El Salvador
2010 Article IV Consultation and First Review Under the Stand-By Arrangement: Staff Report; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for El Salvador

The Salvadoran economy was severely affected by the global economic slowdown. Further strengthening the economy’s growth prospects and reducing poverty will depend on a durable fiscal consolidation effort and improvements in the investment climate through continued commitment to macroeconomic and financial stability. A recent IMF/World Bank Financial System Stability Assessment (FSSA) confirmed that the Salvadoran financial system withstood the global financial crisis well and was well capitalized and liquid. The FSSA recommended enhancements to the legal and regulatory frameworks as well as measures to reduce some remaining vulnerabilities.

Abstract

The Salvadoran economy was severely affected by the global economic slowdown. Further strengthening the economy’s growth prospects and reducing poverty will depend on a durable fiscal consolidation effort and improvements in the investment climate through continued commitment to macroeconomic and financial stability. A recent IMF/World Bank Financial System Stability Assessment (FSSA) confirmed that the Salvadoran financial system withstood the global financial crisis well and was well capitalized and liquid. The FSSA recommended enhancements to the legal and regulatory frameworks as well as measures to reduce some remaining vulnerabilities.

I. Background and Overview

1. The 2010 Article IV consultation and first review under the Stand-By Arrangement (SBA) took place against a background of a moderate recovery of external demand.1 Owing to its strong linkages to the U.S. economy, the effects of the 2009 crisis in El Salvador were relatively more severe than in the rest of the region, as consumption, investment, and exports all fell sharply, and real GDP declined by 3½ percent. 2 Economic activity is recovering modestly in 2010.

2. The government’s economic strategy aims at ensuring fiscal and debt sustainability, while safeguarding social spending. The strategy is underpinned by a continued commitment to the dollarization regime as the key anchor of macroeconomic policy. On March 17, 2010, the Fund approved a 3-year SBA in support of this strategy (with total access of 300 percent of quota), which the authorities are treating as precautionary. President Funes has been able to generate political majorities in Congress to advance key initiatives to bolster his economic strategy, including approval of a tax package in December 2009. However, going forward, forging consensus on future key initiatives and reforms remains challenging.3

3. A key medium-term challenge is to improve the growth performance of the economy, which has lagged that of the region. Real GDP growth averaged 2.1 percent during the last 5 years, compared with 5.1 percent in the rest of Central America; over the same period, private investment averaged 15 percent of GDP, compared with 21 percent in the region. By end-2008 40 percent of households were living under the poverty line. To address this situation, in mid-2009, the Funes administration put in place its flagship General Anti-Crisis Plan (PGA), which channels spending of about 1 percent of GDP to social programs.4 To spur growth and investment during the remainder of their term, the authorities plan to undertake fiscal reforms to create space for priority expenditures, assume a more active role in promoting exports, and foster “public private partnerships” to promote investment in infrastructure, including in the electricity and energy sectors. The government is also looking to enhance the role of public banks to support lending to the productive sector.

4. A recent IMF/World Bank Financial System Stability Assessment (FSSA) confirmed that the Salvadoran financial system withstood the global financial crisis well and was well-capitalized and liquid. The FSSA recommended enhancements to the legal and regulatory frameworks as well as measures to reduce some remaining vulnerabilities.5

II. Recent Economic Developments

5. Developments in 2010 are broadly in line with projections contained in the March 2010 staff report (Figure 1).

  • Output. The economic recovery is gaining strength, albeit at a modest pace. Real GDP fell by only ½ percent (y/y) in the first quarter of 2010 after declining 4.9 percent in the last quarter of 2009. The monthly index of economic activity rose 1.9 percent (y/y) in June, the fourth consecutive monthly gain, and real GDP growth for the year as a whole may be close to the 1 percent envisaged in the program.

  • Prices. Inflation was zero in 2009, and by July 2010 it had risen to only 1.0 percent (y/y). Core inflation (excluding food and energy) was 0.9 percent in July (y/y), compared with 2.6 percent at end-2009.

  • Trade and remittances. Exports (in U.S. dollars) declined 16 percent in 2009, but increased by 14 percent (y-t-d) through July 2010. Imports rose by more during the same period (17 percent), though some of the increase reflects higher oil prices (non-oil imports are up 12 percent). Remittances rose by only 2.5 percent (y-t-d) through July (Figure 2).

  • Net capital flows. Capital account flows are weaker than envisaged at the time of program approval, mainly owing to delays in disbursements from international financial institutions (IFIs). For the year as a whole, net international reserves of the central bank are projected to fall by close to US$200 million compared with an increase of US$100 million projected in the March staff report.

  • Financial system: Most bank indicators have improved in 2010. Deposits have risen (3½ percent) through June, profitability is recovering, and non-performing loans have leveled off (after increasing significantly in 2009). Liquidity and capital ratios remain well above their pre-crisis levels, due to a shift to low-risk, liquid assets and some capital injections (Figure 3). Credit to the private sector, which fell by 4½ percent in 2009, has continued to decline through mid-2010, though there are indications that lending is resuming in the third quarter.

