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El Salvador: Staff Report for the 2016 Article IV Consultation

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
July 2016
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Inadequate Growth and Tough Challenges

1. GDP growth has averaged 2 percent over 2000-2014, well below the Central American regional average of 4½ percent (Figure 1). Alongside, GDP per capita has risen slowly and well behind the frontrunners in the region.

Figure 1.El Salvador: Long-term Growth and Poverty

Structural bottlenecks have inhibited long-term growth.

Sources: ECLAC; and World Bank, World Development Indicators, Doing Business Indicators, and Global Competitiveness Indicators.

1/ Simple average of Costa Rica, Guatemala, Honduras, Nicaragua, Panama, andthe Dominican Republic.

2/ Simple average of Brazil, Chile, Colombia, Mexico, and Peru.

2. While the underlying causes of the low growth are complex, a key channel through which they are expressed appears to be low investment. 1 El Salvador’s investment rate has averaged only 15½ percent of GDP since 2000. Data gaps preclude strong conclusions, but the available evidence suggests that the likely culprits include:

GDP per Capita in Central America, 2000-15

(US Dollars)

Sources: WEO and Fund Staff estimates.

  • political polarization;
  • high crime;
  • rising unit labor costs;
  • worsening terms of trade (until recently);
  • high energy and logistics costs;
  • barriers to entry and expansion of business;
  • high exposure to natural disasters;
  • fiscal and regulatory uncertainty; and
  • limited human capital.

However, along many of these dimensions El Salvador does not appear materially worse than its faster-growing neighbors aside from the inter-related forces of high levels of outward migration and violent crime. Most likely, it is the complex interaction of all of these factors that is at the core and, as such, resolving low growth will require action along multiple fronts.

Factors Underlying Low Growth in El Salvador

3. The adverse effect of high emigration on growth goes beyond its impact on investment. Emigration since the civil war, triggered in part by insecurity, reduced labor supply, particularly among the more flexible and potentially productive young workers, restraining growth. And while there was a concurrent surge in remittances that supported consumption, this also likely raised reservation wages and limited competitiveness. Moreover, in recent years the growth of remittances has been lower than in neighboring countries, reflecting the earlier start of migration and more mature family unification process.

4. The low-growth feeds a number of vicious cycles. First, it hinders efforts to reduce the high crime rate and improve educational attainment, which in turn deters investment and growth. It also encourages emigration, which limits labor supply and in turn dampens growth. Low growth also creates fiscal pressures, as social demands continue to increase while fiscal revenues remain subdued. The resulting adverse trends in public debt increase macroeconomic instability and undermine investor confidence. Breaking these vicious cycles will require strong concerted efforts.

5. El Salvador’s competitiveness problem has been exacerbated by the run-up in the U.S. dollar (Annex III). Staff’s estimates using the three EBA-lite methodologies suggest REER overvaluation close to 10 percent. International reserves are broadly adequate by traditional metrics but fall short against more suitable risk-weighted benchmarks that are tailored to a fully dollarized economy. And after an initial post civil war spurt El Salvador’s export performance has been stagnant since 1998, with its share of world goods and services exports flat at 0.03 percent.

Composition of Net International Reserves, Dec. 2015

(Millions of U.S. $)

Source: Central Bank of El Salvador, and IMF staff calculations.

Reserve Adequacy Metrics, 2015

(Percent of GDP)

Source: National authorities and Fund staff estimates.

Notes:The ARA metric for fixed exchange rate regimes is calculated as follows: 10% × Exports + 10% × Broad Money + 30% × Short-term Debt + 20% × Other Liabilities.

The Authorities’ metric includes coverage of: (i) liquidity requirements and a liquidity fund, amounting to 22 percent of deposits, (ii) a newly created lender of last resort, with resources amounting to 8 percent of deposits over the medium term, and (iii) deposit insurance with 5 percent of deposits.

El Salvador: Exchange Rate Assessment Results
EBA-lite CA methodologyCA norm (% of GDP)Underlying CA (% of GDP)1/REER gap2/
−3.7−5.813.9
EBA-lite IREER methodologyln(REER) normln(REER) actualREER gap2/
4.04.60.7
CA norm (% of GDP)Underlying CA (% of GDP)REER gap2/
EBA-lite ES methodology2/−2.8−5.014.1
Source: Fund staff estimates and projections.

Oil prices are assumed to affect the CA norm and underlying CA symmetrically.

(+): overvaluation. In the CA and ES methodologies, export elasticity: -0.71, import elasticity: 0.92.

The CA norm stabilizes the net IIP position at the target level of -50% of GDP.

Source: Fund staff estimates and projections.

Oil prices are assumed to affect the CA norm and underlying CA symmetrically.

(+): overvaluation. In the CA and ES methodologies, export elasticity: -0.71, import elasticity: 0.92.

The CA norm stabilizes the net IIP position at the target level of -50% of GDP.

6. Political gridlock is an obstacle even to incremental reform. The authorities’ 5-year plan puts growth as the overriding priority, and many growth-promoting measures have been pursued. However, while there is broad agreement on the need to increase inclusive growth and public sector efficiency, and to reduce crime and corruption, the main political parties are far apart on how to achieve these objectives, resulting in legislative stalemate on many important initiatives.

Developments, Outlook, and Risks

7. Low oil prices helped growth and the current account improve in 2015 alongside low headline inflation (Table 1). GDP grew 2½ percent in 2015, up from 1½ percent in 2014, supported by steady growth in the US which increased remittances, robust export growth to the rest of Central America, and a stimulus from lower oil prices. Investment also increased significantly, helped by better corporate balance sheets (also in part a consequence of low oil prices). Headline inflation was slightly negative (-0.7 percent), anchored by the fully dollarized regime and lower energy prices. The current account deficit fell 1½ percentage points to 3½ percent of GDP (Figure 3).

Table 1.El Salvador: Selected Economic Indicators
Rank in UNDP Development Index 2013 (of 187)115Population (million)6.3
Per capita income (U.S. dollars)4,129Life expectancy at birth in years (2014)72
Percent of pop. below poverty line (2013)30Infant mortality (per 1,000 live births, 2014)19
Gini index (2014)38Primary education completion rate (percent, 2013)100
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

Est.Proj.
2011201220132014201520162017
Income and Prices
Real GDP growth (percent)2.21.91.81.42.52.32.4
Consumer price inflation (average, percent)5.11.70.81.1−0.72.11.9
GDP deflator (percent)5.71.00.41.40.71.81.7
Terms of trade, percent change−2.50.5−1.63.312.4−1.6−1.6
Real effective exchange rate (+ = appreciation)2.6−1.5−0.80.50.0
External sovereign bond spread (basis points)374448378400497
Money and Credit
Credit to the private sector39.840.242.544.144.945.145.3
Broad money43.643.243.342.243.443.443.4
Interest rate (time deposits, percent)1.82.53.43.84.2
External Sector
Current account balance−4.8−5.4−6.5−5.2−3.6−3.7−4.9
Trade balance−20.6−20.7−21.7−20.8−19.1−19.2−20.2
Exports (f.o.b. excluding maquila)18.317.817.817.016.916.516.7
Imports (f.o.b. excluding maquila)−39.0−38.5−39.5−37.8−36.1−35.7−36.9
Services and income (net)−0.7−1.6−1.6−1.3−1.4−1.5−1.7
Transfers (net)16.616.916.816.916.917.016.9
Foreign direct investment0.92.00.71.21.71.51.8
Gross international reserves (millions of U.S. dollars)2,5033,1752,7452,6932,7872,9082929
Nonfinancial Public Sector
Overall balance−3.9−3.9−4.1−3.5−3.4−4.0−4.0
Primary balance−1.7−1.6−1.6−1.1−0.9−1.2−1.0
Of which: tax revenue13.814.415.415.115.215.415.7
Public sector debt 1/52.257.357.659.260.662.263.7
National Savings and Investment
Gross domestic investment14.414.115.013.614.014.214.7
Public sector2.42.52.52.12.12.52.5
Private sector11.911.612.511.511.911.712.2
National savings9.68.78.58.410.410.49.8
Public sector−2.0−1.2−1.2−0.9−0.9−1.0−1.1
Private sector11.59.99.79.311.311.510.9
Net Foreign Assets of the Financial System
Millions of U.S. dollars2,8113,2292,4732,2111,9312,1771,882
Percent of deposits28.832.624.021.617.819.516.2
Memorandum Items:
Nominal GDP (billions of U.S. dollars)23.123.824.425.125.926.928.0
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

8. The fiscal deficit fell by 0.1 percentage point to 3.4 percent of GDP in 2015 (Figure 2). Fiscal expenditure remained broadly constant as a percent of GDP. The wage bill increased slightly by 0.1 percent of GDP, largely reflecting ingrained indexation in selected sectors, and the interest bill also rose marginally. However, the authorities took advantage of low oil prices to reduce energy subsidies. Capital expenditure remained subdued at 2¾ percent of GDP. Revenues were helped by the banking transactions tax (BTT) adopted in the second half of 2014 but were lower than expected. New taxes on telecommunications services and large enterprise profits were introduced in late-2015 to finance a needed increase in law enforcement and security spending.

