Central America Competitiveness Report Post Covid-19. Building a Resilient and More Sustainable Recovery in El Salvador, Guatemala, and Honduras 1 Acknowledgements The preparation of this report was led by Xavier Cirera (Senior Economist, ETIMT), Barbara Cunha (Senior Economist, ELCMU), and Woori Lee (Economist, ELCMU). Core team members included Sara Brolhato de Oliveira (Consultant, ETIFE) and Christian Sebastian Zambaglione (ET Consultant, ELCMU). The team is grateful for the inputs and contributions provided by Bishakha Barman, Marcio Cruz, Roberto Galván, Thomas Haven, Hemanth Kalathuru, Silvia Muzi, Mayra Del Carmen Alfaro De Moran, Melvin Enrique Redondo, Roberto Echandi, Ana Fernandes, Santiago Reyes Ortega, and Domenico Viganola. The work greatly benefited from guidance and encouragement by Yira Mascaro (Practice Manager, ELCFN), Doerte Doemeland (Practice Manager, ELCMU), Jorge Araujo (former Practice Manager, ELCMU), Pedro Rodriguez (Program Leader, ELCDR), Michel Kerf (Country Director, LCC2C) and Robert Taliercio (Regional Director, ELCDR). The team is very grateful to the peer reviewers for their excellent comments and suggestions: Paul Brenton (Lead Economist, EMTRI), Thomas Haven (Senior Private Sector Specialist, ELCFN), and Samer Matta (Senior Economist, EAWM2). Administrative support came from Paula Houser (Program Assistant, ELCFN). 2 Key messages The Covid-19 pandemic has had widespread negative effects in developing countries around the world, but hit hard El Salvador, Guatemala and Honduras. The pandemic substantially affected domestic and international firms, especially in sectors such as retail, tourism and hospitality. Furthermore, the pandemic put additional fiscal pressure on national governments, precluding a timely and efficient policy response to support affected households and firms, as well as delaying necessary structural reforms to support long-term growth and poverty reduction. Right when countries were in the path to recovery, the war in Ukraine is posing additional challenges to these economies, through its impact on growth, trade, inflation and financial distress. The spike in commodity and energy prices increase inflationary pressure, affecting balance of payments as well as livelihoods. Increases in global food, energy and fertilizer prices is likely to exacerbate food insecurity in CA3 countries, already hit by the Covid-19 pandemic. Acute food insecurity is expected to continue in 2022 in El Salvador, Guatemala, and Honduras due to the combined shocks of the Covid-19 pandemic and the Ukraine war. Further, the war and the monetary policy normalization in the United States also triggers tighter financial conditions, increasing fiscal and external vulnerabilities in CA3 countries. Given the uncertainty of current and future shocks, the best way to increase resilience is by accelerating the implementation of structural reforms to sustain economic growth and increase economic resilience. Improving the business environment, enhancing regional integration, simplifying and introducing flexibility in labor legislation, strengthening education and human capital formation and promoting incentives to research, innovation and digitalization can push the recovery process and create a favorable environment for continued and robust economic growth. In addition, the continued rise in working-age populations over the next two decades and abundant remittances flows constitute an important opportunity to finance investment in human and physical capital, which can help foster long-term economic growth. Economic reforms should focus both on fostering economic growth and addressing social issues, ensuring that economic gains are divided among society, reducing poverty and inequality. The Covid-19 pandemic and the more recent shocks are an opportunity and incentive to accelerate structural reforms in the region to address existing constraints to growth and imp rove countries’ resilience to future shocks. The structural agenda presented in the report are ever more relevant in the current context of evolving challenges from the Covid-19 shock to the war in Ukraine and high inflation. A thorough understanding of how the Covid-19 shock affected these economies, the government responses, and recovery path provide valuable lessons to coping with other potential external shocks in the future. 3 Table of Contents Executive Summary....................................................................................................................................... 5 I. Introduction ........................................................................................................................................ 15 The evolution of the Covid-19 pandemic in CA3 countries .................................................................... 16 Drivers and transmission mechanisms behind the Covid-19 crisis ......................................................... 18 II. Impact of Covid-19 on the economy: Macro evidence ....................................................................... 20 Macro-fiscal impact of the pandemic ..................................................................................................... 20 Trade and investment effects of the pandemic ...................................................................................... 31 III. Impact of Covid-19 on firms: Micro evidence ................................................................................. 43 Supply shocks and uncertainty ............................................................................................................... 44 Operations and employment .................................................................................................................. 46 Sales and markup .................................................................................................................................... 49 Trade and global value chains ................................................................................................................. 53 Financial risks .......................................................................................................................................... 54 Firm responses: Digitalization and innovation........................................................................................ 56 IV. Policy responses to the Covid-19 pandemic ................................................................................... 57 Policy responses ...................................................................................................................................... 57 V. Reform agenda: Designing more effective and sustainable recovery policies ................................... 66 Looking forward: Post-Covid-19 ............................................................................................................. 70 Drivers of productivity and sustained growth ........................................................................................ 71 A comprehensive reform agenda to unleash sustainable growth .......................................................... 89 References ................................................................................................................................................ 100 Annexes ..................................................................................................................................................... 108 Annex 1. Trade policy responses to the Covid-19 pandemic ........................................................... 108 Annex 2. Drivers of productivity growth framework ....................................................................... 121 Annex 3. Long-term growth model for CA3 ..................................................................................... 124 Annex 4. Additional figures .............................................................................................................. 127 4 Executive Summary The Covid-19 pandemic has had widespread negative effects in developing countries around the world, generating an unprecedented shock. Since the outbreak of the pandemic, economies have been directly affected by a combination of supply and demand shocks, with varying intensity and persistence. Supply shocks included various restrictions on economic activities and mobility imposed by governments, social distancing norms, and supply chain disruptions. At the same time, demand has been affected by changes in consumer behavior due to fear of exposure to the virus, reduced income, unemployment, and heightened uncertainty. This has substantially affected firms, especially in sectors such as retail, tourism and hospitality. The pandemic also put additional fiscal pressure on national governments, precluding a timely and efficient policy response to support affected households and firms, as well as delaying necessary structural reforms to support long-term growth and poverty reduction. Latin America and the Caribbean (LAC) was a particularly affected region, recording a significant contraction in regional GDP and international trade in 2020. The fall in regional GDP more than doubled the world’s average and nearly four-folded the emerging markets figure in 2020. Due to features intrinsic to the region, such as high informality rates, lack of technological readiness, limited fiscal space, and scarcity of automatic stabilizers, GDP in LAC fell by 6.6 percent in 2020, far more than the global average (-3.1 percent) and the Emerging Economies (-2.0 percent). The region also saw sharp contractions in trade in 2020, as the virus and lockdown measures spread globally. LAC was one of the harder hit regions, with exports and imports in 2020 dropping by 8.3 percent and 16.5 percent, respectively, compared to 2019. This report focuses on the impact of Covid-19 and recovery in El Salvador, Guatemala and Honduras. These three Central American countries (CA3), albeit unique in their history and characteristics, share many similarities in their economic context and challenges for achieving sustained growth. The region includes one of the poorest countries in the Western Hemisphere, with low economic growth rates relative to other Latin American countries. Structural features of CA3 countries, such as high rates of informality and the lack of technological readiness, accelerated the impact of the global pandemic. As the reduction of human mobility constituted the core of the dysfunctionality introduced in the economic systems, the Covid-19 crisis disproportionately hit the informal and self-employment sectors. These segments of the labor market are characterized by reduced buffers to cope with a significant drop in disposable income due to their limited access to credit and social protection networks. Self-employment represents about half of the employment in Central American countries, while the informal economy is close to 80 percent, much above the rest of the world. Furthermore, the Covid-19 crisis accelerated the pre-existing trend to telework, disadvantaging those with lower possibilities to carry out work remotely. Internet access is limited in CA3 countries and the quality of access in terms of internet speed is also poor. The war in Ukraine poses additional challenges to these economies, through its impact on growth, trade, inflation and financial distress. The spike in commodity and energy prices increase inflationary pressure, affecting balance of payments as well as livelihoods. Increases in global food, energy and fertilizer prices is likely to exacerbate food insecurity in CA3 countries, already hit by the Covid-19 pandemic. Acute food insecurity is expected to continue in 2022 in El Salvador, Guatemala, and Honduras due to the combined shocks of the Covid-19 pandemic and the Ukraine war (World Food Programme 2022). Further, the war and the monetary policy normalization in the United States also triggers tighter financial conditions, increasing fiscal and external vulnerabilities in CA3 countries. 5 The region is in need of urgent structural reforms to foster productivity growth, ensuring long-run economic development and improved living conditions. CA3 countries faced significant structural challenges even before the pandemic: weak institutions, political polarization, low productivity, and high levels of crime and violence. These socioeconomic conditions, along with recent climatic issues and natural disasters, contribute to a high share of migration from the CA3 region to other countries, especially the United States. Estimates from 2013 reveal that the fraction of citizens living outside of their home country was equal to 20 percent for El Salvador, 6 percent for Guatemala and 8 percent for Honduras.1 In fact, remittances from citizens living abroad correspond to an important part of the region’s GDP, and an important source of foreign exchange and of disposable income, with a consistent upward trend since 2011.2 The Covid-19 pandemic and the more recent shocks are an opportunity and incentive to accelerate structural reforms in the region to address existing constraints to growth and improve countries’ resilience to future shocks. Given the uncertainty of current and future shocks, the best way to increase resilience is by accelerating structural reforms. Improving the business environment, enhancing regional integration, simplifying and introducing flexibility in labor legislation, strengthening education and human capital formation and promoting incentives to research, innovation and digitalization can push the recovery process and create a favorable environment for continued and robust economic growth. In addition, the continued rise in working-age populations over the next two decades and abundant remittances flows constitute an important opportunity to finance investment in human and physical capital, which can help foster long-term economic growth. Economic reforms should focus both on fostering economic growth and addressing social issues, ensuring that economic gains are divided among society, reducing poverty and inequality. This report documents the impact of the Covid-19 crisis on the CA3 economies using both macro- and micro-level evidence, taking stock of the policy responses to the pandemic, and proposing a comprehensive reform agenda that will lead to a robust recovery and sustained growth in the CA3 region. The structural agenda presented in the report are ever more relevant in the current context of evolving challenges from the Covid-19 shock to the war in Ukraine and high inflation. A thorough understanding of how the Covid-19 shock affected these economies, the government responses, and recovery path provide valuable lessons to coping with other potential external shocks in the future. Macro-fiscal impact of the pandemic Covid-19 led to a large contraction in GDP, averaging 4.3 percent in 2020 for the CA3 countries. Guatemala’s GDP fell by 1.5 percent, while in Honduras and El Salvador activity drop rates reached 9 percent and 7.9 percent respectively (Table 1). The contraction in 2020 implied a difference of 7.2 percentage points (p.p.) compared to the previously expected trend for CA3, slightly higher than the World’s (5.9 p.p.) and Emerging Economies’ average (6.5 p.p.), but below Latin America (8.5 p.p.). Value- added in most sectors declined in 2020 in the CA3 economies, but the largest drops occurred in those most exposed to the Covid crisis dynamics, such as a consumption basket that focused on essential activities, as well as mobility restrictions and reduction in tourism. Fiscal positions and public debt in CA3 countries weakened sharply as revenues fell and expenditure increased, in response to the Covid-19 shock. Fiscal revenue fell in 2020 in CA3, due to the recession and explicit stimulus measures undertaken to cope with the pandemic. Simultaneously, massive fiscal 1 Sousa and García-Suaza 2018. Migration flows from the region are still large. From 2007 to 2015, the population of immigrants from CA3 countries in the United States has increased by 25 percent (Cohn et al., 2017). 2 In 2020, they corresponded to 24.0 percent of GDP in El Salvador, 23.6 percent in Honduras and 14.6 percent in Guatemala (Staff estimates based on IMF balance of payments data, and World Bank and OECD GDP estimates). 6 responses to strengthen the health sector and support households’ incomes led to higher expenditure. The deterioration of the fiscal position and economic recession led to an increase in public debt which has showed a stable trend in the years preceding the Covid-19 outbreak. The largest increase was observed in El Salvador (+17.2 p.p. of GDP), which also had the highest public debt level pre-pandemic (71 percent of GDP in 2019). Public debt in Honduras stood at 48.9 percent of GDP in 2020, climbing 7 p.p. compared to 41.9 percent of GDP in 2019. Guatemala had the lowest levels of public debt in 2019 (26.6 percent of GDP) and the lowest increase in 2020 (+5.2 p.p. of GDP) among the CA3 countries. Reduced economic activity and workplace closures increased unemployment. The fall in economic activity and workplace closures imposed by governments hit the labor market. A significant rise in the unemployment rate - of around 3 p.p. - was observed in 2020 in CA3. Inflation remained subdued in 2020 in CA3, in an environment of a sharp decline in private demand. Unlike other cases in LAC, and despite the decline in external incomes towards the middle of the year, there was no significant currency depreciation. The external drivers that led to the steep slowdown reversed rapidly by the end of 2020. Remittances fell sharply in CA3 during Q2 2020 (-11.0 percent YoY) - an equivalent drop of USD 600 million. However, remittances influx was strongly rebuilt during the second half of 2020, underpinned by the rapid recovery of employment in the United States as one of the main drivers. Recovery outpaced the initial drop, to such an extent that in 2020 remittances to CA3 grew by 6 percent compared to 2019. Exports displayed a similar dynamic: in Q2 2020 exports by CA3 countries collapsed by an average of 30.0 percent YoY, but the contraction moderated sharply in Q3 (-4.4 percent YoY) and slightly positive figures emerged towards year-end (+0.9 percent YoY in Q4). For tourism, the decline was steeper and the recovery slower: tourism revenues entered negative territory already in Q1 (-17.6 percent YoY), and in Q2 and Q3 they experienced a sharp reduction, which exceeded 80 percent. The rapid reversion of the external shocks and fewer restrictions on circulation and workplaces underpinned a V-shaped recovery, but new and remaining challenges lie ahead. With the aforementioned reversal of factors stemming from the external sector - remittances, exports, tourism - and further loosening of restrictions on circulation and workplaces, economic activity began to recover towards the end of 2021. GDP contraction narrowed to 4.5 percent YoY by Q3 2020 and balanced in Q4 2020, apart from Honduras which suffered a second wave by the end of 2020. The recovery continued further in 2021, with YoY growth almost doubling the losses of 2020, and sustaining an annual growth above 10 percent. However, the war in Ukraine presents a new external shock to these economies and may reverse some signs of recovery from the pandemic. In the medium term, it is critical to implement structural reforms to promote productivity growth and support a robust recovery. Impact of Covid-19 on trade and investment The Covid-19 pandemic has had severe impacts on international trade and global supply chains. As the virus and its containment measures expanded globally, the world experienced widespread disruptions in supply and demand across the world as well as disruptions in global value chains (GVCs). Like much of the world, the LAC region saw sharp contractions in trade in 2020, peaking in the second quarter. The trade effects of the pandemic varied across countries and regions, depending on their trade profile —such as diversification in terms of sector and partner countries—as well as the severity of the virus and lockdown measures. In LAC, exports dropped by 26.2 percent in Q2 2020 compared to the same period in 2019 while imports fell by over 30 percent. The global contraction in trade continued through the third quarter in all regions except East Asia and Pacific, despite lessening in magnitude. 7 Various stages along GVCs have seen sharp trade contractions, most notably in sectors such as transport equipment and textile and apparel. Disruptions in apparel supply chains and reduced demand have been important for CA3 countries, where the apparel sector plays a key role in countries’ exports and GVC participation. For example, the clothing industry accounted for nearly 45 percent of total merchandise exports for El Salvador and Honduras before the pandemic. El Salvador was one of the countries with strongest export contractions, largely driven by the textiles and clothing industry. In May 2020, El Salvador reported a 60 percent year-on-year drop in exports and a 44 percent drop in imports. Exports from the CA3 countries dropped by an average of over 30 percent in the second quarter of 2020, compared to the same period in 2019. The magnitude of the impact, however, varied widely across the CA3 countries. El Salvador was the hardest hit, with an average contraction over 50 percent in the second quarter of 2020, recording a peak contraction of nearly 60 percent in May 2020. In Honduras and Guatemala, year-on-year (y-o-y) exports in Q2 of 2020 fell by an average of 37 percent and 12 percent, respectively. The dynamics in imports were similar, with the contraction peaking in May 2020. However, the drop in imports remained substantial going into the third quarter, recording an average of 19 percent y-o-y drop in July and August 2020, while export contraction averaged less than 10 percent in the same months. The trade collapse and recovery in CA3 was largely driven by the textiles and apparel sector, which plays a key role in countries’ exports and GVC participation. Exports of CA3 economies are highly concentrated both in terms of sectors and destination markets, especially in El Salvador and Honduras. The trade collapse in the second quarter of 2020 was primarily driven by trade contractions in the manufacturing sector, and to a lesser extent, the agro-industrial sector. Exports to the United States, the biggest market for these exports, dropped by over 70 percent and 45 percent y-o-y in the second quarter of 2020 for El Salvador and Guatemala, respectively. However, the same sectors also drove a strong recovery in 2021. The Covid-19 pandemic caused a substantial drop in foreign direct investment (FDI). Global flows of FDI dropped by 35 percent in 2020 compared to 2019. The decline was heavily skewed toward developed economies, where FDI fell by 58 percent. While the drop was more moderate in developing countries, at 8 percent, the trend varied widely across regions. FDI flows to developing Asia was resilient, with inflows to China increasing by 6 percent, while FDI flows to Africa fell by 16 percent. In LAC, FDI inflows plummeted by 45 percent, the sharpest decline among developing regions, as many economies in the region are dependent on investment in natural resources and tourism, both of which collapsed. The pandemic was detrimental to FDI inflows for CA3 countries, accelerating the downward trend in the preceding years. FDI inflows to the three countries fell by an average of 22.7 percent in 2020. Again, the impact and recovery patterns varied widely across countries. In El Salvador, the pandemic accelerated the declining trend in FDI in 2020, declining by 56 percent, followed by a modest recovery (12.2 percent) in 2021. FDI inflows to Honduras fell by 16 percent in 2020 but had a strong rebound in 2021, increasing by 67.3 percent. The impact of the Covid-19 pandemic on FDI inflows to Guatemala was minimal, with a 4.5 percent decrease in 2020, followed by an exceptional 273 percent increase in 2021, largely due to an acquisition of a telecoms company. The Covid-19 pandemic and resulting disruptions in trade and international supply chains sparked a discussion on the vulnerability of GVCs. Some policymakers and researchers argue that GVCs create economic vulnerabilities by propagating shocks, therefore exacerbating protectionist sentiments, calling for shortening or reshoring of GVCs and greater self-sufficiency. The pandemic has reinforced concerns that supply chains have gone too far, with some governments resorting to protectionism and restricting trade, for example by imposing export bans of critical medical equipment or food. However, evidence 8 from prior crises suggest that turning inward will not improve resilience, and export bans drive up world prices and make short-term shortages even worse. Integration into GVCs and the global market can be a source of resilience itself and pave the way for a strong recovery. When the recovery from the economic downturn is uneven, with demand being revamped at different paces, supply chain linkages ensure that the recovery is also transmitted through the value chain. Well-operating GVCs therefore are a source of resilience more than a source of vulnerability (Brenton, Ferrantino, and Maliszewska 2022). Early evidence show that globally engaged firms are recovering faster from the adverse impact of the pandemic, possibly due to higher capabilities and heightened response (Constantinescu et al. 2022). In addition, countries and firms that are more internationally connected, through GVCs and exports, are more resilient to domestic shocks due to their diversification of suppliers and markets. It is therefore crucial to find ways to leverage GVCs as a means to enhance resilience and mitigate the impact of shocks. A potential realignment of GVCs and FDI in the post-Covid world may offer new opportunities for the region as firms seek to enhance resilience by nearshoring or diversifying the sources of production. Some multinational firms are considering the reconfiguration of their supply chains to improve speed and flexibility, seeking more local-to-local and closer supply chains to retail markets. Evidence from prior shocks, such as natural disasters, suggest that a consequent reconfiguration of GVCs could motivate firms to switch suppliers, particularly from developing countries and larger countries where scale economies could be realized. However, firms may also choose to maintain their existing supply chain relationships during and after the crisis, given the significant cost of finding and establishing new supplier networks, limiting the reshaping of GVCs. Early evidence suggests that some reconfiguration and diversification are taking place along supply chains., with firms increasing their supplier base, including through nearshoring, building up inventories, and regionalizing supply chains. These trends may offer significant opportunities for CA3 countries which have competitive advantages such as the strategic geographical location and access to major markets though preferential trade agreements. Table 1. Summary of Covid-19 impact on CA3 countries, 2019-2021 (percent change unless otherwise indicated) El Salvador Guatemala Honduras LAC 2019 2020 2021 2019 2020 2021 2019 2020 2021 2019 2020 2021 GDP growth rate 2.4 -8.2 10.3 4.0 -1.8 8.0 2.7 -9.0 12.5 0.7 -6.6 6.6 Fiscal balance 0.7 -4.8 -0.4 -0.6 -3.2 0.5 0.2 -4.2 -2.3 -4.35 -9.05 -4.20 (% of GDP) Public debt 73.7 91.8 85.6 26.5 31.5 30.6 43.5 54.1 53.1 61.6 72.3 66.4 (% of GDP) Current Account -0.6 0.5 -3.6 2.3 5.1 3.1 2.9 -3.1 -3.5 -2.1 0.1 -1.2 (% of GDP) Remittances 21.0 24.1 26.2 13.6 14.6 17.8 21.6 23.5 25.4 2.0 2.6 2.8 inflow (% of GDP) Unemployment 4.2 6.2 5.9 2.2 3.6 2.2 5.7 8.4 8.6 7.9 10.1 10.0 rate (percent) Exports 0.0 -14.8 31.8 1.8 -0.6 22.7 1.7 -12.6 33.0 -1.1 -8.8 27.3 Imports 1.2 -11.7 47.1 1.1 -8.4 46.1 -2.5 -15.7 46.9 -2.8 -15.5 36.8 FDI inflows -23.0 -56.0 12.2 -0.5 -4.5 272.6 -48.2 -16.0 67.3 10.3 -45.4 n.a. Source: National Authorities, MPO SM22, ILO, UNCTAD, and World Bank WDI, Covid-19 Trade Watch. Impact of Covid-19 on firms The Covid-19 pandemic led to supply chain disruptions that significantly affected firms’ operations and trade, coupled with substantial uncertainty about the duration of the crisis. Supply chain disruptions were pervasive across the region and prevented firms’ timely access to production inputs, either due to 9 international trade or domestic restrictions. In Guatemala, 33 percent of firms had to cancel orders due to the unavailability of inputs, while this figure was equal to 26 percent in El Salvador and 23 percent in Honduras. These cancelled orders represented approximately 20 percent of total firm sales in the region. Despite elevated uncertainty regarding the following six months, firms in CA3 countries are more optimistic than the global average, expecting sales growth of 8 percent in El Salvador, and 13 percent in both Guatemala and Honduras, compared to the global expectation of a 5 percent retraction in sales. The initial shock led to temporary closures, reductions in operating hours and adjustments in employment. Shortly after mobility restrictions were imposed, a large fraction of firms was closed temporarily, ranging from 15 percent of firms in Guatemala to 36 percent in Honduras. Additionally, 90 percent of the establishments in CA3 have responded to the initial shock by reducing the number of operating hours. At the end of 2020, activity had significantly recovered and 95 percent of firms in the region were operating in a full or partial regime, conditional on survival. Regarding employment adjustment, the most widely adopted measures focused on the intensive margin, that is, reducing wages or hours worked. By December 2020, over 40 percent of firms in CA3 had already increased their size in response to recovering economic conditions, even if downsizes were still being adopted by a significant share. The crisis led to a sharp drop in firm sales, with persistent effects and ongoing recovery. In June and July 2020, establishments in El Salvador and Honduras saw a drop in sales of 58 percent relative to the same period in 2019, while in Guatemala reduction was of 46 percent, on average. The initial negative impact over sales for firms in CA3 was intense in comparison to the rest of the world. The recovery process is more aligned with international experience, despite the persistence of the effects. By the end of 2020, sales for firms in CA3 remained, on average, 28 percent lower than in 2019 in El Salvador and Guatemala, and 34 percent in Honduras. These effects are heterogeneous on firm characteristics, and sales reductions were more intense for smaller businesses and service industries, especially in hospitality. The average drop on sales was lower for exporting firms compared to non-exporters and the recovery was also faster. The Covid-19 shock and supply chain disruptions led to a strong decline in firm-level imports and exports. In El Salvador, the contraction in trade was sharpest in the second quarter of 2020, with firms’ exports and imports declining by 52 percent and 42 percent respectively, compared to levels in 2019. These negative effects were more pronounced for GVC firms, potentially due to the propagation of the shock along the value chain. However, firms engaging in international trade were more likely to heighten their response to the pandemic by ramping up digitalization during the recovery phase. Specifically, the probability of starting or increasing the use of digital technologies in El Salvador was significantly higher for exporters than non-exporters in the Covid-19 initial and recovery phases, by 5 to 7 percentage points. Firm liquidity has shown signs of recovery over the course of 2020. Liquidity has increased modestly across the region, although firms are still largely dependent of external sources of finance in cases of adversities impacting revenue. Nonetheless, about half of the firms in CA3 were either already in arrears by the end of 2020 or expected to fall into arrears within the first six months of 2021 (60 percent in El Salvador, 58 percent in Honduras and 46 percent in Guatemala), and liquidity was lower, on average, for smaller firms. Even though firms’ outstanding liabilities have remained stable, debt repayment capacity has deteriorated, and its evolution is conditional on sales recovery. The restrictions imposed by Covid-19 have encouraged firms to adopt digital technologies to minimize its negative effects on firm performance. The fraction of firms using digital technologies in CA3 countries increased about 20 percentage points from June to December 2020. Moreover, the shock has motivated over 75 percent of firms in the region to innovate by changing their mix of products and services since March 2020. The process of digitalization was widespread across firms, regardless of the number of 10 employees or sector, although larger firms had a higher probability of adopting digital technologies within the business. Lastly, firms engaging in international trade were more likely to heighten their response to the pandemic by ramping up digitalization during the recovery phase. Policy responses to the Covid-19 pandemic The sharp decrease in activity in the second quarter of 2020 due to the pandemic shock required governments and monetary authorities to implement a loose monetary stance and expand credit. During the first half of 2020, Central Banks around the world lowered interest rates to contain the effects of the pandemic on output, and CA3 countries were no exception. In addition, to provide liquidity and avoid bankruptcy, authorities gave more flexibility to banks’ reserve requirements and introduced forbearance measures. Finally, central banks in the region implemented open market operations to reduce exchange rate volatility. The initial months of the pandemic triggered short-term changes in trade policy, later followed by the introduction of structural policy measures to boost the economy in the medium-term. Amid heightened uncertainty and disruptions in supply chains and logistics, countries tried to tackle the immediate threats and protect people by securing the necessary medical supplies related to Covid-19 and basic food supply. This led both to trade-liberalizing measures – such as temporary elimination of import duties and value- added tax (VAT) – and trade-restrictive measures, such as export bans of food and medical products. Safety guidelines were also implemented for cargo transport to minimize the risk of Covid-19 at borders. As time passed, governments focused more on plans for recovery and support. These included measures to support key sectors and firms that were affected by the pandemic, to improve trade facilitation and logistics, and promote foreign investment. Support policies issued by local governments have been an important instrument to minimize the negative effects over employment and business closures. Since March 2020, local governments have adopted a variety of programs to support firms, avoid mass business closures and increases in unemployment. These measures included cash transfers, fiscal subsidies, facilitated credit, technical support, and many others. By June 2020, 26 percent of firms in Guatemala, 12 percent in El Salvador and 11 percent in Honduras had received at least one form of government support from the policies available in each country. At the end of 2020, this figure had remained stable in Guatemala, while it increased to 18 percent in Honduras, and to a striking 52 percent in El Salvador. However, the probability of accessing support measures was higher for medium and large firms, highlighting the importance of policy targeting, but also monitoring the outcomes and adapting policies according to the evolution of firms’ needs. Outlook and reform agenda The region has had limited progress in closing the income gap relative to other countries, and its future performance will rely heavily on productivity growth. Over the last decades, economic growth in the CA3 countries has been mainly based on factor accumulation, while the contribution of productivity has been negligible or even negative. In this context, the Covid-19 pandemic has put additional pressure on already fragile economies with persistent negative shocks on output, firm performance, employment and income. Policy reforms aimed at tackling factors that hinder productivity growth could boost long-term growth rates and outpace the potential scarring impact of Covid-19. The impact of the Covid-19 pandemic can be long-lasting even if the recovery has been faster than expected in 2021. The pandemic has affected growth fundamentals which could influence long term growth if not addressed. School closures and the lack of resources for widespread remote learning could have long-lasting effects on human capital and increase inequality particularly given the unequal distribution of internet services. In addition, firms’ closure and resource shifting forced by the pandemic could lead to a less efficient allocation of factors compared to pre-pandemic, hence hurting total factor productivity. Even a small deceleration in growth 11 rates could have a scarring effect on GDP per capita in the long run. The importance of addressing structural issues in the region becomes even more significant in the current economic context and new economic shock in 2022 resulting from the war in Ukraine. Table 2 presents a summary of the main policy recommendations for the region, differentiating between short- and long-term priorities. Policies should strive to increase the predictability of the business environment, provide macroeconomic stability and reduce the cost of regulation for businesses in all industries. In the short run, essential initiatives to be undertaken include the simplification of regulations for firm entry, operation and exit, and strengthening the insolvency framework. These actions should be accompanied by longer-term policies tackling structural issues in the business environment, such as strengthening contract enforcement and the competition framework, promoting alternative dispute resolution mechanisms within and outside the judiciary, and simplifying processes for obtaining licenses and permits, including in construction. Competition within domestic markets can be intensified with solid anticompetitive regulation, implementing competition law to regulate anticompetitive practices, as well as designating and enabling a competition agency to ensure effective implementation of the law. A key reform area for CA3 countries to better integrate into regional and global supply chains is to improve trade facilitation and connectivity, which would reduce the time and cost of cross-border trade. Actions to recover domestic sectors from disruptions in international trade should include simplifying procedures for registration and permits, streamlining and digitalizing border control agencies trade procedures. The region should also leverage regional trade agreements to include and implement essential provisions, including those in trade facilitation, services, competition, and intellectual property rights. Another critical aspect of policy implementation should be enhancing security at the border by tackling violence, corruption, drug-trafficking and money laundering. Strengthening financial markets and promoting investment in CA3 countries are essential for developing productive capacities for sustainable growth. In the short run, governments should address the negative impacts of the crisis on business liquidity and deepening financial inclusion, while encouraging investment by improving the strategic framework for FDI attraction, defining priority sectors and goals. Meanwhile, solving structural issues in the region with focus on long-term economic growth requires a broader effort to strengthen the liquidity framework and financial sector instruments, rethink and redesign overly restrictive credit requirements, generally improve credit access to MSMEs, as well as to improve financial and credit infrastructure. Governments should also ensure that, in the long-run, investments are being translated into competitiveness and innovation, and that these gains are overflowing to domestic firms. Policies directed at the labor market should support jobs and income during the recovery, but future growth ultimately depends on the development of a skilled labor force and increasing participation. It is particularly important to support the population during the economic recovery trajectory, for example by providing solid unemployment insurance, cash transfers to the self-employed, and implementing wage subsidies to prevent job losses. Additionally, increasing labor force participation, especially among women, facilitating and providing incentives for formalization, and developing a skilled labor force. Providing incentives for entrepreneurship and digitalization lead to increased firm dynamics, competition, and innovation. In the short-run, it would be desirable to stimulate entrepreneurship by developing a start-up grant program and adopting policies to support business training. Meanwhile, digitalization can be intensified by implementing ICT and internet educational programs, along with a large-scale business training for micro and small firms, to develop human capital and management skills that are complementary to the use of technology. Governments should simultaneously advance medium- and long-term reforms strengthening local high-potential entrepreneurial ecosystems, connecting firms 12 and knowledge providers, and by identifying potential financial instruments to encourage research and innovation. Table 2. Summary matrix of short- and long-term policy recommendations 1. Enabling environment and competition Short-term • Streamline key regulatory processes for business entry, operation and exit, e.g., by adding online processes and payments to MiEmpresa.gob.sv (SLV) and fully implementing Minegocio.gt (GTM). • Strengthen the insolvency framework by passing an insolvency law (SLV). • Simplify procedures for sanitary registration and import permits of controlled goods, following regional best practices (SLV). Long-term • Improve the contractual environment by strengthening contract enforcement and promoting alternative dispute resolution mechanisms. • Implement the regulatory improvement agenda and its legal framework across all agencies and levels (including municipal) (SLV). • Enact and implement a competition law to regulate anti-competitive practices, supervise mergers and acquisitions, and eliminate entry barriers (GTM). • Amend current laws on issues related to e-Commerce and enact laws on data protection and cybercrime (GTM). 2. International trade and regional integration Short-term • Identify and implement measures to stimulate recovery of selected sectors, e.g., by developing a "safe tourism" certification program and increasing online presence of tourism businesses (SLV). • Improve and digitalize cross border trade procedures. • Fully implement the customs union (deep integration) between Guatemala, Honduras, and El Salvador. • Enhance security at borders, increase law enforcement efforts and provide more funding and training for port security. • Simplify trade regimes for small-scale traders which can provide a first step towards more formal participation in trade. • Make coordinated efforts to refrain from the use of export bans and reduce or eliminate tariffs on essential products. Long-term • Identify and implement key interventions for strategic repositioning of selected GVCs, including related to improving infrastructure, fostering human capital, enhancing the provision of sector-specific public goods, improving market access, and digitization (SLV). • Coordinate with public and private stakeholders to implement selected interventions. • Simplify procedures for registration and permits following regional best practices. • Leverage deep trade agreements to include and implement trade facilitation provisions. • Improve the region's transport and border-crossing infrastructure, including the modernization of border-crossing points, and the development of regional corridors. • Increase trade diversification, both in terms of products and trade partners, including better information to enhance matching between exporting firms and potential suppliers and buyers. 3. Financial markets, investment and remittances 13 Short-term • Strengthen the liquidity framework and mitigate credit risk associated with the pandemic by promoting BANDESAL's Fondo Salvadoreño de Garantías and designing public sector programs (SLV). • Promote digitalization of transactions to distribute government assistance programs, facilitate payments, and promote financial inclusion (SLV). • Improve the strategic framework for FDI attraction, including clear objectives, targets, institutional roles, and priority sectors. • Conduct a detailed assessment of the regulatory environment for investments to identify investment constraints in key economic sectors (GTM). Long-term • Strengthen the Emergency Liquidity Assistance framework at Banco Central de Reserva and implement the National Financial Inclusion Policy (SLV). • Enact a legal framework to enable market entry and growth of fintech firms, including e-money operators and crowdfunding platforms (GTM). • Strengthen the role of financial cooperatives in MSME finance by enacting a dedicated legal framework (GTM). • Develop a program to foster linkages between FDI and the local economy (SLV). • Conduct a cost-benefit analysis of the existing incentives regime to identify its efficiency and suitability in a post Covid-19 environment with reduced fiscal space (GTM). 4. Labor market, education and skills Short-term • Strengthen unemployment insurance, cash transfers and time-bound wage subsidies to support recovery from the pandemic. • Increase the participation of women in training programs supporting the development of digital skills, such as coding, crisis recovery, adaptation, and digitalization. Long-term • Promote policies and mechanisms to optimize the use of public spending in higher education systems, to strengthen the contribution of these institutions to economic growth and the effectiveness of interventions in entrepreneurship systems to generate knowledge, technologies and creative outputs. 5. Entrepreneurship, innovation, and technology adoption Short-term • Implement large-scale business training to micro and small firms for crisis recovery, adaptation, and digitization (SLV). • Implement technology adoption / innovation grant program to help firms digitize and transform production, including to meet post-Covid demands (SLV). Long-term • Develop start-up grant program to help high-potential entrepreneurs take advantage of post-pandemic crisis opportunities (SLV). • Study how to strengthen local high-potential entrepreneurship ecosystems, e.g. digital technologies in San Salvador, high-tech manufacturing in La Libertad, etc (SLV). • Review existing incubation and acceleration programs to see if there is substantial unserved demand. • Strengthen linkages between firms and knowledge providers, e.g. through voucher program for firms to purchase knowledge services (SLV). • Leveraging digital technologies to boost entrepreneurship in the region: digital financial tools to increase access to finance; e-government services to reduce the regulatory burden on businesses; online learning tools to boost managerial capabilities. 14 I. Introduction The Covid-19 pandemic has had widespread negative effects in developing countries around the world, generating an unprecedented shock to economies. Since the outbreak of the pandemic, economies around the world have been directly affected by a combination of supply- and demand-side shocks, with varying intensity and persistence. First, supply shocks included various restrictions on economic activities imposed by national governments, mobility restrictions and social distancing norms (especially in sectors such as retail, accommodation and food services), along with supply chain disruptions leading to a deep contraction in international trade. At the same time, demand has been affected by changes in consumer behavior due to fear of exposure to the virus, reduced household income, unemployment, and heightened uncertainty. This has substantially affected businesses, especially in sectors such as retail, tourism and hospitality. Moreover, the current pandemic puts additional fiscal pressure on national governments, precluding a timely and efficient policy response to support affected households and firms, as well as delaying necessary structural reforms to support long-term growth and poverty reduction. The Covid-19 pandemic was characterized by two critical elements that accounted for a strong global economic impact, which was far more extended than previous crisis episodes. In the first place, the virus’ rapid transmissibility in a hyper-globalized world: in a few months after the first surge the virus spread in practically every region in the world. Second, in the absence of vaccines, the main palliative measure consisted in restricting circulation and human contact, two fundamental pillars in modern economic exchange systems. Lockdowns and restrictions on circulation, in a context of fear of contagion, have in turn two concurrent impacts on the economic dynamics: (i) in a direct way, by trammeling production and restricting economic exchange, which leads to lower household income, and (ii) indirectly, by truncating the available consumption basket only to essential goods and services. Thus, the nature of this crisis was explained by a simultaneous supply and demand shock. This report focuses on the impact of Covid-19 and recovery in El Salvador, Guatemala and Honduras. These three Central American countries (CA3), albeit unique in their history and characteristics, share many similarities in their economic context and challenges for achieving sustained growth. 