  • Fiscal: The performance criteria on the deficit of the nonfinancial public sector for March and June were met with comfortable margins. Restraint on current spending (except for subsidy outlays) and slow implementation of the public investment program were key factors contributing to the overperformance; government revenues were in line with program targets (Figure 4). Performance criteria on public debt flows and on the non-accumulation of payments arrears were also observed.

Figure 1.
Figure 1.

El Salvador: Economic Activity and Inflation

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Sources: Central Reserve Bank of El Salvador; Haver Analytics; and Fund staff calculations.
Figure 2.
Figure 2.

El Salvador: Balance of Payments Developments

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Sources: Central Reserve Bank of El Salvador; Haver Analytics; National sources; and Fund staff calculations.
Figure 3.
Figure 3.

El Salvador: Financial Sector Developments

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Sources: Financial System Superintendency; Central Reserve Bank of El Salvador; Haver Analytics; and Fund staff calculations.
Figure 4.
Figure 4.

El Salvador: Fiscal Developments

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Sources: Ministry of Finance; and Fund staff calculations.1/ Includes VAT refunds and income tax refunds in current transfers.

III. Policy Discussions

A. Macroeconomic Outlook

6. There was agreement that the medium-term outlook presented in the March 2010 staff request for the SBA remains appropriate. External demand has picked up as projected, and the domestic economy is recovering slowly, as was envisaged. Real GDP growth continues to be projected at 1 percent in 2010 and 2½ percent in 2011, though downside risks have decreased. Inflation is on track to rise to 1½ percent in 2010, and evolve in line with U.S. inflation thereafter.

Macroeconomic Framework

(In percent of GDP, unless otherwise noted)

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

7. The medium-term external current account deficit is expected to be somewhat higher than envisaged. As in the March staff report, the current account deficit for 2010 is expected to rise to 2.8 percent of GDP (from 1.8 percent in 2009), as import growth outweighs that of exports and remittances. Thereafter, however, the deficit is projected to stabilize at around 3.3 percent of GDP (compared with below 3 percent of GDP in the March staff report owing to a higher projected oil import bill and stable remittances). The current account deficit is expected to be financed by net FDI flows on the order of 2 percent of GDP, net government borrowing for about 1 percent of GDP, and other private capital inflows.

B. Fiscal Policy

8. It was agreed that the strategy of gradual fiscal consolidation that underpins the three-year SBA and the projected fiscal stance for 2010 remain appropriate. The fiscal deficit for 2010 is expected to decline to 4.8 percent of GDP on the back of higher tax revenue (reflecting the recovery of demand and tax measures taken at end-2009) and expenditure restraint. On a cyclically-adjusted basis, this decline would represent a withdrawal of fiscal stimulus of 0.6 percent of GDP; that would be followed by a withdrawal twice as large in 2011, anchored on continued expenditure restraint and subsidy reform.

Fiscal Impulse

(in percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates.

Defined as the inverse of the change in the the cyclically-adjusted overall balance; a positive figure means fiscal stimulus.

9. Staff underscored that the gradual fiscal consolidation strategy is fraught with risks and left little scope for slippages. The fiscal consolidation envisaged for 2010–12 is not expected to result in a significant decline in debt levels. Under the agreed strategy, public debt levels are envisaged to start declining only in 2012. Staff presented a stochastic debt sustainability analysis showing that the debt dynamics in this scenario are highly sensitive to growth and interest rate shocks and policy slippages (Box 2). The authorities recognized these risks, but felt that pushing for a more ambitious fiscal effort could jeopardize the political consensus for fiscal consolidation in general. Nonetheless, they restated their commitment to take all measures necessary to adhere to the deficit targets envisaged under the program.

uA01fig01

El Salvador 2009

(public sector debt to GDP)

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

10. The near-term fiscal strategy hinges on subsidy reform, continued expenditure restraint, and strengthened tax administration.

  • Reforming energy subsidies is key. Subsidies are poorly targeted and a drain on government resources (staff estimates their cost at 1.4 percent of GDP in 2009). 6 Some remedial measures envisaged under the program (e.g., adjusting electricity tariffs) experienced delays, but the authorities have reaffirmed their commitment to reduce subsidies on liquefied gas (LPG) and electricity which would be redirected to other social policies.

  • Strict control of government spending in 2010–11 will be critical. While revenues are expected to recover gradually (by over 1 percent of GDP in 2011), mainly reflecting gains from tax administration improvements, a recovery in tax collections, especially on the income tax, and a step up in Millennium Challenge Corporation grants, the authorities underlined their commitment to contain government spending. They underscored that outlays on wages, goods and services, and discretionary transfers (excluding energy subsidies) will be kept broadly constant in real terms, which would yield savings of almost 1 percent of GDP in 2011; this will provide space to channel savings from energy subsidy reform to social sectors and infrastructure.

  • Tax administration has improved, but further progress is necessary. There have been improvements in the areas of auditing and control of large taxpayers, and these are expected to continue in 2011 when steps to enhance coordination between the internal revenue directorate (DGII) and customs (DGA) are completed.