Figure 2.El Salvador: Fiscal Developments

Spending restraint helped cut the deficit somewhat, but financing remains a concern

Sources: National authorities and Fund staff calculations.

Figure 3.El Salvador: Balance of Payments Developments

Sources: Central Reserve Bank of El Salvador, Haver Analytics, and Fund staff calculations.

Energy and Transport Subsidies

(percent of GDP)

Source: El Salvador Ministry of Finance

9. However, fiscal risks are rising. Reflecting a parliamentary impasse over approval to access external financing, domestic financing rose sharply in 2015 and early 2016, pushing up yields on government short term domestic securities (LETES). Without a resolution of the impasse, the authorities are likely to reach the limits of the domestic system to finance the budget toward the end of this year, raising the prospect of disorderly adjustment. Moreover, despite recent declines EMBI spreads relative to other emerging markets remain elevated, raising risks that external financing could be more expensive than earlier envisaged. The tightening liquidity position of the budget has increased difficulties in making timely payments to suppliers and exporters (for VAT refunds).

Stock of short-term T-bills

($million)

Source: El Salvador Ministry of Finance

Banks’ Liqudity Position

(Percent of deposits and securities)

Source: BCR, IMF

10. The financial sector is stable but is exposed to the rising sovereign risks (Figure 4). Banking sector capital remains high (17.2 percent of risk-weighted assets), substantially above the minimum statutory level of 12 percent. Provisioning is adequate (nearly 115 percent of NPLs) and asset quality continues to improve. Banking system liquidity appears ample. However, bank profitability is relatively low due to a narrowing loan to deposit rate spread and high liquidity. Deposits and credit to the private sector grew by around 6 and 5 percent, respectively, in 2015 as corporate credit picked up and household credit slowed. Credit to the private sector nudged up to nearly 45 percent of GDP. Financial sector credit to the public sector, on the other hand, increased by nearly 15 percent and now accounts for about 35 percent of private financial system assets, increasing the exposure of the financial sector to fiscal shocks such as a repricing of sovereign risk.

Figure 4.El Salvador: Financial Sector Developments

Sources: National authorities, IMF Financial Soundness Indicators, and Fund staff calculations.

1/ Simple average of Brazil, Chile, Colombia, Mexico, and Peru.

2/ Simple average of Costa Rica, Guatemala, Honduras, Panama, and the Dominican Republic.

3/ CAPDR for year 2015 includes Costa Rica, Honduras and Guatemala.

4/ The latest data available for ECU are till July 2015

11. GDP growth is expected to be 2.3 percent in 2016 and 2.4 percent in 2017, falling over the medium-term toward a potential growth rate of 2 percent (Tables 2-7).2 There is some near-term upside risk if several significant investment projects get underway (notably a large gas project). However, US growth (with which Salvadoran growth is highly correlated) is projected to decline over the medium term. Moreover, oil prices are expected to trend upwards over the medium term, tempering the recent boost to demand. Inflation is expected to remain anchored by the fully dollarized regime. Given the rise in oil import prices and difficult prospects to strengthen and diversify exports the current account deficit is expected to rise to 5½ percent of GDP by 2021.

Table 2.El Salvador: Medium-Term Baseline Scenario
Projections
2012201320142015201620172018201920202021
(Annual percentage change)
Real GDP growth1.91.81.42.52.32.42.32.12.02.0
Domestic demand1.82.20.42.83.23.42.82.22.02.4
Inflation (end of period)0.80.80.51.01.92.02.02.02.02.0
(Contributions to growth, percentage points)
Private consumption2.20.71.71.62.22.52.21.71.82.1
Private investment−0.21.5−0.91.20.71.10.80.60.50.5
Government0.20.4−0.30.50.90.40.40.30.20.4
Net exports−0.3−0.71.0−0.9−1.5−1.6−1.1−0.5−0.5−1.0
(Percent of GDP)
Nonfinancial public sector balance−3.9−4.1−3.5−3.4−4.0−4.0−4.5−5.0−5.3−5.6
Primary balance−1.6−1.6−1.1−0.9−1.2−1.0−1.1−1.3−1.4−1.6
Public sector gross debt 1/57.357.659.260.662.263.765.567.970.573.2
External current account balance−5.4−6.5−5.2−3.6−3.7−4.9−5.3−5.4−5.5−5.5
Exports of goods17.817.817.016.916.516.716.816.917.117.1
Imports of goods−38.5−39.5−37.8−36.1−35.7−36.9−37.3−37.5−37.6−37.8
Current transfers16.916.816.916.917.016.916.816.816.816.8
Gross domestic investment14.115.013.614.014.214.715.015.115.015.1
Private11.612.511.511.911.712.212.512.612.712.8
Public2.52.52.12.12.52.52.52.52.32.3
Gross national saving8.78.58.410.410.49.89.69.79.69.6
Private9.99.79.311.311.510.911.311.812.012.3
Public−1.2−1.2−0.9−0.9−1.0−1.1−1.6−2.1−2.4−2.7
External saving5.46.55.23.63.74.95.35.45.55.5
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

Table 3.El Salvador: Balance of Payments
Projections
2012201320142015201620172018201920202021
(In millions of U.S. dollars)
Current Account−1,288−1,574−1,306−920−1,006−1,386−1,567−1,659−1,737−1,821
Merchandise trade balance−4,927−5,295−5,208−4,940−5,163−5,667−6,016−6,275−6,530−6,863
Export of goods (f.o.b.)4,2354,3344,2564,3814,4434,6924,9245,1725,4195,668
Import of goods (f.o.b.)−9,162−9,629−9,463−9,321−9,606−10,358−10,940−11,447−11,949−12,531
Services508618741786790790825879931971
Exports of processing services424440375464468482483485485484
Income−890−997−1,074−1,137−1,200−1,254−1,312−1,399−1,480−1,489
Current transfers4,0214,1004,2344,3724,5674,7454,9365,1355,3435,559
Workers’ remittances (credits)3,8943,9544,1334,2704,4844,6724,8685,0735,2865,508
Financial and Capital Account2,1161,1387661,1631,1271,4061,5711,7741,8541,950
Capital account2011016466144172176136136136
Public sector financial flows91213788−13301621803051
Disbursements1,2022691,0593323383633771,227386402
Amortization−290−256−271−345−308−347−356−1,147−355−351
Private sector financial flows1,3521901,100448341441463493514514
Foreign direct investment484176311429400500521551571571
Portfolio investment8681478919−59−59−58−58−57−57
Other 1/−349835−1,1866636127769101,0631,1731,249
Errors and Omissions−177109508−130000000
Change in Reserves (- = increase)−65132733−113−121−21−4−115−117−128
(Percent of GDP)
Current Account−5.4−6.5−5.2−3.6−3.7−4.9−5.3−5.4−5.5−5.5
Merchandise trade balance−20.7−21.7−20.8−19.1−19.2−20.2−20.5−20.6−20.6−20.7
Export of goods (f.o.b.)17.817.817.016.916.516.716.816.917.117.1
Import of goods (f.o.b.)−38.5−39.5−37.8−36.1−35.7−36.9−37.3−37.5−37.6−37.8
Petroleum and products−8.0−8.1−7.0−5.2−4.2−4.9−5.0−5.0−5.1−5.1
Services2.12.53.03.02.92.82.82.92.92.9
Exports of processing services1.81.81.51.81.71.71.61.61.51.5
Income−3.7−4.1−4.3−4.4−4.5−4.5−4.5−4.6−4.7−4.5
Current transfers16.916.816.916.917.016.916.816.816.816.8
Workers’ remittances (credits)16.416.216.516.516.716.716.616.616.616.6
Financial and Capital Account8.94.73.14.54.25.05.45.85.85.9
Capital account0.80.40.30.30.50.60.60.40.40.4
Public sector financial flows3.80.13.1−0.10.10.10.10.30.10.2
Private sector financial flows5.70.84.41.71.31.61.61.61.61.6
Foreign direct investment2.00.71.21.71.51.81.81.81.81.7
Portfolio investment3.60.13.10.1−0.2−0.2−0.2−0.2−0.2−0.2
Other 1/−1.53.4−4.72.62.32.83.13.53.73.8
(Annual percentage change)
Merchandise Trade (f.o.b.)
Exports (nominal)−0.22.3−1.82.91.45.65.05.04.84.6
Volume−1.34.0−3.31.07.05.54.84.64.64.6
Price1.1−1.61.51.9−5.30.10.20.40.20.0
Imports (nominal)1.65.1−1.7−1.53.17.85.64.64.44.9
Volume1.05.00.08.67.16.04.73.73.64.3
Price0.60.1−1.7−9.3−3.81.70.90.90.80.5
Terms of trade0.5−1.63.312.4−1.6−1.6−0.7−0.5−0.6−0.5
Memorandum Items
Gross international reserves (US$ million) 2/3,1752,7452,6932,7872,9082,9292,9323,0473,1643,292
In months of imports (excluding maquila) 3/3.43.03.02.92.82.62.52.52.52.5
In percent of total short-term external debt208148133138138132124120117114
External debt (in percent of GDP)56.157.960.956.656.857.358.059.460.962.3
Of which: public sector debt32.131.934.633.134.134.835.837.238.740.1
Of which: private sector debt24.026.026.323.522.622.522.222.222.222.1
External public debt servicing (US$ million)5805825987797438128781,7539741,043
Percent of exports of goods and services9.59.19.211.610.310.510.820.610.911.2
Gross external financing requirement (US$ million)3,3113,8773,9693,7493,6604,1524,4595,4734,9245,178
Percent of GDP13.915.915.814.513.614.815.217.915.515.6
Sources: Central Reserve Bank of El Salvador and Fund staff estimates.