3 The CA3 region includes one of the poorest countries in the Western Hemisphere, with low economic growth rates relative to other Latin American countries. In 2019, per capita GDP adjusted for PPP was equal to US$5,981 in Honduras, US$9,019 in Guatemala and US$9,164 in El Salvador. Almost half of the population in Guatemala and Honduras live in poverty. In El Salvador, poverty amounts to 22.3 percent of the population, a figure consistent with the average for LAC, at 22.5 percent, but still much higher than in upper-middle income countries, where on average 16.1 percent of people live below the poverty line.4 CA3 countries faced significant structural challenges even before the pandemic: weak institutions, political polarization, low productivity, and high levels of crime and violence. These socioeconomic conditions, along with recent climatic issues and natural disasters, contribute to a high share of migration from the CA3 region to other countries, especially the United States. Estimates from 2013 reveal that the fraction of citizens living outside of their home country was equal to 20 percent for El Salvador, 6 percent for Guatemala and 8 percent for Honduras (Sousa and García-Suaza 2018).5 In fact, remittances from citizens living abroad correspond to an important part of the region’s GDP, and an important source of 3 El Salvador, Guatemala, and Honduras are sometimes referred to as the Northern Triangle. In the remainder of the report, we refer to them as CA3. 4 The statistics refer to the poverty headcount ratio at $5.50 a day (2011 PPP). Data from the World Bank’s World Development Indicators. The statistics refer to the year of 2019, except for Guatemala, where the most recent data available is from 2014. 5 Migration flows from the region are still large. From 2007 to 2015, the population of immigrants from CA3 countries in the United States has increased by 25 percent (Cohn et al., 2017). 15 foreign exchange and of disposable income, with a consistent upward trend since 2011 (in 2020, they corresponded to 24.0 percent of GDP in El Salvador, 23.6 percent in Honduras and 14.6 percent in Guatemala).6 The region is in need of urgent structural reforms to foster productivity growth, ensuring long-run economic development and improved living conditions. The former predominantly agricultural economies in the region experienced a period of sustained growth following a series of market-oriented economic policies in the 1980s and 1990s, which granted macroeconomic stability, promoted international trade and sectoral diversification. While El Salvador and Guatemala were somewhat successful in catching up with the rest of the world during this period, Honduras lagged behind (Ulku and Zaourak 2021b). However, up to this point economic growth was achieved mainly due to the expansion of working-age population and capital accumulation, and even today the economies remain largely dependent on agriculture. Retail and service industries, especially tourism, also play an important part in economic activity. Productivity growth in the future plays a crucial role in sustaining growth and improving economic development in the region. This report documents the impact of the crisis on the CA3 economies using both macro- and micro-level evidence, taking stock of the policy responses to the pandemic, and proposing a comprehensive reform agenda that will lead to a robust recovery and sustained growth in the CA3 region. The reports builds on a recent growth study by the World Bank (Ulku and Zaourak 2021b), by investigating the impact of the Covid-19 pandemic on the CA3 economies using both macro and- and micro-level data. It proposes specific policy recommendations targeted to enhance productivity and achieve a robust recovery and sustained growth. The structural agenda outlined in this report becomes even more pressing in the context of the war in Ukraine which, through its impact on prices, GVCs, and the global economy, exacerbates challenges from the Covid-19 pandemic faced by these economies.7 The remainder of the report is organized as follows. The rest of Chapter I describes the evolution of the Covid-19 pandemic in the CA3 countries and presents the mechanisms through which the economies have been affected. The next two chapters document the impact of the pandemic on the CA3 countries. Chapter II presents the impact on macro-fiscal outcomes, trade, and investment using data at the aggregate level, while Chapter III provides firm-level evidence on how the pandemic affected the private sector across multiple dimensions. Chapter IV then characterizes how governments and firms have responded to the pandemic with the goal of minimizing its negative effects. Finally, Chapter V describes the key constraints to growth for the CA3 countries and suggests a comprehensive reform agenda and specific policy recommendations to promote a robust recovery and a sustainable long-term economic growth. The evolution of the Covid-19 pandemic in CA3 countries The outbreak of Covid-19 caused a sudden and steep decline in economic activity, mainly due to mobility restrictions and fear of contamination. The shock induced by the pandemic consists of a steep decline in demand, due mainly to limited mobility and fear of contamination, along with the supply-side effects of restrictions on operations and disruptions in input supply. Moreover, economic activity is negatively affected by a drop in income, a tightening of credit conditions and rising uncertainty as to the magnitude and duration of the shock. 6World Bank staff estimates based on official sources. 7This report does not cover in detail the new challenges faced by CA3 countries due to the war in Ukraine due to the lack of sufficient data for a systematic analysis. 16 The CA3 countries experienced reductions in urban mobility larger than the global average. Following the initial shock in March 2020, the observed mobility drop in El Salvador, Guatemala and Honduras was more intense relative to the global average, as well as to other Latin American countries such as Brazil and Nicaragua (Figure 1). By the end of 2020, although restrictions had mostly converged to the global average in El Salvador and Guatemala, observed mobility levels were still significantly lower than before the pandemic. Taking into consideration that there are many factors affecting mobility levels, one possibility is that the initial imposing of restrictions had lasting effects on mobility through changes in people’s behavior and habits. Honduras, on the other hand, did not significantly loosen restriction measures even by the beginning of 2021, which is reflected in a slower recovery of mobility levels. Figure 1. Mobility trends and stringency of restrictions Note: Mobility trends data are from Google (2020), and the stringency of measures was obtained from Hale et al. (2021). Mobility trends are smoothed using weighed moving averages, where the previous 30 days are considered with weights equal to one, the previous 31-60 days are considered with wage 0.5, and so on. The surge in Covid-19 was particularly intense during the second and third quarters of 2020 in CA3. Confirmed Covid-19 cases in Guatemala, Honduras, and El Salvador showed an upward trend in Q1 2020, and by June they outpaced the world average (Figure 2). Confirmed cases reached 50 daily cases per million inhabitants in El Salvador and 85 daily cases per million inhabitants in Guatemala. The Covid -19 propagation in CA3 displayed a similar dynamic as LAC, one of the most affected regions by the pandemic. The curve for confirmed deaths showed an analogous shape as the confirmed cases, with Honduras being the most affected country in CA3 (outpacing the 4 daily deaths per million inhabitants). Figure 2. New Covid-19 cases and related deaths Cases per 1M people (7 days rolling average) Deaths per 1M people (7 day rolling average) 800 10 600 400 5 200 0 0 May-20 May-20 Jan-21 Mar-21 May-21 Jan-22 Mar-22 Jul-20 Sep-20 Dec-20 Feb-21 Jul-21 Sep-21 Dec-21 Feb-22 Apr-20 Oct-20 Nov-20 Apr-21 Oct-21 Nov-21 Jun-20 Aug-20 Jun-21 Aug-21 May-20 May-20 Jan-21 Mar-21 May-21 Jan-22 Mar-22 Sep-20 Feb-21 Sep-21 Feb-22 Jul-20 Dec-20 Jul-21 Dec-21 Apr-20 Jun-20 Aug-20 Oct-20 Nov-20 Apr-21 Jun-21 Aug-21 Oct-21 Nov-21 Guatemala Honduras El Salvador Guatemala Honduras El Salvador LATAM World LATAM World Source: Our World In Data. As the virus spread rapidly, governments imposed restrictions on circulation, international travel, quarantines, and workplace closures, slowing down economic activity. Circulation of people reduced sharply in the second quarter of 2020, coinciding with the steep increase in confirmed cases and deaths. 17 Reduced mobility was partly due to the inherent response of the population, who voluntarily limited movement towards strict and essential needs in the face of a new contagious disease without existing vaccines. However, reduced mobility was also due to restrictive measures undertaken by governments to cope with the rising curves of confirmed cases and deaths.8 Compared to pre-pandemic levels, circulation of people traveling to workplaces reduced between 60 and 70 percent, while mobility related to recreation fell around 80 percent. Restrictive measures were undertaken as a health response to the crisis, but also represented an endogenous shock that affected the dynamics of economic activity, complementing the exogenous shocks stemming from the external sector. Alongside warmer weather later in 2020, confirmed cases and deaths reduced markedly, and mobility recovered steadily. Towards the end of 2020, with milder temperatures, confirmed cases and deaths experienced a sharp decline. In CA3 countries, confirmed cases hovered below 60 daily cases per million inhabitants and confirmed deaths stood below 2 daily deaths per million inhabitants. Concurrently, the circulation of people showed a sustained increase, reaching the previous levels in the case of recreation and stood just 20 percent below the pre-pandemic levels in the case of labor mobility. The recovery of mobility towards the end of 2020, as it constituted the reversal of one of the main factors that explained the economic slowdown, underpinned the subsequent recovery (Figure 3). The second wave hit strongly in 2021, but the setback in mobility reduction was not as intense. Confirmed cases rose sharply again at the beginning of 2021, being particularly intense in Honduras, which reached more than 100 daily cases and 6 deaths per million inhabitants. However, despite specific moments, mobility continued its previous recovery path. Differences in mobility between the first and second waves can be attributed to learned experience: for example, protocols that did not exist during the first wave, the vaccination campaigns kickoff and the start of the population’s immunization in 2021, and the awareness of the economic cost of extended quarantines and workplace closures. In this sense, the resurgence of Covid-19 in 2021 did not constitute a major threat to the economic recovery that began to materialize towards the end of 2020. Figure 3. Google mobility Index (% difference from the baseline) Change in community movement relative to the period before the pandemic (%) Change in community movement relative to the period before the pandemic (%) Workplace Retail & recreation 80 40 60 20 40 0 20 0 -20 -20 -40 -40 -60 -60 -80 -80 -100 Source: Our World In Data. Drivers and transmission mechanisms behind the Covid-19 crisis The economic impact of the Covid-19 crisis in Central American countries was driven by exogenous and endogenous factors, which operated through multiple transmission channels. In the absence of vaccines, 8 In March 2020, Guatemala declared the State of Calamity and disposed of restrictions on international arrivals; El Salvador’s Legislative Assembly approved an Exception State to limit circulation and the Executive Power declared the first quarantine, and in Honduras the government declared the Sanitary Emergency and the first curfew. 18 the main response undertaken by most countries to control the infections curve and avoid collapses in the health systems consisted in applying restrictions on the mobility of people. This resulted in a sharp contraction of economic activity, international trade, and tourism flows. International Labor Organization (ILO) figures indicated that by June 2020 around 93 percent of the world’s workers resided in countries with some sort of workplace closure measure, resulting in an estimated loss of 155 million full-time jobs in Q1 2020. According to the World Trade Organization (WTO), trade flows fell by 7.5 percent in 2020 while World Tourism Organization’s figures showed a sharp decline in international tourists’ arrivals (-74 percent). World GDP stepped back by 3.4 percent in 2020, the largest drop since WW2. These impacts constituted strong exogenous shocks stemming from the external sector for countries in Central America, where exports, remittances, and tourism inflows are of crucial relevance. These impacts were combined with local responses to coping with the pandemic, which affected economic activity by limiting the circulation of people and disposing of workplace closures that trammeled production, which consequently tightened households’ disposable income. Amidst the sharp decline in private demand, governments stepped in with massive fiscal stimulus to support households’ consumption capacity and to strengthen the stressed health sectors. Consequently, the Covid-19 pandemic’s impact was simultaneously macroeconomic and fiscal. Given the deep impact both in the economy (activity fall, loss of disposable income, and employment destruction) and the health sector (with steep increases in demand for assistance that stressed system capacity), governments stepped in unfolding various monetary and fiscal expansive actions. This push partially limited the fall in economic activity and kept afloat the health sectors, but fiscal positions rapidly deteriorated and public debt ratios lifted. The Covid-19 crisis implied a simultaneous slowdown in supply and demand, affecting the labor market and depressing disposable income. Shocks stemming from the external sector affected disposable income directly and severely in the CA3 economies, through lower exports, remittances, and tourism incomes, which jointly represented nearly 40 percent of GDP in 2019. For remittances, which represent nearly 20 percent of CA3 GDP, labor market disruption in the United States was particularly relevant given that 90 percent of the inflows correspond to that origin in CA3. The civilian unemployment rate in the United States jumped from 3.5 percent in February 2020 to 14.8 percent in April 2020. Restrictions on circulation impacted the economy through two main channels: in the first place, due to workplace closures, which directly affected production levels -particularly the ones considered non- essential (Figure 4). Secondly, because the consumption basket narrowed to essential goods and services, thus sternly affecting the rest of the activities’ demand. This environment determ ined lower production and employment levels in most of the economic sectors, depressing firms' cash flows and households’ disposable income. In this sense, the Covid-19 crisis implied a simultaneous slowdown in supply and demand, with the inherent risk of feedbacking and unleashing second-round effects if economic agents’ expectations of the situation weren’t deemed as transitory. However, as it would be described afterward, the economic impact was intense but short-ranged, and the rapid reversion of the slowdown drivers constitute the central factor explaining the projected recovery for the medium term. Although the impact of the crisis was global, structural features of CA3 countries performed as accelerators, such as high informality rates and self-employment, and lack of technological readiness. As the reduction of human mobility constituted the core of the dysfunctionality introduced in the economic systems, the Covid-19 crisis disproportionately hit the informal and self-employment sectors. These segments of the labor market are characterized by reduced buffers to cope with a significant drop in disposable income due to their limited access to credit, and are also often not covered by social 19 protection networks. Self-employment represents around half of the employment in Central American countries, while the informal economy is close to 80 percent, significantly above the rest of the world. Figure 4. Covid-19 pandemic channels of transmission Furthermore, the Covid-19 crisis accelerated the pre-existing trend to telework, and this disadvantaged the population segments with lower possibilities to carry out work remotely . In CA3 countries internet access is not widespread, with only a third of the population using internet in 2017.9 The quality of access is also poor as they are ranked below 80th place in the Internet speed world ranking.10 In this regard, limited automatic stabilizers also explained the magnitude of the economic shock in the region. In CA3 countries, informality and poverty rates are high, women participation in the labor market and technological readiness is low and youth unemployment doubles national figures. Hence, the most vulnerable segments of the population were disproportionately hit by the crisis. II. Impact of Covid-19 on the economy: Macro evidence Macro-fiscal impact of the pandemic Overview of the macroeconomic impact in CA3 countries Covid-19 led to a large contraction in GDP, averaging 4.1 percent in 2020 for the CA3 countries. The average drop of 4.1 percent for CA3 countries was a contraction rate not seen since the civil wars’ period. There was, however, a large disparity between countries: Guatemala’s GDP fell by 1.8 percent, while in Honduras and El Salvador the contraction reached 9.0 percent and 8.2 percent, respectively. The 2020 recession also implied a retraction of about 6 percent in the average GDP per capita, with falls of between 8 and 10 percentage points (p.p.) in El Salvador and Honduras respectively, and a slight decline in Guatemala. Given that the dynamics of domestic prices exceeded that of exchange rates, the retraction in GDP per capita measured in US dollars was milder than real GDP per capita. The recovery in 2021 was faster than expected, supported by a strong recovery in the US, which increased demand for exports and remittances inflows in CA3. All three countries surpassed the pre Covid-19 activity level by end 2021 and GDP growth doubled the 2020 fall, outperforming the regional and LAC averages. Private consumption and investment drove growth in CA3 countries, supported by the 9 Source: Ookla and International Telecommunications Union. 10 Source: Ookla and International Telecommunications Union. 20 large inflow of remittances, and to a lesser extent to an increase in exports, due to the fast recovery in the US labor markets. However, they fell short the recovery experienced by developing countries, which grew three-fold what they had lost in 2020. Figure 5. GDP Growth 2020-2021 (percent) 15% 12.5% 10.2% 9.3% 10.3% 10% 6.8% 8.0% 6.1% 6.6% 5.2% 5% 0% -5% -2.0% -1.8% -3.1% -4.1% -4.5% -10% -6.6% -7.5% -9.0% -8.2% -15% World Guatemala Honduras El Salvador Advanced Economies CA3 Emerging Economies Latin America Sources: National authorities, IMF WEO (April 2022), WBG GEP Jan-20 and MPO SM22 Central America Economic impact, however, should not only be measured by comparing the year-on-year GDP loss, but also against previous expectations trend. Before the Covid-19 outbreak, CA3 countries were expected to grow at an approximate rate of 3 percent in 2020, in line with the last decade’s average. Thus, the fall in 2020 implied a difference of 7.1 p.p. compared to the previous expectations trend, slightly higher than the World’s (6.4 p.p.) and Emerging Economies’ average (6.4 p.p.), but below Latin America (8.4 p.p.). Once again, the disparity was a distinctive feature: the differential in Honduras (12.5 p.p.) and El Salvador (10.7 p.p.) largely exceeded the corresponding to Guatemala (4.8 p.p.). Furthermore, the strong recovery in 2021 surpassed the growth projected for that year before the pandemic, closing the gap with potential output and decreasing the difference to only 1.1 p.p. the pre-pandemic trend. Most notably, Guatemala’s growth rate in 2021 allowed the country to close the gap with the pre-pandemic growth trend (Figure 6). What is more, Guatemala has been the least affected country in the region, and the second least affected in LAC only below Paraguay. The low level of urbanization in Guatemala which prevented the virus to expand as quickly as in El Salvador and Honduras may have contributed to the lower impact of the pandemic on the economy.11 ( Furthermore, the higher level of trade diversification of the Guatemalan economy is also likely to have mediated the impact of the Covid-19 shock. 11 48.2 percent of Guatemalan population lived in rural areas compared to 26.6 and 41.6 percent in El Salvador and Honduras, respectively (World Development Indicators). 21 Figure 6. GDP Growth Pre- vs Post-Covid19, 2020-2021 (in percent) Pre-COVID Actual Differential 2020 2021 2020 2021 2020 2021 Cummulative World 3.3% 3.4% -3.1% 6.1% -6.4% 2.7% -3.7% Advanced Economies 1.6% 1.6% -4.5% 5.2% -6.1% 3.6% -2.5% Emerging Economies 4.4% 4.6% -2.0% 6.8% -6.4% 2.2% -4.2% Latin America 1.8% 2.4% -6.6% 6.6% -8.4% 4.2% -4.3% Central America 3.0% 3.3% -7.5% 10.2% -10.5% 6.9% -3.6% CA3 3.0% 3.3% -4.1% 9.3% -7.1% 6.0% -1.1% Guatemala 3.0% 3.2% -1.8% 8.0% -4.8% 4.8% 0.0% Honduras 3.5% 3.5% -9.0% 12.5% -12.5% 9.0% -3.4% El Salvador 2.5% 2.5% -8.2% 10.3% -10.7% 7.8% -2.9% Rest of Central America 3.0% 3.4% -10.1% 11.1% -13.1% 7.6% -5.5% Rest of LATAM 1.7% 2.4% -6.6% 6.6% -8.2% 4.3% -4.0% Sources Sources:: IMF WEO authorities, National (April 2022),IMF WBG GEP(April WEO Jan-202022), WBGSM22 and MPO GEP Jan-20 and MPO SM22 From the production approach, activity in most of the economic sectors declined in 2020. However, the retraction was concentrated in 6 sectors that explained about 80 percent of the fall. Value-added in most of the economic sectors declined in 2020 in the CA3 economies; (i) In Guatemala, 11 out of 17 sectors displayed negative figures; (ii) 14 out of 20 sectors did so in El Salvador; and (iii) In Honduras, it was more generalized, with 12 out of 16 sectors showing a retraction. The largest drops occurred in those sectors most exposed to the Covid crisis dynamics, both due to a consumption basket that focused on essential activities, as well as the reduction in tourism and restrictions on the circulation of people. The most paradigmatic cases were Hotels and restaurants, Construction, and Transportation. The Manufacturing, Mining, and Trade sectors were also strongly affected, although to a lesser extent than the previous cases due to the inherent heterogeneity within them. These 6 sectors (which account for nearly half of employment in CA3 countries) doubled the fall in GDP in CA3 economies and explained almost 80 percent of the global drop in economic activity (Figure 7). The rest of the sectors also contracted in 2020 but not in such a marked or generalized way. For example, in Guatemala Agriculture, Public Services, Information, and Communication sectors and Financial Intermediation ended 2020 with positive figures; in Honduras, strong growth was observed in the Health and Information and Communication sectors; and finally in El Salvador growth was observed in the Health, Public Services and Banks sectors. 22 Figure 7. GDP by production approach 2020, CA (%) El Salvador Honduras Guatemala Banks Information & communication Utilities Other Services Health Public administration & education Agriculture GDP -8.2% -9.0% -1.8% Manufacturing Minining & Quarrying Trade Construction Hotels & Restaurants Transportation -50% -40% -30% -20% -10% 0% 10% Sources: Banco de Guatemala, Banco Central de Honduras and Banco Central de Reserva El Salvador The recovery in 2021 was widespread with the expansion of all sectors. Hotels and Restaurants was the sectors that grew the most in all three countries, though it was also due to the low base effect as it was the most affected by the mobility restrictions. Trade and manufacturing were the sectors that most contributed to the growth rates, promoting a fast recovery in the labor markets as well. These two sectors accounted for at least a third of the recovery in Guatemala and El Salvador, and almost half in Honduras. Due to activity fall and workplace closures, unemployment climbed in 2020. The fall in economic activity and workplace closures imposed by governments hit the labor market. In LAC, the main impact was observed in the participation and employment rates, which fell on average by around 5 p.p., with greater intensity in the sectors most exposed to human contact. The fall in employment rates did not translate vis-à-vis into an increase in unemployment rates, partly because the same restrictions on movement hindered job search, and partly because public measures aimed to strengthen households’ incomes alleviated the need to circulate for work purposes. However, a significant rise in the unemployment rate - of around 3 p.p. was observed in 2020 in CA3 (Figure 8). It should be pointed that these countries were characterized by having limited and relatively stable unemployment rates over the last decade, although women and youth unemployment figures stand above national levels - thus resulting in disproportionate impacts. Following a fast recovery in 2021, Guatemala’s labor market is estimated to have returned to the pre-pandemic unemployment rate, whereas Honduras and El Salvador sill suffered the effects of the pandemic and would only recover the pre-pandemic employment rate in 2022. Inflation and currency depreciation pressures remained subdued in 2020, but this trend reversed in 2021. Inflation remained subdued in 2020 in CA3, in an environment of a sharp decline in private demand. In Honduras and El Salvador inflation in 2020 was similar to the previous year. In Guatemala, domestic consumer prices showed a modest rise (4.8 percent, up from 3.4 percent in 2019), mainly due to specific rises in food and transportation in two particular months (June and October). However, this trend was reversed in 2021, when international prices started to raise, impacting domestic prices. Both in El Salvador and Honduras annual inflation surpassed 5 percent by the end of the year, with El Salvador reaching 6 percent in December 2021. On the other hand, Guatemala managed to keep inflation at around 3 percent.-Unlike other cases in LAC, and despite the decline in external incomes towards the middle 2020, there was no significant currency depreciation. And currencies remained stable through 2021, supported by the inflow of remittances. 23 Figure 8. Unemployment Rate, CA3 10% Guatemala El Salvador Honduras 8% 6% 4% 2% 0% 2016 2017 2018 2019 2020 2021 Source: ILO (modelled estimates) and national Authorities Due to the steep decline in private and external demand and the step forward of the public sector, fiscal positions in CA3 weakened sharply. Fiscal revenues were undermined given the steep decline in private and external demand. Simultaneously, massive fiscal responses aimed at strengthening Health sectors and supporting households’ and firms’ incomes led to increases in primary expenditure. Consequently, primary balances in CA3 weakened sharply in 2020 (Figure 9). Fiscal accounts improved in 2021 as the GDP rebounded, which increased tax revenues, especially those related to consumption. In addition, the scale back of emergency spending contributed to a fast improvement in the fiscal accounts, particularly in Guatemala and El Salvador. Figure 9. Primary Balance, CA3 (share of GDP) 2% 1% 0% -1% -2% -3% -4% -5% Guatemala El Salvador Honduras -6% 2017 2018 2019 2020 2021 Sources: National data and World Bank The simultaneous worsening of primary balances and the macroeconomic environment pushed debt ratios in 2020. Public debt lifted sharply in CA3, displaying a strong increase which more than doubled the rise that occurred during the international financial crisis of 2008-2009. However, a disparity between countries was observed: in El Salvador, public debt climbed 18.2 p.p. of GDP while the increase in Guatemala stood only at 5.0 p.p. (Figure 10). Public debt in CA3 countries reached the highest levels in the last three decades. The worsening of the fiscal positions partially explained public debt rise, but it is to mention that macroeconomic dynamics also had an impact, especially in El Salvador and Honduras. In this way, as mentioned, the economic and fiscal impacts of the 2020 crisis are intrinsically related. Going forward, following the decrease in fiscal deficits and the increase in GDP, CA3 actually managed to reduce their debt burden in 2021. However, in 2022 El Salvador and Guatemala are expected to reduce further their debt burden as their fiscal adjustment has been steeper that in Honduras. 24 Figure 10. Change in Public Debt in CA3, 2020-22 (share of GDP) 20% + 18.2% 15% + 10.6% 10% + 5.0% 5% + 2.3% 0% -0.9% -0.9% -0.3% -1.0% -5% -6.3% -10% Guatemala El Salvador Honduras Source: WBG MPO (SM22) The Covid-19 pandemic crisis and recovery The external drivers that led to the steep slowdown reversed rapidly by the end of 2020 and further improved in 2021. Remittances fell sharply in CA3 during Q2 2020 (-11.0 percent YoY) - an equivalent drop of USD 600 million -, registering the lowest income for an April-June period since 2017 (Figure 11). However, and underpinned by the rapid recovery of employment in the United States as one of the main drivers, remittances influx was strongly rebuilt during the second half of 2020. Recovery outpaced the initial drop, to such an extent that in 2020 remittances to CA3 grew 6 percent compared to 2019. This dynamic not only continued through 2021 but deepened as remittances inflows grew double digits every month. As a result, remittances increased around 30 percent YoY in 2021 in CA3 countries, reaching 25 percent of GDP in El Salvador and Honduras, and 16 percent of GDP in Guatemala. Goods exports displayed a similar dynamic: in Q2 2020 exports collapsed almost 21.7 percent YoY, but contraction moderated sharply in Q3 (-3.2 percent YoY) and positive figures emerged towards year-end (+2.7 percent YoY) (Figure 12). Merchandise exports benefited further from the surge in global demand of goods, particularly from the U.S., but also from the increase in agricultural commodity prices, particularly in coffee and bananas. As a consequence, export of goods increased by an average of 29 percent YoY in CA3.12 Tourism was the most impacted sector by the pandemic worldwide in 2021, and CA3 countries were not exempt, and it remained subdued during 2021. For tourism, the decline was steeper and the recovery slower: tourism revenues entered negative territory already in Q1 (-17.6 percent YoY), and in Q2 and Q3 they experienced a sharp reduction which exceeded 80 percent. It is to mention that the size of this decline did not constitute an anomaly within the context of global tourism in 2020, where arrivals to the Americas region fell almost 80 percent YoY. Furthermore, the retraction continued in 2021 Q1, with the exception of El Salvador, where tourism revenues already bottomed up in 2020 Q4 and were only 25 percent below than in 2019 Q4. The downward trend started to revert in 2021 Q2, though tourism revenues remained subdued, 70 percent below the level of 2019 tourism inflows, while El Salvador ended 2021 only 25 percent of the 2019 level The link between CA3 economies and the United States has been evident during the pandemic and recovery period through multiple dimensions such as remittances, exports, and tourism. In addition to a large source of remittances’ inflows, the United States is the main trading partner and main source of tourism of CA3 countries, making them highly dependent on the U.S. economic cycle. The U.S. is the main destination of migrants from the CA3 countries and therefore, the main source of remittances, which are 12 See next section for a more detailed description of the impact of the pandemic on trade. 25 crucial to sustain consumption and finance imports. In addition, the North American country is the main destination of CA3 exports; it represents almost a third of Guatemalan merchandise exports and around half of El Salvador and Honduras exports. Consequently, the business cycle of the U.S. has a large impact in the CA3 countries, which was a main factor in the fast recovery these countries experienced in 2021. However, this will have further policy implications for the CA3 countries going forwards as the U.S. growth is showing signs of slowing down. Figure 11. Remittances in CA3: YoY var (%), quarterly Figure 12. Exports in CA3: YoY var (%), quarterly 140% 60% 40% 90% 20% 40% 0% -10% -20% -60% I-19 II-19 III-19 IV-19 I-20 II-20 III-20 IV-20 I-21 II-21 III-21 IV-21 I-19 II-19 III-19 IV-19 I-20 II-20 III-20 IV-20 I-21 II-21 III-21 IV-21 Guatemala El Salvador Honduras CA3 Guatemala El Salvador Honduras CA3 Source: National data. The rapid reversion of the external shocks and fewer restrictions on circulation and workplaces underpinned a V-shaped recovery throughout 2020. GDP in CA3 contracted by 13 percent YoY in Q2 2020, where all factors - endogenous and exogenous - operated negatively and simultaneously. With the aforementioned reversal of factors stemming from the external sector - remittances, exports, tourism - and further looseness of restrictions on circulation and workplaces, economic activity began to recover towards the end of the year. GDP contraction narrowed to 4.5 percent YoY by Q3 2020 and balanced in Q4 2020, apart from Honduras which suffered a second wave by the end of 2020. The recovery continued further in 2021, with YoY growth almost doubling the losses of 2020, and sustaining an annual growth above 10 percent (Figure 13). Fiscal response timing underpinned the observed economic dynamic, although with disparity across countries. Primary expenditure accelerated since Q2 2020 in CA3, although with disparity across countries. Guatemala displayed a constant acceleration of primary expenditures throughout the year, while in El Salvador intensity was larger during mid-year -and falling by year-end. In Honduras, primary expenditure only displayed a year-on-year growth in Q4 2020. 26 Figure 13. GDP in CA3: YoY var (%), quarterly 30% 20% 10% 0% -10% -20% -30% I-19 II-19 III-19 IV-19 I-20 II-20 III-20 IV-20 I-21 II-21 III-21 IV-21 Guatemala El Salvador Honduras CA3 Source: National data Towards the medium term a sustained economic growth path is expected in CA3, and GDP outpaced pre-pandemic levels in 2021. The reversal of the multiple and simultaneous shocks that explained the steep decline in activity by mid-2020 is expected to persist over the medium term. Consequently, the V- shaped recovery that displayed throughout 2020 underpins the expected upward path projected for the subsequent years. On average, the region would recover pre-pandemic activity levels in the next few years, albeit with heterogeneous growth rates across countries. For 2021-23, Guatemala is expected to grow at 4.9 percent annually, Honduras at 6.2 percent per year, and El Salvador at an annual rate of 5.2 percent. All three countries would exceed the pre-pandemic level in 2021 (Figure 14). Notwithstanding the expected recovery, only Guatemala would stand above the pre-Covid medium term projected trend. When comparing with the pre-Covid expected GDP trajectory, only recovery in Guatemala will suffice to compensate for the loss of value registered in 2020. Measured in current dollars, the cumulative loss in 2021-2023 will be moderate in Honduras (-5.2 percent) and in El Salvador (-3.2 percent). Figure 14. Projected GDP 2022-2023 (2019=100), CA3 115 110 105 100 95 90 2019 2020 2021 2022 2023 Guatemala El Salvador Honduras Pre-COVID level Source: National data and World Bank Fiscal impact The fiscal position in CA3 countries weakened sharply due to a simultaneous fall in revenue and increase in expenditure. Fiscal revenue fell during 2020 in CA3, undermined by recession and explicit stimulus measures undertaken to cope with the pandemic. Measured in local currency units, revenues fell 15 percent YoY in Honduras, down from an 8 percent average growth in 2016-2019. In El Salvador and Guatemala the decline was slightly milder (-6 percent and -4 percent YoY, compared to average growth in 27 2016-2019 of 4 percent respectively). In Guatemala and El Salvador, revenue fall was mainly led by indirect taxes: VAT and import duties accounted for half of the revenue reduction in nominal terms. In Honduras, however, these two indirect taxes explained less than a third of the revenue drop, even though the recession was steeper. The sharp fall in income tax collection, which reached 25 percent YoY (compared to 2 percent and 1.4 percent in Guatemala and Honduras), accounted for this difference. Measured in terms of GDP, fiscal revenue declined moderately in Guatemala (-0.5 p.p.) but abruptly in Honduras (-3.2 p.p.). In El Salvador, fiscal revenue increased in terms of GDP (+0.4 p.p.) given the pronounced drop in nominal gross domestic product (Figure 15). Figure 15. Primary balance: 2020 vs 2019 (in p.p.) 8% 6.2% 6% 4% 2.1% 2% 0.7% 1.2% 0% -2% -0.5% -4% -2.6% -3.2% -6% -4.4% -5.5% -8% Revenues Primary Expenditures Primary Balance Guatemala El Salvador Honduras Source: WBG MPO (SM22) Regarding primary spending, sharp spikes were observed in Guatemala (+18.6 percent) and El Salvador (+11.8 percent YoY), which in real terms implied increases of 14.9 percent and 12.2 percent respectively, and in both cases, accelerating strongly compared to the previous year’s dynamics. In Honduras, on the contrary, primary spending fell 1 percent in nominal terms which, after discounting inflation, implied a decline of 4.3 percent YoY. In terms of GDP, primary spending increased in all countries in CA3, rising by 5 p.p. in El Salvador, 2.1 p.p. in Guatemala, and 1.2 p.p. in Honduras. Revenue fall with rising expenditures resulted in an erosion of the primary balance in all the countries of the region. In Guatemala, the primary deficit reached 3.2 percent of GDP - down 2.6 p.p. compared to 2019 -, in Honduras 3.8 percent of GDP and El Salvador 4.2 percent of GDP. In the last two cases, the impairment compared to 2019 reached 4.4 p.p. and 4.5 p.p. of GDP, respectively. Massive fiscal response unfolded by the government to cope with the pandemic largely explained the impairment in fiscal positions (Figure 16). Worsening of primary balances in CA3 was largely led by expenditure rise and, to a lesser extent, by forgone revenues. Most of the explicit measures unfolded to cope with the pandemic consisted in expenditure deployment, thus explaining fiscal worsening to a large extent. Revenue-based measures focused mainly on tax exemptions intended to underpin the cash flow of firms. Major expenditure-related measures consisted of cash transfers aimed at strengthening informal and self-employed incomes - also as a way to enforce quarantines - and to bolster up the health system - the weaker link in the Covid-19 pandemic. 28 Figure 16. Fiscal responses in CA3 to Covid-19 crisis (% of GDP) Increase in TOTAL primary deficit 2020 Guatemala 2.6% 2.6% Honduras 2.9% 4.4% El Salvador 6.2% 5.5% Source: World Bank In Guatemala, support to vulnerable families stood out (1.5 percent of GDP). The Bono Familia program (1.0 percent) - Q1,000 during 3 months - was the most significant action along with the Bono de Protección del Empleo - a daily payment of Q75 for temporarily suspended workers - followed by support to food programs, public utilities, and small farmers. Transfers to firms (0.6 percent of GDP) consisted in supporting firms mainly with preferential rates and subsidized credit. In El Salvador, the main palliative measure on the revenue side was temporary elimination of import tax during the emergency state for some essential products, a temporary suspension of the special tourism contribution, and the extension of tax payment dates. Expenditure-based measures had a larger wingspan, led by cash grants and food baskets to vulnerable people and aids to the informal sector (2.1 percent of GDP), strengthening state budget (1.6 percent of GDP), grants bonuses to first responders (1.3 percent of GDP) and health sector strengthening (0.6 percent of GDP). Alongside, Legislative Power approved two special borrowings totaling 12 percent of GDP that partially funded the aforementioned measures and also served to refinance short-term debt, constitute a municipal special fund and aid SMEs. El Salvador also temporarily suspended the fiscal responsibility law and unfolded monetary policy actions, led by a large liquidity injection and other measures aimed at promoting credit and alleviating borrowers’ stress due to the crisis. In Honduras, forgone revenues measures totaled 0.6 percent of GDP. Among them were the reduced advance payments in income tax to firms and a one-off income tax credit equivalent to 10 percent of salary expenses -partially explaining the differential dynamics compared to Guatemala and El Salvador in terms of income tax-, and a tax exemption extension for companies in Free Economic Zones -including VAT exemptions for medical supplies. Regarding expenses, measures were granted for 2.2 percent of GDP, mainly focused on vulnerable sectors (1.3 percent of GDP): unemployment benefits to formal workers, cash transfers to informal workers, and food supplies. Strengthening the health system also stood out, with a fiscal effort of 1 percent of GDP. The increase in primary spending was almost entirely driven by current expenditures, particularly in transfers to the private sector. Transfers to the private sector was the primary spending item that increased the most in CA3 countries. The design of the measures was well-oriented considering the social structure of the region and the impact of a sudden drop in the disposable income of large segments of the population with limited buffers or social safety nets. However, although the size of the measures stood out compared to the historical public spending levels in the region, it was insufficient to offset the impact on disposable income and employment loss. The fiscal gap shows that the tax collection was insufficient to cover primary current expenditures in any of the CA3 countries in 2020. After years of stability, public debt in CA3 countries rose sharply in 2020. Public debt in CA3 showed a stable trend in recent years but climbed in 2020 due to the deterioration of the fiscal position and economic recession (Figure 17). The largest public debt increase was observed in El Salvador (+17.2 p.p. of GDP), which also has the highest level of public debt (71 percent of GDP in 2019) among CA3 countries. Public debt in Honduras stood at 48.9 percent of GDP in 2020, climbing 7 p.p. compared to 41.9 percent 29 in 2019. Guatemala had both the lowest levels of public debt in 2019 (26.6 percent of GDP) and the lowest increase in 2020 (+5.2 p.p. of GDP). The worsening of the fiscal position was an important driver of public debt growth: in Guatemala and Honduras, it accounted for 60 percent of the increase, although only a fifth in El Salvador. Economic recession and interest burden also stood out as relevant drivers behind the increase in public debt, especially in El Salvador. The contribution of GDP dynamics, as the denominator, was particularly important in Honduras and El Salvador, accounting for half of the rise. In El Salvador the contribution of the real interest rate was also relevant, explaining a quarter of the increase in the debt-to-GDP ratio. Figure 17. Public Debt in CA3 (% of GDP) 100% 91.8% 85.8% 80% 54.1% 55.5% 60% 40% 31.6% 29.5% 20% Guatemala El Salvador Honduras 0% 2015 2016 2017 2018 2019 2020 2021 2022 2023 Source: WBG MPO (SM 22) The public debt/GDP ratio can also be broken down to analyze the contribution of the nominal increase in debt - associated with fiscal needs - and shifts in the denominator - related to the macroeconomic performance. In recent years, public debt ratios in CA3 would have increased on average between 1.8 p.p. (Guatemala) and 3.5 p.p. (El Salvador) per year, only due to nominal growth in public debt; however, a robust growth trend allowed to keep public debt ratios stable. In 2020, the nominal public debt rise accelerated sharply, tripling in the case of Guatemala and El Salvador, and doubling in the case of Honduras. Alongside, the GDP fall contributed negatively to the public debt ratio in Honduras and El Salvador and had a neutral impact in Guatemala. In 2021, this trend was reverted, and the high growth rates contributed to reduce the debt burden, despite fiscal balances were still negative. As growth rate converge to potential, debt stabilization hinges on fiscal consolidation plans in a combination of pandemic related spending unwind and revenue mobilization. After the worsening of the fiscal position in 2020, a gradual consolidation path is expected for the medium term. As a result of the cyclical recovery of revenues and a gradual disarming of the massive fiscal response unfolded in 2020, CA3 countries are expected to display a fiscal consolidation path over the medium term, although with somewhat heterogeneous speeds (Figure 18). Honduras is expected to rebalance the primary balance in the next five years, while in the same period El Salvador and Guatemala would reduce its primary deficit substantially. In the first case, expenditure reduction in terms of GDP would be the main contribution to fiscal consolidation, driven by the economic recovery. In the case of El Salvador and Guatemala, the revenue dynamic is expected to have the largest contribution to fiscal consolidation, since the weight of primary spending in terms of GDP is not projected to be rapidly reduced. 30 Figure 18. Primary balance, CA3 (% of GDP) 1% 0% -1% -2% -3% -4% -5% -6% 2019 2020 2021 2022 2023 2024 Guatemala El Salvador Honduras Source: National data and WBG MPO (SM22) Public debt is expected to stabilize over the medium term assuming that economic activity resumes to the pre-pandemic growth trend and a gradual fiscal consolidation path. The main drivers that pushed public debt in 2020 are expected to reverse over the short- and medium-term. Consequently, the public debt path in CA3 is envisaged to stabilize in the next few years, although at a varying pace. In Guatemala, debt burden is projected to have peaked in 2020, as fiscal consolidation was undertaken faster than expected, and reach 29 percent in 2024. Public debt in Honduras is expected to reach 56 percent of GDP in 2024, increasing by 1.7 p.p. compared to the 2020 levels, but displaying a stable medium-term trajectory. In Guatemala, primary deficit and real interest rate will be the main factors contributing to public debt rise over the medium-term. However, due to the strong economic performance and the expected fiscal consolidation, the public debt ratio will remain stable and subdued. In Honduras, primary deficit will play a larger role and exchange rate depreciation is also expected to lift the public debt ratio. However, public debt is expected to stabilize due to the moderate interest burden and the robust growth prospects. Public debt is expected to reach 86 percent of GDP by 2025 in El Salvador, decreasing by 6 p.p. compared to 2020 if fiscal consolidation plans are executed. Trade and investment effects of the pandemic The trade collapse and recovery: Global and regional impacts The Covid-19 pandemic had severe impacts on international trade and GVCs. As the virus and its containment measures expanded globally, the world experienced widespread disruptions in supply and demand across the world as well as disruptions in GVCs. The trade effects of the pandemic have varied across countries and regions, depending on their trade profile—such as diversification in terms of sector and partner countries—as well as the severity of the virus and lockdown measures. Like much of the world, the LAC region saw sharp contractions in trade in the second quarter (Q2) of 2020. Exports in 2020 Q2 dropped by 26.2 percent in LAC compared to the same period in 2019 while imports fell by over 30 percent (Figure 19). The global contraction in trade continued through the third quarter in all regions except East Asia and Pacific, despite lessening in magnitude. 