11. The financing mix of the fiscal deficits in 2010–11 will be somewhat different than anticipated. Congress has yet to approve several external loans envisaged at the time of program approval, and some of these will only be disbursed in 2011. In view of this, the deficit in 2010 is being financed through the drawdown of government deposits and by placing debt in the domestic market (at very low rates).7 Staff urged the authorities to seek early congressional approval for the 2011 borrowing program and encouraged them to take advantage of current market conditions to refinance a US$650 million Eurobond that matures in the second half of 2011. The authorities stressed that they are already in discussions with Congress and expect to have full approval of their external borrowing program shortly, and they are working with financial advisors to roll over the Eurobond.

Medium-term issues

12. The authorities’ medium-term fiscal strategy hinges on reaching agreement on a fiscal pact to increase government revenue by at least 1½ percent of GDP. The authorities indicated that discussions on key elements of the pact are moving forward with a broad range of stakeholders. On the revenue side, they are working (with the Fund’s technical assistance) on designing measures that would underpin the fiscal pact (including improvements in tax administration, expanding the tax base and, as a final alternative, a possible increase in some tax rates). The authorities were confident that they would reach agreement on a satisfactory fiscal pact by 2012 and were reluctant to shorten the timetable because it could endanger the entire set of reforms. Staff urged the authorities to stand ready to adopt the revenue measures envisaged in the pact should they be needed for meeting the targets in their fiscal strategy.

13. The authorities are committed to public financial management reforms to support fiscal consolidation. El Salvador’s budget process has several shortcomings, including: (i) a requirement of supermajorities in Congress for approval of long-term financing; and (ii) the absence of a multi-year expenditure framework. The authorities indicated their commitment to remedy these weaknesses. They noted that IMF technical assistance missions are visiting San Salvador in August-September to advise on improving budget management and execution and to design a multi-year expenditure framework (the latter also being supported by the World Bank). In addition, they noted that they had requested a fiscal transparency ROSC (a mission will visit San Salvador in the fourth quarter of 2010).

14. Debt management could be improved. Public sector debt management is fragmented (with some elements in the ministry of finance and others at the central bank). Staff advised the authorities to consolidate these functions in one unit to avoid duplications and facilitate the design of a consistent public debt strategy. The authorities noted that they are working to improve debt management practices, including through the assistance of an external expert, but did not see a need to consolidate all debt operations under one agency.

C. Full Dollarization and Financial Sector Issues

15. The authorities reiterated that full dollarization will remain a key anchor of their macroeconomic framework despite its limitations. Staff discussed the results of a study assessing El Salvador’s performance under full dollarization. The study finds that dollarization had reduced exchange rate risk and provided a strong nominal anchor that had secured low inflation. The study also found that the Salvadoran economy’s dynamic response to shocks had not been affected by dollarization, although the country had suffered more severe shocks in the post-dollarization period than under the previous fixed exchange rate system (Box 3, Figure 5). The authorities recognized the key role that dollarization had played in preserving macroeconomic stability, but stressed that the inability to use monetary and exchange rate policy to mitigate external shocks imposed non-negligible costs to the adjustment process.

Figure 5.
Figure 5.

El Salvador: Economic Performance Under Dollarization

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Source: Fund staff calculations.

16. The exchange rate regime’s ability to withstand liquidity shocks should be broadened. While commercial banks’ liquid asset holdings are roughly comparable to those in other fully-dollarized economies, the “free” reserves of the central bank, which may be used to meet withdrawals in excess of the reserves of an individual bank, are relatively small. Moreover, there are legal hurdles to channeling reserves or borrowed liquidity to financial institutions with temporary liquidity problems. The authorities agreed that some of the problems regarding liquidity support stem from existing regulations and not from the dollarization regime, and they are considering reforms that would allow the central bank to undertake limited lender-of-last-resort (LOLR) functions, in line with FSSA recommendations.

uA01fig02

Commercial Bank Liquidity

(percent of deposits and securities, May 2010)

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Sources: IMF, International Financial Statistics; and Fund staff calculations.1/ Net international reserves in excess of commercial bank claims on the central bank.2/ Commercial bank holdings of central bank and central government securities.3/ Deposits at the central bank, deposits abroad, and securities abroad.

17. Staff discussed the main findings of the recent FSSA. The update found that banking system soundness had improved since the previous FSSA (in 2004), solvency ratios could withstand another moderate recession, and there have been advances in supervisory practices. However, the report also considered that progress in approving key norms had been slow, and recommended enhancements to the legal framework and bank safety net arrangements (Box 4). The authorities were in broad agreement with the findings and recommendations and noted that they were moving forward with key regulations in some areas. They also reiterated their commitment to secure congressional approval of the financial supervision and regulation law that has been with Congress for more than a year.

18. The new financial supervision and regulation law will create one superintendency in charge of banks, pensions, insurance, and securities, and shift regulatory powers to the central bank. The new structure for financial sector oversight is expected to reduce supervisory gaps, facilitate consolidated supervision and reduce regulatory arbitrage. The authorities noted that they will ensure that supervisory vigilance is maintained during the merger and that the central bank will issue key norms to enhance supervision. The issuance of norms on corporate governance of commercial banks is being proposed as a structural benchmark.