Assumed to include both private and potential public sector flows, including 75 percent of the fiscal financing gap.

Gold in international reserves is valued at the price determined by the London Bullion Market.

Expressed in terms of following year’s imports.

Sources: Central Reserve Bank of El Salvador and Fund staff estimates.

Assumed to include both private and potential public sector flows, including 75 percent of the fiscal financing gap.

Gold in international reserves is valued at the price determined by the London Bullion Market.

Expressed in terms of following year’s imports.

Table 4.El Salvador: Operations of the Nonfinancial Public Sector
Projections.
2012201320142015201620172018201920202021
(In millions of U.S. dollars)
Revenue and Grants4,5074,6784,7394,9235,2365,5875,8416,0906,2856,557
Current revenue4,3294,6074,6924,8705,1965,4995,7516,0036,2606,532
Tax revenue3,4343,7453,7723,9184,1554,4104,6134,8175,0265,245
Nontax revenue7347567978369429821,0261,0691,1131,161
Operating surplus of the public enterprises16210612411598107112117122127
Capital revenue0000000000
Official grants178714653418891872524
Expenditure5,4275,6655,6265,7996,3236,7077,1597,6237,9628,412
Current expenditure4,6094,8894,9265,0985,4775,8106,2276,6567,0177,427
Wages and salaries2,0052,1152,2282,3262,5002,6482,8092,9713,1393,324
Goods and services9351,0751,0491,0831,1411,1951,2491,3011,3541,413
Interest5405946096447638429881,1481,2301,334
Current transfers1,1281,1051,0401,0451,0741,1251,1811,2371,2941,356
Nonpension payments709663573560508529553576600626
Pension payments419442467485566595628661694731
Capital expenditure818776700701846897932967945985
Primary Balance−379−393−278−233−324−278−329−386−447−521
Overall Balance−919−987−887−876−1,087−1,120−1,317−1,533−1,677−1,855
Financing9199878878761,0871,1201,3171,5331,6771,855
External91213788−13301621803051
Disbursements1,2022691,0593323383633771,227386402
Amortization−290−256−271−345−308−347−356−1,147−355−351
Domestic7975100889100511515531564401
Change in deposits at central bank (- = increase)−737758−524000000
Banking system162−171−557732−22200000
Private sector 1/582388662133322511515531564401
Unidentified financing9575937819221,0831,404
Memorandum Items:
Current revenue minus current expenditure−279−282−234−228−281−311−476−653−757−894
Gross financing needs1,8772,1802,2441,6282,4122,1022,3363,3602,7123,087
Public sector debt (gross) 2/13,64114,03114,82715,66316,75017,86919,18720,72022,39724,252
(In percent of GDP)
Revenue and Grants18.919.218.919.019.519.919.920.019.819.8
Current revenue18.218.918.718.819.319.619.619.719.719.7
Tax revenue14.415.415.115.215.415.715.715.815.815.8
Nontax revenue3.13.13.23.23.53.53.53.53.53.5
Operating surplus of the public enterprises0.70.40.50.40.40.40.40.40.40.4
Official grants0.70.30.20.20.20.30.30.30.10.1
Expenditure22.823.322.522.423.523.924.425.025.125.4
Current expenditure19.420.119.719.720.420.721.321.822.122.4
Wages and salaries8.48.78.99.09.39.49.69.79.910.0
Goods and services3.94.44.24.24.24.34.34.34.34.3
Interest2.32.42.42.52.83.03.43.83.94.0
Current transfers4.74.54.24.04.04.04.04.14.14.1
Nonpension payments3.02.72.32.21.91.91.91.91.91.9
Pension payments1.81.81.91.92.12.12.12.22.22.2
Capital expenditure3.43.22.82.73.13.23.23.23.03.0
Primary Balance−1.6−1.6−1.1−0.9−1.2−1.0−1.1−1.3−1.4−1.6
Overall Balance−3.9−4.1−3.5−3.4−4.0−4.0−4.5−5.0−5.3−5.6
Memorandum Items:
Current revenue minus current expenditure−1.2−1.2−0.9−0.9−1.0−1.1−1.6−2.1−2.4−2.7
Gross financing needs7.99.09.06.39.07.58.011.08.59.3
Public sector debt (gross) 2/57.357.659.260.662.263.765.567.970.573.2
Nominal GDP23,81424,35125,05425,85026,90828,03429,29330,52131,77433,148
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

Includes financing for education, health, pension trust funds, and other non-depositary corporations.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

Includes financing for education, health, pension trust funds, and other non-depositary corporations.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

Table 5.El Salvador: Summary Accounts of the Financial System
Proj.
20092010201120122013201420152016
(End of period stocks; in millions of U.S. dollars)
I. Central Bank
Net Foreign Assets2,5942,5502,1772,8312,2902,2752,3932,514
Of which: Net international reserves 1/2,9832,8812,5023,1732,7212,6612,6702,792
Net Domestic Assets3536300−450278309285309
Nonfinancial public sector (net)219490688−49710704726750
Claims836833833832832831830830
Liabilities61734314588112212710379
Rest of the financial system (net)981091751861191399393
Nonfinancial private sector (claims)151000000
Other items (net)−298−564−563−587−551−533−534−534
Liabilities2,6292,5862,4762,3812,5662,5822,6752,823
Base Money2,2822,3542,2752,2292,4812,4742,5692,716
Currency in circulation335544445
Liabilities to depositary corporations2,2502,3492,2712,2242,4762,4702,5652,712
Other liabilities to the public34723220115285109107107
II. Depository corporations
Net Foreign Assets376697295−62−417−672−963−804
Net Domestic Assets8,8328,9879,3839,98510,61410,85311,80912,094
Nonfinancial public sector (net)499445465578373258762494
Claims6806276817626725461,0151,015
Liabilities181182215184299287254521
Rest of the financial system (net)1,5711,9281,8881,9812,1502,1582,2142,350
Credit to the private sector8,5728,5598,9849,33210,07810,53911,02811,535
Other items (net)−1,809−1,946−1,955−1,907−1,988−2,102−2,195−2,285
Liabilities to the Private Sector9,2099,6839,6789,92310,19610,18110,84611,290
Deposits9,0439,4749,4139,6389,9079,86310,49810,927
Securities166209264285289318348362
III. Other financial corporations 2/
Net Foreign Assets58132339460600608501467
Net Domestic Assets5,2605,7896,1086,6877,1217,7948,5009,140
Nonfinancial public sector (net)3,6074,2814,9605,6606,0366,4487,0197,598
Rest of the financial system (net)1,6201,4901,1219871,0079431,1051,150
Credit to the private sector166195215242279508569592
Other items (net)−133−177−188−201−201−198−277−289
Liabilities to the Private Sector5,3185,9216,4477,1477,7218,4029,0019,607
Pension fund contributions5,1395,7346,2476,9317,4708,1338,7299,329
IV. Financial System
Net Foreign Assets3,0283,3782,8113,2292,4732,2111,9312,177
Net Domestic Assets11,87812,46313,51913,99715,53316,48418,02718,831
Net claims on nonfinancial public sector4,3255,2166,1136,1897,1187,4108,5078,843
Credit to private sector8,7538,7559,1999,57410,35711,04711,59712,127
Other−1,200−1,508−1,793−1,766−1,942−1,973−2,077−2,138
Liabilities to the Private Sector14,90615,84116,33117,22618,00618,69519,95721,008
Money2,1832,5422,6692,6812,7592,7883,1083,237
Quasi-money7,5847,5657,4157,6147,7777,7758,1208,442
Pension fund contributions5,1395,7346,2476,9317,4708,1338,7299,329
Memorandum Items:(Percent changes relative to previous year’s liabilities to the private sector)
Net domestic assets−0.83.96.72.98.99.014.67.2
Nonfinancial public sector3.06.05.70.55.42.810.43.0
Credit to the private sector−3.30.02.82.34.56.65.24.7
Liabilities to the private sector5.06.33.15.54.56.511.99.4
(Percent of GDP)
Credit to the private sector42.440.939.840.242.544.144.945.1
Liabilities to the private sector72.174.070.672.373.974.677.278.1
Excluding pension contributions47.347.243.643.243.342.243.443.4
(Annual percentage change, unless otherwise noted)
Credit to the private sector−5.00.05.14.18.26.75.04.6
Private sector deposits in depository corporations1.84.8−0.62.42.8−0.46.44.1
Depository corporations liquid deposits at central bank
(In percent of total deposits)24.924.824.123.125.025.024.424.8
(In percent of NIR)75.481.590.770.191.092.896.197.1
Sources: Central Reserve Bank of El Salvador and Fund staff estimates.

