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Nicaragua: Latin America's Other Socialist-Spawned Crisis

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2018 was the year when, yet again, the socialist model proved its inability to generate benefits for a population. The example most discussed by the media was that of Venezuela. In a humanitarian crisis unprecedented in the Americas, this South American country is deteriorating every day, but it is not the only one. Another country in Latin America that is suffering the consequences of socialist authoritarianism, and leaving its economy at the edge of the abyss and its people in collective misery, is Nicaragua.

The Reform That Caused the Crisis

Daniel Ortega’s government tried to pass a reform to the Nicaraguan Institute of Social Security’s (INSS for its acronym in Spanish) pension system, allegedly for the purpose of “improving the financial balance of the pension system.” In order to heal a deficit of more than $76 million dollars, a plan was presented to increase employer’s contributions by 3.5 percent (bringing their total contributions to 22.5 percent), to increase workers’ contributions by 0.75 percent (bringing their total contributions to 7 percent), and to reduce retirees’ pensions by 5 percent. This triggered a wave of protests in which hundreds of people took to the streets to reject the reforms. The government made the terrible decision to repress the protestors by using force, which helped the demonstrators gain more followers. In little time the protests served to unite thousands of people against corruption, censorship, and the lack of democracy. People from different social sectors, socioeconomic contexts, and ideologies protested for a change in the system. However, the situation worsened when violence with the police escalated, leaving dozens of people dead or political prisoners.

In the wake of the political crisis, the Ortega regime reversed the reform. But the damage had been done. The violent protests continued, the number of political prisoners increased, and all the while the silent victim was the Nicaraguan economy. In this article, different facets of this crisis will be described in detail in order to show how badly the current year could end for Nicaragua.

The Economic Crisis of 2018

According to the World Bank and the International Monetary Fund, in 2018 the Nicaraguan economy fell by more than 4 percent in terms of GDP. According to the Nicaraguan Foundation for Economic and Social Development (FUNIDES for its acronym in Spanish), poverty increased by 9.3 percent in 2018, reaching 38.9 percent. More than 157,000 jobs were lost, another 300,000 were suspended, and more than 10,000 entrepreneurs had to close down their businesses. The environment of extreme insecurity, uncertainty, and fear brought on by the repression and violent protests gravely affected consumer and investor confidence, and growth figures of previous years (almost 5 percent over the GDP) became a thing of the past. The wave of murders, injuries, and imprisonments caused by Ortega’s repression resulted in a significant downturn in the economy that affected practically all of the productive sectors. In a domino effect, the crisis then went on to affect tax and social security income collection and also caused a massive outflow of Nicaraguan migrants.

The situation grew worse when United States congressmen began to take note of the disaster brewing in Central America. The “Nica Act,” or Nicaraguan Investment Conditionality Act, was proposed by some United States senators who wanted to press the Ortega government to hold free and transparent elections. After two failed attempts in the United States Congress, and following the outbreak of the political crisis, the law was approved. The law limited loans from international financial organizations to the Ortega government. It also imposed sanctions on Ortega regime officials, such as blocking their U.S. assets and prohibiting them from conducting transactions using the United States financial system.   

This law touched on one of the fundamental pillars of Nicaragua’s economy: its dependence on the United States and its allies. This dependence is due as much to the large quantity of remittances that enter the country as it is to the quantity of public investment financed by loans from international cooperation aid agencies (more than 70 percent of public investment in 2017). This dependence is also due to the fact that, at the beginning of 2018, 65 percent of deposits in the country were in dollars.

The projections for 2019 are not at all encouraging. International entities and FUNIDES estimate an economic downturn of between 7 and 10 percent. The political situation is unclear in the short term. Uncertainty is rampant in business circles, and the contraction of economic activity is evident in the streets, where hundreds of businesses remain closed. But of all the affected industries, perhaps the most critical is the banking sector.

A Slow Death for the Banking System

According to Professor Richard Feinberg and researcher Beatriz Miranda, in the essay “A Nicaraguan Tragedy: From Consensus to Coercion,” the IMF believed that the banking system in Nicaragua had liquidity and solvency standards that were much higher than international ones, and that its alliances with the government gave it a comfortable legal environment which made it possible to attain large profits. However, in the middle of the crisis, loans fell into default, profits disappeared, and banking capital was jeopardized.

The government’s violent actions provoked panic among savers and investors, resulting in massive withdrawals from the Nicaraguan banking system. The people making the withdrawals included everybody from small savers who withdrew money in case of emergencies, to large investors who took it out of the country. According to FUNIDES, between March 31 and December 31 of 2018, more than 28 percent of the banking system’s total deposits were withdrawn.