19. Staff welcomed the authorities’ plans to improve the legal framework of domestic capital markets. Domestic capital markets are underdeveloped and have played a limited role in financial intermediation, partly owing to shortcomings in the regulatory and supervisory framework. As a first step, the authorities reaffirmed their commitment to obtain congressional approval of the Investment Funds Law (a structural benchmark under the program), which would provide a legal basis and accounting and valuation standards for investment funds. They noted, however, that Congress will consider this bill only after the financial supervision and regulation bill has been approved.

20. Efforts to bolster the bank resolution framework were also welcomed. Staff and the authorities agreed that the bank resolution framework should be improved, and that the deposit insurance fund (IGD), financial system supervisor, and central bank should develop mutually-agreed comprehensive procedures, manuals, and standardized contracts. The authorities noted that coordination among domestic regulatory agencies involved in the safety net is improving, and that they are designing a financial stability strategy, as recommended by the FSSA. They also plan to carry out a comprehensive bank resolution simulation exercise in the coming months (a proposed structural benchmark under the program, MEFP ¶5) and are seeking to promote cross-border crisis prevention and management arrangements with neighboring countries.

21. Staff discussed the authorities’ plans to strengthen the role of public banks in El Salvador. The two-pronged approach consists of: (i) scaling up lending to priority sectors through two existing public banks (with a combined share in banking system assets of around 5 percent as of end-2009), and (ii) converting an existing second-tier bank into a new national development bank (Banco Nacional de Desarrollo) that would be in charge of an economic development trust fund (to catalyze IFI and private-sector lending for large projects) and a guarantee trust fund to support private-bank lending. Staff acknowledged that bank lending to certain sectors had become scarce, but highlighted the difficulties in ensuring continued adherence to transparent criteria in state-owned banks and limiting potential fiscal risks. The authorities shared staff’s concerns, but indicated that the new entities would not represent a fiscal burden as risks would be contained.

D. Competitiveness Issues

22. The authorities agreed that the real effective exchange rate appears to be broadly in line with fundamentals. Staff discussed the results from its assessment, which pointed to a small undervaluation of the real exchange rate (according to the macro balance and external stability approaches) and a somewhat larger (in absolute terms) overvaluation according to estimates from the equilibrium real exchange rate approach (Box 5). The authorities were of the view that the three approaches taken together were an indication that the real effective exchange rate is in line with fundamentals.

23. Staff stressed that improvements in the investment climate to boost competitiveness should be a key priority (Box 6). They underscored that domestic and foreign investment remains low both in nominal terms and relative to regional peers. Staff acknowledged that El Salvador generally compares well against other countries in the region under various measures of “doing business” and scores in the top half under a range of “competitiveness” measures, but noted that there are relative weaknesses in certain areas such as security, education and innovation.8 Lower sub-ranking scores are consistent with firm-level data that cite crime and workforce education as key concerns in El Salvador relative to regional peers. Private-sector representatives agreed that the investment climate had been adversely affected by a deterioration of internal security, though some also cited uncertainties related to the policy direction of the government.

24. The authorities agreed that addressing the security situation is a priority in the near term, and noted that their economic program contemplates allocating more resources to this area and to education. They were also confident that public banks would facilitate business start-ups and spur private investment. They stressed that their Five-Year Plan includes proposals to address the aforementioned issues, as well as promoting innovation, modernizing key productive sectors, and increasing regional integration.

E. Downside Risks

25. A slower recovery and the breakdown of political support for the fiscal consolidation process continue to pose the main risks to the government’s strategy. If either of these risks were to materialize, tighter expenditure restraint would be the only available tool to preserve macroeconomic stability.

  • Although risks to the growth forecast are roughly balanced, a prolonged period of low growth or a double-dip recession would result in lower-than-envisaged tax collections and possible untenable pressure on the spending side. As noted in Box 2, the sensitivity of El Salvador’s public debt path to adverse growth outturns would result in unsustainable debt dynamics.

  • Insufficient political support could endanger the authorities’ fiscal strategy, including by delaying approval of IFI loans and stalling further reforms necessary for fiscal consolidation.

26. The government would need to take additional measures if the above risks were to materialize. The authorities’ strategy provides a solid basis to move forward in a baseline scenario, but they should stand ready to respond to a more adverse scenario. If external financing fails to materialize, or if the government is unable to garner the necessary congressional support for further reforms on the revenue side, spending would need to be reduced to avoid recourse to riskier forms of financing (such as the issuance of short-term debt). An important safeguard in this regard is the authorities’ plan to reprioritize the public investment program to identify projects that could be delayed, while minimizing the social impact.

IV. Program Modalities

27. The main elements of the program approved in March 2010 were ratified for this review. The authorities and staff reached understandings on the following updates (Table 14):

  • Quantitative performance criteria: The original indicative targets for end-2010 on the ceiling on the deficit of the nonfinancial public sector (US$1,047 million, 4.8 percent of GDP) and the accumulation of public sector debt (US$1,117 million) were converted to performance criteria. The adjuster for revenue overperformance has been maintained.