Beginning in 2010, gold in international reserves is valued at the price determined by the London Bullion Market (resulting in a valuation gain of US$170 million).

Includes private pension funds, insurance corporations, and the state Development Bank.

Sources: Central Reserve Bank of El Salvador and Fund staff estimates.

Beginning in 2010, gold in international reserves is valued at the price determined by the London Bullion Market (resulting in a valuation gain of US$170 million).

Includes private pension funds, insurance corporations, and the state Development Bank.

Table 6.El Salvador: Selected Vulnerability Indicators(In percent of GDP; unless otherwise indicated)
Projections
2011201220132014201520162017
Fiscal Indicators
Overall balance of the nonfinancial public sector−3.9−3.9−4.1−3.5−3.4−4.0−4.0
Primary balance of the nonfinancial public sector−1.7−1.6−1.6−1.1−0.9−1.2−1.0
Gross public sector financing requirement9.07.99.09.06.39.07.5
Public sector debt (gross) 1/52.257.357.659.260.662.263.7
Public sector external debt28.832.131.934.633.134.134.8
External interest payments to total fiscal revenue (percent)7.87.27.77.68.18.38.0
External amortization payments to total fiscal revenue (percent) 2/22.46.45.55.77.05.96.2
Financial Indicators
Broad money (percent change, end-of-period)−0.22.12.30.36.34.04.1
Private sector credit (percent change, end-of-period)5.14.18.26.75.04.64.7
Ratio of capital to risk-weighted assets17.117.317.316.616.8
Ratio of loans more than 90 days past due to total loans3.62.92.32.42.3
Ratio of provisions to total loans3.83.32.92.82.7
Ratio of provisions to loans more than 90 days past due107.8113.3121.6119.0115.9
Return on average equity12.212.412.410.07.9
Return on average total assets1.51.61.61.31.0
Loans as percent of deposits88.993.797.2103.2102.1
Ratio of liquid assets to total deposits37.031.930.728.132.3
External Indicators
Exports of goods and services (percent change, 12-month basis)18.33.75.40.93.57.76.9
Imports of goods and services (percent change, 12-month basis)18.73.15.6−1.4−0.86.88.6
Current account balance−4.8−5.4−6.5−5.2−3.6−3.7−4.9
Capital and financial account balance4.58.94.73.14.54.25.0
Gross international reserves (millions of U.S. dollars)2,5033,1752,7452,6932,7872,9082,929
Months of imports of goods and services, excluding maquila3.13.73.23.23.12.92.8
Percent of short-term debt204208148133138138132
Percent of gross external financing requirements74967168747971
Percent of broad money24.830.826.125.524.824.924.1
Public external debt service 2/5.32.42.42.43.02.82.9
External debt to exports of goods and services (percent)204206219236218211208
External interest payments to exports of goods and services (percent)11.115.316.217.317.717.116.7
External amortization to exports of goods and services (percent) 2/38.933.235.941.142.236.735.8
REER, depreciation is negative (percent change, end-of-period)2.6−1.5−0.80.50.00.00.0
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, Financial System Superintendency, and Fund staff estimates.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

In 2011, includes rollover of a maturing external bond.

Sources: Central Reserve Bank of El Salvador, Ministry of Finance, Financial System Superintendency, and Fund staff estimates.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

In 2011, includes rollover of a maturing external bond.

Table 7.El Salvador: Authorities’ Recent Key Growth-Promoting Steps
Key growth-promoting stepsStatusAssessment/effects
Public Private Partnerships (2013)Law adopted but creation of any PPPs has yet to happenLegal interpretation and project selection issues caused delays
Large project implementation (2014-)Progress is being made, particularly on two large projects (Fomilenio-2 and gas plant)Implementation processes improved relative to the past, but projects are still at early stage
Central bank credit facilitation (2015)Central bank introduced incentives reducing liquidity requirements on loans to certain “productive sectors”Design interferes with prudential policies, while credit growth has remained relatively low
Ministry of Economy’s measures (2015)Nine laws on aspects of business facilitation supplemented by other steps supporting sectorsCross-cutting simplification measures are sometimes accompanied by ad-hoc exemptions and incentives
Crime prevention (2015-16)Many measures have been announced, with key financing to come from two new taxesReceipts from the new taxes so far have proved insufficient and there have been delays in approving financing for the security measures
Public investment (2016, planned)The authorities have committed to achieve a 70% average execution rateThe execution rate is so far around 60-65% due to budget constraints and political impasse for project loan approval

12. The fiscal deficit is expected to widen to 4 percent of GDP in 2016, with further increases over the medium term absent measures. While revenues are expected to increase, reflecting full-year impacts of recent measures and rising import taxes as oil prices rise, expenditures are projected to rise faster. In addition to wage pressures and higher interest payments, the authorities plan additional security-related expenses of 0.6 percent of GDP over 2016–17 to counter the recent uptick in crime. Public investment is also assumed to recover from recent lows. Alongside, public debt is expected to exceed 70 percent of GDP by 2021 (see the DSA).

13. Risks to the outlook are significant and tilted to the downside.

  • Increased global financial market turmoil could limit access or raise the cost of external fiscal financing, adding to fiscal strains.
  • A surge in the US dollar could further undermine El Salvador’s competitiveness relative to non-dollarized neighboring countries and weaken growth prospects. Also, the forthcoming implementation of the Trans Pacific Partnership agreement may intensify competition from Asia.
  • Weaker than expected global growth would depress Salvadoran growth, particularly without the exchange rate as a shock absorber (although lower oil prices that accompany weaker growth would be a mitigant).
  • Increased de-risking by major international banks could increase intermediation costs and hamper the flow of remittances to El Salvador, dampening consumption and growth.
  • Rising fiscal risks could undermine confidence and depress medium term growth below staff estimates.
  • On the upside, lower energy prices would support the economy, suppress inflation and support the balance of payments. Sustained strong implementation of public and private investment projects would also create an upside to growth.

14. The authorities were more optimistic about the outlook and balance of risks. In particular, they believed that the pickup in domestic investment observed in 2015 would endure and that the large investment projects in the pipeline, together with efforts to promote growth more generally, would support an increase in potential growth above 2½ percent.