Situations like this place significant pressure on banks to comply with the cash demands of their account holders, which in turn creates pressure for the early recovery of credit portfolios or the acquisition of lines of credit from other financial institutions. And, indeed, credit was affected. The loan portfolio contracted by 13 percent in 2018. The contraction of credit is particularly important because it reduces the capacity of other agents in the economy to leverage and improve their returns, which in turn removes an important lifesaver from an economy in recession. Furthermore, the banks rushed to buy dollars from the Central Bank of Nicaragua in order to cover the demand for foreign currency for withdrawals or the conversion of córdobas.

Access to international lines of credit became complicated, since after the “Nica Act,” US banks that had done business with Nicaraguan banks decided to withdraw from the country. Towards the end of 2018, Wells Fargo, Bank of America, JP Morgan Chase and Citi, four of the most important banks in the United States, decided to end relations with Nicaraguan banks, complaining of significant risk increases in the country and the difficulties imposed by the restrictions of the Nica Act. International rating agencies have also punished the country, decreasing the country’s ranking because of socio-political risks and raising the country’s risk premium, making international credit more expensive. All of these problems caused the bank to take desperate savings measures such as closing branches, firing employees, and even pursuing clients with overdue loan payments.

Faced with a massive lack of foreign credit lines, the central bank tried to inject liquidity into the banks. However, with the amount of withdrawals from the system, and the lack of other lines of credit, this has only resulted in the loss of monetary reserves, jeopardizing the exchange rate stability. Between April and December of 2018, the reserves decreased by 30 percent. If this rate of withdrawals should continue, they could run out of reserves by this year or next.

Risk of a Bank Freeze, Risk of Devaluation

As of right now, one of the greatest risks in Nicaragua is the loss of exchange-rate stability. The exchange rate in Nicaragua has been administered by the Central Bank of Nicaragua (BCN in Spanish) since the 1990s via a crawling peg exchange rate system, whereby the exchange rate of the córdoba against the US dollar depreciates by 5 percent per year and is adjusted daily so that the devaluation is linear. However, in recent months, the BCN has been making a series of erratic decisions that warn of future exchange problems.

One such decision was making the monthly rate of currency convertibility discretionary. This means that the president of the central bank will decide on a monthly basis how much he wishes to devalue the currency, which could break with the traditional 5 percent that has been in place for the last 25 years. At the time, this decision caused a wave of speculation about severe devaluations, but the BCN has respected the 5 percent rule since it was eliminated in October of 2018. It is not viable to modify it any time soon, because a large part of the Nicaraguan economy is dollarized (as are loans). However, even though the rule had been respected up until now, it is no longer a rule. This only increases uncertainty for economic agents that remain at the mercy of the will of the central bank, an institution that should be among the most stable and trustworthy in order for a country to develop at the macroeconomic level the way it should.

Significant withdrawals of dollar deposits and the consequent loss of reserves risk a de facto devaluation. The risk also derives from the lack of reserves available to the Central Bank of Nicaragua. The reserves were drastically affected by the demand in commercial banks for dollar withdrawals, with the BCN covering 74 percent of the dollars demanded by banks for this purpose. As mentioned earlier, an unsustainable decrease in reserves would force the central bank to choose one of two options:

  • Liberate the exchange rate at once
  • Limit the outflow of dollars in some way

The first option, ideal for stabilizing the market, would be very painful for an economy that is already in recession and, as a result, is not politically feasible. Another solution suggested by economists is to eliminate the indexation of certain goods and services, so that the exchange rate hit does not affect interest rates or salaries. However, this measure would generate great uncertainty among economic agents, which would worsen the process of devaluation.

The second option, limiting the outflow of dollars, is an path well-known by Latin American governments facing currency crises. In some way, this option has already been put in motion with another decision by the BCN: to limit financial institutions’ ability to purchase dollars online. In October of 2018, the central bank notified the banks that, in order to cover their dollar needs, they needed to place a request in writing 48 hours in advance, indicating the amount, purpose, and the entities involved. This kind of “pre-corralito” (a bank freeze) in which the amount of dollars given to banks begins to be restricted, opens the door to rigid control of exchanges given to any person or institution in the future, resulting in the loss of free currency convertibility.  From there, the BCN can decide to whom it will or will not sell dollars. Then, when reserves reach unsustainable lows, the BCN will begin to limit dollars to what the regime considers its priorities, thus hurting the rest of the economy.

One strategy adopted by the BCN in order to fight the reduction in reserves was to take national currency out of circulation. The idea was to limit the amount of córdobas in order to try to counteract the decrease of dollars, and to maintain the 2.8 ratio the central bank manages in order to stabilize its foreign exchange operations. The big problem with this measure is that intentionally reducing the amount of money in circulation slows the economy by leaving economic agents with less liquidity, as well as shrinking credit. In an economy in recession, decreasing money aggravates the recession even more, as evidenced by the Great Depression in the United States in the 1930s.