  • Structural benchmarks: Approval of a budget for 2011 consistent with a fiscal deficit of 3.5 percent of GDP was added as a new structural benchmark (SB). The timetable for tax administration improvements regarding coordination between the internal revenue service (DGII) and customs office (DGA) was updated. Approval of the financial supervision and regulation law (originally expected for July 2010) is now expected by end-2010 and included as an SB for the second review. Congressional approval of the investment funds law (originally expected for October 2010) has also been pushed back to March 2011. The arrangement also includes two new SBs for the second review: undertaking a bank resolution simulation exercise, and issuing norms on corporate governance of commercial banks.

  • Consultation clauses: The two consultation clauses under which the authorities commit to consult with Fund staff and reach understandings on corrective measures remain in force.9

28. The authorities have made progress in addressing the recommendations of last year’s safeguards assessment, but vulnerabilities remain. The most recent safeguards assessment is to be completed in September 2010 and will note that the BCR has made progress in implementing the recommendations of the 2009 assessment in the areas of internal control and legal structure. The authorities have incorporated the recommendations of the 2009 assessment on the legal framework in the financial supervision and regulation law awaiting congressional approval. The principal risk is in the area of financial reporting, where the assessment recommends the adoption of an international financial reporting framework. The assessment also recommends publishing the opinions of external auditors and creating a framework to monitor the implementation of audit recommendations.

V. Staff Appraisal

29. A modest economic recovery is underway. Inflation remains contained, the external current account is widening as envisaged, and fiscal consolidation is proceeding appropriately. The precautionary SBA with the Fund has helped bolster investor confidence and financial stability, and performance under the program has been good. All quantitative performance criteria for the first review were met, and progress is being made, albeit more slowly than originally envisaged, on the structural front.

30. The key medium-term challenge faced by the authorities is to improve the economy’s growth prospects. Poverty remains high, and growth is relatively low, even by regional standards. Improving the investment climate through a continued commitment to macroeconomic and financial stability and the allocation of government spending to more productive areas would be key. Staff welcome the authorities’ immediate efforts to mitigate the impact of rising poverty, and their commitment to strengthen financial sector oversight; ensure fiscal sustainability; boost spending on education, security, and infrastructure; and improve the climate for business start-ups.

31. The authorities’ fiscal strategy of gradual fiscal consolidation remains appropriate, but downside risks are not negligible. The small deficit reduction envisaged for 2010 and 2011 is consistent with the gradual economic recovery currently anticipated. Together with the tax package approved in late 2009 and envisaged improvements in tax administration, the modest recovery should increase tax revenues to the levels implied by the deficit target. The planned reform of energy subsidies should provide the space to increase spending on infrastructure, security, and social programs, including education. Staff welcomed the authorities’ intentions to boost investment spending, which has lagged in 2010 and would support medium-term growth prospects.

32. Sustainability of the public finances over the medium term will require a significant increase in revenue. Staff continue to support the authorities’ strategy to seek a national consensus on a fiscal pact that is to be implemented no later than 2012 and would include a tax reform aimed at increasing tax revenue by at least 1½ percent of GDP. Such a reform would provide a sustainable resource base to finance needed social, security, and infrastructure spending, while ensuring that fiscal deficits decline and the public debt-to-GDP ratio is put on a durable downward path. Accelerating the implementation timetable of the fiscal pact (or the revenue elements thereof) would speed up fiscal consolidation and allow greater expenditure on priority areas in the near term.

33. Fiscal performance would be enhanced by actions to improve public expenditure and debt management. Staff welcome the authorities’ efforts to address shortcomings in the budgetary process and to bolster public debt management. Staff would urge the authorities to avoid delays in moving forward on their plans to roll over the Eurobond coming due next year.

34. Dollarization continues to be a cornerstone of macroeconomic and financial stability. In the almost ten years since El Salvador adopted the U.S. dollar, interest rates have been lower than under the previous regime as exchange rate risk has disappeared, inflation has remained low, and the real exchange rate has remained broadly in line with fundamentals. Moreover, despite frequent and sizable supply-side shocks, the economy´s reaction to shocks has not been significantly different when compared to the previous fixed exchange rate regime. Nonetheless, while banks in El Salvador have liquid asset holdings roughly comparable to the other fully-dollarized economies in Latin America and are solidly placed to withstand moderate shocks, staff would urge the authorities to move expeditiously in improving systemic liquidity management and strengthen their lender-of-last resort capabilities.

35. Close monitoring of the financial system remains a high priority. Staff is encouraged by the recent FSSA findings regarding banks’ resilience to macroeconomic shocks and the upgrading of supervisory practices. Staff welcomes the authorities’ continued pursuit of congressional approval of the financial supervision and regulation law and their intention to continue to strengthen the regulatory framework by: (i) upgrading the bank resolution framework, including through a comprehensive bank resolution exercise; (ii) issuing norms to enhance supervision; and (iii) improving the legal framework of domestic capital markets. Staff caution the authorities to maintain strict oversight of financial markets through the merger of the superintendencies of banks, pensions and securities. Staff also recommend the prompt adoption of measures to ensure that the revamped public sector banks channel credit to the private sector in a transparent manner and without adding to fiscal risks.