31 Figure 19. Quarterly trade year-on-year growth by region, 2020-2021 (a) Exports 120 90 Year-on-year percent change (%) 60 30 0 -30 -60 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 (b) Imports 120 90 Year-on-year percent change (%) 60 30 0 -30 -60 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa North America South Asia Sub-Saharan Africa World Source: Authors’ calculations using data from World Bank, Covid-19 Trade Watch. Various stages along GVCs saw sharp trade contractions, most notably in sectors such as transport equipment and textile and apparel. Disruptions in apparel supply chains and reduced demand have been important for Central American countries, where the apparel sector plays a key role in countries’ exports and GVC participation. For example, El Salvador was one of the countries with strongest export contractions, largely driven by the textiles and clothing industry. In May 2020, El Salvador reported a 60 percent year-on-year drop in exports and a 44 percent drop in imports. The significant drop in exports in apparel could be attributed to both the intrinsic vulnerability of apparel value chains linked to the collapse of foreign demand and the CA3 countries’ position in these supply chains with reliance on a small number of suppliers and buyers. Exports from the CA3 countries dropped by an average of 30 percent in the second quarter of 2020, compared to the same period in 2019. The magnitude of the impact, however, varied widely across the CA3 countries. El Salvador was the hardest hit, with a contraction over 50 percent in Q2 of 2020, recording a peak contraction of nearly 60 percent in May 2020 (Figure 20). In Honduras and Guatemala, year-on- year (y-o-y) exports in Q2 2020 fell by 37.1 percent and 12.3 percent, respectively. The dynamics in imports were similar, with the contraction peaking in 2020 Q2. However, unlike exports, the drop in imports remained substantial going into the third quarter, recording an average of 15.1 percent y-o-y drop, while export contraction averaged less than 5 percent in the same period. 32 Figure 20. Quarterly trade year-on-year growth for Guatemala, Honduras, and El Salvador, 2020-2021 (a) Exports 150 120 Year-on-year percent change (%) 90 Guatemala 60 Honduras 30 El Salvador 0 CA3 -30 -60 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 (b) Imports 100 80 Year-on-year percent change (%) 60 Guatemala 40 Honduras 20 El Salvador 0 CA3 -20 -40 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 Source: Staff estimates based on World Bank Global Economic Monitor and Central Banks. As the first wave of Covid-19 abated, global trade started showing timid signs of a recovery in the last quarter of 2020, followed by a more robust recovery in 2021. Global trade slightly increased by 3.8 percent in Q4 2020, compared to levels in 2019, although the pace of recovery was uneven (Figure 19). The initial recovery was largely led by East Asia and the Pacific and Sub-Saharan Africa, with Middle East and North Africa, North America and South Asia still recording export contractions. The trade recovery was more robust in 2021, with all regions reporting positive y-o-y growth in the first quarter. Global exports increased by about 45 percent in Q2 2021, with 58 percent growth for LAC, compared to levels in 2020. This bounce back was sufficient to recover the export levels before the pandemic (Figure 21). Figure 21. Quarterly exports and imports by region, 2020-2021 (2019=100) (a) Exports 140 Exports (2019 levels=100) 120 100 80 60 40 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 33 (b) Imports 160 Imports (2019 levels=100) 140 120 100 80 60 40 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa North America South Asia Sub-Saharan Africa World Source: Authors’ calculations using data from World Bank, Covid-19 Trade Watch. Note: Quarterly levels in 2019=100 The recovery in exports and imports for CA3 countries mostly started in 2021. In the first quarter of 2021, exports increased by an average of 9.4 percent while imports jumped by 18.9 percent, compared to 2020. This was followed by a much stronger recovery in Q2 with exports and imports increasing by 61.8 percent and 74.4 percent, respectively (Figure 20). The rate of recovery in 2021 more than compensated for the contractions in 2020, as values of exports were between 12 and 25 percent higher for all quarters in 2021 compared to pre-pandemic levels (Figure 22). The growth in imports were even larger in magnitude, with quarterly increases between 15 and 45 percent compared to 2019. Figure 22. Quarterly exports and imports for Guatemala, Honduras, and El Salvador, 2020-2021 (2019=100) (a) Exports 140 120 Exports (2019 levels=100) 100 Guatemala Honduras El Salvador 80 CA3 60 40 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 (b) Imports 160 140 Imports (2019 levels =100) Guatemala 120 Honduras 100 El Salvador CA3 80 60 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 Source: Staff estimates based on World Bank Global Economic Monitor and Central Banks. Note: Quarterly levels in 2019=100. 34 Country export profiles and the impact of the pandemic in CA3 Guatemala Guatemala’s main export sector is manufacturing, accounting for 45 percent of total merchandise exports in 2019. Textile and apparel are the biggest component of manufacturing, accounting for 35 percent of manufacturing exports and 16 percent of total exports (Figure 23, panel a). Agro-industrial is the second-largest export sector, with high levels of concentration on sugar, coffee, and palm oil. The three products alone accounted for 15 percent of total Guatemalan exports in 2019. Compared to El Salvador and Honduras, Guatemala’s exports are relatively diversified in terms of destination countries. Before the pandemic, approximately a third of exports were headed to other Central American countries, another third to the United States, and the remaining third split between Europe, rest of LAC, and the rest of the World (Figure 23, panel b). Among Central American countries, El Salvador was the largest destination market, accounting for 12 percent of total Guatemalan exports, followed by Honduras (9 percent). Figure 23. Guatemala export composition, 2019 (a) Export by sectors and key products (b) Export destinations Minin Rest of Costa Rica, Sugar, 6% Rest of the g, 5% LAC, 4% World, 14% 12% Coffee, 6% El Salvador, Manufacturing, 12% 45% Palm oil, 3% Europe, 10% Central Agroindustri al, 28% America, 32% Honduras, 9% Other, 13% Agriculture, United States, 32% Nicaragua, 5% 22% Panama, 2% Source: World Bank staff estimates using data from Bank of Guatemala. Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. The global pandemic caused a drop in exports in Guatemala, but to a much lesser extent than in Honduras and El Salvador. The exports contraction, between March and June 2020, was largely driven by the manufacturing sector, in particular in the textile and apparel sector (Figure 24). Manufacturing exports contracted by approximately 20 percent between March and May 2020, the first months where the pandemic and containment measures spread globally, compared to the same period in 2019 (Figure A.3). The fall in total exports, however, was moderate—less than 10 percent year-on-year (y-o-y)—as the agro- industrial sector continued positive growth. Export contraction peaked in June 2020 with continued contraction in the manufacturing sector, and the agro-industrial also reporting a significant 19 percent fall. In contrast, y-o-y growth in agricultural exports remained positive throughout 2020.13 13Mining exports collapsed in 2020 but did not contribute significantly to the overall drop as it accounts for a small share in exports. 35 Figure 24. Guatemala: Monthly exports growth, contribution by sector, 2020-2021 Year-on-year percent change (%) 50 and contribution by sector (p.p) 40 30 Mining 20 Manufacturing 10 Agroindustrial 0 Agriculture -10 Total -20 Jan-20 Mar-20 Jan-21 Mar-21 May-20 May-21 Feb-20 Jul-20 Sep-20 Dec-20 Feb-21 Jul-21 Sep-21 Dec-21 Apr-20 Oct-20 Nov-20 Apr-21 Oct-21 Nov-21 Jun-20 Aug-20 Jun-21 Aug-21 Source: World Bank staff estimates using data from Bank of Guatemala. Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. In terms of destinations, the fall in exports and recovery were largely driven by changes in exports to the United States, Guatemala’s main export market for textile and clothing and agro-industrial products. Increased exports to other Central American countries also played a key role during the recovery phase in 2021, contributing to nearly half of the y-o-y export growth between April and December 2021 (Figure 25). In May and June 2021, exports to Central America grew by more than 50 percent, compared to the same months in 2020. Exports to Europe have been quite volatile between 2020 and 2021, with y-o-y monthly growth exceeding 90 percent in October and December 2020, and June 2021 (Figure A.4). The manufacturing sector has also largely driven the recovery of exports in Guatemala, recording positive year-on-year growth since August 2020. Recovery of exports in the agro-industrial sector was somewhat delayed, starting a steady positive growth in December 2020. Increased exports to other Central American countries and the United States contributed significantly to the recovery. Figure 25. Guatemala: Monthly exports growth, contribution by destination, 2020-2021 50 40 30 Year-on-year percentage change (%) Rest of the World and contribution by region (p.p.) 20 Europe 10 United States 0 Rest of LAC -10 Central America -20 Total -30 Jan-20 Mar-20 May-20 Jan-21 Mar-21 May-21 Feb-20 Sep-20 Feb-21 Sep-21 Jul-20 Dec-20 Jul-21 Dec-21 Apr-20 Jun-20 Aug-20 Oct-20 Nov-20 Apr-21 Jun-21 Aug-21 Oct-21 Nov-21 Source: World Bank staff estimates using data from Bank of Guatemala. Note: Central America does not include Dominican Republic. Honduras Honduran exports are heavily reliant on the textile sector, which alone comprises 44 percent of total merchandise exports. The majority of exports come from the maquila industry, which accounted for 52 percent of total exports in 2019. Agro-industrial exports are also substantial, with 25 percent of total exports, and coffee in particular is a key export product (Figure 26, panel a). United States is by far the biggest export market for Honduras, accounting for more than half of total exports. Exports to other 36 Central American countries accounted for 22 percent of total exports in 2019, with El Salvador being the largest destination (Figure 26, panel b). Figure 26. Honduras export composition, 2019 (a) Export by sectors and key products (b) Export destinations Rest of Rest of the LAC, 4% Europe, 1% percent World, 8% 13% Manufacturing, Coffee, 11% El Salvador, 63% 10% (of which Central textile and America, Agroindustrial, Palm oil, 4% Guatemala, apparel, 44%) 22% 26% 4% Shrimp, 3% United (other States, 53% Nicaragua, manufacturing, Other, 8% Agriculture, 7% 19%) 9% Mining, 2% Source: World Bank staff estimates using data from Central Bank of Honduras. Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. Manufacturing includes maquila trade, reported separately. The trade collapse and recovery during the pandemic in Honduras was almost entirely driven by the manufacturing sector, and in particular textile and apparel (Figure 27). As the textile and apparel sector saw a fall in demand as well as supply chain disruptions, exports of manufacturing plummeted in the second quarter of 2020 by a weighty 62 percent (Figure A.5). The fall in manufacturing exports has driven the exports contraction in Honduras at the early stages of the pandemic, while other sectors’ exports remained resilient. Trade flows to the United States, being their main export destination, drove the contraction throughout 2020. Figure 27. Honduras: Quarterly exports growth, contribution by sector, 2020-2021 100 80 Year-on-year percentage change (%) and contribution by sector (p.p.) 60 Mining Other Manufacturing 40 Textile & Apparel 20 Agroindustrial 0 Agricultural -20 Total -40 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 Source: World Bank staff estimates using data from Central Bank of Honduras. Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. Manufacturing includes maquila trade, reported separately at a quarterly basis. Honduran exports started its recovery in the first quarter of 2021 and saw a strong rebound in the second quarter, again largely driven by the textile sector. The strong performance of manufacturing and agro-industrial exports in 2021 compensated for the significant drop in agricultural exports, which was 37 partly due to hurricanes Eta and Iota at the end of 2020. Exports recovery was led by those to the United States and Central America (Figure 28). Figure 28. Honduras: Quarterly exports growth, contribution by destination, 2020-2021 100 80 Year-on-year percentage change (%) 60 Rest of the World and contribution by region (p.p.) Europe 40 United States 20 Rest of LAC 0 Central America -20 Total -40 2020 Q1 2020 Q2 2020 Q3 2020 Q4 2021 Q1 2021 Q2 2021 Q3 2021 Q4 Source: World Bank staff estimates using data from Central Bank of Honduras. Note: Data includes maquila trade, reported separately at a quarterly basis. Central America does not include Dominican Republic. El Salvador El Salvador’s exports are heavily concentrated in the manufacturing sector, which accounted for 78 percent of total exports in 2019. Textile and clothing are a major sector, contributing over 44 percent to the country’s total exports. Knitted and crocheted clothing products alone account for nearly a third of total exports (32 percent), a share that is greater than the contribution of the agroindustry (17 percent), mining (3 percent) and agriculture (2 percent) sectors altogether (Figure 29, panel a). In the agro-industrial sector, sugar is the most-exported product, accounting for nearly 4 percent of total exports in 2019. Export markets are highly concentrated with the bulk of El Salvador’s exports going to the United States and Central America, each accounting for nearly half of total exports in 2019 (Figure 29, panel b). Figure 29. El Salvador export composition, 2019 (a) Export by sectors and key products (b) Export destinations Rest of the World, 4% Europe, 4% Rest of Knitted or LAC, 5% Costa Rica, Mining, 5% 3% crocheted clothing, 32% Guatemala, 13% Plastics goods, 7% Central Agroindust Manufacturing, Paper goods, 6% rial, 17% America, 78% Honduras, United 42% States, 46% 14% Other, 33% Nicaragua, 6% Panama, 3% Agriculture, 2% Source: World Bank staff estimates using data from Central Reserve Bank of El Salvador. Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. El Salvador’s exports were the strongest hit by the Covid-19 pandemic among the CA3 countries (and in Central America), recording a 60 percent drop in May 2020 compared to levels in 2019. Although exports of all sectors except from agriculture reported a contraction in the second quarter of 2020, the export 38 contraction was driven by the manufacturing sector. In particular, exports of textile and clothing collapsed by 80 percent year-on-year between April and June of 2020, contributing an average of 34 percentage points to the drop in exports (Figure 30). Manufacturing contracted by 60 percent in this period, compared to 2019 (Figure A.7). However, the recovery was also driven by the textile sector and other manufacturing. The second quarter of 2021 recorded extraordinary exports growth in these sectors. Exports in manufacturing grew by 172 percent between April and June 2021, and textile and apparel by an astonishing 390 percent, compared to 2020 values. Figure 30. El Salvador: Monthly exports growth, contribution by sector, 2020-2021 160 120 Year-on-year percentage change (%) and contribution by sector (p.p.) Mining 80 Other Manufacturing 40 Textile & Apparel 0 Agroindustrial Agriculture -40 Total -80 Mar-20 Mar-21 Jan-20 May-20 Jan-21 May-21 Feb-20 Sep-20 Dec-20 Feb-21 Sep-21 Dec-21 Apr-20 Jul-20 Nov-20 Apr-21 Jul-21 Nov-21 Jun-20 Aug-20 Oct-20 Jun-21 Aug-21 Oct-21 Source: World Bank staff estimates using data from Central Reserve Bank of El Salvador. Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. Figure 31. El Salvador: Monthly exports growth, contribution by destination, 2020-2021 160 120 Year-on-year percentage change (%) Rest of the World and contribution by region (p.p.) 80 Europe 40 Rest of LAC 0 Central America United States -40 Total -80 Mar-20 Mar-21 Jan-20 May-20 Jan-21 Dec-20 May-21 Feb-20 Sep-20 Feb-21 Sep-21 Dec-21 Apr-20 Jul-20 Nov-20 Apr-21 Jul-21 Nov-21 Jun-20 Aug-20 Oct-20 Jun-21 Aug-21 Oct-21 Source: World Bank staff estimates using data from Central Reserve Bank of El Salvador. Note: Central America does not include Dominican Republic. Foreign direct investment The Covid-19 pandemic caused a substantial drop in investment. Global flows in FDI dropped by 35 percent in 2020 compared to 2019 (Figure 32). The decline in FDI was heavily skewed toward developed economies, where FDI fell by 58 per cent. While the drop in FDI was more moderate in developing countries, at 8 percent, the trend varied widely across regions. FDI flows to developing Asia was resilient, with inflows to China increasing by 6 percent, and FDI flows to Africa fell by 16 percent. In LAC, FDI inflows plummeted by 45 percent, the sharpest decline among developing regions. Many economies in the continent are dependent on investment in natural resources and tourism, both of which collapsed. FDI in South America declined by 54 percent, Central America and Mexico by 24 percent, and the Caribbean by 36 percent (excluding offshore financial centers) (UNCTAD 2021). 39 Figure 32. FDI flows by region, 2019 and 2020 (Billions of dollar and percent) Percent World 1530 999 -35 723 Developing economies 663 -8 Africa 47 -16 40 Latin America and the Caribbean 160 -45 88 Asia 516 4 535 58 Transition economies 24 -58 Developed economies 749 312 -58 Europe 363 -80 73 North America 309 -42 180 2019 2020 Source: UNCTAD (2021). World Investment Report 2021. Similar to trade flows, the impact of the pandemic on global FDI was concentrated in the first half of 2020. In the second half, cross-border mergers and acquisitions and international project finance deals largely recovered. However, greenfield investment, which is more important for developing countries, continued its negative trend throughout 2020 and into the first quarter of 2021. The impact of the pandemic was particularly strong on the tourism sector. Foreign investments in tourism infrastructure fell by 45 percent globally in the first quarter of 2020, compared to the same period in 2019 (UNCTAD 2021). The Covid-19 pandemic was detrimental to FDI inflows in 2020 for Central American countries. Before 2020, the region showed a modest upward trend, although largely driven by Panama and Costa Rica, which stabilized around US$10 billion between 2011 and 2019. However, the pandemic had a huge hit in 2020, reducing FDI to Central America by 58.5 per cent to US$4 billion (Figure 33). Notably, FDI flows to Panama plunged by 85 percent between 2019 and 2020, while inflows to El Salvador and Nicaragua also dropped significantly, by about 56 percent and 48 percent, respectively. The impact on Guatemala and Honduras was relatively moderate, with FDI falling by 4.5 percent and 16 percent, respectively. Figure 33. Annual FDI inflows in Central America, 2000-2021 12 10 Panama 8 Nicaragua 6 USD, billions Honduras 4 Guatemala El Salvador 2 Costa Rica 0 Source: World Bank staff elaboration using data from UNCTADstat and Central Banks (2021). Note: FDI are on a net basis, i.e., net incurrence of liabilities for inward FDI. Thus, negative net incurrence in liabilities is recorded as negative inward FDI. These are instances of reverse investment or disinvestment (UNCTAD 2021b). 40 In El Salvador, the pandemic accelerated the declining trend in FDI inflows in 2020, followed by a modest recovery in 2021. FDI inflows in 2020 fell by 56 percent to US$280 million (Figure 34). The decline was largely driven by services sectors, including construction and utilities, business services, and hospitality and retail services. While aggregate FDI increased in 2021, by 12 percent to reach US$314 million, there were large difference across origin countries and sectors. FDI inflows from the Americas and in business services, tourism, and construction drove the recovery while FDI from Europe and in transport and logistics sectors and manufacturing fell. Figure 34. El Salvador: Annual FDI inflows by origin and sector, 2017-2021 (a) Levels (USD, millions) 1,000 1,000 800 800 FDI inflows (USD, millions) FDI inflows (USD, millions) 600 600 400 400 200 200 0 0 -200 -200 2017 2018 2019 2020p 2021p 2017 2018 2019 2020p 2021p Others Costruction & utilities Central America Rest of Americas Transport, storage & telecomm Business & financial services Rest of the World United States Commerce, restaurants & hotels Manufacturing Europe Total Agriculture & mining Total (b) Year-on-year change (percent) and contribution by origin and sector (percentage points) 200 200 Year-on-year percentage change (%) Year-on-year percentage change (%) and contribution by sector (p.p.) 150 150 and contribution by origin (p.p.) 100 100 50 50 0 0 -50 -50 -100 -100 -150 -150 -200 2017 2018 2019p 2020p 2021p -200 Others Construction & utilities 2017 2018 2019p 2020p 2021p Transport, storage & telecomm Business & financial services Central America Rest of Americas Rest of the World Commerce, restaurants & hotels Manufacturing United States Europe Total Agriculture & mining Total Source: Central Reserve Bank of El Salvador. Note: p=preliminary. FDI are on a net basis, i.e., net incurrence of liabilities for inward FDI. Thus, negative net incurrence in liabilities is recorded as negative inward FDI. These are instances of reverse investment or disinvestment (UNCTAD 2021b). FDI to Honduras fell by 16 percent in 2020 but had a strong rebound in 2021, increasing by 67 percent. Interestingly, FDI inflows to the non-maquila manufacturing sector and business services increased in 2020, partially offsetting the reduced inflows to the transport, maquila, and construction sectors (Figure 35). The sectoral trends somewhat reversed for the recovery in 2021 where inflows to the maquila sector turned largely positive and inflows to other manufacturing halted. Figure 35. Honduras annual FDI inflows by origin and sector, 2017-2021 (a) Levels (USD, millions) 41 1,400 1,400 1,200 1,200 FDI inflows (USD, millions) FDI inflows (USD, millions) 1,000 1,000 800 800 600 600 400 400 200 200 0 0 -200 -200 2017 2018 2019 2020p 2021p 2017 2018 2019 2020p 2021p Transport, storage & telecomm Maquila industry Central America Europe Manufacturing Costruction & utilities Rest of Americas Rest of the World Commerce, restaurants & hotels Business & financial services United States Total Agriculture & mining Total (b) Year-on-year change (percent) and contribution by origin and sector (percentage points) 150 160 120 Year-on-year percent change (%) and contribution by region (p.p.) 100 80 50 40 0 0 -40 -50 -80 -120 -100 2018 2019 2020p 2021p 2018 2019p 2020p 2021p Construction & utilities Transport, storage & telecomm Central America Europe Business & financial services Commerce, restaurants & hotels Rest of Americas Rest of the World Maquila industry Manufacturing United States Total Agriculture & mining Total Source: Central Bank of Honduras Note: p=preliminary. FDI are on a net basis, i.e., net incurrence of liabilities for inward FDI. Thus, negative net incurrence in liabilities is recorded as negative inward FDI. These are instances of reverse investment or disinvestment (UNCTAD 2021b). The impact of the Covid-19 pandemic on FDI inflows to Guatemala was minimal. In 2020, FDI inflows dropped by 4.5 percent, followed by an exceptional 273 percent increase in 2021. The moderate decline in 2020 was due to reduced, but still positive, inflows to the transport, logistics, and agriculture sectors. This was more than offset with a dramatic increase in 2021, largely driven by the acquisition of a telecoms company, but also due to FDI recovery in tourism-related services sectors. Figure 36. Guatemala annual FDI inflows by origin, 2017-2021 (a) Levels (USD, millions) 3,800 3,800 3,400 3,400 FDI inflows (USD, millions) 3,000 3,000 FDI inflows (USD, millions) 2,600 2,600 2,200 2,200 1,800 1,800 1,400 1,400 1,000 1,000 600 600 200 200 -200 -200 2017 2018 2019p 2020p 2021p* 2017 2018 2019p 2020p 2021p* Others Costruction & utilities Central America Rest of Americas Transport, storage & telecomm Business & financial services Rest of the World United States Commerce, restaurants, hotels Manufacturing Europe Total Agriculture & mining Total (b) Year-on-year change (percent) and contribution by origin and sector (percentage points) 42 280 280 Year-on-year percent change (%) and contribution by sector (p.p.) 240 240 Year-on-year percent change (%) and contribution by region (p.p.) 200 200 160 160 120 120 80 80 40 40 0 0 -40 -40 2017 2018 2019p 2020p 2021p* 2017 2018 2019p 2020p 2021p* Others Construction & utilities Central America Rest of Americas Transport, storage & telecomm Business & financial services Rest of the World United States Commerce, restaurants & hotels Manufacturing Europe Total Agriculture & mining Total Source: Bank of Guatemala Note: p=preliminary. In 2021, Millicom, a European telecoms company, acquired its venture partner Tigo, the largest provider of the Guatemalan market, for $2.2 billion. This was the largest ever single foreign investment in Guatemala and led to a substantial increase FDI in 2021 (Financial Times 2021). FDI are on a net basis, i.e., net incurrence of liabilities for inward FDI. Thus, negative net incurrence in liabilities is recorded as negative inward FDI. These are instances of reverse investment or disinvestment (UNCTAD 2021b). The onset of the Covid-19 pandemic created opportunities for countries to attract investment into the healthcare sector. Costa Rica, the Dominican Republic, El Salvador, and Honduras had clothing companies convert their factories to manufacturing of medical gear, face masks and gowns. The multinational enterprises (MNEs) already present in these countries expanded production and brought in some foreign investment. A good example of how a country brought in targeted measured for MNEs is Panama. The Government approved a new investment incentives regime, mainly in the form of tax benefits, targeting multinational companies that carry out operations from Panama and provide manufacturing services (UNCTAD 2021). The onset of the war in Ukraine has substantially impacted global value chains and it brings new challenges for recovery in CA3 countries. The recent war has affected international trade through supply shocks stemming from destruction in infrastructure, reduced production from countries involved in war, international sanctions14, limited transportation of goods, along with other indirect effects such as the rise in commodity prices. High inflation and the surge in energy prices have also increased transportation costs broadly across sectors. Although there is still a lot of uncertainty about the magnitude and duration of the effects from the shock, the region will likely face long-lasting effects in its participation in global markets. III. Impact of Covid-19 on firms: Micro evidence Understanding the magnitude and persistence of the shock and the heterogeneous effects across firms and industries is crucial for designing effective support policies. The Covid-19 crisis has deteriorated firm performance and plummeted sales, leading firms to postpone investment and R&D decisions. This could substantially impair long-term economic growth if it undermines countries’ productive capacity by harming the most productive firms. However, the current context induces firms to adapt and invest in measures to offset the negative impact of the pandemic, such as adopting digital technologies, expanding 14For a comprehensive summary and timeline of government sanctions imposed on Russia, and actions taken by companies and organizations in response to the outbreak of the war, see https://graphics.reuters.com/UKRAINE- CRISIS/SANCTIONS/byvrjenzmve/. 43 the set of provided goods and services, and enabling employees to work remotely. The effect of these incentives on competition and productivity are still unknown, as well as the long-term consequences. This chapter aims at providing a comprehensive understanding of the effects of the crisis and its persistence on firm performance. It quantifies how firms in the CA3 countries were initially affected by the Covid-19 outbreak and describes the persistence of the effects and the recovery process after the initial shock. A comprehensive understanding of the effects of the crisis enables governments to more efficiently address the needs of the private sector, respond to short-term job losses, ensure a sustainable recovery, and set the path for long-term growth. This chapter uses data from the Business Pulse Survey (BPS), consisting of two follow-up waves from the Enterprise Surveys (WBES), collected by the World Bank, assessing the impact of the Covid-19 pandemic on the private sector for over 120,000 businesses in 81 countries. Data for the first survey wave was collected in the initial period after the shock, between June and July 2020, and later a second wave was collected between the months of December 2020 and January 202115 (Figure 37). Data was collected almost exclusively through phone interviews, considering the firms which were previously included in the WBES samples. The sample consists of formal firms operating in manufacturing, retail and other service industries. Thus, the results should be interpreted as evidence on the magnitude and persistence of the effects following the Covid-19 outbreak in the region, with a caveat that a significant part of economic activity is not included in the analysis.16 Figure 37. Survey period in context Note: Data from Google (2020). Mobility trends are smoothed using 30-day moving averages. Supply shocks and uncertainty The Covid-19 pandemic led to supply chain disruptions that significantly affected firms’ operations and trade. Supply chain disruptions were pervasive across the region and restrained sales for at least a quarter of businesses. The impossibility of timely accessing production inputs, either due to barriers in 15 Given the current economic context, new waves of the Enterprise Surveys (WBES) will need to be collected during 2022 and 2023 in order to quantify the micro impacts of the war in Ukraine. The different nature of this new shock could lead to long-term effects resulting from firm restructuring to mitigate possible effects of future political and supply shocks. 16 Economic activity in CA3 countries relies heavily in the agricultural sector, which is not included in the BPS. Likewise, the sample does not include informal firms, which account for a large share of GDP in the region. 44 international trade or domestic restrictions in production, were another indirect effect of the pandemic consisting of a supply shock. In Guatemala, the most affected country, 33 percent of firms had been forced to cancel orders due to the unavailability of inputs during November 2020.17 In El Salvador and Honduras, the share of firms with sales affected by supply chain disruptions was 26 percent and 23 percent, respectively, from the beginning of the pandemic until the end of 2020 (Figure 38, panel a). Retail industries seem to have been the most affected by difficulties in accessing inputs. In all three countries, retail was the sector with the highest fraction of firms reporting loss of sales due to the lack of production inputs. In Honduras, with the largest impact on retail industries, it is estimated that 41 percent of retail firms canceled orders during the month previous to the survey (Figure A.9). Figure 38. Canceled orders due to supply chain disruptions (a) Share of firms with canceled orders (b) Sales share of canceled orders Note: Fraction of firms on each country reporting, on the Note: Predicted mean share of canceled sales due to the lack second wave, having to cancel orders in the previous 30 days of inputs for production, resulting from country-level linear due to the lack of inputs for production. regressions controlling for firm size, sector and mobility relative to the pre-pandemic level. Canceled orders resulting from supply chain disruptions represented a significant share of firms’ total sales. Approximately 20 percent of sales were canceled due to supply chain disruptions in CA3 countries (Figure 38, panel b). Another important result is that, although a smaller fraction of firms was affected by input supply shocks in manufacturing and other service activities, these canceled orders actually represent a higher magnitude in terms of sales relative to retail (Figure A.10). The pandemic has also brought many challenges to firms and individuals by generating substantial uncertainty about the duration of the shock and the lasting effects of the crisis . Altig et al. (2020) document an unprecedented spike in uncertainty measures following the shock that encompass almost every possible aspect related to the pandemic, from the characteristics of the virus to the implementation of public policies and the efficiency of working from home arrangements. An important reason to consider the evolution of uncertainty levels is that it affects business decisions. For example, Bartik et al. (2020) reports that firm closure is negatively related to the expected length of the crisis, which in turn varies greatly across firms. By the end of 2020, the region was optimistic about future sales growth relative to the rest of the world, but uncertainty was still pervasive. On average, businesses in the CA3 region expected sales to increase in the following six months, compared to the same period in the previous year, by 8 percent in El Salvador and 13 percent in Guatemala and Honduras (Figure 39). These figures imply a surprisingly more optimist scenario compared to the global average, which expected a sales retraction of 5 percent over the following 17The question refers to canceled orders during the last completed month relative to the survey timing. The specific reference period depends on the exact survey date for each firm. 45 six months. Despite positive expected growth rates, there is still a lot of uncertainty regarding the future, as indicated by the high standard deviation of the predictions. 18 Uncertainty in the region is similar, ranging from 10 percentage points in Guatemala and 14 in Honduras, much lower than the 25 percentage points observed for the global average. Although uncertainty levels regarding Covid-19 continued to decrease in 2021, the war in Ukraine has generated a new wave of uncertainty with immediate effects on global markets. Russia’s invasion of Ukraine in February 24th 2022 has resulted in widespread supply chain disruptions and spiked uncertainty in the business environment concerning the duration and long-term consequences of the conflict. The availability of inputs has reduced due to limited supply of goods, with rising prices and transportation costs. The magnitude and the duration of the effects, along with the long-term consequences of the shock, are still unknown. Besides, the sequence of uncertainty shocks in recent years resulting from the Covid- 19 pandemic, the unstable political environment, climatic issues and the war in Ukraine could induce significant structural changes in the economy, for example by encouraging businesses to restructure supply chains and move production facilities locally to diminish their dependence on foreign markets. Figure 39. Expectations and uncertainty about the future Note: The left panel for each country plots the unweighted average of expected sales growth. For each firm, expected sales growth is computed as a weighted mean of expected growth for three distinct scenarios (regular, optimistic and pessimistic) and their respective probabilities. The right panel plots the average uncertainty of the prediction, computed as the average standard deviation of firms’ expected growth sales in each scenario. Data from the second wave. Operations and employment Firms in the region are getting back to full operational status, although a few marginal closures remained until the end of 2020. Mobility restrictions and the decrease in economic activity have led firms to temporarily close and reduce the number of operating hours, either due to direct enforcement or to their own choice. In the initial months after mobility restrictions were imposed, a large fraction of firms were closed temporarily, ranging from 15 percent of firms in Guatemala to 36 percent in Honduras, where operations were affected the most. At the end of 2020, activity had significantly recovered. The share of 18We measure expectations regarding sales growth by asking firms what their expected growth is considering regular, optimistic and pessimistic scenarios, along with the assigned probabilities to each scenario. Based on this information, we compute a measure of uncertainty equal to the average weighted standard deviation of expected sales growth. To compute the standard deviation, we consider firms’ expected sales growth and probabilities assigned to each scenario. 46 firms operating in a full or partial regime, conditional on survival, was over 95 percent for the three CA3 countries (Figure 40). Although the effects on business operations have been felt across all industries, service activities have been affected severely. The initial fraction of temporarily closed businesses was higher in service industries, relative to retail and manufacturing, in the CA3 countries (Figure A.11). Except for Honduras, these differences are still clear through the recovery process. This result is consistent with the fact that non-essential services that are more reliable on human interaction, such as hospitality, entertainment, and personal services, are more likely to face reduced demand in the context of social distancing norms. In fact, the overall impact of Covid-19 on service activities is directly related to the severity of mobility restrictions and the potential degree of adaptability to home-based work during the initial months of the pandemic (Avdiu and Nayyar 2020). Adjustments to the shock have also occurred at the intensive margin, i.e. by reducing the number of operating hours. Even among firms which remained open, in June and July 2020 about 90 percent of the establishments in all countries reported having reduced the number of operating hours in the month preceding the survey, relative to the same period in 2019. At the end of 2020, recovery was clear, but more slowly relative to firms’ operational status. Still, half of the firms in the region were operating with reduced opening hours relative to the previous year (Figure 41). Figure 40. Status of the business at the time of interview Note: Fraction of firms in the sample reporting its operating status as open or partially open, and temporarily closed at the time of the interview. 47 Figure 41. Shock to operating hours Note: Fraction of firms reporting that the number of operating hours has increased, remained the same or decreased in the previous 30 days, relative to the same period in 2019. Data from the World Bank Enterprise Survey. Adjustments to the labor force have been undertaken both at the extensive (e.g. firing workers) and the intensive (e.g. cutting wages or work hours) margins. As a consequence of the pandemic and its negative effects on demand and supply, almost half of firms in the CA3 region have adjusted by reducing the total number of workers (Figure A.12). By December 2020, over 40 percent of firms in all countries had already increased their size in response to recovering economic conditions, even if downsizes were still being adopted by a significant share. However, the most important and widely used employment adjustments measures were at the intensive margin, that is, reductions in wages or hours worked. These measures allow firms the flexibility to cut operational costs and accommodate reductions in sales without laying off workers, which would accentuate aggregate employment and income losses. Reduction in work hours were the most popular employment adjustment in the region, adopted by 47 percent of firms in Honduras, 45 percent in El Salvador, and 34 percent in Guatemala (Figure 42). It is important to note that these adjustment mechanisms may be affecting workers in varying intensities, according to their occupation and individual characteristics. Adams-Prassl et al. (2020) show that women and less educated workers are more likely to be negatively affected by labor adjustment measures following the pandemic, as well as workers in activities less or not suitable for home-based work. Figure 42. Adjustments in the labor force 48 Note: Fraction of firms that have adopted each measure of labor adjustment during the previous 30 days. The second survey round asks about adjustments in employment made since the first round of interviews. Sales and markup The crisis led to a sharp drop in firm sales, with persistent effects and ongoing recovery. Variations in sales levels are a useful measure for understanding the magnitude and the persistence of the effects from the pandemic, as they capture both supply and demand shocks affecting businesses. In the initial months after the Covid-19 outbreak, firm-level sales have consistently dropped across the world (Cirera et al. 2020). El Salvador and Honduras were the most affected in the region in June and July 2020, where the average firm saw a drop in sales of 58 percent relative to the same period in 2019 (Figure 43). In Guatemala, the effects on firm performance were also intense, and sales were reduced by an average of 46 percent. However, these effects were not felt homogeneously across firms, especially in El Salvador, where the median firm faced a striking reduction of 70 percent in sales relative to the previous year. Although recovery is ongoing, the negative effects from the shock are persistent, and firms’ sales have not yet reached the pre-pandemic levels. Even nearly a year after the initial shock, sales for firms in CA3 remain, on average, 28 percent lower than in 2019 in El Salvador and Guatemala, and 34 percent in Honduras (Figure 43). The slower recovery process in Honduras is consistent with the inferior mobility levels and stricter restrictions depicted in Figure 1. Even when controlling for firm characteristics (size and sector) and the level of mobility at the time of the survey, the magnitude of the effects is not significantly altered, along with the recovery trajectory (Figure A.13). Figure 43. Change in sales (relative to the same period in 2019) Note: Unconditional mean of percentage change in sales for the previous 30 days, relative to the same period in 2019. The initial negative impact over sales for firms in CA3 was intense in comparison to the rest of the world. However, the recovery process is more aligned with international experience. While the initial average sales decrease in Guatemala is consistent with the median effect felt in the rest of the world, El Salvador 49 and Honduras have seen a more intense reduction in sales relative to the previous year.19 By the end of 2020, the remaining effects on sales in the CA3 countries were more consistent with international experience, even if the sample of countries for which data is available in this period is smaller (Figure A.14). The recovery process was heterogeneous, with increasing presence of bimodality that suggests two distinct recovery paths. While a considerable share of firms has mostly recovered from the initial negative shock in March 2020, there is a sizeable portion of businesses still struggling with its negative consequences, which can be inferred from the distribution of sales change in the second survey wave (Figure 44). This duality, particularly clear in El Salvador, suggests that a large share of firms still face sales levels about 50 percent lower relative to the same period in 2019. Recovery is more prominent in Guatemala, where a significant fraction of firms had reached sales similar to pre-pandemic levels by the end of 2020, while in Honduras the majority of firms still face lower sales than before Covid-19. Figure 44. Percentage change in sales Note: Distribution by wave of the percentage change in sales in the previous 30 days relative to the same period in 2019. The negative shock over sales was more intense for smaller businesses and for service industries, especially in hospitality. There is a clear negative relationship between firm size and the magnitude of the impact: the reduction in sales faced by micro and small firms was more intense than in medium and large firms (Figure 45). The average micro firm, with up to four employees, saw its sales decrease 68 percent relative to 2019 shortly after the shock, and 50 percent after half a year. Meanwhile, the average large firm, with over 100 employees, initially had a 37 percent drop in sales, recovering to a drop of 18 percent on the second survey wave. The effects on sales are also heterogeneous across industries. On average, firms in other service industries - especially in accommodation and food activities – experienced a larger drop in sales (Figure A.15 and Figure A.16). These differences are still visible through the recovery process, and the stronger negative effects on these industries persist even after several months after the outbreak of Covid-19. 19These results are obtained by controlling for the size and sector composition in the sample of each country included in the BPS, as well as the severity of mobility restrictions at the time of the survey. 50 Figure 45. Change in sales relative to the same period in 2019 in CA3 countries, by firm size Note: Predicted mean of percentage change in sales by firm size, resulting from a linear regression controlling for country, firm size, sector and mobility relative to the pre-pandemic level. Data from World Bank Enterprise Survey. One major concern from the economic crisis resulting from the pandemic is that hardships inflicted on different types of firms will have a detrimental effect on productive capacity. If the most productive firms have been disproportionately harmed during the crisis, the shrinkage and exit of these firms would increase resource misallocation, which in turn reduces aggregate productivity and could have long-term consequences on economic development. On the other hand, if the most productive firms can survive and avoid most of the negative consequences, for example by improving their production processes or adapting the products and services they offer, the crisis could accelerate the process of creative destruction, driving unproductive firms out of the market and benefiting economic growth in the long- run. Understanding how Covid-19 has affected heterogeneous firms is essential for mapping its effects on the resource reallocation process, as well as for designing and targeting public support policies accordingly. Productivity and innovation intensity prior to the pandemic is associated with better firm performance after the Covid-19 outbreak. Even though the negative effects from the shock were widespread across the region, the more productive firms had, on average, a lower reduction in sales than the less productive ones (Figure 46).20 This result suggests that the most productive firms can, to some extent, avoid the adverse effects from the crisis relative to its counterparts.21 Similarly, we find a clear negative relationship between the innovation intensity prior to the pandemic and the magnitude of the decline in sales for the average firm in El Salvador and Honduras (Figure A.19). 22 This negative relationship is less clear for Guatemala, mostly due to the large sales drop observed in the third quartile. However, there is a lot of heterogeneity in the magnitude of sales change, which is reflected in the standard errors and wide confidence intervals of the estimates, preventing any statistically significant inference. 