Fiscal Strains

15. There was agreement that without assertive fiscal consolidation public debt will continue to rise. A frontloaded primary balance adjustment of at least 3 percent of GDP over 2017-19 is the minimum needed to reverse the upward debt dynamics over the medium term, with more needed over a longer horizon to entrench sustainability. Under plausible multipliers the adjustment could reduce growth below 2 percent in the short run. However, a more solid and credible fiscal position, combined with vigorous structural reforms, would create the conditions for a rebound in growth toward 3 percent over the medium term. Incorporating longer-term factors, staff estimates indicate a fiscal sustainability gap of about 4–5 percent of GDP, the result of the significant structural primary deficit and rising demographic pressures in pension and health spending. 3 Still more adjustment would be needed to create fiscal space to fully implement the authorities’ crime prevention strategy and credibly fund the authorities’ LOLR facility. Successful consolidation will require both revenue and expenditure measures, and a stronger fiscal framework. The authorities agreed in principle, and noted that their Medium-term Fiscal Framework targets adjustment of 2½ percent of GDP, although no specific set of measures have been agreed upon. However, they considered that this adjustment, at least in non-pension fiscal accounts, was close to the maximum feasible given low growth and pressing social needs.

Public Debt Ratios Under Medium-term Adjustment Scenarios

Percent of GDP, adjustment with short-term multipliers at 0.5 and long-term at 0.2

Source: Fund staff estimates and projections.

16. Given the need to increase growth, revenue-raising measures should be accompanied by cuts in distortionary taxation. Raising the VAT rate to 15 percent, broadly around the regional average, would increase revenues by 1¼ percent of GDP. Efforts to establish a property tax should be strengthened. A corporate tax rate of 35 percent appears too high given low investment and high informality, and should be reduced significantly, while limiting incentives and loopholes to broaden the tax base. There may also be scope for less-distortionary progressive taxation by introducing a wealth tax, taxing (highly inequitable) pensions, or increasing personal income tax rates for the highest earners. The bank transactions tax and telecommunications tax have relatively low yield but significantly hamper financial intermediation and inclusion, and should be reduced or phased out. Also, all other taxes should be reviewed, phasing out those with low yield but high distortionary effects. Finally, plans to boost tax collection should be carefully calibrated to avoid dampening the investment climate.

El Salvador: Comparison of Medium-Term Scenarios 1/(In percent of GDP, unless otherwise noted)
Projections
201620172018201920202021
Real GDP growth (percent)
Baseline2.32.42.32.12.02.0
Adjustment2.31.72.12.22.82.7
Nonfinancial public sector balance
Baseline−4.0−4.0−4.5−5.0−5.3−5.6
Adjustment−4.0−2.6−2.3−1.9−1.8−1.8
Primary balance
Baseline−1.2−1.0−1.1−1.3−1.4−1.6
Adjustment−1.20.40.91.61.61.6
Public sector gross debt
Baseline62.263.765.567.970.573.2
Adjustment62.262.862.561.960.859.7
Gross fiscal financing requirement
Baseline9.07.58.011.08.59.3
Adjustment9.06.15.87.95.15.5
Unidentified fiscal financing 2/
Baseline3.62.12.73.03.44.2
Adjustment3.60.70.5−0.10.00.5
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

The adjustment scenario is predicated on (i) a cumulative effort of 3 percentage points of GDP in 2017–19, including 1.5 percentage point effort in 2017; (ii) impact fiscal multiplier of 0.5 and cumulative multiplier of 0.2; and (iii) positive growth effects of structural reforms (0.3 pp in 2019, 0.5 pp starting from 2020).

Residual financing need after accounting for normal domestic and official external financing sources.

Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and Fund staff estimates.

The adjustment scenario is predicated on (i) a cumulative effort of 3 percentage points of GDP in 2017–19, including 1.5 percentage point effort in 2017; (ii) impact fiscal multiplier of 0.5 and cumulative multiplier of 0.2; and (iii) positive growth effects of structural reforms (0.3 pp in 2019, 0.5 pp starting from 2020).

Residual financing need after accounting for normal domestic and official external financing sources.

El Salvador: Tax Rates in Latest Available Year
Top personal income tax rateCorporate income tax rateVAT rate
Costa Rica253013
Dominican Republic252718
El Salvador 1/3035(30)13
Guatemala72512
Honduras253015
Panama252515
Nicaragua303015
CAPDR average23.927.814.4
LAC average33.124.117.2
Source: National authorities.

For El Salvador, reflects an additional recent 5 pp surcharge on corporate profits exceeding $0.5 million.

Source: National authorities.

For El Salvador, reflects an additional recent 5 pp surcharge on corporate profits exceeding $0.5 million.

Potential Menu of Measures in 2017–19(Cumulative, percent of GDP)
Wage bill1.4
VAT increase to 15%1.2
Adoption of full-fledged property tax0.6
Savings in good and services0.4
Targeting subsidy0.4
Progressive taxation0.4
Removal of tax exemptions0.1
Streamlining of “nuisance taxes”−0.7
Social support to offset VAT regressive effects−0.3
Total:3.5
Source: Fund staff estimates.
Source: Fund staff estimates.

17. The authorities were supportive of property, wealth and progressive individual income taxation. However, they believed that the distortionary effects of the BTT and telecom tax were modest and indicated that raising VAT would be politically difficult because of its effects on the poor. They were however optimistic about the yield from several administrative initiatives that were underway to strengthen tax collections.

18. The authorities agreed that durable consolidation will require addressing the sources of expenditure pressures. Recent revenue-based consolidation has largely been offset by increased spending, notably on the wage bill which has risen by 1 percent of GDP in the past 5 years, and is projected to rise by a further one percent of GDP by 2021 without measures. Addressing wage pressures will require eliminating the generous wage indexation mechanism (escalafon) in the health sector, limiting general wage indexation to increases below the rate of inflation, and curbing nontransparent bonuses. Also, hiring in all sectors—except security—should be significantly reduced. There is need to strengthen the efficiency of expenditure across a range of functions (notably reducing the fragmentation of the health system and improving the targeting of school assistance programs to protect the needy). There is scope for further rationalizing LPG and electricity subsidies. However, public investment should be increased to alleviate infrastructure bottlenecks, and the social safety net should be enhanced. The authorities were open to considering measures in all these areas, but were not yet prepared to commit to specific steps along those lines.

19. The authorities are continuing efforts to upgrade the fiscal framework to support consolidation efforts, including developing a fiscal responsibility law (FRL). 4 El Salvador’s fiscal framework: (i) has incomplete coverage of different government levels; (ii) allows higher spending with routine legislative approval if new financing becomes available; (iii) has highly rigid spending (80 percent of spending is deemed rigid); (iv) incompletely identifies general government financing needs and sources in the annual budget (excludes short-term debt, tax refunds, and some future debt issuances and repayments); (v) lacks a medium-term (MT) orientation, and (vi) is typically based on optimistic macroeconomic projections. These problems have contributed to an upward drift in spending, high deficits, and periodic financing strains.

20. A draft FRL is currently under discussion and should:

  • Adopt strong procedures to increase transparency and comprehensiveness of budget presentation, improve forecasting and spending control, and reduce the upper limit on LETES issuance. Ideally, the regular budgetary process should also include the pre-approval of all the necessary financing for the budget year, thereby reducing the probability of financing crunches.
  • Include a formal numerical target. One option could be a budget balance rule with countercyclical properties, incorporating a clear link to a prudent debt objective and corrective mechanisms to achieve it, which appears appropriate for El Salvador’s political and economic circumstances. An expenditure-based rule, or a combination of expenditure and deficit-based rules, could also be options should they command bipartisan support.

The authorities’ current draft FRL contains many of the above elements, including a combination of deficit-based and expenditure-based rules. However, it still lacks clarity on the hierarchy of procedural and numerical rules and, as currently framed, the draft does not garner broad political and societal support.

21. Pension reforms are essential to ensure fiscal and social sustainability. 5 The transition to a fully funded defined contribution (DC) system has sputtered due to inadequate asset returns that have led the government to periodically top up and guarantee pension benefits. The pension deficit is currently about 2 percent of GDP and will rise substantially in the next decade without policy change. Unfunded liabilities are estimated at almost 100 percent of GDP in NPV terms; future replacement rates under the DC system are projected to almost halve; coverage, participation, and contribution payments are low; benefits are highly unequal across pensioners; and there is poor diversification and low financial returns, partly because the private pension funds are mandated to buy government pension bonds at very low rates, although a recent Constitutional Court decision to raise those rates would change this going forward.

Actuarial deficit of the pension system of El Salvador

(millions of US dollars)

Source: Salvadoran Authorities.

22. Faced with a difficult political environment, the authorities’ pension reform proposed in February seeks to buy time but does not secure the long run sustainability of the system. The proposal would (i) reverse some of the recent benefit top-ups, (ii) transfer to the public sector over half of contributions and private pension system assets (reducing measured deficits and debt), and (iii) offer lower-income contributors a flat pension. However, preliminary calculations suggest that it would not materially reduce the NPV of future unfunded pension liabilities, while introducing legal risks given public opposition to nationalization of private assets.