36. A protracted recession or unexpected difficulties in forging a political consensus for the government’s fiscal strategy remain the key risks of the program. Risks to the growth projections are somewhat mitigated by the conservative path for economic recovery that underpins the authorities’ program. Faltering political support could endanger the authorities’ fiscal strategy by delaying the approval of IFI loans or blocking a consensus-based fiscal pact. So far, though, the administration has been able to move its agenda forward, and its social and economic program is beginning to yield results.

37. Staff recommend the completion of the first review under the SBA. Performance under the program has been good, and the authorities’ policies appear adequate to meet the targets under the program, support the recovery of the economy, and maintain external stability.

38. It is proposed that the next Article IV consultation with El Salvador be held in accordance with the July 15, 2002 decision on consultation cycles.

Past Fund Policy Recommendations and Implementation

The previous Article IV consultation with El Salvador (IMF Country Report 09/35) was concluded in the early days of the global financial crisis and highlighted the need to focus on crisis preparedness and structural reforms. At that time, staff recommended a fiscal consolidation strategy to continue lowering the public debt-to-GDP ratio to 30 percent. The onset of the global crisis drastically changed the outlook for El Salvador’s economy, and the authorities requested Fund assistance in the form of a precautionary SBA that was approved by the Board on January 16, 2009. Some of the specific recommendations made during the 2008 Article IV consultation were:

  • Financial contingency measures. Monitor banks’ liquidity and their short-term borrowing closely, draw up concrete action plans to deal with stress in the banking system, and negotiate contingent credit lines. Response: In the context of the precautionary SBA approved by the Fund ahead of the 2009 presidential elections, the authorities secured commitments from the IDB to support the financial sector in the event of adverse shocks. In addition, the government that took office in July 2009 requested a financial system stability assessment (FSSA), which has been completed, and the authorities are developing a strategy to address liquidity-related issues and other recommendations made by the FSSA.

  • Short-term fiscal policy. Maintain fiscal restraint and seek a political agreement to access long-term financing from IFIs. Response: The authorities decided to accommodate the cyclical decline in revenues associated with the global downturn, but exercised commendable expenditure restraint during 2009, and redirected spending toward social sectors.

Structural reforms. Strengthen financial sector regulation and supervision and the sector’s ability to confront shocks; improve the efficiency and targeting of subsidies; and implement a parametric reform of the pension system. Response: Limited progress has been achieved on these fronts. The authorities have submitted financial supervision and regulation legislation to Congress (to consolidate regulation of the financial sector), but Congress has yet to approve the law. In 2009, the authorities were able to eliminate electricity subsidies to corporations, reduce the transport subsidy by 40 percent, and lower water subsidies; further reforms to liquefied gas (LPG) and electricity subsidies are planned for late 2010. The authorities are strengthening tax administration, despite delays in enhancing coordination between the internal revenue service and customs. The authorities recognize the need for pension system reform, but see this as a longer-term concern, while their immediate policy focus has been to protect the economic recovery and lay the basis for fiscal sustainability.

Public Debt Dynamics and Medium-Term Targets

This box presents two exercises related to El Salvador’s public debt. First a stochastic debt sustainability analysis (DSA) suggests that subpar economic growth or interruptions to fiscal consolidation would place the public debt on an unsustainable path and pose significant risks to the government’s strategy. Second, two approaches to calculate sustainable debt levels shed light on the appropriate medium-term target.

A stochastic DSA suggests that placing El Salvador’s public debt on a downward path would require durable fiscal consolidation (compared with the evidence from cross-country historical experience) and is very sensitive to adverse shocks to growth and interest rates. Drawing on Celasun, Debrun, and Ostry (2007), alternative debt paths for El Salvador were obtained based on stochastic projections for key variables—GDP growth, interest rates, and the real effective exchange rate (Figure 6). 1 The results, which are highly dependent on the historical data and relations used, including the relatively passive average policy response to shocks, highlight the sensitivity of El Salvador’s debt dynamics to lower-than-projected output and interest rates, with debt levels as high as 75 percent of GDP lying within the 80 percent confidence interval.

Figure 6.
Figure 6.

El Salvador: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Sources: International Monetary Fund, country desk data, and Fund staff estimates.1/ Shaded areas represent actual or estimated data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ Ten percent of GDP shock to contingent liabilities occurs in 2011.