20 We compute labor productivity before the pandemic for firms participating in previous Enterprise Surveys, to ensure that the productivity measure itself was not affected by the shock we are aiming to quantify. Labor productivity is measured as the value added per worker, available in the Enterprise Survey (2016 for El Salvador and Honduras, and 2017 for Guatemala). 21 This relationship,however, is less clear when disaggregating results at the sector level for each of the three countries, although it remains visible in retail and service sectors in Honduras, for example (Figure A.18). 22 Figure A.19 plots the average change in sales by innovation intensity, measured as R&D expenditure per worker. A disadvantage of this measure is that it is highly unbalanced: 87 percent of firms in the survey report no expenditures on R&D. We deal with this issue by including in the first quartile, Q1, all firms with innovation intensity equal to zero. The other three quartiles are built such that each contain 33 percent of the observations with positive expenditure on R&D. Throughout this note, all quartiles are computed within countries and sectors to control for intrinsic differences in industry characteristics. We use sampling weights available in the Enterprise Survey (2016 and 2017) to estimate percentiles that are representative across the entire population of firms within sectors in each country. To avoid conditioning firm outcomes on individual characteristics that are also potentially affected by the Covid shock, we use past firm information from the Enterprise Surveys for 2016 (El Salvador and Honduras) and 2017 (Guatemala). A drawback from this strategy is that it only includes a restricted sample of firms that simultaneously 1) were born before 2016; 2) survived until 2020; and 3) are respondents in the follow-up rounds of the survey in 2020. 51 Figure 46. Change in sales and productivity Note: Binned scatterplots of the percentage change in sales (first wave) and log productivity, measured as value added per worker. Firm-level observations are grouped into bins according to the magnitude of productivity levels. For each bin, a dot is plotted indicating the average percentage change in sales within that group. The fit line illustrates a least squares linear regression of change in sales on productivity. Productivity measures refer to 2016 for El Salvador and Honduras, and 2017 for Guatemala. Data from the World Bank Enterprise Survey. Although international trade was strongly affected by the pandemic, the average drop on sales for exporting firms was lower compared to non-exporters and the recovery was also faster (Figure 47). The higher resilience and faster recovery of globally engaged firms may be attributed to their stronger capabilities as firms with higher pre-pandemic productivity, better management practices, or higher digital readiness self-select into global engagement. Such resilience of globally engaged firms is apparent not only in sales, but also in other outcomes such as financial fragility. Furthermore, the impact on globally engaged firms also varied by firm characteristics, with those with higher pre-pandemic digital readiness experiencing a faster recovery (Constantinescu et al. 2022). Figure 47. Change in sales relative to the same period in 2019 by exporting status Note: Predicted mean of percentage change in sales by exporting status, resulting from a linear regression that controls for country, firm size, sector and mobility relative to the pre-pandemic level. Data from the World Bank Enterprise Survey. 52 The perception of competition levels and markups largely remained the same in the last months of 2020. The majority of firms in the region reported no change in perceived competition over the month previous to the second survey wave, with little variation across sectors (Figure A.17). Consistently, changes in markup were also not significant, with only a slight decrease observed on average. There is a mild positive relationship between change in sales and change in markups, suggesting that firms more adversely affected by the shock might have adjusted their pricing strategies to attenuate the decrease in sales (Figure 48).23 These results are consistent with the findings in Balleer et al. (2020) that negative impacts resulting from the pandemic increase the probability of firms decreasing prices up to 11 percentage points. Figure 48. Change in markups and change in sales in CA3 countries Note: Binned scatterplots of the percentage change in sales and percentage change in markups in the second survey wave. Firm-level observations are grouped into bins according to the magnitude of percentage change in sales. For each bin, a dot is plotted indicating the average percentage change in markups within that group. The fitted line illustrates a least squares linear regression of change in markups on change in sales. Trade and global value chains The adverse impact of Covid-19 on international trade is also evident at the firm level, with firms’ exports and imports falling dramatically in 2020.24 The pandemic led to a stronger decline in quarterly firm-level exports than imports in El Salvador. The contraction in trade was sharpest in the second quarter with firms’ exports and imports declining by 52 percent and 42 percent respectively, compared to levels in 2019 (Figure 49). The decline in exports and imports was also evident in the number of products and partner countries (Figure A.20). Among firms engaging in international trade, the negative effects were more pronounced for GVC firms. GVC firms, defined as those that participate in both exports and imports, relative to firms engaged only in exports or only in imports. The declines in firm imports are more persistent for GVC firms, remaining strong in the last two quarters of 2020 (Figure 50). GVC firms also experience larger and more persistent declines in their numbers of products and partner countries (Figure A.21). The vulnerability of GVC firms to the Covid-19 pandemic may be explained by the need for their inputs and products to cross borders multiple times. GVC firms are likely to have been more affected by sudden drops in demand of products manufactured along a specific value chain as they specialize in different stages of the production process 23 Figure 48 groups firms according to their percentage change in sales and, for each group, plots the average percentage change in markups in the y-axis along with the linear fit from a regression including all firm-level observations. It is important to note that, while changes in sales are reported for the previous 30 days, changes in markups refer to the period from the outbreak of the pandemic until the time of the interview. 24 The findings presented in this section use data from World Bank Enterprise Surveys and Customs data from El Salvador, following the specification from Constantinescu et al. (2022). Results are presented only for El Salvador as the Customs data for 2020 is not available for Guatemala and Honduras. 53 and are often linked by strong and durable trading relationships. As a result, shocks that occur in any part of the GVCs propagate along the value chain, and can magnify the impact on GVC firms (Constantinescu et al. 2022). Figure 49. El Salvador: Year-on-year quarterly change in firm exports and imports, 2020 Source: Staff estimates based on customs data for El Salvador from the expansion of the Exporter Dynamics Database and specifications from Constantinescu et al. (2022). Note: The sample includes 4,100 firm-quarter observations in the left panel and 21,569 firm-quarter observations in the right panel. Figure 50. El Salvador: Year-on-year quarterly change in firm exports by GVC participation, 2020 Source: Staff estimates based on customs data for El Salvador from the expansion of the Exporter Dynamics Database and specifications from Constantinescu et al. (2022). Notes: The sample includes 4,100 firm-quarter observations in the left panel and 21.569 firm-quarter observations in the right panel. GVC firms are defined as those that export and import in 2019. Financial risks Lack of access to finance in the CA3 region was already a significant barrier to entrepreneurship before the pandemic, which could have been accentuated by the crisis following the Covid-19 outbreak. The liquidity shocks associated with Covid-19 impose a serious financial burden on firms, and risk increasing the incidence of zombie firms - a term for firms unable to cover debt servicing costs for an extended period of time (Caballero, Hoshi, and Kashyap 2008; Banerjee and Hofmann 2018). In fact, (Dai, Hu, and Zhang 2020) show that 20 percent of micro and small enterprises in China would not be able to survive an additional month with the interruption of cash flow at the time of the survey. Even just a few weeks after the initial Covid-19 shock, there were already mass layoffs and business closures among small firms. 54 Liquidity is increasing, suggesting recovery relative to the initial shock. One measure of liquidity, the average number of weeks for which firms are able to cover operating costs in the absence of sales, indicates that firms in CA3 countries are not able to survive much longer than two months given the initial circumstances of the pandemic. According to this measure, liquidity has increased across the region over the course of 2020. However, this increase has been modest, increasing in two weeks the duration of operations financed with available cash, and firms are still largely dependent of external sources of finance in cases of adversities impacting revenue (Figure 51). The BPS estimates that about half of the firms in CA3 countries were either already in arrears by the end of 2020 or expected to fall into arrears within the first six months of 2021 (60 percent in El Salvador, 58 percent in Honduras and 46 percent in Guatemala). Smaller firms are more likely to fall into arrears than large firms (Figure A.22). Figure 51. Availability of cash: average number of weeks firms can cover with current cash available Note: Unweighted mean of the number of weeks during which firms could cover costs with the cash available. The first and second columns refer to the number of weeks businesses could continue paying all costs and payments (payroll, suppliers, taxes or loan repayments) with the cash currently available, for the first and second waves, respectively. The third column refers to the second wave and additionally considers external sources of finance to which firms have access. On one hand, since the outbreak of the pandemic, firms’ outstanding liabilities have remained relatively stable. Firms’ outstanding liabilities as a share of 2019 annual sales has remained fairly constant, at around 17 percent in Guatemala and Honduras, and 24 percent in El Salvador, suggesting that, on average, firms did not increase credit as a response to Covid-19 (Figure 52). This result is consistent with (Didier et al. 2021), pointing out that the widespread negative effects of the pandemic have resulted in decreased lending. This occurred mainly as a consequence of the uncertainty regarding the magnitude and duration of the shock, which directly affect firms’ repayment capacity and survival probability. Figure 52. Ratio of outstanding liabilities to total sales in 2019 Note: The first and second columns present the unweighted mean for the ratio of outstanding liabilities, in January and September 2020, respectively, to the total value of annual sales in 2019. The third column presents the average ratio of outstanding liabilities 55 in September 2020 to an adjusted, estimated value of current annual sales. We estimate current sales as the total value of sales in 2019 multiplied by the percentage change in sales reported for the last 30 days (relative to the previous year). On the other hand, debt repayment capacity has deteriorated and is conditional on recovery. Since sales have been severely impacted by the pandemic, repayment capacity could have worsened significantly, and this decrease in revenue should be taken into consideration. We estimate an adjusted ratio of total debt to sales considering this impact, by multiplying annual 2019 sales by the percentage change in sales reported by each firm for the second wave of the survey (November and December 2020). In Figure 52, this adjusted ratio of debt to sales indicates that repayment capacity has deteriorated for firms in El Salvador and Honduras, which could be dangerous if the negative effects on sales persist for much longer. According to this measure, currently the average firm in these countries face liabilities equal to 36 percent and 32 percent of their annual sales in 2020. Firm responses: Digitalization and innovation The restrictions imposed by Covid-19 have encouraged firms to adopt digital technologies to minimize its negative effects on firm performance. The share of firms having started or increased the use of internet, social media or other digital platforms for business use has increased in all CA3 countries between June and December 2020. Controlling for sample composition, we find that in the three countries the fraction of firms using digital technologies increased about 20 percentage points from June to December 2020 (Figure A.23). The probability of starting or increasing use of digital technology was also about 20 percentage points higher in December than in June 2020, controlling for size, sector and mobility relative to the pre-pandemic level (Figure 53). The shock has motivated over 75 percent of firms in the region to innovate by changing their mix of products and services since March 2020. The process of digitalization was widespread across firms, regardless of the number of employees or sector, although larger firms had a higher probability of adopting digital technologies within the business (Figure A. 24). Firms engaging in international trade were more likely to heighten their response to the pandemic by ramping up digitalization during the recovery phase. Specifically, the probability of starting or increasing the use of digital technologies in El Salvador was significantly higher for exporters than non-exporters in the Covid-19 initial and recovery phases, by 5 to 7 percentage points. Figure 53. Probability of starting or increasing the use of digital technologies Note: Predicted probability of starting or increasing the use of internet, online social media, specialized apps, or digital platforms in response to Covid-19. Probabilities were estimated with a Probit model, controlling for size, sector and mobility relative to the pre-pandemic level. 56 Figure 54. El Salvador: Probability of starting or increasing the use of digital technologies by exporting status Source: Staff estimates based on World Bank Enterprise Surveys data for El Salvador from the expansion of the Exporter Dynamics Database and specifications from Constantinescu et al (2022). Note: The sample includes 474 firms. IV. Policy responses to the Covid-19 pandemic Policy responses Macro and monetary response The sharp decrease in activity in the second quarter of 2020 due to the pandemic shock required governments and monetary authorities to implement a loose monetary stance and expand credit. During the first half of 2020, Central Banks around the world lowered interest rates to contain the effects of the pandemic on output, and CA3 countries were no exception. In addition, to provide liquidity and avoid bankruptcy, authorities gave more flexibility to banks’ reserve requirements and introduced forbearance measures. Finally, central banks in the region implemented open market operations to reduce exchange rate volatility. In Guatemala, the Central Bank used a wide range of instruments to support economic activity, it even provided monetization of the deficit to the Ministry of Finance. To boost liquidity in credit markets, the Central Bank took an aggressive monetary stance and reduced the policy interest rate three times during the year, from 2.75 percent in late March to 1.75 percent in late June. Furthermore, it took additional measures to provide liquidity, including a relaxation of the calculation of the banking reserve requirement, which allowed Banks to cover up to 7 percent of the reserve requirement with bond holdings. Moreover, the Central bank monetized USD 1.4 billion at market conditions to reduce pressure on domestic markets. 25 Finally, in accordance with the exchange rate policy, the Central Bank intervened in the exchange rate market to stabilize the Guatemalan Quetzal and avoid excessive volatility. In addition, financial sector authorities temporarily enacted forbearance measures to enable loan restructuring, loan payments moratorium, and the use of generic provisions for borrowers impacted by the Covid-19 crisis (World Bank, 2020; International Monetary Fund, 2020). El Salvador Central Bank also introduced temporary financial measures, aimed at providing increased liquidity to the economy. In March 2020 the monetary authority introduced debtor-relief measures, such as freeze in the credit ratings of borrowers and moratorium on debt service payments. In addition, it 25 The Congress has invoked an exception contemplated in the Art. 133 of the Constitution in which under extraordinary circumstances, the Central Bank is allowed to provide direct or indirect financing, guarantees, or guarantor’s endorsements to the State. 57 reduced banks’ reserve requirements by about 12 percentage points of deposits. Furthermore, the Central Bank allowed banks to discount their reserve requirements with the Central Bank by 25 percent of newly issued loans and reduce overall reserve requirements for various other liabilities. As a consequence, Banks used the liquidity to increase credit to the government and the private sector, and to strengthen their external position (International Monetary Fund, 2021; International Monetary Fund, 2020). Finally, in Honduras the authorities also implemented monetary and financial policies to mitigate the impact of the pandemic. The Central Bank reduced its policy rate by 225 basis points during 2020 to provide liquidity to the market. They also extended the Emergency lending Facility and reduced the spread over the policy rate by 50 basis points and the repo rate by 25 basis points. In addition, the authorities suspended liquidity absorption operations, accelerated elimination of obligatory investments and provided temporary debt service relief to companies and individuals within affected sectors. Furthermore, they introduced a credit guarantee scheme, underpinned in the credit guarantee fund for MSMEs, to increase credit and provide subsidized loans. Finally, through the public development bank, the authorities provided additional financing for SME loans, mortgages, and expedited approval of subsidized agricultural loans (International Monetary Fund, 2020a; International Monetary Fund, 2020b). Trade policy response This section documents trade policy responses to offset the shock of the pandemic and the recovery plans, both short-term and more structural policies. The initial months of the pandemic triggered short- term changes in trade policy, particularly towards exports and imports of essential medical products and food. As time passed, governments focused more on plans for recovery and support. Table 3 provides a non-exhaustive list of policy measures adopted by El Salvador, Guatemala and Honduras. Detailed information on the policies is presented in Annex 1. Immediate (short-term) trade policy responses The initial months of the Covid-19 pandemic triggered short-term changes in trade policy, particularly towards exports and imports of essential medical products and food. Amid heightened uncertainty and disruptions in supply chains and logistics, countries tried to tackle the immediate threats and protect people by securing the necessary medical supplies related to Covid-19 and basic food supply. This led both to trade-liberalizing measures – such as temporary elimination of import duties and value-added tax (VAT) – and trade-restrictive measures, such as export bans, to ensure sufficient domestic supply of food and medical products. Safety guidelines were also implemented for cargo transport to minimize the risk of Covid-19 at borders. On one hand, governments responded to the Covid-19 pandemic by liberalizing trade, primarily for the imports of medical goods, personal protective equipment (PPE), and selected food products. For example, El Salvador temporarily eliminated import duties on certain medical products and PPE, including medicaments, disinfectants, rubber gloves, soap and cleaning products, as well as food products, such as wheat, flour, prepared food and vegetable products.26 Guatemala authorized the import of white corn with zero tariff to supply the deficiency of the local market.27 To support exporters, the government of El Salvador authorized $100 million refund of VAT to exporters in May 2020. 26Decree 604, adopted in response to Covid-19, affected 31 ten-digits tariff lines (source: Global Trade Alert). 27 Ministerial Agreement No. 232-2021 in the Diario de Centroamerica, available at https://www.mineco.gob.gt/sites/default/files/publicacion_dca_232-2021_maiz_blanco_75000.pdf 58 On the other hand, countries implemented trade-restrictive measures such as export bans and cargo transport restrictions. The governments of El Salvador and Honduras adopted a temporary export ban on red beans in March 2020 aiming to ensure national supply and stabilize local prices.28 At the onset of the pandemic, Central American countries also introduced restrictions on regional cargo transport as an attempt to mitigate the spread of Covid-19, for example by imposing a 72-hour limit for freight drivers to conduct border formalities and unload and reload goods from vehicles.29 El Salvador was amongst the first to introduce such restrictions, followed by reciprocal restrictive measures in Honduras and Guatemala, as the controversy lasted for several months with continued protests at regional borders. The measure was later revoked to ensure commercial operations and maintain the supply of food and production inputs. The Central American cargo transport sector introduced Biosafety Guidelines for the Covid-19 pandemic to prevent the spread of the virus and guarantee the health of cargo transporters. The Guidelines established coordinated procedures to prevent the spread of the pandemic, such as enhancing the cleaning and disinfection of means of transport, promoting the fluidity of trade at land border posts, and safeguarding the health of citizens and officials who exercise controls at land border posts. It also included measures to detect sick carriers at the entry points via health screening process, temperature measurement and symptom control at the loading and unloading points. The loading and unloading processes were done through machinery to minimize contact between transport personnel and the merchandise. Efforts were also made to establish and implement inter-institutional coordination and cooperation mechanisms at the national and binational levels to prevent the spread of Covid-19. Table 3. Summary of trade and investment policy responses to Covid-19 Policy measure Country Elimination of import duties on medical products, personal GTM, SLV protective equipment (PPE), and selected food products Trade- Immediate VAT refund to exporters SLV liberalizing (short- Elimination of customs duties on imports received as donation GTM term) to the National Coordinator for Disaster Relief responses Trade- Export ban on red beans HND, SLV restrictive Restrictions on regional cargo transport GTM, HND, SLV Other Biosafety guidelines for Covid-19 in cargo transport GTM, HND, SLV Single window for exports GTM Trade Inter-institutional Control Post GTM facilitation/ Investment in transport (road) infrastructure GTM, HND logistics Paperless customs program HND “Single Customsâ€? system GTM Sectoral Export promotion with White Seal certificate GTM Structural support/ Support for farmers/agricultural producers (coffee, fish farming, (medium- GTM, HND, SLV export and agri-food sector) term) promotion Support for informal trade sector GTM responses Special Economic Development Zones GTM, HND Foreign America Crece: MoU with United States to promote investment GTM, HND, SLV investment Investment promotion strategies MSME Digitization Plan HND MSME Loans, debt relief, and guarantee funds support Training Source: Government websites, Global Trade Alert, News outlets, etc. 28 Executive Decree No. 512 affected products classified under tariff line 0713.33.40.00 (source: Global Trade Alert). 29 https://centralamericadata.com/en/article/home/Central_America_Threats_to_the_Supply_Chain 59 Note: More details available in Annex 1. The use of temporary trade measures could also affect resilience in the long term if adopted permanently. Most temporary measures discussed above have been reversed after a few months. However, trade liberalization measures, such as the elimination of tariffs on medical and food products, can increase resilience to future shocks by reducing costs and improving the availability of essential goods. It is also important to avoid using measures that undermine resilience, at the regional level, such as export bans on foods and medicines. This could, for instance, be raised in the context of regional integration where commitments to refrain from using export bans would contribute to an environment more conducive to investment in critical tradeable products. Structural (medium-term) trade policy responses In addition to policy measures responding to the immediate risks and challenges of Covid-19, governments also introduced structural policy measures to boost the economy in the medium term. These included measures to support key sectors and firms that were affected by the pandemic, to improve trade facilitation and logistics, and promote foreign investment. To improve trade facilitation and logistics, governments adopted measures to improve customs and other border processes as well as road infrastructure. As part of the Regional Trade Facilitation Strategy, Honduras launched the Paperless Customs program (“Aduanas Sin Papelesâ€?) which would modernize, optimize and make the customs processes transparent through digital facilities. The reform aims to reduce times in the customs clearance process, eliminate the use of paper by 90 percent, and enhance competitiveness through agile trade processes.30 The government of Guatemala also advanced the trade facilitation initiative by preparing the launch of the Single Window for Foreign Trade (Ventanilla Única para el Comercio Exterior, VUCE) portal, installing four anti-smuggling Interinstitutional Control Post (PCIs) to prevent customs smuggling and tax fraud, and consolidating a “Single Customsâ€? system with Mexico.31 Sectoral measures to support small-scale producers and reduce poverty were largely targeted at the agricultural sector. For example, the coffee industry, a key sector for CA3 countries, received support from governments through the Agricultural Rescue Master Plan (“Plan Maestro de Rescate Agropecuarioâ€?) in El Salvador and the Coffee Bonus (“Bono Cafetaleroâ€?) in Honduras. Specific measures included production modernization, technical assistance and the supply of fertilizers and other equipment. 32 Honduras also introduced Agrocrédito 8.7 (2020) and 5.0 (2021) financial program to improve access to financing for agricultural producers by offering grants with up to 3 years of grace period and a term of 10 years at an annual interest rate of 8.7 percent and 5.0 percent, respectively, in 2020 and 2021. The Blue Lagoon project and the Honduras “Se Levantaâ€? initiative offered production bonuses to fish farmers and supported micro-entrepreneurs engaged in artisanal fishing. Honduran authorities also agreed to review the import tariffs of aquaculture products to increase competitiveness in foreign markets.33 Guatemala developed a “White Sealâ€? certificate representing quality and trust for MSMEs and to help with the 30 https://acontecerinformativohn.com/2021/02/22/aduanas-honduras-sin-papeles-modernizan-administracion-aduanera/ 31 https://www.mineco.gob.gt/ministerio-de-econom percentCA3 percentADa-prepara-portal-de-la-ventanilla- percentCA3 percentBAnica-para-el-comercio-exterior; https://alejandrogiammattei.presidencia.gob.gt/presidente-inaugura-cuarto-puesto- de-control-aduanero-en-chimaltenango/; https://www.prensalibre.com/economia/buenas-noticias-para-quienes-comercian- con-mexico-gracias-a-un-acuerdo-binacional-aprobado-esta-semana/ 32 https://www.presidencia.gob.sv/los-cafetaleros-juntan-esfuerzos-con-el-gobierno-para-impulsar-una-politica-que-beneficie- al-sector-a-traves-del-dialogo-productivo/; http://presidencia.gob.hn/press/blog-node/bono-cafetalero-mejora-la-vida-de-m percentCA3 percentA1s-de-175000-productores 33 https://presidencia.gob.hn/index.php/sala-de-prensa/9498-por-medio-de-honduras-se-levanta-gobierno-ayuda-a- pescadores-de-la-mosquitia-con-2-7-millones-de-lempiras-en-equipo; https://www.marcahonduras.hn/en/new-actions-are- implemented-to-strengthen-the-tilapia-industry-in-honduras/ 60 visibility and promotion of their products nationally and internationally (Box 1). Guatemala also introduced the Popular Trade Support Fund (Fondo de Apoyo al Comercio Popular) to support families engaged in informal trade that was affected by the Covid-19.34 Box 1. Guatemala’s White Seal (“Sello Blancoâ€?) Program The government of Guatemala introduced the White Seal plan in May 2021 to support Guatemalan MSMEs through a consumer social responsibility approach, enhancing their visibility in the international market and promote local development. The White Seal is a certificate that is granted to producers or service providers who demonstrate compliance with the established rules of origin, such as the details on geographical area as well as persons and entities involved. The certificate is intended for the end consumer in foreign countries to know that they are supporting someone to get out of poverty by consuming the labeled product, hence promoting consumer social responsibility.35 It aims to represent quality, trust and support for the producers, and promote more inclusive value chains. Furthermore, achieving the certificate will help merchants promote their product, improve the entrepreneurial environment in Guatemala, and develop export markets. The products recognized with the White Seal may be of three types: - Those made by small and medium-sized individual producers from any productive sector; - Those that come from formal producers belonging to micro, small and medium-sized enterprises (MSMEs) and/or organized groups; and - Those from entrepreneurs or producers who achieved production chains, which can be marketed in local or international markets In November 2021, five companies received the first White Seal certificates, recognizing them as companies with export quality. The selection went to a cooperative that produces blown glass; an expert artisan making bracelets; a coffee producer; the network of women chocolatiers, and an artisanal enterprise producing cornhusk dolls. The program aims to grant the certificate to 100 producers in 2022. The White Seal program is framed by the General Government Plan (PGG), within the pillar of "Economy, Competitiveness and Prosperity", which seeks greater economic growth sustainable increases in employment. It is also part of the priority actions for 2021 of the Plan for the Economic Recovery of Guatemala, whose main axes include employment generation, the attraction of strategic investments and the increased consumption of national products at a local, regional and global level. As part of the program, technical assistance is provided to participants on strengthening business skills to allow commercialization and later obtain the While Seal certificate. CABEI, a strategic ally, is also providing technical assistance to the White Seal Program dedicated to cleaner production as per the commitments to the United Nations Sustainable Development Goals as well as marketing plans.36 To attract foreign investment, countries developed investment promotion strategies, economic development zones and investment initiatives such as the America Crece. For example, Guatemala approved the operation of Special Public Economic Development Zone (Zona de Desarrollo Económico Especial Público, ZDEEP) in Pajapita, San Marcos, called “Puerta del Istmoâ€? in December 2020. Located 3.3 34 https://alejandrogiammattei.presidencia.gob.gt/jornada-presidencial-presidente-se-reune-con-representantes-del-comercio- informal/ 35 https://alejandrogiammattei.presidencia.gob.gt/presidente-destaca-el-proyecto-sello-blanco-para-combatir-la-pobreza/; https://lahora.gt/giammattei-anunciara-medidas-especiales-para-departamentos-con-alza-de-casos-de-covid-19/ 36 https://guatemala.gob.gt/sello-blanco-abre-a-las-mipymes-guatemaltecas-el-camino-hacia-mercados-internacionales/ 61 kilometers from the border with Mexico, the ZDEEP aims to attract new investments by providing tax benefits, building a multimodal terminal and a railway section connecting the Guatemalan and Central American market with Mexico, the United States and Canada.37 The governments of Honduras, Guatemala, and El Salvador have each signed MOUs on the America Crece Initiative in 2020. The initiative aims to foster job creation and boost economic growth by promoting investment in infrastructure. Governments supported MSMEs by offering loans, training and digitalization. The government of Honduras introduced the MSME digitization plan, offering free licenses for entrepreneurs to have a digital page to display and market their products online, signed the Debt Relief Agreement which allows the restructuring of low-risk MSMEs’ loans, and created a Guarantee Fund. 38 El Salvador launched the “Reconvirtiendo el territorioâ€? (or Reconverting the Territory) contest to provide non-reimbursable loans to MSME for developing new projects across agribusiness, manufacturing, food and beverage, fishing, tourism, and aquaculture sectors in the coastal zone and also offered training and technology to improve entrepreneurs’ access and use of financial services through the “Despeguemosâ€? program (or Taking-off) in Surf City.39 Micro response In response to Covid-19, governments introduced policy measures at the micro-level to mitigate the short-term effects of the crisis on income, unemployment and business closures. In CA3 countries, governments adopted a wide range of policies directed at firms with the goal of sustaining productive capacity, preventing business closures and mass layoffs. Among these measures are the deferral of taxes and other payments, wage subsidies, low-interest credit, along with loans directed at small and medium enterprises (SMEs) and the informal sector. Governments complemented these policies by supporting workers and households to attenuate income losses and prevent further deterioration of economic activity, which would only prolong the negative effects of the shock. In this regard, the most widely observed policies in the region were cash transfers to vulnerable households and the unemployed, provision of basic foodstuffs or food coupons, and the deferral of taxes, utilities and other payments.40 In El Salvador, the government rapidly responded to the shock by introducing support measures for businesses, including the deferral of payments and taxes, low-interest credit and wage subsidies. Just a few hours before the first confirmed Covid-19 case in the country on March 18th, president Nayib Bukele announced the “Plan de respuesta y alivio económicoâ€?, a set of measures addressed at mitigating the 37 The construction, however, has not yet started (as of February 3, 2022) due to complications in the legal contract between the Railway Development Company SA (Ferrovías Guatemala) and the Puerta del Istmo Company Remed, SA. Source: https://www.prensalibre.com/economia/continuan-las-dudas-y-dificultades-por-el-contrato-para-reactivar-el-servicio- ferroviario/ 38 https://presidencia.gob.hn/index.php/sala-de-prensa/9374-mas-de-15-000-empresas-se-integran-de-manera-gratuita-al- plan-de-digitalizacion-mipyme-en-honduras; https://www.cnbs.gob.hn/blog/2020/11/03/mipymes-recibiran-alivio-financiero- mediante-acuerdo-firmado-entre-el-gobierno-y-el-sector-bancario-comercial-del-pais/#:~:text=Este percent20alivio percent20financiero percent20est percentCA3 percentA1 percent20dirigido,de percent20diciembre percent20del percent20presente percent20a percentCA3 percentB1o percent2C ; https://banhprovi.gob.hn/fondo-de-garantias-banhprovi/ 39 https://www.presidencia.gob.sv/gobierno-ayuda-a-las-pequenas-y-medianas-empresas-de-la-zona-costera-con-un- financiamiento-no-reembolsable-para-revertir-el-impacto-economico-por-la-pandemia/; https://www.presidencia.gob.sv/gobierno-firma-convenio-con-la-empresa-privada-para-dinamizar-las-micro-y-pequenas- empresas-con-el-programa-despeguemos/ 40 The description of policies in response to Covid-19 in this section relies on a set of comprehensive compilations produced by: Americas Society Councils of the Americas (https://www.as-coa.org/articles/coronavirus-latin-america); ACAPS COVID-19 Government Measures Dataset (https://data.humdata.org/dataset/acaps-covid19-government-measures-dataset); International Labour Organization Country Policy Responses (https://www.ilo.org/global/topics/coronavirus/regional- country/country-responses/lang--en/index.htm); OECD Country Policy Tracker (https://www.oecd.org/coronavirus/country- policy-tracker/). 62 negative impacts of the virus on economic activity. These measures introduced the deferral for three months of payments for utilities, mortgages, phone and internet bills, personal loans and credit cards, among other payment categories, and were directed both at businesses and individuals. After the three- month period, payments would be resumed, but the deferred amount would be spread over the course of two years.41 Moreover, the “Plan de reactivación económicaâ€? issued in April introduced a new set of measures directed at firms, including US$ 600 million to be used in low-interest loans for SMEs, an additional US$ 90 million credit for the informal sector, wage subsidies of 50 percent for SMEs, and the deferral of the income tax.42 Short-term response measures in El Salvador also included a set of strict mobility restrictions, widespread cash transfers, and provision of basic foodstuffs. Responding to the initial outbreak of Covid- 19, the government in El Salvador introduced strict mobility restrictions including lockdown, mandatory quarantine and business closures.43 Simultaneously, widespread support to workers and households was introduced, including a monthly cash transfer of approximately US$ 300 that reached 75 percent of Salvadoran households, at an estimated cost of US$ 450 million (1.7 percent of GDP).44 Support was also provided in the form of food provision to households, with monthly disbursements of US$ 50 million.45 Support for businesses in Guatemala was mostly provided in the form of credit. The “Fondo de crédito para capital de trabajoâ€?, a measure implemented with a Q 3 billion budget from from Credito Hipotecario Nacional (CHN), supported firms directly affected by the crisis to finance working capital and business operations with individual loans of up to Q 250,000. Another credit line implemented in Guatemala, this time focused on SMEs, was the “Fondo para las micro, pequeñas y medianas empresasâ€?. It consisted of a total budget of Q 650 million (US$ 84 million), of which Q 400 million would be allocated toward a specific program directed at rural and urban SMEs.46 Lastly, the “Fondo de protección de capitalesâ€?, also managed by the CHN, provided a total of Q 250 million in credit for individual traders, entrepreneurs, self-employed, firms and credit unions.47 Guatemala also implemented a wide array of policies to support vulnerable households by providing cash transfers and delivering basic foodstuffs. The “Fondo para la protección del empleoâ€? granted employees with suspended work contracts a transfer of up to Q 75 (about US$ 9) daily. Informal workers were also eligible for a one-time Q 1,000 transfer that was estimated to reach 200,000 people. “Fondo bono familiaâ€? also provided three monthly grants of Q 1,000 grants for 2 million low-income families.48 Support was also provided in the form of food delivery to vulnerable households (“ Juntos saldremos adelanteâ€?, with a reach of 200,000 families), schools and the elderly, and food coupons.49 Lastly, the 41 https://elfaro.net/es/202003/el_salvador/24137/El-Salvador-anuncia-su-primer-caso-de-coronavirus-y-lanza-medidas- econ%C3%B3micas-anticrisis.htm 42 https://lapagina.com.sv/nacionales/gobierno-y-anep-anuncian-plan-de-reactivacion-economica/ 43 https://historico.elsalvador.com/historico/706772/cuarentena-covid-19-coronavirus.html 44 https://www.semana.com/mundo/articulo/coronavirus-las-medidas-de-nayib-bukele-que-aplauden-en-redes/658641/; https://www.oecd.org/coronavirus/country-policy-tracker/ 45 https://www.oecd.org/coronavirus/country-policy-tracker/ 46 https://www.ilo.org/global/topics/coronavirus/regional-country/country-responses/lang--en/index.htm#GT 47 https://legal.dca.gob.gt/GestionDocumento/VisualizarDocumento?verDocumentoPrevia=True&versionImpresa=False&doc=5 8434 48 https://legal.dca.gob.gt/GestionDocumento/VisualizarDocumento?verDocumentoPrevia=True&versionImpresa=False&doc=5 8800 49 https://nomada.gt/pais/entender-la-politica/estos-son-los-10-programas-de-ayuda-economica-y-los-requisitos-para-optar-a- ellos/ 63 interruption of basic services was prohibited in the case of unpaid bills, including, utilities, telephone, and internet services.50 Honduras responded to the outbreak of Covid-19 by issuing short-term measures to provide firms with access to credit, tax subsidies, participation in public procurement and flexibility for remote work. As mentioned in the macro and monetary response policies, the Honduras Congress approved a set of economic measures for supporting economic activity aimed at firms and workers. Among these measures is the introduction of a trust fund, handled by the Central Bank and the development bank "Banco Hondureño para la Producción y la Vivienda" (Bahnprovi), that guarantees loans to the agricultural sector and SMEs.51 To help sustain employment, Honduras provided tax subsidies to firms which did not suspend any worker contracts and continued to timely pay for employees’ wages and benefits.52 The government also supported the operation of small businesses by passing a legislation that allowed the procurement of public goods and services directly from self-employers and SMEs53, and by implementing tax deferrals for small and medium businesses.54 Honduras also passed a legislation authorizing and regulating remote work in the public and private sectors, providing more flexibility to firms and workers where the required technology is available, and activities are suitable for home-based work.55 Public support in Honduras was complemented with cash transfers and food distribution to vulnerable households. The support program “Aporte solidario temporalâ€? implemented cash transfers to furloughed workers of up to L 6,000 (corresponding to about US$ 244 at the time of implementation) for up to three months in sectors particularly affected by the pandemic, such as the maquila and tourism industries.56 The government also launched the operation “Honduras solidariaâ€?, which included the distribution of food rations to over 800,00 families affected by the pandemic.57 Targeting Support policies issued by local governments have been an important instrument used with the attempt to minimize the negative effects over employment and business closures. Since March 2020, when mobility restrictions were imposed and a large number of businesses were required to temporarily close, local governments have adopted a variety of programs to support firms, avoid mass business closures and increases in unemployment. These measures included cash transfers, fiscal subsidies, facilitated credit, technical support, and many others. However, just as important as providing timely support to affected firms is increasing the efficiency of existing policies, taking into account firms’ needs and improving targeting over time. Resources should be allocated towards productive firms that would not survive otherwise, with the goal of preserving the productive capacity of industries through the crisis. Evidence in Humphries, Neilson, and Ulyssea (2020) for the United States shows that program design and information frictions resulted in support resources being disproportionately directed at larger firms, increasing misallocation and harming long-term productivity growth. 50 https://www.prensalibre.com/guatemala/comunitario/coronavirus-decreto-15-2020-que-garantiza-servicios-basicos-es- publicado-en-el-diario-oficial-breaking/ 51 https://www.laprensa.hn/honduras/congreso-nacional-honduras-ley-poyo-mipymes-coronavirus-covid-19-JALP1369437 52 https://www.tsc.gob.hn/web/leyes/Decreto-33-2020.pdf 53 https://www.tsc.gob.hn/web/leyes/PCM-031-2020.pdf 54 https://www.laprensa.hn/honduras/prorroga-impuesto-sobre-renta-pequeno-mediano-contribuyente-pago-agosto- BGLP1387341 55 https://www.tsc.gob.hn/web/leyes/PCM-031-2020.pdf 56 https://www.laprensa.hn/honduras/trabajadores-suspendidos-rap-honduras-coronavirus-AGLP1386071 57 https://www.tsc.gob.hn/web/leyes/PCM-025-2020.pdf 64 The fraction of firms with access to public support in the CA3 region has varied widely across countries. It is estimated that by June 2020, 26 percent of firms in Guatemala, 12 percent in El Salvador and 11 percent in Honduras had received at least one form of government support from the policies available in each country (Figure 55). This figure remained stable in Guatemala, and increased to 18 percent in Honduras by December 2020. In El Salvador, access to support has risen sharply from the first to the second survey wave, and by the end of the year more than half of all firms in the country had access to at least one support measure. Figure 55. Fraction of businesses with access to public support Note: Fraction of businesses reporting having received any national or local government measures issued in response to the crisis since the outbreak of Covid-19. The sample includes the panel of firms included in either survey wave. Access to public support has not been equally available for all firms, and policies in response to the pandemic were not always successfully targeted at firms that were most affected. In El Salvador and Honduras, there is a negative relationship between firm size and the probability of obtaining access to support policies (Figure 56). This suggests that support was provided horizontally across firms, given the urgency for policy implementation and the widespread effects of the shock. In fact, only in Guatemala support was concentrated in firms with the highest drop in sales (Figure 57). As the shock persists, however, it is vital to channel scarce resources towards productive firms that are most in need. Figure 56. Probability of accessing public support by firm sizes 65 Note: Predicted probabilities of receiving access to public support, estimated through a Probit model, controlling for firm size, sector, and mobility relative to the pre-pandemic level. Figure 57. Probability of accessing public support conditional on change in sales Note: Predicted probability of access to support by firms’ change in sales quartiles, resulting from country-level linear regressions that controls for firm size, sector, and mobility relative to the pre- pandemic level. Data from the World Bank Enterprise Survey. V. Reform agenda: Designing more effective and sustainable recovery policies The pandemic hit hard the CA3 countries - El Salvador, Guatemala and Honduras - which were already among the poorest nations in the Western Hemisphere. These countries have been facing significant structural challenges for economic growth including weak institutions, political polarization, and high levels of crime and violence. Thus, the challenges imposed by the pandemic, as described in the previous chapters, add up to a broad list of unfinished reforms required in the region to propel sustainable and more equitable growth. Although macroeconomic stability since the 1990s has sustained low but steady growth rates in the region, it has not been enough to close the income gap relative to more developed economies . During 66 the last three decades, some countries with income levels similar to that of CA3 in 1990, such as Indonesia or Sri Lanka, were able to improve their relative performance and increase the rate of convergence to the GDP per capita of the United States. Meanwhile, the region’s performance has been stagnant. In 2020, Guatemala’s GDP per capita - the highest in the region - reached 14.0 percent of that in the United States, while in El Salvador and Honduras these figures were equal to 13.3 percent and 8.5 percent, with no significant narrowing the gap during the last 30 years (Figure 58). Figure 58. GDP per capita and labor productivity. Note: The Figure shows, on the left panel, the evolution of GDP per capita relative to the USA for selected countries, from 1990 to 2020. The right panel shows the evolution of labor productivity, GDP per worker, relative to the USA from 1991 to 2020. GDP is based on purchasing power parity (PPP) and measured in constant 2017 international dollars. The measures of GDP per capita and GDP per worker for CA3 were computed as the simple average among El Salvador, Guatemala and Honduras. Data is from World Development Indicators, derived using data from International Labor Organization. The failure in decreasing the income gap relative to other countries can be attributed to low productivity growth rates. There is robust evidence that productivity accounts for a significant portion of cross-country income differences (Easterly and Levine 2001; Caselli 2005; Hsieh and Klenow 2010). Over the last decades, economic growth in the CA3 region has been mainly based on factor accumulation, through increasing labor participation and capital investments. Conversely, the contribution of productivity to aggregate growth has been negligible or even negative at times (Ulku and Zaourak 2021b). The right panel of Figure 58 illustrates that the lack of income convergence since the 90’s coincides with a lagging labor productivity performance, as measured by GDP per worker. If we consider total factor productivity, that is, taking into consideration the contribution of multiple inputs to production, this result is even more striking. Figure 59 illustrates that aggregate productivity has a clear negative trend starting around 1980 in the two countries with data available, Guatemala and Honduras. The slowdown in labor force growth and decreasing returns to capital limit the role of factor accumulation for economic growth in the future. Hence, boosting productivity is critical for sustaining long-run development, increasing relative income and translating economic gains into improved living conditions for people in the region. In this context, the Covid-19 pandemic has put additional pressure on already fragile economies with persistent negative shocks on output, firm performance, employment and income. The pandemic has resulted in activity and mobility restrictions that have severely impacted economic activity and firm performance, with persistent effects over one year after the outbreak of Covid-19. Evidence in Blyde, Daude, and Fernández-Arias (2010) shows that large aggregate output drops are often followed by a persistent decline in productivity. The pandemic adds pressure to an already stressed fiscal situation, limiting the room for government response and threatening to undermine recent progress in macroeconomic stability and poverty reduction. 