What is most likely is that the central bank will make a set of two joint strategies. On the one hand, given its discretionary power, it could change the crawling peg rate of the córdoba while maintaining control of the outflow of dollars. In 2019, the crisis will be aggravated by the INSS and tax reforms (see the following section), which will worsen the outflow of capital. Reducing the supply of money, deciding at their discretion to whom they will sell dollars, and controlling the outflow of currency from the economy will cause the already waning business confidence to disappear and create the worst crisis the Nicaraguans have seen since the time of the Sandinistas.

The Coup de Grace: Tax Reform and Social Security (INSS) Reform

Nine months after the INSS reform could not be passed in 2018, Ortega and his congress approved modifications to social security. The reform increased employers’ contributions from 19 percent to 22.5 percent, and workers’ contributions from 6.25 percent to 7 percent. Additionally, according to FUNIDES, new retirees’ pensions were reduced by 35 percent on average.

Despite the private sector’s categorical rejection of the reform, the government turned a deaf ear. For employers, it will reduce hiring and cause more layoffs and higher unemployment. For workers, it will leave them with lower incomes, which will end up damaging their already decreased purchasing power. The businesses most affected will be those that mainly rely on manual labor, but in general unemployment is expected to increase.

It is true that the reform was vital, because if the income of the INSS had not been increased in some way, the program would have gone bankrupt. However, the abrupt way in which it was done less gradually than the reform proposed in 2018 will cause a reduction in the liquidity among businesses and families, thus aggravating the crisis.

However, the “coup de grace” for Nicaragua’s economy was the government’s tax reform. The reform was considered “confiscatory” by civil society, and sought only to improve the state finances that the same government had worsened by provoking the 2018 crisis. In the reform, many previously untaxed food products began to be taxed, the ISR (income tax) increased, certain specific taxes were raised, and there were many obstacles preventing a product from being exonerated from the IVA tax (value added tax, or VAT). However, the most outlandish feature was the 1.5 percent tax on exports.

The tax on food products will limit family consumption. It will also push businesses to decrease their productive activity, which leads to cutbacks, more unemployment, and a crisis on a downward spiral. According to the Nicaraguan Chamber of Industry, consumer prices could increase by 50 to 70 percent. If the government’s goal was to raise more money, the effect will be the exact opposite after reducing the economy and damaging public finances, because it will contract the economy further and diminish tax revenues.

It is absurd to increase costs in an economy that is already in recession because it ends up taking away the little liquidity left in the system, such that businesses are left with three options: fire employees and save to an extreme extent, decrease production to a minimum, or close down their businesses. Nicaragua’s potential for competitiveness has been lost with these damages to its industries, but it is mainly the ordinary people who suffer. Unemployment pushes people towards the informal market, illegal immigration, or crime, and any of the three options will decrease Nicaraguans’ quality of life. And, not satisfied with the damage it has already caused, the government has the power to raise taxes again in May if the tax collection does not meet expectations.

So, What to Expect in 2019?

In 2019 it is sensible to expect a more accelerated reduction of the economy, with it falling possibly even more than 10 percent. The possibility of banking crises continues to rise if withdrawals continue as they are or if they increase. Also possible are a pronounced devaluation or a “corralito” (bank freeze) that limits the foreign currency that is available to people and businesses. The worst thing of all is that the political situation is the real cause of these evils, and it does not seem likely that it will change in the short term. According to The Economist, elections are not expected unless political conditions deteriorate drastically, since Ortega has the support of the army.

Businesses not only have to deal with less sales, fewer operations, lower international prices of raw materials, and a lack of access to financing, but now they also have to deal with higher taxes and higher labor costs. The uncertainty that the Ortega regime introduced into the economy, the crisis it created, and the economic collapse through which this small Central American country is suffering, are examples of the tremendous damage authoritarianism causes to economies that are institutionally weak. According to FUNIDES, businesses are already facing a shortage of supplies, credit is either scarce or too expensive, and providers do not want to give many credit days because of the exchange rate risk.

We do not know how many years it could take for Nicaragua to recover from this hit, but every day that Ortega stays in power, this period lengthens. If Maduro, with an even worse crisis, has been able to withstand international sanctions against Venezuela, Ortega seems likely to continue clinging to power. As if they were mirrors, Syria and Venezuela reflect cases of authoritarian regimes that have caused severe crises and who maintain power by controlling state institutions with the unconditional support of the military. But, unless Nicaragua wants to continue along the tortuous road that both of those countries have traveled, it should change its governing leadership or all efforts will be in vain.

Originally published by UFM Market Trends

Jorge Eduardo García

Jorge Eduardo García is currently completing the fourth year of a degree in Economics with a specialization in Finance at the Francisco Marroquín University.

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