By Drew Sample for IFPRI.

Central American countries remain susceptible to global economic downturns and need to consider policy options that would counter the effects of a potential worldwide recession, according to a new paper from the International Food Policy Research Institute (IFPRI).

“External Shocks, Food Security, and Development: Exploring Scenarios for Central America” examines the economies of five Central American countries – Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua – and finds that flexible exchange rates are a critical policy tool that allowed economies to recover more quickly after a downturn. In that regard, a lack of monetary policy tools leaves El Salvador uniquely vulnerable.

“Among the countries we examined, El Salvador’s adoption of the dollar as its domestic currency limits its ability to respond to an external macroeconomic shock,” says Eugenio Diaz-Bonilla, senior research fellow at IFPRI and lead author of the report. “Our analysis found that a flexible exchange rate was preferable to a fixed exchange rate for maintaining GDP per capita in the face of negative economic pressure.”

Recent history suggests the likelihood of another recession in the near future. In that event, fiscal constraints would prevent a strong fiscal and monetary policy response comparable to the one that followed the last recession. “The policy toolkit is relatively constrained,” argues Diaz-Bonilla, “but an aggregate demand response that included a combination of public investments and tax cuts would increase GDP per capita, while direct transfers to the poor would also be needed.”

The study modeled a scenario with decelerated world growth, lower commodity prices, and a decline in remittances and capital flows to Central American countries at a rate half as severe as the 2009 crisis. The researchers suggest that under such a scenario, a combination of policy responses could help cushion the blow.

According to Valeria Piñeiro, research coordinator at IFPRI and co-author to the report, “direct transfers to the poor would have little impact on average GDP per capita in this scenario, but would be of great importance for helping them weather the shock.”

The research stressed that these measures would be most effective when deployed in tandem with currency adjustments.  The authors also noted that for most countries, exchange rate flexibility could speed the recovery, but El Salvador would be unable to mount an adequate response without external funds.

Photo: Nan Palmero/FlickrCC BY 2.0