67 Figure 59. Total factor productivity Note: The Figure shows the evolution of total factor productivity (TFP) for Guatemala (1954-2019) and Honduras (1970-2019), computed at current PPP, relative to the United States. Data is from Penn World Table 10.0. The Covid-19 pandemic and resulting disruptions in trade and international supply chains sparked a discussion on the vulnerability of GVCs. Some policymakers and researchers argue that GVCs create economic vulnerabilities by propagating shocks, therefore exacerbating protectionist sentiments, calling for shortening or reshoring of GVCs and greater self-sufficiency. The tight interconnectedness between firms helps the transmission of shocks through supply chain linkages (Barrot and Sauvagnat 2016; Boehm, Flaaen, and Pandalai-Nayar 2019; Carvalho et al. 2021). The pandemic has reinforced concerns that supply chains have gone too far, with some governments resorting to protectionism and restricting trade, for example by imposing export bans of critical medical equipment or food. However, evidence from prior crises suggest that turning inward will not improve resilience, and export bans drive up world prices and make short-term shortages even worse (Baldwin and Evenett 2020; Irwin 2020). Integration into GVCs and the global market can be a source of resilience itself and pave the way for a strong recovery. Just like shocks can propagate along value chains, recovery does too. When the recovery from the economic downturn is uneven, with demand being revamped at different paces, supply chain linkages ensure that the recovery is also transmitted through the value chain. Well-operating GVCs therefore are a source of resilience more than a source of vulnerability (Brenton, Ferrantino, and Maliszewska 2022). Firm-level data show that globally engaged firms are recovering faster from the adverse impact of the pandemic, possibly due to higher capabilities and heightened response (Constantinescu et al. 2022). In addition, countries and firms that are more internationally connected, through GVCs and exports, are more resilient to domestic shocks due to their diversification of suppliers and markets (Hyun, Kim, and Shin 2020; Espitia et al. 2022). It is therefore crucial to find ways to leverage GVCs as a means to enhance resilience and mitigate the impact of shocks. A potential realignment of GVCs in the post-Covid world may offer new opportunities for the region as firms seek to enhance resilience by nearshoring or diversifying the sources of production. Some multinational firms are considering the reconfiguration of their supply chains to improve speed and flexibility, seeking more local-to-local and closer supply chains to retail markets.58 Evidence from prior shocks, such as natural disasters, suggest that a consequent reconfiguration of GVCs could motivate firms to switch suppliers, particularly from developing countries and larger countries where scale economies could be realized.59 However, firms may also choose to maintain their existing supply chain relationships during and after the crisis, given the significant cost of finding and establishing new supplier networks. 58 https://blogs.worldbank.org/voices/how-covid-19-transforming-global-value-chains-lessons-ethiopia-and-vietnam 59 https://voxeu.org/article/how-natural-disasters-reshape-supply-chains 68 Relationships along sophisticated GVCs are likely to be especially persistent as intermediate inputs are often specific and customized, making it more difficult to replace compared to final goods. Research on natural disasters find little evidence of increased diversification or reshoring of production after the negative shock to GVCs (Freund et al. 2021). In this context, the reshaping of GVCs due to the Covid-19 pandemic may be less pronounced than expected by some. Early evidence suggests that reshoring of production has been minimal, but some reconfiguration and diversification are taking place along supply chains. Firms are increasing their supplier base, including through nearshoring, building up inventories, and regionalizing supply chains. Redesigning supply chains does not happen rapidly, and seeing the effect in data takes time. However, early indicators suggest, for example, that there is increasing interest from American firms searching for suppliers in Mexico as well as from Chinese firms seeking to relocate, largely due to its access to the North American market.60 These trends may offer significant opportunities for CA3 countries which also has competitive advantages including the strategic geographical location and access to major markets though preferential trade agreements. In the course of the post-pandemic recovery, the CA3 region has the opportunity to accelerate pending structural reforms that are necessary to ensure productivity enhancements and sustained growth. This will require increasing the effectiveness and improving the targeting of existing policies and programs. Efforts from the governments, private sector, and international community to improve national economic fundamentals and enhance intraregional connectivity would also attract foreign investment and boost countries’ trade and GVC participation. This in turn can diversify their economy and trade, helping a strong and resilient recovery, and sustained growth. Structural reforms in the region are even more fundamental given the global shock induced by the war in Ukraine and potential future shocks. The current economic context brings new challenges for businesses in an already fragile environment, before full recovery from the Covid-19 pandemic. The ongoing events relating to the war will require careful monitoring and the design of new initiatives to quantify the effects from the shock and support businesses given the nature of these new adversities. But what is clear at this stage is that increasing economic resilience to this shock and potential future shocks entail advancing in structural reforms. In this scenario, addressing structural issues are paramount for securing economic recovery in the long-run and increasing economic resilience. This chapter describes the key constraints to growth in the CA3 countries using a productivity lens, and suggests policy implementation to promote robust recovery from the pandemic and generate sustainable long-term economic growth. Our discussion builds on previous analytical work providing a diagnostic of critical constraints to economic and productivity growth in the region, along with the priorities identified in Chapters II and III, assessing the main impact of the Covid-19 pandemic on the regions’ economies. The rest of the chapter is organized as follows: The next section provides a medium-term outlook for CA3 economies post-Covid, followed by a discussion on drivers of productivity growth and diagnosis of structural challenges currently faced by CA3 countries. The last section presents a comprehensive reform agenda that could help to overcome these issues and generate productivity and output growth, with specific policy recommendations both in the short- and long-run. 60 The Economist (2022). The structure of the world’s supply chains is changing: The pandemic and war in Ukraine have speeded up the transformation. Available at: https://www.economist.com/briefing/2022/06/16/the- structure-of-the-worlds-supply-chains-is-changing 69 Looking forward: Post-Covid-19 For the medium term, global V-shaped recovery is expected, and new Covid-19 waves are not expected to impact the economy as severely as the shock in 2020. Medium-term prospects show a robust sustainable growth path for the global economy and international trade, diminishing the risk of new external exogenous shocks for CA3 economies. Furthermore, due to the past lessons’ learnings and the ongoing vaccination campaigns, a new “supply and demandâ€? simultaneous shock has a low probability of occurrence. Figure 60. GDP growth (%) 10% 8% 6% 4% 2% 0% -2% -4% -6% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 World Advanced Economies Emerging Economies Source: IMF WEO (April 2022) However, the Covid-19 pandemic continues to present challenges and structural struggles are back on the agenda. Even though exogenous shocks stemming from the external sector or tough restrictions on circulation are not expected in the face of potential new waves, accelerating the vaccination schemes constitutes a crucial factor to underpin the undergoing recovery. Guatemala and Honduras still show low levels of people fully vaccinated, with 33 percent and 48 percent of the population inoculated respectively, while only El Salvador has more than 2/3 of its population fully vaccinated by the end of April 2022. Addressing potential scarring effects also poses challenges for CA3 countries, although the explicit effects are yet to be unfolded. Preparing for the new normal portrays renewed dares for the countries in the region, given the need to strengthen the efforts in formalizing the workforce, underpin technological readiness, and address productivity issues. When the tide goes out, structural challenges will have to be reprioritized in the regional agenda. In this sense, strategies for tackling violence, corruption, poverty, gender, and financial inclusion issues will necessarily have to be reprioritized to make the expected recovery process more sustainable and inclusive. The recovery has been faster than expected in 2021 but the impact of Covid-19 pandemic can be long- lasting. The pandemic has affected growth fundamentals which could affect long term growth rates if not addressed. School closures and the lack of resources for widespread remote learning could have long- lasting effects on human capital and increase inequality as internet services are not equally distributed. In addition, firms’ closure and resource shifting forced by the pandemic could allocate factors in a less efficient way than in the pre-pandemic, hence hurting total factor productivity. In this regard, growth rates could slow down before returning to pre-pandemic trends. The Long-term growth model, presented in Annex 3, estimates that even a small deceleration in growth rates in Guatemala could have a scarring 70 impact on income levels in the long run, a cumulative loss in real GDP per capita of USD 260. 61 These differences amplify in El Salvador and Honduras, where the impact on growth rates is estimated to be larger and the long-term impact in real GDP per capita could ascend to USD 290 and USD 330 respectively (Figure A.2). Structural reforms aimed at tackling factors that hinder productivity growth could boost long-term growth rates and outpace the scarring impact of Covid-19. Productivity growth in CA3 has been very limited over the past decade, with TFP growth below 0.3 percent in all three countries, and even negative in Honduras. 62 Therefore, reforms that foster improvements in areas such as innovation, education, market efficiency, infrastructure, and institutions could boost TFP growth and, therefore, GDP Long-term growth rate (Kim and Loayza 2019). In this regard, if CA3 countries could improve the TFP determinants to the level of the 75th percentile of Latin America by 2030, growth rate could increase by 1.51 percent, 2.16 percent and 1.68 percent by 2040 in Guatemala, Honduras and El Salvador respectively (Figure A.2). Consequently, real GDP per capita could be boosted and improve livelihoods in the Central American countries. Drivers of productivity and sustained growth Achieving sustained growth requires accelerating productivity growth, which in turn requires identifying the drivers and barriers of productivity that policies should target. In order to prioritize reforms and inform policies this section builds on the framework to understand productivity growth based on its dynamic decomposition developed in Cusolito and Maloney (2019). 63 Productivity growth can be decomposed as a combination of three components: increments in average firm productivity (within-firm), resource reallocation across firms with varying levels of productivity (between-firm), and changes in firm composition through entry and exit (selection). These components are inextricably linked, so that productivity-enhancing policies need to focus on addressing the constraints in all three mechanisms of productivity growth. Within-firm improvements in efficiency increase firm growth and wages. The growth of productive firms is essential to generate competition and selection, reallocating resources across firms, eliminating the least efficient firms from the market and leading to further productivity gains. An important implication from this framework is that governments should monitor the constraints to the three channels and ensure an institutional environment that promotes competition, allows successful firms to survive and grow, and encourages entrepreneurs to create innovative businesses. Furthermore, institutions and market structure interact with other factors constraining productivity growth, leveraging or weakening how these factors translate into changes in aggregate productivity. For example, strengthening a country’s infrastructure might not induce individual firms to invest and expand if there are simultaneous binding constraints such as widespread corruption, high levels of crime, or weak rule of law. The opposite effect is also possible, and improvements in the business environment can lead to a virtuous cycle of productivity growth, increasing the expected returns from investing and expanding into new markets, for example, which will result in even more productivity-enhancing dynamics. This section describes the relevant factors that impact productivity growth, along with the related structural challenges currently faced by the CA3 countries. It also gives an overview of the binding 61 See Annex 3 for an explanation of the Long-Term Growth Model and the assumptions. The LTGM builds on Hevia and Loayza (2012). See Pennings (2020) for a full model description. The LTGM spreadsheet is available for download at www.worldbank.org/LTGM. 62 Penn World tables 10.0. Feenstra, Inklaar, and Timmer (2015), "The Next Generation of the Penn World Table" American Economic Review, 105(10), 3150-3182, available for download at www.ggdc.net/pwt 63 Details on the framework of productivity growth decomposition and drivers are available in Annex 2. 71 constraints for sustainable growth in the region and describe how these elements have been affected since the beginning of the Covid-19 pandemic. We apply the framework described in Annex 2, using information from existing diagnostics and from the impact of the pandemic described in detail in the previous chapter. An enabling environment The quality of institutions and governance, including public transparency, accountability, corruption, crime and enforcement of property rights, positively impacts productivity. One dimension through which these factors affect aggregate productivity is uncertainty. Specifically, the risk of crime-related losses, expropriation and the unpredictability of government decisions will discourage entrepreneurship, innovation, and investment, both domestic and foreign. Corruption and crime also divert resources from productive use to be used as bribes or security-related expenses, for example, decreasing within-firm productivity. The prevalence of crime also affects aggregate productivity by crowding out public investment that could be used to boost human capital, infrastructure, public health and other measures to improve efficiency. These factors can also contribute to an inefficient allocation of resources. For example, corruption can imply that politically connected firms can obtain preferential access to credit or government contracts. Meanwhile, weak enforcement of property rights can restrict firms from gaining access to credit, since land without titles cannot be used by entrepreneurs as collateral. The rule of law and domestic institutional capacity is also essential to reap the benefits of regional integration and foreign investment. Poor state capacity undermines the effectiveness of RTAs through its impact on implementation and compliance. Domestic institutions also influence governments’ external credibility, thus determining the effectiveness of RTAs in attracting foreign investment (Gómez-Mera and Varela 2021). Protection of property rights and IPR is also critical. Macroeconomic uncertainty impacts firm decision making, affecting the feasibility and expected returns from expansion and investments, and limiting the flexibility of responses to other factors. Macroeconomic instability has a detrimental effect on aggregate productivity, distorting individual firms’ decisions and discouraging firm-level investment and growth. This in turn limits the role of resource reallocation from high- to low-productivity firms (Nick Bloom 2006). Additionally, economic instability affects innovation by making R&D less responsive to business conditions and technology policies (Nick Bloom 2007), which could have long-run consequences on productivity. Informality hinders productivity growth by allowing the survival of unproductive firms and preventing the reallocation of resources towards formal and more productive firms. Informal businesses tend to be small and have low productivity, as they are often run by poorly educated entrepreneurs, producing low- quality products and services with little value added for low-income consumers (La Porta and Shleifer, 2014).64 These firms consist mostly of self-employed workers, usually do not grow over time, and are only able to survive due to the lower operation costs they face by avoiding taxes and regulations. Hence, a large informal sector is negatively associated with aggregate productivity. Informality also induces inefficiencies in the allocation of capital across firms through two channels. First, informal firms retain production inputs that could be directed at productive firms in the formal sector. Second, informality distorts firm-level decisions on margins such as firm size and employment (Ulyssea 2018). Lastly, selection, the dynamic process that drives unproductive firms out of the market, is substantially weaker in the informal sector (Ulyssea 2020). This result is rationalized by the absence of firm expansion and market appropriation among informal firms, which culminate in reduced competition and selection. 64 Reflecting productivity levels, wages are also significantly lower in informal firms (La Porta and Shleifer 2008). 72 Competition is critical for productivity growth. Competition is intensified by any process that lowers market concentration, that is, either increases the number of competitors or reduces the level of rents. Competition increases aggregate productivity through all three components of the decomposition. First, competition increases productivity in individual firms by providing incentives for management to adopt new technologies, engage in R&D and innovate, cut on production costs and reduce prices in key input markets, to improve the efficiency of the production process and raise product quality (Nickell 1996; Blundell, Griffith, and Van Reenen 1999).65 However, the literature on trade liberalization has provided extensive empirical evidence that large and robust effects of competition occur through firm selection and factor reallocation (Pavcnik 2002; Bernard, Jensen, and Schott 2006). In a competitive environment, the most productive firms are able to capture a larger share of the market and expand, in detriment of the least productive ones, which shrink and end up leaving the market. Diagnostic Excessive regulation, weak contract enforcement and rule of law, and unpredictability of the economic environment in CA3 countries discourage firms’ investment and GVC participation, thereby lowering aggregate productivity and growth. A strong rule of law encourages investments by creating a predictable economic environment and ensuring the well-functioning of institutions. For example, it contributes to solving judicial issues quickly, battling crime and corruption, assigning and protecting property rights.66 The quality of rule of law in CA3 countries ranks poorly relative to the average of LAC and far below advanced economies (Figure 61, panel b). Among them, Guatemala has the worst performance, ranked 180th out of 209 countries, while El Salvador and Honduras rank 163rd and 173rd, respectively. Within Central America, the rule of law in CA3 countries performs well below Costa Rica, which ranks 63rd. Lastly, the enforcement of intellectual property rights is a significant issue that needs to be addressed in El Salvador and Guatemala.67 Crime and violence have detrimental impacts on economic growth and aggregate productivity, imposing direct costs on firms and restraining growth and investment. Firm-level efficiency is directly affected by crime and violence by imposing additional production costs and losses to firms, which decrease productivity. El Salvador, Guatemala and Honduras are among the most violent countries in the world.68 In 2016, over 60 percent of firms in the region reported paying for security services, and in El Salvador this share reached 80 percent. Additionally, about 30 percent of firms in the region have experienced direct losses from theft and vandalism. Aggregate productivity is also indirectly affected through decreased dynamics and competition, by discouraging entrepreneurship, investment, and growth. A substantial fraction of firms perceives crime and violence as a major constraint (49 percent in El Salvador, 38 percent in Guatemala and 30 percent in Honduras).69 In particular, crime and violence are critical bottlenecks for growth in El Salvador, where the direct and indirect costs associated with violence 65 There has been evidence, however, that rising competition will eventually reach a point where innovation incentives diminish, resulting in an inverted-U relationship between product market competition and innovation (Aghion et al. 2005). 66 The perception of the rule of law index included in the Worldwide Governance Indicators (WGI) measures the degree of confidence in the quality of contract enforcement, property rights, the police, the courts, as well as the likelihood of crime and violence. 67 World Economic Forum, Global Competitiveness Report (2019). 68 In 2018, El Salvador had an intentional homicide rate of 52.0 per 100,000 people, one of the highest in the world. El Salvador had the highest homicide rate in 2019 of 141 countries included in the Global Competitiveness Report (GCR), published by the World Economic Forum. Even if it has plummeted to half of its magnitude since 2015, from a rate of 105.2. Honduras has the second highest homicide rate in the region, 38.9, followed by Guatemala, 22.5. With the exception of Guatemala, these crime levels are well above the average for LAC, 22.3. 69 Computed by Ulku and Zaourak (2021), using data from the World Bank Enterprise Surveys. 73 were estimated at 18 percent of the national GDP in 2019.70 El Salvador was also classified as having the second highest security issues from 141 countries covered in the Global Competitiveness Report (GCR). Guatemala and Honduras did not perform much better, ranking 134th and 137th, respectively. Figure 61. Enabling environment in CA3 countries a. Competitiveness index (2019) b. Governance indicators (2020) Institutions Innovation 100 Infrastructu Control of corruption capability re 1.5 80 1 Business 60 ICT Voice and 0.5 Government dynamism adoption accountability 0 effectiveness 40 -0.5 20 Macroecon -1 -1.5 Market size 0 omic Stability Political stability/ Rule of law Finacial absence of violence Health System Labor Regulatory quality Skills Market Product Market Advanced economies Guatemala OECD El Salvador Guatemala Honduras El Salvador LAC Honduras LAC Source: World Economic Forum. Source: World Bank World Governance Indicators. Excessive taxation and labor market regulations in the region culminate in a substantially large informal sector characterized by low-productivity firms. Informality in the region is widespread and encompasses a large share of economic activity. In 2018, the size of the informal sector as a percentage of official GDP was estimated at 42.8 percent in El Salvador, 49.8 percent in Guatemala and 45.6 percent in Honduras.71 In terms of employment, the size of the informal sector is even more striking. In 2017, informal workers represented 70.2 percent of the labor force in El Salvador. In Guatemala and Honduras, over three-quarters of workers are unregistered, respectively 80.1 percent and 82.6 percent.72 While informality is partially the result of costly regulations, it also highlights problems with the quality of entrepreneurship in the region (see below), and both regulatory reforms and entrepreneurship programs need to go hand in hand to promote sustainable growth. Corruption in CA3 countries is prevalent and constitutes a relevant constraint to doing business. The region performs poorly in international comparisons of corruption. Particularly, corruption perceptions in Guatemala and Honduras are among the highest in the world. Guatemala and Honduras rank 147 th and 157th, respectively, out of 179 countries included in the 2020 Corruption Perceptions Index (CPI) compiled by Transparency International (TI).73 Meanwhile, El Salvador occupies the 104th position. This perception directly affects firm operations by diverting productive resources into the purpose of corruption, but also by creating an anti-competitive environment where certain firms or sectors receive 70 Economic Value of Peace (2021), published by the Institute for Economics and Peace. Available at https://www.visionofhumanity.org/wp-content/uploads/2021/01/EVP-2021-web.pdf 71 We consider the Multiple Indicators Multiple Causes Model-Based (MIMIC) estimates of informal output, measured as the percentage of official GDP. Data is from Elgin et al. (2021). 72 The latest estimates available for informal employment are for 2017. Data is from the harmonized series from International Labor Organization, available in (Elgin et al. (2021). 73 To provide some comparison, Guatemala and Honduras perform similarly in corruption perception as Iran (149th ), Mozambique (149th), Nigeria (149th), Zimbabwe (157th) and Iraq (160th). 74 discretionary advantages. In the CA3 region, corruption is pointed as a major obstacle by a large share of firms - 48 percent in El Salvador, 69 percent in Guatemala and 65 percent in Honduras.74 These figures are higher than for LAC, 37 percent, and even more so relative to the Europe and Central Asia region, where 21 percent of firms have identified corruption as a major constraint to operations. The pandemic had further negative consequences on the business environment by raising uncertainty, in an already uncertain setting. Uncertainty makes it difficult for firms to plan and make strategic decisions such as investing in physical capital, expanding into new markets, obtaining financial credit, or even hiring new workers. Thus, reducing the uncertainty associated to the business environment is important per se, but also in relation to the recovery after the large negative shock experienced during the pandemic. The simplification of certain costly processes, some of which were adopted as temporary measures during the pandemic, can shed some light on this agenda. The level of domestic competition is low in El Salvador and Honduras, hindering productivity growth through resource reallocation and dynamic selection. In these two countries, low competition is mainly the result of the distorting effects of taxes and subsidies on competition, as well as market concentration. Even factors not directly related to competition, but which contribute to generating misallocation, reduce competitive pressure for firms and restrict factor reallocation across firms and sectors. Central America has been described as having overly regulated product markets (Fajnzylber, Guasch, and Lopez 2008; Swiston and Barrot 2011; Araujo et al. 2014) and, specifically in the case of Guatemala, it lacks a clear competition policy, a competition authority to address anticompetitive behavior and high market concentrations, and a merger control regime for both general application and for regulated sectors (World Bank 2021a). Competition in services is also a significant issue restricting domestic competition in the case of Honduras.75 While Honduras ranks 93rd for domestic competition out of 141 countries in 2019, El Salvador’s rank is 105th (mainly due to the adverse effects of taxes and competition). Guatemala’s overall performance is the best among the three countries. It is ranked 59th place, with only a moderate degree in each distortion measured by the Global Competitiveness Report. International trade and regional integration International trade and participation in GVCs raise aggregate productivity and promote growth through increased competition, resource reallocation and technology upgrading. The intensity of international trade in a given country reflects trade costs arising either from direct restrictions to commerce, such as import tariffs and quotas, or from high transportation costs due to elements such as geographical conditions and poor infrastructure. Through the availability of a new consumer base, international trade generates aggregate productivity gains by inducing the reallocation of resources to the most efficient firms as they expand into foreign markets. Simultaneously, intensified competition resulting from foreign firms operating in the domestic market drives the least efficient firms out the market, changing the composition of operating firms and increasing aggregate productivity. Finally, trade contributes to within-firm productivity growth by facilitating the adoption of new technologies and allowing access to cheaper, high quality production inputs from abroad. International trade reinforces competition in domestic markets by increasing contestability, entry, and rivalry through increased presence of foreign products, services, and investment. Trade liberalization generates pro-competitive effects and reduces markup (Loecker et al. 2016). Research shows that industries and countries that face higher levels of import competition tend to have lower markups, as well 74 Data from the World Bank Enterprise Surveys (2016). 75 World Economic Forum’s Global Competitiveness Report (2019). 75 as those with a large number of domestic firms or fewer domestic entry restrictions (Kee and Hoekman 2007; Hoekman, Kee, and Olarreaga 2004). The pro-competitive effects of trade openness can materialize through preferential trade agreements (PTAs) as well as multilateral liberalization (Crowley, Han, and Prayer 2021). Increased foreign competition can also incentivize firms to invest in technology upgrading, as seen in the case of MERCOSUR where Argentinean firms in industries facing higher reductions in tariffs increased investment in technology faster (Bustos 2011). Active competition within national markets can also improve export performance by providing greater incentives for domestic firms to foster productivity, innovation, and efficiency, leading to enhanced competitiveness of exporters and potential exporters. Empirical evidence suggests that the elimination of entry barriers, increased rivalry, and a level playing field in upstream sectors contribute to export competitiveness in downstream manufacturing sectors, and industries with more intense domestic competition tend to export more (Goodwin and Pierola 2015). Pro-competitive market regulations and the enforcement of competition laws, therefore, can enhance export performance and is complementary to trade reforms. In addition, domestic competition can facilitate the opening of markets to trade and investment by mitigating vested interests (Licetti, Miralles, and Teh 2020). Trade liberalization can boost aggregate productivity and lead to higher growth through a more efficient allocation of resources. Opening up to trade leads to a reshuffling of resources and output from less to more efficient producers as less productive firms exit and the remaining productive ones expand (Melitz 2003). Evidence from Chilean plants show that trade liberalization led to productivity growth in the import-competing sectors, 3 to 10 percent more than in the non-traded goods sector, and that exiting plants are on average about 8 percent less productive than those who continue to produce (Pavcnik 2002). Industry-level productivity indices also suggest that the reallocation of market shares and resources from less to more efficient producers is an important channel of productivity improvement. Last but not least, international trade promotes technological upgrading through knowledge transfer, access to sophisticated inputs, and incentives to innovate. Trade liberalization and GVCs allow domestic firms to have access to newer differentiated input varieties (Rivera-Batiz and Romer 1991b) and diffuse knowledge and technology through matches between quality-differentiated suppliers and users (Alvarez, Buera, and Lucas 2013; Buera and Oberfield 2020), leading to higher productivity and growth. Trade barriers that prevent access to new imported varieties of intermediate inputs can act as a technological constraint. Evidence shows that firms that are more exposed to input liberalization not only increase their exports of existing, but also export new varieties, suggesting that trade liberalization can lead to product innovation or imitation, increasing the capability of domestic producers to introduce new varieties. Increased market access through trade and regional integration increases potential profits and incentives for innovation (Grossman and Helpman 1994; Rivera-Batiz and Romer 1991a). Furthermore, increased engagement in international trade and GVCs can lead to skill upgrading through “learning-by-exportingâ€? or increased offering of on-the-job training (Bastos, Silva, and Proença 2016; A. Park et al. 2010). Regional trade agreements play a key role in enhancing countries’ integration to the regional and global economy, leading to increased trade, GVC participation, and foreign investment. As a primary function, RTAs reduce trade costs by eliminating tariff and non-tariff barriers. As modern RTAs get deeper and address a wide range of behind-the-border regulations, they often include commitments to harmonize domestic regulations and increase policy transparency. In addition, deep RTAs can also attract more foreign investment to member countries by improving member countries’ investment climate, through provisions on intellectual property, competition policy, and standards harmonization, and acting as commitment mechanisms that signal policy predictability (Büthe and Milner 2008; Medvedev 2006). 76 Trade facilitation provisions in deep RTAs can play an important role in reducing trade costs and times for firms participating in GVCs (Lee, Checcucci, and Alfaro De Moran 2022). For countries to maximize the gains from regional trade agreements, proper implementation and complimentary structural reforms are critical. As deep RTAs include substantial commitments across a wide range of policy areas, implementation is often a challenge, especially for developing countries with limited resources and institutional capacity. Implementation is particularly an issue for reforms in trade facilitation, for instance, which entail a significant investment of time and resources over several years in often volatile political environments (Lee, Checcucci, and Alfaro De Moran, 2022). Rule of law and institutional capacity to protect intellectual property rights (IPRs) are also essential to enforce and implement the existing commitments and to attract FDI to the region (W. G. Park 2011). Complementary reforms in broader policy areas are essential to ensure that trade gains are maximized, and countries also benefit from increased productivity and growth. Trade stimulates growth in countries with higher levels of human capital, more developed financial markets, stronger institutions and infrastructure networks, higher intensity in R&D investment, and less stringent regulations (Calderón & Poggio, 2011). The negotiation of CAFTA-DR pioneered the concept of a “complementary agendaâ€? to RTAs (Box 2). Reforms in infrastructure, labor mobility, and trade facilitation were identified as key complementary agenda for CAFTA-DR member countries to minimize frictions and adjustment costs (Jaramillo et al. 2006; Lopez and Shankar 2011). Box 2. CAFTA-DR and the complementary reform agenda76 CAFTA-DR pioneered the concept of a “complementary agendaâ€? to RTAs, generating an organizing framework around which countries elaborated national action plans. At the onset of the agreement, many researchers and policy institutions proposed a set of complementary structural reforms that would help member countries maximize the benefits from the agreement in terms of increased trade and foreign investment (Jaramillo et al. 2006; Lopez and Shankar 2011). Infrastructure, trade facilitation, and institutions were among those identified as major areas where Central American countries should direct their efforts to make the structural change process as frictionless as possible. Overall high domestic transportation costs and bottlenecks at land border crossings present one of the biggest hurdles to international trade in Central America. Total trade costs, including tariffs, transport and trade facilitation costs are equivalent to an intra-regional tariff rate of 74 percent (Ulku and Zaourak 2021a). In addition, the costs related to the reception of grains at the port of entry, including those stemming from phytosanitary and sanitary revisions, are sometimes significant and are a potential source of cost saving through trade facilitation (Fernández et al. 2011). Fostering intra-regional trade could deepen GVC participation of member countries as they could achieve scale economies through agglomeration, since domestic markets are not large enough. Hence, increased trade facilitation policies in the borders could have a significant impact on trade and growth. CAFTA-DR lays out a comprehensive set of provisions to raise intellectual property standards and enforcement mechanisms in the region, covering not just patent rights, but also trademarks, copyrights, geographical indications, and trade secrets. However, enforcement in practice has lagged the agenda to strengthen IPRs (W. G. Park 2011). For instance, piracy rates in CAFTA-DR countries were above the regional average and IPR violators are not fully prosecuted. For Central American countries to benefit from FDI in terms of securing financing for private sector development and technology transfers, firms’ perception that their IPRs are protected are critical. The substantive IPR reforms envisaged under 76 This box draws from a background note on CAFTA-DR, prepared by Christian Zambaglione and Woori Lee. 77 CAFTA-DR will encourage investment and technology transfer in the long run only if institutions evolve so that they are strong enough to enforce the new regulations (W. G. Park 2011). Furthermore, the benefits of deep integration and increased trade in terms of productivity enhancement and growth hinges on the ability of countries to adjust their productive structures and allocate resources from affected industries to more productive ones. Jaramillo et al. (2006) argued that the impact of CAFTA-DR would be unambiguously positive if the economies were able to change its structure and re-allocate resources to more competitive sectors. In addition, compensation for those who bear the costs of adjustment would ensure that gains from trade are well distributed. Flexibility in labor markets is essential to ensure that the adjustment is smooth and workers can be reallocated efficiently into productive sectors. Early evidence shows a limited impact of CAFTA-DR on employment outcomes, suggesting that the labor markets in member countries are not responding to incentives of trade due to the lack of flexibility in the labor market, lack of mobility from one activity to another, and the lack of retraining, among others (Bussolo et al. 2011). This calls for complementary reforms that allow for reallocation and flexibility in times of economic changes, such as training and reallocation programs. Further, compensation mechanisms and social safety nets for workers who lose their employment due to external competition will help alleviate the trade shock to adversely impacted households. In addition to providing the necessary infrastructure for labor mobility across sectors, improving access to credit, including microcredit, could also help in the transition process (Kose, Rebucci, and Schipke 2005). Furthermore, reform efforts should also focus on the rule of law, education, infrastructure, international financial integration, and the development of domestic financial markets (Calderón and Poggio 2011). Improving trade facilitation would enable tapping into the synergies of the region as a cluster and benefit from economies of scale, therefore further exploiting the growth potential of GVCs . A steady and concerted effort to reduce the time and cost of cross-border trade is particularly important in the world of GVCs. Inefficient borders and high uncertainty of import and export procedures are more costly when goods cross borders multiple times as part of a production chain. Firm-level analysis of Peru shows that trade facilitation provisions boost the export performance of GVC firms through efficiency enhancements at their own borders. Because GVC firms rely on the timely and reliable delivery of foreign inputs, their export competitiveness is enhanced when import procedures become more efficient. In addition, some trade facilitation commitments in DTAs are nondiscriminatory and generate positive spillover effects to GVC firms that import inputs from countries other than the DTA partner country (Lee, Rocha, and Ruta 2021). In particular, Guatemala, Honduras, and El Salvador would benefit from a single, harmonized, and digitalized border-crossing process for all intra-regional trade, which would promote the development of intra-regional value chain linkages. Improvements in trade facilitation can also provide opportunities for upgrading to higher-value segments along existing value chains.77 Trade facilitation remains critical to limit the negative impacts of the Covid-19 pandemic. Distribution of vaccines will require careful storage, handling and expedited delivery (i.e. simplified import, export, 77For Honduras, Guatemala, and El Salvador, examples include upgrading in coffee (to small-batch specialty coffee), cocoa (to niche bean-to-bar cocoa), tropical fruit (to ready-to-eat for sophisticated international markets), and apparel (to sustainable fashion), among others. Freshness, traceability, and time to market are key factors to be competitive in these niches, and countries would benefit from faster, cheaper, and digital border crossing procedures (World Bank XXXX). 78 and transit processes and procedures) to ensure that the unprecedented number of vaccine shipments remain viable through transport across borders. Diagnostic Countries in the CA3 region are characterized by a lack of diversification in international trade, both in terms of products and partner countries, restricting their participation in GVC and productivity gains. The region’s exports are highly concentrated in lower-value-added manufacturing products, particularly in textiles, and its product composition has not changed much over time. The region’s trading partners are also highly concentrated, with exports to the United States accounting for over half of total exports from Honduras, over 40 percent from El Salvador, and about a third from Guatemala in 2019. At the same time, over 30 percent of imports from the three countries come from the United States (Figure 23, Figure 26, and Figure 29). Despite the region’s geographic advantages, the intensity of international trade is generally low relative to countries with similar development levels. Using the total value of international trade as a share of GDP as a measure of openness to trade, Guatemala was the country with the lowest engagement in trade within the region in 2020, 41.8 percent, followed by El Salvador, with 69.4 percent. Honduras is an exception in the region, with an intensity of trade equal to 85.7 percent of its GDP.78 After the outbreak of Covid-19, international trade levels have dropped, halting demand for domestic exports and disrupting supply chains. The Covid-19 pandemic has demonstrated the risks associated with a high concentration of international trade with a single market, which increases the vulnerability to sudden demand shocks or policy changes within partner countries. Central America remains among one of the least integrated regions. On average, only about 17 percent of Central America’s total trade flows are intra-regional, compared, for instance, to above 51 percent and 68 percent in the East Asia and Pacific and Europe and Central Asia regions, respectively. Similarly, an IMF study79 finds that all Central American countries under-trade globally and regionally – El Salvador and Costa Rica under-trade globally, but have strong regional ties; Honduras and Guatemala under-trade globally and regionally. Intra-regional trade is essential for exploiting the benefits of GVCs, among other reasons, but it is stymied by high trade and transport costs, red tape, inefficient customs procedures, and infrastructural and logistical bottlenecks. Central America has much to gain by further leveraging existing RTAs to enhance regional integration and improve trade and investment outcomes. Central American countries are among those with a higher number of PTAs in the region, including with some of the major economies, such as the European Union and United States. However, there are gaps in terms of the content and depth of these agreements as well as implementation status. Given the wide availability of existing RTAs, both within and extra-regional, countries in the region can benefit significantly by ensuring that existing agreements and complementary policy agendas are well-implemented and achieve deep integration rather than signing new agreements.80 The Dominican Republic-Central America-United States Free Trade Agreement (CAFTA-DR), for example, has unexploited potential to further improve trade and economic performance. The agreement entered 78 Data from World Bank national accounts data, and OECD National Accounts data files. 