the short term. There has been little access, legal limitations and distribution of a broad array of alternative sources of financing and other financial services. Relative prices: Relative prices have not benefited Nicaragua, until finally in 2007. Starting in the third quarter of that year, the competitiveness of its exports improved and the international market became more attractive than the national market. Salary, employment and labor productivity: Labor productivity is low due to problems with workers’ health and education, their insufficient training and skills, inadequate supervision and incentives, and low opportunity costs of losing a job because the probability of finding work (with low income or underemployment) is high, the probability of receiving remittances is high and real wages are low. The rigidity of the labor market, hiring and firing of employees and cooperation in employerworker relations do not seem to represent a problem in Nicaragua. The problems rather seem to have to do with the fragile institutionality and structural issues, resolvable in longer time periods. Tax burden and incomes: Nicaragua’s tax system still suffers from a set of incentives, exemptions and exonerations, which means that some activities, population segments and economic groups pay a high tax rate and others pay little or nothing. Nicaragua’s total tax burden is among the highest in Latin America, with an average of 17.7 percent of GDP, and is mainly collected on the population’s consumption. Energy: Nicaragua has the most expensive energy of any country in Central America. The high costs inhibit technological development and productivity increases, for example through irrigation in agriculture, and impact directly on family incomes. Logistics costs: Logistics and infrastructure also cover costs associated with suppliers’ prices. These costs in Nicaragua could represent between 17 and 48 percent of the delivery price of a set of products. Logistics costs in developed countries do not exceed 10 percent. Innovation. The objective of innovation is to improve processes aimed at developing the businesses, which involves investing, but the high risk-uncertainty levels make investing in innovation unattractive. Uncertainty. Uncertainty about institutionality issues is reflected in alarming indicators. The factors perceived as the most problematic in Nicaragua include political instability, corruption, inefficient governmental bureaucracy, inadequate education of the labor force, inadequate provision of infrastructures, and others, in that order. 7 EXECUTIVE SUMMARY Recommendations In addition to maintaining and deepening the macroeconomic stability, the following should also be done: re-found the public finances management system and eliminate the tax system’s horizontal and vertical inequalities; reduce the forms of protection enjoyed by some sectors; relax the financial restrictions; improve competitiveness and labor productivity; reduce energy and logistics costs; re-found the road infrastructure; increase social spending, particularly in education; and reduce uncertainty through the establishment of the rule of law. Some specific corrective measures are presented below: Financial restrictions. Produce a more competitive environment in the financial market: make possible the existence of more and more diverse financial intermediation businesses in the national market. The whole process regarding land ownership and all those assets whose rights are still in litigation or lacking some procedure to be able to alienate, sell, etc. should be speeded up and finalized. In addition, social security must be reviewed, as this is one of the few sources of long-term funds in Nicaragua and mechanisms should be designed that permit those funds to be able to profitably, safely and reliably finance long-term projects. Relative prices. It is crucial to keep Nicaragua’s inflation in line with international inflation and to revalue the exchange rate system. The process of transmitting international prices to the national market must be improved, which would strengthen competition. Salary, employment and labor productivity. Implement more continual and intense induction and training systems at a business level and review remuneration and incentive schemes that link payments to workers directly to productivity and quality. Also establish a close and ongoing relationship between companies and technical, vocational and commercial training schools, as well as with public and private universities. Tax burden and incomes. Improving Public Finance Management is fundamental. It requires a realistic budget to which the public can have access and which is prepared taking public policy into account. Mechanisms of control and custody of public funds must exist; registries must be prepared and revealed: and mechanisms to scrutinize public finances must be applied. It is also crucial to make explicit all public money and all public spending and tax spending; evaluate the impact and scope of spending; evaluate the consequences of the current tax burden; and move to a budget by objectives that can be monitored and evaluated independently and continuously. Energy. Ways must be found to lower energy prices to increase competitiveness. Investments in this area need to be increased to generate more energy, preferably renewable, and modernize the institutional and operational framework of the Central American electricity market. Logistics costs. Implement a National Infrastructure Plan and review the procedures related to the entire “supply chain,” particularly customs and warehousing red tape, to simplify and modernize them without neglecting control. Innovation. Establish an innovation policy. Uncertainty. It is necessary to promote the construction of a new social order among the diverse groups of society as well as society as a whole in which all citizens have equal rights and social and legal duties and in which the laws and compliance with them are for everybody. It is not possible to substantively change Nicaragua’s economic trends without constructing a new set of values on which society is based, a new set of rules of the game applicable to all and conceived for all. This is an urgent task, but one with long-term results. Please find the complete document in spanish at www. funides.com. Determinants of Nicaragua’s long-term economic growth June 20 11 T he N ic a r a gu an Foundation f or Economic and Social De v el op m en t w w w.yo utube . com/funide s ww w.twitte r. co m/funide s ww w.facebook. co m/funide s nicaragua w w w.blog. funide s . com info@ funide s . co m w ww. funide s . com ww w.sou ndcloud. co m/funide s and the nicaraguan private sector