IMF Executive Board Concludes 2014 Article IV Consultation with El Salvador

KEY ISSUESFocus: The main themes centered on tackling macroeconomic vulnerabilities andimproving the medium-term outlook by achieving an ambitious fiscal adjustment while protecting social spending, creating an environment for higher private sector-led growth, and building a robust financial sector.Main policy issues• A reduction in the fiscal deficit of 3½ percent of GDP is needed over the next three years to place public debt on a sustainable path to maintain access to market financing on favorable terms. This adjustment should be accompanied by well- targeted social spending to protect the most vulnerable and continued progress in lessening inequality.• A broad strategy is also needed to reduce the growing imbalances in the pension system and restore its sustainability for future generations. In this regard, a broad- based dialog across all segments of Salvadoran society is needed to build support for a reform that should include an increase in the retirement age and introduce a progressive taxation of benefits. Steps are also needed to further strengthen public financial management to mitigate key fiscal risks, including by enhancing expenditure monitoring and control (to avoid future spending arrears) and recording contingent fiscal liabilities transparently in the fiscal accounts.• The authorities’ goal of raising potential growth to 3 percent while reducing inequality will require substantial supply-side measures to enhance productivity and competitiveness. These should aim to reduce red-tape, increase access to credit, upgrade infrastructure, provide access to and lower the cost of energy, and diversifying the economy. The FOMILENIO II grant from the U.S. provides a valuable opportunity to catalyze such growth-enhancing reforms.• Banking indicators appear sound, a product of prudent supervision and regulation. Nonetheless, there is scope to further strengthen the institutional underpinningsfor financial stability by upgrading the legal framework for bank resolution and bycreating an appropriate liquidity safety net for banks.

Abstract

KEY ISSUESFocus: The main themes centered on tackling macroeconomic vulnerabilities andimproving the medium-term outlook by achieving an ambitious fiscal adjustment while protecting social spending, creating an environment for higher private sector-led growth, and building a robust financial sector.Main policy issues• A reduction in the fiscal deficit of 3½ percent of GDP is needed over the next three years to place public debt on a sustainable path to maintain access to market financing on favorable terms. This adjustment should be accompanied by well- targeted social spending to protect the most vulnerable and continued progress in lessening inequality.• A broad strategy is also needed to reduce the growing imbalances in the pension system and restore its sustainability for future generations. In this regard, a broad- based dialog across all segments of Salvadoran society is needed to build support for a reform that should include an increase in the retirement age and introduce a progressive taxation of benefits. Steps are also needed to further strengthen public financial management to mitigate key fiscal risks, including by enhancing expenditure monitoring and control (to avoid future spending arrears) and recording contingent fiscal liabilities transparently in the fiscal accounts.• The authorities’ goal of raising potential growth to 3 percent while reducing inequality will require substantial supply-side measures to enhance productivity and competitiveness. These should aim to reduce red-tape, increase access to credit, upgrade infrastructure, provide access to and lower the cost of energy, and diversifying the economy. The FOMILENIO II grant from the U.S. provides a valuable opportunity to catalyze such growth-enhancing reforms.• Banking indicators appear sound, a product of prudent supervision and regulation. Nonetheless, there is scope to further strengthen the institutional underpinningsfor financial stability by upgrading the legal framework for bank resolution and bycreating an appropriate liquidity safety net for banks.

On December 11, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with El Salvador1 and considered and endorsed the staff appraisal without a meeting.2

Background

El Salvador’s growth—driven by private consumption—has continued to lag the Central American region. In 2013, growth decelerated to 1.7 percent, as private consumption slowed against weaker remittances. Growth accelerated slightly to 2 percent in the first half of 2014 as remittances recovered. Inflation—anchored by full dollarization—has remained low at 1-2 percent.

The fiscal deficit has remained high and external imbalance has risen since 2010. Despite strong revenue performance through 2013, the fiscal deficit has remained at 4 percent of GDP due to higher wage bill and current transfers. The resulting tight financing situation has lowered public investment and caused an accumulation of payment arrears; the latter reduced sizably following the issuance of a US$800 million Eurobond in September. However, public debt is set to reach 60 percent of GDP by end-2014. The rising current account deficit reflects a decline in private saving/investment balance and sustained fiscal deficits. In 2013, it reached 6½ percent of GDP as exports faced broad-based weaknesses. The external position is, however, improving in 2014 due to lower imports, services exports, recovering remittances, and the recent drop in oil prices.