79 Beaton, E. et. al. (2017); Trade Integration in Latin America: A Network Perspective; IMF WP/17/148. 80 Fontagne et al. (2021) find that deepening trade agreements would deliver larger gains than signing new agreements for countries in LAC. Gómez-Mera and Varela (2021) also argue that it is the depth and quality, not the quantity, of trade agreements that matters, showing that a greater number of RTAs is associated with lower FDI inflows in the Americas between 2001 and 2015, while depth is associated with higher investment inflows. 79 into force on a rolling basis: El Salvador, Honduras, Nicaragua, Guatemala and United States in 2006, the Dominican Republic in 2007, and Costa Rica in 2009. It includes 300 provisions across 19 policy areas, about 25 percent more than the average for LAC RTAs, making it one of the more comprehensive extra- regional RTAs along with NAFTA/USMCA (Figure 62). CAFTA-DR is particularly comprehensive in investment, services, public procurement, movement of capital, trade facilitation, and labor markets, while it tends to include less provisions on competition, anti-dumping, state-owned enterprises, IPR, and migration. Figure 62. Depth of Preferential Trade Agreements of Guatemala, Honduras, and El Salvador EU - Central America (2013) Canada - Honduras (2014) CAFTA-DR (2006) Panama - El Salvador (2003) Mexico - Central America (2012) Panama - Honduras (2009) Panama - Guatemala (2009) El Salvador - Honduras - Chine (2008) Chile - El Salvador (2002) Chile - Guatemala (2010) Guatemala - Chinese Taipei (2006) Chile - Honduras (2008) Colombia - Northern Triangle (2009) Dominican Republic - Central A (2001) Central American Common Market (1961) LAC PTAs El Salvador-Cuba (2012) (average) NAFTA MERCOSUR Pacific Alliance 0 50 100 150 200 250 300 350 400 450 Number of provisions Source: Own elaboration based on World Bank Deep Trade Agreements database (Mattoo, Rocha, and Ruta 2020) Note: Agreements’ total number of provisions used as a proxy for depth. CAFTA-DR fell short on generating the expected benefits in terms of trade flows and investment. The agreement was not only conceived as an FTA with the U.S., but also among the Central American countries and the Dominican Republic to promote intra-regional trade. However, trade flows between member states of CAFTA-DR did not see a sharp increase after the agreement’s entry into force. Although trade barriers in Central America are lower than other LAC sub-regions, intra-regional trade is still behind other sub-regions in the world such as East Asia and the Pacific and Europe and Central Asia (Ulku and Zaourak 2021a). Furthermore, CAFTA-DR was expected to attract multinational corporations seeking duty-free access to the U.S. market, similar to the experience of NAFTA and Mexico, where FDI inflows increased as the agreement was perceived as a commitment device for liberalization and a reform program. However, foreign investment has not had the expected behavior in most Central American countries.81 The region has had limited progress in improving enforcement and implementing complementary reforms, therefore restricting the benefits from trade agreements. For countries to maximize the gains from CAFTA-DR and other deep trade agreements, proper implementation and complementary 81 Costa Rica has been relatively successful in attracting new FDI since the CAFTA-DR, and the sectoral composition of foreign investment also changed considerably. FDI in the service sector, which represented only 2 percent of total inflows before 2004, increased to 18 percent of total FDI by 2009, and then further to 39 percent in 2012 after ratification and the liberalization of telecommunications and insurance sectors (Koehler-Geib and Sanchez 2015). The impact was prominent in two sectors where Costa Rica has been able to grow and export: High-tech and pharmaceutical. The share of medical devices and business services has been on an impressive upward path after CAFTA-DR came into effect (Ulku 2015). Surveys and interviews suggest that CAFTA- DR was an important factor in the investment decisions of many firms, which reinforced the government’s commitment to liberalize trade and adopt FDI-friendly policies (Thorbum 2015). 80 structural reforms are critical. The negotiation of CAFTA-DR pioneered the concept of a “complementary agendaâ€? to RTAs and reforms in infrastructure, labor mobility, and trade facilitation were identified as key complementary agenda for CAFTA-DR member countries to minimize frictions and adjustment costs (Jaramillo et al. 2006; Lopez and Shankar 2011). However, infrastructure, institutions and governance indicators remain weak for Guatemala, Honduras, and El Salvador, undermining competitiveness (Figure 61). In addition, labor markets tend to be rigid with limited social safety nets. Exports and imports processes and logistics tend to be costly and time-consuming in the region, implying large potential gains from trade facilitation. While El Salvador, Guatemala and Honduras perform well in some areas, such as advance rulings and appeal procedures, large gaps with advanced economies (OECD) remain in other areas, such as border agency cooperation and automation (Figure 63, panel a). Logistics in infrastructure and customs also lag behind the average of LAC, and well-behind that of OECD countries (Figure 63, panel b). Regional collaboration to decrease trade and transport costs within Central America, as well as between the subregion and Mexico, could lead to substantial gains for all Central American countries. Results from a recent growth study (Ulku and Zaourak 2021a) indicate that a full implementation of TFA commitments could reduce trade costs by 15.5 percent in Central America, increasing intra-regional trade by 61 percent and the subregion’s GDP by 4.3 percent by 2030. In addition, extending the implementation of the WTO TFA to Mexico would increase trade between Central America and Mexico by 130 percent and Central America’s GDP by 6.7 percent by 2030. A 10 percent decline in intra-regional transport costs could boost intra-regional trade by 5 percent and the subregion’s GDP by 0.3 percent by 2030. Extending the reduction in transport cost between Central America and Mexico would further increase the subregion’s GDP by 0.4 percent by 2030. Figure 63. Trade Facilitation in El Salvador, Guatemala, and Honduras a. Average Index (2019) OECD Trade Facilitation b. Logistics Performance Index (2018) Overall LPI Trade score Facilitation… 150.0 Governance 2.0 Information Overall LPI Timeliness & impartiality availability 100.0 rank 1.5 Ext. border Involvement agency 1.0 of trade 50.0 cooperation community 0.5 Tracking and Int. border 0.0 Customs Advance tracing agency 0.0 rulings cooperation Logistics Appeal Procedures quality and Infrastructure procedures competence Fees & International Automation charges shipments Documents OECD El Salvador Guatemala OECD El Salvador Guatemala Honduras LAC Honduras LAC Source: OECD Trade Facilitation Index and Logistics Performance Index. The low intensity of intra-regional trade, high concentration in a few exported products of low value- added and the significant transportation costs suggest large potential gains from improving trade-related infrastructure, diversifying products and trade partners, and strategic repositioning into higher GVCs. 81 Available finance, infrastructure and investment Financial frictions hinder productivity growth by preventing the growth of productive firms and distorting selection. At the firm level, financial markets enable entrepreneurs to collect enough capital to start their own business, but also allows the expansion of successful businesses (Aghion, Fally, and Scarpetta 2007) by increasing the quantity of production inputs, and to engage in productivity-enhancing investments and R&D. The presence of financial constraints prevents an efficient resource allocation by affecting the evolution of the firm size distribution (Cabral and Mata 2003) and distorting the selection of firms, given the distribution of entrepreneurial ability (Buera, Kaboski, and Shin 2011). These effects are more pronounced in industries with higher capital intensity. FDI contributes to aggregate productivity growth through technology transfer and increased competition, while remittances promote capital accumulation but have limited effects on productivity. An important source of investment for any country consists in the process of foreign firms’ expansion into local markets. FDI directly increases firm-level productivity through spillovers: domestic firms benefit from the technology transfer induced by the presence of foreign firms, and by the knowledge transmitted by workers as they relocate from foreign to domestic firms (Isaksson 2007; Keller and Yeaple 2009). Input linkages can also provide firms with better and cheaper inputs, resulting in within-firm productivity growth even in sectors that are not directly participating in FDI (Fernandes and Paunov 2012). Besides generating direct efficiency gains, FDI also induces resource reallocation since the new players in the market and technology diffusion promotes a more intense level of competition. However, it is important to note that aggregate productivity gains might not be attained in the presence of certain market conditions such as low competition levels or barriers in technology access, or that productivity increases might be heterogeneous on firm characteristics (Aitken and Harrison 1999). On the other hand, remittances, monetary transfers sent from individuals residing abroad, do not have any direct impact on firm-level productivity (Senbeta 2013), since these resources are mostly used by households to complement consumption (Zarate-Hoyos 2004). Despite this limited role, remittances can still positively impact aggregate productivity by enhancing investment and supporting consumption (León-Ledesma and Piracha 2004). Investments in infrastructure are positively related to productivity growth. Investments in infrastructure impact economic growth both by increasing the amount of resources and by incrementing the productivity of existing resources (Munnell 1992). For example, the provision of reliable electrical infrastructure allows firms to use machines to automate production and adopt digital technologies. Infrastructure also promotes integration across the country and reduces transportation and trade costs, expanding the number of trade partners and increasing international competitiveness. These productivity gains foment firm expansion and private sector investments. The increased competition, firm growth and trade intensification resulting from investments in infrastructure also lead to productivity gains through resource reallocation and dynamic selection, operating through the mechanisms described in Annex 2. Diagnostic Financial development in CA3 countries is limited and presents a critical constraint to growth, particularly in Guatemala. Access to finance in the region is limited due to restrictive credit conditions such as high interest rates and collateral constraints. These financial frictions disproportionately affect small and medium enterprises (SMEs). Even in El Salvador and Honduras, where access to credit for businesses is moderate, credit for small firms is disproportionately low. In 2020, Honduras had the highest financial depth in the CA3 region, measured as the amount of domestic credit to the private sector as a 82 percentage of GDP, equal to 69.7 percent, followed by El Salvador with 62.1 percent.82 These values are above the average for LAC, which is equal to 59.7 percent, but below that for Europe and Central Asia (96.1 percent). However, financial depth is a serious constraint in Guatemala, where credit to the private sector only reaches 35.9 percent of GDP. The importance of well-functioning financial markets was accentuated by the Covid-19 pandemic, which has deteriorated firms’ cash flow and increased liquidity needs. Since the outbreak of Covid-19, firms’ financial risk has deteriorated, mainly due to a swift reduction in sales. Even with the adverse effects of the pandemic raising firms’ liquidity needs, the average magnitude of outstanding liabilities as a share of 2019 annual sales have remained fairly constant. One possibility is that this result arises due to financial frictions, and disrupted credit access did not allow firms to borrow resources to cope with the shortage in sales during the first few months after the shock. Another possibility, however, is that firms did not resort to credit markets to cover their financing needs because of the substantial uncertainty regarding the economic environment, including the duration of the crisis and response policies to be provided by the public sector, all which directly influence their capacity for repaying these loans. Technology transfer in the region is slowed down by a moderate flow on FDI in the region, while low and decreasing public investment fail to provide the infrastructure and economic integration to promote productivity growth. From 2010 to 2019, annual FDI as a share of GDP has been, on average, 1.5 percent for El Salvador, 2.0 percent for Guatemala and 5.6 percent for Honduras.83 Public investment has been low and decreasing in El Salvador and Guatemala. The fiscal pressure brought by the Covid-19 crisis and the support policies adopted by the national governments will reduce space for intensifying public investment in the next few years. Despite a significant inflow of cash transfers to the countries in the CA3 region, these resources are mostly used privately by households as a poverty alleviation tool, instead of promoting investment, entrepreneurship, and other productivity-enhancing processes. A large share of nationals from the three countries migrate to other countries in search of improved living conditions, a majority to the Unites States.84 As a consequence, remittances - monetary transfers sent from abroad - make up a significant source of revenue for resident families in the region, and comprise a large share of GDP in all three countries.85 In 2020, remittances made up 24.1 percent of GDP in El Salvador, 23.4 percent in Honduras and 14.7 percent in Guatemala. 86 However, these resources are mostly used to complement family income, and are not reinvested into the economy through entrepreneurship and the expansion of existing businesses. Since the outbreak of Covid-19, these monetary flows have been an important crisis relief to households and a complement to cash transfer programs implemented by local governments . In 2021, the flow of remittances to Latin American countries surged to a historic high, reflecting the continuation of the pandemic but also an increase in the number of migrants to other countries, in particular to the United States. Considering the magnitude of remittances as a percentage of GDP, El Salvador and Honduras are 82 Data from the International Monetary Fund, International Financial Statistics and data files, and World Bank and OECD GDP estimates. 83 Data from the International Monetary Fund, International Financial Statistics and Balance of Payments databases, World Bank, International Debt Statistics, and World Bank and OECD GDP estimates. 84 In 2013, the fraction of citizens living outside of their home country was 20 percent for El Salvador, 6 percent for Guatemala and 8 percent for Honduras (Sousa and García-Suaza 2018). 85 Although the already large and increasing fraction of emigrants results in large monetary flows to the countries, they affect the supply of human capital in the region and harm growth and development. 86 Data from the World Bank Open Data Portal. Statistics are World Bank staff estimates based on IMF balance of payments data, and World Bank and OECD GDP estimates. 83 the largest recipients in LAC. Remittances account to 26.6 percent and 26.2 percent of GDP, respectively, amounting to over US$ 7 billion in each of these countries. Guatemala is not far behind, as the fourth largest in the region with transfers accounting for 18.0 percent of GDP.87 A labor market that supports business dynamism Stringent labor market regulation increases production costs and limits firms’ adjustment capacity, with consequences over resource reallocation and selection. Labor market regulations influence within-firm productivity by altering the total cost associated with labor inputs. In addition to affecting firms directly, inflexible regulations alter workers’ incentives and can increase labor informality. On the perspective of allocation efficiency, excessive regulation makes labor adjustment costly and reduces firm responsiveness (Haltiwanger, Scarpetta, and Schweiger 2014), contributing to misallocation and undermining the process of creative destruction (Caballero et al. 2013). Reducing rigidities in the labor market is also critical in the context of regional integration and trade. Flexible labor markets that facilitate the reallocation of labor can assist workers and households in the transition process. Trade liberalization entails a reallocation of workers to more productive sectors and firms, and this can incur adjustment costs. Regional integration and GVC participation can also increase the demand for certain skills where specialization occurs while decreasing demand in others. Flexibility in labor market regulations can help this structural transformation occur smoothly while minimizing adjustment costs. Diagnostic Low levels of human capital contribute to the stagnation of aggregate productivity, resulting from a combination of low public spending in education, low years of schooling, insufficient learning, and youth gang participation. Human capital is a major bottleneck for growth in all countries located in the CA3 region (Ulku and Zaourak 2021b). The poor educational outcomes of the region are explained by a combination of low public spending in education, low enrollment rates and years of schooling. Additionally, mass emigration has resulted in a brain drain process, further diminishing the stock of human capital. The average number of schooling years is equal to 6 in all CA3 countries, and the overall level of skill in the workforce is relatively low. From 141 countries evaluated by the Global Competitiveness Report (GCR) in 2019, Guatemala was ranked 103rd, Honduras was 108th, and El Salvador had the lowest skill levels, ranking 112th. Access to education and enrollment rates are a necessary but not sufficient condition for improving educational outcomes. The quality of education is a fundamental condition for boosting human capital and creating the skills that are needed in the labor market. A significant share of firms considers that finding workers with the suitable skill levels is a major constraint for operations - 26 percent in El Salvador, 32.5 percent in Guatemala and 35 percent in Honduras.88 More importantly, human capital is a necessary complementary factor for innovation and technology adoption. Intense labor regulation in the CA3 region increases hiring costs and discourages both firm growth and formal employment, hindering productivity growth. In 2017, informal workers accounted for 70.2 percent of employment in El Salvador, 80.1 percent in Guatemala and 82.6 percent in Honduras (Elgin et al. 2021). Rigid labor regulations, along with high minimum wages and tax-wedges discourage formal employment and partly explains the extensive informal sector in the region. Another obstacle to development and growth in the region is the low female participation in the workforce, which was already 87 Estimates for 2021 from (Ratha et al. 2021). 88 World Bank Enterprise Surveys (2016). 84 significant before the pandemic. In 2019, the fraction of women in the labor force was equal to 45.3 percent in El Salvador, 40.5 percent in Guatemala and 52.2 percent in Honduras.89 This low participation is largely driven by social norms and the lack of a support system for parents. Following the Covid-19 pandemic, layoffs and other employment adjustments, such as the reduced hours worked and wages, have more intensively affected vulnerable workers: women, less educated and workers in the informal sector. Following the outbreak of Covid-19 and the associated mobility restrictions, a significant share of firms halted operation throughout the CA3 countries. An additional concern for the region is that there is evidence that women, less educated workers, and workers in occupations not adaptable to remote working conditions have been more adversely affected by labor adjustment measures following the pandemic (Adams-Prassl et al. 2020), groups which were already more vulnerable prior to the shock. In fact, we observe a sharp drop of three percentage points in female participation in the labor force from 2019 to 2020 in all CA3 countries. Governments should also be alert on the specific negative impacts of the pandemic on informal workers, as it has been shown that informal workers have been immensely exposed to unemployment and job loss (Kesar et al. 2021). The importance of innovation, entrepreneurs and technology for productivity growth Entrepreneurship promotes productivity growth by fostering competition and selection through increased business dynamism and knowledge spillovers. Entrepreneurs stimulate competition and introduce a variety of new business ideas. Over time, firms with successful ideas survive, grow, and aggregate productivity increases as these more productive new establishments replace less productive ones (Foster, Haltiwanger, and Krizan 2006). Another positive effect of entrepreneurship is that it raises average firm productivity through the transfer of ideas and knowledge externalities (D. B. Audretsch and Keilbach 2004). Newborn firms also contribute to within-firm productivity growth as they can more easily adopt state-of-the-art technology and invest in modern capital goods at the time of their creation. In this sense, entrepreneurship has indirect effects on productivity growth through advancements in innovation. Good entrepreneurs tend to be more innovative, and innovation and technology adoption boost production efficiency and encourage competition. Innovation can take place through products, such as the invention of a brand new or improved product, or through processes that increase production efficiency, e.g. by adopting digital technologies. Since this is a rather abstract concept, empirical studies usually focus on measures of inputs to innovation, such as expenditure in R&D, or outputs from innovation activities, such as patents. A direct consequence of innovation, especially in the digitalization and adoption of information technology, is the increase of within-firm productivity by allowing firms to increase output given a set of inputs. This can be achieved by process automation, better organization of inputs into production, improving management decision-making, or even by facilitating the dispersion of information and best practices across production units (Syverson 2011). Innovation also induces reallocation by way of the growth of innovative firms following innovation, as they increase market participation. 90 Digitalization is also an important driver of reallocation, enabling firms to expand by advertising to new potential consumers and accessing new markets through online sales platforms. Lastly, as the components to productivity growth are tightly linked, the resulting resource reallocation intensifies market competition and sharpens dynamic selection. 89 Data from the World Bank’s World Development Indicators, computed from International Labor Organization’s ILOSTAT database. 90 Foster et al. (2018) demonstrate that periods of intense innovation may be shortly followed by an experimentation phase in which productivity dispersion increases, but subsequently decreases as competition and reallocation favor successful innovative firms, leading to aggregate productivity growth. 85 Human capital and management practices are also an important component of firm-level efficiency, and they play a vital role in resource reallocation by enabling firm growth. A firm’s level of human capital, given by the education, skills and experience of its workers, directly affects within-firm productivity by increasing the efficiency of labor (Black and Lynch 1996). Likewise, human capital affects a firm’s ability to carry out innovation (Romer 1990) and to implement new technologies, since skills are required to operate them. At the same time, managerial capital, the knowledge and abilities that determine management practices, is used to efficiently organize and allocate inputs into production, to identify growth opportunities and to improve strategic and operational decisions. More recently, data availability has produced a comprehensive set of evidence that managerial practices are positively associated with firm-level productivity by increasing the efficiency and quality with which output is produced (Bruhn, Karlan, and Schoar 2018; Nicholas Bloom et al. 2013; Nicholas Bloom and Van Reenen 2010). Additionally, these studies show that the lack of managerial capital is a binding constraint to firm growth, distorting the relationship between firm productivity and size. In this context, overall improvements in management practices allow the most efficient firms to grow and results in aggregate productivity gains (Akcigit, Alp, and Peters 2021). Diagnostic Entrepreneurship is a key factor in CA3 to create better jobs, generate competition and incentives for innovation. However, the region faces an important shortage of entrepreneurs. Entrepreneurship activity relies on the local environment providing the needed resources for starting, expanding and upgrading businesses. For example, a successful business requires adequate access to production inputs, including labor, human capital and entrepreneurial skills, access to capital and production technology, financial instruments, a consumer market, and institutions that facilitate the creation, production, marketing, selling, and knowledge diffusion processes (D. Audretsch, Cruz, and Torres 2020). CA3 countries face large gaps in these pillars for entrepreneurship ecosystems, especially in access to finance, inadequate physical infrastructure, lack of managerial capabilities, and burdensome regulations (Cruz and Torres 2020). As a result, entrepreneurship in the region is characterized by a low level of dynamism, limited capabilities to scale up, and significant lags in technology adoption. Cruz and Torres (2020) describe that entry rates for El Salvador, Guatemala and Honduras are low relative to Latin America and other countries with a comparable level of income. Firm growth over the life cycle is also low: older firms are relatively small and present low innovation levels, suggesting binding restrictions for firm operations and growth. Innovation capabilities are very low in the region. Expenditure in R&D throughout the region is low and has been declining over the last few years. The percentage of GDP directed at R&D was equal to 0.16 percent in El Salvador (2018), while in Guatemala and Honduras it accounted for less than 0.1 percent of GDP. When designing and implementing public policies to foster research and digitalization, it is important to take into account that poor innovation outcomes are partly associated with demand-side restrictions, such as lack of digital skills or low educational outcomes in the labor force. One possible determinant behind low R&D, product development and technology adoption is the lack of qualified employment to engage in these activities, or managers that identify high-return potential projects, engage in the long- term planning required for their gestation, and then recruit, train, and motivate the talent to implement them (Cirera and Maloney 2017). Low innovation, even if incremental, reduces the capacity of increasing the within component of productivity growth. The CA3 is characterized by low levels of digital technology adoption. Many firms still face challenges with the availability of general-purpose technology and access to adequate infrastructure, such as reliable electricity. Data from 2019 shows that, in Honduras, only 75 percent of the population had access to 86 electricity, while in El Salvador and Guatemala this figure exceeds 90 percent.91 Low connectivity is a relevant bottleneck for the adoption of digital technologies in Guatemala. In all countries within the region, the quantity of mobile-broadband subscriptions is significantly higher than fixed-broadband internet subscriptions. Digital solutions to current burdensome regulations, for example the availability of e- government services, would also improve the business environment, promote entrepreneurship and increase firm efficiency. The regulatory framework of the region has not yet been adapted to a context of digital economies: fintechs, electronic invoices, consumer protection, cybersecurity, data protection, and other regulations.92 The mobility restrictions imposed by the Covid-19 pandemic induced digitalization among firms, but the average intensity of digitalization is still low. Businesses adapted to the impossibility of being fully operational and the limits to personal interactions by selling their products through online platforms, implementing delivery logistics, expanding their market base through online marketing campaigns, adapting to remote work and using communication software. Over three-quarters of businesses in the region have also changed the composition of products and services offered, responding to supply and demand shifts. Increased demand for these digital needs has also provided business opportunities for services trade using digital technology. Nevertheless, for the vast majority of firms, either sales are only performed in person, or online channels represent only a small fraction of total sales. Even though the Covid-19 crisis triggered the use of digital platforms, its scope could be limited by the demand for these technologies, as they rely on skills and specific abilities to operate them. Since March 2020, the uptake of digital technologies was higher in larger firms and among businesses that already previously used some form of digital technology. This suggests some persistence in technology adoption and that the technology gap may be widening in these countries. Governments in the region should target reducing this digital gap, given the change in willingness to adopt digital solutions that the pandemic has brought. 91 World Economic Forum’s Global Competitiveness Report (2019). 92 Local entrepreneurship ecosystems in Central America: Challenges and opportunities of digital technologies (2020). 87 Table 2: Policy areas and channels of impact to productivity growth Policy areas Within-firm Between-firm Selection Distorts competition through lower Informality drives down average Informality and Distorts firm-level decisions, crowds costs by informal firms. Corruption productivity, corruption and crime divert business environment out public investment will provide advantages for arbitrary productive resources from production. firms and industries. Allows firms with new ideas to enter the Allows firms with new ideas to enter Entrepreneurship market and compete with incumbents. Entrepreneurship the market and compete with Knowledge spillovers. incumbents. Knowledge spillovers. Adoption of new technologies, Growth of innovative firms. Access Innovation and Increased competition and creative innovative products of production to new markets, expansion of technology adoption destruction. processes. consumer base through digital platforms. Increased human capital, workers’ skills Managerial capital enables growth Creative destruction resulting from Education and skills and managerial capabilities. of productive firms. resource reallocation. Creative destruction resulting from Labor regulations distort firms’ Labor market Decreases the cost of labor. resource reallocation. input decisions. Allows productive firms to survive Improves the allocation efficiency of Promotes investment in capital, R&D, and foment the process of creative Financial markets capital and entrepreneurial talent and technology adoption. destruction. across firms FDI promotes technology trans Increased competition and Investment and remittances Increased competition. fer and knowledge spillovers. creative destruction. Increases incentives for innovation and Drives unproductive firms out of Competition Induces growth of productive firms. improvements in efficiency. the market. Technology adoption, access to Increased competition in local Increased competition and Trade cheaper and higher-quality production markets, exporters’ expansion into creative destruction. inputs. foreign markets. Increase productivity of production Facilitate firm expansion and Increased competition and Infrastructure inputs. competition. creative destruction. 88 A comprehensive reform agenda to unleash sustainable growth This section provides policy recommendations addressing both the immediate needs associated with the Covid-19 shock, but also recovering the structural issues described in the previous section. In the short run, the focus of the region should be in recovery programs that are effective, sustainable and inclusive. For that to happen, recovery policies need to go accompanied of more ambitious structural reforms. These more short-term recovery policies are a direct response to the problems caused by the pandemic that require a faster implementation to unleash the growth of a fragile private sector. An effective and sustainable recovery requires a combination of both short-term recovery measures and structural reforms. In the short run, the focus of the region should be in effective recovery programs that address the immediate needs related to the Covid-19 shocks. For these recovery measures to lead to a robust recovery and sustained and inclusive growth, they need to be accompanied with more ambitious structural reforms, focusing on the structural issues identified in the previous section. This section provides a comprehensive agenda of reform based on the priority areas discussed in the previous section. It presents concrete actions that can be adopted to address these proposed reforms, tailored to the specific context of each country. We distinguish between priority measures in the short- term, considering a one-year horizon, and policies with implementation taking place in the medium- and long-run. Policy measures that require a short period of time for implementation and address the immediate needs from the Covid-19 shock are included in short-term policies. Long-term measures focus on the structural issues mapped for the region and necessary reforms for sustainable growth, income catch up, and regional integration.93 Enabling environment and competition A strong macroeconomic framework requires fiscal policy consistent with stabilizing debt dynamics while pursuing essential development objectives such as improving human capital, reducing informality and enhancing productivity. Public finances have been hard hit by pandemic, as governments needed to expand spending while revenues plummeted, as highlighted in Chapter II. Therefore, the CA3 countries are undergoing fiscal consolidation efforts to stabilize debt and reduce its burden. 94 Scaling back on emergency spending has helped reduce the deficit in 2021, but further spending reduction should be carefully designed to avoid reversing any necessary expansion of social programs and safety nets. In a region where public goods are scarce, expenditure reduction may have adverse impacts on social indicators and hinder the improvement of much needed public infrastructure. 95 In this regard, efforts should focus on reducing spending inefficiencies and increasing revenue by deepening tax administration improvements. 96 Furthermore, expanding the tax base should be a regional objective, since large informality in the CA region not only affects tax collections but also productivity. In addition, public infrastructure also requires additional resources and access to credit, which depends on sound fiscal frameworks. 93 The compilation of the suggested reforms included in this section were collected from various studies produced by the World Bank in recent years providing a detailed overview of Central America and specific policy recommendations (Ulku and Zaourak 2021b; World Bank 2021a; 2021b; Cruz and Torres 2020). 94 Debt sustainability is particularly worrisome in El Salvador, where Debt-to-GDP ratio surpassed 90 percent and has currently the highest Emerging Market Bond Index (EMBI) spread in the region. 95 In the case of Guatemala, social spending was expanded during the pandemic to a population which had never been reached before, which will continue to need support. 96 A forthcoming World Bank Public Expenditure Review for Honduras provides and in-depth analysis and recommendations on fiscal measures. World Bank (2022, forthcoming). Honduras Public Expenditure Review: Strengthening Fiscal Resilience. 89 Policies should strive to increase the predictability of the business environment and reduce the cost of regulation for businesses in all industries. In the short run, essential initiatives to be undertaken include the simplification of regulations for firm entry, operation and exit, and strengthening the insolvency framework. Reforms in these areas would facilitate firm adjustment in the context of the pandemic, allowing faster firm recovery and easing resource reallocation across firms. These actions should be accompanied by longer-term policies tackling structural issues in the business environment, such as strengthening contract enforcement and the competition framework, promoting alternative dispute resolution mechanisms within and outside the judiciary, and simplifying processes for obtaining licenses and permits, including in construction. Designing and implementing a regulatory governance framework would also benefit firms by reducing unpredictability in the business environment, promoting the adoption of digital platforms and solutions for public services, and would reduce bureaucracy and facilitate administrative procedures. Lastly, property rights issues in the region, especially dealing with land registration, could be dealt with by improving property registration procedures and strengthening the quality of the land administration system. Competition within domestic markets can be intensified with solid anticompetitive regulation and effective competition authority. Countries can foster competition by taking direct actions, implementing competition law to regulate anticompetitive practices, as well as designating and enabling a competition agency to ensure effective implementation of the law. These reforms are especially important in the context of Guatemala, which lacks a clear competition policy, a competition authority, and a merger control regime, which result in anticompetitive behavior in various sectors (World Bank 2021a). Competition can also be fostered indirectly with other measures that improve the business environment, encourage firm entry, simplify burdensome regulation, and democratize access to credit, allowing the growth of productive firms and intensifying dynamic selection. Short-term policy recommendations â?– Streamline key regulatory processes for business entry, operation, and exit, e.g. by adding online processes and payments to MiEmpresa.gob.sv (SLV). â?– Implement the electronic signature and the e-Commerce Law (SLV). â?– Pass an insolvency law (SLV). â?– Simplify procedures for sanitary registration and import permits of controlled goods, following regional best practices (SLV). â?– Streamline key regulatory processes for business entry, operation, and exit. E.g., by approving the Law on Simplification of Requirements and Administrative Red Tape; fully implementing “Minegocio.gtâ€?; and improving the “Agile Windowâ€? for construction permits (GTM). â?– Implement the Law on the Recognition of Communications and Electronic Signatures in G2B and G2C public services, and speed up the G2B and G2C digitalization process, focusing on high volume, high frequency, and high impact procedures. At the same time, based on Article 23 of the Law for the Simplification of Procedures and Administrative Requirements, promote systems that allow the completion of procedures and issuance of resolutions by electronic means (GTM). â?– Deepen tax administration measures and generalize the use of electronic invoicing to reduce tax evasion (GTM) â?– Resume and sustain the compliance with the Fiscal Responsibility Law by 2023, including through further advancements in revenue mobilization and spending controls, prioritization and rightsizing (e.g. wage bill), while advancing electricity sector reforms and strengthening the response to climate-induced natural disasters (HND) 90 â?– Improve the quality and efficiency of public expenditures, especially in procurement, wage bill, and targeted transfers. Conduct spending efficiency review to identify ways to rationalize and increase the effectiveness and efficiency of public spending. (HND) â?– Increase tax revenue by increasing excise taxes on goods with negative externalities and aligning the VAT rate with LAC and regional averages; also introducing a surcharge on CIT for large companies and introduce taxes on capital gains and streaming services. (SLV) â?– Streamline spending by realigning the wage bill to make public sector wages consistent with private sector comparators, eliminating indexation rules. In addition, improve targeting subsidies— particularly on fossil fuels— and centralizing purchases of goods and large investment projects (SLV). Long-term policy recommendations â?– Implement the regulatory improvement agenda and its legal framework across all agencies and levels (including municipal) (SLV). â?– Implement the digital agenda to facilitate G2C, G2B, B2B, and B2C transactions (legal and regulatory foundation, processes, promotion, etc.) (SLV). â?– Increase public consultations and private sector involvement in regulatory policy formulation and implementation (SLV). â?– Strengthen contract enforcement and promote alternative dispute resolution mechanisms (SLV, GTM). â?– Improve the contractual environment by strengthening contract enforcement and promoting alternative dispute resolution mechanisms. Likewise, increase the protection of minority investors by modifying the Commercial Code to increase the rights of shareholders (GTM). â?– Design and implement a regulatory governance framework, e.g., by designing a law on regulatory improvement with establishing formal participation of the social and productive sectors in the design of regulations (GTM). â?– Enact and implement a competition law to regulate anti-competitive practices (e.g., monopolies and cartels), supervise mergers and acquisitions, and eliminate entry barriers in the Guatemalan market. Amend the draft Competition bill (initiative 5074), so that it is consistent with the development and competitiveness of the Guatemalan economy, especially in international markets (GTM). â?– Amend current laws on issues related to e-Commerce and enact laws on data protection and cybercrime (GTM). â?– Revise intellectual property regulations and systems to effectively support the digital industry. â?– Promote the adoption of financial regulatory sandboxes or pilot schemes that allow for financial innovation while maintaining stability of banking systems. Develop competitive schemes that promote electronic payments, digital wallets, insurance, and models of person-to-person lending (P2P) and crowdfunding, among other innovations. â?– Strengthen domestic revenue mobilization by aligning VAT and income tax rates ot ist regional peers and expanding the tax bases reducing informality, in order to increase state capacity and expand the provision of public goods (GTM) â?– Restore market confidence to reduce bond spreads and restore debt sustainability, which will enable to decrease debt burden and debt service to reallocate resources into development priorities (SLV) â?– Modernize the Public Financial Management framework by strengthening the execution control and quality of spending; and improve the design and implementation of the Medium-Term Fiscal Framework, and make it public in addition to develop a Medium Term Expenditure Framework (SLV). 91 International trade and regional integration A key reform area for Central American countries to better integrate into regional and global supply chains is to improve trade facilitation and connectivity, which would reduce the time and cost of cross- border trade. Actions to recover domestic sectors from disruptions in international trade should include simplifying procedures for registration and permits, streamlining and digitalizing border control agencies trade procedures. Governments should also identify and implement specific short-term measures to stimulate the recovery of impacted industries, for example introducing digital solutions to licensing, registration and payments in the tourism sector. These measures should be supplemented by an active effort to promote regional integration within CA3 and Central America, coordinating import and export procedures and facilitating international trade. CA3 countries should also leverage regional trade agreements to include and implement essential provisions, including those in trade facilitation, services, competition, and intellectual property rights. However, the benefits of such commitments are not easily earned and require significant investment of time and resources as well as coordinating efforts between relevant agents for a successful implementation. A robust governance framework can drive the reform process to enhance implementation and ensure participation of all relevant agencies, including the private sector. Deep RTAs also reduce the uncertainty that exporters face by enhancing the transparency of rules and regulations. Trade policy, regulatory measures and other relevant information should be made public and easily accessible, including through electronic publication. For CA3 countries, enhancing security at the border by tackling violence, corruption, drug-trafficking and money laundering is critical. Ports in Guatemala, Honduras, and El Salvador have long been vulnerable to organized crime, drug trafficking and corruption within the custom authorities. Corruption in customs disincentivizes foreign investors and is detrimental for GVCs, for which smooth import of inputs and export of goods are critical. Central American countries are also vulnerable to high levels of illicit financial flows, such as trade-based money laundering which uses international trade transactions to transfer value and obscure the origins of illicit proceeds. To strengthen legitimate and transparent trade, it is critical for countries to address security vulnerabilities. For example, governments could increase law enforcement efforts and provide more funding and training for port security. Upgrading the legal framework, simplification and automation of border processes can also help reduce corruption in customs. Laws and regulatory reforms should be supplemented by behavioral mechanisms that create appropriate incentives and address discrepancies between formal rules and entrenched informal practices (World Bank 2020). Countries should also implement policies to address vulnerabilities in trade and GVCs that were exposed during the Covid-19 pandemic, such as pursuing increased diversification and upgrading along value chains. El Salvador and Honduras saw a sharp contraction in trade at the early months of the pandemic, largely related to their high concentration of exports in textile and apparel industry. The pandemic and reduced demand lead to sudden cancellations of contracts by apparel buyers in major markets such as the United States and Europe.97 Measures to prevent such sudden cancellations in face of a crisis include those that help exporting firms deepen their integration into GVCs by upgrading becoming more valuable in the network and improving information on buyers available to exporters to help make better matches to firms with stronger corporate governments who are less likely to break 97 Apparel exporters in Bangladesh and Cambodia suffered from such sudden cancellation of contracts. 