The results from the exercise underscore the importance of adhering to the key fiscal commitments under the program, namely firm expenditure restraint and subsidy reform and, starting in 2012, a major tax reform to strengthen the underlying fiscal position. They also point to the need for designing contingency measures in order to contain any deterioration of the fiscal balance should risks materialize.

uA01fig03

El Salvador 2009

(public sector debt to GDP)

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

The optimal debt literature suggests that El Salvador’s current level of public debt, at over 50 percent of GDP, is high. Following the “debt intolerance” literature, annual data for 1989–2009 for a sample of middle-income countries was used to calculate public debt levels that would allow El Salvador to improve its creditworthiness and belong to a “debt club” with easier access to market financing (as provided by International Investor Rating). 2 The exercise yields a target debt for El Salvador of 25 percent of GDP. A second approach takes as a starting point a notional maximum debt-to-GDP ratio of 50 percent (the level used as a reference point in the discussions of macroeconomic convergence in the Central American Monetary Council). Subtracting from this level the space that would be needed to absorb contingent liabilities from natural disasters (averaging costs of 3 percent of GDP in El Salvador) and/or financial crises (averaging 12 percent of GDP in the region) yields a debt level for El Salvador of about 35 percent of GDP.

1 O. Celasun, X. Debrun, and J.D. Ostry (2007), “Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A Fan Chart Approach,” IMF Staff papers, Vol. 53 (3). The stochastic projections were derived from an unrestricted VAR model, with shocks around the deterministic projection calibrated to match the historical properties of the data. The stochastic projections were then combined with an estimated fiscal policy reaction function to produce 1,000 public debt paths and obtain a “fan chart” for the debt projection.2 C. Reinhart, K. Rogoff, and M. Savastano (2003), “Debt Intolerance”, Brookings Papers on Economic Activity, No. 1.

El Salvador’s Economic Performance Under Dollarization

El Salvador’s economic performance since the adoption of the U.S. dollar as legal tender has been on many key dimensions not functionally different from its performance under the previous exchange rate regime (a peg to the U.S. dollar). Under dollarization, nominal and real interest rates have been lower, while the costs associated with the lack of independent monetary policy have been mitigated by the economic cycle’s close correlation with that of the United States.

There has been no structural change in the economy’s response to shocks under dollarization. Using a two-variable (output and inflation) structural VAR model to identify supply and demand shocks, staff estimate that responses to shocks did not change after the adoption of official dollarization in 2001. Under dollarization, the response of inflation to supply shocks has been smaller, but slightly more persistent than under the peg, while the response of output to those shocks under the two regimes has been similar. At the same time, inflation has been less sensitive to demand shocks under dollarization than under the peg, while the opposite has happened with output.

The reduction in exchange rate risk brought about by official dollarization has been beneficial. Staff estimate that adopting the dollar has reduced the exchange rate risk component of commercial bank interest rates by 500 basis points, generating average annual net interest savings to the Salvadoran private sector of about ½ percent of GDP since 2001, and annual savings of about ¼ percent of GDP for the public sector (with interest cost savings of around ½ percent of GDP outweighing the loss of potential seigniorage). These results follow from applying an estimate of the exchange rate risk premium implicit in interest rates under the pegged system (some 4 and 5 percentage points for loans and deposits, respectively), projecting them over the dollarization period, and applying the results to the stocks of credit and deposits.

U.S. monetary policy during official dollarization seems to have had better stabilizing properties on El Salvador’s output than did domestic monetary policy under the peg. Staff estimated the output stabilization properties of monetary policy under alternative regimes using simple Taylor rules. During the 1990s, domestic monetary policy tightened in response to higher inflation, and tended to ease when output growth was rising, increasing output volatility. Under official dollarization, changes in the U.S. monetary policy rate have helped reduce the volatility of domestic output.

Using standard pass-through analysis, the transmission of monetary policy rates to commercial bank lending and deposit rates has not been significantly different in the two regimes. The pass-through of interest rates in El Salvador has been similar to Panama’s. At the same time, market views of fiscal sustainability (proxied by El Salvador’s EMBI spread) and indicators of banking system health have been important factors behind the gap between Salvadoran and U.S. commercial bank interest rates.

Key Recommendations of the FSSA

The 2010 FSSA found that El Salvador’s financial system had withstood the global financial crisis, and was well-capitalized and liquid. The FSSA report identified several vulnerabilities and areas for further reforms, making the following key recommendations:

  • Financial supervision and regulation law (structural benchmark, SB, for the second review). The FSSA supported the draft law currently before Congress, but acknowledged that the merger of three superintendencies and transfer of regulatory authority to the central bank would bring about challenges. At the same time, it noted that the law should provide an explicit mandate for financial stability; broaden and clarify the powers and improve the governance and independence of the Financial System Superintendency (SSF); and increase accountability. The FSSA also proposed addressing some gaps in the current draft legislation, including on strengthening the legal protection for supervisors and augmenting the remedial action powers of the SSF in the early preventive stages..

  • Comprehensive liquidity and banking crisis resolution arrangements. The FSSA noted the constraints posed by official dollarization and urged the authorities to develop a comprehensive policy to provide liquidity support to the financial system in situations of stress. A key pillar of this policy would be the formation of a comprehensive liquidity policy which could include a fund that pools liquid resources from banks (similar to the one in Ecuador). The FSSA also recommended easing some legal restrictions on the central bank to channel its own reserves or borrowed funds to banks and noted that coordination among safety net providers should be strengthened by developing mutually-agreed strategies on financial stability and banking crisis resolution.