The banking system is broadly sound. The mostly foreign-owned banking sector is highly liquid and reports strong capital positions, with low non-performing loans and high provisioning. Credit growth has been moderate (7 percent in 2013–14), but partially funded by external borrowing in the absence of corresponding deposit growth.

Under current policies, growth is expected to be around 2 to 2¼ percent in 2014-15, and reach about 2½ percent in 2016–18 reflecting private and public investment projects expected to come on stream. The ongoing reduction in external current account deficit would unwind in the medium term partly as the fiscal deficit is projected to widen to 5½ percent of GDP and public debt would rise above 70 percent of GDP by 2019.

Key risks include global uncertainties linked to the normalization of U.S. monetary policy or a deteriorating economic outlook for advanced and emerging markets, which could interact with domestic fiscal and external vulnerabilities. On the upside, a more sustained fall in oil prices could lessen external imbalances and have some positive growth effects, while better-than-expected growth in the U.S. would have positive spillovers to El Salvador. In addition, promoting regional cooperation, including under the Alliance for Prosperity in the Northern Triangle, could also attract further private investment and provide sustained job creation.

Executive Board Assessment

In concluding the 2014 Article IV consultation with El Salvador, Executive Directors endorsed staff’s appraisal as follows:

El Salvador’s growth has been modest and macroeconomic vulnerabilities are rising. The persistently low growth reflects both domestic policy weaknesses and a fragile external environment. Public debt dynamics are becoming unsustainable, the fiscal and current account deficits have grown, and gross financing needs are sizable.

The new government has an opportunity to build on the emerging broad social and political consensus to address the economic imbalances and social challenges. There is agreement on the need to strengthen the foundations for growth, address the country’s fiscal imbalances, and deepen efforts to support the poor. Progress has been achieved in recent years to raise tax revenues, lower inequality, and maintain financial stability, but significant challenges remain. The ongoing parliamentary discussion of the draft Fiscal Responsibility Law has brought fiscal issues to the forefront. However, the support for the necessary fiscal adjustment is lacking, and social and political pressures ahead of the 2015 congressional elections are delaying effective policymaking.

An ambitious fiscal adjustment that protects social spending should be a top priority. With medium-term gross financing needs projected to remain high, policies must focus on mitigating potential risks posed by a future increase in global risk aversion or higher global interest rates. A fiscal adjustment of around 3½ percent of GDP over the next three years will help maintain access to market financing on favorable terms and place debt on a sustainable path, while reducing the risks of a disorderly macroeconomic adjustment. The adjustment would likely have an adverse growth impact, but it could accelerate to 3 percent in the medium term with the benefit of supply-side reforms. The fiscal adjustment should occur alongside an increase in targeted social spending to protect the most vulnerable and lessen income inequality. A broader strategy will also be needed to attain a sustainable pension system and strengthen budget procedures.

A better business environment is imperative to enable private-sector led growth. Raising potential growth to 3 percent is an achievable goal but will require determined and ambitious supply-side reforms that substantially raise productivity and competitiveness and improve security. The envisaged steps aim to bolster public investment and promote economic transformation by diversifying the energy matrix, prioritizing key manufacturing and tradable service sectors, and upgrading infrastructure. Reforms to reduce red-tape and bureaucracy, increase financing for SMEs, improve access to energy and lower its costs, and better security should be quickly legislated to attract high-quality private investment. FOMILENIO II offers an opportunity to accelerate such reforms.

Improving the institutional framework for the banking sector is important. Financial indicators generally appear sound, a product of ongoing prudent supervision and regulation. Nonetheless, there is still scope to upgrade the legal framework for bank resolution and install an appropriately funded safety net for the banks.

Table.

El Salvador: Selected Economic Indicators

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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.

1

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

2

The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal can be considered without convening formal discussions.