92 contracts during a crisis. Increased diversification, both in terms of products and trading partners, would also boost resilience to future shocks. Finally, a coordinated effort to refrain from the use of export bans and reduce or eliminate tariffs on essential products in a permanent basis would help the responses to future shocks. With the right policies in place, CA3 countries have a high potential for increased exports, GVC participation, and upgrading in their complexity and sophistication levels, leading to economic development. Income and job creation are boosted through the implementation of strategic repositioning toward more sophisticated segments of GVCs, facilitation of services trade, increasing value added of exported products with the coordination from public and private stakeholders. As discussed in the previous section, it is also essential to pursue complementary reforms that go beyond trade issues, such as strengthening institutions and the rule of law, improving physical and digital infrastructure, and reducing rigidities in the factor markets to facilitate the adjustment process and maximize the gains from trade and regional integration. Short-term policy recommendations â?– Assign entity responsible for coordinating value chain development within the government and with industry representatives (SLV). â?– Identify and implement short-term measures to stimulate recovery of selected sectors. For example, for tourism: Develop a “safe tourismâ€? certification program and help tourist facilities get certified (in light of Covid-19); Improve digitization and online presence of tourism businesses (given that travelers may require more information online, e.g., on health protocols, prior to a trip, as well as to conduct more transactions on- line prior to and during trips.) (SLV). â?– Accelerate the implementation of the Customs Integrated Modernization Plan to enhance post- clearance audits, controls, and allow faster clearance and release of goods (GTM). â?– Improve and digitalize cross border procedures of MAG, MSPAS, DIPAFRONT and other border control organisms, including sanitary and phytosanitary license management systems. Initiate implementation of the “Universal Window for Foreign Tradeâ€?, integrating the procedures of all the border control agencies. Reinforce and fully implement the integrated risk management system, with a fully electronic single window, and strengthen ICT and technical capacities of border control agencies. â?– Digitize border procedures and utilize innovative technologies. Improve the payment infrastructure to facilitate electronic transfers through the use of the shared regional payment system (Sistema de Interconexion de Pagos, SIPA). It is also crucial to reinforce and fully implement the integrated risk management system, with a fully electronic single window, and strengthen ICT and technical capacities of border control agencies. â?– Fully implement the customs union (deep integration) between Guatemala, Honduras, and El Salvador, and adopt measures that go beyond trade facilitation.98 Continue the implementation of the customs union, accelerating the adhesion of El Salvador to full operation, revising current procedures and adding other measures beyond the customs union. The expanded deep 98The Deep Integration Process between Guatemala and Honduras entered into force in July 2017, with the two countries creating a single territory and adopting a series of measures to facilitate and increase bilateral trade. The implementation of El Salvador's accession to the customs union, planned for 2022, will create a market of 33 million inhabitants, representing 63 percent of regional GDP and 72.4 percent of intraregional exports (calculated based on GDP data for 2020 from SIECA and WDI). As it has been several years since Guatemala and Honduras started the deep integration, it is essential to evaluate the results and make necessary corrections to the existing procedures. 93 integration will also promote regional value chains particularly if adopted measures go beyond trade facilitation, such as a single sanitary registry; coordinated innovation policies in strategic sectors; development of trinational clusters; regulatory convergence measures impacting the business climate; development of logistics corridors; implementation of regional flights in the single territory; and a joint plan to develop trinational physical infrastructure. â?– Enhance policy transparency. Establish notification requirements for central and local government bodies on trade-related regulations and subsidy programs, creating a central open access database or requiring an annual report on regulations. â?– To improve border security, increase law enforcement efforts and provide more funding and training for port security. Simplification and automation of border processes can also help reduce corruption in customs. â?– Simplify trade regimes for small-scale traders which can provide a first step towards more formal participation in trade. â?– Make coordinated efforts to refrain from the use of export bans and reduce or eliminate tariffs on essential products. Long-term policy recommendations â?– Fully implement the WTO Trade Facilitation Agreement (TFA).99 â?– Fully implement integrated risk management system for import/export; implement joint procedures with Guatemala and Honduras border control authorities (SLV). â?– Identify / validate key interventions for medium-term strategic repositioning of selected GVCs, including related to improving infrastructure, fostering human capital, enhancing the provision of sector-specific public goods, improving market access, and digitization (SLV). â?– Coordinate with public and private stakeholders to implement selected interventions (SLV). â?– Identify and validate key interventions for medium-term strategic development of selected GVCs and coordinate with public and private stakeholders to implement selected interventions (GTM). â?– Invest or incentivize investment in R&D to develop products and processes necessary to upgrade Guatemala’s participation in strategic value chains. For instance, invest in R&D for identification of fine cocoa aromas best adapted to terroir (cocoa), invest in R&D to develop new local fibers such as hemp or cactus (sustainable fashion), and offer technical assistance to local companies in the provision of more sophisticated BPO services (GTM). â?– Improve access to destination markets and attraction of FDI in the targeted segments (GTM). â?– Align sanitary and phytosanitary practices to international standards and streamline the application. For example, simplify procedures for sanitary registration and import permits of controlled goods using electronic notifications following regional best practices (e.g., Colombia and Mexico). â?– Leverage deep trade agreements to include and implement trade facilitation provisions and beyond. â?– Improve the region’s transport and border-crossing infrastructure. The modernization of border- crossing points, such as inspection facilitates and laboratories for agricultural and food products (phytosanitary analysis), cold storage warehouses, and high-performing fast track lanes, would 99The CA3 countries ratified the WTO TFA between 2016 and 2017, but are yet to fully implement all of the commitments. As of February 2022, Guatemala is committed to implement 98.3 percent of the provisions, Honduras 59.2 percent, and El Salvador 94.1 percent. The three countries are committed to implement 100 percent between 2024 and 2027. A recent analysis estimates that a full implementation of TFA commitments could reduce trade costs by 15.5 percent in Central America, increasing intra- regional trade by 61 percent and the subregion’s GDP by 4.3 percent by 2030 (Ulku and Zaourak 2021b). 94 increase the efficiency at the border. The development of regional corridors can reduce the cost of intra-regional trade and promote regional integration. â?– Increase trade diversification, both in terms of products and trade partners. Improve information to enhance matching between exporting firms and potential suppliers and buyers. Financial markets, investment and remittances Lifting restrictions to credit access, deepening financial inclusion and providing liquidity support for firms recovering from the economic crisis are essential for strengthening financial markets and maintaining productive capacities for sustainable growth. In the short run, governments should address the negative impacts of the crisis on business liquidity. Important measures include expanding the role of state-owned banks to address Covid-19 financing needs and designing programs that support liquidity in most affected firms and industries. Immediate action can also be taken to tackle one of the main structural problems regarding financial markets in the CA3, implementing policies that deepen financial inclusion. Solving structural issues in the region with focus on long-term economic growth requires a broader effort to strengthen the liquidity framework and financial sector instruments, rethink and redesign overly restrictive credit requirements, generally improve credit access to MSMEs, as well as to improve financial and credit infrastructure. The agenda for promoting investment in CA3 countries involve a set of strategies for attracting investment, foreign and domestic, and strengthening technology transfer to domestic firms. Immediate actions to boost recovery include improving the strategic framework for FDI attraction, defining priority sectors and goals, while taking into account the current state of the economy and the impacts of Covid- 19 on specific industries. Investment would also be significantly encouraged by simplifying the current regulatory framework, strengthening institutions and adopting increasing digital tools and platforms, and disseminating successful investor experience and feature the government’s response in light of the pandemic. In addition to these measures, a program should be kept to evaluate the effectiveness of current incentives, redesigning them when needed and adapting them to industries needs based on the recovery trajectory. Ultimately, the government should also ensure that, in the long-run, investments are being translated into competitiveness and innovation, and that these gains are overflowing to domestic firms. To create linkages between FDI and local businesses, it is essential that institutions are strengthened, contracts are enforced, labor force is mobile, and that specific programs target interaction between foreign and domestic firms. Short-term policy recommendations â?– Strengthen, capitalize and promote BANDESAL’s Fondo Salvadoreño de Garantías to mitigate the increasing credit risk associated with the pandemic (SLV). â?– Design public sector programs, administered by State Owned Financial Institutions, to expand liquidity through the financial sector (SLV). â?– Promote digitalization of transactions to distribute government assistance programs (subsidies - G2P) and facilitate payments (and consequently increase financial access) (SLV). â?– Review the legal framework for microfinance institutions and identify barriers to licensing for existing MFIs. Strengthen the ecosystem for electronic factoring (GTM). â?– Improve the strategic framework for FDI attraction, including clear objectives, targets, institutional roles, and priority sectors (taking into account the impacts of the Covid-10 crisis on sector viability/attractiveness). Assess the new InvestSV promotion strategy and its sectoral implications (SLV). 95 â?– Design and implement an inter-institutional coordination mechanism for investment promotion (SLV). â?– Increase capacity of the Exports and Investment Promotion Agency of El Salvador (PROESA) to provide key services to investors including aftercare and advocacy activities considering Covid- induced challenges) (SLV). â?– Revise pre Covid-19 approaches and develop a targeted FDI attraction strategy, aligned with “Proyecto Guatemala no se Detieneâ€?, aimed at encouraging investments in specific sectors and niches with a high potential for growth and jobs in the new post-Covid context, taking into account potential opportunities for nearshoring (GTM). â?– Conduct a detailed assessment of the regulatory environment for investments to identify investment constraints in key economic sectors (GTM). Long-term policy recommendations â?– Strengthen the Emergency Liquidity Assistance framework at Banco Central de Reserva (SLV). â?– Implement the National Financial Inclusion Policy (SLV). â?– Enact a Credit Bureau Law and an Insolvency Law with necessary implementing regulations. Build capacity to improve the insolvency system. The current bill for the Insolvency Law (initiative 5446) could be amended or replaced to align with international good practices (GTM). â?– Implement the Leasing Law and build capacity of the industry to develop and scale leasing products (GTM). â?– Enact a legal framework to enable market entry and growth of fintech firms, including e-money operators and crowdfunding platforms (GTM). â?– Improve the institutional sustainability, capitalization, and market outreach of the partial credit guarantee fund (GTM). â?– Strengthen the role of financial cooperatives in MSME finance by enacting a dedicated legal framework and secondary legislation to establish prudential and market conduct supervision of financial cooperatives by SIB and encouraging integration and modernization within the sector (GTM). â?– In alignment with currently implemented efforts, evaluate the effectiveness of existing incentives via cost-benefit analyses and qualitative assessments. Redesign and/or replace with lower fiscal cost instruments if necessary (including non-fiscal incentives) (SLV). â?– Develop a program to foster linkages between FDI and the local economy (SLV). â?– Continue strengthening PRONACOM as a functioning Investment Promotion Agency (in addition to its other functions) or design and establish a new (or redesigned) government agency for the proactive promotion of investment in accordance with international best practices with a single mandate of investment promotion (GTM). â?– Review the Foreign Investment Law of 1998 and other regulations to align them with modern investment laws per international best practices and international commitments (GTM). â?– Conduct a cost-benefit analysis of the existing incentives regime to identify its efficiency and suitability in a post Covid-19 environment with reduced fiscal space and use findings to design an incentive targeting regime that reaches the marginal investor (GTM). Labor market, education and skills Policies directed at the labor market should support jobs and income during the economic recovery, but future growth ultimately depends on the development of a skilled labor force and increasing participation. In the current economic crisis, household income was severely affected by firms’ decisions to halt or reduce production. It is particularly important to support the population during the economic recovery trajectory, for example by providing solid unemployment insurance, cash transfers to the self- 96 employed, and implementing wage subsidies to prevent job losses. Achieving an increase in women participation in the labor force requires immediate action, but also focusing on medium-term goals, providing economic support to parents and addressing gender norms that discourage women from working. Governments could adopt policies to widen the access to childcare services and to arrange the participation of women in training programs developing highly demanded skills such as coding and operating digital technologies, which would promote the inclusion of women while simultaneously raising the share of skilled workers. Improving governance and regulatory frameworks are also essential to include informal workers into the formal sector. Large pockets of informal labor are related with an inefficient human capital allocation, as skilled workers in the informal sector tend to represent underutilized labor. Hence, reducing barriers to move workers from self-employment and informal activities to formal jobs could boost productivity and growth. Ulku and Zaourak (2021) argue that reducing and simplifying tax regulation and administration would reduce formalization costs, and at the same could increase tax revenues. In addition, they suggest that governance effectiveness in general is associated with lower informality; thus, reducing regulatory costs could also encourage formalization the in CA3. Short-term policy recommendations â?– For the recovery, strengthen unemployment insurance, time-bound wage subsidies and cash transfers. â?– Increasing the participation of women in training programs supporting the development of digital skills, such as coding, crisis recovery, adaptation, and digitalization. Long-term policy recommendations â?– Promote policies and mechanisms to optimize the use of public spending in higher education systems, to strengthen the contribution of these institutions to economic growth and the effectiveness of interventions in entrepreneurship systems to generate knowledge, technologies and creative outputs. Entrepreneurship, innovation, and technology adoption/digitalization Entrepreneurship can lead to increased firm dynamics and competition through the adoption of policies encouraging firm entry and strengthening entrepreneurship ecosystems. Immediate actions for stimulating entrepreneurship during the current crisis involve developing a start-up grant program and adopting policies to support business training. These measures can help to increase the region’s low entry rate and help incumbent firms recover from the negative effects of the pandemic by undertaking new projects and business opportunities. Governments should simultaneously advance medium- and long- term reforms strengthening local high-potential entrepreneurial ecosystems, for example creating technology centers to offer extension services, or laboratories for testing and prototyping. Existing incubation and acceleration programs should also be reviewed and adapted, if necessary, checking if there is unserved demand or if it is possible to establish new programs creating partnerships between the private sector and research institutions. Despite advances in firm digitalization as a response to the pandemic, public policy should strive to provide continuous incentives for digitalization of smaller avoid overall decreases in innovation due to a liquidity crisis. The accentuated uncertainty environment resulting from Covid-19 discourages investment and R&D expenditure, aggravating the issue of low innovation in the CA3 region. In the context of recovery from the pandemic, it is critical to stimulate innovation and technology adoption with grants to be used specifically for that purpose. Another relevant barrier to technology adoption, especially in 97 small firms, is the need for specific skills to operate and interact with digital platforms. In the short run, it would be desirable to implement ICT and internet educational programs, along with a large-scale business training for micro and small firms, to develop human capital and management skills that are complementary to the use of technology. Our results in the previous chapter pointed to information frictions as a binding constraint to firms in accessing government support policies. These barriers to support could be weakened by initiatives that consolidate information on support programs available and publicize new initiatives, so they reach target populations. Monitoring and evaluation of these initiatives is essential to ensure that public resources are being spent efficiently, measuring the impact of policies and indicating whether strategies should be changed to obtain better results. In the long run, sustainable innovation and digitalization in the region can be achieved by connecting firms and knowledge providers, and by identifying potential financial instruments to encourage research and innovation. Short-term policy recommendations â?– Implement large-scale business training to micro and small firms for crisis recovery, adaptation, and digitization (SLV). â?– Implement technology adoption / innovation grant program to help firms digitize and transform production, including to meet post-Covid demands (SLV). Long-term policy recommendations â?– Develop start-up grant program to help high-potential entrepreneurs take advantage of post- pandemic crisis opportunities (SLV). â?– Study how to strengthen local high-potential entrepreneurship ecosystems, e.g. digital technologies in San Salvador, high-tech manufacturing in La Libertad, etc (SLV). â?– Review existing incubation and acceleration programs to see if there is substantial unserved demand. If so, investigate partnership schemes with the private sector and/or academia to create new programs. â?– Strengthen linkages between firms and knowledge providers, e.g. through voucher program for firms to purchase knowledge services (SLV). â?– Strengthen the collaboration among businesses in these industries to substitute for the lack of spillover effects. â?– Support digitization initiatives geared to- ward strategic repositioning. â?– Leveraging digital technologies to boost entrepreneurship in the region: digital financial tools to increase access to finance; e-government services to reduce the regulatory burden on businesses; online learning tools to boost managerial capabilities. â?– Harmonize regulations of data privacy and international data transfer, promote regional e- commerce transactions, harmonize consumer protection standards, reduce the cost of electronic banking transfers, promote regional electronic invoices, among other opportunities to expand and scale up regional digital markets. Policy targeting and efficiency Beyond specific measures, there is an important policy delivery and targeting agenda for the region. Governments should strive to improve the targeting and efficiency of existing policies, and to mobilize resources efficiently. It is also essential to adopt policies with significant impact in the long-run, addressing structural issues that will create a nurturing environment for businesses, ensuring that recovery is robust and long-lasting. It is important to note that, although the discussion is based on more broad and common challenges faced by CA3 countries, policies should be adapted to the specific context and realities of each country. 98 The lack of fiscal space implies that policies for the recovery need to be more targeted, and it is also necessary to reduce the costs of application and improve the dissemination of information regarding available support programs and eligibility criteria. Consistent with our results, Apedo-Amah et al. (2020) and Cirera et al. (2020) show that, for a large sample of countries, public support was skewed towards medium- sized and large firms, even though smaller firms have been more intensely affected by the crisis induced by the pandemic. Lack of fiscal resources demand better targeting to those firms where the social returns are larger. Humphries, Neilson, and Ulyssea (2020) show that information frictions combined with a â€?first come first servedâ€? program design prevented smaller firms from timely applying to subsidized loans in the U.S. as a response to the Covid-19 shock. This led to program resources being allocated toward larger firms, even though smaller firms have been more negatively affected by the crisis. Guerrero- Amezaga et al. (2022) support these findings using survey data from small firms in Latin America, and shows that smaller firms were less aware about support policies available, and were less likely to apply for those programs. In the previous chapter, we show that firms perceive information frictions as an obstacle to public support, especially in El Salvador and Honduras, where it was the most common reason pointed by firms for not having received any support. Good dissemination and transparency are critical for policy access. Adapt public support available according to the timing of the crisis and specific firm needs. Since the outbreak of Covid-19, the severity of restrictions, the level of economic activity and impacts on firms have not been constant across time. We show that firm preference for support changes reflecting their current situation. Thus, it is important to adapt support policies available to the current timing of the crisis, given firms’ specific needs and the recovery of economic activity. 99 References Adams-Prassl, Abi, Teodora Boneva, Marta Golin, and Christopher Rauh. 2020. “Inequality in the Impact of the Coronavirus Shock: Evidence from Real Time Surveys.â€? 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(2021). Unleashing Central America's Growth Potential. Washington, DC. The World Bank. (2021a). Unleashing Central America’s Growth Potential - Cross-Cutting Themes. Thorburn, C. W. (2015). Insurance: The End of a Monopoly, and a New Beginning for a Market. In F. (. Koehler-Geib, & S. M. Sanchez, Costa Rica Five Years after CAFTA-DR. Assessing Early Results (pp. 43-62). Washington, DC: World Bank Group. World Bank. (2020). Crisis Response and Recovery in Guatemala Development Policy Loan. Washington, DC. World bank. (2020). The Human Capital Index 2020 Update : Human Capital in the Time of COVID-19. Washington, DC: © World Bank. Retrieved from https://openknowledge.worldbank.org/handle/10986/34432 107 Annexes Annex 1. Trade policy responses to the Covid-19 pandemic Immediate (short-term) trade policy responses The initial months of the Covid-19 pandemic triggered short-term changes in trade policy, particularly towards exports and imports of essential medical products and food. As countries tried to tackle the immediate threats from the pandemic and protect people and livelihoods by securing the necessary medical supplies related to Covid-19 and basic food supply as well, during times of high uncertainty and disruptions in supply chains and logistics. This led both to trade-liberalizing measures – such as temporary elimination of import duties and value-added tax (VAT) – and trade-restrictive measures, such as export bans, to ensure sufficient domestic supply of food and medical products. Safety guidelines were also implemented for cargo transport to minimize the risk of Covid-19 at borders. Trade-liberalizing measures • Elimination of import duties on medical products and personal protective equipment (PPE) o The government of El Salvador eliminated import duties on certain medical products and PPE, including medicaments, disinfectants, rubber gloves, soap and cleaning products. 100 The measure entered into force on March 20, 2020 and was announced as temporary, until the National Emergency State was in place. According to the WTO tariff download facility, the new import duties have been reduced from values ranging between 3.33 percent and 16.25 percent depending on the product to 0 percent. After several extensions of the Sanitary Emergency State, the government decided to terminate the measure on September 2020, unless otherwise renewed. • Elimination of import duties and/or VAT on food products o The government of El Salvador eliminated import duties on certain food products, including wheat, flour, prepared food and vegetable products. 101 The legislation also eliminated temporarily the import duties on red beans and rice for a quota of 25,000 metric tons (Mt) and 7,500 Mt respectively.102 The measure entered into force on March 20th 2020 and was announced as temporary, until the National Emergency State was in place. According to the WTO tariff download facility, the new import duties have been reduced from values ranging between 3.33 percent and 16.25 percent depending on the product to 0 percent. After several extensions of the Sanitary Emergency State, the government decided to terminate the measure in September 2020, unless otherwise renewed. o The Ministry of Economy in Guatemala authorized the import of white corn with zero tariff to supply the deficiency of the local market. The elimination of duties, announced in May 18th 2021, applies to the import of 75,000 Mt of white corn.103 • VAT refund to exporters o The government of El Salvador authorized $100 million refund of VAT to exporters in May 2020. 104 The measure was adopted in response to requests from the Salvadoran 100 Decree 604, adopted in response to Covid-19, affected 31 ten-digits tariff lines (source: Global Trade Alert). 101 Decree 604, adopted in response to Covid-19, affected 31 ten-digits tariff lines (source: Global Trade Alert). 102 According to the WTO tariff download facility, the duties outside the quota are 18 percent and 40 percent respectively for red beans and rice. 103 Ministerial Agreement No. 232-2021 in the Diario de Centroamerica; https://centralamericadata.com/en/article/home/Guatemala_to_Import_corn_with_0_Tariff; https://www.mineco.gob.gt/sites/default/files/publicacion_dca_232-2021_maiz_blanco_75000.pdf 104 https://www.presidencia.gob.sv/gobierno-cuenta-con-mas-herramientas-para-enfrentar-el-covid-19/ 108 Association of Industrialists (ASI), who asked for a prompt refund in VAT to exporters through treasury notes.105 • Elimination of customs duties on imports received as donation to the National Coordinator for Disaster Relief o The authorities of Guatemala adopted new legislation exempting duties and value-added tax (VAT) on all imports received as a donation in favor of the National Coordinator for Disaster Relief (i.e. Coordinadora Nacional para Ia Reduccion de Desastres, CONRED) and other charitable associations. 106 The measure was adopted in April 1st 2020 as a temporary measure while the State of Public Calamity is in force. The government announced in September 2020 that it would not extend the State of Public Calamity any longer, hence terminating the temporary measure. Trade-restrictive measures • Export ban on red beans o The government of El Salvador approved a temporary export ban on red beans to guarantee food supplies and stabilize local prices.107 The measure entered into force on March 26th 2020 and applied until December 31st 2020. o The government of Honduras approved a temporary export ban on red beans to ensure national supply during the pandemic. The measure was adopted on March 31st 2020 in the context of the National Sanitary Emergency.108 • Restrictions on regional cargo transport o To mitigate the spread of Covid-19, governments of El Salvador, Costa Rica and Panama set a 72-hour time limit, in May 2020, for freight drivers operating in the region to make the formalities at the borders and to unload and reload goods from vehicles. 109 The measure was opposed by transporters who stated that the whole process requires at least 10 days, and hundreds of units decided to halt their operations as a measure of pressure. 110 The government of Costa Rica introduced further restrictions on regional cargo transport to keep the number of foreign transporters in the country as low as possible. The measure allowed only transporters that make direct border-to-border transit to enter Costa Rican territory, whose units must be subject to police surveillance, as of May 18th 2020. 111 Other Central American countries responded by imposing reciprocal restrictive measures: Honduras decided to grant Costa Rican pilots only 72 hour in the country to unload and load goods (as of May 25th 2020)112; and Guatemala required Costa Rican pilots to unload at the customs, without being allowed to continue their journey further (as of June 9th 2020)113. The controversy lasted for several months with continued protests at regional borders and reciprocal measures. In July 2020, El Salvador 105 https://en.centralamericadata.com/en/article/home/El_Salvador_Industrialists_Ask_for_Fiscal_Breaks 106 Decree 12-2020 was adopted by the government of Guatemala on April 1st, 2020 (source: Global Trade Alert) 107 Executive Decree No. 512 affected products classified under tariff line 0713.33.40.00 (source: Global Trade Alert). 108 https://presidencia.gob.hn/index.php/sala-de-prensa/7140-gobierno-prohibe-exportaciones-de-frijol-rojo-para-garantizar- abastecimiento-en-emergencia-por-coronavirus 109 https://centralamericadata.com/en/article/home/Central_America_Threats_to_the_Supply_Chain 110 Authorities in El Salvador later eased the restriction to extend the maximum time for international cargo transport to unload and load merchandise from 3 to 10 days. https://centralamericadata.com/en/article/home/Cargo_Transport_El_Salvador_Makes_Measures_More_Flexible 111 https://centralamericadata.com/en/article/home/Cargo_Transport_Costa_Rica_Tightens_Restrictions 112 https://centralamericadata.com/en/article/home/Transporte_de_carga_Honduras_responde_a_Costa_Rica 113 https://centralamericadata.com/en/article/home/Cargo_Transport_Guatemala_Applies_Reciprocal_Measures 109 revoked the 72-hour provision and extended the permanence of Central American cargo transportation to 10 days to ensure commercial operations and maintain the supply of food and production inputs.114 Other • Biosafety guidelines for Covid-19 in the cargo transport sector o To prevent the spread of Covid-19 and guarantee the health of cargo transporters, the Central American cargo transport sector introduced Biosafety Guidelines for the Covid-19 pandemic. The measures were approved during an intersectoral meeting of the Council of Ministers of Economic Integration (El Consejo de Ministros de Integración Económica, COMIECO), the Council of Ministers of Health in Central America (El Consejo de Ministros de Salud de Centroamérica, COMISCA) and the Central American Federation of Transportation (Federación Centroamericana de Transporte, FECATRANS), and entered into force in June 7th 2020. 115 The Guidelines establish coordinated procedures to prevent the spread of Covid-19, enhance cleaning and disinfection of means of transport, promote the fluidity of trade at land border posts, and safeguard the health of citizens and officials who exercise controls at land border posts and users. It also included measures to detect sick carriers at the entry points via health screening process, temperature measurement and symptom control at the loading and unloading points. The loading and unloading processes will be done through machinery to minimize contact between transport personnel and the merchandise. Efforts were also made to establish and implement inter- institutional coordination and cooperation mechanisms at the national and cross-border binational levels to prevent the spread of Covid-19.116 Structural (medium-term) trade policy responses In addition to policy measures responding to the immediate risks and challenges of Covid-19, governments also introduced structural policy measures to boost the economy in the medium term. These included measures to support key sectors and firms that were affected by the pandemic, to improve trade facilitation and logistics, and promote foreign investment. Trade facilitation and logistics • Single window for exports o In May 2020, Guatemala’s Ministry of Economy (MINECO) started to prepare the launch of the Single Window for Foreign Trade (Ventanilla Única para el Comercio Exterior, VUCE) portal, an electronic platform to expedite access to information and the management of the export and import processes of companies operating in Guatemala. VUCE’s aim is to make available to the general public and those interested in foreign trade operations, a tool for facilitating information and managing import and export processes, in a single reference point.117 114 https://www.migracion.gob.sv/noticias/migracion-amplia-el-plazo-a-10-dias-de-permanencia-del-transporte-de-carga-en- territorio-nacional/; https://www.presidencia.gob.sv/gobierno-autoriza-estadia-de-10-dias-a-transportistas-de-carga-para-la-seguridad-alimentaria/ 115 https://presidencia.gob.hn/index.php/sala-de-prensa/7443-honduras-lidera-acuerdo-para-desbloquear-el-comercio- regional-por-la-frontera-entre-nicaragua-y-costa-rica 116 https://sde.gob.hn/2020/06/06/este-domingo-entran-en-vigencia-lineamientos-de-bioseguridad-para-transportistas-de-la- region/ 117 https://www.mineco.gob.gt/ministerio-de-econom percentCA3 percentADa-prepara-portal-de-la-ventanilla- percentCA3 percentBAnica-para-el-comercio-exterior 110 • Establishment of Inter-institutional Control Post (PCI) – Guatemala o Guatemala installed four anti-smuggling Interinstitutional Control Post (PCIs) to prevent customs smuggling and tax fraud. The four locations are Pajapita, San Marcos (established in May 2020), Entre Ríos, Puerto Barrios, Izabal (September 2020), Pasaco, Jutiapa (January 2021), and Patzicía, Chimaltenango (May 2021). The PCIs aim to identify, intercept and confiscate goods entering the country which evade customs controls, through the presence and permanent coordination among the Governorate, National Defense, Ministry of Public Health and Social Assistance, Public Ministry, and the Superintendence of Tax Administration (SAT).118 • Investment in transport (road) infrastructure o Given the damage caused by the health emergency and tropical storms Eta and Iota, the government of Honduras implemented measures to improve road infrastructure. The Invest-H (Inversión Estratégica de Honduras) initiative has developed projects to improve road infrastructure and living conditions in different communities since 2015, as the executing agency for managing funds from international organizations, including the IDB, World Bank, and US AID.119 In December 2020, Invest-H audit board announced a plan to prioritize the coffee road network in two stages, one of 1,500 km and another of 1,505 km to serve 3 out of 4 km of the road network in the country. In Santa Barbara alone, more than 500 kilometers will be served with an investment of more than 192 million lempiras.120 The coffee sector and producers have been significantly affected by the lack of good roads, especially since it has inhibited biosafety kits being easily delivered to coffee growers.121 By April 2021, a total of 4,596 million lempiras have been approved by the National Congress to be allocated by Invest-H to rural development, conservation of road assets, infrastructure and the emergency due to Covid-19, creating about 20,000 direct and indirect jobs.122 In addition, the government’s Economic Reactivation included the rehabilitation of 128 kilometers of road sections in the departments of Yoro, Comayagua and El Paraíso, among others.123 o The government of Guatemala started works to asphalt a rural road in Sacapulas, Quiché, in January 2021. The highway section will have 6.7 km of asphalt and connect the Pie del Ã?guila hamlet and the Guatajau village, helping residents to improve the competitiveness of their products in the national and international market. 124 The government also progressed on the 19 infrastructure projects, inherited from the previous government.125 • “Single Customsâ€? between Guatemala and Mexico 118 https://alejandrogiammattei.presidencia.gob.gt/presidente-inaugura-cuarto-puesto-de-control-aduanero-en- chimaltenango/ 119 http://www.investhonduras.hn/resena-historica/ 120 https://presidencia.gob.hn/index.php/gob/el-presidente/8619-gobierno-atendera-3-050-kilometros-de-carreteras-de-zonas- productoras-de-cafe 121 https://presidencia.gob.hn/index.php/sala-de-prensa/8621-habilitacion-de-carreteras-y-apoyo-al-sector-cafe-ha-sido- fundamental-en-santa-barbara 122 https://presidencia.gob.hn/index.php/sala-de-prensa/9353-obras-de-invest-h-benefician-a-la-poblacion-con-empleos-y- rehabilitacion-vial 123 https://presidencia.gob.hn/index.php/sala-de-prensa/9229-gobierno-anuncia-plan-de-reactivacion-economica-para- generar-inversiones-y-empleos 124 https://alejandrogiammattei.presidencia.gob.gt/presidente-inicia-los-trabajos-para-asfaltar-un-camino-rural-de-sacapulas/ 125 https://www.bnamericas.com/en/features/spotlight-guatemalas-infra-woes 111 o Guatemala and Mexico consolidated the “Single Customsâ€? system to facilitate the exchange of information on trade between the two countries, which will speed merchandise clearance and reduce waiting times. In November 2021, the Guatemalan government ratified the Agreement on Mutual Administrative Assistance and Information Exchange in Customs Matters with Mexico, a significant step forward in modernizing its customs services. One of the main advantages will be the speeding up and simplification of procedures carried out at border posts, due to the reliability of information and less selectivity as only one procedure will be carried out. The model is an adaptation of the customs operations between Mexico and the United States, which is now replicated with Guatemala, to streamline procedures. The implementation is expected to take place in 2022. The agreement will also enable a new customs office between Guatemala and Mexico in the Ingenieros village in Ixcán, Quiché and Nuevo Orizaba in Benemérito Las Américas, Chiapas. With this customs reform, exporters from Alta Verapaz and Quiché, especially from the agricultural sector, will be able to access the Mexican market more easily. 126 • Paperless customs program (“Adunas Sin Papelesâ€?) o To modernize, optimize and make the processes transparent through digital facilities, the government of Honduras launched the Paperless Customs program. The initiative is part of the Regional Trade Facilitation Strategy with Emphasis on Border Management, which promotes strengthening capacity and competitiveness of Central American countries, especially El Salvador, Guatemala, and Honduras.127 The objectives are to reduce times in the customs clearance process, eliminate the use of paper by 90 percent, and enhance competitiveness through agile trade processes. 128 As part of its Paperless Customs program, the Honduran Customs Administration will facilitate the adhesion contract service through a digital platform for individual merchants and legal entities. 129 The process can be carried out at any time and from any place, which will facilitate the entire document process. The user is given a username and access code to enter the electronic trading platform of Honduras and for the electronic registration of the declaration of value in customs, aimed to reduce the time invested in the dispatch management by 50 percent.130 If the user wants to go to the Honduran Customs offices, they can request their appointment through the virtual office. Amid the covid-19 pandemic, many public procedures were already taking place online and with this new form the user can save much time doing everything from home. Within the Digital Government of Honduras (Gobierno Digital de Honduras, GDH), which is a platform where different services and public institutions are linked, most of the procedures that previously involved making a much more difficult process can be carried out through digital platforms. GDH will also help safeguard the health of Hondurans, being an important aspect in the framework of the Covid-19 pandemic.131 126 https://www.prensalibre.com/economia/buenas-noticias-para-quienes-comercian-con-mexico-gracias-a-un-acuerdo- binacional-aprobado-esta-semana/ 127 https://aduananews.com/honduras-iniciara-aduanas-sin-papeles-en-puerto-cortes/ 128 https://portal.sat.gob.gt/portal/aduana-sin-papeles/ 129 An adhesion contract is a document that is drawn up by only one of the parties, and in this case natural or legal persons, either by themselves or through their legal representative, adhere or accept with their signature. 130 https://www.laprensa.hn/honduras/1444863-410/tramites-aduanas-plataforma-digital-aduanas-honduras-usuarios 131 https://presidencia.gob.hn/index.php/sala-de-prensa/9023-aduanas-de-honduras-facilita-tramites-a-usuarios-mediante- plataforma-digital 112 Sectoral support measures Agriculture • Export promotion measures in White Seal (Sello Blanco) project o To reduce poverty and support exports of small-scale and rural producers, the government of Guatemala implemented the White Seal plan in May 2021. The White Seal is a certificate that is granted to producers or service providers who demonstrate compliance with the established rules of origin, such as the details on geographical area as well as persons and entities involved. 132 The certificate is intended for the end consumer in foreign countries to know that they are supporting someone to get out of poverty by consuming the labeled product, hence promoting consumer social responsibility.133 It aims to represent quality, trust and support for the producers, and promote more inclusive value chains. Furthermore, achieving the certificate will help merchants promote their product, improve the entrepreneurial environment in Guatemala, and develop export markets. In November 2021, a group of five companies received the first “White Sealsâ€? recognizing them as companies with export quality.134 • Support for farmers/agricultural producers – Guatemala, El Salvador, Honduras (Productive Solidarity Bonus) o El Salvador developed and implemented the Agricultural Rescue Master Plan (“Plan Maestro de Rescate Agropecuarioâ€?) which aims to guarantee food security, support coffee plantation, and promote the development of rural areas. As part of this plan, the government presented a directory of exportable products135 and coordinated a dialogue with the private sector, including coffee growers and banks, on ways to promote the coffee industry.136 The Government has also provided support in agronomic practices and grain marketing, started a renovation plan for the coffee fields, and it made available modern equipment to evaluate the quality of the drink obtained from the harvest.137 • Coffee Bonus (Bono Cafetalero) o To support small and medium producers of coffee, the government of Honduras introduced the coffee bonus in response to a request from the Honduras Coffee Institute (IHCAFE). Honduras is a leading coffee producer in Central America, but the pandemic hampered the labor force and the deluge in late 2020 from hurricanes Iota and Eta accelerated coffee bean maturation. As a result, the Honduran Coffee Institute (IHCAFE) said that the output may shrink as much as 2.5 percent, or 160,000 bags if not more.138 In response to a request from IHCAFE, the Coffee Bonus was introduced in 2020, aiming to improve cultivations of the coffee beans through production modernization and improvements in output, with a 300-million-lempira investment (over US$ 12 million) for both 2020 and 2021. 139 The initiative delivered fertilizer to coffee producers, together 132 https://alejandrogiammattei.presidencia.gob.gt/presidente-destaca-el-proyecto-sello-blanco-para-combatir-la-pobreza/ 133 https://lahora.gt/giammattei-anunciara-medidas-especiales-para-departamentos-con-alza-de-casos-de-covid-19/ 134 https://www.mineco.gob.gt/sello-blanco-abre-las-mipymes-guatemaltecas-el-camino-hacia-mercados-internacionales 135 https://www.presidencia.gob.sv/gobierno-presenta-el-directorio-de-productos-exportables-una-de-las-acciones- contempladas-en-el-plan-maestro-de-rescate-agropecuario/ 136 https://www.presidencia.gob.sv/los-cafetaleros-juntan-esfuerzos-con-el-gobierno-para-impulsar-una-politica-que-beneficie- al-sector-a-traves-del-dialogo-productivo/ 137 https://www.presidencia.gob.sv/cafe-salvadoreno-avanza-sobre-la-ruta-de-la-recuperacion-con-diferentes-medidas-de- apoyo/ 138 https://www.bloomberg.com/news/articles/2020-12-01/honduras-coffee-growers-face-escalating-woes-after-hurricanes 139 https://www.iica.org.br/en/press/news/honduras-undertakes-most-extensive-agricultural-support-strategy-its-history- supervision#:~:text=The percent20new percent20coffee percent20bonus percent20is,modernization percent20and percent20improvements percent20in percent20output 113 with technical assistance, to improve the quality and quantity of coffee harvests. By 2021, more than 175,000 small and medium producers have benefited, which translates into 1.04 million quintals of coffee formula, 1,000 motor fumigation pumps, 1,000 moisture meters, 7,000 solar dryers, among other supplies delivered to producers.140 • Agrocrédito 8.7 (2020) and 5.0 (2021) o To strengthen the agri-food sector, improve access to financing, and ensure food security, the government of Honduras introduced the Agrocredit 8.7 financial program for agricultural producers in March 2020. The grants offer up to 3 years of grace period and a term of 10 years, with an annual interest rate of 8.7 percent.141 Agrocredit 8.7 disbursed 2,170 million lempiras in 2020, through the Honduran Bank for Production and Housing (Banhprovi), to rural producers amidst the Covid-19 pandemic.142 The investment focused on the acquisition of irrigation system, agricultural machinery, agricultural infrastructure such as mesh houses and tunnels, coffee, basic grains and vegetables. In January 2021, the government extended the program and launched Agrocrédito 5.0 for 2021 to support the entire national agri-food and agribusiness sector with financial resources at a final interest rate of 5 percent per year, with the government subsidizing 3.7 percent. With 2,625 million lempiras being allocated for the year, Agrocrédito 5.0 aims to generate 62,175 new jobs, benefit 64,662 families and help 323,310 direct and 1,616,550 indirect beneficiaries, promoting the reactivation of the national economy.143 Support will also be given to the value chains of the agri-food and agro-industrial sector, emphasizing those that have been affected by tropical storms Eta and Iota, which severely damaged the agricultural production system, and those affected by the crisis generated by covid-19. • Productive Solidarity Bonus (Bono de Solidaridad Productiva) o To improve harvests of basic grains and living conditions of small producers, the government of Honduras introduced the Productive Solidarity Bonus. The program provides improved genetic materials such as bean and corn seed, and fertilizer to improve the development of the crops. The investment in Productive Solidarity Bonus was over 200 million lempiras in 2020 which benefitted more than 342,000 small producers.144 The Bonus was continued in 2021, with another investment of over 200 million lempiras for more than 89,000 producers. 