23. There is an urgent need for the following additional steps to secure the sustainability of the pension system in the face of looming population aging pressures:

  • Parametric reforms to increase the retirement age and contribution rates (key to supporting long-term fiscal sustainability in the PAYG component and social sustainability in the DC component). Steps to better-align the number of years of contributions with benefits would also be important, especially if they are accompanied by measures to encourage formal employment.
  • Greater coverage through an expansion of the means-tested basic universal pension and incentive schemes and other steps to encourage labor force formalization.
  • A credible commitment to fund projected pension deficits from general revenue sources. The evolution of pension deficits over the long run would depend on the strength of the parametric reform package and coverage objectives.

Financial Sector Stability, Deepening, and Inclusion

24. Stress tests suggest that financial buffers are adequate to contain most risks. The largest banks are international banking groups, which currently enjoy access to foreign financing, and the system is characterized by very limited interbank exposures, which reduces the risk of internal contagion. At the same time, this structure exposes the sector to external risks. The central bank (BCR) and the Financial Superintendent (SSF) have run credit and liquidity risk sensitivity tests which suggest adequate resilience of the system to stress scenarios.

25. The authorities have made good progress on implementing the financial reforms recommended in the 2010 FSAP, the 2014 Financial Stability Strategy, and other TA reports but a substantial agenda remains.

  • Emergency liquidity backstops. While dollarization helps contain currency and interest rate risks, it can amplify liquidity risks. Importantly, in the absence of sufficient lender of last resort (LOLR) capacity and robust bank resolution structures, institution-specific liquidity shocks could have systemic repercussions. And relying on high institution-specific buffers reduces the capacity of banks to lend to the economy. A plan for a liquidity fund based on a partial pooling of the banks’ liquid assets is nearing completion, which could be helpful in addressing non-systemic liquidity needs, but coordination and governance issues need to be fully resolved. Staff encouraged the authorities to credibly increase annual budget allocations to the LOLR, revive and expand an IDB credit line for the LOLR that has expired, and resolve the remaining hurdles to establishing the liquidity fund in consultation with stake-holders. Also, given the key role of the central bank in the operation of the LOLR its financial position should also be protected.
  • Regulation and supervision. Coordination between the financial supervisor and the central bank has improved. Risk-based supervision is being implemented, and the implementation of Basel III has been initiated. The process of extending the supervisory perimeter to smaller and cooperative banks and savings and loans associations (to encompass 90 percent of deposits in that sector) is ongoing and will need to be completed.
  • Bank resolution and crisis management. In line with staff advice the authorities are finalizing a strategy to mitigate weaknesses while comprehensive legislation that thoroughly addresses the key challenges is developed. Staff encouraged the authorities to expedite progress in both areas, noting that the legal reforms should make the Systemic Risk Committee permanent, strengthen crisis prevention and bank resolution authority and procedures, clarify procedures for the cooperative financial institutions, abolish the three-day notification to a bank before taking resolution measures, and strengthen legal protection for supervisors. Also, domestic interagency coordination as well as cross-border cooperation should be strengthened with clear and comprehensive MoUs between relevant agencies. The preparation of contingent bank-by-bank recovery and resolution plans should be accelerated. Finally, the deposit insurance agency should be strengthened by increasing bank contributions and clarifying protocols for its role in a crisis.

26. There was agreement that financial deepening and advancing financial inclusion could have a meaningful impact on both growth and poverty (Figure 5). 6 Household access to financial services is relatively low with only 34 percent of individuals holding bank accounts. Steps to increase mobile banking and improve dispute resolutions mechanisms could boost the penetration of banking services, and in this regard staff welcomed the recent passage of the Financial Inclusion Law. However, staff also stressed that recent legal changes limiting the acquisition, transfer, and storage of debtor information in credit bureaus increase credit risks and intermediation costs in the financial system, and should be reconsidered. A modern law and improved corporate financial reporting standards are needed to support the expansion of the securities market, which could help pension funds increase returns and improve pricing and liquidity of government debt.

Figure 5.El Salvador: Financial Sector Inclusion

Sources: World Bank Global Findex; World Bank Enterprise Survey; Economic Intelligence Unit Global Microscope and Fund staff calculations.

El Salvador. Use of Financial Services in Households and Enterprises

27. To date the loss of correspondent banking relationships has been manageable. Some larger international banks have left, but have been replaced by other, regional, banks, with the overall nominal value of the correspondent lines broadly unchanged thus far. The authorities continue to work to maintain sound AML/CFT standards, and maintain active engagement with the US Treasury in this area. A recent bank collapse in Honduras amid money laundering charges by the US government appears to have had no impact on El Salvador, but has heightened concerns and increased regulators’ supervisory vigilance. Staff argued for quickly undertaking contingency planning to delineate the authorities’ response in the event of a broader loss of correspondent banking relationships.

SUPPLY SIDE REFORMS

28. The authorities broadly concurred that investment and inclusive growth can be improved by forging social consensus around sound policies that:

  • Enhance the flexibility of wages and prices, given the fully dollarized economy. In this context, staff recommended that it would be advisable to contain minimum wage increases until there is clear evidence of rising productivity. The authorities responded, however, that a balance would have to be struck given the need to increase incomes of the poor and rural populations.
  • Ease barriers to entry and competition, curb anti-competitive practices such as price fixing in key sectors, including air transport, pharmaceuticals, iron, and agricultural markets such as sugar, rice and fertilizers, and improve the staffing and sanctions effectiveness of the Competition Superintendent. Lowering entry barriers in transport and electricity sectors would help reduce utility and logistics costs.
  • Boost educational attainment (particularly for secondary and vocational education) by creating the necessary fiscal space and improving accountability for results.
  • Reduce crime and corruption (including by effectively implementing the AML/CFT and anti-corruption frameworks)—the authorities’ plan “For a Safe El Salvador” unveiled in early 2015, and recent follow-up plans, lay out a comprehensive strategy, but financing (estimated at 1.7 percent of GDP annually) is a key bottleneck.

Staff encouraged the authorities to press on with their 2014–19 plan which targets potential growth of 3 percent, taking advantage also of the FOMILENIO II grant from the U.S. and the funding for the “Northern triangle” countries to raise productivity and competitiveness.

Doing Business Ranking, 2016

Source: World Bank Doing Business Indicators.

Global Competitiveness Index Ranking, 2015-16

Source: World Economic Forum Global Competitiveness Indicators.

STATISTICS

29. Data provision is adequate for surveillance. Staff encouraged the authorities to publish revised national accounts in line with their public commitment and best practices. The technical work is nearing completion and the authorities have requested Fund assistance in crafting an appropriate communication strategy ahead of publishing the improved data.

STAFF APPRAISAL

30. El Salvador continues to suffer from significantly lower growth than neighboring countries amid low investment, high crime and emigration, and weak competitiveness. Several factors appear to be contributing to the low growth rate, but along many dimensions El Salvador is not materially different from neighboring countries except for the interrelated forces of high crime and emigration. Most likely, the low growth is the result of the complex interaction of several factors that reduce the expected return to investment, reduce labor supply, and increase uncertainty, and as such resolving low growth will require action along multiple fronts. The low-growth in turn feeds a number of vicious cycles: it hinders efforts to reduce the high crime rate and improve educational attainment; encourages outward migration and weakens labor force participation; and creates fiscal pressures (as social demands continue to increase while fiscal revenues remain subdued). Moreover, political gridlock is an obstacle to even incremental reform.

31. Strong efforts are needed to address rising fiscal risks. Without a resolution of the parliamentary impasse blocking external financing, the authorities are likely to reach the limits of the domestic system to finance the budget toward the end of this year, raising the prospect of disorderly adjustment. Moreover, substantial frontloaded fiscal adjustment is needed to reverse the upward trajectory of public debt, entrench fiscal sustainability, and create space to credibly fund the public LOLR and the authorities’ crime prevention strategy over the medium term. In addition, the authorities’ current pension reform proposals should be adjusted to include parametric changes essential to ensure the long run fiscal and social sustainability of the system as the population ages.

32. The authorities have made good progress in financial sector reforms, but there remains an important unfinished agenda. While dollarization helps contain currency and interest rate risks, it can amplify liquidity risks. Thus, annual budget allocations for the LOLR should be credibly increased, and the IDB credit line for the LOLR facility revived and expanded. Also, the hurdles to establishing the bank liquidity fund should be resolved in consultation with stake-holders. Progress in risk-based supervision should continue, and the supervisory perimeter extended to smaller financial institutions. The bank resolution and crisis management framework should be strengthened as soon as possible by a comprehensive legislative reform to address various weaknesses, clarifying the authority, protocols, and legal protections of regulators.