  • Investment Funds Law (SB for the third review). The FSSA encouraged the approval of the draft law, welcoming its potential to broaden the investor base and help develop domestic capital markets.

  • Norms on key financial sector risks. Noting that the SSF had initiated an ambitious project to move toward risk-based supervision, the FSSA observed that regulation in several areas was lacking, including on corporate governance, credit risk, liquidity risk, market risk, and operational risk. Draft regulations in several areas were well-advanced, and the FSSA recommended their prompt implementation.

  • Enhancements to bank resolution and deposit insurance. The FSSA recommended reforms to bring bank resolution practices and the deposit insurance scheme in line with international best practices, including: increasing the target level and sources of funding for the deposit insurance fund, eliminating the requirement to notify a bank three days prior to the suspension of operations, setting the least-cost criterion as the measure of the maximum deposit insurance support, and allowing the removal of a bank’s board upon commencement of judicial intervention. These recommendations are being considered by the authorities.

Exchange Rate Assessment

El Salvador’s real effective exchange rate (REER) has remained relatively stable during the last decade, reflecting the absence of a domestic currency beginning in 2001 and relatively low and stable rates of inflation.

uA01fig04

Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

uA01fig05

Nominal Effective Exchange Rate

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

CGER-based assessment. An assessment of El Salvador’s exchange rate based on the three CGER methodologies suggests that (as of end-2009) there is no evidence of misalignment.1 Two approaches under CGER, the Macroeconomic Balance and the External Sustainability methodologies, suggest a small undervaluation, while the Equilibrium Real Exchange Rate methodology suggests an overvaluation of about 6-7 percent.

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Based on a projected CA deficit of 3.5% in 2015, adjusted for forecast change in the REER

Depreciation (+= appreciation) needed to close the gap between the CA norm and CA projection

Impact of remittances. Given large remittance inflows to El Salvador, it may be necessary to adjust the CGER methodology to account explicitly for the influence of remittances on household consumption. If in equilibrium, spending on imports moves in tandem with remittances, the current account norm would be unaffected by remittance flows. However, if households decide to save the entire remittance inflow, the current account norm would be impacted one-for-one by remittance flows, thereby lowering the calculated current account norm deficit.

1/ Analysis applies regression estimates provided in IMF Occasional Paper 261.

Competitiveness in El Salvador

Export performance. Despite far-reaching reforms to the trade and investment regimes, exports in El Salvador remained stable at about 21 percent of GDP, from 2001–2009, some 5–9 percentage points of GDP below the average of its regional peers. Trends in exports have persisted despite their changing composition and varying degrees of export concentration.

uA01fig06

Exports as percent of GDP

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Investment levels. Investment rates, domestic and foreign, have remained low despite far-reaching reforms. These low investment rates have contributed to lagging competitiveness and low overall rates of economic growth. Domestic investment, averaging around 17 percent of GDP over the past 20 years, is below the Latin American average of 20 percent of GDP and Central American average of 21 percent of GDP.

Investment climate. Investment remains low even though several indicators of El Salvador’s investment climate, including the World Bank’s Doing Business Indicators and the World Economic Forum’s Global Competitiveness Indicators (GCI), compare favorably with El Salvador’s regional peers. At the same time, component rankings reveal some relative weaknesses, including in the area of security. El Salvador also ranks in the bottom half for innovation, and below Costa Rica, Panama and the Dominican Republic for higher education. These component rankings are consistent with firm-level data collected by the World Bank that highlight specific areas that individual firms deemed to be problematic. Crime and workforce education are two such key areas. Improving the investment climate will require a strategy to overcome the shortcomings in these areas.

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GCI rank out of 133 countries; Doing Business rank out of 183 economies Selected components, GCI (higher score = stronger performance)
Figure 7.
Figure 7.

El Salvador: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2010, 307; 10.5089/9781455208678.002.A001

Sources: International Monetary Fund, Country desk data, and Fund staff estimates.1/ Shaded areas represent actual or estimated data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
Table 1.

El Salvador: Selected Economic Indicators

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

IMF Country Report No. 10/82.

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

Table 2.

El Salvador: Balance of Payments

(In US$ millions)

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

Expressed in terms of following year’s imports.

Table 3.

El Salvador: Operations of the Nonfinancial Public Sector

(In US$ millions)

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

IMF Country Report No. 10/82.

Includes financing for education, health, and pension trust funds.

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

Public sector gross debt less government deposits held at the central bank or commercial banks.

Table 4.

El Salvador: Operations of the Nonfinancial Public Sector

(In percent of GDP)

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

IMF Country Report No. 10/82.

Includes financing for education, health, and pension trust funds.

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

Public sector gross debt less government deposits held at the central bank or commercial banks.

Table 5.

El Salvador: Operations of the Nonfinancial Public Sector

(In percent of GDP)

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

Includes financing for education, health, and pension trust funds.

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

Public sector gross debt less government deposits held at the central bank or commercial banks.