145 Regarding the incentive for agricultural and livestock production, the Sales Tax (ISV) on raw materials and tools for agricultural and agro- industrial production was eliminated, a historical support that contributes to the growth of this item. • Trust for the Reactivation of the Honduran Agrifood Sector (Firsa) 140 http://presidencia.gob.hn/press/blog-node/bono-cafetalero-mejora-la-vida-de-m percentCA3 percentA1s-de-175000- productores 141 https://presidencia.gob.hn/index.php/gob/el-presidente/7448-productores-de-cane-tendran-acceso-al-financiamiento-de- agrocredito-8-7 142 https://presidencia.gob.hn/index.php/gob/el-presidente/7867-agrocredito-8-7-ha-entregado-600-millones-de-lempiras-a-1- 400-productores-agricolas-durante-pandemia 143 https://presidencia.gob.hn/index.php/gob/el-presidente/9000-con-agrocredito-5-0-este-sera-un-ano-unico-para-el-agro-de- honduras-afirma-el-presidente-hernandez 144 https://presidencia.gob.hn/index.php/sala-de-prensa/7884-apoyo-financiero-del-gobierno-al-agro-garantiza-el- abastecimento-de-alimentos 145 https://presidencia.gob.hn/index.php/gob/el-presidente/9430-89-000-productores-mejoraran-sus-siembras-gracias-al- bono-de-solidaridad-productiva 114 o FIRSA granted a credit line of 150 million lempiras (US$ 6 million) to reactivate the production chain, benefiting 1,500 producers. The Honduran Bank for Production and Housing (BANHPROVI) will disburse the resources, prioritizing producers located in remote regions, lending up to 300 thousand lempiras (US 12 thousand) to each producer with an 8.7 percent interest rate.146 Additionally, FIRSA granted D'leite financing for 6 million lempiras (US$ 244 thousand) to open a fruit and vegetable export plant. The plant will collect the harvest of an average of 80 small local producers, and will generate employment in packing areas, administrative tasks, and cleaning for 115 families. The company will increase its exports to Spain and Canada, without impediments associated with health concerns, given that the design of the plant and its operating standards were approved by technical specialists from the United States Department of Agriculture (USDA).147 • Support for fish farming sector o To strengthen, improve and diversify the fish farming sector, the government of Honduras implemented two initiatives: The Blue Lagoon project and the Honduras Se Levanta initiative. o To improve the nutritional diet of Hondurans and promote social development through export diversification, the government of Honduras allocated production bonuses for producers of the different types of fish. The Blue Lagoon project aims to have more tilapia fingerlings produced in the country. The production of tilapia offers more due to its lower food requirement, and it allows to obtain a greater quantity of meat by not needing much energy. The tilapia´s resistance to diseases, ease of feeding, and ease of reproduction make it a great fish product to grow and market. The government also wants to increase the production of cold-water species such as trout and surgeon, for high-altitude areas that have potential, in addition to encouraging the export of sterlet sturgeon caviar. Currently the fishermen are fishing in a traditional way, without technical competitiveness in production and quality, so the commercialization does not respond to market demand, this is a problem that will be solved through this initiative. o Honduras Se Levanta initiative aims to strengthen artisanal fishing chain in the region and to potentiate the development of artisanal fishing with the capacity to supply the local market. The National Service for Entrepreneurship and Small Businesses (Senprende) and the La Mosquitia Region Business Development Center have allocated 2.7 million lempiras to support micro-entrepreneurs engaged in artisanal fishing in the region.148 Honduras Se Levanta initiative gave the fishermen seed capital in kind, such as an ice machine and a desalination machine to transform salt water into fresh water. This intends to guarantee a good job and thus lower operating costs. Honduras Se Levanta initiative is estimated to benefit 432 women directly and 1,500 indirectly: 568 young people directly and 3,500 indirectly. 146 Gobierno habilita línea de crédito con fondos Firsa a través de Banhprovi para productores – Diario La Tribuna 147 https://www.elpais.hn/2021/01/14/inauguran-planta-exportadora-de-vegetales-en-comayagua/ 148 https://presidencia.gob.hn/index.php/sala-de-prensa/9498-por-medio-de-honduras-se-levanta-gobierno-ayuda-a- pescadores-de-la-mosquitia-con-2-7-millones-de-lempiras-en-equipo 115 • Support for informal trade sector o To support families engaged in informal trade that was affected by the Covid-19 pandemic, the government of Guatemala introduced the Popular Trade Support Fund (Fondo de Apoyo al Comercio Popular). The program was directed by the Ministry of Social Development and over 100 thousand people have benefitted from a contribution of 1,000 quetzals (as of December 2020).149 The communes prepared an official list of beneficiaries, who could withdraw the money at ATMs with their personal identification document, making the process transparent. The plan was part of the Economic Reactivation Plan, promoted by the government to mitigate the effects of the pandemic in the country. Textile • Prioritized ease of restrictions for textile sector o Prioritized ease of restrictions for the textile sector in El Salvador. The Government implemented a staggered plan to reactivate the economy. The first phase began in June 2020 with the reactivation of sectors such as construction, textile, and electronics manufacturing, the aeronautical industry, seaports, medical services, among others.150 Foreign investment and multinational enterprises support • Economic Development Zones o Special Public Economic Development Zone in Pajapita (Guatemala): The Guatemalan authorities approved the operation of Special Public Economic Development Zone (Zona de Desarrollo Económico Especial Público, ZDEEP) in Pajapita, San Marcos, called “Puerta del Istmoâ€? in December 2020. Located 3.3 kilometers from the border with Mexico, Puerta del Istmo covers an area of 77 thousand square meters. The ZDEEP aims to attract new investments by providing benefits such as the exemption from income tax payments for a period of 10 years for new investment; temporary exemptions from VAT for activities carried out within the zone, temporary suspension of taxes such as tariffs and VAT on imports of materials and intermediate inputs.151 The ZDEEP will also build a multimodal railway terminal and a railway section that will connect the Guatemalan and Central American market with Mexico, the United States and Canada.152 The strategic position allows to take advantage of its proximity to Mexico and will facilitate international trade, allowing a greater amount of cargo per trip and reducing transport times. With a US$ 26.3 million investment and 20 hectares of land, the terminal and railway will contribute to the creation of 1,000 formal jobs in addition to over 15,000 formal jobs that Puerta del Istmo plans to generate.153 o Employment and Economic Development Zones (Zonas de Empleo y Desarrollo Económico, ZEDEs) in Honduras: In May 2021, Honduras’ executive Government introduced before Congress a bill to reform the Organic Law of Employment Development 149 https://alejandrogiammattei.presidencia.gob.gt/jornada-presidencial-presidente-se-reune-con-representantes-del- comercio-informal/ 150 https://www.efe.com/efe/america/economia/el-salvador-arranca-con-la-primera-fase-de-reactivacion-economica-por- pandemia/20000011-4273279 151 https://newsinamerica.com/pdcc/economia/2020/inauguran-puerta-del-istmo-primera-zona-de-desarrollo-economico- especial-publicas/ 152 https://dca.gob.gt/noticias-guatemala-diario-centro-america/pais-prepara-conexion-ferroviaria-con-mexico/ 153 The construction, however, has not yet started (as of February 3, 2022) due to complications in the legal contract between the Railway Development Company SA (Ferrovías Guatemala) and the Puerta del Istmo Company Remed, SA. Source: https://www.prensalibre.com/economia/continuan-las-dudas-y-dificultades-por-el-contrato-para-reactivar-el-servicio- ferroviario/ 116 Zones, which entered into force in 2013. Modifications aim a tax interpretation and exemptions for these zones. However, the bill found opposition from Honduras’ Alternative Movement of Community and Environmental Revindication, who argue that ZEDEs create tax heavens, promoting corruption and illegal activities. Also by opponents that denounce harms to sovereignty. ZEDEs’ benefits are not conditioned to specific industries or large companies; according to analysts, small and medium-size companies are part of this model that benefits from a one percent rate for income and property taxes. Estimations suggest that in 40 years, ZEDEs’ GDP could reach US$50,000, compared to US US$20,000 from regions not incorporated into these special zones. • America Crece: MOU with the United States to promote investment o America Crece (or Growth in the Americas) is a public-private partnership initiative of the United States to promote private sector investment in infrastructure in Latin America and the Caribbean (LAC).154 Launched in 2018, it aims to channel the tools and resources of the U.S. Government to catalyze private sector investment and growth in the region. As part of the initiative, individual governments of LAC sign Memorandums of Understanding (MOUs) with the U.S. International Development Finance Corporation (DFC), laying out areas of focus for which types of projects will be included in the funding. The Governments of Honduras, Guatemala, and El Salvador have each signed on for $1 billion in U.S. government funding for infrastructure projects. In addition to these countries, the U.S. has also signed similar frameworks with Argentina, Brazil, Chile, Colombia, Ecuador, Jamaica, and Panama.155 o The governments of El Salvador and the United States signed a MOU to begin the implementation of the America Crece program in January, 2020. One of the objectives of the agreement is to foster job creation and jumpstart economic growth by facilitating urgently needed infrastructure projects. Based on this agreement, El Salvador and the United States will establish a working group to identify specific investment opportunities in the generation of energy and infrastructure projects. A key approach to this cooperation will be to address political, legal, regulatory, institutional and market barriers in order to stimulate private sector investment. This will enable El Salvador to achieve its energy and infrastructure priorities. The United States will provide technical training and facilitate exchange processes with energy and infrastructure experts. It will also promote business collaboration and exchange of market information.156 o The governments of Honduras and the United States signed a MOU to establish a framework for bilateral cooperation in support for the America Crece initiative in July 2020. The initiative aims to promote economic growth and improve quality of life in Honduras while addressing regional security concerns. It also seeks to help Honduras weather the health and economic challenges of the Covid-19 pandemic. Priority areas of investment include energy security, digital connectivity, and critical infrastructure to facilitate trade, investment, and job creation; health systems, medical supply chains, and access to water, sanitation, and nutrition to build more resilient communities; financial services to create economic opportunity, especially for small businesses, women, and rural populations.157 154 https://www.state.gov/growth-in-the-americas/ 155 https://towardfreedom.org/story/america-crece-washingtons-new-investment-push-in-latin-america/ 156 https://sv.usembassy.gov/signing-of-memorandum-of-understanding-to-implement-america-crece/ 157 https://www.dfc.gov/media/press-releases/dfc-aims-finance-1-billion-private-sector-investment-honduras 117 o The governments of Guatemala and the United States signed a MOU on the America Crece Initiative in December 2020. Through this memorandum, the United States and Guatemala agreed to expand intergovernmental collaboration in the areas of infrastructure development and financing, energy, and telecommunications to promote the prosperity and well-being of Guatemala and its citizens. 158 The Initiative seeks to attract more investment from the US private sector in Guatemala through various activities such as organizing business-to-business and business-to-government roundtables, supporting trade missions and study tours, conducting commercial viability, providing technical expertise to improve the investment climate and supporting project finance. The key areas of focus are energy, housing, and “social infrastructureâ€? including public health and schools, as well as the promotion of small and woman-run businesses. During the pandemic, the DFC approved $200 million for Guatemala’s health sector. • Honduras Investment Promotion Strategy o In August 2020, amidst the Covid-19 pandemic, the National Council of Investment, the Honduran Tourism Institute, the Ministry of Economic Development, and the Foreign Affairs Ministry implemented a strategy informing Honduran Diplomats about the activities each agency develops regarding investment, tourism, and exports. The objective was to provide updated and strategic information on the benefits of investing in Honduras, which could be used by the diplomatic representations in the USA, Canada, Mexico, Latin America, Asia, Europe, and Africa to reach and attract potential investors. The strategy also included launching the “Honduras, un mundo de oportunidadesâ€? (or Honduras, a world of opportunities) campaign to promote Country’s competitive advantages.159 • “Guatemala does not stopâ€? (Guatemala no se detieneâ€?) o Guatemala initiated a new program "Guatemala does not stop" to attract FDI, increase exports, and create new jobs.160 The program was a result of a multi-sectoral agreement, signed between the Ministries of Economy, Foreign Relations and Finance; the Bank of Guatemala, the Municipality of Guatemala, the Guatemalan Association of Exporters (AGEXPORT) and the Foundation for the Development of Guatemala (FUNDESA).161 The plan aims to increase exports in sectors in which Guatemala already performs well, such as clothing and textiles, agriculture, food, beverages and chemicals. It also seeks to attract new investment, taking advantage of the proximity to major markets through sectors such as pharmaceuticals, medical devices, electronics manufacturing and the Business Processing Outsourcing (BPOs) industry. 162 The program will strengthen the Economy, Competitiveness and Prosperity Pillar which is part of the General Government Policy 2020-2024. Other • Increased renewable energy production – El Salvador 158 https://gt.usembassy.gov/es/estados-unidos-y-guatemala-firman-memorando-de-entendimiento-sobre-la-iniciativa- america-crece/ 159 https://www.sefin.gob.hn/gobierno-implementa-estrategia-de-promocion-de-inversion-de-honduras/ 160 https://alejandrogiammattei.presidencia.gob.gt/jornada-presidencial-guatemala-no-se-detiene-el-programa-para-fortalecer- la-atraccion-de-inversion-extranjera/ 161 http://dca.gob.gt/noticias-guatemala-diario-centro-america/gobierno-suscribe-convenio-para-atraer-inversiones-a- guatemala/ 162 https://noticias.uvg.edu.gt/guatemala-no-se-detiene/ 118 o Renewable energy production increased with the creation of two new photovoltaic power plants in the period 2019-2020. Government expects the beginning of operations of the first wind power plant in Metapán, as well as to finish the construction of a solar plant with a capacity of 9.9 MW, four photovoltaic plants for 6.9 MW and two biogas plants for 1.6 MW. By June 2020 only 20 percent of energy used in the country came from petroleum derivatives, and 0.2 percent was imported.163 MSME support • MSME Digitization Plan o After the national emergency was decreed due to the covid-19 pandemic, authorities of Honduras installed different work groups to attend to the crisis, including one for micro, small, and medium enterprises (MSME, or las micro, pequeñas y medianas empresas, MIPYME). Through the work team, 15,000 free licenses were made available to national entrepreneurs to have a digital page to display their products and market them via the Internet. The objective is to reduce the fatality rate of micro and small businesses, making it visible on the internet and allowing you to have your own smart web page on Google for free and permanently. Jointly with the IDB, Honduras also launched a Digital Checkup platform to support MSMEs in the face of Covid-19. The new platform Check Digital allows to measure the level of digitization of a MSME to identify its strengths, weaknesses and opportunities before starting a process of technological transformation that implies a cultural and strategic change within the company if you want to take advantage of the maximum available technology. The MSME Digitization Plan achieved positive results since it began in early 2020, and by April 2021, more than 15,000 companies participated.164 • Economy, Competitiveness and Prosperity pillar of the General Government Policy 2020-2024 – Guatemala o In January 2020, the Government of Guatemala presented nine objectives of economic, competitiveness, and prosperity pillars to be attained by 2024. The objectives included 1) increasing the real GDP rate by 2.6 percentage points, 2) reaching the 85th position in the Global Competitiveness Index, 3) ranking 88 in Doing Business index, 4) decreasing job informality by 6 percent, 5) increasing the population access to electricity to 93.5 percent, 6) improve by 1 percent banking system’s solvency ratio, 7) increase by 3.1 percent the solvency margin of insurance companies, 8) allocating 35 million quetzals for agricultural insurance for small farmers, 9) increasing to 200 million quetzals the number of credits for poor households’ enterprises.165 • MSME loans and training o El Salvador’s Ministry of Economy, supported by the IADB, launched the contest “Reconvirtiendo el territorioâ€? (or Reconverting the Territory) in August 2021 with a USD $1.8 million budget. The contest aims to provide non-reimbursable loans to MSME for developing new projects in 52 municipalities located on the coastal zone. Loans range 163 https://www.presidencia.gob.sv/el-salvador-aumenta-produccion-de-energia-renovable-espera-nuevas-inversiones/ 164 https://presidencia.gob.hn/index.php/sala-de-prensa/9374-mas-de-15-000-empresas-se-integran-de-manera-gratuita-al- plan-de-digitalizacion-mipyme-en-honduras 165 https://www.prensalibre.com/opinion/columnasdiarias/economia-competitividad-y-prosperidad-2020-2024/ 119 between USD$15,000 to USD$50,000. MSME benefits could include agribusiness, manufacturing, food and beverage industry, fishing, tourism, and aquaculture sectors.166 o Private sector and the Economic cabinet signed a MOU to implement the “Despeguemosâ€? program (or Taking-off) in Surf City. The initiative aims to strengthen entrepreneurs’ financial and business skills, providing training and technology to improve the access and use of financial services. Loans are also considered.167 • MSME debt relief, guarantee fund o Approximately 80,000 MSMEs could be benefited from the Debt Relief Agreement signed by the Government of Honduras and the Honduran Association of Banking Institutions in October 2020. The agreement establishes that low-risk MSMEs loans could be restructured until December of the same year; the repayment period would range from five to 15 years depending on funding sources. Benefits also include lowering the interest rates up to 2 percent, the non-capitalization of interest, nor the collection of default interest, and other charges associated with overdue balances.168 o The Central Bank of Honduras and BANHPROVI created a Guarantee Fund of 2,500 million lempiras for the Reactivation of approximately 300,000 MSMEs that had been affected by a decrease in their cashflows derived from the Covid-19 pandemic. A guarantee could cover from 65 percent to 90 percent of the loan, depending on the amount granted by financial institutions (90 percent coverage when loans are below 300,000 lempiras, and 65 percent for a credit up to 35 million lempiras). Loans payable in a maximum of 48 months should be used for working capital and investment in fixed assets.169 • MSME training o The government of Honduras announced a training program in Social Market Economy for Entrepreneurs. 6,000 MSME will receive training from the German Konrad Adenauer Foundation. The program aims to promote the principle of subsidiarity in government financing projects during 2021, strengthen MSMEs, and boost economic reactivation.170 166 https://www.presidencia.gob.sv/gobierno-ayuda-a-las-pequenas-y-medianas-empresas-de-la-zona-costera-con-un- financiamiento-no-reembolsable-para-revertir-el-impacto-economico-por-la-pandemia/ 167 https://www.presidencia.gob.sv/gobierno-firma-convenio-con-la-empresa-privada-para-dinamizar-las-micro-y-pequenas- empresas-con-el-programa-despeguemos/ 168 https://www.cnbs.gob.hn/blog/2020/11/03/mipymes-recibiran-alivio-financiero-mediante-acuerdo-firmado-entre-el- gobierno-y-el-sector-bancario-comercial-del-pais/#:~:text=Este percent20alivio percent20financiero percent20est percentCA3 percentA1 percent20dirigido,de percent20diciembre percent20del percent20presente percent20a percentCA3 percentB1o percent2C 169 https://banhprovi.gob.hn/fondo-de-garantias-banhprovi/ 170 https://sedis.gob.hn/node/6303/ 120 Annex 2. Drivers of productivity growth framework Productivity is defined as the efficiency through which an individual firm is able to convert production inputs into outputs. Fundamentally, a firm increases its productivity level if, given a set of inputs, it is able to increase its production. Productivity shifts can take many forms, from technology innovations to better input quality, better management, improved worker skills, and many other factors. However, a country’s aggregate productivity level relies not only on individual firms’ production efficiency, but also on the dynamics that change the participation and composition of firms over time. Decomposing productivity growth plays an important role in the literature for understanding the drivers of productivity and identifying the barriers to productivity growth that policies should target. This methodology has helped researchers to understand the underlying causes of productivity growth in successful countries, but also in determining why other countries are lagging behind and are unable to catch up. The dynamic effects on aggregate productivity growth can be expressed as a combination of three components: increments in average firm productivity, resource reallocation across firms with varying levels of productivity, and changes in firm composition through entry and exit.171 The first component measures the increase in aggregate productivity that is accounted for by within- firm improvements in efficiency. Aggregate productivity changes measured by this component reflect variation in the average productivity across all firms in the market. This component incorporates all drivers of productivity that occur within individual firms, that is, improvements the production process that allow a firm to produce a given quantity of output using less inputs. These include, but are not limited to, improvements in managerial practices and firm structure, adoption of new technologies, process and product innovation, and increasing the quality of capital, labor and materials. When this within-firm component is low, policies need to target barriers that are affecting the ability of firms to invest on innovation and improvements in management and upgrading. The second component, commonly referred to as between-firm, reflects how shifts in the distribution of resources across firms translates into aggregate productivity. One way of achieving aggregate productivity growth is to reallocate production resources from less to more efficient firms. However, reallocation is often constrained by distortions, limited competition and factors that deter input adjustment of the most productive firms, such and financial constraints, restrictions to international trade, or labor regulations. The relevance of this mechanism has been emphasized by numerous studies showing evidence of significant variation in productivity levels across firms, even when considering narrowly defined industries (Hsieh and Klenow, 2009), indicating potential for boosting aggregate performance through reallocation. The third component measures the contribution of selection, firm entry and exit, which impacts aggregate productivity by altering the composition of operating firms across time. Governments should encourage innovative entrepreneurs to enter the market, while securing a well-functioning business environment that drives the least productive firms out of the market. In this case, a competitive environment and low regulatory barriers are key to appropriating productivity gains via the selection mechanism. The components of productivity growth are inextricably linked, so that productivity-enhancing policies need to focus on addressing the constraints in all three mechanisms of productivity growth. Within-firm improvements in efficiency increase firm growth and wages. The growth of productive firms is essential to generate competition and selection, reallocating resources across firms, eliminating the least efficient 171 See Melitz and Polanec (2015) for a review of existing productivity decomposition methods. 121 firms from the market and leading to further productivity gains. One important implication from this framework is that governments should monitor the constraints to the three channels and ensure an institutional environment that promotes competition, allows successful firms to survive and grow, and encourages entrepreneurs to create innovative businesses. Figure A.1. Drivers of productivity growth Source: Cusolito and Maloney (2018) Furthermore, institutions and market structure interact with other factors constraining productivity growth, leveraging or weakening how these factors translate into changes in aggregate productivity. For example, strengthening a country’s infrastructure might not induce individual firms to invest and expand if there are simultaneous binding constraints such as widespread corruption, high levels of crime, or weak rule of law. The opposite effect is also possible, and improvements in the business environment can lead to a virtuous cycle of productivity growth, increasing the expected returns from investing and expanding into new markets, for example, which will result in even more productivity-enhancing dynamics. Prioritizing policies to support productivity growth Operationalizing and prioritizing policies to achieve productivity growth requires acting in different domains and combining structural reforms. Table A.1 and Table A.2 summarize the different channels and importance on how the different factors and policy areas affect productivity growth described in this subsection. The important element is that governments must act in different policy domains to unleash productivity growth. Table A.1. Policies and productivity Policy Areas Within-firm Between-firm Selection Informality and business *** *** * environment Entrepreneurship *** ** ** Innovation and tech *** ** * adoption Education and skills *** ** * Labor market *** *** * Financial markets * *** *** Investment and remittances *** *** ** Competition * *** *** Trade ** *** *** Infrastructure * *** ** 122 Table A.2. Policy areas and channels of impact to productivity growth Policy areas Within-firm Between-firm Selection Informality and business Informality drives down average Distorts firm-level decisions, crowds Distorts competition through lower environment productivity, corruption and crime out public investment costs by informal firms. Corruption will divert productive resources from provide advantages for arbitrary firms production. and industries. Entrepreneurship Allows firms with new ideas to enter Entrepreneurship Allows firms with new ideas to enter the market and compete with the market and compete with incumbents. Knowledge spillovers. incumbents. Knowledge spillovers. Innovation and technology Adoption of new technologies, Growth of innovative firms. Access to Increased competition and creative adoption innovative products of production new markets, expansion of consumer destruction. processes. base through digital platforms. Education and skills Increased human capital, workers’ Managerial capital enables growth of Creative destruction resulting from skills and managerial capabilities. productive firms. resource reallocation. Labor market Decreases the cost of labor. Labor regulations distort firms’ input Creative destruction resulting from decisions. resource reallocation. Financial markets Promotes investment in capital, R&D, Improves the allocation efficiency of Allows productive firms to survive and and technology adoption. capital and entrepreneurial talent foment the process of creative across firms destruction. Investment and remittances FDI promotes technology trans Increased competition. Increased competition and creative fer and knowledge spillovers. destruction. Competition Drives unproductive firms out of Increases incentives for innovation and Induces growth of productive firms. improvements in efficiency. the market. Trade Technology adoption, access to Increased competition in local Increased competition and creative cheaper and higher-quality production markets, exporters’ expansion into destruction. inputs. foreign markets. Infrastructure Increase productivity of production Facilitate firm expansion and Increased competition and creative inputs. competition. destruction. Informality and business Informality drives down average environment productivity, corruption and crime divert productive resources from production. 123 Annex 3. Long-term growth model for CA3 The Long-Term Growth Model (LTGM) is an Excel-based tool to analyze long-term growth scenarios building on the Solow-Swan Growth Model, adapted for growth analysis in developing countries. 172 The model assumes a standard production function: 1−𝛽 𝑌𝑡 = 𝐴𝑡 𝐾𝑡 (ℎ𝑡 𝐿𝑡 )𝛽 where Yt is GDP, At is the total factor productivity, Kt is the capital stock, ht human capital per worker, and Lt is the number of workers. 𝛽 is the labor share. The number of workers can be decomposed into 𝐿𝑡 = 𝜌𝑡 𝜔𝑡 í µí±?𝑡 where 𝜌𝑡 is the participation rate, 𝜔𝑡 is the working age population rate and í µí±?𝑡 is the total population. We can divide by í µí±?𝑡 to get all variables in per capita: í µí±?í µí±? 𝑌𝑡 𝑌𝑡 1−𝛽 𝛽 𝑦𝑡 = = 𝜌 𝜔 = 𝑦𝑡 𝜌𝑡 𝜔𝑡 = 𝐴𝑡 𝜌𝑡 𝜔𝑡 𝑘𝑡 ℎ𝑡 í µí±?𝑡 𝐿𝑡 𝑡 𝑡 í µí±?í µí±? 𝑦𝑡+1 Dividing í µí±?í µí±? , taking logs and using the log-linear approximation, we can rewrite the equation as: 𝑦𝑡 í µí±?í µí±? 𝑔𝑦,𝑡+1 ≈ 𝑔𝐴,𝑡+1 + 𝑔𝜔,𝑡+1 + 𝑔𝜌,𝑡+1 + (1 − 𝛽)𝑔𝑘,𝑡+1 + 𝛽𝑔ℎ,𝑡+1 Where 𝑔𝑥,𝑡+1 is the growth of variable x from t to t+1. Capital in the next period 𝐾𝑡+1 is formed by new investment minus depreciation: 𝐾𝑡+1 = (1 − 𝛿)𝐾𝑡 + 𝐼𝑡 Dividing per worker, taking logs and rearranging: 𝐼𝑡 𝐾𝑡 𝑔𝑘,𝑡+1 ≈ / − 𝛿 − í µí±”í µí±?,𝑡+1 − 𝑔𝜌,𝑡+1 − 𝑔𝜔,𝑡+1 𝑌𝑡 𝑌𝑡 Inserting in per capita growth equation: í µí±?í µí±? 𝐼𝑡 𝐾𝑡 𝑔𝑦,𝑡+1 ≈ 𝑔𝐴,𝑡+1 + 𝛽(𝑔𝜔,𝑡+1 + 𝑔𝜌,𝑡+1 + 𝑔ℎ,𝑡+1 ) + (1 − 𝛽) [ / − 𝛿 − í µí±”í µí±?,𝑡+1 ] 𝑌𝑡 𝑌𝑡 In this regard, GDP per capita growth depends on; (i) TFP growth, (ii) human capital growth, (iii) labor force participation growth, (iv) working age population share growth, (v) population growth and (vi) increase in investment. From the last equation, the model needs 5 parameters to be calibrated: 1. 𝛽: Labor share 2. 𝛿: Capital depreciation rate 3. Initial Capital-to-output ratio 4. Initial GDP per capita 5. Population growth In addition, the different scenarios are built from assumption on 4 variables: 1. Human Capital Index growth 2. Total Factor productivity Growth 172The LTGM builds on Hevia and Loayza (2012). See Pennings (2020) for a full model description. The LTGM spreadsheet is available for download at www.worldbank.org/LTGM. 124 3. Labor Participation rate growth 4. Investment-to-GDP ratio Assumptions Table A.3. Baseline parameter assumptions El Salvador Guatemala Honduras 0.33 -0.01 TFP Growth (PWT 10 10yr avg (2010-19)) 0.06 percent percent percent 1.41 1.75 HC Growth (PWT 10 10yr avg (2010-19)) 1.18 percent percent percent Labor Share (PWT 10 Labor Share) 50 percent 49 percent 56 percent Capital-to-Output Ratio (MFMOD) 2.74 2.00 2.92 18.33 14.50 19.97 Investment-to-GDP Ratio (MFMOD 10yr avg (2011-20)) percent percent percent 0.5 1.65 1.57 Population Growth in 2019…2050 (World Bank Human percent.. percent.. percent.. Development Network Estimates) -0.03 0.75 1.00 percent percent percent 79.6 88.0 Male Labor Force Participation Rate (2018) 88.2 percent percent percent 49.3 54.3 Female Labor Force Participation Rate (2018) 42.5 percent percent percent 4.54 4.88 Depreciation Rate (PWT 10) 3.82 percent percent percent GDP PC Level US$ 2010 (year 2019 - WDI) 4,003 4,254 2,499 Covid scenario - TFP growth change was extracted from MFMOD (MPO SM22) until 2024, then it is assumed to revert to pre-pandemic growth rate - HC growth for 2020 and 2021 was calculated following the Covid-19 Shock to The Under-5 Cohorts to calculate the loss of HC due to loss in income and Covid-19 Shock to School-age Cohorts to estimate the loos in HC due to school closure (World bank, 2020). To estimate the Learning Adjusted years of School using the excel tool “Country tool for simulating the potential impacts of Covid-19 school closures on schooling and learning outcomesâ€? Azevedo et al. (2020) was used. - Labor force participation came from ILO modelled estimates (Nov. 2021) for 2020. Reversion to the pre-pandemic trend was assumed in 2021 for Guatemala, and in 2022 for Honduras and El Salvador to reflect the different pace of recovery of each country. - Investment-to-GDP ratio was extracted from MFMOD from 2021 and 2022, it was assumed a reversion to pre-pandemic trend from 2022 TFP reform scenario The TFP extension of the model, LTGM-TFP, is an Excel-based companion to the standard LTGM that helps users assess a country’s potential for improving its TFP growth rate over the next few decades. The LTGM-TFP toolkit combines a country’s scores for innovation, education, market efficiency, infrastructure, and institutions—which have been shown in the literature to affect TFP growth—into a new “TFP determinant indexâ€?. Based on a fixed-effects regression model, the “TFP determinant indexâ€? then quantifies the future 125 path for TFP growth in the LTGM-TFP toolkit for each country. The methodology is described in Kim and Loayza (2019). To estimate the reform scenario, it was assumed that CA3 countries would achieve a level of TFP fundamentals equivalent to the 75th percentile TFP determinant Index of LCR countries. Figure A.2. Real GDP growth rates in GDP per capita projections a. GDP growth rate – Guatemala b. Real GDP per capita (2010 USD) - Guatemala 7.0% 7,500 6.0% 7,000 5.0% 6,500 4.0% 3.0% 6,000 2.0% 5,500 1.0% 5,000 0.0% 4,500 -1.0% 4,000 -2.0% -3.0% 3,500 No-Covid Covid TFP reform No-Covid Covid TFP reform c. GDP growth rate – Honduras d. Real GDP per capita (2010 USD) - Honduras 6.0% 4,500 5.0% 4,000 4.0% 3.0% 3,500 2.0% 1.0% 3,000 0.0% 2,500 -1.0% -2.0% 2,000 No-Covid Covid TFP reform No-Covid Covid TFP reform e. GDP growth rate – El Salvador f. Real GDP per capita (2010 USD) – El Salvador 5.0% 7,500 4.0% 7,000 3.0% 6,500 2.0% 6,000 1.0% 5,500 0.0% 5,000 -1.0% 4,500 -2.0% 4,000 -3.0% 3,500 No-Covid Covid TFP reform No-Covid Covid TFP reform Source: WBG staff calculations 126 127 Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) -20 -10 0 -40 -20 10 20 30 40 50 0 20 40 60 100 200 300 -100 0 -60 -40 -20 0 20 40 60 80 Jan-20 Jan-20 Jan-20 Jan-20 Feb-20 Feb-20 Feb-20 Feb-20 Mar-20 Mar-20 Apr-20 Mar-20 Mar-20 Apr-20 May-20 Apr-20 Apr-20 May-20 Jun-20 May-20 May-20 Jun-20 Jul-20 Jul-20 Jun-20 Jun-20 Aug-20 Aug-20 Jul-20 Jul-20 Sep-20 Sep-20 Aug-20 Aug-20 Oct-20 Oct-20 Sep-20 Sep-20 Nov-20 Nov-20 Oct-20 Oct-20 Dec-20 Dec-20 Nov-20 Nov-20 Dec-20 Dec-20 Rest of LAC Mining Jan-21 Jan-21 Jan-21 Jan-21 Agriculture United States Feb-21 Feb-21 Mar-21 Mar-21 Feb-21 Feb-21 Apr-21 Apr-21 Mar-21 Mar-21 May-21 May-21 Apr-21 Apr-21 Jun-21 Jun-21 May-21 May-21 Annex 4. Additional figures Jul-21 Jul-21 Jun-21 Jun-21 Aug-21 Aug-21 Jul-21 Jul-21 Sep-21 Sep-21 Aug-21 Aug-21 Oct-21 Oct-21 Sep-21 Sep-21 Nov-21 Nov-21 Oct-21 Oct-21 Dec-21 Dec-21 Nov-21 Nov-21 Note: Central America does not include Dominican Republic. Dec-21 Dec-21 Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) Source: World Bank staff estimates using data from Bank of Guatemala. Source: World Bank staff estimates using data from Bank of Guatemala. -40 -20 100 120 0 20 40 60 80 -20 -10 0 10 20 30 40 50 60 70 -20 -10 0 10 20 30 40 50 60 -40 -20 0 20 40 60 80 Jan-20 Jan-20 Feb-20 Feb-20 Jan-20 Jan-20 Mar-20 Mar-20 Feb-20 Feb-20 Apr-20 Apr-20 Mar-20 Mar-20 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. May-20 May-20 Apr-20 Apr-20 Jun-20 Jun-20 May-20 May-20 Jul-20 Jun-20 Jun-20 Jul-20 Aug-20 Jul-20 Jul-20 Aug-20 Aug-20 Sep-20 Sep-20 Aug-20 Sep-20 Sep-20 Oct-20 Oct-20 Oct-20 Oct-20 Nov-20 Nov-20 Nov-20 Dec-20 Nov-20 Dec-20 Dec-20 Dec-20 Europe Jan-21 Jan-21 Jan-21 Feb-21 Jan-21 Figure A.3. Guatemala: monthly exports growth by sector, 2020-2021 Feb-21 Feb-21 Agroindustrial Manufacturing Feb-21 Central America Mar-21 Mar-21 Figure A.4. Guatemala: monthly exports growth by destination, 2020-2021 Mar-21 Apr-21 Mar-21 Apr-21 Apr-21 May-21 Apr-21 May-21 May-21 Jun-21 May-21 Jun-21 Jun-21 Jul-21 Jun-21 Jul-21 Jul-21 Aug-21 Jul-21 Aug-21 Aug-21 Aug-21 Sep-21 Sep-21 Sep-21 Sep-21 Oct-21 Oct-21 Oct-21 Oct-21 Nov-21 Nov-21 Nov-21 Nov-21 Dec-21 Dec-21 Dec-21 Dec-21 Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between Figure A.5. Honduras: quarterly exports growth by sector, 2020-2021 Agriculture Agroindustrial 30 70 Year-on-year percent change (%) Year-on-year percent change (%) 20 60 10 50 40 0 30 -10 20 -20 10 -30 0 -40 -10 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2020 2021 2020 2021 Mining Manufacturing 120 200 Year-on-year percent change (%) Year-on-year percent change (%) 100 150 80 100 60 50 40 0 20 -50 0 -100 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2020 2021 Q2 Q3 Q4 Q2 Q3 Q4 Q1 Q1 2020 2021 Source: World Bank staff estimates using data from Central Bank of Honduras. Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. Manufacturing includes maquila trade, reported separately at a quarterly basis. Figure A.6. Honduras: monthly exports growth by destination, 2020-2021 United States Central America 120 120 Year-on-year percent change (%) Year-on-year percent change (%) 90 90 60 60 30 30 0 0 -30 -60 -30 -90 -60 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2020 2021 2020 2021 Rest of LAC Europe 80 100 Year-on-year percent change (%) Year-on-year percent change (%) 60 80 40 60 20 40 0 20 -20 0 -40 -20 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2020 2021 2020 2021 Source: World Bank staff estimates using data from Central Bank of Honduras. Note: Central America does not include Dominican Republic. Manufacturing includes maquila trade which is reported separately. 2021 Q4 excludes December. 128 129 Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) -10 0 10 20 30 40 50 60 70 -60 -40 -20 100 0 20 40 60 80 -60 -30 120 150 0 30 60 90 -50 100 150 200 250 300 350 -100 0 50 Jan-20 Jan-20 Jan-20 Jan-20 Feb-20 Feb-20 Feb-20 Feb-20 Mar-20 Mar-20 Mar-20 Mar-20 Apr-20 Apr-20 Apr-20 May-20 Apr-20 May-20 May-20 May-20 Jun-20 Jun-20 Jun-20 Jul-20 Jun-20 Jul-20 Jul-20 Jul-20 Aug-20 Aug-20 Aug-20 Sep-20 Aug-20 Sep-20 Sep-20 Oct-20 Sep-20 Oct-20 Oct-20 Nov-20 Oct-20 Nov-20 Nov-20 Dec-20 Nov-20 Rest of LAC Dec-20 Mining Jan-21 Dec-20 Dec-20 Jan-21 Agriculture Jan-21 United States Feb-21 Jan-21 Feb-21 Feb-21 Mar-21 Feb-21 Apr-21 Mar-21 Mar-21 Mar-21 May-21 Apr-21 Apr-21 Apr-21 Jun-21 May-21 May-21 May-21 Jul-21 Jun-21 Jun-21 Jun-21 Aug-21 Jul-21 Jul-21 Jul-21 Sep-21 Aug-21 Aug-21 Aug-21 Oct-21 Sep-21 Sep-21 Sep-21 Nov-21 Oct-21 Oct-21 Oct-21 Dec-21 Nov-21 Nov-21 Nov-21 Note: Central America does not include Dominican Republic. Dec-21 Dec-21 Dec-21 Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) Year-on-year percent change (%) -50 -60 -40 -20 100 150 200 250 -100 0 0 50 20 40 60 80 -60 -40 -20 100 120 0 20 40 60 80 -60 -40 -20 100 120 0 20 40 60 80 Jan-20 Jan-20 Jan-20 Jan-20 Feb-20 Feb-20 Feb-20 Feb-20 Mar-20 Mar-20 Mar-20 Mar-20 Apr-20 Apr-20 Apr-20 Apr-20 11-24, mining between chapters 25-27, and manufacturing between chapters 28-97. May-20 May-20 May-20 May-20 Jun-20 Jun-20 Source: World Bank staff estimates using data from Central Reserve Bank of El Salvador. Source: World Bank staff estimates using data from Central Reserve Bank of El Salvador. Jun-20 Jun-20 Jul-20 Jul-20 Jul-20 Jul-20 Aug-20 Aug-20 Aug-20 Aug-20 Sep-20 Sep-20 Sep-20 Sep-20 Oct-20 Oct-20 Oct-20 Oct-20 Europe Nov-20 Nov-20 Nov-20 Nov-20 Dec-20 Dec-20 Dec-20 Dec-20 Jan-21 Jan-21 Jan-21 Jan-21 Agroindustrial Manufacturing Feb-21 Figure A.7. El Salvador: monthly exports growth by sector, 2020-2021 Feb-21 Feb-21 Central America Feb-21 Mar-21 Mar-21 Mar-21 Figure A.8. El Salvador monthly exports growth by destination, 2020-2021 Mar-21 Apr-21 Apr-21 Apr-21 Apr-21 May-21 May-21 May-21 May-21 Jun-21 Jun-21 Jun-21 Jun-21 Jul-21 Jul-21 Jul-21 Jul-21 Aug-21 Aug-21 Aug-21 Aug-21 Sep-21 Sep-21 Sep-21 Sep-21 Oct-21 Oct-21 Oct-21 Oct-21 Nov-21 Nov-21 Nov-21 Nov-21 Dec-21 Dec-21 Dec-21 Dec-21 Note: Agriculture includes HS headings between chapters 1-10; agro-industrial includes the coffee industry and HS chapters between Figure A.9. Share of firms with canceled orders due to lack of inputs by sector Note: Predicted probability of canceling sales due to lack of inputs for production by sector, resulting from country-level linear regressions that controls for firm size, sector and mobility relative to the pre-pandemic level. Figure A.10: Value of orders canceled due to lack of inputs as fraction of sales, across sectors Note: Predicted mean share of canceled sales due to lack of inputs for production, resulting from country-level linear regressions that controls for firm size, sector and mobility relative to the pre- pandemic level. 130 Figure A.11: Fraction of fully or partially open businesses, across sectors Note: Percentage of firms reporting operating status as fully or partially open, by sector and survey wave. Figure A.12: Changes in employment Note: Unconditional percentage of firms that have adjusted employment during the 30 days prior to the survey. 131 Figure A.13. Change in sales (relative to the same period in 2019) Note: Predicted mean of percentage change in sales for the previous 30 days, relative to the same period in 2019, resulting from a linear regression that controls for country, firm size, sector and mobility relative to the pre-pandemic level. Data from the World Bank Enterprise Survey. Figure A.14. Change in sales across countries Note: Predicted mean of percentage change in sales for the previous 30 days, relative to the same period in 2019, resulting from a linear regression that controls for country, firm size, sector and mobility relative to the pre-pandemic level. Data from the World Bank Enterprise Survey. 132 Figure A.15. Year-on-year change in sales in CA3 countries, by sector Note: Predicted mean of percentage change in sales by sector, resulting from a linear regression that controls for country, firm size, sector and mobility relative to the pre-pandemic level. Data from the World Bank Enterprise Survey. Figure A.16. Year-on-year change in sales in CA3 countries, by detailed industry Note: Predicted mean of percentage change in sales by disaggregated industries, resulting from a linear regression that controls for country, firm size, sector and mobility relative to the pre-pandemic level. Data from the World Bank Enterprise Survey. Figure A.17. Change in competition in the last 30 days, by sector Note: Percentage of firms reporting that sector-level competition has increased, decreased or remained the same during the previous 30 days. 133 Figure A.18. Average change in sales by productivity quartiles, by sector Note: Predicted mean, by sector, of percentage change in sales by quartiles of baseline productivity levels, resulting from country- level linear regressions that controls for firm size, sector, and mobility relative to the pre-pandemic level. Productivity is defined as value added per worker in the previous fiscal year. Productivity levels refer to 2016 for El Salvador and Honduras and 2017 for Guatemala. Data from the World Bank Enterprise Survey. 134 Figure A.19. Average change in sale (year-on-year) by innovation intensity Note: Predicted mean of percentage change in sales by quartiles of baseline innovation intensity, resulting from country-level linear regressions that controls for firm size, sector, and mobility relative to the pre- pandemic level. Innovation intensity is defined as total R&D expenditure during the previous fiscal year, divided by the number of employees. Innovation intensity refers to 2016 for El Salvador and Honduras, and 2017 for Guatemala. Data from the World Bank Enterprise Survey. Figure A.20. El Salvador: Year-on-year quarterly change in firm exports and imports, 2020 a. Number of products exported and imported per firm (percent change) b. Number of export destinations and import source countries per firm (percent change) 135 Source: Staff estimates based on customs data for El Salvador from the expansion of the Exporter Dynamics Database and specifications from Constantinescu et al. (2022). Notes: The sample includes 4,100 firm-quarter observations in the left panel and 21.569 firm-quarter observations in the right panel. Figure A.21. El Salvador: Year-on-year quarterly change in firm exports and imports by GVC participation, 2020 a. Number of products exported and imported per firm (percent change) b. Number of export destinations and import source countries per firm (percent change) Source: Staff estimates based on customs data for El Salvador from the expansion of the Exporter Dynamics Database and specifications from Constantinescu et al. (2022). Notes: The sample includes 4,100 firm-quarter observations in the left panel and 21.569 firm-quarter observations in the right panel. 136 Figure A.22. Probability of falling into arrears, by firm size Note: Predicted probabilities of falling into arrears within the following six months, estimated through a Probit model, controlling for size, sector and mobility relative to the pre-pandemic level. Figure A.23. Fraction of businesses that started or increased the use of digital technologies Note: Unconditional fraction of firms that have started or increased the use of internet, online social media, specialized apps, or digital platforms in response to the outbreak of Covid-19. Probabilities were estimated with a Probit model, controlling for size, sector and mobility relative to the pre-pandemic level. 137 Figure A. 24. Probability of starting or increasing the use of digital technology by firm size Note: Predicted probability, by firm size, of starting or increasing use of internet, online social media, specialized apps, or digital platforms in response to the outbreak of Covid-19. Probabilities were estimated with a Probit model, controlling for size, sector and mobility relative to the pre- pandemic level. 138