33. Investment and inclusive growth can be improved by forging social consensus around sound policies that: enhance the flexibility of wages and prices (including by limiting increases in minimum wages); ease barriers to entry and competition, curb anti-competitive practices in key sectors, including air transport, pharmaceuticals, iron, and agricultural markets, and improve the effectiveness of the Competition Agency; create fiscal space and improve accountability to boost secondary and vocational educational attainment; reduce crime and corruption; and reduce utility and logistics costs by allowing greater competition in those sectors.

34. Staff recommends that the next Article IV Consultation be held on the standard 12-month cycle.

Risk Assessment Matrix1
Main ThreatsLikelihood of Realization of the ThreatExpected Impact if Threat is RealizedPolicy Response
Medium/HighHigh
Tighter or more volatile global financial conditionsInvestors could reassess underlying risk in the global economy. Improving US economic prospects could lead to a further dollar surge.Constrained access to international capital markets and higher cost of external financing, worsening public debt dynamics. Dollar appreciation could further undermine El Salvador’s competitiveness.Implement fiscal consolidation to both reduce external financing needs and improve debt dynamics. Improve fiscal and external buffers. Implement structural reforms to improve competitiveness.
MediumHigh
Sharper-than-expected global growth slowdownA sharper-than expected downturn in China or other large EMs, or structurally weak growth in key AEs and EMs could take place.Negative spillovers to growth are likely to be larger in the absence of the exchange rate as a shock absorber.Structural reforms to boost private investment and growth. Strengthen tax administration and expenditure management to protect the fiscal position.
MediumMedium/High
Dislocation in capital flowsBroader loss in correspondent banking services.Increased costs for transfer of funds, which could reduce remittances, dampening consumption and growth.Further strengthen the AML/CFT framework to minimize the withdrawal of correspondent banking services, and strengthen the bank resolution framework.
HighMedium/High
Persistently lower energy pricesEnergy supply factors could reverse only gradually.Higher consumption and growth, with lower inflation and current account deficit.Save a part of the windfall from lower energy prices.
MediumHigh
Fiscal pressuresDelays in Congress in approval of external financing.Higher financing costs and the prospect of disorderly adjustment, worsening macroeconomic imbalances and growth outlook.Forge consensus in Congress on the fiscal agenda. Fiscal consolidation to both reduce external financing needs and improve debt dynamics.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities.

Annex I. Implementation of Fund Policy Advice

The 2014 Article IV Consultation focused on reaching social and political consensus to enhance growth and social objectives, while pursuing a much needed fiscal adjustment and reforms to improve the investment climate. Directors recommended:

  • Reaching broad political and social consensus to address economic inequalities and low economic growth. While there is broad consensus on the objectives of reducing inequality and increasing underlying growth, there is little political agreement on the means to achieve these aims. Political intransigence is obstructing short- and medium-term reforms to support stability and growth.
  • Implementing fiscal consolidation while protecting social spending to lower the deficits by 3.5 percentage points of GDP in 2015–17 to stabilize the public debt ratio. Consolidation efforts have not been sufficient with the 2014–15 deficits falling cumulatively by around 0.7 percent of GDP reflecting lower current transfers and capital expenditures.
  • Promoting a better investment climate to achieve higher, private-sector lead growth. While progress on diversifying the energy mix and improving security (in recent months) has been made, the political gridlock is preventing meaningful progress on expanding investment and creating sustainable fiscal space to achieve security and social objectives, as well as making meaningful progress on reducing red tape.
  • Improving the financial institutional framework for the banking sector, including the legal framework and appropriate safety net for banks. Risk-based supervision is being implemented and short-term legal fixes have been identified while a new banking sector law is being prepared. A bank liquidity pool decree is nearly complete but progress on financing LOLR capacity has not been made.
Annex II. El Salvador: Debt Sustainability Analysis (Higher Scrutiny Case)

The debt stock is estimated at around 61 percent of GDP at end-2015 and is set to rise to 73 percent of GDP in 2021 under current policies.7The drivers for the increase include relatively high fiscal deficits, low growth, and rising interest rates. While the gross financing requirement is not high compared to other emerging markets, it is elevated for a fully dollarized economy. Susceptibility to growth shocks is an additional risk. Shortcomings in pension system design and uncertainty over the proposed pension reform are sources of significant long-term risks that are exacerbated by population aging over the next few decades. Vulnerabilities are moderated by a relatively high maturity of existing debt, a stable investor base, and the fact that some of the public debt (14 percent of GDP) was issued to pre-finance future pensions obligations.

A. Key Assumptions

Debt definition. El Salvador’s public debt is defined as the sum of gross debt of nonfinancial public sector (including explicit pension-related debt) and the external debt of the central bank (currently about ½ percent of GDP). This definition aims to better capture quasi-fiscal liabilities (relating to public enterprises and the public financial sector) due to the large role of a fiscal backstop under a dollarized economy’s funding constraints. The definition of the nonfinancial public sector debt as reported by the Ministry of Finance excludes liabilities of municipalities and some public enterprises.

Growth. The baseline reflects the estimated growth potential of around 2 percent. Susceptibility to shocks (including natural disasters and external economic shocks) is a downside risk.

Fiscal policy and financing. The baseline scenario assumes no fiscal adjustment and no pension reform, with the primary deficit rising gradually largely reflecting generous public wage indexation for certain key sectors. The headline deficit would increase above 5 percent of GDP in the medium term, also due to the higher interest bill from rising debt and (US LIBOR-dependent) servicing costs. The scenario assumes that unidentified financing gaps are filled with long-term loans from official and private creditors. Alternatively, the debt profile could become riskier from the financing perspective, reflecting a growing share of short-term debt. The proposed pension reform has significant implications for short-term headline debt and deficit dynamics, but a relatively minor impact on long-term debt sustainability.

B. Results and Assessment

Baseline results. The public debt ratio would reach 73 percent of GDP in 2021, staying on an upward trajectory thereafter. The gross financing needs would average 8–9 percent of GDP, increasing to 11 percent of GDP in 2019 due to a Eurobond repayment that year.

Drivers. The upward debt dynamics are driven by real interest rates and primary deficits (contributing about 2¼ and 1¼ percent of GDP on an annual basis respectively). Real GDP growth would reduce the ratio by less than 1½ percent of GDP annually.

Assessment. Most standard debt profile characteristics are of concern (see heat-map). Moreover, the heat-map on balance may understate risks: (i) the threshold for gross financing (15 percent of GDP) does not take into account funding constraints of full dollarization; and (ii) the measured share of “foreign currency” debt (close to zero) reflects the legal adoption of the US dollar, not the implied benefits of issuing an own-currency.

Mitigating factors. Unlike many countries, El Salvador has pre-funded some of its future pension liabilities (but the overall assessment of the pension system is less reassuring (see below)). Existing debt has a relatively long average debt maturity (12 years) and a stable investor base (over one-half of the debt is held by domestic pension funds and official creditors) – in the latter aspect, the heat-map may overstate risks from “nonresident holdings.” Remittances are over 16 percent of GDP. The authorities believe that GNDI would be a better denominator than GDP, and have provided alternative calculations.

El Salvador: Composition of Public Debt by Creditor, end-2015,

percent, includes CIP-B bonds

Source: Ministry of Finance of El Salvador.

Stress tests. Real GDP, interest rate, and contingent liability shocks have a relatively significant impact. Hence a “combined macro-fiscal shock” would be particularly challenging. The vulnerability to a rise in global interest rates has been recently reduced with the interest rate on pension bonds being de-linked from LIBOR in February 2016, though this has increased interest payments in the baseline scenario. If there is greater recourse to short-term borrowing (assuming that one-half of the projected financing gaps is filled with short-term borrowing), public gross financing needs would rise to 15 percent of GDP in 2021.

Idiosyncratic risks and issues. These include: (i) a potentially substantial one-off downward revision of nominal GDP; (ii) pension-related liabilities, estimated at around 100 percent of GDP in NPV terms (there is also the need to recognize as public debt recognition bonds already issued equivalent to 6 percent of GDP); (iii) potential assumption of enterprise debt; (iv) municipal debt that is not officially recorded as public debt (around 2 percent of GDP); and (v) contingent liabilities from future PPP projects (the PPP law is relatively new, adopted in 2013).

