Statement by Ramon Guzman, Executive Director for El Salvador and Alvaro Umaña, Senior Advisor to Executive Director November 12, 2008

El Salvador’s 2008 Article IV Consultation examines the country's economic developments and policies. In 2007, the fiscal position improved, the public debt-to-GDP ratio declined, and economic growth reached its highest level in a decade. The rise in global commodity prices has also generated substantial inflation pressures. The stock of bank deposits has stagnated relative to end-2007, while deposit rates have increased slightly. Interbank repo rates have also risen recently, reflecting tighter funding conditions, and banks have increased their external borrowing, in part to build up liquidity.

Abstract

El Salvador’s 2008 Article IV Consultation examines the country's economic developments and policies. In 2007, the fiscal position improved, the public debt-to-GDP ratio declined, and economic growth reached its highest level in a decade. The rise in global commodity prices has also generated substantial inflation pressures. The stock of bank deposits has stagnated relative to end-2007, while deposit rates have increased slightly. Interbank repo rates have also risen recently, reflecting tighter funding conditions, and banks have increased their external borrowing, in part to build up liquidity.

November 12, 2008

We would like to thank staff for their efforts in the consultation process and for a concise and well-written report. Sustained economic reforms and sound macro-economic policies implemented by El Salvador over the last four years have paid off in terms of economic growth, which reached its highest level in a decade in 2007. At the same time, poverty has been reduced significantly, the fiscal situation has improved and public debt has declined as a percentage of GDP over the same period. In spite of these important achievements, given the present global crisis, the external environment is challenging for all countries, and there are also some uncertainties associated with the upcoming elections.

The Central American region has started to feel the effects of the slowdown in the US economy, its main economic partner. In the case of El Salvador, the links to the US economy are particularly important both as a destination for exports as well as the source of remittances. Although the growth of remittances has slowed down to 5.3 percent (through September 2008), total remittances have continued to grow in absolute terms. Export growth, close to 16 percent, has been strong, particularly from coffee, maquila and non-traditional sectors. Given these positive results and a strong public investment program, the growth rate is only expected to slow down to 3.5 percent in 2008 and to stay at that level in 2009.

World price increases in food and oil have impacted inflationary levels in the Central American region considerably and El Salvador has not been the exemption; however, the latest figures available (October 2008) show inflation slowing slightly to 7.4 percent, one of the lowest levels in the region. Import growth has been driven primarily by oil and food price increases and this has put pressure on the balance of payments this year. However, recent price decreases in oil and commodities are likely to contribute to easing this pressure as we move into 2009.

The international financial crisis and internal conditions have contributed to some tightening in domestic financial conditions and credit growth has slowed down. The central government has rolled over most of the US$250 million of debt due during the rest of 2008, including a CABEI purchase of US$100 million in one-year LETES, which was completed this past week.

It is important to clarify that El Salvador’s sovereign debt rating has not been downgraded by Standard & Poor’s. Its rating remains BB+, one notch below investment grade. The outlook, however, has been changed from stable to negative. Sovereign debt spreads have fluctuated in line with other Latin American countries.

The banking system, which is now almost entirely foreign owned, is well capitalized, liquid and profitable. Capital adequacy is well above the regulatory minima, liquidity ratios are above 30 percent and, thus far, the system has shown resilience to the present global turmoil.

The fiscal position, which had improved in 2007, with a deficit 0.3 percent better than the budget, has suffered from high oil and commodity prices in 2008. The government has attempted to offset high oil prices with energy subsidies for electricity, gas and public transportation, as well as with an austerity program for the public sector. Household electricity consumption is subsidized below 99 KWH per month with a cost of US$60 million, or 0.3 percent of GDP. LPG and public transportation are also subsidized and, to partially offset these costs, the government has passed a new tax on incoming international telephone calls that is expected to yield 0.3 percent of GDP. Also, a US$0.10/gal tax on fuels has been adopted to finance the public transportation subsidy. Decreases in world oil prices will have a positive impact on the cost of these subsidies and there are some opportunities for improving the targeting of LPG subsidy.

The government has also put in place or expanded programs to respond to high commodity prices. The Red Solidaria, a well-targeted cash transfer program has been expanded. The Alianza para la Familia initiative, a broad effort to support working and non-working families includes increases in education and health tax deductions, higher spending for school food programs, free secondary education, and improved seed programs for rural communities. These programs can be accommodated within the 2009 budget leading to a targeted public deficit of 2.2 percent of GDP in that year.

The short-term outlook is challenging due to the difficulties in the external environment and internal factors mentioned earlier. Real growth is expected to remain near 3.5 percent in 2009 and to recover to levels near 4 percent later on, while inflation would gradually fall to about 3 percent in 2010. Public investment will increase by more than 25 percent, including construction of a new hydroelectric project, the start of operations of the new port at La Unión, and a new road in the northern part of the country financed by the Millennium Challenge Account. At the same time the current account deficit would narrow allowing for a reduction in external debt. The real effective exchange rate (REER) is broadly in line with fundamentals. Standard competitive indicators show that the export sector remains competitive.

Key policy decisions in the short term are focused on maintaining macroeconomic stability and enhancing financial sector crisis preparedness, including increasing liquid asset requirements on banks, as well as close monitoring and drawing action plans on how to deal with stress situations in the banking system. It is important to stress that the financial system remains strong and resilient.

Restoring access to longer-term financing is also and important priority and there has been considerable progress on this front since the Article IV consultation. A total of US$950 million has been initially approved by Congress on November 5 from multilateral development institutions, including a US$ 500 million from the IADB and a US$450 million loan from the World Bank. Out of these resources, US$650 million will be used to finance the government’s 2011 Eurobond and the remaining resources will go to health, education and priority social spending projects. These loans still require a final approval by Congress, but the use of these funds have been agreed to by the government and the opposition parties.

Over the medium term, the fiscal strategy is geared to reducing public debt to about 30 percent of GDP by improving the public sector primary surplus between 2009 and 2013 through tax revenue measures of around 1 percent of GDP and improving the efficiency and targeting of public spending. However, the authorities have not agreed to potential increase in the VAT rate or pension reform. Other measures such as eliminating the electricity subsidy for the nonresidential sector or better targeting of the gas and transportation subsidies are under consideration but are dependent on the future path of international oil and gas prices.

Structural reforms are needed to increase the resilience of the financial system and these include the passage of a bill to strengthen financial sector supervision, increasing the deposit insurance fund to 5 percent of total deposits and passage of a bill to enhance the legal basis for mutual funds.

In spite of the global economic slowdown, El Salvador is taking concrete and effective contingency measures to face a potential liquidity crisis, it is maintaining a responsible fiscal policy, it is undertaking a solid public investment program, it has a dynamic export sector that has continued to grow, and its economy remains competitive. All these factors will undoubtedly contribute to a prompt recovery in growth rates once the global situation has improved.

El Salvador: 2008 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for El Salvador
Author: International Monetary Fund