Abstract
El Salvador continues to suffer from significantly lower growth than neighboring countries amid low investment, high outward migration, weak competitiveness, and political gridlock. Fiscal pressures remain substantial.
The Salvadoran authorities thank staff for the constructive and frank engagement on the occasion of the Article IV consultation. They consider the report objective and clear in depicting the main economic and social issues the country faces. In fact, they coincide with most of the assessment of the different sectors and policies with some nuances on the approach and timeliness of the report.
The authorities concur that insecurity and low investment are relevant factors to explain El Salvador’s low potential growth. They believe any fiscal consolidation plan should take into account at least three key particularities of the Salvadoran economy. First, dollarization has helped maintain inflation under control but has eliminated the scope to undertake monetary and exchange rate policies and has also reduced flexibility to face external shocks as well as natural disasters. Second, the scarcity of development funds constrains a smoother consolidation path. Finally, a series of negative cycles between low growth, fiscal imbalances -including pension system- and low development, poverty, inequality and social inclusion.
Recent Developments
The country is enjoying the windfall from low oil prices and the U.S. economic recovery which was reflected in the decrease of the current account deficit from 5.2 percent of GDP in 2014 to 3.6 percent in 2015. Electricity price has gone down markedly which is helping business competitiveness and families’ income. Inflation continues under control at 0.86 percent (Apr. 2016). Driven by investment (private and public) and consumption, growth is on track to end 2016 within a range of 2.3-2.6 percent. This projection is reinforced by the behavior of other variables: (1) Credit to private sector has grown at 5.3 percent, similar to 2015, with corporate credit growing at 6.9 percent (Apr. 2016), faster than consumption credit. (2) Public investment at USD230.5 million (Jan.-Apr. 2016) has grown at 33.9 percent compared with the same period last year. (3) Remittances are growing at 6.8 percent (Jan.-Apr. 2016) compared with the same period last year.
While political gridlock has been a constant barrier for needed reforms, the recent approval of USD152 million earmarked to strengthen domestic security proves that political agreement can be achieved and sends a positive signal for the oncoming reform agenda.
Fiscal Policy
The authorities concur on the need to pursue fiscal consolidation and agree that without measures debt could rise to unsustainable levels. They are planning a fiscal adjustment of 2.5 percent of GDP -close to staff’s recommendation- balanced between revenues and expenditures measures. A large adjustment might jeopardize country stability since cuts on key social expenditure and investment would be needed. The authorities find the adjustment period (2017-2019) proposed by staff tight, given El Salvador’s known low-growth problem and that fiscal uncertainty is not the main factor in explaining it –as rightly asserted in the report. Absent of financing to smooth the adjustment period, growth would be markedly hurt.
The authorities concur that, given the need to increase growth, efficiency on taxation is a relevant issue. They will continue looking for options to introduce less-distortionary progressive taxation. Unlike staff, the authorities consider that the yield of taxes on bank transactions and telecommunications is not negligible and their distortionary effects are not currently extreme. In the case of the telecommunication tax, it is levied on consumers who currently own 11 million mobiles. (Salvadorans own almost two mobiles each on average.) Proceeds from this tax are earmarked to increase law enforcement and security spending which is key to counter recent uptick in crime. The bank transactions tax is relevant to the treasury (USD80 million) while credit to business grew at 6.9 percent during the first four months of the year.
The government and staff share most of the measures on tax policy. They agree on the importance to introduce less-distortionary progressive taxation to wealth, property, and high inequitable pensions. They also concur on increasing personal income tax rates for the highest earners and reduce the corporate tax rate while broadening the base. In the case of increasing the VAT rate they would use it as a last-resort measure given its well-known regressive effects and above-mentioned recession risk.
With regard to the expenditure control measures, the authorities in principle agree with the idea laid out in the report to limit wage indexation to increases below the rate of inflation. However, they are examining options for the lower-income tiers since minimum wages are about USD250 per month and the low-income consumer basket grows at a higher rate than the CPI. They need to protect this segment of the population in order to avoid impact on poverty and exacerbate income inequality. The authorities have taken advantage of low oil prices to reduce subsidies in transport, electricity and LPG. They agree there is space to continue strengthening the energy subsidies targeting. The government is analyzing other ways to create fiscal space in order to strengthen security and social spending.
In addition, the authorities are negotiating a pension reform initiative in order to reduce the short-term financial gap. They recognize that further reforms would be needed to restore long-run sustainability of the system, including parametric changes, but further political support is still needed.
Financial Sector
Current levels of financial buffers are sufficient to contain mayor risk, as demonstrated by the different sets of stress tests run by the central bank and the financial superintendent. Despite growing credit to the public sector, credit to the private sector has been showing healthy rates of growth. The withdrawal of correspondent banking relations has been manageable; while some international banks have left, they have been replaced by large regional banks. Most of the risks are self-contained by the sector’s structure or alleviated by the authorities’ actions. International and large regional banks maintain a strong presence, in fact, currently about 90 percent of the remittances flows pass across these banks. Supervisory vigilance has been tightened and the authorities keep close collaboration with international and bilateral initiatives on tax compliance. The AML/CFT framework keeps improving and fulfilling international standards and the authorities are ready to act should any regulatory gap persist or new international standards are brought up.
The authorities continue working on the establishment of the lender-of-last-resort facility (LOLR) with the support of MCM Department’s technical assistance. There is agreement that the central bank should coordinate and manage the facility so final details are being worked out.
Finally, the report characterizes the current political scenario generally as one of gridlock and polarization, mentioning this as a constrain even to incremental reform. The authorities would have preferred a more cautious approach to the domestic political environment to better serve the dialogue to advance needed structural reforms. The government is working on building political consensus, they are negotiating a financial plan with the main opposition party in order to swap short-term domestic bonds (LETES) for Eurobonds and to attain Congress’ endorsement of external loans. Agreements were also reached on security funds, as described above.