El Salvador’s pension system would be a key additional driver of the long-term debt dynamics. Under current rules, the system would increase spending over the next 15 years by about ½ percent of GDP relative to the assumption of constant primary balance, as the actuarial deficit is projected to increase over the next few years. After 2030, fiscal pension spending burden is expected to ease, but this assumption would depend on the pension system surviving in the current form, and the proposed pension reform would change this conclusion. Significant long-term population aging8 is expected to put an additional burden on pension and health expenditure, not least due to pressures of significantly increasing the low coverage in both systems.

El Salvador: Public Sector Debt Sustainability Analysis (DSA) - Baseline Scenario

(in percent of GDP unless otherwise indicated)

Source: Fund staff estimates and projections.

1/ Public sector is defined as non-financial public sector, including external central bank debt.

2/ Based on available data.

3/ Long-term bond spread over U.S. bonds.

4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.

5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate;

a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.

7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).

8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.

9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

El Salvador: Public DSA – Composition of Public Debt and Alternative Scenarios

Source: Fund staff estimates and projections.

El Salvador: Public DSA – Realism of Baseline Assumptions

Source: Fund Staff estimates.

1/ Plotted distribution includes program countries, percentile rank refers to all countries.

2/ Projections made in the spring WEO vintage of the preceding year.

3/ Not applicable for El Salvador.

4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.

El Salvador: Public DSA – Stress Test

Source: Fund staff estimates and projections.

El Salvador: Public DSA Risk Assessment

Source: Fund staff estimates and projections.

1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.

2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.

3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are:

200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.

4/ Long-term bond spread over U.S. bonds, an average over the last 3 months, 08-Jan-16 through 07-Apr-16.

5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.

Annex III. External Assessment

El Salvador’s real effective exchange rate (REER) is assessed to be moderately overvalued. Non-price indicators also point to diminished competitiveness.

Since 2001, the CPI-based REER has appreciated by 6 percent. This appreciation is due to a 10 percent real appreciation vis-à-vis the U.S. (El Salvador’s largest trading partner buying 47 percent of exports), while a real depreciation with respect to Guatemala and Honduras (the second and third largest trading partners accounting each for 14 percent of exports) offset somewhat this appreciation.

REER, NEER, RCPI

(2005 = 100)

Source: Fund staff estimates.

IMF’s multilaterally consistent estimates suggest that El Salvador’s REER is moderately weaker than the level consistent with medium term fundamentals and desirable policies:

  • The EBA-lite CA estimate based on existing fundamentals (including remittances which are significant for El Salvador) and desirable policies points to a sustainable cyclically-adjusted CA deficit norm of 3.7 percent of GDP, which is 2 percentage points below a cyclically-adjusted deficit of 5.8 percent. This gap mainly reflects fiscal and reserve adequacy policy gaps. The identified fiscal gap of 1.2 percent and reserve adequacy gap of 1.4 percent are significant contributors to El Salvador’s current account gap. At the same time, oil prices are assumed to affect the CA norm and underlying CA symmetrically (i.e. the 5.8 percent of GDP current account deficit incorporates an adjustment for savings from the lower oil prices which amounted to 2.5 percent of GDP in 2015).
    El Salvador: Exchange Rate Assessment Results
    EBA-lite CA methodologyCA norm (% of GDP)Underlying CA (% of GDP)1/REER gap2/
    −3.7−5.813.9
    EBA-lite REER methodologyln(REER) normln(REER) actualREER gap2/
    4.04.60.7
    CA norm (% of GDP)Underlying CA (% of GDP)REER gap2/
    EBA-lite ES methodology3/−2.8−5.014.1
    Source: Fund staff estimates and projections.

    Oil prices are assumed to affect the CA norm and underlying CA symmetrically.

    (+): overvaluation. In the CA and ES methodologies, export elasticity: -0.71, import elasticity: 0.92.

    The CA norm stabilizes the net IIP position at the target level of -50% of GDP.

    Source: Fund staff estimates and projections.

    Oil prices are assumed to affect the CA norm and underlying CA symmetrically.

    (+): overvaluation. In the CA and ES methodologies, export elasticity: -0.71, import elasticity: 0.92.

    The CA norm stabilizes the net IIP position at the target level of -50% of GDP.

  • The EBA-lite External Sustainability (ES) estimate compares projected medium-term CA with the level that stabilizes the external position (i.e., IIP) at its current level (-60 percent of GDP) or at somewhat improved level (-50 percent of GDP). This approach suggests an overvaluation of 11 percent of GDP, if the IIP position is to be stabilized at -50 percent of GDP.
  • The EBA-lite REER estimate based on existing fundamentals and desirable policies that would affect the REER directly or indirectly through changes to the CA balance points to a REER which is broadly in line with fundamentals and desirable policies.

El Salvador’s labor costs are on the rise. Labor costs have been rising since 2008, and, if the recent government-proposed increase of 118 percent in minimum wage in agriculture (and around 20 percent in other areas) passes and is binding, that would entail significant increases in labor costs that would erode the competitiveness of businesses.

Other indicators suggest no improvement in competitiveness. Notably, El Salvador’s world export market share has been flat over the past 15 years.

SLV: Labor Market Efficiency, 2015-16

Source: World Economic Forum Global Competitiveness Indicators.

El Salvador’s investment climate faces multiple challenges. According to the World Bank’s Doing Business indicators, El Salvador ranks poorly relative to other countries in Central and Latin America in starting a business, dealing with construction permits, access to and cost of electricity, protection of investors, and paying taxes. El Salvador ranks 125 (out of 189 countries) in terms of regulations on starting a business. It has a very low new business entry density compared to the LA-5 and other CAPDR economies. According to the Global Competitiveness indicators, El Salvador lags behind other CAPDR and LA-5 countries in terms of the institutional and macro environment, labor market efficiency, financial market development, higher education, and innovation. The WB-OECD Product Market Regulation indicators also suggest that there are certain barriers to entrepreneurship (e.g. license and permits system), and to trade and investment. In addition, state control in certain sectors may hinder market entry and a level playing field for all enterprises. According to Salvadoran think tank Fusades business surveys, uncertainty and crime/extortion are the most important factors explaining the weak business confidence in El Salvador.

World Export Market Share, Goods and Services

(Percent)

Source: WEO, and IMF staff calculations.

Property Crime, 2010

(Percent)

Source: WB Enterprise Surveys.

Gross financing needs are large. While the oil price fall contributed to reduce the current account deficit, the external gross financing requirements were still high at 14 percent of GDP in 2015. In the medium term, gross financing requirements are projected to peak at 17.5 percent of GDP in 2019 and stabilize at 15.5 percent of GDP, reflecting high current account deficits and an increase in the amortization on private sector external debt (and amortization of public long-term bonds in 2019).

The net international investment position (IIP) remains significantly negative. In 2015, the net IIP was -64 percent of GDP and is projected to worsen further to -80 percent of GDP in the medium term. Large current account deficits are backed by a rapid accumulation of private and public sector liabilities, mostly concentrated in FDI and other investment (external bonds needed to fill the fiscal gap). The stock of international reserves has fallen over the past few years and, at 10 percent of GDP, is well below the Fund’s composite ARA metric which suggests a level of reserves of 19 percent of GDP to be adequate for a fully-dollarized country.

IIP Composition, by Instrument

(in percent of GDP, based on IIP data from EWN database)

Source: Lane and Milesi-Ferretti’s External Wealth of Nations Dataset, IMF WEO

1Chapter I of the accompanying Selected Issues Paper examines the causes of low growth in El Salvador, and the macroeconomic effects of remittances.
2Chapter II of the accompanying Selected Issues Paper discusses the potential growth rate of El Salvador.
3The fiscal sustainability gap is the total amount of fiscal measures that (if immediately implemented) would assure a non-explosive path for government debt over the long run. Kanda (IMF WP/11/164) describes the methodology underpinning the estimates.
4Chapter III of the accompanying Selected Issues Paper discusses the fiscal framework and rules for El Salvador.
5Chapter IV of the accompanying Selected Issues Paper examines the pension system of El Salvador and explores options for reform.
6Chapter V of the accompanying Selected Issues Paper examines financial inclusion in El Salvador.
7Staff estimates public debt threshold for El Salvador within the 40–50 percent range (see IMF Country report 15/13).
8El Salvador is so far in a demographic “sweet spot,” but the share of population over 64 is projected to increase from 7 percent now to 16 percent in 2050 and 29 percent in 2100. Emigration of the young population can exacerbate those trends.

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